Introduction to Finance: Markets, Investments, and Financial Management, 16th Edition Enhanced

654 Pages·2016·8.421 MB·English

by  Ronald W Melicher, Edgar A Norton

Introduction to Finance
Markets, Investments, and Financial Management
16th Edition
RONALD W. MELICHER
Professor of Finance
University of Colorado at Boulder
EDGAR A. NORTON
Professor of Finance
Illinois State University
To my parents, William and Lorraine, and
to my wife, Sharon, and our children,
Michelle, Sean, and Thor
Ronald W. Melicher
To my best friend and wife, Becky;
our son Matthew and his wife, Angie;
our daughter Amy and her husband, Jake
Edgar A. Norton
EDITORIAL DIRECTOR Michael McDonald
EDITORIAL MANAGER Karen Staudinger
SENIOR PRODUCTION EDITOR Suzie Pfi ster
SENIOR CONTENT MANAGER Dorothy Sinclair
DESIGNER Thomas Nery
ACQUISITIONS EDITOR Emily McGee
DEVELOPMENT EDITOR Courtney Jordan
EDITORIAL ASSISTANT Anna Durkin
DIRECTOR OF MARKETING Kevin Witt
MARKETING MANAGER Lauren Harrell
MARKETING ASSISTANT Ashley Migliaro
PRODUCT DESIGNER Matthew Origoni
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10 9 8 7 6 5 4 3 2 1
Preface
The sixteenth edition of Introduction to Finance: Markets, perspective adds value to student learning and an understand-
Investments, and Financial Management builds upon the suc- ing of the fi eld.
cesses of its earlier editions while maintaining fresh and up- Second, we wrote the book as an introductory survey of
to-date coverage of the fi eld of fi nance. This edition introduces fi nance with a readable and user-friendly focus in mind. We
several new electronic features to assist with student access to seek to convey basic knowledge, concepts, and terms that will
the textbook and with learning. serve the nonfi nance major into the future and that will form
Our text is designed to present a more-balanced fi rst a foundation upon which the fi nance major can build. Some
course in fi nance, one that off ers students perspectives on fi nan- fi ner points, discussions of theory, and complicated topics are
cial markets, investing, and fi nancial management. We use a reserved for “Learning Extensions” in selected chapters. We
successful pedagogy that reviews, fi rst, markets and institu- aim to make students using our text fi nancially literate and
tions; then, the world of investments; and fi nally, the concepts cognizant of the richness of fi nance. The book provides a good
and applications of business fi nancial management. foundation for students to build upon in later courses in fi nan-
Unlike other textbooks with a singular “corporate fi nance” cial management, investments, or fi nancial markets.
focus, our text off ers a balanced fi rst course in fi nance. Eighteen Third, we focus on the practice of fi nance in the settings of
chapters cover the three major fi nancial areas involving the markets, investments, and fi nancial management. We focus on the
fi nancial system, investments, and business fi nance. For the stu- descriptive in each of these fi elds. We don’t want students to be
dent who does not plan to take additional courses in fi nance, unable to see the forest of fi nance because the trees of quantitative
this book provides a valuable overview of the discipline’s methods obscure their view or scare them away. When we do in-
major concepts. For the student who wants to take additional troduce equations and mathematical concepts that are applicable
courses in fi nance, the overview presented provides a solid to fi nance, we will show step-by-step solutions.
foundation upon which future courses can build. By learning about markets (including gaining knowledge
Introduction to Finance is meant to be used in a course about institutions), investments, and management as the three
whose purpose is to survey the foundations of the fi nance dis- major strands of fi nance, students will fi nish their course with
cipline. As such, it is designed to meet the needs of students in a greater understanding of how these three fi elds interrelate.
various programs. Specifi cally, Introduction to Finance can be Financial markets will be seen as the arena to which businesses
used in any of the following four ways: and fi nancial institutions go to raise funds, and as the mechan-
ism through which individuals can invest their savings to meet
1. As the fi rst course in fi nance at a college or university where their future goals. The topic of investments is important in
the department wants to expose students to a broad founda- facilitating the savings–investment process. Understanding the
tional survey of the discipline. trade-off of risk and return, as well as the valuation of bonds
2. As the fi rst and only course in fi nance for nonfi nance business and stocks, is essential to investors and businesses raising
students. fi nancial capital. Understanding how securities markets work
3. As an appropriate text to use at a school that seeks to provide is equally important. Financial management uses information
liberal arts majors with a business minor or business concen- it obtains from securities and other fi nancial markets to effi -
tration. The writing level is appropriate to provide students ciently and profi tably manage assets and to raise needed funds
with a good foundation in the basics of our discipline. in a cost-effi cient manner.
