Accounting Books Pdf: Fundamentals of Financial Management 13thE VanHorne

Fundamentals of Financial Management 13thE VanHorne

http://www.freeaccountingbooks.com/fundamentals-of-financial-management-13the-vanhorne/

Brief Contents

l l l Part 1 Introduction to Financial Management

1 The Role of Financial Management 1

2 The Business, Tax and Financial Environments 17

l l l Part 2 Valuation

3 The Time Value of Money 41

4 The Valuation of Long-Term Securities 73

5 Risk and Return 97

Appendix A Measuring Portfolio Risk 117

Appendix B Arbitrage Pricing Theory 119

l l l Part 3 Tools of Financial Analysis and Planning

6 Financial Statement Analysis 127

Appendix Deferred Taxes and Financial Analysis 158

7 Funds Analysis, Cash-Flow Analysis, and Financial Planning 169

Appendix Sustainable Growth Modeling 190

l l l Part 4 Working Capital Management

8 Overview of Working Capital Management 205

9 Cash and Marketable Securities Management 221

10 Accounts Receivable and Inventory Management 249

11 Short-Term Financing 281

l l l Part 5 Investment in Capital Assets

12 Capital Budgeting and Estimating Cash Flows 307

13 Capital Budgeting Techniques 323

Appendix A Multiple Internal Rates of Return 341

Appendix B Replacement Chain Analysis 343

14 Risk and Managerial (Real) Options in Capital Budgeting 353

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

l l l Part 6 The Cost of Capital, Capital Structure,

and Dividend Policy

15 Required Returns and the Cost of Capital 381

Appendix A Adjusting the Beta for Financial Leverage 407

Appendix B Adjusted Present Value 408

16 Operating and Financial Leverage 419

17 Capital Structure Determination 451

18 Dividend Policy 475

l l l Part 7 Intermediate and Long-Term Financing

19 The Capital Market 505

20 Long-Term Debt, Preferred Stock, and Common Stock 527

Appendix Refunding a Bond Issue 544

21 Term Loans and Leases 553

Appendix Accounting Treatment of Leases 567

l l l Part 8 Special Areas of Financial Management

22 Convertibles, Exchangeables, and Warrants 577

Appendix Option Pricing 589

23 Mergers and Other Forms of Corporate Restructuring 603

Appendix Remedies for a Failing Company 630

24 International Financial Management 647

Appendix 679

Glossary 689

Commonly Used Symbols 705

Index 707

Brief Contents

viii

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

Contents

Acknowledgements xix

Preface xxi

l l l Part 1 Introduction to Financial Management

1 The Role of Financial Management 1

Objectives 1

Introduction 2

What Is Financial Management? 2

The Goal of the Firm 3

Corporate Governance 8

Organization of the Financial Management Function 8

Organization of the Book 10

Key Learning Points 13

Questions 14

Selected References 14

2 The Business, Tax, and Financial Environments 17

Objectives 17

The Business Environment 18

The Tax Environment 20

The Financial Environment 27

Key Learning Points 35

Questions 36

Self-Correction Problems 37

Problems 37

Solutions to Self-Correction Problems 38

Selected References 39

l l l Part 2 Valuation

3 The Time Value of Money 41

Objectives 41

The Interest Rate 42

Simple Interest 43

Compound Interest 43

Compounding More Than Once a Year 59

Amortizing a Loan 62

Summary Table of Key Compound Interest Formulas 63

Key Learning Points 63

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

Questions 64

Self-Correction Problems 64

Problems 65

Solutions to Self-Correction Problems 69

Selected References 71

4 The Valuation of Long-Term Securities 73

Objectives 73

Distinctions Among Valuation Concepts 74

Bond Valuation 75

Preferred Stock Valuation 78

Common Stock Valuation 79

Rates of Return (or Yields) 83

Summary Table of Key Present Value Formulas for Valuing Long-Term

Securities 88

Key Learning Points 88

Questions 89

Self-Correction Problems 90

Problems 91

Solutions to Self-Correction Problems 93

Selected References 95

5 Risk and Return 97

Objectives 97

Defining Risk and Return 98

Using Probability Distributions to Measure Risk 99

Attitudes Toward Risk 101

Risk and Return in a Portfolio Context 103

Diversification 104

The Capital-Asset Pricing Model (CAPM) 106

Efficient Financial Markets 114

Key Learning Points 116

Appendix A: Measuring Portfolio Risk 117

Appendix B: Arbitrage Pricing Theory 119

Questions 121

Self-Correction Problems 122

Problems 122

Solutions to Self-Correction Problems 125

Selected References 126

l l l Part 3 Tools of Financial Analysis and Planning

6 Financial Statement Analysis 127

Objectives 127

Contents

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

Financial Statements 128

A Possible Framework for Analysis 134

Balance Sheet Ratios 138

Income Statement and Income Statement/Balance Sheet Ratios 141

Trend Analysis 152

Common-Size and Index Analysis 153

Key Learning Points 156

Summary of Key Ratios 156

Appendix: Deferred Taxes and Financial Analysis 158

Questions 159

Self-Correction Problems 160

Problems 161

Solutions to Self-Correction Problems 165

Selected References 167

7 Funds Analysis, Cash-Flow Analysis, and Financial Planning 169

Objectives 169

Flow of Funds (Sources and Uses) Statement 170

Accounting Statement of Cash Flows 176

Cash-Flow Forecasting 180

Range of Cash-Flow Estimates 184

Forecasting Financial Statements 186

Key Learning Points 190

Appendix: Sustainable Growth Modeling 190

Questions 194

Self-Correction Problems 195

Problems 197

Solutions to Self-Correction Problems 200

Selected References 203

l l l Part 4 Working Capital Management

8 Overview of Working Capital Management 205

Objectives 205

Introduction 206

Working Capital Issues 208

Financing Current Assets: Short-Term and Long-Term Mix 210

Combining Liability Structure and Current Asset Decisions 215

Key Learning Points 216

Questions 216

Self-Correction Problem 217

Problems 217

Solutions to Self-Correction Problem 218

Selected References 219

Contents

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

9 Cash and Marketable Securities Management 221

Objectives 221

Motives for Holding Cash 222

Speeding Up Cash Receipts 223

S-l-o-w-i-n-g D-o-w-n Cash Payouts 228

Electronic Commerce 231

Outsourcing 233

Cash Balances to Maintain 234

Investment in Marketable Securities 235

Key Learning Points 244

Questions 245

Self-Correction Problems 245

Problems 246

Solutions to Self-Correction Problems 247

Selected References 248

10 Accounts Receivable and Inventory Management 249

Objectives 249

Credit and Collection Policies 250

Analyzing the Credit Applicant 258

Inventory Management and Control 263

Key Learning Points 273

Questions 274

Self-Correction Problems 274

Problems 275

Solutions to Self-Correction Problems 278

Selected References 279

11 Short-Term Financing 281

Objectives 281

Spontaneous Financing 282

Negotiated Financing 287

Factoring Accounts Receivable 298

Composition of Short-Term Financing 300

Key Learning Points 301

Questions 302

Self-Correction Problems 302

Problems 303

Solutions to Self-Correction Problems 305

Selected References 306

l l l Part 5 Investment in Capital Assets

12 Capital Budgeting and Estimating Cash Flows 307

Objectives 307

The Capital Budgeting Process: An Overview 308

Contents

xii

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

Generating Investment Project Proposals 308

Estimating Project “After-Tax Incremental Operating Cash Flows” 309

Key Learning Points 318

Questions 318

Self-Correction Problems 319

Problems 319

Solutions to Self-Correction Problems 321

Selected References 322

13 Capital Budgeting Techniques 323

Objectives 323

Project Evaluation and Selection: Alternative Methods 324

Potential Difficulties 330

Project Monitoring: Progress Reviews and Post-Completion Audits 340

Key Learning Points 340

Appendix A: Multiple Internal Rates of Return 341

Appendix B: Replacement Chain Analysis 343

Questions 345

Self-Correction Problems 346

Problems 347

Solutions to Self-Correction Problems 349

Selected References 350

14 Risk and Managerial (Real) Options in Capital Budgeting 353

Objectives 353

The Problem of Project Risk 354

Total Project Risk 357

Contribution to Total Firm Risk: Firm-Portfolio Approach 364

Managerial (Real) Options 368

Key Learning Points 373

Questions 373

Self-Correction Problems 374

Problems 375

Solutions to Self-Correction Problems 377

Selected References 379

l l l Part 6 The Cost of Capital, Capital Structure, and Dividend Policy

15 Required Returns and the Cost of Capital 381

Objectives 381

Creation of Value 382

Overall Cost of Capital of the Firm 383

The CAPM: Project-Specific and Group-Specific Required Rates of Return 396

Evaluation of Projects on the Basis of Their Total Risk 401

Key Learning Points 406

Contents

xiii

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

Appendix A: Adjusting the Beta for Financial Leverage 407

Appendix B: Adjusted Present Value 408

Questions 410

Self-Correction Problems 411

Problems 412

Solutions to Self-Correction Problems 415

Selected References 417

16 Operating and Financial Leverage 419

Objectives 419

Operating Leverage 420

Financial Leverage 427

Total Leverage 435

Cash-Flow Ability to Service Debt 436

Other Methods of Analysis 439

Combination of Methods 440

Key Learning Points 441

Questions 442

Self-Correction Problems 443

Problems 444

Solutions to Self-Correction Problems 446

Selected References 449

17 Capital Structure Determination 451

Objectives 451

A Conceptual Look 452

The Total-Value Principle 456

Presence of Market Imperfections and Incentive Issues 458

The Effect of Taxes 461

Taxes and Market Imperfections Combined 463

Financial Signaling 465

Timing and Financial Flexibility 465

Financing Checklist 466

Key Learning Points 467

Questions 468

Self-Correction Problems 468

Problems 469

Solutions to Self-Correction Problems 471

Selected References 473

18 Dividend Policy 475

Objectives 475

Passive versus Active Dividend Policies 476

Factors Influencing Dividend Policy 481

Dividend Stability 484

Contents

xiv

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

Stock Dividends and Stock Splits 486

Stock Repurchase 491

Administrative Considerations 495

Key Learning Points 496

Questions 497

Self-Correction Problems 498

Problems 499

Solutions to Self-Correction Problems 501

Selected References 502

l l l Part 7 Intermediate and Long-Term Financing

19 The Capital Market 505

Objectives 505

Déjà Vu All Over Again 506

Public Issue 507

Privileged Subscription 509

Regulation of Security Offerings 512

Private Placement 516

Initial Financing 519

Signaling Effects 520

The Secondary Market 522

Key Learning Points 522

Questions 523

Self-Correction Problems 524

Problems 524

Solutions to Self-Correction Problems 525

Selected References 526

20 Long-Term Debt, Preferred Stock, and Common Stock 527

Objectives 527

Bonds and Their Features 528

Types of Long-Term Debt Instruments 529

Retirement of Bonds 532

Preferred Stock and Its Features 534

Common Stock and Its Features 538

Rights of Common Shareholders 539

Dual-Class Common Stock 542

Key Learning Points 543

Appendix: Refunding a Bond Issue 544

Questions 546

Self-Correction Problems 547

Problems 548

Solutions to Self-Correction Problems 550

Selected References 551

Contents

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

21 Term Loans and Leases 553

Objectives 553

Term Loans 554

Provisions of Loan Agreements 556

Equipment Financing 558

Lease Financing 559

Evaluating Lease Financing in Relation to Debt Financing 562

Key Learning Points 567

Appendix: Accounting Treatment of Leases 567

Questions 570

Self-Correction Problems 571

Problems 572

Solutions to Self-Correction Problems 573

Selected References 575

l l l Part 8 Special Areas of Financial Management

22 Convertibles, Exchangeables, and Warrants 577

Objectives 577

Convertible Securities 578

Value of Convertible Securities 581

Exchangeable Bonds 584

Warrants 585

Key Learning Points 589

Appendix: Option Pricing 589

Questions 595

Self-Correction Problems 596

Problems 597

Solutions to Self-Correction Problems 599

Selected References 600

23 Mergers and Other Forms of Corporate Restructuring 603

Objectives 603

Sources of Value 604

Strategic Acquisitions Involving Common Stock 608

Acquisitions and Capital Budgeting 615

Closing the Deal 617

Takeovers, Tender Offers, and Defenses 620

Strategic Alliances 622

Divestiture 623

Ownership Restructuring 626

Leveraged Buyouts 627

Key Learning Points 629

Appendix: Remedies for a Failing Company 630

Questions 635

Self-Correction Problems 636

Problems 638

Contents

xvi

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

Solutions to Self-Correction Problems 641

Selected References 643

24 International Financial Management 647

Objectives 647

Some Background 648

Types of Exchange-Rate Risk Exposure 652

Management of Exchange-Rate Risk Exposure 656

Structuring International Trade Transactions 668

Key Learning Points 671

Questions 672

Self-Correction Problems 673

Problems 674

Solutions to Self-Correction Problems 676

Selected References 677

Appendix 679

Table I: Future value interest factor 680

Table II: Present value interest factor 682

Table III: Future value interest factor of an (ordinary) annuity 684

Table IV: Present value interest factor of an (ordinary) annuity 686

Table V: Area of normal distribution that is Z standard deviations

to the left or right of the mean 688

Glossary 689

Commonly Used Symbols 705

Index 707

Contents

xvii

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

Supporting resources

Visit www.pearsoned.co.uk/wachowicz to find valuable online resources

Companion Website for students

l Learning objectives for each chapter

l Multiple choice, true/false and essay questions to test your understanding

l PowerPoint presentations for each chapter to remind you of key concepts

l An online glossary to explain key terms and flash cards to test your knowledge of key terms and

definitions in each chapter

l Excel templates for end of chapter problems to help you model a spread sheet approach to solving

the problem

l Link to author’s own award-winning website with even more multiple choice and true/false

questions, as well as web-based exercises and regularly updated links to additional support

material

l New to this edition, PowerPoint presentations for each chapter integrating and demonstrating how

Excel can be used to help solve calculations.

For instructors

l Extensive Instructor’s Manual including answers to questions, solutions to problems and solutions

to self-correction problems

l PowerPoint slides plus PDF’s of all figures and tables from the book

l Testbank of additional question material.

Also: The Companion Website provides the following features:

l Search tool to help locate specific items of content

l E-mail results and profile tools to send results of quizzes to instructors

l Online help and support to assist with website usage and troubleshooting.

For more information please contact your local Pearson Education representative

or visit www.pearsoned.co.uk/wachowicz

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

Acknowledgements

We would like to express our gratitude to the following academics, as well as additional

anonymous reviewers, who provided invaluable feedback on this book during the development

of the thirteenth edition:

Dr Brian Wright, at Exeter University

Dr Axel F.A. Adam-Muller, at Lancaster University

Dr Graham Sadler, at Aston University

We are grateful to the following for permission to reproduce copyright material:

Figure 10.3 D&B Composite Rating from a Reference Book and a Key to Ratings, 2003.

Reprinted by permission, Dun & Bradstreet, 2007; Cartoon on page 272 from “What is

needed to make a ‘just-in-time’ system work,” Iron Age Magazine, June 7, 1982. Reprinted by

permission, Iron Age.

Anheuser-Busch Companies, Inc., for permission to reproduce their logo and an extract

reserved; Cameco Corporation, for permission to reproduce their logo and an extract from

the Cameco Corporation Annual Report 2006 (www.cameco.com/investor_relations/annual/

extracts adapted from “Ask Alice about Ethics” and “Ask Alice about Accountants”, reproduced

from www.toolkit.cch.com. Reproduced with permission from CCH Business Owner’s

Toolkit, published and copyrighted by CCH Incorporated; CFO Publishing Corporation for

permission to reproduce the CFO Asia logo and extracts reproduced from “Virtue Rewarded,”

CFO Asia, O’Sullivan K., (November 2006), pp. 58–63 and “One Continent, One Payment

to reproduce the CFO logo and extracts adapted from “A Trade Secret Comes to

Light, Again,” CFO, by Leone M., November 2005, pp. 97–99. “Four Eyes are Better,” CFO, by

O’Sullivan K., June 2006, p. 21; “More Rules, Higher Profits,” CFO, Durfee D., August 2006,

p. 24 and “Buy it Back, And Then?” CFO, Durfee D., September 2006, p. 22, www.cfo.com.

Coca-Cola Company for extracts from their Annual Report, 2006 (Form 10-k) pp. 59 and 65,

and permission to reproduce their registered trademarks: Coca-Cola and the Contour Bottle.

Coca-Cola and the Contour Bottle are registered trademarks of The Coca-Cola Company;

Crain Communications Inc., for permission to reproduce the Financial Week logo and adapt

extracts from: “Shell Game Grows as an Exit Strategy,” Financial Week, by Byrt F., January 15

2007, pp. 3 and 18; “New Leasing Rules Could Hammer Corporate Returns,” Financial Week,

by Scott M., April 2 2007; “Spin-Off Frenzy Sets New Record,” Financial Week, by Byrt F.,

April 9 2007, pp. 3 and 21 and “A Bent for Cash. Literally,” Financial Week, by Johnston M.,

its Supply & Demand Chain Executive logo and an extract from “More than $1 Trillion

Seen Unnecessarily Tied Up in Working Capital,” Supply & Demand Chain Executive,

Check’s in the Box,” Canadian National Treasurer, by Yergen D., December 2005/January

xix

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

their logo and extracts in Chapter 6, p. 127, “Speaking in tongues” adapted from Speaking

in Tongues, The Economist, pp. 77–78, www.economist.com © The Economist Newspaper

Limited, London (19–25 May 2007), Used with permission; Chapter 23, p. 603, Textbox

Feature from The Economist, p. 90, www.economist.com © The Economist Newspaper Limited,

London (13 January 2007), Used with permission; Chapter 24, p. 654, “Big Mac Purchasing –

Power Parity”, Based on data in “Cash and carry – The hamburger standard” table at www.

economist.com/finance/displaystory.cfm?story_id=9448015 in The Economist © The Economist

Newspaper Limited, London (2007), Used with permission; Financial Executives International

Incorporated for permission to reproduce their logo and extracts from “Bridging the Finance-

Marketing Divide,” Financial Executive, by See, E., July/August 2006, pp. 50–53; “Sarbanes-

Oxley Helps Cost of Capital: Study,” Financial Executive, by Marshall J. and Heffes E.M., October

2006, p. 8; “Soul-Searching over U.S. Competitiveness,” Financial Executive, by Cheny G.A.,

June 2007, pp. 18–21; “BPO: Developing Market, Evolving Strategies,” Financial Executive, June

“The Basics of Trade and Exchange,” www.newyorkfed.org/education/fx/foreign.html;

Hermes Pensions Management Ltd for extracts reproduced from “The Hermes Principles:

What Shareholders Expect of Public Companies – and What Companies Should Expect of

their Investors,” p. 11, www.hermes.co.uk/pdf/corporate_governance/Hermes_Principles.pdf.

from “Sustainability: Why CFOs Need to Pay Attention,” Canadian Treasurer, by Hartshorn J.,

to reproduce their logo and extracts from www.fool.com; Nasdaq Stock Market Inc.

for permission to reproduce an extract from “Market Mechanics: A Guide to US Stock

Markets, release 1.2,” The NASDAQ Stock Market Educational Foundation Inc., by Angel J.J.,

reserved; Penton Media Inc. for permission to reproduce the Business Finance logo and

extracts from “Asset-based Lending Goes Mainstream,” Business Finance, by Kroll K.M., May

2006, pp. 39–42, “M&A Synergies/Don’t Count On It,” Business Finance, by Cummings J.,

October 2006, p. 14, “Payment Processing: The Sea Change Continues,” Business Finance, by

Kroll K.M., December 2006, “7 Steps to Optimize A/R Management,” Business Finance,

We are grateful to the Financial Times Limited for permission to reprint the following

material:

Chapter 20 “It’s a question of the right packaging” © Financial Times, 25 July 2007;

Chapter 20 “One share, one-vote hopes dashed” © Financial Times, 5 June 2007; Chapter 22

“Warrants win over the bulls” © Financial Times, 13 March 2007; Chapter 23 “Chapter 11 is

often lost in translation” © Financial Times, 25 July 2007; Chapter 24 “Islamic bonds recruited

out for purchase of 007’s favorite car” © Financial Times, 17/18 March 2007; Chapter 24

“European bond market puts US in the shade” © Financial Times, 15 January 2007.

We are grateful to the following for permission to use copyright material:

Chapter 18 “Debating Point: Are Share Buybacks a Good Thing?” from The Financial

Times Limited, 28 June 2006, © Richard Dobbs and Werner Rehm.

In some instances we have been unable to trace the owners of copyright material, and we

would appreciate any information that would enable us to do so.

Acknowledgements

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

xxi

Preface

Financial management continues to change at a rapid pace. Advancements are occurring not

only in the theory of financial management but also in its real-world practice. One result has

been for financial management to take on a greater strategic focus, as managers struggle to

create value within a corporate setting. In the process of value creation, financial managers are

increasingly supplementing the traditional metrics of performance with new methods that

encourage a greater role for uncertainty and multiple assumptions. Corporate governance

issues, ethical dilemmas, conflicting stakeholder claims, a downsized corporate environment,

the globalization of finance, e-commerce, strategic alliances, the growth of outsourcing, and

a host of other issues and considerations now permeate the landscape of financial decision

making. It is indeed a time of both challenge and opportunity.

The purpose of the thirteenth edition of Fundamentals of Financial Management is to

enable you to understand the financial decision-making process and to interpret the impact

that financial decisions will have on value creation. The book, therefore, introduces you to the

three major decision-making areas in financial management: the investment, financing, and

asset management decisions.

We explore finance, including its frontiers, in an easy-to-understand, user-friendly manner.

Although the book is designed for an introductory course in financial management, it

can be used as a reference tool as well. For example, participants in management development

programs, candidates preparing for various professional certifications (e.g., Certified

Management Accountant and Chartered Certified Accountant), and practicing finance and

accounting professionals will find it useful. And, because of the extensive material available

through the text’s website (which we will discuss shortly), the book is ideal for web-based

training and distance learning.

There are many important changes in this new edition. Rather than list them all, we will

explain some essential themes that governed our revisions and, in the process, highlight some

of the changes. The institutional material – necessary for understanding the environment in

which financial decisions are made – was updated. The book continues to grow more international

in scope. New sections, examples, and boxed features have been added throughout

the book that focus on the international dimensions of financial management. Attention was

also given to streamlining coverage and better expressing fundamental ideas in every chapter.

Chapter 1, The Role of Financial Management, has benefitted from an expanded discussion

of corporate social responsibility to include sustainability. A discussion of how “bonus

depreciation” works under the Economic Stimulus Act (ESA) of 2008 has been incorporated

into Chapter 2, The Business, Tax, and Financial Environments. (Note: While bonus

depreciation is a “temporary” situation in the US, it has been a recurring phenomenon.)

Chapter 6, Financial Statement Analysis, has benefitted from the addition of a discussion of

the push for “convergence” of accounting standards around the world. Accounts receivable

conversion (ARC), the Check Clearing for the 21st Century Act (Check 21), remote deposit

capture (RDC), and business process outsourcing (BPO) are all introduced in Chapter 9, Cash

and Marketable Securities Management.

Chapter 13, Capital Budgeting Techniques, has its discussion devoted to sensitivity analysis

expanded to address possible uncertainty surrounding a project’s initial cash outlay (ICO),

while Chapter 19, The Capital Market, introduces a host of new terms and concepts resulting

from recent SEC Securities Offering Reform.

In Chapter 20, Long-Term Debt, Preferred Stock, and Common Stock, an expanded discussion

of “Proxies, e-Proxies, and Proxy Contests” is followed by new material devoted to

plurality voting, majority voting, and “modified” plurality voting procedures. In Chapter 21,

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

Preface

xxii

Term Loans and Leases, the reader is alerted to impending, and perhaps dramatic, changes in

lease accounting. Revisions to the recent changes in accounting treatment for mergers and

acquisitions are noted in Chapter 23, Mergers and Other Forms of Corporate Restructuring.

The last chapter of the book, which is devoted to International Financial Management, has

been updated and a number of new items have been added, including a discussion of Islamic

bonds (Sukuk).

Finally, we continued our efforts to make the book more “user friendly.” Many new boxed

items and special features appear to capture the reader’s interest and illustrate underlying

concepts. Many of these boxed features come from new, first-time contributors to the text –

Canadian Treasurer, Financial Executive, and Supply & Demand Chain Executive magazines;

Financial Week newspaper; and BP p.l.c., Cameco Corporation, and Hermes Pensions

Management Limited.

Take Note

The order of the chapters reflects one common sequence for teaching the course, but the

instructor may reorder many chapters without causing the students any difficulty. For

example, some instructors prefer covering Part 3, Tools of Financial Analysis and Planning,

before Part 2, Valuation. Extensive selected references at the ends of chapters give the reader

direct access to relevant literature utilized in preparing the chapters. The appendices at the

ends of some chapters invite the reader to go into certain topics in greater depth, but the

book’s continuity is maintained if this material is not covered.

A number of materials supplement the text. For the teacher, a comprehensive Instructor’s

Manual contains suggestions for organizing the course, answers to chapter questions, and

solutions to chapter problems. Another aid is a Test-Item File of extensive questions and

problems, prepared by Professor Gregory A. Kuhlemeyer, Carroll College. This supplement

is available as a custom computerized test bank (for Windows) through your Pearson or

Prentice Hall sales representative. In addition, Professor Kuhlemeyer has done a wonderful

job preparing an extensive collection of more than 1,000 Microsoft PowerPoint slides as

outlines (with examples) to go along with this text. The PowerPoint presentation graphics

are available for downloading off the following Pearson Education Companion Website:

www.pearsoned.co.uk/wachowicz. All text figures and tables are available as transparency

masters through the same web site listed above. Computer application software prepared

by Professor Al Fagan, University of Richmond, that can be used in conjunction with

end-of-chapter problems identified with a PC icon (shown in the margin), is available in

Microsoft Excel format on the same web site. The Companion Website also contains an

Online Study Guide by Professor Kuhlemeyer. Designed to help students familiarize themselves

with chapter material, each chapter of the Online Study Guide contains a set of chapter

objectives, multiple-choice, true/false, and short answer questions, PowerPoint slides, and

Excel templates.

For the student, “self-correction problems” (i.e., problems for which step-by-step solutions

are found a few pages later) appear at the end of each chapter in the textbook. These are in

addition to the regular questions and problems. The self-correction problems allow students

to self-test their understanding of the material and thus provide immediate feedback on their

understanding of the chapter. Alternatively, the self-correction problems coupled with the

detailed solutions can be used simply as additional problem-solving examples.

Learning finance is like learning a foreign language. Part of the difficulty is simply learning

the vocabulary. Therefore, we provide an extensive glossary of more than 400 business terms

in two formats – a running glossary (appears alongside the textual material in the margins) and

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

an end-of-book cumulative glossary. In addition, the Pearson Education Companion Website:

www.pearsoned.co.uk/wachowicz contains an online version of our glossary plus interactive

flashcards to test your knowledge of key terms and definitions in each chapter.

Take Note

We purposely have made limited use of Internet addresses (i.e., the address you type into

your browser window that usually begins “http://www.”) in the body of this text. Websites

are extremely transient – any website that we mention in print could change substantially,

alter its address, or even disappear entirely by the time you read this. Therefore, we use

our website to flag websites that should be of interest to you. We then constantly update our

web listings and check for any broken or dead links. We strongly encourage you to make use

of our text’s website as you read each chapter. Although the text’s website was created with

students uppermost in mind, we are pleased to report that it has found quite a following

among business professionals. In fact, the website has received favorable reviews in a

number of business publications, including the Financial Times newspaper, The Journal of

Accountancy, Corporate Finance, CFO Asia, and Strategic Finance magazines.

To help harness the power of the Internet as a financial management learning device,

students (and instructors) are invited to visit the text’s award-winning website, Wachowicz’s

Web World, web.utk.edu/~jwachowi/wacho_world.html. (Note: The Pearson website –

www.pearsoned.co.uk/wachowicz – also has a link to Wachowicz’s Web World.) This website

provides links to hundreds of financial management web sites grouped to correspond with

the major headings in the text (e.g., Valuation, Tools of Financial Analysis and Planning, and

so on). In addition, the website contains interactive true/false and multiple-choice quizzes (in

addition to those found on the Companion Website), and interactive web-based exercises.

Finally, PowerPoint slides and Microsoft Excel spreadsheet templates can be downloaded

from the website as well.

The authors are grateful for the comments, suggestions, and assistance given by a number

of business professionals in preparing this edition. In particular, we would like to thank

Jennifer Banner, Schaad Companies; Rebecca Flick, The Home Depot; Alice Magos, CCH,

Inc.; and Selena Maranjian, The Motley Fool. We further want to thank Ellen Morgan,

Pauline Gillett, Michelle Morgan, Angela Hawksbee and Flick Williams at Pearson and Helene

Bellofatto, Mary Dalton, Jane Ashley, and Sasmita Sinha, who helped with the production of

this edition. Finally, we would like to thank Jean Bellmans, Free University of Brussels for his

endorsement on the cover of this book.

We hope that Fundamentals of Financial Management, thirteenth edition, contributes to

your understanding of finance and imparts a sense of excitement in the process. You, the

reader, are the final judge. We thank you for choosing our textbook, and welcome your comments

and suggestions (please e-mail: jwachowi@utk.edu).

JAMES C. VAN HORNE Palo Alto, California

JOHN M. WACHOWICZ, JR. Knoxville, Tennessee

Preface

xxiii

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

1 Part 1

Introduction to Financial

Management

Contents

l Introduction

l What Is Financial Management?

