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finance 4e

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finance 4e

Marcia Millon Cornett Bentley University

Troy A. Adair Jr. Harvard Business School

John Nofsinger University of Alaska Anchorage

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M: FINANCE, FOURTH EDITION

Published by McGraw-Hill Education, 2 Penn Plaza, New York, NY 10121. Copyright © 2019 by McGraw-Hill Education. All rights reserved. Printed in the United States of America. Previous editions © 2016, 2014 and 2012. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of McGraw-Hill Education, including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning.

Some ancillaries, including electronic and print components, may not be available to customers outside the United States.

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a note from the authors “There is a lot to cover in this course so I focus on the core concepts, theories, and problems.”

“I like to teach the course by using examples from their own individual lives.”

“My students come into this course with varying levels of math skills.”

How many of these quotes might you have said while teaching the undergraduate corporate finance course? Our many years of teaching certainly reflect such sentiments, and as we prepared to write this book, we conducted many market research studies that confirm just how much these statements—or ones similar—are common across the country. This critical course covers so many crucial topics that instructors need to focus on core ideas to ensure that students are getting the preparation they need for future classes—and for their lives beyond college.

We did not set out to write this book to change the way finance is taught, but rather to parallel and support the way that instructors from across the country currently teach finance. Well over 600 instructors teaching this course have shared their class experiences and ideas via a variety of research methods that we used to develop the framework for this text. We are excited to have authored a book that we think you will find fits your classroom style perfectly.

KEY THEMES This book’s framework emphasizes three themes. See the next section in this preface for a description of features in our book that support these themes.

Finance is about connecting core concepts. We all struggle with fitting so many topics into this course, so this text strives to make it easier for you by getting back to the core concepts, key research, and current topics. We realize that today’s students expect to learn more in class from lectures than in closely studying their textbooks, so we’ve created brief chapters that clearly lead students to crucial material that they need to review if they are to understand how to approach core financial concepts. The text is also organized around learning goals, making it easier for you to prep your course and for students to study the right topics. Finance can be taught using a personal perspective. Most long-term finance instructors have often heard students ask “How is this course relevant to me?” on the first day of class. We no longer teach classes dedicated solely to finance majors; many of us now must teach the first finance course to a mix of business majors. We need to give finance majors the rigor they need while not overwhelming class members from other majors. For years, instructors have used individual examples to help teach these concepts, but this is the first text to integrate this personal way of teaching into the chapters. Finance focuses on solving problems and decision making. This isn’t to say that concepts and theories aren’t important, but students will typically need to solve some kind of mathematical problem—or at least understand the impact of different numerical scenarios—to make the right decision on common finance issues. If you, as an instructor, either assign problems for homework or create exams made up almost entirely of mathematical material, you understand the need for good problems (and plenty of them). You also understand from experience the number of office hours you spend tutoring students and grading homework. Students have different learning styles, and this text aims to address that challenge to allow you more time in class to get through the critical topics.

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changes in the fourth edition Based on feedback from users and reviewers, we undertook an ambitious revision in order to make the book follow your teaching strategy even more closely. Below are the changes we made for this fourth edition, broken out by chapter.

OVERALL Simplified figures where appropriate and added captions to emphasize the main “takeaways” Updated data, company names, and scenarios to reflect latest available data and real-world changes Cross-referenced numbered examples with similar end-of-chapter problems and self-test problems so students can easily model their homework Updated the numbers in the end-of-chapter problems to provide variety and limit the transfer of answers from previous classes

chapter one INTRODUCTION TO FINANCIAL MANAGEMENT

Updated the Personal Application with information on firms that have filed for bankruptcy more recently Changed Learning Goal 1-9 to address the ramifications of China’s slowdown and the drop in the price of oil Revised the Finance at Work—Markets box to discuss quantitative easing in the United States and around the world Revised the Finance at Work—Corporate box to cover the proposed merger of AB InBev and SABMiller Updated the data in Example 1-2 on executive compensation Replaced Section 1.7 on the financial crisis with a new Section 1.7: Big Picture Environment, including discussions of the ramifications of plummeting oil prices and China’s economic slowdown

chapter two REVIEWING FINANCIAL STATEMENTS

Added a discussion of difference between EBIT and operating income Included extended definitions of net sales, cost of goods sold, and operating expenses Added a discussion of the interpretation of a cash-based income statement Added a new Finance at Work box

chapter three ANALYZING FINANCIAL STATEMENTS

Added more discussion of debt ratios

chapter four TIME VALUE OF MONEY 1: ANALYZING SINGLE CASH FLOWS

Updated the data in Figure 4.5 on gold prices Added equation functions to Table 4.2 and Table 4.4 Revised the data for the end-of-chapter Excel problem

