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Finance for Executives: Managing for © 2015, Cengage Learning EMEA

Value Creation, 5th Edition WCN: 02-300
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PART I FINANCIAL CONCEPTS AND TECHNIQUES 1
CHAPTER 1 Financial Management and Value Creation: An Overview 1
CHAPTER 2 The Time Value of Money 29
CHAPTER 3 Risk and Return 51
PART II ASSESSING BUSINESS PERFORMANCE 97

CHAPTER 4 Interpreting Financial Statements 97
CHAPTER 5 Analyzing Operational Efficiency and Liquidity 151
c HAP TE R 6 Analyzing Profitability, Risk, and Growth 18 7
PART m MAKING INVESTMENT DECISIONS 22 7

CHAPTER 7 Using the Net Present Value Rule to Make Value-Creating
Investment Decisions 22 7
CHAPTER 8 Alternatives to the Net Present Value Rule 261
CHAPTER 9 Identifying and Estimating a Project's Cash Flows 287
PART IV MAKING FINANCING DECISIONS 315

CHAPTER 1o Valuing Bonds and Stocks 315
CHAPTER 11 Raising Capital and Paying Out Cash 359
c HAP TE R 1 2 Estimating the Cost of Capital 411
CHAPTER 13 Designing a Capital Structure 445
PART V MAKING BUSINESS DECISIONS 485

CHAPTER 14 Valuing and Acquiring a Business 485
CHAPTER 15 Managing Corporate Risk 529
CHAPTER 16 Making International Business Decisions 569
CHAPTER 17 Managing for Value Creation 603
Answers to Self-Test Questions 641
Glossary 689
Credits 709
Index 711
•
Vl
PART I FINANCIAL CONCEPTS AND TECHNIQUES 1
CHAPTER I Financial Management and Value Creation: An Overview 1
The Key Question: Will Your Decision Create Value? 2
The Importance of Managing for Value Creation 3
The Saturn Story 4
The Fundamental Finance Principle 5
Measuring Value Creation with Net Present Value 5
Only Cash Matters 6
Discount Rates 6
A Proposal's Cost of Capital 7
Applying the Fundamental Finance Principle 8
The Capital Budgeting Decision 8
The Payout Policy 10
The Capital Structure Decision 11
The Business Acquisition Decision 11
The Foreign Investment Decision 12
The Role of Financial Markets 12
The Equity Market 13
The Vioxx Recall 14
External Versus Internal Financing 15
The Business Cycle 15
HLC's Financial Statements 17
The Balance Sheet 17
A Variant of the Standard Balance Sheet: The Managerial Balance Sheet 19
The Income Statement 20
How Profitable Is the Firm? 21
The Profitability of Equity Capital 21
The Profitability of Invested Capital 22
How Much Cash Has the Firm Generated? 22
Sources and Uses of Cash 23
The Statement of Cash Flows 23
How Risky Is the Firm? 23
Has the Firm Created Value? 25
Key Points 25
Further Reading 27
Self-Test Questions 27
••
Vll
Copyright 20 15 Cengage Learning. All !lights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
•••
Vlll FINANCE FOR EXECUTIVES
CHAPTER 2 The Time Value of Money 29

Present Values and Future Values 30
Compounding 31
Discounting 32
Using a Financial Calculator to Solve Time Value of
Money Problems 33
Using a Spreadsheet to Solve Time Value of Money Problems 34
Interest Rate Quotation and Calculation 34
The Annual Percentage Rate Versus the Effective Annual Rate 35
Nominal Versus Real Rates 36
The Present Value of a Stream of Future Cash Flows 36
The Net Present Value (NPV) Rule 37
The Internal Rate of Return (IRR) Rule 37
The Present Value of a Perpetual Cash-Flow Stream 38
The Present Value of a Growing Perpetuity 39
The Present Value of a Standard Annuity 40
The Present Value of a Growing Annuity 42
The Future Value of an Annuity 44
Key Points 45
APPEN01x 2.1 Proof of Formula 2.9 and Formula 2.6 47

Further Reading 47
Review Questions 48
CHAPTER 3 Risk and Return 51

Measures of Return 52
Realized Returns 52
Expected Return 53
Annualized Returns 5 3
Measures of Risk 53
Measuring Risk with the Variance of Returns 53
Measuring Risk with the Standard Deviation of Returns 54
Variance versus Standard Deviation 54
Annualized Measures of Risk 54
Return Distributions 55
Mean-Variance Analysis 55
Attitudes toward Risk 5 8
Evidence from Financial Markets 59
Combining Two Stocks into a Portfolio 59
Portfolio Expected Return 61
Portfolio Risk and Correlations 61
•
CONTENTS 1X
Diversification Can Reduce Risk and Raise Return 63

