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Financial ManagementPrinciples and Practice

Financial ManagementPrinciples and Practice

Sixth Edition

Timothy J. GallagherProfessor of FinanceColorado State University

FINANCIAL MANAGEMENT: PRINCIPLES AND PRACTICE, 6th Edition

Copyright 2013, 2010 by Timothy Gallagher. Published by Freeload Press

Copyright 2007 by Gallagher and Andrew. Published by Freeload Press

Previous editions © 2003, 2000, and 1997 by Pearson Education, Inc.

All rights reserved. Printed in the United States of America. No part of this book may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying and recording, or by any information storage or retrieval system without the prior written permission of the authors.

ISBN 1-930789-15-7

Library of Congress Cataloging-in-Publication Data

Gallagher, Timothy James, 1952–

Financial Management: Principles and Practice/Timothy J. Gallagher— 6th ed. p. cm.Includes bibliographical references and index. 1. Corporation—Finance. I. Andrew, Joseph D. II. TitleHG4026. G348 2006 658.15—dc21 2002074888

This book was previously published by: Pearson Education, Inc.

To my family— my parents, Bob and Lois my wife, Susan and Em, Justin, Ellie, and Zach

vii

Preface xixAbout the Author xxvii

PART I THE WORLD OF FINANCE 1 1 Finance and the Firm 2

2 Financial Markets and Interest Rates 24

3 Financial Institutions 44

PART II ESSENTIAL CONCEPTS IN FINANCE 65

4 Review of Accounting 66

5 Analysis of Financial Statements 92

6 Forecasting for Financial Planning 134

7 Risk and Return 160

8 The Time Value of Money 194

PART III CAPITAL BUDGETING AND BUSINESS VALUATION 237

9 The Cost of Capital 238

10 Capital Budgeting Decision Methods 270

11 Estimating Incremental Cash Flows 314

12 Business Valuation 338

PART IV LONG-TERM FINANCING DECISIONS 381

13 Capital Structure Basics 382

14 Corporate Bonds, Preferred Stock, and Leasing 414

15 Common Stock 440

16 Dividend Policy 464

PART V SHORT-TERM FINANCING DECISIONS 485

17 Working Capital Policy 486

18 Managing Cash 508

19 Accounts Receivable and Inventory 534

20 Short-Term Financing 568

PART VI FINANCE IN THE GLOBAL ECONOMY 593

21 International Finance 594

Appendix A-1

Glossary G-1

Index I-1

ix

Preface xixAbout the Author xxvii

PART I THE WORLD OF FINANCE 1 1 Finance and the Firm 2

Learning Objectives 3Chapter Overview 5The Field of Finance 5

Finance Career Paths 6Financial Management 6

The Role of the Financial Manager 6Finance in the Organization of the Firm 6The Organization of the Finance Team 7

The Basic Financial Goal of the Firm 7In Search of Value 8

The Importance of Cash Flow 9The Effect of Timing on Cash Flows 10The Influence of Risk 10Profits versus Company Value 11

Legal and Ethical Challenges in Financial Management 11

Agency Issues 11The Agency Problem 12Agency Costs 13

The Interests of Other Groups 13The Interests of Society as a Whole 14

Forms of Business Organization 14The Proprietorship 14The Partnership 15

Special Kinds of Partnerships 16The Corporation 16

Special Kinds of Corporations 17Limited Liability Companies (LLCs) 18

What’s Next 18Summary 18 • Self‑Test 20 • Review

Questions 20 • Build Your Communication Skills 21 • Problems 21 • Answers to Self‑Test 22

2 Financial Markets and Interest Rates 24Learning Objectives 25Chapter Overview 25The Financial System 25

Securities 26Financial Intermediaries 26

Investmen Bankers 26Brokers 27Dealers 27

Financial Markets 27The Primary Market 27The Secondary Market 27The Money Market 28The Capital Market 28Security Exchanges 28The Over-the-Counter (OTC) Market 28Market Efficiency 29

Securities in the Financial Marketplace 29Securities in the Money Market 29

Treasury Bills 29Negotiable Certificates of Deposit 30Commercial Paper 30Banker’s Acceptances 30

Securities in the Capital Market 30Bonds 30Bond Terminology and Types 31Treasury Notes and Bonds 31Municipal Bonds 32Corporate Bonds 32Corporate Stock 32Common Stock 32Preferred Stock 33

x Contents

Interest 33Determinants of Interest Rates 33

The Real Rate of Interest 33The Inflation Premium 34The Default Risk Premium 35The Illiquidity Risk Premium 35The Maturity Risk Premium 35

The Yield Curve 36Making Use of the Yield Curve 36



3 Financial Institutions 44Learning Objectives 45Chapter Overview 45Financial Intermediation 45

Denomination Matching 46Maturity Matching 46Absorbing Credit Risk 47Commercial Banks 47Bank Regulation 47Commercial Bank Operations 48

Commercial Bank Reserves 48The Federal Reserve System 49

Organization of the Fed 49Controlling the Money Supply 50The Discount Window 52

Government Sponsored Enterprises and the Mortgage Market (GSEs) 52

Savings and Loan Associations 53Regulation of S&Ls 53Mutual Companies versus Stockholder-Owned

