F I F T H E D I T I O N

Foundations of FinanceT H E L O G I C A N D P R A C T I C E O F F I N A N C I A L M A N A G E M E N T

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F I F T H E D I T I O N

Foundations of FinanceT H E L O G I C A N D P R A C T I C E O F F I N A N C I A L M A N A G E M E N T

A R T H U R J . K E O W N

Virginia Polytechnic Institute and State UniversityR. B. Pamplin Professor of Finance

J O H N D . M A R T I N

Baylor UniversityProfessor of Finance

Carr P. Collins Chair in Finance

J . W I L L I A M P E T T Y

Baylor UniversityProfessor of Finance

W. W. Caruth Chair in Entrepreneurship

D A V I D F . S C O T T , J R .

University of Central FloridaExecutive Director, Dr. Phillips Institute

for the Study of American Business Activity and Professor of Finance

Upper Saddle River, New Jersey 07458

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Library of Congress Cataloging-in-Publication DataFoundations of finance : the logic and practice of financial management / Arthur J. Keown

... [et al.].5th ed.p. cm.

Includes bibliographical references and indexes.ISBN 0-13-185605-71. CorporationsFinance. I. Keown, Arthur J.

HG4026 .F67 2006658.15--dc22 2005045934

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To my parents, from whom I learned the most.Arthur J. Keown

To my grandson Luke and his little brother who arrives in June 2005.

John D. Martin

To Bobbye and LaVerne, loving and supportive wives to my brothers and the most wonderful sisters

I could ever have.J. William Petty

To my sister, Dianne, and her husband, Ron, who have been both supportive family

and engaging friends over so many years.David F. Scott, Jr.

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A B O U T T H E A U T H O R S

A R T H U R J . K E O W N is the R. B. Pamplin Professor of Finance at Virginia PolytechnicInstitute and State University. He received his bachelors degree from Ohio WesleyanUniversity, his M.B.A. from the University of Michigan, and his doctorate from IndianaUniversity. An award-winning teacher, he is a member of the Academy of TeachingExcellence; has received five Certificates of Teaching Excellence at Virginia Tech, the W. E.Wine Award for Teaching Excellence, and the Alumni Teaching Excellence Award; and in1999 received the Outstanding Faculty Award from the State of Virginia. Professor Keown iswidely published in academic journals. His work has appeared in The Journal of Finance, theJournal of Financial Economics, the Journal of Financial and Quantitative Analysis, The Journal ofFinancial Research, the Journal of Banking and Finance, Financial Management, the Journalof Portfolio Management, and many others. In addition to Foundations of Finance, two other ofhis books are widely used in college finance classes all over the countryBasic FinancialManagement and Personal Finance: Turning Money into Wealth. Professor Keown is a Fellow ofthe Decision Sciences Institute, a member of the Board of Directors of the FinancialManagement Association, and former head of the finance department at Virginia Tech. Inaddition, he recently served as the co-editor of The Journal of Financial Research for six and ahalf years and as the co-editor of the Financial Management Associations Survey and Synthesisseries for six years. He lives with his wife and two children in Blacksburg, Virginia, where hecollects original art from Mad Magazine.

J O H N D . M A R T I N is Professor of Finance and the holder of the Carr P. Collins Chair ofFinance at Baylor University. Dr. Martin came to Baylor University in 1998 from theUniversity of Texas at Austin where he taught for nineteen years and was the Margaretand Eugene McDermott Centennial Professor of Finance. He teaches corporate finance andhis research interests are in corporate governance, the evaluation of firm performance,and the design of incentive compensation plans. Dr. Martin has published widely in acade-mic journals including the Journal of Financial Economics, The Journal of Finance, Journal ofMonetary Economics, Journal of Financial and Quantitative Analysis, Journal of CorporateFinance, Financial Management, and Management Science. His work has also appeared in anumber of professional publications including Directors and Boards, the Financial AnalystsJournal, the Journal of Portfolio Management, and the Journal of Applied Corporate Finance. Inaddition to this book Dr. Martin is co-author of nine books including Financial Management(9th ed., Prentice Hall), The Theory of Finance (Dryden Press), Financial Analysis (2nd ed.,McGraw Hill), and Value Based Management (Harvard Business School Press), and he is cur-rently writing a book on interest rate modeling. He serves on the editorial boards of eightjournals and has delivered executive education programs for a number of firms includingShell Chemical, Shell E&P, Texas Instruments, and The Associates.

J . W I L L I A M P E T T Y is Professor of Finance and the W. W. Caruth Chairholder ofEntrepreneurship at Baylor University. He holds a Ph.D. and M.B.A. from the Universityof Texas at Austin, and a B.S. from Abilene Christian University. He has taught at VirginiaTech University and Texas Tech University, and served as the dean of the business school atAbilene Christian University. His research interests include the creation and financing ofhigh-potential entrepreneurial firms and shareholder value-based management. He is alsothe Director of the Entrepreneurship Program at Baylor University. He has served as theco-editor for the Journal of Financial Research and the editor of the Journal of Entrepreneurialand Small Business Finance. He has published in a number of finance journals and is the co-author of two leading corporate finance textbooks, Basic Financial Management andFoundations of Finance, and co-author of a widely used text, Small Business Management. Dr.Petty serves on the board of a publicly traded oil and gas firm. He has also served as a sub-ject matter expert on a best-practices study by the American Productivity and QualityCenter on the topic of shareholder value-based management. He recently served on aresearch team for the Australian Department of Industry to study the feasibility of estab-lishing a public equity market for small and medium-sized enterprises in Australia.

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D A V I D F. S C O T T, J R . received his Ph.D. from the University of Florida, an M.B.A.from the University of Detroit, and a B.S.B.A. from the University of Akron. He holds thePhillips-Schenck Chair in American Private Enterprise, is Executive Director, Dr. PhillipsInstitute for the Study of American Business Activity, and is Professor of Finance at theUniversity of Central Florida. From 1977 to 1982 he was Area Coordinator, then Head,Department of Finance, Insurance, and Business Law at Virginia Polytechnic Institute andState University. During 19851986 he was President of the Financial ManagementAssociation, an international group with 9,000 members. He was a member of the Board ofTrustees of FMA from 1986 to 1993.

Dr. Scott is a member of the Board of Directors of CompBenefits Corporation,headquartered in Atlanta, Georgia. He is a past member of the local Board of Directors ofBankFIRST-Goldenrod (Florida), which specializes in commercial banking services forsmall businesses. He served on the Investment Policy Committee of the University ofCentral Florida Foundation for over 10 years. Dr. Scott is also past founding co-editorof the Journal of Financial Research, past associate editor for the Akron Business and EconomicReview, and past associate editor for Financial Management. He is past president of theSouthern Finance Association. In addition to Foundations of Finance, Dr. Scott is co-authorof Basic Financial Management, Cases in Finance, and Guide to Financial Analysis. He is widelypublished in academic journals including Financial Management, Engineering Economist,Journal of Financial and Quantitative Analysis, Business Economics, and many others.

Dr. Scotts op-ed and research pieces have appeared in several leading outlets intendedfor consumer and practitioner audiences. These include USA Today, The Miami Herald, TheSt. Petersburg Times, Florida Today, Orlando Sentinel, and Florida Trend.