4. A s a “lower division” service course whose goal is to A broad exposure to the discipline of fi nance will meet
attract freshmen and sophomores to business and to attract the needs of nonmajors who should know the basics of fi nance
them to become fi nance majors. so they can read the The Wall Street Journal, visit business-
related Internet sites, and analyze other business information
The philosophy behind the book is threefold. First, we sources intelligently. It will help the nonfi nance major work
believe that a basic understanding of the complex world of as a member of a cross-functional work team, a team that will
fi nance should begin with a survey course that covers an include fi nance professionals. In addition, this overview of fi n-
introduction to fi nancial markets, investments, and fi nancial ance will start the fi nance major off on the right foot. Rather
management or business fi nance. Students can gain an integ- than receiving a compartmentalized idea of fi nance—often
rated perspective of the interrelationships among these three viewed through the corporate fi nance lens that many texts
areas. They will appreciate how businesses and individuals use—the fi nance major will receive a practical introduction to
are aff ected by markets and institutions, as well as of how the diff erent disciplines of fi nance, and will better appreciate
markets and institutions can be used to meet the goals of the relationships among them.
individuals or fi rms. Given the events in the fi nancial markets Part 1 of the book contains six chapters on the fi nancial
and the economy in 2007–2009 and the fi nancial implications system, with primary emphasis on fi nancial markets and the
of the United Kingdom’s 2016 decision to withdraw from tools and skills necessary to better understand how such markets
the European Union (known as “Brexit”), this integrated work. We begin with an overview of the three main subfi elds
iv PREFACE
of fi nance, identify the “six principles of fi nance,” and discuss binder-ready version is available as well for those preferring
career opportunities. The principles of fi nance are the following: a paper copy.
• Coordinated chapter learning objectives, chapter summar-
1. Money has a time value.
ies, and end-of-chapter review questions. Each chapter
2. Higher returns are expected for taking on more risk.
learning objective is numbered; the expanded chapter sum-
3. Diversifying one’s investments can reduce risk. maries review each individual learning objective and each
4. Financial markets are effi cient in pricing securities. review question is keyed to a specifi c learning objective
5. The objectives of managers and stockholders may diff er. number.
6. Reputation matters. • Every chapter contains 3 or 4 Discussion Questions that
can be used in class, assigned to students, or used by the
We discuss fi nance and the role and functions of the fi nan- instructor on learning management systems such as Black-
cial system to a nation’s economy. The role of banks, other fi n- board, Moodle, Sakai, and others to form the basis of graded
ancial intermediaries, and the Federal Reserve are reviewed, as or ungraded class participation and critical thinking.
are their functions in the fi nancial system. Part 1 introduces the
• The e-book version presents, at the end of each section
international role of fi nance and how modern economies are
(corresponding to each learning objective) several multiple
aff ected by exchange rates, trade, and the fl ow of global funds.
choice questions for students to use as a review of chapter
Following this introduction to the fi nancial system, Part 2
concepts.
focuses on investments. We review the role of savings in an
economy and the ways in which funds fl ow to and from dif- • Some of the tables, charts, and graphics include interactive
ferent sectors. Interest rates are introduced, and the discussion features that allow students to sort, categorize, or focus on a
centers on making the student aware of the diff erent infl uences single graph feature at a time as it changes values over time.
on interest rate levels and why the rates change over time. Be- Other downloadable spreadsheets allow students to practice
cause interest rates measure the cost of moving money across some of the chapter’s calculations.
time, this section reviews basic time-value-of-money concepts • Excel templates have been updated and revised to refl ect the
with many worked-out examples, including the keystrokes that book’s content.
students can use when working with fi nancial calculators.
