Principles of Managerial Finance - … Capital Budgeting Techniques 430 11 Capital Budgeting Cash Flows 471 12 Risk and Refinements in Capital Budgeting

Principles of

Managerial Finance

A01_ZUTT6315_15_SE_FM.indd 1 27/11/17 8:03 PM

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The Pearson Series in Finance

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Chad J. ZutterUniversity of Pittsburgh

Scott B. SmartIndiana University

Principles of

Managerial Finance

FIFTEENTH EDITION

New York, NY


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Dedicated to our good friend and mentor,

Dr. Lawrence J. Gitman,

who trusted us as coauthors and successors

of Principles of Managerial Finance.

CJZ

SBS



Brief Contents

Contents ix

About the Authors xxix

Preface xxxi

Acknowledgments xliv

vii

PART 6 Long-Term Financial Decisions 551

13 Leverage and Capital Structure 552

14 Payout Policy 606

PART 7 Short-Term Financial Decisions 645

15 Working Capital and Current Assets Management 646

16 Current Liabilities Management 689

PART 8 Special Topics in Managerial Finance 725

17 Hybrid and Derivative Securities 726

18 Mergers, LBOs, Divestitures, and Business Failure 765

19 International Managerial Finance 809

Appendix A-1

Glossary G-1

Index I-1

PART 1 Introduction to Managerial Finance 1

1 The Role of Managerial Finance 2 2 The Financial Market Environment 41

PART 2 Financial Tools 75

3 Financial Statements and Ratio Analysis 76

4 Long- and Short-Term Financial Planning 142

5 Time Value of Money 189

PART 3 Valuation of Securities 255

6 Interest Rates and Bond Valuation 256

7 Stock Valuation 305

PART 4 Risk and the Required Rate of Return 345

8 Risk and Return 346

9 The Cost of Capital 396

PART 5 Long-Term Investment Decisions 429

10 Capital Budgeting Techniques 430

11 Capital Budgeting Cash Flows 471

12 Risk and Refinements in Capital Budgeting 509



Contents

ix

About the Authors xxix

Preface xxxi

Acknowledgments xliv

1.1 Finance and the Firm 4What Is Finance? 4What Is a Firm? 5What Is the Goal of the Firm? 5

FOCUS ON ETHICS: Do Corporate Executives Have a Social Responsibility? 6

The Role of Business Ethics 10

➔ REVIEW QUESTIONS 11

FOCUS ON PRACTICE: Must Search Engines Screen Out Fake News? 12

1.2 Managing The Firm 12

The Managerial Finance Function 13


1.3 Organization Forms, Taxation, and the Principal-Agent Relationship 21

Legal Forms of Business Organization 21

Agency Problems and Agency Costs 28

Corporate Governance 28


in practice

in practice

1.4 Developing Skills for Your Career 32

Critical Thinking 32

Communication and Collaboration 33

Financial Computing Skills 33

Summary 33

Opener-In-Review 35

Self-Test Problem 35

Warm-Up Exercises 36

Problems 37

Spreadsheet Exercise 40

PART 1 Introduction to Managerial Finance 1

1 The Role of Managerial Finance 2

▲ Brookdale Senior Living––Is Brookdale’s Management About to Be Retired? 3


2.1 Financial Institutions 43

Commercial Banks, Investment Banks, and the Shadow Banking System 43


2.2 Financial Markets 45

The Relationship Between Institutions and Markets 45

The Money Market 46

The Capital Market 47

FOCUS ON PRACTICE: Berkshire Hathaway: Can Buffett Be Replaced? 48

The Role of Capital Markets 52

FOCUS ON ETHICS: Should Insider Trading Be Legal? 54


2.3 Regulation of Financial Markets and Institutions 55

Regulations Governing Financial Institutions 55

Regulations Governing Financial Markets 56


2.4 The Securities Issuing Process 57

Issuing Common Stock 57


2.5 Financial Markets in Crisis 65

Financial Institutions and Real Estate Finance 65

Spillover Effects and Recovery from the Great Recession 68


Summary 69

Opener-In-Review 70



Problems 72


INTEGRATIVE CASE 1 Merit Enterprise Corp. 74

in practice

in practice

2 The Financial Market Environment 41

▲ Airbnb––Billions of VC Funding Gives Airbnb Plenty of Room 42

x Contents


Contents xi

PART 2 Financial Tools 75

3 Financial Statements and Ratio Analysis 76

▲ Kroger––Ratios Point to Trouble at Kroger 77

3.1 The Stockholders’ Report 78

The Letter to Stockholders 78

GLOBAL FOCUS: More Countries Adopt International Financial Reporting Standards 78

The Four Key Financial Statements 79

FOCUS ON ETHICS:Earnings Shenanigans 79

Notes to the Financial Statements 85

Consolidating International Financial Statements 85


3.2 Using Financial Ratios 87

Interested Parties 87

Types of Ratio Comparisons 87

Cautions About Using Ratio Analysis 90


3.3 Liquidity Ratios 92

Current Ratio 92

Quick (Acid-Test) Ratio 94


3.4 Activity Ratios 95

Inventory Turnover 95

Average Collection Period 96

Average Payment Period 98

Total Asset Turnover 98

➔ REVIEW QUESTION 99

3.5 Debt Ratios 99

Debt Ratio 101

Debt-to-Equity Ratio 101

Times Interest Earned Ratio 102

Fixed-Payment Coverage Ratio 103


3.6 Profitability Ratios 103

Common-Size Income Statements 103

Gross Profit Margin 104

Operating Profit Margin 106

Net Profit Margin 106

Earnings Per Share (EPS) 107

Return on Total Assets (ROA) 108

Return on Equity (ROE) 108


3.7 Market Ratios 110

Price/Earnings (P/E) Ratio 111

Market/Book (M/B) Ratio 113


3.8 A Complete Ratio Analysis 114

Summarizing of Whole Foods’ Financial Condition 114

DuPont System of Analysis 118


Summary 121

Opener-In-Review 123

Self-Test Problems 123


Problems 125


in practice

in practice


4.1 The Financial Planning Process 144

Long-Term Strategic Financial Plans 144

Short-Term (Operating) Financial Plans 145


4.2 Measuring the Firm’s Cash Flow 146

Depreciation 146

Depreciation Methods 147

Developing the Statement of Cash Flows 149

Free Cash Flow 154

FOCUS ON ETHICS: Is Excess Cash Always a Good Thing? 155

FOCUS ON PRACTICE:Free Cash Flow at LinkedIn 156


4.3 Cash Planning: Cash Budgets 157

The Sales Forecast 157

Preparing the Cash Budget 158

Evaluating the Cash Budget 163

Coping with Uncertainty in the Cash Budget 164

Cash Flow within the Month 165


4.4 Profit Planning: Pro Forma Statements 165

Preceding Year’s Financial Statements 166

Sales Forecast 166


4.5 Preparing the Pro Forma Income Statement 167

Considering Types of Costs and Expenses 168


4.6 Preparing the Pro Forma Balance Sheet 169


4.7 Evaluation of Pro Forma Statements 171


Summary 172




Problems 176


in practice

in practice

4 Long- and Short-Term Financial Planning 142

▲ Netflix Inc.––Not Streaming at Netflix— Cash Flow 143

xii Contents


5.1 The Role of Time Value in Finance 191

Future Value Versus Present Value 191

Computational Tools 192

Basic Patterns of Cash Flow 194


5.2 Single Amounts 195

Future Value of a Single Amount 195

Present Value of a Single Amount 199


➔ EXCEL REVIEW QUESTIONS 202

5.3 Annuities 203

Types of Annuities 203

Finding the Future Value of an Ordinary Annuity 204

Finding the Present Value of an Ordinary Annuity 205

Finding the Future Value of an Annuity Due 207

Finding the Present Value of an Annuity Due 208

Finding the Present Value of a Perpetuity 210



5.4 Mixed Streams 212

Future Value of a Mixed Stream 212

Present Value of a Mixed Stream 214


➔ EXCEL REVIEW QUESTION 215

5.5 Compounding Interest More Frequently Than Annually 215

Semiannual Compounding 215

Quarterly Compounding 216

A General Equation for Compounding 217

Using Computational Tools for Compounding 217

Continuous Compounding 218

Nominal and Effective Annual Rates of Interest 219


FOCUS ON ETHICS: Was the Deal for Manhattan a Swindle? 221


5.6 Special Applications of Time Value 222

Determining Deposits Needed to Accumulate a Future Sum 222

Loan Amortization 223

Finding Interest or Growth Rates 225

FOCUS ON PRACTICE: New Century Brings Trouble for Subprime Mortgages 225

Finding an Unknown Number of Periods 228



Summary 230




Problems 234


INTEGRATIVE CASE 2 Track Software, Inc. 251

in practice

in practice

5 Time Value of Money 189

▲ Mega Millions Jackpot––Pay Me Now or Pay Me Later 190

Contents xiii


PART 3 Valuation of Securities 255

xiv Contents

6 Interest Rates and Bond Valuation 256

▲ Aston Martin Bond Issue––The Name Is Bond—Junk Bond 257

6.1 Interest Rates and Required Returns 258

Interest Rate Fundamentals 258

Term Structure of Interest Rates 263

FOCUS ON PRACTICE: I-Bonds Adjust for Inflation 264

Risk Premiums: Issuer and Issue Characteristics 269


6.2 Government and Corporate Bonds 270

Legal Aspects of Corporate Bonds 271

Cost of Bonds to the Issuer 272

General Features of a Bond Issue 273

Bond Yields 274

Bond Prices 274

Bond Ratings 275

Common Types of Bonds 275

International Bond Issues 276

FOCUS ON ETHICS: “Can Bond Ratings Be Trusted?” 277


6.3 Valuation Fundamentals 279

Key Inputs 279

Basic Valuation Model 280


6.4 Bond Valuation 281

Bond Fundamentals 282

Bond Valuation 282

Semiannual Interest Rates and Bond Values 284

Changes in Bond Values 286

Yield to Maturity (YTM) 289



Summary 291




Problems 296


in practicein practice



7.1 Differences Between Debt and Equity 307

Voice in Management 307

Claims on Income and Assets 307

Maturity 308

Tax Treatment 308


7.2 Common and Preferred Stock 308

Common Stock 309

Preferred Stock 312


7.3 Common Stock Valuation 314

Market Efficiency and Stock Valuation 314

Common Stock Dividend Valuation Model 316

FOCUS ON PRACTICE: Understanding Human Behavior Helps Us Understand Investor Behavior 317

Free Cash Flow Valuation Model 321

Other Approaches to Common Stock Valuation 324

FOCUS ON ETHICS: Index Funds and Corporate Governance 326


7.4 Decision Making and Common Stock Value 328

Changes in Expected Dividends 329

Changes in Risk 329

Combined Effect 330


Summary 330




Problems 334


INTEGRATIVE CASE 3 Encore International 343



Contents xv

7 Stock Valuation 305

▲ Tesla Inc.––Stock Prices Are All About the Future 306


8.1 Risk and Return Fundamentals 348

What Is Risk? 348

What Is Return? 348

FOCUS ON ETHICS: If It Seems Too Good to Be True, It Probably Is 349

Risk Preferences 351


8.2 Risk of a Single Asset 352

Risk Assessment 352

Risk Measurement 355


8.3 Risk of a Portfolio 360

Portfolio Return and Standard Deviation 360

Correlation 362

Diversification 363

Correlation, Diversification, Risk, and Return 365

International Diversification 366

GLOBAL FOCUS: An International Flavor to Risk Reduction 367


8.4 Risk and Return: The Capital Asset Pricing Model (CAPM) 368

Types of Risk 368

The Model: CAPM 369


Summary 378




Problems 382


in practice

in practice

xvi Contents

PART 4 Risk and the Required Rate of Return 345

8 Risk and Return 346

▲ Legg Mason Global Asset Management–– Miller’s Time 347


9.1 Overview of the Cost of Capital 398

FOCUS ON ETHICS:The Cost of Capital Also Rises 398

The Basic Concept 399

Sources of Long-Term Capital 401


9.2 Cost of Long-Term Debt 402

Net Proceeds 402

Before-Tax Cost of Debt 403

After-Tax Cost of Debt 405



9.3 Cost of Preferred Stock 406

Preferred Stock Dividends 407

Calculating the Cost of Preferred Stock 407


9.4 Cost of Common Stock 407

Finding the Cost of Common Stock Equity 408

Cost of Retained Earnings 411


9.5 Weighted Average Cost of Capital 412

Calculating Weighted Average Cost of Capital (WACC) 412

FOCUS ON PRACTICE: Uncertain Times Make for an Uncertain Weighted Average Cost of Capital 414

Capital Structure Weights 415


Summary 416




Problems 419


INTEGRATIVE CASE 4 Eco Plastics Company 427

in practice

in practice

Contents xvii

9 The Cost of Capital 396

▲ J&J––Exceeding Expectations 397


PART 5 Long-Term Investment Decisions 429

xviii Contents

10 Capital Budgeting Techniques 430

▲ Maritime Resources Corp.––The Gold Standard for Evaluating Gold Mines 431

10.1 Overview of Capital Budgeting 432

Motives for Capital Expenditure 432

Steps in the Process 432

Basic Terminology 433

Capital Budgeting Techniques 434


10.2 Payback Period 435

Decision Criteria 436

Pros and Cons of Payback Analysis 436

FOCUS ON PRACTICE: Limits on Payback Analysis 438


10.3 Net Present Value (NPV) 440


NPV and the Profitability Index 442

NPV and Economic Value Added 443



10.4 Internal Rate of Return (IRR) 444


Calculating the IRR 445



10.5 Comparing NPV and IRR Techniques 448

Net Present Value Profiles 448

Conflicting Rankings 449

Which Approach is Better? 453

FOCUS ON ETHICS: Baby You Can Drive My Car—Just Not a VW Diesel 455


Summary 456




Problems 460


in practice

in practice


11.1 Project Cash Flows 473

Major Cash Flow Types 473

Replacement Versus Expansion Decisions 474

Sunk Costs and Opportunity Costs 475

FOCUS ON ETHICS: Fumbling Sunk Costs 476

International Capital Budgeting and Long-Term Investments 477


GLOBAL FOCUS: Changes May Influence Future Investments in China 478

11.2 Finding the Initial Investment 479

Installed Cost of the New Asset 479

After-Tax Proceeds from the Sale of the Old Asset 479

Change in Net Working Capital 482

Calculating the Initial Investment 483


11.3 Finding the Operating Cash Flows 484

Interpreting the Term Cash Flows 485

Interpreting the Term After-Tax 485

Interpreting the Term Incremental 488


11.4 Finding the Terminal Cash Flow 489

After-Tax Proceeds from the Sale of New and Old Assets 490

Change in Net Working Capital 490


11.5 Summarizing the Net Cash Flows 491


Summary 493




Problems 496


in practice

in practice

Contents xix

11 Capital Budgeting Cash Flows 471

▲ Moulson Coors Brewing Company––Brewing Up a Deal 472


12.1 Introduction to Risk in Capital Budgeting 511


12.2 Behavioral Approaches for Dealing with Risk 511

Breakeven Analysis 512

Scenario Analysis 513

Simulation 514

FOCUS ON PRACTICE: The Monte Carlo Method: The Forecast Is for Less Uncertainty 516



