DISCUSS WHAT AGENCY PROBLEM MEANS FOR FIRMS AND HOW MANAGERS ACT?

The textbook mentions the agency problem wherein managers do not act in the best interest of their principals. Discuss what the agency problem means for firms in Saudi Arabia, especially in the context of Saudi Vision 2030, and whether you have experienced any examples of the agency problem.

Search the library or the Internet for an academic or industry-related article regarding this thesis, as well as its implications for Saudi Arabia and Saudi Vision 2030.

For your discussion post, your first step is to summarize the article in two paragraphs, describing what you think are the most important points made by the authors (remember to use citations where appropriate). For the second step, include the reference listing with a hyperlink to the article. Do not copy the article into your post and limit your summary to two paragraphs.

Chapter 1

An Introduction
to the Foundations

of Financial
Management

Learning Objectives

• Identify the goal of the firm.
• Understand the basic principles of finance,

their importance, and the importance of
ethics and trust.

• Describe the role of finance in business.
• Distinguish between the different legal

forms of business organization.
• Explain what has led to the era of the

multinational corporation.

THE GOAL
OF THE FIRM

The Goal of the Firm

• The goal of the firm is to create value for
the firm’s owners (that is, its shareholders).
Thus the goal of the firm is to “maximize
shareholder wealth” by maximizing the price
of the existing common stock.

• Good financial decisions will increase stock
price and poor financial decisions will lead to
a decline in stock price.

FIVE PRINCIPLES
THAT FORM THE FOUNDATIONS

OF FINANCE

Principle 1:
Cash Flow Is What Matters

• Accounting profits are not equal to cash flows. It is
possible for a firm to generate accounting profits
but not have cash or to generate cash flows but not
report accounting profits in the books.

• Cash flow, and not profits, drive the value of a
business.

• We must determine incremental or marginal cash
flows when making financial decisions.
– Incremental cash flow is the difference between the

projected cash flows if the project is selected, versus what
they will be, if the project is not selected.

Principle 2:
Money Has a Time Value

• A dollar received today is worth more than a
dollar received in the future.
– Since we can earn interest on money received

today, it is better to receive money sooner rather
than later.

Principle 2:
Money Has a Time Value (cont.)

• Opportunity Cost – It is the cost of making
a choice in terms of next best alternative
that must be foregone.

– Example: By lending money to your friend at
zero percent interest, there is an opportunity
cost of 1% that could potentially be earned by
depositing the money in a savings account in a
bank.

Principle 3:
Risk Requires a Reward

• Investors will not take on additional risk
unless they expect to be compensated with
additional reward or return.

• Investors expect to be compensated for
“delaying consumption” and “taking on risk.”
– Thus, investors expect a return when they

deposit their savings in a bank (ex. delayed
consumption) and they expect to earn a
relatively higher rate of return on stocks
compared to a bank savings account (ex. taking
on risk).

Principle 4: Market Prices
Are Generally Right

• In an efficient market, the market prices of all
traded assets (such as stocks and bonds) fully
reflect all available information at any instant in
time.

• Thus stock prices are a useful indicator of the value
of the firm. Price changes reflect changes in
expected future cash flows. Good decisions will tend
to increase in stock price and vice versa.

• Note there are inefficiencies in the market that may
distort the market prices from value of assets. Such
inefficiencies are often caused by behavioral biases.

Principle 5: Conflicts of Interest
Cause Agency Problems

• The separation of

management

and the
ownership of the firm creates an agency
problem. Managers may make decisions
that are not consistent with the goal of
maximizing shareholder wealth.
– Agency conflict is reduced through monitoring

(ex. annual reports), compensation schemes
(ex. stock options), and market mechanisms
(ex. takeovers)

Discussion: The Global
Financial Crisis

• What factors contributed to the global
financial crisis?

• What do we mean by subprime loans?
• How are mortgages securitized?
• How have unemployment rates fared?
• How can the financial crisis be explained

using the five principles of finance?

Ethics & Trust in Business

• Ethical behavior is doing the right thing! …
but what is the right thing?

• Ethical dilemma — Each person has his or
her own set of values, which forms the basis
for personal judgments about what is the
right thing.

• Sound ethical standards are important for
business and personal success. Unethical
decisions can destroy shareholder wealth
(ex. Enron scandal).

THE ROLE
OF FINANCE
IN BUSINESS

The Role of Finance
in Business

Three basic issues addressed by the study of
finance:
• What long-term investments should the firm

undertake? (Capital budgeting decision)
• How should the firm raise money to fund these

investments? (Capital structure decision)
• How to manage cash flows arising from day-to-

day operations? (Working capital decision)

The Role of Finance in Business
(cont.)

• Knowledge of financial tools is relevant for
decision making in all areas of business
(be it marketing, production etc.) and also
in managing personal finances.

• Decisions involve an element of time and
uncertainty … financial tools help adjust for
time and risk.

• Decisions taken in business should be
financially viable … financial tools help
determine the financial viability of decisions.

THE LEGAL FORMS
OF BUSINESS ORGANIZATION

The Legal Forms of
Business Organization

Business Forms

Sole
Proprietorship

Partnership Corporation Hybrid

S-Type LLC

Sole Proprietorship

• Business owned by an individual
• Owner maintains title to assets and profits
• Unlimited liability
• Termination occurs on owner’s death or by

the owner’s choice

Partnership

• Two or more persons come together as co-owners
• General Partnership: All partners are fully

responsible for liabilities incurred by the
partnership.

• Limited Partnerships: One or more partners can
have limited liability, restricted to the amount of
capital invested in the partnership. There must be
at least one general partner with unlimited liability.
Limited partners cannot participate in the
management of the business and their names
cannot appear in the name of the firm.

Corporation

• Legally functions separate and apart from its owners
– Corporation can sue, be sued, purchase, sell, and own

property
• Owners (shareholders) dictate direction and policies

of the corporation, oftentimes through elected board
of directors.

• Shareholder’s liability is restricted to amount of
investment in company.

• Life of corporation does not depend on the owners …
corporation continues to be run by managers after
transfer of ownership through sale or inheritance.

The Trade-offs:
Corporate Form

• Benefits: Limited liability, easy to transfer
ownership, easier to raise capital, unlimited
life (unless the firm goes through corporate
restructuring such as mergers and
bankruptcies).

• Drawbacks: No secrecy of information,
maybe delays in decision making, greater
regulation, double taxation.

Double Taxation Example

• Assume earnings before tax = $1,000
Federal Tax @ 25% = $250
After tax income available for distribution to
shareholders = $750

• Compute the taxes if the company chooses
to distribute the entire after-tax profits to
shareholders as dividends.

Double Taxation Example

• If corporation distributes profits as
dividends to shareholders, shareholders will
be taxed again.

• Assuming dividends are taxed @ 15%
Dividend tax = 15% of $750 = $112.50

==>Total tax = 250 + 112.5 = $362.5 or
36.25%

Hybrid Organizations:
S-Corporation and Limited Liability
Companies (LLCs)

• S-Type Corporations
– Benefits

• Limited liability
• Taxed as partnership (no double taxation like

corporations)
– Limitations

• Owners must be people so cannot be used for a joint
ventures between two corporations

• Limited Liability Companies (LLC)
– Benefits

• Limited liability
• Taxed like a partnership

– Limitations
• Qualifications vary from state to state
• Cannot appear like a corporation otherwise it will be

taxed like one

Hybrid Organizations:
S-Corporation and Limited Liability
Companies (LLCs) (cont.)

FINANCE AND THE
MULTINATIONAL FIRM:

THE NEW ROLE

Finance and The Multinational
Firm: The New Role

• Coca-Cola, among other companies, receive
significant profits from overseas sales.

• U.S. firms are looking to international expansion to
discover profits.

• In addition to U.S. firms going abroad, we have
also witnessed many foreign firms making their
mark in the United States. For example, domination
of auto industry by Toyota, Honda, Nissan, and
BMW.

Review: Key Terms

• Agency problem
• Capital budgeting
• Capital structure

decisions

• Corporation
• Efficient market
• Financial markets
• General partnership

• Incremental cash flow
• Limited partnership
• Limited Liability

Company (LLC)

• Partnership
• Opportunity cost
• Sole proprietorship
• S-corporation
• Working capital

management

Foundations of Finance
The Logic and Practice of Financial Management
Eighth Edition

Bekaert/Hodrick
International Financial Management
Berk/DeMarzo
Corporate Finance*
Berk/DeMarzo
Corporate Finance: The Core*
Berk/DeMarzo/Harford
Fundamentals of Corporate Finance*
Brooks
Financial Management: Core Concepts*
Copeland/Weston/Shastri
Financial Theory and Corporate Policy
Dorfman/Cather
Introduction to Risk Management and Insurance
Eiteman/Stonehill/Moffett
Multinational Business Finance
Fabozzi
Bond Markets: Analysis and Strategies
Fabozzi/Modigliani
Capital Markets: Institutions and Instruments
Fabozzi/Modigliani/Jones
Foundations of Financial Markets and Institutions
Finkler
Financial Management for Public, Health, and
Not-for-Profit Organizations
Frasca
Personal Finance
Gitman/Zutter
Principles of Managerial Finance*
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Principles of Managerial Finance—Brief Edition*
Haugen
The Inefficient Stock Market: What Pays Off and
Why
Haugen
The New Finance: Overreaction, Complexity, and
Uniqueness
Holden
Excel Modeling in Corporate Finance
Holden
Excel Modeling in Investments
Hughes/MacDonald
International Banking: Text and Cases
Hull
Fundamentals of Futures and Options Markets
Hull
Options, Futures, and Other Derivatives
Keown
Personal Finance: Turning Money into Wealth*
Keown/Martin/Petty
Foundations of Finance: The Logic and Practice of
Financial Management*
Kim/Nofsinger
Corporate Governance
Madura
Personal Finance*
Marthinsen
Risk Takers: Uses and Abuses of Financial Derivatives
McDonald
Derivatives Markets
McDonald
Fundamentals of Derivatives Markets
Mishkin/Eakins
Financial Markets and Institutions
Moffett/Stonehill/Eiteman
Fundamentals of Multinational Finance
Nofsinger
Psychology of Investing
Ormiston/Fraser
Understanding Financial Statements
Pennacchi
Theory of Asset Pricing
Rejda
Principles of Risk Management and Insurance
Seiler
Performing Financial Studies: A Methodological
Cookbook
Smart/Gitman/Joehnk
Fundamentals of Investing*
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Global Investments
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Cases in Financial Management
Titman/Keown/Martin
Financial Management: Principles and
Applications*
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Valuation: The Art and Science of Corporate
Investment Decisions
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Takeovers, Restructuring, and Corporate
Governance
The Pearson Series in Finance
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Foundations of Finance
The Logic and Practice of Financial Management
Eighth Edition
Arthur J. Keown
Virginia Polytechnic Institute and State University
R. B. Pamplin Professor of Finance
John D. Martin
Baylor University
Professor of Finance
Carr P. Collins Chair in Finance
J. William Petty
Baylor University
Professor of Finance
W. W. Caruth Chair in Entrepreneurship
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Library of Congress Cataloging-in-Publication Data
Keown, Arthur J.
Foundations of finance : the logic and practice of financial management / Arthur J. Keown, John D. Martin, J. William Petty. — 8th ed.
p. cm. — (The Pearson series in finance)
Includes index.
ISBN 978-0-13-299487-3
1. Corporations—Finance. I. Martin, John D., II. Petty, J. William, III. Title.
HG4026.F67 2014
658.15–dc23
2012041146
Copyright © 2014, 2011, 2008, Pearson Education, Inc.
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To my parents, from whom I learned the most.
Arthur J. Keown
To the Martin women—wife Sally and daughter-in-law Mel,
the Martin men—sons Dave and Jess, and
Martin boys—grandsons Luke and Burke.
John D. Martin
To my wife, Donna, who has been my friend,
encourager, and supporter for more years than
we care to admit. How quickly time has passed
since we first met all the way back in high school.
J. William Petty

vi Part 1 • Financial Planning
Arthur J. Keown is the Department Head and R. B. Pamplin Professor of Finance at
Virginia Polytechnic Institute and State University. He received his bachelor’s degree from
Ohio Wesleyan University, his M.B.A. from the University of Michigan, and his doctor-
ate from Indiana University. An award-winning teacher, he is a member of the Academy
of Teaching Excellence; has received five Certificates of Teaching Excellence at Virginia
Tech, the W. E. Wine Award for Teaching Excellence, and the Alumni Teaching Excel-
lence Award; and in 1999 received the Outstanding Faculty Award from the State of Vir-
ginia. Professor Keown is widely published in academic journals. His work has appeared
in the Journal of Finance, the Journal of Financial Economics, the Journal of Financial and
Quantitative Analysis, the Journal of Financial Research, the Journal of Banking and Finance,
Financial Management, the Journal of Portfolio Management, and many others. In addition
to Foundations of Finance, two other of his books are widely used in college finance classes
all over the country—Basic Financial Management and Personal Finance: Turning Money into
Wealth. Professor Keown is a Fellow of the Decision Sciences Institute, was a member of
the Board of Directors of the Financial Management Association, and is the head of the
finance department at Virginia Tech. In addition, he recently served as the co-editor of the
Journal of Financial Research for 6½ years and as the co-editor of the Financial Management
Association’s Survey and Synthesis series for 6 years. He lives with his wife and two children
in Blacksburg, Virginia, where he collects original art from Mad Magazine.
John D. Martin holds the Carr P. Collins Chair in Finance in the Hankamer School
of Business at Baylor University, where he teaches in the Baylor EMBA programs and has
three times been selected as the outstanding teacher. John joined the Baylor faculty in 1998
after spending 17 years on the faculty of the University of Texas at Austin. Over his career
he has published over 50 articles in the leading finance journals, including papers in the
Journal of Finance, Journal of Financial Economics, Journal of Financial and Quantitative Analy-
sis, Journal of Monetary Economics, and Management Science. His recent research has spanned
issues related to the economics of unconventional energy sources (both wind and shale gas),
the hidden cost of venture capital, and managed versus unmanaged changes in capital struc-
tures. He is also co-author of several books, including Financial Management: Principles and
Practice (11th ed., Prentice Hall), Foundations of Finance (8th ed., Prentice Hall), Theory of
Finance (Dryden Press), Financial Analysis (3rd ed., McGraw Hill), Valuation: The Art & Sci-
ence of Corporate Investment Decisions (2nd ed., Prentice Hall), and Value Based Management
with Social Responsibility (2nd ed., Oxford University Press).
J. William Petty, PhD, University of Texas at Austin, is Professor of Finance and
W. W. Caruth Chair of Entrepreneurship. Dr. Petty teaches entrepreneurial finance, both
at the undergraduate and graduate levels. He is a University Master Teacher. In 2008, the
Acton Foundation for Entrepreneurship Excellence selected him as the National Entrepre-
neurship Teacher of the Year. His research interests include the financing of entrepreneur-
ial firms and shareholder value-based management. He has served as the co-editor for the
Journal of Financial Research and the editor of the Journal of Entrepreneurial Finance. He has
published articles in various academic and professional journals including Journal of Finan-
cial and Quantitative Analysis, Financial Management, Journal of Portfolio Management, Jour-
nal of Applied Corporate Finance, and Accounting Review. Dr. Petty is co-author of a leading
textbook in small business and entrepreneurship, Small Business Management: Launching and
Growing Entrepreneurial Ventures. He also co-authored Value-Based Management: Corporate
America’s Response to the Shareholder Revolution (2010). He serves on the Board of Directors
of a publicly traded oil and gas firm. Finally, he has served as the Executive Director of the
Baylor Angel Network, a network of private investors who provide capital to startups and
early-stage companies.
About the Authors
vi

Chapter 4 • Tax Planning and Strategies vii
vii
Brief Contents
Part 1 The Scope and Environment of
Financial Management 2
1 An Introduction to the Foundations of Financial Management 2
2 The Financial Markets and Interest Rates 20
3 Understanding Financial Statements and Cash Flows 50
4 Evaluating a Firm’s Financial Performance 102
Part 2 The Valuation of Financial Assets 142
5 The Time Value of Money 142
6 The Meaning and Measurement of Risk and Return 182
7 The Valuation and Characteristics of Bonds 220
8 The Valuation and Characteristics of Stock 250
9 The Cost of Capital 274
Part 3 Investment in Long-Term Assets 304
10 Capital-Budgeting Techniques and Practice 304
11 Cash Flows and Other Topics in Capital Budgeting 344
Part 4 Capital Structure and Dividend Policy 380
12 Determining the Financing Mix 380
13 Dividend Policy and Internal Financing 416
Part 5 Working-Capital Management and International
Business Finance 436
14 Short-Term Financial Planning 436
15 Working-Capital Management 456
16 International Business Finance 484
Web 17 Cash, Receivables, and Inventory Management
Available online at www.myfinancelab.com
Web Appendix A Using a Calculator
Available online at www.myfinancelab.com
Glossary 505
Indexes 513

www.myfinancelab.com

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ix
Contents
Preface xix
Part 1 The Scope and Environment of Financial
Management 2
1 An Introduction to the Foundations of Financial
Management 2
The Goal of the Firm 3
Five Principles That Form the Foundations of Finance 4
Principle 1: Cash Flow Is What Matters 4
Principle 2: Money Has a Time Value 5
Principle 3: Risk Requires a Reward 5
Principle 4: Market Prices Are Generally Right 6
Principle 5: Conflicts of Interest Cause Agency Problems 7
The Current Global Financial Crisis 8
Avoiding Financial Crisis—Back to the Principles 9
The Essential Elements of Ethics and Trust 10
The Role of Finance in Business 11
Why Study Finance? 11
The Role of the Financial Manager 12
The Legal Forms of Business Organization 13
Sole Proprietorships 13
Partnerships 13
Corporations 14
Organizational Form and Taxes: The Double Taxation on Dividends 14
S-Corporations and Limited Liability Companies (LLC) 14
Which Organizational Form Should Be Chosen? 15
Finance and the Multinational Firm: The New Role 15
Chapter Summaries 16 • Review Questions 18 • Mini Case 18
2 The Financial Markets and Interest Rates 20
Financing of Business: The Movement of Funds Through the Economy 21
Public Offerings Versus Private Placements 23
Primary Markets Versus Secondary Markets 23
The Money Market Versus the Capital Market 24
Spot Markets Versus Futures Markets 24
Stock Exchanges: Organized Security Exchanges Versus Over-the-Counter Markets,
a Blurring Difference 25
Selling Securities to the Public 26
Functions 27
The Demise of the Stand-Alone Investment-Banking Industry 27
Distribution Methods 28
Private Debt Placements 30
Flotation Costs 31
Cautionary Tale: Forgetting Principle 5: Conflicts of Interest Cause Agency
Problems 31
Regulation Aimed at Making the Goal of the Firm Work: The Sarbanes-Oxley Act 32
Rates of Return in the Financial Markets 32
Rates of Return over Long Periods 32
Interest Rate Levels in Recent Periods 33

x Contents
Interest Rate Determinants in a Nutshell 36
Estimating Specific Interest Rates Using Risk Premiums 36
Real Risk-Free Interest Rate and the Risk-Free Interest Rate 37
Real and Nominal Rates of Interest 37
Can You Do It? 37
Did You Get It? 38
Inflation and Real Rates of Return: The Financial Analyst’s Approach 39
Can You Do It? Solving for the Real Rate of Interest 39
Did You Get It? Solving for the Real Rate of Interest 40
The Term Structure of Interest Rates 41
Observing the Historical Term Structures of Interest Rates 41
Can You Do It? Solving for the Nominal Rate of Interest 41
Did You Get It? Solving for the Nominal Rate of Interest 42
What Explains the Shape of the Term Structure? 43
Chapter Summaries 44 • Review Questions 47 • Study Problems 47 • Mini Case 49
3 Understanding Financial Statements and
Cash Flows 50
The Income Statement 52
Income Statement Illustrated: The Home Depot, Inc. 53
Home Depot’s Common-Sized Income Statement 54
The Balance Sheet 56
Types of Assets 57
Types of Financing 59
Balance Sheet Illustrated: The Home Depot, Inc. 60
Working Capital 62
The Balance Sheet and Income Statement—as One Picture 64
Can You Do It? Preparing an Income Statement and a
Balance Sheet 65
Measuring Cash Flows 65
Profits Versus Cash Flows 65
Did You Get It? Preparing an Income Statement and a
Balance Sheet 66
A Beginning Look: Determining Sources and Uses of Cash 67
Statement of Cash Flows 67
Finance at Work: Managing Your Cash Flows 68
Concluding Suggestions for Computing Cash Flows 74
Conclusions About Home Depot’s Financial Position 74
Finance at Work: What Did Home Depot’s Management Have to Say? 75
Can You Do It? Measuring Cash Flows 75
GAAP and IFRS 76
Did You Get It? Measuring Cash Flows 76
Income Taxes and Finance 76
Computing Taxable Income 77
Computing the Taxes Owed 77
Can You Do It? Computing a Corporation’s Income Taxes 79
Accounting Malpractice and Limitations of
Financial Statements 80
Did You Get It? Computing a Corporation’s Income Taxes 80
Chapter Summaries 81 • Review Questions 84 • Study Problems 85 • Mini Case 92

Contents xi
Appendix 3A: Free Cash Flows 95
What Is a Free Cash Flow? 95
Computing Free Cash Flow 95
The Other Side of the Coin: Financing Cash Flows 98
Financing Cash Flows 98
A Concluding Thought 99
Appendix Summary 99 • Study Problems 99
4 Evaluating a Firm’s Financial Performance 102
The Purpose of Financial Analysis 102
Finance at Work: Home Depot and Lowe’s: The Histories 105
Measuring Key Financial Relationships 106
Question 1: How Liquid Is the Firm? Can It Pay Its Bills? 107
Question 2: Are the Firm’s Managers Generating Adequate Operating Profits from the
Company’s Assets? 112
Question 3: How Is the Firm Financing Its Assets? 117
Question 4: Are the Firm’s Managers Providing a Good Return on the Capital Provided by
the Shareholders? 119
Question 5: Are the Firm’s Managers Creating Shareholder Value? 122
The Limitations of Financial Ratio Analysis 128
Chapter Summaries 129 • Review Questions 132 • Study Problems 132 • Mini Case 139
Part 2 The Valuation of Financial Assets 142
5 The Time Value of Money 142
Compound Interest, Future, and Present Value 143
Using Timelines to Visualize Cash Flows 143
Techniques for Moving Money Through Time 147
Two Additional Types of Time Value of Money Problems 151
Applying Compounding to Things Other Than Money 152
Present Value 153
Cautionary Tale: Forgetting Principle 4: Market Prices Are Generally Right 155
Can You Do It? Solving for the Present Value with Two Flows in
Different Years 156
Annuities 157
Compound Annuities 157
Did You Get It? Solving for the Present Value with Two Flows in
Different Years 158
The Present Value of an Annuity 159
Annuities Due 161
Amortized Loans 162
Making Interest Rates Comparable 165
Finding Present and Future Values with Nonannual Periods 166
Can You Do It? How Much Can You Afford to Spend on a House? An Amortized
Loan with Monthly Payments 166
Did You Get It? How Much Can You Afford to Spend on a House? An Amortized
Loan with Monthly Payments 168
The Present Value of an Uneven Stream and Perpetuities 169
Perpetuities 170
Chapter Summaries 171 • Review Questions 174 • Study Problems 174 • Mini Case 180

xii Contents
6 The Meaning and Measurement of Risk
and Return 182
Expected Return Defined and Measured 184
Can You Do It? Computing Expected Cash Flow and Expected Return 185
Risk Defined and Measured 186
Did You Get It? Computing Expected Cash Flow and Expected Return 187
Can You Do It? Computing the Standard Deviation 190
Finance at Work: A Different Perspective of Risk 190
Did You Get It? Computing the Standard Deviation 193
Rates of Return: The Investor’s Experience 193
Risk and Diversification 194
Diversifying Away the Risk 195
Measuring Market Risk 196
Can You Do It? Estimating Beta 199
Measuring a Portfolio’s Beta 202
Risk and Diversification Demonstrated 203
Did You Get It? Estimating Beta 204
The Investor’s Required Rate of Return 206
The Required Rate of Return Concept 206
Measuring the Required Rate of Return 206
Finance at Work: Does Beta Always Work? 207
Can You Do It? Computing a Required Rate of Return 209
Did You Get It? Computing a Required Rate of Return 209
Chapter Summaries 209 • Review Questions 212 • Study Problems 213 • Mini Case 217
7 The Valuation and Characteristics of Bonds 220
Types of Bonds 221
Debentures 221
Subordinated Debentures 222
Mortgage Bonds 222
Eurobonds 222
Convertible Bonds 222
Terminology and Characteristics of Bonds 223
Claims on Assets and Income 223
Par Value 223
Coupon Interest Rate 223
Maturity 224
Call Provision 224
Indenture 224
Bond Ratings 224
Finance at Work: J.C. Penney Credit Rating Reduced to Junk 225
Defining Value 226
What Determines Value? 227
Valuation: The Basic Process 228
Can You Do It? Computing an Asset’s Value 229
Valuing Bonds 229
Did You Get It? Computing an Asset’s Value 231
Can You Do It? Computing a Bond’s Value 233

Contents xiii
Did You Get It? Computing a Bond’s Value 235
Bond Yields 235
Yield to Maturity 235
Current Yield 237
Bond Valuation: Three Important Relationships 238
Can You Do It? Computing the Yield to Maturity and Current Yield 239
Did You Get It? Computing the Yield to Maturity and Current Yield 240
Chapter Summaries 242 • Review Questions 246 • Study Problems 246 • Mini Case 248
8 The Valuation and Characteristics of Stock 250
Preferred Stock 251
The Characteristics of Preferred Stock 251
Valuing Preferred Stock 253
Finance at Work: Reading a Stock Quote in the wall
street journal 254
Can You Do It? Valuing Preferred Stock 256
Common Stock 256
The Characteristics of Common Stock 257
Did You Get It? Valuing Preferred Stock 257
Valuing Common Stock 258
Can You Do It? Measuring Johnson & Johnson’s Growth Rate 261
Did You Get It? Measuring Johnson & Johnson’s Growth Rate 262
Can You Do It? Calculating Common Stock Value 263
The Expected Rate of Return of Stockholders 263
Did You Get It? Calculating Common Stock Value 264
The Expected Rate of Return of Preferred Stockholders 264
The Expected Rate of Return of Common Stockholders 265
Can You Do It? Computing the Expected Rate of Return 266
Did You Get It? Computing the Expected Rate of Return 267
Chapter Summaries 268 • Review Questions 271 • Study Problems 271 • Mini Case 273
9 The Cost of Capital 274
The Cost of Capital: Key Definitions and Concepts 275
Opportunity Costs, Required Rates of Return, and the Cost of Capital 275
Can You Do It? Determining How Flotation Costs Affect the Cost of Capital 276
The Firm’s Financial Policy and the Cost of Capital 276
Determining the Costs of the Individual Sources of Capital 276
The Cost of Debt 277
Did You Get It? Determining How Flotation Costs Affect the
Cost of Capital 277
Can You Do It? Calculating the Cost of Debt Financing 278
The Cost of Preferred Stock 279
Can You Do It? Calculating the Cost of Preferred Stock Financing 279
Did You Get It? Calculating the Cost of Debt Financing 280
The Cost of Common Equity 281
The Dividend Growth Model 281

xiv Contents
Did You Get It? Calculating the Cost of Preferred Stock Financing 281
Issues in Implementing the Dividend Growth Model 282
The Capital Asset Pricing Model 283
Can You Do It? Calculating the Cost of New Common Stock Using the Dividend
Growth Model 284
Can You Do It? Calculating the Cost of Common Stock Using the CAPM 284
Issues in Implementing the CAPM 284
Finance at Work: IPOs: Should a Firm Go Public? 285
Did You Get It? Calculating the Cost of New Common Stock Using the Dividend
Growth Model 285
Did You Get It? Calculating the Cost of Common Stock Using the CAPM 286
The Weighted Average Cost of Capital 286
Capital Structure Weights 287
Calculating the Weighted Average Cost of Capital 287
Cautionary Tale: Forgetting Principle 3: Risk Requires a Reward 289
Calculating Divisional Costs of Capital 290
Estimating Divisional Costs of Capital 290
Using Pure Play Firms to Estimate Divisional WACCs 290
Finance at Work: The Pillsbury Company Adopts Eva with a Grassroots Education
Program 293
Can You Do It? Calculating the Weighted Average Cost of Capital 293
Did You Get It? Calculating the Weighted Average Cost of Capital 293
Using a Firm’s Cost of Capital to Evaluate New Capital Investments 294
Chapter Summaries 295 • Review Questions 297 • Study Problems 298 • Mini Cases 302
Part 3 Investment in Long-Term Assets 304
10 Capital-Budgeting Techniques and Practice 304
Finding Profitable Projects 305
Cautionary Tale: Forgetting Principle 3: Risk Requires a Reward and Principle 4:
Market Prices Are Generally Right 306
Capital-Budgeting Decision Criteria 307
The Payback Period 307
The Net Present Value 310
Using Spreadsheets to Calculate the Net Present Value 312
Can You Do It? Determining the Npv of a Project 313
The Profitability Index (Benefit–Cost Ratio) 313
Did You Get It? Determining the Npv of a Project 314
The Internal Rate of Return 316
Can You Do It? Determining the IRR of a Project 318
Viewing the Npv–IRR Relationship: The Net Present Value Profile 319
Did You Get It? Determining the IRR of a Project 319
Complications with the IRR: Multiple Rates of Return 320
The Modified Internal Rate of Return (MIRR)2 321
Using Spreadsheets to Calculate the MIRR 324
Capital Rationing 325
The Rationale for Capital Rationing 325
Capital Rationing and Project Selection 326
Ranking Mutually Exclusive Projects 326
The Size-Disparity Problem 327
The Time-Disparity Problem 328
The Unequal-Lives Problem 329

Contents xv
Ethics in Financial Management: The Financial Downside of Poor Ethical
Behavior 332
Chapter Summaries 332 • Review Questions 335 • Study Problems 336 • Mini Case 342
11 Cash Flows and Other Topics in Capital Budgeting 344
Guidelines for Capital Budgeting 345
Use Free Cash Flows Rather Than Accounting Profits 345
Think Incrementally 345
Beware of Cash Flows Diverted from Existing Products 345
Look for Incidental or Synergistic Effects 346
Work in Working-Capital Requirements 346
Consider Incremental Expenses 346
Remember That Sunk Costs Are Not Incremental Cash Flows 347
Account for Opportunity Costs 347
Decide If Overhead Costs Are Truly Incremental Cash Flows 347
Ignore Interest Payments and Financing Flows 347
Finance at Work: Universal Studios 348
Calculating a Project’s Free Cash Flows 348
What Goes into the Initial Outlay 348
What Goes into the Annual Free Cash Flows Over the Project’s Life 349
What Goes into the Terminal Cash Flow 350
Calculating the Free Cash Flows 350
A Comprehensive Example: Calculating Free Cash Flows 354
Can You Do It? Calculating Operating Cash Flows 355
Did You Get It? Calculating Operating Cash Flows 357
Can You Do It? Calculating Free Cash Flows 357
Options in Capital Budgeting 358
The Option to Delay a Project 358
Did You Get It? Calculating Free Cash Flows 358
The Option to Expand a Project 359
The Option to Abandon a Project 359
Options in Capital Budgeting: The Bottom Line 360
Risk and the Investment Decisions 360
What Measure of Risk Is Relevant in Capital Budgeting? 361
Measuring Risk for Capital-Budgeting Purposes with a Dose of Reality—Is Systematic
Risk All There Is? 362
Incorporating Risk into Capital Budgeting 362
Risk-Adjusted Discount Rates 363
Measuring a Project’s Systematic Risk 365
Using Accounting Data to Estimate a Project’s Beta 365
The Pure Play Method for Estimating Beta 366
Examining a Project’s Risk Through Simulation 366
Conducting a Sensitivity Analysis Through Simulation 368
Chapter Summaries 369 • Review Questions 371 • Study Problems 371 • Mini Case 376
Appendix 11A: The Modified Accelerated Cost of
Recovery System 378
What Does All This Mean? 379
Study Problems 379
Part 4 Capital Structure and Dividend Policy 380
12 Determining the Financing Mix 380
Understanding the Difference Between Business and Financial Risk 382
Business Risk 382
Operating Risk 383

xvi Contents
Break-Even Analysis 383
Essential Elements of the Break-Even Model 383
Finding the Break-Even Point 385
The Break-Even Point in Sales Dollars 386
Can You Do It? Analyzing the Break-Even Sales Level 387
Did You Get It? Analyzing the Break-Even Sales Level 388
Sources of Operating Leverage 388
Can You Do It? Analyzing the Effects of Operating Leverage 388
Did You Get It? Analyzing the Effects of Operating Leverage 389
Can You Do It? Analyzing the Effects of Financial Leverage 389
Did You Get It? Analyzing the Effects of Financial Leverage 390
Financial Leverage 390
Combining Operating and Financial Leverage 391
Can You Do It? Analyzing the Combined Effects of Operating and Financial
Leverage 392
Did You Get It? Analyzing the Combined Effects of Operating and Financial
Leverage 392
Finance at Work: When Financial Leverage Proves to Be Too Much to
Handle 393
Capital Structure Theory 393
Cautionary Tale: Forgetting Principle 3: Risk Requires
a Reward 395
A Quick Look at Capital Structure Theory 395
The Importance of Capital Structure 396
Independence Position 396
The Moderate Position 397
Firm Value and Agency Costs 400
Agency Costs, Free Cash Flow, and Capital Structure 401
Managerial Implications 402
The Basic Tools of Capital Structure Management 402
EBIT-EPS Analysis 402
Comparative Leverage Ratios 405
Industry Norms 406
A Glance at Actual Capital Structure Management 406
Finance at Work: Capital Structures Around the World 407
Chapter Summaries 408 • Review Questions 411 • Study Problems 412 • Mini Cases 414
13 Dividend Policy and Internal Financing 416
Key Terms 417
Does Dividend Policy Matter to Stockholders? 418
Three Basic Views 418
Making Sense of Dividend Policy Theory 420
What Are We to Conclude? 423
The Dividend Decision in Practice 424
Legal Restrictions 424
Liquidity Constraints 424
Earnings Predictability 424
Maintaining Ownership Control 424
Alternative Dividend Policies 424
Dividend Payment Procedures 425
Stock Dividends and Stock Splits 426
Stock Repurchases 427
A Share Repurchase as a Dividend Decision 427
The Investor’s Choice 428

Contents xvii
Finance at Work: Companies Increasingly Use Share Repurchases to Distribute
Cash to Their Stockholders 429
A Financing or Investment Decision? 429
Practical Considerations—The Stock Repurchase Procedure 429
Chapter Summaries 430 • Review Questions 432 • Study Problems 432 • Mini Case 435
Part 5 Working-Capital Management and International
Business Finance 436
14 Short-Term Financial Planning 436
Financial Forecasting 437
The Sales Forecast 437
Forecasting Financial Variables 437
The Percent of Sales Method of Financial Forecasting 438
Analyzing the Effects of Profitability and Dividend Policy on DFN 439
Analyzing the Effects of Sales Growth on a Firm’s DFN 440
Can You Do It? Percent of Sales Forecasting 441
Did You Get It? Percent of Sales Forecasting 442
Limitations of the Percent of Sales Forecasting Method 443
Constructing and Using a Cash Budget 444
Budget Functions 444
Ethics in Financial Management: To Bribe or Not to Bribe 445
The Cash Budget 445
Ethics in Financial Management: Being Honest About the Uncertainty of the
Future 446
Chapter Summaries 447 • Review Questions 448 • Study Problems 449 • Mini Case 454
15 Working-Capital Management 456
Managing Current Assets and Liabilities 457
The Risk–Return Trade-Off 457
The Advantages of Current Liabilities: Return 458
The Disadvantages of Current Liabilities: Risk 458
Determining the Appropriate Level of Working Capital 459
The Hedging Principles 459
Permanent and Temporary Assets 459
Temporary, Permanent, and Spontaneous Sources of Financing 460
The Hedging Principle: A Graphic Illustration 460
Cautionary Tale: Forgetting Principle 3: Risk Requires a Reward 460
The Cash Conversion Cycle 462
Can You Do It? Computing the Cash Conversion Cycle 462
Did You Get It? Computing the Cash Conversion Cycle 463
Estimating the Cost of Short-Term Credit Using the Approximate
Cost-of-Credit Formula 464
Can You Do It? The Approximate Cost of Short-Term Credit 466
Sources of Short-Term Credit 466
Did You Get It? The Approximate Cost of Short-Term Credit 466
Finance at Work: Managing Working Capital by Trimming
Receivables 467
Unsecured Sources: Accrued Wages and Taxes 467

xviii Contents
Can You Do It? The Cost of Short-Term Credit (Considering
Compounding Effects) 468
Unsecured Sources: Trade Credit 468
Did You Get It? The Cost of Short-Term Credit (Considering Compounding
Effects) 469
Unsecured Sources: Bank Credit 469
Unsecured Sources: Commercial Paper 471
Secured Sources: Accounts-Receivable Loans 473
Secured Sources: Inventory Loans 475
Chapter Summaries 476 • Review Questions 479 • Study Problems 479
16 International Business Finance 484
The Globalization of Product and Financial Markets 485
Foreign Exchange Markets and Currency Exchange Rates 486
Foreign Exchange Rates 487
Exchange Rates and Arbitrage 489
Asked and Bid Rates 489
Cross Rates 489
Can You Do It? Using the Spot Rate to Calculate a
Foreign Currency Payment 489
Types of Foreign Exchange Transactions 490
Did You Get It? Using the Spot Rate to Calculate a Foreign Currency
Payment 491
Exchange Rate Risk 492
Can You Do It? Computing a Percent-per-Annum Premium 492
Did You Get It? Computing a Percent-per-Annum Premium 493
Interest Rate Parity 494
Purchasing-Power Parity and the Law
of One Price 495
The International Fisher Effect 496
Capital Budgeting for Direct Foreign Investment 497
Foreign Investment Risks 497
Chapter Summaries 498 • Review Questions 500 • Study Problems 501 • Mini Case 502
web 17 Cash, Receivables, and Inventory Management
Available online at www.myfinancelab.com
web Appendix A Using a Calculator
Available online at www.myfinancelab.com
Glossary 505
Indexes 513

www.myfinancelab.com

xix
Preface
The study of finance focuses on making decisions that enhance the value of the firm. This is
done by providing customers with the best products and services in a cost-effective way. In
a sense we, the authors of Foundations of Finance, are trying to do the same thing. That is, we
have tried to present financial management to students in a way that makes their studies as
easy and productive as possible by using a step-by-step approach to walking them through
each new concept or problem.
We are very proud of the history of this volume, as it was the first “shortened book”
of financial management when it was published in its first edition. The book broke new
ground by reducing the number of chapters down to the foundational materials and by try-
ing to present the subject in understandable terms. We continue our quest for readability
with the Eighth Edition.
Pedagogy That Works
This book provides students with a conceptual understanding of the financial decision-
making process, rather than just an introduction to the tools and techniques of finance. For
the student, it is all too easy to lose sight of the logic that drives finance and to focus in-
stead on memorizing formulas and proce-
dures. As a result, students have a difficult
time understanding the interrelationships
among the topics covered. Moreover, later
in life when the problems encountered do
not match the textbook presentation, stu-
dents may find themselves unprepared to
abstract from what they learned. To over-
come this problem, the opening chapter
presents five underlying principles of fi-
nance, which serve as a springboard for the
chapters and topics that follow. In essence,
the student is presented with a cohesive,
interrelated perspective from which future
problems can be approached.
With a focus on the big picture, we
provide an introduction to financial deci-
sion making rooted in current financial theory and in the current state of world economic
conditions. This focus is perhaps most apparent in the attention given to the capital mar-
kets and their influence on corporate financial decisions. What results is an introductory
treatment of a discipline rather than the treatment of a series of isolated problems that face
the financial manager. The goal of this text is not merely to teach the tools of a discipline
or trade but also to enable students to abstract what is learned to new and yet unforeseen
problems—in short, to educate the student in finance.
Innovations and Distinctive Features in the
Eighth Edition
NEW! A Multistep Approach to Problem Solving and Analysis
As anyone who has taught the core undergraduate finance course knows, there is a wide
range of math comprehension and skill. Students who do not have the math skills needed
4 Part 1 • The Scope and Environment of Financial Management
Obviously, there are some serious practical problems in using changes in the firm’s
stock to evaluate financial decisions. Many things affect stock prices; to attempt to identify
a reaction to a particular financial decision would simply be impossible, but fortunately that
is unnecessary. To employ this goal, we need not consider every stock price change to be a
market interpretation of the worth of our decisions. Other factors, such as changes in the
economy, also affect stock prices. What we do focus on is the effect that our decision should
have on the stock price if everything else were held constant. The market price of the firm’s
stock reflects the value of the firm as seen by its owners and takes into account the com-
plexities and complications of the real-world risk. As we follow this goal throughout our
discussions, we must keep in mind one more question: Who exactly are the shareholders?
The answer: Shareholders are the legal owners of the firm.
Concept Check
1. What is the goal of the firm?
2. How would you apply this goal in practice?
Five Principles That Form the Foundations
of Finance
To the first-time student of finance, the subject matter may seem like a collection of un-
related decision rules. This could not be further from the truth. In fact, our decision rules,
and the logic that underlies them, spring from five simple principles that do not require
knowledge of finance to understand. These five principles guide the financial manager in
the creation of value for the firm’s owners (the stockholders).
As you will see, while it is not necessary to understand finance to understand these
principles, it is necessary to understand these principles in order to understand finance.
Although these principles may at first appear simple or even trivial, they provide the driving
force behind all that follows, weaving together the concepts and techniques presented in
this text, and thereby allowing us to focus on the logic underlying the practice of financial
management. Now let’s introduce the five principles.
Principle 1: Cash Flow Is What Matters
You probably recall from your accounting classes that a company’s profits can differ dra-
matically from its cash flows, which we will review in Chapter 3. But for now understand
that cash flows, not profits, represent money that can be spent. Consequently, it is cash
flow, not profits, that determines the value of a business. For this reason when we analyze
the consequences of a managerial decision we focus on the resulting cash flows, not profits.
In the movie industry, there is a big difference between accounting profits and cash
flow. Many a movie is crowned a success and brings in plenty of cash flow for the studio but
doesn’t produce a profit. Even some of the most successful box office hits—Forrest Gump,
Coming to America, Batman, My Big Fat Greek Wedding, and the TV series Babylon 5—
realized no accounting profits at all after accounting for various movie studio costs. That’s
because “Hollywood Accounting” allows for overhead costs not associated with the movie
to be added on to the true cost of the movie. In fact, the movie Harry Potter and the Order of
the Phoenix, which grossed almost $1 billion worldwide, actually lost $167 million according
to the accountants. Was Harry Potter and the Order of the Phoenix a successful movie? It sure
was—in fact it was the 16th highest grossing film of all time. Without question, it produced
cash, but it didn’t make any profits.
There is another important point we need to make about cash flows. Recall from your
economics classes that we should always look at marginal, or incremental, cash flows
when making a financial decision. The incremental cash flow to the company as a whole is
the difference between the cash flows the company will produce both with and without the investment
it’s thinking about making. To understand this concept, let’s think about the incremental
cash flows of the Pirates of the Caribbean movies. Not only did Disney make money on the
1
rinciple
2 Understand the basic
principles of finance, their
importance, and the
importance of ethics and trust.
incremental cash flow the difference
between the cash flows a company will produce
both with and without the investment it is
thinking about making.
M01_KEOW4873_CH01_pp002-019.indd 4 05/10/12 3:40 PM

xx Preface
to master the subject sometimes end up memorizing formulas rather than focusing on the
analysis of business decisions using math as a tool. We address this problem both in terms
of text content and pedagogy.
● First, we present math only as a tool to help us analyze problems, and only when neces-
sary. We do not present math for its own sake.
● Second, finance is an analytical subject and requires that students be able to solve prob-
lems. To help with this process, numbered chapter examples appear throughout the
book. Each of these examples follows a very detailed and multistep approach to prob-
lem solving that helps students develop their problem-solving skills.
Step 1: Formulate a Solution Strategy. For example, what is the appropriate formula to
apply? How can a calculator or spreadsheet be used to “crunch the numbers”?
Step 2: Crunch the Numbers. Here we provide a completely worked out step-by-step
solution. We first present a description of the solution in prose and then a correspond-
ing mathematical implementation.
Step 3: Analyze Your Results. We end each solution with an analysis of what the solution
means. This stresses the point that problem solving is about analysis and decision mak-
ing. Moreover, in this step we emphasize that decisions are often based on incomplete
information, which requires the exercise of managerial judgment, a fact of life that is
often learned on the job.
NEW! Financial Decision Tools
This feature recaps keys equations shortly
after their application in the chapter.
NEW! Chapter Summaries
These have been rewritten to make it easier
for students to connect the summary with
each of the in-chapter sections and learning
objectives.
NEW! Key Terms List for Each Chapter
New terminology introduced in the chapter is listed along with a brief definition.
NEW! Study Problems
The end-of-chapter study problems have been improved and dramatically expanded to al-
low for a wider range of student practice. In addition, the study problems are now organized
according to learning objective so that both the instructor and student can readily align text
and problem materials.
NEW! A Focus on Valuation
Although many professors and instructors make valuation the central theme of their course,
students often lose sight of this focus when reading their text. We have revised this edition
to reinforce this focus in the content and organization of our text in some very concrete
ways:
● We build our discussion around five finance principles that provide the foundation for
the valuation of any investment.
● New topics are introduced in the context of “what is the value proposition?” and “how
is the value of the enterprise affected?”
110 Part 1 • The Scope and Environment of Financial Management
As we did with days in receivables and accounts receivable turnover, we can restate days
in inventory as inventory turnover, which is calculated as follows:6
Name of Tool Formula What It Tells You
Current ratio
current assets
current liabilities
Measures a firm’s liquidity. A higher ratio means greater
liquidity.
Acid-test ratio cash + accounts receivable
current liabilities
Gives a more stringent measure of liquidity than the cur-
rent ratio in that it excludes inventories and other current
assets from the numerator. A higher ratio means greater
liquidity.
Days in receivables accounts receivable
annual credit sales , 365
Indicates how rapidly a firm is collecting its receivables. A
longer (shorter) period means a slower (faster) collection of
receivables and that the receivables are of lesser (greater)
quality.
Accounts receivable turnover annual credit sales
accounts receivable
Tells how many times a firm’s accounts receivable are
collected, or turned over, during a year. Provides the same
information as the days in receivables, just expressed
differently, where a high (low) number indicates slow (fast)
collections.
Days in inventory inventory
cost of goods sold , 365
Measures how many days a firm’s inventories are held on
average before being sold; the more (less) days required,
the lower (higher) the quality of the inventory.
Inventory turnover cost of goods sold
inventory
Gives the number of times a firm’s inventory is sold and
replaced during the year; as with days in inventory, serves
as an indicator of the quality of the inventories; the higher
the number, the better the inventory quality.
Financial Decision tools
inventory turnover a firm’s cost of goods
sold divided by its inventory. This ratio measures
the number of times a firm’s inventories are sold
and replaced during the year, that is, the relative
liquidity of the inventories.
6However, some of the industry norms provided by financial services are computed using sales in the numerator of inven-
tory turnover. To make comparisons with ratios from these services, we will want to use sales in our computation
of inventory turnover.
Inventory turnover =
cost of goods sold
inventory
(4-6)
For Home Depot:
Inventory turnover =
$44,693M
$10,625M
= 4.21X
Lowe’s inventory turnover 3.81X
Hence, we see that Home Depot is moving (turning over) its inventory more quickly
than Lowe’s—4.21 times per year, compared with 3.81 times for Lowe’s. This suggests that
Home Depot’s inventory is more liquid than Lowe’s.
To conclude, the current ratio indicates that Home Depot is less liquid than Lowe’s, but
this result assumes that Home Depot’s accounts receivable and inventory are of similar quality
to Lowe’s. However, this is not the case given Home Depot’s lower accounts receivable turn-
over (more days in receivables) and higher inventory turnover (fewer days in inventory). The
acid-test ratio, on the other hand, suggests that Home Depot is more liquid than Lowe’s, but
we know that Home Depot’s accounts receivable are a bit less liquid than Lowe’s. We therefore
have a mixed outcome, and cannot say definitively whether Home Depot is more or less liquid.
Thus, we have to conclude that Home Depot’s and Lowe’s liquidity are probably very similar.
We have completed our presentation of liquidity decision tools, which can be summa-
rized as follows:
or
or
M04_KEOW4873_CH04_pp102-141.indd 110 09/10/12 5:51 PM

Preface xxi
“Cautionary Tale” Boxes
These give students insights into how the core concepts of finance apply in the real world.
Each “Cautionary Tale” box goes behind the headlines of finance pitfalls in the news to
show how one of the five principles was forgotten or violated.
Real-World Opening Vignettes
Each chapter begins with a story about a current, real-world company faced with a financial
decision related to the chapter material that follows. These vignettes have been carefully
prepared to stimulate student interest in the topic to come and can be used as a lecture tool
to provoke class discussion.
Use of an Integrated Learning System
The text is organized around the learning objectives that appear at the beginning of each
chapter to provide the instructor and student with an easy-to-use integrated learning
system. Numbered icons identifying each objective appear next to the related material
throughout the text and in the summary, allowing easy location of material related to each
objective.
Can you Do it?
solvIng FoR The Real RaTe oF InTeResT
Your banker just called and offered you the chance to invest your savings for 1 year at a quoted rate of 10 percent. You also saw on
the news that the inflation rate is 6 percent. What is the real rate of interest you would be earning if you made the investment? (The
solution can be found on page 40.)
M02_KEOW4873_CH02_pp020-049.indd 39 06/11/12 5:32 PM
40 Part 1 • The Scope and Environment of Financial Management
following relationship (which comes from equation (2-2)), an approximation method, to
estimate the real rate of interest over a selected past time frame.
Nominal interest rate 2 inflation rate > real interest rate
The concept is straightforward, but its implementation requires that several judgments
be made. For example, suppose we want to use this relationship to determine the real risk-
free interest rate, which interest rate series and maturity period should be used? Suppose we
settle for using some U.S. Treasury security as a surrogate for a nominal risk-free interest
rate. Then, should we use the yield on 3-month U.S. Treasury bills or, perhaps, the yield
on 30-year Treasury bonds? There is no absolute answer to the question.
So, we can have a real risk-free short-term interest rate, as well as a real risk-free long-
term interest rate, and several variations in between. In essence, it just depends on what the
analyst wants to accomplish. Of course we could also calculate the real rate of interest on
some rating class of 30-year corporate bonds (such as Aaa-rated bonds) and have a risky real
rate of interest as opposed to a real risk-free interest rate.
Furthermore, the choice of a proper inflation index is equally challenging. Again, we have
several choices. We could use the consumer price index, the producer price index for finished
goods, or some price index out of the national income accounts, such as the gross domestic
product chain price index. Again, there is no precise scientific answer as to which specific price
index to use. Logic and consistency do narrow the boundaries of the ultimate choice.
Let’s tackle a very basic (simple) example. Suppose that an analyst wants to estimate the
approximate real interest rate on (1) 3-month Treasury bills, (2) 30-year Treasury bonds,
and (3) 30-year Aaa-rated corporate bonds over the 1987–2011 time frame. Furthermore,
the annual rate of change in the consumer price index (measured from December to De-
cember) is considered a logical measure of past inflation experience. Most of our work is
already done for us in Table 2-2. Some of the data from Table 2-2 are displayed here.
SECURITY
MEAN NOMINAL
YIELD (%)
MEAN INFLATION
RATE (%)
INFERRED REAL
RATE (%)
3-month Treasury bills 3.85 2.92 0.93
30-year Treasury bonds 6.14 2.92 3.22
30-year Aaa-rated corporate bonds 7.00 2.92 4.08
DiD you Get it?
solvIng FoR The Real RaTe oF InTeResT
Nominal or quoted 5 real rate of 1 inflation 1 product of the real rate of
rate of interest interest rate interest and the inflation rate
0.10 5 real rate of interest 1 0.06 1 0.06 3 real rate of interest
0.04 5 1.06 3 real rate of interest
Solving for the real rate of interest:
real rate of interest 5 0.0377 5 3.77%
Notice that the mean yield over the 25 years from 1987 to 2011 on all three classes of
securities has been used. Likewise, the mean inflation rate over the same time period has
been used as an estimate of the inflation premium. The last column provides the approxi-
mation for the real interest rate on each class of securities.
Thus, over the 25-year examination period the real rate of interest on 3-month Treasury
bills was 0.93 percent versus 3.22 percent on 30-year Treasury bonds, versus 4.08 percent on
30-year Aaa-rated corporate bonds. These three estimates (approximations) of the real interest
rate provide a rough guide to the increase in real purchasing power associated with an in-
M02_KEOW4873_CH02_pp020-049.indd 40 06/11/12 5:32 PM
“Can You Do It?” and
“Did You Get It?”
The text provides examples for the
students to work at the conclusion
of each major section of a chapter,
which we call “Can You Do It?” fol-
lowed by “Did You Get It?” a few
pages later in the chapter. This tool
provides an essential ingredient to
the building-block approach to the
material that we use.
Chapter 1 • An Introduction to the Foundations of Financial Management 11
means and that each of us has his or her personal set of values. These values form the basis
for what we think is right and wrong. Moreover, every society adopts a set of rules or laws
that prescribe what it believes constitutes “doing the right thing.” In a sense, we can think
of laws as a set of rules that reflect the values of a society as a whole.
You might ask yourself, “As long as I’m not breaking society’s laws, why should I care
about ethics?” The answer to this question lies in consequences. Everyone makes errors
of judgment in business, which is to be expected in an uncertain world. But ethical errors
are different. Even if they don’t result in anyone going to jail, they tend to end careers and
thereby terminate future opportunities. Why? Because unethical behavior destroys trust,
and businesses cannot function without a certain degree of trust. Throughout this book, we
will point out some of the ethical pitfalls that have tripped up managers.
Concept Check
1. According to Principle 3, how do investors decide where to invest their money?
2. What is an efficient market?
3. What is the agency problem and why does it occur?
4. Why are ethics and trust important in business?
3 Describe the role of finance in
business.
capital budgeting the decision-making
process with respect to investment in fixed assets.
capital structure decision the
decision- making process with funding choices
and the mix of long-term sources of funds.
working capital management the
management of the firm’s current assets and
short-term financing.
M01_KEOW4873_CH01_pp002-019.indd 11 05/10/12 3:40 PM
Concept Check
At the end of most major sections, this tool highlights the key
ideas just presented and allows students to test their understand-
ing of the material.
52 Part 1 • The Scope and Environment of Financial Management
Our goal is not to make you an accountant, but instead
to provide you with the tools to understand a firm’s financial
situation. With this knowledge, you will be able to under-
stand the financial consequences of a company’s decisions and
actions—as well as your own.
The financial performance of a firm matters to a lot
of groups—the company’s management, its employees, and
its investors, just to name a few. If you are an employee,
the firm’s performance is important to you because it may
determine your annual bonus, your job security, and your
opportunity to advance your professional career. This is
true whether you are in the firm’s marketing, finance,
or human resources department. Moreover, an employee
who can see how decisions affect a firm’s finances has a
competitive advantage. So regardless of your position in
the firm, it is in your own best interest to know the basics
of financial statements—even if accounting is not your
greatest love.
Let’s begin our review of financial statements by looking
at the format and content of the income statement.
The Income Statement
An income statement, or profit and loss statement, indicates the amount of profits gen-
erated by a firm over a given time period, such as 1 year. In its most basic form, the income
statement may be represented as follows:
Sales – expenses = profits
* units sold = total sales).
2. Cost of goods sold, which is the cost of producing or acquiring the goods or services
that were sold.
3. Operating expenses, which include:
a. Marketing and selling expenses (the expenses related to marketing, selling, and
distributing the products or services).
b. The firm’s overhead expenses (general and administrative expenses, and deprecia-
tion expenses).
1
RemembeR YoUR PRinCiPleS
Two principles are especially important in this chapter.
Principle 1 tells us that Cash Flow Is What Matters. At times,
cash is more important than profits. Thus, considerable time
is devoted to measuring cash flows. Principle 5 warns us that
there may be a conflict when managers and owners have dif-
ferent incentives. That is, Conflicts of Interest Cause Agency
Problems. Because managers’ incentives are at times different
from those of owners, the firm’s common stockholders, as well
as other providers of capital (such as bankers), need information
that can be used to monitor the managers’ actions. Because the
owners of large companies do not have access to internal infor-
mation about the firm’s operations, they must rely on public
information from any and all sources. One of the main sources of
such information comes from the company’s financial statements
provided by the firm’s accountants. Although this information is
by no means perfect, it is an important source used by outsiders
to assess a company’s activities. In this chapter, we learn how to
use data from the firm’s public financial statements to monitor
management’s actions.
rinciple
M03_KEOW4873_CH03_pp050-101.indd 52 29/10/12 5:26 PM
Remember Your Principles
These in-text inserts appear throughout to allow the student to take time out and
reflect on the meaning of the material just presented. The use of these inserts,
coupled with the use of the five principles, keeps the student focused on the inter-
relationships and motivating factors behind the concepts.

xxii Preface
Comprehensive Mini Cases
A comprehensive Mini Case appears at the end of al-
most every chapter, covering all the major topics in-
cluded in that chapter. This Mini Case can be used
as a lecture or review tool by the professor. For the
students, it provides an opportunity to apply all the
concepts presented within the chapter in a realistic
setting, thereby strengthening their understanding of
the material.
Given this information, what should the nominal rate of interest on Ford bonds maturing in 0–1
year, 1–2 years, 2–3 years, and 3–4 years be?
2-13. (Term structure of interest rates) You want to invest your savings of $20,000 in government
securities for the next 2 years. Currently, you can invest either in a security that pays interest of 8
percent per year for the next 2 years or in a security that matures in 1 year but pays only 6 percent
interest. If you make the latter choice, you would then reinvest your savings at the end of the first
year for another year.
a. Why might you choose to make the investment in the 1-year security that pays an interest rate
of only 6 percent, as opposed to investing in the 2-year security paying 8 percent? Provide numeri-
cal support for your answer. Which theory of term structure have you supported in your answer?
b. Assume your required rate of return on the second-year investment is 11 percent; otherwise,
you will choose to go with the 2-year security. What rationale could you offer for your preference?
2-14. (Yield curve) If yields on Treasury securities were currently as follows:
T E R M Y I E L D
6 months 1.0%
1 year 1.7%
2 years 2.1%
3 years 2.4%
4 years 2.7%
5 years 2.9%
10 years 3.5%
15 years 3.9%
20 years 4.0%
30 years 4.1%
a. Plot the yield curve.
b. Explain this yield curve using the unbiased expectations theory and the liquidity preference theory.
Mini Case
This Mini Case is available in MyFinanceLab.
On the first day of your summer internship, you’ve been assigned to work with the chief financial officer
(CFO) of SanBlas Jewels Inc. Not knowing how well trained you are, the CFO has decided to test your
understanding of interest rates. Specifically, she asked you to provide a reasonable estimate of the nomi-
nal interest rate for a new issue of Aaa-rated bonds to be offered by SanBlas Jewels Inc. The final format
that the chief financial officer of SanBlas Jewels has requested is that of equation (2-1) in the text. Your
assignment also requires that you consult the data in Table 2-2.
Some agreed-upon procedures related to generating estimates for key variables in equation (2-1) follow.
a. The current 3-month Treasury bill rate is 2.96 percent, the 30-year Treasury bond rate is 5.43 per-
cent, the 30-year Aaa-rated corporate bond rate is 6.71 percent, and the inflation rate is 2.33 percent.
b. The real risk-free rate of interest is the difference between the calculated average yield on
3-month Treasury bills and the inflation rate.
c. The default-risk premium is estimated by the difference between the average yield on Aaa-rated
bonds and 30-year Treasury bonds.
d. The maturity-risk premium is estimated by the difference between the average yield on 30-year
Treasury bonds and 3-month Treasury bills.
e. SanBlas Jewels’ bonds will be traded on the New York Bond Exchange, so the liquidity-risk
premium will be slight. It will be greater than zero, however, because the secondary market for
the firm’s bonds is more uncertain than that of some other jewel sellers. It is estimated at 4 basis
points. A basis point is one one-hundredth of 1 percent.
Now place your output into the format of equation (2-1) so that the nominal interest rate can be estimat-
ed and the size of each variable can also be inspected for reasonableness and discussion with the CFO.
Chapter 2 • The Financial Markets and Interest Rates 49
M02_KEOW4873_CH02_pp020-049.indd 49 06/11/12 5:32 PM
Financial Calculators
The use of financial calculators has been in-
tegrated throughout this text, especially with
respect to the presentation of the time value
of money. Where appropriate, calculator solu-
tions appear in the margin.
Content Updates
In addition to the innovations of this edition, we have made some chapter-by-chapter up-
dates in response to both the continued development of financial thought, reviewer com-
ments, and the recent economic crisis. Some of these changes include:
Chapter 1
An Introduction to the Foundations of Financial Management
● Revised and updated discussion of the five principles
● New section on the current global financial crisis
Chapter 2
The Financial Markets and Interest Rates
● Revised to reflect recent changes in financial markets
● Simplified to make it livelier and more relevant to students
● Revised coverage of securities markets, reflecting recent technological advances cou-
pled with deregulation and increased competition, which have blurred the difference
between an organized exchange and the over-the-counter market
● Updated investment banking coverage, reflecting the dramatic impact of the recent
financial crisis on investment banking firms
● Simplified, more intuitive discussion on interest rate determinants
● Additional problems on the determination of interest rates
Chapter 3
Understanding Financial Statements and Cash Flows
● Presents a live company, The Home Depot, instead of a hypothetical company, to illus-
trate financial statements
● Expanded coverage of balance sheets, focusing on what can be learned from them
● More comprehensive and intuitive presentation of cash flows
● New explanation of fixed and variable costs as part of presenting an income statement
● New appendix that presents free cash flows
154 Part 2 • The Valuation of Financial Assets
E x A M P L E 5.5 Calculating the present value of a savings bond
You’re on vacation in a rather remote part of Florida and see an advertisement stat-
ing that if you take a sales tour of some condominiums “you will be given $100 just for
taking the tour.” However, the $100 that you get is in the form of a savings bond that
[equation (5-2)] is used extensively to evaluate new investment proposals, it should be stressed that
the equation is actually the same as the future value, or compounding equation [equation (5-1)],
only it solves for present value instead of future value.
E x A M P L E 5.4 Calculating the discounted value to be received in 10 years
What is the present value of $500 to be received 10 years from today if our discount rate
is 6 percent?
sTeP 1: FoRMulATe A soluTion sTRATeGY
The present value to be received can be calculated using equation (5-2) as follows:
Present value = FVn c
1
(1 + r)n
d (5-2)
sTeP 2: cRuncH THe nuMbeRs
Substituting FV = $500, n = 10, and r = 6 percent into equation (5-2), we find:
Present value = $500 c 1
(1 + 0.06)10
d
= $500(0.5584)
= $279.20
cAlculAToR soluTion
Data Input Function Key
10 N
6 I/Y
-500 FV
0 PMT
Function Key Answer
CPT
PV 279.20
M05_KEOW4873_CH05_pp142-181.indd 154 26/10/12 2:04 PM

Preface xxiii
Chapter 4
Evaluating a Firm’s Financial Performance
● Continues the use of The Home Depot’s financial data to illustrate how we evaluate a
firm’s financial performance, compared to industry norms or a peer group. In this case,
we compare Home Depot’s financial performance to that of Lowe’s, a major competitor
● Includes comments from Home Depot’s management regarding the firm’s financial
performance
● Revised presentation of evaluating a company’s liquidity to align more closely with how
business managers talk about liquidity
Chapter 5
The Time Value of Money
● Revised to appeal to students regardless of level of numerical skills
● Increased emphasis on the intuition behind the time value of money, stressing visual-
izing and setting up the problem
● Additional problems emphasizing complex streams of cash flows
Chapter 6
The Meaning and Measurement of Risk and Return
● Updated information on the rates of return that investors have earned over the long
term with different types of security investments
● Updated examples of rates of return earned from investing in individual companies
Chapter 7
The Valuation and Characteristics of Bonds
● Expanded explanation of efficient markets
● New example of a company’s credit rating being lowered, which has been a more
frequent occurrence in recent times
Chapter 8
The Valuation and Characteristics of Stock
● More current explanation of options for getting stock quotes from the Wall Street
Journal
Chapter 9
The Cost of Capital
● Streamlined exposition and reduced quantity of learning objectives
● Rewritten discussion of the divisional cost of capital
Chapter 10
Capital-Budgeting Techniques and Practice
● New introduction looks at Disney’s decision to build the Shanghai Disney Resort
● Simplified presentation of the payback period and discounted payback period
Chapter 11
Cash Flows and Other Topics in Capital Budgeting
● New introduction examines the complications Toyota faced in estimating future cash
flows when it introduced the Prius
● New discussion of the iPad as an example of synergistic effects
● New appendix that presents the modified accelerated cost recovery system
Chapter 12
Determining the Financing Mix
● Simplified presentation of chapter materials, including a reduced number of learning
objectives

xxiv Preface
Chapter 13
Dividend Policy and Internal Financing
● Simplified presentation of chapter materials, including a reduced number of learning
objectives
● Rewritten introduction focuses on Apple Computer, Inc.’s decision to re-initiate its
cash dividend
● Problem set extensively revised with the addition of 13 new exercises
Chapter 14
Short-Term Financial Planning
● New study problem added, focusing on the limitations of the percent of sales forecast
method
● New discussion of the regression method of forecasting financial variables in conjunc-
tion with the percent of sales method
Chapter 15
Working-Capital Management
● Simplified presentation of chapter materials, including reducing the number of learn-
ing objectives
Chapter 16
International Business Finance
● Comprehensively revised and updated to reflect changes in exchange rates and global
financial markets in general
● Simplified and streamlined coverage in the section on interest rate parity, discus-
sion of purchasing-power parity and the law of one price, and international capital
budgeting
Web Chapter 17
Cash, Receivables, and Inventory Management
● Simplified presentation of chapter materials, including reducing the number of learn-
ing objectives
A Complete Support Package for the Student
and Instructor
MyFinanceLab
This fully integrated online homework system gives students the hands-on practice and
tutorial help they need to learn finance efficiently. Ample opportunities for online practice
and assessment in MyFinanceLab are seamlessly integrated into each chapter. For more
details, see the inside front cover.
Instructor’s Resource Center
This password-protected site, accessible at www.pearsonhighered.com/irc, hosts all of the
instructor resources that follow. Instructors should click on the “IRC Help Center” link for
easy-to-follow instructions on getting access or may contact their sales representative for
further information.
Test Bank
This online Test Bank, prepared by Curtis Bacon of Southern Oregon University, pro-
vides more than 1,600 multiple-choice, true/false, and short-answer questions with com-
plete and detailed answers. The online Test Bank is designed for use with the TestGen-EQ

www.pearsonhighered.com/irc

Preface xxv
test-generating software. This computerized package allows instructors to custom de-
sign, save, and generate classroom tests. The test program permits instructors to edit,
add, or delete questions from the test bank; analyze test results; and organize a database
of tests and student results. This software allows for greater flexibility and ease of use. It
provides many options for organizing and displaying tests, along with a search and sort
feature.
Instructor’s Manual with Solutions
Written by the authors, the Instructor’s Manual follows the textbook’s organization
and represents a continued effort to serve the teacher’s goal of being effective in the
classroom. Each chapter contains a chapter orientation, an outline of each chapter
(also suitable for lecture notes), answers to end-of-chapter review questions, and solu-
tions to end-of-chapter study problems.
The Instructor’s Manual is available electronically and instructors can download
this file from the Instructor’s Resource Center by visiting www.pearsonhighered.com/
irc.
The PowerPoint Lecture Presentation
This lecture presentation tool, prepared by Philip Samuel Russel of Philadelphia Univer-
sity, provides the instructor with individual lecture outlines to accompany the text. The
slides include many of the figures and tables from the text. These lecture notes can be used
as is or instructors can easily modify them to reflect specific presentation needs.
Companion Web Site
(www.pearsonhighered.com/keown) The Web site contains various resources related spe-
cifically to the Eighth Edition of Foundations of Finance: The Logic and Practice of Financial
Management, including Web Chapter 17 and Appendix A.
Excel Spreadsheets
Created by the authors, these spreadsheets correspond to end-of-chapter problems
from the text. This student resource is available on both the companion Web site and
MyFinanceLab.
CourseSmart for Instructors
CourseSmart goes beyond traditional teaching resources to provide instant, online access to
the textbooks and course materials you need at a lower cost to students. And while students
save money, you can save time and hassle with a digital textbook that allows you to search
the most relevant content at the very moment you need it. Whether it’s for evaluating
textbooks or creating lecture notes to help students with difficult concepts, CourseSmart
can make life a little easier. See how by visiting the CourseSmart Web site at www
.coursesmart.com/instructors.
CourseSmart for Students
CourseSmart goes beyond traditional expectations providing instant, online access
to the textbooks and course materials students need at a lower cost. Students can also
search, highlight, and take notes anywhere at any time. See all the benefits to students at
www.coursesmart.com/students.

www.pearsonhighered.com/irc

www.pearsonhighered.com/keown

www.coursesmart.com/instructors

www.coursesmart.com/students

xxvi Preface
Acknowledgments
We gratefully acknowledge the assistance, support, and encouragement of those individuals
who have contributed to Foundations of Finance. Specifically, we wish to recognize the very
helpful insights provided by many of our colleagues. For their careful comments and help-
ful reviews of the text, we are indebted to:
We also thank our friends at Pearson. They are a great group of folks. We offer our
personal expression of appreciation to our editor-in-chief Donna Battista, who provided
the leadership and direction to this project. She is the best, and she settles for nothing less
than perfection—thanks Donna. We would also like to thank Katie Rowland, our finance
editor. Katie is new to Pearson and full of energy and drive with amazing insights and
intuition about what makes up a great book. We would also like to thank Emily Biberger,
our editorial project manager, for her administrative deftness. She was superb. With Emily
watching over us, there was no way the ball could be dropped. On top of this, Emily is just
a great person—our hats are off to you Emily. We would also like to extend our thanks to
Meredith Gertz, who served as our production supervisor and guided the book through a very
Haseeb Ahmed, Johnson C. Smith University
Joan Anderssen, Arapahoe Community College
Chris Armstrong, Draughons Junior College
Curtis Bacon, Southern Oregon University
Deb Bauer, University of Oregon
Pat Bernson, County College of Morris
Ed Boyer, Temple University
Joe Brocato, Tarleton State University
Joseph Brum, Fayetteville Technical Community College
Lawrence Byerly, Thomas More College
Juan R. Castro, LeTourneau University
Janice Caudill, Auburn University
Ting-Heng Chu, East Tennessee State University
David Daglio, Newbury College
Julie Dahlquist, University of Texas at San Antonio
David Darst, Central Ohio Technical College
Maria de Boyrie, New Mexico State University
Kate Demarest, Carroll Community College
Khaled Elkhal, University of Southern Indiana
Cheri Etling, University of Tampa
Robert W. Everett, Lock Haven University
Cheryl Fetterman, Cape Fear Community College
David R. Fewings, Western Washington University
Dr. Charles Gahala, Benedictine University
Harry Gallatin, Indiana State University
Deborah Giarusso, University of Northern Iowa
Gregory Goussak, University of Nevada, Las Vegas
Lori Grady, Bucks County Community College
Ed Graham, University of North Carolina Wilmington
Barry Greenberg, Webster University
Gary Greer, University of Houston Downtown
Indra Guertler, Simmons College
Bruce Hadburg, University of Tampa
Thomas Hiebert, University of North Carolina, Charlotte
Marlin Jensen, Auburn University
John Kachurick, Misericordia University
Okan Kavuncu, University of California at Santa Cruz
Gary Kayakachoian, Rbode Island College
David F. Kern, Arkansas State University
Brian Kluger, University of Cincinnati
Lynn Phillips Kugele, University of Mississippi
Mary LaPann, Adirondack Community College
Carlos Liard-Muriente, Central Connecticut State
University
Christopher Liberty, College of St Rose,
Empire State College
Lynda Livingston, University of Puget Sound
Y. Lal Mahajan, Monmouth University
Edmund Mantell, Pace University
Peter Marks, Rhode Island College
Mario Mastrandrea, Cleveland State University
Anna McAleer, Arcadia University
Robert Meyer, Parkland College
Ronald Moy, St. John’s University
Elisa Muresan, Long Island University
Michael Nugent, Stony Brook University
Tony Plath, University of North Carolina at Charlotte
Anthony Pondillo, Siena College
Walter Purvis, Coastal Carolina Community College
Emil Radosevich, Central New Mexico Community
College
Deana Ray, Forsyth Technical Community College
Clarence Rose, Radford University
Ahmad Salam, Widener University
Jeffrey Schultz, Christian Brothers University
Thomas W. Secrest, Coastal Carolina University
Ken Shakoori, California State University, Bakersfield
Michael Slates, Bowling Green State University
Suresh Srivastava, University of Alaska Anchorage
Maurry Tamarkin, Clark University
Fang Wang, West Virginia University
Paul Warrick, Westwood College
Jill Wetmore, Saginaw Valley State University
Kevin Yost, Auburn University
Jingxue Yuan, Texas Tech University
Mengxin Zhao, Bentley College

Preface 1
complex production process. Meredith kept us on schedule while maintaining extremely
high quality. Our thanks also go to Mary Sanger of Cenveo Publisher Services, who served
as the project manager and did a superb job. Even more, she was fun to work with, always
keeping us on task. It seemed that a day did not go by when we didn’t call Mary to ask
her advice or help on something, and she was always able and willing to help out. Miguel
Leonarte, who worked on MyFinanceLab, also deserves a word of thanks for making My-
FinanceLab flow so seamlessly with the book. He has continued to refine and improve
MyFinanceLab, and as a result of his efforts, it has become a learning tool without equal.
We also thank Melissa Honig, our media producer, who did a great job of making sure we
are on the cutting edge in terms of Web applications and offerings.
As a final word, we express our sincere thanks to those who are using Foundations of
Finance in the classroom. We thank you for making us a part of your teaching-learning
team. Please feel free to contact any member of the author team should you have questions
or needs.
—A.J.K. / J.D.M. / J.W.P.

An Introduction to
the Foundations of
Financial Management
Learning Objectives
After reading this chapter, you should be able to:
1 Identify the goal of the firm. The Goal of the Firm
2 Understand the basic principles of finance, their Five Principles That Form the
importance, and the importance of ethics and trust. Foundations of Finance
3 Describe the role of finance in business. The Role of Finance in Business
4 Distinguish between the different legal forms of business. The Legal Forms of Business Organization
5 Explain what has led to the era of the Finance and the Multinational Firm: The
multinational corporation. New Role
2
Apple Computer (AAPL) ignited the personal computer revolution in the 1970s with the Apple II and reinvented
the personal computer in the 1980s with the Macintosh. But by 1997, it looked like it might be nearing the end
for Apple. Mac users were on the decline, and the company didn’t seem to be headed in any real direction. It was
at that point that Steve Jobs reappeared, taking back his old job as CEO of Apple, the company he cofounded in
1976. To say the least, things began to change. In fact, between then and April 2012, the price of Apple’s com-
mon stock climbed by over one hundred and sixteen-fold!
How did Apple accomplish this? The company did it by going back to what it does best, which is to
produce products that make the optimal trade-off between ease of use, complexity, and features. Apple
took its special skills and applied them to more than just computers, introducing new products such as
the iPod, iTunes, the sleek iMac, the MacBook Air, iPod Touch, and the iPhone along with its unlimited
“apps.” Although all these products have done well, the success of the iPod has been truly amazing.
Between the introduction of the iPod in October 2001 and the beginning of 2005, Apple sold more than
6 million of the devices. Then, in 2004, it came out with the iPod Mini, about the length and width
of a business card, which has also been a huge success, particularly among women. How successful
1

has this new product been? By 2004, Apple was selling
more iPods than its signature Macintosh desktop and
notebook computers.
How do you follow up on the success of the iPod? You
keep improving your products and you keep developing
and introducing new products that consumers want. With
this in mind, in October 2011, Apple unveiled its iPhone
4S, selling over 4 million phones in the first week. Then,
in March 2012, during the same week that Apple’s App
Store downloads topped 25 billion, Apple introduced the
New iPad, selling over 3 million units in the first week.
In effect, Apple seems to have a never-ending supply of
new, exciting products that we all want.
How did Apple make a decision to introduce the original
iPod and now the iPad? The answer is by identifying a customer
need, combined with sound financial management. Finan-
cial management deals with the maintenance and creation
of economic value or wealth by focusing on decision making
with an eye toward creating wealth. As such, this text deals
with financial decisions such as when to introduce a new
product, when to invest in new assets, when to replace exist-
ing assets, when to borrow from banks, when to sell stocks or
bonds, when to extend credit to a customer, and how much
cash and inventory to maintain. All of these aspects of finan-
cial management were factors in Apple’s decision to intro-
duce and continuously improve the iPod, Apple TV, iPhone,
and iPad, and the end result is having a major financial impact
on Apple.
In this chapter, we lay the foundation for the entire book by explaining the key goal that
guides financial decision making: maximizing shareholder wealth. From there we introduce
the thread that ties everything together: the five basic principles of finance. Finally, we
discuss the legal forms of business. We close the chapter with a brief look at what has led to
the rise in multinational corporations.
The Goal of the Firm
The fundamental goal of a business is to create value for the company’s owners (that is,
its shareholders). This goal is frequently stated as “maximization of shareholder wealth.”
Thus, the goal of the financial manager is to create wealth for the shareholders, by making
decisions that will maximize the price of the existing common stock. Not only does this
goal directly benefit the shareholders of the company but it also provides benefits to society
as scarce resources are directed to their most productive use by businesses competing to
create wealth.
We have chosen maximization of shareholder wealth—that is, maximizing the market
value of the existing shareholders’ common stock—because all financial decisions ultimately
affect the firm’s stock price. Investors react to poor investment or dividend decisions by
causing the total value of the firm’s stock to fall, and they react to good decisions by push-
ing up the price of the stock. In effect, under this goal, good decisions are those that create
wealth for the shareholder.
33
1 Identify the goal of the firm.

4 Part 1 • The Scope and Environment of Financial Management
Obviously, there are some serious practical problems in using changes in the firm’s
stock to evaluate financial decisions. Many things affect stock prices; to attempt to identify
a reaction to a particular financial decision would simply be impossible, but fortunately that
is unnecessary. To employ this goal, we need not consider every stock price change to be a
market interpretation of the worth of our decisions. Other factors, such as changes in the
economy, also affect stock prices. What we do focus on is the effect that our decision should
have on the stock price if everything else were held constant. The market price of the firm’s
stock reflects the value of the firm as seen by its owners and takes into account the com-
plexities and complications of the real-world risk. As we follow this goal throughout our
discussions, we must keep in mind one more question: Who exactly are the shareholders?
The answer: Shareholders are the legal owners of the firm.
Concept Check
1. What is the goal of the firm?
2. How would you apply this goal in practice?
Five Principles That Form the Foundations
of Finance
To the first-time student of finance, the subject matter may seem like a collection of un-
related decision rules. This could not be further from the truth. In fact, our decision rules,
and the logic that underlies them, spring from five simple principles that do not require
knowledge of finance to understand. These five principles guide the financial manager in
the creation of value for the firm’s owners (the stockholders).
As you will see, while it is not necessary to understand finance to understand these
principles, it is necessary to understand these principles in order to understand finance.
Although these principles may at first appear simple or even trivial, they provide the driving
force behind all that follows, weaving together the concepts and techniques presented in
this text, and thereby allowing us to focus on the logic underlying the practice of financial
management. Now let’s introduce the five principles.
Principle 1: Cash Flow Is What Matters
You probably recall from your accounting classes that a company’s profits can differ dra-
matically from its cash flows, which we will review in Chapter 3. But for now understand
that cash flows, not profits, represent money that can be spent. Consequently, it is cash
flow, not profits, that determines the value of a business. For this reason when we analyze
the consequences of a managerial decision we focus on the resulting cash flows, not profits.
In the movie industry, there is a big difference between accounting profits and cash
flow. Many a movie is crowned a success and brings in plenty of cash flow for the studio but
doesn’t produce a profit. Even some of the most successful box office hits—Forrest Gump,
Coming to America, Batman, My Big Fat Greek Wedding, and the TV series Babylon 5—
realized no accounting profits at all after accounting for various movie studio costs. That’s
because “Hollywood Accounting” allows for overhead costs not associated with the movie
to be added on to the true cost of the movie. In fact, the movie Harry Potter and the Order of
the Phoenix, which grossed almost $1 billion worldwide, actually lost $167 million according
to the accountants. Was Harry Potter and the Order of the Phoenix a successful movie? It sure
was—in fact it was the 16th highest grossing film of all time. Without question, it produced
cash, but it didn’t make any profits.
There is another important point we need to make about cash flows. Recall from your
economics classes that we should always look at marginal, or incremental, cash flows
when making a financial decision. The incremental cash flow to the company as a whole is
the difference between the cash flows the company will produce both with and without the investment
it’s thinking about making. To understand this concept, let’s think about the incremental
cash flows of the Pirates of the Caribbean movies. Not only did Disney make money on the
1
rinciple
2 Understand the basic
principles of finance, their
importance, and the
importance of ethics and trust.
incremental cash flow the difference
between the cash flows a company will produce
both with and without the investment it is
thinking about making.

Chapter 1 • An Introduction to the Foundations of Financial Management 5
movies, but it also increased the number of people attracted to Disney theme parks to go
on the “Pirates of the Caribbean” ride. So, if you were to evaluate a Pirates of the Caribbean
movie, you’d want to include its impact on sales throughout the entire company.
Principle 2: Money Has a Time Value
Perhaps the most fundamental principle of finance is that money has a “time” value. Very
simply, a dollar received today is more valuable than a dollar received one year from now
because we can invest the dollar we have today to earn interest so that at the end of one year
we will have more than one dollar.
For example, suppose you have a choice of receiving $1,000 either today or one year
from now. If you decide to receive it a year from now, you will have passed up the oppor-
tunity to earn a year’s interest on the money. Economists would say you suffered an “op-
portunity loss” or an “opportunity cost.” The cost is the interest you could have earned on
the $1,000 if you invested it for one year. The concept of opportunity costs is fundamental
to the study of finance and economics. Very simply, the opportunity cost of any choice you
make is the highest-valued alternative that you had to give up when you made the choice. So if you
loan money to your brother at no interest, money that otherwise would have been loaned
to a friend for 8 percent interest (who is equally likely to repay you), then the opportunity
cost of making the loan to your brother is 8 percent.
In the study of finance, we focus on the creation and measurement of value. To measure
value, we use the concept of the time value of money to bring the future benefits and costs
of a project, measured by its cash flows, back to the present. Then, if the benefits or cash
inflows outweigh the costs, the project creates wealth and should be accepted; if the costs or
cash outflows outweigh the benefits or cash inflows, the project destroys wealth and should
be rejected. Without recognizing the existence of the time value of money, it is impossible
to evaluate projects with future benefits and costs in a meaningful way.
Principle 3: Risk Requires a Reward
Even the novice investor knows there are an unlimited number of investment alternatives to
consider. But without exception, investors will not invest if they do not expect to receive a
return on their investment. They will want a return that satisfies two requirements:
◆ A return for delaying consumption. Why would anyone make an investment that would
not at least pay them something for delaying consumption? They won’t—even if there
is no risk. In fact, investors will want to receive at least the same return that is available
for risk-free investments, such as the rate of return being earned on U.S. government
securities.
◆ An additional return for taking on risk. Investors generally don’t like risk. Thus, risky
investments are less attractive—unless they offer the prospect of higher returns. That
said, the more unsure people are about how an investment will perform, the higher the
return they will demand for making that investment. So, if you are trying to persuade
investors to put money into a risky venture you are pursuing, you will have to offer
them a higher expected rate of return.
Figure 1-1 (on page 6) depicts the basic notion that an investor’s rate of return should
equal a rate of return for delaying consumption plus an additional return for assuming
risk. For example, if you have $5,000 to invest and are considering either buying stock in
International Business Machines (IBM) or investing in a new bio-tech startup firm that has
no past record of success, you would want the startup investment to offer the prospect of
a higher expected rate of return than the investment in an established company like IBM.
Notice that we keep referring to the expected return rather than the actual return. As
investors, we have expectations about what returns our investments will earn. However, we
can’t know for certain what they will be. For example, if investors could have seen into the
future, no one would have bought stock in AEterna Zentaris, Inc. (AEZS), the late-stage
drug development company, on April 2, 2012. Why? Because on that day AEterna Zentaris
2
rinciple
3
rinciple
opportunity cost the cost of making a choice
in terms of the next best alternative that must
be foregone.

6 Part 1 • The Scope and Environment of Financial Management
reported its colon cancer treatment failed to improve survival rates in a late-stage clinical
trial. The result was that within minutes of the announcement, the company’s stock price
dropped by a whopping 66 percent.
The risk–return relationship will be a key concept as we value stocks, bonds, and pro-
posed new investment projects throughout this text. We will also spend some time deter-
mining how to measure risk. Interestingly, much of the work for which the 1990 Nobel
Prize for economics was awarded centered on the graph in Figure 1-1 and how to measure
risk. Both the graph and the risk–return relationship it depicts will reappear often in our
study of finance.
Principle 4: Market Prices Are Generally Right
To understand how securities such as bonds and stocks are valued or priced in the financial
markets, it is necessary to have an understanding of the concept of an efficient market. An
efficient market is one where the prices of the assets traded in that market fully reflect all avail-
able information at any instant in time.
Security markets such as the stock and bond markets are particularly important to our
study of finance since these markets are the place where firms can go to raise money to
finance their investments. Whether a security market such as the New York Stock Ex-
change (NYSE) is efficient depends on the speed with which newly released information
is impounded into prices. Specifically, an efficient stock market is characterized by a large
number of profit-driven individuals who act very quickly by buying (or selling) shares of
stock in response to the release of new information.
If you are wondering just how vigilant investors in the stock market are in watching for
good and bad news, consider the following set of events. While Nike (NKE) CEO William
Perez flew aboard the company’s Gulfstream jet one day in November 2005, traders on the
ground sold off a significant amount of Nike’s stock. Why? Because the plane’s landing
gear was malfunctioning, and they were watching TV coverage of the event! Before Perez
landed safely, Nike’s stock dropped 1.4 percent. Once Perez’s plane landed, Nike’s stock
price immediately bounced back. This example illustrates that in the financial market there
are ever-vigilant investors who are looking to act even in the anticipation of the release of
new information.
Another example of the speed with which stock prices react to new information deals
with Disney. Beginning with Toy Story in 1995, Disney (DIS) and Pixar (PIXR) were on a roll,
making animated hits one after another, including A Bug’s Life, Toy Story 2, Monsters, Inc.,
Finding Nemo, and The Incredibles. So in 2006, the hopes for the animated movie Cars
were very high. However, in the movie’s opening weekend, it grossed only $60 million,
or about $10 million less than investors expected. How did the stock market respond? On
the Monday following the opening weekend, Disney stock opened over 2 percent lower.
4
rinciple
efficient market a market in which the prices
of securities at any instant in time fully reflect all
publicly available information about the
securities and their actual public values.
Ex
pe
ct
ed
r
et
ur
n
Additional
expected return
for taking on
added risk
Risk
Expected return
for delaying
consumption
FIGURE 1-1 The Risk–Return Trade-off

Chapter 1 • An Introduction to the Foundations of Financial Management 7
Apparently, the news of the disappointing box office receipts was reflected in Disney’s
opening stock price, even before it traded!
The key learning point here is the following: Stock market prices are a useful barometer
of the value of a firm. Specifically, managers can expect their company’s share prices to
respond quickly to investors’ assessment of their decisions. If investors on the whole agree
that the decision is a good one that creates value, then they will push up the price of the
firm’s stock to reflect that added value. On the other hand, if investors feel that a decision
is bad for share prices, then the firm’s share value will be driven down.
Unfortunately, this principle doesn’t always work perfectly in the real world. You just
need to look at the housing price bubble that helped bring on the economic downturn in
2008–2009 to realize that prices and value don’t always move in lockstep. Like it or not, the
psychological biases of individuals impact decision making, and as a result, our decision-
making process is not always rational. Behavioral finance considers this type of behavior and
takes what we already know about financial decision making and adds in human behavior
with all its apparent irrationality.
We’ll try and point out the impact of human behavior on decisions throughout our
study. But understand that the field of behavioral finance is a work in progress—we under-
stand only a small portion of what may be going on. We can say, however, that behavioral
biases have an impact on our financial decisions. As an example, people tend to be overcon-
fident and many times mistake skill for luck. As Robert Shiller, a well-known economics
professor at Yale put it, “people think they know more than they do.”1 This overconfidence
applies to their abilities, their knowledge and understanding, and forecasting the future.
Since they have confidence in their valuation estimates, they may take on more risk than
they should. These behavioral biases impact everything in finance, from investment analy-
sis, to analyzing new projects, to forecasting the future.
agency problem problems and conflicts
resulting from the separation of the
management and ownership of the firm.
1See Robert J. Shiller, Irrational Exuberance, Broadway Books, 2000, page 142.
Principle 5: Conflicts of Interest Cause Agency Problems
Throughout this book we will describe how to make financial decisions that increase the
value of a firm’s shares. However, managers do not always follow through with these deci-
sions. Often they make decisions that actually lead to a decrease in the value of the firm’s
shares. When this happens, it is frequently because the managers’ own interests are best
served by ignoring shareholder interests. In other words, there is a conflict of interest be-
tween what is best for the managers and the stockholders. For example, it may be the case
that shutting down an unprofitable plant is in the best interests of the firm’s stockholders,
but in so doing the managers will find themselves out of a job or having to transfer to a
different job. This very clear conflict of interest might lead the management of the plant to
continue running the plant at a loss.
Conflicts of interest lead to what are referred to by economists as an agency cost or
agency problem. That is, managers are the agents of the firm’s stockholders (the owners)
and if the agents do not act in the best interests of their principal, this leads to an agency
cost. Although the goal of the firm is to maximize shareholder value, in reality the agency
problem may interfere with the implementation of this goal. The agency problem results from
the separation of management and the ownership of the firm. For example, a large firm may be
run by professional managers or agents who have little or no ownership in the firm. Because
of this separation of the decision makers and owners, managers may make decisions that
are not in line with the goal of maximizing shareholder wealth. They may approach work
less energetically and attempt to benefit themselves in terms of salary and perquisites at the
expense of shareholders.
Managers might also avoid any projects that have risk associated with them—even if
they are great projects with huge potential returns and a small chance of failure. Why is
this so? Because if the project doesn’t turn out, these agents of the shareholders may lose
their jobs.
The costs associated with the agency problem are difficult to measure, but occasionally
we see the problem’s effect in the marketplace. If the market feels management is damaging
5
rinciple

8 Part 1 • The Scope and Environment of Financial Management
shareholder wealth, there may be a positive reaction in stock price to the removal of that
management. For example, on the announcement of the death of Roy Farmer, the CEO
of Farmer Brothers (FARM), a seller of coffee-related products, Farmer Brothers’ stock
price rose about 28 percent. Generally, the tragic loss of a company’s top executive raises
concerns over a leadership void, causing the share price to drop, but in the case of Farmer
Brothers, investors thought a change in management would have a positive impact on the
company.
If the firm’s management works for the owners, who are the shareholders, why doesn’t
the management get fired if it doesn’t act in the shareholders’ best interest? In theory,
the shareholders pick the corporate board of directors and the board of directors in turn
picks the management. Unfortunately, in reality the system frequently works the other
way around. Management selects the board of director nominees and then distributes the
ballots. In effect, shareholders are offered a slate of nominees selected by the management.
The end result is that management effectively selects the directors, who then may have
more allegiance to managers than to shareholders. This, in turn, sets up the potential for
agency problems, with the board of directors not monitoring managers on behalf of the
shareholders as it should.
The root cause of agency problems is conflicts of interest. Whenever they exist in busi-
ness, there is a chance that individuals will do what is in their best interests rather than the
best interests of the organization. For example, in 2000 Edgerrin James was a running back
for the Indianapolis Colts and was told by his coach to get a first down and then fall down.
That way the Colts wouldn’t be accused of running up the score against a team they were
already beating badly. However, since James’ contract included incentive payments asso-
ciated with rushing yards and touchdowns, he acted in his own self-interest and ran for a
touchdown on the very next play.
We will spend considerable time discussing monitoring managers and trying to align
their interests with those of shareholders. As an example, managers can be monitored by rat-
ing agencies and by auditing financial statements, and compensation packages may be used
to align the interests of managers and shareholders. Additionally, the interests of managers
and shareholders can be aligned by establishing management stock options, bonuses, and
perquisites that are directly tied to how closely managers’ decisions coincide with the interest
of shareholders. In other words, what is good for shareholders must also be good for managers.
If that is not the case, managers will make decisions in their best interest rather than
maximizing shareholder wealth.
The Current Global Financial Crisis
Beginning in 2007 the United States experienced its most severe financial crisis since the
Great Depression of the 1930s. As a result, some financial institutions collapsed while the
government bailed others out, unemployment skyrocketed, the stock market plummeted,
and the United States entered into a recession. Although the recession is now officially
over, the economy still faces the lingering effects of the financial crisis that continue in the
form of both a high rate of unemployment and a dramatic rise in our country’s debt. Europe
continues to face a financial crisis of its own. Many members of the European Union (EU)
are experiencing severe budget problems, including Greece, Italy, Ireland, Portugal, and
Spain. These nations are all unable to balance their budgets and face a very real prospect of
defaulting on payments tied to government loans.
While many factors contributed to the financial crisis, the most immediate cause has
been attributed to the collapse of the real estate market in the United States and the result-
ing real estate loan (mortgage) defaults. The focus of the loan defaults has been on what
are commonly referred to as subprime loans. These are loans made to borrowers whose
ability to repay them is highly doubtful. When the market for real estate began to falter in
2006, many of the homebuyers with subprime mortgages began to default. As the economy
contracted during the recession, people lost their jobs and could no longer make their
mortgage loan payments, resulting in even more defaults.
To complicate the problem, most real estate mortgages were packaged in portfolios
and resold to investors around the world. This process of packaging mortgages is called

Chapter 1 • An Introduction to the Foundations of Financial Management 9
securitization. Basically, securitization is a very useful tool for increasing the supply of new mon-
ey that can be lent to new homebuyers. Here’s how mortgages are securitized: First, home-
buyers borrow money by taking out a mortgage to finance a home purchase. The lender,
generally a bank, savings and loan, or mortgage broker that made the loan, then sells the mort-
gage to another firm or financial institution that pools together a portfolio of many different
mortgages. The purchase of the pool of mortgages is financed through the sale of securities
(called mortgage-backed securities, or MBS) that are sold to investors who can hold them as an
investment or resell them to other investors. This process allows the mortgage bank or other
financial institution that made the original mortgage loan to get its money back out of the loan
and lend it to someone else. Thus, securitization provides liquidity to the mortgage market and
makes it possible for banks to loan more money to homebuyers.
Ok, so what’s the catch? As long as lenders properly screen the mortgages to make
sure the borrowers are willing and able to repay their home loans and real estate values
remain higher than the amount owed, everything works fine. However, if lenders make
loans to individuals who really cannot afford to make the payments and real estate
prices drop precipitously as they began to do in 2006, there will be problems and many
mortgages (especially those where the amount of the loan was a very high percentage of
the property value) will be “under water.” That is, the homeowner will owe more than
the home is worth. When this occurs homeowners may start to default on their mort-
gage loans. This is especially true when the economy goes into a recession and people
lose their jobs and, correspondingly, the ability to make their mortgage payments. This
was the scenario in 2006. In essence, this was a perfect storm of bad loans, falling hous-
ing prices, and a contracting economy.
Where are we now? As of this writing, in 2012, the recession is officially over, having
ended in 2009; however, despite this pronouncement there is evidence that the economy
is still not back to normal. Unemployment numbers are still higher than historical norms
for nonrecession years. Moreover, these unemployment numbers do not accurately reflect
what has become known as underemployment, whereby individuals are taking jobs but
these jobs do not take advantage of the individuals’ employment credentials (for example,
college professors driving taxi cabs). Finally, the risk of financial crisis in many European
countries remains at a very high level. Despite a series of financial “fixes” to the imbalances
in the budgets of Greece, Spain, and several other European countries, for example, the
budgetary woes in Europe continue into 2012.
Avoiding Financial Crisis—Back to the Principles
Four significant economic events that have occurred during the last decade all point to the
importance of keeping our eye closely affixed to the five principles of finance: the dot.com
bubble; the accounting scandals headlined by Enron, WorldCom, and Bernie Madoff; the
housing bubble; and, finally, the recent economic crisis. Specifically, the problems that
firms encounter in times of crisis are often brought on by, and made worse as a result of,
not paying close attention to the foundational principles of finance. To illustrate, consider
the following:
◆ Forgetting Principle 1: Cash Flow Is What Matters (Focusing on earnings instead
of cash flow). The financial fraud committed by Bernie Madoff, WorldCom, and others
at the turn of the 21st century was a direct result of managerial efforts to manage the firm’s
reported earnings to the detriment of the firm’s cash flows. The belief in the importance of
current period earnings as the most critical determinant of the market valuation
of the firm’s shares led some firms to sacrifice future cash flows in order to maintain
the illusion of high and growing earnings.
◆ Forgetting Principle 2: Money Has a Time Value (Focusing on the short run). When
trying to put in place a system that would align the interests of managers and sharehold-
ers, many firms tied managerial compensation to short-run performance. Consequently,
the focus shifted in many firms from what was best in the long run to what was best in
the short run.

10 Part 1 • The Scope and Environment of Financial Management
◆ Forgetting Principle 3: Risk Requires a Reward (Excessive risk taking due to under-
estimation of risk). Relying on historical evidence, managers often underestimated the
real risks that their decisions entailed. This underestimation of the underlying riskiness
of their decisions led managers to borrow excessively. This excessive use of borrowed
money (or financial leverage) led to financial disaster and bankruptcy for many firms as
the economy slipped into recession. Moreover, the financial crisis was exacerbated by
the fact that many times companies simply didn’t understand how much risk they were
taking on. For example, AIG (AIG), the giant insurance company that the government
bailed out, was involved in investments whose value is based on the price of oil in 50
years. Let’s face it, no one knows what the price of oil will be in a half a century—being
involved in this type of investment is blind risk.
◆ Forgetting Principle 4: Market Prices Are Generally Right (Ignoring the efficiency
of financial markets). Huge numbers of so-called hedge funds sprang up over the last
decade and entered into investment strategies that presupposed that security prices
could be predicted. Many of these same firms borrowed heavily in an effort to boost
their returns and later discovered that security markets were a lot smarter than they
thought and consequently realized huge losses on their highly leveraged portfolios.
◆ Forgetting Principle 5: Conflicts of Interest Cause Agency Problems (Executive
compensation is out of control). Executive compensation in the United States is
dominated by performance-based compensation in the form of stock options and
grants. The use of these forms of compensation over the last decade in the face of
one of the longest bull markets in history has resulted in tremendous growth in
executive compensation. The motivations behind these methods of compensation
are primarily tied to a desire to make managers behave like stockholders (owners).
Unfortunately, this practice has resulted in pay for nonperformance in many cases
and a feeling among the general public that executive compensation is excessive.
We are reminded again that solving the principal–agent problem is not easy to do,
but it has to be done!
In this edition of Foundations of Finance we believe that now, perhaps more than at any
time in our memory, adhering to the fundamental principles of finance is critical. In addi-
tion, to further emphasize the “back to principles theme” we include a feature called “Cau-
tionary Tales” that highlights specific examples where a failure to adhere to one or more of
the five principles led to problems.
The Essential Elements of Ethics and Trust
While not one of the five principles of finance, ethics and trust are essential elements of the
business world. In fact, without ethics and trust nothing works. This statement could be
applied to almost everything in life. Virtually everything we do involves some dependence
on others. Although businesses frequently try to describe the rights and obligations of their
dealings with others using contracts, it is impossible to write a perfect contract. Conse-
quently, business dealings between people and firms ultimately depend on the willingness
of the parties to trust one another.
Ethics or, rather, a lack of ethics in finance is a recurring theme in the news. Finan-
cial scandals at Enron, WorldCom, Arthur Andersen, and Bernard L. Madoff Investment
Securities demonstrate the fact that ethical lapses are not forgiven in the business world.
Not only is acting in an ethical manner morally correct, it is a necessary ingredient to long-
term business and personal success.
Ethical behavior is easily defined. It’s simply “doing the right thing.” But what is the
right thing? For example, Bristol-Myers Squibb (BMY) gives away heart medication to peo-
ple who can’t afford it. Clearly, the firm’s management feels this is socially responsible and
the right thing to do. But is it? Should companies give away money and products or should
they leave such acts of benevolence to the firm’s shareholders? Perhaps the shareholders
should decide if they personally want to donate some of their wealth to worthy causes.
Like most ethical questions, there is no clear-cut answer to the dilemma posited above.
We acknowledge that people have a right to disagree about what “doing the right thing”

Chapter 1 • An Introduction to the Foundations of Financial Management 11
means and that each of us has his or her personal set of values. These values form the basis
for what we think is right and wrong. Moreover, every society adopts a set of rules or laws
that prescribe what it believes constitutes “doing the right thing.” In a sense, we can think
of laws as a set of rules that reflect the values of a society as a whole.
You might ask yourself, “As long as I’m not breaking society’s laws, why should I care
about ethics?” The answer to this question lies in consequences. Everyone makes errors
of judgment in business, which is to be expected in an uncertain world. But ethical errors
are different. Even if they don’t result in anyone going to jail, they tend to end careers and
thereby terminate future opportunities. Why? Because unethical behavior destroys trust,
and businesses cannot function without a certain degree of trust. Throughout this book, we
will point out some of the ethical pitfalls that have tripped up managers.
Concept Check
1. According to Principle 3, how do investors decide where to invest their money?
2. What is an efficient market?
3. What is the agency problem and why does it occur?
4. Why are ethics and trust important in business?
The Role of Finance in Business
Finance is the study of how people and businesses evaluate investments and raise capital
to fund them. Our interpretation of an investment is quite broad. When Apple designed
its Apple TV, it was clearly making a long-term investment. The firm had to devote
considerable expenses to designing, producing, and marketing the device with the hope
that it would eventually become an essential living room companion. Similarly, Apple
is making an investment decision whenever it hires a fresh new graduate, knowing that
it will be paying a salary for at least 6 months before the employee will have much to
contribute.
Thus, there are three basic types of issues that are addressed by the study of finance:
1. What long-term investments should the firm undertake? This area of finance is gener-
ally referred to as capital budgeting.
2. How should the firm raise money to fund these investments? The firm’s funding
choices are generally referred to as capital structure decisions.
3. How can the firm best manage its cash flows as they arise in its day-to-day operations?
This area of finance is generally referred to as working capital management.
We’ll be looking at each of these three areas of business finance—capital budgeting,
capital structure, and working capital management—in the chapters ahead.
Why Study Finance?
Even if you’re not planning a career in finance, a working knowledge of finance will take
you far in both your personal and professional life.
Those interested in management will need to study topics like strategic planning, per-
sonnel, organizational behavior, and human relations, all of which involve spending money
today in the hopes of generating more money in the future. For example, GM made a stra-
tegic decision to introduce an electric car and invested $740 million to produce the Chevy
Volt, only to find car buyers balk at the $40,000 sticker price. Similarly, marketing majors
need to understand and decide how aggressively to price products and the amount to spend
on advertising. Since aggressive marketing today costs money but allows firms to reap re-
wards in the future, it should be viewed as an investment that the firm needs to finance.
Production and operations management majors need to understand how best to manage a
firm’s production and control its inventory and supply chain. These are all topics that in-
volve risky choices that relate to the management of money over time, which is the central
3 Describe the role of finance in
business.
capital budgeting the decision-making
process with respect to investment in fixed assets.
capital structure decision the
decision- making process with funding choices
and the mix of long-term sources of funds.
working capital management the
management of the firm’s current assets and
short-term financing.

12 Part 1 • The Scope and Environment of Financial Management
focus of finance. While finance is primarily about the management of money, a key component of
finance is the management and interpretation of information. Indeed, if you pursue a career in
management information systems or accounting, the finance managers are likely to be your
most important clients. For the student with entrepreneurial aspirations, an understanding
of finance is essential—after all, if you can’t manage your finances, you won’t be in business
very long.
Finally, an understanding of finance is important to you as an individual. The fact that you
are reading this book indicates that you understand the importance of investing in yourself. By
obtaining a higher education degree, you are clearly making sacrifices in the hopes of making
yourself more employable and improving your chances of having a rewarding and challeng-
ing career. Some of you are relying on your own earnings and the earnings of your parents to
finance your education, whereas others are raising money or borrowing it from the financial
markets, or institutions and procedures that facilitate financial transactions.
Although the primary focus of this book is on developing corporate finance tools that
are used in business, much of the logic and tools we develop apply to the decisions you will
have to make regarding your own personal finances. Financial decisions are everywhere,
both for you and the firm you work for. In the future, both your business and personal life
will be spent in the world of finance. Since you’re going to be living in that world, it’s time
to learn the basics about it.
The Role of the Financial Manager
A firm can assume many different organizational structures. Figure 1-2 shows a typical pre-
sentation of how the finance area fits into a firm. The vice president for finance, also called
the chief financial officer (CFO), serves under the firm’s chief executive officer (CEO)
and is responsible for overseeing financial planning, strategic planning, and controlling the
firm’s cash flow. Typically, a treasurer and controller serve under the CFO. In a smaller
financial markets those institutions and
procedures that facilitate transactions in all types
of financial claims.
FIGURE 1-2 How the Finance Area Fits into a Firm
Board of Directors
Chief Executive Officer
(CEO)
Vice President—Finance
or
Chief Financial Officer (CFO)
Duties:
Oversee financial planning
Strategic planning
Control cash flow
Duties:
Cash management
Credit management
Capital expenditures
Raising capital
Financial planning
Management of foreign currencies
Duties:
Taxes
Financial statements
Cost accounting
Data processing
Vice President—Marketing
Treasurer Controller
Vice President—Production
and Operations

Chapter 1 • An Introduction to the Foundations of Financial Management 13
firm, the same person may fill both roles, with just one office handling all the duties. The
treasurer generally handles the firm’s financial activities, including cash and credit manage-
ment, making capital expenditure decisions, raising funds, financial planning, and managing
any foreign currency received by the firm. The controller is responsible for managing the
firm’s accounting duties, including producing financial statements, cost accounting, paying
taxes, and gathering and monitoring the data necessary to oversee the firm’s financial well-
being. In this textbook, we focus on the duties generally associated with the treasurer and
on how investment decisions are made.
Concept Check
1. What are the basic types of issues that are addressed by the study of finance?
2. What are the duties of a treasurer? Of a controller?
The Legal Forms of Business Organization
In the chapters ahead we focus on financial decisions for corporations because, although the
corporation is not the only legal form of business available, it is the most logical choice for
a firm that is large or growing. It is also the dominant business form in terms of sales in this
country. In this section we explain why this is so.
Although numerous and diverse, the legal forms of business organization fall into three
categories: the sole proprietorship, the partnership, and the corporation. To understand
the basic differences between each form, we need to define each one and understand its
advantages and disadvantages. As the firm grows, the advantages of the corporation begin
to dominate. As a result, most large firms take on the corporate form.
Sole Proprietorships
A sole proprietorship is a business owned by an individual. The owner retains the title
to the business’s assets and is responsible, generally without limitation, for the liabili-
ties incurred. The proprietor is entitled to the profits from the business but must also
absorb any losses. This form of business is initiated by the mere act of beginning the
business operations. Typically, no legal requirement must be met in starting the opera-
tion, particularly if the proprietor is conducting the business in his or her own name.
If a special name is used, an assumed-name certificate should be filed, requiring a small
registration fee. Termination of the sole proprietorship occurs on the owner’s death or
by the owner’s choice. Briefly stated, the sole proprietorship is for all practical purposes
the absence of any formal legal business structure.
Partnerships
The primary difference between a partnership and a sole proprietorship is that the partner-
ship has more than one owner. A partnership is an association of two or more persons coming
together as co-owners for the purpose of operating a business for profit. Partnerships fall into two
types: (1) general partnerships and (2) limited partnerships.
General Partnerships In a general partnership each partner is fully responsible for the
liabilities incurred by the partnership. Thus, any partner’s faulty conduct, even having the
appearance of relating to the firm’s business, renders the remaining partners liable as well.
The relationship among partners is dictated entirely by the partnership agreement, which
may be an oral commitment or a formal document.
Limited Partnerships In addition to the general partnership, in which all partners are
jointly liable without limitation, many states provide for limited partnerships. The state
statutes permit one or more of the partners to have limited liability, restricted to the amount of capi-
tal invested in the partnership. Several conditions must be met to qualify as a limited partner.
First, at least one general partner must have unlimited liability. Second, the names of the
limited partners may not appear in the name of the firm. Third, the limited partners may
4 Distinguish between the
different legal forms of
business.
sole proprietorship a business owned by a
single individual.
partnership an association of two or more
individuals joining together as co-owners to
operate a business for profit.
general partnership a partnership in which
all partners are fully liable for the indebtedness
incurred by the partnership.
limited partnership a partnership in which
one or more of the partners has limited liability,
restricted to the amount of capital he or she
invests in the partnership.

14 Part 1 • The Scope and Environment of Financial Management
not participate in the management of the business. Thus, a limited partnership provides
limited liability for a partner who is purely an investor.
Corporations
The corporation has been a significant factor in the economic development of the United
States. As early as 1819, U.S. Supreme Court Chief Justice John Marshall set forth the
legal definition of a corporation as “an artificial being, invisible, intangible, and existing
only in the contemplation of law.”2 This entity legally functions separate and apart from its
owners. As such, the corporation can individually sue and be sued and purchase, sell, or
own property, and its personnel are subject to criminal punishment for crimes. However,
despite this legal separation, the corporation is composed of owners who dictate its direc-
tion and policies. The owners elect a board of directors, whose members in turn select
individuals to serve as corporate officers, including the company’s president, vice presi-
dent, secretary, and treasurer. Ownership is reflected in common stock certificates, each
designating the number of shares owned by its holder. The number of shares owned rela-
tive to the total number of shares outstanding determines the stockholder’s proportionate
ownership in the business. Because the shares are transferable, ownership in a corpora-
tion may be changed by a shareholder simply remitting the shares to a new shareholder.
The shareholder’s liability is confined to the amount of the investment in the company,
thereby preventing creditors from confiscating stockholders’ personal assets in settle-
ment of unresolved claims. This is an extremely important advantage of a corporation.
After all, would you be willing to invest in USAirways if you would be held liable if one
of its planes crashed? Finally, the life of a corporation is not dependent on the status of
the investors. The death or withdrawal of an investor does not affect the continuity of the
corporation. Its managers continue to run the corporation when stock is sold or when it
is passed on through inheritance.
2The Trustees of Dartmouth College v. Woodard, 4 Wheaton 636 (1819).
Organizational Form and Taxes: The Double Taxation
on Dividends
Historically, one of the drawbacks of the corporate form was the double taxation of divi-
dends. This occurs when a corporation earns a profit, pays taxes on those profits (the first
taxation of earnings), and pays some of those profits back to the shareholders in the form
of dividends, and then the shareholders pay personal income taxes on those dividends (the
second taxation of those earnings). This double taxation of earnings does not take place
with proprietorships and partnerships. Needless to say, that had been a major disadvantage
of corporations. However, in an attempt to stimulate the economy, the tax rate on dividends
was cut with the passage of the Tax Act of 2003.
Before the 2003 tax changes, you paid your regular, personal income tax rate on your
dividend income, which could be as high as 35 percent. However, with the new law, qualified
dividends from domestic corporations and qualified foreign corporations are now taxed
at a maximum rate of 15 percent. Moreover, if your personal income puts you in the
10 percent or 15 percent income rate bracket, your dividends will be taxed at only 5 per-
cent, and in 2008, this rate dropped to 0 percent. Unless Congress takes further action, this
tax break on dividends will end after 2012 and individuals will once again be taxed at their
regular personal tax rate.
S-Corporations and Limited Liability Companies (LLCs)
One of the problems that entrepreneurs and small business owners face is that they need
the benefits of the corporate form to expand, but the double taxation of earnings that comes
with the corporate form makes it difficult to accumulate the necessary wealth for expansion.
Fortunately, the government recognizes this problem and has provided two business forms
corporation an entity that legally functions
separate and apart from its owners.

Chapter 1 • An Introduction to the Foundations of Financial Management 15
that are, in effect, crosses between a partnership and a corporation with the tax benefits of
partnerships (no double taxation of earnings) and the limited liability benefit of corpora-
tions (your liability is limited to what you invest).
The first is the S-corporation, which provides limited liability while allowing the business’s
owners to be taxed as if they were a partnership—that is, distributions back to the owners are
not taxed twice as is the case with dividends distributed by regular corporations. Unfortu-
nately, a number of restrictions accompany the S-corporation that detract from the desir-
ability of this business form. Thus, an S-corporation cannot be used for a joint venture
between two corporations. As a result, this business form has been losing ground in recent
years in favor of the limited liability company.
The limited liability company (LLC) is also a cross between a partnership and a cor-
poration. Just as with the S-corporation, the LLC retains limited liability for its owners
but runs and is taxed like a partnership. In general, it provides more flexibility than the
S-corporation. For example, corporations can be owners in an LLC. However, because
LLCs operate under state laws, both states and the IRS have rules for what qualifies as an
LLC, and different states have different rules. But the bottom line in all this is that the LLC
must not look too much like a corporation or it will be taxed as one.
Which Organizational Form Should Be Chosen?
Owners of new businesses have some important decisions to make in choosing an organi-
zational form. Whereas each business form seems to have some advantages over the others,
the advantages of the corporation begin to dominate as the firm grows and needs access to
the capital markets to raise funds.
Because of the limited liability, the ease of transferring ownership through the sale of
common shares, and the flexibility in dividing the shares, the corporation is the ideal busi-
ness entity in terms of attracting new capital. In contrast, the unlimited liabilities of the sole
proprietorship and the general partnership are deterrents to raising equity capital. Between
the extremes, the limited partnership does provide limited liability for limited partners,
which has a tendency to attract wealthy investors. However, the impracticality of having a
large number of partners and the restricted marketability of an interest in a partnership pre-
vent this form of organization from competing effectively with the corporation. Therefore,
when developing our decision models we assume we are dealing with the corporate form
and corporate tax codes.
Concept Check
1. What are the primary differences between a sole proprietorship, a partnership, and a corporation?
2. Explain why large and growing firms tend to choose the corporate form.
3. What is an LLC?
Finance and the Multinational Firm:
The New Role
In the search for profits, U.S. corporations have been forced to look beyond our coun-
try’s borders. This movement has been spurred on by the collapse of communism and
the acceptance of the free market system in third-world countries. All this has taken
place at a time when information technology has experienced a revolution brought
on by the personal computer and the Internet. Concurrently, the United States went
through an unprecedented period of deregulation of industries. These changes resulted
in the opening of new international markets, and U.S. firms experienced a period of
price competition here at home that made it imperative that businesses look across
borders for investment opportunities. The end result is that many U.S. companies, in-
cluding General Electric, IBM, Walt Disney, and American Express, have restructured
their operations to expand internationally.
S-corporation a corporation that, because of
specific qualifications, is taxed as though it were
a partnership.
limited liability company (LLC) a cross
between a partnership and a corporation under
which the owners retain limited liability but the
company is run and is taxed like a partnership.
5 Explain what has led to the
era of the multinational
corporation.

16 Part 1 • The Scope and Environment of Financial Management
The bottom line is what you think of as a U.S. firm may be much more of a multina-
tional firm than you would expect. For example, Coca-Cola earns over 80 percent of its
profits from overseas sales and more money from its sales in Japan than it does from all its
domestic sales. This is not uncommon. In fact, in 2011, close to 50 percent of the sales of
S&P 500 listed companies came from outside the United States.
In addition to U.S. firms venturing abroad, foreign firms have also made their mark
in the United States. You need only look to the auto industry to see what effects the
entrance of Toyota, Honda, Nissan, BMW, and other foreign car manufacturers have had
on the industry. In addition, foreigners have bought and now own such companies as Brooks
Brothers, RCA, Pillsbury, A&P, 20th Century Fox, Columbia Pictures, and Firestone Tire
& Rubber. Consequently, even if we wanted to, we couldn’t keep all our attention focused
on the United States, and even more important, we wouldn’t want to ignore the opportuni-
ties that are available across international borders.
Concept Check
1. What has brought on the era of the multinational corporation?
2. Has looking beyond U.S. borders been a profitable experience for U.S. corporations?
Chapter Summaries
Identify the goal of the firm. (pgs. 3–4)
SUMMARy: This chapter outlines the framework for the maintenance and creation of share-
holder wealth, which should be the goal of the firm and its managers. The goal of maximization
of shareholder wealth is chosen because it deals well with uncertainty and time in a real-world
environment. As a result, the maximization of shareholder wealth is found to be the proper
goal for the firm.
Understand the basic principles of finance, their importance, and the
importance of ethics and trust. (pgs. 4–11)
SUMMARy: The five basic principles of finance are:
1. Cash Flow Is What Matters—Incremental cash received and not accounting profits drives value.
2. Money Has a Time Value—A dollar received today is more valuable to the recipient than a
dollar received in the future.
3. Risk Requires a Reward—The greater the risk of an investment, the higher will be the inves-
tor’s required rate of return, and, other things remaining the same, the lower will be its value.
4. Market Prices Are Generally Right—For example, product market prices are often slower
to react to important news than are prices in financial markets, which tend to be very efficient
and quick to respond to news.
5. Conflicts of Interest Cause Agency Problems—Large firms are typically run by pro-
fessional managers who own a small fraction of the firms’ equity. The individual actions
of these managers are often motivated by self-interest, which may result in managers not
acting in the best interests of the firm’s owners. When this happens, the firm’s owners will
lose value.
While not one of the five principles of finance, ethics and trust are also essential elements of
the business world, and without them, nothing works.
1
2

Describe the role of finance in business. (pgs. 11–13)
Summary: Finance is the study of how people and businesses evaluate investments and raise capi-
tal to fund them. There are three basic types of issues that are addressed by the study of finance: (1)
What long-term investments should the firm undertake? This area of finance is generally referred
to as capital budgeting. (2) How should the firm raise money to fund these investments? The firm’s
funding choices are generally referred to as capital structure decisions. (3) How can the firm best
manage its cash flows as they arise in its day-to-day operations? This area of finance is generally
referred to as working capital management.
Key TermS
3
Capital budgeting, page 11 The decision-
making process with respect to investment in
fixed assets.
Capital structure decision, page 11 The
decision-making process with funding choices
and the mix of long-term sources of funds.
Working capital management, page 11 The
management of the firm’s current assets and
short-term financing.
Financial markets, page 12 Those institu-
tions and procedures that facilitate transactions
in all types of financial claims.
Distinguish between the different legal forms of business. (pgs. 13–15)
Summary: The legal forms of business are examined. The sole proprietorship is a business opera-
tion owned and managed by an individual. Initiating this form of business is simple and generally
does not involve any substantial organizational costs. The proprietor has complete control of the
firm but must be willing to assume full responsibility for its outcomes.
The general partnership, which is simply a coming together of two or more individuals, is similar
to the sole proprietorship. The limited partnership is another form of partnership sanctioned by
states to permit all but one of the partners to have limited liability if this is agreeable to all partners.
The corporation increases the flow of capital from public investors to the business community.
Although larger organizational costs and regulations are imposed on this legal entity, the corpora-
tion is more conducive to raising large amounts of capital. Limited liability, continuity of life, and
ease of transfer in ownership, which increase the marketability of the investment, have contributed
greatly in attracting large numbers of investors to the corporate environment. The formal control
of the corporation is vested in the parties who own the greatest number of shares. However, day-
to-day operations are managed by the corporate officers, who theoretically serve on behalf of the
firm’s stockholders.
Key TermS
4
Key TermS
Incremental cash flow, page 4 The difference
between the cash flows a company will produce
both with and without the investment it is thinking
about making.
Opportunity cost, page 5 The cost of making
a choice in terms of the next best alternative that
must be foregone.
Efficient market, page 6 A market in which
the prices of securities at any instant in time fully
reflect all publicly available information about the
securities and their actual public values.
Agency problem, page 7 Problems and
conflicts resulting from the separation of the
management and ownership of the firm.
Sole proprietorship, page 13 A business
owned by a single individual.
Partnership, page 13 An association of two or
more individuals joining together as co-owners
to operate a business for profit.
General partnership, page 13 A partner-
ship in which all partners are fully liable for
the indebtedness incurred by the partnership.
Limited partnership, page 13 A partnership
in which one or more of the partners has
limited liability, restricted to the amount of
capital he or she invests in the partnership.
Corporation, page 14 An entity that legally
functions separate and apart from its owners.
S-corporation, page 15 A corporation that,
because of specific qualifications, is taxed as
though it were a partnership.
Chapter 1 • An Introduction to the Foundations of Financial Management 17

Explain what has led to the era of the multinational corporation. (pg. 15)
Summary: With the collapse of communism and the acceptance of the free market system in third-
world countries, U.S. firms have been spurred on to look beyond their own boundaries for new busi-
ness. The end result has been that it is not uncommon for major U.S. companies to earn over half their
income from sales abroad. Foreign firms are also increasingly investing in the United States.
review Questions
All Review Questions are available in MyFinanceLab.
1-1. What are some of the problems involved in implementing the goal of maximization of share-
holder wealth?
1-2. Firms often involve themselves in projects that do not result directly in profits. For example,
Apple, which we featured in the chapter introduction, donated $50 million to Stanford University
hospitals and another $50 million to the African aid organization (Product) RED, a charity fighting
against AIDS, tuberculosis, and malaria. Do these projects contradict the goal of maximization of
shareholder wealth? Why or why not?
1-3. What is the relationship between financial decision making and risk and return? Would all
financial managers view risk–return trade-offs similarly?
1-4. What is the agency problem and how might it impact the goal of maximization of shareholder
wealth?
1-5. Define (a) sole proprietorship, (b) partnership, and (c) corporation.
1-6. Identify the primary characteristics of each form of legal organization.
1-7. Using the following criteria, specify the legal form of business that is favored: (a) organiza-
tional requirements and costs, (b) liability of the owners, (c) the continuity of the business, (d) the
transferability of ownership, (e) management control and regulations, (f) the ability to raise capital,
and (g) income taxes.
1-8. There are a lot of great business majors. Check out the Careers in Business Web site at
www.careers-in-business.com. It covers not only finance but also marketing, accounting, and man-
agement. Find out about and provide a short write-up describing the opportunities investment
banking and financial planning offer.
1-9. Like it or not, ethical problems seem to crop up all the time in finance. Some of the worst
financial scandals are examined at http://projects.exeter.ac.uk/RDavies/arian/scandals/classic.
html. Take a look at the write-ups dealing with “The Credit Crunch,” “The Dot-Com Bubble and
Investment Banks,” and “Bernard L. Madoff Investment Securities.” Provide a short write-up on
these events.
1-10. We know that if a corporation is to maximize shareholder wealth, the interests of the manag-
ers and the shareholders must be aligned. The simplest way to align these interests is to structure
executive compensation packages appropriately to encourage managers to act in the best interests
of shareholders through stock and option awards. However, has executive compensation gotten
out of control? Take a look at the Executive Pay Watch Web site at www.aflcio.org/corporate-
watch/paywatch to see to whom top salaries have gone (click on “100 Highest-paid CEOs” on the
right-hand side of the page). What are the most recent total compensation packages for the head of
Oracle (ORCL), Home Depot (HD), Disney (DIS), and ExxonMobil (XOM)? (Hint: you’ll want
to look in the CEO Pay Database in the Executive Pay Watch.)
mini Case
This Mini Case is available in MyFinanceLab.
The final stage in the interview process for an assistant financial analyst at Caledonia Products
involves a test of your understanding of basic financial concepts. You are given the following
5
Limited liability company (LLC),
page 15 A cross between a partnership and
a corporation under which the owners retain
limited liability but the company is run and is
taxed like a partnership.
18 Part 1 • The Scope and Environment of Financial Management

www.careers-in-business.com

http://projects.exeter.ac.uk/RDavies/arian/scandals/classic.html

www.aflcio.org/corporatewatch/paywatch

memorandum and asked to respond to the questions. Whether you are offered a position at Cale-
donia will depend on the accuracy of your response.
To: Applicants for the position of Financial Analyst
From: Mr. V. Morrison, CEO, Caledonia Products
Re: A test of your understanding of basic financial concepts and of the corporate tax code
Please respond to the following questions:
a. What is the appropriate goal for the firm and why?
b. What does the risk–return trade-off mean?
c. Why are we interested in cash flows rather than accounting profits in determining the value
of an asset?
d. What is an efficient market and what are the implications of efficient markets for us?
e. What is the cause of the agency problem and how do we try to solve it?
f. What do ethics and ethical behavior have to do with finance?
g. Define (1) sole proprietorship, (2) partnership, and (3) corporation.
Chapter 1 • An Introduction to the Foundations of Financial Management 19

The Financial Markets
and Interest Rates
Learning Objectives
1 Describe key components of the U.S. financial market Financing of Business: The Movement of
system and the financing of business. Funds Through the Economy
2 Understand how funds are raised in the capital markets. Selling Securities to the Public
3 Be acquainted with recent rates of return. Rates of Return in the Financial Markets
4 Explain the fundamentals of interest rate Interest Rate Determinants in a Nutshell
determination and the popular theories of
the term structure of interest rates.
20
Back in 1995, when they first met, Larry Page and Sergey Brin were not particularly fond of one another. Larry
was on a weekend visit to Stanford University, and Sergey was in a group of students assigned to show him
around. Nonetheless, in short time the two began to collaborate and even built their own computer housings
in Larry’s dorm room. That computer housing later became Google’s first data center. From there things didn’t
move as smoothly as one might expect, there just wasn’t the interest from the search-engine players of the
day, so Larry and Sergey decided to go it alone. Stuck in a dorm room with maxed-out credit cards, the problem
they faced was money—they didn’t have any. So they put together a business plan and went looking for money.
Fortunately for all of us who use Google today, they met up with one of the founders of Sun Microsystems, and
after a short demo he had to run off somewhere and upon leaving said, “Instead of us discussing all the details,
why don’t I just write you a check?” It was made out to Google Inc. and was for $100,000.
With that, Google Inc. (GOOG) was founded, and over the next 10 years it became anything but a conven-
tional company, with an official motto of “don’t be evil”; a goal to make the world a better place; on-site meals
prepared by a former caterer for the Grateful Dead; lava lamps; and a fleet of Segways to move employees
about the Google campus to roller-hockey games in the parking lot and to other on-site diversions. It was not
unexpected that when Google needed more money in 2004 it would raise that money in an unusual way—
through a “Dutch auction.” With a Dutch auction investors submit bids, saying how many shares they’d like and
at what price. Next, Google used these bids to calculate an issue price that was just low enough to ensure that
all the shares were sold, and everyone who bid at least that price got to buy shares at the issue price.
E ventually, Google settled on an issue price of $85 per share, and on August 19, 2004, it raised $1.76 billion dollars.
How did those initial investors do? On the first day of trading Google’s shares rose by 18 percent, and by mid-March
2

2121
2005 the price of Google stock
had risen to about $340 per share!
In September 2005, Google went
back to the financial markets and
sold another 14.18 million shares
at $295 per share, and by August
2012 it was selling at around $641
per share.
As you read this chapter you
will learn about how funds are
raised in the financial markets.
This will help you, as an emerging
business executive specializing in
accounting, finance, marketing, or strategy, understand the basics of acquiring financial capital in
the funds marketplace.
Long-term sources of financing, such as bonds and common stock, are raised in the capital
markets. By the term capital markets, we mean all the financial institutions that help a busi-
ness raise long-term capital, where “long term” is defined as a security with a maturity date of
more than one year. After all, most companies are in the business of selling products and
services to their customers and do not have the expertise on their own to raise money to
finance the business. Examples of these financial institutions that you may have heard of
would include Bank of America (BAC), Goldman Sachs (GS), Citigroup (C), Morgan Stan-
ley (MS), UBS AG (UBS), and Deutsche Bank (DB).
This chapter focuses on the procedures by which businesses raise money in the capital
markets. It helps us understand how the capital markets work. We will introduce the logic
of how investors determine their required rate of return for making an investment. In ad-
dition, we will study the historical rates of returns in the capital markets so that we have a
perspective on what to expect. This knowledge of financial market history will permit you
as both a financial manager and an investor to realize that earning, say, a 40 percent annual
return on a common stock investment does not occur very often.
As you work through this chapter, be on the lookout for direct applications of several
of our principles from Chapter 1 that form the basics of business financial management.
Specifically, your attention will be directed to: Principle 3: Risk Requires a Reward and
Principle 4: Market Prices Are Generally Right.
Financing of Business: The Movement of
Funds Through the Economy
Financial markets play a critical role in a capitalist economy. In fact, when money quit flow-
ing through the financial markets in 2008, our economy ground to a halt. When our econ-
omy is healthy, funds move from saving-surplus units—that is, those who spend less money
than they take in—to savings-deficit units—that is, those who have a need for additional
funding. What are some examples of savings-deficit units? Our federal government, which
is running a huge deficit, takes much less in from taxes than it is spending. Hulu, the online
video service, would like to build new facilities but does not have the $50 million it needs
to fund the expansion. Rebecca Swank, the sole proprietor of the Sip and Stitch, a yarn and
coffee shop, would like to open a second store but needs $100,000 to finance a second shop.
Emily and Michael Dimmick would like to buy a house for $240,000 but have only $50,000
1 Describe key components
of the U.S. financial market
system and the financing of
business.
capital markets all institutions and
procedures that facilitate transactions in
long-term financial instruments.

22 Part 1 • The Scope and Environment of Financial Management
saved up. In each case, our government, a large company, a small business owner, and a
family are all in the same boat—they would like to spend more than they take in.
Where will this money come from? It will come from savings-surplus units in the
economy—that is, from those who spend less than they take in. Examples of savings
surplus units might include individuals, companies, and governments. For example,
John and Sandy Randolph have been saving for retirement and earn $10,000 more each
year than they spend. In addition, the firm John works for contributes $5,000 every year
to his retirement plan. Likewise, ExxonMobil (XOM) generates about $50 billion in
cash annually from its operations and invests about half of that on new exploration—the
rest is available to invest. Also, there are a number of governments around the world
that bring in more money than they spend—countries like China, the United Arab
Emirates, and Saudi Arabia.
Now let’s take a look at how savings are transferred to those who need the money. Ac-
tually, there are three ways that savings can be transferred through the financial markets to
those in need of funds. These are displayed in Figure 2-1.
Let’s take a closer look at these three methods:
1. Direct transfer of funds Here the firm seeking cash sells its securities directly to
savers (investors) who are willing to purchase them in hopes of earning a large return.
A startup company is a good example of this process at work. The new business may
go directly to a wealthy private investor called an angel investor or business angel for
funds or it may go to a venture capitalist for early funding. That’s how Koofers.com
got up and running. The founders of Koofers were students at Virginia Tech who put
together an interactive Web site that provides a place for students to share class notes
and course and instructor ratings/grade distributions, along with study guides and past
exams. The Web site proved to be wildly popular, and in 2009 received $2 million of
funding from two venture capitalists to expand, who, in return, received part owner-
ship of Koofers.
2. Indirect transfer using an investment-banking firm An investment-banking
firm is a financial institution that helps companies raise capital, trades in securities,
and provides advice on transactions such as mergers and acquisitions. In helping
angel investor a wealthy private investor
who provides capital for a business start-up.
venture capitalist an investment firm (or
individual investor) that provides money to
business start-ups.
FIgURE 2-1 Three Ways to Transfer Capital in the Economy
1
Direct transfer of funds
2
Indirect transfer using the
investment banker
3
Indirect transfer using the
financial intermediary
The business firm
(a savings-deficit unit)
Fi
rm
‘s
se
cu
rit
ie
s
Fi
rm
‘s
se
cu
rit
ie
s
In
te
rm
ed
ia
rie
s
in
ve
st
Sa
ve
rs
in
ve
st
Sa
ve
rs
in
ve
st
The business firm
(a savings-deficit unit)
The business firm
(a savings-deficit unit)
Investment-
banking firm
Financial
intermediary
Sa
ve
rs
in
ve
st
Savers (savings-
surplus units)
In
te
rm
ed
ia
ry
‘s
se
cu
rit
ie
s
Savers (savings-
surplus units)
Fi
rm
is
su
es
s
ec
ur
iti
es
(s
to
ck
s,
b
on
ds
)
Savers (savings-
surplus units)
Sa
ve
rs
in
ve
st
in
th
e
bu
si
ne
ss
Fi
rm
‘s
se
cu
rit
ie
s

Chapter 2 • The Financial Markets and Interest Rates 23
firms raise capital, an investment banker frequently works together with other
investment bankers in what is called a syndicate. The syndicate will buy the entire
issue of securities from the firm that is in need of financial capital. The syndicate
will then sell the securities at a higher price to the investing public (the savers)
than it paid for them. Morgan Stanley and Goldman Sachs are examples of banks
that perform investment-banking duties. Notice that under this second method of
transferring savings, the securities being issued just pass through the investment-
banking firm. They are not transformed into a different type of security.
3. Indirect transfer using the financial intermediary This is the type of system life
insurance companies, mutual funds, and pension funds operate within. The financial
intermediary collects the savings of individuals and issues its own (indirect) securities
in exchange for these savings. The intermediary then uses the funds collected from the
individual savers to acquire the business firm’s (direct) securities, such as stocks and bonds.
A good financial system is one that efficiently takes money from savers and gets it to the
individuals who can best put that money to use, and that’s exactly what our system does. This
may seem like common sense, but it is not necessarily common across the world. In spite of
the fact that the U.S. financial system recently experienced some problems, it provides more
choices for both borrowers and savers than most other financial systems, and as a result, it does
a better job of allocating capital to those who can more productively use it. As a result, we all
benefit from the three transfer mechanisms displayed in Figure 2-1, and capital formation and
economic wealth are greater than they would be in the absence of this financial market system.
There are numerous ways to classify the financial markets. These markets can take the
form of anything from an actual building on Wall Street in New York City to an electronic
hookup among security dealers all over the world. Let’s take a look at five sets of dichoto-
mous terms that are used to describe the financial markets.
Public Offerings Versus Private Placements
When a corporation decides to raise external capital, those funds can be obtained by making
a public offering or a private placement. In a public offering, both individual and institu-
tional investors have the opportunity to purchase the securities. The securities are usually made
available to the public at large by an investment-banking firm, which is a firm that special-
izes in helping other firms raise money. This process of acting as an intermediary between
an issuer of a security and the investing public is called underwriting, and the investment
firm that does this is referred to as an underwriter. This is a very impersonal market, and
the issuing firm never actually meets the ultimate purchasers of the securities.
In a private placement, also called a direct placement, the securities are offered and sold
directly to a limited number of investors. The firm will usually hammer out, on a face-to-face
basis with the prospective buyers, the details of the offering. In this setting, the investment-
banking firm may act as a finder by bringing together potential lenders and borrowers. The
private placement market is a more personal market than its public counterpart.
A venture capital firm is an example of investors who are active in the private placement
market. A venture capital firm first raises money from institutional investors and high net worth
individuals, to then pool the funds and invest in start-ups and early-stage companies that have
high-return potential but are also very risky investments. These companies are not appeal-
ing to the broader public markets owing to their (1) small absolute size, (2) very limited or
no historical track record of operating results, (3) obscure growth prospects, and (4) their
inability to sell the stock easily or quickly. Most venture capitalists invest for 5 to 7 years, in
the hopes of selling the firms or taking them public through an IPO.
Due to the high risk, the venture capitalist will occupy a seat or seats on the young
firm’s board of directors and will take an active part in monitoring the company’s manage-
ment activities. This situation should remind you of Principle 3: Risk Requires a Reward.
Primary Markets Versus Secondary Markets
A primary market is a market in which new, as opposed to previously issued, securities are traded.
For example, if Google issues a new batch of stock, this issue would be considered a primary
3
rinciple
public offering a security offering where all
investors have the opportunity to acquire a
portion of the financial claims being sold.
private placement a security offering limited
to a small number of potential investors.
primary market a market in which securities
are offered for the first time for sale to potential
investors.

24 Part 1 • The Scope and Environment of Financial Management
market transaction. In this case, Google would issue new shares of stock and receive money
from investors. The primary market is akin to the new car market. For example, the only
time that Ford ever gets money for selling a car is the first time the car is sold to the public.
The same is true with securities in the primary market. That’s the only time the issuing firm
ever gets any money for the securities, and it is the type of transaction that introduces new
financial assets—for example, stocks and bonds—into the economy. The first time a company
issues stock to the public is referred to as an initial public offering or IPO. This is what hap-
pened with Google on August 19, 2004, when it first sold its common stock to the public
at $85 per share and raised $1.76 billion dollars. When Google went back to the primary
market in September 2005 and sold more Google stock, worth an additional $4.18 billion,
it was considered a seasoned equity offering, or SEO. A seasoned equity offering is the
sale of additional shares by a company whose shares are already publicly traded and is also called a
secondary share offering.
The secondary market is where currently outstanding securities are traded. You can think
of it as akin to the used car market. If a person who bought some shares of the Google
stock subsequently sells them, he or she does so in the secondary market. Those shares can
go from investor to investor, and Google never receives any money when they are traded.
In effect, all transactions after the initial purchase in the primary market take place in the
secondary market. These sales do not affect the total amount of financial assets that exists
in the economy.
The job of regulation of the primary and secondary mar-
kets falls on the Security and Exchange Commission, or SEC.
For example, before a firm can offer its securities for sale in
the primary markets, it must register them with the SEC, and
it is the job of the SEC to make sure that the information
provided to investors is adequate and accurate. The SEC also
regulates the secondary markets, making sure that investors
are provided with enough accurate information to make in-
telligent decisions when buying and selling in the secondary
markets.
The Money Market Versus
the Capital Market
The key distinguishing feature between the money and capi-
tal markets is the maturity period of the securities traded in
them. The money market refers to transactions in short-term
debt instruments, with short-term meaning maturity periods
of 1 year or less. Short-term securities are generally issued
by borrowers with very high credit ratings. The major in-
struments issued and traded in the money market are U.S.
Treasury bills, various federal agency securities, bankers’ ac-
ceptances, negotiable certificates of deposit, and commercial
paper. Stocks, either common or preferred, are not traded
in the money market. Keep in mind that the money market
isn’t a physical place. You do not walk into a building on Wall
Street that has the words “Money Market” etched in stone
over its arches. Rather, the money market is primarily a tele-
phone and computer market.
As we explained, the capital market refers to the market for long-term financial instru-
ments. Long-term here means having maturity periods that extend beyond 1 year. In the
broad sense, this encompasses term loans, financial leases, and corporate stocks and bonds.
Spot Markets Versus Futures Markets
Cash markets are where something sells today, right now, on the spot—in fact, cash markets
are often called spot markets. Futures markets are where you can buy or sell something
initial public offering, IPO the first time a
company issues its stock to the public.
seasoned equity offering, SEO the sale of
additional stock by a company whose shares are
already publicly traded.
money market all institutions and proce-
dures that facilitate transactions for short-term
instruments issued by borrowers with very high
credit ratings.
secondary market a market in which
currently outstanding securities are traded.
ReMeMbeR YouR PRIncIPles
In this chapter, we cover material that introduces
the financial manager to the process involved in raising funds
in the nation’s capital markets and how interest rates in those
markets are determined.
Without question the United States has a highly developed,
complex, and competitive system of financial markets that al-
lows for the quick transfer of savings from people and organi-
zations with a surplus of savings to those with a savings deficit.
Such a system of highly developed financial markets allows
great ideas (such as the personal computer) to be financed and
increases the overall wealth of the economy. Consider your
wealth, for example, compared to that of the average family in
Russia. Russia lacks the complex system of financial markets to
facilitate securities transactions. As a result, real capital forma-
tion there has suffered.
Thus, we return now to Principle 4: Market Prices Are
generally Right. Financial managers like the U.S. system of
capital markets because they trust it. This trust stems from the
fact that the markets are efficient, and so prices quickly and
accurately reflect all available information about the value of
the underlying securities. This means that the expected risks
and expected cash flows matter more to market participants
than do simpler things such as accounting changes and the
sequence of past price changes in a specific security. With
security prices and returns (such as interest rates) competitively
determined, more financial managers (rather than fewer)
participate in the markets and help ensure the basic concept
of efficiency.
rinciple
spot market cash market.
futures markets markets where you can buy
or sell something at a future date.

Chapter 2 • The Financial Markets and Interest Rates 25
at some future date—in effect, you sign a contract that states what you’re buying, how
much of it you’re buying, at what price you’re buying it, and when you will actually
make the purchase. The difference between purchasing something in the spot market
and purchasing it in the futures market is when it is delivered and when you pay for it.
For example, say it is May right now and you need 250,000 euros in December. You
could purchase 125,000 euros today in the spot market and another 125,000 euros in
the futures market for delivery in December. You get the euros you purchased in the
spot market today, and you get the euros you purchased in the futures market seven
months later.
Stock Exchanges: Organized Security Exchanges Versus Over-
the-Counter Markets, a Blurring Difference
Many times markets are differentiated as being organized security exchanges or over-the-
counter markets. Because of the technological advances over the past 10 years coupled with
deregulation and increased competition, the difference between an organized exchange and
the over-the-counter market has been blurred. Still, these remain important elements of the
capital markets. Organized security exchanges are tangible entities; that is, they physi-
cally occupy space (such as a building or part of a building), and financial instruments are
traded on their premises. The over-the-counter markets include all security markets ex-
cept the organized exchanges. The money market, then, is an over-the-counter market be-
cause it doesn’t occupy a physical location. Because both markets are important to financial
officers concerned with raising long-term capital, some additional discussion is warranted.
Today, the mechanics of trading have changed dramatically and 80 to 90 percent of
all trades are done electronically, blurring the difference between trading on an organized
exchange versus trading on the over-the-counter market. Even if your stock is listed on the
New York Stock Exchange (NYSE), the odds are that it won’t be executed on the floor
of the exchange, but rather will be executed electronically in the maze of computers that
make up the global trading network. In effect, today there is little difference between how
a security is traded on an organized security exchange versus the over-the-counter market.
Organized Security Exchanges The New York Stock Exchange is consider a national
stock exchange, and in addition to it there are several others generally termed regional stock
exchanges. If a firm’s stock trades on a particular exchange, it is said to be listed on that
exchange. Securities can be listed on more than one exchange. All of these active exchanges
are registered with the Securities and Exchange Commission. Firms whose securities are
traded on the registered exchanges must comply with reporting requirements of both the
specific exchange and the SEC.
The NYSE, also called the “Big Board,” is the oldest of all the organized exchanges.
Without question, the NYSE is the big player, with the total value of the shares of stock
listed in 2012 at over $14 trillion. Today, the NYSE is a hybrid market, allowing for
face-to-face trading between individuals on the floor of the stock exchange in addition to
automated, electronic trading. As a result, during times of extreme flux in the market, at
the opening or close of the market, or on large trades, human judgment can be called on to
make sure that the trade is executed appropriately.
Over-the-Counter Markets Many publicly held firms either don’t meet the listing re-
quirements of the organized stock exchanges or simply would rather be listed on NASDAQ,
which is an electronic stock exchange. In effect, NASDAQ is a computerized system that
provides price quotes on over 5,000 over-the-counter stocks and also facilitates trades by
matching up buyers and sellers. Recently, Facebook decided to list its stock on NASDAQ
rather than the NYSE because of its lower fees and expertise with technology companies.
Stock Exchange Benefits Both corporations and investors enjoy several benefits provided
by the existence of organized security exchanges. These include
1. Providing a continuous market This may be the most important function of an
organized security exchange. A continuous market provides a series of continuous
organized security exchanges formal
organizations that facilitate the trading of
securities.
over-the-counter markets all security
markets except organized exchanges. The
money market is an over-the-counter market.
Most corporate bonds also are traded in the
over-the-counter market.

26 Part 1 • The Scope and Environment of Financial Management
security prices. Price changes from trade to trade tend to be smaller than they would
be in the absence of organized markets. The reasons are that there is a relatively large
sales volume of each security traded, trading orders are executed quickly, and the range
between the price asked for a security and the offered price tends to be narrow. The
result is that price volatility is reduced.
2. Establishing and publicizing fair security prices An organized exchange permits
security prices to be set by competitive forces. They are not set by negotiations off the
floor of the exchange, where one party might have a bargaining advantage. The bid-
ding process flows from the supply and demand underlying each security. This means
the specific price of a security is determined in the manner of an auction. In addition,
the security prices determined at each exchange are widely publicized.
3. Helping business raise new capital Because a continuous secondary market exists, it
is easier for firms to float, or issue, new security offerings at competitively determined
prices. This means that the comparative values of securities offered in these markets
are easily observed.
Concept Check
1. Explain the difference between (a) public offerings and private placements, (b) primary markets
and secondary markets, (c) the money market and the capital market, and (d) organized security
exchanges and over-the-counter markets.
2. Name the benefits derived from the existence of stock exchanges.
Selling Securities to the Public
Most corporations do not raise long-term capital frequently. The activities of working-
capital management go on daily, but attracting long-term capital is, by comparison, episod-
ic. The sums involved can be huge, so these situations are considered of great importance
to financial managers. Because most managers are unfamiliar with the subtleties of raising
long-term funds, they enlist the help of an expert, an investment banker. It is with the help
of an investment banker serving as the underwriter that stocks and bonds are generally
sold in the primary markets. The underwriting process involves the purchase and subse-
quent resale of a new security issue with the risk of selling the new issue at a satisfactory
price being assumed by the investment banker. The difference between the price the corporation
gets and the public offering price is called the underwriter’s spread.
Table 2-1 gives us some idea of who the major players are within the investment-bank-
ing industry. It lists the top 10 houses in 2011 based on the dollar volume of security issues
that were managed. Today, there are no very large, stand-alone investment-banking firms;
2 Understand how funds are
raised in the capital market.
investment banker a financial specialist
who underwrites and distributes new securities
and advises corporate clients about raising new
funds.
underwriting the purchase and subsequent
resale of a new security issue. The risk of selling
the new issue at a satisfactory (profitable) price
is assumed (underwritten) by the investment
banker.
underwriter’s spread the difference
between the price the corporation raising money
gets and the public offering price of a security.
Source: “Underwriter Rankings for 2011.” Copyright © 2011 Renaissance Capital, Greenwhich, CT. Reprinted by permission. www.renaissancecapital.com.
Rank Underwriter Proceeds (Millions)
1 Morgan Stanley $9,656.2
2 Bank of America Merrill Lynch 8,262.1
3 Goldman Sachs 6,054.6
4 J. P. Morgan 3,757.4
5 Citi 3,192.0
6 Barclays Capital 1,191.0
7 Credit Suisse 966.5
8 Deutsche Bank Securities 746.2
9 Raymond James 601.2
10 UBS Investment Bank 597.4
TABLE 2-1 Underwriter Rankings for 2011

www.renaissancecapital.com

Chapter 2 • The Financial Markets and Interest Rates 27
they are all banks that are also investment bankers. You’ll notice that only six bankers had
over $1 trillion in proceeds in 2011.
Actually, we use the term “investment banker” to describe both the firm itself and the
individuals who work for it in that capacity. Just what does this intermediary role involve?
The easiest way to understand it is to look at the basic investment-banking functions.
Functions
The investment banker performs three basic functions: (1) underwriting, (2) distributing,
and (3) advising.
Underwriting The term underwriting is borrowed from the field of insurance. It means assum-
ing a risk. The investment banker assumes the risk of selling a security issued at a satisfactory
price. A satisfactory price is one that generates a profit for the investment-banking house.
The procedure goes like this. The managing investment banker and its syndicate
will buy the security issue from the corporation in need of funds. The syndicate is a group
of other investment bankers that is invited to help buy and resell the issue. The managing house
is the investment-banking firm that originated the business because its corporate client
decided to raise external funds. On a specific day, the client that is raising capital is presented
with a check from the managing house in exchange for the securities being issued. At this point
the investment-banking syndicate owns the securities. The client has its cash, so it is immune
from the possibility that the security markets might turn sour. That is, if the price of the newly
issued security falls below that paid to the firm by the syndicate, the syndicate will suffer a loss.
The syndicate, of course, hopes that the opposite situation will result. Its objective is to sell the
new issue to the investing public at a price per security greater than its cost.
Distributing Once the syndicate owns the new securities, it must get them into the hands
of the ultimate investors. This is the distribution or selling function of investment banking.
The investment banker may have branch offices across the United States, or it may have
an informal arrangement with several security dealers who regularly buy a portion of each
new offering for final sale. It is not unusual to have 300 to 400 dealers involved in the sell-
ing effort. The syndicate can properly be viewed as the security wholesaler, and the dealer
organization can be viewed as the security retailer.
Advising The investment banker is an expert in the issuance and marketing of securities.
A sound investment-banking house will be aware of prevailing market conditions and can
relate those conditions to the particular type of security and the price at which it should
be sold at a given time. For example, business conditions may be pointing to a future in-
crease in interest rates, so the investment banker might advise the firm to issue its bonds
in a timely fashion to avoid the higher interest rates that are forthcoming. The banker can
analyze the firm’s capital structure and make recommendations about what general source
of capital should be issued. In many instances the firm will invite its investment banker to sit
on the board of directors. This permits the banker to observe corporate activity and make
recommendations on a regular basis.
The Demise of the Stand-Alone Investment-Banking Industry
From the time of George Washington until the Great Depression that occurred in the 1930s,
the U.S. economy experienced a recurring financial panic and banking crisis about every
15 years. During the Great Depression and the banking failures of 1933, some 4,004 banks
closed their doors and Congress enacted a series of reforms that were designed to put an end to
these recurring financial crises. The lynchpin of this reform was the Glass-Steagall Act, or the
Banking Act of 1933. An important component of the Glass-Steagall Act was the creation of the
Federal Deposit Insurance Corporation (FDIC), which provides deposit insurance for bank
deposits in member banks of up to $250,0001 per depositor per bank. The creation of the FDIC,
syndicate a group of investment bankers who
contractually assist in the buying and selling of a
new security issue.
1On December 31, 2013, the standard coverage limit will return to $100,000 for all deposit categories except IRAs and
certain retirement accounts, which will continue to be insured up to $250,000 per owner, unless Congress takes action to
extend the limits beyond the end of 2013.

28 Part 1 • The Scope and Environment of Financial Management
With the repeal of Glass-Steagall in 1999, many commercial banks merged with large
investment-banking firms; for example, Chase Manhattan Bank merged with J.P. Morgan,
forming JPMorgan-Chase & Co. (JPM). The advantage of this to the investment banks was
the access to stable funding through bank deposits along with the ability to borrow from the
Fed in the case of an emergency, while the commercial bank gained access to the more lu-
crative, albeit more risky, securities industry. Then in 2008 as a result of the financial crisis
and banking meltdown, the remaining stand-alone investment-banking firms that did not
fail in the crisis, including Morgan Stanley and Goldman Sachs, quickly found commercial
bank partners. At the end of the day, there were no stand-alone investment-banking firms
left. Today, the investment-banking function is provided by “universal banks,” that is, com-
mercial banks that also provide investment-banking services.
Distribution Methods
Several methods are available to the corporation for placing new security offerings in the
hands of investment bankers followed by final investors. The investment banker’s role is dif-
ferent in each of these. (Sometimes, in fact, it is possible to bypass the investment banker.)
These methods are described in this section. Private placements, because of their impor-
tance, are treated later in the chapter.
A Negotiated Purchase In a negotiated underwriting, the firm that needs funds makes
contact with an investment banker, and deliberations concerning the new issue begin. If all
goes well, a method is negotiated for determining the price the investment banker and the
syndicate will pay for the securities. For example, the agreement might state that the syndi-
cate will pay $2 less than the closing price of the firm’s common stock on the day before the
offering date of a new stock issue. The negotiated purchase is the most prevalent method of
securities distribution in the private sector. It is generally thought to be the most profitable
technique as far as investment bankers are concerned.
A Competitive Bid Purchase The method by which the underwriting group is deter-
mined distinguishes the competitive bid purchase from the negotiated purchase. In a com-
petitive underwriting, several underwriting groups bid for the right to purchase the new
issue from the corporation that is raising funds. The firm does not directly select the invest-
ment banker. Instead, the investment banker that underwrites and distributes the issue is
chosen by an auction process. The one willing to pay the greatest dollar amount per new
security will win the competitive bid.
Most competitive bid purchases are confined to three situations, compelled by legal
regulations: (1) railroad issues, (2) public utility issues, and (3) state and municipal bond
issues. The argument in favor of competitive bids is that any undue influence of an in-
vestment banker over the firm is mitigated and the price received by the firm for each
security should be higher. Thus, we would intuitively suspect that the cost of capital in
a competitive bidding situation would be less than in a negotiated purchase situation.
Evidence on this question, however, is mixed. One problem with the competitive bid-
ding purchase as far as the fund-raising firm is concerned is that the benefits gained
from the advisory function of the investment banker are lost. It may be necessary to use
an investment banker for advisory purposes and then by law exclude the banker from
the competitive bid process.
A Commission or Best-Efforts Basis Here, the investment banker acts as an agent rather
than as a principal in the distribution process. The securities are not underwritten. The
investment banker attempts to sell the issue in return for a fixed commission on each
was an effort to provide assurance to depositors that their deposits were secure, thereby prevent-
ing runs on banks. Another key element of Glass-Steagall was the separation of the commer-
cial-banking and investment-banking industries. The purpose of this was to keep banks safe by
prohibiting them from entering the securities industry, where it is possible to incur large losses,
and as a result, a strong “stand-alone” investment-banking industry emerged with names like
Lehman Brothers, Bear Stearns, and J.P. Morgan.

Chapter 2 • The Financial Markets and Interest Rates 29
security actually sold. Unsold securities are then returned to the corporation. This arrange-
ment is typically used for more speculative issues. The issuing firm may be smaller or less
established than the banker would like. Because the underwriting risk is not passed on to the
investment banker, this distribution method is less costly to the issuer than a negotiated or
competitive bid purchase. On the other hand, the investment banker only has to give it his
or her “best effort.” A successful sale is not guaranteed.
A Privileged Subscription Occasionally, the firm may feel that a distinct market already
exists for its new securities. When a new issue is marketed to a definite and select group of inves-
tors, it is called a privileged subscription. Three target markets are typically involved: (1)
current stockholders, (2) employees, or (3) customers of the firm. Of these, distributions di-
rected at current stockholders are the most prevalent. Such offerings are called rights offer-
ings. In a privileged subscription the investment banker may act only as a selling agent. It is
also possible that the issuing firm and the investment banker might sign a standby agreement,
which obligates the investment banker to underwrite the securities that are not purchased
by the privileged investors.
Dutch Auction As we explained at the beginning of the chapter, with a Dutch auction,
investors first bid on the number of shares they would like to buy and the price they are
willing to pay for them. Once all the bids are in, the prices that were bid along with the
number of shares are ranked from the highest price to the lowest price. The selling price
for the stock is then calculated as the highest price that allows for all the stock to be sold.
Although Google really brought this method to the public’s eye, it has been used by a num-
ber of other companies, including Overstock.com (OSTK) and Salon (SLNM). Figure 2-2
explains in more detail how a Dutch auction works.
Dutch auction a method of issuing securities
(common stock) by which investors place bids
indicating how many shares they are willing to
buy and at what price. The price the stock is then
sold for becomes the lowest price at which the
issuing company can sell all the available shares.
FIgURE 2-2 A Dutch Auction Primer
Adding it up
The auctioneer starts by
gathering all the bids and
sorting them according to price.
A company is planning to use a Dutch auction to set the price of the shares in
its initial public offering. Here is how the auction process will find the highest
price at which all shares can be sold.
1
Bid price per share, sorted from lowest to highest
SUCCESSFUL BIDDERS
$ FINAL PRICE HIGHEST PRICE $
Setting the price
The auctioneer works
back from the highest
bid until all the shares
are sold.
2
The final price that fills the
quota of shares to sell
becomes the offering price
to all successful bidders.
3
THE BIDS
Number
of shares
privileged subscription the process of
marketing a new security issue to a select group
of investors.

30 Part 1 • The Scope and Environment of Financial Management
A Direct Sale In a direct sale the issuing firm sells the securities directly to the investing public
without involving an investment banker. Even among established corporate giants, this procedure
is relatively rare. A variation of the direct sale involves the private placement of a new issue by
the fund-raising corporation without the use of an investment banker as an intermediary. Texa-
co (now Chevron (CVX)), Mobil Oil (now ExxonMobil (XOM)), and International Harvester
(now Navistar (NAV)) are examples of large firms that have followed this procedure.
Private Debt Placements
Earlier in this chapter we discussed the private placement market. Here we take a closer
look at the debt side of the private placement market and how it is used by seasoned corpo-
rations as distinct from start-ups. Thus, when we talk of private placements in this section,
we are focusing on debt contracts rather than stock offerings. This debt side of the private
placement market makes up a significant portion of the total private market.
Private placements are an alternative to the sale of securities to the public or to a re-
stricted group of investors through a privileged subscription. Any type of security can be
privately placed (directly placed). The major investors in private placements are large fi-
nancial institutions. Based on the volume of securities purchased, the three most important
investor groups are (1) life insurance companies, (2) state and local retirement funds, and
(3) private pension funds.
In arranging a private placement, the firm may (1) avoid the use of an investment banker
and work directly with the investing institutions or (2) engage the services of an investment
banker. If the firm does not use an investment banker, of course, it does not have to pay
a fee. However, investment bankers can provide valuable advice in the private placement
process. They are usually in contact with several major institutional investors; thus, they
will know who the major buyers able to invest in the proposed offering are, and they can
help the firm evaluate the terms of the new issue.
Private placements have advantages and disadvantages compared with public offerings.
The financial manager must carefully evaluate both sides of the question. The advantages
associated with private placements are:
1. Speed The firm usually obtains funds more quickly through a private placement than
a public offering. The major reason is that registration of the issue with the SEC is not
required.
2. Reduced costs These savings result because the lengthy registration statement for
the SEC does not have to be prepared, and the investment-banking underwriting and
distribution costs do not have to be absorbed.
3. Financing flexibility In a private placement the firm deals on a face-to-face basis
with a small number of investors. This means that the terms of the issue can be
tailored to meet the specific needs of the company. For example, if the investors
agree to loan $50 million to a firm, the management does not have to take the full
$50 million at one time. They may instead borrow as they need it and thereby pay
interest only on the amount actually borrowed. However, the company may have
to pay a commitment fee of, say, 1 percent on the unused portion of the loan. That
is, if the company borrows only $35 million, it will have to pay interest on that
amount and pay a commitment fee of 1 percent or so on the remaining $15 million.
This provides some insurance against capital market uncertainties, and the firm
does not have to borrow the funds if the need does not arise. There is also the pos-
sibility of renegotiation. The terms of the debt issue can be altered. The term to
maturity, the interest rate, or any restrictive covenants can be discussed among the
affected parties.
The following disadvantages of private placements must be evaluated.
1. Interest costs It is generally conceded that interest costs on private placements exceed
those of public issues. Whether this disadvantage is enough to offset the reduced costs
associated with a private placement is a determination the financial manager must
make. There is some evidence that on smaller issues, say $500,000 as opposed to $30
million, the private placement alternative would be preferable.
direct sale the sale of securities by a
corporation to the investing public without
the services of an investment-banking firm.

Chapter 2 • The Financial Markets and Interest Rates 31
2. Restrictive covenants A firm’s dividend policy, working-capital levels, and the rais-
ing of additional debt capital may all be affected by provisions in the private placement
debt contract. This is not to say that such restrictions are always absent in public debt
contracts. Rather, the firm’s financial officer must be alert to the tendency for these
covenants to be especially burdensome in private contracts.
3. The possibility of future SEC registration If the lender (investor) should decide to
sell the issue to a public buyer before maturity, the issue must be registered with the
SEC. Some lenders, then, require that the issuing firm agree to a future registration at
their option.
Flotation Costs
The firm raising long-term capital incurs two types of flotation costs: (1) the underwriter’s
spread and (2) issuing costs. Of these two costs, the underwriter’s spread is the larger. The
underwriter’s spread is simply the difference between the gross and net proceeds from a
given security issue expressed as a percent of the gross proceeds. The issue costs include (1)
the printing and engraving of the security certificates, (2) legal fees, (3) accounting fees, (4)
trustee fees, and (5) several other miscellaneous components. The two most significant is-
sue costs are printing and engraving and legal fees.
Data published by the SEC have consistently revealed two relationships about flotation
costs. First, the costs associated with issuing common stock are notably greater than the
costs associated with preferred stock offerings. In turn, preferred stock costs exceed those
of bonds. Second, flotation costs (expressed as a percentage of gross proceeds) decrease as
the size of the security issue increases.
In the first instance, the stated relationship reflects the fact that issue costs are sensitive
to the risks involved in successfully distributing a security issue. Common stock is riskier
to own than corporate bonds. Underwriting risk is, therefore, greater with common stock
than with bonds. Thus, flotation costs just mirror these risk relationships as identified in
Principle 3: Risk Requires a Reward. In the second case, a portion of the issue costs is 3
rinciple
flotation costs the transaction cost incurred
when a firm raises funds by issuing a particular
type of security.
Cautionary tale
FoRgeTTIng PRIncIPle 5: conFlIcTs oF InTeResT cause agencY PRobleMs
In 2004, America found itself in the midst of a housing boom.
Fueled by low interest rates and government legislation aimed
at allowing more people to qualify for housing loans, including
those who wouldn’t ordinarily qualify, new home construction
rates were at a 20-year high. Homeownership was on the rise.
And before long, even more first-time homebuyers would real-
ize the American dream.
That was good news for investment bankers like Michael Fran-
cis, whose business entailed working with lenders on the West
Coast who supplied him with mortgages he could package up as
securities and sell to investors who, in turn, collected the interest
monthly. For Francis, it didn’t matter if the mortgages defaulted;
after all, he collected his fees as soon as the mortgages were pack-
aged up and sold as securities. If the mortgages went bad, it wasn’t
the bank that experienced a loss, it was the last one holding them.
But Francis could only sell the mortgages to big investors
once they had been approved by a credit rating agency. The
agency’s appraisal signaled to investors that the securities were
“safe” investments. However, the rating agencies were paid by
the people selling the securities, and the more securities that
were issued, the more they got paid, and that created a huge
temptation to go easy.
Michael Francis admits he had doubts about the risk level of
these securities, but the economy was booming and housing
prices continued to climb. At the time, the mortgages seemed
like safe enough investments to earn the “safe” rating from cred-
it rating agencies. Besides, the investment bank Francis worked
for (which he declined to name) was making oodles of money.
If this is starting to sound like one too many conflicts of inter-
est, it should. The acts (or failures to act) of these investment
banks and rating agencies are prime examples of how conflicts
of interest can lead to agency problems and unethical behavior.
Looking back, Francis says the judgment of many in the financial
institutions was cloudy. He summed up the way lenders failed
to adequately qualify borrowers as, “we removed the litmus
test. No income, no asset. Not verifying income . . . breathe on a
mirror and if there’s fog you sort of get a loan.”
Many players had a hand in the eventual housing bust that
followed, but the credit rating agencies that gave risky securities
a “safe” rating, investment banks that failed to question those rat-
ings, and lenders who offered bad loans to homebuyers in the first
place are all key players. The appeal of short-term profits and a mas-
sive failure to self-regulate caused these institutions to lose sight of
the long-term interests of their clients. Many think these conflicts of
interest and failure of self-governance all led to the financial crisis of
2009 and the economic downturn that followed.
Source: “House of Cards,” directed by David Faber, CNBC Original Production (2009).

32 Part 1 • The Scope and Environment of Financial Management
fixed. Legal fees and accounting costs are good examples. So, as the size of the security issue
rises, the fixed component is spread over a larger gross proceeds base. As a consequence,
average flotation costs vary inversely with the size of the issue.
Regulation Aimed at Making the goal of the Firm Work: The
Sarbanes-Oxley Act
Because of growing concerns about both agency and ethical issues, in 2002 Congress passed
the Sarbanes-Oxley Act, or SOX as it is commonly called. One of the primary inspirations
for this new law was Enron, which failed financially in December 2001. Prior to bankruptcy,
Enron’s board of directors actually voted on two occasions to temporarily suspend its own
“code of ethics” to permit its CFO to engage in risky financial ventures that benefited the
CFO personally while exposing the corporation to substantial risk.
SOX holds corporate advisors who have access to or influence on company decisions
(such as a firm’s accountants, lawyers, company officers, and boards of directors) legally
accountable for any instances of misconduct. The act very simply and directly identifies its
purpose as being “to protect investors by improving the accuracy and reliability of corpo-
rate disclosures made pursuant to the securities laws, and for other purposes” and mandates
that senior executives take individual responsibility for the accuracy and completeness of
the firm’s financial reports.2
3 Be acquainted with recent
rates of return.
opportunity cost of funds the next-best
rate of return available to the investor for a given
level of risk.
2Sarbanes-Okley Act, Pub.L.107-204, 116 Stat. 745, enacted July 29, 2002.
SOX safeguards the interests of the shareholders by providing greater protection against
accounting fraud and financial misconduct. Unfortunately, all this has not come without a
price. While SOX has received praise from the likes of the former Federal Reserve Chair-
man Alan Greenspan and has increased investor confidence in financial reporting, it has
also been criticized. The demanding reporting requirements are quite costly and, as a
result, may inhibit firms listing on U.S. stock markets.
Concept Check
1. What is the main difference between an investment banker and a commercial banker?
2. What are the three major functions that an investment banker performs?
3. What are the five key methods by which securities are distributed to final investors?
4. Within the financial markets, explain what we mean by “private placements” and what the
advantages and disadvantages are.
Rates of Return in the Financial Markets
In this chapter we’ve discussed the process of raising funds to finance new projects. As you
might expect, to raise those funds a firm must offer a rate of return competitive with the next-
best investment alternative available to that saver (investor).
This rate of return on the next-best investment alternative to the saver is known as the in-
vestor’s opportunity cost of funds. The opportunity cost concept is crucial in financial
management and is referred to often.
Next we review the levels and variability in rates of return. This review focuses on re-
turns from a wide array of financial instruments. In Chapter 6, we will explain the relation-
ship of rates of return and risk more completely. Then in Chapter 9 we discuss at length
the concept of an overall cost of capital. Part of that overall cost of capital is attributed to
interest rate levels at given points in time. So we follow this initial broad look at interest rate
levels with a discussion of the more recent period of 1981 through 2011.
Rates of Return over Long Periods
History can tell us a great deal about the returns that investors earn in the financial markets.
First, what should we expect in terms of return and risk? From Principle 3: Risk Requires
a Reward we know that with higher returns we should expect to see higher risk, and that’s
3
rinciple

Chapter 2 • The Financial Markets and Interest Rates 33
exactly the case. Common stocks of small firms have more risk and produce higher average
annual returns than large stock, with the annual return on small-company stocks averaging
11.9 percent and the annual return on large-company stocks averaging 9.8 percent.
The data are summarized visually in Figure 2-3, which presents the relationship be-
tween the average annual observed rates of return for different types of securities along
with the average annual rate of inflation. Over this period, the average inflation rate was 3.0
percent. We refer to this rate as the “inflation-risk premium.” The investor who earns only
the rate of inflation has earned no “real return.” That is, the real return is the return earned
above the rate of increase in the general price level for goods and services in the economy,
which is the inflation rate. In addition to the danger of not earning above the inflation rate,
investors are concerned about the risk of the borrower defaulting, or failing to repay the
loan when due. Thus, we would expect investors to earn a default-risk premium for invest-
ing in long-term corporate bonds versus long-term government bonds because corporate
bonds are considered more risky. The premium for 1926 to 2011, as shown in Figure 2-3,
was 0.4 percent, or what is called 40 basis points (6.1 percent on long-term corporate bonds
minus 5.7 percent on long-term government bonds). We would also expect an even greater
risk premium for common stocks vis-à-vis long-term corporate bonds, because the variabil-
ity in average returns is greater for common stocks. The results show such a risk premium:
Common stocks earned 3.7 percent more than long-term corporate bonds (9.8 percent for
common stocks minus 6.1 percent for long-term corporate bonds).
Remember that these returns are “averages” across many securities and over an extended
period of time. However, these averages reflect the conventional wisdom regarding risk
premiums: The greater the risk, the greater will be the expected returns. Such a relation-
ship is shown in Figure 2-3, where the average returns are plotted against their standard
deviations; note that higher average returns have historically been associated with higher
dispersion in these returns.
Interest Rate Levels in Recent Periods
The nominal interest rates on some key fixed-income securities are displayed within both
Table 2-2 (on page 34) and Figure 2-4 (on page 34) for the 1987–2011 time frame. The rate
of inflation at the consumer level is also presented in those two exhibits. This allows us to
observe quite easily several concepts that were mentioned in the previous section. Specifi-
cally, we can observe (1) the inflation-risk premium, (2) the default-risk premium across the
FIgURE 2-3 Rates of Return and Standard Deviations, 1926 to 2011
Pe
rc
en
ta
ge
r
et
ur
ns
0
0 0% Risk
2
Treasury bills
Long-term corporate bonds
Inflation
Long-term government bonds
Small stocks
4
6
8
14% Return
12
10
5 10 15
Standard deviation of returns
20 25 30 35
Large stocks

34 Part 1 • The Scope and Environment of Financial Management
Source: Federal Reserve System, Release H-15, Selected Interest Rates.
Year
3-month
Treasury Bills %
30-yr Treasury
Bonds %
30-yr Corporate
Bonds %
Inflation
Rate %
1987 5.78 8.59 9.38 3.7
1988 6.67 8.96 9.71 4.1
1989 8.11 8.45 9.26 4.8
1990 7.5 8.61 9.32 5.4
1991 5.38 8.14 8.77 4.2
1992 3.43 7.67 8.14 3
1993 3 6.59 7.22 3
1994 4.25 7.37 7.97 2.6
1995 5.49 6.88 7.59 2.8
1996 5.01 6.71 7.37 2.9
1997 5.06 6.61 7.27 2.3
1998 4.78 5.58 6.53 1.6
1999 4.64 5.87 7.05 2.2
2000 5.82 5.94 7.62 3.4
2001 3.4 5.49 7.08 2.8
2002 1.61 5.43 6.49 1.6
2003 1.01 4.93 5.66 2.3
2004 1.37 4.86 5.63 2.7
2005 3.15 4.51 5.23 3.4
2006 4.73 4.91 5.59 3.2
2007 4.36 4.84 5.56 2.9
2008 1.37 4.28 5.63 3.8
2009 0.15 4.08 5.31 −0.4
2010 0.14 4.25 4.94 1.6
2011 0.05 3.91 4.64 3.2
Mean 3.85 6.14 7.00 2.92
TABLE 2-2 Interest Rate Levels and Inflation Rates, 1987 through 2011
FIgURE 2-4 Interest Rate Levels and Inflation Rates, 1987 through 2011
20101990 19921986 1988
Year
1994 1996 1998 2002 2008 2012200620042000
Pe
rc
en
t
Re
tu
rn
s
14.00%
12.00%
10.00%
8.00%
6.00%
4.00%
2.00%
0.00%
30-year Aaa Corporate Bonds
30-year Treasury Bonds
Mean
3-month Treasury Bills
Inflation rate
Source: Federal Reserve System, Release H-15, Selected Interest Rates.

Chapter 2 • The Financial Markets and Interest Rates 35
several instruments, and (3) the approximate real return for each instrument. Looking at
the mean (average) values for each security and the inflation rate at the bottom of Table 2-2
will facilitate the discussion.
While inflation appears to have dropped a bit between 1987 and 2011, it was much higher
just before this period. In fact, from 1979 through 1981 it averaged over 10 percent each
year, peaking at 13.5 percent in 1980. As a result of this drop in the rate of inflation, inter-
est rates have come down. This only makes sense according to the logic of the financial
markets. Investors require a nominal (or quoted) rate of interest that exceeds the inflation
rate or else their realized real return will be negative.
Table 2-2 indicates that between 1987 and 2011, on average, investor rationality
prevailed. For example, the average return premium demanded on U.S. Treasury bills
with a 3-month maturity was 0.93 percent (or 93 basis points, where a basis point is one
one-hundredth of 1 percent) in excess of the inferred inflation premium of 2.92 percent.
That is, an average 3.85 percent yield on Treasury bills over the period minus the aver-
age inflation rate of 2.92 percent over the same period produces a premium of 0.93 per-
cent. This 0.93 percent can be thought of as the real risk-free short-term interest rate that
prevailed over the 1987–2011 period. You’ll notice that this rate becomes negative between
2009 and 2011. That’s because the Federal Reserve took action to keep short-term interest
rates artificially low in an attempt to stimulate the economy.
The default-risk premium is also evident in Table 2-2 and Figure 2-4:
SECURITY AVERAgE YIELD
30-year Treasury bonds 6.14%
30-year Aaa corporate bonds 7.00%
nominal (or quoted) rate of interest the
interest rate paid on debt securities without an
adjustment for any loss in purchasing power.
inflation premium a premium to
compensate for anticipated inflation that is equal
to the price change expected to occur over the
life of the bond or investment instrument.
default-risk premium the additional return
required by investors to compensate them for
the risk of default. It is calculated as the differ-
ence in rates between a U.S. Treasury bond and
a corporate bond of the same maturity and
marketability.
Again, the basic rationale of the financial markets prevailed. The default-risk pre-
mium on 30-year high-rated (Aaa) corporate bonds relative to long-term Treasury
bonds of 30-year maturity was 0.86 percent (7.00 percent minus 6.14 percent), or 86
basis points.
The preceding array of numbers can also be used to identify another factor that af-
fects interest rate levels. It is referred to as the maturity-risk premium. The maturity-risk
premium can be defined as the additional return required by investors in longer-term securities
(bonds in this case) to compensate them for the greater risk of price fluctuations on those securities
caused by interest rate changes. This maturity-risk premium arises even if securities possess
equal (or approximately equal) odds of default. Notice that Treasury bonds with a 30-year
maturity commanded a 2.29 percent yield differential over the shorter, 3-month-to-matu-
rity Treasury bonds. (Both types of bonds are considered risk-free because they are issued
and backed by the U.S. government.) This provides an estimate of the maturity premium
demanded by all investors over this specific 1987–2011 period.
When you study the basic mathematics of financial decisions and the characteristics of
fixed-income securities in later chapters, you will learn how to quantify this maturity pre-
mium that is imbedded in nominal interest rates.
One other type of risk premium that helps determine interest rate levels needs to be
identified and defined. It is known as the “liquidity-risk premium.” The liquidity-risk
premium is defined as the additional return required by investors in securities that cannot be
quickly converted into cash at a reasonably predictable price. The
secondary markets for small-bank stocks, especially commu-
nity banks, provide a good example of the liquidity premium.
A bank holding company that trades on the New York
Stock Exchange, such as Wells Fargo, will be more liquid to
investors than, say, the common stock of Century National
Bank of Orlando, Florida. Such a liquidity premium is re-
flected across the spectrum of financial assets, from bonds to
stocks.
ReMeMbeR YouR PRIncIPles
Our third principle, Principle 3: Risk Requires a
Reward, established the fundamental risk–return relation-
ship that governs the financial markets. We are now trying to
provide you with an understanding of the kinds of risks that
are rewarded in the risk–return relationship presented in
Principle 3.
rinciple
maturity-risk premium the additional
return required by investors in longer-term
securities to compensate them for the greater
risk of price fluctuations on those securities
caused by interest rate changes.
liquidity-risk premium the additional
return required by investors for securities that
cannot be quickly converted into cash at a
reasonably predictable price.

36 Part 1 • The Scope and Environment of Financial Management
Concept Check
1. What is the “opportunity cost of funds”?
2. Over long periods of time is the “real rate of return” higher on 30-year Treasury bonds or
30-year Aaa corporate bonds?
3. Distinguish between the concepts of the “inflation premium” and the “default-risk premium.”
4. Distinguish between the concepts of the “maturity-risk premium” and the “liquidity-risk
premium.”
Interest Rate Determinants in a Nutshell
Using the logic from Principle 3: Risk Requires a Reward, we can deconstruct the inter-
est rate paid on a security into a simple equation with the nominal interest rate equal to
the sum of the real risk-free interest rate plus compensation for taking on several different
types of risk and several risk premiums, where the real risk-free interest rate is a required
rate of return on a fixed-income security that has no risk in an economic environment of zero infla-
tion. The real risk-free interest rate can be thought of as the return demanded by investors
in U.S. Treasury securities during periods of no inflation. The equation for the nominal
interest rate is
Nominal interest rate 5 real risk-free interest rate (2-1)
1 inflation premium
1 default-risk premium
1 maturity-risk premium
1 liquidity-risk premium
where
Nominal interest rate 5 the quoted interest rate and is the interest rate paid on
debt securities without an adjustment for any loss in pur-
chasing power.
Real risk-free interest rate 5 the interest rate on a fixed-income security that has no
risk in an economic environment of zero inflation. It
could also be stated as the nominal interest rate less the
inflation, default-risk, maturity-risk, and liquidity-risk
premium.
Inflation premium 5 a premium to compensate for anticipated inflation that is
equal to the price change expected to occur over the life
of the bond or investment instrument.
Default-risk premium 5 the additional return required by investors to
compensate for the risk of default. It is calculated as the
difference in rates between a U.S. Treasury bond and a
corporate bond of the same maturity and
marketability.
Maturity-risk premium 5 the additional return required by investors in
longer-term securities to compensate them for the
greater risk of price fluctuation on those securities
caused by interest rate changes.
Liquidity-risk premium 5 the additional return required by investors for
securities that cannot quickly be converted into cash
at a reasonably predictable price.
Estimating Specific Interest Rates Using Risk Premiums
By using knowledge of various risk premiums as contained in equation (2-1), the
financial manager can generate useful information for the firm’s financial planning process.
For instance, if the firm is about to offer a new issue of corporate bonds to the investing
3
rinciple
4 Explain the fundamentals of
interest rate determination
and the popular theories of
the term structure of interest
rates.
real risk-free interest rate the required
rate of return on a fixed-income security that
has no risk in an economic environment of zero
inflation.

Chapter 2 • The Financial Markets and Interest Rates 37
marketplace, it is possible for the financial manager or analyst to estimate and better under-
stand what interest rate (yield) would satisfy the market to help ensure that the bonds are
actually bought by investors. To make sense out of the different interest rate terminology—
nominal, risk-free, and real—let’s take a closer look at the difference between them.
Real Risk-Free Interest Rate and the Risk-Free Interest Rate
What’s the difference between the real risk-free interest rate and the risk-free interest rate?
The answer is that the risk-free interest rate includes compensation for inflation while the
real risk-free interest rate is the risk-free rate after inflation. As a result,
risk-free interest rate 5 real risk-free interest rate 1 inflation premium
or
real risk-free interest rate 5 risk-free interest rate 2 inflation premium
In effect, when you see the term “real” in front of an interest rate, that interest rate is
referring to an “after inflation adjusted” return, that is, the impact of inflation has been
subtracted from the interest rate. Furthermore, the term “risk-free” indicates there is no
compensation for default risk, maturity risk, or liquidity risk. As a result, the term “real
risk-free” indicates that the interest rate does not include compensation for the inflation,
default-risk, maturity-risk, and liquidity-risk premiums. That is, it is the return if there was
no risk and no inflation.
Real and Nominal Rates of Interest
When a rate of interest is quoted, it is generally the nominal, or observed, rate. The nomi-
nal rate of interest tells you how much more money you will have. As we just learned, real
rate of interest, in contrast, represents the rate of increase in your actual purchasing power,
after adjusting for inflation. In effect, the real rate of interest tells you how much more pur-
chasing power you will have. Keep in mind that the real rate of interest is not a risk-free
rate, that is, the real rate of interest includes both the real risk-free rate of interest along
with compensation for the default-risk, maturity-risk, and liquidity-risk premiums. The
nominal interest rate can be calculated to be
Nominal interest rate > (approximately equals) real rate of interest 1 inflation premium
(2-2)
real rate of interest the nominal (quoted)
rate of interest less any loss in purchasing power
of the dollar during the time of the investment.
Can you Do it?
You have been asked to provide a reasonable estimate of the nominal interest rate for a new issue of 30-year Aaa-rated bonds (that is,
very high quality corporate bonds) to be offered by Big Truck Producers Inc. The final format that the CFO of Big Truck has requested
is that of equation (2-1) in the text.
After some thought, you decided to estimate the different premiums in equation (2-1) as follows:
1. The real risk-free rate of interest is the difference between the calculated average yield on 3-month Treasury bills and the inflation
rate.
2. The inflation premium is the rate of inflation expected to occur over the life of the bond under consideration.
3. The default-risk premium is estimated by the difference between the average yield on 30-year Aaa-rated corporate bonds and
30-year Treasury bonds.
4. The maturity-risk premium is estimated by the difference between the calculated average yield on 30-year Treasury bonds and
3-month Treasury bills.
You next conducted research and found the following: The current 3-month Treasury bill rate is 4.89 percent, the 30-year Treasury bond rate
is 5.38 percent, the 30-year Aaa-rated corporate bond rate is 6.24 percent, and the inflation rate is 3.60 percent. Finally, you have estimated
that Big Truck’s bonds will have a slight liquidity-risk premium of 0.03 percent because of the infrequency with which they are traded.
Now place your output into the format of equation (2-1) so that the nominal interest rate can be estimated and the size of each
variable can also be inspected for reasonableness and discussion with the chief financial officer. (Solution can be found on page 38.)

38 Part 1 • The Scope and Environment of Financial Management
Equation 2-2 just says that the nominal rate of interest is approximately equal to the real
interest rate plus the inflation premium and provides a quick and approximate way of estimating
the real rate of interest by solving directly for this rate. You’ll notice it is very similar to equa-
tion (2-1), except it lumps all the different risk premiums in with the real risk-free rate of inter-
est to come up with the real rate of interest. This basic relationship in equation (2-2) contains
important information for the financial decision maker. It has also been for years the subject of
fascinating and lengthy discussions among financial economists.
As we saw in equation (2-2), a quick approximation for the nominal rate of interest is the
real interest rate plus the inflation premium. Let’s take a closer look at this relationship. Let’s
begin by assuming that you have $100 today and lend it to someone for 1 year at a nominal rate
DiD you Get it?
Let’s now look at the building blocks that will comprise our forecast of the nominal interest rate on Big Truck’s new issue of bonds.
The nominal rate that is forecast to satisfy the market turns out be 6.27 percent. The following tables illustrate how we obtained this
estimate.
Thus, we see that:
1. The real risk-free rate of interest is 1.29 percent, which is the difference between the average yield on a 3-month Treasury bill and
the inflation rate (column 1 less column 4).
2. The inflation premium of 3.60 percent is the inflation rate (column 4).
3. The default-risk premium of 0.86 is the difference in the average rate available to investors in the least risky (30-year Aaa-rated)
corporate bonds that mature in 30 years and the average return for a Treasury bond that matures in 30 years (column 3 minus
column 2).
4. The maturity-risk premium of 0.49 percent is the rate earned by investors on 30-year Treasury bonds less the rate on 3-month
Treasury bills (column 2 minus column 1).
5. The liquidity-risk premium is 0.03 percent, based on your earlier assumption.
When we put this all together as an estimate of the nominal interest rate needed to satisfy the financial markets on Big Truck’s new
bond issue, we have
Nominal rate on Big Truck’s bonds 5 1.29 1 3.60 1 0.86 1 0.49 1 0.03 5 6.27%
Understanding this analysis will help you deal with the Mini Case at the end of this chapter. We move now to an examination of the
relationship between real and nominal interest rates.
(1)
3-month Treasury
Bills %
4.89
(2)
30-year Treasury
Bonds %
5.38
(3)
30-year Aaa-Rated
Corporate Bonds %
6.24
(4)
Inflation
Rate %
3.60
Table Columns Shown Above Equation (2-1)
(1) – (4) real risk-free interest rate 1.29
1 1
(4) inflation premium 3.60
1 1
(3) – (2) default-risk premium 0.86
1 1
(2) – (1) maturity-risk premium 0.49
1 1
Given liquidity-risk premium 0.03
5 5
nominal interest rate 6.27

Chapter 2 • The Financial Markets and Interest Rates 39
of interest of 11.3 percent. This means you will get back $111.30 in 1 year. But if during the
year, the prices of goods and services rise by 5 percent, it will take $105 at year-end to purchase
the same goods and services that $100 purchased at the beginning of the year. What was your
increase in purchasing power over the year? The quick and dirty answer is found by subtracting
the inflation rate from the nominal rate, 11.3% 2 5% 5 6.3%, but this is not exactly correct.
We can also express the relationship among the nominal interest rate, the rate of inflation (that
is, the inflation premium), and the real rate of interest as follows:
1 1 nominal interest rate 5 (1 1 real rate of interest )(1 1 rate of inflation) (2-3)
Solving for the nominal rate of interest,
Nominal interest rate
5 real rate of interest 1 rate of inflation 1 (real rate of interest) (rate of inflation)
Consequently, the nominal rate of interest is equal to the sum of the real rate of interest,
the inflation rate, and the product of the real rate and the inflation rate. This relationship
among nominal rates, real rates, and the rate of inflation has come to be called the Fisher
effect.3 What does the product of the real rate of interest and the inflation rate represent?
It represents the fact that the money you earn on your investment is worth less because of
inflation. All this demonstrates that the observed nominal rate of interest includes both the
real rate and an inflation premium.
Substituting into equation (2-3) using a nominal rate of 11.3 percent and an inflation
rate of 5 percent, we can calculate the real rate of interest as follows:
3This relationship was analyzed many years ago by Irving Fisher. For those who want to explore Fisher’s theory of inter-
est in more detail, a fine overview is contained in Peter N. Ireland, “Long-Term Interest Rate and Inflation: A Fisherian
Approach,” Federal Reserve Bank of Richmond, Economic Quarterly, 82 (Winter 1996), pp. 22–26.
4In Chapter 5, we will study more about the time value of money.
Nominal or quoted
rate of interest
0.113
0.063
5
5
5
real rate of interest
real rate of interest
1.05 3 real rate of interest
1
1
inflation
rate
0.05
product of the real rate of
interest and the inflation rate
0.05 3 real rate of interest
1
1
0.063/1.05 5 real rate of interest
Solving for the real rate of interest:
Real rate of interest 5 0.06 5 6%
Thus, at the new higher prices, your purchasing power will have increased by only
6 percent, although you have $11.30 more than you had at the start of the year. To see why,
let’s assume that at the outset of the year, one unit of the market basket of goods and ser-
vices costs $1, so you could purchase 100 units with your $100. At the end of the year, you
have $11.30 more, but each unit now costs $1.05 (remember the 5 percent rate of inflation).
How many units can you buy at the end of the year? The answer is $111.30 4 $1.05 5 106,
which represents a 6 percent increase in real purchasing power.4
Inflation and Real Rates of Return: The Financial
Analyst’s Approach
Although the algebraic methodology presented in the previous section is strictly cor-
rect, few practicing analysts or executives use it. Rather, they employ some version of the
Can you Do it?
solvIng FoR The Real RaTe oF InTeResT
Your banker just called and offered you the chance to invest your savings for 1 year at a quoted rate of 10 percent. You also saw on
the news that the inflation rate is 6 percent. What is the real rate of interest you would be earning if you made the investment? (The
solution can be found on page 40.)

