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Foundations of Finance: The Logic and Practice of Financial Management,

Seventh Edition, by Arthur J. Keown, John D. Martin, and J. IMlliam Petty. Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.

fi
EAR
EBIT EBITDA
E01

beta effective annual rate earnings before interest and taxes earnings before interest, taxes, depreciation, and amortization Economic Value Added the annual free cash flow in time period t the future value of $1 at the end of year i the initial outlay internal rate of return weighted average cost of capital cost of common equity cost of new common equity cost of debt financing the modified internal rate of return

FCFt
FVi 10

IRR
Kwacc

the number of years until payment will be received or during which compounding occurs net present value operating return on assets current selling price of a security profitability index the annuity payment deposited or received each period over the life of the annuity. the present value of a future sum of money required rate of return of an investor. risk free rate of interest. expected rate of return on the market portfolio of all risky investments.

NPV
OROA P

PI PMT

PV
r

ROA

return on assets standard deviation

Foundations of Finance; The Logic and Practice of Financial Management, Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.

Seventh Edition, by Arthur J. Keown, John D. Martin, and J. William Petty.

Foundations of Finance: The Logic and Practice of Financial Management, Seventh Edition, by Arthur J. Keown, John D. Martin, and J. William Petty. Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.

Foundations of Finance
The Logic and Practice of Financial Management

Seventh Edition

Foundations of Finance: The Logic and Practice of Financial Management, Seventh Edition, by Arthur J. Keown, John D. Martin, and J. William Petty. Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.

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Seventh Edition, by Arthur J. Keown, John D. Martin, and J. William Petty. Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.

Foundations of Finance: The Logic and Practice of Financial Management,

Foundations of Finance
The Logic and Practice of Financial Management

Seventh Edition

Arthur
Virginia

J.

I(eown

Polytechnic Institute and State University R. B. Pamplin Professor of Finance

John D. Martin
Baylor University Professor of Finance Carr P.Collins Chair in Finance

J. William

Petty

Baylor University Professor of Finance W. W. Caruth Chair in Entrepreneurship

Prentice Hall
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Foundations of Finance: The Logic and Practice of Financial Management, Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc. Seventh Edition, by Arthur J. Keown, John D. Martin, and J. William Petty.

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Keown, Arth "r .J . Foundations of finance: the logic and practice of fin,lllcial management I Arthur]. Keown, John D. Martin,]. vVilliam Petty.-7th cd. p. cm. Includes bibliographical references and index. ISBN-13: 978-0-13-611365-2 ISBN-IO: 0-13-611365-6 I. Corporations-Finance. I.i\1artin, John D. II. Petty,]. vVilliam. III. Title HG4026.F672011

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Foundations of Finance: The Logic and Practice of Financial Management,

Seventh Edition, by Arthur J. Keown, John D. Martin, and J. IIV1l1iam Petty. Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.

To my parents, from whom I learned the most.


Arthur J. Keown

To the Martin women-wife Sally and daughter-in-law Mel, the Martin men-sons Dave andJess, and Martin boys-grandsons Luke and Burke.
John D. Martin

To my grandchildren, Mackenzie Kate, Ashley Kate, Cameron Petty, John Carter, and Erin Marie, who bless me every day and make my life so much fun.
J. William Petty

Foundations of Finance; The Logic and Practice of Financial Management, Seventh Edition, by Arthur J Keown, John D. Martin, and J. William Petty. Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.

Foundations of Finance: The Logic and Practice of Financial Management, Seventh Edition, by Arthur J. Keown, John D Martin, and J. IMlliam Petty. Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.

About the Authors


Arthur J. Keown is the R. B. Pamplin Professor of Finance at Virginia Polytechnic Institute and State University. He received his bachelor's degree from Ohio Wesleyan University, his M.B.A. from the University of Michigan, and his doctorate from Indiana University. An award-winning teacher, he is a member of the Academy of 'leaching Excellence; has received five Certificates of Teaching Excellence at Virginia 'Iech, the \tv. E. Wine Award for 'leaching Excellence, and the Alumni 'leaching Excellence Award; and in 1999 received the Outstanding Faculty Award from the State of Virginia. Professor Keown is widely published in academic journals. His work has appeared in The Journal (!f Finance, the Joun1fl1 of Financial Economics, the Journal of Fin (tncial and Quantitative Ana~y.ri.r, The Journal of Financial Re.rearcb, the Journal of Banking and Finance, Financial N!anagement, the Journal of Portfolio A1anagement, and many others. In addition to Foundation.r of Finance , two other of his books are widely used in college finance classes all over the country-Basic Financial lV!anagement and Personal Finance: Turning lV1one.y into realth. Professor Keown is a Fellow of the Decision Sciences Institute, a member of the Board of Directors of the Financial Management Association, and former head of the finance department at Virginia Tech. In addition, he recently served as the co-editor of The J01l1'nal of Financial Re.rearcb for six and a half years and as the co-editor of the Financial Management Association's Survey and Syntbe.ri.r series for six years. TIe lives with his wife and two children in Blacksburg, Virginia, where he collects original art from
}VIad Magazine.

John D. Martin

is Professor of Finance and the holder of the Carr P. Collins Chair of Finance at Baylor University. Dr. Martin came to Baylor University in 1998 from the University of Texas at Austin where he taught for nineteen years and was the 1\1argaret and Eugene 1\1cDennott Centennial Professor of Finance. He teaches corporate finance and his research interests are in corporate governance, the evaluation of firm performance, and the design of incentive compensation plans. Dr. Martin has published widely in academic journals including the Journal of Financial Economics, The Journal ofFinrmce,

Journal of i110netary EconomirI, Journal of Financial and Quantitative Analysi.r, Journal of Corporate Finance, Financial iWanagement, and iWanagement Science. His work has also appeared in a number of professional publications including Directors and Boards, the Financial Analy.rts' .Journal, the .Journal of Portfolio lV!anagement, and the .Journal of Applied Corporate Finance. In addition to this book Dr. Martin is co-author of nine books including Financial il1anagement (9th ed., Prentice Hall), The Tbeory of Finance (Dryden Press), Financial Analysis (2nd ed., McGraw Hill), and Value Based Management (Harvard

Business School Press), and he is currently writing a book on interest rate modeling. He serves on the editorial boards of eight journals and has delivered executive education programs for a number of firms including Shell Chemical, Shell E&P, 1exas Instruments, and The Associates.

J. William Petty, Ph 0,

University onexas at Austin, is Professor of Finance and W. \tv. Caruth Chair of Entrepreneurship. Dr. Petty teaches entrepreneurial finance, both at the undergraduate and graduate levels. He is a University Master 'Teacher. Tn 2008, the Acton Foundation for Entrepreneurship Excellence selected him as the National Entrepreneurship 'Teacher ofthe Year. His research interests include the financing of entrepreneurial firms and shareholder value-based management. He has served as the co-editor for the .Journal of Financial Re.rearcb and the editor of the Journal of E'lt1'epreneurial Finance. He has published articles in various academic and professional

vii
Foundations of Finance: The Logic and Practice of Financial Management, Seventh Edition. by Arthur J. Keown, John D. Martin, and J. William Petty. Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.

Foundations of Finance: The Logic and Practice of Financial Management,

Seventh Edition, by Arthur J. Keown, John D. Martin, and J. William Petty. Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.

Contents
Preface xxm

IZ!D

The Scope and Environment of Financial Management 2


An Introduction Management
The Goal of the Firm

to the Foundations of Financial 2


3 of Finance 4

Five Principles that Form the Foundations


Principle Principle Principle Principle Principle Avoiding 1: Cash Flow Is What Matters 2: Money Has a Time Value 3: Risk Requires a Reward 5: Conflicts 5 Right 4: Market Prices Are Generally Financial Crisis-Back 4 4

6 7 8

of Interest Cause Agency Problems to the Principles 9

The Essential Elements of Ethics and Trust

Ethics in Financial Management Quiz 10

The Wall Street Journal Workplace-Ethics

The Role of Finance in Business


Why Study Finance? The Role ofthe 11 Financial Manager

10
11

The Legal Forms of Business Organization


Sole Proprietorships Partnerships Corporations Organizational 5-Corporations 13 13 12

12

Form and Taxes:The Double Taxation on Dividends and Limited Liability Companies (LLC) 14 14 Form Should Be Chosen?

