THE FRANK J. FABOZZI SERIES

FINANCECapital Markets, Financial Management,and Investment Management

FRANK J. FABOZZI • PAMELA PETERSON DRAKE

FABOZZIDRAKEFIN

AN

CECapital M

arkets, Financial M

anagement,

and Investment M

anagement

Financial managers and investment professionals

need a solid foundation in fi nance principles fi

and applications in order to make the best

decisions in today’s ever-changing financial world. fi

Written by the experienced author team of Frank

Fabozzi and Pamela Peterson Drake, Finance examinesethe essential elements of this discipline and makes

them understandable to a wide array of individuals,

from seasoned professionals looking to fine-tune fi

their fi nancial skills to newcomers seeking genuinefi

guidance through the dynamic world of finance.fi

Divided into four comprehensive parts, this reliable

resource opens with an informative introduction to

the basic tools of investing and fi nancing decision-fi

making—financial mathematics and fifi nancial fi

analysis (Part I). From here, you’ll become familiar

with the fundamentals of capital market theory,

including financial markets, fifi nancial intermediaries, fi

and regulators of financial activities (Part II). You’ll fi

also gain a better understanding of interest rates,

bond and stock valuation, asset pricing theory, and

derivative instruments in this section.

Part III moves on to detail decision-making within a

business enterprise. Topics touched upon here include

capital budgeting—that is, whether or not to invest

in specifi c long-lived projects—and capital structure. fi

Management of current assets and risk management

are also addressed.

By covering the basics of investment decision-making,

Part IV skillfully wraps up this accessible overview

of fi nance. Beginning with the determination of an fi

investment objective, this part proceeds to demonstrate

portfolio theory and performance evaluation, and also

takes the time to outline techniques for managing

equity and bond portfolios as well as discuss the best

ways to use derivatives in the portfolio management

process.

Filled with in-depth insights and practical advice,

Finance puts this fie eld in perspective. And while a lot fi

of ground is covered in this book, this information

will help you appreciate and understand the complex

fi nancial issues that today’s companies and investors fi

constantly face.

FRANK J. FABOZZI, PHD, CFA, CPA, is Professor

in the Practice of Finance and Becton Fellow at Yale

University’s School of Management, Editor of the

Journal of Portfolio Management, and Associate Editor ttof the Journal of Structured Finance and the e Journal of Fixed Income.

PAMELA PETERSON DRAKE, PHD, CFA, is the

J. Gray Ferguson Professor of Finance and Department

Head of Finance and Business Law at James Madison

University.

Jacket Photograph: © Jupiter Images

Created by the experienced author team of Frank Fabozzi and Pamela Peterson

Drake, Finance examines the essential elements of this discipline and makes e

them accessible to a wide array of readers—from seasoned veterans looking for

a review to newcomers needing to get their footing in finance.fi

Divided into four comprehensive parts, this reliable resource opens with a

detailed discussion of the basic tools of investing and fi nancing decision-fi

making—financial mathematics and fifi nancial analysis. After this informative fi

introduction, you’ll quickly become familiar with the three primary areas

of fi nance —capital markets (Part II), fifi nancial management (Part III), and fi

investment/asset management (Part IV) —and discover how these different

areas are interconnected.

Finance is a well-rounded guide to this dynamic fie eld. The straightforward fi

insights found here will put you in a better position to understand what

the principles of modern finance are and how they can be used to make the fi

right decisions when managing risk and return in today’s complex financial fi

environment.