• Existing test bank items were re-examined and new ques-
Next, after reviewing the characteristics of bonds and
tions added to refl ect the many content changes and to better
stocks, students will learn to apply time-value-of-money con-
test student knowledge.
cepts to fi nd the prices of these securities. Continuing our
overview of investments, we discuss investment banking basics The content of Introduction to Finance has been updated
and the operations of securities markets, as well as the funda- to incorporate many of the economic and fi nancial events of the
mentals of investment risks and returns, to conclude Part 2. past few years. The fi nancial crisis of 2007–2008, the subsequent
Advanced classes may want to review the fi nancial deriv- recession and recovery—along with the behavior of the Federal
atives basics, which are explained in a Learning Extension of Reserve and securities markets—provide a means to highlight
Chapter 11’s discussion of securities and markets. causes, eff ects, and the integration of fi nance into our everyday
The raising of funds by businesses in the institutional and lives, as well as the implications for markets, investments, and
market environments is covered in Parts 1 and 2. Next, in Part 3, business fi nance. A fi nancial crisis colored label, denoting a
the fi nal six chapters of the text introduce students to fi nancial “Focus Point,” is placed next to relevant text material.
management. The discussion begins with the diff erent ways in We continue with our innovation found in previous edi-
which to organize a business, and the fi nancial implications of tions, featuring a real fi rm (Walgreens, the retail drugstore
each organizational form. We introduce accounting concepts, chain) in many of the chapters on investments and fi nancial
such as the balance sheet, income statement, and statement of management as a means of presenting and analyzing data.
cash fl ows, with simple examples. We discuss fi nancial ratios, In addition to these broad improvements, all chapters have
which assist in the process of analyzing a fi rm’s strengths and been updated and revised to refl ect recent events and data.
weaknesses. We review their use as a means of helping man- Specifi c notable changes in this sixteenth edition include the
agers plan ahead for future asset and fi nancing needs. Strategies following:
for managing a fi rm’s current assets and current liabilities are
examined, as are the funding sources fi rms use to tap the fi nan- Chapter 1, The Financial Environment, provides an over-
cial markets for short-term fi nancing. Finally, we introduce stu- view of the fi nancial system and environment including eco-
dents to capital budgeting basics and capital structure concepts. nomic and fi nancial developments during the 2007–2008 fi n-
ancial crisis and the 2008–2009 Great Recession. The chapter
has been reorganized with “careers in fi nance” being presented
New and Improved
near the end of the chapter after students have been introduced
to basic fi nance terms and concepts.
Many new pedagogical features are included in the textbook,
including the following:
Chapter 2, Money and the Monetary System, discusses
• A n e-book format for electronic and “cloud” access to the the process of moving savings into investments and provides
textbook and related learning material. A black-and-white, an overview of the monetary system. While physical money
PREFACE v
(coin and paper currency) in the United States continues to be Chapter 8, Interest Rates, discusses the supply and demand
our focus, we recognize possible growth in the use of digital for loanable funds and the components of market interest rates.
currencies including bitcoin. The relationship between money This chapter was substantially rewritten and uses current in-
supply and economic activity is discussed in light of continued terest rates when examining interest rates. The relationship
easy monetary policies. between interest rates and the maturity of comparable-quality
debt remains at historically low levels and is due, in part, to
Chapter 3, Banks and Other Financial Institutions, covers
the Fed’s easy monetary policy. Recent default risk premium
the types and roles of fi nancial institutions. During the 2007–09
levels are also presented and discussed.
period, falling housing prices, mortgage loan defaults, and
declining values on mortgage-backed securities that resulted Chapter 9, Time Value of Money, conveys the importance
in many fi nancial institutions not having adequate equity cap- of compounding (earning interest on interest) in building
ital to continue to operate, and, thus, needing to merge or be wealth over time. We continue to present examples of how
“bailed out.” The ability of banks to maintain sound balance to perform time value calculations using formulas, interest
sheets, including adequate capital ratios, continues to be of factor tables, step-by-step fi nancial calculator keystrokes, and
concern to regulators, politicians, and others. Excel spreadsheets. While historically low interest rates make
it attractive to fi nance the purchase of homes and other dur-
Chapter 4, Federal Reserve System, describes the current
able goods, low rates also make it diffi cult for individuals to
structure and operations of the Federal Reserve (the Fed).
build wealth over time.