14

Which Organizational

Finance and the Multinational Summary 15' Key Terms

Firm: The New Role


.J 6 Review Questions

15 16' Mini Case 17

The Financial Markets and Interest Rates


Financing of Business:The Movement
Public Offerings Versus Private Placements Markets 23 Markets 23 Primary Markets Versus Secondary 21 22 22

18
19

of Funds through the Economy

The Money Market Versus the Capital Market Spot Markets Versus Futures Markets Organized

Security Exchanges Versus Over-the-Counter

The Investment-Banking
Functions Distribution 2S

Function

25
Industry 26

The Demise of the Stand-Alone Methods 27

Investment-Banking

Private Debt Placements


Flotation Costs 30

29

Cautionary Problems
Regulation

Tale Forgetting 30

Principle 5: Conflicts of Interest Cause Agency


Sarbanes-Oxley Act 31

Aimed at Making the Goal of the Firm Work:The

Rates of Return in the Financial Markets


Rates of Return over Long Periods Interest Rate Levels in Recent Periods 31 32

31

xi

Foundations of Finance: The Logic and Practice of Financial Management, Seventh Edition, by Arthur J. Keown, John D. Martin, and J. William Petty. Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.

About the Authors

journals including Journal of Financial and Quantitative Analysis, Financial lV!anagement, Journal of Portfolio lV!anagement, Journal of Applied Corporate Finance, and Accounting Review. Dr. Petty is co-author of a leading textbook in small business and entrepreneurship, Small Business A1anagement: Launching and Growing Ent7-epreneurial Ventures. He also co-authored Value-Based iVlanagement: Corporate America's Response to the Shareholder Revolmion, 2010. Finally, he serves on the Board of Directors of a publicly-traded oil and gas firm.

Foundations of Finance: The Logic and Practice of Financial Management,

Seventh Edition, by Arthur J. Keown, John D. Martin, and J. William Petty. Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.

Brief Contents
IIZ!i1D
1 2 3 4

The Scope and Environment of Financial Management 2


An Introduction Understanding to the Foundations of Financial Management 18 46 84 Financial Statements and Cash Flows 2 The Financial Markets and Interest Rates Evaluating a Firm's Financial Performance

&D
5 6 7 8 9

The Valuation of Financial Assets


The Time Value of Money 118 The Meaning and Measurement of Risk and Return The Valuation and Characteristics of Bonds The Valuation and Characteristics of Stock The Cost of Capital 188 212

118
156

234

Ii'!iJII
10

Investment in Long-Term Assets


Capital-Budgeting Techniques and Practice 264 Cash Flows and Other Topics in Capital Budgeting

264
302

11

Capital Structure and Dividend Policy


12 13
Determining the Financing Mix

336

336 372

Dividend Policy and Internal Financing

Working-Capital Management and International Business Finance 392


14 15 16 17
Short-Term Financial Planning Working-Capital International Management Current Asset Management Business Finance 491 392 412

436
466

Appendix A: Using a Calculator Glossary Indexes

503 512

ix
Foundations of Finance: The Logic and Practice of Financial Management, Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc. Seventh Edition, by Arthur J. Keown, John D. Martin, and J. William Petty.

Contents

Capital Rationing
Capital Rationing

282
282 283 and Project Selection

The Rationale for Capital Rationing

Ranking Mutually
The Size-Disparity The Time-Disparity The Unequal-Lives

Exclusive Projects
Problem Problem Problem 284 28S 286

284

Ethics in Financial Management Behavior 289

The Financial Downside of Poor Ethical

Ethics in Capital Budgeting

289 Practices 289 290 294

A Glance at Actual Capital-Budgeting Finance and the Multinational

Firm: Capital Budgeting

Summary 291. Key Terms 293 Re"iew Questions 29.3 Self-Test Problems Stlldlj Problems 294 Mini Case 299 SeiFTeslSolnliol1 .301

11

Cash Flows and Other Topics in Capital Budgeting


Guidelines for Capital Budgeting
Think Incrementally Look for Incidental Consider Account 303 from Existing Products Effects 305 Cash Flows Cash Flows 305 305 305 305 Flows 304 304 304 or Synergistic Expenses Costs

302

302
Profits 303

Use Free Cash Flows Rather than Accounting Beware of Cash Flows Diverted Work in Working-Capital Incremental RememberThat

Requirements

Sunk Costs Are Not Incremental Costs Are Truly Incremental

for Opportunity

Decide If Overhead

Ignore Interest Payments and Financing

Finance at Work Universal Studios

306 306

An Overview of the Calculations of a Project's Free Cash Flows


What Goes Into the Initial Outlay What Goes Into the Annual Calculating 306 307 308 Free Cash Flows 312 Free Cash Flows over the Project's Life 309

What Goes Into the Terminal Cash Flow the Free Cash Flows A Comprehensive Example: Calculating

Can You Do It? Calculating Did You Get It? Calculating Can You Do It? Calculating

Operating Operating

Cash Flows Cash Flows 315

312 313

Free Cash Flows 315

Options in Capital Budgeting Did You Get It? Calculating


The Option The Option The Option Options to Delay a Project to Expand a Project to Abandon a Project

Free Cash Flows


316 317 317 Bottom Line

316

in Capital Budgeting:The

317

Risk and the Investment


Measuring

Decision

318
318 Systematic Risk Purposes with a Dose of Reality-Is

What Measure of Risk Is Relevant in Capital Budgeting? Risk for Capital-Budgeting 320 All There Is?

Incorporating
Risk-Adjusted Measuring

Risk Into Capital Budgeting


Discount Rates 321 Risk 322

320

a Project's Systematic

Using Accounting

Data to Estimate a Project's Beta for Estimating Beta 323

323

The Pure Play Method

Examining a Project's Risk through Simulation


Simulation: Conducting Explained and Illustrated a Sensitivity 324 Simulation Analysis through

324
325

Foundations of Finance: The Logic and Practice of Financial Managemenl, Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.

Seventh Edition, by Arthur J. Keown, John D. Martin, and J. William Petty.

Contents

Can You Do It? Calculating Can You Do It? Calculating Did You Get It? Calculating Did You Get It? Calculating
Issues in Implementing Issues in Implementing

the Cost of Debt Financing

240 240

the Cost of Preferred Stock Financing the Cost of Debt Financing 241

the Cost of Preferred Stock Financing


Growth 242 Model 241 242

241

the Dividend the CAPM

The Capital Asset Pricing Model

Can You Do It? Calculating Growth Model 243 Can You Do It? Calculating

the Cost of New Common

Stock Using the Dividend

the Cost of Common

Stock Using the CAPM 244

243

Finance at Work IPOs: Should a Firm Go Public? The Weighted Average Cost of Capital 245

Did You Get It? Calculating Growth Model 245

the Cost of New Common

Stock Using the Dividend

Did You Get It? Calculating


Capital Structure Calculating Weights the Weighted

the Cost of Common Stock Using the CAPM


246 246

245

Average Cost of Capital

Cautionary Calculating

Tale Forgetting

Principle 3: Risk Requires a Reward 248

248

Divisional Costs of Capital: PepsiCo Inc. the Weighted

Can You Do It? Calculating

Average Cost of Capital

248

Finance at Work The Pillsbury Company Adopts EVA with a Grassroots Education Program 249 the Weighted Average Cost of Capital 250 251 252

Did You Get It? Calculating

Using a Firm's Cost of Capital to Evaluate New Capital Investments Finance at Work Weighted Average Costs of Capital Estimates: 1993-2005 Finance and the Multinational Countries? 253 253 254 Firm:Why

Do Interest Rates Differ Between

Can You Do It? Evaluating Interest Rate Parity Across Countries Did You Get It? Evaluating Interest Rate Parity Across Countries Summary 255' Study Problems Key Terms 256' Review Questions 257' 258' MiJli Case 260' Self-Test Solutions

Self-Test Problems 261

257

mIll
10

Investment in Long-Term Assets 264

Capital-Budgeting Techniques and Practice


Finding Profitable Projects 265

264

Cautionary Tale Forgetting Principle 3: Risk Requires a Reward and Principle 4: Market Prices Are Generally Right 266 Capital-Budgeting
The Payback Period The Net Present Value Using Spreadsheets

Decision Criteria
267 268

267

to Calculate the Net Present Value

271

Can You Do It? Determining


The Profitability

the NPVof
Ratio)

a Project
272

271

Index (Benefit-Cost

Did You Get It? Determining


The Internal Rate of Return

the NPV of a Project


274

273

Can You Do It? Determining


Viewing the NPV-IRR

the IRR of a Project

276
277

Relationship:The

Net Present Value Profile

Did You Get It? Determining


Complications The Modified Internal

The lRR of a Project


Rates of Return 279 281

277
278

with the IRR: Multiple

Rate of Return (MlRR)3 to Calculate the MIRR

Using Spreadsheets

Foundations of Finance: The Logic and Practice of Financial Management,

Seventh Edition, by Arthur J. Keown, John D. Martin, and J. William Petty. Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.

Contents

Interest Rate Determinants

in a Nutshell

35 35

Estimating Specific Interest RatesUsing Risk Premiums: An Example Realand Nominal Ratesof Interest 35 Can You Do It? Did You Get It?

