Intermediate Financial Management - GBV

Intermediate Financial

Management

TENTH EDITION

Eugene F. Brigham

University of Florida

Phillip R. Daves

University of Tennessee

/ c> SOUTH-WESTERN

t c? CENGAGE Learning'

Australia ? Brazil ? Japan ? Korea ? Mexico ? Singapore ? Spain ? United Kingdom ? United States

CONTENTS

Preface iv

PART1 Fundamental Concepts of Corporate Finance i

Chapter 1 An Overview of Financial Management 2

Beginning-of-Chapter Questions 3 About Using the Text 3 The Primary Objective of the Corporation: Value

Maximization 4 Box: Ethics for Individuals and Businesses 6 Box: Corporate Scandals and Maximizing

Stock Price 8 Agency Relationships 9 Transparency in Financial Reporting 15 Financial Securities and the Cost of Money 18 A Preview of What's Ahead 22 e-Resources 23 Summary 24

Chapter 2 Risk and Return: Part 28

Beginning-of-Chapter Questions 29 Investment Returns 29 Box: Corporate Valuation and Risk 30 Stand-Alone Risk 31 Box: The Trade-Off between Risk

and Return 39 Risk in a Portfolio Context 41 Box: The Benefits of Diversifying Overseas 48 Calculating Beta Coefficients 53 The Relationship between Risk and Rates

of Return 56

The CAPM, Risk, and Return: Is Something Missing? 61

Summary 62

Chapter 3 Risk and Return: Part II 72

Beginning-of-Chapter Questions 73 Box: Corporate Valuation and Risk 73 Efficient Portfolios 74 Choosing the Optimal Portfolio 78 The Basic Assumptions of the Capital Asset

Pricing Model 81 The Capital Market Line and the Security

Market Line 82 Calculating Beta Coefficients 86 Empirical Tests of the CAPM 93 Arbitrage Pricing Theory 96 The Fama-French Three-Factor Model 99 An Alternative Theory of Risk and Return:

Behavioral Finance 102 Summary 104

Chapter 4 Bond Valuation n o

Beginning-of-Chapter Questions 111 Box: Corporate Valuation and Risk 111 Who Issues Bonds? 112 Key Characteristics of Bonds 113 Bond Valuation 117 Bond Yields 121 Changes in Bond Values over Time 124 Box: Drinking Your Coupons 127 Bonds with Semiannual Coupons 127 The Determinants of Market Interest Rates 128 The Real Risk-Free Rate of Interest, r* 130

XXI

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The Inflation Premium (IP) 130 The Nominal, or Quoted, Risk-Free

Rate of Interest, rRF 132 The Default Risk Premium (DRP) 133 The Liquidity Premium (LP) 138 The Maturity Risk Premium (MRP) 139 The Term Structure of Interest Rates 142 Junk Bonds 144 Bankruptcy and Reorganization 145 Summary 146

Chapter 5 Basic Stock Valuation 154

Beginning-of-Chapter Questions 155 Box: Corporate Valuation and Stock Risk 155 Legal Rights and Privileges of Common

Stockholders 156 Types of Common Stock 157 Stock Market Reporting 158 Common Stock Valuation 159 Constant Growth Stocks 162 Expected Rate of Return on a Constant

Growth Stock 166 Valuing Stocks That Have a Nonconstant

Growth Rate 168 Stock Valuation by the Free Cash Flow

Approach 171 Market Multiple Analysis 172 Preferred Stock 173 Stock Market Equilibrium 1 74 The Efficient Markets Hypothesis 117 Summary 180

Chapter 6 Financial Options 190

Beginning-of-Chapter Questions 191 Financial Options 191 Box: Financial Reporting for Employee

Stock Options 197 Introduction to Option Pricing Models: The

Binomial Approach 197 The Black-Scholes Option Pricing Model

(OPM) 203

Box: Taxes and Stock Options 207 The Valuation of Put Options 208 Applications of Option Pricing in Corporate

Finance 209 Summary 211

Chapter 7 Accounting for Financial Management 215

Beginning-of-Chapter Questions 216 Box: Corporate Valuation and Financial

Statements 216 Financial Statements and Reports 217 The Balance Sheet 217 The Income Statement 218 Statement of Retained Earnings 220 Net Cash Flow 221 Box: Financial Analysis on the Internet 222 Statement of Cash Flows 223 Modifying Accounting Data for Managerial

Decisions 226 Box: Financial Bamboozling: How to Spot It 230 MVA and EVA 234 Box: Sarbanes-Oxley and Financial Fraud 237 The Federal Income Tax System 238 Summary 243