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Added a new end-of-chapter Excel problem

chapter five TIME VALUE OF MONEY 2: ANALYZING ANNUITY CASH FLOWS

Revised the chapter introduction to discuss Boeing Added equation functions to Tables 5.1, 5.2, 5.5, and 5.6 Updated the present value of multiple annuities example to discuss the new David Price contract with the Boston Red Sox Changed the Finance at Work—Behavioral box to address the record Powerball jackpot of $1.5 billion on January 12, 2016 Added a new end-of-chapter Excel problem

chapter six UNDERSTANDING FINANCIAL MARKETS AND INSTITUTIONS

Updated all figures, tables, and values in the body of the chapter Added a section on the loanable funds theory/determination of equilibrium interest rates Added new end-of-chapter problems Decreased the coverage of the financial crisis (detailed information is available in the Web Appendix for Chapter 6 available in Connect or at mhhe.com/Cornett4e)

chapter seven VALUING BONDS

Updated the Personal Application with new data Updated Figures 7.1–7.5 on bond issuance, interest rate path, yield to maturities, new bond quotes, and a summary of the bond market Added equation functions to Tables 7.3 and 7.5 Revised the data for the end-of-chapter Excel problem Added a new end-of-chapter Excel problem

chapter eight VALUING STOCKS

Updated all table and figure values in the body of the chapter Updated the coverage of the stock market exchange in Section 8.2 to discuss the changes that have occurred in the NYSE and elsewhere Revised Example 8-1 to include new Coca-Cola data Updated Example 8-4 with new P/E data for Caterpillar Added a new end-of-chapter Excel problem

chapter nine CHARACTERIZING RISK AND RETURN

Revised the example that runs throughout the chapter to discuss Staples Updated all table and figure values in the body of the chapter Added equation functions to Table 9.3 and Table 9.5

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Updated Example 9-2 to include new Mattel data Updated the data in the Finance at Work—Markets box Revised the data for the end-of-chapter Excel problem Added a new end-of-chapter Excel problem

chapter ten ESTIMATING RISK AND RETURN

Updated values and data in Tables 10.1–10.4 Added a new end-of-chapter Excel problem

chapter eleven CALCULATING THE COST OF CAPITAL

Clarified and expanded the discussion of use of market values versus book values in the calculation of WACC Expanded the discussion of when to use CAPM versus the constant-growth model when estimating the cost of equity Expanded the discussion of computation of marginal tax rate for WACC Enhanced the discussion of use of firm versus project WACCs Enhanced the discussion of appropriateness of divisional WACCs

chapter twelve ESTIMATING CASH FLOWS ON CAPITAL BUDGETING PROJECTS

Clarified the definition of salvage value Expanded the discussion of substitutionary and complementary effects Enhanced the discussion of income tax shield from a project having taxable losses Enhanced the discussion of NWC changes “leading” changes in sales Expanded the discussion of the half-year convention in depreciation

chapter thirteen WEIGHING NET PRESENT VALUE AND OTHER CAPITAL BUDGETING CRITERIA

Clarified the discussion of the goal of capital budgeting decision rules and the differing environments of investment and capital budgeting decisions Expanded the discussion of why using rate-based and time-based decision statistics to choose across projects can be misleading with regards to NPV

chapter fourteen WORKING CAPITAL MANAGEMENT AND POLICIES

Expanded the discussion of the rationale for NWC and the tradeoffs inherent in having too little or too much Refined discussion of cash flows vs. the cash account