Investment Decision • Financing Decision •

Asset Management Decision

l The Goal of the Firm

Value Creation • Agency Problems • Corporate

Social Responsibility (CSR)

l Corporate Governance

The Role of the Board of Directors •

Sarbanes-Oxley Act of 2002

l Organization of the Financial Management

Function

l Organization of the Book

The Underpinnings • Managing and Acquiring

Assets • Financing Assets • A Mixed Bag

l Key Learning Points

l Questions

l Selected References

Increasing shareholder value over time is the bottom line of every

move we make.

—ROBERTO GOIZUETA

Former CEO, The Coca-Cola Company

Objectives

After studying Chapter 1, you should be able to:

l Explain why the role of the financial manager

today is so important.

l Describe “financial management” in terms of

the three major decision areas that confront the

financial manager.

l Identify the goal of the firm and understand why

shareholders’ wealth maximization is preferred

over other goals.

l Understand the potential problems arising when

management of the corporation and ownership

are separated (i.e., agency problems).

l Demonstrate an understanding of corporate

governance.

l Discuss the issues underlying social responsibility

of the firm.

l Understand the basic responsibilities of financial

managers and the differences between a “treasurer”

and a “controller.”

The Role of Financial

Management

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

Introduction

The financial manager plays a dynamic role in a modern company’s development. This has

not always been the case. Until around the first half of the 1900s financial managers primarily

raised funds and managed their firms’ cash positions – and that was pretty much it. In

the 1950s, the increasing acceptance of present value concepts encouraged financial managers

to expand their responsibilities and to become concerned with the selection of capital investment

projects.

Today, external factors have an increasing impact on the financial manager. Heightened

corporate competition, technological change, volatility in inflation and interest rates, worldwide

economic uncertainty, fluctuating exchange rates, tax law changes, environmental

issues, and ethical concerns over certain financial dealings must be dealt with almost daily. As

a result, finance is required to play an ever more vital strategic role within the corporation.

The financial manager has emerged as a team player in the overall effort of a company to

create value. The “old ways of doing things” simply are not good enough in a world where

old ways quickly become obsolete. Thus today’s financial manager must have the flexibility

to adapt to the changing external environment if his or her firm is to survive.

The successful financial manager of tomorrow will need to supplement the traditional

metrics of performance with new methods that encourage a greater role for uncertainty

and multiple assumptions. These new methods will seek to value the flexibility inherent in

initiatives – that is, the way in which taking one step offers you the option to stop or continue

down one or more paths. In short, a correct decision may involve doing something today

that in itself has small value, but gives you the option to do something of greater value in

the future.

If you become a financial manager, your ability to adapt to change, raise funds, invest in

assets, and manage wisely will affect the success of your firm and, ultimately, the overall

economy as well. To the extent that funds are misallocated, the growth of the economy will be

slowed. When economic wants are unfulfilled, this misallocation of funds may work to the

detriment of society. In an economy, efficient allocation of resources is vital to optimal growth

in that economy; it is also vital to ensuring that individuals obtain satisfaction of their highest

levels of personal wants. Thus, through efficiently acquiring, financing, and managing assets,

the financial manager contributes to the firm and to the vitality and growth of the economy

as a whole.

What Is Financial Management?

Financial management is concerned with the acquisition, financing, and management of

assets with some overall goal in mind. Thus the decision function of financial management

can be broken down into three major areas: the investment, financing, and asset management

decisions.

l l l Investment Decision

The investment decision is the most important of the firm’s three major decisions when it

comes to value creation. It begins with a determination of the total amount of assets needed

to be held by the firm. Picture the firm’s balance sheet in your mind for a moment. Imagine

liabilities and owners’ equity being listed on the right side of the balance sheet and its assets

on the left. The financial manager needs to determine the dollar amount that appears above

the double lines on the left-hand side of the balance sheet – that is, the size of the firm. Even

when this number is known, the composition of the assets must still be decided. For example,

how much of the firm’s total assets should be devoted to cash or to inventory? Also, the flip

Part 1 Introduction to Financial Management

Financial

management

Concerns the

acquisition, financing,

and management of

assets with some

overall goal in mind.

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

side of investment – disinvestment – must not be ignored. Assets that can no longer be

economically justified may need to be reduced, eliminated, or replaced.

l l l Financing Decision

The second major decision of the firm is the financing decision. Here the financial manager

is concerned with the makeup of the right-hand side of the balance sheet. If you look at the

mix of financing for firms across industries, you will see marked differences. Some firms

have relatively large amounts of debt, whereas others are almost debt free. Does the type of

financing employed make a difference? If so, why? And, in some sense, can a certain mix

of financing be thought of as best?

In addition, dividend policy must be viewed as an integral part of the firm’s financing

decision. The dividend-payout ratio determines the amount of earnings that can be retained

in the firm. Retaining a greater amount of current earnings in the firm means that fewer

dollars will be available for current dividend payments. The value of the dividends paid to

stockholders must therefore be balanced against the opportunity cost of retained earnings lost

as a means of equity financing.

Once the mix of financing has been decided, the financial manager must still determine

how best to physically acquire the needed funds. The mechanics of getting a short-term loan,

entering into a long-term lease arrangement, or negotiating a sale of bonds or stock must be

understood.

l l l Asset Management Decision

The third important decision of the firm is the asset management decision. Once assets

have been acquired and appropriate financing provided, these assets must still be managed

efficiently. The financial manager is charged with varying degrees of operating responsibility

over existing assets. These responsibilities require that the financial manager be more concerned

with the management of current assets than with that of fixed assets. A large share

of the responsibility for the management of fixed assets would reside with the operating

managers who employ these assets.

The Goal of the Firm

Efficient financial management requires the existence of some objective or goal, because

judgment as to whether or not a financial decision is efficient must be made in light of some

standard. Although various objectives are possible, we assume in this book that the goal of

the firm is to maximize the wealth of the firm’s present owners.

Shares of common stock give evidence of ownership in a corporation. Shareholder wealth

is represented by the market price per share of the firm’s common stock, which, in turn, is a

reflection of the firm’s investment, financing, and asset management decisions. The idea is

that the success of a business decision should be judged by the effect that it ultimately has on

share price.

l l l Value Creation

Frequently, profit maximization is offered as the proper objective of the firm. However,

under this goal a manager could continue to show profit increases by merely issuing stock and

using the proceeds to invest in Treasury bills. For most firms, this would result in a decrease

in each owner’s share of profits – that is, earnings per share would fall. Maximizing earnings

per share, therefore, is often advocated as an improved version of profit maximization.

However, maximization of earnings per share is not a fully appropriate goal because it does

1 The Role of Financial Management

Dividend-payout ratio

Annual cash dividends

divided by annual

earnings; or,

alternatively,

dividends per

share divided by

earnings per share.

The ratio indicates

the percentage of a

company’s earnings

that is paid out to

shareholders in cash.

Profit maximization

Maximizing a firm’s

earnings after

taxes (EAT).

Earnings per share

(EPS) Earnings after

taxes (EAT) divided

by the number of

common shares

outstanding.

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

not specify the timing or duration of expected returns. Is the investment project that will produce

a $100,000 return five years from now more valuable than the project that will produce

annual returns of $15,000 in each of the next five years? An answer to this question depends

on the time value of money to the firm and to investors at the margin. Few existing stockholders

would think favorably of a project that promised its first return in 100 years, no

matter how large this return. Therefore our analysis must take into account the time pattern

of returns.

Another shortcoming of the objective of maximizing earnings per share – a shortcoming

shared by other traditional return measures, such as return on investment – is that risk is not

considered. Some investment projects are far more risky than others. As a result, the prospective

stream of earnings per share would be more risky if these projects were undertaken. In

addition, a company will be more or less risky depending on the amount of debt in relation

to equity in its capital structure. This financial risk also contributes to the overall risk to the

investor. Two companies may have the same expected earnings per share, but if the earnings

stream of one is subject to considerably more risk than the earnings stream of the other, the

market price per share of its stock may well be less.

Finally, this objective does not allow for the effect of dividend policy on the market price

of the stock. If the only objective were to maximize earnings per share, the firm would never

pay a dividend. It could always improve earnings per share by retaining earnings and investing

them at any positive rate of return, however small. To the extent that the payment of

dividends can affect the value of the stock, the maximization of earnings per share will not be

a satisfactory objective by itself.

For the reasons just given, an objective of maximizing earnings per share may not be the

same as maximizing market price per share. The market price of a firm’s stock represents the

focal judgment of all market participants as to the value of the particular firm. It takes into

account present and expected future earnings per share; the timing, duration, and risk of these

earnings; the dividend policy of the firm; and other factors that bear on the market price of

the stock. The market price serves as a barometer for business performance; it indicates how

well management is doing on behalf of its shareholders.

Management is under continuous review. Shareholders who are dissatisfied with management

performance may sell their shares and invest in another company. This action, if taken

by other dissatisfied shareholders, will put downward pressure on market price per share.

Thus management must focus on creating value for shareholders. This requires management

to judge alternative investment, financing, and asset management strategies in terms of their

effect on shareholder value (share price). In addition, management should pursue productmarket

strategies, such as building market share or increasing customer satisfaction, only if

they too will increase shareholder value.

Part 1 Introduction to Financial Management

“Creating superior shareholder value is our top

priority.”

Source: Associated Banc-Corp 2006 Annual Report.

“The Board and Senior Management recognize their

responsibility to represent the interests of all shareholders

and to maximize shareholder value.”

Source: CLP Holdings Limited, the parent company of the China

Light & Power Group, Annual Report 2006.

“FedEx’s main responsibility is to create shareholder

value.”

Source: FedEx Corporation, SEC Form Def 14A for the period

ending 9/25/2006.

“. . . we [the Board of Directors] are united in our goal to

ensure McDonald’s strives to enhance shareholder value.”

Source: McDonald’s Corporation 2006 Annual Report.

“The desire to increase shareholder value is what drives

our actions.”

Source: Philips Annual Report 2006.

“. . . the Board of Directors plays a central role in the

Company’s corporate governance system; it has the

power (and the duty) to direct Company business, pursuing

and fulfilling its primary and ultimate objective of

creating shareholder value.”

Source: Pirelli & C. SpA. Milan Annual Report 2006.

What Companies Say About Their Corporate Goal

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

l l l Agency Problems

It has long been recognized that the separation of ownership and control in the modern

corporation results in potential conflicts between owners and managers. In particular, the

objectives of management may differ from those of the firm’s shareholders. In a large corporation,

stock may be so widely held that shareholders cannot even make known their

objectives, much less control or influence management. Thus this separation of ownership

from management creates a situation in which management may act in its own best interests

rather than those of the shareholders.

We may think of management as the agents of the owners. Shareholders, hoping that the

agents will act in the shareholders’ best interests, delegate decision-making authority to them.

Jensen and Meckling were the first to develop a comprehensive theory of the firm under

agency arrangements.1 They showed that the principals, in our case the shareholders, can

assure themselves that the agents (management) will make optimal decisions only if appropriate

incentives are given and only if the agents are monitored. Incentives include stock

options, bonuses, and perquisites (“perks,” such as company automobiles and expensive

offices), and these must be directly related to how close management decisions come to

the interests of the shareholders. Monitoring is done by bonding the agent, systematically

reviewing management perquisites, auditing financial statements, and limiting management

decisions. These monitoring activities necessarily involve costs, an inevitable result of the

separation of ownership and control of a corporation. The less the ownership percentage

of the managers, the less the likelihood that they will behave in a manner consistent with

maximizing shareholder wealth and the greater the need for outside shareholders to monitor

their activities.

Some people suggest that the primary monitoring of managers comes not from the

owners but from the managerial labor market. They argue that efficient capital markets

provide signals about the value of a company’s securities, and thus about the performance

of its managers. Managers with good performance records should have an easier time finding

other employment (if they need to) than managers with poor performance records. Thus, if

the managerial labor market is competitive both within and outside the firm, it will tend to

discipline managers. In that situation, the signals given by changes in the total market value

of the firm’s securities become very important.

l l l Corporate Social Responsibility (CSR)

Maximizing shareholder wealth does not mean that management should ignore corporate

social responsibility (CSR), such as protecting the consumer, paying fair wages to employees,

maintaining fair hiring practices and safe working conditions, supporting education, and

becoming involved in such environmental issues as clean air and water. It is appropriate for

management to consider the interests of stakeholders other than shareholders. These stakeholders

include creditors, employees, customers, suppliers, communities in which a company

operates, and others. Only through attention to the legitimate concerns of the firm’s various

stakeholders can the firm attain its ultimate goal of maximizing shareholder wealth.

Over the last few decades sustainability has become a growing focus of many corporate

social responsibility efforts. In a sense, corporations have always been concerned with their

ability to be productive, or sustainable, in the long term. However, the concept of sustainability

has evolved to such an extent that it is now viewed by many businesses to mean

meeting the needs of the present without compromising the ability of future generations to

meet their own needs. Therefore, more and more companies are being proactive and taking

steps to address issues such as climate change, oil depletion, and energy usage.

1 The Role of Financial Management

Agent(s) Individual(s)

authorized by another

person, called the

principal, to act on

the latter’s behalf.

Agency (theory)

A branch of

economics relating

to the behavior of

principals (such as

owners) and their

agents (such as

managers).

Corporate social

responsibility (CSR) A

business outlook that

acknowledges a firm’s

responsibilities to its

stakeholders and the

natural environment.

Stakeholders All

constituencies with a

stake in the fortunes

of the company. They

include shareholders,

creditors, customers,

employees, suppliers,

and local and

international

communities in which

the firm operates.

Sustainability

Meeting the needs of

the present without

compromising the

ability of future

generations to meet

their own needs.

1Michael C. Jensen and William H. Meckling, “Theory of the Firm: Managerial Behavior, Agency Costs and

Ownership Structure,” Journal of Financial Economics 3 (October 1976), 305–360.

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

Many people feel that a firm has no choice but to act in socially responsible ways. They

argue that shareholder wealth and, perhaps, the corporation’s very existence depend on its

being socially responsible. Because the criteria for social responsibility are not clearly defined,

however, formulating consistent policies is difficult. When society, acting through various

Part 1 Introduction to Financial Management

Companies are suddenly discovering the profit potential

of social responsibility.

When Al Gore, the former US vice president, shows

up at Wal-Mart headquarters, you have to wonder

what’s going on. As it turns out, Gore was invited to visit

the retailer in July to introduce a screening of his documentary

about global warming, An Inconvenient Truth.

An odd-couple pairing – Gore and a company known

for its giant parking lots? Certainly. But also one of the

many recent signs that “corporate social responsibility”,

once seen as the purview of the hippie fringe, has gone

mainstream.

In the 1970s and 1980s, companies like Ben & Jerry’s

and The Body Shop pushed fair-labor practices and

environmental awareness as avidly and effectively as

Cherry Garcia ice cream and cocoa-butter hand cream.

They were widely admired but rarely imitated.

Today, more than 1,000 companies in 60 countries

have published sustainability reports proclaiming their

concern for the environment, their employees, and their

local communities. Giant corporations from BP to

General Electric have launched marketing campaigns

emphasizing their focus on alternative energy. Wal-Mart,

too, has announced new environmental goals – hence

the Gore visit. The retailer has pledged to increase the

efficiency of its vehicle fleet by 25% over the next three

years, cut the amount of energy used in its stores by at

least 25%, and reduce solid waste from US stores by the

same amount.

Changing expectations

The sudden burst of idealism can be traced to several

sources. First among them: the wave of corporate scandals.

“Enron was sort of the tipping point for many

CEOs and boards. They realized that they were going to

continue to be the subject of activist, consumer, and

shareholder focus for a long time,” says Andrew Savitz,

author of The Triple Bottom Line and a former partner in

PricewaterhouseCoopers’s sustainability practice. “People

are now very interested in corporate behavior of all kinds.”

Second, thanks to the internet, everyone has rapid

access to information about that behavior. Word of an

oil spill or a discrimination lawsuit can spread worldwide

nearly instantly. “If you had a supplier using child

labor or dumping waste into a local river, that used to be

pretty well hidden,” says Andrew Winston, director of

the Corporate Environmental Strategy project at Yale

University and co-author of Green to Gold. “Now, someone

walks by with a camera and blogs about it.”

Real concerns about resource constraints, driven by

the rising costs of such crucial commodities as steel

and oil, are a third factor spurring executives to action.

Wal-Mart chief Lee Scott has said he discovered that by

packaging just one of the company’s own products in

smaller boxes, he could dramatically cut down its distribution

and shipping costs, reducing energy use at the

same time. Such realizations have driven the company’s

re-examination of its packaging and fleet efficiency.

Critics of corporate social responsibility, or CSR, have

long held that the business of business is strictly to

increase profits, a view set forth most famously by the

economist Milton Friedman. Indeed, in a recent survey

of senior executives about the role of business in society,

most respondents “still fall closer to Milton Friedman

than to Ben & Jerry,” says Bradley Googins, executive

director of Boston College’s Center for Corporate

Citizenship, which conducted the survey. “But they see

the Milton Friedman school as less and less viable today,”

due to the change in expectations of business from nearly

every stakeholder group. In a study conducted by the

center in 2005, more than 80% of executives said social

and environmental issues were becoming more important

to their businesses.

“This debate is over,” says Winston. “The discussion

now is about how to build these intangibles into the

business.”

Virtue Rewarded

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

representative bodies, establishes the rules governing the trade-offs between social goals, environmental

sustainability, and economic efficiency, the task for the corporation is clearer. We

can then view the company as producing both private and social goods, and the maximization

of shareholder wealth remains a viable corporate objective.

1 The Role of Financial Management

No longer just the right thing to do, sustainability can

affect an organization’s reputation, brand and longterm

profitability.

The surging interest in sustainable developments is

driven by the recognition that corporations, more

than any other organizations (including national governments),

have the power, the influence over financial,

human and natural resources, the means and arguably

the responsibility to promote a corporate agenda that

considers not only the economics of growth but also the

health of the environment and society at large.

Most early sustainability efforts fell under the

umbrella of corporate social responsibility, which corporations

practiced with a sense that it was the right

thing to do. The concept has changed since then, and its

evolution has serious implications for the way financial

professionals do their work. Sustainability has emerged

as a business strategy for maintaining long-term growth

and performance and to satisfy corporate obligations

to a range of stakeholders including shareholders.

As they should, profit-oriented corporations prioritize

their fiduciary responsibilities and consider mainly

the effects of their decisions on their direct shareholders.

The interests and values of other stakeholders and the

wider society affected by their actions often take lower or

no priority.

Under the principles of sustainability, a negative

impact on stakeholder values becomes a cost to a corporation.

The cost is usually defined as the expenditure

of resources that could be used to achieve something else

of equal or greater value. Customarily, these costs

have remained external to the organization and never

make their way onto an income statement. They may

include the discharge of contaminants and pollutants

into the environment and other abuses of the public

good.

Now these costs have begun to appear in corporate

financial statements through so-called triple-bottomline

accounting. This accounting approach promotes the

incorporation into the income statement of not only

tangible financial costs but also traditionally less tangible

environmental and social costs of doing business.

Organizations have practiced such green accounting

since the mid-1980s, as they recognize that financial

indicators alone no longer adequately identify and communicate

the opportunities and risks that confront them.

These organizations understand that failure in nonfinancial

areas can have a substantial impact on shareholder

value. Non-financial controversy has dogged

companies such as Royal Dutch/Shell (Brent Spar sinking

and Niger River delta operations), Talisman Energy

Inc. (previous Sudan investments) and Wal-Mart Stores

Inc. (labor practices).

To corporations, sustainability presents both a stick

and a carrot. The stick of sustainability takes the form of

a threat to attracting financing. Investors, particularly

institutions, now ask more penetrating questions about

the long-term viability of the elements in their portfolios.

If a company cannot demonstrate that it has taken

adequate steps to protect itself against long-term nonfinancial

risks, including risks to its reputation and

brand, it may become a much less attractive asset to

investors. Lenders, too, increasingly look at sustainability

in their assessment of their debt portfolios.

The carrot of sustainability comes in a variety of

forms. Carbon-management credits are becoming a

source of income for some companies. Younger consumers

are increasingly green-minded, screening their

investment and consumption choices by filtering out less

socially and environmentally responsibly organizations.

Organizations can learn how to account more completely

for environmental and social issues and then

define, capture and report on these non-financial indicators

as part of their performance measurement. In the

process, they can uncover new ways to safeguard their

reputation, build trust among stakeholders, consolidate

their license to operate and ultimately enhance their

growth and profitability.

Sustainability: Why CFOs Need to Pay Attention

Source: James Hartshorn, “Sustainability: Why CFOs Need to Pay Attention,” Canadian Treasurer (22 June/July 2006), p. 15. (www.tmac.ca)

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

Part 1 Introduction to Financial Management

Corporate Governance

Corporate governance refers to the system by which corporations are managed and controlled.

It encompasses the relationships among a company’s shareholders, board of directors,

and senior management. These relationships provide the framework within which corporate

objectives are set and performance is monitored. Three categories of individuals are, thus,

key to corporate governance success: first, the common shareholders, who elect the board of

directors; second, the company’s board of directors themselves; and, third, the top executive

officers led by the chief executive officer (CEO).

The board of directors – the critical link between shareholders and managers – is potentially

the most effective instrument of good governance. The oversight of the company is

ultimately their responsibility. The board, when operating properly, is also an independent

check on corporate management to ensure that management acts in the shareholders’ best

interests.

l l l The Role of the Board of Directors

The board of directors sets company-wide policy and advises the CEO and other senior

executives, who manage the company’s day-to-day activities. In fact, one of the board’s most

important tasks is hiring, firing, and setting of compensation for the CEO.

Boards review and approve strategy, significant investments, and acquisitions. The board

also oversees operating plans, capital budgets, and the company’s financial reports to common

shareholders.

In the United States, boards typically have 10 or 11 members, with the company’s CEO

often serving as chairman of the board. In Britain, it is common for the roles of chairman

and CEO to be kept separate, and this idea is gaining support in the United States.

l l l Sarbanes-Oxley Act of 2002

There has been renewed interest in corporate governance in this last decade caused by major

governance breakdowns, which led to failures to prevent a series of recent corporate scandals

involving Enron, WorldCom, Global Crossing, Tyco, and numerous others. Governments

and regulatory bodies around the world continue to focus on the issue of corporate governance

reform. In the United States, one sign of the seriousness of this concern was that

Congress enacted the Sarbanes-Oxley Act of 2002 (SOX).

Sarbanes-Oxley mandates reforms to combat corporate and accounting fraud, and imposes

new penalties for violations of securities laws. It also calls for a variety of higher standards

for corporate governance, and establishes the Public Company Accounting Oversight Board

(PCAOB). The Securities and Exchange Commission (SEC) appoints the chairman and the

members of the PCAOB. The PCAOB has been given the power to adopt auditing, quality

control, ethics, and disclosure standards for public companies and their auditors as well as

investigate and discipline those involved.

Organization of the Financial Management Function

Whether your business career takes you in the direction of manufacturing, marketing,

finance, or accounting, it is important for you to understand the role that financial management

plays in the operations of the firm. Figure 1.1 is an organization chart for a typical

manufacturing firm that gives special attention to the finance function.

As the head of one of the three major functional areas of the firm, the vice president of

finance, or chief financial officer (CFO), generally reports directly to the president, or chief

Corporate

governance The

system by which

corporations are

managed and

controlled. It

encompasses

the relationships

among a company’s

shareholders, board

of directors, and

senior management.

Sarbanes-Oxley

Act of 2002 (SOX)

Addresses, among

other issues,

corporate governance,

auditing and

accounting, executive

compensation, and

enhanced and timely

disclosure of

corporate information.

Public Company

Accounting Oversight

Board (PCAOB)

Private-sector,

nonprofit corporation,

created by the

Sarbanes-Oxley Act

of 2002 to oversee

the auditors of public

companies in order to

protect the interests

of investors and

further the public

interest in the

preparation of

informative, fair,

and independent

audit reports.

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

1 The Role of Financial Management

New research shows that good governance practices

may reduce your cost of capital.

All too often, the drive for corporate-governance

reform feels like a costly exercise in wishful thinking.

After all, can you really find a strong correlation between

a mandatory retirement age for directors and a bigger net

profit margin?

You can, as it happens. A growing body of research

suggests that the governance practices promoted by such

proxy groups as Institutional Shareholder Services (ISS)

and the Investor Responsibility Research Center are

indeed associated with better corporate performance and

a lower cost of capital. One 2003 study by researchers at

Harvard University and the Wharton School found that

companies with greater protections for shareholders had

significantly better equity returns, profits, and sales

growth than others. A more recent study, by ISS, found

that companies that closely follow its governance advice

have higher price–earnings ratios.

More Rules, Higher Profits

Figure 1.1

Financial management

on the organization

chart

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

Part 1 Introduction to Financial Management

executive officer (CEO). In large firms, the financial operations overseen by the CFO will be

split into two branches, with one headed by a treasurer and the other by a controller.

The controller’s responsibilities are primarily accounting in nature. Cost accounting, as

well as budgets and forecasts, concerns internal consumption. External financial reporting is

provided to the IRS, the Securities and Exchange Commission (SEC), and the stockholders.

The treasurer’s responsibilities fall into the decision areas most commonly associated

with financial management: investment (capital budgeting, pension management), financing

(commercial banking and investment banking relationships, investor relations, dividend

disbursement), and asset management (cash management, credit management). The organization

chart may give you the false impression that a clear split exists between treasurer and

controller responsibilities. In a well-functioning firm, information will flow easily back and

forth between both branches. In small firms the treasurer and controller functions may be

combined into one position, with a resulting commingling of activities.

Organization of the Book

We began this chapter by offering the warning that today’s financial manager must have the

flexibility to adapt to the changing external environment if his or her firm is to survive. The

recent past has witnessed the production of sophisticated new technology-driven techniques

for raising and investing money that offer only a hint of things to come. But take heart.

Although the techniques of financial management change, the principles do not.

As we introduce you to the most current techniques of financial management, our focus

will be on the underlying principles or fundamentals. In this way, we feel that we can best

prepare you to adapt to change over your entire business career.

Could a different reporting structure have prevented

the WorldCom fraud? Harry Volande thinks so.

The Siemens Energy & Automation CFO reports to

the board of directors, rather than to the CEO. He says

the structure, which Siemens refers to as the “four-eye

principle,” makes it easier for finance chiefs to stay

honest. “The advantage is that you have a CFO who does

not depend on the CEO for reviews or a remuneration

package,” says Volande. “That gives him the freedom to

voice an independent opinion.” The reporting structure,

which is more common in Germany, applies throughout

the German electronics conglomerate. In the United States,

such a reporting practice is rare, in part because at many

companies the CEO also chairs the board. “Most CEOs

would resist such a change in the hierarchy,” says James

Owers, professor of finance at Georgia State University.

With a change in the reporting model unlikely,

governance watchdogs are advocating frequent and

independent meetings between the CFO and the board.

Many CFOs have access to the board only when the

CEO requests a finance presentation, says Owers.

Espen Eckbo, director of the Center for Corporate

Governance at Dartmouth’s Tuck School of Business,

says boards should consider taking more responsibility

for evaluating the CFO and determining his or her compensation,

rather than relying solely on the CEO’s opinion.

Such a practice would provide more independence

for the finance chief, he says.

Of course, there are drawbacks when the CFO reports

directly to the board. Volande admits that it can slow

the decision-making process. For example, if there are

disagreements about a possible merger, the board

ultimately has to make the decision. “You require

additional communication, which can be useful, but it

takes longer,” says Volande. He acknowledges that the

structure is not for everyone, as conflicts can arise when

senior executives share power: “It takes a CEO and CFO

with a certain amount of humility and flexibility.”

Four Eyes Are Better

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

1 The Role of Financial Management

l l l The Underpinnings

In Part 1, Chapter 1, we define financial management, advocate maximization of shareholder

wealth as the goal of the firm, and look at the position that financial management holds on

the firm’s organization chart. Our next aim is to arm you with certain background material

and some of the basic tools of financial analysis. Therefore, in Chapter 2 we examine the

legal setting for financial management as it relates to organizational form and to taxes. The

function of financial markets and institutions, as well as of interest rates, is also included

Dear Alice,

With all the sound and fury going on about our national

moral crisis, do you have any words of wisdom and encouragement

on the subject of business ethics?

Hopeful in Hawaii

Dear Hopeful,

Glad to hear someone out there still has some faith in the

immortality of morality in these troubled times. I don’t

know why business ethics should be a subset of general,

run-of-the-mill ethics, but I’m willing to make a stab at

defining how one’s ethics can impact one’s business.

The way I see it, a business person needs several fundamental

ingredients to succeed. These might include skills

specific to the trade he or she is in, sufficient capital, a

willingness to apply a generous amount of elbow grease,

and a whole lot of luck. But even given all of the above,

if the ingredient of integrity is absent, true success will

elude the enterprise – for what kind of a business can

survive without a good reputation? And what is reputation,

after all, but ethics and integrity?

To be sure, much morality is imposed externally these

days. Laws and regulations tend to make individuals,

corporations, and even countries more virtuous than

they might otherwise be. Good intentions are fine, but a

little external incentive never hurts to get the job done.

Yet the true hope for the future of ethics in society

stems from the fact that the vast majority of folks have an

internal moral compass and would do the right thing

even without extraordinary external pressure.

And while these times may indeed appear to be

troubled, they are no more so than times gone by.