40 Part 1 • The Scope and Environment of Financial Management
following relationship (which comes from equation (2-2)), an approximation method, to
estimate the real rate of interest over a selected past time frame.
nominal interest rate 2 inflation rate > real interest rate
The concept is straightforward, but its implementation requires that several judgments
be made. For example, suppose we want to use this relationship to determine the real risk-
free interest rate, which interest rate series and maturity period should be used? Suppose we
settle for using some U.S. Treasury security as a surrogate for a nominal risk-free interest
rate. Then, should we use the yield on 3-month U.S. Treasury bills or, perhaps, the yield
on 30-year Treasury bonds? There is no absolute answer to the question.
So, we can have a real risk-free short-term interest rate, as well as a real risk-free long-
term interest rate, and several variations in between. In essence, it just depends on what the
analyst wants to accomplish. Of course we could also calculate the real rate of interest on
some rating class of 30-year corporate bonds (such as Aaa-rated bonds) and have a risky real
rate of interest as opposed to a real risk-free interest rate.
Furthermore, the choice of a proper inflation index is equally challenging. Again, we have
several choices. We could use the consumer price index, the producer price index for finished
goods, or some price index out of the national income accounts, such as the gross domestic
product chain price index. Again, there is no precise scientific answer as to which specific price
index to use. Logic and consistency do narrow the boundaries of the ultimate choice.
Let’s tackle a very basic (simple) example. Suppose that an analyst wants to estimate the
approximate real interest rate on (1) 3-month Treasury bills, (2) 30-year Treasury bonds,
and (3) 30-year Aaa-rated corporate bonds over the 1987–2011 time frame. Furthermore,
the annual rate of change in the consumer price index (measured from December to De-
cember) is considered a logical measure of past inflation experience. Most of our work is
already done for us in Table 2-2. Some of the data from Table 2-2 are displayed here.
Security
Mean noMinal
yield (%)
Mean inflation
rate (%)
inferred real
rate (%)
3-month Treasury bills 3.85 2.92 0.93
30-year Treasury bonds 6.14 2.92 3.22
30-year Aaa-rated corporate bonds 7.00 2.92 4.08
DiD You Get it?
Solving For the real rate oF intereSt
Nominal or quoted 5 real rate of 1 inflation 1 product of the real rate of
rate of interest interest rate interest and the inflation rate
0.10 5 real rate of interest 1 0.06 1 0.06 3 real rate of interest
0.04 5 1.06 3 real rate of interest
Solving for the real rate of interest:
real rate of interest 5 0.0377 5 3.77%
notice that the mean yield over the 25 years from 1987 to 2011 on all three classes of
securities has been used. Likewise, the mean inflation rate over the same time period has
been used as an estimate of the inflation premium. The last column provides the approxi-
mation for the real interest rate on each class of securities.
Thus, over the 25-year examination period the real rate of interest on 3-month Treasury
bills was 0.93 percent versus 3.22 percent on 30-year Treasury bonds, versus 4.08 percent on
30-year Aaa-rated corporate bonds. These three estimates (approximations) of the real interest
rate provide a rough guide to the increase in real purchasing power associated with an in-

Chapter 2 • The Financial Markets and Interest Rates 41
vestment position in each security. Remember that the real rate on the corporate bonds is
expected to be greater than that on long-term government bonds because of the default-risk
premium placed on the corporate securities. We move in the next section to a more detailed
discussion of the maturity-risk premium—specifically looking at the relationship between
interest rates and the number of years to maturity.
The Term Structure of Interest Rates
The relationship between a debt security’s rate of return and the length of time until the debt
matures is known as the term structure of interest rates or the yield to maturity. For
the relationship to be meaningful to us, all the factors other than maturity, meaning factors
such as the chance of the bond defaulting, must be held constant. Thus, the term structure
reflects observed rates or yields on similar securities, except for the length of time until maturity, at
a particular moment in time.
Figure 2-5 shows an example of the term structure of interest rates. The curve is
upward sloping, indicating that longer terms to maturity command higher returns, or
yields. In this hypothetical term structure, the rate of interest on a 5-year note or bond is
7.5 percent, whereas the comparable rate on a 20-year bond is 9 percent.
term structure of interest rates the
relationship between interest rates and the term
to maturity, where the risk of default is held
constant.
yield to maturity the rate of return a
bondholder will receive if the bond is held to
maturity.
Can you Do it?
solvIng FoR The noMInal RaTe oF InTeResT
If you would like to earn a real rate of interest of 6 percent while the inflation rate is 4 percent, what nominal rate of interest would you
have? (The solution can be found on page 42.)
FIgURE 2-5 The Term Structure of Interest Rates
10
8 7.5%
9%
6
4
2515 20105
In
te
re
st
r
at
e
Years to maturity
Observing the Historical Term Structures of Interest Rates
As we might expect, the term structure of interest rates changes over time, depending on
the environment. The particular term structure observed today may be quite different from
the term structure 1 month ago and different still from the term structure 1 month from
now. A perfect example of the changing term structure, or yield curve, was witnessed during
the early days of the first Persian Gulf Crisis, which occurred in August 1990. Figure 2-6
(on page 42) shows the yield curves 1 day before the Iraqi invasion of Kuwait and then
again just 3 weeks later. The change is noticeable, particularly for long-term interest rates.
Investors quickly developed new fears about the prospect of increased inflation to be caused

42 Part 1 • The Scope and Environment of Financial Management
by the crisis and, consequently, increased their required rates of return. Although the up-
ward-sloping term-structure curves in Figures 2-5 and 2-6 are the ones most commonly ob-
served, yield curves can assume several shapes. Sometimes the term structure is downward
sloping; at other times it rises and then falls (is humpbacked); and at still other times it may
be relatively flat. Figure 2-7 shows some yield curves at different points in time.
As you can see in Figure 2-7, the yield curve in April 2012 was very low, with short-term
rates close to zero and historically low long-term rates at 3.13 percent. In response to the
DiD you Get it?
solvIng FoR The noMInal RaTe oF InTeResT
Nominal or quoted 5 real rate of 1 inflation 1 product of the real rate of interest
rate of interest interest rate and the inflation rate
5 0.06 1 0.04 1 (0.06 3 0.04)
5 0.1024 5 10.24%
FIgURE 2-6 Changes in the Term Structure of Interest Rates for government
Securities at the Outbreak of the First Persian gulf Crisis
9.0
8.5
August 22, 1990
August 1, 1990
8.0
7.5
7.0
301021 3 4 5 7
In
te
re
st
r
at
e
Years to maturity
FIgURE 2-7 Historical Term Structures of Interest Rates for
government Securities
13
11
October 31, 1979
March 31, 1990
November 13, 1991
April 19, 2012
9
7
5
301021 3 4 5 7
In
te
re
st
r
at
e
Years to maturity
Source: Federal Reserve System, Release H-15.
Source: Federal Reserve System, Release H-15.

Chapter 2 • The Financial Markets and Interest Rates 43
banking crisis and economic collapse, the government moved to reduce interest rates. In addi-
tion, interest rates came down as the economy slowed, while investors further pushed interest
rates on Treasury securities as they moved money into Treasuries to escape the risk of the stock
market. The reason the government worked to keep interest rates down was to help restart the
economy by making borrowing inexpensive—hoping to help individuals buy new homes or
refinance their mortgages and allow businesses to borrow money at low rates to invest.
What Explains the Shape of the Term Structure?
A number of theories may explain the shape of the term structure of interest rates at any
point in time. Three possible explanations are prominent: (1) the unbiased expectations
theory, (2) the liquidity preference theory, and (3) the market segmentation theory.5 Let’s
look at each in turn.
unbiased expectations theory the theory
that the shape of the term structure of interest
rates is determined by an investor’s expectations
about future interest rates.
5See Richard Roll, The Behavior of Interest Rates: An Application of the Efficient Market Model to U.S. Treasury Bills (New
York: Basic Books, 1970).
The Unbiased Expectations Theory The unbiased expectations theory says that the
term structure is determined by an investor’s expectations about future interest rates.6 To see how
this works, consider the following investment problem faced by Mary Maxell. Mary has
$10,000 that she wants to invest for 2 years, at which time she plans to use her savings to
make a down payment on a new home. Wanting not to take any risk of losing her savings,
she decides to invest in U.S. government securities. She has two choices. First, she can
purchase a government security that matures in 2 years, which offers her an interest rate of
9 percent per year. If she does this, she will have $11,881 in 2 years, calculated as follows:7
6Irving Fisher thought of this idea in 1896. The theory was later refined by J. R. Hicks in Value and Capital (London:
Oxford University Press, 1946) and F. A. Lutz and V. C. Lutz in The Theory of Investment in the Firm (Princeton, NJ:
Princeton University Press, 1951).
7We could also calculate the principal plus interest for Mary’s investment using the following compound interest
equation: $10,000 (1 1 0.09)2 5 $11,881. We study the mathematics of compound interest in Chapter 5.
Alternatively, Mary could buy a government security maturing in 1 year that pays an
8 percent rate of interest. She would then need to purchase another 1-year security at the
end of the first year. Which alternative Mary chooses obviously depends in part on the rate
of interest she expects to receive on the government security she will purchase a year from
now. We cannot tell Mary what the interest rate will be in a year; however, we can at least
calculate the rate that will give her the same 2-year total savings she would get from her first
choice, or $11,881. The interest rate can be calculated as follows:
Principal amount $10,000
Plus year 1 interest (0.09 × $10,000) 900
Principal plus interest at the end of year 1 $10,900
Plus year 2 interest (0.09 × $10,900) 981
Principal plus interest at the end of year 2 $ 11,881
Savings needed in 2 years $ 11,881
Savings at the end of year 1 [$10,000(1 1 0.08)] $10,800
Interest needed in year 2 $ 1,081
For Mary to receive $1,081 in the second year, she would have to earn about 10 percent
on her second-year investment, computed as follows:
Interest received in year 2
Investment made at beginning of year 2
$1,081
$10,8005
5 10%

44 Part 1 • The Scope and Environment of Financial Management
So the term structure of interest rates for our example consists of the 1-year interest
rate of 8 percent and the 2-year rate of 9 percent. This exercise also gives us information
about the expected 1-year rate for investments made 1 year hence. In a sense, the term struc-
ture contains implications about investors’ expectations of future interest rates; thus, this
explains the unbiased expectations theory of the term structure of interest rates.
Although we can see a relationship between current interest rates with different maturi-
ties and investors’ expectations about future interest rates, is this the whole story? Are there
other influences? Probably, so let’s continue to think about Mary’s dilemma.
The Liquidity Preference Theory In presenting Mary’s choices, we have suggested that
she would be indifferent to a choice between the 2-year government security offering a
9 percent return and two consecutive 1-year investments offering 8 and 10 percent, re-
spectively. However, that would be so only if she is unconcerned about the risk associated
with not knowing the rate of interest on the second 1-year security as of today. If Mary
is risk averse (that is, she dislikes risk), she might not be satisfied with expectations of a
10 percent return on the second 1-year government security. She might require some ad-
ditional expected return to be truly indifferent. Mary might in fact decide that she will
expose herself to the uncertainty of future interest rates only if she can reasonably expect to
earn an additional 0.5 percent in interest, or 10.5 percent, on the second 1-year investment.
This risk premium (additional required interest rate) to compensate for the risk of changing
future interest rates is nothing more than the maturity premium introduced earlier, and this
concept underlies the liquidity preference theory of the term structure.8 According to the
liquidity preference theory, investors require maturity-risk premiums to compensate them for
buying securities that expose them to the risks of fluctuating interest rates.
8This theory was first presented by John R. Hicks in Value and Capital (London: Oxford University Press, 1946),
pp. 141–145, with the risk premium referred to as the liquidity premium. For our purposes we use the term maturity-risk
premium to describe this risk premium, thereby keeping our terminology consistent within this chapter.
liquidity preference theory the theory
that the shape of the term structure of interest
rates is determined by an investor’s additional
required interest rate in compensation for
additional risks.
The Market Segmentation Theory The market segmentation theory of the term
structure of interest rates is built on the notion that legal restrictions and personal prefer-
ences limit choices for investors to certain ranges of maturities. For example, commercial
banks prefer short- to medium-term maturities as a result of the short-term nature of their
deposit liabilities. They prefer not to invest in long-term securities. Life insurance com-
panies, on the other hand, have long-term liabilities, so they prefer longer maturities in
investments. At the extreme, the market segmentation theory implies that the rate of inter-
est for a particular maturity is determined solely by demand and supply for a given maturity and
that it is independent of the demand and supply for securities having different maturities. A more
moderate version of the theory allows investors to have strong maturity preferences, but it
also allows them to modify their feelings and preferences if significant yield changes occur.
Concept Check
1. What is the “nominal rate of interest”? Explain how it differs from the “real rate of interest.”
2. Write an equation that includes the building blocks of the nominal rate of interest.
3. Identify three prominent theories that attempt to explain the term structure of interest rates.
4. Which shape of the yield curve is considered to be the most typical?
Chapter Summaries
Describe key components of the U.S. financial market system and the
financing of business. (pgs. 21–26)
SUMMary: This chapter centers on the market environment in which corporations raise long-
term funds, including the structure of the U.S. financial markets, the institution of investment
1
market segmentation theory the theory
that the shape of the term structure of interest
rates implies that the rate of interest for a
particular maturity is determined solely by
demand and supply for a given maturity. This
rate is independent of the demand and supply
for securities having different maturities.

Chapter 2 • The Financial Markets and Interest Rates 45
banking, and the various methods for distributing securities. It also discusses the role interest rates
play in allocating savings to ultimate investment.
Corporations can raise funds through public offerings or private placements. The public market is im-
personal in that the security issuer does not meet the ultimate investors in the financial instruments. In a
private placement, the securities are sold directly to a limited number of institutional investors.
The primary market is the market for new issues. The secondary market represents transactions in
currently outstanding securities. Both the money and capital markets have primary and secondary
sides. The money market refers to transactions in short-term debt instruments. The capital market,
on the other hand, refers to transactions in long-term financial instruments. Trading in the capital
markets can occur in either the organized security exchanges or the over-the-counter market. The
money market is exclusively an over-the-counter market.
Key TerMS
Capital markets, page 21 All institutions and
procedures that facilitate transactions in long-
term financial instruments.
Angel investor, page 22 A wealthy private
investor who provides capital for a business
start-up.
Venture capitalist, page 22 An investment
firm (or individual investor) that provides
money to business start-ups.
Public offering, page 23 A security offering
where all investors have the opportunity to ac-
quire a portion of the financial claims being sold.
Private placement, page 23 A security
offering limited to a small number of potential
investors.
Primary market, page 23 A market in which
securities are offered for the first time for sale
to potential investors.
Initial public offering, IPO, page 24 The first
time a company sells its stock to the public.
Seasoned equity offering, SEO, page 24 The
sale of additional stock by a company whose
shares are already publically traded.
Secondary market, page 24 A market in which
currently outstanding securities are traded.
Money market, page 24 All institutions and
procedures that facilitate transactions in short-
term instruments issued by borrowers with
very high credit ratings.
Spot market, page 24 Cash market.
Futures market, page 24 Markets where you
can buy or sell something at a future date.
Organized security exchanges, page 25
Formal organizations that facilitate the trading
of securities.
Over-the-counter markets, page 25 All
security markets except the organized exchanges.
The money market is an over-the-counter
market. Most corporate bonds also are traded
in the over-the-counter market.
Understand how funds are raised in the capital markets. (pgs. 26–32)
SUMMary: The investment banker is a financial specialist involved as an intermediary in the
merchandising of securities. He or she performs the functions of (1) underwriting, (2) distributing,
and (3) advising. Major methods for the public distribution of securities include (1) the negotiated
purchase, (2) the competitive bid purchase, (3) the commission or best-efforts basis, (4) privileged
subscriptions, and (5) direct sales. The direct sale bypasses the use of an investment banker. The
negotiated purchase is the most profitable distribution method to the investment banker. It also
provides the greatest amount of investment-banking services to the corporate client. Today, there
are no major stand-alone investment bankers.
Privately placed debt provides an important market outlet for corporate bonds. Major investors in this
market are (1) life insurance firms, (2) state and local retirement funds, and (3) private pension funds.
Several advantages and disadvantages are associated with private placements. The financial officer must
weigh these attributes and decide if a private placement is preferable to a public offering.
Flotation costs consist of the underwriter’s spread and issuing costs. The flotation costs of common
stock exceed those of preferred stock, which, in turn, exceed those of debt. Moreover, flotation costs
as a percent of gross proceeds are inversely related to the size of the security issue.
Key TerMS
2
Investment banker, page 26 A financial
specialist who underwrites and distributes new
securities and advises corporate clients about
raising new funds.
Underwriting, page 26 The purchase and
subsequent resale of a new security issue. The
risk of selling the new issue at a satisfactory
(profitable) price is assumed (underwritten) by
the investment banker.

46 Part 1 • The Scope and Environment of Financial Management
Underwriter’s spread, page 26 The differ-
ence between the price the corporation raising
the money gets and the public offering price of
a security.
Syndicate, page 27 A group of investment
bankers who contractually assist in the buying
and selling of a new security issue.
Privileged subscription, page 29 The
process of marketing a new security to a select
group of investors.
Dutch auction, page 29 A method of issuing
securities (common stock) by which investors
place bids indicating how many shares they are
willing to buy and at what price. The price the
stock is then sold for becomes the lowest price
at which the issuing company can sell all the
available shares.
Direct sale, page 30 The sale of securities by
a corporation to the investing public without
the services of an investment-banking firm.
Flotation costs, page 31 The transaction cost
incurred when a firm raises funds by issuing a
particular type of security.
Be acquainted with recent rates of return. (pgs. 32–36)
SUMMary: From Principle 3: Risk Requires a Reward, we know that with higher returns we should
expect to see higher risk, and that’s exactly the case. Common stocks of small firms have more risk and
produce higher average annual returns than large-company stock. In recent years interest rates have
fallen dramatically, with the rate on 3-month Treasury bills approaching zero and the rate on 30-year
Treasury bonds dropping under 4 percent for 2011— down from close to 9 percent 25 years prior.
Key TerMS
3
Opportunity cost of funds, page 32 The
next-best rate of return available to the inves-
tor for a given level of risk.
Nominal (or quoted) rate of interest,
page 35 The interest rate paid on debt
securities without an adjustment for any loss in
purchasing power.
Inflation premium, page 35 A premium to
compensate for anticipated inflation that is
equal to the price change expected to occur
over the life of the bond or investment
instrument.
Default-risk premium, page 35 The
additional return required by investors to
compensate them for the risk of default. It is
calculated as the difference between a U.S.
Treasury bond and a corporate bond of the
same maturity and marketability.
Maturity-risk premium, page 35 The
additional return required by investors in
longer-term securities to compensate them
for greater risk of price fluctuations on those
securities caused by interest rate changes.
Liquidity-risk premium, page 35 The
additional return required by investors for
securities that cannot be quickly converted into
cash at a reasonably predictable price.
explain the fundamentals of interest rate determination and the popular
theories of the term structure of interest rates. (pgs. 36–44)
SUMMary: When lenders loan money they must take into account the anticipated loss in pur-
chasing power that results during a period of price inflation. Consequently, nominal or observed
rates of interest incorporate an inflation premium that reflects the anticipated rate of inflation over
the period of the loan.
The term structure of interest rates (also called the yield curve) defines the relationship between
rates of return for similar securities that differ only with respect to their time to maturity. For
instance, if long-term government bonds offer a higher rate of return than do U.S. Treasury bills,
then the yield curve is upward sloping. But if the Treasury bill is paying a higher rate of interest
than its long-term counterparts, then the yield curve is downward sloping.
Key TerMS
4
Real risk-free interest rate, page 36 The
required rate of return on a fixed-income
security that has no risk in an economic
environment of zero inflation.
Real rate of interest, page 37 The nominal
(quoted) rate of interest less any loss in
purchasing power of the dollar during the time
of the investment.
Term structure of interest rates,
page 41 The relationship between interest
rates and the term to maturity, where the risk
of default is held constant.

Chapter 2 • The Financial Markets and Interest Rates 47
Yield to maturity, page 41 The rate of return
a bondholder will receive if the bond is held to
maturity.
Unbiased expectations theory, page 43
The theory that the shape of the term
structure of interest rates is determined by an
investor’s expectations about future interest rates.
Liquidity preference theory, page 44 The
theory that the shape of the term structure of
interest rates is determined by an investor’s ad-
ditional required interest rate in compensation
for additional risks.
Market segmentation theory, page 44 The
theory that the shape of the term structure of
interest rates implies that the rate of interest for
a particular maturity is determined solely by de-
mand and supply for a given maturity. This rate is
independent of the demand and supply for
securities having different maturities.
Key eqUaTionS
Nominal interest rate = real risk-free interest rate
1 inflation premium
1 default-risk premium
1 maturity-risk premium
1 liquidity-risk premium
Nominal interest rate > (approximately equals) real rate of interest 1 inflation-risk premium
1 1 nominal interest rate = (1 1 real rate of interest)(1 1 rate of inflation)
OR
Nominal or quoted = real rate of 1 inflation 1 product of the real rate of interest
rate of interest interest rate and the inflation rate
review questions
All Review Questions are available in MyFinanceLab.
2-1. Distinguish between the money and capital markets.
2-2. What major benefits do corporations and investors enjoy because of the existence of orga-
nized security exchanges?
2-3. What general criteria does an organized exchange examine to determine whether a firm’s securities
can be listed on the exchange? (Specific numbers are not needed here but rather areas of investigation.)
2-4. Why do you think most secondary-market trading in bonds takes place over the counter?
2-5. What is an investment banker, and what major functions does he or she perform?
2-6. What is the major difference between a negotiated purchase and a competitive bid purchase?
2-7. Why is an investment-banking syndicate formed?
2-8. Why might a large corporation want to raise long-term capital through a private placement
rather than a public offering?
2-9. As a recent business school graduate, you work directly for the corporate treasurer. Your cor-
poration is going to issue a new security and is concerned with the probable flotation costs. What
tendencies about flotation costs can you relate to the treasurer?
2-10. Identify three distinct ways that savings are ultimately transferred to business firms in need of
cash.
2-11. Explain the term opportunity cost with respect to the cost of funds to the firm.
2-12. Compare and explain the historical rates of return for different types of securities.
2-13. Explain the impact of inflation on rates of return.
2-14. Define the term structure of interest rates.
2-15. Explain the popular theories for the rationale of the term structure of interest rates.
Study Problems
All Study Problems are available in MyFinanceLab.
2-1. (Calculating the default-risk premium) At present, 10-year Treasury bonds are yielding 4%
while a 10-year corporate bond is yielding 6.8%. If the liquidity-risk premium on the corporate
bond is 0.4%, what is the corporate bond’s default-risk premium?
2-2. (Calculating the maturity-risk premium) At present, the real risk-free rate of interest is 2%,
while inflation is expected to be 2% for the next 2 years. If a 2-year Treasury note yields 4.5%, what
is the maturity-risk premium for this 2-year Treasury note?
3

2-3. (Inflation and interest rates) You’re considering an investment that you expect will produce an
8 percent return next year, and you expect that your real rate of return on this investment will be 6
percent. What do you expect inflation to be next year?
2-4. (Inflation and interest rates) What would you expect the nominal rate of interest to be if the real
rate is 4 percent and the expected inflation rate is 7 percent?
2-5. (Inflation and interest rates) Assume the expected inflation rate to be 4 percent. If the current
real rate of interest is 6 percent, what ought the nominal rate of interest to be?
2-6. (Real interest rates: approximation method) The CFO of your firm has asked you for an approxi-
mate answer to this question: What was the increase in real purchasing power associated with both
3-month Treasury bills and 30-year Treasury bonds? Assume that the current 3-month Treasury
bill rate is 4.34 percent, the 30-year Treasury bond rate is 7.33 percent, and the inflation rate is 2.78
percent. Also, the chief financial officer wants a short explanation should the 3-month real rate turn
out to be less than the 30-year real rate.
2-7. (Real interest rates: approximation method) You are considering investing money in Treasury
bills and wondering what the real risk-free rate of interest is. Currently, Treasury bills are yield-
ing 4.5% and the future inflation rate is expected to be 2.1% per year. Ignoring the cross product
between the real rate of interest and the inflation rate, what is the real risk-free rate of interest?
2-8. (Real interest rates: approximation method) If the real risk-free rate of interest is 4.8% and the rate of
inflation is expected to be constant at a level of 3.1%, what would you expect 1-year Treasury bills to
return if you ignore the cross product between the real rate of interest and the inflation rate?
2-9. (Default risk premium) At present, 20-year Treasury bonds are yielding 5.1% while some 20-year
corporate bonds that you are interested in are yielding 9.1%. Assuming that the maturity-risk premium
on both bonds is the same and that the liquidity-risk premium on the corporate bonds is 0.25% while it
is 0.0% on the Treasury bonds, what is the default-risk premium on the corporate bonds?
2-10. (Interest rate determination) If the 10-year Treasury bond rate is 4.9%, the inflation premium
is 2.1%, and the maturity-risk premium on 10-year Treasury bonds is 0.3%, assuming that there is
no liquidity-risk premium on these bonds, what is the real risk-free interest rate?
2-11. (Interest rate determination) You’ve just taken a job at a investment banking firm and been given the
job of calculating the appropriate nominal interest rate for a number of different Treasury bonds with
different maturity dates. The real risk-free interest rate that you have been told to use is 2.5%, and this
rate is expected to continue on into the future without any change. Inflation is expected to be constant
over the future at a rate of 2.0%. Since these are bonds that are issued by the U.S. Treasury, they do not
have any default risk or any liquidity risk (that is, there is no liquidity-risk premium). The maturity-risk
premium is dependent upon how many years the bond has to maturity. The maturity-risk premiums
are as follows:
4
48 Part 1 • The Scope and Environment of Financial Management
B o n D M aT U r e S i n : M aT U r i T y – r i S K P r e M i U M :
0–1 year 0.05%
1–2 years 0.30%
2–3 years 0.60%
3–4 years 0.90%
B o n D M aT U r e S i n : M aT U r i T y – r i S K P r e M i U M :
0–1 year 0.07%
1–2 years 0.35%
2–3 years 0.70%
3–4 years 1.00%
Given this information, what should the nominal rate of interest on Treasury bonds maturing in
0–1 year, 1–2 years, 2–3 years, and 3–4 years be?
2-12. (Interest rate determination) You’re looking at some corporate bonds issued by Ford, and you
are trying to determine what the nominal interest rate should be on them. You have determined
that the real risk-free interest rate is 3.0%, and this rate is expected to continue on into the future
without any change. In addition, inflation is expected to be constant over the future at a rate of
3.0%. The default-risk premium is also expected to remain constant at a rate of 1.5%, and the
liquidity-risk premium is very small for Ford bonds, only about 0.02%. The maturity-risk premium
is dependent upon how many years the bond has to maturity. The maturity-risk premiums are as
follows:

Given this information, what should the nominal rate of interest on Ford bonds maturing in 0–1
year, 1–2 years, 2–3 years, and 3–4 years be?
2-13. (Term structure of interest rates) You want to invest your savings of $20,000 in government
securities for the next 2 years. Currently, you can invest either in a security that pays interest of 8
percent per year for the next 2 years or in a security that matures in 1 year but pays only 6 percent
interest. If you make the latter choice, you would then reinvest your savings at the end of the first
year for another year.
a. Why might you choose to make the investment in the 1-year security that pays an interest rate
of only 6 percent, as opposed to investing in the 2-year security paying 8 percent? Provide numeri-
cal support for your answer. Which theory of term structure have you supported in your answer?
b. Assume your required rate of return on the second-year investment is 11 percent; otherwise,
you will choose to go with the 2-year security. What rationale could you offer for your preference?
2-14. (Yield curve) If yields on Treasury securities were currently as follows:
T E R M Y I E L D
6 months 1.0%
1 year 1.7%
2 years 2.1%
3 years 2.4%
4 years 2.7%
5 years 2.9%
10 years 3.5%
15 years 3.9%
20 years 4.0%
30 years 4.1%
a. Plot the yield curve.
b. Explain this yield curve using the unbiased expectations theory and the liquidity preference theory.
Mini Case
This Mini Case is available in MyFinanceLab.
On the first day of your summer internship, you’ve been assigned to work with the chief financial officer
(CFO) of SanBlas Jewels Inc. Not knowing how well trained you are, the CFO has decided to test your
understanding of interest rates. Specifically, she asked you to provide a reasonable estimate of the nomi-
nal interest rate for a new issue of Aaa-rated bonds to be offered by SanBlas Jewels Inc. The final format
that the chief financial officer of SanBlas Jewels has requested is that of equation (2-1) in the text. Your
assignment also requires that you consult the data in Table 2-2.
Some agreed-upon procedures related to generating estimates for key variables in equation (2-1) follow.
a. The current 3-month Treasury bill rate is 2.96 percent, the 30-year Treasury bond rate is 5.43 per-
cent, the 30-year Aaa-rated corporate bond rate is 6.71 percent, and the inflation rate is 2.33 percent.
b. The real risk-free rate of interest is the difference between the calculated average yield on
3-month Treasury bills and the inflation rate.
c. The default-risk premium is estimated by the difference between the average yield on Aaa-rated
bonds and 30-year Treasury bonds.
d. The maturity-risk premium is estimated by the difference between the average yield on 30-year
Treasury bonds and 3-month Treasury bills.
e. SanBlas Jewels’ bonds will be traded on the New York Bond Exchange, so the liquidity-risk
premium will be slight. It will be greater than zero, however, because the secondary market for
the firm’s bonds is more uncertain than that of some other jewel sellers. It is estimated at 4 basis
points. A basis point is one one-hundredth of 1 percent.
Now place your output into the format of equation (2-1) so that the nominal interest rate can be estimat-
ed and the size of each variable can also be inspected for reasonableness and discussion with the CFO.
Chapter 2 • The Financial Markets and Interest Rates 49

Understanding Financial
Statements and Cash Flows
Learning Objectives
1 Compute a company’s profits, as reflected by The Income Statement
its income statement.
2 Determine a firm’s financial position at a point in time The Balance Sheet
based on its balance sheet.
3 Measure a company’s cash flows. Measuring Cash Flows
4 Explain the differences between GAAP and IFRS. GAAP and IFRS
5 Compute taxable income and income taxes owed. Income Taxes and Finance
6 Describe the limitations of financial statements. Accounting Malpractice and Limitations
of Financial Statements
7 Calculate a firm’s free cash flows and financing cash flows. Free Cash Flows
50
You have been offered a marketing position at Home Depot. In trying to decide whether or not to accept the
offer, you have been searching the Internet for information about the company. Your Uncle Harry told you
that he had read in the local newspaper that the firm has been having some financial problems. He could not
remember for certain, but thought the article mentioned that the company’s problems were tied to the down-
turn in the economy, particularly from being in the home-improvement industry. He suggested that you acquire
a copy of the firm’s 10-K. Not wanting to look uninformed, you responded, “great idea,” but thought to yourself,
“What is a 10-K?”
At your first opportunity, you went to the Home Depot Web site (www.homedepot.com), clicked on the
investor relations link and then selected the Financial Reports link to find both the firm’s annual
report and the 10-K that your Uncle Harry mentioned. You quickly discovered that the 10-K is an annual report
that all publicly traded firms must file with the Securities and Exchange Commission (SEC). Among other things,
the report presents the company’s financial results, along with commentary about the company’s financial
3

www.homedepot.com

5151
performance, in the section en-
titled “Management Discussion and
Analysis.” As you peruse the annual
report for the fiscal year ended Janu-
ary 30, 2011,1 you read the letter to the
shareholders written by Frank S. Blake,
the firm’s chairman and CEO, where
he comments on the firm’s recent
performance (as shown below).
1The Home Depot, Inc.’s fiscal year is a 52- or
53-week period ending on the Sunday nearest
to January 31. Fiscal year 2010 ended January
30, 2011, and fiscal year 2009 ended January 31,
2010.
Finally, you begin looking at the
firm’s financial statements, where you
see an income statement, a balance
sheet, and a statement of cash flows.
You are not certain exactly how to
read these statements, so you try to
remember what you learned in your
finance course in college. Fortunately,
you had saved your finance textbook
and began reading the chapter on
financial statements.
This chapter and the next chapter
provide you with exactly what you
need to understand Home Depot’s
financial statements, as well as any
company’s financial statements. Un-
derstanding financial statements is
vital for any manager, since in some
ways accounting is the “language” of
business. To begin, we examine the
three basic financial statements that
are used to understand how a firm is
doing financially: (1) the income state-
ment, or what is sometimes called the
profit and loss statement, (2) the bal-
ance sheet, which provides a snapshot
on a particular date of a firm’s finan-
cial position, and (3) the statement of
cash flows, which identifies the sourc-
es and uses of a company’s cash. In the
appendix at the end of the chapter we
present another important measure
of cash flows called free cash flows.
Dear Shareholders:
In 2010, we achieved our �rst year of positive sales growth since �scal year 2006….
Our sales growth occurred against a backdrop of continued weakness in the
housing market. In the U.S., private �xed residential investment as a percent of
GDP reached a new 60 plus year low of 2.24 percent in the third quarter of 2010.
Despite this, we had positive comp sales for all four quarters of 2010, and by the
end of 2010, we were seeing strength across the U.S., as 49 of the 50 states had
positive “same-store” sales for the fourth quarter. We view this as an indicator that
our business can stabilize and improve even as the housing market remains under
stress.
Over the course of 2010, we made signi�cant improvements in our merchandising
systems, with foundational work on our data warehouse and improved tools for
forecasting and replenishment. We will continue on that path in 2011, and we are
also continuing our investments in multi-channel—or interconnected—retailing.
Through our mobile applications, website and social media presence, we are
creating the capability to serve our customers “when, where and how” they want to
be served.
At The Home Depot, our goal is to provide the best customer service and the best
product values in our market, with an underlying principle of disciplined capital
allocation. Our approach to capital allocation is straightforward: after making the
necessary investments in our business, we will return excess cash to our
shareholders through dividends and share repurchases. We have a goal of
achieving a 15 percent return on invested capital, and we have a plan to reach that
goal by the end of 2013.
I hope as you spend time in our stores or on our web site or on our mobile
applications, you will see continued improvement in our service and our
commitment to our customers.
Frank S. Blake
Chairman & Chief Executive Of�cer
March 24, 2011
Source: Fiscal Year 2010 Form 10-K by The Home Depot, Inc. Copyright © 2010 The Home Depot, Inc. Reprinted by permission.

52 Part 1 • The Scope and Environment of Financial Management
Our goal is not to make you an accountant, but instead
to provide you with the tools to understand a firm’s financial
situation. With this knowledge, you will be able to under-
stand the financial consequences of a company’s decisions and
actions—as well as your own.
The financial performance of a firm matters to a lot
of groups—the company’s management, its employees, and
its investors, just to name a few. If you are an employee,
the firm’s performance is important to you because it may
determine your annual bonus, your job security, and your
opportunity to advance your professional career. This is
true whether you are in the firm’s marketing, finance,
or human resources department. Moreover, an employee
who can see how decisions affect a firm’s finances has a
competitive advantage. So regardless of your position in
the firm, it is in your own best interest to know the basics
of financial statements—even if accounting is not your
greatest love.
Let’s begin our review of financial statements by looking
at the format and content of the income statement.
The Income Statement
An income statement, or profit and loss statement, indicates the amount of profits gen-
erated by a firm over a given time period, such as 1 year. In its most basic form, the income
statement may be represented as follows:
Sales – expenses = profits (3-1)
The format for an income statement is shown in Figure 3-1. The income statement
begins with sales or revenue, from which we subtract the cost of goods sold (the cost of
producing or acquiring the product or service to be sold) to yield gross profits. Next, operat-
ing expenses are deducted to determine operating income (also called operating profits or
earnings before interest and taxes or EBIT), where operating expenses consist of:
1. Marketing and selling expenses—the cost of promoting the firm’s products or services
to customers.
2. General and administrative expenses—the firm’s overhead expenses, such as executive
salaries and rent expense.
3. Depreciation expense—a noncash expense to allocate the cost of depreciable assets,
such as plant and equipment, over the life of the asset.
Take another look at Figure 3-1, and notice something important: In the left margin
of the figure we see that operating income is the result of management’s decisions relat-
ing only to the operations of the business and is not affected at all by how much debt the
company owes. In other words, the firm’s financing expenses, its interest expense resulting
from borrowing money, have no effect on operating income. Rather, the operating income
of a firm reports the results of the following important activities:
1. Sales (revenues), which is equal to the selling price of the products or services to be
sold times the number of units sold (selling price * units sold = total sales).
2. Cost of goods sold, which is the cost of producing or acquiring the goods or services
that were sold.
3. Operating expenses, which include:
a. Marketing and selling expenses (the expenses related to marketing, selling, and
distributing the products or services).
b. The firm’s overhead expenses (general and administrative expenses, and deprecia-
tion expenses).
1 Compute a company’s profits,
as reflected by its income
statement.
income statement (profit and loss
statement) a basic accounting statement
that measures the results of a firm’s operations
over a specified period, commonly 1 year. The
bottom line of the income statement, net profits
(net income), shows the profit or loss for the
period that is available for a company’s owners
(shareholders).
operating expenses marketing and selling
expenses, general and administrative expenses,
and depreciation expense.
gross profit sales or revenue minus the cost
of goods sold.
operating income (earnings before
interest and taxes) sales less the cost of
goods sold less operating expenses.
cost of goods sold the cost of producing or
acquiring a product or service to be sold in the
ordinary course of business.
RemembeR YoUR PRinCiPleS
Two principles are especially important in this chapter.
Principle 1 tells us that Cash Flow Is What Matters. At times,
cash is more important than profits. Thus, considerable time
is devoted to measuring cash flows. Principle 5 warns us that
there may be a conflict when managers and owners have dif-
ferent incentives. That is, Conflicts of Interest Cause Agency
Problems. Because managers’ incentives are at times different
from those of owners, the firm’s common stockholders, as well
as other providers of capital (such as bankers), need information
that can be used to monitor the managers’ actions. Because the
owners of large companies do not have access to internal infor-
mation about the firm’s operations, they must rely on public
information from any and all sources. One of the main sources of
such information comes from the company’s financial statements
provided by the firm’s accountants. Although this information is
by no means perfect, it is an important source used by outsiders
to assess a company’s activities. In this chapter, we learn how to
use data from the firm’s public financial statements to monitor
management’s actions.
rinciple
Form 10-K an annual report required by the
Securities and Exchange Commission (SEC) that
provides such information as the firm’s history,
audited financial statements, management’s
analysis of the company’s performance, and
executive compensation.

Chapter 3 • Understanding Financial Statements and Cash Flows 53
FIGuRE 3-1 The Income Statement: An Overview
Result of
Borrowing
Money
Re
su
lt
o
f
O
pe
ra
ti
ng
A
ct
iv
it
ie
s
Income tax
–
Interest expense
(cost of borrowing money)
Operating expenses
(marketing and selling, general and
administrative, and depreciation expenses)
Cost of goods sold
(cost of producing or acquiring product
or service to be sold)
Net income
=
Earnings before taxes
=
Operating income
(earnings before interest and taxes)
Gross profit
Sales (revenue)
=
=
–
–
–
We next determine the earnings before taxes, or taxable income, by deducting the
interest expense paid on the firm’s debt. Next, the firm’s income taxes are calculated based
on its earnings before taxes and the applicable tax rate for the amount of income reported.
For instance, if a firm had earnings before taxes of $100,000, and its tax rate is 28 percent,
then it would owe $28,000 in taxes (0.28 * $100,000 = $28,000).
The next and final number in the income statement is the net income, or earnings
available to common stockholders, which represents income that may be reinvested in
the firm or distributed to its owners—provided, of course, the cash is available to do so. As
you will come to understand, a positive net income on an income statement does not neces-
sarily mean that a firm has generated positive cash flows.
Income Statement Illustrated: The Home Depot, Inc.
2Publicly traded companies make their financial statements available online. Go to Yahoo! Finance and you can obtain
the latest financial statements of most publicly traded businesses. You can also find annual reports (which include
financial statements) of publicly traded companies on www.annualreports.com, or you can go to a specific company’s
Web site to see its financial statements.
Let’s apply what we have learned by looking at the income statement for Home Depot2 for
the 12 months ended January 30, 2011, as presented in Table 3-1(on page 54). When reading
earnings before taxes (taxable income)
operating income minus interest expense.
net income (net profit, or earnings
available to common stockholders) the
earnings available to the firm’s common and
preferred stockholders.

www.annualreports.com

54 Part 1 • The Scope and Environment of Financial Management
earnings per share net income on a per
share basis.
dividends per share the amount of
dividends a firm pays for each share outstanding.
common-sized income statement an
income statement in which a firm’s expenses and
profits are expressed as a percentage of its sales.
3This presentation of Home Depot’s income statement and later its balance sheet have been simplified for learning
purposes. The original statements can be found in Home Depot’s annual report at www.homedepot.com. Also, the
percentages shown in the right column are subject to rounding errors and may not add up precisely. Data from The
Home Depot, Inc., Fiscal Year 2010 Form 10-K.
Table 3.1 The Home Depot, Inc.: Income Statement (expressed in millions, except
per share data, and as a percentage of sales) for the Year ended January 30, 20113
Sales $67,977 100.0%
Cost of goods sold (44,693) 65.7%
Gross profits $23,304 34.3%
Operating expenses:
Marketing, general and administrative expenses ($15,885) 23.4%
Depreciation expenses (1,616) 2.4%
Total operating expenses ($17,501) 25.7%
Operating income (earnings before interest and taxes) $ 5,803 8.5%
Interest expense (530) 0.8%
Earnings before taxes (taxable income) $ 5,273 7.8%
Income taxes (1,935) 2.8%
Net income (earnings available to common stockholders)
Income from operating
activities. Also called operating
profits, or earnings before
interest and taxes (EBIT).
$ 3,338 4.9%
Additional information:
Number of common shares outstanding 1,623
gross profit margin
operating profit margin
net profit margin
Cost of
debt
financing
Income from operating
and financing activities. Also
called net profits or
earnings available to
common shareholders.
Home Depot’s financial statements, understand that they are expressed in millions. For exam-
ple, look at the first line in Home Depot’s income statement, which reads $67,997. That is, the
company’s sales were $67,997 million. But realize that $67,997 million is really $67.997 billion.
(Notice that we use the decimal point when we express a number in billion, instead of a comma
when we express the number in millions.) So any time a number in Home Depot’s financial
statements is $1,000 million or more, it is actually a billion dollars or more.
So let’s begin. In the first line of Table 3-1, we see that Home Depot had sales of
$67,997 million for the year, but we understand that the sales were actually $67.997 billion.
The cost of goods sold was $44.693 billion, resulting in gross profits of $23.304 billion. The firm
then had $17.501 billion of operating expenses. After deducting the operating expenses, the
firm’s operating income (earnings before interest and taxes) was $5.803 billion. To this point, we
have calculated the profits resulting only from operating the business, without regard for
any interest paid on money borrowed.
We next deduct the $530 million in interest expense (the amount paid for borrowing
money) to arrive at the company’s earnings before taxes (taxable income) of $5.273 billion. We
then subtract the income taxes of $1.935 billion to determine the company’s net income, or
earnings available to common stockholders, of $3.338 billion.
At this point, we have completed the income statement. However, the firm’s owners
(common stockholders) like to know how much income the firm made on a per share basis,
or what is called earnings per share. We calculate earnings per share as net income divided
by the number of common stock shares outstanding. Because Home Depot had 1,623 million
shares (1.623 billion) outstanding for the year (see Table 3-1), its earnings per share was
$2.06 ($2.06 = $3.338 billion net income , 1.623 billion shares).
Investors also want to know the amount of dividends a firm pays for each share outstand-
ing, or the dividends per share. In Table 3-1 we see that Home Depot paid $1.569 billion
in dividends during the year. We can then determine that the firm paid $0.97 in dividends
per share ($0.97 = $1.569 billion total dividends , 1.623 billion shares outstanding).
Home Depot’s Common-Sized Income Statement
What conclusions can we draw from Home Depot’s income statement? To answer this ques-
tion, it is helpful to look at each item in the income statement as a percentage of sales. Such a
revision is called a common-sized income statement and is presented in the right column of
Earnings per share (net income ÷ number of shares) $ 2.06
Dividends per share (total dividends ÷ number of shares) $ 0.97
Dividends paid to stockholders $ 1,569

www.annualreports.com

Chapter 3 • Understanding Financial Statements and Cash Flows 55
profit margins financial ratios (sometimes
simply referred to as margins) that reflect the
level of the firm’s profits relative to its sales.
Examples include the gross profit margin (gross
profit divided by sales), operating profit margin
(operating income divided by sales), and the net
profit margin (net income , sales).
gross profit margin gross profit divided by net
sales. It is a ratio denoting the gross profit earned
by the firm as a percentage of its net sales.
fixed costs costs that remain constant,
regardless of any change in a firm’s activity.
variable costs costs that change in
proportion to changes in a firm’s activity.
net profit margin net income divided by
sales. A ratio that measures the net income of
the firm as a percent of sales.
operating profit margin operating
income divided by sales. This ratio serves as an
overall measure of the company’s operating
effectiveness.
semivariable costs costs composed of a
mixture of fixed and variable components.

Table 3-1. The common-sized income statement allows us to express expenses and profits on
a relative basis, so that we can more easily compare a firm’s income performance across time
and with competitors. The profits-to-sales relationships are defined as profit margins. In the
right-hand margin of Home Depot’s income statement (Table 3-1), we see that the firm earned
1. A 34.3 percent gross profit margin (34.3% = $23.304 billion of gross profits ,
$67.997 billion of sales)
2. An 8.5 percent operating profit margin (8.5% = $5.803 billion of operating income ,
$67.997 billion of sales)
3. A 4.9 percent net profit margin (4.9% = $3.338 billion of net income , $67.997
billion of sales)
In practice, managers pay close attention to the firm’s profit margins. Profit margins are
considered to be an important measurement of how well the firm is doing financially. Managers
carefully watch for any changes in margins, up or down. They also compare the firm’s margins
with those of competitors—something we will discuss in Chapter 4. For the time being, simply
remember that profit-to-sales relationships, or profit margins, are important in assessing a firm’s
performance.
Finally, in Home Depot’s income statement, no mention was made about which
expenses are fixed and which are variable. This distinction is extremely important to a manager
wanting to know what will happen to profits when sales change. Fixed costs are costs and
expenses that do not vary at all with sales volume. Examples include property taxes and rent
expenses, which must be paid no matter how much a company’s sales change, particularly in the
short term, such as a year. Variable costs are costs and expenses that vary directly and propor-
tionately with changes in sales volume, such as the costs of material used in production and sales
commissions. Finally, there are also semivariable costs that vary in the direction of, but not
proportionately with, changes in the volume of sales. Examples include certain types of payrolls
that change as a firm becomes larger but do not change proportionally with sales changes.
Much more will be said in Chapter 12 about the effect that fixed and variable costs and
expenses have on a company’s income as sales change.
E x A M P L E 3.1 Constructing an income statement
Menielle, Inc. is a wholesale distributor of electronics. It sells laptops, cameras, and other
electronic gadgets. Use the scrambled information below to construct an income state-
ment, along with a common-sized income statement. Also calculate the firm’s earnings
per share and dividends per share.
Interest expense $ 35,000 Sales $400,000
Cost of goods sold $150,000 Common stock dividends $ 15,000
Selling and marketing expenses $ 40,000 Income taxes $ 40,000
Administrative expenses $ 30,000 Depreciation expense $ 20,000
Number of shares outstanding 20,000
Sales
Less: Cost of goods sold
Equals: Gross profits
Less: Operating expenses (selling and marketing expenses +
Depreciation expense + Administrative expenses)
Equals: Operating income
Less: Interest expense
Equals: Earnings before taxes
Less:
Equals:
Income taxes
Net income
SteP 1: FoRmUlate a SolUtion StRategY
The following template provides the format of the income statement:

56 Part 1 • The Scope and Environment of Financial Management
SteP 2: CRUnCh the nUmbeRS
Your results should be as follows:
2 Determine a firm’s financial
position at a point in time
based on its balance sheet.
balance sheet a statement that shows a firm’s
assets, liabilities, and shareholder equity at a
given point in time. It is a snapshot of the firm’s
financial position on a particular date.

Dollars
Percentage
of Sales
Sales $400,000 100.0%
Cost of goods sold (150,000) 37.5%
Gross profit $250,000 62.5%
Operating expenses:
Selling and marketing expenses ($ 40,000) 10.0%
Administrative expenses (30,000) 7.5%
Depreciation expense (20,000) 5.0%
Total operating expenses ($ 90,000) 22.5%
Operating income $160,000 40.0%
Interest expense (35,000) 8.8%
Earnings before taxes $125,000 31.3%
Income taxes (40,000) 10.0%
Net income $ 85,000 21.3%
Earnings per share ($85,000 net income , 20,000 shares) $4.25
Dividends per share ($15,000 dividends , 20,000 shares) $0.75
SteP 3: analYze YoUR ReSUltS
There are some important observations we can make about Menielle’s income state-
ment. First, the firm is profitable, earning a net income of $85,000, or $4.25 on a per
share basis, and then paying $15,000 in dividends to the shareholders, or $0.75 per share.
Also, for every $100 of sales, Menielle earned $62.50 in gross profits, $40 in operating
income, and $21.30 in net income. Finally, the rate of dividends to earnings, or what is
called the dividend payout ratio, is $15,000 , $85,000 = 17.6%, indicating that the
firm is retaining most of its earnings to grow the business.
Concept Check
1. What can we learn by reviewing a firm’s income statement?
2. What basic relationship can we see in an income statement?
3. How are gross profits, operating income, and net income different as they relate to the areas of
business activity reported in the income statement?
4. What are earnings per share and dividends per share?
5. What is a profit margin? What are the different types of profit margins?
The Balance Sheet
We have observed that a firm’s income statement reports the results from operating a busi-
ness for a period of time, such as 1 year. A firm’s balance sheet, on the other hand, provides
a snapshot of the firm’s financial position at a specific point in time, presenting its asset hold-
ings, liabilities, and owner-supplied capital (stockholders’ equity).
In its simplest form, a balance sheet is represented by the following balance sheet equation:
Total assets = total debt (liabilities) + total shareholders
,
equity (3-2)
where total assets represent the resources owned by the firm, and total liabilities (debt) and
total shareholders’ equity indicate how those resources were financed.
The conventional practice is to report the amount of a firm’s various assets in the bal-
ance sheet by using the actual cost of acquiring them. Thus, the balance sheet does not
dividend-payout ratio percentage of
earnings paid out in dividends to the
shareholders.

Chapter 3 • Understanding Financial Statements and Cash Flows 57
represent the current market value of a company’s assets and consequently does not reflect
the value of the company itself. Rather, it reports historical transactions at their cost.4
accounting book value the value of an
asset as shown on a firm’s balance sheet. It
represents the depreciated historical cost of
the asset rather than its current market value or
replacement cost.
liquidity the ability to convert an asset into
cash quickly without a significant loss of its value.
current assets (gross working capital)
current assets consist primarily of cash,
marketable securities, accounts receivable,
inventories, and other current assets.
FIGuRE 3-2 The Balance Sheet: An Overview
• Cash
• Accounts receivable
• Inventories
• Other current assets
Current assets
• Net property, plant and
equipment
• Other long-term assets
Long-term (fixed) assets:• Fixed Assets (net property,
plant, and equipment)
• Other long-term assets
Long-term (fixed) assets
• Long-term debt (notes payable)
• Mortgages
Long-term liabilities
• Preferred stock
• Common stock
• Par value
• Paid in capital
• Retained earnings
Stockholders’ equity
Total Assets Total Liabilities (Debt) +
Stockholders’ Equity
• Accounts payable
• Short-term debt (notes payable)
• Other current liabilities
Short-term debt (Current liabilities)
=
Stockholders’ Equity =
(total assets – total liabilities)
Net Working Capital =
(current assets – current liabilities)
4There are exceptions to showing all assets at their historical cost. For example, investments held to be sold will be
reported at their current market value.
Therefore, the balance sheet reports a company’s accounting book value, which is
simply equal to a firm’s total assets as listed in its balance sheet.
Figure 3-2 shows us the basic components of a balance sheet. On the left side of Figure 3-2,
assets are listed according to their type; on the right side, we see the different sources of financ-
ing that companies frequently use to finance their assets.
Types of Assets
On the balance sheet, assets are listed from the most liquid to the least liquid, that is, in the
order of decreasing liquidity. Liquidity refers to the ability to quickly convert an asset into
cash without lowering the selling price. A highly liquid asset can be sold quickly without
causing a decrease in the value of the asset, whereas an illiquid asset either cannot be easily
converted to cash or can only be sold quickly at a significant discount. For example, govern-
ment securities are much more liquid than a building.
Liquidity is important because holding liquid assets reduces the chance that a firm
will experience financial distress. However, liquid assets usually generate less return than
illiquid assets. For example, holding cash would earn no return at all. Therefore, financial
managers have to choose a reasonable percentage of liquid assets so that the company can
enjoy the benefits of liquidity without significantly hurting a firm’s profitability.
As shown in Figure 3-2, a company’s assets fall into two basic categories: (1) current
assets and (2) long-term assets, which include fixed assets (property, plant and equipment)
and other long-term assets.
Current Assets A company’s current assets, or gross working capital as it is sometimes
called, are those assets that are expected to be converted into cash within 12 months. Cur-
rent assets include a firm’s cash, accounts receivable, inventories, and other current assets.

58 Part 1 • The Scope and Environment of Financial Management
◆ Cash. Every firm must have cash to conduct its business operations. A reservoir of
cash is needed because of the unequal flow of funds into (cash receipts) and out of (cash
expenditures) the business.
◆ Accounts receivable. A firm’s accounts receivable are the amounts owed to the
firm by its customers who buy on credit.
◆ Inventories. A company’s inventories consist of raw materials, work in progress, and
finished goods held by the firm for eventual sale.
◆ Other current assets. Other current assets include such items as prepaid expenses.
For example, a company’s insurance premium might be due before the actual insurance
coverage begins; or the firm’s rent might have to be paid in advance. These expendi-
tures are considered assets because they represent an investment that’s been made by
the company. Only when, for example, the insurance premium is used up following the
coverage period is the premium considered an expense.
Long-term Assets A company’s long-term assets fall into two categories: (1) fixed assets
(property, plant, and equipment) and (2) all other long-term assets.
Fixed Assets (Property, Plant, and Equipment) A firm’s fixed assets, also called prop-
erty, plant, and equipment, include such assets as machinery and equipment, buildings, and
land. These assets will be used over a number of years.
When a firm purchases a fixed asset, it does not immediately report the expenditure for
the asset as an expense in its income statement. Instead, it is shown as an asset in the balance
sheet. Some of these assets, such as machinery and equipment, will depreciate in value over
time due to obsolescence or daily wear and tear; others may not, such as land.
With a depreciable asset, the original cost of the asset is allocated as an expense in the in-
come statement over the asset’s expected useful life. The amount allocated as the cost each year
is shown as a depreciation expense in the income statement. The sum of all depreciation taken
over the life of the asset to date is shown as accumulated depreciation in the balance sheet.
To illustrate, assume that a truck purchased for $20,000 is to be evenly depreciated over
a 4-year life.5 The depreciation expense to be reported in the income statement for each year
would be $5,000 ($20,000 asset cost , 4 years). When a firm buys the truck, the $20,000 original
cost of the asset is added to the balance sheet as a gross fixed asset.The cumulative depreciation
taken over the asset’s life is reported as accumulated depreciation. We subtract the accumulated
depreciation each year from the gross fixed assets to determine net fixed assets. In this example,
the income statements for each year and balance sheets over time would appear as follows:
inventories raw materials, work in progress, and
finished goods held by the firm for eventual sale.
fixed assets assets such as equipment,
buildings, and land.
depreciation expense a noncash expense
to allocate the cost of depreciable assets, such
as plant and equipment, over the life of the asset.
accumulated depreciation the sum of
all depreciation taken over the entire life of a
depreciable asset.
gross fixed assets the original cost of a firm’s
fixed assets.
net fixed assets gross fixed assets minus the
accumulated depreciation taken over the life of
the assets.
Depreciation Expense in the Income Statement
F O R T H E Y E A R E N D E D
1 2 3 4
Depreciation expense $5,000 $5,000 $5,000 $5,000
other current assets other short-term assets
that will benefit future time periods, such as
prepaid expenses.
5In this instance, we are using a straight-line depreciation method. Other methods allow a firm to accelerate the
depreciation expenses in the early years of the asset’s life and report less in the later years.
Accumulated Depreciation in the Balance Sheet
E N D O F Y E A R
1 2 3 4
Gross fixed assets $20,000 $20,000 $20,000 $20,000
Accumulated depreciation (5,000) (10,000) (15,000) (20,000)
Net fixed assets $15,000 $10,000 $ 5,000 $ 0
cash cash on hand, demand deposits, and
short-term marketable securities that can quickly
be converted into cash.
accounts receivable money owed by
customers who purchased goods or services
from the firm on credit.
It is important to understand the distinction between gross fixed assets and net fixed
assets and how depreciation expense in the income statement relates to accumulated depre-
ciation in the balance sheet.
Other Long-Term Assets Other long-term assets are all of the firm’s assets that are not
current assets or fixed assets. They include, for example, long-term investments and intan-
gible assets such as the company’s patents, copyrights, and goodwill.

Chapter 3 • Understanding Financial Statements and Cash Flows 59
Types of Financing
We now turn to the right side of the balance sheet in Figure 3-2 labeled “Total Liabilities
(Debt) + Stockholders’ Equity,” which indicates how the firm finances its assets. Debt
(liabilities) is money that has been borrowed and must be repaid at some predetermined date.6
Equity, on the other hand, represents the shareholders’ (owners’) investment in the company.
debt liabilities consisting of such sources as credit
extended by suppliers or a loan from a bank.
equity stockholders’ investment in the firm and
the cumulative profits retained in the business
up to the date of the balance sheet.
long-term debt loans from banks or other
sources that lend money for longer than
12 months.
mortgage a loan to finance real estate where
the lender has first claim on the property in the
event the borrower is unable to repay the loan.
short-term notes (debt) amounts
borrowed from lenders, mostly financial
institutions such as banks, where the loan is to
be repaid within 12 months.
accrued expenses expenses that have been
incurred but not yet paid in cash.
accounts payable (trade credit) credit
provided by suppliers when a firm purchases
inventory on credit.
6Just for simplicity, we will use the terms debt and liabilities interchangeably, which is not always done in practice. Debt is
frequently used to refer to loans that require the borrower to pay interest, such as a bank loan, while liabilities may refer
to non-interest-bearing liabilities, such as accounts-payable (credit provided by a company’s suppliers.)
Debt (Liabilities) Debt capital is financing provided by a creditor. As shown in
Figure 3-2, it is divided into (1) current or short-term debt and (2) long-term debt.
Short-Term Debt (Current Liabilities) A firm’s short-term debt, or current liabilities,
includes borrowed money that must be repaid within the next 12 months. The sources of a
firm’s current debt include the following:
◆ Accounts payable. The firm’s accounts payable represent the credit that suppliers
have extended to the firm when it purchased inventories. The purchasing firm may
have 30, 60, or even 90 days to pay for the inventory. This form of credit extension is
also called trade credit.
◆ Accrued expenses. Accrued expenses are short-term liabilities that have been
incurred in the firm’s operations but not yet paid. For example, the company’s employ-
ees might have done work for which they will not be paid until the following week or
month, and these are recorded as accrued wages.
◆ Short-term notes. Short-term notes represent amounts borrowed from a bank or
other lending source that are due and payable within 12 months.
Long-Term Debt The firm’s long-term debt includes loans from banks or other sources
for longer than 12 months.7
common stockholders investors who own
the firm’s common stock. Common stockholders
are the residual owners of the firm.
par value the arbitrary value a firm puts on
each share of stock prior to its being offered
for sale.
paid-in capital the amount a company
receives above par value from selling stock to
investors.
preferred stockholders stockholders who
have claims on the firm’s income and assets after
creditors, but before common stockholders.
common stock shares that represent
ownership in a corporation.
current debt (short-term liabilities)
debt due to be paid within 12 months.
7Note that any part of long-term debt that must be repaid within 12 months will be shown as short-term debt. For exam-
ple, if you borrow $5,000 to be repaid in equal principal payments of $1,000 per year, the first year’s payment of $1,000
will be considered to be short-term debt with the remaining $4,000 reported as long-term debt.
A firm might borrow money for 5 years to buy equipment, or it might borrow money
for as long as 25 or 30 years to purchase real estate, such as land and buildings. Usually
a loan to finance real estate is called a mortgage, where the lender has first claim on the
property in the event the borrower is unable to repay the loan.
Equity Equity includes the shareholders’ investment—both preferred stockholders and
common stockholders—in the firm.
◆ Preferred stockholders generally receive a dividend that is fixed in amount. In the
event of the firm being liquidated, these stockholders are paid after the firm’s creditors
but before the common stockholders.
◆ Common stockholders are the residual owners of a business. They “own” whatever
income is left over after paying all expenses. In the event the firm is liquidated, the com-
mon stockholders receive only what is left over—good or bad—after the creditors and
preferred stockholders are paid. The amount of a firm’s common equity is equal to the
sum of two items:
1. The amount a company receives from selling stock to investors. This amount
may simply be shown as common stock in the balance sheet or it may be divided
into par value (an arbitrary amount a firm puts on each share of stock when it is sold,
frequently a penny or a dollar) and paid-in capital above par (also called capital sur-
plus). Paid-in capital is the amount of money above par value a firm receives when it
issues new shares to investors. For instance, if a company sells a new issue of common
stock for $50 per share and sets the par value of the stock at $1 per share, then the $49
($50-$1) would be shown as paid-in capital. So if it sold 1 million shares, the total

60 Part 1 • The Scope and Environment of Financial Management
paid-in capital would be $49 million ($49 * 1 million shares). Finally, the amount
of common stock issued will be offset by any stock that has been repurchased by the
company from its shareholders, which is shown as treasury stock.
To illustrate how a company might record an issuance of common stock, assume
that a firm issues 1,000 shares of common stock for $100 per share. The company
has a policy of assigning a $1 par value to each share of stock. (It could just as easily
have chosen a par value of a penny a share. The decision is totally arbitrary.) The
remaining $99 per share would be added to paid-in capital. Thus, the total increase
in the common equity in the balance sheet would appear as follows:
treasury stock the firm’s stock that has been
issued and then repurchased by the firm.
Par value ($1 * 1,000 shares) $ 1,000
Paid-in capital ($99 * 1,000 shares) 99,000
Total increase in common stock $100,000
8Sometimes retained earnings will be affected by some unusual or extraordinary accounting transactions in addition to
the reported net income and the dividends paid to stockholders. However, we are ignoring this possibility when explain-
ing retained earnings.
retained earnings cumulative profits
retained in a business up to the date of the
balance sheet.
2. The amount of a firm’s retained earnings. Retained earnings is the net income
that has been retained in the business rather than being distributed to the sharehold-
ers over the life of the company; in other words, the cumulative total of all the net in-
come over the firm’s life less the common stock dividends that have been paid over these years.
More simply, retained earnings at the end of a given year is determined as follows:8
Beginning
retained
earnings
+
net
income
for the year
–
dividends
paid during
the year
=
ending
retained
earnings
(3-3)
But remember, profits and cash are not the same; do not think of retained earnings
as a big bucket of cash. It is not!
To conclude, the common stockholders’ equity can be represented as follows:
Balance Sheet Illustrated: The Home Depot, Inc.
Let’s return to Home Depot to see a live firm’s balance sheet. Balance sheets for the company
are presented in Table 3-2 as of January 31, 2010 and January 30, 2011. In addition to reporting
the two individual balance sheets in columns 1 and 2, we also show in column 3 the changes
in the balance sheets between the two years. By looking at these changes, we learn something
about what happened to the company during the year that can be observed in no other way.
Finally, in columns 4 and 5, we restate the balance sheets for both years on a relative basis by
restating all the dollar numbers to percentages of total assets, or what we call a common-sized
balance sheet. This restatement allows us to compare the firm’s balance sheets across time and
against other companies more easily. We will consider both in turn.
Changes in Home Depot’s Balance Sheet Looking at the changes in the balance sheets
for Home Depot, as presented in column 3 of Table 3-2, we observe the following:
1. The firm’s total assets decreased $752 million, going from $40.877 billion in assets
to $40.125 billion. Why the decrease? Two primary reasons: the reduction in current
assets and in net fixed assets.
a. Decrease in current assets. The most significant reduction in current assets by
far came from the company’s decrease in cash in the amount of $876 million. Later
Common
equity
=
common
shareholders’
investment
+ cumulative
profits
– cumulative dividends paid
to common stockholders
earnings retained
within the busniess
$””””’%””””’&
(3-4)

Chapter 3 • Understanding Financial Statements and Cash Flows 61
9Par value of common stock increased from $85.8 million on January 31, 2010 to $86.1 million on January 31, 2011. The
balance sheet didn’t show the change because the amount was negligible when expressed in millions.
TABLE 3-2 The Home Depot, Inc. Balance Sheets ($ millions) for Years Ended January 31, 2010 and January 30, 2011
Dollar Value Common-Sized Balance Sheets
Year ended
(Col. 1)
Jan 31, 2010
(Col. 2)
Jan 30, 2011
(Col. 3)
2010–2011
Changes
(Col. 2 − Col. 1)
(Col. 4)
Jan 31, 2010
(Col. 1 ÷ Total
Assets)
(Col. 5)
Jan 30, 2011
(Col. 2 ÷ Total
Assets)
ASSETS
Cash $ 1,421 $ 545 ($ 876) 3.5% 1.4%
Accounts receivable 964 1,085 121 2.4% 2.7%
Inventories 10,188 10,625 437 24.9% 26.5%
Other current assets 1,327 1,224 (103) 3.2% 3.1%
Total current assets $13,900 $13,479 ($ 421) 34.0% 33.6%
Gross fixed assets $37,345 $ 38,471 $1,126 91.4% 95.9%
Accumulated depreciation (11,795) (13,411) (1,616) -28.9% -33.4%
Net fixed assets $25,550 $25,060 ($ 490) 62.5% 62.5%
Other assets 1,427 1,586 159 3.5% 4.0%
Total assets $40,877 $40,125 ($ 752) 100.0% 100.0%
LIABILITIES (DEBT) AND EQUITY
Accounts payable $ 9,343 $ 9,080 ($ 263) 22.9% 22.6%
Short-term notes payable 1,020 1,042 22 2.5% 2.6%
Total current liabilities $10,363 $10,122 ($ 241) 25.4% 25.2%
Long-term debt 11,121 11,114 (7) 27.2% 27.7%
Total liabilities $21,484 $21,236 ($ 248) 52.6% 52.9%
Common stock:
Par value9 $ 86 $ 86 $ 0 0.2% 0.2%
Additional paid-in capital (capital surplus) 6,666 7,001 335 16.3% 17.4%
Total common stock sold $ 6,752 $ 7,087 $ 335 16.5% 17.7%
Treasury stock (stock repurchased) (585) (3,193) (2,608) -1.4% -8.0%
Total common stock $ 6,167 $ 3,894 ($2,273) 15.1% 9.7%
Retained earnings 13,226 14,995 1,769 32.4% 37.4%
Total common equity $19,393 $18,889 ($ 504) 47.4% 47.1%
Total liabilities and equity $40,877 $40,125 ($ 752) 100.0% 100.0%
in this chapter, we will see specifically why this happened, but for now know that
it would have been something the lenders and shareholders alike would want to
understand. The decrease in cash was offset in part by the increases in accounts
receivable, and especially inventories.
b. Decrease in fixed assets. The reduction in the net fixed assets in the amount
of $490 million came from two offsetting changes: purchasing new fixed assets
(increase in gross fixed assets) in the amount of $1.126 billion, but taking
$1.616 billion in depreciation of the fixed assets. So we see that the change in a
firm’s net fixed assets is driven by (1) how much the firm spends on new fixed assets
and (2) how much depreciation expense it takes on the fixed assets in place.
2. We next review the changes in the firm’s debt and equity, which amounts to a
$752 million decrease, exactly the amount of the decrease in total assets—as it must
be. (Remember, total assets = total debt + total equity.) Primarily this change is the
consequence of the following actions:
a. Paying off $263 million owed to suppliers (reduction in accounts payable).
b. Repurchasing stock from its shareholders in the amount of $2.608 billion (increase
in treasury stock) less $335 million the firm received from issuing new stock.
c. Retaining $1.769 billion of the firm’s profits within the business (increase in retained
earnings).
Source: Data from The Home Depot, Inc., Fiscal Year 2010 and 2011 Form 10-K.

62 Part 1 • The Scope and Environment of Financial Management
Much of what we notice from looking at the changes in the balance sheet will appear
again when we study Home Depot’s statement of cash flows in the next section of the chapter.
Home Depot’s Common-Sized Balance Sheet Finally, we can gain additional perspec-
tive on a company’s financial position by looking at each item on the balance sheet as a
percentage of total assets (and total debt and equity). A balance sheet expressed this way
is called a common-sized balance sheet. The last two columns (columns 4 and 5) of
Table 3-2 show common-sized balance sheets for Home Depot.
Based on the percentages, we can observe that:
1. Inventories make up most of the current assets, amounting to about one-fourth of all
the assets owned by the company.
2. The company’s total assets consist of about one-third current assets and two-thirds
fixed assets.
3. Approximately one-half of Home Depot’s financing comes from debt, with the remain-
ing half coming from equity. To be more precise, we can calculate the debt ratio,
which is the percentage of a company’s assets financed by debt. For Home Depot, the debt
ratios on January 31, 2010 and January 30, 2011, respectively, were 52.6 percent and
52.9 percent:
net working capital the difference between
a firm’s current assets and its current liabilities.
When the term working capital is used, it is
frequently intended to mean net working capital.
common-sized balance sheet a balance
sheet in which a firm’s assets and sources of debt
and equity are expressed as a percentage of its
total assets.
debt ratio a firm’s total liabilities divided by its
total assets. It is a ratio that measures the extent
to which a firm has been financed with debt.
F I S c a l y E a r E n d E d
J a n ua r y 31, 2010 J a n ua r y 30, 2011
debt ratio =
total debt
total assets

$21,484M
$40,877M
= 52.6%
$21,236M
$40,125M
= 52.9%
The debt ratio is an important measure to lenders and investors because it indicates the
amount of financial risk the company is bearing—the more debt a company uses to finance
its assets, the greater is its financial risk. We will discuss this topic in detail in Chapter 12.
Working Capital
Earlier we noted that the term current assets is also referred to as gross working capital. These
two terms are used interchangeably. By contrast, net working capital is equal to a com-
pany’s current assets less its current liabilities. That is,
Net working capital = current asset – current liabilities (3-5)
Thus, net working capital compares the amount of current assets (assets that should
convert into cash within the next 12 months) to the current liabilities (debt that must be
paid within 12 months). The larger the net working capital a firm has, the more able the
firm will be to pay its debt as it comes due. Thus, the amount of net working capital is
important to a company’s lenders, who are always concerned about a company’s ability to
repay its loans. For Home Depot, net working capital is computed as follows:
Most firms have a positive amount of net working capital because their current assets are
greater than their current debts. There are a few exceptions. For example, Disney actually has
almost as much in current liabilities as in current assets. How do you think this could happen?
Very simply, a big part of Disney’s sales are cash generated in the theme parks, collecting cash
immediately from its customers. However, Disney’s suppliers have probably granted Disney
30 days or more to pay its bills. In other words, Disney collects early and pays late.
Gross working
capital is the same
as current assets
F I S c a l y E a r E n d E d
J a n ua r y 31, 2010 J a n ua ry 30, 2011
Gross working capital $13,900 $13,479
current liabilities (10,363) (10,122)
net working capital $ 3,537 $ 3,357

Chapter 3 • Understanding Financial Statements and Cash Flows 63
Gross fixed assets $75,000 Accounts receivable $ 50,000
Cash $10,000 Long-term bank note $ 5,000
Other assets $15,000 Mortgage $ 20,000
Accounts payable $40,000 Common stock $100,000
Retained earnings $15,000 Inventories $ 70,000
Accumulated depreciation $20,000 Short-term notes $ 20,000
Current assets Current liabilities
+ Long-term (fixed) assets + Long-term liabilities
+ Shareholders’ equity
= Total assets = Total liabilities + Shareholders’ equity
e x a m p l e 3.2 Constructing a balance sheet
Given the information below for Menielle, Inc., construct a balance sheet and a
common-sized balance sheet. As a percent of assets, what are the firm’s largest invest-
ments and sources of financing?
Step 1: Formulate a Solution Strategy
The balance sheet can be visualized as follows:
Step 2: CrunCh the numberS
Your results should be as follows:
Balance Sheet
Assets: Liabilities and Equities:
Cash $ 10,000 Accounts payable $ 40,000
Accounts receivable 50,000 Short-term notes 20,000
Inventories 70,000 Total short-term debt $ 60,000
Total current assets $130,000 Long-term bank note $ 5,000
Gross fixed assets $ 75,000 Mortgage 20,000
Accumulated depreciation (20,000) Total long-term debt $ 25,000
Net fixed assets $ 55,000 Total debt $ 85,000
Other assets 15,000 Common stock 100,000
Total assets $200,000 Retained earnings 15,000
Total equity $115,000
Total debt and equity $200,000
Common-Sized Balance Sheet
Assets: Liabilities and Equities:
Cash 5.0% Accounts payable 20.0%
Accounts receivable 25.0% Short-term notes 10.0%
Inventories 35.0% Total short-term debt 30.0%
Total current assets 65.0% Long-term bank note 2.5%
Gross fixed assets 37.5% Mortgage 10.0%
Accumulated depreciation (10.0%) Total long-term debt 12.5%
Net fixed assets 27.5% Total debt 42.5%
Other assets 7.5% Common stock 50.0%
Total assets 100.0% Retained earnings 7.5%
Total equity 57.5%
Total debt and equity 100.0%

64 Part 1 • The Scope and Environment of Financial Management
SteP 3: analYze YoUR ReSUltS
We see that the firm has invested a total of $200,000 in its assets, comprised of
$130,000 in current assets (65% of total assets), $55,000 in fixed assets (27.5% of
total assets), and $15,000 in other assets (7.5% of total assets). Second, the firm
has $130,000 tied up in current assets and $60,000 in current liabilities, leaving the
firm with a net working capital position of $130,000 – $60,000 = $70,000. Third,
the firm uses more equity (57.5% of total assets) than debt (42.5% of total assets) to
finance its business.
The Balance Sheet and Income Statement—as
One Picture
We have already stated that an income statement is for a period of time while a balance
sheet is prepared at a specific date in time. Now that we have looked at both an income
statement and a balance sheet, let’s return to the difference in time perspectives between an
income statement and a balance sheet. By examining two balance sheets, one at the begin-
ning of a year and one at the end of the year, along with the income statement for the year,
we have a better picture of a firm’s operations. For instance, we could see what a company
looked like at the beginning of 2013 (by looking at its balance sheet on December 31, 2012),
what happened during the year (by looking at its income statement for 2013), and the final
outcome at the end of 2013 (by looking at its balance sheet on December 31, 2013). The
distinction between an income statement and a balance sheet is represented graphically as
Figure 3-3.
Concept Check
1. What does the basic balance sheet equation state, and what does it mean?
2. What is a firm’s “accounting book value”?
3. What are a firm’s two principal sources of financing? Of what do these sources consist?
4. What is gross working capital? Net working capital?
5. What is a debt ratio?
6. What is the difference between the time frame of the income statement
and the balance sheet?
FIGuRE 3-3 The Income Statement and Balance Sheet as One Picture
Reports a firm’s financial
position at beginning of 2013
(end of 2012)
Reports a firm’s financial
position at end of 2013
Balance Sheet on
December 31, 2012
Balance Sheet on
December 31, 2013
Income statement reports the profits from
January 1, 2013 through December 31, 2013
January 1 December 31

Chapter 3 • Understanding Financial Statements and Cash Flows 65
Measuring Cash Flows
Despite the fact that cash is the lifeblood of a business—the fuel that keeps the engine
running—some managers do not fully understand what drives a firm’s cash flows. Poor
cash-flow management, especially for smaller firms, can result in a business failing. Managers
must understand that profits and cash flows are not the same thing.
Profits Versus Cash Flows
You need to be aware that the profits shown on a company’s income statement are not the same as its
cash flows! In the words of author Jan Norman, “Even profitable companies can go broke.
That’s a difficult truth for start-up business owners to swallow. But the sooner you learn
that when you’re out of cash, you’re out of business, the better your chances for survival will
be.”10 Many a profitable business on paper has had to file bankruptcy because the amount
of cash coming in did not compare with the amount of cash going out. Without adequate
cash flow, little problems become major problems!
Can you do it?
PRePaRing an inCome Statement and a balanCe Sheet
Below is a scrambled list of accounts of Zhong, Inc., an energy company (in $ thousands). Complete the firm’s income statement and
balance sheet. Also calculate the earnings per share and dividends per share.
(The solution to this problem can be found on page 66.)
Accounts payable $ 4,400
Account receivable $ 2,500
Accumulated depreciation $ 4,200
Cash $ 3,300
Cost of goods sold $17,000
Common stock $13,800
Depreciation expense $ 1,500
Dividends $ 40
Gross fixed assets $24,500
Income taxes $ 150
Interest expense $ 1,000
Long-term debt $10,000
Number of shares outstanding $ 800
Other assets $15,600
Inventories $ 1,500
Retained earnings $ 8,000
Sales $30,000
Selling, marketing, and administrative expenses $10,000
Short-term notes $ 7,000
3 Measure a company’s cash
flows.
10“How To Manage Your Cash Flow: You’re making sales, but are you making money?” by Jan Norman from
Entrepreneur, June 1, 1998.
An income statement is not a measure of cash flows because it is calculated on an ac-
crual basis rather than a cash basis. Let’s say it again for emphasis: An income statement is not
a measure of cash flows because it is calculated on an accrual basis rather than a cash basis. This
is an important point to understand. In accrual basis accounting, profits are recorded
when earned—whether or not the profits have been received in cash—and expenses are re-
corded when they are incurred—even if money has not actually been paid out. In cash basis
accounting, profits are reported when cash is received and expenses are recorded when
they are paid.
accrual basis accounting a method of
accounting whereby revenue is recorded when it
is earned, whether or not the revenue has been
received in cash. Likewise, expenses are recorded
when they are incurred, even if the money has
not actually been paid out.
cash basis accounting a method of
accounting whereby revenue is recorded when
physical cash is actually received. Likewise,
expenses are recorded when physical cash is
paid out.

66 Part 1 • The Scope and Environment of Financial Management
For a number of reasons, profits based on an accrual accounting system will differ from
the firm’s cash flows. These reasons include the following:
1. Sales reported in an income statement include both cash sales and credit sales. Thus,
total sales do not correspond to the actual cash collected. A company may have had
sales of $1 million for the year but not collected all these sales. If accounts receivable
increased $80,000 from the beginning of the year to the end of the year, then we would
know that only $920,000 of the sales had been collected ($920,000 = $1,000,000 sales
– $80,000 increase in accounts receivable).
2. Some inventory purchases are financed by credit, so inventory purchases do not exactly
equal cash spent for inventory. Consider a business that purchased $500,000 in inven-
tories during the year, but the supplier extended credit of $100,000 for the purchases.
The actual cash paid for inventories would only be $400,000 ($400,000 = $500,000
total inventory purchases – $100,000 additional credit granted by the supplier).
3. The depreciation expense shown in the income statement is a noncash expense. It
reflects the costs associated with using an asset that benefits the firm’s operations over
a period of multiple years, such as a piece of equipment used over 5 years. Thus, if a
business had profits of $250,000 that included depreciation expenses of $40,000, then
the cash flows would be $290,000 ($250,000 profits + $40,000 depreciation expense).
We could give you more examples to show why a firm’s profits differ from its cash
flows, but the point should be clear: Profits and cash flows are not the same thing. In fact,
a business could be profitable but have negative cash flows, even to the point of going
did you get it?
PRePaRing an inCome Statement and a balanCe Sheet
On page 65, we provided data for Zhong, Inc. and asked you to prepare an income statement and a balance sheet and to calculate the
earnings per share and dividends per share based on the information. Your results should be as follows:
Income statement:
Sales $30,000
Cost of goods sold (17,000)
Gross profit $13,000
Operating expenses:
Selling, marketing, and administrative expenses ($10,000)
Depreciation expense (1,500)
Total operating expenses $ 11,500
Operating income $ 1,500
Interest expense (1,000)
Earnings before tax $ 500
Income taxes (150)
Net income $ 350
Earnings per share ($350 net income , 800 shares) $ 0.44
Dividends per share ($40 dividends , 800 shares) $ 0.05
Balance sheet:
Cash $ 3,300 Accounts payable $ 4,400
Accounts receivable 2,500 Short-term notes 7,000
Inventories 1,500 Total short-term debt $11,400
Total current assets $ 7,300 Long-term debt 10,000
Gross fixed assets $24,500 Total debt $21,400
Accumulated depreciation (4,200) Common stock 13,800
Net fixed assets $20,300 Retained earnings 8,000
Other assets 15,600 Total equity $21,800
Total assets $43,200 Total debt and equity $43,200
Source: Data from The Home Depot, Inc. Fiscal Year 2010 Form 10-K.

Chapter 3 • Understanding Financial Statements and Cash Flows 67
bankrupt. So, understanding a firm’s cash flows is very important to its managers. Cash
flows are also important when applying for a loan. A banker will not make a loan with-
out a clear indication that the firm’s cash flows will adequately service the proposed loan.
Revenue growth and profits are all fine, but only historical cash flows can demonstrate the
ability to collect accounts receivable and properly manage inventory and accounts payable.
So you had better understand the ins and outs of your firm’s cash flows.
A Beginning Look: Determining Sources and Uses of Cash
To begin, we need to understand that changes in a firm’s balance sheets have implications
for its cash flows. To determine whether a change in a balance sheet account is a source or
a use of cash, you need to understand the following relationships:
S ources of Cash Uses of Cash
Decrease in an Asset
Example: Selling inventories or collecting
receivables provides cash.
Increase in an Asset
Example: Investing in fixed assets or buying more
inventories uses cash.
Increase in Liability or Equity
Example: Borrowing funds or selling stock
provides the firm with cash.
Decrease in a Liability or Equity
Example: Paying off a loan or buying back stock
uses cash.
TABLE 3-3 The Home Depot, Inc.: Sources and Uses of Cash for
Year Ending January 30, 2011 ($ millions)
Account Balance as of:
Jan 31, 2010 Jan 30, 2011 Change Sources Use
Balance Sheet Changes
Accounts receivable $ 964 $ 1,085 $ 121 $ 121
Inventories 10,188 10,625 437 437
Other current assets 1,327 1,224 (103) 103
Gross fixed assets 37,345 38,471 1,126 1,126
Other assets 1,427 1,586 159 159
Accounts payable 9,343 9,080 (263) 263
Short-term notes payable 1,020 1,042 22 22
Long-term debt 11,121 11,114 (7) 7
Common stock sold 6,752 7,087 335 335
Stock repurchased (treasury stock) (585) (3,193) (2,608) 2,608
To illustrate the above relationships, return to Home Depot’s balance sheets in Table 3-2.
Earlier we studied the changes in the balance sheet, but this time we want to determine whether
these changes result in sources or uses of cash. In Table 3-3, we list some of the changes in
Home Depot’s balance sheet and indicate whether the changes are sources or uses of cash. This
information is then used in the next section to prepare the company’s statement of cash flows.
So keep in mind the relationships between changes in the balance sheet and the firm’s cash
flows, as shown in Table 3-3.
Statement of Cash Flows
There are two common approaches to measuring a firm’s cash flows. First, we can use the
conventional accountant’s presentation called a statement of cash flows, which is always in-
cluded in the financial section of a firm’s annual report. This method for presenting cash flows
focuses on identifying the sources and uses of cash that explain the change in a firm’s cash bal-
ance reported in the balance sheet. Alternatively, we can calculate a company’s free cash flows
and financing cash flows, which are measurements that managers and investors alike consider
critically important. Once a firm has paid all of its operating expenses and taxes and made all of
its investments, any remaining cash is free to be distributed to the creditors and shareholders.
Alternatively, if the free cash flows are negative, management will have to acquire financing
from creditors or shareholders. Understanding and calculating a company’s free cash flows is
statement of cash flows a statement that
shows how changes in balance sheet accounts
and income affect cash and cash equivalents,
and breaks the analysis down to operating,
investing, and financing activities.
free cash flows the amount of cash available
from operations after the firm pays for the
investments it has made in operating working
capital and fixed assets. This cash is available to
distribute to the firm’s creditors and owners.
financing cash flows the amount of cash
received from or distributed to the firm’s
investors, usually in the form of interest,
dividends, issuance of debt, or issuance or
repurchase of stocks.
Source: Data from The Home Depot, Inc. Fiscal Year 2010 Form 10-K.

68 Part 1 • The Scope and Environment of Financial Management
explained in the appendix to this chapter. But for now we will focus on the statement of cash
flows that all publicly traded firms must provide for their lenders and investors.
As shown in Figure 3-4, there are three key activities that determine the cash inflows
and outflows of a business:
1. Generating cash flows from day-to-day business operations. It is informative to
know how much cash is being generated in the normal course of operating a busi-
ness, beginning with purchasing inventories on credit, selling on credit, paying for the
inventories, and finally collecting on the sales made on credit.
2. Investing in fixed assets and other long-term investments. When a company pur-
chases or sells fixed assets, like equipment and buildings, there can be significant cash
inflows from selling these assets and outflows from purchasing these assets.
3. Financing the business. Cash inflows and outflows occur from borrowing or repay-
ing debt, paying dividends, and from issuing stock (equity) or repurchasing stock from
the shareholders.
If we know the cash flows from the activities above, we can combine them to determine
a company’s change in cash and prepare a statement of cash flows. To understand how this
is done, we will once again return to Home Depot’s income statement (Table 3-1 on page
54) and balance sheets (Table 3-2 on page 61).
FIGuRE 3-4 Statement of Cash Flows: An Overview
Net change in cash
=
Cash flows from financing activities
Cash flows from operations
Cash flows from investment opportunities
Cash Inflows
Cash inflows generated
from normal operations
Cash Outflows
Cash expenditures from
normal operations
Plus sales of plant and
equipment and other
long-term investments
Less purchase of plant
and equipment and other
long-term investments
Increase in debt,
issue preferred stock
and common stock
Less repayment of debt,
repurchase preferred
and common stock, and
cash dividend payments
FinanCe at work
managing YoUR CaSh FlowS
If you want to improve cash flows, take a close look at your most
recent financial statements. Watch out for:
• Money tied up in excess inventory that could be used to
grow your business.
• Expensive office space. Don’t spend for a prime location if
you don’t need it.
• Unpaid invoices from customers. Collect payments promptly.
• Not asking suppliers to extend credit terms. They might give
you an extra 15 or even 30 days before you have to pay for
purchases, if you simply ask.
• Not closely monitoring cash flows, which can take away
money to grow your business.
Source: Adapted from Edward Marram,”6 Weeks to a Better Bottom Line,”
Entrepreneur Magazine, January 2010, http://www.entrepreneur.com/magazine/
entrepreneur/2010/january/204390.html, accessed June 4, 2012.

http://www.entrepreneur.com/magazine/entrepreneur/2010/january/204390.html

Chapter 3 • Understanding Financial Statements and Cash Flows 69
Cash Flow Activity 1: Cash Flows from Day-to-Day Operations Here we want to con-
vert the company’s income statement from an accrual basis to a cash basis. This conversion
can be accomplished in five steps. We begin with the firm’s net income and then we:
1. Add back depreciation expense since it is not a cash expense;
2. Subtract (add) any increase (decrease) in accounts receivable;
3. Subtract (add) any increase (decrease) in inventory;
4. Subtract (add) any increase (decrease) in other current assets;
5. Add (subtract) any increase (decrease) in accounts payable and other accrued expenses.
Why we add back depreciation should be clear; it simply is not a cash expense. The
changes in accounts receivable, inventories, other current assets, and accounts payable may
be less intuitive. Four comments are helpful:
1. A firm’s sales are either cash sales or credit sales. If accounts receivable increase, that
means customers did not pay for everything they purchased during the year. Thus, any
increase in accounts receivable needs to be subtracted from sales to determine the cash
that has not been collected from customers. On the other hand, if accounts receivable
decrease, then a firm has collected more than it has sold, which indicates a cash inflow.
In equation form, we can compute the cash collected from sales as follows:
Cash collections
from sales = sales –
change in
accounts receivable
(3-6)
2. An increase in inventories shows that we bought inventories, and a decrease in inven-
tories shows that we sold inventories.
3. Other current assets include prepaid expenses, like prepaid insurance and prepaid rent. If
other current assets increase (decrease), that means there has been a cash outflow (inflow).
4. While an increase in inventories indicates a cash outflow occurred, if accounts payable
(credit extended by a supplier) increase as well, then we know that the firm’s suppliers
provided credit to the firm, which is a source of cash. The firm did not pay for all the
inventories purchased. Thus, the net payment for inventories is equal to the change in
inventories less the change in accounts payable. If, on the other hand, accounts payable
decreased, there has been a cash outflow.
Figure 3-5 (on page 70) shows a graphical presentation of the procedure for computing
a firm’s cash flows from operations.
Cash Flows from Operations Illustrated: Home Depot Given the basic framework for
a statement of cash flows just explained, we can now prepare this section of the cash flow
statement for Home Depot. Referring back to the company’s income statement and bal-
ance sheets, we can compute the cash flows from operations (expressed in $ millions) as
follows:
Net income $3,338
Cash inflows
Plus depreciation $1,616
Less increase in accounts receivable (121)
Less increase in inventories (437)
Plus decrease in other current assets 103
Cash outflows
Less decrease in accounts payable (263)
Total adjustments to net income 898
Cash flows from operating activities $4,236
Since depreciation
is not a cash expense,
we add it back
to income.

70 Part 1 • The Scope and Environment of Financial Management
FIGuRE 3-5 Cash Flow from Operations
Cash Flow Activity 2: Investing in Long-Term Assets Long-term assets include
fixed assets and other long-term assets. For example, when a company purchases
(sells) fixed assets, such as equipment or buildings, these activities are shown as an
increase (decrease) in gross fixed assets in the balance sheet and are cash outflows and
cash inflows, respectively.
Cash flow from operations
=
–
Increase in accounts payable
Derease in accounts payable
+
Decrease in other current assets
+
Increase in other current assets
–
+
Increase in inventory
Decrease in inventory
–
Decrease in accounts receivable
+
Increase in accounts receivable
–
Net income
Depreciation
+
or
or
or
or
Ch
an
ge
s
in
c
ur
re
nt
a
ss
et
s
(e
xc
ep
t
ca
sh
)

Chapter 3 • Understanding Financial Statements and Cash Flows 71
Investing in Long-Term Assets Illustrated: Home Depot As shown in their balance
sheets (Table 3-2), Home Depot spent $1.126 billion on new plant and equipment for the
year ended January 30, 2011, based on the change in gross fixed assets from $37.345 billion
to $38.471 billion. It also spent $159 million on other assets.
Cash Flow Activity 3: Financing the Business Cash flows associated with financing
a business are as follows:
Cash Inflow : Cash O utflow :
The firm borrows more money (an increase in
short-term and/or long-term debt)
The firm repays debt (a decrease in short-term
and/ or long-term debt)
Owner(s) invest in the business (an increase in
stockholders’ equity)
The firm pays dividends to the owner(s) or
repurchases the owners’ stocks (a decrease in
equity)
11Par value of common stock increased from $85.8 million on January 31, 2010 to $86.1 million on January 31, 2011.
The balance sheet didn’t show the change because the amount rounds to zero when expressed in whole millions.
When we talk about borrowing or repaying debt in financing activities, we do not
include accounts payable and any accrued operating expenses. These items were in-
cluded in cash-flow activity 1 when we computed cash flows from operations. Here in
activity 3, we include only debt from such sources as banks in the form of short-term
notes and long-term debt.
Financing the Business Illustrated: Home Depot Continuing with Home Depot, we see
from the income statement (Table 3-1) that it paid $1.569 billion in dividends to the share-
holders. Then from their balance sheets (Table 3-2), we see that short-term notes increased
$22 million (a source of cash), and long-term debt decreased $7 million (a use of cash). Also, the
firm issued $335 million in common stock. This increase is reflected in the balance sheets in the
combined changes in common stock par value and paid-in capital, which was $335 million.11
Finally, it repurchased $2.608 billion in common stock. Thus, in net, Home Depot had
$3.827 billion cash outflows in financing activities, shown as follows:
Cash inflows from borrowing money
Increase in short-term notes payable $ 22
Cash inflow
Decrease in long-term debt (7)
Cash outflow
Issued new common stock:
Increase in par value 0
Increase in additional paid-in capital 335
Total stock issued $ 335
Less repurchased common stock (treasury stock) (2,608)
Less dividends paid to owners (1,569)
Financing cash flows ($3,827)
Using the computations to this point, we can now complete a statement of cash flows
for Home Depot, which is shown in Table 3-4 (on page 72). From the table we see that
the firm generated $4.236 billion in cash flows from operations; invested $1.285 billion in
plant and equipment and other assets; and paid out $3.827 billion in financing activities,
for a net decrease in cash of $876 million. This can be verified from the balance sheets (see
Table 3-2), which show that Home Depot’s cash decreased $876 million from January 31,
2010 to January 30, 2011 (from $1.421 billion to $545 million). Earlier in the chapter, we
commented on the large decrease in cash and wondered about the cause. Now we know:
The company generated positive cash flows from operations but used these cash flows and
more to purchase fixed assets and make large distributions to creditors and stockholders in
the form of interest, dividends, and share repurchases.

72 Part 1 • The Scope and Environment of Financial Management
TABLE 3-4 The Home Depot, Inc. Statement of Cash Flows ($ millions)
Year Ended January 30, 2011
Operating activities:
a. Net income $3,338
b. Adjustments to net income to compute cash flow from operating activities
1. Add depreciation expense (Source of cash) $1,616
2. Increased accounts receivable (Use of cash) (121)
3. Increased inventories (Use of cash) (437)
4. Decreased other current assets (Source of cash) 103
5. Decreased accounts payable (Use of cash) (263)
Total adjustments to net income $ 898
Cash flows from operating activities $4,236
Investing activities:
c. Increased gross fixed assets (Use of cash) ($1,126)
d. Increased other assets (Use of cash) (159)
Cash flows from investing activities ($1,285)
Financing activities:
e. Increased short-term notes payable (Source of cash) $ 22
f. Decreased long-term debt (Use of cash) (7)
g. Increased (issued) new common stock (increase in par value and
paid-in capital) (Source of cash) 335
h. Repurchased common stock (increased treasury stock) (Use of cash) (2,608)
i. Dividends paid to shareholders (Use of cash) (1,569)
Cash flows from financing activities ($3,827)
Summary:
j. Change in cash and cash equivalents ($ 876)
k. Beginning cash (January 31, 2010) 1,421
l. Ending cash (January 30, 2011) $ 545
Same as the cash
balances in Home
Depot’s balance
sheets
Legend:
Operating Activities
a. Home Depot had net income of $3,338.
b. Adjustments to net income to compute cash flows from operations:
1. Depreciation. Since Home Depot’s depreciation expense is a noncash charge, we add back $1,616 in
depreciation to net income when calculating Home Depot’s cash flow.
2. Increase in accounts receivable. Home Depot’s accounts receivable rose by $121 million, which is
a use of cash.
3. Increase in inventories. Home Depot increased its inventories by $437 million, which is a use of cash.
4. Decrease in other current assets. Home Depot’s other current assets decreased by $103 million, which
represents a cash inflow.
5. Decrease in accounts payable. Home Depot’s accounts payable decreased by $263 million, which is a cash outflow.
Cash flows from operating activities add up to a $4.236 billion net inflow of cash.
Investing Activities
c. Increase in gross fixed assets. Home Depot spent $1.126 billion on fixed assets during the current year,
resulting in a cash outflow.
d. Increase in other assets. Home Depot spent $159 million on its other assets, resulting in a cash outflow.
Cash flows from investment activities. The total on this line is the sum of the investments listed above,
$1.285 billion.
Financing Activities
e. Increase in short-term notes payable. Home Depot borrowed an additional $22 million from its bank, which
was a cash inflow.
f. Decrease in long-term debt. Home depot repaid a net $7 million of its long-term debt, which is a cash outflow.
g. Issued new common stock. Home Depot issued new common stock of $335 million. Common stock includes
both par value and additional paid-in capital. This increase is a cash inflow.
h. Repurchased common stock. Home Depot repurchased $2.608 billion of its common stock, which is a cash outflow.
i. Dividends paid to shareholders. Home Depot paid out $1.569 billion in dividends, which is a cash outflow.
Cash flows from financing activities. The sum of the five financing entries equals a negative $3.827 billion.

Chapter 3 • Understanding Financial Statements and Cash Flows 73
Increase in accounts receivable $13 Dividends $ 5
Increase in inventories 25 Change in common stock 0
Net income 33 Increase in gross fixed assets 55
Beginning cash 15 Depreciation expense 7
Increase in accounts payable 20
Increase in accrued expenses 5
Increase in long-term notes payable 28
Cash flow from operating activities
Plus/Minus: Cash flow from investing activities
Plus/Minus: Cash flow from financing activities
Equals: Change in cash
Plus: Beginning cash balance
Equals: Ending cash balance
Net income $33
Adjustments:
Depreciation expense $ 7
Less increase in accounts receivable (13)
Less increase in inventories (25)
Plus increase in accounts payable 20
Plus increase in accrued expense 5
Total adjustments ($ 6)
Cash flow from operating activities $27
Investing activity:
Increase in gross fixed assets ($55)
Financing activities:
Increase in long-term notes payable $28
Change in common stock 0
Common stock dividends (5)
Total financing activities $23
Change in cash ($ 5)
Beginning cash 15
Ending cash $10
Summary:
j. Change in cash and cash equivalents. The net sum of the operating activities, investing activities, and
financing activities resulted in an $876 million net decrease in cash during the fiscal year, mainly caused
by stock repurchases, dividends paid, and investments in fixed assets.
k. Beginning cash. Home Depot began the fiscal year with $1.421 billion of cash.
l. Ending cash. Home Depot ended the 2011 fiscal year with $545 million of cash, the $1.421 billion it started
with minus the $876 million net decrease in cash during 2011.
E x A M P L E 3.3 Measuring cash flows
Given the following information for Menielle, Inc., prepare a statement of cash flows.
SteP 1: FoRmUlate a SolUtion StRategY
The cash flow statement uses information from the firm’s balance sheets and income
statement to identify the net sources and uses of cash for a specific period of time. More-
over, the sources and uses are organized into cash from operating activities, from invest-
ing activities, and from financing activities.
SteP 2: CRUnCh the nUmbeRS
Your results should be as follows:

74 Part 1 • The Scope and Environment of Financial Management
SteP 3: analYze YoUR ReSUltS
Menielle’s cash decreased $5 from $15 to $10 because of (1) a $27 cash inflow from
operations, (2) less a $55 cash outflow in investing, and (3) plus a $23 cash inflow from
financing activities. The cash-flow statement portrays a firm that is investing in fixed
assets at a pace that is roughly twice the firm’s operating cash flows, which requires the
firm to finance the difference.
Concluding Suggestions for Computing Cash Flows
When calculating cash flows, there are some little things to remember, which, while small,
can be very frustrating if not understood. They are:
1. Don’t look at the cash-flow statement as a whole. It can be intimidating. Just work
on the three parts of the statement individually, then put it all together to get to
the whole. That just helps you focus on what needs to be done without being over-
whelmed. After some time, it becomes much more intuitive, especially when it is
your money!
2. Depreciation expense and net profits are the only two numbers you need from the
income statement.
3. You need to be certain that you have used every change in the company’s balance
sheet, with two exceptions:
a. Ignore accumulated depreciation and net fixed assets since they involve the noncash
item of depreciation. Use only the change in gross fixed assets.
b. Ignore the change in retained earnings since it equals the net profits less dividends
paid, two items that are captured elsewhere.
Conclusions About Home Depot’s Financial Position
To conclude our discussion on financial statements, consider some of the main things we
learned about Home Depot:
◆ Home Depot’s inventories made up 79 percent of the current assets. Home Depot’s
total assets consisted of about one-third current assets and two-thirds fixed assets.
◆ For every $1 of sales, Home Depot earned 34 cents in gross profits, 9 cents in operating
income, and 5 cents in net income.
◆ The firm financed its assets with slightly more debt than equity. It had a debt ratio of
52.9 percent.
◆ The firm had $4.236 billion in cash flows from operations.
◆ Management invested $1.285 billion in long-term assets and paid out $3.827 billion to
lenders and shareholders.
◆ The firm’s primary investments in 2010 were in additional long-term assets, mostly
fixed assets, in the amount of $1.285 billion, and an increase in inventories amounting
to $437 million.
◆ The cash flows received from investors came in the form of newly issued stock for
$335 million.
◆ The primary cash flows going to investors were dividends ($1.569 billion) and stock
repurchases ($2.608 billion). However, the firm also paid $530 million in inter-
est expense, which can only be seen in the income statement. Since the statement
of cash flows as prepared by the accountants begins with net income, interest
expense was deducted when computing cash flows from operations. But from a pure
finance perspective, it is very much a financing activity and should be recognized
as such.

Chapter 3 • Understanding Financial Statements and Cash Flows 75
FinanCe at work
what did home dePot’S management have to SaY?
We have studied Home Depot’s financial statements and drawn
some conclusions about what we believe the statements told
us. Let’s now see what the firm’s management concluded. Be-
low are a few of management’s comments that appeared in the
firm’s annual report.
About profits?
Our U.S. stores experienced gross profit margin increase in fis-
cal 2010 as we realized benefits from better product assortment
management through our portfolio approach and leveraging of
our newly developed merchandising tools. Lower levels of clear-
ance inventory in our stores for fiscal 2010 compared to last year
also contributed to this increase. Additionally, we realized gross
profit margin increase from our non-U.S. businesses, primarily
Canada, due primarily to a change in the mix of products sold.
About the firm’s cash position?
As of January 30, 2011, we had $545 million in cash and cash
equivalents. We believe that our current cash position, access to
the debt capital markets and cash flow generated from opera-
tions should be sufficient to enable us to complete our capital
expenditure programs and fund dividend payments, share re-
purchases and any required long-term debt payments through
the next several fiscal years.
About cash flows from operations?
Cash flow generated from operations provides us with a
significant source of liquidity. For fiscal 2010, Net Cash
Provided by Operating Activities was approximately
$4.6 billion compared to approximately $5.1 billion for fiscal
2009. This decrease was primarily a result of changes in in-
ventory levels and other net working capital items partially
offset by increased earnings.*
*Because we simplified Home Depot’s financial statements for learning
purposes, all cash-flow activities (cash flow from operations, cash flow from
investing, and cash flow from financing) presented in our example are slightly
different from the actual amount given in Home Depot’s 10-K.
About cash flows from investing?
Net Cash Used in Investing Activities for fiscal 2010 was
$1.0 billion compared to $755 million for fiscal 2009. This change
was primarily due to increased Capital Expenditures and lower
Proceeds from Sales of Property and Equipment.
And about cash flows from financing?
Net cash used in financing activities for fiscal 2010 was $4.5
billion compared to $3.5 billion for fiscal 2009. This increase
was primarily due to $2.4 billion more in Repurchases of
Common Stock than in fiscal 2009, and was partially off-
set by a $998 million increase in Proceeds from Long-Term
Borrowings and a $745 million decrease in Repayments of
Long-Term Debt in fiscal 2010.
Can you do it?
meaSURing CaSh FlowS
Given the following information for an electronics company, prepare a statement of cash flows.
(The solution can be found on page 76.)
Increase in accounts receivable $ 300 Common stock dividends $ 40
Increase in inventories 80 Increase in common stock 10
Increase in long-term debts 80 Increase in gross fixed assets 50
Beginning cash 1,785 Depreciation expense 1,500
Increase in accounts payable 60 Net income 485
Increase in other current assets 150
Concept Check
1. Why doesn’t an income statement provide a measure of a firm’s cash flows?
2. What are three main parts of a statement of cash flows?
3. What does each part tell us about a company?

76 Part 1 • The Scope and Environment of Financial Management
GAAP and IFRS
The United States follows Generally Accepted Accounting Principles (GAAP). GAAP
is a set of rule-based accounting standards established by the Financial Accounting Stan-
dards Board (FASB). It sets out the standards, conventions, and rules that accountants must
follow when preparing audited financial statements. It is complex, providing more than 150
“pronouncements” as to how to account for different types of transactions.
Most other countries follow the International Financial Reporting Standards
(IFRS). IFRS is a set of principle-based accounting standards that were established by the
International Accounting Standards Board (IASB). IFRS sets out broad and general prin-
ciples that accountants should follow when preparing financial statements. It leaves more
room for discretion than GAAP does, permitting managers to exercise their own judgment
when deciding how to report their financial statements, as long as they follow the spirit of
the standards. Thus, IFRS offers simplicity but also possibly more leeway for accounting
malpractice than does GAAP.
In 2008, the Securities and Exchange Commission (SEC) announced its plan to convert
U.S. companies from GAAP to IFRS, by as early as 2014, even though there is considerable
controversy about the switch. The U.S. accounting standard is going to undergo significant
changes in the future.
Concept Check
1. What are the differences between GAAP and IFRS?
4 Explain the differences
between GAAP and IFRS.
Generally Accepted Accounting Prin-
ciples (GAAP) rule-based set of accounting
principles, standards, and procedures that com-
panies use to compile their financial statements.
These principles are issued by the Financial
Accounting Standards Board.
International Financial Reporting
Standards (IFRS) a principle-based set of
international accounting standards stating how
particular types of transactions and other events
should be reported in financial statements. The
principles are issued by the International
Accounting Standards Board.
did you get it?
meaSURing CaSh FlowS
On page 75 we asked you to calculate an electronics company’s cash flows. Your results should be as follows:
Net income $ 485
Plus depreciation 1,500
Less increase in accounts receivable (300)
Less increase in inventories (80)
Less increase in other current assets (150)
Plus increase in accounts payable 60
Cash flow from operating activities $1,515
Investment activity
Increase in gross fixed assets ($ 50)
Financing activity
Increase in long-term debts $ 80
Increase in common stock 10
Common stock dividends (40)
Total financing activities $ 50
Change in cash $1,515
Beginning cash 1,785
Ending cash $3,300
Income Taxes and Finance
Income tax is one of the largest expenses that a business encounters, and as a result, it
must be considered in making investment and financing decisions. But understanding
income taxes is a profession unto itself. Tax accountants spend a lifetime attempting to
5 Compute taxable income and
income taxes owed.

Chapter 3 • Understanding Financial Statements and Cash Flows 77
taxable income gross income from all
sources, except for allowable exclusions, less any
tax-deductible expenses.
capital gains gains from selling any asset that
is not part of the ordinary operations.
remain current with the tax laws. So we will limit our discussion to the basic issue of
computing a corporation’s income taxes and let the tax accountants provide us counsel
on the rest.
For our purposes, we simply need to know that taxable income for a corporation con-
sists of two basic components: operating income and capital gains. Operating income, as
we have already defined, is essentially gross profits less any operating expenses, such as
marketing expenses, administrative expenses, and so forth. We should also remember that
while interest expense is a tax-deductible expense, dividends paid to shareholders are not.
Capital gains occur when a firm sells a capital asset, which is any asset that is not part
of its ordinary operations. For example, when a company sells a piece of equipment or land,
any gain or loss (sales price less the cost of the asset) is treated as a capital gain or loss.
Computing Taxable Income
To demonstrate how to compute a corporation’s taxable income, consider the J and S Cor-
poration, a manufacturer of home accessories. The firm, originally established by Kelly
Stites, had sales of $50 million for the year. The cost of producing the accessories totaled
$23 million. Operating expenses were $10 million. The corporation has $12.5 million in
debt outstanding, with an 8 percent interest rate, which resulted in $1 million interest ex-
pense ($12,500,000 * 0.08 = $1,000,000). Management paid $1 million in dividends to
the firm’s common stockholders. No other income, such as interest or dividend income,
was received. The taxable income for the J and S Corporation would be $16 million, as
shown in Table 3-5.
Once we know J and S Corporation’s taxable income, we can determine the amount of
taxes the firm owes.
Computing the Taxes Owed
The taxes to be paid by the corporation on its taxable income are based on the corporate
tax rate structure. The specific rates for corporations, as of 2012, are given in Table 3-6.
Table 3-5 J and S Corporation Taxable Income
Sales $50,000,000
Cost of goods sold 23,000,000
Gross profits $27,000,000
Operating expenses
Administrative expenses $4,000,000
Depreciation expenses 1,500,000
Marketing expenses 4,500,000
Total operating expenses $10,000,000
Operating income (earnings before interest and taxes) $17,000,000
Other income 0
Interest expense 1,000,000
Taxable Income $16,000,000
Dividends paid to common stockholders ($1,000,000) are not tax-deductible expenses.
15% $0–$50,000
25% $50,001–$75,000
34% $75,001–$10,000,000
35% over $10,000,000
Additional surtax:
• 5% on income between $100,000 and $335,000
• 3% on income between $15,000,000 and $18,333,333
Table 3-6 Corporate Tax Rates

78 Part 1 • The Scope and Environment of Financial Management
average tax rate the tax rate on average that
a company pays on its total taxable income.
Given that the J and S Corporation owes $5,530,000 in taxes on $16 million taxable
income, the firm’s average tax rate, computed as taxes owed divided by taxable income,
is 34.56 percent (34.56% = $5,530,000 , $16,000,000). However, J and S Corporation’s
marginal tax rate is 38 percent (this is because $16 million falls into the 35 percent tax
bracket with a 3 percent surtax); that is, the next dollar of any income will be taxed at a rate
of 38 percent. However, after taxable income exceeds $18,333,333, the marginal tax rate
declines to 35 percent, since the 3 percent surtax no longer applies.
For financial decision making, it’s the marginal tax rate rather than the average tax rate
that we are concerned with. Why? Because, generally speaking, the marginal rate is the
rate that a corporation pays on the next dollar that is earned. We always want to consider
the tax consequences of any financial decision. The marginal tax rate is the rate that will
be applicable for any changes in earnings that occur as a result of the decision being made.
Thus, when making financial decisions involving taxes, always use the marginal tax rate in
your calculations.12
E A R n I n G S : M A R G I n A L TAx R AT E = TAx E S
$ 50,000 * 15% = $ 7,500
25,000 * 25% = 6,250
9,925,000 * 34% = 3,374,500
6,000,000 * 35% = 2,100,000
Total income $16,000,000 $5,488,250
Additional surtaxes:
• Add 5% surtax on income
between $100,000 and
$335,000 (5% *
[$335,000 – $100,000])
11,750
• Add 3% surtax on income
between $15,000,000 and
$18,333,333 (3% *
[$16,000,000 – $15,000,000])
30,000
Total tax liability $5,530,000
12On taxable income between $335,000 and $10 million, both the marginal and average tax rates equal 34 percent
because of the imposition of the 5 percent surtax that applies to taxable income between $100,000 and $335,000.
This surtax eliminates the benefit of having the first $75,000 of taxable income taxed at the rates lower than
34 percent. After the company’s taxable income exceeds $18,333,333, both the marginal and average tax rates equal
35 percent because the 3 percent surtax on income between $15 million and $18,333,333 eliminates the benefits of
having the first $10 million of income taxed at 34 percent rather than 35 percent.
The tax rates shown in Table 3-6 are the marginal tax rates, or rates applicable to the
next dollar of income. For instance, if a firm has earnings of $60,000 and is contemplating
an investment that would yield $10,000 in additional profits, the tax rate to be used in
calculating the taxes on this added income is 25 percent; that is, the marginal tax rate
is 25 percent.
The rates in Table 3-6 go up to a top marginal corporate tax rate of 35 percent for tax-
able income in excess of $10 million, and a surtax of 3 percent on taxable income between
$15 million and $18,333,333. This means the corporation’s marginal tax rate on income
between $15 million and $18,333,333 is 38 percent (the 35 percent rate plus the 3 percent
surtax). There is also a 5-percent surtax on taxable income between $100,000 and $335,000,
which means the marginal rate on income between $100,000 and $335,000 is 39 percent
(the 34 percent rate plus the 5 percent surtax). For example, the tax liability for J and S
Corporation, which had $16 million in taxable earnings, would be $5,530,000, calculated
as follows:
marginal tax rate the tax rate that would be
applied to the next dollar of income.

Chapter 3 • Understanding Financial Statements and Cash Flows 79
E x A M P L E 3.3 Computing a corporation’s income taxes
Assume that the Griggs Corporation had sales during the past year of $5 million; its
cost of goods sold was $3 million; and it incurred operating expenses of $950,000. In
addition, it received $185,000 in interest income. In turn, it paid $40,000 in interest and
$75,000 in common stock dividends. Compute the tax due for the Griggs Corporation.
Sales
Less: Cost of goods sold
Equals: Gross profits
Less: Operating expenses
Equals: Operating income
Less: Interest expense
Plus: Interest income
Equals: Taxable income
SteP 1: FoRmUlate a SolUtion StRategY
The following template provides us a useful guide for computing the taxable income:
Use Table 3-6 to find the appropriate tax rate. Don’t forget the additional surtax.
SteP 2: CRUnCh the nUmbeRS
Sales $ 5,000,000
Cost of goods sold ($ 3,000,000)
Gross profit $ 2,000,000
Operating expenses ($ 950,000)
Operating income $ 1,050,000
Other taxable income and expenses:
Interest income $185,000
Interest expense (40,000) $ 145,000
Taxable income $ 1,195,000
Tax computation
15% * $ 50,000 = $ 7,500
25% * 25,000 = 6,250
34% * 1,120,000 = 380,800
$1,195,000 $394,550
Add 5% surtax for income between $100,000 and $335,000 11,750
Tax liability $406,300
SteP 3: analYze YoUR ReSUltS
Note that the $75,000 Griggs paid in common stock dividends is not tax deductible. The
marginal tax rate and the average tax rate both equal 34 percent; thus, we could have
computed Griggs’s tax liability as 34 percent of $1,195,000, or $406,300.
Concept Check
1. How is taxable income computed?
2. How are taxes owed computed?
3. Why should we be more concerned with the marginal tax rate rather than the average tax rate?
Can you do it?
ComPUting a CoRPoRation’S inCome taxeS
A manufacturing company had sales during the past year of $32 million; its cost of goods sold was $17 million; and it incurred operat-
ing expenses of $12 million. In addition, it received $0.8 million in interest income. In turn, it paid $1 million in interest and $0.5 million
in common stock dividends. Compute the company’s taxes.
(The solution can be found on page 80.)

80 Part 1 • The Scope and Environment of Financial Management
6

describe the limitations of
financial statements.
accounting Malpractice and Limitations
of Financial Statements
Financial statements are prepared following the Financial Accounting Standards Board’s
generally accepted accounting principles (GAAP). When reviewing financial statements,
keep in mind that accounting rules give managers discretion; thus they may take advantage
of the leeway, as long as it doesn’t violate GAAP to produce the high or stable earnings
that investors are looking for. In other words, if two companies have the same financial
performance, their financial statements can be different, depending on how and when the
managers choose to report certain transactions.
Sometimes, managers may even break the rules, which results in accounting malprac-
tice/accounting fraud. There have been many cases of accounting fraud, and the managers
involved have faced criminal charges for their illegal acts. In 2010, it was revealed in a re-
port by the bankruptcy court examiner that Lehman Brothers used Repo 105 three times
and didn’t disclose it to investors. Repo 105 is a repurchase agreement that results in an
“accounting gimmick” where a short-term loan is classified as a sale. The cash obtained
through this “sale” is then used to pay down debt, allowing the company to appear to be
paying down liabilities—just long enough to reflect on the company’s published balance
sheet. After the company’s financial reports are published, the company borrows cash and
repurchases its original assets.
Concept Check
1. What are the limitations of financial statements?
This chapter has provided a basic understanding of financial statements, as demon-
strated using Home Depot’s financial data. In the next chapter, we will dig even deeper by
conducting what is called financial analysis. We will continue using Home Depot to illus-
trate the use of this financial tool.
DiD You Get it?
Computing A CorporAtion’s inCome tAxes
Sales $32,000,000
cost of goods sold (17,000,000)
Gross profit $15,000,000
Operating expenses (12,000,000)
Operating income $ 3,000,000
Other taxable income and expenses:
Interest income $ 800,000
Interest expense (1,000,000) ($ 200,000)
Taxable income $ 2,800,000
Tax computation
15% * $ 50,000 = $ 7,500
25% * 25,000 = 6,250
34% * 2,725,000 = 926,500
$2,800,000 $ 940,250
add 5% surtax for income between $100,000
and $335,000 11,750
Tax liability $ 952,000

Chapter 3 • Understanding Financial Statements and Cash Flows 81
Chapter Summaries
Compute a company’s profits, as reflected by its income statement.
(pgs. 52–56)
SuMMARY:
1. A firm’s profits may be viewed as follows:
Gross profit = sales – cost of goods sold
Earnings before interest and taxes (operating profits) = gross profit – operating expenses
Net profit (net income) = earnings before interest and taxes (operating profits) – interest
expense – taxes
2. The following five activities determine a company’s net income:
a. The revenue derived from selling the company’s product or service
b. The cost of producing or acquiring the goods or services to be sold
c. The operating expenses related to (1) marketing and distributing the product or service to
the customer and (2) administering the business
d. The financing costs of doing business—namely, the interest paid to the firm’s creditors
e. The payment of taxes
KEY TERMS
1
Income statement (profit and loss
statement), page 52 a basic accounting
statement that measures the results of a firm’s
operations over a specified period, commonly
1 year. The bottom line of the income
statement, net profits (net income), shows the
profit or loss for the period that is available for
a company’s owners (shareholders).
Cost of goods sold, page 52 the cost of
producing or acquiring a product or service to
be sold in the ordinary course of business.
Gross profit, page 52 sales or revenue minus
the cost of goods sold.
Operating expenses, page 52 marketing and
selling expenses, general and administrative
expenses, and depreciation expense.
Operating income (earnings before inter-
est and taxes), page 52 sales less the cost of
goods sold less operating expenses.
Earnings before taxes (taxable income), page
53 operating income minus interest expense.
Net income (net profit, or earnings
available to common stockholders),
page 53 the earnings available to the firm’s
common and preferred stockholders.
Earnings per share, page 54 net income on a
per share basis.
Dividends per share, page 54 the amount
of dividends a firm pays for each share
outstanding.
Common-sized income statement,
page 55 an income statement in which a firm’s
expenses and profits are expressed as a
percentage of its sales.
Profit margins, page 55 financial ratios
(sometimes simply referred to as margins) that
reflect the level of the firm’s profits relative
to its sales. Examples include the gross profit
margin (gross profit divided by sales),
operating profit margin (operating income
divided by sales), and the net profit margin
(net income divided by sales).
Gross profit margin, page 55 gross profit
divided by net sales. It is a ratio denoting the gross
profit earned by the firm as a percentage of its net
sales.
Operating profit margin, page 55 operating
income divided by sales. This ratio serves as
an overall measure of the company’s operating
effectiveness.
Net profit margin, page 55 net income
divided by sales. A ratio that measures the net
income of the firm as a percent of sales.
Fixed costs, page 55 costs that remain constant,
regardless of any change in a firm’s activity.
Variable costs, page 55 costs that change in
proportion to changes in a firm’s activity.
Semivariable costs, page 55 costs composed
of a mixture of fixed and variable components.
KEY EquATIOn
Sales – expenses = profits

82 Part 1 • The Scope and Environment of Financial Management
Balance sheet, page 56 a statement that shows
a firm’s assets, liabilities, and shareholder equity
at a given point in time. It is a snapshot of the
firm’s financial position on a particular date.
Accounting book value, page 57 the value of
an asset as shown on a firm’s balance sheet. It
represents the depreciated historical cost of the
asset rather than its current market value or
replacement cost.
Liquidity, page 57 the ability to convert an
asset into cash quickly without a significant loss
of its value.
Current assets (gross working capital),
page 57 current assets consist primarily of
cash, marketable securities, accounts receivable,
inventories, and prepaid expenses.
Cash, page 58 cash on hand, demand
deposits, and short-term marketable securities
that can quickly be converted into cash.
Accounts receivable, page 58 money owed
by customers who purchased goods or services
from the firm on credit.
Inventories, page 58 raw materials, work in
progress, and finished goods held by the firm
for eventual sale.
Other current assets, page 58 other
short-term assets that will benefit future time
periods, such as prepaid expenses.
Fixed assets, page 58 assets such as
equipment, buildings, and land.
Depreciation expense, page 58 a noncash
expense to allocate the cost of depreciable
assets, such as plant and equipment, over the
life of the asset.
Accumulated depreciation, page 58 the sum
of all depreciation taken over the entire life of
a depreciable asset.
Gross fixed assets, page 58 the original cost
of a firm’s fixed assets.
Net fixed assets, page 58 gross fixed assets
minus the accumulated depreciation taken over
the life to date of the assets.
Debt, page 59 liabilities consisting of such
sources as credit extended by suppliers or a
loan from a bank.
Equity, page 59 stockholders’ investment in
the firm and the cumulative profits retained in
the business up to the date of the balance sheet.
Current debt (short-term liabilities),
page 59 debt due to be paid within 12 months.
Accounts payable (trade credit), page 59
credit provided by suppliers when a firm
purchases inventory on credit.
Accrued expenses, page 59 expenses that
have been incurred but not yet paid in cash.
Short-term notes (debt), page 59 amounts
borrowed from lenders, mostly financial
institutions such as banks, where the loan is to
be repaid within 12 months.
Long-term debt, page 59 loans from banks
or other sources that lend money for longer
than 12 months.
Mortgage, page 59 a loan to finance real
estate where the lender has first claim on the
property in the event the borrower is unable to
repay the loan.
Preferred stockholders, page 59
stockholders who have claims on the firm’s
income and assets after creditors, but before
common stockholders.
Common stockholders, page 59 investors who
own the firm’s common stock. Common stock-
holders are the residual owners of the firm.
Common stock, page 59 shares that
represent ownership in a corporation.
Par value, page 59 the arbitrary value a firm
puts on each share of stock prior to its being
offered for sale.
Paid-in capital, page 59 the amount a
company receives above par value from selling
stock to investors.
Treasury stock, page 60 the firm’s stock that
has been issued and then repurchased by the
firm.
Determine a firm’s financial position at a point in time based on its balance
sheet. (pgs. 56–64)
SuMMARY: The balance sheet presents a company’s assets, liabilities, and equity on a specific
date. Its total assets represent all the investments that the firm has made in the business. The
total assets must equal the firm’s total debt and equity because every dollar of assets has been
financed by the firm’s lenders or stockholders. The firm’s assets include its current assets, fixed
assets, and other assets. Its debt includes both its short-term and long-term debt. The firm’s
equity includes (1) common stock, which may be shown as par value plus paid-in capital, and
(2) retained earnings. All the numbers in a balance sheet are based on historical costs, rather
than current market values.
KEY TERMS
2

Chapter 3 • Understanding Financial Statements and Cash Flows 83
KEY EquATIOnS
Total assets = total liabilities (debt) + total shareholders’ equity
Beginning retained earnings + net income for the year – dividends paid during the year = end-
ing retained earnings
Common equity = common shareholders’ investment + cumulative profits – cumulative
dividends paid to common stockholders
Net working capital = current assets – current liabilities
Measure a company’s cash flows. (pgs. 65–75)
SuMMARY: A firm’s profits are not an adequate measure of its cash flows. To measure a company’s
cash flows requires that we look both at the income statement and the changes in the balance sheet.
There are three main parts of a statement of cash flows: cash flows from operations, investment
cash flows, and financing cash flows. Examining these three parts of the statement of cash flows
helps us understand where cash came from and how it was used.
3
Retained earnings, page 60 cumulative
profits retained in a business up to the date of
the balance sheet.
Common-sized balance sheet, page 62 a
balance sheet in which a firm’s assets and
sources of debt and equity are expressed as a
percentage of its total assets.
Debt ratio, page 62 a firm’s total liabilities
divided by its total assets. It is a ratio that
measures the extent to which a firm has been
financed with debt.
Net working capital, page 62 the difference
between a firm’s current assets and its
current liabilities. When the term working
capital is used, it is frequently intended to mean
net working capital.
Accrual basis accounting, page 65 a method
of accounting whereby revenue is recorded
when it is earned, whether or not the revenue
has been received in cash. Likewise, expenses
are recorded when they are incurred, even if
the money has not actually been paid out.
Cash basis accounting, page 65 a method of
accounting whereby revenue is recorded when
cash is actually received. Likewise, expenses are
recorded when physical cash is paid out.
Statement of cash flows, page 67 a state-
ment that shows how changes in balance sheet
accounts and income affect cash and cash
equivalents, and breaks the analysis down to
operating, investing, and financing activities.
Free cash flows, page 67 the amount of cash
available from operations after the firm pays
for the investments it has made in operating
working capital and fixed assets. This cash is
available to distribute to the firm’s creditors
and owners.
Financing cash flows, page 67 the amount
of cash received from or distributed to
the firm’s investors, usually in the form of
interest, dividends, issuance of debt, or
issuance or repurchase of stocks.
Explain the differences between GAAP and IFRS. (pg. 76)
SuMMARY: GAAP is rules-based and sets out rules that accountants must follow when preparing
financial statements. IFRS is principles-based and sets out general principles. IFRS leaves more
room for discretion than GAAP does, permitting managers to exercise their own judgment
when deciding how to report in their financial statements, as long as they follow the spirit of the
standards.
4
KEY EquATIOnS
Cash
change in

collections = sales –
accounts receivable

from sales
KEY TERMS

Compute taxable income and income taxes owed. (pgs. 76–79)
SuMMARY: For the most part, taxable income for the corporation is equal to the firm’s operating
income plus capital gains less any interest expense. Tax consequences, particularly marginal tax
rates, have a direct bearing on the decisions of the financial manager.
KEY TERMS
5
Taxable income, page 77 income from all
sources, except for allowable exclusions, less
any tax-deductible expenses.
Capital gains, page 77 gains from selling any
asset that is not part of the ordinary operations.
Marginal tax rate, page 78 the tax rate that
would be applied to the next dollar of income.
Average tax rate, page 78 the tax rate on
average that a company pays on its total taxable
income.
Describe the limitations of financial statements. (pg. 80)
SuMMARY: Accounting rules give managers discretion. Therefore what we see in financial state-
ments may not exactly reflect the company’s financial situation. Sometimes, managers may even
break the rules, which results in accounting malpractice/accounting fraud.
Review questions
All Review Questions are available in MyFinanceLab.
3-1. A company’s financial statements consist of the balance sheet, income statement, and state-
ment of cash flows. Describe what each statement tells us.
3-2. How do gross profits, operating profits, and net income differ?
3-3. How do dividends and interest expense differ?
3-4. Why is it that the preferred stockholders’ equity section of the balance sheet changes only
when new shares are sold or repurchased, whereas the common stockholders’ equity section
changes from year to year regardless of whether new shares are bought or sold?
3-5. What is net working capital?
3-6. Why might one firm have positive cash flows and be headed for financial trouble, whereas
another firm with negative cash flows could actually be in a good financial position?
3-7. Why is the examination of only the balance sheet and income statement not adequate in
evaluating a firm?
3-8. What are the differences between GAAP and IFRS?
3-9. Why are dividends paid to a firm’s owners not a tax-deductible expense?
3-10. What are the limitations of financial statements?
3-11. See the annual report for the Dell Corporation by going to www.dell.com. Scroll to
the bottom of the page, click, “About Dell,” then “Investors,” then “Financial Reporting,”
and finally the link “Annual Reports.” Scan the list to determine which year you would like to
review. Alternatively, select one of the other links (such as “Financial History”) to learn addi-
tional financial information about Dell, Inc.
3-12. Go to www.homedepot.com for the home page of the Home Depot Corporation. Scroll to
the bottom of the page and select “Investor Relations,” and then “Financial Reports.” Look for
keywords in the income statement that appear in this chapter, such as sales, gross profits, and net
income. What do you learn about the firm from its financial statements that you find interesting?
6
KEY TERMS
Generally Accepted Accounting Principles
(GAAP), page 76 rules-based accounting
principles, standards, and procedures that
companies use to compile their financial
statements. These principles are issued by the
Financial Accounting Standards Board (FASB).
International Financial Reporting
Standards (IFRS), page 76 principles-based
set of international accounting standards
stating how particular types of transactions
and other events should be reported in
financial statements. IFRS are issued by the
International Accounting Standards Board
(IASB).
84 Part 1 • The Scope and Environment of Financial Management

www.dell.com

www.homedepot.com

3-13. Go to the Wall Street Journal home page at www.wsj.com. Search for Barnes & Noble (ticker
symbol BKS). Find the firm’s earnings announcements. What did you learn about the company
from the announcements? Also, search www.barnesandnoble.com to find the same information.
Study Problems
All Study Problems are available in MyFinanceLab.
3-1. (Computing earnings per share) If ABC Company earned $280,000 in net income and paid cash
dividends of $40,000, what are ABC’s earnings per share if it has 80,000 shares outstanding?
3-2. (Preparing an income statement) Prepare an income statement and a common-sized income
statement from the following information.
1
Sales $525,000
Cost of goods sold 200,000
General and administrative expenses 62,000
Depreciation expenses 8,000
Interest expense 12,000
Income taxes 97,200
Cash $ 50,000
Accounts receivable 42,700
Accounts payable 23,000
Short-term notes payable 10,500
Inventories 40,000
Gross fixed assets 1,280,000
Other current assets 5,000
Long-term debt 200,000
Common stock 490,000
Other assets 15,000
Accumulated depreciation 312,000
Retained earnings ?
Cash $ 30,000
Accounts receivable 63,800
Accounts payable 52,500
Short-term notes payable 11,000
Inventories 66,000
Gross fixed assets 1,061,000
Accumulated depreciation 86,000
Long-term debt 210,000
Common stock 480,000
Other assets 25,000
Retained earnings ?
3-3. (Preparing a balance sheet) Prepare a balance sheet from the following information. What is the
net working capital and debt ratio?
2
3-4. (Preparing a balance sheet) Prepare a balance sheet and a common-sized balance sheet from the
following information.
Chapter 3 • Understanding Financial Statements and Cash Flows 85

www.wsj.com

www.barnesandnoble.com

86 Part 1 • The Scope and Environment of Financial Management
3-6. (Working with an income statement and balance sheet) Prepare a balance sheet and income
statement for the Warner Company from the following scrambled list of items.
a. What is the firm’s net working capital and debt ratio?
b. Complete a common-sized income statement and a common-sized balance sheet.
c. Interpret your findings.
Inventory $ 6,500
Common stock 45,000
Cash 16,550
Operating expenses 1,350
Short-term notes payable 600
Interest expense 900
Depreciation expense 500
Sales 12,800
Accounts receivable 9,600
Accounts payable 4,800
Long-term debt 55,000
Cost of goods sold 5,750
Buildings and equipment 122,000
Accumulated depreciation 34,000
Taxes 1,440
General and administrative expenses 850
Retained earnings ?
Depreciation expense $ 66,000
Cash 225,000
Long-term debt 334,000
Sales 573,000
Accounts payable 102,000
General and administrative expenses 79,000
Buildings and equipment 895,000
Notes payable 75,000
Accounts receivable 153,000
Interest expense 4,750
Accrued operating expenses 7,900
Common stock 289,000
Cost of goods sold 297,000
Inventory 99,300
Taxes 50,500
Accumulated depreciation 263,000
Prepaid expenses 14,500
Taxes payable 53,000
Retained earnings 262,900
3-7. (Working with an income statement and balance sheet) Prepare an income statement and a balance
sheet from the following scrambled list of items. What is the firm’s net working capital and debt
ratio?
3-5. (Working with an income statement and balance sheet) Prepare a balance sheet and income
statement for Belmond, Inc. from the following information.

Chapter 3 • Understanding Financial Statements and Cash Flows 87
Sales $550,000
Accumulated depreciation 190,000
Cash ?
Cost of goods sold 320,000
Accounts receivable 73,000
Depreciation expenses 38,000
Accounts payable 65,000
Interest expense 26,000
Short-term notes payable 29,000
Income taxes 59,850
Inventories 47,000
Marketing, general, and administrative expenses 45,000
Gross fixed assets 648,000
Long-term debt 360,000
Common stock 120,000
Other assets 15,000
Retained earnings 138,500
In addition, the firm has 10,000 shares outstanding and paid $15,000 in common stock
dividends during the year.
Increase in accounts receivable $25
Increase in inventories 30
Operating income 75
Interest expense 25
Increase in accounts payable 25
Dividends 15
Increase in common stock 20
Increase in net fixed assets 23
Depreciation expense 12
Income taxes 17
Beginning cash 20
Net income $ 680
Depreciation expense 125
Profits before depreciation 805
Increase in accounts receivable (200)
Increase in inventories (240)
Increase in accounts payable 120
Increase in accrued expenses 81
Cash flow from operations $ 566
Investment activity
Change in fixed assets (1,064)
Financing activity
Increase in long-term debt $ 640
Common stock dividends (120)
Total financing activities $ 520
Change in cash $ 22
Beginning cash 500
Ending cash $ 522
3-8. (Working with a statement of cash flows) Given the following information, prepare a statement of
cash flows.
3
3-9. (Analyzing a statement of cash flows) Interpret the following information regarding Westlake
Corporation’s cash flows.

88 Part 1 • The Scope and Environment of Financial Management
3-10. (Working with a statement of cash flows) Given the following information, prepare a statement
of cash flows.
Beginning Cash $ 20
Dividends 25
Increase in common stock 27
Increase in accounts receivable 65
Increase in inventories 5
Operating income 215
Increase in accounts payable 40
Interest expense 50
Depreciation expense 20
Increase in bank debt 48
Increase in accrued expenses 15
Increase in gross fixed assets 55
Income taxes 45
Abrahams Manufacturing Company Balance Sheet for 12/31/2011
and 12/31/2012
2011 2012
Cash $ 89,000 $100,000
Accounts receivable 64,000 70,000
Inventory 112,000 100,000
Prepaid expenses 10,000 10,000
Total current assets 275,000 280,000
Gross plant and equipment 238,000 311,000
Accumulated depreciation (40,000) (66,000)
Total assets $473,000 $525,000
Accounts payable $ 85,000 $ 90,000
Accrued liabilities 68,000 63,000
Net income $ 370
Depreciation expense 60
Profits before depreciation 430
Increase in accounts receivable (300)
Increase in inventories (400)
Increase in accounts payable 200
Increase in accrued expenses 40
Cash flow from operations ($ 30)
Investment activity
Change in fixed assets ($1,500)
Financing activity
Increase in short-term notes $ 100
Repayment of long-term debt (250)
Repurchase common stock (125)
Common stock dividends (75)
Total financing activities ($ 350)
Change in cash ($1,880)
Beginning cash 3,750
Ending cash $1,870
3-11. (Analyzing a statement of cash flows) Interpret the following information regarding Maness
Corporation’s statement of cash flows.
3-12. (Working with a statement of cash flows) Prepare a statement of cash flows for Abrahams
Manufacturing Company for the year ended December 31, 2012. Interpret your results.

Chapter 3 • Understanding Financial Statements and Cash Flows 89
Increase in inventories $ 7,000
Operating income 219,000
Dividends 29,000
Increase in accounts payable 43,000
Interest expense 45,000
Increase in common stock (par) 5,000
Depreciation expense 17,000
Increase in accounts receivable 69,000
Increase in long-term debt 53,000
Increase in short-term notes payable 15,000
Increase in gross fixed assets 54,000
Increase in paid in capital 20,000
Income taxes 45,000
Beginning cash 250,000
Additional Information
1. The only entry in the accumulated depreciation account is for 2012 depreciation.
2. The firm paid $22,000 in common stock dividends during 2012.
Total current debt 153,000 153,000
Mortgage payable 70,000 0
Preferred stock 0 120,000
Common stock 205,000 205,000
Retained earnings 45,000 47,000
Total debt and equity $473,000 $525,000
3-14. (Working with financial statements) Given the information on page 90 for Pamplin Inc.:
a. How much is the firm’s net working capital and what is the debt ratio?
b. Complete a common-sized income statement, a common-sized balance sheet, and a statement of
cash flows for 2012. Interpret your results.
3-13. (Working with a statement of cash flows) Prepare a statement of cash flows from the
following scrambled list of items.
Abrahams Manufacturing Company Income Statement for
the Year Ended 12/31/2012
2012
Sales $184,000
Cost of goods sold 60,000
Gross profit $124,000
Selling, general, and administrative expenses 44,000
Depreciation expense 26,000
Operating income $ 54,000
Interest expense 4,000
Earnings before taxes $ 50,000
Taxes 16,000
Preferred stock dividends 10,000
Earnings available to common shareholders $ 24,000

Pamplin Inc. Income Statement for Years Ended 12/31/2011 and 12/31/2012
2011 2012
Sales $1,200 $1,450
Cost of goods sold 700 850
Gross profit $ 500 $ 600
Selling, general, and administrative expenses $ 30 $ 40
Depreciation 220 250 200 240
Operating income $ 250 $ 360
Interest expense $ 50 64
Net income before taxes $ 200 $ 296
Taxes (40%) 80 118
Net income $ 120 $ 178
Pamplin Inc. Balance Sheet at 12/31/2011 and 12/31/2012
A S S E T S
2011 2012
Cash $ 200 $ 150
Accounts receivable 450 425
Inventory 550 625
Current assets $1,200 $1,200
Plant and equipment $2,200 $2,600
Less accumulated depreciation (1,000) (1,200)
Net plant and equipment $1,200 $1,400
Total assets $2,400 $2,600
L I A B I L I T I E S A N D O W N E R S’ E Q U I T Y
2011 2012
Accounts payable $ 200 $ 150
Notes payable—current (9%) 0 150
Current liabilities $ 200 $ 300
Bonds $ 600 $ 600
Owners’ equity
Common stock $ 900 $ 900
Retained earnings 700 800
Total owners’ equity $1,600 $1,700
Total liabilities and owners’ equity $2,400 $2,600
90 Part 1 • The Scope and Environment of Financial Management
3-15. (Working with financial statements) Based on the information for T. P. Jarmon Company for
the year ended December 31, 2012:
a. How much is the firm’s net working capital and what is the debt ratio?
b. Complete a statement of cash flows for the period. Interpret your results.
c. Compute the changes in the balance sheets from 2011 to 2012. What do you learn about
T. P. Jarmon from these computations? How do these numbers relate to the statement
of cash flows?

T. P. Jarmon Company Balance Sheet for 12/31/2011 and 12/31/2012
A S S E T S
2011 2012
Cash $ 15,000 $ 14,000
Marketable securities 6,000 6,200
Accounts receivable 42,000 33,000
Inventory 51,000 84,000
Prepaid rent $ 1,200 $ 1,100
Total current assets $115,200 $138,300
Net plant and equipment 286,000 270,000
Total assets $401,200 $408,300
L I A B I L I T I E S A N D E Q U I T Y
2011 2012
Accounts payable $ 48,000 $ 57,000
Accruals 6,000 5,000
Notes payable 15,000 13,000
Total current liabilities $ 69,000 $ 75,000
Long-term debt $160,000 $150,000
Common stockholders’ equity $172,200 $183,300
Total liabilities and equity $401,200 $408,300
3-16. (Computing income taxes) The William B. Waugh Corporation is a regional Toyota dealer.
The firm sells new and used trucks and is actively involved in the parts business. During the most
recent year, the company generated sales of $3 million. The combined cost of goods sold and the
operating expenses were $2.1 million. Also, $400,000 in interest expense was paid during the year.
Calculate the corporation’s tax liability.
3-17. (Computing income taxes) Sales for L. B. Menielle Inc. during the past year amounted to
$5 million. The firm provides parts and supplies for oil field service companies. Gross profits for
the year were $3 million. Operating expenses totaled $1 million. The interest income from the
securities it owned was $20,000. The firm’s interest expense was $100,000. Compute the corpora-
tion’s tax liability.
3-18. (Computing income taxes) Sandersen Inc. sells minicomputers. During the past year, the
company’s sales were $3 million. The cost of its merchandise sold came to $2 million, and cash
5
T. P. Jarmon Company Income Statement for the Year Ended 12/31/2012
Sales $600,000
Less cost of goods sold 460,000
Gross profit $140,000
Operating and interest expenses
General and administrative $30,000
Interest 10,000
Depreciation 30,000
Total operating and interest expenses $ 70,000
Earnings before taxes $ 70,000
Taxes 27,100
Net income available to common stockholders $ 42,900
Cash dividends 31,800
Change in retained earnings $ 11,100
Chapter 3 • Understanding Financial Statements and Cash Flows 91

92 Part 1 • The Scope and Environment of Financial Management
operating expenses were $400,000; depreciation expense was $100,000, and the firm paid $150,000
in interest on its bank loans. Also, the corporation paid $25,000 in the form of dividends to its own
common stockholders. Calculate the corporation’s tax liability.
Mini Case
This Mini Case is available in MyFinanceLab.
In July 2011, the finale to the Harry Potter movie series, Harry Potter and the Deathly Hallows—
Part 2, from Time Warner Inc.’s Warner Bros. Pictures, earned an estimated $307 million in
59 countries overseas for the opening week, topping the previous best international debut of
$260.4 million set in May 2011 by Disney’s Pirates of the Caribbean: On Stranger Tides. Time
Warner Inc. and Walt Disney Co. both run diversified lines of entertainment and are ma-
jor competitors with each other in many areas. According to Disney’s annual report of fiscal
2010: “The Walt Disney Company, together with its subsidiaries, is a diversified worldwide
entertainment company with operations in five business segments: Media Networks, Parks and
Resorts, Studio Entertainment, Consumer Products and Interactive Media.” And in the annual
report of Time Warner: “Time Warner Inc., a Delaware corporation, is a leading media and
entertainment company. The Company classifies its businesses into the following three report-
ing segments: Networks, Filmed Entertainment, and Publishing.” Except for parks and resorts,
Time Warner runs almost the same business lines as Disney.13
13Time Warner classifies its interactive media business as a part of the “Filmed Entertainment,” and for Disney, publish-
ing is a part of its “Consumer Products.” Source: The Walt Disney Co. Fiscal Year 2010 Form 10-K.
Below are the financial statements for the two firms. Time Warner’s fiscal year ends on De-
cember 31; thus, the statements are for end-of-year 2009 and 2010. Disney, on the other hand, has
a fiscal year ending on the Saturday closest to September 30; fiscal year 2009 ended on October 3,
2009, and fiscal year 2010 ended on October 2, 2010. As a result, Disney’s financials are 3 months
earlier than the financials for Time Warner.
a. How did Time Warner’s profit margins change from 2009 to 2010? To what would you
attribute the differences? Answer the same questions for Disney.
b. Compare the profit margins between Time Warner and Disney. How are they different?
How would you explain these differences?
c. What differences do you notice in the common-sized balance sheets that might indicate
that one of the firms is doing better than the other?
d. Conduct an Internet search on the two firms to gain additional insights as to causes of the
financial differences between the firms in 2010 and continuing into 2011.
e. How are the two companies doing financially today?
Time Warner Inc. Annual Income Statement and Common-Sized Income Statement for Years Ending
December 31, 2009 and 2010 (in $ millions except earnings per share)
2009 2010
Dollar value Percentage of sales Dollar value Percentage of sales
Sales $25,388 100.0% $26,888 100.0%
Cost of goods sold 14,235 56.1% 15,023 55.9%
Gross profits $11,153 43.9% $11,865 44.1%
Selling, general, and administrative expenses 6,073 23.9% 6,126 22.8%
Depreciation and amortization 280 1.1% 264 1.0%
Other operating expenses 330 1.3% 47 0.2%
Operating income $ 4,470 17.6% $ 5,428 20.2%
Interest expense 1,166 4.6% 1,178 4.4%
Nonoperating income (expenses) (67) -0.3% (331) -1.2%
Earnings before tax $ 3,237 12.8% $ 3,919 14.6%
Income taxes 1,153 4.5% 1,348 5.0%
Net income (loss) $ 2,084 8.2% $ 2,571 9.6%

Common shares outstanding 1,184.0 1,128.4
Earnings per share $ 1.76 $ 2.28
Source: The Time Warner Cable 2010 Annual Report.

Chapter 3 • Understanding Financial Statements and Cash Flows 93
Time Warner Inc. Balance Sheet and Common-Sized Balance Sheet for Years Ending
December 31, 2009 and 2010 ($ millions)
D E C E M B E R 31, 2009 D E C E M B E R 31, 2010
A S S E T S Dollar value
Percentage of
total assets Dollar value
Percentage of
total assets
Cash and short-term investments $ 4,733 7.2% $ 3,663 5.5%
Receivables 5,875 8.9% 6,413 9.6%
Inventories 1,769 2.7% 1,920 2.9%
Other current assets 1,315 2.0% 1,142 1.7%
Total current assets $ 13,692 20.7% $ 13,138 19.7%
Gross fixed assets $ 14,950 22.6% $ 15,824 23.8%
Accumulated depreciation and amortization (3,732) -5.6% (4,169) -6.3%
Net fixed assets $ 11,218 17.0% $ 11,655 17.5%
Other assets 41,149 62.3% 41,731 62.7%
TOTAL ASSETS $ 66,059 100.0% $ 66,524 100.0%
L I A B I L I T I E S
Accounts payable and accruals $ 7,807 11.8% $ 7,733 11.6%
Short-term notes payable 862 1.3% 26 0.0%
Other current liabilities 804 1.2% 884 1.3%
Total current liabilities $ 9,473 14.3% $ 8,643 13.0%
Long-term debt 15,346 23.2% 16,523 24.8%
Deferred taxes 1,607 2.4% 1,950 2.9%
Other liabilities 6,236 9.4% 6,463 9.7%
TOTAL LIABILITIES $ 32,662 49.4% $ 33,579 50.5%
E q u I T Y
Common equity:
Common stock:
Par value $ 16 0.0% $ 16 0.0%
Capital surplus 158,129 239.4% 157,146 236.2%
Total common stock sold $158,145 239.4% $157,162 236.2%
Less: Treasury stock—total dollar amount (27,034) -40.9% (29,033) -43.6%
Total common stock $131,111 198.5% $128,129 192.6%
Retained earnings (97,714) (147.9%) (95,184) (143.1%)
Total common equity $ 33,397 50.6% $ 32,945 49.5%
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY $ 66,059 100.0% $ 66,524 100.0%
Source: The Time Warner Cable 2010 Annual Report.

94 Part 1 • The Scope and Environment of Financial Management
Walt Disney Co. Balance Sheet and Common-Sized
Balance Sheet for Years Ending October 3, 2009 and October 2, 2010 ($ millions)
O C TO B E R 3, 2009 O C TO B E R 2, 2010
A S S E T S Dollar value
Percentage of
total assets Dollar value
Percentage of
total assets
Cash and cash equivalents $ 3,417 5.4% $ 2,722 3.9%
Receivables 4,854 7.7% 5,784 8.4%
Inventories 1,271 2.0% 1,442 2.1%
Other current assets 2,347 3.7% 2,277 3.3%
Total current assets $11,889 18.8% $12,225 17.7%
Gross fixed assets $32,475 51.5% $32,875 47.5%
Accumulated depreciation and amortization (17,395) -27.6% (18,373) -26.5%
Net fixed assets $15,080 23.9% $14,502 21.0%
Other assets 36,148 57.3% 42,479 61.4%
TOTAL ASSETS $63,117 100.0% $69,206 100.0%
L I A B I L I T I E S
Accounts payable and accruals $ 5,616 8.9% $ 6,109 8.8%
Short-term notes payable 1,206 1.9% 2,350 3.4%
Other current liabilities 2,112 3.3% 2,541 3.7%
Total current liabilities $ 8,934 14.2% $11,000 15.9%
Long-term debt 11,495 18.2% 10,130 14.6%
Deferred taxes 1,819 2.9% 2,630 3.8%
Other liabilities 5,444 8.6% 6,104 8.8%
TOTAL LIABILITIES $27,692 43.9% $29,864 43.2%
E q u I T Y
Common equity:
Total common stock sold $27,038 42.8% $28,736 41.5%
Less: Treasury stock—total dollar amount (22,693) -36.0% (23,663) -34.2%
Total common stock $ 4,345 6.9% $ 5,073 7.3%
Retained earnings 31,033 49.2% 34,327 49.6%
Other equity 47 0.1% (58) -0.1%
Total common equity $35,425 56.1% $39,342 56.8%
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY $63,117 100.0% $69,206 100.0%
Walt Disney Co. Annual Income Statement and Common-Sized Income Statement for
Years Ending October 3, 2009 and October 2, 2010 (in $ millions except earnings per share)
2009 2010
Dollar value Percentage of sales Dollar value Percentage of sales
Sales $36,149 100.0% $38,063 100.0%
Cost of goods sold 28,821 79.7% 29,624 77.8%
Gross profits $ 7,328 20.3% $ 8,439 22.2%
Selling, general, and administrative expenses 2,123 5.9% 1,983 5.2%
Operating income $ 5,205 14.4% $ 6,456 17.0%
Interest expense 466 1.3% 409 1.1%
Nonoperating income (expenses) 919 2.5% 580 1.5%
Earnings before tax $ 5,658 15.7% $ 6,627 17.4%
Income taxes 2,049 5.7% 2,314 6.1%
Net income (loss) $ 3,609 10.0% $ 4,313 11.3%
Common shares outstanding 1,875 1,948
Earnings per share $ 1.92 $ 2.21
Source: Data from The Walt Disney Company’s 2010 Annual Financial Report.
Source: Data from The Walt Disney Company’s 2010 Annual Financial Report.

Chapter 3 • Understanding Financial Statements and Cash Flows 95
Appendix 3A
Free Cash Flows
During recent years, free cash flow has come to be viewed by many executives as an impor-
tant measure of a firm’s performance. Jack Welch, the former CEO of General Electric,
explains the importance of free cash flows to management in these words:
[T]here’s cash flow, which is valuable because it just does not lie. All your other profit-and-loss
numbers, like net income, have some art to them. They’ve been massaged through the accounting
process, which is filled with assumptions. But free cash flow tells you the true condition of the
business.14
What Is a Free Cash Flow?
We can think of a firm as a group of assets that produce cash flow. Once the firm
has paid all its operating expenses and made all its investments, the remaining cash
flows are free to be distributed to the firm’s creditors and shareholders—thus, the
term free cash flows. Being more specific, a company’s free cash flows result from two
activities:
1. After-tax cash flows from operations are the cash flows a firm generates from day-to-day
operations after taxes are paid but before any investments in working capital or long-
term assets are made. While not exactly true, you may think of it as the cash flows of
a business if it were not getting larger or smaller in size. (You should note that when
computing free cash flows, the term cash flows from operations is not the same as in the
statement of cash flows presented earlier in the chapter.)
2. Asset investments, which include investments in (1) a company’s net operating work-
ing capital and (2) its long-term assets. For the first item, net operating working capi-
tal, understand that this term is not exactly the same as net working capital described
earlier in the chapter. The insertion of the word operating will change the meaning
of the term. So watch for the subtle difference as you learn to compute free cash
flows.
Computing Free Cash Flow
Simply stated, free cash flows are calculated as follows:

Free cash

flow
= c after@tax
cash flows from operations
d
less £
increase in
net operating
working capital
§ or plus £
decrease in
net operating
working capital
§ (3-1A)
and
less c increase in
long@term assets
d or plus c decrease in
long@term assets
d
14Source: “How Healthy Is Your Company?” by Jack and Suzy Welch from Bloomberg Businessweek, May 8, 2006.
7 Calculate a firm’s free cash flows
and financing cash flows.

96 Part 1 • The Scope and Environment of Financial Management
So the procedure for computing a firm’s free cash flows involves three steps:
1. Compute the after-tax cash flows from operations by converting the income state-
ment from an accrual basis to a cash basis. But be aware that when computing free
cash flows, the term cash flows from operations is not the same as in the statement of
cash flows.
2. Calculate the increase or decrease in the firm’s investment in net operating working
capital. As already mentioned, net working capital is now called net operating working
capital, which we will explain shortly.
3. Compute the increase or decrease in investments made in long-term assets, including
fixed assets and other long-term assets (such as intangible assets).
Let’s look at each of the steps involved in calculating free cash flows.
STEP 1 Determine the after-tax cash flows from operations, computed as follows:
Operating income (earnings before interest and taxes, or EBIT)
+ depreciation expense
– income tax expense15
Operating income (EBIT) $ 5,803
Depreciation expense 1,616
Income tax expense 1,935
15We should be subtracting actual taxes paid, which is frequently different from the income-tax expense shown in the
income statement. But let’s just keep things simple and assume they are the same for Home Depot.
Operating income (EBIT) $ 5,803
Plus depreciation 1,616
Less income tax expense (1,935)
After-tax cash flows from operations $ 5,484
= after-tax cash flows from operations
Thus, we compute after-tax cash flows from operations by adding back depre-
ciation expense to operating income, because depreciation expense is not a cash
expense, and then subtracting taxes to get the cash flows on an after-tax basis.
To illustrate how to compute a firm’s after-tax cash flows from operations, return to
the Home Depot’s income statement in Table 3-1 on page 54, where we find the following
information expressed in $ millions:
Given this information, we find Home Depot’s after-tax cash flows from operations to be
$5.484 billion, computed as follows:
STEP 2 Calculate the change in the net operating working capital. For the second step, the
change in net operating working capital is equal to the:
c change in
current assets
d – £
change in
non@interest@bearing
current liabilities
§

Chapter 3 • Understanding Financial Statements and Cash Flows 97
where non-interest-bearing current liabilities are any short-term liabilities
that do not require the firm to pay interest. This typically includes accounts
payable (credit provided by the firm’s suppliers) and any accrued operating
expenses, such as accrued wages.
For Home Depot, the increase or decrease in net operating working capital is found by
looking at the firm’s balance sheets on January 31, 2010 and January 30, 2011 in Table 3-2,
where we see that:
$ M I L L I O n S
After-tax cash flows from operations $5,484
Less investments in net operating working capital (158)
Investment in long-term assets:
Investment in fixed assets ($1,126)
Investment in other assets (159)
Total investments in long-term assets ($1,285)
Free cash flows $4,357
Thus, Home Depot reduced its investments in current assets by $421 million and decreased
(paid off) $263 million in accounts payable. It is important to remember that a decrease in an
asset is a cash inflow and a decrease in a liability is a cash outflow. So, in net, there was a reduction
in net operating working capital, resulting in a cash inflow of $158 million ($158 million
net cash inflow = $421 million cash inflow from reducing current assets – $263 million
outflow from payments to creditors).
STEP 3 Compute the change in long-term assets. The final step involves computing the
change in gross fixed assets (not net fixed assets) and other long-term assets.
Again returning to the Home Depot’s balance sheets, we see that there was an
increase in gross fixed assets of $1.126 billion from $37.345 to $38.471 billion
and an increase in other assets of $159 million from $1.427 to $1.586 billion.
So Home Depot invested a total of $1.285 billion in long-term assets, the
total of $1.126 billion and $159 million.
Wrapping up. We now have the three pieces to compute Home Depot’s free cash flows: (1)
after-tax cash flows from operations, (2) changes (investments) in net operating working
capital, and (3) changes (investments) in long-term assets. As shown below (expressed in
millions), the firm’s free cash flows are $4.357 billion.
J A n 31, 2010 J A n 30, 2011 C H A n G E S
Current assets $13,900 $13,479 ($421)
Accounts payable* 9,343 9,080 (263)
Net operating working capital $ 4,557 $ 4,399 ($158)
*Accounts payable is Home Depot’s non-interest-bearing debt.
Given these computations, we see that the firm’s free cash flows were positive in the amount
of $4.357 billion, as a result of:
1. Generating $5.484 billion in after-tax cash flows from operations,
2. Reducing its investments in net working capital by $158 million, and
3. Investing $1.285 billion in plant and equipment and other long-term assets.

98 Part 1 • The Scope and Environment of Financial Management
The Other Side of the Coin:
Financing Cash Flows
In the previous section, we saw that Home Depot’s operations generated more than
enough to finance its growth. So the question becomes, “What did Home Depot do
with all the extra cash?” The answer: Positive free cash flows are distributed to the
firm’s investors. Negative free cash flows require that investors infuse money into the
business. As we explain in the next section, any money coming from or paid to investors
is called financing cash flows.
Financing Cash Flows
A firm can either receive money from or distribute money to its investors, or some of both.
In general, cash flows between investors and the firm, which we will call financing cash flows,
occur in one of four ways. The firm can:
1. Pay interest to lenders.
2. Pay dividends to stockholders.
3. Increase or decrease interest-bearing debt.
4. Issue new stock to shareholders or repurchase stock from current investors.
When we speak of investors in this context, we include both lenders and shareholders.
However, we do not include financing provided by non-interest-bearing current liabili-
ties, such as accounts payable, which were recognized earlier as part of the firm’s net
operating working capital.
We will now return to Home Depot to illustrate the process for calculating the firm’s
financing cash flows, which will also let us determine how the $4.357 billion free cash flows
that Home Depot experienced were distributed.
To compute the financing cash flows for Home Depot, we first determine the interest
expense paid to lenders and the dividends paid to shareholders, which are provided in the
firm’s income statement (Table 3-1). We then refer to the balance sheet (Table 3-2) to see
the changes in interest-bearing debt (both short-term and long-term) and common stock.
The results are as follows:
Interest paid to lenders $ (530) Use of cash
Common stock dividends (1,569) Use of cash
Change in interest-bearing debt:
Increase in short-term debt 22 Source of cash
Decrease in long-term debt (7) Use of cash
Change in equity:
Increase in common stock (par value + paid-in capital) 335 Source of cash
Repurchased common stock (treasury stock) (2,608) Use of cash
Financing cash flows $(4,357)
So, the firm:
◆ Paid $530 million in interest and $1.569 billion in dividends.
◆ Spent $2.608 billion to repurchase outstanding common stock.
◆ Borrowed (increased) $22 million in short-term interest-bearing debt and paid back
(reduced) $7 million of its long-term interest-bearing debt.
◆ Received $335 million by issuing new common stock.

Chapter 3 • Understanding Financial Statements and Cash Flows 99
Add it all up and Home Depot distributed a net amount of $4.357 billion to its creditors
and shareholders. You should take a minute to compare this amount with the $3.827 billion
shown as financing activities in Home Depot’s statement of cash flows on page 72. By doing
so, you will see that the difference is $530 million, which is exactly the amount of interest
paid to lenders. Again, in the statement of cash flows, interest expense is included in operat-
ing cash flows, which is not the case here.
A Concluding Thought
It is not a coincidence that Home Depot’s free cash flows exactly equal its financing cash
flows. They will always be equal. The firm’s free cash flows, if positive, will be the amount
distributed to the investors; and if the free cash flow is negative, it will be the amount that
the investors provide to the firm to cover the shortage in free cash flows.
Based on our review of Home Depot’s free cash flows and financing cash flows, we
know that the company had significant positive cash flows from operations, more than
enough to cover its investments and distribute large sums of money to its investors.
Appendix Summary
Calculate a firm’s free cash flows and financing cash flows. (pgs. 95–101)
SuMMARY: Free cash flows and financing cash flows are important measurements in making
financial decisions. Only by understanding these cash flows can managers truly know how well a
company is doing.
KEY EquATIOn
Free cash

flow
= c after@tax
cash flows from operations
d
less £
increase in
net operating
working capital
§ or plus £
decrease in
net operating
working capital
§ and
less c increase in
long@term assets
d or plus c decrease in
long@term assets
d
Study Problems
All Study Problems are available in MyFinanceLab.
3A-1 (Computing free cash flows) Given the following information, compute the firm’s free cash
flows and the financing cash flows.
7
Dividends $ 25
Change in common stock $ 27
Change in inventories $ 32
Change in accounts receivable $ 78
Change in other current assets $ 25
Operating income $215
Interest expense $ 50
Depreciation expense $ 20
Increase in accounts payable $ 48
Increase in gross fixed assets $ 55
Income taxes $ 45

3A-2 (Free cash flow analysis) Interpret the following information regarding Bates Corporation’s
free cash flows and financing cash flows.
100 Part 1 • The Scope and Environment of Financial Management
3A-3 (Computing free cash flows and financing cash flows) In Problem 3-12, you were asked to prepare
a statement of cash flows for Abrahams Manufacturing Company. Use the information given in
the problem to compute the firm’s free cash flows and the financing cash flows, and interpret your
results.
3A-4 (Computing free cash flows and financing cash flows) In Problem 3-14, you were asked to
prepare a statement of cash flows for Pamplin Inc. Pamplin’s financial statements are provided
again below. Using this information, compute the firm’s free cash flows and the financing cash
flows, and interpret your results.
Pamplin Inc. Balance Sheet at 12/31/2011 and 12/31/2012
A S S E T S
2011 2012
Cash $ 200 $ 150
Accounts receivable 450 425
Inventory 550 625
Current assets $1,200 $1,200
Plant and equipment $2,200 $2,600
Less accumulated depreciation (1,000) (1,200)
Net plant and equipment $1,200 $1,400
Total assets $2,400 $2,600
Maness Corporation Free Cash Flows and Financing Cash Flows
F r e e C a S h F lo w S
Operating income (EBIT) $ 954
Depreciation expense 60
Tax expense (320)
After-tax cash flows from operations $ 694
Increase in net working capital:
Increase in current assets ($899)
Increase in accounts payable 175
Increase in net working capital ($ 724)
Change in long-term assets:
Decrease in fixed assets 2,161
Free cash flows $2,131

F I n a n C I n g C a S h F lo w S
Interest paid to lenders ($ 364)
Repayment of long-term debt (850)
Repurchase of common stock (1,024)
Common stock dividends (1,341)
Financing cash flows ($3,579)

L I A B I L I T I E S A N D O W N E R S’ E Q U I T Y
2011 2012
Accounts payable $ 200 $ 150
Notes payable—current (9%) 0 150
Current liabilities $ 200 $ 300
Bonds $ 600 $ 600
Owners’ equity
Common stock $ 900 $ 900
Retained earnings 700 800
Total owners’ equity $1,600 $1,700
Total liabilities and owners’ equity $2,400 $2,600
Pamplin Inc. Income Statement for Years Ended 12/31/2011 and 12/31/2012
2011 2012
Sales $1,200 $1,450
Cost of goods sold 700 850
Gross profit $ 500 $ 600
Selling, general, and administrative expenses $ 30 $ 40
Depreciation 220 250 200 240
Operating income $ 250 $ 360
Interest expense $ 50 64
Net income before taxes $ 200 $ 296
Taxes (40%) 80 118
Net income $ 120 $ 178
Chapter 3 • Understanding Financial Statements and Cash Flows 101

Evaluating a Firm’s
Financial Performance
Learning Objectives
1 Explain the purpose and importance of financial analysis. The Purpose of Financial Analysis
2 Calculate and use a comprehensive set of measurements Measuring Key Financial Relationships
to evaluate a company’s performance.
3 Describe the limitations of financial ratio analysis. The Limitations of Financial Ratio Analysis
102
As introduced in Chapter 3, you are giving serious consideration to joining the Home Depot, Inc. after gradua-
tion. You have been offered a position in marketing that you believe fits both your educational background and
interests. Your Uncle Harry suggested that you learn more about the company’s financial position by studying
the firm’s 10-K filed with the Securities and Exchange Commission, which you have done. You have studied the
three financial statements provided by Home Depot but now want to dig deeper to interpret the information
in the statements. You wonder how else you can use Home Depot’s financial statements to evaluate the firm’s
financial strengths and weaknesses. Also, you wonder how you might compare Home Depot’s financial perfor-
mance with that of Lowe’s, Inc., a major competitor.
As it turns out, this chapter is a natural extension of Chapter 3. It will help you evaluate a firm’s financial
performance in the same way as is done by any group having a financial interest in a business, including
managers, employees, lenders, and shareholders. Specifically, we will look at key financial relationships, in
the form of ratios, as a way to gain a better understanding of a company’s financial performance—what we
might call financial analysis. Before presenting the specific methods, let’s start by first understanding the basic
purpose and intent of conducting financial analysis.
The Purpose of Financial Analysis
As explained in Chapter 1, the fundamental objective of financial management is not to focus on accounting
numbers like earnings, but to create shareholder value. In a perfect world, we would rely totally on market
values of a firm’s assets to guide decision-making, rather than on its accounting data. However, since we
rarely have market values for all of a firm’s assets, accounting information can be a very useful substitute.
4
1 Explain the
purpose and
importance
of financial
analysis.

103103
To begin, realize that financial
analysis is about more than review-
ing financial statements; it can be
used both to evaluate historical
performance and to serve as the
basis for making projections about
and improving future financial
performance. The analysis helps us
see critical relationships that might
not otherwise be readily identifi-
able. Ratios are used to standard-
ize financial information so that we
can make comparisons. Otherwise,
it is really difficult to compare the
financial statements of two firms of
different sizes or even of the same
firm at different times.
Financial ratios give us two ways of making meaningful comparisons of a firm’s finan-
cial data: (1) We can examine the ratios across time (say, for the past 5 years) to compare
a firm’s current and past performance; and (2) we can compare the firm’s ratios with those
of other firms. In comparing a firm with other companies, we could select a peer group of
companies or we could use industry norms published by firms such as Dun & Bradstreet,
Risk Management Association (RMA), Standard & Poor’s, Value Line, and Prentice Hall.
Dun & Bradstreet, for instance, annually publishes a set of 14 key ratios for each of 125 lines
of business. The Risk Management Association (the association of bank loan and credit
officers) publishes a set of 16 key ratios for more than 350 lines of business. The firms
are grouped according to the North American Industrial Classification System (NAICS)
codes. They are also segmented by firm size to provide the basis for more meaningful
comparisons.
Figure 4-1 (on page 104) shows the financial statement
information as reported by Risk Management Association for
Software Publishers. The report shows the information by
two asset-size and sales-size categories. The complete report
(not provided here) presents other size categories. The bal-
ance sheet data in the report are provided as a percentage of
total assets, or as what we called in Chapter 3 a common-sized
balance sheet. Likewise, the income statement data are report-
ed as a percentage of sales as a common-sized income statement.1
In presenting the financial ratios in the bottom portion of the
report, RMA gives three results for each ratio, representing
the firms at the 75th, 50th, and 25th percentiles, respectively.
financial ratios accounting data restated in
relative terms in order to help people identify
some of the financial strengths and weaknesses
of a company.
1In Chapter 3, we presented a common-sized income statement and common-
sized balance sheet for Home Depot. (See pages 54 and 61.)
Financial analysis is not a tool just for financial managers;
it can also be used effectively by investors, lenders, suppliers,
employees, and customers. Within the firm, managers use finan-
cial ratios to:
◆ Identify deficiencies in the firm’s performance and take
corrective action.
◆ Evaluate employee performance and determine incentive
compensation.
REmEmbER YouR PRinciPlEs
As in Chapter 3 when we talked about financial
statements, a primary rationale for evaluating a company’s
financial performance relates to Principle 5: Conflicts of
Interest Cause Agency Problems. Thus, the firm’s common
stockholders need information that can be used to monitor
managers’ actions. Interpreting the firm’s financial statements
through the use of financial ratios is a key monitoring tool.
Of course, the firm’s managers also need metrics to monitor
the company’s performance so that corrective actions can be
taken when necessary.
Principle 4: Market Prices Are Generally Right is also
relevant when it comes to evaluating a firm’s financial per-
formance. Only if there are exceptionally profitable markets,
where investments earn rates of return that exceed the oppor-
tunity cost of the money invested, can managers create share-
holder value. Furthermore, financial ratios can help us have a
sense of whether managers have indeed made exceptionally
good investments or bad ones.
Finally, Principle 3: Risk Requires a Reward is also at work
in this chapter. As we will see, how managers choose to finance
the business affects the company’s risk and, as a result, the rate
of return stockholders receive on their investments.
rinciple

104 Part 1 • The Scope and Environment of Financial Management
FIGuRE 4-1 Financial Statement Data by Industry: Norms for Software Publishers
I N F O R M A T I O N — S O F T W A R E P U B L I S H E R S N A I C S 5 1 1 2 1 0
% % RATIOS % %
3.0 6.7 4.4 5.5
13.2 30.2 Sales/Working Capital 27.2 18.1
−15.6 −8.2 −18.2 −12.7
7.0 2.7 14.0 6.9
(31) 4.0 (49) 10.9 EBIT/Interest (31) 2.7 (118) 1.4
−0.9 −1.8 −4.6 −1.2
2.8 18.9 3.8
(14) 1.3
Net Profit+Depr., Dep.,
(10) 2.3 (34) 1.5
0.2
Amort./Cur. Mat. L/T/D
0.3 0.2
−0.4 0.3 0.1 0.2
−0.4 −0.1 Fixed Assets/Net Worth 1.0 −2.6
−0.1 0.0 −0.1 −0.1
2.6 4.0 1.4 1.9
−7.4 −2.0 Debt/Net Worth 7.8 −8.0
−1.8 −1.4 −3.3 −1.7
111.4 33.1 % Profit Before 133.4 71.0
(17) 23.2 (25) 22.2 Taxes/Tangible (28) 21.9 (68) 22.0
0.7 −8.5 Net Worth 4.4 −6.3
12.4 5.5 14.8 10.3
4.9 −0.3 % Profit Before Taxes/ 7.1 1.4
−4.1 −7.5 Total Assets −7.2 −5.2
34.5 37.2 53.7 42.0
16.4 22.7 Sales/Net Fixed Assets 30.4 22.5
9.3 12.5 16.7 11.6
1.1 1.0 2.5 1.8
0.8 0.6 Sales/Total Assets 1.4 1.0
0.6 0.4 1.1 0.6
1.9 2.7
% Depr., Dep.,
1.0 1.5
(23) 4.3 (13) 3.6
Amort./Sales
(31) 2.4 (70) 3.1
7.2 4.2 4.2 6.1
2548082M 6738043M Net Sales ($) 728430M 12099435M
2604550M 9439953M Total Assets ($) 551806M 13514540M
% % ASSETS % %
23.0
20.0
1.9
6.9
51.8
7.2
34.1
6.9
100.0
24.6
32.3
1.3
7.0
65.3
9.1
16.1
9.6
100.0
14.6
13.8
0.6
5.4
34.4
5.0
51.8
8.8
100.0
1.9
2.9
7.8
1.0
30.3
46.9
21.7
2.0
19.9
12.5
100.0
3.9
11.9
11.9
0.9
34.6
63.3
8.3
0.4
15.8
12.3
100.0
0.5
2.0
5.4
0.5
23.5
31.9
24.6
3.4
25.0
15.1
100.0
0.2
4.4
5.1
0.4
29.9
40.0
20.7
1.1
24.1
14.1
23.3 Cash and Equivalents
17.3 Trade Receivables (net)
2.7 Inventory
8.1 All Other Current
51.3 Total Current
7.6 Fixed Assets (net)
34.9 Intangibles (net)
6.2 All Other Non-current
100.0 Total
LIABILITIES
Notes Payable Short Term
Cur. Mat.-L/T/D
Trade Payables
Income Taxes Payable
All Other Current
Total Current
Long Term Debt
Deferred Taxes
All Other Non-current
Net Worth
Total Liabilities
100.0 and Net Worth
INCOME DATA
100.0 Net Sales
89.3 Operating Expenses
10.7 Operating Profit
All Other
Expenses (net)6.4
4.4
100.0
92.1
7.9
5.0
2.9
100.0
95.9
4.1
2.3
1.7
100.0
93.1
6.9
6.5
0.4 Profit Before Taxes
RATIOS
1.8 1.5 2.1 1.8
1.2 1.1 Current 1.1 1.2
0.9 0.8 0.8 0.8
1.5 1.2 1.9 1.4
1.0 0.9 Quick (768) 0.9 (1302) 1.0
0.6 0.6 0.6 0.6
42
58
71
7.8
6.0
4.4
47
61
83
45 47
62
82
7.7
5.9
4.5
8.1 8.6
61 6.0 Sales/Receivables 6.3
97 3.8 4.7
M � $ thousand MM � $ million
C U R R E N T D A T A S O R T E D C U R R E N T D A T A S O R T E D
B Y A S S E T S B Y S A L E S
50- 25MM
100MM 100-250MM 10-25MM and OVER
C U R R E N T D ATA S O R T E D C U R R E N T D A T A S O R T E D
B Y A S S E T S B Y S A L E S
50- 25MM
100MM 100-250MM 10-25MM and OVER
© 2011 by RMA. All rights reserved. No part of this report may be reproduced or utilized in any form or by any means, electronic or mechanical, including photocopying, recording, or by information storage and
retrieval system, without permission in writing from RMA–The Risk Management Association. www.rmahq.org.
◆ Compare the financial performance of the firm’s different divisions.
◆ Prepare, at both the firm and division levels, financial projections, such as those associated
with the launch of a new product.
◆ Understand the financial performance of the firm’s competitors.
◆ Evaluate the financial condition of a major supplier.
Outside the company, financial ratios can be used by:
◆ Lenders to decide whether or not to make a loan to the company.
◆ Credit-rating agencies to determine the firm’s creditworthiness.

www.rmahq.org

Chapter 4 • Evaluating a Firm’s Financial Performance 105
◆ Investors to decide whether or not to invest in a company.
◆ Major suppliers to decide whether or not to grant credit terms to a company.
The conclusion: Financial analysis tools can help a wide group of individuals in a vari-
ety of purposes. However, in this chapter we will focus on how the firm itself uses finan-
cial ratios to evaluate its performance. But remember that personnel in marketing, human
Finance at Work
We are spending a lot of time with Home Depot and to a lesser
extent Lowe’s as we draw on them to understand financial
statements. We thought you might enjoy knowing a little about
their histories.
The Home Depot’s History2
Under Buchan’s management, the store focused on hardware
and building materials. In 1946, at the start of the post–World
War II housing boom, the company began carrying more whole-
sale products to cater to professional contractors. The housing
boom brought such a demand for supplies that sales were often
made out of the freight cars that ran by the store.
In 1952, Carl Buchan and Jim Lowe separated over differences
in their views of the future of the business, with Buchan taking
control of the hardware and building supply business. In 1960,
Buchan died of a heart attack at the age of 44; his management
team, which included Robert Strickland and Leonard Herring, as-
sumed the leadership of the company. In 1961, the firm went
public on the New York Stock Exchange, and in the next year was
operating 21 stores with reported annual revenues of $32 million.
In the late 1970s, Lowe’s experienced a slowdown as a result
of a decline in housing construction. In response, the company
began reaching out to retail consumers as well as to contrac-
tors. With fewer people building new homes, consumers were
refurbishing their current homes, doing more of the work them-
selves. By 1983, Lowe’s was making more money selling to con-
sumers than it was selling to contractors.
At about the same time, Home Depot entered the market, set-
ting a new trend of big warehouse-style stores that dwarfed the
average Lowe’s store. Nevertheless, Lowe’s maintained its exist-
ing business model, thinking that smaller towns where it oper-
ated could not support the mega-stores. With time, however,
Lowe’s realized its mistake and began building its own mega-
stores, creating the Lowe’s we know today. While not as large
as Home Depot, Lowe’s is certainly a major competitor of Home
Depot’s, having 1,712 stores in the U.S. and 33 stores in Canada
and Mexico, for a total of 1,745 stores. For the fiscal year ending
February 2012, Lowe’s had $50.2 billion in sales, with $1.9 billion
in net income.
2 Our History (n.d.), retrieved May 26, 2012 from: https://corporate.homedepot
.com/OurCompany; History/Pages/default.aspx, retrieved June 1, 2012; The Home
Depot (n.d.), retrieved May 15, 2012 from: http://www.thehistoryofcorporate
.com; companies-by-industry/traderetail/the-home-depot, retrieved May 17,
2012; and Form 10-K, The Home Depot, Inc. for the year ended January 29, 2012,
retrieved April 26, 2012.
The Home Depot was founded in 1978 by Bernie Marcus, Arthur
Blank, Ron Brill, and Pat Farrah. The Home Depot’s proposition
was to build home-improvement warehouses that were larger
than any of their competitors’ facilities. The first two stores were
opened on June 22, 1979 in Atlanta, Georgia, creating a new
concept of do-it-yourself retail. With 60,000 square feet of prod-
uct and floor space each, these two stores were the first mega-
stores in the home-improvement industry.
The founders wanted to provide customers the knowledge
they needed to undertake do-it-yourself projects. Employees
were trained to advise customers on buying tools, selecting
materials, and completing projects on their own.
In 1981, only 3 years after the first stores opened, the com-
pany went public on the NASDAQ, and in 1984, moved to the
New York Stock Exchange. In 1989, 10 years after the founding
of the company, Home Depot celebrated the opening of the
100th store.
In 2000, after the retirement of the company’s founders, Robert
Nardelli became the CEO and chairman of the board of
directors. Nardelli was credited with improving gross rev-
enue and lowering costs, almost doubling the company’s net
income over the course of his tenure. But according to some, his
bottom-line management style negatively affected employee
morale, which in turn hurt customer service. In 2007, Nardelli
resigned amid complaints regarding his relatively high com-
pensation and the company’s stagnant stock price. Frank Blake
followed Nardelli as Home Depot’s CEO.
By 2012, Home Depot had over 2,200 stores, with almost
300 stores outside the United States. For the fiscal year ending
on January 9, 2012, Home Depot had $70.4 billion in sales and
$3.9 billion in profits—up 18 percent from the prior year.
Lowe’s History3
3 Our Heritage (n.d.), retrieved May 27, 2012 from: http://media.lowes.com/history;
Lowe’s Companies, Inc. History (n.d.), retrieved May 27, 2012 from: http://www
.fundinguniverse.com; company-histories/lowe-s-companies-inc-history,
retrieved May 27, 2012; and Form 10-K, Lowe’s Companies, Inc. for the year
ended February 3, 2012, retrieved May 25, 2012.
In 1921, Lucius S. Lowe opened Lowe’s North Wilkesboro Hardware
in North Wilkesboro, North Carolina. When Lucius died in 1940, his
daughter, Ruth, inherited the business. She later sold the company
to her brother, Jim, who then added Carl Buchan as a partner.
HomE DEPot anD lowE’s: tHE HistoRiEs

http://www.thehistoryofcorporate.com

http://www.fundinguniverse.com

http://media.lowes.com/history

https://corporate.homedepot.com/OurCompany

106 Part 1 • The Scope and Environment of Financial Management
resources, information systems, and other groups within a firm can use financial ratios for
a variety of other reasons.
Concept Check
1. What is the basic purpose of financial analysis?
2. How does a firm use financial ratios? Who else might use financial ratios and why?
3. Where can we find financial ratios for different companies or for peer groups?
Measuring Key Financial Relationships
Instructors usually take one of two approaches to teaching students about financial ratios.
The first approach reviews the different types or categories of ratios, whereas the second
approach uses ratios to answer important questions about a firm’s operations. We prefer
the latter approach and have chosen the following five questions to help you map out the
process of using financial ratios:
1. How liquid is the firm?
2. Are the firm’s managers generating adequate operating profits from the company’s
assets?
3. How is the firm financing its assets?
4. Are the firm’s managers providing a good return on the capital provided by the
shareholders?
5. Are the firm’s managers creating shareholder value?
Let’s look at each of these five questions in turn. In doing so, we will use Home Depot
to illustrate the use of financial ratios. The company’s financial statements for fiscal year
ended January 30, 2011, which were originally presented in Chapter 3, are shown again in
Table 4-1 and Table 4-2. As we remember from Chapter 3, the numbers in Home Depot’s
financial statements are expressed in millions, so that any number exceeding $1,000 million
is actually over a billion dollars. We have color coded the numbers in the ratio computa-
tions so that you can readily determine whether a particular number is coming from the
income statement (red numbers) or the balance sheet (blue numbers).
In addition to calculating Home Depot’s financial ratios, we will provide the same ratios
for Lowe’s Companies, Inc., a home improvement stores company we learned about on
the previous page in the Finance at Work box. By comparing Home Depot’s results with
Lowe’s, we gain additional perspective about its performance relative to a major competitor.
2 Calculate and use a
comprehensive set of
measurements to evaluate a
company’s performance.
TAbLE 4-1 The Home Depot, Inc. Income Statement for
Year Ending January 30, 2011 ($ millions)
Sales $ 67,997
Cost of goods sold (44,693)
Gross profits $ 23,304
Operating expenses:
Marketing expenses and general and administrative expenses ($ 15,885)
Depreciation expenses (1,616)
Total operating expenses ($ 17,501)
Operating income $ 5,803
Interest expense (530)
Earnings before taxes $ 5,273
Income taxes (1,935)
Net income (earnings available to common stockholders) $ 3,338
Additional information:
Numbers of common shares outstanding (millions) 1,623
Earnings per share (net income , number of shares) $ 2.06
Dividends paid to stockholders $ 1,569
Dividends per share (total dividends ÷ number of shares) $ 0.97

Chapter 4 • Evaluating a Firm’s Financial Performance 107
We will begin our analysis by addressing the first question shown above, “How liquid is
the firm?” and then proceed through the remaining questions in the order listed.
Question 1: How Liquid Is the Firm—Can It Pay Its bills?
A liquid asset is one that can be converted quickly and routinely into cash at the current
market price. So the liquidity of a business is a function of its ability to have cash available
when needed to meet its financial obligations. Very simply, can we expect a company to be
able to pay creditors on a timely basis?
We answer this question by comparing a firm’s assets that can be converted quickly and
easily into cash—namely its current assets—with the firm’s current liabilities. In our analy-
sis we are interested in both (1) the amount of current assets relative to current liabilities
and (2) the quality of the individual current assets that will be used in meeting current debt
payments.
When it comes to examining the relative size of current assets to current liabilities, the
most commonly used measure of a firm’s short-term solvency is the current ratio:
Current ratio =
current assets
current liabilities
(4-1)
For Home Depot:
Current ratio =
current assets
current liabilities
=
$13,479M
$10,122M
= 1.33
where M represents millions.
Lowe’s current ratio 1.40
current ratio the firm’s current assets divided
by its current liabilities. This ratio indicates a
company’s degree of liquidity by comparing its
current assets to its current liabilities.
liquidity a firm’s ability to pay its bills on time.
Liquidity is related to the ease and speed with
which a firm can convert its noncash assets into
cash.
TAbLE 4-2 The Home Depot, Inc. balance Sheets ($ millions) January 30, 2011
Assets
Cash $ 545
Account receivables 1,085
Inventories 10,625
Other current assets 1,224
Total current assets $13,479
Gross fixed assets $38,471
Accumulated depreciation (13,411)
Net fixed assets $25,060
Other assets 1,586
Total assets $40,125
Liabilities and Equity
Accounts payable $ 9,080
Short-term notes payable 1,042
Total current liabilities $10,122
Long-term debt $11,114
Total liabilities $21,236
Common equity:
Common stock:
Par value $ 86
Paid-in capital 7,001
Total common stock sold $ 7,087
Treasury stock (3,193)
Total common stock $ 3,894
Retained earnings 14,995
Total common equity $18,889
Total liabilities and equity $40,125

108 Part 1 • The Scope and Environment of Financial Management
Based on the current ratio, Home Depot is less liquid than Lowe’s. The company has
$1.33 in current assets for every $1 in current liabilities, while Lowe’s has $1.40.
When we use the current ratio, we assume that the firm’s accounts receivable will be
collected and turned into cash on a timely basis and that its inventories can be sold without
any extended delay. Given that a company’s inventory by its very nature is less liquid than
its accounts receivable—it must first be sold before any cash can be collected—a more strin-
gent measure of liquidity would exclude the inventories and include only the firm’s cash and
accounts receivable in the numerator. This revised ratio is called the acid-test (or quick)
ratio. It is calculated as follows:
Acid-test ratio =
cash + accounts receivable
current liabilities
(4-2)
For Home Depot:
Acid-test ratio =
cash + accounts receivable
current liabilities
=
$545M + $1,085M
$10,122M
= 0.16
Lowe’s acid-test ratio 0.12
Based on the acid-test ratio, Home Depot appears to be more liquid than Lowe’s. It
has $0.16 in cash and accounts receivable per $1 in current debt, compared to $0.12 for
Lowe’s.
So what should we conclude? The current ratio suggests that Lowe’s is more liquid,
while the acid-test ratio tells us that Home Depot is. The difference must come from the
amount of inventories each firm has relative to their current liabilities; that is, the higher
current ratio for Lowe’s indicates that it has relatively more inventory then Home Depot.
Thus, we will want to know more about the quality of Lowe’s inventories compared to
Home Depot’s. That answer will come shortly.4
acid-test (quick) ratio the sum of a firm’s
cash and accounts receivable divided by its cur-
rent liabilities. This ratio is a more stringent mea-
sure of liquidity than the current ratio because
it excludes inventories and other current assets
(those that are least liquid) from the numerator.
days in receivables (average collection
period) a firm’s accounts receivable divided
by the company’s average daily credit sales
(annual credit sales , 365). This ratio expresses
how many days on average it takes to collect
receivables.
We now want to evaluate the quality of a firm’s accounts receivable and inventories
in terms of the firm’s ability to convert these assets into cash on a timely basis. A firm
might have a higher current ratio, as Lowe’s does relative to Home Depot, but have
more uncollectible receivables and/or be carrying a lot of obsolete inventory. So know-
ing the quality of these assets is necessary if we are to have a complete understanding
of a firm’s liquidity.
Converting Accounts Receivable to Cash The conversion of accounts receivable into cash
can be measured by computing how long it takes to collect the firm’s receivables on aver-
age. We can answer this question by computing a firm’s days in receivables (or average
collection period) as follows:5
4Is it possible that a firm’s current ratio or acid-test ratio could be too high? Absolutely. Liquid assets generally provide
little in the way of profitability. For example, tying too much money up in inventories may prevent a company from
investing in assets that will generate more profits. In other words, there is usually a tradeoff between having more
liquidity and generating profits.
5When computing a given ratio that uses information from both the income statement and the balance sheet,
we should remember that the income statement is for a given time period (for example, 2010), whereas balance
sheet data are at a point in time (for example, January 30, 2011). If there has been a significant change in an asset
balance from the beginning of the period to the end, it would be better to use the average balance for the year.
For example, if the accounts receivable for a company have increased from $1,000 at the beginning of the year to
$2,000 at the end of the year, it would be more appropriate to use the average accounts receivable of $1,500 in our
computations. Nevertheless, in an effort to simplify, we will use year-end amounts from the balance sheet in our
computations.
Days in receivables =
accounts receivable
daily credit sales
=
accounts receivable
annual credit sales , 365
(4-3)
Note that in this equation, we are including only sales where the customer purchases on
credit, omitting cash sales. As you would expect, businesses like Home Depot have mostly cash
sales. Specifically, we estimate that only 30 percent of their sales are on credit, so credit sales

Chapter 4 • Evaluating a Firm’s Financial Performance 109
amounted to about $20.399 billion ($20.399 billion = $67.997 billion total sales * 30% credit
sales). Thus, Home Depot’s days in receivables is 19.41 days, computed as follows:
Days in receivables =
accounts receivable
annual credit sales , 365
=
$1,085M
$20,399M , 365
=
$1,085M
$55.89M
= 19.41 days
Lowe’s days in receivables 16 days
So on average Home Depot collected its accounts receivable in about 19.4 days com-
pared to 16 days for Lowe’s. Thus, Home Depot is slower at collecting its receivables than
Lowe’s, suggesting that its receivables are less liquid than Lowe’s.
We could have reached the same conclusion by measuring how many times accounts
receivable are “rolled over” during a year, using the accounts receivable turnover ratio.
If Home Depot collects its accounts receivable every 19.41 days, then it is collecting 18.8
times per year (18.8 times = 365 days , 19.41 days). The accounts receivable turnover
can also be calculated as follows:
Accounts receivable turnover =
annual credit sales
accounts receivable
(4-4)
For Home Depot:
Accounts receivable turnover =
annual credit sales
accounts receivable
=
$20,399M
$1,085M
= 18.80X
Lowe’s accounts receivable turnover 22.81X
Whether we use the days in receivables or the accounts receivable turnover ratio, the
conclusion is the same. Home Depot collects its accounts receivable more slowly than
Lowe’s. In other words, Home Depot’s accounts receivable are of lesser quality. (Think
about this: If Home Depot’s days in receivables were as low as Lowe’s, it would have less
accounts receivable and its current ratio would be lower.)
Converting Inventories to Cash We now want to know the quality of Home Depot’s
inventory, as indicated by how long the inventory is held before being sold. This is called
days in inventory, which is computed as follows:
Days in inventory =
inventory
daily cost of goods sold
=
inventory
annual cost of goods sold , 365
(4-5)
For Home Depot:
Days in inventory =
inventory
annual cost of goods sold , 365
=
$10,625M
$44,693M , 365
=
$10,625M
$122.45M
= 86.77 days
Lowe’s days in inventory 95.80 days
Note that when we calculated accounts receivable turnover or days in receivables, we use
sales in our computation. But when calculating days in inventory or inventory turnover, we
use cost of goods sold. We do this because inventory is measured at cost.
accounts receivable turnover ratio a
firm’s credit sales divided by its accounts receiv-
able. This ratio expresses how often accounts
receivable are “rolled over” during a year.
days in inventory inventory divided by
daily cost of goods sold. This ratio measures the
number of days a firm’s inventories are held on
average before being sold; it also indicates the
quality of the inventory.

