Foundations of Financial Management THIRTEENTH EDITION STANLEY B. BLOCK Texas Christian University GEOFFREY A. HIRT DePaul University BARTLEY R. DANIELSEN North Carolina State University Me McGraw-Hill Graw Hill Irwin Boston Burr Ridge, IL Dubuque, IA New York San Francisco St. Louis Bangkok Bogota Caracas Kuala Lumpur Lisbon London Madrid Mexico City Milan Montreal New Delhi Santiago Seoul Singapore Sydney Taipei Toronto The McGraw-Hill Companies McGraw-Hill I Me To our wonderful wives, Cathy, Linda, and Patricia, and children— Grauu Ih lA Iin Michelle, Randy, Amy, Brian, Munroe, Ford, and Mary Gray. Hill Stanley B. Block\ Geoffrey A. Hirt\ Bartley R. Danielsen FOUNDATIONS OF FINANCIAL MANAGEMENT Published by McGraw-Hill/Irwin, a business unit of The McGraw-Hill Companies, Inc., 1221 Avenue of the Americas, New York, NY, 10020. Copyright © 2009, 2008, 2005, 2002, 2000, 1997, 1994, 1992, 1989, 1987, 1984, 1981, 1978 by The McGraw-Hill Companies, Inc. All rights reserved. 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Printed in China 34567890 CTP/CTP 11 10 ISBN 978-0-07-128525-4 MHID 0-07-128525-3 We would like to thank the following companies for permission to use their logos in this text: Nortel Networks, Southwest Airlines, Nestlé, eBay, Mack Trucks, Deutsche Bank, Sony, Sears, 3M, McGraw-Hill, Microsoft, Renault, Johnson & Johnson, Amazon.com, Eli Lilly, McDonald’s, Continental Airlines, Coca- Cola, Calloway’s Nursery, Celera, General Electric, Ericsson, Textron, Standard & Poor’s, IBM, Wendy’s International, Honeywell International, Hitachi, Procter & Gamble, Pfizer, Nokia, Kellogg, SBC, Fujitsu, Dell, Dun & Bradstreet, Target, Earthlink, General Motors, Liebert, Mattel, Del Monte, Tootsie Roll, Archer Daniels Midland Company, EchoStar Communications, Hewlett-Packard, Viacom, Kmart, Yahoo! Inc., Duke Energy, Schlumberger, CEMEX, and Foster Wheeler. eBay is a trademark of eBay Inc. The Sears Logo within this book is reprinted by arrangement with Sears, Roebuck and Co. and is protected under copyright. No duplication is permitted. Used with permission from McDonald’s Corporation. Kellogg’s® is a Registered trademark of Kellogg Company. All rights reserved. Used with permission. The Dell logo is a trademark of Dell Computer Corporation. Nestlé and Nest Design is a registered trademark of Nestlé. Amazon.com is the registered trademark of Amazon.com, Inc. The SBC logo is a registered trademark of SBC Properties, L.p. The IBM logo is reprinted with permission and is a registered trademark of International Business Machines Corporation. Microsoft is a registered trademark of Microsoft Corporation. Yahoo: Used with permission by Yahoo! Inc. YAHOO! and the YAHOO! logo are trademarks of Yahoo! Inc. Duke Energy: © & ® 2000 Duke Energy Corp. All Rights Reserved. www.mhhe.com About the Authors Stanley B. Block Professor Block teaches financial management and investments at Texas Christian University, where he received the Burlington Northern Outstanding Teaching Award and the M. J. Neeley School of Business Distinguished Teaching Award. His research interests include financial markets, mergers, and high- yield bonds. He has served as president of the Southwestern Finance Association and is a Chartered Financial Analyst and a Certified Cash Manager. He enjoys sports and has run the NY Marathon. Professor Block holds a BA from the University of Texas at Austin, an MBA from Cornell University, and a PhD from LSU. In 2001, his former students established the Dr. Stan Block $1.5 million Endowed Chair in Finance at Texas Christian University. He is the first chairholder of the named chair. In 2006, he was selected as the university’s outstanding professor. Geoffrey A. Hirt Dr. Hirt is currently Professor of Finance at DePaul University. He received his PhD in Finance from the Uni­ versity of Illinois at Champaign-Urbana, his MBA from Miami University of Ohio, and his BA from Ohio-Wesleyan University. Geoff directed the Chartered Financial Analysts Study program for the Investment Analysts Society of Chicago (now the CFA Institute of Chicago) from 1987 to 2001 and was on the Board of Directors of the CFA Institute of Chicago from 2002 through 2005. He was also Director of Equity Research at Mesirow Finan­ cial from 1998 to 2001. Dr. Hirt developed the real dollar invest­ ment fund at Illinois State University and taught real dollar investment classes at TCU and DePaul University. In 2006 he received the Spirit of DePaul Award from DePaul University. Bartley R. Danielsen Dr. Danielsen is an Associate Professor at North Carolina State University where he teaches graduate and undergraduate corporate finance courses. His research interests focus on financial market efficiency, short sale constraints, mar­ ket microstructure, and the interaction of derivatives markets with spot markets. His research appears in the Journal