Consider the virtual caste system declaimed by Aristotle,

the rampant corruption of the late Roman Empire, the

blood and guts of the Middle Ages, not to mention the

exploitation of colonialism in more recent times.

If you’d like to see a wonderful example of how

the ethical dilemmas of ancient times apply even

today, take a look at this very pithy essay on honest

business dealings. Here you will find a journal article

by Randy Richards of St. Ambrose University titled

“Cicero and the Ethics of Honest Business Dealings.”

(www.stthom.edu/Public/getFile.asp?isDownload=1&File_

Content_ID=518) It tells about how Cicero came to

write his treatise On Duties, in which he addresses what

we ought to do when what is right and ethical conflicts

with what seems advantageous.

Cicero sent his son off to school in Athens, where

Junior proved to be a less-than-stellar pupil. Word

got back to Rome about excessive partying and lack

of attention to scholarship, and Dad was inspired to

write a long letter to his offspring on the subject of doing

one’s duty. Cicero’s examples of problems in doing

one’s duty, as described by the article’s author, are as

contemporary as any of the business ethics cases you

read about in your daily newspaper. Manipulating earnings

and stock values à la Enron and Andersen! Covering

up a defect in a product or property à la Firestone! Same

race, different rats!

So keep the faith and remain hopeful. Mankind has

been struggling with ethical challenges fairly successfully

for the two millennia since that wise old Roman fired

off a letter to his kid. And as long as the struggle to do

the right thing continues, civilization will continue to

improve – despite our temporary epidemic of sex, lies

and media hype.

Ask Alice About Ethics

Source: Adapted from Alice Magos, “Ask Alice About Ethics.” Retrieved from www.toolkit.cch.com/advice/096askalice.asp. Reproduced

with permission from CCH Business Owner’s Toolkit, published and copyrighted by:

CCH Incorporated

2700 Lake Cook Road

Riverwoods, Illinois 60015

(www.toolkit.cch.com)

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

as pertinent background information. In particular, we will focus on how business firms

interact with financial markets. The time value of money, valuation, and the twin concepts of

risk and return are explored in Part 2, Chapters 3, 4, and 5, because an understanding of these

fundamentals is essential to sound financial decisions. Indeed, the foundation for maximizing

shareholder wealth lies in valuation and in an understanding of the trade-offs between risk

and return. As a result, we explore these topics early on.

Question If I have no intention of becoming a financial manager, why do I need to understand

financial management?

Answer One good reason is “to prepare yourself for the workplace of the future.” More and

more businesses are reducing management jobs and squeezing together the various

layers of the corporate pyramid. This is being done to reduce costs and boost

productivity. As a result, the responsibilities of the remaining management positions

are being broadened. The successful manager will need to be much more of a team

player who has the knowledge and ability to move not just vertically within an

organization but horizontally as well. Developing cross-functional capabilities will

be the rule, not the exception. Thus a mastery of basic financial management skills is

a key ingredient that will be required in the workplace of your not-too-distant future.

To invest in, finance, and manage assets efficiently, financial managers must plan carefully.

For one thing, they must project future cash flows and then assess the likely effect of these

flows on the financial condition of the firm. On the basis of these projections, they also must

plan for adequate liquidity to pay bills and other debts as they come due. These obligations

may make it necessary to raise additional funds. In order to control performance, the financial

manager needs to establish certain norms. These norms are then used to compare actual

performance with planned performance. Because financial analysis, planning, and control

underlie a good deal of the discussion in this book, we examine these topics in Part 3,

Chapters 6 and 7.

l l l Managing and Acquiring Assets

Decisions regarding the management of assets must be made in accordance with the underlying

objective of the firm: to maximize shareholder wealth. In Part 4, we examine cash,

marketable securities, accounts receivable, and inventories. We shall explore ways of efficiently

managing these current assets in order to maximize profitability relative to the amount of

funds tied up in the assets. Determining a proper level of liquidity is very much a part of

this asset management. The optimal level of a current asset depends on the profitability and

flexibility associated with that level in relation to the cost involved in maintaining it. In the

past, the management of working capital (current assets and their supporting financing)

dominated the role of financial managers. Although this traditional function continues to

be vital, expanded attention is now being paid to the management of longer-term assets and

liabilities.

In Part 5, under capital budgeting, we consider the acquisition of fixed assets. Capital budgeting

involves selecting investment proposals whose benefits are expected to extend beyond

one year. When a proposal requires an increase or decrease in working capital, this change is

treated as part of the capital budgeting decision and not as a separate working capital decision.

Because the expected future benefits from an investment proposal are uncertain, risk is

Part 1 Introduction to Financial Management

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

1 The Role of Financial Management

necessarily involved. Changes in the business-risk complexion of the firm can have a

significant influence on the firm’s value in the marketplace. Because of this important effect,

attention is devoted to the problem of measuring risk for a capital investment project. In

addition to risk, an investment project sometimes embodies options for management to alter

previous decisions. Therefore the effect of managerial options on project desirability is

studied. Capital is apportioned according to an acceptance criterion. The return required of

the project must be in accord with the objective of maximizing shareholder wealth.

l l l Financing Assets

A major facet of financial management involves providing the financing necessary to support

assets. A wide variety of financing sources are available. Each has certain characteristics as

to cost, maturity, availability, claims on assets, and other terms imposed by the suppliers of

capital. On the basis of these factors, the financial manager must determine the best mix of

financing for the firm. Implications for shareholder wealth must be considered when these

decisions are made.

In Part 6 we discuss the capital structure (or permanent long-term financing makeup) of a

firm. We look at the concept of financial leverage from a number of different angles in an

effort to understand financial risk and how this risk is interrelated with business (or operating)

risk. In addition, we analyze the retention of earnings as a source of financing. Because

this source represents dividends forgone by stockholders, dividend policy very much impinges

on financing policy and vice versa. Whereas in Part 4, previously discussed, we examine the

various sources of short-term financing, in Part 7 the sources of long-term financing are

explored. Both parts reveal the features, concepts, and problems associated with alternative

methods of financing.

l l l A Mixed Bag

In Part 8 we cover some of the specialized areas of financial management in detail. Some of

the more exotic financing instruments – convertibles, exchangeables, and warrants – are discussed.

Mergers, strategic alliances, divestitures, restructurings, and remedies for a failing

company are explored. Growth of a company can be internal, external, or both, and domestic

or international in flavor. Finally, because the multinational firm has come into prominence,

it is particularly relevant that we study growth through international operations.

Financial management, then, involves the acquisition, financing, and management of

assets. These three decision areas are all interrelated: the decision to acquire an asset necessitates

the financing and management of that asset, whereas financing and management costs

affect the decision to invest. The focus of this book is on the investment, financing, and asset

management decisions of the firm. Together, these decisions determine the value of the firm

to its shareholders. Mastering the concepts involved is the key to understanding the role of

financial management.

Key Learning Points

l Financial management is concerned with the acquisition,

financing, and management of assets with some

overall goal in mind.

l The decision function of financial management can be

broken down into three major areas: the investment,

financing, and asset management decisions.

l We assume in this book that the goal of the firm is to

maximize the wealth of the firm’s present owners (or

shareholders). Shareholder wealth is represented by

the market price per share of the firm’s common stock,

which, in turn, is a reflection of the firm’s investment,

financing, and asset management decisions.

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

Part 1 Introduction to Financial Management

l The market price of a firm’s stock represents the focal

judgment of all market participants as to the value

of the particular firm. It takes into account present

and prospective future earnings per share; the timing,

duration, and risk of these earnings; the dividend

policy of the firm; and other factors that bear on the

market price of the stock.

l Agency theory suggests that managers (the agents),

particularly those of large, publicly owned firms,

may have different objectives from those of the

shareholders (the principals). The shareholders can

assure themselves that the managers will make shareholder

wealth-maximizing decisions only if management

receives appropriate incentives and only if

management is monitored.

l Maximizing shareholder wealth does not relieve the firm

of the responsibility to act in socially responsible ways.

l Corporate governance is the system by which corporations

are managed and controlled. It encompasses the

relationships among a company’s shareholders, board

of directors, and senior management.

l In large firms, the finance function is the responsibility

of the vice president of finance, or chief financial

officer (CFO), who generally reports directly to the

president, or chief executive officer (CEO). The financial

operations overseen by the CFO will be split into

two branches, with one headed by a treasurer and the

other by a controller. The controller’s responsibilities

are primarily accounting in nature, whereas the treasurer’s

responsibilities fall into the decision areas most

commonly associated with financial management.

Questions

1. If all companies had an objective of maximizing shareholder wealth, would people overall

tend to be better or worse off ?

2. Contrast the objective of maximizing earnings with that of maximizing wealth.

3. What is financial management all about?

4. Is the goal of zero profits for some finite period (three to five years, for example) ever

consistent with the maximization-of-wealth objective?

5. Explain why judging the efficiency of any financial decision requires the existence of a goal.

6. What are the three major functions of the financial manager? How are they related?

7. Should the managers of a company own sizable amounts of common stock in the company?

What are the pros and cons?

8. During the last few decades, a number of environmental, hiring, and other regulations

have been imposed on businesses. In view of these regulatory changes, is maximization of

shareholder wealth any longer a realistic objective?

9. As an investor, do you think that some managers are paid too much? Do their rewards

come at your expense?

10. How does the notion of risk and reward govern the behavior of financial managers?

11. What is corporate governance? What role does a corporation’s board of directors play in

corporate governance?

12. Compare and contrast the roles that a firm’s treasurer and controller have in the operation

of the firm.

Selected References

Ang, James S., Rebel A. Cole, and James Wuh Lin. “Agency

Costs and Ownership Structure.” Journal of Finance 55

(February 2000), 81–106.

Barnea, Amir, Robert A. Haugen, and Lemma W. Senbet.

“Management of Corporate Risk,” in Advances in Financial

Planning and Forecasting. New York: JAI Press, 1985.

—— . Agency Problems and Financial Contracting.

Englewood Cliffs, NJ: Prentice Hall, 1985.

Bauer, Christopher. “A Preventive Maintenance Approach

to Ethics.” Financial Executive 21 (May 2005), 18–20.

Bernstein, Peter L. Capital Ideas. New York: Free Press,

1992.

Brennan, Michael. “Corporate Finance Over the Past 25

Years.” Financial Management 24 (Summer 1995), 9–22.

Brickley, James A., Clifford W. Smith, Jr., and Jerold L.

Zimmerman. “Corporate Governance, Ethics, and

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

1 The Role of Financial Management

Organizational Architecture.” Journal of Applied Corporate

Finance 15 (Spring 2003), 34–45.

Brounen, Dirk, Abe de Jong, and Kees Koedijk. “Corporate

Finance in Europe: Confronting Theory with Practice.”

Financial Management 33 (Winter 2004), 71–101.

Chambers, Donald R., and Nelson J. Lacey. “Corporate

Ethics and Shareholder Wealth Maximization.” Financial

Practice and Education 6 (Spring–Summer 1996), 93–

96.

Chen, Andrew H., James A. Conover, and John W.

Kensinger. “Proven Ways to Increase Share Value.”

Journal of Applied Finance 12 (Spring/Summer 2002),

89–97.

Dore, Lucia. “Corporate Governance in Europe.” Shareholder

Value 3 (January/February 2003), 54–59.

Felo, Andrew J., and Steven A. Solieri. “New Laws, New

Challenges: Implications of Sarbanes-Oxley.” Strategic

Finance (February 2003), 31–34.

Friedman, Milton. “The Social Responsibility of Business

Is to Increase Its Profits.” New York Times Magazine

(September 13, 1970).

Haywood, M. Elizabeth, and Donald E. Wygal. “Corporate

Greed vs. IMA’s Ethics Code.” Strategic Finance 86

(November 2004), 45–49.

Holmstrom, Bengt, and Steven N. Kaplan. “The State of

US Corporate Governance: What is Right and What’s

Wrong?” Journal of Applied Corporate Finance 15 (Spring

2003), 8–20.

Howell, Robert A. “The CFO: From Controller to Global

Strategic Partner.” Financial Executive 22 (April 2006),

20–25.

Jensen, Michael C., and William H. Meckling. “Theory

of the Firm: Managerial Behavior, Agency Costs and

Ownership Structure.” Journal of Financial Economics 3

(October 1976), 305–360.

Jensen, Michael C., and Clifford W. Smith Jr. “Stockholder,

Manager, and Creditor Interests: Applications of Agency

Theory.” In Recent Advances in Corporate Finance, ed.

Edward I. Altman and Marti G. Subrahmanyam, 93–132.

Homewood, IL: Richard D. Irwin, 1985.

Koller, Tim, Marc Goedhart, and David Wessels. Valuation:

Measuring and Managing the Value of Companies, 4th ed.

Hoboken, NJ: John Wiley, 2005.

Megginson, William L. “Outside Equity.” Journal of Finance

55 (June 2000), 1005–1038.

Millman, Gregory J. “New Scandals, Old Lessons: Financial

Ethics After Enron.” Financial Executive 18 (July/August

2002), 16–19.

Persaud, Avinosh, and John Plender. All You Need to Know

About Ethics and Finance: Finding a Moral Compass in

Business Today. London: Longtail Publishing, 2006.

Porter, Michael E., and Mark R. Kramer. “Strategy &

Society: The Link Between Competitive Advantage and

Corporate Responsibility.” Harvard Business Review 36

(December 2006), 78–92.

Rappaport, Alfred. Creating Shareholder Value: A Guide for

Managers and Investors, rev. ed. New York: Free Press,

1997.

Seitz, Neil. “Shareholder Goals, Firm Goals and Firm

Financing Decisions.” Financial Management 11 (Autumn

1982), 20–26.

Shivdasani, Anil, and Marc Zenner. “Best Practices in

Corporate Governance: What Two Decades of Research

Reveals.” Journal of Applied Corporate Finance 16

(Spring/Summer 2004), 29–41.

Special Issue on International Corporate Governance.

Journal of Financial and Quantitative Analysis 38 (March

2003). Entire issue (ten articles) devoted to recent empirical

and theoretical research in the area of international

corporate governance.

Statement on Management Accounting No. 1C (revised),

Standards of Ethical Conduct for Practitioners of Management

Accounting and Financial Management. Montvale,

NJ: Institute of Management Accountants, April 30,

1997.

Stewart, G. Bennett. The Quest for Value. New York: Harper

Business, 1991.

Sundaram, Anant K. “Tending to Shareholders,” in FT

Mastering Financial Management, Part 1. Financial Times

(May 26, 2006), 4–5.

Treynor, Jack L. “The Financial Objective in the Widely

Held Corporation.” Financial Analysts Journal 37

(March–April 1981), 68–71.

Vershoor, Curtis C. “Do the Right Thing: IMA Issues New

Ethics Guidelines.” Strategic Finance 87 (November

2005), 42–46.

Part I of the text’s website, Wachowicz’s Web World,

contains links to many finance websites and online

articles related to topics covered in this chapter.

(web.utk.edu/~jwachowi/wacho_world.html)

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

The Business, Tax, and

Financial Environments

Contents

l The Business Environment

Sole Proprietorships • Partnerships •

Corporations • Limited Liability Companies

(LLCs)

l The Tax Environment

Corporate Income Taxes • Personal Income

Taxes

l The Financial Environment

The Purpose of Financial Markets • Financial

Markets • Financial Intermediaries • Financial

Brokers • The Secondary Market • Allocation of

Funds and Interest Rates

l Key Learning Points

l Questions

l Self-Correction Problems

l Problems

l Solutions to Self-Correction Problems

l Selected References

Corporation, n. An ingenious device for obtaining individual profit

without individual responsibility.

—AMBROSE BIERCE

The Devil’s Dictionary

Objectives

After studying Chapter 2, you should be able to:

l Describe the four basic forms of business organization

in the United States – and the advantages

and disadvantages of each.

l Understand how to find a corporation’s taxable

income and how to determine the corporate tax

rate – both average and marginal.

l Understand various methods of depreciation.

l Explain why acquiring assets through the use of

debt financing offers a tax advantage over both

common and preferred stock financing.

l Describe the purpose and makeup of financial

markets.

l Demonstrate an understanding of how letter

ratings of the major rating agencies help you

to judge a security’s default risk.

l Understand what is meant by the “term structure

of interest rates” and relate it to a “yield

curve.”

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

To understand better the role of financial managers, you must be familiar with the environments

in which they operate. The form of business organization that a firm chooses is one

aspect of the business setting in which it must function. We will explore the advantages and

disadvantages of the various alternative forms of business organization. Next, we will look

at the tax environment in order to gain a basic understanding of how tax implications may

impact various financial decisions. Finally, we investigate the financial system and the everchanging

environment in which capital is raised.

The Business Environment

In the United States there are four basic forms of business organization: sole proprietorships

(one owner), partnerships (general and limited), corporations, and limited liability

companies (LLCs). Sole proprietorships outnumber the others combined by over 2 to 1, but

corporations rank first by far when measured by sales, assets, profits, and contribution to

national income. As this section unfolds, you will discover some of the pluses and minuses of

each alternative form of business organization.

l l l Sole Proprietorships

The sole proprietorship is the oldest form of business organization. As the title suggests, a

single person owns the business, holds title to all its assets, and is personally responsible for

all of its debts. A proprietorship pays no separate income taxes. The owner merely adds any

profits or subtracts any losses from the business when determining personal taxable income.

This business form is widely used in service industries. Because of its simplicity, a sole proprietorship

can be established with few complications and little expense. Simplicity is its

greatest virtue.

Its principal shortcoming is that the owner is personally liable for all business obligations.

If the organization is sued, the proprietor as an individual is sued and has unlimited liability,

which means that much of his or her personal property, as well as the assets of the business,

may be seized to settle claims. Another problem with a sole proprietorship is the difficulty

in raising capital. Because the life and success of the business is so dependent on a single

individual, a sole proprietorship may not be as attractive to lenders as another form of organization.

Moreover, the proprietorship has certain tax disadvantages. Fringe benefits, such as

medical coverage and group insurance, are not regarded by the Internal Revenue Service as

expenses of the firm and therefore are not fully deductible for tax purposes. A corporation

often deducts these benefits, but the proprietor must pay for a major portion of them from

income left over after paying taxes. In addition to these drawbacks, the proprietorship form

makes the transfer of ownership more difficult than does the corporate form. In estate planning,

no portion of the enterprise can be transferred to members of the family during the proprietor’s

lifetime. For these reasons, this form of organization does not afford the flexibility

that other forms do.

l l l Partnerships

A partnership is similar to a proprietorship, except there is more than one owner. A

partnership, like a proprietorship, pays no income taxes. Instead, individual partners include

their share of profits or losses from the business as part of their personal taxable income.

One potential advantage of this business form is that, relative to a proprietorship, a greater

amount of capital can often be raised. More than one owner may now be providing personal

capital, and lenders may be more agreeable to providing funds given a larger owner investment

base.

Part 1 Introduction to Financial Management

Sole proprietorship

A business form for

which there is one

owner. This single

owner has unlimited

liability for all debts

of the firm.

Partnership A

business form in

which two or more

individuals act as

owners. In a general

partnership all

partners have

unlimited liability

for the debts of the

firm; in a limited

partnership one or

more partners may

have limited liability.

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

1The Trustees of Dartmouth College v. Woodward, 4 Wheaton 636 (1819).

In a general partnership all partners have unlimited liability; they are jointly liable for the

obligations of the partnership. Because each partner can bind the partnership with obligations,

general partners should be selected with care. In most cases a formal arrangement, or partnership

agreement, sets forth the powers of each partner, the distribution of profits, the

amounts of capital to be invested by the partners, procedures for admitting new partners,

and procedures for reconstituting the partnership in the case of the death or withdrawal of

a partner. Legally, the partnership is dissolved if one of the partners dies or withdraws. In

such cases, settlements are invariably “sticky,” and reconstitution of the partnership can be

a difficult matter.

In a limited partnership, limited partners contribute capital and have liability confined to

that amount of capital; they cannot lose more than they put in. There must, however, be at

least one general partner in the partnership, whose liability is unlimited. Limited partners

do not participate in the operation of the business; this is left to the general partner(s). The

limited partners are strictly investors, and they share in the profits or losses of the partnership

according to the terms of the partnership agreement. This type of arrangement is frequently

used in financing real estate ventures.

l l l Corporations

Because of the importance of the corporate form in the United States, the focus of this book

is on corporations. A corporation is an “artificial entity” created by law. It can own assets

and incur liabilities. In the famous Dartmouth College decision in 1819, Justice Marshall

concluded that

a corporation is an artificial being, invisible, intangible, and existing only in contemplation

of the law. Being a mere creature of law, it possesses only those properties which the

charter of its creation confers upon it, either expressly or as incidental to its very existence.1

The principal feature of this form of business organization is that the corporation exists legally

separate and apart from its owners. An owner’s liability is limited to his or her investment.

Limited liability represents an important advantage over the proprietorship and general

partnership. Capital can be raised in the corporation’s name without exposing the owners

to unlimited liability. Therefore, personal assets cannot be seized in the settlement of claims.

Ownership itself is evidenced by shares of stock, with each stockholder owning that proportion

of the enterprise represented by his or her shares in relation to the total number of

shares outstanding. These shares are easily transferable, representing another important

advantage of the corporate form. Moreover, corporations have found what the explorer Ponce

de Leon could only dream of finding – unlimited life. Because the corporation exists apart

from its owners, its life is not limited by the lives of the owners (unlike proprietorships and

partnerships). The corporation can continue even though individual owners may die or sell

their stock.

Because of the advantages associated with limited liability, easy transfer of ownership

through the sale of common stock, unlimited life, and the ability of the corporation to raise

capital apart from its owners, the corporate form of business organization has grown

enormously in the twentieth century. With the large demands for capital that accompany an

advanced economy, the proprietorship and partnership have proven unsatisfactory, and the

corporation has emerged as the most important organizational form.

A possible disadvantage of the corporation is tax related. Corporate profits are subject

to double taxation. The company pays tax on the income it earns, and the stockholder is

also taxed when he or she receives income in the form of a cash dividend. (We will take a

2 The Business, Tax, and Financial Environments

Limited partner

Member of a limited

partnership not

personally liable

for the debts of

the partnership.

General partner

Member of a

partnership with

unlimited liability for

the debts of the

partnership.

Corporation A

business form

legally separate

from its owners.

Its distinguishing

features include

limited liability, easy

transfer of ownership,

unlimited life, and an

ability to raise large

sums of capital.

Double taxation

Taxation of the same

income twice. A

classic example is

taxation of income at

the corporate level

and again as dividend

income when received

by the shareholder.

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

closer look at taxes in the next section.2) Minor disadvantages include the length of time to

incorporate and the red tape involved, as well as the incorporation fee that must be paid to

the state in which the firm is incorporated. Thus, a corporation is more difficult to establish

than either a proprietorship or a partnership.

l l l Limited Liability Companies (LLCs)

A limited liability company (LLC) is a hybrid form of business organization that combines

the best aspects of both a corporation and a partnership. It provides its owners (called

“members”) with corporate-style limited personal liability and the federal-tax treatment of a

partnership.3 Especially well suited for small and medium-sized firms, it has fewer restrictions

and greater flexibility than an older hybrid business form – the S corporation (which we discuss

in the section on taxes).

Until 1990 only two states, Wyoming and Florida, allowed the formation of LLCs. A 1988

Internal Revenue Service (IRS) ruling that any Wyoming LLC would be treated as a partnership

for federal-tax purposes opened the floodgates for the remaining states to start enacting

LLC statutes. Though new to the United States, LLCs have been a long-accepted form of business

organization in Europe and Latin America.

Limited liability companies generally possess no more than two of the following four

(desirable) standard corporate characteristics: (1) limited liability, (2) centralized management,

(3) unlimited life, and (4) the ability to transfer ownership interest without prior

consent of the other owners. LLCs (by definition) have limited liability. Thus members are

not personally liable for any debts that may be incurred by the LLC. Most LLCs choose to

maintain some type of centralized management structure. One drawback to an LLC, however,

is that it generally lacks the corporate feature of “unlimited life,” although most states do

allow an LLC to continue if a member’s ownership interest is transferred or terminated.

Another drawback is that complete transfer of an ownership interest is usually subject to the

approval of at least a majority of the other LLC members.

Although the LLC structure is applicable to most businesses, service-providing professionals

in many states who want to form an LLC must resort to a parallel structure. In those

states, accountants, lawyers, doctors, and other professionals are allowed to form a professional

LLC (PLLC) or limited liability partnership (LLP), a PLLC look-alike. One indication of

the popularity of the PLLC/LLP structure among professionals can be found in the fact that

all of the “Big Four” accounting firms in the United States are LLPs.

The Tax Environment

Most business decisions are affected either directly or indirectly by taxes. Through their

taxing power, federal, state, and local governments have a profound influence on the behavior

of businesses and their owners. What might prove to be an outstanding business decision

in the absence of taxes may prove to be very inferior with taxes (and sometimes, vice

versa). In this section we introduce you to some of the fundamentals of taxation. A basic

understanding of this material will be needed for later chapters when we consider specific

financial decisions.

We begin with the corporate income tax. Then we briefly consider personal income taxes.

We must be mindful that tax laws frequently change.

2An S corporation, named for a subchapter of the Internal Revenue Code, is a special type of corporate structure open

only to qualifying “small corporations.” Since its reason for being is entirely tax motivated, we defer its discussion

until the section on taxes.

3Many states permit single-member LLCs. Qualified single-member LLCs are taxed as sole proprietorships.

Part 1 Introduction to Financial Management

Limited liability

company (LLC) A

business form that

provides its owners

(called “members”)

with corporate-style

limited personal

liability and the

federal-tax treatment

of a partnership.

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

l l l Corporate Income Taxes

A corporation’s taxable income is found by deducting all allowable expenses, including depreciation

and interest, from revenues. This taxable income is then subjected to the following

graduated tax structure:

CORPORATE TAXABLE INCOME

AT LEAST BUT LESS THAN TAX RATE (%) TAX CALCULATION

$ 0 $ 50,000 15 0.15 × (income over $0)

50,000 75,000 25 $ 7,500 + 0.25 × (income over 50,000)

75,000 100,000 34 13,750 + 0.34 × (income over 75,000)

100,000 335,000 39a 22,250 + 0.39 × (income over 100,000)

335,000 10,000,000 34 113,900 + 0.34 × (income over 335,000)

10,000,000 15,000,000 35 3,400,000 + 0.35 × (income over 10,000,000)

15,000,000 18,333,333 38b 5,150,000 + 0.38 × (income over 15,000,000)

18,333,333 – 35 6,416,667 + 0.35 × (income over 18,333,333)

aBetween $100,000 and $335,000 there is a built-in surtax of 5 percent over the 34 percent rate. This results

in corporations with taxable income between $335,000 and $10,000,000 “effectively” paying a flat 34 percent

rate on all of their taxable income.

bBetween $15,000,000 and $18,333,333 there is a built-in surtax of 3 percent over the 35 percent rate. This

results in corporations with taxable income over $18,333,333 “effectively” paying a flat 35 percent rate on all

of their taxable income.

The tax rate – the percentage of taxable income that must be paid in taxes – that is applied to

each income bracket is referred to as a marginal rate. For example, each additional dollar of

taxable income above $50,000 is taxed at the marginal rate of 25 percent until taxable income

reaches $75,000. At that point, the new marginal rate becomes 34 percent. The average tax rate

for a firm is measured by dividing taxes actually paid by taxable income. For example, a firm

with $100,000 of taxable income pays $22,250 in taxes, and therefore has an average tax rate

of $22,250/$100,000, or 22.25 percent. For small firms (i.e., firms with less than $335,000

of taxable income), the distinction between the average and marginal tax rates may prove

important. However, the average and marginal rates converge at 34 percent for firms with

taxable income between $335,000 and $10 million and, finally, converge again, this time to the

35 percent rate, for firms with taxable income above $18,333,333.

Alternative Minimum Tax. Companies dislike paying taxes and will take advantage of all

the deductions and credits that the law allows. Therefore, the Internal Revenue Service has

devised a special tax to ensure that large firms that benefit from the tax laws pay at least a

minimum amount of tax. This special tax is called the alternative minimum tax (AMT). The

tax – 20 percent of alternative minimum taxable income (AMTI) – applies only when the AMT

would be greater than the firm’s normally computed tax. To broaden the base of taxable

income, AMTI is calculated by applying adjustments to items that had previously received

some tax preference.

Quarterly Tax Payments. Corporations of any significant size are required to make quarterly

tax payments. Specifically, calendar-year corporations are required to pay 25 percent of

their estimated taxes in any given year on or before April 15, June 15, September 15, and

December 15. When actual income differs from that which has been estimated, adjustments

are made. A company that is on a calendar-year basis of accounting must make final settlement

by March 15 of the subsequent year.

Depreciation. Depreciation is the systematic allocation of the cost of a capital asset over a

period of time for financial reporting purposes, tax purposes, or both. Depreciation deductions

taken on a firm’s tax return are treated as expense items. Thus depreciation lowers taxable

income. Everything else being equal, the greater the depreciation charges, the lower the

2 The Business, Tax, and Financial Environments

Depreciation The

systematic allocation

of the cost of a

capital asset over

a period of time for

financial reporting

purposes, tax

purposes, or both.

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

tax. There are a number of alternative procedures for depreciating capital assets, including

straight-line depreciation and various accelerated depreciation methods. The depreciation

methods chosen may differ for tax reporting versus financial reporting. Most firms with

taxable income prefer to use an accelerated depreciation method for tax reporting purposes –

one that allows for a more rapid write-off and, hence, a lower taxable income figure.