110 Part 1 • The Scope and Environment of Financial Management
As we did with days in receivables and accounts receivable turnover, we can restate days
in inventory as inventory turnover, which is calculated as follows:6
Name of Tool Formula What It Tells You
Current ratio
current assets
current liabilities
Measures a firm’s liquidity. A higher ratio means greater
liquidity.
Acid-test ratio cash + accounts receivable
current liabilities
Gives a more stringent measure of liquidity than the cur-
rent ratio in that it excludes inventories and other current
assets from the numerator. A higher ratio means greater
liquidity.
Days in receivables accounts receivable
annual credit sales , 365
Indicates how rapidly a firm is collecting its receivables. A
longer (shorter) period means a slower (faster) collection of
receivables and that the receivables are of lesser (greater)
quality.
Accounts receivable turnover annual credit sales
accounts receivable
Tells how many times a firm’s accounts receivable are
collected, or turned over, during a year. Provides the same
information as the days in receivables, just expressed
differently, where a high (low) number indicates fast (slow)
collections.
Days in inventory inventory
annual cost of goods sold , 365
Measures how many days a firm’s inventories are held on
average before being sold; the more (less) days required, the
lower (higher) the quality of the inventory.
Inventory turnover cost of goods sold
inventory
Gives the number of times a firm’s inventory is sold and
replaced during the year; as with days in inventory, serves as
an indicator of the quality of the inventories; the higher the
number, the better the inventory quality.
Financial Decision Tools
inventory turnover a firm’s cost of goods
sold divided by its inventory. This ratio measures
the number of times a firm’s inventories are sold
and replaced during the year, that is, the relative
liquidity of the inventories.
6However, some of the industry norms provided by financial services are computed using sales in the numerator of inven-
tory turnover. To make comparisons with ratios from these services, we will want to use sales in our computation
of inventory turnover.
Inventory turnover =
cost of goods sold
inventory
(4-6)
For Home Depot:
Inventory turnover =
$44,693M
$10,625M
= 4.21X
Lowe’s inventory turnover 3.81X
Hence, we see that Home Depot is moving (turning over) its inventory more quickly
than Lowe’s—4.21 times per year, compared with 3.81 times for Lowe’s. This suggests that
Home Depot’s inventory is more liquid than Lowe’s.
To conclude, the current ratio indicates that Home Depot is less liquid than Lowe’s, but
this result assumes that Home Depot’s accounts receivable and inventory are of similar quality to
Lowe’s. However, this is not the case given Home Depot’s lower accounts receivable turnover
(more days in receivables) and higher inventory turnover (fewer days in inventory). The acid-test
ratio, on the other hand, suggests that Home Depot is more liquid than Lowe’s, but we know that
Home Depot’s accounts receivable are a bit less liquid than Lowe’s. We therefore have a mixed
outcome, and cannot say definitively whether Home Depot is more or less liquid. Thus, we have
to conclude that Home Depot’s liquidity and Lowe’s liquidity are probably very similar.
We have completed our presentation of liquidity decision tools, which can be summa-
rized as follows:
or
or

Chapter 4 • Evaluating a Firm’s Financial Performance 111
Current assets $ 13,757
Cash 2,722
Accounts receivable 6,182
Inventories 2,269
Credit sales 27,262
Cash sales 13,631
Total sales 40,893
Cost of goods sold 31,221
Total current liabilities 12,088
Current ratio 1.17
Acid-test ratio 0.92
Accounts receivable turnover 5.80X
Inventory turnover 18.30X
DISNEY INDuSTRY
Current ratio 1.14 1.17
Acid-test ratio 0.74 0.92
Accounts receivable turnover 4.41X 5.8X
Inventory turnover 13.78X 18.3X
E x A M P L E 4.1 Evaluating Disney’s liquidity
The following information (expressed in $ millions) is taken from the Walt Disney
Company’s 2011 financial statements:
Evaluate Disney’s liquidity based on the following norms in the broadcasting and
entertainment industry:
stEP 1: FoRmulatE a DEcision stRatEgY
We analyze a company’s liquidity by looking at selected ratios. These include the
current ratio, acid-test ratio, accounts receivable turnover (or days in receivables), and
inventory turnover (or days in inventory). The formulas are:
Current ratio =
current assets
current liabilities
Acid-test ratio =
cash + accounts receivable
current liabilities
Accounts receivable turnover =
annual credit sales
accounts receivable
Inventory turnover =
cost of goods sold
inventory
stEP 2: cRuncH tHE numbERs
stEP 3: analYzE YouR REsults
Based on these results, Disney is not as liquid as the average firm in the industry! The
company has smaller amounts of liquid assets relative to its current liabilities than does
its average competitor. The firm does not convert its receivables to cash as quickly as do
its competitors, and is slower at turning inventory.
Concept Check
1. What information about the firm is provided by liquidity measures?
2. Describe the two perspectives available for measuring liquidity.
3. Why might a very high current ratio actually indicate there’s a problem with a firm’s inventory
or accounts receivable management? What might be another reason for a high current ratio?
4. Why might a successful (liquid) firm have an acid-test ratio that is less than 1?
Source: Data from The Walt Disney Company’s Fiscal Year 2011 Annual Financial Report.

112 Part 1 • The Scope and Environment of Financial Management
Question 2: Are the Firm’s Managers Generating Adequate
Operating Profits from the Company’s Assets?7
7We will use the term operating profits throughout this chapter. We could just as correctly use the term operating income.
We also could use the term earnings before interest and taxes—frequently abbreviated as EBIT. After all, operating profits
are usually the firm’s earnings before subtracting interest and taxes. So you may see these terms used interchangeably in
practice. Just understand that they are for the most part the same.
We now switch to a different dimension of performance—the firm’s profitability. The
question here is, “Do the firm’s managers produce adequate profits from the company’s
assets?” From the perspective of the firm’s shareholders, there is no more important ques-
tion to be asked. One of the most important ways managers create shareholder value is to
earn strong profits on the assets in which they have invested.
To answer this all-important question, think about the process of financing a company.
In its simplest form, a firm’s shareholders invest in a business. The company may also
borrow additional money from other sources (banks and so forth). The purpose of mak-
ing these investments is to create profits. Figure 4-2 graphically illustrates this process for
Home Depot, where we see that the shareholders invested $18.889 billion in the company,
and that the company borrowed another $21.236 billion, which together allowed the com-
pany to finance $40.125 billion of assets. These assets were then used to produce $5.803
billion in operating profits.
FIGuRE 4-2 Home Depot Operating Profits Resulting from Asset Investments
Produces
Total assets
$40.125
billion
Used to
finance
$5.803 billion
Operating profits
Common
equity
$18.889 billion
Debt
$21.236 billion
Operating profits
exclude interest
expense, the cost
of financing the
business
Notice that we are using operating profits rather than net income. Operating profits are
the income generated from the firm’s assets independent of how the firm is financed. The
effect of financing will be explicitly considered in the two questions that follow, but for now
we want to isolate only the operating aspects of the company’s profits.
While knowing the dollar amount of a firm’s operating profits is important, we also
want to know the amount of operating profits relative to the total assets employed. In other
words, we want to know how much operating profit is generated per dollar of assets used;
that is, we are interested in a firm’s return on its asset investment. We find this return by
calculating the operating return on assets (OROA) as follows:
Operating return on assets =
operating profits
total assets
(4-7)
For Home Depot:
Operating return
on assets
=
operating profits
total assets
=
$5,803M
$40,125M
= 0.145 = 14.5%
Lowe’s operating return on assets 10.6%
Thus, Home Depot earned a higher return on its assets relative to Lowe’s—14.5 cents of
operating profits for every $1 of assets for Home Depot, compared to 10.6 cents for Lowe’s.
Clearly, Home Depot was doing something better than Lowe’s when it came to earn-
ing a higher return on its assets. But what? The answer lies in two areas: (1) how effec-
tively the company’s income statement was being managed or what we will call opera-
tions management, which involves the day-to-day buying and selling of a firm’s goods
or services as reflected in the income statement; and (2) how efficiently assets are being
operating return on assets (OROA) the
ratio of a firm’s operating profits divided by its
total assets. This ratio indicates the rate of return
being earned on the firm’s assets.
operations management how effectively
management is performing in the day-to-day
operations in terms of how well management is
generating revenues and controlling costs and
expenses; in other words, how well is the firm
managing the activities that directly affect the
income statement?

Chapter 4 • Evaluating a Firm’s Financial Performance 113
managed to generate sales, or, asset management. That these two issues relate to the
operating return on assets can be seen by using two other ratios—operating profit margin
and total asset turnover. We can compute operating return on assets using the following
revised equation and get the same answer as we did with equation (4-7):
Operating return
on assets
=
operating profit
margin
*
total asset
turnover
(4-8a)
calculated as follows:
Operating return
on assets
=
operating profit
sales
*
sales
total assets
(4-8b)
The operating profit margin is the result of how a company manages its day-to-day opera-
tions (operations management), and the total asset turnover is the result of how efficiently the
company’s assets are being managed (asset management). Let’s consider managing opera-
tions and asset management in turn.
Managing Operations The first component of the operating return on assets (OROA),
the operating profit margin, is an indicator of how well the company manages its opera-
tions—that is, how well revenues are being generated and costs and expenses controlled.
The operating profit margin measures how well a firm is managing its cost of operations,
in terms of both the cost of goods sold and operating expenses (marketing expenses, general
and administrative expenses, and depreciation expenses) relative to the firm’s revenues. All
else being equal, the objective for managing operations is to keep costs and expenses low
relative to sales. Thus, we use the operating profit margin to measure how well the firm is
managing its income statement, where:
Operating profit margin =
operating profits
sales
(4-9)
For Home Depot:
Operating profit margin =
operating profits
sales
=
$5,803M
$67,997M
= 0.085 = 8.5%
Lowe’s operating profit margin 7.3%
The foregoing result clearly indicates that Home Depot’s managers were better at man-
aging its cost of goods sold and operating expenses than Lowe’s. Home Depot had lower
costs per sales dollar, which resulted in a higher operating profit margin. Put another way,
Home Depot was better than Lowe’s at managing its income statement. Thus, one reason
for Home Depot’s higher operating return on assets was its higher operating profit margin.
Now let’s look at the second driver of a company’s operating return on assets—how
efficiently assets are being managed.
Managing Assets The second component in equation (4-8) is the total asset turnover. This
ratio tells us how efficiently a firm is using its assets to generate sales. To clarify, assume that
Company A generates $3 in sales for every $1 invested in assets, whereas Company B generates
the same $3 in sales but has invested $2 in assets. In other words, Company A is using its assets
more efficiently to generate sales, which leads to a higher return on the firm’s investment in
assets. This efficiency is captured by the total asset turnover ratio, shown again as follows:
Total asset turnover =
sales
total assets
(4-10)
For Home Depot:
Total asset turnover =
sales
total assets
=
$67,997M
$40,125M
= 1.69X
Lowe’s total asset turnover 1.45X
operating profit margin a firm’s operating
profits divided by sales. This ratio serves as an
overall measure of operating effectiveness.
asset management how efficiently manage-
ment is using the firm’s asset’s to generate sales.
total asset turnover a firm’s sales divided by
its total assets. This ratio is an overall measure of
asset efficiency based on the relation between a
firm’s sales and the total assets.

114 Part 1 • The Scope and Environment of Financial Management
We now know that Home Depot is using its assets more efficiently than Lowe’s, gen-
erating $1.69 in sales per dollar of assets, whereas Lowe’s produces only $1.45. This is the
second reason for Home Depot’s higher operating return on assets—the first being the
higher operating profit margin.
However, we should not stop here with our analysis of Home Depot’s asset manage-
ment. We have learned that, in general, Home Depot’s managers are making efficient use
of the firm’s assets, but this may not be the case for each type of asset. We also want to know
how well the firm is managing its main operating assets, accounts receivable, inventories,
and fixed assets, respectively.
To answer this question, we can compute the turnover ratios for each of these asset
categories. Of course, we have already calculated the turnover ratios for the company’s
accounts receivable and inventories and concluded that Home Depot’s managers were not
managing accounts receivable as efficiently as Lowe’s, but were turning over inventories
more quickly. We still need to compute the fixed asset turnover, which we do as follows:
Fixed asset
turnover
=
sales
net fixed assets
(4-11)
For Home Depot:
Fixed asset
turnover
=
sales
net fixed assets
=
$67,997M
$25,060M
= 2.71X
Lowe’s fixed asset turnover 2.21X
Thus, Home Depot has a smaller investment in fixed assets relative to the firm’s sales
than does Lowe’s.
We can now look at all the asset efficiency ratios together to summarize Home Depot’s
asset management:
fixed asset turnover a firm’s sales divided
by its net fixed assets. This ratio indicates how
efficiently the firm is using its fixed assets.
H O M E D E P O T L O W E ’S
Total asset turnover 1.69X 1.45X
Accounts receivable turnover 18.80X 22.81X
Inventory turnover 4.21X 3.81X
Fixed assets turnover 2.71X 2.21X
FIGuRE 4-3 Analysis of Home Depot’s Operating Return on Assets
Accounts receivable
turnover
Home Depot 18.80
Lowe’s 22.81
Inventory
turnover
Home Depot 4.21
Lowe’s 3.81
Fixed asset
turnover
Home Depot 2.71
Lowe’s 2.21
Operating return
on assets
Operating profit
margin
Home Depot 8.5%
Lowe’s 7.3%
Home Depot 1.69
Lowe’s 1.45
Total asset
turnover
� �
Operating return
on assets
Operating profits
Total assets
�
Home Depot 14.5%
Lowe’s 10.6%
Home Depot’s situation with respect to asset management is now clear. Overall, Home
Depot’s managers are utilizing their firm’s assets efficiently, based on the firm’s total asset turn-
over. This overall asset efficiency results from better management of the firm’s inventories and
fixed assets (which have higher turnovers than Lowe’s). However, the firm is not managing its
accounts receivable as well: Home Depot’s accounts receivable turnover is lower than Lowe’s.

Chapter 4 • Evaluating a Firm’s Financial Performance 115
Figure 4-3 (on page 114) provides a summary of our evaluation of Home Depot’s
operating and asset management performance. We began by computing the operating
return on assets to determine if managers were producing good returns on the assets. We
then broke the operating return on assets into its two pieces, operations management
(operating profit margin) and asset management (asset turnover ratios), to explain why
Home Depot’s operating return on assets was higher than Lowe’s. We can also provide a
summary of the financial ratios being used as tools to evaluate a firm’s profitability as follows:
Name of Tool Formula What It Tells You
Operating return on assets (OROA)
operating profits
total assets

or
operating profit margin * total assets turnover
The rate of return being earned on a firm’s assets. A
higher (lower) return indicates more (less) operating
profits per dollar of assets invested.
Operating profit margin operating profits
sales

Overall measure of day-to-day operating effective-
ness—how well revenues are being generated and
costs and expenses controlled. A higher (lower) margin
means a firm is better (worse) at managing its day-to-
day operations.
Total asset turnover sales
total assets
Measures how efficiently a firm is using its total assets.
A higher turnover means the firm is using its assets
more efficiently.
Days in receivables accounts receivable
annual credit sales , 365
Measures how rapidly a firm is collecting its receivables.
A longer (shorter) period means slower (faster) collec-
tions and a larger (smaller) investment in receivables.
Accounts receivable turnover annual credit sales
accounts receivable
The number of times a firm’s accounts receivable
are collected, or turned over, during a year. Provides
the same information as the days in receivables, just
expressed differently.
Days in inventory inventory
annual cost of goods sold , 365
Measures how many days a firm’s inventories are held
on average before being sold; the more (less) days
required, the larger (smaller) will be the investment in
inventories.
Inventory turnover cost of goods sold
inventory
The number of times a firm’s inventories are sold and
replaced during the year; provides the same informa-
tion as the days in inventory, just expressed differently.
Fixed asset turnover
sales
net fixed assets
Measures how efficiently the firm is using its fixed assets.
A higher (lower) turnover means the firm is using its
fixed assets more (less) efficiently.
Financial Decision tools
or
or
Concept Check
1. Which number in a company’s income statement should be used to measure its profitability
relative to its total assets? Why?
2. What two broad areas of the firm’s management does the operating return on assets assess?
3. What factors influence the operating profit margin?
4. A low total asset turnover indicates that a firm’s total assets are not being managed efficiently.
What additional information would you want to know when this is the case?

116 Part 1 • The Scope and Environment of Financial Management
E x A M P L E 4.2 Evaluating Disney’s operating return on assets
Given the following financial information for the Walt Disney Company (expressed in
$ millions), evaluate the firm’s operating return on its assets (OROA).
D I S N E Y I N D u S T RY
Operating return on assets
$7,781
$72,124
10.79% 7.25%
Operating profit margin
$7,781
$40,893
19.03% 16.10%
Total asset turnover
$40,893
$72,124
0.57X 0.45X
Accounts receivable turnover
$27,262
$6,182
4.41X 7.10X
Inventory turnover
$31,221
$2,269
13.76X 18.30X
Fixed assets turnover
$40,893
$19,695
2.08X 1.05X
Accounts receivable $ 6,182
Inventories 2,269
Sales 40,893
Credit sales 27,262
Cost of goods sold 31,221
Operating profits 7,781
Net fixed assets 19,695
Total assets 72,124
The industry norms are as follows:
Operating return on assets 7.25%
Operating profit margin 16.10%
Total asset turnover 0.45X
Accounts receivable turnover 7.10X
Inventory turnover 18.30X
Fixed assets turnover 1.05X
stEP 1: FoRmulatE a DEcision stRatEgY
The operating return on assets is determined by two factors: managing operations and
managing assets. Recall equation (4-8a):
Operating
return on assets
=
operating profit
margin
*
total asset
turnover
Substituting for the operating profit margin and total asset turnover (equation 4-8b):
Operating
return on assets
=
operating profits
sales
*
sales
total assets
We can further analyze the total asset turnover ratio by looking at the efficiency of
various components of total assets, including accounts receivable turnover, inventory
turnover, and fixed assets turnover.
stEP 2: cRuncH tHE numbERs
Source: Data from The Walt Disney Company’s Fiscal Year 2011 Annual Financial Report.

Chapter 4 • Evaluating a Firm’s Financial Performance 117
stEP 3: analYzE YouR REsults
Disney generated a higher return on its assets than the average firm in the industry,
10.79 percent compared to 7.25 percent for the industry. Disney provided a higher
operating return on its assets by (1) managing its operations better, achieving a higher
operating profit margin (19 percent compared to 16.10 percent), and (2) making better
use of its assets, as indicated by a higher total asset turnover (0.57X versus 0.45X). How-
ever, the higher total asset turnover is caused entirely by a much higher fixed-asset turn-
over (2.08X compared to 1.05X), which more than offsets the lower accounts receivable
turnover (4.41X as compared to 7.10X) and the less efficient management of inventories,
as reflected by the lower inventory turnover (13.76X versus 18.30X).
Question 3: How Is the Firm Financing Its Assets?
We now turn to the matter of how a firm is financed. (We will return to the issue of profit-
ability shortly.) The key issue is management’s choice between financing with debt or with
equity. To begin, we want to know what percentage of the firm’s assets is financed by debt,
including both short-term and long-term debt, realizing that the remaining percentage
must be financed by equity. To answer this question, we compute the debt ratio as follows:8 debt ratio a firm’s total liabilities divided by
its total assets. This ratio measures the extent to
which a firm has been financed with debt.
8Instead of using the debt ratio, we could use the debt–equity ratio. The debt–equity ratio is simply a transformation of
the debt ratio:
Debt-equity ratio =
total debt
total equity
=
debt ratio
1 – debt ratio
; Debt ratio =
debt/equity
1 + debt/equity

Debt ratio =
total debt
total assets
(4–12)
For Home Depot:
Debt ratio =
total debt
total assets
=
$21,236M
$40,125M
= 0.53 = 53%
Lowe’s debt ratio 46%
Home Depot finances 53 percent of its assets with debt (taken from Home Depot’s
balance sheet in Table 4-2), compared with Lowe’s 46 percent. Stated differently, Home
Depot finances with 47 percent equity, whereas Lowe’s is 54 percent equity. Thus, Home
Depot uses more debt than Lowe’s. As we will see in later chapters, more debt financing
results in more financial risk.
Our second perspective regarding the firm’s financing decisions comes from looking
at the income statement. When the firm borrows money, it must at least pay the interest
on what it has borrowed. Thus, it is informative to compare (1) the amount of operating
profits that are available to pay the interest with (2) the amount of interest that has to be
paid. Stated as a ratio, we compute the number of times the firms is earning its interest. The
times interest earned ratio is commonly used when examining a firm’s debt position and
is computed in the following manner:
times interest earned a firm’s operating
profits divided by interest expense. This ratio
measures a firm’s ability to meet its interest pay-
ments from its annual operating earnings.Times interest earned =
operating profits
interest expense
(4–13)
For Home Depot:
Times interest earned =
operating profits
interest expense
=
$5,803M
$530M
= 10.9X
Lowe’s times interest earned 9.0X
Home Depot’s interest expense is $530 million, which when compared to its operating
profits of $5.803 billion ($5,803 million) indicates that its interest expense is consuming
less of the operating profits than is the case for Lowe’s. Home Depot’s higher times interest
earned can be attributed to the firm’s relatively higher operating profits, as reflected in a

118 Part 1 • The Scope and Environment of Financial Management
E x A M P L E 4.3 Evaluate Disney’s financing decisions
Given the information below (expressed in $ millions) for the Disney Corporation, cal-
culate the firm’s debt ratio and its times interest earned. How do Disney’s ratios compare
to those of the industry in which it operates? What are the implications of your findings?
Total debt $32,671
Total assets 72,124
Operating profits 7,781
Interest expense 526
Industry norms:
Debt ratio 34.21%
Times interest earned 8.5X
stEP 1: FoRmulatE a DEcision stRatEgY
A company’s financing decisions can be evaluated by considering two questions: (1) How
much debt is used to finance the firm’s assets, and (2) Does the company have the ability
to service its interest payments? These two issues can be assessed by using the debt ratio
and the times interest earned ratio, respectively, calculated as follows:
Debt ratio =
total debt
total assets
Times interest earned =
operating profits
interest expense
stEP 2: cRuncH tHE numbERs
A comparison of Disney’s debt ratio and times interest earned with the industry is as
follows:
higher operating return on assets. The higher the profits, the higher will be the time inter-
ested earned. Home Depot’s higher debt ratio would most likely lower the times interest
earned, relative to Lowe’s, since the more debt you have, the more interest you will pay.
However, Home Depot’s higher income apparently more than covers any additional inter-
est expense on its greater amount of debt.
Before concluding our discussion regarding times interest earned, we should under-
stand that interest is not paid with income but with cash. Moreover, in addition to the
interest that must be paid, the firm will also be required to repay the debt principal. Thus,
the times interest earned ratio is only a crude measure of the firm’s capacity to service its
debt. Nevertheless, it does give us a general indication of a company’s financial risk and its
capacity to borrow.
So the two ratios that can be used as financial decision tools are as follows:
D I S N E Y I N D u S T RY
Debt ratio 45.30% 34.21%
Times interest earned 14.79X 8.50X
Name of Tool Formula What It Tells You
Debt Ratio total debt
total assets
The percentage of assets that is financed with debt. The higher (lower) the
debt ratio, the more (less) financial risk the firm is assuming.
Times interest earned
operating profits
interest expense
The number of times a firm is earning its interest expense. Indicates a
company’s ability to service its fixed interest payments. A higher (lower)
value means the firm is more (less) able to service its debt.
Financial Decision tools

Chapter 4 • Evaluating a Firm’s Financial Performance 119
stEP 3: analYzE YouR REsults
Disney uses significantly more debt financing than the average firm in the industry. The
higher debt ratio implies that the firm has greater financial risk. Even so, Disney appears
to have no difficulty servicing its debt, covering its interest almost 15 times compared to
only 8.5 times for the average firm in the industry. Disney’s higher times interest earned
is attributable to significantly higher operating profits on its assets, which more than
offsets the firm’s use of more debt.
Concept Check
1. What information is provided by the debt ratio?
2. Why is it important to calculate the times interest earned ratio, even for firms that have low debt
ratios?
3. Why do operating profits not give a complete picture of a firm’s ability to service its debt?
Question 4: Are the Firm’s Managers Providing a Good Return
on the Capital Provided by the Shareholders?
We now want to determine if the firm’s owners (shareholders) are receiving an attractive
return on their equity investment when compared to the return on equity at competing
firms. For this, we use the return on equity (frequently shortened to ROE), which is com-
puted as follows:
Return on equity =
net income
total common equity
(4–14)
For Home Depot:
Return on equity =
net income
total common equity
=
$3,338M
$18,889M
= 0.177 = 17.7%
Lowe’s return on equity 11.1%
In the computation above, remember that the total common equity includes all com-
mon equity in the balance sheet, including par value, paid-in capital, and retained earnings,
less any treasury stock. (After all, profits retained within the business are as much of an
investment for the common stockholders as are their purchases of a company’s stock.)
The returns on equity for Home Depot and Lowe’s are 17.7 percent and 11.1 percent,
respectively. Hence, the owners of Home Depot are receiving a higher return on their
equity investment than are the shareholders of Lowe’s. How are they doing it? To answer,
we need to draw on what we have already learned, namely, that:
1. We know from our analysis of Question 2 that Home Depot is receiving a higher oper-
ating return on its assets—14.5 percent for Home Depot, compared to 10.6 percent
for Lowe’s. A higher (lower) return on the firm’s assets will always result in a higher
(lower) return on equity.
2. Home Depot uses more debt (less equity) financing than Lowe’s—53 percent debt for
Home Depot and 46 percent debt for Lowe’s. As we will see shortly, the more debt a firm
uses, the higher its return on equity will be, provided that the firm is earning a return on
assets greater than the interest rate on its debt. Conversely, the less debt a firm uses, the
lower its return on equity will be (again, provided that the firm is earning a return on assets
greater than the interest rate on its debt). Thus, Home Depot has increased its return for
the shareholders by using more debt. That’s the good news. The bad news for Home
Depot’s shareholders is that the more debt a firm uses, the greater is the company’s finan-
cial risk, which translates into more risk for the shareholders.
To help us understand the foregoing explanation for Home Depot’s higher return on
equity and its implications, consider the following hypothetical example.
return on equity a firm’s net income divided
by its common book equity. This ratio is the
accounting rate of return earned on the common
stockholders’ investment.

120 Part 1 • The Scope and Environment of Financial Management
Assume that two companies, Firms A and B, are identical in size. Both have $1,000
in total assets and an operating return on assets of 14 percent. However, they are differ-
ent in one respect: Firm A uses all equity and no debt financing; Firm B finances 60 per-
cent of its investments with debt and 40 percent with equity. We will also assume the
interest rate on any debt is 6 percent, and for simplicity we will assume that there are
no income taxes. The financial statements for the two companies would be as follows:
Computing the return on equity for both companies, we see that Firm B has a more
attractive return of 26 percent compared with Firm A’s 14 percent. The calculations are as
follows:
Why the difference? The answer is straightforward. Firm B is earning 14 percent on all
of its $1,000 in assets but only having to pay 6 percent to the lenders on the $600 debt prin-
cipal. The difference between the 14 percent return on the firm’s assets (operating return
on assets) and the 6 percent interest rate goes to the owners, thus boosting Firm B’s return
on equity above that of Firm A.
This is an illustration of favorable financial leverage. What’s favorable, you might ask.
Well, the company is earning 14 percent on its assets while only paying 6 percent to the
bankers, thus allowing the shareholders to receive the 8 percent spread (14 percent return
on assets – 6 percent interest paid to the bankers) on each dollar of debt financing. The
result is an increase in the return on equity for Firm B’s owners when compared to Firm
A’s. What a great deal for Firm B’s shareholders! So if debt enhances owners’ returns, why
doesn’t Firm A borrow money or Firm B borrow even more money?
The good outcome for Firm B shareholders is based on the assumption that the firm
does in fact earn a 14 percent operating return on its assets. But what if the economy falls
into a deep recession, business declines sharply, and Firms A and B only earn a 2 percent
operating return on their assets? Let’s recompute the return on equity given the new
conditions:
F I R M A F I R M b
Operating profits (OROA = 2%) $ 20 $ 20
Less interest expense 0 (36)
Net income $ 20 ($ 16)
Return on equity:
net income
common equity

$ 20
$1,000
= 2%
($ 16)
$400
= (4%)
F I R M A F I R M b

Return on
common equity
=
net income
common equity
=
$140
$1,000
= 14%
$104
$400
= 26%
F I R M A F I R M b
b A L A N C E S H E E T
Total assets $1,000 $1,000
Debt (6% interest rate) $0 $ 600
Equity 1,000 400
Total debt and equity $1,000 $1,000
I N CO M E S TAT E M E N T
Operating profits (OROA = 14%) $ 140 $ 140
Interest expense (6%) (0) (36)
Net income $ 140 $ 104
$36 = 0.06 interest rate
* $600 debt principal
$140 = 0.14 OROA
* $1,000 total assets

Chapter 4 • Evaluating a Firm’s Financial Performance 121
Now the use of financial leverage has a negative influence on the return on equity,
with Firm B earning less than Firm A for its owners. This results from Firm B’s earn-
ing less than the interest rate of 6 percent; consequently, the shareholders have to
make up the difference. Thus, financial leverage is a two-edged sword: When times
are good, financial leverage can make them very, very good, but when times are bad,
financial leverage makes them very, very bad. Financial leverage can enhance the returns
of the shareholders, but it also increases the possibility of losses, thereby increasing
the uncertainty, or risk, for the owners. Chapter 12 will address financial leverage in
greater detail.
Returning to Home Depot, Figure 4-4 provides a summary of our discussion of the
return on equity and helps us visualize the two fundamental factors affecting a firm’s return
on equity:
1. There is a direct relationship between a firm’s operating return on assets (OROA) and
the resulting return on equity (ROE). As we have explained, the higher the operat-
ing return on assets (OROA), the higher will be the return on equity (ROE). Even
more precisely, the greater the difference between the firm’s operating return on assets
(OROA) and the interest rate (i) being paid on the firm’s debt, the higher the return on
equity will be. So increasing the operating return on assets relative to the interest rate
(OROA-i) increases the return on equity (ROE). But if OROA-i decreases, then ROE
will decrease as well.
2. Increasing the amount of debt financing relative to the amount of equity
(increasing the debt ratio) increases the return on equity if the operating return
on assets is higher than the interest rate being paid. If the operating return on
assets falls below the interest rate, more debt financing will decrease the return on
equity.
In short, the return on equity is driven by (1) the difference between the operating return
on assets and the interest rate (OROA-i) and (2) how much debt is used, as measured by
the debt ratio.
To recap, remember that the return on equity is the financial analysis tool that we use
to measure the return on the owners’ equity, which is shown as follows:
FIGuRE 4-4 Return on Equity Relationships for Home Depot, Inc.
Return on
equity (ROE)
17.7%
Use of debt
financing
53%
Operating
return on
assets (OROA)
14.5%
less
Interest rate
(i)
not known
Operations management
Operating profit margin 8.5%
Total asset
turnover 1.69X

122 Part 1 • The Scope and Environment of Financial Management
e x a m p l e 4.4 evaluating Disney’s Return on equity
The net income and also the common equity invested by Disney’s shareholders
(expressed in $ millions) are provided here, along with the average return on equity for
the industry. Evaluate the rate of return being earned on the common stockholders’
equity investment. In addition to comparing the Disney Corporation’s return on equity
to the industry, consider the implications Disney’s operating return on assets and its debt
financing practices have on the firm’s return on equity.
Net income $4,807
Total common equity
Common stock (par value) 27
Paid-in capital 30,269
Retained earnings 35,745
Treasury stock (26,588)
Industry average return on equity 8.31%
Step 1: Formulate a DeciSion Strategy
To evaluate return on equity, recall equation 4-14:
Return on equity =
net income
total common equity
Step 2: crunch the numberS
First, we determine Disney’s total common equity to be $39.453 billion by adding all the
individual equity items shown above. Then, dividing net income of $4.807 billion by the
total common equity, we find Disney’s return on equity to be 12.2 percent (12.2% =
$4.807 billion net income , $39.453 billion total common equity), compared to 8.31
percent for the industry average.
Step 3: analyze your reSultS
Disney’s higher return on equity is a result of the firm’s having a higher operating return
on assets and using more debt financing than the average firm in the industry.
Concept Check
1. How is a company’s return on equity related to the firm’s operating return on assets?
2. How is a company’s return on equity related to the firm’s debt ratio?
3. What is the upside of debt financing? What is the downside?
Question 5: are the Firm’s managers Creating Shareholder Value?
To this point, we have relied exclusively on accounting data to assess the performance of a
firm’s managers. We now want to look at management’s performance in terms of creating
or destroying shareholder value. To answer this question, we use two approaches: (1) we
examine market-value ratios and (2) we estimate the value being created for shareholders,
as measured by a popular technique called Economic Value Added (EVA™).
Name of Tool Formula What It Tells You
Return on equity net income
total common equity
The shareholders’ accounting return on their investment, which is the
result of how well management does at generating a good operating
return on assets and how the firm is financed.
Financial Decision Tools

Chapter 4 • Evaluating a Firm’s Financial Performance 123
price/earnings ratio the price the market
places on $1 of a firm’s earnings. For example,
if a firm has an earnings per share of $2, and a
stock price of $30 per share, its price/earnings
ratio is 15. ($30 , $2).
Market-Value Ratios There are two ratios commonly used to compare a firm’s stock
price to its earnings and to accounting book value of its equity. These two ratios indicate
what investors think of management’s past performance and future prospects.
Price/Earnings Ratio The price/earnings (P/E) ratio indicates how much investors
are willing to pay for $1 of reported earnings. Returning to Home Depot, the firm had
net income in the fiscal year of 2010 of $3.338 billion and 1.623 billion shares of com-
mon stock outstanding. (See Table 4-1.) Accordingly, its earnings per share were $2.06
($2.06 = $3,338 million net income , 1,623 million shares). At the time, the firm’s
stock was selling for $36.77 per share. Thus, the price/earnings ratio was 17.85 times,
calculated as follows:
Price/earnings ratio =
market price per share
earnings per share
(4-15)
For Home Depot:
Price/earnings ratio =
market price per share
earnings per share
=
$36.77
$2.06
= 17.85X
Lowe’s price/earnings ratio 16.90X
Home Depot’s price/earnings ratio tells us that the investors were willing to pay $17.85
for every dollar of earnings per share that Home Depot produced, compared to only $16.90
for $1 of earnings from Lowe’s. Thus, investors were willing to pay somewhat more for
Home Depot’s earnings than they were for Lowe’s. Why might that be? The price/earn-
ings ratio will be higher for companies that investors think have strong earnings growth
prospects and/or less risk. Thus, investors must perceive Home Depot to have more growth
potential and/or smaller risk than Lowe’s.
Price/Book Ratio A second frequently used indicator of investors’ assessment of the firm
is its price/book ratio. This ratio compares the market value of a share of stock to its book
value per share. Book value per share comes from of the firm’s total common equity in its
balance sheet. We already know that the market price of Home Depot’s common stock was
$36.77. To determine the equity book value per share, we divide the firm’s equity book
value (total common equity) by the number of shares of stock outstanding. From Home
Depot’s balance sheet (Table 4-2), we see that the equity book value was $18.889 billion.
Given that Home Depot had 1.623 billion shares outstanding, the equity book value per
share is $11.64 ($11.64 = $18.889 billion book equity value , 1.623 billion shares. With
this information, we determine the price/book ratio to be:
Price/book ratio =
market price per share
equity book value per share
(4-16)
For Home Depot:
Price/book ratio =
market price per share
equity book value per share
=
$36.77
$11.64
= 3.16X
Lowe’s price/book ratio 1.95X
Given that the book value per share is an accounting number that reflects historical costs,
we can think of it roughly as the amount shareholders have invested in the business over its
lifetime. Thus, a ratio greater than 1 indicates that investors believe the firm is more valuable
than the amount shareholders have invested in it. Conversely, a ratio less than 1 suggests that
investors do not believe the stock is worth the amount shareholders have invested in it. Clearly,
investors believed that Home Depot’s stock was worth more than was originally invested in the
company, since they were willing to pay $3.16 per share for each dollar of equity book value
(total common equity). In comparison, Lowe’s stock was selling for only $1.95 for every $1 in
book equity. Again, the investors were signaling that they believed that Home Depot had more
growth prospects relative to its risk.
price/book ratio the market value of a share
of the firm’s stock divided by the book value per
share of the firm’s reported equity in the balance
sheet. Indicates the market price placed on $1 of
capital that was invested by shareholders.

124 Part 1 • The Scope and Environment of Financial Management
Economic Value Added (EVA™) The price/book ratio, as just described, indicates whether the
shareholders think the firm’s equity is worth more or less than the amount of capital they origi-
nally invested. If the firm’s market value is above the accounting book value (price/book 7 1),
then management has created value for shareholders, but if the firm’s market value is below
book value (price/book 6 1), then management has destroyed shareholder value.
How is shareholder value created or destroyed? Quite simply, shareholder value is cre-
ated when a firm earns a rate of return on the capital invested that is greater than the inves-
tors’ required rate of return. If we invest in a firm and have a 12 percent required rate of
return, and the firm earns 15 percent on our capital, then the firm’s managers have created
value for investors. If instead the firm earns only 10 percent, then value has been destroyed.
This concept is regularly applied by firms when they decide whether or not to make large
capital investments in plant and equipment; however, it has not been generally applied to
the analysis of a firm’s day-to-day operations. Instead, managers have traditionally focused
on accounting results, such as earnings growth, profit margins, and the return on equity.
In recent years, however, investors have been demanding that managers show evidence
that they are creating shareholder value. Although several techniques have been developed
for making this assessment, the one that has received the most attention is Economic Value
Added (EVA™).
E x A M P L E 4.5 Computing Disney’s price/earnings ratio and price/book ratio
Consider the following about Disney:
1. At the time of our analysis, Disney’s stock was selling for $33.
2. The firm’s net income was $3.963 billion, and its total common equity in the
balance sheet (book equity) was $37.519 billion.
3. There were 1.915 billion shares outstanding.
Given the information above, calculate the firm’s earnings per share and its book value
per share. Calculate the price/earnings ratio and the price/book ratio. The average firm
in the industry sold for 11 times earnings and 1.6 times book value. What do the share-
holders think about Disney’s performance and future growth prospects relative to its
competitors?
stEP 1: FoRmulatE a DEcision stRatEgY
Calculating the price/earnings ratio and the price-to-book ratio for Disney shows how
much investors are willing to pay for 1 dollar of Disney’s earnings and how much value
has been created on a dollar of equity capital invested (book value of equity). The equa-
tions to be used are as follows:
Price/earnings ratio =
market price per share
earnings per share
Price/book ratio =
market price per share
equity book value per share
stEP 2: cRuncH tHE numbERs
We compute Disney’s price/earnings ratio and price/book ratio as follows:
Earnings per share =
net income
number of shares
=
$3,963M
1,915M shares
= $2.07
Equity book value per share =
total common equity
number of shares
=
$37,519 million
1,915 million shares
= $19.59

Chapter 4 • Evaluating a Firm’s Financial Performance 125
Price/earnings ratio =
market price per share
earning per share
=
$33
$2.07
= 15.94X
Price/book ratio =
market price per share
equity book value per share
=
$33.00
$19.59
= 1.68
stEP 3: analYzE YouR REsults
Disney’s stock is selling for 15.94 times its earnings and 1.68 times its book value. At the same
time, the average firm in the industry was selling for 11 times its earnings and 1.6 times its
book value. Thus, investors see Disney as having greater growth prospects and/or less risk.
Economic Value Added is a financial performance measure developed by the invest-
ment consulting firm Stern Stewart & Co. EVA attempts to measure a firm’s economic
profit, rather than accounting profit, in a given year. Economic profits assign a cost to the
equity capital (the opportunity cost of the funds provided by the shareholders) in addition
to the interest cost on the firm’s debt—even though accountants recognize only the interest
expense as a financing cost when calculating a firm’s net income.
For example, assume a firm has total assets of $1,000; 40 percent ($400) is financed with
debt, and 60 percent ($600) is financed with equity. If the interest rate on the debt is 5 per-
cent, the firm’s interest expense is $20 ($20 = $400 * 0.05), which would be reported on
the firm’s income statement. However, there would be no cost shown on the income state-
ment for the equity financing. To estimate economic profits, we include not only the $20 in
interest expense but also the opportunity cost of the $600 equity capital invested in the firm.
For example, if the shareholders could earn 15 percent on another investment of similar
risk (their opportunity cost is 15 percent), then we should count that cost just as we do the
interest expense. This would involve subtracting not only the $20 in interest but also $90
($90 = $600 equity * 0.15) as the cost of equity. Thus, the firm has earned an economic
profit only if its operating profit exceeds $110 ($20 interest cost + $90 opportunity cost of
equity). Stated as a percentage, the firm must earn at least an 11 percent operating return on
its assets (11% = $110 , $1,000) in order to meet the investors’ required rate of return.
We can calculate Economic Value Added (EVA)—the value created for the sharehold-
ers for a given year—as follows:
EVA = aoperating return
on assets
–
cost of
capital
b * total assets (4-17)
where the cost of capital is the cost of the entire firm’s capital, both debt and equity. That
is, the value created by management is determined by (1) the amount a firm earns on its
invested capital relative to the investors’ required rate of return and (2) the total amount of
capital invested in the firm (total assets).9
economic value added measures a
company’s economic profits, as compared to its
accounting profits, by including not only interest
expense as a cost but also the shareholders’
required rate of return on their investment.
9In Chapter 9, we will explain how the firm’s cost of capital is calculated.
Continuing with our previous example, assume that our company is earning a
16 percent operating return on its assets (total invested capital). Then the firm’s Economic
Value Added is $50, calculated as follows:
EVA = aoperating return
on assets
–
cost of
capital
b * total assets
= (0.16 – 0.11) * $1000 = $50
Let’s see what we find when we estimate Home Depot’s Economic Value Added. We
know from our previous calculations that in fiscal year ending January 30, 2011, Home
Depot had an operating return on assets of 14.5 percent. In other words, the firm was earn-
ing operating profits of 14.5 percent on every dollar invested in assets, and it had invested
a total of $40.125 billion in assets. If we assume that the firm’s cost of capital (the required

126 Part 1 • The Scope and Environment of Financial Management
rate of all the investors) was 10 percent, then we can calculate the Economic Value Added
for Home Depot as follows:
EVA = aoperating return
on assets
–
cost of
capital
b * total assets
= (0.145 – 0.10) * $40.125 billion = $1.806 billion
The foregoing explains the EVA concept in its simplest form. However, computing
EVA requires converting a firm’s financial statements from an accountant’s perspective
(GAAP) to an economic book value. This process is much more involved than we will go
into here, but the basic premise involved in its computation is the same.
A summary of the ratios to be used to determine whether managers are creating share-
holder value is as follows:
Financial Decision tools
Name of Tool Formula What It Tells You
Price/earnings ratio
market price per share
earnings per share
The price that the market places on $1 of a firm’s earn-
ings. The higher (lower) the ratio, the more (less) value
investors assign to the firm’s earnings.
Price/book ratio
market price per share
equity book value per share
The price that the market places on $1 of the sharehold-
ers’ investment in the business, measured by the equity
book value per share. The higher (lower) the number, the
greater (lesser) the market value investors assign to each
dollar invested in the company.
Economic value added aoperating return
on assets
–
cost of
capital
b * total assets
A measure of a company’s economic profits (as
compared to its accounting profits), which includes not
only interest expense as a cost but also the shareholders’
required rate of return on their investment. A positive
number says managers created shareholder value, while
a negative number indicates that shareholder value
was destroyed.
To conclude, a summary of all the ratios we used to analyze the financial performance of
Home Depot is provided in Table 4-3.
E x A M P L E 4.6 Calculating Disney’s Economic Value Added
Earlier in the chapter, we determined that Disney’s operating return on assets (OROA)
was 10.79 percent. If Disney’s cost of capital (the cost of both its debt and equity capital)
was 9 percent at that time, what was the Economic Value Added (EVA) for the firm
when its total assets were approximately $72.124 billion?
stEP 1: FoRmulatE a DEcision stRatEgY
Economic Value Added includes the opportunity cost of the equity in the total cost of
capital, to measure a firm’s economic profit.
stEP 2: cRuncH tHE numbERs
Disney’s Economic Value Added is calculated as follows:
EVA = aoperating return
on assets
–
cost of
capital
b * total assets
= (0.1079 – 0.09) * $72.124 billion = $1.29 billion

Chapter 4 • Evaluating a Firm’s Financial Performance 127
stEP 3: analYzE YouR REsults
Disney created approximately $1.29 billion in shareholder value by earning a rate of
return on the firm’s assets, 10.79 percent, that was higher than the investors’ required
rate of return of 9 percent.
TAbLE 4.3 Home Depot, Inc. Financial Ratio Analysis
F I N A N C I A L R AT I O S H O M E D E P OT LO W E ’S
1. F I R M L I Q u I D I T Y
Current ratio =
current assets
current liabilities
$13,479M
$10,122M
= 1.33 1.40

Acid test
ratio
=
cash + accounts receivable
current liabilities
$545M + $1,085M
$10,122M
= 0.16 0.12

Days in
receivables
=
accounts receivable
daily credit sales
$1,085M
$20,399M , 365
= 19.41 days 16 days

Accounts
receivable
turnover
=
annual credit sales
accounts receivable
$20,399M
$1,085M
= 18.80X 22.81X

Days in
inventory
=
inventory
daily cost of goods sold
$10,625M
$44,693M , 365
= 86.77 days
95.8 days

Inventory
turnover
=
cost of goods sold
inventory
$44,693M
$10,625M
= 4.21X
3.81X
2. O P E R AT I N G P R O F I TA b I L I T Y

Operating
return
on assets
=
operating profits
total assets
$5,803M
$40,125M
= 14.5, 10.6%

Operating
profit margin
=
operating profits
sales
$5,803M
$67,997M
= 8.50, 7.3%
Total asset
turnover
=
sales
total assets
$67,997M
$40,125M
= 1.69X
1.45X

Accounts
receivable
turnover
=
annual credit sales
accounts receivable
$20,399M
$1,085M
= 18.80X
22.81X

Inventory
turnover
=
cost of goods sold
inventory
$44,693M
$10,625M
= 4.21X
3.81X
Fixed asset
turnover
=
sales
net fixed assets
$67,997M
$25,060M
= 2.71X
2.21X
3. F I N A N C I N G D E C I S I O N S
Debt ratio =
total debt
total assets
$21,236M
$40,125M
= 53, 46%
Times interest
earned
=
operating profits
interest
$5,803M
$530M
= 10.9X
9.0X
4. R E T u R N O N E Q u I T Y
Return on
equity
=
net income
total common equity
$3,338M
$18,889M
= 17.7,
11.10%
(Continued)

128 Part 1 • The Scope and Environment of Financial Management
Concept Check
1. What determines whether a firm is creating or destroying shareholder value?
2. What measures can we use to determine whether a firm is creating shareholder value?
3. What is indicated by a price/book ratio that is greater than 1? Less than 1?
4. How does the information provided by a firm’s price/book ratio differ from that provided by its
price/earnings ratio?
5. How do the profits shown in an income statement differ from economic profits?
6. What is Economic Value Added? What does it tell you?
The Limitations of Financial Ratio Analysis
We conclude this chapter by offering several caveats about using financial ratios. We have
described how financial ratios can be used to understand a company’s financial position.
That said, anyone who works with these ratios needs to be aware of the limitations related
to their use. The following list includes some of the more important pitfalls you will en-
counter as you compute and interpret financial ratios:
1. It is sometimes difficult to determine the industry to which a firm belongs when the
firm engages in multiple lines of business. In this case, you must select your own set of
peer firms and construct your own norms.
2. Published peer group or industry averages are only approximations. They provide
the user with general guidelines, rather than scientifically determined averages of the
ratios for all—or even a representative sample—of the firms within an industry.
3. An industry average is not necessarily a desirable target ratio or norm. There is nothing
magical about an industry norm. At best, an industry average indicates the financial posi-
tion of the average firm within the industry. It does not mean that value is the ideal or
best value for the ratio. For various reasons, a well-managed company might be above
the average, whereas another equally good firm might choose to be below the average.
4. Accounting practices differ widely among firms. For example, different firms choose
different methods to depreciate their fixed assets. Differences such as these can make
the computed ratios of different firms difficult to compare.
5. Financial ratios can be too high or too low. For example, a current ratio that exceeds
the industry norm might signal the presence of excess liquidity, resulting in lower prof-
its relative to the firm’s investment in assets. On the other hand, a current ratio that
falls below the norm might indicate that (1) the firm has inadequate liquidity and may
at some future date be unable to pay its bills on time, or (2) the firm is managing its
accounts receivable and inventories more efficiently than other, similar firms.
6. Many firms experience seasonal changes in their operations. As a result, their balance sheet
entries and their corresponding ratios will vary with the time of year the statements are
prepared. To avoid this problem, an average account balance should be used (one calculated
3 Describe the limitations of
financial ratio analysis.
TAbLE 4.3 Home Depot, Inc. Financial Ratio Analysis (Continued)
F I N A N C I A L R AT I O S H O M E D E P OT LO W E ’S
5. C R E AT I N G S H A R E H O L D E R VA Lu E
Price earrnings
ratio
=
market price per share
earnings per share
$36.77
$2.06
= 17.85X 16.90X

Price
book ratio
=
market price per share
equity book value per share
$36.77
$11.64
= 3.16X 1.95X
EVA = aoperating return
on assets
–
cost of
capital
b * total
assets
(0.145 – 0.10) * $40.125 billion
= $1.806 billion
Not
computed

Chapter 4 • Evaluating a Firm’s Financial Performance 129
on the basis of several months or quarters during the year) rather than the year-end account
balance. For example, an average of the firm’s month-end inventory balance might be used
to compute its inventory turnover ratio versus a year-end inventory balance.
In spite of their limitations, financial ratios are very useful tools for assessing a firm’s
financial condition. We should, however, be aware of their potential weaknesses. In many
cases, the “real” value derived from the ratios is that they tell us what additional questions
we need to ask about the firm.
Concept Check
1. When comparing a firm to its peers, why is it difficult to determine the industry to which the
firm belongs?
2. Why do differences in the accounting practices of firms limit the usefulness of financial ratios?
3. Why should you be careful when comparing a firm with industry norms?
Chapter Summaries
Explain the purpose and importance of financial analysis. (pgs. 102–106)
SuMMARY: A variety of groups find financial ratios useful. For instance, both managers and share-
holders use them to measure and track a company’s performance over time. Financial analysts outside
of the firm who have an interest in its economic well-being also use financial ratios. An example of this
group would be a loan officer of a commercial bank who wishes to determine the creditworthiness
of a loan applicant and its ability to pay the interest and principal associated with the loan request.
KEY TERMS
1
Financial ratios, page 103 accounting data
restated in relative terms in order to help
people identify some of the financial strengths
and weaknesses of a company.
Calculate and use a comprehensive set of measurements to evaluate a
company’s performance. (pgs 106–128)
SuMMARY: Financial ratios are the principal tool of financial analysis. Sometimes referred to sim-
ply as benchmarks, ratios standardize the financial information of firms so that comparisons can be
made between firms of varying sizes.
Financial ratios can be used to answer at least five questions: (1) How liquid is the company? (2)
Are the company’s managers effectively generating profits on the firm’s assets? (3) How is the firm
financed? (4) Are the firm’s managers providing a good return on the capital provided by the share-
holders? (5) Are the firm’s managers creating or destroying shareholder value?
Two methods can be used to analyze a firm’s financial ratios. (1) We can examine the firm’s ratios
across time (say, for the past 5 years) to compare its current and past performance, and (2) we can
compare the firm’s ratios with those of other firms. In our example, Lowe’s was chosen as a com-
parison firm for analyzing the financial position of Home Depot.
Financial ratios provide a popular way to evaluate a firm’s financial performance. However, when
evaluating a company’s use of its assets (capital) to create firm value, a financial ratio analysis based
entirely on the firm’s financial statements may not be enough. If we want to understand how the
market assesses the performance of a company’s managers, we can use the market price of the firm’s
stock relative to its accounting earnings and equity book value.
Economic Value Added (EVA™) provides another approach for evaluating a firm’s performance
in terms of shareholder value creation. EVA is equal to the difference between the return on a
company’s invested capital and the investors’ opportunity cost of the funds times the total amount
of the capital invested.
2

130 Part 1 • The Scope and Environment of Financial Management
KEY EQuATIONS
Current ratio =
current assets
current liabilities

Acid-test ratio =
cash + accounts receivable
current liabilities

Days in receivable =
accounts receivable
daily credit sales
=
accounts receivable
annual credit sales , 365

KEY TERMS
Liquidity, page 107 a firm’s ability to pay its
bills on time. Liquidity is related to the ease
and speed with which a firm can convert its
noncash assets into cash, as well as to the size
of the firm’s investment in noncash assets
relative to its short-term liabilities.
Current ratio, page 107 a firm’s current assets
divided by its current liabilities. This ratio
indicates the firm’s degree of liquidity by compar-
ing its current assets to its current liabilities.
Acid-test (quick) ratio, page 108 the sum of
a firm’s cash and accounts receivable divided
by its current liabilities. This ratio is a more
stringent measure of liquidity than the current
ratio because it excludes inventories and other
current assets (those that are least liquid) from
the numerator.
Days in receivables (average collection
period), page 108 a firm’s accounts receivable
divided by the company’s average daily credit
sales (annual credit sales ÷ 365). This ratio
expresses how many days on average it takes to
collect receivables.
Accounts receivable turnover ratio, page 109
a firm’s credit sales divided by its accounts
receivable. This ratio expresses how often ac-
counts receivable are “rolled over” during a year.
Days in inventory, page 109 inventory
divided by daily cost of goods sold. This ratio
measures the number of days a firm’s invento-
ries are held on average before being sold; it
also indicates the quality of the inventory.
Inventory turnover, page 110 a firm’s cost of
goods sold divided by its inventory. This ratio
measures the number of times a firm’s invento-
ries are sold and replaced during the year (that
is, the relative liquidity of the inventories).
Operating return on assets (OROA),
page 112 the ratio of a firm’s operating profits
divided by its total assets. This ratio indicates the
rate of return being earned on the firm’s assets.
Operations management, page 112 how
effectively management is performing in
the day-to-day operations in terms of how
well management is generating revenues and
controlling costs and expenses; in other words,
how well is the firm managing the activities
that directly affect the income statement?
Asset management, page 113 how efficiently
management is using the firm’s asset’s to gener-
ate sales.
Operating profit margin, page 113 a firm’s
operating profits divided by sales. This ratio
serves as an overall measure of operating
effectiveness.
Total asset turnover, page 113 a firm’s sales
divided by its total assets. This ratio is an
overall measure of asset efficiency based on
the relation between a firm’s sales and the total
assets.
Fixed asset turnover, page 114 a firm’s
sales divided by its net fixed assets. This ratio
indicates how efficiently the firm is using its
fixed assets.
Debt ratio, page 117 a firm’s total liabilities
divided by its total assets. This ratio measures
the extent to which a firm has been financed
with debt.
Times interest earned, page 117 a firm’s
operating profits divided by interest expense.
This ratio measures a firm’s ability to meet its
interest payments from its annual operating
earnings.
Return on equity, page 119 a firm’s net income
divided by its total common book equity. This
ratio is the accounting rate of return earned on
the common stockholders’ investment.
Price/earnings ratio, page 123 the price the
market places on $1 of a firm’s earnings. For
example, if a firm has an earnings per share of
$2, and a stock price of $30 per share, its price/
earnings ratio is 15. ($30 , $2).
Price/book ratio, page 123 the market value
of a share of the firm’s stock divided by the
book value per share of the firm’s reported eq-
uity in the balance sheet. Indicates the market
price placed on $1 of capital that was invested
by shareholders.
Economic value added, page 125 measures
a company’s economic profits, as compared
to its accounting profits, by including not
only interest expense as a cost but also the
shareholders’ required rate of return on their
investment.

Chapter 4 • Evaluating a Firm’s Financial Performance 131
Accounts receivable turnover =
annual credit sales
accounts receivable

Days in inventory =
inventory
daily cost of goods sold
=
inventory
annual cost of goods sold , 365

Inventory turnover =
cost of goods sold
inventory

Operating return on assets =
operating profits
total assets

Operation return on assets = operating profit margin * total asset turnover
Operation return on assets =
operating profits
sales
*
sales
total assets

Operating profit margin =
operating profits
sales

Total asset turnover =
sales
total assets

Fixed asset turnover =
sales
net fixed assets

Debt ratio =
total debt
total assets

Times interest earned =
operating profits
interest expense

Return on equity =
net income
total common equity

Price/earnings ratio =
market price per share
earnings per share

Price/book ratio =
market price per share
equity book value per share

EVA = aoperating return
on assets
–
cost of
capital
b * total assets
Describe the limitations of financial ratio analysis. (pgs. 128–129)
SuMMARY: The following are some of the limitations that you will encounter as you compute and
interpret financial ratios:
1. It is sometimes difficult to determine an appropriate industry within which to place the
firm.
2. Published industry averages are only approximations, not scientifically determined averages.
3. Accounting practices differ widely among firms and can lead to differences in computed
ratios.
4. An industry average may not be a desirable target ratio or norm.
5. Many firms experience seasonal business conditions. As a result, the ratios calculated for them
will vary with the time of year the statements are prepared.
In spite of their limitations, financial ratios provide us with a very useful tool for assessing a firm’s
financial condition.
3

132 Part 1 • The Scope and Environment of Financial Management
Review Questions
All Review Questions are available in MyFinanceLab.
4-1. Describe the “five-question approach” to using financial ratios.
4-2. Discuss briefly the two perspectives that can be taken when performing a ratio analysis.
4-3. Where can we obtain industry norms?
4-4. What are the limitations of industry average ratios? Discuss briefly.
4-5. What is liquidity, and what is the rationale for its measurement?
4-6. Distinguish between a firm’s operating return on assets and operating profit margin.
4-7. Why is a firm’s operating return on assets a function of its operating profit margin and total
asset turnover?
4-8. What is the difference between a firm’s gross profit margin, operating profit margin, and net
profit margin?
4-9. What information do the price/earnings ratio and the price/book ratio give us about the firm
and its investors?
4-10. Explain what determines a company’s return on equity.
4-11. What is Economic Value Added? Why is it used?
4-12. Go to the Web site for IBM at www.ibm.com/investor. Click “Investor tools” and then
“Investment guides” for a guide to reading financial statements. How does the guide differ from
the presentation in Chapter 3 and this chapter?
Study Problems
All Study Problems are available in MyFinanceLab.
4-1. (Evaluating liquidity) Brashear Inc. currently has $2,145,000 in current assets and $858,000 in
current liabilities. The company’s managers want to increase the firm’s inventory, which will be
financed by a short-term note with the bank. What level of inventories can the firm carry without
its current ratio falling below 2.0?
4-2. (Evaluating profitability) The Allen Corporation had sales in 2013 of $65 million, total as-
sets of $42 million, and total liabilities of $20 million. The interest rate on the company’s debt is
6 percent and its tax rate is 30 percent. The operating profit margin was 12 percent. What were the
company’s operating profits and net income? What was the operating return on assets and return
on equity? Assume that interest must be paid on all of the debt.
4-3. (Evaluating profitability) Last year, Davies Inc. had sales of $400,000 with a cost of goods sold
of $112,000. The firm’s operating expenses were $130,000, and its increase in retained earnings
was $58,000. There are currently 22,000 common stock shares outstanding and the firm pays a
$1.60 dividend per share.
a. Assuming the firm’s earnings are taxed at 34 percent, construct the firm’s income statement.
b. Compute the firm’s operating profit margin.
c. What was the times interest earned?
4-4. (Price book) Greene Inc.’s balance sheet shows a stockholders’ equity book value (total com-
mon equity) of $750,500. The firm’s earnings per share were $3, resulting in a price/earnings ratio
of 12.25X. There are 50,000 shares of common stock outstanding. What is the price/book ratio?
What does this indicate about how shareholders view Greene Inc.?
4-5. (Evaluating liquidity) The Mitchem Marble Company has a target current ratio of 2.0 but has
experienced some difficulties financing its expanding sales in the past few months. At present, the
firm has current assets of $2.5 million and a current ratio of 2.5. If Mitchem expands its receivables
and inventories using its short-term line of credit, how much additional short-term funding can it
borrow before its current ratio standard is reached?
2

www.ibm.com/investor

Chapter 4 • Evaluating a Firm’s Financial Performance 133
Calculate the following ratios:
Current ratio Operating return on assets
Times interest earned Debt ratio
Inventory turnover Average collection period
Total asset turnover Fixed-asset turnover
Operating profit margin Return on equity
4-7. (Analyzing operating return on assets) The R. M. Smithers Corporation earned an operating
profit margin of 10 percent based on sales of $10 million and total assets of $5 million last year.
a. What was Smithers’ total asset turnover ratio?
b. During the coming year the company president has set a goal of attaining a total asset turn-
over of 3.5. How much must firm sales rise, other things being the same, for the goal to be
achieved? (State your answer in both dollars and percentage increase in sales.)
c. What was Smithers’ operating return on assets last year? Assuming the firm’s operating
profit margin remains the same, what will the operating return on assets be next year if the
total asset turnover goal is achieved?
4-8. (Evaluating liquidity) The Brenmar Sales Company had a gross profit margin (gross profits ÷
sales) of 30 percent and sales of $9 million last year. Seventy-five percent of the firm’s sales are on
credit and the remainder are cash sales. Brenmar’s current assets equal $1.5 million, its current li-
abilities equal $300,000, and it has $100,000 in cash plus marketable securities.
a. If Brenmar’s accounts receivable are $562,500, what is its average collection period?
b. If Brenmar reduces its days in receivable (average collection period) to 20 days, what will
be its new level of accounts receivable?
c. Brenmar’s inventory turnover ratio is 9 times. What is the level of Brenmar’s inventories?
b A L A N C E S H E E T ( $000 )
Cash $ 500
Accounts receivable 2,000
Inventories 1,000
Current assets $3,500
Net fixed assets 4,500
Total assets $8,000
Accounts payable $1,100
Accrued expenses 600
Short-term notes payable 300
Current liabilities $2,000
Long-term debt 2,000
Owners’ equity 4,000
Total liabilities and owners’ equity $8,000
I N CO M E S TAT E M E N T ( $000 )
Sales (all credit) $8,000
Cost of goods sold (3,300)
Gross profit 4,700
Operating expenses (includes $500 depreciation) (3,000)
Operating profits $1,700
Interest expense (367)
Earnings before taxes $1,333
Income taxes (40%) (533)
Net income $ 800
4-6. (Ratio analysis) The balance sheet and income statement for the J. P. Robard Mfg. Company
are as follows:

134 Part 1 • The Scope and Environment of Financial Management
4-9. (Ratio analysis) The financial statements and industry norms are shown below for Pamplin, Inc.:
a. Compute the financial ratios for Pamplin to compare both for 2012 and 2013 against the
industry norms.
b. How liquid is the firm?
c. Are its managers generating an adequate operating profit on the firm’s assets?
d. How is the firm financing its assets?
e. Are its managers generating a good return on equity?
Pamplin Inc. balance Sheet at 12/31/2012 and 12/31/2013
A S S E T S 2012 2013
Cash $ 200 $ 150
Accounts receivable 450 425
Inventory 550 625
Current assets $1,200 $1,200
Plant and equipment $2,200 $ 2,600
Less accumulated depreciation (1,000) (1,200)
Net plant and equipment $1,200 $1,400
Total assets $2,400 $2,600
L I A b I L I T I E S A N D O W N E R S’ E Q u I T Y
Accounts payable $ 200 $ 150
Notes payable—current (9%) 0 150
Current liabilities $ 200 $ 300
Bonds (8.33% interest) 600 600
Total debt $ 800 $ 900
Owners’ equity Common stock $ 300 $ 300
Paid-in capital 600 600
Retained earnings 700 800
Total owners’ equity $1,600 $1,700
Total liabilities and owners’ equity $2,400 $2,600
I N D u S T RY N O R M
Current ratio 5.00
Acid-test (quick) ratio 3.00
Inventory turnover 2.20
Average collection period 90.00
Debt ratio 0.33
Times interest earned 7.00
Total asset turnover 0.75
Fixed-asset turnover 1.00
Operating profit margin 20%
Return on common equity 9%

Chapter 4 • Evaluating a Firm’s Financial Performance 135
Pamplin Inc. Income Statement for Years Ending 12/31/2012 and 12/31/2013
2012 2013
Sales* $1,200 $1,450
Cost of goods sold 700 850
Gross profit $ 500 $ 600
Operating expenses 30 40
Depreciation 220 250 200 240
Operating profits $ 250 $ 360
Interest expense 50 64
Net income before taxes $ 200 $ 296
Taxes (40%) 80 118
Net income $ 120 $ 178
* 15% of sales are cash sales, with the remaining 85% being credit sales.
Current assets $ 500,000 Liabilities $1,000,000
Net fixed assets 1,500,000 Owners’ equity 1,000,000
$2,000,000 $2,000,000
Sales $4,500,000
Less cost of goods sold (3,500,000)
Gross profit $1,000,000
Less operating expenses (500,000)
Operating profits $ 500,000
Less interest expense (100,000)
Earnings before taxes $ 400,000
Less taxes (50%) (200,000)
Net income $ 200,000
4-10. (Evaluating current and proforma profitability) (Financial ratios—investment analysis) The an-
nual sales for Salco Inc. were $4.5 million last year. All sales are on credit. The firm’s end-of-year
balance sheet was as follows:
The firm’s income statement for the year was as follows:
a. Calculate Salco’s total asset turnover, operating profit margin, and operating return on
assets.
b. Salco plans to renovate one of its plants, which will require an added investment in plant
and equipment of $1 million. The firm will maintain its present debt ratio of 0.5 when
financing the new investment and expects sales to remain constant. The operating profit
margin will rise to 13 percent. What will be the new operating return on assets for Salco
after the plant’s renovation?
c. Given that the plant renovation in part (b) occurs and Salco’s interest expense rises by
$50,000 per year, what will be the return earned on the common stockholders’ investment?
Compare this rate of return with that earned before the renovation.
4-11. (Financial analysis) The T. P. Jarmon Company manufactures and sells a line of exclusive
sportswear. The firm’s sales were $600,000 for the year just ended, and its total assets exceeded
$400,000. The company was started by Mr. Jarmon just 10 years ago and has been profitable every
year since its inception. The chief financial officer for the firm, Brent Vehlim, has decided to seek
a line of credit totaling $80,000 from the firm’s bank. In the past, the company has relied on its
suppliers to finance a large part of its needs for inventory. However, in recent months tight money
conditions have led the firm’s suppliers to offer sizable cash discounts to speed up payments for
purchases. Mr. Vehlim wants to use the line of credit to replace a large portion of the firm’s pay-
ables during the summer, which is the firm’s peak seasonal sales period.
The firm’s two most recent balance sheets were presented to the bank in support of its loan
request. In addition, the firm’s income statement for the year just ended was provided. These state-
ments are found in the following tables:

136 Part 1 • The Scope and Environment of Financial Management
R AT I O N O R M
Current ratio 1.8
Acid-test ratio 0.9
Debt ratio 0.5
Times interest earned 10.0
Average collection period 20.0
Inventory turnover (based on cost of goods sold) 7.0
Return on common equity 12.0%
Operating return on assets 16.8%
Operating profit margin 14.0%
Total asset turnover 1.20
Fixed asset turnover 1.80
T. P. Jarmon Company, Income Statement for the Year Ended 12/31/2013
Sales (all credit) $600,000
Less cost of goods sold 460,000
Gross profit $140,000
Less operating and interest expenses
General and administrative $30,000
Interest 10,000
Depreciation 30,000
Total 70,000
Earnings before taxes $ 70,000
Less taxes 27,100
Net income available to common stockholders $ 42,900
Less cash dividends 31,800
Change in retained earnings $ 11,100
Jan Fama, associate credit analyst for the Merchants National Bank of Midland, Michigan, was
assigned the task of analyzing Jarmon’s loan request.
a. Calculate the financial ratios for 2013 corresponding to the industry norms provided as follows:
T. P. Jarmon Company, balance Sheet for 12/31/2012 and 12/31/2013
2012 2013
Cash $ 15,000 $ 14,000
Marketable securities 6,000 6,200
Accounts receivable 42,000 33,000
Inventory 51,000 84,000
Prepaid rent 1,200 1,100
Total current assets $115,200 $138,300
Net plant and equipment 286,000 270,000
Total assets $401,200 $408,300
Accounts payable $ 48,000 $ 57,000
Notes payable 15,000 13,000
Accruals 6,000 5,000
Total current liabilities $ 69,000 $ 75,000
Long-term debt 160,000 150,000
Common stockholders’ equity 172,200 183,300
Total liabilities and equity $401,200 $408,300

Chapter 4 • Evaluating a Firm’s Financial Performance 137
b. Which of the ratios reported in the industry norms do you feel should be most crucial in
determining whether the bank should extend the line of credit?
c. Prepare Jarmon’s statement of cash flows for the year ended December 31, 2013. Interpret
your findings.
d. Use the information provided by the financial ratios and the cash flow statement to decide
if you would support making the loan.
4-12. (Economic Value Added) Stegemoller Inc.’s managers want to evaluate the firm’s prior-year
performance in terms of its contribution to shareholder value. This past year, the firm earned an
operating return on investment of 12 percent, compared to an industry norm of 11 percent. It has
been estimated that the firm’s investors have an opportunity cost on their funds of 14 percent,
which is the same as its overall cost of capital. The firm’s total assets for the year were $100 million.
Compute the amount of economic value created or destroyed by the firm. How does your find-
ing support or fail to support what you would conclude using ratio analysis to evaluate the firm’s
performance?
4-13. Being able to identify an industry to use for benchmarking your firm’s results with similar
companies is frequently not easy. Choose a type of business and go to www.naics.com. This Web
site allows you to do a free search for the NAICS (North American Industry Classification System,
pronounced “Nakes”) number for different types of businesses. Choose keywords such as “athletic
shoes” or “auto dealers” and others to see to which industry they have been assigned.
4-14. (Market-value ratios) Bremmer Industries has a price/earnings ratio of 16.29X.
a. If Bremmer’s earnings per share are $1.35, what is the price per share of Bremmer’s stock?
b. Using the price per share you found in part (a), determine the price/book ratio if Brem-
mer’s equity book value per share is $9.58.
4-15. (Financing decisions) Ellie’s Electronics Incorporated has total assets of $63 million and total
debt of $42 million. The company also has operating profits of $21 million with interest expenses
of $6 million.
a. What is Ellie’s debt ratio?
b. What is Ellie’s times interest earned?
c. Based on the information above, would you recommend to Ellie’s management that the
firm is in a strong enough position to assume more debt and increase interest expense to
$9 million?
4-16. (Economic Value Added) Callaway Concrete uses Economic Value Added as a financial per-
formance measure. Callaway has $240 million in assets, and the firm has financed its assets with
37 percent equity and 63 percent debt with an interest rate of 6 percent. The firm’s opportunity
cost on its funds is 12 percent, while the operating return on the firm’s assets is 14 percent.
a. What is the Economic Value Added created or destroyed by Callaway Concrete?
b. What does Economic Value Added measure?
4-17. (Ratio analysis) Seward, Inc.’s financial statements for 2013 are shown below:
Sales $ 4,500
Cost of goods sold (2,800)
Gross profits $ 1,700
Operating expenses:
Marketing and general and administrative expenses $(1,000)
Depreciation expenses (200)
Total operating expenses $(1,200)
Operating profits $ 500
Interest expense (60)
Earnings before taxes (taxable income) $ 440
Income taxes (125)
Net Income $ 315
Cash $ 500
Account receivables 600
(Continued)

www.naics.com

138 Part 1 • The Scope and Environment of Financial Management
The chief financial officer for Seward has acquired industry averages for the following ratios:
Current ratio 3.0
Acid-test ratio 1.50
Days in receivables 40.0
Days in inventories 70.2
Operating return on assets 12.5%
Operating profit margin 8.0%
Total asset turnover 1.6
Fixed-asset turnover 3.1
Debt ratio 33%
Times interest earned 6.0
Return on equity 11.0%
a. Compute the ratios listed above for Seward.
b. Compared to the industry:
1. How liquid is the firm?
2. Are its managers generating attractive operating profit on the firm’s assets?
3. How is the firm financing its assets?
4. Are its managers generating a good return on equity?
4-18. (Computing ratios) Use the information from the balance sheet and income statement below
to calculate the following ratios:
Current ratio Days in receivables
Acid-test ratio Operating return on assets
Times interest earned Debt ratio
Inventory turnover Return on equity
Total asset turnover Fixed asset turnover
Operating profit margin
Inventories 900
Total current assets $ 2,000
Gross fixed assets $ 2,100
Accumulated depreciation (800)
Net fixed assets $ 1,300
Total assets $ 3,300
L I A b I L I T I E S ( D E b T ) A N D E Q u I T Y
Accounts payable $ 500
Short-term notes payable 300
Total current liabilities $ 800
Long-term debt 400
Total liabilities $1,200
Common equity:
Common stock (par and paid in capital) $ 500
Retained earnings 1,600
Total common equity $2,100
Total liabilities and equity $3,300

Chapter 4 • Evaluating a Firm’s Financial Performance 139
Mini Case
This Mini Case is available in MyFinanceLab.
After graduating from college in December 2011, Alyssa Randall started her career at the G&S
Corporation, a small- to medium-sized warehouse distributor in Nashville, Tennessee. The com-
pany was founded by Jack Griggs and Johnny Stites in 1998, after they had worked together in
management at Wal-Mart. Although Randall had an offer from Sam’s Club, she became excited
about the opportunity with G&S. Griggs and Stites, as CEO and VP-marketing, respectively,
assured her that she would be given every opportunity to take a leadership role in the business as
quickly as she was ready.
In addition to receiving a competitive salary, Randall will immediately be entitled to a bonus
based on how well the company does financially. The bonus is determined by the amount of
Economic Value Added (EVA) that is generated in a year. To begin, she would receive 1 percent
of the firm’s EVA each year, to be paid half in stock and half in cash. In any year that the EVA is
negative, she will not receive a bonus. Also, the firm’s stock is traded publicly on the American
Stock Exchange.
The year of 2012 turned out to be a good year financially for the business. But in the ensuing year,
2013, the company experienced a 5.3 percent sales reduction, where sales declined from $5.7 million
to $5.4 million. The downturn then led to other financial problems, including a 50 percent reduc-
tion in the company’s stock price. The share price went from $36 per share at the end of 2012 to
$18 per share at the conclusion of 2013!
Cash $100,000
Accounts receivable 30,000
Inventory 50,000
Prepaid expenses 10,000
Total current assets $190,000
Gross plant and equipment 401,000
Accumulated depreciation (66,000)
Total assets $525,000
Accounts payable $ 90,000
Accrued liabilities 63,000
Total current debt $153,000
Long-term debt 120,000
Common stock 205,000
Retained earnings 47,000
Total debt and equity $525,000
Sales* $210,000
Cost of goods sold (90,000)
Gross profit $120,000
Selling, general, and administrative expenses (29,000)
Depreciation expense (26,000)
Operating profits $65,000
Interest expense (8,000)
Earnings before taxes $57,000
Taxes (16,000)
Net income $41,000
*12% of sales are cash sales.

Income taxes (230) (65)
Net Income $ 410 $ 180
Additional information:
Number of common shares outstanding 150 150
Dividends paid to stockholders $ 120 $ 120
Market price per share $ 36 $ 18
G&S Corporation Income Statements
2012 2013
Sales $ 5,700 $ 5,400
Cost of goods sold (3,700) (3,600)
Gross profits $ 2,000 $ 1,800
Operating expenses:
Selling and G&A expenses $ (820) $ (780)
Depreciation expenses (340) (500)
Total operating expenses $(1,160) $(1,280)
Operating profits $ 840 $ 520
Interest expense (200) (275)
Earnings before taxes (taxable income) $ 640 $ 245
Financial information for G&S for both years is shown below, where all the numbers, except for
per-share data, are shown in $ thousands.
a. Using what you have learned in this chapter and Chapter 3, prepare a financial analysis
of G&S, comparing the firm’s financial performance between the two years. In addition
to the financial information provided below, the company’s chief financial officer, Mike
Stegemoller, has estimated the company’s average cost of capital for all its financing to be
10.5 percent.
b. What conclusions can you make from your analysis?
c. How much will Randall’s bonus be in 2012 and 2013, both in the form of cash and stock?
How many shares of the stock will Randall receive?
d. What recommendations would you make to management?
140 Part 1 • The Scope and Environment of Financial Management

G&S Corporation balance Sheets
2012 2013
A S S E T S
Cash $ 300 $ 495
Accounts receivable 700 915
Inventories 600 780
Other current assets 125 160
Total current assets $1,725 $2,350
Gross fixed assets $4,650 $4,950
Accumulated depreciation (1,700) (2,200)
Net fixed assets $2,950 $2,750
Total assets $4,675 $5,100
L I A b I L I T I E S ( D E b T ) A N D E Q u I T Y
Accounts payable $ 400 $ 640
Short-term notes payable 250 300
Total current liabilities $ 650 $ 940
Long-term debt 1,250 1,325
Total liabilities $1,900 $2,265
Common equity:
Common stock $1,100 $1,100
Retained earnings 1,675 1,735
Total common equity $2,775 $2,835
Total liabilities and equity $4,675 $5,100
Chapter 4 • Evaluating a Firm’s Financial Performance 141

The Time Value of Money
Learning Objectives
1 Explain the mechanics of compounding Compound Interest, Future, and Present
and bringing the value of money back to the present. Value
2 Understand annuities. Annuities
3 Determine the future or present value of a sum when Making Interest Rates Comparable
there are nonannual compounding periods.
4 Determine the present value of an uneven stream The Present Value of an Uneven
of payments and understand perpetuities. Stream and Perpetuities
142
In business, there is probably no other single concept with more power or applications than that of the time
value of money. In his landmark book, A History of Interest Rates, Sidney Homer noted that if $1,000 was
invested for 400 years at 8 percent interest, it would grow to $23 quadrillion—that would work out to approxi-
mately $5 million per person on earth. He was not giving a plan to make the world rich but effectively pointing
out the power of the time value of money.
The time value of money is certainly not a new concept. Benjamin Franklin had a good understanding of
how it worked when he left £1,000 each to Boston and Philadelphia. With the gift, he left instructions that the
cities were to lend the money, charging the going interest rate, to worthy apprentices. Then, after the money
had been invested in this way for 100 years, they were to use a portion of the investment to build something of
benefit to the city and hold some back for the future. Two hundred years later, Franklin’s Boston gift resulted
in the construction of the Franklin Union, has helped countless medical students with loans, and still has over
$3 million left in the account. Philadelphia, likewise, has reaped a significant reward from his gift with its
portion of the gift growing to over $2 million. Bear in mind that all this has come from a gift of £2,000 with
some serious help from the time value of money.
The power of the time value of money can also be illustrated through a story Andrew Tobias tells in his book
Money Angles. There he tells of a peasant who wins a chess tournament put on by the king. The king asks the
peasant what he would like as the prize. The peasant answers that he would like for his village one piece of grain
to be placed on the first square of his chessboard, two pieces of grain on the second square, four pieces on the
third, eight on the fourth, and so forth. The king, thinking he was getting off easy, pledged on his word of honor
that it would be done. Unfortunately for the king, by the time all 64 squares on the chessboard were filled, there
were 18.5 million trillion grains of wheat on the board—the kernels were compounding at a rate of 100 percent
over the 64 squares of the chessboard. Needless to say, no one in the village ever went hungry; in fact, that is so
much wheat that if each kernel were one-quarter inch long (quite frankly, I have no idea how long a kernel of
5

143143
wheat is, but Andrew Tobias’s guess
is one-quarter inch), if laid end to
end, they could stretch to the sun
and back 391,320 times.
Understanding the techniques of
compounding and moving money
through time is critical to almost
every business decision. It will help
you to understand such varied things
as how stocks and bonds are valued,
how to determine the value of a new
project, how much you should save
for your children’s education, and
how much your mortgage payments
will be.
In the next six chapters, we focus on determining the value of the firm and the desirability
of the investments it considers making. A key concept that underlies this material is the time
value of money; that is, a dollar today is worth more than a dollar received a year from now.
Intuitively this idea is easy to understand. We are all familiar with the concept of interest.
This concept illustrates what economists call an opportunity cost of passing up the earning
potential of a dollar today. This opportunity cost is the time value of money.
To evaluate and compare investment proposals, we need to examine how dollar values
might accrue from accepting these proposals. To do this, all the dollar values must first be
comparable. In other words, we must move all dollar flows back to the present or out to a
common future date. An understanding of the time value of money is essential, therefore,
to an understanding of financial management, whether basic or advanced.
Compound Interest, Future, and Present Value
We begin our study of the time value of money with some basic tools for visualizing the
time pattern of cash flows. While timelines seem simple at first glance, they can be a tre-
mendous help for more complicated problems.
Using Timelines to Visualize Cash Flows
As a first step in visualizing cash flows, we can construct a timeline, a linear representation
of the timing of cash flows. A timeline identifies the timing and amount of a stream of cash
flows—both cash received and cash spent—along with the interest rate it earns. Timelines
are a critical first step used by financial analysts to solve financial problems. We will refer
to them often throughout this text.
To illustrate how to construct a timeline, consider the following example, where we
receive annual cash flows over the course of 4 years. The following timeline shows our cash
inflows and outflows from time period 0 (the present) until the end of year 4:
1 Explain the mechanics of
compounding and bringing
the value of money back to the
present.
Y E A R S 0 1 2 4
Cash Flow
r = 10%
30–100 20
3
–10 50
Today &
Beginning
of Period 1
End of Period 2
& Beginning
of Period 3
End of Period 4
& Beginning
of Period 5

144 Part 2 • The Valuation of Financial Assets
For our purposes, time periods are identified on the top of the timeline, and in this
example, the time periods are measured in years, which are indicated on the far left of the
timeline. Thus, time period 0 is both today and the beginning of the first year. The dollar
amount of the cash flow received or spent at each time period is shown below the timeline.
Positive values represent cash inflows. Negative values represent cash outflows. For example,
in the timeline shown, a $100 cash outflow occurs today, or at time 0, followed by cash
inflows of $30 and $20 at the end of years 1 and 2, a negative cash flow (a cash outflow) of
$10 at the end of year 3, and finally a cash inflow of $50 at the end of year 4.
The units of measurement on the timeline are time periods and are typically expressed
in years but could be expressed as months, days, or any unit of time. However, for now,
let’s assume we’re looking at cash flows that occur annually. Thus, the distance between 0
and 1 represents the period between today and the end of the first year. Consequently, time
period 0 indicates today, while time period 1 represents the end of the first year, which is
also the beginning of the second year. (You can think of it as being both the last second of
the first year and the first second of the second year.) The interest rate, which is 10 percent
in this example, is listed above the timeline.
In this chapter and throughout the text, we will often refer to the idea of moving money
through time. Because this concept is probably not familiar to everyone, we should take
a moment to explain it. Most business investments involve investing money today. Then,
in subsequent years, the investment produces cash that comes back to the business. To
evaluate an investment, you need to compare the amount of money the investment requires
today with the amount of money the investment will return to you in the future and adjust
these numbers for the fact that a dollar today is worth more than a dollar in the future.
Timelines simplify solving time value of money problems, and they are not just for begin-
ners; experienced financial analysts use them as well. In fact, the more complex the problem
you’re trying to solve, the more valuable a timeline will be in terms of helping you visualize
exactly what needs to be done.
Most of us encounter the concept of compound interest at an early age. Anyone who
has ever had a savings account or purchased a government savings bond has received
compound interest. Compound interest occurs when interest paid on the investment
during the first period is added to the principal; then, during the second period, interest is
earned on this new sum.
For example, suppose we place $100 in a savings account that pays 6 percent interest,
compounded annually. How will our savings grow? At the end of the first year we have
earned 6 percent, or $6 on our initial deposit of $100, giving us a total of $106 in our sav-
ings account, thus,
Value at the end of year 1 = present value * (1 + interest rate)
= $100(1 + 0.06)
= $100(1.06)
= $106
Carrying these calculations one period further, we find that we now earn the 6 percent
interest on a principal of $106, which means we earn $6.36 in interest during the second year.
Why do we earn more interest during the second year than we
did during the first? Simply because we now earn interest on the
sum of the original principal and the interest we earned in the
first year. In effect we are now earning interest on interest; this is
the concept of compound interest. Examining the mathematical
formula illustrating the earning of interest in the second year,
we find
Value at the end of year 2 = value at the end of year 1 * (1 + r)
where r = the annual interest (or discount) rate, which for our example gives
Value at the end of year 2 = $106 * (1.06)
= $112.36
compound interest the situation in which
interest paid on an investment during the first
period is added to the principal. During the
second period, interest is earned on the original
principal plus the interest earned during the first
period.
ReMeMbeR YouR PRinciPles
In this chapter we develop the tools to incorporate
Principle 2: Money Has a Time Value into our calculations.
In coming chapters we use this concept to measure value by
bringing the benefits and costs from a project back to the present.
rinciple

Chapter 5 • The Time Value of Money 145
Looking back, we can see that the future value at the end of year 1, or $106, is actually
equal to the present value times (1 + r), or $100(1 + 0.06). Moving forward to year 2 we
find,
Value at the end of year 2 = present value * (1 + r) * (1 + r)
= present value * (1 + r)2
Carrying this forward into the third year, we find that we enter the year with $112.36
and we earn 6 percent, or $6.74 in interest, giving us a total of $119.10 in our savings ac-
count. This can be expressed as
Value at the end of year 3 = present value * (1 + r) * (1 + r) * (1 + r)
= present value * (1 + r)3
By now a pattern is becoming apparent. We can generalize this formula to illustrate the
future value of our investment if it is compounded annually at a rate of r for n years to be
Future value = present value * (1 + r)n
Letting FVn stand for the future value at the end of n periods and PV stand for the present
value, we can rewrite this equation as
FVn = PV(1 + r)n (5-1)
We also refer to (1 + r)n as the future value factor. Thus, to find the future value of
a dollar amount, all you need to do is multiply that dollar amount times the appropriate
future value factor,
Future value = present value * (future value factor)
where future value factor = (1 + r)n.
Figure 5-1 illustrates how this investment of $100 would continue to grow for the
first 20 years at a compound interest rate of 6 percent. Notice how the amount of inter-
est earned annually increases each year. Again, the reason is that each year interest is
future value the amount to which your
investment will grow, or a future dollar amount.
future value factor the value of (1 + r)n
used as a multiple to calculate an amount’s
future value.
FIgURE 5-1 $100 Compounded at 6 Percent Over 20 Years
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
$300
$250
$200
$150
$100
$50
$0
$350
Interest earned on interest
Interest earned on the
initial investment of $100
Initial investment of $100
Number of years
Fu
tu
re
v
al
ue
o
f $
10
0

146 Part 2 • The Valuation of Financial Assets
received on the sum of the original investment plus any interest earned in the past. The
situation in which interest is earned on interest that was earned in the past is referred
to as compound interest. If you only earned interest on your initial investment, it would be
referred to as simple interest.
When we examine the relationship between the number of years an initial investment
is compounded for and its future value, as shown graphically in Figure 5-2, we see that we
can increase the future value of an investment by either increasing the number of years for
which we let it compound or by compounding it at a higher interest rate. We can also see
this from equation (5-1) because an increase in either r or n while the present value is held
constant results in an increase in the future value.
E x A M P L E 5.1 Calculating the future value of an investment
If we place $1,000 in a savings account paying 5 percent interest compounded annually,
how much will our account accrue to in 10 years?
sTeP 1: FoRMulATe A soluTion sTRATeGY
The future value of the savings account takes into account the present value of the ac-
count and multiplies it by the annual interest rate each year it is applied, that is,
Future value = present value * (1 + r)n (5-1)
where r = annual interest rate and n = the number of years.
sTeP 2: cRuncH THe nuMbeRs
Substituting present value, percent, and 10 years into equation (5-1), we get the following:
FVn = $1,000(1 + 0.05)10
= $1,000(1.62889) (5-1)
= $1,628.89
sTeP 3: AnAlYZe YouR ResulTs
At the end of the 10 years, we will have $1,628.89 in our savings account.
simple interest if you only earned interest on
your initial investment, it would be referred to as
simple interest.
FIgURE 5-2 The Future Value of $100 Initially Deposited and Compounded at 0, 5, 10, and 15 Percent
Number of years
0
2 4 6 8 10 12 14 16 18
0%
5%
10%
15%
20
Fu
tu
re
v
al
ue
(d
ol
la
rs
)
200
400
600
800
1,000
1,200
1,400
1,600
2,000
1,800

Chapter 5 • The Time Value of Money 147
Techniques for Moving Money Through Time
There are three different approaches that you can use to solve a time value of money problem.
The first is to simply do the math. Financial calculators are a second alternative, and there
are a number of them that do a good job of solving time value of money problems. Based
on many years of experience, the Texas Instruments BA II Plus or the Hewlett-Packard
10BII calculators would be excellent choices. Finally, spreadsheets can move money through
time, and in the real world, they are without question the tool of choice. Now let’s take a
look at all three alternatives.
Mathematical Calculations If we want to calculate the future value of an amount of
money, the mathematical calculations are relatively straightforward. However, as we will
see, time value of money calculations are easier using a financial calculator or spreadsheet.
Those are the chosen methods in the real world.
E x A M P L E 5.2 Calculating future value of an investment
If we invest $500 in a bank where it will earn 8 percent interest compounded annually,
how much will it be worth at the end of 7 years?
sTeP 1: FoRMulATe A soluTion sTRATeGY
The future value of the savings account is found using the same method as in Example
5.1 using equation (5-1) as follows:
Future value = present value * (1 + r)n (5-1)
sTeP 2: cRuncH THe nuMbeRs
Substituting into equation (5-1) we compute the future value of our account as follows:
FV = $500(1 + 0.08)7 = $856.91
sTeP 3: AnAlYZe YouR ResulTs
At the end of 7 years, we will have $856.91 in our savings account. In the future we will
find several uses for equation (5-1); not only can we find the future value of an invest-
ment but we can also solve for the present value, r, or n.
Using a Financial Calculator Before we review the use of the financial calculator, let’s
review the five “time value of money” keys on a financial calculator. Although the specific
keystrokes used to perform time value of money calculations differ slightly when using
financial calculators made by different companies, the symbols used are basically the same.
Below are the keystrokes as they appear on a Texas Instruments BA II Plus calculator.
M E N U K E Y D E S C R I P T I O N
Menu Keys we will use in this chapter include:
N Stores (or calculates) the total number of payments or compounding periods.
I/Y Stores (or calculates) the interest (or discount or growth) rate per period.
PV Stores (or calculates) the present value of a cash flow (or series of cash flows).
FV Stores (or calculates) the future value, that is, the dollar amount of a final cash flow
(or the compound value of a single flow or series of cash flows).
PMT Stores (or calculates) the dollar amount of each annuity (or equal) payment
deposited or received.
The keys shown here correspond to the TI BA II Plus calculator. Other financial calcula-
tors have essentially the same keys. They are simply labeled a little differently. We should
stop and point out that the labels on the keys of financial calculators are slightly different

148 Part 2 • The Valuation of Financial Assets
than what we have been using in our mathematical formulas. For example, we have used
a lowercase n to refer to the number of compounding periods, whereas an uppercase N
appears on the Texas Instruments BA II Plus calculator. Likewise, the I/Y key refers to the
rate of interest per period, whereas we have used r. Some financial calculators also have a
CPT key, which stands for “compute.” It is simply the key you press when you want the
calculator to begin solving your problem. Finally, the PMT key refers to a fixed payment
received or paid each period.
At this point you might be wondering exactly why we are using different symbols in this
book than are used on calculators. The answer is that, unfortunately, the symbols used by
the different companies that design and make financial calculators are not consistent. The
symbols in Microsoft Excel are somewhat different as well.
An important thing to remember when using a financial calculator is that cash out-
flows (investments you make rather than receive) generally have to be entered as nega-
tive numbers. In effect, a financial calculator sees money as “leaving your hands” and
therefore taking on a negative sign when you invest it. The calculator then sees the
money “returning to your hands” and therefore taking on a positive sign after you’ve
earned interest on it. Also, every calculator operates a bit differently with respect to
entering variables. Needless to say, it is a good idea to familiarize yourself with exactly
how your calculator functions.1
1Appendix A at www.pearsonhighered.com/keown provides a tutorial that covers both the Texas Instruments BA II Plus
and the Hewlett-Packard 10BII calculators.
Once you’ve entered all the variables you know, including entering a zero for any vari-
able with a value of zero, you can let the calculator do the math for you. If you own a Texas
Instruments BA II Plus calculator, press the compute key (CPT), followed by the key cor-
responding to the unknown variable you’re trying to determine. With a Hewlett-Packard
calculator, once the known variables are entered, you need only press the key corresponding
to the final variable to calculate its value.
A good starting place when working a problem is to write down all the variables you
know. Then assign a value of zero to any variables that are not included in the problem.
Once again, make sure that the sign you give to the different variables reflects the direction
of the cash flow.
Calculator Tips—Getting It Right Calculators are pretty easy to use. But there are some
common mistakes that are often made. So, before you take a crack at solving a problem us-
ing a financial calculator ensure that you take the following steps:
1. Set your calculator to one payment per year. Some financial calculators use monthly
payments as the default. Change it to annual payments. Then consider n to be the
number of periods and r the interest rate per period.
2. Set your calculator to display at least four decimal places or to floating decimal
place (nine decimal places). Most calculators are preset to display only two decimal
places. Because interest rates are so small, change your decimal setting to at least four.
3. Set your calculator to the “end” mode. Your calculator will assume cash flows occur
at the end of each time period.
When you’re ready to work a problem, remember:
1. Every problem must have at least one positive and one negative number. The
pre-programming within the calculator assumes that you are analyzing problems in
which money goes out (outflows) and comes in (inflows), so you have to be sure to
enter the sign appropriately. If you are using a BA II Plus calculator and get an “Error
5” message, that means you are solving for either r or n and you input both the present
and future values as positive numbers—correct that and re-solve the problem.
2. You must enter a zero for any variable that isn’t used in a problem, or you have
to clear the calculator before beginning a new problem. If you don’t clear your
calculator or enter a value for one of the variables, your calculator won’t assume that
that variable is zero. Instead, your calculator will assume it carries the same number as

www.pearsonhighered.com/keown

Chapter 5 • The Time Value of Money 149
it did during the previous problem. So be sure to clear out the memory (CLR, TVM)
or enter zeros for variables not included in the problem.
3. Enter the interest rate as a percent, not a decimal. That means 10 percent must be
entered as 10 rather than 0.10.
Two popular financial calculators are the Texas Instruments BA II Plus (TI BA II Plus)
and the Hewlett-Packard 10BII (HP 10BII). If you’re using one of these calculators and
encounter any problems, take a look at Appendix A at www.pearsonhighered.com/keown.
It provides a tutorial for both of these calculators.
Spreadsheets Practically speaking, most time value of money calculations are now done on
computers with the help of spreadsheet software. Although there are competing spreadsheet
programs, the most popular is Microsoft Corporation’s Excel®. Just like financial calculators,
Excel has “built-in” functions that make it really easy to do future value calculations.
Excel Tips—Getting It Right
1. Take advantage of the formula help that Excel offers. All Excel functions are set
up the same way: First, with the “=” sign; second, with the function’s name (for exam-
ple, FV or PV); and third, with the inputs into that function enclosed in parentheses.
The following, for example, is how the future value function looks:
= FV(rate,nper,pmt,pv)
When you begin typing in your Excel function in a spreadsheet cell (that is, a box where
you enter a single piece of data), all the input variables will appear at the top of the
spreadsheet in their proper order, so you will know what variable must be entered next.
For example, = FV(rate,nper,pmt,pv,type) will come into view, with rate appearing
in bold because rate is the next variable to enter. This means you don’t really need to
memorize the functions because they will appear when you begin entering them.
2. If you’re lost, click on “Help.” On the top row of your Excel spreadsheet you’ll
notice the word Help listed—another way to get to the help link is to hit the F1 but-
ton. When you’re lost, the help link is your friend. Click on it and enter “PV” or “FV”
in the search bar, and the program will explain how to calculate each. All of the other
financial calculations you might want to find can be found the same way.
3. Be careful about rounding the r variable. For example, suppose you’re dealing with
the interest rate 6.99 percent compounded monthly. This means you will need to enter
the interest rate per month, which is = 6.99%/12, and since you are performing divi-
sion in the cell, you need to put an “=” sign before the division is performed. Don’t
round the result of 0.0699/12 to 0.58 and enter 0.58 as r. Instead, enter = 6.99/12 or
as a decimal = 0.0699/12 for r.
Also, you’ll notice that while the inputs using an Excel spreadsheet are almost identical
to those on a financial calculator, the interest rate in Excel is entered as either a decimal
(0.06) or a whole number followed by a % sign (6%) rather than a 6 (as you would enter
if you were using a financial calculator).
4. Don’t let the Excel notation fool you. Excel doesn’t use r or I/Y to note the inter-
est rate. Instead, it uses the term rate. Don’t let this bother you. All of these notations
refer to the same thing—the interest rate. Similarly, Excel doesn’t use n to denote the
number of periods. Instead, it uses nper. Once again, don’t let this bother you. Both n
and nper refer to the number of periods.
5. Don’t be thrown off by the “Type” input variable. You’ll notice that Excel asks for
a new variable that we haven’t talked about yet, “type.” Again, if you type “= FV” in a
cell, “= FV(rate,nper,pmt,pv,type)” will immediately appear just below that cell. Don’t
let this new variable, “type,” throw you off. The variable “type” refers to whether the
payments, pmt, occur at the end of each period (which is considered type = 0) or the
beginning of each period (which is considered type = 1). But you don’t have to worry
about it at all because the default on “type” is 0. Thus, if you don’t enter a value for “type,”
it will assume that the payments occur at the end of each period. We’re going to assume they

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150 Part 2 • The Valuation of Financial Assets
occur at the end of each period, and if they don’t, we’ll deal with them another way
that will be introduced later in this chapter. You’ll also notice that since we assume
that all payments occur at the end of each period unless otherwise stated, we ignore the
“type” variable.
Some of the more important Excel functions that we will be using throughout the book
include the following (again, we are ignoring the “type” variable because we are assuming
cash flows occur at the end of the period):
C A LC U L AT I O N ( W H AT I S B E I N g S O LV E D F O R ) F O R M U L A
Present value = PV(rate, nper, pmt, fv)
Future value = FV(rate, nper, pmt, pv)
Payment = PMT(rate, nper, pv, fv)
Number of periods = NPER(rate, pmt, pv, fv)
Interest rate = RATE(nper, pmt, pv, fv)
Reminders: First, just as in using a financial calculator, the outflows have to be entered as
negative numbers. In general, each problem will have two cash flows—one positive and one
negative. Second, a small, but important, difference between a spreadsheet and a financial
calculator: When using a financial calculator, you enter the interest rate as a percent. For
example, 6.5 percent is entered as 6.5. However, with the spreadsheet, the interest rate is
entered as a decimal, thus 6.5 percent would be entered as 0.065 or, alternatively, as 6.5
followed by a % sign.
E x A M P L E 5.3 Calculating the future value of an investment
If you put $1,000 into an investment paying 20 percent interest compounded annually,
how much will your account grow to in 10 years?
sTeP 1: FoRMulATe A soluTion sTRATeGY
Let’s start with a timeline to help you visualize the problem:
The future value of our savings account can be computed using equation (5-1) as follows:
Future value = present value * (1 + r)n (5-1)
sTeP 2: cRuncH THe nuMbeRs
using the Mathematical Formulas
Substituting present value = $1,000, r = 20 percent, and n = 10 years into equation
(5-1), we get
Future value = present value * (1 + r)n (5-1)
= $1,000(1 + 0.20)10
= $1,000(6.19174)
= $6,191.74
Thus, at the end of 10 years, you will have $6,191.74 in your investment. In this problem
we’ve invested $1,000 at 20 percent and found that it will grow to $6,191.74 after
10 years. These are actually equivalent values expressed in terms of dollars from different
time periods where we’ve assumed a 20 percent compound rate.
–1,000
Y E A R S
Cash Flows Future
Value = ?
r = 20%
0 5 6 109871 2 43

Chapter 5 • The Time Value of Money 151
Using a Financial Calculator
A financial calculator makes this even simpler. If you are not familiar with the use of
a financial calculator, or if you have any problems with these calculations, check out
the tutorial on financial calculators in Appendix A at www.pearsonhighered.com/keown.
There you’ll find an introduction to financial calculators and the time value of money
along with calculator tips to make sure that you come up with the right answers.
Enter 10 20 −1,000 0
N I/N PV PMT FV
Solve for 6,192
Notice that you input the present value with a negative sign. In effect, a financial calcula-
tor sees money as “leaving your hands” and therefore taking on a negative sign when you
invest it. In this case you are investing $1,000 right now, so it takes on a negative sign—as
a result, the answer takes on a positive sign.
Using an Excel Spreadsheet
You’ll notice the inputs using an Excel spreadsheet are almost identical to those on a
financial calculator. The only difference is that the interest rate in Excel is entered as
either a decimal (0.20) or a whole number followed by a % sign (20%) rather than as 20
(as you would enter if you were using a financial calculator). Again, the present value
should be entered with a negative value so that the answer takes on a positive sign.
STEP 3: ANALYZE YOUR RESULTS
Thus, at the end of 10 years, you will have $6,192 in your investment. In this problem
we’ve invested $1,000 at 20 percent and found that it will grow to $6,192 after 10 years.
These are actually equivalent values expressed in terms of dollars from different time
periods where we’ve assumed a 20 percent compound rate.
Two Additional Types of Time Value of Money Problems
Sometimes the time value of money does not involve determining either the present value
or future value of a sum, but instead deals with either the number of periods in the future,
n, or the rate of interest, r. For example, to answer the following question you will need to
calculate the value for n.
◆ How many years will it be before the money I have saved will be enough to buy a sec-
ond home?
Similarly, questions such as the following must be answered by solving for the interest rate, r.
◆ What rate do I need to earn on my investment to have enough money for my newborn
child’s college education (n = 18 years)?
◆ What interest rate has my investment earned?
Fortunately, with the help of a financial calculator or an Excel spreadsheet, you can easily
solve for r or n in any of the above situations. It can also be done using the mathematical
formulas, but it’s much easier with a calculator or spreadsheet, so we’ll stick to them.

www.pearsonhighered.com/keown

152 Part 2 • The Valuation of Financial Assets
Solving for the Number of Periods Suppose you want to know how many years it will
take for an investment of $9,330 to grow to $20,000 if it’s invested at 10 percent annually.
Let’s take a look at solving this using a financial calculator and an Excel spreadsheet.
Using a Financial Calculator With a financial calculator, all you do is substitute in the
values for I/Y, PV, and FV and solve for N:
Enter 10 −9,330 0 20,000
N I/Y PV PMT FV
Solve for 8
You’ll notice that PV is input with a negative sign. In effect, the financial calculator is
programmed to assume that the $9,330 is a cash outflow, whereas the $20,000 is money
that you receive. If you don’t give one of these values a negative sign, you can’t solve the
problem.
Using an Excel Spreadsheet With Excel, solving for n is straightforward. You simply use
the = NPER function and input values for rate, pmt, pv, and fv.
Solving for the Rate of Interest You have just inherited $34,946 and want to use it to
fund your retirement in 30 years. If you have estimated that you will need $800,000 to fund
your retirement, what rate of interest would you have to earn on your $34,946 investment?
Let’s take a look at solving this using a financial calculator and an Excel spreadsheet to
calculate the interest rate.
Using a Financial Calculator With a financial calculator, all you do is substitute in the
values for N, PV, and FV, and solve for I/Y:
Enter 30 −34,946 0 800,000
N I/Y PV PMT FV
Solve for 11
Using an Excel Spreadsheet With Excel, the problem is also very easy. You simply use the
= RATE function and input values for nper, pmt, pv, and fv.
Applying Compounding to Things Other Than Money
While this chapter focuses on moving money through time at a given interest rate, the con-
cept of compounding applies to almost anything that grows. For example, let’s assume you’re

Chapter 5 • The Time Value of Money 153
interested in knowing how big the market for wireless printers will be in 5 years and assume
the demand for them is expected to grow at a rate of 25 percent per year over the next
5 years. We can calculate the future value of the market for printers using the same formula
we used to calculate future value for a sum of money. If the market is currently 25,000 print-
ers per year, then 25,000 would be the present value, n would be 5, r would be 25%, and
substituting into equation (5-1) you would be solving FV,
Future value = present value * (1 + r)n (5-1)
= 25,000(1 + 0.20)5 = 76,293
In effect, you can view the interest rate, r, as a compound growth rate and solve for the
number of periods it would take for something to grow to a certain level—what something
will grow to in the future. Or you could solve for r, that is, solve for the rate that something
would have to grow at in order to reach a target level.
Present Value
Up to this point we have been moving money forward in time; that is, we know how much
we have to begin with and are trying to determine how much that sum will grow in a cer-
tain number of years when compounded at a specific rate. We are now going to look at the
reverse question: What is the value in today’s dollars of a sum of money to be received in
the future? The answer to this question will help us determine the desirability of invest-
ment projects in Chapters 10 and 11. In this case we are moving future money back to the
present. We will determine the present value of a lump sum, which in simple terms is
the current value of a future payment. In fact, we will be doing nothing other than inverse
compounding. The differences in these techniques come about merely from the investor’s
point of view. In compounding, we talked about the compound interest rate and the initial
investment; in determining the present value, we will talk about the discount rate and pres-
ent value of future cash flows. Determining the discount rate is the subject of Chapter 9 and
can be defined as the rate of return available on an investment of equal risk to what is being
discounted. Other than that, the technique and the terminology remain the same, and the
mathematics are simply reversed. In equation (5-1) we were attempting to determine the
future value of an initial investment. We now want to determine the initial investment or
present value. By dividing both sides of equation (5-1) by (1 + r)n, we get
Present value = future value at the end of year n * c 1
(1 + r)n
d
or
PV = FVn c 1(1 + r)n d (5-2)
The term in the brackets in equation (5-2) is referred to as the present value factor. Thus,
to find the present value of a future dollar amount, all you need to do is multiply that future
dollar amount times the appropriate present value factor:
Present value = future value (present value factor)
where
Present value factor = J 1
(1 + r)n
R
Because the mathematical procedure for determining the present value is exactly the inverse
of determining the future value, we also find that the relationships among n, r, and present value
are just the opposite of those we observed in future value. The present value of a future sum of
money is inversely related to both the number of years until the payment will be received and
the discount rate. This relationship is shown in Figure 5-3. Although the present value equation
present value the value in today’s dollars of
a future payment discounted back to present at
the required rate of return.
present value factor the value of 1(1 + r)n
used as a multiplier to calculate an amount’s
present value.

154 Part 2 • The Valuation of Financial Assets
E x A M P L E 5.5 Calculating the present value of a savings bond
You’re on vacation in a rather remote part of Florida and see an advertisement stat-
ing that if you take a sales tour of some condominiums “you will be given $100 just for
taking the tour.” However, the $100 that you get is in the form of a savings bond that
[equation (5-2)] is used extensively to evaluate new investment proposals, it should be stressed that
the equation is actually the same as the future value, or compounding equation [equation (5-1)],
only it solves for present value instead of future value.
E x A M P L E 5.4 Calculating the discounted value to be received in 10 years
What is the present value of $500 to be received 10 years from today if our discount rate
is 6 percent?
sTeP 1: FoRMulATe A soluTion sTRATeGY
The present value to be received can be calculated using equation (5-2) as follows:
Present value = FVn c
1
(1 + r)n
d (5-2)
sTeP 2: cRuncH THe nuMbeRs
Substituting FV = $500, n = 10, and r = 6 percent into equation (5-2), we find:
Present value = $500 c 1
(1 + 0.06)10
d
= $500(0.5584)
= $279.20
sTeP 3: AnAlYZe YouR ResulTs
Thus, the present value of the $500 to be received in 10 years is $279.20.
FIgURE 5-3 The Present Value of $100 to Be Received at a Future Date and
Discounted Back to the Present at 0, 5, 10, and 15 Percent
Number of years
0
2 4 6 8 10 12 14 16 18
0%
5%
10%
15%
20
Pr
es
en
t
va
lu
e
(d
ol
la
rs
)
10
20
30
40
50
60
70
80
90
100
cAlculAToR soluTion
Data Input Function Key
10 N
6 I/Y
-500 FV
0 PMT
Function Key Answer
CPT
PV 279.20

Chapter 5 • The Time Value of Money 155
cAlculAToR soluTion
Data Input Function Key
10 N
6 I/Y
−100 FV
0 PMT
Function Key Answer
CPT
PV 55.84
will not pay you the $100 for 10 years. What is the present value of $100 to be received
10 years from today if your discount rate is 6 percent?
sTeP 1: FoRMulATe A soluTion sTRATeGY
The present value of our savings bond can be computed using equation (5-2) as follows:
Present value = FVn c
1
(1 + r)n
d (5-2)
sTeP 2: cRuncH THe nuMbeRs
Substituting FV = $100, n = 10, and r = 6 percent into equation (5-2), we compute
the present value as follows:
Present value = $100 c 1
(1 + 0.06)10
d
= $100(0.5584)
= $55.84
sTeP 3: AnAlYZe YouR ResulTs
Thus, the value in today’s dollars of that $100 savings bond is only $55.84.
Cautionary tale
FoRGeTTinG PRinciPle 4: MARkeT PRices ARe GeneRAllY RiGHT
In the Cautionary Tale for Chapter 2, we looked at the role the
mortgage crisis played in the recent financial collapse from the
viewpoint of conflicts of interest and failed corporate gover-
nance. But there are many lenses through which we can look
to analyze the crisis. One such lens is the principle of efficient
markets.
In 2007, several U.S. real estate markets entered a housing
bubble. To look more closely at the underlying factors that led
to the recent housing bubble (and burst), let’s take a step back
for a moment.
Beginning in the mid-1990s, the federal government made
moves to relax conventional lending standards. In one such
move, the government required the Federal National Mortgage
Association, commonly known as Fannie Mae, and the Federal
Home Loan Mortgage Corporation, known as Freddie Mac, to
increase their holdings of loans to low- and moderate-income
borrowers. Then in 1999, the U.S. Department of Housing and
Urban Development (HUD) regulations required Fannie Mae
and Freddie Mac to accept more loans with little or no down
payment. As a result, the government had opened the door to
very risky loans that would not have been made without this
government action.
After the 2001 terrorist attack on the World Trade Center,
the government made another move that acted against what
we know about competitive markets. The Fed lowered short-
term interest rates to ensure that the economy did not seize up.
These low, short-term interest rates made adjustable rate loans
with low down payments highly attractive to homebuyers. As
a result of the low interest rate, when individuals took out vari-
able rate mortgages, they often qualified for bigger mortgages
than they could have afforded during a normal interest rate pe-
riod. But in 2005 and 2006, to control inflation, the Fed returned
these short-term interest rates to higher levels and the adjust-
able rates reset, causing the monthly payments on these loans
to increase. Housing prices began to fall and defaults soared.
These actions prevented supply and demand from acting
naturally. As a result, housing prices were unnaturally inflated
and the listed value of the mortgages, when packaged as secu-
rities, was a poor indicator of their actual worth. When home-
owners defaulted on their loans in spades, investors were left
holding the bad mortgages. These defaulted mortgages also led
to a lot more houses on the market that the banks couldn’t sell,
which led to the market drying up, as it then became very dif-
ficult for anyone to get a new loan.
We now know that these events put into motion the hous-
ing bubble that contributed to our recent economic downturn.
Competitive markets operate with natural forces of supply and
demand, and while they tend to eliminate huge returns, com-
petitive markets can also help to prevent the occurrence of
short-lived false values—such as the temporarily low monthly
interest payments for new homebuyers—that lead to an even-
tual crash. If we take one lesson away from this, it should be this:
Don’t mess with efficient markets. if the markets move interest
rates to higher levels, it’s for a reason.

156 Part 2 • The Valuation of Financial Assets
Again, we have only one present-value–future-value equation; that is, equations (5-1) and
(5-2) are different formats of the same equation. We have introduced them as separate equations
to simplify our calculations; in one case we are determining the value in future dollars, and in the
other case the value in today’s dollars. In either case, the reason is the same: to compare values
on alternative investments and to recognize that the value of a dollar received today is not the
same as that of a dollar received at some future date. In other words, we must measure the dollar
values in dollars of the same time period. For example, if we looked at these projects—one that
promised $1,000 in 1 year, one that promised $1,500 in 5 years, and one that promised $2,500
in 10 years—the concept of present value allows us to bring their flows back to the present and
make those projects comparable. Moreover, because all present values are comparable (they
are all measured in dollars of the same time period), we can add and subtract the present value
of inflows and outflows to determine the present value of an investment. Let’s now look at an
example of an investment that has two cash flows in different time periods and determine the
present value of this investment.
E x A M P L E 5.6 Calculating the present value of an investment
What is the present value of an investment that yields $1,000 to be received in 7 years
and $1,000 to be received in 10 years if the discount rate is 6 percent?
sTeP 1: FoRMulATe A soluTion sTRATeGY
The present value of our investment can be computed using equation (5-2) for each
yield, then adding these values together as follows:
Present value = FVn c 1(1 + r)n d + FVn c
1
(1 + r)n
d (5-2)
sTeP 2: cRuncH THe nuMbeRs
Substituting into equation (5-2), we compute the future value as follows:
Present value = $1,000 c 1
(1 + 0.06)7
d + $1,000 c 1
(1 + 0.06)10
d
= $665.06 + $558.39 = $1,223.45
sTeP 3: AnAlYZe YouR ResulTs
Again, present values are comparable because they are measured in the same time
period’s dollars.
With a financial calculator, this becomes a three-step solution, as shown in the mar-
gin. First, you’ll solve for the present value of the $1,000 received at the end of 7 years,
then you’ll solve for the present value of the $1,000 received at the end of 10 years,
and finally, you’ll add the two present values together. Remember, once you’ve found
the present value of those future cash flows you can add them together because they’re
measured in the same period’s dollars.
Can you Do it?
solVinG FoR THe PResenT VAlue WiTH TWo FloWs in DiFFeRenT YeARs
What is the present value of an investment that yields $500 to be received in 5 years and $1,000 to be received in 10 years if the dis-
count rate is 4 percent?
(The solution can be found on page 158.)
STEP 1
cAlculAToR soluTion
Data Input Function Key
7 N
6 I/Y
-1,000 FV
0 PMT
Function Key Answer
CPT
PV 665.06
STEP 2
cAlculAToR soluTion
Data Input Function Key
10 N
6 I/Y
-1,000 FV
0 PMT
Function Key Answer
CPT
PV 558.39
STEP 3
Add the two present values that you
just calculated together:
$ 665.06
558.39
$1,223.45

Chapter 5 • The Time Value of Money 157
Concept Check
1. Principle 2 states that “money has a time value.” Explain this statement.
2. How does compound interest differ from simple interest?
3. Explain the formula FVn = PV(1 + r)n.
4. Why is the present value of a future sum always less than that sum’s future value?
Annuities
An annuity is a series of equal dollar payments for a specified number of years. When we talk about
annuities, we are referring to ordinary annuities unless otherwise noted. With an ordinary an-
nuity the payments occur at the end of each period. Because annuities occur frequently in finance—
for example, as bond interest payments—we treat them specially. Although compounding and
determining the present value of an annuity can be dealt with using the methods we have just
described, these processes can be time-consuming, especially for larger annuities. Thus, we have
modified the single cash flow formulas to deal directly with annuities.
Compound Annuities
A compound annuity involves depositing or investing an equal sum of money at the end of each
year for a certain number of years and allowing it to grow. Perhaps we are saving money for
education, a new car, or a vacation home. In any case, we want to know how much our sav-
ings will have grown at some point in the future.
Actually, we can find the answer by using equation (5-1), our compounding equation,
and compounding each of the individual deposits to its future value. For example, if to pro-
vide for a college education we are going to deposit $500 at the end of each year for the next
5 years in a bank where it will earn 6 percent interest, how much will we have at the end of
5 years? Compounding each of these values using equation (5-1), we find that we will have
$2,818.50 at the end of 5 years.
FV5 = $500(1 + 0.6)4 + $500(1 + 0.6)3 + $500(1 + 0.6)2 + $500(1 + 0.6) + $500
= $500(1.262) + $500(1.191) + $500(1.124) + $500(1.060) + $500
= $631.00 + $595.50 + $562.00 + $530.00 + $500.00
= $2,818.50
By examining the mathematics involved and the graph of the movement of money
through time in Table 5-1, we can see that all we are really doing is adding up the future
values of different cash flows that initially occurred in different time periods. Fortunately,
there is also an equation that helps us calculate the future value of an annuity:
Future value of an annuity = PMT J future value factor – 1
r
R
= PMT J (1 + r)n – 1
r
R (5-3)
annuity a series of equal dollar payments
made for a specified number of years.
2 Understand annuities.
ordinary annuity an annuity where the cash
flows occur at the end of each period.
compound annuity depositing an equal
sum of money at the end of each year for a
certain number of years and allowing it to grow.
TABLE 5-1 growth of a 5-Year, $500 Annuity Compounded at 6 Percent
Y E A R 0 1 2 3 4 5
Dollar deposits at end of year 500 500 500 500 500
$ 500.00
530.00
562.00
595.50
631.00
Future value of the annuity $2,818.50
r = 6%

158 Part 2 • The Valuation of Financial Assets
To simplify our discussion, we will refer to the value in brackets in equation (5-3) as the
annuity future value factor. It is defined as J (1 + r)n – 1
r
R .
Using this new notation, we can rewrite equation (5-3) as follows:
FVn = PMT J (1 + r)n – 1r R = PMT (annuity future value factor)
Rather than asking how much we will accumulate if we deposit an equal sum in a savings
account each year, a more common question to ask is how much we must deposit each year
to accumulate a certain amount of savings. This problem frequently occurs with respect to
saving for large expenditures.
For example, if we know that we need $10,000 for college in 8 years, how much must we
deposit in the bank at the end of each year at 6 percent interest to have the college money
ready? In this case we know the values of n, r, and FVn in equation (5-3); what we do not
know is the value of PMT. Substituting these example values in equation (5-3), we find
$10,000 = PMT J (1 + 0.06)8 – 1
0.06
R
$10,000 = PMT (9.8975)

$10,000
9.8975
= PMT
$1,010.36 = PMT
annuity future value factor the value of
c (1 + r)
n – 1
r
d used as a multiplier to
calculate the future value of an annuity.
DiD you Get it?
solVinG FoR THe PResenT VAlue WiTH TWo FloWs in DiFFeRenT YeARs
There are several different ways you can solve this problem—using the mathematical formulas, a financial calculator, or a spreadsheet—
each one giving you the same answer.
1. Using the Mathematical Formula. Substituting the values of n = 5, r = 4 percent, and FV5 = $500; and n = 10, r = 4
percent, and FV10 = $1,000 into equation (5-2) and adding these values together, we find
Present value = $500J 1
(1 + 0.04)5
R + $1,000J 1
(1 + 0.04)10
R
= $500(0.822) + $1,000(0.676)
= $411 + $676 = $1,087
2. Using a Financial Calculator. Again, it is a three-step process. First calculate the present value of each cash flow individually,
and then add the present values together.
STEP 1
cAlculAToR soluTion
Data Input Function Key
5 N
4 I/Y
-500 FV
0 PMT
Function Key Answer
CPT
PV 410.96
STEP 2
cAlculAToR soluTion
Data Input Function Key
10 N
4 I/Y
-1,000 PV
0 PMT
Function Key Answer
CPT
PV 675.56
STEP 3
Add the two present values that you
just calculated together:
$ 410.96
675.56
$1,086.52
3. Using an Excel Spreadsheet. Using Excel, the cash flows are brought back to the present using the =PV function. If the future
values were entered as positive values, our answer will come out as a negative number.
cAlculAToR soluTion
Data Input Function Key
8 N
6 I/Y
-10,000 FV
0 PV
Function Key Answer
CPT
PMT 1,010.36

Chapter 5 • The Time Value of Money 159
Thus, we must deposit $1,010.36 in the bank at the end of each year for 8 years at
6 percent interest to accumulate $10,000 at the end of 8 years.
E x A M P L E 5.7 Calculating deposit amount to accumulate $5,000
How much must we deposit in an 8 percent savings account at the end of each year to
accumulate $5,000 at the end of 10 years?
sTeP 1: FoRMulATe A soluTion sTRATeGY
In order to determine the amount we must deposit, we have to use equation (5-3) as
follows:
FV = PMT c (1 + r)
n – 1
r
d (5-3)
sTeP 2: cRuncH THe nuMbeRs
Substituting into equation (5-3), we compute the future value as follows:
$5,000 = PMT c (1 + 0.06)
8 – 1
0.06
d
$5,000 = PMT (14.4866)
5,000
14.4866
= PMT = $345.15
sTeP 3: AnAlYZe YouR ResulTs
Thus, we must deposit $345.15 per year for 10 years at 8 percent to accumulate $5,000.
cAlculAToR soluTion
Data Input Function Key
10 N
8 I/Y
-5,000 FV
0 PV
Function Key Answer
CPT
PMT 345.15
The Present Value of an Annuity
Pension payments, insurance obligations, and the interest owed on bonds all involve annui-
ties. To compare these three types of investments we need to know the present value of each.
For example, if we wish to know what $500 received at the end of each of the next 5 years
is worth today given a discount rate of 6 percent, we can simply substitute the appropriate
values into equation (5-2), such that
PV = $500J 1
(1 + 0.06)1
R + $500J 1
(1 + 0.06)2
R + $500J 1
(1 + 0.06)3
R
+ $500J 1
(1 + 0.06)4
R + $500J 1
(1 + 0.06)5
R
= $500(0.943) + $500(0.890) + $500(0.840) + $500(0.792) + $500(0.747)
= $2,106
Thus, the present value of this annuity is $2,106.00. By examining the mathematics in-
volved and the graph of the movement of money through time in Table 5-2, we can see that
all we are really doing is adding up the present values of different cash flows that initially oc-
curred in different time periods. Fortunately, there is also an equation that helps us calculate
the present value of an annuity:
Present value of an annuity = PMT J1 – present value factor
r
R
= PMT J1 – (1 + r)-n
r
R (5-4)

160 Part 2 • The Valuation of Financial Assets
annuity present value factor the value of
c 1 – (1 + r)
-n
r
d used as a multiplier to
calculate the present value of an annuity
TABLE 5-2 Illustration of a 5-Year, $500 Annuity Discounted to the
Present at 6 Percent
Y E A R 0 1 2 3 4 5
Dollars received at end of year 500 500 500 500 500
$ 471.50
445.00
420.00
396.00
373.50
Present value of the annuity $2,106.00
r = 6%
To simplify our discussion, we will refer to the value in the brackets in equation (5-4) as
the annuity present value factor. It is defined as J1 – (1 + r)-n
r
R .
E x A M P L E 5.8 Calculating the present value of an annuity
What is the present value of a 10-year $1,000 annuity discounted back to the present at
5 percent?
sTeP 1: FoRMulATe A soluTion sTRATeGY
The present value of the annuity can be computed using equation (5-4) as follows:
PV = PMT c 1 – (1 + r)
– n
r
d (5-4)
sTeP 2: cRuncH THe nuMbeRs
Substituting into equation (5-4), we compute the present value as follows:
PV = $1,000 c 1 – (1 + 0.05)
– 10
0.05
d
= $1,000(7.722)
= $7,722
sTeP 3: AnAlYZe YouR ResulTs
Thus, the present value of this annuity is $7,722.
When we solve for PMT, the financial interpretation of this action would be: How
much can be withdrawn, perhaps as a pension or to make loan payments, from an ac-
count that earns r percent compounded annually for each of the next n years if we wish
to have nothing left at the end of n years? For example, if we have $5,000 in an account
earning 8 percent interest, how large of an annuity can we draw out each year if we want
nothing left at the end of 5 years? In this case the present value, PV, of the annuity is
$5,000, n = 5 years, r = 8 percent, and PMT is unknown. Substituting this into equa-
tion (5-4), we find
$5,000 = PMT J1 – (1 + 0.08)-5
0.08
R = PMT(3.993)
$1,252 = PMT
Thus, this account will fall to zero at the end of 5 years if we withdraw $1,252 at the
end of each year.
cAlculAToR soluTion
Data Input Function Key
10 N
5 I/Y
-1,000 PMT
0 PV
Function Key Answer
CPT
PV 7,722
cAlculAToR soluTion
Data Input Function Key
5 N
8 I/Y
-5,000 PV
0 FV
Function Key Answer
CPT
PMT 1,252

Chapter 5 • The Time Value of Money 161
Annuities Due
Annuities due are really just ordinary annuities in which all the annuity payments have been
shifted forward by 1 year. Compounding them and determining their future and present value
is actually quite simple. With an annuity due, each annuity payment occurs at the beginning
of each period rather than at the end of the period. Let’s first look at how this affects our
compounding calculations.
Because an annuity due merely shifts the payments from the end of the year to the
beginning of the year, we now compound the cash flows for one additional year. Therefore,
the compound sum of an annuity due is simply
annuity due an annuity in which the
payments occur at the beginning of each period.
Future value of an annuity due:
STEP 1
CALCULATOR SOLUTION
Data Input Function Key
5 N
6 I/Y
0 PV
-500 PMT
Function Key Answer
CPT
FV 2,818.55
STEP 2
$2,818.55
* 1.06
$2,987.66
Future value of an annuity due = future value of an annuity * (1 + r)
FVn(annuity due) = PMT J (1 + r)n – 1r R (1 + r) (5-5)
In an earlier example on saving for college, we calculated the value of a 5-year ordinary
annuity of $500 invested in the bank at 6 percent to be $2,818.50. If we now assume this to
be a 5-year annuity due, its future value increases from $2,818.50 to $2,987.66.
FV5 = $500J (1 + 0.06)5 – 10.06 R (1 + 0.06)
= $500(5.637093)(1.06)
= $2,987.66
Likewise, with the present value of an annuity due, we simply receive each cash flow
1 year earlier—that is, we receive it at the beginning of each year rather than at the end
of each year. Thus, because each cash flow is received 1 year earlier, it is discounted back
for one less period. To determine the present value of an annuity due, we merely need to
find the present value of an ordinary annuity and multiply that by (1 + r), which in effect
cancels out 1 year’s discounting.
Present value of an annuity due = present value of an annuity * (1 + r)
PV(annuity due) = PMT J1 – (1 + r)-n
r
R (1 + r) (5-6)
Reexamining the earlier college saving example in which we calculated the present
value of a 5-year ordinary annuity of $500 given a discount rate of 6 percent, we now find
that if it is an annuity due rather than an ordinary annuity, the present value increases from
$2,106 to $2,232.55.
Present value of an annuity due:
STEP 1
CALCULATOR SOLUTION
Data Input Function Key
5 N
6 I/Y
−500 PMT
0 FV
Function Key Answer
CPT
PV 2,106.18
STEP 2
$2,106.18
* 1.06
$2,232.55
PV = $500J1 – (1 + 0.06)-5
0.06
R (1 + 0.06)
= $500(4.21236)(1.06)
= $2,232.55
With a financial calculator, first treat it as if it were an ordinary annuity and find the future
or present value. Then multiply the present value times (1 + r), in this case times 1.06;
this is shown in the margin.
The result of all this is that both the future and present values of an annuity due are
larger than those of an ordinary annuity because in each case all payments are received
earlier. Thus, when compounding, an annuity due compounds for 1 additional year, whereas
when discounting, an annuity due discounts for 1 less year. Although annuities due are used
with some frequency in accounting, their usage is quite limited in finance. Therefore, in the
remainder of this text, whenever the term annuity is used, you should assume that we are
referring to an ordinary annuity.

162 Part 2 • The Valuation of Financial Assets
e x a m p l e 5.9 Calculating the lotto payments on $2 million
Forty-three states run lotteries and most of those lotteries are similar: You must select
6 out of 44 numbers correctly in order to win the jackpot. If you come close, there are
some significantly lesser prizes, which we ignore for now. For each million dollars in the
lottery jackpot, you receive $50,000 per year for 20 years, and your chance of winning
is 1 in 7.1 million. A recent advertisement for a particular state lottery went as follows:
“Okay, you got two kinds of people. You’ve got the kind who play Lotto all the time,
and the kind who play Lotto some of the time. You know, like only on a Saturday when
they stop in at the store on the corner for some peanut butter cups and diet soda and
the jackpot happens to be really big. I mean, my friend Ned? He’s like ‘Hey, it’s only
$2 million this week.’ Well, hellloooo, anybody home? I mean, I don’t know about you,
but I wouldn’t mind having a measly 2 mill coming my way. . . .”
What is the present value of these payments?
STEP 1: FORMULATE A SOLUTION STRATEGY
The answer to this question depends on what assumption you make about the time value
of money. In this case, let’s assume that your required rate of return on an investment
with this level of risk is 10 percent. Keeping in mind that the Lotto is an annuity due—
that is, on a $2 million lottery you would get $100,000 immediately and $100,000 at
the end of each of the next 19 years.Thus, the present value of this 20-year annuity due
discounted back to present at 10 percent becomes:
PV(annuity due) = PMT c 1 – (1 + r)
– n
r
d
STEP 2: CRUNCH THE NUMBERS
Solving this is a two-step process. In step 1, you treat the jackpot as if it were an ordinary
annuity and find the present value. Then multiply the present value times (1 + r), in this
case times 1.10.
Substituting into equation (5-6), we compute the present value as follows:
PV = $100,000 c 1 – (1 + 0.10)
– 20
0.10
d (1 + 0.10)
= $100,000(8.51356)(1.10)
= $936,492
STEP 3: ANALYZE YOUR RESULTS
Thus, the present value of the $2 million Lotto jackpot is less than $1 million if 10 percent
is the discount rate. Moreover, because the chance of winning is only 1 in 7.1 million,
the expected value of each dollar “invested” in the lottery is only (1/7.1 million) *
($936,492) = 13.19¢. That is, for every dollar you spend on the lottery you should ex-
pect to get, on average, about 13 cents back—not a particularly good deal. Although this
ignores the minor payments for coming close, it also ignores taxes. In this case, it looks
like “my friend Ned” is doing the right thing by staying clear of the lottery. Obviously,
the main value of the lottery is entertainment. Unfortunately, without an understanding
of the time value of money, it can sound like a good investment.
amortized loan a loan that is paid off in equal
periodic payments.
Present value of an annuity due:
STEP 1
CALCULATOR SOLUTION
Data Input Function Key
20 N
10 I/Y
-100,000 PMT
0 FV
Function Key Answer
CPT
PV 851,356
STEP 2
$851,356
* 1.10
$936,492
amortized loans
The procedure of solving for PMT, the annuity payment value when r, n, and PV are known,
is also used to determine what payments are associated with paying off a loan in equal
installments over time. Loans that are paid off this way, in equal periodic payments, are called
amortized loans. Actually, the word amortization comes from the Latin word meaning
“about to die.” When you pay off a loan using regular, fixed payments, that loan is am-
ortized. Although the payments are fixed, different amounts of each payment are applied

Chapter 5 • The Time Value of Money 163
toward the principal and the interest. With each payment, you owe a bit less toward the
principal. As a result, the amount that has to go toward the interest payment declines with
each payment, whereas the portion of each payment that goes toward the principal in-
creases. Figure 5-4 illustrates the process of amortization.
For example, suppose a firm wants to purchase a piece of machinery. To do this, it
borrows $6,000 to be repaid in four equal payments at the end of each of the next 4 years,
and the interest rate that is paid to the lender is 15 percent on the outstanding portion of the
loan. To determine what the annual payments associated with the repayment of this debt
will be, we simply use equation (5-4) and solve for the value of PMT, the annual annuity. In
this case, we know PV, r, and n. PV, the present value of the annuity, is $6,000; r, the annual
interest rate, is 15 percent; and n, the number of years for which the annuity will last, is
4 years. PMT, the annuity payment received (by the lender and paid by the firm) at the end
of each year, is unknown. Substituting these values into equation (5-4), we find
cAlculAToR soluTion
Data Input Function Key
4 N
15 I/Y
-6,000 PV
0 FV
Function Key Answer
CPT
PMT 2,101.59
FIgURE 5-4 The Amortization Process
Part of each
payment related
to principal
Part of each
payment related
to interest
In early years, a larger
proportion of each payment
goes toward interest. This
amount declines over time.
In later years, a greater
proportion of each payment
goes toward repayment of
the principal.
Fixed payment
Number of payments
1 2 3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . n
$6,000 = PMT J1 – (1 + 0.15)-4
0.15
R
$6,000 = PMT(2.85498)
$2,101.59 = PMT
To repay the principal and interest on the outstanding loan in 4 years, the annual payments
would be $2,101.59. The breakdown of interest and principal payments is given in the loan
amortization schedule in Table 5-3, with very minor rounding error. As you can see, the interest
portion of the payment declines each year as the loan outstanding balance declines.
TABLE 5-3 Loan Amortization Schedule Involving a $6,000 Loan
at 15 Percent to Be Repaid in 4 Years
aThe interest portion of the annuity is calculated by multiplying the outstanding loan balance at the beginning of the year by the interest rate of
15 percent. Thus, for year 1 it was $6,000 * 0.15 = $900.00, for year 2 it was $4,798.41 * 0.15 = $719.76, and so on.
bRepayment of the principal portion of the annuity was calculated by subtracting the interest portion of the annuity (column 2) from the annuity
(column 1).
Year Annuity
Interest Portion
of the
Annuitya
Repayment
of the principal
Portion of
the Annuityb
Outstanding
Loan Balance
After the Annuity
Payment
0 0 0 0 $6,000.00
1 $2,101.59 $900.00 $1,201.59 4,798.41
2 2,101.59 719.76 1,381.83 3,416.58
3 2,101.59 512.49 1,589.10 1,827.48
4 2,101.59 274.12 1,827.48

164 Part 2 • The Valuation of Financial Assets
Now let’s use a spreadsheet to look at a loan amortization problem and calculate the
monthly mortgage payment, and then determine how much of a specific payment goes
toward interest and principal.
To buy a new house you take out a 25-year mortgage for $100,000. What will your
monthly payments be if the interest rate on your mortgage is 8 percent? To solve this
problem, you must first convert the annual rate of 8 percent into a monthly rate by dividing
it by 12. Second, you have to convert the number of periods into months by multiplying
25 years times 12 months per year for a total of 300 months. We’ll look at this process in
more detail in the next section.
C A LC U L AT I O N F U N C T I O N
Interest portion of payment = IPMT(rate, per, nper, pv, fv)
Principal portion of payment
where per refers to the number of an individual periodic payment
= PPMT(rate, per, nper, pv, fv)
You can also use Excel to calculate the interest and principal portion of any loan amortiza-
tion payment. You can do this using the following Excel functions:
For this example, you can determine how much of the 48th monthly payment goes toward
interest and principal as follows,
Concept Check
1. What is an amortized loan?
2. What functions in Excel help determine the amount of interest and principal in a mortgage
payment?

Chapter 5 • The Time Value of Money 165
3 Determine the future or
present value of a sum when
there are nonannual
compounding periods.
effective annual rate (EAR) the annual
compound rate that produces the same return as
the nominal, or quoted, rate when something is
compounded on a nonannual basis. In effect, the
EAR provides the true rate of return.
Making Interest Rates Comparable
In order to make intelligent decisions about where to invest or borrow money, it is im-
portant that we make the stated interest rates comparable. Unfortunately, some rates are
quoted as compounded annually, whereas others are quoted as compounded quarterly or
compounded daily. But it is not fair to compare interest rates with different compounding
periods to each other. Thus, the only way interest rates can logically be compared is to
convert them to a common compounding period.
In order to understand the process of making different interest rates comparable, it
is first necessary to define the nominal, or quoted, interest rate. The nominal, or quot-
ed, rate is the rate of interest stated on the contract. For example, if you shop around
for loans and are quoted 8 percent compounded annually and 7.85 percent compounded
quarterly, then 8 percent and 7.85 percent would both be nominal rates. Unfortunately,
because on one rate the interest is compounded annually, but on the other interest is
compounded quarterly, the two rates are not comparable. In fact, it is never appropri-
ate to compare nominal rates unless they include the same number of compounding
periods per year. To make them comparable, we must calculate their equivalent rate at
some common compounding period. We do this by calculating the effective annual
rate (EAR). This is the annual compound rate that produces the same return as the nominal
or quoted rate.
Let’s assume that you are considering borrowing money from a bank at 12 percent
compounded monthly. If you borrow $1 at 1 percent per month for 12 months you’d
owe,
$1.00(1.01)12 = $1.126825
In effect, you are borrowing at 12.6825 percent rather than just by 12 percent. Thus, the
EAR for 12 percent compounded monthly is 12.6825. It tells us the annual rate that would
produce the same loan payments as the nominal rate. In other words, you’ll end up with
the same monthly payments if you borrow at 12.6825 percent compounded annually or
12 percent compounded monthly. Thus, 12.6825 is the effective annual rate (EAR) for
12 percent compounded monthly.
Generalizing on this process, we can calculate the EAR using the following equation:
EAR = ¢1 + quoted rate
m
≤m – 1 (5-7)
where EAR is the effective annual rate and m is the number of compounding periods within
a year. Given the wide variety of compounding periods used by businesses and banks, it
is important to know how to make these rates comparable so that logical decisions can
be made.
E x A M P L E 5.10 Calculating the EAR on a credit card
You’ve just received your first credit card and the problem is the rate. It looks pretty high
to you. The quoted rate is 21.7 percent, and when you look closer, you notice that the
interest is compounded daily. What’s the EAR, or effective annual rate, on your credit
card?
sTeP 1: FoRMulATe A soluTion sTRATeGY
To calculate the EAR we can use equation (5-7) as follows:
EAR = c1 + quoted rate
m
d
m
– 1

166 Part 2 • The Valuation of Financial Assets
sTeP 2: cRuncH THe nuMbeRs
Substituting into equation (5-7), we compute the EAR as follows:
EAR = c1 + 0.217
365
d
365
– 1
EAR = 1.242264 – 1 = 0.242264, or 24.2264 percent.
sTeP 3: AnAlYZe YouR ResulTs
Thus, in reality, the effective annual rate is actually 24.2264 percent.
Finding Present and Future Values with Nonannual Periods
The same logic that applies to calculating the EAR also applies to calculating present and
future values when the periods are semiannual, quarterly, or any other nonannual period.
Previously when we moved money through time we assumed that the cash flows occurred
annually and the compounding or discounting period was always annual. However, it need
not be, as evidenced by the fact that bonds generally pay interest semiannually and most
mortgages require monthly payments.
For example, if we invest our money for 5 years at 8 percent interest compounded
semiannually, we are really investing our money for ten 6-month periods during which we
receive 4 percent interest each period. If it is 8 percent compounded quarterly for 5 years,
we receive 2 percent interest per period for twenty 3-month periods. This process can easily
be generalized, giving us the following formula for finding the future value of an investment
for which interest is compounded in nonannual periods:
FVn = PV J1 + rm Rm #n
where FVn = the future value of the investment at the end of n years
n = the number of years during which the compounding occurs
r = annual interest (or discount) rate
PV = the present value or original amount invested at the beginning of the first year
m = the number of times compounding occurs during the year
In fact, all the formulas for moving money through time can be easily modified to accom-
modate nonannual periods. In each case, we begin with the formulas we introduced in this
chapter, and make two adjustments—the first where n, the number of years, appears, and
the second where r, the annual interest rate, appears. Thus, the adjustment involves two
steps:
◆ n becomes the number of periods or n (the number of years) times m (the number of
times compounding occurs per year). Thus, if it is monthly compounding for 10 years,
n becomes 10 * 12 = 120 months in 10 years, and if it is daily compounding over
10 years, it becomes 10 * 365 = 3,650 days in 10 years.
Can you Do it?
HoW MucH cAn You AFFoRD To sPenD on A House?
An AMoRTiZeD loAn WiTH MonTHlY PAYMenTs
You’ve been house shopping and aren’t sure how big a house you can afford. You figure you can handle monthly mortgage payments
of $1,250 and you can get a 30-year loan at 6.5 percent. How big of a mortgage can you afford? In this problem, you are solving for PV,
which is the amount of money you can borrow today.
(The solution can be found on page 168.)

Chapter 5 • The Time Value of Money 167
◆ r becomes the interest rate per period or r (the annual interest rate) divided by m (the
number of times compounding occurs per year). Thus, if it is a 6 percent annual rate
with monthly compounding, r becomes 6% , 12 = 0.5 percent per month, and if it
is a 6 percent annual rate compounded daily, then r becomes (6% , 365) per day.
We can see the value of intrayear compounding by examining Table 5-4. Because “in-
terest is earned on interest” more frequently as the length of the compounding period de-
clines, there is an inverse relationship between the length of the compounding period and
the effective annual interest rate: The shorter the compounding period is, the higher the
effective interest rate will be. Conversely, the longer the compounding period is, the lower
the effective interest rate will be.
E x A M P l E 5.11 Calculating the growth of an investment
If we place $100 in a savings account that yields 12 percent compounded quarterly, what
will our investment grow to at the end of 5 years?
STEP 1: FORMULATE A SOLUTION STRATEGY
The future value of our savings account can be computed using equation (5-8) as follows:
Future value = present value * a1 + r
m
b
m~n
STEP 2: CRUNCH THE NUMBERS
Substituting into equation (5-8), we compute the future value as follows:
FV = $100 a1 + 0.12
4
b
4 #5
= $100(1.8061) = $180.61
STEP 3: ANALYZE YOUR RESULTS
Thus, we will have $180.61 at the end of 5 years. In this problem, n becomes the
number of quarters in 5 years while r/m becomes the interest rate per period—in effect,
3 percent per quarter for 20 quarters.
TAblE 5-4 The Value of $100 Compounded at Various Intervals
FOR 1 YEAR AT r PERCENT
r = 2% 5% 10% 15%
Compounded annually $102.00 $105.00 $110.00 $115.00
Compounded semiannually 102.01 105.06 110.25 115.56
Compounded quarterly 102.02 105.09 110.38 115.87
Compounded monthly 102.02 105.12 110.47 116.08
Compounded weekly (52) 102.02 105.12 110.51 116.16
Compounded daily (365) 102.02 105.13 110.52 116.18
FOR 10 YEARS AT r PERCENT
r = 2% 5% 10% 15%
Compounded annually $121.90 $162.89 $259.37 $404.56
Compounded semiannually 122.02 163.86 265.33 424.79
Compounded quarterly 122.08 164.36 268.51 436.04
Compounded monthly 122.10 164.70 270.70 444.02
Compounded weekly (52) 122.14 164.83 271.57 447.20
Compounded daily (365) 122.14 164.87 271.79 448.03
CALCULATOR SOLUTION
Data Input Function Key
20 N
12/4 I/Y
100 PV
0 PMT
Function Key Answer
CPT
FV -180.61

168 Part 2 • The Valuation of Financial Assets
DiD You Get it?
HOW MUCH CAN YOU AFFORD TO SPEND ON A HOUSE?
AN AMORTIZED LOAN WITH MONTHLY PAYMENTS
There are several different ways you can solve this problem—
using the mathematical formulas, a financial calculator, or a
spreadsheet—each one giving you the same answer.
1. Using the Mathematical Formulas. Again, you need to
multiply n times m and divide r by m, where m is the number
of compounding periods per year. Thus,
PV = $1,250
1 –
1
a1 + 0.065
12
b
30 #12
0.065
12
PV = $1,250£ 1 –
1
(1 + 0.00541667)360
0.00541667
§
PV = $1,250£ 1 –
1
6.99179797
0.00541667
§
PV = $1,250(158.210816)
PV = $197,763.52
2. Using a Financial Calculator. First, you must convert every-
thing to months. To do this you would first convert n into
months by multiplying n times m (30 times 12) and enter this
into N . Next you would enter the interest rate as a monthly
rate by dividing r by m and entering this number into I/Y .
Finally, make sure that the value entered as PMT is a
monthly figure, that is, it is the monthly payment value.
CALCULATOR SOLUTION
Data Input Function Key
360 N
6.5/12 I/Y
-1,250 PMT
0 FV
Function Key Answer
CPT
PV 197,763.52
3. Using an Excel Spreadsheet.
CALCULATOR SOLUTION
Data Input Function Key
13.0/12 I/Y
10,000 PV
-400 PMT
0 FV
Function Key Answer
CPT
N 29.3
E x a M p l E 5.12 Calculating the future value of an investment
In 2009 the average U.S. household owed about $10,000 in credit card debt, and the
average interest rate on credit card debt was 13.0 percent. On many credit cards the
minimum monthly payment is 4 percent of the debt balance. If the average household
paid off 4 percent of the initial amount it owed each month, that is, made payments of
$400 each month, how many months would it take to repay this credit card debt? Use a
financial calculator to solve this problem.
STEP 1: FORMULATE A SOLUTION STRATEGY
The easiest approach here is to either use your financial calculator or use Excel to solve
for N, the number of periods. Using Excel, you would simply use the =NpEr function
and input values for rate, pmt, pv, and fv. Using your financial calculator, you would
simply solve for N; however, you’ll need to make sure that I/Y is expressed as a monthly
rate because you are solving for the number of months necessary to repay the credit card.
STEP 2: CRUNCH THE NUMBERS
The solution, using a financial calculator, appears in the margin. You’ll notice in the
solution that the value for pMT goes in as a negative.

Chapter 5 • The Time Value of Money 169
Concept Check
1. Why does the future value of a given amount increase when interest is compounded nonannually
as opposed to annually?
2. How do you adjust the present- and future-value formulas when interest is compounded monthly?
The Present Value of an Uneven
Stream and Perpetuities
Although some projects will involve a single cash flow and some will involve annuities, many
projects will involve uneven cash flows over several years. Chapter 10, which examines in-
vestments in fixed assets, presents this situation repeatedly. There we will be comparing not
only the present value of cash flows generated by different projects but also the cash inflows
and outflows generated by a particular project to determine that project’s present value.
However, this will not be difficult because the present value of any cash flow is measured in
today’s dollars and thus can be compared, through addition for inflows and subtraction for
outflows, to the present value of any other cash flow also measured in today’s dollars. For
example, if we wished to find the present value of the following cash flows
4 Determine the present value of
an uneven stream of payments
and understand perpetuities.
STEP 3: ANALYZE YOUR RESULTS
The answer is over 29 months before you pay off your credit card if you pay off 4 percent
of the initial amount owed each month—obviously, if you keep using the credit card, it
will take longer.
given a 6 percent discount rate, we would merely discount the flows back to the present and total
them by adding in the positive flows and subtracting the negative ones. However, this problem
is complicated by the annuity of $500 that runs from years 4 through 10. To accommodate this,
we can first discount the annuity back to the beginning of period 4 (or end of period 3) and get
its present value at that point in time. We then bring this single cash flow (which is the present
value of the 7-year annuity) back to the present. In effect, we discount twice, first back to the end
of period 3, then back to the present. This is shown graphically in Table 5-5 and numerically in
Table 5-6. Thus, the present value of this uneven stream of cash flows is $2,185.69.
Table 5-5 The Present Value of an Uneven Stream Involving One
annuity Discounted to the Present at 6 Percent: an example
Y E A R 0 1 2 3 4 5 6 7 8 9 1 0
Dollars received 0 200 −400 500 500 500 500 500 500 500
at end of year
$ 178.00
−335.85
$2,791.19
2,343.54
Total present value $2,185.69
r = 6%
STEP 1
Bring the $200 at the end of year 2
back to present:
CALCULATOR SOLUTION
Data Input Function Key
2 N
6 I/Y
200 FV
0 PMT
Function Key Answer
CPT
PV -178.00
STEP 2
Bring the negative $400 at the end of
year 3 back to present:
CALCULATOR SOLUTION
Data Input Function Key
3 N
6 I/Y
0 PMT
-400 FV
Function Key Answer
CPT
PV 335.85
STEP 3
Bring the 7-year, $500 annuity
beginning at the end of year 4 back
to the beginning of year 4, which is
the same as the end of year 3:
CALCULATOR SOLUTION
Data Input Function Key
7 N
6 I/Y
500 PMT
0 FV
Function Key Answer
CPT
PV -2,791.19
Y e a R C a S H F lO W Y e a R C a S H F lO W
1 $ 0 6 500
2 200 7 500
3 -400 8 500
4 500 9 500
5 500 10 500

170 Part 2 • The Valuation of Financial Assets
Remember, once the cash flows from an investment have been brought back to the
present, they can be combined by adding and subtracting to determine the project’s total
present value.
Concept Check
1. How would you calculate the present value of an investment that produced cash flows of $100
received at the end of year 1 and $700 at the end of year 2?
Perpetuities
A perpetuity is an annuity that continues forever; that is, every year following its establish-
ment this investment pays the same dollar amount. An example of a perpetuity is preferred
stock that pays a constant dollar dividend infinitely. Determining the present value of a
perpetuity is delightfully simple; we merely need to divide the constant flow by the discount
rate. For example, the present value of a $100 perpetuity discounted back to the present at
5 percent is $100/0.05 = $2,000. Thus, the equation representing the present value of a
perpetuity is
PV =
PP
r
(5-9)
where: PV = the present value of the perpetuity
PP = the constant dollar amount provided by the perpetuity
r = the annual interest (or discount) rate
E x A M P L E 5.13 Calculating the future value of an investment
What is the present value of a $500 perpetuity discounted back to the present at
8 percent?
sTeP 1: FoRMulATe A soluTion sTRATeGY
The present value of the perpetuity can be calculated using equation (5-9) as follows:
PV =
PP
r
sTeP 2: cRuncH THe nuMbeRs
Substituting PP = $500 and r = 0.08 into equation (5-9), we find
PV =
$500
0.08
= $6, 250
sTeP 3: AnAlYZe YouR ResulTs
Thus, the present value of this perpetuity is $6,250.
TABLE 5-6 Determining the Present Value of an Uneven Stream Involving
One Annuity Discounted to the Present at 6 Percent: An Example
1. Present value of $200 received at the end of 2 years at 6% = $ 178.00
2 Present value of a $400 outflow at the end of 3 years at 6% = -335.85
3. (a) Value at end of year 3 of a $500 annuity, years 4–10 at 6% = $2,791.19
( b) Present value of $2,791.19 received at the end of year 3 at 6% =

2,343.54
4. Total present value = $2,185.69
STEP 4
Bring the value we just calculated,
which is the value of the 7-year
annuity of $500 at the end of
year 3, back to present.
cAlculAToR soluTion
Data Input Function Key
3 N
6 I/Y
2,791.19 FV
0 PMT
Function Key Answer
CPT
PV -2,343.54
STEP 5
Add the present value of the cash
inflows and subtract the present
value of the cash outflow (the $400
from the end of year 3) calculated in
steps 1, 2, and 4.
$ 178.00
-335.85
+2,343.54
$ 2,185.69
perpetuity an annuity with an infinite life.

Chapter 5 • The Time Value of Money 171
Concept Check
1. What is a perpetuity?
2. When r, the annual interest (or discount) rate, increases, what happens to the present value of a
perpetuity? Why?
Table 5-7 Summary of Time Value of Money equations
Calculation equation
Future value of a single payment FVn = PV (1 + r)n
Present value of a single payment PV = FVn J 1(1 + r )n R
Future value of an annuity FV of an annuity = PMT J (1 + r)n – 1
r
R
Present value of an annuity PV of an annuity = PMT J1 – (1 + r)-n
r
R
Future value of an annuity due FVn (annuity due) = future value of an annuity * (1 + r)
Present value of an annuity due PV (annuity due) = present value of an annuity * (1 + r)
Effective annual return (EAR) = c1 + quoted rate
m
d
m
– 1
Future value of a single payment with
nonannual compounding
FVn = PV ¢1 + rm ≤mn
Present value of a perpetuity PV =
PP
r
Notations: FVn = the future value of the investment at the end of n years
n = the number of years until payment will be received or during which compounding occurs
r = the annual interest or discount rate
PV = the present value of the future sum of money
m = the number of times compounding occurs during the year
PMT = the annuity payment deposited or received at the end of each year
PP = the constant dollar amount provided by the perpetuity
Chapter Summaries
explain the mechanics of compounding and bringing the value of money
back to the present. (pgs. 143–157)
SuMMary: Compound interest occurs when interest paid on an investment during the first pe-
riod is added to the principal; then, during the second period, interest is earned on this new sum.
The formula for this appears in Table 5-7.
Although there are several ways to move money through time, they all give you the same result. In
the business world, the primary method is through the use of a financial spreadsheet, with Excel
being the most popular. If you can use a financial calculator, you can easily apply your skills to a
spreadsheet.
Actually, we have only one formula with which to calculate both present value and future
value—we simply solve for different variables—FV and PV. This single compounding formula is
FVn = PV(1 + r)n and is presented in Table 5-7.
1

172 Part 2 • The Valuation of Financial Assets
Key Terms
Key equaTions
Future value at the end of year n = present value * (1 + r)n
Present value = future value at the end of year n *
1
(1 + r)n
understand annuities. (pgs. 157–164)
summary: An annuity is a series of equal payments made for a specified number of years. In
effect, it is calculated as the sum of the present or future value of the individual cash flows over the
life of the annuity. The formula for an annuity due is given in Table 5-7.
If the cash flows from an annuity occur at the end of each period, the annuity is referred to
as an ordinary annuity. If the cash flows occur at the beginning of each period, the annuity is
referred to as an annuity due. We will assume that cash flows occur at the end of each period
unless otherwise stated.
The procedure for solving for PMT, the annuity payment value when i, n, and PV are known,
is also used to determine what payments are associated with paying off a loan in equal in-
stallments over time. Loans that are paid off this way, in equal periodic payments, are called
amortized loans. Although the payments are fixed, different amounts of each payment are
applied toward the principal and the interest. With each payment you make, you owe a bit
less on the principal. As a result, the amount that goes toward the interest payment declines
with each payment made, whereas the portion of each payment that goes toward the principal
increases.
Key Terms
2
Annuity, page 157 A series of equal dollar
payments made for a specified number of years.
Ordinary annuity, page 157 An annuity
where the cash flows occur at the end of each
period.
Compound annuity, page 157 Depositing an
equal sum of money at the end of each year for a
certain number of years and allowing it to grow.
Annuity future value factor, page 158 The
value of c (1 + r)
n – 1
r
d used as a multiplier to
calculate the future value of an annuity.
Annuity present value factor, page 160 The
value of c 1 – (1 + r)
-n
r
d used as a multiplier
to calculate the present value of an annuity.
Annuity due, page 161 An annuity in which
the payments occur at the beginning of each
period.
Amortized loan, page 162 A loan that is paid
off in equal periodic payments.
Compound interest, page 144 The situation
in which interest paid on an investment
during the first period is added to the principal.
During the second period, interest is earned on
the original principal plus the interest earned
during the first period.
Future value, page 145 The amount to
which your investment will grow, or a future
dollar amount.
Future value factor, page 145 The value
of (1 + r)n used as a multiple to calculate an
amount’s future value.
Simple interest, page 146 If you only earned
interest on your initial investment, it would be
referred to as simple interest.
Present value, page 153 The value in today’s
dollars of a future payment discounted back to
present at the required rate of return.
Present value factor, page 153 The value of
1
(1 + r)n
used as a multiplier to calculate an
amount’s present value.

Chapter 5 • The Time Value of Money 173
Key equaTions
Future value of an annuity = PMT c (1 + r)
n – 1
r
d
Present value of an annuity = PMT
£ 1 –
1
(1 + r)n
r
§
Future value of an annuity due = PMT c (1 + r)
n – 1
r
d * (1 + r)
Present value of an annuity = PMT
£ 1 –
1
(1 + r)n
r
§
* (1 + r)
Determine the future or present value of a sum when there are nonannual
compounding periods. (pgs. 165–169)
summary: With nonannual compounding, interest is earned on interest more frequently
because the length of the compounding period is shorter. As a result, there is an inverse rela-
tionship between the length of the compounding period and the effective annual interest rate.
The formula for solving for the future value of a single payment with nonannual compounding
is given in Table 5-7.
Key Term
3
Key equaTions
Effective annual rate (EAR) = a1 + quoted rate
m
b
m
– 1
FVn = PV c1 + rm d
m # n
Determine the present value of an uneven stream of payments and
understand perpetuities. (pgs. 169–171)
summary: Although some projects will involve a single cash flow and some will involve annuities,
many projects will involve uneven cash flows over several years. However, finding the present or
future value of these flows is not difficult because the present value of any cash flow measured in
today’s dollars can be compared, by adding the inflows and subtracting the outflows, to the present
value of any other cash flow also measured in today’s dollars.
A perpetuity is an annuity that continues forever; that is, every year following its establishment
the investment pays the same dollar amount. An example of a perpetuity is preferred stock,
which pays a constant dollar dividend infinitely. Determining the present value of a perpetuity
is delightfully simple. We merely need to divide the constant flow by the discount rate.
Key Term
Perpetuity, page 170 An annuity with
an infinite life.
Key equaTion
Present value of a perpetuity =
constant dollar amount provided by the perpetuity
r
4
Effective annual rate (EAR), page 165 The
annual compound rate that produces the same
return as the nominal, or quoted, rate when
something is compounded on a nonannual
basis. In effect, the EAR provides the true rate
of return.

174 Part 2 • The Valuation of Financial Assets
Review Questions
All Review Questions are available in MyFinanceLab.
5-1. What is the time value of money? Why is it so important?
5-2. The process of discounting and compounding are related. Explain this relationship.
5-3. How would an increase in the interest rate (r) or a decrease in the holding period (n) affect the
future value (FVn) of a sum of money? Explain why.
5-4. Suppose you were considering depositing your savings in one of three banks, all of which pay
5 percent interest; bank A compounds annually, bank B compounds semiannually, and bank C
compounds daily. Which bank would you choose? Why?
5-5. What is an annuity? Give some examples of annuities. Distinguish between an annuity and a
perpetuity.
5-6. Compare some of the different financial calculators that are available on the Internet. Look
at www.dinkytown.net, www.bankrate.com/calculators.aspx, and www.interest.com/calculators.
Which financial calculators do you find to be the most useful? Why?
Study Problems
All Study Problems are available in MyFinanceLab.
5-1. (Compound interest) To what amount will the following investments accumulate?
a. $5,000 invested for 10 years at 10 percent compounded annually
b. $8,000 invested for 7 years at 8 percent compounded annually
c. $775 invested for 12 years at 12 percent compounded annually
d. $21,000 invested for 5 years at 5 percent compounded annually
5-2. (Compound value solving for n) How many years will the following take?
a. $500 to grow to $1,039.50 if invested at 5 percent compounded annually
b. $35 to grow to $53.87 if invested at 9 percent compounded annually
c. $100 to grow to $298.60 if invested at 20 percent compounded annually
d. $53 to grow to $78.76 if invested at 2 percent compounded annually
5-3. (Compound value solving for r) At what annual rate would the following have to be invested?
a. $500 to grow to $1,948.00 in 12 years
b. $300 to grow to $422.10 in 7 years
c. $50 to grow to $280.20 in 20 years
d. $200 to grow to $497.60 in 5 years
5-4. (Present value) What is the present value of the following future amounts?
a. $800 to be received 10 years from now discounted back to the present at 10 percent
b. $300 to be received 5 years from now discounted back to the present at 5 percent
c. $1,000 to be received 8 years from now discounted back to the present at 3 percent
d. $1,000 to be received 8 years from now discounted back to the present at 20 percent
5-5. (Compound value) Stanford Simmons, who recently sold his Porsche, placed $10,000 in a sav-
ings account paying annual compound interest of 6 percent.
a. Calculate the amount of money that will have accrued if he leaves the money in the bank
for 1, 5, and 15 years.
b. If he moves his money into an account that pays 8 percent or one that pays 10 percent,
rework part (a) using these new interest rates.
c. What conclusions can you draw about the relationship between interest rates, time, and
future sums from the calculations you have completed in this problem?
5-6. (Future value) Sarah Wiggum would like to make a single investment and have $2 million
at the time of her retirement in 35 years. She has found a mutual fund that will earn 4 percent
annually. How much will Sarah have to invest today? What if Sarah were a finance major and
learned how to earn a 14 percent annual return, how much would she have to invest today?
5-7. (Future value) Sales of a new finance book were 15,000 copies this year and were expected to
increase by 20 percent per year. What are expected sales during each of the next 3 years? Graph
this sales trend and explain.
1

www.dinkytown.net

www.bankrate.com/calculators.aspx

www.interest.com/calculators

Chapter 5 • The Time Value of Money 175
5-8. (Future value) Albert Pujols hit 47 home runs in 2009. If his home-run output grew at a rate of
12 percent per year, what would it have been over the following 5 years?
5-9. (Solving for r in compound interest) If you were offered $1,079.50 10 years from now in return
for an investment of $500 currently, what annual rate of interest would you earn if you took the
offer?
5-10. (Solving for r in compound interest) You lend a friend $10,000, for which your friend will repay
you $27,027 at the end of 5 years. What interest rate are you charging your “friend”?
5-11. (Present-value comparison) You are offered $1,000 today, $10,000 in 12 years, or $25,000 in
25 years. Assuming that you can earn 11 percent on your money, which should you choose?
5-12. (Solving for r in compound interest—financial calculator needed) In September 1963, the first
issue of the comic book X-MEN was issued. The original price for that issue was $0.12. By
September 2013, 50 years later, the value of the near-mint copy of this comic book had risen to
$33,000. What annual rate of interest would you have earned if you had bought the comic in 1963
and sold it in 2013?
5-13. (Compounding using a calculator) Bart Simpson, age 10, wants to be able to buy a really cool
new car when he turns 16. His really cool car costs $15,000 today, and its cost is expected to in-
crease 3 percent annually. Bart wants to make one deposit today (he can sell his mint-condition
original Nuclear Boy comic book) into an account paying 7.5 percent annually in order to buy his
car in 6 years. How much will Bart’s car cost, and how much does Bart have to save today in order
to buy this car at age 16?
5-14. (Compounding using a calculator) Lisa Simpson wants to have $1 million in 45 years by making
equal annual end-of-the-year deposits into a tax-deferred account paying 8.75 percent annually.
What must Lisa’s annual deposit be?
5-15. (Future value) Bob Terwilliger received $12,345 for his services as financial consultant to the
mayor’s office of his hometown of Springfield. Bob says that his consulting work was his civic duty
and that he should not receive any compensation. So, he has invested his paycheck into an account
paying 3.98 percent annual interest and left the account in his will to the city of Springfield on the
condition that the city could not collect any money from the account for 200 years. How much
money will the city receive from Bob’s generosity in 200 years?
5-16. (Solving for r) Kirk Van Houten, who has been married for 23 years, would like to buy his
wife an expensive diamond ring with a platinum setting on their 30-year wedding anniversary. As-
sume that the cost of the ring will be $12,000 in 7 years. Kirk currently has $4,510 to invest. What
annual rate of return must Kirk earn on his investment to accumulate enough money to pay for
the ring?
5-17. (Solving for n) Jack asked Jill to marry him, and she has accepted under one condition: Jack
must buy her a new $330,000 Rolls-Royce Phantom. Jack currently has $45,530 that he may invest.
He has found a mutual fund that pays 4.5% annual interest in which he will place the money. How
long will it take Jack to win Jill’s hand in marriage?
5-18. (Present value) Ronen Consulting has just realized an accounting error which has resulted in
an unfunded liability of $398,930 due in 28 years. Toni Flanders, the company’s CEO, is scram-
bling to discount the liability to the present to assist in valuing the firm’s stock. If the appropriate
discount rate is 7 percent, what is the present value of the liability?
5-19. (Future value) Selma and Patty Bouvier are twins and both work at the Springfield DMV. Selma
and Patty Bouvier decide to save for retirement, which is 35 years away. They’ll both receive an 8 per-
cent annual return on their investment over the next 35 years. Selma invests $2,000 per year at the end
of each year only for the first 10 years of the 35-year period—for a total of $20,000 saved. Patty doesn’t
start saving for 10 years and then saves $2,000 per year at the end of each year for the remaining 25
years—for a total of $50,000 saved. How much will each of them have when they retire?
5-20. (Compound annuity) What is the accumulated sum of each of the following streams of
payments?
a. $500 a year for 10 years compounded annually at 5 percent
b. $100 a year for 5 years compounded annually at 10 percent
c. $35 a year for 7 years compounded annually at 7 percent
d. $25 a year for 3 years compounded annually at 2 percent
5-21. (Present value of an annuity) What is the present value of the following annuities?
a. $2,500 a year for 10 years discounted back to the present at 7 percent
b. $70 a year for 3 years discounted back to the present at 3 percent
2

176 Part 2 • The Valuation of Financial Assets
c. $280 a year for 7 years discounted back to the present at 6 percent
d. $500 a year for 10 years discounted back to the present at 10 percent
5-22. (Solving for r with annuities) Nicki Johnson, a sophomore mechanical engineering student,
receives a call from an insurance agent, who believes that Nicki is an older woman ready to retire
from teaching. He talks to her about several annuities that she could buy that would guarantee her
an annual fixed income. The annuities are as follows:
A N N U I T Y
I N I T I A l
PAYM E N T I N TO
A N N U I T Y
( AT t = 0 )
A M O U N T O F
M O N E Y
R E C E I V E D P E R
Y E A R
D U R AT I O N
O F A N N U I T Y
( Y E A R S )
A $50,000 $8,500 12
B $60,000 $7,000 25
C $70,000 $8,000 20
If Nicki could earn 11 percent on her money by placing it in a savings account, should she place it
instead in any of the annuities? Which ones, if any? Why?
5-23. (Loan amortization) Mr. Bill S. Preston, Esq., purchased a new house for $80,000. He
paid $20,000 down and agreed to pay the rest over the next 25 years in 25 equal end-of-year
payments plus 9 percent compound interest on the unpaid balance. What will these equal
payments be?
5-24. (Solving for PMT of an annuity) To pay for your child’s education, you wish to have accumu-
lated $15,000 at the end of 15 years. To do this you plan on depositing an equal amount into the
bank at the end of each year. If the bank is willing to pay 6 percent compounded annually, how
much must you deposit each year to reach your goal?
5-25. (Future value of an annuity) In 10 years you are planning on retiring and buying a house in
Oviedo, Florida. The house you are looking at currently costs $100,000 and is expected to increase
in value each year at a rate of 5 percent. Assuming you can earn 10 percent annually on your invest-
ments, how much must you invest at the end of each of the next 10 years to be able to buy your
dream home when you retire?
5-26. (Compound value) The Aggarwal Corporation needs to save $10 million to retire a
$10 million mortgage that matures in 10 years. To retire this mortgage, the company plans to put a
fixed amount into an account at the end of each year for 10 years, with the first payment occurring
at the end of 1 year. The Aggarwal Corporation expects to earn 9 percent annually on the money
in this account. What equal annual contribution must it make to this account to accumulate the
$10 million in 10 years?
5-27. (Loan amortization) On December 31, Beth Klemkosky bought a yacht for $50,000, paying
$10,000 down and agreeing to pay the balance in 10 equal end-of-year installments and 10 percent
interest on the declining balance. How big would the annual payments be?
5-28. (Solving for r of an annuity) You lend a friend $30,000, which your friend will repay in five
equal annual end-of-year payments of $10,000, with the first payment to be received 1 year from
now. What rate of return does your loan receive?
5-29. (Loan amortization) A firm borrows $25,000 from the bank at 12 percent compounded annu-
ally to purchase some new machinery. This loan is to be repaid in equal installments at the end of
each year over the next 5 years. How much will each annual payment be?
5-30. (Compound annuity) You plan on buying some property in Florida 5 years from today.
To do this you estimate that you will need $20,000 at that time for the purchase. You would
like to accumulate these funds by making equal annual deposits in your savings account, which
pays 12 percent annually. If you make your first deposit at the end of this year, and you would
like your account to reach $20,000 when the final deposit is made, what will be the amount of
your deposits?
5-31. (Loan amortization) On December 31, Son-Nan Chen borrowed $100,000, agreeing to repay
this sum in 20 equal end-of-year installments and 15 percent interest on the declining balance.
How large must the annual payments be?

Chapter 5 • The Time Value of Money 177
5-32. (Loan amortization) To buy a new house you must borrow $150,000. To do this you take out
a $150,000, 30-year, 10 percent mortgage. Your mortgage payments, which are made at the end of
each year (one payment each year), include both principal and 10 percent interest on the declining
balance. How large will your annual payments be?
5-33. (Spreadsheet problem) If you invest $900 in a bank in which it will earn 8 percent compounded
annually, how much will it be worth at the end of 7 years? Use a spreadsheet to do your calculations.
5-34. (Spreadsheet problem) In 20 years you’d like to have $250,000 to buy a vacation home, but
you have only $30,000. At what rate must your $30,000 be compounded annually for it to grow to
$250,000 in 20 years? Use a spreadsheet to calculate your answer.
5-35. (Compounding using a calculator and annuities due) Springfield mogul Montgomery Burns, age
80, wants to retire at age 100 in order to steal candy from babies full time. Once Mr. Burns retires,
he wants to withdraw $1 billion at the beginning of each year for 10 years from a special offshore
account that will pay 20 percent annually. In order to fund his retirement, Mr. Burns will make 20
equal end-of-the-year deposits in this same special account that will pay 20 percent annually. How
much money will Mr. Burns need at age 100, and how large of an annual deposit must he make to
fund this retirement account?
5-36. (Compounding using a calculator and annuities due) Imagine Homer Simpson actually invested
$100,000 5 years ago at a 7.5 percent annual interest rate. If he invests an additional $1,500 a year
at the beginning of each year for 20 years at the same 7.5 percent annual rate, how much money
will Homer have 20 years from now?
5-37. (Solving for r in an annuity) Your folks just called and would like some advice from you. An
insurance agent just called them and offered them the opportunity to purchase an annuity for
$21,074.25 that will pay them $3,000 per year for 20 years, but they don’t have the slightest idea
what return they would be making on their investment of $21,074.25. What rate of return will they
be earning?
5-38. (Compound interest with nonannual periods)
a. Calculate the future sum of $5,000, given that it will be held in the bank 5 years at an annual
interest rate of 6 percent.
b. Recalculate part (a) using compounding periods that are (1) semiannual and (2) bimonthly.
c. Recalculate parts (a) and (b) for a 12 percent annual interest rate.
d. Recalculate part (a) using a time horizon of 12 years (annual interest rate is still 6 percent).
e. With respect to the effect of changes in the stated interest rate and holding periods on
future sums in parts (c) and (d), what conclusions do you draw when you compare these
figures with the answers found in parts (a) and (b)?
5-39. (Compound interest with nonannual periods) After examining the various personal loan rates
available to you, you find that you can borrow funds from a finance company at 12 percent com-
pounded monthly or from a bank at 13 percent compounded annually. Which alternative is more
attractive?
5-40. (Solving for n with nonannual periods) About how many years would it take for your investment
to grow fourfold if it were invested at 16 percent compounded semiannually?
5-41. (Spreadsheet problem) To buy a new house you take out a 25-year mortgage for $300,000.
What will your monthly payments be if the interest rate on your mortgage is 8 percent? Use a
spreadsheet to calculate your answer. Now, calculate the portion of the 48th monthly payment that
goes toward interest and principal.
5-42. (Nonannual compounding using a calculator) Prof. Finance is thinking about trading cars. He
estimates he will still have to borrow $25,000 to pay for his new car. How large will Prof. Finance’s
monthly car loan payment be if he can get a 5-year (60 equal monthly payments) car loan from the
university’s credit union at 6.2 percent?
5-43. (Nonannual compounding using a calculator) Bowflex’s television ads say you can get a fitness
machine that sells for $999 for $33 a month for 36 months. What rate of interest are you paying
on this Bowflex loan?
5-44. (Nonannual compounding using a calculator) Ford’s current incentives include 4.9 percent
financing for 60 months or $1,000 cash back for a Mustang. Let’s assume Suzie Student wants
to buy the premium Mustang convertible, which costs $25,000, and she has no down payment
other than the cash back from Ford. If she chooses the $1,000 cash back, Suzie can borrow
from the VTech Credit Union at 6.9 percent for 60 months (Suzie’s credit isn’t as good as
Prof. Finance’s). What will Suzie Student’s monthly payment be under each option? Which
option should she choose?
3

178 Part 2 • The Valuation of Financial Assets
5-45. (Nonannual compounding using a calculator) Ronnie Rental plans to invest $1,000 at the end of
each quarter for 4 years into an account that pays 6.4 percent compounded quarterly. He will use
this money as a down payment on a new home at the end of the 4 years. How large will his down
payment be 4 years from today?
5-46. (Nonannual compounding using a calculator) Dennis Rodman has a $5,000 debt balance on his
Visa card that charges 12.9 percent compounded monthly. Dennis’s current minimum monthly
payment is 3 percent of his debt balance, which is $150. How many months (round up) will it take
Dennis to pay off his credit card if he pays the current minimum payment of $150 at the end of
each month?
5-47. (Nonannual compounding using a calculator) Should we have bet the kids’ college fund at
the dog track? Let’s look at one specific case of a college professor (let’s call him Prof. ME)
with two young children. Two years ago, Prof. ME invested $160,000 hoping to have $420,000
available 12 years later when the first child started college. However, the account’s balance is
now only $140,000. Let’s figure out what is needed to get Prof. ME’s college savings plan back
on track.
a. What was the original annual rate of return needed to reach Prof. ME’s goal when he
started the fund 2 years ago?
b. Now with only $140,000 in the fund and 10 years remaining until his first child starts col-
lege, what annual rate of return would the fund have to earn to reach Prof. ME’s $420,000
goal if he adds nothing to the account?
c. Shocked by his experience of the past 2 years, Prof. ME feels the college mutual fund
has invested too much in stocks. He wants a low-risk fund in order to ensure he has the
necessary $420,000 in 10 years, and he is willing to make end-of-the-month deposits to the
fund as well. He later finds a fund that promises to pay a guaranteed return of 6 percent
compounded monthly. Prof. ME decides to transfer the $140,000 to this new fund and
make the necessary monthly deposits. How large of a monthly deposit must Prof. ME make
into this new fund to meet his $420,000 goal?
d. Now Prof. ME gets sticker shock from the necessary monthly deposit he has to make into
the guaranteed fund in the preceding question. He decides to invest the $140,000 today
and $500 at the end of each month for the next 10 years into a fund consisting of 50 percent
stock and 50 percent bonds and hope for the best. What annual rate of return would the
fund have to earn in order to reach Prof. ME’s $420,000 goal?
5-48. (Present value of an uneven stream of payments) You are given three investment alternatives to
analyze. The cash flows from these three investments are as follows:
4
I N V E S T M E N T
E N D O F Y E A R A B C
1 $10,000 $10,000
2 10,000
3 10,000
4 10,000
5 10,000 $10,000
6 10,000 50,000
7 10,000
8 10,000
9 10,000
10 10,000 10,000
Assuming a 20 percent discount rate, find the present value of each investment.
5-49. (Present value) The Kumar Corporation is planning on issuing bonds that pay no inter-
est but can be converted into $1,000 at maturity, 7 years from their purchase. To price these
bonds competitively with other bonds of equal risk, it is determined that they should yield
10 percent, compounded annually. At what price should the Kumar Corporation sell these
bonds?

Chapter 5 • The Time Value of Money 179
5-50. (Perpetuities) What is the present value of the following?
a. A $300 perpetuity discounted back to the present at 8 percent
b. A $1,000 perpetuity discounted back to the present at 12 percent
c. A $100 perpetuity discounted back to the present at 9 percent
d. A $95 perpetuity discounted back to the present at 5 percent
5-51. (Complex present value) How much do you have to deposit today so that beginning
11 years from now you can withdraw $10,000 a year for the next 5 years (periods 11 through
15) plus an additional amount of $20,000 in that last year (period 15)? Assume an interest rate
of 6 percent.
5-52. (Complex present value) You would like to have $50,000 in 15 years. To accumulate this
amount you plan to deposit each year an equal sum in the bank, which will earn 7 percent interest
compounded annually. Your first payment will be made at the end of the year.
a. How much must you deposit annually to accumulate this amount?
b. If you decide to make a large lump-sum deposit today instead of the annual deposits,
how large should this lump-sum deposit be? (Assume you can earn 7 percent on this
deposit.)
c. At the end of 5 years you will receive $10,000 and deposit this in the bank toward your goal
of $50,000 at the end of 15 years. In addition to this deposit, how much must you deposit
in equal annual deposits to reach your goal? (Again assume you can earn 7 percent on this
deposit.)
5-53. (Comprehensive present value) You are trying to plan for retirement in 10 years, and cur-
rently you have $100,000 in a savings account and $300,000 in stocks. In addition you plan on
adding to your savings by depositing $10,000 per year in your savings account at the end of
each of the next 5 years and then $20,000 per year at the end of each year for the final 5 years
until retirement.
a. Assuming your savings account returns 7 percent compounded annually, and your invest-
ment in stocks will return 12 percent compounded annually, how much will you have at the
end of 10 years? (Ignore taxes.)
b. If you expect to live for 20 years after you retire, and at retirement you deposit all of your
savings in a bank account paying 10 percent, how much can you withdraw each year after
retirement (20 equal withdrawals beginning 1 year after you retire) to end up with a zero
balance upon your death?
5-54. (Present value) The state lottery’s million-dollar payout provides for $1 million to be paid
over 19 years in 20 payments of $50,000. The first $50,000 payment is made immediately, and
the 19 remaining $50,000 payments occur at the end of each of the next 19 years. If 10 percent
is the appropriate discount rate, what is the present value of this stream of cash flows? If 20
percent is the appropriate discount rate, what is the present value of the cash flows?
5-55. (Complex annuity) Upon graduating from college 35 years ago, Dr. Nick Riviera was already
thinking of retirement. Since then he has made deposits into his retirement fund on a quarterly
basis in the amount of $300. Nick has just completed his final payment and is at last ready to retire.
His retirement fund has earned 9% interest compounded quarterly.
a. How much has Nick accumulated in his retirement account?
b. In addition to all this, 15 years ago, Nick received an inheritance check for $20,000 from
his beloved uncle. He decided to deposit the entire amount into his retirement fund. What
is his current balance in the fund?
5-56. (Complex annuity and future value) Milhouse, 22, is about to begin his career as a rocket
scientist for a NASA contractor. Being a rocket scientist, Milhouse knows that he should begin
saving for retirement immediately. Part of his inspiration came from reading an article on
Social Security in Newsweek, where he saw that the ratio of workers paying taxes to retirees col-
lecting checks will drop dramatically in the future. In fact, the ratio was 8.6 workers for every
retiree in 1955; today the ratio is 3.3, and it will drop to 2 workers for every retiree in 2040.
Milhouse’s retirement plan pays 9 percent interest annually and allows him to make equal
yearly contributions. Upon retirement Milhouse plans to buy a new boat, which he estimates
will cost him $300,000 in 43 years (he plans to retire at age 65). He also estimates that in order
to live comfortably he will require a yearly income of $80,000 for each year after he retires.
Based on family history, Milhouse expects to live until age 80 (that is, he would like to receive
15 payments of $80,000 at the end of each year). When he retires, Milhouse will purchase his
boat in one lump sum and place the remaining balance into an account, which pays 6% inter-
est, from which he will withdraw his $80,000 per year. If Milhouse’s first contribution is made

180 Part 2 • The Valuation of Financial Assets
1 year from today, and his last is made the day he retires, how much money must he contribute
each year to his retirement fund?
5-57. (Present value of a complex stream) Don Draper has signed a contract that will pay
him $80,000 at the end of each year for the next 6 years, plus an additional $100,000 at the
end of year 6. If 8 percent is the appropriate discount rate, what is the present value of this contract?
5-58. (Present value of a complex stream) Don Draper has signed a contract that will pay him $80,000
at the beginning of each year for the next 6 years, plus an additional $100,000 at the end of year 6. If
8 percent is the appropriate discount rate, what is the present value of this contract?
5-59. (Complex stream of cash flows) Roger Sterling has decided to buy an ad agency and is going to
finance the purchase with seller financing—that is, a loan from the current owners of the agency. The
loan will be for $2,000,000 financed at a 7 percent nominal annual interest rate. This loan will be paid off
over 5 years with end-of-month payments along with a $500,000 balloon payment at the end of year 5.
That is, the $2 million loan will be paid off with monthly payments and there will also be a final payment
of $500,000 at the end of the final month. How much will the monthly payments be?
5-60. (Future and present value using a calculator) In 2013 Bill Gates was worth about $28 billion
after he reduced his stake in Microsoft from 21 percent to around 14 percent by moving billions
into his charitable foundation. Let’s see what Bill Gates can do with his money in the following
problems.
a. I’ll take Manhattan? Manhattan’s native tribe sold Manhattan Island to Peter Minuit
for $24 in 1626. Now, 387 years later in 2013, Bill Gates wants to buy the island from
the “current natives.” How much would Bill have to pay for Manhattan if the “current
natives” want a 6 percent annual return on the original $24 purchase price? Could he
afford it?
b. (Nonannual compounding using a calculator) How much would Bill have to pay for Manhat-
tan if the “current natives” want a 6% return compounded monthly on the original $24
purchase price?
c. Microsoft Seattle? Bill Gates decides to pass on Manhattan and instead plans to buy the city
of Seattle, Washington, for $60 billion in 10 years. How much would Mr. Gates have to
invest today at 10 percent compounded annually in order to purchase Seattle in 10 years?
d. Now assume Bill Gates wants to invest only about half his net worth today, $14 billion, in
order to buy Seattle for $60 billion in 10 years. What annual rate of return would he have
to earn in order to complete his purchase in 10 years?
e. Margaritaville? Instead of buying and running large cities, Bill Gates is considering quit-
ting the rigors of the business world and retiring to work on his golf game. To fund his
retirement, Bill Gates would invest his $28 billion fortune in safe investments with an
expected annual rate of return of 7 percent. Also, Mr. Gates wants to make 40 equal annual
withdrawals from this retirement fund beginning a year from today. How much can Mr.
Gates’s annual withdrawal be in this case?
Mini Case
This Mini Case is available in MyFinanceLab.
For your job as the business reporter for a local newspaper, you are given the task of putting to-
gether a series of articles that explain the power of the time value of money to your readers. Your
editor would like you to address several specific questions in addition to demonstrating for the
readership the use of time value of money techniques by applying them to several problems. What
would be your response to the following memorandum from your editor?
To: Business Reporter
From: Perry White, Editor, Daily Planet
Re: Upcoming Series on the Importance and Power of the Time Value of Money
In your upcoming series on the time value of money, I would like to make sure you cover several
specific points. In addition, before you begin this assignment, I want to make sure we are all reading
from the same script, as accuracy has always been the cornerstone of the Daily Planet. In this regard,
I’d like a response to the following questions before we proceed:
a. What is the relationship between discounting and compounding?
b. What is the relationship between the present-value factor and the annuity present-value
factor?

Chapter 5 • The Time Value of Money 181
c. 1. What will $5,000 invested for 10 years at 8 percent compounded annually grow to?
2. How many years will it take $400 to grow to $1,671 if it is invested at 10 percent
compounded annually?
3. At what rate would $1,000 have to be invested to grow to $4,046 in 10 years?
d. Calculate the future sum of $1,000, given that it will be held in the bank for 5 years and earn
10 percent compounded semiannually.
e. What is an annuity due? How does this differ from an ordinary annuity?
f. What is the present value of an ordinary annuity of $1,000 per year for 7 years dis-
counted back to the present at 10 percent? What would be the present value if it were an
annuity due?
g. What is the future value of an ordinary annuity of $1,000 per year for 7 years compounded
at 10 percent? What would be the future value if it were an annuity due?
h. You have just borrowed $100,000, and you agree to pay it back over the next 25 years in
25 equal end-of-year payments plus 10 percent compound interest on the unpaid balance.
What will be the size of these payments?
i. What is the present value of a $1,000 perpetuity discounted back to the present at
8 percent?
j. What is the present value of a $1,000 annuity for 10 years, with the first payment occurring
at the end of year 10 (that is, ten $1,000 payments occurring at the end of year 10 through
year 19), given a discount rate of 10 percent?
k. Given a 10 percent discount rate, what is the present value of a perpetuity of $1,000 per
year if the first payment does not begin until the end of year 10?

The Meaning and Measurement
of Risk and Return
Learning Objectives
1 Define and measure the expected rate of return Expected Return Defined and Measured
of an individual investment.
2 Define and measure the riskiness of an individual Risk Defined and Measured
investment.
3 Compare the historical relationship between risk and Rates of Return: The Investor’s
rates of return in the capital markets. Experience
4 Explain how diversifying investments affects the Risk and Diversification
riskiness and expected rate of return of a portfolio
or combination of assets.
5 Explain the relationship between an investor’s The Investor’s Required Rate of Return
required rate of return on an investment and the
riskiness of the investment.
182
One of the most important concepts in finance is risk and return, which is the total focus of our third principle
of finance—Risk Requires a Reward. You only have to look at what happened in the stock markets during the
past 5 years from 2007 to 2012 to see an overwhelming presence of investment risk. To illustrate, if you had
been so unfortunate to buy a portfolio consisting of stocks making up the Standard & Poor’s 500 Index in July
2007 and sold in February 2009, you would have lost 54 percent of your investment value. But if you had in-
stead purchased the stock in July 2009 and held until March 2012, you would have a gain of 105 percent. Then
if you had held the portfolio of stock for the entire 5 years, 2007–2012, you would still have lost 10 percent of
your investment.
6

183183
Instead of investing in a port-
folio of stocks, as represented by
the Standard & Poor’s 500 Index,
you could have chosen to invest in
a single stock, such as JP Morgan
Chase. If you were so fortunate as
to buy the stock in November 2010
and sell 5 months later in April
2011, you would have doubled
your money! On the other hand, if
you had bought in April 2011, by
June 2012 you would have lost half
of your investment. Of course, you
could have bought Apple at the be-
ginning of 2012 and by June 2012
have a gain of 50 percent. Finally, if
you were one of the investors who were eager to buy Facebook
stock when it was issued to the public in May 2012, within 3 weeks
your investment would have lost 30 percent of its value.
Clearly, owning stocks in recent times has not been for the
faint of heart, where in a single day you could have earned
as much as 5 percent on your investment, or lost even more.
The market crash and extreme volatility in stock prices in 2008 and 2009 are what Nassim
Nicholas Taleb would call a black swan—a highly improbable event that has a massive impact.1
As a consequence, our confidence in forecasting the future has been undermined. Further-
more, our lives have been impacted and future plans delayed. We are much more cognizant of
the financial risks that we face, both individually and in business.
1In his book The Black Swan: The Impact of the Highly Improbable (New York: Random House, 2007), Nassim Nicholas
Taleb uses the analogy of a black swan, which represents a highly unlikely event. Until black swans were discovered in
Australia, everyone assumed that all swans were white. Thus, for Taleb, the black swan symbolizes an event that no one
thinks possible.
In this chapter, we will help you understand the nature of risk and how risk should relate
to expected returns on investments. We will look back beyond the past few years to see what
we can learn about long-term historical risk-and-return relationships. These are topics that
should be of key interest to us all in this day and age.
The need to recognize risk in financial decisions has already been apparent in earlier chap-
ters. In Chapter 2, we referred to the discount rate, or the interest rate, as the opportunity
cost of funds, but we did not look at the reasons why that rate might be high or low. For
example, we did not explain why in June 2012 you could buy bonds issued by Office Depot
that promised to pay a 6.8 percent rate of return, or why you could buy Dole Foods bonds
that would give you an 8.0 percent rate of return, provided that both firms make the pay-
ments to the investors as promised.
In this chapter, we learn that risk is an integral force underlying rates of return. To begin
our study, we define expected return and risk and offer suggestions about how these important
concepts of return and risk can be measured quantitatively. We also compare the historical re-
lationship between risk and rates of return. We then explain how diversifying investments can
affect the expected return and riskiness of those investments. We also consider how the riskiness
of an investment should affect the required rate of return on an investment.
Let’s begin our study by looking at what we mean by the expected rate of return and
how it can be measured.
ReMeMbeR YouR PRinciPles
This chapter has one primary objective, that of
helping you understand Principle 3: Risk Requires a Reward.
rinciple

184 Part 2 • The Valuation of Financial Assets
Expected Return Defined and Measured
The expected benefits, or returns, an investment generates come in the form of cash flows.
Cash flow, not accounting profit, is the relevant variable the financial manager uses to
measure returns. This principle holds true regardless of the type of security, whether it is a
debt instrument, preferred stock, common stock, or any mixture of these (such as convert-
ible bonds).
To begin our discussion about an asset’s expected rate of return, let’s first understand
how to compute a historical or realized rate of return on an investment. It may also be
called a holding-period return. For instance, consider the dollar return you would have
earned had you purchased a share of Google on April 23, 2012, for $598.45 and sold it less
than 1 month later on May 17 for $637.85. The dollar return on your investment would
have been $39.40 ($39.40 = $637.85-$598.45), assuming that the company paid no divi-
dend. In addition to the dollar gain, we can calculate the rate of return as a percentage. It is
useful to summarize the return on an investment in terms of a percentage because that way
we can see the return per dollar invested, which is independent of how much we actually
invest.
The rate of return earned from the investment in Google can be calculated as the ratio
of the dollar return of $39.40 divided by your $598.45 investment in the stock, or 6.58 per-
cent (6.58% = 0.0658 = $39.40 , $598.45).
We can formalize the return calculations using equations (6-1) and (6-2):
Holding-period dollar gain would be:
Holding@period
dollar gain, DG
= priceend of period +
cash distribution
(dividend)
– pricebeginning of period (6-1)
and for the holding-period rate of return
Holding@period
rate of return, r
=
dollar gain
pricebeginning of period
=
priceend of period + dividend – pricebeginning of period
pricebeginning of period

(6-2)
The method we have just used to compute the holding-period return on our investment
in Google tells us the return we actually earned during a historical time period. However,
the risk–return trade-off that investors face on a day-to-day basis is based not on realized
rates of return but on what the investor expects to earn on an investment in the future. We
can think of the rate of return that will ultimately be realized from making a risky invest-
ment in terms of a range of possible return outcomes, much like the distribution of grades
for this class at the end of the term. To describe this range of possible returns, it is custom-
ary to use the average of the different possible returns. We refer to the average of the pos-
sible rates of return as the investment’s expected rate of return.
Accurately measuring expected future cash flows is not easy in a world of uncertainty.
To illustrate, assume you are considering an investment costing $10,000, for which the fu-
ture cash flows from owning the security depend on the state of the economy, as estimated
in Table 6-1.
holding-period return (historical or
realized rate of return) the rate of return
earned on an investment, which equals the
dollar gain divided by the amount invested.
expected rate of return The arithmetic
mean or average of all possible outcomes where
those outcomes are weighted by the probability
that each will occur.
1 Define and measure the
expected rate of return of an
individual investment.
TabLE 6-1 Measuring the Expected Return of an Investment
State of
the Economy
Probability
of the
Statesa
Cash Flows
from the
Investment
Percentage Returns
(Cash Flow ,
Investment Cost)
Economic recession 20% $1,000 10% ($1,000 , $10,000)
Moderate economic growth 30% 1,200 12% ($1,200 , $10,000)
Strong economic growth 50% 1,400 14% ($1,400 , $10,000)
aThe probabilities assigned to the three possible economic conditions have to be determined subjectively, which requires managers to have a thorough
understanding of both the investment cash flows and the general economy.