Companies 53The Problem of Matching Loan and Deposit

Maturities 54S&Ls’ Real Assets 55

Credit Unions 55The Common Bond Requirement 55Members as Shareholders 55Credit Unions Compared with Banks 56Credit Union Regulation 56

Finance Companies, Insurance Companies, and Pension Funds 56

Types of Finance Companies 56Consumer Finance Companies 56Commercial Finance Companies 56Sales Finance Companies 56

Insurance Companies 56Life Insurance Companies 57Property and Casualty Insurance Companies 57

Pension Funds 58Annuities 58

Legislation After the Financial Crisis 59What’s Next 60Summary 60 • Self‑Test 61 • Review


PART II ESSENTIAL CONCEPTS IN FINANCE 65

4 Review of Accounting 66Learning Objectives 67Chapter Overview 67Review of Accounting Fundamentals 67Basic Accounting Financial Statements 68

The Income Statement 68Revenues 69Expenses 69Cost of Goods Sold 69Selling and Administrative Expenses 69Depreciation Expense 70Operating Income and Interest Expense 70Net Income 70Earnings per Share (EPS) 70Common Stock Dividends and Retained Earnings 71

The Balance Sheet 72The Asset Accounts 72Current Assets 72Fixed Assets 72The Liabilities and Equity Accounts 73Liabilities 73Common Stock and Retained Earning 74

The Statement of Cash Flows 74Operating Activities 74Adjustment for Depreciation Expense 74Changes in Balance Sheet Accounts 75Operating Activities 76Investment Activities 77Financing Activities 77Net Cash Flow during the Period 77

Depreciation 77Calculating the Amount of Depreciation Expense 78

Depreciation Methods 78

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Income Taxes 79Average Tax Rates 80



5 Analysis of Financial Statements 92Learning Objectives 93Chapter Overview 93Assessing Financial Health 94

Misleading Numbers 94Financial Ratios 94

The Basic Financial Ratios 95Calculating the Ratios 95Profitability Ratios 96

Gross Profit Margin 96Operating Profit Margin 97Net Profit Margin 98Return on Assets 98Return on Equity 98Mixing Numbers from Income Statements

and Balance Sheets 99Liquidity Ratios 100

The Current Ratio 100The Quick Ratio 100

Debt Ratios 101Debt to Total Assets 101Times Interest Earned 101

Asset Activity Ratios 102Average Collection Period 102Inventory Turnover 103Total Asset Turnover 103

Market Value Ratios 103Price to Earnings Ratio 104Market to Book Value 104

Economic Value Added and Market Value Added 105

Economic Value Added (EVA) 105Market Value Added (MVA) 107

Relationships among Ratios: The Du Pont System 107

Trend Analysis and Industry Comparisons 110Trend Analysis 110Industry Comparisons 110

Summary Analysis: Trend and Industry Comparisons Together 112

Locating Information about Financial Ratios 114

What’s Next 114Summary 115 • Equations Introduced in This

Chapter 116 • Self‑Test 117 • Review Questions 118 • Build Your Communication Skills 118 • Problems 119 • Answers to Self‑Test 132

6 Forecasting for Financial Planning 134Learning Objectives 135Chapter Overview 135Why Forecasting Is Important 136

Forecasting Approaches 136Experience 136Probability 136Correlation 137

Why Forecasts Are Sometimes Wrong 137Forecasting Sales 137Forecasting Financial Statements 138

Budgets 138Producing Pro Forma Financial Statements 139

Choosing the Forecasting Basis 139The Pro Forma Income Statement 140The Sales Projection 140Cost of Goods Sold (COGS) and Selling

and Marketing Expenses 140General and Administrative Expenses 141Depreciation Expense 142Interest Expense 142Income Taxes 142Dividends Paid and Additions to Retained

Earnings 142The Pro Forma Balance Sheet 142Cash and Marketable Securities 142Accounts Receivable and Inventory 143Property, Plant, and Equipment 143Accounts Payable 144Notes Payable 144Long‑Term Debt 144Common Stock and Capital in Excess of Par 144Retained Earnings 144Additional Funds Needed 145A Note on Interest Expense 146

Analyzing Forecasts for Financial Planning 146What’s Next 148Sutmmary 148 • Self‑Test 149 • Review


xii Contents

7 Risk and Return 160Learning Objectives 161Chapter Overview 161Risk 161Risk Aversion 162The Risk‑Return Relationship 162Measuring Risk 163

Using Standard Deviation to Measure Risk 163Calculating the Standard Deviation 164Interpreting the Standard Deviation 166

Using the Coefficient of Variation to Measure Risk 167The Types of Risks Firms Encounter 168

Business Risk 169Measuring Business Risk 169The Influence of Sales Volatility 169The Influence of Fixed Operating Costs 169

Financial Risk 170Measuring Financial Risk 171

Portfolio Risk 171Correlation 173Calculating the Correlation Coefficient 174Calculating the Standard Deviation of a Two‑Asset

Portfolio 175Nondiversifiable Risk 176Measuring Nondiversifiable Risk 177

Dealing with Risk 178Risk-Reduction Methods 178

Reducing Sales Volatility and Fixed Costs 178Reducing Sales Volatility 178Insurance 178Diversification 179

