Introduction to Finance: Markets, Investments, and Financial Management

Introduction to Finance, 17^th Edition offers students a balanced introduction to the three major areas of finance: institutions and markets, investments, and financial management. Updated to incorporate recent economic and financial events, this new edition is an ideal textbook for first courses in finance—reviewing the discipline’s essential concepts, principles, and practices in a clear, reader-friendly manner. Students gain an integrated perspective of finance by learning how markets and institutions influence, and are influenced by, individuals, businesses, and governments.

Designed to impart financial literacy to readers with no previous background in the subject, the text provides a solid foundation for students to build upon in later courses in financial management, investments, or financial markets. Equations and mathematical concepts are kept to a minimum, and include understandable, step-by-step solutions. Divided into three parts, the book explains financial markets, discusses the functions of financial systems, reviews savings and investments in different sectors, describes accounting concepts and organizational structures, and more. Real-world examples featured throughout the text help students understand important concepts and appreciate the role of finance in various local, national, and global settings.

Preface iv

Author Bios xii

Part 1 Institutions and Markets

1 The Financial Environment 5

1.1 What is Finance? 6

1.2 Why Study Finance? 8

1.3 Six Principles of Finance 10

1.4 Overview of the Financial System 13

1.5 Financial Markets: Characteristics and Types 17

1.6 Careers in Finance 18

1.7 The Plan of Study 20

Applying Finance To. . . 21

Summary 21

Key Terms 22

Review Questions 22

Exercises 22

2 Money and the Monetary System 24

2.1 The 2007–2008 Financial Crisis and Subsequent Recovery 25

2.2 Process of Moving Savings into Investments 26

2.3 Overview of the Monetary System 28

2.4 Characteristics and Functions of Money 29

2.5 Development of Money in the United States 31

2.6 Money Market Securities 37

2.7 Measures of the U.S. Money Supply 38

2.8 Money Supply and Economic Activity 41

2.9 International Monetary System 42

Applying Finance To. . . 44

Summary 44

Key Terms 45

Review Questions 45

Exercises 46

Problems 47

3 Banks and Other Financial Institutions 49

3.1 Financial Institution Problems During the 2007–2008 Financial Crisis 50

3.2 Types and Roles of Financial Institutions 51

3.3 Overview of the Banking System 55

3.4 Historical Development of the U.S. Banking System 58

3.5 Regulation of the Banking System 60

3.6 Structure of Banks 65

3.7 The Bank Balance Sheet 66

3.8 Bank Management 71

3.9 International Banking and Foreign Systems 75

Applying Finance To. . . 76

Summary 77

Key Terms 78

Review Questions 78

Exercises 79

Problems 79

4 Federal Reserve System 82

4.1 U.S. Central Bank Response to the Financial Crisis and Great Recession 83

4.2 The U.S. Banking System Prior to the Fed 84

4.3 Structure of the Federal Reserve System 86

4.4 Monetary Policy Functions and Instruments 92

4.5 Fed Supervisory and Regulatory Functions 99

4.6 Fed Service Functions 101

4.7 Central Banks in Other Countries 103

Applying Finance To. . . 104

Summary 104

Key Terms 105

Review Questions 105

Exercises 106

Problems 107

5 Policy Makers and the Money Supply 109

5.1 National Economic Policy Objectives 110

5.2 Four Policy Maker Groups 112

5.3 Government Influence on the Economy 114

5.4 Treasury Cash and General Management Responsibilities 116

5.5 Treasury Deficit Financing and Debt Management Responsibilities 120

5.6 Changing the Money Supply 122

5.7 Factors Affecting Bank Reserves 128

5.8 The Monetary Base and the Money Multiplier 131

Applying Finance To. . . 133

Summary 133

Key Terms 134

Review Questions 134

Exercises 135

Problems 135

6 International Finance and Trade 137

6.1 International Monetary System 138

6.2 European Unification 140

6.3 Currency Exchange Markets and Rates 142

