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vi Contents
4 Bond Valuation 118 Box: Corporate Valuation and Stock

Beginning of Chapter Questions 119 Prices 165
Who Issues Bonds? 119 Types of Common Stock 166
Box: intrinsic Value and the Cost of The Market Stock Price versus Intrinsic
debt 120 Value 167
Box: the Global Economic Crisis: Stock Market Reporting 169
Betting With or Against the Valuing Common Stocks 170
U.S. Government: the Case of Valuing a Constant Growth
treasury Bond Credit default Stock 173
Swaps 121 Expected Rate of Return on a Constant
Key Characteristics of Bonds 122 Growth Stock 177
Bond Valuation 126 Valuing Nonconstant Growth
Changes in Bond Values over Time 130 Stocks 179
Bonds with Semiannual Coupons 133 Stock Valuation by the Free Cash Flow
Box: drinking Your Coupons 133 Approach 183
Bond Yields 134 Market Multiple Analysis 183
The Pre-Tax Cost of Debt: Determinants of Preferred Stock 184
Market Interest Rates 138 Stock Market Equilibrium 185
The Real Risk-Free Rate of Interest, r* 139 The Efficient Markets Hypothesis 189
The Inflation Premium (IP) 140 Box: Rational Behavior versus
The Nominal, or Quoted, Risk-Free Rate Animal Spirits, Herding, and
of Interest, rRF 141 Anchoring Bias 192
The Default Risk Premium (DRP) 142 Summary 193
Box: the Global Economic 6 Financial options 204
Crisis: insuring with Credit Beginning of Chapter Questions 205
default Swaps: Let the Buyer Box: the intrinsic Value of Stock
Beware! 144 options 205
Box: the Global Economic Overview of Financial Options 206
Crisis: U.S. treasury Bonds Box: Financial Reporting for
downgraded! 146 Employee Stock options 209
Box: the Few, the Proud, the… The Single-Period Binomial Option
AAA-Rated Companies! 147 Pricing Approach 209
Box: the Global Economic Crisis: The Single-Period Binomial Option
Are investors Rational? 148 Pricing Formula 214
The Liquidity Premium (LP) 149 The Multi-Period Binomial Option Pricing
The Maturity Risk Premium (MRP) 149 Model 216
The Term Structure of Interest Rates 152 The Black-Scholes Option Pricing Model
Financing with Junk Bonds 153 (OPM) 219
Bankruptcy and Reorganization 154 Box: taxes and Stock
Summary 155 options 224
5 Basic Stock Valuation 163 The Valuation of Put Options 225
Beginning of Chapter Questions 164 Applications of Option Pricing in
Legal Rights and Privileges of Common Corporate Finance 227
Stockholders 164 Summary 230
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Contents vii
7 Accounting for Financial Tying the Ratios Together: The Du Pont

Management 234 Equation 299
Beginning of Chapter Questions 235 Comparative Ratios and
Financial Statements and Reports 235 Benchmarking 301
Box: intrinsic Value, Free Cash Flow, Uses and Limitations of Ratio
and Financial Statements 236 Analysis 302
The Balance Sheet 236 Box: Ratio Analysis on the
Box: the Global Economic Crisis: Web 303
Let’s Play Hide-and-Seek! 238 Looking beyond the Numbers 304
The Income Statement 238 Summary 304
Statement of Stockholders’
Equity 240
Net Cash Flow 241 Part ii CorPoratE valuation
Box: Financial Analysis on the 9 Financial Planning and
Web 242 Forecasting Financial
Statement of Cash Flows 243 Statements 316
Box: Filling in the GAAP 246 Beginning of Chapter Questions 317
Modifying Accounting Data for Overview of Financial Planning 317
Managerial Decisions 247 Box: Corporate Valuation and
Box: Financial Bamboozling: How to Financial Planning 318
Spot it 250 Sales Forecast 320
MVA and EVA 256 Additional Funds Needed (AFN)
Box: Sarbanes-oxley and Financial Equation Method 322
Fraud 259 Forecasted Financial Statements
The Federal Income Tax System 260 Method 327
Summary 266 Forecasting When the Ratios
8 Analysis of Financial Change 342
Statements 278 Summary 345
Beginning of Chapter Questions 279 10 determining the Cost of
Financial Analysis 279 Capital 356
Box: intrinsic Value and Analysis of Beginning of Chapter Questions 357
Financial Statements 280 The Weighted Average Cost of
Liquidity Ratios 281 Capital 357
Asset Management Ratios 284 Box: Corporate Valuation and the
Box: the Global Economic Crisis: the Cost of Capital 358
Price is Right (or Wrong!) 285 Basic Definitions 360
Debt Management Ratios 287 Cost of Debt, rd(1 – T) 361
Profitability Ratios 290 Cost of Preferred Stock, rps 364
Box: the World Might be Flat, but Box: GE and Warren Buffett: the
Global Accounting isn’t: iFRS Cost of Preferred Stock 365
Versus FASB 292 Cost of Common Stock, rs 366
Market Value Ratios 294 The CAPM Approach 367
Trend Analysis, Common Size Dividend-Yield-Plus-Growth-Rate,
Analysis, and Percentage Change or Discounted Cash Flow (DCF),
Analysis 297 Approach 375
viii Contents
Own-Bond-Yield-Plus-Judgmental-Risk- Employee Stock Ownership Plans

