The Scope and Environment of Financial Management 2

The Scope and Environment of Financial Management 2

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Foundations of Finance The Logic and Practice of Financial Management

Eighth Edition

Arthur J. Keown Virginia Polytechnic Institute and State University

R. B. Pamplin Professor of Finance

John D. Martin Baylor University

Professor of Finance Carr P. Collins Chair in Finance

J. William Petty Baylor University

Professor of Finance W. W. Caruth Chair in Entrepreneurship

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Library of Congress Cataloging-in-Publication Data

Keown, Arthur J. Foundations of finance : the logic and practice of financial management / Arthur J. Keown, John D. Martin, J. William Petty. — 8th ed. p. cm. — (The Pearson series in finance) Includes index. ISBN 978-0-13-299487-3 1. Corporations—Finance. I. Martin, John D., II. Petty, J. William, III. Title. HG4026.F67 2014 658.15–dc23

2012041146

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www.pearsonhighered.com ISBN-13: 978-0-13-299487-3

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

To the Martin women—wife Sally and daughter-in-law Mel, the Martin men—sons Dave and Jess, and Martin boys—grandsons Luke and Burke.

John D. Martin

To my wife, Donna, who has been my friend, encourager, and supporter for more years than we care to admit. How quickly time has passed

since we first met all the way back in high school. J. William Petty

vi Part 1 • Financial Planning

Arthur J. Keown is the Department Head and R. B. Pamplin Professor of Finance at Virginia Polytechnic Institute and State University. He received his bachelor’s degree from Ohio Wesleyan University, his M.B.A. from the University of Michigan, and his doctor- ate from Indiana University. An award-winning teacher, he is a member of the Academy of Teaching Excellence; has received five Certificates of Teaching Excellence at Virginia Tech, the W. E. Wine Award for Teaching Excellence, and the Alumni Teaching Excel- lence Award; and in 1999 received the Outstanding Faculty Award from the State of Vir- ginia. Professor Keown is widely published in academic journals. His work has appeared in the Journal of Finance, the Journal of Financial Economics, the Journal of Financial and Quantitative Analysis, the Journal of Financial Research, the Journal of Banking and Finance, Financial Management, the Journal of Portfolio Management, and many others. In addition to Foundations of Finance, two other of his books are widely used in college finance classes all over the country—Basic Financial Management and Personal Finance: Turning Money into Wealth. Professor Keown is a Fellow of the Decision Sciences Institute, was a member of the Board of Directors of the Financial Management Association, and is the head of the finance department at Virginia Tech. In addition, he recently served as the co-editor of the Journal of Financial Research for 6½ years and as the co-editor of the Financial Management Association’s Survey and Synthesis series for 6 years. He lives with his wife and two children in Blacksburg, Virginia, where he collects original art from Mad Magazine.

John D. Martin holds the Carr P. Collins Chair in Finance in the Hankamer School of Business at Baylor University, where he teaches in the Baylor EMBA programs and has three times been selected as the outstanding teacher. John joined the Baylor faculty in 1998 after spending 17 years on the faculty of the University of Texas at Austin. Over his career he has published over 50 articles in the leading finance journals, including papers in the Journal of Finance, Journal of Financial Economics, Journal of Financial and Quantitative Analy- sis, Journal of Monetary Economics, and Management Science. His recent research has spanned issues related to the economics of unconventional energy sources (both wind and shale gas), the hidden cost of venture capital, and managed versus unmanaged changes in capital struc- tures. He is also co-author of several books, including Financial Management: Principles and Practice (11th ed., Prentice Hall), Foundations of Finance (8th ed., Prentice Hall), Theory of Finance (Dryden Press), Financial Analysis (3rd ed., McGraw Hill), Valuation: The Art & Sci- ence of Corporate Investment Decisions (2nd ed., Prentice Hall), and Value Based Management with Social Responsibility (2nd ed., Oxford University Press).

J. William Petty, PhD, University of Texas at Austin, is Professor of Finance and W. W. Caruth Chair of Entrepreneurship. Dr. Petty teaches entrepreneurial finance, both at the undergraduate and graduate levels. He is a University Master Teacher. In 2008, the Acton Foundation for Entrepreneurship Excellence selected him as the National Entrepre- neurship Teacher of the Year. His research interests include the financing of entrepreneur- ial firms and shareholder value-based management. He has served as the co-editor for the Journal of Financial Research and the editor of the Journal of Entrepreneurial Finance. He has published articles in various academic and professional journals including Journal of Finan- cial and Quantitative Analysis, Financial Management, Journal of Portfolio Management, Jour- nal of Applied Corporate Finance, and Accounting Review. Dr. Petty is co-author of a leading textbook in small business and entrepreneurship, Small Business Management: Launching and Growing Entrepreneurial Ventures. He also co-authored Value-Based Management: Corporate America’s Response to the Shareholder Revolution (2010). He serves on the Board of Directors of a publicly traded oil and gas firm. Finally, he has served as the Executive Director of the Baylor Angel Network, a network of private investors who provide capital to startups and early-stage companies.

About the Authors

vi

Chapter 4 • Tax Planning and Strategies vii

vii

Brief Contents

Part 1 The Scope and Environment of Financial Management 2

1 An Introduction to the Foundations of Financial Management 2 2 The Financial Markets and Interest Rates 20 3 Understanding Financial Statements and Cash Flows 50 4 Evaluating a Firm’s Financial Performance 102

Part 2 The Valuation of Financial Assets 142 5 The Time Value of Money 142 6 The Meaning and Measurement of Risk and Return 182 7 The Valuation and Characteristics of Bonds 220 8 The Valuation and Characteristics of Stock 250 9 The Cost of Capital 274

Part 3 Investment in Long-Term Assets 304 10 Capital-Budgeting Techniques and Practice 304 11 Cash Flows and Other Topics in Capital Budgeting 344

Part 4 Capital Structure and Dividend Policy 380 12 Determining the Financing Mix 380 13 Dividend Policy and Internal Financing 416

Part 5 Working-Capital Management and International Business Finance 436

14 Short-Term Financial Planning 436 15 Working-Capital Management 456 16 International Business Finance 484 Web 17 Cash, Receivables, and Inventory Management Available online at www.myfinancelab.com Web Appendix A Using a Calculator Available online at www.myfinancelab.com

Glossary 505

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