12.3 International Risk Considerations 516


12.4 Risk-Adjusted Discount Rates 518

Determining Risk-Adjusted Discount Rates (RADRs) 518

FOCUS ON ETHICS: Remain Calm—All Is Well 521

Applying RADRs 521

Portfolio Effects 524

RADRs in Practice 524


12.5 Capital Budgeting Refinements 526

Comparing Projects with Unequal Lives 526

Recognizing Real Options 529

Capital Rationing 531



Summary 534




Problems 538


INTEGRATIVE CASE 5 Lasting Impressions Company 549

in practice

in practice

xx Contents

12 Risk and Refinements in Capital Budgeting 509

▲ General Motors–– Venezuelan Government Seizes Factory Owned by GM 510


PART 6 Long-Term Financial Decisions 551

Contents xxi

13 Leverage and Capital Structure 552

▲ Apple—Apple Leverages Its Brand 553

13.1 Leverage 554

Breakeven Analysis 555

Operating Leverage 558

FOCUS ON PRACTICE:Qualcomm’s Leverage 561

Financial Leverage 562

Total Leverage 565

FOCUS ON ETHICS: Repo 105 Man 568


13.2 The Firm’s Capital Structure 569

Types of Capital 569

External Assessment of Capital Structure 570

Capital Structure of Non–U.S. Firms 571

Capital Structure Theory 572

Optimal Capital Structure 581


13.3 EBIT–EPS Approach to Capital Structure 583

Presenting a Financing Plan Graphically 584

Comparing Alternative Capital Structures 585

Considering Risk in EBIT–EPS Analysis 586

Basic Shortcoming of EBIT–EPS Analysis 587


13.4 Choosing the Optimal Capital Structure 587

Linkage 587

Estimating Value 588

Maximizing Value Versus Maximizing EPS 589

Some Other Important Considerations 589


Summary 590




Problems 595


in practice

in practice


14.1 The Basics of Payout Policy 608

Elements of Payout Policy 608

Trends in Earnings and Dividends 608

Trends in Dividends and Share Repurchases 610

FOCUS ON ETHICS: Buyback Mountain 612


14.2 The Mechanics of Payout Policy 612

Cash Dividend Payment Procedures 613

Share Repurchase Procedures 615

Tax Treatment of Dividends and Repurchases 616

FOCUS ON PRACTICE:Capital Gains and Dividend Tax Treatment Extended to 2012 and Beyond for Some 617

Dividend Reinvestment Plans 618

Stock Price Reactions to Corporate Payouts 618


14.3 Relevance of Payout Policy 619

Residual Theory of Dividends 619

The Dividend Irrelevance Theory 620

Arguments for Dividend Relevance 621


14.4 Factors Affecting Dividend Policy 622

Legal Constraints 622

Contractual Constraints 624

Growth Prospects 624

Owner Considerations 624

Market Considerations 625


14.5 Types of Dividend Policies 625

Constant-Payout-Ratio Dividend Policy 625

Regular Dividend Policy 626

Low-Regular-and-Extra Dividend Policy 627


14.6 Other Forms of Dividends 627

Stock Dividends 627

Stock Splits 629


Summary 631




Problems 634


INTEGRATIVE CASE 6 O’Grady Apparel Company 642

in practice

in practice

xxii Contents

14 Payout Policy 606

▲ Whirlpool Corporation–– Increasing Dividends 607


PART 7 Short-Term Financial Decisions 645

Contents xxiii

15 Working Capital and Current Assets Management 646

▲ The Hackett Group Survey––Are CFOs Afraid of the Ghost of Financial Crisis Past? 647

15.1 Net Working Capital Fundamentals 648

Working Capital Management 648

Net Working Capital 649

Trade-Off between Profitability and Risk 649


15.2 Cash Conversion Cycle 651

Calculating the Cash Conversion Cycle 652

Funding Requirements of the Cash Conversion Cycle 653

Strategies for Managing the Cash Conversion Cycle 656


15.3 Inventory Management 657

Differing Viewpoints about Inventory Level 657

Common Techniques for Managing Inventory 658

FOCUS ON PRACTICE: In Bed with RFID 662

International Inventory Management 663


15.4 Accounts Receivable Management 663

Credit Selection and Standards 664

FOCUS ON ETHICS: If You Can Bilk It, They Will Come 665

Credit Terms 669

Credit Monitoring 671


15.5 Management of Receipts and Disbursements 673

Float 674

Speeding Up Collections 674

Slowing Down Payments 675

Cash Concentration 675

Zero-Balance Accounts 676

Investing in Marketable Securities 677


Summary 679




Problems 683


in practice

in practice


16.1 Spontaneous Liabilities 691

Accounts Payable Management 691

Accruals 696


16.2 Unsecured Sources of Short-Term Loans 696

FOCUS ON ETHICS: Bank Loans and Shareholder Wealth 697

Bank Loans 697

Commercial Paper 703

FOCUS ON PRACTICE: The Ebb and Flow of Commercial Paper 704

International Loans 705


16.3 Secured Sources of Short-Term Loans 707

Characteristics of Secured Short-Term Loans 707

Use of Accounts Receivable as Collateral 708

Use of Inventory as Collateral 710


Summary 712




Problems 715


INTEGRATIVE CASE 7 Casa de Diseño 723

in practice

in practice

xxiv Contents

16 Current Liabilities Management 689

▲ FastPay––Getting Cash into the Hands of Online Media Companies 690


PART 8 Special Topics in Managerial Finance 725

Contents xxv

17 Hybrid and Derivative Securities 726

▲ Advanced Micro Devices––AMD Taps the Bond Market for Cash 727

17.1 Overview of Hybrids and Derivatives 728


17.2 Leasing 728

Types of Leases 728

Leasing Arrangements 729

FOCUS ON PRACTICE: I’d Like to Return This (Entire Store), Please 730

Lease-Versus-Purchase Decision 731

Effects of Leasing on Future Financing 735

Advantages and Disadvantages of Leasing 736


17.3 Convertible Securities 737

Types of Convertible Securities 737

General Features of Convertibles 738

Financing with Convertibles 740

Determining the Value of a Convertible Bond 741


17.4 Stock Purchase Warrants 744

Key Characteristics 744

Implied Price of an Attached Warrant 745

Values of Warrants 746


17.5 Options 748

Calls and Puts 748

Options Markets 749

Options Trading 749

Role of Call and Put Options in Fund Raising 751

Hedging Foreign-Currency Exposures with Options 751

FOCUS ON ETHICS: Banking on Options 752


Summary 753




Problems 757


in practice

in practice


18.1 Merger Fundamentals 767

Terminology 767

Motives for Merging 769

FOCUS ON ETHICS: Is There Any Good in Greed? 770

Types of Mergers 772


18.2 LBOs and Divestitures 773

Leveraged Buyouts (LBOs) 773

Divestitures 774


18.3 Analyzing and Negotiating Mergers 776

Valuing the Target Company 776

Stock Swap Transactions 778

Merger Negotiation Process 784

Holding Companies 785

International Mergers 787


GLOBAL FOCUS: International Mergers 789

18.4 Business Failure Fundamentals 790

Types of Business Failure 790

Major Causes of Business Failure 790

Voluntary Settlements 791


18.5 Reorganization and Liquidation in Bankruptcy 793

Bankruptcy Legislation 793

Reorganization in Bankruptcy (Chapter 11) 794

Liquidation in Bankruptcy (Chapter 7) 796


Summary 798




Problems 801


in practice

in practice

xxvi Contents

18 Mergers, LBOs, Divestitures, and Business Failure 765

▲ Dell, Inc.––Carl Icahn and Founder Michael Dell Fight for Computer Maker 766


19.1 The Multinational Company and Its Environment 811

Key Trading Blocs 811

GATT and the WTO 813

Legal Forms of Business Organization 813

Taxes 814

Financial Markets 816


19.2 Financial Statements 818

Subsidiary Characterization and Functional Currency 818

Translation of Individual Accounts 818


19.3 Risk 820

Exchange Rate Risks 820

Political Risks 825

FOCUS ON ETHICS: Is Fair-Trade Coffee Fair? 827


19.4 Long-Term Investment and Financing Decisions 828

Foreign Direct Investment 828

Investment Cash Flows and Decisions 828

Capital Structure 829

Long-Term Debt 830

GLOBAL FOCUS: Take an Overseas Assignment to Take a Step Up the Corporate Ladder 831

Equity Capital 832


19.5 Short-Term Financial Decisions 834

Cash Management 836

Credit and Inventory Management 838


19.6 Mergers and Joint Ventures 839


Summary 841




Problems 844


INTEGRATIVE CASE 8 Organic Solutions 847

in practice

in practice

Contents xxvii

19 International Managerial Finance 809

▲ Mazda Motor Corp.––Selling More Cars and Making Less Money 810

Appendix A-1

Glossary G-1

Index I-1



xxix

About the Authors

Chad J. Zutter is a finance professor and the Dean’s Excellence Faculty Fel-low at the Katz Graduate School of Business at the University of Pittsburgh. Dr. Zutter received his B.B.A. from the University of Texas at Arlington and his Ph.D. from Indiana University. His research has a practical, applied focus and has been the subject of feature stories in, among other prominent outlets, The Economist and CFO Magazine. His papers have been cited in arguments before the U.S. Supreme Court and in consultation with companies such as Google and Intel. Dr. Zutter won the prestigious Jensen Prize for the best paper published in the Journal of Financial Economics and a best paper award from the Journal of Corporate Finance. He has won teaching awards at the Kelley School of Business at Indiana University and the Katz Graduate School of Business at the University of Pittsburgh. Prior to his career in academics, Dr. Zutter was a submariner in the U.S. Navy. Dr. Zutter and his wife have four children and live in Pittsburgh, Pennsylvania. In his free time he enjoys horseback riding and downhill skiing.

Scott B. Smart is a finance professor and the Whirlpool Finance Faculty Fellow at the Kelley School of Business at Indiana University. Dr. Smart received his B.B.A. from Baylor University and his M.A. and Ph.D. from Stanford University. His research focuses primarily on applied corporate finance topics and has been published in journals such as the Journal of Finance, the Journal of Financial Economics, the Journal of Corporate Finance, Financial Management, and others. His articles have been cited by business publications including The Wall Street Journal, The Economist, and Business Week. Winner of more than a dozen teaching awards, Dr. Smart has been listed multiple times as a top busi-ness school teacher by Business Week. He has held Visiting Professor positions at the University of Otago and Stanford University, and he worked as a Visiting Scholar for Intel Corporation, focusing on that company’s mergers and acqui-sitions activity during the ‘‘Dot-com’’ boom in the late 1990s. As a volunteer, Dr. Smart currently serves on the boards of the Indiana University Credit Union and Habitat for Humanity. In his spare time he enjoys outdoor pursuits such as hiking and fly fishing.



xxxi

Preface

NEW TO THIS EDITION

Finance is a dynamic discipline, as illustrated on this book’s cover by the evolu-tion of payment methods from coins and paper currency to bitcoin. Technology is rapidly reshaping finance, just as it has other industries. For example, in September 2017 Google introduced a new payment technology in India. Tez, a method of transferring money using sounds to connect two devices, was down-loaded by millions of consumers in a matter of days. As we made plans to publish the fifteenth edition, we were mindful of changes in managerial finance practices that have taken hold in recent years. We carefully assessed feedback from users of the fourteenth edition as well as instructors not currently using our text about content changes that would improve this teaching and learning tool.

In every chapter, our changes were designed to make the material more up to date and more relevant for students. A number of new topics have been added at appropriate places, and new features appear in each chapter:

• We replaced nearly all of the chapter-opening vignettes with stories gathered from the business press in recent years that illustrate key ideas in each chapter. Many of the chapter openers feature companies such as Airbnb, Kroger, Netflix, Apple, Tesla, General Motors, Whirlpool, and Dell that are familiar to students. We designed these opening vignettes to impress upon students that the material they will see in each chapter is relevant for business in the “real world.”

• At the end of each chapter we return to the opening vignette with an Opener-In- Review question that asks students to apply a concept that they have learned in the chapter to the business situation described in the chapter opener.

• We have rewritten all of the Focus on Ethics boxes, using new examples to highlight situations in which businesses or individuals have engaged in unethi-cal behavior. The boxes explore the consequences of ethical lapses and the ways in which markets and governments play a role in enforcing ethical standards.

• New in this edition are Chapter Introduction Videos and animations. In the introduction videos the authors explain the importance of the chapter content within the context of managerial finance. The animations for select in-chapter figures and examples allow students to manipulate inputs to determine out-puts in order to illustrate concepts and reinforce learning. MyLab Finance also offers new and updated Solution Videos that allow students to watch a video of the author discussing or solving in-chapter examples. We have also updated the financial calculator images that appear in the book to better match the financial calculator available on MyLab Finance.

• The chapter-ending Spreadsheet Exercises as well as select end-of-chapter problems in the text are now offered in MyLab Finance as auto-graded Excel Projects. Using proven, field-tested technology, auto-graded Excel Projects allow instructors to seamlessly integrate Microsoft Excel content into their course without having to manually grade spreadsheets. Students have the opportunity to practice important finance skills in Excel, helping them to master key concepts and gain proficiency with the program.


• We added new problems to each chapter, many of which require students to use real-world data to reach a solution.

The chapter sequence is essentially unchanged from the prior edition, but there are some noteworthy changes within each chapter. This edition contains nineteen chapters divided into eight parts. Each part is introduced by a brief over-view, which is intended to give students an advance sense for the collective value of the chapters included in the part.

Part 1 contains two chapters. Chapter 1 provides an overview of the role of managerial finance in a business enterprise. It contains new, expanded content focusing on the goal of the firm and the broad principles that financial managers use in their pursuit of that goal. Chapter 2 describes the financial market context in which firms operate, with new coverage focusing on the transactions costs investors face when trading in secondary markets.