Premium Approach 378 (ESOPs) 438
Comparison of the CAPM, DCF, and Summary 441
Own-Bond-Yield-Plus-Judgmental-
Risk-Premium Methods 379
Adjusting the Cost of Equity for Flotation Part iii ProjECt valuation
Costs 380 12 Capital Budgeting: decision
Composite, or Weighted Average, Cost Criteria 452
of Capital, WACC 382 Beginning of Chapter Questions 453
Box: Global Variations in the Cost of An Overview of Capital
Capital 384 Budgeting 453
Factors That Affect the WACC 385 Box: Corporate Valuation and
Adjusting the Cost of Capital for Capital Budgeting 454
Risk 387 Net Present Value (NPV) 456
Privately Owned Firms and Small Internal Rate of Return (IRR) 459
Businesses 390 Multiple Internal Rates of Return 462
Four Mistakes to Avoid 391 Reinvestment Rate Assumptions 464
Summary 392 Modified Internal Rate of Return
11 Corporate Valuation and Value- (MIRR) 466
Based Management 404 NPV Profiles 468
Beginning of Chapter Questions 405 Profitability Index (PI) 471
Overview of Corporate Valuation 405 Payback Period 472
Box: Corporate Valuation: Putting Conclusions on Capital Budgeting
the Pieces together 406 Methods 475
The Corporate Valuation Model 407 Decision Criteria Used in Practice 477
Value-Based Management 415 Other Issues in Capital Budgeting 477
Managerial Behavior and Shareholder Summary 484
Wealth 424 13 Capital Budgeting: Estimating
Corporate Governance 425 Cash Flows and Analyzing
Box: Let’s Go to Miami! iBM’s 2009 Risk 495
Annual Meeting 427 Beginning of Chapter Questions 496
Box: the Global Economic Crisis: Conceptual Issues 496
Would the U.S. Government Box: Corporate Valuation, Cash
Be an Effective Board Flows, and Risk Analysis 497
director? 430 Analysis of an Expansion Project 502
Box: the Global Economic Crisis: Risk Analysis in Capital Budgeting 508
Shareholder Reactions to the Measuring Stand-Alone Risk 509
Crisis 433 Sensitivity Analysis 510
Box: the Sarbanes-oxley Act Scenario Analysis 512
of 2002 and Corporate Monte Carlo Simulation 515
Governance 434 Box: the Global Economic Crisis:
Box: international Corporate Are Bank Stress tests Stressful
Governance 437 Enough? 519
Contents ix
Project Risk Conclusions 520 16 Capital Structure decisions:

Box: Capital Budgeting Part ii 613
Practices in the Asian/Pacific Beginning of Chapter Questions 614
Region 521 Capital Structure Theory: Arbitrage
Replacement Analysis 522 Proofs of the Modigliani-Miller
Real Options 523 Models 614
Phased Decisions and Decision Box: Corporate Valuation and
Trees 525 Capital Structure decisions 615
Summary 529 Introducing Personal Taxes: The Miller
14 Real options 544 Model 625
Beginning of Chapter Questions 545 Criticisms of the MM and Miller
Valuing Real Options 545 Models 629
The Investment Timing Option: An Extension of the MM Model:
An Illustration 546 Nonzero Growth and a Risky Tax
The Growth Option: Shield 631
An Illustration 556 Risky Debt and Equity as an
Concluding Thoughts on Real Option 634
Options 560 Capital Structure Theory: Our View 639
Summary 563 Summary 641
17 distributions to Shareholders:
Part iv stratEgiC FinanCing dividends and Repurchases 648
DECisions Beginning of Chapter Questions 649
15 Capital Structure decisions: An Overview of Cash Distributions 649
Part i 570 Box: Uses of Free Cash
Beginning of Chapter Questions 571 Flow: distributions to
A Preview of Capital Structure Shareholders 650
Issues 571 Procedures for Cash Distributions 651
Box: Corporate Valuation and Cash Distributions and Firm Value 654
Capital Structure 572 Clientele Effect 657
Business Risk and Financial Risk 574 Information Content, or Signaling,
Capital Structure Theory 581 Hypothesis 658
Box: Yogi Berra on the MM Implications for Dividend Stability 660
Proposition 583 Setting the Target Distribution Level:
Capital Structure Evidence and The Residual Distribution
Implications 590 Model 660
Box: taking a Look at Global Capital Box: the Global Economic Crisis:
Structures 592 Will dividends Ever Be the
Estimating the Optimal Capital Same? 661
Structure 594 The Residual Distribution Model in
Anatomy of a Recapitalization 599 Practice 663
Box: the Global Economic Crisis: A Tale of Two Cash Distributions:
deleveraging 603 Dividends versus Stock
Summary 604 Repurchases 664
x Contents
The Pros and Cons of Dividends and Box: tVA Ratchets down its interest
Repurchases 673 Expenses 721
Box: dividend Yields around the Managing the Risk Structure of Debt with
World 675 Project Financing 723
Other Factors Influencing Summary 725
Distributions 675 19 Lease Financing 732
Summarizing the Distribution Policy Beginning of Chapter Questions 733
Decision 676 Types of Leases 733
Stock Splits and Stock Tax Effects 736
Dividends 678 Financial Statement Effects 737
Box: the Global Economic Box: off–Balance Sheet Financing: is
Crisis: talk about a Split it Going to disappear? 740
Personality! 679 Evaluation by the Lessee 740
Dividend Reinvestment Plans 681 Evaluation by the Lessor 745
Summary 682 Other Issues in Lease Analysis 747
Box: What You don’t Know Can
Part v taCtiCal FinanCing Hurt You! 748
DECisions Box: Lease Securitization 750
Other Reasons for Leasing 751
18 initial Public offerings, investment
Summary 753
Banking, and Financial
Restructuring 692 20 Hybrid Financing: Preferred
Beginning of Chapter Questions 693 Stock, Warrants, and
The Financial Life Cycle of a Start-up Convertibles 760
Beginning of Chapter Questions 761
Company 693
Preferred Stock 761
The Decision to Go Public 694
Box: the Romance Had no
The Process of Going Public: An Initial
Chemistry, But it Had a Lot of
Public Offering 696
Preferred Stock! 763
Equity Carve-outs: A Special Type of
Box: Hybrids Aren’t only for
IPO 705
Corporations 764
Other Ways to Raise Funds in the Capital
Warrants 766
Markets 705
Convertible Securities 772
Box: Bowie Bonds CH-CH-Change
A Final Comparison of
Asset Securitization 709
Warrants and Convertibles 780
Investment Banking Activities and
Reporting Earnings When
Their Role in the Global Economic
Warrants or Convertibles Are
Crisis 710
Outstanding 781
The Decision to Go Private 711
Summary 782
Box: the Global Economic Crisis:
What Was the Role of investment
Banks? 712 Part vi Working CaPital
Managing the Maturity managEmEnt
Structure of Debt 714 21 Working Capital Management 790
Refunding Operations 716 Beginning of Chapter Questions 791
Contents xi
Current Asset Holdings 791 The Payments Pattern Approach to