Compensating for the Presence of Risk 179Adjusting the Required Rate of Return 179

Relating Return and Risk: The Capital Asset Pricing Model 179



8 The Time Value of Money 194Learning Objectives 195Chapter Overview 195Why Money Has Time Value 196Measuring the Time Value of Money 196The Future Value of a Single Amount 196

The Sensitivity of Future Values to Changes in Interest Rates or the Number of Compounding Periods 199

The Present Value of a Single Amount 201The Sensitivity of Present Values to Changes in the

Interest Rate or the Number of Compounding Periods 203

Working with Annuities 203Future Value of an Ordinary Annuity 205The Present Value of an Ordinary Annuity 208Future and Present Values of Annuities Due 209Perpetuities 211Present Value of an Investment with UnevenCash Flows 212

Special Time Value of Money Problems 213Finding the Interest Rate 213

Finding k of a Single‑Amount Investment 213Finding k for an Annuity Investment 215

Finding the Number of Periods 216Solving for the Payment 217Loan Amortization 219

Compounding More Than Once per Year 219Annuity Compounding Periods 221Continuous Compounding 222



PART III CAPITAL BUDGETING AND BUSINESS VALUATION 237

9 The Cost of Capital 238Learning Objectives 239Chapter Overview 239The Cost of Capital 239Sources of Capital 240

The Cost of Debt 240The After‑Tax Cost of Debt (AT kd) 240

The Cost of Preferred and Common Stock Funds 242

The Cost of Preferred Stock (kp) 242The Cost of Internal Common Equity (kS) 243Using the Dividend Growth Model to

Estimate kS 244The CAPM Approach to Estimating kS 245Deciding How to Estimate kS 246The Cost of Equity from New Common

Stock (kn) 246The Weighted Average Cost of Capital (WACC) 247

xiiiContents

The Marginal Cost of Capital (MCC) 249The Firm’s MCC Schedule 250

Finding the Break Points in the MCC Schedule 250Debt Break Points 250The Equity Break Point 252Calculating the Amount the MCC Changes 253The MCC Up to the First Break Point 253

The MCC Schedule and Capital Budgeting Decisions 254

The Optimal Capital Budget 256The Importance of MCC to Capital Budgeting

Decisions 256Crowdfunding 258What’s Next 258Summary 259 • Equations Introduced in This


10 Capital Budgeting Decision Methods 270Learning Objectives 271Chapter Overview 271The Capital Budgeting Process 271

Decision Practices 272Types of Projects 272Capital Budgeting Cash Flows 272Stages in the Capital Budgeting Process 273

Capital Budgeting Decision Methods 273The Payback Method 273

How to Calculate the Payback Period 273Payback Method Decision Rule 274Problems with the Payback Method 274

The Net Present Value (NPV) Method 274Calculating NPV 275NPV Decision Rules 277The NPV Profile 278Problems with the NPV Method 279

The Internal Rate of Return (IRR) Method 280Calculating Internal Rate of Return:

Trial‑and‑Error Method 280Calculating Internal Rate of Return:

Financial Calculator 282IRR and the NPV Profile 282IRR Decision Rule 282Benefits of the IRR Method 283Problems with the IRR Method 283

Conflicting Rankings between the NPV and IRR Methods 283

The Modified Internal Rate of Return (MIRR) Method 284

Capital Rationing 286 Risk and Capital Budgeting 287

Measuring Risk in Capital Budgeting 287Computing Changes in the Coefficient of Variation 287

Adjusting for Risk 289Risk‑Adjusted Discount Rates (RADRs) 289



Appendix 10A: Wrinkles in Capital Budgeting 307Nonsimple Projects 307Multiple IRRs 308Mutually Exclusive Projects with Unequal Project

Lives 309Comparing Projects with Unequal Lives 311

The Replacement Chain Approach 311The Equivalent Annual Annuity (EAA) 311

Equations Introduced in This Appendix 312

11 Estimating Incremental Cash Flows 314Learning Objectives 315Chapter Overview 315Incremental Cash Flows 315Types of Incremental Cash Flows 316

Initial Investment Cash Flows 316Purchase Price, Installation, and Delivery 316Changes in Net Working Capital 316

Operating Cash Flows 317Taxes 317Depreciation and Taxes 317Opportunity Costs 317Externalities 317

Shutdown Cash Flows 319Financing Cash Flows 320Incremental Cash Flows of an Expansion

Project 321Initial Investment Cash Flows 321Operating Cash Flows 322Shutdown Cash Flows 322Cash Flow Summary and Valuation 323

Asset Replacement Decisions 325Real Options 326What’s Next 328Summary 330 • Self‑Test 330 • Review


xiv Contents

12 Business Valuation 338Learning Objectives 339Chapter Overview 340The Importance of Business Valuation 340A General Valuation Model 340

Applying the General Valuation Model to Businesses 341

Valuing Current Liabilities and Long-Term Debt 342Long‑Term Debt 342

Bond Valuation 342Semiannual Coupon Interest Payments 345The Yield to Maturity of a Bond 345

Calculating a Bond’s Yield to Maturity 346The Relationship between Bond YTM and Price 348