of Financial and Quantitative Analysis, the Review of Financial Studies, and numer­ ous other academic finance and real estate journals. Dr. Danielsen received his PhD in financial economics from the University of Florida and a Masters of Accounting from the University of Geor­ gia. As a Certified Public Accountant he has provided financial consulting services to numerous multinational companies. Preface Thirty-two years have passed since we began writing the first edition of this text, and many things have changed during that time. First of all, the field of finance has become much more analytical, with the emphasis on decision-oriented approaches to problems rather than the old, descriptive approach. We have increased the use of analytical approaches to financial problems in virtu­ ally every chapter of the book. But we also have stayed with our basic mission of making sure the student is able to follow us in our discussions throughout the text. While the 13th edition is considerably more sophisticated than the initial edition, it is still extremely “reader friendly.” As the analytical skills demanded of students have increased, so has the authors’ care in presenting the material. Using computers has become considerably more important over the last quarter century, and this is also reflected in the 13th edition. We offer Web Exercises at the end of every chapter, URL citations throughout the text, Standard & Poor’s computer exercises at the end of selected chapters, an Online Learning Center for students and faculty, and computerized testing software and Powerpoint® for the faculty. Throughout the past 32 years, this text has been a leader in bringing the real world into the classroom, and this has never been more apparent than in the 13th edition. Each section of the book highlights an influential figure in the business world, each chapter opens with a real-world vignette, and the Finance in Action boxes (found in virtually every chapter) describe real-world activities and decisions made by actual businesses. Not only are hundreds of corporations discussed, but actual corporate logos are shown for the most important corporations covered in the book. The authors are also up-to-date on the latest tax and financial reporting legislation. The international world of finance has become much more important over the last 32 years, and the text has expanded its international coverage tenfold since the first edition. Where there is an international application for a financial issue, you are very likely to find it in this text. More recently, the “new” economy, associated with high technology, has gained importance and in this latest edition there are more references to the eBays, Amazon .corns, and Oracles than ever before. However, there is one thing that has not changed over the last 32 years—the authors still write the entire book and all of the problems themselves! We believe our devotion of time, energy, and commitment over these years is the reason for our reputation for having produced a high-quality and successful text—edition after edition. And we are excited to announce the addition of Bartley R. Danielsen, North Carolina State Univer­ sity, to our author team. Bart cares deeply about good teaching and quality research, and his involvement is greatly valued as we are working harder than ever to produce the best book content and supplementary materials for instructors and students. Preface vii Employers of business graduates report that the most successful analysts, planners, Reinforcing and executives are both effective and confident in their financial skills. We concur. Prerequisite One of the best ways to increase your facility in finance is to integrate your knowl­ Knowledge edge from prerequisite courses. Therefore, the text is designed to build on your basic knowledge from courses in accounting and economics. By applying tools learned in these courses, you can develop a conceptual and analytical understanding of financial management. We realize, however, that for some students time has passed since you have completed your accounting courses. Therefore, we have included Chapter 2, a thorough review of accounting principles, finance terminology, and financial statements. With a working knowledge of Chapter 2, you will have a more complete understanding of the impact of business decisions on financial statements. Furthermore, as you are about to begin your career you will be much better prepared when called upon to apply financial concepts. The 13th edition specifically covers the following new topics: Content Changes in the Capital Markets Chapter 1 provides a discussion of the major stock Improvements exchanges that have gone public since the last edition and the continuing consoli­ dation of global securities markets. These topics also receive significant additional coverage in Chapter 14 (Capital