The Opportunity Set of a Two-Stock Portfolio 63
The Optimal Portfolio of a Risk-Averse Investor 66
Changes in the Correlation Coefficient 66
Combining More Than Two Stocks into a Portfolio 66
Portfolio Expected Return 67
Portfolio Risk and Diversification 67
Portfolio Diversification in Practice 70
Firm-specific Risk versus Market Risk 71
The Opportunity Set with More Than Two Stocks 72
Optimal Portfolios when there is a Riskless Asset 73
The Efficient Investment Line 73
The Sharpe Ratio 74
Making Optimal Investment Choices 75
The Market Portfolio and the Capital Market Line 77
The Expected Return of the Market Port(olio 77
Proxies for the Market Port(olio 77
The Sharpe Ratio and the Efficiency of the Market
Portfolio 78
The Capital Market Line 78
Modern Investment Management: Allocation Beats Selection 80
A Closer Look at Systematic Risk 81
Beta and the Market Model 82
Calculating Beta 82
The Properties of Beta 83
Estimated Stock Betas 83
Portfolio Beta 84
The Capital Asset Pricing Model 85
The Expected Return of an Individual Stock 85
Using the CAPM to Estimate a Company's Cost of Equity Capital 86
Using the CAPM to Evaluate Investment Performance 87
Using the CAPM to Test the Informational Efficiency of
Stock Markets 88
Key Points 89
Further Reading 90
APPENDIX 3. I How to Get the SML Equation 91

Review Questions 93
PART II ASSESSING BUSINESS PERFORMANCE 97

CHAPTER 4 Interpreting Financial Statements 97
Financial Accounting Statements 97
The Balance Sheet 98
x FINANCE FoR EXECUTIVES
Current or Short-Term Assets 99

Noncurrent or Fixed Assets 103
Current or Short-Term Liabilities 105
N oncurrent Liabilities 106
Owners' Equity 108
The Managerial Balance Sheet 108
Working Capital Requirement 109
The Income Statement 112
Net Sales or Turnover 114
Gross Profit 114
Operating Profit 115
Earnings Before Interest and Tax (EBIT) 115
Earnings Before Tax (EBT) 116
Earnings After Tax (EAT) 116
Earnings Before Interest, Tax, Depreciation and Amortization
(EBITDA) 116
Reconciling Balance Sheets and Income Statements 117
The Structure of the Owners' Equity Account 118
Preparing a Statement of Cash Flows 120
Net Cash Flow from Operating Activities 121
Net Cash Flow from Investing Activities 123
Net Cash Flow from Financing Activities 124
Problems with the Statement of Cash Flows 125
Free Cash Flow 126
Key Points 127
APPENDIX 4.1 Obtaining the Net Cash Flow from Operating

Activities Using Balance Sheet and Income
Statement Accounts 130
Measuring Cash Inflow from Sales 130
Measuring Cash Outflow from Operating Activities 130
Cash Outflow from Purchases 130
Cash Outflow from SG&A and Tax Expenses 131
Cash Outflow from Net Interest Expense 132
Net Cash Flow from Operating Activities 132
APPENDIX 4.2 Specimen Financial Statements 134

The GlaxoSmithKline (GSK) Financial Statements 134
GSK's Balance Sheets and Managerial Balance Sheets 134
GSK's Balance Sheets 134
GSK's Managerial Balance Sheets 137
•
CONTENTS X1
GSK's Income Statements 137

GSK's Statements of Cash Flows 140
Further Reading 142
Review Questions 146
c HAP TE R 5 Analyzing Operational Efficiency and Liquidity 151