Chapter 6 • The Meaning and Measurement of Risk and Return 185
In any given year, the investment could produce any one
of three possible cash flows, depending on the particular state
of the economy. With this information, how should we select
the cash flow estimate that means the most for measuring the
investment’s expected rate of return? One approach is to cal-
culate an expected cash flow. The expected cash flow is simply
the weighted average of the possible cash flow outcomes such
that the weights are the probabilities of the various states of
the economy occurring. Stated as an equation:
Expected
cash flow, CF = °
cash flow probability
in state 1 * of state 1
(CF1) (Pb1)
¢ + °
cash flow probability
in state 2 * of state 2
(CF2) (Pb2)
¢
+ c + °
cash flow probability
in state 3 * of state 3
(CF3) (Pb3)
¢ (6-3)
For the present illustration:
Expected cash flow = (0.2)($1,000) + (0.3)($1,200)
+ (0.5)($1,400)
= $1,260
In addition to computing an expected dollar return from an investment, we can also cal-
culate an expected rate of return earned on the $10,000 investment. Similar to the expected
cash flow, the expected rate of return is a weighted average of all the possible returns, weighted
by the probability that each return will occur. As the last column in Table 6-1 shows, the $1,400
cash inflow, assuming strong economic growth, represents a 14 percent return ($1,400 ,
$10,000). Similarly, the $1,200 and $1,000 cash flows result in 12 percent and 10 percent
returns, respectively. Using these percentage returns in place of the dollar amounts, the
expected rate of return can be expressed as follows:
Expected
rate of return, r
= °
rate of return probability
for state 1 * of state 1
(r1) (Pb1)
¢ + °
rate of return probability
for state 2 * of state 2
(r2) (Pb2)
¢
+ c + °
rate of return probability
for state 3 * of state 3
(r3) (Pb3)
¢ (6-4)
In our example:
r = (0.2)(10,) + (0.3)(12,) + (0.5)(14,) = 12.6,
RemembeR YouR PRinciPles
Remember that future cash flows, not reported earn-
ings, determine the investor’s rate of return. That is, Principle 1:
Cash Flow Is What Matters.
rinciple
Can You Do It?
comPuting exPected cash Flow and exPected RetuRn
You are contemplating making a $5,000 investment that would
have the following possible outcomes in cash flow each year. What
is the expected value of the future cash flows and the expected
rate of return?
(The solution can be found on page 187.)
P r o b a b I l I t y C a s h F lo W
0.30 $350
0.50 625
0.20 900

186 Part 2 • The Valuation of Financial Assets
To this point, we have learned how to calculate a historical holding-period return, expressed
both in dollars and percentages. Also, we have seen how to estimate dollar and percentage re-
turns that we expect to earn in the future. These financial tools may be summarized as follows:
2 Define and measure the
riskiness of an individual
investment.
Name of tool Formula What It tells you
Holding-period dollar gain
Holding@period
dollar gain, DG
= priceend of period
+
cash distribution
(dividend)
– pricebeginning of period
Measures the dollar gain on an
investment for a period of time
Holding-period rate of return
Holding@period
rate of return, r
=
dollar gain
pricebeginning of period
=
priceend of period + dividend – pricebeginning of period
pricebeginning of period

Calculates the percentage rate of
return for a security held for a period
of time
Expected cash flow
Expected
cash flow, CF
= °
cash flow probability
in state 1 * of state 1
(CF1) (Pb1)
¢
+ °
cash flow probability
in state 2 * of state 2
(CF2 ) (Pb2 )
¢
+ c + °
cash flow probability
in state 3 * of state 3
(CF3 ) (Pb3 )
¢
Estimates the cash flows that can
be expected from an investment,
recognizing that there are multiple
possible outcomes from the
investment
Expected rate of return
Expected
rate of return, r
= °
rate of return probability
for state 1 * of state 1
(r1) (Pb1)
¢
+ °
rate of return probability
for state 2 * of state 2
(r2) (Pb2)
¢
+ c + °
rate of return probability
for state 3 * of state 3
(r3) (Pb3)
¢
An estimate of the expected rate of
return on an investment, recognizing
that there are multiple possible
outcomes from the investment
FInanCIal DeCIsIon tools
Concept Check
1. When we speak of “benefits” from investing in an asset, what do we mean?
2. Why is it difficult to measure future cash flows?
3. Define expected rate of return.
risk Defined and Measured
Because we live in a world where events are uncertain, the way we see risk is vitally impor-
tant in almost all dimensions of our life. The Greek poet and statesman Solon, writing in
the sixth century b.c., put it this way:
There is risk in everything that one does, and no one knows where he will make his landfall when
his enterprise is at its beginning. One man, trying to act effectively, fails to foresee something and
falls into great and grim ruination, but to another man, one who is acting ineffectively, a god gives
good fortune in everything and escape from his folly.2
2From Iambi et Elegi Graeci ante Alexandrum Cantati, vol. 2. Edited by M.L. West, translated by Arthur W.H. Adkins.
(Oxford: Clarendon Press, 1972).
With our concept and measurement of expected returns, let’s consider the other side of
the investment coin: risk.

Chapter 6 • The Meaning and Measurement of Risk and Return 187
risk potential variability in future cash flows.
In our study of risk, we want to consider these questions:
1. What is risk?
2. How do we know the amount of risk associated with a given investment; that is, how
do we measure risk?
3. If we choose to diversify our investments by owning more than one asset, as most of us do,
will such diversification reduce the riskiness of our combined portfolio of investments?
Without intending to be trite, risk means different things to different people, depend-
ing on the context and on how they feel about taking chances. For the student, risk is the
possibility of failing an exam or the chance of not making his or her best grades. For the coal
miner or the oil field worker, risk is the chance of an explosion in the mine or at the well
site. For the retired person, risk means perhaps not being able to live comfortably on a fixed
income. For the entrepreneur, risk is the chance that a new venture will fail.
While certainly acknowledging these different kinds of risk, we limit our attention to
the risk inherent in an investment. In this context, risk is the potential variability in future
cash flows. The wider the range of possible events that can occur, the greater the risk.4 If we
think about it, this is a relatively intuitive concept.
DID You Get It?
coMPuTing exPecTed cash Flow and exPecTed ReTuRn
The possible returns are equal to the possible cash flows divided by the $5,000 investment. The expected cash flow and return are
equal to the possible cash flows and possible returns multiplied by the probabilities.
P o S S i b l E E x P E C T E D
P R O b a b I L I T y C a S h F LO W R E T u R N C a S h F LO W R E T u R N
0.30 $350 7.0% $105.00 2.1%
0.50 625 12.5% 312.50 6.3%
0.20 900 18.0% 180.00 3.6%
Expected cash flow and rate of return $597.50 12.0%
Solon would have given more of the credit to Zeus than we would for the outcomes of
our ventures. However, his insight reminds us that little is new in this world, including the
need to acknowledge and compensate as best we can for the risks we encounter. In fact, the
significance of risk and the need for understanding what it means in our lives is noted by
Peter Bernstein in the following excerpt:
What is it that distinguishes the thousands of years of history from what we think of as modern
times? The answer goes way beyond the progress of science, technology, capitalism, and democracy.
The distant past was studded with brilliant scientists, mathematicians, inventors, technologists,
and political philosophers. . . . [T]he skies had been mapped, the great library of Alexandria
built, and Euclid’s geometry taught. . . . Coal, oil, iron, and copper have been at the service of
human beings for millennia. . . .
The revolutionary idea that defines the boundary between modern times and the past is the
mastery of risk. . . . Until human beings discovered a way across that boundary, the future was
a mirror of the past or the murky domain of oracles and soothsayers. . . .3
3From “Introduction” in Against the Gods: The Remarkable Story of Risk by Peter Bernstein, published by John Wiley &
Sons, Inc., New York: 1996.
4When we speak of possible events, we must not forget that it is the highly unlikely event that we cannot anticipate that
may have the greatest impact on the outcome of an investment. So, we evaluate investment opportunities based on the
best information available, but there may be a black swan that we cannot anticipate.

188 Part 2 • The Valuation of Financial Assets
To help us grasp the fundamental meaning of risk within this context, consider two
possible investments:
1. The first investment is a U.S. Treasury bond, a government security that matures in
10 years and promises to pay an annual return of 2 percent. If we purchase and hold this
security for 10 years, we are virtually assured of receiving no more and no less than 2 per-
cent on an annualized basis. For all practical purposes, the risk of loss is nonexistent.
2. The second investment involves the purchase of the stock of a local publishing com-
pany. Looking at the past returns of the firm’s stock, we have made the following esti-
mate of the annual returns from the investment:
Investing in the publishing company could conceivably provide a return as high as
30 percent if all goes well, or a loss of 10 percent if everything goes against the firm. How-
ever, in future years, both good and bad, we could expect a 14 percent return on average.5
5We assume that the particular outcome or return earned in 1 year does not affect the return earned in the subsequent
year. Technically speaking, the distribution of returns in any year is assumed to be independent of the outcome in any
prior year.
FIguRE 6-1 The Probability Distribution of the Returns on Two Investments
Treasury bond
Possible returns (%)
Pr
ob
ab
ili
ty
o
f o
cc
ur
re
nc
e
1
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1
Pr
ob
ab
ili
ty
o
f o
cc
ur
re
nc
e
0
0.05
0.1
0.15
0.2
0.25
0.3
0.35
0.4
2 3 4
Possible returns (%)
–10 5 15 25 30
Publishing company
C h a N C E O F O CC u R R E N C E R aT E O F R E T u R N O N I N v E S T M E N T
1 chance in 10 (10% chance) -10%
2 chances in 10 (20% chance) 5%
4 chances in 10 (40% chance) 15%
2 chances in 10 (20% chance) 25%
1 chance in 10 (10% chance) 30%
Expected return = (0.10)(-10%) + (0.20)(5%) + (0.40)(15%) + (0.20)(25%)
+ (0.10)(30%)
= 14%
Comparing the Treasury bond investment with the publishing company investment, we
see that the Treasury bond offers an expected 2 percent annualized rate of return, whereas
the publishing company has a much higher expected rate of return of 14 percent. However,
our investment in the publishing firm is clearly more “risky”—that is, there is greater un-
certainty about the final outcome. Stated somewhat differently, there is a greater variation
or dispersion of possible returns, which in turn implies greater risk.6 Figure 6-1 shows these
differences graphically in the form of discrete probability distributions.
6How can we possibly view variations above the expected return as risk? Should we even be concerned with the positive
deviations above the expected return? Some would say “no,” viewing risk as only the negative variability in returns from
a predetermined minimum acceptable rate of return. However, as long as the distribution of returns is symmetrical, the
same conclusions will be reached.

Chapter 6 • The Meaning and Measurement of Risk and Return 189
Although the return from investing in the publishing firm is clearly less certain than for
Treasury bonds, quantitative measures of risk are useful when the difference between two
investments is not so evident. We can quantify the risk of an investment by computing the
variance in the possible investment returns and its square root, the standard deviation (s).
For the case where there are n possible returns (that is, states of the economy), we calculate
the variance as follows:
Variance in
rates of return
(s2)
= £ °
rate of return
for state 1
(r1)
–
expected rate
of return
r
¢
2
*
probability
of state 1
(Pb1)
§
+ £ °
rate of return expected rate
for state 2 – of return
(r2) r
¢
2
*
probability
of state 2
(Pb2)
§

+ g + £ °
rate of return expected rate
for state n – of return
(rn) r
¢
2
*
probability
of state n §
(Pbn)

(6-5)
For the publishing company’s common stock, we calculate the standard deviation using the
following five-step procedure:
STEP 1 Calculate the expected rate of return of the investment, which was calculated
above to be 14 percent.
STEP 2 Subtract the expected rate of return of 14 percent from each of the possible rates
of return and square the difference.
STEP 3 Multiply the squared differences calculated in step 2 by the probability that those
outcomes will occur.
STEP 4 Sum all the values calculated in step 3 together. The sum is the variance of
the distribution of possible rates of return. Note that the variance is actually
the average squared difference between the possible rates of return and the expected
rate of return.
STEP 5 Take the square root of the variance calculated in step 4 to calculate the standard
deviation of the distribution of possible rates of return.
Table 6-2 illustrates the application of this process, which results in an estimated standard
deviation for the common stock investment of 11.14 percent. This compares to the Trea-
sury bond investment, which is risk-free, and has a standard deviation of zero percent. The
more risky the investment, the higher is its standard deviation.
standard deviation a statistical measure
of the spread of a probability distribution
calculated by squaring the difference between
each outcome and its expected value, weighting
each value by its probability, summing over all
possible outcomes, and taking the square root
of this sum.
TabLE 6-2 Measuring the variance and Standard Deviation of the Publishing
Company Investment
State of the
World Rate of Return
Chance or
Probability Step 2 Step 3
A b C D = b * C E = (b – r)2 F = E * C
1 -10% 0.10 -1% 576% 57.6%
3 5% 0.20 1% 81% 16.2%
4 15% 0.40 6% 1% 0.40%
4 25% 0.20 5% 121% 24.2%
5 30% 0.10 3% 256% 25.6%
Step 1: Expected Return (r) = 14%
Step 4: Variance = 124%
Step 5: Standard Deviation = 11.14%

190 Part 2 • The Valuation of Financial Assets
Alternatively, we could use equation (6-5) to calculate the standard deviation in invest-
ment returns as follows:
s = £
(-10% – 14%)2(0.10) + (5% – 14%)2(0.20)
+ (15% – 14%)2(0.40) + (25% – 14%)2(0.20)
+ (30% – 14%)2(0.10)
§
1
2
= 2124% = 11.14%
Although the standard deviation of returns provides us with a quantitative measure of
an asset’s riskiness, how should we interpret the result? What does it mean? Is the 11.14
percent standard deviation for the publishing company investment good or bad? First, we
should remember that statisticians tell us that two-thirds of the time, an event will fall
within 1 standard deviation of the expected value (assuming the distribution is normally
distributed; that is, it is shaped like a bell). Thus, given a 14 percent expected return and
a standard deviation of 11.14 percent for the publishing company investment, we can rea-
sonably anticipate that the actual returns will fall between 2.86 percent and 25.14 percent
(14, { 11.14,) two-thirds of the time. In other words, there is not much certainty with
this investment.
A second way of answering the question about the meaning of the standard deviation
comes by comparing the investment in the publishing firm against other investments. Obvi-
ously the attractiveness of a security with respect to its return and risk cannot be determined
in isolation. Only by examining other available alternatives can we reach a conclusion about
a particular investment’s risk. For example, if another investment, say, an investment in a
firm that owns a local radio station, has the same expected return as the publishing com-
pany, 14 percent, but with a standard deviation of 7 percent, we would consider the risk as-
sociated with the publishing firm, 11.14 percent, to be excessive. In the technical jargon of
modern portfolio theory, the radio station investment is said to “dominate” the publishing
firm investment. In commonsense terms, this means that the radio station investment has
the same expected return as the publishing company investment but is less risky.
Can You Do It?
coMPuTing The sTandaRd deviaTion
P R O b a b I L I T y R E T u R N S
0.30 7.0%
0.50 12.5%
0.20 18.0%
in the preceding “Can You Do it?” on page 185, we computed
the expected cash flow of $597.50 and the expected return of
12 percent on a $5,000 investment. Now let’s calculate the
standard deviation of the returns. The probabilities of possible
returns are given as follows:
(The solution can be found on page 193.)
FInanCe at Work
a diFFeRenT PeRsPecTive oF Risk
The first Chinese symbol shown here represents danger; the
second stands for opportunity. The Chinese define risk as the
combination of danger and opportunity. Greater risk, according
to the Chinese, means we have greater opportunity to do well
but also greater danger of doing badly.

Chapter 6 • The Meaning and Measurement of Risk and Return 191
What if we compare the investment in the publishing company with one in a quick oil-
change franchise, an investment in which the expected rate of return is an attractive 24 percent
but the standard deviation is estimated at 13 percent? Now what should we do? Clearly, the oil-
change franchise has a higher expected rate of return, but it also has a larger standard deviation.
In this example, we see that the real challenge in selecting the better investment comes when one
investment has a higher expected rate of return but also exhibits greater risk. Here the final choice
is determined by our attitude toward risk, and there is no single right answer. You might select the pub-
lishing company, whereas I might choose the oil-change investment, and neither of us would be
wrong. We would simply be expressing our tastes and preferences about risk and return.
To summarize, the riskiness of an investment is of primary concern to an investor,
where the standard deviation is the conventional measure of an investment’s riskiness. This
decision tool is represented as follows:
Name of tool Formula What It tells you
Standard
deviation
in rates of return
= 1variance
Variance in
rates of return
(s2)

= £ °
rate of return expected rate
for state 1 – of return
(r1) r
¢
2
*
probability
of state 1 §
(Pb1)

+ £ °
rate of return
for state 2
(r2)
–
expected rate
of return
r
¢
2 probability
* of state 2 §
(Pb2)
+ c + £ °
rate of return
for state n
(rn)
–
expected rate
of return
r
¢
2 probability
* of state n §
(Pbn)
A measure of risk,
as determined by
the square root of
the variance of cash
flows or rates of
returns, which mea-
sures the volatility of
cash flows or returns
FInanCIal DeCIsIon tools
e x a M P l e 6.1 Computing the expected return and standard deviation
You are considering two investments, X and Y. The distributions of possible returns are
shown below:
P o S S i b l E R E T u R n S
P r o b a b I l I t y I N v e s t M e N t x I N v e s t M e N t y
0.05 -10% 0%
0.25 5% 5%
0.40 20% 16%
0.25 30% 24%
0.05 40% 32%
Compute the expected return and standard deviation for each investment. Do you have a
preference for one investment over the other if you were making the decision?
steP 1: FoRmulate a solution stRategY
To compute the expected return for each investment, equation (6-4) is used, where there
are five possible outcomes or states:
Expected rate
of return, r =
°
rate of return
for state 1
(r1)
*
probability of
state 1
(Pb1)
¢
+ °
rate of return
for state 2
(r2)
*
probability of
state 2
(Pb2)
¢ + c + °
rate of return
for state 5
(r5)
*
probability of
state 5
(Pb5)
¢

192 Part 2 • The Valuation of Financial Assets
To calculate the riskiness of each investment, as measured by the standard deviation of
returns, we rely on equation (6-5) for five possible outcomes:
Variance in
rates of return
(s2)
= £ °
rate of return expected rate
for state 1 – of return
(r1) r
¢
2
*
probability
of state 1
(Pb1)
§
+ £ °
rate of return expected rate
for state 2 – of return
(r2) r
¢
2

probability
* of state 2 §
(Pb2 )

+ g + £ °
rate of return expected rate
for state n – of return
(rn) r
¢
2
*
probability
of state n
(Pbn)
§
Standard deviation (s) = 1variance
STEP 2: CrunCh ThE numbErS
For investment X:
Expected rate
of return, r
= (0.05)(-10%) + (0.25)(5%) + (0.40)(20%)
+ (0.25)(30%) + (0.05)(40%)
= 18.25%
Variance in
rates of returns
(s2)
= (0.05)(-10% – 18.25%)2 + (0.25)(5% – 18.25%)2
+ (0.40)(20% – 18.25%)2 + (0.25)(30% – 18.25%)2
+ (0.05)(40% – 18.25%)2
= 143.19%
Standard deviation of
rates of returns
(s)
= 1variance = 1143.19% = 11.97%
For investment Y:
Expected rate
of return, r
= (0.05)(0%) + (0.25)(5%) + (0.40)(16%) + (0.25)(24%)
+ (0.05)(32%)
= 15.25%
Variance in
rates of returns
(s2)
= (0.05)(0% – 15.25%)2 + (0.25)(5% – 15.25%)2
+ (0.40)(16% – 15.25%)2 + (0.25)(24% – 15.25%)2
+ (0.05)(32% – 15.25%)2
= 71.29%
Standard deviation of
rates of returns
(s)
= 1variance = 171.29% = 8.44%
STEP 3: AnAlyzE your rESulTS
The results are as follows:
I n v e s t m e n t e x p e c t e d R e t u R n s ta n d a R d d e v I at I o n
Investment X 18.25% 11.97%
Investment Y 15.25% 8.44%

Chapter 6 • The Meaning and Measurement of Risk and Return 193
DID You Get It?
coMPuTing The sTandaRd deviaTion
D E v I aT I O N ( P O S S I b L E R E T u R N2
12% E x P E C T E D R E T u R N )
D E v I aT I O N
S q ua R E D P R O b a b I L I T y
P R O b a b I L I T y :
D E v I aT I O N S q ua R E D
-5.0% 25.00% 0.30 7.500%
0.5% 0.25% 0.50 0.125%
6.0% 36.00% 0.20 7.200%
Sum of squared deviations * probability (variance) 14.825%
Standard deviation 3.85%
Concept Check
1. How is risk defined?
2. How does the standard deviation help us measure the riskiness of an investment?
3. Does greater risk imply a bad investment?
Rates of Return: The Investor’s Experience
So far, we have mostly used hypothetical examples of expected rates of return and risk; however,
it is also interesting to look at returns that investors have actually received on different types of
securities. For example, Ibbotson Associates publishes the long-term historical annual rates of
return for the following types of investments beginning in 1926 and continuing to the present:
1. Common stocks of large companies
2. Common stocks of small firms
3. Long-term corporate bonds
4. Long-term U.S. government bonds
5. Intermediate-term U.S. government bonds
6. U.S. Treasury bills (short-term government securities)
Before comparing these returns, we should think about what to expect. First, we would
intuitively expect a Treasury bill (short-term government securities) to be the least risky of
the six portfolios. Because a Treasury bill has a short-term maturity date, the price is less
volatile (less risky) than the price of an intermediate- or long-term government security. In
turn, because there is a chance of default on a corporate bond, which is essentially nonexis-
tent for government securities, a long-term government bond is less risky than a long-term
corporate bond. Finally, the common stocks of large companies are more risky than corpo-
rate bonds, with small-company stocks being more risky than large-firm stocks.
With this in mind, we could reasonably expect different rates of return to the holders
of these varied securities. If the market rewards an investor for assuming risk, the average
annual rates of return should increase as risk increases.
A comparison of the annual rates of return for five portfolios and the inflation rate for the
years 1926 to 2011 is provided in Figure 6-2. Four aspects of these returns are included: (1) the
nominal average annual rate of return; (2) the standard deviation of the returns, which measures
the volatility, or riskiness, of the returns; (3) the real average annual rate of return, which is the
nominal return less the inflation rate; and (4) the risk premium, which represents the additional
return received beyond the risk-free rate (Treasury bill rate) for assuming risk. Looking at the
3 Compare the historical
relationship between risk and
rates of return in the capital
markets.
In this case, you will have to take on more risk if you want additional expected return.
(There is no money tree.) Thus, the choice depends on the investor’s preference for risk
and return. There is no single right answer.

194 Part 2 • The Valuation of Financial Assets
first two columns of nominal average annual returns and standard deviations, we get a good
overview of the risk–return relationships that have existed over the 86 years ending in 2011. In
every case, there has been a positive relationship between risk and return, with Treasury bills
being least risky and small-company stocks being most risky.
The return information in Figure 6-2 clearly demonstrates that only common stock
has in the long run served as an inflation hedge and provided any substantial risk premium.
However, it is equally apparent that the common stockholder is exposed to a sizable amount
of risk, as is demonstrated by the 20.3 percent standard deviation for large-company stocks
and the 32.5 percent standard deviation for small-company stocks. In fact, in the 1926 to
2011 time frame, common shareholders of large firms received negative returns in 22 of the
86 years, compared with only 1 (1938) in 86 years for Treasury bills.
Concept Check
1. What is the additional compensation for assuming greater risk called?
2. In Figure 6-2, which rate of return is the risk-free rate? Why?
Risk and Diversification
More can be said about risk, especially about its nature, when we own more than one asset
in our investment portfolio. Let’s consider for the moment how risk is affected if we diver-
sify our investment by holding a variety of securities.
Let’s assume that you graduated from college in December 2011. Not only did you get
the good job you had hoped for but you also finished the year with a little nest egg—not
enough to take that summer fling to Europe like some of your college friends but a nice sur-
plus. Besides, you suspected that they used credit cards to go anyway. So right after gradu-
ation, you used some of your nest egg to buy Harley-Davidson stock. Then a couple of
months later, you purchased Starbucks stock. (As the owner of a Harley Softail motorcycle,
you’ve had a passion for riding since your high school days. And you give Starbucks credit
for helping you get through many long study sessions.) But since making these investments,
you have focused on your career and seldom thought about your investments. Your first ex-
tended break from work came in June 2012. After a lazy Saturday morning, you decided to
get on the Internet to see how your investments had done over the previous several months.
You bought Harley-Davidson for $37, and the stock was now trading at almost $50. “Not
4 Explain how diversifying
investments affects the
riskiness and expected rate of
return of a portfolio or
combination of assets.
FIguRE 6-2 historical Rates of Return
Large-
company
stocks
Securities
Nominal
Average
Annual
Returns
Standard
Deviation
of Returns
Real
Average
Annual
Returnsa
Risk
Premiumb
11.8% 20.3% 8.7% 8.0%
16.5% 32.5% 13.4% 12.7%
6.4% 8.4% 3.3% 2.6%
5.5% 5.7% 3.0% 2.3%
3.8% 3.1% 0.7% 0.0%
3.1% 4.2%
Small-
company
stocks
Corporate
bonds
Intermediate-term
government
bonds
U.S.
Treasury bills
Inflation
aThe real return equals the nominal returns less the inflation rate of 3.1 percent.
bThe risk premium equals the nominal security return less the average risk-free rate
(Treasury bills) of 3.8 percent.
Source: Data from Summary Statistics of Annual Total Returns: 1926 to 2011 Yearbook. Copyright® 2012 ibbotson Associates inc.

Chapter 6 • The Meaning and Measurement of Risk and Return 195
bad,” you thought. But then the bad news—Starbucks was selling for $54, compared to the
$62 that you paid for the stock.
Clearly, what we have described about Harley-Davidson and Starbucks were events
unique to these two companies, and as we would expect, investors reacted accordingly; that
is, the value of the stock changed in light of the new information. Although we might have
wished we had owned only Starbucks stock at the time, most of us would prefer to avoid
such uncertainties; that is, we are risk averse. Instead, we would like to reduce the risk as-
sociated with our investment portfolio, without having to accept a lower expected return.
Good news: It is possible by diversifying your portfolio!
Diversifying away the Risk
If we diversify our investments across different securities rather than invest in only one
stock, the variability in the returns of our portfolio should decline. The reduction in risk
will occur if the stock returns within our portfolio do not move precisely together over
time—that is, if they are not perfectly correlated. Figure 6-3 shows graphically what we
could expect to happen to the variability of returns as we add additional stocks to the port-
folio. The reduction occurs because some of the volatility in returns of a stock are unique to
that security. The unique variability of a single stock tends to be countered by the unique-
ness of another security. However, we should not expect to eliminate all risk from our
portfolio. In practice, it would be rather difficult to cancel all the variations in returns of a
portfolio, because stock prices have some tendency to move together. Thus, we can divide
the total risk (total variability) of our portfolio into two types of risk: (1) company-unique
risk, or unsystematic risk, and (2) market risk, or systematic risk. Company-unique
risk might also be called diversifiable risk, in that it can be diversified away. Market risk is
nondiversifiable risk; it cannot be eliminated through random diversification. These two types
of risk are shown graphically in Figure 6-3. Total risk declines until we have approximately
20 securities, and then the decline becomes very slight.
The remaining risk, which would typically be about 40 percent of the total risk, is the port-
folio’s systematic, or market, risk. At this point, our portfolio is highly correlated with all secu-
rities in the marketplace. Events that affect our portfolio now are not so much unique events
as changes in the general economy, major political events, and sociological changes. Examples
include changes in interest rates in the economy, changes in tax legislation that affect all com-
panies, or increasing public concern about the effect of business practices on the environment.
Our measure of risk should, therefore, measure how responsive a stock or portfolio is to changes
in a market portfolio, such as the New York Stock Exchange or the S&P 500 Index.7
company-unique risk see unsystematic risk.
unsystematic risk the risk related to an
investment return that can be eliminated
through diversification. Unsystematic risk is the
result of factors that are unique to the particular
firm. Also called company-unique risk or
diversifiable risk.
market risk see systematic risk.
systematic risk (1) the risk related to an
investment return that cannot be eliminated
through diversification. Systematic risk results
from factors that affect all stocks. Also called
market risk or nondiversifiable risk. (2) The risk of
a project from the viewpoint of a well-diversified
shareholder. This measure takes into account
that some of the project’s risk will be diversified
away as the project is combined with the firm’s
other projects, and, in addition, some of the
remaining risk will be diversified away by
shareholders as they combine this stock with
other stocks in their portfolios.
diversifiable risk see unsystematic risk.
nondiversifiable risk see systematic risk.
7The New York Stock Exchange Index is an index that reflects the performance of all stocks listed on the New York Stock
Exchange. The Standard & Poor’s (S&P) 500 Index is similarly an index that measures the combined stock-price performance
of the companies that constitute the 500 largest companies in the United States, as designated by Standard & Poor’s.
FIguRE 6-3 variability of Returns Compared with Size of Portfolio
Number of stocks in portfolio
Va
ri
ab
ili
ty
in
r
et
ur
ns
(s
ta
nd
ar
d
de
vi
at
io
n)
Unsystematic, or diversifiable,
risk (related to company-unique events)
1 10 20 25
Systematic or nondiversifiable
risk (result of general
market influences)
Total
risk

196 Part 2 • The Valuation of Financial Assets
Measuring Market Risk
To help clarify the idea of systematic risk, let’s examine the relationship between the com-
mon stock returns of Home Depot and the returns of the S&P 500 Index.
The monthly returns for Home Depot and the S&P 500 Index for the 12 months end-
ing June 2012 are presented in Table 6-3 and Figure 6-4. These monthly returns, or holding-
period returns, as they are often called, are calculated as follows.8
Monthly holding return =
priceend of month – pricebeginning of month
pricebeginning of month
=
priceend of month
pricebeginning of month
– 1 (6-6)
8For simplicity’s sake, we are ignoring the dividend that the investor receives from the stock as part of the total return.
In other words, letting Dt equal the dividend received by the investor in month t, the holding-period return would more
accurately be measured as
r1 =
Pt + Dt
Pt – 1
– 1 (6-7)
FIguRE 6-4 Monthly holding-Period Returns: home Depot versus the
S&P 500 Index, July 2011 Through June 2012
Jul-11
Sep-11
Nov-11 Jan-12 Mar-12
May-12
4%
Pe
rc
en
ta
ge
C
ha
ng
e
–8%
–10%
–4%
–6%
–2%
0%
2%
6%
8%
10%
12% S&P 500 Index
Home Depot
Months
For instance, the holding-period return for Home Depot and the S&P 500 Index for
January 2012 is computed as follows:
The Home Depot return =
stock price at end of January 2012
stock price at end of December 2011
– 1
=
$44.39
$42.04
– 1 = 0.0559 = 5.59%
The S&P 500 Index return =
index value at end of January 2012
index value at end of December 2011
– 1
=
$1,312.41
$1,257.60
– 1 = 0.0436 = 4.36%
At the bottom of Table 6-3, we have also computed the averages of the returns for the
12 months, for both Home Depot and the S&P 500 Index, and the standard deviation for
these returns. Because we are using historical return data, we assume each observation has
Source: Data from Yahoo Finance

Chapter 6 • The Meaning and Measurement of Risk and Return 197
an equal probability of occurrence. Thus, the average holding-period return is found by
summing the returns and dividing by the number of months; that is,
Average holding@period
return
=
return in month 1 + return in month 2 + g + return in last month
number of monthly returns
(6-8)
and the standard deviation is computed as follows:
Standard
deviation
= A (return in month 1 – average return)2 + (return in month 2 – average return)2 + g + (return in last month – average return)2number of monthly returns – 1
table 6-3 Monthly holding-Period returns, home Depot versus the s&P 500
Index, June 2011 through June 2012
home Depot s&P 500 Index
Month and year Price returns Price returns
2011
June $36.22 $1,320.64
July 34.93 -3.56% 1,292.28 -2.15%
August 33.38 -4.44% 1,218.89 -5.68%
September 32.87 -1.53% 1,131.42 -7.18%
october 35.80 8.91% 1,253.30 10.77%
november 39.22 9.55% 1,246.96 -0.51%
December 42.04 7.19% 1,257.60 0.85%
2012
January 44.39 5.59% 1,312.41 4.36%
February 47.57 7.16% 1,365.68 4.06%
March 50.31 5.76% 1,408.47 3.13%
April 51.79 2.94% 1,397.91 -0.75%
May 49.34 -4.73% 1,310.33 -6.27%
June 52.83 7.07% 1,355.69 3.46%
Average return 3.33% 0.34%
Standard deviation 5.40% 5.23%
Source: Data from Yahoo Finance
(6-9)
In looking at Table 6-3 and Figure 6-4, we notice the following things about Home
Depot’s holding-period returns over the 12 months ending in June 2012.
1. Home Depot’s shareholders realized significantly higher monthly holding-period
returns on average than the general market, as represented by the Standard & Poor’s
500 Index (S&P 500). Over the 12 months, Home Depot’s stock had an average 3.33
percent monthly return compared only to 0.34 percent for the S&P 500 Index.
2. While Home Depot had higher average monthly holding-period returns than the general
market (S&P 500 Index), at least for the 12-month period ending June 2012, the volatility
(standard deviation) of the returns was only slightly higher for Home Depot than for the
market—5.40 percent for Home Depot versus 5.23 percent for the S&P 500 Index.
3. We should also notice the tendency, although not perfect, of Home Depot’s stock
price to increase when the value of the S&P 500 Index increases and vice versa. This
was the case in 10 of the 12 months. That is, there is a moderate positive relationship
between Home Depot’s stock returns and the S&P 500 Index returns.
With respect to our third observation, that there is a relationship between the stock re-
turns of Home Depot and the S&P 500 Index, it is helpful to see this relationship by graph-
ing Home Depot’s returns against the S&P 500 Index returns. We provide such a graph in

198 Part 2 • The Valuation of Financial Assets
Source: Data from Yahoo Finance
Figure 6-5. In the figure, we have plotted Home Depot’s returns on the vertical axis and
the returns for the S&P 500 Index on the horizontal axis. Each of the 12 dots in the figure
represents the returns of Home Depot and the S&P 500 Index for a particular month.
For instance, the returns for January 2012 for Home Depot and the S&P 500 Index were
5.59 percent and 4.36 percent, respectively, which are noted in the figure.
In addition to the dots in the graph, we have drawn a line of “best fit,” which we call the
characteristic line. The slope of the characteristic line measures the average relationship between a
stock’s returns and those of the S&P 500 Index; or stated differently, the slope of the line indicates
the average movement in a stock’s price in response to a movement in the S&P 500 Index price. We
can estimate the slope of the line visually by fitting a line that appears to cut through the
middle of the dots. We then compare the rise (increase of the line on the vertical axis) to
the run (increase on the horizontal axis). Alternatively, we can enter the return data into a
financial calculator or in an Excel spreadsheet, which will calculate the slope based on sta-
tistical analysis. For Home Depot, the slope of the line is 0.82, which means that on aver-
age that as the market returns (S&P 500 Index returns) increase or decrease 1 percent, the
return for Home Depot on average increases or decreases 0.82 percentage points.
We can also think of the 0.82 slope of the characteristic line as indicating that Home
Depot’s returns are 0.82 times as volatile on average as those of the overall market (S&P
500 Index). This slope has come to be called beta (b) in investor jargon, and it measures the
average relationship between a stock’s returns and the market’s returns. It is a term you will see al-
most any time you read an article written by a financial analyst about the riskiness of a stock.
Looking once again at Figure 6-5, we see that the dots (returns) are scattered all about
the characteristic line—most of the returns do not fit neatly on the characteristic line.
That is, the average relationship may be 0.82, but the variation in Home Depot’s returns
is only partly explained by the stock’s average relationship with the S&P 500 Index. There
are other driving forces unique to Home Depot that also affect the firm’s stock returns.
(Earlier, we called this company-unique risk.) If we were, however, to diversify our
FIgure 6-5 Monthly holding-Period returns for home Depot versus the
s&P 500 Index, July 2011 through June 2012
10
5
50
Slope = Rise/Run = 8.2%/10% = .82
Rise = 8.2% = 11.2% – 3%
–5 10–10 2015–20
15
20
Home Depot monthly stock returns (%)
S&P 500 monthly returns (%)
–15
–5
–15
–20
Run = 10%
–10
January 2012 return
Characteristic line
3%
11.2%
Calculating beta:
Visual—the slope of a straight line can be estimated visually by drawing a straight line that best “fits”
the scatter of Home Depot‘s stock returns and those of the market index. The beta coefficient then is the
“rise over the run.” For example, when the S&P 500 Index is 10% shown on the horizontal axis (the
run), Home Depot shown on the vertical axis (the rise) begins at 3% and goes to 11.2%, which is a rise
of 8.2%. Thus, beta is the rise divided by the run, or 0.82 = 8.2% ÷ 10%.
Financial calculator—financial calculators have built in functions for computing the beta coefficient.
However, since the procedure varies from one calculator to another we do not present it here.
Excel—Excel’s Slope function can be used to calculate the slope, =slope(return values for Home
Depot,return values for S&P). For example, =slope(c5:c16,e5:e16) = 0.82.
characteristic line the line of “best fit”
through a series of returns for a firm’s stock rela-
tive to the market’s returns. The slope of the line,
frequently called beta, represents the average
movement of the firm’s stock returns in response
to a movement in the market’s returns.
beta the relationship between an investment’s
returns and the market’s returns. This is a
measure of the investment’s nondiversifiable
risk.

Chapter 6 • The Meaning and Measurement of Risk and Return 199
holdings and own, say, 20 stocks with betas of 0.82, we could essentially eliminate the
variation about the characteristic line. That is, we would remove almost all the volatility in
returns, except for that caused by the general market, which is represented by the slope of
the line in Figure 6-5. If we plotted the returns of our 20-stock portfolio against the S&P
500 Index, the points in our new graph would fit nicely along a straight line with a slope of
0.82, which means that the beta (b) of the portfolio is also 0.82. The new graph would look
something like the one shown in Figure 6-6. In other words, by diversifying our portfolio,
we can essentially eliminate the variations about the characteristic line, leaving only the
variation in returns for a company that comes from variations in the general market returns.
So beta (b)—the slope of the characteristic line—is a measure of a firm’s market risk or
systematic risk, which is the risk that remains for a company even after we have diversified
FIguRE 6-6 holding-Period Returns for a hypothetical Portfolio and the
S&P 500 Index
10
10
Characteristic line
Holding-period returns
–10 20 0302––30
20
30
Portfolio returns (%)
S&P 500 Index returns (%)
–10
–20
–30
Can You Do It?
esTiMaTing beTa
below, we provide the end-of-month prices for Toyota stock and the Standard & Poor’s 500 index for December 2011 through June
2012. Given the information, compute the following both for Toyota and the S&P 500: (1) the monthly holding-period returns, (2)
the average monthly returns, and (3) the standard deviation of the returns. Next, graph the holding-period returns of Toyota on the
vertical axis against the holding-period returns of the S&P 500 on the horizontal axis. Draw a line on your graph similar to what we did
in Figure 6-5 to estimate the average relationship between the stock returns of Toyota and the returns of the overall market as repre-
sented by the S&P 500. What is the approximate slope of your line? What does this tell you?
(in working this problem, it would be easier if you used an Excel spreadsheet including the slope function.)
D aT E TOyOTa S & P 500 I N D E x
Dec-11 $66.13 $1,257.60
Jan-12 73.48 1,312.41
Feb-12 82.71 1,365.68
Mar-12 86.82 1,408.47
Apr-12 81.78 1,397.91
May-12 76.89 1,310.33
June-12 76.30 1,355.69
(The solution can be found on page 204.)
Source: Data from Yahoo Finance

200 Part 2 • The Valuation of Financial Assets
our portfolio. It is this risk—and only this risk—that matters for investors who have broadly
diversified portfolios.
Although we have said that beta is a measure of a stock’s systematic risk, how should we
interpret a specific beta? For instance, when is a beta considered low and when is it consid-
ered high? In general, a stock with a beta of zero has no systematic risk; a stock with a beta
of 1 has systematic or market risk equal to the “typical” stock in the marketplace; and a stock
with a beta exceeding 1 has more market risk than the typical stock. Most stocks, however,
have betas between 0.60 and 1.60.
We should also realize that calculating beta is not an exact science. The final estimate of
a firm’s beta is heavily dependent on one’s methodology. For instance, it matters whether
you use 24 months in your measurement or 60 months, as most professional investment
companies do. Take our computation of Home Depot’s beta. We said Home Depot’s beta
is 0.82, but Value Line, a well-known investment service, has estimated Home Depot’s beta
to be 0.95. Value Line’s beta estimates for a number of firms are as follows:
CO M Pa N y N a M E b E Ta S
Amazon 1.05
Apple 1.05
Coca-Cola 0.60
ebay 1.10
ExxonMobil 0.80
General Electric 1.20
ibM 0.85
lowe’s 0.95
Merck 0.80
Nike 0.85
PepsiCo 0.60
WalMart 0.60
D aT E h a R L E y – D av I D S O N S & P 500 I N D E x
June-11 $ 40.97 $1,320.64
July-11 43.39 1,292.28
Aug-11 38.66 1,218.89
Sept-11 34.33 1,131.42
oct-11 38.90 1,253.30
Nov-11 36.77 1,246.96
Dec-11 38.87 1,257.60
Jan-12 44.19 1,312.41
Feb-12 46.58 1,365.68
Mar-12 49.08 1,408.47
Apr-12 52.33 1,397.91
May-12 48.18 1,310.33
June-12 46.18 1,355.69
E x a M P L E 6.2
Calculating monthly returns, average returns, standard
deviation, and estimating beta
Given the following price data for Harley-Davidson and the S&P 500 Index, compare
the returns and the volatility of the returns, and estimate the relationship of the returns
for Harley-Davidson and the S&P 500 Index. What do you conclude?

Chapter 6 • The Meaning and Measurement of Risk and Return 201
sTeP 1: FoRMulaTe a decision sTRaTegY
The following equations are needed to solve the problem:
Monthly holding-period returns:
Monthly holding return =
priceend of month – pricebeginning of month
pricebeginning of month
=
priceend of month
pricebeginning of month
– 1
Average monthly returns:
H A R l E Y – D AV i D S o N S & P 500 i N D E x
M O N T h P R I C E R E T u R N P R I C E R E T u R N
Jun-11 $40.97 $1,320.64
Jul-11 43.39 5.9% 1,292.28 -2.1%
Aug-11 38.66 -10.9% 1,218.89 -5.7%
Sep-11 34.33 -11.2% 1,131.42 -7.2%
oct-11 38.9 13.3% 1,253.30 10.8%
Nov-11 36.77 -5.5% 1,246.96 -0.5%
Dec-11 38.87 5.7% 1,257.60 0.9%
Jan-12 44.19 13.7% 1,312.41 4.4%
Feb-12 46.58 5.4% 1,365.68 4.1%
Mar-12 49.08 5.4% 1,408.47 3.1%
Apr-12 52.33 6.6% 1,397.91 -0.7%
May-12 48.18 -7.9% 1,310.33 -6.3%
Jun-12 46.18 -4.2% 1,355.69 3.5%
Average return
Standard deviation
Slope of the characteristic line

1.36% 0.34%
8.87% 5.23%
1.34
Average holding@period return =
return in month 1 + return in month 2 + g + return in last month
number of monthly returns
Standard deviation of the returns:
Standard
deviation
= A (return in month 1 – average return)2 + (return in month 2 – average return)2 + g + (return in last month – average return)2number of monthly returns – 1
Determining the historical relationship between Harley-Davidson’s stock returns and
those of the S&P 500 Index requires our eye balling the line that best fits the average
relationship, or using a financial calculator, or using a spreadsheet.
sTeP 2: cRunch The nuMbeRs
Given the price data, we have calculated the monthly returns, the average returns, and
the standard deviation of returns as follows, as well as the slope of the characteristic line
(using a spreadsheet):

202 Part 2 • The Valuation of Financial Assets
The relationship between the Harley-Davidson returns and the S&P 500 Index are
shown in the graph below:
10
5
5
Slope = Rise/Run = 13.4%/10% = 1.34
Rise = 13.4% = 14.4% – 1%
–5 10–10 2015–20
15
20
Harley-Davidson monthly stock returns (%)
S&P 500 monthly returns (%)
–15
–5
–15
–20
Run = 10%
–10
1%
14.4%
STEP 3: AnAlyzE your rESulTS
We can see that the average return for Harley-Davidson was significantly higher than the re-
turns for the S&P 500. (Remember these are only monthly returns.) But the volatility of the
returns for Harley-Davidson is also higher than for the S&P 500. Then when we regress the
Harley-Davidson returns on the market (S&P 500) returns, we see that the average relation-
ship is 1.34, which is a measure of systematic risk. That is, for every 1 percent that the market
returns move up or down, Harley-Davidson’s returns will on average move 1.34 percent.
Source: Data from Yahoo Finance.
Measuring a Portfolio’s Beta
What if we were to diversify our portfolio, as we have just suggested, but instead of acquir-
ing stocks with the same beta as Home Depot (0.82), we buy 8 stocks with betas of 1.0 and
12 stocks with betas of 1.5. What would the beta of our portfolio become? As it works out,
the portfolio beta is merely the average of the individual stock betas. It is a weighted aver-
age of the individual securities’ betas, with the weights being equal to the proportion of the portfolio
invested in each security. Thus, the beta (b) of a portfolio consisting of n stocks is equal to
Portfolio
beta
= °
percentage of beta for
portfolio invested * asset 1
in asset 1 (b1)
¢
+ °
percentage of beta for
portfolio invested * asset 2
in asset 2 (b2 )
¢
+ c + °
percentage of beta for
portfolio invested * asset n
in asset n (bn )
¢ (6-10)
So, assuming we bought equal amounts of each stock in our new 20-stock portfolio, the
beta would simply be 1.3, calculated as follows:
Portfolio beta = ¢ 8
20
* 1.0≤ + ¢ 12
20
* 1.50≤ = 1.3
portfolio beta the relationship between a
portfolio’s returns and the market returns. It is a
measure of the portfolio’s nondiversifiable risk.
To this point, we have talked about measuring an individual stock’s beta. We will now
consider how to measure the beta for a portfolio of stocks.

Chapter 6 • The Meaning and Measurement of Risk and Return 203
Thus, whenever the general market increases or decreases 1 percent, our new portfo-
lio’s returns would change 1.3 percent on average, which means that our new portfolio has
more systematic, or market, risk than the market has as a whole.
We can conclude that the beta of a portfolio is determined by the betas of the individual
stocks. If we have a portfolio consisting of stocks with low betas, then our portfolio will
have a low beta. The reverse is true as well. Figure 6-7 presents these situations graphically.
Before leaving the subject of risk and diversification, we want to share a study that dem-
onstrates the effects of diversifying our investments, not just across different stocks but also
across different types of securities.
Risk and Diversification Demonstrated
To this point, we have described the effect of diversification on risk and return in a general
way. Also, when we spoke of diversification, we were diversifying by holding more stocks
in our portfolio. Now let’s look briefly on how risk and return change as we (1) diversify
between two different types of assets—stocks and bonds, and (2) increase the length of time
that we hold a portfolio of assets.
Notice that when we previously spoke about diversification, we were diversifying by
holding more stock, but the portfolio still consisted of all stocks. Now we examine diversi-
fying between a portfolio of stocks and a portfolio of bonds. Diversifying among different
kinds of assets is called asset allocation, compared with diversification within the different
asset classes, such as stocks, bonds, real estate, and commodities. We know from experience
that the benefit we receive from diversifying is far greater through effective asset allocation
than from astutely selecting individual stocks to include with an asset category.
Figure 6-8 presents the range of rolling returns for several mixtures of stocks
and bonds depending on whether we held the investments 12 months, 60 months, or
120 months between 1926 and 2011. For the 12-month holding period, we would have pur-
chased the investment at the beginning of each year and sold at the end of each year, repeating
this process every year from 1926 to 2011. Then for the 60 months, we would have invested at
the beginning of the year and held the investment for 60 months. In other words, we invested at
the beginning of 1926 and sold at the end of 1930, then did the same for 1927–1931, repeating
the process for all 60-month periods all the way through 2011. Finally, we would have invested
at the beginning of each year, holding each investment for 120 months.
FIguRE 6-7 holding-Period Returns: high- and Low-beta Portfolios
and the S&P 500 Index
5
10
15
Portfolio returns (%)
S&P 500
5
� = 1.5
High-beta portfolio characteristic line
Low-beta portfolio characteristic line
� = 0.5
–5 10–10 15–15
–5
–10
–15
asset allocation identifying and selecting the
asset classes appropriate for a specific invest-
ment portfolio and determining the proportions
of those assets within the portfolio.

204 Part 2 • The Valuation of Financial Assets
As we observe in Figure 6-8, moving from an all-stock portfolio to a mixture of stocks and
bonds and finally to an all-bond portfolio reduces the variability of returns (our measure for
risk) significantly along with declining average rates of return. Stated differently, if we want to
increase our expected returns, we must assume more risk. That is, there is a clear relationship
between risk and return, which reminds us of Principle 3: Risk Requires a Reward.
Equally important, how long we hold our investments matters greatly when it comes
to reducing risk. As we move from 12 months to 60 months, and finally to 120 months, we
see the range of return falling sharply, especially when we move from 12-month holding
periods to 60-month holding periods. As a side note, notice that there has never been a time
between 1926 and 2011 when investors lost money if they held an all-stock portfolio—the
most risky portfolio—for 10 years. In other words, the market rewards the patient investor.
3
rinciple
DiD You Get it?
ESTimATing BETA
The holding-period returns, average monthly returns, and the standard deviations for Toyota and the S&P 500 data are as follows:
The graph would appear as follows:
The average relationship between Toyota’s stock returns and the S&P 500’s returns is estimated by the slope of the characteristic
line in the graph above. Using a spreadsheet, we find the slope to be 1.54, where the rise of the line is about 7.5 percent relative to a
run (horizontal axis) of 5 percent. Thus, Toyota’s stock returns are more volatile than the market’s returns. When the market rises (or
falls) 1 percent, Toyota’s stock will rise (or fall) 1.5 percent. (We should, however, be hesitant to draw any firm conclusions here, given
the limited number of return observations.)
ToYoTA S & P 500
P r i c e s r e t u r n s P r i c e s r e t u r n s
Dec-11 $66.13 $1,257.60
Jan-12 73.48 11.11% 1,312.41 4.36%
Feb-12 82.71 12.56% 1,365.68 4.06%
Mar-12 86.82 4.97% 1,408.47 3.13%
Apr-12 81.78 -5.81% 1,397.91 -0.75%
May-12 76.89 -5.98% 1,310.33 -6.27%
Jun-12 76.30 -0.77% 1,355.69 3.46%
Average return 2.68% 1.33%
Standard deviation 8.16% 4.16%
Slope 1.54
10
5
5–5 10–10 2015–20
15
20
Toyota (%)
S&P 500 (%)
–15
–5
–10
–15
–20
Run
Holding-period
returns Toyota’s
characteristic line
with a slope = 1.54
Rise
Source: Data from Yahoo Finance

Chapter 6 • The Meaning and Measurement of Risk and Return 205
Name of Tool Formula What It Tells You
Monthly
holding-
period return
Monthly holding@period return =
Priceend of month – Pricebeginning of month
Pricebeginning of month
=
Priceend of month
Pricebeginning of month
– 1
Calculates the
percentage
rate of return
for a security
held for a
single month.
Average
monthly
holding-
period rate of
return
Average monthly holding@period
return
=
return in month 1 + return in month 2 + g + return in last month
number of monthly returns
Finds the
average
monthly
holding-
period return
for a number
of monthly
returns.
Standard
deviation
of monthly
holding-
period returns
Standard
Deviation
= A (return in month 1 – average return)2 + (return in month 2 – average return)2 + g + (return in last month – average return)2number of monthly returns – 1
Measure of
the volatility
of monthly
holding-
period returns
over a series
of months.
Portfolio beta
Portfolio
beta
= °
percentage of beta for
portfolio invested * asset 1
in asset 1 (b1)
¢
+ °
percentage of beta for
portfolio invested * asset 2
in asset 2 (b2)
¢
+ c + °
percentage of beta for
portfolio invested * asset n
in asset n (bn)
¢
Finds the beta
for an entire
portfolio of
stocks.
FIgure 6-8 The effect of Diversifying and Investing for Longer Periods of Time on risk and returns
0%
–100%
100% Stocks 75% Stocks/
25% Bonds
50% Stocks/
50% Bonds
25% Stocks/
75% Bonds
100% Bonds
–50%
50%
100%
150%
200% 12-month holding periods
60-month holding periods
120-month holding periods
Compound annual return
9.6% 8.9% 8.0% 6.8% 5.4%
In the next section, we complete our study of risk and returns by connecting risk—market
or systematic risk—to the investor’s required rate of return. After all, although risk is an impor-
tant issue, it is primarily important in its effect on the investor’s required rate of return.
We now can recap the financial decision tools used to measure market risk for a single
investment and for a portfolio of investments. They can be shown as follows:
Financial Decision Tools
Source: Data from Summary Statistics of Annual Total Returns: 1926 to 2011 Yearbook. Copyright® 2012 Ibbotson Associates, Inc.

206 Part 2 • The Valuation of Financial Assets
Concept Check
1. Give specific examples of systematic and unsystematic risk. How many different securities must
be owned to essentially diversify away unsystematic risk?
2. What method is used to measure a firm’s market risk?
3. After reviewing Figure 6-5, explain the difference between the plotted dots and the firm’s char-
acteristic line. What must be done to eliminate the variations?
The Investor’s Required Rate of Return
In this section, we examine the concept of the investor’s required rate of return, especially
as it relates to the riskiness of an asset, and then we see how the required rate of return
might be measured.
The Required Rate of Return Concept
An investor’s required rate of return can be defined as the minimum rate of return neces-
sary to attract an investor to purchase or hold a security. This definition considers the investor’s
opportunity cost of funds of making an investment in the next-best investment. This forgone
return is an opportunity cost of undertaking the investment and, consequently, is the inves-
tor’s required rate of return. In other words, we invest with the intention of achieving a rate
of return sufficient to warrant making the investment. The investment will be made only if
the purchase price is low enough relative to expected future cash flows to provide a rate of
return greater than or equal to our required rate of return.
To help us better understand the nature of an investor’s required rate of return, we
can separate the return into its basic components: the risk-free rate of return plus a risk
premium. Expressed as an equation:
Investor,s required
rate of return
=
risk@free rate of
return
+
risk
premum
(6-11)
The risk-free rate of return is the required rate of return, or discount rate, for riskless
investments. Typically, our measure for the risk-free rate of return is the U.S. Treasury bill
rate. The risk premium is the additional return we must expect to receive for assuming risk.
As the level of risk increases, we will demand additional expected returns. Even though we
may or may not actually receive this incremental return, we must have reason to expect it;
otherwise, why expose ourselves to the chance of losing all or part of our money?
To illustrate, assume you are considering the purchase of a stock that you believe will
provide a 10 percent return over the next year. If the expected risk-free rate of return, such
as the rate of return for 90-day Treasury bills, is 2 percent, then the risk premium you are
demanding to assume the additional risk is 8 percent (10% − 2%).
Measuring the Required Rate of Return
We have seen that (1) systematic risk is the only relevant risk—the rest can be diversified
away, and (2) the required rate of return, k, equals the risk-free rate plus a risk premium.
We will now examine how we can estimate investors’ required rates of return.
The finance profession has had difficulty in developing a practical approach to measure
an investor’s required rate of return; however, financial managers often use a method called
the capital asset pricing model (CAPM). The capital asset pricing model is an equation
that equates the expected rate of return on a stock to the risk-free rate plus a risk premium for the
stock’s systematic risk. Although certainly not without its critics, the CAPM provides an in-
tuitive approach for thinking about the return that an investor should require on an invest-
ment, given the asset’s systematic or market risk.
Equation (6-11) above provides the natural starting point for measuring the investor’s
required rate of return and sets us up for using the CAPM. Rearranging this equation to
solve for the risk premium we have
Risk
premium
=
investor,s required
rate of return, r
–
risk@free rate of
return, rf
(6-12)
5 Explain the relationship
between an investor’s required
rate of return on an investment
and the riskiness of the
investment.
required rate of return minimum rate of
return necessary to attract an investor to
purchase or hold a security.
risk-free rate of return the rate of return
on risk-free investments. The interest rates on
short-term U.S. government securities are
commonly used to measure this rate.
risk premium the additional return expected
for assuming risk.
capital asset pricing model (CaPM)
an equation stating that the expected rate of
return on an investment (in this case a stock)
is a function of (1) the risk-free rate, (2) the
investment’s systematic risk, and (3) the
expected risk premium for the market portfolio
of all risky securities.

Chapter 6 • The Meaning and Measurement of Risk and Return 207
which simply says that the risk premium for a security equals the investor’s required re-
turn less the risk-free rate existing in the market. For example, if the required return is
12 percent and the risk-free rate is 3 percent, the risk premium is 9 percent. Also, if the
required return for the market portfolio is 10 percent, and the risk-free rate is 3 percent, the
risk premium for the market would be 7 percent. This 7 percent risk premium would apply
to any security having systematic (nondiversifiable) risk equivalent to the general market,
or a beta (b) of 1.
In this same market, a security with a beta (b) of 2 should provide a risk premium of
14 percent, or twice the 7 percent risk premium existing for the market as a whole. Hence, in
general, the appropriate required rate of return for a given security should be determined by
Required return on
security, r
=
risk free
rate of return, rf
+
beta for
security, b
* ° required return
on the market portfolio, rm
–
risk@free
rate of return, rf
¢
(6-13)
Equation (6-13) is the CAPM. This equation designates the risk–return trade-off
existing in the market, where risk is measured in terms of beta. Figure 6-9 graphs the
CAPM as the security market line.9 The security market line is the graphic represen-
tation of the CAPM. It is the line that shows the appropriate required rate of return given a
stock’s systematic risk
9Two key assumptions are made in using the security market line. First, we assume that the marketplace where securities are
bought and sold is highly efficient. Market efficiency indicates that the price of an asset responds quickly to new information,
thereby suggesting that the price of a security reflects all available information. As a result, the current price of a security is
considered to represent the best estimate of its future price. Second, the model assumes that a perfect market exists. A perfect
market is one in which information is readily available to all investors at a nominal cost. Also, securities are assumed to be
infinitely divisible, with any transaction costs incurred in purchasing or selling a security being negligible. Furthermore, inves-
tors are assumed to be single-period wealth maximizers who agree on the meaning and significance of the available
information. Finally, within the perfect market, all investors are price takers, which simply means that a single investor’s actions
cannot affect the price of a security. These assumptions are obviously not descriptive of reality. However, from the perspective
of positive economics, the mark of a good theory is the accuracy of its predictions, not the validity of the simplifying assump-
tions that underlie its development.
FInanCe at Work
does beTa alwaYs woRk?
At the start of 1998, Apple Computer was in deep trouble. As
a result, its stock price fluctuated wildly—far more than other
computer firms, such as ibM. However, based on the capital as-
set pricing model (CAPM) and its measure of beta, the required
return of Apple’s investors would have been only 8 percent,
compared with 12 percent for ibM’s stockholders. Equally inter-
esting, when Apple’s situation improved in the spring of that
year, and its share price became less volatile, Apple’s investors,
at least according to the CAPM, would have required a rate of
return of 11 percent—a 3 percentage point increase from the
earlier required rate of return. That is not what intuition would
suggest should have happened.
So what should we think? Just when Apple’s future was most
in doubt and its shares most volatile, its beta was only 0.47, sug-
gesting that Apple’s stock was only half as volatile as the overall
stock market. in reality, beta is meaningless here. The truth is
that Apple was in such a dire condition that its stock price sim-
ply “decoupled” itself from the stock market. So, as ibM and its
peer stock prices moved up and down with the rest of the mar-
ket, Apple shares reacted solely to news about the company,
without regard for the market’s movements. The stock’s beta
thus created the false impression that Apple shares were more
stable than the stock market.
The lesson here is that beta may at times be misleading
when used with individual companies. instead, its use is far
more reliable when applied to a portfolio of companies. if a firm
that was interested in acquiring Apple Computer in 1998, for
instance, had used the beta in computing the required rate of
return for the acquisition, it would without a doubt have over-
valued Apple.
So does that mean that CAPM is worthless? No, not as long as
company-unique risk is not the main driving force in a company’s
stock price movements or if investors are able to diversify away spe-
cific company risk. Then they would bid up the price of such shares
until they reflected only market risk. For example, a mutual fund
that specializes in “distressed stocks” might purchase a number of
“Apple Computer-type companies,” each with its own problems,
but for different reasons. For such investors, betas work pretty well.
Thus, the moral of the story is to exercise common sense and judg-
ment when using a beta.
security market line the return line that
reflects the attitudes of investors regarding the
minimum acceptable return for a given level of
systematic risk associated with a security.

208 Part 2 • The Valuation of Financial Assets
As presented in this figure, securities with betas equal to 0, 1,
and 2, should have required rates of return as follows:
If b = 0: required rate of return = 3% + 0(10% – 3%) = 3%
If b = 1: required rate of return = 3% + 1(10% -3%) = 10%
If b = 2: required rate of return = 3% + 2(10%-3%) = 17%
where the risk-free rate is 3 percent, and the required return
for the market portfolio is 10 percent.
A large part of this chapter has been spent in explaining and measuring an investment’s
expected rate of return and the corresponding amount of risk. However, one step remains—
providing the financial tool or criterion to determine if the investment should be made.
Only by knowing the investor’s required rate of return for a particular investment can we
answer this question. The formulas used to answer this question were presented in this sec-
tion and can be summarized as follows:
Name of Tool Formula What It Tells you
investor’s required
rate of return
investor
,
s required rate of return = risk@free rate of return + risk premium
Measures an investor’s required
rate of return based on a risk-
free rate plus a return premium
for assuming risk
Risk premium Risk premium = investor
,
s required rate of return, r – risk@free rate of return, rf
indicates the additional return
an investor should require to
assume additional risk
investor’s required
rate of return
Required
return on security, r
=
risk free
rate of return, rf
+
beta for
security, b
* ¢ required return
on the market portfolio, rm
–
risk@free
rate of return, rf
≤ Calculates the rate of return an investor should require based on the capital asset pricing model, which only considers systematic risk to determine the
appropriate risk premium
FIguRE 6-9 Security Market Line
Ex
pe
ct
ed
r
et
ur
n
(%
)
Beta
20
18
16
14
12
10
8
6
4
2
0.5 1.5
Se
cur
ity
m
ark
et
lin
e
1.0 2.0 2.5
Risk-free required
return when beta = 0
Required return when
beta = 2
Market required rate of
return when beta = 1
ReMeMbeR YouR PRinciPles
The conclusion of the matter is that Principle 3 is
alive and well. it tells us, Risk Requires a Reward. That is, there
is a risk–return trade-off in the market.
rinciple
FInanCIal DeCIsIon tools

Chapter 6 • The Meaning and Measurement of Risk and Return 209
Can You Do It?
coMPuTing a RequiRed RaTe oF ReTuRn
Determine a fair expected (or required) rate of return for a stock that has a beta of 1.25 when the risk-free rate is 3 percent and the
expected market return is 9 percent.
(The solution can be found below.)
DID You Get It?
coMPuTing a RequiRed RaTe oF ReTuRn
The appropriate rate of return would be:
Required return = risk@free rate + [beta * (market return – risk@free rate)]
= 3% + [1.25 * (9% – 3%)]
= 10.5%
Chapter Summaries
In Chapter 2, we referred to the discount rate as the interest rate, or the opportunity cost of funds.
At that point, we considered a number of important factors that influence interest rates, including
the price of time, expected or anticipated inflation, the risk premium related to maturity (liquidity),
and the variability of future returns. In this chapter, we have returned to our study of rates of return
and looked ever so carefully at the relationship between risk and rates of return.
Define and measure the expected rate of return of an individual
investment. (pgs 184–186)
SuMMaRy: When we speak of “returns” on an investment, either we are talking about historical
return, what we earned on an investment in the past, or expected returns, where we are attempting
to determine the return we can “expect” to receive in the future. In a world of uncertainty, we can-
not make forecasts with certitude. Thus, we must speak in terms of expected events. The expected
return on an investment may therefore be stated as a weighted average of all possible returns,
weighted by the probability that each will occur.
KEy TERMS
1
Holding-period return (historical or realized
rate of return), page 184 The rate of return
earned on an investment, which equals the
dollar gain divided by the amount invested.
Expected rate of return, page 184 The
arithmetic mean or average of all possible
outcomes where those outcomes are weighted
by the probability that each will occur.
Concept Check
1. How does opportunity cost affect an investor’s required rate of return?
2. What are the two components of the investor’s required rate of return?
3. How does beta fit into factoring the risk premium in the CAPM equation?
4. Assuming the market is efficient, what is the relationship between a stock’s price and the security
market line?

210 Part 2 • The Valuation of Financial Assets
Key equations
Holding@period dollar gain, DG
= priceend of period + cash distribution (dividend) – pricebeginning of period
Holding@period rate of return, r
=
dollar gain
pricebeginning of period
=
priceend of period + dividend – pricebeginning of period
pricebeginning of period

Expected
cash flow, CF = °
cash flow probability
in state 1 * of state 1
(CF1) (Pb1)
¢ + °
cash flow probability
in state 2 * of state 2
(CF2) (Pb2)
¢
+ c + °
cash flow probability
in state n * of state n
(CFn) (Pbn)
¢
Expected
rate of return, r = °
rate of return probability
for state 1 * of state 1
(r1) (Pb1)
¢ + °
rate of return probability
for state 2 * of state 2
(r2) (Pb2)
¢
+ c + °
rate of return probability
for state n * of state n
(rn) (Pbn)
¢
Define and measure the riskiness of an individual investment. (pgs 186–193)
summary: Risk associated with a single investment is the variability of cash flows or returns and
can be measured by the standard deviation.
Key terms
2
Risk, page 187 Potential variability in future
cash flows.
Standard deviation, page 189 A statistical
measure of the spread of a probability
distribution calculated by squaring the
difference between each outcome and its
expected value, weighting each value by its
probability, summing over all possible
outcomes, and taking the square root of
this sum.
Key equation
Variance in
rates of return
(s2)
= £ °
rate of return
for state 1
(r1)
–
expected rate
of return
r
¢
2
*
probability
of state 1 §
(Pb1)
+ £ °
rate of return expected rate
for state 2 – of return
(r2) r
¢
2

probability
* of state 2 §
(Pb2 )

+ g + £ °
rate of return
for state n
(rn)
–
expected rate
of return
r
¢
2
*
probability
of state n §
(Pbn)

Compare the historical relationship between risk and rates of return in the
capital markets. (pgs 193–194)
summary: Ibbotson Associates have provided us with annual rates of return earned on different
types of security investments as far back as 1926. They summarize among other things, the annual
returns for six portfolios of securities made up of
1. Common stocks of large companies
2. Common stocks of small firms
3. Long-term corporate bonds
3

4. Long-term U.S. government bonds
5. Intermediate-term U.S. government bonds
6. U.S. Treasury bills
A comparison of the annual rates of return for these respective portfolios for the years 1926 to
2011 shows a positive relationship between risk and return, with Treasury bills being least risky and
common stocks of small firms being most risky. From the data, we are able to see the benefit of di-
versification in terms of improving the return–risk relationship. Also, the data clearly demonstrate
that only common stock has in the long run served as an inflation hedge, and that the risk associated
with common stock can be reduced if investors are patient in receiving their returns.
explain how diversifying investments affects the riskiness and expected rate
of return of a portfolio or combination of assets. (pgs 194–206)
summary: We made an important distinction between nondiversifiable risk and diversifiable
risk. We concluded that the only relevant risk, given the opportunity to diversify our portfolio,
is a security’s nondiversifiable risk, which we called by two other names: systematic risk and
market-related risk.
Key terms
4
Systematic risk (market risk or
nondiversifiable risk), page 195 (1) The risk
related to an investment return that cannot be
eliminated through diversification. Systematic
risk results from factors that affect all stocks.
Also called market risk or nondiversifiable risk.
(2) The risk of a project from the viewpoint of
a well-diversified shareholder. This measure
takes into account that some of the project’s
risk will be diversified away as the project is
combined with the firm’s other projects, and, in
addition, some of the remaining risk will be
diversified away by shareholders as they
combine this stock with other stocks in their
portfolios.
Unsystematic risk (company unique risk or
diversifiable risk), page 195 The risk related
to an investment return that can be eliminated
through diversification. Unsystematic risk is
the result of factors that are unique to the
particular firm. Also called company-unique
risk or diversifiable risk.
Characteristic line, page 198 The line of
“best fit” through a series of returns for a
firm’s stock relative to the market’s returns.
The slope of the line, frequently called beta,
represents the average movement of the firm’s
stock returns in response to a movement in the
market’s returns.
Beta, page 198 The relationship between an
investment’s returns and the market’s returns.
This is a measure of the investment’s
nondiversifiable risk.
Portfolio beta, page 202 The relationship
between a portfolio’s returns and the market
returns. It is a measure of the portfolio’s
nondiversifiable risk.
Asset allocation, page 203 Identifying
and selecting the asset classes appropriate
for a specific investment portfolio and
determining the proportions of those assets
within the portfolio.
Key equations
Monthly holding return =
Priceend of month – Pricebeginning of month
Pricebeginning of month
=
Priceend of month
Pricebeginning of month
– 1
Average holding@period return =
return in month 1 + return in month 2 + g + return in last month
number of monthly returns
Standard
deviation
= A (return in month 1 – average return)2 + (return in month 2 – average return)2 + g (return in last month – average return)2number of monthly returns – 1
Chapter 6 • The Meaning and Measurement of Risk and Return 211

212 Part 2 • The Valuation of Financial Assets
Portfolio
beta = °
percentage of beta for
portfolio invested * asset 1
in asset 1 (b1)
¢
+ °
percentage of beta for
portfolio invested * asset 2
in asset 2 (b2)
¢
+ c + °
percentage of beta for
portfolio invested * asset n
in asset n (bn)
¢
explain the relationship between an investor’s required rate of return on an
investment and the riskiness of the investment. (pgs. 206–209)
summary: The capital asset pricing model provides an intuitive framework for understanding
the risk–return relationship. The CAPM suggests that investors determine an appropriate required
rate of return, depending upon the amount of systematic risk inherent in a security. This minimum
acceptable rate of return is equal to the risk-free rate plus a risk premium for assuming risk.
Key terms
5
Required rate of return, page 206 Mini-
mum rate of return necessary to attract an
investor to purchase or hold a security.
Risk-free rate of return, page 206 The rate
of return on risk-free investments. The interest
rates on short-term U.S. government securities
are commonly used to measure this rate.
Risk premium, page 206 The additional
return expected for assuming risk.
Capital asset pricing model (CAPM),
page 206 An equation stating that the
expected rate of return on an investment
(in this case a stock) is a function of (1) the
risk-free rate, (2) the investment’s systematic
risk, and (3) the expected risk premium for the
market portfolio of all risky securities.
Security market line, page 207 The return
line that reflects the attitudes of investors
regarding the minimum acceptable return for
a given level of systematic risk associated with
security.
Key equations
Investor,s required rate of return = risk@free rate of return + risk premium
Risk premium = investor,s required rate of return, r – risk@free rate of return, rf
Required return on
security, r
=
risk free
rate of return, rf
+
beta for
security, b
* ¢ required return
on the market portfolio, rm
–
risk@free
rate of return, rf
≤
review questions
All Review Questions are available in MyFinanceLab.
6-1. a. What is meant by the investor’s required rate of return?
b. How do we measure the riskiness of an asset?
c. How should the proposed measurement of risk be interpreted?
6-2. What is (a) unsystematic risk (company-unique or diversifiable risk) and (b) systematic risk
(market or nondiversifiable risk)?
6-3. What is a beta? How is it used to calculate r, the investor’s required rate of return?
6-4. What is the security market line? What does it represent?
6-5. How do we measure the beta of a portfolio?
6-6. If we were to graph the returns of a stock against the returns of the S&P 500 Index, and the
points did not follow a very ordered pattern, what could we say about that stock? If the stock’s
returns tracked the S&P 500 returns very closely, then what could we say?

Chapter 6 • The Meaning and Measurement of Risk and Return 213
6-7. Over the past eight decades, we have had the opportunity to observe the rates of return and
the variability of these returns for different types of securities. Summarize these observations.
6-8. What effect will diversifying your portfolio have on your returns?
study Problems
All Study Problems are available in MyFinanceLab.
6-1. (Expected return and risk) Universal Corporation is planning to invest in a security that has
several possible rates of return. Given the following probability distribution of returns, what is the
expected rate of return on the investment? Also compute the standard deviations of the returns.
What do the resulting numbers represent?
2
P r o b a b i l i t y r e t u r n
0.15 6%
0.30 9%
0.40 10%
0.15 15%
Co M M o n S To C k A Co M M o n S To C k B
P r o b a b i l i t y r e t u r n P r o b a b i l i t y r e t u r n
0.30 11% 0.20 -5%
0.40 15% 0.30 6%
0.30 19% 0.30 14%
0.20 22%
6-2. (Average expected return and risk) Given the holding-period returns shown here, calculate the
average returns and the standard deviations for the Kaifu Corporation and for the market.
m o n t h K a i f u Co r P. m a r K e t
1 4% 2%
2 6 3
3 0 1
4 2 -1
6-3. (Expected rate of return and risk) Carter Inc. is evaluating a security. Calculate the investment’s
expected return and its standard deviation.
P r o b a b i l i t y r e t u r n
0.10 -10%
0.20 5%
0.30 10%
0.40 25%
6-4. (Expected rate of return and risk) Summerville Inc. is considering an investment in one of two
common stocks. Given the information that follows, which investment is better, based on the risk
(as measured by the standard deviation) and return of each?
6-5. (Standard deviation) Given the following probabilities and returns for Mik’s Corporation, find
the standard deviation.

6-6. (Expected return) Go to http://finance.yahoo.com. Select the link Investing, and then choose
Education. Go to Financial Glossary. Find the terms Expected Return and Expected Value in the
glossary. What did you learn from these definitions?
6-7. Go to www.investopedia.com/university/beginner, where there is an article on “Investing
101: Introduction.” Read the article and explain what it says about risk tolerance.
6-8. Go to www.moneychimp.com. Select the link Volatility. Complete the retirement planning
calculator, making the assumptions that you believe are appropriate for you. Then go to the Monte
Carlo simulation calculator. Assume that you invest in large-company common stocks during your
working years and then invest in long-term corporate bonds during retirement. Use the nominal
average returns and standard deviations shown in Figure 6-2. What did you learn?
6-9. (Holding-period returns) From the price data that follow, compute the holding-period returns
for periods 2 through 4.
3
4
P e r i o d S to c k P r i c e
1 $10
2 13
3 11
4 15
214 Part 2 • The Valuation of Financial Assets
P r o b a b i l i t y r e t u r n S
0.40 7%
0.25 4%
0.15 18%
0.20 10%
P e r i o d J a z m a n S o lo m o n
1 $ 9 $27
2 11 28
3 10 32
4 13 29
6-10. (Computing holding-period returns)
a. From the price data here, compute the holding-period returns for Jazman and Solomon for
periods 2 through 4.
m o n t h z e m i n co r P. m a r k e t
1 6% 4%
2 3 2
3 -1 1
4 -3 -2
5 5 2
6 0 2
b. How would you interpret the meaning of a holding-period return?
6-11. (Measuring risk and rates of return)
a. Given the holding-period returns shown here, compute the average returns and the
standard deviations for the Zemin Corporation and for the market.

www.investopedia.com/university/beginner

http://finance.yahoo.com

www.moneychimp.com

Chapter 6 • The Meaning and Measurement of Risk and Return 215
b. If Zemin’s beta is 1.54 and the risk-free rate is 4 percent, what would be an appropriate
required return for an investor owning Zemin? (Note: Because the returns of Zemin Cor-
poration are based on monthly data, you will need to annualize the returns to make them
compatible with the risk-free rate. For simplicity, you can convert from monthly to yearly
returns by multiplying the average monthly returns by 12.)
c. How does Zemin’s historical average return compare with the return you believe to be a
fair return, given the firm’s systematic risk?
6-12. (Holding period dollar gain and return) Suppose you purchased 16 shares of Disney stock for
$24.22 per share on May 1, 2012. On September 1 of the same year, you sold 12 shares of the stock
for $25.68. Calculate the holding-period dollar gain for the shares you sold, assuming no dividend
was distributed, and the holding-period rate of return.
6-13. (Asset allocation) Go to http://cgi.money.cnn.com/tools and then go to the heading, investing
and click the link Fix Your Asset Allocation. Answer the questions and click, Calculate. Try differ-
ent options and see how the calculator suggests you allocate your investments.
6-14. (Expected return, standard deviation, and capital asset pricing model) The following are the end-
of-month prices for both the Standard & Poor’s 500 Index and Nike’s common stock.
a. Using the data here, calculate the holding-period returns for each of the months.
5
n i k e S & P 500 i n d e x
2011
June $89.98 $1,320.64
July 90.15 1,292.28
August 86.65 1,218.89
September 85.51 1,131.42
October 96.35 1,253.30
November 96.18 1,246.96
December 96.37 1,257.60
2012
January 103.99 1,312.41
February 107.92 1,365.68
March 108.44 1,408.47
April 111.87 1,397.91
May 108.18 1,310.33
June 98.45 1,355.69
b. Calculate the average monthly return and the standard deviation for both the S&P 500 and
Nike.
c. Develop a graph that shows the relationship between the Nike stock returns and the S&P
500 Index. (Show the Nike returns on the vertical axis and the S&P 500 Index returns on
the horizontal axis as done in Figure 6-5.)
d. From your graph, describe the nature of the relationship between Nike stock returns and
the returns for the S&P 500 Index.
6-15. (Capital asset pricing model) Using the CAPM, estimate the appropriate required rate of return
for the three stocks listed here, given that the risk-free rate is 5 percent and the expected return for
the market is 12 percent.
S to c k b e ta
A 0.75
B 0.90
C 1.40

http://cgi.money.cnn.com/tools

216 Part 2 • The Valuation of Financial Assets
6-16. (Expected return, standard deviation, and the Capital Asset Pricing Model) Below you have been
provided the prices for Merck and the S&P 500 Index.
M E R C K S & P 500 I N D E x
2011
June $32.27 $1,320.64
July 32.75 1,292.28
August 30.87 1,218.89
September 29.49 1,131.42
october 31.83 1,253.30
November 29.59 1,246.96
December 30.33 1,257.60
2012
January 31.60 1,312.41
February 35.74 1,365.68
March 36.90 1,408.47
April 41.02 1,397.91
May 39.19 1,310.33
June 42.50 1,355.69
S TO C K P E R C E N Tag E O F P O R T F O L I O b E Ta E x P E C T E D R E T u R N
1 40% 1.00 12%
2 25 0.75 11
3 35 1.30 15
a. Calculate the monthly holding-period returns for Merck and the S&P 500 Index.
b. What are the average monthly returns and standard deviations for each?
c. Graph the Merck returns against the S&P 500 Index returns.
d. Use a spreadsheet to compute the slope of the characteristic line.
e. Interpret your findings.
6-17. (Security market line)
a. Determine the expected return and beta for the following portfolio:
4%
4% 8% 12%–12% –8% –4%
8%
12%
Holding-period returns
Aram Inc.
S&
P
50
0
In
de
x
–4%
–8%
–12%
b. Given the foregoing information, draw the security market line and show where the
securities and portfolio fit on the graph. Assume that the risk-free rate is 2 percent and
that the expected return on the market portfolio is 8 percent. How would you interpret
these findings?
6-18. (Required rate of return using CAPM)
a. Compute a fair rate of return for Intel common stock, which has a 1.2 beta. The risk-free
rate is 2 percent, and the market portfolio (New York Stock Exchange stocks) has an ex-
pected return of 11 percent.
b. Why is the rate you computed a fair rate?
6-19. (Estimating beta) From the graph in the margin relating the holding-period returns for Aram
Inc. to the S&P 500 Index, estimate the firm’s beta.
6-20. (Capital asset pricing model) Levine Manufacturing Inc. is considering several invest-
ments. The rate on Treasury bills is currently 2.75 percent, and the expected return for the
market is 12 percent. What should be the required rates of return for each investment (using
the CAPM)?

Chapter 6 • The Meaning and Measurement of Risk and Return 217
6-21. (Capital asset pricing model) MFI Inc. has a beta of 0.86. If the expected market return is 11.5
percent and the risk-free rate is 3 percent, what is the appropriate required return of MFI (using
the CAPM)?
6-22. (Capital asset pricing model) The expected return for the general market is 12.8 per-
cent, and the risk premium in the market is 9.3 percent. Tasaco, LBM, and Exxos have
betas of 0.864, 0.693, and 0.575, respectively. What are the corresponding required rates
of return for the three securities?
6-23. (Portfolio beta and security market line) You own a portfolio consisting of the stocks below:
S e c u r i t y B e ta
A 1.50
B 0.90
C 0.70
D 1.15
S to c k
P e r c e n tag e
o f P o r t f o l i o B e ta e x P e c t e d r e t u r n
1 20% 1.00 12%
2 30 0.85 8
3 15 1.20 12
4 25 0.60 7
5 10 1.60 16
The risk-free rate is 3 percent. Also, the expected return on the market portfolio is 11 percent.
a. Calculate the expected return of your portfolio. (Hint: The expected return of a portfolio
equals the weighted average of the individual stocks’ expected returns, where the weights
are the percentage invested in each stock.)
b. Calculate the portfolio beta.
c. Given the foregoing information, plot the security market line on paper. Plot the stocks
from your portfolio on your graph.
d. From your plot in part (c), which stocks appear to be your winners and which ones appear
to be losers?
e. Why should you consider your conclusion in part (d) to be less than certain?
6-24. (Portfolio beta) Assume you have the following portfolio.
S to c k W e i g h t B e ta
Apple 38% 1.50
Green Mountain Coffee 15% 1.44
Disney 27% 1.15
Target 20% 1.20
What is the portfolio’s beta?
Mini case
This Mini Case is available in MyFinanceLab.
Note: Although not absolutely necessary, you are advised to use a computer spreadsheet to work
the following problem.

218 Part 2 • The Valuation of Financial Assets
a. Use the price data from the table that follows for the Standard & Poor’s 500 Index, Wal-
mart, and Target to calculate the holding-period returns for the 24 months from July 2010
through June 2012.
M O N T h S & P 500 Wa L – M a R T Ta R g E T
June-10 $1,030.71 $48.07 $49.17
Jul-10 1,101.60 51.19 51.32
Aug-10 1,049.33 50.14 51.16
Sep-10 1,141.20 53.52 53.44
oct-10 1,183.26 54.17 51.94
Nov-10 1,180.55 54.09 56.94
Dec-10 1,257.64 53.93 60.13
Jan-11 1,286.12 56.07 54.83
Feb-11 1,327.22 51.98 52.55
Mar-11 1,325.83 52.05 50.01
Apr-11 1,363.61 54.98 49.10
May-11 1,345.20 55.22 49.53
Jun-11 1,320.64 53.14 46.91
Jul-11 1,292.28 52.71 51.49
Aug-11 1,218.89 53.19 51.67
Sep-11 1,131.42 51.90 49.04
oct-11 1,253.30 56.72 54.75
Nov-11 1,246.96 58.90 52.70
Dec-11 1,257.60 59.76 51.22
Jan-12 1,312.41 61.36 50.81
Feb-12 1,365.68 59.08 56.69
Mar-12 1,408.47 61.20 58.27
Apr-12 1,397.91 58.91 57.94
May-12 1,310.33 65.82 57.91
Jun-12 1,355.69 67.70 57.40
b. Calculate the average monthly holding-period returns and the standard deviation of these
returns for the S&P 500 Index, Wal-mart, and Target.
c. Plot (1) the holding-period returns for Wal-mart against the Standard & Poor’s 500 Index,
and (2) the Target holding-period returns against the Standard & Poor’s 500 Index. (Use
Figure 6-5 as the format for your graph.)
d. From your graphs in part (c), describe the nature of the relationship between the stock
returns for Wal-mart and the returns for the S&P 500 Index. Make the same comparison
for Target.
e. Assume that you have decided to invest one-half of your money in Wal-mart and the re-
mainder in Target. Calculate the monthly holding-period returns for your two-stock port-
folio. (Hint: The monthly return for the portfolio is the average of the two stocks’ monthly
returns.)
f. Plot the returns of your two-stock portfolio against the Standard & Poor’s 500 Index as you
did for the individual stocks in part (c). How does this graph compare to the graphs for the
individual stocks? Explain the difference.
g. The following table shows the returns on an annualized basis that were realized from
holding long-term government bonds for the same period. Calculate the average
monthly holding-period returns and the standard deviations of these returns. (Hint:
You will need to convert the annual returns to monthly returns by dividing each return
by 12 months.)

Chapter 6 • The Meaning and Measurement of Risk and Return 219
h. Now assuming that you have decided to invest equal amounts of money in Wal-mart,
Target, and long-term government securities, calculate the monthly returns for your three-
asset portfolio. What is the average return and the standard deviation?
i. Make a comparison of the average returns and the standard deviations for all the individual
assets and the two portfolios that we designed. What conclusions can be reached by your
comparison?
j. According to Standard & Poor’s, the betas for Wal-mart and Target are 0.45 and 0.60,
respectively. Compare the meaning of these betas relative to the standard deviations calcu-
lated above.
k. Assume that the current Treasury bill rate is 3 percent and that the expected market return
is 10 percent. Given the betas for Wal-mart and Target in part (j), estimate an appropriate
rate of return for the two firms.
M o N t h a N D y e a r a N N ua l I z e D r at e o F r e t u r N
Jun-10 4.03%
Jul-10 3.71%
Aug-10 3.82%
Sep-10 3.35%
oct-10 3.40%
nov-10 3.66%
Dec-10 3.95%
Jan-11 4.18%
Feb-11 4.37%
Mar-11 4.24%
Apr-11 4.27%
May-11 4.14%
Jun-11 3.83%
Jul-11 4.12%
Aug-11 3.72%
Sep-11 3.10%
oct-11 2.51%
nov-11 2.73%
Dec-11 2.82%
Jan-12 2.67%
Feb-12 2.65%
Mar-12 2.80%
Apr-12 3.00%
May-12 2.76%
Jun-12 2.13%

The Valuation and
Characteristics of Bonds
Learning Objectives
1 Distinguish between different kinds of bonds. Types of Bonds
2 Explain the more popular features of bonds. Terminology and Characteristics of
Bonds
3 Define the term value as used for several different
purposes.
Defining Value
4 Explain the factors that determine value. What Determines Value?
5 Describe the basic process for valuing assets. Valuation: The Basic Process
6 Estimate the value of a bond. Valuing Bonds
7 Compute a bond’s expected rate of return and
its current yield.
Bond Yields
8 Explain three important relationships that exist in
bond valuation.
Bond Valuation: Three Important
Relationships
220
On August 16, 2011, the headlines read, “AT&T Sells $5 Billion of Bonds to Help Refinance Maturing Debt.” Bonds are
a form of long-term debt issued by companies needing financing for a variety of reasons, including the need to repay
debt that is coming due, as was the case for AT&T when it issued the $5 billion in new bonds. Some of the bonds
matured in 5 years, some in 10 years, and others not until 30 years. Just 3 months earlier the company had issued
$3 billion in bonds. Then in June 2012 the company decided to issue more bonds in the amount of $2 billion. Although
few companies could begin to issue billions of dollars in bonds as AT&T does, this form of debt is an important source
of financing for many publicly traded companies. Companies were particularly tempted to issue bonds in 2011 and
7

221221
2012 when interest rates were at all-time lows. AT&T, for example,
only had to pay about 3 percent in interest on bonds that were
being issued in 2011 and 2012.
When AT&T’s management was deciding to issue bonds,
there were a number of decisions that had to be made, such
as the type of bond—not all bonds are the same—and the
terms to be offered to the investors. Then there is always the
issue of valuing the bond.
Understanding how to value financial securities is essential
if managers are to meet the objective of maximizing the
value of the firm. If they are to maximize the investors’
value, they must know what drives the value of an asset.
Specifically, they need to understand how bonds and stocks
are valued in the marketplace; otherwise, they cannot act in
the best interest of the firm’s investors.
In this chapter, we begin by identifying the different
kinds of bonds. We next look at the features or character-
istics of most bonds. We then examine the concepts of and
procedures for valuing an asset and apply these ideas to
valuing bonds.
We now begin our study by considering the different
kinds of bonds.
Types of Bonds
A bond is a type of debt or long-term promissory note, issued by
the borrower, promising to pay its holder a predetermined and
fixed amount of interest per year and the face value of the bond
at maturity. However, there is a wide variety of such crea-
tures. Just to mention a few, we have
Debentures Eurobonds
Subordinated debentures Convertible bonds
Mortgage bonds
The following sections briefly explain each of these types of bonds.
Debentures
The term debenture applies to any unsecured long-term debt. Because these bonds are
unsecured, the earning ability of the issuing corporation is of great concern to the
bondholder. They are also viewed as being more risky than secured bonds and, as a
result, must provide investors with a higher yield than secured bonds provide. Often
the firm issuing debentures attempts to provide some protection to the holder of the
debenture by agreeing not to issue more secured long-term debt that would further tie
up the firm’s assets. To the issuing firm, the major advantage of debentures is that no
property has to be secured by them. This allows the firm to issue debt and still preserve
some future borrowing power.
1 Distinguish between different
kinds of bonds.
bond a long-term (10-year or more) promissory
note issued by the borrower, promising to pay
the owner of the security a predetermined, fixed
amount of interest each year.
debenture any unsecured long-term debt.

222 Part 2 • The Valuation of Financial Assets
Subordinated Debentures
Many firms have more than one issue of debentures outstanding. In this case a hierarchy
may be specified, in which some debentures are given subordinated standing in case of insol-
vency. The claims of the subordinated debentures are honored only after the claims of
secured debt and unsubordinated debentures have been satisfied.
Mortgage Bonds
A mortgage bond is a bond secured by a lien on real property. Typically, the value of the real
property is greater than that of the mortgage bonds issued. This provides the mortgage
bondholders with a margin of safety in the event the market value of the secured property
declines. In the case of foreclosure, trustees, who represent the bondholders and act on
their behalf, have the power to sell the secured property and use the proceeds to pay the
bondholders. The bond trustee, usually a banking institution or trust company, oversees
the relationship between the bondholder and the issuing firm, protecting the bondholder
and seeing that the terms of the indenture are carried out. In the event that the proceeds
from this sale do not cover the bonds, the bondholders become general creditors, similar to
debenture bondholders, for the unpaid portion of the debt.
Eurobonds
Eurobonds are not so much a different type of security. They are simply securities, in this
case bonds, issued in a country different from the one in which the currency of the bond is denomi-
nated. For example, a bond that is issued in Europe or in Asia by an American company
and that pays interest and principal to the lender in U.S. dollars would be considered a
Eurobond. Thus, even if the bond is not issued in Europe, it merely needs to be sold in a
country different from the one in which the bond’s currency is denominated to be consid-
ered a Eurobond.
The primary attractions of Eurobonds to borrowers, aside from favorable rates, are the
relative lack of regulation (Eurobonds are not registered with the Securities and Exchange
Commission [SEC]), less-rigorous disclosure requirements than those of the SEC, and the
speed with which they can be issued. Interestingly, not only are Eurobonds not registered
with the SEC, but they may not be offered to U.S. citizens and residents.
Convertible Bonds
Convertible bonds are debt securities that can be converted into a firm’s stock at a pre-
specified price. For instance, you might have a convertible bond with a face, or par, value
of $1,000 that pays 6 percent interest, or $60, each year. The bond matures in 5 years, at
which time the company must pay the $1,000 par value to the bondholder. However, at the
time the bond was issued, the firm gave the bondholder the option of either collecting the
$1,000 or receiving shares of the firm’s stock at a conversion price of $50. In other words,
the bondholder would receive 20 shares (20 = $1,000 par value , $50 conversion price).
What would you do if you were the bondholder? If the stock were selling for more than
$50, then you would want to give up the $1,000 par value and take the stock. Thus, it’s the
investor’s choice either to take the $1,000 promised when the bond was issued or to convert
the bond into the firm’s stock.
Consider Ingersoll Rand Company, a diversified equipment manufacturer. In 2009, the
firm issued $300 million of 5 percent convertible debt. The bonds can be converted at any
time into Ingersoll Rand common stock at a conversion price of $17.94 per share. Because
the par value for each bond is $1,000, a bondholder can convert one bond into 55.74 shares
(55.74 shares = $1,000 , $17.94 price per share). This option allows the investor to be
repaid the $1,000 par value or to convert into stock if the total value of the stock exceeds
$1,000. Thus, with convertible bonds, the investor gets to participate in the upside if the
company does well. For instance, 3 months after the bonds were issued, the firm’s stock
was selling for $27. If you had been an investor, you could have converted the bonds into
55.74 shares of stock, which would be worth about $1,500. Not bad for 3 months.
subordinated debenture a debenture that
is subordinated to other debentures in terms of
its payments in case of insolvency.
mortgage bond a bond secured by a lien on
real property.
Eurobond a bond issued in a country different
from the one in which the currency of the bond
is denominated; for example, a bond issued in
Europe or Asia by an American company that
pays interest and principal to the lender in U.S.
dollars.
convertible bond a debt security that can
be converted into a firm’s stock at a prespecified
price.

Chapter 7 • The Valuation and Characteristics of Bonds 223
Concept Check
1. How do debentures, subordinated debentures, and mortgage bonds differ with regard to their
risk? How would investors respond to the varying types of risk?
2. How is a Eurobond different from a bond issued in Asia that is denominated in dollars?
3. Why would a convertible bond increase much more in value than a bond that is not convertible?
Now that you have an understanding of the kinds of bonds firms might issue, let’s look
at some of the characteristics and terminology of bonds.
Terminology and Characteristics of Bonds
Before valuing bonds, we first need to understand the terminology related to bonds. Then
we will be better prepared to determine the value of a bond.
When a firm or nonprofit institution needs financing, one source is bonds. As already
noted, this type of financing instrument is simply a long-term promissory note, issued by
the borrower, promising to pay its holder a predetermined and fixed amount of interest
each year. Some of the more important terms and characteristics that you might hear about
bonds are as follows:
Claims on assets and income Call provision
Par value Indenture
Coupon interest rate Bond ratings
Maturity
Let’s consider each in turn.
Claims on Assets and Income
In the case of insolvency, claims of debt, including bonds, are generally honored before
those of both common stock and preferred stock. In general, if the interest on bonds is not
paid, the bond trustees can classify the firm as insolvent and force it into bankruptcy. Thus,
the bondholders’ claim on income is more likely to be honored than that of the common
stockholders, whose dividends are paid at the discretion of the firm’s management. How-
ever, different types of debt can have a hierarchy among themselves as to the order of their
claims on assets.
Par Value
The par value of a bond is its face value, which is returned to the bondholder at maturity. In
general, corporate bonds are issued in denominations of $1,000, although there are some
exceptions to this rule. Also, when bond prices are quoted, either by financial managers
or in the financial press, prices are generally expressed as a percentage of the bond’s par
value. For example, a Morgan Stanley bond was recently quoted as selling for $103.83.
That does not mean you can buy the bond for $103.83. It means that this bond is selling for
103.83 percent of its par value of $1,000. Hence, the market price of this bond is actually
$1,038.30. At maturity in 2017, the bondholder will receive $1,000.
Coupon Interest Rate
The coupon interest rate on a bond indicates the percentage of the par value of the bond
that will be paid out annually in the form of interest. Thus, regardless of what happens to the
price of a bond with a 5 percent coupon interest rate and a $1,000 par value, it will pay out
$50 annually in interest until maturity (0.05 * $1,000 = $50). For the Morgan Stanley
bonds, the coupon rate is 5.95 percent; thus an investor owning the bonds would receive
5.95 percent of its par value of $1,000, or $59.50 ($59.50 = 0.0595 * $1,000) per year. The
investor receives a fixed dollar income each year from the interest; thus, these bonds are
called fixed-rate bonds.
2 Explain the more popular
features of bonds.
par value on the face of a bond, the stated
amount that the firm is to repay upon the
maturity date.
fixed-rate bond a bond that pays a fixed
amount of interest to the investor each year.
coupon interest rate the interest rate
contractually owed on a bond as a percent of
its par value.

224 Part 2 • The Valuation of Financial Assets
Occasionally, a firm will issue bonds that have zero or very low coupon rates, thus the
name zero coupon bonds. Instead of paying interest, the company sells the bonds at a sub-
stantial discount below the $1,000 par or face value. Thus, the investor receives a large part
(or all with zero coupon bonds) of the return from the appreciation of the bond value as it
moves in time to maturity. For example, Amgen, the biotech company, issued $3.95 billion
face value bonds with a coupon rate of only 1/8th of 1 percent. Thus, the investors would
hardly receive any interest income. But the bonds were issued to the investors at $500 for
each $1,000 face value bond. Investors who purchased these bonds for $500 could hold
them until they mature and would then receive the $1,000 par value.
Maturity
The maturity of a bond indicates the length of time until the bond issuer returns the par value
to the bondholder and terminates or redeems the bond.
Call Provision
If a company issues bonds and then later the prevailing interest rate declines, the firm may
want to pay off the bonds early and then issue new bonds with a lower interest rate. To do so,
the bond must be callable, or redeemable; otherwise, the firm cannot force the bondholder to
accept early payment. The issuer, however, usually must pay the bondholders a premium,
such as 1 year’s interest. Also, there frequently is a call protection period where the firm
cannot call the bond for a prespecified time period.
Indenture
An indenture is the legal agreement between the firm issuing the bonds and the trustee who
represents the bondholders. The indenture provides the specific terms of the loan agreement,
including a description of the bonds, the rights of the bondholders, the rights of the issu-
ing firm, and the responsibilities of the trustee. This legal document may run 100 pages
or more in length, with the majority of it devoted to defining protective provisions for the
bondholder.
Typically, the restrictive provisions included in the indenture attempt to protect the
bondholders’ financial position relative to that of other outstanding securities. Common
provisions involve (1) prohibiting the sale of the firm’s accounts receivable, (2) limiting
common stock dividends, (3) restricting the purchase or sale of the firm’s fixed assets, and
(4) setting limits on additional borrowing by the firm. Not allowing the sale of accounts re-
ceivable is specified because such sales would benefit the firm’s short-run liquidity position
at the expense of its future liquidity position. Common stock dividends may not be allowed
if the firm’s liquidity falls below a specified level, or the maximum dividend payout might be
limited to some fraction, say, 50 or 60 percent of earnings. Fixed-asset restrictions generally
require permission before they can be liquidated or used as collateral on new loans. Con-
straints on additional borrowing usually involve limiting the amount and type of additional
long-term debt that can be issued. All these restrictions have one thing in common: They
attempt to prohibit actions that would improve the status of other securities at the expense
of bonds and to protect the status of bonds from being weakened by any managerial action.
Bond Ratings
John Moody first began to rate bonds in 1909. Since that time three rating agencies—
Moody’s, Standard & Poor’s, and Fitch Investor Services—have provided ratings on
corporate bonds. These ratings involve a judgment about
the future risk potential of the bonds. Although they deal
with expectations, several historical factors seem to play a
significant role in their determination. Bond ratings are
favorably affected by (1) a greater reliance on equity as op-
posed to debt in financing the firm, (2) profitable opera-
tions, (3) a low variability in past earnings, (4) large firm
zero coupon bond a bond issued at a
substantial discount from its $1,000 face value
and that pays little or no interest.
maturity the length of time until the bond
issuer returns the par value to the bondholder
and terminates the bond.
callable bond (redeemable bond) an
option available to a company issuing a bond
whereby the issuer can call (redeem) the bond
before it matures. This is usually done if interest
rates decline below what the firm is paying on
the bond.
call protection period a prespecified time
period during which a company cannot recall
a bond.
indenture the legal agreement between the
firm issuing bonds and the bond trustee who
represents the bondholders, providing the
specific terms of the loan agreement.
RememBeR YouR PRinCiPles
When we say that a lower bond rating means a higher
interest rate charged by the investors (bondholders), we are
observing an application of Principle 3: Risk Requires a Reward.
rinciple

Chapter 7 • The Valuation and Characteristics of Bonds 225
size, and (5) little use of subordinated debt. In turn, the rating a bond receives affects
the interest rate demanded on the bond by the investors. The poorer the bond rating,
the higher the interest rate demanded by investors. (Table 7-1 describes these ratings.)
Thus, bond ratings are extremely important for the financial manager. They provide
an indicator of default risk that in turn affects the interest rate that must be paid on
borrowed funds.
Toward the bottom end of the rating spectrum, we have junk bonds, which are high-
risk debt with ratings of BB or below by Moody’s and Standard & Poor’s. The lower the
rating, the higher the chance of default. The lowest rating is CC for Standard & Poor’s
Source: Adapted from www.standardandpoors.com, December 2005.
AAA This is the highest rating assigned by Standard & Poor’s for debt obligation and indicates an extremely
strong capacity to pay principal and interest.
AA Bonds rated AA also qualify as high-quality debt obligations. Their capacity to pay principal and interest
is very strong; in the majority of instances, they differ from AAA issues only by a small degree.
A Bonds rated A have a strong capacity to pay principal and interest, although they are somewhat more
susceptible to the adverse effects of changes in circumstances and economic conditions.
BBB Bonds rated BBB are regarded as having an adequate capacity to pay principal and interest. Whereas
they normally exhibit adequate protection parameters, adverse economic conditions or changing
circumstances are more likely to lead to a weakened capacity to pay principal and interest for bonds
in this category than for bonds in the A category.
BB
B
CCC
CC
Bonds rated BB, B, CCC, and CC are regarded, on balance, as predominantly speculative with respect to
the issuer’s capacity to pay interest and repay principal in accordance with the terms of the obligation.
BB indicates the lowest degree of speculation and CC the highest. Although such bonds will likely have
some quality and protective characteristics, these are outweighed by large uncertainties or major risk
exposures to adverse conditions.
C The rating C is reserved for income bonds on which no interest is being paid.
D Bonds rated D are in default, and payment of principal and/or interest is in arrears.
Plus (+) or Minus (-): To provide more detailed indications of credit quality, the ratings from AA to BB may be
modified by the addition of a plus or minus sign to show relative standing within the major rating categories.
TABLE 7-1 Standard & Poor’s Corporate Bond Ratings
Finance at Work
J.C. PenneY CRediT RaTing ReduCed To Junk
In March 2012, J.C. Penney reported that it had a net loss of $163
million in the first quarter of the year, mainly due to the firm’s
new pricing strategy for its products. The plan eliminated Pen-
ney’s practice of frequent sales in favor of everyday prices that
were 40 percent below the sales prices the year before. Penney’s
customers, accustomed to big markdowns and coupons, resisted
the new approach. The outcome was a 20-percent reduction in
revenues.
As a consequence, in May Standard & Poor’s announced it
was cutting Penney’s credit rating from BB+ to BB, which is a rat-
ing category for junk bonds. Fitch, another rating agency, also
lowered the firm’s credit ratings to junk.
The two rating agencies attributed the cut to poor
performance in the first quarter of the year. In addition,
S&P placed all of Penney’s bonds on CreditWatch “with
negative implications.” The CreditWatch indicates that the
rating was vulnerable to a further downgrade after Standard
& Poor’s reassessed the company’s business and financial
strategies.
Then in June, Mike Francis, the new president and a former
Target executive, left the company unexpectedly. Francis was in
charge of marketing the new pricing strategy.
One month later in July, Standard & Poor’s further lowered
Penney’s credit rating from BB to B+, which means that the rat-
ing agency believes that the firm may have difficulty not only in
paying interest, but also repaying the debt principal as it comes
due. An even bigger issue was the growing concern that man-
agement may not be able to turn the business around.
In the meantime, Penney’s stock fell by half in a mere five
months. Only time will tell if the business can be saved.
Sources: Lance Murray, “J.C. Penney’s Credit Rating Cut Again by S&P,” Dallas
Business Journal, http://cxa.gtm.idmanagedsolutions.com/finra/BondCenter/
BondDetail.aspx?ID=NTk0OTE4QU02, accessed June 26, 2012; “S&P Cuts J.C.
Penney Rating to ‘BB’/, Reuters, http://www.reuters.com/article/2012/05/17/
idUSWNA755420120517, accessed June 26, 2012; and Melodie Warner, “S&P
Cuts J.C. Penney Rating to Junk,” Market Watch, Wall Street Journal, http://www
.marketwatch.com/story/sp-cuts-jc-penney-rating-to-junk-2012-03-07, assessed
June 26, 2012, and http:/www.kansascity.com/2012/07/11/3701158/sp-cuts-jc-
penney-credit-rating.html#storylink=cpy, accessed August 15, 2012.
junk bond any bond rated BB or below.
∂

www.standardandpoors.com

http://www.reuters.com/article/2012/05/17/idUSWNA755420120517

http://www.marketwatch.com/story/sp-cuts-jc-penney-rating-to-junk-2012-03-07

http:/www.kansascity.com/2012/07/11/3701158/sp-cuts-jcpenney-credit-rating.html#storylink=cpy

http://cxa.gtm.idmanagedsolutions.com/finra/BondCenter/BondDetail.aspx?ID=NTk0OTE4QU02

226 Part 2 • The Valuation of Financial Assets
and Ca for Moody’s. Originally, the term junk bonds was used to describe firms with sound
financial histories that were facing severe financial problems and suffering from poor credit
ratings. Junk bonds are also called high-yield bonds because of the high interest rates they
pay the investor. Typically, they have an interest rate between 3 and 5 percent more than
AAA-grade long-term debt.
Until the early 1970s, credit-rating agencies were paid by the investors who wanted
impartial information about a firm’s creditworthiness. But beginning in the 1970s, the firms
issuing bonds began paying the agencies for their services. This arrangement has frequently
raised a concern that the agencies have a conflict of interest, where the company being
evaluated is also their client. This criticism became particularly loud during the financial
crisis beginning in 2007. The agencies gave some types of debt securities high ratings, only
for them to default when the borrower could no longer pay
on the loan.
We are now ready to think about bond valuation. To be-
gin, we must first clarify precisely what we mean by value.
Next, we need to understand the basic concepts of valua-
tion and the process for valuing an asset. Then we may apply
these concepts to valuing a bond, and in Chapter 8, to valuing
stocks.
Concept Check
1. What are some important features of a bond? Which features determine the cash flows associ-
ated with a bond?
2. What restrictions are typically included in an indenture in order to protect the bondholder?
3. How does the bond rating affect an investor’s required rate of return? What actions could a firm
take to receive a more favorable rating?
Defining Value
The term value is often used in different contexts, depending on its application. Book value
is the value of an asset as shown on a firm’s balance sheet. It represents the historical cost of the
asset rather than its current worth. For instance, the book value of a company’s common
stock is the amount the investors originally paid for the stock and, therefore, the amount
the firm received when the stock was issued.
Liquidation value is the dollar sum that could be realized if an asset were sold individually
and not as part of a going concern. For example, if a firm’s operations were discontinued and
its assets were divided up and sold, the sales price would represent the asset’s liquidation
value.
The market value of an asset is the observed value for the asset in the marketplace. This
value is determined by supply and demand forces working together in the marketplace,
whereby buyers and sellers negotiate a mutually acceptable price for the asset. For instance,
the market price for Harley-Davidson’s common stock on June 20, 2012, was $50 per share.
This price was reached by a large number of buyers and sellers working through the New
York Stock Exchange. In theory, a market price exists for all assets. However, many assets
have no readily observable market price because trading seldom occurs. For instance, the
market price for the common stock of Liberty Capital Bank, a new bank in Dallas, Texas,
would be more difficult to establish than the market value of Harley-Davidson’s common
stock.
The intrinsic, or economic, value of an asset—also called the fair value—is the present
value of the asset’s expected future cash flows. This value is the amount an investor should be
willing to pay for the asset given the amount, timing, and riskiness of its future cash flows.
Once the investor has estimated the intrinsic value of a security, this value could be com-
pared with its market value when available. If the intrinsic value is greater than the market
value, then the security is undervalued in the eyes of the investor. Should the market value
exceed the investor’s intrinsic value, then the security is overvalued.
high-yield bond see junk bond.
RememBeR YouR PRinCiPles
Some have thought junk bonds were fundamen-
tally different from other securities, but they are not. They are
bonds with a great amount of risk and, therefore, promise high
expected returns. Thus, Principle 3: Risk Requires a Reward.
rinciple
3 Define the term value as used
for several different purposes.
book value (1) the value of an asset as shown
on the firm’s balance sheet. It represents the
historical cost of the asset rather than its current
market value or replacement cost. (2) The depre-
ciated value of a company’s assets (original cost
less accumulated depreciation) less outstanding
liabilities.
liquidation value the dollar sum that could
be realized if an asset were sold.
market value the value observed in the
marketplace.
intrinsic, or economic, value the present
value of an asset’s expected future cash flows.
This value is the amount the investor considers
to be fair value, given the amount, timing, and
riskiness of future cash flows.
fair value the present value of an asset’s
expected future cash flows.

Chapter 7 • The Valuation and Characteristics of Bonds 227
We hasten to add that if the securities market is working efficiently, the market value
and the intrinsic value of a security will be equal. Whenever a security’s intrinsic value dif-
fers from its current market price, the competition among investors seeking opportunities
to make a profit will quickly drive the market price back to its intrinsic value. Thus, we may
define an efficient market as one in which the values of all securities at any instant fully reflect
all available public information, which results in the market value and the intrinsic value being
the same. If the markets are efficient, it is extremely difficult for an investor to make extra
profits from an ability to predict prices.
Should we expect markets to be efficient or inefficient? For a market to be inefficient,
there would need to be a trading strategy that allows investors to make money without as-
suming a proportionate amount of risk. But for that to happen, there must be traders who
are willing to sell underpriced stocks to you and buy overpriced stocks from you. Instead,
if you buy a stock because you believe it to be underpriced, the investor selling the stock
must believe it is overpriced. Furthermore, if there were a strategy that allowed you to make
profits without assuming risk, then other investors would adopt the strategy until the op-
portunity to make excess profits would disappear.
The market could be inefficient because investors act irrationally. For this reason, financial
economists have been interested in studying to see if investors are rational in their invest-
ment behavior. Competitive markets assume that investors act rationally in their decisions.
Thus, the field of behavioral finance studies the rationality of investors when making
decisions. For example, they suggest that some investors may be overconfident in their own
opinions when making investments and ignore information that becomes available if it does
not support their own opinion.
What does the evidence suggest about market efficiency? There have been thousands of
studies testing for market efficiency over the past several decades. Some of the studies found
evidence that the markets have at times been somewhat inef-
ficient. However, with time these anomalies have been largely
eliminated by professional investors who seek out such oppor-
tunities. Thus, we would agree that the markets are certainly
not perfectly efficient, but any such inefficiencies probably
only provide enough return to cover the cost of implementing
a given strategy. But no doubt this issue will continue to cause
debate in the years ahead.
Concept Check
1. Explain the different types of value.
2. Why should the market value equal the intrinsic value?
What Determines Value?
For our purposes, the value of an asset is its intrinsic value or the present value of its expected fu-
ture cash flows, when these cash flows are discounted back to the present using the investor’s
required rate of return. This statement is true for valuing all assets, and it serves as the basis
of almost all that we do in finance. Thus, value is affected by three elements:
1. The amount and timing of the asset’s expected cash flows
2. The riskiness of these cash flows
3. The investor’s required rate of return for undertaking the investment
The first two factors are characteristics of the asset. The third one, the required rate of
return, is the minimum rate of return necessary to attract an investor to purchase or hold
a security. This rate of return is determined by the rates of return available on similar invest-
ments, or what we learned in Chapter 2 is called the opportunity cost of funds. This rate
must be high enough to compensate the investor for risk perceived in the asset’s future cash
flows. (The required rate of return was explained in Chapter 6.)
efficient market market where the values of
all securities fully recognize all available public
information.
behavioral finance the field of study
examining when investors act rationally or
irrationally when making investment decisions.
RememBeR YouR PRinCiPles
The fact that investors have difficulty identifying
stocks that are undervalued relates to Principle 4: Market
Prices Are Generally Right. In an efficient market, the price
reflects all available public information about the security and,
therefore, it is priced fairly.
rinciple
4 Explain the factors that
determine value.

228 Part 2 • The Valuation of Financial Assets
Figure 7-1 depicts the basic factors involved in valuation.
As the figure shows, finding the value of an asset involves the
following steps:
1. Assessing the asset’s characteristics, which include the
amount and timing of the expected cash flows and the
riskiness of these cash flows
2. Determining the investor’s required rate of return, which
embodies the investor’s attitude about assuming risk and
the investor’s perception of the riskiness of the asset
3. Discounting the expected cash flows back to the present,
using the investor’s required rate of return as the discount rate
Thus, intrinsic value is a function of the cash flows yet to be
received, the riskiness of these cash flows, and the investor’s
required rate of return.
Concept Check
1. What are the three important elements of asset valuation?
Valuation: The Basic Process
The valuation process can be described as follows: It is assigning value to an asset by calcu-
lating the present value of its expected future cash flows using the investor’s required rate
of return as the discount rate. The investor’s required rate of return, r, is determined by the
level of the risk-free rate of interest and risk premium that the investor feels is necessary
compensation. Therefore, a basic asset valuation model can be defined mathematically as
follows:
Investor attributes
Determine
Investor’s required rate of return
Asset characteristics
Amount of expected cash flows
Asset value = present value of expected
cash flows discounted using the
investor’s required rate of return
Timing of expected cash flows
Riskiness of expected cash flows
Investor’s assessment of the
riskiness of the asset’s cash flows
Investor’s willingness to bear risk
FIGuRE 7-1 Basic Factors Determining an Asset’s Value
RememBeR YouR PRinCiPles
Our discussions should remind us of three
of our principles that help us understand finance:
Principle 1: Cash Flow Is What Matters.
Principle 2: Money Has a Time Value.
Principle 3: Risk Requires a Reward.
Determining the economic worth or value of an asset always
relies on these three principles. Without them, we would have
no basis for explaining value. With them, we can know that
the amount and timing of cash, not earnings, drive value. Also,
we must be rewarded for taking risk; otherwise, we will not
invest.
rinciple
5 Describe the basic process for
valuing assets.
Asset
value
=
cash flow
in year 1
a1 + required
rate of return
b
1 +
cash flow
in year 2
a1 + required
rate of return
b
2 + c +
cash flow
in year n
a1 + required
rate of return
b
n (7-1a)
Or stated in symbols, we have:
V =
C1
(1 + r)1
+
C2
(1 + r)2
+ . . . +
Cn
(1 + r)n
(7-1b)

Chapter 7 • The Valuation and Characteristics of Bonds 229
where V = the intrinsic value, or present value, of an asset producing expected future cash
flows, Ct, in years 1 through n
Ct = cash flow to be received at time t
r = the investor’s required rate of return
Using equation (7-1), there are three basic steps in the valuation process:
StEp 1 Estimate the Ct in equation (7-1), which is the amount and timing of the future
cash flows the security is expected to provide.
StEp 2 Determine r, the investor’s required rate of return.
StEp 3 Calculate the intrinsic value, V, as the present value of expected future cash flows
discounted at the investor’s required rate of return.
Equation (7-1), which measures the present value of future cash flows, is the basis of
the valuation process. It is the most important equation in this chapter because all the re-
maining equations in this chapter and in Chapter 8 are merely reformulations of this one
equation. If we understand equation (7-1), all the valuation work we do, and a host of other
topics as well, will be much clearer in our minds.
With the foregoing principles of valuation as our foundation, let’s now look at how
bonds are valued.
Valuing Bonds
The value of a bond is the present value of both the future interest to be received and the
par or maturity value of the bond. It’s that simple.
The process for valuing a bond, as depicted in Figure 7-2, requires knowing three essen-
tial elements: (1) the amount and timing of the cash flows to be received by the investor, (2)
the time to maturity of the bond, and (3) the investor’s required rate of return. The amount of
cash flows is dictated by the periodic interest to be received and by the par value to be paid at
maturity. Given these elements, we can compute the value of the bond, or the present value.
To illustrate the process for valuing a bond, consider a bond issued by Pioneer Natural
Resources with a maturity date of 2016 and a stated annual coupon rate of 5.875 percent.1
can You Do it?
ComPuTing an asseT’s Value
You purchased an asset that is expected to provide $5,000 cash flow per year for 4 years. If you have a 6 percent required rate of return,
what is the value of the asset for you?
(The solution can be found on page 231.)
6 Estimate the value of a bond.
(A) Cash flow information
(B) Term to maturity
(C) Investor’s required rate of return
Periodic interest payments.
For example, $65 per year.
Principal amount or par value.
For example, $1,000.
For example, 12 years.
For example, 4%.
FIGuRE 7-2 Data Requirements for Bond Valuation
1Pioneer Natural Resources pays interest to its bondholders on a semiannual basis on June 15 and December 15. However,
for the moment, assume the interest is to be received annually. The effect of semiannual payments is examined shortly.

230 Part 2 • The Valuation of Financial Assets
In 2012, with 4 years left to maturity, investors owning the bonds were requiring a 4.16
percent rate of return. We can calculate the value of the bonds to these investors using the
following three-step valuation procedure:
StEp 1 Estimate the amount and timing of the expected future cash flows. Two types of
cash flows are received by the bondholder:
a. Annual interest payments equal to the coupon rate of interest times the face
value of the bond. In this example, the bond’s coupon interest rate is 5.875
percent; thus, the annual interest payment is $58.75 ($58.75 = .05875 *
$1,000). Assuming that 2012 interest payments have already been made, these
cash flows will be received by the bondholder in each of the 4 years before the
bond matures (2013 through 2016 = 4 years).
b. The face value of $1,000 to be received in 2016.
To summarize, the cash flows received by the bondholder are as follows:
2013 2014 2015 2016
$58.75 $58.75 $58.75 $ 58.75
$1,000.00
$1,058.75
StEp 2 Determine the investor’s required rate of return by evaluating the riskiness of
the bond’s future cash flows. A 4.16 percent required rate of return for the bond-
holders is given. However, we should recall from Chapter 6 that an investor’s
required rate of return is equal to a rate earned on a risk-free security plus a risk
premium for assuming risk.
In this case, the Pioneer Natural Resources bonds are rated BBB by Standard
& Poor’s, which indicates that the bonds are not considered high-risk bonds
(junk bonds), but neither are they AAA investment grade. Thus, S&P believes
the company has the capacity to make interest and principal payments, provided
that circumstances do not change adversely.
StEp 3 Calculate the intrinsic value of the bond as the present value of the expected
future interest and principal payments discounted at the investor’s required rate
of return.
In general, the present value of a bond is found as follows:
Bond value = Vb =
$ interest in year 1
11 + required rate of return21 (7-2a)
+
$ interest in year 2
11 + required rate of return22
+
$ interest in year 3
11 + required rate of return23
+ . . .
+
$ interest in year n
11 + required rate of return2n
+
$ maturity value of bond
11 + required rate of return2n
Using It to represent the interest payment in year t, M to represent the bond’s maturity
(or par) value, and rb to equal the bondholder’s required rate of return, we can express the
value of a bond maturing in year n as follows:
Vb =
$I1
11 + rb21
+
$I2
11 + rb22
+
$I3
11 + rb23
+ . . . +
$In
11 + rb2n +
$M
11 + rb2n (7-2b)

Chapter 7 • The Valuation and Characteristics of Bonds 231
Notice that equation (7-2b) is a restatement of equation (7-1), where now the cash flows
are represented by the interest received each period and the par value of the bond when it
matures. In either equation, the value of an asset is the present value of its future cash flows.
The equation for finding the value of the Pioneer bonds would be as follows:
Vb =
$58.75
11 + 0.041621 +
$58.75
11 + 0.041622 +
$58.75
11 + 0.041623 +
$58.75
11 + 0.041624 +
$1,000
11 + 0.041624
Finding the value of the Pioneer bonds can be represented graphically as follows:
DiD You Get it?
Computing An Asset’s VAlue
The value of an asset generating $5,000 per year for 4 years, given
a 6 percent required rate of return, would be $17,325.53. Using a
TI BA II Plus calculator, we find the answer as follows:
CAlCulAtor solution
Data Input Function Key
6 I/Y
4 N
-5,000 +/- PMT
0 FV
Function Key Answer
CPT
PV $17,325.53
If an investor owns an asset that pays $1,062.02 in cash flows each year for 4 years, he would earn exactly his required rate of return
of 6 percent if he paid $17,325.53 today.
YEAR 0 2013 2014 2015 2016
Dollars received $58.75 $58.75 $58.75 $ 58.75
at end of year $1,000.00
$1,058.75
Present value $1,062.02
Using a TI BA II Plus financial calculator, we find the value of the bond to be $1,062.02,
as calculated in the margin.2 Thus, if investors consider 4.16 percent to be an appropriate
required rate of return in view of the risk level associated with Pioneer bonds, paying a price
of $1,062.02 would satisfy their return requirement.
2As noted in Chapter 5, we are using the TI BA II Plus. You may want to return to the Chapter 5 section “Moving
Money Through Time with the Aid of a Financial Calculator” or Appendix A at www.pearsonhighered.com/keown, to
see a more complete explanation of using the TI BA II Plus.
CAlCulAtor solution
Data Input Function Key
4 N
4.16 I/Y
58.75 +/- PMT
1,000 +/- FV
Function Key Answer
CPT
PV 1,062.02
We can also solve for the value of Pioneer’s bonds using a spreadsheet. The solution
using Excel appears as follows:

www.pearsonhighered.com/keown

232 Part 2 • The Valuation of Financial Assets
E X A M P L E 7.1 Valuing a bond
Verso Paper Holdings, a producer of coated papers, has a bond outstanding with a cou-
pon interest rate of 8.75 percent that will mature in 7 years. The investors who have
purchased the bonds are requiring a really high rate of return of 25.34 percent! Compute
the value of the bonds for the current investors. Earning a 25 percent rate of return is
fantastic—sure beats government Treasury bond rates. So why would many investors
choose not to invest in these bonds, in spite of the high rate of return?
sTeP 1: FoRmulaTe a soluTion sTRaTegY
The formula for valuing a bond is shown below:
Bond value = Vb =
$ interest in year 1
11 + required rate of return21
+
$ interest in year 2
11 + required rate of return22
+
$ interest in year 3
11 + required rate of return23
+ . . .
+
$ interest in year n
11 + required rate of return2n
+
$ maturity value of bond
11 + required rate of return2n
sTeP 2: CRunCH THe numBeRs
The value of the Verso bonds can be computed by using either a financial calculator or
a spreadsheet. But first we must determine the annual interest payment, which is $87.50
($87.50 = 0.0875 coupon interest rate * $1,000 par value). As shown below, the value of
the bond is $480.02.
Using a financial calculator:
CalCulaToR soluTion
Data Input Function Key
7 N
25.34 I/Y
87.50 +/- PMT
1,000 +/- FV
Function Key Answer
CPT
PV 480.02
Then, using a spreadsheet:

Chapter 7 • The Valuation and Characteristics of Bonds 233
sTeP 3: analYZe YouR ResulTs
Only by buying the bond at a low price compared to the bond’s par value, $480.02,
relative to $1,000 (par value) can the investors earn such a high rate of return of 25.34 percent.
Furthermore, for a bond to sell at such a large discount and thereby provide a high rate of
return indicates that investors perceive there to be a high likelihood of default. In other
words, the 25.34 percent is not the true expected rate of return, but rather the rate that will
be earned if Verso does not default on interest or principal payments. There is certainly
the possibility that the investors will receive the high return, but there is apparently con-
siderable risk that the company will default. So only investors who are prepared to accept
a large dose of risk will be interested in buying the bond.
can You Do it?
ComPuTing a Bond’s Value
La Fiesta Restaurants issued bonds that have a 6 percent coupon interest rate. Interest is paid annually. The bonds mature in 12 years.
If your required rate of return is 8 percent, what is the value of a bond to you?
(The solution can be found on page 235.)
To this point we have provided the basic present-value equation to determine the value of
an asset based on its expected future cash flows. This same equation was then applied to
valuing a bond. These two equations served as the financial tools for valuing an asset and
are represented as follows:
Financial Decision tools
Name of Tool Formula What It Tells You
Asset value
Asset
value
=
cash flow
in year 1
a1 + required
rate of return
b
1 +
cash flow
in year 2
a1 + required
rate of return
b
2 + c +
cash flow
in year n
a1 + required
rate of return
b
n
Indicates that the value of
an asset, be it a security or
an investment in plant and
equipment, is equal to the
present value of future cash
flows expected to be received
from the investment.
Bond value
Bond value = Vb =
$ interest in year 1
(1 + required rate of return)1
+
$ interest in year 2
(1 + required rate of return)2
+
$ interest in year 3
(1 + required rate of return)3
+ . . .
+
$ interest in year n
(1 + required rate of return)n
+
$ maturity value of bond
(1 + required rate of return)n
and
Vb =
$I1
(1 + rb)1
+
$I2
(1 + rb)2
+
$I3
(1 + rb)3
+ . . . +
$In
(1 + rb)n
+
$M
(1 + rb)n
Calculates the value of a
bond as the present value
both of future interest pay-
ments and the par value of
the bond to be received at
maturity.
Concept Check
1. What two factors determine an investor’s required rate of return?
2. How does the required rate of return affect a bond’s value?

234 Part 2 • The Valuation of Financial Assets
To conclude, we previously valued bonds assuming that interest was paid to the inves-
tors on an annual basis. However, since bonds typically pay interest semiannually, we need
a slightly revised financial tools shown as follows:
In the preceding illustration using Pioneer Natural Resources, the interest pay-
ments were assumed to be paid annually. However, companies typically pay interest
to bondholders semiannually. For example, Pioneer actually pays a total of $58.75 for
each bond per year, but disburses the interest semiannually ($29.375 each June 15 and
December 15).
Several steps are involved in adapting equation (7-2b) for semiannual interest pay-
ments.3 First, thinking in terms of periods instead of years, a bond with a life of n years pay-
ing interest semiannually has a life of 2n periods. In other words, a 4-year bond (n = 4) that
remits its interest on a semiannual basis actually makes 8 payments. Although the number
of periods has doubled, the dollar amount of interest being sent to the investors for each
period and the bondholders’ required rate of return are half of the equivalent annual figures.
It becomes It/2 and rb is changed to rb/2; thus, for semiannual compounding, equation (7-2b)
becomes
3The logic for calculating the value of a bond that pays interest semiannually is similar to the material presented in
Chapter 5, where compound interest with nonannual periods was discussed.
Vb =
$I1/2¢1 + rb
2
≤1 + $I2/2¢1 + rb
2
≤2 + $I3/2¢1 + rb
2
≤3 + . . . + $I2n/2¢1 + rb
2
≤2n + $M¢1 + rb
2
≤2n (7-3)
We can now compute the value of the Pioneer bonds, recognizing that interest is being
paid semiannually. We simply change the number of periods from 4 years to 8 semiannual
periods and the required rate of return from 4.16 percent annually to 2.08 percent per
semiannual period and divide interest payment by 2 to get $29.375. The value of the bond
would now be $1,062.60. Not a big change, but just more accurate when interest is paid
semiannually.
This solution can be found using a calculator as shown in the margin or a spreadsheet
that would look as follows:
CalCulaToR soluTion
Data Input Function Key
2n S 2 × 4 S 8 N
4.16 ÷ 2 S 2.08 I/Y
29.375 +/- PMT
1,000 +/- FV
Function Key Answer
CPT
PV 1,062.60
Name of Tool Formula What It Tells You
Bond value when
interest is paid
semiannually
Vb =
$I1/2¢1 + rb
2
≤1 + $I2/2¢1 + rb
2
≤2 + $I3/2¢1 + rb
2
≤3 + . . . + $I2n/2¢1 + rb
2
≤2n + $M¢1 + rb
2
≤2n Calculates the value of a bond as the present value both of future interest
payments received semi-
annually and the par value
of the bond to be received
at maturity.
Financial Decision tools

Chapter 7 • The Valuation and Characteristics of Bonds 235
Concept Check
1. How do semiannual interest payments affect the asset valuation equation?
Now that we know how to value a bond, we will next examine a bondholder’s rate of
return from investing in a bond, or what is called bond yields.
Bond Yields
There are two calculations used to measure the rate of return a bondholder receives from
owning a bond: the yield to maturity and the current yield.
Yield to Maturity
Theoretically, each bondholder could have a different required rate of return for a particu-
lar bond. However, the financial manager is interested only in the expected rate of return
that is implied by the market prices of the firm’s bonds, or what we call the yield to maturity.
To measure the bondholder’s expected rate of return, rb, we would find the discount
rate that equates the present value of the future cash flows (interest and maturity value) with the
current market price of the bond.4 It is also the rate of return the investor will earn if the bond is
held to maturity, thus the name yield to maturity. So, when referring to bonds, the terms
expected rate of return and yield to maturity are often used interchangeably.
To solve for the expected rate of return for a bond, we would use the following equation:
Market price = P0 =
$ interest in year 1
11 + expected rate of return21 (7-4)
+
$ interest in year 2
11 + expected rate of return22
+
$ interest in year 3
11 + expected rate of return23
+ g
+
$ interest in year n
11 + expected rate of return2n
+
$ maturity value of bond
11 + expected rate of return2n
DiD You Get it?
ComPuTing a Bond’s Value
The La Fiesta bond with a 6 percent coupon rate pays $60 in
interest per year ($60 = 0.06 coupon rate × $1,000 par value).
Thus, you would receive $60 per year for 12 years plus the $1,000
in par value in year 12. Assuming an 8 percent required rate of
return, the value of the bond would be $849.28.
CalCulaToR soluTion
Data Input Function Key
8 I/Y
12 N
60 +/- PMT
1,000 +/- FV
Function Key Answer
CPT
PV 849.28
If an investor owns a bond that pays $60 in interest each year for 12 years, she would earn exactly her required rate of return of
8 percent if she paid $849.28 today.
7 Compute a bond’s expected rate
of return and its current yield.
4When we speak of computing an expected rate of return, we are not describing the situation very accurately. Expected
rates of return are ex ante (before the fact) and are based on “expected and unobservable future cash flows” and, therefore,
can only be “estimated.”
expected rate of return (1) the discount
rate that equates the present value of the future
cash flows (interest and maturity value) of a
bond with its current market price. It is the rate
of return an investor will earn if the bond is held
to maturity. (2) The rate of return the investor
expects to receive on an investment by paying
the existing market price of the security.
yield to maturity The rate of return a bond-
holder will receive if the bond is held to maturity.
(It is equivalent to the expected rate of return.)

236 Part 2 • The Valuation of Financial Assets
To illustrate this concept, consider the Brister Corporation’s bonds, which are selling
for $1,100. The bonds carry a coupon interest rate of 6 percent and mature in 10 years.
(Remember, the coupon rate determines the interest payment—coupon rate × par value.)
To determine the expected rate of return (rb) implicit in the current market price, we
need to find the rate that discounts the anticipated cash flows back to a present value of
$1,100, the current market price (P0) for the bond.
The expected return for the Brister Corporation bondholders is 4.72 percent, which
can be found as presented in the margin by using the TI BA II Plus calculator, or by using
a computer spreadsheet, as follows:
CalCulator Solution
Data Input Function Key
10 N
1,100 +/- PV
60 PMT
1,000 FV
Function Key Answer
CPT
I/Y 4.72
Solving for the yield to maturity (expected rate of return)
In Example 7.1 you were asked to calculate the value of bonds issued by Verso Paper
Holdings, where the coupon interest rate was 8.75 percent, which indicated an interest
payment of $87.50, and the maturity date was 7 years. The investors who had purchased
the bonds were requiring a rate of return of 25.34 percent. Given this information, we
found the bond value to be $480.02; if you had gone to www.finance.yahoo.com, on June
28, 2012, you would have found that the market price for the bonds was indeed $480.
But what if investors changed their required rates of return to the point that the bonds
were selling for $700? In that case, what would be the expected rate of return, or yield to
maturity, if you purchased the bonds at the higher value? Explain what happened.
StEP 1: FormulatE a Solution StratEgy
The formula for computing the expected rate of return (yield to maturity) for the Verso
bonds at a market price of $700 is shown below:
Market price = P0 =
$ interest in year 1
11 + expected rate of return21
+
$ interest in year 2
11 + expected rate of return22
+
$ interest in year 3
11 + expected rate of returns23
+ g
+
$ interest in year n
11 + expected rate of return2n
+
$ maturity value of bond
11 + expected rate of return2n
where we are solving for the expected rate of return in the equation.
StEP 2: CrunCh thE numbErS
The expected rate of return (yield to maturity) for the Verso bonds can be computed by
using either a financial calculator a spreadsheet.
E X A M P L E 7.2

www.finance.yahoo.com

Chapter 7 • The Valuation and Characteristics of Bonds 237
Using a TI BA II Plus financial calculator, the expected rate of return is found to be
16.23 percent:
CalCulaToR soluTion
Data Input Function Key
7 N
700 +/- PV
87.50 PMT
1,000 FV
Function Key Answer
CPT
I/Y 16.23
Then using a spreadsheet:
sTeP 3: analYZe YouR ResulTs
If you are willing to pay the higher price of $700 for the Verso bonds, it means that you
are prepared to accept a lower yield to maturity (expected rate of return) on your invest-
ment. In other words, you are willing to accept the riskiness of the investment and re-
ceive a smaller expected return. Thus, as rates of return decrease, the value of a security
of a security will always increase.
Current Yield
The current yield on a bond refers to the ratio of the annual interest payment to the bond’s
current market price. If, for example, we have a bond with a 4 percent coupon interest
rate, a par value of $1,000, and a market price of $920, it would have a current yield of
4.35 percent:
Current yield =
annual interest payment
current market price of the bond
(7-5)
In our example
Current yield =
0.04 * $1,000
$920
=
$40
$920
= 0.0435 = 4.35%
We should understand that the current yield, although frequently quoted in the popu-
lar press, is an incomplete picture of the expected rate of return from holding a bond.
The current yield indicates the cash income that results from holding a bond in a given
year, but it fails to recognize the capital gain or loss that will occur if the bond is held
to maturity. As such, it is not an accurate measure of the bondholder’s expected rate of
return.
We now have financial tools to determine the rate of return a bondholder can ex-
pect to earn: (1) if the bond is held until it matures when the bondholder receives the
current yield the ratio of a bond’s annual
interest payment to its market price.

238 Part 2 • The Valuation of Financial Assets
par value of the bond, and (2) if we only consider the interest payment being received
relative to the current market price of the bond. These two financial tools are stated
as follows:
Name of Tool Formula What It Tells You
Yield to matu-
rity or expected
rate of return
Market
price
= P0 =
$ interest in year 1
(1 + expected rate of return)1
+
$ interest in year 2
11 + expected rate of return22
+
$ interest in year 3
11 + expected rate of return23
+ g
+
$ interest in year n
11 + expected rate of return2n
+
$ maturity value of bond
11 + expected rate of return2n
The expected rate
of return (yield to
maturity) of a bond
if held until maturity,
given its current
market price.
Current yield Current yield =
annual interest payment
current market price of the bond
The yield today
determined by divid-
ing the interest pay-
ment by the current
market price.
Financial Decision tools
Concept Check
1. What assumption is being made about the length of time a bond is held when computing the
yield to maturity?
2. What does the current yield tell us?
3. How are the yield to maturity and the current yield different?
Bond Valuation: Three Important
Relationships
We have now learned to find the value of a bond (Vb), given (1) the amount of interest
payments (It), (2) the maturity value (M), (3) the length of time to maturity (n periods), and
(4) the investor’s required rate of return, rb. We also know how to compute the expected
rate of return (rb), which also happens to be the current interest rate on the bond, given
(1) the current market value (P0), (2) the amount of interest payments (It), (3) the maturity
value (M), and (4) the length of time to maturity (n periods). We now have the basics.
But let’s go further in our understanding of bond valuation by studying several important
relationships:
◆ Relationship 1. The value of a bond is inversely related to changes in the investor’s
present required rate of return. In other words, as interest rates increase (decrease), the
value of the bond decreases (increases).
To illustrate, assume that an investor’s required rate of return for a given bond is
5 percent. The bond has a par value of $1,000 and annual interest payments of $50,
indicating a 5 percent coupon interest rate ($50 , $1,000 = 5%). Assuming a 5-year
maturity date, the bond would be worth $1,000, computed as follows:
Vb =
$I1
(1 + rb)1
+ . . . +
$In
(1 + rb)n
+
$M
(1 + rb)n
8 Explain three important
relationships that exist in bond
valuation.

Chapter 7 • The Valuation and Characteristics of Bonds 239
CalCulaToR soluTion
Data Input Function Key
8 I/Y
5 N
50 +/- PMT
1,000 +/- FV
Function Key Answer
CPT
PV 880.22
In our example,
Vb =
$50
(1 + 0.05)1
+
$50
11 + 0.0522 +
$50
11 + 0.0523 +
$50
11 + 0.0524 +
$50
11 + 0.0525 +
$1,000
11 + 0.0525
Using a calculator, we find the value of the bond to be $1,000.
can You Do it?
ComPuTing THe Yield To maTuRiTY and CuRRenT Yield
The Argon Corporation bonds are selling for $1,100. They have a 5 percent coupon interest rate paid annually and mature in 8 years.
What is the yield to maturity for the bonds if an investor buys them at the $1,100 market price? What is the current yield?
(The solution can be found on page 240.)
CalCulaToR soluTion
Data Input Function Key
5 I/Y
5 N
50 +/- PMT
1,000 +/- FV
Function Key Answer
CPT
PV 1,000
If, however, the investors’ required rate of return increases from 5 percent to 8 percent,
the value of the bond would decrease to $880.22, computed as follows:
On the other hand, if the investor’s required rate of return decreases to 2 percent, the
bond would increase in value to $1,141.40.
CalCulaToR soluTion
Data Input Function Key
2 I/Y
5 N
50 +/- PMT
1,000 +/- FV
Function Key Answer
CPT
PV $1,141.40
This inverse relationship between the investor’s required rate of return and the
value of a bond is presented in Figure 7-3. Clearly, as investors demand a higher rate
of return, the value of a bond decreases: The higher rate of return can be achieved only
by paying less for the bond. Conversely, a lower required rate of return yields a higher
market value for the bond.

240 Part 2 • The Valuation of Financial Assets
Changes in bond prices represent an element of uncertainty for the bond investor.
If the current interest rate (required rate of return) changes, the price of a bond also
fluctuates. An increase in interest rates causes the bondholder to incur a loss in market
value. Because future interest rates and the resulting bond value cannot be predicted
with certainty, a bond investor is exposed to the risk of changing values as interest rates
vary. This risk has come to be known as interest rate risk.
M
ar
ke
t
va
lu
e
$1,200
$1,100
$1,141
$880
$1,000
$900
$800
6%
Required rates of return (%)
1% 2% 3% 4% 5% 7% 8%
$1,141
$1,000
$880
Bond value if required
rate of return is 2%
Bond value if required
rate of return is 5%
Bond value if required
rate of return is 8%
FIGuRE 7-3 Value and Required Rates for a 5-Year Bond at a 5 Percent Coupon Rate
interest rate risk the variability in a bond’s
value caused by changing interest rates.
DiD You Get it?
ComPuTing THe Yield To maTuRiTY and CuRRenT Yield
The Argon bonds pay $50 in interest per year ($50 = 0.05
coupon rate * $1,000 par value) for the duration of the
bond, or for 8 years. The investor will then receive $1,000
at the bond’s maturity. Given a market price of $1,100 the
yield to maturity would be 3.54 percent.
CalCulaToR soluTion
Data Input Function Key
8 N
1,100 PV
50 +/- PMT
1,000 +/- FV
Function Key Answer
CPT
I/Y 3.54
Current yield =
annual interest payment
current market price of the bond
=
$50
$1,100
= 0.0455 = 4.55%
If an investor paid $1,100 for a bond that pays $50 in interest each year for 8 years, along with the $1,000 par value in the eighth year,
he would earn exactly 3.54 percent on the investment.

Chapter 7 • The Valuation and Characteristics of Bonds 241
◆ Relationship 2. The market value of a bond will be less than the par value if the
required rate of return of investors is above the coupon interest rate; but it will be
valued above par value if the required rate of return of investors is below the coupon
interest rate.
Using the previous example, we observed that
• The bond has a market value of $1,000, equal to the par, or maturity, value, when the
required rate of return demanded by investors equals the 5 percent coupon interest
rate. In other words, if
required rate = coupon rate, then market value = par value
5% = 5%, then $1,000 = $1,000
• When the required rate is 8 percent, which exceeds the 5 percent coupon rate, the
market value of the bond falls below par value to $880.22; that is, if
required rate 7 coupon rate, then market value 6 par value
8% 7 5%, then $880.22 6 $1,000
In this case the bond sells at a discount below par value; thus, it is called a discount bond.
• When the required rate is only 2 percent, or less than the 5 percent coupon rate, the
market value, $1,141.40, exceeds the bond’s par value. In this instance, if
required rate 6 coupon rate, then market value 7 par value
2% 6 5%, then $1,141.40 7 $1,000
The bond is now selling at a premium above par value; thus, it is a premium bond.
◆ Relationship 3. Long-term bonds have greater interest rate risk than do short-term
bonds.
As already noted, a change in current interest rates (the required rate of return)
causes an inverse change in the market value of a bond. However, the impact on value
is greater for long-term bonds than it is for short-term bonds.
In Figure 7-3 we observed the effect of interest rate changes on a 5-year bond
paying a 5 percent coupon interest rate. What if the bond did not mature until
10 years from today instead of 5 years? Would the changes in market value be the same?
Absolutely not. The changes in value would be more significant for the 10-year bond. For
example, what if the current interest rates increase from 2 percent to 5 percent and then
to 8 percent? In this case, a 10-year bond’s value would drop more sharply than a 5-year
bond’s value would. The values for both the 5-year and the 10-year bonds are shown here.
discount bond a bond that sells at a discount,
or below par value.
premium bond a bond that is selling above
its par value.
The reason long-term bond prices fluctuate more than short-term bond prices in
response to interest rate changes is simple. Assume an investor bought a 10-year bond
yielding a 5 percent interest rate. If the current interest rate for bonds of similar risk
increased to 8 percent, the investor would be locked into the lower rate for 10 years.
If, on the other hand, a shorter-term bond had been purchased—say, one maturing in
2 years—the investor would have to accept the lower return for only 2 years and not
the full 10 years. At the end of year 2, the investor would receive the maturity value
of $1,000 and could buy a bond offering the higher 8 percent rate for the remaining
8 years. Thus, interest rate risk is determined, at least in part, by the length of time an
investor is required to commit to an investment.
R E q u I R E D R AT E 5 Y E A R S 10 Y E A R S
2% $1,141.40 $1,269.48
5% 1,000.00 1,000.00
8% 880.22 798.70
MARKET VALUE FOR A 5%
COUPON-RATE BOND MATURING IN

242 Part 2 • The Valuation of Financial Assets
Using these values and the required rates, we can graph the changes in values for
the two bonds relative to different interest rates. These comparisons are provided in
Figure 7-4. The figure clearly illustrates that the price of a long-term bond (say, 10 years)
is more responsive or sensitive to interest rate changes than the price of a short-term
bond (say, 5 years). However, the holder of a long-term bond can take some comfort
from the fact that long-term interest rates are usually not as volatile as short-term
rates.
Concept Check
1. Why does a bond sell at a discount when the coupon rate is lower than the required rate of return
and vice versa?
2. As interest rates increase, why does the price of a long-term bond decrease more than that of a
short-term bond?
M
ar
ke
t
va
lu
e
of
b
on
d
9%
Required rates of return (%)
1% 2% 3% 6%4% 5% 7% 8%
$1,200
$1,269
$1,141
$1,100
$1,000
$900
$800
$799
$1,000
$880
Value of 10-year bond
as required rates of
return change
Value of 5-year bond
as required rates of
return change
Figure 7-4 The Market Values of a 5-Year and a 10-Year Bond at Different
required rates of return
Chapter Summaries
Distinguish between different kinds of bonds. (pgs 221–223)
SuMMarY: There is a variety of types of bonds, including:
Debentures Eurobonds
Subordinated debentures Convertible bonds
Mortgage bonds
1

Chapter 7 • The Valuation and Characteristics of Bonds 243
Bond, page 221 A long-term (10-year or
more) promissory note issued by the borrower,
promising to pay the owner of the security a
predetermined, fixed amount of interest each
year.
Debenture, page 221 Any unsecured long-
term debt.
Subordinated debenture, page 222 A
debenture that is subordinated to other
debentures in terms of its payments in case of
insolvency.
Mortgage bond, page 222 A bond secured by
a lien on real property.
Eurobond, page 222 A bond issued in a
country different from the one in which the
currency of the bond is denominated; for
example, a bond issued in Europe or Asia by
an American company that pays interest and
principal to the lender in U.S. dollars.
Convertible bond, page 222 A debt security
that can be converted into a firm’s stock at a
prespecified price.
KEY TERMS
Explain the more popular features of bonds. (pgs 223–226)
SuMMARY: Some of the more popular terms and characteristics used to describe bonds include
the following:
Claims on assets and income Call provision
Par value Indenture
Coupon interest rate Bond ratings
Maturity
KEY TERMS
2
par value, page 223 On the face of a bond,
the stated amount that the firm is to repay
upon the maturity date.
Coupon interest rate, page 223 The interest
rate contractually owed on a bond as a percent
of its par value.
Fixed-rate bond, page 223 A bond that pays
a fixed amount of interest to the investor each
year.
Zero coupon bond, page 224 A bond issued
at a substantial discount from its $1,000 face
value and that pays little or no interest.
Maturity, page 224 The length of time until
the bond issuer returns the par value to the
bondholder and terminates the bond.
Callable bond (redeemable bond),
page 224 An option available to a company
issuing a bond whereby the issuer can call
(redeem) the bond before it matures. This is
usually done if interest rates decline below
what the firm is paying on the bond.
Call protection period, page 224 A
prespecified time period during which a
company cannot recall a bond.
Indenture, page 224 The legal agreement
between the firm issuing bonds and the bond
trustee who represents the bondholders, pro-
viding the specific terms of the loan agreement.
Junk bond, page 225 Any bond rated BB or
below.
High-yield bond, page 226 See junk bond.
Define the term value as used for several different purposes. (pgs 226–227)
SuMMARY: Value is defined differently depending on the context. But for us, value is the present
value of future cash flows expected to be received from an investment, discounted at the investor’s
required rate of return.
KEY TERMS
3
Book value, page 226 (1) The value of an
asset as shown on the firm’s balance sheet. It
represents the historical cost of the asset rather
than its current market value or replacement
cost. (2) The depreciated value of a company’s
assets (original cost less accumulated
depreciation) less outstanding liabilities.
Liquidation value, page 226 The dollar sum
that could be realized if an asset were sold.
Market value, page 226 The value observed
in the marketplace.
Intrinsic, or economic, value, page 226 The
present value of an asset’s expected future cash
flows. This value is the amount the investor
considers to be fair value, given the amount,
timing, and riskiness of future cash flows.

244 Part 2 • The Valuation of Financial Assets
Explain the factors that determine value. (pgs 227–228)
SuMMARY: Three basic factors determine an asset’s value: (1) the amount and timing of future
cash flows, (2) the riskiness of the cash flows, and (3) the investor’s attitude about the risk.
4
Fair value, page 226 The present value of an
asset’s expected future cash flows.
Efficient market, page 227 Market where
the values of all securities fully recognize all
available public information.
Behavioral finance, page 227 The field
of study examining when investors act
rationally or irrationally when making
investment decisions.
Describe the basic process for valuing assets. (pgs 228–229)
SuMMARY: The valuation process can be described as follows: It is assigning value to an asset
by calculating the present value of its expected future cash flows using the investor’s required rate
of return as the discount rate. The investor’s required rate of return, r, equals the risk-free rate of
interest plus a risk premium to compensate the investor for assuming risk.
KEY EquATIONS
Asset
value
=
cash flow
in year 1
a1 + required
rate of return
b
1 +
cash flow
in year 2
a1 + required
rate of return
b
2 + c +
cash flow
in year n
a1 + required
rate of return
b
n
V =
C1
(1 + r)1
+
C2
(1 + r)2
+ . . . +
Cn
(1 + r)n
5
Estimate the value of a bond. (pgs 229–235)
SuMMARY: The value of a bond is the present value of both future interest to be received and the
par or maturity value of the bond.
KEY EquATIONS
Bond value = Vb =
$ interest in year 1
11 + required rate of return21
+
$ interest in year 2
11 + required rate of return22
+
$ interest in year 3
11 + required rate of return23
+ . . .
+
$ interest in year n
11 + required rate of return2n
+
$ maturity value of bond
11 + required rate of return2n
Vb =
$I1
(1 + rb)1
+
$I2
(1 + rb)2
+
$I3
(1 + rb)3
+ . . . +
$In
(1 + rb)n
+
$M
(1 + rb)n
Vb =
$I1/2¢1 + rb
2
≤1 + $I2/2¢1 + rb
2
≤2 + $I3/2¢1 + rb
2
≤3 + . . . + $In/2¢1 + rb
2
≤2n + $M¢1 + rb
2
≤2n
6

Chapter 7 • The Valuation and Characteristics of Bonds 245
Compute a bond’s expected rate of return and its current yield. (pgs 235–238)
SuMMARY: To measure bondholder’s expected rate of return, we find the discount rate that equates
the present value of the future cash flows (interest and maturity value) with the current market price
of the bond. The expected rate of return for a bond is also the rate of return the investor will earn
if the bond is held to maturity, or the yield to maturity. We may also compute the current yield as
the annual interest payment divided by the bond’s current market price, but this is not an accurate
measure of a bondholder’s expected rate of return.
KEY TERMS
7
Expected rate of return, page 235 (1) The
discount rate that equates the present value
of the future cash flows (interest and maturity
value) of a bond with its current market price.
It is the rate of return an investor will earn if
the bond is held to maturity. (2) The rate of
return the investor expects to receive on an
investment by paying the existing market price
of the security.
Yield to maturity, page 235 The rate of
return a bondholder will receive if the bond
is held to maturity. (It is equivalent to the
expected rate of return.)
Current yield, page 237 The ratio of a
bond’s annual interest payment to its market
price.
KEY EquATIONS
Market price = P0 =
$ interest in year 1
11 + expected rate of return21
+
$ interest in year 2
(1 + expected rate of return)2
+
$ interest in year 3
11 + expected rate of return23
+ g
+
$ interest in year n
11 + expected rate of return2n
+
$ maturity value of bond
11 + expected rate of return2n
Current yield =
annual interest payment
current market price of the bond
Explain three important relationships that exist in bond valuation. (pgs 238–242)
SuMMARY: Certain key relationships exist in bond valuation, these being:
1. A decrease in interest rates (the required rates of return) will cause the value of a bond to
increase; by contrast, an interest rate increase will cause a decrease in value. The change in
value caused by changing interest rates is called interest rate risk.
2. If the required rate of return (current interest rate):
a. Equals the coupon interest rate, the bond will sell at par, or maturity value.
b. Exceeds the bond’s coupon rate, the bond will sell below par value, or at a discount.
c. Is less than the bond’s coupon rate, the bond will sell above par value, or at a premium.
3. A bondholder owning a long-term bond is exposed to greater interest rate risk than one own-
ing a short-term bond.
8
KEY TERMS
Interest rate risk, page 240 The variability
in a bond’s value caused by changing interest
rates.
Discount bond, page 241 A bond that sells at
a discount, or below par value.
premium bond, page 241 A bond that is sell-
ing above its par value.

246 Part 2 • The Valuation of Financial Assets
Review questions
All Review Questions are available in MyFinanceLab.
7-1. Distinguish between debentures and mortgage bonds.
7-2. Define (a) Eurobonds, (b) zero coupon bonds, and (c) junk bonds.
7-3. Describe the bondholder’s claim on the firm’s assets and income.
7-4. a. How does a bond’s par value differ from its market value?
b. Explain the difference between a bond’s coupon interest rate, current yield, and required
rate of return.
7-5. What factors determine a bond’s rating? Why is the rating important to the firm’s
manager?
7-6. What are the basic differences between book value, liquidation value, market value, and
intrinsic value?
7-7. What is a general definition of the intrinsic value of an asset?
7-8. Explain the three factors that determine the intrinsic, or economic, value of an asset.
7-9. Explain the relationship between the required rate of return and the value of a security.
7-10. Define the expected rate of return to bondholders.
Study Problems
All Study Problems are available in MyFinanceLab.
7-1. (Bond valuation) Trico bonds have an annual coupon rate of 8 percent and a par value of $1,000
and will mature in 20 years. If you require a return of 7 percent, what price would you be willing
to pay for the bond? What happens if you pay more for the bond? What happens if you pay less for
the bond?
7-2. (Bond valuation) Sunn Co.’s bonds, maturing in 7 years, pay 4 percent interest on a $1,000 face
value. However, interest is paid semiannually. If your required rate of return is 5 percent, what is
the value of the bond? How would your answer change if the interest were paid annually?
7-3. (Bond valuation) You own a 20-year, $1,000 par value bond paying 7 percent interest annually.
The market price of the bond is $875, and your required rate of return is 10 percent.
a. Compute the bond’s expected rate of return.
b. Determine the value of the bond to you, given your required rate of return.
c. Should you sell the bond or continue to own it?
7-4. (Bond valuation) Calculate the value of a bond that will mature in 14 years and has a $1,000
face value. The annual coupon interest rate is 5 percent, and the investor’s required rate of return
is 7 percent.
7-5. (Bond valuation) At the beginning of the year, you bought a $1,000 par value corporate bond
with a 6 percent annual coupon rate and a 10-year maturity date. When you bought the bond, it
had an expected yield to maturity of 8 percent. Today the bond sells for $1,060.
a. What did you pay for the bond?
b. If you sold the bond at the end of the year, what would be your one-period return on the
investment?
7-6. (Bond valuation) Shelly Inc. bonds have a 6 percent coupon rate. The interest is paid semiannually,
and the bonds mature in 8 years. Their par value is $1,000. If your required rate of return is 4 percent,
what is the value of the bond? What is the value if the interest is paid annually?
7-7. (Bond relationship) Crawford Inc. has two bond issues outstanding, both paying the same annual
interest of $55, called Series A and Series B. Series A has a maturity of 12 years, whereas Series B
has a maturity of 1 year.
a. What would be the value of each of these bonds when the going interest rate is (1) 4 percent,
(2) 7 percent, and (3) 10 percent? Assume that there is only one more interest payment to
be made on the Series B bonds.
b. Why does the longer-term (12-year) bond fluctuate more when interest rates change than
does the shorter-term (1-year) bond?
6

Chapter 7 • The Valuation and Characteristics of Bonds 247
7-8. (Bond valuation) ExxonMobil 20-year bonds pay 6 percent interest annually on a $1,000 par
value. If bonds sell at $945, what is the bonds’ expected rate of return?
7-9. (Bond valuation) National Steel 15-year, $1,000 par value bonds pay 5.5 percent interest annu-
ally. The market price of the bonds is $1,085, and your required rate of return is 7 percent.
a. Compute the bond’s expected rate of return.
b. Determine the value of the bond to you, given your required rate of return.
c. Should you purchase the bond?
7-10. (Bond valuation) You own a bond that pays $70 in annual interest, with a $1,000 par value. It
matures in 15 years. Your required rate of return is 7 percent.
a. Calculate the value of the bond.
b. How does the value change if your required rate of return (1) increases to 9 percent or
(2) decreases to 5 percent?
c. Explain the implications of your answers in part (b) as they relate to interest rate risk, pre-
mium bonds, and discount bonds.
d. Assume that the bond matures in 5 years instead of 15 years. Recompute your answers in
part (b).
e. Explain the implications of your answers in part (d) as they relate to interest rate risk, pre-
mium bonds, and discount bonds.
7-11. (Bond valuation) New Generation Public Utilities issued a bond with a $1,000 par value that
pays $30 in annual interest. It matures in 20 years. Your required rate of return is 4 percent.
a. Calculate the value of the bond.
b. How does the value change if your required rate of return (1) increases to 7 percent or
(2) decreases to 2 percent?
c. Explain the implications of your answers in part (b) as they relate to interest rate risk, pre-
mium bonds, and discount bonds.
d. Assume that the bond matures in 10 years instead of 20 years. Recompute your answers in
part (b).
e. Explain the implications of your answers in part (d) as they relate to interest rate risk, pre-
mium bonds, and discount bonds.
7-12. (Bond valuation—zero coupon) The Logos Corporation is planning on issuing bonds that
pay no interest but can be converted into $1,000 at maturity, 7 years from their purchase. To
price these bonds competitively with other bonds of equal risk, it is determined that they should
yield 6 percent, compounded annually. At what price should the Logos Corporation sell these
bonds?
7-13. (Bond valuation) You are examining three bonds with a par value of $1,000 (you receive $1,000
at maturity) and are concerned with what would happen to their market value if interest rates (or
the market discount rate) changed. The three bonds are
Bond A—a bond with 3 years left to maturity that has a 6 percent annual coupon interest rate,
but the interest is paid semiannually.
Bond B—a bond with 7 years left to maturity that has a 6 percent annual coupon interest rate,
but the interest is paid semiannually.
Bond C—a bond with 20 years left to maturity that has a 6 percent annual coupon interest rate,
but the interest is paid semiannually.
What would be the value of these bonds if the market discount rate were
a. 6 percent per year compounded semiannually?
b. 3 percent per year compounded semiannually?
c. 9 percent per year compounded semiannually?
d. What observations can you make about these results?
7-14. (Bond valuation) Bank of America has bonds that pay a 6.5 percent coupon interest rate and
mature in 5 years. If an investor has a 4.3 percent required rate of return, what should she be willing
to pay for the bond? What happens if she pays more or less?
7-15. (Bond valuation) Xerox issued bonds that pay $67.50 in interest each year and will mature in
5 years. You are thinking about purchasing the bonds. You have decided that you would need to
receive a 5 percent return on your investment. What is the value of the bond to you, first assuming
that the interest is paid annually and then semiannually?

248 Part 2 • The Valuation of Financial Assets
7-16. (Bondholders’ expected rate of return) Sharp Co. bonds are selling in the market for $1,045.
These 15-year bonds pay 7 percent interest annually on a $1,000 par value. If they are purchased at
the market price, what is the expected rate of return?
7-17. (Bondholders’ expected rate of return) The market price is $900 for a 10-year bond ($1,000 par
value) that pays 6 percent interest (6 percent semiannually). What is the bond’s expected rate of
return?
7-18. (Bondholders’ expected rate of return) You own a bond that has a par value of $1,000 and ma-
tures in 5 years. It pays a 5 percent annual coupon rate. The bond currently sells for $1,100. What
is the bond’s expected rate of return?
7-19. (Expected rate of return and current yield ) Time Warner has bonds that are selling for $1,371.
The coupon interest rate on the bonds is 9.15 percent and they mature in 21 years. What is the
yield to maturity on the bonds? What is the current yield?
7-20. (Expected rate of return and current yield ) Citigroup issued bonds that pay a 5.5 percent coupon
interest rate. The bonds mature in 5 years. They are selling for $1,076. What would be your
expected rate of return (yield to maturity) if you bought the bonds? What would the current
yield be?
7-21. (Bondholders’ expected rate of return) Zenith Co.’s bonds mature in 12 years and pay 7 percent
interest annually. If you purchase the bonds for $1,150, what is your expected rate of return?
7-22. (Yield to maturity) Assume the market price of a 5-year bond for Margaret Inc. is $900, and
it has a par value of $1,000. The bond has an annual interest rate of 6 percent that is paid semi-
annually. What is the yield to maturity of the bond?
7-23. (Current yield) Assume you have a bond with a semiannual interest payment of $35, a par
value of $1,000, and a current market of $780. What is the current yield of the bond?
7-24. (Yield to maturity) An 8-year bond for Katy Corporation has a market price of $700 and a par
value of $1,000. If the bond has an annual interest rate of 6 percent, but pays interest semiannually,
what is the bond’s yield to maturity?
7-25. (Expected rate of return) Assume you own a bond with a market value of $820 that matures in
7 years. The par value of the bond is $1,000. Interest payments of $30 are paid semiannually. What
is your expected rate of return on the bond?
7-26. (Yield to maturity) You own a 10-year bond that pays 6 percent interest annually. The par
value of the bond is $1,000 and the market price of the bond is $900. What is the yield to maturity
of the bond?
7-27. (Bondholders’ expected rate of return) You purchased a bond for $1,100. The bond has a coupon
rate of 8 percent, which is paid semiannually. It matures in 7 years and has a par value of $1,000.
What is your expected rate of return?
Mini Case
This Mini Case is available in MyFinanceLab.
Here are data on $1,000 par value bonds issued by Microsoft, GE Capital, and Morgan Stanley at
the end of 2012. Assume you are thinking about buying these bonds as of January 2013. Answer
the following questions:
a. Assuming interest is paid annually, calculate the values of the bonds if your required rates
of return are as follows: Microsoft, 6 percent; GE Capital, 8 percent; and Morgan Stanley,
10 percent; where
7
M i C r o s o f t G E C a p i ta l M o r G a n s ta n l E y
Coupon interest rate 5.25% 4.25% 4.75%
Years to maturity 30 10 5

Chapter 7 • The Valuation and Characteristics of Bonds 249
b. At the end of 2008, the bonds were selling for the following amounts:
Microsoft $1,100
GE Capital $1,030
Morgan Stanley $1,015
What were the expected rates of return for each bond?
c. How would the value of the bonds change if (1) your required rate of return (rb) increased
2 percentage points or (2) decreased 2 percentage points?
d. Explain the implications of your answers in part (b) in terms of interest rate risk, premium
bonds, and discount bonds.
e. Should you buy the bonds? Explain.

The Valuation and
Characteristics of Stock
Learning Objectives
1 Identify the basic characteristics of preferred stock. Preferred Stock
2 Value preferred stock. Valuing Preferred Stock
3 Identify the basic characteristics of common stock. Common Stock
4 Value common stock. Valuing Common Stock
5 Calculate a stock’s expected rate of return. The Expected Rate of Return of
Stockholders
250
In the entertainment industry, Netflix was a well-recognized success story. That is, it was a success until 2011
when it changed how it charged its customers who subscribed to its services. Previously, you could stream vid-
eos to your television or computer or order videos through the mail, all for about $10. The firm’s management
changed the subscription plan so that you had to purchase the two plans separately, paying about $8 for each.
Thus, if you wanted to continue with what you had previously, the cost became almost $16—a 60-percent in-
crease in your cost. The price increase sparked 80,000 comments on the company’s Facebook page. Netflix lost
subscribers as well as stock market value in the wake of the controversial price increase.
To compound the problem, pay channel Starz, which controls the rights to movies from Sony Pictures and
Walt Disney Pictures, announced it would not renew a deal allowing Netflix to stream those films. Some analysts
considered the partnership with Starz to be worth as much as $300 million.
Netflix’s CEO responded with a letter, saying, “We hate making our subscribers upset with us, but we feel like
we provide a fantastic service and we’re working hard to further improve the quality and range of our stream-
ing content.”
Not only did Netflix lose customers, but the stockholders saw the value of their stock plummet. In one day,
the price was down 17 percent. By year end, the stock price had declined from almost $300 to slightly more than
$70, with the price still in the $80 range in June 2012. Lazard Capital Markets analyst Barton Crockett called the
news “a rare, large and surprising misstep” for the company.
How much value was destroyed for the firm’s owners? The total value of Netflix’s stock declined by some
$12 billion to slightly over $4 billion! It could be that the large loss in stock value, which is tied to the loss
in customers, has kept the Netflix management up late at night. After all, creating shareholder value, not
8

251251
destroying it, is a basic goal for man-
agement. In this chapter, we will look
closely at how stock is valued, which
is vital for a manager to understand.
Source: Ben Fritz, “Netflix Shares Tumble as Subscribers Leave After Price Increase,” Los Angeles Times, September 11, 2011,
http://latimesblogs.latimes.com/entertainmentnewsbuzz/2011/09/netflix-shares-tumble-as-subscribers-leave-following-
price-increase.html, accessed May 26, 2012; “Netflix to Lose Starz, Its Most Valuable Source of New Movies,” Los Angeles
Times, September 1, 2011, http://latimesblogs.latimes.com/entertainmentnewsbuzz/2011/09/netflix-to-lose-starz-its-
most-valuable-source-of-new-movies.html, accessed May 27, 2012; “Netflix Revenue and Guidance Disappoints Wall
Street,” Los Angeles Times, July 25, 2011, http://latimesblogs.latimes.com/entertainmentnewsbuzz/2011/07/netflix-stock-
drops-as-wall-street-disappointed-with-revenue-and-guidance.html, accessed May 27, 2012: and “Netflix Misses on Revenve,
Stock Plunges” by Matt Rosoff, from BUSINESS INSIDER, July 25, 2011.”
In Chapter 7, we developed a gen-
eral concept about valuation, and
economic value was defined as the
present value of the expected future
cash flows generated by an asset. We
then applied that concept to valuing
bonds.
We continue our study of valua-
tion in this chapter, but we now give
our attention to valuing stocks, both preferred stock and common stock. As already noted
at the outset of our study of finance and on several occasions since, the financial manager’s
objective should be to maximize the value of the firm’s common stock. Thus, we need to
understand what determines stock value. Also, only with an understanding of valuation can
we compute a firm’s cost of capital, a concept essential to making effective capital invest-
ment decisions—an issue to be discussed in Chapter 9.
Preferred Stock
Preferred stock is often referred to as a hybrid security because it has many characteristics of
both common stock and bonds. Preferred stock is similar to common stock in that (1) it has no
fixed maturity date, (2) if the firm fails to pay dividends, it does not bring on bankruptcy,
and (3) dividends are not deductible for tax purposes. On the other hand, preferred stock is
similar to bonds in that dividends are fixed in amount.
The amount of the preferred stock dividend is generally fixed either as a dollar amount
or as a percentage of the par value. For example, Georgia Pacific has preferred stock out-
standing that pays an annual dividend of $53, whereas AT&T has some 63>8 percent pre-
ferred stock outstanding. The AT&T preferred stock has a par value of $25; hence, each
share pays 6.375 percent * $25, or $1.59 in dividends annually.
To begin, we first discuss several features associated with almost all preferred stock.
Then we take a brief look at methods of retiring preferred stock. We close by learning how
to value preferred stock.
The Characteristics of Preferred Stock
Although each issue of preferred stock is unique, a number of characteristics are common
to almost all issues. Some of these more frequent traits include
♦ Multiple series of preferred stock
♦ Preferred stock’s claim on assets and income
1 Identify the basic
characteristics of preferred
stock.
preferred stock a hybrid security with
characteristics of both common stock and bonds.
Preferred stock is similar to common stock in that
it has no fixed maturity date, the nonpayment
of dividends does not bring on bankruptcy, and
dividends are not deductible for tax purposes.
Preferred stock is similar to bonds in that
dividends are limited in amount.

http://latimesblogs.latimes.com/entertainmentnewsbuzz/2011/09/netflix-shares-tumble-as-subscribers-leave-followingprice-increase.html

http://latimesblogs.latimes.com/entertainmentnewsbuzz/2011/09/netflix-to-lose-starz-itsmost-valuable-source-of-new-movies.html

http://latimesblogs.latimes.com/entertainmentnewsbuzz/2011/07/netflix-stockdrops-as-wall-street-disappointed-with-revenue-and-guidance.html

252 Part 2 • The Valuation of Financial Assets
♦ Cumulative dividends
♦ Protective provisions
♦ Convertibility
♦ Retirement provisions
All these features are presented in the discussion that follows.
Multiple Series If a company desires, it can issue more than one series of preferred stock,
and each series can have different characteristics. In fact, it is quite common for firms that
issue preferred stock to issue more than one series. These issues can be differentiated in that
some are convertible into common stock and others are not, and they have varying protec-
tive provisions in the event of bankruptcy. For instance, the Xerox Corporation has a Series
B and Series C preferred stock.
Claim on Assets and Income Preferred stock has priority over common stock with re-
gard to claims on assets in the case of bankruptcy. The preferred stock claim is honored
after that of bonds and before that of common stock. Multiple issues of preferred stock may
be given an order of priority. Preferred stock also has a claim on income before common
stock. That is, the firm must pay its preferred stock dividends before it pays common stock
dividends. Thus, in terms of risk, preferred stock is safer than common stock because it has
a prior claim on assets and income. However, it is riskier than long-term debt because its
claims on assets and income come after those of debt, such as bonds.
Cumulative Dividends Most preferred stocks carry a cumulative feature that requires
all past, unpaid preferred stock dividends be paid before any common stock dividends are declared.
The purpose is to provide some degree of protection for the preferred shareholder.
Protective Provisions In addition to the cumulative feature, protective provisions are
common to preferred stock. These protective provisions generally allow for voting rights
in the event of nonpayment of dividends, or they restrict the payment of common stock dividends
if the preferred stock payments are not met or if the firm is in financial difficulty. For example,
consider the stocks of Tenneco Corporation and Reynolds Metals. Tenneco preferred stock
has a protective provision that provides preferred stockholders with voting rights whenever
six quarterly dividends are in arrears. At that point, the preferred shareholders are given
the power to elect a majority of the board of director’s. Reynolds Metals preferred stock
includes a protective provision that precludes the payment of common stock dividends dur-
ing any period in which the preferred stock payments are in default. Both provisions offer
preferred stockholders protection beyond that provided by the cumulative provision and
further reduce their risk. Because of these protective provisions, preferred stockholders
do not require as high a rate of return. That is, they will accept a lower dividend payment.
Convertibility Much of the preferred stock that is issued
today is convertible preferred stock; that is, at the discre-
tion of the holder, the stock can be converted into a predetermined
number of shares of common stock. In fact, today about one-third
of all preferred stock issued has a convertibility feature. The
convertibility feature is, of course, desirable to the investor
and, thus, reduces the cost of the preferred stock to the issuer.
Retirement Provisions Although preferred stock does not
have a set maturity date associated with it, issuing firms gen-
erally provide for some method of retiring the stock, usually
in the form of a call provision or a sinking fund. A call provi-
sion entitles a company to repurchase its preferred stock from hold-
ers at stated prices over a given time period. In fact, the Securities
and Exchange Commission discourages firms from issuing
preferred stock without some call provision. For example,
cumulative feature a requirement that
all past, unpaid preferred stock dividends be
paid before any common stock dividends are
declared.
protective provisions provisions for
preferred stock that protect the investor’s
interest. The provisions generally allow for
voting in the event of nonpayment of dividends,
or they restrict the payment of common stock
dividends if sinking-fund payments are not met
or if the firm is in financial difficulty.
convertible preferred stock preferred
shares that can be converted into a
predetermined number of shares of common
stock, if investors so choose.
call provision a provision that entitles the
corporation to repurchase its preferred stock
from investors at stated prices over specified
periods.
RemembeR YouR PRinCiPleS
Valuing preferred stock relies on three of our prin-
ciples presented in Chapter 1, namely:
Principle 1: Cash Flow Is What Matters.
Principle 2: Money Has a Time Value.
Principle 3: Risk Requires a Reward.
Determining the economic worth, or value, of an asset
always relies on these three principles. Without them, we
would have no basis for explaining value. With them, we can
know that the amount and timing of cash, not earnings, drives
value. Also, we must be rewarded for taking risk; otherwise, we
will not invest.
rinciple

Chapter 8 • The Valuation and Characteristics of Stocks 253
Apartment Investment and Management Company, a real estate investment trust that
engages in acquiring and managing apartment properties, published the following news release:
Denver, January 26, 2012 (BUSINESS WIRE)—Apartment Investment and Manage-
ment Company (“Aimco”) announced it will redeem all outstanding shares of its Cumula-
tive Preferred Stock.… Redemptions will occur on July 26, 2012, at $25.00 per share plus
an amount equal to accumulated and unpaid dividends of $0.0646 per share. The total
redemption payments of $25.0646 per share is payable only in cash. After the redemption
date, the Preferred Stock no longer will be outstanding and holders of Preferred Stock
will have only the right to receive payment of the redemption price in exchange for their
Preferred Stock certificates.
The call feature on preferred stock usually requires buyers to pay an initial premium of
approximately 10 percent above the par value or issuing price of the preferred stock. Then,
over time, the call premium generally decreases. By setting the initial call price above the
initial issue price and allowing it to decline slowly over time, the firm protects the investor
from an early call that carries no premium. A call provision also allows the issuing firm to
plan the retirement of its preferred stock at predetermined prices.
A sinking-fund provision requires the firm to periodically set aside an amount of money for
the retirement of its preferred stock. This money is then used to purchase the preferred stock in
the open market or to call the stock, whichever method is cheaper. For instance, the Xerox
Corporation has two preferred stock issues, one that has a 7-year sinking-fund provision
and another with a 17-year sinking-fund provision.
Valuing Preferred Stock
As already explained, the owner of preferred stock generally receives a constant divi-
dend from the investment in each period. In addition, most preferred stocks are per-
petuities (nonmaturing). In this instance, finding the value (present value) of preferred
stock, (Vps), with a level cash-flow stream continuing indefinitely, may best be explained
by an example.
Consider Pacific & Gas Electric’s preferred stock issue. In similar fashion to valuing
bonds in Chapter 7, we use a three-step valuation procedure.
StEP 1 Estimate the amount and timing of the receipt of the future cash flows the preferred
stock is expected to provide. PG&E’s preferred stock pays an annual dividend of
$1.25. The shares do not have a maturity date; that is, they are a perpetuity.
StEP 2 Evaluate the riskiness of the preferred stock’s future dividends and determine
the investor’s required rate of return. The investor’s required rate of return is
assumed to equal 5 percent for the preferred stock.1
sinking-fund provision a protective
provision that requires the firm periodically to
set aside an amount of money for the retirement
of its preferred stock. This money is then used
to purchase the preferred stock in the open
market or through the use of the call provision,
whichever method is cheaper.
2 Value preferred stock.
1In Chapter 6, we learned about measuring an investor’s required rate of return.
StEP 3 Calculate the economic, or intrinsic, value of the PG&E share of preferred stock,
which is the present value of the expected dividends discounted at the investor’s
required rate of return. The valuation model for a share of preferred stock, Vps, is
therefore defined as follows:
Preferred Stock Value =
dividend in year 1
(1 + required rate of return)1
(8-1)
+
dividend in year 2
(1 + required rate of return)2
+ g +
dividend in infinity
(1 + required rate of return)∞
=
D1
(1 + rps)1
+
D2
(1 + rps)2
+ g +
D∞
(1 + rps)∞

254 Part 2 • The Valuation of Financial Assets
Because the dividends in each period are equal for preferred stock, equation (8-1) can
be reduced to the following relationship:2
Preferred stock value =
annual dividend
required rate of return
=
D
rps
(8-2)
2To verify this result, we begin with equation (8-1):
Vps =
D1
(1 + rps )1
+
D2
(1 + rps )2
+ g +
Dn
(1 + rps )n

If we multiply both sides of this equation by (l + rps), we have
Vps (1 + rps ) = D1 +
D2
(1 + rps )
+ g +
Dn
(1 + rps )n- 1
(8-1i)
Subtracting (8-1) from (8-1i) yields
Vps (1 + rps – 1) = D1 –
Dn
(1 + rps )n
(8-1ii)
As n approaches infinity, Dn/(1 + rps)n approaches zero. Consequently,
Vps rps = D1 and Vps =
D1
rps
(8-1iii)
Because D1 = D2 = g = Dn, we need not designate the year. Therefore,
Vps =
D
rps
(8-2)
Finance at Work
Reading a SToCk QuoTe in The Wall Street Journal
If you want to check on a stock, you can look in the hard
copy of the Wall Street Journal to find the ticker symbol, the
closing prices of the stock on the previous day, and the per-
centage change in the price from the day before. However,
the list only includes the 1,000 largest companies. If you
would like to have more information for all publicly traded
stock, you will need to go to the online version of the Wall
Street Journal (http://online.wsj.com), choose markets, and
select stocks. You can then select from a number of options
for finding stock quotes. For instance, if you want to look at
all the stocks traded on the New York Stock Exchange, you
would choose the link for markets, then the market data link,
and then the link for U.S. stocks. At that point, you will see a
list of different exchanges. Choose the NYSE stocks link. You
will then see all the stocks listed on the New York Exchange.
At this link, you will find more complete information about
a stock, including:
• The stock’s ticker symbol
• The opening, high, low, and closing price for the day, as well
as the high and low prices for the past 52 weeks
• The dollar and percentage change in the price of the stock
from the prior day
• The percentage change in the stock price from a year ago
• The number of shares that were traded during the day
• The stock’s dividend per share, dividend yield (dividend per
share , stock price), and the price/earnings ratio (stock
price , earnings per share)
P r I C E S F o r J u lY 5 , 2012
S yM b O L O P E n H I g H LO W C LO S E n E T C H g % C H g
GE 20.34 20.48 20.29 20.33 -0.1 -0.049
V O Lu M E
O F S H A R E S
T R A D E D 52 W E E k H I g H 52 W E E k LO W
D I V I D E n D P E R
S H A R E
D I V I D E n D
y I E L D
P R I C E TO
E A R n I n g S y T D % C H g
28,622,062 21.00 14.02 0.68 3.34 16.51 13.51
To illustrate, on July 5, 2012, the following information was
provided for General Electric:
Notice that equation (8-1) is a restatement in a slightly different form of equation (7-1) in
Chapter 7. Recall that equation (7-1) states that the value of an asset is the present value of
future cash flows to be received by the investor.

http://online.wsj.com

Chapter 8 • The Valuation and Characteristics of Stocks 255
Equation (8-2) represents the present value of an infinite stream of cash flows, when the
cash flows are the same each year.
We can now determine the value of the PG&E preferred stock, as described on
page 253, as follows:
VPS =
D
rp
=
$1.25
0.05
= $25
In summary, the value of a preferred stock is the present value of all future dividends.
But because most preferred stocks are nonmaturing—the dividends continue to infinity—
we rely on a shortcut for finding value as represented by equation (8-2).
e x a m p l e 8.1 Solving for the value of a preferred stock
Deutsche Bank has several preferred stock issues outstanding. One issue, a 7.35 percent
preferred stock, was sold at its par value of $25. The stock pays an annual dividend of
$1.84. The firm has the right to redeem the stock at 10 percent above par.
1. If investors have a 6 percent required rate of return today, in order to be interested in
buying the stock, what value would they assign to the stock?
2. How would your answer change if their required return was only 4 percent? What if
it increased to 9 percent?
3. How do you feel about the stock being redeemable?
STEP 1: FORMULATE A SOLUTION STRATEGY
The basic framework for valuing preferred stock is provided by equation (8-1), which is
shown as follows:
Preferred stock value =
dividend in year 1
(1 + required rate of return)1
+
dividend in year 2
(1 + required rate of return)2
+ g +
dividend in infinity
(1 + required rate of return)∞
=
D1
(1 + rps)1
+
D2
(1 + rps)2
+ g +
D∞
(1 + rps)∞
While equation (8-1) conveys the fundamental concept that the value of a preferred stock is
equal to the present value of all dividends continuing in perpetuity, it does not allow us to
solve the problem. Instead, equation (8-2) reduces equation (8-1) to a workable solution, as
long as the dividends are constant each year and the security does not mature.
Preferred stock value =
annual dividend
required rate of return
=
D
rps
(8-2)
STEP 2: CRUNCH THE NUMBERS
Values of the Deutsche Bank preferred stock for the different required rates of return
are as follows:
R e q u i R e d R at e
o f R e t u R n S o lu t i o n a n S w e R
6% $1.84
0.06
= $30.67
4% $1.84
0.04
= $46.00
9%
$1.84
0.09
= $20.44

256 Part 2 • The Valuation of Financial Assets
STeP 3: analYZe YouR ReSulTS
When the Deutsche Bank preferred stock was sold at the $25 par value, the investors’
required rate of return was equal to the coupon dividend rate of 7.35 percent. However,
there is an inverse relationship between value and rates of return. As an investor’s re-
quired rate of return increases (decreases) the security value decreases (increases).
You would prefer that the stock not be redeemable. The firm will recall the stock
only if it is in its best interest, not yours. For instance if with time the firm could issue
preferred stock with a lower dividend rate, it would be inclined to do so, and at the same
time you might not be able to find a comparable stock with the same return. Thus, an
investor should require a slightly higher required rate of return if a stock is redeemable.
can You Do it?
Valuing PReFeRRed SToCk
If a preferred stock pays 4 percent on its par, or stated, value of $100, and your required rate of return is 7 percent, what is the stock
worth to you?
(The solution can be found on page 257.)
3 Identify the basic
characteristics of common
stock.
common stock shares that represent the
ownership in a corporation.
Concept Check
1. What features of preferred stock are different from bonds?
2. What provisions are available to protect a preferred stockholder?
3. What cash flows associated with preferred stock are included in the valuation model equation (8-1)?
Why is the valuation model simplified in equation (8-2)?
Common Stock
Common stock is a certificate that indicates ownership in a corporation. (An example of a stock
certificate is shown in Figure 8-1.) In effect, bondholders and preferred stockholders can be
viewed as creditors, whereas the common stockholders are the true owners of the firm. Com-
mon stock does not have a maturity date but exists as long as the firm does. Common stock also
does not have an upper limit on its dividend payments. Dividend payments must be declared
each period (usually quarterly) by the firm’s board of directors. In the event of bankruptcy, the
common stockholders, as owners of the corporation, will not receive any payment until the
firm’s creditors, including the bondholders and preferred shareholders, have been paid. Next
we look at several characteristics of common stock. Then we focus on valuing common stock.
In conclusion, we can understand the process for valuing preferred stock as well as the
method for valuing preferred stock by using the following two financial tools:
Financial Decision tools
name of Tool Formula What It Tells you
Preferred stock valuation equation
Preferred
stock value
=
dividend in year 1
(1 + required rate of return)1
+
dividend in year 2
(1 + required rate of return)2
+ g +
dividend in infinity
(1 + required rate of return)∞
=
D1
(1 + rps)1
+
D2
(1 + rps)2
+ g +
D∞
(1 + rps)∞
The value of a preferred stock is equal
to the present value of all future divi-
dends in perpetuity.
Preferred stock valuation with
constant dividend
Vps =
annual dividend
required rate of return
=
D
rps
The value of a preferred stock where all
dividends are equal in perpetuity.

Chapter 8 • The Valuation and Characteristics of Stocks 257
DiD You Get it?
Valuing PReFeRRed SToCk
The value of the preferred stock would be $57.14:
Value =
dividend
required rate return
=
0.04 * $100
0.07
=
$4
0.07
= $57.14
In other words, a preferred stock, or any security for that matter, that pays a constant $4 annually in perpetuity because it has no ma-
turity date is valued by dividing the annual payment by the investor’s required rate of return. With this simple computation, you are
finding the present value of the future cash-flow stream.
The Characteristics of Common Stock
We now examine common stock’s claim on income and assets, its limited liability feature,
and holders’ voting and preemptive rights.
Claim on Income As the owners, the common shareholders have the right to the residual
income after creditors and preferred stockholders have been paid. This income may be paid
directly to the shareholders in the form of dividends or retained within the firm and rein-
vested in the business. Although it is obvious the shareholder benefits immediately from the
distribution of income in the form of dividends, the reinvestment of earnings also benefits
the shareholder. Plowing back earnings into the firm should result in an increase in the val-
ue of the firm, its earning power, future dividends, and, ultimately, an increase in the value
of the stock. In effect, residual income is distributed directly to shareholders in the form of
dividends or indirectly in the form of capital gains (value increases) on their common stock.
The right to residual income has advantages and disadvantages for the common stock-
holder. The advantage is that the potential return is limitless. Once the claims of the senior
securities, such as bonds and preferred stock, have been satisfied, the remaining income flows
to the common stockholders in the form of dividends or capital gains. The disadvantage is that
if the bond and preferred stock claims on income totally absorb earnings, common sharehold-
ers receive nothing. In years when earnings fall, it is the common shareholders who suffer first.
FIguRE 8-1 Sample Stock
Antone Common Stock
John B. Doe
100 Main St
Anywhere, U.S.A 12345
One-thousand, two-hundred shares
Date issued: December 14, 1996
******** ********

258 Part 2 • The Valuation of Financial Assets
Claim on Assets Just as common stock has a residual claim on income, it also has a re-
sidual claim on assets in the case of liquidation. Unfortunately, when bankruptcy does oc-
cur, the claims of the common shareholders generally go unsatisfied because debt holders
and preferred stockholders have first and second claims on the assets. This residual claim on
assets adds to the risk of common stock. Thus, although common stocks have historically
provided a large return, averaging 10 percent annually since the late 1920s, there is also a
higher risk associated with common stock.
Limited Liability Although the common shareholders are the actual owners of the cor-
poration, their liability in the case of bankruptcy is limited to the amount of their investment. The
advantage is that investors who might not otherwise invest their funds in the firm become
willing to do so. This limited liability feature aids the firm in raising funds.
Voting Rights The common stock shareholders are entitled to elect the board of direc-
tors and are, in general, the only security holders given a vote. Common shareholders have
the right not only to elect the board of directors but also to approve any change in the
corporate charter. A typical change might involve the authorization to issue new stock or to
accept a merger proposal. Voting for directors and charter changes occurs at the corpora-
tion’s annual meeting. Although shareholders can vote in person, the majority generally
vote by proxy. A proxy gives a designated party the temporary power of attorney to vote for the
signee at the corporation’s annual meeting. The firm’s management generally solicits proxy
votes, and, if the shareholders are satisfied with the firm’s performance, has little problem
securing them. However, in times of financial distress or when managerial takeovers are
threatened, proxy fights—battles between rival groups for proxy votes—occur.
Although each share of common stock carries the same number of votes, the voting pro-
cedure is not always the same from company to company. The two procedures commonly
used are majority and cumulative voting. Under majority voting, each share of stock allows
the shareholder one vote and each position on the board of directors is voted on separately. Because
each member of the board of directors is elected by a simple majority, a majority of shares
has the power to elect the entire board of directors.
With cumulative voting, each share of stock allows the stockholder a number of votes equal to
the number of directors being elected. The shareholder can then cast all of his or her votes for a
single candidate or split them among the various candidates. The advantage of a cumulative
voting procedure is that it gives minority shareholders the power to elect a director.
In theory, the shareholders pick the corporate board of directors, generally through proxy
voting, and the board of directors, in turn, picks the management. In reality, shareholders are
offered a slate of nominees selected by management from which to choose. The end result is
that management effectively selects the directors, who then may have more allegiance to the
managers than to the shareholders. This sets up the potential for agency problems in which a
divergence of interests between managers and shareholders is allowed to exist, with the board of
directors not monitoring the managers on behalf of the shareholders as they should.
Preemptive Rights The preemptive right entitles the common shareholder to maintain a
proportionate share of ownership in the firm. When new shares are issued, common sharehold-
ers have the first right of refusal. If a shareholder owns 25 percent of the corporation’s
stock, then he or she is entitled to purchase 25 percent of the new shares. Certificates issued
to the shareholders giving them an option to purchase a stated number of new shares of stock at a
specified price during a 2- to 10-week period are called rights. These rights can be exercised
(generally at a price set by management below the common stock’s current market price),
allowed to expire, or sold in the open market.
Valuing Common Stock
Like bonds and preferred stock, a common stock’s value is equal to the present value of
all future cash flows—dividends in this case—expected to be received by the stockholder.
However, in contrast to preferred stock dividends, common stock does not provide the
limited liability a protective provision
whereby the investor is not liable for more than
the amount he or she has invested in the firm.
proxy a means of voting in which a designated
party is provided with the temporary power
of attorney to vote for the signee at the
corporation’s annual meeting.
proxy fight a battle between rival groups for
proxy votes in order to control the decisions
made in a stockholders’ meeting.
majority voting voting in which each share
of stock allows the shareholder one vote and
each position on the board of directors is voted
on separately. As a result, a majority of shares has
the power to elect the entire board of directors.
cumulative voting voting in which each
share of stock allows the shareholder a number
of votes equal to the number of directors being
elected. The shareholder can then cast all of his
or her votes for a single candidate or split them
among the various candidates.
preemptive right the right entitling the
common shareholder to maintain his or her
proportionate share of ownership in the firm.
right a certificate issued to common
stockholders giving them an option to purchase
a stated number of new shares at a specified
price during a 2- to 10-week period.
4Value common stock.