The Tax Reform Act of 1986 allows companies to use a particular type of accelerated depreciation

for tax purposes; it is known as the Modified Accelerated Cost Recovery System

(MACRS, pronounced “makers”).4 Under MACRS, machinery, equipment, and real estate are

assigned to one of eight classes for purposes of determining a prescribed life, called a cost

recovery period, and a depreciation method. The property class in which an asset falls determines

its cost recovery period or prescribed life for tax purposes – a life that may differ from

the asset’s useful or economic life. A general description of the property classes is provided in

Table 2.1. (The reader should refer to the Internal Revenue Code for more detail.)

To illustrate some of the various methods of depreciation, let’s first consider straight-line

depreciation. If the fully installed acquisition cost of a five-year property class asset is $10,000,

annual depreciation charges using straight-line depreciation would be $10,000/5, or $2,000.

(For tax purposes, expected salvage value does not affect depreciation charges.)

Declining-balance depreciation, on the other hand, calls for an annual charge that is a

“fixed percentage” of the asset’s net book value (acquisition cost minus accumulated depreciation)

at the beginning of the year to which the depreciation charge applies. For example, when

using the double-declining-balance (DDB) method, we compute a rate by dividing 1 by the

number of years of depreciable life for the asset. Then we double that rate. (Other decliningbalance

methods use other multiples.) Under the declining-balance methods the general

formula for determining the depreciation charge in any period is

m(1/n)NBV (2.1)

where m is the multiple, n is the depreciable life of the asset, and NBV is the asset’s net book

value at the start of the year. For a $10,000 asset, with a five-year life, the depreciation charge

in the first year using the DDB method would be

2(1/5)$10,000 = $4,000

4The term “Modified Accelerated Cost Recovery System” (MACRS) is used to distinguish the deductions computed under

post-1986 rules from deductions prescribed under pre-1987 rules of the Accelerated Cost Recovery System (ACRS).

Part 1 Introduction to Financial Management

Table 2.1

Property classes

under MACRS

l 3-Year 200% Class. Includes property with a midpoint life of 4 years or less, except automobiles

and light trucks. Under the Asset Depreciation Range (ADR) system, assets are grouped within

classes and a guideline (midpoint) life is determined by the Treasury Department.

l 5-Year 200% Class. Includes property with an ADR midpoint life of more than 4 to less than

10 years. Also included are automobiles, light trucks, most technological and semiconductor

manufacturing equipment, switching equipment, small power production facilities, research and

experimental equipment, high technology medical equipment, computers, and certain office

equipment.

l 7-Year 200% Class. Includes property with ADR midpoints of 10 to less than 16 years and singlepurpose

agricultural structures. Also includes office furniture and any other property for which no

class life is specified by law.

l 10-Year 200% Class. Includes property with ADR midpoints of 16 to less than 20 years.

l 15-Year 150% Class. Includes property with ADR midpoints of 20 to less than 25 years, sewage

treatment plants, and telephone distribution plants.

l 20-Year 150% Class. Includes property with ADR midpoints of 25 years or more, other than real

property described below.

l 27.5-Year Straight-Line Class. Includes residential rental property.

l 39-Year Straight-Line Class. Includes other real estate.

Declining-balance

depreciation Methods

of depreciation calling

for an annual charge

based on a fixed

percentage of the

asset’s depreciated

book value at the

beginning of the

year for which the

depreciation charge

applies.

Straight-line

depreciation

A method of

depreciation that

allocates expenses

evenly over the

depreciable life

of the asset.

Accelerated

depreciation Methods

of depreciation that

write off the cost of

a capital asset faster

than under straightline

depreciation.

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

For our example, 2(1/5) determines the “fixed percentage,” or 40 percent, that is applied

against the declining net book value each year. The depreciation charge in the second year is

based on the depreciated net book value of $6,000. We arrive at the $6,000 by subtracting the

first year’s depreciation charge, $4,000, from the asset’s original acquisition cost. The depreciation

charge in the second year would be

2(1/5)$6,000 = $2,400

The third year’s charge would be

2(1/5)$3,600 = $1,440

and so on.

Modified Accelerated Cost Recovery System. For the 3-, 5-, 7-, and 10-year property

classes, the double declining balance (also called 200% declining balance) depreciation

method is used. This method then switches to straight-line depreciation for the remaining

undepreciated book value in the first year that the straight-line method yields an equal or

greater deduction than the declining-balance method. Assets in the 15- and 20-year classes are

depreciated using the 150 percent declining balance method, again switching to straight-line

at the optimal time. The straight-line method must be used for all real estate.

Normally, the half-year convention must be applied to all declining-balance methods. This

calls for a half year of depreciation in the year an asset is acquired, regardless of the date of

purchase. There is also a half year of depreciation in the year an asset is sold or retired from

service. If property is held for longer than its recovery period, a half year of depreciation is

allowed for the year following the end of the recovery period. Thus 5-year property class assets

held for 6 years or longer have depreciation spread over 6 years.

To illustrate for the 5-year 200 percent property class, assume that an asset costing $10,000

is acquired in February. For our example, the declining-balance formula yields 2(1/5) = 40%

as the fixed percentage annual depreciation. However, in the first year the half-year convention

is employed, so first-year depreciation is 20 percent, or $2,000. In the fourth year it

is favorable to switch to straight-line depreciation. Thus the depreciation schedule is as

follows:

DEPRECIATION DEPRECIATION NET BOOK VALUE

YEAR CALCULATION CHARGE (end of year)

0 – – $10,000

1 (0.2)$10,000 $2,000 8,000

2 (0.4)$8,000 3,200 4,800

3 (0.4)$4,800 1,920 2,880

4 $2,880/2.5 years 1,152 1,728

5 $2,880/2.5 years 1,152 576

6 (0.5)$2,880/2.5 years 576 0

At the beginning of the fourth year, the net book value at the end of the third year is divided

by the remaining life to get straight-line depreciation. The remaining life is 2.5 years, owing

to the half-year convention in the sixth year. Finally, in the sixth year the remaining balance

is $576, or one-half the yearly straight-line amount.

Take Note

Instead of making such calculations (which as you can see can be quite a chore), one can use

depreciation percentages of original cost for each property class (see Table 2.1) published by

the Treasury. The first four property categories are seen in the following table.

2 The Business, Tax, and Financial Environments

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

PROPERTY CLASS

RECOVERY YEAR 3-YEAR 5-YEAR 7-YEAR 10-YEAR

1 33.33% 20.00% 14.29% 10.00%

2 44.45 32.00 24.49 18.00

3 14.81 19.20 17.49 14.40

4 7.41 11.52 12.49 11.52

5 11.52 8.93 9.22

6 5.76 8.92 7.37

7 8.93 6.55

8 4.46 6.55

9 6.56

10 6.55

11 3.28

Totals 100.00% 100.00% 100.00% 100.00%

These percentages correspond to the principles on which our previous calculations are based,

and they are used for determining depreciation deductions.

“Temporary” Tax Relief Provision(s). In May 2008 President Bush signed an economicstimulus

bill – Economic Stimulus Act (ESA) of 2008 – into law. The Act has a number of provisions

that are supposed to be only “temporary.” For students of finance, one provision is

especially important because it can dramatically affect a company’s federal tax payments and

capital budgeting decisions. The critical provision involves “bonus depreciation.”

Under the 2008 Act businesses are allowed to take an additional first-year depreciation

deduction, commonly known as “bonus depreciation,” equal to 50 percent of the original

“adjusted (depreciable) basis” – usually the fully installed cost – of qualified property.

Property eligible for this treatment includes property to which MACRS depreciation applies

with a recovery period of 20 years or less. Certain types of water utility property, software, and

leasehold improvements also qualify for bonus depreciation. Property must generally be purchased

and placed in service in 2008. The bonus depreciation is allowed for both the regular

tax and the alternative minimum tax (AMT).

In addition, the business is entitled to “normal” first-year depreciation. However, the

depreciable basis of the property and the regular depreciation allowances are adjusted to

reflect the additional first-year depreciation deduction. And, finally, a taxpayer may elect out

of the 50 percent bonus depreciation by asset class and be subject to “normal” tax depreciation

on the original “adjusted (depreciable) basis.”

EXAMPLE (with 50 percent bonus depreciation and assuming the half-year convention):

On September 8, 2008, a calendar-year reporting business, bought and placed in service,

a $100,000 five-year property class piece of equipment. The business may claim a firstyear

(2008) depreciation allowance of $60,000 – i.e., a $50,000 bonus depreciation

($100,000 times 50%) plus a $10,000 normal first-year MACRS depreciation calculated on

the new adjusted basis ([$100,000 minus $50,000] times 20%). In the second year (2009),

the MACRS depreciation would be $16,000 ([$100,000 minus $50,000] times 32%). And

so on.

In the above example, the “effective” depreciation percentage for the first year is a whopping

60 percent [($50,000 bonus depreciation plus $10,000 normal first-year depreciation)

divided by the $100,000 original adjusted basis]. In the second year, the “effective” depreciation

is 16 percent [$16,000 divided by $100,000]. And so on.

Part 1 Introduction to Financial Management

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

5For any dividend income to be tax exempt, however, the corporation must have owned the stock for at least 45 days.

If a corporation owns 20 percent or more of another corporation’s stock, however, 80 percent of any dividend

received is tax exempt. Also, if a corporation owns 80 percent or more of the stock of another firm, it can file a

consolidated tax return. In this way, any funds transferred between the two entities are generally not considered

dividends for tax purposes, and no tax is paid on such transfers.

6A corporation has the option, however, of forgoing the carryback and simply carrying the loss forward up to 20 years.

For example, a corporation might elect to forgo the loss carryback if it anticipated a significant increase in tax rates

in future years.

Take Note

Since the 50 percent “bonus depreciation” deduction is “temporary” and currently scheduled

to expire by the end of 2008, you will probably not have to make any Economic

Stimulus Act of 2008 “bonus depreciation” choices in a real job situation. Therefore, all our

examples and problems involving MACRS depreciation will ignore “bonus depreciation”

provisions.

It is important to note, however, that “temporary” bonus depreciation may very well

return again during your professional future – so be prepared. A little historical background

may help to convince you of that. Under the Job Creation and Worker Assistance Act of 2002

(JCWAA), businesses were allowed to take a 30 percent bonus depreciation on a “temporary”

basis. The following year the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA)

increased bonus depreciation from 30 to 50 percent also on a “temporary” basis (expiring at

the end of 2004). To learn more about JCWAA, visit web.utk.edu/~jwachowi/hr3090.html.

And, for more information on JGTRRA, see web.utk.edu/~jwachowi/hr2.html. And, finally,

for additional information on ESA, see web.utk.edu/~jwachowi/hr5140.html.

Interest Expense versus Dividends Paid. Interest paid on outstanding corporate debt is

treated as an expense and is tax deductible. However, dividends paid to preferred or common

stockholders are not tax deductible. Thus, for a profitable, tax-paying company, the use of

debt (e.g., bonds) in its financing mix results in a significant tax advantage relative to the use

of preferred or common stock. Given a marginal tax rate of 35 percent, a firm that pays out

$1 in interest lowers its tax bill by 35 cents because of its ability to deduct the $1 of interest

from taxable income. The after-tax cost of $1 of interest for this firm is really only 65 cents –

$1 × (1 − tax rate). On the other hand, the after-tax cost of $1 of dividends paid by the firm

is still $1 – there is no tax advantage here. Therefore there are tax advantages associated

with using debt financing that are simply not present with either preferred or common stock

financing.

Dividend Income. A corporation may own stock in another company. If it receives a

cash dividend on this stock, normally 70 percent of the dividend is tax exempt.5 The tax laws

allow this tax break for corporations (not individuals) to help reduce the effects of multiple

taxation of the same earnings. The remaining 30 percent is taxed at the corporate income

tax rate. A firm that receives $10,000 in dividend income pays taxes on only $3,000 of this

income. At a marginal tax rate of 35 percent, taxes would amount to $1,050, as opposed to

$3,500 if the entire dividend income were treated as taxable income.

Carryback and Carryforward. If a corporation sustains a net operating loss, this loss may

generally be carried back 2 years and forward up to 20 years to offset taxable income in those

years.6 Any loss carried back must first be applied to the earliest preceding year. If a firm sustained

an operating loss of $400,000 in 2008 it would first carry this loss back to 2006. If the

2 The Business, Tax, and Financial Environments

Cash dividend

Cash distribution

of earnings to

stockholders, usually

on a quarterly basis.

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

company had net profits of $400,000 in that year and paid taxes of $136,000, it would recompute

its taxes for 2006 to show zero profit for tax purposes. Consequently, the company would

be eligible for a tax refund of $136,000. If the 2008 operating loss was greater than operating

profits in 2006, the residual would be carried back to 2007 and taxes recomputed for that year.

However, if the net operating loss was greater than the net operating income in both years, the

residual would be carried forward in sequence to future profits in 2009 to 2028. Profits in each

of these years would be reduced for tax purposes by the amount of the unused loss carried

forward. This feature of the tax laws is designed to avoid penalizing companies that have

sharply fluctuating net operating income.

Capital Gains and Losses. When a capital asset (as defined by the Internal Revenue

Service) is sold, a capital gain or loss is generally incurred. Often in the history of our tax laws

there has been a differential tax treatment of capital gains income and operating income, with

capital gains being treated more favorably. Under the Revenue Reconciliation Act of 1993,

however, capital gains are taxed at the ordinary income tax rates for corporations, or a maximum

of 35 percent. Capital losses are deductible only against capital gains.

l l l Personal Income Taxes

The subject of personal taxes is extremely complex, but our main concern here is with the personal

taxes of individuals who own businesses – proprietors, partners, members (of LLCs),

and shareholders. Any income reported by a sole proprietorship, partnership, or properly

structured LLC becomes income of the owner(s) and is taxed at the personal rate. For individuals

there are currently six progressive tax brackets: 10, 15, 25, 28, 33, and 35 percent. The

marginal tax rates apply up to certain levels of taxable income, which vary depending on the

individual’s filing status – that is, single, married filing a joint return, married filing separately,

or head of household. Even within a filing category, however, the taxable income levels that

trigger the marginal tax rate will generally vary from year to year because they are indexed

to account for inflation. There are also standard deductions and personal exemptions that

enable those with very low income to pay no taxes.

Interest, Dividends, and Capital Gains. For the individual, interest received on corporate

and Treasury securities is fully taxable at the federal level. (Interest on Treasury securities

is not taxable at the state level.) However, interest received on most municipal securities is

exempt from federal taxation. Taxable interest is subject to the ordinary income tax rates. The

current maximum dividend and capital gains tax rates for most (but not all) cash dividends

received and realized net capital gains are both 15 percent for qualifying taxpayers.

Subchapter S. Subchapter S of the Internal Revenue Code allows the owners of small corporations

to elect to be taxed as an S corporation. In making this election, the company gets to

use the corporate organization form but is taxed as though the firm were a partnership. Thus

the owners are able to avail themselves of the legal advantages extended to corporations, but

are able to avoid any tax disadvantages that might result. They simply declare any corporate

profits as personal income on a pro rata basis and pay the appropriate tax on this income. This

treatment eliminates the double taxation normally associated with dividend income – that is,

the corporation paying dividends from after-tax income, and shareholders paying taxes on the

dividend income they receive. In addition, stockholders active in the business may deduct any

operating losses on a pro rata basis against their personal income.

As discussed earlier, a limited liability company (LLC) provides benefits similar to those

of an S corporation, but with fewer limitations (e.g., no restriction as to the number and type

of owners). Many predict that the LLC form of business will grow in numbers to surpass the

S corporation form.

Part 1 Introduction to Financial Management

Capital gain (loss)

The amount by which

the proceeds from the

sale of a capital asset

exceeds (is less than)

the asset’s original

cost.

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

The Financial Environment

In varying degrees, all businesses operate within the financial system, which consists of a

number of institutions and markets serving business firms, individuals, and governments.

When a firm invests temporarily idle funds in marketable securities, it has direct contact with

financial markets. More important, most firms use financial markets to help finance their

investment in assets. In the final analysis, the market price of a company’s securities is the

test of whether the company is a success or a failure. While business firms compete with each

other in the product markets, they must continually interact with the financial markets.

Because of the importance of this environment to the financial manager, as well as to the individual

as a consumer of financial services, this section is devoted to exploring the financial

system and the ever-changing environment in which capital is raised.

l l l The Purpose of Financial Markets

Financial assets exist in an economy because the savings of various individuals, corporations,

and governments during a period of time differ from their investment in real assets.

By real assets, we mean such things as houses, buildings, equipment, inventories, and durable

goods. If savings equaled investment in real assets for all economic units in an economy

over all periods of time, there would be no external financing, no financial assets, and no

money or capital markets. Each economic unit would be self-sufficient. Current expenditures

and investment in real assets would be paid for out of current income. A financial asset is

created only when the investment of an economic unit in real assets exceeds its savings,

and it finances this excess by borrowing or issuing stock. Of course, another economic unit

must be willing to lend. This interaction of borrowers with lenders determines interest

rates. In the economy as a whole, savings-surplus units (those whose savings exceed their

investment in real assets) provide funds to savings-deficit units (those whose investments

in real assets exceed their savings). This exchange of funds is evidenced by investment

instruments, or securities, representing financial assets to the holders and financial liabilities

to the issuers.

The purpose of financial markets in an economy is to allocate savings efficiently to ultimate

users. If those economic units that saved were the same as those that engaged in capital

formation, an economy could prosper without financial markets. In modern economies,

however, most nonfinancial corporations use more than their total savings for investing in

real assets. Most households, on the other hand, have total savings in excess of total investment.

Efficiency entails bringing the ultimate investor in real assets and the ultimate saver

together at the least possible cost and inconvenience.

l l l Financial Markets

Financial markets are not so much physical places as they are mechanisms for channeling

savings to the ultimate investors in real assets. Figure 2.1 illustrates the role of financial

markets and financial institutions in moving funds from the savings sector (savings-surplus

units) to the investment sector (savings-deficit units). From the figure we can also note the

prominent position held by certain financial institutions in channeling the flow of funds in

the economy. The secondary market, financial intermediaries, and financial brokers are the key

institutions that enhance funds flows. We will study their unique roles as this section unfolds.

Money and Capital Markets. Financial markets can be broken into two classes – the money

market and the capital market. The money market is concerned with the buying and

selling of short-term (less than one year original maturity) government and corporate debt

2 The Business, Tax, and Financial Environments

Financial markets

All institutions and

procedures for

bringing buyers and

sellers of financial

instruments together.

Money market The

market for short-term

(less than one year

original maturity)

government and

corporate debt

securities. It also

includes government

securities originally

issued with maturities

of more than one year

but that now have

a year or less until

maturity.

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

securities. The capital market, on the other hand, deals with relatively long-term (greater

than one year original maturity) debt and equity instruments (e.g., bonds and stocks).

This section gives special attention to the market for long-term securities – the capital

market. The money market and the securities that form its lifeblood are covered in Part 4

of this book.

Primary and Secondary Markets. Within money and capital markets there exist both

primary and secondary markets. A primary market is a “new issues” market. Here, funds

raised through the sale of new securities flow from the ultimate savers to the ultimate investors

in real assets. In a secondary market, existing securities are bought and sold. Transactions

in these already existing securities do not provide additional funds to finance capital investment.

(Note: On Figure 2.1 there is no line directly connecting the secondary market with the

investment sector.) An analogy can be made with the market for automobiles. The sale of

new cars provides cash to the auto manufacturers; the sale of used cars in the used-car market

does not. In a real sense, a secondary market is a “used-car lot” for securities.

The existence of used-car lots makes it easier for you to consider buying a new car because

you have a mechanism at hand to sell the car when you no longer want it. In a similar fashion,

Part 1 Introduction to Financial Management

Capital market The

market for relatively

long-term (greater

than one year original

maturity) financial

instruments (e.g.,

bonds and stocks).

Primary market

A market where new

securities are bought

and sold for the first

time (a “new issues”

market).

Secondary market

A market for existing

(used) securities

rather than new

issues.

Figure 2.1

Flow of funds in the

economy and the

mechanism that

financial markets

provide for channeling

savings to the

ultimate investors

in real assets

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

the existence of a secondary market encourages the purchase of new securities by individuals

and institutions. With a viable secondary market, a purchaser of financial securities

achieves marketability. If the buyer needs to sell a security in the future, he or she will be

able to do so. Thus, the existence of a strong secondary market enhances the efficiency of the

primary market.

l l l Financial Intermediaries

The flow of funds from savers to investors in real assets can be direct; if there are financial

intermediaries in an economy, the flow can also be indirect. Financial intermediaries consist

of financial institutions, such as commercial banks, savings institutions, insurance companies,

pension funds, finance companies, and mutual funds. These intermediaries come between

ultimate borrowers and lenders by transforming direct claims into indirect claims. Financial

intermediaries purchase direct (or primary) securities and, in turn, issue their own indirect

(or secondary) securities to the public. For example, the direct security that a savings and

loan association purchases is a mortgage; the indirect claim issued is a savings account or a

certificate of deposit. A life insurance company, on the other hand, purchases corporate

bonds, among other things, and issues life insurance policies.

Financial intermediation is the process of savers depositing funds with financial intermediaries

(rather than directly buying stocks and bonds) and letting the intermediaries do the

lending to the ultimate investors. We usually think of financial intermediation making the

markets more efficient by lowering the cost and/or inconvenience to consumers of financial

services.

Among the various financial intermediaries, some institutions invest much more heavily

in the securities of business firms than others. In what follows, we concentrate on those

institutions involved in buying and selling corporate securities.

Deposit Institutions. Commercial banks are the most important source of funds for business

firms in the aggregate. Banks acquire demand (checking) and time (savings) deposits from

individuals, companies, and governments and, in turn, make loans and investments. Among

the loans made to business firms are seasonal and other short-term loans, intermediate-term

loans of up to five years, and mortgage loans. Besides performing a banking function, commercial

banks affect business firms through their trust departments, which invest in corporate

bonds and stocks. They also make mortgage loans available to companies and manage pension

funds.

Other deposit institutions include savings and loan associations, mutual savings banks,

and credit unions. These institutions are primarily involved with individuals, acquiring their

savings and making home and consumer loans.

Insurance Companies. There are two types of insurance companies: property and casualty

companies and life insurance companies. These are in the business of collecting periodic

payments from those they insure in exchange for providing payouts should events, usually

adverse, occur. With the funds received in premium payments, insurance companies build

reserves. These reserves and a portion of the insurance companies’ capital are invested in

financial assets.

Property and casualty companies insure against fires, thefts, car accidents, and similar

unpleasantness. Because these companies pay taxes at the full corporate income tax rate, they

invest heavily in municipal bonds, which offer tax-exempt interest income. To a lesser extent

they also invest in corporate stocks and bonds.

Life insurance companies insure against the loss of life. Because the mortality of a large

group of individuals is highly predictable, these companies are able to invest in long-term

securities. Also, the income of these institutions is partially exempt from taxes owing to the

buildup of reserves over time. They therefore seek taxable investments with yields higher

2 The Business, Tax, and Financial Environments

Financial

intermediaries

Financial institutions

that accept money

from savers and use

those funds to make

loans and other

financial investments

in their own name.

They include

commercial banks,

savings institutions,

insurance companies,

pension funds,

finance companies,

and mutual funds.

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

than those of tax-exempt municipal bonds. As a result, life insurance companies invest

heavily in corporate bonds. Also important are mortgages, some of which are granted to

business firms.

Other Financial Intermediaries. Pension funds and other retirement funds are established

to provide income to individuals when they retire. During their working lives, employees

usually contribute to these funds, as do employers. Funds invest these contributions and

either pay out the cumulative amounts periodically to retired workers or arrange annuities.

In the accumulation phase, monies paid into a fund are not taxed. When the benefits are paid

out in retirement, taxes are paid by the recipient. Commercial banks, through their trust

departments, and insurance companies offer pension funds, as do the federal government,

local governments, and certain other noninsurance organizations. Because of the long-term

nature of their liabilities, pension funds are able to invest in longer-term securities. As a result,

they invest heavily in corporate stocks and bonds. In fact, pension funds are the largest single

institutional investors in corporate stocks.

Mutual investment funds also invest heavily in corporate stocks and bonds. These funds

accept monies contributed by individuals and invest them in specific types of financial assets.

The mutual fund is connected with a management company, to which the fund pays a fee

(frequently 0.5 percent of total assets per annum) for professional investment management.

Each individual owns a specified percentage of the mutual fund, which depends on that

person’s original investment. Individuals can sell their shares at any time, as the mutual

fund is required to redeem them. Though many mutual funds invest only in common stocks,

others specialize in corporate bonds; in money market instruments, including commercial

paper issued by corporations; or in municipal securities. Various stock funds have different

investment philosophies, ranging from investing for income and safety to a highly aggressive

pursuit of growth. In all cases, the individual obtains a diversified portfolio managed by professionals.

Unfortunately, there is no evidence that such management results in consistently

superior performance.

Finance companies make consumer installment loans, personal loans, and secured loans to

business enterprises. These companies raise capital through stock issues as well as through

borrowings, some of which are long term but most of which come from commercial banks.

In turn, the finance company makes loans.

l l l Financial Brokers

Certain financial institutions perform a necessary brokerage function. When brokers bring

together parties who need funds with those who have savings, they are not performing a direct

lending function but rather are acting as matchmakers, or middlemen.

Investment bankers are middlemen involved in the sale of corporate stocks and bonds.

When a company decides to raise funds, an investment banker will often buy the issue (at

wholesale) and then turn around and sell it to investors (at retail). Because investment

bankers are continually in the business of matching users of funds with suppliers, they can sell

issues more efficiently than can the issuing companies. For this service investment bankers

receive fees in the form of the difference between the amounts received from the sale of the

securities to the public and the amounts paid to the companies. Much more will be said about

the role of investment bankers in Part 7, when we consider long-term financing.

Mortgage bankers are involved in acquiring and placing mortgages. These mortgages

come either directly from individuals and businesses or, more typically, through builders

and real estate agents. In turn, the mortgage banker locates institutional and other investors

for the mortgages. Although mortgage bankers do not typically hold mortgages in their

own portfolios for very long, they usually service mortgages for the ultimate investors. This

involves receiving payments and following through on delinquencies. For this service they

receive fees.

Part 1 Introduction to Financial Management

Investment banker

A financial institution

that underwrites

(purchases at a fixed

price on a fixed date)

new securities for

resale.

Mortgage banker

A financial institution

that originates (buys)

mortgages primarily

for resale.

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

l l l The Secondary Market

Various security exchanges and markets facilitate the smooth functioning of the financial

system. Purchases and sales of existing financial assets occur in the secondary market.

Transactions in this market do not increase the total amount of financial assets outstanding,

but the presence of a viable secondary market increases the liquidity of financial assets and

therefore enhances the primary or direct market for securities. In this regard, organized

exchanges, such as the New York Stock Exchange, the American Stock Exchange, and the

New York Bond Exchange, provide a means by which buy and sell orders can be efficiently

matched. In this matching, the forces of supply and demand determine price.

In addition, the over-the-counter (OTC) market serves as part of the secondary market for

stocks and bonds not listed on an exchange as well as for certain listed securities. It is composed

of brokers and dealers who stand ready to buy and sell securities at quoted prices. Most

corporate bonds, and a growing number of stocks, are traded OTC as opposed to being traded

on an organized exchange. The OTC market has become highly mechanized, with market

participants linked together by a telecommunications network. They do not come together in

a single place as they would on an organized exchange. The National Association of Securities

Dealers Automated Quotation Service (NASDAQ, pronounced “nas-dac”) maintains this

network, and price quotations are instantaneous. Whereas once it was considered a matter

of prestige, as well as a necessity in many cases, for a company to list its shares on a major

exchange, the electronic age has changed that. Many companies now prefer to have their

shares traded OTC, despite the fact that they qualify for listing, because they feel that they get

as good or sometimes better execution of buy and sell orders.

Although there are a number of other financial institutions, we have looked only at those

interacting with business firms. As the book continues, we will become better acquainted with

many of those discussed. Our purpose here was only to introduce you briefly to them; further

explanation will come later.

2 The Business, Tax, and Financial Environments

QWhat are OTC-issued stocks?

AOTC officially stands for “over the counter,” but

“over the computer” is more apt today. Long ago, to

buy or sell a stock that didn’t trade on an exchange, you

would call your broker. He would call another broker

and make the trade over the phone – not a terribly

efficient system. Then, in 1971, Nasdaq was established,

offering an automated system. Suddenly, it was much

easier to get the best price on your transaction, and

trading activity could be monitored.

Stocks that are listed on exchanges are traded face to

face at one location, in “pits.” All others are OTC stocks,

traded electronically via a network of dealers across the

country. The Nasdaq market is the main OTC system in

the US, listing over 5,500 companies. It encompasses

a range of firms, from young, relatively unknown

enterprises to behemoths such as Microsoft and Intel.

Thousands of more obscure OTC companies that don’t

meet Nasdaq’s requirements trade separately, often with

their prices listed only once daily, on “pink sheets.” Little

information is often available about these companies,

and they’re frequently penny stocks, shunned by Fools.

Ask the Fool

The Motley Fool, at www.fool.com, is the world’s premier online investment

education site. Its mission is “To educate, amuse and enrich.” Co-founder brothers

David and Tom Gardner have written several best-selling books, and the Fool

also has a weekly nationally syndicated newspaper feature (running in more

than 150 papers) and radio show (airing in more than 100 regions).

From time to time, The Motley Fool will be sharing some questions they’ve

answered in their newspaper feature or at their website. Here’s one now . . .

Source: The Motley Fool (www.fool.com). Reproduced with the permission of The Motley Fool.

