Financial Management

Principles and Practice

Financial Management

Principles and Practice

Sixth Edition

Timothy J. Gallagher
Professor of Finance
Colorado State University

FINANCIAL MANAGEMENT: PRINCIPLES AND PRACTICE, 6th Edition

Copyright 2013, 2010 by Timothy Gallagher. Published by Freeload Press
Copyright 2007 by Gallagher and Andrew. Published by Freeload Press
Previous editions 2003, 2000, and 1997 by Pearson Education, Inc.
All rights reserved. Printed in the United States of America. No part of this book may be reproduced
or transmitted in any form or by any means, electronic or mechanical, including photocopying and
recording, or by any information storage or retrieval system without the prior written permission
of the authors.
ISBN 1-930789-15-7
Library of Congress Cataloging-in-Publication Data
Gallagher, Timothy James, 1952
Financial Management: Principles and Practice/Timothy J. Gallagher 6th ed.

p. cm.
Includes bibliographical references and index.
1. CorporationFinance. I. Andrew, Joseph D. II. Title
HG4026. G348 2006
658.15dc21
2002074888

This book was previously published by: Pearson Education, Inc.

To my family
my parents, Bob and Lois
my wife, Susan
and Em, Justin, Ellie, and Zach

Preface xix
About the Author xxvii

PART I THE WORLD OF FINANCE 1

PART IV LONG-TERM FINANCING

DECISIONS 381

1  Finance and the Firm 2

13  Capital Structure Basics 382

2  Financial Markets and Interest Rates 24

14 Corporate Bonds, Preferred Stock,

and Leasing 414

3  Financial Institutions 44

15  Common Stock 440

PART II ESSENTIAL CONCEPTS

IN FINANCE 65

16  Dividend Policy 464

4  Review of Accounting 66

PART V SHORT-TERM FINANCING

DECISIONS 485

5  Analysis of Financial Statements 92

17  Working Capital Policy 486

6  Forecasting for Financial Planning 134

18  Managing Cash 508

7  Risk and Return 160

19  Accounts Receivable and Inventory 534

8  The Time Value of Money 194

20  Short-Term Financing 568

PART III CAPITAL BUDGETING AND

BUSINESS VALUATION 237

PART VI FINANCE IN THE GLOBAL

ECONOMY 593

9  The Cost of Capital 238

21  International Finance 594

10  Capital Budgeting Decision Methods 270

Appendix A-1

11  Estimating Incremental Cash Flows 314

Glossary G-1

12  Business Valuation 338

Index I-1

vii

Preface xix
About the Author xxvii

PART I THE WORLD OF FINANCE 1

2  Financial Markets and Interest Rates 24

1  Finance and the Firm 2

Learning Objectives 25
Chapter Overview 25
The Financial System 25

Learning Objectives 3
Chapter Overview 5
The Field of Finance 5

Securities 26
Financial Intermediaries 26
Investmen Bankers 26
Brokers 27
Dealers 27

Finance Career Paths 6

Financial Management 6
The Role of the Financial Manager 6
Finance in the Organization of the Firm 6
The Organization of the Finance Team 7

Financial Markets 27

The Basic Financial Goal of the Firm 7

The Primary Market 27

The Secondary Market 27
The Money Market 28
The Capital Market 28
Security Exchanges 28
The Over-the-Counter (OTC) Market 28
Market Efficiency 29

In Search of Value 8
The Importance of Cash Flow 9
The Effect of Timing on Cash Flows 10
The Influence of Risk 10
Profits versus Company Value 11

Legal and Ethical Challenges in Financial

Management 11

Securities in the Financial Marketplace 29

Agency Issues 11
The Agency Problem 12
Agency Costs 13
The Interests of Other Groups 13
The Interests of Society as a Whole 14

Securities in the Money Market 29

Treasury Bills 29
Negotiable Certificates of Deposit 30
Commercial Paper 30
Bankers Acceptances 30
Securities in the Capital Market 30
Bonds 30
Bond Terminology and Types 31
Treasury Notes and Bonds 31
Municipal Bonds 32
Corporate Bonds 32
Corporate Stock 32
Common Stock 32
Preferred Stock 33

Forms of Business Organization 14

The Proprietorship 14
The Partnership 15
Special Kinds of Partnerships 16
The Corporation 16
Special Kinds of Corporations 17
Limited Liability Companies (LLCs) 18

Whats Next 18
Summary 18 SelfTest 20 Review
Questions 20 Build Your Communication
Skills 21 Problems 21 Answers to
SelfTest 22

ix

Contents

Interest 33
Determinants of Interest Rates 33
The Real Rate of Interest 33
The Inflation Premium 34
The Default Risk Premium 35
The Illiquidity Risk Premium 35
The Maturity Risk Premium 35
The Yield Curve 36
Making Use of the Yield Curve 36

Whats Next 37
Summary 37 SelfTest 39 Review
Questions 39 Build Your Communication
Skills 40 Problems 40 Answers to
SelfTest 42
3  Financial Institutions 44

Learning Objectives 45
Chapter Overview 45
Financial Intermediation 45
Denomination Matching 46
Maturity Matching 46
Absorbing Credit Risk 47
Commercial Banks 47
Bank Regulation 47
Commercial Bank Operations 48
Commercial Bank Reserves 48

The Federal Reserve System 49

Organization of the Fed 49
Controlling the Money Supply 50
The Discount Window 52

Government Sponsored Enterprises

and the Mortgage Market (GSEs) 52
Savings and Loan Associations 53
Regulation of S&Ls 53
Mutual Companies versus Stockholder-Owned
Companies 53
The Problem of Matching Loan and Deposit
Maturities 54
S&Ls Real Assets 55

