Fundamentals of Financial Management (12th edition)

755 Pages·2009·47.91 MB·English

by  Eugene F. Brigham

F U N D A M E N T A L S
O F F I N A N C I A L
M A N A G E M E N T
Twelfth Edition
Eugene F. Brigham
UNIVERSITY OF FLORIDA
Joel F. Houston
UNIVERSITY OF FLORIDA
Australia•Brazil•Japan•Korea•Mexico•Singapore•Spain•UnitedKingdom•UnitedStates
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P R E F A C E
WhenthefirsteditionofFundamentalswaspublished31yearsago,wewantedto
provide an introductory text that students would find interesting and easy to
understand.Fundamentalsimmediatelybecametheleadingundergraduatefinance
text,andithasmaintainedthatpositioneversince.Ourgoalwiththiseditionwas
to produce a book and ancillary package that would maintain its lead and set a
new standard for finance textbooks.
Important changes in the financial environment have occurred since the last
edition. New technology and increased globalization continue to transform practices
and markets. Continued improvements in communications and transportation have
made it easier for businesses to operate on a worldwide basis—a company can be
headquarteredinNewYork,developproductsinIndia,manufacturetheminChina,
and sell them anywhere in the world. This has led to major changes in the labor
markets,especiallytoanincreaseinoutsourcing,whichhasresultedingenerallylower
consumer prices; but it has caused job losses for some U.S. workers and gains for
others.Therehavealsobeendramaticrisesandfallsinthestockmarket,andinterest
rates have remained low even as energy prices continue to rise. Corporate scandals
have led to important changes in the laws governing corporate management and
financial reporting, as well as to equally important changes in managerial compen-
sation. These issues are discussed in this edition of Fundamentals, where we analyze
them from financial and ethical perspectives.
Our target audience is undergraduate students taking their first, and often only,
financecourse.Somestudentswilldecidetomajorinfinanceandgoontotakecourses
in investments, money and capital markets, and advanced corporate finance. Others
willchoosemarketing,management,orsomeothernonfinancemajor.Stillotherswill
majorinareasotherthanbusinessandtakefinanceandafewotherbusinesscourses
to gain information that will help them in law, real estate, and other fields.
Ourchallengewastoprovideabookthatservesalloftheseaudienceswell.Our
conclusion was that we should focus on the core principles of finance (i.e., on basic
topics such as the time value of money, risk analysis, and valuation). Moreover, we
concluded that we should address these topics from two points of view: (1) as an
investor who is seeking to make intelligent investment choices and (2) as a business
manager trying to maximize the value of his or her firm's stock. Note that both
investors and managers need to know the same set of principles, so the core topics
are important to students regardless of what they choose to do after they finish the
course.
THE FINANCIAL CRISIS OF 2008
As everyone knows, the financial markets experienced a meltdown in the fall of
2008. The average stock's price declined by about 50%, which wiped out trillions
of dollars of savings. The (sick) joke was that 401 (k) retirement plans were
becoming 201 (k) plans. These market losses delayed many retirements and also
caused many retirees to go back to work. Housing construction virtually ceased,
and home prices plunged by about 20% nationwide and by as much as 50% in
some parts of the country, wiping out trillions more of savings. Millions of
homeowners found that their mortgages exceeded the value of their homes, and
defaults and foreclosures followed. This led to huge losses by banks and other
lenders, which in turn led to bankruptcies, restructuring, and massive layoffs.
Threeyearsago,thereweremanystrong,old,andindependentglobalinvestment
banks. Today, all of those in the U.S. are gone—icons like Merrill Lynch and
iii
iv Preface
MorganStanleyhaveeithergonebankrupt,soldoutatrockbottomprices,orbeen
forced to convert into regulated banks that are partially owned by the federal
government.
The credit markets literally froze up. Banks needed to conserve their cash to
meetwithdrawals;hencetheyrefusedtomakeloanseventostrongindustrialand
retail companies, or home and auto purchasers. This quickly led to a severe
slowdown in non-financial businesses, accompanied by still more bankruptcies
and layoffs. This happened all over the world, and the specter of a 1930s type
depressionwasonthemindsofcentralbankersandtreasuryofficialsworldwide.
Asaresult,coordinatedgovernmentrescueplanswereputintooperationinmost
developed nations. We don't know at this point what will happen next. The best
bet is that a depression will be avoided but a bad recession will occur. Going
forward, companies and individuals will recognize that an excessive use of debt
was the root cause of the financial meltdown, hence there will be a smaller and
more responsible use of debt in the future—at least until memories of 2008 fade.