Part 2 contains three chapters focused on basic financial skills such as finan-cial statement analysis, cash flow analysis, and time-value-of-money calculations. Chapter 3 provides an in-depth ratio analysis using real data from Whole Foods just prior to its acquisition by Amazon. The ratios provide opportunities for interesting discussion about some of the possible motives for that acquisition. We reorganized the flow of material in Chapter 4 to emphasize first the broad goals of strategic and operational financial planning and then the importance of cash flow within any financial plan. In Chapter 5, we rewrote much of the discussion to make time-value-of-money concepts simpler and more intuitive. We also added new coverage of growing perpetuities.

Part 3 focuses on bond and stock valuation. We placed these two chapters just ahead of the risk and return chapter to provide students with exposure to basic material on bonds and stocks that is easier to grasp than some of the more theoretical concepts in the next part. New in Chapter 6 is a discussion of the neg-ative interest rates prevailing on government bonds in Japan and some European countries, as well as an expanded discussion of the tendency of the yield curve to invert prior to a recession. Chapter 7 offers new coverage of the use of price-to-earnings multiples to value stocks.

Part 4 contains the risk and return chapter as well as the chapter on the cost of capital. We believe that following the risk and return chapter with the cost of capital material helps students understand the important principle that the expectations of a firm’s investors shape how the firm should approach major investment decisions (which are covered in Part 5). In other words, Part 4 is designed to help students understand where a project “hurdle rate” comes from before they start using hurdle rates in capital budgeting problems. Updates to Chapter 8 include new historical data on stocks, bonds, and Treasury bills, as well as examples and problems featuring real data on companies such as Apple, Google, Coca-Cola, and Wal-Mart. Chapter 9 contains new material on the use of market-value-based weights in the cost of capital calculation featuring actual data on the capital structure of Netflix. Throughout the chapter we have revised examples and problems to reflect today’s low interest rate environment and the correspondingly low after-tax cost of debt faced by most public companies.

Part 5 contains three chapters on various capital budgeting topics. The first chapter focuses on capital budgeting methods such as payback and net present value analysis. A new feature of this chapter is an updated discussion of eco-nomic value added using data from Exxon Mobil Corp. The second chapter in this part explains how financial analysts construct cash flow projections, which

xxxii Preface


Preface xxxiii

are a required component of net present value analysis. The final chapter in this section describes how firms analyze the risks associated with capital investments.

Parts 6 deals with the topics of capital structure and payout policy. These two chapters contain updated material on trends in firms’ use of leverage and their payout practices. Chapter 13 provides a new Focus on Practice box dis-cussing how Qualcomm’s highly skilled labor force turns what often is thought of as a variable cost into a fixed cost and thereby creates operating leverage. The chapter also contains new expanded coverage of the role that expected bank-ruptcy costs play in capital structure decisions. A new discussion in Chapter 14 highlights how and why companies have shifted their payout policies away from dividends and toward share repurchases over time.

Part 7 contains two chapters centered on working capital issues. A major development in business has been the extent to which firms have found new ways to economize on working capital investments. The first chapter in Part 7 explains why and how firms work hard to squeeze resources from their investments in current assets such as cash and inventory. The second chapter in this part focuses more on management of current liabilities.

Finally, Part 8 has three chapters covering a variety of topics, including hybrid securities, mergers and other forms of restructurings, and international finance. These subjects are some of the most dynamic areas in financial prac-tice, and we have made a number of changes here to reflect current practices. Chapter 17 contains new examples of convertible securities issued by firms such as STMicroelectronics and Tesla. Chapter 18 covers important merger concepts with examples featuring recent transactions involving Anthem-Cigna, Fiat-Chrysler, Dow-DuPont, Berkshire Hathaway-Oncor, and Broadcom Ltd.-Maxlinear.

Although the text content is sequential, instructors can assign almost any chapter as a self-contained unit, enabling instructors to customize the text to various teaching strategies and course lengths.

Like the previous editions, the fifteenth edition incorporates a proven learning system, which integrates pedagogy with concepts and practical applica-tions. It concentrates on the knowledge that is needed to make keen financial decisions in an increasingly competitive business environment. The strong peda-gogy and generous use of examples—many of which use real data from markets or companies—make the text an easily accessible resource for in-class learning or out-of-class learning, such as online courses and self-study programs.

SOLVING TEACHING AND LEARNING CHALLENGES

The desire to write Principles of Managerial Finance came from the experience of teaching the introductory managerial finance course. Those who have taught the introductory course many times can appreciate the difficulties that some stu-dents have absorbing and applying financial concepts. Students want a book that speaks to them in plain English and explains how to apply financial concepts to solve real-world problems. These students want more than just description; they also want demonstration of concepts, tools, and techniques. This book is written with the needs of students in mind, and it effectively delivers the resources that students need to succeed in the introductory finance course.

Courses and students have changed since the first edition of this book, but the goals of the text have not changed. The conversational tone and wide use of examples set off in the text still characterize Principles of Managerial Finance.


Building on those strengths, fifteen editions, numerous translations, and well over half a million U.S. users, Principles has evolved based on feedback from both instructors and students, from adopters, nonadopters, and practitioners. In this edition, we have worked to ensure that the book reflects contemporary thinking and pedagogy to further strengthen the delivery of the classic topics that our users have come to expect. Below are descriptions of the most important resources in Principles that help meet teaching and learning challenges.

Users of Principles of Managerial Finance have praised the effectiveness of the book’s Teaching and Learning System, which they hail as one of its hall-marks. The system, driven by a set of carefully developed learning goals, has been retained and polished in this fifteenth edition. The “walkthrough” on the pages that follow illustrates and describes the key elements of the Teaching and Learning System. We encourage both students and instructors to acquaint them-selves at the start of the semester with the many useful features the book offers.

2

1

LEARNING GOALS

Define finance and the managerial finance function.

Describe the goal of the firm, and explain why maximizing the value of the firm is an appropriate goal for a business.

Identify the primary activities of the financial manager.

Explain the key principles that financial managers use when making business decisions.

Describe the legal forms of business organization.

Describe the nature of the principal–agent relationship between the owners and managers of a corporation, and explain how various corporate governance mechanisms attempt to manage agency problems.

LG 1

LG 2

LG 3

LG 4

LG 5

LG 6

The Role of Managerial Finance

WHY THIS CHAPTER MATTERS TO YOU

In your professional lifeACCOUNTING You need to understand the relationships between the accounting and finance functions within the firm, how decision makers rely on the financial statements you prepare, why maximizing a firm’s value is not the same as maximizing its profits, and the ethical duty you have when reporting financial results to investors and other stakeholders.

INFORMATION SYSTEMS You need to understand why financial information is important to managers in all functional areas, the documentation that firms must produce to comply with various regulations, and how manipulating information for personal gain can get managers into serious trouble.

MANAGEMENT You need to understand the various legal forms of a business organization, how to communicate the goal of the firm to employees and other stakeholders, the advantages and disadvantages of the agency relationship between a firm’s managers and its owners, and how compensation systems can align or misalign the interests of managers and investors.

MARKETING You need to understand why increasing a firm’s revenues or market share is not always a good thing, how financial managers evaluate aspects of customer relations such as cash and credit management policies, and why a firm’s brands are an important part of its value to investors.

OPERATIONS You need to understand the financial benefits of increasing a firm’s production efficiency, why maximizing profit by cutting costs may not increase the firm’s value, and how managers have a duty to act on behalf of investors when operating a corporation.

In your personal lifeMany principles of managerial finance also apply to your personal life. Learning a few simple principles can help you manage your own money more effectively.

CH

AP

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MyLab Finance Chapter Introduction Video

M01B_ZUTT6315_15_SE_C01_pp002-040.indd 2 07/11/17 2:53 PM

Six Learning Goals at the start of the chapter highlight the most impor-tant concepts and techniques in the chapter. Students are reminded to think about the learning goals while working through the chapter by stra-tegically placed learning goal icons.

To help students understand the rel-evance of a chapter within the over-arching framework of managerial finance, every chapter has available in MyLab Finance a short chapter intro-duction video by an author.

Every chapter opens with a feature, titled Why This Chapter Matters to You, that helps motivate student interest by highlighting both profes-sional and personal benefits from achieving the chapter learning goals.

Its first part, In Your Professional Life, discusses the intersection of the finance topics covered in the chapter with the concerns of other major business disciplines. It encourages students majoring in accounting, information systems, management, marketing, and operations to appre-ciate how financial acumen will help them achieve their professional goals.

xxxiv Preface

The second part, In Your Personal Life, identifies topics in the chapter that will have particular application to personal finance. This feature also helps students appreciate the tasks performed in a business setting by pointing out that the tasks are not necessarily different from those that are relevant in their personal lives.


Each chapter begins with a short opening vignette that describes a recent real-company event related to the chapter topic. These stories raise interest in the chapter by demonstrating its relevance in the business world. Most of these opening vignettes are entirely new to this edition. New! In MyLab Finance, users will find a brief video providing an overview of each chapter’s content.

42

Billions of VC Funding Gives Airbnb Plenty of Room

T he daughter of Chinese immigrants and founder of

the venture capital firm, Cowboy Ventures, Aileen Lee

added a new term to the business lexicon in her 2013

blog post on Tech Crunch. Lee used the word unicorn to

describe a privately held tech startup worth more than $1 billion. Prior to 2013, private

companies with valuations that high were about as rare as the mythical one-horned equine

creature. But by 2017, less than four years after Lee coined the term, more than 200 startups

had achieved unicorn status around the world. Most of those called the United States home,

with the greatest concentration in California’s Silicon Valley.

One example was the room-sharing service, Airbnb. Founded in 2008, Airbnb received more

than $3 billion in funding from venture capital firms, with the latest $1 billion arriving in 2017 and

bringing the company’s total estimated value to $31 billion. The company’s rapid growth fueled

speculation that it—along with other unicorns, such as the ride-sharing service Uber—would soon

convert from a privately held company to a public corporation through an initial public offering

(IPO) of common stock. Airbnb’s cofounder, Brian Chesky, noted that most companies raising

money in an IPO do so because they need the money to finance new investment, want to create a

more visible brand, wish to allow existing shareholders to liquidate some of their investments, or

desire to use shares of stock as a currency to make new acquisitions. Chesky claimed that none of

those situations applied to Airbnb. The company had plenty of money and was profitable, it was

already well known among consumers, and its private investors had been patient. Most analysts

believed that at some point in the near future, the venture capitalists and other investors who

provided Airbnb with its early funding would want to cash out their investment, and an IPO proved

the most likely way to create that opportunity.

Source: “Welcome to the Unicorn Club: Learning from Billion-dollar Startups,” by Aileen Lee, November 2, 2013, Tech Crunch.

AIRBNB

Russell Hart/Alamy Stock Photo

M02_ZUTT6315_15_SE_C02_pp041-074.indd 42 07/11/17 4:00 PM4 PART ONE Introduction to Managerial Finance

1.1 Finance and the Firm

The field of finance is broad and dynamic. Finance influences everything that firms do, from hiring personnel to building factories to launching new advertis-ing campaigns. Because almost any aspect of business has important financial dimensions, many financially oriented career opportunities await those who understand the principles of finance described in this textbook. Even if you see yourself pursuing a career in another discipline such as marketing, operations, accounting, supply chain, or human resources, you’ll find that understanding a few crucial ideas in finance will enhance your professional success. Knowing how financial managers think is important, especially if you’re not one yourself, because they are often the gatekeepers of corporate resources. Fluency in the lan-guage of finance will improve your ability to communicate the value of your ideas to your employer. Financial knowledge will also make you a smarter con-sumer and a wiser investor with your own money.

WHAT IS FINANCE?

Finance is the science and art of how individuals and firms raise, allocate, and invest money. The science of finance utilizes financial theories and concepts to establish general rules that can guide managers in their decisions. The art of finance involves adapting theory to particular business situations with their own unique circum-stances. Managerial finance is concerned with the responsibilities of a financial manager working in a business. Though business finance is the primary focus of this book, the principles of finance apply to both personal and professional decision making. At the personal level, for instance, finance helps individuals decide how much of their earnings to spend, how much to save, and how to invest their savings. Financial thinking helps consumers decide when borrowing money is appropriate and enables them to critically evaluate loan offers with different terms. In a business context, finance involves the same types of decisions: how firms raise money from investors, how firms invest money in attempting to create value for their investors, and how firms decide whether to reinvest earnings in the business or distribute

LG 1 LG 2earnings back to investors. The keys to good financial decisions are much the same for businesses and individuals, which is why most students will benefit from an understanding of finance regardless of their profession. Learning the techniques of good financial analysis will not only help you make better financial decisions as a consumer but will also assist you in understanding the financial consequences of important business decisions, no matter what career path you follow.

WHAT IS A FIRM?

What is a firm? Put simply, a firm is a business organization that sells goods or services. However, a more complete answer attempts to explain why firms exist. They exist because investors want access to risky investment opportunities. In other words, firms are risky business organizations that, if not for investors’ will-ingness to bear risk, would have difficulty generating the necessary investment capital to operate. For example, most investors do not have the expertise or wealth required to start a personal computer company, so instead they invest in a company like Apple. Even when a few individuals, such as Steve Jobs, Steve Woz-niak, and Ronald Wayne, had the requisite expertise and wealth to start Apple Computer in a garage in 1976, vast amounts of additional money (i.e., invest-ment capital) from investors were necessary for the firm to grow into what Apple is today. So, ultimately, firms are intermediaries that bring together investors and risky investment opportunities. Firms pool investment capital, make risky invest-ment decisions, and manage risky investments all on behalf of investors who would otherwise not be able to do so effectively or efficiently on their own.

WHAT IS THE GOAL OF THE FIRM?

What goal should managers pursue? This question has no shortage of possible answers. Some might argue that managers should focus entirely on satisfying customers. Firms pursuing this goal could measure their products’ market shares to gauge progress. Others suggest that managers must first inspire and motivate employees; in that case, employee turnover might be the key success metric to watch. Clearly, the goal or goals that managers select will affect many of the decisions they make, so choosing an objective is a critical determinant of how businesses operate.

Maximize Shareholder Wealth

Finance teaches that the primary goal of managers should be to maximize the wealth of the firm’s owners—the stockholders or shareholders. Through the years, that recommendation has generated a lot of controversy. The Economist magazine once referred to shareholder value maximization as “the most powerful idea in business,” but Jack Welch, the long-time Chief Executive Officer (CEO) of General Electric and a man Fortune magazine named “Manager of the Century,” once called maximizing shareholder value “the dumbest idea in the world.” Welch’s assessment is particularly ironic because during his leadership, almost no company generated more wealth for its shareholders than General Electric. A $1,000 invest-ment in GE stock made in 1981 when Welch took the reigns as CEO would have grown to roughly $67,000 by the time he retired in 2001. The simplest and best measure of stockholder wealth is the share price, so most finance textbooks (includ-ing ours) instruct managers to take actions that increase the firm’s share price.

financeThe science and art of how indi-viduals and firms raise, allocate, and invest money.

managerial financeConcerns the duties of the financial manager in a business.