The Fed’s response to the recent fi nancial crisis and economic
downturn as well as its eff orts to stimulate economic growth Chapter 10, Bond and Stocks: Characteristics and Valu-
through quantitative easing and other means is covered. The ations, has its bond valuation section rewritten to use the
Fed used quantitative easing, among other things, to stimulate “annual percentage rate” (APR) approach as opposed to the
economic growth and is fi nding it diffi cult to move towards “eff ective interest rate” (EAR) approach. The chapter contains
more-traditional interest rate levels. Janet Yellen, the current updated data and improved discussions of bonds and stocks.
chair of the Fed’s board of governors, is faced with the diffi cult We have revised the discussion of the risks facing investors in
task of simultaneously maintaining economic growth raising the low interest rate environment sustained by the Fed since
interest rates that are near zero. the Great Recession. Spreadsheet examples show how to apply
time value concepts to calculate bond prices and stock prices.
Chapter 5, Policy Makers and the Money Supply, describes
how the four policy maker groups (Federal Reserve System, Chapter 11, Securities and Markets, incorporates changes in
the president, Congress, and the U.S. Treasury) are respons- securities trading, including high-frequency trading and events
ible for carrying out the national economic policy objectives such as the New York Stock Exchange and Intercontinental
of economic growth, high employment, and price stability. We Exchange (NYSE–ICE) merger, as well as an overview of the
cover the U.S. government’s response to the perfect fi nancial Facebook initial public off ering (IPO) and some of its issues.
storm involving the fi nancial crisis and the subsequent Great This chapter’s Learning Extension on futures and options has
Recession. New material on the current size of the national been revised to refl ect reviewer suggestions.
debt and the eff orts of the U.S. Treasury to manage the national
Chapter 12, Financial Returns and Risk Concepts, is one of
debt are presented.
the more mathematical chapters; it shows how to do calcula-
Chapter 6, International Finance and Trade, covers the tions with step-by-step calculator keystrokes and spreadsheet
evolution of the international monetary system and eff orts functions. Its content is updated, especially evidence regarding
by European countries to achieve unifi cation, although the the diffi culty in “beating the market” by active investors.
recent decision by the United Kingdom to withdraw from
Chapter 13, Business Organization and Financial Data,
the European Union has caused concern about the future
features data from Walgreens’ fi nancial statements, with high-
economic and fi nancial viability of the European Union.
lights about the merger with Boots Alliance. We maintain that
Material on currency exchange rates and the factors that af-
a fi rm’s goal is to maximize shareholder wealth, and we dis-
fect currency exchange rates have been substantially rewrit-
cuss “sustainability” in light of this goal.
ten. We discuss the use of hedging, forward contracts, and
forward rates in the section that covers managing currency Chapter 14, Financial Analysis and Long-Term Financial
exchange risk. We also have added a Learning Extension Planning, uses updated data from Walgreens and the retail
that discusses the use of forward contracts in international drugstore industry in a practical example of fi nancial ratio
business transactions. analysis using industry averages. We focus on changes in
Walgreens’ fi nancial ratios following its merger with Boots
Chapter 7, Savings and Investment Process, discusses the re-
Alliance to form Walgreens Boots Alliance.
lationship between gross domestic product and capital forma-
tion, and covers the major sources of income and outlays in- Chapter 15, Managing Working Capital, expands the dis-
volved in the annual federal budget. Recent data on personal cussion of managing cash in a diffi cult business environment
and corporate savings are presented and discussed. The role with low interest rates. We discuss a new reason why fi rms
played by individuals in the 2007–09 fi nancial crisis and the hold large amounts of cash, with the tax cost of repatriating the
Great Recession is also covered. funds back to the home country.
vi PREFACE
Chapter 16, Short-Term Business Financing, contains in- Spreadsheet Illustrations: We show how to use spread-
formation on real fi rms’ working capital fi nancing strategies sheets to solve problems, and to teach students about the power
and on the implications of the fi nancial crisis on a fi rm’s abil- of spreadsheet functions and analysis.
ity to obtain short-term fi nancing, including the role of “sup-
ply chain fi nancing” by some banks and suppliers. We include Boxed Features: Throughout the book, boxes are used to
a section on the American Energy and Infrastructure Jobs Act focus on current topics or applications of interest. They are
of 2012 (JOBS Act of 2012), a tool to help small fi rms obtain designed to illustrate concepts and practices in the dynamic
fi nancing, including the use of “crowdfunding.” fi eld of fi nance.