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brief contents

part one INTRODUCTION 3 chapter 1 Introduction to Financial Management 3

part two FINANCIAL STATEMENTS 27 chapter 2 Reviewing Financial Statements 27

chapter 3 Analyzing Financial Statements 59

part three VALUING OF FUTURE CASH FLOWS 89 chapter 4 Time Value of Money 1: Analyzing Single Cash Flows 89

chapter 5 Time Value of Money 2: Analyzing Annuity Cash Flows 115

part four VALUING OF BONDS AND STOCKS 147

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chapter 6 Understanding Financial Markets and Institutions 147

Appendix 6A: The Financial Crisis: The Failure of Financial Institution Specialness (located at www.mhhe.com/Cornett4e) 186

chapter 7 Valuing Bonds 199

chapter 8 Valuing Stocks 233

part five RISK AND RETURN 261 chapter 9 Characterizing Risk and Return 261

chapter 10 Estimating Risk and Return 289

part six CAPITAL BUDGETING 315 chapter 11 Calculating the Cost of Capital 315

chapter 12 Estimating Cash Flows on Capital Budgeting Projects 339

Appendix 12A: MACRS Depreciation Tables 362

chapter 13 Weighing Net Present Value and Other Capital Budgeting Criteria 369

part seven WORKING CAPITAL MANAGEMENT AND FINANCIAL PLANNING 399 chapter 14 Working Capital Management and Policies 399

Appendix 14A: The Cash Budget 422

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contents CHAPTER 1 INTRODUCTION TO FINANCIAL MANAGEMENT 3 1.1 • FINANCE IN BUSINESS AND IN LIFE 4

What Is Finance? 5 Subareas of Finance 8

Application and Theory for Financial Decisions 9 Finance versus Accounting 10

1.2 • THE FINANCIAL FUNCTION 11 The Financial Manager 11

Finance in Other Business Functions 11 Finance in Your Personal Life 12

1.3 • BUSINESS ORGANIZATION 12 Sole Proprietorships 12

Partnerships 13 Corporations 14

Hybrid Organizations 15 1.4 • FIRM GOALS 15 1.5 • AGENCY THEORY 17

Agency Problem 17

Corporate Governance 18 The Role of Ethics 19

1.6 • FINANCIAL MARKETS, INTERMEDIARIES, AND THE FIRM 21 1.7 • BIG PICTURE ENVIRONMENT 21

Oil Prices Plummet 21

China Slows Down 22

CHAPTER 2 REVIEWING FINANCIAL STATEMENTS 27 2.1 • BALANCE SHEET 28

Assets 29

Liabilities and Stockholders’ Equity 29

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Managing the Balance Sheet 30

2.2 • INCOME STATEMENT 33 Debt versus Equity Financing 35

Corporate Income Taxes 36 2.3 • STATEMENT OF CASH FLOWS 38

GAAP Accounting Principles 39 Noncash Income Statement Entries 39

Sources and Uses of Cash 40 2.4 • FREE CASH FLOW 42 2.5 • STATEMENT OF RETAINED EARNINGS 44 2.6 • CAUTIONS IN INTERPRETING FINANCIAL STATEMENTS 44

CHAPTER 3 ANALYZING FINANCIAL STATEMENTS 59 3.1 • LIQUIDITY RATIOS 60 3.2 • ASSET MANAGEMENT RATIOS 62

Inventory Management 62

Accounts Receivable Management 63 Accounts Payable Management 63

Fixed Asset and Working Capital Management 64 Total Asset Management 64

3.3 • DEBT MANAGEMENT RATIOS 66 Debt versus Equity Financing 66

Coverage Ratios 67 3.4 • PROFITABILITY RATIOS 68 3.5 • MARKET VALUE RATIOS 70 3.6 • DUPONT ANALYSIS 71

3.7 • OTHER RATIOS 75 Spreading the Financial Statements 75 Internal and Sustainable Growth Rates 76

3.8 • TIME SERIES AND CROSS-SECTIONAL ANALYSES 77 3.9 • CAUTIONS IN USING RATIOS TO EVALUATE FIRM PERFORMANCE 78

CHAPTER 4 TIME VALUE OF MONEY 1: ANALYZING SINGLE CASH FLOWS 89 4.1 • ORGANIZING CASH FLOWS 90 4.2 • FUTURE VALUE 91

Single-Period Future Value 91

Compounding and Future Value 92 4.3 • PRESENT VALUE 98

Discounting 98 4.4 • USING PRESENT VALUE AND FUTURE VALUE 101

Moving Cash Flows 101 4.5 • COMPUTING INTEREST RATES 103

Return Asymmetries 105 4.6 • SOLVING FOR TIME 105

CHAPTER 5 TIME VALUE OF MONEY 2: ANALYZING ANNUITY CASH FLOWS 115 5.1 • FUTURE VALUE OF MULTIPLE CASH FLOWS 116

Finding the Future Value of Several Cash Flows 116 Future Value of Level Cash Flows 118

