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 700 Word Summary

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MINIMUM 1 Academic Source 

Summary of Chapter 12

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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

page iv

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

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ISBN 978-1-259-91963-3
MHID 1-259-91963-3

All credits appearing on page or at the end of the book are considered to be an extension of the copyright page.

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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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page viii

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

page ix

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

page x

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

page xi

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page xii

The Connect eBook makes it easy for students to access their reading material on smartphones and tablets.
They can study on the go and don’t need internet access to use the eBook as a reference, with full
functionality.

Multimedia content such as videos, simulations, and games drive student engagement and critical thinking
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The Connect Insight dashboard delivers data on performance, study behavior, and effort. Instructors can
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Connect offers comprehensive service, support, and training throughout every phase of your implementation.

If you’re looking for some guidance on how to use Connect, or want to learn tips and tricks from super users,
you can find tutorials as you work. Our Digital Faculty Consultants and Student Ambassadors offer insight
into how to achieve the results you want with Connect.

www.mheducation.com/connect

page xiii

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

page xvii

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

page xviii

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

page 1

finance 4e

Part One

page 2

page 3

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.

page 4

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
upgrading a factory all cost money. A firm spends its capital on these projects to foster growth. Understanding how
finance professionals evaluate those projects will help you be successful in your business focus. In addition,
everyone will benefit in their personal life from learning finance and understanding financial decisions.

And what exactly makes up this engine of financial decision making? Successful application of financial theories
helps money flow from individuals who want to improve their financial future to businesses that want to expand the
scale or scope of their operations. These exchanges lead to a growing economy and more employment opportunities
for people at all income levels. So, two important things result from this simple exchange: The economy will be
more productive, and individuals’ wealth will grow into the future.

page 6

?

page 5

personal APPLICATION
Dagmar is becoming interested in investing some of her money. However, she has heard about several corporations in which the
investors lost all of their money. Recently, Dagmar has heard that RadioShack (2015), Wet Seal (2015), and THQ (2013) have all filed
for bankruptcy. These firms’ stockholders lost their entire investments in these firms.

Many of the stockholders who lost money were employ