Chapter 17, Capital Budgeting Analysis, relates the cash • S mall Business Practice boxes highlight aspects of the
fl ow estimation process for a project to the fi rm’s statement chapter topics relating directly to small businesses and
of cash fl ows found in Chapter 13 and reviews standard cap- entrepreneurship.
ital budgeting analysis tools, such as net present value (NPV),
• C areer Opportunities in Finance boxes provide information
internal rate of return (IRR), profi tability index (PI), and mod-
about various careers in fi nance and appear in many chapters.
ifi ed internal rate of return (MIRR).
• P ersonal Financial Planning boxes provide insight into how the
Chapter 18, Capital Structure and the Cost of Capital, chapter’s content can be applied to an individual’s fi nances.
contains updated discussions of trends in the use of debt by
corporations and the use of debt fi nancing in the low interest Learning Extensions: Chapter appendixes, called Learn-
rate environment that has existed since the Great Recession. ing Extensions, are included in many chapters. Learning
We include information of how managers compute capital Extensions provide additional in-depth coverage of topics
costs from the Cost of Capital Survey issued by the Associ- related to their respective chapters, and many challenge stu-
ation of Finance Professionals. dents to use their mathematical skills.
End-of-Chapter Materials: Each chapter provides the
following:
Learning and Teaching Aids
• Review Questions, keyed to specifi c chapter learning ob-
jectives that review chapter material
The sixteenth edition of Introduction to Finance off ers the fol-
• Exercises for students to solve and exercise their mathem-
lowing aids for students and instructors:
atical skills
Chapter Openers: Each chapter begins with the following: • Problems that are more diffi cult and that should be solved
by using spreadsheets. Downloadable templates are availa-
• Chapter Learning Objectives, which students can use to re-
ble for each problem.
view the chapter’s main points and which instructors can
use as a basis for in-class lecture or discussion;
Companion Website: The text’s website at www.wiley.
• Where We Have Been statements that remind students of com/college/melicher contains a myriad of resources and links
what was covered in the previous chapters; to aid learning and teaching.
• Where We Are Going, which are previews of chapters to
come; Instructor’s Manual and Test Bank: The Instructor’s
Manual is available to adopters of this text. It features detailed
• How This Chapter Applies To Me that explain how the con-
chapter outlines, lecture tips, and answers to end-of-chapter
tent of the chapter, no matter how technical or business spe-
review questions and problems.
cifi c, has applications to the individual student.
Computerized Test Bank: There is a test bank for the
Applying Finance To: These boxes show how the topic
text. A Test-Generating Program that allows instructors to cus-
of each chapter relates to the fi nance fi elds of institutions and
tomize their exams also is provided.
markets, investments, and fi nancial management.
Powerpoint Presentations: Created by the authors, a
Learning Activities: We direct the student to relevant
PowerPoint presentation is provided for each chapter of the
websites at diff erent points in each chapter.
text. Slides include outline notes on the chapter, additional
presentation topics, and fi gures and tables from the text.
Margin Defi nitions: Margin defi nitions of key terms are
provided to assist students in learning the language of fi nance. Spreadsheet Templates: Excel-compatible templates,
developed by Robert Ritchey of Texas Tech University, are
Focus Icons: Icons are placed by relevant text to indicate available on the text website. Students can use the fi nancial
discussions of fi nance principles, implications of the recent analysis tools worksheets and templates to help apply what
fi nancial crisis, fi nancial or business ethical issues, and global they’ve learned in the text and solve some of the end-of-chapter
or international discussions. problems and challenge problems.