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

l l l Allocation of Funds and Interest Rates

The allocation of funds in an economy occurs primarily on the basis of price, expressed in

terms of expected return. Economic units in need of funds must outbid others for their use.

Although the allocation process is affected by capital rationing, government restrictions,

and institutional constraints, expected return constitutes the primary mechanism by which

supply and demand are brought into balance for a particular financial instrument across

financial markets. If risk is held constant, economic units willing to pay the highest expected

return are the ones entitled to the use of funds. If people are rational, the economic units

bidding the highest prices will have the most promising investment opportunities. As a result,

savings will tend to be allocated to the most efficient uses.

It is important to recognize that the process by which savings are allocated in an economy

occurs not only on the basis of expected return but on the basis of risk as well. Different financial

instruments have different degrees of risk. In order for them to compete for funds, these

instruments must provide different expected returns, or yields. Figure 2.2 illustrates the idea

of the market-imposed “trade-off ” between risk and return for securities – that is, the higher

the risk of a security, the higher the expected return that must be offered to the investor. If all

securities had exactly the same risk characteristics, they would provide the same expected

returns if markets were in balance. Because of differences in default risk, marketability,

maturity, taxability, and embedded options, however, different instruments pose different

degrees of risk and provide different expected returns to the investor.

Default Risk. When we speak of default risk, we mean the danger that the borrower may

not meet payments due on principal or interest. Investors demand a risk premium (or extra

expected return) to invest in securities that are not default free. The greater the possibility

that the borrower will default, the greater the default risk and the premium demanded by the

marketplace. Because Treasury securities are usually regarded as default free, risk and return

are judged in relation to them. The greater the default risk of a security issuer, the greater the

expected return or yield of the security, all other things the same.7

For the typical investor, default risk is not judged directly but rather in terms of quality

ratings assigned by the principal rating agencies, Moody’s Investors Service and Standard &

7For an extended discussion of the influence of default risk on yields, as well as a review of the various empirical

studies, see Van Horne, Financial Market Rates and Flows, Chapter 8. This book also presents a detailed examination

of the other major security attributes that affect expected return.

Part 1 Introduction to Financial Management

Default The failure

to meet the terms

of a contract, such

as failure to make

interest or principal

payments when due

on a loan.

Figure 2.2

Risk–expected return

profile for securities

showing the greater

the risk of a given

security, the higher

the expected return

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

Poor’s. These investment agencies assign and publish letter grades for the use of investors.

In their ratings, the agencies attempt to rank issues in order of the perceived probability

of default. The ratings used by the two agencies are shown in Table 2.2. The highest-grade

securities, judged to have negligible default risk, are rated triple-A.

Credit ratings in the top four categories (for Moody’s, Aaa to Baa; for Standard and Poor’s,

AAA to BBB) are considered “investment grade quality.” This term is used by regulatory

agencies to identify securities that are eligible for investment by financial institutions such as

commercial banks and insurance companies. Securities rated below the top four categories

are referred to as “speculative grade.” Because of the limited institutional demand for these

securities and their higher default risk, they must offer considerably higher expected returns

than investment-grade securities.

Marketability. The marketability (or liquidity) of a security relates to the owner’s ability to

convert it into cash. There are two dimensions to marketability: the price realized and the

amount of time required to sell the asset. The two are interrelated in that it is often possible

to sell an asset in a short period if enough price concession is given. For financial instruments,

marketability is judged in relation to the ability to sell a significant volume of securities in a

short period of time without significant price concession. The more marketable the security,

the greater the ability to execute a large transaction near the quoted price. In general, the

lower the marketability of a security, the greater the yield necessary to attract investors. Thus

the yield differential between different securities of the same maturity is caused not by differences

in default risk alone, but also by differences in marketability.

Maturity. Securities with about the same default risk, having similar marketability, and not

faced with different tax implications can still trade at different yields. Why? “Time” is the

answer. The maturity of a security can often have a powerful effect on expected return, or

yield. The relationship between yield and maturity for securities differing only in the length of

time (or term) to maturity is called the term structure of interest rates. The graphical representation

of this relationship at a moment in time is called a yield curve. An example of the

yield-maturity relationship for default-free Treasury securities on a particular date is shown

in Figure 2.3. Maturity is plotted on the horizontal axis and yield on the vertical. What results

is a line, or yield curve, fitted to the observations.

The most commonly observed yield pattern is the positive (i.e., upward-sloping) yield curve

– where short-term yields are lower than long-term yields. Most economists attribute the

tendency for positive yield curves to the presence of risk for those who invest in long-term

securities as opposed to short-term securities. In general, the longer the maturity, the greater

2 The Business, Tax, and Financial Environments

Marketability

(or liquidity) The

ability to sell a

significant volume of

securities in a short

period of time in the

secondary market

without significant

price concession.

Maturity The life of a

security; the amount

of time before the

principal amount of a

security becomes due.

Term structure of

interest rates The

relationship between

yield and maturity for

securities differing

only in the length of

time (or term) to

maturity.

Yield curve A graph

of the relationship

between yields and

term to maturity for

particular securities.

Table 2.2

Ratings by investment

agencies

MOODY’S INVESTORS SERVICE STANDARD & POOR’S

Aaa Best quality AAA Highest grade

Aa High quality AA High grade

A Upper medium grade A Higher medium grade

Baa Medium grade BBB Medium grade

Ba Possess speculative elements BB Speculative

B Generally lack characteristics of B Very speculative

desirable investment

Caa Poor standing; may be in default CCC–CC Outright speculation

Ca Highly speculative; often in default C Bankruptcy petition filed

C Lowest grade D In payment default

Note: The top four categories indicate “investment grade quality” securities; the categories below the

dashed line are reserved for securities below investment grade.

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

the risk of fluctuation in the market value of the security. Consequently, investors need to be

offered risk premiums to induce them to invest in long-term securities. Only when interest

rates are expected to fall significantly are they willing to invest in long-term securities yielding

less than short- and intermediate-term securities.

Taxability. Another factor affecting the observed differences in market yields is the differential

impact of taxes. The most important tax, and the only one that we will consider here, is

income tax. The interest income on all but one category of securities is taxable to taxable

investors. Interest income from state and local government securities is tax exempt. Therefore

state and local issues sell in the market at lower yields to maturity than Treasury and corporate

securities of the same maturity. For corporations located in states with income taxes,

interest income on Treasury securities is exempt from state income taxes. Therefore such

instruments may hold an advantage over the debt instruments issued by corporations or

banks because the interest they pay is fully taxable at the state level. Under present law,

capital gains arising from the sale of any security at a profit are taxed at the ordinary tax rates

for corporations, or at a maximum of 35 percent.

Option Features. Another consideration is whether a security contains any option features,

such as a conversion privilege or warrants, which upon exercise allow the investor to obtain

common stock. Other options include the call feature, which enables a company to prepay its

debt, and a sinking-fund provision, which allows a company to retire bonds periodically with

cash payments or by buying bonds in the secondary market. If the investors receive options,

the issuing company should be able to borrow at a lower interest cost. Conversely, if the

issuing company receives an option, such as a call feature, the investors must be compensated

with a higher yield. The valuation principles behind options are complex. Chapter 22 covers

these principles in detail.

Inflation. In addition to the preceding factors, which affect the yield of one security relative

to that of another, inflation expectations have a substantial influence on interest rates overall.

It is generally agreed that the nominal (observed) rate of interest on a security embodies a

premium for inflation. The higher the expected inflation, the higher the nominal yield on the

security; and the lower the expected inflation, the lower the nominal yield. Many years ago

Irving Fisher expressed the nominal rate of interest on a bond as the sum of the real rate of

interest (i.e., the interest rate in the absence of price level changes) and the rate of price change

expected to occur over the life of the instrument.8 If the annual real rate of interest in the

8Appreciation and Interest (New York: Macmillan, 1896).

Part 1 Introduction to Financial Management

Figure 2.3

Example of Treasury

positive yield curve

Inflation A rise in

the average level of

prices of goods and

services.

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

2 The Business, Tax, and Financial Environments

economy was 4 percent for low-risk securities and inflation of 6 percent per annum was

expected over the next 10 years, this would imply a yield of 10 percent for 10-year, high-grade

bonds. (Note: It is the expected rate of inflation, not the observed or reported rate of inflation,

that is added to the real rate of interest.) This states merely that lenders require a nominal rate

of interest high enough for them to earn the real rate of interest after being compensated for

the expected decrease in the buying power of money caused by inflation.

Behavior of Yields on Corporate Securities. Differences in default risk, marketability,

maturity, taxability, and option features affect the yield of one security relative to another

at a point in time. In addition, the security yields themselves (and hence the cost of funds to

business firms) will vary over time. Fluctuations in supply and demand pressures in financial

markets, as well as changing inflation expectations, help explain this variability in yields.

Key Learning Points

l The four basic forms of business organization are

the sole proprietorship, the partnership, the corporation,

and the limited liability company (LLC).

l The corporation has emerged as the most important

organizational form owing to certain advantages

that it has over the other organizational forms. These

advantages include limited liability, easy transfer of

ownership, unlimited life, and an ability to raise large

sums of capital.

l Most firms with taxable income prefer to use an

accelerated depreciation method for tax reporting

purposes in order to lower their taxes. A firm that

is profitable for financial reporting purposes may, in

fact, show losses for tax purposes.

l Interest paid by corporations is considered a taxdeductible

expense; however, dividends paid are not

tax deductible.

l Financial assets (securities) exist in an economy

because an economic unit’s investment in real assets

(such as buildings and equipment) frequently differs

from its savings. In the economy as a whole, savingssurplus

units (those whose savings exceed their investment

in real assets) provide funds to savings-deficit

units (those whose investments in real assets exceed

their savings). This exchange of funds is evidenced

by investment instruments, or securities, representing

financial assets to the holders and financial liabilities

to the issuers.

l The purpose of financial markets in an economy is to

allocate savings efficiently to ultimate users.

l Financial intermediaries help make the financial

markets more efficient. Intermediaries come between

ultimate borrowers and lenders by transforming

direct claims into indirect claims. Financial intermediaries

purchase direct (or primary) securities and, in

turn, issue their own indirect (or secondary) securities

to the public.

l Financial brokers, such as investment bankers and

mortgage bankers, bring together parties who need

funds with those who have savings. These brokers are

not performing a direct lending function but rather

are acting as matchmakers, or middlemen.

l Financial markets can be broken into two classes – the

money market and the capital market. The money

market is concerned with the buying and selling of

short-term government and corporate debt securities.

The capital market deals with relatively long-term

debt and equity instruments.

l Within the money and capital markets there exist both

primary and secondary markets. A primary market is a

“new issues” market, and a secondary market is a “used

issues” market.

l The secondary market for long-term securities, comprising

the organized exchanges and the OTC market,

increases the liquidity (marketability) of financial

assets, and therefore enhances the primary market for

long-term securities.

l The allocation of savings in an economy occurs

primarily on the basis of expected return and risk.

l Differences in default risk, marketability, maturity,

taxability, and option features affect the yield of

one security relative to another at a point in time.

Fluctuations in supply and demand pressures in

financial markets, as well as changing inflation

expectations, help explain variability in yields over

time.

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

Questions

1. What is the principal advantage of the corporate form of business organization? Discuss

the importance of this advantage to the owner of a small family restaurant. Discuss the

importance of this advantage to a wealthy entrepreneur who owns several businesses.

2. How does being a limited partner in a business enterprise differ from being a stockholder,

assuming the same percentage of ownership?

3. What are some of the disadvantages of (a) a sole proprietorship? (b) a partnership? (c) a

limited liability company (LLC)?

4. What kind of corporation benefits from the graduated income tax?

5. In general, what are the principles on which the Modified Accelerated Cost Recovery

System (MACRS) is based?

6. Interest on Treasury securities is not taxable at the state level, whereas interest on

municipal securities is not taxable at the federal level. What is the reason for this feature?

7. Are individual tax rates progressive or regressive in the sense of increasing or decreasing

with income levels?

8. If capital gains were to be taxed at a lower rate than ordinary income, as has been the case

in the past, what types of investments would be favored?

9. The method of depreciation does not alter the total amount deducted from income

during the life of an asset. What does it alter and why is that important?

10. If the owners of a new corporation are very few in number, does becoming an S corporation

make sense for tax purposes? Explain.

11. Tax laws have become extremely complex. In addition, there is little theoretical or moral

justification for a substantial number of tax incentives (loopholes). Why and how are

these incentives created? In your opinion, is there any indication that these incentives will

be eliminated?

12. What is the purpose of the carryback and the carryforward provisions in the tax laws?

13. What is the purpose of financial markets? How can this purpose be accomplished

efficiently?

14. Discuss the functions of financial intermediaries.

15. A number of factors give rise to different interest rates or yields being observed for different

types of debt instruments. What are these factors?

16. What is meant by making the financial markets more efficient? More complete?

17. What is the purpose of stock market exchanges such as the New York Stock Exchange?

18. In general, what would be the likely effect of the following occurrences on the money and

capital markets?

a. The savings rate of individuals in the country declines.

b. Individuals increase their savings at savings and loan associations and decrease their

savings at banks.

c. The government taxes capital gains at the ordinary income tax rate.

d. Unanticipated inflation of substantial magnitude occurs, and price levels rise

rapidly.

e. Savings institutions and lenders increase transaction charges for savings and for

making loans.

19. Pick a financial intermediary with which you are familiar and explain its economic role.

Does it make the financial markets more efficient?

20. What is the distinction between the money market and the capital market? Is the distinction

real or artificial?

21. How do transaction costs affect the flow of funds and the efficiency of financial markets?

22. What are the major sources of external financing for business firms?

23. In addition to financial intermediaries, what other institutions and arrangements

facilitate the flow of funds to and from business firms?

Part 1 Introduction to Financial Management

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

2 The Business, Tax, and Financial Environments

Self-Correction Problems

1. John Henry has a small housecleaning business that currently is a sole proprietorship. The

business has nine employees, annual sales of $480,000, total liabilities of $90,000, and total

assets of $263,000. Including the business, Henry has a personal net worth of $467,000 and

nonbusiness liabilities of $42,000, represented by a mortgage on his home. He would like

to give one of his employees, Tori Kobayashi, an equity interest in the business. Henry is

considering either the partnership form or the corporate form, where Kobayashi would be

given some stock. Kobayashi has a personal net worth of $36,000.

a. What is the extent of Henry’s exposure under the sole proprietorship in the case of a

large lawsuit (say, $600,000)?

b. What is his exposure under a partnership form? Do the partners share the risk?

c. What is his exposure under the corporate form?

2. Bernstein Tractor Company has just invested in new equipment costing $16,000. The

equipment falls in the five-year property class for cost recovery (depreciation) purposes.

What depreciation charges can it claim on the asset for each of the next six years?

3. Wallopalooza Financial, Inc., believes that it can successfully “intermediate” in the

mortgage market. At present, borrowers pay 7 percent on adjustable rate mortgages. The

deposit interest rate necessary to attract funds to lend is 3 percent, also adjustable with

market conditions. Wallopalooza’s administrative expenses, including information costs,

are $2 million per annum on a base business of $100 million in loans.

a. What interest rates on mortgage loans and on deposits would you recommend to

obtain business?

b. If $100 million in loans and an equal amount of deposits are attracted with a mortgage

rate of 6.5 percent and a deposit interest rate of 3.5 percent, what would be

Wallopalooza’s annual before-tax profit on the new business? (Assume that interest

rates do not change.)

4. Suppose that 91-day Treasury bills currently yield 6 percent to maturity and that 25-year

Treasury bonds yield 7.25 percent. Lopez Pharmaceutical Company recently has issued

long-term, 25-year bonds that yield 9 percent to maturity.

a. If the yield on Treasury bills is taken to be the short-term, risk-free rate, what premium

in yield is required for the default risk and lower marketability associated with the

Lopez bonds?

b. What premium in yield above the short-term, risk-free rate is attributable to maturity?

Problems

1. Zaharias-Liras Wholesalers, a partnership, owes $418,000 to various shipping companies.

Armand Zaharias has a personal net worth of $1,346,000, including a $140,000 equity

interest in the partnership. Nick Liras has a personal net worth of $893,000, including

the same equity interest in the business as his partner. The partners have kept only a

moderate equity base of $280,000 in the business, with earnings being taken out as partner

withdrawals. They wish to limit their risk exposure and are considering the corporate

form.

a. What is their liability now for the business? What would it be under the corporate form?

b. Will creditors be more or less willing to extend credit with a change in organization

form?

2. The Loann Le Milling Company is going to purchase a new piece of testing equipment for

$28,000 and a new machine for $53,000. The equipment falls in the three-year property

class, and the machine is in the five-year class. What annual depreciation will the company

be able to take on the two assets?

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

3. Tripex Consolidated Industries owns $1.5 million in 12 percent bonds of Solow

Electronics Company. It also owns 100,000 shares of preferred stock of Solow, which

constitutes 10 percent of all outstanding Solow preferred shares. In the past year, Solow

paid the stipulated interest on its bonds and dividends of $3 per share on its preferred

stock. The marginal tax rate of Tripex is 34 percent. What taxes must Tripex pay on this

interest and dividend income?

4. The Castle Cork Company was founded in 20X1 and had the following taxable income

through 20X5:

20X1 20X2 20X3 20X4 20X5

$0 $35,000 $68,000 −$120,000 $52,000

Compute the corporate income tax or tax refund in each year, assuming the graduated tax

rates discussed in the chapter.

5. Loquat Foods Company is able to borrow at an interest rate of 9 percent for one year. For

the year, market participants expect 4 percent inflation.

a. What approximate real rate of return does the lender expect? What is the inflation

premium embodied in the nominal interest rate?

b. If inflation proves to be 2 percent for the year, does the lender suffer? Does the borrower

suffer? Why?

c. If inflation proves to be 6 percent, who gains and who loses?

6. From a recent Monday Wall Street Journal, collect yield information on yields for a longterm

Treasury bond, a public utility bond (probably AA in quality), municipal bonds

as described by the municipal bond index, Treasury bills, and commercial paper. (This

information appears at the back of the paper under the Bond Market section, the Money

Market Rates section, and the Treasury Issues section.) What reasons can you give for the

differences in yield on these various instruments?

Solutions to Self-Correction Problems

1. a. Henry is responsible for all liabilities, book as well as contingent. If the lawsuit were lost,

he would lose all his net assets, as represented by a net worth of $467,000. Without the

lawsuit, he still is responsible for $90,000 in liabilities if for some reason the business is

unable to pay them.

b. He still could lose all his net assets because Kobayashi’s net worth is insufficient to make

a major dent in the lawsuit: $600,000 − $36,000 = $564,000. As the two partners have

substantially different net worths, they do not share equally in the risk. Henry has much

more to lose.

c. Under the corporate form, he could lose the business, but that is all. The net worth of

the business is $263,000 − $90,000 = $173,000, and this represents Henry’s personal

financial stake in the business. The remainder of his net worth, $467,000 − $173,000 =

$294,000, would be protected under the corporate form.

2. Depreciation charges for the equipment:

YEAR PERCENT AMOUNT

1 20.00% $ 3,200.00

2 32.00 5,120.00

3 19.20 3,072.00

4 11.52 1,843.20

5 11.52 1,843.20

6 5.76 921.60

Total $16,000.00

Part 1 Introduction to Financial Management

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

2 The Business, Tax, and Financial Environments

3. a. At $2 million in expenses per $100 million in loans, administrative costs come to 2 percent.

Therefore, just to break even, the firm must set rates so that (at least) a 2 percent

difference exists between the deposit interest rate and the mortgage rate. In addition,

market conditions dictate that 3 percent is the floor for the deposit rate, and 7 percent

is the ceiling for the mortgage rate. Suppose that Wallopalooza wished to increase the

current deposit rate and lower the current mortgage rate by equal amounts while

earning a before-tax return spread of 1 percent. It would then offer a deposit rate of

3.5 percent and a mortgage rate of 6.5 percent. Of course, other answers are possible,

depending on your profit assumptions.

b. Before-tax profit of 1 percent on $100 million in loans equals $1 million.

4. a. The premium attributable to default risk and to lower marketability is 9% − 7.25% =

1.75%.

b. The premium attributable to maturity is 7.25% − 6% = 1.25%. In this case, default risk

is held constant, and marketability, for the most part, is also held constant.

Selected References

Fabozzi, Frank J., and Franco Modigliani. Capital Markets:

Institutions and Instruments, 2nd ed. Upper Saddle River,

NJ: Prentice Hall, 1995.

Fleischman, Gary M., and Jeffrey J. Bryant. “C Corporation,

LLC, or Sole Proprietorship: What Form is Best for Your

Business?” Management Accounting Quarterly 1 (Spring

2000), 14–21.

Kidwell, David S., David Blackwell, David Whidbee, and

Richard Peterson. Financial Institutions, Markets, and

Money, 9th ed. Hoboken, NJ: Wiley, 2006.

Rose, Peter, and Milton Marquis. Money and Capital

Markets: Financial Institutions in a Global Marketplace,

9th ed. New York: McGraw-Hill/Irwin, 2006.

Van Horne, James C. “Of Financial Innovations and

Excesses,” Journal of Finance 40 (July 1985).

——. Financial Market Rates and Flows, 6th ed. Upper

Saddle River, NJ: Prentice Hall, 2001.

Part I of the text’s website, Wachowicz’s Web World,

contains links to many finance websites and online

articles related to topics covered in this chapter.

(web.utk.edu/~jwachowi/wacho_world.html)

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

41 Part 2

Valuation

Contents

l The Interest Rate

l Simple Interest

l Compound Interest

Single Amounts • Annuities • Mixed Flows

l Compounding More Than Once a Year

Semiannual and Other Compounding Periods •

Continuous Compounding • Effective Annual

Interest Rate

l Amortizing a Loan

l Summary Table of Key Compound Interest

Formulas

l Key Learning Points

l Questions

l Self-Correction Problems

l Problems

l Solutions to Self-Correction Problems

l Selected References

Objectives

After studying Chapter 3, you should be able to:

l Understand what is meant by “the time value of

money.”

l Understand the relationship between present

and future value.

l Describe how the interest rate can be used to

adjust the value of cash flows – both forward and

backward – to a single point in time.

l Calculate both the future and present value of:

(a) an amount invested today; (b) a stream of

equal cash flows (an annuity); and (c) a stream

of mixed cash flows.

l Distinguish between an “ordinary annuity” and

an “annuity due.”

l Use interest factor tables and understand how

they provide a shortcut to calculating present

and future values.

l Use interest factor tables to find an unknown

interest rate or growth rate when the number of

time periods and future and present values are

known.

l Build an “amortization schedule” for an

installment-style loan.

The Time Value of Money

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

The Interest Rate

Which would you prefer – $1,000 today or $1,000 ten years from today? Common sense tells

us to take the $1,000 today because we recognize that there is a time value to money. The

immediate receipt of $1,000 provides us with the opportunity to put our money to work and

earn interest. In a world in which all cash flows are certain, the rate of interest can be used to

express the time value of money. As we will soon discover, the rate of interest will allow us to

adjust the value of cash flows, whenever they occur, to a particular point in time. Given this

ability, we will be able to answer more difficult questions, such as: which should you prefer –

$1,000 today or $2,000 ten years from today? To answer this question, it will be necessary to

position time-adjusted cash flows at a single point in time so that a fair comparison can be made.

If we allow for uncertainty surrounding cash flows to enter into our analysis, it will be

necessary to add a risk premium to the interest rate as compensation for uncertainty. In

later chapters we will study how to deal with uncertainty (risk). But for now, our focus is on

the time value of money and the ways in which the rate of interest can be used to adjust the

value of cash flows to a single point in time.

Most financial decisions, personal as well as business, involve time value of money considerations.

In Chapter 1, we learned that the objective of management should be to maximize

shareholder wealth, and that this depends, in part, on the timing of cash flows. Not surprisingly,

one important application of the concepts stressed in this chapter will be to value a

stream of cash flows. Indeed, much of the development of this book depends on your understanding

of this chapter. You will never really understand finance until you understand the

time value of money. Although the discussion that follows cannot avoid being mathematical

in nature, we focus on only a handful of formulas so that you can more easily grasp the

fundamentals. We start with a discussion of simple interest and use this as a springboard to

develop the concept of compound interest. Also, to observe more easily the effect of compound

interest, most of the examples in this chapter assume an 8 percent annual interest rate.

Take Note

Before we begin, it is important to sound a few notes of caution. The examples in the chapter

frequently involve numbers that must be raised to the nth power – for example, (1.05) to

the third power equals (1.05)3 equals [(1.05) × (1.05) × (1.05)]. However, this operation is

easy to do with a calculator, and tables are provided in which this calculation has already

been done for you. Although the tables provided are a useful aid, you cannot rely on them

for solving every problem. Not every interest rate or time period can possibly be represented

in each table. Therefore you will need to become familiar with the operational formulas on

which the tables are based. (As a reminder, the appropriate formula is included at the top of

every table.) Those of you possessing a business calculator may feel the urge to bypass both

the tables and formulas and head straight for the various function keys designed to deal with

time value of money problems. However, we urge you to master first the logic behind the

procedures outlined in this chapter. Even the best of calculators cannot overcome a faulty

sequence of steps programmed in by the user.

Part 2 Valuation

Interest Money paid

(earned) for the use

of money.

The chief value of money lies in the fact that one lives in a world in

which it is overestimated.

—H. L. MENCKEN

A Mencken Chrestomathy

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

Simple Interest

Simple interest is interest that is paid (earned) on only the original amount, or principal,

borrowed (lent). The dollar amount of simple interest is a function of three variables: the

original amount borrowed (lent), or principal; the interest rate per time period; and the number

of time periods for which the principal is borrowed (lent). The formula for calculating

simple interest is

SI = P0(i )(n) (3.1)

where SI = simple interest in dollars

P0 = principal, or original amount borrowed (lent) at time period 0

i = interest rate per time period

n = number of time periods

For example, assume that you deposit $100 in a savings account paying 8 percent simple

interest and keep it there for 10 years. At the end of 10 years, the amount of interest accumulated

is determined as follows:

$80 = $100(0.08)(10)

To solve for the future value (also known as the terminal value) of the account at the end

of 10 years (FV10), we add the interest earned on the principal only to the original amount

invested. Therefore

FV10 = $100 + [$100(0.08)(10)] = $180

For any simple interest rate, the future value of an account at the end of n periods is

FVn = P0 + SI = P0 + P0(i )(n)

or, equivalently,

FVn = P0[1 + (i )(n)] (3.2)

Sometimes we need to proceed in the opposite direction. That is, we know the future value

of a deposit at i percent for n years, but we don’t know the principal originally invested –

the account’s present value (PV0 = P0). A rearrangement of Eq. (3.2), however, is all that

is needed.

PV0 = P0 = FVn /[1 + (i )(n)] (3.3)

Now that you are familiar with the mechanics of simple interest, it is perhaps a bit cruel

to point out that most situations in finance involving the time value of money do not rely

on simple interest at all. Instead, compound interest is the norm; however, an understanding

of simple interest will help you appreciate (and understand) compound interest all the

more.

Compound Interest

The distinction between simple and compound interest can best be seen by example. Table 3.1

illustrates the rather dramatic effect that compound interest has on an investment’s value over

time when compared with the effect of simple interest. From the table it is clear to see why

some people have called compound interest the greatest of human inventions.

The notion of compound interest is crucial to understanding the mathematics of finance.

The term itself merely implies that interest paid (earned) on a loan (an investment) is

3 The Time Value of Money

Simple interest

Interest paid (earned)

on only the original

amount, or principal,

borrowed (lent).

Future value

(terminal value) The

value at some future

time of a present

amount of money, or

a series of payments,

evaluated at a given

interest rate.

Present value The

current value of a

future amount of

money, or a series of

payments, evaluated

at a given interest

rate.

Compound interest

Interest paid (earned)

on any previous

interest earned, as

well as on the

principal borrowed

(lent).

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

periodically added to the principal. As a result, interest is earned on interest as well as the

initial principal. It is this interest-on-interest, or compounding, effect that accounts for the

dramatic difference between simple and compound interest. As we will see, the concept of

compound interest can be used to solve a wide variety of problems in finance.

l l l Single Amounts

Future (or Compound) Value. To begin with, consider a person who deposits $100 into a

savings account. If the interest rate is 8 percent, compounded annually, how much will the

$100 be worth at the end of a year? Setting up the problem, we solve for the future value

(which in this case is also referred to as the compound value) of the account at the end of the

year (FV1).

FV1 = P0(1 + i )

= $100(1.08) = $108

Interestingly, this first-year value is the same number that we would get if simple interest were

employed. But this is where the similarity ends.

What if we leave $100 on deposit for two years? The $100 initial deposit will have grown to

$108 at the end of the first year at 8 percent compound annual interest. Going to the end of

the second year, $108 becomes $116.64, as $8 in interest is earned on the initial $100, and

$0.64 is earned on the $8 in interest credited to our account at the end of the first year. In

other words, interest is earned on previously earned interest – hence the name compound

interest. Therefore, the future value at the end of the second year is

FV2 = FV1(1 + i ) = P0(1 + i )(1 + i ) = P0(1 + i )2

= $108(1.08) = $100(1.08)(1.08) = $100(1.08)2

= $116.64

At the end of three years, the account would be worth

FV3 = FV2(1 + i ) = FV1(1 + i )(1 + i ) = P0(1 + i )3

= $116.64(1.08) = $108(1.08)(1.08) = $100(1.08)3

= $125.97

In general, FVn, the future (compound) value of a deposit at the end of n periods, is

FVn = P0(1 + i )n (3.4)

FVn = P0(FVIFi,n) (3.5)

where we let FVIFi,n (i.e., the future value interest factor at i% for n periods) equal (1 + i)n.

