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0132994879/.DS_Store
__MACOSX/0132994879/._.DS_Store
0132994879/Appendix.pdf
A-1
Using a Calculator
As you prepare for a career in business, the ability to use a
financial calculator is essential,
whether you are in the finance division or the marketing
department. For most positions,
it will be assumed that you can use a calculator in making
computations that at one time
were simply not possible without extensive time and effort. The
following examples let us
see what is possible, but they represent only the beginning of
using the calculator in finance.
With just a little time and effort, you will be surprised at how
much you can do with
the calculator, such as calculating a stock’s beta, or determining
the value of a bond on a
specific day given the exact date of maturity, or finding net
present values and internal rates
of return, or calculating the standard deviation. The list is
almost endless.
In demonstrating how calculators may make our work easier, we
must first decide which
calculator to use. The options are numerous and largely depend

on personal preference.
We have chosen the Texas Instruments BA II Plus and the
Hewlett-Packard 10BII.
We will limit our discussion to the following issues:
I. Introductory Comments
II. An Important Starting Point
III. Calculating Values for:
A. Future value of $1
B. Present value of $1
C. Future value of an annuity of $1 for n periods
D. Present value of an annuity of $1 for n periods
IV. Calculating Present Values
V. Calculating Future Values (compound sum)
VI. Calculating the Number of Payments or Receipts
VII. Calculating the Payment Amount
VIII. Calculating the Interest Rate
IX. Bond Valuation
A. Computing the value of a bond
B. Calculating the yield to maturity of a bond
X. Computing the Net Present Value and Internal Rate of
Return
A. Where future cash flows are equal amounts in each period
(annuity)
B. Where future cash flows are unequal amounts in each period
I. Introductory Comments
In the examples that follow, you are told (1) which keystrokes
to use, (2) the resulting ap-
pearance of the calculator display, and (3) a supporting
explanation.

The keystrokes column tells you which keys to press. The
keystrokes shown in a white
box tell you to use one of the calculator’s dedicated or “hard”
keys. For example, if + /- is
shown in the keystrokes instruction column, press that key on
the keyboard of the calcula-
tor. With the Texas Instruments BA II Plus, to use a function
printed in a shaded box above
a dedicated key, always press the shaded key 2nd first, then the
function key. The HP 10BII
has two shift keys, one purple (PRP) and one orange (ORG). To
use the functions printed
in purple (stats) on the keypad, press the purple button first. To
use the functions printed
in orange (shift) on the keypad, press the orange button first.
Appendix A
A-2 Appendix A
I I . A n I m p o r t A n t S t A r t I n g p o I n t - t e x A S I
n S t r u m e n t S B A I I p l u S
Example: You want to display four numbers to the right of the
decimal.
Keystrokes Display Explanation
2nd
FORMAT DEC =
4 ENTER DEC = 4.0000 Sets display to show four numbers to

the right of the decimal
CE/C CE/C 0.0000 Clears display
2nd
P/Y P/Y =
2 ENTER P/Y = 2.0000 Sets number of payments per year at 2
2nd
BGN END Sets timing of payment at the end of each period
2nd
P/Y P/Y =
2nd
2nd
CLR TVM 0.0000 Clears TVM variables

1 +/ - PV = - 1.0000 Stores initial $1 as a negative present
value.
PV Otherwise the answer will appear as negative.
5 N N = 5.0000 Stores number of periods
12 I/Y I/Y = 12.0000 Stores interest rate
CPT FV FV = 1.7623 Future value
Example: You want to display two payments per year to be paid
at the end of each period.
ORG, C ALL 0.00 Clears registers
ORG, Disp, 4 0.0000 Displays 4 decimal places
2, ORG, P/YR 2.0000 Sets payments per year
ORG, BEG/END 2.0000 Sets END mode unless BEGIN
enunciator on
I I . A n I m p o r t A n t S t A r t I n g p o I n t - H e w l e t
t - p A c k A r d 1 0 B I I
Example: You want to display four numbers to the right of the
decimal. Note that ORG refers to the orange key,
which is a “shifted” function used to access the functions
printed in orange. There is also a purple shift key that

gives you access to the statistical functions in purple.
Example: You want to display two payments per year to be paid
at the end of the period.
I I I . c A l c u l A t I n g t A B l e V A l u e S - t e x A S I
n S t r u m e n t S B A I I p l u S
A. The future value of $1
Example: What is the future value or compound sum of $1 5
years from now at a 12 percent annual interest rate?
Appendix A A-3
B. The present value of $1
Example: What is the present value of $1 received 8 years from
now at a 10 percent annual interest rate?
2nd
P/Y P/Y =
2nd

2nd
1 +/ - FV = - 1.0000 Stores future amount as negative value
FV
CPT PV PV = 0.4665 Present value
2nd
P/Y P/Y =
2nd
2nd
1 +/ - PMT = - 1.0000 Stores annual payment (annuity) as a
negative number.
PMT Otherwise the answer will appear as a negative.

CPT PV PV = 7.1607 Present value
2nd
P/Y P/Y =
2nd
2nd
1 +/ - PMT = - 1.0000 Stores annual payment (annuity) as a
negative number.
PMT Otherwise the answer will appear as a negative.
CPT FV FV = 8.5355 Future value
C. The future value of an annuity of $1 for n periods

Example: What is the future value or compound sum of an
annuity of $1 for 6 years at a 14 percent annual
interest rate?
D. The present value of an annuity of $1 for n periods
Example: What is the present value of an annuity of $1 for 12
years at a 9 percent annual interest rate?
A-4 Appendix A
1, ORG, P/YR 1.0000 Sets number of payments per year at 1
ORG, BEG/END 1.0000 Sets timing of payment at the end of
each period
(If BEGIN shows press ORG, BEG/END again)
1, + /- , PMT - 1.0000 Stores the annual payment (annuity) as a
negative number.
Otherwise the answer will appear as a negative.
6, N 6.0000 Stores the number of periods
14, I/YR 14.0000 Stores interest rate
FV 8.5355 Future value

I I I . c A l c u l A t I n g t A B l e V A l u e S - H e w l e t t
- p A c k A r d 1 0 B I I
A. The future value of $1
Example: What is the future value of $1 in 5 years at 12 percent
annual interest rate?
each period
(If BEGIN shows then press ORG, BEG/END again)
1, + /- , PV - 1.0000 Stores initial $1 as a negative present
value.
5, N 5.0000 Stores number of periods
FV 1.7623 Future value

each period
1, + /- , PMT - 1.0000 Stores the annual payment (annuity) as a
negative number.
9, I/Y 9.0000 Stores interest rate
PV 7.1607 Future value
B. The present value of $1
Example: What is the present value of $1 received 8 years at a
10 percent annual interest rate?
each period
1, + /-, FV - 1.0000 Stores future amount as negative value

PV 0.4665 Present value
C. The future value of an annuity of $1 for n periods
Example: What is the future value or compound sum of an
annuity of $1 for 6 years at a 14 percent annual
interest rate?
D. The present value of an annuity of $1 for n periods
Example: What is the present value of an annuity of $1 for 12
years at a 9 percent annual interest rate?
Appendix A A-5
I V . c A l c u l A t I n g p r e S e n t V A l u e S - t e x A S
I n S t r u m e n t S B A I I p l u S
Example: You are considering the purchase of a franchise of
quick oil-change locations, which you believe will
provide an annual cash flow of $50,000. At the end of 10 years,
you believe that you will be able to sell the fran-
chise for an estimated $900,000. Calculate the maximum
amount you should pay for the franchise (present value)
in order to realize at least an 18 percent annual yield.
each period

10, N 10.0000 Stores n, the holding period
18, I/Y 18.0000 Stores i, the required rate of return
50,000, PMT 50,000.0000 Stores PMT, the annual cash flow to
be received
900,000, FV 900,000.0000 Stores FV, the cash flow to be
received at the end of the project
PV - 396,662.3350 The present value, given a required rate of
return of 18 percent.
(Note: The present value is displayed with a minus sign since it
represents cash paid out.)
2nd
2nd
10 N N = 10.0000 Stores n, the holding period
18 I/Y I/Y = 18.0000 Stores i, the required rate of return

50,000 PMT PMT = 50,000.0000 Stores PMT, the annual cash
flow to be received
900,000 FV FV = 900,000.0000 Stores FV, the cash flow to be
received at the end of the project
CPT PV PV = - 396,662.3350 The present value, given a
required rate of return of 18 percent.
(Note: The present value is displayed with a minus sign since it
represents cash paid out.)
I V . c A l c u l A t I n g p r e S e n t V A l u e S - H e w l e
t t - p A c k A r d 1 0 B I I
Example: You are considering the purchase of a franchise of
quick oil-change locations, which you believe will
provide an annual cash flow of $50,000. At the end of 10 years,
you believe that you will be able to sell the fran-
chise for an estimated $900,000. Calculate the maximum
amount you should pay for the franchise (present value)
in order to realize at least an 18 percent annual yield.
2nd
2nd
SET BGN Sets timing of payments to beginning of each period
2nd

P/Y P/Y =
12 ENTER P/Y = 2.0000 Sets 12 payments per year
(continues on next page)
V . c A l c u l A t I n g F u t u r e V A l u e S ( c o m p o u n
d S u m ) - t e x A S I n S t r u m e n t S B A I I p l u S
Example: If you deposit $300 a month (at the beginning of each
month) into a new account that pays 6.25 per-
cent annual interest compounded monthly, how much will you
have in the account after 5 years?
A-6 Appendix A
V I . c A l c u l A t I n g t H e n u m B e r o F p A y m e n t
S o r r e c e I p t S - H e w l e t t - p A c k A r d 1 0 B I I
Example: If you wish to retire with $500,000 saved and can
only afford payments of $500 at the beginning of
each month, how long will you have to contribute toward your
retirement if you can earn a 10 percent return on
your contributions?
V . c A l c u l A t I n g F u t u r e V A l u e S ( c o m p o u n
d S u m ) - H e w l e t t - p A c k A r d 1 0 B I I
Example: If you deposit $300 a month (at the beginning of each
month) into a new account that pays 6.25 per-
cent annual interest compounded monthly, how much will you
have in the account after 5 years?