How should the 2008 Crisis affect the contents of this textbook? Here is our
conclusion:
l The fundamental concepts of finance are unchanged; hence all the concepts
covered in the book are still applicable.
l The problems of 2008 resulted largely because businesses, individuals, and
government officialsdid not pay sufficient attention to the basic principles of
finance as covered in the book.
l Therefore, there is no reason to change most of the book.
l We should, however, use the 2008 experience to illustrate the basic points
made in the book. For example, we talk about risk, and 2008 can and should
be used to drive home how risk can be measured and dealt with.
The economic situation is fluid and dynamic. We may have a rapid recovery,
whichwouldbegreat,but,wemighthavealong,deep,andpainfulrecession.We
plantousetheInternetintheyearsahead,whilethebookisinuse,toupdatethe
situationonachapter-by-chapterbasis.Aseventsrelatedtothedifferentchapters
occur,wewillprovideupdatedvignettesandotherinformationonthebook'web
site.Weanticipatemanyimportantdevelopments,hencealotofupdates.Still,the
good news is that the basic, fundamental contents of the book will remain the
same.
ORGANIZATION OF THE CHAPTERS: A VALUATION FOCUS
As we discuss in Chapter 1, in an enterprise system such as that of the United
States, the primary goal of financial management is to help managers maximize
their firms' values, subject to constraints such as not polluting the environment,
not engaging in unfair labor practices, and not engaging in antitrust activities.
Therefore, valuation underlies everything in Fundamentals. In Chapter 1, we dis-
cuss the concept of valuation, explain how it depends on future cash flows and
risk, and show why value maximization is good for society in general. The val-
uation theme runs throughout the text.
Values are not established in a vacuum—stock and bond values are deter-
mined in the financial markets, so an understanding of those markets is essential
to anyone involved with finance. Therefore, Chapter 2 covers the major types of
financialmarkets,thereturnsthatinvestorshavehistoricallyearned,andtherisks
inherent in different types of securities. This information is important for anyone
working in finance. It is also important for anyone who has or hopes to own
financial assets.
Preface v
Asset values depend in a fundamental way on earnings and cash flows as
reported in the accounting statements. Therefore, we review those statements in
Chapter3.TheninChapter4,weshowhowaccountingdatacanbeanalyzedand
usedtomeasurehowwellacompanyhasoperatedinthepastandhowitislikely
to perform in the future.
Chapter 5 covers the time value of money (TVM), perhaps the most funda-
mental concept in finance. The basic valuation model, which ties together cash
flows, risk, and interest rates, is based on TVM concepts; and these concepts are
used throughout the remainder of the book. Therefore, students should allocate
plenty of time to Chapter 5.
Chapter 6 deals with interest rates, a key determinant of asset values. We
discuss how interest rates are affected by risk, inflation, liquidity, the supply of
and demand for capital in the economy, and the actions of the Federal Reserve.
ThediscussionofinterestratesleadsdirectlytobondsinChapter7andstocks
in Chapters 8 and 9. We show how stocks and bonds (and all other financial
assets) are valued using the basic TVM model.
Chapters 1 through 9 provide background information that is essential to
investors and corporate managers. These are “finance” topics, not “business” or
“corporate finance” topics as those terms are commonly used. Thus, Chapters 1
through9discusstheconceptsandmodelsusedtoestablishvalues,andwegoon
in Chapters 10 through 21 to discuss specific actions managers can take to max-
imize their firms' values.
Asnotedpreviously,mostbusinessstudentsdon'tplantospecializein finance,
sotheymightnotthinkthe“businessfinance”chaptersarerelevanttothem.Thisis
not true, and in the later chapters, we show that all important business decisions
involveallofafirm'sdepartments—marketing,accounting,production,andsoforth.
Thus, while capital budgeting can be thought of as a financial decision, marketing
people provide input on likely unit sales and sales prices, manufacturing people
provide inputs on costs, and so forth. Moreover, capital budgeting decisions influ-
encethesizeofthefirm,itsproducts,anditsprofits;andthosefactorsaffectallthe
firm's employees, from the CEO to the mail room staff.
STRUCTURAL CHANGES
We made two important structural changes in this new edition:
1. WemovedthematerialonfinancialmarketsandinstitutionsfromChapter5to
Chapter 2. Markets and institutions follow naturally from Chapter 1, and this
materialprovidesusefulbackgroundinformationfortheremainderofthebook.
2. Wemovedthetimevalueofmoney(TVM)chapterfromChapter2toChapter5.
Under the previous structure, we covered TVM concepts, then covered the
accounting and financial markets chapters before applying TVM concepts to
bond and stock valuation. We liked the idea of covering TVM early, but we
concluded that it was pedagogically better to cover TVM concepts and then
immediately focus on applications, as we do now.