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B R I E F C O N T E N T S

P A R T 1 : T H E S C O P E A N D E N V I R O N M E N T

O F F I N A N C I A L M A N A G E M E N T 2

C H A P T E R 1An Introduction to the Foundations of Financial ManagementThe Ties That Bind 5

C H A P T E R 2The Financial Markets and Interest Rates 31

C H A P T E R 3Understanding Financial Statements and Cash Flows 73

C H A P T E R 4Evaluating a Firms Financial Performance 101

P A R T 2 : V A L U A T I O N O F F I N A N C I A L A S S E T S 1 3 4

C H A P T E R 5The Time Value of Money 137

C H A P T E R 6The Meaning and Measurement of Risk and Return 173

C H A P T E R 7Valuation and Characteristics of Bonds 205

C H A P T E R 8Valuation and Characteristics of Stock 231

P A R T 3 : I N V E S T M E N T I N L O N G - T E R M A S S E T S 2 5 6

C H A P T E R 9Capital-Budgeting Techniques and Practice 259

C H A P T E R 1 0Cash Flows and Other Topics in Capital Budgeting 295

C H A P T E R 1 1Cost of Capital 329

P A R T 4 : C A P I T A L S T R U C T U R E

A N D D I V I D E N D P O L I C Y 3 6 4

C H A P T E R 1 2Determining the Financing Mix 367

C H A P T E R 1 3Dividend Policy and Internal Financing 415

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x B R I E F C O N T E N T S

P A R T 5 : W O R K I N G - C A P I T A L M A N A G E M E N T

A N D I N T E R N A T I O N A L B U S I N E S S F I N A N C E 4 4 4

C H A P T E R 1 4Short-Term Financial Planning 447

C H A P T E R 1 5Working-Capital Management 469

C H A P T E R 1 6Current Asset Management 491

C H A P T E R 1 7International Business Finance 527

A P P E N D I X A Using a Calculator 551A P P E N D I X B Compound Sum of $1 FVIFi%, n years 563A P P E N D I X C Present Value of $1 PVIFi%, n years 565A P P E N D I X D Sum of an Annuity of $1 for n Periods FVIFAi%, n years 567A P P E N D I X E Present Value of an Annuity of $1 for n Periods PVIFAi%, n years 569A P P E N D I X F Check Figures for Selected End-of-Chapter Study Problems 571

Glossary 575

Indexes 585

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C O N T E N T S

About the Authors vi

Preface xxi

P A R T : 1 T H E S C O P E A N D E N V I R O N M E N T

O F F I N A N C I A L M A N A G E M E N T 2

C H A P T E R 1An Introduction to the Foundations of Financial ManagementThe Ties That Bind 5

Goal of the Firm 6Legal Forms of Business Organization 7AN ENTREPRENEURS PERSPECTIVE: Limited Liability and the Entrepreneur 10Federal Income Taxation 11Ten Principles That Form the Foundations of Financial Management 16PRINCIPLE 1: The RiskReturn Trade-OffWe Wont Take On Additional Risk Unless

We Expect to Be Compensated with Additional Return 16PRINCIPLE 2: The Time Value of MoneyA Dollar Received Today Is Worth More

Than a Dollar Received in the Future 17PRINCIPLE 3: CashNot ProfitsIs King 17PRINCIPLE 4: Incremental Cash FlowsIts Only What Changes That Counts 17PRINCIPLE 5: The Curse of Competitive MarketsWhy Its Hard to Find

Exceptionally Profitable Projects 18PRINCIPLE 6: Efficient Capital MarketsThe Markets Are Quick and the Prices Are

Right 19PRINCIPLE 7: The Agency ProblemManagers Wont Work for the Owners Unless Its

in Their Best Interest 20PRINCIPLE 8: Taxes Bias Business Decisions 20PRINCIPLE 9: All Risk Is Not EqualSome Risk Can Be Diversified Away, and Some

Cannot 21PRINCIPLE 10: Ethical Behavior Is Doing the Right Thing, and Ethical Dilemmas Are

Everywhere in Finance 22ETHICS IN FINANCIAL MANAGEMENT: The Enron Lessons: Trust 23AN ENTREPRENEURS PERSPECTIVE: The Entrepreneur and Finance 24Finance and the Multinational Firm: The New Role 24Summary 25Key Terms 26Study Questions 26Self-Test Problem 27Study Problems 27Comprehensive Problem 28Self-Test Solution 29

C H A P T E R 2The Financial Markets and Interest Rates 31

The Financial Manager, Internal and External Funds, and Flexibility 34The Mix of Corporate Securities Sold in the Capital Market 36

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xii C O N T E N T S

Why Financial Markets Exist 37Financing of Business: The Movement of Funds Through the Economy 39Components of the U.S. Financial Market System 41The Investment Banker 45ACROSS THE HALL: Management and Selection Criteria for an Investment Banker 48Private Placements 48Flotation Costs 50Regulation 50Rates of Return in the Financial Markets 55Interest Rate Levels over Recent Periods 56ACROSS THE HALL: EconomicsCommercial Banking and the Importance ofInterest Rates 59Interest Rate Determinants in a Nutshell 60The Term Structure of Interest Rates 63Finance and the Multinational Firm: Efficient Financial Markets and Intercountry Risk 67Summary 67Key Terms 69Study Questions 69Study Problems 70Web Works 70Comprehensive Problems 71

C H A P T E R 3Understanding Financial Statements and Cash Flows 73

Income Statement 74FINANCIAL MANAGEMENT IN PRACTICE: Starbucks Corporation: A Firm on the Go 76Balance Sheet 77ACROSS THE HALL: Want to Start a New Business? Better Know Your Numbers 78FINANCIAL MANAGEMENT IN PRACTICE: Being Profitable Is Vital: Just Ask FordMotor Company 81Measuring Cash Flows 82FINANCIAL MANAGEMENT IN PRACTICE: Profits and Cash Matter: The FedExDilemma 86FINANCIAL MANAGEMENT IN PRACTICE: Measuring Free Cash Flows: The TycoInternational Way 87ETHICS IN FINANCIAL MANAGEMENT: Financial Scandals: European Style 88Summary 89Key Terms 90Study Questions 91Self-Test Problem 91Study Problems 92Web Works 96Comprehensive Problem 97Self-Test Solution 99

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C H A P T E R 4Evaluating a Firms Financial Performance 101

The Purpose of Financial Analysis 102FINANCIAL MANAGEMENT IN PRACTICE: Only with Financial Analysis Can We KnowHow We Are Doing 104Measuring Key Financial Relationships 105FINANCIAL MANAGEMENT IN PRACTICE: Keeping Your Eyes on the Numbers 111FINANCIAL MANAGEMENT IN PRACTICE: Managing by the Numbers 113FINANCIAL MANAGEMENT IN PRACTICE: Economic Value Added Used to Measure aFirms Financial Performance 122Limitations of Financial Ratio Analysis 122Summary 123Key Terms 124Study Questions 125Self-Test Problems 125Study Problems 126Web Works 131Comprehensive Problem 131Self-Test Solutions 132

P A R T 2 : V A L U A T I O N O F F I N A N C I A L A S S E T S 1 3 4

C H A P T E R 5The Time Value of Money 137

Compound Interest and Future Value 138Tables, Calculators, and SpreadsheetsThree Alternatives to Solving Time Value ofMoney Problems 140Present Value 145Annuities 149Annuities Due 154Compound Interest with Nonannual Periods 158Present Value of an Uneven Stream 160Perpetuities 161The Multinational Firm: The Time Value of Money 161Summary 162Key Terms 163Study Questions 163Self-Test Problems 163Study Problems 163Web Works 169Comprehensive Problem 170Self-Test Solutions 171

C H A P T E R 6The Meaning and Measurement of Risk and Return 173

Expected Return Defined and Measured 174Risk Defined and Measured 175

C O N T E N T S xiii

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xiv C O N T E N T S

FINANCIAL MANAGEMENT IN PRACTICE: Want Big and Risky Returns: Think Small 178Rates of Return: The Investors Experience 179Risk and Diversification 181ACROSS THE HALL: Bankers Have to Diversify Too 185FINANCIAL MANAGEMENT IN PRACTICE: Do Stocks Always Give Higher ReturnsThan Bonds? 191The Investors Required Rate of Return 192FINANCIAL MANAGEMENT IN PRACTICE: Does Beta Always Work? 194Summary 195Key Terms 196Study Questions 196Self-Test Problems 197Study Problems 198Web Works 200Comprehensive Problem 200Self-Test Solutions 202

C H A P T E R 7Valuation and Characteristics of Bonds 205

Types of Bonds 206Terminology and Characteristics of Bonds 208FINANCIAL MANAGEMENT IN PRACTICE: Co-Cos: A Good Deal for Whom? 211Definitions of Value 211Determinants of Value 212FINANCIAL MANAGEMENT IN PRACTICE: Ethics: Keeping Perspective 214Valuation: The Basic Process 214Bond Valuation 215Yield to Maturity 218FINANCIAL MANAGEMENT IN PRACTICE: AT&T Bond Prices Fall Thanks toWorldCom 219Bond Valuation: Three Important Relationships 220Summary 224Key Terms 225Study Questions 225Self-Test Problems 225Study Problems 225Web Works 227Comprehensive Problem 227Self-Test Solutions 228