Chapter 8

Analysis of Financial Statements 254

Beginning-of-Chapter Questions 255 Box: Corporate Valuation and Analysis of Financial

Statements 255 Financial Analysis 256 Liquidity Ratios 256 Asset Management Ratios 259 Debt Management Ratios 262 Profitability Ratios 265 Box: International Accounting Differences Create

Headaches for Investors 266 Market Value Ratios 268 Trend Analysis, Common Size Analysis,

and Percentage Change Analysis 271 Tying the Ratios Together: The Du Pont

Equation 274

Contents ? xxiii

Comparative Ratios and Benchmarking 276 Uses and Limitations of Ratio Analysis 277 Box: Ratio Analysis in the Web 278 Looking beyond the Numbers 279 Summary 280

PART 2 Corporate Valuation 291

Chapter 9 Financial Planning and Forecasting

Financial Statements 292

Beginning-of-Chapter Questions 293

Box: Corporate Valuation and Financial

Planning 293

Overview of Financial Planning 294

Sales Forecast 295

The Additional Funds Needed (AFN)

Formula 297

Forecasted Financial Statement (FFS) Method 300

Forecasting Financial Requirements

When the Balance Sheet Ratios Are

Subject to Change 311

Summary 315

/

Chapter 10 Determining the Cost of Capital 324

Beginning-of-Chapter Questions 325 Box: Corporate Valuation and the Cost

of Capital 325 The Weighted Average Cost of Capital 326 Cost of Debt, rd(1 - T) 326 Cost of Preferred Stock, rps 329 Cost of Common Stock, rs 330 The CAPM Approach 331 Dividend-Yield-Plus-Growth-Rate, or Discounted

Cash Flow (DCF), Approach 337 Bond-Yield-Plus-Risk-Premium Approach 340 Comparison of the CAPM, DCF, and

Bond-Yield-Plus-Risk-Premium Methods 340 Adjusting the Cost of Stock for Flotation

Costs 341

Composite, or Weighted Average, Cost of Capital, WACC 343

Box: Global Variations in the Cost of Capital 345 Factors that Affect the Weighted Average Cost '

of Capital 346

Adjusting the Cost of Capital for Risk 347 Privately Owned Firms and Small Businesses 350 Four Mistakes to Avoid 351 Summary 352

Chapter 11 Corporate Valuation and Value-Based

Management 363

Beginning-of-Chapter Questions 364 Box: Corporate Valuation: Putting

the Pieces Together 364 Overview of Corporate Valuation 365 The Corporate Valuation Model 366 Value-Based Management 374 Box: Value-Based Management in Practice 383 Managerial Behavior and Shareholder

Wealth 384 Corporate Governance 385 Box: The Sarbanes-Oxley Act of 2002

and Corporate Governance 392 Box: International Corporate Governance 394 Employee Stock Ownership Plans (ESOPs) 396 Summary 399

PART 3 Project Valuation 409

Chapter 12 Capital Budgeting: Decision Criteria 41 o

Beginning-of-Chapter Questions 411 Box: Corporate Valuation and Capital

Budgeting 411 Overview of Capital Budgeting 412 Net Present Value (NPV) 413 Internal Rate of Return (IRR) 415 Comparison of the NPV and IRR Methods 41 7 Multiple IRRs 420

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Contents

Modified Internal Rate of Return (MIRR) 422 Profitability Index 424 Payback Methods 425 Conclusions on Capital Budgeting

Methods 428 Business Practices 430 Special Applications of Cash Flow

Evaluation 431 The Optimal Capital Budget 434 Summary 436

Chapter 13 Capital Budgeting: Estimating Cash Flows

and Analyzing Risk 447

Beginning-of-Chapter Questions 448 Box: Corporate Valuation, Cash Flows,

and Risk Analysis 448 Estimating Cash Flows 448 Project Analysis: An Example 450 Issues in Project Analysis 456 Depreciation 459 Adjusting for Inflation 462 Project Risk Analysis: Techniques for Measuring

Stand-Alone Risk 463 Box: Capital Budgeting Practices in the Asia/Pacific

Region 469 Project Risk Conclusions 473 Incorporating Project Risk into Capital

Budgeting 474 Managing Risk Through Phased Decisions:

Decision Trees 475 Introduction to Real Options 477 Summary 479

Strategic Financing Decisions 515

Chapter 15 Capital Structure Decisions: Part I 516

Beginning-of-Chapter Questions 517 Box: Corporate Valuation and Capital

Structure 517 A Preview of Capital Structure Issues 518 Business Risk and Financial Risk 520 Capital Structure Theory 526 Box: Yogi Berra on the MM Proposition 528 Capital Structure Evidence and Implications 535 Box: Taking a Look at Global Capital