PREFACE vii
Acknowledgments
We would like to thank the Wiley Publishing team of Acquisitions Editor, John K. Mullen, Clarkson University
Emily McGee, Senior Production Editor, Suzie Pfi ster, Development Michael Murray, Winona State University
Editor, Courtney Jordan, and Product Designer, Matthew Origoni for Napoleon Overton, University of Memphis
their role in preparing and publishing the sixteenth edition of Introduc- Michael Owen, Montana State University
tion to Finance. Marco Pagani, San Jose State University
In addition, we are especially grateful to the reviewers for Jason Powers, Strayer University
their comments and constructive criticisms of this and previous Barbara L. Purvis, Centura College
editions: Alan Questell, Richmond Community College
Ernest Scarbrough, Arizona State University
Saul W. Adelman, Miami University, Ohio Raymond Shovlain, St. Ambrose University
Tim Alzheimer, Montana State University Amir Tavakkol, Kansas State University
Allan Blair, Palm Beach Atlantic College Jim Washam, Arkansas State University
Stewart Bonem, Cincinnati State Technical and Community College Howard Whitney, Franklin University
Linda K. Brown, St. Ambrose University Lawrence Wolken, Texas A&M University
Joseph M. Byers, Community College of Allegheny County, South K. Matthew Wong, St. John’s University
Campus David Zalewski, Providence College
Robert L. Chapman, Orlando College
William Chittenden, Texas State University Likewise, we appreciate the comments from students and
Sara J. Conroy, Community College of Allegheny County teachers, who have used previous editions, and the assistance
Will Crittendon, Bronx Community College from the dozens of reviewers, who have commented about the
David R. Durst, University of Akron early editions. Special recognition goes to Carl Dauten, who
Sharon H. Garrison, Florida Atlantic University coauthored the fi rst four editions, and Merle Welshans, who
Asim Ghosh, Saint Joseph’s University was a coauthor on the fi rst nine editions of the book. Finally,
Stephen S. Gray, Western Illinois University
and perhaps most importantly, we wish to thank our families
Lester Hadsell, University of Albany
for their understanding and support during the writing of the
Irene M. Hammerbacher, Iona College
sixteenth edition.
Kim Hansen, Mid-State Technical College
Jeff Hines, Davenport College
Jeff Jewell, Lipscomb University
Lisa Johnson, Centura College
Ed Krohn, Miami Dade Community College RONALD W. MELICHER,
Jessica Lancaster, McCann School of Business and Technology Boulder, Colorado
P. John Limberopoulos, University of Colorado Boulder
Leslie Mathis, University of Memphis EDGAR A. NORTON,
Michael B. McDonald, Fairfi eld University Normal, Illinois
Author Bios
RON MELICHER is professor emeritus of fi nance and EDGAR A. NORTON is professor of fi nance and director
previously served three diff erent terms as chair of the Finance of the Institute for Financial Planning and Analysis in the Col-
Division, Leeds School of Business, University of Colorado, lege of Business at Illinois State University. He holds a double
Boulder. He is a past president of the Financial Management major in computer science and economics from Rensselaer
Association. Ron earned undergraduate, M.B.A., and doctoral Polytechnic Institute and received his M.S. and Ph.D. from
degrees from Washington University in St. Louis, Missouri. the University of Illinois at Urbana–Champaign. A Chartered
While at the University of Colorado, he received several distin- Financial Analyst (CFA), he regularly receives certifi cates
guished teaching awards and was designated a university-wide of achievement in the fi eld of investments. He has consulted
President’s Teaching Scholar. Ron has taught corporate fi nance with COUNTRY Financial, Maersk, and the CFA Institute;
and fi nancial strategy and valuation in M.B.A. and Executive does pro bono fi nancial planning; and is a past president of
M.B.A. programs in addition to entrepreneurial fi nance and the Midwest Finance Association. His research has appeared
investment banking to undergraduate students. He also has in numerous journals, such as Financial Review, Journal of
taught fi nancial management materials in executive education Business Venturing, and Journal of Business Ethics. He has
courses and in in-house corporate programs. His research has coauthored four textbooks, including Introduction to Finance.
been published in major fi nance journals, including the Journal
of Finance, Journal of Financial and Quantitative Analysis,
and Financial Management. He is also the coauthor of Entre-
preneurial Finance, fi fth edition (Cengage Learning, 2015).
viii