The Structure of the Managerial Balance Sheet 152
The Three Components of a Firm's Invested Capital 152
The Two Components of a Firm's Capital Employed 156
The Structure of OS Distributors' Managerial Balance Sheet 156
The Matching Strategy 156
A Measure of Liquidity Based on the Funding Structure of Working
Capital Requirement 158
Improving Liquidity through Better Management of the Operating
Cycle 161
The Effect of the Firm's Economic Sector on Its Working Capital
Requirement 161
The Effect of Managerial Efficiency on Working Capital Requirement 163
The Effect of Sales Growth on Working Capital Requirement 165
Traditional Measures of Liquidity 166
Net Working Capital 166
The Current Ratio 168
The Acid Test or Quick Ratio 169
Key Points 169
APP EN o Ix 5. I Financing Strategies 171
APP EN o Ix 5. 2 The GlaxoSmithKline Liquidity and Operational Efficiency 174
GSK's Liquidity Position 174
GSK's Management of the Operating Cycle 176
Further Reading 177
CHAPTER 6 Analyzing Profitability, Risk, and Growth 187

Measures of Profitability 188
Return on Equity 188
Measuring Return on Equity 188
The Effect of Operating Decisions on Return on Equity 189
The Effect of Financing Decisions on Return on Equity 195
The Incidence of Taxation on Return on Equity 197
Putting It All Together: The Structure of a Firm's Profitability 198
The Structure of Return on Equity Across Industries 200
xii FINANCE FoR EXECUTIVES
Other Measures of Profitability 201

Earnings Per Share (EPS) 201
The Price-to-Earnings Ratio (PIE) 201
The Market-to-Book Ratio 202
Financial Leverage and Risk 202
How Does Financial Leverage Work? 203
Two Related Caveats: Risk and the Ability to Create Value 204
Self-Sustainable Growth 205
Key Points 209
APPENDIX 6.1 GlaxoSmithKline's Profitability 211

GSK's Profitability Structure 211
The Effect of GSK's Operating Profitability on Its Return on Equity 211
The Effect of Operating Margin on GSK's Operating Profitability 211
The Effect of Invested Capital Turnover on GSK's Operating Profitability 216
The Effect of GSK's Financial Policy on Its Return on Equity 216
The Effect of Taxation on GSK's Return on Equity 217
Further Reading 218
PART ID MAKING INvESTMENT DECISIONS 22 7

ca APTER 7 Using the Net Present Value Rule to Make Value-Creating Investment
Decisions 22 7
The Capital Investment Process 228
Would You Buy This Parcel of Land? 230
The Alternative Investment 230
The Opportunity Cost of Capital 231
The Net Present Value Rule 232
A One-Period Investment 232
A Two-Period Investment without an Intermediate Cash Flow 234
A Two-Period Investment with an Intermediate Cash Flow 235
Multiple-Period Investments 236
Applying the Net Present Value Rule to a Capital Investment
Decision 23 7
Why the NPV Rule Is a Good Investment Rule 238
NPV Is a Measure of Value Creation 239
NPV Adjusts for the Timing of the Project's Cash Flows 240
NPV Adjusts for the Risk of the Project's Cash Flows 240
NPV Is Additive 244
Special Cases of Capital Budgeting 246
Comparing Projects of Unequal Size 246
Comparing Projects with Unequal Life Spans 248
•••
CONTENTS Xlll
Limitations of the Net Present Value Criterion 251

Managerial or Real Options Embedded in Investment Projects 251
Dealing with Managerial Options 253
Key Points 254
Further Reading 256
CHAPTER 8 Alternatives to the Net Present Value Rule 261

The Payback Period 261
The Payback Period Rule 262
Why do Managers Use the Payback Period Rule? 265
The Discounted Payback Period 267
The Discounted Payback Period Rule 268
The Discounted Payback Period Rule versus the Ordinary
Payback Period Rule 269
The Internal Rate of Return 270
The IRR Rule 271
The IRR Rule May Be Unreliable 273
Why Do Managers Usually Prefer the IRR Rule to the NPV Rule? 276
The Profitability Index 2 77
The Profitability Index Rule 277
Use of the Profitability Index Rule 278
The Average Accounting Return 2 79
The Average Accounting Return Rule 280
Key Points 280
Further Reading 282
CHAPTER 9 Identifying and Estimating a Project's Cash Flows 287

The Actual Cash Flow Principle 287
The With/Without Principle 288
The Designer Desk Lamp Project 290
Identifying a Project's Relevant Cash Flows 292
Sunk Costs 292
Opportunity Costs 293
Costs Implied by Potential Sales Erosion 293
Allocated Costs 294
Depreciation Expense 294
Tax Expense 294
Financing Costs 295
I nfiation 296
xiv FINANCE FoR EXECUTIVES
Estimating a Project's Relevant Cash Flows 297