ORG, BEG/END 0.0000(BEGIN) Sets timing of payments to
beginning of each period
12, ORG, P/YR 12.0000 Sets 12 payments per year
60, N 60.0000 Stores n, the number of months for the
investment
6.25, I/Y 6.2500 Stores I, the annual rate
300 , +/- , PMT - 300.0000 Stores PMT, the monthly amount
invested (with a minus
sign for cash paid out)
FV 21,175.7613 The future value after 5 years
2nd
60 N N = 60.0000 Stores n, the number of months for the
investment
6.25 I/Y I/Y = 6.2500 Stores i, the annual rate
300 +/-
PMT

PMT = - 300.0000 Stores PMT, the monthly amount invested
(with a minus sign for
cash paid out)
CPT FV FV = 21,175.7613 The future value after 5 years
2nd
BGN BGN Verifies timing of payment at the beginning of each
period
2nd
P/Y P/Y = 12.0000
2nd
10 I/Y I/Y = 10.0000 Stores i, the interest rate
500 + /-
PMT
(with a minus sign
for cash paid out)

500,000
FV
FV = 500,000.0000 The value we want to achieve
CPT N N = 268.2539 Number of months (since we considered
monthly payments)
required to achieve our goal
V I . c A l c u l A t I n g t H e n u m B e r o F p A y m e n t
S o r r e c e I p t S - t e x A S I n S t r u m e n t S
B A I I p l u S
Example: If you wish to retire with $500,000 saved, and can
only afford payments of $500 at the beginning of
each month, how long will you have to contribute toward your
retirement if you can earn a 10 percent return on
your contributions?
ORG, BEG/END 0.0000 (BEGIN) Sets timing of payments to
Appendix A A-7

ORG, BEG/END 0.0000(BEGIN) Sets timing of payments to the
12.5, I/YR 12.5000 Stores I, the interest rate
480 N N = 480.0000 Stores n, the number of periods until we
stop contributing
(40 years * 2 months/year = 480 months)
750,000, FV 750,000.0000 The value we want to achieve
PMT - 53.8347 Monthly contribution required to achieve our
ultimate goal
(shown as a negative since it represents cash paid out)
10, I/YR 10.0000 Stores I, the interest rate
500, + /- MT 500.0000 Stores PMT, the monthly amount
invested (with a minus sign
for cash paid out)
500,000, FV 500,000.0000 The value we want to achieve
N 268.2539 Number of months (since we considered monthly
payments)
required to achieve our goal

V I I . c A l c u l A t I n g t H e p A y m e n t A m o u n t - t
e x A S I n S t r u m e n t S B A I I p l u S
Example: Suppose your retirement needs were $750,000. If you
are currently 25 years old and plan to retire at age
65, how much will you have to contribute at the beginning of
each month for retirement if you can earn
12.5 percent on your savings?
2nd
BGN BGN Verifies timing of payment at the beginning of each
period
2nd
P/Y P/Y = 12.0000
2nd
12.5 I/Y I/Y = 12.5000 Stores i, the interest rate
480 N N = 480.0000 Stores n, the number of periods until we
stop contributing
(40 years * 12 months/year = 480 months)
750,000 FV FV = 750,000.0000 The value we want to achieve

CPT PMT PMT = - 53.8347 Monthly contribution required to
achieve our ultimate goal
(shown as negative since it represents cash paid out)
V I I . c A l c u l A t I n g t H e p A y m e n t A m o u n t -
H e w l e t t - p A c k A r d 1 0 B I I
Example: Suppose your retirement needs are $750,000. If you
are currently 25 years old and plan to retire at
age 65, how much will you have to contribute at the beginning
of each month for retirement if you can earn
12.5 percent on your savings?
V I I I . c A l c u l A t I n g t H e I n t e r e S t r A t e - t e x
A S I n S t r u m e n t S B A I I p l u S
Example: If you invest $300 at the end of each month for 6
years (72 months) for a promised $30,000 return at
the end, what interest rate are you earning on your investment?
2nd
BGN BGN Sets timing of payments to beginning of each period
A-8 Appendix A

2nd
BGN END Verifies timing of payments to end of each period
2nd
P/Y P/Y = 12.0000
2 ENTER P/Y = 2.0000 Sets 2 payments per year; end mode
(END) assumes cash flows
are at the end of each 6-month period
2nd
20 N N = 20.0000 Stores the number of semiannual periods (10
years * 2)
12 I/Y I/Y = 12.0000 Stores annual rate of return
45 PMT PMT = 45.0000 Stores the semiannual interest payment
1,000 FV FV = 1,000.0000 Stores the bond’s maturity or par
value
CPT PV PV = - 827.9512 Value of the bond, expressed as a
negative number
SOLUTION Using the Bond Feature:

2nd
BOND SDT = 1-01-1970 (This will be the last date entered)
2nd
SET END Sets timing of payments to end of each period
2nd
P/Y P/Y = 12.0000
2nd
72 N N = 72.0000 Stores n, the number of deposits
(investments)
300 + /-
PMT
(with a minus sign
for cash paid out)
30,000 FV FV = 30,000.0000 Stores the future value to be
received in 6 years
CPT I/Y I/Y = 10.5892 The annual interest rate earned on the
investment

ORG, BEG/END 0.0000 Sets timing of payments to the end of
each period
72, N 72.000 Stores n, the number of deposits (investments)
300, + /- , PMT −300.0000 Stores PMT, the monthly amount
invested (with a minus sign
for cash paid out)
30,000, FV 30,000.0000 Stores the future value to be received
in 6 years
I/YR 10.5892 The annual interest rate earned on the investment
V I I I . c A l c u l A t I n g t H e I n t e r e S t r A t e - H e
w l e t t - p A c k A r d 1 0 B I I
Example: If you invest $300 at the end of each month for 6
years (72 months) for a promised $30,000 return at
the end, what interest rate are you earning on your investment?
I x . B o n d V A l u A t I o n - t e x A S I n S t r u m e n t S
B A I I p l u S
Example: Assume the current date is January 1, 2006, and that
you want to know the value of a bond that matures in
10 years and has a coupon rate of 9 percent (4.5 percent
semiannually). Your required rate of return is 12 percent.

Appendix A A-9
2nd
2nd
P/Y P/Y = 12.0000
2 ENTER P/Y = 2.0000 Sets 2 payments per year; end mode
(END) assumes cash
flows are at the end of each 6-month period
2nd
16 N N = 16.0000 Stores the number of semiannual periods (8
years * 2)
1100 + / - PV = - 1,100.0000 Value of the bond, expressed as a
negative number
PV
60 PMT PMT = 60.0000 Stores the semiannual interest

payments
1,000 FV FV = 1,000.0000 Stores the bond’s maturity or par
value
CPT I/Y I/Y = 10.1451 The yield to maturity, expressed on an
annual basis
SOLUTION Using the Bond Feature:
2nd
Bond SDT = 1-01-1993 (This will be the last date entered)
2nd
CLR WORK SDT = 1-01-1993 Clears BOND variables
1.01.06 ENTER SDT = 1-01-2006 Stores the current date
(month, date, year)
T CPN = 0.0000
12 ENTER CPN = 12.0000 Stores the coupon interest rate
T RDT = 1-01-2003 (This will be the last date entered)
1.01.14 ENTER RDT = 1-01-2014 Stores the maturity date in 8
years
T RV = 100.0000 Verifies bond’s maturity or par value
T 360

2nd
2nd
CLR WORK SDT = 1-01-1970 Clears BOND variables
1.01.06 ENTER SDT = 1-01-2006 Stores the current date
(month, date, year)
T CPN = 0.0000
9 ENTER CPN = 9.0000 Stores the coupon interest rate
T RDT = 12-31-1990 (This will be the last date entered)
1.01.16 ENTER RDT = 1-01-2016 Stores the maturity date in 10
years
T RV = 100.0000 Verifies bond maturity or par value
T ACT
2nd
SET 360 Sets calculations to be based on 360-day year
T 2/Y Verifies semiannual compounding rate
T YLD = 0.0000
12 ENTER YLD = 12.0000 Stores the investor’s required rate of
return
T PRI = 0.0000

CPT PRI = 82.7951 Value of bond as a percent of par value;
i.e., value of bond is $827.95
B. Computing the yield to maturity of a bond
you want to know your yield to maturity on a bond that
matures in 8 years and has a coupon rate of 12 percent (6
percent semiannually). The bond is selling for $1,100.
A-10 Appendix A
I x . B o n d V A l u A t I o n - H e w l e t t - p A c k A r d 1
0 B I I
you want to know the value of a bond that matures
in 10 years and has a coupon rate of 9 percent (4.5 percent
semiannually). Your required rate of return is 12 percent.
2nd
2nd
P/Y P/Y = 12.0000
1 ENTER P/Y = 1.0000 Sets 1 payment per year; end mode
(END) assumes cash flows

are at the end of each year
SET ACT Sets calculations to be based on 360-day year
Verifies semiannual compounding rate
T 2/Y
T YLD = 0.0000
T PRI = 0.0000
110 ENTER PRI = 110.0000 Stores the bond value as a
percentage of par value
c YLD = 0.0000
CPT YLD = 10.1451 Bond’s yield to maturity
2, ORG, P/YR 2.0000 Sets payments at 2 per year END mode
20, N 20.0000 Stores the number of semiannual periods
12, I/YR 12.0000 Stores annual rate of return
45, PMT 45.0000 Stores the semiannual interest payments
1000, FV 1,000.0000 Stores the bond’s maturity or par value

