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Global Global
edition edition
edition
Global
For these Global Editions, the editorial team at Pearson has
Foundations of Finance
collaborated with educators across the world to address a wide range
of subjects and requirements, equipping students with the best possible
learning tools. This Global Edition preserves the cutting-edge approach
and pedagogy of the original, but also features alterations, customization,
and adaptation from the North American version.
edition
Ninth
Keown • Martin • Petty
Foundations of Finance
This is a special edition of an established title widely Ninth edition
used by colleges and universities throughout the world.
Pearson published this exclusive edition for the benefit
of students outside the United States and Canada. If you
purchased this book within the United States or Canada,
Arthur J. Keown • John D. Martin • J. William Petty
you should be aware that it has been imported without
the approval of the Publisher or Author.
Pearson Global Edition
Keown_09_1292155132_Final.indd 1 29/04/16 7:45 AM

6 Part 4 • Managing Your Investments
J. William Petty, PhD, Baylor University, is Professor of Finance and

W. W. Caruth Chair of Entrepreneurship. Dr. Petty teaches entrepreneurial finance
at both the undergraduate and graduate levels. He is a University Master Teacher.
In 2008, the Acton Foundation for Entrepreneurship Excellence selected him as the
National Entrepreneurship Teacher of the Year. His research interests include the
financing of entrepreneurial firms and shareholder value-based management. He
has served as the co-editor for the Journal of Financial Research and the editor of the
Journal of Entrepreneurial Finance. He has published articles in various academic and
professional journals, including Journal of Financial and Quantitative Analysis, Financial
Management, Journal of Portfolio Management, Journal of Applied Corporate Finance, and
Accounting Review. Dr. Petty is co-author of a leading textbook in small business and
entrepreneurship, Small Business Management: Launching and Growing Entrepreneurial
Ventures. He also co-authored Value-Based Management: Corporate America’s Response
to the Shareholder Revolution (2010). He serves on the Board of Directors of a publicly
traded oil and gas firm. Finally, he serves on the Board of the Baylor Angel Network,
a network of private investors who provide capital to start-ups and early-stage
companies.
A01_KEOW5135_09_GE_FM.indd 6 06/05/16 6:46 PM

Brief Contents
Preface 16
Part 1 The Scope and Environment

of Financial Management 26
1 An Introduction to the Foundations of Financial Management 26
2 The Financial Markets and Interest Rates 46
3 Understanding Financial Statements and Cash Flows 78
4 Evaluating a Firm’s Financial Performance 130
Part 2 The Valuation of Financial Assets 176

5 The Time Value of Money 176
6 The Meaning and Measurement of Risk and Return 220
7 The Valuation and Characteristics of Bonds 260
8 The Valuation and Characteristics of Stock 292
9 The Cost of Capital 318
Part 3 Investment in Long-Term Assets 350

10 Capital-Budgeting Techniques and Practice 350
11 Cash Flows and Other Topics in Capital Budgeting 392
Part 4 Capital Structure and Dividend Policy 430

12 Determining the Financing Mix 430
13 Dividend Policy and Internal Financing 468
Part 5 orking-Capital Management and International

W
Business Finance 490
14 Short-Term Financial Planning 490
15 Working-Capital Management 510
16 International Business Finance 538
Web 17 Cash, Receivables, and Inventory Management
Available online at www.myfinancelab.com
Web Appendix A Using a Calculator
Glossary 560
Indexes 569

Contents
Preface 16
Part 1 The Scope and Environment

of Financial Management 26
1 An Introduction to the Foundations of Financial

Management 26
The Goal of the Firm 27
Five Principles That Form the Foundations of Finance 28
Principle 1: Cash Flow Is What Matters 28
Principle 2: Money Has a Time Value 29
Principle 3: Risk Requires a Reward 29
Principle 4: Market Prices Are Generally Right 30
Principle 5: Conflicts of Interest Cause Agency Problems 32
The Global Financial Crisis 33
Avoiding Financial Crisis—Back to the Principles 34
The Essential Elements of Ethics and Trust 35
The Role of Finance in Business 36
Why Study Finance? 36
The Role of the Financial Manager 37
The Legal Forms of Business Organization 38
Sole Proprietorships 38
Partnerships 38
Corporations 39
Organizational Form and Taxes: The Double Taxation on Dividends 39
S-Corporations and Limited Liability Companies (LLCs) 40
Which Organizational Form Should Be Chosen? 40
Finance and the Multinational Firm: The New Role 41
Chapter Summaries 42 • Review Questions 44 • Mini Case 45
2 The Financial Markets and Interest Rates 46

Financing of Business: The Movement of Funds Through
the Economy 48
Public Offerings Versus Private Placements 49
Primary Markets Versus Secondary Markets 50
The Money Market Versus the Capital Market 51
Spot Markets Versus Futures Markets 51
Stock Exchanges: Organized Security Exchanges Versus Over-the-Counter
Markets, a Blurring Difference 51
Selling Securities to the Public 53
Functions 53
Distribution Methods 54
Private Debt Placements 55
Flotation Costs 57
Regulation Aimed at Making the Goal of the Firm Work: The Sarbanes-Oxley
Act 57
Rates of Return in the Financial Markets 58
Rates of Return over Long Periods 58
Interest Rate Levels in Recent Periods 59

Contents 9
Interest Rate Determinants in a Nutshell 62

Estimating Specific Interest Rates Using Risk Premiums 62
Real Risk-Free Interest Rate and the Risk-Free Interest Rate 63
Real and Nominal Rates of Interest 63
Inflation and Real Rates of Return: The Financial Analyst’s Approach 65
The Term Structure of Interest Rates 67
Shifts in the Term Structures of Interest Rates 67
What Explains the Shape of the Term Structure? 69
Chapter Summaries 71 • Review Questions 74 • Study Problems 74 • Mini Case 77
3 Understanding Financial Statements and Cash

Flows 78
The Income Statement 80
Coca-Cola’s Income Statement 82
Restating Coca-Cola’s Income Statement 83
The Balance Sheet 85
Types of Assets 85
Types of Financing 87
Coca-Cola’s Balance Sheet 89
Working Capital 90
Measuring Cash Flows 93
Profits Versus Cash Flows 93
The Beginning Point: Knowing When a Change in the Balance Sheet Is a Source
or Use of Cash 95
Statement of Cash Flows 95
Concluding Suggestions for Computing Cash Flows 102
What Have We Learned about Coca-Cola? 103
GAAP and IFRS 103
Income Taxes and Finance 104
Computing Taxable Income 104
Computing the Taxes Owed 105
The Limitations of Financial Statements and Accounting
Malpractice 107
Chapter Summaries 109 • Review Questions 112 • Study Problems 113 • Mini Case 121
Appendix 3A: Free Cash Flows 124

Computing Free Cash Flows 124
Computing Financing Cash Flows 127
Study Problems 128
4 Evaluating a Firm’s Financial Performance 130

The Purpose of Financial Analysis 130
Measuring Key Financial Relationships 134
Question 1: How Liquid Is the Firm—Can It Pay Its Bills? 135
Question 2: Are the Firm’s Managers Generating Adequate Operating Profits
on the Company’s Assets? 140
Managing Operations 142
Managing Assets 143
Question 3: How Is the Firm Financing Its Assets? 147
Question 4: Are the Firm’s Managers Providing a Good Return on the Capital
Provided by the Company’s Shareholders? 150
Question 5: Are the Firm’s Managers Creating Shareholder Value? 155

10 Contents
The Limitations of Financial Ratio Analysis 162
Chapter Summaries 163 • Review Questions 166 • Study Problems 166

• Mini Case 174
Part 2 The Valuation of Financial Assets 176
5 The Time Value of Money 176

Compound Interest, Future Value, and Present Value 178
Using Timelines to Visualize Cash Flows 178
Techniques for Moving Money Through Time 181
Two Additional Types of Time Value of Money Problems 186
Applying Compounding to Things Other Than Money 187
Present Value 188
Annuities 192
Compound Annuities 192
The Present Value of an Annuity 194
Annuities Due 196
Amortized Loans 197
Making Interest Rates Comparable 199
Calculating the Interest Rate and Converting It to an EAR 201
Finding Present and Future Values With Nonannual Periods 202
Amortized Loans With Monthly Compounding 205
The Present Value of an Uneven Stream and Perpetuities 206
Perpetuities 207

• Mini Case 219
6 The Meaning and Measurement of Risk

and Return 220
Expected Return Defined and Measured 222
Risk Defined and Measured 225
Rates of Return: The Investor’s Experience 232
Risk and Diversification 233
Diversifying Away the Risk 234
Measuring Market Risk 235
Measuring a Portfolio’s Beta 242
Risk and Diversification Demonstrated 243
The Investor’s Required Rate of Return 246
The Required Rate of Return Concept 246
Measuring the Required Rate of Return 246

• Mini Case 258
7 The Valuation and Characteristics

of Bonds 260
Types of Bonds 261
Debentures 261
Subordinated Debentures 262
Mortgage Bonds 262
Eurobonds 262
Convertible Bonds 262

Contents 11
Terminology and Characteristics of Bonds 263

Claims on Assets and Income 263
Par Value 263
Coupon Interest Rate 264
Maturity 264
Call Provision 264
Indenture 264
Bond Ratings 265
Defining Value 266
What Determines Value? 268
Valuation: The Basic Process 269
Valuing Bonds 270
Bond Yields 276
Yield to Maturity 276
Current Yield 278
Bond Valuation: Three Important Relationships 279

• Mini Case 291
8 The Valuation and Characteristics

of Stock 292
Preferred Stock 293
The Characteristics of Preferred Stock 294
Valuing Preferred Stock 295
Common Stock 299
The Characteristics of Common Stock 299
Valuing Common Stock 301
The Expected Rate of Return of Stockholders 306
The Expected Rate of Return of Preferred Stockholders 307
The Expected Rate of Return of Common Stockholders 308

• Mini Case 317
9 The Cost of Capital 318

The Cost of Capital: Key Definitions and Concepts 319
Opportunity Costs, Required Rates of Return, and the Cost of
Capital 319
The Firm’s Financial Policy and the Cost of Capital 320
Determining the Costs of the Individual Sources
of Capital 321
The Cost of Debt 321
The Cost of Preferred Stock 323
The Cost of Common Equity 325
The Dividend Growth Model 326
Issues in Implementing the Dividend Growth Model 327
The Capital Asset Pricing Model 328
Issues in Implementing the CAPM 329
The Weighted Average Cost of Capital 331
Capital Structure Weights 332
Calculating the Weighted Average Cost of Capital 332

12 Contents
Calculating Divisional Costs of Capital 335

Estimating Divisional Costs of Capital 335
Using Pure Play Firms to Estimate Divisional WACCs 335
Using a Firm’s Cost of Capital to Evaluate New Capital Investments 337

• Mini Cases 348
Part 3 Investment in Long-Term Assets 350
10 Capital-Budgeting Techniques and Practice 350

Finding Profitable Projects 351
Capital-Budgeting Decision Criteria 352
The Payback Period 352
The Net Present Value 356
Using Spreadsheets to Calculate the Net Present Value 359
The Profitability Index (Benefit–Cost Ratio) 359
The Internal Rate of Return 362
Computing the IRR for Uneven Cash Flows with a Financial Calculator 364
Viewing the NPV–IRR Relationship: The Net Present Value Profile 365
Complications with the IRR: Multiple Rates of Return 367
The Modified Internal Rate of Return (MIRR) 368
Using Spreadsheets to Calculate the MIRR 371
A Last Word on the MIRR 371
Capital Rationing 372
The Rationale for Capital Rationing 373
Capital Rationing and Project Selection 373
Ranking Mutually Exclusive Projects 374
The Size-Disparity Problem 374
The Time-Disparity Problem 375
The Unequal-Lives Problem 376

• Mini Case 390
11 Cash Flows and Other Topics in Capital

Budgeting 392
Guidelines for Capital Budgeting 393
Use Free Cash Flows Rather Than Accounting Profits 393
Think Incrementally 393
Beware of Cash Flows Diverted from Existing Products 394
Look for Incidental or Synergistic Effects 394
Work in Working-Capital Requirements 394
Consider Incremental Expenses 395
Remember That Sunk Costs Are Not Incremental Cash Flows 395
Account for Opportunity Costs 395
Decide If Overhead Costs Are Truly Incremental Cash Flows 395
Ignore Interest Payments and Financing Flows 396
Calculating a Project’s Free Cash Flows 396
What Goes into the Initial Outlay 396
What Goes into the Annual Free Cash Flows over the Project’s Life 397
What Goes into the Terminal Cash Flow 399
Calculating the Free Cash Flows 399
A Comprehensive Example: Calculating Free Cash Flows 403
Options in Capital Budgeting 406
The Option to Delay a Project 407
The Option to Expand a Project 407
The Option to Abandon a Project 408
Options in Capital Budgeting: The Bottom Line 408

Contents 13
Risk and the Investment Decision 409

What Measure of Risk Is Relevant in Capital Budgeting? 410
Measuring Risk for Capital-Budgeting Purposes with a Dose of Reality—Is
Systematic Risk All There Is? 411
Incorporating Risk into Capital Budgeting 411
Risk-Adjusted Discount Rates 411
Measuring a Project’s Systematic Risk 414
Using Accounting Data to Estimate a Project’s Beta 415
The Pure Play Method for Estimating Beta 415
Examining a Project’s Risk Through Simulation 415
Conducting a Sensitivity Analysis Through Simulation 417