C H A P T E R 8Valuation and Characteristics of Stock 231

Preferred Stock 232FINANCIAL MANAGEMENT IN PRACTICE: Reading a Stock Quote in the Wall StreetJournal 234Common Stock 236FINANCIAL MANAGEMENT IN PRACTICE: What Does a Stock Look Like? 238FINANCIAL MANAGEMENT IN PRACTICE: What Do You Tell Your Shareholders? 239The Stockholders Expected Rate of Return 247

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Summary 251Key Terms 252Study Questions 252Self-Test Problems 252Study Problems 253Web Works 254Comprehensive Problem 255Self-Test Solutions 255

P A R T 3 : I N V E S T M E N T I N L O N G - T E R M A S S E T S 2 5 6

C H A P T E R 9Capital-Budgeting Techniques and Practice 259

Finding Profitable Projects 260Capital-Budgeting Decision Criteria 261FINANCIAL MANAGEMENT IN PRACTICE: Finding Profitable Projects in CompetitiveMarketsCreating Them by Developing a Cost Advantage 263ACROSS THE HALL: Marketing 266Capital Rationing 276Problems in Project Ranking: Capital Rationing, Mutually Exclusive Projects, andProblems with the IRR 278ETHICS IN FINANCIAL MANAGEMENT: The Financial Downside to Poor EthicalBehavior 282Ethics in Capital Budgeting 282A Glance at Actual Capital-Budgeting Practices 283Finance and the Multinational Firm: Capital Budgeting 284Summary 284Key Terms 286Study Questions 286Self-Test Problem 287Study Problems 287Web Works 291Comprehensive Problem 291Self-Test Solution 293

C H A P T E R 1 0Cash Flows and Other Topics in Capital Budgeting 295

Guidelines for Capital Budgeting 296FINANCIAL MANAGEMENT IN PRACTICE: Universal Studios 299An Overview of the Calculations of a Projects Free Cash Flows 299ACROSS THE HALL: Marketing 306Options in Capital Budgeting 308Risk and the Investment Decision 310Incorporating Risk into Capital Budgeting 313Examining a Projects Risk Through Simulation 316Finance and the Multinational Firm: Calculating Cash Flows and the InternationalDimension of Risk 319Summary 319Key Terms 320

C O N T E N T S xv

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Study Questions 320Self-Test Problem 321Study Problems 321Web Work 325Comprehensive Problem 325Self-Test Solution 327

C H A P T E R 1 1Cost of Capital 329

The Cost of Capital: Key Definitions and Concepts 330Determining Individual Costs of Capital 331FINANCIAL MANAGEMENT IN PRACTICE: IPOs: Should a Firm Go Public? 338The Weighted Average Cost of Capital 339Calculating Divisional Costs of Capital: PepsiCo, Inc. 342FINANCIAL MANAGEMENT IN PRACTICE: The Pillsbury Company Adopts EVA witha Grassroots Education Program 343Using a Firms Cost of Capital to Evaluate New Capital Investments 344Shareholder ValueBased Management 346FINANCIAL MANAGEMENT IN PRACTICE: New Users Explain Their Goals andObjectives in Adopting EVA 348Finance and the Multinational Firm: Why Do Interest Rates Differ BetweenCountries? 351FINANCIAL MANAGEMENT IN PRACTICE: Tying Incentive Compensation toEconomic Value Added 352Summary 353Key Terms 356Study Questions 356Self-Test Problems 356Study Problems 357Web Works 361Comprehensive Problem 361Self-Test Solutions 362

P A R T 4 : C A P I T A L S T R U C T U R E

A N D D I V I D E N D P O L I C Y 3 6 4

C H A P T E R 1 2Determining the Financing Mix 367

Business and Financial Risk 369Break-Even Analysis 370ACROSS THE HALL: AccountingCost Structure, Forecasting, and Investment 371FINANCIAL MANAGEMENT IN PRACTICE: General Motors: Pricing Strategy in a SlowAggregate Economy 377Operating Leverage 377Financial Leverage 380Combination of Operating and Financial Leverage 383FINANCIAL MANAGEMENT IN PRACTICE: Coca-Cola Financial Policies 385Planning the Financing Mix 385

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FINANCIAL MANAGEMENT IN PRACTICE: The Enron Lessons: Leverage 386A Quick Look at Capital Structure Theory 387FINANCIAL MANAGEMENT IN PRACTICE: Georgia-Pacific on Capital Structure 396Basic Tools of Capital Structure Management 396FINANCIAL MANAGEMENT IN PRACTICE: The Walt Disney Company on CapitalCosts and Capital Structure 401A Glance at Actual Capital Structure Management 402Finance and the Multinational Firm: Business Risk and Global Sales 404Summary 404Key Terms 406Study Questions 406Self-Test Problem 407Study Problems 407Web Works 411Comprehensive Problems 412Self-Test Solution 413

C H A P T E R 1 3Dividend Policy and Internal Financing 415

Key Terms 416Does Dividend Policy Affect Stock Price? 417The Dividend Decision in Practice 426Alternative Dividend Policies 427Dividend Payment Procedures 430Stock Dividends and Stock Splits 431Stock Repurchases 433FINANCIAL MANAGEMENT IN PRACTICE: Many Concerns Use Excess Cash toRepurchase Their Shares 435Finance and the Multinational Firm: The Case of Low-Dividend Payments; So WhereDo We Invest? 436Summary 438Key Terms 439Study Questions 439Self-Test Problems 440Study Problems 440Web Works 441Comprehensive Problem 442Self-Test Solutions 443

P A R T 5 : W O R K I N G - C A P I T A L M A N A G E M E N T

A N D I N T E R N A T I O N A L B U S I N E S S F I N A N C E 4 4 4

C H A P T E R 1 4Short-Term Financial Planning 447

Financial Forecasting 448The Sustainable Rate of Growth 453FINANCIAL MANAGEMENT IN PRACTICE: Sustainable GrowthA BroaderPerspective at DuPont 454Limitations of the Percent of Sales Forecast Method 454

C O N T E N T S xvii

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xviii C O N T E N T S

FINANCIAL MANAGEMENT IN PRACTICE: To Bribe or Not to Bribe 456Constructing and Using a Cash Budget 456FINANCIAL MANAGEMENT IN PRACTICE: Being Honest About the Uncertainty of theFuture 458Summary 458Key Terms 459Study Questions 459Self-Test Problems 459Study Problems 460Web Works 465Comprehensive Problem 466Self-Test Solutions 467

C H A P T E R 1 5Working-Capital Management 469

Managing Current Assets and Liabilities 470Appropriate Level of Working Capital 471Estimation of the Cost of Short-Term Credit 474Sources of Short-Term Credit 475FINANCIAL MANAGEMENT IN PRACTICE: Managing Working Capital by TrimmingReceivables 476Multinational Working-Capital Management 483Summary 484Key Terms 485Study Questions 485Self-Test Problems 486Study Problems 486Web Works 488Self-Test Solutions 489

C H A P T E R 1 6Current Asset Management 491

Why a Company Holds Cash 492Cash Management Objectives and Decisions 494Collection and Disbursement Procedures 495Evaluation of Costs of Cash Management Services 501Composition of Marketable-Securities Portfolio 502Accounts-Receivable Management 508Inventory Management 511Summary 517Key Terms 518Study Questions 518Self-Test Problems 518Study Problems 519Web Works 523Comprehensive Problem 523Self-Test Solutions 524

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C H A P T E R 1 7International Business Finance 527

The Globalization of Product and Financial Markets 528Exchange Rates 528ACROSS THE HALL: Marketing 536Interest-Rate Parity Theory 536FINANCIAL MANAGEMENT IN PRACTICE: The Euro Has Yet to Spark Hoped-ForFinancial Revolution 537Purchasing-Power Parity Theory 537Exposure to Exchange Rate Risk 539Multinational Working-Capital Management 542International Financing and Capital Structure Decisions 543Direct Foreign Investment 544Summary 546Key Terms 546Study Questions 547Self-Test Problem 547Study Problems 548Web Works 548Comprehensive Problem 548Self-Test Solution 549

Appendixes 551

A P P E N D I X A Using a Calculator 551

A P P E N D I X B Compound Sum of $1 FVIFi%, n years 563

A P P E N D I X C Present Value of $1 PVIFi%, n years 565

A P P E N D I X D Sum of an Annuity of $1 for n Periods FVIFAi%, n years 567

A P P E N D I X E Present Value of an Annuity of $1 for n Periods PVIFAi%, n years 569

A P P E N D I X F Check Figures for Selected End-of-Chapter Study Problems 571

Glossary 575

Indexes 585

C O N T E N T S xix

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P R E F A C E

In finance, our goal is to create wealth. This is done by providing customers with the bestproduct and service possible, and it is the market response that determines whether wereach our goal. We are very proud of the market reaction to Foundations of Finance; themarkets response has been overwhelming. With its success comes an even greaterresponsibility to deliver the finest possible textbook and supplementary package possible.We have done this with a two-pronged approach of refinement, based on users comments,and of remaining the innovative leaders in the field, focusing on value-added innovations.