Chapter 8 • The Valuation and Characteristics of Stocks 259
investor with a predetermined, constant dividend. For common stock, the dividend is based
on the profitability of the firm and its decision to pay dividends or to retain the profits for
reinvestment. As a consequence, dividend streams tend to increase with the growth in cor-
porate earnings. Thus, the growth of future dividends is a prime distinguishing feature of
common stock.
The Growth Factor in Valuing Common Stock What is meant by the term growth when
used in the context of valuing common stock? A company can grow in a variety of ways. It
can become larger by borrowing money to invest in new projects. Likewise, it can issue new
stock for expansion. Managers can also acquire another company to merge with the existing
firm, which would increase the firm’s assets. Although it can accurately be said that the firm
has grown, the original stockholders may or may not participate in this growth. Growth is
realized through the infusion of new capital. The firm size clearly increases, but unless the
original investors increase their investment in the firm, they will own a smaller portion of
the expanded business.
Another means of growing is internal growth, which requires that managers retain some
or all of the firm’s profits for reinvestment in the firm, resulting in the growth of future earn-
ings and, hopefully, the value of the common stock. This process underlies the essence of
potential growth for the firm’s current stockholders and is the only relevant growth for our
purposes of valuing a firm’s common shares.3
internal growth a firm’s growth rate
resulting from reinvesting the company’s profits
rather than distributing them as dividends. The
growth rate is a function of the amount retained
and the return earned on the retained funds.
profit-retention rate the company’s
percentage of profits retained.
3We are not arguing that the existing common stockholders never benefit from the use of external financing; however,
such benefit is nominal if capital markets are efficient.
To illustrate the nature of internal growth, assume that the return on equity for PepsiCo
is 16 percent.4 If PepsiCo decides to pay all the profits out in dividends to its stockholders,
the firm will experience no growth internally. It might become larger by borrowing more
money or issuing new stock, but internal growth will come only through the retention of
profits. If, on the other hand, PepsiCo retains all of the profits, the stockholders’ investment
in the firm would grow by the amount of profits retained, or by 16 percent. If, however,
PepsiCo keeps only 50 percent of the profits for reinvestment, the common shareholders’
investment would increase only by half of the 16 percent return on equity, or by 8 percent.
We can express this relationship by the following equation:
4The return on equity is the accounting rate of return on the common shareholders’ investment in the company and is
computed as follows:
Return on equity =
net income
(common stock + retained earnings)
g = ROE * pr (8-3)
where g = the growth rate of future earnings and the growth in the common stockholders’
investment in the firm
ROE = the return on equity (net income/common book value)
pr = the company’s percentage of profits retained, called the profit-retention rate5
dividend-payout ratio dividends as a
percentage of earnings.
5The retention rate is also equal to (1 – the percentage of profits paid out in dividends). The percentage of profits paid out in
dividends is often called the dividend-payout ratio.
Therefore, if only 25 percent of the profits were retained by PepsiCo, we would expect the
common stockholders’ investment in the firm and the value of the stock price to increase,
or grow, by 4 percent; that is,
g = 16% * 0.25 = 4%
In summary, common stockholders frequently rely on an increase in the stock price
as a source of return. If the company is retaining a portion of its earnings for reinvest-
ment, future profits and dividends should grow. This growth should be reflected by an
increase in the market price of the common stock in future periods. Therefore, both
types of return (dividends and price appreciation) must be recognized in valuing com-
mon stock.

260 Part 2 • The Valuation of Financial Assets
Dividend Valuation Model The value of a common stock when defining value as the pres-
ent value of future dividends relies on the same basic equation that we used with preferred
stock [equation (8-1)], with the exception that we are using the required rate of return of
common stockholders, rcs. That is,
Vcs =
D1
(1 + rcs)1
+
D2
(1 + rcs)2
+ g +
Dn
(1 + rcs )n
+ g +
D∞
(1 + rcs)∞
(8-4)
If you turn back to Chapter 7 and compare equation (7-1) with equation (8-4), you will
notice that equation (8-4) is merely a restatement of equation (7-1). Recall that equation
(7-1), which is the basis for our work in valuing securities, states that the value of an asset is
the present value of future cash flows to be received by the investor. Equation (8-4) simply
applies equation (7-1) to valuing common stock.
Equation (8-4) indicates that we are discounting the dividend at the end of the first
year, D1, back 1 year; the dividend in the second year, D2, back 2 years; the dividend in the
nth year back n years; and the dividend in infinity back an infinite number of years. The
required rate of return is rcs. In using equation (8-4), note that the value of the stock is es-
tablished at the beginning of the year, say January 1, 2013. The most recent past dividend,
D0, would have been paid the previous day, December 31, 2012. Thus, if we purchased the
stock on January 1, the first dividend would be received in 12 months, on December 31,
2013, which is represented by D1.
Fortunately, equation (8-4) can be reduced to a much more manageable form if divi-
dends grow each year at a constant rate, g. The constant-growth, common-stock valuation
equation can be presented as follows:6
6When common stock dividends grow at a constant rate of g every year, we can express the dividend in any year in terms
of the dividend paid at the end of the previous year, D0. For example, the expected dividend year 1 hence is simply
D0(1 + g). Likewise, the dividend at the end of t years is D0(1 + g)t. Using this notation, the common stock valuation
equation in (8-4) can be rewritten as follows:
Vcs =
D0 (1 + rcs)1
(1 + g)1
+
D0 (1 + g)2
(1 + rcs )2
+ g +
D0 (1 + g)n
(1 + rcs )n
+ g +
D0 (1 + g)∞
(1 + rcs )∞
(8-4i)
If both sides of equation (8-4i) are multiplied by (1 + rcs)/(1 + g) and then equation (8-5) is subtracted from the product,
the result is
Vcs (1 + rcs )
1 + g
– Vcs = D0 –
D0 (1 + g)∞
(1 + rcs )∞
(8-4ii)
If rcs 7 g, which normally should hold, [D0(1 + g)/(1 + rcs)∞] approaches zero. As a result,

Vcs (1 + rcs )
1 + g
– Vcs = D0
Vcs a
1 + rcs
1 + g
b – Vcs a
1 + g
1 + g
b = D0
Vcs c
(1 + rcs) – (1 + g)
1 + g
d = D0 (8-4iii)
Vcs (rcs – g) = D0 (1 + g)
Vcs =
D1
rcs – g
Common stock value =
dividend in year 1
required rate of return – growth rate
Vcs =
D1
rcs – g
(8-5)
In other words, the intrinsic value (present value) of a share of common stock whose
dividends grow at a constant annual rate can be calculated using equation (8-5). Although
the interpretation of this equation might not be intuitively obvious, simply remember that
it solves for the present value of the future dividend stream growing at a rate, g, to infinity,
assuming that rcs is greater than g.
To illustrate the process of valuing a common stock, consider the valuation of a share of
common stock that paid a $2 dividend at the end of last year and is expected to pay a cash

Chapter 8 • The Valuation and Characteristics of Stocks 261
dividend every year from now to infinity. Each year the dividends are expected to grow at a
rate of 4 percent. Based on an assessment of the riskiness of the common stock, the inves-
tor’s required rate of return is 14 percent. Using this information, we would compute the
value of the common stock as follows:
1. Because the $2 dividend was paid last year, we must compute the next dividend to be
received, that is, D1, where
D1 = D0 (1 + g)
= $2(1 + 0.04)
= $2.08
2. Now, using equation (8-5),
Vcs =
D1
rcs – g
=
$2.08
0.14 – 0.04
= $20.80
We have argued that the value of a common stock is equal to the present value of all future
dividends, which is without question a fundamental premise of finance. In practice, however,
managers, along with many security analysts, often talk about the relationship between stock
value and earnings, rather than dividends. We would encourage you to be very cautious in
using earnings to value a stock. Even though it may be a popular practice, significant available
evidence suggests that investors look to the cash flows generated by the firm, not the earnings,
for value. A firm’s value truly is the present value of the cash flows it produces.
E x A M P L E 8.2 Solving for the value of a common stock
During 2012, Starbucks Coffee’s common stock had been selling for between $30 and $60. Its
most recent earnings per share was $1.73, and the firm was expected to pay a dividend of $0.68.
The company’s return on equity (net income , total common equity) has been 25 percent.
You are planning on investing in 100 shares of the stock, but you want a 17 percent return
on your investment. Given the limited information, what growth rate would you estimate
for Starbucks? What price would be required for you to earn your required return?
STeP 1: FoRmulaTe a SoluTion STRaTegY
Solving for the value of the Starbucks stock requires you to estimate a future growth rate,
which we have suggested you do by multiplying the firm’s return on equity times the
percentage of its earnings being retained to be reinvested in the company. The equation
(8-3) is as follows:
g = ROE * pr
can You Do it?
meaSuRing JohnSon & JohnSon’S gRoWTh RaTe
In 2012, Johnson & Johnson had a return on equity of 19.47 percent,
as computed to the right. The firm’s earnings per share was
$4.63 and it paid $1.87 in dividends per share. If these relation-
ships hold in the future, what will be the firm’s internal growth
rate?
return on
equity (roE)
=
net income
common stock + retained earnings
=
$12,849
$66,499
= 0.1932 = 19.32,
(The solution can be found on page 262.)

262 Part 2 • The Valuation of Financial Assets
We then solve for the stock value, using equation (8-5):
Common stock value =
dividend in year 1
required rate of return – growth rate
Vcs =
D1
rcs – g
STeP 2: CRunCh The numbeRS
Starbucks pays out 39 percent of its earning to the shareholders (39% = $0.68 divi-
dends per share , $1.73 earnings per share). Thus, it is retaining 61 percent (61% =
100% – 39%).
Given the firm’s return on equity of 25 percent, we could expect the company to grow
at 15.25 percent:
Growth rate = 25% return on equity * 61% earnings retention = 15.25%
Then solving for the stock value that would satisfy a 17 percent required rate of return:
Value =
dividend
required rate of return – growth rate
=
$0.68
0.17 – 0.1525
= $38.86
STeP 3: analYZe YouR ReSulTS
While Starbucks was selling for about $50 when this problem was written, you should
not be willing to pay the $50 market price; otherwise, if our assumptions are reasonable
you would not earn your required rate of return. Besides, Starbucks was experiencing
growth problems in 2012, actually closing some stores.
DiD You Get it?
meaSuRing JohnSon & JohnSon’S gRoWTh RaTe
To compute Johnson & Johnson’s internal growth rate, we must know (1) the firm’s return on equity, and (2) what percentage of the
earnings are being retained and reinvested in the business—that is, used to grow the business.
The return on equity was computed to be 19.47 percent. We then calculate the percentage of the profits that is being retained as
follows:
Percentage of
profits retained
= 1 –
dividends per share
earnings per share
= 1 –
$1.87
$4.63
= 1 – 0.404
= 0.596 = 59.6%
Thus, Johnson & Johnson is paying out 40.4 percent of its earnings, which means it is retaining 59.6 percent.
Then we compute the internal growth rate as follows:
Internal growth
rate
=
return on
equity
*
percentage of
earnings retained
= 19.47% * 59.6%
= 11.6%
The ability of a firm to grow is critical to its future, but only if the firm has attractive opportunities in which to invest. Also, there must
be a way to finance the growth, which can occur by borrowing more, issuing stock, or not distributing the profits to the owners (not
paying dividends). The last option is called internal growth. Johnson & Johnson was able to grow internally by almost 12 percent by
earning 19.47 percent on the equity’s investment and retaining about 60 percent of the profits in the business.

Chapter 8 • The Valuation and Characteristics of Stocks 263
Concept Check
1. What features of common stock indicate ownership in the
corporation versus preferred stock or bonds?
2. In what two ways does a shareholder benefit from ownership?
3. How does internal growth versus the infusion of new capital
affect the original shareholders?
4. Describe the process for common stock valuation.
RemembeR YouR PRinCiPleS
Valuing common stock is no different from valuing
preferred stock; only the pattern of the cash flows changes.
Thus, the valuation of common stock relies on the same three
principles developed in Chapter 1 that were used in valuing
preferred stock:
Principle 1: Cash Flow Is What Matters.
Principle 2: Money Has a Time Value.
Principle 3: Risk Requires a Reward.
Determining the economic worth, or value, of an asset always
relies on these three principles. Without them, we would have
no basis for explaining value. With them, we can know that the
amount and timing of cash, not earnings, drives value. Also, we
must be rewarded for taking risk; otherwise, we will not invest.
rinciple
can You Do it?
CalCulaTing Common SToCk Value
The Abraham Corporation paid $1.32 in dividends per share last year. The firm’s projected growth rate is 6 percent for the foreseeable
future. If the investor’s required rate of return for a firm with Abraham’s level of risk is 10 percent, what is the value of the stock?
(The solution can be found on page 264.)
Financial Decision tools
name of Tool Formula What It Tells you
Dividend growth rate Growth = return on equity * percentage of profits retained
Estimation of a company’s
growth rate to be used in
valuing the stock.
Common stock valuation Vcs =
D1
(1 + rcs)1
+
D2
(1 + rcs)2
+ g +
Dn
(1 + rcs )n
+ g +
D∞
(1 + rcs)∞
The value of a common stock is
the present value of all future
dividends in perpetuity.
Common stock valuation
assuming constant dividend
growth
Common stock value =
dividend in year 1
required rate of return – growth rate
Vcs =
D1
rcs – g
The value of common stock
assuming that dividends are
growing at a constant growth
rate in perpetuity.
The Expected Rate of Return of Stockholders
As stated in Chapter 7, the expected rate of return, or yield to maturity, on a bond is the
return the bondholder expects to receive on the investment by paying the existing market
price for the security. This rate of return is of interest to the financial manager because
it tells the manager about investors’ expectations. The same can be said for the financial
manager needing to know the expected rate of return of the firm’s stockholders, which is
the topic of this section.
5 Calculate a stock’s expected
rate of return.
We now have the financial decision tools to value common stock assuming that divi-
dends grow at a constant rate in perpetuity, which are shown as follows:

264 Part 2 • The Valuation of Financial Assets
The Expected Rate of Return of Preferred Stockholders
To compute the expected rate of return of preferred stockholders, we use the valuation
equation for preferred stock. Earlier, equation (8-2) specified the value of a preferred stock,
Vps, as
Preferred stock value (Vps) =
annual dividend
required rate of return
=
D
rps
Solving equation (8-2) for rps, we have
Required rate of return (rps) =
annual dividend
preferred stock value
=
D
Vps
(8-6)
Thus, the required rate of return of preferred stockholders simply equals the stock’s an-
nual dividend divided by the stock’s intrinsic value. We can also use this equation to solve
for a preferred stock’s expected rate of return, rps, as follows:7
DiD You Get it?
CalCulaTing Common SToCk Value
Abraham’s stock value would be $35:
Value =
dividend year 1
required rate of return – growth rate

=
$1.32 * (1 + .06)
0.10 – 0.06
=
$1.40
0.04
= $35
So the value of a common stock, much like preferred stock, is the present value of all future dividends. However, unlike preferred stock,
common stock dividends are assumed to increase as the firm’s profits increase. So the dividend is growing over time. And with a bit of
calculus—keep the faith, baby—we can find the stock value by taking the dividend that is expected to be received at the end of the
coming year and dividing it by the investor’s required rate of return less the assumed constant growth rate. When we do, we have the
present value of the dividends, which is the value of the stock.
7We will use r to represent a security’s expected rate of return versus r for investors’ required rate of return.
Expected rate of return (rps) =
annual dividend
preferred stock market price
=
D
Pps
(8-7)
Note that we have merely substituted the current market price, Pps, for the intrinsic
value, Vps. The expected rate of return, rps, therefore, equals the annual dividend relative
to the price the stock is currently selling for, Pps. Thus, the expected rate of return, rps, is
the rate of return the investor can expect to earn from the investment if it is bought at the current
market price.
For example, if the present market price of the preferred stock is $50, and it pays a $3.64
annual dividend, the expected rate of return implicit in the present market price is
rps =
D
Pps
=
$3.64
$50
= 7.28%
Therefore, investors (who pay $50 per share for a preferred security that is paying $3.64 in
annual dividends) are expecting a 7.28 percent rate of return.
So we now have the decision tools for calculating a stockholder’s required rate of return
and the stock’s expected rate of return shown as follows:
expected rate of return The rate of return
investors expect to receive on an investment by
paying the current market price of the security.

Chapter 8 • The Valuation and Characteristics of Stocks 265
E x A M P L E 8.3 Solving for the expected rate of return for a preferred stock
In Example 8-1, we calculated the value of Deutsche Bank’s preferred stock, where the stock
had a par value of $25 and a coupon dividend rate of 7.35 percent, which resulted in a $1.84
dividend. In the earlier example, we computed the value of the stock given different required
rates of returns. At the time, the stock was actually selling for $26 in the market. What is the
expected rate of return if you purchased the stock at the current market price?
STeP 1: FoRmulaTe a SoluTion STRaTegY
To determine the expected rate of return for preferred stock. We need only compute the
stock’s dividend yield, as measured in equations (8-7), as follows:
rps =
annual dividend
preferred stock market price
=
D
Pps
STeP 2: CRunCh The numbeRS
Expected rate of return =
$1.84
$26
= 0.0708 = 7.08%
STeP 3: analYZe YouR ReSulTS
The investors owning the Deutsche Bank stock are expecting to earn less than the
coupon dividend rate of 7.35 percent. This outcome is the result of the investors being
willing to pay above the par value of the stock.
The Expected Rate of Return of Common Stockholders
The valuation equation for common stock was defined earlier in equation (8-4) as
Common stock value =
dividend in year 1
(1 + required rate of return)1
+
dividend in year 2
(1 + required rate of return)2
+ g +
dividend in year infinity
(1 + required rate of return)∞
Vcs =
D1
(1 + rcs )1
+
D2
(1 + rcs )2
+ g +
D∞
(1 + rcs )∞
Owing to the difficulty of discounting to infinity, we made the key assumption that the
dividends, Dt, increase at a constant annual compound growth rate of g. If this assumption
is valid, equation (8-5) was shown to be equivalent to
Common stock value =
dividend in year 1
required rate of return – growth rate
Vcs =
D1
rcs – g
Financial Decision tools
name of Tool Formula What It Tells you
Preferred stockholder’s required rate of return rps =
annual dividend
preferred stock value
=
D
Vps
The required rate of return for a preferred
stockholder, given the value the investor
assigns to the stock.
Preferred stock expected rate of return rps =
annual dividend
preferred stock market price
=
D
Pps
Calculates the expected rate of return for a
preferred stock, given the current market
price of the stock.

266 Part 2 • The Valuation of Financial Assets
Thus, Vcs represents the maximum value that investors having a required rate of return
of rcs would pay for a security having an anticipated dividend in year 1 of D1 that is expected
to grow in future years at rate g. Solving equation (8-5) for rcs, we can compute the common
stockholders’ required rate of return as follows:8
8At times the expected dividend at year-end (D1) is not given. Instead, we might only know the most recent dividend
(paid yesterday), that is, D0. If so, equation (8-5) must be restated as follows:
Vcs =
D1
(rcs – g)
=
D0 (1 + g )
(rcs – g )
rcs =
D1
Vcs
+ g (8-8)
dividend
yield
annual growth
rate
e x a m p l e 8.4 Solving for the expected rate of return of a common stock
In Example 8-2, we valued Starbucks Coffee at $38.86, given your required rate of return
of 17 percent. This answer was based on an anticipated growth rate of 15.25 percent.
Also, the stock was expected to pay a $0.68 dividend. The stock was actually selling
for $50 at the time. What would be the expected rate of return for investors purchasing
the stock at the current price of $50?
STEP 1: FORMULATE A SOLUTION STRATEGY
To estimate the expected rate of return on a common stock, we use the following equation:
According to this equation, the required rate of return is
equal to the dividend yield plus a growth factor. Although
the growth rate, g, applies to the growth in the company’s
dividends, given our assumptions, the stock’s value can also
be expected to increase at the same rate. For this reason, g
represents the annual percentage growth in the stock value. In
other words, the required rate of return of investors is satis-
fied by their receiving dividends and capital gains, as reflected
by the expected percentage growth rate in the stock price.
As was done for preferred stock earlier, we may revise
equation (8-8) to measure a common stock’s expected rate of
return, rcs. Replacing the intrinsic value, Vcs, in equation (8-8)
with the stock’s current market price, Pcs, we may express the
stock’s expected rate of return as follows:
rcs =
dividend in year 1
market price
+ growth rate =
D1
Pcs
+ g (8-9)
To illustrate, Pearson, Inc. will pay a dividend of $2 this year. Management anticipates
that the firm will grow at about 6 percent per year. You are interested in buying 100 shares
of the stock, which is currently priced at $45. Your required rate of return is 12 percent.
Should you buy the stock?
rcs =
$2
$45
+ 0.06 = 4.44% + 6% = 10.44%
You would not want to buy the stock. The expected return is less than your required return.
Historically, most of the returns on stocks come from price appreciation, or capital
gains, with a smaller part of the return coming from dividends, with 2008–2009 being the
REMEMbER YOUR PRINcIPLES
We have just learned that, on average, the expected
return will be equal to the investor’s required rate of return.
This equilibrium condition is achieved by investors paying for
an asset only the amount that will exactly satisfy their required
rate of return. Thus, finding the expected rate of return based
on the current market price for the security relies on two of the
principles given in Chapter 1:
principle 2: money Has Time Value.
principle 3: Risk Requires a Reward.
rinciple

Chapter 8 • The Valuation and Characteristics of Stocks 267
Can You Do It?
cOMPUTING THE EXPEcTED RATE OF RETURN
Calculate the expected rate of return for the two following stocks:
Preferred stock: The stock is selling for $80 and pays a 5 percent dividend on its $100 par or stated value.
Common stock: The stock paid a dividend of $4 last year and is expected to increase each year at a 5 percent growth rate. The stock
sells for $75.
(The solution can be found below.)
DID You Get It?
cOMPUTING THE EXPEcTED RATE OF RETURN
Preferred stock:
Expected return =
dividend
stock price
=
$5
$80
= 0.0625, or 6.25%
Common stock:
Expected return =
dividend in year 1
stock price
+ growth rate
=
$4 * (1 + 0.05)
$75
+ 5% =
$4.20
$75
+ 5%
= 5.6% + 5% = 10.6%
At this point, we are not concerned what the value of the stock is to us. Instead, we want to know what rate of return we could
expect if we buy a common stock at the current market price. So the price is given, and we are finding the corresponding expected
return based on the current market price. We can then ask ourselves if the expected rate of return is acceptable, given the amount of
risk we would be assuming.
exception. The Standard & Poor’s 500 Index, for example, returned a 10 percent annual
return on average since 1926. But the dividend yield (dividend , stock price) accounted
for only about 2–3 percent of the return. The remaining 7–8 percent resulted from price
appreciation.
rcs =
dividend in year 1
market price
+ growth rate =
D1
Pcs
+ g
STEP 2: cRUNcH THE NUMbERS
The expected rate of return for the Starbucks stock would be 16.61 percent.
Expected rate of return =
dividend
market price
+ growth rate
=
$0.68
$50
+ 0.1525
= 0.0136 + 0.1525 = 0.1661 = 16.61%
STEP 3: ANALYZE YOUR RESULTS
Of the expected rate of return at the $50 market price, only a small portion is attributable
to the dividend received by the investors. The investors are essentially relying on the
firm to achieve a growth rate of about 15 percent per year into the future. Not an easy
thing to do for many firms.

268 Part 2 • The Valuation of Financial Assets
Concept Check
1. In computing the required rate of return for common stock, why should the growth factor be
added to the dividend yield?
2. Explain the difference between a stockholder’s required and expected rates of return.
3. How does an efficient market affect the required and expected rates of return?
As a final note, we should understand that the expected rate of return implied by a given
market price equals the required rate of return for investors at the margin. For these inves-
tors, the expected rate of return is just equal to their required rate of return and, therefore,
they are willing to pay the current market price for the security. These investors’ required
rate of return is of particular significance to the financial manager because it represents the
cost of new financing to the firm.
In summary, we can use the following decision tools to estimate a common stockhold-
er’s required rate of return and the stocks expected return:
Chapter Summaries
Valuation is an important process in financial management. An understanding of valuation, both
the concepts and procedures, supports the financial objective of creating shareholder value.
Identify the basic characteristics of preferred stock. (pgs. 251–253)
SummaRy: Preferred stock has no fixed maturity date, and the dividends are fixed in amount.
Some of the more common characteristics of preferred stock include the following:
• There are multiple classes of preferred stock.
• Preferred stock has a priority claim on assets and income over common stock.
• Any dividends, if not paid as promised, must be paid before any common stock dividends
may be paid; that is, they are cumulative.
• Protective provisions are included in the contract with the shareholder to reduce the inves-
tor’s risk.
• Some preferred stocks are convertible into common stock shares.
• In addition, there are provisions frequently used to retire an issue of preferred
stock, such as the ability of the firm to call its preferred stock or to use a sinking-fund
provision.
1
FInanCIal DeCIsIon tools
Name of Tool Formula What It Tells you
Common stockholder’s required rate of return
rcs =
D1
Vcs
+ g
dividend yield annual growth rate
Calculates the required rate of return for
a common stockholder, given the value
the investor assigns to the stock.
Common stock expected rate of return rcs =
dividend in year 1
market price
+ growth rate =
D1
Pcs
+ g
Calculates the expected rate of return for
a common stock, given the current market
price of the stock and the projected growth
rate in future dividends.

Chapter 8 • The Valuation and Characteristics of Stocks 269
kEy TERMS
Preferred stock, page 251 A hybrid security
with characteristics of both common stock and
bonds. Preferred stock is similar to common
stock in that it has no fixed maturity date, the
nonpayment of dividends does not bring on
bankruptcy, and dividends are not deductible
for tax purposes. Preferred stock is similar to
bonds in that dividends are limited in amount.
Cumulative feature, page 252 A require-
ment that all past, unpaid preferred stock
dividends be paid before any common stock
dividends are declared.
Protective provisions, page 252 Provisions
for preferred stock that protect the investor’s
interest. The provisions generally allow for
voting in the event of nonpayment of
dividends, or they restrict the payment of
common stock dividends if sinking-fund
payments are not met or if the firm is in
financial difficulty.
Convertible preferred stock,
page 252 Preferred shares that can be
converted into a predetermined number of
shares of common stock, if investors so choose.
Call provision, page 252 A provision that
entitles the corporation to repurchase its
preferred stock from investors at stated prices
over specified periods.
Sinking-fund provision, page 253 A protec-
tive provision that requires the firm periodi-
cally to set aside an amount of money for the
retirement of its preferred stock. This money
is then used to purchase the preferred stock in
the open market or through the use of the call
provision, whichever method is cheaper.
Value preferred stock. (pgs. 253– 256)
SuMMARy: Value is the present value of future cash flows discounted at the investor’s required
rate of return. Although the valuation of any security entails the same basic principles, the proce-
dures used in each situation vary. For example, we learned in Chapter 7 that valuing a bond involves
calculating the present value of the future interest to be received plus the present value of the
principal returned to the investor at the maturity of the bond. For securities with cash flows that
are constant in each year but with no specified maturity, such as preferred stock, the present value
equals the dollar amount of the annual dividend divided by the investor’s required rate of return.
kEy EquATIOn
Preferred Stock Value (Vps) =
dividend in year 1
(1 + required rate of return)1
+
dividend in year 2
(1 + required rate of return)2
+ g +
dividend in infinity
(1 + required rate of return)∞
=
D1
(1 + rps)1
+
D2
(1 + rps)2
+ g +
D∞
(1 + rps)∞
Preferred stock value (Vps) =
annual dividend
required rate of return
=
D
rps
Identify the basic characteristics of common stock. (pgs. 256–258)
SuMMARy: Common stock involves ownership in the corporation. In effect, bondholders and
preferred stockholders can be viewed as creditors, whereas common stockholders are the owners of
the firm. Common stock does not have a maturity date but exists as long as the firm does. Nor does
common stock have an upper limit on its dividend payments. Dividend payments must be declared
by the firm’s board of directors before they are issued. In the event of bankruptcy, the common
stockholders, as owners of the corporation, cannot exercise claims on assets until the firm’s credi-
tors, including its bondholders and preferred shareholders, have been satisfied. However, common
stockholders’ liability is limited to the amount of their investment.
The common stockholders are entitled to elect the firm’s board of directors and are, in general, the
only security holders given a vote. Common shareholders also have the right to approve any change
in the company’s corporate charter. Although each share of stock carries the same number of votes,
the voting procedure is not always the same from company to company.
2
3

kEy TERM
The preemptive right entitles the common shareholder to maintain a proportionate share of own-
ership in the firm.
Common stock, page 256 Shares that
represent the ownership in a corporation.
Limited liability, page 258 A protective
provision whereby the investor is not liable for
more than the amount he or she has invested
in the firm.
Proxy, page 258 A means of voting in which
a designated party is provided with the
temporary power of attorney to vote for the
signee at the corporation’s annual meeting.
Proxy fight, page 258 A battle between rival
groups for proxy votes in order to control the
decisions made in a stockholders’ meeting.
Majority voting, page 258 Voting in which
each share of stock allows the shareholder one
vote and each position on the board of
directors is voted on separately. As a result, a
majority of shares has the power to elect the
entire board of directors.
Cumulative voting, page 258 Voting
in which each share of stock allows the
shareholder a number of votes equal to the
number of directors being elected. The
shareholder can then cast all of his or her votes
for a single candidate or split them among the
various candidates.
Preemptive right, page 258 The right
entitling the common shareholder to maintain
his or her proportionate share of ownership in
the firm.
Right, page 258 A certificate issued to
common stockholders giving them an option
to purchase a stated number of new shares at a
specified price during a 2- to 10-week period.
Value common stock. (pgs 258–263)
SuMMARy: As with bonds and preferred stock, the value of a common stock is equal to the present
value of future cash flows.
When using the dividend-growth model to value a stock, growth relates to internal growth only—
growth achieved by retaining part of the firm’s profits and reinvesting them in the firm—as op-
posed to growth achieved by issuing new stock or acquiring another firm.
Growth in and of itself does not mean that a firm is creating value for its stockholders. Only if prof-
its are reinvested at a rate of return greater than the investor’s required rate of return will growth
result in increased stockholder value.
kEy TERMS
4
Internal growth, page 259 A firm’s growth rate
resulting from reinvesting the company’s profits
rather than distributing them as dividends. The
growth rate is a function of the amount retained
and the return earned on the retained funds.
Profit-retention rate, page 259 The
company’s percentage of profits retained.
Dividend-payout ratio, page 259 Dividends
as a percentage of earnings.
kEy EquATIOnS
Growth = return on equity * percentage of profits retained in the firm
Common stock value (Vcs) =
D1
(1 + rcs)1
+
D2
(1 + rcs)2
+ g +
Dn
(1 + rcs )n
+ g +
D∞
(1 + rcs)∞
Common stock value =
dividend in year 1
required rate of return – growth rate
Vcs =
D1
rcs – g
Calculate a stock’s expected rate of return. (pgs. 263–268)
SuMMARy: The expected rate of return on a security is the required rate of return of investors who are
willing to pay the present market price for the security, but no more. This rate of return is important to
the financial manager because it equals the required rate of return of the firm’s investors.
5
270 Part 2 • The Valuation of Financial Assets
Expected rate of return, page 264 The rate
of return investors expect to receive on an
investment by paying the current market price
of the security.
kEy TERMS

Chapter 8 • The Valuation and Characteristics of Stocks 271
kEy EquATIOnS
Required rate of return (rps) =
annual dividend
preferred stock value
=
D
Vps
Expected rate of return (rps) =
annual dividend
preferred stock market price
=
D
Pps
rcs =
D1
Vcs
+ g
dividend yield annual growth rate
rcs =
dividend in year 1
market price
+ growth rate =
D1
Pcs
+ g
Review questions
All Review Questions are available in MyFinanceLab.
8-1. Why is preferred stock referred to as a hybrid security? It is often said to combine the worst
features of common stock and bonds. What is meant by this statement?
8-2. Because preferred stock dividends in arrears must be paid before common stock dividends,
should they be considered a liability and appear on the right-hand side of the balance sheet?
8-3. Why would a preferred stockholder want the stock to have a cumulative dividend feature and
protective provisions?
8-4. Why is preferred stock frequently convertible? Why is it callable?
8-5. Compare valuing preferred stock and common stock.
8-6. Define investors’ expected rate of return.
8-7. State how investors’ expected rate of return is computed.
8-8. The common stockholders receive two types of return from their investment. What are they?
Study Problems
All Study Problems are available in MyFinanceLab.
8-1. (Preferred stock valuation) What is the value of a preferred stock when the dividend rate is 16
percent on a $100 par value? The appropriate discount rate for a stock of this risk level is 12 percent.
8-2. (Preferred stock valuation) The preferred stock of Armlo pays a $2.75 dividend. What is the
value of the stock if your required return is 9 percent?
8-3. (Preferred stock valuation) What is the value of a preferred stock when the dividend rate is 14 percent
on a $100 par value? The appropriate discount rate for a stock of this risk level is 12 percent.
8-4. (Preferred stock valuation) Pioneer preferred stock is selling for $33 per share in the market and
pays a $3.60 annual dividend.
a. What is the expected rate of return on the stock?
b. If an investor’s required rate of return is 10 percent, what is the value of the stock for that
investor?
c. Should the investor acquire the stock?
8-5. (Preferred stock valuation) Calculate the value of a preferred stock that pays a dividend of $6 per
share if your required rate of return is 12 percent.
8-6. (Preferred stock valuation) You are considering an investment in one of two preferred stocks,
TCF Capital or TAYC Capital Trust. TCF Capital pays an annual dividend of $2.69, while TAYC
Capital pays an annual dividend of $2.44. If your required return is 12 percent, what value would
you assign to the stocks?
8-7. (Preferred stock valuation) You are considering an investment in Double Eagle Petroleum’s
preferred stock. The preferred stock pays a dividend of $2.31. Your required return is 12 percent.
Value the stock.
2

272 Part 2 • The Valuation of Financial Assets
8-8. (Common stock valuation) Crosby Corporation common stock paid $1.32 in dividends last year
and is expected to grow indefinitely at an annual 7 percent rate. What is the value of the stock if
you require an 11 percent return?
8-9. (Measuring growth) The Fisayo Corporation wants to achieve a steady 7 percent growth rate.
If it can achieve a 12 percent return on equity, what percentage of earnings must Fisayo retain for
investment purposes?
8-10. (Common stock valuation) Dalton Inc. has an 11.5 percent return on equity and retains
55 percent of its earnings for reinvestment purposes. It recently paid a dividend of $3.25 and the
stock is currently selling for $40.
a. What is the growth rate for Dalton Inc.?
b. What is the expected return for Dalton’s stock?
c. If you require a 13 percent return, should you invest in the firm?
8-11. (Common stock valuation) Bates Inc. pays a dividend of $1 and is currently selling for $32.50.
If investors require a 12 percent return on their investment from buying Bates stock, what growth
rate would Bates Inc. have to provide the investors?
8-12. (Common stock valuation) You intend to purchase Marigo common stock at $50 per share,
hold it 1 year, and then sell it after a dividend of $6 is paid. How much will the stock price have to
appreciate for you to satisfy your required rate of return of 15 percent?
8-13. (Common stock valuation) Header Motor Inc. paid a $3.50 dividend last year. At a constant
growth rate of 5 percent, what is the value of the common stock if the investors require a 20 percent
rate of return?
8-14. (Measuring growth) Given that a firm’s return on equity is 18 percent and management plans
to retain 40 percent of earnings for investment purposes, what will be the firm’s growth rate?
8-15. (Common stock valuation) Honeywag common stock is expected to pay $1.85 in dividends next
year, and the market price is projected to be $42.50 per share by year-end. If investors require a rate
of return of 11 percent, what is the current value of the stock?
8-16. (Common stock valuation) The common stock of NCP paid $1.32 in dividends last year.
Dividends are expected to grow at an 8 percent annual rate for an indefinite number of years.
a. If NCP’s current market price is $23.50 per share, what is the stock’s expected rate of return?
b. If your required rate of return is 10.5 percent, what is the value of the stock for you?
c. Should you make the investment?
8-17. (Measuring growth) Pepperdine Inc.’s return on equity is 16 percent, and the management
plans to retain 60 percent of earnings for investment purposes. What will be the firm’s growth rate?
8-18. (Common stock valuation) Abercrombie & Fitch’s common stock pays a dividend of $0.70. It is
currently selling for $34.14. If the firm’s investors require a 10 percent return on their investment
from buying Abercrombie & Fitch stock, what growth rate would Abercrombie & Fitch have to
provide the investors?
8-19. (Common stock valuation) Schlumberger is selling for $64.91 per share and paid a dividend
of $1.10 last year. The dividend is expected to grow at 4 percent indefinitely. What is the stock’s
expected rate of return?
8-20. (Preferred stockholder expected return) You own 250 shares of Dalton Resources preferred
stock, which currently sells for $38.50 per share and pays annual dividends of $3.25 per share.
a. What is your expected return?
b. If you require an 8 percent return, given the current price, should you sell or buy more stock?
8-21. (Preferred stock expected return) You are planning to purchase 100 shares of preferred stock
and must choose between Stock A and Stock B. Stock A pays an annual dividend of $4.50 and is
currently selling for $35. Stock B pays an annual dividend of $4.25 and is selling for $36. If your
required return is 12 percent, which stock should you choose?
8-22. (Preferred stockholder expected return) Solitron preferred stock is selling for $42.16 per share
and pays $1.95 in dividends. What is your expected rate of return if you purchase the security at
the market price?
8-23. (Preferred stockholder expected return) You own 200 shares of Somner Resources preferred
stock, which currently sells for $40 per share and pays annual dividends of $3.40 per share.
a. What is your expected return?
b. If you require an 8 percent return, given the current price, should you sell or buy more stock?
4
5

Chapter 8 • The Valuation and Characteristics of Stocks 273
8-24. (Preferred stock expected return) You are planning to purchase 100 shares of preferred stock
and must choose between stock in Kristen Corporation and Titus Corporation. Your required
rate of return is 9 percent. If the stock in Kristen pays a dividend of $2 and is selling for $23 and
the stock in Titus pays a dividend of $3.25 and is selling for $31, which stock should you choose?
8-25. (Preferred stockholder expected return) You own 150 shares of James Corporation preferred
stock at a market price of $22 per share. James pays dividends of $1.55. What is your expected rate
of return? If you have a required rate of return of 9 percent, should you buy more stock?
8-26. (Preferred stock expected return) You are considering the purchase of 150 shares of preferred
stock. Your required return is 11 percent. If the stock is currently selling for $40 and pays a divi-
dend of $5.25, should you purchase the stock?
8-27. (Preferred stockholder expected return) You are considering the purchase of Davis stock at a
market price of $36.72 per share. Assume the stock pays an annual dividend of $2.33. What would
be your expected return? Should you purchase the stock if your required return is 8 percent?
8-28. (Common stockholder expected return) Blackburn & Smith common stock currently sells for
$23 per share. The company’s executives anticipate a constant growth rate of 10.5 percent and an
end-of-year dividend of $2.50.
a. What is your expected rate of return?
b. If you require a 17 percent return, should you purchase the stock?
8-29. (Common stockholder expected return) Made-It common stock currently sells for $22.50 per
share. The company’s executives anticipate a constant growth rate of 10 percent and an end-of-year
dividend of $2.
a. What is your expected rate of return if you buy the stock for $22.50?
b. If you require a 17 percent return, should you purchase the stock?
8-30. (Common stockholder expected return) The common stock of Zaldi Co. is selling for $32.84 per
share. The stock recently paid dividends of $2.94 per share and has a projected constant growth rate
of 9.5 percent. If you purchase the stock at the market price, what is your expected rate of return?
8-31. (Common stockholder expected return) The market price for Hobart common stock is $43 per
share. The price at the end of 1 year is expected to be $48, and dividends for next year should be
$2.84. What is the expected rate of return?
8-32. (Common stockholder expected return) If you purchased 125 shares of common stock that pays
an end-of-year dividend of $3, what is your expected rate of return if you purchased the stock for
$30 per share? Assume the stock is expected to have a constant growth rate of 7 percent.
8-33. (Common stockholder expected return) Daisy executives anticipate a growth rate of 12 percent
for the company’s common stock. The stock is currently selling for $42.65 per share and pays an
end-of-year dividend of $1.45. What is your expected rate of return if you purchase the stock for
its current market price of $42.65?
Mini Case
This Mini Case is available in MyFinanceLab.
You have finally saved $10,000 and are ready to make your first investment. You have the three
following alternatives for investing that money:
• Bank of America bonds with a par value of $1,000, that pays a 6.35 percent on its par value
in interest, sells for $1,020, and matures in 5 years.
• Southwest Bancorp preferred stock paying a dividend of $2.63 and selling for $26.25.
• Emerson Electric common stock selling for $52, with a par value of $5. The stock recently
paid a $1.60 dividend and the firm’s earnings per share has increased from $2.23 to $3.30
in the past 5 years. The firm expects to grow at the same rate for the foreseeable future.
Your required rates of return for these investments are 5 percent for the bond, 8 percent for the
preferred stock, and 12 percent for the common stock. Using this information, answer the follow-
ing questions.
a. Calculate the value of each investment based on your required rate of return.
b. Which investment would you select? Why?
c. Assume Emerson Electric’s managers expect an earnings to grew at 1 percent above the
historical growth rate. How does this affect your answers to parts (a) and (b)?
d. What required rates of return would make you indifferent to all three options?

The Cost of Capital
Learning Objectives
1 Understand the concepts underlying the firm’s The Cost of Capital: Key
cost of capital Definitions and Concepts
2 Evaluate the costs of the individual sources of capital Determining the Costs of the Individual
Sources of Capital
3 Calculate a firm’s weighted average cost of capital The Weighted Average Cost of Capital
4 Estimate divisional costs of capital Calculating Divisional Costs of Capital
274
In the third quarter of 2011 ExxonMobil (XON) earned a record $9.4 billion, which was almost double what it
earned in the same quarter of 2008! But is ExxonMobil creating value for its shareholders? The key to answer-
ing this question rests not just on the level of the firm’s earnings but also on (i) how large an investment has
been made in the company in order to produce these earnings and (ii) how risky the firm’s investors perceive
the company’s investments to be. In other words, we need to know two things: What rate of return did the
company earn on its invested capital, and what is the market’s required rate of return on that invested capi-
tal (the company’s cost of capital)?
The firm’s cost of capital provides an estimate of the rate of return the firm’s combined investors expect
from the company. Estimating a firm’s cost of capital is very intuitive in theory but can be somewhat tedious
in practice. In theory, what is required is the following: (i) identify all of the firm’s sources of capital and their
relative importance (that is, what fraction of the firm’s invested capital comes from each source); (ii) estimate
the market’s required rate of return for each source of capital the firm has used; (iii) calculate an average of the
required rates of return for each source of capital where the required rate of return for each source has been
weighted by its contribution to the total capital invested in the firm.
The cost of capital is not only important when evaluating the company’s overall performance but is also used
when evaluating individual investment decisions made by the firm. For example, when ExxonMobil is consider-
ing the development of a new oil production property in Nigeria, the company needs to estimate just how much
return is needed to justify the investment. Similarly, when it is considering a chemical plant in Southeast Asia
the company’s analysts need a benchmark return to compare to the investment’s expected return. The cost of
capital provides this benchmark.
Not to hold you in suspense any longer, in 2011 ExxonMobil Corporation earned a whopping 26.93 percent
rate of return on the book value of the firm’s equity and a 10 percent rate of return on the market value of the
firm’s total assets. Given that the firm had to earn less than 10 percent to satisfy all of its investors (both equity
9

275275
and debt), it created a lot of value for its investors even in
the midst of a worsening financial crisis. In this chapter, we
investigate how to estimate the cost of funds to the firm.
We will refer to the combined cost of borrowed money and
money invested in the company by the firm’s stockholders
as the weighted average cost of capital or simply the firm’s
cost of capital.
Having studied the connection between risk and investor
required rates of return (Chapter 6) and, specifically, in-
vestor required rates of return for bondholders and stock-
holders in Chapters 7 and 8, we are now ready to consider
required rates of return for the firm as a whole. That is, just
as the individuals that lend the firm money (bondholders)
and those that invest in its stock have their individual re-
quired rates of return, we can also think about a combined
required rate of return for the firm as a whole. This re-
quired rate of return for the firm is a blend of the required
rates of return of all investors that we will estimate using
a weighted average of the individual rates of return called
the firm’s weighted average cost of capital or simply the
firm’s cost of capital. Just like any cost of doing business,
the firm must earn at least this cost if it is to create value
for its owners.
In this chapter, we discuss the fundamental determi-
nants of a firm’s cost of capital and the rationale for its
calculation and use. This entails developing the logic for
estimating the cost of debt capital, preferred stock, and
common stock. Chapter 12 takes up consideration of the
impact of the firm’s financing mix on the cost of capital.
The Cost of Capital: Key Definitions
and Concepts
Opportunity Costs, Required Rates of Return,
and the Cost of Capital
The firm’s cost of capital is sometimes referred to as the firm’s opportunity cost of
capital. The term opportunity cost comes from the study of economics and is defined as
the cost of making a choice in terms of the next best opportunity that is foregone. For
example, the opportunity cost of taking a part-time job at Starbucks (SBUX) is the lost
wages from the on-campus job you would have taken otherwise. Similarly, when a firm
chooses to invest money it has raised from investors, it is in essence deciding not to return
the money to the investors. Thus, the opportunity cost of investing the money is the cost
the firm incurs by keeping the money and not returning it to the investors, which is the
firm’s cost of capital.
Is the investor’s required rate of return the same thing as the cost of capital? Not exactly.
Consequently, in this chapter we will use the symbol k to refer to the cost of financing,
whereas in Chapters 7 and 8 we used r to refer to the investor’s required rate of return. Two
weighted average cost of capital an
average of the individual costs of financing used
by the firm. A firm’s weighted cost of capital is a
function of (1) the individual costs of capital, and
(2) the capital structure mix.
1 Understand the concepts
underlying the firm’s cost of
capital.
opportunity cost the cost of making a choice
defined in terms of the next best alternative that
is foregone.

276 Part 2 • The Valuation of Financial Assets
factors drive a wedge between the investor’s required rate of return and the cost of capital
to the firm.
1. Taxes. When a firm borrows money to finance the purchase of an asset, the interest
expense is deductible for federal income tax calculations. Consider a firm that borrows
at 9 percent and then deducts its interest expense from its revenues before paying taxes
at a rate of 34 percent. For each dollar of interest it pays, the firm reduces its taxes by
$0.34. Consequently, the actual cost of borrowing to the firm is only 5.94% [0.09 –
(0.34 * 0.09) = 0.09(1 – 0.34) = 0.0594, or 5.94%].
2. Flotation costs. Here we are referring to the costs the firm incurs when it raises funds
by issuing a particular type of security. As you learned in Chapter 2, these are sometimes
called transaction costs. For example, if a firm sells new shares for $25 per share but
incurs transaction costs of $5 per share, then the cost of capital for the new common
equity is increased. Assume that the investor’s required rate of return is 15 percent for
each $25 share; then 0.15 * $25 = $3.75 must be earned each year to satisfy the inves-
tor’s required return. However, the firm has only $20 to invest, so the cost of capital (k)
is calculated as the rate of return that must be earned on the $20 net proceeds that will
produce a return of $3.75; that is,
$20k = $25 * 0.15 = $3.75
k =
$3.75
$20.00
= 0.1875, or 18.75%
We will have more to say about both these considerations shortly when we discuss the costs
of the individual sources of capital to the firm.
The Firm’s Financial Policy and the Cost of Capital
A firm’s financial policy—that is, the policies regarding the sources of finances it plans to use and
the particular mix (proportions) in which they will be used—governs its use of debt and equity
financing. The particular mixture of debt and equity that the firm uses can impact the firm’s
cost of capital. However, in this chapter, we assume that the firm maintains a fixed financial
policy that is reflected in a fixed debt-equity ratio. Determining the target mix of debt and
equity financing is the subject of Chapter 12.
Concept Check
1. How is an investor’s required rate of return related to an opportunity cost?
2. How do flotation costs impact the firm’s cost of capital?
Determining the Costs of the Individual
Sources of Capital
In order to attract new investors, companies have created a wide variety of financing instru-
ments or securities. In this chapter, we stick to three basic types: debt, preferred stock, and
common stock. In calculating the respective cost of financing using each of these types of
securities, we estimate the investor’s required rate of return after properly adjusting for
any transaction or flotation costs. In addition, because we will be discounting after-tax cash
Can You Do It?
DeTermining How FloTaTion CosTs aFFeCT THe CosT oF CapiTal
McDonald’s Corporation sold a portion of its ownership interest in its rapidly growing fast-food Mexican restaurant Chipotle in January
of 2006 for $22.00 per share. If the investor’s required rate of return on these shares was 18 percent, and McDonald’s incurred transac-
tion costs totaling $2.00 per share, what was the cost of capital to McDonald’s after adjusting for the effects of the transaction costs?
(The solution can be found on page 277.)
financial policy the firm’s policies regarding
the sources of financing it plans to use and the
particular mix (proportions) in which they will
be used.
2 Evaluate the costs of the
individual sources of capital.

Chapter 9 • The Cost of Capital 277
flows, we adjust our cost of capital for the effects of corporate taxes. In summary, the cost of
a particular source of capital is equal to the investor’s required rate of return after adjusting
for the effects of both flotation costs and corporate taxes.
The Cost of Debt
In Chapter 7 we learned that the value of a bond can be described in terms of the present
value of the bond’s future interest and principal payments. For example, if the bond has 3
years until maturity and pays interest annually, its value can be expressed as follows:
Bond
market
price
=
interest paid
in year 1
a1 + bondholder
,
s required
rate of return 1rd2 b
1 +
interest paid
in year 2
a1 + bondholder
,
s required
rate of return 1rd2 b
2
+
interest paid
in year 3
a1 + bondholder
,
s required
rate of return 1rd2
b
3 +
principal
a1 + bondholder
,s required
rate of return 1rd2
b
3 (9-1)
In Chapter 7, we use the above bond price equation to estimate the bondholder’s required rate
of return. This required rate of return is commonly referred to as the bond’s yield to maturity.
Since firms must pay flotation costs when they sell bonds, the net proceeds per bond
received by the firm is less than the market price of the bond. Consequently, the cost of
debt capital (kd) is higher than the bondholder’s required rate of return and is calculated
using equation (9-2) as follows:
Net proceeds
per bond
=
interest paid
in year 1
a1 + cost of debt
capital or kd
b
1 +
interest paid
in year 2
a1 + cost of debt
capital or kd
b
2
+
interest paid
in year 3
a1 + cost of debt
capital or kd
b
3 +
principal
a1 + cost of debt
capital or kd
b
3 (9-2)
Note that the adjustment for flotation costs simply involves replacing the market price of the
bond with the net proceeds per bond received by the firm after paying these costs. The result
of this adjustment is that the discount rate that solves equation (9-2) is now the firm’s cost of
debt financing before adjusting for the effect of corporate taxes—that is, the before-tax cost
of debt (kd). The final adjustment we make is to account for the fact that interest is tax deduct-
ible. Thus, the after-tax cost of debt capital is simply the before-tax cost of debt (kd) times 1
minus the corporate tax rate.
cost of debt the rate that has to be received
from an investment in order to achieve the
required rate of return for the creditors.
flotation costs the costs incurred by the firm
when it issues securities to raise funds.
DID You Get It?
DeTermining How FloTaTion CosTs aFFeCT THe CosT oF CapiTal
If the required rate of return on the shares was 18 percent, and the shares sold for $22.00 with $2.00 in transaction costs incurred per
share, then the cost of equity capital for Chipotle Mexican Grill is found by grossing up the investor’s required rate of return as follows:
Cost of equity capital =
investor
,
s required rate of return
(1 – % flotation costs)
=
18%
1 – a $2.00
$22.00
b
= 19.80%
Incidentally, although the shares were sold to the public for $22.00 per share, they doubled to $44.00 by the end of the day after being
traded in the secondary market.

278 Part 2 • The Valuation of Financial Assets
Can You Do It?
CalCulaTing THe CosT oF DebT FinanCing
General Auto Parts Corporation recently issued a 2-year bond with a face value of $20 million and a coupon rate of 5.5 percent per year
(assume interest is paid annually). The subsequent cash flows to General Auto Parts were as follows:
TODAY YEAR 1 YEAR 2
Principal $18 million ($0.00 million) ($20 million)
Interest ($0.99 million) ($0.99 million)
Total $18 million ($0.99 million) ($20.99 million)
What was the cost of capital to General Auto Parts for the debt issue?
(The solution can be found on page 280.)
E x A m P L E 9.1 Calculating the after-tax cost of debt financing
Synopticom Inc. plans a bond issue for the near future and wants to estimate its current
cost of debt capital. After talking with the firm’s investment banker, the firm’s chief
financial officer has determined that a 20-year maturity bond with a $1,000 face value
and 8 percent coupon (paying 8% * $1,000 = $80 per year in interest) can be sold to
investors for net proceeds of $908.32. If the Synopticom tax rate is 34 percent, what is
the after-tax cost of debt financing to the firm?
sTep 1: FormulaTe a soluTion sTraTegy
The cost of debt financing is estimated as the bondholder’s required rate of return,
which we learned in Chapter 7 is the discount rate used to calculate the value of a bond,
that is, using equation (9-1):
Net proceeds
per bond
=
interest paid
in year 1
a1 + bondholder
,s required
rate of return (kd)
b
1 +
interest paid
in year 2
a1 + bondholder
,s required
rate of return (kd)
b
2 + c
+
interest paid
in year N
a1 + bondholder
,s required
rate of return (kd)
b
N +
principle paid in year N
a1 + bondholder
,s required
rate of return (kd)
b
N
Note that we allow for N years of interest payments but omitted writing in the payments
for years 3 through N − 1 for space considerations. Substituting what we know about
the Synopticom bond into equation (9-1) above, we can then solve for the bondholder’s
required rate of return, kd. Finally, we calculate the after-tax required rate of return by
multiplying kd by 1 minus the tax rate, T, or
After@tax
cost of debt
=
bondholder,s required
rate of return (kd)
* a1 – tax
rate
b
sTep 2: CrunCH THe numbers
Substituting the characteristics of Synopticom’s bond issue into equation (9-1), we get
the following:
$908.32 =
0.08 * $1,000
(1 + kd)1
+
0.08 * $1,000
(1 + kd)2
+ g +
0.08 * $1,000
(1 + kd)20
+
$1,000
(1 + kd)20

Chapter 9 • The Cost of Capital 279
We can solve for rd using the calculator, which equals 9 percent, as demonstrated in the
margin. The after-tax cost of debt can now be calculated as follows:
After@tax
cost of debt
=
bondholder,s required
rate of return (kd)
* a1 – tax
rate
b
= 0.09 * 11 – 0.342 = 0.0594, or 5.94%
sTep 3: analyze your resulTs
It appears that Synopticom’s bondholders require a 9 percent rate of return when they
purchase the firm’s bonds at their current market price of $908.32. However, since Syn-
opticom can deduct the interest it pays on its debt from its taxable income, the firm saves
$0.34 for each dollar of interest it pays. As a consequence, the 9 percent required return
of the firm’s bondholders only costs the firm 5.94 percent.
If Synopticom is issuing new bonds, then it will incur the costs of selling the new bonds
(that is, flotation costs). If the firm estimates that it will net $850 per new bond like the one
described above since it must pay $58.32 per bond in flotation costs, then we substitute
$850 for the bond price and compute the required rate of return (after flotation costs) to be
9.73 percent, and the corresponding after-tax cost of newly issued bonds is 6.422 percent.
CalCulaTor soluTion
Data Input Function Key
20 N
-850 PV
80 PMT
1,000 FV
Function Key Answer
CPT
I/Y 9.73
The Cost of Preferred Stock
You may recall from Chapter 8 that the price of a share of preferred stock (cost of preferred
equity) is equal to the present value of the constant stream of preferred stock dividends, that is,
Price of a share of
preferred stock =
preferred stock dividend
required rate of
return of the preferred stockholder 1rps2
(9-3)
If we can observe the price of the share of preferred stock and we know the preferred stock
dividend, we can calculate the preferred stockholder’s required rate of return as follows:
Required rate of return
of the preferred stockholder (rps)
=
preferred stock dividend
price of a share of
preferred stock
(9-4)
Once again, because flotation costs are usually incurred when new preferred shares are
sold, the investor’s required rate of return is less than the cost of preferred capital to the
firm. To calculate the cost of preferred stock, we must adjust the required rate of return to
reflect these flotation costs. We replace the price of a preferred share in equation (9-4) with
the net proceeds per share from the sale of new preferred shares. The resulting formula can
be used to calculate the cost of preferred stock to the firm.
Cost of preferred stock (kps) =
preferred stock dividend
net proceeds per preferred share
(9-5)
Note that the net proceeds per share are equal to the price per share of preferred stock
minus flotation cost per share of newly issued preferred stock.
What about corporate taxes? In the case of preferred stock, no tax adjustment must be
made because, unlike interest payments, preferred dividends are not tax deductible.
cost of preferred equity the rate of return
that must be earned on the preferred stockholders’
investment in order to satisfy their required rate
of return.
Can You Do It?
CalCulaTing THe CosT oF preFerreD sToCk FinanCing
Carson Enterprises recently issued $25 million in preferred stock at a price of $2.50 per share. The preferred shares carry a 10 percent
dividend, or $0.25 per share (assume that it is paid annually). After paying all the fees and costs associated with the preferred issue the
firm realized $2.25 per share issued.
What was the cost of capital to Carson Enterprises from the preferred stock issue?
(The solution can be found on page 281.)

280 Part 2 • The Valuation of Financial Assets
E x A m P L E 9.2 Calculating the cost of preferred stock financing
San Antonio Edison has a preferred stock issue outstanding on which it pays an annual
dividend of $4.25 per share. On August 24, 2011, the stock price was $58.50 per share.
If the firm were to sell a new issue of preferred stock today with the same characteristics
as its outstanding issue, it would incur flotation costs of $1.375 per share. Based on the
most recent closing price for the preferred stock, what would you estimate the cost of
preferred stock financing to be for the firm?
sTep 1: FormulaTe a soluTion sTraTegy
The cost of preferred stock financing can be computed from the basic valuation equation
for a share of preferred stock just like we estimate the cost of debt financing from the
valuation equation for a bond. Specifically, solving for the cost of preferred stock we can
be computed using equation (9-5) as follows:
Cost of preferred stock (kps) =
preferred stock dividend
net proceeds per preferred share

Note that net proceeds per preferred share reflects the difference in the price for which
each preferred share is sold and the flotation costs per share incurred to sell new shares.
sTep 2: CrunCH THe numbers
Substituting into equation (9-5), we compute the cost of a new preferred stock issue as
follows:
Cost of preferred stock (kps) =
$4.25
($58.50 – $1.375)
= 0.0744, or 7.44%
sTep 3: analyze your resulTs
If San Antonio Edison were to issue preferred stock today, it could sell the shares for
$58.50 per share (assuming the preferred stock paid the same dividend as the outstand-
ing shares). However, in order to sell the shares it would have to pay an investment
banker a fee to market the issue, and the cost of doing this is $1.375 per share. Thus,
after considering the costs of selling the issue, the firm would incur a cost of 7.44 percent
in order to raise preferred stock financing.
DID You Get It?
CalCulaTing THe CosT oF DebT FinanCing
General Auto Parts Corporation receives $18 million from the sale of the bonds (after paying flotation costs) and is required to make prin-
cipal plus interest payments at the end of the next 2 years. The total cash flows (both the inflow and the outflows) are summarized below:
TODAY YEAR 1 YEAR 2
Principal $18 million ($0.00 million) ($20 million)
Interest ($0.99 million) ($0.99 million)
Total $18 million ($0.99 million) ($20.99 million)
We can estimate the before-tax cost of capital from the bond issue by solving for kd in the following bond valuation equation:
Net bond proceedstoday =
interest paid in year 1
(1 + kd)1
+
interest paid in year 2
(1 + kd)2
+
principal paid in year 2
(1 + kd)2
$18,000,000 =
$990,000
(1 + kd)1
+
$990,000
(1 + kd)2
+
$20,000,000
(1 + kd)2
kd = 10.77%

Chapter 9 • The Cost of Capital 281
The Cost of Common Equity
Common equity is unique in two respects. First, the cost of common equity is more
difficult to estimate than the cost of debt or cost of preferred stock because the common
stockholders’ required rate of return is not observable. For example, there is no stated
coupon rate or set dividend payment they receive. This results from the fact that common
stockholders are the residual owners of the firm, which means that their return is equal to
what is left of the firm’s earnings after paying the firm’s bondholders their contractually set
interest and principal payments and the preferred stockholders their promised dividends.
Second, common equity can be obtained either from the retention and reinvestment of firm
earnings or through the sale of new shares. The costs associated with each of these sources
are different from one another because the firm does not incur any flotation costs when it
retains earnings, but it does incur costs when it sells new common shares.
We discuss two methods for estimating the common stockholders’ required rate of
return, which is the foundation for our estimate of the firm’s cost of equity capital. These
methods are based on the dividend growth model and the capital asset pricing model, which
were both discussed in Chapter 8 when we discussed stock valuation.
The Dividend Growth model
Recall from Chapter 8 that the value of a firm’s common stock is equal to the present value
of all future dividends. When dividends are expected to grow at a rate g forever, and g is less
than the investor’s required rate of return, kcs, then the value of a share of common stock,
Pcs, can be written as
Pcs =
D1
kcs – g
(9-6)
where D1 is the dividend expected to be received by the firm’s common shareholders 1 year
hence. The expected dividend is simply the current dividend (D0) multiplied by 1 plus the
annual rate of growth in dividends (that is, D1 = D0 (1 + g)). The investor’s required rate of
return then is found by solving equation (9-6) for kcs.
kcs =
D1
Pcs
+ g (9-7)
Note that kcs is the investor’s required rate of return for investing in the firm’s stock. It
also serves as our estimate of the cost of equity capital, where new equity capital is obtained
by retaining a part of the firm’s current-period earnings. Recall that common equity financ-
ing can come from one of two sources: the retention of earnings or the sale of new common
shares. When the firm retains earnings, it doesn’t incur any flotation costs; thus, the investor’s
required rate of return is the same as the firm’s cost of new equity capital in this instance.
If the firm issues new shares to raise equity capital, then it incurs flotation costs. Once
again we adjust the investor’s required rate of return for flotation costs by substituting the
net proceeds per share, NPcs, for the stock price, Pcs, in equation (9-7) to estimate the cost
of new common stock, kncs.
kncs =
D1
NPcs
+ g (9-8)
cost of common equity the rate of return
that must be earned on the common stockhold-
ers’ investment in order to satisfy their required
rate of return.
DID You Get It?
CalCulaTing THe CosT oF preFerreD sToCk FinanCing
Carson Enterprises sold its shares of preferred stock for net proceeds of $2.25 a share, and each share entitles the holder to a $0.25
cash dividend every year. Because the dividend payment is constant for all future years, we can calculate the cost of capital raised by
the sale of preferred stock (kps) as follows:
Cost of preferred stock (kps) =
preferred stock dividend
net proceeds per preferred share
=
$0.25
$2.25
= 11.11%

282 Part 2 • The Valuation of Financial Assets
E x A m P L E 9.3 Calculating the cost of common stock financing
The Talbot Corporation’s common shareholders anticipate receiving a $2.20 per share
dividend next year, based on the fact that they received $2 last year and expect dividends
to grow 10 percent next year. Furthermore, analysts predict that dividends will continue
to grow at a rate of 10 percent into the foreseeable future. If Talbot were to issue new
common stock, the firm would incur a $7.50 per share cost to sell the new shares. Based
on the most recent closing price for the firm’s common stock, what would you estimate
the cost of a common stock to be for the firm? What is the cost of a new common stock
issue?
sTep 1: FormulaTe a soluTion sTraTegy
The cost of common stock financing can be computed from the basic valuation equation
for a share of common stock just like we estimate the cost of debt financing from the
valuation equation for a bond. Specifically, solving for the cost of common stock, it can
be computed using equation (9-7) as follows:
Cost of common
stock 1kcs2 =
common stock dividend
price per common share
+
growth
rate 1g2
If Talbot were to issue new common stock, then the $7.50 per share flotation costs
would be incurred, such that the cost of a new common stock issue would be computed
using equation (9-8) as follows:
Cost of common
stock 1kncs2 =
common stock dividend
net proceeds per common share
+
growth
rate 1g2
Note that net proceeds per common share reflects the difference in the price for which
each common share is sold and the flotation costs per share incurred to sell new shares.
sTep 2: CrunCH THe numbers
Inputting the numbers into equation (9-7), we compute the cost of common stock as
follows:
Cost of common
stock 1kcs2
=
$2.20
$50.00
+ 0.10 = 0.144, or 14.4%
The cost of a new common stock issue is computed by substituting net proceeds per new
common share issued for the firm’s stock price, that is,
Cost of common
stock 1kncs2 =
$2.20
$50.00 – $7.50
+ 0.10 = 0.1518, or 15.18%
sTep 3: analyze your resulTs
The cost of common stock or common equity to Talbot is 14.4 percent; however, if the
firm makes a new stock issue, it will incur an issue or flotation cost of $7.50 such that the
cost of a new common stock issue is 15.18 percent.
Issues in Implementing the Dividend Growth model
The principal advantage of the dividend growth model as a basis for calculating the firm’s
cost of capital as it relates to common stock is the model’s simplicity. To estimate an inves-
tor’s required rate of return, the analyst needs only to observe the current dividend and
stock price and to estimate the rate of growth in future dividends. The primary drawback
relates to the applicability or appropriateness of the valuation model. That is, the dividend
growth model is based on the fundamental assumption that dividends are expected to grow
at a constant rate g forever. To avoid this assumption, analysts frequently utilize more com-
plex valuation models in which dividends are expected to grow for, say, 5 years at one rate
and then grow at a lower rate from year 6 forward. We do not consider these more complex
models here.

Chapter 9 • The Cost of Capital 283
Even if the constant growth rate assumption is acceptable, we must arrive at an es-
timate of that growth rate. We could estimate the rate of growth in historical dividends
ourselves or go to published sources of growth rate expectations. Investment advisory
services such as Value Line provide their own analysts’ estimates of earnings growth
rates (generally spanning up to 5 years), and the Institutional Brokers’ Estimate System
(I/B/E/S) collects and publishes earnings per share forecasts made by more than 1,000
analysts for a broad list of stocks. These estimates are helpful but still require the care-
ful judgment of an analyst in their use because they relate to earnings (not dividends)
and extend only 5 years into the future (not forever, as required by the dividend growth
model). Nonetheless, these estimates provide a useful guide to making your initial divi-
dend growth rate estimate.
The Capital Asset Pricing model
Recall from Chapter 6 that the capital asset pricing model (CAPM) provides a basis for
determining the investor’s expected or required rate of return from investing in a firm’s
common stock. The model depends on three things:
1. The risk-free rate, rf
2. The systematic risk of the common stock’s returns relative to the market as a whole, or
the stock’s beta coefficient, b
3. The market-risk premium, which is equal to the difference in the expected rate of
return for the market as a whole, that is, the expected rate of return for the “average
security” minus the risk-free rate, or in symbols, rm – rf
Using the CAPM, the investor’s required rate of return can be written as follows:
kcs = rf + b1rm – rf 2 (9-9)
E x A m P L E 9.4
Calculating the cost of common stock financing using
the CAPm
The Talbot Corporation’s beta coefficient is estimated to be 1.40. Furthermore, the
risk-free rate of interest is currently 3.75%, and the expected rate of return on a diversi-
fied portfolio of all common stocks is 12 percent. Use the capital asset pricing model
(CAPM) to estimate the cost of equity capital for Talbot.
sTep 1: FormulaTe a soluTion sTraTegy
In Example 9.3 we estimated the cost of common stock using a constant rate of growth
and the discounted cash-flow model. In this example, we estimate that same cost of
common stock using the capital asset pricing model, or CAPM. Specifically, the cost of
common stock can be estimated using equation (9-9) as follows:
Cost of common
stock 1kcs2 = rf + b1rm – rf2
sTep 2: CrunCH THe numbers
Inserting the values into equation (9-9), we compute the cost of a common stock as follows:
Cost of common
stock 1kcs2 = rf + b1rm – rf2 = 0.0375 + 1.410.12 – 0.03752 = 0.153, or 15.3%
sTep 3: analyze your resulTs
Our estimate of the cost of common stock or common equity to Talbot using the
CAPM is 15.3 percent. Note that since no transaction costs are considered when using
the CAPM, this estimate is for the cost of internal common equity or the retention of
earnings.

284 Part 2 • The Valuation of Financial Assets
Issues in Implementing the CAPm
The CAPM approach has two primary advantages when it comes to calculating a firm’s cost
of capital as it relates to common stock. First, the model is simple and easy to understand
and implement. The model variables are readily available from public sources, with the
possible exception of beta coefficients for small firms and/or privately held firms. Second,
because the model does not rely on dividends or any assumption about the growth rate in
dividends, it can be applied to companies that do not currently pay dividends or are not
expected to experience a constant rate of growth in dividends.
Of course, using the CAPM requires that we obtain estimates of each of the three
model variables—rf , b, and (rm − rf). Let’s consider each in turn. First, the analyst has a wide
range of U.S. government securities on which to base an estimate of the risk-free rate (rf).
Treasury securities with maturities from 30 days to 20 years are readily available. Unfortu-
nately, the CAPM offers no guidance about the appropriate choice. In fact, the model itself
assumes that there is but one risk-free rate, and it corresponds to a one-period return (the
length of the period is not specified, however). Consequently, we are left to our own judg-
ment about which maturity we should use to represent the risk-free rate. For applications
of the cost of capital involving long-term capital expenditure decisions, it seems reasonable
to select a risk-free rate of comparable maturity. So, if we are calculating the cost of capital
to be used as the basis for evaluating investments that will provide returns over the next
20 years, it seems appropriate to use a risk-free rate corresponding to a U.S. Treasury bond
of comparable maturity.
Second, estimates of security beta (b) coefficients are available from a wide variety of
investment advisory services, including Merrill Lynch and Value Line, among others. Al-
ternatively, we could collect historical stock market returns for the company of interest as
well as a general market index (such as the Standard and Poor’s 500 Index) and estimate
the stock’s beta as the slope of the relationship between the two return series—as we did
Can You Do It?
CalCulaTing THe CosT oF new Common sToCk using
THe DiViDenD growTH moDel
In March of 2012 the Mayze Corporation sold an issue of common stock in a public offering. The shares sold for $100 per share. Mayze’s
dividend in 2011 was $8 per share, and analysts expect that the firm’s earnings and dividends will grow at a rate of 6 percent per year
for the foreseeable future. What is the common stock investor’s required rate of return (and the cost of retained earnings)?
Although the shares sold for $100 per share, Mayze received net proceeds from the issue of only $95 per share. The difference
represents the flotation cost paid to the investment banker.
What is your estimate of the cost of new equity for Mayze using the dividend growth model?
(The solution can be found on page 285.)
Can You Do It?
CalCulaTing THe CosT oF Common sToCk using THe Capm
The Mayze Corporation issued common stock in March 2012 for $100 per share. However, before the issue was made, the firm’s chief
financial officer (CFO) asked one of his financial analysts to estimate the cost of the common stock financing using the CAPM. The
analyst looked on Yahoo! Finance and got an estimate of 0.90 for the firm’s beta coefficient. She also consulted online sources to get
the current yield on a 10-year U.S. Treasury bond, which was 5.5 percent. The final estimate she needed to complete her calculation of
the cost of equity using the CAPM was the market-risk premium, or the difference in the expected rate of return on all equity securities
and the rate of return on the 10-year U.S. Treasury bond. After a bit of research she decided that the risk premium should be based on
a 12 percent expected rate of return for the market portfolio and the 5.5 percent rate on the Treasury bond.
What is your estimate of the cost of common stock for Mayze using the CAPM?
(The solution can be found on page 286.)

Chapter 9 • The Cost of Capital 285
in Chapter 6. However, because beta estimates are widely available for a large majority of
publicly traded firms, analysts frequently rely on published sources for betas.
Finally, estimating the market-risk premium can be accomplished by looking at the
history of stock returns and the premium earned over (under) the risk-free rate of interest.
In Chapter 6, we reported a summary of the historical returns earned on risk-free securities
and common stocks in Figure 6-2. We saw that on average over the past 70 years, common
stocks have earned a premium of roughly 5.5 percent over long-term government bonds.
Thus, for our purposes, we will utilize this estimate of the market-risk premium (rm − rf)
when estimating the investor’s required rate of return on equity using the CAPM.
FInanCe at Work
ipos: sHoulD a Firm go publiC?
When a privately owned company decides to distribute its
shares to the general public, it goes through a process known as
an initial public offering (IPO). There are a number of advantag-
es to having a firm’s shares traded in the public equity market,
including the following:
• New capital is raised. When the firm sells its shares to the
public, it acquires new capital that can be invested in the
firm.
• The firm’s owners gain liquidity of their share holdings.
Publicly traded shares are more easily bought and sold,
so the owners can more easily liquidate all or part of their
investment in the firm.
• The firm gains future access to the public capital mar-
ket. Once a firm has raised capital in the public markets, it is
easier to go back a second and third time.
• Being a publicly traded firm can benefit the firm’s busi-
ness. Public firms tend to enjoy a higher profile than their
privately held counterparts. This may make it easier to make
sales and attract vendors to supply goods and services to the
firm.
However, all is not rosy as a publicly held firm. There are a num-
ber of potential disadvantages, including the following:
• Reporting requirements can be onerous. Publicly held
firms are required to file periodic reports with the Securities
and Exchange Commission (SEC). This is not only onerous in
terms of the time and effort required but also some business
owners feel they must reveal information to their competi-
tors that could be potentially damaging.
• The private equity investors now must share any new
wealth with the new public investors. Once the firm is a
publicly held company, the new shareholders share on an
equal footing with the company founders the good (and
bad) fortune of the firm.
• The private equity investors lose a degree of control
over the organization. Outsiders gain voting control over
the firm to the extent that they own its shares.
• An IPO is expensive. A typical firm may spend 15 to 25 per-
cent of the money raised on expenses directly connected to
the IPO. This cost is increased further if we consider the cost
of lost management time and disruption of business associ-
ated with the IPO process.
• Exit of the company’s owners is usually limited. The
company’s founders may want to sell their shares through
the IPO, but this is not allowed for an extended period of
time following the IPO. Therefore, this is not usually a good
mechanism for cashing out the company founders.
• Everyone involved faces legal liability. The IPO partici-
pants are jointly and severally liable for each others’ actions.
This means that they can be sued for any omissions from the
IPO’s prospectus should the market valuation fall below the
IPO offering price.
Carefully weighing the financial consequences of each of these
advantages and disadvantages can provide a company’s own-
ers (and managers) with some basis for answering the question
of whether they want to become a public corporation.
Other Sources: Professor Ivo Welch’s Web site, welch.som.yale.edu, provides a
wealth of information concerning IPOs.
DID You Get It?
CalCulaTing THe CosT oF new Common sToCk using
THe DiViDenD growTH moDel
We can estimate the cost of equity capital using the dividend growth model by substituting into the following equation:
Cost of new common stock (kncs) =
expected dividend next year (D1)
net proceeds per share (NPcs)
+ dividend growth rate (g) =
$8.00 (1.06)
$95.00
+ 0.06 = 14.92%

286 Part 2 • The Valuation of Financial Assets
In addition to the historical average market-risk premium, we can also utilize surveys
of professional economists’ opinions regarding future premiums.1 For example, in a survey
conducted in 1998 by Yale economist Ivo Welch, the median 30-year market-risk premium
for all survey participants was 7 percent. When the survey was repeated in 2000, the cor-
responding market-risk premium had fallen to 5 percent. These results suggest two things.
First, the market-risk premium is not fixed. It varies through time with the general busi-
ness cycle. In addition, it appears that using a market-risk premium somewhere between
5 percent and 7 percent is reasonable when estimating the cost of capital using the capital
asset pricing model.
Concept Check
1. Define the cost of debt, preferred equity, and common equity financing.
2. The cost of common equity financing is more difficult to estimate than the costs of debt and
preferred equity. Explain why.
3. What is the dividend growth model, and how is it used to estimate the cost of common equity
financing?
4. Describe the capital asset pricing model and how it can be used to estimate the cost of common
equity financing.
5. What practical problems are encountered in using the CAPM to estimate common equity capital
cost?
The Weighted Average Cost of Capital
Now that we have calculated the individual costs of capital for each of the sources of financing
the firm might use, we turn to the combination of these capital costs into a single weighted
average cost of capital. To estimate the weighted average cost of capital, we need to know
the cost of each of the sources of capital used and the capital structure mix. We use the term
capital structure to refer to the proportions of each source of financing used by the firm. Although
a firm’s capital structure can be quite complex, we focus our examples on the three basic
sources of capital: bonds, preferred stock, and common equity.
In words, we calculate the weighted average cost of capital for a firm that uses only debt
and common equity using the following equation:
Weighted
average cost
of capital
= £after@taxcost of
debt
*
proportion
of debt
financing
≥ + £cost of
equity
*
proportion
of equity
financing
≥ (9-10)
1The results reported here come from Ivo Welch, “Views of Financial Economists on the Equity Premium and on
Professional Controversies,” Journal of Business 73–74 (October 2000), pp. 501–537; and Ivo Welch, “The Equity
Premium Consensus Forecast Revisited,” Cowles Foundation Discussion Paper No. 1325 (September 2001).
3 Calculate a firm’s weighted
average cost of capital.
capital structure the mix of long-term
sources of funds used by the firm. This is also
called the firm’s capitalization. The relative total
(percentage) of each type of fund is emphasized.
DID You Get It?
CalCulaTing THe CosT oF Common sToCk using THe Capm
The CAPM can be used to estimate the investor’s required rate of return as follows:
Cost of
common equity (kcs)
= a risk@free
rate of interest (rf )
b + aMayze
,
s beta
coefficient (b)
b * c expected market
rate of return (rm)
–
risk@free
rate of interest (rf )
d
Making the appropriate substitutions, we get the following estimate of the investor’s required rate of return using the CAPM model:
Cost of common equity (kcs) = 0.055 + 0.90 * (0.12 – 0.055) = 0.1135, or 11.35%

Chapter 9 • The Cost of Capital 287
For example, if a firm borrows money at 6 percent after taxes, pays 10 percent for equity,
and raises its capital in equal proportions from debt and equity, its weighted average cost of
capital is 8 percent, that is,
Weighted average cost of capital = [0.06 * 0.5] + [0.10 * 0.5] = 0.08, or 8%
In practice, the calculation of the cost of capital is more complex than this example.
For one thing, firms often have multiple debt issues with different required rates of
return, and they also use preferred equity as well as common equity financing. Fur-
thermore, when common equity capital is raised, it is sometimes the result of retaining
and reinvesting the firm’s earnings, and at other times it involves a new stock offering.
Of course, in the case of retained earnings, the firm does not incur the costs associated
with selling new common stock. This means that equity from retained earnings is less
costly than a new stock offering. In the examples that follow, we address each of these
complications.
Capital Structure Weights
The reason we calculate a cost of capital is that it enables us to evaluate one or more of the
firm’s investment opportunities. Remember that the cost of capital should reflect the riski-
ness of the project being evaluated, so a firm should calculate multiple costs of capital when
it makes investments in multiple divisions or business units having different risk character-
istics. Thus, for the calculated cost of capital to be meaningful, it must correspond directly
to the riskiness of the particular project being analyzed. That is, in theory the cost of capital
should reflect the particular way in which the funds are raised (the capital structure used)
and the systemic risk characteristics of the project. Consequently, the correct way to cal-
culate capital structure weights is to use the actual dollar amounts of the various sources of
capital actually used by the firm.2
In practice, the mixture of financing sources used by a firm will vary from year to year. For
this reason, many firms find it expedient to use target capital structure proportions when
calculating the firm’s weighted average cost of capital. For example, a firm might use its
target mix of 40 percent debt and 60 percent equity to calculate its weighted average cost
of capital even though, in that particular year, it raised the majority of its financing require-
ments by borrowing. Similarly, it would continue to use the target proportions in the sub-
sequent year, when it might raise the majority of its financing needs by reinvesting earnings
or issuing new stock.
Calculating the Weighted Average Cost of Capital
The weighted average cost of capital, kwacc, is simply a weighted average of all the
capital costs incurred by the firm. Table 9-1 illustrates the procedure used to estimate
kwacc for a firm that has debt, preferred stock, and common equity in its target capital
structure mix. Two possible scenarios are described in the two panels. First, in Panel
A the firm is able to finance all of its target capital structure requirements for common
equity using retained earnings. Second, in Panel B the firm must use a new equity of-
fering to raise the equity capital it requires. For example, if the firm has set a 75 percent
target for equity financing and has current earnings of $750,000, then it can raise
up to $750,000/0.75 = $1,000,000 in new financing before it has to sell new equity.
For $1,000,000 or less in capital spending, the firm’s weighted average cost of capital
would be calculated using the cost of equity from retained earnings (following Panel A
of Table 9-1). For more than $1,000,000 in new capital, the cost of capital would rise
to reflect the impact of the higher cost of using new common stock (following Panel
B of Table 9-1).
2There are instances when we will want to calculate the cost of capital for the firm as a whole. In this case, the appropri-
ate weights to use are based on the market value of the various capital sources used by the firm. Market values rather than
book values properly reflect the sources of financing used by a firm at any particular point in time. However, when a firm
is privately owned, it is not possible to get market values of its securities, and book values are often used.

288 Part 2 • The Valuation of Financial Assets
PANEL A: COMMON EQUITY RAISED BY RETAINED EARNINGS
Capital Structure
Source of Capital Weights 3 Cost of Capital 5 Product
Bonds wd kd (1 – Tc) wd * kd (1 – Tc)
Preferred stock wps kps wps * kps
Common equity
Retained earnings wcs kcs wcs * kcs
Sum = 100% Sum = kwocc
TABLE 9-1 Calculating the Weighted Average Cost of Capital
PANEL B: COMMON EQUITY RAISED BY SELLING NEW COMMON STOCK
Capital Structure
Source of Capital Weights 3 Cost of Capital 5 Product
Bonds wd kd (1 – Tc) wd * kd (1 − Tc)
Preferred stock wps kps wps * kps
Common equity
Common stock wncs kncs wncs * kncs
Sum = 100% Sum = kwacc
E x A M P L E 9.5 Calculating a firm’s weighted average cost of capital
Ash Inc.’s capital structure and estimated capital costs are found in Table 9-2. Note
that the sum of the capital structure weights must equal 100 percent if we have properly
accounted for all sources of financing and in the correct amounts. For example, Ash
plans to invest a total of $3 million in common equity to fund a $5 million investment.
Because Ash has earnings equal to the $3,000,000 it needs in new equity financing, the
entire amount of new equity will be raised by retaining earnings.
STEP 1: FORMULATE A SOLUTION STRATEGY
We calculate the weighted average cost of capital following the procedure described
in Panel A of Table 9-1 and using the information found in Table 9-2. Note that the
cost of capital for Ash Inc. varies with the amount of financing being considered. For
example, for up to $5 million in new capital the firm can use retained earnings to sup-
ply the needed common equity to make up 60 percent of the total. However, for each
dollar over $5 million Ash Inc. will have to issue new common shares, which carry a
higher cost of financing than retained earnings since transaction costs are incurred to
sell more common stock.
The formula used to calculate the weighted average cost of capital, kwacc, is summa-
rized in Table 9-1; however, we can write the equation down as follows:
kwacc = wd * kd * (1 – Tc) + (wps * kcs) + (wcs * kcs)
Note that kwacc is simply an average of the after-tax costs of debt, preferred stock, and
common stock where these costs are weighted by their relative importance in the firm’s
capital structure. To compute the cost of raising more than $5 million in total financing
we simply substitute the cost of new common stock, kncs, for the cost of equity.
STEP 2: CRUNCH THE NUMBERS
Panel A of Table 9-3 computes an estimate of Ash Inc.’s weighted average cost of up to
$5 million in new capital, which is 12.7 percent. Should the firm need to raise more than
$5 million, then new shares of common stock will have to be issued and the cost of this
equity capital is 18 percent (compared to 16 percent for internally generated common
equity or retained earnings). The net result is that the firm’s cost of capital for each dollar
over $5 million rises to 13.9 percent.

Chapter 9 • The Cost of Capital 289
sTep 3: analyze your resulTs
The firm’s weighted average cost of capital is an estimate of the blend of sources of capi-
tal the firm has used. For Ash Inc., the cost of raising up to $5 million is 12.70 percent,
whereas raising more than $5 million requires the firm to issue new shares of common
stock and incur flotation costs such that the overall weighted average cost of capital rises
to 13.9 percent.
PANEL A: COST OF CAPITAL FOR $0 TO $5,000,000 IN NEW CAPITAL
Capital Structure
Source of Capital Weights Cost of Capital Product
Bonds 35% 7% 2.45%
Preferred stock 5% 13% 0.65%
Retained earnings 60% 16% 9.60%
Total 100% kwacc = 12.70%
PANEL B: COST OF CAPITAL FOR mORE THAN $5,000,000
Capital Structure
Source of Capital Weights Cost of Capital Product
Bonds 35% 7% 2.45%
Preferred stock 5% 13% 0.65%
New common stock 60% 18% 10.80%
Total 100% kwacc = 13.90%
TABLE 9-3 The Weighted Average Cost of Capital for Ash Inc.
Source of Capital
Amount of Funds
Raised ($)
Percentage
of Total
After-Tax
Cost of Capital
Bonds 1,750,000 35% 7%
Preferred stock 250,000 5% 13%
Retained earnings 3,000,000 60% 16%
Total 5,000,000 100%
TABLE 9-2 Capital Structure and Capital Costs for Ash Inc.
CautIonarY tale
ForgeTTing prinCiple 3: risk requires a rewarD
What happens to a firm’s cost of capital when the capital market
that the firm depends on for financing simply stops working? In-
vestment banking firm Goldman Sachs discovered the answer to
this question the hard way. In 2008, as potential lenders became
very nervous about the future of the economy, the credit mar-
kets from which Goldman Sachs borrowed money on a regular
basis simply stopped functioning. The effect of this shutdown
was that Goldman Sachs no longer had access to cheap short-
term debt financing. And this meant the firm was at greater risk
of financial distress. This high risk of firm failure caused its equity
holders to demand a much higher rate of return and thus, Gold-
man Sachs’s cost of equity financing skyrocketed.
Ultimately, faced with a crisis, Goldman arranged for a $10
billion loan from the U.S. Government’s Troubled Asset Relief
Fund (TARP) and obtained a $5 billion equity investment from
famed investor Warren Buffett. The combined effects of these
actions stabilized the firm’s financial situation and lowered the
firm’s cost of capital dramatically. Goldman Sachs and Morgan
Stanley are the only two large investment banking firms to sur-
vive the financial crisis.
So what can Goldman Sachs learn from this experience?
Debt financing, and in particular short-term debt financing,
may offer higher returns in the short run, but this use of financial
leverage comes with a significant increase in risk to the equity
holders, and this translates to higher costs of equity financing
for the firm.

290 Part 2 • The Valuation of Financial Assets
Concept Check
1. A firm’s capital structure and its target capital structure proportions are important determinants
of a firm’s weighted average cost of capital. Explain.
2. Explain in words the calculation of a firm’s weighted average cost of capital. What exactly are we
averaging and what do the weights represent?
Calculating Divisional Costs of Capital
Estimating Divisional Costs of Capital
Firms that have multiple operating divisions where each division’s risk is unique and differ-
ent from that of the firm as a whole often use different costs of capital for each division in
an effort to properly account for risk. The idea here is that the divisions take on investment
projects with unique levels of risk and, consequently, the WACC used in each division is
potentially unique to that division. Generally, divisions are defined either by geographical
regions (for example, the Latin American division) or industry (for example, exploration
and production, pipelines, and refining for a large integrated oil company).
The advantages of using a divisional WACC include the following:
◆ It provides different discount rates that reflect differences in the systematic risk of the
projects evaluated by the different divisions.
◆ It entails only one cost of capital estimate per division (as opposed to unique discount
rates for each project), thereby minimizing the time and effort of estimating the cost of
capital.
◆ The use of a common discount rate throughout the division limits managerial latitude
and the attendant influence costs as managers would otherwise be tempted to lobby for
a lower cost of capital for pet projects.
Using Pure Play Firms to Estimate Divisional WACCs
One approach that can be taken to deal with differences in the costs of capital for each of
the firm’s business units involves identifying what we will call “pure play” comparison firms
(or “comps”) that operate in only one of the individual business areas (where possible). For
example, Valero Energy Corporation (VLO) is a Fortune 500 manufacturer and marketer
of transportation fuels headquartered in San Antonio, Texas. The firm owns 14 refineries
and is one of the largest U.S. retail operators with over 5,800 retail stores. Specifically, the
firm’s operations are concentrated in the “downstream” segment of the petroleum industry,
which involves refining crude oil into gasoline and other transportation fuels and the sale
of those products to the public.
To estimate the cost of capital for each of these different types of activities, we use the
WACCs for comparison firms that are not fully integrated and operate in only one of Vale-
ro’s business segments. For example, to estimate the WACC for its business unit engaged in
refining crude oil, Valero might use a WACC estimate for firms that operate in the refinery
industry (SIC industry 2911) to estimate the relevant WACC for this division.3 To estimate
the WACC for the retail component of Valero’s operations, we could use firms that operate
primarily in the retail convenience store industry, which is SIC 5411.
Divisional WACC Example Table 9-4 contains hypothetical estimates of the divisional
WACC for the refining and retail (convenience store) industries.
Panel A contains estimates of the after-tax cost of debt financing to the refining and
retailing industries where the firm’s marginal income tax rate is assumed to be 38 percent.
Note that the borrowing costs are slightly different, which reflects both the amount of
money borrowed (see Panel C) and the risk differences perceived by lenders to the two
industries. Panel B contains the after-tax cost of equity capital based on the capital asset
4 Estimate divisional costs of
capital
divisional WACC the cost of capital for a
specific business unit or division.
3SIC is the four-digit Standard Industrial Classification code that is widely used to identify different industries.

Chapter 9 • The Cost of Capital 291
pricing model. The only difference in the cost of equity for the two industries corresponds
to the beta estimates. Finally, in Panels D and E we estimate the WACCs for the two in-
dustry segments. The refining industry has a 9.29 percent WACC estimate, while the retail
industry has a 6.13 percent WACC. If the firm were to use a composite of the two WACC
estimates to evaluate new projects, the WACC would be somewhere between these two
industry estimates. This would mean that the firm would take on too many refining projects
and too few retail investments.
Divisional WACC—Estimation Issues and Limitations Although the divisional WACC
is generally a significant improvement over the single, company-wide WACC, the way that
it is often implemented using industry-based comparison firms has a number of potential
limitations:
◆ The sample of those in a given industry may firms include those that are not good matches
for the firm or one of its divisions. For example, the Valero company analyst may select two
or three firms whose risk profiles more nearly match their refining division as opposed to
using a composite made of all firms found in the petroleum refining industry (SIC 2911).
The firm’s management can easily address this problem by selecting appropriate compari-
son firms with similar risk profiles from among the many firms included in these industries.
◆ The division being analyzed may not have a capital structure that is similar to the sam-
ple of firms in the industry data. The division may be more or less leveraged than the
PANEL A. AFTER-TAx COST OF DEBT
Pre-Tax
Cost of Debt 3 (1 2 Tax Rate)
After-Tax
Cost of Debt
Refining 9.00% * 0.62 0.0558
Retailing—Convenience Stores 7.50% * 0.62 0.0465
TABLE 9-4 Divisional WACC Computations
PANEL B. AFTER-TAx COST OF EQUITY
Risk-Free
Rate 1 Beta 3
market-Risk
Premium 5
Cost of
Equity
Refining 0.02 + 1.1 * 0.07 = 0.097
Retailing—Convenience Stores 0.02 + 0.8 * 0.07 = 0.076
PANEL C. TARGET DEBT RATIOS
Target Debt Ratio
Refining 10%
Retailing—Convenience Stores 50%
PANEL D. DIvISIONAL WACC FOR REFINING
Capital Structure
Weight 3
After-Tax
Cost of Capital 5 Product
Debt 0.10 * 0.0558 = 0.0056
Equity 0.90 * 0.0970 = 0.0873
WACC = 0.0929 or 9.29%
PANEL E. DIvISIONAL WACC FOR RETAIL (CONvENIENCE STORES)
Capital Structure
Weight 3
After-Tax
Cost of Capital 5 Product
Debt 0.50 * 0.0465 = 0.0233
Equity 0.50 * 0.0760 = 0.03580
WACC = 0.0613 or 6.13%

292 Part 2 • The Valuation of Financial Assets
firms whose costs of capital are used to proxy for the divisional cost of capital. For
example, ExxonMobil raised only 4 percent of its capital using debt financing, whereas
Valero Energy (VLO) has raised 35 percent of its capital with debt at the end of 20114.
◆ The firms in the chosen industry that are used to proxy for divisional risk may not
be good reflections of project risk. Firms, by definition, are engaged in a variety of
activities, and it can be very difficult to identify a group of firms that are predominantly
engaged in activities that are truly comparable to a given project. Even within divisions,
individual projects can have very different risk profiles. This means that even if we are
able to match divisional risks very closely, there may still be significant differences in
risk across projects undertaken within a division. For example, some projects may entail
extensions of existing production capabilities, while others involve new-product devel-
opment. Both types of investments take place within a given division, but they have very
different risk profiles.
◆ Good comparison firms for a particular division may be difficult to find. Most pub-
licly traded firms report multiple lines of business, yet each company is classified into a
single industry group. In the case of Valero we found two operating divisions (refining
and retail) and identified an industry proxy for each.
The preceding discussion suggests that although the use of divisional WACCs to deter-
mine project discount rates may represent an improvement over the use of a company-wide
WACC, this methodology is far from perfect. However, if the firm has investment opportu-
nities with risks that vary principally with industry-risk characteristics, the use of a divisional
WACC has clear advantages over the use of the firm’s WACC. It provides a methodology
that allows for different discount rates, and it avoids some of the influence costs associated
with giving managers complete leeway to select project-specific discount rates. Table 9-5
summarizes the cases for using a single-firm WACC and divisional WACCs to evaluate
investment opportunities.
4This estimate is based on year-end 2011 financial statements, using book values of interest-bearing short- and long-term
debt and the market value of the firm’s equity on March 30, 2012.
There are good reasons for using a single, company-wide WACC to evaluate the firm’s investments even where there are differences in the risks of the projects
the firm undertakes. The most common practice among firms that use a variety of discount rates to evaluate new investments in an effort to accommodate risk
differences is the divisional WACC. The latter represents something of a compromise that minimizes some of the problems encountered when attempting to
estimate both the project-specific costs of capital and the costs that arise where a single discount rate is used that is equal to the firm’s WACC.
method Description Advantages Disadvantages When to Use
WACC Estimated WACC for the firm as
an entity; used as the discount
rate on all projects.
• Familiar concept to most busi-
ness executives.
• Minimizes estimation costs, as
there is only one cost of capital
calculation for the firm.
• Reduces the problem of
influence cost issues.
• Does not adjust discount rates
for differences in project risk.
• Does not provide for flexibility
in adjusting for differences
in project debt in the capital
structure.
• Projects are similar in risk to
the firm as a whole.
• Using multiple discount rates
creates significant problems
with influence costs.
Divisional WACC Estimated WACC for individual
business units or divisions
within the firm; used as the
only discount rates within each
division.
• Uses division-level risk to
adjust discount rates for
individual projects.
• Reduces influence costs to the
competition among division
managers to lower their
division’s cost of capital.
• Does not capture intra-
division risk differences in
projects.
• Does not account for differ-
ences in project debt capaci-
ties within divisions.
• Potential influence costs asso-
ciated with the choice of dis-
count rates across divisions.
• Difficult to find single-division
firms to proxy for divisions.
• Individual projects within
each division have similar risks
and debt capacities.
• Discount rate discretion
creates significant influence
costs within divisions but not
between divisions.
TABLE 9-5 Choosing the Right WACC—Discount Rates and Project Risk

Chapter 9 • The Cost of Capital 293
FInanCe at Work
THe pillsbury Company aDopTs eVa wiTH a grassrooTs eDuCaTion program
A key determinant of the success of any incentive-based program
is employee buy-in. If employees simply view a new performance
measurement and reward system as “just another” reporting re-
quirement, the program will have little impact on their behavior
and, consequently, little effect on the firm’s operating performance.
In addition, if a firm’s employees do not understand the measure-
ment system, it is very likely that it will be distrusted and may even
have counterproductive effects on the firm’s performance.
So how do you instill in your employees the notion that your
performance measurement and reward system does indeed
lead to the desired result? Pillsbury took a unique approach to
the problem by using a simulation exercise in which the value of
applying the principles of Economic Value Added (EVA®) could
be learned by simulating the operations of a hypothetical facto-
ry. Employees used the simulation to follow the value-creation
process from the factory’s revenue, to net operating profit after
taxes, to the weighted average cost of capital. The results were
gratifying. One Pillsbury manager noted, “you saw the lights go
on in people’s eyes” as employees realized, “Oh, this really does
impact my work environment.”
Briggs and Stratton used a similar training program to instill
the basic principles of EVA in its employees. Its business-simulation
example was even more basic than the Pillsbury factory. Briggs
and Stratton used a convenience store’s operations to teach
line workers the importance of controlling waste, utilizing assets
fully, and managing profit margins. Stern Stewart and Company,
which coined the term EVA, has also developed a training tool,
the EVA Training Tutor.™ The EVA Training Tutor addresses four
basic issues using CD-ROM technology:
• Why is creating shareholder wealth an important corporate
and investor goal?
• What is the best way to measure wealth and business success?
• Which business strategies have created wealth, and which
have failed?
• What can you do to create wealth and increase the stock
price of your company?
The educational programs described briefly here are exam-
ples of how major corporations are seeing the need to improve
the financial literacy of their employees to make the most of
their human and capital resources.
Sources: Adapted from George Donnelly, “Grassroots EVA,” CFO.com (May 1, 2000),
www.cfo.com and The EVA Training Tutor™ (Stern Stewart and Company).
DID You Get It?
CalCulaTing THe weigHTeD aVerage CosT oF CapiTal
The weighted average cost of capital (WACC) for Grey Manufacturing can be calculated using the following table:
SOURCE OF CAPITAL PERCENTAGE OF TOTAL CAPITAL AFTER-TAx COST OF CAPITAL PRODUCT
Debt 40% 5.20% 2.0800%
Common stock 60% 14.50% 8.7000%
WACC = 10.7800%
Consequently, we estimate Grey’s WACC to be 10.78 percent.
Can You Do It?
CalCulaTing THe weigHTeD aVerage CosT oF CapiTal
In the fall of 2009, Grey Manufacturing was considering a major expansion of its manufacturing operations. The firm has sufficient
land to accommodate the doubling of its operations, which will cost $200 million. To raise the needed funds Grey’s management has
decided to simply mimic the firm’s present capital structure as follows:
SOURCE OF CAPITAL AmOUNT OF FUNDS RAISED ($) PERCENTAGE OF TOTAL AFTER-TAx COST OF CAPITAL*
Debt $ 80,000,000 40% 5.20%
Common stock 120,000,000 60% 14.50%
Total $200,000,000 100%
What is your estimate of Grey’s weighted average cost of capital?
*You may assume that these after-tax costs of capital have been appropriately adjusted for any transaction costs incurred when raising the funds.
(The solution appears below.)

www.cfo.com

294 Part 2 • The Valuation of Financial Assets
Calculating a firm’s cost of capital involves using a number of financial decision tools.
Specifically, the analyst must estimate the after-tax cost of debt, the cost of preferred stock
financing, the cost of common equity financing, and the weighted average cost of capital
itself.
Name of Tool Formula What It Tells You
After-tax cost of debt Step 1: The cost of debt (before taxes) is calculated as follows:
Net Proceeds
(NPd)
=
interest (year 1)
(1 + kd)1
+
interest (year 2)
(1 + kd)2
+ g
+
principal
(1 + kd)2
Step 2: The after-tax cost of debt is calculated as follows:
kd(1 – Tc)
Where Tc is the corporate tax rate.
The cost of borrowed funds to
the firm after considering the tax
deductibility of interest expense
Cost of preferred stock The ratio of the present value of the future free cash flows to the initial outlay:
kps =
preferred stock dividend
net proceeds per share of preferred stock (NPps)
The cost of raising funds by selling
new shares of preferred stock
Cost of common equity
(dividend growth model)
Cost of raising common equity by retaining and reinvesting firm earnings:
kcs =
common stock dividend in year 1
current price of common stock (Pcs)
+
dividend growth
rate (g)
Cost of raising external equity funding by selling new shares of common stock:
kcs =
common stock dividend in year 1
net proceeds per share of preferred stock (NPcs)
+
dividend growth
rate (g)
The cost of raising common
equity funds
Cost of common equity
(capital asset pricing model) kcs =
risk@free
rate (rf)
+
equity
beta (b)
a market
return (rm)
–
risk@free
rate (rf)
b The cost of raising common equity funds
Weighted average cost of
capital (WACC)
WACC = °
after@tax
cost of
debt
*
proportion
of debt
financing
¢ + °cost of
equity
*
proportion
of equity
financing
¢
• The opportunity cost of money
invested in the firm
• Projects that earn higher rates
of return than the WACC create
shareholder wealth
FInanCIal DeCIsIon tools
Using a Firm’s Cost of Capital to Evaluate
New Capital Investments
If a firm has traditionally used a single cost of capital for all projects undertaken within each
of several operating divisions (or companies) with very different risk characteristics, then
the company will likely encounter resistance from the high-risk divisions if it changes to a
divisional cost of capital structure. Consider the case of the hypothetical firm Global Energy,
whose divisional costs of capital are illustrated in Figure 9-1. Global Energy is an integrated
oil company that engages in a wide range of hydrocarbon-related businesses, including ex-
ploration and development, pipelines, and refining. Each of these businesses has its unique
set of risks. In Figure 9-1 we see that the overall, or enterprise-wide, cost of capital for Global
Energy is 11 percent, reflecting an average of the firm’s divisional costs of capital, ranging
from a low of 8 percent for pipelines up to 18 percent for exploration and development.
At present, Global Energy is using a cost of capital of 11 percent to evaluate its new
investment proposals from all three operating divisions. This means that exploration and
development projects earning as little as 11 percent are being accepted even though the
capital market dictates that projects of this risk should earn 18 percent. Thus, Global Energy
overinvests in high-risk projects. Similarly, the company will underinvest in its two lower-
risk divisions, where the company-wide cost of capital is used.

Chapter 9 • The Cost of Capital 295
Now consider the prospect of moving to division costs of capital and the implica-
tions this might have for the three divisions. Specifically, the managers of the explora-
tion and development division are likely to see this as an adverse move for them because
it will surely cut the level of new investment capital flowing into their operations. In
contrast, the managers of the remaining two divisions will see the change as good news
because, under the company-wide cost of capital system, they have been rejecting proj-
ects earning more than their market-based costs of capital (8 percent and 10 percent
for pipelines and refining, respectively) but less than the company’s 11 percent cost of
capital.
Concept Check
1. What are the implications for a firm’s capital investment decisions of using a company-wide cost
of capital when the firm has multiple operating divisions that each have unique risk attributes
and capital costs?
2. If a firm has decided to move from a situation in which it uses a company-wide cost of capital to
divisional costs of capital, what problems is it likely to encounter?
Chapter Summaries
Understand the concepts underlying the firm’s cost of capital. (pgs. 275–276)
SUmmARY: A firm’s cost of capital is equal to a weighted average of the opportunity costs of each
source of capital used by the firm, including debt, preferred stock, and common equity. To properly
capture the cost of all these sources of capital, the individual costs are based on current market
conditions and not historical costs.
KEY TERmS
1
Co
st
o
f c
ap
it
al
Risk
8%
10%
11%
18%
Pipelines
Company-wide cost of capital
Chemicals
and refining
Exploration
and development
FIGURE 9-1 Global Energy Divisional Costs of Capital
Using a company-wide cost of capital for a multidivisional firm results in systematic
overinvestment in high-risk projects and underinvestment in low-risk projects.
Weighted average cost of capital, page 275
an average of the individual costs of financing
used by the firm.
Opportunity cost, page 275 The cost of
making a choice defined in terms of the next
best alternative that is foregone.
Financial policy, page 276 the firm’s policies
regarding the sources of financing it plans to use
and the particular mix (proportions) in which
they will be used.

296 Part 2 • The Valuation of Financial Assets
Evaluate the costs of the individual sources of capital. (pgs. 276–286)
SUMMARY: The after-tax cost of debt is typically estimated as the yield-to-maturity of the prom-
ised principal and interest payments for an outstanding debt agreement. This means that we solve
for the rate of interest that makes the present value of the promised interest and principal payments
equal to the current market value of the debt security. We then adjust this cost of debt for the effect
of taxes by multiplying it by 1 minus the firm’s tax rate. The cost of preferred stock financing is
estimated in a manner very similar to debt but with two differences. First, since preferred stock
typically does not mature, the present-value equation for valuing the preferred stock involves solving
for the value of a level perpetuity. Second, since preferred dividends are not tax deductible, there is
no adjustment to the cost of preferred stock for taxes.
The cost of common equity is somewhat more difficult to estimate than either debt or preferred
stock since the common stockholders do not have a contractually specified return on their invest-
ment. Instead, the common stockholders receive the residual earnings of the firm or what’s left over
after all other claims have been paid.
Two approaches are widely used to estimate the cost of common equity financing. The first is based
on the dividend growth model, which is used to solve for the rate that will equate the present value
of future dividends with the current price of the firm’s shares of stock. The second uses the capital
asset pricing model.
KEY TERMS
2
Cost of debt, page 277 The rate that has
to be received from an investment in order
to achieve the required rate of return for the
creditors. This rate must be adjusted for the
fact that an increase in interest payments will
result in lower taxes. The cost is based on the
debt holders’ opportunity cost of debt in the
capital markets.
Flotation costs, page 277 The costs incurred
by the firm when it issues securities to raise
funds.
Cost of preferred equity, page 279 The rate
of return that must be earned on the
preferred stockholders’ investment in order
to satisfy their required rate of return. The
cost is based on the preferred stockholders’
opportunity cost of preferred stock in the
capital markets.
Cost of common equity, page 281 The rate
of return that must be earned on the
common stockholders’ investment in order
to satisfy their required rate of return. The
cost is based on the common stockholders’
opportunity cost of common stock in the
capital markets.
KEY EQUATIONS
The cost of debt financing can be calculated as follows:
Net proceeds
per bond
=
interest paid in year 1
a1 + cost of debt
financing (kd)
b
1 +
interest paid in year 2
a1 + cost of debt
financing (kd)
b
2
+
interest paid in year 3
a1 + cost of debt
financing (kd)
b
3 +
principal paid in year 3
a1 + cost of debt
financing (kd)
b
3
This equation works for a 3-year bond. Longer-term bonds include more interest payments. The
result is an estimate of the before-tax cost of debt financing to the firm. To adjust for taxes, we
multiply this rate of return by 1 minus the corporate tax rate.
The cost of preferred stock is calculated by solving for kps:
Net proceeds
per preferred
share
=
preferred dividend
cost of preferred stock (kps)
The cost of common stock—discounted cash-flow method is calculated using the following equation:
Cost of common
stock 1kcs2 =
common stock dividend for year 1
market price of common stock
+ agrowth rate in
dividends
b

Chapter 9 • The Cost of Capital 297
The cost of common stock—capital asset pricing method is calculated as follows:
Cost of common
stock 1kcs2 =
risk@free
rate
+
equity beta
coefficient
a expected return on
the market portfolio
–
risk@free
rate
b
Calculate a firm’s weighted average cost of capital. (pgs. 286–290)
SUMMARY: The firm’s WACC is defined as follows:
Weighted
average cost
of capital (WACC)
= £ aafter@tax cost
of debt 1kd2
b * °
proportion of
debt financing
1wd2
¢ §
+ £ acost of equity 1kcs2
b * °
proportion of
equity financing
1wcs2
¢ §
where kd, kps, and kcs are the cost of capital for the firm’s debt, preferred stock, and common equity,
respectively. Note that the costs of these sources of capital must be properly adjusted for the ef-
fect of issuance or flotation costs. T is the marginal corporate tax rate and wd, wps, and wcs are the
fractions of the firm’s total financing (weights) that are comprised of debt, preferred stock, and
common equity, respectively. The weights used to calculate WACC should theoretically reflect
the market values of each capital source as a fraction of the total market value of all capital sources
(that is, the market value of the firm). In some cases, market values are not observed and analysts
use book values instead.
KEY TERM
3
capital structure, 286 The mix of long-term
sources of funds used by the firm. This is also
called the firm’s capitalization. The rela-
tive total (percentage) of each type of fund is
emphasized.
Estimate divisional costs of capital. (pgs. 290–295)
SUMMARY: Finance theory is very clear about the appropriate rate at which the cash flows of
investment projects should be discounted. The appropriate discount rate should reflect the oppor-
tunity cost of capital, which in turn reflects the risk of the investment being evaluated.
However, an investment evaluation policy that allows managers to use different discount rates for
different investment opportunities may be difficult to implement. First, coming up with discount
rates for individual projects can be time-consuming and difficult and may simply not be worth the
effort. In addition, when firms allow the cost of capital to vary for each project, overzealous manag-
ers may waste corporate resources lobbying for a lower discount rate to help ensure the approval
of their pet projects.
To reduce these estimation and lobbying costs, most firms have either just one corporate cost of
capital or a single cost of capital for each division of the company. Divisional WACCs are generally
determined by using information from publicly traded single-segment firms.
KEY TERM
4
Divisional WACC, page 290 The cost of
capital for a specific business unit or division.
Review Questions
All Review Questions are available in MyFinanceLab.
9-1. Define the term cost of capital.
9-2. In 2009, ExxonMobil (XOM) acquired XTO Energy for $41 billion. The acquisition pro-
vided ExxonMobil an opportunity to engage in the development of shale and unconventional nat-
ural gas resources within the continental United States. This acquisition added to ExxonMobil’s

298 Part 2 • The Valuation of Financial Assets
existing upstream (exploration and development) activities. In addition to this business segment,
ExxonMobil was also engaged in chemicals and downstream operations related to the refining
of crude oil into a variety of consumer and industrial products. How do you think the company
should approach the determination of its cost of capital for making new capital investment deci-
sions?
9-3. Why do firms calculate their weighted average cost of capital?
9-4. In computing the cost of capital, which sources of capital should be considered?
9-5. How does a firm’s tax rate affect its cost of capital? What is the effect of the flotation costs
associated with a new security issue on a firm’s weighted average cost of capital?
9-6. a. Distinguish between internal common equity and new common stock.
b. Why is there a cost associated with internal common equity?
c. Describe two approaches that could be used in computing the cost of common equity.
9-7. What might we expect to see in practice in the relative costs of different sources of capital?
Study Problems
All Study Problems are available in MyFinanceLab.
9-1. (Terminology) Match the following terms with their definitions:
TERmS DEFINITIONS
Opportunity cost The target mix of sources of funds that the firm uses when raising new
money to invest in the firm.
Financial policy A weighted average of the required rates of return of the firm’s sources
of capital (after adjusting for flotation costs and tax considerations).
Cost of capital The cost of making a choice in terms of the next best alternative that
must be foregone.
Transaction costs The expenses that a firm incurs when raising funds by issuing a particu-
lar type of security.
9-2. (Individual or component costs of capital) Compute the cost of the following:
a. A bond that has $1,000 par value (face value) and a contract or coupon interest rate of
11 percent. A new issue would have a flotation cost of 5 percent of the $1,125 market value.
The bonds mature in 10 years. The firm’s average tax rate is 30 percent and its marginal
tax rate is 34 percent.
b. A new common stock issue that paid a $1.80 dividend last year. The par value of the stock
is $15, and earnings per share have grown at a rate of 7 percent per year. This growth rate
is expected to continue into the foreseeable future. The company maintains a constant
dividend–earnings ratio of 30 percent. The price of this stock is now $27.50, but 5 percent
flotation costs are anticipated.
c. Internal common equity when the current market price of the common stock is $43. The
expected dividend this coming year should be $3.50, increasing thereafter at a 7 percent
annual growth rate. The corporation’s tax rate is 34 percent.
d. A preferred stock paying a 9 percent dividend on a $150 par value. If a new issue is offered,
flotation costs will be 12 percent of the current price of $175.
e. A bond selling to yield 12 percent after flotation costs, but before adjusting for the mar-
ginal corporate tax rate of 34 percent. In other words, 12 percent is the rate that equates
the net proceeds from the bond with the present value of the future cash flows (principal
and interest).
9-3. (Cost of equity) Salte Corporation is issuing new common stock at a market price of $27. Divi-
dends last year were $1.45 and are expected to grow at an annual rate of 6 percent forever. Flotation
costs will be 6 percent of market price. What is Salte’s cost of equity?
9-4. (Cost of debt) Belton is issuing a $1,000 par value bond that pays 7 percent annual interest and
matures in 15 years. Investors are willing to pay $958 for the bond. Flotation costs will be 11 percent
of market value. The company is in an 18 percent tax bracket. What will be the firm’s after-tax cost
of debt on the bond?
1
2

Chapter 9 • The Cost of Capital 299
9-5. (Cost of preferred stock) The preferred stock of Julian Industries sells for $36 and pays $3.00 in
dividends. The net price of the security after issuance costs is $32.50. What is the cost of capital
for the preferred stock?
9-6. (Cost of debt) The Zephyr Corporation is contemplating a new investment to be financed
33 percent from debt. The firm could sell new $1,000 par value bonds at a net price of $945. The
coupon interest rate is 12 percent, and the bonds would mature in 15 years. If the company is in a
34 percent tax bracket, what is the after-tax cost of capital to Zephyr for bonds?
9-7. (Cost of preferred stock) Your firm is planning to issue preferred stock. The stock sells for $115;
however, if new stock is issued, the company would receive only $98. The par value of the stock
is $100, and the dividend rate is 14 percent. What is the cost of capital for the stock to your firm?
9-8. (Cost of internal equity) Pathos Co.’s common stock is currently selling for $23.80. Dividends
paid last year were $0.70. Flotation costs on issuing stock will be 10 percent of market price. The
dividends and earnings per share are projected to have an annual growth rate of 15 percent. What
is the cost of internal common equity for Pathos?
9-9. (Cost of equity) The common stock for the Bestsold Corporation sells for $58. If a new issue is
sold, the flotation costs are estimated to be 8 percent. The company pays 50 percent of its earnings in
dividends, and a $4 dividend was recently paid. Earnings per share 5 years ago were $5. Earnings are
expected to continue to grow at the same annual rate in the future as during the past 5 years. The firm’s
marginal tax rate is 34 percent. Calculate the cost of (a) internal common equity and (b) external com-
mon equity.
9-10. (Growth rate in stock dividends and the cost of equity) Clearview Productions is a publicly held
company whose common stock has recently been selling for $50.00 a share. The firm is expected to
pay an annual cash dividend of $5.00 a share next year, and the firm’s investors anticipate an annual
rate of return of 15%.
a. If the firm is expected to provide a constant annual rate of growth in dividends, what is that
growth rate?
b. If the risk-free rate of interest is 3% and the market risk premium is 6%, what must the
firm’s beta be to warrant a 15% expected rate of return on the firm’s stock?
9-11. (Individual or component costs of capital) Compute the cost for the following sources of
financing:
a. A $1,000 par value bond with a market price of $970 and a coupon interest rate of
10 percent. Flotation costs for a new issue would be approximately 5 percent. The bonds
mature in 10 years and the corporate tax rate is 34 percent.
b. A preferred stock selling for $100 with an annual dividend payment of $8. The flotation
cost will be $9 per share. The company’s marginal tax rate is 30 percent.
c. Retained earnings totaling $4.8 million. The price of the common stock is $75 per share, and
dividend per share was $9.80 last year. The dividend is not expected to change in the future.
d. New common stock when the most recent dividend was $2.80. The company’s dividends
per share should continue to increase at an 8 percent growth rate into the indefinite future.
The market price of the stock is currently $53; however, flotation costs of $6 per share are
expected if the new stock is issued.
9-12. (Cost of debt) Sincere Stationery Corporation needs to raise $500,000 to improve its manufac-
turing plant. It has decided to issue a $1,000 par value bond with a 14 percent annual coupon rate
and a 10-year maturity. The investors require a 9 percent rate of return.
a. Compute the market value of the bonds.
b. What will the net price be if flotation costs are 10.5 percent of the market price?
c. How many bonds will the firm have to issue to receive the needed funds?
d. What is the firm’s after-tax cost of debt if its average tax rate is 25 percent and its marginal
tax rate is 34 percent?
9-13. (Cost of debt)
a. Rework Problem 9-12 as follows: Assume an 8 percent coupon rate. What effect does
changing the coupon rate have on the firm’s after-tax cost of capital?
b. Why is there a change?
9-14. (Capital structure weights) Caraway Seeds estimated its weighted average cost of capital to be
9.2% based on the fact that its after-tax cost of debt financing was 6 percent and its cost of equity
was 10 percent. What are the firm’s capital structure weights (that is, the proportion of financing
that came from debt and equity)?
3

300 Part 2 • The Valuation of Financial Assets
9-15. (Weighted average cost of capital) Crawford Enterprises is a publicly held company located
in Arnold, Kansas. The firm began as a small tool and die shop but grew over its 35-year life to
become a leading supplier of metal fabrication equipment used in the farm tractor industry. At the
close of 2009 the firm’s balance sheet appeared as follows:
Cash $ 540,000
Accounts receivable 4,580,000
Inventories 7,400,000 Long-term debt $12,590,000
Net property, plant, and equipment 18,955,000 Common equity 18,885,000
Total assets $31,475,000 Total debt and equity $31,475,000
At present the firm’s common stock is selling for a price equal to its book value, and the firm’s
bonds are selling at par. Crawford’s managers estimate that the market requires a 15 percent return
on its common stock, the firm’s bonds command a yield to maturity of 8 percent, and the firm faces
a tax rate of 34 percent.
a. What is Crawford’s weighted average cost of capital?
b. If Crawford’s stock price were to rise such that it sold at 1.5 times book value, causing the
cost of equity to fall to 13 percent, what would the firm’s cost of capital be (assuming the
cost of debt and tax rate do not change)?
9-16. (Weighted average cost of capital) The capital structure for the Carion Corporation is provided
here. The company plans to maintain its debt structure in the future. If the firm has a 5.5 percent
after-tax cost of debt, a 13.5 percent cost of preferred stock, and an 18 percent cost of common
stock, what is the firm’s weighted average cost of capital?
CAPITAL STRUCTURE ($000)
Bonds $1,083
Preferred stock 268
Common stock 3,681
$5,032
9-17. (Weighted average cost of capital) ABBC Inc. operates a very successful chain of yogurt and
coffee shops spread across the southwestern part of the United States and needs to raise funds for
its planned expansion into the Northwest. The firm’s balance sheet at the close of 2009 appeared
as follows:
At present the firm’s common stock is selling for a price equal to 2.5 times its book value, the firm’s
investors require an 18 percent return, the firm’s bonds command a yield to maturity of 8 percent,
and the firm faces a tax rate of 35 percent. At the end of the previous year ABBC’s common stock
was selling for a price of 2.5 times its book value, and its bonds were trading near their par value.
a. What does ABBC’s capital structure look like?
b. What is ABBC’s weighted average cost of capital?
c. If ABBC’s stock price were to rise such that it sold at 3.5 times its book value and the cost of
equity fell to 15 percent, what would the firm’s weighted average cost of capital be (assuming
the cost of debt and tax rate do not change)?
9-18. (Determining a firm’s capital budget) Newcomb Vending Company manages soft drink dis-
pensing machines in western Tennessee for several of the major bottling companies in the area.
When a machine malfunctions the company sends out a repair technician, and if he cannot repair
it on the spot he puts in a replacement machine so that the broken one can be taken to the firm’s
Cash $ 2,010,000
Accounts receivable 4,580,000
Inventories 1,540,000 Long-term debt $ 8,141,000
Net property, plant, and equipment 32,575,000 Common equity 32,564,000
Total assets $40,705,000 Total debt and equity $40,705,000

Chapter 9 • The Cost of Capital 301
repair facility in Murfreesboro, Tennessee. Betsy Newcomb recently completed her BBA from
a nearby university and has been trying to incorporate as much of what she learned as possible
into the operations of her family business. Specifically, Betsy recently reviewed the firm’s capital
structure and estimated that the firm’s weighted average cost of capital is approximately 12%. She
hopes to help her father determine which of several major capital expenditures he should make in
the current year based on a comparison of the rates of return she estimated for each project (that
is, the internal rate of return) and the firm’s cost of capital. Specifically, the firm is considering the
following projects (ranked by their internal rate of return):
P R O j E C T I N v E S T E D C A P I TA L I N T E R N A L R AT E O F R E T U R N
A $ 450,000 18%
B 1,200,000 16%
C 800,000 13%
D 600,000 10%
E 1,450,000 8%
If all five of the investments being considered by Newcomb are of similar risk and that risk is very
similar to that of the company as a whole, which project(s) should Betsy recommend the firm un-
dertake? You may assume that the firm can raise all the capital it needs to fund its investments at
the cost of capital of 12%. Explain your answer.
9-19. (Divisional costs of capital) LPT Inc. is an integrated oil company headquartered in Dallas,
Texas. The company has three operating divisions: oil exploration and production (commonly
referred to as E&P), pipelines, and refining. Historically, LPT did not spend a great deal of time
thinking about the opportunity costs of capital for each of its divisions and used a company-wide
weighted average cost of capital of 14 percent for all new capital investment projects. Recent
changes in its businesses have made it abundantly clear to LPT’s management that this is not a
reasonable approach. For example, investors demand a much higher expected rate of return for
exploration and production ventures than for pipeline investments. Although LPT’s management
agrees, in principle at least, that different operating divisions should face an opportunity cost of
capital that reflects their individual risk characteristics, they are not in agreement about whether a
move toward divisional costs of capital is a good idea based on practical considerations.
a. Pete Jennings is the chief operating officer for the E&P division, and he is concerned that
going to a system of divisional costs of capital may restrain his ability to undertake very
promising exploration opportunities. He argues that the firm really should be concerned
about finding those opportunities that offer the highest possible rate of return on invested
capital. Pete contends that using the firm’s scarce capital to take on the most promising
projects would lead to the greatest increase in shareholder value. Do you agree with Pete?
Why or why not?
b. The pipeline division manager, Donna Selma, has long argued that charging her division
the company-wide cost of capital of 14 percent severely penalizes her opportunities to increase
shareholder value. Do you agree with Donna? Explain.
9-20. (Divisional costs of capital and investment decisions) In May of this year Newcastle Mfg. Company’s
capital investment review committee received two major investment proposals. One of the proposals
was put forth by the firm’s domestic manufacturing division, and the other came from the firm’s dis-
tribution company. Both proposals promise internal rates of return equal to approximately 12 percent.
In the past Newcastle has used a single firm-wide cost of capital to evaluate new investments.
However, managers have long recognized that the manufacturing division is significantly more
risky than the distribution division. In fact, comparable firms in the manufacturing division have
equity betas of about 1.6, whereas distribution companies typically have equity betas of only 1.1.
Given the size of the two proposals, Newcastle’s management feels it can undertake only one, so it
wants to be sure that it is taking on the more promising investment. Given the importance of get-
ting the cost of capital estimate as close to correct as possible, the firm’s chief financial officer has
asked you to prepare cost of capital estimates for each of the two divisions. The requisite informa-
tion needed to accomplish your task is contained here:
♦ The cost of debt financing is 8 percent before taxes of 35 percent. You may assume this cost of
debt is after any flotation costs the firm might incur.
♦ The risk-free rate of interest on long-term U.S. Treasury bonds is currently 4.8 percent, and
the market-risk premium has averaged 7.3 percent over the past several years.
4

302 Part 2 • The Valuation of Financial Assets
♦ Both divisions adhere to target debt ratios of 40 percent.
♦ The firm has sufficient internally generated funds such that no new stock will have to be sold
to raise equity financing.
a. Estimate the divisional costs of capital for the manufacturing and distribution divisions.
b. Which of the two projects should the firm undertake (assuming it cannot do both due to
labor and other nonfinancial restraints)? Discuss.
9-21. (Divisional costs of capital and investment decisions) Belton Oil and Gas Inc. is a Houston-based
independent oil and gas firm. In the past Belton’s managers have used a single firmwide cost of
capital of 13 percent to evaluate new investments. However, the firm has long recognized that its
exploration and production division is significantly more risky than the pipeline and transportation
division. In fact, comparable firms to Belton’s E&P division have equity betas of about 1.7, whereas
distribution companies typically have equity betas of only 0.8. Given the importance of getting the
cost of capital estimate as close to correct as possible, the firm’s chief financial officer has asked you
to prepare cost of capital estimates for each of the two divisions. The requisite information needed
to accomplish your task is contained here:
♦ The cost of debt financing is 7 percent before taxes of 35 percent. However, if the E&P divi-
sion were to borrow based on its projects alone, the cost of debt would probably be 9 percent,
and the pipeline division could borrow at 5.5 percent. You may assume these costs of debt are
after any flotation costs the firm might incur.
♦ The risk-free rate of interest on long-term U.S. Treasury bonds is currently 4.8 percent, and
the market-risk premium has averaged 7.3 percent over the past several years.
♦ The E&P division adheres to a target debt ratio of 10 percent, whereas the pipeline division
utilizes 40 percent borrowed funds.
♦ The firm has sufficient internally generated funds such that no new stock will have to be sold
to raise equity financing.
a. Estimate the divisional costs of capital for the E&P and pipeline divisions.
b. What are the implications of using a company-wide cost of capital to evaluate new invest-
ment proposals in light of the differences in the costs of capital you estimated previously?
mini Cases
These Mini Cases are available in MyFinanceLab.
9-1. Nealon Energy Corporation engages in the acquisition, exploration, development, and produc-
tion of natural gas and oil in the continental United States. The company has grown rapidly over the
last 5 years as it has expanded into horizontal drilling techniques for the development of the massive
deposits of both gas and oil in shale formations. The company’s operations in the Haynesville shale
(located in northwest Louisiana) have been so significant that it needs to construct a natural gas gath-
ering and processing center near Bossier City, Louisiana, at an estimated cost of $70 million.
To finance the new facility Nealon has $20 million in profits that it will use to finance a portion
of the expansion and plans to sell a bond issue to raise the remaining $50 million. The decision
to use so much debt financing for the project was largely due to the argument by company CEO
(Douglas Nealon Sr.) that debt financing is relatively cheap relative to common stock (which the
firm has used in the past). Company CFO Doug Nealon Jr. (son of the company founder) did not
object to the decision to use all debt but pondered the issue of what cost of capital to use for the
expansion project. There is no doubt but that the out-of-pocket cost of financing was equal to
the new interest that must be paid on the debt. However, the CFO also knew that by using debt
for this project the firm would eventually have to use equity in the future if it wanted to maintain
the balance of debt and equity it had in its capital structure and not become overly dependent on
borrowed funds.
The following balance sheet reflects the mix of capital sources that Nealon has used in the past.
Although the percentages would vary over time, the firm tended to manage its capital structure
back toward these proportions:
S O U R C E O F F I N A N C I N G TA R G E T C A P I TA L S T R U C T U R E W E I G H T S
Bonds 40%
Common Stock 60%

Chapter 9 • The Cost of Capital 303
The firm currently has one issue of bonds outstanding. The bonds have a par value of $1,000 per
bond, carry an 8 percent coupon rate of interest, have 16 years to maturity, and are selling for
$1,035. Nealon’s common stock has a current market price of $35 and the firm paid a $2.50 divi-
dend last year that is expected to increase at an annual rate of 6 percent for the foreseeable future.
a. What is the yield to maturity for Nealon’s bonds under current market conditions?
b. What is the cost of new debt financing to Nealon based on current market prices after both
taxes (you may use a 34 percent marginal tax rate for your estimate) and flotation costs of
$30 per bond have been considered?
c. What is the investor’s required rate of return for Nealon’s common stock? If Nealon were
to sell new shares of common stock, it would incur a cost of $2.00 per share. What is your
estimate of the cost of new equity financing raised from the sale of common stock?
d. Compute the weighted average cost of capital for Nealon’s investment using the weights
reflected in the actual financing mix (that is, $20 million in retained earnings and
$50 million in bonds).
e. Compute the weighted average cost of capital for Nealon where the firm maintains its
target capital structure by reducing its debt offering to 40 percent of the $70 million in
new capital, or $28 million, using $20 million in retained earnings and raising $22 million
through a new equity offering.
f. If you were the CFO for the company, would you prefer to use the calculation of the cost
of capital in part (d) or (e) to evaluate the new project? Why?
9-2. ExxonMobil (XOM) is one of the half-dozen major oil companies in the world. The firm has
four primary operating divisions (upstream, downstream, chemical, and global services) as well as a
number of operating companies that it has acquired over the years. A recent major acquisition was
XTO Energy, which was acquired in 2009 for $41 billion. The XTO acquisition gave ExxonMobil a
significant presence in the development of domestic unconventional natural gas resources, includ-
ing the development of shale gas formations, which was booming at the time.
Assume that you have just been hired to be an analyst working for ExxonMobil’s chief financial of-
ficer. Your first assignment was to look into the proper cost of capital for use in making corporate
investments across the company’s many business units.
a. Would you recommend that ExxonMobil use a single company-wide cost of capital for
analyzing capital expenditures in all its business units? Why or why not?
b. If you were to evaluate divisional costs of capital, how would you go about estimating these
costs of capital for ExxonMobil? Discuss how you would approach the problem in terms of
how you would evaluate the weights to use for various sources of capital as well as how you
would estimate the costs of individual sources of capital for each division.

Capital-Budgeting
Techniques and Practice
Learning Objectives
1 Discuss the difficulty encountered in finding Finding Profitable Projects
profitable projects in competitive markets and the
importance of the search.
2 Determine whether a new project should be accepted or Capital-Budgeting Decision Criteria
rejected using the payback period, the net present value,
the profitability index, and the internal rate of return.
3 Explain how the capital-budgeting decision process Capital Rationing
changes when a dollar limit is placed on the
capital budget.
4 Discuss the problems encountered when deciding Ranking Mutually Exclusive Projects
among mutually exclusive projects.
304
10
Back in 1955, the Walt Disney Company changed the face of entertainment when it opened Disneyland, its
first theme park, in Anaheim, California, at a cost of $17.5 million. Since then Disney has opened theme parks
in Orlando, Florida; Tokyo, Japan; Paris, France; and in September 2005, , or Hong Kong
Disneyland, was opened. This $3.5 billion project, with much of that money provided by the Hong Kong govern-
ment, was opened in hopes of reaching what has largely been an untapped Chinese market. For Disney, a market
this size was simply too large to pass up.
Unfortunately, while Hong Kong Disneyland’s opening was spectacular, it has yet to earn a profit. One of
the unexpected problems it has faced has been knockoff rides by rival Asian theme parks, which used the Hong
Kong Disneyland’s advance publicity to design their rides and put them in use before Hong Kong Disneyland’s
opening.
For Disney, keeping its theme parks and resorts division healthy is extremely important because this divi-
sion accounts for over one-quarter of the company’s revenues. Certainly, there are opportunities for Disney in
China; with a population of 1.26 billion people, it accounts for 20 percent of the entire world’s total popula-
tion and Hong Kong Disneyland was supposed to provide Disney with a foothold in the potentially lucrative
China market. While Hong Kong Disneyland has not lived up to Disney’s expectations, Disney has not given up

on the Chinese market and with 330
million people living within a 3-hour
drive or train ride from Shanghai, it
picked its next location. Work has
already begun on the Shanghai Dis-
ney Resort, which will be the home
to Shanghai Disneyland, targeted
to open at the end of 2015. Learn-
ing from its mistakes in Hong Kong,
Disney’s new proposed park will be
much larger and easier for Chinese
families to visit, but Disney has been
a bit vague on the specifics of the
park in an attempt to avoid a repeat
of competition from knockoff rides
that it experienced in Hong Kong.
To say the least, with a total in-
vestment of over $8 billion shared
by Disney and its Chinese partner, the outcome of this decision will have a major effect on
Disney’s future. Whether this was a good or a bad decision, only time will tell. The question we
will ask in this chapter is: How did Disney go about making this decision to enter the Chinese
market and build Hong Kong Disneyland, and, after losing money on its Hong Kong venture,
how did it go about making the decision to build Shanghai Disney Resort? The answer is that
the company did it using the decision criteria we will examine in this chapter.
This chapter is actually the first of two chapters dealing with the process of decision mak-
ing with respect to making investments in fixed assets—that is, should a proposed project
be accepted or rejected? We will refer to this process as capital budgeting. In this chapter,
we will look at the methods used to evaluate new projects. In deciding whether to accept a
new project, we will focus on free cash flows. Free cash flows represent the benefits gener-
ated from accepting a capital-budgeting proposal. We will assume we know what level of
free cash flows is generated by a project and will work on determining whether that project
should be accepted. In the following chapter, we will examine what a free cash flow is and
how we measure it. We will also look at how risk enters into this process.
Finding Profitable Projects
Without question it is easier to evaluate profitable projects or investments in fixed assets, a
process referred to as capital budgeting, than it is to find them. In competitive markets,
generating ideas for profitable projects is extremely difficult. The competition is brisk for
new profitable projects, and once they have been uncovered, competitors generally rush
in, pushing down prices and profits. For this reason a firm must have a systematic strat-
egy for generating capital-budgeting projects based on these ideas. Without this flow of
new projects and ideas, the firm cannot grow or even survive for long. Instead, it will be
forced to live off the profits from existing projects with limited lives. So where do these
ideas come from for new products, or for ways to improve existing products or make them
more profitable? The answer is from inside the firm—from everywhere inside the firm,
in fact.
Typically, a firm has a research and development (R&D) department that searches
for ways of improving existing products or finding new products. These ideas may come
305305
1 Discuss the difficulty
encountered in finding
profitable projects in
competitive markets and the
importance of the search.
capital budgeting the process of decision
making with respect to investments made in
fixed assets—that is, should a proposed project
be accepted or rejected.

306 Part 3 • Investment in Long-Term Assets
from within the R&D department or may be based on referral ideas from executives, sales
personnel, anyone in the firm, or even customers. For example, at Ford Motor Company
before the 1990s, ideas for product improvements had typically been generated in Ford’s
R&D department. Unfortunately, this strategy was not enough to keep Ford from losing
much of its market share to Japanese competitors. In an attempt to cut costs and improve
product quality, Ford moved from strict reliance on an R&D department to seeking the
input of employees at all levels for new ideas. Bonuses are now provided to workers for their
cost-cutting suggestions, and assembly-line personnel who can see the production process
from a hands-on point of view are now brought into the hunt for new projects. The effect
on Ford has been positive and it helped Ford avoid the bankruptcy problems that befell GM
and Chrysler. Although not all suggested projects prove to be profitable, many new ideas
generated from within the firm turn out to be good ones.
Another way an existing product can be applied to a new market is illustrated by Kimberly-
Clark, the manufacturer of Huggies disposable diapers. The company took its existing dia-
per product line, made the diapers more waterproof, and began marketing them as dispos-
able swim pants called Little Swimmers. Sara Lee Hosiery boosted its market by expanding
its offerings to appeal to more customers and more customer needs. For example, Sara Lee
Hosiery introduced Sheer Energy pantyhose for support, Just My Size pantyhose aimed at
larger-women sizes, and Silken Mist pantyhose in shades better suited for African American
women.
Big investments such as these go a long way toward determining the future of the com-
pany, but they don’t always work as planned. Just look at Burger King’s development of
its new french fries. It looked like a slam-dunk great idea. Burger King took an uncooked
french fry and coated it with a layer of starch that made it crunchier and kept it hot longer.
The company spent over $70 million on the new fries and even gave away 15 million or-
ders on a “Free Fryday.” Unfortunately, the product didn’t go down with consumers, and
Burger King was left to eat the loss. Given the size of the investment we’re talking about,
you can see why such a decision is so important.
Concept Check
1. Why is it so difficult to find an exceptionally profitable project?
2. Why is the search for new profitable projects so important?
Cautionary tale
ForgeTTing PrinCiPle 3: risk requires A rewArd And PrinCiPle 4:
MArkeT PriCes Are generAlly righT
In the world of investing, you win some, you lose some. A com-
mon misconception is that high-risk investments always pro-
vide high returns. In fact, there are no guarantees. That’s why
consistently high returns paid year in and year out from a fund
known for its exclusivity and its double-digit rates of return
should have given investors pause.
In December of 2008 an investor in the fund, quoted in Time
magazine, wrote, “All we knew was that my wife’s entire family
had been in the fund for decades and lived well on the returns,
which ranged from 15 percent to 22 percent. It was all very se-
cretive and tough to get into, which, looking back, was a bril-
liant strategy to lure suckers.”
The fund in question is the one we now know as the Ponzi
scheme orchestrated by Bernard “Bernie” Madoff. A Ponzi scheme
is an investment that pays returns to investors from the money
they originally invested along with money provided by new investors,
rather than any profits earned. A Ponzi scheme is destined to col-
lapse because the payments made exceed any earnings from the
investment. Madoff’s scam is considered to be the biggest Wall
Street fraud ever attempted. Prosecutors estimate the size of the
scam as somewhere between $50 billion to $54.8 billion.
In efficient markets, high returns are extremely difficult to
achieve in good and bad years. Harry Markopolos, who once
worked for one of Madoff’s competitors, long suspected that
Madoff’s returns were simply too good to be true and wrote
letters for at least a decade to the Securities and Exchange
Commission trying to persuade them to investigate Madoff. As
Markopolos observed, one thing that we know from efficient
markets is that if an investment promises a return that looks too
good to be true, it probably is.
Source: Robert Chew, “How I Got Screwed by Bernie Madoff,” Time, December 15,
2008, http://www.time.com/time/business/article/0,8599,1866398,00.html.

http://www.time.com/time/business/article/0,8599,1866398,00.html

Chapter 10 • Capital-Budgeting Techniques and Practice 307
Capital-Budgeting Decision Criteria
As we explained, when deciding whether to accept a new project, we focus on cash flows
because cash flows represent the benefits generated from accepting a capital-budgeting
proposal. In this chapter we assume a given cash flow is generated by a project and work on
determining whether that project should be accepted.
We consider four commonly used criteria for determining the acceptability of invest-
ment proposals. The first one is the least sophisticated in that it does not incorporate the
time value of money into its calculations; the other three do take it into account. For the
time being, the problem of incorporating risk into the capital-budgeting decision is ig-
nored. This issue is examined in Chapter 11. In addition, we assume that the appropriate
discount rate, required rate of return, or cost of capital is given.
The Payback Period
The payback period is the number of years needed to recover the initial cash outlay related to an in-
vestment. Thus, the payback period becomes the number of years prior to the year of complete
recovery of the initial outlay plus the unrecovered dollar amount at the beginning of the year
recovery is completed divided by the cash flow in the year in which recovery is completed:
Payback period =
number of years just
prior to complete
payback
+
unpaid@back amount
at beginning of year
free cash flow in year
payback is completed
(10-1)
The accept/reject criteria for the payback period is if the payback period is less than the re-
quired payback period, then the project is accepted. Shorter payback periods are preferred
over longer payback periods because the shorter the payback period, the quicker you get your
money back. Because this criterion measures how quickly the project will return its original
investment, it deals with free cash flows, which measure the true timing of the benefits, rather
than accounting profits. Unfortunately, it also ignores the time value of money and does not
discount these free cash flows back to the present. Rather, the accept/reject criterion centers
on whether the project’s payback period is less than or equal to the firm’s maximum desired
payback period. For example, if a firm’s maximum desired payback period is 3 years, and an
investment proposal requires an initial cash outlay of $10,000 and yields the following set of
annual cash flows, what is its payback period? Should the project be accepted?
payback period the number of years it takes
to recapture a project’s initial outlay.
2 Determine whether a new
project should be accepted or
rejected using the payback
period, the net present value,
the profitability index, and the
internal rate of return.
Y E a R F R E E C a s h F LO w
1 $2,000
2 4,000
3 3,000
4 3,000
5 9,000
In this case, after 3 years the firm will have recaptured $9,000 on an initial investment
of $10,000, leaving $1,000 of the initial investment to be recouped. During the fourth year
$3,000 will be returned from this investment, and, assuming it will flow into the firm at a
constant rate over the year, it will take one-third of the year ($1,000/$3,000) to recapture
the remaining $1,000. Thus, the payback period on this project is 3½ years, which is more
than the desired payback period. Using the payback period criterion, the firm would reject
this project without even considering the $9,000 cash flow in year 5.
Although the payback period is used frequently, it does have some rather obvious draw-
backs that are best demonstrated through the use of an example. Consider two investment
projects, A and B, which involve an initial cash outlay of $10,000 each and produce the
annual cash flows shown in Table 10-1. Both projects have a payback period of 2 years;
therefore, in terms of the payback criterion both are equally acceptable. However, if we had
our choice, it is clear we would select A over B, for at least two reasons. First, regardless of
what happens after the payback period, project A returns more of our initial investment to
us faster within the payback period ($6,000 in year 1 versus $5,000). Thus, because there
is a time value of money, the cash flows occurring within the payback period should not be

308 Part 3 • Investment in Long-Term Assets
weighted equally, as they are. In addition, all cash flows that occur after the payback period
are ignored. This violates the principle that investors desire more in the way of benefits
rather than less—a principle that is difficult to deny, especially when we are talking about
money. Finally, the choice of the maximum desired payback period is arbitrary. That is,
there is no good reason why the firm should accept projects that have payback periods less
than or equal to 3 years rather than 4 years.
Although these deficiencies limit the value of the payback period as a tool for investment
evaluation, the payback period has several positive features. First, it deals with cash flows,
as opposed to accounting profits, and therefore focuses on the true timing of the project’s
benefits and costs, even though it does not adjust the cash flows for the time value of money.
Second, it is easy to visualize, quickly understood, and easy to calculate. Third, the payback
period may make sense for the capital-constrained firm, that is, the firm that needs funds
and is having problems raising additional money. These firms need cash flows early on to
allow them to continue in business and to take advantage of future investments. Finally,
although the payback period has serious deficiencies, it is often used as a rough screening
device to eliminate projects whose returns do not materialize until later years. This method
emphasizes the earliest returns, which in all likelihood are less uncertain, and provides for
the liquidity needs of the firm. Although its advantages are certainly significant, its disad-
vantages severely limit its value as a discriminating capital-budgeting criterion.
Discounted Payback Period To deal with the criticism that the payback period ignores the
time value of money, some firms use the discounted payback period approach. The discounted
payback period method is similar to the traditional payback period except that it uses discounted
free cash flows rather than actual undiscounted free cash flows in calculating the payback period.
The discounted payback period is defined as the number of years it takes to recapture a project’s
initial outlay from the discounted free cash flows. This equation can be written as
Discounted
payback
period
=
number of years just prior
to complete payback
from discounted free
cash flows
+
unpaid@back amount at
the beginning
of year
discounted free cash
flow in year
payback is completed
(10-2)
The accept/reject criterion then becomes whether the project’s discounted payback period
is less than or equal to the firm’s maximum desired discounted payback period. Using the
assumption that the required rate of return on projects A and B illustrated in Table 10-1
is 17 percent, the discounted cash flows from these projects are given in Table 10-2. On
project A, after 3 years, only $74 of the initial outlay remains to be recaptured, whereas year
4 brings in a discounted free cash flow of $1,068. Thus, if the $1,068 comes in at a constant
rate over the year, it will take about 7/100 of the year ($74/$1,068) to recapture the remain-
ing $74. The discounted payback period for project A is 3.07 years, calculated as follows:
Discounted payback periodA = 3.0 + $74/$1,068 = 3.07 years
PROjECTs
a B
Initial cash outlay -$10,000 -$10,000
Annual free cash inflows
Year 1 $ 6,000 $ 5,000
2 4,000 5,000
3 3,000 0
4 2,000 0
5 1,000 0
TaBLE 10-1 Payback Period Example
discounted payback period the number
of years it takes to recapture a project’s initial
outlay from the discounted free cash flows.

Chapter 10 • Capital-Budgeting Techniques and Practice 309
If project A’s discounted payback period was less than the firm’s maximum desired dis-
counted payback period, then project A would be accepted. Project B, however, does not
have a discounted payback period because it never fully recovers the project’s initial cash
outlay and thus should be rejected. The major problem with the discounted payback period
comes in setting the firm’s maximum desired discounted payback period. This is an arbitrary
decision that affects which projects are accepted and which ones are rejected. In addition,
cash flows that occur after the discounted payback period are not included in the analysis.
Thus, although the discounted payback period is superior to the traditional payback period,
in that it accounts for the time value of money in its calculations, its use is limited by the
arbitrariness of the process used to select the maximum desired payback period. Moreover,
as we will soon see, the net present value criterion is theoretically superior and no more dif-
ficult to calculate. These two payback period rules can be summarized as follows:
Project A
Year
Undiscounted Free
cash Flows
Discounted Free
cash Flows at 17%
cumulative Discounted
Free cash Flows
0 -$10,000 -$10,000 -$10,000
1 6,000 5,130 -4,870
2 4,000 2,924 -1,946
3 3,000 1,872 -74
4 2,000 1,068 994
5 1,000 456 1,450
Project B
Year
Undiscounted Free
cash Flows
Discounted Free
cash Flows at 17%
cumulative Discounted
Free cash Flows
0 −$10,000 −$10,000 −$10,000
1 5,000 4,275 −5,725
2 5,000 3,655 −2,070
3 0 0 −2,070
4 0 0 −2,070
5 0 0 −2,070
tABle 10-2 Discounted Payback, Period example Using a 17 Percent
required rate of return
Name of tool Formula What It tells You
Payback period Number of years required to recapture the initial investment from the free
cash flows:
Payback period =
number of years
just prior to
complete
payback
+
unpaid@back amount
at beginning of year
free cash flow in year
payback is completed
• How long it will take to recapture the
initial investment
• The shorter the payback period, the
better
• If it is less than the maximum accept-
able payback period, it is accepted
Discounted
payback period
Number of years required to recapture the initial investment from the
discounted free cash flows:
Discounted
payback period
=
number of years
just prior to
complete
payback from
discounted free
cash flows
+
unpaid@back amount
at beginning of year
discounted free cash flow in year
payback is completed
• How long it will take to recapture the
initial investment from the discounted
cash flows
• The shorter the discounted payback
period, the better
• If it is less than the maximum accept-
able discounted payback period, it is
accepted.
Financial Decision Tools

310 Part 3 • Investment in Long-Term Assets
The Net Present Value
The net present value (NPV) of an investment proposal is equal to the present value of its
annual free cash flows less the investment’s initial outlay. The net present value can be expressed
as follows:
NPV = (present value of all the future annual free cash flows) – (the initial cash outlay)
=
FCF1
(1 + k)1
+
FCF2
(1 + k)2
+ g +
FCFn
(1 + k)n
– IO (10-1)
where FCFt = the annual free cash flow in time period t (this can take on either positive or
negative values)
k = the firm’s required rate of return or cost of capital1
IO = the initial cash outlay
n = the project’s expected life
If any of the future free cash flows (FCFs) are cash outflows rather than inflows, say for
example that there is another large investment in year 2 that results in the FCF2 being nega-
tive, then the FCF2 would take on a negative sign when calculating the project’s net present
value. In effect, the NPV can be thought of as the present value of the benefits minus the
present value of the costs,
NPV = PVbenefits – PVcosts
A project’s NPV measures the net value of the investment
proposal in terms of today’s dollars. Because all cash flows
are discounted back to the present, comparing the difference
between the present value of the annual cash flows and the
investment outlay recognizes the time value of money. The
difference between the present value of the annual cash flows
and the initial outlay determines the net value of the invest-
ment proposal. Whenever the project’s NPV is greater than or
equal to zero, we will accept the project; whenever the NPV
is negative, we will reject the project. If the project’s NPV is
zero, then it returns the required rate of return and should be accepted. This accept/reject
criterion is represented as follows:
NPV Ú 0.0: accept
NPV 6 0.0: reject
Realize, however, that the worth of the NPV calculation is a function of the accuracy of the
cash-flow predictions.
The following example illustrates the use of NPV as a capital-budgeting criterion.
E x a M P L E 10.1 Calculating net present value
Ski-Doo is considering new machinery that would reduce manufacturing costs associ-
ated with its Mach Z snowmobile for which the free cash flows are shown in Table 10-3.
If the firm has a 12 percent required rate of return, what is the NPV of the project?
Should the company accept the project?
sTeP 1: ForMulATe A soluTion sTrATegy
The net present value (NPV) of an investment proposal is equal to the present value of
its annual free cash flows less the investment’s initial outlay. Given the company’s free
cash flows information, the NPV can be calculated as:
net present value (NPV) the present value
of an investment’s annual free cash flows less the
investment’s initial outlay.
1The required rate of return or cost of capital is the rate of return necessary to justify raising funds to finance the project
or, alternatively, the rate of return necessary to maintain the firm’s current market price per share. These terms were
defined in detail in Chapter 9.
reMeMBer your PrinCiPles
The final three capital-budgeting criteria all incorpo-
rate Principle 2: Money Has a Time Value in their calculations.
If we are to make rational business decisions, we must recog-
nize that money has a time value. In examining the following
three capital-budgeting techniques, you will notice that this
principle is the driving force behind each of them.
rinciple

Chapter 10 • Capital-Budgeting Techniques and Practice 311
NPV = (present value of all the future annual free cash flows) – (the initial cash outlay)
=
FCF1
(1 + k)1
+
FCF2
(1 + k)2
+ c +
FCFn
(1 + k)n
– IO (10-1)
where FCFt = the annual free cash flow in time period t (this can take on either positive
or negative values)
k = the firm’s required rate of return or cost of capital
IO = the initial cash outlay
n = the project’s expected life
sTeP 2: CrunCh The nuMBers
If the firm has a 12 percent required rate of return, the present value of the free cash flow
is $47,675, as calculated in Table 10-4. Subtracting the $40,000 initial outlay leaves an
NPV of $7,675.
CAlCulATor soluTion (using A
TexAs insTruMenTs BA ii Plus):
Data and Key Input Display
CF ; -40,000; ENTER CFo = -40,000.
; 15,000; ENTER C01 = 15,000.
; 1; ENTER F01 = 1.00
; 14,000; ENTER C02 = 14,000.
; 1; ENTER F02 = 1.00
; 13,000; ENTER C03 = 13,000.
; 1; ENTER F03 = 1.00
; 12,000; ENTER C04 = 12,000.
; 1; ENTER F04 = 1.00
; 11,000; ENTER C05 = 11,000
; 1; ENTER F05 = 1.00
NPV I = 0.00
12; ENTER I = 1200
; CPT NPV = 7,675.
Free Cash Flow
Initial outlay -$40,000
Inflow year 1 15,000
Inflow year 2 14,000
Inflow year 3 13,000
Inflow year 4 12,000
Inflow year 5 11,000
TaBLE 10-3 ski-Doo’s Investment in New Machinery and
Its associated Free Cash Flows
sTeP 3: AnAlyZe your resulTs
The NPV tells us how much value is created if the project is accepted, and if the NPV
is positive, value is created; if the NPV is negative, the project destroys value. In this
case because this value is greater than zero, this project creates value and should be
accepted.
PREsENT VaLUE
Free Cash Flow 3 Factor at 12 Percent 5 Present Value
Inflow year 1 $15,000 * 1
(1 + 0.12)1
= $13,393
Inflow year 2 14,000 * 1
(1 + 0.12)2
= 11,161
Inflow year 3 13,000 * 1
(1 + 0.12)3
= 9,253
Inflow year 4 12,000 * 1
(1 + 0.12)4
= 7,626
Inflow year 5 11,000 * 1
(1 + 0.12)5
= 6,242
Present value of
free cash flows
$47,675
Initial outlay -40,000
Net present value $ 7,675
TaBLE 10-4 Calculating the NPV of ski-Doo’s Investment in New Machinery

312 Part 3 • Investment in Long-Term Assets
The NPV criterion is the capital-budgeting decision tool we find most favorable for
several reasons. First of all, it deals with free cash flows rather than accounting profits. In
this regard it is sensitive to the true timing of the benefits resulting from the project. More-
over, recognizing the time value of money allows the benefits and costs to be compared in
a logical manner. Finally, because projects are accepted only if a positive NPV is associated
with them, the acceptance of a project using this criterion will increase the value of the firm,
which is consistent with the goal of maximizing the shareholders’ wealth.
The disadvantage of the NPV method stems from the need for detailed, long-term fore-
casts of the free cash flows accruing from the project’s acceptance. Despite this drawback,
the NPV is the most theoretically correct criterion that we will examine. The following
example provides an additional illustration of its application.
e x a m p l e 10.2 Calculating net present value
A firm is considering the purchase of a new computer system, which will cost $30,000
initially, to aid in credit billing and inventory management. The free cash flows resulting
from this project are provided below:
F R e e C a S H F lO W
Initial outlay -$30,000
Inflow year 1 15,000
Inflow year 2 15,000
Inflow year 3 15,000
The required rate of return demanded by the firm is 10 percent. Determine the system’s
NPV. Should the firm accept the project?
STEP 1: FORMULATE A SOLUTION STRATEGY
To determine the system’s NPV, the 3-year $15,000 cash flow annuity is first discounted
back to the present at 10 percent. The present value of the $15,000 annuity can be found us-
ing a calculator (as is done in the margin), or by using the relationship from equation (5-4),
PV = PMT
£ 1 –
1
(1 + k)n
k
§
.
STEP 2: CRUNCH THE NUMBERS
Using the mathematical relationship we get:
PV = $15,000
£ 1 –
1
(1 + 0.10)3
0.10
§
= $15,000 (2.4869) = $37,303
STEP 3: ANALYZE YOUR RESULTS
Seeing that the cash inflows have been discounted back to the present, they can now
be compared with the initial outlay because both of the flows are now stated in terms
of today’s dollars. Subtracting the initial outlay ($30,000) from the present value of the
cash inflows ($37,303), we find that the system’s NPV is $7,303. Because the NPV on this
project is positive, the project should be accepted.
Using Spreadsheets to Calculate the Net present Value
Although we can calculate the NPV by hand or with a financial calculator, it is more com-
monly done with the help of a spreadsheet. Just as with the keystroke calculations on a
CALCULATOR SOLUTION
STEP 1
Calculate payment value of inflows
Data Input Function Key
3 N
10 I/Y
-15,000 PMT
0 FV
Function Key Answer
CPT
PV 37,303
STEP 2
Subtract initial outlay from present
value of inflows
$ 37,303
-30,000
$ 7,303

Chapter 10 • Capital-Budgeting Techniques and Practice 313
financial calculator, a spreadsheet can make easy work of NPV calculations. The only real
glitch here is that in Excel, along with most other spreadsheets, the =NPV function calcu-
lates the present value of only the future cash flows and ignores the initial outlay in its NPV
calculations. Sounds strange? Well, it is. It is essentially just a carryforward of an error in
one of the first spreadsheets. That means that the actual NPV is the Excel-calculated NPV
minus the initial outlay:
Actual NPV = Excel@calculated NPV – initial outlay
This can be input into a spreadsheet cell as:
=NPV (rate,inflow 1,inflow 2, . . . inflow 29)-initial outlay
Looking back at the Ski-Doo example in Table 10-3, we can use a spreadsheet to cal-
culate the net present value of the investment in machinery as long as we remember to
subtract the initial outlay in order to get the correct number.
Can You Do It?
DETERMINING THE NPV OF A PROJECT
Determine the NPV for a new project that costs $7,000, is expected to produce 10 years’ worth of annual free cash flows of $1,000 per
year, and has a required rate of return of 5 percent.
(The solution can be found on page 314.)
Entered value in cell c18:
=NPV(D8,D12:D16)–40000
The profitability Index (Benefit–Cost Ratio)
The profitability index (PI), or benefit–cost ratio, is the ratio of the present value of the
future free cash flows to the initial outlay. Although the NPV investment criterion gives a mea-
sure of the absolute dollar desirability of a project, the profitability index provides a relative
profitability index (PI) or benefit–cost
ratio the ratio of the present value of an invest-
ment’s future free cash flows to the investment’s
initial outlay.

314 Part 3 • Investment in Long-Term Assets
measure of an investment proposal’s desirability—that is, the ratio of the present value of
its future net benefits to its initial cost. The profitability index can be expressed as follows:
PI =
present value of all the future annual free cash flows
initial cash outlay
=
FCF1
(1 + k)1
+
FCF2
(1 + k)2
+ g +
FCFn
(1 + k)n
IO
(10-2)
where FCFt = the annual free cash flow in time period t (this can take on either positive or
negative values)
k = the firm’s required rate of return or cost of capital
IO = the initial cash outlay
n = the project’s expected life
The decision criterion is to accept the project if the PI is greater than or equal to 1.00
and to reject the project if the PI is less than 1.00.
PI Ú 1.0: accept
PI 6 1.0: reject
Looking closely at this criterion, we see that it yields the same accept/reject decision
as the NPV criterion. Whenever the present value of the project’s free cash flows is greater
than the initial cash outlay, the project’s NPV will be positive, signaling a decision to accept.
When this is true, then the project’s PI will also be greater than 1 because the present value
of the free cash flows (the PI’s numerator) is greater than the initial outlay (the PI’s denomi-
nator). Thus, these two decision criteria will always yield the same decision, although they
DiD you Get it?
deTerMining The NPV oF A ProJeCT
You were asked to determine the NPV for a project with an ini-
tial outlay of $7,000 and free cash flows in years 1 through 10 of
$1,000, given a 5 percent required rate of return.
NPV = (present value of all future free cash flows) − (initial outlay)
1. Using the Mathematical Formulas.
sTEP 1 Determine the present value of the future cash flows.
Substituting these example values in equation (5-4), we find
PV = $1,000
C 1 – 1(1 + 0.05)10
0.05
S
= $1,000 [(1 – 1/1.62889463)/0.05]
= $1,000 [(1 – 0.61391325)/0.05]
= $1,000 (7.72173493) = $7,721.73
sTEP 2 Subtract the initial outlay from the present value of
the free cash flows.
$7,721.73
-$7,000.00
$ 721.73
2. Using a Financial Calculator.
sTEP 1 Determine the present value of the future cash flows.
Data Input Function Key
10 N
5 I/Y
-1,000 PMT
0 FV
Function Key Answer
CPT
PV 7,721.73
sTEP 2 Subtract the initial outlay from present value of the
free cash flows.
$7,721.73
-$7,000.00
$ 721.73
Alternatively, you could use the CF button on your calculator
(using a TI BA II Plus).
Data and Key Input Display
CF ; 2nd ; CE/C CFo = 0. (this clears out
any past cash flows)
-7,000; ENTER CFo = −7,000.
; 1,000; ENTER C01 = 1,000.
; 10; ENTER F01 = 10.00
NPV I = 0.
5; ENTER I = 5.00
NPV = 0.
CPT NPV = 721.73

Chapter 10 • Capital-Budgeting Techniques and Practice 315
will not necessarily rank acceptable projects in the same order. This problem of conflicting
ranking is dealt with at a later point.
Because the NPV and PI criteria are essentially the same, they have the same advantages
over the other criteria examined. Both employ free cash flows, recognize the timing of the
cash flows, and are consistent with the goal of maximizing shareholders’ wealth. The major
disadvantage of the PI criterion, similar to the NPV criterion, is that it requires long, de-
tailed free cash flow forecasts.
E x a M P L E 10.3 Calculating the profitability index
A firm with a 10 percent required rate of return is considering investing in a new ma-
chine with an expected life of 6 years. The free cash flows resulting from this investment
are given in Table 10-5. Determine the firm’s profitability index. According to the prof-
itability index, should the firm accept the investment?
Free Cash Flow
Initial outlay -$50.000
Inflow year 1 15,000
Inflow year 2 8,000
Inflow year 3 10,000
Inflow year 4 12,000
Inflow year 5 14,000
Inflow year 6 16,000
TaBLE 10-5 The Free Cash Flows associated with an Investment in New Machinery
sTeP 1: ForMulATe A soluTion sTrATegy
The profitability index can be calculated using equation (10-2) as follows:
PI =
present value of all the furure annual free cash flows
initial cash outlay
=
FCF1
(1 + k)1
+
FCF2
(1 + k)2
+ c +
FCFn
(1 + k)n
IO

where FCFt = the annual free cash flow in time period t (this can take on either positive or
negative values)
k = the firm’s required rate of return or cost of capital
IO = the initial cash outlay
n = the project’s expected life
sTeP 2: CrunCh The nuMBers
Discounting the project’s future net free cash flows back to the present yields a present
value of $53,682; dividing this value by the initial outlay of $50,000 yields a profitability
index of 1.0736, as shown in Table 10-6.
sTeP 3: AnAlyZe your resulTs
This tells us that the present value of the future benefits accruing from this project is
1.0736 times the level of the initial outlay. Because the profitability index is greater than
1.0, the project should be accepted. In addition, because the profitability index is greater
than 1.0 we also know that the NPV is positive—that’s because the present value of the
future benefits is greater than the initial outlay. These two measures always give consis-
tent accept/reject decisions on investment projects.

316 Part 3 • Investment in Long-Term Assets
The Internal Rate of Return
The internal rate of return (IRR) attempts to answer the question, what rate of return
does this project earn? For computational purposes, the internal rate of return is defined
as the discount rate that equates the present value of the project’s free cash flows with the project’s
initial cash outlay. Mathematically, the internal rate of return is defined as the value IRR in
the following equation:
IRR = the rate of return that equates the present value of the project’s free cash flows
with the initial outlay
IO =
FCF1
(1 + IRR)1
+
FCF2
(1 + IRR)2
+ c +
FCFn
(1 + IRR)n
(10-3)
where FCFt = the annual free cash flow in time period t (this can take on either positive or
negative values)
IO = the initial cash outlay
n = the project’s expected life
IRR = the project’s internal rate of return
In effect, the IRR is analogous to the concept of the yield to maturity for bonds, which
was examined in Chapter 7. In other words, a project’s IRR is simply the rate of return that
the project earns.
The decision criterion is to accept the project if the IRR is greater than or equal to the
firm’s required rate of return. We reject the project if its IRR is less than the required rate
of return. This accept/reject criterion can be stated as
IRR Ú firm’s required rate of return or cost of capital: accept
IRR 6 firm’s required rate of return or cost of capital: reject
If the IRR on a project is equal to the firm’s required rate of return, then the project
should be accepted because the firm is earning the rate that its shareholders are demanding.
By contrast, accepting a project with an IRR below the investors’ required rate of return will
decrease the firm’s stock price.
Free Cash
Flow 3
Present Value Factor
at 10 Percent 5
Present
Value
Inflow year 1 15,000 *
1
(1 + 0.10)1
= 13,636
Inflow year 2 8,000 *
1
(1 + 0.10)2 = 6,612
Inflow year 3 10,000 *
1
(1 + 0.10)3
= 7,513
Inflow year 4 12,000 *
1
(1 + 0.10)4 = 8,196
Inflow year 5 14,000 *
1
(1 + 0.10)5
= 8,693
Inflow year 6 16,000 *
1
(1 + 0.10)6
= 9,032
PI =
FCF1
(1 + k)1
+
FCF2
(1 + k)2
+ c +
FCFn
(1 + k)n
IO
=
$13,636 + $6,612 + $7,513 + $8,196 + $8,693 + $9,032
$50,000
=
$53,682
$50,000
= 1.0736
TaBLE 10-6 Calculating the PI of an Investment in New Machinery
internal rate of return (IRR) the rate of
return that the project earns. For computational
purposes, the internal rate of return is defined as
the discount rate that equates the present value
of the project’s free cash flows with the project’s
initial cash outlay.

Chapter 10 • Capital-Budgeting Techniques and Practice 317
If the NPV is positive, then the IRR must be greater than the required rate of return, k.
Thus, all the discounted cash-flow criteria are consistent and will result in similar accept/
reject decisions. One disadvantage of the IRR relative to the NPV deals with the implied
reinvestment rate assumptions made by these two methods. The NPV assumes that cash
flows over the life of the project are reinvested back in projects that earn the required rate
of return. That is, if we have a mining project with a 10-year expected life that produces
a $100,000 cash flow at the end of the second year, the NPV technique assumes that this
$100,000 is reinvested over years 3 though 10 at the required rate of return. The use of the
IRR, however, implies that cash flows over the life of the project can be reinvested at the
IRR. Thus, if the mining project we just looked at has a 40 percent IRR, the use of the IRR
implies that the $100,000 cash flow that is received at the end of year 2 could be reinvested
at 40 percent over the remaining life of the project. In effect, the NPV method implicitly as-
sumes that cash flows over the life of the project can be reinvested at the project’s required rate of
return, whereas the use of the IRR method implies that these cash flows could be reinvested at the
IRR. The better assumption is the one made by the NPV—that the cash flows can be rein-
vested at the required rate of return because they can either be (1) returned in the form of
dividends to shareholders, who demand the required rate of return on their investments, or
(2) reinvested in a new investment project. If these cash flows are invested in a new project,
then they are simply substituting for external funding on which the required rate of return
is again demanded. Thus, the opportunity cost of these funds is the required rate of return.
The bottom line of all this is that the NPV method makes the best reinvestment rate
assumption, and, as such, is superior to the IRR method. Why should we care which method
is used if both methods result in similar accept/reject decisions? The answer, as we will see,
is that although they may result in the same accept/reject decision, they may rank projects
differently in terms of desirability.
Computing the IRR with a Financial Calculator With today’s calculators, determining
an IRR is merely a matter of a few keystrokes. In Chapter 5, whenever we were solving time
value of money problems for i, we were really solving for the IRR. For instance, in Chapter 5
when we solve for the rate at which $100 must be compounded annually for it to grow to
$179.10 in 10 years, we are actually solving for that problem’s IRR. Thus, with financial cal-
culators we need only input the initial outlay, the cash flows, and their timing and then input
the function key “I/Y” or the “IRR” button to calculate the IRR. On some calculators it is
necessary to press the compute key, CPT, before pressing the function key to be calculated.
Computing the IRR with a spreadsheet Calculating the IRR using a spreadsheet is ex-
tremely simple. Once the cash flows have been entered on the spreadsheet, all you need to do
is input the Excel IRR function into a spreadsheet cell and let the spreadsheet do the calcula-
tions for you. Of course, at least one of the cash flows must be positive and at least one must be
negative. The IRR function to be input into a spreadsheet cell is: = IRR(values), where “values”
is simply the range of cells in which the cash flows including the initial outlay are stored.
Entered value in cell B14:=IRR(B8:B12)
Entered value in cell C14:=IRR(C8:C12)
Entered value in cell D14:=IRR(D8:D12)

318 Part 3 • Investment in Long-Term Assets
computing the IRR for Uneven cash Flows with a Financial calculator Solving for
the IRR when the cash flows are uneven is quite simple with a calculator: One need only
key in the initial cash outlay, the cash flows, and their timing and press the “IRR” button.
Let’s take a look at how you might solve a problem with uneven cash flows using a finan-
cial calculator. Every calculator works a bit differently, so you’ll want to be familiar with
how to input data into yours, but that being said, they all work essentially the same way.
As you’d expect, you will enter all the cash flows, then solve for the project’s IRR. With a
Texas Instruments BA II Plus calculator, you begin by hitting the CF button. Then, CFo
indicates the initial outlay, which you’ll want to give a negative value; C01 is the first free
cash flow; and F01 is the number of years in which the first free cash flow appears. Thus, if
the free cash flows in years 1, 2, and 3 are all $1,000, then F01 = 3. C02 then becomes the
second free cash flow, and F02 is the number of years in which the second free cash flow
appears. You’ll notice that you move between the different cash flows using the down ar-
row (T) located on the top row of your calculator. Once you have inputted the initial outlay
and all the free cash flows, you then calculate the project’s IRR by hitting the “IRR” button
followed by “CPT,” the compute button. Let’s look at a quick example. Consider the fol-
lowing investment proposal:
Initial outlay -$5,000
FCF in year 1 2,000
FCF in year 2 2,000
FCF in year 3 3,000
CALCULATOR SOLUTION
(USING A TI BA II PLUS):
Data and Key Input Display
CF ; -5,000; ENTER CFo = -5,000.00
2,000; ENTER C01 = 2,000.00
2; ENTER F01 = 2.00
3,000; ENTER C02 = 3,000.00
1; ENTER F02 = 1.00
IRR ; CPT IRR = 17.50%
e x A m P l e 10.4 calculating internal rate of return
Consider the following investment proposal:
Initial outlay -$10,010
FCF in year 1 1,000
FCF in year 2 3,000
FCF in year 3 6,000
FCF in year 4 7,000
If the required rate of return is 15 percent, should this project be accepted?
STEP 1: FORMULATE A SOLUTION STRATEGY
Because the cash flows are uneven, you’ll want to either use Excel or use a financial cal-
culator. Let’s use a financial calculator; specifically, let’s use a Texas Instruments BA II
Plus calculator.
can You Do iT?
DETERMINING THE IRR OF A PROJECT
Determine the IRR for a new project that costs $5,019 and is expected to produce 10 years’ worth of annual free cash flows of $1,000
per year.
(The solution can be found on page 319.)

Chapter 10 • Capital-Budgeting Techniques and Practice 319
sTeP 2: CrunCh The nuMBers
Calculate the internal rate of return using the calculator.
CAlCulATor soluTion
(using A Ti BA ii Plus)
Data and Key Input Display
CF ; -10,010; ENTER CFo = -10,010.00
1,000; ENTER C01 = 1,000.00
1; ENTER F01 = 1.00
3,000; ENTER C02 = 3,000.00
1; ENTER F02 = 1.00
6,000; ENTER C03 = 6,000.00
1; ENTER F03 = 1.00
7,000; ENTER C04 = 7,000.00
1; ENTER F04 = 1.00
IRR ; CPT IRR = 19.00%
sTeP 3: AnAlyZe your resulTs
In this case, the project’s IRR is 19 percent, which is above the required rate of return
of 15 percent. That means that this project would add value to the firm and should be
accepted. In addition, we also know that since the IRR is greater than the required rate
of return, the NPV must also be positive.
Viewing the NPV–IRR Relationship: The Net Present Value Profile
Perhaps the easiest way to understand the relationship between the IRR and the NPV value
is to view it graphically through the use of a net present value profile. A net present value
profile is simply a graph showing how a project’s NPV changes as the discount rate changes. To
graph a project’s net present value profile, you simply need to determine the project’s NPV,
first using a 0 percent discount rate, then slowly increasing the discount rate until a repre-
sentative curve has been plotted. How does the IRR enter into the net present value profile?
The IRR is the discount rate at which the NPV is zero.
Let’s look at an example of a project that involves an after-tax initial outlay of $105,517
with free cash flows expected to be $30,000 per year over the project’s 5-year life. Calculating
the NPV of this project at several different discount rates results in the following:
Discount Rate Project’s NPV
0% $44,483
5% $24,367
10% $ 8,207
13% $ 0
15% -$ 4,952
20% -$15,798
25% -$24,839
net present value profile a graph showing
how a project’s NPV changes as the discount rate
changes.
DiD you Get it?
deTerMining The IRR oF A ProJeCT
You were asked to determine the IRR for a project with an initial
outlay of $5,019 and free cash flows in years 1 through 10 of $1,000.
1. Using a Financial Calculator. Substituting in a financial cal-
culator, we are solving for i.
Data Input Function Key
10 N
-5,019 PV
1,000 PMT
0 FV
Function Key Answer
CPT
I/Y 15
Alternatively, you could use the CF button on your calculator
(using a TI BA II Plus):
Data and Key Input Display
CF ; -5,019; ENTER CFo = -5,019.
; 1,000; ENTER C01 = 1,000.
; 10; ENTER F01 = 10.00
IRR ; CPT IRR = 15
2. Using Excel. Using Excel, the IRR could be calculated using
the = IRR function.

320 Part 3 • Investment in Long-Term Assets
Plotting these values yields the net present value profile in Figure 10-1.
Where is the IRR in this figure? Recall that the IRR is the discount rate that equates
the present value of the inflows with the present value of the outflows; thus, the IRR is the
point at which the NPV is equal to zero—in this case, 13 percent. This is exactly the process
that we use in computing the IRR for a series of uneven cash flows—we simply calculate the
project’s NPV using different discount rates and the discount rate that makes the NPV equal
to zero is the project’s IRR.
From the net present value profile you can easily see how a project’s NPV varies in-
versely with the discount rate—as the discount rate is raised, the NPV drops. By analyzing
a project’s net present value profile, you can also see how sensitive the project is to your
selection of the discount rate. The more sensitive the NPV is to the discount rate, the more
important it is that you use the correct one in your calculations.
Complications with the IRR: Multiple Rates of Return
Although any project can have only one NPV and one PI, a single project under certain
circumstances can have more than one IRR. The reason for this can be traced to the calcu-
lations involved in determining the IRR. Equation (10-3) states that the IRR is the discount
rate that equates the present value of the project’s future net cash flows with the project’s
initial outlay:
IO =
FCF1
(1 + IRR)1
+
FCF2
(1 + IRR)2
+ g +
FCFn
(1 + IRR)n
(10-3)
However, because equation (10-3) is a polynomial of a degree n, it has n solutions. Now
if the initial outlay (IO) is the only negative cash flow and all the annual free cash flows (FCF)
are positive, then all but one of these n solutions is either a negative or an imaginary number
and there is no problem. But problems occur when there are sign reversals in the cash-flow
stream; in fact, there can be as many solutions as there are sign reversals. A normal, or “con-
ventional,” pattern with a negative initial outlay and positive annual free cash flows after
that (-, +, +, +, . . . , +) has only one sign reversal, hence, only one positive IRR. However,
an “unconventional” pattern with more than one sign reversal can have more than one IRR.
N
et
p
re
se
nt
v
al
ue
($
in
t
ho
us
an
ds
)
Discount rate
50
40
30
20
10
0
–10
–20
–30
–40
25%20%
15%
10%5%
IRR = 13%
NPV < 0 NPV > 0
FIgURE 10-1 an Example of the Net Present Value Profile of a Project
F R E E C a s h F LO w
Initial outlay -$ 1,600
Year 1 free cash flow +$10,000
Year 2 free cash flow -$10,000

Chapter 10 • Capital-Budgeting Techniques and Practice 321
In this pattern of cash flows, there are two sign reversals: one from -$1,600 to +$10,000
and one from +$10,000 to -$10,000, so there can be as many as two positive IRRs that will
make the present value of the free cash flows equal to the initial outlay. In fact, two internal
rates of return solve this problem: 25 percent and 400 percent. Graphically, what we are
solving for is the discount rate that makes the project’s NPV equal to zero. As Figure 10-2
illustrates, this occurs twice.
Which solution is correct? The answer is that neither solution is valid. Although each
fits the definition of IRR, neither provides any insight into the true project returns. In sum-
mary, when there is more than one sign reversal in the cash-flow stream, the possibility of
multiple IRRs exists, and the normal interpretation of the IRR loses its meaning. In this case,
try the NPV criterion instead.
The Modified Internal Rate of Return (MIRR)2
Problems with multiple rates of return and the reinvestment rate assumption make the NPV
superior to the IRR as a capital-budgeting technique. However, because of the ease of inter-
pretation, the IRR is preferred by many practitioners. Recently, a new technique, the modified
internal rate of return (MIRR), has gained popularity as an alternative to the IRR method
because it avoids multiple IRRs and allows the decision maker to directly specify the ap-
propriate reinvestment rate. As a result, the MIRR provides the decision maker with the
intuitive appeal of the IRR coupled with an improved reinvestment rate assumption.
Is this really a problem? The answer is yes. One of the problems of the IRR is that
it creates unrealistic expectations both for the corporation and for its shareholders. For
example, the consulting firm McKinsey & Company examined one firm that approved 23
major projects over 5 years based on average IRRs of 77 percent.3 However, when McKinsey
adjusted the reinvestment rate on these projects to the firm’s required rate of return, this
return rate fell to 16 percent. The ranking of the projects also changed with the top-ranked
project falling to the 10th most attractive project. Moreover, the returns on the highest-
ranked projects with IRRs of 800, 150, and 130 percent dropped to 15, 23, and 22 percent,
respectively, once the reinvestment rate was adjusted downward.
The driving force behind the MIRR is the assumption that all free cash flows over the
life of the project are reinvested at the required rate of return until the termination of the
project. Thus, to calculate the MIRR, we:
STEP 1 Determine the present value of the project’s free cash outflows. We do this by
discounting all the free cash outflows back to the present at the required rate of
return. If the initial outlay is the only free cash outflow, then the initial outlay is
the present value of the free cash outflows.
N
et
p
re
se
nt
v
al
ue
Discount rates
–$1,500
$1,500
–$1,000
$1,000
–$500
$500
$0
100% 200% 300% 400% 500%
FIgURE 10-2 Multiple IRRs
3John C. Kellecher and Justin J. MacCormack, “Internal Rate of Return: A Cautionary Tale,” McKinsey Quarterly,
September 24, 2004, pp. 1–4.
modified internal rate of return (MIRR)
the discount rate that equates the present value
of the project’s future free cash flows with the
terminal value of the cash inflows.
2This section is relatively complex and can be omitted without loss of continuity.

322 Part 3 • Investment in Long-Term Assets
STEP 2 Determine the future value of the project’s free cash inflows. Take all the annual
free cash inflows and find their future value at the end of the project’s life, com-
pounded forward at the required rate of return. We will call this the project’s
terminal value, or TV.
STEP 3 Calculate the MIRR. The MIRR is the discount rate that equates the present
value of the free cash outflows with the project’s terminal value.4
Mathematically, the modified internal rate of return is defined as the value of MIRR in the
following equation:
PVoutflows =
TVinflows
(1 + MIRR)n
(10-4)
where PVoutflows = the present value of the project’s free cash outflows
TVinflows = the project’s terminal value, calculated by taking all the annual free cash
inflows and finding their future value at the end of the project’s life,
compounded forward at the required rate of return
n = the project’s expected life
MIRR = the project’s modified internal rate of return
In terms of decision rules, if the project’s MIRR is greater than or equal to the project’s
required rate of return, it should be accepted. While we have now introduced a number of
different capital-budgeting decision rules, interestingly the NPV, PI, IRR, and MIRR will al-
ways give the same accept/reject decision for independent projects. These financial decision
rules can be summarized as follows:
4You will notice that we differentiate between annual cash inflows and annual cash outflows, compounding all the
inflows to the end of the project and bringing all the outflows back to the present as part of the present value of the cost.
Although there are alternative definitions of the MIRR, this is the most widely accepted definition.
Name of Tool Formula What It Tells You
Net present value (NPV) The present value of all the future annual free cash
flows minus the initial cash outlay:
=
FCF1
(1 + k)1
+
FCF2
(1 + k)2
+ g +
FCFn
(1 + k)n
– IO
• The amount of wealth that is created if the project is
accepted
• If the NPV is positive, then wealth is created and the
project should be accepted.
Profitability index (PI)
(Also referred to as the
benefit–cost ratio)
The ratio of the present value of the future free cash flows
to the initial outlay:
=
FCF1
(1 + k)1
+
FCF2
(1 + k)2
+ g +
FCFn
(1 + k)n
IO
• The ratio of the present value of future benefits to the
initial cost
• If it is greater than 1.0, the NPV must be positive; the
project creates value and should be accepted.
Internal rate of return (IRR) The discount rate that equates the present value of the
project’s future free cash flows with the project’s initial
outlay:
IO =
FCF1
(1 + IRR)1
+
FCF2
(1 + IRR)2
+ g +
FCFn
(1 + IRR)n
Where IRR = the project’s internal rate of return
• The rate of return that the project earns
• If the project earns more than the required rate of return,
then the NPV must be positive; the project creates value
and should be accepted.
Modified internal rate of
return (MIRR)
The discount rate that equates the present value of the
project’s future free cash flows with the terminal value of
the cash inflows
PVoutflows =
TVinflows
(1 + MIRR)n
• What the IRR would be if it was based upon the assump-
tion that cash flows are reinvested at the required rate of
return
Financial Decision Tools

Chapter 10 • Capital-Budgeting Techniques and Practice 323
E x a M P L E 10.5 Calculating the MIRR
Let’s look at an example of a project with a 3-year life and a required rate of return of
10 percent assuming the following cash flows are associated with it:
F R E E C a s h F LO w s
Initial outlay −$6,000
Year 1 2,000
Year 2 $3,000
Year 3 4,000
Determine the MIRR of the project.
sTeP 1: ForMulATe A soluTion sTrATegy
The calculation of the MIRR can be viewed as a three-step process:
STEP 1 Determine the present value of the project’s free cash outflows.
STEP 2 Determine the terminal value of the project’s free cash inflows.
STEP 3 Determine the discount rate that equates the present value of the terminal
value and the present value of the project’s cash outflows.
Mathematically, the modified internal rate of return is defined as the value of MIRR in
the following equation:
PVoutflows =
TVinflows
(1 + MIRR)n
(10-4)
where PVoutflows = the present value of project’s free cash outflows
TVinflows = the project’s terminal value, calculated by taking all the annual free cash
inflows and finding their future value at the end of the project’s life,
compounded forward at the required rate of return
n = the project’s expected life
MIRR = the project’s modified internal rate of return
sTeP 2: CrunCh The nuMBers
Using the three-step process:
STEP 1 Determine the present value of the project’s free cash outflows. In this case,
the only outflow is the initial outlay of $6,000, which is already at the present;
thus, it becomes the present value of the cash outflows.
STEP 2 Determine the terminal value of the project’s free cash inflows. To do this, we
merely use the project’s required rate of return to calculate the future value of
the project’s three cash inflows at the termination of the project.
In this case, the terminal value becomes $9,720.
STEP 3 Determine the discount rate that equates the present value of the terminal
value and the present value of the project’s cash outflows. Thus, the MIRR is
calculated to be 17.446 percent.
The calculations are as follows:
Y E A R
Cash flow 2,000–6,000 3,000 4,000
$ 4,000
3,300
2,420
Terminal value $
k = 10%
9,720PVoutflows = $6,000 MIRR = 17.446%
31 20
FIgURE 10-3 Calculating the MIRR

324 Part 3 • Investment in Long-Term Assets
$6,000 =
TVinflows
(1 + MIRR)n
$6,000 =
$2,000(1 + 0.10)2 + $3,000(1 + 0.10)1 + $4,000(1 + 0.10)0
(1 + MIRR)3
$6,000 =
$2,420 + $3,300 + $4,000
(1 + MIRR)3
$6,000 =
$9,720
(1 + MIRR)3
MIRR = 17.45%
sTeP 3: AnAlyZe your resulTs
Thus, the MIRR for this project (17.45 percent) is less than its IRR, which comes out to
20.614 percent. In this case, it only makes sense that the IRR should be greater than the
MIRR, because the IRR implicitly assumes intermediate cash inflows to grow at the IRR
rather than the required rate of return.
In terms of decision rules, if the project’s MIRR is greater than or equal to the project’s
required rate of return, then the project should be accepted; if not, it should be rejected:
MIRR Ú required rate of return: accept
MIRR 6 required rate of return: reject
Because of the frequent use of the IRR in the real world as a decision-making tool and
its limiting reinvestment rate assumption, the MIRR has become increasingly popular as
an alternative decision-making tool.
Using spreadsheets to Calculate the MIRR
As with other financial calculations using a spreadsheet, calculating the MIRR is extremely
simple. The only difference between this calculation and that of the traditional IRR is that with
a spreadsheet you also have the option of specifying both a financing rate and a reinvestment rate.
The financing rate refers to the rate at which you borrow the money needed for the invest-
ment, whereas the reinvestment rate is the rate at which you reinvest the cash flows. Generally,
it is assumed that these two values are one and the same. Thus, we enter the value of k, the
appropriate discount rate, for both of these values. Once the cash flows have been entered on
the spreadsheet, all you need to do is input the Excel MIRR function into a spreadsheet cell and
let the spreadsheet do the calculations for you. Of course, as with the IRR calculation, at least
one of the cash flows must be positive and at least one must be negative. The MIRR function
to be input into a spreadsheet cell is 5MIRR(values,finance rate,reinvestment rate), where
values is simply the range of cells where the cash flows are stored, and k is entered for both the
finance rate and the reinvestment rate.
Entered value in cell C20:
=MIRR(C15:C18,10%,10%)

Chapter 10 • Capital-Budgeting Techniques and Practice 325
Concept Check
1. Provide an intuitive definition of an internal rate of return for a project.
2. What does a net present value profile tell you, and how is it constructed?
3. What is the difference between the IRR and the MIRR?
4. Why do the net present value and profitability index always yield the same accept/reject decision
for any project?
Capital Rationing
The use of our capital-budgeting decision rules developed in this chapter implies that the
size of the capital budget is determined by the availability of acceptable investment propos-
als. However, a firm may place a limit on the dollar size of the capital budget. This situation is
called capital rationing. As we will see, examining capital rationing not only better enables
us to deal with complexities of the real world but also serves to demonstrate the superiority
of the NPV method over the IRR method for capital budgeting. It is always somewhat un-
comfortable to deal with problems associated with capital rationing because, under ration-
ing, projects with positive net present values are rejected. This is a situation that violates
the firm’s goal of shareholder wealth maximization. However, in the real world, capital
rationing does exist, and managers must deal with it. Often when firms impose capital
constraints, they are recognizing that they do not have the ability to profitably handle more
than a certain number of new and/or large projects.
Using the IRR as the firm’s decision rule, a firm accepts all projects with an IRR greater
than the firm’s required rate of return. This rule is illustrated in Figure 10-4, where projects
A through E would be chosen. However, when capital rationing is imposed, the dollar size
of the total investment is limited by the budget constraint. In Figure 10-4, the budget con-
straint of $X precludes the acceptance of an attractive investment, project E. This situation
obviously contradicts prior decision rules. Moreover, choosing the projects with the highest
IRR is complicated by the fact that some projects are indivisible. For example, it may be il-
logical to recommend that half of project D be undertaken.
The Rationale for Capital Rationing
In general, three principal reasons are given for imposing a capital-rationing constraint.
First, managers may think market conditions are temporarily adverse. In the period sur-
rounding the downturn in the economy in the late 2000s, this reason was frequently given.
At that time stock prices were depressed, which made the cost of funding projects high.
Second, there may be a shortage of qualified managers to direct new projects; this can hap-
pen when projects are of a highly technical nature. Third, there may be intangible consid-
erations. For example, managers may simply fear debt, wishing to avoid interest payments
at any cost. Or perhaps the firm wants to limit the issuance of common stock to maintain a
stable dividend policy.
3 Explain how the capital-
budgeting decision process
changes when a dollar limit is
placed on the capital budget.
capital rationing placing a limit on the dollar
size of the capital budget.
IR
R
(%
)
$X Dollars
Dollar budget constraint
(cutoff criterion under capital rationing)
Required rate of return
(cutoff criterion without
capital rationing)
A
B
C D
E
G
I J
H
F
FIgURE 10-4 Projects Ranked by the IRR

326 Part 3 • Investment in Long-Term Assets
So what is capital rationing’s effect on the firm? In brief, the effect is negative. To what
degree it is negative depends on the severity of the rationing. If the rationing is minor and
short-lived, the firm’s share price will not suffer to any great extent. In this case, capital
rationing can probably be excused, although it should be noted that any capital-rationing
action that rejects projects with positive NPVs is contrary to the firm’s goal of maximization
of shareholders’ wealth. If the capital rationing is a result of the firm’s decision to limit dra-
matically the number of new projects or to use only internally generated funds for projects,
then this policy will eventually have a significantly negative effect on the firm’s share price.
For example, a lower share price will eventually result from lost competitive advantage if,
because of a decision to arbitrarily limit its capital budget, a firm fails to upgrade its prod-
ucts and manufacturing processes.
Capital Rationing and Project selection
If a firm decides to impose a capital constraint on its investment projects, the appropriate
decision criterion is to select the set of projects with the highest NPV subject to the capital
constraint. In effect, it should select the projects that increase shareholders’ wealth the
most. This guideline may preclude merely taking the highest-ranked projects in terms of
the PI or the IRR. If the projects shown in Figure 10-4 are divisible, the last project accepted
will be only partially accepted. Although partial acceptance may be possible, as we have
said, in some cases, the indivisibility of most capital investments prevents it. For example,
purchasing half a sales outlet or half a truck is impossible.
Consider a firm with a budget constraint of $1 million and five indivisible projects
available to it, as given in Table 10-7. If the highest-ranked projects were taken, projects A
and B would be taken first. At that point there would not be enough funds available to take
on project C; hence, projects D and E would be taken on. However, a higher total NPV is
provided by the combination of projects A and C. Thus, projects A and C should be selected
from the set of projects available. This illustrates our guideline: to select the set of projects
that maximizes the firm’s NPV.
Concept Check
1. What is capital rationing?
2. How might capital rationing conflict with the goal of maximizing shareholders’ wealth?
3. What are mutually exclusive projects? How might they complicate the capital-budgeting process?
Ranking Mutually Exclusive Projects
In the past, we have proposed that all projects with a positive NPV, a PI greater than 1.0,
or an IRR greater than the required rate of return be accepted, assuming there is no capital
rationing. However, this acceptance is not always possible. In some cases, when two proj-
ects are judged acceptable by the discounted cash-flow criteria, it may be necessary to select
only one of them because they are mutually exclusive. Mutually exclusive projects are
projects that, if undertaken, would serve the same purpose. For example, a company considering
the installation of a computer system might evaluate three or four systems, all of which have
positive NPVs. However, the acceptance of one system automatically means rejection of the
others. In general, to deal with mutually exclusive projects, we simply rank them by means
Project Initial Outlay
Profitability
Index
Net Present
Value
A $200,000 2.4 $280,000
B 200,000 2.3 260,000
C 800,000 1.7 560,000
D 300,000 1.3 90,000
E 300,000 1.2 60,000
TaBLE 10-7 Capital Rationing: Choosing among Five Indivisible Projects
4 Discuss the problems encoun-
tered when deciding among
mutually exclusive projects.
mutually exclusive projects projects that,
if undertaken, would serve the same purpose.
Thus, accepting one will necessarily mean reject-
ing the others.