• Mini Case 426
Appendix 11A: The Modified Accelerated Cost

Recovery System 428
What Does All This Mean? 429
Study Problems 429
Part 4 Capital Structure and Dividend Policy 430
12 Determining the Financing Mix 430

Understanding the Difference Between Business and Financial
Risk 432
Business Risk 433
Operating Risk 433
Break-Even Analysis 433
Essential Elements of the Break-Even Model 434
Finding the Break-Even Point 436
The Break-Even Point in Sales Dollars 437
Sources of Operating Leverage 438
Financial Leverage 440
Combining Operating and Financial Leverage 442
Capital Structure Theory 444
A Quick Look at Capital Structure Theory 446
The Importance of Capital Structure 446
Independence Position 446
The Moderate Position 448
Firm Value and Agency Costs 450
Agency Costs, Free Cash Flow, and Capital Structure 452
Managerial Implications 452
The Basic Tools of Capital Structure Management 453
EBIT-EPS Analysis 453
Comparative Leverage Ratios 456
Industry Norms 457
Net Debt and Balance-Sheet Leverage Ratios 457
A Glance at Actual Capital Structure Management 457

• Mini Cases 466
13 Dividend Policy and Internal Financing 468

Key Terms 469
Does Dividend Policy Matter to Stockholders? 470
Three Basic Views 470
Making Sense of Dividend Policy Theory 473
What Are We to Conclude? 475

14 Contents
The Dividend Decision in Practice 476

Legal Restrictions 476
Liquidity Constraints 476
Earnings Predictability 477
Maintaining Ownership Control 477
Alternative Dividend Policies 477
Dividend Payment Procedures 477
Stock Dividends and Stock Splits 478
Stock Repurchases 479
A Share Repurchase as a Dividend Decision 480
The Investor’s Choice 481
A Financing or an Investment Decision? 482
Practical Considerations—The Stock Repurchase Procedure 482

• Mini Case 489
Part 5 orking-Capital Management and International

W
Business Finance 490
14 Short-Term Financial Planning 490

Financial Forecasting 491
The Sales Forecast 491
Forecasting Financial Variables 491
The Percent of Sales Method of Financial Forecasting 492
Analyzing the Effects of Profitability and Dividend Policy
on DFN 493
Analyzing the Effects of Sales Growth on a Firm’s DFN 494
Limitations of the Percent of Sales Forecasting Method 497
Constructing and Using a Cash Budget 498
Budget Functions 498
The Cash Budget 499

• Mini Case 508
15 Working-Capital Management 510

Managing Current Assets and Liabilities 511
The Risk–Return Trade-Off 512
The Advantages of Current versus Long-term Liabilities: Return 512
The Disadvantages of Current versus Long-term Liabilities: Risk 512
Determining the Appropriate Level of Working
Capital 513
The Hedging Principle 513
Permanent and Temporary Assets 514
Temporary, Permanent, and Spontaneous Sources of Financing 514
The Hedging Principle: A Graphic Illustration 515
The Cash Conversion Cycle 516
Estimating the Cost of Short-Term Credit Using the Approximate
Cost-of-Credit Formula 518
Sources of Short-Term Credit 520
Unsecured Sources: Accrued Wages and Taxes 521
Unsecured Sources: Trade Credit 522
Unsecured Sources: Bank Credit 523
Unsecured Sources: Commercial Paper 525

Contents 15
Secured Sources: Accounts-Receivable Loans 527

Secured Sources: Inventory Loans 529
16 International Business Finance 538

The Globalization of Product and Financial Markets 539
Foreign Exchange Markets and Currency Exchange Rates 540
Foreign Exchange Rates 541
What a Change in the Exchange Rate Means for Business 541
Exchange Rates and Arbitrage 544
Asked and Bid Rates 544
Cross Rates 544
Types of Foreign Exchange Transactions 546
Exchange Rate Risk 548
Interest Rate Parity 550
Purchasing-Power Parity and the Law of One Price 551
The International Fisher Effect 552
Capital Budgeting for Direct Foreign Investment 552
Foreign Investment Risks 553

• Mini Case 558
Web 17 Cash, Receivables, and Inventory Management

Web Appendix A Using a Calculator

Glossary 560
Indexes 569

Preface
The study of finance focuses on making decisions that enhance the value of the firm.
This is done by providing customers with the best products and services in a cost-
effective way. In a sense we, the authors of Foundations of Finance, share the same
purpose. We have tried to create a product that provides value to our customers—
both students and instructors who use the text. It was this priority that led us to write
Foundations of Finance: The Logic and Practice of Financial Management, which was the
first “shortened book” of financial management when it was first published. This
text launched a trend that has since been followed by all the major competing texts
in this market. The text broke new ground not only by reducing the breadth of mate-
rials covered but also by employing a more intuitive approach to presenting new
material. From that first edition, the text has met with success beyond our expecta-
tions for eight editions. For that success, we are eternally grateful to the multitude of
finance instructors who have chosen to use the text in their classrooms.
New to the Ninth Edition

Technology is ever present in our lives today, and we are beginning to see its effec-
tive use in education. One form of learning technology that we believe has great
merit today is the lecture video. For all the numbered in-text examples in the Ninth
Edition, we have recorded brief (10- to 15-minute) lecture videos that students can
replay as many times as they need to help them understand more fully each of the
in-text examples. We are confident that many students will enjoy having the authors
“tutoring” them when it comes to the primary examples in the text. The videos can
be found in the eText within MyFinanceLab.
In addition to the innovations of this edition, we have made some chapter-by-
chapter updates in response to the continued development of financial thought,
reviewer comments, and the recent economic crisis. Some of these changes include:
Chapter 1
An Introduction to the Foundations of Financial Management
◆ Revised and updated chapter introduction
◆ Revised and updated discussion of the five principles
Chapter 2
The Financial Markets and Interest Rates
◆ Revised coverage of the term structure of interest rates to address the very low
rates that characterize today’s markets
◆ Simplified, more intuitive discussion on interest rate determinants
◆ Added coverage of the term structure of interest rates into the end-of-chapter
problems
Chapter 3
Understanding Financial Statements and Cash Flows
◆ Uses The Coca-Cola Company, a firm all students are familiar with, to help them
understand financial statements
◆ Expanded coverage of balance sheets, focusing on what can be learned from them
16

Preface 17
◆ More intuitive presentation of cash flows

◆ New explanation of fixed and variable costs as part of presenting an income
statement
◆ Four lecture videos accompany the in-chapter examples.
Chapter 4
Evaluating a Firm’s Financial Performance
◆ Continues the use of The Coca-Cola Company’s financial data to illustrate how
we evaluate a firm’s financial performance, compared to industry norms or a
peer group. In this case, we compare Coca-Cola’s financial performance to that of
PepsiCo, a major competitor.
◆ Provides a new Finance at Work box, based on an example from the soft-drink
industry
◆ Revised presentation of evaluating a company’s liquidity to align more closely
with how business managers talk about liquidity
Chapter 5
The Time Value of Money
◆ Revised to appeal to all students regardless of their level of mathematical skill
◆ New section added on “Making Interest Rates Comparable,” with new end-of-
chapter questions dealing with calculation of the effective annual rate
◆ Additional problems emphasizing complex streams of cash flows
◆ Thirteen lecture videos accompany the in-chapter examples.
Chapter 6
The Meaning and Measurement of Risk and Return
◆ Updated information on the rates of return that investors have earned over the
long term with different types of security investments
◆ Numerous new examples involving companies the students are familiar with are
presented throughout the chapter to illustrate the concepts and applications in
the chapter.
◆ Two lecture videos accompany the in-chapter examples.
Chapter 7
The Valuation and Characteristics of Bonds
◆ A number of new examples involving real-life firms
Chapter 8
The Valuation and Characteristics of Stock
◆ More current explanation of options for getting stock quotes from the Wall Street
Journal
Chapter 9
The Cost of Capital
◆ Five lecture videos correspond to the five major in-chapter examples
◆ End-of-chapter problems revised or replaced by new problem exercises

18 Preface
Chapter 10
Capital-Budgeting Techniques and Practice
◆ Extensively revised chapter introduction, which looks at Disney’s decision to
build the Shanghai Disney Resort
◆ Addition of a new section along with additional discussion of the modified inter-
nal rate of return that not only summarizes the tool, but also provides important
caveats concerning its use
◆ Eight lecture videos accompany the in-chapter e
xamples.
Chapter 11
Cash Flows and Other Topics in Capital Budgeting
◆ Revised introduction examining the difficulties Toyota faced in estimating future
cash flows when it introduced the Prius
◆ New Finance at Work box dealing with Disney World
◆ Problem set revised to include additional coverage of real options
◆ Three lecture videos accompany the in-chapter e
xamples.
Chapter 12
Determining the Financing Mix
◆ Problem set revised to include two new and one revised exercise
Chapter 13
Dividend Policy and Internal Financing
◆ Updated discussion of the tax code for personal tax treatment of dividends and
capital gains
◆ A lecture video accompanies the in-chapter example.
Chapter 14
Short-Term Financial Planning
◆ Two new problems added
Chapter 15
Working-Capital Management
◆ Four new problem exercises added
◆ Five lecture videos accompany the in-chapter e
xamples.
Chapter 16
International Business Finance
◆ Revised extensively to reflect changes in exchange rates and global financial m
arkets
◆ A new section titled “What a Change in the Exchange Rate Means for Business”
deals with the implications of exchange rate changes
◆ Three lecture videos accompany the in-chapter e xamples.
Web Chapter 17
Cash, Receivables, and Inventory Management
◆ Simplified presentation of chapter materials

4 PART 1 • The Scope and Environment of Financial Management
Obviously, some serious practical problems arise when we use changes in the
value of 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 sim-
ply 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 affectPreface
stock prices. 19
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 complexities and
complications of the real-world risk. As we follow this goal throughout our discus-
sions, we must keep in mind one more question: Who exactly are the shareholders?
Pedagogy That Works

The answer: Shareholders are the legal owners of the firm.
Concept Check
In our opinion, the success of this textbook derives from our1. focus What is theon maintaining
goal of the firm?
2. How would you apply this goal in practice?
pedagogy that works. We endeavor to provide students with a conceptual understand-
ing of the financial decision-making
process that includes a survey of the
LO2 Understand the basic Five Principles That Form the Foundations
tools and techniques of finance. For principles of finance,
their importance, and the
of Finance
the student, it is all too easy to lose importance of ethics and trust.
To the first-time student of finance, the subject matter may seem like a collection of
sight of the logic that drives finance unrelated decision rules. This impression could not be further from the truth. In fact,
our decision rules, and the logic that underlies them, spring from five simple princi-
and to focus instead on memoriz- ples that do not require knowledge of finance to understand. These five principles
ing formulas and procedures. As guide the financial manager in the creation of value for the firm’s owners (the stock-
holders).
a result, students have a difficult As you will see, although it is not necessary to understand finance to understand
these principles, it is necessary to understand these principles in order to understand
time understanding the interrela- finance. These principles may at first appear simple or even trivial, but they provide
tionships among the topics covered. the driving force behind all that follows, weaving together the concepts and tech-
niques presented in this text, and thereby allowing us to focus on the logic underly-
Moreover, later in life, when the ing the practice of financial management. Now let’s introduce the five principles.
problems encountered do not match
Principle 1: Cash Flow Is What Matters
principle
the textbook presentation, students 1

You probably recall from your accounting classes that a company’s profits can differ
may find themselves unprepared dramatically 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.
to abstract from what they have Consequently, it is cash flow, not profits, that determines the value of a business. For
learned. We have worked to be “good at the basics.” To achieve this
this reason whengoal,
we analyze wethehave
consequences of a managerial decision, we focus on
the resulting cash flows, not profits.
refined the book over the last eight editions to include the following features.
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
Building on Foundational Finance Principles 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
Chapter 1 presents five foundational principles of finance which are the threads that fact, the movie Harry Potter and the Order of the Phoenix, which grossed almost $1 bil-
bind all the topics of the book. Then throughout the text, we provide reminders of lion worldwide, actually lost $167 million according to the accountants. Was Harry
Potter and the Order of the Phoenix a successful movie? It certainly was—in fact, it was
the foundational principles in “Remember Your Principles” boxes. the 27th highest grossing film of all time. Without question, it produced cash, but it
didn’t make any profits.
The five principles of finance allow us to provide an introduction to financial
decision making rooted in current financial theory and in the current state of world
economic conditions. What results is an introductory treatment of a discipline rather
than the treatment of a series of isolated financial problems that managers encounter.
M01_KEOW3285_09_SE_C01.indd 4 28/11/15 2:53 PM
Use of an Integrated Learning System

The text is organized around the learning objectives that appear at the beginning of
each chapter to provide the instructor and student with an easy-to-use integrated
learning system. Numbered icons identifying each objective appear next to the
related material throughout the text and in the summary, allowing easy location of
material related to each objective.
A Focus on Valuation
Although many professors and instructors make valuation the central theme of their
course, students often lose sight of this focus when reading their text. We reinforce
this focus in the content and organization of our text in some very concrete ways:
◆ We build our discussion around the five finance principles that provide the foun-
dation for the valuation of any investment.
◆ We introduce new topics in the context of “what is the value proposition?” and
“how is the value of the enterprise affected?”
Real-World Opening Vignettes