PV - 827.9512 Value of the bond, expressed as a negative
number
2, ORG, P/YR 2.0000 Sets payments at 2 per year END mode
16, N 16.0000 Stores the number of semiannual periods (8 years
* 2)
1100, + / - , PV - 1,100.0000 Value of the bond expressed as a
negative number
60, PMT 60.0000 Stores the semiannual interest payments
1000, FV 1,000.0000 Stores the bond’s maturity or par value
I/YR 10.1451 The yield to maturity expressed on an annual
basis
B. Computing the yield to maturity of a bond
you want to know your yield to maturity on a bond
that matures in 8 years and has a coupon rate of 12 percent (6
percent semiannually). The bond is selling for $1,100.
x . c o m p u t I n g t H e n e t p r e S e n t V A l u e A n d
I n t e r n A l r A t e o F r e t u r n - t e x A S
I n S t r u m e n t S B A I I p l u S

(annuity)
Example: The firm is considering a capital project that would
cost $80,000. The firm’s cost of capital is 12 per-
cent. The project life is 10 years, during which time the firm
expects to receive $15,000 per year. Calculate the
NPV and IRR.
Appendix A A-11
CF CF0 = 0.0000
2nd
CLR WORK CF0 = 0.0000 Clears cash flow variables
110,000 + /- CF0 = - 110,000.0000 Stores CF0, the initial
investment (with a minus sign for a
negative cash flow)
ENTER
T CO1 = 0.0000 Stores CF1, the first year’s cash flow (with a
minus sign for a
negative cash flow)
250,000 + /- CO1 = - 25,000.0000

ENTER
T FO1 = 1.0000 Stores the number of years CF1 is repeated (in
this case, 1 year only)
ENTER
T CO2 = 0.0000
50,000 CO2 = 50,000.0000 Stores CF2
ENTER
T FO2 = 1.0000
ENTER FO2 = 1.0000 Stores the number of years CF2 is
repeated
T CO3 = 0.0000
60,000 CO3 = 60,000.0000 Stores CF3
ENTER
T FO3 = 2.0000 Stores the number of years CF3 is repeated
2 ENTER (here, 2 years, so our response is 2 to the FO3
prompt)
T CO4 = 0.0000
100,000 CO4 = 100,000.0000 Stores CF4, $70,000 plus
expected $30,000
ENTER
T FO4 = 1.0000 Stores the number CF4
ENTER

2nd
QUIT 0.0000 Ends storage of individual cash flows
NPV I = 0.0000
15 ENTER I = 15.0000 Stores interest rate
cost $110,000. The firm’s cost of capital is
15 percent. The project life is 5 years, with the following
expected cash flows: - $ 25,000, $50,000, $60,000,
$60,000 and $70,000. In addition, you expect to receive $30,000
in the last year from the salvage value of the
equipment. Calculate the NPV and IRR.
2nd
15,000 PMT PMT = 15.0000 Stores the annual cash flows of
$15,000
10 N N = 10.0000 Stores the life of the project
12 I/Y I/Y = 12.0000 Stores the cost of capital
CPT PV PV = - 84,753.3454 Calculates present value
+ /- 84,753.3454 Changes PV to positive
- 80,000 = 4,753.3454 Calculates net present value by

subtracting the cost of the
project
80,000 + /- - 80,000.0000
PV PV = - 80,000.0000
CPT I/Y I/Y = 13.4344 Calculates the IRR
A-12 Appendix A
ORG, BEG/END 0.0000 Verifies timing of payments to end of
each period
1, ORG, P/YR 1.0000 Sets 1 payment per year; end mode
(END); assumes cash
flows are at the end of each year
15,000, PMT 15,000.0000 Stores annual cash flows of $15,000
10, N 10.0000 Stores the life of the project
12, I/YR 12.0000 Stores the cost of capital
PV - 84,753.3454 Calculates present value
+ /- 84,753.3454 Changes PV to positive

- 80,000, = 4753.3454 Calculates net present value by
subtracting the cost of the
project
80,000, + /- - 80,000.0000
PV - 80,000.0000
I/YR 13.4344 Calculates the IRR
1, ORG, P/YR 1.0000 Sets 1 payment per year END mode
110,000, + /- CFj - 110,000.0000 Stores CF0, the initial
investment (with a minus sign for
negative cash flow)
250,000 + /- , CFj - 25,000.0000 Stores CF1, the first year’s
cash flow (with a minus sign
for negative cash flow)
50,000, CFj 50,000.0000 Stores CF2
60,000, CFj 60,000.0000 Stores CF3
2, ORG, Nj 2.0000 Stores the number of years CF3 is repeated
100,000, CFj 100,000.0000 Stores CF4, $70,000 plus expected
$30,000

ORG, NPV 29,541.8951 Calculates the project’s NPV at the
stated interest rate
ORG, IRR/YR 22.0633 Calculates the project’s IRR
x . c o m p u t I n g t H e n e t p r e S e n t V A l u e A n d
I n t e r n A l r A t e o F r e t u r n - H e w l e t t -
p A c k A r d 1 0 B I I
(annuity)
cost $80,000. The firm’s cost of capital is 12 per-
cent. The project life is 10 years, during which time the firm
expects to receive $15,000 per year. Calculate the
NPV and IRR.
T NPV = 0.0000
CPT NPV = 29,541.8951 Calculates the project’s NPV at the
stated interest rate
IRR IRR = 0.0000
CPT IRR = 22.0633 Calculates the project’s IRR
cost $110,000. The firm’s cost of capital is 15

percent. The project life is 5 years, with the following expected
cash flows: −$25,000, $50,000, $60,000, $60,000,
and $70,000. In addition, you expect to receive $30,000 in the
last year from the salvage value of the equipment.
Calculate the NPV and IRR.
__MACOSX/0132994879/._Appendix.pdf
0132994879/Chapter 01.pdf
An Introduction to
the Foundations of
Financial Management
Learning Objectives
After reading this chapter, you should be able to:
1 Identify the goal of the firm. The Goal of the Firm
2 Understand the basic principles of finance, their Five
Principles That Form the
importance, and the importance of ethics and trust. Foundations
of Finance
3 Describe the role of finance in business. The Role of Finance
in Business
4 Distinguish between the different legal forms of business. The
Legal Forms of Business Organization
5 Explain what has led to the era of the Finance and the
Multinational Firm: The
multinational corporation. New Role

2
Apple Computer (AAPL) ignited the personal computer
revolution in the 1970s with the Apple II and reinvented
the personal computer in the 1980s with the Macintosh. But by
1997, it looked like it might be nearing the end
for Apple. Mac users were on the decline, and the company
didn’t seem to be headed in any real direction. It was
at that point that Steve Jobs reappeared, taking back his old job
as CEO of Apple, the company he cofounded in
1976. To say the least, things began to change. In fact, between
then and April 2012, the price of Apple’s com-
mon stock climbed by over one hundred and sixteen-fold!
How did Apple accomplish this? The company did it by going
back to what it does best, which is to
produce products that make the optimal trade-off between ease
of use, complexity, and features. Apple
took its special skills and applied them to more than just
computers, introducing new products such as
the iPod, iTunes, the sleek iMac, the MacBook Air, iPod Touch,
and the iPhone along with its unlimited
“apps.” Although all these products have done well, the success
of the iPod has been truly amazing.
Between the introduction of the iPod in October 2001 and the
beginning of 2005, Apple sold more than
6 million of the devices. Then, in 2004, it came out with the
iPod Mini, about the length and width
of a business card, which has also been a huge success,
particularly among women. How successful
1
M01_KEOW4873_CH01_pp002-019.indd 2 05/10/12 3:40 PM

has this new product been? By 2004, Apple was selling
more iPods than its signature Macintosh desktop and
notebook computers.
How do you follow up on the success of the iPod? You
keep improving your products and you keep developing
and introducing new products that consumers want. With
this in mind, in October 2011, Apple unveiled its iPhone
4S, selling over 4 million phones in the first week. Then,
in March 2012, during the same week that Apple’s App
Store downloads topped 25 billion, Apple introduced the
New iPad, selling over 3 million units in the first week.
In effect, Apple seems to have a never-ending supply of
new, exciting products that we all want.
How did Apple make a decision to introduce the original
iPod and now the iPad? The answer is by identifying a customer
need, combined with sound financial management. Finan-
cial management deals with the maintenance and creation
of economic value or wealth by focusing on decision making
with an eye toward creating wealth. As such, this text deals
with financial decisions such as when to introduce a new
product, when to invest in new assets, when to replace exist-
ing assets, when to borrow from banks, when to sell stocks or
bonds, when to extend credit to a customer, and how much
cash and inventory to maintain. All of these aspects of finan-
cial management were factors in Apple’s decision to intro-
duce and continuously improve the iPod, Apple TV, iPhone,
and iPad, and the end result is having a major financial impact
on Apple.
In this chapter, we lay the foundation for the entire book by
explaining the key goal that
guides financial decision making: maximizing shareholder
wealth. From there we introduce

the thread that ties everything together: the five basic principles
of finance. Finally, we
discuss the legal forms of business. We close the chapter with a
brief look at what has led to
the rise in multinational corporations.
The Goal of the Firm
The fundamental goal of a business is to create value for the
company’s owners (that is,
its shareholders). This goal is frequently stated as
“maximization of shareholder wealth.”
Thus, the goal of the financial manager is to create wealth for
the shareholders, by making
decisions that will maximize the price of the existing common
stock. Not only does this
goal directly benefit the shareholders of the company but it also
provides benefits to society
as scarce resources are directed to their most productive use by
businesses competing to
create wealth.
We have chosen maximization of shareholder wealth—that is,
maximizing the market
value of the existing shareholders’ common stock—because all
financial decisions ultimately
affect the firm’s stock price. Investors react to poor investment
or dividend decisions by
causing the total value of the firm’s stock to fall, and they react
to good decisions by push-
ing up the price of the stock. In effect, under this goal, good
decisions are those that create
wealth for the shareholder.
33
1 Identify the goal of the firm.

