Thirteenth Edition

Global Edition

Financial Management
Principles and Applications

She rid a n Tit ma n

University of Texas at Austin
Walter W. McAllister Centennial Chair in Financial Services

Ar t hur J . Ke own
Virginia Polytechnic Institute and State University
Alumni Distinguished Professor and R. B. Pamplin Professor of Finance

J ohn D. Ma r t in
Baylor University
Carr P. Collins Chair in Finance

Harlow, England • London • New York • Boston • San Francisco • Toronto • Sydney • Dubai • Singapore • Hong Kong
Tokyo • Seoul • Taipei • New Delhi • Cape Town • Sao Paulo • Mexico City • Madrid • Amsterdam • Munich • Paris • Milan

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 Brief
Contents
Preface 22

Part 1: Introduction to Financial Management

CHAPTER 1
Getting Started—Principles of Finance 34
CHAPTER 2
Firms and the Financial Markets 50
CHAPTER 3
Understanding Financial Statements 70
CHAPTER 4
Financial Analysis—Sizing Up Firm Performance 110

Part 2: Valuation of Financial Assets

CHAPTER 5
The Time Value of Money—The Basics 160
CHAPTER 6
The Time Value of Money—Annuities
and Other Topics 190
CHAPTER 7
An Introduction to Risk and Return—History of Financial
Market Returns 224
CHAPTER 8
Risk and Return—Capital Market Theory 254
CHAPTER 9
Debt Valuation and Interest Rates 286
CHAPTER 10
Stock Valuation 332

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 BRIEF CONTENTS |    7

Part 3: Capital Budgeting

CHAPTER 11
Investment Decision Criteria 360
CHAPTER 12
Analyzing Project Cash Flows 404
CHAPTER 13
Risk Analysis and Project Evaluation 440
CHAPTER 14
The Cost of Capital 476

Part 4: Capital Structure and Dividend Policy

CHAPTER 15
Capital Structure Policy 514
CHAPTER 16
Dividend and Share Repurchase Policy 558

Part 5: Liquidity Management and Special Topics

in Finance

CHAPTER 17
Financial Forecasting and Planning 584
CHAPTER 18
Working-Capital Management 608
CHAPTER 19
International Business Finance 638
CHAPTER 20
Corporate Risk Management 664

Appendices   Available in MyLab Finance

Glossary 699
Indexes 707

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 Contents
Preface 22

Part 1: Introduction to Financial Management

CHAPTER 1
Getting Started—Principles of Finance 34
P Principle 1: Money Has a Time Value 35
P Principle 2: There Is a Risk-Return Tradeoff 35
P Principle 3: Cash Flows Are the Source of Value 35
P Principle 4: Market Prices Reflect Information 35
P Principle 5: Individuals Respond to Incentives 35
1.1 Finance: An Overview 36
What Is Finance? 36
Why Study Finance? 36
1.2 Three Types of Business Organizations 37
Sole Proprietorship 37
Partnership 38
Corporation 39
How Does Finance Fit into the Firm’s Organizational Structure? 40
1.3 The Goal of the Financial Manager 41
Maximizing Shareholder Wealth 41
Ethical Considerations in Corporate Finance 42
Regulation Aimed at Making the Goal of the Firm Work: The Sarbanes-Oxley Act 43
1.4 The Five Basic Principles of Finance 43
Principle 1: Money Has a Time Value 43
Principle 2: There Is a Risk-Return Tradeoff 44
Principle 3: Cash Flows Are the Source of Value 44
Principle 4: Market Prices Reflect Information 45
Principle 5: Individuals Respond to Incentives 45
Chapter Summaries 47
Study Questions 49

CHAPTER 2
Firms and the Financial Markets 50
P Principle 2: There Is a Risk-Return Tradeoff 51
P Principle 4: Market Prices Reflect Information 51
P Principle 5: Individuals Respond to Incentives 51
2.1 The Basic Structure of the U.S. Financial Markets 52
2.2 The Financial Marketplace: Financial Institutions 52
Commercial Banks: Everyone’s Financial Marketplace 53
Nonbank Financial Intermediaries 54
FINANCE FOR LIFE: Controlling Costs in Mutual Funds 56
2.3 The Financial Marketplace: Securities Markets 57
How Securities Markets Bring Corporations and Investors Together 58
Types of Securities 59
FINANCE IN A FLAT WORLD: Where’s the Money Around the World 64
Chapter Summaries 66
Study Questions 68

