The Basics of Finance
The Frank J. Fabozzi Series Fixed Income Securities, Second Edition by Frank J. Fabozzi Focus on Value: A Corporate and Investor Guide to Wealth Creation by James L. Grant and James A. Abate Handbook of Global Fixed Income Calculations by Dragomir Krgin Managing a Corporate Bond Portfolio by Leland E. Crabbe and Frank J. Fabozzi Real Options and Option-Embedded Securities by William T. Moore Capital Budgeting: Theory and Practice by Pamela P. Peterson and Frank J. Fabozzi The Exchange-Traded Funds Manual by Gary L. Gastineau Professional Perspectives on Fixed Income Portfolio Management, Volume 3 edited by Frank J. Fabozzi Investing in Emerging Fixed Income Markets edited by Frank J. Fabozzi and Efstathia Pilarinu Handbook of Alternative Assets by Mark J. P. Anson The Global Money Markets by Frank J. Fabozzi, Steven V. Mann, and Moorad Choudhry The Handbook of Financial Instruments edited by Frank J. Fabozzi Interest Rate, Term Structure, and Valuation Modeling edited by Frank J. Fabozzi Investment Performance Measurement by Bruce J. Feibel The Handbook of Equity Style Management edited by T. Daniel Coggin and Frank J. Fabozzi The Theory and Practice of Investment Management edited by Frank J. Fabozzi and Harry M. Markowitz Foundations of Economic Value Added, Second Edition by James L. Grant Financial Management and Analysis, Second Edition by Frank J. Fabozzi and Pamela P. Peterson Measuring and Controlling Interest Rate and Credit Risk, Second Edition by Frank J. Fabozzi, Steven V. Mann, and Moorad Choudhry Professional Perspectives on Fixed Income Portfolio Management, Volume 4 edited by Frank J. Fabozzi The Handbook of European Fixed Income Securities edited by Frank J. Fabozzi and Moorad Choudhry The Handbook of European Structured Financial Products edited by Frank J. Fabozzi and Moorad Choudhry The Mathematics of Financial Modeling and Investment Management by Sergio M. Focardi and Frank J. Fabozzi Short Selling: Strategies, Risks, and Rewards edited by Frank J. Fabozzi The Real Estate Investment Handbook by G. Timothy Haight and Daniel Singer Market Neutral Strategies edited by Bruce I. Jacobs and Kenneth N. Levy Securities Finance: Securities Lending and Repurchase Agreements edited by Frank J. Fabozzi and Steven V. Mann Fat-Tailed and Skewed Asset Return Distributions by Svetlozar T. Rachev, Christian Menn, and Frank J. Fabozzi Financial Modeling of the Equity Market: From CAPM to Cointegration by Frank J. Fabozzi, Sergio M. Focardi, and Petter N. Kolm Advanced Bond Portfolio Management: Best Practices in Modeling and Strategies edited by Frank J. Fabozzi, Lionel Martellini, and Philippe Priaulet Analysis of Financial Statements, Second Edition by Pamela P. Peterson and Frank J. Fabozzi Collateralized Debt Obligations: Structures and Analysis, Second Edition by Douglas J. Lucas, Laurie S. Goodman, and Frank J. Fabozzi Handbook of Alternative Assets, Second Edition by Mark J. P. Anson Introduction to Structured Finance by Frank J. Fabozzi, Henry A. Davis, and Moorad Choudhry Financial Econometrics by Svetlozar T. Rachev, Stefan Mittnik, Frank J. Fabozzi, Sergio M. Focardi, and Teo Jasic Developments in Collateralized Debt Obligations: New Products and Insights by Douglas J. Lucas, Laurie S. Goodman, Frank J. Fabozzi, and Rebecca J. Manning Robust Portfolio Optimization and Management by Frank J. Fabozzi, Peter N. Kolm, Dessislava A. Pachamanova, and Sergio M. Focardi Advanced Stochastic Models, Risk Assessment, and Portfolio Optimizations by Svetlozar T. Rachev, Stogan V. Stoyanov, and Frank J. Fabozzi How to Select Investment Managers and Evaluate Performance by G. Timothy Haight, Stephen O. Morrell, and Glenn E. Ross Bayesian Methods in Finance by Svetlozar T. Rachev, John S. J. Hsu, Biliana S. Bagasheva, and Frank J. Fabozzi The Handbook of Commodity Investing by Frank J. Fabozzi, Roland Fuss, ¨ and Dieter G. Kaiser The Handbook of Municipal Bonds edited by Sylvan G. Feldstein and Frank J. Fabozzi Subprime Mortgage Credit Derivatives by Laurie S. Goodman, Shumin Li, Douglas J. Lucas, Thomas A Zimmerman, and Frank J. Fabozzi Introduction to Securitization by Frank J. Fabozzi and Vinod Kothari Structured Products and Related Credit Derivatives edited by Brian P. Lancaster, Glenn M. Schultz, and Frank J. Fabozzi Handbook of Finance: Volume I: Financial Markets and Instruments edited by Frank J. Fabozzi Handbook of Finance: Volume II: Financial Management and Asset Management edited by Frank J. Fabozzi Handbook of Finance: Volume III: Valuation, Financial Modeling, and Quantitative Tools edited by Frank J. Fabozzi Finance: Capital Markets, Financial