4 Part 1 • The Scope and Environment of Financial Management
Obviously, there are some serious practical problems in using
changes in the firm’s
stock to evaluate financial decisions. Many things affect stock
prices; to attempt to identify
a reaction to a particular financial decision would simply be
impossible, but fortunately that
is unnecessary. To employ this goal, we need not consider every
stock price change to be a
market interpretation of the worth of our decisions. Other
factors, such as changes in the
economy, also affect stock prices. What we do focus on is the
effect that our decision should
have on the stock price if everything else were held constant.
The market price of the firm’s
stock reflects the value of the firm as seen by its owners and
takes into account the com-
plexities and complications of the real-world risk. As we follow
this goal throughout our
discussions, we must keep in mind one more question: Who
exactly are the shareholders?
The answer: Shareholders are the legal owners of the firm.
Concept Check
1. What is the goal of the firm?
2. How would you apply this goal in practice?
Five Principles That Form the Foundations
of Finance
To the first-time student of finance, the subject matter may

seem like a collection of un-
related decision rules. This could not be further from the truth.
In fact, our decision rules,
and the logic that underlies them, spring from five simple
principles that do not require
knowledge of finance to understand. These five principles guide
the financial manager in
the creation of value for the firm’s owners (the stockholders).
As you will see, while it is not necessary to understand finance
to understand these
principles, it is necessary to understand these principles in order
to understand finance.
Although these principles may at first appear simple or even
trivial, they provide the driving
force behind all that follows, weaving together the concepts and
techniques presented in
this text, and thereby allowing us to focus on the logic
underlying the practice of financial
management. Now let’s introduce the five principles.
Principle 1: Cash Flow Is What Matters
You probably recall from your accounting classes that a
company’s profits can differ dra-
matically from its cash flows, which we will review in Chapter
3. But for now understand
that cash flows, not profits, represent money that can be spent.
Consequently, it is cash
flow, not profits, that determines the value of a business. For
this reason when we analyze
the consequences of a managerial decision we focus on the
resulting cash flows, not profits.
In the movie industry, there is a big difference between
accounting profits and cash
flow. Many a movie is crowned a success and brings in plenty

of cash flow for the studio but
doesn’t produce a profit. Even some of the most successful box
office hits—Forrest Gump,
Coming to America, Batman, My Big Fat Greek Wedding, and
the TV series Babylon 5—
realized no accounting profits at all after accounting for various
movie studio costs. That’s
because “Hollywood Accounting” allows for overhead costs not
associated with the movie
to be added on to the true cost of the movie. In fact, the movie
Harry Potter and the Order of
the Phoenix, which grossed almost $1 billion worldwide,
actually lost $167 million according
to the accountants. Was Harry Potter and the Order of the
Phoenix a successful movie? It sure
was—in fact it was the 16th highest grossing film of all time.
Without question, it produced
cash, but it didn’t make any profits.
There is another important point we need to make about cash
flows. Recall from your
economics classes that we should always look at marginal, or
incremental, cash flows
when making a financial decision. The incremental cash flow to
the company as a whole is
the difference between the cash flows the company will produce
both with and without the investment
it’s thinking about making. To understand this concept, let’s
think about the incremental
cash flows of the Pirates of the Caribbean movies. Not only did
Disney make money on the
1
rinciple
2 Understand the basic

principles of finance, their
importance, and the
importance of ethics and trust.
incremental cash flow the difference
between the cash flows a company will produce
both with and without the investment it is
thinking about making.
Chapter 1 • An Introduction to the Foundations of Financial
Management 5
movies, but it also increased the number of people attracted to
Disney theme parks to go
on the “Pirates of the Caribbean” ride. So, if you were to
evaluate a Pirates of the Caribbean
movie, you’d want to include its impact on sales throughout the
entire company.
Principle 2: Money Has a Time Value
Perhaps the most fundamental principle of finance is that money
has a “time” value. Very
simply, a dollar received today is more valuable than a dollar
received one year from now
because we can invest the dollar we have today to earn interest
so that at the end of one year
we will have more than one dollar.
For example, suppose you have a choice of receiving $1,000
either today or one year
from now. If you decide to receive it a year from now, you will
have passed up the oppor-

tunity to earn a year’s interest on the money. Economists would
say you suffered an “op-
portunity loss” or an “opportunity cost.” The cost is the interest
you could have earned on
the $1,000 if you invested it for one year. The concept of
opportunity costs is fundamental
to the study of finance and economics. Very simply, the
opportunity cost of any choice you
make is the highest-valued alternative that you had to give up
when you made the choice. So if you
loan money to your brother at no interest, money that otherwise
would have been loaned
to a friend for 8 percent interest (who is equally likely to repay
you), then the opportunity
cost of making the loan to your brother is 8 percent.
In the study of finance, we focus on the creation and
measurement of value. To measure
value, we use the concept of the time value of money to bring
the future benefits and costs
of a project, measured by its cash flows, back to the present.
Then, if the benefits or cash
inflows outweigh the costs, the project creates wealth and
should be accepted; if the costs or
cash outflows outweigh the benefits or cash inflows, the project
destroys wealth and should
be rejected. Without recognizing the existence of the time value
of money, it is impossible
to evaluate projects with future benefits and costs in a
meaningful way.
Principle 3: Risk Requires a Reward
Even the novice investor knows there are an unlimited number
of investment alternatives to
consider. But without exception, investors will not invest if
they do not expect to receive a

return on their investment. They will want a return that satisfies
two requirements:
◆ A return for delaying consumption. Why would anyone make
an investment that would
not at least pay them something for delaying consumption?
They won’t—even if there
is no risk. In fact, investors will want to receive at least the
same return that is available
for risk-free investments, such as the rate of return being earned
on U.S. government
securities.
◆ An additional return for taking on risk. Investors generally
don’t like risk. Thus, risky
investments are less attractive—unless they offer the prospect
of higher returns. That
said, the more unsure people are about how an investment will
perform, the higher the
return they will demand for making that investment. So, if you
are trying to persuade
investors to put money into a risky venture you are pursuing,
you will have to offer
them a higher expected rate of return.
Figure 1-1 (on page 6) depicts the basic notion that an
investor’s rate of return should
equal a rate of return for delaying consumption plus an
additional return for assuming
risk. For example, if you have $5,000 to invest and are
considering either buying stock in
International Business Machines (IBM) or investing in a new
bio-tech startup firm that has
no past record of success, you would want the startup
investment to offer the prospect of
a higher expected rate of return than the investment in an

established company like IBM.
Notice that we keep referring to the expected return rather than
the actual return. As
investors, we have expectations about what returns our
investments will earn. However, we
can’t know for certain what they will be. For example, if
investors could have seen into the
future, no one would have bought stock in AEterna Zentaris,
Inc. (AEZS), the late-stage
drug development company, on April 2, 2012. Why? Because on
that day AEterna Zentaris
2
rinciple
3
rinciple
opportunity cost the cost of making a choice
in terms of the next best alternative that must
be foregone.
reported its colon cancer treatment failed to improve survival
rates in a late-stage clinical
trial. The result was that within minutes of the announcement,
the company’s stock price
dropped by a whopping 66 percent.
The risk–return relationship will be a key concept as we value

stocks, bonds, and pro-
posed new investment projects throughout this text. We will
also spend some time deter-
mining how to measure risk. Interestingly, much of the work for
which the 1990 Nobel
Prize for economics was awarded centered on the graph in
Figure 1-1 and how to measure
risk. Both the graph and the risk–return relationship it depicts
will reappear often in our
study of finance.
Principle 4: Market Prices Are Generally Right
To understand how securities such as bonds and stocks are
valued or priced in the financial
markets, it is necessary to have an understanding of the concept
of an efficient market. An
efficient market is one where the prices of the assets traded in
that market fully reflect all avail-
able information at any instant in time.
Security markets such as the stock and bond markets are
particularly important to our
study of finance since these markets are the place where firms
can go to raise money to
finance their investments. Whether a security market such as the
New York Stock Ex-
change (NYSE) is efficient depends on the speed with which
newly released information
is impounded into prices. Specifically, an efficient stock market
is characterized by a large
number of profit-driven individuals who act very quickly by
buying (or selling) shares of
stock in response to the release of new information.
If you are wondering just how vigilant investors in the stock
market are in watching for

good and bad news, consider the following set of events. While
Nike (NKE) CEO William
Perez flew aboard the company’s Gulfstream jet one day in
November 2005, traders on the
ground sold off a significant amount of Nike’s stock. Why?
Because the plane’s landing
gear was malfunctioning, and they were watching TV coverage
of the event! Before Perez
landed safely, Nike’s stock dropped 1.4 percent. Once Perez’s
plane landed, Nike’s stock
price immediately bounced back. This example illustrates that
in the financial market there
are ever-vigilant investors who are looking to act even in the
anticipation of the release of
new information.
Another example of the speed with which stock prices react to
new information deals
with Disney. Beginning with Toy Story in 1995, Disney (DIS)
and Pixar (PIXR) were on a roll,
making animated hits one after another, including A Bug’s Life,
Toy Story 2, Monsters, Inc.,
Finding Nemo, and The Incredibles. So in 2006, the hopes for
the animated movie Cars
were very high. However, in the movie’s opening weekend, it
grossed only $60 million,
or about $10 million less than investors expected. How did the
stock market respond? On
the Monday following the opening weekend, Disney stock
opened over 2 percent lower.
4
rinciple
efficient market a market in which the prices
of securities at any instant in time fully reflect all

publicly available information about the
securities and their actual public values.
Ex
p
ec
te
d
r
et
ur
n
Additional
expected return
for taking on
added risk
Risk
Expected return
for delaying
consumption
FIGURE 1-1 The Risk–Return Trade-off
Management 7