Preferred Stock Valuation 349Finding the Present Value of Preferred Stock

Dividends 349The Yield on Preferred Stock 350

Common Stock Valuation 351Valuing Individual Shares of Common Stock 351

The Constant Growth Dividend Model 352The Nonconstant, or Supernormal, Growth Model 353The P/E Model 354

Valuing Total Common Stockholders’ Equity 355Book Value 355Liquidation Value 356

The Free Cash Flow DCF Model 356Free Cash Flows 356A Real World Example 357

The Yield on Common Stock 362Valuing Complete Businesses 363

The Free Cash Flow DCF Model Applied to a Complete Business 363

The Replacement Value of Assets Method 363Whats Next 364Summary 364 • Equations Introduced in This


PART IV LONG-TERM FINANCING DECISIONS 381

13 Capital Structure Basics 382Learning Objectives 383Chapter Overview 383Capital Structure 383

Operating Leverage 384Calculating the Degree of Operating Leverage 384The Effect of Fixed Costs on DOL 385

The Alternate Method of Calculating DOL 386The Risk of Operating Leverage 387

Financial Leverage 387Calculating the Degree of Financial Leverage

(DFL) 387Another Method of Calculating Financial

Leverage 388How Interest Expense Affects Financial Leverage 389The Risk of Financial Leverage 389

Combined Leverage 389Fixed Costs and Combined Leverage 390

Breakeven Analysis and Leverage 391Constructing a Sales Breakeven Chart 392

Revenue Data 393Cost Data 393Plotting Data on the Breakeven Chart 394

Applying Breakeven Analysis 395LBOs 398Capital Structure Theory 398

Tax Deductibility of Interest 399Modigliani and Miller 399Toward an Optimal Capital Structure 400

The Lower Cost of Debt 400How Capital Costs Change as Debt Is Added 400The Effect of Risk 400Establishing the Optimal Capital Structure in

Practice 401What’s Next 402Summary 402 • Equations Introduced in This


14 Corporate Bonds, Preferred Stock, and Leasing 414Learning Objectives 415Chapter Overview 415Bond Basics 415Features of Bond Indentures 416

Security 417Plans for Paying Off Bond Issues 417

Staggered Maturities 417Sinking Funds 417Call Provisions 417

A Sample Bond Refunding Problem 418Restrictive Covenants 421

Limitations on Future Borrowings 421Restrictions on Dividends 421Minimum Levels of Working Capital 421

The Independent Trustee of the Bond Issue 422

xvContents

Types of Bonds 422Secured Bonds 422

Mortgage Bonds 422Unsecured Bonds (Debentures) 422Convertible Bonds 423

Features of Convertible Bonds 424The Conversion Ratio 424The Conversion Value 424The Straight Bond Value 424

Variable-Rate Bonds 425Putable Bonds 425Junk Bonds 426International Bonds 426Super Long-Term Bonds 426

Preferred Stock 427Preferred Stock Dividends 427Preferred Stock Investors 427Convertible Preferred Stock 428

Leasing 428Genuine Leases versus Fakes 428Operating and Financial (Capital) Leases 429

Accounting Treatment of Leases 429Lease or Buy? 430

A Lease or Buy Decision Example 430What’s Next 433Summary 433 • Equations Introduced in This


15 Common Stock 440Learning Objectives 441Chapter Overview 441The Characteristics of Common Stock 441

Stock Issued by Private Corporations 443Stock Issued by Publicly Traded Corporations 443Institutional Ownership of Common Stock 443

Voting Rights of Common Stockholders 444Proxies 444Board of Directors Elections 444

The Pros and Cons of Equity Financing 447Disadvantages of Equity Financing 447Advantages of Equity Financing 447

Issuing Common Stock 448The Function of Investment Bankers 449

Underwriting versus Best Efforts 449Pricing New Issues of Stock 449

Valuing the Stock of a Company That Is Not Publicly Traded 450

Rights and Warrants 451Preemptive Rights 451

The Number of Rights Required to Buy a New Share 451

The Value of a Right 452Warrants 454

Warrant Valuation 454What’s Next 456Summary 456 • Equations Introduced in This


16 Dividend Policy 464Learning Objectives 465Chapter Overview 465Dividends 465Why a Dividend Policy Is Necessary 466Factors Affecting Dividend Policy 466

Need for Funds 466Management Expectations and Dividend Policy 466Stockholders’ Preferences 466Restrictions on Dividend Payments 467

Cash versus Earnings 468Leading Dividend Theories 469

The Residual Theory of Dividends 469The Clientele Dividend Theory 470The Signaling Dividend Theory 470The Bird-in-the-Hand Theory 470Modigliani and Miller’s Dividend Theory 471

The Mechanics of Paying Dividends 471Dividend Reinvestment Plans 472

Alternatives to Cash Dividends 472Stock Dividends and Stock Splits 473

Stock Dividends 473Adjustment of a Stockʼs Market Price after a

Stock Dividend 474Stock Splits 475Adjustment of a Stock’s Market Price

after a Stock Split 476The Rationale for Stock Splits 476

What’s Next 477Summary 477 • Equations Introduced inThis Chapter 478 • Self‑Test 478 • Review


xvi Contents

PART V SHORT-TERM FINANCING DECISIONS 485

17 Working Capital Policy 486Learning Objectives 487Chapter Overview 487Managing Working Capital 487Why Businesses Accumulate Working Capital 488

