Foundations of Finance
Inhoudsopgave
Chapter 1 An introduction to the Foundations of Financial management .......................................................................................................... 3
1.1 The goal of the firm ............................................................................................................................................................................... 3
1.2 Five principles that form the foundations of finance ........................................................................................................................... 3
1.3 The role of finance in business .............................................................................................................................................................. 4
1.4 The legal forms of business organization ............................................................................................................................................. 5
1.5 Finance and the multinational firm: the new role ............................................................................................................................... 6
1.6 Developing skills for your career ........................................................................................................................................................... 7
Chapter 2 The financial markets and interest rates ............................................................................................................................................ 7
2.1 Financing of business: the movement of funds through the economy ............................................................................................... 7
2.2 Selling securities to the public............................................................................................................................................................... 8
2.3 Rates of return in the financial markets ............................................................................................................................................. 10
2.4 Interest rate determinants in a nutshell ............................................................................................................................................. 10
Chapter 3 Understanding financial statements and cash flows ........................................................................................................................ 11
3.1 The income statement ........................................................................................................................................................................ 11
3.2 The balance sheet................................................................................................................................................................................ 12
3.3 Measuring cash flows ......................................................................................................................................................................... 14
3.4 The limitations of financial statements and accounting malpractice .............................................................................................. 18
Chapter 4 Evaluating a firm’s financial performance ........................................................................................................................................ 18
4.1 Purpose of financial analysis............................................................................................................................................................... 18
4.2 Measuring key financial relationships ................................................................................................................................................ 19
4.3 The Limitations of Financial Ratio Analysis ........................................................................................................................................ 22
Chapter 5 The time value of money ................................................................................................................................................................. 22
5.1 Compound interest, future value, and present value ........................................................................................................................ 22
5.2 Annuities .............................................................................................................................................................................................. 25
5.3 Making interest rates comparable ..................................................................................................................................................... 27
5.4 The present value of an uneven stream and perpetuities ................................................................................................................. 29
Chapter 6 The meaning and measurement of risk and return .......................................................................................................................... 30
6.1 Expected return defines and measured.............................................................................................................................................. 30
6.2 Risk defined and measured ................................................................................................................................................................. 31
6.3 Rates of return: the investor’s experience.......................................................................................................................................... 32
6.4 Risk and diversification........................................................................................................................................................................ 33
6.5 The investor’s required rate of return ................................................................................................................................................ 35
Chapter 7 the valuation and characteristics of bonds....................................................................................................................................... 36
7.1 Types of bonds ..................................................................................................................................................................................... 36
7.2 Terminology and characteristics of bonds ......................................................................................................................................... 37
7.3 Defining value ...................................................................................................................................................................................... 38
7.4 What determines value? ..................................................................................................................................................................... 39
1
, 7.5 Valuation: the basic process ............................................................................................................................................................... 39
7.6 Valuing bonds ...................................................................................................................................................................................... 39
7.7 Bond yields ........................................................................................................................................................................................... 40
7.8 Bond valuation: three important relationships .................................................................................................................................. 41
Chapter 8 The valuation and characteristics of stock ....................................................................................................................................... 42
8.1 Preferred stock .................................................................................................................................................................................... 42
8.2 Valuing preferred stock ....................................................................................................................................................................... 43