Foundations of Finance has gained the reputation for being intuitiveallowing thereader to see the forest through the treesand lively and easy to read. In the fifthedition of Foundations of Finance, we have tried to build on these strengths, introducing thelatest concepts and developments in finance in a practical and intuitive manner.

P E D A G O G Y T H A T W O R K S

This book provides students with a conceptual understanding of the financial decision-making process, rather than just an introduction to the tools and techniques of finance. Forthe student, it is all too easy to lose sight of the logic that drives finance and focus insteadon memorizing formulas and procedures. As a result, students have a difficult timeunderstanding the interrelationships among the topics covered. Moreover, later in lifewhen the problems encountered do not match the textbook presentation, students may findthemselves unprepared to abstract from what they learned. To overcome this problem, theopening chapter presents 10 underlying principles of finance, which serve as a springboardfor the chapters and topics that follow. In essence, the student is presented with a cohesive,interrelated perspective from which future problems can be approached.

With a focus on the big picture,we provide an introduction tofinancial decision making rooted incurrent financial theory and in thecurrent state of world economicconditions. This focus is perhaps mostapparent in the attention given to thecapital markets and their influence oncorporate financial decisions. Whatresults is an introductory treatment ofa discipline rather than the treatmentof a series of isolated problems thatface the financial manager. The goal ofthis text is not merely to teach thetools of a discipline or trade but also toenable students to abstract what islearned to new and yet unforeseenproblemsin short, to educate thestudent in finance.

I N N O V A T I O N S A N D D I S T I N C T I V E F E A T U R E S

I N T H E F O U R T H E D I T I O N

PA R T- O P E N I N G I N T E R V I E W S W I T H B U S I N E S S P R O F E S S I O N A L SThese give students in-the-trenches insights into the application of theory to practice inthe real world and provide perspective for anyone who is planning a career in business.

O b j e c t i v e 4 T E N P R I N C I P L E S T H A T F O R M T H E F O U N D A T I O N S O F F I N A N C I A L M A N A G E M E N T

To the first-time student of finance, the subject matter may seem like a collection of unre-lated decision rules. This could not be further from the truth. In fact, our decision rules,and the logic that underlies them, spring from 10 simple principles that do not requireknowledge of finance to understand. However, although it is not necessary to understand financein order to understand these principles, it is necessary to understand these principles in order tounderstand finance. Keep in mind that although these principles may at first appear simple oreven trivial, they provide the driving force behind all that follows. These principles weavetogether concepts and techniques presented in this text, thereby allowing us to focus on thelogic underlying the practice of financial management.

PRINCIPLE 1 The RiskReturn Trade-OffWe Wont Take On Additional RiskUnless We Expect to Be Compensated with Additional Return

At some point we have all saved some money. Why have we done this? The answer issimple: to expand our future consumption opportunities. We are able to invest those sav-ings and earn a return on our dollars because some people would rather forgo future con-sumption opportunities to consume more now. Maybe theyre borrowing money to open anew business or a company is borrowing money to build a new plant. Assuming there are alot of different people who would like to use our savings, how do we decide where to putour money?

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xxii P R E FA C E

N E W A C R O S S T H E H A L LB O X E SA new box feature titled Across the Hallhas been introduced in this edition ofFoundations of Finance. This box draws onprofessionals and their experiences frommarketing, management, and accountingto illustrate how the material beingpresented pertains to what they do.

E X C E L S P R E A D S H E E T SExcel spreadsheets are used to move money through time, deal with valuation of financialassets, and evaluate capital budgeting projects. These spreadsheet solutions are integratedthroughout the text with spreadsheet problems now appearing at the end of various chapters,where appropriate.

A C R O S S

T H E H A L L

Robert A. Bennett, a banker, says that diversifying is importantfor any business, including banks. He makes the point thatbankers need to understand the importance of diversifying,especially in uncertain times.

In the quest to increase their earnings, many banks forgot theimportance of diversification. Rushing into the momentshottest businesses, they abandoned activities that at the timeseemed lackluster. The go-go businesses of the 1990s reflectedthe stock markets boom: investment banking, stock brokerage,wealth management and equity investment. On the other side,banks were dumping what seemed to be slow-growth activities:mortgage banking, auto financing and credit cards.In these uncertain times it is unclear which way to turn. It appearsthe best gamble is to spread your bets across a wide spectrum.Citigroup is a case in point. The decline in the stock marketswalloped the earnings of its investment banking activities,where income dropped $497 million in the first quarter. That,

indeed was a severe blow that was primarily responsible for the7% decline in Citis year-overs-year first-quarter earnings.But as Sandy Weill, Citis CEO, said in the companys earningsreport: This is precisely the kind of market that demonstratesthe power of our franchise. The strength and diversity of ourearnings by business, geography, and customer helped to delivera strong bottom line in a period of market uncertainty.Considering the plunge in investment banking income, thingscould have been a lot worse. Despite the drop in income frominvestment activities, Citi succeeded in getting a 22.5% return onequity. Thats even better than its 22% return last year, and betterthan its average ROE of 19% for the three-year period 19982000.As David S. Berry, head of research at Keefe, Bruyette &Woods, put it: Citigroup again demonstrated the benefits ofdiversification and leadership across its business lines.

Source: Robert A. Bennett, When in Doubt, Diversify, U.S. Banker, vol. 11,no. 5 (May 2001), p. 6.

BANKERS HAVE TO DIVERSIFY TOO

N E W A N E N T R E P R E N E U R SP E R S P E C T I V E B O X E SA new box feature titled An EntrepreneursPerspective that highlights issues faced bysmall and medium-sized firms has beenintroduced. These boxes look at financefrom the point of view of someone whowould like to start his or her own successfulbusiness.

A N E N T R E P R E N E U R S

P E R S P E C T I V E

Do you ever think about wanting to someday own your ownbusiness? Does being an entrepreneur have any appeal to you?Well, it does for a lot of people. During the past decade, startingand growing companies have been the preferred avenue manyhave chosen for careers. In fact, while many of the large compa-nies are reducing the number of employees, smaller companiesare creating new jobs by the thousands. A lot of individuals havethought that there was greater security in working with a bigcompany, only to be disillusioned in the end when they wereinformed that Friday is your last day.

Defining an entrepreneur is not an easy thing to do. But wecan say with some clarity what entrepreneurship is about.Entrepreneurship has been defined as a relentless pursuit ofopportunity for the purpose of creating value, without concernfor the resources owned.

To be successful, the entrepreneurial process requires thatthe entrepreneur be able to:

Identify a good opportunity. Oftentimes we may have a goodidea, but it may not be a good opportunity. Opportunitiesare market driven. There must be enough customers whowant to buy our product or service at a price that covers ourexpenses and leaves an attractive profitno matter howmuch we may like the idea.

Gain access to the resources needed. For any venture, thereare critical resourceshuman, financial, and physicalthatmust be available. The entrepreneur usually does not have

the capital to own all the resources that are needed. So theentrepreneur must have access to resources but usually can-not afford to own them. Its what we call bootstrapping. Thegoal is to do more with less.

Launch the venture. All the planning in the world is notenough. The entrepreneur must be action oriented. Itrequires a can do spirit.

Grow the business. A business has to grow if it is to be suc-cessful. Frequently, the firm will not break even for severalyears, which means that we will be burning up cash eachmonth. Being able to survive during the time that cashflows are negative is no easy task. If we grow too slow, welose, but also if we grow too fast, we may lose as well.During this time, additional capital will be needed, whichrequires that we know how to value the firm and how tostructure financing.