Each chapter begins with a story about a current, real-world company faced with a
financial decision related to the chapter material that follows. These vignettes have

20 Preface
been carefully prepared to stimulate student interest in the topic to come and can be
used as a lecture tool to provoke class discussion.
• The Financial Markets and Interest Rates 41
A Step-by-Step Approach to Problem Solving
CHAPTER 2
someone for 1 year at a nominal rate of interestand Analysis

of 11.3 percent. This means you will
get back $111.30 in 1 year. But if during the year, the prices of goods and services rise
by 5 percent, it will take $105 at year-end to purchase the same goods and services
As anyone who has taught the core undergraduate finance course knows, students
that $100 purchased at the beginning of the year. What was your increase in purchas-
ing power over the year? The quick and dirty answer is found by subtracting the
demonstrate a wide range of math comprehension and skill. Students who do not
inflation rate from the nominal rate, 11.3% 2 5% 5 6.3%, but this is not exactly cor-
have the math skills needed to master the subject sometimes end up memorizing for-
rect. We can also express the relationship among the nominal interest rate, the rate of
inflation (that is, the inflation premium), and the real rate of interest as follows:
1 1 nominal interest rate 5 (1 1 real rate of mulas rather
interest)(1 1 than focusing
rate of inflation) (2-3) on the analysis of business decisions using math as a tool.
Solving for the nominal rate of interest, We address this problem in terms of both text content and pedagogy.
Nominal interest rate
◆ rate
5 real rate of interest 1 rate of inflation 1 (real First, we present math only as a tool to help us analyze problems, and only when
of interest) (rate of inflation)
necessary. We do not present math for its own sake.
Consequently, the nominal rate of interest is equal to the sum of the real rate of
interest, the inflation rate, and the product of the real rate and the inflation rate. This
relationship among nominal rates, real rates, and◆ Second, finance is an analytical subject and requires that students be able to
therate of inflation has come to be
called the Fisher effect. What does the product of the real rate of interest and the infla-
solve problems. To help with this process, numbered chapter examples appear
tion rate represent? It represents the fact that the money you earn on your investment
throughout the book. All of these examples follow a very detailed and struc-
is worth less because of inflation. All this demonstrates that the observed nominal
rate of interest includes both the real rate and an inflation premium.
tured three-step approach to problem solving that helps students develop their
Substituting into equation (2-3) using a nominal rate of 11.3 percent and an infla-
tion rate of 5 percent, we can calculate the real rate of interest as follows:
problem-solving skills:
Nominal or quoted 5 real rate of interest 1 inflation 1 product of the real rate of
rate of interest
0.113 5 real rate of interest 1
Step
rate
0.05
1: Formulate a Solution Strategy. For example, what is the appropriate for-
interest and the inflation rate
1 0.05 3 real rate of interest
0.063 5 1.05 3 real rate of interest mula to apply? How can a calculator or spreadsheet be used to “crunch the
0.063/1.05 5 real rate of interest numbers”?
Solving for the real rate of interest: Step 2: Crunch the Numbers. Here we provide a completely worked out step-by-
Real rate of interest = 0.06 = 6%
step solution. We present first a description of the solution in prose and then a
Thus, at the new higher prices, your purchasing power will have increased by only 6
percent, although you have $11.30 more than you had at corresponding mathematical
the start of the year. To see why, implementation.
let’s assume that at the outset of the year, one unit ofStep 3: Analyze
the market basket of goods Your
and Results. We end each solution with an analysis of what the
services cost $1, so you could purchase 100 units with your $100. At the end of the year,
you have $11.30 more, but each unit now costs $1.05 solution
(remember themeans. This
5 percent rate of stresses the point that problem solving is about analysis and
inflation). How many units can you buy at the end of the year? The answer is
$111.30 4 $1.05 5 106, which represents a 6 percent increase in real purchasing power.Moreover, in this step we emphasize that decisions are often
decision making. 2
based on incomplete information, which requires the exercise of managerial

Inflation and Real Rates of Return: The Financial
Analyst’s Approach judgment, a fact of life that is often learned on the job.
Although the algebraic methodology presented in the previous section is strictly cor-
rect, few practicing analysts or executives use it. Rather, they employ some version of
CAN YOU DO IT? “Can You Do It?” and

Solving for the Real Rate of Interest “Did You Get It?”
Your banker just called and offered you the chance to invest your savings for 1 year at a quoted rate of 10 percent. You also saw on
42 thePART
news 1 • The
that the inflation
Scope andrate is 6 percent. What
Environment is the real Management
of Financial rate of interest you would be earning if you made the investment? (The
solution can be found on page 42.) The text provides examples for the
students to work at the conclusion
PART 1 • The Scope and Environment
DID YOU GET IT?Management
of Financial
of each major section of a chapter,
2
In Chapter 5, we will study more about the time value of money.
Solving for the Real Rate of Interest which we call “Can You Do It?,” fol-
right thing.” NominalInoraquoted
sense,5 we can
rate of interest
real think
rate of of laws
interest
as a set1 ofinterest
1 inflation
rate
rules
product that
of reflect
the real rate of the values of
and the inflation rate
lowed by “Did You Get It?” later in
a society as a 0.10 whole. 5 real rate of interest 1 0.06 1 0.06 3 real rate of interest the chapter. This tool provides an
You might0.04 ask yourself,5 1.06 “As
3 real long as I’m not breaking society’s laws, why should I
M02_KEOW3285_09_SE_C02.indd 41
rate of interest
care about ethics?” The answer to this question lies in consequences. Everyone makes 28/11/15 essential ingredient in the building-
2:54 PM
Solving for the real rate of interest:

errors of judgment in business, which is to be expected in an uncertain world. But ethi- block approach to the material that
Real rate of interest 5 0.0377 5 3.77%
cal errors are different. Even if they don’t result in anyone going to jail, they tend to end we use.
careers and thereby terminate future opportunities. Why? Because unethical behavior
destroys trust, and businesses cannot
the following function
relationship without
(which comesa from
certain degree
equation of an
(2-2)), trust.
approximation
method, to estimate the real rate of interest over a selected past time frame.
Concept Check
Nominal interest rate 2 inflation rate > real interest rate Concept Check
The concept is straightforward, but its implementation requires that several judg-
ments be made. For example, suppose we want to use their
this relationship
money? to determine
1. According to Principle 3, how do investors decide where to invest
the real risk-free interest rate. Which interest rate series and maturity period should At the end of major chapter sections
2. What is an efficient market?
be used? Suppose we settle for using some U.S. Treasury security as a surrogate for a we include a brief list of questions
3. What is the agency problem, and whyinterest
nominal risk-free does itrate.
occur?
Then, should we use the yield on 3-month U.S.
Treasury
4. Why are ethics and trust bills or, perhaps,
important the yield on 30-year Treasury bonds? There is no absolute
in business? that are designed to highlight key
answer to the question.
So, we can have a real risk-free short-term interest rate, as well as a real risk-free ideas presented in the section.
long-term interest rate, and several variations in between. In essence, it just depends
on what the analyst wants to accomplish. Of course we could also calculate the real
The Role of Finance in Business

rate of interest on some rating class of 30-year corporate bonds (such as Aaa-rated
bonds) and have a risky real rate of interest as opposed to a real risk-free interest rate.
3 Describe the role of Furthermore, the choice of a proper inflation index is equally challenging. Again,
finance in business. Finance is the study ofwehow havepeople
several choices. We could use the
and businesses consumerinvestments
evaluate price index, the and
producer price
raise
index for finished goods, or some price index out of the national income accounts,
capital to fund them. Our suchinterpretation of an
as the gross domestic investment
product chain priceisindex.
quite broad.
Again, thereWhen Apple
is no precise scien-
designed its Apple Watch, it was
tific answer clearly
as to making
which specific priceaindex
long-term investment.
to use. Logic and consistencyThedofirm
narrow
had to devote considerable the boundaries
expenses of theto
ultimate choice. producing, and marketing the
designing,
Let’s tackle a very basic (simple) example. Suppose that an analyst wants to esti-
device with the hope that mate it thewould
approximateeventually become
real interest indispensable
rate on (1) 3-month Treasury tobills,
everyone.
(2) 30-year
Similarly, Apple is making Treasury anbonds,
investment decision
and (3) 30-year whenever
Aaa-rated corporate bondsit hires a fresh
over the new
1990–2014 time
frame. Furthermore, the annual rate of change
graduate, knowing that it will be paying a salary for at least 6 months before the in the consumer price index (mea-
sured from December to December) is considered a logical measure of past inflation
employee will have much to contribute.
experience. Most of our work is already done for us in Table 2-2. Some of the data
Thus, the study of finance
from Table addresses threehere.
2-2 are displayed basic types of issues:
STEP 3: Analyze Your Results
Pre
30 Disney’s higher return on equity is due to the firm having a higher operating return
on assets (13.54 percent for Coca-Cola versus 7.50 percent for the industry) and using
20 more debt financing (46.6 percent debt ratio for Disney, compared to 34.21 percent
for the industry).
10
0
2 4 6 8 10 12 14Concept
16 Check
18 20 Preface 21
Number of years 1. How is a company’s return on equity related to the firm’s operating return on assets?
2. How is a company’s return on equity related to the firm’s debt ratio?
3. What is the upside of debt financing? What is the downside?
Financial Decision Tools

EXAMPLE 5.4
A feature that has proven popular with students FI NANCI AL D E CI S I ON TOOLS
Calculating the
has been Discounted
our recapping ofValue to Be Received
key equations shortly in 10
Name Years
of Tool
MyFinanceLab
Formula
Video
What It Tells You
What isafter their discussion.
the present Students
value of $500 to beget to see an
received equa- from today if our discountnet income
10 years Measures the shareholders’ accounting return on
Return on equity
rate is 6tion within the context of related equations.
percent? total common equity their investment.
STEP 1: Formulate a Solution Strategy

Financial
The present value to beCalculators
received can be calculated using equation (5-2) as follows:
CALCULATOR SOLUTION
and Excel Spreadsheets
1 M04_KEOW3285_09_SE_C04.indd 130
Data Input Function Key 02/12/15 2:00 PM
Present value = FVn c d (5-2)

+ r)n
(1 calculators
The use of financial and Excel spreadsheets has been integrated 10 N
throughout the text, especially with respect to presentation of the time 6 I/Y
STEP 2:value
Crunch the Numbers
of money and valuation. Where appropriate, actual calculator and - 500 FV
Substituting FV = $500,
spreadsheet n = appear
solutions r =
10, and in the6 text.
percent into equation (5-2), we find: 0 PMT
1 Function Key Answer

Present value = $500 c d
(1 + 0.06)10 466
CPT
Part 4 • Capital Structure and Dividend Policy
= $500(0.5584) PV 279.20
Chapter Summaries That Bring Together Con-
= $279.20 12-9. (EBIT-EPS analysis) A group of retired college professors has decided to form
cepts, Terminology, and Applications a small manufacturing corporation. The company will produce a full line of tradi-
tional office furniture. The investors have proposed two financing plans. Plan A is an
all-common-equity alternative. Under this agreement, 1 million common shares will
STEP 3: Analyze Your Results be sold to net the firm $20 per share. Plan B involves the use of financial leverage.
The chapter summaries have been written in a way that connects A debt issue them to the
with a 20-year in-period will be privately placed. The debt issue
maturity
Thus, the present value of the $500 to be received in 10 years is $279.20.
chapter sections and learning objectives. For each learning objective,
will carry anthe student
interest rate of 10 sees
percent, and the principal borrowed will amount to
$6 million. The marginal corporate tax rate is 50 percent.
in one place the concepts, new terminology, and key equationsa.that were
Find the presented
EBIT indifference level associated with the two financing proposals.
in the objective. b. Prepare a pro forma income statement that proves EPS will be the same re-
gardless of the plan chosen at the EBIT level found in part (a).
c. Prepare an EBIT-EPS analysis chart for this situation.
EXAMPLE 5.5 d. If a detailed financial analysis projects that long-term EBIT will always be close
Revised Study Problems to $2.4 million annually, which plan will provide for the higher EPS?
Calculating the Present Value of a Savings Bond 12-10. (Assessing leverage use) Financial data for three corporations are displayed here.
MyFinanceLab Video
With each edition, we have provided new and revised end-of-chapter study prob-FIRM B
You’re on
lemsvacation in a their
to refresh ratherusefulness
remote part of Floridafinance.
in teaching and seeAlso,
an advertisement
MEASURE
theDebtstudy
ratio
stat-
problems
FIRM A
20% con-25%
FIRM C
40%
INDUSTRY NORM
20%
ing thattinue
if youtotake a sales tour
be organized of some to
according condominiums “youso
learning objective will beboth
that given
Times the
interest $100 just
instructor
earned 8 times and 10 times 7 times 9 times
for taking the tour.”