8.3 Common stock ..................................................................................................................................................................................... 43
8.4 Valuing common stock ........................................................................................................................................................................ 43
8.5 The expected rate of return of stockholders ...................................................................................................................................... 44
Chapter 9 The cost of capital ............................................................................................................................................................................ 45
9.1 The cost of capital: key definitions and concepts .............................................................................................................................. 45
9.2 Determining the costs of the individual sources of capital ............................................................................................................... 46
9.3 The weighted average cost of capital ................................................................................................................................................ 48
9.4 Calculating divisions costs of capital .................................................................................................................................................. 49
Chapter 10 Capital-budgeting techniques and practice .................................................................................................................................... 51
10.1 Finding profitable projects .................................................................................................................................................................. 51
10.2 Capital-budgeting decision criteria .................................................................................................................................................... 51
10.3 Capital rotation ................................................................................................................................................................................... 53
10.4 Ranking mutually exclusive projects................................................................................................................................................... 54
Chapter 11 Cash flows and other topics in capital budgeting ........................................................................................................................... 54
11.1 Guidelines for capital budgeting......................................................................................................................................................... 54
11.2 Calculating a project’s free cash flows ............................................................................................................................................... 55
11.3 Options in capital budgeting............................................................................................................................................................... 57
11.4 Risk and the investment decision ....................................................................................................................................................... 58
Chapter 12 Determining the financing mix ....................................................................................................................................................... 59
12.1 Understanding the difference between business and financial risk ................................................................................................. 60
12.2 Break-even analysis ............................................................................................................................................................................. 60
12.3 Sources of operating leverage ............................................................................................................................................................ 62
12.4 Capital structure theory ...................................................................................................................................................................... 63
12.5 The basic tools of capital structure management ............................................................................................................................. 66
Chapter 13 Dividend policy and internal financing ........................................................................................................................................... 68
13.1 How do firms distribute firm profits to their stockholders? .............................................................................................................. 68
13.2 Does dividend policy matter to stockholders? ................................................................................................................................... 68
13.3 The dividend decision in practice ........................................................................................................................................................ 70
13.4 Stock dividends and stock splits .......................................................................................................................................................... 70
13.5 Stock repurchases................................................................................................................................................................................ 71
2
,Chapter 1 An introduction to the Foundations of
Financial management
1.1 The goal of the firm
The goal of the firm is to create value for the firm’s owners (that is, its shareholders). Thus the goal of
the firm is to “maximize shareholder wealth” by maximizing the price of the existing common stock.
Good financial decisions will increase stock price, and poor financial decisions will lead to a decline in
stock price.
Some serious practical problems arise when we use changes in the value of the firm’s stock to
evaluate financial decisions. Many things affect stock prices. Attempting to identify a reaction to a
particular financial decision would simply be impossible. To employ this goal, we need to consider
every stock price change to be a market interpretation of the worth or our decisions. Other factors,
such as changes in the economy, also affect stock prices.
1.2 Five principles that form the foundations of finance
Although it is not necessary to understand finance to understand these principles, it is necessary to
understand these principles in order to understand finance.
Principle 1: Cash flow is what matters
Accounting profits are not equal to cash flows. It is possible for a firm to generate accounting profits
but not have cash or to generate cash flows and not report accounting profits in the books.
Cash flow, and not profits, drive the value of a business.
We must determine incremental or marginal cash flows when making financial decisions.
• Incremental cash flow is the difference between the cash flows the company will produce with
versus without the investment it’s thinking about making (e.g. merchandise).
Principle 2: Money has a time value
A dollar received today is worth more than a dollar received in the future. Because we can earn
interest on money received today, it is better to receive money sooner rather than later.
Opportunity Cost – It is the cost of making a choice in terms of next best alternative that must be
forgone. Example: By lending money to your friend at zero percent interest, there is an opportunity
cost of 1% that could potentially be earned by depositing the money in a savings account in a bank.
If the benefits or cash inflows outweigh the costs, the project creates wealth and should be accepted;
if the costs or outflows outweigh the benefits or cash inflows, the project destroys wealth and should
be rejected.
Principle 3: Risk requires a reward
Investors will not take on additional risk unless they expect to be compensated with additional reward
or return. Investors expect to be compensated for “delaying consumption’’ and “taking on risk.’’
Thus, investors expect a return when they deposit their savings in a bank (e.g., delayed consumption),
and they expect to earn a relatively higher rate of return on stocks compared to a bank savings
account (e.g., taking on risk).