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 10 CONTENTS |

CHAPTER 3
Understanding Financial Statements 70
P Principle 1: Money Has a Time Value 71
P Principle 3: Cash Flows Are the Source of Value 71
P Principle 4: Market Prices Reflect Information 71
P Principle 5: Individuals Respond to Incentives 71
3.1 An Overview of the Firm’s Financial Statements 72
Basic Financial Statements 72
Why Study Financial Statements? 73
What Are the Accounting Principles Used to Prepare Financial Statements? 73
3.2 The Income Statement 74
The Income Statement of H. J. Boswell, Inc. 74
Connecting the Income Statement and Balance Sheet 76
Interpreting Firm Profitability Using the Income Statement 76
GAAP and Earnings Management 77
3.3 Corporate Taxes 79
Computing Taxable Income 79
Federal Income Tax Rates for Corporate Income 79
Marginal and Average Tax Rates 80
Dividend Exclusion for Corporate Stockholders 80
3.4 The Balance Sheet 81
The Balance Sheet of H. J. Boswell, Inc. 81
Firm Liquidity and Net Working Capital 84
Debt and Equity Financing 85
Book Values, Historical Costs, and Market Values 87
FINANCE FOR LIFE: Your Personal Balance Sheet and Income Statement 88
3.5 The Cash Flow Statement 90
Sources and Uses of Cash 90
H. J. Boswell’s Cash Flow Statement 92
FINANCE IN A FLAT WORLD: GAAP vs. IFRS 93
Chapter Summaries 99
Study Questions 102
Study Problems 103
Mini-Case 107

CHAPTER 4
Financial Analysis—Sizing Up Firm Performance 110
P Principle 3: Cash Flows Are the Source of Value 111
P Principle 4: Market Prices Reflect Information 111
P Principle 5: Individuals Respond to Incentives 111
4.1 Why Do We Analyze Financial Statements? 112
4.2 Common-Size Statements: Standardizing Financial Information 113
The Common-Size Income Statement: H. J. Boswell, Inc. 113
The Common-Size Balance Sheet: H. J. Boswell, Inc. 114
4.3 Using Financial Ratios 115
Liquidity Ratios 115
Capital Structure Ratios 121
Asset Management Efficiency Ratios 122
Profitability Ratios 126
Market Value Ratios 133
FINANCE FOR LIFE: Your Cash Budget and Personal Savings Ratio 134
Summing Up the Financial Analysis of H. J. Boswell, Inc. 137
FINANCE IN A FLAT WORLD: Ratios and International
Accounting Standards 137

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 CONTENTS |   11
4.4 Selecting a Performance Benchmark 139
Trend Analysis 139
Peer-Firm Comparisons 140
4.5 Limitations of Ratio Analysis 141
Chapter Summaries 143
Study Questions 146
Study Problems 146
Mini-Case 159

Part 2: Valuation of Financial Assets

CHAPTER 5
The Time Value of Money—The Basics 160
P Principle 1: Money Has a Time Value 161
5.1 Using Timelines to Visualize Cash Flows 162
5.2 Compounding and Future Value 164
Compound Interest and Time 165
Compound Interest and the Interest Rate 165
Techniques for Moving Money Through Time 165
Applying Compounding to Things Other Than Money 167
Compound Interest with Shorter Compounding Periods 167
FINANCE FOR LIFE: Saving for Your First House 171
5.3 Discounting and Present Value 171
The Mechanics of Discounting Future Cash Flows 172
Two Additional Types of Discounting Problems 174
The Rule of 72 175
5.4 Making Interest Rates Comparable 177
Calculating the Interest Rate and Converting It to an EAR 179
To the Extreme: Continuous Compounding 180
FINANCE IN A FLAT WORLD: Financial Access at Birth 181
Chapter Summaries 182
Study Questions 184
Study Problems 185
Mini-Case 189