Table 3.2, showing the future values for our example problem at the end of years 1 to 3 (and

beyond), illustrates the concept of interest being earned on interest.

A calculator makes Eq. (3.4) very simple to use. In addition, tables have been constructed

for values of (1 + i)n – FVIFi,n – for wide ranges of i and n. These tables, called (appropriately)

Part 2 Valuation

Table 3.1

Future value of $1

invested for various

time periods at an 8%

annual interest rate

YEARS AT SIMPLE INTEREST AT COMPOUND INTEREST

2 $ 1.16 $ 1.17

20 2.60 4.66

200 17.00 4,838,949.59

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

future value interest factor (or terminal value interest factor) tables, are designed to be used

with Eq. (3.5). Table 3.3 is one example covering various interest rates ranging from 1

to 15 percent. The Interest Rate (i) headings and Period (n) designations on the table are similar

to map coordinates. They help us locate the appropriate interest factor. For example,

the future value interest factor at 8 percent for nine years (FVIF8%,9) is located at the intersection

of the 8% column with the 9-period row and equals 1.999. This 1.999 figure means

that $1 invested at 8 percent compound interest for nine years will return roughly $2 – consisting

of initial principal plus accumulated interest. (For a more complete table, see Table I

in the Appendix at the end of this book.)

If we take the FVIFs for $1 in the 8% column and multiply them by $100, we get figures

(aside from some rounding) that correspond to our calculations for $100 in the final column

of Table 3.2. Notice, too, that in rows corresponding to two or more years, the proportional

increase in future value becomes greater as the interest rate rises. A picture may help make this

point a little clearer. Therefore, in Figure 3.1 we graph the growth in future value for a $100

initial deposit with interest rates of 5, 10, and 15 percent. As can be seen from the graph, the

greater the interest rate, the steeper the growth curve by which future value increases. Also,

the greater the number of years during which compound interest can be earned, obviously the

greater the future value.

3 The Time Value of Money

Table 3.2

Illustration of

compound interest

with $100 initial

deposit and 8%

annual interest rate

Table 3.3

Future value interest

factor of $1 at i % at

the end of n periods

(FVIFi,n)

(FVIFi,n) = (1 + i )n

INTEREST RATE (i )

PERIOD (n) 1% 3% 5% 8% 10% 15%

1 1.010 1.030 1.050 1.080 1.100 1.150

2 1.020 1.061 1.102 1.166 1.210 1.322

3 1.030 1.093 1.158 1.260 1.331 1.521

4 1.041 1.126 1.216 1.360 1.464 1.749

5 1.051 1.159 1.276 1.469 1.611 2.011

6 1.062 1.194 1.340 1.587 1.772 2.313

7 1.072 1.230 1.407 1.714 1.949 2.660

8 1.083 1.267 1.477 1.851 2.144 3.059

9 1.094 1.305 1.551 1.999 2.358 3.518

10 1.105 1.344 1.629 2.159 2.594 4.046

25 1.282 2.094 3.386 6.848 10.835 32.919

50 1.645 4.384 11.467 46.902 117.391 1,083.657

INTEREST EARNED

BEGINNING DURING PERIOD ENDING

YEAR AMOUNT (8% of beginning amount) AMOUNT (FVn )

1 $100.00 $ 8.00 $108.00

2 108.00 8.64 116.64

3 116.64 9.33 125.97

4 125.97 10.08 136.05

5 136.05 10.88 146.93

6 146.93 11.76 158.69

7 158.69 12.69 171.38

8 171.38 13.71 185.09

9 185.09 14.81 199.90

10 199.90 15.99 215.89

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

Part 2 Valuation

Figure 3.1

Future values with

$100 initial deposit

and 5%, 10%, and

15% compound

annual interest rates

TIP•TIP

On a number of business professional (certification) exams you will be provided with interest

factor tables and be limited to using only basic, non-programmable, hand-held calculators.

So, for some of you, it makes added sense to get familiar with interest factor tables now.

Compound Growth. Although our concern so far has been with interest rates, it is important

to realize that the concept involved applies to compound growth of any sort – for example,

in gas prices, tuition fees, corporate earnings, or dividends. Suppose that a corporation’s most

recent dividend was $10 per share but that we expect this dividend to grow at a 10 percent

compound annual rate. For the next five years we would expect dividends to look as shown in

the table.

YEAR GROWTH FACTOR EXPECTED DIVIDEND/SHARE

1 (1.10)1 $11.00

2 (1.10)2 12.10

3 (1.10)3 13.31

4 (1.10)4 14.64

5 (1.10)5 16.11

Question In 1790 John Jacob Astor bought approximately an acre of land on the east side of

Manhattan Island for $58. Astor, who was considered a shrewd investor, made many

such purchases. How much would his descendants have in 2009, if instead of buying

the land, Astor had invested the $58 at 5 percent compound annual interest?

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

Answer In Table I, in the Appendix at the end of the book, we won’t find the FVIF of $1 in

219 years at 5 percent. But notice that we can find the FVIF of #1 in 50 years – 11.467 –

and the FVIF of $1 in 19 years – 2.527. So what, you might ask. Being a little creative,

we can express our problem as follows:1

FV219 = P0 × (1 + i)219

= P0 × (1 + i)50 × (1 + i)50 × (1 + i)50 × (1 + i)50 × (1 + i)19

= $58 × 11.467 × 11.467 × 11.467 × 11.467 × 2.527

= $58 × 43,692.26 = $2,534,151.08

Given the current price of land in New York City, Astor’s one-acre purchase seems

to have passed the test of time as a wise investment. It is also interesting to note that

with a little reasoning we can get quite a bit of mileage out of even a basic table.

Similarly, we can determine the future levels of other variables that are subject to compound

growth. This principle will prove especially important when we consider certain valuation

models for common stock, which we do in the next chapter.

Present (or Discounted) Value. We all realize that a dollar today is worth more than a

dollar to be received one, two, or three years from now. Calculating the present value of

future cash flows allows us to place all cash flows on a current footing so that comparisons

can be made in terms of today’s dollars.

An understanding of the present value concept should enable us to answer a question that

was posed at the very beginning of this chapter: which should you prefer – $1,000 today or

$2,000 ten years from today?2 Assume that both sums are completely certain and your opportunity

cost of funds is 8 percent per annum (i.e., you could borrow or lend at 8 percent). The

present worth of $1,000 received today is easy – it is worth $1,000. However, what is $2,000

received at the end of 10 years worth to you today? We might begin by asking what amount

(today) would grow to be $2,000 at the end of 10 years at 8 percent compound interest. This

amount is called the present value of $2,000 payable in 10 years, discounted at 8 percent.

In present value problems such as this, the interest rate is also known as the discount rate

(or capitalization rate).

Finding the present value (or discounting) is simply the reverse of compounding. Therefore,

let’s first retrieve Eq. (3.4):

FVn = P0(1 + i )n

Rearranging terms, we solve for present value:

PV0 = P0 = FVn /(1 + i )n

= FVn[1/(1 + i )n] (3.6)

Note that the term [1/(1 + i)n] is simply the reciprocal of the future value interest factor at i%

for n periods (FVIFi,n). This reciprocal has its own name – the present value interest factor at i%

for n periods (PVIFi,n ) – and allows us to rewrite Eq. (3.6) as

PV0 = FVn(PVIFi,n) (3.7)

A present value table containing PVIFs for a wide range of interest rates and time periods

relieves us of making the calculations implied by Eq. (3.6) every time we have a present value

problem to solve. Table 3.4 is an abbreviated version of one such table. (Table II in the

Appendix found at the end of the book is a more complete version.)

1We make use of one of the rules governing exponents. Specifically, Am+n = Am × An

2Alternatively, we could treat this as a future value problem. To do this, we would compare the future value of $1,000,

compounded at 8 percent annual interest for 10 years, to a future $2,000.

Discount rate

(capitalization rate)

Interest rate used to

convert future values

to present values.

3 The Time Value of Money

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

Part 2 Valuation

(PVIFi,n ) = 1/(1 + i )n

INTEREST RATE (i )

PERIOD (n) 1% 3% 5% 8% 10% 15%

1 0.990 0.971 0.952 0.926 0.909 0.870

2 0.980 0.943 0.907 0.857 0.826 0.756

3 0.971 0.915 0.864 0.794 0.751 0.658

4 0.961 0.888 0.823 0.735 0.683 0.572

5 0.951 0.863 0.784 0.681 0.621 0.497

6 0.942 0.837 0.746 0.630 0.564 0.432

7 0.933 0.813 0.711 0.583 0.513 0.376

8 0.923 0.789 0.677 0.540 0.467 0.327

9 0.914 0.766 0.645 0.500 0.424 0.284

10 0.905 0.744 0.614 0.463 0.386 0.247

Table 3.4

Present value interest

factor of $1 at i % for

n periods (PVIFi,n)

We can now make use of Eq. (3.7) and Table 3.4 to solve for the present value of $2,000 to

be received at the end of 10 years, discounted at 8 percent. In Table 3.4, the intersection of the

8% column with the 10-period row pinpoints PVIF8%,10 – 0.463. This tells us that $1 received

10 years from now is worth roughly 46 cents to us today. Armed with this information, we get

PV0 = FV10(PVIF8%,10)

= $2,000(0.463) = $926

Finally, if we compare this present value amount ($926) with the promise of $1,000 to be

received today, we should prefer to take the $1,000. In present value terms we would be

better off by $74 ($1,000 − $926).

Discounting future cash flows turns out to be very much like the process of handicapping.

That is, we put future cash flows at a mathematically determined disadvantage relative to current

dollars. For example, in the problem just addressed, every future dollar was handicapped

to such an extent that each was worth only about 46 cents. The greater the disadvantage

assigned to a future cash flow, the smaller the corresponding present value interest factor

(PVIF). Figure 3.2 illustrates how both time and discount rate combine to affect present value;

the present value of $100 received from 1 to 10 years in the future is graphed for discount rates

of 5, 10, and 15 percent. The graph shows that the present value of $100 decreases by a

decreasing rate the further in the future that it is to be received. The greater the interest rate,

of course, the lower the present value but also the more pronounced the curve. At a 15 percent

discount rate, $100 to be received 10 years hence is worth only $24.70 today – or roughly

25 cents on the (future) dollar.

Question How do you determine the future value (present value) of an investment over a time

span that contains a fractional period (e.g., 11/4 years)?

Answer Simple. All you do is alter the future value (present value) formula to include the

fraction in decimal form. Let’s say that you invest $1,000 in a savings account that

compounds annually at 6 percent and want to withdraw your savings in 15 months (i.e.,

1.25 years). Since FVn = P0(1 + i )n, you could withdraw the following amount 15 months

from now:

FV1.25 = $1,000(1 + 0.06)1.25 = $1,075.55

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

Unknown Interest (or Discount) Rate. Sometimes we are faced with a time-value-ofmoney

situation in which we know both the future and present values, as well as the

number of time periods involved. What is unknown, however, is the compound interest

rate (i ) implicit in the situation.

Let’s assume that, if you invest $1,000 today, you will receive $3,000 in exactly 8 years. The

compound interest (or discount) rate implicit in this situation can be found by rearranging

either a basic future value or present value equation. For example, making use of future value

Eq. (3.5), we have

FV8 = P0(FVIFi,8)

$3,000 = $1,000(FVIFi,8)

FVIFi,8 = $3,000/$1,000 = 3

Reading across the 8-period row in Table 3.3, we look for the future value interest factor

(FVIF) that comes closest to our calculated value of 3. In our table, that interest factor is 3.059

and is found in the 15% column. Because 3.059 is slightly larger than 3, we conclude that the

interest rate implicit in the example situation is actually slightly less than 15 percent.

For a more accurate answer, we simply recognize that FVIFi,8 can also be written as (1 + i )8,

and solve directly for i as follows:

(1 + i )8 = 3

(1 + i ) = 31/8 = 30.125 = 1.1472

i = 0.1472

(Note: Solving for i, we first have to raise both sides of the equation to the 1/8 or 0.125 power.

To raise “3” to the “0.125” power, we use the [yx] key on a handheld calculator – entering “3,”

pressing the [yx] key, entering “0.125,” and finally pressing the [=] key.)

3 The Time Value of Money

Figure 3.2

Present values with

$100 cash flow and

5%, 10%, and 15%

compound annual

interest rates

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

Unknown Number of Compounding (or Discounting) Periods. At times we may need to

know how long it will take for a dollar amount invested today to grow to a certain future value

given a particular compound rate of interest. For example, how long would it take for an

investment of $1,000 to grow to $1,900 if we invested it at a compound annual interest rate of

10 percent? Because we know both the investment’s future and present value, the number of

compounding (or discounting) periods (n) involved in this investment situation can be determined

by rearranging either a basic future value or present value equation. Using future value

Eq. (3.5), we get

FVn = P0(FVIF10%,n)

$1,900 = $1,000(FVIF10%,n)

FVIF10%,n = $1,900/$1,000 = 1.9

Reading down the 10% column in Table 3.3, we look for the future value interest factor

(FVIF) in that column that is closest to our calculated value. We find that 1.949 comes

closest to 1.9, and that this number corresponds to the 7-period row. Because 1.949 is a little

larger than 1.9, we conclude that there are slightly less than 7 annual compounding periods

implicit in the example situation.

For greater accuracy, simply rewrite FVIF10%,n as (1 + 0.10)n, and solve for n as follows:

(1 + 0.10)n = 1.9

n(ln 1.1) = ln 1.9

n = (ln 1.9)/(ln 1.1) = 6.73 years

To solve for n, which appeared in our rewritten equation as an exponent, we employed a

little trick. We took the natural logarithm (ln) of both sides of our equation. This allowed

us to solve explicitly for n. (Note: To divide (ln 1.9) by (ln 1.1), we use the [LN] key on a

handheld calculator as follows: enter “1.9”; press the [LN] key; then press the [÷] key; now

enter “1.1”; press the [LN] key one more time; and finally, press the [=] key.)

l l l Annuities

Ordinary Annuity. An annuity is a series of equal payments or receipts occurring over a

specified number of periods. In an ordinary annuity, payments or receipts occur at the end of

each period. Figure 3.3 shows the cash-flow sequence for an ordinary annuity on a time line.

Assume that Figure 3.3 represents your receiving $1,000 a year for three years. Now let’s

further assume that you deposit each annual receipt in a savings account earning 8 percent compound

annual interest. How much money will you have at the end of three years? Figure 3.4

provides the answer (the long way) – using only the tools that we have discussed so far.

Expressed algebraically, with FVAn defined as the future (compound) value of an annuity,

R the periodic receipt (or payment), and n the length of the annuity, the formula for FVAn is

FVAn = R(1 + i )n −1 + R(1 + i )n −2 + . . . + R(1 + i )1 + R(1 + i )0

= R[FVIFi,n −1 + FVIFi,n −2 + . . . + FVIFi,1 + FVIFi,0]

As you can see, FVAn is simply equal to the periodic receipt (R) times the “sum of the future

value interest factors at i percent for time periods 0 to n − 1.” Luckily, we have two shorthand

ways of stating this mathematically:

(3.8)

or equivalently,

FVAn = R(FVIFAi,n) (3.9)

where FVIFAi,n stands for the future value interest factor of an annuity at i% for n periods.

FVA R i R i i n

n t

= ( + ([( )n )

⎡

⎣ ⎢⎢

⎤

⎦ ⎥⎥

− = + −

= Σ

1 ) 1 1]/

Part 2 Valuation

Annuity A series of

equal payments or

receipts occurring

over a specified

number of periods.

In an ordinary annuity,

payments or receipts

occur at the end

of each period; in

an annuity due,

payments or receipts

occur at the beginning

of each period.

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

Bill Veeck once bought the Chicago White Sox baseball

team franchise for $10 million and then sold it 5 years

later for $20 million. In short, he doubled his money in

5 years. What compound rate of return did Veeck earn

on his investment?

A quick way to handle compound interest problems

involving doubling your money makes use of the “Rule

of 72.” This rule states that if the number of years, n, for

which an investment will be held is divided into the value

72, we will get the approximate interest rate, i, required

for the investment to double in value. In Veeck’s case,

the rule gives

72/n = i

72/5 = 14.4%

Alternatively, if Veeck had taken his initial investment

and placed it in a savings account earning 6 percent compound

interest, he would have had to wait approximately

12 years for his money to have doubled:

72/i = n

72/6 = 12 years

Indeed, for most interest rates we encounter, the

“Rule of 72” gives a good approximation of the interest

rate – or the number of years – required to double your

money. But the answer is not exact. For example, money

doubling in 5 years would have to earn at a 14.87 percent

compound annual rate [(1 + 0.1487)5 = 2]; the “Rule of

72” says 14.4 percent. Also, money invested at 6 percent

interest would actually require only 11.9 years to double

[(1 + 0.06)11.9 = 2]; the “Rule of 72” suggests 12.

However, for ballpark-close money-doubling approximations

that can be done in your head, the “Rule of 72”

comes in pretty handy.

Psst! Want to Double Your Money? The “Rule of 72” Tells You How

TIP•TIP

It is very helpful to begin solving time value of money problems by first drawing a time line

on which you position the relevant cash flows. The time line helps you focus on the problem

and reduces the chance for error. When we get to mixed cash flows, this will become

even more apparent.

3 The Time Value of Money

Figure 3.3

Time line showing the

cash-flow sequence

for an ordinary annuity

of $1,000 per year for

3 years

Figure 3.4

Time line for

calculating the future

(compound) value of

an (ordinary) annuity

[periodic receipt =

R = $1,000; i = 8%;

and n = 3 years]

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

An abbreviated listing of FVIFAs appears in Table 3.5. A more complete listing appears in

Table III in the Appendix at the end of this book.

Making use of Table 3.5 to solve the problem described in Figure 3.4, we get

FVA3 = $1,000(FVIFA8%,3)

= $1,000(3.246) = $3,246

This answer is identical to that shown in Figure 3.4. (Note: Use of a table rather than a formula

subjects us to some slight rounding error. Had we used Eq. (3.8), our answer would

have been 40 cents more. Therefore, when extreme accuracy is called for, use formulas rather

than tables.)

Return for the moment to Figure 3.3. Only now let’s assume the cash flows of $1,000 a year

for three years represent withdrawals from a savings account earning 8 percent compound

annual interest. How much money would you have to place in the account right now (time

period 0) such that you would end up with a zero balance after the last $1,000 withdrawal?

Figure 3.5 shows the long way to find the answer.

As can be seen from Figure 3.5, solving for the present value of an annuity boils down to

determining the sum of a series of individual present values. Therefore, we can write the

general formula for the present value of an (ordinary) annuity for n periods (PVAn) as

PVAn = R[1/(1 + i )1] + R[1/(1 + i )2] + . . . + R[1/(1 + i )n ]

= R[PVIFi,1 + PVIFi,2 + . . . + PVIFi,n]

Part 2 Valuation

Table 3.5

Future value interest

factor of an (ordinary)

annuity of $1 per

period at i % for n

periods (FVIFAi,n)

INTEREST RATE (i )

PERIOD (n) 1% 3% 5% 8% 10% 15%

1 1.000 1.000 1.000 1.000 1.000 1.000

2 2.010 2.030 2.050 2.080 2.100 2.150

3 3.030 3.091 3.153 3.246 3.310 3.473

4 4.060 4.184 4.310 4.506 4.641 4.993

5 5.101 5.309 5.526 5.867 6.105 6.742

6 6.152 6.468 6.802 7.336 7.716 8.754

7 7.214 7.662 8.142 8.923 9.487 11.067

8 8.286 8.892 9.549 10.637 11.436 13.727

9 9.369 10.159 11.027 12.488 13.579 16.786

10 10.462 11.464 12.578 14.487 15.937 20.304

(FVIFAi n i i i

n t

) = (1 + ) − = [(1 + ) − 1]/

= Σ

Figure 3.5

Time line for

calculating the

present (discounted)

value of an (ordinary)

annuity [periodic

receipt = R = $1,000;

i = 8%; and n = 3

years]

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

Notice that our formula reduces to PVAn being equal to the periodic receipt (R) times the

“sum of the present value interest factors at i percent for time periods 1 to n.” Mathematically,

this is equivalent to

(3.10)

and can be expressed even more simply as

PVAn = R(PVIFAi,n) (3.11)

where PVIFAi,n stands for the present value interest factor of an (ordinary) annuity at i percent

for n periods. Table IV in the Appendix at the end of this book holds PVIFAs for a wide range

of values for i and n, and Table 3.6 contains excerpts from it.

We can make use of Table 3.6 to solve for the present value of the $1,000 annuity for three

years at 8 percent shown in Figure 3.5. The PVIFA8%,3 is found from the table to be 2.577.

(Notice this figure is nothing more than the sum of the first three numbers under the 8%

column in Table 3.4, which gives PVIFs.) Employing Eq. (3.11), we get

PVA3 = $1,000(PVIFA8%,3)

= $1,000(2.577) = $2,577

Unknown Interest (or Discount) Rate. A rearrangement of the basic future value (present

value) of an annuity equation can be used to solve for the compound interest (discount) rate

implicit in an annuity if we know: (1) the annuity’s future (present) value, (2) the periodic

payment or receipt, and (3) the number of periods involved. Suppose that you need to have

at least $9,500 at the end of 8 years in order to send your parents on a luxury cruise. To accumulate

this sum, you have decided to deposit $1,000 at the end of each of the next 8 years in

a bank savings account. If the bank compounds interest annually, what minimum compound

annual interest rate must the bank offer for your savings plan to work?

To solve for the compound annual interest rate (i) implicit in this annuity problem, we

make use of future value of an annuity Eq. (3.9) as follows:

FVA8 = R(FVIFAi,8)

$9,500 = $1,000(FVIFAi,8)

FVIFAi,8 = $9,500/$1,000 = 9.5

Reading across the 8-period row in Table 3.5, we look for the future value interest factor of

an annuity (FVIFA) that comes closest to our calculated value of 9.5. In our table, that interest

factor is 9.549 and is found in the 5% column. Because 9.549 is slightly larger than 9.5, we

PVA R i R i i n

= /( + [( [ )n ]

⎡

⎣ ⎢⎢

⎤

⎦ ⎥⎥

= − +

= Σ

1 1 ) 1 1/(1 ])/

3 The Time Value of Money

Table 3.6

Present value interest

factor of an (ordinary)

annuity of $1 per

period at i % for n

periods (PVIFAi,n)

INTEREST RATE (i )

PERIOD (n) 1% 3% 5% 8% 10% 15%

1 0.990 0.971 0.952 0.926 0.909 0.870

2 1.970 1.913 1.859 1.783 1.736 1.626

3 2.941 2.829 2.723 2.577 2.487 2.283

4 3.902 3.717 3.546 3.312 3.170 2.855

5 4.853 4.580 4.329 3.993 3.791 3.352

6 5.795 5.417 5.076 4.623 4.355 3.784

7 6.728 6.230 5.786 5.206 4.868 4.160

8 7.652 7.020 6.463 5.747 5.335 4.487

9 8.566 7.786 7.108 6.247 5.759 4.772

10 9.471 8.530 7.722 6.710 6.145 5.019

(PVIFAi n i i i

) = 1/(1 + ) = (1 − [1/(1 + ) ])/

= Σ

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

conclude that the interest rate implicit in the example situation is actually slightly less than

5 percent. (For a more accurate answer, you would need to rely on trial-and-error testing of

different interest rates, interpolation, or a financial calculator.)

Unknown Periodic Payment (or Receipt). When dealing with annuities, one frequently

encounters situations in which either the future (or present) value of the annuity, the interest

rate, and the number of periodic payments (or receipts) are known. What needs to be determined,

however, is the size of each equal payment or receipt. In a business setting, we most

frequently encounter the need to determine periodic annuity payments in sinking fund (i.e.,

building up a fund through equal-dollar payments) and loan amortization (i.e., extinguishing

a loan through equal-dollar payments) problems.

Rearrangement of either the basic present or future value annuity equation is necessary to

solve for the periodic payment or receipt implicit in an annuity. Because we devote an entire

section at the end of this chapter to the important topic of loan amortization, we will illustrate

how to calculate the periodic payment with a sinking fund problem.

How much must one deposit each year end in a savings account earning 5 percent compound

annual interest to accumulate $10,000 at the end of 8 years? We compute the payment

(R) going into the savings account each year with the help of future value of an annuity

Eq. (3.9). In addition, we use Table 3.5 to find the value corresponding to FVIFA5%,8 and

proceed as follows:

FVA8 = R(FVIFA5%,8)

$10,000 = R(9.549)

R = $10,000/9.549 = $1,047.23

Therefore, by making eight year-end deposits of $1,047.23 each into a savings account earning

5 percent compound annual interest, we will build up a sum totaling $10,000 at the end

of 8 years.

Perpetuity. A perpetuity is an ordinary annuity whose payments or receipts continue forever.

The ability to determine the present value of this special type of annuity will be required

when we value perpetual bonds and preferred stock in the next chapter. A look back to PVAn

in Eq. (3.10) should help us to make short work of this type of task. Replacing n in Eq. (3.10)

with the value infinity (∞) gives us

PVA∞ = R[(1 − [1/(1 + i )∞])/i ] (3.12)

Because the bracketed term – [1/(1 + i)∞] – approaches zero, we can rewrite Eq. (3.12) as

PVA∞ = R[(1 − 0)/i ] = R(1/i )

or simply

PVA∞ = R/i (3.13)

Thus the present value of a perpetuity is simply the periodic receipt (payment) divided by

the interest rate per period. For example, if $100 is received each year forever and the interest

rate is 8 percent, the present value of this perpetuity is $1,250 (that is, $100/0.08).

Annuity Due. In contrast to an ordinary annuity, where payments or receipts occur at the

end of each period, an annuity due calls for a series of equal payments occurring at the beginning

of each period. Luckily, only a slight modification to the procedures already outlined for

the treatment of ordinary annuities will allow us to solve annuity due problems.

Figure 3.6 compares and contrasts the calculation for the future value of a $1,000 ordinary

annuity for three years at 8 percent (FVA3) with that of the future value of a $1,000 annuity

due for three years at 8 percent (FVAD3). Notice that the cash flows for the ordinary annuity

are perceived to occur at the end of periods 1, 2, and 3, and those for the annuity due are perceived

to occur at the beginning of periods 2, 3, and 4.

Part 2 Valuation

Perpetuity An ordinary

annuity whose

payments or receipts

continue forever.

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

Notice that the future value of the three-year annuity due is simply equal to the future

value of a comparable three-year ordinary annuity compounded for one more period. Thus

the future value of an annuity due at i percent for n periods (FVADn) is determined as

FVADn = R(FVIFAi,n)(1 + i ) (3.14)

Take Note

Whether a cash flow appears to occur at the beginning or end of a period often depends on

your perspective, however. (In a similar vein, is midnight the end of one day or the beginning

of the next?) Therefore, the real key to distinguishing between the future value of an

ordinary annuity and an annuity due is the point at which the future value is calculated. For

an ordinary annuity, future value is calculated as of the last cash flow. For an annuity due,

future value is calculated as of one period after the last cash flow.

The determination of the present value of an annuity due at i percent for n periods

(PVADn) is best understood by example. Figure 3.7 illustrates the calculations necessary to

determine both the present value of a $1,000 ordinary annuity at 8 percent for three years

(PVA3) and the present value of a $1,000 annuity due at 8 percent for three years (PVAD3).

As can be seen in Figure 3.7, the present value of a three-year annuity due is equal to the

present value of a two-year ordinary annuity plus one nondiscounted periodic receipt or

payment. This can be generalized as follows:

PVADn = R(PVIFAi,n−1) + R

= R(PVIFAi,n−1 + 1) (3.15)

3 The Time Value of Money

Figure 3.6

Time lines for

calculating the future

(compound) value of

an (ordinary) annuity

and an annuity due

[periodic receipt =

R = $1,000; i = 8%;

and n = 3 years]

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

Alternatively, we could view the present value of an annuity due as the present value of an

ordinary annuity that had been brought back one period too far. That is, we want the present

value one period later than the ordinary annuity approach provides. Therefore, we could calculate

the present value of an n-period annuity and then compound it one period forward.

The general formula for this approach to determining PVADn is

PVADn = (1 + i )(R)(PVIFAi,n) (3.16)

Figure 3.7 proves by example that both approaches to determining PVADn work equally well.

However, the use of Eq. (3.15) seems to be the more obvious approach. The time-line

approach taken in Figure 3.7 also helps us recognize the major differences between the present

value of an ordinary annuity and an annuity due.

Take Note

In solving for the present value of an ordinary annuity, we consider the cash flows as

occurring at the end of periods (in our Figure 3.7 example, the end of periods 1, 2, and 3)

and calculate the present value as of one period before the first cash flow. Determination

of the present value of an annuity due calls for us to consider the cash flows as occurring

at the beginning of periods (in our example, the beginning of periods 1, 2, and 3) and to

calculate the present value as of the first cash flow.

Part 2 Valuation

Figure 3.7

Time lines for

calculating the

present (discounted)

value of an (ordinary)

annuity and an

annuity due [periodic

receipt = R = $1,000;

i = 8%; and n = 3

years]

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

3 The Time Value of Money

Each year, on your birthday, you invest $2,000 in a tax-free retirement investment account. By age 65 you will have

accumulated:

COMPOUND ANNUAL STARTING AGE

INTEREST RATE (i) 21 31 41 51

6% $ 425,487 $222,870 $109,730 $46,552

8 773,011 344,634 146,212 54,304

10 1,437,810 542,048 196,694 63,544

12 2,716,460 863,326 266,668 74,560

From the table, it looks like the time to start saving is now!