Chapter 10 • Capital-Budgeting Techniques and Practice 327
of the discounted cash-flow criteria and select the project with the highest ranking. On oc-
casion, however, problems of conflicting ranking may arise. As we will see, in general, the
NPV method is the preferred decision-making tool because it leads to the selection of the
project that increases shareholder wealth the most.
When dealing with mutually exclusive projects, there are three general types of ranking
problems: the size-disparity problem, the time-disparity problem, and the unequal-lives
problem. Each involves the possibility of conflict in the ranks yielded by the various dis-
counted cash-flow, capital-budgeting criteria. As noted previously, when one discounted
cash-flow criterion gives an accept signal, they will all give an accept signal, but they will
not necessarily rank all projects in the same order. In most cases this disparity is not critical;
however, for mutually exclusive projects the ranking order is important.
The size-Disparity Problem
The size-disparity problem occurs when mutually exclusive projects of unequal size are
examined. This problem is most easily clarified with an example.
E x a M P L E 10.6 The size-disparity problem
Suppose a firm is considering two mutually exclusive projects, A and B; both have re-
quired rates of return of 10 percent. Project A involves a $200 initial outlay and a cash
inflow of $300 at the end of year 1, whereas project B involves an initial outlay of $1,500
and a cash inflow of $1,900 at the end of year 1. The net present values, profitability
indexes, and internal rates of return for these projects are given in Table 10-8.
PROjECT a
k = 10%
YEaRs 0 1
Cash Flow
NPV = $72.73
PI = 1.36
IRR = 50%
-200 300
PROjECT B
k = 10%
YEaRs 0 1
Cash Flow
NPV = $227.28
PI = 1.15
IRR = 27%
-1,500 1,900
TaBLE 10-8 The size-Disparity Ranking Problem
In this case, if the NPV criterion is used, project B should be accepted; whereas if the PI
or IRR criterion is used, project A should be chosen. The question now becomes, which
project is better?
sTeP 1: ForMulATe A soluTion sTrATegy
The answer depends on whether capital rationing exists.
sTeP 2: CrunCh The nuMBers
Without capital rationing, project B is better because it provides the largest increase
in shareholders’ wealth; that is, it has a larger NPV. If there is a capital constraint, the
problem then focuses on what can be done with the additional $1,300 that is freed up if
project A is chosen (costing $200, as opposed to $1,500). If the firm can earn more on
project A plus the project financed with the additional $1,300 than it can on project B,
then project A and the marginal project should be accepted. In effect, we are attempting
to select the set of projects that maximize the firm’s NPV. Thus, if the marginal project
has an NPV greater than $154.55 ($227.28 – $72.73), selecting it plus project A with an
NPV of $72.73 will provide an NPV greater than $227.28, the NPV for project B.

328 Part 3 • Investment in Long-Term Assets
sTeP 3: AnAlyZe your resulTs
In summary, whenever the size-disparity problem results in conflicting rankings between
mutually exclusive projects, the project with the largest NPV will be selected, provided
there is no capital rationing. When capital rationing exists, the firm should select the set
of projects with the largest NPV.
The Time-Disparity Problem
The time-disparity problem and the conflicting rankings that accompany it result from the
differing reinvestment assumptions made by the net present value and internal rate of return
decision criteria. The NPV criterion assumes that cash flows over the life of the project can be
reinvested at the required rate of return or cost of capital, whereas the IRR criterion implicitly
assumes that the cash flows over the life of the project can be reinvested at the IRR. One pos-
sible solution to this problem is to use the MIRR method introduced earlier. As you recall, this
method allows you to explicitly state the rate at which cash flows over the life of the project
will be reinvested. Again, this problem may be illustrated through the use of an example.
E x a M P L E 10.7 The time-disparity problem
Suppose a firm with a required rate of return or cost of capital of 10 percent and with no
capital constraint is considering the two mutually exclusive projects illustrated in Table 10-9.
How to solve this time-disparity problem?
PROjECT a
k = 10%
YEaRs 0 1 2 3
Cash Flow
NPV = $758.83
PI = 1.759
IRR = 35%
-1,000 100 200 2,000
PROjECT B
k = 10%
YEaRs 0 1 2 3
Cash Flow
NPV = $616.45
PI = 1.616
IRR = 43%
-1,000 650 650 650
TaBLE 10-9 The Time-Disparity Ranking Problem
sTeP 1: ForMulATe A soluTion sTrATegy
Which criterion would be followed depends on which reinvestment assumption is used.
The NPV and PI indicate that project A is the better of the two, whereas the IRR indi-
cates that project B is the better. Project B receives its cash flows earlier than project A,
and the different assumptions made about how these flows can be reinvested result in the
difference in rankings.
sTeP 2: CrunCh The nuMBers
The NPV criterion assumes that cash flows over the life of the project can be reinvested at
the required rate of return or cost of capital, whereas the IRR criterion implicitly assumes
that the cash flows over the life of the project can be reinvested at the IRR.
sTeP 3: AnAlyZe your resulTs
The NPV criterion is preferred in this case because it makes the most acceptable assump-
tion for the wealth-maximizing firm. It is certainly the most conservative assumption
that can be made, because the required rate of return is the lowest possible reinvestment
rate. Moreover, as we have already noted, the NPV method maximizes the value of the
firm and the shareholders’ wealth.

Chapter 10 • Capital-Budgeting Techniques and Practice 329
The Unequal-Lives Problem
The final ranking problem to be examined asks whether it is appropriate to compare
mutually exclusive projects with different life spans. The incomparability of projects with
different lives arises because future, profitable investment proposals will be precluded
without ever having been considered. For example, let’s say you own an older hotel on
some prime beachfront property on Hilton Head Island, and you’re considering either
remodeling the hotel, which will extend its life by 5 years, or tearing it down and building
a new hotel that has an expected life of 10 years. Either way you’re going to make money
because beachfront property is exactly where everyone would like to stay. But clearly, you
can’t do both.
Is it fair to compare the NPVs on these two projects? No. Why not? Because if you
accept the 10-year project, you will not only be rejecting the 5-year project but also
the chance to do something else profitable with the property in years 5 through 10.
In effect, if the project with the shorter life were taken, at its termination you could
either remodel again or rebuild and receive additional benefits, whereas accepting the
project with the longer life would exclude this possibility, which is not included in the
analysis. The key question thus becomes: Does today’s investment decision include
all future profitable investment proposals in its analysis? If not, the projects are not
comparable.
E x a M P L E 10.8 The unequal-lives problem
Suppose a firm with a 10 percent required rate of return must replace an aging ma-
chine and is considering two replacement machines, one with a 3-year life and one
with a 6-year life. The relevant cash-flow information for these projects is given in
Figure 10-5.
NPV = $243.43
PI = 1.243
IRR = 23.4%
NPV = $306.58
PI = 1.307
IRR = 19.9%
YEARS 0
–1,000
–1,000
PROJECT A:
PROJECT B:
k = 10%
k = 10%
Cash Flows
YEARS 0 1
300
2
300
3
300
1
500
2
500
3
500
4
300
5
300
6
300Cash Flows
FIgURE 10-5 Unequal Lives Ranking Problem
Examining the discounted cash-flow criteria, we find that the net present value
and profitability index criteria indicate that project B is the better project, whereas
the internal rate of return favors project A. This ranking inconsistency is caused by
the different life spans of the projects being compared. In this case, the decision is a
difficult one because the projects are not comparable. How to solve this unequal-lives
problem?

330 Part 3 • Investment in Long-Term Assets
sTeP 1: ForMulATe A soluTion sTrATegy
There are several methods to deal with this situation. The first option is to assume that
the cash inflows from the shorter-lived investment will be reinvested at the required
rate of return until the termination of the longer-lived asset. Although this approach
is the simplest because it merely involves calculating the net present value, It actually
ignores the problem at hand—the possibility of undertaking another replacement op-
portunity with a positive net present value. Thus, the proper solution involves project-
ing reinvestment opportunities into the future—that is, making assumptions about
possible future investment opportunities. Unfortunately, whereas the first method is
too simplistic to be of any value, the second is extremely difficult, requiring extensive
cash-flow forecasts. The final technique for confronting the problem is to assume
that the firm’s reinvestment opportunities in the future will be similar to its current
ones. The two most common ways of doing this are by creating a replacement chain
to equalize the life spans of projects or by calculating the equivalent annual annuity
(EAA) of the projects.
Using a replacement chain, the present example would call for the creation of a
two-chain cycle for project A; that is, we assume that project A can be replaced with
a similar investment at the end of 3 years. Thus, project A would be viewed as two A
projects occurring back to back, as illustrated in Figure 10-6. The first project begins
with a $1,000 outflow in year 0, or the beginning of year 1. The second project would
have an initial outlay of $1,000 at the beginning of year 4, or end of year 3, followed
by $500 cash flows in years 4 through 6. As a result, in year 3 there would be a $500
inflow associated with the first project along with a $1,000 outflow associated with
repeating the project, resulting in a net cash flow in year 3 of -$500. The net present
value on this replacement chain is $426.32, which can be compared with project B’s
net present value.
NPV = $426.32
–1,000
k = 10%
YEARS 0 1
500
2
500
3
–500
4
500
5
500
6
500Cash Flows
FIgURE 10-6 Replacement Chain Illustration: Two Project a’s Back to Back
Therefore, project A should be accepted because the net present value of its replace-
ment chain is greater than the net present value of project B. One problem with replace-
ment chains is that, depending on the life of each project, it can be quite difficult to
come up with equivalent lives. For example, if the two projects had 7- and 13-year lives,
because the lowest common denominator is 7 * 13 = 91, a 91-year replacement chain
would be needed to establish equivalent lives. In this case, it is easier to determine the
project’s equivalent annual annuity (EAA). A project’s EAA is simply an annuity cash
flow that yields the same present value as the project’s NPV.
To calculate an EAA, we need only calculate a project’s NPV and then determine
what annual annuity (PMT on your financial calculator) it is equal to. This can be done
in two steps as follows:
STEP 1 Calculate the project’s NPV.
STEP 2 Calculate the EAA.
sTeP 2: CrunCh The nuMBers
STEP 1 Calculate the project’s NPV. In Figure 10-5 we determined that project A had
an NPV of $243.43, whereas project B had an NPV of $306.58.
STEP 2 Calculate the EAA. The EAA is determined by using the NPV as the project’s
present value (PV), the number of years in the project as N, the required rate
equivalent annual annuity (EAA) an
annuity cash flow that yields the same present
value as the project’s NPV.

Chapter 10 • Capital-Budgeting Techniques and Practice 331
of return as I/Y, entering a 0 for the future value (FV), and solving for the
annual annuity (PMT). This determines the level of an annuity cash flow
that would produce the same NPV as the project. For project A the calcula-
tions are:
Name of Tool Formula what It Tells You
Equivalent annual
annuity (EAA)
The annuity cash
flow that yields
the same present
value as the proj-
ect’s NPV
• It makes mutually exclusive projects with unequal
lives comparable by determining the level of an
annual annuity that produces an NPV equivalent to
the project’s NPV.
• The EAAs for projects with unequal lives can be com-
pared because they represent annual annuities.
FinanCial DeCision tools
CAlCulATor soluTion
Data Input Function Key
3 N
10 I/Y
-243.43 PV
0 FV
Function Key Answer
CPT
PMT 97.89
sTeP 3: AnAlyZe your resulTs
How do we interpret the EAA? For a project with an n-year life, it tells us what
the dollar value is of an n-year annual annuity that would provide the same NPV
as the project. Thus, for project A, it means that a 3-year annuity of $97.89 with
a discount rate of 10 percent would produce a net present value the same as proj-
ect A’s net present value, which is $243.43. We can now compare the equivalent
annual annuities directly to determine which project is better. We can do this
because we now have found the level of annual annuity that produces an NPV
equivalent to the project’s NPV. Thus, because they are both annual annuities,
they are comparable.
For project B, the calculations are:
CAlCulATor soluTion
Data Input Function Key
6 N
10 I/Y
−306.58 PV
0 FV
Function Key Answer
CPT
PMT 70.39
Concept Check
1. What are the three general types of ranking problems?

332 Part 3 • Investment in Long-Term Assets
ethiCs in FinanCial ManaGeMent
The FinAnCiAl downside oF Poor eThiCAl BehAvior
As we discussed in Chapter 1, ethics and trust are essential ele-
ments of the business world. Knowing the inevitable outcome—
for truth does percolate—why do bright and experienced
people ignore it? For even if the truth is known only within the
confines of the company, it will get out. Circumstances beyond
even the best manager’s control take over once the chance has
passed to act on the moment of truth. Consider the following
cases:
Dow Corning didn’t deserve its bankruptcy or the multibillion-
dollar settlements for its silicone implants because the science
didn’t support the alleged damages. However, there was a mo-
ment of truth when those implants, placed on a blotter, left a
stain. The company could have disclosed the possible leakage,
researched the risk, and warned doctors and patients. Given the
congressional testimony on the implants, many women would
have chosen them despite the risk. Instead, they sued because
they were not warned.
Beech-Nut’s crisis was a chemical concoction instead of ap-
ple juice in its baby food products. Executives there ignored an
in-house chemist who tried to tell them they were selling adul-
terated products.
Kidder-Peabody fell despite warnings from employees about
a glitch in its accounting system that was reporting bond swaps
as sales and income.
In 2004, Merck removed one of the world’s best-selling pain-
killers from the market after a study showed Vioxx caused an in-
creased risk of serious cardiovascular events, such as stroke and
heart attack. Producing Vioxx wasn’t Merck’s problem; its prob-
lem was that, according to an editorial in the New England Jour-
nal of Medicine, Merck was alleged to have withheld data and
information that would affect conclusions drawn in an earlier
study that appeared in the New England Journal of Medicine in
2000. Now, Merck faces thousands of lawsuits, and studies con-
tinue to deliver bad news about the drug. In fact, in one case, a
jury awarded $51 million to a retired FBI agent who suffered a
heart attack after taking the drug.
As a now-infamous memo reveals, Ford and Firestone did
not feel obligated to reveal to the U.S. Transportation Depart-
ment that certain tires were being recalled in overseas markets.
The companies should have realized that it was not a question
of whether the recall would be reported but by whom.
These cases all have several things in common. First, their
moments of truth came and went while the companies took no
action. Second, employees who raised the issue were ignored
or, in some cases, fired. Third, there were lawyers along for the
ride, as they were with Ford and Firestone.
Never rely on a lawyer in these moments of truth. Lawyers
are legal experts but are not particularly good at controlling
damage. They shouldn’t make business decisions; managers
should. More importantly, moments of truth require managers
with strong ethics who will do more than the law requires.
Do businesses ever face a moment of truth wisely? One ex-
ample is Foxy brand lettuce, which in 2006, shortly after E. coli–
contaminated spinach was linked to three deaths, recalled all
its lettuce after it discovered irrigation water on its farms tested
positive for the bacterium. Although the lettuce was not found
to be carrying any bacterium, it did everything possible to pro-
tect the public and, as a result, has very loyal customers.
Source: Kevin Kingsbury, “Corporate News: Merck Settles Claims Over Vioxx
Ads,” Wall Street Journal, May 21, 2008, p. B3; “Manager’s Journal: Ford-Firestone
Lesson: Heed the Moment of Truth,” Wall Street Journal, September 11, 2000,
p. A44; “Foxy’s lettuce recalled after E. coli scare,” USA Today, October 9, 2006,
p. A10; and Joe Queenan, “Juice Men—Ethics and the Beech-Nut Sentences,”
Barron’s, June 20, 1988, p. 14.
Chapter summaries
Discuss the difficulty encountered in finding profitable projects in competitive
markets and the importance of the search. (pgs. 305–306)
sUMMaRY: The process of capital budgeting involves decision making with respect to invest-
ments in fixed assets. Before a profitable project can be adopted, it must be identified or found.
Unfortunately, coming up with ideas for new products, for ways to improve existing products, or
for ways to make existing products more profitable is extremely difficult. In general, the best source
of ideas for new, potentially profitable products is within the firm.
KEY TERM
1
Capital budgeting, page 305 The process of
decision making with respect to investments
made in fixed assets—that is, should a proposed
project be accepted or rejected.

Chapter 10 • Capital-Budgeting Techniques and Practice 333
Determine whether a new project should be accepted or rejected using the
payback period, the net present value, the profitability index, and the
internal rate of return. (pgs. 307–325)
Summary: We examine four commonly used criteria for determining the acceptance or rejection
of capital-budgeting proposals. The first method, the payback period, does not incorporate the time
value of money into its calculations. However, the net present value, profitability index, and internal
rate of return methods do account for the time value of money. These methods are summarized in
Table 10-10.
2
1A. Payback period = number of years required to recapture the initial investment from the free cash flows
Accept if payback period … maximum acceptable payback period
Reject if payback period 7 maximum acceptable payback period
advantages: Disadvantages:
• Uses free cash flows. • Ignores the time value of money.
• Is easy to calculate and understand. • Ignores cash flows occurring after the payback period.
• Benefits the capital-constrained firm. • Selection of the maximum acceptable payback period is
• May be used as rough screening device. arbitrary.
1B. Discounted payback period = the number of years needed to recover the initial cash outlay from the
discounted free cash flows
Accept if discounted payback … maximum acceptable discounted payback period
Reject if discounted payback 7 maximum acceptable discounted payback period
advantages: Disadvantages:
• Uses cash flows. • Ignores cash flows occurring after the payback period.
• Is easy to calculate and understand. • Selection of the maximum acceptable discounted payback
• Considers time value of money. period is arbitrary.
2. Net present value = present value of the future free cash flows less the investment’s initial outlay
NPV = present value of all the future annual free cash flows – the initial cash outlay
Accept if NPV Ú 0.0
Reject if NPV 6 0.0
advantages: Disadvantage:
• Uses free cash flows. • Requires detailed long-term forecasts of a project’s cash flows.
• Recognizes the time value of money.
• Is consistent with the firm’s goal of
shareholder wealth maximization.
3. Profitability index = the ratio of the present value of the future free cash flows to the initial outlay.
Accept if PI Ú 1.0
Reject if PI 6 1.0
advantages: Disadvantage:
• Uses free cash flows. • Requires detailed long-term forecasts of a project’s cash flows.
• Recognizes the time value of money.
• Is consistent with the firm’s goal of shareholder wealth maximization.
4A. Internal rate of return = the discount rate that equates the present value of the project’s future free cash
flows with the project’s initial outlay
IRR = the rate of return that equates the present value of the project’s free cash flows with the initial outlay
Accept if IRR Ú required rate of return
Reject if IRR 6 required rate of return
advantages: Disadvantages:
• Uses free cash flows. • Requires detailed long-term forecasts of a project’s cash flows.
• Recognizes the time value of money. • Possibility of multiple IRRs.
• Is, in general, consistent with the firm’s • Assumes cash flows over the life of the project can be
goal of shareholder wealth maximization. reinvested at the IRR.
Table 10-10 Capital-budgeting methods: a Summary
(Continued)

334 Part 3 • Investment in Long-Term Assets
Key equaTionS
Payback period =
number of years just
prior to complete
payback
+
unpaid@back amount
at beginning of year
free cash flow in year
payback is completed
Discounted
payback
period
=
number of years just prior
to complete payback
from discounted free
cash flows
+
unpaid@back amount at
the beginning
of year
discounted free cash
flow in year
payback is completed
Net present value =
FCF1
(1 + k)1
+
FCF2
(1 + k)2
+ g +
FCFn
(1 + k)n
– IO
Profitability index (PI ) or benefit-cost ratio =
FCF1
(1 + k)1
+
FCF2
(1 + k)2
+ g +
FCFn
(1 + k)n
IO
Internal rate of return (IRR): IO =
FCF1
(1 + IRR)1
+
FCF2
(1 + IRR)2
+ g +
FCFn
(1 + IRR)n
Modified internal rate of return (MIRR): PVoutflows =
TVinflows
(1 + MIRR)n
Payback period, page 307 The number of
years it takes to recapture a project’s initial
outlay.
Discounted payback period, page 308 The
number of years it takes to recapture a project’s
initial outlay from the discounted free cash
flows.
Net present value (NPV), page 310 The
present value of an investment’s annual free
cash flows less the investment’s initial outlay.
Profitability Index (PI) or benefit–cost
ratio, page 313 The ratio of the present value
of an investment’s future free cash flows to the
investment’s initial outlay.
Internal rate of return (IRR), page 316 The
rate of return that the project earns. For com-
putational purposes, the internal rate of return
is defined as the discount rate that equates the
present value of the project’s free cash flows
with the project’s initial cash outlay.
Net present value profile, page 319 A graph
showing how a project’s NPV changes as the
discount rate changes.
Modified internal rate of return (MIRR),
page 321 The discount rate that equates
the present value of the project’s future free
cash flows with the terminal value of the cash
inflows.
Key TermS
Table 10-10 (Continued)
4B. Modified internal rate of return = the discount rate that equates the present value of the cash outflows with
the terminal value of the cash inflows
Accept if MIRR Ú required rate of return
Reject if MIRR 6 required rate of return
advantages: Disadvantage:
• Uses free cash flows. • Requires detailed long-term cash-flow forecasts.
• Recognizes the time value of money.
• Is consistent with the firm’s goal of
shareholder wealth maximization.
• Allows reinvestment rate to be directly
specified.

Chapter 10 • Capital-Budgeting Techniques and Practice 335
Explain how the capital-budgeting decision process changes when a dollar
limit is placed on the capital budget. (pgs. 325–326)
3
sUMMaRY: There are several complications related to the capital-budgeting process. First, we
examined capital rationing and the problems it can create by imposing a limit on the dollar size of
the capital budget. Although capital rationing does not, in general, maximize shareholders’ wealth,
it does exist. The goal of maximizing shareholders’ wealth remains, but it is now subject to a budget
constraint.
KEY TERM
Capital rationing, page 325 Placing a limit
on the dollar size of the capital budget.
Discuss the problems encountered when deciding among mutually
exclusive projects. (pgs. 326–331)
sUMMaRY: There are a number of problems associated with evaluating mutually exclusive proj-
ects. Mutually exclusive projects occur when different investments, if undertaken, would serve the
same purpose. In general, to deal with mutually exclusive projects, we rank them by means of the
discounted cash-flow criteria and select the project with the highest ranking. Conflicting rankings
can arise because of the projects’ size disparities, time disparities, and unequal lives. The incompa-
rability of projects with different life spans is not simply a result of the different life spans; rather, it
arises because future profitable investment proposals will be rejected without being included in the
initial analysis. Replacement chains and equivalent annual annuities can solve this problem.
A perpetuity is an annuity that continues forever; that is, every year following its establishment the
investment pays the same dollar amount. An example of a perpetuity is preferred stock, which pays
a constant dollar dividend infinitely. Determining the present value of a perpetuity is delightfully
simple. We merely need to divide the constant flow by the discount rate.
KEY TERMs
4
Mutually exclusive projects, page 326
Projects that, if undertaken, would serve the
same purpose. Thus, accepting one will neces-
sarily mean rejecting the others.
Equivalent annual annuity (EAA), page 330
An annuity cash flow that yields the same
present value as the project’s NPV.
Review questions
All Review Questions are available in MyFinanceLab.
10-1. Why is capital budgeting such an important process? Why are capital-budgeting errors so costly?
10-2. What are the disadvantages of using the payback period as a capital-budgeting technique?
What are its advantages? Why is it so frequently used?
10-3. In some countries, the expropriation (seizure) of foreign investments is a common practice.
If you were considering an investment in one of those countries, would the use of the payback
period criterion seem more reasonable than it otherwise might? Why or why not?
10-4. Briefly compare and contrast the NPV, PI, and IRR criteria. What are the advantages and
disadvantages of using each of these methods?
10-5. What are mutually exclusive projects? Why might the existence of mutually exclusive proj-
ects cause problems in the implementation of the discounted cash-flow capital-budgeting criteria?
10-6. What are common reasons for capital rationing? Is capital rationing rational?
10-7. How should managers compare two mutually exclusive projects of unequal size? Should the
approach change if capital rationing is a factor?
10-8. What causes the time-disparity ranking problem? What reinvestment rate assumptions are
associated with the NPV and IRR capital-budgeting criteria?
10-9. When might two mutually exclusive projects having unequal lives be incomparable? How
should managers deal with this problem?

336 Part 3 • Investment in Long-Term Assets
Study Problems
All Study Problems are available in MyFinanceLab.
10-1. (IRR calculation) Determine the IRR on the following projects:
a. An initial outlay of $10,000 resulting in a single free cash flow of $17,182 after 8 years
b. An initial outlay of $10,000 resulting in a single free cash flow of $48,077 after 10 years
c. An initial outlay of $10,000 resulting in a single free cash flow of $114,943 after 20 years
d. An initial outlay of $10,000 resulting in a single free cash flow of $13,680 after 3 years
10-2. (IRR calculation) Determine the IRR on the following projects:
a. An initial outlay of $10,000 resulting in a free cash flow of $1,993 at the end of each year
for the next 10 years
b. An initial outlay of $10,000 resulting in a free cash flow of $2,054 at the end of each year
for the next 20 years
c. An initial outlay of $10,000 resulting in a free cash flow of $1,193 at the end of each year
for the next 12 years
d. An initial outlay of $10,000 resulting in a free cash flow of $2,843 at the end of each year
for the next 5 years
10-3. (IRR calculation) Determine to the nearest percent the IRR on the following projects:
a. An initial outlay of $10,000 resulting in a free cash flow of $2,000 at the end of year 1,
$5,000 at the end of year 2, and $8,000 at the end of year 3
b. An initial outlay of $10,000 resulting in a free cash flow of $8,000 at the end of year 1,
$5,000 at the end of year 2, and $2,000 at the end of year 3
c. An initial outlay of $10,000 resulting in a free cash flow of $2,000 at the end of years 1
through 5 and $5,000 at the end of year 6
10-4. (NPV, PI, and IRR calculations) Fijisawa Inc. is considering a major expansion of its product
line and has estimated the following cash flows associated with such an expansion. The initial outlay
would be $1,950,000, and the project would generate incremental free cash flows of $450,000 per
year for 6 years. The appropriate required rate of return is 9 percent.
a. Calculate the NPV.
b. Calculate the PI.
c. Calculate the IRR.
d. Should this project be accepted?
10-5. (Payback period, NPV, PI, and IRR calculations) You are considering a project with an initial
cash outlay of $80,000 and expected free cash flows of $20,000 at the end of each year for 6 years.
The required rate of return for this project is 10 percent.
a. What is the project’s payback period?
b. What is the project’s NPV ?
c. What is the project’s PI ?
d. What is the project’s IRR ?
10-6. (NPV, PI, and IRR calculations) You are considering two independent projects, project A and
project B. The initial cash outlay associated with project A is $50,000, and the initial cash outlay as-
sociated with project B is $70,000. The required rate of return on both projects is 12 percent. The
expected annual free cash inflows from each project are as follows:
2
P r o j e c t A P r o j e c t B
Initial outlay -$50,000 -$70,000
Inflow year 1 12,000 13,000
Inflow year 2 12,000 13,000
Inflow year 3 12,000 13,000
Inflow year 4 12,000 13,000
Inflow year 5 12,000 13,000
Inflow year 6 12,000 13,000
Calculate the NPV, PI, and IRR for each project and indicate if the project should be accepted.

Chapter 10 • Capital-Budgeting Techniques and Practice 337
10-7. (Payback period calculations) You are considering three independent projects, project A,
project B, and project C. Given the following cash-flow information, calculate the payback period
for each.
P R O j E C T a P R O j E C T B P R O j E C T C
Initial outlay -$1,000 -$10,000 -$5,000
Inflow year 1 600 5,000 1,000
Inflow year 2 300 3,000 1,000
Inflow year 3 200 3,000 2,000
Inflow year 4 100 3,000 2,000
Inflow year 5 500 3,000 2,000
P R O j E C T a P R O j E C T B P R O j E C T C
Initial outlay -$50,000 -$100,000 -$450,000
Cash inflows:
Year 1 $10,000 $125,000 $200,000
Year 2 15,000 25,000 200,000
Year 3 20,000 25,000 200,000
Year 4 25,000 25,000 —
Year 5 30,000 25,000 —
If you require a 3-year payback before an investment can be accepted, which project(s) would be
accepted?
10-8. (NPV with varying required rates of return) Gubanich Sportswear is considering building a
new factory to produce aluminum baseball bats. This project would require an initial cash outlay of
$5,000,000 and will generate annual free cash inflows of $1,000,000 per year for 8 years. Calculate
the project’s NPV given:
a. A required rate of return of 9 percent
b. A required rate of return of 11 percent
c. A required rate of return of 13 percent
d. A required rate of return of 15 percent
10-9. (IRR calculations) Given the following free cash flows, determine the IRR for the three inde-
pendent projects A, B, and C.
10-10. (NPV with varying required rates of return) Big Steve’s, a maker of swizzle sticks, is consider-
ing the purchase of a new plastic stamping machine. This investment requires an initial outlay of
$100,000 and will generate free cash inflows of $18,000 per year for 10 years.
a. If the required rate of return is 10 percent, what is the project’s NPV?
b. If the required rate of return is 15 percent, what is the project’s NPV?
c. Would the project be accepted under part (a) or (b)?
d. What is the project’s IRR?
10-11. (NPV with different required rates of return) Mooby’s is considering building a new theme
park. After estimating the future cash flows, but before the project could be evaluated, the economy
picked up and with that surge in the economy interest rates rose. That rise in interest rates was
reflected in the required rate of return Mooby’s used to evaluate new products. As a result, the
required rate of return for the new theme park jumped from 9.5 percent to 11.00 percent. If the
initial outlay for the park is expected to be $250 million and the project is expected to return free
cash flows of $50 million in years 1 through 5 and $75 million in years 6 and 7, what is the project’s
NPV using the new required rate of return? How much did the project’s NPV change as a result of
the rise in interest rates?
10-12. (IRR with uneven cash flows) The Tiffin Barker Corporation is considering introducing a
new currency verifier that has the ability to identify counterfeit dollar bills. The required rate of

338 Part 3 • Investment in Long-Term Assets
return on this project is 12 percent. What is the IRR on this project if it is expected to produce the
following cash flows?
Initial outlay -$927,917
FCF in year 1 200,000
FCF in year 2 300,000
FCF in year 3 300,000
FCF in year 4 200,000
FCF in year 5 200,000
FCF in year 6 160,000
10-13. (NPV calculation) Calculate the NPV given the following cash flows if the appropriate re-
quired rate of return is 10%.
Y E a R C a s h F LO w s
0 -$60,000
1 20,000
2 20,000
3 10,000
4 10,000
5 30,000
6 30,000
Y E a R C a s h F LO w s
0 -$70,000
1 30,000
2 30,000
3 30,000
4 -30,000
5 30,000
6 30,000
Should the project be accepted?
10-14. (NPV calculation) Calculate the NPV given the following cash flows if the appropriate re-
quired rate of return is 10%.
Y E a R C a s h F LO w s
0 -$50,000
1 25,000
2 25,000
3 25,000
4 -25,000
5 25,000
6 25,000
Should the project be accepted?
10-15. (MIRR calculation) Calculate the MIRR given the following cash flows if the appropriate
required rate of return is 10% (use this as the reinvestment rate).
Should the project be accepted?

Chapter 10 • Capital-Budgeting Techniques and Practice 339
10-16. (PI calculation) Calculate the PI given the following cash flows if the appropriate required
rate of return is 10%.
Y e A r c A s h F lo W s
0 -$55,000
1 10,000
2 10,000
3 10,000
4 10,000
5 10,000
6 10,000
Y e A r
P r o j e c t
c A s h F lo W
0 -$150 million
1 90 million
2 70 million
3 90 million
4 100 million
Y e A r
P r o j e c t
c A s h F lo W
0 -$50,000
1 20,000
2 20,000
3 20,000
4 20,000
Should the project be accepted? Without calculating the NPV, do you think it would be positive
or negative? Why?
10-17. (Discounted payback period) Gio’s Restaurants is considering a project with the following
expected cash flows:
If the project’s appropriate discount is 12 percent, what is the project’s discounted payback?
10-18. (Discounted payback period) You are considering a project with the following cash flows:
If the appropriate discount rate is 10 percent, what is the project’s discounted payback period?
10-19. (Discounted payback period) Assuming an appropriate discount rate of 11 percent, what is the
discounted payback period on a project with an initial outlay of $100,000 and the following cash flows?
Year 1 = $30,000
Year 2 = $35,000
Year 3 = $25,000
Year 4 = $25,000
Year 5 = $30,000
Year 5 = $20,000
10-20. (IRR) Jella Cosmetics is considering a project that costs $800,000, and is expected to last for
10 years and produce future cash flows of $175,000 per year. If the appropriate discount rate for
this project is 12 percent, what is the project’s IRR?
10-21. (IRR) Your investment advisor has offered you an investment that will provide you with one
cash flow of $10,000 at the end of 20 years if you pay premiums of $200 per year at the end of each
year for 20 years. Find the internal rate of return on this investment.

340 Part 3 • Investment in Long-Term Assets
10-22. (IRR, payback, and calculating a missing cash flow) Mode Publishing is considering a new print-
ing facility that will involve a large initial outlay and then result in a series of positive cash flows for
4 years. The estimated cash flows associated with this project are:
Y e A r
P r o j e c t
c A S h F lo W
0 -$100,000
1 20,000
2 60,000
3 70,000
4 50,000
5 40,000
If you know that the project has a regular payback of 2.5 years, what is the project’s internal rate
of return?
10-23. (Discounted payback period) Sheinhardt Wig Company is considering a project that has the
following cash flows:
P r o j e c t co S t P r o F I tA B I l I t Y I N D e x
A $4,000,000 1.18
B 3,000,000 1.08
C 5,000,000 1.33
D 6,000,000 1.31
E 4,000,000 1.19
F 6,000,000 1.20
G 4,000,000 1.18
If the appropriate discount rate is 10 percent, what is the project’s discounted payback?
10-24. (IRR of uneven cash-flow stream) Microwave Oven Programming, Inc. is considering the con-
struction of a new plant. The plant will have an initial cash outlay of $7 million, and will produce
cash flows of $3 million at the end of year 1, $4 million at the end of year 2, and $2 million at the
end of years 3 through 5. What is the internal rate of return on this new plant?
10-25. (MIRR) Dunder Mifflin Paper Company is considering purchasing a new stamping ma-
chine that costs $400,000. This new machine will produce cash inflows of $150,000 each year at
the end of years 1 through 5, then at the end of year 7 there will be a cash outflow of $200,000. The
company has a weighted average cost of capital of 12 percent (use this as the reinvestment rate).
What is the MIRR of the investment?
10-26. (MIRR calculation) Artie’s Wrestling Stuff is considering building a new plant. This plant
would require an initial cash outlay of $8 million and will generate annual free cash inflows of
$2 million per year for 8 years. Calculate the project’s MIRR given:
a. A required rate of return of 10 percent
b. A required rate of return of 12 percent
c. A required rate of return of 14 percent
10-27. (Capital rationing) The Cowboy Hat Company of Stillwater, Oklahoma, is considering
seven capital investment proposals for which the total funds available are limited to a maximum of
$12 million. The projects are independent and have the following costs and profitability indexes
associated with them:
3
Y e A r
P r o j e c t
c A S h F lo W
0 (initial outlay) ?
1 $800 million
2 400 million
3 300 million
4 500 million

Chapter 10 • Capital-Budgeting Techniques and Practice 341
a. Under strict capital rationing, which projects should be selected?
b. What problems are there with capital rationing?
10-28. (Mutually exclusive projects) Nanotech, Inc. currently has a production electronics facility and
it is cost-prohibitive to expand this production facility. Nanotech is deciding between the following
four contracts:
Co n t r aC t ’s N P V U s e o f P r o d U C t i o n faC i l i t y
A $100 million 100%
B $ 90 million 80%
C $ 60 million 60%
D $ 50 million 40%
y e a r
P r o j e C t a
C a s h f lo w
P r o j e C t B
C a s h f lo w
0 -$100,000 -$100,000
1 33,000 0
2 33,000 0
3 33,000 0
4 33,000 0
5 33,000 220,000
Which project or projects should they accept?
10-29. (Mutually exclusive projects and NPV) You have been assigned the task of evaluating two mu-
tually exclusive projects with the following projected cash flows:
P r o j e C t a P r o j e C t B
Initial outlay -$500 -$5,000
Inflow year 1 700 6,000
P r o j e C t a P r o j e C t B
Initial outlay -$50,000 -$ 50,000
Inflow year 1 15,625 0
Inflow year 2 15,625 0
Inflow year 3 15,625 0
Inflow year 4 15,625 0
Inflow year 5 15,625 100,000
If the appropriate discount rate on these projects is 10 percent, which would be chosen and why?
10-30. (Size-disparity problem) The D. Dorner Farms Corporation is considering purchasing one of
two fertilizer-herbicides for the upcoming year. The more expensive of the two is better and will
produce a higher yield. Assume these projects are mutually exclusive and that the required rate of
return is 10 percent. Given the following free cash flows:
a. Calculate the NPV of each project.
b. Calculate the PI of each project.
c. Calculate the IRR of each project.
d. If there is no capital-rationing constraint, which project should be selected? If there is a
capital-rationing constraint, how should the decision be made?
10-31. (Time-disparity problem) The State Spartan Corporation is considering two mutually exclu-
sive projects. The free cash flows associated with those projects are as follows:

342 Part 3 • Investment in Long-Term Assets
The required rate of return on these projects is 10 percent.
a. What is each project’s payback period?
b. What is each project’s NPV ?
c. What is each project’s IRR ?
d. What has caused the ranking conflict?
e. Which project should be accepted? Why?
10-32. (Replacement chains) Destination Hotels currently owns an older hotel on the best beach-
front property on Hilton Head Island, and it is considering either remodeling the hotel or tearing it
down and building a new convention hotel, but because they both would occupy the same physical
location, the company can only do one—that is, these are mutually exclusive projects. Both these
projects have the same initial outlay of $1,000,000. The first project, since it is a remodel of an
existing hotel, has an expected life of 8 years and will provide free cash flows of $250,000 at the
end of each year for all 8 years. In addition, this project can be repeated at the end of 8 years at
the same cost and with the same set of future cash flows. The proposed new convention hotel has
an expected life of 16 years and will produce cash flows of $175,000 per year. The required rate
of return on both of these projects is 10 percent. Calculate the NPV using replacement chains to
compare these two projects.
10-33. (Equivalent annual annuity) Rib & Wings-R-Us is considering the purchase of a new smoker
oven for cooking barbecue, ribs, and wings. It is looking at two different ovens. The first is a rela-
tively standard smoker and would cost $50,000, last for 8 years, and produce annual cash flows of
$16,000 per year. The alternative is the deluxe, award-winning Smoke-alator, which costs $78,000
and, because of its patented humidity control, produces the “moistest, tastiest barbecue in the
world.” The Smoke-alator would last for 11 years and produce cash flows of $23,000 per year.
Assuming a 10 percent required rate of return on both projects, compute their equivalent annual
annuity (EAA).
Mini Case
This Mini Case is available in MyFinanceLab.
Your first assignment in your new position as assistant financial analyst at Caledonia Products is to
evaluate two new capital-budgeting proposals. Because this is your first assignment, you have been
asked not only to provide a recommendation but also to respond to a number of questions aimed at
assessing your understanding of the capital-budgeting process. This is a standard procedure for all
new financial analysts at Caledonia, and it will serve to determine whether you are moved directly
into the capital-budgeting analysis department or are provided with remedial training. The memo-
randum you received outlining your assignment follows:
To: The New Financial Analysts
From: Mr. V. Morrison, CEO, Caledonia Products
Re: Capital-Budgeting Analysis
Provide an evaluation of two proposed projects, both with 5-year expected lives and identical initial
outlays of $110,000. Both of these projects involve additions to Caledonia’s highly successful Avalon
product line, and as a result, the required rate of return on both projects has been established at
12 percent. The expected free cash flows from each project are as follows:
P r o j e C t a P r o j e C t B
Initial outlay −$110,000 −$110,000
Inflow year 1 20,000 40,000
Inflow year 2 30,000 40,000
Inflow year 3 40,000 40,000
Inflow year 4 50,000 40,000
Inflow year 5 70,000 40,000

Chapter 10 • Capital-Budgeting Techniques and Practice 343
In evaluating these projects, please respond to the following questions:
a. Why is the capital-budgeting process so important?
b. Why is it difficult to find exceptionally profitable projects?
c. What is the payback period on each project? If Caledonia imposes a 3-year maximum ac-
ceptable payback period, which of these projects should be accepted?
d. What are the criticisms of the payback period?
e. Determine the NPV for each of these projects. Should they be accepted?
f. Describe the logic behind the NPV.
g. Determine the PI for each of these projects. Should they be accepted?
h. Would you expect the NPV and PI methods to give consistent accept/reject decisions?
Why or why not?
i. What would happen to the NPV and PI for each project if the required rate of return in-
creased? If the required rate of return decreased?
j. Determine the IRR for each project. Should they be accepted?
k. How does a change in the required rate of return affect the project’s internal rate of return?
l. What reinvestment rate assumptions are implicitly made by the NPV and IRR methods?
Which one is better?
You have also been asked for your views on three unrelated sets of projects. Each set of projects
involves two mutually exclusive projects. These projects follow.
m. Caledonia is considering two investments with 1-year lives. The more expensive of the two
is the better and will produce more savings. Assume these projects are mutually exclusive
and that the required rate of return is 10 percent. Given the following free cash flows:
P r o j e c t A P r o j e c t B
Initial outlay -$195,000 -$1,200,000
Inflow year 1 240,000 1,650,000
1. Calculate the NPV for each project.
2. Calculate the PI for each project.
3. Calculate the IRR for each project.
4. If there is no capital-rationing constraint, which project should be selected? If there is a
capital-rationing constraint, how should the decision be made?
n. Caledonia is considering two additional mutually exclusive projects. The free cash flows
associated with these projects are as follows:
P r o j e c t A P r o j e c t B
Initial outlay -$100,000 -$100,000
Inflow year 1 32,000 0
Inflow year 2 32,000 0
Inflow year 3 32,000 0
Inflow year 4 32,000 0
Inflow year 5 32,000 200,000
The required rate of return on these projects is 11 percent.
1. What is each project’s payback period?
2. What is each project’s NPV ?
3. What is each project’s IRR ?
4. What has caused the ranking conflict?
5. Which project should be accepted? Why?

Cash Flows and Other Topics
in Capital Budgeting
Learning Objectives
1 Identify guidelines by which we measure cash flows. Guidelines for Capital Budgeting
2 Explain how a project’s benefits and costs—that is, its Calculating a Project’s Free Cash Flows
free cash flows—are calculated.
3 Explain the importance of options, or flexibility, in Options in Capital Budgeting
capital budgeting.
4 Understand, measure, and adjust for project risk. Risk and the investment Decisions
344
In 2001, when Toyota introduced the first-generation model of its gas-electric hybrid car, the Prius, it seemed
more like a little science experiment than real competition for the auto industry. In fact, in 2004, General Mo-
tors vice chairman Bob Lutz dismissed hybrids as “an interesting curiosity.” But that’s all changed. As gas prices
climbed to around $4 a gallon in 2008, suddenly the gas-electric hybrid car seemed to be the way to go. In fact,
from its humble beginnings in 2001 through April 2012 Toyota sold a total of 4 million hybrids and today is
selling them at a pace of over 1 million per year.
How did Toyota gain leadership in the gas-electric hybrid car market? It started with its capital-
budgeting decision to enter the gas-electric hybrid car market with the Prius and a very large investment—
in excess of $1 billion. This action vaulted Toyota into the lead in the hybrid car market and could leave
Toyota in great shape for the future if ExxonMobil is right in its forecast that by 2040, hybrids and other
advanced vehicles will account for nearly 50 percent of light-duty vehicles on the road, compared to only
about 1 percent today.
Still, according to many analysts, the Prius is not yet a big money maker for Toyota. In fact, when the Prius
first came out, Toyota had it priced so that it was losing about $3,000 on each car it sold. For the Prius to be
profitable there needed to be enough in the way of sales to cover its fixed costs, and that has finally happened
as sales on the Prius have soared.
Toyota’s initial decision to introduce the Prius and enter the hybrid car market was a difficult one.
Would it simply move Toyota customers from one Toyota car to another, or would it bring new customers
to Toyota? Was this a chance to gain a foothold on the new technology of the future, or were hybrid cars
simply a fad?
11

How did Toyota make the deci-
sion to go ahead with the Prius and
the flexible-fuel car? lt used the ba-
sic techniques described in the pre-
vious chapter; but before it could
apply those techniques, Toyota had
to come up with the cash-flow fore-
casts and adjust for the risk associ-
ated with the project. That’s what
we’ll be looking at in this chapter.
Guidelines for Capital Budgeting
To evaluate investment proposals, we must first set guidelines by which we measure
the value of each proposal. In effect, we are deciding what is and what isn’t a relevant
cash flow.
Use Free Cash Flows Rather Than Accounting Profits
We use free cash flows, not accounting profits, as our measurement. The firm receives
and is able to reinvest free cash flows, whereas accounting profits are shown when they are
earned rather than when the money is actually in hand. Unfortunately, a firm’s account-
ing profits and free cash flows may not be timed to occur together. For example, capital
expenses, such as vehicles and plant and equipment, are depreciated over several years, with
their annual depreciation subtracted from profits. Free cash flows correctly reflect the tim-
ing of benefits and costs—that is, when the money is received, when it can be reinvested,
and when it must be paid out.
Think Incrementally
Unfortunately, calculating free cash flows from a project may not be enough. Decision
makers must ask, What new free cash flows will the company as a whole receive if the company
takes on a given project? What if the company does not take on the project? Interestingly, we
may find that not all cash flows a firm expects from an investment proposal are incremental
in nature. When measuring free cash flows, however, the trick is to think incrementally.
In doing so, we will see that only incremental after-tax free cash flows matter. As such, our
guiding rule in deciding if a free cash flow is incremental is to look at the company with,
versus without, the new project. As you will see in the upcoming sections, this may be easier
said than done.
Beware of Cash Flows Diverted from
Existing Products
Assume for a moment that we are managers of a firm consid-
ering a new product line that might compete with one of our
existing products and possibly reduce its sales. In determin-
ing the free cash flows associated with the proposed project,
we should consider only the incremental sales brought to the
company as a whole. New-product sales achieved at the cost
345345
1 Identify guidelines by which
we measure cash flows.
RememBeR YOuR PRinCiPles
If we are to make intelligent capital-budgeting de-
cisions, we must accurately measure the timing of a project’s
benefits and costs, that is, when we receive money and when
it leaves our hands. Principle 1: Cash Flow Is What Matters
speaks directly to this. Remember, it is cash inflows that can be
reinvested and cash outflows that involve paying out money.
rinciple

346 Part 3 • Investment in Long-Term Assets
of losing sales of other products in our line are not considered a benefit. For example, when
Quaker Oats introduced Cap’n Crunch’s Cozmic Crunch, the product competed directly
with the company’s Cap’n Crunch and Crunch Berries cereals. (In fact, Cozmic Crunch was
almost identical to Crunch Berries, with the shapes changed to stars and moons, along with
a packet of orange space dust that turns milk green.) Quaker meant to target the market
niche held by Post Fruity Pebbles, but there was no question that sales recorded by Cozmic
Crunch bit into—literally cannibalized—Quaker’s existing product line.
Remember that we are interested only in the sales dollars to the firm if the project is
accepted, as opposed to what the sales dollars would be if the project were rejected. Just
moving sales from one product line to a new product line does not bring anything new
into the company. But if sales are captured from competitors or if sales that would have
been lost to new competing products are retained, then these are relevant incremental
free cash flows.
Look for Incidental or Synergistic Effects
Although in some cases a new project may take sales away from a firm’s current projects, in
other cases a new effort might actually bring new sales to the existing line.
In April 2010, Apple introduced the first-generation iPad. To say the least, the iPad
has been extremely successful with total sales since it was introduced easily topping the
100 million mark by the end of 2012. Without question, Apple has made a lot of money
on sales of the iPad, but introducing the iPad has also resulted in increased sales of other
Apple products. Impressed by the simplicity and elegance of the iPad, many PC users began
making the switch to other Apple products. As a result, the introduction of the iPad not
only generated iPad sales but also led to increased sales of Macs and iPhones as many new
customers switched their user systems to exclusively Apple products. In addition, the ease of
use of the iPad also convinced many corporate customers to give Apple products a second
look. This is called a synergistic effect—the cash flow that comes from the sale of any Apple
product that would not have occurred if a customer had not purchased an iPad. Synergistic
effects are quite common in the business world.
If you owned a convenience store and were considering adding gas pumps, would you
evaluate the project looking only at cash flows from the sale of gas? No. You would look at
any new sales to any part of your business that the new gas pumps brought in. No doubt the
additional traffic that the gas pumps bring in would increase your convenience-store sales.
As such, these cash flows would be considered in evaluating whether or not to install the gas
pumps. In effect, you should look at any change in cash flow to the company as a whole that
results from the project being evaluated.
Work in Working-Capital Requirements
Many times a new project involves an additional investment in working capital. This may
take the form of new inventory to stock a sales outlet, an additional investment in accounts
receivable resulting from additional credit sales, or an increased investment in cash to op-
erate cash registers, and more. Working-capital requirements are considered a free cash
flow even though they do not leave the company. Generally, working-capital requirements
are tied up over the life of the project. When the project terminates, there is usually an
offsetting cash inflow as the working capital is recovered, although this offset is not perfect
because of the time value of money.
Consider Incremental Expenses
Just as cash inflows from a new project are measured on an incremental basis, expenses, or
cash outflows, should also be measured on an incremental basis. For example, if introduc-
ing a new product line necessitates training the sales staff, the after-tax cash flow associated
with the training program must be considered a cash outflow and charged against the proj-
ect. Likewise, if accepting a new project dictates that a production facility be reengineered,
the cash flows associated with that capital investment should be charged against the proj-
ect, and they will then be depreciated over the life of the project. Again, any incremental

Chapter 11 • Cash Flows and Other Topics in Capital Budgeting 347
after-tax cash flow affecting the company as a whole is a relevant cash flow, whether it is
flowing in or flowing out.
Remember That Sunk Costs Are Not Incremental Cash Flows
Only cash flows that are affected by the decision making at the moment are relevant in capital
budgeting. The manager asks two questions: (1) Will this cash flow occur if the project is ac-
cepted? (2) Will this cash flow occur if the project is rejected? Yes to the first question and no
to the second equals an incremental cash flow. For example, let’s assume you are considering
introducing a new taste treat called Puddin’ in a Shoe. You would like to do some test-marketing
before production. If you are considering the decision to test-market and have not yet done so,
the costs associated with the test-marketing are relevant cash flows. Conversely, if you have
already test-marketed, the cash flows involved in test-marketing are no longer relevant to the
project’s evaluation. It’s a matter of timing. Regardless of what you might decide about future
production, the cash flows allocated to the marketing test have already occurred. Cash flows that
have already taken place are often referred to as “sunk costs” because they have been sunk into
the project and cannot be undone. As a rule, any cash flows that are not affected by the accept/
reject criterion should not be included in capital-budgeting analysis.
Account for Opportunity Costs
Now we will focus on the cash flows that are lost because a given project consumes scarce
resources that would have produced cash flows if that project had been rejected. This is the
opportunity cost of doing business. For example, a product consumes valuable floor space
in a production facility. Although the cash flow is not obvious, the real question remains:
What else could be done with this space? The space could have been rented out, or another
product could have been stored there. The key point is that opportunity-cost cash flows
should reflect the net cash flows that would have been received if the project under consid-
eration were rejected. Again, we are analyzing the cash flows to the company as a whole,
with or without the project.
Decide If Overhead Costs Are Truly Incremental Cash Flows
Although we certainly want to include any incremental cash flows resulting in changes
from overhead expenses such as utilities and salaries, we also want to make sure that these
are truly incremental cash flows. Many times, overhead expenses—heat, light, rent—occur
whether a given project is accepted or rejected. There is often not a single, specific project
to which these expenses can be allocated. Thus, the question is not whether the project
benefits from the overhead costs a firm spends but whether they are incremental cash flows
associated with the project and relevant to capital budgeting.
Ignore Interest Payments and Financing Flows
To evaluate new projects and determine cash flows, we must separate the investment deci-
sion from the financing decision. Interest payments and other financing cash flows that might
result from raising funds to finance a project should not be considered incremental cash flows.
If accepting a project means we have to raise new funds by issuing bonds, the interest charges
associated with raising funds are not a relevant cash outflow. Why? Because when we discount
the incremental cash flows back to the present at the required rate of return, we are implicitly
accounting for the cost of raising funds to finance the new project. In essence, the required rate
of return reflects the cost of the funds needed to support the project. Managers first determine
the desirability of the project and then determine how best to finance it.
Concept Check
1. What is an incremental cash flow? What is a sunk cost? Why must you account for opportunity
costs?
2. If Ford introduces a new auto line, might some of the cash flows from that new car line be
diverted from existing product lines? How should you deal with this?

348 Part 3 • Investment in Long-Term Assets
Calculating a Project’s Free Cash Flows
As we have explained, in measuring cash flows, we will focus our attention on the difference
in the firm’s after-tax free cash flows with versus without the project—the project’s free cash
flows. The worth of our decision depends on the accuracy of our cash flow estimates. For
this reason, we first examined the question of which cash flows are relevant. Now we will
see that, in general, a project’s free cash flows will fall into one of three categories: (1) the
initial outlay, (2) the annual free cash flows over the project’s life, and (3) the terminal free
cash flow. Once we have taken a look at these categories, we will take on the task of measur-
ing these free cash flows.
What Goes into the Initial Outlay
The initial outlay is the immediate cash outflow necessary to purchase the asset and put it in
operating order. This amount includes (1) the cost of purchasing the asset and getting it op-
erational, including the purchase price, shipping and installation, and any training costs for
employees who will be operating the equipment, and (2) any increases in working-capital
requirements. The working capital includes any increases in current assets, less any increase
in accounts payable. If we are considering a new sales outlet, there might be additional cash
flows associated with making a net investment in working capital in the form of increased
accounts receivable, inventory, and cash necessary to operate the outlet. Although these
cash flows are not included in the cost of the asset or even shown as an expense on the in-
come statement, they must be included in our analysis. The after-tax cost of expense items
incurred as a result of the new investment must also be included as cash outflows—for ex-
ample, any training expenses that would not have been incurred otherwise.
Finally, if the investment decision is a replacement decision, the cash inflow associated
with the selling price of the old asset, in addition to any tax effects resulting from its sale,
must be included. It should be stressed that the incremental nature of the cash flow is of
great importance. In many cases, if the project is not accepted, then status quo for the firm
2 Explain how a project’s benefits
and costs—that is, its free cash
flows—are calculated.
initial outlay the immediate cash outflow
necessary to purchase the asset and put it in
operating order.
Finance at Work
univeRsal sTudiOs
A major capital-budgeting decision led Universal Studios to build
its Islands of Adventure theme park. The purpose of this $2.6 billion
investment by Universal was to get first crack at the tourist’s dollar
in Orlando, Florida. Although this capital-budgeting decision may,
on the surface, seem like a relatively simple one, forecasting the
expected cash flows associated with the theme park was, in fact,
quite complicated.
To begin with, Universal was introducing a product that
competes directly with itself. The original Universal Stu-
dios park features rides such as “Back to the Future,” Jimmy
Neutron’s Nicktoon Blast,” and “Men in Black Alien Attack.”
Were there enough tourist dollars to support both theme
parks, or would the new Islands of Adventure park simply
cannibalize ticket sales from the older Universal Studios
park? In addition, what would happen if Disney countered
with a new park of its own?
In the case of Universal’s Islands of Adventure, we could
ask what would happen to attendance at the original Univer-
sal Studios park if the new park were not opened versus what
the attendance would be with the new park? In addition, would
tourist traffic through the Islands of Adventure lead to addi-
tional sales and viewership of Comcast offerings and NBC Uni-
versal television and movies? Why do we care? Comcast owns
51 percent of NBC Universal, and Universal Parks and Resorts is
owned by NBC Universal.
From Universal’s point of view, the objective may have
been threefold: to increase its share of the tourist market, to
keep from losing market share as tourists look for the latest in
technological rides and entertainment, and to promote NBC
Universal’s ventures such as television and movies. However,
for companies in very competitive markets, the evolution and
introduction of new products may serve more to preserve mar-
ket share than to expand it. That explains Universal’s proposed
quarter of a billion dollar expansion of Harry Potter’s Wizarding
World to include the Gringotts Bank. After all, when Wizarding
World first opened, attendance for the entire park climbed by
52 percent, and the park’s hotels, dining, shopping, and all else
in the park became more profitable. The bottom line here is that
with respect to estimating cash flows, things are many times
more complicated than they first appear. As such, we have to
dig deep to understand how a firm’s free cash flows are affected
by the decision at hand.

Chapter 11 • Cash Flows and Other Topics in Capital Budgeting 349
will simply not continue. Thus, we must be realistic in estimating what the cash flows to the
company would be if the new project were not accepted.
In a replacement decision, the initial outlay is equal to the cost of the new asset, less the
amount we received from selling the old asset. Typically, when the old asset is sold there will be
a gain or loss from the sale, which means we will have to pay taxes if there is a gain from the sale
or a reduction of taxes if there is a loss. Thus the initial outlay is calculated as follows:
Initial
outlay
=
cost of
new asset
–
sales price
of the old asset
+/-
taxes recovered or paid from a loss
or gain on the sale of the old asset
So we need to state the sale of the old asset on an after-tax basis. When it comes to the taxes,
there are three possible situations that can result:
1. The old asset is sold for a price above the depreciated value. Here the difference
between the old machine’s selling price and its depreciated value is considered a taxable
gain and is taxed at the marginal corporate tax rate. If, for example, the old machine
was originally purchased for $15,000, had a book value of $10,000, and was sold for
$17,000, assuming the firm’s marginal corporate tax rate is 34 percent, the taxes due
from the gain would be ($17,000 – $10,000) * (0.34), or $2,380.
2. The old asset is sold for its depreciated value. In this case, no taxes result, because there
is neither a gain nor a loss in the asset’s sale.
3. The old asset is sold for less than its depreciated value. In this case, the difference
between the depreciated book value and the salvage value of the asset is a taxable loss
and can be used to offset capital gains and thus results in a tax savings. For example,
if the depreciated book value of the asset is $10,000 and it is sold for $7,000, we have
a $3,000 loss. Assuming the firm’s marginal corporate tax rate is 34 percent, the cash
inflow from the tax savings is ($10,000 – $7,000) * (0.34), or $1,020.
What Goes into the Annual Free Cash Flows Over the Project’s Life
Annual free cash flows come from operating cash flows (that is, what you’ve made as a result
of taking on the project), changes in working capital, and any capital spending that might
take place. In our calculations we’ll begin with our pro forma statements and work from
there. We will have to make adjustments for interest, depreciation, and working capital,
along with any capital expenditures that might occur.
Before we look at the calculations, let’s look at the types of adjustments that we’re going
to have to make to go from operating cash flows to free cash flows. To do this we’ll have to
make adjustments for:
◆ Depreciation and taxes Depreciation is a non–cash-flow expense. It occurs because
you bought a fixed asset (for example, you built a plant) in an earlier period, and now,
through depreciation, you’re expensing it over time—but depreciation does not involve
a cash flow. That means the firm’s net income understates cash flows by this amount.
Therefore, we’ll want to compensate for this by adding depreciation back into our mea-
sure of accounting income when calculating cash flows.
Although depreciation expense is a non-cash expense, it does affect cash flow
because it is a tax-deductible expense. The higher the depreciation expense, the lower
the firm’s profits, which results in lower taxes.
There are a number of different methods for computing depreciation expense. For
instance, we could use the Accelerated Cost Recovery System (ACRS) provided by the
IRS. However, for our purposes, we will use a simplified straight-line method, where
we calculate annual depreciation by taking the project’s initial depreciable value and
dividing by its depreciable life as follows:
Annual depreciation using the
simplified straight@line method
=
initial depreciable value
depreciable life

350 Part 3 • Investment in Long-Term Assets
The initial depreciable value is equal to the cost of the asset plus any expenses necessary
to get the new asset into operating order.
This is not how depreciation would actually be calculated. The reason we have simplified
the calculation is to allow you to focus directly on what should and should not be included in
the cash-flow calculations. Moreover, because the tax laws change rather frequently, we are
more interested in recognizing the tax implications of depreciation than in understanding
the specific depreciation provisions of the current tax laws.
◆ Interest expenses There’s no question that if you take on a new project, you’ll have to
pay for it somehow—either through internally generated cash or, say, by selling new stocks
or bonds. In other words, there’s a cost to that money. We recognize this principle when we
discount future cash flows back to the present at the required rate of return. Remember, the
project’s required rate of return is the rate of return that it must earn to justify your taking
on the project. It recognizes the risk of the project and the fact that there is an opportunity
cost of money. If we discounted the future cash flows back to the present and also subtracted
out interest expenses, then we would have double counted the cost of money—accounting
for the cost of money once when we subtracted out interest expenses and once when we
discounted the cash flows back to the present. Therefore, we want to make sure that cash
flows are not lowered by financing costs such as interest payments. That means we’ll want
to make sure that financing flows (interest expense) are not included.
◆ Changes in net working capital As we have explained, many projects require an
increased investment in working capital. For example, some of the new sales may be
credit sales resulting in an increased investment in accounts receivable. Also, in order to
produce and sell the product, the firm may have to increase its investment in inventory.
On the other hand, some of this increased working-capital investment may be financed
by an increase in accounts payable. Because all these potential changes are changes in
assets and liabilities, they don’t affect accounting income. Thus, if this project brings
with it a positive change in net working capital, then it means money is going to be tied
up in increased working capital, and this would be a cash outflow. That means we’ll
have to make sure we account for any changes in working capital that might occur.
◆ Changes in capital spending From an accounting perspective, the cash flow associ-
ated with the purchase of a fixed asset is not an expense. For example, when Marriott
spends $50 million on building a new hotel resort, although there is a significant cash
outflow, there is no accompanying expense. Instead, the $50 million cash outflow cre-
ates an annual depreciation expense over the life of the hotel. We’ll want to make sure
we include any changes in capital spending such as this in our cash-flow calculations.
What Goes into the Terminal Cash Flow
The terminal cash flow is associated with the project’s termination and includes the annual
free cash flow and salvage value of the project plus or minus any taxable gains or losses as-
sociated with its sale. Under the current tax laws, in most cases there will be tax payments
associated with the salvage value at termination. This is because the current laws allow all
projects to be depreciated to zero. So, if a project has a book value of zero at termination
and a positive salvage value, then that salvage value will be taxed. The tax effects associ-
ated with the salvage value of the project at termination are determined exactly like the tax
effects on the sale of the old machine associated with the initial outlay. The salvage value
proceeds are compared with the depreciated value, in this case zero, to determine the tax.
In addition to the salvage value, there may be a cash outlay associated with the project
termination. For example, at the close of a strip-mining operation, the mine must be refilled
in an ecologically acceptable manner.
Now let’s put this all together and measure the project’s free cash flows.
Calculating the Free Cash Flows
Free cash-flow calculations can be broken down into three basic parts: cash flows from
operations, cash flows associated with working-capital requirements, and capital-spending

Chapter 11 • Cash Flows and Other Topics in Capital Budgeting 351
cash flows. Let’s begin our discussion by looking at how to measure cash flows from opera-
tions and then move on to discuss measuring cash flows from working-capital requirements
and capital spending.
STEP 1 Measure the project’s change in the firm’s after-tax operating cash flows. An easy way
to calculate operating cash flows is to take the information provided on the firm’s
projected income statement and simply convert the accounting information into
cash-flow information. To do this we take advantage of the fact that the differ-
ence between the change in sales and the change in costs should be equal to the
change in earnings before interest and taxes (EBIT) plus depreciation.
Under this method, the calculation of a project’s operating cash flow involves
three steps. First, we determine the company’s earnings before interest and taxes
(EBIT) with and without this project. Second, we subtract out the change in
taxes. Keep in mind that in calculating the change in taxes, we will ignore any
interest expenses. Third, we adjust this value for the fact that depreciation, a
non–cash-flow item, has been subtracted out in the calculation of EBIT. We do
this by adding back depreciation. Thus, operating cash flows are calculated as
follows:
Operating cash flows = change in earnings before interest and taxes (EBIT)
– change in taxes
+ change in depreciation
E x A M P L E 11.1 Calculating the operating cash flows
Assume that a new project will annually generate additional revenues of $1,000,000
and additional fixed and variable costs of $500,000, while increasing depreciation by
$150,000 per year. If the firm’s marginal tax rate is 34 percent, what are the operating
cash flows to the firm?
sTeP 1: FORmulaTe a sOluTiOn sTRaTeGY
The calculation of the operating cash flows based on the firm’s earnings before interest
and taxes (EBIT) is
EBIT = revenue – fixed and variable costs – depreciation
After determining the firm’s EBIT, we subtract out the change in taxes. Finally, we ad-
just this value for the fact that depreciation, a non–cash-flow item, has been subtracted
out in the calculation of EBIT. Thus, we add back depreciation to calculate the operat-
ing cash flows.
Operating cash flows = change in earnings before interest and taxes
– change in taxes
+ change in depreciation
sTeP 2: CRunCH THe numBeRs
Given this, the firm’s net profit after tax, or net income, can be calculated as follows:
Revenue $1,000,000
– Fixed and variable costs 500,000
– Depreciation 150,000
= EBIT $ 350,000
– Taxes (34%) 119,000
= Net income $ 231,000

352 Part 3 • Investment in Long-Term Assets
The operating cash flows are calculated as follows:
Operating cash flows = change in earnings before interest and taxes
– change in taxes
+ change in depreciation
= $350,000 – $119,000 + $150,000 = $381,000
sTeP 3: analYZe YOuR ResulTs
By converting the firm’s accounting information into cash flows, we are able to measure
the exact timing of cash flows from operations. In this case it appears that the new project
can annually generate $381,000 operating cash flows to the firm.
STEP 2 Calculate the cash flows from the change in the firm’s net working capital. As we men-
tioned earlier in this chapter, many times a new project will involve additional
investment in working capital—perhaps new inventory to stock a new sales outlet
or simply additional investment in accounts receivable. There also may be some
spontaneous short-term financing—for example, increases in accounts payable—
that result from the new project. Thus, the change in net working capital is the
additional investment in current assets minus any additional short-term liabilities
that were generated.
STEP 3 Calculate the cash flows from the change in the firm’s capital spending. Although there
is generally a large cash outflow associated with a project’s initial outlay, there
may also be additional capital-spending requirements over the life of the project.
For example, you may know ahead of time that the plant will need some minor
retooling in the second year of the project in order to keep the project abreast
of new technological changes that are expected to take place. In effect, we will
look at the company with and without the new project, and any changes in capital
spending that occur are relevant.
STEP 4 Putting it together: calculating a project’s free cash flows. Thus, a project’s free cash
flows are:
Project’s free cash flows = change in earnings before interest and taxes (EBIT)
– change in taxes
+ change in depreciation
– change in net working capital
– change in capital spending
To estimate the changes in EBIT, taxes, depreciation, net working capital, and capi-
tal spending, we start with estimates of how many units we expect to sell, what the
costs—both fixed and variable—will be, what the selling price will be, and what the
required capital investment will be. From there we can put together a pro forma
statement that should provide us with the data we need to estimate the project’s free
cash flows. However, you must keep in mind that our capital-budgeting decision will
only be as good as our estimates of the costs and future demand associated with the
project. In fact, most capital-budgeting decisions that turn out to be bad decisions
are not so because of using a bad decision rule but because the estimates of future
demand and costs were inaccurate. Let’s look at an example.
E x A M P L E 11.2 Calculating a project’s free cash flows
You are considering expanding your product line that currently consists of Lee’s Press-
on Nails to take advantage of the fitness craze. The new product you are consider-
ing introducing is Press-on Abs. You feel you can sell 100,000 of these per year for
4 years (after which time this project is expected to shut down because forecasters predict
looking healthy will no longer be in vogue and looking like a couch potato will). The

Chapter 11 • Cash Flows and Other Topics in Capital Budgeting 353
Press-on Abs would sell for $6.00 each, with variable costs of $3.00 for each one pro-
duced. Annual fixed costs associated with production would be $90,000. In addition,
there would be a $200,000 initial capital expenditure associated with the purchase of new
production equipment. It is assumed that this initial expenditure will be depreciated, us-
ing the simplified straight-line method, down to zero over 4 years. The project will also
require a one-time initial investment of $30,000 in net working capital associated with
the inventory. Finally, assume that the firm’s marginal tax rate is 34 percent. What are
the free cash flows to the firm?
sTeP 1: FORmulaTe a sOluTiOn sTRaTeGY
In general, a project’s free cash flows will fall into one of three categories: (1) the initial
outlay, (2) the annual free cash flows over the project’s life, and (3) the terminal cash
flow. Let’s begin by calculating the initial outlay.
sTeP 2: CRunCH THe numBeRs
initial Outlay
In this example, the initial outlay is the $200,000 initial capital expenditure plus the in-
vestment of $30,000 in net working capital, for a total of $230,000.
annual Free Cash Flows
Table 11-1 calculates the annual change in earnings before interest and taxes. This cal-
culation begins with the change in sales (Δ Sales) and subtracts the change in fixed and
variable costs in addition to the change in depreciation, to arrive at the change in earn-
ings before interest and taxes (Δ EBIT). Depreciation is calculated using the simpli-
fied straight-line method, which is simply the depreciable value of the asset ($200,000)
divided by the asset’s expected life of 4 years. Taxes are then calculated assuming a
34 percent marginal tax rate. Once we have calculated EBIT and taxes, we don’t need
to go any further, because these are the only two values from the income statement that
we need. In addition, in this example there is not any annual increase in working capital
associated with the project under consideration. Also notice that we have ignored any
interest payments and financing flows that might have occurred. As mentioned earlier,
when we discount the free cash flows back to the present at the required rate of return,
we are implicitly accounting for the cost of the funds needed to support the project.
The project’s annual change in operating cash flow is calculated in Table 11-2.
Remember: The project’s annual free cash flow is simply the change in operating cash flow less any
change in net working capital and less any change in capital spending.
TABLE 11-2 Calculating the Annual Change in Operating Cash Flow,
Press-on Abs Project
∆ Earnings before interest and taxes (EBIT) $160,000
Minus: ∆ Taxes $ 54,400
Plus: ∆ Depreciation $ 50,000
Equals: ∆ Operating cash flow $155,600
TABLE 11-1 Calculating the Annual Change in Earnings Before Interest
and Taxes for the Press-on Abs Project
∆ Sales (100,000 units at $6.00/unit) $ 600,000
Less: ∆ Variable costs (variable cost $3.00/unit) $ 300,000
Less: ∆ Fixed costs $ 90,000
Equals: EBITDA (assuming amortization is 0) $ 210,000
Less: ∆ Depreciation ($200,000/4 years) $ 50,000
Equals: ∆ EBIT $ 160,000
Less: ∆ Taxes: (taxed at 34%) $ 54,400
Equals: ∆ Net income $ 105,600

354 Part 3 • Investment in Long-Term Assets
TABLE 11-3 Calculating the Terminal Free Cash Flow, Press-on Abs Project
∆ Earnings before interest and taxes (EBIT) $160,000
Minus: ∆ Taxes $ 54,400
Plus: ∆ Depreciation $ 50,000
Minus: ∆ Net working capital ($ 30,000)*
Equals: ∆ Free cash flow $185,600
FIGURE 11-1 Free Cash-Flow Diagram for Press-on Abs
YEAR 0 1
155,600
2
155,600
3
155,600–$230,000
4
185,600Cash Flow
Terminal Cash Flow
For this project, the terminal cash flow is quite simple. The only unusual cash flow at
the project’s termination is the recapture of the net working capital associated with the
project. In effect, the investment in inventory of $30,000 is liquidated when the project
is shut down in 4 years
Keep in mind that in calculating free cash flow we subtract out the change in net
working capital, but because the change in net working capital is negative (we are re-
ducing our investment in inventory), we are subtracting a negative number, which has
the effect of adding it back in. Thus, working capital was a negative cash flow when the
project began and we invested in inventory, but at termination it becomes a positive
offsetting cash flow when the inventory was liquidated. The calculation of the terminal
free cash flow is illustrated in Table 11-3.
sTeP 3: analYZe YOuR ResulTs
In this example there are no changes in net working capital and capital spending over
the life of the project. This is not the case for all projects that you will consider. For ex-
ample, on a project where sales increase annually, it is likely that working capital will also
increase each year to support a larger inventory and a higher level of accounts receivable.
Similarly, on some projects the capital expenditures may be spread out over several years.
The point here is that what we are trying to do is look at the firm with this project and
without this project and measure the change in cash flows other than any interest pay-
ments and financing flows that might occur.
If we were to construct a free cash-flow diagram from this example (Figure 11-1),
it would have an initial outlay of $230,000, the free cash flows during years 1 through
3 would be $155,600, and the free cash flow in the terminal year would be $185,600.
A Comprehensive Example: Calculating Free Cash Flows
Now let’s put what we know about capital budgeting together and look at a capital-
budgeting decision for a firm in the 34 percent marginal tax bracket with a 15 percent
required rate of return or cost of capital. The project we are considering involves the
introduction of a new electric scooter line by Raymobile. Our first task is that of es-
timating cash flows, which is the focus of this section. This project is expected to last
5 years and then, because this is somewhat of a fad product, be terminated. Thus, our
first task becomes that of estimating the initial outlay, the annual free cash flows, and
the terminal free cash flow. Given the information in Table 11-4, we want to deter-
mine the free cash flows associated with the project. Once we have that, we can easily
calculate the project’s net present value, the profitability index, and the internal rate of
return and apply the appropriate decision criteria.
*Because the change in net working capital is negative (we are reducing our investment in inventory), we are subtracting a negative number,
which has the effect of adding it back in.

Chapter 11 • Cash Flows and Other Topics in Capital Budgeting 355
Cost of new plant and equipment
Shipping and installation costs
Unit sales
Sales price per unit
Variable cost per unit
Annual fixed costs
Working-capital requirements
The depreciation method
$9,700,000
$ 300,000
$150/unit in years 1 through 4, $130/unit in year 5
$80/unit
$500,000 in years 1–5
There will be an initial working-capital requirement of $100,000 just
to get production started. Then, for each year, the total investment
in net working capital will be equal to 10 percent of the dollar value
of sales for that year. Thus, the investment in working capital will
increase during years 1 and 2, then decrease in year 4. Finally, all
working capital will be liquidated at the termination of the project
at the end of year 5.
We use the simplified straight-line method over 5 years. It is
assumed that the plant and equipment will have no salvage value
after 5 years. Thus, annual depreciation is $2,000,000/year for
5 years.
Y E A R U N I T S S O L D
1 50,000
2 100,000
3 100,000
4 70,000
5 50,000
TABLE 11-4 Raymobile Scooter Line Capital-Budgeting Example
To determine the differential annual free cash flows, we first need to determine the
annual change in operating cash flow. To do this we will take the change in EBIT, subtract
out the change in taxes, and then add in the change in depreciation. This is shown in Sec-
tion II of Table 11-5. We first determine what the change in sales revenue will be by mul-
tiplying the units sold times the sale price. From the change in sales revenue, we subtract
out variable costs, which are $80 per unit. Then, the change in fixed costs is subtracted out,
and the result is earnings before interest, taxes, depreciation, and amortization (EBITDA).
Subtracting the change in depreciation and amortization, which in this case is assumed to
be zero, from EBITDA then leaves us with the change in earnings before interest and taxes
(EBIT). From the change in EBIT, we can then calculate the change in taxes, which are
assumed to be 34 percent of EBIT.
Using the calculations provided in Section I of Table 11-5, we then calculate the oper-
ating cash flow in Section II of Table 11-5. As you recall, the operating cash flow is simply
EBIT minus taxes, plus depreciation.
To calculate the annual free cash flows from this project, we subtract the change in
net working capital and the change in capital spending from operating cash flow. Thus,
the first step becomes determining the change in net working capital, which is shown
in Section III of Table 11-5. The change in net working capital generally includes
both increases in inventory and increases in accounts receivable that naturally occur
as sales increase from the introduction of the new product line. Some of the increase
can You Do it?
CalCulaTinG OPeRaTinG CasH FlOws
Assume that a new project will generate revenues of $300,000 annually, and the annual cash expenses, including both fixed and
variable costs, will be $190,000 per year. Depreciation will be $20,000 per year. In addition, the firm’s marginal tax rate is 40 percent.
Calculate the operating cash flows.
(The solution can be found on page 357.)

356 Part 3 • Investment in Long-Term Assets
TABLE 11-5 Calculating the Free Cash Flow for Raymobile Scooters
Year 0 1 2 3 4 5
Section I. Calculate the Change in EBIT, Taxes, and Depreciation
(This Becomes an Input in the Calculation of Operating Cash Flow in Section II)
Units sold 50,000 100,000 100,000 70,000 50,000
Sales price $ 150 $ 150 $ 150 $ 150 $ 130
Sales revenue $7,500,000 $15,000,000 $15,000,000 $10,500,000 $6,500,000
Less: Variable costs 4,000,000 8,000,000 8,000,000 5,600,000 4,000,000
Less: Fixed costs 500,000 500,000 500,000 500,000 500,000
Equals: EBITDA $3,000,000 $ 6,500,000 $ 6,500,000 $ 4,400,000 $2,000,000
Less: Depreciation (amortization is assumed to be 0) 2,000,000 2,000,000 2,000,000 2,000,000 2,000,000
Equals: EBIT $1,000,000 $ 4,500,000 $ 4,500,000 $ 2,400,000 0
Taxes (@34%) 340,000 1,530,000 1,530,000 816,000 0
Section II. Calculate Operating Cash Flow
(This Becomes an Input in the Calculation of Free Cash Flow in Section IV)
Operating cash flow:
EBIT
$1,000,000 $ 4,500,000 $ 4,500,000 $ 2,400,000 $ 0
Minus: Taxes 340,000 1,530,000 1,530,000 816,000 0
Plus: Depreciation 2,000,000 2,000,000 2,000,000 2,000,000 2,000,000
Equals: Operating cash flows $2,660,000 $ 4,970,000 $ 4,970,000 $ 3,584,000 $2,000,000
Section III. Calculate the Net Working Capital
(This Becomes an Input in the Calculation of Free Cash Flow in Section IV)
Change in net working capital:
Revenue $7,500,000 $15,000,000 $15,000,000 $10,500,000 $6,500,000
Initial working-capital requirement $ 100,000
Net working-capital needs 750,000 1,500,000 1,500,000 1,050,000 650,000
Liquidation of working capital 650,000
Change in working capital 100,000 650,000 750,000 0 (450,000) (1,050,000)
Section IV. Calculate Free Cash Flow
(Using Information Calculated in Sections II and III, in Addition to the Change in Capital Spending)
Free cash flow:
Operating cash flow
$2,660,000 $ 4,970,000 $ 4,970,000 $ 3,584,000 $2,000,000
Minus: Change in net working capital $ 100,000 650,000 750,000 0 (450,000) (1,050,000)
Minus: Change in capital spending 10,000,000 0 0 0 0 0
Equals: Free cash flow $(10,100,000) $2,010,000 $ 4,220,000 $ 4,970,000 $ 4,034,000 $3,050,000
in accounts receivable may be offset by increases in accounts payable, but, in general,
most new projects involve some type of increase in net working capital. In this example,
there is an initial working capital requirement of $100,000. In addition, for each year
the total investment in net working capital will be equal to 10 percent of sales for each
year. Thus, the investment in working capital for year 1 is $750,000 (because sales are
estimated to be $7,500,000). Working capital will already be at $100,000, so the change
in net working capital will be $650,000. Net working capital will continue to increase
during years 1 and 2, then decrease in year 4. Finally, all working capital is liquidated
at the termination of the project at the end of year 5.
With the operating cash flow and the change in net working capital already calcu-
lated, the calculation of the project’s free cash flow becomes easy. All that is missing is
the change in capital spending, which in this example will simply be the $9,700,000 for
plant and equipment plus the $300,000 for shipping and installation. Thus, the change
in capital spending becomes $10,000,000. We then need merely to take operating cash
flow and subtract from it both the change in net working capital and the change in capi-
tal spending. This is done in Section IV of Table 11-5 with the annual free cash flows
given in the last row in that table. A free cash flow diagram for this project is provided
in Figure 11-2.

Chapter 11 • Cash Flows and Other Topics in Capital Budgeting 357
DiD You Get it?
CalCulaTinG OPeRaTinG CasH FlOws
You were asked to determine the operating cash flows for a project. Operating cash flows are calculated as:
Operating cash flows = change in earnings before interest and taxes (EBIT)
– change in taxes
+ change in depreciation
STEP 1 Calculate the change in EBIT
Revenue $300,000
-Cash fixed and variable expenses 190,000
-Depreciation 20,000
=EBIT $ 90,000
STEP 2 Calculate taxes by multiplying the increase in EBIT times the marginal tax rate of 40 percent
Change in EBIT $90,000
Times: Taxes (40%) = $36,000
STEP 3 Calculate operating cash flows
Operating cash flows = change in earnings before interest and taxes (EBIT)
– change in taxes
+ change in depreciation
= $90,000 – $36,000 + $20,000 = $74,000
The operating cash flows of $74,000 then become an input to the calculation of the free cash flows.
can You Do it?
CalCulaTinG FRee CasH FlOws
Hurley’s Hidden Snacks is introducing a new product and has an expected change in EBIT of $800,000. Hurley’s Hidden Snacks has a
40 percent marginal tax rate. This project will also produce $100,000 of depreciation per year. In addition, this project will also cause
the following changes in year 1:
What is the project’s free cash flow in year 1?
(The solution can be found on page 360.)
W I T h O U T T h E P R O j E C T W I T h T h E P R O j E C T
Accounts receivable $35,000 $63,000
Inventory 65,000 70,000
Accounts payable 70,000 90,000
FIGURE 11-2 Free Cash-Flow Diagram for the Raymobile Scooter Line
YEAR 2
4,220,000
1
2,010,000
r = 15%
0 3
4,970,000
4
4,034,000–$10,100,000
5
3,050,000Cash Flow

358 Part 3 • Investment in Long-Term Assets
Concept Check
1. In general, a project’s cash flows will fall into one of three categories. What are these categories?
2. What is a free cash flow? How do we calculate it?
3. Although depreciation is not a cash-flow item, it plays an important role in the calculation of
cash flows. How does depreciation affect a project’s cash flows?
Options in Capital Budgeting
The use of discounted cash-flow decision criteria, such as the NPV method, provides an
excellent framework within which to evaluate projects. However, what happens if the proj-
ect being analyzed has the potential to be modified after some future uncertainty has been
resolved? For example, if a project that had an expected life of 10 years turns out to be bet-
ter than anticipated, it may be expanded or continued past 10 years, perhaps going on for
20 years. On the other hand, if its cash flows do not meet expectations, it may not last a
full 10 years and be scaled back, abandoned, or sold. In addition, suppose the project were
delayed for a year or two. This flexibility is something that the NPV and our other decision-
making criteria have difficulty dealing with. In fact, the NPV may actually understate the
value of the project if the future opportunities associated with modifying it have a positive
value. It is this value of flexibility that we will be examining using options.
Three of the most common option types that can add value to a capital-budgeting proj-
ect are (1) the option to delay a project until the future cash flows are more favorable—this
option is common when the firm has exclusive rights, perhaps a patent, to a product or tech-
nology; (2) the option to expand a project, perhaps in size or even to develop new products
that would not have otherwise been feasible; and (3) the option to abandon a project if the
future cash flows fall short of expectations.
The Option to Delay a Project
There is no question that the estimated cash flows associated with a project can change
over time. In fact, as a result of changing expected cash flows, a project that currently has
a negative net present value may have a positive net present value in the future. Let’s take
another look at the gas-electric hybrid car market we examined in the introduction to this
chapter. This time, let’s assume that you’ve developed a high-voltage, nickel-metal hydride
battery that can be used to increase the mileage on hybrid cars to up to 150 miles per
gallon. However, as you examine the costs of producing this new battery, you realize that it
3 Explain the importance of
options, or flexibility, in capital
budgeting.
DiD You Get it?
CalCulaTinG FRee CasH FlOws
You were asked to determine the free cash flows in year 1 for a new product being introduced by Hurley’s Hidden Snacks.
STEP 1 Calculate the change in net working capital.
The change in net working capital equals the increase in accounts receivable and inventory less the increase in accounts
payable = $28,000 – $5,000 – $20,000 = $13,000.
STEP 2 Calculate the change in free cash flows.
Project’s free cash flows = change in earnings before interest and taxes (EBIT)
– change in taxes
+ change in depreciation
– change in net working capital
– change in capital spending
= $800,000 – ($800,000 * 0.40) + $100,000 – $13,000 – $0 = $567,000
The project’s free cash flows represent the “Cash Flow Is What Matters” that we discussed in Principle 1.

Chapter 11 • Cash Flows and Other Topics in Capital Budgeting 359
is still relatively expensive to manufacture and that, given the costs, the market for a car us-
ing this battery is quite small right now. Does that mean that the rights to the high-voltage,
nickel-metal hydride battery have no value? No, they have value because you may be able
to improve on this technology in the future and make the battery even more efficient and
less expensive. They also have value because oil prices might rise even further, which would
lead to a bigger market for super–fuel-efficient cars. In effect, the ability to delay this proj-
ect with the hope that technological and market conditions will change, making this project
profitable, lends value to the project.
Another example of the option to delay a project until the future cash flows are more
favorable involves a firm that owns the oil rights to some oil-rich land and is considering an
oil-drilling project. Suppose after all of the costs and the expected oil output are considered,
the project has a negative net present value. Does that mean the firm should give away its
oil rights or that those oil rights have no value? Certainly not. There is a chance that in the
future oil prices could rise to the point that this negative NPV project could become a posi-
tive NPV project. It is this ability to delay development that provides value. Thus, the value
in this seemingly negative NPV project is provided by the option to delay it until the future
cash flows are more favorable.
The Option to Expand a Project
Just as we saw with the option to delay a project, the estimated cash flows associated with a
project can change over time, making it valuable to expand a project. Again, this flexibility
to adjust production to demand has value. For example, a firm might deliberately build a
production plant with excess capacity so that if the product has more-than-anticipated de-
mand, the firm can simply increase production. Alternatively, taking on this project might
provide the firm with a foothold in a new industry and lead to other products that would not
have otherwise been feasible. This reasoning has led many firms to expand into e-businesses,
hoping to gain know-how and expertise that will lead to other profitable projects down the
line. It also provides some of the rationale for research and development expenditures to
explore new markets.
Let’s go back to our example of the gas-electric hybrid car and examine the option to
expand that project. One of the reasons that most of the major automobile firms are intro-
ducing gas-electric hybrid cars is that they feel if gas prices keep moving beyond the $2 to
$3 per gallon price, these hybrids may become the future of the industry, and the only way
to gain the know-how and expertise to produce a hybrid is to do it. As the cost of technology
declines and the demand increases—perhaps pushed on by increases in gas prices—then
the companies will be ready to expand into full-fledged production. This strategy becomes
clear when you look at Honda, which first introduced the Insight in 2000, and Toyota,
which introduced the Prius in 2001.
When hybrids were first introduced, analysts estimated that Honda was losing about $8,000
on each Insight it sold, whereas Toyota was losing about $3,000 per car, but both firms hoped to
break even in a few years. Still, these projects made sense because they allowed these automakers
to gain the technological and production expertise to profitably produce a gas-electric hybrid
car. And, as mentioned in the chapter introduction, with predictions that hybrids will account
for half of the light-duty vehicles on the road by 2040, it is a big market they’re looking at.
Moreover, the technology Honda and Toyota developed with the Insight and Prius may have
profitable applications for other cars or in other areas. In effect, it is the option of expanding
production in the future that brings value to this project.
The Option to Abandon a Project
The option to abandon a project as the estimated cash flows associated with it change over
time also has value. Again, it is this flexibility to adjust to new information that provides the
value. For example, a project’s sales in the first year or two might not live up to expecta-
tions, with the project being barely profitable. The firm might then decide to liquidate the
project and sell the plant and all of the equipment. That liquidated value may be more than
the value of keeping the project going.

360 Part 3 • Investment in Long-Term Assets
Again, let’s go back to our example of the gas-electric hybrid car and, this time, examine
the option to abandon that project. If after a few years the cost of gas falls dramatically while
the cost of technology remains high, the gas-electric hybrid car might not become profit-
able. At that point the manufacturer might decide to abandon the project and sell the tech-
nology, including all the patent rights to it. In effect, the original project, the gas-electric
hybrid car, may not be of value, but the technology that has been developed might be. As a
result, the value of abandoning the project and selling the technology might be more than
the value of keeping the project running. Again, it is the value of flexibility associated with
the possibility of modifying the project in the future—in this case abandoning the project—
that can produce positive value.
Options in Capital Budgeting: The Bottom Line
Because of the potential to be modified in the future after some future uncertainty has
been resolved, we may find that a project with a negative net present value based upon its
expected free cash flows is a “good” project and should be accepted. This demonstrates the
value of options. In addition, we may find that a project with a positive net present value
may be of more value if its acceptance is delayed. Options also explain the logic that drives
firms to take on negative NPV projects that allow them to enter new markets. The option
to abandon a project explains why firms hire employees on a temporary basis rather than
permanently, why they lease rather than buy equipment, and why they enter into contracts
with suppliers on an annual basis rather than long term.
Concept Check
1. Give an example of an option to delay a project. Why might this be of value?
2. Give an example of an option to expand a project. Why might this be of value?
3. Give an example of an option to abandon a project. Why might this be of value?
Risk and the Investment Decisions
Up to this point we have ignored risk in capital budgeting; that is, we have discounted ex-
pected cash flows back to the present and ignored any uncertainty that there might be sur-
rounding that estimate. In reality, the future cash flows associated with the introduction of
a new sales outlet or a new product are estimates of what is expected to happen in the future,
not necessarily what will happen. For example, when Coca-Cola decided to replace Classic
Coke with “New Coke,” you can bet that the expected cash flows it based its decision on
were nothing like the cash flows it realized. As a result, it didn’t take Coca-Cola long to re-
introduce Classic Coke. Other famous failures that didn’t produce the cash flows that were
expected include Bic disposable underwear, Thirsty Dog! beef-flavored bottled water for
dogs, and Coors Rocky Mountain Spring Water. The cash flows we have discounted back
to the present so far have only been our best estimate of the expected future cash flows. A
cash-flow diagram based on the possible outcomes of an investment proposal rather than
the expected values of these outcomes appears in Figure 11-3.
In this section, we assume that we do not know beforehand what cash flows will actually
result from a new project. However, we do have expectations concerning the possible outcomes
4 Understand, measure, and
adjust for project risk.
FIGURE 11-3 A Free Cash-Flow Diagram Based on Possible Outcomes
Possible Outcomes
Annual free cash flows
Initial
outlay
Terminal
free cash flow
YEAR 210 3 4
Cash Flow

Chapter 11 • Cash Flows and Other Topics in Capital Budgeting 361
and are able to assign probabilities to these outcomes. Stated another way, although we do
not know what the cash flows resulting from the acceptance of a new project will be, we can
formulate the probability distributions from which the flows will be drawn. As we learned in
Chapter 6, risk occurs when there is some question about the future outcome of an event.
In the remainder of this chapter, we assume that although future cash flows are not known
with certainty, the probability distribution from which they are derived can be estimated. Also,
because we have illustrated that the dispersion of possible outcomes reflects risk, we are pre-
pared to use a measure of dispersion, or variability, later in the chapter when we quantify risk.
In the pages that follow, remember that there are only two basic issues that we address:
(1) What is risk in terms of capital-budgeting decisions, and how should it be measured?
and (2) How should risk be incorporated into a capital-budgeting analysis?
What Measure of Risk Is Relevant in Capital Budgeting?
Before we begin our discussion of how to adjust for risk, it is important to determine just
what type of risk we are to adjust for. In capital budgeting, a project’s risk can be looked
at on three levels. First, there is the project standing alone risk, which is a project’s risk
ignoring the fact that much of this risk will be diversified away. Second, we have the project’s
contribution-to-firm risk, which is the amount of risk that the project contributes to the firm as
a whole; this measure considers the fact that some of the project’s risk will be diversified away as the
project is combined with the firm’s other projects and assets, but it ignores the effects of the diversifica-
tion of the firm’s shareholders. Finally, there is systematic risk, which is the risk of the project
from the viewpoint of a well-diversified shareholder; this measure takes into account that some of a
project’s risk will be diversified away as the project is combined with the firm’s other projects, and,
in addition, some of the remaining risk will be diversified away by shareholders as they combine this
stock with other stocks in their portfolios. Graphically, this is shown in Figure 11-4.
Should we be interested in the project standing alone risk? The answer is no. Perhaps the
easiest way to understand why not is to look at an example. Let’s take the case of research and
development projects at Johnson & Johnson. Each year Johnson & Johnson takes on hundreds
of new R&D projects, knowing that they have only about a 10 percent probability of being
successful. If they are successful, the profits can be enormous; if they fail, the investment is
lost. If the company has only one project, and it is an R&D project, the company would have a
90 percent chance of failure. Thus, if we look at these R&D projects individually and measure
their stand-alone risk, we would have to judge them to be enormously risky. However, if we
project standing alone risk a project’s risk
ignoring the fact that much of this risk will be
diversified away.
contribution-to-firm risk the amount of
risk that the project contributes to the firm as a
whole; this measure considers the fact that some
of the project’s risk will be diversified away as
the project is combined with the firm’s other
projects and assets but ignores the effects of
diversification of the firm’s shareholders.
systematic risk the risk of the project from
the viewpoint of a well-diversified shareholder;
this measure takes into account that some
of a project’s risk will be diversified away as
the project is combined with the firm’s other
projects, and, in addition, some of the remaining
risk will be diversified away by shareholders as
they combine this stock with other stocks in their
portfolios.
FIGURE 11-4 Looking at Three Measures of a Project’s Risk
Measures of Risk Risk That Is
Diversified Away
Project standing alone: Ignores
diversification within the firm and within
the shareholder’s portfolio.
Project from the company’s perspective:
Ignores diversification within the
shareholder’s portfolio, but allows for
diversification within the firm.
Project from the shareholder’s perspective:
Allows for diversification within the firm
and within the shareholder’s portfolio.
Perspective
Systematic risk
Project’s contribution-
to-firm risk
Project standing
alone risk
Risk diversified away
within the firm as this
project is combined
with the firm’s other
projects and assets
Risk diversified
away by shareholders as
securities are combined
to form diversified
portfolios; also called
unsystematic risk

362 Part 3 • Investment in Long-Term Assets
consider the effect of the diversification that comes about from taking on several hundred
independent R&D projects a year, all with a 10 percent chance of success, we can see that
each R&D project does not add much risk to Johnson & Johnson. In short, because much
of a project’s risk is diversified away within the firm, the project standing alone risk is an
inappropriate measure of the meaningful level of risk of a capital-budgeting project.
Should we be interested in the project’s contribution-to-firm risk? Once again, at least
in theory, the answer is no, provided investors are well diversified and there are no bank-
ruptcy costs. From our earlier discussion of risk in Chapter 6, we saw that as shareholders,
if we combined an individual security with other securities to form a diversified portfolio,
much of the risk of the individual security would be diversified away. In short, all that affects
the shareholders is the systematic risk of the project and, as such, it is all that is theoretically
relevant for capital budgeting.
Measuring Risk for Capital-Budgeting Purposes with a Dose of
Reality—Is Systematic Risk All There Is?
According to the capital asset pricing model (CAPM) we discussed in Chapter 6, systematic
risk is the only relevant risk for capital-budgeting purposes. However, reality complicates
this somewhat. In many instances a firm will have undiversified shareholders, including
owners of small corporations. Because they are not diversified, for those shareholders the
relevant measure of risk is the project’s contribution-to-firm risk.
The possibility of bankruptcy also affects our view of what measure of risk is relevant. As
you recall in developing the CAPM, we made the assumption that bankruptcy costs were zero.
Because the project’s contribution-to-firm risk reflects risk that the firm faces, that is, the risk
that may lead to bankruptcy, this may be an appropriate measure of risk: Quite obviously, there
is a cost associated with bankruptcy. First, if a firm fails, its assets, in general, cannot be sold for
their true economic value. Moreover, the amount of money actually available for distribution
to stockholders is further reduced by liquidation and legal fees that must be paid. Finally, the
opportunity cost associated with the delays related to the legal process further reduces the funds
available to the shareholder. Therefore, because costs are associated with bankruptcy, reducing
the chance of a bankruptcy has a very real value associated with it.
The indirect costs of bankruptcy also affect other areas of the firm, including production,
sales, and the quality and efficiency of management. For example, firms with a higher prob-
ability of bankruptcy may have a more difficult time recruiting and retaining quality managers
because jobs with that firm are viewed as being less secure. Suppliers may be less willing to sell
to the firm on credit. Finally, customers may lose confidence and fear that the firm is cutting
corners in terms of quality and/or will not be around to honor a warranty or supply spare parts
for products in the future. As a result, as the probability of bankruptcy increases, an eventual
bankruptcy can become self-fulfilling as potential customers and suppliers flee. The end result
is that because a project’s contribution-to-firm risk affects the probability of bankruptcy for the
firm, it may be a relevant risk measure for capital budgeting.
Finally, problems in measuring a project’s systematic risk make its implementation ex-
tremely difficult. It is much easier talking about a project’s systematic risk than measuring it.
Given all this, what risk measure do we use? The answer is that we will give consideration
to both systematic risk and contribution-to-firm risk measures. We know in theory systematic
risk is correct. We also know that bankruptcy costs and undiversified shareholders violate the
assumptions of the theory, which makes the concept of a project’s contribution-to-firm risk a
relevant measure. Still, the concept of systematic risk holds value for capital-budgeting decisions
because that is the risk that shareholders are compensated for assuming. Therefore, we will con-
cern ourselves with both the project’s contribution-to-firm risk and the project’s systematic risk
and not try to make any specific allocation of importance between the two for capital-budgeting
purposes.
Incorporating Risk into Capital Budgeting
Because different investment projects do in fact contain different levels of risk, let’s now
look at the risk-adjusted discount rate, which is based on the notion that investors require
higher rates of return on more risky projects.

Chapter 11 • Cash Flows and Other Topics in Capital Budgeting 363
Risk-Adjusted Discount Rates
The use of risk-adjusted discount rates is based on the concept that investors demand
higher returns for more risky projects. This is the basic principle behind Principle 3 and the
CAPM and is illustrated graphically in Figure 11-5.
As we know from Principle 3, the expected rate of return on any investment should include
compensation for delaying consumption equal to the risk-free rate of return, plus compensation
for any risk taken on. Under the risk-adjusted discount rate approach, if the risk associated with
the investment is greater than the risk involved in a typical endeavor, the discount rate is adjusted
upward to compensate for this added risk. Once the firm determines the appropriate required rate
of return for a project with a given level of risk, the cash flows are
discounted back to the present at the risk-adjusted discount rate.
Then the normal capital-budgeting criteria are applied, except in
the case of the IRR. For the IRR, the hurdle rate with which the
project’s IRR is compared now becomes the risk-adjusted discount
rate. Expressed mathematically, the NPV using the risk-adjusted
discount rate becomes
Risk@adjusted
NPV
= E present value of all thefuture annual free cashflows discounted back U – Ethe initial cash outlay
to present at the risk@adjusted
rate of return
U
(11-1)
=
FCF1
(1 + k*)1
+
FCF2
(1 + k*)2
+ g +
FCFn
(1 + k*)n
– IO
where FCFt = the annual free cash flow expected in time period t
IO = the initial cash outlay
k* = the risk-adjusted discount rate
n = the project’s expected life
The logic behind the risk-adjusted discount rate stems from the idea that if the level of
risk associated with a project is different from that of the typical project, then managers must
incorporate the shareholders’ probable reaction to this new endeavor into the decision-making
process. For example, if the project has more risk than a typical project, then a higher required
rate of return should apply. Otherwise, marginal projects will lower the firm’s share price—that
is, reduce shareholders’ wealth. This will occur as the market raises its required rate of return
on the firm to reflect the addition of the more risky project, because the incremental cash flows
resulting from it might not be large enough to offset this risk. By the same logic, if the proj-
ect has less than normal risk, a reduction in the required rate of return is appropriate. Thus,
the risk-adjusted discount method attempts to apply more stringent standards—that is, require
a higher rate of return—to projects that will increase the firm’s risk level. This risk-adjusted
financial decision rule can be summarized as follows:
risk-adjusted discount rate a method of
risk adjustment when the risk associated with
the investment is greater than the risk involved
in a typical endeavor. Using this method, the
discount rate is adjusted upward to compensate
for this added risk.
FIGURE 11-5 The Risk–Return Relationship
Expected return
for taking on
added risk
Expected return
for delayed
consumption
Risk
Ex
pe
ct
ed
r
et
ur
n
rf
RememBeR YOuR PRinCiPles
All the methods used to compensate for risk in
capital budgeting find their roots in Principle 3: Risk Requires
a Reward. In fact, the risk-adjusted discount method puts this
concept directly into play.
rinciple

364 Part 3 • Investment in Long-Term Assets
E x A M P L E 11.3 Risk-adjusted discount rates
A toy manufacturer is considering introducing a line of fishing equipment with an ex-
pected life of 5 years. In the past, the firm has been quite conservative in its investment
in new products, sticking primarily to standard toys. In this context, the introduction of a
line of fishing equipment is considered an abnormally risky project. Management thinks
that the normal required rate of return for the firm of 10 percent is not sufficient. In-
stead, the minimum acceptable rate of return on this project should be 15 percent. The
initial outlay would be $110,000, and the expected cash flows are as follows:
Name of Tool Formula What It Tells You
Risk-adjusted net
present value (NPV)
The present value of all the future annual free cash flows minus the initial cash
outlay discounted back to present at the risk-adjusted discount rate:
=
FCF1
(1 + k*)1
+
FCF2
(1 + k*)2
+ c +
FCFn
(1 + k*)n
– IO
• What the NPV would be if the project’s
cash flows were discounted back to
present at the appropriate (risk-
adjusted) discount rate
• The amount of wealth that is created if
the project is accepted
• If the risk-adjusted NPV is positive,
then wealth is created and the project
should be accepted.
Financial Decision tools
Y E A R E x P E C T E D F R E E C A S h F LO W
1 $30,000
2 30,000
3 30,000
4 30,000
5 30,000
What is the NPV using the risk-adjusted discount rate? Should the project be accepted?
sTeP 1: FORmulaTe a sOluTiOn sTRaTeGY
The NPV using the risk-adjusted discount rate can be calculated using equation (11-1)
as follows:
NPV = E present value of all thefuture annual free cashflows discounted back U – Ethe initial cash outlay
to present at the risk@adjusted
rate of return
U

=
FCF1
(1 + k*)1
+
FCF2
(1 + k*)2
+ g +
FCFn
(1 + k*)n
– IO
where FCFt = the annual free cash flow expected in time period t
IO = the initial cash outlay
k* = the risk-adjusted discount rate
n = the project’s expected life
sTeP 2: CRunCH THe numBeRs
The present value of the future free cash flows discounted to the present at 15 percent is
$100,560. The initial outlay on this project is $110,000. Substituting into equation (11-1),
we compute the NPV issue as follows:

Chapter 11 • Cash Flows and Other Topics in Capital Budgeting 365
NPV = E present value of all thefuture annual free cashflows discounted back U – Ethe initial cash outlay
to present at the risk@adjusted
rate of return
U

= $100,560 – $110,000 = -$9,435
sTeP 3: analYZe YOuR ResulTs
The risk-adjusted NPV is -$9,435, thus the project should be rejected. If the normal
required rate of return of 10 percent had been used as the discount rate, the project
would have had a positive NPV of $3,724.
In practice, when the risk-adjusted discount rate is used, projects are generally grouped
according to purpose, or risk class; then the discount rate preassigned to that purpose or
risk class is used. For example, a firm with a required rate of return of 12 percent might use
the following rate-of-return categorization:
P R O j E C T R E q U I R E D R AT E O F R E T U R N ( % )
Replacement decision 12
Modification or expansion of existing
product line
15
Project unrelated to current operations 18
Research and development operations 25
The purpose of this categorization of projects is to make their evaluation easier, but it
also introduces a sense of arbitrariness into the calculations that makes the evaluation less
meaningful. The trade-offs involved in the preceding classification are obvious: Time and
effort are minimized but only at the cost of precision.
Measuring a Project’s Systematic Risk
When we initially talked about systematic risk or the beta, we were talking about measuring
it for the entire firm. As you recall, although we could estimate a firm’s beta using historical
data, we did not have complete confidence in our results. As we will see, estimating the ap-
propriate level of systematic risk for a single project is even more fraught with difficulties.
To truly understand what it is we are trying to do and the difficulties we will encounter, let’s
step back a bit and examine systematic risk and the risk adjustment for a project.
What we are trying to do is use the CAPM to determine the level of risk and the ap-
propriate risk–return trade-offs for a particular project. We then take the expected return
on this project and compare it to the required return suggested by the CAPM to determine
whether the project should be accepted. If the project appears to be a typical one for the
firm, using the CAPM to determine the appropriate risk–return trade-offs and then judg-
ing the project against them may be a warranted approach. But if the project is not a typical
project, what do we do? Historical data generally do not exist for a new project. In fact, for
some capital investments—for example, a truck or a new building—historical data would
not have much meaning. What we need to do is make the best of a bad situation. We either
(1) fake it—that is, use historical accounting data, if available, to substitute for historical
price data in estimating systematic risk—or (2) attempt to find a substitute firm in the same
industry as the capital-budgeting project and use the substitute firm’s estimated systematic
risk as a proxy for the project’s systematic risk.
Using Accounting Data to Estimate a Project’s Beta
When we are dealing with a project that is identical to the firm’s other projects, we need
only estimate the level of systematic risk for the firm and use that estimate as a proxy for the

366 Part 3 • Investment in Long-Term Assets
project’s risk. Unfortunately, when projects are not typical of the firm, this approach does
not work. For example, when Altria, which owns Philip Morris, the tobacco company, and
Ste. Michelle Wine Estates, introduces a new dessert wine, this new product most likely
carries with it a different level of systematic risk than what is typical for Altria as a whole.
To get a better approximation of the systematic risk level on this project, it would be
great if we could estimate the level of systematic risk for the wine division and use that as a
proxy for the project’s systematic risk. Unfortunately, historical stock price data are avail-
able only for the company as a whole, and as you recall, historical stock return data are
generally used to estimate a firm’s beta. Thus, we are forced to use accounting return data
rather than historical stock return data for the division to estimate the division’s systematic
risk. To estimate a project’s beta using accounting data we need only run a time-series re-
gression of the division’s return on assets (net income/total assets) on the market index (the
S&P 500). The regression coefficient from this equation would be the project’s accounting
beta and would serve as an approximation for the project’s true beta, or measure of sys-
tematic risk. Alternatively, a multiple regression model based on accounting data could be
developed to explain betas. The results of this model could then be applied to firms that are
not publicly traded to estimate their betas.
How good is the accounting beta technique? It certainly is not as good as a direct calcula-
tion of the beta. In fact, the correlation between the accounting beta and the beta calculated on
historical stock return data is only about 0.6. However, better luck has been experienced with
multiple regression models used to predict betas. Unfortunately, in many cases there may not
be any realistic alternative to the calculation of the accounting beta. Because adjusting for a
project’s risk is so important, the accounting beta method is much preferred to doing nothing.
The Pure Play Method for Estimating Beta
Whereas the accounting beta method attempts to directly estimate a project’s or division’s
beta, the pure play method attempts to identify publicly traded firms that are engaged
solely in the same business as the project or division. Once the proxy or pure play firm is
identified, its systematic risk is determined and then used as a proxy for the project’s or
division’s level of systematic risk. What we are doing is looking for a publicly traded firm with
a project like ours and using that firm’s required rate of return to judge our project. In doing so
we are presuming that the systematic risk and the capital structure of the proxy firm are
identical to those of the project.
In using the pure play method it should be noted that a firm’s capital structure is reflected in
its beta. When the capital structure of the proxy firm is different from that of the project’s firm,
some adjustment must be made for this difference. Although not a perfect approach, it does
provide some insights about the level of systematic risk a project might have.
Examining a Project’s Risk through Simulation
Another method for evaluating risk in the investment decision is through the use of
simulation. The risk-adjusted discount rate approach provided us with a single value
for the risk-adjusted NPV, whereas a simulation approach gives us a probability distri-
bution for the investment’s NPV or IRR. Simulation involves the process of imitating the
performance of the project under evaluation. This is done by randomly selecting observations
from each of the distributions that affect the outcome of the project and continuing with this
process until a representative record of the project’s probable outcome is assembled.
The easiest way to develop an understanding of the computer simulation process is to fol-
low through an example simulation for an investment project evaluation. Suppose a chemical
producer is considering an extension to its processing plant. The simulation process is portrayed
in Figure 11-6. First, the probability distributions are determined for all the factors that affect
the project’s returns. In this case, let us assume there are nine such variables:
1. Market size
2. Selling price
3. Market growth rate
4. Share of market (which results in physical sales volume)
pure play method a method for estimating
a project’s or division’s beta that attempts to
identify publicly traded firms engaged solely in
the same business as the project or division.
simulation a method for dealing with risk
where the performance of the project under
evaluation is estimated by randomly selecting
observations from each of the distributions that
affect the outcome of the project and continuing
with this process until a representative record of
the project’s probable outcome is assembled.

Chapter 11 • Cash Flows and Other Topics in Capital Budgeting 367
FIGURE 11-6 Capital-Budgeting Simulation
Step 2: Randomly select
values from these
distributions.
Market
size
Step 1: Develop probability distributions for key factors.
Step 4: Continue to repeat this process until a clear
portrait of the results is obtained.
Step 3: Combine these factors and determine an internal rate of return or NPV.
Step 5: Evaluate the resultant probability distribution.
Pr
ob
ab
ili
ty
Value range
Selling
price
Fixed
costs
Market
growth
rate
Investment
required
Residual
value of
investment
Share of
market
Operating
costs
Useful life
of facilities
Pr
ob
ab
ili
ty
Internal rate of return
5. Investment required
6. Residual value of investment
7. Operating costs
8. Fixed costs
9. Useful life of facilities

368 Part 3 • Investment in Long-Term Assets
Then the computer randomly selects one observation from each of the probability dis-
tributions, according to its chance of actually occurring in the future. These nine observa-
tions are combined, and an NPV or IRR figure is calculated. This process is repeated as
many times as desired, until a representative distribution of possible future outcomes is
assembled. Thus, the inputs to a simulation include all the principal factors affecting the
project’s profitability, and the simulation output is a probability distribution of net present
values or internal rates of return for the project. The decision maker bases the decision
on the full range of possible outcomes. The project is accepted if the decision maker feels
that enough of the distribution lies above the normal cutoff criteria (NPV Ú 0 or IRR Ú
required rate of return).
Suppose the output from the simulation of a chemical producer’s project is as shown in
Figure 11-7. This output provides the decision maker with the probability of different out-
comes occurring in addition to the range of possible outcomes. Sometimes called scenario
analysis, it identifies the range of possible outcomes under the worst, best, and most likely cases. The
firm’s management then examines the distribution to determine the project’s level of risk
and makes the appropriate decisions.
You’ll notice that although the simulation approach helps us to determine the amount
of total risk a project has, it does not differentiate between systematic and unsystematic risk.
However, it does provide important insights about the total risk level of a given investment
project. Now we will look briefly at how the simulation approach can be used to perform
sensitivity analysis.
Conducting a Sensitivity Analysis Through Simulation
Sensitivity analysis involves determining how the distribution of possible net present values or
internal rates of return for a particular project is affected by a change in one particular input vari-
able. This is done by changing the value of one input variable while holding all other input
variables constant. The distribution of possible net present values or internal rates of return
that is generated is then compared with the distribution of possible returns generated be-
fore the change was made to determine the effect of the change. For this reason sensitivity
analysis is commonly called what-if analysis.
For example, the chemical producer that is considering a possible expansion to its plant
may wish to determine the effect of a more pessimistic forecast of the anticipated market
growth rate. After the more pessimistic forecast replaces the original forecast in the model,
the simulation is rerun. The two outputs are then compared to determine how sensitive the
results are to the revised estimate of the market growth rate.
Concept Check
1. Is a project’s standing alone risk the appropriate level of risk for capital budgeting? Why or why not?
2. What problems are associated with using systematic risk as the measure for risk in capital budgeting?
scenario analysis a simulation approach for
gauging a project’s risk under the worst, best,
and most likely outcomes. The firm’s manage-
ment examines the distribution of the outcomes
to determine the project’s level of risk and then
makes the appropriate adjustment.
sensitivity analysis a method for dealing
with risk where the change in the distribution
of possible net present values or internal rates
of return for a particular project resulting from
a change in one particular input variable is
calculated. This is done by changing the value of
one input variable while holding all other input
variables constant.
FIGURE 11-7 Output from Simulation
Pr
ob
ab
ili
ty
o
f o
cc
ur
re
nc
e
Internal rate of return (%)
0 15 30

Chapter 11 • Cash Flows and Other Topics in Capital Budgeting 369
3. What is the most commonly used method for incorporating risk into the capital-budgeting deci-
sion? How is this technique related to Principle 3?
4. Explain how simulations work.
5. What is a scenario analysis? What is a sensitivity analysis? When would you perform a sensitivity
analysis?
Chapter Summaries
Identify guidelines by which we measure cash flows. (pgs. 345–347)
SUMMARY: In this chapter, we examined the measurement of the incremental cash flows associ-
ated with a firm’s investment proposals and methods used to evaluate those proposals. Relying on
Principle 1: Cash Flow Is What Matters we focused only on the incremental, or differential,
after-tax cash flows attributed to an investment proposal. Care is taken to beware of cash flows
diverted from existing products, look for incidental or synergistic effects, consider working-capital
requirements, consider incremental expenses, ignore sunk costs, account for opportunity costs, ex-
amine overhead costs carefully, and ignore interest payments and financing flows.
Explain how a project’s benefits and costs—that is, its free cash flows—are
calculated. (pgs. 348–358)
SUMMARY: To measure a project’s benefits, we use the project’s free cash flows:
Project’s free cash flows = project’s change in operating cash flows
– change in net working capital
– change in capital spending
We can rewrite this, inserting our calculation for the project’s change in operating cash flows, to get
Project’s free cash flows = change in earnings before interest and taxes
– change in taxes
+ change in depreciation
– change in net working capital
– change in capital spending
KEY TERMS
1
2
Initial outlay, page 348 The immediate cash
outflow necessary to purchase the asset and put
it in operating order.
Explain the importance of options, or flexibility, in capital budgeting.
(pgs. 358–360)
SUMMARY: There are several complications related to the capital-budgeting process. First, we
examined capital rationing and the problems it can create by imposing a limit on the dollar size of
the capital budget. Although capital rationing does not, in general, maximize shareholders’ wealth,
it does exist. The goal of maximizing shareholders’ wealth remains, but it is now subject to a budget
constraint.
Understand, measure, and adjust for project risk. (pgs. 360–369)
SUMMARY: Options, or flexibility, can make it worthwhile to pursue projects that would otherwise
be rejected or make projects undertaken more valuable. Three of the most common types of op-
tions that can add value to a capital-budgeting project are (1) the option to delay a project until the
3
4

370 Part 3 • Investment in Long-Term Assets
KEY TERMS
Project standing alone risk, page 361 A
project’s risk ignoring the fact that much of
this risk will be diversified away.
Contribution-to-firm risk, page 361 The
amount of risk that the project contributes to the
firm as a whole; this measure considers the fact
that some of the project’s risk will be diversified
away as the project is combined with the firm’s
other projects and assets but ignores the effects of
diversification of the firm’s shareholders.
Systematic risk, page 361 The risk of a
project from the viewpoint of a well-diversified
shareholder. This measure takes into account
that some of the project’s risk will be diversi-
fied away as the project is combined with the
firm’s other projects, and, in addition, some of
the remaining risk will be diversified away by
shareholders as they combine this stock with
other stocks in their portfolios.
Risk-adjusted discount rate, page 363
A method of risk adjustment when the risk
associated with the investment is greater than
the risk involved in a typical endeavor. Using
this method, the discount rate is adjusted
upward to compensate for this added risk.
Pure play method, page 366 A method for
estimating a project’s or division’s beta that
attempts to identify publicly traded firms
engaged solely in the same business as the
project or division.
Simulation, page 366 A method for dealing
with risk where the performance of the project
under evaluation is estimated by randomly
selecting observations from each of the
distributions that affect the outcome of the
project and continuing with this process until a
representative record of the project’s probable
outcome is assembled.
Scenario analysis, page 368 A simulation
approach for gauging a project’s risk under
the worst, best, and most likely outcomes. The
firm’s management examines the distribution
of the outcomes to determine the project’s
level of risk and then makes the appropriate
adjustment.
Sensitivity analysis, page 368 A method
for dealing with risk where the change in the
distribution of possible net present values or
internal rates of return for a particular project
resulting from a change in one particular input
variable is calculated. This is done by changing
the value of one input variable while holding
all other input variables constant.
KEY EqUATIONS
Risk@adjusted
NPV
= E present value of all thefuture annual free cashflows discounted back U – Ethe initial cash outlay
to present at the risk@adjusted
rate of return
U
=
FCF1
(1 + k*)1
+
FCF2
(1 + k*)2
+ g +
FCFn
(1 + k*)n
– IO
future cash flows are more favorable (this option is common when the firm has an exclusive right,
perhaps a patent, to a product or technology); (2) the option to expand a project, perhaps in size or
even to introduce new products that would not have otherwise been feasible; and (3) the option to
abandon a project if its future cash flows fall short of expectations.
There are three types of capital-budgeting risk: the project standing alone risk, the project’s
contribution-to-firm risk, and the project’s systematic risk. In theory, systematic risk is the appropriate
risk measure, but bankruptcy costs and the issue of undiversified shareholders also give weight to con-
sidering a project’s contribution-to-firm risk as the appropriate risk measure. Both measures of risk are
valid, and we avoid making any specific allocation of the importance between the two.
The risk-adjusted discount rate relies on Principle 3: Risk Requires a Reward and involves an
upward adjustment of the discount rate to compensate for risk. This method is based on the con-
cept that investors demand higher returns for riskier projects. Thus, projects are evaluated using
the appropriate, or risk-adjusted, discount rate.
The simulation method is used to provide information about the location and shape of the distribu-
tion of possible outcomes of the project. Decisions can be based directly on this method or used as
an input to make decisions using the risk-adjusted discount rate method.

Chapter 11 • Cash Flows and Other Topics in Capital Budgeting 371
Review questions
All Review Questions are available in MyFinanceLab.
11-1. Why do we focus on cash flows rather than accounting profits in making our capital-budgeting
decisions? Why are we interested only in incremental cash flows rather than total cash flows?
11-2. If depreciation is not a cash-flow expense, does it affect the level of cash flows from a project
in any way? Why?
11-3. If a project requires an additional investment in working capital, how should this be treated
when calculating the project’s cash-flows?
11-4. How do sunk costs affect the determination of cash flows associated with an investment proposal?
11-5. In the preceding chapter we examined the payback period capital-budgeting criterion. Often this
capital-budgeting criterion is used as a risk-screening device. Explain the rationale behind its use.
11-6. Use the concept of real options to explain why large restaurant chains often introduce new
concept restaurants that have negative NPVs.
11-7. Explain how simulation works. What is the value in using a simulation approach?
Study Problems
All Study Problems are available in MyFinanceLab.
11-1. (Relevant cash flows) Captins’ Cereal is considering introducing a variation of its current
breakfast cereal, Crunch Stuff. The new cereal will be similar to the old with the exception that it
will contain sugarcoated marshmallows shaped in the form of stars and will be called Crunch Stuff
n’ Stars. It is estimated that the sales for the new cereal will be $25 million; however, 20 percent of
those sales will be former Crunch Stuff customers who have switched to Crunch Stuff n’ Stars but
who would not have switched if the new product had not been introduced. What is the relevant
sales level to consider when deciding whether to introduce Crunch Stuff n’ Stars?
11-2. (Consideration of sunk and opportunity costs) Hewlett-Packard has designed a new type of printer that
produces professional-quality photos. These new printers took 2 years to develop, with research and
development running at $10 million after taxes over that period. Now all that’s left is an investment of
$22 million after taxes in new production equipment. It is expected that this new product line will bring
in free cash flows of $5 million per year for each of the next 10 years. In addition, if Hewlett-Packard
goes ahead with the new line of printers, the current production facility for the old printers that are to
be replaced with this new line could be sold to a competitor, generating $3 million after taxes.
a. How should the $10 million of research and development be treated?
b. How should the $3 million from the sale of the existing production facility for the old
printers be treated?
c. Given the information above, what are the cash flows associated with the new printers?
11-3. (Capital gains tax) The J. Harris Corporation is considering selling one of its old assembly
machines. The machine, purchased for $30,000 5 years ago, had an expected life of 10 years and
an expected salvage value of zero. Assume Harris uses simplified straight-line depreciation (depre-
ciation of $3,000 per year) and could sell this old machine for $35,000. Also assume Harris has a
34 percent marginal tax rate.
a. What would be the taxes associated with this sale?
b. If the old machine were sold for $25,000, what would be the taxes associated with this sale?
c. If the old machine were sold for $15,000, what would be the taxes associated with this sale?
d. If the old machine were sold for $12,000, what would be the taxes associated with this sale?
11-4. (Calculating free cash flows) Racin’ Scooters is introducing a new product and has an ex-
pected change in EBIT of $475,000. Racin’ Scooters has a 34 percent marginal tax rate. The
project will also produce $100,000 of depreciation per year. In addition, the project will also
cause the following changes in year 1:
1
2
W I T h O U T T h E P R O j E C T W I T h T h E P R O j E C T
Accounts receivable $45,000 $63,000
Inventory 65,000 80,000
Accounts payable 70,000 94,000
What is the project’s free cash flow in year 1?

372 Part 3 • Investment in Long-Term Assets
11-5. (Calculating free cash flows) Spartan Stores is expanding operations with the introduction
of a new distribution center. Not only will sales increase but investment in inventory will de-
cline due to increased efficiencies in getting inventory to showrooms. As a result of this new
distribution center, Spartan expects a change in EBIT of $900,000. While inventory is ex-
pected to drop from $90,000 to $70,000, accounts receivables are expected to climb as a result
of increased credit sales from $80,000 to $110,000. In addition, accounts payable are expected
to increase from $65,000 to $80,000. This project will also produce $300,000 of depreciation
per year, and Spartan Stores is in the 34 percent marginal tax rate. What is the project’s free
cash flow in year 1?
11-6. (Calculating operating cash flows) Assume that a new project will annually generate revenues of
$2,000,000. Cash expenses including both fixed and variable costs will be $800,000, and deprecia-
tion will increase by $200,000 per year. In addition, let’s assume that the firm’s marginal tax rate is
34 percent. Calculate the operating cash flows.
11-7. (Calculating free cash flows) At present, Solartech Skateboards is considering expanding its
product line to include gas-powered skateboards; however, it is questionable how well they will be
received by skateboarders. While you feel there is a 60 percent chance you will sell 10,000 of these
per year for 10 years (after which time this project is expected to shut down because solar-powered
skateboards will become more popular), you also recognize that there is a 20 percent chance that
you will only sell 3,000 and also a 20 percent chance you will sell 13,000. The gas skateboards
would sell for $100 each and have a variable cost of $40 each. Regardless of how many you sell,
the annual fixed costs associated with production would be $160,000. In addition, there would be
a $1,000,000 initial expenditure associated with the purchase of new production equipment. It is
assumed that this initial expenditure will be depreciated using the simplified straight-line method
down to zero over 10 years. Because of the number of stores that will need inventory, the working-
capital requirements are the same regardless of the level of sales, and this project will require a
one-time initial investment of $50,000 in net working capital, and that working-capital investment
will be recovered when the project is shut down. Finally, assume that the firm’s marginal tax rate
is 34 percent.
a. What is the initial outlay associated with the project?
b. What are the annual free cash flows associated with the project for years 1 through 9 under
each sales forecast? What are the expected annual free cash flows for years 1 through 9?
c. What is the terminal cash flow in year 10 (that is, what is the free cash flow in year 10 plus
any additional cash flows associated with the termination of the project)?
d. Using the expected free cash flows, what is the project’s NPV given a 10 percent required
rate of return? What would the project’s NPV be if 10,000 skateboards were sold?
11-8. (Calculating free cash flows) You are considering new elliptical trainers and you feel you can sell
5,000 of these per year for 5 years (after which time this project is expected to shut down when it
is learned that being fit is unhealthy). The elliptical trainers would sell for $1,000 each and have a
variable cost of $500 each. The annual fixed costs associated with production would be $1,000,000.
In addition, there would be a $5,000,000 initial expenditure associated with the purchase of new
production equipment. It is assumed that this initial expenditure will be depreciated using the
simplified straight-line method down to zero over 5 years. This project will also require a one-time
initial investment of $1,000,000 in net working capital associated with inventory, and that working-
capital investment will be recovered when the project is shut down. Finally, assume that the firm’s
marginal tax rate is 34 percent.
a. What is the initial outlay associated with this project?
b. What are the annual free cash flows associated with this project for years 1 through 4?
c. What is the terminal cash flow in year 5 (that is, what is the free cash flow in year 5 plus any
additional cash flows associated with the termination of the project)?
d. What is the project’s NPV given a 10 percent required rate of return?
11-9. (New project analysis) The Chung Chemical Corporation is considering the purchase of a
chemical analysis machine. Although the machine being considered will result in an increase in
earnings before interest and taxes of $35,000 per year, it has a purchase price of $100,000, and it
would cost an additional $5,000 to properly install the machine. In addition, to properly operate
the machine, inventory must be increased by $5,000. This machine has an expected life of 10 years,
after which it will have no salvage value. Also, assume simplified straight-line depreciation and that
this machine is being depreciated down to zero, a 34 percent marginal tax rate, and a required rate
of return of 15 percent.
a. What is the initial outlay associated with this project?
b. What are the annual after-tax cash flows associated with this project for years 1 through 9?

Chapter 11 • Cash Flows and Other Topics in Capital Budgeting 373
c. What is the terminal cash flow in year 10 (what is the annual after-tax cash flow in year 10
plus any additional cash flows associated with the termination of the project)?
d. Should this machine be purchased?
11-10. (New project analysis) Raymobile Motors is considering the purchase of a new production
machine for $500,000. The purchase of this machine will result in an increase in earnings before
interest and taxes of $150,000 per year. To operate this machine properly, workers would have
to go through a brief training session that would cost $25,000 after taxes. It would cost $5,000 to
install the machine properly. Also, because the machine is extremely efficient, its purchase would
necessitate an increase in inventory of $30,000. This machine has an expected life of 10 years,
after which it will have no salvage value. Assume simplified straight-line depreciation and that this
machine is being depreciated down to zero, a 34 percent marginal tax rate, and a required rate of
return of 15 percent.
a. What is the initial outlay associated with this project?
b. What are the annual after-tax cash flows associated with this project for years 1 through 9?
c. What is the terminal cash flow in year 10 (what is the annual after-tax cash flow in year 10
plus any additional cash flows associated with the termination of the project)?
d. Should the machine be purchased?
11-11. (New project analysis) Garcia’s Truckin’ Inc. is considering the purchase of a new production
machine for $200,000. The purchase of this machine will result in an increase in earnings before
interest and taxes of $50,000 per year. To operate the machine properly, workers would have to go
through a brief training session that would cost $5,000 after taxes. It would cost $5,000 to install the
machine properly. Also, because this machine is extremely efficient, its purchase would necessitate
an increase in inventory of $20,000. This machine has an expected life of 10 years, after which it
will have no salvage value. Finally, to purchase the new machine, it appears that the firm would
have to borrow $100,000 at 8 percent interest from its local bank, resulting in additional interest
payments of $8,000 per year. Assume simplified straight-line depreciation and that the machine is
being depreciated down to zero, a 34 percent marginal tax rate, and a required rate of return of
10 percent.
a. What is the initial outlay associated with this project?
b. What are the annual after-tax cash flows associated with this project for years 1 through 9?
c. What is the terminal cash flow in year 10 (what is the annual after-tax cash flow in year 10
plus any additional cash flows associated with the termination of the project)?
d. Should the machine be purchased?
11-12. (Calculating free cash flows) Vandelay Industries is considering a new project with a 4-year
life with the following cost and revenue data. This project will require an investment of $140,000
in new equipment. This new equipment will be depreciated down to zero over 4 years using the
simplified straight-line method and has no salvage value. This new project will generate additional
sales revenue of $112,000 while additional operating costs, excluding depreciation, will be $68,000.
Vandelay’s marginal tax rate is 35 percent. What is the project’s free cash flow in year 1?
11-13. (Calculating free cash flows) Doublemeat Palace is considering a new plant for a temporary
customer, and its finance department has determined the following characteristics. The company
owns much of the plant and equipment to be used for the product. This equipment was originally
purchased for $90,000; however, if the project is not undertaken, this equipment will be sold for
$50,000 after taxes; in addition, if the project is not accepted, the plant used for the project could
be sold for $105,000 after taxes—the plant originally cost $40,000. The rest of the equipment will
need to be purchased at a cost of $150,000. This new equipment will be depreciated by the straight-
line method over the project’s 3-year life, after which it will have zero salvage value. No change in
net operating working capital would be required, and management expects revenues resulting from
this new project to be $234,000 per year for 3 years, while increased operating expenses, excluding
depreciation, are expected to be $82,000 per year over the project’s 3-year life. The average tax rate
is 25 percent and the marginal tax rate is 30 percent. The required rate of return for this project is
8 percent. What is the project’s NPV ?
11-14. (Comprehensive problem) Traid Winds Corporation, a firm in the 34 percent marginal
tax bracket with a 15 percent required rate of return or cost of capital, is considering a new
project. This project involves the introduction of a new product. The project is expected to
last 5 years and then, because this is somewhat of a fad product, be terminated. Given the fol-
lowing information, determine the free cash flows associated with the project, the project’s net
present value, the profitability index, and the internal rate of return. Apply the appropriate
decision criteria.

374 Part 3 • Investment in Long-Term Assets
Cost of new plant and equipment $14,800,000
Shipping and installation costs $ 200,000
Unit sales
Sales price per unit $300/unit in years 1 through 4, $250/unit in year 5
Variable cost per unit $140/unit
Annual fixed costs $700,000 per year in years 1–5
Working-capital requirements There will be an initial working-capital requirement of
$200,000 just to get production started. For each year,
the total investment in net working capital will be equal
to 10 percent of the dollar value of sales for that year.
Thus, the investment in working capital will increase
during years 1 and 2, then decrease in year 4. Finally, all
working capital is liquidated at the termination of the
project at the end of year 5.
The depreciation method Use the simplified straight-line method over 5 years.
Assume that the plant and equipment will have no sal-
vage value after 5 years.
Y E A R U N I T S S O L D
1 70,000
2 120,000
3 120,000
4 80,000
5 70,000
Cost of new plant and equipment $6,900,000
Shipping and installation costs $ 100,000
Unit sales
Sales price per unit $250/unit in years 1 through 4, $200/unit in year 5
Variable cost per unit $130/units
Annual fixed costs $300,000 per year in years 1–5
Working-capital requirements There will be an initial working-capital requirement of
$100,000 just to get production started. For each year, the
total investment in net working capital will be equal to
10 percent of the dollar value of sales for that year. Thus,
the investment in working capital will increase during years
1 through 3, then decrease in year 4. Finally, all working
capital is liquidated at the termination of the project at the
end of year 5.
The depreciation method Use the simplified straight-line method over 5 years.
Assume that the plant and equipment will have no salvage
value after 5 years.
Y E A R U N I T S S O L D
1 80,000
2 100,000
3 120,000
4 70,000
5 70,000
11-15. (Comprehensive problem) The Shome Corporation, a firm in the 34 percent marginal tax
bracket with a 15 percent required rate of return or cost of capital, is considering a new project.
The project involves the introduction of a new product. This project is expected to last 5 years and
then, because this is somewhat of a fad product, be terminated. Given the following information,
determine the free cash flows associated with the project, the project’s net present value, the profit-
ability index, and the internal rate of return. Apply the appropriate decision criteria.

Chapter 11 • Cash Flows and Other Topics in Capital Budgeting 375
11-16. (Real options) Hurricane Katrina brought unprecedented destruction to New Orleans and
the Mississippi gulf coast in 2005. Notably, the burgeoning casino gambling industry along the
Mississippi coast was virtually wiped out overnight. GCC Corporation owns one of the oldest
casinos in the Biloxi, Mississippi, area, and its casino was damaged but not destroyed by the tidal
surge from the storm. The reason was that it had been located several blocks back from the beach
on higher ground. However, since the competitor casinos were completely destroyed and will have
to rebuild from scratch, GCC believes that it is likely to have a number of good opportunities. You
have been hired to provide GCC with strategic advice. What have you learned about real options
that will help you develop a strategy for GCC?
11-17. (Real options and capital budgeting) You have come up with a great idea for a Tex-Mex-Thai
fusion restaurant. After doing a financial analysis of this venture, you estimate that the initial outlay
will be $6 million. You also estimate that there is a 50 percent chance that this new restaurant will
be well received and will produce annual cash flows of $800,000 per year forever (a perpetuity),
while there is a 50 percent chance of it producing a cash flow of only $200,000 per year forever (a
perpetuity) if it isn’t received well.
a. What is the NPV of the restaurant if the required rate of return you use to discount the
project cash flows is 10 percent?
b. What are the real options that this analysis may be ignoring?
c. Explain why the project may be worthwhile even though you have just estimated that its
NPV is negative.
11-18. (Real options and capital budgeting) Go-Power Batteries has developed a high-voltage
nickel-metal hydride battery that can be used to power a hybrid automobile. It can sell the
technology immediately to Toyota for $10 million, or alternatively, Go-Power Batteries can
invest $50 million in a plant and produce the batteries for itself and sell them. Unfortunately,
given the current size of the market for hybrids, the present value of the cash flows from such
a plant would be only $40 million, implying that the plant has a negative expected NPV of
-$10 million. What are the real options that are being ignored in this analysis? Can you come
up with a compelling reason why Go-Power should keep the technology rather than sell it to
Toyota?
11-19. (Risk-adjusted NPV) The Hokie Corporation is considering two mutually exclusive projects.
Both require an initial outlay of $10,000 and will operate for 5 years. Project A will produce ex-
pected cash flows of $5,000 per year for years 1 through 5, whereas project B will produce expected
cash flows of $6,000 per year for years 1 through 5. Because project B is the riskier of the two
projects, the management of Hokie Corporation has decided to apply a required rate of return of
15 percent to its evaluation but only a 12 percent required rate of return to project A. Determine
each project’s risk-adjusted net present value.
11-20. (Risk-adjusted discount rates and risk classes) The G. Wolfe Corporation is examining two
capital-budgeting projects with 5-year lives. The first, project A, is a replacement project; the sec-
ond, project B, is a project unrelated to current operations. The G. Wolfe Corporation uses the
risk-adjusted discount rate method and groups projects according to purpose, and then it uses a
required rate of return or discount rate that has been preassigned to that purpose or risk class. The
expected cash flows for these projects are given here:
3
4
P R O j E C T A P R O j E C T B
Initial investment -$250,000 -$400,000
Cash inflows:
Year 1 $130,000 $135,000
Year 2 40,000 135,000
Year 3 50,000 135,000
Year 4 90,000 135,000
Year 5 130,000 135,000

376 Part 3 • Investment in Long-Term Assets
Determine each project’s risk-adjusted net present value.
Mini Case
This Mini Case is available in MyFinanceLab.
It’s been 2 months since you took a position as an assistant financial analyst at Caledonia Products.
Although your boss has been pleased with your work, he is still a bit hesitant about unleashing you
without supervision. Your next assignment involves both the calculation of the cash flows associ-
ated with a new investment under consideration and the evaluation of several mutually exclusive
projects. Given your lack of tenure at Caledonia, you have been asked not only to provide a recom-
mendation but also to respond to a number of questions aimed at judging your understanding of
the capital-budgeting process. The memorandum you received outlining your assignment follows:
To: The Assistant Financial Analyst
From: Mr. V. Morrison, CEO, Caledonia Products
Re: Cash Flow Analysis and Capital Rationing
We are considering the introduction of a new product. Currently we are in the 34 percent marginal
tax bracket with a 15 percent required rate of return or cost of capital. This project is expected to
last 5 years and then, because this is somewhat of a fad product, be terminated. The following in-
formation describes the new project:
Cost of new plant and equipment $7,900,000
Shipping and installation costs $ 100,000
Unit sales
Sales price per unit $300/unit in years 1 through 4, $260/unit in year 5
Variable cost per unit $180/unit
Annual fixed costs $200,000 per year in years 1–5
Working-capital requirements There will be an initial working-capital requirement of
$100,000 just to get production started. For each year,
the total investment in net working capital will be equal
to 10 percent of the dollar value of sales for that year.
Thus, the investment in working capital will increase dur-
ing years 1 through 3, then decrease in year 4. Finally,
all working capital is liquidated at the termination of the
project at the end of year 5.
The depreciation method Use the simplified straight-line method over 5 years.
Assume that the plant and equipment will have no sal-
vage value after 5 years.
Y E A R U N I T S S O L D
1 70,000
2 120,000
3 140,000
4 80,000
5 60,000
P U R P O S E R E q U I R E D R AT E O F R E T U R N
Replacement decision 12%
Modification or expansion of existing product line 15
Project unrelated to current operations 18
Research and development operations 20
a. Should Caledonia focus on cash flows or accounting profits in making its capital-budgeting
decisions? Should the company be interested in incremental cash flows, incremental prof-
its, total free cash flows, or total profits?
The purpose/risk classes and preassigned required rates of return are as follows:

Chapter 11 • Cash Flows and Other Topics in Capital Budgeting 377
b. How does depreciation affect free cash flows?
c. How do sunk costs affect the determination of cash flows?
d. What is the project’s initial outlay?
e. What are the differential cash flows over the project’s life?
f. What is the terminal cash flow?
g. Draw a cash-flow diagram for this project.
h. What is its net present value?
i. What is its internal rate of return?
j. Should the project be accepted? Why or why not?
k. In capital budgeting, risk can be measured from three perspectives. What are those three
measures of a project’s risk?
l. According to the CAPM, which measurement of a project’s risk is relevant? What compli-
cations does reality introduce into the CAPM view of risk, and what does that mean for our
view of the relevant measure of a project’s risk?
m. Explain how simulation works. What is the value in using a simulation approach?
n. What is sensitivity analysis and what is its purpose?

378 Part 3 • Investment in Long-Term Assets
Appendix 11A
The Modified Accelerated Cost
of Recovery System
To simplify our computations we have used straight-line depreciation throughout this
chapter. However, firms use accelerated depreciation for calculating their taxable income.
In fact, the modified accelerated cost recovery system (MACRS) has been used since 1987.
Under the MACRS the depreciation period is based on the asset depreciation range (ADR)
system, which groups assets into classes by asset type and industry and then determines the
actual number of years to be used in depreciating the asset. In addition, the MACRS re-
stricts the amount of depreciation that may be taken in the year an asset is acquired or sold.
These limitations have been called averaging conventions. The two primary conventions,
or limitations, may be stated as follows:
1. Half-Year Convention: Personal property, such as machinery, is treated as having been
placed in service or disposed of at the midpoint of the taxable year. Thus, a half-year of
depreciation generally is allowed for the taxable year in which property is placed in service
and in the final taxable year. As a result, a 3-year property class asset has a depreciation cal-
culation that spans 4 years, with only a half a year’s depreciation in the first and fourth years.
In effect, it is assumed the asset is in service for 6 months during both the first and last year.
2. Mid-Month Convention: Real property, such as buildings, is treated as being placed in ser-
vice or disposed of in the middle of the month. Accordingly, a half-month of depreciation
is allowed for the month the property is placed in service and also for the final month of
service.
Using the MACRS results in a different percentage of the asset being depreciated each
year; these percentages are shown in Table 11A-1.
TABLE 11A-1 Percentages for Property Classes
Recovery Year 3-Year 5-Year 7-Year 10-Year 15-Year 20-Year
1 33.3% 20.0% 14.3% 10.0% 5.0% 3.8%
2 44.5 32.0 24.5 18.0 9.5 7.2
3 14.8 19.2 17.5 14.4 8.6 6.7
4 7.4 11.5 12.5 11.5 7.7 6.2
5 11.5 8.9 9.2 6.9 5.7
6 5.8 8.9 7.4 6.2 5.3
7 8.9 6.6 5.9 4.9
8 4.5 6.6 5.9 4.5
9 6.5 5.9 4.5
10 6.5 5.9 4.5
11 3.3 5.9 4.5
12 5.9 4.5
13 5.9 4.5
14 5.9 4.5
15 5.9 4.5
16 3.0 4.5
17 4.5
18 4.5
19 4.5
20 4.5
21 1.7
Total 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%

Chapter 11 • Cash Flows and Other Topics in Capital Budgeting 379
To demonstrate the use of the MACRS, assume that a piece of equipment costs $12,000
and has been assigned to a 5-year class. Using the percentages in Table 11A-1 for a 5-year
class asset, the depreciation deductions would be calculated as shown in Table 11A-2.
Note that the averaging convention that allows for the half-year of depreciation in the
first year results in a half-year of depreciation beyond the fifth year, or in year 6.
What Does All This Mean?
Depreciation, while an expense, is not a cash-flow item. However, depreciation expense
lowers the firm’s taxable income, which in turn reduces the firm’s tax liability and increases
its cash flow. Throughout our calculations in Chapter 11 we used a simplified straight-
line depreciation method to keep the calculations simple, but in reality you would use the
MACRS method. The advantage of accelerated depreciation is that you end up with more
depreciation expense (a non-cash item) in the earlier years and less depreciation expense in
the latter years. As a result, you have less taxable profits in the early years and more taxable
profits in the latter years. This reduces taxes in the earlier years when the present values
are greatest, while increasing taxes in the latter years when the present values are smaller.
In effect, the MACRS allows you to postpone paying taxes. Regardless of whether you use
straight-line or accelerated depreciation (MACRS), the total depreciation is the same—it is
just the timing of when the depreciation is expensed that changes.
Most corporations prepare two sets of books, one for calculating taxes for the IRS in
which they use the MACRS, and one for their stockholders in which they use straight-line
depreciation. For capital-budgeting purposes, only the set of books used to calculate taxes
is relevant.
Study Problems
All Study Problems are available in MyFinanceLab.
11A-1. (Depreciation) Compute the annual depreciation for an asset that costs $250,000 and is in
the 5-year property class. Use the MACRS in your calculation.
11A-2. (Depreciation) The Mason Falls Mfg. Company just acquired a depreciable asset this year,
costing $500,000. Furthermore, the asset falls into the 7-year property class using the MACRS.
a. Using the MACRS, compute the annual depreciation.
b. What assumption is being made about when the asset was bought within the year?
TABLE 11A-2 MACRS Demonstrated
Year Depreciation Percentage Annual Depreciation
1 20.0% $ 2,400
2 32.0 3,840
3 19.2 2,304
4 11.5 1,380
5 11.5 1,380
6 5.8 696
100.0% $12,000

Determining the Financing Mix
Learning Objectives
1 Distinguish between business and financial risk. Understanding the Difference Between
Business and Financial Risk
2 Use break-even analysis. Break-even Analysis
3 Understand the relationships between operating, Sources of Operating Leverage
financial, and combined leverage.
4 Discuss the concept of an optimal capital structure. Capital Structure Theory
5 Use the basic tools of capital structure management. The Basic Tools of Capital Structure
Management
380
What do telecom giant AT&T (T) and Heineken (HINKY.PK) (one of the world’s largest brewers of beer)
share in common? In the spring of 2012 they both borrowed a lot of money by issuing bonds in the public
markets. AT&T raised $3 billion in April 2012 by issuing bonds while Heineken raised a paltry $750 million.
The decision to issue debt was in both instances a choice made by the firm’s respective management team
and board of directors. Why corporate bonds; why not common or preferred stock? These are the questions
we address in this chapter.
When a firm needs funds to support its investment plans, it typically raises them internally by reinvesting
all or part of its earnings. This process of reinvesting firm earnings is tantamount to increasing the investment
of the firm’s common shareholders in the firm because the earnings represent what is left for the common
stockholders after everyone else has been paid. However, occasionally firms find that they need to raise funds
externally from the capital markets either because they do not have sufficient earnings to reinvest or they want
to rebalance their capital structures. Historically, when firms tried to raise external sources of funds, they had to
go to the public capital market where they sold bonds or stocks with the help of investment bankers to a diverse
group of investors. However, today private equity firms are a growing source of external capital.
12

Earlier chapters allowed us to develop
an understanding of how financial
assets are valued in the marketplace.
Drawing on the tenets of valuation
theory, we presented various ap-
proaches to measuring the cost of
funds to the business organization.
This chapter presents concepts that
relate to the valuation process and
the cost of capital; it also discusses
the crucial problem of planning the
firm’s financing mix.
The cost of capital provides a
direct link between the formulation
of the firm’s asset structure and its
financial structure. This is illus-
trated in Figure 12-1. Recall that
the cost of capital is a basic input to
the time-adjusted, capital-budgeting models. Therefore, it affects the capital-budgeting, or
asset-selection, process. The cost of capital is affected, in turn, by the composition of the
right-hand side of the firm’s balance sheet—that is, its financial structure.
This chapter examines tools that can be useful aids to the financial manager in de-
termining the firm’s proper financial structure. First, we review the notion of risk from
the perspective of the firm’s shareholders as it relates to the potential volatility in share-
holder earnings. Corporate CEOs and boards of directors are very sensitive to the earnings
numbers they report to Wall Street, so it behooves the financial manager to understand
fully how the firm’s capital structure affects the variability of earnings.
381381
FigURe 12-1 The Cost of Capital as a Link Between a Firm’s Asset Structure
and Financial Structure
The discount or hurdle
rate input to “correct”
capital-budgeting models:
(1) internal rate of return
(2) net present value
(3) profitability index
Cost of capital
The financial structure
affects the level and
variability of the cash
flows after taxes
available to the
common shareholders.
The decision to employ
financial leverage
affects the determination
of the financial
structure of the firm.
This is an input to
choosing the amount
of financial leverage
the firm should employ.
Directly influences the
determination of the
asset structure of the
firm through the project
evaluation process
The asset structure
affects the level and
variability of the
firm’s net operating
income (EBIT).

382 Part 4 • Capital Structure and Dividend Policy
Next, we turn to a discussion of capital structure theory and the basic tools of capital
structure management. Actual capital structure practices are also placed in perspective.
What is it about the nature of business that causes changes in sales revenues to trans-
late into larger variations in net income and, finally, the earnings available to the common
shareholders? It would be a good planning tool for management to be able to decompose
such fluctuations into those policies associated with the operating side of the business and
those policies associated with the financing side of the business.
If you understand the material and analytical processes in this chapter, you will be able
to make positive contributions to company strategies that deal with the firm’s financing mix.
You will be able to formulate a defensible answer to the question: “Should we finance our
next capital project with a new issue of bonds or a new issue of common stock?” You can also
help a lot of firms avoid making serious financial errors, the consequences of which can last
for many years.
Understanding the Difference Between
Business and Financial Risk
If investors are surprised by lower-than-expected corporate earnings, this can lead to a
downward revision in their expectations of the firm’s future prospects and, consequently,
reduce the firm’s common stock price. Thus, corporate executives and their boards of
directors pay close attention to the earnings that they report to Wall Street. For this
reason the financial analyst needs to understand the sources of volatility in firm earnings
per share.
In this section we separate the variation in the firm’s income stream into one of three
sources:
1. Choice of business line—the variation in firm earnings that arises out of the natural
volatility in revenues attributable to the industry in which it operates. For example,
if the firm operates in a highly volatile industry in which revenues fluctuate with the
business cycle, then the firm’s earnings will be more volatile than another firm that
operates in an industry that is less sensitive to the business cycle. We will refer to this
source of variation in firm earnings as business risk.
2. Choice of an operating cost structure—the volatility in the firm’s operating earn-
ings that results from the firm’s cost structure,1 that is, the mix of fixed and variable
operating costs the firm pays to do business. Greater fixed operating costs (versus vari-
able costs) increase the variability in operating earnings in response to changes in rev-
enues. The firm’s mixture of fixed versus variable operating costs is largely determined
by the industry in which the firm operates. For example, automobile manufacturing
requires that large investments be made in plant and equipment. This results in high
fixed operating costs regardless of the level of plant operations. We will refer to this
source of variation in the firm earnings as operating risk.
1 Distinguish between business
and financial risk.
operating risk risk driven by the mix of
fixed versus variable costs the firm incurs to do
business.
financial risk risk driven by the presence of
fixed finance costs in the firm’s capital structure
(as opposed to variable finance costs such as
dividends declared and paid).
business risk the risk of the firm’s future
earnings that is a direct result of the particular
line of business chosen by the firm.
1Recall that the term EBIT is the acronym for earnings before interest and taxes. If what accountants call other income and
other expenses are equal to zero, then EBIT is equal to net operating income. For our purposes we use these two terms
interchangeably.
3. Choice of a capital structure—the source of variation in the firm’s earnings that
results from its use of sources of financing that require a fixed return, such as debt
financing. We will refer to this source of variation in earnings as financial risk.
We now spend some time developing an understanding of all three of these sources of
volatility in firm earnings.
Business Risk
The amount of business risk the firm decides to take on is most critical at the time the business
is started. However, because business risk can affect the volatility of a firm’s revenues, it can

Chapter 12 • Determining the Financing Mix 383
affect the firm’s earnings per share. Thus, it behooves us to spend a little time discussing the
sources of business risk. We identify four basic determinants of a firm’s business risk:
1. The stability of the domestic economy. Firms that operate in more volatile econ-
omies, such as those of developing nations, are subject to swings in revenue that is
much more severe than those that operate within developed countries. For example, a
chain of clothing stores operating within the United States faces a less volatile revenue
stream than, say, a chain located in Nigeria or even Brazil.
2. The exposure to, and stability of, foreign economies. In today’s global economy,
more and more firms produce and sell their products in multiple countries. This means
that it is not only the natural volatility of the firm’s home country that drives the vola-
tility of the firm’s revenues but also that of the countries in which its goods and services
are produced and sold.
3. Sensitivity to the business cycle. Some industries are more sensitive to the busi-
ness cycle than others. For example, the sales of consumer durable goods such as auto-
mobiles, housing, and appliances tend to be more sensitive to swings in the business
cycle than necessities such as food and clothing.
4. Competitive pressures in the firm’s industry. Here we refer to the forces of other
firms within the firm’s marketplace that provide the same (or close substitute) products
and services. Greater competitive pressures will force the firm to make price conces-
sions sooner and deeper than would otherwise be the case.
Although business risk is obviously a critical determinant of earnings volatility, for the bal-
ance of this chapter we will assume that the firm’s business risk is fixed, or given. This will allow
us to focus on operating and financial risks, over which managers have more control.
Operating Risk
Operating risk increases when the firm incurs more fixed versus variable costs. Fixed costs
do not vary with the firm’s revenues, but variable costs, as the name implies, do rise and fall
with revenues. A key tool for evaluating operating risk is break-even analysis. Therefore, we
open our discussion of operating risk by defining the break-even chart.
Concept Check
1. Why do managers care about the volatility of their firms’ earnings?
2. What are the three determinants of the volatility of a firm’s earnings?
3. Describe the sources of business risk.
4. What is the determinant of a firm’s operating risk?
Break-even Analysis
Both small and large organizations utilize the break-even analysis tool for two reasons: It
is based on straightforward assumptions, and companies have found that the information
gained from the break-even model is beneficial in decision-making situations. A break-even
analysis is used to determine the break-even quantity of the firm’s output. What is meant
by the break-even quantity of output? It is that quantity of output, denominated in units,
that results in operating income (or EBIT) equal to zero. In other words, a break-even
analysis enables the analyst (1) to determine the quantity of output that must be sold to
cover all operating costs, as distinct from financial costs and (2) to calculate the EBIT that
will be achieved at various output levels.
essential elements of the Break-even Model
To implement the break-even model, we must separate the production costs of the com-
pany into two mutually exclusive categories: fixed costs and variable costs. You will recall
from your study of basic economics that in the long run all costs are variable. The break-
even analysis, therefore, is a short-run concept.
2 Use break-even analysis.
break-even quantity the number of units a
firm must sell before it starts to earn a profit.

384 Part 4 • Capital Structure and Dividend Policy
Fixed Costs Fixed costs, also referred to as indirect costs, do not vary with either the
firm’s sales or output. As the production volume increases, the fixed cost per unit of product
falls, because the firm’s total fixed costs are spread over larger and larger quantities of
output. Figure 12-2 graphs the behavior of total fixed costs with respect to the company’s
relevant range of units produced and sold. This total is shown to be unaffected by the quan-
tity of product that is manufactured and sold. Over some other output range, the amount of
total fixed costs might be higher or lower for the same company.
In a manufacturing setting, some specific examples of fixed costs are
1. Administrative salaries
2. Depreciation
3. Insurance
4. Lump sums spent on intermittent advertising programs
5. Property taxes
6. Rent
Variable Costs Variable costs are sometimes referred to as direct costs. Variable costs
per unit vary as output changes. Total variable costs are computed by taking the variable cost
per unit and multiplying it by the total quantity produced and sold. The break-even mod-
el assumes proportionality between total variable costs and sales. Thus, if sales rise by
10 percent, it is assumed that variable costs will rise by 10 percent. Notice that if zero units of
the product are manufactured, then variable costs are zero, but fixed costs are greater than zero.
This implies that some contribution to the coverage of fixed costs occurs as long as the selling
price per unit exceeds the variable costs per unit. This helps explain why some firms will operate
a plant even when sales are temporarily depressed—that is, to try to cover fixed costs.
Some examples of variable costs include
1. Direct labor
2. Direct materials
3. Energy costs (fuel, electricity, natural gas) associated with production
4. Freight costs for products leaving the plant
5. Packaging
6. Sales commissions
Figure 12-2 also graphs total costs with respect to the company’s relevant range of out-
put. Total cost is simply the sum of the firm’s fixed and variable costs.
More on the Behavior of Costs No one really believes that all costs behave as neatly
as we have illustrated the fixed and variable costs in Figure 12-2. Nor does any law or
accounting principle dictate that a certain element of the firm’s total costs always will
be classified as fixed or variable. This depends on each firm’s specific circumstances. In
direct costs see variable costs.
variable costs expenses that vary in total as
output changes. Also called direct costs.
FigURe 12-2 The Behavior of Total, Fixed, and Variable Costs Over a Relevant
Range of Output
Fixed costs
Total costs
Variable cost
s
0
Units produced and sold
Co
st
s
($
)
fixed costs costs that do not vary in total dol-
lar amount as sales volume or quantity of output
changes. Also called indirect costs.
indirect costs see fixed costs.

Chapter 12 • Determining the Financing Mix 385
one firm, energy costs may be predominantly fixed, whereas in another they may vary
with output.2
total revenue total sales dollars.
volume of output the number of units
produced and sold for a particular period of time.
2In a greenhouse operation, in which plants are grown (manufactured) under strictly controlled temperatures, heat costs
will tend to be fixed whether the building is full or only half-full of seedlings. In a metal stamping operation, in which
levers are being produced, there is no need to heat the plant to as high a temperature when the machines are stopped and
the workers are not there. In this latter case, the heat costs will tend to be variable.
Furthermore, some costs may be fixed for a while, then rise sharply to a higher level as
a higher output is reached, remain fixed, and then rise again with further increases in pro-
duction. Such costs may be termed either semivariable or semifixed. The label is your choice
because both are used in practice. An example might be the salaries paid to production
supervisors. Should output be cut back by 15 percent for a short period, the organization
is not likely to lay off 15 percent of its supervisors. Similarly, the percentage commissions
paid to salespeople are often incrementally stepped up the more they sell. This sort of cost
behavior is shown in Figure 12-3.
To implement the break-even model and deal with such a complex cost structure, the
financial manager must (1) identify the most relevant output range for planning purposes
and then (2) approximate the cost effect of semivariable items over this range by segregat-
ing a portion of them to fixed costs and a portion to variable costs. In the actual business
setting this procedure is not fun. It is not unusual for the analyst who deals with the figures
to spend considerably more time allocating costs to fixed and variable categories than doing
the actual break-even calculations.
Total Revenue and Volume of Output Besides fixed and variable costs, the essential
elements of the break-even model include total revenue from sales and volume of output.
Total revenue means total sales dollars and is equal to the selling price per unit multiplied
by the quantity sold. The volume of output refers to the firm’s level of operations and may
be indicated either as a unit quantity or as sales dollars.
Finding the Break-even Point
Finding the break-even point in terms of units of production can be accomplished in several
ways. All approaches require the essential elements of the break-even model just described.
The break-even model is a simple adaptation of the firm’s income statement expressed in
the following analytical format:
Sales – (total variable cost + total fixed cost) = profit (12-1)
On a units-of-production basis, it is necessary to introduce (1) the price at which each
unit is sold and (2) the variable cost per unit of output. Because the profit item studied in
a break-even analysis is EBIT, we use this acronym instead of the word profit. In terms of
units, the income statement shown in equation (12-1) becomes the break-even model by
setting EBIT equal to zero:
aSales price
per unit
b * aunits
sold
b – c avariable cost
per unit
b * aunits
sold
b + atotal fixed
cost
b d = EBIT = $0 (12-2)
FigURe 12-3 Semivariable Cost Behavior Over a Relevant Range of Output
0
Units produced and sold
Semivariable
(semifixed) costs
Co
st
s
($
)

386 Part 4 • Capital Structure and Dividend Policy
Our task now becomes finding the number of units that must be produced and sold in
order to satisfy equation (12-2)—that is, to arrive at EBIT = $0. This can be done by sim-
ply solving equation (12-2) for the number of units sold that make EBIT = 0.
Specifically, the break-even number of units sold is found to equal:
Break@even
level of
units
=
total fixed cost
asales price
per unit
– variable cost
per unit
b
(12-3)
e x A M P L e 12.1 Calculating the break-even level of units
Even though Pierce Grain Company manufactures several different products, it has ob-
served over a lengthy period that its product mix is rather constant. This allows man-
agement to conduct its financial planning by using a “normal” sales price per unit and a
“normal” variable cost per unit. The “normal” sales price and variable cost per unit are
calculated from the constant product mix. It is like assuming that the product mix is one
big product. The selling price is $10 and the variable cost is $6. Total fixed costs for the
firm are $100,000 per year. What is the break-even point in units produced and sold for
the company during the coming year?
STEP 1: ForMulaTE a SoluTion STraTEgy
We are interested in knowing the number of the product mix Pierce Grain Company
must sell before all its costs are covered. That is, EBIT (profit) will be equal to zero.
Equation (12-3), which was derived from this general idea, is again shown below:
Break@even =
total fixed costs
(sales price per unit – variable cost per unit)
Comparing what we know from the question and this equation, we know:
1. Total fixed costs = $100,000
2. Sales prices per unit = $10
3. Variable cost per unit = $6
STEP 2: CrunCh ThE nuMbErS
Substituting this information into equation (12-3) yields:
Break@even =
$100,000
(10 – 6) $/unit
Break@even = 25,000 units
STEP 3: analyzE your rESulTS
Thus, Pierce Grain must sell 25,000 units in the coming year to cover only its fixed costs.
In essence, after selling 25,000 units, Pierce Grain will have covered the costs it incurred
to produce the 25,000 units and EBIT = 0.
Break@even =
total fixed costs
a1 – variable costs
revenues
b
The Break-even Point in Sales Dollars
For the multiproduct firm, it is convenient to compute the break-even point in terms of sales
dollars rather than units sold. Sales, in effect, become a common denominator associated with

Chapter 12 • Determining the Financing Mix 387
a particular product mix. Furthermore, an outside analyst might not have access to internal
unit cost data. He or she may, however, be able to obtain annual reports for the firm. If
the analyst can separate the firm’s total costs as identified from its annual reports into their
fixed and variable components, he or she can calculate a general break-even point in sales
dollars.
We illustrate this procedure using Pierce Grain Company’s cost structure. Suppose
that the reported financial information is arranged in the format shown in Table 12-1. If we
are aware of the simple mathematical relationships on which cost-volume-profit analysis is
based, we can use Table 12-1 to find the break-even point in sales dollars for Pierce Grain
Company.
We can solve for the break-even level of revenues (as opposed to units sold) using equa-
tion (12-4) as follows:
Break@even level of revenues =
total fixed costs
a1 – variable costs
revenues
b
(12-4)
In the Pierce Grain Company example the ratio of the firm’s variable costs ($180,000)
to revenues ($300,000) is $180,000/$300,000, or 0.60, and is assumed to be constant for all
revenue levels. Consequently, we can use equation (12-4) to solve for Pierce’s break-even
level of revenues as follows:
Break@even level of revenues =
$100,000
a1 – $180,000
$300,000
b
= $250,000
CAN YOU DO IT?
analyzing ThE brEaK-EVEn SalES lEVEl
Creighton Manufacturing Company assembles brake controllers used to upgrade the brake systems of vintage automobiles that are
being restored. The firm’s revenues for the past year were $20 million, on which the firm had earnings before interest and taxes (EBIT)
of $10 million. Fixed expenses were $2 million. Variable costs were of $8 million, or 40 percent of the firm’s revenues. What do you
estimate the firms break-even level of revenues to be based on its current cost structure?
(The solution can be found on page 388.)
TABLe 12-1 income Statement for Pierce grain Company
Sales $300,000
Less: Total variable costs 180,000
Revenue before fixed costs $120,000
Less: Total fixed costs 100,000
EBIT $ 20,000
FINANCIAl DeCIsION TOOls
Name of Tool Formula What it Tells You
Break-even level of revenues
Break@even level of revenues =
total fixed costs
a1 – variable costs
revenues
b
• The dollar amount of firm revenues needed for
the firm to cover its fixed and variable costs
• To get break-even units divide break-even
revenue level by the product price.

388 Part 4 • Capital Structure and Dividend Policy
Concept Check
1. Distinguish among fixed costs, variable costs, and semivariable costs.
2. When is it useful or sometimes necessary to compute the break-even point in terms of sales dol-
lars rather than units of output?
Sources of Operating Leverage
When a firm has fixed operating costs, then it is subject to the effects of operating lever-
age. Moreover, the operating leverage increases the sensitivity of the firm’s operating in-
come to changes in sales.
For example, highly leveraged firms will see their incomes rise sharply when their sales
rise. By contrast, firms with less leverage will see less-sharp rises in their incomes when
their sales rise. To illustrate how this works, consider the Pierce Grain Company example.
The firm’s current sales are equal to $300,000, as found in Table 12-2. If Pierce’s sales were
to rise by 20 percent, up to $360,000, we calculate that the firm’s EBIT would rise from
$20,000 to $44,000. Note in the last column of Table 12-2 that we calculate the percent
change in both revenues and EBIT. Revenues increase by just 20 percent, but the EBIT
3 Understand the relationship
between operating leverage,
financial leverage, and
combined leverage.
operating leverage results from operating
costs that are fixed and do not vary with the level
of firm sales.
DID YOU GeT IT?
analyzing ThE brEaK-EVEn SalES lEVEl
Creighton Manufacturing Company has fixed operating costs of $2 million and pays variable costs equal to $8 million/$20 million =
40 percent. Therefore, using equation (12-4), we can solve for the firm’s break-even sales level as follows:
Break@even level of revenues =
$2,000,000
a1 – $8,000,000
$20,000,000
b
= $3,333,333
CAN YOU DO IT?
analyzing ThE EFFECTS oF oPEraTing lEVEragE
JGC Electronics operates in a very cyclical business environment such that it is not uncommon for the firm’s sales to increase or de-
crease by 20 percent or more from year to year. Moreover, the firm has made a substantial investment in plant and equipment. The
company’s high fixed operating expenses associated with the plant and equipment make the firm’s earnings before interest and taxes
(EBIT) very sensitive to changes in revenues. In fact, if revenues were to rise by 20 percent, the firm’s managers estimate that EBIT
would rise by 40 percent. If JGC’s revenues were to fall by 20 percent from their current level of $10 million, what percentage decline
in EBIT would you anticipate for the firm?
(The solution can be found on page 389.)
TABLe 12-2 How Operating Leverage Affects eBiT: An increase in Pierce grain
Company’s Sales
item
Base Sales
Level, t
Forecast Sales
Level, t + 1 Percentage Change
Sales $300,000 $360,000 +20%
Less: Total variable costs 180,000 216,000
Revenue before fixed costs $120,000 $144,000
Less: Total fixed costs 100,000 100,000
EBIT $ 20,000 $ 44,000 +120%

Chapter 12 • Determining the Financing Mix 389
increases by a whopping 120 percent. The reason for this difference is the effect of operat-
ing leverage. If Pierce had no operating leverage (that is, all of its operating costs were vari-
able), then the increase in EBIT would have been 20 percent, just like revenues. Note also
that if Pierce had experienced a 20 percent decline in revenues, it would have experienced
a 120 percent decline in EBIT, as the numbers in Table 12-3 illustrate. Clearly, a higher
operating leverage means higher volatility in EBIT!
So, what does this all mean for the management team at Pierce Grain? Is there
something they can or should do in response to having high operating leverage? Yes,
there is. Recognizing that firm operating earnings will be very sensitive to changes in
firm revenues should make management very wary about using lots of financial leverage
that carries with it fixed principal and interest payments. Moreover, with highly vari-
able operating earnings, Pierce’s management will probably want to hold a safety net of
cash and marketable securities to help the firm weather any periods when revenue falls
below the break-even level.
Before we complete this discussion of operating leverage and move on to the subject
of financial leverage, ask yourself, “Which type of leverage is more under the control of
management?” You will probably (and correctly) come to the conclusion that the firm’s
managers have less control over the operating cost structure and almost complete control
over its financial structure. What the firm actually produces, for example, will determine to
a significant degree the division between fixed and variable costs. However, there is more
room for substitution among the various sources of financial capital than there is among
the labor and real capital inputs that enable the firm to meet its production requirements.
Thus, you can anticipate more arguments over the choice of the firm’s financial structure
than operating structure.
TABLe 12-3 How Operating Leverage Affects eBiT: A Decrease in Pierce grain
Company’s Sales
item
Base Sales
Level, t
Forecast Sales
Level, t + 1 Percentage Change
Sales $300,000 $240,000 -20%
Less: Total variable costs 180,000 144,000
Revenue before fixed costs $120,000 $ 96,000
Less: Total fixed costs 100,000 100,000
EBIT $ 20,000 $ -4,000 -120%
DID YOU GeT IT?
analyzing ThE EFFECTS oF oPEraTing lEVEragE
At its current level of sales, JGC anticipates that any percentage change in revenues will result in double that percentage change in
EBIT. Thus, a decline in revenues by 20 percent would be expected to result in a decline in EBIT of 40 percent. Recall, however, that this
relationship between percentage changes in revenues and EBIT changes as the level of revenue changes.
CAN YOU DO IT?
analyzing ThE EFFECTS oF FinanCial lEVEragE
JGC Electronics currently uses no financial leverage in its capital structure. Should the firm’s earnings before interest and taxes (EBIT)
increase by 20 percent, what percentage change would you expect in JGC’s earnings per share?
(The solution can be found on page 390.)

390 Part 4 • Capital Structure and Dividend Policy
Financial Leverage
Financial leverage arises from financing a portion of the firm’s assets with securities bearing
a fixed (limited) rate of return in hopes of increasing the ultimate return to the common
stockholders. The decision to use debt or preferred stock in the financial structure of the
corporation means that those who own the common shares of the firm are exposed to fi-
nancial risk. Any given level of variability in EBIT is magnified by the firm’s use of financial
leverage, and such additional variability is embodied in the variability of earnings available
to the common stockholder and earnings per share.
Let’s now focus on the responsiveness of the company’s earnings per share to
changes in its EBIT. (We are not saying that earnings per share is the appropriate crite-
rion for all financing decisions. In fact, the weakness of such a contention is examined
later. Rather, the use of financial leverage produces a certain type of effect on earnings
per share.)
Let us assume that Pierce Grain Company is in the process of getting started as a going
concern. The firm’s potential owners have estimated that $200,000 is needed to purchase
the necessary assets to conduct the business. Three possible financing plans have been iden-
tified for raising the $200,000; they are presented in Table 12-4. In plan A no financial risk
is assumed: The entire $200,000 is raised by selling 2,000 common shares for $100 per
share. In plan B a moderate amount of financial risk is assumed: 25 percent of the assets
are financed with a debt issue that carries an 8 percent annual interest rate. Plan C would
use the most financial leverage: 40 percent of the assets would be financed with a debt issue
costing 8 percent.
Table 12-5 presents an analysis of the impact of financial leverage on earnings per share.
If EBIT should increase from $20,000 to $40,000, then earnings per share would rise by 100
percent under plan A. The same change in EBIT would result in an earnings-per-share rise
of 125 percent under plan B and 147 percent under plan C. In plans B and C, the 100 percent
increase in EBIT (from $20,000 to $40,000) is magnified to a greater-than-100-percent
DID YOU GeT IT?
analyzing ThE EFFECTS oF FinanCial lEVEragE
Because JGC uses no financial leverage, there is no magnification effect of the percent change in EBIT on earnings per share. Therefore,
a 20 percent increase in EBIT would lead to an equal 20 percent increase in the firm’s earnings per share.
financial leverage results from the firm’s use
of sources of financing that require a fixed rate
of return. The primary example of such a form
of financing is fixed interest rate debt whereby
the firm must pay predetermined interest and
principal on specified dates.
TABLe 12-4 Possible Capital Structures for Pierce grain Company
PLAN A: 0% DeBT
Total debt $ 0
Common equity 200,000a
Total assets $200,000 Total liabilities and equity $200,000
PLAN B: 25% DeBT AT 8% iNTeReST RATe
Total debt $ 50,000
Common equity 150,000b
Total assets $200,000 Total liabilities and equity $200,000
PLAN C: 40% DeBT AT 8% iNTeReST RATe
Total debt $ 80,000
Common equity 120,000c
Total assets $200,000 Total liabilities and equity $200,000
a2,000 common shares outstanding. b1,500 common shares outstanding. c1,200 common shares outstanding.

Chapter 12 • Determining the Financing Mix 391
increase in earnings per share. The firm is employing financial leverage and exposing its own-
ers to financial risk when the following situation exists:
percentage change in earnings per share
percentage change in EBIT
7 1.00
As we have illustrated using the Pierce Grain Company example, the greater the firm’s
use of financial leverage, the greater will be the ratio of the percent change in earnings per
share divided by the corresponding percent change in EBIT. To reiterate, this means that
the use of financial leverage magnifies the effect of changes in EBIT on earnings per share.
If, for example, the aforementioned ratio were 2, then a 20 percent change in EBIT (either
positive or negative) would lead to a 40 percent change in earnings per share. For a firm that
had even more financial leverage in its capital structure, the ratio might be 3, such that a
20 percent change in EBIT would lead to a 60 percent change in earnings per share.
Combining Operating and Financial Leverage
Operating leverage causes changes in sales revenues to lead to even greater changes in
EBIT. Additionally, changes in EBIT due to financial leverage translate into larger varia-
tions in both earnings per share (EPS) and the net income available to the common share-
holders (NI), if the firm chooses to use financial leverage. It should be no surprise, then, to
find out that combining operating and financial leverage causes rather large variations in
earnings per share. This entire process is visually displayed in Figure 12-4.
Because the risk associated with possible earnings per share is affected by the use of
combined, or total, leverage, it is useful to quantify the effect. To illustrate, we refer
once more to Pierce Grain Company. The cost structure identified for Pierce Grain in our
discussion of break-even analysis still holds. Furthermore, assume that plan B, which carried
TABLe 12-5 An Analysis of Financial Leverage at Different eBiT Levels:
Pierce grain Company
(1) (2) (3)= (1)− (2) (4)=(3) : 0.5 (5)= (3)− (4) (6)
eBiT interest eBT Taxes
Net income
to Common
Shareholders
earnings
Per
Share
PLAN A: 0% DeBT; $200,000 COMMON eQUiTY; 2,000 SHAReS
$ 0 $ 0 $ 0 $ 0 $ 0 $ 0
100%
20,000 0 20,000 10,000 10,000 5.00
100%
40,000 0 40,000 20,000 20,000 10.00
60,000 0 60,000 30,000 30,000 15.00
80,000 0 80,000 40,000 40,000 20.00
PLAN B: 25% DeBT; 8% iNTeReST RATe; $150,000 COMMON eQUiTY; 1,500 SHAReS
$ 0 $4,000 $ (4,000) $ (2,000)a $(2,000) $ (1.33)
100%
20,000 4,000 16,000 8,000 8,000 5.33
125%
40,000 4,000 36,000 18,000 18,000 12.00
60,000 4,000 56,000 28,000 28,000 18.67
80,000 4,000 76,000 38,000 38,000 25.33
PLAN C: 40% DeBT; 8% iNTeReST RATe; $120,000 COMMON eQUiTY; 1,200 SHAReS
$ 0 $6,400 $ (6,400) $ (3,200)a $(3,200) $ (2.67)
100%
20,000 6,400 13,600 6,800 6,800 5.67
147%
40,000 6,400 33,600 16,800 16,800 14.00
60,000 6,400 53,600 26,800 26,800 22.33
80,000 6,400 73,600 36,800 36,800 30.67
aThe negative tax bill recognizes the credit arising from the carryback and carryforward provision of the tax code.
e
e
f
f
e f
combined, or total, leverage the result
of the combined effects of both operating and
financial leverage.

392 Part 4 • Capital Structure and Dividend Policy
a 25 percent debt ratio, was chosen to finance the company’s assets. Turn your attention to
Table 12-6 to see how the effects of operating and financial leverage are combined.
In Table 12-6 an increase in output for Pierce Grain from 30,000 to 36,000 units is ana-
lyzed. This increase represents a 20 percent rise in sales revenues. From our earlier discus-
sion of operating leverage and from the data in Table 12-6, we can see that this 20 percent
increase in sales is magnified into a 120 percent rise in EBIT. Moreover, the 120 percent
rise in EBIT induces a change in earnings per share and earnings available to the common
shareholders of 150 percent. The upshot of the analysis is that the modest 20 percent rise in
sales has been magnified to produce a 150 percent change in earnings per share.
Pierce Grain’s use of both operating and financial leverage will cause any percentage
change in sales (from the specific base level) to be magnified by a factor of 7.50 when the
effect on earnings per share is computed. A 10 percent change in sales, for example, will
result in a 75 percent change in earnings per share.
The total risk exposure the firm assumes can be managed by combining operating and
financial leverage in different degrees. Knowing the various leverage measures will help
you determine the proper level of overall risk that should be accepted. For example, if a
high degree of business risk is inherent in the specific line of commercial activity, then a
low amount of financial risk will minimize additional earnings fluctuations stemming from
changes in the firm’s sales. Conversely, the firm that by its very nature incurs a low level of
DID YOU GeT IT?
analyzing ThE CoMbinED EFFECTS oF oPEraTing anD FinanCial lEVEragE
Peterson’s CFO estimates that firm’s revenues will increase by 20 percent, EBIT will increase by 30 percent, and earnings per share will
rise 60 percent. Consequently, Peterson’s operating leverage produces an increase in EBIT that is 1.5 times the 20 percent increase in sales,
and an earnings per share increase by 60 percent, which is twice the percent change in EBIT that is 30 percent. Once again, we see that op-
erating and financial leverage interact in a multiplicative fashion. That is, the percent increase in earnings per share is 2 times the increase in
EBIT, which is 1.5 times the increase in sales. The net result is that the percent increase in earnings per share is equal to 1.5 * 2 = 3 times the
percent increase in sales. Consequently, the 20 percent increase in sales results in a 3 * 20 percent = 60 percent increase in earnings
per share.
FigURe 12-4 Leverage and earnings Fluctuations
Combined leverage
Operating leverage Financial leverage
EBITSales EPS (or NI)%%%
CAN YOU DO IT?
analyzing ThE CoMbinED EFFECTS oF oPEraTing anD FinanCial lEVEragE
Peterson Timber Company operates sawmills throughout the redwood areas of the Pacific Northwest. The firm’s current level of rev-
enues, EBIT, and earnings per share are $10 million, $4 million, and $1.00 per share, respectively. Peterson’s CFO recently forecasted
the firm’s revenues and profits for next year and estimated that total revenues will grow to $12 million, EBIT will rise to $5.2 million, and
earnings per share will be $1.60 a share. Analyze the effects of operating, financial, and combined leverage for Peterson.
(The solution can be found on page 392.)

Chapter 12 • Determining the Financing Mix 393
fixed operating costs might choose to use a high degree of financial leverage in the hope of
increasing earnings per share and the rate of return on its common equity.
Concept Check
1. When is operating leverage present in the firm’s cost structure? What condition is necessary for
operating leverage not to be present in the firm’s cost structure?
2. What is the effect of operating leverage on the volatility of a firm’s EBIT?
3. What creates financial leverage in a firm’s capital structure?
4. How does financial leverage affect the volatility of firm earnings in response to changes in EBIT?
5. If the ratio of the percent change in earnings per share to the corresponding percent change in
EBIT were 2, what percent change in earnings would you expect to follow a 15 percent decline
in EBIT?
6. How do operating and financial leverage interact to affect the volatility of a firm’s earnings per share?
Capital Structure Theory
It is now time to consider the determination of the appropriate financing mix for the firm.
A complete listing of the sources of financing a firm has used to finance its assets is found
in the right-hand side of the firm’s balance sheet. We will refer to this list of all sources of
4Discuss the concept of an
optimal capital structure.
TABLe 12-6 The Combined-Leverage effect on Pierce grain Company’s
earnings per Share
item
Base Sales
Level, t
Forecast
Sales Level,
t + 1
Percentage
Change
Sales $300,000 $360,000 +20%
Less: Total variable costs 180,000 216,000
Revenue before fixed costs $120,000 $144,000
Less: Total fixed costs 100,000 100,000
EBIT $ 20,000 $ 44,000 +120%
Less: Interest expense 4,000 4,000
Earnings before taxes (EBT) $ 16,000 $ 40,000
Less: Taxes at 50% 8,000 20,000
Net income $ 8,000 $ 20,000 +150%
Less: Preferred dividends 0 0
Earnings available to common shareholders (EAC) $ 8,000 $ 20,000 +150%
Number of common shares 1,500 1,500
Earnings per share (EPS) $5.33 $13.33 +150%
FINANCe AT WORK
WhEn FinanCial lEVEragE ProVES To bE Too MuCh To hanDlE
The financial crisis that began in 2007 and the ensuing eco-
nomic slowdown had a heavy toll on U.S. automakers. General
Motors (GM), once the largest automaker in the world, found
itself drowning in more debt than it could afford. So, facing the
prospect of not being able to honor its financial obligations
the company approached its creditors with an offer to restruc-
ture its debt. The offer included the following for each dollar
of debt owed: $0.08 in cash, $0.16 in unsecured debt, plus a
90% stake in the automaker. With about $28 billion in debt to
bondholders, the GM offer translated into $2.2 billion in cash and
$4.3 billion in unsecured debt plus a stake in the restructured
firm. Although the terms may sound extreme for the firm’s
bondholders, they were even harsher on the current stockhold-
ers, who went from owning 100% of the firm’s equity down to
only 10%! Of course, if the firm were to declare bankruptcy, the
common stockholders would likely be wiped out completely.
Source: Reuters UK, http://uk.reuters.com/article/businessNews/
idUKTRE52T6ZZ20090331, accessed April 2, 2009.

http://uk.reuters.com/article/businessNews/idUKTRE52T6ZZ20090331

394 Part 4 • Capital Structure and Dividend Policy
financing as the firm’s financial structure. For example, in Table 12-7 we see a balance
sheet for a firm that has $300 in assets that have been financed using a mixture of sources
of financing that consists of $80 in current liabilities (debts that must be repaid within a
period of 1 year or less), $70 in long-term debt, $50 in preferred stock, and finally $100 in
common equity.
Note that some of the firm’s current liabilities arise naturally as the firm carries out
its day-to-day operations. We are referring to accounts payable and accrued expenses. For
example, when the firm orders additional items of inventory its suppliers automatically
extend credit to the firm, which appears on the balance sheet as accounts payable. Moreover,
the firm accrues interest and other expenses continually over time but pays it only periodi-
cally (for example, semiannually). These accrued expenses then represent a liability of the
firm that also arises naturally as the firm carries out its day-to-day business. Since accounts
payable and accrued expense items arise automatically in response to the events that cre-
ate them, these liabilities are not the ones we are directly concerned about in this chapter.
Specifically, we are interested in that part of the firm’s financial structure that requires the
discretionary management by the firm. We refer to this as the firm’s capital structure. In
Table 12-7 the financial structure consists of all $300 of liabilities and owners’ equity found
on the right-hand side of the balance sheet, whereas the capital structure excludes accounts
payable and accrued expenses and totals $275.
The relationship between a firm’s financial structure and capital structure can be ex-
pressed in equation form as follows:
Financial
structure
= a non@interest@
bearing liabilities
b + a capital
structure
b (12-5)
financial structure the mix of all sources of
fundings that appears on the right-hand side of
the balance sheet.
capital structure the mix of interest-bearing
short- and long-term debt plus equity funds
used by the firm.
TABLe 12-7 Distinguishing Between a Firm’s Financial Structure
and its Capital Structure
Current assets $ 100 Accounts payable $ 10
Fixed assets 200 Accrued expenses 15
Total assets $ 300 Short-term debt 50
Current portion of long-term debt 5
Current liabilities $ 80
Long-term debt 70
Preferred equity 50
Common equity 100
Total liabilities and owners’ equity $300
Financial
structure
Capital
structure
accounts payable
accrued expenses
short-term debt
long-term debt
preferred stock
common equity
Note that we refer to accounts payable and accrued expenses as non-interest-bearing
liabilities. The reason for this is that there is no explicit interest expense associated with
these liabilities. An explicit interest expense would be something like the interest you pay
on a bank loan. When a firm purchases items of inventory on credit, the credit terms sim-
ply say that the amount of the purchase must be paid within a specific time interval, such
as 30 days. Consequently, the supplier is providing 30 days of credit to the firm without
specifying a rate of interest. The supplier is aware of the fact that it is supplying credit and
surely will incorporate some interest cost in the price terms for the items. The important
point, however, is that this interest is hidden and not explicitly stated, so accounts payable
and accrued expenses do not give rise to interest expense to the firm.

Chapter 12 • Determining the Financing Mix 395
The design of a prudent capital structure requires that we address two questions:
1. Debt maturity composition—what mix of short-term and long-term debt should the
firm use?
2. Debt–equity composition—what mix of debt and equity should the firm use?
The primary influence on the debt maturity composition of the firm’s capital structure
(short- versus long-term debt) is the nature of the assets owned by the firm. Firms that are
heavily committed to investments in fixed assets that are expected to produce cash flow over
many years generally favor long-term debt to the extent that they borrow. Firms that tend
to invest more heavily in assets that produce relatively short-lived cash flows tend to finance
more heavily using short-term debt.
The focus of this chapter is on the debt-equity composition or what is usually called
capital structure management. A firm’s capital structure should mix the permanent sources of
funds used by the firm in a manner that will maximize the company’s common stock price
or, put differently, minimize the firm’s composite cost of capital. We can call this proper mix of
fund sources the optimal capital structure.
Table 12-7 looks at equation (12-5) in terms of a balance sheet. It helps us visualize the over-
riding problem of capital structure management. The sources of funds that give rise to financing
fixed costs (long-term debt and preferred equity) must be combined with common equity in the
proportions most suitable to the investment marketplace. If that mix can be found, then holding
all other factors constant, the firm’s common stock price will be maximized.
Obviously, taking on excessive financial risk can put the firm into bankruptcy proceed-
ings. But using too little financial leverage results in an undervaluation of the firm’s shares.
The financial manager must know how to find the area of optimum financial leverage use—
this will enhance share value, all other considerations being held constant.
The rest of this chapter covers three main areas. First, we briefly discuss the theory of
capital structure. Second, we examine the basic tools of capital structure management. We
conclude with a real-world look at actual capital structure management.
A Quick Look at Capital Structure Theory
In this section of the chapter we address the theoretical underpinnings as to why a firm’s
capital structure is important to the firm’s common stockholders. To do this we first discuss
a world in which capital structure is unimportant—that is, where the particular mix of debt
and equity in the firm’s capital structure has no effect on the value of the firm or its cost
optimal capital structure the capital
structure that minimizes the firm’s composite
cost of capital (maximizes the common stock
price) for raising a given amount of funds.
CAUTIONARY TAle
ForgETTing PrinCiPlE 3: riSK rEQuirES a rEWarD
In 2008, we learned that when faced with a severe economic
downturn, even the smartest of the Wall Street investment
bankers can be done in. As 2008 dawned, there were five major
independent investment banks. Now, there are only two (Gold-
man Sachs and Morgan Stanley). So what did the others in? The
answer, very simply, is the excessive use of financial leverage.
Leverage can be a double-edged sword. In booming times,
using leverage helped the investment banks increase their
rates of return significantly. Of course, higher returns entail
higher risk. And these banks—Bear Stearns, Lehman Brothers,
and Merrill Lynch—were in effect exposing themselves to two
types of risk: First, they were faced with the risk that their invest-
ments might not earn more than the costs to finance them. For
example, if the rate of return the banks earned on their assets
dropped below the rate they were paying for financing, then
the shortfall in earnings came out of the stockholders’ return.
Second, the investment banks were borrowing funds using
short-term loans called commercial paper and then investing
this borrowed money in long-term investments. This meant
that they continuously faced a refinancing risk as they needed
to continually issue and re-issue commercial paper.
When the commercial paper market shut down as a re-
sult of the financial crisis in 2008, this left the investment banks
without a source of financing, forcing them to sell their long-
term investments at distressed prices. The result was that Bear
Stearns, Lehman Brothers, and Merrill Lynch all found them-
selves unable to continue their operations. Merrill Lynch was
bought by Bank of America, Bear Stearns was purchased by
JPMorgan, and Lehman declared bankruptcy, and the British
investment banking firm Barclays purchased many of its assets.
debt maturity composition the mix of
short- and long-term debt used by the firm.
debt–equity composition the mix of
debt and equity used by the firm in its capital
structure.

396 Part 4 • Capital Structure and Dividend Policy
of capital (Chapter 9). The reason we do this is to make it very clear why capital structure
matters and to help us make prudent decisions about its composition. The heart of the ar-
gument about the importance of capital structure is found in the following question:
Can the Firm Affect Its Overall Cost of Funds, Either Favorably or Unfavorably, by Varying the
Mixture of Financing Sources Used?
This controversy has taken many elegant forms in the finance literature and tends to ap-
peal more to academics than financial practitioners. To emphasize the ingredients of capital
structure theory that have practical applications for business financial management, we will
pursue an intuitive, or nonmathematical, approach to reach a better understanding of the
underpinnings of this cost of capital, or capital structure, argument.
The importance of Capital Structure
It makes economic sense for the firm to strive to minimize the cost of using financial capital.
Both capital costs and other costs, such as manufacturing costs, share a common charac-
teristic in that they potentially reduce the size of the cash dividend that could be paid to
common stockholders.
independence Position
Two Nobel Prize–winning financial economists, Franco Modigliani and Merton Miller
(hereafter MM), analyzed the importance of the capital structure decision within the con-
text of a very restrictive set of assumptions about the world in which businesses operate.
Specifically, MM assumed that a firm’s investment policies (that is, the set of investments it
would undertake) and dividend policy (the amount of the firm’s earnings paid to stockhold-
ers in dividends) were fixed such that they are not influenced by the firm’s capital structure
decision. They then demonstrated, under a set of assumptions, that the firm’s capital struc-
ture mix did not affect the firm’s cost of capital or the value of the firm’s common equity.
This position is sometimes referred to as capital structure independence since the value of
the firm is independent of how it has been financed (that is, its capital structure). Some of
the key assumptions underlying the MM independence proposition include the following:
1. Corporate income is not subject to taxation.
2. Capital structures consist only of stocks and bonds.
3. Investors make homogeneous forecasts of net operating income (what we earlier called
EBIT).
4. Stocks and bonds are traded in perfect or efficient markets.
In this market setting, the answer to the question, “Can the firm affect its overall cost of funds,
either favorably or unfavorably, by varying the mixture of financing sources used?” is no.
To summarize, the Modigliani and Miller hypothesis, or the MM view, puts forth that
within the perfect economic world previously described, the total market value of the firm’s
outstanding securities will be unaffected by the manner in which the right-hand side of the
balance sheet is arranged. This means the sum of the market value of outstanding common
stock plus outstanding debt will always be the same regardless of how much or how little
debt is actually used by the company. This MM view is sometimes called the independence
hypothesis, as firm value is independent of capital structure design.
The crux of this position on financing choice is illustrated in Figure 12-5. Here the firm’s
asset mix (the left-hand side of the balance sheet) is held constant. All that is different is the
way the assets are financed. Under financing mix A, the firm funds 30 percent of its assets with
common stock and the other 70 percent with bonds. Under financing mix B, the firm reverses
this mix and funds 70 percent of the assets with common stock and only 30 percent with bonds.
From our earlier discussions we know that financing mix A is the more heavily leveraged plan.
Notice, however, that the size of the “pies” in Figure 12-5 are exactly the same. The pie
represents firm value—the total market value of the firm’s outstanding securities. Thus, the
total firm value associated with financing mix A equals that associated with financing mix B.
Firm value is independent of the actual financing mix that has been chosen.