3
, Figure 1-1 depicts the basic notion that an investor’s rate of return should equal a rate of return of
delaying consumption plus an additional return for assuming risk.
As investors, we have expectations about what returns our investment will earn. However, we can’t
know for certain what they will be.
Principle 4: Market prices are generally right
In an efficient market, the market prices of all traded assets (such as stocks and bonds) fully reflect all
available information at any moment in time.
Thus stock prices are a useful indicator of the value of the firm. Price changes reflect changes in
expected future cash flows. Good decisions will tend to increase in stock price and vice versa.
Note there are inefficiencies in the market that may distort the market prices from value of assets.
Such inefficiencies are often caused by behavioral biases.
Principle 5: Conflicts of interest cause agency problems
The separation of management and the ownership of the firm creates an agency problem. Managers
may make decisions that are not consistent with the goal of maximizing shareholder wealth.
Agency conflict is reduced through monitoring (e.g., annual reports), compensation schemes (e.g.,
stock options), and market mechanisms (e.g., takeovers).
The essential elements of ethics and trust
Without ethics and trust, nothing works. Virtually everything we do involves some dependence on
others. Ethical behavior is doing the right thing! But what is the right thing?
Ethical dilemma—Each person has his or her own set of values, which forms the basis for personal
judgments about what is the right thing.
Sound ethical standards are important for business and personal success. Unethical decisions can
destroy shareholder wealth (e.g., Enron scandal).
1.3 The role of finance in business
Three basic issues are addressed by the study of finance:
- What long-term investments should the firm undertake? (Capital budgeting decision)
- How should the firm raise money to fund these investments? (Capital structure decision)
- How should cash flows arising from day-to-day operations be managed? (Working capital
decision)
Knowledge of financial tools is relevant for decision making in all areas of business (be it marketing,
production, etc.) and also in managing personal finances.
Decisions involve an element of time and uncertainty; financial tools help adjust for time and risk.
Decisions taken in business should be financially viable; financial tools help determine the financial
viability of decisions.
Why study finance?
4
Inhoudsopgave
Chapter 1 An introduction to the Foundations of Financial management .......................................................................................................... 3
1.1 The goal of the firm ............................................................................................................................................................................... 3
1.2 Five principles that form the foundations of finance ........................................................................................................................... 3
1.3 The role of finance in business .............................................................................................................................................................. 4
1.4 The legal forms of business organization ............................................................................................................................................. 5
1.5 Finance and the multinational firm: the new role ............................................................................................................................... 6
1.6 Developing skills for your career ........................................................................................................................................................... 7
Chapter 2 The financial markets and interest rates ............................................................................................................................................ 7
2.1 Financing of business: the movement of funds through the economy ............................................................................................... 7
2.2 Selling securities to the public............................................................................................................................................................... 8
2.3 Rates of return in the financial markets ............................................................................................................................................. 10
2.4 Interest rate determinants in a nutshell ............................................................................................................................................. 10
Chapter 3 Understanding financial statements and cash flows ........................................................................................................................ 11
3.1 The income statement ........................................................................................................................................................................ 11
3.2 The balance sheet................................................................................................................................................................................ 12
3.3 Measuring cash flows ......................................................................................................................................................................... 14
3.4 The limitations of financial statements and accounting malpractice .............................................................................................. 18
Chapter 4 Evaluating a firm’s financial performance ........................................................................................................................................ 18
4.1 Purpose of financial analysis............................................................................................................................................................... 18
4.2 Measuring key financial relationships ................................................................................................................................................ 19
4.3 The Limitations of Financial Ratio Analysis ........................................................................................................................................ 22
Chapter 5 The time value of money ................................................................................................................................................................. 22
5.1 Compound interest, future value, and present value ........................................................................................................................ 22
5.2 Annuities .............................................................................................................................................................................................. 25
5.3 Making interest rates comparable ..................................................................................................................................................... 27
5.4 The present value of an uneven stream and perpetuities ................................................................................................................. 29
Chapter 6 The meaning and measurement of risk and return .......................................................................................................................... 30
6.1 Expected return defines and measured.............................................................................................................................................. 30
6.2 Risk defined and measured ................................................................................................................................................................. 31
6.3 Rates of return: the investor’s experience.......................................................................................................................................... 32
6.4 Risk and diversification........................................................................................................................................................................ 33
6.5 The investor’s required rate of return ................................................................................................................................................ 35
