Introduction to Finance

Markets, Investments, and Financial

Management

Ronald W. Melicher Professor Emeritus of Finance University of Colorado at Boulder

and

Edgar A. Norton Professor of Finance Illinois State University

WILEY

Contents

Preface iv Author Bios xii

1.1 What Is Finance?, 6 1.1.1 TwoThemes, 8

1.2 Why Study Finance?, 8 1.3 Six Principles of Finance, 10

1.3.1 Time Value of Money, 10 1.3.2 Risk Versus Return, 10 1.3.3 Diversification of Risk, 11 1.3.4 Financial Markets Are Efßcient, 11 1.3.5 Management Versus Owner Objectives, 12 1.3.6 Reputation Matters, 12

1.4 Overview of the Financial System, 13 1.4.1 Characteristics and Requirements, 13 1.4.2 Financial System Components and Financial Functions, 15 1.4.3 Creating Money, 15 1.4.4 Transferring Money, 15 1.4.5 Accumulating Savings, 16 1.4.6 Lending and Investing Savings, 16 1.4.7 Marketing Financial Assets, 16 1.4.8 Transferring Financial Assets, 16

1.5 Financial Markets: Characteristics and Types, 17 1.5.1 Money and Capital Markets, 17 1.5.2 Primary and Secondary Markets, 17 1.5.3 Major Types of Financial Markets, 18

1.6 Careers in Finance, 18 1.7 The Plan of Study, 20 Applying Finance To..., 21 Summary, 21 Key Terms, 22 Review Questions, 22 Exercises, 22

xv

Money and the Monetary System 24

2.1 The 2007-2008 Financial Crisis and Subsequent Recovery, 25 2.2 Process of Moving Savings into Investments, 26 2.3 Overview of the Monetary System, 28 2.4 Characteristics and Functions of Money, 29 2.5 Development of Money in the United States, 31

2.5.1 Physical Money (Coin and Paper Currency), 31 2.5.2 Credit Money and Deposit Money, 35

2.6 Money Market Securities, 37 2.7 Measures of the U.S. Money Supply, 38

2.7.1 Ml Money Supply, 38 2.7.2 M2 Money Supply, 39 2.7.3 Exclusions from the Money Supply, 40

2.8 Money Supply and Economic Activity, 41 2.9 International Monetary System, 42 Applying Finance To. .., 44 Summary, 44 Key Terms, 45 Review Questions, 45 Exercises, 46 Problems, 47

Banks and Other Financial Institutions 49

3.1 Financial Institution Problems Düring the 2007-2008 Financial Crisis, 50 3.2 Types and Roles of Financial Institutions, 51

3.2.1 Depository Institutions, 52 3.2.2 Contractual Savings Organizations, 52 3.2.3 Securities Firms, 53 3.2.4 Finance Firms, 54

3.3 Overview of the Banking System, 55 3.3.1 Commercial, Investment, and Universal Banking, 55 3.3.2 Functions of Banks and the Banking System, 56

3.4 Historical Development of the U.S. Banking System, 58 3.4.1 Before the Civil War, 58 3.4.2 Entry of Thrift Institutions, 60

3.5 Regulation of the Banking System, 60 3.5.1 General Banking Legislation, 60 3.5.2 The Savings and Loan 1980s-l990s Crisis, 63 3.5.3 Protection of Depositors'Funds, 64

3.6 Structure of Banks, 65 3.6.1 Bank Charters, 65 3.6.2 Degree of Branch Banking, 65 3.6.3 Bank Holding Companies, 66

Contents xvii

3.7 The Bank Balance Sheet, 66 3.7.1 Assets, 67 3.7.2 Liabilities and Stockholders' Equity, 69

3.8 Bank Management, 71 3.8.1 Liquidity Management, 71 3.8.2 Capital Management, 73

3.9 International Banking and Foreign Systems, 75 Applying Finance To..., 76 Summary, 77 Key Terms, 78 Review Questions, 78 Exercises, 79 Problems, 79