35 36
37 37 38

Inflation and RealRatesof Return:The Financial Analyst's Approach Can You Do It? Solving for the Real Rate of Interest Did You Get It? Solving for the Real Rate of Interest

The Term Structure of Interest Rates 39 Observing the Historical Term Structures of Interest Rates 39 Can You Do It? Solving for the Nominal Rate of Interest Did You Get It? Solving for the Nominal Rate of Interest What Explains the Shape of the Term Structure? Finance and the Multinational Intercountry Risk 42 44 Revieu' Questions 44' Study Problems 45 40 39 40

Firm: Efficient Financial Markets and

Summary 43 Key Terms Mini Case 45

Understanding Financial Statements and Cash Flows 46


The Income Statement 47 49 51 53 Finance at Work The Lessons of Adversity

Can You Do It? Preparing an Income Statement Did You Get It? Preparing an Income Statement The Balance Sheet Types of Assets 54 Finance at Work Goldman Sachs Announces Earnings 56 Types of Financing 56 Working Capital 58 Debt Ratio 59 Can You Do It? Preparing a Balance Sheet Did You Get It? Preparing a Balance Sheet Measuring Cash Flows 61 59 60 53

First Quarter 2009

Can You Do It? How Much Can You Trust a Brother-In-Law? Did You Get It? How Much Can You Trust a Brother-In-Law? Can You Do It? Measuring Did You Get It? Measuring Income Taxes and Finance Computing Taxable Income Computing the TaxesOwed Can You Do It? Computing Did You Get It? Computing Cash Flows Cash Flows 69 69 70 a Corporation's a Corporation's Income Taxes Income Taxes 68 69

66 68

71 71 Selj~ Test Problems 82 73

Summary 72' Key Tenus 72 RC'(Jiew Questions 73' Study Problems 74' Mini Case 79' Self-Test Solution

Evaluating a Firm's Financial Performance


The Purpose of Financial Analysis Measuring 86 88 Key Financial Relationships

84

Question 1:How Liquid Isthe Firm-Can It PayIts Bills? 89 Cautionary Tale Forgetting Principle 3: Risk Requires a Reward 90

Foundations of Finance: The Logic and Practice of Financial Management, Seventh Edition, by Arthur J. Keown,John D. Martin, and J. William Petty. Publishedby Prentice Hall. Copyright 2011 by Pearson Education,Inc.

Contents

Can You Do It? Evaluating Disney's Liquidity


Question 2: Are the Firm's Managers Generating Assets? 92 Company's

92
Adequate Operating Profits on the

Did You Get It? Evaluating Disney's Liquidity Finance at Work Managing by the Numbers

93 95 Return on Assets 97 96

Can You Do It? Evaluating Disney's Operating Ethics in Financial Management


Question

Fraud's Red Flags


Its Assets? 97

3: How Is the Firm Financing

Did You Get It? Evaluating Disney's Operating

Return on Assets 99

98

Can You Do It? Evaluating Disney's Financing Decisions


Question 4: Are the Firm's Managers Shareholders? Providing 99 by the Company's

a Good Return on the Capital Provided

Did You Get It? Evaluating Disney's Financing Decisions Can You Do It? Evaluating Disney's Return on Equity Did You Get It? Evaluating Disney's Return on Equity
Question 5:Are the Firm's Managers Creating Shareholder

100 102 103

Value?

103

Can You Do It? Computing Ratio 104

Disney's Price/Earnings

Ratio and Price/Book

Did You Get It? Computing Ratio 105

Disney's Price/Earnings

Ratio and Price/Book

Can You Do It? Calculating The Limitations

Disney's Economic Value Added 107

107

of Financial Ratio Analysis

Did You Get it? Calculating Summa!"y 108 Study Problems

Disney's Economic Value Added

108 110

Key Terms 109 Reviel.l' Questions 109 SelF Test Problems 111 iVliuiCase :L16 SelFTest Solutions lJ6

miD
5

The Valuation of Financial Assets 118


The Time Value of Money
Compound
Techniques Applying

118
119
119 Time 123 127 128

Interest and Future Value


to Visualize Cash Flows Money Through Types ofTime for Moving Compounding

Using Timelines Two Additional

Value of Money Problems

to Things Other Than Money

Present Value Cautionary Right

129 Principle 4: Market Prices Are Generally

Tale Forgetting

131

Can You Do It? Solving for the Present Value with Two Flows in Different Years Annuities
Compound

131 132
Annuities 132

Did You Get It? Solving for the Present Value with Two Flows in Different Years
Annuities Amortized

133
134 Due Loans 136 138

The Present Value of an Annuity

Making Interest Rates Comparable


Finding

140
Periods 141

Present and Future Values with Nonannual

Can You Do It? How Much Can You Afford to Spend on a House? An Amortized Loan with Monthly Payments 142

Did You Get It? How Much Can You Afford to Spend on a House? An Amortized Loan with Monthly Payments 143

Foundations of Finance: The Logic and Practice of Financial Management, Seventh Edition, by Arthur J. Keown, John D. Martin, and J. William Petty. Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.

Contents

The Present Value of an Uneven Stream


Perpetu ities 145

144

The Multinational

Firm: The Time Value of Money

145 SelrTest 155 Problems 148

Summary 147' Key Terms 147' Review Questions 148' Study Problems 148' Mini Case 154' Self-Test Solutions

The Meaning and Measurement of Risk and Return 156


Expected Return Defined and Measured Can You Do It? Computing 157 159 Expected Cash Flow and Expected Return 159 Expected Cash Flow and Expected Return the Standard Deviation 163 164 163 160

Risk Defined and Measured Did You Get It? Computing Can You Do It? Computing

Finance at Work A Different Perspective of Risk Ethics in Financial Management Did You Get It? Computing

"I Should Have Said No" 165

the Standard Deviation 165

Rates of Return: The Investor's Experience Finance at Work Hard Lessons Risk and Diversification
Diversifying Measuring Away the Risk Market Risk 168

166

167
167

Can You Do It? Estimating


Measuring a Portfolio's Beta

Beta
173

172

Did You Get It? Estimating


Risk and Diversification

Beta

174
174

Demonstrated

The Investor's Required Rate of Return


The Required Measuring Rate of Return Concept Rate of Return 176 176 the Required

175

Finance at Work Does BE;!ta Always Work? Can You Do It? Computing Did You Get It? Computing Summary 179' Study Problems

177 178 179 Self-Test Problems 186 180

a Required Rate of Return a Required Rate of Return

KC1)Terms 179' Review Questious 180' 181' Miui Case 184' Selj~Test Solutions

The Valuation and Characteristics of Bonds


Types of Bonds
Debentures Subordinated Mortgage Eurobonds Convertible 189 Debentures 190 190 190 Bonds 190 Bonds

188

189

Finance at Work Alcoa: How to Raise $1.5 Billion Ahead of Weak Earnings Terminology
Par Value Coupon Maturity Indenture Bond Ratings

191

and Characteristics
192 192

of Bonds

191

Claims on Assets and Income Interest Rate 192 192 193 193 192

Call Provision

Finance at Work Clear Channel Rating Is Cut Defining Value What Determines 194 Value? 195

194

Foundations of Finance: The Logic and Practice of Financial Management,

Seventh Edition, by Arthur J. Keown, John D. Martin, and J. William Petty. Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.

Contents

Valuation:The

Basic Process

196 197

Can You Do It? Computing Valuing Bonds 197

an Asset's Value

Did You Get It? Computing Can You Do It? Computing Did You Get It? Computing Bond Yields 201

an Asset's Value a Bond's Value a Bond's Value

199 200 201

Yield to Maturity 201 Current Yield 202 Bond Valuation: Three Important Can You Do It? Computing Did You Get It? Computing Relationships 202 and Current Yield 203 204 208

the Yield to Maturity

the Yield to Maturity and Current Yield

Summary 206 .Key Terms 207 Review Questions 207 Self-Test Problems Studtf Problems 208 Mini Case 210 SelF Test Solutious 210

The Valuation and Characteristics of Stock


Preferred Stock 214 214 The Characteristics of Preferred Stock Valuing Preferred Stock 215

21 2

Finance at Work Reading a Stock Quote in the Wall Street Journal Can You Do It? Valuing Preferred Stock Did You Get It? Valuing Preferred Stock Common Stock 218 218 217 218

217

The Characteristics of Common Stock

Finance at Work Does Stock by Any Other Name Smell as Sweet? Valuing Common Stock Cautionary Tale Forgetting 220 Principle 4-Market

219

Prices Are Generally Right 222 224

222

Can You Do It? Measuring Johnson & Johnson's Growth Rate Did You Get It? Measuring Johnson & Johnson's Growth Rate Can You Do It? Calculating Common Stock Value 224 225 225 225 226 227 227

The Expected Rate of Return of Stockholders

The Expected Rate of Return of Preferred Stockholders Did You Get It? Calculating Common Stock Value

The Expected Rate of Return of Common Stockholders Can You Do It? Computing Did You Get It? Computing

the Expected Rate of Return the Expected Rate of Return

Summary 228 .Key Terms 229 Review Questiolls 229 Self-Test Problems Study Problems 230 Mini Case 232 Self-Test Solutions 232

230

The Cost of Capital

234
and Concepts 235 235 236

The Cost of Capital: Key Definitions

Opportunity Costs,Required Ratesof Return,and the Cost of Capital Can You Do It? Determining

How Flotation Costs Affect the Cost of Capital 236 236

The Firm'sFinancial Policy and the Cost of Capital Determining the Costs of the Individual 237

Sources of Capital

The Cost of Debt

Did You Get It? Determining

How Flotation Costs Affect the Cost of Capital

237

The Cost of Preferred Stock 238 The Cost of Common Equity 239 The Dividend Growth Model 239

Foundations of Finance: The Logic and Practice of Financial Management, Seventh Edition, by Arthur J. Keown, John D. Martin, and J. William Petty. Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.