Box: Corporate Valuation Monitoring Receivables 846
and Working Capital Analyzing Proposed Changes in Credit
Management 792 Policy 851
Current Assets Financing Policies 794 Analyzing Proposed Changes in Credit
The Cash Conversion Cycle 797 Policy: Incremental Analysis 853
Box: Some Firms operate with The Cost of Bank Loans 859
negative Working Capital! 803 Choosing a Bank 866
The Cash Budget 803 Summary 867
Cash Management and the Target Cash 23 other topics in Working Capital
Balance 807 Management 877
Box: the CFo Cash Management Beginning of Chapter Questions 878
Scorecard 808 The Concept of Zero Working Capital 878
Cash Management Techniques 809 Setting the Target Cash Balance 879
Box: Your Check isn’t in the Inventory Control Systems 885
Mail 811 Accounting for Inventory 886
Inventory Management 812 The Economic Ordering Quantity (EOQ)
Box: Supply Chain Model 888
Management 812 EOQ Model Extensions 895
Receivables Management 814 Summary 900
Box: Supply Chain Finance 816
Accruals and Accounts Payable
(Trade Credit) 818 Part vii sPECial toPiCs
Box: A Wag of the Finger or tip of 24 derivatives and Risk
the Hat? the Colbert Report Management 908
and Small Business Payment Beginning of Chapter Questions 909
terms 819 Reasons to Manage Risk 909
Short-Term Marketable Securities 822 Box: Corporate Valuation and Risk
Short-Term Financing 824 Management 910
Short-Term Bank Loans 824 Background on Derivatives 913
Commercial Paper 828 Derivatives in the News 914
Use of Security in Short-Term Other Types of Derivatives 917
Financing 829 Corporate Risk Management 923
Summary 830 Box: Enterprise Risk Management
22 Providing and obtaining and Value at Risk 926
Credit 842 Using Derivatives to Reduce Risks 927
Beginning of Chapter Questions 843 Box: Risk Management in the Cyber
Credit Policy 843 Economy 931
Setting the Credit Period and Summary 935
Standards 844 25 Bankruptcy, Reorganization, and
Setting the Collection Policy 845 Liquidation 940
Cash Discounts 845 Beginning of Chapter Questions 941
Other Factors Influencing Credit Financial Distress and Its
Policy 846 Consequences 941
xii Contents
Issues Facing a Firm in Financial Holding Companies 1007

Distress 943 Summary 1009
Settlements without Going through 27 Multinational Financial
Formal Bankruptcy 944 Management 1016
Federal Bankruptcy Law 946 Beginning of Chapter Questions 1017
Reorganization in Bankruptcy 947 Multinational, or Global,
Liquidation in Bankruptcy 957 Corporations 1017
Other Motivations for Bankruptcy 960 Box: Corporate Valuation in a
Box: A nation of defaulters? 961 Global Context 1018
Some Criticisms of Bankruptcy Multinational versus Domestic Financial
Laws 962 Management 1019
Summary 963 Exchange Rates 1020
26 Mergers, LBos, divestitures, and Exchange Rates and International
Holding Companies 970 Trade 1023
Beginning of Chapter Questions 971 The International Monetary System and
Rationale for Mergers 972 Exchange Rate Policies 1025
Types of Mergers 975 Trading in Foreign Exchange 1029
Level of Merger Activity 975 Interest Rate Parity 1030
Hostile versus Friendly Takeovers 976 Purchasing Power Parity 1032
Merger Regulation 978 Box: Hungry for a Big Mac? Go to
Overview of Merger Analysis 979 Ukraine! 1034
The Adjusted Present Value (APV) Inflation, Interest Rates, and Exchange
Approach 980 Rates 1036
The Free Cash Flow to Equity (FCFE) International Money and Capital
Approach 983 Markets 1037
Illustration of the Three Valuation Box: Greasing the Wheels of
Approaches for a Constant Capital international Business 1037
Structure 985 Box: Stock Market indices around
Setting the Bid Price 991 the World 1040
Analysis When There Is a Multinational Capital Budgeting 1041
Permanent Change in Capital Box: Consumer Finance in
Structure 993 China 1042
Taxes and the Structure of the Takeover International Capital Structures 1045
Bid 995 Multinational Working Capital
Box: tempest in a teapot? 996 Management 1047
Financial Reporting for Mergers 999 Summary 1050
Analysis for a “True Consolidation” 1001
The Role of Investment Bankers 1002 Appendixes
Who Wins: The Empirical Appendix A Values of the Areas under
Evidence 1003 the Standard Normal Distribution
Box: Merger Mistakes 1004 Function 1057
Corporate Alliances 1005 Appendix B Answers to End-of-Chapter
Leveraged Buyouts 1006 Problems 1059
Divestitures 1006 Appendix C Selected Equations 1069
Contents xiii
Glossary 1085 Web Extension 10-A The Required