Fluctuating Current Assets 488Permanent and Temporary Current Assets 489

Liquidity versus Profitability 490Establishing the Optimal Level of Current Assets 491Managing Current Liabilities: Risk and Return 491Three Working Capital Financing Approaches 492

The Aggressive Approach 492The Conservative Approach 492The Moderate Approach 494

Working Capital Financing and Financial Ratios 494What’s Next 496Summary 496 • Self‑Test 498 • Review


18 Managing Cash 508Learning Objectives 509Chapter Overview 509Cash Management Concepts 509Determining the Optimal Cash Balance 510

The Desired Minimum Cash Balance 510Raising Cash Quickly When Needed 510Predicting Cash Needs 510Coping with Emergencies 511

The Desired Maximum Cash Balance 511Available Investment Opportunities 511Expected Return on Investments 511Transaction Cost of Making Investments 512

The Optimal Cash Balance 512The Miller–Orr Cash Management Model 512

Forecasting Cash Needs 514Developing a Cash Budget 515

Managing the Cash Flowing In and Out of the Firm 519Increasing Cash Inflows 519Decreasing Cash Outflows 519Speeding Up Cash Inflows 520Slowing Down Cash Outflows 523

What’s Next 523

Summary 524 • Equations Introduced in This Chapter 525 • Self‑Test 525 • Review Questions 526 • Build Your Communication Skills 526 • Problems 527 • Answers to Self‑Test 532

19 Accounts Receivable and Inventory 534Learning Objectives 535Chapter Overview 535Why Firms Accumulate Accounts Receivable and

Inventory 535How Accounts Receivable and Inventory Affect

Profitability and Liquidity 536Finding Optimal Levels of Accounts Receivable and

Inventory 537The Optimal Level of Accounts Receivable 538

Credit Policy 538Analyzing Accounts Receivable Levels 538

The Optimal Level of Inventory 543The Costs of Maintaining Inventory 544Analyzing Inventory Levels 544

Inventory Management Approaches 549The ABC Inventory Classification System 549Just-in-Time Inventory Control (JIT) 550

Making Credit Decisions 551Collection Policies to Handle Bad Debts 551What’s Next 554Summary 554 • Equations Introduced in This


20 Short-Term Financing 568Learning Objectives 569Chapter Overview 569The Need for Short‑Term Financing 569Short‑Term Financing versus Long‑Term

Financing 570Short‑Term Financing Alternatives 570

Short-Term Loans from Banks and Other Institutions 571

Self‑Liquidating Loans 571The Line of Credit 571

Trade Credit 572Computing the Cost of Trade Credit 572

Commercial Paper 573Calculating the Cost of Commercial Paper 574

xviiContents

How Loan Terms Affect the Effective Interest Rate of a Loan 576

The Effective Interest Rate 576Discount Loans 576Compensating Balances 577Loan Maturities Shorter Than One Year 578

Annualizing Interest Rates 578A Comprehensive Example 580

Computing the Interest Cost in Dollars 580Computing the Net Amount Received 580Computing the Effective Annual Interest Rate 581

Computing the Amount to Borrow 581Collateral for Short‑Term Loans 582

Accounts Receivable as Collateral 582Inventory as Collateral 583



PART VI FINANCE IN THE GLOBAL ECONOMY 593

21 International Finance 594Learning Objectives 595Chapter Overview 595Multinational Corporations 595

Financial Advantages of Foreign Operations 595Ethical Issues Facing Multinational Corporations 596Comparative Advantage 596

Exchange Rates and Their Effects 597Fluctuating Exchange Rates 598Cross Rates 599Exchange Rate Effects on MNCS 600Exchange Rate Effects on Foreign Stock and Bond

Investments 601

Managing Risk 601Hedging 601Diversification Benefits of Foreign Investments 602American Depository Receipts 603

Exchange Rate Theories 603Purchasing Power Parity Theory 603International Fisher Effect 604Interest Rate Parity Theory 604Other Factors Affecting Exchange Rates 604Government Intervention in Foreign Exchange

Markets 605Political and Cultural Risks Facing MNCs 605

Political Risk 605Cultural Risk 606

International Trade Agreements 606NAFTA 606GATT 607European Union 607Free Trade versus Fair Trade 608

Summary 608 • Equations Introduced in This Chapter 610 • Self‑Test 610 • Review Questions 610 • Build Your Communication Skills 610 • Problems 611 • Answers to Self‑Test 613

Appendix A-1

Glossary G-1

Index I-1

xix

The ChallengeThis sixth edition of Financial Management: Principles and Practice continues to lead the way in presenting classroom tested and continuously updated and relevant material in the field of financial management. In the fifth edition we were the first book to incorporate the implications of the Financial Crisis for financial management. This sixth edition continues to examine these implications but with added perspective. Crowdfunding, the Facebook IPO, and the financial crisis in Europe are some of the new areas addressed in this sixth edition. There are two sets of optional materials available to those students and instructors who wish to incorporate Excel® spreadsheets into financial problem solving. One is called Spreadsheet TutorpakTM. The other is called Spreadsheet Templates.