MATTER OF FACT

Finance Professors Aren’t Like Everyone Else

Professionals who advise individual investors know that many people are more willing to invest in the stock market if it has been rising in the recent past and are less willing to do so if it has been falling. Such “trend-chasing” behavior often leaves investors worse off than if they had invested consistently over time. Classical finance theory suggests that past performance of the stock market is a very poor predictor of future performance, and therefore individuals should not base investment decisions on the market’s recent history. A survey found that at least one group of investors did not fall prey to trend chasing in the stock market. When deciding whether to invest in stocks, finance profes-sors were not influenced by the market’s recent trend, presumably because they know that past performance does not predict the future. That’s just one of the lessons in this book that can help you make better choices with your own money.

Source: Hibbert, Lawrence, and Prakash, 2012, “Do finance professors invest like everyone else?” Financial Analysts Journal.


Learning goal icons tie chapter content to the learning goals and appear next to related text sec-tions and again in the chapter-end summary, end-of-chapter problems and exercises, and supplements such as the Test Bank and MyLab.

10 PART ONE Introduction to Managerial Finance

To illustrate, consider that in March 2017, the online retailing giant Amazon reported that it earned a profit of $4.90 per share over the previous 12 months. Another company, Clorox, reported almost identical earnings per share of $4.92. Yet the stock prices of these two companies could not have been more different. Amazon was trading for $850 per share, whereas Clorox stock was selling for just $137. In other words, investors were willing to pay 6 times more for shares of Amazon even though it reported virtually the same EPS as Clorox. Why? Sev-eral factors may contribute, but the most plausible answer is that investors envi-sion rosier long-term prospects for Amazon. If the only matter of concern to investors was short-term profits, then the prices of Amazon and Clorox should have been much closer because their profits, at least in the short term, were nearly identical.

Third, the stakeholder perspective is intrinsically difficult to implement, and advocates of the idea that managers should consider all stakeholders’ interests along with those of shareholders do not typically indicate how man-agers should carry it out. For example, how much emphasis should managers place on the interests of different stakeholder groups? Are the interests of employees more or less important than the desires of customers? Should mem-bers of the local community who do no business with the firm have an equal say with the firm’s suppliers? When different stakeholder groups disagree on the action a firm should take, how should managers make important decisions? In contrast, the goal of shareholder maximization clarifies what actions man-agers should take.

Fourth, many people misinterpret the statement that managers should maxi-mize shareholder wealth as implying that managers should take any action, including illegal or unethical actions, that increases the stock price. Even the most ardent supporters of shareholder value maximization as the firm’s primary goal acknowledge that managers must act within ethical and legal boundaries.

THE ROLE OF BUSINESS ETHICS

Business ethics are the standards of conduct or moral judgment that apply to persons engaged in commerce. Violations of these standards involve a variety of actions: “creative accounting,” earnings management, misleading financial fore-casts, insider trading, fraud, excessive executive compensation, options backdat-ing, bribery, and kickbacks. The financial press has reported many such violations in recent years, involving such well-known companies as Wells Fargo, where employees opened new accounts without authorization from customers, and Volkswagen, where engineers set up elaborate deceptions to get around pol-lution controls. In these and similar cases, the offending companies suffered various penalties, including fines levied by government agencies, damages paid to plaintiffs in lawsuits, or lost revenues from customers who abandoned the firms because of their errant behavior. Most companies have adopted formal ethical standards, although clearly adherence to and enforcement of those stan-dards vary. The goal of such standards is to motivate business and market par-ticipants to adhere to both the letter and the spirit of laws and regulations concerned with business and professional practice. Most business leaders believe that businesses actually strengthen their competitive positions by maintaining high ethical standards.

business ethicsStandards of conduct or moral judgment that apply to persons engaged in commerce.


For help in study and review, boldfaced key terms and their definitions appear in the margin where they are first introduced. These terms are also bold-faced in the book’s index and appear in the end-of-book glossary.

4 PART ONE Introduction to Managerial Finance

1.1 Finance and the Firm

The field of finance is broad and dynamic. Finance influences everything that firms do, from hiring personnel to building factories to launching new advertis-ing campaigns. Because almost any aspect of business has important financial dimensions, many financially oriented career opportunities await those who understand the principles of finance described in this textbook. Even if you see yourself pursuing a career in another discipline such as marketing, operations, accounting, supply chain, or human resources, you’ll find that understanding a few crucial ideas in finance will enhance your professional success. Knowing how financial managers think is important, especially if you’re not one yourself, because they are often the gatekeepers of corporate resources. Fluency in the lan-guage of finance will improve your ability to communicate the value of your ideas to your employer. Financial knowledge will also make you a smarter con-sumer and a wiser investor with your own money.

WHAT IS FINANCE?

Finance is the science and art of how individuals and firms raise, allocate, and invest money. The science of finance utilizes financial theories and concepts to establish general rules that can guide managers in their decisions. The art of finance involves adapting theory to particular business situations with their own unique circum-stances. Managerial finance is concerned with the responsibilities of a financial manager working in a business. Though business finance is the primary focus of this book, the principles of finance apply to both personal and professional decision making. At the personal level, for instance, finance helps individuals decide how much of their earnings to spend, how much to save, and how to invest their savings. Financial thinking helps consumers decide when borrowing money is appropriate and enables them to critically evaluate loan offers with different terms. In a business context, finance involves the same types of decisions: how firms raise money from investors, how firms invest money in attempting to create value for their investors, and how firms decide whether to reinvest earnings in the business or distribute

LG 1 LG 2earnings back to investors. The keys to good financial decisions are much the same for businesses and individuals, which is why most students will benefit from an understanding of finance regardless of their profession. Learning the techniques of good financial analysis will not only help you make better financial decisions as a consumer but will also assist you in understanding the financial consequences of important business decisions, no matter what career path you follow.

WHAT IS A FIRM?

What is a firm? Put simply, a firm is a business organization that sells goods or services. However, a more complete answer attempts to explain why firms exist. They exist because investors want access to risky investment opportunities. In other words, firms are risky business organizations that, if not for investors’ will-ingness to bear risk, would have difficulty generating the necessary investment capital to operate. For example, most investors do not have the expertise or wealth required to start a personal computer company, so instead they invest in a company like Apple. Even when a few individuals, such as Steve Jobs, Steve Woz-niak, and Ronald Wayne, had the requisite expertise and wealth to start Apple Computer in a garage in 1976, vast amounts of additional money (i.e., invest-ment capital) from investors were necessary for the firm to grow into what Apple is today. So, ultimately, firms are intermediaries that bring together investors and risky investment opportunities. Firms pool investment capital, make risky invest-ment decisions, and manage risky investments all on behalf of investors who would otherwise not be able to do so effectively or efficiently on their own.

WHAT IS THE GOAL OF THE FIRM?

What goal should managers pursue? This question has no shortage of possible answers. Some might argue that managers should focus entirely on satisfying customers. Firms pursuing this goal could measure their products’ market shares to gauge progress. Others suggest that managers must first inspire and motivate employees; in that case, employee turnover might be the key success metric to watch. Clearly, the goal or goals that managers select will affect many of the decisions they make, so choosing an objective is a critical determinant of how businesses operate.

Maximize Shareholder Wealth

Finance teaches that the primary goal of managers should be to maximize the wealth of the firm’s owners—the stockholders or shareholders. Through the years, that recommendation has generated a lot of controversy. The Economist magazine once referred to shareholder value maximization as “the most powerful idea in business,” but Jack Welch, the long-time Chief Executive Officer (CEO) of General Electric and a man Fortune magazine named “Manager of the Century,” once called maximizing shareholder value “the dumbest idea in the world.” Welch’s assessment is particularly ironic because during his leadership, almost no company generated more wealth for its shareholders than General Electric. A $1,000 invest-ment in GE stock made in 1981 when Welch took the reigns as CEO would have grown to roughly $67,000 by the time he retired in 2001. The simplest and best measure of stockholder wealth is the share price, so most finance textbooks (includ-ing ours) instruct managers to take actions that increase the firm’s share price.

financeThe science and art of how indi-viduals and firms raise, allocate, and invest money.

managerial financeConcerns the duties of the financial manager in a business.

MATTER OF FACT

Finance Professors Aren’t Like Everyone Else

Professionals who advise individual investors know that many people are more willing to invest in the stock market if it has been rising in the recent past and are less willing to do so if it has been falling. Such “trend-chasing” behavior often leaves investors worse off than if they had invested consistently over time. Classical finance theory suggests that past performance of the stock market is a very poor predictor of future performance, and therefore individuals should not base investment decisions on the market’s recent history. A survey found that at least one group of investors did not fall prey to trend chasing in the stock market. When deciding whether to invest in stocks, finance profes-sors were not influenced by the market’s recent trend, presumably because they know that past performance does not predict the future. That’s just one of the lessons in this book that can help you make better choices with your own money.

Source: Hibbert, Lawrence, and Prakash, 2012, “Do finance professors invest like everyone else?” Financial Analysts Journal.


Matter of Fact boxes provide interesting empirical facts, usually featuring recent data, that add back-ground and depth to the material covered in the chapter.

Preface xxxv


Examples are an important component of the book’s learning system. Numbered and clearly set off from the text, they provide an immediate and concrete demonstration of how to apply financial concepts, tools, and techniques. Many of these feature real-world data.

Examples illustrating time-value-of-money techniques often show the use of time lines, equations, financial cal-culators, and spreadsheets (with cell formulas). For instructors who prefer to use tables with interest rate fac-tors, an IRF icon appearing with some examples indicates that the example can be solved using the interest rate factors. The reader can access the Interest Rate Factor Supplement in MyLab Finance. The Interest Rate Factor Supplement is a self-contained supplement that explains how the reader should use the interest rate factors and documents how the in-chapter examples can be solved by using them.

MyLab Finance contains additional resources to demonstrate the examples. The MyLab Financial Calculator refer-ence indicates that the reader can use the finance calculator tool in MyLab Finance to find the solution for an example by inputting the keystrokes shown in the calculator screenshot. The MyLab Finance Solution Video refer-ence indicates that the reader can go to MyLab Finance to watch a video of the author discussing or solving the example. The MyLab Finance Video reference indicates that the reader can watch a video on related core topical areas.

Personal Finance Examples demonstrate how students can apply managerial finance concepts, tools, and techniques to their personal financial decisions.

CHAPTER 5 Time Value of Money 209

In Example 5.8 involving Braden Company, we found the present value of Braden’s $700, 5-year ordinary annuity discounted at 4% to be $3,116.28. We now assume that Braden’s $700 annual cash in flow occurs at the start of each year and is thereby an annuity due. The following timeline illustrates the new situation.

EXAMPLE 5.10IRF

MyLab Finance Animation

Timeline for present value of an annuity due ($700 beginning-of-year cash flows, discounted at 4%, over 5 years)

0 1 2 3 4 5Year

$700

700.00673.08647.19622.30598.36

$3,240.93

$

Present Value

$700 $700 $700 $700

MyLab Finance Financial Calculator

PMTI/YNCPTPV

Note: Switch calculatorto BEGIN mode.

SolutionCPT RCL ENTER CPT CPTCF NPV IRR DEL INSN I/Y PV

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54700

Function

–3,240.93

PRESENT VALUE OF AN ANNUITY DUEAnnual annuity paymentAnnual rate of interestNumber of yearsPresent value

12345

$7004%5

–$3,240.93

Entry in Cell B5 is =PV(B3,B4,B2,0,1).The minus sign appears before the $3,240.93

in B5 because the annuity’s present valueis a cost and therefore a cash outflow.

A B

period, we discount each annuity due cash flow 1 fewer period than an ordinary annuity. The algebraic formula for the present value of an annuity due is

PV0 = aCF0

rb * c1 -

1(1 + r)n d * (1 + r) (5.6)

Notice the similarity between this equation and Equation 5.4. The two equations are identical except that Equation 5.6 uses CF0 to indicate that the first cash flow arrives immediately in an annuity due, and Equation 5.6 has an extra term at the end, (1 + r). The reason for this extra term is the same as when we calculated the future value of the annuity due. In the annuity due, each payment arrives 1 year earlier (compared to the ordinary annuity), so each payment has a higher present value. To be specific, each payment of the annuity due is discounted one less period so it’s worth r% more than each ordinary annuity payment.

We can calculate its present value using a calculator or a spreadsheet.

Calculator use Before using your calculator to find the present value of an annuity due, you must either switch it to BEGIN mode or use the DUE key, depending on the specifics of your calculator. Then, using the inputs shown at the left, you will find the present value of the annuity due to be $3,240.93 (Note: Because we nearly always assume end-of-period cash flows, be sure to switch your calculator back to END mode when you have completed your annuity-due calculations.)

Spreadsheet use The following spreadsheet shows how to calculate the present value of the annuity due.

XMyLab

M05_ZUTT6315_15_SE_C05_pp189-254.indd 209 10/11/17 4:07 PM

204 PART TWO Financial Tools

FINDING THE FUTURE VALUE OF AN ORDINARY ANNUITY

One way to find the future value of an ordinary annuity is to calculate the future value of each cash flow and then add up those figures. Fortunately, several short-cuts lead to the answer. You can calculate the future value after n years of an ordinary annuity that makes n annual cash payments equal to CF1 by using Equation 5.3:

FVn = CF1 * e 3(1 + r)n - 14r

f (5.3)

As before, in this equation r represents the interest rate, and n represents the number of payments in the annuity (or, equivalently, the number of years over which the annuity is spread). The subscript 1 on the term CF1 highlights that with an ordinary annuity, the first payment comes after 1 year (or, more gener-ally, after 1 period). The calculations required to find the future value of an ordi-nary annuity are illustrated in the following example.

Fran Abrams wishes to determine how much money she will have after 5 years if she chooses annuity A, the ordi-

nary annuity. She will deposit the $1,000 annual payments that the annuity pro-vides at the end of each of the next 5 years into a savings account paying 7% annual interest. This situation is depicted on the following timeline.