Name Index 1109 Return Assuming Nonconstant
Subject Index 1115 Dividends and Stock Repurchases
No Web Extension for Chapter 11
Web Extension 12-A The Accounting
Web Chapters Rate of Return (ARR)
28 Time Value of Money Web Extension 13-A Certainty
29 Basic Financial Tools: A Review Equivalents and Risk-Adjusted
30 Pension Plan Management Discount Rates
31 Financial Management in Not-for- Web Extension 14-A The Abandonment
Profit Businesses Real Option
Web Extension 14-B Risk-Neutral
Web Extensions Valuation
Web Extension 1-A An Overview of Web Extension 15-A Degree of Leverage
Derivatives No Web Extension for Chapter 16
Web Extension 1-B A Closer Look at the No Web Extension for Chapter 17
Stock Markets Web Extension 18-A Rights Offerings
Web Extension 2-A Continuous Web Extension 19-A Leasing Feedback
Probability Distributions Web Extension 19-B Percentage Cost
Web Extension 2-B Estimating Beta with Analysis
a Financial Calculator Web Extension 19-C Leveraged Leases
No Web Extension for Chapter 3 Web Extension 20-A Calling Convertible
Web Extension 4-A A Closer Look at Issues
Zero Coupon Bonds Web Extension 21-A Secured Short-Term
Web Extension 4-B A Closer Look at TIPS: Financing
Treasury Inflation-Protected Securities No Web Extension for Chapter 22
Web Extension 4-C A Closer Look at No Web Extension for Chapter 23
Bond Risk: Duration Web Extension 24-A Risk Management
Web Extension 4-D The Pure with Insurance
Expectations Theory and Estimation of Web Extension 25-A Multiple
Forward Rates Discriminant Analysis
Web Extension 5-A Derivation of Web Extension 26-A Projecting
Valuation Equations Consistent Debt and Interest Expenses
No Web Extension for Chapter 6 No Web Extension for Chapter 27
Web Extension 7-A The Federal Income Web Extension 28-A The Tabular
Tax System for Individuals Approach
No Web extension for Chapter 8 Web Extension 28-B Derivation of
Web Extension 9-A Advanced Annuity Formulas
Techniques for Forecasting Financial Web Extension 28-C Continuous
Statements Accounts Compounding
© Nikada/iStockphoto.com
Preface
Much has happened in finance recently. Years ago, when the body of knowledge
was smaller, the fundamental principles could be covered in a one-term lecture
course and then reinforced in a subsequent case course. This approach is no longer
WEB
feasible. There is simply too much material to cover in one lecture course.
As the body of knowledge expanded, we and other instructors experienced students: Access the
increasing difficulties. Eventually, we reached these conclusions: Intermediate Financial
Management 11e com-
• The introductory course should be designed for all business students, not just
panion site and online
for finance majors, and it should provide a broad overview of finance. There- student resources by visit-
fore, a text designed for the first course should cover key concepts but avoid ing www.cengagebrain.
confusing students by going beyond basic principles. com, searching ISBN
• Finance majors need a second course that provides not only greater depth on 9781111530266, and
the core issues of valuation, capital budgeting, capital structure, cost of capital, clicking “Access Now”
and working capital management but also covers such special topics as merg- under “Study Tools” to go
ers, multinational finance, leasing, risk management, and bankruptcy. to the student textbook
• This second course should also utilize cases that show how finance theory is companion site.
used in practice to help make better financial decisions. instructors: Access the
Intermediate Financial
When we began teaching under the two-course structure, we tried two types Management 11e com-
of existing books, but neither worked well. First, there were books that emphasized panion site and instructor
theory, but they were unsatisfactory because students had difficulty seeing the use- resources by going to
fulness of the theory and consequently were not motivated to learn it. Moreover, login.cengage.com, log-
these books were of limited value in helping students deal with cases. Second, there ging in with your faculty
were books designed primarily for the introductory MBA course that contained account username and
the required material, but they also contained too much introductory material. We password, and using ISBN
eventually concluded that a new text was needed, one designed specifically for the 9781111530266 to reach
second financial management course, and that led to the creation of Intermediate the site through your ac-
count “Bookshelf.”
Financial Management, or IFM for short.
The Next Level: Intermediate Financial

Management
In your introductory finance course you learned a number of terms and concepts.
However, an intro course cannot make you “operational” in the sense of actually
“doing” financial management. For one thing, introductory courses necessarily fo-
cus on individual chapters and even sections of chapters, and first-course exams
generally consist of relatively simple problems plus short-answer questions. As a
result, it is hard to get a good sense of how the various parts of financial man-
agement interact with one another. Second, there is not enough time in the intro
course to allow students to set up and work out realistic problems, nor is there time
to delve into actual cases that illustrate how finance theory is applied in practice.
xvi Preface
Now it is time to move on. In Intermediate Financial Management, we first re-

view materials that were covered in the introductory course, then take up new ma-
terial. The review is absolutely essential, because no one can remember everything
that was covered in the first course, yet all of the introductory material is essential
for a good understanding of the more advanced material. Accordingly, we revisit
topics such as the net present value (NPV) and internal rate of return (IRR) methods,
but now we delve into them more deeply, considering how to streamline and auto-
mate the calculations, how to obtain the necessary data, and how errors in the data
might affect the outcome. We also relate the topics covered in different chapters to
one another, showing, for example, how cost of capital, capital structure, dividend
policy, and capital budgeting combine forces to affect the firm’s value.
Also, because spreadsheets such as Excel, not financial calculators, are used for
most real-world calculations, students need to be proficient with spreadsheets so
that they will be more marketable after graduation. Therefore, we explain how to
do various types of financial analysis with Excel. Working with Excel actually has
two important benefits: (1) a knowledge of Excel is important in the workplace and
the job market, and (2) setting up spreadsheet models and analyzing the results also
provide useful insights into the implications of financial decisions.
Corporate Valuation as a Unifying Theme