Management, and Investment Management by Frank J. Fabozzi and Pamela Peterson Drake Active Private Equity Real Estate Strategy edited by David J. Lynn Foundations and Applications of the Time Value of Money by Pamela Peterson Drake and Frank J. Fabozzi Leveraged Finance: Concepts, Methods, and Trading of High-Yield Bonds, Loans, and Derivatives by Stephen Antczak, Douglas Lucas, and Frank J. Fabozzi Modern Financial Systems: Theory and Applications by Edwin Neave Institutional Investment Management: Equity and Bond Portfolio Strategies and Applications by Frank J. Fabozzi Quantitative Equity Investing: Techniques and Strategies by Frank J. Fabozzi, Sergio M. Focardi, Petter N. Kolm Basics of Finance: An Introduction to Financial Markets, Business Finance, and Portfolio Management by Frank J. Fabozzi and Pamela Peterson Drake Simulation and Optimization in Finance: Modeling with MATLAB, @Risk, or VBA by Dessislava Pachamanova and Frank J. Fabozzi
The Basics of Finance An Introduction to Financial Markets, Business Finance, and Portfolio Management
PAMELA PETERSON DRAKE FRANK J. FABOZZI
John Wiley & Sons, Inc.
C 2010 by John Wiley & Sons. All rights reserved. Copyright
Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions. Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002. Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our web site at www.wiley.com. Library of Congress Cataloging-in-Publication Data: Fabozzi, Frank J. The basics of finance : an introduction to financial markets, business finance, and portfolio management / Frank J. Fabozzi, Pamela Peterson Drake. p. cm. – (Frank J. Fabozzi series ; 192) Includes index. ISBN 978-0-470-60971-2 (cloth); 978-0-470-87743-2 (ebk); 978-0-470-87771-5 (ebk); 978-0-470-87772-2 (ebk) 1. Finance. I. Peterson Drake, Pamela, 1954- II. Title. HG173.F25 2010 332–dc22 2010010863 Printed in the United States of America. 10 9 8 7 6 5 4 3 2 1
To my husband, Randy, and my children, Ken and Erica —P.P.D. To my wife, Donna, and my children, Francesco, Patricia, and Karly —F.J.F.
Contents
Preface CHAPTER 1 What Is Finance? Capital Markets and Capital Market Theory Financial Management Investment Management Organization of This Book The Bottom Line Questions
xiii
1 3 4 6 7 8 8
PART ONE
The Financial System CHAPTER 2 Financial Instruments, Markets, and Intermediaries The Financial System The Role of Financial Markets The Role of Financial Intermediaries Types of Financial Markets The Bottom Line Questions
13 13 17 18 24 33 33
CHAPTER 3 The Financial System’s Cast of Characters
37
Domestic Nonfinancial Sectors Nonfinancial Businesses Domestic Financial Sectors Foreign Investors The Bottom Line Questions
39 42 43 60 60 61
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CONTENTS
PART TWO
Financial Management CHAPTER 4 Financial Statements Accounting Principles: What Are They? The Basic Financial Statements How Are the Statements Related? Why Bother about the Footnotes? Accounting Flexibility U.S. Accounting vs. Outside of the U.S. The Bottom Line Solutions to Try It! Problems Questions
CHAPTER 5 Business Finance Forms of Business Enterprise The Objective of Financial Management The Bottom Line Solutions to Try It! Problems Questions
65 66 67 81 82 83 83 84 85 86
89 90 97 104 105 105
CHAPTER 6 Financial Strategy and Financial Planning
109
Strategy and Value The Budgeting Process Budgeting Performance Evaluation Strategy and Value Creation The Bottom Line Questions
110 115 119 120 124 128 129
CHAPTER 7 Dividend and Dividend Policies Dividends Stock Distributions Dividend Policies Stock Repurchases The Bottom Line Solutions to Try It! Problems Questions
133 134 137 141 147 150 151 151
Contents
CHAPTER 8 The Corporate Financing Decision Debt vs. Equity Financial Leverage and Risk Financial Distress The Cost of Capital Optimal Capital Structure: Theory and Practice The Bottom Line Solutions to Try It! Problems Questions
CHAPTER 9 Financial Risk Management The Definition of Risk Enterprise Risk Management Managing Risks The Bottom Line Questions
ix
155 156 164 168 171 175 180 182 183
185 185 188 193 197 198
PART THREE
Valuation and Analytical Tools CHAPTER 10 The Math of Finance Why the Time Value of Money? Calculating the Future Value Calculating a Present Value Determining the Unknown Interest Rate The Time Value of a Series of Cash Flows Annuities Loan Amortization Interest Rates and Yields The Bottom Line Solutions to Try It! Problems Questions
CHAPTER 11 Financial Ratio Analysis Classifying Financial Ratios Liquidity
201 201 203 213 216 217 221 230 232 238 239 240
243 244 247
