S I X T H E D I T I O N

PRINCIPLE

MANAGERIAL FINAN

Lawrence J. Gitman San Diego State University

HarperCollinsPublisbers

Contents in Detail To the Instructor xxi

To the Student xxxv

PART ONE/THE GOALS AND ENVIRONMENT OF MANAGERIAL FINANCE 1

Chapter 1 / The Role of Finance and the Financial Manager 3 Disney: Magic and Financial Control 3

Finance as an Area of Study 4

Basic Forms of Business Organization 6

The Managerial Finance Function 10

Pepsico's Focus on Cash Flows and the Market's Response 12

Goal of the Financial Manager 15

Long-Term Thinking Carries Michelin to the Top 18

Stock Options at Pepsico, Heinz, and Disney 20

Low Debt Gives Montgomery Ward the Last Laugh 21

An Overview of the Text 24

International Managerial Finance: Introduction 26

Summary 27 Questions 27 Problem 28

Chapter 2 / The Operating Environment of the Firm 30 Life and Death at Bread Loaf Construction Company 30

Business Taxation 31

Financial Institutions and Markets: An Overview 37

Fashion Meets Finance in The New Yorker 38

Shareholders React to First Interstate's Misdeeds 40

The Capital Market 44

Economics 101 and the Stock Market 47

ix

X Contents in Detail

Interest Rates and Required Returns 48

Inflationary Expectations Do Matter 55

International Managerial Finance: The Environment 59

Summary 59 Questions 60 Self-Test Problem 61 Problems 62 Solution to Self-Test Problem 67

Chapter 3/Financial Statements, Depreciation, and Cash Flow 68 McKesson Corporation's Idea: The Fat-Free Financial Statement 68

The Stockholders' Report 69

Questioning Blockbuster Entertainment Corporations' Accounting Methods 70

Basic Financial Statements 72

Deteriorating Financials at Interco 76

Depreciation 77

Seriously, Depreciation Can Be a Black Tie Affair 80

Analyzing the Firm's Cash Flow 82

Southland Corporation Says "Aloha" to Get Cash Flow 85

International Managerial Finance: Financial Statements 90

Summary 90 Questions 91 Self-Test Problem 92 Problems 92 Solution to Self-Test Problem 100

Part One Case: Track Software, Inc. 101

PART TWO/BASIC FINANCIAL CONCEPTS 105

Chapter 4 /The Time Value of Money 107 Time Value Is Fundamental to Financial Decision-Making—Both Personal and Corporate 107

Future Value of a Single Amount 109 The Power of Compound Interest at American Airlines 111

Future Value of an Annuity 120 Where Other Firms See Trouble, Hillenbrand Sees Opportunity 124

Present Value of a Single Amount 127 Time Is Money for National Remittance Centers 131

Contents in Detail x i

Present Value of Cash Flow Streams 132

Using Present Value to Balance Social Security 134

Special Applications of Time Value 137

Summary 143 Questions 143 Self-Test Problems 145 Problems 146 Solutions to Self-Test Problems 154

Chapter 5/Risk and Return 157 Diversification at Bausch & Lomb 157

Risk and Return Fundamentals 158

The Change in Integrated Resources' Value during 1989 160

Basic Risk Concepts: A Single Asset 161

Expectations and Reality at Humana 162

Time Diversification at Paine Webber 169

Risk of a Portfolio 169

Risk and Return: The Capital Asset Pricing Model (CAPM) 176

Applying the CAPM at Phillips Petroleum 183

International Managerial Finance: Risk 188

Summary 188 Questions 190 Self-Test Problems 191 Problems 192 Solutions to Self-Test Problems 201

Chapter 6/Valuation 204 Estimating the Value of Eclectic Communications, Inc. 204

Valuation Fundamentals 205

Bond Valuation 208

Valuing Government-Backed Zeros at the Failed Peoples Heritage Savings 214 Common Stock Valuation 217