Federal Reserve System 82

4.1 U.S. Central Bank Response to the Financial Crisis and Great Recession, 83 4.2 The U.S. Banking System Prior to the Fed, 84

4.2.1 Weaknesses of the National Banking System, 84 4.2.2 The Movement to Central Banking, 85

4.3 Structure of the Federal Reserve System, 86 4.3.1 Member Banks, 86 4.3.2 Federal Reserve District Banks, 87 4.3.3 Board of Governors, 89 4.3.4 Federal Open Market Committee, 89 4.3.5 Advisory Committees, 89 4.3.6 Role of the Chair of the Fed Board of Governors, 90

4.4 Monetary Policy Functions and Instruments, 92 4.4.1 Overview of Responsibilities, 92 4.4.2 Reserve Requirements, 93 4.4.3 Fed Lending Rate Policy, 95 4.4.4 Open-Market Operations, 96 4.4.5 Quantitative Easing, 97 4.4.6 Implementation of Monetary Policy, 98

4.5 Fed Supervisory and Regulatory Functions, 99 4.5.1 Specific Supervisory Responsibilities, 99 4.5.2 Specific Regulatory Responsibilities, 99

4.6 Fed Service Functions, 101 4.6.1 The Payments Mechanism, 101 4.6.2 Transfer of Credit, 102 4.6.3 Other Service Activities, 102

4.7 Central Banks in Other Countries, 103 Applying Finance To.. ., 104 Summary, 104

Contents

Key Terms, 105 Review Questions, 105 Exercises, 106 Problems, 107

Policy Makers and the Money Supply 109

5.1 National Economic Policy Objectives, 110 5.1.1 Economic Growth, 110 5.1.2 High Employment, 111 5.1.3 Price Stability, 111 5.1.4 Domestic and International Implications, 112

5.2 Four Policy Maker Croups, 112 5.2.1 Ethical Behavior in Government, 113 5.2.2 Policy Makers in the European Economic Union, 113

5.3 Government Influence on the Economy, 114 5.3.1 Government Reaction to the Perfect Financial Storm, 115

5.4 Treasury Cash and General Management Responsibilities, 116 5.4.1 Managing the Treasury's Cash Balances, 116 5.4.2 Powers Relating to the Federal Budget and to Surpluses or Deficits, 117 5.4.3 Financial Crisis Related Activities, 119

5.5 Treasury Deficit Financing and Debt Management Responsibilities, 120 5.6 Changing the Money Supply, 122

5.6.1 Checkable Deposit Expansion, 122 5.6.2 Offsetting or Limiting Factors, 126 5.6.3 Contraction of Deposits, 126

5.7 Factors Affecting Bank Reserves, 128 5.7.1 Changes in the Demand for Currency, 128 5.7.2 Federal Reserve System Transactions, 129

5.8 The Monetary Base and the Money Multiplier, 131 Applying Finance To.. ., 133 Summary, 133 Key Terms, 134 Review Questions, 134 Exercises, 135 Problems, 135

International Finance and Trade 137

6.1 International Monetary System, 138 6.1.1 Development of International Finance, 138 6.1.2 How the International Monetary System Evolved, 138

6.2 European Unification, 140 6.2.1 European Union, 140 6.2.2 Eurozone Members, 140

Contents xix

PART 2

6.2.3 The Euro, 141 6.2.4 European Union Financial Crises, 141

6.3 Currency Exchange Markets and Rates, 142 6.3.1 Currency Exchange Markets, 142 6.3.2 Exchange Rate Quotations, 142 6.3.3 Currency Exchange Rate Appreciation and Depreciation, 144

6.4 Factors that Affect Currency Exchange Rates, 145 6.4.1 Basic Supply and Demand Relationships, 145 6.4.2 Inflation, Interest Rates, and Other Factors, 146 6.4.3 Arbitrage, 148