Contents

Can You Do It? Calculating Can You Do It? Calculating Did You Get It? Calculating Did You Get It? Calculating
Issues in Implementing Issues in Implementing

the Cost of Debt Financing

240 240

the Cost of Preferred Stock Financing the Cost of Debt Financing 241

the Cost of Preferred Stock Financing


Growth 242 Model 241 242

241

the Dividend the CAPM

The Capital Asset Pricing Model

Can You Do It? Calculating Growth Model 243

the Cost of New Common

Stock Using the Dividend

Can You Do It? Calculating

the Cost of Common Stock Using the CAPM 244

243

Finance at Work IPOs: Should a Firm Go Public? The Weighted Average Cost of Capital 245

Did You Get It? Calculating Growth Model 245

the Cost of New Common

Stock Using the Dividend

Did You Get It? Calculating


Capital Structure Calculating Weights the Weighted

the Cost of Common


246

Stock Using the CAPM


246

245

Average Cost of Capital

Cautionary Calculating

Tale Forgetting Divisional

Principle 3: Risk Requires a Reward 248

248

Costs of Capital: PepsiCo Inc. the Weighted

Can You Do It? Calculating

Average Cost of Capital

248

Finance at Work The Pillsbury Company Adopts EVA with a Grassroots Education Program 249 the Weighted Average Cost of Capital 250 251 252

Did You Get It? Calculating

Using a Firm's Cost of Capital to Evaluate New Finance at Work Weighted

Capital Investments

Average Costs of Capital Estimates: 1993-2005 Firm:Why

Finance and the Multinational Countries? 253

Do Interest Rates Differ Between

Can You Do It? Evaluating Interest Rate Parity Across Countries Did You Get It? Evaluating Interest Rate Parity Across Countries Summary 255 Study Problems Key Terms 256 Review Questious 257 258 Mini Case 260 Selj~ Test Solutions

253 254 257

Self-Test Problems 261

milD
10

Investment in Long-TermAssets 264


Capital-Budgeting Techniques and Practice
Finding Profitable Cautionary Projects 265 Principle 3: Risk Requires a Reward and Principle 4: 266 267 Tale Forgetting

264

Market Prices Are Generally Right Capital-Budgeting


The Payback Period The Net Present Value Using Spreadsheets

Decision Criteria
267 268

to Calculate the Net Present Value

271

Can You Do It? Determining


The Profitability

the NPVof
Ratio)

a Project
272

271

Index (Benefit-Cost

Did You Get It? Determining


The Internal Rate of Return

the NPV of a Project


274

273

Can You Do It? Determining


Viewing

the JRR of a Project

276
277

the NPV-IRR Relationship:The

Net Present Value Profile

Did You Get It? Determining


Complications The Modified Internal

The IRR of a Project


Rates of Return

277
278

with the IRR: Multiple

Rate of Return (MIRR)3 to Calculate the MIRR

Using Spreadsheets

279 281

Foundations of Finance: The Logic and Practice of Financial Management,

Seventh Edition, by Arthur J. Keown, John D. Martin, and J. William Petty. Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.

Contents

Capital Rationing
Capital Rationing

282
282 283 and Project Selection

The Rationale for Capital Rationing

Ranking Mutually
The Size-Disparity The Time-Disparity The Unequal-Lives

Exclusive Projects
Problem Problem Problem 284 285 286

284

Ethics in Financial Management Behavior 289

The Financial Downside of Poor Ethical

Ethics in Capital Budgeting

289 Practices 289 290 Self- Test Pmblems 301 294

A Glance at Actual Capital-Budgeting Finance and the Multinational

Firm: Capital Budgeting

Summary 291 Key Terms 293 Review Questions 293 Study Problems 294 Milli Case 299 Selj~ Test Solutioll

11

Cash Flows and Other Topics In Capital Budgeting


Guidelines for Capital Budgeting
Think Incrementally Look for Incidental 303 from Existing Products Effects 305 Cash Flows Cash Flows 305 305 305 305 Flows 304 304 304 or Synergistic Expenses Costs

302

302
Profits 303

Use Free Cash Flows Rather than Accounting Beware of Cash Flows Diverted Work in Working-Capital Consider Incremental RememberThat Account for Opportunity

Requirements

Sunk Costs Are Not Incremental Costs Are Truly Incremental

Decide If Overhead

Ignore Interest Payments and Financing

Finance at Work Universal Studios

306 306

An Overview of the Calculations of a Project's Free Cash Flows


What Goes Into the Initial Outlay 306 307 308 Free Cash Flows 312 What Goes Into the Annual Free Cash Flows over the Project's Life What Goes Into the Terminal Cash Flow Calculating the Free Cash Flows 309 A Comprehensive Example: Calculating

Can You Do It? Calculating Operating Did You Get It? Calculating Can You Do It? Calculating Operating

Cash Flows Cash Flows 315

312 313

Free Cash Flows 315

Options in Capital Budgeting Did You Get It? Calculating


The Option The Option The Option Options to Delay a Project to Expand a Project to Abandon a Project

Free Cash Flows


316 317 317 Bottom Line

316

in Capital Budgeting:The

317

Risk and the Investment


Measuring

Decision

318
318 Systematic Risk Purposes with a Dose of Reality-Is

What Measure of Risk Is Relevant in Capital Budgeting' Risk for Capital-Budgeting 320 All There Is?

Incorporating
Risk-Adjusted Measuring

Risk Into Capital Budgeting


Discount Rates 321 Risk 322

320

a Project's Systematic

Using Accounting

Data to Estimate a Project's Beta for Estimating Beta 323

323

The Pure Play Method

Examining a Project's Risk through Simulation


Simulation: Conducting Explained and Illustrated 324 Simulation a Sensitivity Analysis through

324
325

Foundations of Finance: The Logic and Practice of Financial Management, Seventh Edition, by Arthur J. Keown, John D. Martin, and J. William Petty. Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.

Contents

Finance and the Multinational International Dimension

Firm: Calculating 326

Cash Flows Amid the

of Risk

Summary 327 Study Problems

Ketj Terms 327 Review Questions 328 329 Mini Case 333 Self-Test Solution

Self-Test Problems 335

328

Capital Structure and Dividend Policy 336


12

Determining
Business Risk Operating Risk 339

the Financing Mix


Risk 338

336

Business and Financial


339

Break-Even

Analysis

340
340 342 342

Essential Elements of the Break-Even Model Finding the Break-Even Point The Break-Even Point in Sales Dollars

Can You Do It? Analyzing the Break-Even Sales Level Operating Leverage 343

343

Did You Get It? Analyzing the Break-Even Sales Level Can You Do It? Analyzing the Effects of Operating Did You Get It? Analyzing the Effects of Operating

344 344 345 345 346

Leverage Leverage

Can You Do It? Analyzing the Effects of Financial Leverage Did You Get It? Analyzing the Effects of Financial Leverage
Financial Leverage 346

Can You Do It? Analyzing the Combined Leverage 347 Did You Get It? Analyzing the Combined Leverage
Combining

Effects of Operating

and Financial

Effects of Operating
348

and Financial

348
Operating and Financial Leverage

Finance at Work When Financial Leverage Proves to Be Too Much to Handle Planning Cautionary the Financing Mix 350 Principle 3: Risk Requires a Reward
3S2 352

349

Tale Forgetting

351

A Quick Look at Capital Structure Theory The Importance Independence The Moderate of Capital Structure Position Position 352 354

The Moderate

View:The

Saucer-Shaped 356

Cost-of-Capital

Curve

355

Firm Value and Agency Costs


Managerial Implications 358

Agency Costs, Free Cash Flow, and Capital Structure

358

The Basic Tools of Capital


EBIT-EPS Analysis Comparative Industry Norms 359

Structure
362

Management

359

Leverage Ratios 362

A Glance at Actual Capital Structure

Management

363

Finance at Work Capital Structures Around the World Summary 366 Study Problems

365 Self-Test Problems 371 367

Key Terms 367 Review Questions 367 368 Mini Case 369 Self-Test Solutions

13

Dividend Policy and Internal Financing


Key Terms 373 Policy Affect
376 379

372
374

Does a Firm's Dividend


Three Basic Views Improving 374 Our Thinking

the Company's

Stock Price?