Structures 537 Estimating the Optimal Capital Structure 538 Summary 550

Chapter 1 6 Capital Structure Decisions: Part II 559

Beginning-of-Chapter Questions 560 Box: Corporate Valuation and Capital Structure

Decisions 560 Capital Structure Theory: Arbitrage Proofs of the

Modigliani-Miller Models 560 Introducing Personal Taxes: The Miller Model 571 Criticisms of the MM and Miller Models 574 An Extension to the MM Model: Nonzero Growth

and a Risky Tax Shield 576 Risky Debt and Equity as an Option 580 Capital Structure Theory: Our View 584 < Summary 586

Chapter 14 Real Options 489

Beginning-of-Chapter Questions 490 Valuing Real Options 490 The Investment Timing Option:

An Illustration 491 The Growth Option: An Illustration 501 Box: Growth Options at Dot-Corn Companies 504 Concluding Thoughts on Real Options 507 Summary 509

Chapter 1 7 Distributions to Shareholders: Dividends

and Repurchases 592

Beginning-of-Chapter Questions 593 An Overview of Cash Distributions 593 Procedures for Cash Distributions 595 Cash Distributions and Firm Value 598 Clientele Effect 600 Information Content, or Signaling, Hypothesis 601 Implications for Dividend Stability 603

Contents

Setting the Target Distribution Level: The Residual Distribution Model 603

Application of the Residual Dividend Model 606 Distributions Through Stock Repurchases 607 Comparison of Dividends and Repurchases 610 Box: Dividend Yields around the World 612 Other Factors Influencing Distributions 612 Summarizing the Distribution Policy Decision 614 Stock Splits and Stock Dividends 615 Dividend Reinvestment Plans 618 Summary 619

Financial Statement Effects 672 Evaluation by the Lessee 674 Evaluation by the Lessor 679 Box: What You Don't Know Can Hurt You! 682 Other Issues in Lease Analysis 682 Box: Lease Securitization 685 Other Reasons for Leasing 686 Summary 687

Chapter 20 Hybrid Financing: Preferred Stock,

Warrants, and Convertibles 694

PARTS Tactical Financing Decisions 627

Chapter 18 Initial Public Offerings, Investment

Banking, and Financial Restructuring 628

Beginning-of-Chapter Questions 629 Box: Corporate Valuation, IPOs, and Financial

Restructuring 629 The Financial Life Cycle of a Start-Up

Company 630 The Decision to Go Public 631 The Process of Going Public: An Initial Public

Offering 633 Equity Carve-Outs: A Special Type of IPO 641 Non-IPO Investment Banking Activities 642 The Decision to Go Private 646 Managing the Maturity Structure of Debt 648 Refunding Operations 650 Box: TVA Ratchets Down Its Interest

Expenses 655 Managing the Risk Structure of Debt 657 Box: Bowie Bonds Ch-Ch-Change Asset

Securitization 660 Summary 661

Chapter 19 Lease Financing 667

Beginning-of-Chapter Questions 668 Types of Leases 668 Tax Effects 671

Beginning-of-Chapter Questions 695 Preferred Stock 695 Box: Where's the Dividend? 697 Box: MIPS, QUIPS, TOPrS, and QUIDS:

A Tale of Two Perspectives 698 Warrants 700 Convertible Securities 707 A Final Comparison of Warrants

and Convertibles 715 Reporting Earnings when Warrants or Convertibles

Are Outstanding 716 Summary 717

PART 6 Working Capital Management 725

Chapter 21 Working Capital Management 726

Beginning-of-Chapter Questions 727 Box: Corporate Valuation and Working Capital

Management 727 The Cash Conversion Cycle 728 Alternative Net Operating Working Capital

Policies 732 Cash Management 733 The Cash Budget 734 Box: The CFO Cash Management Scorecard 738 Cash Management Techniques 738 Inventory 740 Box: Supply Chain Management 741 Receivables Management 742 Box: Supply Chain Finance 744

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Accruals and Accounts Payable (Trade Credit) 747 Alternative Short-Term Financing Policies 750 Short-Term Investments: Marketable

Securities 752 Short-Term Financing 753 Short-Term Bank Loans 754 Commercial Paper 756 Use of Security in Short-Term Financing 757 Summary 758

Chapter 22 Providing and Obtaining Credit 769

Beginning-of-Chapter Questions 770 Box: Corporate Valuation and Credit

Policy 770 Credit Policy 771 Setting the Credit Period and Standards 771 Setting the Collection Policy 772 Cash Discounts 773 Other Factors Influencing Credit Policy 773 The Payments Pattern Approach to Monitoring