6.5 Conducting Business Internationally, 149 6.5.1 Exchange Rate Developments for the U.S. Dollar, 149 6.5.2 Managing Currency Exchange Risk, 150 6.5.3 Ethical Considerations, 151

6.6 Financing International Trade, 151 6.6.1 Financing by the Exporter, 151 6.6.2 Financing by the Importer, 153 6.6.3 Banker's Acceptance, 156 6.6.4 Other Aids to International Trade, 156

6.7 Developments in U.S. International Transactions, 157 6.7.1 International Business Issues, 158 6.7.2 Balance-of-Payments Accounts, 158

Applying Finance To.. ., 161 Summary, 161 Key Terms, 162 Review Questions, 162 Exercises, 163 Problems, 164 6.8 Exchange Rate Risks in Global Business, 166

Hedging Cash Flows, 167 Speculating or Taking Educated Guesses on Exchange Rate Movements, 168 Where to Invest?, 168

Summary, 169 Review Questions, 170

Investments

Savings and Investment Process II?

7.1 Gross Domestic Product and Capital Formation, 174 7.1.1 GDP Components, 175 7.1.2 Implications of International Payment Imbalances, 176

xx Contents

7.2 Federal Government Receipts and Expenditures, 177 7.2.1 The Budget, 177 7.2.2 Fiscal Policy Makers, 179 7.2.3 Debt Financing, 179

7.3 Role and Major Sources of Savings, 180 7.3.1 Historical Sources, 180 7.3.2 Creation of Savings, 181 7.3.3 Personal Savings, 181 7.3.4 Corporate Savings, 183

7.4 Factors Affecting Savings, 184 7.4.1 Levels of Income, 184 7.4.2 Economic Expectations, 185 7.4.3 Economic Cycles, 185 7.4.4 Life Stages of the Individual Saver, 186 7.4.5 Life Stages of the Corporation and Other Business Firms, 186

7.5 Capital Market Securities, 187 7.6 Mortgage Markets, 189

7.6.1 Types of Mortgages and Mortgage-Backed Securities, 189 7.6.2 Credit Ratings and Scores, 190 7.6.3 Major Participants in the Secondary Mortgage Markets, 190

7.7 Role of the Individual in the 2007-2008 Financial Crisis and Today, 191 7.7.1 Early Factors, 191 7.7.2 A Borrowing-Related Cultural Shift, 192 7.7.3 Subsequent Recovery, 192

Applying Finance To..., 193 Summary, 193 Key Terms, 194 Review Questions, 194 Exercises, 195 Problems, 195

3 Interest Rates 197

8.1 Supply and Demand for Loanable Funds, 198 8.1.1 Historical Changes in U.S. Interest Rate Levels, 199 8.1.2 Loanable Funds Theory, 200

8.2 Components of Market Interest Rates, 203 8.3 Default Risk-Free Securities: U.S. Treasury Debt Instruments, 205

8.3.1 Marketable Securities, 205 8.3.2 Dealer System, 207 8.3.3 Tax Status of Federal Obligations, 207 8.3.4 Ownership of Public Debt Securities, 207 8.3.5 Maturity Distribution of Marketable Debt Securities, 208

Contents xxi

8.4 Term or Maturity Structure of Interest Rates, 210 8.4.1 Relationship Between Yield Curves and the Economy, 211 8.4.2 Term Structure Theories, 211

8.5 Inflation Premiums and Price Movements, 213 8.5.1 Historical International Price Movements, 213 8.5.2 Inflation in the United States, 214 8.5.3 Types of Inflation, 216

8.6 Default Risk Premiums, 218 Applying Finance To..., 220 Summary, 220 Key Terms, 221 Review Questions, 221 Exercises, 222 Problems, 223