Measuring the Cash Flows Generated by a Project 298
Estimating the Project's Initial Cash Outflow 299
Estimating the Project's Intermediate Cash Flows 303
Estimating the Project's Terminal Cash Flow 304
Should SMC Launch the New Product? 305
Sensitivity of the Project's NPV to Changes in the Lamp Price 306
Sensitivity of NPV to Sales Erosion 306
Key Points 307
Further Reading 308
PART IV MAKING FINANCING DECISIONS 315

CHAPTER IO Valuing Bonds and Stocks 315
What Are Bonds and Common Stocks? 316
Bond Features and Terminology 316
Common Stock Features and Terminology 317
The Discounted Cash-Flow (DCF) Model 318
Valuing Bonds 320
Finding the Price of a Bond when its Yield Is Known 320
How Changes in Yield Affect Bond Prices 321
Bond Price versus Face Value 322
Finding the Yield of a Bond when its Price Is Known 322
The Market Yield of a Bond is the Cost of Debt to the Firm 323
Price Quotation and Yield Conventions 323
The Case of Zero-Coupon Bonds 324
The Case of Perpetual Bonds 326
A Closer Look at Bond Yields and Risk 327
Risk is the Major Determinant of Bonds' Yield 327
Credit Risk, Credit Ratings and Credit Spreads 32 7
The Term Structure of Interest Rates 329
Finding the Price and the Yield of a Bond if the
Spot Rates are Known 333
Interest-Rate Risk 334
Duration as a Measure of Interest-Rate Risk 335
Valuing Common Stocks 336
Valuation Based on the Dividend-Discount Model (DDM) 336
Valuation Based on Discounted Free Cash Flows 339
Valuing PEC with the Discounted Free Cash Flow Model 341
Valuation Based on Discounted Cash Flows to Equity Holders 343
Comparing the Three Discounted Cash Flow Models 345
Valuation Based on Comparable Firms 345
Direct Valuation of a Firm's Equiry Based on the Price-to-Earnings
Ratio 346
CONTENTS XV
Direct Valuation of a Finn's Equiry Based on the Price-to-Book Value

Ratio 347
Indirect Valuation of a Firm's Equity Based on the EV-to-EBITDA
Ratio 347
Key Points 348
APPENDIX 10.1 The Properties of Duration 350

Further Reading 353
CHAPTER 11 Raising Capital and Paying Out Cash 359

Estimating the Amount of Required External Funds 360
The Financial System: Its Structure and Functions 364
Direct Financing 364
Indirect or Intermediated Financing 364
Securities Markets 367
How Firms Issue Securities 371
Private Placement 371
Public Offerings 371
Raising Debt Capital 375
Borrowing through Bank Loans 376
Borrowing through Lease Agreements 376
Borrowing by Issuing Short-Term Securities 379
Borrowing by Issuing Corporate Bonds 379
Raising Equity Capital 383
Preferred Stocks 383
Tracking Stock 385
Equity Warrants 385
Contingent Value Rights 385
Distributing Cash to Shareholders 386
Observed Payout Policies 3 86
How and Why Firms Pay Dividends and Buy
Back their Shares 390
How Firms Pay Dividends 390
How Firms Repurchase their Shares 391
Differences Between Dividend Payments and
Share Repurchases 392
Does a Firm Payout Policy Affect Its Share Price and
the Wealth of Its Shareholders? 394
Paying an Immediate Special Dividend of $250 million 396
Buying Back $250 million of Shares in the Open Market 397
Issuing $100 million of New Equity to Pay an Immediate Dividend of $350
million 398
xvi FINANCE FoR EXECUTIVES
Investing $250 million in a Project 398

Payout Policy Is Irrelevant in a Perfect Market Environment as Long as
the Firm's Investing and Financing Policies do not Change 399
Payout Policy with Market Imperfections 400
Key Points 402
Further Reading 405
c HAP TE R 12 Estimating the Cost of Capital 411

Identifying Proxy or Pure-Play Firms 412
Estimating the Cost of Debt 413
Estimating the Cost of Equity 415
Estimating the Cost of Equity Using the Dividend-Discount Model 415
Estimating the Cost of Equity Using the Capital Asset Pricing Model 417
Estimating the Cost of Capital of a Firm 426
What Is a Firm's Cost of Capital? 426
The Firm's Target Capital Structure 427
The Firm's Costs of Debt and Equity 429
Summary of the Firm's WACC Calculations 430
Estimating the Cost of Capital of a Project 430
The Project's Risk is Similar to the Risk of the Firm 430
The Project's Risk is Different from the Risk of the Firm 430
Three Mistakes to Avoid When Estimating a Project's Cost of
Capital 434
Key Points 438
Further Reading 439
CHAPTER 13 Designing a Capital Structure 445