$125.00 USA / $150.00 CAN

( c o n t i n u e d o n b a c k f l a p )

( c o n t i n u e d f r o m f r o n t f l a p )

FINANCE

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Finance

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The Frank J. Fabozzi SeriesFixed Income Securities, Second Edition by Frank J. FabozziFocus on Value: A Corporate and Investor Guide to Wealth Creation by James L. Grant and James A. AbateHandbook of Global Fixed Income Calculations by Dragomir KrginManaging a Corporate Bond Portfolio by Leland E. Crabbe and Frank J. FabozziReal Options and Option-Embedded Securities by William T. MooreCapital Budgeting: Theory and Practice by Pamela P. Peterson and Frank J. FabozziThe Exchange-Traded Funds Manual by Gary L. GastineauProfessional Perspectives on Fixed Income Portfolio Management, Volume 3 edited by Frank J. FabozziInvesting in Emerging Fixed Income Markets edited by Frank J. Fabozzi and Efstathia PilarinuHandbook of Alternative Assets by Mark J. P. AnsonThe Global Money Markets by Frank J. Fabozzi, Steven V. Mann, and Moorad ChoudhryThe Handbook of Financial Instruments edited by Frank J. FabozziInterest Rate, Term Structure, and Valuation Modeling edited by Frank J. FabozziInvestment Performance Measurement by Bruce J. FeibelThe Handbook of Equity Style Management edited by T. Daniel Coggin and Frank J. FabozziThe Theory and Practice of Investment Management edited by Frank J. Fabozzi and Harry M. MarkowitzFoundations of Economic Value Added, Second Edition by James L. GrantFinancial Management and Analysis, Second Edition by Frank J. Fabozzi and Pamela P. PetersonMeasuring and Controlling Interest Rate and Credit Risk, Second Edition by Frank J. Fabozzi,

Steven V. Mann, and Moorad ChoudhryProfessional Perspectives on Fixed Income Portfolio Management, Volume 4 edited by Frank J. FabozziThe Handbook of European Fixed Income Securities edited by Frank J. Fabozzi and Moorad ChoudhryThe Handbook of European Structured Financial Products edited by Frank J. Fabozzi and Moorad ChoudhryThe Mathematics of Financial Modeling and Investment Management by Sergio M. Focardi and Frank J. FabozziShort Selling: Strategies, Risks, and Rewards edited by Frank J. FabozziThe Real Estate Investment Handbook by G. Timothy Haight and Daniel SingerMarket Neutral Strategies edited by Bruce I. Jacobs and Kenneth N. LevySecurities Finance: Securities Lending and Repurchase Agreements edited by Frank J. Fabozzi and Steven V. MannFat-Tailed and Skewed Asset Return Distributions by Svetlozar T. Rachev, Christian Menn, and Frank J. FabozziFinancial Modeling of the Equity Market: From CAPM to Cointegration by Frank J. Fabozzi, Sergio M.

Focardi, and Petter N. KolmAdvanced Bond Portfolio Management: Best Practices in Modeling and Strategies edited by Frank J. Fabozzi,

Lionel Martellini, and Philippe PriauletAnalysis of Financial Statements, Second Edition by Pamela P. Peterson and Frank J. FabozziCollateralized Debt Obligations: Structures and Analysis, Second Edition by Douglas J. Lucas, Laurie S.

Goodman, and Frank J. FabozziHandbook of Alternative Assets, Second Edition by Mark J. P. AnsonIntroduction to Structured Finance by Frank J. Fabozzi, Henry A. Davis, and Moorad ChoudhryFinancial 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. ManningRobust Portfolio Optimization and Management by Frank J. Fabozzi, Peter N. Kolm,

Dessislava A. Pachamanova, and Sergio M. FocardiAdvanced Stochastic Models, Risk Assessment, and Portfolio Optimizations by Svetlozar T. Rachev,

Stogan V. Stoyanov, and Frank J. FabozziHow to Select Investment Managers and Evaluate Performance by G. Timothy Haight, Stephen O. Morrell,

and Glenn E. RossBayesian Methods in Finance by Svetlozar T. Rachev, John S. J. Hsu, Biliana S. Bagasheva, and Frank J. FabozziThe Handbook of Municipal Bonds edited by Sylvan G. Feldstein and Frank J. FabozziSubprime Mortgage Credit Derivatives by Laurie S. Goodman, Shumin Li, Douglas J. Lucas,

Thomas A Zimmerman, and Frank J. FabozziIntroduction to Securitization by Frank J. Fabozzi and Vinod KothariStructured Products and Related Credit Derivatives edited by Brian P. Lancaster, Glenn M. Schultz, and

Frank J. FabozziHandbook of Finance: Volume I: Financial Markets and Instruments edited by Frank J. FabozziHandbook of Finance: Volume II: Financial Management and Asset Management edited by Frank J. FabozziHandbook of Finance: Volume III: Valuation, Financial Modeling, and Quantitative Tools edited by

Frank J. Fabozzi

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John Wiley & Sons, Inc.