Markets). Misuse of Accounting Data Chapter 2 provides a lively discussion of the backdat­ ing of stock options as an improper tool to enhance the compensation of top man­ agement. Other similar good and bad practices by top management are discussed throughout the text and are related to stockholder wealth maximization. Expanded Coverage of the Use of Technology to Manage Investments in Working Capital In Chapters 6, 7, and 8, examples are provided of how Hewlett-Packard, Wal-Mart, General Motors, and other firms use advanced technology (including the Internet) to manage working capital. The Collapse of the Subprime Lending Market In Chapter 8, the reasons and conse­ quences of the downfall in this market are discussed. The Power of the Time Value of Money In Chapter 9, an updated feature on the time value of money indicates what would happen at 4 percent inflation over 50 years. Tuition would go to over one million dollars. Other similar numbers are presented. The Use of Debt by Major U.S. Corporations In the discussion of the cost of capital in Chapter 11, new debt related information is provided for major U.S. corporations. , The Movement to Capitalism in the Soviet Union China, and Elsewhere In Chapter 14, this topic is discussed along with the impact of free trade agreements on inter­ national capital markets. Reorganization of Material Related to the U.S. Capital Markets Electronic Com­ munication Networks (ECNs) and advanced technology have changed the way the financial markets operate in the United States, and Chapter 14 is reorganized and updated to reflect this transition. Faculty and students will view this material in the most current context possible. viii Preface Regulatory Changes in Investment Banking The demise of Bear Steams has called for a new way of regulating investment banking, and Chapter 15 covers potential new changes. Foreign Exchange Considerations in the Capital Markets New relationships between the U.S. dollar and other foreign currencies have taken place since the last edition, and this topic is carefully covered in Chapter 21. Successful improvements from the previous editions that we have built on in the 13th edition include: Functional IntegrationWe have taken care to include examples that are not just applica­ ble to finance students, but also to marketing, management, and accounting majors. Small Business Since over two-thirds of jobs created in the U.S. economy are from small businesses, we have continued to note when specific financial techniques are performed differently by large and small businesses. Comprehensive International Coverage We have updated and expanded coverage on international companies and events throughout the text. Contemporary CoverageThe 13th edition has continued to provide updated real-world examples, using companies easily recognizable by students to illustrate financial concepts presented in the text. Internet Presence Helpful Web sites are listed throughout the text as well as featured in many of the Finance in Action boxes. Web exercises are featured in each chapter and Standard & Poor’s problems are included in relevant chapters to further show­ case real-world material. Chapter Features New! Integration of Learning Objectives to Discussion Questions and Problems The Learning Objectives (LO) presented at the beginning of each chapter serve as a quick introduction to the material students will learn and should understand fully before Discussion moving to the next chapter. Every discus­ Questions 1. If we divide users of ratios into short-term lenders, long-term lenders, and stockholders, which ratios would each group be most interested in. and Tor sion question and problem at the end of what reasons? CL02) 2. Explain how the Du Pont system of analysis breaks* down return on assets. Also each chapter now refers back to the learn­ explain how it breaks down return on stockholders’ equity. (L03) 3. If the accounts receivable turnover ratio is decreasing, what will be happening to the average collection period? (L02) ing objective to which it applies. This allows 4. What advantage does the fixed charge coverage ratio offer over simply using times interest earned? (LQ2) instructors to easily emphasize the Learning — > S. Is there any »aridity in nile-of-thumb ratios for all corporations, for example, a cunent ratio of 2 to 1 or debt to assets of 50 percent? (L02) Objective(s) as they choose. Preface ix Part Openers_______________________ In addition to listing the germane chapters, the Part Openers feature Related Part Web sites so ** you are able to easily reference the most cur­ rent and relevant information on the Web. Working Capital Management RELATED WEB SITES www.stlouisfed .org www.calloways.com www.mcgraw-hill.com Current Asset Management www.abercrombie.com www.abercrombiekids.cor www.covisint.com www.ebreviate.com Updated! News Makers