Credit Unions 55
The Common Bond Requirement 55
Members as Shareholders 55
Credit Unions Compared with Banks 56
Credit Union Regulation 56

Finance Companies, Insurance Companies,

and Pension Funds 56
Types of Finance Companies 56
Consumer Finance Companies 56
Commercial Finance Companies 56
Sales Finance Companies 56

Insurance Companies 56
Life Insurance Companies 57
Property and Casualty Insurance Companies 57
Pension Funds 58
Annuities 58

Legislation After the Financial Crisis 59

Whats Next 60
Summary 60 SelfTest 61 Review
Questions 61 Build Your Communication
Skills 62 Problems 62 Answers to
SelfTest 63

PART II ESSENTIAL CONCEPTS

INFINANCE 65
4  Review of Accounting 66

Learning Objectives 67
Chapter Overview 67
Review of Accounting Fundamentals 67
Basic Accounting Financial Statements 68
The Income Statement 68
Revenues 69
Expenses 69
Cost of Goods Sold 69
Selling and Administrative Expenses 69
Depreciation Expense 70
Operating Income and Interest Expense 70
Net Income 70
Earnings per Share (EPS) 70
Common Stock Dividends and Retained Earnings 71
The Balance Sheet 72
The Asset Accounts 72
Current Assets 72
Fixed Assets 72
The Liabilities and Equity Accounts 73
Liabilities 73
Common Stock and Retained Earning 74
The Statement of Cash Flows 74
Operating Activities 74
Adjustment for Depreciation Expense 74
Changes in Balance Sheet Accounts 75
Operating Activities 76
Investment Activities 77
Financing Activities 77
Net Cash Flow during the Period 77

Depreciation 77
Calculating the Amount of Depreciation Expense 78
Depreciation Methods 78

Contents

Income Taxes 79
Average Tax Rates 80

Whats Next 81
Summary 81 SelfTest 82 Review
Questions 83 Build Your Communication
Skills 84 Problems 84 Answers to
SelfTest 90
5  Analysis of Financial Statements 92

Learning Objectives 93
Chapter Overview 93
Assessing Financial Health 94
Misleading Numbers 94
Financial Ratios 94

The Basic Financial Ratios 95

Calculating the Ratios 95
Profitability Ratios 96
Gross Profit Margin 96
Operating Profit Margin 97
Net Profit Margin 98
Return on Assets 98
Return on Equity 98
Mixing Numbers from Income Statements
and Balance Sheets 99
Liquidity Ratios 100
The Current Ratio 100
The Quick Ratio 100
Debt Ratios 101
Debt to Total Assets 101
Times Interest Earned 101
Asset Activity Ratios 102
Average Collection Period 102
Inventory Turnover 103
Total Asset Turnover 103
Market Value Ratios 103
Price to Earnings Ratio 104
Market to Book Value 104
Economic Value Added and Market
Value Added 105
Economic Value Added (EVA) 105
Market Value Added (MVA) 107
Relationships among Ratios:
The Du Pont System 107

Trend Analysis and Industry Comparisons 110

Trend Analysis 110
Industry Comparisons 110

Summary Analysis: Trend and Industry

Comparisons Together 112
Locating Information about Financial Ratios 114

Whats Next 114

Summary 115 Equations Introduced in This
Chapter 116 SelfTest 117 Review
Questions 118 Build Your Communication
Skills 118 Problems 119 Answers to
SelfTest 132
6  Forecasting for Financial Planning 134

Learning Objectives 135

Chapter Overview 135
Why Forecasting Is Important 136
Forecasting Approaches 136
Experience 136
Probability 136
Correlation 137
Why Forecasts Are Sometimes Wrong 137

Forecasting Sales 137

Forecasting Financial Statements 138
Budgets 138
Producing Pro Forma Financial Statements 139
Choosing the Forecasting Basis 139
The Pro Forma Income Statement 140
The Sales Projection 140
Cost of Goods Sold (COGS) and Selling
and Marketing Expenses 140
General and Administrative Expenses 141
Depreciation Expense 142
Interest Expense 142
Income Taxes 142
Dividends Paid and Additions to Retained
Earnings 142
The Pro Forma Balance Sheet 142
Cash and Marketable Securities 142
Accounts Receivable and Inventory 143
Property, Plant, and Equipment 143
Accounts Payable 144
Notes Payable 144
Long-Term Debt 144
Common Stock and Capital in Excess of Par 144
Retained Earnings 144
Additional Funds Needed 145
A Note on Interest Expense 146
Analyzing Forecasts for Financial Planning 146

Whats Next 148

Sutmmary 148 SelfTest 149 Review
Questions 150 Build Your Communication
Skills 150 Problems 151 Answers to
SelfTest 158

xi

xii

Contents

7  Risk and Return 160

Learning Objectives 161

Chapter Overview 161
Risk 161
Risk Aversion 162
The Risk-Return Relationship 162
Measuring Risk 163
Using Standard Deviation to Measure Risk 163
Calculating the Standard Deviation 164
Interpreting the Standard Deviation 166
Using the Coefficient of Variation to Measure Risk 167

The Types of Risks Firms Encounter 168

Business Risk 169
Measuring Business Risk 169
The Influence of Sales Volatility 169
The Influence of Fixed Operating Costs 169
Financial Risk 170
Measuring Financial Risk 171
Portfolio Risk 171
Correlation 173
Calculating the Correlation Coefficient 174
Calculating the Standard Deviation of a Two-Asset
Portfolio 175
Nondiversifiable Risk 176
Measuring Nondiversifiable Risk 177

Dealing with Risk 178

Risk-Reduction Methods 178
Reducing Sales Volatility and Fixed Costs 178
Reducing Sales Volatility 178
Insurance 178
Diversification 179
Compensating for the Presence of Risk 179
Adjusting the Required Rate of Return 179