The Capital Structure Decision in a World without Taxes and Financial
Distress Costs 446
Effects of Borrowing on the Firm's Profitability (No Taxes and No
Financial Distress Costs) 446
Understanding the Trade-Off between Profitability and Risk 449
Effect of Borrowing on the Value of the Firm's Assets and Its Share Price
(No Taxes and No Financial Distress Costs) 450
Effect of Borrowing on the Firm's Cost of Capital
(No Taxes and No Financial Distress Costs) 453
The Capital Structure Decision in a World with Corporate Income
Taxes But without Financial Distress Costs 455
••
CONTENTS XVll
Effect of Borrowing on the Value of a Firm's Assets (with Corporate

Income Taxes and No Financial Distress Costs) 456
Effect of Borrowing on the Firm's Market Value of Equity (with Corporate
Income Taxes and No Financial Distress Costs) 460
Effect of Borrowing on the Firm's Share Price (with Corporate Income
Taxes and No Financial Distress Costs) 460
Effect of Borrowing on the Cost of Capital (with Corporate Income Taxes
and No Financial Distress Costs) 461
The Capital Structure Decision when Financial Distress Is Costly 463
Formulating a Capital Structure Policy 466
A Closer Look at the Trade-Off Model of Capital Structure 467
Factors Other than Taxes That May Favor Borrowing 4 70
Factors Other Than Financial Distress Costs That May Discourage
Borrowing 473
Is There a Preference for Retained Earnings? 4 75
Putting It All Together 476
Key Points 4 79
Further Reading 480
PARTV MAKING BUSINESS DECISIONS 485

-------
CHAPTER 14 Valuing and Acquiring a Business 485
Alternative Valuation Methods 486
Valuing a Firm's Equity Using Comparable Firms 487
Direct Estimation of a Firm's Equity Value Based on
the Equity Value of Comparable Firms 490
Indirect Estimation of a Firm's Equity Value Based
on the Enterprise Value of Comparable Firms 492
Valuing a Firm's Business Assets and Equity Using
the Discounted Cash Flow (DCF) Method 494
Estimation of OS Distributors' Enterprise and Equity Values 495
Step 1: Determination of the Length of the Forcasting Period 496
Step 2: Estimation of the Free Cash Flow from Business Assets 496
Step 3: Estimation of the Weighted Average Cost of Capital 5 00
Step 4: Estimation of the Terminal Value of Business Assets at
the End of Year 2020 501
Step 5: Estimation of the DCF Value of Business Assets (Enterprise Value) 502
Step 6: Estimation of the DCF Value of Equity 502
Comparison of DCF Valuation and Valuation by Comparables 503
Estimating the Acquisition Value of OS Distributors 503
Identifying the Potential Sources of Value Creation in an Acquisition 503
Why Conglomerate Mergers Are Unlikely to Create Lasting
Value through Acquisitions 5 06
The Acquisition Value of OS Distributors' Equity 508
Copyright 2015 Cengage Leaming. All Rights Reserved. May not be copied, scanned, or dup licated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review bas deemed that any suppressed content does not materially affect the overall learning experience. Cengage Leaming reserves the right to remove additional content at any time if subsequent rights restrictions require it.
•••
XVlll FINANCE FoR EXECUTIVES
Estimating the Leveraged Buyout Value of OS Distributors 512

Estimating the Leveraged Buyout Value of Business Assets Using
the Adjusted Present Value Method (The APV Method) 514
Will OS Distributors Be Able to Service Its Debt? 518
Key Points 521
Further Reading 523
CHAPTER 15 Managing Corporate Risk 529