These changes improve the flow of the text significantly—there is a much
smoother transition from chapter to chapter in the first part of the book.
OTHER CHANGES
We made many other changes, but the following are the most significant:
1. Editing. We edit each new edition toimprove clarity, but we did more in this
edition than ever before. We put the entire text on digital files, which
vi Preface
facilitated shifting things around to improve transitions and flow. Students
will find it easier to read the book than in the past.
2. Beginning-of-Chapter Vignettes and Within-Chapter Boxes. Many events have
transpired in the financial markets during the past three years—for example,
in 2008 credit markets tightened almost to the point of collapse, the housing
andautomarketsareinterribleshape,themajorinvestmentbanksallfailedor
were forced to reorganize as regulated commercial banks, and the heads of a
number ofmajorcorporations were fired. We usetheseevents asthe subjects
ofmanyvignettesandboxes,andtheyillustrateverywellthepointsmadein
the chapters.
3. Learning Objectives. To help students see what we expect them to take away
from the chapters, we added a set of learning objectives at the beginning of
each chapter.
4. Excel. Spreadsheets, especially Excel, are becoming increasingly important in
business; and students who are familiar with Excel have a significant
advantageinthejobmarketandlateronthejob.WeusedExcelintwoways.
First, we worked all the in-text examples, end-of-chapter problems, and test
bankproblemswithbothExcelandacalculator,usingthecalculatortomake
suretheproblemwasworkablewithacalculatorandusingExceltocheckfor
accuracy.Second,weusedExceltocreatemanyofthetablesandgraphsinthe
text, we displayed them as Excel pictures, and we have made available the
models we used. Students do not need to know how to use Excel to go
through the book, but if they are somewhat familiar with this software, they
will see how many common financial problems can be set up and solved
efficiently with Excel. Students who are not familiar with Excel may also be
motivated to learn something about it.
5. Tie-In between Self-Test Questions, End-of-Chapter Questions, and the Test Bank.
Becausetestingisimportant,wespentagreatdealoftimeimprovingthetest
bank. Every question and problem was reviewed for clarity, accuracy, and
consistencywiththetext.Also,wesetupself-testquestionsattheendofeach
majorsectionwithinthetexttoenablestudentstotakereal-timetestsontheir
ownbeforemovingon.Theend-of-chapter(EOC)questionsandproblemsare
similar to, but often go beyond, the self-test questions, and the test bank
questionsandproblemsaresimilartotheEOCmaterials.Ifstudents readthe
text, do the self-test questions as they go along, and then work a sampling of
the EOC questionsand problems,they shoulddo well on examsdrawn from
the test bank.
6. Accounting Statements and Free Cash Flow. Most students in the basic finance
course arefamiliarwith balance sheetsand income statements, but many don't
understand the statement of cash flows and its relationship to free cash flows.
Reviewerstoldusthatinthelasteditionwetriedtodotoomanythings—such
as present alternative ways to calculate free cash flow—and that we should
delete some of those items and better explain what remained. We agreed, and
this edition does a much better job in this regard.
7. Cash Flows and Risk in Capital Budgeting. In the last edition, the first two
chapters on capital budgeting (Chapters 11 and 12) were not tied together
very well. In that edition, we used relatively simple and straightforward
illustrative projects in Chapter 11 but switchedto entirely different and more
complex projects in Chapter 12. For this edition, we rewrote Chapter 12,
continuing with the Chapter 11 examples. We also reordered materials to
presenttheminamorelogicalsequence.Onereviewerstatedthatthischapter
was the single biggest improvement in the twelfth edition.
8. Financial Forecasting. As we were rewriting Chapter 17, GE's chairman
announced that heexpected toreport higherearnings shortly,but twoweeks
laterheannouncedasignificantearningsdecline,whichledtoasharpdropin
Preface vii
GE'sstockprice.Weusedthisexampletoillustratetheimportanceofaccurate
forecasts and to liven up our discussion of strategic financial planning. In
addition, we used an improved Excel model to streamline our illustrative
forecast and to make the forecasting process simpler and clearer to students.
9. Capital Budgeting. We moved the analysis of projects with unequal lives back
from Chapter 13 to Chapter 12 because unequal life analysis is more
closely related to the other topics in Chapter 12. An additional benefit is that
Chapter 13 is now more streamlined and focuses on real options.