What Are We to Conclude?

Foundations of Finance: The Logic and Practice of Financial Management,

Seventh Edition, by Arthur J. Keown, John D. Martin, and J. William Petty. Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.

Contents

The Dividend
Liquidity

Decision in Practice
380 380 380 Control 380

380

Legal Restrictions Constraints Earnings Predictability Maintaining

Ownership

Alternative Dividend

Dividend

Policies

380 381 382

Payment Procedures

Stock Dividends and Stock Splits Stock Repurchases


A Share Repurchase The Investor's Choice A Financing

383
as a Dividend 384 Decision? 384 Decision 383

or Investment

Finance at Work Companies Increasingly to Their Stockholders


Practical Considerations-The

Use Share Repurchases to Distribute


Procedure 385

Cash

385
Stock Repurchase

Summary 386' Study Problems

Key Terms 387' Review Questions 387' 388' Milli Case 389' Seif- Tl'st So/utiolls

Self-Test Problems 391

388

Em
14

Working-Capital Management Business Finance 392 Short-Term Financial Planning


Financial Forecasting
The Sales Forecast Forecasting Analyzing Analyzing 393 393 of Financial Forecasting and Dividend

and International

392

393

Financial Variables

The Percent of Sales Method

394

the Effects of Profitability

Policy on DFN

396

the Effects of Sales Growth on a Firm's DFN

396

Can You Do It? Percent of Sales Forecasting Did You Get It? Percent of Sales Forecasting limitations Constructing

397 398 399

of the Percent of Sales Forecasting Method and Using a Cash Budget


400

400

Budget Functions

Ethics in Financial ManagementTo


The Cash Budget 401

Bribe or NotTo Bribe

401

Ethics in Financial Management of the Future 402

Being Honest About the Uncertainty

Summary 403' Study Problems 15

Key Terms 403' Review Questiolls 403' 405' Mini Case 409' Self-Test Solutions

Self-Test Problems 410

403

Working-Capital
Managing
The Risk-Return The Advantages Trade-Off

Management
413 Return Risk 414 414

412
413

Current Assets and liabilities


of Current Liabilities:

The Disadvantages

of Current Liabilities:

The Appropriate
The Hedging Permanent Temporary, The Hedging

Level of Working Capital


415 Assets 415 and Spontaneous

415

Principles and Temporary Permanent,

Sources of Financing 416

416

Principle: A Graphic Illustration

Cautionary

Tale Forgetting

Principle 3: Risk Requires a Reward 418 418 419

416

The Cash Conversion Cycle Can You Do It? Computing Did You Get It? Computing

the Cash Conversion Cycle the Cash Conversion Cycle

Foundations of Finance: The Logic and Practice of Financial Management, Seventh Edition, by Arthur J Keown, John D. Martin, and J. IMlliam Petty. Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.

Contents

Estimating the Cost of Short-Term Cost-of-Credit Formula 420 Can You Do It?The Approximate Sources of Short-Term Credit

Credit Using the Approximate

Cost of Short-Term Credit 421

421

Unsecured Sources:Accrued Wages and Taxes 421 Did You Get It?The Approximate Cost of Short-Term Credit 421 422

Finance at Work Managing Working Capital by Trimming Can You Do It?The Cost of Short-Term Credit (Considering Effects) 423 423 Unsecured Sources:TradeCredit

Receivables Compounding

Did You Get It?The Cost of Short-Term Credit (Considering Effects) 424 Unsecured Sources:Bank Credit 424 Unsecured Sources:Commercial Paper 426 Secured Sources:Accounts-Receivable Loans 427 Secured Sources:Inventory Loans 429 Multinational Working-Capital Management 429

Compounding

Summary 430' Key Terms 430' Review Questions Study Problems 432' Self-Test Solutions 435
16

431 Self-Test Problems

431

Current Asset Management


Why a Company Holds Cash The Cash Flow Process 437 Motives for Holding Cash 438 Cash Management 437

436

Objectives and Decisions 439

439

The Risk-Return Trade-Off Objectives 440 Decisions 440

Collection and Disbursement

Procedures

440

Managing the Cash Inflow-Speeding Up Collections 440 The Lockbox Arrangement 441 Managing the Cash Outflow-Slowing Down Disbursements Evaluating the Costs of Cash Management Services 444 Can You Do It? Evaluating the Cost of Cash Management The Composition of a Marketable-Securities Portfolio

442 Services 444 Services 445 444

Did You Get It? Evaluating the Cost of Cash Management General Selection Criteria 445 Marketable-Security Alternatives Accounts-Receivable 448 449

Management

The Terms of Sale-A Decision Variable 450 The Type of Customer-A Decision Variable 451 The Collection Effort-A Decision Variable 452 Inventory Management 452 454 455 457

Types of Inventory 453 Inventory Management Techniques Can You Do It? Calculating Did You Get It? Calculating

the Economic Order Quantity the Economic Order Quantity

Summary 458' Key Terms 459' Review Questiolls 459' Self-Test Problems Study Problems 460' Mini Case 464' Self-Test Solutions 465

460

17

International BusinessFinance 466


The Globalization Exchange Rates of Product and Financial Markets 468 467

Floating Exchange Rates 468 The Foreign Exchange Market 468


Foundations of Finance: The Logic and Practice of Financial Management, Seventh Edition, by Arthur J. Keown, John D. Martin, and J. William Petty. Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.

Contents

Spot Exchange Rates Asked and Bid Rates Cross Rates 471

469 471 471

Exchange Rates and Arbitrage

Can You Do It? Using the Spot Rate to Calculate a Foreign Currency Payment
Forward Exchange Rates 472

471

Did You Get It? Using the Spot Rate to Calculate a Foreign Currency Payment Can You Do It? Computing
Exchange Rate Risk 474

472

a Percent-Per-Annum

Premium

474

Did You Get It? Computing Interest Rate Parity Purchasing-Power


The International

a Percent-Per-Annum

Premium

475

475 Parity Theory


477 477

476

The Law of One Price

Fisher Effect

Exposure to Exchange Rate Risk


Translation Transaction Economic Exposure Exposure Exposure 478 479 481

478

Multinational

Working-Capital
Strategies

Management
482 of Funds

481
482

Leading and Lagging Cash Management

and the Positioning

International

Financing and Capital Structure Decisions 483


484

482

Direct Foreign Investment


Business Risk and Financial Risk Political Risk 484 484 Exchange Rate Risk

Summary 485 Study Problems

Key Terms
487

486 Review Questions 486 Mini Case 488 Self-Test Solution 491

Self~Test Problems 489

487

Appendix A: Using a Calculator Glossary Indexes 503 512

Foundations of Finance: The Logic and Practice of Financial Management, Seventh Edition, by Arthur J Keown, John D. Martin, and J. William Petty. Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.

Foundations of Finance: The Logic and Practice of Financial Management,

Seventh Edition, by Arthur J. Keown, John D. Martin, and J. William Petty. Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.

Preface
The study of finance focuses on making decisions that enhance the value of the firm. This is done by providing customers with the best products and services in a cost-effective way. In a sense we, the authors of Foundatio77s ojFiml11ce, are trying to do the same thing. That is, we have tried to present the study of financial management in a way that makes your study as easy and productive as possible by using a step-by-step approach to walking you through each new concept or problem. We are very proud of the history of this volume as it was the first "shortened book" of financial management when it was published in its first edition. The book broke new ground by reducing the number of chapters down to the foundational materials and by trying to present the subject in understandable terms. \IVe continue our quest for readability with the Seventh Edition.