The Impact of Good and Bad Announcements: Enzon and Metropolitan Savings 220

Variable Dividends at Glaxo Holdings 226

Ashland Oil's Break-up Value Exceeds Its Stock Price 227

Decision Making and Common Stock Value 229

Summary 231 Questions 233 Self-Test Problems 234 Problems 235 Solutions to Self-Test Problems 243

Part Two Case: Encore International 246

Xli Contents in Detail

PART THREE/FINANCIAL ANALYSIS AND PLANNING 249

Chapter 7/The Analysis of Financial Statements 251 Financial Analysis of RJR Nabisco Causes Its Plans to Go Up in Smoke 251

The Use of Financial Ratios 252

Numbers Teil the Story at Fiat 256

Analyzing Liquidity 260

Analyzing Activity 262

LIFO, Taxes, and the Inventory Turnover Ratio 264

Analyzing Debt 267

Paying the Piper at Black & Decker 270

Analyzing Profitability 272

Top Managers Watch the Bottom Line at Bruno's 276

A Complete Ratio Analysis 276

Summary 283 Questions 284 Self-Test Problems 285 Problems 286 Solutions to Self-Test Problems 295

Chapter 8/Financial Planning 297 Financial Planning at Digital Equipment Corporation 297

The Financial Planning Process 298

Lobsters, Jet Lag, and Financial Planning 300

Cash Planning: Cash Budgets 301

Cash Flow Beats Two-of-a-Kind at Caesars World 307

Cash Flow Estimation in Iran Is Indeed Difficult 311

Profit Planning: Pro Forma Statement Fundamentals 311

Preparing the Pro Forma Income Statement 313

Preparing the Pro Forma Balance Sheet 316 Nestle Company's Difficulty in Preparing Pro Formas 318

Evaluation of Pro Forma Statements 319

Summary 320 Questions 321 Self-Test Problems 322 Problems 323 Solutions to Self-Test Problems 329

Part Three Gase: Steel Works, Inc. 331

Contents in Detail xiii

PART FOUR/LONG-TERM INVESTMENT DECISIONS 335

Chapter 9/Capital Budgeting and Cash Flow Principles 337 Genentech: A Prescription for Ailing Cash Flows 337

The Capital Budgeting Decision Process 339

Horizontal Drilling: A Success Story for Oryx Energy 341

The Relevant Cash Flows 344

Finding the Initial Investment 347

Gillette Invests $300 Million in a $4 Razor 348

Finding the Operating Cash Flows 354

KKR Underestimates Cash Flows, and Hillsborough Fails 356

Finding the Terminal Cash Flow 359

Terminal Cash Flow Drives Vehicle Selection at Pfizer 361

Summarizing the Relevant Cash Flows 361

International Managerial Finance: Long-Term Investments 362

Summary 362 Questions 363 Self-Test Problems 364 Problems 365 Solutions to Self-Test Problems 375

Chapter 10/Capital Budgeting Techniques: Certainty, Risk, and Some Refinements 379

Business Investment during the 1990s 379

Capital Budgeting Techniques 380

Payback Periods among Angels 382 Calculating Settlement NPVs at McNay Financial Services 385

Comparing NPV and IRR Techniques 390

Approaches for Dealing with Risk 395

Claremont's Views of the 1990s 399

Risk-Adjustment Techniques 399

Capital Budgeting Refinements 409 When Capital Rationing Was Limiting the Limited's Growth 412

xiv Contents in Detail

International Managerial Finance: Investment Cash Flows and Decisions 414

Summary 415 Questions 416 Self-Test Problems 417 Problems 418 Solutions to Self-Test Problems 431

Part Four Case: Lasting Impressions Company 436

PART FIVE/COST OF CAPITAL, LEVERAGE, AND CAPITAL STRUCTURE 439

Chapter 11 /The Cost of Capital 441 The Impact of the Decline of Junk Bonds on Capital Costs 441