Management’s goal is to maximize firm value. Job candidates who understand the
theoretical underpinning for value maximization and have the practical skills to an-
alyze business decisions within this context make better, more valuable employees.
Our goal is to provide you with both this theoretical underpinning and a practical
skill set. To this end we have developed several integrating features that will help
you to keep the big picture of value maximization in mind while you are honing
your analytical skills:
• Every chapter starts off with a series of integrating Beginning of Chapter Ques-
tions that will help you to place the material in the broader context of financial
management.
• Most chapters have a valuation graphic and description that show exactly how
the material relates to corporate valuation.
• Each chapter has a Mini Case that provides a business context for the material.
• Each chapter has an Excel spreadsheet Tool Kit that steps through all of the
calculations in the chapter.
• Each chapter has a spreadsheet Build-a-Model that steps you through con-
structing an Excel model to work problems. We’ve designed these features and
tools so that you’ll finish your course with the skills to analyze business deci-
sions and the understanding of how these decisions impact corporate value.
Design of the Book

Based on more than 30 years working on Intermediate Financial Management and
teaching the advanced undergraduate financial management course, we have con-
cluded that the book should include the following features:
• Completeness. Because IFM is designed for finance majors, it should be self-
contained and suitable for reference purposes. Therefore, we specifically and
purposely included (a) some material that overlaps with introductory finance
Preface xvii
texts and (b) more material than can realistically be covered in a single course.
We included in Chapters 2 through 5 some fundamental materials borrowed
directly from other Cengage Learning texts. If an instructor chooses to cover
this material, or if an individual student feels a need to cover it on his or her
own, it is available. In other chapters, we included relatively brief reviews of
first-course topics. This was necessary both to put IFM on a stand-alone basis
and to help students who have a delay between their introductory and second
financial management courses get up to speed before tackling new material.
This review is particularly important for working capital management and such
“special topics” as mergers, lease analysis, and convertibles—all of which are
often either touched on only lightly or skipped in the introductory course.
Thus, the variety of topics covered in the text provides adopters with a choice
of materials for the second course, and students can use materials that were
not covered for reference purposes. We note, though, that instructors must be
careful not to bite off more than their students can chew.
• Theory and applications. Financial theory is useful to financial decision mak-
ers, both for the insights it provides and for direct application in several im-
portant decision areas. However, theory can seem sterile and pointless unless
its usefulness is made clear. Therefore, in IFM, we present theory in a decision-
making context, which motivates students by showing them how theory can
lead to better decisions. The combination of theory and applications also makes
the text more usable as a reference for case courses as well as for real-world
decision making.
• Computer orientation. Today, a business that does not use computers in its
financial planning is about as competitive as a student who tries to take a
finance exam without a financial calculator. Throughout the text we provide
computer spreadsheet examples for the calculations and spreadsheet problems
for the students to work. This emphasis on spreadsheets both orients students
to the business environment they will face upon graduation and helps them
understand key financial concepts better.
• Global perspective. Successful businesses know that the world’s economies are
rapidly converging, that business is becoming globalized, and that it is difficult
to remain competitive without being a global player. Even purely domestic
firms cannot escape the influence of the global economy, because interna-
tional events have a significant effect on domestic interest rates and economic
activity. All of this means that today’s finance students—who are tomorrow’s
financial executives—must develop a global perspective. To this end, IFM also
contains an entire chapter on multinational financial management. In addition,
to help students “think global,” we provide examples throughout the text that
focus on the types of global problems companies face. Of course, we cannot
make multinational finance experts out of students in a conventional corporate
finance course, but we can help them recognize that insular decision making is
insufficient in today’s world.
Beginning of Chapter Questions

We start each chapter with several Beginning of Chapter (BOC) questions. You will
be able to answer some of the questions before you even read the chapter, and you
will be able to give better answers after you have read it. Other questions are harder,
and you won’t feel truly comfortable answering them until after they have been dis-
cussed in class. We considered putting the questions at the ends of the chapters, but
xviii Preface
we concluded that they would best serve our purposes if placed at the beginning.
Here is a summary of our thinking as we wrote the questions:
• The questions indicate to you the key issues covered in the chapter and the
things you should know when you complete the chapter.
• Some of the questions were designed to help you remember terms and concepts
that were covered in the introductory course. Others indicate where we will be
going beyond the intro course.
• You need to be able to relate different parts of financial management to one
another, so some of the BOC questions were designed to get you to think about
how the various chapters are related to one another. These questions tend to be
harder, and they can be answered more completely after a classroom discus-
sion.
• You also need to think about how financial concepts are applied in the real
world, so some of the BOC questions focus on the application of theories to the
decision process. Again, complete answers to these questions require a good bit
of thought and discussion.
• Some of the BOC questions are designed to help you see how Excel can be used
to make better financial decisions. These questions have accompanying models
that provide tutorials on Excel functions and commands. The completed mod-
els are available on the textbook’s website. Going through them will help you
learn how to use Excel as well as give you valuable insights into the financial
issues covered in the chapter. We have also provided an “Excel Tool Locater,”
which is an index of all of the Excel skills that the BOC models go over. This
index is in the Excel file, Excel Locations.xls. Because recruiters like students
who are good with Excel, this will also help you as you look for a good job. It
will also help you succeed once you are in the workplace.
We personally have used the BOC questions in several different ways:
• In some classes we simply told students to use the BOC questions or not, as they
wished. Some students did study them and retrieve the Excel models from the
Web, but many just ignored them.
• We have also assigned selected BOC questions and then used them, along with
the related Excel models, as the basis for some of our lectures.
• Most recently, we literally built our course around the BOC questions.1 Here we
informed students on day one that we would start each class by calling on them
randomly and grading them on their answers.2 We also informed them that our
exams would be taken verbatim from the BOC questions. They complained a bit
about the quizzes, but the students’ course evaluations stated that the quizzes
should be continued because without them they would have come to class less
well prepared and hence would have learned much less than they did.
• The best way to prepare for the course as we taught it was by first reading
the questions, then reading the chapter, and then writing out notes outlining
answers to the questions in preparation for the oral quiz. We expected students
to give complete answers to “easy” questions, but we gave them good grades if
1
Actually, we broke our course into two segments, one where we covered selected text chapters and
another where we covered cases that were related to and illustrated the text chapters. For the case
portion of the course, students made presentations and discussed the cases. All of the cases required
them to use Excel.
2
Most of our students were graduating seniors who were interviewing for jobs. We excused them from
class (and the quizzes) if they informed us by e-mail before class that they were interviewing.
Preface xix
they could say enough about the harder questions to demonstrate that they had
thought about how to answer them. We would then discuss the harder ques-
tions in lieu of a straight lecture, going into the related Excel models both to
explain Excel features and to provide insights into different issues.
• Our midterm and final exams consisted of five of the harder BOC questions, of
which three had to be answered in two hours in an essay format. It took a much
more complete answer to earn a good grade than would have been required
on the oral quizzes. We also allowed students to use a four-page “cheat sheet”
on the exams.3 That reduced time spent trying to memorize things as opposed
to understanding them. Also, students told us that making up the cheat sheets
was a great way to study.
Major Changes in the Eleventh Edition