Chapter 12 • Determining the Financing Mix 397
This implication is taken further in Figure 12-6 where we see that the firm’s overall cost
of capital, kwacc, is unaffected by an increased use of financial leverage. If more debt is used
with a cost of kd in the capital structure, the cost of common equity, kcs, will rise at the same
rate additional earnings are generated. This will keep the composite cost of capital to the
corporation unchanged. Furthermore, because the overall cost of capital does not change
with leverage use, neither will the firm’s common stock price.
The lesson of this view on financing choices is that debt financing is not as cheap as it
first appears to be because the composite cost of funds or the firm’s weighted average cost
of capital is constant over the full range of financial leverage use. The stark implication for
financial officers is that one capital structure is just as good as any other.
Recall, though, the strict assumptions used to define the economic world in which this
theory was developed. We next turn to a market and legal environment that relaxes these
extreme assumptions.
The Moderate Position
We turn now to a more moderate description of the relationship between the firm’s cost
of capital and its capital structure that has wide appeal to both business practitioners and
academics. This moderate view is based on the relaxation of two of the very restrictive as-
sumptions underlying the MM independence theory:
1. Interest expense is tax deductible—when a firm incurs debt on which it pays interest
that interest is tax deductible, which reduces the cost of debt to the firm by an amount
0
Financial leverage
kcs (Cost of equity)
kwacc (Weighted average
cost of capital)
kd (Cost of debt)
Ca
pi
ta
l c
os
ts
FigURe 12-5 Firm Value and Capital Structure Design
FigURe 12-6 Capital Costs and Financial Leverage: No Taxes—independence
Hypothesis
Common
stock
30%
Firm value Firm value
Financing mix A Financing mix B
Bonds
70%
Bonds
30%
= Common
stock
70%

398 Part 4 • Capital Structure and Dividend Policy
equal to the reduced taxes the firm must pay. This constitutes an advantage of using
debt financing rather than equity since the dividends paid to stockholders are not tax
deductible.
2. Debt financing increases the risk of default—since the interest and principal pay-
ments associated with borrowing must be paid in accordance with the debt contract,
the firm faces the risk of being forced into bankruptcy if it fails to meet its contrac-
tual interest and principal payment obligations. This constitutes a disadvantage of
using debt financing, for using more debt leads to an increased likelihood of financial
distress. Financial distress, in turn, forces the firm to incur added costs and may even
lead to bankruptcy, which could result in the total destruction of the value of the
common shares of the firm.
Combining the plus of interest tax deductibility with the minus of added risk of financial
distress provides the conceptual basis for designing a prudent capital structure.
The Benefits of Financial Leverage—interest Tax Savings Table 12-8 illustrates this impor-
tant element of the U.S. system of corporate taxation. We assume that Skip’s Camper Manufac-
turing Company has an expected level of earnings before interest and taxes (EBIT) of $2 million
and faces a corporate tax rate (made simple for example purposes) of 50 percent. Two financing
plans are analyzed. The first is an unleveraged capital structure. The other assumes that Skip’s
Camper has $8 million of bonds outstanding that carry an interest rate of 6 percent per year.
Notice that if corporate income were not taxed, then earnings before taxes of $2 million
per year could be paid to shareholders in the form of cash dividends or to bond investors
in the form of interest payments, or any combination of the two. This means that the sum
of the cash flows that Skip’s Camper could pay to its contributors of debt or equity is not
affected by its financing mix.
When corporate income is taxed by the government, and bond interest is a tax-deductible
expense, the sum of the cash flows earned for all contributors of financial capital is affected by
the firm’s financing mix. Table 12-8 illustrates this point.
If Skip’s Camper chooses the leveraged capital structure, the total payments to equity
and debt holders will be $240,000 greater than under the all-common-equity capitalization.
Where does this $240,000 come from? The answer is that the government’s take, through
taxes collected, is lower by that amount. This difference, which flows to Skip’s Camper secu-
rity holders, is called the tax shield on debt. In general, it may be calculated by equation
(12-6), where rd is the interest rate paid or interest tax savings on the debt, M is the principal
amount of the debt, and Tc is the firm’s marginal tax rate:
Tax shield = rd (M )(Tc) (12-6)
The moderate position on the importance of capital structure presumes that the tax
shield must have value in the marketplace. Accordingly, this tax benefit will increase the to-
tal market value of the firm’s outstanding securities relative to the all-equity financing mix.
Note that in this case financial leverage does affect firm value. Because the cost of capital is
just the other side of the valuation coin, financial leverage also affects the firm’s composite
cost of capital. Can the firm increase firm value indefinitely and lower its cost of capital
continuously by using more and more financial leverage? Common sense would tell us no!
tax shield the reduction in taxes due to the tax
deductibility of interest expense.
TABLe 12-8 Skip’s Camper Cash Flows to All investors—The Case of Taxes

Unleveraged
Capital Structure
Leveraged Capital
Structure
Expected level of net operating income $2,000,000 $2,000,000
Less: Interest expense 0 480,000
Earnings before taxes $2,000,000 $1,520,000
Less: Taxes at 50% 1,000,000 760,000
Earnings available to common stockholders $1,000,000 $ 760,000
Interest paid to creditors 0 480,000
Expected payments to all security holders $1,000,000 $1,240,000

Chapter 12 • Determining the Financing Mix 399
So would most financial managers and academicians. The acknowledgment of bankruptcy
costs provides one possible rationale.
The Likelihood of Firm Failure The probability that the firm will be unable to meet the
financial obligations identified in its debt contracts increases as more debt is employed.
The highest costs would be incurred if the firm actually went into bankruptcy proceedings.
Here, assets would be liquidated and often at distressed sale prices. If these assets do sell
for something less than their perceived market values, both equity investors and debt hold-
ers could suffer losses. Other problems accompany bankruptcy proceedings. Additional
lawyers and accountants have to be hired and paid. Managers must spend time preparing
lengthy reports for those involved in the legal action. Moreover, all this distracts the firm’s
management from the efficient running of the business, and this causes missed opportuni-
ties and lost value.
Milder forms of financial distress also have their costs, as we have discussed. As the firm’s
financial condition weakens, creditors may take action to restrict normal business activity. Sup-
pliers may not deliver materials on credit. Profitable capital investments may have to be forgone,
and dividend payments may even be interrupted. At some point the expected cost of default will
be large enough to outweigh the tax shield advantage of debt financing. The firm will turn to
other sources of financing, mainly common equity (retained earnings).
The Saucer-Shaped Cost-of-Capital Curve This moderate view of the relationship be-
tween financing mix and the firm’s cost of capital is depicted in Figure 12-7. The result
is a saucer-shaped (or U-shaped) weighted-average-cost-of-capital curve, kwacc. The firm’s
average cost of equity, kcs, is seen to rise as the firm uses more debt financing. For a while
the firm can borrow funds at a relatively low after-tax cost of debt, kd. Even though the cost
of equity is rising, it does not rise at a fast enough rate to offset the use of the less-expensive
debt financing. Thus, between points 0 and A on the financial-leverage axis, the average
cost of capital declines and stock price rises.
Eventually, however, the threat of financial distress causes the cost of debt to rise. In
Figure 12-7 this increase in the cost of debt shows up in the after-tax average-cost-of-debt
curve, kd, at point A. Between points A and B, mixing debt and equity funds produces an av-
erage cost of capital that is (relatively) flat. The firm’s optimal range of financial leverage
lies between points A and B. All capital structures between these two points are optimal because
they produce the lowest composite cost of capital. As we said earlier in this chapter, finding this
optimal range of financing mixes is the objective of capital structure management.
optimal range of financial leverage the
range of debt use in the firm’s capital structure
that yields the lowest overall cost of capital for
the firm.
FigURe 12-7 Capital Costs and Financial Leverage: The Moderate View,
Considering Taxes and Financial Distress
0
Financial leverage (Debt ratio)
kwacc (Weighted average
cost of capital)
kcs (Cost of equity)
kd (Cost of debt)
Ca
pi
ta
l c
os
ts
A B

400 Part 4 • Capital Structure and Dividend Policy
FigURe 12-8 The Agency Costs of Debt: Trade-Offs
No protective bond covenants Many protective bond covenants
High interest rates
Low monitoring costs
No lost operating
efficiencies
Low interest rates
High monitoring costs
Many lost operating
efficiencies
Point B signifies the firm’s debt capacity. Debt capacity is the maximum amount of debt
the firm can include in its capital structure and still maintain its current credit rating. Beyond
point B, additional fixed-charge capital can be attracted only at very costly interest rates. At
the same time, this excessive use of financial leverage would cause the firm’s cost of equity
to rise at a faster rate than it did previously. The composite cost of capital would then rise
quite rapidly, and the firm’s stock price would decline.
Firm Value and Agency Costs
In Chapter 1 we mentioned the notion of agency problems. Recall that agency problems
give rise to agency costs, which tend to occur in business organizations because the owners
of the firm do not run the business, managers do. Thus, the firm’s managers can properly
be thought of as agents of the firm’s stockholders. To ensure that agent-managers act in
the stockholders’ best interests requires that (1) they have proper incentives to do so and (2)
their decisions are monitored. The incentives usually take the form of executive compensa-
tion plans and perquisites (or “perks” ). The perquisites, though, might be a bloated support
staff, country club memberships, luxurious corporate planes, or other amenities. Monitor-
ing this requires that certain costs be borne by the stockholders, such as (1) bonding the
managers, (2) auditing financial statements, (3) structuring the organization in unique ways
that limit managerial decisions, and (4) reviewing the costs and benefits of management
perquisites. This list is indicative, not exhaustive. The main point is that monitoring costs
are ultimately covered by the owners of the company—its common stockholders.
Capital structure management also gives rise to agency costs. Agency problems stem
from conflicts of interest, and capital structure management gives rise to a natural conflict
between stockholders and bondholders. For example, if acting in the stockholders’ best in-
terests causes managers to invest in extremely risky projects, existing investors in the firm’s
bonds could logically take a dim view of such an investment policy. This is because chang-
ing the risk structure of the firm’s assets would change the business-risk exposure of the
firm. This could lead to a downward revision of the bond rating the firm currently enjoys.
A lowered bond rating, in turn, would lower the current market value of the firm’s bonds.
Clearly, bondholders would be unhappy with this result.
To reduce this conflict of interest, the creditors (bond investors) and stockholders
may agree to include several protective covenants in the bond contract. These bond
covenants were discussed in more detail in Chapter 7, but essentially they may be
thought of as restrictions on managerial decision making. Typical covenants restrict
the payment of cash dividends on common stock, limit the acquisition or sale of assets,
or limit further debt financing. To make sure managers comply with the protective
covenants means that monitoring costs are incurred. Like all monitoring costs, they are
borne by common stockholders. Furthermore, like many costs, they involve the analysis
of an important trade-off.
Figure 12-8 displays some of the trade-offs involved with the use of protective bond
covenants. Note (in the left panel of Figure 12-8) that the firm might be able to sell bonds
that carry no protective covenants only by incurring very high interest rates. With no pro-
tective covenants, there are no associated monitoring costs. Also, there are no lost operating
efficiencies, such as being able to move quickly to acquire a particular company in the
debt capacity the maximum amount of debt
that the firm can include in its capital structure
and still maintain its current credit rating.

Chapter 12 • Determining the Financing Mix 401
acquisitions market. Conversely, restrictive covenants could reduce the explicit cost of the
debt contract, but this would involve incurring significant monitoring costs and losing some
operating efficiencies (which also translates into higher costs). When the debt issue is first
sold, then a trade-off will be made.
Next, we have to consider the presence of monitoring costs at low and higher levels of
leverage. When the firm operates at a low debt-to-equity ratio, there is little need for credi-
tors to insist on a long list of bond covenants. The financial risk is not sufficient to require
that type of activity. The firm will likewise benefit from low explicit interest rates when
leverage is low. When the debt-to-equity ratio is high, however, it is logical for creditors
to demand a great deal of monitoring. This increase in agency costs will raise the implicit
cost (the true total cost) of debt financing. It seems logical, then, to suggest that monitoring
costs will rise as the firm’s use of financial leverage increases. Just as the likelihood of firm
failure (financial distress) raises a company’s overall cost of capital (kwacc), so do agency costs.
On the other side of the coin, this means that total firm value (the total market value of the
firm’s securities) will be lower because of agency costs. Taken together, the agency costs and
the costs associated with financial distress argue in favor of the concept of an optimal capital
structure for the individual firm.
Agency Costs, Free Cash Flow, and Capital Structure
In 1986, Professor Michael C. Jensen further extended the concept of agency costs into
the area of capital structure management. The contribution revolves around a concept that
Jensen labels “free cash flow,” which he defines as follows:
Free cash flow is cash flow in excess of that required to fund all projects that have positive net
present values when discounted at the relevant cost of capital.3
3“Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers” by Michael C. Jensen, from American Economic
Review 76 (May 1986).
Jensen then proposed that substantial free cash flow can lead to misbehavior by manag-
ers and poor decisions that are not in the best interests of the firm’s common stockholders.
In other words, managers have an incentive to hold onto the
free cash flow and have “fun” with it, rather than “disgorge”
it, say, in the form of higher cash dividend payments.
But all is not lost. This leads to what Jensen calls his
“Control hypothesis” for using debt. This means that by
leveraging up (taking on debt), the firm’s shareholders will
enjoy increased control over their management team. For
example, if the firm issues new debt and uses the proceeds
to retire outstanding common stock, then managers are
obligated to pay out cash to service the debt—this simul-
taneously reduces the amount of free cash flow available to
them to have fun with.
We can also refer to this motive for financial leverage use
as the “threat hypothesis.” Managers work under the threat
of financial failure; therefore, according to the “free cash flow
theory of capital structure,” they work more efficiently. This
is supposed to reduce the agency costs of free cash flow, which
will in turn be recognized by the marketplace in the form of
greater returns on the common stock.
Note that the free cash flow theory of capital structure does not give a theoretical solu-
tion to the question of just how much financial leverage is enough. Nor does it suggest how
much leverage is too much. It is a way of thinking about why shareholders and their boards
of directors might use more debt to control managerial behavior and decisions. The basic
decision tools of capital structure management still have to be utilized. They are presented
later in this chapter.
rEMEMbEr your PrinCiPlES
The discussions on agency costs, free cash flow, and
the control hypothesis for debt creation return us to Principle 5:
Conflicts of interest Cause Agency Problems. The con-
trol hypothesis put forth by Jensen suggests that managers
will work harder for shareholder interests when they have to
“sweat it out” to meet contractual interest payments on debt
securities. But we also learned that managers and bond inves-
tors can have a conflict that leads to agency costs associated
with using debt capital. Thus, the theoretical benefits that flow
from minimizing the agency costs of free cash flow by using
more debt will cease when the rising agency costs of debt
exactly offset those benefits. You can see how very difficult it
is, then, for financial managers to identify precisely their true
optimal capital structure.
rinciple

402 Part 4 • Capital Structure and Dividend Policy
Managerial implications
Where does our examination of capital structure theory leave us? The upshot is that
determining the firm’s financing mix is centrally important to the financial manager
because the firm’s stockholders are affected by capital structure decisions. At the very
least, and before bankruptcy costs and agency costs become detrimental, the tax shield
effect will cause the shares of a leveraged firm to sell at a higher price than they would
if the company had avoided debt financing. Because both the risk of failure and agency
costs accompany the excessive use of leverage, the financial manager must exercise cau-
tion in the use of fixed-charge capital. This problem of searching for the optimal range
of financial leverage is our next task.
You have now developed a workable knowledge of capital structure theory. This
makes you better equipped to search for your firm’s optimal capital structure. Several
tools are available to help you in this search process and simultaneously help you make
prudent financing choices. These tools are decision oriented. They help us answer the
question, “The next time we need $20 million, should we issue common stock or sell
long-term bonds?”
Concept Check
1. What is the objective of capital structure management?
2. What is the basic controversy surrounding capital structure theory?
3. Explain the independence hypothesis as it relates to capital structure management.
4. Explain the moderate view of the relationship between a firm’s financing mix and its average cost
of capital.
5. How do agency costs and free cash flow relate to capital structure management?
The Basic Tools of Capital Structure
Management
We will review two basic tools that are commonly used in the evaluation of capital structure
decisions. The first is the EBIT-EPS chart, which provides a way to visualize the effects of
alternative capital structures on both the level and volatility of the firm’s earnings per share
(EPS). The second tool we review entails the analysis of the capital structures of compa-
rable firms through the use of financial leverage ratios. Here we use ratios to standardize
capital structure information as we did when we discussed financial ratios in Chapter 4 so
that we can compare the capital structures of similar firms.
eBiT-ePS Analysis
Before we launch into an analysis of the relationship between earnings per share (EPS)
and EBIT for alternative capital structures, we need to remind ourselves why this is
important. Specifically, in light of our discussions of capital structure theory you might
ask, “Why should the firm’s owners care about the effects of the capital structure on
earnings per share (EPS)?” One possible response to this question is that corporate
CEOs and boards of directors are very sensitive to the earnings numbers they report to
Wall Street. The reason we offered earlier for this sensitivity relates to the perception
of investors that the level of a firm’s reported EPS signals important information about
the firm’s future prospects. For example, when a firm announces that its earnings will
fall short of analyst expectations, this often triggers a revision in investor expectations
regarding the future earnings prospects for the firm. This downward revision, in turn,
results in a drop in the firm’s stock price. Thus, corporate executives are very aware
of the importance investors attach to earnings and take this information into account
when considering the design of the firm’s capital structure.
5 Use the basic tools of capital
structure management.

Chapter 12 • Determining the Financing Mix 403
e x A M P L e 12.2 eBiT-ePS analysis
Assume that plan B presented earlier in Table 12-4 is the existing capital structure for
the Pierce Grain Company. Furthermore, the asset structure of the firm is such that
EBIT is expected to be $20,000 per year for a very long time. A capital investment is
available to Pierce Grain that will cost $50,000. Acquisition of this asset is expected to
raise the projected EBIT level to $30,000 permanently. The firm can raise the needed
cash by one of two ways:
1. Selling 500 shares of common stock at $100 each
2. Selling the new bonds that will net the firm $50,000 and carry an interest rate of
8.5 percent.
These capital structures and corresponding EPS amounts are summarized in Table 12-9.
At the projected EBIT level of $30,000 the EPS for the common stock and debt al-
ternatives are $6.50 and $7.25, respectively. Both are considerably above the $5.33 that
would occur if the new project were rejected and the new capital were not raised. Based
on a criterion of selecting the financing plan that will provide the highest EPS, the bond
alternative is favored. But what if the basic business risk to which the firm is exposed
causes the EBIT to vary over a considerable range? Can we be sure that the bond alter-
native will always have the higher EPS associated with it?
STEP 1: ForMulaTE a SoluTion STraTEgy
The best way to address this issue will be to use graphic analysis of earnings per share
and earnings before interest and taxes for the proposed alternatives (that is, an EBIT-
EPS chart). EBIT is plotted on the horizontal axis and EPS is plotted on the vertical
axis. The intercepts on the horizontal (EBIT) axis represent the before-tax equivalent
financing charges related to each plan. The straight lines for each plan tell us the EPS
amounts that will occur at different EBIT amounts.
STEP 2: CrunCh ThE nuMbErS
A review of the EBIT-EPS chart found in Figure 12-9 reveals that the answer to this ques-
tion is no. That is, the bond alternative will not always have the higher EPS. Creating the
TABLe 12-9 Analyzing Pierce grain Company’s Financing Choices
PART A: CAPiTAL STRUCTUReS
existing Capital
Structure
With New Common
Stock Financing
With New
Debt Financing
Long-term debt at 8% $ 50,000 Long-term debt at 8% $ 50,000 Long-term debt at 8% $ 50,000
Common stock 150,000 Common stock 200,000 Long-term debt at 8.5% 50,000
Common stock 150,000
Total liabilities and equity $200,000 Total liabilities and equity $250,000 Total liabilities and equity $250,000
Common shares outstanding 1,500 Common shares outstanding 2,000 Common shares outstanding 1,500
PART B: PROJeCTeD ePS LeVeLS

existing
Capital
Structure
With New
Common Stock
Financing
With New
Debt
Financing
EBIT $20,000 $30,000 $30,000
Less: Interest expense 4,000 4,000 8,250
Earnings before taxes (EBT) $16,000 $26,000 $21,750
Less: Taxes at 50% 8,000 13,000 10,875
Net income $ 8,000 $13,000 $10,875
Less: Preferred dividends 0 0 0
Earnings available to common shareholders $ 8,000 $13,000 $10,875
EPS $ 5.33 $ 6.50 $ 7.25

404 Part 4 • Capital Structure and Dividend Policy
EBIT-EPS analysis chart allows the decision maker to visualize the impact of different fi-
nancing plans on the EPS over a range of EBIT levels.
Note that using the data on the common stock plan at an EBIT of $4,000 this financ-
ing plan provides an EPS of zero. EPS is zero with the debt plan where EBIT is equal
to $8,250. Note that $8,250 for the debt plan consists of the current interest expense of
$4,000 plus the new interest cost of $4,250.
The bond plan financing option has a steeper slope than the common stock financing
plan. This tells us that the bond plan’s EPS is more sensitive to changes in EPS than the
common stock financing plan. This is due to the financial leverage employed. Another
observation is that the lines intersect. At that point, EPS is exactly the same for both
financing plans. Above the intersection point, the EPS for the plan with greater lever-
age will exceed that for the plan with lesser leverage. The intersection point, circled in
Figure 12-9, occurs at an EBIT level of $21,000. This intersection of the two capital
structure options is at an EPS of $4.25. For all levels of EBIT above $21,000 the debt
plan provides higher EPS, and for levels of EBIT below $21,000 the equity option offers
the higher EPS.
STEP 3: analyzE your rESulTS
The EBIT-EPS analysis tells the analyst the level of EPS for a given EBIT. How-
ever, since the firm’s EBIT is uncertain and can never be known with certainty in ad-
vance, the capital structure that produces the highest level of EPS cannot be known
for certain.
Computing indifference Points The point of intersection in Figure 12-9 is called the
EBIT-EPS indifference point. It identifies the EBIT level at which the EPS will be the same
regardless of the financing plan chosen by the financial manager. This indifference point, some-
times called the break-even point, has major implications for financial planning. At EBIT
amounts in excess of the EBIT indifference level, the more heavily leveraged financing
plan will generate a higher EPS. At EBIT amounts below the EBIT indifference level, the
eBiT-ePS indifference point the level of
earnings before interest and taxes (EBIT) that will
equate earnings per share (EPS) between two
different financing plans.
FigURe 12-9 eBiT-ePS Analysis Chart for Pierce grain Company
EBIT ($000)
EP
S
(d
ol
la
rs
)
0
$1.00
$2.00
$3.00
$4.00
$21,000
$4.25
$6.50
$7.25
Common stock
plan
Bond plan
$5.00
$6.00
$7.00
10 20 30 40 50
$30,000

Chapter 12 • Determining the Financing Mix 405
financing plan involving less leverage will generate a higher EPS. It is important, then, to
know the EBIT indifference level.
We can find it graphically, as in Figure 12-9. At times it may be more efficient, though,
to calculate the indifference point directly. This can be done by using the following equation:
EPS: STOCK PLAN EPS: BOND PLAN
(EBIT – Is)(1 – Tc) – P
Ss
=
(EBIT – Ib)(1 – Tc) – P
Sb
(12-7)
where Ss and Sb are the numbers of common shares outstanding under the stock and bond
plans, respectively; I is interest expense; Tc is the firm’s income tax rate; and P is preferred
dividends paid. In the present case, P is zero because there is no preferred stock outstand-
ing. If preferred stock is associated with one of the financing alternatives, keep in mind that
the preferred dividends, P, are not tax deductible. Equation (12-7) does take this fact into
consideration.
For the present example, we calculate the indifference level of EBIT as
(EBIT – $4,000)(1 – 0.5) – 0
2,000
=
(EBIT – $8,250)(1 – 0.5) – 0
1,500
When the expression above is solved for EBIT, we obtain $21,000. If EBIT turns out to be
$21,000, then EPS will be $4.25 under both plans.
A Word of Caution Okay, now we know that using more financial leverage may pro-
vide higher firm earnings if EBIT is above the break-even point. But this is not all that
we need to take away from this analysis. For example, assume that EBIT is expected
to be above the break-even point 99.9 percent of the time for two alternative capital
structure policies. Does this mean that we should automatically select the higher le-
verage option? The answer, as you might have suspected, is no, and here’s the logic
for this answer. The higher the firm’s use of financial leverage, the steeper the slope
of the EBIT-EPS line, which means the firm will experience larger swings in EPS for
any given change in EBIT. CEOs and corporate boards care about these swings for the
reason we noted earlier. That is, if the firm fails to meet its earnings expectations, in-
vestors may revise their expectations for the firm’s future earnings prospects downward,
at which point the share price might suffer. So, higher financial leverage increases the
likelihood that an unanticipated swing in the firm’s EBIT might have a very detrimental
effect on the reported EPS, and this is a real source of concern.
How then are we to interpret and use the EBIT-EPS chart to analyze capital structure
design issues? The answer, like many tools of financial analysis, entails the use of mana-
gerial judgment. The EBIT-EPS chart is simply a tool that can be used to learn about
the consequences of using more or less financial leverage. The decision as to whether to
use more or less financial leverage must be made after weighing all the factors that impinge
on a firm’s capital structure decision. For example, in the next section we look at the use
of comparative financial ratios, which indicate the degree of similarity of the firm’s capital
structure to others in its same industry, or peer group.
Comparative Leverage Ratios
In Chapter 4 we explored the overall usefulness of financial ratio analysis. Leverage ra-
tios, one of the categories of financial ratios, are identified in that chapter. We emphasize
here that the computation of leverage ratios is one of the basic tools of capital structure
management.
Two types of leverage ratios must be computed when a financing decision faces the
firm. We call these balance-sheet leverage ratios and coverage ratios. The firm’s bal-
ance sheet supplies inputs for computing the balance-sheet leverage ratios. In various forms
these balance-sheet metrics compare the firm’s use of funds supplied by creditors with those
supplied by owners.
balance-sheet leverage ratios ratios of a
firm’s use of financial leverage or debt capital to
either the firm’s total capital or equity. Since the
needed information for computing these ratios
is found in the balance sheet we refer to them as
balance sheet leverage ratios.
coverage ratios ratios of the firm’s earnings
to the interest and principal related to a firm’s
borrowing.

406 Part 4 • Capital Structure and Dividend Policy
Inputs to the coverage ratios generally come from the firm’s income statement. At
times the analyst may have to refer to balance-sheet information to construct some of these
needed estimates. Regardless of the source of data, coverage ratios provide estimates of
the firm’s ability to service its financing contracts. High coverage ratios, compared with a
standard, imply unused debt capacity.
In reality, we know that EBIT might be expected to vary over a considerable range of
outcomes. For this reason the coverage ratios should be calculated several times, each at
a different level of EBIT. If this is accomplished over all possible values of EBIT, a prob-
ability distribution for each coverage ratio can be constructed. This provides the financial
manager with much more information than simply calculating the coverage ratios based on
the expected value of EBIT.
industry Norms
The comparative leverage ratios have utility only if they can be compared with some stan-
dard. Generally, corporate financial analysts, investment bankers, commercial bank loan
officers, and bond-rating agencies rely on industry classes to compute “normal” ratios. Al-
though industry groupings may actually contain firms whose basic business-risk exposure
differs widely, the practice is entrenched in American business behavior. At the very least,
then, the financial officer must be interested in industry standards because almost every-
body else is.
Capital structure ratios tend to differ among industry classes. For example, random
samplings of the common equity ratios of large retail firms seem to differ statistically from
those of major steel producers. The major steel producers use financial leverage to a lesser
degree than do the large retail organizations. On the whole, firms operating in the same
industry tend to exhibit capital structure ratios that cluster around a central value that we
call a norm. The degree of business risk varies from industry to industry as well. As a con-
sequence, the capital structure norms vary from industry to industry.
This is not to say that all companies in the industry will maintain leverage ratios “close”
to the norm. For instance, firms that are very profitable might display high coverage ratios
and high balance-sheet leverage ratios. The moderately profitable firm, though, might find
such a posture unduly risky. Here the usefulness of industry-normal leverage ratios is clear.
If the firm chooses to deviate substantially from the accepted values for the key ratios, it
must have a sound reason.
A glance at Actual Capital Structure Management
We now examine some opinions and practices of financial executives that reinforce the
importance of capital structure management. A survey of 392 corporate executives revealed
the importance of a variety of factors that are believed to be either important or very impor-
tant in deciding whether to use debt in their firm’s capital structure.4
4John Graham and Campbell Harvey, “How do CFOs make capital budgeting and capital structure decisions?,” Journal of
Applied Corporate Finance, Volume 15, Number 1, Spring 2002, 8–23.
The 10 factors provide some practical guidance to the financial manager who is wres-
tling with capital structure design and management issues. Let’s briefly consider each factor
to see why it is relevant.
Financial Flexibility When a firm needs to raise additional funds, its bargaining
position is better if it has options or choices. For example, firms that have used very
little debt in the past will find it easier to borrow or sell new shares of stock than firms
that have borrowed heavily.
Credit Rating Dropping a notch in the rating system leads to an increase in
the firm’s borrowing costs, so managers like to avoid this if at all possible.5 Moreover,
sometimes firms have contractual provisions inserted into some of their other debt
agreements that require the firm to maintain a particular credit rating. For example,
5We discussed bond ratings in Chapter 7.

Chapter 12 • Determining the Financing Mix 407
Enron’s bankruptcy was triggered by the firm dropping one credit rating, which put the
firm below investment-grade status. The firm had billions of dollars in outstanding debt
that contained a covenant requiring them to maintain a BBB or higher rating.
FINANCe AT WORK
CaPiTal STruCTurES arounD ThE WorlD
The use of debt financing by firms is influenced by many factors,
and one of them apparently is the home country of the firm. To
illustrate, consider the listing of median leverage ratios (total
debt divided by the market value of the firm) by country pro-
vided below.*
The highest leverage ratio is observed in South Korea where the
leverage ratio is close to 70%, while the lowest is only 10%, ob-
served in Greece. The median leverage ratio in the United States
is only 16%, which may seem quite low. However, this is the re-
sult of the fact that these ratios are based on the market values
of the firms rather than their book value.
What kind of factors might encourage the use of debt in dif-
ferent countries? One factor that researchers found is that firms
that operate in countries where the legal systems provide bet-
ter protection for financial claimants tend to use less total debt,
and the debt they use tends to be of a longer-term maturity. In
addition, as you might expect, the tax policy of the country that
the firm operates within also plays a role in the level of debt that
a firm uses.
CO U N T RY L e V e R Ag e R AT i O
South Korea 70%
Pakistan 49%
Brazil 47%
Thailand 46%
India 40%
Japan 33%
China 33%
France 28%
Belgium 26%
Mexico 26%
Chile 21%
Germany 17%
United Kingdom 16%
United States 16%
Greece 10%
*The market value of the firm is defined to be the market value of common
equity plus the book values of preferred stock and total debt.
Source: Joseph P. H. Fan, Sheridan Titman, and Garry J. Twite, “An International
Comparison of Capital Structure and Debt Maturity Choices” (October 2008). AFA
2005 Philadelphia Meetings available at SSRN: http://ssrn.com/abstract=423483.
Insufficient Internal Funds It has long been known that firms tend to follow a
priority list when raising new funds that has been referred to as a “pecking order.” The
order in which firms typically finance their operations begins with internally generated
profits, followed by debt financing, and, finally, by issuing new equity.
Level of Interest Rates Other things being the same, firms prefer to borrow
when they feel interest rates are low relative to their expectations. For example, when
interest rates are historically very low, a CFO may feel more inclined to enter into long-
term debt agreements. However, there is little evidence that a CFO, or anyone for that
matter, has any talent for knowing when rates are low and about to rise or high and
about to fall. Nonetheless, all that is required for this factor to be considered important
is a strong opinion about the future path of interest rates.
Interest Tax Savings Interest expense, unlike dividends paid to shareholders, is
a tax-deductible expense. This tax-savings feature serves as a subsidy to corporate bor-
rowing and makes debt appear cheap relative to alternative sources of financing.
Transaction Costs and Fees When a firm chooses between debt and equity,
it faces very different costs of issuing the two types of securities. For example, debt
holders receive interest and principal payments as prescribed in the debt contract
(indenture). This type of security is relatively straightforward, and its value hinges
on the creditworthiness of the firm. However, when a firm issues equity, there are
no rules prescribing how much will be paid back to the buyers of the stock. This
means that it can be much more costly to entice investors to become stockholders

http://ssrn.com/abstract=423483

408 Part 4 • Capital Structure and Dividend Policy
than to entice them to loan money to the firm. Thus, the differentially higher costs
of issuing equity make it less attractive as a source of financing.
Equity Undervaluation/Overvaluation Earlier we mentioned that CFOs often
try to time their debt offerings to take advantage of abnormally low interest rates. The
same holds true for equity offerings. For example, if the CFO thinks that the firm’s
shares of stock are undervalued, he or she will want to borrow money rather than sell
new shares and risk the price of the shares falling further. Once again, there is no evi-
dence that corporate executives are any better at forecasting their own share prices than
they are at predicting the future of interest rates, but they only have to think they are
good at it to believe it is an important factor.
Comparable Firm Debt Levels Firms in similar businesses tend to have similar
capital structures. This is made doubly important by virtue of the fact that lenders and
credit-rating agencies often compare a firm’s debt ratios to those of comparable firms
when deciding credit terms and ratings.
Bankruptcy/Distress Costs The more debt a firm has used in the past, the higher
the likelihood is that the firm will at some point face financial distress and possibly fail.
This risk forms the basis for the firm’s credit rating.
Customer/Supplier Discomfort An important source of financial distress
brought on by the use of debt financing comes in the form of pressures from both the
firm’s customers (who fear that financial distress may interrupt their source of supply)
and the firm’s suppliers (who fear that financial distress may interrupt an important
source of demand for their goods and services). The latter is compounded further if the
supplier has provided the firm with trade credit, which is at risk if the firm fails.
After reading through the discussion of each of the 10 factors, you are probably
beginning to think that capital structure management is more art than science. In other
words, there simply is no magic formula that you can use to solve for the optimal capital
structure. However, you should be gaining an appreciation for the basic considerations
that go into the judgment call that the CFOs ultimately must make and that drives the
capital structure of firms. Furthermore, selected comments from financial executives
point to the widespread use of target debt ratios.
Concept Check
1. Explain the meaning of the EBIT-EPS indifference point.
2. How are various leverage ratios and industry norms used in capital structure management?
3. Identify several factors that influence the decision to issue debt.
4. Why is capital structure design both an art and a science?
Chapter Summaries
Distinguish between business and financial risk. (pgs. 382–383)
SUMMARY: A firm’s business risk arises out of the competitive environment in which the firm
operates. The risk results in fluctuations in firm sales in response to changes in the overall
economy and the conditions within the specific industry or industries in which the firm oper-
ates. Firms can make further choices that can amplify this volatility even more if, for example,
they choose to purchase plant and equipment rather than rent it. In the former case, the firm
will incur the fixed costs of the plant and equipment even if it produces nothing and this adds
risk to the firm. Moreover, firms can choose to use sources of capital in their financial structure
that entail a fixed financial obligation such as interest and principal payments on the debt. The
effects of business, operating, and financial risk work in concert to determine the riskiness of
the firm’s future earnings streams.
1

Chapter 12 • Determining the Financing Mix 409
Business risk, page 382 The risk of the firm’s
future earnings that is a direct result of the par-
ticular line of business chosen by the firm.
Operating risk, page 382 Risk driven by
the mix of fixed versus variable costs the firm
incurs to do business. For example, the greater
the firm’s fixed operating costs, other things
remaining the same, the more volatile will be
the firm’s earnings in response to changes in
firm sales.
Financial risk, page 382 Risk driven by the
presence of fixed finance costs in the firm’s
capital structure (as opposed to variable finance
costs such as dividends declared and paid). The
net effect of financial leverage (which corre-
sponds to the firm’s use of debt financing that
entails the payment of predetermined
interest and principal payments) is to make
firm earnings more volatile.
Use break-even analysis. (pgs. 383–388)
SUMMARY: A key number in any business’s operations is the break-even quantity or sales level.
Breakeven is key because it tells the firm’s managers the minimum sales (dollars or units sold) that
are needed to pay the firm’s short-term liabilities.
KeY TeRMS
2
Break-even quantity, page 383 The number
of units a firm must sell before it starts to earn
a profit.
Fixed costs, page 384 The expenses of the
firm that do not vary with the level of firm
sales. An example would be salaries paid to the
firm’s management team.
Indirect costs, page 384 costs that do not
vary in total dollar amount as sales volume or
quantity of output changes.
Variable costs, page 384 Expenses that move
up and down with the level of firm sales.
Direct costs, page 384 Expenses that vary in
total as output changes.
Total revenue, page 385 The total dollar
sales for a particular period of time.
Volume of output, page 385 The number of
units produced and sold for a particular period
of time.
KeY eQUATiON
Break@even level
of revenues
=
total fixed costs
1 –
variable costs
revenues
Understand the relationships between operating, financial, and combined
leverage. (pgs. 388–393)
SUMMARY: The volatility of a firm’s reported earnings over time is an important piece of informa-
tion to investors and thus it is important that the firm’s management understand what causes this
volatility. It turns out that the volatility of earnings over time is largely driven by choices the firm’s
management has made. These choices relate to the type of business the firm runs; the operating
decisions the firm has made, which, in turn, determine it’s fixed versus operating costs; and financ-
ing decisions regarding the use of borrowed money. The combination of the firm’s choice of type
of business, operating models (fixed versus variable operating expenses), and financial risk (fixed
versus variable financial expenses) dictates just how the firm’s earnings will change in response
to changing economic conditions. For example, should the economy swing into a period of rapid
growth, then firms that sell products people want in periods of expansion (expensive cars, boats, and
consumer durable goods) will experience an abnormally large upswing in sales. If these same firms
were to experience a downturn in the economy their sales would drop disproportionately when
compared to firms selling more essential goods and services such as food and clothing. The net re-
sult would be that the earnings of firms selling consumer durable and luxury goods will experience
a large decline in earnings.
3
KeY TeRMS

410 Part 4 • Capital Structure and Dividend Policy
KeY TeRMS
Discuss the concept of an optimal capital structure. (pgs. 393–402)
SUMMARY: A firm’s capital structure is defined by the mix of sources of financing the firm has
used to raise money in the past. The cost of each of the component sources then determines the
overall cost of capital to the firm, which, in Chapter 9, we defined to be the weighted average cost
of capital. The idea of an optimal capital structure is simply a particular mix of financing sources
that results in the lowest possible weighted average cost of capital.
Many theories of capital structure have been developed that attempt to explain how a firm’s cost
of capital changes as the mix of financing sources is changed. Early theories used very restrictive
sets of assumptions about investor behavior to argue that a firm’s capital structure did not vary with
the particular mix of financing sources the firm used. This result, however, ignored the tax bias
built into the corporate tax code whereby the interest expense paid for debt is tax deductible to the
corporation, whereas dividends paid to preferred or common stockholders are not tax deductible.
This meant that using more debt was, other things being the same, advantageous to the firm. At
this juncture it seemed that the best thing a firm could do with its capital structure was to borrow
as much as it could. Alas, there are costs to becoming too highly leveraged. Having too much debt
means that the firm could, in very bad economic circumstances, find itself unable to pay its inter-
est and principle and default on its debt. The net result of such a default is that the firm’s common
stockholders would lose all they had invested in the firm, as the firm’s creditors would take over in
bankruptcy. Thus, most practicing managers believe that there is a trade-off between the “good”
that comes with debt (tax deductibility of interest) and the “bad” (increasing risk of default), which
forms the basis for believing there is indeed an optimal capital structure where these costs and
benefits are just equal.
KeY TeRMS
4
Financial structure, page 394 The mix of all
sources of funding that appears on the
right-hand side of the firm’s balance sheet.
Capital structure, page 394 The mix of
interest-bearing short- and long-term debt
plus equity funds used by the firm.
Debt maturity composition, page 395 The
mix of short- and long-term debt used by the
firm.
Debt–equity composition, page 395 The
mix of debt and equity used by the firm in its
capital structure.
Optimal capital structure, page 395 The
capital structure that minimizes the firm’s
composite cost of capital for raising a given
amount of funds.
Tax shield, page 398 The reduction in taxes
due to the tax deductibility of interest expense.
Optimal range of financial leverage,
page 399 The range of debt use in the firm’s
capital structure that yields the lowest overall
cost of capital for the firm.
Debt capacity, page 400 The maximum
amount of debt that a firm can include in its
capital structure and still maintain its current
credit rating.
Use the basic tools of capital structure management. (pgs. 402–408)
SUMMARY: Although there are many theories concerning the existence of an optimal capital
structure, it is difficult to analyze what this optimal structure might be. As a result, it is common
practice for managers to begin their analysis of capital structure by looking at other firms and
5
Operating leverage, page 388 Results from
operating costs that are fixed (rather than
those that vary up and down with the level of
output or sales).
Financial leverage, page 390 Results from
the firm’s use of sources of financing that
require a fixed rate of return. The primary
example of such a form of financing is fixed
interest rate debt whereby the firm must pay
pre-determined interest and principal on
specified dates.
Combined, or total, leverage, page 391 The
result of the combined effects of both
operating and financial leverage. Operating
and financial leverage tend to magnify one
another such that combining lots of operating
and financial leverage will make the total
leverage of the firm much greater.

Chapter 12 • Determining the Financing Mix 411
analyzing what they have done. In other words, they first emulate other, similar firms and then
analyze the consequences of deviating from the practices of what they feel are comparable firms.
Managers also analyze the effect of different capital structure choices on the volatility of the firm’s
reported earnings. The idea here is that using more debt results in more volatile firm earnings and
investors typically dislike uncertainty.
KeY TeRMS
EBIT-EPS indifference point,
page 404 The level of earnings before
interest and taxes (EBT) that will equate earn-
ings per share (EPS) between two different
financing plans.
Balance-sheet leverage ratios,
page 405 Ratios of a firm’s use of financial
leverage or debt capital to either the firm’s
total capital or equity. Since the needed infor-
mation for computing these ratios is found in
the balance sheet we refer to them as balance
sheet leverage ratios.
Coverage ratios, page 405 Ratios of the
firm’s earnings to the interest and principal
related to a firm’s borrowing.
KeY eQUATiONS
Earnings per share (Equity plan) = Earnings per share (Debt plan)
(EBIT – Is)(1 – Tc)
Ss
=
(EBIT – Ib)(1 – Tc)
Sb
where
EBIT = earnings before interest and taxes
I = interest expuse
Tc = tax rate
S = number of common shares
and the s and b subscripts refer to the equity and bond or debt financing plan, respectively.
Review Questions
All Review Questions are available in MyFinanceLab.
12-1. In the chapter introduction we learned that AT&T (T) borrowed $3 billion by issuing bonds
in the public bond market. Although this may sound like a lot of money, AT&T owed almost
$65 billion in corporate debt at the end of 2011. The company had over $270 billion in total assets
in 2011. How much will the new bond issue increase AT&T’s debt-to-total-assets ratio?
12-2. Distinguish between business risk and financial risk. What gives rise to, or causes, each type
of risk?
12-3. Define the term financial leverage. Does the firm use financial leverage if preferred stock is
present in its capital structure?
12-4. Define the term operating leverage. What type of effect occurs when the firm uses operating
leverage?
12-5. A manager in your firm decides to employ a break-even analysis. Of what shortcomings
should this manager be aware?
12-6. A break-even analysis assumes linear revenue and cost functions. In reality, these linear func-
tions deviate over large output and sales levels. Why?
12-7. Define the following terms:
a. Financial structure
b. Capital structure
c. Optimal capital structure
d. Debt capacity
12-8. What is the primary weakness of using EBIT-EPS analysis as a financing decision tool?
12-9. What is the objective of capital structure management?
12-10. Why might firms whose sales levels change drastically over time choose to use debt only
sparingly in their capital structures?
12-11. What does the term independence hypothesis mean as it applies to capital structure theory?

412 Part 4 • Capital Structure and Dividend Policy
12-12. Many CFOs believe that the firm’s composite cost of capital is saucer-shaped or U-shaped.
What does this mean?
12-13. Define the EBIT-EPS indifference point.
12-14. Explain how industry norms might be used by the financial manager in the design of the
company’s financing mix.
Study Problems
All Study Problems are available in MyFinanceLab.
12-1. (Business and financial risk) Which of the following sources of new earnings volatility repre-
sents the effect of business versus financial risk (discuss the rationale for your decisions):
a. Amos Gooding Real Estate Company recently constructed a new office building and bor-
rowed 100 percent of the money needed to fund the project.
b. Clearing House Outsourcing has historically paid a printer to prepare all of its printed
documents. However, last year the firm acquired its own printing press (paying cash).
c. Smithers Enterprises has been a specialty retail shop that sold outdoor camping equipment.
The firm recently decided to purchase a golf course.
12-2. (Break-even analysis) You have developed the following income statement for the Hugo Boss
Corporation. It represents the most recent year’s operations, which ended yesterday.
1
2
Sales $ 50,439,375
Variable costs (25,137,000)
Revenue before fixed costs $ 25,302,375
Fixed costs (10,143,000)
EBIT $ 15,159,375
Interest expense (1,488,375)
Earnings before taxes $ 13,671,000
Taxes at 50% (6,835,500)
Net income $ 6,835,500
Your supervisor in the controller’s office has just handed you a memorandum asking for written
responses to the following questions:
a. What is the firm’s break-even point in sales dollars?
b. If sales should increase by 30 percent, by what percent would earnings before taxes (and net
income) increase?
12-3. (Break-even point and selling price) Parks Castings Inc. will manufacture and sell 200,000 units
next year. Fixed costs will total $300,000, and variable costs will be 60 percent of sales.
a. The firm wants to achieve a level of earnings before interest and taxes of $250,000. What
selling price per unit is necessary to achieve this result?
b. Set up an analytical income statement to verify your solution to part (a).
12-4. (Break-even point and operating leverage) Footwear Inc. manufactures a complete line of men’s
and women’s dress shoes for independent merchants. The average selling price of its finished prod-
uct is $85 per pair. The variable cost for this same pair of shoes is $58. Footwear Inc. incurs fixed
costs of $170,000 per year.
a. What is the break-even point in pairs of shoes for the company?
b. What is the dollar sales volume the firm must achieve to reach the break-even point?
c. What would be the firm’s profit or loss at the following units of production sold: 7,000
pairs of shoes? 9,000 pairs of shoes? 15,000 pairs of shoes?
3

12-5. (Operating leverage) Rocky Mount Metals Company manufactures an assortment of wood-
burning stoves. The average selling price for the various units is $500. The associated variable cost
is $350 per unit. Fixed costs for the firm average $180,000 annually.
a. What is the break-even point in units for the company?
b. What is the dollar sales volume the firm must achieve to reach the break-even point?
c. What is the degree of operating leverage for a production and sales level of 5,000 units for
the firm? (Calculate to three decimal places.)
d. What will be the projected effect on earnings before interest and taxes if the firm’s sales
level should increase by 20 percent from the volume noted in part (c)?
12-6. (Capital structure theory) Match each of the following definitions to the appropriate terms: 4
T e R M S D e F i N i T i O N S
Independence theory—with corporate taxes The cost of capital is unaffected by the firm’s
choice of debt and equity financing.
Independence theory—no taxes The cost of capital decreases as the firm initially
uses debt to substitute for equity financing but
eventually begins to increase as extreme levels of
debt are used.
Saucer-shaped cost of capital curve The cost of capital decreases continuously as the
firm increases its reliance on debt financing.
Chapter 12 • Determining the Financing Mix 413
12-7. (Capital structure theory) Which of the following statements most appropriately describes how
agency costs affect a firm’s choice of capital structure (explain)?
a. When firm owners borrow money they have an incentive to engage in excessive risk
taking (that is, investing in very risky projects) since they are managing someone else’s
money.
b. When firms have very limited investment opportunities and little debt financing combined
with healthy profits that provide them with free cash flow, their management team might
squander the firm’s earnings on questionable investments.
12-8. (EBIT-EPS analysis) Two inventive entrepreneurs have interested a group of ven-
ture capitalists in backing a new business project. The proposed plan would consist of a se-
ries of international retail outlets to distribute and service a full line of ingenious home garden
tools. The stores would be located in high-traffic cities in Latin America such as Panama City,
Bogotá, São Paulo, and Buenos Aires. Two financing plans have been proposed by the entre-
preneurs. Plan A is an all common-equity structure. Five million dollars would be raised by
selling 160,000 shares of common stock. Plan B would involve the use of long-term debt fi-
nancing. Three million dollars would be raised by marketing bonds with an effective inter-
est rate of 14 percent. Under the alternative, another $2 million would be raised by selling
64,000 shares of common stock. With both plans, $5 million is needed to launch the new firm’s op-
erations. The debt funds raised under plan B are considered to have no fixed maturity date, because
this portion of financial leverage is thought to be a permanent part of the company’s capital struc-
ture. The two promising entrepreneurs have decided to use a 35 percent tax rate in their analysis,
and they have hired you on a consulting basis to do the following:
a. Find the EBIT indifference level associated with the two financing proposals.
b. Prepare income statements for the two plans that prove EPS will be the same regardless of
the plan chosen at the EBIT level found in part (a).
12-9. (EBIT-EPS analysis) A group of retired college professors has decided to form a small manu-
facturing corporation. The company will produce a full line of traditional office furniture. Two
financing plans have been proposed by the investors. Plan A is an all-common-equity alternative.
Under this agreement, 1 million common shares will be sold to net the firm $20 per share. Plan B
involves the use of financial leverage. A debt issue with a 20-year maturity period will be privately
placed. The debt issue will carry an interest rate of 10 percent, and the principal borrowed will
amount to $6 million. The corporate tax rate is 50 percent.
5

a. Find the EBIT indifference level associated with the two financing proposals.
b. Prepare an analytical income statement that proves EPS will be the same regardless of the
plan chosen at the EBIT level found in part (a).
c. Prepare an EBIT-EPS analysis chart for this situation.
d. If a detailed financial analysis projects that long-term EBIT will always be close to
$2.4 million annually, which plan will provide for the higher EPS?
12-10. (Assessing leverage use) Some financial data for three corporations are displayed here.
Output level 80,000 units
Operating assets $4,000,000
Operating asset turnover 8 times
Return on operating assets 32%
Degree of operating leverage 6 times
Interest expense $600,000
Tax rate 35%
M e A S U R e F i R M A F i R M B F i R M C i N D U S T RY N O R M
Debt ratio 20% 25% 40% 20%
Times interest covered 8 times 10 times 7 times 9 times
Price/earnings ratio 9 times 11 times 6 times 10 times
414 Part 4 • Capital Structure and Dividend Policy
a. Which firm appears to be excessively leveraged?
b. Which firm appears to be employing financial leverage to the most appropriate degree?
c. What explanation can you provide for the higher price/earnings ratio enjoyed by firm B as
compared with firm A?
Mini Cases
These Mini Cases are available in MyFinanceLab.
1. Imagine that you were hired recently as a financial analyst for a relatively new, highly leveraged
ski manufacturer located in the foothills of Colorado’s Rocky Mountains. Your firm manufactures
only one product, a state-of-the-art snow ski. The company has been operating up to this point
without much quantitative knowledge of the business and financial risks it faces.
Ski season just ended, however, so the president of the company has started to focus more on
the financial aspects of managing the business. He has set up a meeting for next week with the CFO,
Maria Sanchez, to discuss matters such as the business and financial risks faced by the company.
Accordingly, Maria has asked you to prepare an analysis to assist her in her discussions with the
president. As a first step in your work, you compiled the following information regarding the cost
structure of the company:
As the next step, you need to determine the break-even point in units of output for the
company. One of your strong points has been that you always prepare supporting work papers,
which show how you arrived at your conclusions. You know Maria would like to see these
work papers to facilitate her review of your work. Therefore, you will have the information
you require to prepare an analytical income statement for the company. You are sure that
Maria would also like to see this statement. In addition, you know that you need it to be able
to answer the following questions. You also know Maria expects you to prepare, in a format
that is presentable to the president, answers to the following questions to serve as a basis for
her discussions with the president:
a. What is the firm’s break-even point in sales dollars?
b. If sales should increase by 30 percent (as the president expects), by what percentage would
EBT (earnings before taxes) and net income increase?
c. Prepare another income statement, this time to verify the calculations from part (b).

Chapter 12 • Determining the Financing Mix 415
2. Camping USA Inc. has been operating for only 2 years in the outskirts of Albuquerque, New
Mexico, and is a new manufacturer of a top-of-the-line camping tent. You are starting an internship
as assistant to the chief financial officer of the company, and the owner and CEO, Tom Charles,
has decided that this is the right time to know more about the business and financial risks his com-
pany must deal with. For this, the CFO has asked you to prepare an analysis to support him in his
next meeting with Tom Charles a week from today.
To make the required calculations, you have put together the following data regarding the cost
structure of the company:
Output level 120,000 units
Operating assets $6,000,000
Operating asset turnover 12 times
Return on operating assets 48%
Degree of operating leverage 10 times
Interest expense $720,000
Tax rate 42%
The CFO has instructed you to first determine the break-even point in units of output for the
company. He requires that you prepare supporting documents, which demonstrate how you ar-
rived at your conclusion and can facilitate his review of your work. Accordingly, you are required
to have the information needed to prepare an analytical income statement for the company to be
presented to the CFO. In a format that is acceptable for a meeting discussion with the CEO, you
also need to prepare answers to the following questions:
a. What is the firm’s break-even point in sales dollars?
b. If sales should increase by 40 percent, by what percentage would EBT (earnings before
taxes) and net income increase?
c. Prepare another income statement, this time to verify the calculations from part (b).

Dividend Policy and
Internal Financing
Learning Objectives
1 Describe the trade-off between paying dividends and
retaining (reinvesting) firm profits.
Key Terms
2 Does dividend policy affect the company’s stock price? Does a Dividend Policy Matter to Stock-
holders?
3 Discuss the constraints on dividend policy, commonly
used dividend policies, and payment procedures.
The Dividend Decision in Practice
4 Describe why firms sometimes pay noncash dividends. Stock Dividends and Stock Splits
5 Distinguish between the use of cash dividends and
share repurchases.
Stock Repurchases
416
13
Technology giant Apple (AAPL) launched a plan to pay a $2.65 fourth quarter cash dividend in addition
to repurchasing $10 billion of its shares in March 2012. The combined effect of paying the dividends and
repurchasing the shares is $45 billion! Interestingly, this is not Apple’s first dividend payment. The firm
paid dividends for 8 years, ending in 1995 when a worsening business outlook led the board to discon-
tinue the dividend.1 At least for the time being the dividend payment looks very secure as Apple expected
to add some $35 billion to its cash holdings during 2011 even after paying dividends and repurchasing
shares.
Why should an investor care about a firm’s cash distributions? The answer, very simply, is that these cash
distributions represent the return on the investment made by the stockholders. As such these distributions are
tangible evidence of the value created by the firm for its owners. But not all companies distribute cash either as
dividends or share repurchases. Apple, for example, did not distribute any cash during the early years of the com-
pany’s life when it was growing rapidly and needed all its internally generated earnings to support its growth.
1Casey Newton, Apple to offer quarterly dividend, buy back shares, SFGate, March 20, 2012 (http://www.sfgate.com/cgi-bin/article.cgi?f=/
c/a/2012/03/19/BU201NN0EH.DTL&type=business).

http://www.sfgate.com/cgi-bin/article.cgi?f=/c/a/2012/03/19/BU201NN0EH.DTL&type=business

Similarly, rapidly growing technol-
ogy giant Google Inc. (GOOG) earned
$9.8 billion from its operations in
2011 and had a cash plus marketable
securities balance of over $44 billion
but paid no cash dividends. So why
did Google’s stock price hover around
$650 on March 26, 2012, if it was not
distributing any cash? The answer is
that it is the investor’s expectation
that at some point in the future the
firm will begin distributing cash just
as Apple has done. So it is the antici-
pated dividends and share repurchases
that are the cash flow (Principle 1)
that underlies stock valuation.
Because the goal of a firm should be to maximize the value of the firm’s common stock, the
success or failure of managerial decisions can be evaluated only in light of their impact on
the price. We observed that the company’s investment (Chapters 10 and 11) and financing
decisions (Chapter 12) can increase the value of the firm. As we look at the firm’s policies
regarding dividends and internal financing (how much of the company’s financing comes
from cash flows generated internally), we return to the same basic question: Can managers
influence the price of the firm’s stock through its dividend policies? After addressing this
important question, we then look at the practical side of the question: What practices do
managers commonly follow when making decisions about paying or not paying a dividend
to the firm’s stockholders? We conclude with a discussion of the share repurchase deci-
sion. Firms have increasingly been repurchasing their shares of stock as an alternative to
paying out cash dividends.
Key Terms
Before taking up the particular issues relating to dividend policy, we must understand several
key terms and interrelationships.
A firm’s dividend policy includes two basic components. First, the dividend payout
ratio indicates the amount of dividends paid relative to the company’s earnings. For instance, if
the dividend per share is $2, and the earnings per share are $4, the payout ratio is 50 percent
($2/$4). The second component is the stability of the dividends over time. As you will learn
later in the chapter, dividend stability can be almost as important to the investor as the
amount of dividends received.
In formulating a dividend policy, the financial manager faces trade-offs. Assuming that
management has already decided how much to invest and has chosen its debt–equity mix
for financing the firm’s investments, the decision to pay a large dividend means simultane-
ously deciding to retain less of the firm’s profits; this in turn results in a greater reliance on
external equity financing. Conversely, given the firm’s investment and financing decisions,
a small dividend payment corresponds to high profit retention, making it less necessary to
generate funds externally. These trade-offs, which are fundamental to our discussion, are
illustrated in Figure 13-1.
417417
1 Describe the trade-off between
paying dividends and retaining
(reinvesting) firm profits.
dividend payout ratio the ratio of
dividends paid per share divided by earnings
per share.

418 Part 4 • Capital Structure and Dividend Policy
Concept Check
1. Provide a financial executive with a useful definition of the term dividend payout ratio.
2. How does the firm’s actual dividend policy affect its need for externally generated financial capital?
Does Dividend Policy Matter
to Stockholders?
What is a sound rationale or motivation for dividend payments? Put another way, given the
firm’s capital-budgeting and borrowing decisions, what is the effect of the firm’s dividend
policies on the stock price? Does a high dividend payment decrease a stock’s value, increase it, or
make no real difference?
At first glance, we might reasonably conclude that a firm’s dividend policy is important.
We have already (in Chapter 8) pointed out that the value of a stock is equal to the pres-
ent value of its expected future dividends. Why else do so many companies pay dividends?
Why are dividend announcements like the Apple announcement reported in the introduc-
tion to this chapter front-page news? How can we not conclude that dividend policies are
important?
Three Basic Views
Some would argue that the amount of a dividend is irrelevant and any time spent on the
decision is a waste of energy. Others contend that a high dividend results in a high stock
price. Still others take the view that dividends actually hurt the value of the dividend-paying
stocks.
Before we delve into the various theories, or “views,” on the dividend policy question,
we need to be very careful about the conditions under which we pose the question. Spe-
cifically, we begin with the basic assumption that the firm plans to undertake all positive
NPV investment opportunities regardless of whether it pays dividends or not. This is critical
because if we allow the decision to pay a dividend to interfere with the firm’s decision to
undertake a good investment, then the policy obviously matters to the firm’s stockholders.
So, assuming that the firm will make the right set of investment decisions, why might the
company’s dividend policy matter?
View 1: A Firm’s Dividend Policy Is Irrelevant Much of the controversy about the divi-
dend issue is based in time-honored disagreements between the academic and professional
communities. Experienced practitioners tend to believe that stock prices change as a result
of dividend announcements and, therefore, see dividends as important. Professors often
argue that the seemingly apparent relationship between dividends and stock prices may be
an illusion.
Given the firm’s investment decisions and
debt–equity mix, then it’s a
choice between
Large dividend
Low profit
retention
Heavy external
equity financing
Small dividend
High profit
retention
Negligible external
equity financing
or
FIguRe 13-1 Dividend-versus-Retention Trade-Offs
2 Does the dividend policy affect
the company’s stock price?

Chapter 13 • Dividend Policy and Internal Financing 419
The notion that dividends are not important rests on two preconditions. First, we must
assume that the firm’s investment and borrowing decisions have already been made and that
these decisions will not be altered by the amount of any dividend payments. Second, perfect
capital markets must exist, which means that (1) investors can buy and sell stocks without incur-
ring any transaction costs, such as brokerage commissions; (2) companies can issue stocks without any
cost of doing so; (3) there are no corporate or personal taxes; (4) complete information about the firm
is readily available; (5) there are no conflicts of interest between managers and stockholders; and (6)
financial distress and bankruptcy costs are nonexistent.
The first assumption—that the firm has already made its investment and financing
decisions—simply keeps us from confusing the issues. We want to know the effect of
dividend decisions on a stand-alone basis, without mixing in other decisions. The second
assumption, that of perfect markets, also allows us to study the effect of dividend deci-
sions in isolation, much as a physicist studies motion in a vacuum to avoid the influence
of friction.
Given these assumptions, the effect of a dividend decision on share price may be stated
unequivocally: There is no relationship between dividend policy and stock value. One dividend
policy is as good as another. In the aggregate, investors are concerned only with total re-
turns from investment decisions; they are indifferent to whether these returns come from
capital gains or dividend income. They also recognize that the dividend decision is really
a choice of financing strategy. That is, to finance growth, the firm (a) may choose to issue
stock, allowing internally generated funds (profits) to be used to pay dividends; or (b) may
use internally generated funds to finance its growth, paying less in dividends but not having
to issue stock. In the first case, shareholders receive dividend income; in the second case, the
value of their stocks should increase. Thus, the nature of the return is the only difference;
total returns should be about the same.
View 2: High Dividends Increase Stock Values The belief that a firm’s dividend policy
is unimportant implicitly assumes that an investor is indifferent about whether the increased
income comes through capital gains (stock price increase) or comes through dividends.
However, dividends are more predictable than capital gains. Managers can control divi-
dends, but they cannot dictate the price of the stock. Investors are less certain of receiving
income from capital gains than from dividends. The incremental risk associated with capital
gains relative to dividend income implies a higher required rate for discounting a dollar of
capital gains than for discounting a dollar of dividends. In other words, we would value a
dollar of expected dividends more highly than a dollar of expected capital gains. We might,
for example, require a 14 percent rate of return for a stock that pays its entire return from
dividends, but a 20 percent return for a high-growth stock that pays no dividends. This
view, which says dividends are more certain than capital gains, has been called the bird-in-the-
hand dividend theory.
The position that dividends are less risky than capital gains and should, therefore, be
valued differently is not without its critics. If we hold to our basic decision not to let the
firm’s dividend policy influence its investment and capital-mix decisions, the company’s
operating cash flows, in both expected amount and variability, are unaffected by its dividend
policy. Because the dividend policy has no impact on the volatility of the company’s overall
cash flows, it has no impact on the riskiness of the firm.
Increasing a firm’s dividend does not reduce the basic riskiness of the stock; rather, if a
dividend payment requires managers to issue new stock, it only transfers risk and ownership
from the current owners to new owners. We would have to acknowledge that the current
investors who receive the dividend trade an uncertain capital gain for a “safe” asset (the
cash dividend). However, if risk reduction is the only goal, the investor could have kept the
money in the bank and not bought the stock in the first place.
View 3: Low Dividends Increase Stock Values The third view of how dividends affect
stock price argues that dividends actually hurt the investors. This belief has largely been
based on the difference in the tax treatment of dividends versus capital gains. Contrary to
the perfect-markets assumption of no taxes, most investors do pay income taxes. For these
taxpayers, the objective is to maximize the after-tax return on an investment relative to the
perfect capital markets markets in which
information flows freely and market prices fully
reflect all available information.
bird-in-the-hand dividend theory the
view that dividends are more certain than capital
gains and therefore more valuable.

420 Part 4 • Capital Structure and Dividend Policy
risk assumed. This is done by minimizing the effective tax rate on the income and, whenever
possible, by deferring the payment of taxes.
Like most tax code complexities, Congress over the years has changed whether capital
gains are taxed at a lower or similar rate to “earned income.” Think of a water faucet being
randomly turned on and then off. From 1987 through 1992, no federal tax advantage was
provided for capital gains income relative to dividend income. A revision in the tax code
that took effect beginning in 1993 did provide a preference for capital gains income. Then
the Taxpayer Relief Act of 1997 made the difference (preference) even more favorable for
capital gains as opposed to cash dividend income. For some taxpayers, if a minimum hold-
ing period had been reached, the tax rate applied to capital gains was reduced to 20 percent
from the previous level of 28 percent. But wait: In 2003, Congress again felt the need to
change the tax code as it pertained to both dividend income and capital gains income. On
May 28, President Bush signed into law the Jobs and Growth Tax Relief Reconciliation Act.
Part of the impetus for this act was the recession that commenced in 2001 and the slow rate
of job creation that followed that recession.
In a nutshell, this 2003 act lowered the top tax rate on dividend income to 15 percent
from a previous top rate of 38.6 percent and also lowered the top rate paid on realized long-
term capital gains to the same 15 percent from a previous 20 percent. For 2005-2012 the
tax rate on both dividends and capital gains was 15 percent. However, as of 2012, dividends
are taxed as ordinary income and capital gains are taxed at 20 percent.
Actually, a different benefit exists for capital gains returns relative to dividend income.
Taxes on dividend income are paid when the dividend is received, whereas taxes on price
appreciation (capital gains) are deferred until the stock is actually sold. Thus, when it comes
to tax considerations, many investors prefer the retention of a firm’s earnings—in expecta-
tion of a later capital gain—as opposed to the near-term payment of cash dividends. Again,
if earnings are retained within the firm, hopefully the stock price increases, but the increase
is not taxed until the stock is sold.
Although the majority of investors are subject to taxes, certain investment companies,
trusts, and pension plans are not when it comes to their dividend income. Also, for tax
purposes, a corporation can generally exclude 70 percent of the dividend income it receives
from another corporation. In these cases, investors will prefer dividends over capital gains.
To summarize, when it comes to taxes, we want to maximize our after-tax return, as
opposed to our before-tax return. Investors try to defer taxes whenever possible. Stocks
that allow tax deferral (low dividends–high capital gains) will possibly sell at a premium
relative to stocks that require current taxation (high dividends–low capital gains). This
suggests that a policy of paying low or no dividends will result in a higher stock price.
That is, high dividends hurt investors, whereas low dividends and high retention help
investors. This is the logic of the advocates of the low-dividend policy. It does presume
that the firm’s management has a roster of positive net present value projects that will put
the dollars retained to productive use. However, since 2003 the low tax rate on dividends
challenges this logic.
Making Sense of Dividend Policy Theory
We have now looked at three views on dividend policy. Which is right? The argument
that dividends are irrelevant is difficult to refute, given the perfect-market assumptions.
However, in the real world, it is not always easy to feel comfortable with such an argument.
Conversely, the high-dividend philosophy, which measures risk by how we split the firm’s
cash flows between dividends and retained earnings, is not particularly appealing when
studied carefully. The third view, which is essentially a tax argument against high dividends,
is persuasive. Even today, although the preferential tax rate for capital gains is limited, the
“deferral advantage” of capital gains is still alive and well. However, if low dividends are
so advantageous and generous dividends are so hurtful, why do companies continue to pay
dividends? It is difficult to believe that managers would forgo such an easy opportunity to
benefit their stockholders. What are we missing?
The need to find the missing elements in our “dividend puzzle” has not been ignored.
When we need to better understand an issue or phenomenon, we can either improve our

Chapter 13 • Dividend Policy and Internal Financing 421
thinking or gather more evidence about the topic. Scholars and practitioners have taken
both approaches. Although no single definitive answer has yet been found that is acceptable
to all, several plausible explanations have been developed. Some of the more popular expla-
nations include (1) the residual dividend theory, (2) the clientele effect, (3) the information
effect, (4) agency costs, and (5) the expectations theory.
The Residual Dividend Theory In perfect markets, there are no costs to the firm when
it issues new securities. However, in reality the process is quite expensive, and the flotation
costs associated with a new offering may be as much as 20 percent of the dollar issue size.
Thus, if managers choose to issue stock rather than retain profits to finance new invest-
ments, a larger amount of securities is required to finance the investment. For example,
if $30 million is needed to finance the investment, more than $30 million will have to be
issued to offset the flotation costs. This means, very simply, that new equity capital raised
through the sale of common stock will be more expensive than capital raised via retained
earnings.
In effect, flotation costs eliminate our indifference by using internal capital versus issu-
ing new common stock. Given these costs, dividends should be paid only if the firm’s profits are
not completely used for investment purposes. That is, only “residual earnings” should be paid
out. This policy is called the residual dividend theory.
Given the existence of flotation costs, the firm’s dividend policy should therefore be as
follows:
1. Accept an investment if the NPV is positive, that is, if the expected rate of return
exceeds the cost of capital.
2. Finance the equity portion of new investments first by using internally generated funds.
Only after this capital is fully utilized should the firm issue new common shares.
3. If any internally generated funds still remain after making all acceptable investments,
pay dividends to the investors. However, if all of the internal capital is needed to
finance acceptable investments, pay no dividends.
Thus, dividend policy is influenced by (1) the company’s investment opportunities and
(2) the availability of internally generated capital. Dividends are then paid only after all ac-
ceptable investments have been financed. According to this concept, a dividend policy is
totally passive in nature and can’t affect the market price of the common stock.
Now, let us consider a dose of corporate reality.
The Clientele effect What if the investors do not like the dividend policy chosen by man-
agers? In perfect markets, in which we incur no costs when buying or selling stock, there is
no problem. Investors can simply satisfy their personal income preferences by purchasing
or selling securities when the dividends they receive do not satisfy their current needs. In
other words, if an investor does not view the dividends received in any given year to be suffi-
cient, he or she can simply sell a portion of stock, thereby “creating a dividend.” In addition,
if the dividend is larger than the investor desired, he or she can simply purchase stock with
the “excess cash” created by the dividend.
However, once we remove the assumption of perfect markets, we find that buying or
selling stock is not cost free. Brokerage fees are incurred, ranging from approximately 1 percent
to 10 percent. Even more costly is the fact that the investor who buys the stock with cash re-
ceived from a dividend will have to pay taxes before reinvesting the cash. And when a stock
is bought or sold, it must first be reevaluated. This can be time-consuming and costly for
investors. Finally, some institutional investors, such as investors in university endowment
funds, are precluded from selling stock.
As a result of these considerations, investors may not be too inclined to buy stocks that
require them to “create” a dividend stream more suitable to their purposes. Rather, if inves-
tors do in fact have a preference between dividends and capital gains, we could expect them
to invest in firms that have a dividend policy consistent with these preferences. They would,
in essence, “sort themselves out” by buying stocks that satisfy their preferences for dividends
and capital gains. For example, individuals and institutions that need current income would
residual dividend theory a theory that a
company’s dividend payment should equal the
cash left after financing all the investments that
have positive net present values.

422 Part 4 • Capital Structure and Dividend Policy
be drawn to companies that have high dividend payouts. Other investors, such as wealthy
individuals, would much prefer to avoid taxes by holding securities that offer no or small
dividend income but large capital gains. In other words, there would be a clientele effect:
Firms draw a given clientele, depending upon their stated dividend policy.
The possibility that clienteles of investors exist might lead us to believe that the firm’s
dividend policy matters. However, unless there is a greater aggregate demand for a particu-
lar policy than the market can satisfy, one policy is as good as the other. The clientele effect
only warns firms to avoid making capricious changes in their dividend policy. Moreover,
given that the firm’s investment decisions are already made, the level of the dividend is still
unimportant. The change in the policy matters only when it requires clientele to shift to
another company.
The Information effect An investor in a world of perfect markets would argue with con-
siderable persuasion that a firm’s value is determined strictly by its investment and financ-
ing decisions and that its dividend policy has no impact on value. Yet we know from experi-
ence that a large, unexpected change in dividends can have a significant impact on the stock
price. For instance, in November 1990, Occidental Petroleum cut its dividend from $2 to
$1. In response, the firm’s stock price went from about $32 to $17. How can we suggest that
dividend policy matters little when we can cite numerous such examples?
Despite such “evidence,” some experts claim we are not looking at the real cause and
effect. It may be that investors use a change in dividend policy as a signal about the firm’s
financial condition, especially its earning power. Thus, a dividend increase that is larger
than expected might signal to investors that managers expect significantly higher earnings
in the future. Conversely, a dividend decrease, or even a less-than-expected increase, might
signal that managers are forecasting less-favorable future earnings.
Likewise, some claim that managers frequently have inside information about the firm
that cannot be made available to investors. This difference in accessibility to information, called
information asymmetry, they believe, can result in a lower or higher stock price than would
otherwise occur.
Dividends may, therefore, be important as a communication tool because managers
may have no other credible way to inform investors about future earnings, or at least no
convincing way that is less costly.
Agency Costs Conflicts often exist between stockholders and a firm’s management. As a
result, the stock price of a company owned by investors who are separate from management
may be less than the stock price of a closely held firm. This potential difference in price is
the cost of the conflict to the owners, which has come to be called agency costs.
Recognizing the possible problem, managers, acting independently or at the insistence
of the firm’s board of directors, frequently take action to minimize agency costs. Such
action, which in itself is costly, includes auditing by independent accountants, assigning
supervisory functions to the company’s board of directors, creating covenants in lending
agreements that restrict managerial powers, and providing incentive compensation plans
for managers that help “bond” them with the owners.
A firm’s dividend policy may be perceived by owners as a tool to minimize agency costs.
Assuming that the payment of a dividend requires managers to issue stock to finance new
investments, new investors will be attracted to the company only if they are convinced that
the capital will be used profitably. Thus, the payment of dividends indirectly results in a
closer monitoring of management’s investment activities. In this case, dividends may make
a meaningful contribution to the value of the firm.
The expectations Theory A common thread through much of our discussion of divi-
dend policy, particularly as it relates to information effects, is the word expected. We should
not overlook the significance of this word when we are making any financial decision
within the firm. No matter what the decision area, how the market price responds to a firm’s ac-
tions is not determined entirely by the action itself; it is also affected by investors’ expectations about
the ultimate decision to be made by management. This concept or idea is called the expectations
theory.
clientele effect the belief that individuals
and institutions will invest in companies whose
dividend payouts match their particular needs
for current versus future cash flow. For example,
those that need current income will invest in
companies that have high dividend payouts.
information asymmetry the notion that
investors do not know as much about the firm’s
operations as the firm’s management.
agency costs the lost value a firm’s security
holders face where there are conflicts of interest
between managers and the security holders.
expectations theory the notion that inves-
tor reactions to a managerial decision are based
on their assessment of the effect of the action on
stock price. For example, the announcement of
a higher dividend not only indicates that more
cash will be received by investors this quarter
but may also signal to investors that the firm’s
future prospects have improved.

Chapter 13 • Dividend Policy and Internal Financing 423
For example, as the time approaches for managers to announce the amount of the firm’s
next dividend, investors form expectations about how much that dividend will be. These
expectations are based on several factors related to the firm, such as past dividend decisions,
current and expected earnings, investment strategies, and financing decisions. Investors
also consider such things as the condition of the general economy, the strength or weakness
of the industry at the time, and possible changes in government policies.
When the actual dividend decision is announced, the investor compares the actual deci-
sion with the expected decision. If the amount of the dividend is as expected, even if it rep-
resents an increase from prior years, the market price of the stock will remain unchanged.
However, if the dividend is higher or lower than expected, investors will reassess their
perceptions of the firm. In short, an actual decision about the firm’s dividend policy is not
likely to be terribly significant unless it departs from investors’ expectations. But if there is a
difference between actual and expected dividends, we will more than likely see a movement
in the stock price.
What Are We to Conclude?
A firm must develop a dividend policy regardless, so here are some of the things we have
learned about the relevance of a firm’s dividend policy.
1. As a firm’s investment opportunities increase, its dividend payout ratio should decrease.
In other words, an inverse relationship should exist between the amount of money a
firm invests with expected rates of return that exceed the cost of capital (positive NPVs)
and the dividends it remits investors. Because of flotation costs, internally generated
equity financing is preferable to selling stock (in terms of the wealth of the current
common shareholders).
2. The firm’s dividend policy appears to be important; however, appearances can be
deceptive. The real issue is the firm’s expected earning power, and investors will use the
dividend payment as a source of information about these earnings. The dividend may
carry greater weight than a statement by management that earnings will be increasing
or decreasing. (Actions speak louder than words.)
3. If dividends influence the stock price, this is probably based on the investor’s desire
to minimize or defer taxes and on the fact that dividends can minimize agency
costs.
4. If the expectations theory has merit, which we believe it does, the firm should avoid
surprising investors when it comes to its dividend decision.
5. The firm’s dividend policy should effectively be treated as a long-term residual. Rather
than project investment requirements for a single year, managers should anticipate
financing needs for several years. If internal funds remain after the firm has undertaken
all acceptable investments, dividends should be paid. Conversely, if over the long term
the entire amount of internally generated capital is needed for reinvestment in the
company, then no dividend should be paid.
In setting a firm’s dividend policy, financial managers must work in the messy world of
reality. This means that our theories do not provide an equation that perfectly explains the
key relationships. However, they give us a more complete view of the world, which can only
help us make better decisions.
Concept Check
1. Summarize the position that a dividend policy may be irrelevant with regard to the firm’s stock
price.
2. What is meant by the bird-in-the-hand dividend theory?
3. Why are cash dividend payments thought to be more certain than capital gains?
4. How might personal taxes affect both the firm’s dividend policy and its share price?
5. Distinguish between the residual dividend theory and the clientele effect.

424 Part 4 • Capital Structure and Dividend Policy
The Dividend Decision in Practice
There are a number of practical considerations that will have an impact on a firm’s decision
to pay dividends. Some of the more obvious ones include the following.
Legal Restrictions
Certain legal restrictions can limit the amount of dividends a firm may pay. These legal
constraints fall into two categories. First, statutory restrictions may prevent a company from
paying dividends. Although the specific limitations vary by state, generally a corporation
may not pay a dividend (1) if the firm’s liabilities exceed its assets, (2) if the amount of the
dividend exceeds the firm’s accumulated profits (retained earnings), and (3) if the dividend
is being paid from capital invested in the firm.
The second type of legal restriction is unique to each firm and results from the restric-
tions in debt and preferred stock contracts. To minimize their risk, investors frequently im-
pose restrictive provisions on managers as a condition to their investment in the company.
These constraints might include the provision that dividends may not be declared before
the debt is repaid. Also, the corporation might be required to maintain a given amount of
working capital. Preferred stockholders might stipulate that common dividends may not be
paid when any preferred dividends are delinquent.
Liquidity Constraints
Contrary to popular opinion, the mere fact that a company shows a large amount of re-
tained earnings in its balance sheet does not indicate that cash is available for the payment
of dividends. The firm’s liquid assets, including its cash, are basically independent of its re-
tained earnings account. Generally, retained earnings are either reinvested in the company
within a short period or used to pay maturing debt. Thus, a firm can be extremely profitable
and still be cash poor. Because dividends are paid with cash, and not with retained earnings,
the firm must have cash available for the dividends to be paid. Hence, the firm’s liquidity
position has a direct bearing on its ability to pay dividends.
earnings Predictability
A company’s dividend payout ratio depends to some extent on the predictability of a firm’s
profits over time. If its earnings fluctuate significantly, the firm’s managers know they can-
not necessarily rely on internally generated funds to meet its future needs. As a result,
when profits are realized, the firm is likely to retain larger amounts to ensure that money
is available when needed. Conversely, a firm with a stable earnings trend will typically pay
out a larger portion of its earnings in dividends. This company has less concern about the
availability of profits to meet its future capital requirements.
Maintaining Ownership Control
For many large corporations, control through the ownership of common stock is not an im-
portant issue. However, for many small and medium-sized companies, maintaining voting
control is a high priority. If the current common stockholders are unable to participate in a
new offering, issuing new stock is unattractive, in that the control of the current stockholder
is diluted. The owners might prefer that managers finance new investments with debt and re-
tained earnings rather than issue new common stock. This firm’s growth is then constrained
by the amount of debt capital available to it and by the company’s ability to generate profits.
Alternative Dividend Policies
Regardless of a firm’s long-term dividend policy, most firms choose one of several year-to-
year dividend payment patterns.
1. A constant dividend payout ratio. Under this policy, the percentage of earnings paid
out in dividends is held constant. Although the dividend-to-earnings ratio is stable, the
dollar amount of the dividend naturally fluctuates from year to year as profits vary.
3 Discuss the constraints on
dividend policy, commonly
used dividend policies, and
payment procedures.
constant dividend payout ratio a
dividend payment policy in which the
percentage of earnings paid out in dividends is
held constant. The dollar amount fluctuates from
year to year as profits vary.

Chapter 13 • Dividend Policy and Internal Financing 425
2. A stable dollar dividend per share. This policy maintains a relatively stable dollar
dividend over time. An increase in the dollar dividend usually does not occur until man-
agement is convinced that the higher dividend level can be maintained in the future.
Conversely, a lower dollar dividend will not be paid until the evidence clearly indicates
that a continuation of the current dividend cannot be supported.
3. A small, regular dividend plus a year-end extra. A corporation following this policy
pays a small, regular dollar dividend plus a year-end extra dividend in prosperous years. The
extra dividend is declared toward the end of the fiscal year after the company’s profits
for the period can be estimated. The objective is to avoid the connotation of a permanent
dividend being paid. However, this purpose may be defeated if recurring extra dividends
come to be expected by investors.
Dividend Payment Procedures
After the firm’s dividend policy has been structured, several procedural details must be ar-
ranged. For instance, how frequently are dividend payments to be made? If a stockholder
sells the shares during the year, who is entitled to the dividend? To answer these questions,
we need to understand dividend payment procedures.
Generally, companies pay dividends quarterly. For example, on February 6, 2009, Gen-
eral Electric (GE) announced that it would pay a quarterly dividend of $0.31 per quarter
to its shareholders for 2009. The annual dividend then would be 4 * $0.31 = $1.24 per
share.
The final approval of a dividend payment comes from the company’s board of directors.
For example, the announcement or declaration date for General Electric’s 2012 dividend
was September 7, 2012, that holders of record as of September 24, 2012, would receive the
dividend on the October 25, 2012, payment date. The date of record, September 24, 2012,
designates when the stock transfer books are to be closed. Investors shown to own the stock
on this date receive the dividend. If a notification of a transfer is recorded subsequent to
September 24, the new owner is not entitled to the dividend. However, a problem could
develop if the stock were sold on September 23, one day prior to the record date. Time would
not permit the sale to be reflected on the stockholder list by the date of record. To address
this problem, stock brokerage companies have uniformly terminated the right of ownership
to the dividend two working days before the record date such that the ex-dividend date for
the GE dividend is September 20 (note that in this instance September 24 was a Monday so
the ex-dividend date was set two business days prior, which was September 20). The dividend
declaration and payment process can be summarized as follows:
stable dollar dividend per share a
dividend policy that maintains a relatively stable
dollar dividend per share over time.
small, regular dividend plus a year-end
extra a corporate policy of paying a small
regular dollar dividend plus a year-end extra
dividend in prosperous years to avoid the
connotation of a permanent dividend.
declaration date the date upon which a
dividend is formally declared by the board of
directors.
payment date the date on which the
company mails a dividend check to each
investor of record.
date of record the date at which the stock
transfer books are to be closed for determining
the investors to receive the next dividend
payment.
ex-dividend date the date upon which stock
brokerage companies have uniformly decided to
terminate the right of ownership to the dividend,
which is two days prior to the date of record.
Declaration date Date of record Payment date
September 7 September 24
September 20
Ex-dividend date
October 25
Concept Check
1. Identify some practical considerations that affect a firm’s payout policy.
2. Identify and explain three different dividend policies. (Hint: One of these is a constant dividend
payout ratio.)
3. What is the typical frequency with which cash dividends are paid to investors?
4. Distinguish among the (a) declaration date, (b) date of record, and (c) ex-dividend date.

426 Part 4 • Capital Structure and Dividend Policy
Stock Dividends and Stock Splits
A stock dividend entails the distribution of additional shares of stock in lieu of a cash pay-
ment. A stock split involves exchanging more (or less in the case of a “reverse” split) shares
of stock for the firm’s outstanding shares. In both cases the number of common shares
outstanding changes but the firm’s investments and future earnings prospects do not. In
essence, the ownership pie is simply cut into more pieces (or fewer pieces in the case of a
reverse split).
The only difference between a stock dividend and a stock split relates to their re-
spective accounting treatments. Both represent a proportionate distribution of additional
shares to the current stockholders. However, for accounting purposes the stock split has
been defined as a stock dividend exceeding 25 percent. Thus, a stock dividend is conven-
tionally defined as a distribution of shares up to 25 percent of the number of shares currently
outstanding.
Although stock dividends and splits occur far less frequently than cash dividends, a
significant number of companies choose to use these share distributions either with or in
lieu of cash dividends. The extent of stock splits and stock dividends over the years can be
made clear by a little price comparison. In 1926, a ticket to the movies cost 25¢—and even
much less in the rural communities. At the same time, the average share price on the New
York Stock Exchange was $35. Today, if we want to go to a new movie, we pay $7 or more.
However, the average share price is still about $35. The relatively constant share price is
the result of the shares being split over and over again. We can only conclude that investors
apparently like it that way. But why do they, if no economic benefit results to the investor
from doing so?
Proponents of stock dividends and splits frequently maintain that stockholders receive
a key benefit because the price of the stock will not fall precisely in proportion to the share
increase. For a two-for-one split, the price of the stock might not decrease a full 50 percent,
so the stockholder is left with a higher total value. There are two reasons for this disequi-
librium. First, many financial executives believe that an optimal price range exists. Within
this range, the total market value of the common stockholders is thought to be maximized.
As the price exceeds this range, fewer investors can purchase the stock, thereby restrain-
ing demand for the shares. Consequently, downward pressure is placed on its price. For
example, Apple (AAPL) has engaged in multiple stock splits each time its share price rose
above $100. It had 2-for-1 splits in 1987, 2000, and 2005. Rumors abounded in 2007 prior
to the onset of the current recession that the company would split again as its stock price
passed $160 in October of that year.
The second explanation relates to the informational content of the dividend-split an-
nouncement. Stock dividends and splits have generally been associated with companies with
growing earnings. The announcement of a stock dividend or split has therefore been per-
ceived as favorable news. The empirical evidence, however, fails to verify these conclusions.
Most studies indicate that investors are perceptive in identifying the true meaning of such a
distribution. If the stock dividend or split is not accompanied by a positive trend in earnings
and increases in cash dividends, price increases surrounding the stock dividend or split are
insignificant. Therefore, we should be suspicious of the assertion that a stock dividend or
split can help increase investors’ net worth.
A second reason for stock dividends or splits is the conservation of corporate cash. If a
company is encountering cash problems, it may substitute a stock dividend for a cash divi-
dend. However, as before, investors will probably look beyond the dividend to ascertain the
underlying reason for conserving cash. If the stock dividend is an effort to conserve cash for
attractive investment opportunities, shareholders might bid up the stock price. If the move
to conserve cash relates to financial difficulties within the firm, the market price will most
likely react adversely.
Concept Check
1. What is the difference between a stock split and a stock dividend?
2. What managerial logic might lie behind a stock split or a stock dividend?
4 Describe why firms sometimes
pay noncash dividends.
stock split a stock dividend exceeding
25 percent of the number of shares currently
outstanding.
stock dividend a distribution of shares of up
to 25 percent of the number of shares currently
outstanding, issued on a pro rata basis to the
current stockholders.

Chapter 13 • Dividend Policy and Internal Financing 427
Stock Repurchases
A stock repurchase (stock buyback) occurs when a firm repurchases its own stock. This
results in a reduction in the number of shares outstanding. For well over three decades, corpora-
tions have been actively repurchasing their own equity securities. In the introduction we
noted that Apple planned to repurchase up to $10 billion in company shares in March 2013.
This new repurchase program follows the completion of a previous $40 billion in share
repurchases. Note the use of the word plan in the announcement. This is important for it
provides Apple leeway as to whether it carries out the planned repurchases in light of the
uncertainties faced in the economic downturn that began with the financial crisis of 2007.
However, uncertain economic times did not influence Walmart (WMT), which announced
on June 5, 2009, that it planned to repurchase $15 billion of its shares. This follows a period
of 5 years during which time the firm repurchased approximately $21 billion of shares.
Also, if you were to look at the balance sheet of almost any publicly held firm, you
would see that the firm’s treasury stock—the amount paid for repurchasing its own stock—
is often-times severalfold the total amount originally invested by the stockholders. This
situation is not unusual for many large companies. Several reasons have been given for stock
repurchases. The benefits include:
1. A means for providing an internal investment opportunity
2. An approach for modifying the firm’s capital structure
3. A favorable impact on earnings per share
4. The elimination of a minority ownership group of stockholders
5. The minimization of the dilution in earnings per share associated with mergers
6. The reduction in the firm’s costs associated with servicing small stockholders
Also, from the shareholders’ perspective, a stock repurchase, as opposed to a cash dividend,
has a potential tax advantage.
A Share Repurchase as a Dividend Decision
Clearly, the payment of a common stock dividend is the conventional method for distribut-
ing a firm’s profits to its owners. However, it need not be the only way. Another approach
is to repurchase the firm’s stock. The concept may best be explained by an example.
e x A M P L e 13.1 Dividends vs. Share Repurchase
Telink, Inc. is planning to pay $4 million ($4 per share) in dividends to its common stock-
holders. The following earnings and market price information is provided for Telink:
5 Distinguish between the use of
cash dividends and share
repurchases.
stock repurchase (stock buyback) the
purchase of outstanding common stock by the
issuing firm.
Net income $7,500,000
Number of shares 1,000,000
Earnings per share $7.50
Price/earnings ratio 8
Expected market price per share after the dividend payment $60
In a recent meeting, several board members, who are also major stockholders, ques-
tioned the need for the dividend payment. They maintained that they did not need
the dividend income and suggested that the firm simply reinvest the earnings to fund
future investments. In response to the question Telink’s management argued that the
firm’s investment opportunities were not sufficiently profitable to justify retention of
the income. Specifically, the required rate of return from the capital market was higher
than the rate of return the firm thought it could earn by reinvesting the money in the
firm.

428 Part 4 • Capital Structure and Dividend Policy
As an alternative to paying dividends or reinvesting the earnings, the company’s chief
financial officer suggested that the firm repurchase company stock. This way the directors
who did not want income from dividends could refrain from selling their shares and avoid
current income.
To illustrate the effects of a share repurchase the company CFO suggested that the
firm repurchase shares at a price of $64, which is the current market price plus the value
of the proposed $4 dividend. He then said that the effect of the share repurchase would
be the same as paying the dividend? Is this right?
SteP 1: Formulate a SolutIon Strategy
If a $4 dividend is paid then each shareholder will end up with a share of stock valued at
$60 plus the dividend or a value of $64. The question then is, will the value of each share
of stock be $64 if the share repurchase is carried out?
SteP 2: CrunCh the numberS
Note first that for $4 million the firm can repurchase 62,500 shares of stock at the $64
price ($4,000,000/$64). Now we can evaluate the price of the firm’s shares after the
repurchase by computing firm earnings per share:
Earnings per share = net income/shares outstanding after the share repurchase
= ($7,500,000/(1,000,000 – 62,500)
= $8 per share
Next we compute the estimated share price per share using the price/earnings multiple
of 8 times, that is
Price per share = earnings per share * price/earnings ratio
= $8.00 * 8 times
= $64.00
SteP 3: analyze your reSultS
In the CFO’s example Telink’s stockholders are provided with the same $64.00 value
whether a dividend is paid or shares are repurchased. Note, however, for the stock-
holders to be truly indifferent that the tax treatment of the $4 dividend must be the
same as the $4 increase in the value of the firm’s shares. This is not the case as the
price appreciation realized by the stockholders that sell their shares may well be taxed
at a lower capital gains tax rate than dividends, which are taxed as ordinary income.
Moreover, if the stockholders do not sell into the repurchase there is no taxable event
such that the gain in share price will be deferred until shares are actually sold.
The Investor’s Choice
Given the choice between a stock repurchase and a dividend payment, which should an in-
vestor prefer? If there are no taxes, no commissions when buying and selling stock, and no
informational content assigned to a dividend, the investor should be indifferent with regard
to the choices. For example, if the investor wants cash flow and the stock he owns does not
pay a dividend, he can create a dividend by simply selling a portion of his shares. Note that
these sales will not necessarily deplete the value of his investment as the value of the firm’s
shares should be growing because the firm’s earnings are not being paid in dividends but
are being reinvested.
There are certainly drawbacks related to repurchasing stock that investors should care
about. First, the firm may have to pay too high a price for the repurchased stock, which is
to the detriment of the remaining stockholders. If a relatively large number of shares are
being bought, the price may be bid up too high, only to fall after the repurchase operation.
Second, as a result of the repurchase, the market may perceive the riskiness of the corpora-
tion as increasing, which would lower the price/earnings ratio and the value of the stock.

Chapter 13 • Dividend Policy and Internal Financing 429
A Financing or Investment Decision?
Repurchasing stock when the firm has excess cash can be regarded as a dividend decision.
However, a stock repurchase can also be viewed as a financing decision. By issuing debt and
then repurchasing stock, a firm can immediately alter its debt–equity mix toward a higher
proportion of debt. Essentially, rather than choose how to distribute cash to the stockholders,
managers are using stock repurchases as a means to change the corporation’s capital structure.
In addition to dividend and financing decisions, many managers consider a stock repur-
chase to be an investment decision. When equity prices are depressed in the marketplace,
they may view the firm’s own stock as being materially undervalued and therefore a good
investment opportunity. Although this may be a wise move, the decision cannot and should
not be viewed in the context of an investment decision. Buying its own stock cannot provide
expected returns as other investments do. No company can survive, much less prosper, by
investing only in its own stock.
Practical Considerations—The Stock Repurchase Procedure
If management intends to repurchase a block of the firm’s outstanding shares, it should
make this information public. All investors should be given the opportunity to work with
complete information. They should be told the purpose of the repurchase as well as the
method to be used to acquire the stock.
Three methods for stock repurchase are available. First, the shares can be bought in the
open market. Here the firm acquires the stock through a stockbroker at the going market
price. This approach can put upward pressure on the stock price. Also, commissions must
be paid to the stockbrokers as a fee for their services.
The second method is to make a tender offer to the firm’s shareholders. A tender offer
is a formal offer by the company to buy a specified number of shares at a predetermined and stated
price. The tender price is set above the current market price in order to attract sellers. A tender of-
fer is best when a relatively large number of shares are to be bought because the company’s
intentions are clearly known and each shareholder has the opportunity to sell the stock at
the tendered price.
Finance at Work
ComPanIeS InCreaSIngly uSe Share rePurChaSeS to DIStrIbute CaSh
to theIr StoCkholDerS
There has been a fundamental shift away from paying divi-
dends and toward the buyback of company shares of stock. This
change is at least partially due to changes in the U.S. tax code,
which charges an additional 15% tax on dividends paid out to
shareholders (before the Bush administration, this tax was as
high as the graduated income tax—in some cases exceeding
35% on the federal level alone).
Evidence supporting the growth in share repurchases is
found in the fact that the firms in the Standard & Poor’s 500
repurchased $349 billion of their shares in 2005 alone. In fact,
firms spent 73% more on buybacks than they did on dividends.
On average, stock repurchases represented 61% of company
earnings and dividends were only 32%. Clearly, there is a strong
preference for share repurchases.*
Obviously firms are finding share repurchases a preferred
way to distribute cash, but is this always best for the investor?
Asked somewhat differently, are there reasons to prefer divi-
dends over share repurchases? The answer is yes. For example,
investors who need cash from their investments to live on may
prefer dividends rather than being forced to sell shares and incur
brokerage fees. Also, there’s something comforting about receiv-
ing a regular check in the mail and not having to worry so much
about fluctuations in the value of your shares from day to day.
Some companies now recognize the varied interests of their
stockholders and attempt to blend share repurchases with cash
dividends. For example, Home Depot has paid out about 65%
of its earnings in a mix of share repurchases and dividend pay-
ments. For example, for the year ended January 29, 2006, the
firm reported total net income of $5.838 billion, paid $0.857 billion
in dividends, and repurchased $2.626 billion in company shares.
This represents a total distribution of 59.7% of company earn-
ings with 45% being distributed via share repurchase and 14.7%
via dividends.**
Source: Leslie Schism, “Many Companies Use Excess Cash to Repurchase Their
Shares,” September 2, 1993, the Wall Street Journal, Eastern edition.
*Matt Krantz, “More companies go for stock buybacks,” USA Today (March 23,
2006).
**http://finance.yahoo.com/q/cf?s=HD&annual.
tender offer a formal offer by the company
to buy a specified number of shares at a
predetermined and stated price. The tender
price is set above the current market price in
order to attract sellers.

http://finance.yahoo.com/q/cf?s=HD&annual

430 Part 4 • Capital Structure and Dividend Policy
The third and final method for repurchasing stock entails the purchase of the stock
from one or more major stockholders. These purchases are made on a negotiated basis.
Care should be taken to ensure a fair and equitable price. Otherwise, the remaining stock-
holders may be hurt as a result of the sale.
Concept Check
1. Identify three reasons why a firm might buy back its own common stock shares.
2. What financial relationships must hold for a stock repurchase to be a perfect substitute for a cash
dividend payment to stockholders?
3. Within the context of a stock repurchase, what is meant by a tender offer?
Chapter Summaries
Describe the trade-off between paying dividends and retaining (reinvesting)
firm profits. (pgs. 417–418)
SuMMARY: When firms decide to pay cash dividends this is a use of cash. That is, cash that oth-
erwise would be sitting in a bank account or be invested in a short-term money market investment.
For example, in the introduction we noted that Apple announced plans to pay out about $45 billion
in dividends and stock repurchases during 2012. This means that this cash will not be available for
Apple to reinvest in new projects.
KeY TeRM
1
Dividend payout ratio, page 417, The ratio
of dividends paid per share divided by earnings
per share.
Does dividend policy affect the company’s stock price? (pgs. 418–423)
SuMMARY: A company’s dividend decision has an immediate impact on the firm’s financial mix.
If the dividend payment is increased, fewer funds are available internally for financing investments.
Consequently, if additional equity capital is needed, the company has to issue new common stock.
In perfect markets, the choice between paying or not paying a dividend does not matter. However,
when we realize that in the real world there are costs of issuing stock, we have a preference to use
internal equity to finance our investment opportunities. Here the dividend decision is simply a
residual factor, in which the dividend payment should equal the remaining internal capital after the
firm finances all of its investments.
Other market imperfections that may cause a company’s dividend policy to affect the firm’s stock
price include (1) the deferred tax benefit of capital gains, (2) agency costs, (3) the clientele effect,
and (4) the informational content of a given policy. Other practical considerations that may affect a
firm’s dividend payment decision include
• Legal restrictions
• The firm’s liquidity position
• The accessibility of capital markets to the company
• The stability of the firm’s earnings
• The desire of investors to maintain control of the company
KeY TeRMS
2
Perfect capital markets, page 419 are markets
in which information flows freely and market
prices fully reflect all available information.
Bird-in-the-hand dividend theory, page 419
The view that dividends are more certain than
capital gains and therefore more valuable.

Chapter 13 • Dividend Policy and Internal Financing 431
Discuss the constraints on dividend policy, commonly used dividend
policies, and payment procedures. (pgs. 424–425)
SuMMARY: Companies typically pay dividends on a quarterly basis. The final approval of a divi-
dend payment comes from the board of directors. The critical dates in this process are as follows:
• Declaration date—the date when the dividend is formally declared by the board of directors
• Date of record—the date when the stock transfer books are closed to determine who owns the
stock
• Ex-dividend date—two working days before the date of record, after which the right to receive
the dividend no longer goes with the stock
• Payment date—the date the dividend check is mailed to the stockholders
In practice, managers have generally followed one of three dividend policies:
• A constant dividend payout ratio, whereby the percentage of dividends to earnings is held
constant
• A stable dollar dividend per share, whereby a relatively stable dollar dividend is maintained over
time
• A small, regular dividend plus a year-end extra, whereby the firm pays a small, regular dollar
dividend plus a year-end extra dividend in prosperous years
Of the three dividend policies, the stable dollar dividend is by far the most common. The Jobs
and Growth Tax Relief Reconciliation Act of 2003 reduced the top tax rate on dividend income to
15 percent and placed the top tax rate on realized long-term capital gains at this same 15 percent
rate. This helped level the investment landscape for dividend income relative to qualifying capital
gains. Taxes paid on capital gains, however, are still deferred until realized, but dividend income is
taxed in the year that it is received by the investing taxpayer.
KeY TeRMS
3
Residual dividend theory, page 421 A theory
that a company’s dividend payment should
equal the cash left after financing all the invest-
ments that have positive net present values.
Clientele effect, page 422 The belief that indi-
viduals and institutions will invest in companies
whose dividend payouts match their particular
needs for current versus future cash flow. For ex-
ample, those that need current income will invest
in companies that have high dividend payouts.
Information asymmetry, page 422 The no-
tion that investors do not know as much about
the firm’s operations as the firm’s management.
Agency costs, page 422 The lost value a
firm’s security holders face where there are
conflicts of interest between managers and the
security holders.
Expectations theory, page 422, The no-
tion that investor reactions to corporate
actions is based on their assessment of the
effect of the action on stock price which can
incorporate their interpretation of what the
action means. For example, the announce-
ment of a higher dividend may signal to
investors that the firm’s future prospects
have improved.
Constant dividend payout ratio, page 424 A
dividend payment policy in which the percent-
age of earnings paid out in dividends is held
constant. The dollar amount fluctuates from
year to year as profits vary.
Stable dollar dividend per share, page 425 A
dividend policy that maintains a relatively stable
dollar dividend per share over time.
Small, regular dividend plus a year-end
extra, page 425 a corporate policy of paying
a small regular dollar dividend plus a year-end
extra dividend in prosperous years to avoid the
connotation of a permanent dividend.
Declaration date, page 425 The date upon
which a dividend is formally declared by the
board of directors.
Payment date, page 425 The date on which
the company mails a dividend check to each
investor of record.
Date of record, page 425 The date at which
the stock transfer books are to be closed for
determining the investors to receive the next
dividend payment.
Ex-dividend date, page 425 The date upon
which stock brokerage firms have uniformly
decided to terminate the right of ownership
to the dividend, which is two days prior to the
date of record.

432 Part 4 • Capital Structure and Dividend Policy
Describe why firms sometimes pay noncash dividends. (pg. 426)
SuMMARY: Stock dividends and stock splits have been used by corporations either in lieu of or to sup-
plement cash dividends. At present, no empirical evidence identifies a relationship between stock divi-
dends and splits and the market price of the stock. Yet a stock dividend or split could conceivably be used
to keep the stock price within an optimal trading range. Also, if investors perceive that the stock dividend
contains favorable information about the firm’s operations, the price of the stock could increase.
KeY TeRMS
4
Stock split, page 426 a stock dividend
exceeding 25 percent of the number of shares
currently outstanding.
Stock dividend, page 426 A distribution of
shares of up to 25 percent of the number of
shares currently outstanding, issued on a pro
rata basis to the current stockholders.
Distinguish between the use of cash dividends and share repurchases.
(pgs. 427–430)
SuMMARY: As an alternative to paying a dividend, the firm can repurchase stock. In perfect mar-
kets, an investor would be indifferent between receiving a dividend or a share repurchase. The
investor could simply create a dividend stream by selling stock when income is needed. If, however,
market imperfections exist, the investor may have a preference for one of the two methods of dis-
tributing the corporate income.
A stock repurchase can also be viewed as a financing decision. By issuing debt and then repurchas-
ing stock, a firm can immediately alter its debt–equity mix toward a higher proportion of debt.
Also, many managers consider a stock repurchase an investment decision—buying the stock when
they believe it to be undervalued.
KeY TeRMS
5
Stock repurchase (stock buyback), page 427
The purchase of outstanding common stock by
the issuing firm.
Review Questions
All Review Questions are available in MyFinanceLab.
13-1. What is meant by the term dividend payout ratio?
13-2. Explain the trade-off between retaining internally generated funds and paying cash dividends.
13-3. a. What is the residual dividend theory?
b. Why is this theory operational only in the long term?
13-4. What legal restrictions may limit the amount of dividends to be paid?
13-5. In the introduction to the chapter we learned that Apple Computer (AAPL) recently rein-
stated the payment of cash dividends, which had been suspended since the 1990s. What are some
reasons that might have influenced the firm’s decision to begin paying dividends again?
13-6. How does a firm’s liquidity position affect the payment of dividends?
13-7. How can ownership control constrain the growth of a firm?
13-8. Explain what a dividend’s declaration date, date of record, and ex-dividend date are.
13-9. What are the advantages of a stock split or dividend over a cash dividend?
13-10. Why would a firm repurchase its own stock?
Study Problems
All Study Problems are available in MyFinanceLab.
13-1. (Dividend payout ratio) Carson Electronics earned $2.4 million in net income last year and for
the first time ever paid its common stockholders a cash dividend of $0.02 per share. The firm has
10 million shareholders. What was Carson’s dividend payout ratio?
1

Chapter 13 • Dividend Policy and Internal Financing 433
13-2. (Dividend policy and the issue of new shares of common stock) Your firm needs to raise $10 million
to finance its capital expenditures for the coming year. The firm earned $4 million last year and will
pay out half this amount in dividends. If the firm’s CFO wants to finance new investments using no
more than 40 percent debt financing, how much common stock will the firm have to issue to raise
the needed $10 million?
13-3. (Dividend policy and stock prices) Explain in your own words the notion of a perfect capital
market.
13-4. (Dividend policy and stock prices) The question as to whether dividend policy has an effect
on share prices raises a question as to whether dividends paid out to stockholders are any more
“certain” than the expected future dividends the stockholders hope to receive from the retention
of firm earnings. This is known as the “bird-in-the-hand’ theory of dividend policy. Do you agree
with this theory? Explain.
13-5. (Residual dividend policy) FarmCo, Inc. follows a policy of paying out cash dividends equal to
the residual amount that remains after funding 60 percent of its planned capital expenditures. The
firm tries to maintain a 40 percent debt and 60 percent equity capital structure and does not plan
on issuing more stock in the coming year. FarmCo’s CFO has estimated that the firm will earn
$12 million in the current year.
a. If the firm maintains its target financing mix and does not issue any equity next year, what
is the most it could spend on capital expenditures next year given its earnings estimate?
b. If FarmCo’s capital budget for next year is $10 million, how much will the firm pay in
dividends and what is the resulting dividend payout percentage?
13-6. (Legal restrictions on dividend payments) Describe the types of limitations firms can face from
legal restrictions on dividend payments.
13-7. (Practical considerations in setting dividend policy) The board of directors of Kensington Enter-
prises has decided to pay cash dividends totaling $5 million in the first quarter of the year. This
payment represents the initiation of a cash dividend for the first time in company history, and your
company CFO has asked you to look into any restrictions or constraints the firm might have in car-
rying out the plan. Write a brief report outlining the types of restrictions Kensington might face.
13-8. (Dividend policies) Final earnings estimates for Chilean Health Spa & Fitness Center have
been prepared for the CFO of the company and are shown in the following table. The firm has
7,500,000 shares of common stock outstanding. As assistant to the CFO, you are asked to deter-
mine the yearly dividend per share to be paid depending on the following possible policies:
a. A stable dollar dividend targeted at 40 percent of earnings over a 5-year period.
b. A small, regular dividend of $0.60 per share plus a year-end extra when the profits in any year
exceed $20,000,000. The year-end extra dividend will equal 50 percent of profits exceeding
$20,000,000.
c. A constant dividend payout ratio of 40 percent.
2
3
Y e A R P R O F I T S A F T e R TAx e S
1 $18,000,000
2 21,000,000
3 19,000,000
4 23,000,000
5 25,000,000
13-9. (Constant dividend payout ratio policy) The Patterson-Hale Trucking Company (PHT) needs
to expand its fleet by 50 percent to meet the demands of two major contracts it just received to
transport military equipment from manufacturing facilities scattered across the United States to
various military bases. The cost of the expansion is estimated to be $14 million. PHT maintains
a 30 percent debt ratio and pays out 50 percent of its earnings in common stock dividends each
year.
a. If PHT earns $4 million in 2013, how much common stock will the firm need to sell in
order to maintain its target capital structure?
b. If PHT wants to avoid selling any new stock but wants to maintain a constant dividend pay-
out percentage of 50 percent, how much can the firm spend on new capital expenditures?

434 Part 4 • Capital Structure and Dividend Policy
13-10. (Constant dollar dividend payout policy) Parker Prints is in negotiation with two of its largest
customers to increase the firm’s sales dramatically. The increase will require that Parker expand its
production facilities at a cost of $30 million. Parker expects to pay out $8 million in dividends to its
shareholders next year. Parker maintains a 40 percent debt ratio in its capital structure.
a. If Parker earns $12 million in 2013, how much common stock will the firm need to sell in
order to maintain its target capital structure?
b. If Parker wants to avoid selling any new stock, how much can the firm spend on new capital
expenditures?
13-11. (Terminology) Define each of the following dates and place them in their proper order with
respect to the payment and receipt of cash dividends: date of record, ex-dividend date, declaration
date, and payment date.
13-12. (Stock dividends) In the spring of 2014 the CFO of Placebo Pharmaceuticals, Inc. took a
proposal to the firm’s board of directors to distribute a noncash dividend to the firm’s shareholders
in the form of new shares of common stock. Specifically, the CFO proposed that the company pay
0.025 shares of stock to the holders of each share of common stock such that the holder of 1,000
shares of stock would receive an additional 25 shares of common stock.
a. If Placebo had total net income for the year of $10,000,000 and 20,000,000 shares of com-
mon stock outstanding before the stock dividend, what are firm earnings per share?
b. After paying the stock dividend, what is the firm’s earnings per share?
c. If you owned 1,000 shares of stock before the stock dividend, how many dollars of earn-
ings did the firm earn on your 1,000 share investment? After the stock dividend is paid,
how many dollars of earnings did the firm earn on your larger share holdings? What effect
would you expect from the payment of the stock dividend on your total investment in the
firm?
13-13. (Stock splits and large stock dividends) Marston Mfg. recently declared a 4-for-1 stock split for
its common shares. Before the split the firm’s share price had risen to $600 per share and the firm’s
CFO felt that this high stock price inhibited trading in the firm’s shares. Prior to the split the firm
had 10 million shares of stock outstanding and had net income of $40 million.
a. Before the stock split what is Marston’s earnings per share?
b. Following the stock split, how many shares of common stock will Marston have outstanding?
c. What are the firm’s earnings per share after the stock split?
d. If you owned 100 shares of stock before the split, how much are the total earnings for your
shares? How much are the total earnings on your post-split shares?
e. Were you better off financially as the holder of 100 shares of pre-split stock after the 4-for-1
split? Explain.
13-14. (Stock splits) The debt and equity section of the Robson Corporation balance sheet is shown
here. The current market price of the common shares is $20. Reconstruct the financial statement
assuming that (a) a 15 percent stock dividend is issued and (b) a 2-for-1 stock split is declared.
4
13-15. (Repurchase of stock) The Dunn Corporation is planning to pay dividends of $500,000. There
are 250,000 shares outstanding, and earnings per share are $5. The stock should sell for $50 after
the ex-dividend date. If, instead of paying a dividend, the firm decides to repurchase stock,
a. What should be the repurchase price?
b. How many shares should be repurchased?
c. What if the repurchase price is set below or above your suggested price in part (a)?
d. If you own 100 shares, would you prefer that the company pay the dividend or repurchase
stock?
5
Debt $1,800,000
Common equity
Par ($2; 100,000 shares) 200,000
Paid-in capital 400,000
Retained earnings 900,000
$3,300,000

Chapter 13 • Dividend Policy and Internal Financing 435
13-16. (Stock repurchases and earnings per share) CareMore, Inc. provides in-home medical assis-
tance to the elderly and earned net income of $5 million that it plans to use to repurchase shares
of the firm’s common stock, which is currently selling for $50 a share. CareMore has 20 million
shares of stock outstanding.
a. What fraction of the firm’s shares can the firm repurchase for $5 million?
b. If the share repurchase has no impact on the firm’s net income, what will be its earnings per
share after the repurchase?
Mini Case
This Mini Case is available in MyFinanceLab.
Assume that you write a column for a very widely followed financial blog titled, “Finance Questions:
Ask the Expert.” Your job is to field readers’ questions that deal with finance. This week you are
going to address two questions from your readers that have to do with dividends.
Question 1: I own 8 percent of the Standlee Corporation’s 30,000 shares of common stock, which
most recently traded for a price of $98 per share. The company has since declared its plans to en-
gage in a two-for-one stock split.
a. What will my financial position be after the stock split, compared to my current position?
(Hint: Assume the stock price falls proportionately.)
b. The executive vice-president in charge of finance believes the price will not fall in propor-
tion to the size of the split and will only fall 45 percent because she thinks the pre-split price
is above the optimal price range. If she is correct, what will be my net gain from the split?
Question 2: You are on the board of directors of the B. Phillips Corporation, and Phillips has an-
nounced its plan to pay dividends of $550,000. Presently there are 275,000 shares outstanding, and
the earnings per share is $6. It looks to you like the stock should sell for $45 after the ex-dividend
date. If instead of paying a dividend, the management decides to repurchase stock
a. What should be the repurchase price that is equivalent to the proposed dividend? (Hint:
Ignore any tax effects.)
b. How many shares should the company repurchase?
c. You want to look out for the small shareholders. If someone owns 100 shares, do you think
he would prefer that the company pay the dividend or repurchase stock?

Short-Term
Financial Planning
Learning Objectives
1 Use the percent of sales method to forecast the Financial Forecasting
financing requirements of a firm.
2 Describe the limitations of the percent of sales Limitations of the Percent of Sales
forecast method. Forecasting Method
3 Prepare a cash budget and use it to evaluate the amount Constructing and Using a Cash Budget
and timing of a firm’s financing needs.
436
In the summer of 2012, the price of a gallon of diesel was over $4.00. If you were a financial manager in July 2012
working on the financial plans for the coming year at the United Parcel Service (UPS), the level of the price of fuel
would be of great concern, given that fuel costs are a major component of the operating expenses of UPS. Clearly,
having an estimate of future fuel costs is a critical variable in the financial forecast of UPS’s future profitability. Yet
there are countless examples of when our ability to predict the future is not very good.
If forecasting the future is so difficult and plans are built on forecasts, why do firms engage in planning efforts?
Obviously, they do, but why? The answer, oddly enough, does not lie in the accuracy of the firm’s projections, for
planning offers its greatest value when the future is the most uncertain. The value of planning is derived out of the
process itself. That is, by thinking about what the future might be like, the firm builds contingency plans that can
improve its ability to respond to adverse events and take advantage of opportunities that arise.
14

Chapter 14 has two primary objectives:
◆ First, it will help you gain an appreciation
for the role forecasting plays in the firm’s
financial planning process. Basically, fore-
casts of future sales revenues and their
associated expenses give the firm the infor-
mation it needs to project its future financ-
ing needs.
◆ Second, this chapter provides an overview
of the basic elements of a financial plan: the
cash budget, pro forma (planned) income
statement, and pro forma balance sheet.
Pro forma financial statements are a very
useful tool for analyzing the effects of the firm’s
forecasts and planned activities on its financial performance, as well as its needs for financ-
ing. In addition, pro forma statements can be used as a benchmark or standard to compare
against actual operating results. Used in this way, pro forma statements are an instrument
for monitoring and controlling the firm’s progress throughout the planning period. For
example, after the first energy crisis of the 1970s, the price of crude oil rose from $2.00 to
more than $20.00 per barrel. Many thought that the price would rise above $50.00. Then in
1986, the price dropped to only $10.00 per barrel, and the $50.00 price looked like a fool-
ish dream. However, in 2008, the price of a barrel of oil rose to $140.00 and then dropped
below $90 in October 2012. What’s next, will the price continue to rise or will it drop again
as it did in an earlier crisis?
Financial Forecasting
Financial forecasting is the process of attempting to estimate a firm’s future financing re-
quirements. The basic steps involved in predicting those financing needs are the following:
STEP 1 Project the firm’s sales revenues and expenses over the planning period.
STEP 2 Estimate the levels of investment in current and fixed assets that are needed to
support the projected sales forecast.
STEP 3 Determine the firm’s financing needs throughout the planning period that are
required to fund its assets.
The Sales Forecast
The key ingredient in the firm’s planning process is the sales forecast. This projection is
generally derived using information from a number of sources. At a minimum, the sales
forecast for the coming year reflects (1) any past trend in sales that is expected to carry
through into the new year and (2) the influence of any anticipated events that might ma-
terially affect that trend.1 An example of the latter is the initiation of a major advertising
campaign or a change in the firm’s pricing policy.
437437

1 Use the percent of sales
method to forecast the
financing requirements of
a firm.
1A complete discussion of forecast methodologies is outside the scope of this book. The interested reader will find a large
number of books on business forecasting with a simple Web search.
Forecasting Financial Variables
Traditional financial forecasting takes the sales forecast as a given and projects its impact
on the firm’s various expenses, assets, and liabilities. The most commonly used method for
making these projections is the percent of sales method.

438 Part 5 • Working-Capital Management and International Business Finance
The Percent of Sales Method of Financial Forecasting
The percent of sales method involves estimating the level of an expense, asset, or liability for a
future period as a percentage of the sales forecast. The percentage used can come from the most
recent financial statement item as a percentage of current sales, from an average computed
over several years, from the judgment of the analyst, or from some combination of these
sources.
Table 14-1 presents a complete example that uses the percent of sales method of finan-
cial forecasting for Drew Inc. In this example each item in the firm’s balance sheet that var-
ies with sales is converted to a percentage of 2013 sales, which was $10 million. The forecast
of the new balance for each item is then calculated by multiplying this percentage times the
$12 million in projected sales for the 2014 planning period. This method offers a relatively
low-cost and easy-to-use way to estimate the firm’s future financing needs.
Note that in the example in Table 14-1, both current and fixed assets are assumed to
vary with the level of sales. This means that the firm does not have sufficient productive
capacity to absorb a projected increase in sales. Thus, if sales were to rise by $1, fixed as-
sets would rise by $0.40, or 40 percent of the projected increase in sales. If instead the fixed
assets the firm currently owns are sufficient to support the projected level of sales, then
the assets will not be converted to a percentage of sales and will be projected to remain
unchanged for the period being forecast.
Also, note that accounts payable and accrued expenses are the only liabilities allowed to
vary with sales. Both these liability accounts might reasonably be expected to rise and fall
with the level of firm sales, hence, the use of the percent of sales forecast. Because these two
percent of sales method a method of
financial forecasting that involves estimating the
level of an expense, asset, or liability for a future
period as a percent of the sales forecast.
TaBLe 14-1 Using the Percent of Sales Method to Forecast Drew Inc.’s Financing Requirements for 2014

Chapter 14 • Short-Term Financial Planning 439
categories of current liabilities normally vary directly with the level of sales, they are often
referred to as sources of spontaneous financing. Included in spontaneous financing are
trade credit and other accounts payable that arise spontaneously in the firm’s day-to-day operations.
Chapter 15, which discusses working-capital management, has more to say about these
forms of financing. Notes payable, long-term debt, common stock, and paid-in capital are
not assumed to vary directly with the level of firm sales. These sources of financing are
termed discretionary financing, which requires an explicit decision on the part of the firm’s
management every time funds are raised. An example is a bank note that requires that negotiations
be undertaken and an agreement signed setting forth the terms and conditions for the financing. Fi-
nally, note that the level of retained earnings does vary with estimated sales. The predicted
change in the level of retained earnings equals the estimated after-tax profits (projected
net income) equal to 5 percent of sales, or $600,000, less the common stock dividends of
$300,000.
In the Drew Inc. example found in Table 14-1, we estimate that firm sales will increase
from $10 million to $12 million, which will cause the firm’s need for total assets to rise to
$7.2 million. These assets will then be financed by $4.9 million in existing liabilities plus
spontaneous liabilities; $1.8 million in owner funds, including an additional $300,000 in
retained earnings from next year’s sales; and finally, $500,000 in discretionary financing,
which can be raised by issuing notes payable, selling bonds, offering an issue of stock, or
some combination of these sources.
In summary, we can estimate the firm’s discretionary financing needs (DFN), using the
percent of sales method of financial forecasting, by following a four-step procedure:
STEP 1 Convert each asset and liability account that varies directly with firm sales to a
percentage of the current year’s sales.
Current assets
sales
=
$2M
$10M
= 0.2, or 20%
STEP 2 Project the level of each asset and liability account in the balance sheet using its
percentage of sales multiplied by projected sales or by leaving the account bal-
ance unchanged when the account does not vary with the level of sales.
Projected current assets = projected sales *
current assets
sales
= $12M * 0.2 = $2.4M
STEP 3 Project the addition to retained earnings available to help finance the firm’s
operations. This equals projected net income for the period less planned com-
mon stock dividends.
Projected addition
to retained earnings
= projected sales *
net income
sales
* a1 – cash dividends
net income
b
= $12M * 0.05 * (1 – 0.5) = $300,000
STEP 4 Project the firm’s DFN as the projected level of total assets less projected liabili-
ties and owners’ equity.
Discretionary financing needed
= projected total assets – projected total liabilities – projected owners’ equity
= $7.2M – $4.9M – $1.8M = $500,000
analyzing the effects of Profitability and Dividend Policy on DFN
Projecting discretionary financing needed, we can quickly and easily evaluate the
sensitivity of our projected financing requirements to changes in key variables. For
example, using the information from the preceding example, we evaluate the ef-
fect of net profit margins (NPMs) equal to 1 percent, 5 percent, and 10 percent in
spontaneous financing the trade
credit and other accounts payable that arise
spontaneously in the firm’s day-to-day
operations.
discretionary financing sources of
financing that require an explicit decision on the
part of the firm’s management every time funds
are raised. Bank notes provide a typical example
of this type of financing.

440 Part 5 • Working-Capital Management and International Business Finance
combination with dividend payout ratios of 30 percent, 50 percent, and 70 percent, as
follows:
Discretionary Financing Needed for Various Net Profit Margins and Dividend Payout Ratios
D I V I D e N D PayO U T R aT I O S = D I V I D e N D S , N e T I N CO M e
N e T P R O F I T M a R g I N 30% 50% 70%
1% $716,000 $740,000 $764,000
5% 380,000 500,000 620,000
10% (40,000) 200,000 440,000
If these NPMs are reasonable estimates of the possible ranges of values the firm might
experience, and if the firm is considering dividend payouts ranging from 30 percent to
70 percent, then we estimate that the firm’s financing requirements will range from
($40,000), which represents a surplus of $40,000, to a situation in which it would need to
acquire $764,000. Lower NPMs mean higher funding requirements. Also, higher dividend
payout percentages, other things remaining constant, lead to a need for more discretionary
financing. This is a direct result of the fact that a high-dividend-paying firm retains less of
its earnings.
analyzing the effects of Sales growth on a Firm’s DFN
In Figure 14-1 we analyzed the DFN for Drew Inc., whose sales were expected to grow
from $10 million to $12 million during the coming year. Recall that the 20 percent ex-
pected increase in sales led to an increase in the firm’s needs for financing in the amount of
$500,000. We referred to this added financing requirement as the firm’s DFN because all
these funds must be raised from sources, such as bank borrowing or a new equity issue, that
require that management exercise its discretion in selecting the source. In this section we
want to investigate how a firm’s DFN varies with different rates of anticipated sales growth.
Table 14-2 expands on the financial forecast found in Table 14-1. Specifically, we use
the same assumptions and prediction methods that underlie Table 14-1 but apply them
to sales growth rates of 0 percent, 20 percent, and 40 percent. The DFN for these sales
growth rates ranges from ($250,000) to $1,250,000. When DFN is negative, this means that
the firm has more money than it needs to finance the assets used to generate the projected
sales. Alternatively, when DFN is positive, this means that the firm must raise additional
FIgURe 14-1 Sales growth and the Discretionary Financing Needs of the Firm
D
is
cr
et
io
na
ry
fi
na
nc
in
g
ne
ed
s
(D
FN
)
2,000,000
1,500,000
1,000,000
500,000
(500,000)
(1,000,000)
40%30%20%10%0%
Sales growth rate
If sales grow at 20%, then the firm will have a
DFN of $500,000 above and beyond its retention
of earnings and spontaneous sources of financing.
50%–10%
If sales grow at 6.667%, then all of the firm’s financing
needs will be supplied by the retention of earnings
plus spontaneous sources of financing (i.e., DFN = 0).

Chapter 14 • Short-Term Financial Planning 441
Can You Do It?
PercenT OF SaleS FOrecaSTing
The CFO for Madrigal Plumbing Supplies Inc. is developing financial plans for next year when he estimates that his sales will reach
$10 million. During the 4 years the firm has been in business, its inventories have represented approximately 15 percent of its revenues.
What would you estimate the firm’s needs for inventories to be next year (using the percent of sales forecast method)? If Madrigal
has economies of scale, would you expect its inventory needs to be more than, the same as, or less than the percent of sales forecast?
(The solution can be found on page 442.)
TaBLe 14-2 Discretionary Financing Needs (DFN) and the growth Rate in Sales
funds in this amount, by either borrowing or issuing stock. We can calculate DFN using the
following relationship:
DFN =
predicted change
in total assets
–
predicted change
in spontaneous liabilities
–
predicted change
in retained earnings
(14-1)
Notice that in defining DFN we consider only changes in spontaneous liabilities, which you
will recall are those liabilities that arise more or less automatically in the course of doing
business (examples include accrued expenses and accounts payable). In Table 14-1 the only
liabilities that are allowed to change with sales are spontaneous liabilities, so we can calcu-
late the change in spontaneous liabilities simply by comparing total liabilities at the current
sales level with total liabilities for the predicted sales level.

442 Part 5 • Working-Capital Management and International Business Finance
Equation (14-1) can be used to estimate the DFN numbers found in Table 14-2. For ex-
ample, when sales are expected to grow at a rate of 10 percent (that is, g equals 10 percent),
DFN can be calculated as follows:
DFN(g = 10%) = ($6,600,000 – $6,000,000) – ($4,700,000 – $4,500,000)
– ($1,475,000 – $1,200,000) = $125,000
Sometimes analysts prefer to calculate a firm’s external financing needs (EFN), which
include all the firm’s needs for financing beyond the funds provided internally through the retention
of earnings. Thus,
EFN = predicted change in total assets – change in retained earnings (14-2)
For an anticipated growth in sales of 10 percent, EFN equals $325,000. The difference
between EFN and DFN equals the $200,000 in added spontaneous financing that the firm
anticipates receiving when its sales rise from $10 million to $11 million. We prefer to use
the DFN concept because it focuses the analyst’s attention on the amount of funds that the
firm must actively seek to meet the firm’s financing requirements.
Figure 14-1 contains a graphic representation of the relationship between growth
rates for sales and DFN. The straight line in the graph depicts the level of DFN
for each of the different rates of growth in firm sales. For example, if sales grow by
20 percent, then the firm projects a DFN of $500,000, which must be raised externally by
DID You Get It?
PercenT OF SaleS FOrecaSTing
Madrigal projects that its inventories will be 15 percent of revenues
such that its projected inventory needs for next year will be the
following:
0.15 * $10 million = $1,500,000
If Madrigal faces economies of scale, then its inventory needs
will be less than the $1,500,000 predicted using the percent of
sales method. When economies of scale are present, the firm’s
inventory needs do not increase proportionately with sales (nor
do they decrease proportionately).
external financing needs that portion of a
firm’s requirements for financing that exceeds its
sources of internal financing (i.e., the retention of
earnings) plus spontaneous sources of financing
(e.g., trade credit).
Name of Tool Formula What It Tells you
Percent of sales forecast
of inventories
Inventory
forecast
=
sales
forecast
*
inventories
sales
• An estimate of inventories for
a particular sales forecast and
assuming the inventories to
sales ratio is constant
• We can substitute any asset or
liability for inventories in this
equation so long as that asset
or liability is expected to vary
proportionately with sales.
Discretionary financing
needed (DFN) DFN =
predicted change
in total assets
–
predicted change
in spontaneous liabilities
–
predicted change
in retained earnings
• An estimate of the amount of
new funding the firm’s manage-
ment must obtain from new
sources that they must actively
negotiate
• Spontaneous funding and
retained earnings are passively
raised as a result of the firm’s
ongoing operations.
FInanCIal DeCIsIon tools

Chapter 14 • Short-Term Financial Planning 443
Concept Check
1. If we cannot predict the future perfectly, then why do firms engage in financial forecasting?
2. Why are sales forecasts so important to developing a firm’s financial plans?
3. What is the percent of sales method of financial forecasting?
4. What are some examples of spontaneous and discretionary sources of financing?
5. What is the distinction between discretionary financing needs (DFN) and external financing
needs (EFN)?
Limitations of the Percent of Sales
Forecasting Method
The percent of sales method of financial forecasting provides reasonable estimates of a
firm’s financing requirements only when asset requirements and financing sources can be
accurately forecast as a constant percent of sales. For example, predicting inventories for
2013 using the percent of sales method involves the following equation.
Predicted inventories
for 2014
= ¢ inventories for 2013
sales for 2013
≤ * predicted sales
for 2014
Figure 14-2A depicts this predictive relationship. Note that the percent of sales predic-
tive model is simply a straight line that passes through the origin (that is, has a zero inter-
cept). There are some fairly common instances in which this type of relationship fails to
describe the relationship between an asset category and sales. Two such examples involve
assets for which there are scale economies and assets that must be purchased in discrete
quantities (“lumpy assets”).
Economies of scale are sometimes realized from investing in certain types of assets.
For example, a new computer system is likely to support a firm’s operations over a wide
range of firm sales. This means that these assets do not increase in direct proportion to
sales. Figure 14-2B reflects one instance in which the firm realizes economies of scale from
its investment in inventory. Note that inventories as a percentage of sales decline from
120 percent of sales, or $120 when sales are $100, to 30 percent of sales, or $300 when sales
equal $1,000. This reflects the fact that there is a fixed component of inventories (in this
case $100) that the firm must have on hand regardless of the level of sales, plus a variable
2 Describe the limitations of the
percent of sales forecast
method.
borrowing or a new equity offering. Note that when sales grow at 6.667 percent, the
firm’s DFN will be exactly zero. For firms that have limited sources of external financ-
ing or choose to grow through internal financing plus spontaneous financing, it is im-
portant that they be able to estimate the sales growth rate that they can “afford,” which
in this case is 6.667 percent.
FIgURe 14-2a Percent of Sales Forecast
In
ve
nt
or
ie
s
100
0 500 1,000
Sales
Inventories = 0.2 � sales
200
Note that the percent of sales forecast line
passes through the origin (that is, when
sales are zero, so are inventories).

444 Part 5 • Working-Capital Management and International Business Finance
component (20 percent of sales). In this instance the predictive equation for inventories is
as follows:
Inventoriest = a + b salest
In this example, a (the intercept2 of the inventories equation) is equal to 100 and b (the
slope coefficient in the equation) is 0.20.
intercept the constant term in a linear
equation. This is the value predicted in a
linear equation for the item being forecast
(e.g., operating expenses) where revenues are
equal to zero.
slope coefficient the rate of change in the
item being forecast with a linear equation and
the change in sales.
3 Prepare a cash budget and use
it to evaluate the amount and
timing of a firm’s financing
needs.
budget an itemized forecast of a company’s
expected revenues and expenses for a future
period.
FIgURe 14-2B economies of Scales
In
ve
nt
or
ie
s
100
0 500 1,000
Sales
Inventories = 100 + 0.2 � sales
200
120
300
100
Note that a fixed amount of inventory
($100) is required to do business. However,
as sales grow, the need for inventory does
not grow as fast as in Figure 14-2A.
FIgURe 14-2C economies of Scale with Lumpy Investments
As sales grow, the firm’s need for plant and
equipment also grows. However, plant and
equipment are purchased in “lumps.”
Pl
an
t
an
d
eq
ui
pm
en
t
1,500
0 200 400
Capacity
600100 300 500
Sales
1,000
500
2,000
2Economies of scale are evidenced by the nonzero intercept value. However, scale economies can also result in nonlinear
relationships between sales and a particular asset category. Later, when we discuss cash management, we will find that
one popular cash management model predicts a nonlinear relationship between the optimal cash balance and the level of
cash transactions.
Figure 14-2C is an example of lumpy assets, that is, assets that must be purchased in
large, nondivisible components. For example, if the firm spends $500 on plant and equip-
ment, it can produce up to $100 in sales per year. If it spends another $500 (for a total of
$1,000), then it can support sales of $200 to $300 per year, and so forth. Note that when a
block of assets is purchased, it creates excess capacity until sales grow to the point at which
the capacity is fully used. The result is a step function like the one depicted in Figure 14-2C.
Thus, if the firm does not expect sales to exceed the current capacity of its plant and equip-
ment, there would be no projected need for added plant and equipment capacity.
Constructing and Using a Cash Budget
The cash budget, like the pro forma income statement and pro forma balance sheet, is an
essential tool of financial planning. The cash budget contains a detailed listing of planned
cash inflows and outflows for each year of the planning period.
Budget Functions
A budget is simply a forecast of future events. For example, students preparing for final exams
make use of time budgets to help them allocate their limited preparation time among their

Chapter 14 • Short-Term Financial Planning 445
courses. Students also must budget their financial resources among competing uses, such as
books, tuition, food, rent, clothes, and extracurricular activities.
Budgets perform three basic functions for a firm.
◆ First, they indicate the amount and timing of the firm’s needs for future financing.
◆ Second, they provide the basis for taking corrective action in the event budgeted figures
do not match actual or realized figures.
◆ Third, budgets provide the basis for performance evaluation and control. Plans are car-
ried out by people, and budgets provide benchmarks that management can use to evalu-
ate the performance of those responsible for carrying out those plans and, in turn, to
control their actions.
Concept Check
1. What, in words, is the fundamental relationship (equation) used in making percent of sales
forecasts?
2. Under what circumstances does a firm violate the basic relationship underlying the percent of
sales forecast method?
The Cash Budget
The cash budget represents a detailed plan of future cash flows and is composed of four ele-
ments: cash receipts, cash disbursements, net change in cash for the period, and new financ-
ing needed.
e x a M P L e 14.1 Constructing a cash budget
To demonstrate the construction and use of the cash budget, consider Salco Furniture
Company Inc., a regional distributor of household furniture. Salco is in the process of
preparing a monthly cash budget for the upcoming 6 months (January through June
2014). The company’s sales are highly seasonal, peaking in the months of March through
May. Roughly 30 percent of Salco’s sales are collected 1 month after the sale, 50 percent
2 months after the sale, and the remainder during the third month following the sale.
Salco attempts to pace its purchases with its forecast of future sales. Purchases
generally equal 75 percent of sales and are made 2 months in advance of anticipated
cash budget a detailed plan of future cash
flows. This budget is composed of four elements:
cash receipts, cash disbursements, net change in
cash for the period, and new financing needed.
ethICs In FInanCIal ManaGeMent
TO BriBe Or nOT TO BriBe
The pressure to “get the forecast right” can be tremendous, and
these pressures can lead managers to engage in practices (espe-
cially in underdeveloped countries) of offering bribes and pay-
offs to public officials because they are considered the norm in
business transactions. This raises a perplexing ethical question.
If paying bribes is not considered unethical in a foreign country,
should you consider it unethical to make these payments?
This situation provides an example of an ethical issue that
gave rise to legislation. The Foreign Corrupt Practices Act of
1977 (as amended in the Omnibus Trade and Competitiveness
Act of 1988) established criminal penalties for making payments
to foreign officials, political parties, or candidates in order to ob-
tain or retain business. Ethical problems are frequently areas
just outside the boundaries of current legislation and often lead
to the passage of new legislation.
Consider the following question: If you were involved in
negotiating an important business deal in a foreign country and
the success or failure of the deal hinged on whether you paid
a local government official to help you consummate the deal,
would you authorize the payment? Assume that the form of
the payment is such that you do not expect to be caught and
punished; for example, your company agrees to purchase sup-
plies from a family member of the government official at a price
slightly above the competitive price. Can you see any pitfalls
related to such a deal?

446 Part 5 • Working-Capital Management and International Business Finance
sales. Payments are made in the month following purchases. For example, June sales
are estimated at $100,000; thus, April purchases are 0.75 * $100,000 = $75,000.
Correspondingly, payments for purchases in May equal $75,000. Wages, salaries,
rent, and other cash expenses are recorded in Table 14-3, which shows Salco’s cash
budget for the 6-month period ended in June 2011. Additional expenditures are
recorded in the cash budget related to the purchase of equipment in the amount of
$14,000 during February and the repayment of a $12,000 loan in May. In June, Salco
will pay $7,500 interest on its $150,000 in long-term debt for the period of January
to June 2011. Interest on the $12,000 short-term note repaid in May for the period
January through May equals $600 and is paid in May.
Salco currently has a cash balance of $20,000 and wants to maintain a minimum balance
of $10,000. Additional borrowing necessary to maintain that minimum balance is estimated
in the final section of Table 14-3. Borrowing takes place at the beginning of the month in
which the funds are needed. Interest on the borrowed funds equals 12 percent per annum,
or 1 percent per month, and is paid in the month following the one in which funds are
borrowed. Thus, interest on funds borrowed in January will be paid in February equal to
1 percent of the loan amount outstanding during January.
STeP 1: FOrmulaTe a SOluTiOn STraTegy
Construct a cash budget that includes estimates of the firm’s cash inflows and outflows
for each of the next 6 months. This requires the preparation of estimates of monthly
revenues and expenses, but this is not the end of the process. The analyst must then es-
timate when the revenues will actually be received (cash sales and collection of accounts
receivable) as well as when the expenses will actually be paid. Once these estimates have
been prepared, we can construct the cash budget and estimate the change in cash for the
firm in each month of the forecast period.
STeP 2: crunch The numBerS
Table 14-3 contains the monthly cash budget and all the supporting estimates that are
required.
STeP 3: analyze yOur reSulTS
The financing-needed line in Salco’s cash budget determines that the firm’s cumulative
short-term borrowing will rise to $97,599 by May. However, this need for borrowing
begins to subside in June and the firm is able to reduce its borrowing to $79,875. Note
that the cash budget indicates not only the amount of financing needed during the pe-
riod but also when the funds will be needed.
ethICs In FInanCIal ManaGeMent
Being hOneST aBOuT The uncerTainTy OF The FuTure
Put yourself in the shoes of Ben Tolbert, who is the CFO of Bonajet
Enterprises. Ben’s CEO is scheduled to meet with a group of out-
side analysts tomorrow to discuss the firm’s financial forecast for
the last quarter of the year. Ben’s analysis suggests that there is a
very real prospect that the coming quarter’s results could be very
disappointing. How would you handle Ben’s dilemma?
As Ben looks over a draft of the report he must submit
to the company CEO, he becomes increasingly concerned.
Although the forecast is below initial expectations, this is
not what worries Ben. The problem is that some of the basic
assumptions underlying his prediction might not come true.
If this is the case, then the company’s performance for the last
quarter of the year will be dramatically below its annual forecast.
The result would be a potentially severe reaction in the invest-
ment community, causing a downward adjustment of unknown
proportions in the firm’s stock price.
Bonajet’s CEO is a no-nonsense guy who really doesn’t like to
see his CFO hedge his predictions, so Ben is under pressure
to decide whether to ignore the downside prospects or make
them known to his CEO. Complicating matters is the fact that
the worst-case scenario would probably give rise to a reorga-
nization of Bonajet that would lead to substantial layoffs of its
workforce. Here is Ben’s dilemma: what should he tell the CEO
in their meeting tomorrow morning?

Chapter 14 • Short-Term Financial Planning 447
Concept Check
1. What is a cash budget?
2. How is a cash budget used in financial planning?
Chapter Summaries
Use the percent of sales method to forecast the financing requirements of a
firm. (pgs. 437–443)
SUMMaRy: The percent of sales method is commonly used to forecast a firm’s assets, liabilities, and
expenses. These forecasts are then used to prepare a financial plan that can be used to estimate the firm’s
future financing requirements. Developing a financial forecast can be viewed as a three step process:
STEP 1 Project the firm’s sales revenues and expenses over the planning period.
STEP 2 Estimate the levels of investment in current and fixed assets that are needed to support
the sales forecast.
STEP 3 Determine the firm’s financing needs throughout the planning period that are required
to fund its assets.
Key TeRMS
1
TaBLe 14-3 Salco Furniture Co. Inc. Cash Budget for 6 Months ended June 30, 2014

Percent of sales method, page 438 A method
of financial forecasting that involves estimating
the level of an expense, asset, or liability for a
future period as a percent of the sales forecast. For
example, to estimate cost of goods sold for the cur-
rent year the analyst might use the ratio of cost of
goods sold for sales for last year multiplied by the
sales forecast for the coming year.

448 Part 5 • Working-Capital Management and International Business Finance
Spontaneous financing, page 439 The credit
and other accounts payable that arise
spontaneously in the course of the firm’s
day-to-day operations.
Discretionary financing, page 439 Sources
of financing that require an explicit decision on
the part of the firm’s management every time
funds are raised. Bank notes provide a typical
example of this type of financing.
External financing needs, page 442 That
portion of a firm’s financing requirements that
exceeds its sources of internal financing (i.e.,
the retention of current earnings) plus sponta-
neous sources of financing (e.g., trade credit).
Describe the limitations of the percent of sales forecast method. (pgs. 443–444)
Summary: The equation or model that underlies a percent of sales forecast is a straight line that passes
through the intercept. Very simply, if we are forecasting a firm’s inventory balance, then the percent of
sales method will predict a zero inventory balance for a zero sales level. Although this may be roughly
correct for some firms, it is often the case that the firm will plan on having inventory items in stock even
when the sales level drops very low. For example, the firm might intend to keep 100,000 units in stock
as a minimum regardless of the level of predicted sales (this recognizes the fact that forecasting is highly
imperfect and also you can’t sell anything if you do not have something to sell). Thus, the percent of
sales method of forecasting is probably “roughly” correct for most things but is inherently inexact where
the relationship between the item being forecast and sales is not linear or where there is some minimum
level of the item the firm plans to have, regardless of the level of firm sales.
Key TermS
2
Intercept, page 444 The constant term in a
linear equation. This is the value predicted in
a linear equation for the item being forecast
(e.g., operating expenses) where revenues are
equal to zero.
Slope coefficient, page 444 The rate of
change in the item being forecast with a linear
equation and the change in sales.
Prepare a cash budget and use it to evaluate the amount and timing of a
firm’s financing needs. (pgs. 444–447)
Summary: The cash budget, like the pro forma income statement and balance sheet, is an es-
sential tool of financial planning. Specifically, the cash budget contains estimates of cash inflows
and outflows organized by month, quarter, or year spanning the entire financial planning period. As
such, the cash budget provides the firm’s CFO and other financial analysts the opportunity to try to
forecast the effect of their operating decisions on the firm’s operations.
Key TermS
3
Budget, page 444 An itemized forecast of
a firm’s expected revenues and expenses for a
future period.
Cash budget, page 445 A detailed plan of
future cash flows. This budget is composed of
four elements: cash receipts, cash
disbursements, net change in cash for the
period, and new financing needed.
review Questions
All Review Questions are available in MyFinanceLab.
14-1. United Parcel Service (UPS) provides package delivery services throughout the United
States and the world. Discuss the impact of seasonal variations in the delivery business for forecast-
ing the firm’s financing requirements.
14-2. Discuss the shortcomings of the percent of sales method of financial forecasting.
14-3. What would be the probable effect on a firm’s cash position of the following events?
a. Rapidly rising sales
b. A delay in the payment of payables

Chapter 14 • Short-Term Financial Planning 449
c. A more liberal credit policy on sales (to the firm’s customers)
d. Holding larger inventories
14-4. A cash budget is usually thought of as a means of planning for future financing needs. Why
would a cash budget also be important for a firm that has excess cash on hand?
Study Problems
All Study Problems are available in MyFinanceLab.
14-1. (Financial forecasting) Zapatera Enterprises is evaluating its financing requirements for the
coming year. The firm has been in business for only 1 year, but its CFO predicts that the firm’s
operating expenses, current assets, net fixed assets, and current liabilities will remain at their cur-
rent proportion of sales.
Last year Zapatera had $12 million in sales, and net income of $1.2 million. The firm anticipates
that next year’s sales will reach $15 million, with net income rising to $2 million. Given its present
high rate of growth, the firm retains all its earnings to help defray the cost of new investments.
The firm’s balance sheet for 2013 is found below:
1
Z apatera enterprises Inc.
B a L a N C e S h e e T
12/31/2013 % O F S a L e S
Current assets $3,000,000 25%
Net fixed assets 6,000,000 50%
Total $9,000,000
L I a B I L I T I e S a N D O W N e R S’ e Q U I T y
Accounts payable $3,000,000 25%
Long-term debt 2,000,000 NAa
Total liabilities $5,000,000
Common stock 1,000,000 NA
Paid-in capital 1,800,000 NA
Retained earnings 1,200,000
Common equity 4,000,000
Total $9,000,000
aNot applicable. This figure does not vary directly with sales and is assumed to remain constant for purposes of making next year’s forecast of
financing requirements.
M O N T h S a L e S M O N T h S a L e S
January $15,000 March $25,000
February 20,000 April (projected) 30,000
Estimate Zapatera’s financing requirements (that is, total assets) for 2014 and its discretionary
financing needs (DFN).
14-2. (Pro forma accounts receivable balance calculation) On March 31, 2013, Mike’s Bike Shop had
outstanding accounts receivable of $17,500. Mike’s sales are roughly evenly split between credit
and cash sales, with the credit sales collected half in the month after the sale and the remainder
2 months after the sale. Historical and projected sales for the bike shop are given here:
a. Under these circumstances, what should the balance in accounts receivable be at the end of
April?
b. How much cash did Mike’s realize during April from sales and collections?
14-3. (Financial forecasting) Sambonoza Enterprises projects its sales next year to be $4 million and
expects to earn 5 percent of that amount after taxes. The firm is currently in the process of project-
ing its financing needs and has made the following assumptions (projections):
1. Current assets will equal 20 percent of sales, and fixed assets will remain at their current level
of $1 million.

2. Common equity is currently $0.8 million, and the firm pays out half its after-tax earnings in
dividends.
3. The firm has short-term payables and trade credit that normally equal 10 percent of sales, and
it has no long-term debt outstanding.
What are Sambonoza’s financing needs for the coming year?
14-4. (Financial forecasting—percent of sales) Tulley Appliances Inc. projects next year’s sales to be
$20 million. Current sales are $15 million, based on current assets of $5 million and fixed assets of
$5 million. The firm’s net profit margin is 5 percent after taxes. Tulley forecasts that its current assets
will rise in direct proportion to the increase in sales but that its fixed assets will increase by only $100,000.
Currently, Tulley has $1.5 million in accounts payable (which vary directly with sales), $2 million in
long-term debt (due in 10 years), and common equity (including $4 million in retained earnings) totaling
$6.5 million. Tulley plans to pay $500,000 in common stock dividends next year.
a. What are Tulley’s total financing needs (that is, total assets) for the coming year?
b. Given the firm’s projections and dividend payments plans, what are its discretionary
financing needs?
c. Based on your projections, and assuming that the $100,000 expansion in fixed assets will
occur, what is the largest increase in sales the firm can support without having to resort to
the use of discretionary sources of financing?
14-5. (Pro forma balance sheet construction) Use the following industry-average ratios to construct a
pro forma balance sheet for Phoebe’s Cat Foods Inc.
Total asset turnover 1.5 times
Average collection period
(assume 365-day year)

15 days

Fixed asset turnover 5 times
Inventory turnover (based
on cost of goods sold)

3 times

Current ratio 2 times
Sales (all on credit) $3.0 million
Cost of goods sold 75% of sales
Debt ratio 50%
Current liabilities
Cash Long-term debt
Accounts receivable Common stock plus
Net fixed assets $ Retained earnings $
14-6. (Percent of sales forecasting) Which of the following accounts would most likely vary directly
with the level of a firm’s sales? Discuss each briefly.
y e S N O y e S N O
Cash Notes payable
Marketable securities Plant and equipment
Accounts payable Inventories
14-7. (Financial forecasting—percent of sales) The balance sheet of the Boyd Trucking Company
(BTC) follows:
B oyd Truck ing Company Balance Sheet, December 31, 2013 ($ M il l ions)
Current assets $10 Accounts payable $ 5
Net fixed assets 15 Notes payable 0
Total $25 Bonds payable 10
Common equity 10
Total $25
BTC had sales for the year ended December 31, 2013, of $25 million. The firm follows a policy
of paying all net earnings out to its common stockholders in cash dividends. Thus, BTC generates
450 Part 5 • Working-Capital Management and International Business Finance

Chapter 14 • Short-Term Financial Planning 451
no funds from its earnings that can be used to expand its operations. (Assume that depreciation
expense is just equal to the cost of replacing worn-out assets.)
a. If BTC anticipates sales of $40 million during the coming year, develop a pro forma bal-
ance sheet for the firm on December 31, 2014. Assume that current assets vary as a percent
of sales, net fixed assets remain unchanged, and accounts payable vary as a percent of sales.
Use notes payable as a balancing entry.
b. How much “new” financing will BTC need next year?
c. What limitations does the percent of sales forecast method suffer from? Discuss briefly.
14-8. (Financial forecasting—discretionary financing needs) The most recent balance sheet for the Armadillo
Dog Biscuit Co. Inc. is shown in the following table. The company is about to embark on an advertising
campaign, which is expected to raise sales from the current level of $5 million to $7 million by the end
of next year. The firm is currently operating at full capacity and will have to increase its investment in
both current and fixed assets to support the projected level of new sales. In fact, the firm estimates that
both categories of assets will rise in direct proportion to the projected increase in sales.
armadil lo Dog Biscuit Co. Inc. ($ M il l ions )
P R e S e N T L e V e L P e R C e N T O F S a L e S P R O J e C T e D L e V e L
Current assets $2.0
Net fixed assets 3.0
Total $5.0
Accounts payable $0.5
Accrued expense 0.5
Notes payable 0
Current liabilities $1.0
Long-term debt $2.0
Common stock 0.5
Retained earnings 1.5
Common equity $2.0
Total $5.0
The firm’s net profits were 6 percent of the current year’s sales but are expected to rise to 7 percent
of next year’s sales. To help support its anticipated growth in asset needs next year, the firm has
suspended plans to pay cash dividends to its stockholders. In past years a $1.50-per-share dividend
has been paid annually. Armadillo’s accounts payable and accrued expenses are expected to vary
directly with sales. In addition, notes payable will be used to supply the funds needed to finance
next year’s operations that are not forthcoming from other sources.
a. Fill in the table and project the firm’s needs for discretionary financing. Use notes payable
as the balancing entry for future discretionary financing needs.
b. Compare Armadillo’s current ratio and debt ratio (total liabilities , total assets) before the
growth in sales and after. What was the effect of the expanded sales on these two dimen-
sions of Armadillo’s financial condition?
c. What difference, if any, would have resulted if Armadillo’s sales had risen to $6 million in
1 year and $7 million only after 2 years? Discuss only; no calculations are required.
14-9. (Forecasting discretionary financing needs) Fishing Charter Inc. estimates that it invests $0.30 in
assets for each dollar of new sales. However, $0.05 in profits are produced by each dollar of addi-
tional sales, of which $0.01 can be reinvested in the firm. If sales rise by $500,000 next year from
their current level of $5 million, and the ratio of spontaneous liabilities to sales is 15 percent, what
will be the firm’s need for discretionary financing? (Hint: In this situation you do not know what
the firm’s existing level of assets is, nor do you know how those assets have been financed. Thus,
you must estimate the change in financing needs and match this change with the expected changes
in spontaneous liabilities, retained earnings, and other sources of discretionary financing.)
14-10. (Forecasting net income) In November of each year the CFO of Barker Electronics begins
the financial forecasting process to determine the firm’s projected needs for new financing during
the coming year. Barker is a small electronics manufacturing company located in Moline, Illinois,
which is best known as the home of the John Deere Company. The CFO begins the process with
the most recent year’s income statement, projects sales growth for the coming year, and then es-
timates net income and finally the additional earnings he can expect to retain and reinvest in the
firm. The firm’s income statement for 2010 follows (in $000):

y e a r S a l e S I n v e n To r I e S
2005 $ 5,250,000 $ 1,590,924
2006 6,200,000 1,724,221
2007 6,940,000 1,899,573
2008 5,650,000 1,530,054
2009 6,255,000 1,772,059
2010 7,100,000 1,919,042
2011 7,350,000 2,012,025
2012 8,010,000 2,006,023
2013 8,775,000 2,292,119
2014 10,390,000 2,537,486
2015 11,500,000
2016 12,000,000
2017 12,500,000
2018 13,000,000
2019 13,500,000
COGS/sales 70%
Operating expenses/sales 15%
Depreciation expense ($000) $50
Interest expense ($000) $10
Tax rate 35%
I ncome Statement ($000)
y e a r e n D e D D e c e m b e r 31, 2010
Sales $ 1,500
Cost of goods sold (1,050)
Gross profit $ 450
Operating costs (225)
Depreciation expense (50)
Net operating profit $ 175
Interest expense (10)
Earnings before taxes $ 165
Taxes (58)
Net income $ 107
Dividends $ 20
Addition to retained earnings $ 87
The electronics business has been growing rapidly over the past 18 months as the economy recovers,
and the CFO estimates that sales will expand by 20 percent in the next year. In addition, he estimates
the following relationships between each of the income statement expense items and sales:
Note that for the coming year both depreciation expense and interest expense are projected to
remain the same as in 2010.
a. Estimate Barker’s net income for 2011 and its addition to retained earnings under the
assumption that the firm leaves its dividends paid at the 2010 level.
b. Reevaluate Barker’s net income and addition to retained earnings where sales grow at
40 percent over the coming year. However, this scenario requires the addition of new plant
and equipment in the amount of $100,000, which increases annual depreciation to $58,000
per year, and interest expense rises to $15,000.
14-11. (Misusing the percent of sales method) The Caraway Seed Company has grown rapidly over the last
decade and is trying to forecast the firm’s inventory requirements for the next 5 years. Historical sales
and inventories for the last 10 years are found below along with projected sales for the next 5 years.
2
452 Part 5 • Working-Capital Management and International Business Finance

Chapter 14 • Short-Term Financial Planning 453
a. Use the percent of sales method for forecasting Caraway’s inventories for the next 5 years
where the percent of sales is equal to the average of the percent of sales for the last 10 years.
b. The following graph includes a plot of the historical relationship between inventories and
sales along with a line representing the percent of sales forecast. Analyze the forecast line
compared to the plot of inventory and sales to see if you see any problems with the percent
of sales forecast. Discuss.
Sales ($ in millions)
6.54.5 8.5 10.5 12.5 14.5
In
ve
nt
or
ie
s
(in
m
ill
io
ns
)
1.0
0.5
1.5
2.0
4.0
3.5
3.0
2.5
14-12. (Forecasting inventories) Findlay Instruments produces a complete line of medical instru-
ments used by plastic surgeons and has experienced rapid growth over the past 5 years. In an
effort to make more accurate predictions of its financing requirements, Findlay is currently
attempting to construct a financial-planning model based on the percent of sales forecasting
method. However, the firm’s chief financial analyst (Sarah Macias) is concerned that the projec-
tions for inventories will be seriously in error. She recognizes that the firm has begun to accrue
substantial economies of scale in its inventory investment and has documented this fact in the
following data and calculations:
a. Plot Findlay’s sales and inventories for the past 5 years. What is the relationship between
these two variables?
b. Estimate firm inventories for 2011, when firm sales are projected to reach $30 million. Use
the average percentage of sales for the past 5 years, the most recent percentage of sales, and
your evaluation of the true relationship between the sales and inventories from part (a) to
make three predictions.
14-13. (Cash budget) The Sharpe Corporation’s projected sales for the first 8 months of 2014
follow on the next page:
y e a R S a L e S ( $000 ) I N V e N TO R y ( $000 ) % O F S a L e S
2006 $15,000 $1,150 7.67%
2007 18,000 1,180 6.56%
2008 17,500 1,175 6.71%
2009 20,000 1,200 6.00%
2010 25,000 1,250 5.00%
Average 6.39%

454 Part 5 • Working-Capital Management and International Business Finance
January $100,000 April $300,000 July $200,000
February 120,000 May 275,000 August 180,000
March 150,000 June 200,000
Of Sharpe’s sales, 10 percent is for cash, another 60 percent is collected in the month following the
sales, and 30 percent is collected in the second month following sales. November and December
sales for 2010 were $220,000 and $175,000, respectively.
Sharpe purchases its raw materials 2 months in advance of its sales. The purchases are equal to
60 percent of the final sales price of Sharpe’s products. The supplier is paid 1 month after it makes a
delivery. For example, purchases for April sales are made in February, and payment is made in March.
In addition, Sharpe pays $10,000 per month for rent and $20,000 each month for other expendi-
tures. Tax prepayments of $22,500 are made each quarter, beginning in March.
The company’s cash balance on December 31, 2013, was $22,000. This is the minimum balance
the firm wants to maintain. Any borrowing that is needed to maintain this minimum is paid off in
the subsequent month if there is sufficient cash. Interest on short-term loans (12 percent) is paid
monthly. Borrowing to meet estimated monthly cash needs takes place at the beginning of the
month. Thus, if in the month of April the firm expects to have a need for an additional $60,500,
these funds would be borrowed at the beginning of April with interest of $605 (0.12 * 1/12 *
$60,500) owed for April and paid at the beginning of May.
a. Prepare a cash budget for Sharpe covering the first 7 months of 2014.
b. Sharpe has $200,000 in notes payable due in July that must be repaid or renegotiated for an
extension. Will the firm have ample cash to repay the notes?
14-14. (Preparation of a cash budget) Lewis Printing has projected its sales for the first 8 months of
2014 as follows:
Lewis collects 20 percent of its sales in the month of the sale, 50 percent in the month follow-
ing the sale, and the remaining 30 percent 2 months following the sale. During November and
December of 2013, Lewis’s sales were $220,000 and $175,000, respectively.
Lewis purchases raw materials 2 months in advance of its sales. These purchases are equal to
65 percent of its final sales. The supplier is paid 1 month after delivery. Thus, purchases for April
sales are made in February and payment is made in March.
In addition, Lewis pays $10,000 per month for rent and $20,000 each month for other expendi-
tures. Tax prepayments of $22,500 are made each quarter beginning in March. The company’s
cash balance as of December 31, 2013, was $28,000; a minimum balance of $25,000 must be main-
tained at all times to satisfy the firm’s bank line of credit agreement. Lewis has arranged with its
bank for short-term credit at an interest rate of 12 percent per annum (1 percent per month) to
be paid monthly. Borrowing to meet estimated monthly cash needs takes place at the end of the
month, and interest is not paid until the end of the following month. Consequently, if the firm
needed to borrow $50,000 during April, then it would pay $500 ( = 0.01 * $50,000) in interest
during May. Finally, Lewis follows a policy of repaying its outstanding short-term debt in any
month in which its cash balance exceeds the minimum desired balance of $25,000.
a. Lewis needs to know what its cash requirements will be for the next 6 months so that it can
renegotiate the terms of its short-term credit agreement with its bank, if necessary. To evaluate
this problem, the firm plans to evaluate the impact of a ±20 percent variation in its monthly sales
efforts. Prepare a 6-month cash budget for Lewis and use it to evaluate the firm’s cash needs.
b. Lewis has a $20,000 note due in June. Will the firm have sufficient cash to repay the loan?
Mini Case
This Mini Case is available in MyFinanceLab.
Phillips Petroleum is an integrated oil and gas company with headquarters in Bartlesville,
Oklahoma, where it was founded in 1917. The company engages in petroleum exploration and
January $190,000 May $300,000
February 120,000 June 270,000
March 135,000 July 225,000
April 240,000 August 150,000

Chapter 14 • Short-Term Financial Planning 455
production worldwide. In addition, it engages in natural gas gathering and processing, as well as
petroleum refining and marketing primarily in the United States. The company has three oper-
ating groups: Exploration and Production, Gas and Gas Liquids, and Downstream Operations,
which encompasses Petroleum Products and Chemicals.
In the mid-1980s, Phillips engaged in a major restructuring following two failed takeover at-
tempts, one led by T. Boone Pickins and the other by Carl Ichan.3 The restructuring resulted in a
$4.5 billion plan to exchange a package of cash and debt securities for roughly half the company’s
shares and to sell $2 billion worth of assets. Phillips’s long-term debt increased from $3.4 billion in
late 1984 to a peak of $8.6 billion in April 1985.
3This discussion is based on a story in the New York Times, January 7, 1986.
4From SEC Online, 1992.
Summar y Financial Information for Phil l ips Petroleum Corporation:
1986 to 1992 ( in M il l ions of Dollars Except for per Share Figures)
1986 1987 1988 1989 1990 1991 1992
Sales $10,018.00 $10,917.00 $11,490.00 $12,492.00 $13,975.00 $13,259.00 $12,140.00
Net income 228.00 35.00 650.00 219.00 541.00 98.00 270.00
EPS 0.89 0.06 2.72 0.90 2.18 0.38 1.04
Current assets 2,802.00 2,855.00 3,062.00 2,876.00 3,322.00 2,459.00 2,349.00
Total assets 12,403.00 12,111.00 11,968.00 11,256.00 12,130.00 11,473.00 11,468.00
Current liabilities 2,234.00 2,402.00 2,468.00 2,706.00 2,910.00 2,503.00 2,517.00
Long-term debt 8,175.00 7,887.00 7,387.00 6,418.00 6,505.00 6,113.00 5,894.00
Total liabilities 10,409.00 10,289.00 9,855.00 9,124.00 9,411.00 8,716.00 8,411.00
Preferred stock 270.00 205.00 0.00 0.00 0.00 0.00 359.00
Common equity 1,724.00 1,617.00 2,113.00 2,132.00 2,719.00 2,757.00 2,698.00
Dividends per share 2.02 1.73 1.34 0.00 1.03 1.12 1.12
Source: Phillips annual reports for 1986 to 1992.
Phillips’s managers are currently developing its financial plans for the next 5 years and want to
develop a forecast of its financing requirements. As a first approximation, they have asked you to
develop a model that can be used to make “ballpark” estimates of the firm’s financing needs under
the proviso that existing relationships found in the firm’s financial statements remain the same over
the period. Of particular interest is whether Phillips will be able to further reduce its reliance on
debt financing. You may assume that Phillips’s projected sales (in millions) for 1993 through 1997
are as follows: $13,000; $13,500; $14,000; $14,500; and $15,500.
a. Project net income for 1993 to 1997 using the percent of sales method based on an average
of this ratio for 1986 to 1992.
b. Project total assets and current liabilities for 1993 to 1997 using the percent of sales method
and your sales projections from part (a).
c. Assuming that common equity increases only as a result of the retention of earnings and hold-
ing long-term debt and preferred stock equal to its 1992 balances, project Phillips’s discretion-
ary financing needs for 1993 to 1997. (Hint: Assume that total assets and current liabilities vary
as a percentage of sales as per your answers to part (b). In addition, assume that Phillips plans to
continue to pay its dividends of $1.12 per share in each of the next 5 years.)
During 1992, Phillips was able to strengthen its financial structure dramatically. Its subsidiary Phil-
lips Gas Company completed an offering of $345 million of Series A 9.32% cumulative preferred
stock. As a result of this action and prior years’ debt reductions, the company lowered its long-term
debt-to-capital ratio over the past 5 years from 75 percent to 55 percent. In addition, the firm re-
financed over a billion dollars of its debt at reduced rates. A company spokesman said, “Our debt-
to-capital ratio is still on the high side, and we’ll keep working to bring it down. But the cost of
debt is manageable, and we’re beyond the point where debt overshadows everything else we do.”4
Highlights of Phillips’s financial condition from 1986 to 1992 are found in the accompanying table.
These data reflect the company’s financial restructuring following the downsizing and reorganiza-
tion of Phillips’s operations begun in the mid-1980s.

Working-Capital
Management
Learning Objectives
1 Describe the risk–return trade-off involved in Managing Current Assets and Liabilities
managing working capital.
2 Describe the determinants of net working capital. Determining the Appropriate Level of
Working Capital
3 Compute the firm’s cash conversion cycle. The Cash Conversion Cycle
4 Estimate the cost of short-term credit. Estimating the Cost of Short-Term Credit
Using the Approximate Cost-of-Credit
Formula
5 Identify the primary sources of short-term credit. Sources of Short-Term Credit
456
Early in its life as a publicly traded firm, the Dell Computer Corporation (DELL) experienced a period of
declining sales that produced a serious cash shortfall. Moreover, the company realized that it had to
accelerate its growth in order to move from the list of declining, second-tier manufacturers to the list
of prospering, top-tier producers, and this required even more cash. The new Dell business model that
emerged was designed to better manage the firm’s working capital. Specifically, the model sought to lower
inventory by 50 percent, improve lead time by 50 percent, reduce assembly costs by 30 percent, and reduce
obsolete inventory by 75 percent.
The net result was that inventory dropped because Dell was aligning its inventory with sales and not holding
inventories in anticipation of future sales. Furthermore, as its inventory disappeared, the company’s profit-
ability grew disproportionately because Dell avoided not only the carrying costs of holding inventories but also
the losses associated with obsolete stock. Additionally, Dell was able to save money on purchasing components
because the component prices were dropping 3 percent per month.
Because the firm’s capital requirements to support its rapidly growing sales did not increase proportionately
with sales, the company’s financial needs were reduced. All this was brought about by better working-capital
management.
15

Chapter 15 addresses two related
topics: It introduces the principles
involved in managing a firm’s in-
vestment in working capital, and it
presents a discussion of short-term
financing. Traditionally, working
capital is defined as the firm’s to-
tal investment in current assets. Net
working capital, on the other
hand, is the difference between the
firm’s current assets and its current
liabilities.
Net working
capital
=
currents
assets
–
current
liabilities
(15-1)
Throughout this chapter, the
term working capital refers to net
working capital. In managing the
firm’s net working capital, we are also managing the firm’s liquidity. This entails managing
two related aspects of the firm’s operations: (1) its investment in current assets, and (2) its
use of short-term or current liabilities.
Short-term sources of financing include all forms of financing that have maturities of
1 year or less—that is, current liabilities. There are two major issues involved in analyzing a
firm’s use of short-term financing: (1) How much short-term financing should the firm use?
and (2) What specific sources of short-term financing should the firm select? We use the
hedging principle of working-capital management to address the first of these questions.
We then address the second issue by considering three basic factors: (1) the effective cost
of credit, (2) the availability of credit in the amount needed and for the period that financ-
ing is required, and (3) the influence of the use of a particular credit source on the cost and
availability of other sources of financing.
Managing Current Assets and Liabilities
A firm’s current assets consist of cash and marketable securities, accounts receivable, in-
ventories, and other assets that the firm’s managers expect to be converted to cash within a
period of a year or less. Consequently, firms that choose to hold more current assets are, in
general, more liquid than firms that do not. Similarly, current liabilities are liabilities that
are payable in 1 year or less. Examples include accounts and notes payable.
The Risk–Return Trade-Off
Actually, firms that want to reduce their risk of illiquidity by holding more current assets do so
by investing in larger cash and marketable securities balances. Holding larger cash and market-
able securities balances has an unfortunate consequence, however. Because investments in cash
and marketable securities earn relatively modest returns when compared with the firm’s other
investments, the firm that holds larger investments in these assets will reduce its overall rate of
return. Thus, the increased liquidity must be traded off against the firm’s reduction in return
on investment. Managing this trade-off is an important theme of working-capital management.
The firm’s use of current versus long-term debt also involves a risk–return trade-
off. Other things remaining the same, the greater the firm’s reliance on short-term debt or
current liabilities in financing its assets, the greater the risk of illiquidity. However, the use of
457457
working capital a concept traditionally
defined as a firm’s investment in current assets.
net working capital the difference between
the firm’s current assets and its current liabilities.
1 Describe the risk–return
trade-off involved in managing
working capital.

458 Part 5 • Working-Capital Management and International Business Finance
current liabilities offers some very real advantages in that they can be less costly than long-
term financing, and they provide the firm with a flexible means of financing its fluctuating
needs for assets. However, if for some reason the firm has problems raising short-term
funds or it should need funds for longer than expected, it can get into real trouble. Thus, a
firm can reduce its risk of illiquidity through the use of long-term debt at the expense of a
reduction in its return on invested funds. Once again we see that the risk–return trade-off
involves an increased risk of illiquidity versus increased profitability.
The Advantages of Current Liabilities: Return
Flexibility Current liabilities offer the firm a flexible source of financing. They can be
used to match the timing of a firm’s needs for short-term financing. If, for example, a firm
needs funds for a 3-month period during each year to finance a seasonal expansion in inven-
tories, then a 3-month loan can provide substantial cost savings over a long-term loan (even
if the interest rate on short-term financing should be higher). The use of long-term debt
in this situation involves borrowing for the entire year rather than for the period when the
funds are needed, which increases the amount of interest the firm must pay. This brings us
to the second advantage generally associated with the use of short-term financing.
Interest Cost In general, interest rates on short-term debt are lower than on long-term debt
for a given borrower. This relationship was introduced in Chapter 2 and is referred to as the
term structure of interest rates. For a given firm, the term structure might appear as follows.
LO A n M AT U R I T y I n T E R E S T R AT E
3 months 4.00%
6 months 4.60
1 year 5.30
3 years 5.90
5 years 6.75
10 years 7.50
30 years 8.25
1The dangers of such a policy are readily apparent in the experiences of firms that have been forced into bankruptcy. Penn
Central, for example, went bankrupt when it had $80 million in short-term debt that it was unable to finance (roll over).
Note that this term structure reflects the rates of interest applicable to a given borrower
at a particular time. It would not, for example, describe the rates of interest available to an-
other borrower or even those applicable to the same borrower at a different time.
The Disadvantages of Current Liabilities: Risk
The use of current liabilities, or short-term debt, as opposed to long-term debt subjects the firm
to a greater risk of illiquidity for two reasons. First, short-term debt, because of its very nature,
must be repaid or rolled over more often, so it increases the possibility that the firm’s financial
condition might deteriorate to a point at which the needed funds might not be available.1
A second disadvantage of short-term debt is the uncertainty of interest costs from year
to year. For example, a firm borrowing during a 6-month period each year to finance a sea-
sonal expansion in current assets might incur a different rate of interest each year. This rate
reflects the current rate of interest at the time of the loan, as well as the lender’s perception
of the firm’s riskiness. If fixed-rate, long-term debt were used, the interest cost would be
stable for the entire period of the loan agreement.
Concept Check
1. How does investing more heavily in current assets (while not increasing the firm’s current liabili-
ties) decrease both the firm’s risk and its expected return on its investment?
2. How does the use of current liabilities enhance profitability and also increase the firm’s risk of
default on its financial obligations?

Chapter 15 • Working-Capital Management 459
Determining the Appropriate
Level of Working Capital
Managing the firm’s net working capital (its liquidity) involves interrelated decisions
regarding its investments in current assets and use of current liabilities. Fortunately, a guid-
ing principle exists that can be used as a benchmark for the firm’s working-capital poli-
cies: the hedging principle, or principle of self-liquidating debt. This principle provides a
guide to the maintenance of a level of liquidity sufficient for the firm to meet its maturing
obligations on time.2
2 Describe the determinants of
net working capital.
hedging principle (principle of
self-liquidating debt) a working-capital
management policy which states that the
cash-flow-generating characteristics of a firm’s
investments should be matched with the
cash-flow requirements of the firm’s sources of
financing. Very simply, short-lived assets should
be financed with short-term sources of financing
while long-lived assets should be financed with
long-term sources of financing.
2A value-maximizing approach to the management of the firm’s liquidity involves assessing the value of the benefits
derived from increasing the firm’s investment in liquid assets and weighing them against the added costs to the firm’s
owners resulting from investing in low-yield current assets. Unfortunately, the benefits derived from increased liquid-
ity relate to the expected costs of bankruptcy to the firm’s owners, and these costs are very difficult to measure. Thus, a
“valuation” approach to liquidity management exists only in the theoretical realm.
In Chapter 12 we discussed the firm’s financing decision in terms of the choice between
debt and equity sources of financing. There is, however, yet another critical dimension of
the firm’s financing decision. This relates to the maturity structure of the firm’s debt. How
should the decision be made about whether to use short-term (current) debt or longer-
maturity debt? This is one of the fundamental questions addressed in this chapter and one
that is critically important to the financial success of the firm.
The Hedging Principles
Very simply, the hedging principle, or principle of self-liquidating debt, involves match-
ing the cash-flow-generating characteristics of an asset with the maturity of the source of financing
used to fund its acquisition. For example, a seasonal expansion in inventories, according to the
hedging principle, should be financed with a short-term loan or current liability. The ratio-
nale underlying the rule is straightforward. The funds are needed for a limited period, and
when that time has passed, the cash needed to repay the loan will be generated by the sale
of the extra inventory items. Obtaining the needed funds from a long-term source (longer
than 1 year) would mean that the firm would still have the funds after the inventories they
helped finance had been sold. In this case the firm would have “excess” liquidity, which
it would either hold in cash or invest in low-yield marketable securities until the seasonal
increase in inventories occurs again and the funds are needed. The result of all this would
be lower profits.
Consider an example in which a firm purchases a new conveyor belt system, which
is expected to produce cash savings to the firm by eliminating the need for two employ-
ees and, consequently, their salaries. This amounts to an annual savings of $24,000. The
conveyor belt costs $250,000 to install and will last 20 years. If the firm chooses to finance
this asset with a 1-year note, then it will not be able to repay the loan from the $24,000
cash-flow-generated by the asset. In accordance with the hedging principle, the firm should
finance the asset with a source of financing that more nearly matches the expected life and
cash-flow-generating characteristics of the asset. In this case, a 15- to 20-year loan would
be more appropriate.
Permanent and Temporary Assets
The notion of the hedging principle (matching the maturities of cash inflows and cash
outflows) can be most easily understood when we think in terms of the distinction between
permanent and temporary investments in assets, as opposed to the more traditional fixed
and current asset categories. Permanent investments in an asset are investments that the
firm expects to hold for a period longer than 1 year. Note that we are referring to the period the
firm plans to hold an investment, not the useful life of the asset. For example, permanent
investments are made in the firm’s minimum level of current assets, as well as in its fixed as-
sets. Temporary investments, by contrast, consist of current assets that will be liquidated and
not replaced within the current year. Thus, some part of the firm’s current assets is permanent
and the remainder is temporary. For example, a seasonal increase in level of inventories is
permanent investment investments that
the firm expects to hold longer than 1 year. The
firm makes permanent investments in fixed and
current assets.
temporary investments a firm’s
investments in current assets that will be
liquidated and not replaced within a period of
1 year or less. Examples include seasonal
expansions in inventories and accounts
receivable.

460 Part 5 • Working-Capital Management and International Business Finance
a temporary investment: the buildup in inventories that will be eliminated when no longer
needed. In contrast, the buildup in inventories to meet a long-term increasing sales trend
is a permanent investment.
Temporary, Permanent, and Spontaneous Sources of Financing
Because total assets must always equal the sum of temporary, permanent, and spontaneous
sources of financing, the hedging approach provides the financial manager with the basis
for determining the sources of financing to use at any point.
What constitutes a temporary, permanent, or spontaneous source of financing? Tem-
porary sources of financing consist of current liabilities. Short-term notes payable are the
most common example of a temporary source of financing. Examples of notes payable in-
clude unsecured bank loans, commercial paper, and loans secured by accounts receivable
and inventories. Permanent sources of financing include intermediate-term loans, long-
term debt, preferred stock, and common equity.
Spontaneous sources of financing consist of trade credit and other accounts payable that
arise spontaneously in the firm’s day-to-day operations. For example, as the firm acquires
materials for its inventories, trade credit is often made available spontaneously or on demand
from the firm’s suppliers when it orders its supplies or more inventory of products to sell. Trade credit
appears on the firm’s balance sheet as accounts payable, and the size of the accounts-payable
balance varies directly with the firm’s purchases of inventory items. In turn, inventory pur-
chases are related to anticipated sales. Thus, part of the financing needed by the firm is
spontaneously provided in the form of trade credit.
In addition to trade credit, wages and salaries payable, accrued interest, and accrued taxes
also provide valuable sources of spontaneous financing. These expenses accrue throughout
the period until they are paid. For example, if a firm has a wage expense of $10,000 a week
and pays its employees monthly, then its employees effectively provide financing equal to
$10,000 by the end of the first week following a payday, $20,000 by the end of the second
week, and so forth, until the workers are paid. Because these expenses generally arise in
direct conjunction with the firm’s ongoing operations, they, too, are referred to as sponta-
neous.
The Hedging Principle: A Graphic Illustration
The hedging principle can now be stated very succinctly: Asset needs of the firm not fi-
nanced by spontaneous sources should be financed in accordance with this rule: Permanent-asset
investments are financed with permanent sources, and temporary investments are financed with
temporary sources.
trade credit credit made available by a firm’s
suppliers in conjunction with the acquisition of
materials. Trade credit appears on the balance
sheet as accounts payable.
Cautionary tale
Forgetting PrinCiPle 3: risk requires a reWard
An important rule of thumb for financing a firm’s assets is some-
thing called the hedging principle. Very simply, this principle
suggests that the firm’s long-term asset investments should be
matched with long-term sources of financing such as long-term
debt or equity. Similarly, the firm’s temporary or short-term assets
can be financed using short-term sources of financing. In fact, this
principle has been summed up in the maxim “never finance long-
term investments using short-term sources of financing.”
When firms violate this basic principle, the immediate effect
may actually be positive as the firm utilizes lower-cost short-
term debt to finance its long-term investments. However, at
some point, the music stops and the financing merry-go-round
stops. This is exactly what happened with many of the nation’s
banks during the financial crisis that began in 2007. These firms
used short-term borrowing to finance their long-term invest-
ments. Moreover, these investments were heavily concentrated
in loans and other securities that were tied to real estate. When
problems developed in the real estate market that raised
concerns about the value of these investments, the firms that
were making these investments quickly found that they could no
longer get favorable terms on their short-term borrowing.
The important lesson learned here is that matching up the
maturity of the sources of financing with the type of invest-
ments being financed can be important to your financial health.

Chapter 15 • Working-Capital Management 461
The hedging principle is depicted in Figure 15-1 and described in Table 15-1. To-
tal assets are broken down into temporary- and permanent-asset investment categories.
The firm’s permanent investment in assets is financed by the use of permanent sources
of financing (intermediate- and long-term debt, preferred stock, and common equity)
or spontaneous sources (trade credit and other accounts payable). For illustration pur-
poses, spontaneous sources of financing are treated as if their amount were fixed. In
practice, of course, spontaneous sources of financing fluctuate with the firm’s purchases
and its expenditures for wages, salaries, taxes, and other items that are paid on a delayed
basis. Its temporary investment in assets is financed with temporary (short-term) debt.
FIGURE 15-1 The Hedging Principle Illustrated
D
ol
la
r
am
ou
nt
Time period
Temporary (short-term)
financing
Permanent plus spontaneous
financing
Fixed
assets
Current
assets
Permanent
current assets
TAbLE 15-1 The Hedging Principle Applied to Working-Capital Management
A firm’s asset needs that are not financed by spontaneous sources of financing should be financed in accordance with the following “matching rule”
—permanent-asset investments are financed with permanent sources, and temporary-asset investments are financed with temporary sources of financing.
Classification of a Firm’s
Investments in Assets Definitions and Examples
Classification of a Firm’s
Sources of Financing Definitions and Examples
Temporary investments Definition: Current assets that will be
liquidated and not replaced within
the year.
Examples: Seasonal expansions in
inventories and accounts receivable.
Spontaneous financing Definition: Financing that arises more or less
automatically in response to the
purchase of an asset.
Examples: Trade credit that accompanies
the purchase of inventories and other
types of accounts payable created by the
purchase of services (for example, wages
payable).
Temporary financing Definition: Current liabilities other than
spontaneous sources of financing.
Examples: Notes payable and revolving
credit agreements that must be repaid in a
period less than 1 year.
Permanent investments Definition: Current and long-term
asset investments that the firm
expects to hold for a period longer
than 1 year.
Examples: Minimum levels of
inventory and accounts receivable
the firm maintains throughout the
year as well as its investments in
plant and equipment.
Permanent financing Definition: Long-term liabilities not due
and payable within the year and equity
financing.
Examples: Term loans, notes, and bonds as
well as preferred and common equity.

462 Part 5 • Working-Capital Management and International Business Finance
Concept Check
1. What is the hedging principle or principle of self-liquidating debt?
2. What are some examples of permanent and temporary investments in current assets?
3. Is trade credit a permanent, temporary, or spontaneous source of financing? Explain.
The Cash Conversion Cycle
Because firms vary widely with respect to their ability to manage their net working capital, there
exists a need for an overall measure of effectiveness. An increasingly popular method for evaluat-
ing the efficient management of a firm’s working capital involves minimizing working capital.
Minimizing working capital is accomplished by speeding up the collection of cash from
sales, increasing inventory turns, and slowing down the disbursement of cash. We can in-
corporate all of these factors in a single measure called the cash conversion cycle.
The cash conversion cycle, or CCC, is simply the sum of days of sales outstanding and
days of sales in inventory less days of payables outstanding:
Cash
conversion
cycle (CCC)
=
days of
sales
outstanding (DSO)
+
days of
sales in
inventory (DSI)
–
days of
payables
outstanding (DPO)
We calculate days of sales outstanding as follows:
Days of
sales
outstanding (DSO)
= accounts receivable
sales/365
(15-2)
Recall from Chapter 4 that DSO can also be thought of as the average age of the firm’s ac-
counts receivable or the average collection period.
Days of sales in inventory is defined as follows:
Days of
sales
in inventory (DSI)
= inventories
cost of goods sold/365
(15-3)
Note that DSI can also be thought of as the average age of the firm’s inventory, that is, the
average number of days that a dollar of inventory is held by the firm.
Days of payables outstanding is defined as follows:
Days of
payables
outstanding (DPO)
=
accounts payable
cost of goods sold/365
(15-4)
This ratio indicates the average age, in days, of the firm’s accounts payable.
To illustrate the use of the CCC metric, consider Dell Computer Corporation. In 1989
Dell was a fledgling start-up whose CCC was 121.88 days. By 1998, Dell had reduced this
number to -5.6 days. (See Table 15-2.) How, you might ask, does a firm reduce its CCC
below zero? The answer is through very aggressive management of its working capital. As
Table 15-2 indicates, Dell achieved this phenomenal reduction in CCC primarily through
very effective management of inventories (days of sales in inventories dropped from 37.36
3 Compute the firm’s cash
conversion cycle.
Can you Do it?
CoMPuting the Cash Conversion CyCle
Harrison Electronics is evaluating its cash conversion cycle and has estimated each of its components as follows:
Days of sales outstanding (DSO) = 38 days
Days of sales in inventory (DSI) = 41 days
Days of payables outstanding (DPO) = 30 days
What is the firm’s cash conversion cycle?
(The solution can be found on page 463.)

Chapter 15 • Working-Capital Management 463
in 1995 to 4.65 in 2005) and more favorable trade credit payment practices (days of payables
outstanding increased from 40.58 in 1995 to 81.46 in 2004). Specifically, Dell, a direct
marketer of personal computers, does not build a computer until an order is received. It
purchases its supplies using trade credit. This business model results in minimal investment
in inventories. Dell has obviously improved its working-capital management practices, as
evidenced in Figure 15-2, where we compare Dell with Apple. Obviously, both firms follow
FIGURE 15-2 Cash Conversion Cycles for Apple and Dell: 1995–2005
Ca
sh
c
on
ve
rs
io
n
cy
cl
e
(d
ay
s)
–
(20.00)
(40.00)
(60.00)
100.00
80.00
60.00
40.00
20.00
1994 1996 1998 2000 2002 2004 2006
Apple
Dell
TAbLE 15-2 The Determinants of Dell Computer Corporation’s Cash Conversion Cycle for 1995–2005
Cash conversion cycle (CCC) = days of sales outstanding (DSO) + days of sales in inventory (DSI) – days of payables outstanding (DPO)
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
Days of sales outstanding (DSO) 50.04 42.48 44.00 49.64 38.69 33.14 26.57 26.66 32.01 32.74 35.59
Days of sales in inventory (DSI) 37.36 15.15 8.92 7.10 7.17 5.79 3.99 9.22 7.75 4.20 4.65
Days of payables outstanding (DPO) 40.58 62.79 62.87 62.34 64.92 62.07 72.87 75.79 79.41 81.46 79.41
Cash conversion cycle (CCC) 46.81 (5.15) (9.96) (5.60) (19.06) (23.14) (42.30) (39.90) (39.64) (44.51) (39.17)
DiD you Get it?
CoMPuting the Cash Conversion CyCle
The cash conversion cycle (CCC) is calculated as follows:
Cash
conversion
cycle (CCC)
= ±
days of
sales outstanding
(DSO)
≤ + ±
days of
sales in inventory
(DSI)
≤ – ±
days of payables
outstanding
(DPO)
≤
Substituting the following:
Days sales outstanding (DSO) = 38 days
Days sales in inventory (DSI) = 41 days
Days of payables outstanding (DPO) = 30 days
What is the firm’s cash conversion cycle?
Cash conversion cycle (CCC) = 38 days + 41 days – 30 days = 49 days
We calculate the CCC to be 49 days. Harrison can reduce its cash conversion cycle by reducing DSO (for example, offering a cash dis-
count for early payment or simply reducing the firm’s credit terms) and DSI (for example, reducing the amount of inventory the firm
carries), or by seeking better credit terms that increase its DPO.

464 Part 5 • Working-Capital Management and International Business Finance
Concept Check
1. What three actions can a firm take to minimize its net working capital?
2. Define days of sales outstanding, days of sales in inventory, and days of payables outstanding.
Estimating the Cost of Short-Term Credit Using
the Approximate Cost-of-Credit Formula
In Chapter 5 when we introduced the time value of money, we first introduced the prin-
ciples that underlie the computation of the cost of credit. However, we repeat much of
that discussion in this chapter because it is critical to gaining an understanding of how to
estimate the cost of short-term credit.
The procedure for estimating the cost of short-term credit is a very simple one and
relies on the basic interest equation:
Interest = principal * rate * time (15-5)
where interest is the dollar amount paid by a borrower to a lender in return for the use of
the principal amount of a loan for a fraction of a year (represented by time). For example,
a 6-month loan for $1,000 at 8 percent interest would require an interest payment of $40.
Interest = $1,000 * 0.08 *
1
2
= $40
We use this basic relationship to solve for the cost of a source of short-term financing or
the annual percentage rate (APR) when the interest amount, the principal sum, and the time
period for financing are known. Thus, solving the basic interest equation for APR produces3
similar strategies and have been very successful in managing their cash conversion cycle in
recent years.
name of Tool Formula What It Tells you
Cash conversion cycle (CCC)
days of
sales
outstanding (DSO)
+
days of
sales in
inventory (DSI)
+
days of
payables
outstanding (DPO)
• The number of days that it takes for cash to
cycle through the firm
• The shorter the cycle, the less money the
firm has tied up in working capital
Days of sales outstanding (DSO)
accounts receivable
sales/365 days
• The average number of days until credit sales
are collected
• The lower the number is, the less money the firm
has tied up in accounts receivable at any time
Days of sales in inventory (DSI)
inventories
cost of goods sold/365 days
• The number of days that an item sits in
inventory before being sold
• The lower the number, the smaller is the
firm’s investment in inventories
Days of payables outstanding
(DPO)
accounts payable
cost of goods sold/365 days
• The number of days that the firm takes to
pay its trade credit
• The higher the number, the lower is the
firm’s need for cash to support its investment
in current assets
FinanCial DeCision tools
4 Estimate the cost of short-term
credit.
3For ease of computation, we assume a 30-day month and 360-day year in this chapter.
APR =
interest
principal * time
(15-6)

Chapter 15 • Working-Capital Management 465
or
APR =
interest
principal
*
1
time
(15-7)
This equation, called the APR calculation, is clarified by the following example.
E x A M P L E 15.1 Estimating the cost of short-term credit
The SKC Corporation plans to borrow $1,000 for a 90-day period. At maturity the firm
will repay the $1,000 principal amount plus $30 interest. The effective annual rate of
interest for the loan can be estimated using the APR equation, as follows:
steP 1: ForMulate a solution strategy
The cost of short-term credit is estimated using the annual percentage rate (APR)
formula, which represents the ratio of interest to principal multiplied by the annualized
time period fraction of the debt, that is,
APR =
interest
principal
*
1
time
Note that interest, in the APR equation above, is the product of the principal, interest
rate, and time. In this example, the interest payment is adjusted to match the time period
of less than 1 year. With the following equation, an annualized interest rate is adjusted
so that payments match the time period of the debt,
Interest = principal * rate * time
steP 2: CrunCh the nuMBers
Substituting the characteristics of SKC Corporation’s short-term credit, we get the
following:
APR =
$30
$1,000
*
1
90/360
= 0.03 *
360
90
= 0.12 = 12%
steP 3: analyZe your results
Because SKC Corporation’s bondholders require a $30 payment of interest over the
90-day time period for the principal amount of $1,000, the effective cost of borrowing
short-term credit is equated by annualizing the bondholders’ required rate of return of
3 percent ($30/$1,000) over the four quarters in the year. The effective annual cost of
funds provided by the loan is, therefore, 12 percent.
The simple APR calculation does not consider compound interest. To account for the
influence of compounding, we can use the following equation:
APY = a1 + i
m
b
m
– 1 (15-8)
where APY is the annual percentage yield, i is the nominal rate of interest per year (12 percent
in the previous example), and m is the number of compounding periods within a year [m =
1/time = 1/(90/360) = 4 in the preceding example]. Thus, the APY on the loan in the
example problem, considering compounding, is
APY = a1 + 0.12
4
b
4
– 1 = 0.126 = 12.6%
Compounding effectively raises the cost of short-term credit. Because the differences
between APR and APY are usually small, we use the simple interest values of APR to com-
pute the cost of short-term credit.