Future Value of Multiple Annuities 119 5.2 • PRESENT VALUE OF MULTIPLE CASH FLOWS 122

Finding the Present Value of Several Cash Flows 122

Present Value of Level Cash Flows 123 Present Value of Multiple Annuities 124

Perpetuity—A Special Annuity 127 5.3 • ORDINARY ANNUITIES VERSUS ANNUITIES DUE 127 5.4 • COMPOUNDING FREQUENCY 129

Effect of Compounding Frequency 129

5.5 • ANNUITY LOANS 133 What Is the Interest Rate? 133

Finding Payments on an Amortized Loan 134

CHAPTER 6 UNDERSTANDING FINANCIAL MARKETS AND INSTITUTIONS 147 6.1 • FINANCIAL MARKETS 148

Primary Markets versus Secondary Markets 148

Money Markets versus Capital Markets 151 Other Markets 153

6.2 • FINANCIAL INSTITUTIONS 155 Unique Economic Functions Performed by Financial Institutions 156

6.3 • INTEREST RATES AND THE LOANABLE FUNDS THEORY 159 Supply of Loanable Funds 161

Demand for Loanable Funds 162 Equilibrium Interest Rate 163

Factors That Cause the Supply and Demand Curves for Loanable Funds to Shift 163 Movement of Interest Rates over Time 167

6.4 • FACTORS THAT INFLUENCE INTEREST RATES FOR INDIVIDUAL SECURITIES 167 Inflation 168

Real Risk-Free Rate 168 Default or Credit Risk 169

Liquidity Risk 170 Special Provisions or Covenants 171

Term to Maturity 171 6.5 • THEORIES EXPLAINING THE SHAPE OF THE TERM STRUCTURE OF INTEREST RATES 174

Unbiased Expectations Theory 174 Liquidity Premium Theory 176

Market Segmentation Theory 177 6.6 • FORECASTING INTEREST RATES 179 Appendix 6A The financial Crisis: The Failure of Financial Institution Specialness 186

CHAPTER 7 VALUING BONDS 199 7.1 • BOND MARKET OVERVIEW 200

Bond Characteristics 200

Bond Issuers 202 Other Bonds and Bond-Based Securities 204

Reading Bond Quotes 207 7.2 • BOND VALUATION 209

Present Value of Bond Cash Flows 209 Bond Prices and Interest Rate Risk 211

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7.3 • BOND YIELDS 213 Current Yield 213 Yield to Maturity 214

Yield to Call 215 Municipal Bonds and Yield 217

Summarizing Yields 218 7.4 • CREDIT RISK 219

Bond Ratings 219 Credit Risk and Yield 221

7.5 • BOND MARKETS 222 Following the Bond Market 223

CHAPTER 8 VALUING STOCKS 233 8.1 • COMMON STOCK 234 8.2 • STOCK MARKETS 235

Tracking the Stock Market 238

Trading Stocks 240 8.3 • BASIC STOCK VALUATION 241

Cash Flows 241 Dividend Discount Models 243

Preferred Stock 245 Expected Return 246

8.4 • ADDITIONAL VALUATION METHODS 248 Variable-Growth Techniques 248

The P/E Model 251 Estimating Future Stock Prices 254

CHAPTER 9 CHARACTERIZING RISK AND RETURN 261 9.1 • HISTORICAL RETURNS 262

Computing Returns 262 Performance of Asset Classes 265

9.2 • HISTORICAL RISKS 266 Computing Volatility 266

Risk of Asset Classes 269

Risk versus Return 270

9.3 • FORMING PORTFOLIOS 271 Diversifying to Reduce Risk 271

Modern Portfolio Theory 274

CHAPTER 10 ESTIMATING RISK AND RETURN 289 10.1 • EXPECTED RETURNS 290

Expected Return and Risk 290

Risk Premiums 292 10.2 • MARKET RISK 294

The Market Portfolio 294 Beta, a Measure of Market Risk 295

The Security Market Line 296 Finding Beta 298

Concerns about Beta 300 10.3 • CAPITAL MARKET EFFICIENCY 301

Efficient Market Hypothesis 302 Behavioral Finance 303

10.4 • IMPLICATIONS FOR FINANCIAL MANAGERS 304 Using the Constant-Growth Model for Required Return 304