Apparently, the news of the disappointing box office receipts
was reflected in Disney’s
opening stock price, even before it traded!
The key learning point here is the following: Stock market
prices are a useful barometer
of the value of a firm. Specifically, managers can expect their
company’s share prices to
respond quickly to investors’ assessment of their decisions. If
investors on the whole agree
that the decision is a good one that creates value, then they will
push up the price of the
firm’s stock to reflect that added value. On the other hand, if
investors feel that a decision
is bad for share prices, then the firm’s share value will be
driven down.
Unfortunately, this principle doesn’t always work perfectly in
the real world. You just
need to look at the housing price bubble that helped bring on
the economic downturn in
2008–2009 to realize that prices and value don’t always move in
lockstep. Like it or not, the
psychological biases of individuals impact decision making, and
as a result, our decision-
making process is not always rational. Behavioral finance
considers this type of behavior and
takes what we already know about financial decision making
and adds in human behavior
with all its apparent irrationality.
We’ll try and point out the impact of human behavior on
decisions throughout our
study. But understand that the field of behavioral finance is a
work in progress—we under-

stand only a small portion of what may be going on. We can
say, however, that behavioral
biases have an impact on our financial decisions. As an
example, people tend to be overcon-
fident and many times mistake skill for luck. As Robert Shiller,
a well-known economics
professor at Yale put it, “people think they know more than they
do.”1 This overconfidence
applies to their abilities, their knowledge and understanding,
and forecasting the future.
Since they have confidence in their valuation estimates, they
may take on more risk than
they should. These behavioral biases impact everything in
finance, from investment analy-
sis, to analyzing new projects, to forecasting the future.
agency problem problems and conflicts
resulting from the separation of the
management and ownership of the firm.
1See Robert J. Shiller, Irrational Exuberance, Broadway Books,
2000, page 142.
Principle 5: Conflicts of Interest Cause Agency Problems
Throughout this book we will describe how to make financial
decisions that increase the
value of a firm’s shares. However, managers do not always
follow through with these deci-
sions. Often they make decisions that actually lead to a decrease
in the value of the firm’s
shares. When this happens, it is frequently because the
managers’ own interests are best
served by ignoring shareholder interests. In other words, there
is a conflict of interest be-
tween what is best for the managers and the stockholders. For
example, it may be the case

that shutting down an unprofitable plant is in the best interests
of the firm’s stockholders,
but in so doing the managers will find themselves out of a job
or having to transfer to a
different job. This very clear conflict of interest might lead the
management of the plant to
continue running the plant at a loss.
Conflicts of interest lead to what are referred to by economists
as an agency cost or
agency problem. That is, managers are the agents of the firm’s
stockholders (the owners)
and if the agents do not act in the best interests of their
principal, this leads to an agency
cost. Although the goal of the firm is to maximize shareholder
value, in reality the agency
problem may interfere with the implementation of this goal. The
agency problem results from
the separation of management and the ownership of the firm.
For example, a large firm may be
run by professional managers or agents who have little or no
ownership in the firm. Because
of this separation of the decision makers and owners, managers
may make decisions that
are not in line with the goal of maximizing shareholder wealth.
They may approach work
less energetically and attempt to benefit themselves in terms of
salary and perquisites at the
expense of shareholders.
Managers might also avoid any projects that have risk
associated with them—even if
they are great projects with huge potential returns and a small
chance of failure. Why is
this so? Because if the project doesn’t turn out, these agents of
the shareholders may lose

their jobs.
The costs associated with the agency problem are difficult to
measure, but occasionally
we see the problem’s effect in the marketplace. If the market
feels management is damaging
5
rinciple
shareholder wealth, there may be a positive reaction in stock
price to the removal of that
management. For example, on the announcement of the death of
Roy Farmer, the CEO
of Farmer Brothers (FARM), a seller of coffee-related products,
Farmer Brothers’ stock
price rose about 28 percent. Generally, the tragic loss of a
company’s top executive raises
concerns over a leadership void, causing the share price to drop,
but in the case of Farmer
Brothers, investors thought a change in management would have
a positive impact on the
company.
If the firm’s management works for the owners, who are the
shareholders, why doesn’t
the management get fired if it doesn’t act in the shareholders’
best interest? In theory,
the shareholders pick the corporate board of directors and the
board of directors in turn

picks the management. Unfortunately, in reality the system
frequently works the other
way around. Management selects the board of director nominees
and then distributes the
ballots. In effect, shareholders are offered a slate of nominees
selected by the management.
The end result is that management effectively selects the
directors, who then may have
more allegiance to managers than to shareholders. This, in turn,
sets up the potential for
agency problems, with the board of directors not monitoring
managers on behalf of the
shareholders as it should.
The root cause of agency problems is conflicts of interest.
Whenever they exist in busi-
ness, there is a chance that individuals will do what is in their
best interests rather than the
best interests of the organization. For example, in 2000
Edgerrin James was a running back
for the Indianapolis Colts and was told by his coach to get a
first down and then fall down.
That way the Colts wouldn’t be accused of running up the score
against a team they were
already beating badly. However, since James’ contract included
incentive payments asso-
ciated with rushing yards and touchdowns, he acted in his own
self-interest and ran for a
touchdown on the very next play.
We will spend considerable time discussing monitoring
managers and trying to align
their interests with those of shareholders. As an example,
managers can be monitored by rat-
ing agencies and by auditing financial statements, and
compensation packages may be used

to align the interests of managers and shareholders.
Additionally, the interests of managers
and shareholders can be aligned by establishing management
stock options, bonuses, and
perquisites that are directly tied to how closely managers’
decisions coincide with the interest
of shareholders. In other words, what is good for shareholders
must also be good for managers.
If that is not the case, managers will make decisions in their
best interest rather than
maximizing shareholder wealth.
The Current Global Financial Crisis
Beginning in 2007 the United States experienced its most severe
financial crisis since the
Great Depression of the 1930s. As a result, some financial
institutions collapsed while the
government bailed others out, unemployment skyrocketed, the
stock market plummeted,
and the United States entered into a recession. Although the
recession is now officially
over, the economy still faces the lingering effects of the
financial crisis that continue in the
form of both a high rate of unemployment and a dramatic rise in
our country’s debt. Europe
continues to face a financial crisis of its own. Many members of
the European Union (EU)
are experiencing severe budget problems, including Greece,
Italy, Ireland, Portugal, and
Spain. These nations are all unable to balance their budgets and
face a very real prospect of
defaulting on payments tied to government loans.
While many factors contributed to the financial crisis, the most
immediate cause has
been attributed to the collapse of the real estate market in the

United States and the result-
ing real estate loan (mortgage) defaults. The focus of the loan
defaults has been on what
are commonly referred to as subprime loans. These are loans
made to borrowers whose
ability to repay them is highly doubtful. When the market for
real estate began to falter in
2006, many of the homebuyers with subprime mortgages began
to default. As the economy
contracted during the recession, people lost their jobs and could
no longer make their
mortgage loan payments, resulting in even more defaults.
To complicate the problem, most real estate mortgages were
packaged in portfolios
and resold to investors around the world. This process of
packaging mortgages is called
Management 9
securitization. Basically, securitization is a very useful tool for
increasing the supply of new mon-
ey that can be lent to new homebuyers. Here’s how mortgages
are securitized: First, home-
buyers borrow money by taking out a mortgage to finance a
home purchase. The lender,
generally a bank, savings and loan, or mortgage broker that
made the loan, then sells the mort-
gage to another firm or financial institution that pools together
a portfolio of many different
mortgages. The purchase of the pool of mortgages is financed

through the sale of securities
(called mortgage-backed securities, or MBS) that are sold to
investors who can hold them as an
investment or resell them to other investors. This process allows
the mortgage bank or other
financial institution that made the original mortgage loan to get
its money back out of the loan
and lend it to someone else. Thus, securitization provides
liquidity to the mortgage market and
makes it possible for banks to loan more money to homebuyers.
Ok, so what’s the catch? As long as lenders properly screen the
mortgages to make
sure the borrowers are willing and able to repay their home
loans and real estate values
remain higher than the amount owed, everything works fine.
However, if lenders make
loans to individuals who really cannot afford to make the
payments and real estate
prices drop precipitously as they began to do in 2006, there will
be problems and many
mortgages (especially those where the amount of the loan was a
very high percentage of
the property value) will be “under water.” That is, the
homeowner will owe more than
the home is worth. When this occurs homeowners may start to
default on their mort-
gage loans. This is especially true when the economy goes into
a recession and people
lose their jobs and, correspondingly, the ability to make their
mortgage payments. This
was the scenario in 2006. In essence, this was a perfect storm of
bad loans, falling hous-
ing prices, and a contracting economy.
Where are we now? As of this writing, in 2012, the recession is

officially over, having
ended in 2009; however, despite this pronouncement there is
evidence that the economy
is still not back to normal. Unemployment numbers are still
higher than historical norms
for nonrecession years. Moreover, these unemployment numbers
do not accurately reflect
what has become known as underemployment, whereby
individuals are taking jobs but
these jobs do not take advantage of the individuals’ employment
credentials (for example,
college professors driving taxi cabs). Finally, the risk of
financial crisis in many European
countries remains at a very high level. Despite a series of
financial “fixes” to the imbalances
in the budgets of Greece, Spain, and several other European
countries, for example, the
budgetary woes in Europe continue into 2012.
Avoiding Financial Crisis—Back to the Principles
Four significant economic events that have occurred during the
last decade all point to the
importance of keeping our eye closely affixed to the five
principles of finance: the dot.com
bubble; the accounting scandals headlined by Enron,
WorldCom, and Bernie Madoff; the
housing bubble; and, finally, the recent economic crisis.
Specifically, the problems that
firms encounter in times of crisis are often brought on by, and
made worse as a result of,
not paying close attention to the foundational principles of
finance. To illustrate, consider
the following:
◆ Forgetting Principle 1: Cash Flow Is What Matters (Focusing
on earnings instead