An Overview of the Cost of Capital 443

Executive Compensation and Divisional Costs of Capital at McKesson Corporation 446

The Cost of Long-Term Debt (Bonds) 448

The Marcade Group's High Debt-Service Costs 449

The Cost of Preferred Stock 451

The Cost of Common Stock 452

Underpricing Berlitz International's Common Stock 456

The Weighted Average Cost of Capital (WACC) 458

First Interstate Bancor's Low Equity Capital Proportion 460

The Marginal Cost and Investment Decisions 461

Summary 466 Questions 468 Self-Test Problem 469 Problems 470 Solution to Self-Test Problem 477

Chapter 12/Leverage and Capital Structure 480 Arco's Changing Financial Leverage 480

Leverage 481

Breakeven Analysis and Time Inc.'s Acquisition of Warner Communications 486

Fine-Tuning Total Leverage at Morrison Knudsen 495

The Firm's Capital Structure 495

The Downside of Business Risk 500

Financial Risk Sinks Tracor 504

Contents in Detail XV

The EBIT-EPS Approach to Capital Structure 509

Choosing the Optimal Capital Structure 513

International Managerial Finance: Capital Structure 517

Summary 517 Questions 518 Self-Test Problems 519 Problems 520 Solutions to Self-Test Problems 527

Part Five Case: O'Grady Apparel Company 531

PART SIX/LONG-TERM FINANCING DECISIONS 535

Chapter 13/Long-Term Debt and Investment Banking 537 A Strategy for Reducing Bond Risk and Cost 537

Characteristics of Long-Term Debt Financing 539 The Hidden Appeal of Berkshire Hathaway's Zero-Coupon Debt 543

Term Loans 543

Corporate Bonds 545

Ford's Complex and Secret Debt Financing Package 550

Investment Banking 556

Selling Genesco Inc.'s Costly Junk Bonds 558

Using ESOPs to Raise New Capital 562

International Managerial Finance: Long-Term Debt 564

Summary 564 Questions 565 Self-Test Problem 566 Problems 566 Solution to Self-Test Problem 570

Chapter 14/Common Stock and Dividend Policy 572 Withdrawal of TLC Beatrice's Initial Public Offering (IPO) 572

The Nature of Equity Capital 573

Common Stock Fundamentals 575

Negative Equity at President Bush's Zapata 576

Stock Rights and Other Considerations 580 Maintaining Control at Vice-President Quayle's Central Newspapers, Inc. 581

Dividend Fundamentals 585 Finding Information in IBM's Dividend Policy 592

XVI Contents in Detail

Types of Dividend Policies 596

Creating Promus, a "Stub Stock," through Payment of Large Dividends 599

Other Forms of Dividends 599

International Managerial Finance: Equity Capital 605

Summary 605 Questions 606 Self-Test Problems 607 Problems 608 Solutions to Self-Test Problems 615

Chapter 15/Preferred Stock, Leasing, Convertibles, Warrants, and Options 617

Hong Kong's Dairy Farms InternationaPs Covered Warrants 617

Preferred Stock 618

Convertible Preferred Stock Reduces Financial Leverage at Forest Oil 622

Leasing 624

Leasing and Debt Work Together at Burger King 630

Convertible Securities 634

Stock-Purchase Warrants 640

Brooksfilms Inc.'s Planned Stock/Warrant Initial Public Offering 641

Options 646

The Options Market Is in for a Big Change 647

Summary 649 Questions 650 Self-Test Problems 651 Problems 652 Solutions to Self-Test Problems 659

Part Six Case: Lonestar Enterprises 662

PART SEVEN/SHORT-TERM FINANCIAL DECISIONS 665

Chapter 16/Net Working Capital and Short-Term Financing 667 Short-Term Financial Management at Via Systems 667