The Magic of Compound Interest

l l l Mixed Flows

Many time value of money problems that we face involve neither a single cash flow nor a

single annuity. Instead, we may encounter a mixed (or uneven) pattern of cash flows.

Question Assume that you are faced with the following problem – on an exam (arghh!),

perhaps. What is the present value of $5,000 to be received annually at the end of

years 1 and 2, followed by $6,000 annually at the end of years 3 and 4, and concluding

with a final payment of $1,000 at the end of year 5, all discounted at 5 percent?

The first step in solving the question above, or any similar problem, is to draw a time

line, position the cash flows, and draw arrows indicating the direction and position to which

you are going to adjust the flows. Second, make the necessary calculations as indicated by

your diagram. (You may think that drawing a picture of what needs to be done is somewhat

“childlike.” However, consider that most successful home builders work from blueprints –

why shouldn’t you?)

Figure 3.8 illustrates that mixed flow problems can always be solved by adjusting each flow

individually and then summing the results. This is time-consuming, but it works.

Often we can recognize certain patterns within mixed cash flows that allow us to take some

calculation shortcuts. Thus the problem that we have been working on could be solved in a

number of alternative ways. One such alternative is shown in Figure 3.9. Notice how our twostep

procedure continues to lead us to the correct solution:

Take Note

l Step 1: Draw a time line, position cash flows, and draw arrows to indicate direction and

position of adjustments.

l Step 2: Perform calculations as indicated by your diagram.

A wide variety of mixed (uneven) cash-flow problems could be illustrated. To appreciate

this variety and to master the skills necessary to determine solutions, be sure to do the problems

at the end of this chapter. Don’t be too bothered if you make some mistakes at first. Time

value of money problems can be tricky. Mastering this material is a little bit like learning to

ride a bicycle. You expect to fall and get bruised a bit until you pick up the necessary skills.

But practice makes perfect.

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

Part 2 Valuation

Figure 3.8

(Alternative 1) Time

line for calculating

the present

(discounted) value

of mixed cash flows

[FV1 = FV2 = $5,000;

FV3 = FV4 = $6,000;

FV5 = $1,000; i = 5%;

and n = 5 years]

Figure 3.9

(Alternative 2) Time

line for calculating

the present

(discounted) value

of mixed cash flows

[FV1 = FV2 = $5,000;

FV3 = FV4 = $6,000;

FV5 = $1,000; i = 5%;

and n = 5 years]

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

Compounding More Than Once a Year

l l l Semiannual and Other Compounding Periods

Future (or Compound) Value. Up to now, we have assumed that interest is paid annually.

It is easiest to get a basic understanding of the time value of money with this assumption.

Now, however, it is time to consider the relationship between future value and interest rates

for different compounding periods. To begin, suppose that interest is paid semiannually. If

you then deposit $100 in a savings account at a nominal, or stated, 8 percent annual interest

rate, the future value at the end of six months would be

FV0.5 = $100(1 + [0.08/2]) = $104

In other words, at the end of one half-year you would receive 4 percent in interest, not 8 percent.

At the end of a year the future value of the deposit would be

FV1 = $100(1 + [0.08/2])2 = $108.16

This amount compares with $108 if interest is paid only once a year. The $0.16 difference

is caused by interest being earned in the second six months on the $4 in interest paid at the

end of the first six months. The more times during the year that interest is paid, the greater

the future value at the end of a given year.

The general formula for solving for the future value at the end of n years where interest is

paid m times a year is

FVn = PV0(1 + [i /m])mn (3.17)

To illustrate, suppose that now interest is paid quarterly and that you wish to know the future

value of $100 at the end of one year where the stated annual rate is 8 percent. The future value

would be

FV1 = $100(1 + [0.08/4])(4)(1)

= $100(1 + 0.02)4 = $108.24

which, of course, is higher than it would be with either semiannual or annual compounding.

The future value at the end of three years for the example with quarterly compounding

FV3 = $100(1 + [0.08/4])(4)(3)

= $100(1 + 0.02)12 = $126.82

compared with a future value with semiannual compounding of

FV3 = $100(1 + [0.08/2])(2)(3)

= $100(1 + 0.04)6 = $126.53

and with annual compounding of

FV3 = $100(1 + [0.08/1])(1)(3)

= $100(1 + 0.08)3 = $125.97

Thus, the more frequently interest is paid each year, the greater the future value. When m in

Eq. (3.17) approaches infinity, we achieve continuous compounding. Shortly, we will take a

special look at continuous compounding and discounting.

Present (or Discounted) Value. When interest is compounded more than once a year, the

formula for calculating present value must be revised along the same lines as for the calculation

of future value. Instead of dividing the future cash flow by (1 + i)n as we do when annual

compounding is involved, we determine the present value by

3 The Time Value of Money

Nominal (stated)

interest rate

A rate of interest

quoted for a year

that has not been

adjusted for frequency

of compounding.

If interest is

compounded more

than once a year,

the effective interest

rate will be higher

than the nominal rate.

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

PV0 = FVn /(1 + [i /m])mn (3.18)

where, as before, FVn is the future cash flow to be received at the end of year n, m is the number

of times a year interest is compounded, and i is the discount rate. We can use Eq. (3.18),

for example, to calculate the present value of $100 to be received at the end of year 3 for a

nominal discount rate of 8 percent compounded quarterly:

PV0 = $100/(1 + [0.08/4])(4)(3)

= $100/(1 + 0.02)12 = $78.85

If the discount rate is compounded only annually, we have

PV0 = $100/(1 + 0.08)3 = $79.38

Thus, the fewer times a year that the nominal discount rate is compounded, the greater the

present value. This relationship is just the opposite of that for future values.

l l l Continuous Compounding

In practice, interest is sometimes compounded continuously. Therefore it is useful to consider

how this works. Recall that the general formula for solving for the future value at the end of

year n, Eq. (3.17), is

FVn = PV0(1 + [i /m])mn

As m, the number of times a year that interest is compounded, approaches infinity (∞), we get

continuous compounding, and the term (1 + [i/m])mn approaches ein, where e is approximately

2.71828. Therefore the future value at the end of n years of an initial deposit of PV0

where interest is compounded continuously at a rate of i percent is

FVn = PV0(e)in (3.19)

For our earlier example problem, the future value of a $100 deposit at the end of three years

with continuous compounding at 8 percent would be

FV3 = $100(e)(0.08)(3)

= $100(2.71828)(0.24) = $127.12

This compares with a future value with annual compounding of

FV3 = $100(1 + 0.08)3 = $125.97

Continuous compounding results in the maximum possible future value at the end of n

periods for a given nominal rate of interest.

By the same token, when interest is compounded continuously, the formula for the present

value of a cash flow received at the end of year n is

PV0 = FVn /(e)in (3.20)

Thus the present value of $1,000 to be received at the end of 10 years with a discount rate of

20 percent, compounded continuously, is

PV0 = $1,000/(e)(0.20)(10)

= $1,000/(2.71828)2 = $135.34

We see then that present value calculations involving continuous compounding are

merely the reciprocals of future value calculations. Also, although continuous compounding

results in the maximum possible future value, it results in the minimum possible present

value.

Part 2 Valuation

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

3The “special case” formula for effective annual interest rate when there is continuous compounding is as follows:

effective annual interest rate = (e)i − 1

Effective annual

interest rate The

actual rate of interest

earned (paid) after

adjusting the nominal

rate for factors such

as the number of

compounding periods

per year.

Question When a bank quotes you an annual percentage yield (APY) on a savings account or

certificate of deposit, what does that mean?

Answer Based on a congressional act, the Federal Reserve requires that banks and thrifts adopt

a standardized method of calculating the effective interest rates they pay on consumer

accounts. It is called the annual percentage yield (APY). The APY is meant to eliminate

confusion caused when savings institutions apply different methods of compounding

and use various terms, such as effective yield, annual yield, and effective rate. The APY is

similar to the effective annual interest rate. The APY calculation, however, is based on

the actual number of days for which the money is deposited in an account in a 365-day

year (366 days in a leap year).

In a similar vein, the Truth-in-Lending Act mandates that all financial institutions

report the effective interest rate on any loan. This rate is called the annual percentage

rate (APR). However, the financial institutions are not required to report the “true”

effective annual interest rate as the APR. Instead, they may report a noncompounded

version of the effective annual interest rate. For example, assume that a bank makes a

loan for less than a year, or interest is to be compounded more frequently than annually.

The bank would determine an effective periodic interest rate – based on usable funds (i.e.,

the amount of funds the borrower can actually use) – and then simply multiply this rate

by the number of such periods in a year. The result is the APR.

l l l Effective Annual Interest Rate

Different investments may provide returns based on various compounding periods. If we want

to compare alternative investments that have different compounding periods, we need to state

their interest on some common, or standardized, basis. This leads us to make a distinction

between nominal, or stated, interest and the effective annual interest rate. The effective

annual interest rate is the interest rate compounded annually that provides the same annual

interest as the nominal rate does when compounded m times per year.

By definition then,

(1 + effective annual interest rate) = (1 + [i /m])(m)(1)

Therefore, given the nominal rate i and the number of compounding periods per year m, we

can solve for the effective annual interest rate as follows:3

effective annual interest rate = (1 + [i /m])m − 1 (3.21)

For example, if a savings plan offered a nominal interest rate of 8 percent compounded

quarterly on a one-year investment, the effective annual interest rate would be

(1 + [0.08/4])4 − 1 = (1 + 0.02)4 − 1 = 0.08243

Only if interest had been compounded annually would the effective annual interest rate have

equaled the nominal rate of 8 percent.

Table 3.7 contains a number of future values at the end of one year for $1,000 earning a

nominal rate of 8 percent for several different compounding periods. The table illustrates

that the more numerous the compounding periods, the greater the future value of (and

interest earned on) the deposit, and the greater the effective annual interest rate.

3 The Time Value of Money

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

Amortizing a Loan

An important use of present value concepts is in determining the payments required for

an installment-type loan. The distinguishing feature of this loan is that it is repaid in equal

periodic payments that include both interest and principal. These payments can be made

monthly, quarterly, semiannually, or annually. Installment payments are prevalent in mortgage

loans, auto loans, consumer loans, and certain business loans.

To illustrate with the simplest case of annual payments, suppose you borrow $22,000 at

12 percent compound annual interest to be repaid over the next six years. Equal installment

payments are required at the end of each year. In addition, these payments must be sufficient

in amount to repay the $22,000 together with providing the lender with a 12 percent return.

To determine the annual payment, R, we set up the problem as follows:

= R(PVIFA12%,6)

In Table IV in the Appendix at the end of the book, we find that the discount factor for a sixyear

annuity with a 12 percent interest rate is 4.111. Solving for R in the problem above, we have

$22,000 = R(4.111)

R = $22,000/4.111 = $5,351

Thus annual payments of $5,351 will completely amortize (extinguish) a $22,000 loan in

six years. Each payment consists partly of interest and partly of principal repayment. The

amortization schedule is shown in Table 3.8. We see that annual interest is determined by

$22,000 1/ 1 0.12)

= ( +

⎡

⎣ ⎢⎢

⎤

⎦ ⎥⎥

= Σ

R t

Part 2 Valuation

Table 3.7

Effects of different

compounding periods

on future values of

$1,000 invested at

an 8% nominal

interest rate

INITIAL COMPOUNDING FUTURE VALUE AT EFFECTIVE ANNUAL

AMOUNT PERIODS END OF 1 YEAR INTEREST RATE*

$1,000 Annually $1,080.00 8.000%

1,000 Semiannually 1,081.60 8.160

1,000 Quarterly 1,082.43 8.243

1,000 Monthly 1,083.00 8.300

1,000 Daily (365 days) 1,083.28 8.328

1,000 Continuously 1,083.29 8.329

*Note: $1,000 invested for a year at these rates compounded annually would provide the same future

values as those found in Column 3.

Amortization

schedule

A table showing the

repayment schedule

of interest and

principal necessary

to pay off a loan by

maturity.

(1) (2) (3) (4)

END ANNUAL PRINCIPAL PRINCIPAL AMOUNT

OF INSTALLMENT INTEREST PAYMENT OWING AT YEAR END

YEAR PAYMENT (4)t −1 × 0.12 (1) − (2) (4)t−1 − (3)

0 – – – $22,000

1 $ 5,351 $ 2,640 $ 2,711 19,289

2 5,351 2,315 3,036 16,253

3 5,351 1,951 3,400 12,853

4 5,351 1,542 3,809 9,044

5 5,351 1,085 4,266 4,778

6 5,351 573 4,778 0

$32,106 $10,106 $22,000

Table 3.8

Amortization schedule

for illustrated loan

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

multiplying the principal amount outstanding at the beginning of the year by 12 percent. The

amount of principal payment is simply the total installment payment minus the interest payment.

Notice that the proportion of the installment payment composed of interest declines

over time, whereas the proportion composed of principal increases. At the end of six years, a

total of $22,000 in principal payments will have been made and the loan will be completely

amortized. The breakdown between interest and principal is important because on a business

loan only interest is deductible as an expense for tax purposes.

Summary Table of Key Compound Interest Formulas

FLOW(S) EQUATION END OF BOOK TABLE

Single Amounts:

FVn = P0(1 + i )n (3.4)

= P0(FVIFi,n) (3.5) I

PV0 = FVn[1/(1 + i )n] (3.6)

= FVn(PVIFi,n) (3.7) II

Annuities:

FVAn = R([(1 + i )n − 1]/i ) (3.8)

= R(FVIFAi,n) (3.9) III

PVAn = R[(1 − [1/(1 + i )n])/i ] (3.10)

= R(PVIFAi,n) (3.11) IV

FVADn = R(FVIFAi,n)(1 + i ) (3.14) III (adjusted)

PVADn = R(PVIFAi,n−1 + 1) (3.15)

= (1 + i)(R)(PVIFAi,n) (3.16) IV (adjusted)

Key Learning Points

l Most financial decisions, personal as well as business,

involve the time value of money. We use the rate of

interest to express the time value of money.

l Simple interest is interest paid (earned) on only the

original amount, or principal, borrowed (lent).

l Compound interest is interest paid (earned) on any

previous interest earned, as well as on the principal

borrowed (lent). The concept of compound interest

can be used to solve a wide variety of problems in

finance.

l Two key concepts – future value and present value –

underlie all compound interest problems. Future

value is the value at some future time of a present

amount of money, or a series of payments, evaluated

at a given interest rate. Present value is the current

value of a future amount of money, or a series of payments,

evaluated at a given interest rate.

l It is very helpful to begin solving time value of money

problems by first drawing a time line on which you

position the relevant cash flows.

l An annuity is a series of equal payments or receipts

occurring over a specified number of periods.

l There are some characteristics that should help you

to identify and solve the various types of annuity

problems:

1. Present value of an ordinary annuity – cash flows

occur at the end of each period, and present value is

calculated as of one period before the first cash flow.

2. Present value of an annuity due – cash flows occur

at the beginning of each period, and present value is

calculated as of the first cash flow.

3. Future value of an ordinary annuity – cash flows

occur at the end of each period, and future value is

calculated as of the last cash flow.

4. Future value of an annuity due – cash flows occur

at the beginning of each period, and future value is

calculated as of one period after the last cash flow.

l Various formulas were presented for solving for

future values and present values of single amounts

and of annuities. Mixed (uneven) cash-flow problems

can always be solved by adjusting each flow individually

and then summing the results. The ability to

recognize certain patterns within mixed cash flows

will allow you to take calculation shortcuts.

3 The Time Value of Money

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

Questions

1. What is simple interest?

2. What is compound interest? Why is it important?

3. What kinds of personal financial decisions have you made that involve compound interest?

4. What is an annuity? Is an annuity worth more or less than a lump sum payment received

now that would be equal to the sum of all the future annuity payments?

5. What type of compounding would you prefer in your savings account? Why?

6. Contrast the calculation of future (terminal) value with the calculation of present value.

What is the difference?

7. What is the advantage of using present value tables rather than formulas?

8. If you are scheduled to receive a certain sum of money five years from now but wish to

sell your contract for its present value, which type of compounding would you prefer to

be used in the calculation? Why?

9. The “Rule of 72” suggests that an amount will double in 12 years at a 6 percent compound

annual rate or double in 6 years at a 12 percent annual rate. Is this a useful rule, and is it

an accurate one?

10. Does present value decrease at a linear rate, at an increasing rate, or at a decreasing rate

with the discount rate? Why?

11. Does present value decrease at a linear rate, at an increasing rate, or at a decreasing rate

with the length of time in the future the payment is to be received? Why?

12. Sven Smorgasbord is 35 years old and is presently experiencing the “good” life. As a

result, he anticipates that he will increase his weight at a rate of 3 percent a year. At

present he weighs 200 pounds. What will he weigh at age 60?

Self-Correction Problems

1. The following cash-flow streams need to be analyzed:

CASH-FLOW END OF YEAR

STREAM 1 2 3 4 5

W $100 $200 $200 $300 1,$300

X $600 – – – –

Y – – – – 11,200

Z $200 – $500 – $0,300

a. Calculate the future (terminal) value of each stream at the end of year 5 with a compound

annual interest rate of 10 percent.

b. Compute the present value of each stream if the discount rate is 14 percent.

2. Muffin Megabucks is considering two different savings plans. The first plan would have her

deposit $500 every six months, and she would receive interest at a 7 percent annual rate,

compounded semiannually. Under the second plan she would deposit $1,000 every year

with a rate of interest of 7.5 percent, compounded annually. The initial deposit with

Plan 1 would be made six months from now and, with Plan 2, one year hence.

a. What is the future (terminal) value of the first plan at the end of 10 years?

b. What is the future (terminal) value of the second plan at the end of 10 years?

Part 2 Valuation

l To compare alternative investments having different

compounding periods, it is often necessary to calculate

their effective annual interest rates. The effective annual

interest rate is the interest rate compounded annually

that provides the same annual interest as the nominal

rate does when compounded m times per year.

l Amortizing a loan involves determining the periodic

payment necessary to reduce the principal amount to

zero at maturity, while providing interest payments on

the unpaid principal balance. The principal amount

owed decreases at an increasing rate as payments are

made.

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

c. Which plan should Muffin use, assuming that her only concern is with the value of her

savings at the end of 10 years?

d. Would your answer change if the rate of interest on the second plan were 7 percent?

3. On a contract you have a choice of receiving $25,000 six years from now or $50,000 twelve

years from now. At what implied compound annual interest rate should you be indifferent

between the two contracts?

4. Emerson Cammack wishes to purchase an annuity contract that will pay him $7,000 a year

for the rest of his life. The Philo Life Insurance Company figures that his life expectancy is

20 years, based on its actuary tables. The company imputes a compound annual interest

rate of 6 percent in its annuity contracts.

a. How much will Cammack have to pay for the annuity?

b. How much would he have to pay if the interest rate were 8 percent?

5. You borrow $10,000 at 14 percent compound annual interest for four years. The loan is

repayable in four equal annual installments payable at the end of each year.

a. What is the annual payment that will completely amortize the loan over four years?

(You may wish to round to the nearest dollar.)

b. Of each equal payment, what is the amount of interest? The amount of loan principal?

(Hint: In early years, the payment is composed largely of interest, whereas at the end it

is mainly principal.)

6. Your late Uncle Vern’s will entitles you to receive $1,000 at the end of every other year for

the next two decades. The first cash flow is two years from now. At a 10 percent compound

annual interest rate, what is the present value of this unusual cash-flow pattern? (Try to

solve this problem in as few steps as you can.)

7. A bank offers you a seven-month certificate of deposit (CD) at a 7.06 percent annual rate

that would provide a 7.25 percent effective annual yield. For the seven-month CD, is interest

being compounded daily, weekly, monthly, or quarterly? And, by the way, having

invested $10,000 in this CD, how much money would you receive when your CD matures

in seven months? That is, what size check would the bank give you if you closed your

account at the end of seven months?

8. A Dillonvale, Ohio, man saved pennies for 65 years. When he finally decided to cash them

in, he had roughly 8 million of them (or $80,000 worth), filling 40 trash cans. On average,

the man saved $1,230 worth of pennies a year. If he had deposited the pennies saved

each year, at each year’s end, into a savings account earning 5 percent compound annual

interest, how much would he have had in this account after 65 years of saving? How much

more “cents” (sense) would this have meant for our “penny saver” compared with simply

putting his pennies into trash cans?

9. Xu Lin recently obtained a 10-year, $50,000 loan. The loan carries an 8 percent compound

annual interest rate and calls for annual installment payments of $7,451.47 at the end of

each of the next 10 years.

a. How much (in dollars) of the first year’s payment is principal?

b. How much total interest will be paid over the life of the loan? (Hint: You do not need

to construct a loan amortization table to answer this question. Some simple math is all

you need.)

Problems

1. The following are exercises in future (terminal) values:

a. At the end of three years, how much is an initial deposit of $100 worth, assuming a

compound annual interest rate of (i) 100 percent? (ii) 10 percent? (iii) 0 percent?

b. At the end of five years, how much is an initial $500 deposit followed by five year-end,

annual $100 payments worth, assuming a compound annual interest rate of (i) 10 percent?

(ii) 5 percent? (iii) 0 percent?

3 The Time Value of Money

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

c. At the end of six years, how much is an initial $500 deposit followed by five year-end,

annual $100 payments worth, assuming a compound annual interest rate of (i) 10 percent?

(ii) 5 percent? (iii) 0 percent?

d. At the end of three years, how much is an initial $100 deposit worth, assuming a quarterly

compounded annual interest rate of (i) 100 percent? (ii) 10 percent?

e. Why do your answers to Part (d) differ from those to Part (a)?

f. At the end of 10 years, how much is a $100 initial deposit worth, assuming an annual

interest rate of 10 percent compounded (i) annually? (ii) semiannually? (iii) quarterly?

(iv) continuously?

2. The following are exercises in present values:

a. $100 at the end of three years is worth how much today, assuming a discount rate of

(i) 100 percent? (ii) 10 percent? (iii) 0 percent?

b. What is the aggregate present value of $500 received at the end of each of the next

three years, assuming a discount rate of (i) 4 percent? (ii) 25 percent?

c. $100 is received at the end of one year, $500 at the end of two years, and $1,000 at the

end of three years. What is the aggregate present value of these receipts, assuming a

discount rate of (i) 4 percent? (ii) 25 percent?

d. $1,000 is to be received at the end of one year, $500 at the end of two years, and $100

at the end of three years. What is the aggregate present value of these receipts assuming

a discount rate of (i) 4 percent? (ii) 25 percent?

e. Compare your solutions in Part (c) with those in Part (d) and explain the reason for

the differences.

3. Joe Hernandez has inherited $25,000 and wishes to purchase an annuity that will provide

him with a steady income over the next 12 years. He has heard that the local savings and

loan association is currently paying 6 percent compound interest on an annual basis. If

he were to deposit his funds, what year-end equal-dollar amount (to the nearest dollar)

would he be able to withdraw annually such that he would have a zero balance after his

last withdrawal 12 years from now?

4. You need to have $50,000 at the end of 10 years. To accumulate this sum, you have

decided to save a certain amount at the end of each of the next 10 years and deposit it in

the bank. The bank pays 8 percent interest compounded annually for long-term deposits.

How much will you have to save each year (to the nearest dollar)?

5. Same as Problem 4 above, except that you deposit a certain amount at the beginning of

each of the next 10 years. Now, how much will you have to save each year (to the nearest

dollar)?

6. Vernal Equinox wishes to borrow $10,000 for three years. A group of individuals agrees

to lend him this amount if he contracts to pay them $16,000 at the end of the three years.

What is the implicit compound annual interest rate implied by this contract (to the

nearest whole percent)?

7. You have been offered a note with four years to maturity, which will pay $3,000 at the end

of each of the four years. The price of the note to you is $10,200. What is the implicit

compound annual interest rate you will receive (to the nearest whole percent)?

8. Sales of the P.J. Cramer Company were $500,000 this year, and they are expected to grow

at a compound rate of 20 percent for the next six years. What will be the sales figure at

the end of each of the next six years?

9. The H & L Bark Company is considering the purchase of a debarking machine that is

expected to provide cash flows as follows:

END OF YEAR

1 2 3 4 5

Cash flow $1,200 $2,000 $2,400 $1,900 $1,600

Part 2 Valuation

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

END OF YEAR

6 7 8 9 10

Cash flow $1,400 $1,400 $1,400 $1,400 $1,400

If the appropriate annual discount rate is 14 percent, what is the present value of this

cash-flow stream?

10. Suppose you were to receive $1,000 at the end of 10 years. If your opportunity rate is

10 percent, what is the present value of this amount if interest is compounded (a) annually?

(b) quarterly? (c) continuously?

11. In connection with the United States Bicentennial, the Treasury once contemplated offering

a savings bond for $1,000 that would be worth $1 million in 100 years. Approximately

what compound annual interest rate is implied by these terms?

12. Selyn Cohen is 63 years old and recently retired. He wishes to provide retirement income

for himself and is considering an annuity contract with the Philo Life Insurance

Company. Such a contract pays him an equal-dollar amount each year that he lives. For

this cash-flow stream, he must put up a specific amount of money at the beginning.

According to actuary tables, his life expectancy is 15 years, and that is the duration on

which the insurance company bases its calculations regardless of how long he actually

lives.

a. If Philo Life uses a compound annual interest rate of 5 percent in its calculations,

what must Cohen pay at the outset for an annuity to provide him with $10,000 per

year? (Assume that the expected annual payments are at the end of each of the

15 years.)

b. What would be the purchase price if the compound annual interest rate is 10 percent?

c. Cohen had $30,000 to put into an annuity. How much would he receive each year if

the insurance company uses a 5 percent compound annual interest rate in its calculations?

A 10 percent compound annual interest rate?

13. The Happy Hang Glide Company is purchasing a building and has obtained a $190,000

mortgage loan for 20 years. The loan bears a compound annual interest rate of 17 percent

and calls for equal annual installment payments at the end of each of the 20 years. What

is the amount of the annual payment?

14. Establish loan amortization schedules for the following loans to the nearest cent (see

Table 3.8 for an example):

a. A 36-month loan of $8,000 with equal installment payments at the end of each month.

The interest rate is 1 percent per month.

b. A 25-year mortgage loan of $184,000 at a 10 percent compound annual interest rate

with equal installment payments at the end of each year.

15. You have borrowed $14,300 at a compound annual interest rate of 15 percent. You feel

that you will be able to make annual payments of $3,000 per year on your loan. (Payments

include both principal and interest.) How long will it be before the loan is entirely paid

off (to the nearest year)?

16. Lost Dutchman Mines, Inc., is considering investing in Peru. It makes a bid to the government

to participate in the development of a mine, the profits of which will be realized

at the end of five years. The mine is expected to produce $5 million in cash to Lost

Dutchman Mines at that time. Other than the bid at the outset, no other cash flows will

occur, as the government will reimburse the company for all costs. If Lost Dutchman

requires a nominal annual return of 20 percent (ignoring any tax consequences), what

is the maximum bid it should make for the participation right if interest is compounded

(a) annually? (b) semiannually? (c) quarterly? (d) continuously?

17. Earl E. Bird has decided to start saving for his retirement. Beginning on his twenty-first

birthday, Earl plans to invest $2,000 each birthday into a savings investment earning a

3 The Time Value of Money

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

7 percent compound annual rate of interest. He will continue this savings program for a

total of 10 years and then stop making payments. But his savings will continue to compound

at 7 percent for 35 more years, until Earl retires at age 65. Ivana Waite also plans

to invest $2,000 a year, on each birthday, at 7 percent, and will do so for a total of 35 years.

However, she will not begin her contributions until her thirty-first birthday. How much

will Earl’s and Ivana’s savings programs be worth at the retirement age of 65? Who is

better off financially at retirement, and by how much?

18. When you were born, your dear old Aunt Minnie promised to deposit $1,000 in a savings

account for you on each and every one of your birthdays, beginning with your first. The

savings account bears a 5 percent compound annual rate of interest. You have just turned

25 and want all the cash. However, it turns out that dear old (forgetful) Aunt Minnie

made no deposits on your fifth, seventh, and eleventh birthdays. How much is in the

account now – on your twenty-fifth birthday?

19. Assume that you will be opening a savings account today by depositing $100,000. The

savings account pays 5 percent compound annual interest, and this rate is assumed to

remain in effect for all future periods. Four years from today you will withdraw R

dollars. You will continue to make additional annual withdrawals of R dollars for a

while longer – making your last withdrawal at the end of year 9 – to achieve the following

pattern of cash flows over time. (Note: Today is time period zero; one year from

today is the end of time period 1; etc.)

How large must R be to leave you with exactly a zero balance after your final R withdrawal

is made at the end of year 9? (Tip: Making use of an annuity table or formula will make

your work a lot easier!)

20. Suppose that an investment promises to pay a nominal 9.6 percent annual rate of interest.

What is the effective annual interest rate on this investment assuming that interest is

compounded (a) annually? (b) semiannually? (c) quarterly? (d) monthly? (e) daily (365

days)? (f ) continuously? (Note: Report your answers accurate to four decimal places –

e.g., 0.0987 or 9.87%.)