Chapter 7 the valuation and characteristics of bonds....................................................................................................................................... 36
7.1 Types of bonds ..................................................................................................................................................................................... 36
7.2 Terminology and characteristics of bonds ......................................................................................................................................... 37
7.3 Defining value ...................................................................................................................................................................................... 38
7.4 What determines value? ..................................................................................................................................................................... 39
1
, 7.5 Valuation: the basic process ............................................................................................................................................................... 39
7.6 Valuing bonds ...................................................................................................................................................................................... 39
7.7 Bond yields ........................................................................................................................................................................................... 40
7.8 Bond valuation: three important relationships .................................................................................................................................. 41
Chapter 8 The valuation and characteristics of stock ....................................................................................................................................... 42
8.1 Preferred stock .................................................................................................................................................................................... 42
8.2 Valuing preferred stock ....................................................................................................................................................................... 43
8.3 Common stock ..................................................................................................................................................................................... 43
8.4 Valuing common stock ........................................................................................................................................................................ 43
8.5 The expected rate of return of stockholders ...................................................................................................................................... 44
Chapter 9 The cost of capital ............................................................................................................................................................................ 45
9.1 The cost of capital: key definitions and concepts .............................................................................................................................. 45
9.2 Determining the costs of the individual sources of capital ............................................................................................................... 46
9.3 The weighted average cost of capital ................................................................................................................................................ 48
9.4 Calculating divisions costs of capital .................................................................................................................................................. 49
Chapter 10 Capital-budgeting techniques and practice .................................................................................................................................... 51
10.1 Finding profitable projects .................................................................................................................................................................. 51
10.2 Capital-budgeting decision criteria .................................................................................................................................................... 51
10.3 Capital rotation ................................................................................................................................................................................... 53
10.4 Ranking mutually exclusive projects................................................................................................................................................... 54
Chapter 11 Cash flows and other topics in capital budgeting ........................................................................................................................... 54
11.1 Guidelines for capital budgeting......................................................................................................................................................... 54
11.2 Calculating a project’s free cash flows ............................................................................................................................................... 55
11.3 Options in capital budgeting............................................................................................................................................................... 57
11.4 Risk and the investment decision ....................................................................................................................................................... 58
Chapter 12 Determining the financing mix ....................................................................................................................................................... 59
12.1 Understanding the difference between business and financial risk ................................................................................................. 60
12.2 Break-even analysis ............................................................................................................................................................................. 60
12.3 Sources of operating leverage ............................................................................................................................................................ 62
12.4 Capital structure theory ...................................................................................................................................................................... 63
12.5 The basic tools of capital structure management ............................................................................................................................. 66
Chapter 13 Dividend policy and internal financing ........................................................................................................................................... 68
13.1 How do firms distribute firm profits to their stockholders? .............................................................................................................. 68
13.2 Does dividend policy matter to stockholders? ................................................................................................................................... 68
13.3 The dividend decision in practice ........................................................................................................................................................ 70
13.4 Stock dividends and stock splits .......................................................................................................................................................... 70
13.5 Stock repurchases................................................................................................................................................................................ 71
2
,Chapter 1 An introduction to the Foundations of
Financial management
1.1 The goal of the firm
The goal of the firm is to create value for the firm’s owners (that is, its shareholders). Thus the goal of
the firm is to “maximize shareholder wealth” by maximizing the price of the existing common stock.
Good financial decisions will increase stock price, and poor financial decisions will lead to a decline in
stock price.