Relating Return and Risk: The Capital Asset Pricing

Model 179
Whats Next 181
Summary 182 Equations Introduced in This
Chapter 183 SelfTest 185 Review
Questions 186 Build Your Communication
Skills 186 Problems 187 Answers to
SelfTest 192
8  The Time Value of Money 194

Learning Objectives 195

Chapter Overview 195
Why Money Has Time Value 196
Measuring the Time Value of Money 196
The Future Value of a Single Amount 196
The Sensitivity of Future Values to Changes in
Interest Rates or the Number of Compounding
Periods 199

The Present Value of a Single Amount 201

The Sensitivity of Present Values to Changes in the
Interest Rate or the Number of Compounding
Periods 203
Working with Annuities 203
Future Value of an Ordinary Annuity 205
The Present Value of an Ordinary Annuity 208
Future and Present Values of Annuities Due 209
Perpetuities 211
Present Value of an Investment with Uneven
Cash Flows 212

Special Time Value of Money Problems 213

Finding the Interest Rate 213
Finding k of a Single-Amount Investment 213
Finding k for an Annuity Investment 215
Finding the Number of Periods 216
Solving for the Payment 217
Loan Amortization 219

Compounding More Than Once per Year 219

Annuity Compounding Periods 221
Continuous Compounding 222

Whats Next 223

Summary 224 Equations Introduced in This
Chapter 225 SelfTest 227 Review
Questions 228 Build Your Communication
Skills 228 Problems 229 Answers to
SelfTest 236

PART III CAPITAL BUDGETING AND

BUSINESS VALUATION 237
9  The Cost of Capital 238

Learning Objectives 239

Chapter Overview 239
The Cost of Capital 239
Sources of Capital 240
The Cost of Debt 240
The After-Tax Cost of Debt (AT kd) 240
The Cost of Preferred and Common Stock
Funds 242
The Cost of Preferred Stock (kp) 242
The Cost of Internal Common Equity (kS) 243
Using the Dividend Growth Model to
Estimate kS 244
The CAPM Approach to Estimating kS 245
Deciding How to Estimate kS 246
The Cost of Equity from New Common
Stock (kn) 246
The Weighted Average Cost of Capital (WACC) 247

Contents

The Marginal Cost of Capital (MCC) 249

The Firms MCC Schedule 250
Finding the Break Points in the MCC Schedule 250
Debt Break Points 250
The Equity Break Point 252
Calculating the Amount the MCC Changes 253
The MCC Up to the First Break Point 253

The MCC Schedule and Capital Budgeting

Decisions 254
The Optimal Capital Budget 256
The Importance of MCC to Capital Budgeting
Decisions 256

Crowdfunding 258
Whats Next 258
Summary 259 Equations Introduced in This
Chapter 260 SelfTest 262 Review
Questions 262 Build Your Communication
Skills 262 Problems 263 Answers to
SelfTest 269
10  Capital Budgeting Decision Methods 270

Learning Objectives 271

Chapter Overview 271
The Capital Budgeting Process 271
Decision Practices 272
Types of Projects 272
Capital Budgeting Cash Flows 272
Stages in the Capital Budgeting Process 273

Capital Budgeting Decision Methods 273

The Payback Method 273
How to Calculate the Payback Period 273
Payback Method Decision Rule 274
Problems with the Payback Method 274
The Net Present Value (NPV) Method 274
Calculating NPV 275
NPV Decision Rules 277
The NPV Profile 278
Problems with the NPV Method 279
The Internal Rate of Return (IRR) Method 280
Calculating Internal Rate of Return:
Trial-and-Error Method 280
Calculating Internal Rate of Return:
Financial Calculator 282
IRR and the NPV Profile 282
IRR Decision Rule 282
Benefits of the IRR Method 283
Problems with the IRR Method 283
Conflicting Rankings between the NPV and IRR
Methods 283
The Modified Internal Rate of Return (MIRR)
Method 284

xiii

Capital Rationing 286

Risk and Capital Budgeting 287
Measuring Risk in Capital Budgeting 287
Computing Changes in the Coefficient of Variation 287
Adjusting for Risk 289
Risk-Adjusted Discount Rates (RADRs) 289

Whats Next 290

Summary 290 Equations Introduced in This
Chapter 292 SelfTest 292 Review
Questions 293 Build Your Communication
Skills 293 Problems 294 Answers to
SelfTest 304
Appendix 10A: Wrinkles in Capital Budgeting 307
Nonsimple Projects 307
Multiple IRRs 308
Mutually Exclusive Projects with Unequal Project
Lives 309
Comparing Projects with Unequal Lives 311
The Replacement Chain Approach 311
The Equivalent Annual Annuity (EAA) 311

Equations Introduced in This Appendix 312

11  Estimating Incremental Cash Flows 314

Learning Objectives 315

Chapter Overview 315
Incremental Cash Flows 315
Types of Incremental Cash Flows 316
Initial Investment Cash Flows 316
Purchase Price, Installation, and Delivery 316
Changes in Net Working Capital 316
Operating Cash Flows 317
Taxes 317
Depreciation and Taxes 317
Opportunity Costs 317
Externalities 317
Shutdown Cash Flows 319
Financing Cash Flows 320
Incremental Cash Flows of an Expansion
Project 321
Initial Investment Cash Flows 321
Operating Cash Flows 322
Shutdown Cash Flows 322
Cash Flow Summary and Valuation 323
Asset Replacement Decisions 325