Pedagogy That Works


This book provides students with a conceptual understanding of the financial decisionmaking process, rather than just an introduction to the tools and techniques of finance. For the student, it is all too easy to lose sight of the logic that drives finance and focus instead on memorizing formulas and procedures. As a result, students have a difficult time understanding the interrelationships among the topics covered. Moreover, later in life when the problems encountered do not match the textbook presentation, students may find themselves unprepared to abstract from what they learned. To overcome this problem, the opening chapter presents 5 underlying principles of finance, which serve as a springboard for the chapters and topics that follow. In essence, the student is presented with a cohesive, interrelated perspective from which future problems can be approached. \iVith a focus on the big picture, we provide an introduction to financial decision ~2 Understand the five basic Five Principles that Form the Foundations making rooted in current financial theory ~ principles of finance and business. the consequences of Finance of forgetting those basic and in the current state of world economic principles of finance, and the 'nJ the first-time snJdent of fin~nce, the subject stem like collection of unreimportance of ethics and trust conditions. This focus is perhaps most apbred decision rules. This could not be further fi'orn the trutil. In fact, our decision rules, :lnd in business. the logic that underlies them, spring from tIn: simple principles that do not n:quin.: knowlparent in the attention given to the capital olgc of fin:mce to understand. These five principles guide the fin<lnt'i::J1IRlOager in the markets and their influence on corporate ficn.::.ltion of "ulue for the firm's owners (the stockholders). As you will sec, while it is not necessary to lllH]crstancJ fin3ncc ro undcrs(3nd these prinnancial decisions.\Vhat results is an introciples, it is necessary to underst;1nd these principles in order understand finance. Although these principles Im)";lt first 3ppe,lr simple or even trivial, thlT provide the driving ductory treatment of a discipline rather force hehind all that follows, we3ving together the concepts ::Jndtechniques presented in (his than the treatment of a series of isolated text. and thereby allowing us to focus on the logic underlying the practice of tlnancl3l n13nagerncnt. Now let's inl"HHillcc the five principles. problems that face the financial manager. The goal of this text is not merely to teach Principle 1: Cash Flow Is What Matters You prob3hly rec-'(ll] from your accounting classes thata company's profit,> differ dr:lmatthe tools of a discipline or trade but also to ieally from its cash tlows which we will review in Chapter 3. But for now understand that enable students to abstract what is learned c:Ish tlows, not profits. represent money that be spent. Consequently, i[ is c<1sh!low, nOt protlts that determines the value of a business. For this n:;1S0n when we analvzc [he conscto new and yet unforeseen problems-in quenccs of a m.anagerial dccisio~ we focu~.on the rt:sl.Jlting cash flows, noty~ofi[s. short, to educate the student in finance.
lTI;}tter In<lV :l 1"0 Clll C1I1

Innovations and Distinctive Features in the Seventh Edition


"Cautionary Tale" Boxes
These give students insights into how the core concepts of finance apply in the real world. Each "Cautionary Tale" box goes behind the headlines of finance pitfalls in the news to show how one of the Five Principles was forgotten or violated.

xxiii

Foundations of Finance: The Logic and Practice of Financial Management. Seventh Edition, by Arthur J. Keown. John D. Martin. and J. William Petty. Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.

Preface

Real-World Opening Vignettes


Each chapter begins with a story about a current, real-world company faced with a financial decision related to the chapter material that follows. These vignettes have been carefully prepared to stimulate student interest in the topic to come and can be used as a lecture tool to provoke class discussion.

New and Improved Problem Sets


The end-of-chapter study problem sets have been improved and expanded to allow for a wider range of student problems.

Use of an Integrated learning System


The text is organized around the learning objectives that appear at the beginning of each chapter to provide the instructor and student with an easy-to-use integrated learning system. Numbered icons identifying each objective appear next to the related material throughout the text and in the summary, allowing easy location of material related to each objective.

"Can You Do It?" and "Did You Get It?"

CAN YOU DO IT?


SOLVING FOR THE REAL RATE OF INTEREST
you the chance What to invest your savings for 1 year at a quoted you would be earning rate of 10 percent. You also saw on the is the real rate of interest Your banker just called and offered news that the inflation rate is 6 percent. tion can be found on page 38.)

if you

made the investment?

(The solu-

The text provides examples for the students to work at the conclusion of each major section of a chapter, which we call, "Can You Do It?" followed by "Did You Get It?" several pages later in the text. This tool provides an essential ingredient to the building-block approach to the material that we use.

DID YOU GET IT?


SOLVING FOR THE REAL RATE OF INTEREST
Nominal or quoted

real rate of

+ +

inflation rate 0,06

.,.
+

product interest

of the

real rate of rate

rate of interest 0.10

~
=

interest
(real rate of interest)

and the inflation

0.06 X real rate of interest

0.04

1.06 X (real rate of interest)

Solving

for the real rate of interest: (real rate of interest) 0.0377

3.77%

Concept Check
At the end of most major sections, this tool highlights the key ideas just presented and allows students to test their understanding of the material.

Concept Check
1. According 2. "Vhat 3. 'What to Principle 3, how do investors decide where to invest their money) is an efficient is the, market)

4. \\Thy are eth

.,a,!~'aii.
Firms A and B arc idcntical in size. Both have SI,OOOin total assets, and both have an operating return on assets of 14 percent. However, they are different in one respect: Firm A uses all equity and no debt financing; Firm B tinanccs 60 percent nfits investments with debt and 40 percent with equity. (For the sake of simplicity, \VC will assume that both firms pay interest at an interest cost of 6 percent, <1I1d there are no income taxes.) The fin<lJ1Cial statements for the two companies would be as follows:
FIRM BALANCE SHEET A FIRM B

Integrated Examples
These provide students with real-wo rld examples to help them apply the concepts pre'sented ]n each chapter.

Totalassets Debt (6% interest rate) Equity Total debt and equity
INCOME STATEMENT

$1,000

$1,000

$0
-.l..QQQ $1,000

'S6oO
----.1QQ $1,000

Operating income (OROA 14%) = Interestexpense (6%) Net income

$ 140 L-..Q) $ 140

$ 140

L-iO)

Foundations of Finance: The Logic and Practice of Financial Management,

Seventh Edition, by Arthur J. Keown, John D. Martin, and J. William Petty. Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.

Preface

ETHICS IN FINANCIAL MANAGEMENT

Extensive Coverage of Ethics


Ethics is covered as a core principle and "Ethics in Financial Management" boxes appear throughout. These show students that ethical behavior is doing the right thing and that ethical dilemmas are everywhere in finance.

THE WALL STREETJOURNAL WORKPLACE-ETHICS QUIZ


Without with question, when you enter the workforce you will be faced

a number of ethical dilemmas that you have never considered. The spread of technology into the workplace has raised a
of new ethical questions, and many old ones still linger.

8. Can you accept a S75 prize won at a raffle at a supplier's conference?


Yes No

variety

The following is a quiz dealing with ethical questions that will both give you some questions to think about and also allow you to compare your answers with those of other Americans surveyed. Office Technology t. Is it wrong to use company ernail for personal reasons?
Yes No

Truth and Lies

9. Due to on-the-job pressure, have you ever abused or lied about sick days? Yes No

10. Due to on-the-job pressure, have you ever taken credit for someone else's work or idea?
Yes No Sources: Ethics Officer AssociatiOn. Belmont. Mass.; EthiCillleadership GrOllI'. Wilmette, III.;surveys sampled a cross-~tion of workef'5 at lafge companies andnatiorlwide

2. Is it wrong to play computer games on office equipment during the workday?


Yes No

3. Is it unethical to blame an error you made on a technological glitch?


Yes No

Gifts and Entertainment 4. Is a $SO gift to a boss unacceptable?

Remember Your Principles


These in-text inserts appear throughout to allow the student to take time out and reflect on the meaning of the material just presented. The use of these inserts, coupled with the use of the 5 principles, keeps the student focused on the interrelationships and motivating factors behind the concepts.

l..f;irtcipte

REMEMBER YOUR PRINCIPLES In this chapter, we cover material that introduces

the )tbal1

financial manager to the process involved in raising funds in the nation's capital markets and how interest rates in those markets are determined. Without question the United States has a highly developed, complex, and competitive system of financial markets that allows for the quick transfer of savings from people and organizations with a surplus of savings to those with a savings deficit. Such a system of highly developed financial markets allows great ideas (such as the personal computer) to be financed and increases the overall wealth of the economy. Consider your wealth, for example, compared to that of the average family in Russia. Russia lacks the complex system of financial markets to facilitate securities transactions. As a result, real capital formation there has suffered. Thus, we return now to Principle 4: Market Prices Are Generally Right. Financial managers like the U.S.system of capital markets because they trust it. This trust stems from the fact that the markets are efficient, and so prices quickly and accurately reflect all available information about the value of the underlying securities. This means that the expected risks and expected cash flows matter more to market participants than do simpler things such as accounting changes and the sequence of past price changes in a specific security. With security prices and returns (such as interest rates) competitively determined, more financial managers (rather than fewer) participate in the markets and help ensure the basic concept of efficiency.