6.4 Factors that Affect Currency Exchange Rates 145

6.5 Conducting Business Internationally 149

6.6 Financing International Trade 151

6.7 Developments in U.S. International Transactions 157

Applying Finance To. . . 161

Summary 161

Key Terms 162

Review Questions 162

Exercises 163

Problems 164

6.8 Exchange Rate Risks in Global Business 166

Hedging Cash Flows 167

Speculating or Taking Educated Guesses on Exchange Rate Movements 168

Where to Invest? 168

Summary 169

Review Questions 170

Part 2 Investments

7 Savings and Investment Process 173

7.1 Gross Domestic Product and Capital Formation 174

7.2 Federal Government Receipts and Expenditures 177

7.3 Role and Major Sources of Savings 180

7.4 Factors Affecting Savings 184

7.5 Capital Market Securities 187

7.6 Mortgage Markets 189

7.7 Role of the Individual in the 2007–2008 Financial Crisis and Today 191

Applying Finance To. . . 193

Summary 193

Key Terms 194

Review Questions 194

Exercises 195

Problems 195

8 Interest Rates 197

8.1 Supply and Demand for Loanable Funds 198

8.2 Components of Market Interest Rates 203

8.3 Default Risk-Free Securities:

8.4 Term or Maturity Structure of Interest Rates 210

8.5 Inflation Premiums and Price Movements 213

8.6 Default Risk Premiums 218

Applying Finance To. . . 220

Summary 220

Key Terms 221

Review Questions 221

Exercises 222

Problems 223

9 Time Value of Money 225

9.1 Basic Time Value Concepts 226

9.2 Compounding to Determine Future Values 228

9.3 Discounting to Determine Present Values 232

9.4 Finding Interest Rates and Time Requirements 237

9.5 Future Value of an Annuity 239

9.6 Present Value of an Annuity 242

9.7 Interest Rates and Time Requirements for Annuities 245

9.8 Determining Periodic Annuity Payments 247

9.9 More Frequent Time Intervals and the Cost of Consumer Credit 249

Applying Finance To. . . 252

Summary 253

Key Terms 253

Review Questions 254

Exercises 254

Problems 254

9.10 Annuity Due Problems 257

Future Value of an Annuity Due 257

Present Value of an Annuity Due 258

Interest Rates and Time Requirements for Annuity Due Problems 259

Summary 260

Questions and Problems 260

10 Bonds and Stocks: Characteristics and Valuations 262

10.1 Long-Term External Financing Sources for Businesses 263

10.2 Bonds 264

10.3 Different Types of Bonds 271

10.4 Corporate Equity Capital 275

10.5 Dividends and Stock Repurchases 279

10.6 Valuation Principles 283

10.7 Valuation of Bonds 286

10.8 Valuation of Stocks 293

Applying Finance To. . . 298

Summary 298

Key Terms 299

Review Questions 300

Problems 301

10.9 Holding Period Returns 305

Annualized Rates of Return 305

Summary 307

Problems 307

11 Securities and Markets 308

11.1 Issuing Securities: Primary Securities Markets 309

11.2 The Facebook IPO 313

11.3 Other Ways to Assist Issuing Firms 316

11.4 Cost of Going Public 318

11.5 Investment Banking Firms: Other Functions Innovations Regulations 321

11.6 Trading Securities – Secondary Securities Markets 323

11.7 Security Transactions 326

11.8 Over-the-Counter Market 330

11.9 What Makes a Good Market? 331

11.10 Security Market Indexes and Trading Foreign Securities 333

11.11 Inside Information and Other Ethical Issues 336

Applying Finance To. . . 338

Summary 339

Key Terms 340

Review Questions 341

Problems 341

11.12 Why Do Derivatives Exist? 344

Futures Contracts 345

Options 346

Option Profit/Loss Diagrams 349

Summary 350

Key Terms 350

Discussion Questions 350

Problems 351

12 Financial Return and Risk Concepts 352

12.1 Historical Return for a Single Financial Asset 353

12.2 Historical Risk Measures for a Single Financial Asset 355

12.3 Where Does Risk Come from? 358

12.4 Expected Measures of Return and Risk 360

12.5 Historical Returns and Risk of Different Assets 364

12.6 Efficient Capital Markets 365

12.7 Portfolio Returns 368

12.8 Variance and Standard Deviation of Return On a Portfolio 369

12.9 Portfolio Risk and the Number of Investments in the Portfolio 372

12.10 Capital Asset Pricing Model 374