As in every revision, we updated and clarified sections throughout the text.
Specifically, we also made the following changes in content:
References to, implications of, and explanations for the global economic crisis.
The text has been updated in almost every chapter to include real-world examples
of the impact of the global economic crisis on financial markets and financial man-
agement. Many chapters have focused “Global Economic Crisis” boxes that discuss
particularly important issues.
Updated big-picture graphics at the start of each chapter.
One of the major challenges students face in this second corporate finance course is
seeing how all of the topics fit together. To aid the students’ integration of the mate-
rial from chapter-to-chapter and across their finance curriculum, we’ve included a
graphic at the beginning of each chapter and in each PowerPoint show that clearly
illustrates where the chapter’s topics fit into the big picture.
Additional integration of the textbook and the accompanying Excel Tool Kit
spreadsheet models for each chapter.
Many figures in the textbook are actually screen shots from the chapter’s Excel Tool
Kit model. This serves two purposes. First, it makes the analysis more transparent
to the student; the student or instructor can go to the Tool Kit and see exactly how
all of the numbers in a figure were calculated. Second, it provides an additional
resource for students and instructors to use in learning Excel.
Significant Changes in Selected Chapters

We made many small improvements within each chapter; some of the more notable
ones are discussed below.
Chapter 1: An Overview of Financial Management and the Financial Environment
We added a new box on globalization, “Columbus Was Wrong—the World Is Flat!
And Hot, And Crowded,” and a new box on the global economic crisis, “Say Hello
to the Global Economic Crisis!” We completely rewrote the section on financial
securities, including a discussion of securitization, and added a new section on the
global crisis. New figures showing the national debt, trade balances, federal budget
3
We did require that students make up their own “cheat sheets,” and we required them to turn their sheets
in with their exams so we could check for independence.
xx Preface
deficits, and the Case-Shiller real estate index help us better illustrate different as-
pects of the global crisis.
Chapter 2: Risk and Return: Part I
We added a new box on the risk that remains even for long-term investors, “What
Does Risk Really Mean?” We added two additional boxes on risk, “How Risky Is a
Large Portfolio of Stocks?” and “Another Kind of Risk: The Bernie Madoff Story.”
Chapter 3: Risk and Return: Part II
We added a box on The Wall Street Journal contest between dart throwers and
investors, “Skill or Luck?” We expanded our discussion of the Fama-French three-
factor model and included a table showing returns of portfolios formed by sorting
on size and the book-to-market ratio.
Chapter 4: Bond Valuation
We added five new boxes related to the global economic crisis: (1) “Betting With
or Against the U.S. Government: The Case of Treasury Bond Credit Default Swaps,”
(2) “Insuring with Credit Default Swaps: Let the Buyer Beware!” (3) “U.S. Treasury
Bonds Downgraded!” (4) “The Few, the Proud, the . . . AAA-Rated Companies!” and
(5) “Are Investors Rational?” We also added a new table summarizing corporate
bond default rates and annual changes in ratings.
Chapter 5: Basic Stock Valuation
We added a new box on behavioral issues, “Rational Behavior versus Animal Spirits,
Herding, and Anchoring Bias.” We also added a new section, “The Market Stock
Price versus Intrinsic Value.”
Chapter 6: Financial Options
We completely rewrote the description of the binomial option pricing model. In ad-
dition to the hedge portfolio, we also discuss replicating portfolios. We now provide
the binomial formula, and we show the complete solution to the two-period model.
To provide greater continuity, the company used to illustrate the binomial example
is now the same company used to illustrate the Black-Scholes model. Our discussion
of put options now includes the Black-Scholes put formula.
Chapter 7: Accounting for Financial Management
We added a new box on the global economic crisis that explains the problems
associated with off-balance-sheet assets, “Let’s Play Hide-and-Seek!” We added a
new figure illustrating the uses of free cash flow. We now have two end-of-chapter
spreadsheet problems, one focusing on the articulation between the income state-
ment and statement of cash flows and one focusing on free cash flow.
Chapter 8: Analysis of Financial Statements
We added a new box on marking to market, “The Price Is Right! (Or Wrong!),” and
a new box on international accounting standards, “The World Might Be Flat, but
Global Accounting Is Bumpy! The Case of IFRS versus FASB.” We have included
discussion of the price/EBITDA ratio, gross profit margin, and operating profit mar-
gin; we also explain how to use the statement of cash flows in financial analysis.
Chapter 9: Financial Planning and Forecasting Financial Statements
It is difficult to do financial planning without using spreadsheet software, so we
completely rewrote the chapter and explicitly integrated the text and the Excel Tool
Kit model. We illustrate the ways that financial policies (i.e., dividend payout and
capital structure choices) affect financial projections, including ways to ensure that
balance sheets balance. The Excel Tool Kit model now shows a very simple way to
incorporate financing feedback effects.
Preface xxi
Chapter 10: Determining the Cost of Capital