CHAPTER 6
The Time Value of Money—Annuities and Other Topics 190
P Principle 1: Money Has a Time Value 191
P Principle 3: Cash Flows Are the Source of Value 191
6.1 Annuities 192
Ordinary Annuities 192
Amortized Loans 200
Annuities Due 201
FINANCE FOR LIFE: Saving for Retirement 204
6.2 Perpetuities 205
Calculating the Present Value of a Level Perpetuity 205
Calculating the Present Value of a Growing Perpetuity 205
6.3 Complex Cash Flow Streams 208
Chapter Summaries 212
Study Questions 213
Study Problems 214
Mini-Case 223

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 12 CONTENTS |

CHAPTER 7
An Introduction to Risk and Return—History of Financial
Market Returns 224
P Principle 2: There Is a Risk-Return Tradeoff 225
P Principle 4: Market Prices Reflect Information 225
7.1 Realized and Expected Rates of Return and Risk 226
Calculating the Realized Return from an Investment 226
Calculating the Expected Return from an Investment 227
Measuring Risk 228
7.2 A Brief History of Financial Market Returns 234
U.S. Financial Markets: Domestic Investment Returns 234
Lessons Learned 236
U.S. Stocks Versus Other Categories of Investments 236
Global Financial Markets: International Investing 236
FINANCE FOR LIFE: Determining Your Tolerance for Risk 238
7.3 Geometric Versus Arithmetic Average Rates of Return 239
Computing the Geometric or Compound Average Rate of Return 239
Choosing the Right “Average” 240
7.4 What Determines Stock Prices? 243
The Efficient Markets Hypothesis 243
Do We Expect Financial Markets to Be Perfectly Efficient? 244
Market Efficiency: What Does the Evidence Show? 245
Chapter Summaries 247
Study Questions 250
Study Problems 250
Mini-Case 253

CHAPTER 8
Risk and Return—Capital Market Theory 254
P Principle 2: There Is a Risk-Return Tradeoff 255
P Principle 4: Market Prices Reflect Information 255
8.1 Portfolio Returns and Portfolio Risk 256
Calculating the Expected Return of a Portfolio 256
Evaluating Portfolio Risk 258
Calculating the Standard Deviation of a Portfolio’s Returns 260
FINANCE IN A FLAT WORLD: International Diversification 263
8.2 Systematic Risk and the Market Portfolio 265
Diversification and Unsystematic Risk 266
Diversification and Systematic Risk 267
Systematic Risk and Beta 267
Calculating the Portfolio Beta 269
8.3 The Security Market Line and the CAPM 270
Using the CAPM to Estimate Expected Rates of Return 272
Chapter Summaries 275
Study Questions 277
Study Problems 278
Mini-Case 285

CHAPTER 9
Debt Valuation and Interest Rates 286
P Principle 1: Money Has a Time Value 287
P Principle 2: There Is a Risk-Return Tradeoff 287
P Principle 3: Cash Flows Are the Source of Value 287

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 CONTENTS |   13
9.1 Overview of Corporate Debt 288
Borrowing Money in the Private Financial Market 288
Borrowing Money in the Public Financial Market 290
Basic Bond Features 293
FINANCE FOR LIFE: Adjustable-Rate Mortgages 295
9.2 Valuing Corporate Debt 297
Valuing Bonds by Discounting Future Cash Flows 297
Step 1: Determine Bondholder Cash Flows 298
Step 2: Estimate the Appropriate Discount Rate 298
Step 3: Calculate the Present Value Using the Discounted Cash Flow 301
9.3 Bond Valuation: Four Key Relationships 305
Relationship 1 305
Relationship 2 307
Relationship 3 307
Relationship 4 308
9.4 Types of Bonds 310
Secured Versus Unsecured 310
Priority of Claims 310
Initial Offering Market 310
Abnormal Risk 310
Coupon Level 310
Amortizing or Non-amortizing 310
Convertibility 311
FINANCE IN A FLAT WORLD: International Bonds 312
9.5 Determinants of Interest Rates 312
Inflation and Real Versus Nominal Interest Rates 312
Interest Rate Determinants—Breaking It Down 314
The Maturity-Risk Premium and the Term Structure of Interest Rates 317
Chapter Summaries 322
Study Questions 326
Study Problems 327
Mini-Case 331