10. Derivatives. We rearranged some of the sections to improve the discussion in
Chapter 18. More specifically, we moved the “Using Derivatives to Reduce
Risk”sectionsothatitimmediatelyfollowsthediscussionof“OtherTypesof
Derivatives,”Wealsoreceivedfeedbacksuggestingthatwefocusedtoomuch
on call options. With that in mind, we added a new Appendix 18A entitled
“Valuation of Put Options.” Finally, we added some problems related to
option pricing using the riskless hedge approach.
11. Mergers. We eliminated the discussion of purchase/pooling accounting
treatment from Chapter 21 since all mergers are now accounted for as pur-
chases. We also moved the discussion of merger regulation to a Web
Appendix to help streamline the chapter.
We could continue to list changes in this edition, but these items provide
instructors (particularly those familiar with the last edition) with a good idea of
the kinds of revisions that were made to this text. It also lets students know how
authors try to improve their texts.
ACKNOWLEDGMENTS
The book reflects the efforts of a great many people—those who worked on
Fundamentals and our related books in the past and those who worked on this
twelfthedition.First,wewouldliketothankDanaAberwaldClark,whoworked
closely with us at every stage of the revision—her assistance was absolutely
invaluable.Second,SusanWhitmanprovidedgreattypingandlogisticalsupport.
Our colleagues Roy Crum, Jim Keys, Andy Naranjo, M. Nimalendran, Jay
Ritter, Mike Ryngaert, Craig Tapley, and Carolyn Takeda gave us many useful
suggestions regarding the ancillaries and many parts of the book, including the
integrated cases. We also benefited from the work of Mike Ehrhardt and Phillip
Daves of the University of Tennessee and Roy Crum of the University of Florida,
who worked with us on companion books. Also, Christopher Buzzard did an
outstanding job helping us develop the Excel models, the web site, and the
PowerPoint® presentations.
Next, we would like to thank the following professors who reviewed this
edition in detail and provided many useful comments and suggestions:
Rebecca Abraham—Nova Southeastern University
Kavous Ardalan—Marist College
Tom Arnold—University of Richmond
Deborah Bauer—University of Oregon
Gary Benesh—Florida State University
Mark S. Bettner—Bucknell University
Elizabeth Booth—Michigan State University
Brian Boscaljon—Penn State University, Erie
Rajesh Chakrabarti—Georgia Institute of Technology
Brent Dalrymple—University of Central Florida
Jim DeMello—Western Michigan University
Anne M. Drougas—Dominican University
viii Preface
Scott Ehrhorn—Liberty University
David Feller—Brevard Community College
Jennifer Foo—Stetson University
Partha Gangopadhyay—St. Cloud State University
Sharon H. Garrison—University of Arizona
Robert P. Hoffman—College of St. Scholastica
Benjamas Jirasakuldech—University of the Pacific
Ashok Kapoor—Augsburg College
Howard Keen—Temple University
Christopher J. Lambert, J.D.—Fairmont State University
Alice Lee—San Francisco State University
Denise Letterman—Robert Morris University
Yulong Ma—California State University, Long Beach
Barry Marchman—Florida A&M
Brian Maris—Northern Arizona University
Matthew Morey—Pace University
Tom C. Nelson—Leeds School of Business, University of Colorado at Boulder
Darshana Palkar—Minnesota State University, Mankato
Narendar V. Rao—Northeastern Illinois University
Charles R. Rayhorn—Northern Michigan University
Oliver Schnusenberg—University of North Florida
Dean S. Sommers—University of Delaware
Michal Spivey—Clemson University
Glenn L. Stevens—Franklin & Marshall College
Lowell E. Stockstill—Wittenberg University
Samantha Thapa—Western Kentucky University
David O. Vang—University of St. Thomas
Sheng Yang—Black Hills State University
David Zalewski—Providence College
Sijing Zong—California State University—Stanislaus