Real Options 326

Whats Next 328
Summary 330 SelfTest 330 Review
Questions 331 Build Your Communication
Skills 331 Problems 332 Answers to
SelfTest 337

xiv

Contents

12  Business Valuation 338

Learning Objectives 339

Chapter Overview 340
The Importance of Business Valuation 340
A General Valuation Model 340
Applying the General Valuation Model to
Businesses 341
Valuing Current Liabilities and Long-Term Debt 342
Long-Term Debt 342

Bond Valuation 342

Semiannual Coupon Interest Payments 345
The Yield to Maturity of a Bond 345
Calculating a Bonds Yield to Maturity 346
The Relationship between Bond YTM and Price 348

Preferred Stock Valuation 349

Finding the Present Value of Preferred Stock
Dividends 349
The Yield on Preferred Stock 350

Common Stock Valuation 351

Valuing Individual Shares of Common Stock 351
The Constant Growth Dividend Model 352
The Nonconstant, or Supernormal, Growth Model 353
The P/E Model 354
Valuing Total Common Stockholders Equity 355
Book Value 355
Liquidation Value 356
The Free Cash Flow DCF Model 356
Free Cash Flows 356
A Real World Example 357
The Yield on Common Stock 362

Valuing Complete Businesses 363

The Free Cash Flow DCF Model Applied to a
Complete Business 363
The Replacement Value of Assets Method 363

Whats Next 364

Summary 364 Equations Introduced in This
Chapter 366 SelfTest 369 Review
Questions 369 Build Your Communication
Skills 370 Problems 370 Answers to
SelfTest 378

PART IV LONG-TERM FINANCING

DECISIONS 381
13  Capital Structure Basics 382

Learning Objectives 383

Chapter Overview 383
Capital Structure 383
Operating Leverage 384
Calculating the Degree of Operating Leverage 384
The Effect of Fixed Costs on DOL 385

The Alternate Method of Calculating DOL 386

The Risk of Operating Leverage 387
Financial Leverage 387
Calculating the Degree of Financial Leverage
(DFL) 387
Another Method of Calculating Financial
Leverage 388
How Interest Expense Affects Financial Leverage 389
The Risk of Financial Leverage 389
Combined Leverage 389
Fixed Costs and Combined Leverage 390

Breakeven Analysis and Leverage 391

Constructing a Sales Breakeven Chart 392
Revenue Data 393
Cost Data 393
Plotting Data on the Breakeven Chart 394
Applying Breakeven Analysis 395

LBOs 398
Capital Structure Theory 398
Tax Deductibility of Interest 399
Modigliani and Miller 399
Toward an Optimal Capital Structure 400
The Lower Cost of Debt 400
How Capital Costs Change as Debt Is Added 400
The Effect of Risk 400
Establishing the Optimal Capital Structure in
Practice 401

Whats Next 402

Summary 402 Equations Introduced in This
Chapter 403 SelfTest 406 Review
Questions 406 Build Your Communication
Skills 406 Problems 407 Answers to
SelfTest 413
14  C
 orporate Bonds, Preferred Stock,
and Leasing 414

Learning Objectives 415

Chapter Overview 415
Bond Basics 415
Features of Bond Indentures 416
Security 417
Plans for Paying Off Bond Issues 417
Staggered Maturities 417
Sinking Funds 417
Call Provisions 417

A Sample Bond Refunding Problem 418

Restrictive Covenants 421
Limitations on Future Borrowings 421
Restrictions on Dividends 421
Minimum Levels of Working Capital 421
The Independent Trustee of the Bond Issue 422

Contents

Types of Bonds 422

Secured Bonds 422
Mortgage Bonds 422
Unsecured Bonds (Debentures) 422
Convertible Bonds 423
Features of Convertible Bonds 424
The Conversion Ratio 424
The Conversion Value 424
The Straight Bond Value 424
Variable-Rate Bonds 425
Putable Bonds 425
Junk Bonds 426
International Bonds 426
Super Long-Term Bonds 426

Preferred Stock 427

Preferred Stock Dividends 427
Preferred Stock Investors 427
Convertible Preferred Stock 428

Leasing 428
Genuine Leases versus Fakes 428
Operating and Financial (Capital) Leases 429
Accounting Treatment of Leases 429
Lease or Buy? 430
A Lease or Buy Decision Example 430

Whats Next 433

Summary 433 Equations Introduced in This
Chapter 434 SelfTest 434 Review
Questions 435 Build Your Communication
Skills 435 Problems 435 Answers to
SelfTest 439
15  Common Stock 440

Learning Objectives 441

Chapter Overview 441
The Characteristics of Common Stock 441
Stock Issued by Private Corporations 443
Stock Issued by Publicly Traded Corporations 443
Institutional Ownership of Common Stock 443

Voting Rights of Common Stockholders 444

Proxies 444
Board of Directors Elections 444

The Pros and Cons of Equity Financing 447

Disadvantages of Equity Financing 447
Advantages of Equity Financing 447

Issuing Common Stock 448

The Function of Investment Bankers 449
Underwriting versus Best Efforts 449
Pricing New Issues of Stock 449
Valuing the Stock of a Company That Is Not Publicly
Traded 450

xv

Rights and Warrants 451

Preemptive Rights 451
The Number of Rights Required to Buy a
New Share 451
The Value of a Right 452
Warrants 454
Warrant Valuation 454

Whats Next 456

Summary 456 Equations Introduced in This
Chapter 457 SelfTest 459 Review
Questions 459 Build Your Communication
Skills 459 Problems 460 Answers to
SelfTest 463
16  Dividend Policy 464

Learning Objectives 465

Chapter Overview 465
Dividends 465
Why a Dividend Policy Is Necessary 466
Factors Affecting Dividend Policy 466
Need for Funds 466
Management Expectations and Dividend Policy 466
Stockholders Preferences 466
Restrictions on Dividend Payments 467