21. “Want to win a million dollars? Here’s how. . . . One winner, chosen at random from all

entries, will win a $1,000,000 annuity.” That was the statement announcing a contest on

the World Wide Web. The contest rules described the “million-dollar prize” in greater

detail: “40 annual payments of $25,000 each, which will result in a total payment of

$1,000,000. The first payment will be made January 1; subsequent payments will be

made each January thereafter.” Using a compound annual interest rate of 8 percent,

what is the present value of this “million-dollar prize” as of the first installment on

January 1?

22. It took roughly 14 years for the Dow Jones Average of 30 Industrial Stocks to go from

1,000 to 2,000. To double from 2,000 to 4,000 took only 8 years, and to go from 4,000 to

8,000 required roughly 2 years. To the nearest whole percent, what compound annual

growth rates are implicit in these three index-doubling milestones?

Part 2 Valuation

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

Solutions to Self-Correction Problems

1. a. Future (terminal) value of each cash flow and total future value of each stream are as

follows (using Table I in the end-of-book Appendix):

FV5 FOR INDIVIDUAL CASH FLOWS RECEIVED TOTAL

CASH-FLOW AT END OF YEAR FUTURE

STREAM 1 2 3 4 5 VALUE

W $146.40 $266.20 $242.00 $330.00 $ 300.00 $1,284.60

X 878.40 – – – – 878.40

Y – – – – 1,200.00 1,200.00

Z 292.80 – 605.00 – 300.00 1,197.80

b. Present value of each cash flow and total present value of each stream (using Table II in

the end-of-book Appendix):

PV0 FOR INDIVIDUAL CASH FLOWS RECEIVED TOTAL

CASH-FLOW AT END OF YEAR PRESENT

STREAM 1 2 3 4 5 VALUE

W $ 87.70 $153.80 $135.00 $177.60 $155.70 $709.80

X 526.20 – – – – 526.20

Y – – – – 622.80 622.80

Z 175.40 – 337.50 – 155.70 668.60

2. a. FV10 Plan 1 = $500(FVIFA3.5%,20)

= $500{[(1 + 0.035)20 − 1]/[0.035]}

= $14,139.84

b. FV10 Plan 2 = $1,000(FVIFA7.5%,10)

= $1,000{[(1 + 0.075)10 − 1]/[0.075]}

= $14,147.09

c. Plan 2 would be preferred by a slight margin – $7.25.

d. FV10 Plan 2 = $1,000(FVIFA7%,10)

= $1,000{[(1 + 0.07)10 − 1]/[0.07]}

= $13,816.45

Now, Plan 1 would be preferred by a nontrivial $323.37 margin.

3. Indifference implies that you could reinvest the $25,000 receipt for 6 years at X% to

provide an equivalent $50,000 cash flow in year 12. In short, $25,000 would double in

6 years. Using the “Rule of 72,” 72/6 = 12%.

Alternatively, note that $50,000 = $25,000(FVIFX%,6). Therefore (FVIFX%,6) =

$50,000/$25,000 = 2. In Table I in the Appendix at the end of the book, the interest factor

for 6 years at 12 percent is 1.974 and that for 13 percent is 2.082. Interpolating, we have

as the interest rate implied in the contract.

For an even more accurate answer, recognize that FVIFX%,6 can also be written as

(1 + i)6. Then, we can solve directly for i (and X% = i[100]) as follows:

(1 + i )6 = 2

(1 + i ) = 21/6 = 20.1667 = 1.1225

i = 0.1225 or X% = 12.25%

4. a. PV0 = $7,000(PVIFA6%,20) = $7,000(11.470) = $80,290

b. PV0 = $7,000(PVIFA8%,20) = $7,000(9.818) = $68,726

5. a. PV0 = $10,000 = R(PVIFA14%,4) = R(2.914)

Therefore R = $10,000/2.914 = $3,432 (to the nearest dollar).

X% = +

−

12% =

2.000 1.974

2.082 1.974

12.24%

3 The Time Value of Money

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

(1) (2) (3) (4)

ANNUAL PRINCIPAL PRINCIPAL AMOUNT

END OF INSTALLMENT INTEREST PAYMENT OWING AT YEAR END

YEAR PAYMENT (4)t −1 × 0.14 (1) − (2) (4)t −1 − (3)

0 – – – $10,000

1 $ 3,432 $1,400 $ 2,032 7,968

2 3,432 1,116 2,316 5,652

3 3,432 791 2,641 3,011

4 3,432 421 3,011 0

$13,728 $3,728 $10,000

6. When we draw a picture of the problem, we get $1,000 at the end of every even-numbered

year for years 1 through 20:

Tip: Convert $1,000 every 2 years into an equivalent annual annuity (i.e., an annuity that

would provide an equivalent present or future value to the actual cash flows) pattern.

Solving for a 2-year annuity that is equivalent to a future $1,000 to be received at the end

of year 2, we get

FVA2 = $1,000 = R(FVIFA10%,2) = R(2.100)

Therefore R = $1,000/2.100 = $476.19. Replacing every $1,000 with an equivalent twoyear

annuity gives us $476.19 for 20 years.

PVA20 = $476.19(PVIFA10%,20) = $476.19(8.514) = $4,054.28

7. Effective annual interest rate = (1 + [i/m])m − 1

= (1 + [0.0706/4])4 − 1

= 0.07249 (approximately 7.25%)

Therefore, we have quarterly compounding. And, investing $10,000 at 7.06 percent

compounded quarterly for seven months (Note: Seven months equals 21⁄3 quarter periods),

we get

$10,000(1 + [0.0706/4])2.33

– = $10,000(1.041669) = $10,416.69

8. FVA65 = $1,230(FVIFA5%,65)

= $1,230[([1 + 0.05]65 − 1)/(0.05)]

= $1,230(456.798) = $561,861.54

Our “penny saver” would have been better off by ($561,861.54 − $80,000) = $481,861.54

– or 48,186,154 pennies – by depositing the pennies saved each year into a savings account

earning 5 percent compound annual interest.

9. a. $50,000(0.08) = $4,000 interest payment

$7,451.47 − $4,000 = $3,451.47 principal payment

b. Total installment payments − total principal payments = total interest payments

$74,514.70 − $50,000 = $24,514.70

Part 2 Valuation

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

Rich, Steven P., and John T. Rose. “Interest Rate Concepts

and Terminology in Introductory Finance Textbooks.”

Financial Practice and Education 7 (Spring–Summer

1997), 113–121.

Shao, Stephen P., and Lawrence P. Shao. Mathematics for

Management and Finance, 8th ed. Cincinnati, OH: South-

Western, 1998.

Part II of the text’s website, Wachowicz’s Web World, contains

links to many finance websites and online articles

related to topics covered in this chapter.

(web.utk.edu/~jwachowi/part2.html) See, especially,

Annuities: Ordinary? Due? What do I do?

(web.utk.edu/~jwachowi/annuity1.html) and Annuity

Problems

(web.utk.edu/~jwachowi/annuity_prob.pdf )

Selected References

3 The Time Value of Money

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

The Valuation of Long-Term

Securities

Contents

l Distinctions Among Valuation Concepts

Liquidation Value versus Going-Concern Value •

Book Value versus Market Value • Market Value

versus Intrinsic Value

l Bond Valuation

Perpetual Bonds • Bonds with a

Finite Maturity

l Preferred Stock Valuation

l Common Stock Valuation

Are Dividends the Foundation? • Dividend

Discount Models

l Rates of Return (or Yields)

Yield to Maturity (YTM) on Bonds • Yield on

Preferred Stock • Yield on Common Stock

l Summary Table of Key Present Value

Formulas for Valuing Long-Term

Securities

l Key Learning Points

l Questions

l Self-Correction Problems

l Problems

l Solutions to Self-Correction Problems

l Selected References

Objectives

After studying Chapter 4, you should be able to:

l Distinguish among the various terms used to

express value, including liquidation value,

going-concern value, book value, market value,

and intrinsic value.

l Value bonds, preferred stocks, and common

stocks.

l Calculate the rates of return (or yields) of different

types of long-term securities.

l List and explain a number of observations

regarding the behavior of bond prices.

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

What is a cynic? A man who knows the price of everything and the

value of nothing.

—OSCAR WILDE

In the last chapter we discussed the time value of money and explored the wonders of compound

interest. We are now able to apply these concepts to determining the value of different

securities. In particular, we are concerned with the valuation of the firm’s long-term securities

– bonds, preferred stock, and common stock (though the principles discussed apply to

other securities as well). Valuation will, in fact, underlie much of the later development of the

book. Because the major decisions of a company are all interrelated in their effect on valuation,

we must understand how investors value the financial instruments of a company.

Distinctions Among Valuation Concepts

The term value can mean different things to different people. Therefore we need to be precise

in how we both use and interpret this term. Let’s look briefly at the differences that exist

among some of the major concepts of value.

l l l Liquidation Value versus Going-Concern Value

Liquidation value is the amount of money that could be realized if an asset or a group of

assets (e.g., a firm) is sold separately from its operating organization. This value is in marked

contrast to the going-concern value of a firm, which is the amount the firm could be sold for

as a continuing operating business. These two values are rarely equal, and sometimes a company

is actually worth more dead than alive.

The security valuation models that we will discuss in this chapter will generally assume that

we are dealing with going concerns – operating firms able to generate positive cash flows to

security investors. In instances where this assumption is not appropriate (e.g., impending

bankruptcy), the firm’s liquidation value will have a major role in determining the value of

the firm’s financial securities.

l l l Book Value versus Market Value

The book value of an asset is the accounting value of the asset – the asset’s cost minus its

accumulated depreciation. The book value of a firm, on the other hand, is equal to the dollar

difference between the firm’s total assets and its liabilities and preferred stock as listed on its

balance sheet. Because book value is based on historical values, it may bear little relationship

to an asset’s or firm’s market value.

In general, the market value of an asset is simply the market price at which the asset (or a

similar asset) trades in an open marketplace. For a firm, market value is often viewed as being

the higher of the firm’s liquidation or going-concern value.

l l l Market Value versus Intrinsic Value

Based on our general definition for market value, the market value of a security is the market

price of the security. For an actively traded security, it would be the last reported price at

which the security was sold. For an inactively traded security, an estimated market price

would be needed.

The intrinsic value of a security, on the other hand, is what the price of a security should

be if properly priced based on all factors bearing on valuation – assets, earnings, future

Part 2 Valuation

Liquidation value

The amount of money

that could be realized

if an asset or a group

of assets (e.g., a firm)

is sold separately

from its operating

organization.

Going-concern value

The amount a firm

could be sold for as a

continuing operating

business.

Book value

(1) An asset: the

accounting value

of an asset – the

asset’s cost minus

its accumulated

depreciation; (2) a

firm: total assets

minus liabilities and

preferred stock as

listed on the balance

sheet.

Market value The

market price at which

an asset trades.

Intrinsic value

The price a security

“ought to have”

based on all factors

bearing on valuation.

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

prospects, management, and so on. In short, the intrinsic value of a security is its economic

value. If markets are reasonably efficient and informed, the current market price of a security

should fluctuate closely around its intrinsic value.

The valuation approach taken in this chapter is one of determining a security’s intrinsic

value – what the security ought to be worth based on hard facts. This value is the present

value of the cash-flow stream provided to the investor, discounted at a required rate of

return appropriate for the risk involved. With this general valuation concept in mind, we

are now able to explore in more detail the valuation of specific types of securities.

Bond Valuation

A bond is a security that pays a stated amount of interest to the investor, period after period,

until it is finally retired by the issuing company. Before we can fully understand the valuation

of such a security, certain terms must be discussed. For one thing, a bond has a face value.1

This value is usually $1,000 per bond in the United States. The bond almost always has a stated

maturity, which is the time when the company is obligated to pay the bondholder the face

value of the instrument. Finally, the coupon rate, or nominal annual rate of interest, is stated

on the bond’s face.2 If, for example, the coupon rate is 12 percent on a $1,000-face-value

bond, the company pays the holder $120 each year until the bond matures.

In valuing a bond, or any security for that matter, we are primarily concerned with discounting,

or capitalizing, the cash-flow stream that the security holder would receive over the

life of the instrument. The terms of a bond establish a legally binding payment pattern at the

time the bond is originally issued. This pattern consists of the payment of a stated amount of

interest over a given number of years coupled with a final payment, when the bond matures,

equal to the bond’s face value. The discount, or capitalization, rate applied to the cash-flow

stream will differ among bonds depending on the risk structure of the bond issue. In general,

however, this rate can be thought of as being composed of the risk-free rate plus a

premium for risk. (You may remember that we introduced the idea of a market-imposed

“trade-off ” between risk and return in Chapter 2. We will have more to say about risk and

required rates of return in the next chapter.)

l l l Perpetual Bonds

The first (and easiest) place to start determining the value of bonds is with a unique class

of bonds that never matures. These are indeed rare, but they help illustrate the valuation

technique in its simplest form. Originally issued by Great Britain after the Napoleonic Wars

to consolidate debt issues, the British consol (short for consolidated annuities) is one such

example. This bond carries the obligation of the British government to pay a fixed interest

payment in perpetuity.

The present value of a perpetual bond would simply be equal to the capitalized value of

an infinite stream of interest payments. If a bond promises a fixed annual payment of I

forever, its present (intrinsic) value, V, at the investor’s required rate of return for this debt

issue, kd, is

1Much like criminals, many of the terms used in finance are also known under a number of different aliases. Thus a

bond’s face value is also known as its par value, or principal. Like a good detective, you need to become familiar with

the basic terms used in finance as well as their aliases.

2The term coupon rate comes from the detachable coupons that are affixed to bearer bond certificates, which, when

presented to a paying agent or the issuer, entitle the holder to receive the interest due on that date. Nowadays,

registered bonds, whose ownership is registered with the issuer, allow the registered owner to receive interest by check

through the mail.

4 The Valuation of Long-Term Securities

Bond A long-term debt

instrument issued by

a corporation or

government.

Face value The stated

value of an asset. In

the case of a bond,

the face value is

usually $1,000.

Coupon rate The

stated rate of interest

on a bond; the annual

interest payment

divided by the bond’s

face value.

Consol A bond that

never matures; a

perpetuity in the form

of a bond.

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

(4.1)

= I (PVIFAkd,∞) (4.2)

which, from Chapter 3’s discussion of perpetuities, we know should reduce to

V = I /k d (4.3)

Thus the present value of a perpetual bond is simply the periodic interest payment divided

by the appropriate discount rate per period. Suppose you could buy a bond that paid $50 a

year forever. Assuming that your required rate of return for this type of bond is 12 percent,

the present value of this security would be

V = $50/0.12 = $416.67

This is the maximum amount that you would be willing to pay for this bond. If the market

price is greater than this amount, however, you would not want to buy it.

Bonds with a Finite Maturity

Nonzero Coupon Bonds. If a bond has a finite maturity, then we must consider not only

the interest stream but also the terminal or maturity value (face value) in valuing the bond.

The valuation equation for such a bond that pays interest at the end of each year is

(4.4)

= I (PVIFAkd,n) + MV(PVIFkd,n) (4.5)

where n is the number of years until final maturity and MV is the maturity value of the bond.

We might wish to determine the value of a $1,000-par-value bond with a 10 percent

coupon and nine years to maturity. The coupon rate corresponds to interest payments of

$100 a year. If our required rate of return on the bond is 12 percent, then

= $100(PVIFA12%,9) + $1,000(PVIF12%,9)

Referring to Table IV in the Appendix at the back of the book, we find that the present value

interest factor of an annuity at 12 percent for nine periods is 5.328. Table II in the Appendix

reveals under the 12 percent column that the present value interest factor for a single payment

nine periods in the future is 0.361. Therefore the value, V, of the bond is

V = $100(5.328) + $1,000(0.361)

= $532.80 + $361.00 = $893.80

The interest payments have a present value of $532.80, whereas the principal payment at

maturity has a present value of $360.00. (Note: All of these figures are approximate because the

present value tables used are rounded to the third decimal place; the true present value of the

bond is $893.44.)

V = + + . . . + +

$100

(1.12)

$100

(1.12)

$100

(1.12)

$1,000

1 2 9 (1.12)9

n n

+ +

+ =

( )

. . .

( )

1 1 1 1

1 1

d d

1 d d

k t

+ +

∞

∞Σ

( )

. . .

( )

1 1 1

1 d

Part 2 Valuation

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

If the appropriate discount rate is 8 percent instead of 12 percent, the valuation equation

becomes

= $100(PVIFA8%,9) + $1,000(PVIF8%,9)

Looking up the appropriate interest factors in Tables II and IV in the Appendix, we determine

that

V = $100(6.247) + $1,000(0.500)

= $624.70 + $500.00 = $1,124.70

In this case, the present value of the bond is in excess of its $1,000 par value because the

required rate of return is less than the coupon rate. Investors would be willing to pay a

premium to buy the bond. In the previous case, the required rate of return was greater than

the coupon rate. As a result, the bond has a present value less than its par value. Investors

would be willing to buy the bond only if it sold at a discount from par value. Now if the

required rate of return equals the coupon rate, the bond has a present value equal to its par

value, $1,000. More will be said about these concepts shortly when we discuss the behavior of

bond prices.

Zero-Coupon Bonds. A zero-coupon bond makes no periodic interest payments but

instead is sold at a deep discount from its face value. Why buy a bond that pays no

interest? The answer lies in the fact that the buyer of such a bond does receive a return.

This return consists of the gradual increase (or appreciation) in the value of the security from

its original, below-face-value purchase price until it is redeemed at face value on its maturity

date.

The valuation equation for a zero-coupon bond is a truncated version of that used for a

normal interest-paying bond. The “present value of interest payments” component is lopped

off, and we are left with value being determined solely by the “present value of principal

payment at maturity,” or

(4.6)

= MV(PVIFkd,n) (4.7)

Suppose that Espinosa Enterprises issues a zero-coupon bond having a 10-year maturity

and a $1,000 face value. If your required return is 12 percent, then

= $1,000(PVIF12%,10)

Using Table II in the Appendix, we find that the present value interest factor for a single

payment 10 periods in the future at 12 percent is 0.322. Therefore:

V = $1,000(0.322) = $322

If you could purchase this bond for $322 and redeem it 10 years later for $1,000, your initial

investment would thus provide you with a 12 percent compound annual rate of return.

Semiannual Compounding of Interest. Although some bonds (typically those issued in

European markets) make interest payments once a year, most bonds issued in the United

States pay interest twice a year. As a result, it is necessary to modify our bond valuation

V =

$1,000

(1.12)10

k n =

(1 ) d

V = + + . . . + +

$100

(1.08)

$100

(1.08)

$100

(1.08)

$1,000

1 2 9 (1.08)9

4 The Valuation of Long-Term Securities

Zero-coupon bond

A bond that pays no

interest but sells

at a deep discount

from its face

value; it provides

compensation to

investors in the form

of price appreciation.

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

equations to account for compounding twice a year.3 For example, Eqs. (4.4) and (4.5) would

be changed as follows

(4.8)

= (I /2)(PVIFAkd /2,2n) + MV(PVIFkd/2,2n) (4.9)

where kd is the nominal annual required rate of interest, I/2 is the semiannual coupon payment,

and 2n is the number of semiannual periods until maturity.

Take Note

Notice that semiannual discounting is applied to both the semiannual interest payments

and the lump-sum maturity value payment. Though it may seem inappropriate to use

semiannual discounting on the maturity value, it isn’t. The assumption of semiannual

discounting, once taken, applies to all inflows.

To illustrate, if the 10 percent coupon bonds of US Blivet Corporation have 12 years to

maturity and our nominal annual required rate of return is 14 percent, the value of one

$1,000-par-value bond is

V = ($50)(PVIFA7%,24) + $1,000(PVIF7%,24)

= ($50)(11.469) + $1,000(0.197) = $770.45

Rather than having to solve for value by hand, professional bond traders often turn to bond

value tables. Given the maturity, coupon rate, and required return, one can look up the present

value. Similarly, given any three of the four factors, one can look up the fourth. Also,

some specialized calculators are programmed to compute bond values and yields, given the

inputs mentioned. In your professional life you may very well end up using these tools when

working with bonds.

TIP•TIP

Remember, when you use bond Eqs. (4.4), (4.5), (4.6), (4.7), (4.8), and (4.9), the variable

MV is equal to the bond’s maturity value, not its current market value.

Preferred Stock Valuation

Most preferred stock pays a fixed dividend at regular intervals. The features of this financial

instrument are discussed in Chapter 20. Preferred stock has no stated maturity date and, given

the fixed nature of its payments, is similar to a perpetual bond. It is not surprising, then, that

we use the same general approach as applied to valuing a perpetual bond to the valuation of

preferred stock.4 Thus the present value of preferred stock is

V = Dp /kp (4.10)

t k

n =

+ =

Σ /

/ )

(1 2 (1 2 1 d

3Even with a zero-coupon bond, the pricing convention among bond professionals is to use semiannual rather than

annual compounding. This provides consistent comparisons with interest-bearing bonds.

4Virtually all preferred stock issues have a call feature (a provision that allows the company to force retirement), and

many are eventually retired. When valuing a preferred stock that is expected to be called, we can apply a modified

version of the formula used for valuing a bond with a finite maturity; the periodic preferred dividends replace the

periodic interest payments and the “call price” replaces the bond maturity value in Eqs. (4.4) and (4.5), and all the

payments are discounted at a rate appropriate to the preferred stock in question.

Part 2 Valuation

Preferred stock

A type of stock that

promises a (usually)

fixed dividend, but at

the discretion of the

board of directors. It

has preference over

common stock in the

payment of dividends

and claims on assets.

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

4 The Valuation of Long-Term Securities

where Dp is the stated annual dividend per share of preferred stock and kp is the appropriate

discount rate. If Margana Cipher Corporation had a 9 percent, $100-par-value preferred stock

issue outstanding and your required return was 14 percent on this investment, its value per

share to you would be

V = $9/0.14 = $64.29

Common Stock Valuation

The theory surrounding the valuation of common stock has undergone profound change

during the last few decades. It is a subject of considerable controversy, and no one method for

valuation is universally accepted. Still, in recent years there has emerged growing acceptance

of the idea that individual common stocks should be analyzed as part of a total portfolio of

common stocks that the investor might hold. In other words, investors are not as concerned

with whether a particular stock goes up or down as they are with what happens to the overall

value of their portfolios. This concept has important implications for determining the

required rate of return on a security. We shall explore this issue in the next chapter. First,

however, we need to focus on the size and pattern of the returns to the common stock

investor. Unlike bond and preferred stock cash flows, which are contractually stated, much

more uncertainty surrounds the future stream of returns connected with common stock.

l l l Are Dividends the Foundation?

When valuing bonds and preferred stock, we determined the discounted value of all the cash

distributions made by the firm to the investor. In a similar fashion, the value of a share of

common stock can be viewed as the discounted value of all expected cash dividends provided

by the issuing firm until the end of time.5 In other words,

5This model was first developed by John B. Williams, The Theory of Investment Value (Cambridge, MA: Harvard

University Press, 1938). And, as Williams so aptly put it in poem form, “A cow for her milk/A hen for her eggs/And

a stock, by heck/For her dividends.”

Common stock

Securities that

represent the

ultimate ownership

(and risk) position in

a corporation.

QWhat’s preferred stock?

AWe generally avoid investing in preferred stocks, but

we’re happy to explain them. Like common stock,

a share of preferred stock confers partial ownership

of a company to its holder. But unlike common stock,

holders of preferred stock usually have no voting privileges.

Shares of preferred stock often pay a guaranteed

fixed dividend that is higher than the common stock

dividend.

Preferred stock isn’t really for individual investors,

though. The shares are usually purchased by other corporations,

which are attracted by the dividends that give

them income taxed at a lower rate. Corporations also like

the fact that preferred stockholders’ claims on company

earnings and assets have a higher priority than that

of common stockholders. Imagine that the One-Legged

Chair Co. (ticker: WOOPS) goes out of business. Many

people or firms with claims on the company will want

their due. Creditors will be paid before preferred stockholders,

but preferred stockholders have a higher priority

than common stockholders.

Ask the Fool

Source: The Motley Fool (www.fool.com). Reproduced with the permission of The Motley Fool.

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

(4.11)

(4.12)

where Dt is the cash dividend at the end of time period t and ke is the investor’s required

return, or capitalization rate, for this equity investment. This seems consistent with what we

have been doing so far.

But what if we plan to own the stock for only two years? In this case, our model becomes

where P2 is the expected sales price of our stock at the end of two years. This assumes that

investors will be willing to buy our stock two years from now. In turn, these future investors

will base their judgments of what the stock is worth on expectations of future dividends

and a future selling price (or terminal value). And so the process goes through successive

investors.

Note that it is the expectation of future dividends and a future selling price, which itself is

based on expected future dividends, that gives value to the stock. Cash dividends are all that

stockholders, as a whole, receive from the issuing company. Consequently, the foundation for

the valuation of common stock must be dividends. These are construed broadly to mean any

cash distribution to shareholders, including share repurchases. (See Chapter 18 for a discussion

of share repurchase as part of the overall dividend decision.)

The logical question to raise at this time is: Why do the stocks of companies that pay

no dividends have positive, often quite high, values? The answer is that investors expect to

sell the stock in the future at a price higher than they paid for it. Instead of dividend income

plus a terminal value, they rely only on the terminal value. In turn, terminal value depends on

the expectations of the marketplace viewed from this terminal point. The ultimate expectation

is that the firm will eventually pay dividends, either regular or liquidating, and that

future investors will receive a company-provided cash return on their investment. In the

interim, investors are content with the expectation that they will be able to sell their stock

at a subsequent time, because there will be a market for it. In the meantime, the company is

reinvesting earnings and, everyone hopes, enhancing its future earning power and ultimate

dividends.

l l l Dividend Discount Models

Dividend discount models are designed to compute the intrinsic value of a share of common

stock under specific assumptions as to the expected growth pattern of future dividends

and the appropriate discount rate to employ. Merrill Lynch, CS First Boston, and a number

of other investment banks routinely make such calculations based on their own particular

models and estimates. What follows is an examination of such models, beginning with the

simplest one.

Constant Growth. Future dividends of a company could jump all over the place; but, if

dividends are expected to grow at a constant rate, what implications does this hold for our

basic stock valuation approach? If this constant rate is g, then Eq. (4.11) becomes

(4.13)

where D0 is the present dividend per share. Thus the dividend expected at the end of period n

is equal to the most recent dividend times the compound growth factor, (1 + g)n. This may

not look like much of an improvement over Eq. (4.11). However, assuming that ke is greater

D g

+ +

∞

( )

. . .

( )

1 1 1 2

= +

∞Σ

)

t (1 1 e

+ +

∞

( )

. . .

( )

e 1 1 1

Part 2 Valuation

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

than g (a reasonable assumption because a dividend growth rate that is always greater than the

capitalization rate would imply an infinite stock value), Eq. (4.13) can be reduced to6

V = D1 /(ke − g) (4.14)

Rearranging, the investor’s required return can be expressed as

ke = (D1 /V) + g (4.15)

The critical assumption in this valuation model is that dividends per share are expected to

grow perpetually at a compound rate of g. For many companies this assumption may be a fair

approximation of reality. To illustrate the use of Eq. (4.14), suppose that LKN, Inc.’s dividend

per share at t = 1 is expected to be $4, that it is expected to grow at a 6 percent rate forever, and

that the appropriate discount rate is 14 percent. The value of one share of LKN stock would be

V = $4/(0.14 − 0.06) = $50

For companies in the mature stage of their life cycle, the perpetual growth model is often

reasonable.

TIP•TIP

A common mistake made in using Eqs. (4.14) and (4.15) is to use, incorrectly, the firm’s

most recent annual dividend for the variable D1 instead of the annual dividend expected by

the end of the coming year.

Conversion to an Earnings Multiplier Approach With the constant growth model, we

can easily convert from dividend valuation, Eq. (4.14), to valuation based on an earnings

multiplier approach. The idea is that investors often think in terms of how many dollars they

are willing to pay for a dollar of future expected earnings. Assume that a company retains a

constant proportion of its earnings each year; call it b. The dividend-payout ratio (dividends

per share divided by earnings per share) would also be constant. Therefore,

(1 − b) = D1 /E1 (4.16)

and

(1 − b)E1 = D1

where E1 is expected earnings per share in period 1. Equation (4.14) can then be expressed as

V = [(1 − b)E1]/(ke − g) (4.17)

6If we multiply both sides of Eq. (4.13) by (1 + ke)/(1 + g) and subtract Eq. (4.13) from the product, we get

Because we assume that ke is greater than g, the second term on the right-hand side approaches zero. Consequently,

V(ke − g) = D0(1 + g) = D1

V = D1 /(ke − g)

This model is sometimes called the “Gordon Dividend Valuation Model” after Myron J. Gordon, who developed it

from the pioneering work done by John Williams. See Myron J. Gordon, The Investment, Financing, and Valuation of

the Corporation (Homewood, IL: Richard D. Irwin, 1962).

4 The Valuation of Long-Term Securities

To download more slides, ebooks, solution manual, and test bank, visit http://downloadslide.blogspot.com

where value is now based on expected earnings in period 1. In our earlier example, suppose

that LKN, Inc., has a retention rate of 40 percent and earnings per share for period 1 are

expected to be $6.67. Therefore,

V = [(0.60)$6.67]/(0.14 − 0.06) = $50

Rearranging Eq. (4.17), we get

Earnings multiplier = V/E1 = (1 − b)/(ke − g) (4.18)

Equation (4.18) thus gives us the highest multiple of expected earnings that the investor

would be willing to pay for the security. In our example,

Earnings multiplier = (1 − 0.40)/(0.14 − 0.06) = 7.5 times

Thus expected earnings of $6.67 coupled with an earnings multiplier of 7.5 values our

common stockBrief Contents