news makers Each part opens with a News Maker feature, that highlights an influential person in finance I he long-term decisions capital expended. The following ment In Calcutta and additionally lor a firm concerning chapters will give you some Idea holds a master's degree In Pub­ ol how PepsiCo made many of its lic and Private Management from or business and their contributions to the field. -A. structure and the selec­ investment decisions. the Yale School of Management tion of capital budgeting projects, Indra Nooyi Is one of the most As you can see, there are a lot of Featured professionals include: Ray Anderson, such as new products and new respected woman executives In operating facilities, are the deci­ the world. Before becoming chair­ Dennis Johnson, Anthony Noto, Indra Nooyi, sions that will maximize or dimin­ man of the board she held other ish shareholder wealth. Someone positions at PepsiCo. She was Bob McCann, and Prince Al-Walid. who oversees this process and previously chief financial officer sets financial policy and strategy (CFO) and was promoted to chief Is Indra Nooyi, chairman of the executive officer in August 2006 board and chief executive officer and a year later to chairman of of PepsiCo. PepsiCo Is a well- the board. As CFO she was known International beverage and responsible for many of Pepsi­ food company with sales of S39.5 Co's corporate functions, includ­ billion In 2007 and is known for Its ing finance, strategy, business soft drinks, Frito Lay snack food process optimization, corporate division, Quaker Oats, Gatorade, platforms. Innovation, procure­ Aquafina, and Tropicana fruit ment, investor relations, and drinks. information technology. She has PepsiCo spent approximately been with PepsiCo since 1994 $2.5 billion dollars on capital when she moved from Motorola, expenditures In 2007, and in where she was a corporate strat­ 2008. Among them, the company egist. After coming to PepsiCo. Revised! Chapter Opening Vignettes In the physical sciences as well as in politics, the on debt. Such was not the case in the next decade term leverage has been popularized to mean when high leverage in the form of high-cost fixed the use of special force and effects to produce assets (airplanes) and high-cost debt was causing We bring in current events (such as business- more than normal results from a given course severe consequences in a weak economy. Among the of action. In business the same concept is applied, affected firms was Atlanta-based Della Airlines. to-business online ventures and competition with the emphasis on the employment of fixed Between 2000 and 2005, Delta saw its EPS go cost items in anticipation of magnifying returns at from $6.87 to a negative $12.80. That’s a pretty among air carriers) as chapter openers to illus­ high levels of operation. The student should rec­ scary ride for any company. Delta had to take ognize that leverage is a two-edged sword— Chapter 11 bankruptcy on September 14, 2005. trate the material to be learned in the upcom­ producing highly favorable results when things It came out of bankruptcy in 2007 and eventu­ go well, and quite the opposite under negative ally merged with Northwest Airlines, but once ing chapter. conditions. again faced negative numbers in 2008. Just ask the airline industry. Firms such as It is widely believed that massive consoli­ American Airlines. Continental, Delta, Southwest, dations (mergers) between the weak and the strong and UAL were all flying high at the tum of the cen­ within the airline industry are necessary as the warn­ tury because of favorable economic conditions, high ing light on the economy comes on because of the capacity utilization, and relatively low interest rates high leverage in the industry. X Preface Expanded! Finance in Action Boxes_____ You Can’t Change Your Grade and Accountants Can’t Illegally Backdate Options Slock options have an important function In decade, and It's gotten them in a lot of trou­ These boxed readings highlight specific topics corporate finance—to incentivize top execu­ ble with the SEC and their own stockholders. otipvetiso nt ois gmraanxtimediz aet as tsopcekc ivfiaeldu ep.r icNeo ormvearl lay 1a0n- aB a-gcikftd."ated options are not an incentive; they're AfiCnaTnIcOe Nin of interest that relate to four main areas: man­ yise atrra pdeinrigo da.t F $o4r 0e xpaemrp sleh,a irfe a ocno mDpeacneym’sb setro c1k, theyIf caorerp noorat tiilolengsa al.c Ttuhaelyly arreep oarnt tehxepme nasse g aifntsd, agerial decisions, global situations, technol­ 2008, the CEO may be granted options to buy a form of extra compensation. In this case. It 100,000 shares at $40 per share between that would be S1,500,000 (100,000 options with a ogy issues, and ethics. The inclusion of ethics date and December 1.2118. Clearly, there is a built-in gain of $15). But backdated options are srotrnomnge nint