Ethics Quiz Answers 1. 34% said personal emall on company computers is wrong 2. 49% said playing computer games at work is wrong 3. 61% said it's unethical to blame your error on technology 4. 35% said a $50 gift to the boss is unacceptable 5. 12% said a $50 gift from the boss is unacceptable 6. 70% said it's unacceptable to take the $200 football tickets 7. 35% said it's unacceptable to take the $100 food basket 8. 40% said it's unacceptable to take the $75 raffle prize 9. 11% reported they lie about sick days 10. 4% reported they take credit for the work or ideas of others
Source: The Wall Street Joumal, October 21. 1999, page Dow Jones & Compaoy. Inc.) All Rights Reserved
81

{Copyright

(:'1999,

Mini

Case

Com prehensive End-of-Chapter Problems


A comp rehensive Mini Case appears at the end of almost every chapter, covering aU the major topics included in that chapter. This Mini Case can be used as a lecture or review tool by the profess or. For the students, it provides an opportunity to apply all the concepts presented within the chapter in a realistic setring, th ereby strengthening their understanding of the material.

The final stage in the irm;n'icw process for an assistant financial analyst at Caledonia Products involves a rest of you!' understanding of basic tlnancial concepts. You are given the following metno~ randum and asked TO respond to the q\HO'stions. \Vhcther yOll arc offcred a position atC:llcdonia \lyill depend on the accuracy of your response. To: Applic:mts for the position of Financial Analyst From: Me \.~Morrison, CEO, Caledoni\l Products Re: A test of your understanding of basic financial concepts and of the corporate tax code Please respond to the following questions: n11at is the appropriate goal for the firm and why? b. \Vhat does the risk-return trade-ofr mean? c. \Vhy arc we interested in cash flows rather than accounting profits in determining the value of an asset? d. \Vhat is an efficiellt marker and what are rhe implications of efficient markets for us? c. \Vhat is the causc of the agency problcm and how do we tnr to solve it? f. Wllar do ethics and etbical behavior have to do with f11 g Dr;flnc (I) sole proprictorship, (2) partnership, and (3) CALCULATOR SOLUTION
ll.

Financial Calculators
The use of financial calculators has been integrated throughout this text, especially with respect to the presentation of the time value of money. vVhere appropriate, calculator solutions appear in the margin.

Data Input 10 6 -500 0 Function Key

Function Key

[&J

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IPMTI Answer 279.20

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Foundations of Finance: The Logic and Practice of Financial Management, Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.

Seventh Edition. by Arthur J. Keown, John D. Martin. and J William Petty.

Preface

Content Updates
In response to both the continued development of financial thought and reviewer comments, changes have been made in the text. Some of these changes include:
Chapter 1 An Introduction

to the Foundations of Financial Management

Updated and revised to make it as intuitive as possible. The principles that form the Foundations of Finan_ce were simplified and consoLidated from 10 principles down to 5 principles. In addition, a section titled Avoiding Financial Crisis-Back to the Principles was introduced. This section examines each of the principles individually and how ignoring them helped bring on the recent financial crisis. A new section on the importance of ethics and trust in financial management was introduced. In addition, new examples were added.
Chapter 2 The Financial Markets and Interest Rates

This chapter was significantly revised to reflect the recent changes in the financial markets. The chapter was simplified to make it livelier and more relevant to students. A ne\v section titled The Financing of Business: The Movement of Funds Through the Economy was added. This section illustrates the role of finance in our economy. The discussion of investment banking was revised to reflect the dramatic impact of tlle recent financial crisis on investment banking firms. GA Cautionary Tale-Forgetting Principle 5: Conflicts of Interest Cause Agency Problems was introduced illustrating the impact of ignoring the principles of finance on the recent financial crisis. The discussion of interest rates determinants was also simplified and made more intuitive . This chapter was rewritten with an eye toward providing the student with need-toknow information that is used as building blocks to understand and introduce material in subsequent chapters.
Chapter 3 Understanding

Financial Statements and Cash Flows

A cautionary tale illustrating the peril of forgetting the principle that cash flows determine value. A new Finance at Work drawing from a recent Fortune magazine article that highlights how the world of finance may change as a result of tlle recent financial crisis. A presentation of Hewlett-Packard's financial statements to let a student see a realworld example. A.nimproved figure that visually presents the make-up of a balance sheet was added. A totally new presentation of cash flows was added . ., The addition of a new section explaining the relevance and computation of income taxes was added. Chapter 4
Evaluating A Firm's Financial Performance

A cautionary tale that shows the danger of forgetting the principle that risk requires reward was added. A new Ethics in Financial Management acting unethically was added. that describes frequent rationalizations for

Foundations of Finance: The Logic and Practice of Financial Management, Seventh Edition, by Arthur J. Keown, John D. Martin, and J. William Petty. Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.

Preface

Chapter 5 The Time Value of Money

A new section on the use of timeJines to visuauze cash flows was added . This chapter was revised with an eye toward making it more accessible to math-phobic students. Coverage of the time value of money tables was dropped. Alternative approaches to solving time value of money problems were provided. A Cautionary Tale-Forgetting Principle 3: Risk Requires a Reward and Principle 4: Market Prices Are Generally Right was introduced. An increased emphasis on the intuition behind the time value of money was provided stressing visuaLizing and setting up the problem. Chapter 6
The Meaning and Measurement of Risk and Return

The chapter provides an expanded presentation of holding-period returns to insure that students understand the foundation concept of returns. ~Then explaining how to compute a standard deviation of returns, we developed a stepby-step approach instead of simply presenting an equation. There is a new Ethics in Financial Management box that tells the story of Aaron Beam, fonner CFO of HealthSouth Corporation, who explains how he gradually slipped in committing fraud, and what life is like for him today. The chapter offers a new presentation of risk and diversification, using Google as an example. There is a new presentation in the chapter showing the relationship between risk and return and the length of the holding period.

Chapter 7
The Valuation and Characteristics of Bonds

This chapter has been revised to provide an updared explanation with examples of the nature and characterisrics of bonds. There are all new real-world examples of how to compute the value and expected rates of returns of a bond.

ChapterS The Characteristics and Value of Stocks

The chapter presents a cautionary tale that lets a student see some of the foolish ways investors try to outperform the market, usually with disastrous results, suggesting that Principle 4, Market Prices i\re Generally Right, is active and working. liVehave simplified the presentation of stock valuation that better fits the needs of a student in a beginning finance class.

Chapter 9
The Cost of Capital

This chapter was moved to appear before the discussion of capital budgeting . The new placement provides a logical transition from the discussion of the determinants of capital market rates of return in Chapter 8 to the application of this material to the estimation of the firm's cost of capital. The plight of Goldman Sachs when the credit markets seized up in 2008 is used to illuso"ate the volatile nature of a firm's cost of capital.

Foundations of Finance. The Logic and Practice of Financial Management. Seventh Edition. by Arthur J. Keown. John D. Martin, and J. William Petty. Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.

Preface

Chapter 10 Capital Budgeting Techniques and Practice

o Added coverage of the discounted payback period was included.


The number of worked out examples were increased in this chapter since this is one of the key chapters in the book and one that traditionally provides students with a great deal of difficulty. Additional problems were added.
Chapter 11 Cash Flows and Other Topics in Capital Budgeting

The discussion of the calculation of a project's free cash flows was simplified and made more intuitive in nature, while additional worked out problems were added to the chapter.
Chapter 12 Determining

the Financing Mix

Increased the discussion linking operating, financial, and combined leverage.


Chapter 13 Dividend Policy and Internal Financing

Additional coverage of the practical considerations underlying the determination firm's dividend policy.
Chapter 14 Short-Term Financing

of a

Increased emphasis on percent of sales forecasting as well as its inherent limitations.


Chapter 15 Working Capital Management

Revised discussion of the cash conversion cycle and its role in reducing a firm's investment in working capital.
Chapter 16 Current Asset Management

Streamlined receivable.
Chapter 17 International

coverage of the methods

used to speed up collections

of accounts

Business Finance

This chapter was revised and updated to reflect changes in exchange rates and in the global financial markets in general. The section on interest rate parity was streamlined and simplified.

A Complete Support Package for the Student and Instructor


MyFinancelab
This fully integrated online homework system gives students the hands-on practice and tutorial help they need to learn finance efficiently. Ample opportunities for online practice and assessment in MyFinanceLab are seamlessly integrated into each chapter. For more details, see the inside front cover.
Foundations of Finance: The Logic and Practice of Financial Management. Seventh Edition. by Arthur J. Keown. John D. Martin. and J. William Petty. Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.

Preface

Instructor's Resource Center


This password-protected site is accessible at \vww.pearsonhighered.com/keown and hosts all of the instructor resources that follow. Instructors should click on the "Help Downloading Instructor Resources" link for easy-to-follow instructions on getting access or may contact their sales represent'ltive for further information.

Test Item File


This Online Test Item File, prepared by Alan D. Eastman ofIndiana University of Pennsylvania, provides more than 1,600 multiple-choice, truelfalse, and short-answer questions with complete and detailed answers. The online 'lest Item File is designed for use \vith the 'IestGen-EQ test generating software. This computerized package allows instructors to custom design, save, and generate classroom tests. The test program permits instructors to edit, add, or delete questions from the test bank; edit existing graphics and create new graphics; analyze test results; and organize a database of tests and student results. This new software allows for greater flexibility and ease of use. It provides many options for organizing and displaying tests, along with a search and sort feature.