Time Value of Money 225

9.1 Basic Time Value Concepts, 226 9.2 Compounding to Determine Future Values, 228

9.2.1 Inflation or Purchasing Power Implications, 231 9.3 Discounting to Determine Present Values, 232

9.3.1 Equating Present Values and Future Values, 236 9.4 Finding Interest Rates and Time Requirements, 237

9.4.1 Solving for Interest Rates, 237 9.4.2 Solving for Time Periods, 238 9.4.3 Rule of 72, 239

9.5 Future Value of an Annuity, 239 9.6 Present Value of an Annuity, 242 9.7 Interest Rates and Time Requirements for Annuities, 245

9.7.1 Solving for Interest Rates, 245 9.7.2 Solving for Time Periods, 246

9.8 Determining Periodic Annuity Payments, 247 9.8.1 Examples Involving Annual Payments, 247 9.8.2 Real Estate Mortgage Loans with Monthly Payments, 248

9.9 More Frequent Time Intervals and the Cost of Consumer Credit, 249 9.9.1 More Frequent Than Annual Compounding or Discounting, 249 9.9.2 Cost of Consumer Credit, 251

Applying Finance To..., 252 Summary, 253 Key Terms, 253 Review Questions, 254 Exercises, 254 Problems, 254

xxii Contents

9.10 Annuity Due Problems, 257 Future Value of an Annuity Due, 257 Present Value of an Annuity Due, 258 Interest Rates and Time Requirements for Annuity Due Problems, 259

Summary, 260 Questions and Problems, 260

3 Bonds and Stocks: Characteristics and Valuations 262

10.1 Long-Term External Financing Sources for Businesses, 263 10.2 Bonds, 264

10.2.1 Who Buys Bonds?, 265 10.2.2 Bond Covenants, 266 10.2.3 Bond Ratings, 267 10.2.4 Global Bond Market, 269 10.2.5 Reading Bond Quotes, 270

10.3 Different Types of Bonds, 271 10.3.1 Time to Maturity, 272 10.3.2 Income from Bonds, 273

10.4 Corporate Equity Capital, 275 10.4.1 Common Stock, 276 10.4.2 Preferred Stock, 277 10.4.3 Reading Stock Quotes, 278

10.5 Dividends and Stock Repurchases, 279 10.5.1 How Do Firms Decide on the Dollar Amount of Dividends?, 280 10.5.2 Stock Dividends and Stock Splits, 282 10.5.3 Share Repurchases, 283

10.6 Valuation Principles, 283 10.7 Valuation of Bonds, 286

10.7.1 Determining a Bond's Present Value, 286 10.7.2 Calculating the Yield to Maturity, 289 10.7.3 Risk in Bond Valuation, 290 10.7.4 Interest Rate Risk, 291

10.8 Valuation of Stocks, 293 10.8.1 Valuing Stocks with Constant Dividends, 294 10.8.2 Valuing Stocks with Constant Dividend Growth Rates, 294 10.8.3 Risk in Stock Valuation, 296 10.8.4 Valuation and the Financial Environment, 296 10.8.5 Global Economic Influences, 297 10.8.6 Domestic Economic Influences, 297 10.8.7 Industry and Competition, 298

Contents xxiii

Applying Finance To..., 298 Summary, 298 Key Terms, 299 Review Questions, 300 Problems, 301 10.9 Holding Period Returns, 305

Annualized Rates of Return, 305 Summary, 307 Problems, 307

Securities and Markets 308

11.1 Issuing Securities: Primary Securities Markets, 309 11.1.1 Primary Market Functions of Investment Bankers, 309

11.2 The Facebook IPO, 313 11.3 Other Ways to Assist Issuing Firnis, 316

11.3.1 ShelfRegistration, 316 11.3.2 Seil Securities to a Private Party, 316 11.3.3 Rights Offerings, 316 11.3.4 Competitive Bidding, 317

11.4 Cost of Going Public, 318 11.5 Investment Banking Firms: Other Functions, Innovations, Regulations, 321

11.5.1 Investment Banking Regulation, 322 11.5.2 Innovations Among Investment Banking Firms, 323

11.6 Trading Securities - Secondary Securities Markets, 323 11.6.1 Organized Security Exchanges, 324 11.6.2 Structure of the New York Stock Exchange, 324