cIne nwtihviec hf otrh teh ec oCrpEoOra ttoio cnr eaantde iatsn setnovcik­ almTohset aSlwEaCy st ecnodnsc etoa lesdp oatn tdh eIllmeg walh.en a cor­ is relevant given the many recent corporate value win prosper. Stock options are granted poration repeatedly appears to pick the lowest as part of a total compensation package, but stock price year after year to grant options. scandals and the resulting governance issues. can be more important than the actual salary This evidence attracts the Feds. in mAalln tyh icsa sise sju.st fine. But what if the fix Is on couInnt inagn pirnotfeersessotirn Egr ikre Lsieea orcf hth ee xUanmivpelres, itya co­f Web site addresses are included in applicable in the granting of options. That could be done Iowa examined the options of Black Box Corp.. by backdating. Here's an example. In the case a network infrastructure services provider boxes for easy access to more information on above the slock was trading at S40 on the date (ticker symbol BOXX). he determined that a Wtheh aot pitti oonn wthaast dgartaen,t ethde (pDaercteiems binevr o1lv, e2d0 p0i8c)k. 9B9la.9ck6 pBeorxc'se not plitkioenlish ooond tdhaayts t hteh aat wtahred instgo cokf that topic or company. the lowest price the stock was trading at In was trading at or near a record low was not a 2008 and backdate the option to that date. coincidence.*___________________________ Updated! Company Logos_____________ The restructuring and management changes at General Motors. IBM, American Express, Sears, and Eastman Kodak during the last decade were a direct result of insti­ tutional investors affecting change by influencing the boards of directors to exercise In this feature, four-color company logos (such control over all facets of the companies' activities. Quite a few boards of directors were viewed as rubber stamps for management before this time. Large institutional as GM, IBM, and Sears) are included in the investors have changed this perception. Without their attempt to maximize the value of their investments, many of the above mentioned restructuring deals would nol have margin of the text where a situation involving taken place. And without the financial markets placing a value on publicly held com­ panies, the restructuring would have been much more difficult to achieve. SEARS the company is used as an example. This fea­ ture helps to call out our strength in providing many real-world examples. Because logos are so easy to recognize, you will have no trouble identifying them with the financial concepts in the example. Functional Use of Four Colors__________ Debt Utilization Ratios— Saxton Company Industry Average 11. Debt to total assets = The 13th edition continues to include the well- Total debt S600.000 _ g75% 33% received functional use of four colors to enhance Total assets $1,600,000 12. Times Interest earned = your understanding of tables, graphs, and exhib­ Income before interest and taxes $550,000 _ u 7 times Interest $50,000 its. For example, the financial analysis chapter 13. Fixed charge coverage = (Chapter 3) uses color to make the origin of the Income before fixed charges and taxes $600,000 _ 6 5.5 times Fixed charges 5100,000 ratios easier to follow. For easy identification, the balance sheet appears in blue and the income statement in red. These same two colors continue to be traced through the numerical ratios, with each number appearing in the same color as the financial statement from which it was derived. This linkage helps identify whether the ratio is a balance sheet ratio, an income statement ratio, or a mixed ratio. In-Book Acetates on Time Value of Money (Chapter 9)____________________ The concept of the “time value of money” is one of the most difficult topics in any finan­ cial management course for professors to communicate to students. We think we have created a visual method for teaching future value and present value of money that will help you understand the concept simply and quickly. The 13th edition includes four- color acetates in the text that visually relate future values and present values. We hope you agree that this innovation is an advancement in financial pedagogy. Review of Accounting LEARNING OBJECTIVES L01 The income statement measures L04 The statement of cash flows profitability. indicates the change in the cash position of the firm. L02 The price-earnings ratio indicates the relative valuation of earnings. L05 Depreciation provides a tax reduction benefit that increases L03 The balance sheet shows assets cash flow. and the financing of those assets with debt and equity. Brinker International is one of the leading data of IBM, General Motors, Microsoft, or any other restaurant chains in the United States, and major U.S. corporation. its holdings include Chili’s Grill and Bar, The language of finance flows logically from Romano’s Macaroni Grill, Maggiano’s Little