Cash versus Earnings 468

Leading Dividend Theories 469
The Residual Theory of Dividends 469
The Clientele Dividend Theory 470
The Signaling Dividend Theory 470
The Bird-in-the-Hand Theory 470
Modigliani and Millers Dividend Theory 471

The Mechanics of Paying Dividends 471

Dividend Reinvestment Plans 472

Alternatives to Cash Dividends 472

Stock Dividends and Stock Splits 473
Stock Dividends 473
Adjustment of a Stocks Market Price after a
Stock Dividend 474
Stock Splits 475
Adjustment of a Stocks Market Price
after a Stock Split 476
The Rationale for Stock Splits 476

Whats Next 477

Summary 477 Equations Introduced in
This Chapter 478 SelfTest 478 Review
Questions 479 Build Your Communication
Skills 479 Problems 479 Answers to
SelfTest 484

xvi

Contents

PART V SHORT-TERM FINANCING

DECISIONS 485
17  Working Capital Policy 486

Learning Objectives 487

Chapter Overview 487
Managing Working Capital 487
Why Businesses Accumulate Working Capital 488
Fluctuating Current Assets 488
Permanent and Temporary Current Assets 489

Liquidity versus Profitability 490

Establishing the Optimal Level of Current Assets 491
Managing Current Liabilities: Risk and Return 491
Three Working Capital Financing Approaches 492
The Aggressive Approach 492
The Conservative Approach 492
The Moderate Approach 494

Working Capital Financing and Financial Ratios 494

Whats Next 496
Summary 496 SelfTest 498 Review
Questions 498 Build Your Communication
Skills 499 Problems 499 Answers to
SelfTest 506
18  Managing Cash 508

Learning Objectives 509

Chapter Overview 509
Cash Management Concepts 509
Determining the Optimal Cash Balance 510
The Desired Minimum Cash Balance 510
Raising Cash Quickly When Needed 510
Predicting Cash Needs 510
Coping with Emergencies 511
The Desired Maximum Cash Balance 511
Available Investment Opportunities 511
Expected Return on Investments 511
Transaction Cost of Making Investments 512
The Optimal Cash Balance 512
The MillerOrr Cash Management Model 512

Forecasting Cash Needs 514

Developing a Cash Budget 515

Managing the Cash Flowing In and Out of theFirm 519

Increasing Cash Inflows 519
Decreasing Cash Outflows 519
Speeding Up Cash Inflows 520
Slowing Down Cash Outflows 523

Whats Next 523

Summary 524 Equations Introduced in

This Chapter 525 SelfTest 525 Review
Questions 526 Build Your Communication
Skills 526 Problems 527 Answers to
SelfTest 532
19  Accounts Receivable and Inventory 534

Learning Objectives 535

Chapter Overview 535
Why Firms Accumulate Accounts Receivable and
Inventory 535
How Accounts Receivable and Inventory Affect
Profitability and Liquidity 536
Finding Optimal Levels of Accounts Receivable and
Inventory 537
The Optimal Level of Accounts Receivable 538
Credit Policy 538
Analyzing Accounts Receivable Levels 538
The Optimal Level of Inventory 543
The Costs of Maintaining Inventory 544
Analyzing Inventory Levels 544

Inventory Management Approaches 549

The ABC Inventory Classification System 549
Just-in-Time Inventory Control (JIT) 550

Making Credit Decisions 551

Collection Policies to Handle Bad Debts 551
Whats Next 554
Summary 554 Equations Introduced in This
Chapter 555 SelfTest 555 Review
Questions 556 Build Your Communication
Skills 556 Problems 557 Answers to
SelfTest 564
20  Short-Term Financing 568

Learning Objectives 569

Chapter Overview 569
The Need for Short-Term Financing 569
Short-Term Financing versus Long-Term
Financing 570
Short-Term Financing Alternatives 570
Short-Term Loans from Banks and Other
Institutions 571
Self-Liquidating Loans 571
The Line of Credit 571
Trade Credit 572
Computing the Cost of Trade Credit 572
Commercial Paper 573
Calculating the Cost of Commercial Paper 574

Contents

How Loan Terms Affect the Effective Interest Rate

of a Loan 576
The Effective Interest Rate 576
Discount Loans 576
Compensating Balances 577
Loan Maturities Shorter Than One Year 578
Annualizing Interest Rates 578
A Comprehensive Example 580
Computing the Interest Cost in Dollars 580
Computing the Net Amount Received 580
Computing the Effective Annual Interest Rate 581
Computing the Amount to Borrow 581

Collateral for Short-Term Loans 582

Accounts Receivable as Collateral 582
Inventory as Collateral 583

Whats Next 584

Summary 584 Equations Introduced in This
Chapter 585 SelfTest 587 Review
Questions 587 Build Your Communication
Skills 587 Problems 588 Answers to
SelfTest 590

PART VI FINANCE IN THE GLOBAL

ECONOMY 593
21  International Finance 594

Learning Objectives 595

Chapter Overview 595
Multinational Corporations 595
Financial Advantages of Foreign Operations 595
Ethical Issues Facing Multinational Corporations 596
Comparative Advantage 596

Exchange Rates and Their Effects 597

Fluctuating Exchange Rates 598
Cross Rates 599
Exchange Rate Effects on MNCS 600
Exchange Rate Effects on Foreign Stock and Bond
Investments 601

xvii

Managing Risk 601

Hedging 601
Diversification Benefits of Foreign Investments 602
American Depository Receipts 603

Exchange Rate Theories 603

Purchasing Power Parity Theory 603
International Fisher Effect 604
Interest Rate Parity Theory 604
Other Factors Affecting Exchange Rates 604
Government Intervention in Foreign Exchange
Markets 605