11.7 Security Transactions, 326 11.7.1 Market Order, 326 11.7.2 Limit Order, 326 11.7.3 Stop-Loss Order, 327 11.7.4 Short Sale, 327 11.7.5 Buying on Margin, 328 11.7.6 Record Keeping, 329 11.7.7 Program Trading, 329

11.8 Over-the-Counter Market, 330 11.8.1 Third and Fourth Security Markets, 330 11.8.2 High Frequency Trading, 331

11.9 What Makes a Good Market?, 331 11.9.1 A Word on Commissions, 333

11.10 Security Market Indexes and Trading Foreign Securities, 333 11.10.1 Indexes, 333 11.10.2 Foreign Securities, 335

xxiv Contents

11.11 Inside Information and Other Ethical Issues, 336 11.11.1 Ethics and Job Opportunities in Investments, 337

Applying Finance To.. ., 338 Summary, 339 Key Terms, 340 Review Questions, 341 Problems, 341 11.12 Why Do Derivatives Exist?, 344

Futures Contracts, 345 Options, 346 Option Profit/Loss Diagrams, 349

Summary, 350 Key Terms, 350 Discussion Questions, 350 Problems, 351

Financial Return and Risk Concepts 352

12.1 Historical Return for a Single Financial Asset, 353 12.1.1 Arithmetic Average Annual Rates of Return, 354

12.2 Historical Risk Measures for a Single Financial Asset, 355 12.2.1 Standard Deviation as a Measure of Risk, 356

12.3 Where Does Risk Come from?, 358 12.4 Expected Measures of Return and Risk, 360 12.5 Historical Retums and Risk of Different Assets, 364 12.6 Efficient Capital Markets, 365 12.7 Portfolio Returns, 368

12.7.1 Expected Return on a Portfolio, 369 12.8 Variance and Standard Deviation of Return On a Portfolio, 369

12.8.1 To Diversify or Not to Diversify?, 371 12.9 Portfolio Risk and the Number of Investments in the Portfolio, 372

12.9.1 Systematic and Unsystematic Risk, 373 12.10 Capital Asset Pricing Model, 374 Applying Finance To..., 378 Summary, 378 Key Terms, 379 Review Questions, 379 Problems, 380 12.IIA Estimating Beta, 384 12.11B Security Market Line, 386 Summary, 387 Problems, 387

Contents xxv

Financial Management

Business Organization and Financial Data 391

13.1 Starting a Business, 392 13.1.1 Strategie Plan with a Vision or Mission, 392 13.1.2 Business and Financial Goals, 393

13.2 Forms of Business Organization in the United States, 394 13.2.1 Proprietorship, 394 13.2.2 Partnership, 396 13.2.3 Corporation, 396

13.3 Accounting Principles, 398 13.3.1 The Annual Report, 400

13.4 Income Statement, 401 13.5 The Balance Sheet, 402

13.5.1 Assets, 403 13.5.2 Liabilities, 404 13.5.3 Owners' Equity, 405

13.6 Statement of Cash Flows, 405 13.7 Financial Statements of Different Companies, 407

13.7.1 Common-Size Financial Statements, 408 13.7.2 The Auto Bailout and Financial Statements, 409

13.8 Goal ofa Firm, 410 13.8.1 Measuring Shareholder Wealth, 410 13.8.2 Linking Strategy and Financial Plans, 412 13.8.3 Criterion for Nonpublic Firms, 413 13.8.4 What About Ethics?, 413

13.9 Corporate Governance, 414 13.9.1 Principal - Agent Problem, 414 13.9.2 Reducing Agency Problems, 416

13.10 Finance in the Organization Chart, 418 Applying Finance To..., 420 Summary, 420 Key Terms, 421 Review Questions, 421 Problems, 422 13.IIA Income Tax, 427 13.IIB DepreciationBasics, 429