Exit the business. If a venture has been successful, the entre-preneur will have created economic value that is locked upin the business. At some point in time, the entrepreneur willwant to capture the value that has been created by the busi-ness. It will be time to harvest.

To be successful as an entrepreneur requires an understandingof finance. At the appropriate places in Financial Management,we will be presenting how finance relates to the entrepreneur-ial journey. It is an interesting topic that we think you willenjoy.

THE ENTREPRENEUR AND FINANCE

R E A L - W O R L D O P E N I N G V I G N E T T E SEach chapter begins with a story about a current, real-world company faced with a financial decisionrelated to the chapter material that follows. These vignettes have been carefully prepared to stimulatestudent interest in the topic to come and can be used as a lecture tool to provoke class discussion.

N E W A N D I M P R O V E D P R O B L E M S E T SThe end-of-chapter study problem sets have been improved and expanded to allow for a wider rangeof student problems.

N E W W E B W O R K S I N T E R N E T P R O B L E M SInternet problems have been introduced at the end of each chapter. These problems direct thestudent to Internet sites that allow them to explore financial issues and solve financial problems usingthe Web.

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I N T E G R A T E D E X A M P L E SThese provide students with real-world examples to helpthem apply the concepts presented in each chapter.

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U S E O F A N I N T E G R A T E D L E A R N I N G S Y S T E MThe text is organized around the learning objectives that appear at the beginning of eachchapter to provide the instructor and student with an easy-to-use integrated learning system.Numbered icons identifying each objective appear next to the related material throughout thetext and in the summary, allowing easy location of material related to each objective.

PA U S E A N D R E F L E C TA timeline often makes it easier to understand time value of money problems. Byvisually plotting the flow of money, you can better determine which formula to use.Arrows placed above the line are inflows, whereas arrows below the line representoutflows. One thing is certain: Timelines reduce errors.

E X A M P L EIf we place $1,000 in a savings account paying 5 percent interest compounded annually,how much will our account accrue to in 10 years? Substituting PV $1,000, i 5 per-cent, and n 10 years into equation (5-6), we get

FVn PV(1 + i)n

$1,000(1 + .05)10 $1,000(1.62889) $1,628.89

Thus, at the end of 10 years we will have $1,628.89 in our savings account.

E T H I C S I N

F I N A N C I A L M A N A G E M E N T

The bankruptcy and failure of the Enron Corporation onDecember 2, 2001, shook the investment community to its verycore and resulted in congressional hearings that could lead tonew regulations with far-reaching implications. Enrons failureprovides a sober warning to employees and investors and a valu-able set of lessons for students of business. The lesson we offerhere reaches far beyond corporate finance and touches on fun-damental principles that have always been true but are some-times forgotten.

Lesson: Trust and Credibility Are Essential to Business SuccessThe viability of any firm hinges critically on the firms credibil-ity with its customers, employees, regulators, investors, andeven to some degree, competitors. This is particularly criticalfor a trading company such as Enron, whose primary businessrests on the willingness of the firms counterpart with whom ittrades to trust in Enrons ability to be there when the timeto settle up arrives. When the faith of the investment commu-nity was tested with the revelation of losses from some ofEnrons largest investments and the subsequent disclosureof Enrons off-balance-sheet liabilities, Enrons trading businessevaporated.

We also were reminded of the fact that investors mustbelieve that a firms published financial reports are a fair repre-sentation of the firms financial condition. Without this trust,outside investors would refuse to invest in the shares of publiclytraded firms, and financial markets would collapse.a

Trust between two entities is hard to sustain when one ofthe parties has dual and conflicting motives. We refer to thepresence of multiple motives as a conflict of interest, and thepotential for conflict-of-interest problems was in abundanceas Enron fell to earth. Some of the following sources of con-flict apply only to Enron, whereas others apply to manyfirms:

Enrons chief financial officer (CFO) attempted to serve twomasters when he was both the CFO and the general partner

THE ENRON LESSONS: TRUSTfor a series of limited partnerships used by Enron to financeits investments and hedge certain investment returns. Therewere times when he represented the interests of Enron incircumstances that were in direct conflict with the interestsof the partners to the partnerships. It is still not clear how hehandled these circumstances, but the source of concern toEnrons shareholders is obvious.

Were corporate insiders (executives) selling their stockbased on their privileged knowledge of the firms true finan-cial condition during the months prior to the firms failure,while outside investors were being duped into holding theirshares? Allegations abound that top corporate executives atEnron were selling their shares long before other employeesand outside investors knew how serious the firms problemswere. Regardless of the outcome in the Enron case, thisraises a serious dilemma for investors, who cannot know asmuch about the financial condition of the firms in whichthey invest as the managers know.

Can auditing firms that accept consulting engagementswith their audit clients be truly independent, or is that inde-pendence compromised? The Enron failure has called intoquestion the wisdom of relying on external auditing firmsthat are beholden to the firms they audit, both for theircontinued employment as an auditor and for consulting feesthat can sometimes dwarf their audit fees.

Finally, investors often rely on the opinions of equity ana-lysts. Investors make the assumption that the analysts areoffering unfettered, independent opinions of a companysfinancial prospects. However, in many cases the analystswork for investment banks that, in turn, rely on investment-banking fees from the very companies the analysts cover.The potential conflict of interest is obvious.

aThis is simply a recasting of the famous result from microeconomics statingthat where informational asymmetry problems between buyers and sellers areextreme, markets will collapse [George Akerlof, The Market for Lemons:Qualitative Uncertainty and the Market Mechanism, Quarterly Journal ofEconomics, 84 (1970), pp. 488500].

WHAT S AHEAD In this chapter, we lay a foundation for the entirebook by discussing what finance is and then explain-ing the key goal that guides financial decision mak-ing: maximization of shareholder wealth. We discussthe legal and tax environment of financial decisions

and describe the golden thread that ties everythingtogether: the 10 basic principles of finance. Finally,we briefly look at what has led to the rise in multina-tional corporations.

W H A T S A H E A DThese features allow students to previewwhats coming up in the chapter. Theyinclude real-world examples to help studentsunderstand the relevance of the concepts tothe financial world.

PA U S E A N D R E F L E C TIn-text inserts appear throughout and focus thestudents attention on the big picture. These insertshelp students identify the interrelationships andmotivating factors behind core concepts.

E X T E N S I V E C O V E R A G EO F E T H I C SEthics is covered as a core principle andEthics in Financial Management boxes appearthroughout. These show students that ethicalbehavior is doing the right thing and thatethical dilemmas are everywhere in finance.

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C O M P R E H E N S I V EE N D - O F - C H A P T E R P R O B L E M SA comprehensive problem appears at the end ofalmost every chapter, covering all the major topicsincluded in that chapter. This comprehensive problemcan be used as a lecture or review tool by the professor.For the students, it provides an opportunity to applyall the concepts presented within the chapter in arealistic setting, thereby strengthening theirunderstanding of the material.

B A C K T O T H E F O U N D A T I O N SThese in-text inserts appear throughout to allow thestudent to take time out and reflect on the meaning of thematerial just presented. The use of these inserts, coupledwith the use of the 10 principles, keeps the studentfocused on the interrelationships and motivating factorsbehind the concepts.

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C O N C E P T C H E C K SAt the end of most major sections, concept checkshighlight the key ideas just presented and allow studentsto test their understanding of the material.

C O N C E P T C H E C K

1. What is an amortized loan?

B A C K T O T H E F O U N D AT I O N S

Valuing common stock is no different from valuing preferred stock; only the pattern of the cash flowschanges. Thus, the valuation of common stock relies on the same three principles developed inChapter 1 that were used in valuing preferred stock:

Principle 1: The RiskReturn Trade-OffWe Wont Take on Additional Risk Unless We Expectto Be Compensated with Additional Return.

Principle 2: The Time Value of MoneyA Dollar Received Today Is Worth More Than a DollarReceived in the Future.

Principle 3: CashNot ProfitsIs King.

Determining the economic worth or value of an asset always relies on these three principles. Withoutthem, we would have no basis for explaining value.With them, we can know that the amount and timing ofcash, not earnings, drives value. Also, we must be rewarded for taking risk; otherwise, we will not invest.