CHAPTER 10
Stock Valuation 332
P Principle 1: Money Has a Time Value 333
P Principle 2: There Is a Risk-Reward Tradeoff 333
P Principle 3: Cash Flows Are the Source of Value 333
P Principle 4: Market Prices Reflect Information 333
P Principle 5: Individuals Respond to Incentives 333
10.1 Common Stock 334
Characteristics of Common Stock 334
FINANCE FOR LIFE: Herd Mentality 335
Agency Costs and Common Stock 336
Valuing Common Stock Using the Discounted Dividend Model 336
10.2 The Comparables Approach to Valuing Common Stock 343
Defining the P/E Ratio Valuation Model 343
What Determines the P/E Ratio for a Stock? 343
An Aside on Managing for Shareholder Value 347
A Word of Caution About P/E Ratios 347
10.3 Preferred Stock 347
Features of Preferred Stock 347
Valuing Preferred Stock 348
A Quick Review: Valuing Bonds, Preferred Stock, and Common Stock 350

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 14 CONTENTS |
Chapter Summaries 353
Study Questions 355
Study Problems 356
Mini-Case 359

Part 3: Capital Budgeting

CHAPTER 11
Investment Decision Criteria 360
P Principle 1: Money Has a Time Value 361
P Principle 2: There Is a Risk-Return Tradeoff 361
P Principle 3: Cash Flows Are the Source of Value 361
P Principle 5: Individuals Respond to Incentives 361
11.1 An Overview of Capital Budgeting 362
The Typical Capital-Budgeting Process 363
What Are the Sources of Good Investment Projects? 363
Types of Capital Investment Projects 363
11.2 Net Present Value 364
Why Is the NPV the Right Criterion? 365
Calculating an Investment’s NPV 365
Independent Versus Mutually Exclusive Investment Projects 366
11.3 Other Investment Criteria 372
Profitability Index 372
Internal Rate of Return 374
Modified Internal Rate of Return 380
FINANCE FOR LIFE: Higher Education as an Investment in Yourself 384
Payback Period 384
Discounted Payback Period 385
Summing Up the Alternative Decision Rules 387
11.4 A Glance at Actual Capital-Budgeting Practices 387
Chapter Summaries 390
Study Questions 393
Study Problems 394
Mini-Cases 401

CHAPTER 12
Analyzing Project Cash Flows 404
P Principle 3: Cash Flows Are the Source of Value 405
P Principle 5: Individuals Respond to Incentives 405
12.1 Project Cash Flows 406
Incremental Cash Flows Are What Matters 407
Guidelines for Forecasting Incremental Cash Flows 407
12.2 Forecasting Project Cash Flows 409
Dealing with Depreciation Expense, Taxes, and Cash Flow 409
Four-Step Procedure for Calculating Project Cash Flows 410
Computing Project NPV 414
12.3 Inflation and Capital Budgeting 416
Estimating Nominal Cash Flows 416
12.4 Replacement Project Cash Flows 417
Category 1: Initial Outlay, CF0 417
Category 2: Annual Cash Flows 417

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 CONTENTS |   15
Replacement Example 418
FINANCE IN A FLAT WORLD: Entering New Markets 422
Chapter Summaries 423
Study Questions 425
Study Problems 426
Mini-Cases 435
Appendix: The Modified Accelerated Cost Recovery System 438

CHAPTER 13
Risk Analysis and Project Evaluation 440
RISKS P Principle 1: Money Has a Time Value 441
P Principle 2: There Is a Risk-Return Tradeoff 441
P Principle 3: Cash Flows Are the Source of Value 441
13.1 The Importance of Risk Analysis 442
13.2 Tools for Analyzing the Risk of Project Cash Flows 443
Key Concepts: Expected Values and Value Drivers 443
Sensitivity Analysis 445
Scenario Analysis 449
Simulation Analysis 452
FINANCE IN A FLAT WORLD: Currency Risk 454
13.3 Break-Even Analysis 454
Accounting Break-Even Analysis 455
Cash Break-Even Analysis 459
NPV Break-Even Analysis 459
Operating Leverage and the Volatility of Project Cash Flows 462
13.4 Real Options in Capital Budgeting 464
The Option to Delay the Launch of a Project 464
The Option to Expand a Project 465
The Option to Reduce the Scale and Scope of a Project 465
Chapter Summaries 467
Study Questions 469
Study Problems 470
Mini-Case 475