13.11.1 A Few Words on Depreciation Methods, 430 Summary, 431 Review Questions and Problems, 431

xxvi Contents

3 Financial Analysis and Long-Term Financial Flanning 432

14.1 Financial Statement Analysis, 433 14.1.1 Ratio Analysis of Balance Sheet and Income Statement, 433 14.1.2 Types of Financial Ratlos, 435

14.2 Liquidity Ratlos and Analysis, 436 14.3 Asset Management Ratios and Analysis, 438 14.4 Financial Leverage Ratios and Analysis, 441 14.5 Profitability Ratios and Analysis, 445 14.6 Market Value Ratios and Analysis, 447

14.6.1 Summary of Ratio Analysis for Walgreens, 449 14.7 Dupont Method of Ratio Analysis, 449 14.8 Long-Term Financial Flanning, 452

14.8.1 Percentage of Sales Technique, 452 14.8.2 Asset Investment Requirements, 453

14.9 Cost-Volume-Profit Analysis, 455 14.10 Degree of Operating Leverage, 456 Applying Finance To. .., 458 Summary, 459 Key Terms, 460 Review Questions, 460 Problems, 461

15.1 Importance ofWorking Capital, 467 15.2 Operating and Cash Conversion Cycles, 468

15.2.1 Operating Cycle, 468 15.2.2 Cash Conversion Cycle, 470 15.2.3 Determining the Length of the Operating Cycle and Cash Conversion Cycle, 470

15.3 Investments in Receivables, Inventory, and Payable Financing, 472 15.4 Cash Budgets, 475

15.4.1 Minimum Desired Cash Balance, 475 15.4.2 Estimated Cash Inflows, 475 15.4.3 Estimated Cash Outflows, 476 15.4.4 Constructing the Cash Budget, 477 15.4.5 Seasonal Versus Level Production, 478

15.5 Management of Current Assets, 480 15.5.1 Cash Management, 480 15.5.2 Marketable Securities, 481

15.6 Getting - and Keeping - the Cash, 488 15.7 Accounts Receivable Management, 490

15.7.1 Credit Analysis, 490 15.7.2 Credit-Reporting Agencies, 491 15.7.3 Credit Terms and Collection Efferts, 492

Managing Working Capital 466

Contents xxvii

15.8 Inventory Management, 494 15.9 Technology and Working Capital Management, 495

15.9.1 Cash Management, 495 15.9.2 Processing Invoices and Float, 496 15.9.3 Tracking Inventory, 496

Applying Finance To.. ., 497 Summary, 497 Key Terms, 498 Review Questions, 498 Problems, 499

Short-Term Business Financing 503

16.1 Strategies for Financing Working Capital, 504 16.1.1 Maturity-Matching Approach, 505 16.1.2 Aggressive Approach, 505 16.1.3 Conservative Approach, 507

16.2 Factors Affecting Short-Term Financing, 507 16.2.1 Operating Characteristics, 507 16.2.2 Other Influences in Short-Term Financing, 511

16.3 Providers of Short-Term Financing, 512 16.3.1 Bank Lines of Credit, 512 16.3.2 Computing Interest Rates, 513 16.3.3 Revolving Credit Agreements, 514 16.3.4 Small Business Administration, 515

16.4 Nonbank Short-Term Financing Sources, 516 16.4.1 Trade Credit from Suppliers, 516 16.4.2 Commercial Finance Companies, 518 16.4.3 Commercial Paper, 519

16.5 Additional Varieties of Short-Term Financing, 521 16.5.1 Accounts Receivable Financing, 521 16.5.2 Acceptances, 524

16.6 Inventory Financing and Other Secured Loans, 525 16.6.1 Inventory Loans, 525 16.6.2 Loans Secured by Stocks and Bonds, 526 16.6.3 Other Forms of Security for Loans, 527