student However,
can readily alignthe $100
text that
and you get
problem is in the form of aPrice/earnings
materials. savings ratio bond 9 times 11 times 6 times 10 times
that will not pay you the $100 for 10 years. What is the present value a.ofWhich $100 firmto be to be excessively leveraged?
appears
received 10 years from today if your discount rate is 6 percent? b. Which firm appears to be employing financial leverage to the most appropri-
Comprehensive Mini Cases ate degree?
c. What explanation can you provide for the higher price/earnings ratio enjoyed
by firm B as compared with firm A?
A comprehensive Mini Case appears at the end of almost
every chapter, covering all the major topics included in Mini Cases
that chapter. Each Mini Case can be used as a lecture or These Mini Cases are available in MyFinanceLab.
review tool by the professor. For the students, the Mini 1. Imagine that you were a new CFO of Beily Inc., a children’s bicycle manufacturer.
Case 165
M05_KEOW3285_09_SE_C05.indd provides an opportunity to apply all the concepts The president, Mr. Zhao, started the business 2 years ago. The firm manufactures two 2:11 PM
02/12/15
types of products, bicycles for girls and bicycles for boys. However, the two products
presented within the chapter in a realistic setting, thereby have the same prices and costs structures, the only differences are the colors and
designs. Recently, the president has started to focus more on the financial aspects
strengthening their understanding of the material. of managing the business. Mr. Zhao has set up a meeting for next week with you, to
discuss matters such as the business and financial risks faced by the company.
Accordingly, you are asked to prepare an analysis to assist his future manage-
ment decisions. As a first step in the work, you are provided the following informa-
tion regarding the company according to the past financial data:
Output level 25,000 units

Operating assets RMB 2,000,000
Operating asset turnover 5 times
Return on operating assets 45%
Degree of operating leverage 5 times
Interest expense RMB 300,000
Tax rate 25%
As the next step, you are required to determine the break-even point in units of
output for the company and report the result to Mr. Zhao. You are going to prepare
an analytical income statement for the company. This statement will also be useful
M12_KEOW5135_09_GE_C12.indd 466 06/05/16 5:49 PM

22 Preface
A Complete Support Package for the

Student and Instructor
MyFinanceLab
This fully integrated online homework system gives students the hands-on prac-
tice and tutorial help they need to learn finance efficiently. Ample opportunities for
online practice and assessment in MyFinanceLab are seamlessly integrated into each
chapter. For more details, see the inside front cover.
Instructor’s Resource Center

This password-protected site, accessible at http://www.pearsonglobaleditions.com/
Keown, hosts all of the instructor resources that follow. Instructors should click on
the “IRC Help Center” link for easy-to-follow instructions on getting access or may
contact their sales representative for further information.
Test Bank
This online Test Bank, prepared by Rodrigo Hernandez of Radford University, pro-
vides more than 1,600 multiple-choice, true/false, and short-answer questions with
complete and detailed answers. The online Test Bank is designed for use with the
TestGen-EQ test-generating software. This computerized package allows instruc-
tors to custom design, save, and generate classroom tests. The test program permits
instructors to edit, add, or delete questions from the Test Bank; analyze test results;
and organize a database of tests and student results. This software allows for greater
flexibility and ease of use. It provides many options for organizing and displaying
tests, along with a search and sort feature.
Instructor’s Manual with Solutions

Written by the authors and updated by Mary Schranz, the Instructor’s Manual
follows the textbook’s organization and represents a continued effort to serve the
teacher’s goal of being effective in the classroom. Each chapter contains a chapter
orientation, answers to end-of-chapter review questions, and solutions to end-of-
chapter study problems.
The Instructor’s Manual is available electronically, and instructors can download
it from the Instructor’s Resource Center by visiting http://www.pearsonglobaleditions
.com/Keown.
The PowerPoint Lecture Presentation

This lecture presentation tool, prepared by Sonya Britt of Kansas State University,
provides the instructor with individual lecture outlines to accompany the text. The
slides include many of the figures and tables from the text. These lecture notes can
be used as is, or instructors can easily modify them to reflect specific presentation
needs.
Excel Spreadsheets
Created by the authors, these spreadsheets correspond to end-of-chapter problems
from the text. This student resource is available on MyFinanceLab.

Preface 23
Acknowledgments
We gratefully acknowledge the assistance, support, and encouragement of those indi-
viduals who have contributed to Foundations of Finance. Specifically, we wish to rec-
ognize the very helpful insights provided by many of our colleagues. For this edition,
we are especially grateful to Mary Schranz, formerly of the University of Wisconsin,
Madison, who performed an incredibly detailed accuracy review. We are also
indebted to many other professionals for their careful reviews and helpful comments:
Haseeb Ahmed, Johnson C. Smith Dr. Charles Gahala, Benedictine
University University
Joan Anderssen, Arapahoe Harry Gallatin, Indiana State
Community College University
Chris Armstrong, Draughons Junior Deborah Giarusso, University of
College Northern Iowa
Curtis Bacon, Southern Oregon Gregory Goussak, University of
University Nevada, Las Vegas
Deb Bauer, University of Oregon Lori Grady, Bucks County
Pat Bernson, County College of Community College
Morris Ed Graham, University of North
Ed Boyer, Temple University Carolina, Wilmington
Joe Brocato, Tarleton State Barry Greenberg, Webster
University University
Joseph Brum, Fayetteville Technical Gary Greer, University of Houston
Community College Downtown
Lawrence Byerly, Thomas More Indra Guertler, Simmons College
College Bruce Hadburg, University of Tampa
Juan R. Castro, LeTourneau Thomas Hiebert, University of
University North Carolina, Charlotte
Janice Caudill, Auburn University Marlin Jensen, Auburn University
Ting-Heng Chu, East Tennessee John Kachurick, Misericordia
State University University
David Daglio, Newbury College Okan Kavuncu, University of
Julie Dahlquist, University of Texas California at Santa Cruz
at San Antonio Gary Kayakachoian, The University
David Darst, Central Ohio Technical of Rhode Island
College David F. Kern, Arkansas State
Maria de Boyrie, New Mexico State University
University Brian Kluger, University of
Kate Demarest, Carroll Community Cincinnati
College Lynn Phillips Kugele, University of
Khaled Elkhal, University of Mississippi
Southern Indiana Mary LaPann, Adirondack
Cheri Etling, University of Tampa Community College
Robert W. Everett, Lock Haven Carlos Liard-Muriente, Central
University Connecticut State University
Cheryl Fetterman, Cape Fear Christopher Liberty, College of Saint
Community College Rose, Empire State College
David R. Fewings, Western Lynda Livingston, University of
Washington University Puget Sound

24 Preface
Y. Lal Mahajan, Monmouth Ahmad Salam, Widener University

University Mary Schranz, University of
Edmund Mantell, Pace University Wisconsin, Madison (retired)
Peter Marks, Rhode Island College Jeffrey Schultz, Christian Brothers
Mario Mastrandrea, Cleveland University
State University Thomas W. Secrest, Coastal
Anna McAleer, Arcadia University Carolina University
Robert Meyer, Parkland College Ken Shakoori, California State
University, Bakersfield
Ronald Moy, St. John’s University
Michael Slates, Bowling Green
Elisa Muresan, Long Island
State University
University
Suresh Srivastava, University of
Michael Nugent, Stony Brook
Alaska, Anchorage
University
Maurry Tamarkin, Clark University
Tony Plath, University of North
Carolina at Charlotte Fang Wang, West Virginia
University
Anthony Pondillo, Siena College
Paul Warrick, Westwood College
Walter Purvis, Coastal Carolina
Community College Jill Wetmore, Saginaw Valley State
University
Emil Radosevich, Central New
Mexico Community College Kevin Yost, Auburn University
Deana Ray, Forsyth Technical Jingxue Yuan, Texas Tech
Community College University
Clarence Rose, Radford University Mengxin Zhao, Bentley College
We also thank our friends at Pearson. They are a great group of folks. We offer
our personal expression of appreciation to Vice President of Business Publishing
Donna Battista, who provided the leadership and direction to this project. She is the
best, and she settles for nothing less than perfection—thanks, Donna. We would also
like to thank Kate Fernandes, our finance editor. Kate is full of energy and drive
with amazing insights and intuition about what makes a great book. Additionally,
Kathryn Dinovo, our program manager, helped us develop new technology—videos
and animations—for this edition. We would also like to thank Meredith Gertz, our
project manager, who guided us through the writing and production processes.
Meredith kept us on schedule while maintaining extremely high quality. Our thanks
also go to Heidi Allgair of Cenveo Publisher Services, who served as the project man-
ager and did a superb job. Even more, she was fun to work with, always keeping us
on task. Miguel Leonarte, who worked on MyFinanceLab, also deserves a word of
thanks for making MyFinanceLab flow so seamlessly with the book. He has contin-
ued to refine and improve MyFinanceLab, and as a result of his efforts, it has become
a learning tool without equal. We also thank Melissa Honig, our media producer,
who did a great job of making sure we are on the cutting edge in terms of Web appli-
cations and offerings.
As a final word, we express our sincere thanks to those who are using Foundations
of Finance in the classroom. We thank you for making us a part of your teaching–
learning team. Please feel free to contact any member of the author team should you
have questions or needs.
—A.J.K. / J.D.M. / J.W.P.

Preface 25
Global Edition Acknowledgments

We gratefully acknowledge the contributions of those individuals who worked with
us on the Foundations of Finance, Global Edition. We are also indebted to many
other professionals for their careful reviews and helpful comments:
Contributors Reviewers
Nino Davitaya, University of Georgia Pauline Ho Hoi Yin, The Hong Kong
Hisham Farag, University of Polytechnic University
Birmingham Ravindran Raman, Wawasan Open
Katharina Fellnhofer, Lappeenranta University
University of Technology Manolis Noikokyris, Kingston University
Catherine Lions, Umea School of Rezart Erindi, Chartered Financial
Business and Economics Analysts
Biljana Pesalj, Rotterdam University of Andrejs Cirjevskis, Riga International
Applied Sciences School of Economics and Business
Jon Snorri Snorrason, Bifröst University Administration

An Introduction to
1
CHAPTER
the Foundations of
Financial Management
Learning Objectives
LO1 Identify the goal of the firm. The Goal of the Firm
LO2 Understand the basic principles of finance, Five Principles That Form the
their importance, and the importance of ethics Foundations of Finance
and trust.
LO3 Describe the role of finance in business. The Role of Finance in Business
LO4 Distinguish among the different legal forms The Legal Forms of Business
of business organization. Organization
LO5 Explain what has led to the era of the multi Finance and the Multinational
national corporation. Firm: The New Role
A
pple 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, 18 years later, in 2015, the price of Apple’s common stock
climbed by 225-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 among 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, the 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 begin-
ning 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
26
M01_KEOW5135_09_GE_C01.indd 26 02/05/16 2:29 PM

been a huge success, particularly among
women. How successful 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 consum-
ers want—the iPhone. With this in mind,
in October 2014, Apple unveiled its
iPhone 6 and 6 Plus, selling over 10 mil-
lion phones in the first week. In effect,
Apple seems to have a never-ending sup-
ply of new, exciting products that we all
want. Then in April 2015, Apple introduced the Apple Watch, and it is now consider-
ing introducing an Apple Car by 2020.
How did Apple make the decision to introduce the original iPod and now the
iPad? The answer is by identifying a customer need, combined with sound financial
management. Financial management deals with the maintenance and creation of
economic value or wealth by focusing on decision making with an eye toward creat-
ing wealth. This text deals with financial decisions such as when to introduce a new
product, when to invest in new assets, when to replace existing assets, when to bor-
row 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 financial man-
agement were factors in Apple’s decision to introduce and continuously improve the
iPod, 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 LO1 Identify the goal of the

firm.
The fundamental goal of a business is to create value for the company’s owners (i.e.,
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 sharehold-
ers 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 deci-
sions 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 pushing up the price of the stock. In effect, under this goal,
good decisions are those that create wealth for the shareholder.
27
M01_KEOW5135_09_GE_C01.indd 27 02/05/16 2:29 PM

28 Part 1 • The Scope and Environment of Financial Management
Obviously, some serious practical problems arise when we use changes in the
value of 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 sim-
ply 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 complexities and
complications of the real-world risk. As we follow this goal throughout our discus-
sions, 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?
LO2 Understand the basic

principles of finance,
Five Principles That Form the Foundations
their importance, and the
importance of ethics and trust.
of Finance
To the first-time student of finance, the subject matter may seem like a collection of
unrelated decision rules. This impression could not be further from the truth. In fact,
our decision rules, and the logic that underlies them, spring from five simple princi-
ples 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 stock-
holders).
As you will see, although it is not necessary to understand finance to understand
these principles, it is necessary to understand these principles in order to understand
finance. These principles may at first appear simple or even trivial, but they provide
the driving force behind all that follows, weaving together the concepts and tech-
niques presented in this text, and thereby allowing us to focus on the logic underly-
ing the practice of financial management. Now let’s introduce the five principles.
principle
Principle 1: Cash Flow Is What Matters
1
You probably recall from your accounting classes that a company’s profits can differ
dramatically 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 bil-
lion worldwide, actually lost $167 million according to the accountants. Was Harry
Potter and the Order of the Phoenix a successful movie? It certainly was—in fact, it was
the 27th highest grossing film of all time. Without question, it produced cash, but it
didn’t make any profits.
M01_KEOW5135_09_GE_C01.indd 28 02/05/16 2:29 PM