For your job as the business reporter for a local newspaper, you are given the task of puttingtogether a series of articles that explain the power of the time value of money to your readers. Youreditor would like you to address several specific questions in addition to demonstrating for the read-ership the use of time value of money techniques by applying them to several problems. Whatwould be your response to the following memorandum from your editor?

To: Business ReporterFrom: Perry White, Editor, Daily PlanetRe: Upcoming Series on the Importance and Power of the Time Value of Money

In your upcoming series on the time value of money, I would like to make sure you cover severalspecific points. In addition, before you begin this assignment, I want to make sure we are all readingfrom the same script, as accuracy has always been the cornerstone of the Daily Planet. In this regard,Id like a response to the following questions before we proceed:

a. What is the relationship between discounting and compounding?b. What is the relationship between the PVIFi, n and PVIFAi, n?c. 1. What will $5,000 invested for 10 years at 8 percent compounded annually grow to?

2. How many years will it take $400 to grow to $1,671 if it is invested at 10 percent com-pounded annually?

3. At what rate would $1,000 have to be invested to grow to $4,046 in 10 years?d. Calculate the future sum of $1,000, given that it will be held in the bank for 5 years and earn

10 percent compounded semiannually.e. What is an annuity due? How does this differ from an ordinary annuity?f. What is the present value of an ordinary annuity of $1,000 per year for 7 years dis-

counted back to the present at 10 percent? What would be the present value if it werean annuity due?

g. What is the future value of an ordinary annuity of $1,000 per year for 7 years compoundedat 10 percent? What would be the future value if it were an annuity due?

h. You have just borrowed $100,000, and you agree to pay it back over the next 25 years in 25equal end-of-year annual payments that include the principal payments plus 10 percentcompound interest on the unpaid balance. What will be the size of these payments?

i. What is the present value of a $1,000 perpetuity discounted back to the present at 8 percent?j. What is the present value of a $1,000 annuity for 10 years, with the first payment occurring

at the end of year 10 (that is, ten $1,000 payments occurring at the end of year 10 throughyear 19), given an appropriate discount rate of 10 percent?

k. Given a 10 percent discount rate, what is the present value of a perpetuity of $1,000 per yearif the first payment does not begin until the end of year 10?

C O M P R E H E N S I V E P R O B L E MC O M P R E H E N S I V E P R O B L E M

K E Y T E R M S I D E N T I F I E D I N T H E M A R G I N SKey terms are called out in the margin and highlighted in the text. They can also be found inthe glossary in the back of the book with definitions, making it easier for the students to checktheir understanding of key terms. At the end of each chapter, key terms are listed along withpage numbers as a study checklist for students.

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F I N A N C I A L C A L C U L A T O R SThe use of financial calculators has been integrated throughout this text, especially withrespect to the presentation of the time value of money. Where appropriate, calculatorsolutions appear in the margin.

C O N T E N T U P D A T I N GIn response to both the continued development of financial thought and reviewercomments, changes have been made in the text. Some of these changes include:

C H A P T E R 1 A N I N T R O D U C T I O N T O T H E F O U N DAT I O N S O F F I N A N C I A LM A N A G E M E N T T H E T I E S T H AT B I N DThe material in this chapter was updated and revised to reflect changes in the personal taxcode that lowered the personal tax rate on dividend income and thereby lessened theimpact of the double taxation of corporate dividends. This chapter also includes anexpanded discussion of S-type corporations and limited liability companies (LLC). Inaddition, an Entrepreneurs Perspective box dealing with difficulties that entrepreneursface in raising capital was added.

C H A P T E R 2 T H E F I N A N C I A L M A R K E T S A N D I N T E R E S T R AT E SSeveral changes, updates, and additions are spread throughout this chapter in order tomake it more lively and relevant to readers. Many of the alterations are in response toreviewer suggestions. The chapter opens with a review of the past six interest rate cycleswith emphasis on (1) the immediate past recession that began in March 2001, (2) theultimate business expansion that led to the tightening of monetary policy commencing inJune 2004, and (3) developments related to the corporate cost of capital through theopportunity cost of funds concept. Along this line, changes in the federal funds target rateand the commercial bank prime lending rate are chronicled from 1994 to 2004.

A new section is provided on the Public Company Accounting Reform and InvestorProtection Act (SarbanesOxley Act of 2002). The material on SarbanesOxley is related tofinancial controls, ethics in finance, and corporate governance. The creation of the PublicCompany Accounting Oversight Board is detailed.

New boxes entitled Across the Hall are provided on both investment banking andcommercial banking. These are related to the need for the student to acquire a basicunderstanding of business finance, regardless of that students undergraduate major. Bothof these new boxes were written by practicing corporate executives.

C H A P T E R 3 U N D E R S TA N D I N G F I N A N C I A L S TAT E M E N T S A N D C A S H F L O W SThe presentation of the financial statements has been revised to be very intuitive and easy tofollow with illustrations that will keep the student interested in the material. Also, at therequest of adopters, the presentation of free cash flows was simplified to help the student graspthis important concept without having to spend unproductive time in computations. Theresult was a more intuitive presentation of the meaning and calculation of free cash flows.

C H A P T E R 4 E VA L U AT I N G A F I R M S F I N A N C I A L S TAT E M E N T SThe financial analysis in this chapter uses the traditional ratios based on accounting databut then adds market-value ratios to connect the accounting data with the firms marketvalue. We then explain how to interpret the market-value ratios in terms of managementsperformance at creating shareholder value. Finally, we use Economic Value Added tohelp the student better understand how management creates shareholder value.

C H A P T E R 5 T H E T I M E VA L U E O F M O N E YThis chapter went through a major revision aimed at making it more accessible to todaysmath-phobic students. Without a sacrifice of rigor or content, the chapter was revised toeliminate the use of summation signs. In addition, there was a large increase in the use of

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calculator examples. The end-of-chapter problems were also expanded and improved,allowing for a significant increase in the number of end-of-chapter problems that arecalculator based.

C H A P T E R 6 T H E M E A N I N G A N D M E A S U R E M E N T O F R I S K A N D R E T U R NTo make it more relevant and interesting to students, we used a firm they would be familiarwithBarnes & Nobleto illustrate the concepts and computations regarding market risk.

C H A P T E R 7 VA L U AT I O N A N D C H A R A C T E R I S T I C S O F B O N D SThis chapter was updated and revised to reflect changes in the capital markets. Several newtopics, such as convertibility, call provisions, and current yield, were also added.

C H A P T E R 8 VA L U AT I O N A N D C H A R A C T E R I S T I C S O F S T O C KThis chapter was updated and revised to reflect changes in the stock market. In addition,the presentation of shareholder valuation based on a firms expected future free cash flowswas simplified and clarified.

C H A P T E R 9 C A P I TA L - B U D G E T I N G T E C H N I Q U E S A N D P R A C T I C EThe use of a financial calculator in calculating the different capital-budgeting decision toolswas expanded along with a significant expansion of margin examples on how to use afinancial calculator to calculate the different capital-budgeting criteria. In addition, themodified internal rate of return (MIRR) was introduced. This capital-budgeting criterionhas become increasingly popular thanks in part to the efforts of the consulting firmMcKinsey & Company. This section can be omitted for those who choose to do so. Inaddition, a new Across the Hall box was introduced highlighting the relationship betweenmarketing and capital budgeting.

C H A P T E R 1 0 C A S H F L O W S A N D O T H E R T O P I C S I N C A P I TA L B U D G E T I N GThe presentation of the calculation of free cash flows was simplified considerably. A newAcross the Hall box was introduced examining the role of marketing in calculating aprojects free cash flows. In addition, the end-of-chapter problem set was expanded.

C H A P T E R 1 1 C O S T O F C A P I TA LIn response to users suggestions, we simplified the discussion of the issues encountered inusing the dividend growth model to estimate the cost of equity capital. Also at the requestof users, we changed notation for equations to reduce the use of mathematical symbols. Forexample, the discounted cash flow model used for estimating the cost of debt financing nowuses a three-year bond with all the terms specified. This change is geared toward makingthe book more accessible to students with math phobia. In addition, two new weightedaverage cost of capital self-test problems were added to help students develop skill inevaluating the firms cost of capital.