Political and Cultural Risks Facing MNCs 605

Political Risk 605
Cultural Risk 606

International Trade Agreements 606

NAFTA 606
GATT 607
European Union 607
Free Trade versus Fair Trade 608

Summary 608 Equations Introduced in This

Chapter 610 SelfTest 610 Review
Questions 610 Build Your Communication
Skills 610 Problems 611 Answers to
SelfTest 613
Appendix A-1
Glossary G-1
Index I-1

The Challenge
This sixth edition of Financial Management: Principles and Practice continues
to lead the way in presenting classroom tested and continuously updated and
relevant material in the field of financial management. In the fifth edition we were
the first book to incorporate the implications of the Financial Crisis for financial
management. This sixth edition continues to examine these implications but with
added perspective. Crowdfunding, the Facebook IPO, and the financial crisis in
Europe are some of the new areas addressed in this sixth edition.
There are two sets of optional materials available to those students and
instructors who wish to incorporate Excel spreadsheets into financial problem
solving. One is called Spreadsheet TutorpakTM. The other is called Spreadsheet
Templates.
6e Spreadsheet Tutorpak TM , prepared by my friend and colleague
Professor Hong Miao in close collaboration with me, is both a tutorial
and a set of applications for solving financial management problems with
Excel spreadsheets. Students will learn the basics of Excel spreadsheet
creation and manipulation with power macros behind the scenes such that the
student experience is straight forward. Another part of this package contains
demonstration spreadsheets, that present key concepts in an easier to understand
way, than what would be possible on a two dimensional page. Examples include
distribution graphs showing diversification benefits, loan amortization tables,
and break-even graphs. Input values can be changed by the student and the
resulting changes on output variables can be seen in a dynamic visual way.
Also, every time a new type of time value of money or capital budgeting
concept is presented, there is a spreadsheet solution the student will create
with prompting from the material in the Spreadsheet TutorpakTM package.
This has been added to this sixth edition to complement the algebraic, table,
and financial calculator keystroke solutions that were presented in the fifth
and earlier editions.
A Spreadsheet TutorpakTM element is available to the student everywhere
this icon is seen.

xix

xx

Preface

For more, see

6e Spreadsheet Templates
for Microsoft Excel

Spreadsheet templates are available for selected end-of-chapter problems. This

will reduce the data entry burden for students as they apply their Excel skills to solve
these problems. A full solution set of Excel spreadsheets is available to the faculty
member using this book. These materials are available in the instructor supplements
pack. End-of-chapter problems for which these spreadsheet templates are available are
marked with this Spreadsheet Template icon.
Finance scares some students. There is the fear of numbers that some students have and
the mistaken belief that the introductory finance course requires high-level mathematics.
Also, some students mistakenly believe finance is an area in which they will not need
competency. Finance concepts often seem far removed from daily life. In spite of this,
almost every major in a college of business, and many majors in other colleges, require
the Principles of Finance course. As a result, many of the students who find themselves
sitting in finance class on the first day of the semester do not want to be there.
This does not need to be the case. Finance is important, dynamic, interesting, and fun.
The challenge to Financial Management: Principles and Practice is to convince students
of this. In order to learn, students must want to learn. If they can see the usefulness of
what is presented to them, they will work hard and they will learn. Students also demand
relevancy. This sixth edition tackles head on the changes we must face in the financial
world and the new information that must be digested before making financial decisions in
the new world we find ourselves in. There are also mistakes made by financial decision
makers and government officials from which we must learn.
Many years of teaching experience has taught me that the introductory financial
management course can be one that students enjoy and that they see as having added
considerable value to their educational experiences. Finance is, after all, central to
any business entity. More CEOs have come up through the finance ranks than any
other discipline. Students need to know that the principles and practices of financial
management apply to any business unitfrom the very large multinational corporation
to the very smallest proprietorship, including the family. Financial ratios tell a story;
they are not numbers to be calculated as an end unto itself. Risk is important and can
be managed. Time value of money has meaning and is understood as the central tool
of valuation. Funds have a cost and different sources of funds have different costs.
Financial performance and condition can be assessed. Amortized loan payments, rates
of return on investment, future value of investment programs, and present value of
payments to be received from bonds and stocks can be calculated. The opportunities
and special challenges of international operations can be understood.

This Approach
Students should walk out of the room after taking the final exam for a finance course
believing that they have learned something useful. They should see a direct benefit to
themselves personally, rather than just the belief that some set of necessary job skills
has been mastered, although the latter will be true if the material is mastered.
Financial Management: Principles and Practice, starts with the student in mind and
then packages the finance material so that the students (1) want to learn and (2)learn the
necessary material. Finance is not medicine, and it cannot be administered as such. Instead,
we believe students must be engaged in such a way that they develop the desire to learn.
There are those who approach the task of teaching finance with the philosophy, Here is
the finance knowledge you need. Learn it! This is not the approach taken by this book.

Preface

Distinctive Focus
Although there are many other introductory financial management books on the market,
none contains the unique style and content of Financial Management: Principles and
Practice, sixth edition. Many texts focus mostly on accounting with little presentation
of the economic theory that underlies the financial techniques presented. Others assume
that the students remember all that was learned in the accounting course that is usually
a prerequisite for this course. Still others claim to take a valuation approach but
present their topics in a straight accounting framework. In this book we are serious
about focusing on what creates value. We are consistent in this approach throughout
the book, addressing issues such as what creates value, what destroys it, how value is
measured, and how value and risk are related. In so doing we maximize the value of
the finance course to the student.