6e Spreadsheet TutorpakTM, prepared by my friend and colleague Professor Hong Miao in close collaboration with me, is both a tutorial and a set of applications for solving financial management problems with Excel® spreadsheets. Students will learn the basics of Excel® spreadsheet creation and manipulation with power macros behind the scenes such that the student experience is straight forward. Another part of this package contains demonstration spreadsheets, that present key concepts in an easier to understand way, than what would be possible on a two dimensional page. Examples include distribution graphs showing diversification benefits, loan amortization tables, and break-even graphs. Input values can be changed by the student and the resulting changes on output variables can be seen in a dynamic visual way. Also, every time a new type of time value of money or capital budgeting concept is presented, there is a spreadsheet solution the student will create with prompting from the material in the Spreadsheet TutorpakTM package. This has been added to this sixth edition to complement the algebraic, table, and financial calculator keystroke solutions that were presented in the fifth and earlier editions.

A Spreadsheet TutorpakTM element is available to the student everywhere this icon is seen.

xx Preface

Spreadsheet templates are available for selected end-of-chapter problems. This will reduce the data entry burden for students as they apply their Excel® skills to solve these problems. A full solution set of Excel® spreadsheets is available to the faculty member using this book. These materials are available in the instructor supplements pack. End-of-chapter problems for which these spreadsheet templates are available are marked with this Spreadsheet Template icon.

Finance scares some students. There is the fear of numbers that some students have and the mistaken belief that the introductory finance course requires high-level mathematics. Also, some students mistakenly believe finance is an area in which they will not need competency. Finance concepts often seem far removed from daily life. In spite of this, almost every major in a college of business, and many majors in other colleges, require the “Principles of Finance” course. As a result, many of the students who find themselves sitting in finance class on the first day of the semester do not want to be there.

This does not need to be the case. Finance is important, dynamic, interesting, and fun. The challenge to Financial Management: Principles and Practice is to convince students of this. In order to learn, students must want to learn. If they can see the usefulness of what is presented to them, they will work hard and they will learn. Students also demand relevancy. This sixth edition tackles head on the changes we must face in the financial world and the new information that must be digested before making financial decisions in the new world we find ourselves in. There are also mistakes made by financial decision makers and government officials from which we must learn.

Many years of teaching experience has taught me that the introductory financial management course can be one that students enjoy and that they see as having added considerable value to their educational experiences. Finance is, after all, central to any business entity. More CEOs have come up through the finance ranks than any other discipline. Students need to know that the principles and practices of financial management apply to any business unit—from the very large multinational corporation to the very smallest proprietorship, including the family. Financial ratios tell a story; they are not numbers to be calculated as an end unto itself. Risk is important and can be managed. Time value of money has meaning and is understood as the central tool of valuation. Funds have a cost and different sources of funds have different costs. Financial performance and condition can be assessed. Amortized loan payments, rates of return on investment, future value of investment programs, and present value of payments to be received from bonds and stocks can be calculated. The opportunities and special challenges of international operations can be understood.

This ApproachStudents should walk out of the room after taking the final exam for a finance course believing that they have learned something useful. They should see a direct benefit to themselves personally, rather than just the belief that some set of necessary job skills has been mastered, although the latter will be true if the material is mastered.

Financial Management: Principles and Practice, starts with the student in mind and then packages the finance material so that the students (1) want to learn and (2) learn the necessary material. Finance is not medicine, and it cannot be administered as such. Instead, we believe students must be engaged in such a way that they develop the desire to learn. There are those who approach the task of teaching finance with the philosophy, “Here is the finance knowledge you need. Learn it!” This is not the approach taken by this book.

For more, see6e Spreadsheet Templates

for Microsoft Excel

xxiPreface

Distinctive FocusAlthough there are many other introductory financial management books on the market, none contains the unique style and content of Financial Management: Principles and Practice, sixth edition. Many texts focus mostly on accounting with little presentation of the economic theory that underlies the financial techniques presented. Others assume that the students remember all that was learned in the accounting course that is usually a prerequisite for this course. Still others claim to take a “valuation approach” but present their topics in a straight accounting framework. In this book we are serious about focusing on what creates value. We are consistent in this approach throughout the book, addressing issues such as what creates value, what destroys it, how value is measured, and how value and risk are related. In so doing we maximize the value of the finance course to the student.

Organization of the TextThe book is organized into six major parts as follows:

Part I. The World of Finance contains chapters on the structure and goals of firm, the role of financial managers, and an examination of the financial environment. Special attention is given to how the Financial Crisis affected nonfinancial companies, financial markets, and financial institutions.

Part II. Essential Concepts in Finance presents chapters on accounting statements and their interpretation, forecasting, risk and return, the time value of money, and security valuation. Special attention is given to systematic risk and its role in the Financial Crisis.

Part III. Capital Budgeting and Business Valuation contains chapters on measuring a firm’s cost of capital, capital budgeting decision methods, incremental cash flow estimation, and business valuation.

Part IV. Long-Term Financing Decisions contains chapters on capital structure basics, corporate bonds, preferred stock, leasing, common stock, and dividend policy. The turmoil in the stock and bond markets during the Financial Crisis is examined.