Instructor's Manual with Solutions


\iVritten by the authors, the Online Instructor's l\1anual follows the textbook's organization and represents a continued effort to serve the teacher in his or her goal of being effective in the classroom. Each chapter contains a chapter orientation, an outline of each chapter (also suitable for lecture notes), answers to end-of-chapter questions, and an extensive problem set for each chapter, including a large number of alternative problems along with answers. The Instructor's Manual is available electronically and instructors can download this file from the Instructor's Resource Center by visiting www.pearsonhighered.com/keown.

The PowerPoint lecture Presentation


This lecture presentation tool, prepared by Philip Samuel Russel of Philadelphia University, provides the instructor with individual lecture outlines to accompany the text. The slides include many of the figures and tables from the text. These lecture notes can be used as is or instructors can easily modify them to reflect specific presentation needs.

Study Guide
The Study Guide to accompany Foundations of Finance: The Logic and Pmctice of Financial j'vIanagement, 7th Edition, was written by the authors with the objective of providing a student-oriented supplement to the text. Each chapter of the Study Guide cont,lins ,ll1orientation of each chapter along with a chapter outline of key topics; problems (with detailed solutions) and self-tests, which can be used to aid in the preparation of outside assignments and in studying for exams; a tutorial on capital budgeting; and a set of tables that not only gives compound sum and present value interest factors but also shows how to compute the interest using a financial calculator.

Companion Website
(www.pearsonhighered.comlkeown) The vVebsite contains vanous activities related specifically to tlle Seventh Edition of FoundatiollI of Finance: Tbe Logic and Practice ofFinrl17rial fvIrl7lagement.

Excel Spreadsheets
Created by the authors, these spreadsheets correspond with the end-of-chapter problems from the text. This student resource is available on both the companion Website and 1'\1yFinanceLab.
Foundations of Finance: The Logic and Practice of Financial Management. Seventh Edition. by Arthur J. Keown. John D. Martin. and J William Petty. Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.

Preface

CourseSmart for Instructors


CourseSmart goes beyond traditional teaching resources to provide instant, online access to the textbooks and course materials you need at a lower cost to students. And while students save money, you can save time and hassle ",ritha digital textbook that allows you to search the most relevant content at the very moment you need it. v\!hether it's for evaluating textbooks or cre,lting lecture notes to help students ,vith difficult concepts, CourseSmart can make life a little easier. See how by visiting the CourseSmart vVeb site at www.coursesmart.com/instructors.

CourseSmart for Students


CourseSmart goes beyond traditional expectations providing instant, online access to the textbooks and course materials students need at lower cost. Students can also search, highlight, and take notes anywhere at any time. See all the benefits to students at www.coursesmart .com/students.

Subscriptions
Analyzing current events is an important skill for economic students to develop. To sharpen this skill and further support the book's theme of exploration and application, Prentice Hall offers you and your student's three news subscription offers:

The Wall Street Journal Print and Interactive Editions Subscription


Prentice Hall has formed a strategic alliance with the rVall Street Journal, the most respected and trusted daily source for information on business and economics. For a small additional charge, Prentice Hall offers students a IS-week subscription to the H7all Street Journal Interactive Edition (wsj.com) and a IS-week complimentary print edition subscription. Upon receipt of 10 student registrations from an adopting institution, a professor can receive a one-year subscription of the print and interactive versions as well as weekly subject-specific f1Iall Street Journal educators' lesson plans.

The Financial Times


We are pleased to ailliounce a special partnership with the Financial Times. For a small additional charge, Prentice Hall offers your students a IS-week subscription to the Financial Times. Upon adoption of a special package containing the book and the subscription booklet, professors will receive a free one-year subscription. Please contact your Prentice Hall representative for details and ordering information.

Economist.com
Through a special arrangement with Economist.com, Prentice Hall offers your students a 12-week subscription to Economist.com for a small additional charge. Upon adoption of a special package containing the book and the subscription booklet, professors will receive a free six-month subscription. Please contact your Prentice Hall representative for further details and ordering information.

Foundations of Finance: The Logic and Practice of Financial Management,

Seventh Edition, by Arthur J. Keown, John D. Martin, and J. William Petty. Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.

Preface

Acknowledgments
,Ne gratefully acknowledge the assistance, support, and encouragement of those individuals who have contributed to the Seventh Edition of Foundations o/Finance. Specifically, we wish to recognize the very helpful insights provided by many of our colleagues. For their careful comments and helpful reviews of the text, we are indebted to: Haseeb Ahmed, Johnson C. Smith University Joan Anderssen, Arapahoe Community CoLlege Chris Armstrong, Draughons Junior College Curtis Bacon, Southern Oregon University Deb Bauer, University of Oregon Pat Bernson, County CoLlege of Monis Ed Boyer, Temple University Joe Brocato, Tarleton State University Joseph Brum, Fayetteville Technical Community College Lawrence Byerly, Thomas More College Janice Caudill, Auburn University Andreas Christofi, Monmouth University David Daglio, Newbury College Julie Dahlquist, University of Texas at San Antonio David Darst, Central Ohio Technical College Maria de Boyrie, New Mexico State University Kate Demarest, Carroll Community College Khaled Elkhal, University of Southern Indiana Cheri Etling, University of Tampa Cheryl Fetterman, Cape Fear Community College David R. Fewings, Western vVashington University Dr. Charles Gahala, Benedictine University Harry Gallatin, Indiana State University Deborah Giarusso, University of Nortllern Iowa Gregory Goussak, University of Nevada, Las Vegas Lori Grady, Bucks County Community College Ed Graham, University of North Carolina \Vilmington Barry Greenberg, Webster University Gary Greer, University ofIlouston Downtown Bruce Hadburg, University of Tampa Thomas Hiebert, University of North Carolina, Charlotte }\1arlinJ emen, Auburn University John Kachurick, Nlisericordia University Okan Kavuncu, University of California at Santa Cruz Gary Kayakachoian, Rbode Island College Lynn Phillips Kugele, University of Mississippi Mary LaPann, Adirondack Community College Carlos Liard-Muriente, Central Connecticut State University Christopher Liberty, College of St Rose, Empire State College Edmund Mantell, Pace University Peter Marks, Rhode Island College Mario Mastrandrea, Cleveland State University Anna McAleer, Arcadia University Robert Meyer, Parkland College Ronald Moy, St. John's University Elisa Muresan, Long Island University Anthony Pondillo, Siena College Walter Purvis, Coastal Carolina Community College Emil Radosevich, Central New i'vlexico Community College Deana Ray, Forsyth Technical Community CoLlege Clarence Rose, Radford University Ahmad Salam, \Videner University Jeffrey Schultz, Christian Brothers University Ken Shakoori, California State University, Bakersfield Michael Slates, Bowling Green State University Suresh Srivastava, University of Alaska Anchorage Mauny Tamarkin, Clark University Fang \Vang, \Vest Virginia University Paul V\Tarrick,\Vestwood CoLlege Jill Wetmore, Saginaw Valley State University Kevin Yost, Auburn University Jingx-ue Yuan, Texas Tech University Mengxin Zhao, Bentley College

vVe also thank our friends at Prentice Hall. Vie offer our personal expression of appreciation to our editor-in-chief Donna Battista who provided the leadership and direction to this project. vVe would also like to tlunk Tessa O'Brien, our finance editor. Tessa has been a pleasure to work with, always full of ideas and driven to help us produce the best book possible. vVewould also like to thank Sara Holliday, our project manager, for her adminisu'ative defU1ess.\Vith Sara watching over us, there W,lS no W,lY the ball could be dropped. Our hats are off to you, Sara. We would also like to extend our thanks to Heather McNally, who served as our production supervisor; we express a very special thank you for seeing the book through a velY complex production process and keeping it all on schedule while maintaining extremely high quality. Our thanks also go to Liz Averbeck for her marketing prowess. Liz has an amazing understanding of the market, coupled with an intuitive understanding of wbat the market is looking for. In addition to being a joy to work with, she is also the hardest working person in America. Vie also thank Nicole Sackin, our media producer, who did a great job of making sure we are on the cutting edge in terms of web applications and offerings. As a final word, we express our sincere thanks to those using Foundations 0/ Finance in the classroom. \Ve thank you for making us a part of your team. Always feel free to give any of us a call or contact us through the Internet when you have questions or needs. -AJ.K./ ].D.i'\1./ ].W.P.
Foundations of Finance; The Logic and Practice of Financial Management, Seventh Edition, by Arthur J. Keown, John D. Martin, and J. William Petty. Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.