of cash flow). The financial fraud committed by Bernie Madoff,
WorldCom, and others
at the turn of the 21st century was a direct result of managerial
efforts to manage the firm’s
reported earnings to the detriment of the firm’s cash flows. The
belief in the importance of
current period earnings as the most critical determinant of the
market valuation
of the firm’s shares led some firms to sacrifice future cash
flows in order to maintain
the illusion of high and growing earnings.
◆ Forgetting Principle 2: Money Has a Time Value (Focusing
on the short run). When
trying to put in place a system that would align the interests of
managers and sharehold-
ers, many firms tied managerial compensation to short-run
performance. Consequently,
the focus shifted in many firms from what was best in the long
run to what was best in
the short run.
10 Part 1 • The Scope and Environment of Financial
Management
◆ Forgetting Principle 3: Risk Requires a Reward (Excessive
risk taking due to under-
estimation of risk). Relying on historical evidence, managers
often underestimated the
real risks that their decisions entailed. This underestimation of
the underlying riskiness
of their decisions led managers to borrow excessively. This

excessive use of borrowed
money (or financial leverage) led to financial disaster and
bankruptcy for many firms as
the economy slipped into recession. Moreover, the financial
crisis was exacerbated by
the fact that many times companies simply didn’t understand
how much risk they were
taking on. For example, AIG (AIG), the giant insurance
company that the government
bailed out, was involved in investments whose value is based on
the price of oil in 50
years. Let’s face it, no one knows what the price of oil will be
in a half a century—being
involved in this type of investment is blind risk.
◆ Forgetting Principle 4: Market Prices Are Generally Right
(Ignoring the efficiency
of financial markets). Huge numbers of so-called hedge funds
sprang up over the last
decade and entered into investment strategies that presupposed
that security prices
could be predicted. Many of these same firms borrowed heavily
in an effort to boost
their returns and later discovered that security markets were a
lot smarter than they
thought and consequently realized huge losses on their highly
leveraged portfolios.
◆ Forgetting Principle 5: Conflicts of Interest Cause Agency
Problems (Executive
compensation is out of control). Executive compensation in the
United States is
dominated by performance-based compensation in the form of
stock options and
grants. The use of these forms of compensation over the last
decade in the face of

one of the longest bull markets in history has resulted in
tremendous growth in
executive compensation. The motivations behind these methods
of compensation
are primarily tied to a desire to make managers behave like
stockholders (owners).
Unfortunately, this practice has resulted in pay for
nonperformance in many cases
and a feeling among the general public that executive
compensation is excessive.
We are reminded again that solving the principal–agent problem
is not easy to do,
but it has to be done!
In this edition of Foundations of Finance we believe that now,
perhaps more than at any
time in our memory, adhering to the fundamental principles of
finance is critical. In addi-
tion, to further emphasize the “back to principles theme” we
include a feature called “Cau-
tionary Tales” that highlights specific examples where a failure
to adhere to one or more of
the five principles led to problems.
The Essential Elements of Ethics and Trust
While not one of the five principles of finance, ethics and trust
are essential elements of the
business world. In fact, without ethics and trust nothing works.
This statement could be
applied to almost everything in life. Virtually everything we do
involves some dependence
on others. Although businesses frequently try to describe the
rights and obligations of their
dealings with others using contracts, it is impossible to write a
perfect contract. Conse-
quently, business dealings between people and firms ultimately

depend on the willingness
of the parties to trust one another.
Ethics or, rather, a lack of ethics in finance is a recurring theme
in the news. Finan-
cial scandals at Enron, WorldCom, Arthur Andersen, and
Bernard L. Madoff Investment
Securities demonstrate the fact that ethical lapses are not
forgiven in the business world.
Not only is acting in an ethical manner morally correct, it is a
necessary ingredient to long-
term business and personal success.
Ethical behavior is easily defined. It’s simply “doing the right
thing.” But what is the
right thing? For example, Bristol-Myers Squibb (BMY) gives
away heart medication to peo-
ple who can’t afford it. Clearly, the firm’s management feels
this is socially responsible and
the right thing to do. But is it? Should companies give away
money and products or should
they leave such acts of benevolence to the firm’s shareholders?
Perhaps the shareholders
should decide if they personally want to donate some of their
wealth to worthy causes.
Like most ethical questions, there is no clear-cut answer to the
dilemma posited above.
We acknowledge that people have a right to disagree about what
“doing the right thing”
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Management 11
means and that each of us has his or her personal set of values.
These values form the basis
for what we think is right and wrong. Moreover, every society
adopts a set of rules or laws
that prescribe what it believes constitutes “doing the right
thing.” In a sense, we can think
of laws as a set of rules that reflect the values of a society as a
whole.
You might ask yourself, “As long as I'm not breaking society’s
laws, why should I care
about ethics?” The answer to this question lies in consequences.
Everyone makes errors
of judgment in business, which is to be expected in an uncertain
world. But ethical errors
are different. Even if they don’t result in anyone going to jail,
they tend to end careers and
thereby terminate future opportunities. Why? Because unethical
behavior destroys trust,
and businesses cannot function without a certain degree of trust.
Throughout this book, we
will point out some of the ethical pitfalls that have tripped up
managers.
Concept Check
1. According to Principle 3, how do investors decide where to
invest their money?
2. What is an efficient market?
3. What is the agency problem and why does it occur?
4. Why are ethics and trust important in business?
The Role of Finance in Business
Finance is the study of how people and businesses evaluate

investments and raise capital
to fund them. Our interpretation of an investment is quite broad.
When Apple designed
its Apple TV, it was clearly making a long-term investment. The
firm had to devote
considerable expenses to designing, producing, and marketing
the device with the hope
that it would eventually become an essential living room
companion. Similarly, Apple
is making an investment decision whenever it hires a fresh new
graduate, knowing that
it will be paying a salary for at least 6 months before the
employee will have much to
contribute.
Thus, there are three basic types of issues that are addressed by
the study of finance:
1. What long-term investments should the firm undertake? This
area of finance is gener-
ally referred to as capital budgeting.
2. How should the firm raise money to fund these investments?
The firm’s funding
choices are generally referred to as capital structure decisions.
3. How can the firm best manage its cash flows as they arise in
its day-to-day operations?
This area of finance is generally referred to as working capital
management.
We’ll be looking at each of these three areas of business
finance—capital budgeting,
capital structure, and working capital management—in the
chapters ahead.

Why Study Finance?
Even if you're not planning a career in finance, a working
knowledge of finance will take
you far in both your personal and professional life.
Those interested in management will need to study topics like
strategic planning, per-
sonnel, organizational behavior, and human relations, all of
which involve spending money
today in the hopes of generating more money in the future. For
example, GM made a stra-
tegic decision to introduce an electric car and invested $740
million to produce the Chevy
Volt, only to find car buyers balk at the $40,000 sticker price.
Similarly, marketing majors
need to understand and decide how aggressively to price
products and the amount to spend
on advertising. Since aggressive marketing today costs money
but allows firms to reap re-
wards in the future, it should be viewed as an investment that
the firm needs to finance.
Production and operations management majors need to
understand how best to manage a
firm’s production and control its inventory and supply chain.
These are all topics that in-
volve risky choices that relate to the management of money over
time, which is the central
3Describe the role of finance in
business.
capital budgeting the decision-making
process with respect to investment in fixed assets.
capital structure decision the
decision- making process with funding choices

and the mix of long-term sources of funds.
working capital management the
management of the firm’s current assets and
short-term financing.
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Management
focus of finance. While finance is primarily about the
management of money, a key component of
finance is the management and interpretation of information.
Indeed, if you pursue a career in
management information systems or accounting, the finance
managers are likely to be your
most important clients. For the student with entrepreneurial
aspirations, an understanding
of finance is essential—after all, if you can’t manage your
finances, you won’t be in business
very long.
Finally, an understanding of finance is important to you as an
individual. The fact that you
are reading this book indicates that you understand the
importance of investing in yourself. By
obtaining a higher education degree, you are clearly making
sacrifices in the hopes of making
yourself more employable and improving your chances of
having a rewarding and challeng-
ing career. Some of you are relying on your own earnings and
the earnings of your parents to

finance your education, whereas others are raising money or
borrowing it from the financial
markets, or institutions and procedures that facilitate financial
transactions.
Although the primary focus of this book is on developing
corporate finance tools that
are used in business, much of the logic and tools we develop
apply to the decisions you will
have to make regarding your own personal finances. Financial
decisions are everywhere,
both for you and the firm you work for. In the future, both your
business and personal life
will be spent in the world of finance. Since you’re going to be
living in that world, it’s time
to learn the basics about it.
The Role of the Financial Manager
A firm can assume many different organizational structures.
Figure 1-2 shows a typical pre-
sentation of how the finance area fits into a firm. The vice
president for finance, also called
the chief financial officer (CFO), serves under the firm’s chief
executive officer (CEO)
and is responsible for overseeing financial planning, strategic
planning, and controlling the
firm’s cash flow. Typically, a treasurer and controller serve
under the CFO. In a smaller
financial markets those institutions and
procedures that facilitate transactions in all types
of financial claims.
FIGURE 1-2 How the Finance Area Fits into a Firm
Board of Directors

Chief Executive Officer
(CEO)
Vice President—Finance
or
Chief Financial Officer (CFO)
Duties:
Oversee financial planning
Strategic planning
Control cash flow
Duties:
Cash management
Credit management
Capital expenditures
Raising capital
Financial planning
Management of foreign currencies
Duties:
Taxes
Financial statements
Cost accounting
Data processing
Vice President—Marketing
Treasurer Controller
Vice President—Production
and Operations
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Management 13
firm, the same person may fill both roles, with just one office
handling all the duties. The
treasurer generally handles the firm’s financial activities,
including cash and credit manage-
ment, making capital expenditure decisions, raising funds,
financial planning, and managing
any foreign currency received by the firm. The controller is
responsible for managing the
firm’s accounting duties, including producing financial
statements, cost accounting, paying
taxes, and gathering and monitoring the data necessary to
oversee the firm’s financial well-
being. In this textbook, we focus on the duties generally
associated with the treasurer and
on how investment decisions are made.
Concept Check
1. What are the basic types of issues that are addressed by the
study of finance?
2. What are the duties of a treasurer? Of a controller?
The Legal Forms of Business Organization
In the chapters ahead we focus on financial decisions for
corporations because, although the
corporation is not the only legal form of business available, it is
the most logical choice for
a firm that is large or growing. It is also the dominant business
form in terms of sales in this
country. In this section we explain why this is so.

