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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. Corporation—Finance.   I. Andrew, Joseph D.   II. Title HG4026. G348 2006 658.15—dc21 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 Banker’s 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 What’s Next  18 Summary  18  •  Self‑Test  20  •  Review Questions  20  •  Build Your Communication Skills  21  •  Problems  21  •  Answers to Self‑Test  22 ix x 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 What’s Next  37 Summary  37  •  Self‑Test  39  •  Review Questions  39  •  Build Your Communication Skills  40  •  Problems  40  •  Answers to Self‑Test  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 What’s Next  60 Summary  60  •  Self‑Test  61  •  Review Questions  61  •  Build Your Communication Skills  62  •  Problems  62  •  Answers to   Self‑Test  63 PART II  ESSENTIAL CONCEPTS IN FINANCE  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 What’s Next  81 Summary  81  •  Self‑Test  82  •  Review Questions  83  •  Build Your Communication Skills  84  •  Problems  84  •  Answers to   Self‑Test   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 What’s Next  114 Summary  115  •  Equations Introduced in This Chapter  116  •  Self‑Test  117  •  Review Questions  118  •  Build Your Communication Skills  118  •  Problems  119  •  Answers to Self‑Test  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 What’s Next  148 Sutmmary  148  •  Self‑Test  149  •  Review Questions  150  •  Build Your Communication Skills  150  •  Problems  151  •  Answers to Self‑Test  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 What’s Next  181 Summary  182  •  Equations Introduced in This   Chapter  183  •  Self‑Test  185  •  Review Questions  186  •  Build Your Communication Skills  186  •  Problems  187  •  Answers to   Self‑Test  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 What’s Next  223 Summary  224  •  Equations Introduced in This Chapter  225  •  Self‑Test  227  •  Review Questions  228  •  Build Your Communication Skills  228  •  Problems  229  •  Answers to   Self‑Test  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 Firm’s 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 What’s Next  258 Summary  259  •  Equations Introduced in This Chapter  260  •  Self‑Test  262  •  Review Questions  262  •  Build Your Communication Skills  262  •  Problems  263  •  Answers to   Self‑Test  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 What’s Next  290 Summary  290  •  Equations Introduced in This Chapter  292  •  Self‑Test  292  •  Review Questions  293  •  Build Your Communication Skills  293  •  Problems  294  •  Answers to   Self‑Test  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 What’s Next  328 Summary  330  •  Self‑Test  330  •  Review Questions  331  •  Build Your Communication Skills  331  •  Problems  332  •  Answers to   Self‑Test  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 Bond’s 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   •  Self‑Test  369  •  Review Questions  369  •  Build Your Communication Skills  370  •  Problems  370  •  Answers to   Self‑Test  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 What’s Next  402 Summary  402  •  Equations Introduced in This Chapter  403  •  Self‑Test  406  •  Review Questions  406  •  Build Your Communication Skills  406  •  Problems  407  •  Answers to Self‑Test  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 What’s Next  433 Summary  433  •  Equations Introduced in This Chapter  434  •  Self‑Test  434  •  Review Questions  435  •  Build Your Communication Skills  435  •  Problems  435  •  Answers to Self‑Test  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 What’s Next  456 Summary  456  •  Equations Introduced in This Chapter  457  •  Self‑Test  459  •  Review Questions  459  •  Build Your Communication Skills  459  •  Problems  460  •  Answers to   Self‑Test  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 Miller’s 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 Stockʼs Market Price after a  Stock Dividend  474 Stock Splits  475 Adjustment of a Stock’s Market Price   after a Stock Split  476 The Rationale for Stock Splits  476 What’s Next  477 Summary  477  •  Equations Introduced in This Chapter  478  •  Self‑Test  478  •  Review Questions  479  •  Build Your Communication Skills  479  •  Problems  479  •  Answers to Self‑Test  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 What’s Next  496 Summary  496  •  Self‑Test  498  •  Review Questions  498  •  Build Your Communication Skills  499  •  Problems  499  •  Answers to   Self‑Test  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 Miller–Orr Cash Management Model   512 Forecasting Cash Needs  514 Developing a Cash Budget  515 Managing the Cash Flowing In and Out of the Firm  519 Increasing Cash Inflows  519 Decreasing Cash Outflows  519 Speeding Up Cash Inflows  520 Slowing Down Cash Outflows  523 What’s Next  523 Summary  524  •  Equations Introduced in   This Chapter  525  •  Self‑Test  525  •  Review  Questions  526  •  Build Your Communication Skills  526  •  Problems  527  •  Answers to   Self‑Test  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 What’s Next  554 Summary  554  •  Equations Introduced in This Chapter  555  •  Self‑Test  555  •  Review Questions  556  •  Build Your Communication Skills  556  •  Problems  557  •  Answers to   Self‑Test  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 What’s Next  584 Summary  584  •  Equations Introduced in This Chapter  585  •  Self‑Test  587  •  Review Questions  587  •  Build Your Communication Skills  587  •  Problems  588  •  Answers to   Self‑Test  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  •  Self‑Test  610  •  Review Questions  610  •  Build Your Communication Skills  610  •  Problems  611  •  Answers to   Self‑Test  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 unit—from 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.