C H A P T E R 1 2 D E T E R M I N I N G T H E F I N A N C I N G M I XThis chapter is now rich with actual company examples and discussions on financingdecisions. For instance, financial leverage, operating leverage, and the combined leverageeffect are demonstrated via examples dealing with Harley-Davidson, Inc., Procter &Gamble Company, and the Boeing Company. Furthermore, General Motors pricingstrategy is discussed within the framework of break-even analysis. And Walt Disneys use ofthe interest-coverage ratio is presented.

A new Web Works section deals with General Motors, Coca-Cola, and the FederalReserve Bank of St. Louis. The latter source, the St. Louis Fed Web site, introduces thestudent to the popular and useful FRED II database; this database is a marvelous site forfinancial and economic time series data and is updated daily by the bank.

C H A P T E R 1 3 D I V I D E N D P O L I C Y A N D I N T E R N A L F I N A N C I N GNew material now centers on the divergent nature of dividend policy across corporations.Three highly different policies are illustrated via data from Starbucks, Coca-Cola, andHarley-Davidson. Later in the chapter an in-depth look at Harley-Davidsons cash payout

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policy is examined over the 19972003 time frame and specifically related to Objective 4of the chapter that details three common and alternative dividend policies.

In similar fashion the unusually large Microsoft dividend payout of $3.00 per commonshare (some $32 billion across all shares), which was announced in the summer of 2004, isdiscussed within the framework of an extra or special dividend.

Moreover, the implications of the Jobs and Growth Tax Reconciliation Act of 2003 forcorporate dividend policy are presented.

C H A P T E R 1 4 S H O R T- T E R M F I N A N C I A L P L A N N I N GIn addition to updating the material in this chapter, a new financial forecasting exercise wascreated that focuses on the projection of a firms earning power. Also, new Internet-basedproblems and exercises connect the book to day-to-day activities in the financial markets.

C H A P T E R 1 5 W O R K I N G - C A P I TA L M A N A G E M E N TA new self-test problem was added aimed at helping students develop the skills necessaryfor analyzing the cost of bank credit under a variety of loan covenants. In addition, newInternet-based problems and exercises connect the book to day-to-day activities in thefinancial markets.

C H A P T E R 1 6 C U R R E N T A S S E T M A N A G E M E N TThis chapter contains several alterations aimed at making the material more relevant todecision making and more up-to-date, which, in turn, will make it of more value tostudents. For example, recent data from Starbucks Corporation and the Walt DisneyCompany are used to demonstrate the value and importance of float reduction within thecontext of corporate cash management.

The Check Clearing for the 21st Century Act, which went into effect on October 28,2004, is reviewed and placed within the context of the Treasury Departments missionwithin the firm to properly manage the float. The implications of this act, commonlyreferred to as Check 21, for the various types of float are discussed.

Additionally, a new Takin It to the Net section introduces the student to the U.S.Department of the Treasurys comprehensive Web site at www.treasurydirect.gov whereindividuals, corporations, and governments can explore detailed information on the arrayof investment products offered by the U.S. Treasury.

C H A P T E R 1 7 I N T E R N AT I O N A L F I N A N C I A L M A N A G E M E N TThis chapter was updated to reflect the changes impacting the global financial markets. Inaddition, a new Across the Hall box was introduced highlighting the role of marketing ininternational finance.

T H E S U P P O R T P A C K A G E

P R I N T S U P P L E M E N T S :

F O R T H E I N S T R U C T O R :T E S T I T E M F I L E This Test Bank, prepared by Alan D. Eastman of Indiana University ofPennsylvania, provides more than 1,600 multiple-choice, true/false, and short-answerquestions with complete and detailed answers. The print Test Bank is designed for use withthe new TestGen-EQ test generating software.

I N S T R U C T O R S M A N U A L W I T H S O L U T I O N S Prepared by the authors, theInstructors Manual follows the textbooks organization and represents a continued effort toserve the teacher in his or her goal of being effective in the classroom. Each chapter con-tains a chapter orientation, an outline of each chapter (also suitable for lecture notes),answers to end-of-chapter questions, and an extensive problem set for each chapter, includ-ing a large number of alternative problems along with answers.

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The Instructors Manual is also available electronically and instructors can downloadthis file from the Instructors Resource Center by visiting www.prenhall.com/keown.

C O L O R T R A N S PA R E N C I E S All figures and tables from the text are reproduced asfull-page, four-color acetates.

F O R T H E S T U D E N T:S T U DY G U I D E The Study Guide to accompany Foundations of Finance: The Logic andPractice of Financial Management, 5th Edition, was written by the authors with the objectiveof providing a student-oriented supplement to the text. Each chapter of the Study Guidecontains an orientation of each chapter along with a chapter outline of key topics, problems(with detailed solutions) and self-tests, which can be used to aid in the preparation of out-side assignments and in studying for exams, a tutorial on capital budgeting, a set of tablesthat not only gives compound sum and present value interest factors but also shows how tocompute the interest using a financial calculator.

T E C H N O L O G Y S U P P L E M E N T S :

C O M PA N I O N W E B S I T E (www.prenhall.com/keown) The Web site contains variousactivities related specifically to the Fifth Edition of Foundations of Finance: The Logic andPractice of Financial Management.

F O R T H E S T U D E N T:

Excel Spreadsheets. Created by the authors, these spreadsheets correspond with theend-of-chapter problems from the text.

Internet Exercises. These activities, prepared by James M. Forjan of York College ofPennsylvania, give students the opportunity to utilize the tools and information availableon the Internet by directing them to various online sites and then providing a summaryand a set of questions about the experience.

Online Study Guide. The Online Study Guide, prepared by Philip Samuel Russel ofPhiladelphia University, offers students another opportunity to sharpen their prob-lem-solving skills and to assess their understanding of the text material. The OnlineStudy Guide is a truly comprehensive set of questions with exceptional coverage ofthe material in the textbook and written by the authors. The Online Study Guidegrades each question submitted by the students, provides immediate feedback forcorrect and incorrect answers, and allows students to e-mail results to up to foure-mail addresses.

F O R T H E I N S T R U C T O R : Syllabus Manager. Allows instructors to create a syllabus that they may publish for

their students to access. Instructors may add exams or assignments of their own, edit anyof the student resources available on the Companion Website, post discussion topics,and more.

Instructors may find downloadable resources from the link for the Instructors ResourceCenter described here.

I N S T R U C T O R S R E S O U R C E C E N T E R This password-protected site is accessible atwww.prenhall.com/keown and hosts all of the resources that follow. Instructors shouldclick on the Help Downloading Instructor Resources link for easy-to-follow instructionson getting access or may contact their sales representative for further information.

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Instructors Manual Solutions to the Internet Exercise activities that are included on the student side of the

Companion Website. The PowerPoint Lecture Presentation: This lecture presentation tool, prepared by

Samuel A. Veraldi of Duke University, provides the instructor with individual lectureoutlines to accompany the text. The slides include many of the figures and tables fromthe text. These lecture notes can be used as is or professors can easily modify them toreflect specific presentation needs.

TestGen-EQ software: The print Test Item File is designed for use with theTestGen-EQ test generating software. This computerized package allows instructors tocustom design, save, and generate classroom tests. The test program permits instruc-tors to edit, add, or delete questions from the test bank; edit existing graphics and cre-ate new graphics; analyze test results; and organize a database of tests and studentresults. This new software allows for greater flexibility and ease of use. It provides manyoptions for organizing and displaying tests, along with a search and sort feature.

O N E K E Y Available by using one of the access codes shrink-wrapped with the book,OneKey is Prentice Halls exclusive new resource for instructors and students. OneKeygives you access to the best online teaching and learning toolsall available 24 hours a day,7 days a week. OneKey means all your resources are in one place for maximum conve-nience, simplicity, and success. Instructors have access online, in the course managementsystem of their choosing, to all available course supplements. Instructors can create andassign tests, quizzes, or graded homework assignments. OneKey saves instructors time bygrading all questions and tracking results in the online course grade book. Students haveaccess to interactive exercises, quizzes, useful links, and much more. The followingresources are available:

Study Guide. Self-Study Quizzes. Graded Homework Assignments. PowerPoint Lecture Notes. Learning Objectives. Chapter Summaries. Research Navigator. Your OneKey course gives you direct access to Prentice Halls

powerful online research tool, Research Navigator. Research Navigator is an online aca-demic research service that helps students learn and master the skills needed to writeeffective papers and complete research assignments. Research Navigator includes threedatabases of credible and reliable source material. EBSCOs ContentSelect Academic Journal database gives you instant access to

thousands of academic journals and periodicals. You can search these on-line jour-nals by keyword, topic, or multiple topics. It also guides students step by stepthrough the writing of a research paper.