CHAPTER 1 • An Introduction to the Foundations of Financial Management 29
We need to make another important point about cash flows. Recall from your
economics classes that we should always look at marginal, or incremental, cash incremental cash flow the difference
flows when making a financial decision. The incremental cash flow to the company between the cash flows a company will
produce both with and without the
as a whole is the difference between the cash flows the company will produce both with and investment it is thinking about making.
without the investment it’s thinking about making. To understand this concept, let’s think
about the incremental cash flows of the movie Frozen. Not only did Disney make
money on this movie, but it also made an awful lot of money on merchandise from
the movie. While Anna and Elsa pulled in an incredible $1.3 billion at the box office,
sales of Frozen toys, clothing, and games along with the soundtrack brought in about
that same amount. With a Broadway version under development and the possibility
of a sequel under way, Disney is going to be singing “Let It Go” all the way to the
bank.
Principle 2: Money Has a Time Value principle
2
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 1 year
from now because we can invest the dollar we have today to earn interest so that at
the end of 1 year we will have more than one dollar.
For example, suppose you have a choice of receiving $1,000 either today or 1 year
from now. If you decide to receive it a year from now, you will have passed up the
opportunity to earn a year’s interest on the money. Economists would say you suf-
fered an “opportunity loss” or an “opportunity cost.” The cost is the interest you
could have earned on the $1,000 if you had invested it for 1 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 opportunity cost the cost of Â�making
had to give up when you made the choice. So if you loan money to your brother at no a choice in terms of the next best
Â�alternative that must be foregone.
interest, money that otherwise would have been loaned to a friend (who is equally
likely to repay you) for 8 percent interest, 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 principle
3
Even the novice investor knows there are an unlimited number of investment alter-
natives 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.â•‡ 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.â•‡ 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 per-
form, 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.
M01_KEOW5135_09_GE_C01.indd 29 06/05/16 2:34 PM

Figure 1-1 The Risk–Return Trade-off
Expected return
Additional
expected return
for taking on
added risk
Expected return
for delaying
consumption
Risk
Figure 1-1 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 Apple (AAPL) or investing in a new biotech 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 Apple.
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 Vascular Biogenics
(VBLT), an Israeli-based clinical-stage biopharmaceutical company, on February 19,
2015. Why? Because on that day the company reported that Phase 2 trials of one of its
drugs aimed at psoriasis and ulcerative colitis failed to meet its primary endpoints.
The result was that, within minutes of the announcement, the company’s stock price
dropped by a whopping 65 percent.
The risk–return relationship will be a key concept as we value stocks, bonds, and
proposed new investment projects throughout this text. We will also spend some
time determining how to measure risk. Interestingly, much of the work for which the
1990 Nobel Prize for economics was awarded centered on the relationship depicted
in 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
Principle 4: Market Prices Are Generally Right
4
To understand how securities such as bonds and stocks are valued or priced in the
financial markets, it is necessary to understand the concept of an efficient market. An
efficient market a market in which efficient market is one in which the prices of the assets traded in that market fully reflect
the prices of securities at any instant in all available information at any instant in time.
time fully reflect all publicly available
information about the securities and Security markets such as the stock and bond markets are particularly important
their actual public values. to our study of finance because 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 Exchange (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
M01_KEOW5135_09_GE_C01.indd 30 02/05/16 2:29 PM

Chapter 1 • An Introduction to the Foundations of Financial Management 31
(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) was on a roll, mak-
ing one hit after another, including Monsters, Inc., Finding Nemo, the Pirates of the
Caribbean series, The Incredibles, the Ironman series, and Frozen. In spite of all this suc-
cess, in 2014, the hopes for Guardians of the Galaxy, based on a relatively unknown
Marvel comic book series starring a tree and a talking raccoon among other charac-
ters, weren’t very high. However, the movie’s opening weekend receipts were amaz-
ing: While it was projected to gross less than $70 million worldwide, it actually
grossed over $160 million and became the top grossing movie of 2014. How did the
stock market respond to the unexpected box office reaction during the movie’s open-
ing weekend? On the Monday following the opening weekend, Disney stock opened
over 2 percent higher. Apparently, the news of the surprisingly strong box office
receipts was reflected in Disney’s opening stock price, even before it traded! The
same speed in the market reaction to new information also happened on February
25, 2015, when it was learned that 60 Minutes would air a potentially damaging story
on Lumber Liquidators later that week. As a result, Lumber Liquidators’ stock price
dropped by 25 percent even before anyone knew what the story was going to be
about—in effect, it dropped before the news. After the 60 Minutes report that out-
lined health and safety concerns with its laminated flooring actually aired on Sunday
evening, Lumber Liquidators opened another 25 percent down.
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. On the
one hand, 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 eco-
nomic 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 understand 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 overconfident and many times mistake luck for skill. 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. Because they have confidence in their
valuation estimates, they may take on more risk than they should. These behavioral
biases impact everything in finance, ranging from making investment analyses to
analyzing new projects to forecasting the future.
1
See Robert J. Shiller, Irrational Exuberance (New York: Broadway Books, 2000), p. 166.
M01_KEOW5135_09_GE_C01.indd 31 02/05/16 2:29 PM

principle
Principle 5: Conflicts of Interest Cause Agency Problems
5
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 decisions. 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 between what is best for the managers and what is best for the
stockholders. For example, shutting down an unprofitable plant may be 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.
agency problem problems and Conflicts of interest lead to what economists describe as an agency cost or
conflicts resulting from the separation agency problem. That is, managers are the agents of the firm’s stockholders (the
of the management and ownership of
the firm. 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 implementation of this goal. The
agency problem results from the separation of the management and 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 between decision mak-
ers 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 fail-
ure. Why is this so? Because if the project isn’t successful, these agents of the share-
holders may lose their jobs.
Agency problems also contributed to our recent financial crisis, with some mort-
gage brokers being paid to find borrowers. The brokers would then make the loan
and sell the mortgage to someone else. Because they didn’t hold the mortgage but
only created it, they didn’t care about the quality of the mortgage. In effect, they
wrote mortgages when the borrower had a low chance of being able to pay off the
mortgage because they got paid per mortgage and then sold the mortgage to some-
one else almost immediately. There was no incentive to screen for the quality of the
borrower, and as a result both the borrower who was misled into thinking he could
afford the mortgage and the holder of the mortgage were hurt.
The costs associated with the agency problem are difficult to measure, but occa-
sionally we see the problem’s effect in the marketplace. If the market feels manage-
ment is damaging shareholder wealth, removal of that management may cause a
positive reaction in stock price. 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; in the case of Farmer Brothers, however, 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 fre-
quently works the other way around. Management selects the board of director
nominees and then distributes the ballots. In effect, shareholders are generally
offered a slate of nominees selected by the management. The end result is that man-
agement effectively selects the directors, who then may have more allegiance to
managers than to shareholders. This, in turn, sets up the potential for agency prob-
lems, with the board of directors not monitoring managers on behalf of the share-
holders as it should.
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Chapter 1 • An Introduction to the Foundations of Financial Management 33
The root cause of agency problems is conflict of interest. Whenever such conflicts
exist in business, individuals may do what is in their own rather than the organiza-
tion’s best interests. 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’s contract included incentive pay-
ments associated 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 the meth-
ods used to align their interests with those of shareholders. As an example, managers
can be monitored by rating agencies and by auditing financial statements, and com-
pensation packages may be used to align the interests of managers and shareholders.
Additionally, the interests of managers and shareholders can be aligned by establish-
ing management stock options, bonuses, and perquisites that are directly tied to how
closely managers’ decisions coincide with the interests 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 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, many Americans still feel the lingering effects of the
financial crisis from lost wages resulting from high unemployment, along with a dra-
matic rise in our country’s debt. Europe also faced a financial crisis of its own. Many
members of the European Union (EU) experienced severe budget problems, includ-
ing Greece, Italy, Ireland, Portugal, and Spain. These nations have all had problems
balancing their budgets and repaying their government loans.
Although 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 resulting 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 portfo-
lios and resold to investors around the world. This process of packaging mortgages
is called securitization. Basically, securitization is a very useful tool for increasing the
supply of new money that can be lent to new homebuyers. Here’s how mortgages
are securitized: First, homebuyers borrow money by taking out a mortgage to
finance a home purchase. The lender, generally a bank, savings and loan, or mort-
gage broker that made the loan, then sells the mortgage 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 invest-
ment 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 liquid-
ity to the mortgage market and makes it possible for banks to loan more money to
homebuyers.
Okay, 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
M01_KEOW5135_09_GE_C01.indd 33 02/05/16 2:29 PM

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DANCE ON STILTS AT THE GIRLS’ UNYAGO, NIUCHI
Newala, too, suffers from the distance of its water-supply—at least

the Newala of to-day does; there was once another Newala in a lovely
valley at the foot of the plateau. I visited it and found scarcely a trace
of houses, only a Christian cemetery, with the graves of several
missionaries and their converts, remaining as a monument of its
former glories. But the surroundings are wonderfully beautiful. A
thick grove of splendid mango-trees closes in the weather-worn
crosses and headstones; behind them, combining the useful and the
agreeable, is a whole plantation of lemon-trees covered with ripe
fruit; not the small African kind, but a much larger and also juicier
imported variety, which drops into the hands of the passing traveller,
without calling for any exertion on his part. Old Newala is now under
the jurisdiction of the native pastor, Daudi, at Chingulungulu, who,
as I am on very friendly terms with him, allows me, as a matter of
course, the use of this lemon-grove during my stay at Newala.
FEET MUTILATED BY THE RAVAGES OF THE “JIGGER”
(Sarcopsylla penetrans)
The water-supply of New Newala is in the bottom of the valley,