CHAPTER 14
The Cost of Capital 476
P Principle 1: Money Has a Time Value 477
P Principle 2: There Is a Risk-Return Tradeoff 477
P Principle 3: Cash Flows Are the Source of Value 477
P Principle 4: Market Prices Reflect Information 477
P Principle 5: Individuals Respond to Incentives 477
14.1 The Cost of Capital: An Overview 478
Investor’s Required Return and the Firm’s Cost of Capital 479
WACC Equation 479
Three-Step Procedure for Estimating the Firm’s WACC 480
14.2 Determining the Firm’s Capital Structure Weights 481
14.3 Estimating the Cost of Individual Sources of Capital 485
The Cost of Debt 485
The Cost of Preferred Equity 486
The Cost of Common Equity 488

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 16 CONTENTS |
14.4 Summing Up: Calculating the Firm’s WACC 495
Use Market-Based Weights 495
Use Market-Based Costs of Capital 495
Use Forward-Looking Weights and Opportunity Costs 495
Weighted Average Cost of Capital in Practice 495
14.5 Estimating Project Costs of Capital 497
The Rationale for Using Multiple Discount Rates 497
Why Don’t Firms Typically Use Project Costs of Capital? 497
Estimating Divisional WACCs 498
Divisional WACC: Estimation Issues and Limitations 499
FINANCE IN A FLAT WORLD: Why Do Interest Rates
Differ Among Countries? 500
14.6 Flotation Costs and Project NPV 501
WACC, Flotation Costs, and the NPV 501
Chapter Summaries 504
Study Questions 507
Study Problems 508
Mini-Case 513

Part 4: Capital Structure and Dividend Policy

Equity
financing
Debt and equity
financing
Debt
CHAPTER 15
Capital Structure Policy 514
financing

Risk
Risk
Risk
P Principle 2: There Is a Risk-Return Tradeoff 515
P Principle 3: Cash Flows Are the Source of Value 515
P Principle 5: Individuals Respond to Incentives 515
15.1 A Glance at Capital Structure Choices in Practice 516
Defining a Firm’s Capital Structure 516
Financial Leverage 519
How Do Firms in Different Industries Finance Their Assets? 519
15.2 Capital Structure Theory 520
A First Look at the Modigliani and Miller Capital Structure Theorem 520
Yogi Berra and the M&M Capital Structure Theory 522
Capital Structure, the Cost of Equity, and the Weighted Average Cost of Capital 522
Why Capital Structure Matters in Reality 524
Making Financing Choices When Managers Are Better Informed than Shareholders 529
Managerial Implications 530
15.3 Why Do Capital Structures Differ Across Industries? 531
15.4 Making Financing Decisions 532
Benchmarking the Firm’s Capital Structure 532
Evaluating the Effect of Financial Leverage on Firm Earnings per Share 533
Using the EBIT-EPS Chart to Analyze the Effect of Capital Structure on EPS 538
Can the Firm Afford More Debt? 540
Survey Evidence: Factors That Influence CFO Debt Policy 541
FINANCE IN A FLAT WORLD: Capital Structures Around the World 542
Lease Versus Buy 543
FINANCE FOR LIFE: Leasing or Buying Your Next Car 545
Chapter Summaries 546
Study Questions 548
Study Problems 550
Mini-Case 554
Appendix: Demonstrating the Modigliani and Miller Theorem 555

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 CONTENTS |   17

CHAPTER 16
Dividend and Share Repurchase Policy 558
P Principle 1: Money Has a Time Value 559
P Principle 3: Cash Flows Are the Source of Value 559
P Principle 4: Market Prices Reflect Information 559
16.1 How Do Firms Distribute Cash to Their Shareholders? 560
Cash Dividends 561
Stock Repurchases 562
How Do Firms Repurchase Their Shares? 562
Personal Tax Considerations: Dividend Versus Capital Gains Income 563
Noncash Distributions: Stock Dividends and Stock Splits 563
16.2 Does Dividend Policy Matter? 564
The Irrelevance of the Distribution Choice 564
Why Dividend Policy Is Important 570
FINANCE FOR LIFE: The Importance of Dividends 573
16.3 Cash Distribution Policies in Practice 573
Stable Dividend Payout Policy 573
Residual Dividend Payout Policy 577
Other Factors Playing a Role in How Much to Distribute 577
Chapter Summaries 578
Study Questions 579
Study Problems 581
Mini-Case 583