Part V. Short-Term Financial Management Decisions includes chapters on working capital policy, cash and marketable securities, accounts receivable and inventory, and short-term financing.

Part VI. Finance in a Global Economy is where international finance topics are covered, in addition to those international topics that are woven throughout the book. The contagion of the Financial Crisis around the world is examined.

xxii Preface

Special Features in the Text6e Spreadsheet TutorpakTM

Extensive new Excel® related material is available with the sixth edition. These materials are available at www.textbookmedia.com from the menu of resources available with this book. First, this package serves as a tutorial. Students are taught how to create and manipulate Excel® spreadsheets. Second, the package demonstrates important financial concepts presented in the book. For example, students can manipulate input variable values for break-even analysis and see the resulting change in output variable values including dynamic graphs. Third, the 6e Spreadsheet TutorpakTM material steps the student through the process for solving various time value of money, capital budgeting, and other types of problems presented throughout the book. Every place a problem is presented that had a financial calculator keystroke solution provided in earlier editions, there is now an Excel® solution provided for the student. Throughout the book this icon is used to indicate where accompanying 6e Spreadsheet TutorpakTM material is available.

Real-World ExamplesEach chapter in Financial Management: Principles and Practice begins with a real-world example, such as the Facebook IPO, that illustrates the concept to be addressed in that chapter. This serves to give the student a reason to learn this material and to show its practical application. Learning objectives are clear.

Excel® Spreadsheet Tutorial and SolutionsA package is available at www.textbookmedia.com that teaches basic and intermediate Excel® skills. Important financial concepts are presented with Excel® including graphics to enhance learning in a dynamic environment. The student steps through the solving of time value of money, capital budgeting, and security valuation problems applying Excel® skills developed by the use of Spreadsheet TutorpakTM.

Financial Calculator SolutionsFinancial calculator solutions to general time value of money and specific security valuation problems are included. This material is presented in such a way that professors’ differing preferences as to the use of financial calculators can be accommodated.

SummariesThe summary for each chapter specifically describes how the learning objectives have been achieved and it also provides a bridge to the next chapter.

Key TermsEach chapter has bolded key terms that are defined in the chapter and in the glossary. There are self-test questions and problems at the end of chapters, along with their solutions, so that students can check their grasp of the material presented.

xxiiiPreface

Practice Questions and ProblemsStudy questions and an abundant number of end-of-chapter problems are included in the appropriate chapters. Many problems from the fifth edition have been redone in the sixth.

Computer Spreadsheet Supported ProblemsA number of end-of-chapter problems are marked with the special computer problem logo shown here. This indicates that a downloadable Excel® spreadsheet template is available at www.textbookmedia.com. This template contains data for the designated end-of-chapter problem that can then be solved in Excel® by the student.

Communication SkillsSuggested assignments to build students’ written and oral communication skills are included in each chapter.

ColorColor is used for pedagogic effect, not just for looks.

Changes in the Sixth Edition

• The few errors in the fifth edition have been corrected.

• A new comprehensive Excel® package is available for use with the sixth edition. My friend and colleague Hong Miao created this new material. It includes a tutorial section to teach Excel® skills. Completed spreadsheets are included to demonstrate elements presented in the book such that the student may change input variable values and see the resulting change in output values, including changing graphics. Each time value of money and capital budgeting problem presented in the chapter body now has an Excel® solution available along with the algebraic, table, and financial calculators solutions made available in earlier editions.

• The fifth edition was the first book in this market to incorporate the Financial Crisis. The sixth edition is the first to come out updating these stories and describing the aftermath. This sixth edition covers the Dodd Frank Act including the Volcker Rule, the Facebook IPO, the JPMorgan Chase trading loss incident, the Federal Reserve’s Operation Twist (of the yield curve) along with QE1, QE2, and the quantitative easing initiatives.

• The financial and economic problems of the Eurozone countries, especially Greece, are described. The financial reasons for these problems are covered.

• References and examples were updated throughout.

• Many end-of-chapter problems, particularly those in Chapters 8 and 10 are new.

• In Chapter 9, The Cost of Capital, a new section on crowdfunding has been added.


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xxiv Preface

Features Retained from the Fifth Edition

• The book is still written in the student-friendly style that was extremely popular in the first and second editions. The concise, easy-to-understand presentation loved by student users is maintained.

• The book provides the level of rigor professors demand. When professors get past the friendly style, they find all the rigor and all the mainstream topics they expect in a book of this type. For example, if you are not already a Financial Management: Principles and Practice user, does your book:

• Address extensively the ramifications of the Financial Crisis on the world of finance, the business world in general, and individuals?

• Cover real options?

• Cover EVA, MVA, and EBITDA?

• Use a value-added (NPV) approach to the inventory and accounts receivable investment coverage rather than the outmoded return on investment ratio approach?

Attempts to expand the book, and to make it longer, have been resisted. The topics that professors actually teach are here. Those that are most likely to be taught in the second course in financial management are left out. Students don’t have to buy more than what they need.

The Learning PackageFinancial Management: Principles and Practice is one component of a complete learning package carefully put together by the Textbook Media team. This package includes a computerized test bank, a study guide/workbook, an instructor’s manual, PowerPoint slides, and downloadable Excel® spreadsheets.