Applying Finance To. . . 378

Summary 378

Key Terms 379

Review Questions 379

Problems 380

12.11A Estimating Beta 384

12.11B Security Market Line 386

Summary 387

Problems 387

Part 3 Financial Management

13 Business Organization and Financial Data 391

13.1 Starting a Business 392

13.2 Forms of Business Organization in the United States 394

13.3 Accounting Principles 398

13.4 Income Statement 401

13.5 The Balance Sheet 402

13.6 Statement of Cash Flows 405

13.7 Financial Statements of Different Companies 407

13.8 Goal of a Firm 410

13.9 Corporate Governance 414

13.10 Finance in the Organization Chart 418

Applying Finance To. . . 420

Summary 420

Key Terms 421

Review Questions 421

Problems 422

13.11A Income Tax 427

13.11B Depreciation Basics 429

13.11.1 A Few Words on Depreciation Methods 430

Summary 431

Review Questions and Problems 431

14 Financial Analysis and Long-Term Financial Planning 432

14.1 Financial Statement Analysis 433

14.2 Liquidity Ratios and Analysis 436

14.3 Asset Management Ratios and Analysis 438

14.4 Financial Leverage Ratios and Analysis 441

14.5 Profitability Ratios and Analysis 445

14.6 Market Value Ratios and Analysis 447

14.7 Dupont Method of Ratio Analysis 449

14.8 Long-Term Financial Planning 452

14.9 Cost–Volume–Profit Analysis 455

14.10 Degree of Operating Leverage 456

Applying Finance To. . . 458

Summary 459

Key Terms 460

Review Questions 460

Problems 461

15 Managing Working Capital 466

15.1 Importance of Working Capital 467

15.2 Operating and Cash Conversion Cycles 468

15.3 Investments in Receivables Inventory and Payable Financing 472

15.4 Cash Budgets 475

15.5 Management of Current Assets 480

15.6 Getting – and Keeping – the Cash 488

15.7 Accounts Receivable Management 490

15.8 Inventory Management 494

15.9 Technology and Working Capital Management 495

Applying Finance To. . . 497

Summary 497

Key Terms 498

Review Questions 498

Problems 499

16 Short-Term Business Financing 503

16.1 Strategies for Financing Working Capital 504

16.2 Factors Affecting Short-Term Financing 507

16.3 Providers of Short-Term Financing 512

16.4 Nonbank Short-Term Financing Sources 516

16.5 Additional Varieties of Short-Term Financing 521

16.6 Inventory Financing and Other Secured Loans 525

16.7 The Cost of Short-Term Financing 527

Applying Finance To. . . 528

Summary 528

Key Terms 529

Review Questions 530

Problems 530

17 Capital Budgeting Analysis 533

17.1 Mission, Vision, and Capital Budgeting 534

17.2 Capital Budgeting Process 537

17.3 Capital Budgeting Techniques – Net Present Value 540

17.4 Capital Budgeting Techniques – Internal Rate of Return 543

17.5 Capital Budgeting Techniques – Modified Internal Rate of Return 547

17.6 Capital Budgeting Techniques – Profitability Index 549

17.7 Capital Budgeting Techniques – Payback Period 549

17.8 Conflicts Between Discounted Cash Flow Techniques 550

17.9 Estimating Project Cash Flows 552

17.10 Keeping Managers Honest 558

17.11 Risk-Related Considerations 559

Applying Finance To. . . 561

Summary 561

Key Terms 563

Review Questions 563

Problems 564

17.12 Project Stages and Cash Flow Estimation 567

Initial Outlay 567

Cash Flows During the Project’s Operating Life 568

Salvage Value and NWC Recovery at Project Termination 568

17.13 Applications 569

Cash Flow Estimation for a Revenue Expanding Project 569

Cash Flow Estimation for a Cost-Saving Project 571

Setting a Bid Price 574

Summary 576

Review Questions 576

Problems 576

18 Capital Structure and the Cost of Capital 578

18.1 Why Choose a Capital Structure? 579

18.2 Required Rate of Return and the Cost of Capital 582

18.3 Cost of Capital 583

18.4 Weighted Average Cost of Capital 587

18.5 Planning Growth Rates 592

18.6 EBIT/eps Analysis 594

18.7 Combined Operating and Financial Leverage Effects 597

18.8 Insights from Theory and Practice 601

Applying Finance To. . . 607

Summary 607

Key Terms 608

Review Questions 609

Problems 610

Appendix A-1

Glossary G-1

Index I-1

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