What Is Risk? 530
Why Should Firms Manage Risk? 531
Risk Management Can Reduce Corporate Income
Tax Payments 532
Risk Management Can Lower the Cost of Protection
Against Risk 532
Risk Management Can Lower Financial Distress Costs 532
Risk Management Can Provide Clearer Information to Investors about the
Firm's Core Activities 532
Risk Management Can Lower Agency Costs 532
Corporate Risk Management 533
Risk Netting 533
Cost Savings 533
Risk Policy 5 34
Risk Learning 534
The Risk Management Process 5 34
Step 1: Risk Identification 535
Step 2: Risk Measurement 543
Step 3: Risk Prioritization 544
Step 4: Risk Policy 545
Step 5: Risk Monitoring 549
A Closer Look at Currency Risk 549
The Foreign-Exchange Market 550
Hedging Contractual Exposure to Currency Risk 552
Hedging Long-Term Contractual Exposure to Currency Risk with Swaps 561
Key Points 563
Further Reading 563
Self-Test Questions 5 63
c HAP TE R 16 Making International Business Decisions 5 69

The Firm's Risk Exposure from Foreign Operations 570
Accounting, or Translation, Exposure 570
Economic Exposure 570
•
CONTENTS XIX
Factors Affecting Changes in Exchange Rates 573

How Differences in Inflation Rates Affect Exchange Rates:
The Purchasing Power Parity Relation 573
The Relationship between Two Countries' Inflation Rates and Interest
Rates: The International Fisher Effect 574
How Differences in Interest Rates Affect Exchange Rates:
The Interest-Rate Parity Relation 575
The Relation between Forward Rates and Future Spot Rates 576
Putting It All Together 577
Analyzing an International Investment Project 578
The Net Present Value Rule: A Brief Review 578
Surf and Zap Cross-Border Alternative Investment Projects 579
Managing Country Risk 585
Invest in Projects with Unique Features 586
Use Local Sourcing 586
Choose a Low-Risk Financial Strategy 586
Design a Remittance Strategy 586
Consider Buying Insurance against Country Risk 5 86
Key Points 587
APP EN o Ix I 6. I Translating Financial Statements with the MonetaryI

Nonmonetary Method and the All Current Method 589
The Monetary/Nonmonetary Method 589
The All Current Method 590
Which Method Is Better? 592
APPENDIX 16.2 The Parity Relations 593

The Law of One Price 593
The Purchasing Power Parity Relation 594
The International Fisher Effect 594
The Interest-Rate Parity Relation 595
Strategy 1: Investment in U.S. Dollars 595
Strategy 2: Investment in Euros 595
Further Reading 597
c HAP TE R I 7 Managing for Value Creation 603

Measuring Value Creation 604
Estimating Market Value Added 605
Interpreting Market Value Added 607
A Look at the Evidence 608
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Leaming reserves the right to remove additional content at any time if subsequent rights restrictions require it.
xx FINANCE FOR EXECUTIVES
Identifying the Drivers of Value Creation 610

Linking Value Creation to Operating Profitability, the Cost of Capital, and
Growth Opportunities 611
Linking Value Creation to Its Fundamental Determinants 614
Linking Operating Performance and Remuneration
to Value Creation 615
Mr. Thomas Hires a General Manager 615
Has the General Manager Achieved His Objectives? 617
Economic Profits versus Accounting Profits 619
Designing Compensation Plans That Induce Managers to
Behave Like Owners 620
Linking the Capital Budgeting Process to Value Creation 621
The Present Value of an Investment's Future EVA Is
Equal to Its MVA 621
Maximizing MVA Is the Same As Maximizing NPV 622
Putting It All Together: The Financial Strategy Matrix 625
The Business Is a Value Creator but Is Short of Cash 626
The Business Is a Value Creator with a Cash Surplus 626
The Business Is a Value Destroyer with a Cash Surplus 62 7
The Business Is a Value Destroyer That Is Short of Cash 627
Key Points 62 7
APP EN o Ix I 7. I Adjusting Book Values to Estimate the Amount of Invested Equity