16.7 The Cost of Short-Term Financing, 527 Applying Finance To..., 528 Summary, 528 Key Terms, 529 Review Questions, 530 Problems, 530

xxviii Contents

Capital Budgeting Analysis 533

17.1 Mission, Vision, and Capital Budgeting, 534 17.1.1 Identifying Potential Capital Budget Projects, 535

17.2 Capital Budgeting Process, 537 17.3 Capital Budgeting Techniques - Net Present Value, 540

17.3.1 Using Spreadsheet Functions, 542 17.4 Capital Budgeting Techniques - Internal Rate of Return, 543

17.4.1 NPV and IRR, 546 17.5 Capital Budgeting Techniques - Modified Internal Rate of Return, 547 17.6 Capital Budgeting Techniques - Profitability Index, 549 17.7 Capital Budgeting Techniques - Payback Period, 549 17.8 Conflicts Between Discounted Cash Flow Techniques, 550

17.8.1 Different Cash Flow Pattems, 550 17.8.2 Different Time Horizons, 550 17.8.3 Different Sizes, 551 17.8.4 Difference Between Theory and Practice, 551

17.9 Estimating Project Cash Flows, 552 17.9.1 Isolating Project Cash Flows, 552 17.9.2 Approaches to Estimating Project Cash Flows, 554

17.10 Keeping Managers Honest, 558 17.11 Risk-Related Considerations, 559 Applying Finance To..., 561 Summary, 561 Key Terms, 563 Review Questions, 563 Problems, 564 17.12 Project Stages and Cash Flow Estimation, 567

Initial Outlay, 567 Cash Flows Düring the Project's Operating Life, 568 Salvage Value and NWC Recovery at Project Termination, 568

17.13 Applications, 569 Cash Flow Estimation for a Revenue Expanding Project, 569 Cash Flow Estimation for a Cost-Saving Project, 571 Setting a Bid Price, 574

Summary, 576 Review Questions, 576 Problems, 576

Capital Structure and the Cost of Capital 578

18.1 Why Choose a Capital Structure?, 579 18.1.1 Trends in Corporate Use of Debt, 580 18.1.2 Cashing in on Low Interest Rates, 581

18.2 Required Rate of Return and the Cost of Capital, 582 18.3 Cost of Capital, 583

18.3.1 CostofDebt, 583 18.3.2 Cost of Preferred Stock, 584 18.3.3 Cost of Common Equity, 584 18.3.4 Cost of New Common Stock, 586

18.4 Weighted Average Cost of Capital, 587 18.4.1 Capital Structure Weights, 587 18.4.2 Measuring the Target Weights, 587 18.4.3 What Do Businesses Use as Their Cost of Capital?, 589 18.4.4 Difficulty of Making Capital Structure Decisions, 591

18.5 Flanning Growth Rates, 592 18.5.1 Internal Growth Rate, 592 18.5.2 Sustainable Growth Rate, 593 18.5.3 Effects of Unexpectedly Higher (or Lower) Growth, 594

18.6 EBIT/eps Analysis, 594 18.6.1 Indifference Level, 595 18.6.2 Implications of EBIT/eps Analysis, 596

18.7 Combined Operating and Financial Leverage Effects, 597 18.7.1 Unit Volume Variability, 597 18.7.2 Price-Variable Cost Margin, 598 18.7.3 FixedCosts, 598 18.7.4 Degree of Financial Leverage, 598 18.7.5 Total Risk, 599

18.8 Insigbts from Theory and Practice, 601 18.8.1 Taxes and Nondebt Tax Shields, 601 18.8.2 Bankruptcy Costs, 601 18.8.3 Agency Costs, 603 18.8.4 A Firm's Assets and Its Financing Policy, 603 18.8.5 The Pecking Order Hypothesis, 604 18.8.6 Market Timing, 604 18.8.7 Beyond Debt and Equity, 605 18.8.8 Guidelines for Financing Strategy, 605

Applying Finance To..., 607 Summary, 607 Key Terms, 608 Review Questions, 609 Problems, 610

Appendix

Glossary

Index