Net Working Capital Fundamentals 668

Net Working Capital Strategies 673

Merrill Lynch Stresses Working Capital Management 673

Spontaneous Sources of Short-Term Financing 679

Paying Quickly Worked for Shawmut Design 685

Contents in Detail xvii

Unsecured Sources of Short-Term Loans 686

Chase Manhattan Wants Small Business Customers Too 692

Secured Sources of Short-Term Loans 693

Valuing Collateral at Mechanics & Farmers Savings Bank 700

International Managerial Finance: Short-Term Financing 703

Summary 703 Questions 706 Self-Test Problems 708 Problems 709 Solutions to Self-Test Problems 715

Chapter 17/Cash and Marketable Securities 718 Cash Management among Japan's Cash-Rich Corporations 718

Cash and Marketable Security Balances 719

Bethlehem Steel's Motives for Holding Cash 720

The Efficient Management of Cash 724

Comparing Cash Conversion Cycles in the Food Industry 727

Worrying about Collecting Receivables at Prime Motor Inns 729

Cash Management Techniques 730

Marketable Securities 739

Investment Guidelines at International Minerals and Chemicals 743

International Managerial Finance: Cash Management 744

Summary 745 Questions 745 Self-Test Problems 746 Problems 747 Solutions to Self-Test Problems 752

Chapter 18/Accounts Receivable and Inventory 754 Accounts Receivable Management at Bell Springs Publishing 754

Credit Selection 755

Credibility Gap at Dun & Bradstreet 757

Changing Credit Standards 761

Changing Credit Terms 766

Collection Policy 769

Managing Receivables at Oracle Systems 770

Inventory Management 773

Increasing Inventory at Oshkosh B'Gosh 775

xviii Contents in Detail

Techniques for Managing Inventory 777 Supplier-Customer Partnership and Just-in-Time Systems 782

International Managerial Finance: Credit and Inventory Management 782

Summary 782 Questions 783 Self-Test Problems 784 Problems 785 Solutions to Self-Test Problems 790

Part Seven Case: Casa de Diseno 792

PART EIGHT/SPECIAL MANAGERIAL FINANCE TOPICS 795

Chapter 19/Mergers, LBOs, Divestitures, and Failure 797 The Art of Merging: Campeau versus May Department Stores 797

Merger Fundamentals 798

BancTec's Horizontal Merger 805

LBOs and Divestitures 805 Sea Containers' Spin-Off of Operating Units to Avoid a Hostile Takeover 808

Analyzing and Negotiating Business Mergers 808 National Presto: An Attractive LBO Candidate with Shark Repellent 820

Business Failure Fundamentals 823 KKR's Out-of-Court Restructuring of Seaman Furniture 826

Reorganization and Liquidation in Bankruptcy 827

International Managerial Finance: Mergers and Joint Ventures 834

Summary 834 Questions 835 Self-Test Problems 837 Problems 838 Solutions to Self-Test Problems 845

Chapter 20 / Internationa] Managerial Finance 848 The Financial Status of Bass PLC's Holiday Inns 848

Introduction 849 Caterpillar's International Barter Transactions 852

The Environment 852

Financial Statements 856

Contents in Detail xix

Risk 859

Macro Political Risk in China: 1990 863

Long-Term Investments 865

Investment Cash Flows and Decisions 866

Capital Structure 867

Long-Term Debt 868

Citicorp—A Major Financial Institution in Asia 870

Equity Capital 871

Short-Term Financing 872

Cash Management 875

Credit and Inventory Management 877

Mergers and Joint Ventures 878

Corning and Coca-Cola's Opposing Views on International Joint Ventures 879

Summary 880 Questions 881 Self-Test Problem 882 Problems 882 Solution to Self-Test Problem 884

Part Eight Case: Organic Solutions 885

APPENDIXES

Appendix A/Financial Tables A-l Appendix B/Career Opportunities in Managerial Finance and Financial Services B-l Appendix C / Instructions for Using the Gitman Software C-l Appendix D/ Using Computers and Spreadsheets D-l Appendix E/Answers to Selected End-of-Chapter Problems E-l

Glossary G-l Index 1-1