We added a new figure to highlight the similarities and differences among capital
structure weights based on book values, market values, and target values. We added
a new box, “GE and Warren Buffett: The Cost of Preferred Stock.” We completely
rewrote our discussion of the market risk premium, which now includes the impact
of stock repurchases on estimating the market risk premium. We also present data
from surveys identifying the market risk premia used by CFOs and professors.
Chapter 11: Corporate Valuation and Value-Based Management
We added three new boxes. The first describes corporate governance issues at IBM,
“Let’s Go to Miami! IBM’s 2009 Annual Meeting.” The second discusses leadership
at bailout recipients, “Would the U.S. Government Be an Effective Board Director?”
The third discusses the 2009 proxy season, “Shareholder Reactions to the Crisis.”
Chapter 12: Capital Budgeting: Decision Criteria
We reworked the numerical examples in this chapter and the next so that they represent
a single, consistent company. We also added a new box, “Why NPV Is Better Than IRR.”
Chapter 13: Capital Budgeting: Estimating Cash Flow and Analyzing Risk
We reworked the numerical examples in this chapter and in the previous one so they
represent a single, consistent company. We also incorporated two additional decimal
places in the MACRS depreciation schedules to reflect the actual rates in the federal
tax tables. We now show how to use tornado diagrams in sensitivity analysis. We re-
wrote our discussion of Monte Carlo simulation and show how to conduct a simulation
analysis without using add-ins but instead using only Excel’s built-in features (Data
Tables and random number generators). We have included an example of replacement
analysis and an example of a decision tree showing abandonment. We added a new
box, “Are Bank Stress Tests Stressful Enough?”
Chapter 15: Capital Structure Decisions: Part I
We improved our discussion of recapitalizations within the context of the FCF valua-
tion model. We added a new box, “Deleveraging,” that discusses the changes in leverage
many companies and individuals are making in light of the global economic crisis.
Chapter 17: Distributions to Shareholders: Dividends and Repurchases
We consolidated the coverage of stock repurchases that had been spread over two
chapters and located it here. We also use the FCF valuation model to illustrate the
different impacts of stock repurchases versus dividend payments. We added two
new boxes. The first discusses recent dividend cuts, “Will Dividends Ever Be the
Same?” and the second discusses Sun Microsystem’s stock splits and recent reverse
split, “Talk About a Split Personality!”
Chapter 18: Initial Public Offerings, Investment Banking, and Financial
Restructuring
We added a new section on investment banking activities. We added a new box on
“Investment Banks and the Global Economic Crisis.”
Chapter 19: Lease Financing
A new box addresses the FASB/IASB movement to capitalize all leases, “Off-Balance
Sheet Financing: Is It Going to Disappear?”
Chapter 20: Hybrid Financing: Preferred Stock, Warrants, and Convertibles
A new box discusses the use of payment-in-kind preferred stock in the merger of
Dow Chemical Company and Rohm & Haas, “The Romance Had No Chemistry, but
It Had a Lot of Preferred Stock!”
xxii Preface
Chapter 21: Working Capital Management

We reorganized the chapter so that we now discuss working capital holdings and
financing before discussing the cash conversion cycle. We rewrote our coverage of
the cash conversion cycle to explain the general concepts and then apply them to
actual financial statement data. We added three new boxes, “Some Firms Operate
with Negative Working Capital!” “Your Check Isn’t in the Mail,” and “A Wag of the
Finger or Tip of the Hat? The Colbert Report and Small Business Payment Terms.”
We added a new section on the cost of bank loans.
Chapter 24: Derivatives and Risk Management
We added a new box on “Value at Risk and Enterprise Risk Management.” Throughout
the chapter we discuss the failure of risk management during the global economic
crisis.
Chapter 25: Bankruptcy, Reorganization, and Liquidation
We added a new box on personal and small business bankruptcies, “A Nation of
Defaulters?”
Chapter 26: Mergers, LBOs, Divestitures, and Holding Companies
We added a section explaining how the stock-swap ratio is determined for mergers
where the payment is in the form of the acquiring company’s stock.
Chapter 27: Multinational Financial Management
We added two new boxes. The first is on regulating international bribery and taxa-
tion, “Greasing the Wheels of International Business.” The second new box discusses
the wave of foreign companies partnering with Chinese banks to provide consumer
finance services, “Consumer Finance in China.”
Test Bank
The instructor’s test bank has been updated and revised with many new questions
and problems.
Other Ways the Book Can be Used