The New York Times Search-by-Subject Archive allows you to search by subjectand by keyword.

Link Library is a collection of links to Web sites, organized by academic subject andkey terms. The links are monitored and updated each week.

Instructor Resource Center.

OneKey for CourseCompass allows instructors to communicate with students,distribute course material, and access student progress online. For access to this material,see www.prenhall.com/coursecompass.

OneKey for WebCT provides content and enhanced features to help instructors createa complete online course. See www.prenhall.com/webct for more information.

Finally, OneKey for Blackboard allows instructors to create online courses using theBlackboard tools, which include design, communications, testing, and course managementtools. See www.prenhall.com/blackboard for more information.

P R E FA C E xxix

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S U B S C R I P T I O N S :

Analyzing current events is an important skill for economic students to develop. To sharpenthis skill and further support the books theme of exploration and application, Prentice Halloffers you and your students three news subscription offers:

The Wall Street Journal Print and Interactive Editions SubscriptionPrentice Hall has formed a strategic alliance with the Wall Street Journal, the mostrespected and trusted daily source for information on business and economics. For a smalladditional charge, Prentice Hall offers your students a 10-week or 15-week subscription tothe Wall Street Journal print edition and the Wall Street Journal Interactive Edition. Uponadoption of a special package containing the book and the subscription booklet, professorswill receive a free one-year subscription of the print and interactive versions as well asweekly subject-specific Wall Street Journal educators lesson plans.

The Financial TimesWe are pleased to announce a special partnership with the Financial Times. For a smalladditional charge, Prentice Hall offers your students a 15-week subscription to the Financial Times. Upon adoption of a special package containing the book andthe subscription booklet, professors will receive a free one-year subscription. Please contactyour Prentice Hall representative for details and ordering information.

Economist.comThrough a special arrangement with Economist.com, Prentice Hall offers your students a12-week subscription to Economist.com for a small additional charge. Upon adoption ofa special package containing the book and the subscription booklet, professors will receive afree six-month subscription. Please contact your Prentice Hall representative for furtherdetails and ordering information.

A C K N O W L E D G M E N T S

We gratefully acknowledge the assistance, support, and encouragement of those individualswho have contributed to Foundations of Finance. Specifically, we wish to recognize the veryhelpful insights provided by many of our colleagues. For their careful comments and helpfulreviews of the text, we are indebted to:

Ibrahim J. AffenehIndiana University of Pennsylvania

Sung C. BaeBowling Green State University

Laurey BerkUniversity of Wisconsin, Green Bay

Ronald W. BestUniversity of South Alabama

Stephen BlackUniversity of Central Oklahoma

Laurence E. BloseUniversity of North Carolina, Charlotte

Robert BoldinIndiana University of Pennsylvania

Michael BondCleveland State University

Waldo L. BornEastern Illinois University

Joe BrocatoTarleton State University

Paul BursikSt. Norbert College

Soku ByounUniversity of Southern Indiana

Anthony K. ByrdUniversity of Central Florida

P. R. ChandyUniversity of North Texas

Santosh ChoudhuryNorfolk State University

K. C. ChenCalifornia State University, Fresno

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Jeffrey S. ChristensenYoungstown State University

M. C. ChungCalifornia State University, Sacramento

Susan ColemanUniversity of Hartford

Steven M. DawsonUniversity of Hawaii

Karen DenningWestern Virginia University

Yashwant S. DhattUniversity of Southern Colorado

Thomas DownsUniversity of Alabama

Edwin DuettMississippi State University

John W. EllisColorado State University

Suzanne EricksonSeattle University

Slim FerianiGeorge Washington University

Greg FilbeckMiami University

Jennifer FrazierJames Madison University

Bruce FredriksonSyracuse University

Joseph F. GrecoCalifornia State University, Fullerton

Karen HallowsGeorge Mason University

Ken HalseyWayne State College

Mary H. HarrisCabrini College

James D. HarrissUniversity of North Carolina, Wilmington

Linda C. HittleSan Diego State University

Robert HullWashburn University

Joel JankowskiUniversity of Tampa

Gerry JensenNorthern Illinois University

Steve JohnsonUniversity of Texas at El Paso

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Ravi KamathCleveland State University

James D. KeysFlorida International University

V. Sivarama KrishnanCameron University

Reinhold P. LambUniversity of North Carolina Charlotte

Larry LangUniversity of Wisconsin

George B. F. LaniganUniversity of North Carolina, Greensboro

Stephen LarsonUniversity of Eastern Illinois

William R. LasherNichols College

David E. LetourneauWinthrop University

Ilene LevinUniversity of MinnesotaDuluth

David LoutonBryant College

Lee McClainWestern Washington University

Ginette M. McManusSt. Josephs University

Michael McMillanNorthern Virginia Community College

James E. McNultyFlorida Atlantic University

Grant McQueenBrigham Young University

Judy E. MaeseNew Mexico State University

Abbas MamoozadehSlippery Rock University

Emil MeurerUniversity of New Orleans

Stuart MichelsonEastern Illinois University

Eric J. MoonSan Francisco State University

Scott MooreJohn Carroll University

Diane MorrisonUniversity of Wisconsin at LaCrosse

Rick H. MullFort Lewis College

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M. P. NarayananUniversity of Michigan

William E. OConnell Jr.College of William & Mary

Thomas M. PatrickThe College of New Jersey

Samuel PenkarUniversity of HoustonDowntown

Jeffrey H. PetersonSt. Bonaventure University

Mario PicconiUniversity of San Diego

Chris PopeUniversity of Georgia

Pradipkumar RamanlalUniversity of Central Florida

P. Raghavendra RauPurdue University

Dan ReederOklahoma Baptist University

Stuart RosensteinClemson University

Ivan C. RotenArizona State University

Marjorie A. RubashBradley University

Atul K. SaxenaMercer University

Hari P. SharmaVirginia State University

Chi ShehUniversity of Houston

Joseph StanfordBridgewater State College

David SukRider University

Charlene SullivanPurdue University

Elizabeth SunSan Jose State University

R. Bruce SwensenAdelphi University

Philip R. SwensenUtah State University

Lee TenpaoNiagara University

Philip ThamesCalifornia State University at Long Beach

Paul A. VanderheidenUniversity of Wisconsin, Eau Claire

Nikhil P. VaraiyaSan Diego State University

K. G. ViswanathanHofstra University

Al WebsterBradley University

Patricia WebsterBradley University

Herbert WeinraubUniversity of Toledo

Sandra WilliamsMoorhead State University

Tony R. WinglerUniversity of North Carolina, Greensboro

Bob G. Wood, Jr.Tennessee Tech University

Jian YangPrairie View A & M University

Ata YesilyaprakColumbus State University

Wold ZernedkunNorfolk State University

Marc ZennerIndiana University

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We also thank our friends at Prentice Hall. They are a great group of folks. To DavidAlexander, our executive editor, we owe an immeasurable debt of gratitude. He continuedto push us to make sure that we delivered the finest textbook and supplementary packagepossible. His efforts go well beyond what one might expect from the best of editors. On topof this, David is just a great personthanks, David. We would also like to thank FrancescaCalogero for her administrative deftness. Not only is she bright, insightful, and attentive todetailin short, a gifted assistant editorbut she also made the revision a fun experience.She is a true friend. With Francesca watching over us, there was no way the ball could bedropped. Our thanks also go to Sharon Koch for her marketing prowess. Sharon has anamazing understanding of the market, coupled with an intuitive understanding of what themarket is looking for. We also thank Nancy Welcher, our media manager, who did a greatjob of making sure we are on the cutting edge in terms of Web applications and offerings.To Denise Culhane, the production editor, we express a very special thank-you for seeingthe book through a very complex production process and keeping it all on schedule whilemaintaining extremely high quality.

As a final word, we express our sincere thanks to those using Foundations of Finance inthe classroom. We thank you for making us a part of your team. Always feel free to give anyof us a call or contact us through the Internet when you have questions or needs.

A.J.K. / J.D.M. / J.W.P. / D.F.S.

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