For the Student• Downloadable Material—Companion downloadable material is available at www.

textbookmedia.com. There are two different Excel® spreadsheet products available. The first is called “6e Spreadsheet Tutorpac TM”. This package teaches the student to create and manipulate Excel® spreadsheets. It demonstrates, with macros and charts, important concepts presented in the book. It also steps the student through solutions, using Excel® functions, of a wide variety of problem-solving skills. The second Excel® spreadsheet product provides Excel® spreadsheet files containing templates that facilitate solving computer icon designated end-of-chapter problems. Such templates are provided for those selected end-of-chapter problems designated with this icon.

• Lecture Notes—Lecture Notes—PowerPoint files may be downloaded from www.textbookmedia.com and used as lecture notes so that students can focus on what their professor is saying without having to simultaneously take copious notes.


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For the Professor• Instructor’s Manual—This provides the professor with chapter outlines and

suggestions for alternative ways to present the material. Key points are identified and a variety of types of assistance for class preparation are presented.

• Solutions Manual—Detailed solutions, not just final answers, are presented for each end-of-chapter question and problem. These have all been personally checked by the author for accuracy.

• Complete Excel® Solutions to Designated End-of-Chapter Problems—Selected end-of-chapter problems are marked throughout the book with a “6e Spreadsheet Template” icon. Adopting professors are provided with the full Excel® solutions for these problems.

• Spreadsheet Solutions—Selected end-of-chapter problems, indicated in the textbook with a 6e Spreadsheet Template icon, are solved completely in Excel® for the instructor’s use. Students are provided with templates that they can use when applying their Excel® skills in solving these problems.

• Test Item File—Multiple-choice, short-answer, and essay questions reflect all the material in the chapter. The program allows for complete customization of an exam according to chapters covered, type of problem, and level of difficulty.

• PowerPoint Slides—Animated slides covering all main topic areas in the text are available to assist the professor during class.

• Author Access—The author is accessible to respond to individual questions that may come up. Tim Gallagher may be reached at [email protected].

In ConclusionStudents will understand the very important finance concepts, and master necessary problem-solving skills, when they complete the course in which this text is used. “Students first” is our philosophy at Textbook Media and this belief shows up throughout the text. Professors who have more enthusiastic students and who grasp the important content, both conceptual and problem solving, will find their classroom experiences more rewarding too. If we have helped to make this happen, we have succeeded in achieving our vision for Financial Management: Principles and Practice, sixth edition.

Acknowledgements The authors gratefully acknowledge the contributions of the many people who contributed to this endeavor. Without their expertise and talent, this book and the supplemental materials would not have been possible.

We send our thanks to a number of colleagues and key reviewers who contributed to this and previous editions. They are Dianne Morrison (University of Wisconsin–LaCrosse), Zhenhu Jin (Illinois Wesleyan University), Denise Letterman (Robert Morris College), Gary Greene (Manatee Community College), John Armstrong (Dominican

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College), Atul K. Saxena (Mercer University), William Hudson (St. Cloud State University), Charles W. Strang (Western New Mexico University), James D. Keys (Florida International University), Vickie Bajtelsmit (Colorado State University), John Elder (Colorado State University), Sue Hine (Colorado State University), Hong Miao (Colorado State University), Rob Schwebach (Colorado State University), Sriram Villupuram (Colorado State University), Chris Stein (Colorado State Univeristy), Joe Brocato (Tarleton State University), Susan Myrick (Allegheny County Community College), Clark Maxam (Montana State University), Gary Walker (Myers University), Ron Filante (Pace University), Andrew Adkinson (University of Nebraska–Kearney), Mark Sunderman (University of Wyoming), Wendy Pirie (Wesleyan University), Frenando Arellano (University of Dallas), and S. R. Das Gupta.

We are also indebted to many people at Prentice Hall who helped with the first three editions. These include: Mickey Cox, PJ Boardman, and Maureen Riopelle. We’d especially like to thank Paul Donnelly and Jill Lectka, who were there from the beginning. These people have made their marks on this book in lasting ways.

For this sixth edition we are particularly indebted to our editor, Ed Laube, of Textbook Media. Ed and his partners Tom Doran and Peggy Morgan had the courage to start a company that redefines textbook publishing. We are excited to be a part of it. This is the future of college textbook publishing. The old model doesn’t work anymore and these people and the others who have created Textbook Media are doing something about it. We’d also like to thank Victoria Putman and Daphne Loecke for their excellent work on the production side of this project. Joe Andrew, my former co-author, has left an indelible mark on this book. My colleague Hong Miao did an outstanding job with the new Excel® material available with this sixth edition from the Publisher.

Last, but not least, I am most especially grateful for the assistance and support of family members: Susan Shattuck, Emily, Justin, Ellie and Zach Peddicord.

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Timothy J. Gallagher (Tim) holds the rank of professor in the Department of Finance and Real Estate at Colorado State University. He currently serves as Chair of Faculty Council and recently served as Vice Chair and Faculty Representative to the Board of Governors of Colorado State University. Tim served as Chair of the Department of Finance & Real Estate for ten years. He believes strongly in shared governance at universities and he is an active member of the American Association of University Professors (AAUP). Tim received his Ph.D. in finance from the University of Illinois at Urbana–Champaign.

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