FinanceCapital Markets,

Financial Management, and Investment Management

FRANK J. FABOZZIPAMELA PETERSON DRAKE

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Copyright © 2009 by John Wiley & Sons, Inc. All rights reserved.

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 transmit-ted in any form or by any means, electronic, mechanical, photocopying, recording, scan-ning, 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 specifi cally disclaim any implied warranties of merchantability or fi tness 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 profi t or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.

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Library of Congress Cataloging-in-Publication Data

Fabozzi, Frank J.Finance : capital markets, fi nancial management, and investment management / Frank J. Fabozzi, Pamela Peterson Drake.p. cm.—(The Frank J. Fabozzi series)ISBN 978-0-470-40735-6 (cloth)1. Finance. 2. Investments. 3. Business enterprises—Finance. 4. Corporations—Finance. I.

Peterson Drake, Pamela, 1954- II. Title.HG173.F27 2009332 –dc22 2009005638

Printed in the United States of America.

10 9 8 7 6 5 4 3 2 1

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FJFTo my wife Donna, and my children

Francesco, Patricia, and Karly

PPDTo my husband Randy

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Contents

vii

Preface xiiiAbout the Authors xv

PART ONEBackground 1

CHAPTER 1What Is Finance? 3

Capital Markets and Capital Market Theory 4Financial Management 5Investment Management 7Summary 8

CHAPTER 2 Mathematics of Finance 11

The Importance of the Time Value of Money 11Determining the Future Value 13Determining the Present Value 20Determining the Unknown Interest Rate 22Determining the Number of Compounding Periods 23The Time Value of a Series of Cash Flows 24Valuing Cash Flows with Different Time Patterns 34Loan Amortization 40The Calculation of Interest Rates and Yields 46Principles of Valuation 51Summary 55

CHAPTER 3Basics of Financial Analysis 57

Financial Ratio Analysis 58Cash Flow Analysis 87

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viii CONTENTS

Usefulness of Cash Flows in Financial Analysis 99Summary 105

PART TWOCapital Markets and Capital Market Theory 109

CHAPTER 4The Financial System 111

Financial Assets/Financial Instruments 111Financial Markets 113Financial Intermediaries 114Regulators of Financial Actitivies 118Classifi cation of Financial Markets 122Market Participants 131Summary 150References 154

CHAPTER 5Interest Rate Determination and the Structure of Interest Rates 155

Theories About Interest Rate Determination 155The Federal Reserve System and the

Determination of Interest Rates 157The Structure of Interest Rates 163Term Structure of Interest Rates 168Summary 178References 179

CHAPTER 6Basics of Derivatives 181

Futures and Forward Contracts 181Options 194Swaps 206Cap and Floor Agreements 209Summary 211Appendix: Black-Scholes Option Pricing Model 212References 219

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Contents ix

CHAPTER 7 Asset Valuation: Basic Bond and Stock Valuation Models 221

Valuing Bonds 221Valuation of Common Stock Using Dividend Discount Models 235Summary 246Appendix: Valuing Convertible Bonds 247References 252

CHAPTER 8Asset Valuation:The Theory of Asset Pricing 255

Characteristics of an Asset Pricing Model 255Capital Asset Pricing Model 256Arbitrage Pricing Theory Model 270Summary 279References 281

PART THREEFinancial Management 283

CHAPTER 9Financial Management 285

Forms of Business Enterprise 286The Objective of Financial Management 291The Agency Relationship 296Dividend and Dividend Policies 302Special Considerations in International Financial Management 314Summary 322References 325

