financial statement analysis.

financial statement analysis.

Corporate Finance.

Stewart C. Myers Gordon Y Billard Professor of Finance at MIT’s Sloan School of Management He is past president of the American Finance Association and a research associate of the National Bureau of Economic Research. His research has focused on financing decisions, valuation methods, the cost of capital, and financial aspects of government regulation of business. Dr. Myers is a director of The Brattle Group Inc. and is active as a financial consultant. He is also the author (with Professor Brealey and Franklin Allen) of this book’s sister text, Principles of Corporate Finance.

Alan J. Marcus Mario Gabelli Professor of Finance in the Carroll School of Management at Boston College His main research interests are in derivatives and securities markets. He is co-author (with Zvi Bodie and Alex Kane) of the texts Investments and Essentials of Invest- ments. Professor Marcus has served as a research fellow at the National Bureau of Economic Research. Professor Marcus also spent two years at Freddie Mac, where he helped to develop mortgage pricing and credit risk models. He currently serves on the Research Foundation Advisory Board of the CFA Institute.

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This book is about corporate finance. It focuses on how companies invest in real assets, how they raise the money to pay for these investments, and how those assets ulti- mately affect the value of the firm. It also provides a broad introduction to the financial landscape, discussing, for example, the major players in financial markets, the role of financial institutions in the economy, and how securities are traded and valued by investors. The book offers a framework for systematically thinking about most of the important financial problems that both firms and individuals are likely to confront.

Financial management is important, interesting, and challenging. It is important because today’s capital investment decisions may determine the businesses that the firm is in 10, 20, or more years ahead. Also, a firm’s success or failure depends in large part on its ability to find the capital that it needs.

Finance is interesting for several reasons. Financial decisions often involve huge sums of money. Large investment projects or acquisitions may involve billions of dollars. Also, the financial community is international and fast-moving, with colorful heroes and a sprinkling of unpleasant villains.

Finance is challenging. Financial decisions are rarely cut and dried, and the finan- cial markets in which companies operate are changing rapidly. Good managers can cope with routine problems, but only the best managers can respond to change. To handle new problems, you need more than rules of thumb; you need to understand why companies and financial markets behave as they do and when common practice may not be best practice. Once you have a consistent framework for making financial decisions, complex problems become more manageable.

This book provides that framework. It is not an encyclopedia of finance. It focuses instead on setting out the basic principles of financial management and applying them to the main decisions faced by the financial manager. It explains why the firm’s own- ers would like the manager to increase firm value and shows how managers choose between investments that may pay off at different points of time or have different degrees of risk. It also describes the main features of financial markets and discusses why companies may prefer a particular source of finance.

We organize the book around the key concepts of modern finance. These concepts, properly explained, simplify the subject. They are also practical. The tools of financial management are easier to grasp and use effectively when presented in a consistent conceptual framework. This text provides that framework.

Modern financial management is not “rocket science.” It is a set of ideas that can be made clear by words, graphs, and numerical examples. The ideas provide the “why” behind the tools that good financial managers use to make investment and financing decisions.

We wrote this book to make financial management clear, useful, interesting, and fun for the beginning student. We set out to show that modern finance and good finan- cial practice go together, even for the financial novice.

Fundamentals and Principles of Corporate Finance This book is derived in part from its sister text Principles of Corporate Finance. The spirit of the two books is similar. Both apply modern finance to give students a work- ing ability to make financial decisions. However, there are also substantial differences between the two books.

First, we provide much more detailed discussion of the principles and mechanics of the time value of money. This material underlies almost all of this text, and we spend a lengthy chapter providing extensive practice with this key concept.

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viii Preface

Second, we use numerical examples in this text to a greater degree than in Prin- ciples. Each chapter presents several detailed numerical examples to help the reader become familiar and comfortable with the material.

Third, we have streamlined the treatment of most topics. Whereas Principles has 34 chapters, Fundamentals has only 25. The relative brevity of Fundamentals neces- sitates a broader-brush coverage of some topics, but we feel that this is an advantage for a beginning audience.

Fourth, we assume little in the way of background knowledge. While most users will have had an introductory accounting course, we review the concepts of account- ing that are important to the financial manager in Chapter 3.

Principles is known for its relaxed and informal writing style, and we continue this tradition in Fundamentals. In addition, we use as little mathematical notation as pos- sible. Even when we present an equation, we usually write it in words rather than sym- bols. This approach has two advantages. It is less intimidating, and it focuses attention on the underlying concept rather than the formula.

Organizational Design Fundamentals is organized in eight parts.

Part 1 (Introduction) provides essential background material. In the first chapter we discuss how businesses are organized, the role of the financial manager, and the financial markets in which the manager operates. We explain how shareholders want managers to take actions that increase the value of their investment, and we introduce the concept of the opportunity cost of capital and the trade-off that the firm needs to make when assessing investment proposals. We also describe some of the mecha- nisms that help to align the interests of managers and shareholders. Of course, the task of increasing shareholder value does not justify corrupt and unscrupulous behavior. We therefore discuss some of the ethical issues that confront managers.

Chapter 2 surveys and sets out the functions of financial markets and institutions. This chapter also reviews the crisis of 2007–2009. The events of those years illustrate clearly why and how financial markets and institutions matter.

A large corporation is a team effort, and so the firm produces financial statements to help the players monitor its progress. Chapter 3 provides a brief overview of these finan- cial statements and introduces two key distinctions—between market and book values and between cash flows and profits. This chapter also discusses some of the shortcom- ings in accounting practice. The chapter concludes with a summary of federal taxes.

Chapter 4 provides an overview of financial statement analysis. In contrast to most introductions to this topic, our discussion is motivated by considerations of valuation and the insight that financial ratios can provide about how management has added to the firm’s value.

Part 2 (Value) is concerned with valuation. In Chapter 5 we introduce the concept of the time value of money, and, since most readers will be more familiar with their own financial affairs than with the big leagues of finance, we motivate our discussion by looking first at some personal financial decisions. We show how to value long- lived streams of cash flows and work through the valuation of perpetuities and annui- ties. Chapter 5 also contains a short concluding section on inflation and the distinction between real and nominal returns.

Chapters 6 and 7 introduce the basic features of bonds and stocks and give students a chance to apply the ideas of Chapter 5 to the valuation of these securities. We show how to find the value of a bond given its yield, and we show how prices of bonds fluctuate as interest rates change. We look at what determines stock prices and how stock valuation formulas can be used to infer the return that investors expect. Finally, we see how investment opportunities are reflected in the stock price and why analysts focus on the price-earnings multiple. Chapter 7 also introduces the concept of market

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