Organization of the Text

The book is organized into six major parts as follows:
Part I. T
 he World of Finance contains chapters on the structure and goals
of firm, the role of financial managers, and an examination of the
financial environment. Special attention is given to how the Financial
Crisis affected nonfinancial companies, financial markets, and financial
institutions.
Part II. E
 ssential Concepts in Finance presents chapters on accounting statements
and their interpretation, forecasting, risk and return, the time value of
money, and security valuation. Special attention is given to systematic
risk and its role in the Financial Crisis.
Part III. C
 apital Budgeting and Business Valuation contains chapters on
measuring a firms cost of capital, capital budgeting decision methods,
incremental cash flow estimation, and business valuation.
Part IV. L
 ong-Term Financing Decisions contains chapters on capital structure
basics, corporate bonds, preferred stock, leasing, common stock, and
dividend policy. The turmoil in the stock and bond markets during the
Financial Crisis is examined.
Part V. S
 hort-Term Financial Management Decisions includes chapters on
working capital policy, cash and marketable securities, accounts
receivable and inventory, and short-term financing.
Part VI. F
 inance in a Global Economy is where international finance topics
are covered, in addition to those international topics that are woven
throughout the book. The contagion of the Financial Crisis around the
world is examined.

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Special Features in the Text

6e Spreadsheet TutorpakTM
Extensive new Excel related material is available with the sixth edition. These materials
are available at www.textbookmedia.com from the menu of resources available with
this book. First, this package serves as a tutorial. Students are taught how to create and
manipulate Excel spreadsheets. Second, the package demonstrates important financial
concepts presented in the book. For example, students can manipulate input variable
values for break-even analysis and see the resulting change in output variable values
including dynamic graphs. Third, the 6e Spreadsheet TutorpakTM material steps the
student through the process for solving various time value of money, capital budgeting,
and other types of problems presented throughout the book. Every place a problem is
presented that had a financial calculator keystroke solution provided in earlier editions,
there is now an Excel solution provided for the student. Throughout the book this icon is
used to indicate where accompanying 6e Spreadsheet TutorpakTM material is available.
Real-World Examples
Each chapter in Financial Management: Principles and Practice begins with a real-world
example, such as the Facebook IPO, that illustrates the concept to be addressed in that
chapter. This serves to give the student a reason to learn this material and to show its
practical application. Learning objectives are clear.
Excel Spreadsheet Tutorial and Solutions
A package is available at www.textbookmedia.com that teaches basic and intermediate
Excel skills. Important financial concepts are presented with Excel including graphics
to enhance learning in a dynamic environment. The student steps through the solving
of time value of money, capital budgeting, and security valuation problems applying
Excel skills developed by the use of Spreadsheet TutorpakTM.
Financial Calculator Solutions
Financial calculator solutions to general time value of money and specific security
valuation problems are included. This material is presented in such a way that professors
differing preferences as to the use of financial calculators can be accommodated.
Summaries
The summary for each chapter specifically describes how the learning objectives have
been achieved and it also provides a bridge to the next chapter.
Key Terms
Each chapter has bolded key terms that are defined in the chapter and in the glossary.
There are self-test questions and problems at the end of chapters, along with their
solutions, so that students can check their grasp of the material presented.

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Preface

Practice Questions and Problems

Study questions and an abundant number of end-of-chapter problems are included
in the appropriate chapters. Many problems from the fifth edition have been redone
in the sixth.
Computer Spreadsheet Supported Problems
A number of end-of-chapter problems are marked with the special computer problem
logo shown here. This indicates that a downloadable Excel spreadsheet template is
available at www.textbookmedia.com. This template contains data for the designated
end-of-chapter problem that can then be solved in Excel by the student.
Communication Skills
Suggested assignments to build students written and oral communication skills are
included in each chapter.
Color
Color is used for pedagogic effect, not just for looks.

Changes in the Sixth Edition

The few errors in the fifth edition have been corrected.

The fifth edition was the first book in this market to incorporate the Financial Crisis.
The sixth edition is the first to come out updating these stories and describing the
aftermath. This sixth edition covers the Dodd Frank Act including the Volcker
Rule, the Facebook IPO, the JPMorgan Chase trading loss incident, the Federal
Reserves Operation Twist (of the yield curve) along with QE1, QE2, and the
quantitative easing initiatives.

The financial and economic problems of the Eurozone countries, especially Greece,
are described. The financial reasons for these problems are covered.

References and examples were updated throughout.

A new comprehensive Excel package is available for use with the sixth edition.
My friend and colleague Hong Miao created this new material. It includes a
tutorial section to teach Excel skills. Completed spreadsheets are included to
demonstrate elements presented in the book such that the student may change
input variable values and see the resulting change in output values, including
changing graphics. Each time value of money and capital budgeting problem
presented in the chapter body now has an Excel solution available along with
the algebraic, table, and financial calculators solutions made available in earlier
editions.

Many end-of-chapter problems, particularly those in Chapters 8 and 10 are new.

In Chapter 9, The Cost of Capital, a new section on crowdfunding has been added.

For more, see

6e Spreadsheet Templates
for Microsoft Excel

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Preface

Features Retained from the Fifth Edition

The book is still written in the student-friendly style that was extremely popular in
the first and second editions. The concise, easy-to-understand presentation loved by
student users is maintained.

The book provides the level of rigor professors demand. When professors get past
the friendly style, they find all the rigor and all the mainstream topics they expect in
a book of this type. For example, if you are not already a Financial Management:
Principles and Practice user, does your book:

Address extensively the ramifications of the Financial Crisis on the world of finance,
the business world in general, and individuals?

Cover real options?

Cover EVA, MVA, and EBITDA?
Use a value-added (NPV) approach to the inventory and accounts receivable

investment coverage rather than the outmoded return on investment ratio approach?

Attempts to expand the book, and to make it longer, have been resisted. The topics
that professors actually teach are here. Those that are most likely to be taught in the
second course in financial management are left out. Students dont have to buy more
than what they need.