PERSONAL FINANCE EXAMPLE 5.7

MyLab Finance Animation

IRF

Timeline for future value of an ordinary annuity ($1,000 end-of-year deposit, earning 7%, after 5 years) $1,000 $1,000 $1,000 $1,000 $1,000

0 1 2 3 4 5

$1,000.001,070.001,144.901,225.041,310.80

$5,750.74 Future Value

Year

As the figure shows, after 5 years, Fran will have $5,750.74 in her account. Note that because she makes deposits at the end of the year, the first deposit will earn interest for 4 years, the second for 3 years, and so on. Plugging the relevant val-ues into Equation 5.3, we have

FV5 = $1,000 * e 3(1 + 0.07)5 - 140.07

f = $5,750.74

Calculator use Using the calculator inputs shown at the left, you can confirm that the future value of the ordinary annuity equals $5,750.74. In this example, we enter the $1,000 annuity payment as a negative value, which in turn causes the calculator to report the resulting future value as a positive value. You can think of each $1,000 deposit that Fran makes into her investment account as

MyLab Finance Financial Calculator

PMTI/YNCPTFV

SolutionCPT RCL ENTER CPT CPTCF NPV IRR DEL INSN I/Y PV

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–1000Function

5,750.74


xxxvi Preface


Key Equations appear in green boxes throughout the text to help readers identify the most important mathematical relation-ships.

Review Questions appear at the end of each major text section. These questions chal-lenge readers to stop and test their under-standing of key concepts, tools, techniques, and practices before moving on to the next section.

NEW! Some sections have dedicated Excel Review Questions that ask students to dem-onstrate their ability to solve a financial problem using Excel.

In Practice boxes offer insights into impor-tant topics in managerial finance through the experiences of real companies, both large and small. There are three categories of In Practice boxes:

Focus on Ethics boxes in every chapter help readers understand and appreciate impor-tant ethical issues and problems related to managerial finance. Nearly all of these boxes are brand new in this edition, and those that are not brand new have been substantially revised.

Focus on Practice boxes take a corporate focus that relates a business event or situation to a specific financial concept or technique.

Global Focus boxes look specifically at the managerial finance experiences of interna-tional companies.

All three types of In Practice boxes end with one or more critical thinking questions to help readers broaden the lesson from the content of the box.


Comparison of an Annuity Due with an Ordinary Annuity Present Value

The present value of an annuity due is always greater than the present value of an otherwise identical ordinary annuity. We can verify this statement by compar-ing the present values of the Braden Company’s two annuities:

Ordinary annuity = $3,116.28 versus Annuity due = $3,240.93

Because the cash flows of the annuity due occur at the beginning of each period rather than at the end, their present values are greater. If we calculate the per-centage difference in the values of these two annuities, we will find that the annu-ity due is 4% more valuable than the annuity (remember that 4% is the discount rate that Braden uses):

($3,240.93 - $3,116.28) , $3,116.28 = 0.04 = 4,

FINDING THE PRESENT VALUE OF A PERPETUITY

A perpetuity is an annuity with an infinite life. In other words, it is an annuity that never stops providing a cash flow at the end of each year.

A number of business and personal investment decisions involve payouts that occur indefinitely into the future and are therefore excellent applications of the idea of a perpetuity. Fortunately, the calculation for the present value of a perpe-tuity is one of the easiest in finance. If a perpetuity pays an annual cash flow of CF1, starting 1 year from now, the present value of the cash flow stream is

PV0 = CF1 , r (5.7)

Ross Clark wishes to endow a chair in finance at his alma mater. In other words, Ross wants to make a lump sum dona-

tion today that will provide an annual stream of cash flows to the university forever. The university indicated that the annual cash flow required to support an endowed chair is $400,000 and that it will invest money Ross donates today in assets earning a 5% return. If Ross wants to give money today so that the university will begin receiving annual cash flows next year, how large must his contribution be? To deter-mine the amount Ross must give the university to fund the chair, we must calculate the present value of a $400,000 perpetuity discounted at 5%. Using Equation 5.7, we can determine that this present value is $8 million when the interest rate is 5%:

PV0 = $400,000 , 0.05 = $8,000,000

In other words, to generate $400,000 every year for an indefinite period requires $8,000,000 today if Ross Clark’s alma mater can earn 5% on its investments. If the university earns 5% interest annually on the $8,000,000, it can withdraw $400,000 per year indefinitely without ever touching the original $800,000 donation.

Many financial applications require analysts to calculate the present value of a cash flow stream that continues forever (i.e., a perpetuity) and grows at a steady rate. Calculating the present value of a growing perpetuity is not much more com-plicated than finding the present value of a level perpetuity. For a cash flow stream

perpetuityAn annuity with an infinite life, providing continual annual cash flow.




that begins next year, pays an initial cash flow of CF1, and grows after next year at a constant rate g forever, the present value of the growing perpetuity is

PV0 = a CF1

r - gb (5.8)

Equation 5.8 applies only when the discount rate is greater than the growth rate in cash flows (i.e., r > g). If the interest rate is less than or equal to the growth rate, cash flows grow so fast that the present value of the stream is infinite.

Suppose, after consulting with his alma mater, Ross Clark learns that the university requires the endowment to provide

a $400,000 cash flow next year, but subsequent annual cash flows must grow by 2% per year to keep up with inflation. How much does Ross need to donate today to cover this requirement? Plugging the relevant values into Equation 5.8, we have:

PV0 =$400,000

0.05 - 0.02= $13,333,333

Compared to the level perpetuity providing $400,000 per year, the growing perpetuity requires Ross to make a much larger initial donation, $13.3 million versus $8 million.

➔ REVIEW QUESTIONS MyLab Finance Solutions 5–10 What is the difference between an ordinary annuity and an annuity

due? Which is more valuable? Why? 5–11 What are the most efficient ways to calculate the present value of an

ordinary annuity? 5–12 How can the formula for the future value of an annuity be modified to

find the future value of an annuity due? 5–13 How can the formula for the present value of an ordinary annuity be

modified to find the present value of an annuity due? 5–14 What is a perpetuity? Why is the present value of a perpetuity equal to

the annual cash payment divided by the interest rate? Why doesn’t this chapter provide an equation showing you how to calculate the future value of a perpetuity?

➔ EXCEL REVIEW QUESTIONS MyLab Finance Solutions 5–15 Because tax time comes around every year, you smartly decide to make

equal contributions to your IRA at the end of every year. Using the information provided at MyLab Finance, calculate the future value of your IRA contributions when you retire.

5–16 You have just graduated from college and begun your new career, and now it is time to buy your first home. Using the information provided at MyLab Finance, determine how much you can spend for your new dream home.




➔ REVIEW QUESTIONS MyLab Finance Solutions 5–20 What effect does compounding interest more frequently than

annually have on (a) future value and (b) the effective annual rate (EAR)? Why?

5–21 How does the future value of a deposit subject to continuous com-pounding compare to the value obtained by annual compounding?

5–22 Differentiate between a nominal annual rate and an effective annual rate (EAR). Define annual percentage rate (APR) and annual percent-age yield (APY).

Was the Deal for Manhattan a Swindle?

FOCUS ON ETHICS in practice

Most schoolchildren marvel when hearing Manhattan was purchased for a song in 1626. As the story goes, Peter Minuit of the Dutch West India Company gave the Lenape Native Americans beads and trinkets worth a mere $24 for the island.

But wait. A letter written by Dutch merchant, Pieter Schage, on Novem-ber 5, 1626 to the directors of the Dutch West India Company confirmed the transaction but valued the goods (which more likely were kettles, mus-kets, powder, and axes) at 60 Dutch guilders. According to the Interna-tional Institute of Social History, 60 Dutch guilders in 1626 are worth

about 787 Euros today after adjusting for inflation. Based on the recent exchange rate between the Euro and the U.S. dollar, that translates to about $871. Now, the deal looks a bit better for the Lenape. But the surface area of Manhattan comprises 636,000 square feet, and condos there sell for an average of $1,700 per square foot. So even after adjusting for price changes since 1626, Minuit still looks pretty sly.

Before closing the case, consider one more factor. The average annual-ized return on U.S. stocks over the last 200 years was 6.6%. If 60 Dutch guil-ders were invested at 6.6% from 1626

to today, the sum would grow to roughly 4 trillion guilders or $2 trillion. Based on New York City’s Depart-ment of Finance property tax assess-ments, $2 trillion is roughly twice the value of all New York City real estate today!

Of course, when the deal for Manhattan was struck, the first asset trading of any kind on a street called Wall lay over 80 years in the future, so the Lenape could not salt the receipts away in stocks. Still, the illustration makes the larger point––compounding is a magical thing! And given this magic, it is less clear who fleeced whom.

People without finance training often fail to appreciate the power of compound interest. Consider the following data for a typical credit card:

Outstanding Balance: $5,000Annual Percentage Rate (APR): 12%Minimum Payment: Larger of [(1% + APR>12) * balance] or $25

Minimum Payment Only $100 Payment Each Month

Monthly Payments to Zero Balance 208 71Total Interest Paid $4,242 $1,993

The first minimum payment is $100, but that minimum will decline each month as the outstanding balance shrinks. Making the minimum payment every month means that the borrower takes 17 years to pay off the card, paying more than $4,000 in interest along the way. By paying $100 each month, however, the borrower repays the debt in one-third the time and at less than half the interest cost.

How much responsibility do lenders have to educate borrowers? Does the fact that the government requires dis-closure statements with a few standardized examples illustrating the time value of money change your answer?



New Century Brings Trouble for Subprime Mortgages

FOCUS ON PRACTICE in practice

As the housing market began to boom at the end of the twentieth century and into the early twenty-first, the market share of subprime mortgages climbed from near 0% in 1997 to about 20% of mortgage originations in 2006. Several factors combined to fuel the rapid growth of lending to borrowers with tar-nished credit, including a low interest rate environment, loose underwriting standards, and innovations in mortgage financing such as “affordability pro-grams” to increase rates of homeown-ership among lower-income borrowers.

Particularly attractive to new home buyers was the hybrid

adjustable rate mortgage (ARM), which featured a low introductory interest rate that reset upward after a preset period of time. Interest rates began a steady upward trend begin-ning in late 2004. In 2006, some $300 billion worth of adjustable ARMs were reset to higher rates. In a market with rising home values, a borrower has the option to refinance the mortgage, using some of the equity created by the home’s increasing value to reduce the mortgage payment. After 2006, however, home prices started a 3-year slide, so refinancing was not an option for many subprime borrowers.

Instead, borrowers in trouble could try to convince their lenders to allow a “short sale,” in which the borrower sells the home for whatever the mar-ket will bear and the lender agrees to accept the proceeds from that sale as settlement for the mortgage debt. For lenders and borrowers alike, fore-closure is the last, worst option.

As a reaction to problems in the subprime area, lenders tightened lending standards. What effect do you think this change had on the housing market?

To attract home buyers who could not afford fixed-rate 30-year mortgages requiring equal monthly payments, lenders offered mortgages low “teaser” inter-est rates that adjusted over time. Recall from Chapter 2 that subprime mortgages are mortgage loans made to borrowers with lower incomes and poorer credit histories as compared to “prime” borrowers. The Focus on Practice box dis-cusses how such mortgages have worked out for some “subprime” borrowers.

FINDING INTEREST OR GROWTH RATES

One of the performance measures that investors and corporate managers focus on most is growth. How fast a firm can grow its sales, earnings, or cash flows is an important signal about its competitive position in the market. Similarly,

LOAN AMORTIZATION SCHEDULE

Year01234

Loan principal Annual rate of interest

Number of yearsAnnual annuity payments

$6,00010%

4

12345

6789

1011

Key Cell EntriesCell B8 is =PMT($D$3,$D$4,$D$2,0,0), copy to B9:B11

Cell C8 is =-$D$3*E7, copy to C9:C11Cell D8 is =B8-C8, copy to D9:D11Cell E8 is =E7+D8, copy to E9:E11

The minus sign appears before the loan paymentsbecause these are cash outflows for the borrower.

A

Total

–$1,892.82–$1,892.82–$1,892.82–$1,892.82

B

To Interest

–$600.00–$470.72–$328.51–$172.07

C

To Principal

–$1,292.82–$1,422.11–$1,564.32–$1,720.75

D

Year-EndPrincipal

$6,000.00$4,707.18$3,285.07$1,720.75

$0.00

EXMyLab


CHAPTER 19 International Managerial Finance 831

currencies other than the currency in which the bond is denominated, it is called a Eurobond. Thus, an MNC based in the United States might float a Eurobond in several European capital markets, underwritten by an international syndicate and denominated in U.S. dollars.

The U.S. dollar and the euro are the most frequently used currencies for Eurobond issues, with the euro rapidly increasing in popularity relative to the U.S. dollar. In the foreign bond category, the U.S. dollar and the euro are major choices. Low interest rates, the general stability of the currency, and the overall efficiency of the European Union’s capital markets are among the primary rea-sons for the growing popularity of the euro.

Eurobonds are much more popular than foreign bonds. These instruments are heavily used, especially in relation to Eurocurrency loans in recent years, by major market participants, including U.S. corporations. Equity-linked Euro-bonds (that is, Eurobonds convertible to equity), especially those offered by a number of U.S. firms, have found strong demand among Euromarket partici-pants. It is expected that more of these innovative types of instruments will emerge on the international scene in the coming years.

A final point concerns the levels of interest rates in international markets. In the case of foreign bonds, interest rates usually directly correlate with the

EurobondA bond issued by an international borrower and sold to investors in countries with currencies other than the currency in which the bond is denominated.

Take an Overseas Assignment to Take a Step Up the Corporate Ladder

GLOBAL FOCUS in practice

There is nothing like an extended stay in a foreign country to get a different perspective on world events, and there are sound career-enhancing rea-sons to work abroad. International experience can give you a competi-tive edge and may be vital to career advancement. Such experience goes far beyond mastering country-specific tax and accounting codes.

That’s one message from the 2016 Global Mobility Trends Survey published by BGRS, a global human resources consulting company. The survey indicated that 61% of respon-dents said their company had com-municated to employees that an international assignment was impor-tant to advance their careers. It’s no wonder that companies place so much emphasis on international assignments, given that 80% of the survey respondents said the main pur-pose of having a globally mobile workforce was to facilitate important global business initiatives. The volume of international assignments reflected

their importance to the success of a firm. The 2016 survey found that 63% of firms either increased or held steady the number of international assignments given to employees rela-tive to the prior year, and 75% of firms said they expected the number of international assignments to remain the same or to increase through 2017.

On arrival in a foreign city, expa-triates tend to live in a section of the city favored by other visitors from home. For security reasons, some executives also travel everywhere chauffeured by an English-speaking driver. It is possible for U.S. execu-tives to live abroad for an extended period without soaking up much of the local culture. Doing so may increase one’s comfort level, but at the loss of some of the valuable les-sons to be learned from living abroad.

Overseas assignments do not come without some sacrifices. Long overseas postings can put stress on a family. The most common reason for turning down an international

assignment (reported by 38% of sur-vey respondents) involved family con-cerns, such as children’s education, family adjustment, partner resistance, and language. The second most com-mon reason (18%) for refusing an assignment was concern for a spouse’s career, not unlike the same concern some employees have about a job that requires a cross-country transfer.