accounting. To ensure that the student is adequately Italy, and On the Border Mexican Grill and Cantina. prepared to study significant financial concepts, (Those fajitas taste great!) we must lock in the preparatory material from the The emphasis at Brinker International is on qual­ accounting area. Much of the early frustration suf­ ity food at reasonable prices. No offense intended for fered by students who have difficulty with finance can Jack in the Box or Burger King, where the service be overcome if such concepts as retained earnings, and food are a little less predictable. shareholders’ equity, depreciation, and historical/ The firm has increased its earnings per share from replacement cost accounting are brought into focus. $.37 in 1997 to $1.75 in 2007. Also, its operating mar­ In this chapter, we examine the three basic types gin of 13.0 percent is only exceeded by Applebee’s of financial statements—the income statement, the International (15.5 percent) for firms in the full-service balance sheet, and the statement of cash flows—with food industry. Blinker’s ticker symbol on the New York particular attention paid to the interrelationships Stock Exchange is appropriately designated as EAT. among these three measurement devices. As special Without accounting data tracking these important preparation for the finance student, we briefly exam­ numbers, financial managers, investors, and bankers ine income tax considerations affecting financial would be flying blind. The same can be said for the decisions. 26 news makers In this section we address the The focus list targets those com­ understanding of how the markets topics of financial analysis. panies that are underperforming operate. Before joining CalPERS, Problems arise in a firm if and in CalPERS’s view could use Mr. Johnson worked as a manag­ the financial statements are some improvements in their cor­ ing director for Citigroup Global not accurate, are manipulated, or porate governance practices. His Market. He has over 25 years of do not meet generally accepted team of analysts also determines experience in the capital markets accounting principles (GAAP). which companies are added to or area. He The concept of corporate gover­ subtracted from the focus list. graduated nance covers the broad area of Mr. Johnson has presented from the how a corporate board of directors CalPERS governance issues Virginia operates the company in accor­ to companies such as United­ Military dance with shareholder goals. A Health Group, Coca-Cola, Scher­ Institute board with good corporate gover­ ing Plough Corp., Home Depot, with a BA nance practices has transparency and Dollar Tree, with the goal of in Econom­ of accounting statements, has convincing them that by adopting ics and good audit committee processes, CalPERS ideas, they will improve earned a Dennis Johnson— and is responsive to shareholder their performance as well as give Master of California Public proposals that might benefit the their shareholders more control Science in Employees Retirement company. As institutional inves­ over the issues that are brought Finance System tors have become larger players before the board of directors and at Virginia Courtesy of CalPERS Office of Public Affairs in the elections of directors for stockholders. In some cases Mr. Common­ corporate boards, they have also Johnson has been successful in w e a l t h become more active in holding convincing companies to alter University. He is a Chartered these boards to good practices of their practices and in others not Financial Analyst (CFA) and corporate governance. as successful. If there is no suc­ member of the CFA Institute. In The California Public Employ­ cessful resolution to the conflicts April 2008 he was elected chair ees Retirement System (Cal- between shareholders and a of the Council of Institutional PERS) is one such activist board of directors, then CalPERS Investors, a nonprofit association pension fund, and with over $250 does have the ability to challenge of public, union, and corporate billion in assets it is also the larg­ the election of directors. If he can pension funds. The combined est public pension fund in the get other institutional investors to assets of this group exceeds $3 United States. Dennis Johnson join CalPERS, he becomes very trillion, so you can imagine the is the director of corporate gover­ influential. respect his colleagues have for nance for CalPERS and his major Dennis Johnson often has the CalPERS and Dennis Johnson. role is to work with companies delicate task of convincing mem­ You can also imagine that corpo­ that are on the CalPERS focus bers of management to do what rate boards will be paying more list to help them improve their they don’t want to do. This takes attention to him when he comes corporate governance practices. a persuasive personality and an knocking on their doors.