The Learning Package

Financial Management: Principles and Practice is one component of a complete learning
package carefully put together by the Textbook Media team. This package includes a
computerized test bank, a study guide/workbook, an instructors manual, PowerPoint
slides, and downloadable Excel spreadsheets.

For more, see

6e Spreadsheet Templates
for Microsoft Excel

For the Student

material is available at www.
Downloadable MaterialCompanion downloadable
textbookmedia.com. There are two different Excel spreadsheet products available.
The first is called 6e Spreadsheet Tutorpac TM. This package teaches the student
to create and manipulate Excel spreadsheets. It demonstrates, with macros and
charts, important concepts presented in the book. It also steps the student through
solutions, using Excel functions, of a wide variety of problem-solving skills. The
second Excel spreadsheet product provides Excel spreadsheet files containing
templates that facilitate solving computer icon designated end-of-chapter problems.
Such templates are provided for those selected end-of-chapter problems designated
with this icon.

Lecture NotesLecture NotesPowerPoint files may be downloaded from www.

textbookmedia.com and used as lecture notes so that students can focus on what
their professor is saying without having to simultaneously take copious notes.

Preface

For the Professor

Instructors ManualThis provides the professor with chapter outlines and
suggestions for alternative ways to present the material. Key points are identified
and a variety of types of assistance for class preparation are presented.

Solutions ManualDetailed solutions, not just final answers, are presented for
each end-of-chapter question and problem. These have all been personally checked
by the author for accuracy.

Complete Excel Solutions to Designated End-of-Chapter ProblemsSelected

end-of-chapter problems are marked throughout the book with a 6e Spreadsheet
Template icon. Adopting professors are provided with the full Excel solutions for
these problems.

Spreadsheet SolutionsSelected end-of-chapter problems, indicated in the

textbook with a 6e Spreadsheet Template icon, are solved completely in Excel for
the instructors use. Students are provided with templates that they can use when
applying their Excel skills in solving these problems.

Test Item FileMultiple-choice, short-answer, and essay questions reflect all the
material in the chapter. The program allows for complete customization of an exam
according to chapters covered, type of problem, and level of difficulty.

PowerPoint SlidesAnimated slides covering all main topic areas in the text are
available to assist the professor during class.

Author AccessThe author is accessible to respond to individual questions that

may come up. Tim Gallagher may be reached at [email protected].

In Conclusion
Students will understand the very important finance concepts, and master necessary
problem-solving skills, when they complete the course in which this text is used.
Students first is our philosophy at Textbook Media and this belief shows up throughout
the text. Professors who have more enthusiastic students and who grasp the important
content, both conceptual and problem solving, will find their classroom experiences
more rewarding too. If we have helped to make this happen, we have succeeded in
achieving our vision for Financial Management: Principles and Practice, sixth edition.

Acknowledgements
The authors gratefully acknowledge the contributions of the many people who
contributed to this endeavor. Without their expertise and talent, this book and the
supplemental materials would not have been possible.
We send our thanks to a number of colleagues and key reviewers who contributed
to this and previous editions. They are Dianne Morrison (University of Wisconsin
LaCrosse), Zhenhu Jin (Illinois Wesleyan University), Denise Letterman (Robert Morris
College), Gary Greene (Manatee Community College), John Armstrong (Dominican

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Preface

College), Atul K. Saxena (Mercer University), William Hudson (St. Cloud State
University), Charles W. Strang (Western New Mexico University), James D. Keys
(Florida International University), Vickie Bajtelsmit (Colorado State University), John
Elder (Colorado State University), SueHine (Colorado State University), Hong Miao
(Colorado State University), Rob Schwebach (Colorado State University), Sriram
Villupuram (Colorado State University), Chris Stein (Colorado State Univeristy),
JoeBrocato (Tarleton State University), Susan Myrick (Allegheny County Community
College), Clark Maxam (Montana State University), Gary Walker (Myers University),
Ron Filante (Pace University), Andrew Adkinson (University of NebraskaKearney),
Mark Sunderman (University of Wyoming), Wendy Pirie (Wesleyan University),
Frenando Arellano (University of Dallas), and S. R. Das Gupta.
We are also indebted to many people at Prentice Hall who helped with the first
three editions. These include: Mickey Cox, PJ Boardman, and Maureen Riopelle.
Wed especially like to thank Paul Donnelly and Jill Lectka, who were there from the
beginning. These people have made their marks on this book in lasting ways.
For this sixth edition we are particularly indebted to our editor, Ed Laube, of
Textbook Media. Ed and his partners Tom Doran and Peggy Morgan had the courage
to start a company that redefines textbook publishing. We are excited to be a part of it.
This is the future of college textbook publishing. The old model doesnt work anymore
and these people and the others who have created Textbook Media are doing something
about it. Wed also like to thank Victoria Putman and Daphne Loecke for their excellent
work on the production side of this project. Joe Andrew, my former co-author, has left
an indelible mark on this book. My colleague Hong Miao did an outstanding job with
the new Excel material available with this sixth edition from the Publisher.
Last, but not least, I am most especially grateful for the assistance and support of
family members: Susan Shattuck, Emily, Justin, Ellie and Zach Peddicord.

Timothy J. Gallagher (Tim) holds the rank of professor in the Department of

Finance and Real Estate at Colorado State University. He currently serves as Chair
of Faculty Council and recently served as Vice Chair and Faculty Representative
to the Board of Governors of Colorado State University. Tim served as Chair of
the Department of Finance & Real Estate for ten years. He believes strongly in
shared governance at universities and he is an active member of the American
Association of University Professors (AAUP). Tim received his Ph.D. in finance
from the University of Illinois at UrbanaChampaign.

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