Yet as globalization has pushed companies across more borders, CFOs with international experience have found themselves in greater demand. Some chief executives value international experience in their CFOs more highly than either mergers and acquisitions or capital-raising experience.

If going abroad for a full-immersion assignment is not possible, what are some substitutes for a global assign-ment that may provide some—albeit limited—global experience?


Preface xxxvii


The end-of-chapter Summary con-sists of two sections. The first sec-tion, Focus on Value, explains how the chapter’s content relates to the firm’s goal of maximizing owner wealth. This feature helps reinforce understanding of the link between the financial manager’s actions and share value.

The second part of the Summary, the Review of Learning Goals, restates each learning goal and summarizes the key material that was presented to support mastery of the goal. This review provides students with an opportunity to reconcile what they have learned with the learning goal and to con-firm their understanding before moving forward.

Opener-In-Review questions at the end of each chapter revisit the opening vignette and ask students to apply lessons from the chapter to that business situation.

Self-Test Problems, keyed to the learning goals, give readers an opportunity to strengthen their understanding of topics by doing a sample problem. For reinforce-ment, solutions to the Self-Test Problems appear in the appendix at the back of the book. An IRF icon indicates that the Self-Test Problem can be solved using the interest rate factors. The reader can access the Interest Rate Factor Supplement in MyLab Finance.

Warm-Up Exercises follow the Self-Test Problems. These short, numerical exercises give students practice in applying tools and tech-niques presented in the chapter.


➔ REVIEW QUESTIONS MyLab Finance Solutions 5–26 How can you determine the size of the equal, end-of-year deposits nec-

essary to accumulate a certain future sum at the end of a specified future period at a given annual interest rate?

5–27 Describe the procedure used to amortize a loan into a series of equal periodic payments.

5–28 How can you determine the unknown number of periods when you know the present and future values—single amount or annuity—and the applicable rate of interest?

➔ EXCEL REVIEW QUESTIONS MyLab Finance Solutions 5–29 You want to buy a new car as a graduation present for yourself, but

before finalizing a purchase you need to consider the monthly payment amount. Using the information provided at MyLab Finance, find the monthly payment amount for the car you are considering.

5–30 As a finance major, you realize that you can quickly estimate your retirement age by knowing how much you need to retire, how much you can contribute each month to your retirement account, and what rate of return you can earn on your retirement investments. With that information, you can solve for the number of years it will take to save the money you need to retire. Using the information provided at MyLab Finance, estimate the age at which you will be able to retire.

FOCUS ON VALUE

The time value of money is an important tool that financial managers and other market participants use to compare cash inflows and outflows occurring at dif-ferent times. Because firms routinely make investments that produce cash inflows over long periods of time, the effective application of time-value-of-money techniques is extremely important. These techniques enable financial managers to compare the costs of investments they make today to the cash inflows those investments will generate in future years. Such comparisons help managers achieve the firm’s overall goal of share price maximization. It will become clear later in this text that the application of time-value techniques is a key part of the valuation process needed to make wealth-maximizing decisions.

REVIEW OF LEARNING GOALS

LG 1 Discuss the role of time value in finance, the use of computational tools, and the basic patterns of cash flow. Financial managers and investors use time-value-of-money techniques when assessing the value of expected cash flow streams. Alternatives can be assessed by either compounding to find future value or discounting to find present value. Financial managers rely primarily on present-value techniques. Financial calculators and electronic spreadsheets

SUMMARY



➔ REVIEW QUESTIONS MyLab Finance Solutions 5–26 How can you determine the size of the equal, end-of-year deposits nec-

essary to accumulate a certain future sum at the end of a specified future period at a given annual interest rate?

5–27 Describe the procedure used to amortize a loan into a series of equal periodic payments.

5–28 How can you determine the unknown number of periods when you know the present and future values—single amount or annuity—and the applicable rate of interest?

➔ EXCEL REVIEW QUESTIONS MyLab Finance Solutions 5–29 You want to buy a new car as a graduation present for yourself, but

before finalizing a purchase you need to consider the monthly payment amount. Using the information provided at MyLab Finance, find the monthly payment amount for the car you are considering.

5–30 As a finance major, you realize that you can quickly estimate your retirement age by knowing how much you need to retire, how much you can contribute each month to your retirement account, and what rate of return you can earn on your retirement investments. With that information, you can solve for the number of years it will take to save the money you need to retire. Using the information provided at MyLab Finance, estimate the age at which you will be able to retire.

FOCUS ON VALUE

The time value of money is an important tool that financial managers and other market participants use to compare cash inflows and outflows occurring at dif-ferent times. Because firms routinely make investments that produce cash inflows over long periods of time, the effective application of time-value-of-money techniques is extremely important. These techniques enable financial managers to compare the costs of investments they make today to the cash inflows those investments will generate in future years. Such comparisons help managers achieve the firm’s overall goal of share price maximization. It will become clear later in this text that the application of time-value techniques is a key part of the valuation process needed to make wealth-maximizing decisions.

REVIEW OF LEARNING GOALS

LG 1 Discuss the role of time value in finance, the use of computational tools, and the basic patterns of cash flow. Financial managers and investors use time-value-of-money techniques when assessing the value of expected cash flow streams. Alternatives can be assessed by either compounding to find future value or discounting to find present value. Financial managers rely primarily on present-value techniques. Financial calculators and electronic spreadsheets

SUMMARY



The chapter opener described a lottery prize that could be taken as a $480 million lump sum payment or mixed stream of 30 payments, with the first payment of $11.42 million coming immediately, followed by 29 additional payments growing at 5% per year. If the lottery winner could earn 2% on cash invested today, should she take the lump sum or the mixed stream? What if the rate of return is 3%? What general principle do those calculations illustrate?

OPENER-IN-REVIEW

LG 2 LG 5 ST5–1 Future values for various compounding frequencies Delia Martin has $10,000 that she can deposit in any of three savings accounts for a 3-year period. Bank A com-pounds interest on an annual basis, bank B compounds interest twice each year, and bank C compounds interest each quarter. All three banks have a stated annual interest rate of 4%.a. What amount would Ms. Martin have after 3 years, leaving all interest paid on

deposit, in each bank?b. What effective annual rate (EAR) would she earn in each of the banks?c. On the basis of your findings in parts a and b, which bank should Ms. Martin

deal with? Why?d. If a fourth bank (bank D), also with a 4% stated interest rate, compounds

interest continuously, how much would Ms. Martin have after 3 years? Does this alternative change your recommendation in part c? Explain why or why not.

LG 3 ST5–2 Future values of annuities Ramesh Abdul has the opportunity to invest in either of two annuities, each of which will cost $38,000 today. Annuity X is an annuity due that makes 6 cash payments of $9,000. Annuity Y is an ordinary annuity that makes 6 cash payments of $10,000. Assume that Ramesh can earn 15% on his investments.a. On a purely intuitive basis (i.e., without doing any math), which annuity do you

think is more attractive? Why?b. Find the future value after 6 years for both annuities.c. Use your finding in part b to indicate which annuity is more attractive. Why?

Compare your finding to your intuitive response in part a.

LG 2 LG 3 ST5–3 Present values of single amounts and streams You have a choice of accepting either of two 5-year cash flow streams or single amounts. One cash flow stream is an ordi-nary annuity, and the other is a mixed stream. You may accept alternative A or B, either as a cash flow stream or as a single amount. Given the cash flow stream and single amounts associated with each (see the following table), and assuming a 9% opportunity cost, which alternative (A or B) and in which form (cash flow stream or single amount) would you prefer?

IRF

LG 4

IRF

SELF-TEST PROBLEMS (Solutions in Appendix)

IRF



The chapter opener described a lottery prize that could be taken as a $480 million lump sum payment or mixed stream of 30 payments, with the first payment of $11.42 million coming immediately, followed by 29 additional payments growing at 5% per year. If the lottery winner could earn 2% on cash invested today, should she take the lump sum or the mixed stream? What if the rate of return is 3%? What general principle do those calculations illustrate?

OPENER-IN-REVIEW

LG 2 LG 5 ST5–1 Future values for various compounding frequencies Delia Martin has $10,000 that she can deposit in any of three savings accounts for a 3-year period. Bank A com-pounds interest on an annual basis, bank B compounds interest twice each year, and bank C compounds interest each quarter. All three banks have a stated annual interest rate of 4%.a. What amount would Ms. Martin have after 3 years, leaving all interest paid on

deposit, in each bank?b. What effective annual rate (EAR) would she earn in each of the banks?c. On the basis of your findings in parts a and b, which bank should Ms. Martin

deal with? Why?d. If a fourth bank (bank D), also with a 4% stated interest rate, compounds

interest continuously, how much would Ms. Martin have after 3 years? Does this alternative change your recommendation in part c? Explain why or why not.

LG 3 ST5–2 Future values of annuities Ramesh Abdul has the opportunity to invest in either of two annuities, each of which will cost $38,000 today. Annuity X is an annuity due that makes 6 cash payments of $9,000. Annuity Y is an ordinary annuity that makes 6 cash payments of $10,000. Assume that Ramesh can earn 15% on his investments.a. On a purely intuitive basis (i.e., without doing any math), which annuity do you

think is more attractive? Why?b. Find the future value after 6 years for both annuities.c. Use your finding in part b to indicate which annuity is more attractive. Why?

Compare your finding to your intuitive response in part a.

LG 2 LG 3 ST5–3 Present values of single amounts and streams You have a choice of accepting either of two 5-year cash flow streams or single amounts. One cash flow stream is an ordi-nary annuity, and the other is a mixed stream. You may accept alternative A or B, either as a cash flow stream or as a single amount. Given the cash flow stream and single amounts associated with each (see the following table), and assuming a 9% opportunity cost, which alternative (A or B) and in which form (cash flow stream or single amount) would you prefer?

IRF

LG 4

IRF

SELF-TEST PROBLEMS (Solutions in Appendix)

IRF



LG 6 ST5–4 Deposits needed to accumulate a future sum Judi Janson wishes to accumulate $8,000 by making equal, end-of-year deposits over the next 5 years. If Judi can earn 7% on her investments, how much must she deposit at the end of each year to meet this goal?

IRF

Year Savings estimate

1 $35,000

2 50,000

3 45,000

4 25,000

5 15,000

Cash flow stream

Year Alternative A Alternative B

1 $700 $1,100

2 700 900

3 700 700

4 700 500

5 700 300

Single amount

At time zero $2,825 $2,800

LG 2 E5–1 Assume that a firm makes a $2,500 deposit into a short-term investment account. If this account is currently paying 0.7% (yes, that’s right, less than 1%!), what will the account balance be after 1 year?

LG 2 LG 5 E5–2 If Bob and Judy combine their savings of $1,260 and $975, respectively, and deposit this amount into an account that pays 2% annual interest, compounded monthly, what will the account balance be after 4 years?

LG 3 E5–3 Gabrielle just won $2.5 million in the state lottery. She is given the option of receiving a lump sum of $1.3 million now, or she can elect to receive $100,000 at the end of each of the next 25 years. If Gabrielle can earn 5% annually on her investments, which option should she take?

LG 4 E5–4 Your firm has the option of making an investment in new software that will cost $130,000 today but will save the company money over several years. You estimate that the software will provide the savings shown in the following table over its 5-year life.

WARM-UP EXERCISES All problems are available in MyLab Finance.

Should the firm make this investment if it requires a minimum annual return of 9% on all investments?


xxxviii Preface


Comprehensive Problems, keyed to the learning goals, are longer and more complex than the Warm-Up Exercises. In this section, instruc-tors will find multiple problems that address the important concepts, tools, and techniques in the chapter.

New! Excel templates for many end-of-chapter problems are available in MyLab Finance. These templates do not solve problems for students, but rather help students reach a solution faster by inputting data for them or by organizing facts presented in problems in a logical way.

A short descriptor identifies the essential concept or technique of the problem. Problems labeled as Integrative tie together related topics.

Personal Finance Problems specifi-cally relate to personal finance situa-tions and Personal Finance Examples in each chapter. These problems will help students see how they can apply the tools and techniques of manage-rial finance in managing their own finances.

All exercises and problems are avail-able in MyLab Finance.


WARM-UP EXERCISES All problems are available in MyLab Finance

LG 2 E4–1 The installed cost of a new computerized controller was $65,000. Calculate the depreciation schedule by year assuming a recovery period of 5 years and using the appropriate MACRS depreciation percentages given in Table 4.2.

LG 3 E4–2 Classify the following changes in each of the accounts as either an inflow or an out-flow of cash. During the year (a) marketable securities increased, (b) land and build-ings decreased, (c) accounts payable increased, (d) vehicles decreased, (e) accounts receivable increased, and (f) dividends were paid.

LG 3 E4–3 Determine the operating cash flow (OCF) for Kleczka Inc., based on the following data. (All values are in thousands of dollars.) During the year the firm had sales of $2,500, cost of goods sold totaled $1,800, operating expenses totaled $300, and depreciation expenses were $200. The firm is in the 35% tax bracket.

LG 3 E4–4 During the year, Xero Inc. experienced an increase in net fixed assets of $300,000 and had depreciation of $200,000. It also experienced an increase in current assets of $150,000 and an increase in accounts payable and accruals of $75,000. If operat-ing cash flow (OCF) for the year was $700,000, calculate the firm’s free cash flow (FCF) for the year.

LG 5 E4–5 Rimier Corp. forecasts sales of $650,000 for 2020. Assume that the firm has fixed costs of $250,000 and variable costs amounting to 35% of sales. Operating expenses are estimated to include fixed costs of $28,000 and a variable portion equal to 7.5% of sales. Interest expenses for the coming year are estimated to be $20,000. Estimate Rimier’s net profits before taxes for 2020.

LG 2 P4–1 Depreciation On March 20, 2019, Norton Systems acquired two new assets. Asset A was research equipment costing $17,000 and having a 3-year recovery period. Asset B was duplicating equipment with an installed cost of $45,000 and a 5-year recovery period. Using the MACRS depreciation percentages in Table 4.2, prepare a depreciation schedule for each of these assets.

LG 2 P4–2 Depreciation In early 2019, Sosa Enterprises purchased a new machine for $10,000 to make cork stoppers for wine bottles. The machine has a 3-year recovery period and is expected to have a salvage value of $2,000. Develop a depreciation schedule for this asset using the MACRS depreciation percentages in Table 4.2.

LG 2 P4–3 MACRS depreciation expense and accounting cash flow Pavlovich Instruments Inc., a maker of precision telescopes, expects to report pretax income of $430,000 this year. The company’s financial manager is considering the timing of a purchase of new computerized lens grinders. The grinders will have an installed cost of $80,000 and a cost recovery period of 5 years. They will be depreciated using the MACRS schedule.