Capital and Operating Profit 629
Adjusting the Book Value of Equity Capital 629
Adjusting Earnings Before Interest and Tax 630
APPENDIX 17 .2 Estimating Market Value Added (MVA) when Future Cash Flows
Are Expected to Grow at a Constant Rate in Perpetuity 632
Further Reading 633
Answers to Self-Test Questions 641
Glossary 689
Credits 709
Index 711
Finance is an essential and exciting area of management that many executives want
to learn or explore in more depth. Most finance textbooks, however, are either too
advanced or too simplistic for many nonfinancial managers. Our challenge was to
write an introductory text that is specifically addressed to executives, and that is
both practical and rigorous.
The target audience includes executives directly and indirectly involved with
financial matters and financial management, which is just about every executive.
Over the past few years, several thousand managers around the world have used
most of the material in this book. The text works well in executive-development pro-
grams including executive masters of business administration (EMBA) programs-
and corporate finance courses for an undergraduate or MBA audience either as a
core text, where a more practical and applied emphasis is desired, or as a companion
to a theoretical text to translate theory to practice.
Finance for Executives has a number of important features:
• The book is based on the principle that managers should manage their
firm's resources with the objective of increasing their firm's value.
Managers must make decisions that are expected to raise their firm's market value.
This fundamental principle underlies our approach to management. This book is
designed to improve managers' ability to make decisions that create value, including
decisions to restructure existing operations, launch new products, buy new assets,
acquire other companies, and finance the firm's investments.
• The book fills the gap between introductory accounting and finance manu-
als for nonfinancial managers and advanced texts in corporate finance.
Finance for Executives is based on modern finance principles. It emphasizes rigor-
ous analysis but avoids formulas that have no direct application to decision making.
Whenever a formula is used in the text, the logic behind it is explained and numeri-
cal examples are provided. Mathematical derivations of the formulas are given in
the appendices that follow the chapter in which they first appear. Recognizing that
executives often approach financial problems from a financial accounting perspec-
tive, we begin with a solid review of the financial accounting system. We then show
how this framework can be extended and used to make sound financial decisions
that enhance the firm's value.
• The chapters are self-contained.
Each chapter can be read without prior reading of the others. When knowledge of a
previous chapter would enhance comprehension of a specific section, we direct the
•
XXl
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PART II ASSESSING BUSINESS PERFORMANCE 97

PART m MAKING INVESTMENT DECISIONS 22 7

PART IV MAKING FINANCING DECISIONS 315

PART V MAKING BUSINESS DECISIONS 485

CHAPTER 2 The Time Value of Money 29

APPEN01x 2.1 Proof of Formula 2.9 and Formula 2.6 47

CHAPTER 3 Risk and Return 51

Diversification Can Reduce Risk and Raise Return 63

APPENDIX 3. I How to Get the SML Equation 91

PART II ASSESSING BUSINESS PERFORMANCE 97

Current or Short-Term Assets 99

APPENDIX 4.1 Obtaining the Net Cash Flow from Operating

APPENDIX 4.2 Specimen Financial Statements 134

GSK's Income Statements 137

c HAP TE R 5 Analyzing Operational Efficiency and Liquidity 151

CHAPTER 6 Analyzing Profitability, Risk, and Growth 187

Other Measures of Profitability 201

APPENDIX 6.1 GlaxoSmithKline's Profitability 211

PART ID MAKING INvESTMENT DECISIONS 22 7

Limitations of the Net Present Value Criterion 251

CHAPTER 8 Alternatives to the Net Present Value Rule 261

CHAPTER 9 Identifying and Estimating a Project's Cash Flows 287

Estimating a Project's Relevant Cash Flows 297

PART IV MAKING FINANCING DECISIONS 315

Direct Valuation of a Finn's Equiry Based on the Price-to-Book Value

APPENDIX 10.1 The Properties of Duration 350

CHAPTER 11 Raising Capital and Paying Out Cash 359

Investing $250 million in a Project 398

c HAP TE R 12 Estimating the Cost of Capital 411

CHAPTER 13 Designing a Capital Structure 445

Effect of Borrowing on the Value of a Firm's Assets (with Corporate

PARTV MAKING BUSINESS DECISIONS 485

Estimating the Leveraged Buyout Value of OS Distributors 512

CHAPTER 15 Managing Corporate Risk 529

c HAP TE R 16 Making International Business Decisions 5 69

Factors Affecting Changes in Exchange Rates 573

APP EN o Ix I 6. I Translating Financial Statements with the MonetaryI

APPENDIX 16.2 The Parity Relations 593

c HAP TE R I 7 Managing for Value Creation 603

Identifying the Drivers of Value Creation 610

APP EN o Ix I 7. I Adjusting Book Values to Estimate the Amount of Invested Equity

MONOD (A.),—WOMAN: HER MISSION, AND HER LIFE.

STEBBING (Henry, D.D. f.r.s.),—JESUS, a Poem in Six

UNIVERSAL ATLAS. Engraved by Becker’s Omnigraph,

WALKER’S (George) TREATISE ON THE GAME OF

WRIGHT’S (Thomas, Esq. m.a. f.s.a.) THE CELT, THE

R. Clay, Printer, Bread Street Hill.

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