some 1,600 feet lower down. The way is not only long and fatiguing,
but the water, when we get it, is thoroughly bad. We are suffering not
only from this, but from the fact that the arrangements at Newala are
nothing short of luxurious. We have a separate kitchen—a hut built
against the boma palisade on the right of the baraza, the interior of
which is not visible from our usual position. Our two cooks were not
long in finding this out, and they consequently do—or rather neglect
to do—what they please. In any case they do not seem to be very
particular about the boiling of our drinking-water—at least I can
attribute to no other cause certain attacks of a dysenteric nature,
from which both Knudsen and I have suffered for some time. If a
man like Omari has to be left unwatched for a moment, he is capable
of anything. Besides this complaint, we are inconvenienced by the
state of our nails, which have become as hard as glass, and crack on
the slightest provocation, and I have the additional infliction of
pimples all over me. As if all this were not enough, we have also, for
the last week been waging war against the jigger, who has found his
Eldorado in the hot sand of the Makonde plateau. Our men are seen
all day long—whenever their chronic colds and the dysentery likewise
raging among them permit—occupied in removing this scourge of
Africa from their feet and trying to prevent the disastrous
consequences of its presence. It is quite common to see natives of
this place with one or two toes missing; many have lost all their toes,
or even the whole front part of the foot, so that a well-formed leg
ends in a shapeless stump. These ravages are caused by the female of
Sarcopsylla penetrans, which bores its way under the skin and there
develops an egg-sac the size of a pea. In all books on the subject, it is
stated that one’s attention is called to the presence of this parasite by
an intolerable itching. This agrees very well with my experience, so
far as the softer parts of the sole, the spaces between and under the
toes, and the side of the foot are concerned, but if the creature
penetrates through the harder parts of the heel or ball of the foot, it
may escape even the most careful search till it has reached maturity.
Then there is no time to be lost, if the horrible ulceration, of which
we see cases by the dozen every day, is to be prevented. It is much
easier, by the way, to discover the insect on the white skin of a
European than on that of a native, on which the dark speck scarcely
shows. The four or five jiggers which, in spite of the fact that I
constantly wore high laced boots, chose my feet to settle in, were
taken out for me by the all-accomplished Knudsen, after which I
thought it advisable to wash out the cavities with corrosive
sublimate. The natives have a different sort of disinfectant—they fill
the hole with scraped roots. In a tiny Makua village on the slope of
the plateau south of Newala, we saw an old woman who had filled all
the spaces under her toe-nails with powdered roots by way of
prophylactic treatment. What will be the result, if any, who can say?
The rest of the many trifling ills which trouble our existence are
really more comic than serious. In the absence of anything else to
smoke, Knudsen and I at last opened a box of cigars procured from
the Indian store-keeper at Lindi, and tried them, with the most
distressing results. Whether they contain opium or some other
narcotic, neither of us can say, but after the tenth puff we were both
“off,” three-quarters stupefied and unspeakably wretched. Slowly we
recovered—and what happened next? Half-an-hour later we were
once more smoking these poisonous concoctions—so insatiable is the
craving for tobacco in the tropics.
Even my present attacks of fever scarcely deserve to be taken
seriously. I have had no less than three here at Newala, all of which
have run their course in an incredibly short time. In the early
afternoon, I am busy with my old natives, asking questions and
making notes. The strong midday coffee has stimulated my spirits to
an extraordinary degree, the brain is active and vigorous, and work
progresses rapidly, while a pleasant warmth pervades the whole
body. Suddenly this gives place to a violent chill, forcing me to put on
my overcoat, though it is only half-past three and the afternoon sun
is at its hottest. Now the brain no longer works with such acuteness
and logical precision; more especially does it fail me in trying to
establish the syntax of the difficult Makua language on which I have
ventured, as if I had not enough to do without it. Under the
circumstances it seems advisable to take my temperature, and I do
so, to save trouble, without leaving my seat, and while going on with
my work. On examination, I find it to be 101·48°. My tutors are
abruptly dismissed and my bed set up in the baraza; a few minutes
later I am in it and treating myself internally with hot water and
lemon-juice.
Three hours later, the thermometer marks nearly 104°, and I make
them carry me back into the tent, bed and all, as I am now perspiring
heavily, and exposure to the cold wind just beginning to blow might
mean a fatal chill. I lie still for a little while, and then find, to my
great relief, that the temperature is not rising, but rather falling. This
is about 7.30 p.m. At 8 p.m. I find, to my unbounded astonishment,
that it has fallen below 98·6°, and I feel perfectly well. I read for an
hour or two, and could very well enjoy a smoke, if I had the
wherewithal—Indian cigars being out of the question.
Having no medical training, I am at a loss to account for this state
of things. It is impossible that these transitory attacks of high fever
should be malarial; it seems more probable that they are due to a
kind of sunstroke. On consulting my note-book, I become more and
more inclined to think this is the case, for these attacks regularly
follow extreme fatigue and long exposure to strong sunshine. They at
least have the advantage of being only short interruptions to my
work, as on the following morning I am always quite fresh and fit.
My treasure of a cook is suffering from an enormous hydrocele which
makes it difficult for him to get up, and Moritz is obliged to keep in
the dark on account of his inflamed eyes. Knudsen’s cook, a raw boy
from somewhere in the bush, knows still less of cooking than Omari;
consequently Nils Knudsen himself has been promoted to the vacant
post. Finding that we had come to the end of our supplies, he began
by sending to Chingulungulu for the four sucking-pigs which we had
bought from Matola and temporarily left in his charge; and when
they came up, neatly packed in a large crate, he callously slaughtered
the biggest of them. The first joint we were thoughtless enough to
entrust for roasting to Knudsen’s mshenzi cook, and it was
consequently uneatable; but we made the rest of the animal into a
jelly which we ate with great relish after weeks of underfeeding,
consuming incredible helpings of it at both midday and evening
meals. The only drawback is a certain want of variety in the tinned
vegetables. Dr. Jäger, to whom the Geographical Commission
entrusted the provisioning of the expeditions—mine as well as his
own—because he had more time on his hands than the rest of us,
seems to have laid in a huge stock of Teltow turnips,[46] an article of
food which is all very well for occasional use, but which quickly palls
when set before one every day; and we seem to have no other tins
left. There is no help for it—we must put up with the turnips; but I
am certain that, once I am home again, I shall not touch them for ten
years to come.
Amid all these minor evils, which, after all, go to make up the
genuine flavour of Africa, there is at least one cheering touch:
Knudsen has, with the dexterity of a skilled mechanic, repaired my 9
× 12 cm. camera, at least so far that I can use it with a little care.
How, in the absence of finger-nails, he was able to accomplish such a
ticklish piece of work, having no tool but a clumsy screw-driver for
taking to pieces and putting together again the complicated
mechanism of the instantaneous shutter, is still a mystery to me; but
he did it successfully. The loss of his finger-nails shows him in a light
contrasting curiously enough with the intelligence evinced by the
above operation; though, after all, it is scarcely surprising after his
ten years’ residence in the bush. One day, at Lindi, he had occasion
to wash a dog, which must have been in need of very thorough
cleansing, for the bottle handed to our friend for the purpose had an
extremely strong smell. Having performed his task in the most
conscientious manner, he perceived with some surprise that the dog
did not appear much the better for it, and was further surprised by
finding his own nails ulcerating away in the course of the next few
days. “How was I to know that carbolic acid has to be diluted?” he
mutters indignantly, from time to time, with a troubled gaze at his
mutilated finger-tips.
Since we came to Newala we have been making excursions in all
directions through the surrounding country, in accordance with old
habit, and also because the akida Sefu did not get together the tribal
elders from whom I wanted information so speedily as he had
promised. There is, however, no harm done, as, even if seen only
from the outside, the country and people are interesting enough.
The Makonde plateau is like a large rectangular table rounded off
at the corners. Measured from the Indian Ocean to Newala, it is
about seventy-five miles long, and between the Rovuma and the
Lukuledi it averages fifty miles in breadth, so that its superficial area
is about two-thirds of that of the kingdom of Saxony. The surface,
however, is not level, but uniformly inclined from its south-western
edge to the ocean. From the upper edge, on which Newala lies, the
eye ranges for many miles east and north-east, without encountering
any obstacle, over the Makonde bush. It is a green sea, from which
here and there thick clouds of smoke rise, to show that it, too, is
inhabited by men who carry on their tillage like so many other
primitive peoples, by cutting down and burning the bush, and
manuring with the ashes. Even in the radiant light of a tropical day
such a fire is a grand sight.
Much less effective is the impression produced just now by the
great western plain as seen from the edge of the plateau. As often as
time permits, I stroll along this edge, sometimes in one direction,
sometimes in another, in the hope of finding the air clear enough to
let me enjoy the view; but I have always been disappointed.
Wherever one looks, clouds of smoke rise from the burning bush,
and the air is full of smoke and vapour. It is a pity, for under more
favourable circumstances the panorama of the whole country up to
the distant Majeje hills must be truly magnificent. It is of little use
taking photographs now, and an outline sketch gives a very poor idea
of the scenery. In one of these excursions I went out of my way to
make a personal attempt on the Makonde bush. The present edge of
the plateau is the result of a far-reaching process of destruction
through erosion and denudation. The Makonde strata are
everywhere cut into by ravines, which, though short, are hundreds of
yards in depth. In consequence of the loose stratification of these
beds, not only are the walls of these ravines nearly vertical, but their
upper end is closed by an equally steep escarpment, so that the
western edge of the Makonde plateau is hemmed in by a series of
deep, basin-like valleys. In order to get from one side of such a ravine
to the other, I cut my way through the bush with a dozen of my men.
It was a very open part, with more grass than scrub, but even so the
short stretch of less than two hundred yards was very hard work; at
the end of it the men’s calicoes were in rags and they themselves
bleeding from hundreds of scratches, while even our strong khaki
suits had not escaped scatheless.
NATIVE PATH THROUGH THE MAKONDE BUSH, NEAR

MAHUTA
I see increasing reason to believe that the view formed some time
back as to the origin of the Makonde bush is the correct one. I have
no doubt that it is not a natural product, but the result of human
occupation. Those parts of the high country where man—as a very
slight amount of practice enables the eye to perceive at once—has not
yet penetrated with axe and hoe, are still occupied by a splendid
timber forest quite able to sustain a comparison with our mixed
forests in Germany. But wherever man has once built his hut or tilled
his field, this horrible bush springs up. Every phase of this process
may be seen in the course of a couple of hours’ walk along the main
road. From the bush to right or left, one hears the sound of the axe—
not from one spot only, but from several directions at once. A few
steps further on, we can see what is taking place. The brush has been
cut down and piled up in heaps to the height of a yard or more,
between which the trunks of the large trees stand up like the last
pillars of a magnificent ruined building. These, too, present a
melancholy spectacle: the destructive Makonde have ringed them—
cut a broad strip of bark all round to ensure their dying off—and also
piled up pyramids of brush round them. Father and son, mother and
son-in-law, are chopping away perseveringly in the background—too
busy, almost, to look round at the white stranger, who usually excites
so much interest. If you pass by the same place a week later, the piles
of brushwood have disappeared and a thick layer of ashes has taken
the place of the green forest. The large trees stretch their
smouldering trunks and branches in dumb accusation to heaven—if
they have not already fallen and been more or less reduced to ashes,
perhaps only showing as a white stripe on the dark ground.
This work of destruction is carried out by the Makonde alike on the
virgin forest and on the bush which has sprung up on sites already
cultivated and deserted. In the second case they are saved the trouble
of burning the large trees, these being entirely absent in the
secondary bush.
After burning this piece of forest ground and loosening it with the
hoe, the native sows his corn and plants his vegetables. All over the
country, he goes in for bed-culture, which requires, and, in fact,
receives, the most careful attention. Weeds are nowhere tolerated in
the south of German East Africa. The crops may fail on the plains,
where droughts are frequent, but never on the plateau with its
abundant rains and heavy dews. Its fortunate inhabitants even have
the satisfaction of seeing the proud Wayao and Wamakua working
for them as labourers, driven by hunger to serve where they were
accustomed to rule.
But the light, sandy soil is soon exhausted, and would yield no
harvest the second year if cultivated twice running. This fact has
been familiar to the native for ages; consequently he provides in
time, and, while his crop is growing, prepares the next plot with axe
and firebrand. Next year he plants this with his various crops and
lets the first piece lie fallow. For a short time it remains waste and
desolate; then nature steps in to repair the destruction wrought by
man; a thousand new growths spring out of the exhausted soil, and
even the old stumps put forth fresh shoots. Next year the new growth
is up to one’s knees, and in a few years more it is that terrible,
impenetrable bush, which maintains its position till the black
occupier of the land has made the round of all the available sites and
come back to his starting point.
The Makonde are, body and soul, so to speak, one with this bush.
According to my Yao informants, indeed, their name means nothing
else but “bush people.” Their own tradition says that they have been
settled up here for a very long time, but to my surprise they laid great
stress on an original immigration. Their old homes were in the
south-east, near Mikindani and the mouth of the Rovuma, whence
their peaceful forefathers were driven by the continual raids of the
Sakalavas from Madagascar and the warlike Shirazis[47] of the coast,
to take refuge on the almost inaccessible plateau. I have studied
African ethnology for twenty years, but the fact that changes of
population in this apparently quiet and peaceable corner of the earth
could have been occasioned by outside enterprises taking place on
the high seas, was completely new to me. It is, no doubt, however,
correct.
The charming tribal legend of the Makonde—besides informing us
of other interesting matters—explains why they have to live in the
thickest of the bush and a long way from the edge of the plateau,
instead of making their permanent homes beside the purling brooks
and springs of the low country.
“The place where the tribe originated is Mahuta, on the southern
side of the plateau towards the Rovuma, where of old time there was
nothing but thick bush. Out of this bush came a man who never
washed himself or shaved his head, and who ate and drank but little.
He went out and made a human figure from the wood of a tree
growing in the open country, which he took home to his abode in the
bush and there set it upright. In the night this image came to life and
was a woman. The man and woman went down together to the
Rovuma to wash themselves. Here the woman gave birth to a still-
born child. They left that place and passed over the high land into the
valley of the Mbemkuru, where the woman had another child, which
was also born dead. Then they returned to the high bush country of
Mahuta, where the third child was born, which lived and grew up. In
course of time, the couple had many more children, and called
themselves Wamatanda. These were the ancestral stock of the
Makonde, also called Wamakonde,[48] i.e., aborigines. Their
forefather, the man from the bush, gave his children the command to
bury their dead upright, in memory of the mother of their race who
was cut out of wood and awoke to life when standing upright. He also
warned them against settling in the valleys and near large streams,
for sickness and death dwelt there. They were to make it a rule to
have their huts at least an hour’s walk from the nearest watering-
place; then their children would thrive and escape illness.”
The explanation of the name Makonde given by my informants is
somewhat different from that contained in the above legend, which I
extract from a little book (small, but packed with information), by
Pater Adams, entitled Lindi und sein Hinterland. Otherwise, my
results agree exactly with the statements of the legend. Washing?
Hapana—there is no such thing. Why should they do so? As it is, the
supply of water scarcely suffices for cooking and drinking; other
people do not wash, so why should the Makonde distinguish himself
by such needless eccentricity? As for shaving the head, the short,
woolly crop scarcely needs it,[49] so the second ancestral precept is
likewise easy enough to follow. Beyond this, however, there is
nothing ridiculous in the ancestor’s advice. I have obtained from
various local artists a fairly large number of figures carved in wood,
ranging from fifteen to twenty-three inches in height, and
representing women belonging to the great group of the Mavia,
Makonde, and Matambwe tribes. The carving is remarkably well
done and renders the female type with great accuracy, especially the
keloid ornamentation, to be described later on. As to the object and
meaning of their works the sculptors either could or (more probably)
would tell me nothing, and I was forced to content myself with the
scanty information vouchsafed by one man, who said that the figures
were merely intended to represent the nembo—the artificial
deformations of pelele, ear-discs, and keloids. The legend recorded
by Pater Adams places these figures in a new light. They must surely
be more than mere dolls; and we may even venture to assume that
they are—though the majority of present-day Makonde are probably
unaware of the fact—representations of the tribal ancestress.
The references in the legend to the descent from Mahuta to the
Rovuma, and to a journey across the highlands into the Mbekuru
valley, undoubtedly indicate the previous history of the tribe, the
travels of the ancestral pair typifying the migrations of their
descendants. The descent to the neighbouring Rovuma valley, with
its extraordinary fertility and great abundance of game, is intelligible
at a glance—but the crossing of the Lukuledi depression, the ascent
to the Rondo Plateau and the descent to the Mbemkuru, also lie
within the bounds of probability, for all these districts have exactly
the same character as the extreme south. Now, however, comes a
point of especial interest for our bacteriological age. The primitive
Makonde did not enjoy their lives in the marshy river-valleys.
Disease raged among them, and many died. It was only after they
had returned to their original home near Mahuta, that the health
conditions of these people improved. We are very apt to think of the
African as a stupid person whose ignorance of nature is only equalled
by his fear of it, and who looks on all mishaps as caused by evil
spirits and malignant natural powers. It is much more correct to
assume in this case that the people very early learnt to distinguish
districts infested with malaria from those where it is absent.
This knowledge is crystallized in the
ancestral warning against settling in the
valleys and near the great waters, the
dwelling-places of disease and death. At the
same time, for security against the hostile
Mavia south of the Rovuma, it was enacted
that every settlement must be not less than a
certain distance from the southern edge of the
plateau. Such in fact is their mode of life at the
present day. It is not such a bad one, and
certainly they are both safer and more
comfortable than the Makua, the recent
intruders from the south, who have made USUAL METHOD OF
good their footing on the western edge of the CLOSING HUT-DOOR
plateau, extending over a fairly wide belt of
country. Neither Makua nor Makonde show in their dwellings
anything of the size and comeliness of the Yao houses in the plain,
especially at Masasi, Chingulungulu and Zuza’s. Jumbe Chauro, a
Makonde hamlet not far from Newala, on the road to Mahuta, is the
most important settlement of the tribe I have yet seen, and has fairly
spacious huts. But how slovenly is their construction compared with
the palatial residences of the elephant-hunters living in the plain.
The roofs are still more untidy than in the general run of huts during
the dry season, the walls show here and there the scanty beginnings
or the lamentable remains of the mud plastering, and the interior is a
veritable dog-kennel; dirt, dust and disorder everywhere. A few huts
only show any attempt at division into rooms, and this consists
merely of very roughly-made bamboo partitions. In one point alone
have I noticed any indication of progress—in the method of fastening
the door. Houses all over the south are secured in a simple but
ingenious manner. The door consists of a set of stout pieces of wood
or bamboo, tied with bark-string to two cross-pieces, and moving in
two grooves round one of the door-posts, so as to open inwards. If
the owner wishes to leave home, he takes two logs as thick as a man’s
upper arm and about a yard long. One of these is placed obliquely
against the middle of the door from the inside, so as to form an angle
of from 60° to 75° with the ground. He then places the second piece
horizontally across the first, pressing it downward with all his might.
It is kept in place by two strong posts planted in the ground a few
inches inside the door. This fastening is absolutely safe, but of course
cannot be applied to both doors at once, otherwise how could the
owner leave or enter his house? I have not yet succeeded in finding
out how the back door is fastened.
MAKONDE LOCK AND KEY AT JUMBE CHAURO