We would also like to thank the following professors, whose reviews and
comments on our earlier books contributed to this edition:
Robert Adams Charles Geof Booth Alva Butcher
Mike Adler Barngrover Waldo Born Bill Campsey
Sharif Ahkam Sam Basu Steven Bouchard Bob Carlson
Syed Ahmad Greg Bauer Kenneth Severin Carlson
Ed Altman Bill Beedles Boudreaux David Cary
Bruce Anderson Brian Belt Rick Boulware Steve Celec
Ron Anderson MosheBen-Horim Helen Bowers Mary Chaffin
Tom Anderson Bill Beranek Oswald Bowlin Charles Chan
John Andrews Tom Berry Don Boyd Don Chance
Bob Angell Will Bertin G. Michael Boyd Antony Chang
Vince Apilado Scott Besley Pat Boyer Susan Chaplinsky
Harvey Dan Best Joe Brandt K. C. Chen
Arbalaez Roger Bey Elizabeth Jay Choi
Henry Arnold Gilbert W. Brannigan S. K. Choudhary
Bob Aubey Bickum Mary Broske Lal Chugh
Gil Babcock Dalton Bigbee Christopher Maclyn Clouse
Peter Bacon John Bildersee Brown Bruce Collins
Kent Baker Laurence E. Blose David T. Brown Mitch Conover
Robert Balik Russ Boisjoly Kate Brown Margaret
Tom Bankston Bob Boldin Larry Brown Considine
Babu Baradwaj Keith Boles Bill Brueggeman Phil Cooley
Les Barenbaum Michael Bond Paul Bursik Joe Copeland
Preface ix
David Cordell Wafica Ghoul Narayanan Ileen Malitz
Marsha Cornett Erasmo Jayaraman Bob Malko
M. P. Corrigan Giambona Zhenhn Jin Phil Malone
John Cotner Armand Gilinsky, Kose John Abbas
Charles Cox Jr. Craig Johnson Mamoozadeh
David Crary Philip Glasgo Keith Johnson Terry Maness
John Crockett, Jr. Rudyard Goode Ramon Johnson Chris Manning
Bill Damon Raymond Steve Johnson Surendra
Morris Danielson Gorman Ray Jones Mansinghka
Joel Dauten Walt Goulet Frank Jordan Timothy Manuel
Steve Dawson Bernie Manuel Jose Terry Martell
Sankar De Grablowsky Sally Joyner David Martin
Fred Dellva Theoharry Alfred Kahl D. J. Masson
Chad Denson Grammatikos Gus Kalogeras John Mathys
James Owen Gregory Rajiv Kalra Ralph May
Desreumaux Ed Grossnickle Ravi Kamath John McAlhany
Bodie Dickerson John Groth John Kaminarides Andy
Bernard Dill Alan Grunewald Michael Keenan McCollough
Gregg Dimkoff Manak Gupta Bill Kennedy Ambrose McCoy
Les Dlabay Darryl Gurley Peppi M. Kenny Thomas McCue
Mark Dorfman Sam Hadaway Carol Kiefer Bill McDaniel
Tom Downs Don Hakala Joe Kiernan John McDowell
Frank Draper Gerald Richard Kish Charles
Gene Drzycimski Hamsmith Robert Kleiman McKinney
Dean Dudley William Hardin Erich Knehans Robyn
David Durst John Harris Don Knight McLaughlin
Ed Dyl Paul Hastings Ladd Kochman James McNulty
Fred J. Ebeid Bob Haugen Dorothy Koehl Jeanette
Daniel Ebels Steve Hawke Jaroslaw Medewitz-
Richard Edelman Stevenson Komarynsky Diamond
Charles Edwards Hawkey Duncan Kretovich Jamshid Mehran
U. Elike Del Hawley Harold Krogh Larry Merville
John Ellis Eric M. Haye Charles Kroncke Rick Meyer
George Engler Robert Hehre Don Kummer Jim Millar
Suzanne Erickson Kath Henebry Robert A. Kunkel Ed Miller
Dave Ewert David Heskel Reinhold Lamb John Miller
John Ezzell George Joan Lamm John Mitchell
L. Franklin Fant Hettenhouse Larry Lang Carol Moerdyk
Richard J. Fendler Hans Heymann David Lange Bob Moore
Michael Ferri Kendall Hill P. Lange Scott Moore
Jim Filkins Roger Hill Howard Lanser Barry Morris
John Finnerty Tom Hindelang EdwardLawrence Gene Morris
Robert Fiore Linda Hittle Martin Lawrence Dianne R.
Susan Fischer Ralph Hocking Wayne Lee Morrison
Peggy Fletcher J. Ronald Jim LePage Chris Muscarella
Steven Flint Hoffmeister David E. David Nachman
Russ Fogler Robert Hollinger LeTourneau Tim Nantell
Jennifer Frazier Jim Horrigan Jules Levine Don Nast
Dan French John Houston John Lewis Edward Nelling
Michael John Howe Jason Lin Bill Nelson
Garlington Keith Howe Chuck Linke Bob Nelson
David Garraty Steve Isberg Bill Lloyd William Nelson
Jim Garven Jim Jackson Susan Long Bob Niendorf
Adam Gehr, Jr. Keith Jakob Judy Maese Bruce Niendorf
Jim Gentry Vahan Janjigian Bob Magee Ben Nonnally, Jr.