CHAPTER 11 CALCULATING THE COST OF CAPITAL 315 11.1 • THE WACC FORMULA 316

Calculating the Component Cost of Equity 317 Calculating the Component Cost of Preferred Stock 318

Calculating the Component Cost of Debt 318 Choosing Tax Rates 319

Calculating the Weights 321 11.2 • FIRM WACC VERSUS PROJECT WACC 322

Project Cost Numbers to Take from the Firm 323 Project Cost Numbers to Find Elsewhere: The Pure-Play Approach 324

11.3 • DIVISIONAL WACC 326 Pros and Cons of a Divisional WACC 326

Subjective versus Objective Approaches 328 11.4 • FLOTATION COSTS 330

Adjusting the WACC 331

CHAPTER 12 ESTIMATING CASH FLOWS ON CAPITAL BUDGETING PROJECTS 339

12.1 • SAMPLE PROJECT DESCRIPTION 340 12.2 • GUIDING PRINCIPLES FOR CASH FLOW ESTIMATION 341

Opportunity Costs 342 Sunk Costs 342

Substitutionary and Complementary Effects 342 Stock Dividends and Bond Interest 343

12.3 • TOTAL PROJECT CASH FLOW 343 Calculating Depreciation 343

Calculating Operating Cash Flow 344 Calculating Changes in Gross Fixed Assets 345

Calculating Changes in Net Working Capital 346 Bringing It All Together 348

12.4 • ACCELERATED DEPRECIATION AND THE HALF-YEAR CONVENTION 349 MACRS Depreciation Calculation 349

Section 179 Deductions 350

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Impact of Accelerated Depreciation 351

12.5 • “SPECIAL” CASES AREN’T REALLY THAT SPECIAL 352 12.6 • CHOOSING BETWEEN ALTERNATIVE ASSETS WITH DIFFERING LIVES: EAC 354 12.7 • FLOTATION COSTS REVISITED 356 APPENDIX 12A: MACRS DEPRECIATION TABLES 362

CHAPTER 13 WEIGHING NET PRESENT VALUE AND OTHER CAPITAL BUDGETING CRITERIA 369

13.1 • THE SET OF CAPITAL BUDGETING TECHNIQUES 371 13.2 • THE CHOICE OF DECISION STATISTIC FORMAT 372 13.3 • PROCESSING CAPITAL BUDGETING DECISIONS 373 13.4 • PAYBACK AND DISCOUNTED PAYBACK 374

Payback Statistic 374

Payback Benchmark 375 Discounted Payback Statistic 375

Discounted Payback Benchmark 376 Payback and Discounted Payback Strengths and Weaknesses 378

13.5 • NET PRESENT VALUE 378 NPV Statistic 378

NPV Benchmark 378 NPV Strengths and Weaknesses 380

13.6 • INTERNAL RATE OF RETURN AND MODIFIED INTERNAL RATE OF RETURN 381 Internal Rate of Return Statistic 382

Internal Rate of Return Benchmark 382 Problems with Internal Rate of Return 383

IRR and NPV Profiles with Non-Normal Cash Flows 384 Differing Reinvestment Rate Assumptions of NPV and IRR 385

Modified Internal Rate of Return Statistic 385 IRRs, MIRRs, and NPV Profiles with Mutually Exclusive Projects 385

MIRR Strengths and Weaknesses 389 13.7 • PROFITABILITY INDEX 390

Profitability Index Statistic 390 Profitability Index Benchmark 390

CHAPTER 14 WORKING CAPITAL MANAGEMENT AND POLICIES 399 14.1 • REVISITING THE BALANCE-SHEET MODEL OF THE FIRM 400 14.2 • TRACING CASH AND NET WORKING CAPITAL 401