CHAPTER 10Financial Strategy and Financial Planning 327

Strategy and Value 328Financial Planning and Budgeting 331Importance of Financial Planning 332Budgeting Process 332Sales Forecasting 334

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x CONTENTS

Seasonal Considerations 337Budgeting 338Pro Forma Financial Statements 346Long-Term Financial Planning 352Financial Modeling 355Performance Evaluation 362Strategy and Value Creation 369Summary 372References 373

CHAPTER 11The Corporate Financing Decision 375

Debt vs. Equity 375The concept of leverage 378Capital Structure and Financial Leverage 381Financial Leverage and Risk 384Capital Structure and Taxes 388Capital Structure and Financial Distress 393The Cost of Capital 397The Agency Relationship and Capital Structure 399Optimal Capital Structure: Theory and Practice 400A Capital Structure Prescription 403Summary 404Appendix: Capital structure: Lessons from

Modigliani and Miller 405References 415

CHAPTER 12Financial Engineering, Asset Securitization, and Project Financing 417

Creation of Structured Notes 419Asset Securitization 427Project Financing 438Summary 446References 448

CHAPTER 13Capital Budgeting: Process and Cash Flow Estimation 449

Investment Decisions and Owners’ Wealth Maximization 450Capital Budgeting Process 452Classifying Investment Projects 454

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Contents xi

Estimating Cash Flows of Capital Budgeting Projects 458Summary 477References 477

CHAPTER 14Capital Budgeting Techniques 479

Evaluation Techniques 479Net Present Value 481Profi tability Index 485Internal Rate of Return 487Modifi ed Internal Rate of Return 491Payback Period 495Discounted Payback Period 496Issues in Capital Budgeting 497Comparing Techniques 500Capital Budgeting Techniques in Practice 503Capital Budgeting and the Justifi cation of New Technology 504Incorporating Risk into Capital Budgeting Analysis 506Summary 523References 524

CHAPTER 15 Managing Current Assets 525

Management of Cash and Marketable Securities 526Cash Management 527Marketable Securities 533Management of Accounts Receivable 534Inventory Management 545Summary 553References 554

CHAPTER 16 Financial Risk Management 555

Risk Defi ned 555Enterprise Risk Management 558Managing Risks 563Risk Transfer 565Summary 572References 574

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xii CONTENTS

PART FOURInvestment Management 575

CHAPTER 17The Basic Principles of Investment Management 577

The Investment Management Process 577The Theory of Portfolio Selection 582Tracking Error 604Measuring and Evaluating Performance 607Summary 622References 624

CHAPTER 18Equity Portfolio Management 625

Stock Market Indicators 625Top-Down vs. Bottom-up Approaches 629Fundamental vs. Technical Analysis 629Popular Stock Market Strategies 631Passive Strategies 643Equity-Style Management 643Types of Stock Market Structures 646The U.S. Stock Markets: Exchanges and OTC Markets 649Trading Mechanics 656Summary 664References 665

CHAPTER 19Bond Portfolio Management 669

Sectors of the Bond Market 669Features of Bonds 679Yield Measures 686Risks Associated with Investing in Bonds 693Measuring Interest Rate Risk 702Bond Indexes 710Active Bond Portfolio Strategies 711Passive Bond Portfolio Strategies 716Summary 719References 720

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Contents xiii

CHAPTER 20Use of Stock Index Futures andTreasury Futures Contracts inPortfolio Management 721

Using Stock Index Futures in Equity Portfolio Management 722Using Treasury Bond and Note Futures Contracts in

Bond Portfolio Management 736Using Stock Index Futures and Treasury Bond Futures to

Implement an Asset Allocation Decision 744Summary 746References 746

CHAPTER 21Use of Options in Portfolio Management 747

Using Stock Options and Index Options in Equity Portfolio Management 747

Using Interest Rate Options in Bond Portfolio Management 761Summary 771Appendix: Pricing Models on Options on Physicals and

Futures Options 771References 773

Index 775

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