Although numerous and diverse, the legal forms of business
organization fall into three
categories: the sole proprietorship, the partnership, and the
corporation. To understand
the basic differences between each form, we need to define each
one and understand its
advantages and disadvantages. As the firm grows, the
advantages of the corporation begin
to dominate. As a result, most large firms take on the corporate
form.
Sole Proprietorships
A sole proprietorship is a business owned by an individual. The
owner retains the title
to the business’s assets and is responsible, generally without
limitation, for the liabili-
ties incurred. The proprietor is entitled to the profits from the
business but must also
absorb any losses. This form of business is initiated by the mere
act of beginning the
business operations. Typically, no legal requirement must be
met in starting the opera-
tion, particularly if the proprietor is conducting the business in
his or her own name.
If a special name is used, an assumed-name certificate should be
filed, requiring a small
registration fee. Termination of the sole proprietorship occurs
on the owner’s death or
by the owner’s choice. Briefly stated, the sole proprietorship is
for all practical purposes
the absence of any formal legal business structure.
Partnerships
The primary difference between a partnership and a sole
proprietorship is that the partner-
ship has more than one owner. A partnership is an association

of two or more persons coming
together as co-owners for the purpose of operating a business
for profit. Partnerships fall into two
types: (1) general partnerships and (2) limited partnerships.
General Partnerships In a general partnership each partner is
fully responsible for the
liabilities incurred by the partnership. Thus, any partner’s faulty
conduct, even having the
appearance of relating to the firm’s business, renders the
remaining partners liable as well.
The relationship among partners is dictated entirely by the
partnership agreement, which
may be an oral commitment or a formal document.
Limited Partnerships In addition to the general partnership, in
which all partners are
jointly liable without limitation, many states provide for limited
partnerships. The state
statutes permit one or more of the partners to have limited
liability, restricted to the amount of capi-
tal invested in the partnership. Several conditions must be met
to qualify as a limited partner.
First, at least one general partner must have unlimited liability.
Second, the names of the
limited partners may not appear in the name of the firm. Third,
the limited partners may
4 Distinguish between the
different legal forms of
business.
sole proprietorship a business owned by a
single individual.
partnership an association of two or more

individuals joining together as co-owners to
operate a business for profit.
general partnership a partnership in which
all partners are fully liable for the indebtedness
incurred by the partnership.
limited partnership a partnership in which
one or more of the partners has limited liability,
restricted to the amount of capital he or she
invests in the partnership.
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Management
not participate in the management of the business. Thus, a
limited partnership provides
limited liability for a partner who is purely an investor.
Corporations
The corporation has been a significant factor in the economic
development of the United
States. As early as 1819, U.S. Supreme Court Chief Justice John
Marshall set forth the
legal definition of a corporation as “an artificial being,
invisible, intangible, and existing
only in the contemplation of law.”2 This entity legally functions
separate and apart from its
owners. As such, the corporation can individually sue and be
sued and purchase, sell, or
own property, and its personnel are subject to criminal

punishment for crimes. However,
despite this legal separation, the corporation is composed of
owners who dictate its direc-
tion and policies. The owners elect a board of directors, whose
members in turn select
individuals to serve as corporate officers, including the
company’s president, vice presi-
dent, secretary, and treasurer. Ownership is reflected in
common stock certificates, each
designating the number of shares owned by its holder. The
number of shares owned rela-
tive to the total number of shares outstanding determines the
stockholder’s proportionate
ownership in the business. Because the shares are transferable,
ownership in a corpora-
tion may be changed by a shareholder simply remitting the
shares to a new shareholder.
The shareholder’s liability is confined to the amount of the
investment in the company,
thereby preventing creditors from confiscating stockholders’
personal assets in settle-
ment of unresolved claims. This is an extremely important
advantage of a corporation.
After all, would you be willing to invest in USAirways if you
would be held liable if one
of its planes crashed? Finally, the life of a corporation is not
dependent on the status of
the investors. The death or withdrawal of an investor does not
affect the continuity of the
corporation. Its managers continue to run the corporation when
stock is sold or when it
is passed on through inheritance.
2The Trustees of Dartmouth College v. Woodard, 4 Wheaton
636 (1819).

Organizational Form and Taxes: The Double Taxation
on Dividends
Historically, one of the drawbacks of the corporate form was the
double taxation of divi-
dends. This occurs when a corporation earns a profit, pays taxes
on those profits (the first
taxation of earnings), and pays some of those profits back to the
shareholders in the form
of dividends, and then the shareholders pay personal income
taxes on those dividends (the
second taxation of those earnings). This double taxation of
earnings does not take place
with proprietorships and partnerships. Needless to say, that had
been a major disadvantage
of corporations. However, in an attempt to stimulate the
economy, the tax rate on dividends
was cut with the passage of the Tax Act of 2003.
Before the 2003 tax changes, you paid your regular, personal
income tax rate on your
dividend income, which could be as high as 35 percent.
However, with the new law, qualified
dividends from domestic corporations and qualified foreign
corporations are now taxed
at a maximum rate of 15 percent. Moreover, if your personal
income puts you in the
10 percent or 15 percent income rate bracket, your dividends
will be taxed at only 5 per-
cent, and in 2008, this rate dropped to 0 percent. Unless
Congress takes further action, this
tax break on dividends will end after 2012 and individuals will
once again be taxed at their
regular personal tax rate.
S-Corporations and Limited Liability Companies (LLCs)
One of the problems that entrepreneurs and small business

owners face is that they need
the benefits of the corporate form to expand, but the double
taxation of earnings that comes
with the corporate form makes it difficult to accumulate the
necessary wealth for expansion.
Fortunately, the government recognizes this problem and has
provided two business forms
corporation an entity that legally functions
separate and apart from its owners.
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Management 15
that are, in effect, crosses between a partnership and a
corporation with the tax benefits of
partnerships (no double taxation of earnings) and the limited
liability benefit of corpora-
tions (your liability is limited to what you invest).
The first is the S-corporation, which provides limited liability
while allowing the business’s
owners to be taxed as if they were a partnership—that is,
distributions back to the owners are
not taxed twice as is the case with dividends distributed by
regular corporations. Unfortu-
nately, a number of restrictions accompany the S-corporation
that detract from the desir-
ability of this business form. Thus, an S-corporation cannot be
used for a joint venture
between two corporations. As a result, this business form has

been losing ground in recent
years in favor of the limited liability company.
The limited liability company (LLC) is also a cross between a
partnership and a cor-
poration. Just as with the S-corporation, the LLC retains limited
liability for its owners
but runs and is taxed like a partnership. In general, it provides
more flexibility than the
S-corporation. For example, corporations can be owners in an
LLC. However, because
LLCs operate under state laws, both states and the IRS have
rules for what qualifies as an
LLC, and different states have different rules. But the bottom
line in all this is that the LLC
must not look too much like a corporation or it will be taxed as
one.
Which Organizational Form Should Be Chosen?
Owners of new businesses have some important decisions to
make in choosing an organi-
zational form. Whereas each business form seems to have some
advantages over the others,
the advantages of the corporation begin to dominate as the firm
grows and needs access to
the capital markets to raise funds.
Because of the limited liability, the ease of transferring
ownership through the sale of
common shares, and the flexibility in dividing the shares, the
corporation is the ideal busi-
ness entity in terms of attracting new capital. In contrast, the
unlimited liabilities of the sole
proprietorship and the general partnership are deterrents to
raising equity capital. Between
the extremes, the limited partnership does provide limited

liability for limited partners,
which has a tendency to attract wealthy investors. However, the
impracticality of having a
large number of partners and the restricted marketability of an
interest in a partnership pre-
vent this form of organization from competing effectively with
the corporation. Therefore,
when developing our decision models we assume we are dealing
with the corporate form
and corporate tax codes.
Concept Check
1. What are the primary differences between a sole
proprietorship, a partnership, and a corporation?
2. Explain why large and growing firms tend to choose the
corporate form.
3. What is an LLC?
Finance and the Multinational Firm:
The New Role
In the search for profits, U.S. corporations have been forced to
look beyond our coun-
try’s borders. This movement has been spurred on by the
collapse of communism and
the acceptance of the free market system in third-world
countries. All this has taken
place at a time when information technology has experienced a
revolution brought
on by the personal computer and the Internet. Concurrently, the
United States went
through an unprecedented period of deregulation of industries.
These changes resulted
in the opening of new international markets, and U.S. firms
experienced a period of
price competition here at home that made it imperative that
businesses look across

borders for investment opportunities. The end result is that
many U.S. companies, in-
cluding General Electric, IBM, Walt Disney, and American
Express, have restructured
their operations to expand internationally.
S-corporation a corporation that, because of
specific qualifications, is taxed as though it were
a partnership.
limited liability company (LLC) a cross
between a partnership and a corporation under
which the owners retain limited liability but the
company is run and is taxed like a partnership.
5 Explain what has led to the
era of the multinational
corporation.
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Management
The bottom line is what you think of as a U.S. firm may be
much more of a multina-
tional firm than you would expect. For example, Coca-Cola
earns over 80 percent of its
profits from overseas sales and more money from its sales in
Japan than it does from all its
domestic sales. This is not uncommon. In fact, in 2011, close to
50 percent of the sales of
S&P 500 listed companies came from outside the United States.