466 Part 5 • Working-Capital Management and International Business Finance
Concept Check
1. What is the fundamental interest equation that underlies the calculation of the approximate cost-
of-credit formula?
2. What is the annual percentage yield (APY ) and how does it differ from the annual percentage
rate (APR)?
Sources of Short-Term Credit
Short-term credit sources can be classified into two basic groups: unsecured and secured.
Unsecured loans include all those sources that have as their security only the lender’s faith in the
ability of the borrower to repay the funds when due. The major sources of unsecured short-term
credit include accrued wages and taxes, trade credit, unsecured bank loans, and commercial
paper. A secured loan involves the pledge of specific assets as collateral in the event the borrower
defaults in payment of principal or interest. Commercial banks, finance companies, and factors
are the primary suppliers of secured credit. The principal sources of collateral include ac-
counts receivable and inventories.
Can you Do it?
the aPProxiMate Cost oF short-terM Credit
Hempstead Electric buys its wiring materials in bulk directly from Hamilton Wire and Cable Company. Hamilton offers credit terms
that involve a cash discount of 3 percent if payment is received in 30 days. Otherwise, the full amount is due in 90 days. What is the
approximate cost of credit to Hempstead if it exceeds 30 days and passes up the cash discount?
(The solution can be found below.)
5 Identify the primary sources of
short-term credit.
unsecured loans all sources of credit that have
as their security only the lender’s faith in the
borrower’s ability to repay the funds when due.
secured loans sources of credit that require
security in the form of pledged assets. In the
event the borrower defaults in payment of
principal or interest, the lender can seize the
pledged assets and sell them to settle the debt.
name of Tool Formula What It Tells you
Annual percentage rate (APR)
interest
principal * time
Interest = dollar interest expense
Principal = face amount of credit extended
Time = the fraction of time for which credit is
extended (e.g., 0.5 for a six-month loan)
�• An estimate of the approximate annual cost of
short-term credit that does not consider the
effects of compounding
Annual percentage yield (APY) ±1 +
nominal rate
of interest (i)
number of compounding
periods per year (m)
≤
m
– 1
�• The compounded annual rate of interest
• The cost of short-term (less than one year) credit
FinanCial DeCision tools
DiD you Get it?
the aPProxiMate Cost oF short-terM Credit
If Hempstead chooses to pass up the cash discount, then the
cost of credit will reflect the loss of the 3 percent discount so that
the firm can use the principal amount of the purchases (that is,
97 percent of each dollar of wire purchased) for a period of
60 days (the difference in the discount period of 30 days and the
end of the credit period of 90 days). The APR is calculated as follows
using equation (15-6):
APR =
interest
principal * time
=
0.03
0.97 *
60
360
= 0.1856, or 18.56%

Chapter 15 • Working-Capital Management 467
Unsecured Sources: Accrued Wages and Taxes
Because most businesses pay their employees only periodically (weekly, biweekly, or monthly),
firms accrue a wages-payable account that is, in essence, a loan from their employees. For
example, if the wage expense for the Appleton Manufacturing Company is $450,000 per week
and it pays its employees monthly, then by the end of a 4-week month the firm will owe its
employees $1.8 million in wages for services they have already performed during the month.
Consequently, the employees finance their own efforts by waiting a full month for payment.
Similarly, firms generally make quarterly income tax payments for their estimated quar-
terly tax liability. This means that the firm has the use of the tax money it owes based on its
FinanCe at Work
Managing Working CaPital By triMMing reCeivaBles
LaFarge Corporation is located in Reston, Virginia, and operates
in the building materials industry. Last year LaFarge was able to
dramatically improve its management of accounts receivable.
This improvement is reflected in a decrease in the days of sales
outstanding ratio (DSO); that is,
DSO =
accounts receivable
sales>365
After reviewing this formula, you may recall that we referred
to DSO in Chapter 4 as the average collection period. The com-
pany’s success is due in large part to the fact that it ties incentive
pay to the return on net assets (RONA) as defined here:
RONA =
earnings before interest and taxes
net assets
Note that improvements in accounts-receivable management
that result in a decrease in DSO also lead to a reduction in the
firm’s net assets and a corresponding increase in RONA. Of
course, this presumes that the reduction in DSO does not have
an adverse impact on the firm’s revenues and, consequently,
earnings.
How Did They Do It?
Pete Sacripanti, vice president and controller of LaFarge’s
Calgary-based construction materials business, credits the firm’s
improved collections to 12 fundamental steps:a
7. Training salespeople on customer profitability, with
particular attention to (1) the link between past-due
accounts and increased risk of bad debt write-offs, (2) the
volume of business required to recover the cost of bad
debts, and (3) higher borrowing costs for the company.
8. Engaging in regular (weekly) credit and collection
meetings with the sales team, the credit manager, and the
general manager.
9. Encouraging constant “in-your-face” executive man-
agement, featuring weekly status updates of collections by
salespeople, including key account information.
10. Facilitating collections through advance phone calls to
establish expected payment amount and availability and to
provide a courier to pick up the payments.
11. Developing collection skills, including partial holdback
releases; offsetting balances owed for services or equip-
ment; use of construction liens, guarantees, letters of credit,
and payment bonds; negotiation techniques for securing
extras in lieu of write-offs; and better knowledge of the
company’s products, its industry, and its customers.
12. Developing unique value by building stronger relation-
ships with customers, such as air-miles loyalty programs,
engineered solutions, quality assurance, and new-product
development.
The key thing to note in this list is that each item represents
a managerial action aimed at improving the firm’s success in
collecting its receivables. The DSO metric captures the success
of these actions, but it is these 12 steps that actually brought
about the improvements.
Measuring Success
LaFarge engaged in a 3-year program aimed at reducing its
investment in working capital. The success of the program
is most clearly evident in the company’s western Canadian
construction-materials operation based in Calgary. This unit
slashed its working capital by 38 percent to around $36 million
while increasing sales by 10 percent to $425 million. The
effect on RONA was dramatic because the firm simultaneously
increased earnings (the numerator of the ratio) and decreased
net assets (the denominator).
aBased on “Dollars in the Details: The 1999 Working Capital Survey” by S. L. Mintz,
CFO.com, July 1, 1999.
1. Focusing on customers and collections, which involves all
layers of management and is not just a finance responsibility.
2. building a base of preferred customers that confers a
competitive advantage.
3. Delineating clear ownership of customer accounts
among the sales staff, which prevents passing the buck on
delinquent accounts.
4. Fixing clear guidelines that govern LaFarge’s commit-
ments and responsibilities to customers.
5. Articulating standard sales terms and conditions, stipu-
lating terms that are negotiable and those that are never
negotiable.
6. Establishing monthly collection targets by salesperson
and division, with collection targets based on the prior
month’s sales plus past-due accounts.

468 Part 5 • Working-Capital Management and International Business Finance
quarterly profits through the end of the quarter. In addition, the firm pays sales taxes and
withholding (income) taxes for its employees on a deferred basis. The longer the period
that the firm holds the tax payments, the greater the amount of financing they provide for
the firm.
Note that these sources of financing rise and fall spontaneously with the level of the firm’s
sales. That is, as the firm’s sales increase, so do its labor expenses, sales taxes collected, and
income tax. Consequently, these accrued expense items provide the firm with automatic, or
spontaneous, sources of financing.
Unsecured Sources: Trade Credit
Trade credit provides one of the most flexible sources of short-term financing available to
the firm. We previously noted that trade credit is a primary source of spontaneous, or on-
demand, financing. That is, trade credit arises spontaneously with the firm’s purchases. To
arrange for credit, the firm need only place an order with one of its suppliers. The supplier
checks the firm’s credit and, if it is good, sends the merchandise. The purchasing firm then
pays for the goods in accordance with the supplier’s credit terms.
Credit Terms and Cash Discounts Very often the credit terms offered with trade credit
involve a cash discount for early payment. For example, a supplier might offer terms of
2/10, net 30, which means that a 2 percent discount is offered if payment is made within
10 days or the full amount is due in 30 days. Thus, a 2 percent penalty is involved for not
paying within 10 days, or for delaying payment from the tenth to the thirtieth day (that is,
for 20 days). The effective annual cost of not taking the cash discount can be quite severe.
Using a $1 invoice amount, the effective cost of passing up the discount period using the
preceding credit terms and our APR equation can be estimated.
APR =
$0.02
$0.98
*
1
20/360
= 0.3673 = 36.73%
Note that the 2 percent cash discount is the interest cost of extending the payment period an
additional 20 days. Note also that the principal amount of the credit is $0.98. This amount
constitutes the full principal amount as of the tenth day of the credit period, after which
time the cash discount is lost. The effective cost of passing up the 2 percent discount for
20 days is quite expensive: 36.73 percent. Furthermore, once the discount period has passed,
there is no reason to pay before the final due date (the thirtieth day). Table 15-3 lists the
effective annual cost of a number of alternative credit terms. Note that the cost of trade
credit varies directly with the size of the cash discount and inversely with the length of time
between the end of the discount period and the final due date.
Can you do it?
the Cost oF short-terM Credit (Considering CoMPounding eFFeCts)
Re-evaluate the cost of short-term credit for Hempstead using the annual percentage yield (APY ), which incorporates compound
interest.
(The solution can be found on page 469.)
TAbLE 15-3 The Rates of Interest on Selected Trade Credit Terms
Credit Terms Effective Rates
2/10, net 60 14.69%
2/10, net 90 9.18
3/20, net 60 27.84
6/10, net 90 28.72

Chapter 15 • Working-Capital Management 469
The Stretching of Trade Credit Some firms that use trade credit engage in a practice
called stretching of trade accounts. This practice involves delaying payments beyond the pre-
scribed credit period. For example, a firm might purchase materials under credit terms of
3/10, net 60; however, when faced with a shortage of cash, the firm might delay payment
until the eightieth day. Continued violation of trade terms can eventually lead to a loss of
credit. However, for short periods, and at infrequent intervals, stretching offers the firm an
emergency source of short-term credit.
The Advantages of Trade Credit As a source of short-term financing, trade credit
has a number of advantages. First, trade credit is conveniently obtained as a normal
part of the firm’s operations. Second, no formal agreements are generally involved in
extending credit. Furthermore, the amount of credit extended expands and contracts
with the needs of the firm; this is why it is classified as a spontaneous, or on-demand,
source of financing.
Unsecured Sources: bank Credit
Commercial banks provide unsecured short-term credit in two basic forms: lines of credit
and transaction loans (notes payable). Maturities of both types of loans are usually 1 year or
less, with rates of interest depending on the creditworthiness of the borrower and the level
of interest rates in the economy as a whole.
Line of Credit A line of credit is generally an informal agreement or understanding between
the borrower and the bank about the maximum amount of credit that the bank will provide the bor-
rower at any one time. Under this type of agreement there is no legal commitment on the part
of the bank to provide the credit. In a revolving credit agreement, which is a variant of this
form of financing, a legal obligation is involved. The line of credit agreement generally covers
a period of 1 year corresponding to the borrower’s fiscal year. Thus, if the borrower is on a
July 31 fiscal year, its lines of credit are based on the same annual period.
Lines of credit generally do not involve fixed rates of interest; instead they state
that credit will be extended at 12 percent over prime or some other spread over the bank’s
prime rate.4 Furthermore, the agreement usually does not spell out the specific use
that will be made of the funds beyond a general statement, such as for working-capital
purposes.
DiD you Get it?
the Cost oF short-terM Credit (Considering CoMPounding eFFeCts)
Using equation (15-8) we can estimate the cost of short-term credit to Hempstead as follows:
APY = a1 + i
m
b
m
– 1 = a1 + 0.18
6
b
6
– 1 = 0.1941, or 19.41%
where i is the nominal annual rate of interest. That is, the cash discount is 3 percent and this gets Hempstead an added 60 days or 1/6th
of a year. Therefore, the nominal rate of interest for a year is 6 * 0.03, or 18 percent. Considering the effects of compound interest,
the cost of short-term credit from deferring payment to Hamilton for wiring until the end of the 90-day credit period is 19.41 percent.
line of credit generally an informal
agreement or understanding between a
borrower and a bank as to the maximum amount
of credit the bank will provide the borrower
at any one time. Under this type of agreement
there is no “legal” commitment on the part of the
bank to provide the stated credit.
revolving credit agreement an
understanding between the borrower and the
bank as to the amount of credit the bank will be
legally obligated to provide the borrower.
compensating balance a balance of a given
amount that the firm maintains in its demand
deposit account. It may be required by either a
formal or an informal agreement with the firm’s
commercial bank. Such balances are usually
required by the bank (1) on the unused portion
of a loan commitment, (2) on the unpaid portion
of an outstanding loan, or (3) in exchange for
certain services provided by the bank, such as
check-clearing or credit information. These
balances raise the effective rate of interest paid
on borrowed funds.4The prime rate of interest is the rate that a bank charges its most creditworthy borrowers.
Lines of credit usually require that the borrower maintain a minimum balance in the bank
throughout the loan period, called a compensating balance. This required balance (which
can be stated as a percentage of the line of credit or the loan amount) increases the effective
cost of the loan to the borrower unless a deposit balance equal to or greater than this bal-
ance requirement is maintained in the bank.
The effective cost of short-term bank credit can be estimated using the APR equation.
Consider the following example.

470 Part 5 • Working-Capital Management and International Business Finance
E x A M P L E 15.2 Calculating the effective annual cost of short-term bank credit
M&M Beverage Company has a $300,000 line of credit that requires a compensating
balance equal to 20 percent of the loan amount. The rate paid on the loan is 10 per-
cent per annum; $200,000 is borrowed for a 6-month period deposit with the lending
bank. The dollar cost of the loan includes the interest expense and the opportunity cost
of maintaining an idle cash balance equal to the 20 percent compensating balance. To
accommodate the cost of the compensating-balance requirement, assume that the added
funds will have to be borrowed and simply left idle in the firm’s checking accounts.
steP 1: ForMulate a solution strategy
The amount actually borrowed (B) will be larger than the $200,000 needed. In fact, the
needed $200,000 will constitute 80 percent of the total borrowed funds because of the
20 percent compensating-balance requirement; hence,
0.80B = $200,000, such that B = $250,000
Thus, interest is paid on a $250,000 loan, of which only $200,000 is available for use by
the firm.5
5The same answer would have been obtained by assuming a total loan of $200,000, of which only 80 percent, or
$160,000, was available for use by the firm; that is,
APR =
$10,000
$160,000
*
1
180/360
= 12.5%
Interest is now calculated on the $200,000 loan amount ¢$10,000 = $200,000 * 0.10 * 1
2
≤
Interest = principal * rate * time
= $250,000 * 0.10 * (180/360) = $12,500
Note that we use the $250,000 as the principal when calculating the interest payment.
The reason is that the firm must borrow the 20 percent compensating balance of $50,000
that is left idle in the firm’s checking account.
The effective annual cost of credit, therefore, is calculated using the APR formula:
APR =
interest
principal
*
1
time
steP 2: CrunCh the nuMBers
Substituting the characteristics of M&M Beverage Company’s bank loan into the APR
equation above, we get the following:
APR =
$12,500
$200,000
*
1
180/360
= 0.125 = 12.5%
Note that we use $200,000 as the principal when calculating the annual percentage rate.
This amount represents the available portion of the loan, or the effective portion; there-
fore, we use it to calculate effective annual cost.
steP 3: analyZe your results
In the M&M Beverage Company example, the loan required the payment of principal
($250,000), which includes the 20 percent compensatory balance, plus interest ($12,500),
a 10 percent rate, at the end of the 6-month loan period. The effective annual cost of
credit was calculated using the ratio of interest ($12,500) to effective principal amount
($200,000). When annualized, this ratio produced an effective annual cost of bank credit
of 12.5 percent.
Frequently, bank loans will be made on a discount basis. That is, the loan interest will be
deducted from the loan amount before the funds are transferred to the borrower. Extending
the M&M Beverage Company example to consider discounted interest involves reducing the
effective loan proceeds ($200,000) in the previous example by the amount of interest for the
full 6 months ($12,500). The effective rate of interest on the loan is now:

Chapter 15 • Working-Capital Management 471
APR =
$12,500
$200,000 – $12,500
*
1
(180/360)
= 0.1333 = 13.33%
The effect of discounting interest was to raise the cost of the loan from 12.5 percent
to 13.33 percent. This results from the fact that the firm pays interest on the same
amount of funds as before ($250,000); however, this time it gets the use of $12,500 less,
or $200,000 – $12,500 = $187,500.6
transaction loan a loan where the proceeds
are designated for a specific purpose—for
example, a bank loan used to finance the
acquisition of a piece of equipment.
commercial paper short-term unsecured
promissory notes sold by large businesses in
order to raise cash. Unlike most other money-
market instruments, commercial paper has no
developed secondary market.
6If M&M needs the use of a full $200,000, then it will have to borrow more than $250,000 to cover both the compensating-
balance requirement and the discounted interest. In fact, the firm will have to borrow some amount B such that
B – 0.2B – a0.10 * 1
2
bB = $200,000
0.75B = $200,000
B =
$200,000
0.75
= $266,667
The cost of credit remains the same at 13.33 percent, as we see here:
APR =
$13,333
$266,667 – $53,333 – $13,333
*
1
180/360
= 0.1333 = 13.33%
Transaction Loans Still another form of unsecured short-term bank credit can be
obtained in the form of a transaction loan. Here the loan is made for a specific purpose. This
is the type of loan that most individuals associate with bank credit and is obtained by signing
a promissory note.
An unsecured transaction loan is very similar to a line of credit with regard to its cost,
term to maturity, and compensating-balance requirements. In both instances commercial
banks often require that the borrower clean up its short-term loans for a 30- to 45-day
period during the year. This means, very simply, that the borrower must be free of any bank
debt for the stated period. The purpose of such a requirement is to ensure that the borrower
is not using short-term bank credit to finance a part of its permanent needs for funds.
Unsecured Sources: Commercial Paper
Only the largest and most creditworthy companies are able to use commercial paper,
which is simply a short-term promise to pay that is sold in the market for short-term debt securities.
The maturity of the credit source is generally 6 months or less, although some issues
carry 270-day maturities. The interest rate on commercial paper is generally slightly lower
(12 to 1 percent) than the prime rate on commercial bank loans. Also, the interest is usually
discounted, although sometimes interest-bearing commercial paper is available.
New issues of commercial paper are either directly placed (sold by the issuing firm
directly to the investing public) or dealer placed. A dealer placement involves the use of
a commercial paper dealer, who sells the issue for the issuing firm. Many major finance
companies, such as General Motors Acceptance Corporation, place their commercial paper
directly. The volume of direct versus dealer placements is roughly 4 to 1 in favor of direct
placements. Dealers are used primarily by industrial firms that either make only infrequent
use of the commercial paper market or, owing to their small size, would have difficulty plac-
ing the issue without the help of a dealer.
Commercial Paper as a Source of Short-Term Credit Several advantages accrue to the
user of commercial paper.
1. Interest rate. Commercial paper rates are generally lower than rates on bank loans
and comparable sources of short-term financing.
2. Compensating-balance requirement. No minimum balance requirements are
associated with commercial paper. However, issuing firms usually find it desirable to
maintain line-of-credit agreements sufficient to back up their short-term financing

472 Part 5 • Working-Capital Management and International Business Finance
needs in the event that a new issue of commercial paper cannot be sold or an outstand-
ing issue cannot be repaid when due.
3. Amount of credit. Commercial paper offers the firm with very large credit needs
a single source for all its short-term financing. Because of loan amount restrictions
placed on the banks by the regulatory authorities, obtaining the necessary funds from a
commercial bank might require borrowing from a number of institutions.7
7Member banks of the Federal Reserve System are limited to 10 percent of their total capital, surplus, and undivided
profits when making loans to a single borrower. Thus, when a corporate borrower’s needs for financing are very large, it
may have to deal with a group of participating banks to raise the needed funds.
4. Prestige. Because it is widely recognized that only the most creditworthy borrowers
have access to the commercial paper market, its use signifies a firm’s credit status.
Using commercial paper for short-term financing, however, involves a very important
risk. The commercial paper market is highly impersonal and denies even the most cred-
itworthy borrower any flexibility in terms of repayment. When bank credit is used, the
borrower has someone with whom he or she can work out any temporary difficulties that
might be encountered in meeting a loan deadline. This flexibility simply does not exist for
the user of commercial paper.
Estimating the Cost of Using Commercial Paper The cost of commercial paper can
be estimated using the simple, effective cost-of-credit equation (APR). The key points to
remember are that commercial paper interest is usually discounted and that if a dealer is
used to place the issue, a fee is charged. Even if a dealer is not used, the issuing firm will
incur costs associated with preparing and placing the issue, and these costs must be included
in estimating the cost of this credit.
E x A M P L E 15.3 Calculating the effective cost of credit
The EPG Manufacturing Company uses commercial paper regularly to support its
needs for short-term financing. The firm plans to sell $100 million in 270-day-maturity
paper, on which it expects to pay discounted interest at a rate of 12 percent per annum
($9 million). In addition, EPG expects to incur a cost of approximately $100,000 in
dealer placement fees and other expenses of issuing the paper. What is the effective cost
of credit to EPG?
steP 1: ForMulate a solution strategy
EPG’s effective cost of credit can be determined using the annual percentage rate for-
mula. By identifying each of the variables and plugging them into the APR equation, the
following calculation is generated:
APR =
interest
principal
*
1
time
(15-7)
where interest is calculated using the formula
interest = (principal * rate * time) + financing fees
In this example, interest will represent the interest itself plus any other financing fees.
The principal is the total cash received from financing, less any interest costs. Finally,
the time period is over 270 days.
steP 2: CrunCh the nuMBers
Substituting the characteristics of EPG’s commercial paper financing strategy into equa-
tion (15-7) we get the following:
APR =
$9,000,000 + $100,000
$100,000,000 – $100,000 – $9,000,000
*
1
270/360
= 0.1335 = 13.35%

Chapter 15 • Working-Capital Management 473
where the interest cost is calculated as $100,000,000 * 0.12 * (270/360) = $9,000,000
plus the $100,000 dealer placement fee. Thus, the effective cost of credit to EPG is
13.35 percent.
steP 3: analyZe your results
It appears that at the 12 percent discount rate, the commercial paper sale will only return
$89,900,000 in cash financing, after the $100,000 of dealer placement fees are included.
This means that $9.1 million is the interest cost of financing $89.9 million. In this case,
the interest represents 13.35 percent of the total cash received, which therefore repre-
sents the effective cost of credit.
Secured Sources: Accounts-Receivable Loans
Secured sources of short-term credit have certain assets of the firm pledged as collateral
to secure the loan. Upon default of the loan agreement, the lender has first claim to the
pledged assets in addition to its claim as a general creditor of the firm. Hence, the secured
credit agreement offers an added margin of safety to the lender.
Generally, a firm’s receivables are among its most liquid assets. For this reason they
are considered by many lenders to be prime collateral for a secured loan. Two basic
procedures can be used in arranging for financing based on receivables: pledging and
factoring.
Pledging Accounts Receivable Under the pledging accounts receivable arrangement,
the borrower simply pledges accounts receivable as collateral for a loan obtained from either a com-
mercial bank or a finance company. The amount of the loan is stated as a percentage of the
face value of the receivables pledged. If the firm provides the lender with a general line on
its receivables, then all of the borrower’s accounts are pledged as security for the loan. This
method of pledging is simple and inexpensive. However, because the lender has no control
over the quality of the receivables being pledged, it will set the maximum loan at a relatively
low percentage of the total face value of the accounts, generally ranging downward from a
maximum of around 75 percent.
Still another approach to pledging involves the borrower presenting specific invoices
to the lender as collateral for a loan. This method is somewhat more expensive because the
lender must assess the creditworthiness of each individual account pledged; however, given
this added knowledge, the lender should be willing to increase the loan as a percentage of
the face value of the invoices. In this case the loan might reach as high as 85 or 90 percent
of the face value of the pledged receivables.
Credit Terms Accounts-receivable loans generally carry an interest rate that is 2 to
5 percent higher than the bank’s prime lending rate. Finance companies charge an even
higher rate. In addition, the lender usually charges a handling fee stated as a percentage
of the face value of the receivables processed, which may be as much as 1 to 2 percent
of the face value.
E x A M P L E 15.4 Calculating the annual percentage rate of
short-term lender credit
The A. B. Good Company sells electrical supplies to building contractors on terms of net
60. The firm’s average monthly sales are $100,000; thus, given the firm’s 2-month credit
terms, its average receivables balance is $200,000. The firm pledges all of its receivables
to a local bank, which in turn advances up to 70 percent of the face value of the receiv-
ables at 3 percent over prime and charges a 1 percent processing fee on all receivables
pledged. A. B. Good follows a practice of borrowing the maximum amount possible, and
the current prime rate is 10 percent. What is the APR of using this source of financing
for a full year?
pledging accounts receivable a loan
the firm obtains from a commercial bank or a
finance company using its accounts receivable
as collateral.

474 Part 5 • Working-Capital Management and International Business Finance
steP 1: ForMulate a solution strategy
In this example, the same annual percentage rate formula is used. However, the key is
identifying the correct characteristics to use as variables in the equation:
Annual percentage rate =
interest
principal
*
1
time
(15-7)
Note that we can calculate interest by adding the interest expense plus the annual pro-
cessing fee. The principal will be represented by the actual amount of credit extended.
Finally, our time period should be over the full year:
APR =
interest expense + processing fee
credit extended
*
1
time
steP 2: CrunCh the nuMBers
Once we substitute the correct variables from above into the equation, we get the fol-
lowing result:
APR =
$18,200 + $12,000
$140,000
*
1
360/360
= 0.2157 = 21.57%
where the total dollar cost of the loan consists of both the annual interest expense (0.13 *
0.70 * $200,000 = $18,200) and the annual processing fee (0.01 * $100,000 *
12 months = $12,000). The amount of credit extended is 0.70 * $200,000 = $140,000.
Note that the processing charge applies to all receivables pledged. Thus, the A. B. Good
Company pledges $100,000 each month, or $1,200,000 during the year, on which a
1 percent fee must be paid, for a total annual charge of $12,000.
steP 3: analyZe your results
It appears that A. B. Good Company’s lender charges a rate of about 14 percent
(13 percent interest and 1 percent annual processing fee) for the 70 percent of receiv-
ables for which they give a receivables advance. In this example the effective APR is
actually more than this charge of 14 percent, because of the discounted amount of
the receivables advance. Since only 70 percent of the receivables are actually cred-
ited, the effective APR is increased to account for the 30 percent of receivables for
which no advance is given.
One more point: The lender, in addition to making advances or loans, may be
providing certain credit services to the borrower. For example, the lender may pro-
vide billing and collection services. The value of these services should be considered
in computing the cost of credit. In the preceding example, A. B. Good Company may
save $10,000 per year in credit department expenses by pledging all of its accounts
and letting the lender provide those services. In this case, the cost of short-term
credit is only:
APR =
$18,200 + $12,000 – $10,000
$140,000
*
1
360/360
= 0.1443 = 14.43%
The Advantages and Disadvantages of Pledging The primary advantage of pledging
as a source of short-term credit is the flexibility it provides the borrower. Financing is
available on a continuous basis. The new accounts created through credit sales provide
the collateral for the financing of new production. Furthermore, the lender may pro-
vide credit services that eliminate or at least reduce the need for similar services within
the firm. The primary disadvantage associated with this method of financing is its cost,
which can be relatively high compared with other sources of short-term credit, owing
to the level of the interest rate charged on loans and the processing fee on pledged
accounts.

Chapter 15 • Working-Capital Management 475
Factoring Accounts Receivable Factoring accounts receivable involves the outright
sale of a firm’s accounts to a financial institution called a factor. A factor is a firm that acquires the
receivables of other firms. The factoring institution might be a commercial finance company
that engages solely in the factoring of receivables (known as an old-line factor) or it might be
a commercial bank. The factor, in turn, bears the risk of collection and, for a fee, services
the accounts. The fee is stated as a percentage of the face value of all receivables factored
(usually 1 to 3 percent).
The factor firm typically does not make payment for factored accounts until the ac-
counts have been collected or the credit terms have been met. Should the firm wish to
receive immediate payment for its factored accounts, it can borrow from the factor, using
the factored accounts as collateral. The maximum loan the firm can obtain is equal to the
face value of its factored accounts less the factor’s fee (1 to 3 percent) less a reserve (6 to
10 percent) less the interest on the loan. For example, if $100,000 in receivables is factored,
carrying 60-day credit terms, a 2 percent factor’s fee, a 6 percent reserve, and interest at
1 percent per month on advances, then the maximum loan or advance the firm can receive
is computed as follows:
factoring accounts receivable the
outright sale of a firm’s accounts receivable to
another party (the factor) without recourse. The
factor, in turn, bears the risk of collection.
factor a firm that, in acquiring the receivables
of other firms, bears the risk of collection and, for
a fee, services the accounts.
inventory loans loans secured by
inventories. Examples include floating or blanket
lien agreements, chattel mortgage agreements,
field-warehouse receipt loans, and
terminal-warehouse receipt loans.
floating lien agreement an agreement,
generally associated with a loan, whereby the
borrower gives the lender a lien against all its
inventory.
field-warehouse agreement a security
agreement in which inventories pledged as
collateral are physically separated from the firm’s
other inventories and placed under the control
of a third-party field-warehousing firm.
Face amount of receivables factored $100,000
Less: Fee (0.02 * $100,000) (2,000)
Reserve (0.06 * $100,000) (6,000)
Interest (0.01 * $92,000 * 2 months) (1,840)
Maximum advance $ 90,160
chattel mortgage agreement a loan
agreement in which the lender can increase his
or her security interest by having specific items
of inventory identified in the loan agreement.
The borrower retains title to the inventory
but cannot sell the items without the lender’s
consent.
Note that interest is discounted and calculated based on a maximum amount of funds
available for advance ($92,000 = $100,000 – $2,000 – $6,000). Thus, the effective cost
of credit can be calculated as follows:
APR =
$1,840 + $2,000
$90,160
*
1
60/360
= 0.2555 = 25.55%
Secured Sources: Inventory Loans
Inventory loans, or loans secured by inventories, provide a second source of security for short-
term credit. The amount of the loan that can be obtained depends on both the marketability
and perishability of the inventory. Some items, such as raw materials (grains, oil, lumber,
and chemicals), are excellent sources of collateral, because they can easily be liquidated.
Other items, such as work-in-process inventories, provide very poor collateral because of
their lack of marketability.
There are several methods by which inventory can be used to secure short-term financ-
ing. These include a floating, or blanket, lien, a chattel mortgage, a field-warehouse receipt,
and a terminal-warehouse receipt.
Under a floating lien agreement, the borrower gives the lender a lien against all of its
inventories. This provides the simplest but least secure form of inventory collateral. The
borrowing firm maintains full control of the inventories and continues to sell and replace
them as it sees fit. Obviously, this lack of control over the collateral greatly dilutes the value
of this type of security to the lender.
Under a chattel mortgage agreement, the inventory is identified (by serial number or
otherwise) in the security agreement, and the borrower retains title to the inventory but cannot sell
the items without the lender’s consent.
Under a field-warehouse agreement, inventories used as collateral are physically separated
from the firm’s other inventories and are placed under the control of a third-party field-warehousing
firm.

476 Part 5 • Working-Capital Management and International Business Finance
A terminal-warehouse agreement differs from a field-warehouse agreement in only
one respect. Here the inventories pledged as collateral are transported to a public warehouse that
is physically removed from the borrower’s premises. The lender has an added degree of safety or
security because the inventory is totally removed from the borrower’s control. Once again
the cost of this type of arrangement is increased because the warehouse firm must be paid
by the borrower; in addition, the inventory must be transported to and, eventually, from
the public warehouse.
Concept Check
1. What are some examples of unsecured and secured sources of short-term credit?
2. What is the difference between a line of credit and a revolving credit agreement?
3. What are the types of credit agreements a firm can get that are secured by its accounts receivable
as collateral?
4. What are some examples of loans secured by a firm’s inventories?
Chapter Summaries
Describe the risk-return trade-off involved in managing working capital.
(pgs. 457–458)
Summary: Working-capital management involves managing the firm’s liquidity, which in turn
involves managing (1) the firm’s investment in current assets and (2) its use of current liabilities.
Each of these problems involves risk–return trade-offs. Investing in current assets reduces the firm’s
risk of illiquidity at the expense of lowering its overall rate of return on its investment in assets. By
contrast, the use of long-term sources of financing enhances the firm’s liquidity while reducing its
rate of return on assets.
Key TermS
1
terminal-warehouse agreement a
security agreement in which the inventories
pledged as collateral are transported to a public
warehouse that is physically removed from the
borrower’s premises. This is the safest (though
costly) form of financing secured by inventory.
Working capital, page 457 A concept
traditionally defined as a firm’s investment in
current assets.
Net working capital, page 457 The
difference between the firm’s current assets
and its current liabilities.
Key equaTion
Net working capital = current assets – current liabilities
Describe the determinants of net working capital. (pgs. 459–462)
Summary: A firm’s net working capital is determined by its need for current assets and the
sources of financing it uses to acquire them. In deciding on the sources of financing, it is im-
portant to note that the firm gets some financing automatically from the firm’s suppliers in the
form of accounts payable. However, the firm typically needs more financing, which can come
in the form of short- (less than 1 year) or long-term financing. Using short-term sources is
often cheaper than long-term sources but adds risk as the firm is faced with a near-term ma-
turity that must be repaid. The hedging principle, or principle of self-liquidating debt, offers
the financial manager one tool for resolving this financing problem. Basically, this methodol-
ogy requires that the firm match up the maturities of its liabilities with the maturity of its
asset needs. For example, if the firm has a seasonal and temporary need to raise its inventories
and accounts receivable (for example, a retailer at Christmas) then short-term financing is
2

Chapter 15 • Working-Capital Management 477
appropriate. However, if the firm has a more permanent need to increase its current assets,
then long-term financing should be used.
Key TermS
Hedging principle (principle of
self-liquidating debt), page 459 A
working-capital management policy which
states that the cash-flow-generating
characteristics of a firm’s investments should
be matched with the cash-flow requirements
of the firm’s sources of financing. Very simply,
short-lived assets should be financed with
short-term sources of financing while
long-lived assets should be financed with
long-term sources of financing.
Permanent investment, page 459
Investments that the firm expects to hold
longer than 1 year. The firm makes permanent
investments in fixed and current assets.
Temporary investments, page 459 A firm’s
investments in current assets that will be
liquidated and not replaced within a period
of 1 year or less. Examples include seasonal
expansions in inventories and accounts
receivable.
Trade credit, page 460 Credit made
available by a firm’s suppliers in conjunction
with the acquisition of materials. Trade credit
appears on the balance sheet as accounts
payable.
Compute the firm’s cash conversion cycle. (pgs. 462–464)
Summary: The cash conversion cycle is a key measure of how efficiently the firm is in man-
aging its net working capital. Specifically, the cash conversion cycle equals the number of days
it takes to collect on credit sales, plus the number of days items are in inventory, less the num-
ber of days that payables are outstanding. The importance of the length of the conversion cycle
is that this is the number of days that the firm has money tied up in inventories and accounts
receivable. The longer is this period, other things being the same, the more money the firm
must invest in current assets.
Key equaTionS
Cash
conversion
cycle (CCC)
=
days of
sales outstanding
(DSO)
+
days of
sales in
inventory (DSI)
–
days of payables
outstanding
(DPO)

Days of
sales outstanding
(DSO)
=
accounts receivable
sales/365

Days of
sales in
inventory (DSI)
=
inventories
cost of goods sold/365

Days of payables
outstanding
(DPO)
=
accounts payable
cost of goods sold/365

estimate the cost of short-term credit. (pgs. 464–466)
Summary: The key consideration in selecting a source of short-term financing is the effec-
tive cost of credit. Since short-term credit is, by definition, extended for a period less than
1 year, the analyst must adjust the interest paid for the term of the financing (less than 1 year)
in order to compute an annual rate of interest. The adjustment can assume simple interest
(that is, not compounded) to compute the annual percentage rate (APR) or the adjustment
can account for compound interest, in which case we compute the annual percentage
yield (APY).
3
4

478 Part 5 • Working-Capital Management and International Business Finance
Key equaTionS
Interest = principal * rate * time
Annual percentage
rate (APR)
=
interest
principal * time

Annual percentage
rate (APR)
=
interest
principal
*
1
time

Annual percentage
yield (APY )
= a1 + i
m
b
m
– 1
identify the primary sources of short-term credit. (pgs. 466–476)
Summary: The various sources of short-term credit can be categorized into two groups: unsecured
and secured. Unsecured credit offers no specific assets as security for the loan agreement. The primary
sources include trade credit, lines of credit, unsecured transaction loans from commercial banks, and
commercial paper. Secured credit is generally provided to business firms by commercial banks, finance
companies, and factors. The most popular sources of security involve the use of accounts receivable and
inventories. Loans secured by accounts receivable include pledging agreements, in which a firm pledges
its receivables as security for a loan, and factoring agreements, in which the firm sells the receivables
to a factor. In a pledging arrangement, the lender retains the right of recourse in the event of default,
whereas in factoring, a lender is generally without recourse. Loans secured by inventories can be made
using one of several types of security arrangements. Among the most widely used are the floating lien,
chattel mortgage, field-warehouse agreement, and terminal-warehouse agreement. The form of agree-
ment used depends on the type of inventories pledged as collateral and the degree of control the lender
wishes to exercise over the collateral.
Key TermS
5
Unsecured loans, page 466 All sources
of credit that have as their security only the
lender’s faith in the borrower’s ability to repay
the funds when due.
Secured loans, page 466 Sources of credit
that require security in the form of pledged
assets. In the event the borrower defaults in
payment of principal or interest, the lender can
seize the pledged assets and sell them to settle
the debt.
Line of credit, page 469 Generally an infor-
mal agreement or understanding between a
borrower and a bank as to the maximum amount
of credit the bank will provide the borrower at
any one time. Under this type of agreement there
is no “legal” commitment on the part of the bank
to provide the stated credit.
Revolving credit agreement, page 469 An
understanding between the borrower and the
bank as to the amount of credit the bank will
be legally obligated to provide the borrower.
Compensating balance, page 469 A balance
of a given amount that the firm maintains in its
demand deposit account. It may be required by
either a formal or an informal agreement with
the firm’s commercial bank. Such balances are
usually required by the bank (1) on the unused
portion of a loan commitment, (2) on the
unpaid portion of an outstanding loan, or (3) in
exchange for certain services provided by the
bank, such as check-clearing or credit
information. These balances raise the effective
rate of interest paid on borrowed funds.
Transaction loan, page 471 A loan where the
proceeds are designated for a specific
purpose—for example, a bank loan used
to finance the acquisition of a piece of
equipment.
Commercial paper, page 471 Short-term
unsecured promissory notes sold by large
businesses in order to raise cash. Unlike most
other money-market instruments, commercial
paper has no developed secondary market.
Pledging accounts receivable, page 473
A loan the firm obtains from a commercial
bank or a finance company using its accounts
receivable as collateral.
Factoring accounts receivable,
page 475 The outright sale of a firm’s
accounts receivable to another party (the
factor) without recourse. The factor, in turn,
bears the risk of collection.
Factor, page 475 A firm that, in acquiring the
receivables of other firms, bears the risk of
collection and, for a fee, services the accounts.
Inventory loans, page 475 Loans secured
by inventories. Examples include floating or

Chapter 15 • Working-Capital Management 479
blanket lien agreements, chattel mortgage
agreements, field-warehouse receipt loans, and
terminal-warehouse receipt loans.
Floating lien agreement, page 475 An
agreement, generally associated with a loan,
whereby the borrower gives the lender a lien
against all its inventory.
Chattel mortgage agreement, page 475
A loan agreement in which the lender can
increase his or her security interest by having
specific items of inventory identified in the
loan agreement. The borrower retains title to
the inventory but cannot sell the items without
the lender’s consent.
Field-warehouse agreement, page 475
A security agreement in which inventories
pledged as collateral are physically separated
from the firm’s other inventories and placed
under the control of a third-party
field-warehousing firm.
Terminal-warehouse agreement, page 476 A
security agreement in which the inventories
pledged as collateral are transported to a public
warehouse that is physically removed from the
borrower’s premises. This is the safest (though
costly) form of financing secured by inventory.
review questions
All Review Questions are available in MyFinanceLab.
15-1. Dell Computer Corporation (DELL) has long been recognized for its innovative approach
to managing its working capital. Describe how Dell pioneered the management of net working
capital to free up resources in the firm.
15-2. Define and contrast the terms working capital and net working capital.
15-3. Discuss the risk–return relationship involved in the firm’s asset-investment decisions as that
relationship pertains to its working-capital management.
15-4. What advantages and disadvantages are generally associated with the use of short-term debt?
Discuss.
15-5. Explain what is meant by the statement “The use of current liabilities as opposed to long-
term debt subjects the firm to a greater risk of illiquidity.”
15-6. Define the hedging principle. How can this principle be used in the management of working
capital?
15-7. Define the following terms:
a. Permanent asset investments
b. Temporary asset investments
c. Permanent sources of financing
d. Temporary sources of financing
e. Spontaneous sources of financing
15-8. How can the formula “interest = principle * rate * time” be used to estimate the cost of
short-term credit?
15-9. How can we accommodate the effects of compounding in our calculation of the effective cost
of short-term credit?
15-10. There are three major sources of unsecured short-term credit other than accrued wages and
taxes. List and discuss the distinguishing characteristics of each.
15-11. What is meant by the following trade credit terms: 2/10, net 30? 4/20, net 60? 3/15, net 45?
15-12. Define the following:
a. Line of credit
b. Commercial paper
c. Compensating balance
d. Prime rate
Study Problems
All Study Problems are available in MyFinanceLab.
15-1. (Risk–return trade-off ) The Carton Packing Company (CPC) is located in rapidly
growing Austin, Texas. To meet its need for funds to finance its growing assets the firm has
1

reinvested earnings and borrowed using short-term bank notes. Balance sheets for the last
5 years are found below:
Carton Packing Company Balance Sheets
J a n – 10 J a n – 11 J a n – 12 J a n – 13 J a n – 14
Sales—Net 2,873 3,475 5,296 7,759 12,327
Receivables 411 538 726 903 1,486
Accounts payable 283 447 466 1,040 1,643
Inventories 220 293 429 251 233
a. Compute CPC’s current ratio (current assets divided by current liabilities) and the
firm’s debt ratio (current plus long-term liabilities divided by total assets) for the
5-year period found above. Describe the firm’s risk using both the current ratio and
debt ratio.
b. Alter the financial statements above such that current liabilities remain constant at $50 and
long-term liabilities increase in the amount needed to meet the firm’s financing require-
ments. Compute CPC’s current ratio (current assets divided by current liabilities) and the
firm’s debt ratio (current plus long-term liabilities divided by total assets) using the revised
financial statements you have prepared for the 5-year period 2010–2014. Describe the
firm’s risk using both the current ratio and debt ratio.
c. Which of the financing plans is more risky? Why?
15-2. (Hedging principle) A popular theory for managing risk to the firm that arises out of its man-
agement of working capital (that is, current assets and current liabilities) involves following some-
thing called the principle of self-liquidating debt. How would this principle be applied in each of
the following situations? Explain your responses to each alternative.
a. Longleaf Homes owns a chain of senior housing complexes in the Seattle, Washington,
area. The firm is presently debating whether it should borrow short or long term to raise
$10 million in needed funds. The funds are to be used to expand the firm’s care facilities,
which are expected to last 20 years.
b. Arrow Chemicals needs $5 million to purchase inventory to support its growing sales vol-
ume. Arrow does not expect the need for additional inventory to diminish in the future.
c. Blocker Building Materials, Inc. is reviewing its plans for the coming year and expects that
during the months of November through January it will need an additional $5 million to
finance the seasonal expansion in inventories and receivables.
15-3. (Cash conversion cycle) Sims Electric Corp. has been striving for the last 5 years to improve its
management of working capital. Historical data for the firm’s sales, accounts receivable, invento-
ries, and accounts payable follow:
Sims electric Corp. Financial Data
2
3
2010 2011 2012 2013 2014
Current assets $100 $130 $160 $190 $220
Fixed assets 250 270 290 310 330
Total $350 $400 $450 $500 $550
Current liabilities $ 50 $ 90 $130 $170 $210
Long-term liabilities 100 100 100 100 100
Owners’ equity 200 210 220 230 240
Total $350 $400 $450 $500 $550
a. Calculate Sims’ days of sales outstanding and days of sales in inventory for each of the
5 years. What has Sims accomplished in its attempts to better manage its investments in
accounts receivable and inventory?
b. Calculate Sims’ cash conversion cycle for each of the 5 years. Evaluate Sims’ overall man-
agement of its working capital.
480 Part 5 • Working-Capital Management and International Business Finance

Chapter 15 • Working-Capital Management 481
15-4. (Estimating the cost of bank credit) Paymaster Enterprises has arranged to finance its seasonal
working-capital needs with a short-term bank loan. The loan will carry a rate of 12 percent per an-
num with interest paid in advance (discounted). In addition, Paymaster must maintain a minimum
demand deposit with the bank of 10 percent of the loan balance throughout the term of the loan.
If Paymaster plans to borrow $100,000 for a period of 3 months, what is the cost of the bank loan?
15-5. (Cost of short-term financing) The R. Morin Construction Company needs to borrow $100,000
to help finance the cost of a new $150,000 hydraulic crane used in the firm’s commercial construc-
tion business. The crane will pay for itself in 1 year, and the firm is considering the following
alternatives for financing its purchase:
Alternative A—The firm’s bank has agreed to lend the $100,000 at a rate of 14 percent.
Interest would be discounted and a 15 percent compensating balance would be required.
However, the compensating-balance requirement would not be binding on R. Morin be-
cause the firm normally maintains a minimum demand deposit (checking account) balance
of $25,000 in the bank.
Alternative B—The equipment dealer has agreed to finance the equipment with a 1-year
loan. The $100,000 loan would require payment of principal and interest totaling $116,300.
a. Which alternative should R. Morin select?
b. If the bank’s compensating-balance requirement were to necessitate idle demand deposits
equal to 15 percent of the loan, what effect would this have on the cost of the bank loan
alternative?
15-6. (Cost of secured short-term credit) The Sean-Janeow Import Co. needs $500,000 for the
3-month period ending September 30, 2013. The firm has explored two possible sources of
credit.
a. S-J has arranged with its bank for a $500,000 loan secured by its accounts receivable. The
bank has agreed to advance S-J 80 percent of the value of its pledged receivables at a rate of
11 percent plus a 1 percent fee based on all receivables pledged. S-J’s receivables average a
total of $1 million year-round.
b. An insurance company has agreed to lend the $500,000 at a rate of 9 percent per annum,
using a loan secured by S-J’s inventory of salad oil. A field-warehouse agreement would
be used, which would cost S-J $2,000 a month. Which source of credit should S-J select?
Explain.
15-7. (Cost of short-term financing) You plan to borrow $20,000 from the bank to pay for in-
ventories for a gift shop you have just opened. The bank offers to lend you the money at
10 percent annual interest for the 6 months the funds will be needed.
a. Calculate the effective rate of interest on the loan.
b. In addition, the bank requires you to maintain a 15 percent compensating balance in the
bank. Because you are just opening your business, you do not have a demand deposit ac-
count at the bank that can be used to meet the compensating-balance requirement. This
means that you will have to put up 15 percent of the loan amount from your own personal
money (which you had planned to use to help finance the business) in a checking account.
What is the cost of the loan now?
c. In addition to the compensating-balance requirement in part (b), you are told that interest
will be discounted. What is the effective rate of interest on the loan now?
15-8. (Estimating the cost of commercial paper) On February 3, 2012, the Burlington Western Company
plans a commercial paper issue of $20 million. The firm has never used commercial paper before but has
been assured by the firm placing the issue that it will have no difficulty raising the funds. The commer-
cial paper will carry a 270-day maturity and require interest based on a rate of 11 percent per annum. In
addition, the firm will have to pay fees totaling $200,000 to bring the issue to market and place it. What
is the effective cost of the commercial paper to Burlington Western?
15-9. (Cost of trade credit) Calculate the effective cost of the following trade credit terms when pay-
ment is made on the net due date:
a. 2/10, net 30
b. 3/15, net 30
c. 3/15, net 45
d. 2/15, net 60
15-10. (Annual percentage yield ) Compute the cost of the trade credit terms in problem 15-3 using
the compounding formula, or effective annual rate.
4

482 Part 5 • Working-Capital Management and International Business Finance
15-11. (Cost of short-term bank loan) On July 1, 2013, the Southwest Forging Corporation arranged
for a line of credit with the First National Bank of Dallas. The terms of the agreement call for
a $100,000 maximum loan with interest set at 1 percent over prime. In addition, the firm has to
maintain a 20 percent compensating balance in its demand deposit account throughout the year.
The prime rate is currently 12 percent.
a. If Southwest normally maintains a $20,000 to $30,000 balance in its checking account with
FNB of Dallas, what is the effective cost of credit under the line-of-credit agreement when
the maximum loan amount is used for a full year?
b. Recompute the effective cost of credit if the firm borrows the compensating balance and
the maximum possible amount under the loan agreement. Again, assume the full amount of
the loan is outstanding for a whole year.
15-12. (Cost of commercial paper) Tri-State Enterprises plans to issue commercial paper for the first
time in the firm’s 35-year history. The firm plans to issue $500,000 in 180-day maturity notes. The
paper will carry a 10 1/2 percent rate with discounted interest and will cost Tri-State $12,000 (paid
in advance) to issue.
a. What is the effective cost of credit to Tri-State?
b. What other factors should the company consider in analyzing whether to issue the com-
mercial paper?
15-13. (Cost of accounts receivable) Johnson Enterprises Inc. is involved in the manufacture and
sale of electronic components used in small AM/FM radios. The firm needs $300,000 to fi-
nance an anticipated expansion in receivables due to increased sales. Johnson’s credit terms
are net 60, and its average monthly credit sales are $200,000. In general, the firm’s customers
pay within the credit period; thus, the firm’s average accounts-receivable balance is $400,000.
Chuck Idol, Johnson’s comptroller, approached the firm’s bank with a request for a loan for
the $300,000 using the firm’s accounts receivable as collateral. The bank offered to make a loan
at a rate of 2 percent over prime plus a 1 percent processing charge on all receivables pledged
($200,000 per month). Furthermore, the bank agreed to lend up to 75 percent of the face value
of the receivables pledged.
a. Estimate the cost of the receivables loan to Johnson when the firm borrows the $300,000.
The prime rate is currently 11 percent.
b. Idol also requested a line of credit for $300,000 from the bank. The bank agreed to grant
the necessary line of credit at a rate of 3 percent over prime and required a 15 percent
compensating balance. Johnson currently maintains an average demand deposit of $80,000.
Estimate the cost of the line of credit to Johnson.
c. Which source of credit should Johnson select? Why?
15-14. (Cost of factoring) MDM Inc. is considering factoring its receivables. The firm has credit sales
of $400,000 per month and has an average receivables balance of $800,000 with 60-day credit terms.
The factor has offered to extend credit equal to 90 percent of the receivables factored less inter-
est on the loan at the rate of 1.5 percent per month. The 10 percent difference in the advance and
the face value of all receivables factored consists of a 1 percent factoring fee plus a 9 percent reserve,
which the factor maintains. In addition, if MDM Inc. decides to factor its receivables, it will sell
them all so that it can reduce its credit department costs by $1,500 a month.
a. What is the cost of borrowing the maximum amount of credit available to MDM Inc.
through the factoring agreement?
b. What considerations other than cost should be accounted for by MDM Inc. in determining
whether to enter the factoring agreement?
15-15. (Cost of factoring) A factor has agreed to lend the JVC Corporation working capital
on the following terms: JVC’s receivables average $100,000 per month and have a 90-day
average collection period. (Note that JVC’s credit terms call for payment in 90 days, and ac-
counts receivable average $300,000 because of the 90-day average collection period.) The fac-
tor will charge 12 percent interest on any advance (1 percent per month paid in advance) and a
2 percent processing fee on all receivables factored and will maintain a 20 percent reserve.
If JVC undertakes the loan, it will reduce its own credit department expenses by $2,000 per
month. What is the annual effective rate of interest to JVC on the factoring arrangement? As-
sume that the maximum advance is taken.
15-16. (Cost of a short-term bank loan) Jimmy Hale is the owner and operator of the grain elevator
in Brownfield, Texas, where he has lived for most of his 62 years. The rains during the spring have
been the best in a decade, and Mr. Hale is expecting a bumper wheat crop. This prompted him
to rethink his current financing sources. He now believes he will need an additional $240,000 for

Chapter 15 • Working-Capital Management 483
the 3-month period ending with the close of the harvest season. After meeting with his banker,
Mr. Hale is puzzling over what the additional financing will actually cost. The banker quoted him a
rate of 1 percent over prime (which is currently 7 percent) and also requested that the firm increase
its current bank balance of $4,000 up to 20 percent of the loan.
a. If interest and principal are all repaid at the end of the 3-month loan term, what is the an-
nual percentage rate on the loan offer made by Mr. Hale’s bank?
b. If the bank were to lower the rate to prime if interest is discounted, should Mr. Hale accept
this alternative?
15-17. (Terminology) Identify each of the following sources of short-term credit in terms of
whether they are secured (include some type of collateral) or are unsecured:
◆ Line of credit
◆ Pledging of accounts receivable
◆ Trade credit
◆ Factoring of accounts receivable
◆ Inventory loans
◆ Commercial paper
5

International Business Finance
Learning Objectives
1 Discuss the internationalization of business. The Globalization of Product and Financial Markets
2 Explain why foreign exchange rates in two Foreign Exchange Markets and Currency Exchange
different countries must be in line with each other. Rates
3 Discuss the concept of interest rate parity. Interest Rate Parity
4 Explain the purchasing-power parity theory Purchasing-Power Parity and the Law of One Price
and the law of one price.
5 Discuss the risks that are unique to the Capital Budgeting for Direct Foreign Investment
capital-budgeting analysis of direct foreign
investment.
484
16
It is generally easier for firms to expand the market for their products rather than develop new products, which
is why most large companies look for new markets around the world. That’s certainly been the direction that
McDonald’s (MCD) has taken in recent years. Today, McDonald’s operates more than 33,000 restaurants in over
123 countries. The busiest McDonald’s restaurant in the world is not in America but thousands of miles away in
Pushkin Square in Moscow, Russia. The store serves 40,000 customers a day, even more than it did on its opening
day, January 31, 1990. The menu is essentially the same as in the United States, with the addition of cabbage
pie among other traditional Russian food items.
Was this an expensive venture? It certainly was. In fact, the food plants that McDonald’s built to supply
burgers, fries, and everything else sold there cost more than $60 million. In addition to the costs, there are a
number of other factors that make opening an outlet outside of the United States both different and challeng-
ing. First, in order to keep the quality consistent with what is served at any McDonald’s anywhere else in the
world, McDonald’s spent 6 years putting together a supply chain that would provide the necessary raw materials
McDonald’s demands. On top of that, there are risks associated with the Russian economy and its currency that
are well beyond the scope of the risk exposures in the United States.
These risks all materialized in 1998 when the Russian economy, along with its currency, the ruble, tanked.
In the summer of 1998, the Russian economy spun out of control, and in August the entire banking system
failed, resulting in a catastrophic decline in the value of the ruble. Because McDonald’s sells its Russian burgers
for rubles, when it came time to trade the rubles for U.S. dollars, McDonald’s Russian outlets were not worth

nearly as much as they were the
year before. In spite of all this, the
Moscow McDonald’s has proven
to be enormously successful since
it opened. In fact, by 2012 there
were 314 McDonald’s restaurants in
Russia with plans to open 40 to 45
new locations each year. It all goes
to show that not all new investment
opportunities require new products;
introducing existing products to new
international markets can be equally
or even more profitable.
This chapter highlights the complications that an international business faces when it deals
in multiple currencies. Effective strategies for reducing foreign exchange risk are discussed.
Working-capital management and capital structure decisions in the international context
are also covered.
The Globalization of Product
and Financial Markets
To say the least, the market for most products crosses many borders. In fact, some industries
and states are highly dependent on the international economy. For example, the electronic
consumer products and automobile industries are widely considered to be global industries.
Ohio ranks fourth in the United States in terms of manufactured exports, and more than
half of Ohio workers are employed by firms that depend to some extent on exports.
There has also been a rise in the global level of international portfolio and direct
investment. Both direct and portfolio investments in the United States have been increas-
ing faster than U.S. investment overseas. Direct foreign investment (DFI) occurs when
the multinational corporation (MNC), a corporation with holdings and/or operations in more
than one country, has control over the investment, such as when it builds an offshore manu-
facturing facility. Portfolio investment involves financial assets with maturities greater than
1 year, such as the purchase of foreign stocks and bonds.
A major reason for direct foreign investment by U.S. companies is the high rates of
return obtainable from these investments. And the amount of U.S. direct foreign invest-
ment (DFI) abroad is large and growing. Significant amounts of the total assets, sales, and
profits of American MNCs are attributable to foreign investments and foreign operations.
Direct foreign investment is not limited to American firms. Many European and Japanese
firms have operations abroad, too. During the past decade, these firms have been increasing
their sales and setting up production facilities abroad, especially in the United States.
Capital flows (portfolio investment) between countries have also been increasing. Many
firms, investment companies, and individuals invest in the capital markets in foreign countries.
The motivation is twofold: to obtain returns higher than those obtainable in the domestic capi-
tal markets and to reduce portfolio risk through international diversification. The increase in
world trade and investment activity is reflected in the recent globalization of financial markets.
The Eurodollar market is now larger than any domestic financial market, and U.S. companies
are increasingly turning to this market for funds. Even companies and public entities that have
no overseas presence are beginning to rely on this market for financing.
485485
1 Discuss the internationalization
of business.
direct foreign investment (DFI) a
company from one country making a physical
investment, such as building a factory, in another
country.
multinational corporation (MNC) a
corporation with holdings and/or operations in
more than one country.
Eurodollars U.S. dollars held by foreign (often
European) banks and financial institutions outside
the United States, and often as a result of
payments to foreign companies for goods or
services.

486 Part 5 • Working-Capital Management and International Business Finance
In addition, most national financial markets are becoming more integrated with global
markets because of the rapid increase in the volume of interest rate and currency swaps.
(We will discuss currency swaps later in the chapter.) Because of the widespread availability
of these swaps, the currency denomination and the source country of financing for many
globally integrated companies are dictated by accessibility and relative-cost considerations,
regardless of the currency ultimately needed by the firm. Even a purely domestic firm that
buys all its inputs and sells all its output in its home country is not immune to foreign com-
petition, nor can it totally ignore the workings of the international financial markets.
Concept Check
1. Why do U.S. companies invest overseas?
Foreign Exchange Markets and Currency
Exchange Rates
The foreign exchange (FX) market is by far the world’s largest financial market, with
daily trading volumes of more than $4 trillion. Trading in this market is dominated by a
few key currencies including the U.S. dollar, the British pound sterling, the Japanese yen,
and the euro. The FX market is an over-the-counter market with participants (buyers and
sellers) located in major commercial and investment banks around the world. Table 16-1
lists the top 10 currencies traded in the FX market.
2 Explain why foreign exchange
rates in two different countries
must be in line with each other.
foreign exchange (FX) market the market
in which the currencies of various countries is
traded.
TablE 16-1 The Market for Foreign Exchange: Most Traded Currencies
Currency Percentage Shares of average Daily Turnover
U.S. dollar 84.9
Euro 39.1
Japanese yen 19.0
Pound sterling 12.9
Australian dollar 7.6
Swiss franc 6.4
Canadian dollar 5.3
Hong Kong dollar 2.4
Swedish krona 2.2
New Zealand dollar 1.6
Other 18.6
Total 200.0
Note: The total is 200% since trading volume includes one trade for buying and one for selling on each transaction, such that volume is double-counted.
Source: Triennial Central Bank Survey (December 2011), Bank for International Settlements.
Some of the major participants in foreign exchange trading include the following:
◆ Importers and exporters of goods and services. For example, when a U.S. importer purchases
goods from a Japanese manufacturer and pays using Japanese yen, the importer will
need to convert dollars to yen in the FX market. Similarly, if an exporter is paid in a
foreign firm’s domestic currency, it will enter the FX market to convert the payment to
its home currency.
◆ Investors and portfolio managers who purchase foreign stocks and bonds. Investors who acquire
the shares of foreign companies that are traded on a foreign exchange need foreign
currency to complete the transaction.
◆ Currency traders who make a market in one or more foreign currencies. Currency traders buy
and sell different currencies, hoping to make money from their trades.

Chapter 16 • International Business Finance 487
Foreign Exchange Rates
An exchange rate is simply the price of one currency stated in terms of another. For ex-
ample, if the exchange rate of U.S. dollars for British pounds was 2 to 1, this means that it
would take $2.00 to purchase 1 pound.
Reading Exchange Rate Quotes Table 16-2 shows the exchange rates from June 14,
2012, which are available online at The Wall Street Journal Online, reuters.com, xe.com, and
The Financial Times Online. In fact, The Financial Times Online even provides a Currencies
Macromap that displays a map of the world with a color-coded view of the performance of
the different world currencies relative to a currency of your choice.1 The first column of
Table 16-2 gives the number of dollars it takes to purchase one unit of foreign currency.
Because the exchange rate is expressed in U.S. dollars, it is referred to as a direct quote.
Given the figures in Table 16-2, we can see that it took $1.5562 to buy 1 British pound (£1),
$1.0518 to buy 1 Swiss franc, and $1.2633 to buy 1 euro. Conversely, an indirect quote
indicates the number of foreign currency units it takes to purchase one American dollar.
The second column shows the indirect exchange rate.
exchange rate the price of one currency
stated in terms of another.
1To view the Currencies Macromap, go to http://markets.ft.com/research/Markets/Currencies and click on Currencies
Macromap.
We can further illustrate the use of direct and indirect quotes with a simple example.
Suppose you want to compute the indirect quote from the direct quote for pounds given
in column 1 of Table 16-2. The direct quote for the British pound is $1.5562. The related
indirect quotes are calculated as the reciprocal of the direct quote as follows:
Indirect quote =
1
direct quote
(16-1)
Thus,
1
1.5562
= £0.6426
Notice that the indirect quote is identical to that shown in the second column of Table 16-2.
E X a M P L E 16.1 Computing an exchange amount using a direct quote
An American business must pay 1,000 euros to a German firm on June 14, 2012. Using
the information in Table 16-2, how many dollars will be required for this transaction?
STEP 1: FORMULATE A SOLUTION STRATEGY
The dollar amount required for this transaction can be computed using the following
equation:
Amount in dollars =
dollar amount
foreign currency
* ;1,000
Note that after finding the direct quote you must then multiply the amount by the
amount of foreign currency required for the transaction in order to obtain the required
dollar amount.
STEP 2: CRUNCH THE NUMBERS
Substituting into the equation we compute the dollar amount required as follows:
Amount in dollars =
$1.2633
; * ;1,000 = $1,263.30
STEP 3: ANALYZE YOUR RESULTS
For the American business to pay the German firm ;1,000, it will require $1,263.30 to
complete the transaction.
direct quote the exchange rate that indicates
the number of units of the home currency
required to buy one unit of a foreign currency.
indirect quote the exchange rate that
expresses the number of units of foreign cur-
rency that can be bought for one unit of home
currency.

http://markets.ft.com/research/Markets/Currencies

488 Part 5 • Working-Capital Management and International Business Finance
TaBLE 16-2 Foreign Exchange Rates (June 14, 2012)
U.S.-Dollar Foreign Exchange Rates in Late New York Trading
Country/currency U.S. $ Equivalent Trading and Currency Per U.S. $
americas
Brazil real 0.4864 2.056
Canada dollar 0.9777 1.0228
Colombia peso 0.0005577 1793.08
Mexico peso 0.0719 13.9004
Venezuela b. fuerte 0.22988506 4.35
asia-Pacific
Australian dollar 1.0025 0.9975
1-mos forward 0.99965778 1
3-mos forward 0.99432028 1.01
6-mos forward 0.98759862 1.01
China yuan 0.1569 6.372
Hong Kong dollar 0.1289 7.7588
India rupee 0.01795 55.69495
Japan yen 0.01260199 79.35
1-mos forward 0.01260671 79.32
3-mos forward 0.01261797 79.25
6-mos forward 0.0126379 79.13
New Zealand dollar 0.7826 1.2778
Pakistan rupee 0.0106 94.355
South Korea won 0.0008587 1164.55
Europe
Euro area euro 1.2633 0.7916
Norway krone 0.1683 5.942
Russia rubleá 0.03078 32.484
Sweden krona 0.1427 7.0092
Switzerland franc 1.0518 0.9508
1-mos forward 1.0524 0.9502
3-mos forward 1.0543 0.9485
6-mos forward 1.0574 0.9457
Turkey lira 0.5509 1.8152
UK pound 1.5562 0.6426
1-mos forward 1.556 0.6427
3-mos forward 1.5556 0.6429
6-mos forward 1.5551 0.643
Middle East/africa
Egypt pound 0.1653 6.0488
Israel shekel 0.2587 3.8655
Saudi Arabia riyal 0.2667 3.7502
South Africa rand 0.1194 8.3751
UAE dirham 0.2723 3.6724
Source: Data from Reuters and Wall Street Journal Online, June 14, 2012.
Note: Slight rounding error explains the fact that the numbers in the “U.S. $ Equivalent” column do not always equal the inverse of the numbers in the
“Currency per U.S. $” column.

Chapter 16 • International Business Finance 489
Exchange Rates and arbitrage
The foreign exchange quotes in two different countries must be in line with each other. If
the exchange rate quotations between the London and New York spot exchange markets
were out of line, then an enterprising trader could make a profit by buying in the market where the
currency was cheaper and selling it in the other. Such a buy-and-sell strategy would involve a
zero net investment of funds and no risk bearing, yet it would provide a sure profit. A per-
son executing this strategy is called an arbitrageur, and the process of buying and selling in
more than one market to make a riskless profit is called arbitrage. Spot exchange markets
are efficient in the sense that arbitrage opportunities do not persist for any length of time.
That is, the exchange rates between two different markets are quickly brought in line, aided
by the arbitrage process. Arbitrage eliminates exchange rate differentials across the markets for
a single currency, as in the preceding example for the New York and London quotes.
Suppose that you could buy a UK pound for $1.5400 in London rather than the $1.5562
quoted in New York in Table 16-2. If you simultaneously bought a pound in London for
$1.54 and sold it in New York for $1.5562, you would have (1) taken a zero net investment
position because you bought £1 and sold £1, (2) locked in a sure profit of $0.0162 on every
pound you bought and sold no matter which way the pound subsequently moves, and (3) set
in motion the forces that will eliminate the different quotes in New York and London. As
others in the marketplace learn of your transaction, they will attempt to make the same
transaction. The increased demand to buy pounds in London will lead to a higher quote
there, and the increased supply of pounds will lead to a lower quote in New York. The
workings of the market will produce a new spot rate that lies between $1.54 and $1.5562
and is the same in New York and in London.
asked and Bid Rates
Two types of rates are quoted in the spot exchange market: the asked and the bid rates. The
asked rate is the rate the bank or the foreign exchange trader “asks” the customer to pay in home
currency for foreign currency when the bank is selling and the customer is buying. The asked rate is
also known as the selling rate or the offer rate. The bid rate is the rate at which the bank buys
the foreign currency from the customer by paying in home currency. The bid rate is also known as
the buying rate. As you would expect, the asking price is greater than the bid price. Note that
Table 16-2 contains only the selling, offer, or asked rates, not the buying rate.
The bank sells a unit of foreign currency for more than it pays for it. Therefore, the
direct asked quote ($/FC) is greater than the direct bid quote. The difference between the asked
quote and the bid quote is known as the bid-asked spread. When there is a large volume of
transactions and the trading is continuous, the spread is small and can be less than 1 percent
(0.01) for the major currencies. The spread is much higher for infrequently traded curren-
cies. The spread exists to compensate the banks for holding the risky foreign currency and
for providing the service of converting currencies.
Cross Rates
A cross rate is the exchange rate between two foreign currencies, neither of which is the
currency of the domestic country. Some cross rates are given in Table 16-3. The following
example illustrates how two cross rates can be used to derive a third cross rate.
arbitrageur an individual involved in the
process of buying and selling in more than one
market to make a riskless profit.
arbitrage trading to eliminate exchange
rate differentials across the markets for a single
currency.
asked rate the rate the bank or the foreign
exchange trader “asks” the customer to pay
when the bank is selling and the customer is
buying. The asked rate is also known as the
selling rate or the offer rate.
bid rate the rate at which the bank buys the
foreign currency from the customer. The bid rate
is also known as the buying rate.
bid-asked spread the difference between
the asked quote and the bid quote.
Can You Do It?
USING THE SPOT RATE TO CALCULATE A FOREIGN CURRENCY PAYMENT
An American business must pay the equivalent of $10,000 in United Arab Emirates (UAE) dirhams to a firm in Dubai on June 14, 2012.
Using the information in Table 16-2, how many dirhams will the firm in Dubai receive?
(The solution can be found on page 491.)
cross rate the exchange rate between two
foreign currencies, neither of which is the
currency of the domestic country.

490 Part 5 • Working-Capital Management and International Business Finance
Dollar Euro Pound SFranc Peso Yen CdnDlr
Canada 1.0228 1.2920 1.5916 1.0757 0.0736 0.0129 …
Japan 79.3526 100.2426 123.4896 83.4613 5.7086 … 77.5860
Mexico 13.9004 17.5598 21.6320 14.6202 … 0.1752 13.5910
Switzerland 0.9508 1.2011 1.4796 … 0.0684 0.0120 0.9296
U.K. 0.6426 0.8117 … 0.6759 0.0462 0.0081 0.6283
Euro 0.7916 … 1.2319 0.8326 0.0569 0.0100 0.7740
U.S. … 1.2633 1.5562 1.0518 0.0719 0.0126 0.9777
E X a M P l E 16.2 Calculating the Canadian dollar/Swiss franc exchange rate
Calculate the Canadian dollar/Swiss franc and Swiss Franc/Canadian dollar exchange
rates using the cross-rates listed in columns 2 and 4 of Table 16-3.
STEP 1: FormulaTE a SoluTion STraTEgy
Columns 2 and 4 of Table 16-3 provide the Canadian dollar/euro and euro/Swiss Franc
rates, which can be used to determine the Canadian dollar/Swiss franc and Swiss franc/
Canadian dollar exchange rates as follows:
Canadian $
; *
;
Swiss franc
=
Canadian $
Swiss franc
Since the Swiss franc/Canadian dollar is reciprocal of this, it can then be calculated as the
reciprocal of the direct quote.
STEP 2: CrunCh ThE numbErS
Substituting into the equation we compute the euro/pound exchange rate:
Canadian $
; *
;
Swiss franc
= 1.2920 * 0.8326 =
1.0757 Canadian $
Swiss franc
Thus, the Swiss Franc/Canadian dollar exchange rate is:
1
1.0757
=
0.9296 Swiss francs
Canadian $
STEP 3: analyZE your rESulTS
The Canadian dollar/Swiss franc exchange rate is 1.0757 Canadian dollars per Swiss
franc, and the Swiss franc/Canadian dollar exchange rate is 0.9296 Swiss francs per
Canadian dollar. You’ll notice that these rates are the same exchange rates as those given
in Table 16-3 under Key Currency Cross Rates.
Types of Foreign Exchange Transactions
Thus far, the exchange rates and transactions we have discussed are those meant for im-
mediate delivery. This type of exchange rate is called a spot exchange rate. Another type
of transaction carried out in the foreign exchange markets is known as a forward exchange
rate, which is an exchange rate agreed upon today but which calls for delivery of currency
at the agreed rate at some future date.
The actual payment of one currency in exchange for the other takes place on a future
date called the delivery date, and the agreement that captures the terms of both the rate
Source: Data from Reuters and Wall Street Journal Online, June 14, 2012, wsj.com.
TablE 16-3 Key Currency Cross Rates, Thursday, June 14, 2012
spot exchange rate an exchange rate for a
transaction that calls for immediate delivery.
forward exchange rate an exchange rate for
a transaction that calls for delivery in the future.
delivery date the date on which the actual
payment of one currency in exchange for another
takes place in a foreign exchange transaction.

Chapter 16 • International Business Finance 491
and delivery is called a futures contract or forward exchange contract.2 For example, a
forward contract agreed upon on March 1 would specify the exchange rate and might call
for delivery on March 31. Note that the forward rate is not necessarily the same as the spot
rate that will exist in the future—in fact, no one knows exactly what the exchange rate will
be in the future. These contracts can be used to manage a firm’s exchange rate risk (the risk
that tomorrow’s exchange rate will differ from today’s rate) and are usually quoted for pe-
riods of between 30 days and 1 year. A contract for any intermediate date can be obtained,
usually with the payment of a small premium.
forward exchange contract an agreement
between two parties to exchange one currency
for another on a future date.
2These contracts are very similar, with one major difference being that futures contracts are exchange traded, while
f orward contracts are traded on the over-the-counter market.
Forward rates, like spot rates, are quoted in both direct and indirect form. The direct
quotes are the dollar/foreign currency rate, and the indirect quotes are the foreign cur-
rency/dollar rate, similar to the spot exchange quotes. The direct quotes for the 30-day
and 90-day forward contracts on pounds, yen, Australian dollars, and Swiss Francs are
given in column 1 of Table 16-2. As with spot rates, the indirect quotes for forward con-
tracts are reciprocals of the direct quotes. The indirect quotes are indicated in column 2
of Table 16-2.
DID You Get It?
USING THE SPOT RATE TO CALCULATE A FOREIGN CURRENCY PAYMENT
On page 489 you were asked to determine how much an American firm had to pay a firm in Dubai in the United Arab Emirates to
receive an equivalent of $10,000 in dirhams.
3.6724 dirhams/$ * $10,000 = 36,724 dirhams
Any time money changes hands internationally, there is a transaction in the foreign currency markets. Interestingly, the dollar is the
most frequently traded currency, accounting for over 42.5 percent of total trading volume, with the euro coming in second with a 19.6
percent share.
In Table 16-2 the 1-month forward quote for pounds is $1.556 per pound. This means
that the bank is contractually bound to deliver £1 at this price, and the buyer of the contract
is legally obligated to buy it at this price in 30 days. Therefore, this is the price the customer
must pay regardless of the actual spot rate prevailing in 30 days. If the spot price of the
pound is less than $1.556, then the customer pays more than the spot price. If the spot price
is greater than $1.556, then the customer pays less than the spot price.
The forward rate is often quoted at a premium or a discount from the existing spot rate. For ex-
ample, the 30-day forward rate for the pound may be quoted as a $0.0002 discount ($1.556
forward rate − $1.5562 spot rate). If the forward rate for the British pound is greater than
the spot rate, it is said to be selling at a premium relative to the dollar, and the dollar is said
to be selling at a discount to the British pound. This premium or discount is also called the
forward-spot differential.
Notationally, the relationship may be written
F – S = premium (F 7 S ) or discount (S 7 F )
where F = the forward rate, direct quote
S = the spot rate, direct quote
The premium or discount can also be expressed as an annual percentage rate, computed
as follows:
F – S
S
*
12
n
* 100 = annualized percentage
premium (F 7 S ) or discount (S 7 F ) (16-2)
where n = the number of months on the forward contract.
forward-spot differential the premium
or discount between forward and spot currency
exchange rates.

492 Part 5 • Working-Capital Management and International Business Finance
E X a M P L E 16.3 Computing the percent-per-annum discount
Using the information from Table 16-1, calculate the percent-per-annum discount on
the 90-day or 3-month pound.
STEP 1: FORMULATE A SOLUTION STRATEGY
First, we have to identify F (the 3-month forward rate), S (the spot rate), and n (the num-
ber of months on the forward contract):
F = 1.5556, S = 1.5562, n = 3 months
Next, because S is greater than F, we compute the annualized percentage discount using
equation (16-2):
F – S
S
*
12
n
* 100 = annualized percentage (16-2)
STEP 2: CRUNCH THE NUMBERS
When we substitute into the equation, we get
Annualized percentage =
1.5556 – 1.5562
1.5562
*
12 months
3 months
* 100 = -0.1542%
STEP 3: ANALYZE YOUR RESULTS
The percent-per-annum premium is negative on the 90-day pound at -0.1542%.
Can You Do It?
COMPUTING A PERCENT-PER-ANNUM PREMIUM
Using the information in Table 16-2, compute the percent-per-annum premium on the 90-day (3 month) yen.
(The solution can be found on page 493.)
Exchange Rate Risk
The concept of exchange rate risk applies to all types of international business. The mea-
surement of these risks, and the type of risk, differ among businesses. Let us see how ex-
change rate risk affects international trade contracts, international portfolio investments,
and direct foreign investments.
Exchange Rate Risk in International Trade Contracts The idea of exchange rate risk in
trade contracts is illustrated in the following situations.
Case I An American automobile distributor agrees to buy a car from the manufacturer in
Detroit. The distributor agrees to pay $25,000 on delivery of the car, which is expected
to be 30 days from today. The car is delivered on the 30th day and the distributor pays
$25,000. Notice that from the day this contract was written until the day the car was deliv-
ered, the buyer knew the exact dollar amount of the liability. There was, in other words, no
uncertainty about the value of the contract.
Case II An American automobile distributor enters into a contract with a British supplier
to buy a car from Britain for £16,065. The amount is payable upon the delivery of the

Chapter 16 • International Business Finance 493
car, 30 days from today. Unfortunately, the exchange rate between British pounds and
U.S. dollars may change in the next 30 days. In effect, the American firm is not certain
what its future dollar outflow will be 30 days hence. That is, the dollar value of the contract
is uncertain.
These two examples help illustrate the idea of foreign exchange risk in international
trade contracts. In the domestic trade contract (Case I), the exact dollar amount of the
future dollar payment is known today with certainty. In the case of the international trade
contract (Case II), in which the contract is written in the foreign currency, the exact dollar
amount of the contract is not known. The variability of the exchange rate causes variability
in the future cash flow of the firm.
Exchange rate risk exists when the contract is written in terms of the foreign currency,
or denominated in foreign currency. There is no direct exchange rate risk if the international
trade contract is written in terms of the domestic currency. That is, in Case II, if the con-
tract were written in dollars, the American importer would face no direct exchange rate risk.
With the contract written in dollars, the British exporter would bear all of the exchange
rate risk because the British exporter’s future pound receipts would be uncertain. That is,
the British exporter would receive payment in dollars, which would have to be converted
into pounds at an unknown (as of today) future pound/dollar exchange rate. In international
trade contracts of this type, at least one of the two parties to the contract always bears the
exchange rate risk.
Certain types of international trade contracts are denominated in a third currency
that is different from either the importer’s or the exporter’s domestic currency. In Case
II, the contract might have been denominated in, say, the Hong Kong dollar. With a
Hong Kong dollar contract, both the importer and exporter would be subject to exchange
rate risk.
Exchange rate risk is not limited to the two-party trade contracts; it exists also in foreign
portfolio investments and direct foreign investments.
Exchange Rate Risk in Foreign Portfolio Investments Let us look at an example of
exchange rate risk in the context of portfolio investments. An American investor buys
a Hong Kong security. The exact return on the investment in the security is unknown.
Thus, the security is a risky investment. The investment return in the holding period of, say,
3 months stated in HK$ could be anything from -2 to +8 percent. In addition, the U.S. dol-
lar/HK$ exchange rate may depreciate by, say, 4 percent or appreciate by 6 percent during
the 3-month period. The return to the American investor in U.S. dollars will, therefore, be
in the range of -6 to +14 percent. Hence, the exchange rate fluctuations may increase the
riskiness of the investments.
DID You Get It?
COMPUTING A PERCENT-PER-ANNUM PREMIUM
Compute the percent-per-annum premium on the 90-day yen.
STEP 1 Identify F, S, and n.
F = $0.01261797/¥, S = $0.01260199/¥, and n = 3 months
STEP 2 Because F is greater than S, we compute the annualized percentage premium:
0.01261797 – 0.01260199
0.01260199
*
12 months
3 months
* 100 = 0.5072%
The percent-per-annum premium on the 90-day yen is 0.5072 percent.

494 Part 5 • Working-Capital Management and International Business Finance
Exchange Rate Risk in Direct Foreign Investment The
exchange rate risk of a direct foreign investment (DFI) is
more complicated. In a DFI, the parent company invests in
assets denominated in a foreign currency. That is, the balance
sheet and the income statement of the subsidiary are writ-
ten in terms of the foreign currency. The parent company, if
based in the United States, receives the repatriated (or con-
verted) profit stream from the subsidiary in dollars. Thus, the
exchange rate risk concept applies to fluctuations in the dollar
value of the assets located abroad as well as to the fluctuations
in the home currency–denominated profit stream. Moreover,
exchange risk not only affects immediate profits but may also
affect the future profit stream as well.
Although exchange rate risk can be a serious complica-
tion in international business activity, remember the principle of the risk–return trade-off:
Traders and corporations find numerous reasons why the returns from international trans-
actions outweigh the risks.
Concept Check
1. What is a spot transaction? What is a direct quote? An indirect quote?
2. Who is an arbitrageur? How does an arbitrageur make money?
3. What is a forward exchange rate?
4. Describe exchange rate risk in direct foreign investment.
Interest Rate Parity
Interest rates can vary dramatically from country to country. For example, in mid-2012 the
1-year interest rate in the United States was approximately 0.87 percent, while in Turkey it
was 7.98 percent. The concepts of interest rate parity and purchasing-power parity, which
we will introduce shortly, provide the basis for understanding how prices and rates of inter-
est across different countries are related to one another.
Interest rate parity (IRP) theory can be used to relate differences in the interest
rates in two countries to the ratios of spot and forward exchange rates of the two countries’
currencies. Specifically, the interest parity condition can be stated as follows:
Difference in
interest rates
=
ratio of the
forward and spot rates¢1 + domestic
rate of interest
≤¢1 + foreign
rate of interest
≤ = ¢ forward exchange ratespot exchange rate ≤ (16-3)
This equation can be rearranged such that,
a1 + domestic
rate of interest
b = a forward exchange rate
spot exchange rate
ba1 + foreign
rate of interest
b (16-3a)
To illustrate how this equation is applied, consider the following situation. Suppose
that the 6-month risk-free rate of interest in the United States was 2 percent. On that date
the spot exchange rate between the U.S. dollar and the Japanese yen ($>¥) was 0.010798
and the forward exchange rate for 6 months hence was 0.010803. According to interest rate
REMEMBER YOUR PRINCIPLES
In international transactions, just as in domestic
transactions, the key to value is the timing and amounts of
cash flow spent and received. However, economic transac-
tions across international borders add an element of risk be-
cause cash flows are often denominated in the currency of the
country in which business is being transacted. Consequently,
the dollar value of the cash flows will depend on the exchange
rate that exists at the time the cash changes hands. The fact re-
mains, however, that it’s cash spent and received that matters.
This is the point of Cash Flow Is What Matters.
rinciple
3 Discuss the concept of interest
rate parity.
interest rate parity (IRP) theory a theory
that states that (except for the effects of small
transaction costs) the forward premium or
discount should be equal and opposite in size to
the difference in the national interest rates for
securities of the same maturity.

Chapter 16 • International Business Finance 495
parity, what would you expect the 6-month risk-free rate of interest to be in Japan? Substi-
tuting into equation (16-3a) we calculate the following:
a1 + U.S. 6@month riskfree
rate of interest
b = a forward exchange rate
spot exchange rate
ba1 + Japanese 6month riskfree
rate of interest
b
(1 + 0.02) = a0.010803
0.010798
ba1 + Japanese 6month riskfree
rate of interest
b
(1 + 0.02) = 1.000463a1 + Japanese 6month riskfree
rate of interest
b
Thus, the Japanese 6-month risk-free rate of interest = 0.019528, or 1.9528 percent.
What this means is that you get the same total return whether you change your dol-
lars to yen and invest in the risk-free rate in Japan and then convert them back to dollars
or simply invest your dollars in the U.S. risk-free rate of interest. For example, if you
started with $100 and converted it to yen at the spot rate of 0.010798 $>¥, you’d have
9,260.97 yen; if you invested those yen at 1.9528 percent, after 6 months you’d have
¥9,441.82. Converting this back to dollars at the forward rate you end up with $102.00,
the same as you would have if you had invested your dollars at the U.S. 6-month rate
of 2 percent.
Concept Check
1. In simple terms, what does the interest rate parity theory mean?
Purchasing-Power Parity and the
Law of One Price
According to the theory of purchasing-power parity (PPP), exchange rates adjust so that
identical goods cost the same amount regardless of where in the world they are purchased.
For example, if an Apple iPad costs $399 in the United States and ;319.20 in France,
according to the purchasing-power parity theory, the spot exchange rate should be $1.25
per euro ($399/;319.20). Thus, if you would like to buy a new iPad, you could either buy
it for $399 in the United States or trade in your $399 for ;319.20 and buy your iPad in
France—either way it costs you the same amount. Stated formally,
Spot exchange
rate for euros ($/;) *
French price of
an iPad
=
U.S. price of
an iPad
More generally, the spot exchange rate for the foreign country (in this case the spot exchange
rate for euros) should be equal to the ratio of the price of the good in the home country (Ph)
to the price of the same good in the foreign country (Pf), that is,
Spot exchange rate =
Ph
Pf
Thus, as we just showed, the spot exchange rate of $/; should be the following:
Spot exchange rate =
Ph
Pf
=
$399
;319.20 = $1.25>;
Therefore, PPP implies that if a new Callaway RAZR Fit golf club cost ;320 in France,
it should cost ;320 * 1.25 = $400 in the United States where the $/; exchange rate
is 1.25.
Underlying the PPP relationship is a fundamental economic principle called the law of
one price. Applied to international trade, this law states that the same goods should sell for
the same price in different countries after making adjustment for the exchange rate between
4 Explain the purchasing-power
parity theory and the law of
one price.
purchasing-power parity (PPP) a theory
that states that exchange rates adjust so that
identical goods cost the same amount regardless
of where in the world they are purchased.
law of one price an economic principle
that states that a good or service cannot sell for
different prices in the same market. Applied to
international markets, this law states that the
same goods should sell for the same price in dif-
ferent countries after making adjustment for the
exchange rate between the two currencies.

496 Part 5 • Working-Capital Management and International Business Finance
the two currencies. The idea is that the worth of a good does not depend on where it is
bought or sold. Thus, in the long run, exchange rates should adjust so that the purchasing
power of each currency is the same. As a result, exchange rates should reflect the interna-
tional differences in inflation rates with currencies with high rates of inflation experiencing
declines in the value of their currency.
There are enough obvious exceptions to the concept of purchasing-power parity that it
may, at first glance, seem difficult to accept. To illustrate differences in purchasing power
across countries, the Economist publishes what it calls its Big Mac Index, which compares
the price of a Big Mac in different countries. In 2012, a Big Mac cost $4.20 in the United
States; and, given the then-existing exchange rates, it cost an equivalent of $2.11 in the
Ukraine, $2.12 in Hong Kong, $2.44 in China, $6.79 in Norway, and $6.81 in Switzerland.
Why aren’t these prices the same? First, tax differences between countries can be one cause.
In addition, labor costs and the rental cost of the McDonald’s outlets may differ across
countries.
So, does this mean that PPP does not hold? Well it clearly does not hold for what econ-
omists call nontraded goods, like restaurant meals and haircuts. As we all know, for these
goods, purchasing-power parity does not hold even within the United States—indeed, a Big
Mac does not sell for the same price in Des Moines as it does in Los Angeles. However, for
goods that can be very cheaply shipped between countries, like expensive gold jewelry, we
expect PPP to hold relatively closely.
Clearly, a dollar doesn’t go very far in Switzerland and Norway, but you get a lot for a
dollar in Asian countries like China, Thailand, and Malaysia. Why does this matter? When
the world is going through economic problems, as it has recently, a strong exchange rate
(that is, one whose domestic currency buys relatively more units of foreign currency) makes
it difficult to sell goods abroad and makes foreign goods look less expensive. On the other
hand, a country with a weak exchange rate (that is, one whose domestic currency buys
relatively fewer units of foreign currency), like China, has an easier time selling goods
abroad (because its goods are less expensive abroad). However, the weak exchange rate
made it more difficult for Chinese consumers to buy pricey imports over cheaper Chinese-
produced goods.
The International Fisher Effect
According to the domestic Fisher effect, nominal interest rates reflect the expected inflation
rate, a real rate of interest and the product of the real rate of interest and the inflation rate.
In other words,
Nominal
interest rate
=
expected
inflation rate
+
real rate
of interest
+ ¢ expected
inflation rate
*
real rate
of interest
≤ (16-4)
Although there is mixed empirical support for the international Fisher effect, it is widely
thought that, for the major industrial countries, the real rate of interest is about 3 percent
when a long-term period is considered. Thus, if the expected inflation rate was 2 percent in
Britain and 4 percent in Japan, the interest rates in Britain and Japan would be 0.02 + 0.03 +
0.0006, or 5.06, percent and 0.04 + 0.03 + 0.0012, or 7.12 percent, respectively.
In effect, the international Fisher effect states that the real interest rate should
be the same all over the world, with the difference in nominal or stated interest rates
simply resulting from the differences in expected inflation rates. As we look at interest
rates around the world, this tells us that we should not necessarily send our money to a
bank account in the country with the highest interest rates. That course of action might
only result in sending our money to a bank in the country with the highest expected
level of inflation.
Concept Check
1. What does the law of one price say?
2. What is the international Fisher effect?

Chapter 16 • International Business Finance 497
Capital Budgeting for Direct Foreign
Investment
Today, there is no ducking the global markets, and it is common for U.S. firms to open
manufacturing and sales operations abroad. In fact, in 2011 Yum! Brands (the parent com-
pany of KFC, Pizza Hut, and Taco Bell) invested over half a billion dollars to purchase the
Chinese hot pot chain Little Sheep. Direct foreign investment occurs when a company
from one country makes a physical investment, perhaps building a factory in another coun-
try. Examples of such a direct foreign investment include Yum! Brands’ store in Dubai and
Dell Computer Corporation’s (DELL) construction of offshore manufacturing facilities in
China, India, and Mexico.
Many European and Japanese firms, like their American counterparts, have operations
abroad as well. During the last decade, these firms have been increasing their sales and set-
ting up production facilities abroad, especially in the United States. A major reason for direct
foreign investment by U.S. companies is the prospect of higher rates of return from these
investments. As you know from Principle 3: Risk Requires a Reward, while there may be
higher expected rates of return with many foreign investments, many of them also come with
increased risk.
The method used by multinational corporations to evaluate foreign investments is
very similar to the method used to evaluate capital-budgeting decisions in a domestic
context—but with some additional considerations. When corporations invest abroad they
generally set up a subsidiary in the country in which they are investing. Funds then are
transferred back, or repatriated, to the parent firm in its home country through dividends,
royalties, and management fees, with both the dividends and royalties subject to taxation
in both the foreign and home countries. Moreover, many countries restrict the flow of
funds back to the home country. As a result, there is often a difference between the cash
flows that a project produces and the cash flows that can be repatriated to its parent coun-
try. To evaluate these investment projects, firms discount the cash flows that are expected to be
repatriated to the parent firm. As we know from Principle 1: Cash Flow Is What Matters, we
are only interested in the cash flows that we expect the subsidiary to return to the parent
company. In most cases, the timing is crucial. If your project generates cash flows in 2015
that cannot be repatriated until 2018, the cash flows must be discounted from the 2018
date when the cash will be actually received. Once the cash flows are estimated, they must
be discounted back to present at the appropriate discount rate or required rate of return,
with both the discount rate and the cash flows being measured in the same currency.
Thus, if the discount rate is based on dollar-based interest rates, the cash flows must also
be measured in dollars.
Foreign Investment Risks
Risk in domestic capital budgeting arises from two sources: (1) business risk related to the
specific attributes of the product or service being provided and the uncertainty associated
with that market, and (2) financial risk, which is the risk imposed on the investment as a re-
sult of how the project is financed. The foreign direct investment opportunity includes both
these sources of risk, plus political risk and exchange rate risk. Since business and finance
risk have been discussed at some length in previous chapters, let us consider the risks that
are unique to international investing.
Political Risk Political risk can arise if the foreign subsidiary conducts its business in
a politically unstable country. A change in a country’s political environment frequently
brings a change in policies with respect to businesses—and especially with respect to
foreign businesses. An extreme change in policy might involve nationalization or even
outright expropriation (government seizure) of certain businesses. For example, in 2007
Venezuela nationalized the country’s largest telecommunications company, several electrical
companies, and four lucrative oil projects that were owned by ExxonMobil, Chevron,
3
rinciple
1
rinciple
5 Discuss the risks that are unique
to the capital-budgeting
analysis of direct foreign
investment.

498 Part 5 • Working-Capital Management and International Business Finance
and ConocoPhillips. These are the political risks of conducting business abroad. Some
examples of political risk are as follows:
1. Expropriation of plants and equipment without compensation
2. Expropriation with minimal compensation that is below actual market value
3. Nonconvertibility of the subsidiary’s foreign earnings into the parent’s currency—the
problem of blocked funds
4. Substantial changes in tax rates
5. Governmental controls in the foreign country regarding the sale price of certain prod-
ucts, wages and compensation paid to personnel, the hiring of personnel, transfer pay-
ments made to the parent, and local borrowing
6. Requirements regarding the local ownership of the business
All of these controls and governmental actions put the cash flows of the investment to
the parent company at risk. Thus, these risks must be considered before making the foreign
investment decision. For example, the MNC might decide against investing in countries
with risks of types 1 and 2 as mentioned above, whereas other risks can be borne—provided
that the returns from the foreign investments are high enough to compensate for them. It
should be noted that although an MNC cannot protect itself against all foreign political
risks, insurance against some types of political risks can be purchased from private insur-
ance companies or from the U.S. government’s Overseas Private Investment Corporation.
Exchange Rate Risk Exchange rate risk is the risk that the value of a firm’s operations
and investments will be adversely affected by changes in exchange rates. For example, if
U.S. dollars must be converted into euros before making an investment in Germany, an
adverse change in the value of the dollar with respect to the euro will affect the total gain or
loss on the investment when the money is converted back to dollars.
Concept Check
1. Define the types of risk that are commonly referred to as political risk, and give some examples
of them.
2. What is exchange rate risk? Why would a multinational firm be concerned about it?
Chapter Summaries
Discuss the internationalization of business. (pgs. 485–486)
SUMMaRY: The growth of our global economy, the increasing number of multinational cor-
porations, and the increase in foreign trade itself underscore the importance of the study of
international finance. In addition, capital flows (portfolio investment) between countries has
been increasing in order to obtain higher returns and reduce portfolio risk through international
diversification.
KEY TERMS
1
Direct foreign investment (DFI),
page 485 A company from one country
making a physical investment such as
building a factory in another country.
Multinational corporation (MNC),
page 485 A corporation with holdings and/or
operations in more than one country.
Eurodollars, page 485 U.S. dollars held by
foreign (often European) banks and finan-
cial institutions outside the United States,
and often as a result of payments to foreign
companies for goods or services.

Chapter 16 • International Business Finance 499
Explain why foreign exchange rates in two different countries must be in
line with each other. (pgs. 486–494)
SUMMaRY: The foreign exchange (FX) market is where one currency is traded for another. This is
by far the largest financial market in the world, with a daily trading volume of more than $4 trillion.
Trading is dominated by a few key currencies, including the U.S. dollar, the British pound sterling,
the Japanese yen, and the euro. The FX market is an over-the-counter market rather than a single
exchange location like the New York Stock Exchange where buyers and sellers get together. This
means that market participants (buyers and sellers) are located in major commercial and investment
banks around the world.
KEY TERMS
2
Foreign exchange (FX) market,
page 486 The market in which the currencies
of various countries is traded.
Exchange rate, page 487 The price of one
currency stated in terms of another.
Direct quote, page 487 The exchange rate
that indicates the number of units of the home
currency required to buy one unit of a foreign
currency.
Indirect quote, page 487 The exchange rate
that expresses the number of units of foreign
currency that can be bought for one unit of
home currency.
Arbitrageur, page 489 An individual in-
volved in the process of buying and selling
in more than one market to make a riskless
profit.
Arbitrage, page 489 Trading to eliminate
exchange rate differentials across the markets
for a single currency.
Asked rate, page 489 The rate the bank or
the foreign exchange trader “asks” the cus-
tomer to pay when the bank is selling and
the customer is buying. The asked rate is also
known as the selling rate or the offer rate.
Bid rate, page 489 The rate at which the bank
buys the foreign currency from the customer.
The bid rate is also known as the buying rate.
Bid-asked spread, page 489 The difference
between the asked quote and the bid quote.
Cross rate, page 489 The exchange rate
between two foreign currencies, neither of
which is the currency of the domestic country.
Spot exchange rate, page 490 An exchange
rate for a transaction that calls for immediate
delivery.
Forward exchange rate, page 490 An
exchange rate for a transaction that calls for
delivery in the future.
Delivery date, page 490 The date on
which the actual payment of one currency in
exchange for another takes place in a foreign
exchange transaction.
Forward exchange contract, page 491 An
agreement between two parties to exchange
one currency for another on a future date.
Forward-spot differential, page 491 The
premium or discount between forward and
spot currency exchange rates.
KEY EQUaTIONS
Indirect quote =
1
direct quote
F – S = e Premium if F 7 S
Discount if F 6 S
F – S
S
*
12
n
* 100 = annualized percentage
where n = the number of months of the forward contract
Discuss the concept of interest rate parity. (pgs. 494–495)
SUMMaRY: The forward exchange market provides a valuable service by quoting rates for the delivery
of foreign currencies in the future. The foreign currency is said to sell at a discount relative to the spot
rate when the forward rate is lower than the spot rate. It is said to sell at a premium relative to the spot
rate when the forward rate is higher than the spot rate. According to the interest rate parity theory, these
premiums and discounts depend solely on the differences in the levels of the interest rates of countries.
3

500 Part 5 • Working-Capital Management and International Business Finance
KEY TERM
Interest rate parity (IRP) theory, page 494
A theory that states that (except for the
effects of small transaction costs) the for-
ward premium or discount should be equal
and opposite in size to the difference in the
national interest rates for securities of the same
maturity.
KEY EQUaTIONS
a1 + domestic
rate of interest
b = a forward exchange rate
spot exchange rate
ba1 + foreign
rate of interest
b
Nominal rate
of interest
=
expected rate
of inflation
+
real rate
of interest
+ aexpected rate
of inflation
ba real rate
of return
b
Explain the purchasing-power parity theory and the law of one
price. (pgs. 495–496)
SUMMaRY: According to the purchasing-power parity (PPP) theory, in the long run, exchange
rates adjust so that the purchasing power of each currency is the same. Thus, exchange rate changes
tend to reflect international differences in inflation rates. As a result, countries with high rates of
inflation tend to experience declines in the value of their currency. Underlying the PPP relationship
is the law of one price. This law is actually a proposition that in competitive markets in which there
are no transportation costs or barriers to trade, the same goods sold in different countries sell for
the same price if all of the different prices are expressed in terms of the same currency.
KEY TERMS
4
Purchasing-power parity (PPP), page 495 A
theory that states that exchange rates adjust
so that identical goods cost the same amount
regardless of where in the world they are
purchased.
Law of one price, page 495 An economic
principle that states that a good or service
cannot sell for different prices in the same mar-
ket. Applied to international markets, this law
states that the same goods should sell for the
same price in different countries after making
adjustment for the exchange rate between the
two currencies.
Discuss the risks that are unique to the capital-budgeting analysis of direct
foreign investment. (pgs. 497–498)
SUMMaRY: The complexities encountered in the direct foreign investment decision include the
usual sources of risk—business and financial—faced by domestic investments, plus additional risks
associated with political considerations and fluctuating exchange rates. Political risk is caused by
differences in political climates, institutions, and processes between the home country and abroad.
Under these conditions, the estimation of future cash flows and the choice of the proper discount
rates are more complicated than for the domestic investment situation.
Review Questions
All Review Questions are available in MyFinanceLab.
16-1. What additional factors are encountered in international as compared with domestic finan-
cial management? Discuss each briefly.
16-2. What different types of businesses operate in the international environment? Why are the
techniques and strategies available to these firms different?
16-3. What is meant by arbitrage profits?
16-4. What are the markets and mechanics involved in generating simple arbitrage profits?
5

Chapter 16 • International Business Finance 501
16-5. How do purchasing-power parity, interest rate parity, and the Fisher effect explain the rela-
tionships among the current spot rate, the future spot rate, and the forward rate?
16-6. What is meant by (a) exchange risk and (b) political risk?
16-7. In the New York exchange market, the forward rate for the Indian currency, the rupee, is
not quoted. If you were exposed to exchange risk in rupees, how could you hedge your position?
16-8. What risks are associated with direct foreign investment? How do these risks differ from
those encountered in domestic investment?
16-9. Are the inputs more complicated to a direct foreign investment than those to the domestic
investment problem? If so, why?
Study Problems
All Study Problems are available in MyFinanceLab.
The data for Study Problems 16-1 through 16-5 are given in the following table:
CO U N T R Y CO N T R aC T $/ F O R E I G N C U R R E N C Y
Canada—dollar Spot 0.8437
30-day 0.8417
90-day 0.8395
Japan—yen Spot 0.004684
30-day 0.004717
90-day 0.004781
Switzerland—franc Spot 0.5139
30-day 0.5169
90-day 0.5315
16-1. (Spot exchange rates) An American business needs to pay (a) 10,000 Canadian dollars, (b) 2
million yen, and (c) 50,000 Swiss francs to businesses abroad. What are the dollar payments to the
respective countries?
16-2. (Spot exchange rates) An American business pays $10,000, $15,000, and $20,000 to suppliers
in, respectively, Japan, Switzerland, and Canada. How much, in local currencies, do the suppliers
receive?
16-3. (Indirect quotes) Compute the indirect quote for the spot and forward Canadian dollar, yen,
and Swiss franc contracts.
16-4. (Exchange rate arbitrage) You own $10,000. The dollar rate in Tokyo is 216.6743. The yen
rate in New York is given in the preceding table. Are arbitrage profits possible? Set up an arbitrage
scheme with your capital. What is the gain (loss) in dollars?
16-5. (Cross rates) Compute the Canadian dollar/yen and the yen/Swiss franc spot rate from the
data in the preceding table.
16-6. (Spot exchange rate) If one euro buys 1.32 U.S. dollars, how many euros can you purchase for
3 U.S. dollars?
16-7. (Spot exchange rate) Suppose the exchange rate between U.S. dollars and Japanese yen is $1
US = ¥79.1 JPY, and the exchange rate between the U.S. dollar and the British pound is $1 US =
£0.64 GBP. What is the cross rate of Japanese yen to British pounds? (In other words, how many
yen are needed to purchase 1 pound?)
16-8. (Spot exchange rate) Suppose 1 year ago, Miller Company had inventory in Britain valued at
1.5 million Swiss francs. The exchange rate for dollars to Swiss francs was 1 franc = 1.15 dollars.
Today, the exchange rate is 1 Swiss franc = 1.06 U.S. dollars. The inventory in Switzerland is still
valued at 1.5 million francs. What is the U.S. dollar gain or loss in inventory value as a result of the
change in exchange rates?
1
2

502 Part 5 • Working-Capital Management and International Business Finance
16-9. (Cross rates) This morning, you noticed the following information in your financial newspaper:
1 British po3und = 103.25 yen (JPY)
1 U.S. dollar = 81.23 yen
1 U.S. dollar = 0.77 euros
Given this information, how many euros did the newspaper likely state could be converted from 1
British pound?
16-10. (Interest rate parity) Suppose 90-day investments in Europe have a 5 percent annualized
return and a 1.25 percent quarterly (90-day) return. In the United States, 90-day investments
of similar risk have a 7 percent annualized return and a 1.75 percent quarterly return. In to-
day’s 90-day forward market, 1 euro equals $1.32. If interest rate parity holds, what is the spot
exchange rate ($/;)?
16-11. (Purchasing-power parity) A McDonald’s Big Mac costs 2.44 yuan in China, but costs $4.20
in the United States. Assuming that purchasing-power parity (PPP) holds, how many Chinese yuan
are required to purchase 1 U.S. dollar?
Mini Case
This Mini Case is available in MyFinanceLab.
For your job as the business reporter for a local newspaper, you are asked to put together a series
of articles on multinational finance and the international currency markets for your readers. Much
recent local press coverage has been given to losses in the foreign exchange markets by JGAR, a
local firm that is the subsidiary of Daedlufetarg, a large German manufacturing firm.
Your editor would like you to address several specific questions dealing with multinational
finance. Prepare a response to the following memorandum from your editor:
To: Business Reporter
From: Perry White, Editor, Daily Planet
Re: Upcoming Series on Multinational Finance
In your upcoming series on multinational finance, I would like to make sure you cover several
specific points. Before you begin this assignment, I want to make sure we are all reading from the
same script because accuracy has always been the cornerstone of the Daily Planet. I’d like a response
to the following questions before we proceed:
a. What new problems and factors are encountered in international, as opposed to domes-
tic, financial management?
b. What does the term arbitrage profits mean?
c. What can a firm do to reduce exchange risk?
d. What are the differences among a forward contract, a futures contract, and options?
Use the following data in your responses to the remaining questions:
Selling Quotes for Foreign Currencies in New York
CO U N T RY — C U R R E N C Y CO N T R aC T $/ F O R E I G N
Canada—dollar Spot 0.8450
30-day 0.8415
90-day 0.8390
Japan—yen Spot 0.004700
30-day 0.004750
90-day 0.004820
Switzerland—franc Spot 0.5150
30-day 0.5182
90-day 0.5328
3
4

Chapter 16 • International Business Finance 503
e. An American business needs to pay (a) 15,000 Canadian dollars, (b) 1.5 million yen, and (c)
55,000 Swiss francs to businesses abroad. What are the dollar payments to the respective
countries?
f. An American business pays $20,000, $5,000, and $15,000 to suppliers in, respectively,
Japan, Switzerland, and Canada. How much, in local currencies, do the suppliers receive?
g. Compute the indirect quote for the spot and forward Canadian dollar contract.
h. You own $10,000. The dollar rate in Tokyo is 216.6752. The yen rate in New York is given
in the preceding table. Are arbitrage profits possible? Set up an arbitrage scheme with your
capital. What is the gain (loss) in dollars?
i. Compute the Canadian dollar/yen spot rate from the data in the preceding table.

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accounting book value—the value of an
asset as shown on a firm’s balance sheet. It
represents the depreciated historical cost
of the asset rather than its current market
value or replacement cost.
accounts payable (trade credit)—credit
provided by suppliers when a firm pur-
chases inventory on credit.
accounts receivable—money owed by
customers who purchased goods or services
from the firm on credit.
accounts receivable turnover ratio—a firm’s
credit sales divided by its accounts receiv-
able. This ratio expresses how often
accounts receivable are “rolled over”
during a year.
accrual basis accounting—a method of
accounting whereby revenue is recorded
when it is earned, whether or not the
revenue has been received in cash. Like-
wise, expenses are recorded when they are
incurred, even if the money has not actually
been paid out.
accrued expenses—expenses that have been
incurred but not yet paid in cash.
accumulated depreciation—the sum of all
depreciation taken over the entire life of a
depreciable asset.
acid-test (quick) ratio—the sum of firm’s
cash and accounts receivable divided by
its current liabilities. This ratio is a more
stringent measure of liquidity than the
current ratio because it excludes invento-
ries and other current assets (those that are
least liquid) from the numerator.
agency costs—the lost value a firm’s security
holders face where there are conflicts of
interest between managers and the security
holders.
agency problem—problems and conflicts re-
sulting from the separation of the manage-
ment and ownership of the firm.
amortized loan—a loan that is paid off in
equal periodic payments.
angel investor—a wealthy private investor
who provides capital for a business start-up.
annuity—a series of equal dollar payments
made for a specified number of years.
annuity due—an annuity in which the pay-
ments occur at the beginning of each period.
annuity future value factor—the value of
c (1 + r)
n – 1
r
d used as a multiplier to
calculate the future value of an annuity.
bond—a long-term (10-year or more)
promissory note issued by the borrower,
promising to pay the owner of the security
a predetermined, fixed amount of interest
each year.
book value—(1) the value of an asset as
shown on the firm’s balance sheet. It
represents the historical cost of the asset
rather than its current market value or
replacement cost. (2) The depreciated value
of a company’s assets (original cost less
accumulated depreciation) less outstanding
liabilities.
break-even quantity—the number of units
a firm must sell before it starts to earn a
profit.
budget—an itemized forecast of a com-
pany’s expected revenues and expenses for
a future period.
business risk—the risk of the firm’s
future earnings that is a direct result of
the particular line of business chosen by
the firm.
call protection period—a prespecified time
period during which a company cannot
recall a bond.
call provision—a provision that entitles the
corporation to repurchase its preferred
stock from investors at stated prices over
specified periods.
callable bond (redeemable bond)—an op-
tion available to a company issuing a bond
whereby the issuer can call (redeem) the
bond before it matures. This is usually
done if interest rates decline below what
the firm is paying on the bond.
capital asset pricing model (CAPM)—an
equation stating that the expected rate
of return on an investment (in this case a
stock) is a function of (1) the risk-free rate,
(2) the investment’s systematic risk, and (3)
the expected risk premium for the market
portfolio of all risky securities.
capital budgeting—the decision-making
process with respect to investment in fixed
assets.
capital gains—gains from selling any
asset that is not part of the ordinary
operations.
capital markets—all institutions and
procedures that facilitate transactions in
long-term financial instruments.
capital rationing—placing a limit on the
dollar size of the capital budget.
annuity present value factor—the value of
c 1 – (1 + r)
-n
r
d used as a multiplier to
calculate the present value of an annuity.
anticipatory buying—buying in anticipa-
tion of a price increase to secure goods at a
lower cost.
arbitrage—trading to eliminate exchange
rate differentials across the markets for a
single currency.
arbitrageur—an individual involved in the
process of buying and selling in more than
one market to make a riskless profit.
asked rate—the rate the bank or the foreign
exchange trader “asks” the customer to pay
when the bank is selling and the customer
is buying. The asked rate is also known as
the selling rate or the offer rate.
asset allocation—identifying and selecting the
asset classes appropriate for a specific invest-
ment portfolio and determining the propor-
tions of those assets within the portfolio.
asset management—how efficiently
management is using the firm’s assets to
generate sales.
average tax rate—the tax rate on average that
a company pays on its total taxable income.
balance sheet—a statement that shows a
firm’s assets, liabilities, and shareholder
equity at a given point in time. It is a
snapshot of the firm’s financial position on
a particular date.
balance-sheet leverage ratios—ratios of a
firm’s use of financial leverage or debt
capital to either the firm’s total capital
or equity. Since the needed information
for computing these ratios is found in the
balance sheet we refer to them as balance
sheet leverage ratios.
behavioral finance—the field of study examin-
ing when investors act rationally or irratio-
nally when making investment decisions.
beta—the relationship between an invest-
ment’s returns and the market’s returns.
This is a measure of the investment’s
nondiversifiable risk.
bid-asked spread—the difference between
the asked quote and the bid quote.
bid rate—the rate at which the bank buys the
foreign currency from the customer. The bid
rate is also known as the buying rate.
bird-in-the-hand dividend theory—the view
that dividends are more certain than capital
gains and therefore more valuable.
505
Glossary

capital structure—the mix of long-term
sources of funds used by the firm. This is
also called the firm’s capitalization. The
relative total (percentage) of each type of
fund is emphasized.
capital structure decision—the decision-
making process with funding choices and
the mix of long-term sources of funds.
cash—cash on hand, demand deposits, and
short-term marketable securities that can
quickly be converted into cash.
cash basis accounting—a method of
accounting whereby revenue is recorded
when physical cash is actually received.
Likewise, expenses are recorded when
physical cash is paid out.
cash budget—a detailed plan of future cash
flows. This budget is composed of four ele-
ments: cash receipts, cash disbursements,
net change in cash for the period, and new
financing needed.
characteristic line—the line of “best fit”
through a series of returns for a firm’s
stock relative to the market’s returns.
The slope of the line, frequently called
beta, represents the average movement
of the firm’s stock returns in response
to a movement in the market’s returns.
chattel mortgage agreement—a loan agree-
ment in which the lender can increase his
or her security interest by having specific
items of inventory identified in the loan
agreement. The borrower retains title to
the inventory but cannot sell the items
without the lender’s consent.
clientele effect—the belief that individuals
and institutions will invest in companies
whose dividend payouts match their par-
ticular needs for current versus future cash
flow. For example, those that need current
income will invest in companies that have
high dividend payouts.
combined, or total, leverage—the result of
the combined effects of both operating and
financial leverage.
commercial paper—short-term unsecured
promissory notes sold by large businesses
in order to raise cash. Unlike most other
money-market instruments, commercial
paper has no developed secondary
market.
common-sized balance sheet—a balance
sheet in which a firm’s assets and sources
of debt and equity are expressed as a
percentage of its total assets.
common-sized income statement—an
income statement in which a firm’s
expenses and profits are expressed as a
percentage of its sales.
common stock—shares that represent
ownership in a corporation.
common stockholders—investors who own
the firm’s common stock. Common stock-
holders are the residual owners of the firm.
company-unique risk—see unsystematic risk.
compensating balance—a balance of a given
amount that the firm maintains in its de-
mand deposit account. It may be required
by either a formal or an informal agree-
ment with the firm’s commercial bank.
Such balances are usually required by the
bank (1) on the unused portion of a loan
commitment, (2) on the unpaid portion of
an outstanding loan, or (3) in exchange for
certain services provided by the bank, such
as check-clearing or credit information.
These balances raise the effective rate of
interest paid on borrowed funds.
compound annuity—depositing an equal sum
of money at the end of each year for a certain
number of years and allowing it to grow.
compound interest—the situation in which
interest paid on an investment during the
first period is added to the principal. Dur-
ing the second period, interest is earned
on the original principal plus the interest
earned during the first period.
constant dividend payout ratio—a dividend
payment policy in which the percentage of
earnings paid out in dividends is held con-
stant. The dollar amount fluctuates from
year to year as profits vary.
contribution-to-firm risk—the amount of
risk that the project contributes to the
firm as a whole; this measure considers the
fact that some of the project’s risk will be
diversified away as the project is combined
with the firm’s other projects and assets but
ignores the effects of diversification of the
firm’s shareholders.
convertible bond—a debt security that can
be converted into a firm’s stock at a pre-
specified price.
convertible preferred stock—preferred
shares that can be converted into a pre-
determined number of shares of common
stock, if investors so choose.
corporation—an entity that legally func-
tions separate and apart from its owners.
cost of common equity—the rate of return
that must be earned on the common stock-
holders’ investment in order to satisfy their
required rate of return.
cost of debt—the rate that has to be
received from an investment in order to
achieve the required rate of return for the
creditors.
cost of goods sold—the cost of producing or
acquiring a product or service to be sold in
the ordinary course of business.
cost of preferred equity—the rate of return
that must be earned on the preferred stock-
holders’ investment in order to satisfy their
required rate of return.
coupon interest rate—the interest rate
contractually owed on a bond as a percent
of its par value.
coverage ratios—ratios of the firm’s earn-
ings to the interest and principal related to
a firm’s borrowing.
credit scoring—the numerical evaluation of
credit applicants where the score is evalu-
ated relative to a predetermined standard.
cross rate—the exchange rate between two
foreign currencies, neither of which is the
currency of the domestic country.
cumulative feature—a requirement that all
past, unpaid preferred stock dividends be
paid before any common stock dividends
are declared.
cumulative voting—voting in which each
share of stock allows the shareholder a
number of votes equal to the number of
directors being elected. The shareholder
can then cast all of his or her votes for a
single candidate or split them among the
various candidates.
current assets (gross working capital)—
current assets consist primarily of cash,
marketable securities, accounts receivable,
inventories, and other current assets.
current debt (short-term liabilities)—debt
due to be paid within 12 months.
current ratio—the firm’s current assets
divided by its current liabilities. This ratio
indicates a company’s degree of liquidity by
comparing its current assets to its current
liabilities.
current yield—the ratio of a bond’s annual
interest payment to its market price.
date of record—the date at which the stock
transfer books are to be closed for deter-
mining the investors to receive the next
dividend payment.
days in inventory—inventory divided by
daily cost of goods sold. This ratio
measures the number of days a firm’s in-
ventories are held on average before
being sold; it also indicates the quality of
the inventory.
days in receivables (average collection
period)—a firm’s accounts receivable
divided by the company’s average daily credit
sales (annual credit sales , 365). This ratio
expresses how many days on average it
takes to collect receivables.
debenture—any unsecured long-term debt.
debt—liabilities consisting of such sources
as credit extended by suppliers or a loan
from a bank.
debt capacity—the maximum amount of
debt that the firm can include in its capital
506 Glossary

Glossary 507
to investors that the firm’s future prospects
have improved.
expected rate of return—The rate of return
investors expect to receive on an invest-
ment by paying the current market price of
the security.
external financing needs—that portion of a
firm’s requirements for financing that ex-
ceeds its sources of internal financing (i.e.,
the retention of earnings) plus spontaneous
sources of financing (e.g., trade credit).
factor—a firm that, in acquiring the receiv-
ables of other firms, bears the risk of col-
lection and, for a fee, services the accounts.
factoring accounts receivable—the outright
sale of a firm’s accounts receivable to another
party (the factor) without recourse. The
factor, in turn, bears the risk of collection.
fair value—the present value of an asset’s
expected future cash flows.
field-warehouse agreement—a security
agreement in which inventories pledged as
collateral are physically separated from the
firm’s other inventories and placed under
the control of a third-party field-
warehousing firm.
financial leverage—results from the firm’s
use of sources of financing that require a
fixed rate of return. The primary example
of such a form of financing is fixed inter-
est rate debt whereby the firm must pay
predetermined interest and principal on
specified dates.
financial markets—those institutions and
procedures that facilitate transactions in all
types of financial claims.
financial policy—the firm’s policies regard-
ing the sources of financing it plans to use
and the particular mix (proportions) in
which they will be used.
financial ratios—accounting data restated
in relative terms in order to help people
identify some of the financial strengths and
weaknesses of a company.
financial risk—risk driven by the presence
of fixed finance costs in the firm’s capital
structure (as opposed to variable finance
costs such as dividends declared and paid).
financial structure—the mix of all sources
of fundings that appears on the right-hand
side of the balance sheet.
financing cash flows—the amount of cash
received from or distributed to the firm’s
investors, usually in the form of interest,
dividends, issuance of debt, or issuance or
repurchase of stocks.
finished-goods inventory—goods on which
the production has been completed but
that are not yet sold.
fixed asset turnover—a firm’s sales divided
by its net fixed assets. This ratio indicates
Dutch auction—a method of issuing securi-
ties (common stock) by which investors
place bids indicating how many shares they
are willing to buy and at what price. The
price the stock is then sold for becomes the
lowest price at which the issuing company
can sell all the available shares.
earnings before taxes (taxable income)—
operating income minus interest expense.
earnings per share—net income on a per
share basis.
EBIT-EPS indifference point—the level of
earnings before interest and taxes (EBIT)
that will equate earnings per share (EPS)
between two different financing plans.
economic value added—measures a com-
pany’s economic profits, as compared to
its accounting profits, by including not
only interest expense as a cost but also the
shareholders’ required rate of return on
their investment.
effective annual rate (EAR)—the annual
compound rate that produces the same
return as the nominal, or quoted, rate when
something is compounded on a nonannual
basis. In effect, the EAR provides the true
rate of return.
efficient market—market where the values
of all securities fully recognize all available
public information.
equity—stockholders’ investment in the firm
and the cumulative profits retained in the
business up to the date of the balance sheet.
equivalent annual annuity (EAA)—an annu-
ity cash flow that yields the same present
value as the project’s NPV.
Eurobond—a bond issued in a country dif-
ferent from the one in which the currency
of the bond is denominated; for example,
a bond issued in Europe or Asia by an
American company that pays interest and
principal to the lender in U.S. dollars.
Eurodollars—U.S. dollars hold by foreign
(often European) banks and financial insti-
tutions outside the United States, and often
as a result of payments to foreign compa-
nies for good or services.
exchange rate—the price of one currency
stated in terms of another.
ex-dividend date—the date upon which
stock brokerage companies have uniformly
decided to terminate the right of ownership
to the dividend, which is two days prior to
the date of record.
expectations theory—the notion that inves-
tor reactions to a managerial decision are
based on their assessment of the effect of the
action on stock price. For example, the an-
nouncement of a higher dividend not only
indicates that more cash will be received by
investors this quarter but may also signal
structure and still maintain its current
credit rating.
debt–equity composition—the mix of debt
and equity used by the firm in its capital
structure.
debt maturity composition—the mix of
short- and long-term debt used by the firm.
debt ratio—a firm’s total liabilities divided
by its total assets. This ratio measures the
extent to which a firm has been financed
with debt.
declaration date—the date upon which a
dividend is formally declared by the board
of directors.
default-risk premium—the additional return
required by investors to compensate them
for the risk of default. It is calculated as the
difference in rates between a U.S. Treasury
bond and a corporate bond of the same
maturity and marketability.
delivery date—the date on which the actual
payment of one currency in exchange for
another takes place in a foreign exchange
transaction.
delivery-time stock—the inventory needed
between the order date and the receipt of
the inventory ordered.
depreciation expense—a noncash expense to
allocate the cost of depreciable assets, such
as plant and equipment, over the life of the
asset.
direct costs—see variable costs.
direct foreign investment (DFI)—a company
from one country making a physical invest-
ment, such as building a factory, in another
country.
direct quote—the exchange rate that indi-
cates the number of units of the home cur-
rency required to buy one unit of a foreign
currency.
direct sale—the sale of securities by a cor-
poration to the investing public without the
services of an investment-banking firm.
discount bond—a bond that sells at a
discount, or below par value.
discounted payback period—the number of
years it takes to recapture a project’s initial
outlay from the discounted free cash flows.
discretionary financing—sources of financ-
ing that require an explicit decision on the
part of the firm’s management every time
funds are raised. Bank notes provide a
typical example of this type of financing.
diversifiable risk—see unsystematic risk.
dividend-payout ratio—dividends as a
percentage of earnings.
dividends per share—the amount of dividends
a firm pays for each share outstanding.
divisional WACC—the cost of capital for a
specific business unit or division.

508 Glossary
insolvency—the inability to meet interest
payments or to repay debt at maturity.
intercept—the constant term in a linear
equation. This is the value predicted in a
linear equation for the item being forecast
(e.g., operating expenses) where revenues
are equal to zero.
interest rate parity (IRP) theory—a theory
that states that (except for the effects
of small transaction costs) the forward
premium or discount should be equal and
opposite in size to the difference in the
national interest rates for securities of the
same maturity.
interest rate risk—the variability in a bond’s
value caused by changing interest rates.
internal growth—a firm’s growth rate
resulting from reinvesting the company’s
profits rather than distributing them as
dividends. The growth rate is a function of
the amount retained and the return earned
on the retained funds.
internal rate of return (IRR)—the rate of
return that the project earns. For computa-
tional purposes, the internal rate of return
is defined as the discount rate that equates
the present value of the project’s free cash
flows with the project’s initial cash outlay.
International Financial Reporting Standards
(IFRS)—a principle-based set of interna-
tional accounting standards stating how
particular types of transactions and other
events should be reported in financial state-
ments. The principles are issued by the
International Accounting Standards Board.
intrinsic, or economic, value—the pres-
ent value of an asset’s expected future
cash flows. This value is the amount the
investor considers to be fair value, given
the amount, timing, and riskiness of future
cash flows.
inventories—raw materials, work in prog-
ress, and finished goods held by the firm
for eventual sale.
inventory loans—loans secured by invento-
ries. Examples include floating or blanket
lien agreements, chattel mortgage agree-
ments, field-warehouse receipt loans, and
terminal-warehouse receipt loans.
inventory management—the control of
assets used in the production process or
produced to be sold in the normal course
of the firm’s operations.
inventory turnover—a firm’s cost of goods
sold divided by its inventory. This ratio
measures the number of times a firm’s
inventories are sold and replaced during
the year, that is, the relative liquidity of the
inventories.
investment banker—a financial specialist
who underwrites and distributes new
statements. These principles are issued by
the Financial Accounting Standards Board.
gross fixed assets—the original cost of a
firm’s fixed assets.
gross profit—sales or revenue minus the
cost of goods sold.
gross profit margin—gross profit divided
by net sales. It is a ratio denoting the gross
profit earned by the firm as a percentage of
its net sales.
hedging principle (principle of self-
liquidating debt)—a working-capital
management policy which states that the
cash-flow-generating characteristics of a
firm’s investments should be matched with
the cash-flow requirements of the firm’s
sources of financing. Very simply, short-
lived assets should be financed with
short-term sources of financing while
long-lived assets should be financed with
long-term sources of financing.
high-yield bond—see junk bond.
holding-period return (historical or realized
rate of return)—the rate of return earned on
an investment, which equals the dollar gain
divided by the amount invested.
income statement (profit and loss
statement)—a basic accounting statement
that measures the results of a firm’s opera-
tions over a specified period, commonly
1 year. The bottom line of the income
statement, net profits (net income), shows
the profit or loss for the period that is
available for a company’s owners
(shareholders).
incremental cash flow—the difference
between the cash flows a company will pro-
duce both with and without the investment
it is thinking about making.
indenture—the legal agreement between
the firm issuing bonds and the bond trustee
who represents the bondholders, providing
the specific terms of the loan agreement.
indirect costs—see fixed costs.
indirect quote—the exchange rate that
expresses the number of units of foreign
currency that can be bought for one unit of
home currency.
inflation premium—a premium to compen-
sate for anticipated inflation that is equal
to the price change expected to occur
over the life of the bond or investment
instrument.
information asymmetry—the notion that
investors do not know as much about the
firm’s operations as the firm’s management.
initial outlay—the immediate cash outflow
necessary to purchase the asset and put it in
operating order.
initial public offering, IPO—the first time a
company issues its stock to the public.
how efficiently the firm is using its fixed
assets.
fixed assets—assets such as equipment,
buildings, and land.
fixed costs—costs that do not vary in total
dollar amount as sales volume or quantity
of output changes. Also called indirect
costs.
fixed-rate bond—a bond that pays a fixed
amount of interest to the investor each
year.
float—the length of time from when a
check is written until the actual recipient
can draw upon the funds.
floating lien agreement—an agreement,
generally associated with a loan, whereby
the borrower gives the lender a lien against
all its inventory.
flotation costs—the costs incurred by the
firm when it issues securities to raise funds.
foreign exchange (FX) market—the market
in which the currencies of various countries
are traded.
Form 10-K—an annual report required
by the Securities and Exchange Commis-
sion (SEC) that provides such information
as the firm’s history, audited financial
statements, management’s analysis of the
company’s performance, and executive
compensation.
forward exchange contract—an agreement
between two parties to exchange one cur-
rency for another on a future date.
forward exchange rate—an exchange rate for
a transaction that calls for delivery in the
future.
forward-spot differential—the premium or
discount between forward and spot cur-
rency exchange rates.
free cash flows—the amount of cash avail-
able from operations after the firm pays for
the investments it has made in operating
working capital and fixed assets. This cash
is available to distribute to the firm’s credi-
tors and owners.
future value—the amount to which your
investment will grow, or a future dollar
amount.
future value factor—the value of (1 + r)n
used as a multiple to calculate an amount’s
future value.
futures markets—markets where you can
buy or sell something at a future date.
general partnership—a partnership in which
all partners are fully liable for the indebted-
ness incurred by the partnership.
Generally Accepted Accounting Principles
(GAAP)—rule-based set of accounting
principles, standards, and procedures that
companies use to compile their financial

Glossary 509
net present value profile—a graph show-
ing how a project’s NPV changes as the
discount rate changes.
net profit margin—net income divided by
sales. A ratio that measures the net income
of the firm as a percent of sales.
net working capital—the difference between
the firm’s current assets and its current
liabilities.
nominal (or quoted) rate of interest—the
interest rate paid on debt securities without
an adjustment for any loss in purchasing
power.
nondiversifiable risk—see systematic risk.
operating expenses—marketing and sell-
ing expenses, general and administrative
expenses, and depreciation expense.
operating income (earnings before interest
and taxes)—sales less the cost of goods sold
less operating expenses.
operating leverage—results from operating
costs that are fixed and do not vary with the
level of firm sales.
operating profit margin—a firm’s operating
profits divided by sales. This ratio serves as
an overall measure of operating effectiveness.
operating return on assets (OROA)—the
ratio of a firm’s operating profits divided by
its total assets. This ratio indicates the rate
of return being earned on the firm’s assets.
operating risk—risk driven by the mix of
fixed versus variable costs the firm incurs to
do business.
operations management—how effectively
management is performing in the day-
to-day operations in terms of how well
management is generating revenues and
controlling costs and expenses; in other
words, how well is the firm managing the
activities that directly affect the income
statement?
opportunity cost—the cost of making a
choice defined in terms of the next best
alternative that is foregone.
opportunity cost of funds—the next-best
rate of return available to the investor for a
given level of risk.
optimal capital structure—the capital structure
that minimizes the firm’s composite cost of
capital (maximizes the common stock price)
for raising a given amount of funds.
optimal range of financial leverage—the
range of debt use in the firm’s capital
structure that yields the lowest overall cost
of capital for the firm.
order point problem—determining how low
inventory should be depleted before it is
reordered.
order quantity problem—determining the
optimal order size for an inventory item
and each position on the board of direc-
tors is voted on separately. As a result, a
majority of shares has the power to elect
the entire board of directors.
marginal tax rate—the tax rate that would
be applied to the next dollar of income.
market risk—see systematic risk.
market segmentation theory—the theory
that the shape of the term structure of
interest rates implies that the rate of inter-
est for a particular maturity is determined
solely by demand and supply for a given
maturity. This rate is independent of the
demand and supply for securities having
different maturities.
market value—the value observed in the
marketplace.
marketable securities—security investments
(financial assets) the firm can quickly con-
vert to cash balances. Also known as near
cash or near-cash assets.
maturity—the length of time until the bond
issuer returns the par value to the bond-
holder and terminates the bond.
maturity-risk premium—the additional
return required by investors in longer-
term securities to compensate them for the
greater risk of price fluctuations on those
securities caused by interest rate changes.
modified internal rate of return (MIRR)—
the discount rate that equates the present
value of the project’s future free cash flows
with the terminal value of the cash inflows.
money market—all institutions and proce-
dures that facilitate transactions for short-
term instruments issued by borrowers with
very high credit ratings.
mortgage—a loan to finance real estate
where the lender has first claim on the
property in the event the borrower is un-
able to repay the loan.
mortgage bond—a bond secured by a lien
on real property.
multinational corporation (MNC)—a corpo-
ration with holdings and/or operations in
more than one country.
mutually exclusive projects—projects that, if
undertaken, would serve the same purpose.
Thus, accepting one will necessarily mean
rejecting the others.
net fixed assets—gross fixed assets minus
the accumulated depreciation taken over
the life of the assets.
net income (net profit, or earnings available
to common stockholders)—the earnings
available to the firm’s common and pre-
ferred stockholders.
net present value (NPV )—the present value
of an investment’s annual free cash flows
less the investment’s initial outlay.
securities and advises corporate clients
about raising new funds.
junk bond—any bond rated BB or below.
just-in-time inventory control system—a
production and management system in
which inventory is cut down to a mini-
mum through adjustments to the time
and physical distance between the various
production operations. Under this system
the firm keeps a minimum level of inven-
tory on hand, relying upon suppliers to
furnish parts “just in time” for them to be
assembled.
law of one price—an economic principle
that states that a good or service cannot
sell for different prices in the same market.
Applied to international markets, this law
states that the same goods should sell for
the same price in different countries after
making adjustment for the exchange rate
between the two currencies.
limited liability—a protective provision
whereby the investor is not liable for more
than the amount he or she has invested in
the firm.
limited liability company (LLC)—a cross
between a partnership and a corporation
under which the owners retain limited li-
ability but the company is run and is taxed
like a partnership.
limited partnership—a partnership in which
one or more of the partners has limited
liability, restricted to the amount of capital
he or she invests in the partnership.
line of credit—generally an informal agree-
ment or understanding between a borrower
and a bank as to the maximum amount of
credit the bank will provide the borrower
at any one time. Under this type of agree-
ment there is no “legal” commitment on
the part of the bank to provide the stated
credit.
liquidation value—the dollar sum that could
be realized if an asset were sold.
liquidity—the ability to convert an asset
into cash quickly without a significant loss
of its value.
liquidity preference theory—the theory that
the shape of the term structure of interest
rates is determined by an investor’s ad-
ditional required interest rate in compensa-
tion for additional risks.
liquidity-risk premium—the additional
return required by investors for securities
that cannot be quickly converted into cash
at a reasonably predictable price.
long-term debt—loans from banks or other
sources that lend money for longer than
12 months.
majority voting—voting in which each share
of stock allows the shareholder one vote

510 Glossary
project standing alone risk—a project’s risk
ignoring the fact that much of this risk will
be diversified away.
protective provisions—provisions for
preferred stock that protect the investor’s
interest. The provisions generally allow
for voting in the event of nonpayment of
dividends, or they restrict the payment of
common stock dividends if sinking-fund
payments are not met or if the firm is in
financial difficulty.
proxy—a means of voting in which a desig-
nated party is provided with the temporary
power of attorney to vote for the signee at
the corporation’s annual meeting.
proxy fight—a battle between rival groups
for proxy votes in order to control the deci-
sions made in a stockholders’ meeting.
public offering—a security offering where
all investors have the opportunity to ac-
quire a portion of the financial claims being
sold.
purchasing-power parity (PPP)—a theory
that states that exchange rates adjust so
that identical goods cost the same amount
regardless of where in the world they are
purchased.
pure play method—a method for estimating
a project’s or division’s beta that attempts
to identify publicly traded firms engaged
solely in the same business as the project or
division.
raw-materials inventory—the basic materials
purchased from other firms to be used in
the firm’s production operations.
real rate of interest—the nominal (quoted)
rate of interest less any loss in purchasing
power of the dollar during the time of the
investment.
real risk-free interest rate—the required rate
of return on a fixed-income security that
has no risk in an economic environment of
zero inflation.
required rate of return—minimum rate of
return necessary to attract an investor to
purchase or hold a security.
residual dividend theory—a theory that a
company’s dividend payment should equal
the cash left after financing all the invest-
ments that have positive net present values.
retained earnings—cumulative profits
retained in a business up to the date of the
balance sheet.
return on equity—a firm’s net income
divided by its common book equity. This
ratio is the accounting rate of return earned
on the common stockholders’ investment.
revolving credit agreement—an understand-
ing between the borrower and the bank as
to the amount of credit the bank will be
legally obligated to provide the borrower.
It is a measure of the portfolio’s nondiver-
sifiable risk.
preemptive right—the right entitling the
common shareholder to maintain his or her
proportionate share of ownership in the
firm.
preferred stock—a hybrid security with
characteristics of both common stock and
bonds. Preferred stock is similar to com-
mon stock in that it has no fixed maturity
date, the nonpayment of dividends does not
bring on bankruptcy, and dividends are not
deductible for tax purposes. Preferred stock
is similar to bonds in that dividends are
limited in amount.
preferred stockholders—stockholders who
have claims on the firm’s income and as-
sets after creditors, but before common
stockholders.
premium bond—a bond that is selling above
its par value.
present value—the value in today’s dollars
of a future payment discounted back to
present at the required rate of return.
present value factor—the value of 1/(1 + r)n
used as a multiplier to calculate an
amount’s present value.
price/book ratio—the market value of a
share of the firm’s stock divided by the
book value per share of the firm’s reported
equity in the balance sheet. Indicates the
market price placed on $1 of capital that
was invested by shareholders.
price/earnings ratio—the price the mar-
ket places on $1 of a firm’s earnings. For
example, if a firm has an earnings per share
of $2, and a stock price of $30 per share, its
price/earnings ratio is 15. ($30 , $2).
primary market—a market in which securi-
ties are offered for the first time for sale to
potential investors.
private placement—a security offering
limited to a small number of potential
investors.
privileged subscription—the process of
marketing a new security issue to a select
group of investors.
profitability index (PI ) or benefit–cost
ratio—the ratio of the present value of an
investment’s future free cash flows to the
investment’s initial outlay.
profit margins—financial ratios (sometimes
simply referred to as margins) that reflect
the level of the firm’s profits relative to its
sales. Examples include the gross profit
margin (gross profit divided by sales),
operating profit margin (operating income
divided by sales), and the net profit margin
(net income , sales).
profit-retention rate—the company’s per-
centage of profits retained.
given its usage, carrying costs, and ordering
costs.
ordinary annuity—an annuity where the
cash flows occur at the end of each period.
organized security exchanges—formal
organizations that facilitate the trading of
securities.
other current assets—other short-term
assets that will benefit future time periods,
such as prepaid expenses.
over-the-counter markets—all security
markets except organized exchanges. The
money market is an over-the-counter mar-
ket. Most corporate bonds also are traded
in the over-the-counter market.
paid-in capital—the amount a company
receives above par value from selling stock
to investors.
par value—for a bond, par value is the
stated amount that the firm is to repay
when the bond comes due (matures); for a
stock, par value is the arbitrary value a firm
assigns to each share of stock when issued
to investors. Any amount received from the
stock sale that is above par value is paid-in-
capital.
partnership—an association of two or more
individuals joining together as co-owners
to operate a business for profit.
payable-through draft (PTD)—a legal
instrument that has the physical appearance
of an ordinary check but is not drawn on
a bank. A payable-through draft is drawn
on and paid by the issuing firm. The bank
serves as a collection point and passes the
draft on to the firm.
payback period—the number of years it
takes to recapture a project’s initial outlay.
payment date—the date on which the
company mails a dividend check to each
investor of record.
percent of sales method—a method of fi-
nancial forecasting that involves estimating
the level of an expense, asset, or liability
for a future period as a percent of the sales
forecast.
perfect capital markets—markets in which
information flows freely and market prices
fully reflect all available information.
permanent investment—investments that
the firm expects to hold longer than 1 year.
The firm makes permanent investments in
fixed and current assets.
perpetuity—an annuity with an infinite life.
pledging accounts receivable—a loan the
firm obtains from a commercial bank or a
finance company using its accounts receiv-
able as collateral.
portfolio beta—the relationship between a
portfolio’s returns and the market returns.

Glossary 511
stock split—a stock dividend exceeding
25 percent of the number of shares cur-
rently outstanding.
subordinated debenture—a debenture that is
subordinated to other debentures in terms
of its payments in case of insolvency.
syndicate—a group of investment bankers
who contractually assist in the buying and
selling of a new security issue.
systematic risk—(1) the risk related to an
investment return that cannot be eliminat-
ed through diversification. Systematic risk
results from factors that affect all stocks.
Also called market risk or nondiversifi-
able risk. (2) The risk of a project from the
viewpoint of a well-diversified shareholder.
This measure takes into account that some
of the project’s risk will be diversified away
as the project is combined with the firm’s
other projects, and, in addition, some of
the remaining risk will be diversified away
by shareholders as they combine this stock
with other stocks in their portfolios.
tax shield—the reduction in taxes due to the
tax deductibility of interest expense.
taxable income—gross income from all
sources, except for allowable exclusions,
less any tax-deductible expenses.
temporary investments—a firm’s investments
in current assets that will be liquidated and
not replaced within a period of 1 year or less.
Examples include seasonal expansions in
inventories and accounts receivable.
tender offer—a formal offer by the com-
pany to buy a specified number of shares
at a predetermined and stated price. The
tender price is set above the current market
price in order to attract sellers.
term structure of interest rates—the re-
lationship between interest rates and the
term to maturity, where the risk of default
is held constant.
terminal-warehouse agreement—a secu-
rity agreement in which the inventories
pledged as collateral are transported to
a public warehouse that is physically re-
moved from the borrower’s premises. This
is the safest (though costly) form of financ-
ing secured by inventory.
terms of sale—the credit terms identifying
the possible discount for early payment.
times interest earned—a firm’s operating
profits divided by interest expense. This
ratio measures a firm’s ability to meet its
interest payments from its annual operating
earnings.
total asset turnover—a firm’s sales divided
by its total assets. This ratio is an overall
measure of asset efficiency based on the
relation between a firm’s sales and the total
assets.
simple interest—if you only earned interest
on your initial investment, it would be
referred to as simple interest.
simulation—a method for dealing with
risk where the performance of the project
under evaluation is estimated by randomly
selecting observations from each of the
distributions that affect the outcome of
the project and continuing with this
process until a representative record of
the project’s probable outcome is
assembled.
sinking-fund provision—a protective provi-
sion that requires the firm periodically to
set aside an amount of money for the re-
tirement of its preferred stock. This money
is then used to purchase the preferred stock
in the open market or through the use of
the call provision, whichever method is
cheaper.
slope coefficient—the rate of change in the
item being forecast with a linear equation
and the change in sales.
small, regular dividend plus a year-end
extra—a corporate policy of paying a
small regular dollar dividend plus a year-
end extra dividend in prosperous years to
avoid the connotation of a permanent
dividend.
sole proprietorship—a business owned by a
single individual.
spontaneous financing—the trade credit and
other accounts payable that arise spontane-
ously in the firm’s day-to-day operations.
spot exchange rate—an exchange rate for
a transaction that calls for immediate
delivery.
spot market—cash market.
stable dollar dividend per share—a dividend
policy that maintains a relatively stable dol-
lar dividend per share over time.
standard deviation—a statistical measure
of the spread of a probability distribution
calculated by squaring the difference be-
tween each outcome and its expected value,
weighting each value by its probability,
summing over all possible outcomes, and
taking the square root of this sum.
statement of cash flows—a statement that
shows how changes in balance sheet ac-
counts and income affect cash and cash
equivalents, and breaks the analysis down
to operating, investing, and financing
activities.
stock dividend—a distribution of shares of
up to 25 percent of the number of shares
currently outstanding, issued on a pro rata
basis to the current stockholders.
stock repurchase (stock buyback)—the pur-
chase of outstanding common stock by the
issuing firm.
right—a certificate issued to common stock-
holders giving them an option to purchase
a stated number of new shares at a specified
price during a 2- to 10-week period.
risk—potential variability in future cash flows.
risk-adjusted discount rate—a method of
risk adjustment when the risk associated
with the investment is greater than the
risk involved in a typical endeavor. Using
this method, the discount rate is adjusted
upward to compensate for this added risk.
risk-free rate of return—the rate of return
on risk-free investments. The interest rates
on short-term U.S. government securities
are commonly used to measure this rate.
risk premium—the additional return ex-
pected for assuming risk.
safety stock—inventory held to accommo-
date any unusually large and unexpected
usage during delivery time.
scenario analysis—a simulation approach for
gauging a project’s risk under the worst,
best, and most likely outcomes. The firm’s
management examines the distribution of
the outcomes to determine the project’s
level of risk and then makes the appropriate
adjustment.
S-corporation—a corporation that, because
of specific qualifications, is taxed as though
it were a partnership.
seasoned equity offering, SEO—the sale
of additional stock by a company whose
shares are already publicly traded.
secondary market—a market in which cur-
rently outstanding securities are traded.
secured loans—sources of credit that
require security in the form of pledged
assets. In the event the borrower defaults in
payment of principal or interest, the lender
can seize the pledged assets and sell them
to settle the debt.
security market line—the return line that
reflects the attitudes of investors regarding
the minimum acceptable return for a given
level of systematic risk associated with a
security.
semivariable costs—costs composed of a
mixture of fixed and variable components.
sensitivity analysis—a method for dealing
with risk where the change in the distribu-
tion of possible net present values or inter-
nal rates of return for a particular project
resulting from a change in one particular
input variable is calculated. This is done
by changing the value of one input variable
while holding all other input variables
constant.
short-term notes (debt)—amounts borrowed
from lenders, mostly financial institutions
such as banks, where the loan is to be
repaid within 12 months.

512 Glossary
working capital—a concept traditionally
defined as a firm’s investment in current
assets.
working capital management—the manage-
ment of the firm’s current assets and short-
term financing.
work-in-process inventory—partially
finished goods requiring additional work
before they become finished goods.
yield to maturity—the rate of return a bond-
holder will receive if the bond is held to
maturity.
zero balance accounts (ZBA)—a cash manage-
ment tool that permits centralized control
over cash outflow while maintaining divi-
sional disbursing authority. Objectives are (1)
to achieve better control over cash payments;
(2) to reduce excess cash balances held in
regional banks for disbursing purposes; and
(3) to increase disbursing float.
zero coupon bond—a bond issued at a sub-
stantial discount from its $1,000 face value
and that pays little or no interest.
unsecured loans—all sources of credit that
have as their security only the lender’s faith
in the borrower’s ability to repay the funds
when due.
unsystematic risk—the risk related to an
investment return that can be eliminated
through diversification. Unsystematic risk
is the result of factors that are unique to
the particular firm. Also called company-
unique risk or diversifiable risk.
variable costs—expenses that vary in total as
output changes. Also called direct costs.
venture capitalist—an investment firm (or
individual investor) that provides money to
business start-ups.
volume of output—the number of units
produced and sold for a particular period
of time.
weighted average cost of capital—an average
of the individual costs of financing used by
the firm. A firm’s weighted cost of capital
is a function of (1) the individual costs of
capital, and (2) the capital structure mix.
total revenue—total sales dollars.
trade credit—credit made available by a
firm’s suppliers in conjunction with the ac-
quisition of materials. Trade credit appears
on the balance sheet as accounts payable.
transaction loan—a loan where the proceeds
are designated for a specific purpose—for
example, a bank loan used to finance the
acquisition of a piece of equipment.
treasury stock—the firm’s stock that has been
issued and then repurchased by the firm.
unbiased expectations theory—the theory
that the shape of the term structure of
interest rates is determined by an investor’s
expectations about future interest rates.
underwriter’s spread—the difference
between the price the corporation raising
money gets and the public offering price of
a security.
underwriting—the purchase and subsequent
resale of a new security issue. The risk of
selling the new issue at a satisfactory (prof-
itable) price is assumed (underwritten) by
the investment banker.

Subject
A
Accelerated Cost Recovery System
(ACRS), 349, 378–379
Accounting
accrual basis, 65
book value, 57
cash basis, 65
Accounting book value, 57
Accounting malpractice, 80
Accounts payable, 59
Accounts receivable, 58
factoring, 475
pledging, 473
turnover ratio, 109
Accounts receivable loans, 473–475
factoring, 475
pledging, 473–474
Accrual basis accounting, 65
Accrued expenses, 59
Accrued wages, 467–468
Accumulated depreciation, 58
Agency costs, 400, 401, 422
firm value and, 400–401
free cash flow and capital structure,
401–492
of debt, 395
Agency problems, 7
conflicts of interest causing, 7–8, 10, 401
Allocation asset, 203
Amortization
process, 163–164
schedule, loan, 163
Amortized loans, 162–164, 166, 167
Angel investor, 22
Annuities, 157–164
amortized loans, 162–164, 166, 167
compound, 157–159
definition of, 157
due, 161–162
equivalent annual, 330
future value factor, 158
ordinary, 157
present value factor, 160
present value of, 159–160
Arbitrage, 489
exchange rates and, 489
Arbitrageur, 489
Asked rate, 489
Asset allocation, 203
coupon interest rate, 223–224
current yield, 237–238
debentures, 221
definition of, 221
discount, 241
Eurobonds, 222
fixed-rate, 223
high-yield, 226
indenture, 224
junk, 225
maturity, 224
mortgage, 222
par value, 223
premium, 241
ratings, 224–225
redeemable, 224
subordinated debentures, 222
terminology, 223–226
types of, 221–223
valuation, 220–249
value, 226–229, 235
valuing, 229–235
yield to maturity, 235–237
zero coupon, 224
Book value, 226
Book value accounting, 57
Break-even analysis, 383–388
behavior costs and, 384
break-even point in sales dollars,
386–388
elements of, 383–388
finding break-even point, 385–386
fixed costs, 384
sales level, 386–388
total revenue and volume of output, 385
variable costs, 384
Brin, Sergey, 20
Budgeting, 444
capital. See Capital budgeting.
cash, 444–447
functions, 444–445
Bush, President George, 420
Business
finance, role in, 11–13
financing, 21–26, 68, 71
Business organization
choice of, 15
corporations, 14
legal forms of, 13–15
partnerships, 13–14
s-type corporations, 14–15
sole proprietorships, 13
taxes and, 14
Asset management, 112–113
Asset structure
and financial structure, 381
Assets
claims on, 223, 258
current, 57, 60–61, 457–458
financing, 117–118
fixed, 58, 61, 68
long-term, 58
management of, 113–114
operating profits and, 112–114
permanent and temporary, 459–460
total, 57
total turnover, 113–114
turnover of fixed, 114
types of, 57–58
value, determination of, 229, 231
Average collection period, 108–109
Average tax rate, 78
B
Balance
compensating, 469
Balance sheet, 56–65
common-sized, 62
construction of, 63–64
Balance-sheet leverage ratios, 405
Bank credit, 469–471
line of credit, 469
short-term, cost of, 470–471
transaction loan, 471
Bankruptcy costs, 408
Behavioral finance, 227
Benefit-cost ratio, 313–317
Bernstein, Peter, 187
Best-efforts basis, 28–29
Beta, 198–200
estimation of, 204, 365–366
measurement of portfolio, 202–203
pure play method for estimating, 366
Bid-asked spread, 489
Bid rate, 489
Bird-in-the-hand dividend theory, 419
Blake, Frank, 51
Bond yields, 235–238
Bonds, 220–249
call provision, 224
callable, 224
characteristics of, 223–226
claims on assets and income, 223
convertible, 222
513
Indexes

Business risk, 382–383
financial risk and, 382
C
Call protection period, 224
Call provision, 224, 252
Callable bond, 224
Capital
capital asset pricing model, 206, 283–285
cost of, 274–303, 381
definition of, 275
determining costs of, 276–286
divisional costs of, 290–293
financial policy and, 276
net working, 350, 457
opportunity cost of, 275
paid-in, 59
sources of costs of, 276
transfer in economy, 22
weighted average cost of, 275, 286–289
working, 457, 459–462
Capital asset pricing model (CAPM), 206,
283–285, 362, 365
calculating cost of common stock,
284, 286
implementation of, 284–285
Capital budgeting, 11
capital rationing, 325–326
cash flows and, 344–379
decision criteria, 307–325, 348
definition of, 305
ethics in, 332
for direct foreign investment, 497–498
guidelines, 345–348
internal rate of return, 316–319
net present value, 310–313
options in, 358–360
payback period, 307
profitability index (benefit-cost ratio),
313–316
profitable projects, finding of, 305–306
risk adjusted discount rates, 363–365
risk in, 361–362
techniques and practice, 304–343
Capital gains, 77
Capital investments
new, 294
Capital markets
definition of, 21
money market versus, 24
perfect, 419
Capital rationing, 325–326
project selection and, 326
rationale for, 325–326
Capital spending, 350
Capital structure, 286, 393
agency costs and, 400
decisions, 11
financial structure versus, 393–394
firm value and, 396–397
importance of, 396
independence position on, 396–397
international, 407
managerial implications, 399, 402
moderate position on, 397–399
optimal, 395
theory, 393–402
Capital structure management
actual, 406–408
comparative leverage ratios, 405–406
graphic analysis, 403–404
indifference points, 404–405
industry norms, 406
tools of, 402–408
Cash, 58
converting inventories to, 109–110
sources and uses of, 67
Cash basis accounting, 65
Cash budget, 444–447
construction of, 445–446
Cash conversion cycle (CCC), 462–464
computing of, 463
Cash discounts
trade credit, 468
Cash flows, 4–5, 50–101
capital budgeting and, 344–379
diagram, 360
diverted from products, 345–346
expected, 497
financial crisis and, 8–9
financing, 67, 98–99
free, 67, 95–97, 345, 354–355
from day-to-day operations, 69
from operations, 69–70
generation of, 68
incidental effects, 346
incremental, 4–5, 347
incremental thinking and, 345
long-term assets and, 70–71
marginal, 4–5
measurement of, 65–74
operating, 351–352, 355–357
opportunity cost and, 347
overhead costs and, 347
profits versus, 65–67
statement of, 67–74
sunk costs and, 347
synergistic effects and, 346
terminal, 350
timelines to visualize, 143–146
Cash inflows, 68
Characteristic line, 198
Chattel mortgage agreement, 475
Chief executive officer (CEO), 11–12
Chief financial officer (CFO), 11–12
Clientele effect, 421–422
Commercial paper, 471–473
as short-term credit, 471–472
estimation of cost of, 472
Commission, 28–29
Common-sized balance sheet, 62
Common-sized income statement, 54–55
Common stock, 59, 256–263
characteristics of, 257–258
claim on assets, 258
claim on income, 257
cost of financing, 282
growth factor in, 259
limited liability, 258
preemptive rights, 258
valuing of, 258–263
voting rights, 258
Common stockholders, 59
expected rate of return, 265–266
Company-unique risk, 195
Compensating balance, 469
commercial paper, 471–472
Competitive bid purchase, 28
Compound annuity, 157–159
Compound interest, 143–156
definition of, 144
Compounding
application of, 152–153
Conflicts of interest, 7–8, 401
financial crisis and, 10
Constant dividend payout ratio, 424
Convertible bonds, 222
Corporate tax rates, 77–78
Corporations, 14
multinational, 485
S-corporation, 14–15
Cost-of-credit formula, 464–465
Cost of goods sold, 52
Costs
agency, 395, 400–402
bankruptcy, 408
behavior of, 384–385
debt, 277–279
direct, 55, 384
divisional, 290–295
financing, 52
fixed, 55, 384
flotation, 31–32, 277
indirect, 384
interest, 458
of capital, 274–303
of capital, weighted average, 286–289
of common equity, 281
of common stock financing, 282
of preferred equity, 279
of preferred stock, 279–280
of short-term credit, 464–466
opportunity, 5, 275, 347
overhead, 347
semivariable, 55
sunk, 347
514 Index

transaction, 276, 407
variable, 55, 384
Coupon interest rate, 223–224
Coverage ratios, 405
Credit
commercial paper and, 472
short-term, 464–476
Credit rating, 406–407
Credit terms
accounts-receivable loans, 473
trade credit, 468
Crockett, Barton, 250
Cross rates, 489–490
Cumulative dividends, 252
Cumulative voting, 258
Currency cross rates, 490
Currency exchange rates, 486–494
Current asset management, 457–458
Current assets, 57, 60–61
other, 58
Current debt, 59
accounts payable, 59
accrued expenses, 59
short-term notes, 59
Current liabilities, 59
advantages of, 458
disadvantages of, 458
Current ratio, 107
Current yield, 237
computing of, 237
Customers
discomfort of, 408
D
Date of record, 425
Days in inventory, 109–110
Days in receivables, 108–109
Debentures, 221
subordinated, 222
Debt, 59
agency costs of, 400–401
capacity, 400
cost of, 277–279
current, 59
financing, 278–279
long-term, 59–60
maturity composition, 385
principle of self-liquidating, 459
ratio, 62, 117
short-term, 59
Debt-equity composition, 395
Debt levels
comparable, 408
Declaration date, 425
Default-risk premium, 35, 36
Delivery date, 490–491
Depreciation
accumulated, 58
expense, 58, 66
taxes and, 349–350
Dimmick, Emily, 21–22
Dimmick, Michael, 21–22
Direct costs, 55, 384
Direct foreign investment (DFI), 485
capital budgeting for, 497–498
exchange rate risk in, 498
Direct placement, 23
Direct quote, 487
Direct sale, 30
Direct transfer of funds, 22
Discount bond, 241
Discount rates
risk-adjusted, 363–365
Discounted payback period, 308–309
Discounted value
calculation of, 154
Discretionary financing, 439–443
Distribution, 27
direct sale, 30
Dutch auction, 29
methods, 28–30
negotiated purchase, 28
privileged subscription, 29
Diversifiable risk, 195
Diversification and risk, 194–205
Dividend growth model, 281–282
calculating cost of common stock
with, 285
implementation of, 282
Dividend payout ratio, 259, 417
Dividend policy
agency costs, 422
alternative, 424–425
as long-term residual, 423
bird-in-the-hand dividend theory, 419
clientele effect, 421–422
earnings predictability, 424
effects of, 439–440
expectation theory, 422–423
firm, 418–419
improving thinking on, 420–423
information effect, 422
internal financing and, 416–435
legal restrictions, 424
liquidity constraints, 424
ownership control, 424
payment procedures, 425
residual dividend theory, 421
stock value and, 418–423
views on, 418–420
Dividend valuation model, 260–261
Dividend-versus-retention tradeoffs, 418
Dividends
and stock splits, 426
cumulative, 252
share repurchase as, 427–429
stability of, 417
stock values and, 419–420
taxation on, 14
Dividends per share, 54
Divisional costs of capital
calculating of, 290–295
E
Earnings
annual change in, 353
predictability, dividend payout, 424
Earnings available to common
stockholders, 53
Earnings before interest and taxes (EBIT),
52, 352, 353, 355, 383, 385, 388–389
financial leverage and, 389–391
operating leverage and, 388–389
Earnings before interest taxes,
depreciation, and amortization
(EBITDA), 355
Earnings before taxes, 53
Earnings per share (EPS), 54
EBIT-EPS analysis chart, 402–406
EBIT-EPS indifference point, 404–405
Economic value, 226
Economic value added (EVATM), 122,
124–126
Economies of scales, 443–444
Effective annual rate (EAR), 165
Efficient markets, 6, 227
Equipment, 58
Equity, 59
common stockholders, 59
overevaluation/underevaluation, 408
preferred stockholders, 59
return on, 119–122
Equity offering, 24
Equivalent annual annuity (EAA), 330
Ethics
essential elements, 10–11
financial downside of, 332
in capital budgeting, 332
Eurobonds, 222
Eurodollars, 485
Ex-dividend date, 425
Exchange rate quotes
reading of, 487
Exchange rate risk, 492–494
in direct foreign investment, 494
in foreign portfolio investments, 494
in international trade contracts, 492–493
Exchange rates, 487
arbitrage and, 489
ask and bid rates, 489
cross rates, 489
foreign, 487–488
foreign exchange market, 486–494
forward, 490
risk, 498
Index 515

516 Index
sources of, 460
spontaneous, 438–439, 460
spot markets, 24
temporary, 460
types of, 59–60
working capital, 62
Financing decisions, 118–119
Financing expenses, 52
Financing flows, 347
Financing mix
determination of, 380–415
Financing needs
external, 440, 442
Firm
discretionary financing needs,
438–443
dividend policy, 418–419
evaluation of financial performance,
102–141
finance area of, 12–13
goal of, 3–4, 32
likelihood of failure, 399
multinational, 15–16
value, 400–401
weighted average cost of capital,
286–289
Fisher effect, 39
international, 496
Fixed asset turnover, 114
Fixed assets, 58, 61
gross, 58, 70
investing in, 68
net, 58
Fixed costs, 55, 384
Fixed-rate bonds, 223
Flexibility
financing, 438
Floating lien agreement, 475
Flotation costs, 31–32
Foreign exchange market, 486
Foreign exchange rates, 487–490
Foreign exchange transactions, 490–491
Foreign investment
direct, 485
Foreign investment risks, 497–498
Form 10-K, 51
Forward exchange contract, 491
Forward exchange rates, 490
Forward-spot differential, 491
Franklin, Benjamin, 142
Free cash flow, 51, 95–97, 345
annual, 349–350
calculating, 348–358
initial outlay, 348–349
Funds
direct transfer of, 22
indirect transfer of, 22–23
movement of, 21–26
opportunity cost of, 32
globalization of, 485–486
interest rates and, 20–49
rates of return in, 32–36
Financial performance
evaluation of firm, 102–141
financial analysis, purpose of, 102–106
Financial planning
short-term, 436–455
Financial policy
capital and, 276
definition of, 276
Financial ratio analysis
accounts receivable turnover, 109
current ratio, 107
debt ratio, 117
gross profit margin, 55
inventory turnover, 110
limitations of, 128–129
operating profit margin, 55, 113
operating return on assets, 112, 116
quick ratio, 108
return on equity, 119–122
total asset turnover, 113–114
Financial ratios, 103
Financial relationships
measurement of, 106–129
Financial risk, 382
business risk and, 382
Financial statements, 50–101
balance sheet, 56–65
data by industry, 103, 104
limitations of, 80
pro forma, 437
Financial structure
and asset structure, 381
capital structure versus, 393–394
Financing
cash flows, 67, 98–99
current debt, 59
debt (liabilities), 59
debt ratio, 62
direct transfer of funds, 22–23
discretionary, 439, 440
equity, 59
flexibility, 438
indirect transfer, 22–23
internal, 416–435
investment banking function, 22–23
long-term debt, 59–60
money market versus capital market, 24
of business, 21–26, 68, 71
organized security exchanges versus
over-the-counter markets, 25–26
permanent, 460
primary markets versus secondary
markets, 23–24
private debt placements, 30–31
public offerings versus private
placements, 23
Expectation theory, 422–423
Expected rate of return, 184–186
computing of, 191–192, 235
of stockholders, 263–268
Expenses
accrued, 59
External financing needs, 440, 442
F
Factor, 475
Factoring accounts receivable, 475
Fair value, 226
Farmer, Roy, 8
Federal Deposit Insurance Corporation
(FDIC), 27–28
Field warehouse agreement, 475
Finance
behavioral, 227
cash flow, 4–5
conflicts of interest and, 7–8
foundations of, 4–11
in firm, 12–13
income taxes and, 76–79
international business, 484–503
market prices, 6–7
multinational firm and, 15–16
reasons for studying, 11–12
risk and, 5–6
role in business, 11–13
time value of money, 5, 9–10
Financial analysis
purpose of, 102–106
Financial calculator
use of, 147–149, 317–318
Financial crisis
avoiding of, 9–10
current global, 8–9
Financial decision tools, 110, 115, 118,
122, 126, 185, 191, 208, 233, 234,
254, 263, 265, 268, 294, 309, 322,
331
Financial flexibility, 406
Financial forecasting, 437
percent of sales method of, 438–439
sales, 437
variables, 437
Financial intermediary, 23
Financial leverage, 389–391
benefits of, 398–399
effects of, 390
operating leverage and, 392
optimal range of, 399
Financial management
foundation of, 2–19
Financial manager
role of, 12–13
Financial markets
definition of, 12

Index 517
Investment-banking industry
demise of, 27–28
distribution methods, 22–23
functions of, 22–23
Investments
calculation of future value
of, 168–169
calculation of growth of, 167
capital, new, 294
in fixed assets, 61, 68
permanent, 459
portfolio, 485
present value of, 156
risk and, 5, 360–369, 497–498
temporary, 459–460
Investors
angel, 22
dividends and, 428
rate of return and, 193–194
required rate of return,
206–208
Issue costs, 31
J
James, Edgerrin, 8
Jensen, Michael C., 401
Jobs, Steve, 2
Junk bonds, 225
L
Law of one price, 495–496
Liabilities
current, 59
limited, 258
short-term, 59
See also Debt
Limited liability, 258
Limited liability corporation (LLC),
14–15
Limited partnerships, 13–14
Line of credit, 469
Liquidation value, 226
Liquidity, 57, 107–111
constraints, 424
measurement of, 111
Liquidity preference theory, 44
Liquidity-risk premium, 35, 36
Loans
accounts-receivable, 473–475
amortized, 162–163, 166, 167
inventory, 475–476
secured, 466
transaction, 471
unsecured, 466, 467–473
Long-term assets, 58
Long-term debt, 59–60
Information effect, 422
Initial outlay, 348–349, 353
Initial public offerings (IPO), 24
Intercept, 444
Interest
compound, 143–156
cost, 30, 439
expense, 350, 397–398
nominal rates of, 37–39
payments, 347
quoted rate of, 35
real rate of, 37
simple, 146
times earned, 117–118
Interest rate
commercial paper, 471
coupon, 223–224
determinants of, 36–44
estimating with risk premiums,
36–37
inflation rates and, 33–35
level of, 407
levels in recent periods, 33–36
making comparable, 165–169
nominal, 33–35, 36, 37–39
parity, 494–495
real, 37–39
real risk-free, 36, 37
risk free, 37
selected trade credit terms, 468
term structure of, 41–44
Interest rate risk
term structure of, 240
Interest tax savings, 396–399, 407
Internal funds
insufficient, 407
Internal growth, 259
Internal rate of return (IRR), 316–321,
325, 363
complications with, 320–321
computing of, 317–319
modified, 321–324
multiple, 320–321
net present value and, 319–320
International business finance
direct foreign investment, 485
International Financial Reporting
Standards (IFRS), 76
International Fisher effect, 496
International trade contracts
exchange rate risk in, 492–493
Intrinsic value, 226
Inventories, 58
converting to cash, 109–110
days in, 109–110
Inventory loans, 475–476
Inventory turnover, 110
Investment banker, 26
functions of, 27
Future value, 143–156
calculation of, 146, 151–152, 168–169
definition of, 145
factor, 145
of annuity, 159
with nonannual periods, 166–169
Futures markets, 24–25
G
General partnerships, 13
Generally accepted accounting principles
(GAAP), 76
Glass-Steagall Act, 27–28
Government securities
interest rates for, 42–43
Great Depression, 27
Greenspan, Alan, 32
Gross fixed asset, 58
Gross profit margin, 55
Gross profits, 52
Gross working capital, 57
H
Hedging principles, 459, 460–462
High-yield bonds, 226
Historical rates of return, 184
Holding-period return, 184
Homer, Sidney, 142
I
Income
claims on, 223, 257
net, 53
taxable, 53, 77
Income statement, 52–56, 58, 64
common-sized, 54–55
preparation of, 55–56
Income taxes
computing corporation, 79
finance and, 76–79
Incremental cash flows, 4–5
Incremental expenses, 346–347
Incremental thinking, 345
Indenture, 224
Indifference points, 404–405
Indirect costs, 384
Indirect quote, 487
Industry norms, 406
Inflation
premium, 35, 36, 39
rate of return and, 38–39
Inflation rates
interest rates and, 33–35
Information asymmetry, 422

518 Index
Par value, 59, 223
Partnerships, 13–14
general, 13
limited, 13–14
Payback period, 307
discounted, 308–309
Payment date, 425
Payment procedures
dividend, 425
Percent of sales method, 438–439
limitations of, 443–444
Percent-per-annum premium
computing of, 492, 493
Perez, William, 6
Permanent assets, 459–460
Permanent financing, 460
Permanent investments, 459
Perpetuities, 170–171
Persian Gulf Crisis, 41, 42
Pledging accounts receivable,
473–474
Political risk, 497
Portfolio beta, 202
Portfolio investment, 485
Portfolios
exchange rate risk in, 498
financial risk, 240
investment, 485
Pound/euro exchange rates, 490
Preemptive rights, 258
Preferred equity
cost of, 279
Preferred stock, 251–253
characteristics of, 251–252
claims on assets and income, 252
convertibility, 252
cost of, 279–280
cumulative dividends, 252
financing, 279, 280
multiple series, 252
protective provisions, 252
retirement provisions, 252
valuing, 253–256, 257
Preferred stockholders, 59
Premium
bonds, 241
default-risk, 35–36
inflation-risk, 35, 36, 39
maturity, 35, 36
Present value, 143–146
definition of, 153
factor, 153
of annuity, 159–160
of investment, 156
of savings bond, 154–155
of uneven stream, 169–170
perpetuities, 170–171
with nonannual periods, 166–169
with two flows, 158
Net operating working capital, 96
Net present value (NPV ), 310–313
calculation of, 310–312
definition of, 310
internal rate of return and, 319–320
profile, 319
spreadsheets, calculating with, 312–313
Net profit margin, 55, 439–440
Net working capital, 350, 457
New York Stock Exchange (NYSE), 6,
25, 226
Nominal interest rate, 33–35, 36
solving for, 37–39
Nonannual periods
present and future values with,
166–169
Nondiversifiable risk, 195
North American Industrial Classification
System (NAICS), 103
O
Operating cash flows
calculation of, 351–352, 353,
355–357
Operating expenses, 52
Operating income, 52
Operating leverage, 388–393
EBIT and, 388–389
financial leverage and, 392
Operating profit margin, 55, 113
Operating profits, 52, 112–113
Operating return on assets (OROA),
112, 116
Operating risk, 382, 383
Operations
management, 112, 113
Opportunity cost, 5, 275, 347
funds, 32
Optimal capital structure, 395
Options
in capital budgeting, 358–360
Ordinary annuities, 157
Organized security exchanges
definition of, 25
over-the-counter markets versus, 25–26
Output
relevant range of, 384
volume, 385
Over-the-counter markets
definition of, 25
organized security exchanges versus,
25–26
Overhead costs, 347
P
Page, Larry, 20
Paid-in capital, 59
M
Madoff, Bernie, 9, 10
Majority voting, 258
Malpractice
accounting, 80
Marginal tax rates, 78
Market prices, 6–7, 155
Market risk
measurement of, 196–202
Market segment theory, 44
Market value, 226
Market-value ratios, 123
Markets
efficient, 6, 227
foreign exchange, 486
futures, 24–25
money, 24
primary versus secondary, 23–24
secondary, definition of, 24
spot, 24–25
Marshall, John, 14
Mathematical calculations, 147
Maturity, 224
yield to, 235
Maturity-risk premium, 35, 36
Miller, Merton, 396
Modified internal rate of return (MIRR),
321–324
calculating of, 321–324
spreadsheets and, 324
Modigliani, Franco, 396
Money
movement through time, 147
time value of, 5, 9–10
Money market
capital market versus, 24
definition of, 24
Moody, John, 224
Mortgage agreement
chattel, 475
Mortgage-backed securities, 9
Mortgage(s), 8–9, 59
bonds, 222
“under water,” 9
Multinational corporations (MNC), 485
finance and, 15–16
Mutually exclusive projects, 326
ranking of, 326–331
size-disparity problem, 327–328
time-disparity problem, 328
unequal-lives problem, 329–331
N
Negotiated purchase, 28
Net fixed assets, 58
Net income, 53

Index 519
investments and, 360–369
market, 195, 196–202
measurement of, 187–191, 362
nondiversifiable, 195
operating, 382, 383
political, 497
project standing alone, 361
rates of return and, 32–33
reward and, 5–6, 10, 32–33, 204–205,
289, 306, 395, 460, 497
systematic, 195, 361, 362
unsystematic, 195
Risk-adjusted discount rates, 363–365
Risk-free rate of return, 206
Risk premium, 206
estimating interest rate with, 36–37
Risk-return relationship, 363
Risk-return tradeoff, 5, 6, 457–458
S
S-type corporation, 14–15
Sales, 52
Sales dollars
break-even point in, 386–387
Sales forecasting, 441, 442
limitations of percent of,
443–444
percent of, 438–439, 443
Sales growth
effects of, 440–443
Sales method
of financial forecasting, 438–439
Sarbanes-Oxley Act (SOX), 32
Scenario analysis, 368
Seasoned equity offering (SEO), 24
Second share offering, 24
Secondary markets
definition of, 24
primary markets versus, 23–24
Secured loans, 466, 473–476
accounts-receivable loans,
473–475
inventory loans, 475–476
Securities
methods of distribution of, 28–30
mortgage-backed, 9
sale to public, 26–32
Securities and Exchange Commission
(SEC), 24, 31, 50
Securitization, 8–9
Security exchanges
organized, definition of, 25
organized, versus over the counter
markets, 25–26
Security market line, 208
Sensitivity analysis, 368
Shareholder value, 122–128
Shareholder wealth maximization, 3
expected, 184–186, 191–192, 235–237,
264–268
in financial, 32–36
internal, 316–325
investors and, 193–194, 206–209
realized, 184
required, 206–209
risk-free, 206
standard deviations and, 33
Ratios. See also Financial ratio analysis
accounts receivable turnover, 109
acid-test (quick), 108
current, 107
debt, 62, 117
market-value, 123
price/book, 123–124
price/earnings, 123
Real rate of interest, 37–39
solving for, 40
Real risk-free interest rate, 36
Realized rate of return, 184
Receivables
days in, 108–109
trimming of, 467
Redeemable bond, 224
Required rate of return
investors and, 206–208
measurement of, 206–207
Reserve
total, 385
Retained earnings, 60
Return on equity (ROE), 119–122
Returns, 458
expected, 184–186, 191–192
holding period, 184
probability distribution of, 188–189
rates and standard deviations of, 33
variability of, 195
Revenues, 52
Revolving credit agreement, 469
Reward
risk and. See Risk, reward and
Rights, 258
preemptive, 258
Risk, 5–6, 458
and return, 182–219
business, 382–383
company unique, 195
contribution-to-firm, 361
current liabilities and, 458
definition of, 186, 190
diversifiable, 195
diversification and, 194–205
examination through simulation,
366–368
exchange rate, 492–494
financial, 382
foreign investment, 497–498
in capital budgeting, 361–362
Price/book ratio, 123, 124–125
Price/earnings (P/E) ratio, 123, 124–125
Primary markets
definition of, 23–24
secondary markets versus, 23–24
Principle of self-liquidating debt, 459
Private debt placements, 30–31
advantages of, 30
disadvantages of, 30–31
Private placements
definition of, 23
public offerings versus, 23
Privileged subscription, 29
Pro forma financial statements, 437
Product market
globalization of, 485–486
Profit and loss statement. See Income
statement
Profit margins, 55, 113
Profit-retention rate, 259
Profitability
effects on discretionary financing,
439–440
Profitability index (PI), 313–316
Profits
gross, 52
operating, 52, 112–113
profitable, 305–306
Project standing alone risk, 361
Project(s)
delaying, 358–359
expansion of, 359
risk of, 361
scenario analysis of, 368
systemic risk of, 365
Proxy, 258
fights, 258
Public offerings
definition of, 23
initial, 24
private placements versus, 23
Purchase
competitive bid, 28
negotiated, 28
Purchasing-power parity (PPP) theory,
495–496
international Fisher effect, 496
law of one price, 495–496
Pure play method, 366
Q
Quick ratio, 108
Quoted rate of interest, 35
R
Rate of return
computing of, 191–192

520 Index
advantages of, 469
stretching of, 469
Transaction costs, 276, 407
Transaction loans, 471
Treasury bonds, 35, 188–189
Treasury stock, 60
Trust
essential elements of, 10–11
U
Unbiased expectations theory, 43–44
Underwriter rankings, 26–27
Underwriter’s spread, 26, 31
Underwriting, 26, 27
Uneven stream
present value of, 169–170
Unsecured loans, 466
accrued wages and taxes, 467
bank credit, 469–471
commercial paper, 471–473
trade credit, 468–469
Unsystematic risk, 195
U.S. Treasury bills, 40, 161, 176
V
Valuation, 228–229
bond, 220–249
data requirements for, 229
Value
book, 226
definition of, 226–227
determination of, 227–228
economic, 226
fair, 226
firm, 400–401
intrinsic, 226
liquidation, 226
market, 226
Value Line, 103, 200, 283
Variable costs, 55, 384
Variance
measurement of, 189
Venture capitalist, 22
Volume of output, 385
W
Wages
accrued, 467–468
Weighted average cost of capital, 286–289
calculating of, 287–289
estimates of, 290
Working capital, 62, 457
appropriate level of, 459–462
gross, 62
hedging principles, 459, 460–462
Stock splits
stock dividends and, 426
Stock values
dividends and, 419–420
Stockholders, 4
common, 59
expected rate of return
of, 263–268
preferred, 59
Subordinated debentures, 222
Sunk costs, 347
Supplier discomfort, 408
Swank, Rebecca, 21
Syndicate, 27
Synergistic effects, 346
Systematic risk, 195, 361
measurement of, 365
T
Talb, Nassim Nicholas, 183
Tax Act of 2003, 14
Tax rates
average, 78
Tax shield, 399–400
Taxable income, 53, 77
Taxation
on dividends, 14
Taxes
capital and, 276, 467–468
depreciation and, 349–350
earnings before, 53
interest savings, 407
organizational form and, 14
owed, 77–78
Taxpayer Relief Act of 1997, 420
Temporary financing, 460
Temporary investments, 459–460
Tender offer, 429
Term structure of interest rates, 41–44
for government securities, 42–43
liquidity preference theory, 44
market segmentation theory, 44
observing historical, 41–43
shape of, 43–44
unbiased expectations theory, 43–44
Terminal cash flow, 350, 354
Terminal warehouse agreement, 476
Time value
of money, 5, 142–181
types of problems, 151–152
Timelines
visualizing cash flow with, 143–146
Times interest earned, 117–118
Tobias, Andrew, 142–143
Tolbert, Ben, 446
Total asset turnover, 113–114
Total revenue, 385
Trade credit, 59, 460, 468
Shareholders, 3–4
Shiller, Robert, 7
Short-term credit, 464–476
approximate cost of, 466
cost of, 465
sources of, 466–476
Short-term debt, 59
Short-term debt instruments, 24
Short-term financial planning, 436–455
cash budget, 444–447
effects of sales growth, 440–443
financial forecasting, 437
profitability and dividend policy,
439–440
Short-term liabilities, 59
Short-term notes, 59
Simple interest, 146
Simulation
examination of risk through, 366–368
output from, 368
sensitivity analysis and, 368
Sinking-fund provision, 253
Slope coefficient, 444
Sole proprietorships, 13
Solon, 186–187
S&P 500 Index, 196–202
Spontaneous financing, 438–439, 460
Spot exchange rates, 489, 490
Spot markets, 24
Spot markets versus futures markets, 24–25
Spreadsheets
internal rate of return, calculating with,
317
modified internal rate of return, calcu-
lating with, 324
net present value, calculating with,
312–313
use of, 149–150, 152
Stable dollar dividend per share, 425
Standard & Poor’s, 103, 224
corporate bond ratings, 224–225
Standard deviation, 33, 189
computing of, 33, 189
measurement of, 189–190
Stock
buyback, 427
common, 59, 256–263
expected rate of return to stockholders,
263–268
preferred, 251–253, 279–280
quotes, reading of, 254
repurchases, 427, 429–430
valuation and characteristics of, 250–273
Stock dividends
and stock splits, 426
Stock exchanges, 25–26
benefits of, 25–26
Stock quote
reading of, 254

Index 521
current assets and liabilities, 457–458
short-term credit sources,
466–476
Y
Year-end extra
regular dividend plus, 425
net, 62, 350, 457
net operating, 96
permanent and temporary assets, 459–460
requirements, 346
trimming receivables and, 467
Working-capital management, 11, 456–483
appropriate level of, 459–462
cash conversion cycle, 462–464
Yield to maturity, 41, 235
computing of, 235–237, 239–240
Yields
current, 237
Z
Zero coupon bonds, 224

522 Index
Corporate
A
AEterna Zentaris, 5–6
Altria, 366
American Express, 15
A&P, 16
Apple Computer, 2–3, 346, 416, 426, 427
Appleton Manufacturing Company, 467
Arthur Andersen, 10
AT&T, 220–221, 380
B
Bank of America, 21
Bear Stearns, 28
Beech-Nut, 332
BMW, 16
Bonajet Enterprises, 446
Bristol-Myers Squibb, 10
Brooks Brothers, 16
C
Century National Bank, 35
Chase Manhattan Bank, 28
Chevron, 30, 497–498
Citigroup, 21
Coca-Cola, 16, 360
Columbia Pictures, 16
ConocoPhillips, 497–498
D
Dell Computer Corporation, 456–457,
462–463
Deutsche Bank, 21, 256–257
Dole Foods, 183
Dow Chemical, 332
Drew, Inc., 438–439, 440
Dun & Bradstreet, 103
E
Enron, 10
Exxon Mobil Corp., 22, 30, 32, 274, 292,
497–498
F
Farmer Brothers, 8
Firestone Tire & Rubber, 16, 332
Fitch Investor Services, 224
Ford Motor Company, 306, 332
Foxy Brand, 332
P
Pacific Gas & Electric, 253
PepsiCo Inc., 259
Phillips Petroleum, 454–455
Pierce Grain Company, 387–393, 403–404
Pillsbury Company, 16, 293
Pioneer Natural Resources, 230–231, 234
Prentice Hall, 103
Q
Quaker Oats, 346
R
Raymobile Scooters, 354–357
RCA, 16
Risk Management Association (RMA), 103
S
Salco Furniture Company, Inc., 445–446,
447
Ski-Doo, 310–311, 313
Skip’s Camper Manufacturing Company,
398–399
Starbucks, 194–195, 261–262, 266, 275,
437
Stern Stewart & Co., 125
T
Talbot Corporation, 282
Telink, Inc., 427–428
Texas Instruments, 147
Time-Warner Inc., 92–93
Toyota, 16, 344–345, 359
20th Century Fox, 16
U
UBS AG, 21
United Parcel Service, 436
Universal Studios, 348
V
Valero Energy Corporation, 290, 292
W
Walmart, 427
Walt Disney Company, 4–5, 6–7, 15, 62,
94, 111, 116–117, 118–119, 122,
124–125, 126–127, 304–305
Wells Fargo, 35
G
General Electric (GE), 15, 95
General Motors (GM), 11
Goldman Sachs, 21
Google, 20–21, 23–24, 184, 417
H
Harley Davidson, 194–195, 201–202, 226
Heineken, 380
Hewlett Packard, 147
Home Depot, 50, 51, 53–55, 60–62, 68,
69–70, 71–75, 96–99, 105, 106–128,
196–199
Honda, 16, 359
I
Ibbotson Associates, 193–194
IBM, 5, 6, 15
International Business Machines (IBM).
See IBM
International Harvester (Navistar), 30
J
J.C. Penney, 225
Johnson & Johnson, 261, 262
research and development, 361–362
J.P. Morgan, 28
J.P. Morgan-Chase & Co., 28, 183
K
Kidder-Peabody, 332
Koofers.com, 22
L
Lehman Brothers, 28
Lowe’s Companies, Inc., 105, 106, 107–123
M
McDonald’s, 484–485
Merck, 332
Morgan Stanley, 21, 28
N
Navistar, 6
Netflix, 250–251
Nike, 6
Nissan, 16
O
Office Depot, 183

Cover
Title Page
Copyright Page
Contents
Preface
Acknowledgments
PART 1 The Scope and Environment of Financial Management
1 An Introduction to the Foundations of Financial Management
The Goal of the Firm
Five Principles That Form the Foundations of Finance
The Role of Finance in Business
The Legal Forms of Business Organization
Finance and the Multinational Firm: The New Role
Chapter Summaries
Review Questions
Mini Case
2 The Financial Markets and Interest Rates
Financing of Business: The Movement of Funds Through the Economy
Selling Securities to the Public
Rates of Return in the Financial Markets
Interest Rate Determinants in a Nutshell
Chapter Summaries
Review Questions
Study Problems
Mini Case
3 Understanding Financial Statements and Cash Flows
The Income Statement
The Balance Sheet
Measuring Cash Flows
GAAP and IFRS
Income Taxes and Finance
Accounting Malpractice and Limitations of Financial Statements
Chapter Summaries
Review Questions
Study Problems
Mini Case
Appendix 3A: Free Cash Flows
What Is a Free Cash Flow?
Computing Free Cash Flow
The Other Side of the Coin: Financing Cash Flows
A Concluding Thought
Appendix Summary
Study Problems
4 Evaluating a Firm’s Financial Performance
The Purpose of Financial Analysis
Measuring Key Financial Relationships
The Limitations of Financial Ratio Analysis
Chapter Summaries
Review Questions
Study Problems
Mini Case

PART 2 The Valuation of Financial Assets
5 The Time Value of Money
Compound Interest, Future, and Present Value
Annuities
Making Interest Rates Comparable
The Present Value of an Uneven Stream and Perpetuities
Chapter Summaries
Review Questions
Study Problems
Mini Case
6 The Meaning and Measurement of Risk and Return
Expected Return Defined and Measured
Risk Defined and Measured
Rates of Return: The Investor’s Experience
Risk and Diversification
The Investor’s Required Rate of Return
Chapter Summaries
Review Questions
Study Problems
Mini Case
7 The Valuation and Characteristics of Bonds
Types of Bonds
Terminology and Characteristics of Bonds
Defining Value
What Determines Value?
Valuation: The Basic Process
Valuing Bonds
Bond Yields
Bond Valuation: Three Important Relationships
Chapter Summaries
Review Questions
Study Problems
Mini Case
8 The Valuation and Characteristics of Stock
Preferred Stock
Valuing Preferred Stock
Common Stock
Valuing Common Stock
The Expected Rate of Return of Stockholders
Chapter Summaries
Review Questions
Study Problems
Mini Case
9 The Cost of Capital
The Cost of Capital: Key Definitions and Concepts
Determining the Costs of the Individual Sources of Capital
The Weighted Average Cost of Capital
Calculating Divisional Costs of Capital
Chapter Summaries
Review Questions
Study Problems
Mini Cases

PART 3 Investment in Long-Term Assets
10 Capital-Budgeting Techniques and Practice
Finding Profitable Projects
Capital-Budgeting Decision Criteria
Capital Rationing
Ranking Mutually Exclusive Projects
Chapter Summaries
Review Questions
Study Problems
Mini Case
11 Cash Flows and Other Topics in Capital Budgeting
Guidelines for Capital Budgeting
Calculating a Project’s Free Cash Flows
Options in Capital Budgeting
Risk and the Investment Decisions
Chapter Summaries
Review Questions
Study Problems
Mini Case
Appendix 11A: The Modified Accelerated Cost of Recovery System
What Does All This Mean?
Study Problems

PART 4 Capital Structure and Dividend Policy
12 Determining the Financing Mix
Understanding the Difference Between Business and Financial Risk
Break-Even Analysis
Sources of Operating Leverage
Capital Structure Theory
The Basic Tools of Capital Structure Management
Chapter Summaries
Review Questions
Study Problems
Mini Cases
13 Dividend Policy and Internal Financing
Key Terms
Does Dividend Policy Matter to Stockholders?
The Dividend Decision in Practice
Stock Dividends and Stock Splits
Stock Repurchases
Chapter Summaries
Review Questions
Study Problems
Mini Case

PART 5 Working-Capital Management and International Business Finance
14 Short-Term Financial Planning
Financial Forecasting
Limitations of the Percent of Sales Forecasting Method
Constructing and Using a Cash Budget
Chapter Summaries
Review Questions
Study Problems
Mini Case
15 Working-Capital Management
Managing Current Assets and Liabilities
Determining the Appropriate Level of Working Capital
The Cash Conversion Cycle
Estimating the Cost of Short-Term Credit Using the Approximate Cost-of-Credit Formula
Sources of Short-Term Credit
Chapter Summaries
Review Questions
Study Problems
16 International Business Finance
The Globalization of Product and Financial Markets
Foreign Exchange Markets and Currency Exchange Rates
Interest Rate Parity
Purchasing-Power Parity and the Law of One Price
Capital Budgeting for Direct Foreign Investment
Chapter Summaries
Review Questions
Study Problems
Mini Case

Glossary
A
B
C
D
E
F
G
H
I
J
L
M
N
O
P
R
S
T
U
V
W
Y
Z
Indexes
Subject
A
B
C
D
E
F
G
H
I
J
L
M
N
O
P
Q
R
S
T
U
V
W
Y
Z
Corporate
A
B
C
D
E
F
G
H
I
J
K
L
M
N
O
P
Q
R
S
T
U
V
W