LG 3

PROBLEMS All problems are available in MyLab Finance. The X

MyLab icon indicates problems in Excel format available in MyLab Finance.


CHAPTER 4 Long- and Short-Term Financial Planning 185

Peabody & Peabody Balance Sheet December 31, 2019 ($000)

Assets Liabilities and stockholders’ equity

Cash $ 400 Accounts payable $1,400

Marketable securities 200 Accruals 400

Accounts receivable 1,200 Other current liabilities 80

Inventories 1,800 Total current liabilities $1,880

Total current assets $3,600 Long-term debt 2,000

Net fixed assets 4,000 Total liabilities $3,880

Total assets $7,600 Common equity 3,720

Total liabilities and

stockholders’ equity $7,600

a. Prepare a pro forma balance sheet dated December 31, 2021.b. Discuss the financing changes suggested by the statement prepared in part a.

LG 5 P4–20 Integrative: Pro forma statements Red Queen Restaurants wishes to prepare finan-cial plans. Use the financial statements and the other information provided below to prepare the financial plans.

The following financial data are also available: (1) The firm has estimated that its sales for 2020 will be $900,000. (2) The firm expects to pay $35,000 in cash dividends in 2020. (3) The firm wishes to maintain a minimum cash balance of $30,000. (4) Accounts receivable represent approximately 18% of annual sales. (5) The firm’s ending inventory will change directly with changes in sales in

2020. (6) A new machine costing $42,000 will be purchased in 2020. Total depreciation

for 2020 will be $17,000. (7) Accounts payable will change directly in response to changes in sales in 2020. (8) Taxes payable will equal one-fourth of the tax liability on the pro forma income

statement. (9) Marketable securities, other current liabilities, long-term debt, and common

stock will remain unchanged.a. Prepare a pro forma income statement for the year ended December 31, 2020,

using the percent-of-sales method.b. Prepare a pro forma balance sheet dated December 31, 2020, using the judgmen-

tal approach.c. Analyze these statements, and discuss the resulting external financing

required.



LG 4 P4–8 Cash receipts A firm has actual sales of $65,000 in April and $60,000 in May. It expects sales of $70,000 in June and $100,000 in July and in August. Assuming that sales are the only source of cash inflows and that half of them are for cash and the remainder are collected evenly over the following 2 months, what are the firm’s expected cash receipts for June, July, and August?

LG 4 P4–9 Cash disbursements schedule Maris Brothers Inc. needs a cash disbursement sched-ule for the months of April, May, and June. Use the format of Table 4.9 and the fol-lowing information in its preparation.

Sales: February = $500,000; March = $500,000; April = $560,000; May = $610,000; June = $650,000; July = $650,000

Purchases: Purchases are calculated as 60% of the next month’s sales, 10% of purchases are made in cash, 50% of purchases are paid for 1 month after pur-chase, and the remaining 40% of purchases are paid for 2 months after purchase.

Rent: The firm pays rent of $8,000 per month.

Wages and salaries: Base wage and salary costs are fixed at $6,000 per month plus a variable cost of 7% of the current month’s sales.

Taxes: A tax payment of $54,500 is due in June.

Fixed asset outlays: New equipment costing $75,000 will be bought and paid for in April.

Interest payments: An interest payment of $30,000 is due in June.

Cash dividends: Dividends of $12,500 will be paid in April.

Principal repayments and retirements: No principal repayments or retirements are due during these months.

LG 4 P4–10 Cash budget: Basic Grenoble Enterprises had sales of $50,000 in March and $60,000 in April. Forecast sales for May, June, and July are $70,000, $80,000, and $100,000, respectively. The firm has a cash balance of $5,000 on May 1 and wishes to maintain a minimum cash balance of $5,000. Given the following data, prepare and interpret a cash budget for the months of May, June, and July.

(1) The firm makes 20% of sales for cash, 60% are collected in the next month, and the remaining 20% are collected in the second month following sale.

(2) The firm receives other income of $2,000 per month. (3) The firm’s actual or expected purchases, all made for cash, are $50,000,

$70,000, and $80,000 for the months of May through July, respectively. (4) Rent is $3,000 per month. (5) Wages and salaries are 10% of the previous month’s sales. (6) Cash dividends of $3,000 will be paid in June. (7) Payment of principal and interest of $4,000 is due in June. (8) A cash purchase of equipment costing $6,000 is scheduled in July. (9) Taxes of $6,000 are due in June.

Personal Finance Problem

LG 4 P4–11 Preparation of cash budget Sam and Suzy Sizeman need to prepare a cash budget for the last quarter of 2020 to make sure they can cover their expenditures during the period. Sam and Suzy have been preparing budgets for the past several years and have been able to identify the percentage of their income that they pay for most of

XMyLab



Provincial Imports Inc. Balance Sheet December 31, 2019


Cash $ 200,000 Accounts payable $ 700,000

Marketable securities 225,000 Taxes payable 95,000

Accounts receivable 625,000 Notes payable 200,000

Inventories 500,000 Other current liabilities 5,000

Total current assets $1,550,000 Total current liabilities $1,000,000

Net fixed assets 1,400,000 Long-term debt 500,000

Total assets $2,950,000 Total liabilities $1,500,000

Common stock 75,000

Retained earnings 1,375,000

Total liabilities and equity $2,950,000

Information related to financial projections for the year 2020 is as follows: (1) Projected sales are $6,000,000. (2) Cost of goods sold in 2019 includes $1,000,000 in fixed costs. (3) Operating expense in 2019 includes $250,000 in fixed costs. (4) Interest expense will remain unchanged. (5) The firm will pay cash dividends amounting to 40% of net profits after taxes. (6) Cash and inventories will double. (7) Marketable securities, notes payable, long-term debt, and common stock will

remain unchanged. (8) Accounts receivable, accounts payable, and other current liabilities will change

in direct response to the change in sales. (9) A new computer system costing $356,000 will be purchased during the year.

Total depreciation expense for the year will be $110,000. (10) The tax rate will remain at 40%.

a. Prepare a pro forma income statement for the year ended December 31, 2020, using the fixed cost data given to improve the accuracy of the percent-of-sales method.

b. Prepare a pro forma balance sheet as of December 31, 2020, using the informa-tion given and the judgmental approach. Include a reconciliation of the retained earnings account.

c. Analyze these statements, and discuss the resulting external financing required.

LG 1 P4–22 ETHICS PROBLEM The SEC is trying to get companies to notify the investment community more quickly when a “material change” will affect their forthcoming financial results. In what sense might a financial manager be seen as “more ethical” if he or she follows this directive and issues a press release indicating that sales will not be as high as previously anticipated?

You have been assigned the task of putting together a statement for the ACME Com-pany that shows its expected inflows and outflows of cash over the months of July 2020 through December 2020.

SPREADSHEET EXERCISE



Provincial Imports Inc. Balance Sheet December 31, 2019


Cash $ 200,000 Accounts payable $ 700,000

Marketable securities 225,000 Taxes payable 95,000

Accounts receivable 625,000 Notes payable 200,000

Inventories 500,000 Other current liabilities 5,000

Total current assets $1,550,000 Total current liabilities $1,000,000

Net fixed assets 1,400,000 Long-term debt 500,000

Total assets $2,950,000 Total liabilities $1,500,000

Common stock 75,000

Retained earnings 1,375,000

Total liabilities and equity $2,950,000

Information related to financial projections for the year 2020 is as follows: (1) Projected sales are $6,000,000. (2) Cost of goods sold in 2019 includes $1,000,000 in fixed costs. (3) Operating expense in 2019 includes $250,000 in fixed costs. (4) Interest expense will remain unchanged. (5) The firm will pay cash dividends amounting to 40% of net profits after taxes. (6) Cash and inventories will double. (7) Marketable securities, notes payable, long-term debt, and common stock will

remain unchanged. (8) Accounts receivable, accounts payable, and other current liabilities will change

in direct response to the change in sales. (9) A new computer system costing $356,000 will be purchased during the year.

Total depreciation expense for the year will be $110,000. (10) The tax rate will remain at 40%.

a. Prepare a pro forma income statement for the year ended December 31, 2020, using the fixed cost data given to improve the accuracy of the percent-of-sales method.

b. Prepare a pro forma balance sheet as of December 31, 2020, using the informa-tion given and the judgmental approach. Include a reconciliation of the retained earnings account.

c. Analyze these statements, and discuss the resulting external financing required.

LG 1 P4–22 ETHICS PROBLEM The SEC is trying to get companies to notify the investment community more quickly when a “material change” will affect their forthcoming financial results. In what sense might a financial manager be seen as “more ethical” if he or she follows this directive and issues a press release indicating that sales will not be as high as previously anticipated?

You have been assigned the task of putting together a statement for the ACME Com-pany that shows its expected inflows and outflows of cash over the months of July 2020 through December 2020.

SPREADSHEET EXERCISE


251

Integrative Case 2

Track Software Inc.

S even years ago, after 15 years in public accounting, Stanley Booker, CPA, re-signed his position as manager of cost systems for Davis, Cohen, and O’Brien

Public Accountants and started Track Software Inc. In the 2 years preceding his de-parture from Davis, Cohen, and O’Brien, Stanley had spent nights and weekends de-veloping a sophisticated cost-accounting software program that became Track’s ini-tial product offering. As the firm grew, Stanley planned to develop and expand the software product offerings, all of which would be related to streamlining the ac-counting processes of medium- to large-sized manufacturers.

Although Track experienced losses during its first 2 years of operation—2013 and 2014—its profit has increased steadily from 2015 to the year just ended (2019). The firm’s profit history, including dividend payments and contributions to retained earnings, is summarized in Table 1.

Stanley started the firm with a $100,000 investment: his savings of $50,000 as equity and a $50,000 long-term loan from the bank. He had hoped to main-tain his initial 100% ownership in the corporation, but after experiencing a $50,000 loss during the first year of operation (2013), he sold 60% of the stock to a group of investors to obtain needed funds. Since then, no other stock trans-actions have taken place. Although he owns only 40% of the firm, Stanley ac-tively manages all aspects of its activities; the other stockholders are not active in its management. The firm’s stock was valued at $4.50 per share in 2018 and at $5.28 per share in 2019.

TABLE 1

Track Software Inc., Profit, Dividends, and Retained Earnings, 2013–2019

YearNet profits after taxes

Dividends paid

Contribution to retained earnings

2013 –$50,000 $ 0 -$50,000 - 0 = -$50,000

2014 –20,000 0 -20,000 - 0 = -20,000

2015 15,000 0 15,000 - 0 = 15,000

2016 35,000 0 35,000 - 0 = 35,000

2017 40,000 1,000 40,000 - 1,000 = 39,000

2018 43,000 3,000 43,000 - 3,000 = 40,000

2019 48,000 5,000 48,000 - 5,000 = 43,000


Every chapter includes a Spreadsheet Exercise. This exercise gives students an opportunity to use Excel software to create one or more spreadsheets with which to analyze a financial problem. The spreadsheet to be created is often modeled on a table or Excel screenshot located in the chapter. Students can access working versions of the Excel screenshots in MyLab Finance.

An Integrative Case at the end of each part of the book challenges students to use what they have learned over the course of several chapters. Additional chapter resources, such as Chapter Cases, Group Exercises, and numerous online resources, intended to provide further means for student learning and assessment are available in MyLab Finance at www.pearson.com/mylab/finance.

Preface xxxix


MyLab FINANCE

Reach Every Student by Pairing this Text with MyLab FinanceMyLab is the teaching and learning platform that empowers you to reach every student. By combining trusted author content with digital tools and a flexible plat-form, MyLab personalizes the learning experience and improves results for each student. Learn more about MyLab Finance at www.pearson.com/mylab/finance.

Deliver Trusted ContentYou deserve teaching materials that meet your own high standards for your course. That’s why Pearson partners with highly respected authors to develop interactive content and course-specific resources that you can trust—and that keep your students engaged.

Empower Each LearnerEach student learns at a different pace. Personalized learning pinpoints the pre-cise areas where each student needs practice, giving all students the support they need—when and where they need it—to be successful.

Teach Your Course Your WayYour course is unique. So whether you’d like to build your own assignments, teach multiple sections, or set prerequisites, MyLab gives you the flexibility to easily create your course to fit your needs.

Improve Student ResultsWhen you teach with MyLab, student performance improves. That’s why instruc-tors have chosen MyLab for over 15 years, touching the lives of over 50 million students.

MyLab opens the door to a powerful Web-based tutorial, testing, and diag-nostic learning system designed specifically for the Zutter/Smart, Principles of Managerial Finance. With MyLab, instructors can select an adaptable precon-figured course or create their own. Both options allow instructors to create, edit, and assign online homework, quizzes, and tests and track all student progress in the downloadable online gradebook. MyLab allows students to supplement and reinforce their in-class learning by taking advantage of a progress-driven Study Plan or self-selected practice problems, quizzes, and tests. For example, all end-of-chapter problems are assignable by instructors or selectable by students in MyLab, and because the problems have algorithmically generated values, no stu-dent will have the same homework as another or work the same problem twice; there is an unlimited opportunity for practice and testing. Students get the help they need, when they need it, from the robust tutorial options, including “View an Example” and “Help Me Solve This,” which breaks the problem into steps and links to the relevant textbook page.

This fully integrated online system gives students the hands-on tutorial, prac-tice, and diagnostic help they need to ensure they are effectively learning finance in the most efficient manner. Utilization of the resources available in MyLab Finance saves instructors time by enabling students to more effectively learn on their own and providing instructors with a full account of student progress, auto grading, and an online gradebook that can seamlessly link with a Learning Management System (e.g., Blackboard Learn, Brightspace by D2L, Canvas, or Moodle) or be downloaded to Excel.

The Multimedia Library in MyLab Finance provides students with access to a variety of chapter resources all intended to reinforce their learning and

xl Preface


understanding of the textbook content. For example, students can access a Chapter Introduction Video for every chapter and dozens of Solution Videos for select in-chapter examples. Students can also access dynamic animations for select figures and examples throughout the book that provide them with the ability to control inputs and drive outputs to better understand the concepts.

The auto-graded Excel feature in MyLab Finance allows instructors to assign all Spreadsheet Exercises and select end-of-chapter problems without having to manually grade spreadsheets. Students have the opportunity to practice important finance skills in Excel and instructors have the ability to assess their learning without the hassle of time-consuming grading. Students simply download a spreadsheet, solve a finance problem in Excel, and then upload the file back to MyLab Finance. Students will receive personalized feedback on their work within minutes that allows them to pin-point where they went wrong on any step of the problem.

Chapter Cases with automatically graded assessment are also provided in MyLab Finance. These cases have students apply the concepts they have learned to a more complex and realistic situation. These cases help strengthen practical application of financial tools and techniques.