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Profitability Ratios Activity Ratios Financial Leverage Return on Investment The DuPont System Common-Size Analysis Using Financial Ratio Analysis The Bottom Line Solutions to Try It! Problems Questions
CHAPTER 12 Cash Flow Analysis Difficulties with Measuring Cash Flow Free Cash Flow Usefulness of Cash Flows Analysis Ratio Analysis The Bottom Line Solutions to Try It! Problems Questions
CHAPTER 13 Capital Budgeting Investment Decisions and Owners’ Wealth The Capital Budgeting Process Determining Cash Flows from Investments Capital Budgeting Techniques The Bottom Line Solutions to Try It! Problems Questions
CHAPTER 14 Derivatives for Controlling Risk Futures and Forward Contracts Options Swaps The Bottom Line Appendix: Black-Scholes Option Pricing Model Solutions to Try It! Problems Questions
253 255 258 262 263 266 268 270 270 271
275 275 283 288 290 292 293 293
295 296 298 303 321 344 344 345
349 350 363 376 379 380 383 385
Contents
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PART FOUR
Investment Management CHAPTER 15 Investment Management Setting Investment Objectives Establishing an Investment Policy Constructing and Monitoring a Portfolio Measuring and Evaluating Performance The Bottom Line Solutions to Try It! Problems Questions
CHAPTER 16 The Theory of Portfolio Selection Some Basic Concepts Estimating a Portfolio’s Expected Return Measuring Portfolio Risk Portfolio Diversification Choosing a Portfolio of Risky Assets Issues in the Theory of Portfolio Selection Behavioral Finance and Portfolio Theory The Bottom Line Solutions to Try It! Problems Questions
CHAPTER 17 Asset Pricing Theory Characteristics of an Asset Pricing Model The Capital Asset Pricing Model The Arbitrage Pricing Theory Model Some Principles to Take Away The Bottom Line Solutions to Try It! Problems Questions
CHAPTER 18 The Structure of Interest Rates The Base Interest Rate The Term Structure of Interest Rates Term Structure of Interest Rates Theories
389 391 393 400 401 410 411 412
415 416 418 421 426 428 434 438 441 442 443
445 446 447 461 465 466 467 467
469 470 476 484
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CONTENTS
Swap Rate Yield Curve The Bottom Line Solutions to Try It! problems Questions
CHAPTER 19 Valuing Common Stock Discounted Cash Flow Models Relative Valuation Methods The Bottom Line Solutions to Try It! Problems Questions
CHAPTER 20 Valuing Bonds Valuing a Bond Conventional Yield Measures Valuing Bonds that Have Embedded Options The Bottom Line Solutions to Try It! Problems Questions
486 487 488 489
491 491 503 509 510 511
513 514 524 532 538 539 540
Glossary
543
About the Authors
571
Index
573
Preface An investment in knowledge pays the best interest. —Benjamin Franklin
he purpose of this book is to provide an introduction to financial decisionmaking, and the framework in which these decisions are made. The Basics of Finance is an accessible book for those who want to gain a better understanding of this field, but lack a strong business background. In this book, we cover the essential concepts, tools, methods, and strategies in finance without delving too far into theory. In Basics of Finance, we discuss financial instruments and markets, portfolio management techniques, understanding and analyzing financial statements, and corporate financial strategy, planning, and policy. We explain concepts in various areas of finance without getting too complicated. We explore, in a basic way, topics such as cash flow analysis, asset valuation, capital budgeting, and derivatives. We also provide a solid foundation in the field of finance, which you can quickly build upon. Along the way, we provide sample problems—Try it! problems—so that you can try out any math that we demonstrate in the chapter. We also provide end-of-chapter questions—with solutions easily accessible on our web site—that test your knowledge of the basic terms and concepts that we discuss in the chapter. Solutions to end-of-chapter problems can be downloaded by visiting www.wiley.com/go/petersonbasics. Please log in to the web site using this password: Petersonbasics123. The Basics of Finance offers essential guidance on financial markets and institutions, business finance, portfolio management, risk management, and much more. If you’re looking to learn more about finance, this is the place to start. We thank Glen Larsen, Professor of Finance at the Kelley School of Business, Indiana University, for coauthoring with us the section on relative valuation in Chapter 19.
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PAMELA PETERSON DRAKE FRANK J. FABOZZI May 2010
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