Some serious practical problems arise when we use changes in the value of the firm’s stock to
evaluate financial decisions. Many things affect stock prices. Attempting to identify a reaction to a
particular financial decision would simply be impossible. To employ this goal, we need to consider
every stock price change to be a market interpretation of the worth or our decisions. Other factors,
such as changes in the economy, also affect stock prices.
1.2 Five principles that form the foundations of finance
Although it is not necessary to understand finance to understand these principles, it is necessary to
understand these principles in order to understand finance.
Principle 1: Cash flow is what matters
Accounting profits are not equal to cash flows. It is possible for a firm to generate accounting profits
but not have cash or to generate cash flows and not report accounting profits in the books.
Cash flow, and not profits, drive the value of a business.
We must determine incremental or marginal cash flows when making financial decisions.
• Incremental cash flow is the difference between the cash flows the company will produce with
versus without the investment it’s thinking about making (e.g. merchandise).
Principle 2: Money has a time value
A dollar received today is worth more than a dollar received in the future. Because we can earn
interest on money received today, it is better to receive money sooner rather than later.
Opportunity Cost – It is the cost of making a choice in terms of next best alternative that must be
forgone. Example: By lending money to your friend at zero percent interest, there is an opportunity
cost of 1% that could potentially be earned by depositing the money in a savings account in a bank.
If the benefits or cash inflows outweigh the costs, the project creates wealth and should be accepted;
if the costs or outflows outweigh the benefits or cash inflows, the project destroys wealth and should
be rejected.
Principle 3: Risk requires a reward
Investors will not take on additional risk unless they expect to be compensated with additional reward
or return. Investors expect to be compensated for “delaying consumption’’ and “taking on risk.’’
Thus, investors expect a return when they deposit their savings in a bank (e.g., delayed consumption),
and they expect to earn a relatively higher rate of return on stocks compared to a bank savings
account (e.g., taking on risk).
3
, Figure 1-1 depicts the basic notion that an investor’s rate of return should equal a rate of return of
delaying consumption plus an additional return for assuming risk.
As investors, we have expectations about what returns our investment will earn. However, we can’t
know for certain what they will be.
Principle 4: Market prices are generally right
In an efficient market, the market prices of all traded assets (such as stocks and bonds) fully reflect all
available information at any moment in time.
Thus stock prices are a useful indicator of the value of the firm. Price changes reflect changes in
expected future cash flows. Good decisions will tend to increase in stock price and vice versa.
Note there are inefficiencies in the market that may distort the market prices from value of assets.
Such inefficiencies are often caused by behavioral biases.
Principle 5: Conflicts of interest cause agency problems
The separation of management and the ownership of the firm creates an agency problem. Managers
may make decisions that are not consistent with the goal of maximizing shareholder wealth.
Agency conflict is reduced through monitoring (e.g., annual reports), compensation schemes (e.g.,
stock options), and market mechanisms (e.g., takeovers).
The essential elements of ethics and trust
Without ethics and trust, nothing works. Virtually everything we do involves some dependence on
others. Ethical behavior is doing the right thing! But what is the right thing?
Ethical dilemma—Each person has his or her own set of values, which forms the basis for personal
judgments about what is the right thing.
Sound ethical standards are important for business and personal success. Unethical decisions can
destroy shareholder wealth (e.g., Enron scandal).
1.3 The role of finance in business
Three basic issues are addressed by the study of finance:
- What long-term investments should the firm undertake? (Capital budgeting decision)
- How should the firm raise money to fund these investments? (Capital structure decision)
- How should cash flows arising from day-to-day operations be managed? (Working capital
decision)
Knowledge of financial tools is relevant for decision making in all areas of business (be it marketing,
production, etc.) and also in managing personal finances.
Decisions involve an element of time and uncertainty; financial tools help adjust for time and risk.
Decisions taken in business should be financially viable; financial tools help determine the financial
viability of decisions.
Why study finance?
4