This is the general way of closing a house. The Makonde at Jumbe
Chauro, however, have a much more complicated, solid and original
one. Here, too, the door is as already described, except that there is
only one post on the inside, standing by itself about six inches from
one side of the doorway. Opposite this post is a hole in the wall just
large enough to admit a man’s arm. The door is closed inside by a
large wooden bolt passing through a hole in this post and pressing
with its free end against the door. The other end has three holes into
which fit three pegs running in vertical grooves inside the post. The
door is opened with a wooden key about a foot long, somewhat
curved and sloped off at the butt; the other end has three pegs
corresponding to the holes, in the bolt, so that, when it is thrust
through the hole in the wall and inserted into the rectangular
opening in the post, the pegs can be lifted and the bolt drawn out.[50]
MODE OF INSERTING THE KEY
With no small pride first one householder and then a second

showed me on the spot the action of this greatest invention of the
Makonde Highlands. To both with an admiring exclamation of
“Vizuri sana!” (“Very fine!”). I expressed the wish to take back these
marvels with me to Ulaya, to show the Wazungu what clever fellows
the Makonde are. Scarcely five minutes after my return to camp at
Newala, the two men came up sweating under the weight of two
heavy logs which they laid down at my feet, handing over at the same
time the keys of the fallen fortress. Arguing, logically enough, that if
the key was wanted, the lock would be wanted with it, they had taken
their axes and chopped down the posts—as it never occurred to them
to dig them out of the ground and so bring them intact. Thus I have
two badly damaged specimens, and the owners, instead of praise,
come in for a blowing-up.
The Makua huts in the environs of Newala are especially
miserable; their more than slovenly construction reminds one of the
temporary erections of the Makua at Hatia’s, though the people here
have not been concerned in a war. It must therefore be due to
congenital idleness, or else to the absence of a powerful chief. Even
the baraza at Mlipa’s, a short hour’s walk south-east of Newala,
shares in this general neglect. While public buildings in this country
are usually looked after more or less carefully, this is in evident
danger of being blown over by the first strong easterly gale. The only
attractive object in this whole district is the grave of the late chief
Mlipa. I visited it in the morning, while the sun was still trying with
partial success to break through the rolling mists, and the circular
grove of tall euphorbias, which, with a broken pot, is all that marks
the old king’s resting-place, impressed one with a touch of pathos.
Even my very materially-minded carriers seemed to feel something
of the sort, for instead of their usual ribald songs, they chanted
solemnly, as we marched on through the dense green of the Makonde
bush:—
“We shall arrive with the great master; we stand in a row and have
no fear about getting our food and our money from the Serkali (the
Government). We are not afraid; we are going along with the great
master, the lion; we are going down to the coast and back.”
With regard to the characteristic features of the various tribes here
on the western edge of the plateau, I can arrive at no other
conclusion than the one already come to in the plain, viz., that it is
impossible for anyone but a trained anthropologist to assign any
given individual at once to his proper tribe. In fact, I think that even
an anthropological specialist, after the most careful examination,
might find it a difficult task to decide. The whole congeries of peoples
collected in the region bounded on the west by the great Central
African rift, Tanganyika and Nyasa, and on the east by the Indian
Ocean, are closely related to each other—some of their languages are
only distinguished from one another as dialects of the same speech,
and no doubt all the tribes present the same shape of skull and
structure of skeleton. Thus, surely, there can be no very striking
differences in outward appearance.
Even did such exist, I should have no time
to concern myself with them, for day after day,
I have to see or hear, as the case may be—in
any case to grasp and record—an
extraordinary number of ethnographic
phenomena. I am almost disposed to think it
fortunate that some departments of inquiry, at
least, are barred by external circumstances.
Chief among these is the subject of iron-
working. We are apt to think of Africa as a
country where iron ore is everywhere, so to
speak, to be picked up by the roadside, and
where it would be quite surprising if the
inhabitants had not learnt to smelt the
material ready to their hand. In fact, the
knowledge of this art ranges all over the
continent, from the Kabyles in the north to the
Kafirs in the south. Here between the Rovuma
and the Lukuledi the conditions are not so
favourable. According to the statements of the
Makonde, neither ironstone nor any other
form of iron ore is known to them. They have
not therefore advanced to the art of smelting
the metal, but have hitherto bought all their
THE ANCESTRESS OF
THE MAKONDE
iron implements from neighbouring tribes.
Even in the plain the inhabitants are not much
better off. Only one man now living is said to
understand the art of smelting iron. This old fundi lives close to
Huwe, that isolated, steep-sided block of granite which rises out of
the green solitude between Masasi and Chingulungulu, and whose
jagged and splintered top meets the traveller’s eye everywhere. While
still at Masasi I wished to see this man at work, but was told that,
frightened by the rising, he had retired across the Rovuma, though
he would soon return. All subsequent inquiries as to whether the
fundi had come back met with the genuine African answer, “Bado”
(“Not yet”).
BRAZIER
Some consolation was afforded me by a brassfounder, whom I

came across in the bush near Akundonde’s. This man is the favourite
of women, and therefore no doubt of the gods; he welds the glittering
brass rods purchased at the coast into those massive, heavy rings
which, on the wrists and ankles of the local fair ones, continually give
me fresh food for admiration. Like every decent master-craftsman he
had all his tools with him, consisting of a pair of bellows, three
crucibles and a hammer—nothing more, apparently. He was quite
willing to show his skill, and in a twinkling had fixed his bellows on
the ground. They are simply two goat-skins, taken off whole, the four
legs being closed by knots, while the upper opening, intended to
admit the air, is kept stretched by two pieces of wood. At the lower
end of the skin a smaller opening is left into which a wooden tube is
stuck. The fundi has quickly borrowed a heap of wood-embers from
the nearest hut; he then fixes the free ends of the two tubes into an
earthen pipe, and clamps them to the ground by means of a bent
piece of wood. Now he fills one of his small clay crucibles, the dross
on which shows that they have been long in use, with the yellow
material, places it in the midst of the embers, which, at present are
only faintly glimmering, and begins his work. In quick alternation
the smith’s two hands move up and down with the open ends of the
bellows; as he raises his hand he holds the slit wide open, so as to let
the air enter the skin bag unhindered. In pressing it down he closes
the bag, and the air puffs through the bamboo tube and clay pipe into
the fire, which quickly burns up. The smith, however, does not keep
on with this work, but beckons to another man, who relieves him at
the bellows, while he takes some more tools out of a large skin pouch
carried on his back. I look on in wonder as, with a smooth round
stick about the thickness of a finger, he bores a few vertical holes into
the clean sand of the soil. This should not be difficult, yet the man
seems to be taking great pains over it. Then he fastens down to the
ground, with a couple of wooden clamps, a neat little trough made by
splitting a joint of bamboo in half, so that the ends are closed by the
two knots. At last the yellow metal has attained the right consistency,
and the fundi lifts the crucible from the fire by means of two sticks
split at the end to serve as tongs. A short swift turn to the left—a
tilting of the crucible—and the molten brass, hissing and giving forth
clouds of smoke, flows first into the bamboo mould and then into the
holes in the ground.
The technique of this backwoods craftsman may not be very far
advanced, but it cannot be denied that he knows how to obtain an
adequate result by the simplest means. The ladies of highest rank in
this country—that is to say, those who can afford it, wear two kinds
of these massive brass rings, one cylindrical, the other semicircular
in section. The latter are cast in the most ingenious way in the
bamboo mould, the former in the circular hole in the sand. It is quite
a simple matter for the fundi to fit these bars to the limbs of his fair
customers; with a few light strokes of his hammer he bends the
pliable brass round arm or ankle without further inconvenience to
the wearer.
SHAPING THE POT
SMOOTHING WITH MAIZE-COB
CUTTING THE EDGE