The Operating Cycle 402

The Cash Cycle 402 14.3 • SOME ASPECTS OF SHORT-TERM FINANCIAL POLICY 403

The Size of the Current Assets Investment 403 Alternative Financing Policies for Current Assets 404

14.4 • THE SHORT-TERM FINANCIAL PLAN 407 Unsecured Loans 407

Secured Loans 408 Other Sources 408

14.5 • CASH MANAGEMENT 409 Reasons for Holding Cash 409

Determining the Target Cash Balance: The Baumol Model 409 Determining the Target Cash Balance: The Miller-Orr Model 410

Other Factors Influencing the Target Cash Balance 411 14.6 • FLOAT CONTROL: MANAGING THE COLLECTION AND DISBURSEMENT OF CASH 413

Accelerating Collections 414

Delaying Disbursements 414 Ethical and Legal Questions 415

14.7 • INVESTING IDLE CASH 415 Why Firms Have Surplus Cash 416

What to Do with Surplus Cash 416 14.8 • CREDIT MANAGEMENT 416

Credit Policy: Terms of the Sale 416 Credit Analysis 416

Collection Policy 417 APPENDIX 14A THE CASH BUDGET 422 VIEWPOINTS REVISITED 426 CHAPTER EQUATIONS 434 INDEX 439

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finance 4e

Part One

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D

chapter one introduction to financial management

© John Lamb/Getty Images/Photodisc

o you know: What finance entails? How financial management functions within the business world? Why you might benefit from studying financial principles? This chapter is the ideal place to get answers to those questions. Finance is the study of applying specific value to things we own, services

we use, and decisions we make. Examples are as varied as shares of stock in a company, payments on a home mortgage, the purchase of an entire firm, and the personal decision to retire early. In this text, we focus primarily on one area of finance, financial management, which concentrates on valuing things from the perspective of a company, or firm.

finance The study of applying specific value to things we own, services we use, and decisions we make.

financial management The process for and the analysis of making financial decisions in the business context.

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LEARNING GOALS

LG1-1 Define the major areas of finance as they apply to corporate financial management. LG1-2 Show how finance is at the heart of sound business decisions. LG1-3 Learn the financial principles that govern your personal decisions. LG1-4 Examine the three most common forms of business organization in the United States today. LG1-5 Distinguish among appropriate and inappropriate goals for financial managers. LG1-6 Identify a firm’s primary agency relationship and discuss the possible conflicts that may arise. LG1-7 Discuss how ethical decision making is part of the study of financial management. LG1-8 Describe the complex, necessary relationships among firms, financial institutions, and financial markets. LG1-9 Explain the business ramifications of the decline in the price of oil and China’s economic slowdown.

viewpoints business APPLICATION Caleb has worked very hard to create and expand his juice stand at the mall. He has finally perfected his products and feels that he is offering the right combination of juice and food. As a result, the stand is making a nice profit. Caleb would like to open more stands at malls all over his state and eventually all over the country.

Caleb knows he needs more money to expand. He needs money to buy more equipment, buy more inventory, and hire and train more people. How can Caleb get the capital he needs to expand? (See the solution at the end of the book.)

Financial management is critically important to the success of any business organization, and throughout the text we concentrate on describing the key financial concepts in corporate finance. As a bonus, you will find that many tools and techniques for handling the financial management of a firm also apply to broader types of financial problems, such as personal finance decisions.

In finance, cash flow is the term that describes the process of paying and receiving money. It makes sense to start our discussion of finance with an illustration of various financial cash flows. We use simple graphics to help explain the nature of finance and to demonstrate the different subareas of the field of finance.

After we have an overall picture of finance, we will discuss three important variables in the business environment that can and do have significant impact on the firm’s financial decisions. These are (1) the organizational form of the business, (2) the agency relationship between the managers and owners of a firm, and (3) ethical considerations as finance is applied in the real world.

1.1 • FINANCE IN BUSINESS AND IN LIFE LG1-1 If your career leads you to making financial decisions, then this book will be indispensable. If not, it is likely that your activities in a business will involve interacting with the finance functions. After all, the important investments of a firm involve capital and, therefore, finance. Expanding marketing channels, developing new products, and u

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