In addition to U.S. firms venturing abroad, foreign firms have
also made their mark
in the United States. You need only look to the auto industry to
see what effects the
entrance of Toyota, Honda, Nissan, BMW, and other foreign car
manufacturers have had
on the industry. In addition, foreigners have bought and now
own such companies as Brooks
Brothers, RCA, Pillsbury, A&P, 20th Century Fox, Columbia
Pictures, and Firestone Tire
& Rubber. Consequently, even if we wanted to, we couldn’t
keep all our attention focused
on the United States, and even more important, we wouldn’t
want to ignore the opportuni-
ties that are available across international borders.
Concept Check
1. What has brought on the era of the multinational
corporation?
2. Has looking beyond U.S. borders been a profitable
experience for U.S. corporations?
Chapter Summaries
Identify the goal of the firm. (pgs. 3–4)
SUMMARy: This chapter outlines the framework for the
maintenance and creation of share-
holder wealth, which should be the goal of the firm and its
managers. The goal of maximization
of shareholder wealth is chosen because it deals well with
uncertainty and time in a real-world
environment. As a result, the maximization of shareholder
wealth is found to be the proper
goal for the firm.

Understand the basic principles of finance, their importance,
and the
importance of ethics and trust. (pgs. 4–11)
SUMMARy: The five basic principles of finance are:
1. Cash Flow Is What Matters—Incremental cash received and
not accounting profits drives value.
2. Money Has a Time Value—A dollar received today is more
valuable to the recipient than a
dollar received in the future.
3. Risk Requires a Reward—The greater the risk of an
investment, the higher will be the inves-
tor’s required rate of return, and, other things remaining the
same, the lower will be its value.
4. Market Prices Are Generally Right—For example, product
market prices are often slower
to react to important news than are prices in financial markets,
which tend to be very efficient
and quick to respond to news.
5. Conflicts of Interest Cause Agency Problems—Large firms
are typically run by pro-
fessional managers who own a small fraction of the firms’
equity. The individual actions
of these managers are often motivated by self-interest, which
may result in managers not
acting in the best interests of the firm’s owners. When this
happens, the firm’s owners will
lose value.
While not one of the five principles of finance, ethics and trust

are also essential elements of
the business world, and without them, nothing works.
1
2
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Describe the role of finance in business. (pgs. 11–13)
Summary: Finance is the study of how people and businesses
evaluate investments and raise capi-
tal to fund them. There are three basic types of issues that are
addressed by the study of finance: (1)
What long-term investments should the firm undertake? This
area of finance is generally referred
to as capital budgeting. (2) How should the firm raise money to
fund these investments? The firm’s
funding choices are generally referred to as capital structure
decisions. (3) How can the firm best
manage its cash flows as they arise in its day-to-day operations?
This area of finance is generally
referred to as working capital management.
Key TermS
3
Capital budgeting, page 11 The decision-
making process with respect to investment in
fixed assets.
Capital structure decision, page 11 The

decision-making process with funding choices
and the mix of long-term sources of funds.
Working capital management, page 11 The
management of the firm’s current assets and
short-term financing.
Financial markets, page 12 Those institu-
tions and procedures that facilitate transactions
in all types of financial claims.
Distinguish between the different legal forms of business. (pgs.
13–15)
Summary: The legal forms of business are examined. The sole
proprietorship is a business opera-
tion owned and managed by an individual. Initiating this form
of business is simple and generally
does not involve any substantial organizational costs. The
proprietor has complete control of the
firm but must be willing to assume full responsibility for its
outcomes.
The general partnership, which is simply a coming together of
two or more individuals, is similar
to the sole proprietorship. The limited partnership is another
form of partnership sanctioned by
states to permit all but one of the partners to have limited
liability if this is agreeable to all partners.
The corporation increases the flow of capital from public
investors to the business community.
Although larger organizational costs and regulations are
imposed on this legal entity, the corpora-
tion is more conducive to raising large amounts of capital.
Limited liability, continuity of life, and
ease of transfer in ownership, which increase the marketability

of the investment, have contributed
greatly in attracting large numbers of investors to the corporate
environment. The formal control
of the corporation is vested in the parties who own the greatest
number of shares. However, day-
to-day operations are managed by the corporate officers, who
theoretically serve on behalf of the
firm’s stockholders.
Key TermS
4
Key TermS
Incremental cash flow, page 4 The difference
between the cash flows a company will produce
both with and without the investment it is thinking
about making.
Opportunity cost, page 5 The cost of making
a choice in terms of the next best alternative that
must be foregone.
Efficient market, page 6 A market in which
the prices of securities at any instant in time fully
reflect all publicly available information about the
securities and their actual public values.
Agency problem, page 7 Problems and
conflicts resulting from the separation of the
management and ownership of the firm.
Sole proprietorship, page 13 A business
owned by a single individual.
Partnership, page 13 An association of two or
more individuals joining together as co-owners
to operate a business for profit.

General partnership, page 13 A partner-
ship in which all partners are fully liable for
the indebtedness incurred by the partnership.
Limited partnership, page 13 A partnership
in which one or more of the partners has
limited liability, restricted to the amount of
capital he or she invests in the partnership.
Corporation, page 14 An entity that legally
functions separate and apart from its owners.
S-corporation, page 15 A corporation that,
because of specific qualifications, is taxed as
though it were a partnership.
Management 17
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Explain what has led to the era of the multinational corporation.
(pg. 15)
Summary: With the collapse of communism and the acceptance
of the free market system in third-
world countries, U.S. firms have been spurred on to look
beyond their own boundaries for new busi-
ness. The end result has been that it is not uncommon for major
U.S. companies to earn over half their
income from sales abroad. Foreign firms are also increasingly
investing in the United States.
review Questions
All Review Questions are available in MyFinanceLab.

1-1. What are some of the problems involved in implementing
the goal of maximization of share-
holder wealth?
1-2. Firms often involve themselves in projects that do not
result directly in profits. For example,
Apple, which we featured in the chapter introduction, donated
$50 million to Stanford University
hospitals and another $50 million to the African aid
organization (Product) RED, a charity fighting
against AIDS, tuberculosis, and malaria. Do these projects
contradict the goal of maximization of
shareholder wealth? Why or why not?
1-3. What is the relationship between financial decision making
and risk and return? Would all
financial managers view risk–return trade-offs similarly?
1-4. What is the agency problem and how might it impact the
goal of maximization of shareholder
wealth?
1-5. Define (a) sole proprietorship, (b) partnership, and (c)
corporation.
1-6. Identify the primary characteristics of each form of legal
organization.
1-7. Using the following criteria, specify the legal form of
business that is favored: (a) organiza-
tional requirements and costs, (b) liability of the owners, (c) the
continuity of the business, (d) the
transferability of ownership, (e) management control and
regulations, (f) the ability to raise capital,
and (g) income taxes.
1-8. There are a lot of great business majors. Check out the
Careers in Business Web site at
www.careers-in-business.com. It covers not only finance but
also marketing, accounting, and man-
agement. Find out about and provide a short write-up describing
the opportunities investment

banking and financial planning offer.
1-9. Like it or not, ethical problems seem to crop up all the time
in finance. Some of the worst
financial scandals are examined at
http://projects.exeter.ac.uk/RDavies/arian/scandals/classic.
html. Take a look at the write-ups dealing with “The Credit
Crunch,” “The Dot-Com Bubble and
Investment Banks,” and “Bernard L. Madoff Investment
Securities.” Provide a short write-up on
these events.
1-10. We know that if a corporation is to maximize shareholder
wealth, the interests of the manag-
ers and the shareholders must be aligned. The simplest way to
align these interests is to structure
executive compensation packages appropriately to encourage
managers to act in the best interests
of shareholders through stock and option awards. However, has
executive compensation gotten
out of control? Take a look at the Executive Pay Watch Web
site at www.aflcio.org/corporate-
watch/paywatch to see to whom top salaries have gone (click on
“100 Highest-paid CEOs” on the
right-hand side of the page). What are the most recent total
compensation packages for the head of
Oracle (ORCL), Home Depot (HD), Disney (DIS), and
ExxonMobil (XOM)? (Hint: you’ll want
to look in the CEO Pay Database in the Executive Pay Watch.)
mini Case
This Mini Case is available in MyFinanceLab.
The final stage in the interview process for an assistant
financial analyst at Caledonia Products
involves a test of your understanding of basic financial
concepts. You are given the following
5

Limited liability company (LLC),
page 15 A cross between a partnership and
a corporation under which the owners retain
limited liability but the company is run and is
taxed like a partnership.
Management
M01_KEOW4873_CH01_pp002-019.indd 18 09/10/12 12:37
PM
memorandum and asked to respond to the questions. Whether
you are offered a position at Cale-
donia will depend on the accuracy of your response.
To: Applicants for the position of Financial Analyst
From: Mr. V. Morrison, CEO, Caledonia Products
Re: A test of your understanding of basic financial concepts and
of the corporate tax code
Please respond to the following questions:
a. What is the appropriate goal for the firm and why?
b. What does the risk–return trade-off mean?
c. Why are we interested in cash flows rather than accounting
profits in determining the value
of an asset?
d. What is an efficient market and what are the implications of
efficient markets for us?
e. What is the cause of the agency problem and how do we try
to solve it?

f. What do ethics and ethical behavior have to do with finance?
g. Define (1) sole proprietorship, (2) partnership, and (3)
corporation.
Management 19
M01_KEOW4873_CH01_pp002-019.indd 19 05/10/12 3:40
PM
__MACOSX/0132994879/._Chapter 01.pdf
0132994879/Chapter 02.pdf
The Financial Markets
and Interest Rates
Learning Objectives
1 Describe key components of the U.S. financial market
Financing of Business: The Movement of
system and the financing of business. Funds Through the
Economy
2 Understand how funds are raised in the capital markets.
Selling Securities to the Public
3 Be acquainted with recent rates of return. Rates of Return in
the Financial Markets
4 Explain the fundamentals of interest rate Interest Rate
Determinants in a Nutshell
determination and the popular theories of
the term structure of interest rates.

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