MyLab also has Group Exercises that students can work together in the context of an ongoing company. Each group creates a company and follows it through the various managerial finance topics and business activities presented in the textbook.

MyLab Finance has an Interest Rate Factor Supplement that explains how to use the interest rate factors in time-value-of-money problems and works seam-lessly with the textbook. The student can go directly to the IRF Supplement and see the in-chapter example solved using the interest rate factors. All examples that appear in the IRF Supplement are indicated in the text with an IRF icon.

Advanced reporting features in MyLab also allow you to easily report on AACSB accreditation and assessment in just a few clicks.

An online glossary, digital flashcards, financial calculator tutorials, videos, Spreadsheet Use examples from the text in Excel, and numerous other premium resources are available in MyLab.

DEVELOPING EMPLOYABILITY SKILLS

For students to succeed in a rapidly changing job market, they should be aware of their career options and how to go about developing a variety of skills. In this book and in MyLab Finance, we focus on developing these skills in a variety of ways.

Excel modeling skills—Each chapter contains a Spreadsheet Exercise that asks students to build an Excel model to help solve a business problem. Many


a payment into the account or a cash outflow, and after 5 years the future value is the balance in the account, or the cash inflow that Fran receives as a reward for investing.

Spreadsheet use To calculate the future value of an annuity in Excel, we will use the same future value function that we used to calculate the future value of a lump sum, but we will add two new input values. Recall that the future value function’s syntax is FV(rate,nper,pmt,pv,type). We have already explained the terms rate, nper, and pv in this function. The term pmt refers to the annual pay-ment the annuity offers. The term type is an input that lets Excel know whether the annuity being valued is an ordinary annuity (in which case the input value for type is 0 or omitted) or an annuity due (in which case the correct input value for type is 1). In this particular problem, the input value for pv is 0 because there is no up-front money received that is separate from the annuity. The only cash flows are those that are part of the annuity stream. The following Excel spread-sheet demonstrates how to calculate the future value of the ordinary annuity.

FUTURE VALUE OF AN ORDINARY ANNUITYAnnual annuity paymentAnnual rate of interestNumber of yearsFuture value

12345

–$1,0007%5

$5,750.74

Entry in Cell B5 is =FV(B3,B4,B2,0,0).The minus sign appears before the $1,000

in B2 because the annuity’s paymentsare cash outflows.

A B

FINDING THE PRESENT VALUE OF AN ORDINARY ANNUITY

Quite often in finance, we need to find the present value of a stream of cash flows spread over several future periods. An annuity is, of course, a stream of equal periodic cash flows. The method for finding the present value of an ordi-nary annuity is similar to the method just discussed. One approach is to calculate the present value of each cash flow in the annuity and then add up those present values. Alternatively, the algebraic shortcut for finding the present value of an ordinary annuity that makes an annual payment of CF1 for n years looks like

PV0 = aCF1

rb * c1 -

1(1 + r)n d (5.4)

Of course, the simplest approach is to solve problems like this one with a finan-cial calculator or spreadsheet program.

Braden Company, a small producer of plastic toys, wants to determine the most it should pay for a particular ordinary annuity. The annuity consists of cash in flows of $700 at the end of each year for 5 years. The firm requires the annuity to provide a minimum return of 4%. The following timeline depicts this situation.

EXAMPLE 5.8

MyLab Finance Solution VideoMyLab Finance Animation

IRF

XMyLab


Preface xli


chapters provide screenshots showing completed Excel models designed to solve in-chapter examples. Many chapters contain Excel Review Questions that prompt students to practice using Excel to solve specific types of problems. In addition, students can access the working Excel screenshots and solutions to the Excel Review Questions in MyLab Finance to further reenforce their learning and understanding. Also, in MyLab students will find dozens of Excel templates, marked in the text with a special icon, that help them model select end-of-chapter problems so they can reach a solution faster and with a deeper understanding of the underlying concepts. Finally, as mentioned above, every Excel Spreadsheet Exercise and select end-of-chapter problems can be assigned and auto graded.

Ethical reasoning skills—The Focus on Ethics boxes appearing in each chapter describe situations in which business professionals have violated eth-ical (and in some cases even legal) standards and have suffered consequences as a result. These boxes will help students recognize the ethical temptations they are likely to face while pursuing a finance career and the consequences that they may suffer if they behave unethically. Each chapter ends with an Ethics Problem that asks students to consider the ethical dimensions of some business decision.

Critical thinking skills—Nearly every significant financial decision requires critical thinking because making optimal decisions means weighing the marginal benefits and costs of alternative plans. To weigh those benefits and costs, one must first identify and quantify them. Nearly every chapter in this textbook dis-cusses how financial analysts place a value on the net benefits associated with a particular decision. Students who master this material will be prepared to ask the tough questions necessary to assess whether a particular course of action creates value for shareholders.

Data analysis skills—Financial work is about data. Financial analysts have to identify the data that are relevant for a particular business problem, and they must know how to process that data in a way that leads to good decision making. In-chapter examples and end-of-chapter problems require students to sort out relevant from irrelevant data and to use the data that they have to make a clear recommendation about what course of action a firm should take.

TABLE OF CONTENTS OVERVIEW

The text’s organization conceptually links the firm’s actions and its value as deter-mined in the financial market. We discuss every significant financial problem or decision in terms of both risk and return to assess the potential impact on owners’ wealth. A Focus on Value element in each chapter’s Summary helps reinforce the student’s understanding of the link between the financial manager’s actions and the firm’s share value.

In organizing each chapter, we have adhered to a managerial decision-making perspective, relating decisions to the firm’s overall goal of wealth maximization. Once a particular concept has been developed, its application is illustrated by an example, which is a hallmark feature of this book. These examples demonstrate, and solidify in the student’s thought, financial decision-making considerations and their consequences.

xlii Preface


INSTRUCTOR TEACHING RESOURCES

Supplements available to instructors at www.pearsonhighered.com/irc Features of the Supplement

Instructor’s Manual • Overview of key topics• Detailed answers and solutions to all Opener-In-Review

Questions, Warm-Up Exercises, end-of-chapter Problems, and Chapter Cases

• Suggested answers to all critical thinking questions in chapter boxes, Ethics Problems, and Group Exercises

• Spreadsheet Exercises• Group Exercises• Integrative Cases

Test Bank More than 3,000 multiple-choice, true/false, short-answer, and graphing questions with these annotations:

• Difficulty level (1 for straight recall, 2 for some analysis, 3 for complex analysis)

• Type (Multiple-choice, true/false, short-answer, essay• Topic (The term or concept the question supports)• Learning outcome• AACSB learning standard (Ethical Understanding and

Reasoning; Analytical Thinking Skills; Information Technol-ogy; Diverse and Multicultural Work; Reflective Thinking; Application of Knowledge)

Computerized TestGen TestGen allows instructors to:

• Customize, save, and generate classroom tests• Edit, add, or delete questions from the Test Item Files• Analyze test results• Organize a database of tests and student results

PowerPoints Slides include all the figures and tables from the textbook.

PowerPoints meet accessibility standards for students with disabilities. Features include, but are not limited to:

• Keyboard and Screen Reader access• Alternative text for images• High color contrast between background and

foreground colors

Preface xliii


Acknowledgments

TO OUR COLLEAGUES, FRIENDS, AND FAMILY

Pearson sought the advice of a great many excellent reviewers, all of whom influ-enced the revisions of this book. The following individuals provided extremely thoughtful and useful comments for the preparation of the fifteenth edition:

Alan Blaylock, Henderson State UniversityHsing Fang, California State University, Los AngelesCarolyn Jarmon, Empire State CollegeJerry Johnson, Austin College

Our special thanks go to the following individuals who contributed to the manuscript in the current and previous editions:

Saul W. AdelmanM. Fall AininaGary A. AndersonRonald F. AndersonJames M. AndreGene L. AndruscoAntonio ApapDavid A. ArbeitAllen ArkinsSaul H. AuslanderPeter W. BaconRichard E. BallThomas BankstonAlexander BargesCharles BarngroverMichael BeckerOmar BenkatoRobert BensonScott BesleyDouglas S. BibleCharles W. BlackwellRussell L. BlockCalvin M. BoardmanPaul BolsterRobert J. BondiJeffrey A. BornJerry D. BoswellDenis O. BoudreauxKenneth J. BoudreauxThomas J. BoultonWayne BoyetRon BraswellChristopher Brown

William BrunsenSamuel B. BulmashFrancis E. CandaOmer CareyPatrick A. CasabonaJohnny C. ChanRobert ChatfieldK. C. ChenRoger G. ClarkeTerrence M. ClauretieMark CockalingamKent CofoidBoyd D. CollierThomas CookMaurice P. CorriganMike CuddDonnie L. DanielPrabir DattaJoel J. DautenLee E. DavisIrv DeGrawRichard F. DeMongPeter A. DeVitoR. Gordon DippelJames P. D’MelloCarleton DonchessThomas W. DonohueLorna DottsVincent R. DriscollBetty A. DriverDavid R. DurstDwayne O. EberhardtRonald L. Ehresman

Ted EllisF. Barney EnglishGreg FilbeckRoss A. FlahertyRich FortinTimothy J. GallagherGeorge W. GallingerSharon GarrisonGerald D. GayDeborah GiarussoR. H. GilmerAnthony J. GiovinoLawrence J. GitmanMichael GiulianoPhilip W. GlasgoJeffrey W. GlazerJoel GoldRon B. GoldfarbDennis W. GoodwinDavid A. GordonJ. Charles GraniczC. Ramon GriffinReynolds GriffithArthur GuarinoLewell F. GunterMelvin W. HarjuJohn E. HarperPhil HarringtonGeorge F. HarrisGeorge T. HarrisJohn D. HarrisMary HartmanR. Stevenson Hawkey

xliv


CHAPTER 5 Risk and Return xlv

Roger G. HehmanHarvey HeinowitzGlenn HendersonRussell H. HerethKathleen T. HevertJ. Lawrence HexterDouglas A. HibbertRoger P. HillLinda C. HittleJames HobanHugh A. HobsonKeith HoweKenneth M. HugginsJerry G. HuntMahmood IslamJames F. JacksonStanley JacobsDale W. JanowskyJeannette R. JesingerNalina JeypalanTimothy E. JohnsonRoger JuchauAshok K. KapoorDaniel J. Kaufman Jr.Joseph K. KielyTerrance E. KingstonRaj K. KohliThomas M. KruegerLawrence KryzanowskiHarry R. KunianskyWilliam R. LaneRichard E. La NearJames LarsenRick LeCompteB. E. LeeScott LeeSuk Hun LeeMichael A. LenarcicA. Joseph LerroThomas J. LieszHao LinAlan LinesLarry LynchChristopher K. MaJames C. MaDilip B. MadanJudy MaeseJames MalletInayat ManglaBala ManiamTimothy A. ManuelBrian MarisDaniel S. MarroneWilliam H. Marsh

John F. MarshallLinda J. MartinStanley A. MartinCharles E. MaxwellTimothy Hoyt McCaugheyLee McClainJay MeiselmanVincent A. MercurioJoseph MessinaJohn B. MitchellDaniel F. MohanCharles MohundroGene P. MorrisEdward A. MosesTarun K. MukherjeeWilliam T. MurphyRandy MyersLance NailDonald A. NastVivian F. NazarG. NewbouldCharles NgassamAlvin NishimotoGary NoreikoDennis T. OfficerKathleen J. OldfatherKathleen F. OppenheimerRichard M. OsborneJerome S. OsteryoungPrasad PadmanabahnRoger R. PalmerDon B. PantonJohn ParkRonda S. PaulBruce C. PayneGerald W. PerrittGladys E. PerryStanley PiascikGregory PierceMary L. PiotrowskiD. Anthony PlathJerry B. PoeGerald A. PogueSuzanne PolleyRonald S. PretekinFran QuinnRich RavichandranDavid RayoneWalter J. ReinhartJack H. ReubensBenedicte ReyesWilliam B. Riley Jr.Ron RizzutoGayle A. Russell

Patricia A. RyanMurray SabrinKanwal S. SachedevaR. Daniel SadlierHadi SalavitabarGary SangerMukunthan

SanthanakrishnanWilliam L. SartorisWilliam SawatskiSteven R. ScheffMichael SchellengerMichael SchinskiTom SchmidtCarl J. SchwendimanCarl SchweserJim ScottJohn W. SettleRichard A. ShickA. M. SibleySandeep SinghSurendra S. SinghviStacy SirmansBarry D. SmithGerald SmolenIra SmolowitzJean SnavelyJoseph V. StanfordJohn A. StockerLester B. StricklerGordon M. StringerElizabeth StrockDonald H. StuhlmanSankar SundarrajanPhilip R. SwensenS. TabriztchiJohn C. TalbottGary TallmanHarry TamuleRichard W. TaylorRolf K. TedefalkRichard TewelesKenneth J. ThygersonRobert D. TollenEmery A. TrahanBarry UzePieter A. VandenbergNikhil P. VaraiyaOscar VarelaMark VaughanKenneth J. VenutoSam VeraldiJames A. VerbruggeRonald P. Volpe


xlvi PART TWO Important Financial Concepts

John M. Wachowicz Jr.Faye (Hefei) WangWilliam H. Weber IIIHerbert WeinraubJonathan B. WelchGrant J. WellsLarry R. WhitePeter WichertC. Don Wiggins

Howard A. WilliamsRichard E. WilliamsGlenn A. Wilt Jr.Bernard J. WingerTony R. WinglerAlan WolkI. R. WoodsJohn C. WoodsRobert J. Wright

Richard H. YanowSeung J. YoonCharles W. YoungPhilip J. YoungJoe W. ZemanJohn ZietlowJ. Kenton ZumwaltTom Zwirlein

Special thanks go to Alan Wolk of the University of Georgia for accuracy checking the quantitative content in the textbook. We are pleased by and proud of his efforts.

A hearty round of applause also goes to the publishing team assembled by Pearson—including Donna Battista, Kate Fernandes, Meredith Gertz, Melissa Honig, Miguel Leonarte, Kathy Smith, and others who worked on the book—for the inspiration and the perspiration that define teamwork. Also, special thanks to the formidable Pearson sales force in finance, whose ongoing efforts keep the business fun!

Finally, and most important, many thanks to our families for patiently pro-viding support, understanding, and good humor throughout the revision process. To them we will be forever grateful.

Chad J. ZutterPittsburgh, Pennsylvania

Scott B. SmartBloomington, Indiana


Documents

Principles of Managerial Finance - … Capital Budgeting Techniques 430 11 Capital Budgeting Cash Flows 471 12 Risk and Refinements in Capital Budgeting