FINISHING THE BOTTOM
LAST SMOOTHING BEFORE

BURNING
FIRING THE BRUSH-PILE

LIGHTING THE FARTHER SIDE OF
THE PILE
TURNING THE RED-HOT VESSEL
NYASA WOMAN MAKING POTS AT MASASI

Pottery is an art which must always and everywhere excite the
interest of the student, just because it is so intimately connected with
the development of human culture, and because its relics are one of
the principal factors in the reconstruction of our own condition in
prehistoric times. I shall always remember with pleasure the two or
three afternoons at Masasi when Salim Matola’s mother, a slightly-
built, graceful, pleasant-looking woman, explained to me with
touching patience, by means of concrete illustrations, the ceramic art
of her people. The only implements for this primitive process were a
lump of clay in her left hand, and in the right a calabash containing
the following valuables: the fragment of a maize-cob stripped of all
its grains, a smooth, oval pebble, about the size of a pigeon’s egg, a
few chips of gourd-shell, a bamboo splinter about the length of one’s
hand, a small shell, and a bunch of some herb resembling spinach.
Nothing more. The woman scraped with the
shell a round, shallow hole in the soft, fine
sand of the soil, and, when an active young
girl had filled the calabash with water for her,
she began to knead the clay. As if by magic it
gradually assumed the shape of a rough but
already well-shaped vessel, which only wanted
a little touching up with the instruments
before mentioned. I looked out with the
MAKUA WOMAN closest attention for any indication of the use
MAKING A POT. of the potter’s wheel, in however rudimentary
SHOWS THE a form, but no—hapana (there is none). The
BEGINNINGS OF THE embryo pot stood firmly in its little
POTTER’S WHEEL
depression, and the woman walked round it in
a stooping posture, whether she was removing
small stones or similar foreign bodies with the maize-cob, smoothing
the inner or outer surface with the splinter of bamboo, or later, after
letting it dry for a day, pricking in the ornamentation with a pointed
bit of gourd-shell, or working out the bottom, or cutting the edge
with a sharp bamboo knife, or giving the last touches to the finished
vessel. This occupation of the women is infinitely toilsome, but it is
without doubt an accurate reproduction of the process in use among
our ancestors of the Neolithic and Bronze ages.
There is no doubt that the invention of pottery, an item in human
progress whose importance cannot be over-estimated, is due to
women. Rough, coarse and unfeeling, the men of the horde range
over the countryside. When the united cunning of the hunters has
succeeded in killing the game; not one of them thinks of carrying
home the spoil. A bright fire, kindled by a vigorous wielding of the
drill, is crackling beside them; the animal has been cleaned and cut
up secundum artem, and, after a slight singeing, will soon disappear
under their sharp teeth; no one all this time giving a single thought
to wife or child.
To what shifts, on the other hand, the primitive wife, and still more
the primitive mother, was put! Not even prehistoric stomachs could
endure an unvarying diet of raw food. Something or other suggested
the beneficial effect of hot water on the majority of approved but
indigestible dishes. Perhaps a neighbour had tried holding the hard
roots or tubers over the fire in a calabash filled with water—or maybe
an ostrich-egg-shell, or a hastily improvised vessel of bark. They
became much softer and more palatable than they had previously
been; but, unfortunately, the vessel could not stand the fire and got
charred on the outside. That can be remedied, thought our
ancestress, and plastered a layer of wet clay round a similar vessel.
This is an improvement; the cooking utensil remains uninjured, but
the heat of the fire has shrunk it, so that it is loose in its shell. The
next step is to detach it, so, with a firm grip and a jerk, shell and
kernel are separated, and pottery is invented. Perhaps, however, the
discovery which led to an intelligent use of the burnt-clay shell, was
made in a slightly different way. Ostrich-eggs and calabashes are not
to be found in every part of the world, but everywhere mankind has
arrived at the art of making baskets out of pliant materials, such as
bark, bast, strips of palm-leaf, supple twigs, etc. Our inventor has no
water-tight vessel provided by nature. “Never mind, let us line the
basket with clay.” This answers the purpose, but alas! the basket gets
burnt over the blazing fire, the woman watches the process of
cooking with increasing uneasiness, fearing a leak, but no leak
appears. The food, done to a turn, is eaten with peculiar relish; and
the cooking-vessel is examined, half in curiosity, half in satisfaction
at the result. The plastic clay is now hard as stone, and at the same
time looks exceedingly well, for the neat plaiting of the burnt basket
is traced all over it in a pretty pattern. Thus, simultaneously with
pottery, its ornamentation was invented.
Primitive woman has another claim to respect. It was the man,
roving abroad, who invented the art of producing fire at will, but the
woman, unable to imitate him in this, has been a Vestal from the
earliest times. Nothing gives so much trouble as the keeping alight of
the smouldering brand, and, above all, when all the men are absent
from the camp. Heavy rain-clouds gather, already the first large
drops are falling, the first gusts of the storm rage over the plain. The
little flame, a greater anxiety to the woman than her own children,
flickers unsteadily in the blast. What is to be done? A sudden thought
occurs to her, and in an instant she has constructed a primitive hut
out of strips of bark, to protect the flame against rain and wind.
This, or something very like it, was the way in which the principle
of the house was discovered; and even the most hardened misogynist
cannot fairly refuse a woman the credit of it. The protection of the
hearth-fire from the weather is the germ from which the human
dwelling was evolved. Men had little, if any share, in this forward
step, and that only at a late stage. Even at the present day, the
plastering of the housewall with clay and the manufacture of pottery
are exclusively the women’s business. These are two very significant
survivals. Our European kitchen-garden, too, is originally a woman’s
invention, and the hoe, the primitive instrument of agriculture, is,
characteristically enough, still used in this department. But the
noblest achievement which we owe to the other sex is unquestionably
the art of cookery. Roasting alone—the oldest process—is one for
which men took the hint (a very obvious one) from nature. It must
have been suggested by the scorched carcase of some animal
overtaken by the destructive forest-fires. But boiling—the process of
improving organic substances by the help of water heated to boiling-
point—is a much later discovery. It is so recent that it has not even
yet penetrated to all parts of the world. The Polynesians understand
how to steam food, that is, to cook it, neatly wrapped in leaves, in a
hole in the earth between hot stones, the air being excluded, and
(sometimes) a few drops of water sprinkled on the stones; but they
do not understand boiling.
To come back from this digression, we find that the slender Nyasa
woman has, after once more carefully examining the finished pot,
put it aside in the shade to dry. On the following day she sends me
word by her son, Salim Matola, who is always on hand, that she is
going to do the burning, and, on coming out of my house, I find her
already hard at work. She has spread on the ground a layer of very
dry sticks, about as thick as one’s thumb, has laid the pot (now of a
yellowish-grey colour) on them, and is piling brushwood round it.
My faithful Pesa mbili, the mnyampara, who has been standing by,
most obligingly, with a lighted stick, now hands it to her. Both of
them, blowing steadily, light the pile on the lee side, and, when the
flame begins to catch, on the weather side also. Soon the whole is in a
blaze, but the dry fuel is quickly consumed and the fire dies down, so
that we see the red-hot vessel rising from the ashes. The woman
turns it continually with a long stick, sometimes one way and
sometimes another, so that it may be evenly heated all over. In
twenty minutes she rolls it out of the ash-heap, takes up the bundle
of spinach, which has been lying for two days in a jar of water, and
sprinkles the red-hot clay with it. The places where the drops fall are
marked by black spots on the uniform reddish-brown surface. With a
sigh of relief, and with visible satisfaction, the woman rises to an
erect position; she is standing just in a line between me and the fire,
from which a cloud of smoke is just rising: I press the ball of my
camera, the shutter clicks—the apotheosis is achieved! Like a
priestess, representative of her inventive sex, the graceful woman
stands: at her feet the hearth-fire she has given us beside her the
invention she has devised for us, in the background the home she has
built for us.
At Newala, also, I have had the manufacture of pottery carried on
in my presence. Technically the process is better than that already
described, for here we find the beginnings of the potter’s wheel,
which does not seem to exist in the plains; at least I have seen
nothing of the sort. The artist, a frightfully stupid Makua woman, did
not make a depression in the ground to receive the pot she was about
to shape, but used instead a large potsherd. Otherwise, she went to
work in much the same way as Salim’s mother, except that she saved
herself the trouble of walking round and round her work by squatting
at her ease and letting the pot and potsherd rotate round her; this is
surely the first step towards a machine. But it does not follow that
the pot was improved by the process. It is true that it was beautifully
rounded and presented a very creditable appearance when finished,
but the numerous large and small vessels which I have seen, and, in
part, collected, in the “less advanced” districts, are no less so. We
moderns imagine that instruments of precision are necessary to
produce excellent results. Go to the prehistoric collections of our
museums and look at the pots, urns and bowls of our ancestors in the
dim ages of the past, and you will at once perceive your error.
MAKING LONGITUDINAL CUT IN
BARK
DRAWING THE BARK OFF THE LOG
REMOVING THE OUTER BARK

BEATING THE BARK
WORKING THE BARK-CLOTH AFTER BEATING, TO MAKE IT

SOFT
MANUFACTURE OF BARK-CLOTH AT NEWALA

To-day, nearly the whole population of German East Africa is
clothed in imported calico. This was not always the case; even now in
some parts of the north dressed skins are still the prevailing wear,
and in the north-western districts—east and north of Lake
Tanganyika—lies a zone where bark-cloth has not yet been
superseded. Probably not many generations have passed since such
bark fabrics and kilts of skins were the only clothing even in the
south. Even to-day, large quantities of this bright-red or drab
material are still to be found; but if we wish to see it, we must look in
the granaries and on the drying stages inside the native huts, where
it serves less ambitious uses as wrappings for those seeds and fruits
which require to be packed with special care. The salt produced at
Masasi, too, is packed for transport to a distance in large sheets of
bark-cloth. Wherever I found it in any degree possible, I studied the
process of making this cloth. The native requisitioned for the
purpose arrived, carrying a log between two and three yards long and
as thick as his thigh, and nothing else except a curiously-shaped
mallet and the usual long, sharp and pointed knife which all men and
boys wear in a belt at their backs without a sheath—horribile dictu!
[51]
Silently he squats down before me, and with two rapid cuts has
drawn a couple of circles round the log some two yards apart, and
slits the bark lengthwise between them with the point of his knife.
With evident care, he then scrapes off the outer rind all round the
log, so that in a quarter of an hour the inner red layer of the bark
shows up brightly-coloured between the two untouched ends. With
some trouble and much caution, he now loosens the bark at one end,
and opens the cylinder. He then stands up, takes hold of the free
edge with both hands, and turning it inside out, slowly but steadily
pulls it off in one piece. Now comes the troublesome work of
scraping all superfluous particles of outer bark from the outside of
the long, narrow piece of material, while the inner side is carefully
scrutinised for defective spots. At last it is ready for beating. Having
signalled to a friend, who immediately places a bowl of water beside
him, the artificer damps his sheet of bark all over, seizes his mallet,
lays one end of the stuff on the smoothest spot of the log, and
hammers away slowly but continuously. “Very simple!” I think to
myself. “Why, I could do that, too!”—but I am forced to change my
opinions a little later on; for the beating is quite an art, if the fabric is
not to be beaten to pieces. To prevent the breaking of the fibres, the
stuff is several times folded across, so as to interpose several
thicknesses between the mallet and the block. At last the required
state is reached, and the fundi seizes the sheet, still folded, by both
ends, and wrings it out, or calls an assistant to take one end while he
holds the other. The cloth produced in this way is not nearly so fine
and uniform in texture as the famous Uganda bark-cloth, but it is
quite soft, and, above all, cheap.
Now, too, I examine the mallet. My craftsman has been using the
simpler but better form of this implement, a conical block of some
hard wood, its base—the striking surface—being scored across and
across with more or less deeply-cut grooves, and the handle stuck
into a hole in the middle. The other and earlier form of mallet is
shaped in the same way, but the head is fastened by an ingenious
network of bark strips into the split bamboo serving as a handle. The
observation so often made, that ancient customs persist longest in
connection with religious ceremonies and in the life of children, here
finds confirmation. As we shall soon see, bark-cloth is still worn
during the unyago,[52] having been prepared with special solemn
ceremonies; and many a mother, if she has no other garment handy,
will still put her little one into a kilt of bark-cloth, which, after all,
looks better, besides being more in keeping with its African
surroundings, than the ridiculous bit of print from Ulaya.
MAKUA WOMEN

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Foundations of Finance, Global Edition

9th Edition, (Ebook PDF)

Pearson Global Edition

Keown_09_1292155132_Final.indd 1 29/04/16 7:45 AM

J. William Petty, PhD, Baylor University, is Professor of Finance and

A01_KEOW5135_09_GE_FM.indd 6 06/05/16 6:46 PM

Part 1 The Scope and Environment

Part 2 The Valuation of Financial Assets 176

Part 3 Investment in Long-Term Assets 350

Part 4 Capital Structure and Dividend Policy 430

Part 5  orking-Capital Management and International

A01_KEOW5135_09_GE_FM.indd 7 06/05/16 6:46 PM

Part 1 The Scope and Environment

1 An Introduction to the Foundations of Financial

Chapter Summaries 42 • Review Questions 44 • Mini Case 45

2 The Financial Markets and Interest Rates 46

A01_KEOW5135_09_GE_FM.indd 8 06/05/16 6:46 PM

Interest Rate Determinants in a Nutshell 62

Chapter Summaries 71 • Review Questions 74 • Study Problems 74 • Mini Case 77

3 Understanding Financial Statements and Cash

Appendix 3A: Free Cash Flows 124

Study Problems 128

4 Evaluating a Firm’s Financial Performance 130

A01_KEOW5135_09_GE_FM.indd 9 06/05/16 6:46 PM

The Limitations of Financial Ratio Analysis 162

Chapter Summaries 163 • Review Questions 166 • Study Problems 166

Part 2 The Valuation of Financial Assets 176

5 The Time Value of Money 176

Chapter Summaries 208 • Review Questions 211 • Study Problems 211

6 The Meaning and Measurement of Risk

Chapter Summaries 249 • Review Questions 253 • Study Problems 253

7 The Valuation and Characteristics

A01_KEOW5135_09_GE_FM.indd 10 06/05/16 6:46 PM

Terminology and Characteristics of Bonds 263

Chapter Summaries 284 • Review Questions 287 • Study Problems 288

8 The Valuation and Characteristics

Chapter Summaries 311 • Review Questions 314 • Study Problems 314

9 The Cost of Capital 318

A01_KEOW5135_09_GE_FM.indd 11 06/05/16 6:46 PM

Calculating Divisional Costs of Capital 335

Chapter Summaries 341 • Review Questions 343 • Study Problems 344

Part 3 Investment in Long-Term Assets 350

10 Capital-Budgeting Techniques and Practice 350

Chapter Summaries 380 • Review Questions 383 • Study Problems 383

11 Cash Flows and Other Topics in Capital

A01_KEOW5135_09_GE_FM.indd 12 06/05/16 6:46 PM

Risk and the Investment Decision 409

Chapter Summaries 418 • Review Questions 420 • Study Problems 420

Appendix 11A: The Modified Accelerated Cost

Study Problems 429

Part 4 Capital Structure and Dividend Policy 430

12 Determining the Financing Mix 430

Chapter Summaries 460 • Review Questions 463 • Study Problems 463

13 Dividend Policy and Internal Financing 468

A01_KEOW5135_09_GE_FM.indd 13 06/05/16 6:46 PM

The Dividend Decision in Practice 476

Chapter Summaries 483 • Review Questions 485 • Study Problems 486

Part 5  orking-Capital Management and International

14 Short-Term Financial Planning 490

Chapter Summaries 501 • Review Questions 502 • Study Problems 503

15 Working-Capital Management 510

A01_KEOW5135_09_GE_FM.indd 14 06/05/16 6:46 PM

Secured Sources: Accounts-Receivable Loans 527

Part 1 The Scope and Environment

Part 5 orking-Capital Management and International

Part 1 The Scope and Environment

Part 5 orking-Capital Management and International

Web 17 Cash, Receivables, and Inventory Management

someone for 1 year at a nominal rate of interestand Analysis