Part 5: Liquidity Management and Special

Topics in Finance

CHAPTER 17
Financial Forecasting and Planning 584
P Principle 2: There Is a Risk-Return Tradeoff 585
17.1 An Overview of Financial Planning 586
17.2 Developing a Long-Term Financial Plan 587
Financial Forecasting Example: Ziegen, Inc. 588
FINANCE FOR LIFE: Your Personal Budget 593
17.3 Developing a Short-Term Financial Plan 596
Cash Budget Example: Melco Furniture, Inc. 596
Uses of the Cash Budget 597
Chapter Summaries 599
Study Questions 600
Study Problems 601
Mini-Case 607

CHAPTER 18
Working-Capital Management 608
P Principle 2: There Is a Risk-Return Tradeoff 609
18.1 Working-Capital Management and the Risk-Return Tradeoff 610
Measuring Firm Liquidity 610
Managing Firm Liquidity 611
Risk-Return Tradeoff 611
18.2 Working-Capital Policy 611
The Principle of Self-Liquidating Debt 611
A Graphic Illustration of the Principle of Self-Liquidating Debt 614

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Step 4: Incorporate Risk into All the Firm’s Decisions and Processes 667
Step 2: Decide Which Types of Risks to Keep and Which to Transfer 667
19.1 Foreign Exchange Markets and Currency Exchange Rates 640
What a Change in the Exchange Rate Means for Business 640

FINANCE FOR LIFE: Do You Need Life Insurance? 670

Hedging Commodity Price Risk Using Forward Contracts 671

Step 5: Monitor and Manage the Firm’s Risk Exposures 668

20.3 Managing Risk by Hedging with Forward Contracts 670

Step 1: Identify and Understand the Firm’s Major Risks 666
Calculating the Operating and Cash Conversion Cycles 616

18.5 Managing the Firm’s Investment in Current Assets 623

19.3 Capital Budgeting for Direct Foreign Investment 651

20.1 Five-Step Corporate Risk Management Process 666

Purchasing-Power Parity and the Law of One Price 648

FINANCE FOR LIFE: International Investing 652

Hedging Currency Risk Using Forward Contracts 671

19.2 Interest Rate and Purchasing-Power Parity 648
Principle 3: Cash Flows Are the Source of Value 639
Calculating the Cost of Short-Term Financing 619

20.2 Managing Risk with Insurance Contracts 669

Managing Cash and Marketable Securities 623

Step 3: Decide How Much Risk to Assume 667

18.3 Operating and Cash Conversion Cycles 614

Principle 2: There Is a Risk-Return Tradeoff 639

665
FINANCE FOR LIFE: Credit Scoring 627

Types of Foreign Exchange Transactions 645

International Business Finance 638
Measuring Working-Capital Efficiency 614

Corporate Risk Management 664

Evaluating the Cost of Trade Credit 620
Evaluating the Cost of Bank Loans 621

Principle 2: There Is a Risk-Return Tradeoff

Principle 1: Money Has a Time Value 665
Managing Accounts Receivable 625
18.4 Managing Current Liabilities 619

The International Fisher Effect 649

Types of Insurance Contracts 669

Why Purchase Insurance? 669
Foreign Investment Risks 655
Foreign Exchange Rates 642
Managing Inventories 629

Interest Rate Parity 648

Chapter Summaries 630

Chapter Summaries 657

20
19
Study Questions 632

Study Questions 659

Study Problems 633

Study Problems 660

Mini-Case 637

Mini-Case 663
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18
 CONTENTS |   19
20.4 Managing Risk with Exchange-Traded Financial Derivatives 675
Futures Contracts 676
Option Contracts 677
20.5 Valuing Options and Swaps 683
The Black-Scholes Option Pricing Model 684
Swap Contracts 688
Credit Default Swaps 689
Chapter Summaries 691
Study Questions 693
Study Problems 694
Mini-Case 697

Appendices   Available in MyLab Finance

Glossary 699
Indexes 707

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