Receivables 774 Analyzing Proposed Changes in Credit

Policy 778 Analyzing Proposed Changes in Credit Policy:

Incremental Analysis 781 The Cost of Bank Loans 787 Choosing a Bank 794 Summary 796

Chapter 23 Other Topics in Working Capital

Management 805

Beginning-of-Chapter Questions 806 Box: Corporate Valuation and Working Capital

Management 806 The Concept of Zero Working Capital 806 Setting the Target Cash Balance 807 Inventory Control Systems 813 Accounting for Inventory 815 The Economic Ordering Quantity (EOQ)

Model 817 EOQ Model Extensions 823 Summary 828

PART 7 Special Topics 833

Chapter 24 Derivatives and Risk Management 834

Beginning-of-Chapter Questions 835 Box: Corporate Valuation and Risk

Management 835 Reasons to Manage Risk 835 Background on Derivatives 838 Derivatives in the News 839 Other Types of Derivatives 843 Corporate Risk Management 850 Box: Microsoft's Goal: Manage Every Risk! 852 Using Derivatives to Reduce Risks 853 Box: Risk Management in the Cyber Economy 857 Summary 861

Chapter 25 Bankruptcy, Reorganization,

and Liquidation 865

Beginning-of-Chapter Questions 866 Financial Distress and Its Consequences 866 Issues Facing a Firm in Financial Distress 868 Settlements without Going through Formal

Bankruptcy 869 Federal Bankruptcy Law 871 Reorganization in Bankruptcy 872 Liquidation in Bankruptcy 882 Other Motivations for Bankruptcy 885 Some Criticisms of Bankruptcy Laws 886 Other Topics in Bankruptcy 887 Summary 887

Chapter 26 Mergers, LBOs, Divestitures, and

Holding Companies 894

Beginning-of-Chapter Questions 895 Rationale for Mergers 896 Types of Mergers 899 Level of Merger Activity 899 Hostile versus Friendly Takeovers 901 Merger Regulation 902

Contents ? xxvii

Overview of Merger Analysis 904 The Adjusted Present Value (APV) Approach 905 The Free Cash Flow to Equity (FCFE) Approach 908 Illustration of the Three Valuation Approaches

for a Constant Capital Structure 910 Setting the Bid Price 915 Analysis When There Is a Permanent Change

in Capital Structure 916 Taxes and the Structure of the Takeover Bid 918 Box: Tempest in a Teapot? 920 Financial Reporting for Mergers 922 Analysis for a "True Consolidation" 925 The Role of Investment Bankers 926 Who Wins: The Empirical Evidence 929 Box: Merger Mistakes 930 Corporate Alliances 930 Leveraged Buyouts 931 Divestitures 933 Holding Companies 934 Summary 936

Chapter 27 Multinational Financial Management 943

Beginning-of-Chapter Questions 944 Multinational, or Global, Corporations 944 Multinational versus Domestic Financial

Management 946 Exchange Rates 947 Exchange Rates and International Trade 951 The International Monetary System and Exchange

Rate Policies 952 Trading in Foreign Exchange 956 Interest Rate Parity 958 Purchasing Power Parity 960 Box: Hungry for a Big Mac? Go to Malaysia! 961 Inflation, Interest Rates, and Exchange Rates 963 International Money and Capital Markets 964 Box: Greasing the Wheels of International

Business 965 Box: Stock Market Indices around

the World 967 Multinational Capital Budgeting 968 International Capital Structures 972 Multinational Working Capital Management 973 Summary 977

Appendixes Appendix A Values of the Areas under

the Standard Normal Distribution Function 983 Appendix B Answers to End-of-Chapter Problems 984 Appendix C Selected Equations and Data 992

Glossary 1005 Name Index 1021 Subject Index 1025

Web Chapters Chapter 28 Time Value of Money Chapter 29 Basic Financial Tools: A Review Chapter 30 Pension Plan Management Chapter 31 Financial Management

in Not-for-Profit Businesses

Web Extensions Web Extension 1-A A Closer Look at

Markets: Securitization and Social Welfare Web Extension 1-B An Overview of Derivatives Web Extension 1-C A Closer Look at the Stock Markets Web Extension 2-A Continuous Probability Distributions Web Extension 2-B Estimating Beta with a Financial Calculator

No Web Extension for Chapter 3

Web Extension 4-A A Closer Look at Zero Coupon Bonds

Web Extension 4-B A Closer Look at TIPS: Treasury Inflation-Protected Securities

Web Extension 4-C Bond Risk and Duration

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