The second corporate finance course can be taught in a variety of other ways,
depending on a school’s curriculum structure and the instructor’s personal prefer-
ences. We have been focusing on the BOC questions and discussions, but we have
used alternative formats, and all can work out very nicely. Therefore, we designed
the book so that it can be flexible.
Mini Cases as a framework for lectures. We originally wrote the Mini Cases specifi-
cally for use in class. We had students read the chapter and the Mini Case, and then we
systematically went through it in class to “explain” the chapter. (See the section titled
“The Instructional Package” later in this Preface for a discussion of lecture aids avail-
able from Cengage Learning.) Here we use a PowerPoint slide show, which is provided
on the Instructor’s Resource CD and on the Instructors website, and which we make
available to students on our own course website. Students bring a printout of the slides
to class, which makes it easier to take good notes. Generally, it takes us about two
hours to frame the issues with the opening questions and then go through a Mini Case,
so we allocate that much time. We want to facilitate questions and class discussion,
and the Mini Case format stimulates both.
The Mini Cases themselves provide case content, so it is not as neces-
sary to use regular cases as it would be if we used lectures based entirely on
Preface xxiii
text chapters. Still, we like to use a number of the free-standing cases that
are available from TextChoice, Cengage Learning’s online case library, at www
.textchoice2.com/casenet, and we have teams of students present their find-
ings in class. The presenters play the role of consultants teaching newly hired
corporate staff members (the rest of the class) how to analyze a particular prob-
lem, and we as instructors play the role of “chief consultant”—normally silent
but available to answer questions if the student “consultants” don’t know the
answers (which is rare). We use this format because it is more realistic to have
students think about how to analyze problems than to focus on the final deci-
sion, which is really the job of corporate executives with far more experience
than undergraduate students.
To ensure that nonpresenting students actually study the case, we call on them
randomly before the presentation begins, we grade them on class participation,
and our exams are patterned closely after the material in the cases. Therefore,
nonpresenting students have an incentive to study and understand the cases and to
participate when the cases are discussed in class. This format has worked well, and
we have obtained excellent results with a relatively small amount of preparation
time. Indeed, some of our Ph.D. students with no previous teaching experience have
taught the course entirely on their own, following our outline and format, and also
obtained excellent results.
An emphasis on basic material. If students have not gained a thorough un-
derstanding of the basic concepts from their earlier finance courses, instructors
may want to place more emphasis on the basics and thus cover Chapters 2
through 5 in detail rather than merely as a review. We even provide a chapter
(Web Chapter 28) on time value of money skills on the textbook’s website for
students who need an even more complete review. Then, Chapters 6 through 17
can be covered in detail, and any remaining time can be used to cover some
of the other chapters. This approach gives students a sound background on the
core of financial management, but it does not leave sufficient time to cover a
number of interesting and important topics. However, because the book is writ-
ten in a modular format, if students understand the fundamental core topics
they should be able to cover the remaining chapters on their own, if and when
the need arises.
A case-based course. At the other extreme, where students have an exceptionally
good background, hence little need to review topics that were covered in the basic
finance course, instructors can spend less time on the early chapters and concen-
trate on advanced topics. When we take this approach, we assign Web Chapter 29 as
a quick review and then assign cases that deal with the topics covered in the early
chapters. We tell students to review the other relevant chapters on their own to the
extent necessary to work the cases, thus freeing up class time for the more advanced
material. This approach works best with relatively mature students, including eve-
ning students with some business experience.
Comprehensive Learning Solutions

Intermediate Financial Management includes a broad range of ancillary materials
designed both to enhance students’ learning and to help instructors prepare for and
conduct classes.
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how the work was going on. I stayed longer than I had intended, and
I want five thousand dollars more of the stock of this company.”
We were much elated over our success, and plans were made for
enlarging the business. I completed the drawings for an additional
machine, wide enough to take in platforms, for which provision had
been made by me in the plan of the building. The only change
suggested by our two years’ experience was the use of air-cushions
behind the hammers in place of steel springs.
But the best-laid schemes o’ mice an’ men, the poet tells us,
“Gang aft a-gley;
And leave us naught but grief and pain
For promised joy.”
Our plans were suddenly ruined. A change in the method of facing

ashlar was introduced and soon became universally adopted.
Instead of being faced by hand, it began to be sawn out of large
blocks. I have since wondered why this had not been done long
before. Blocks of marble had been sawn into slabs by gang-saws no
one knows how long, and all that had to be done was to apply the
same system to blocks of building-stone. It was found to cost no
more to saw ashlar than it had done to split it out at the quarry. All
the cost of facing and much stone were saved. Our stone-cutting
machine became useless, and I learned that disappointments were
not confined to the legal profession.
The speed of 300 revolutions per minute had proved to be
admirably suited for the machine. Familiarity with this speed in the
running of the stone-dressing machine made me alive to the value of
high rotative speeds in all cases to which they are adapted.
In looking back over this period I see that the success of the
stone-dressing machine was due to the following causes:
First, I went about the work of facing stone by machinery in the
natural way.
Second, the machine was superabundantly strong and substantial
in every part.
Third, it was made with absolute mechanical truth.
Fourth, the speed was splendid.
Fifth, the blow was peculiar. In the Hastings machine the cutting-
tool was driven into the stone. In mine it rested on the stone and was
moved back horizontally by the feed. This changed slightly the
angular position of the tool-holder, so that the blow was received by
it at the lower edge of its back. This gave to the tool a motion forward
and upward, so that the vertical effect on the stone was trifling.
This was the vital feature of my improvement, and that in a double
sense; for it was only by convincing my associates beforehand that a
machine operating in this manner could not break the stone that I
was able to obtain their financial support.
Sixth, the two-faced hammer saved the stone from all
unnecessary force of the blow.
The final cause of its success was the two-table system. The two
operations of setting and cutting occupied each about the same time,
and twenty tables each averaging thirty square feet of surface,
measured after being squared up, were easily finished in a day of
ten hours.
A description of some of the constructive methods employed by
me may be interesting:
The bar of steel which was to be made into six separate tool-
holders had to have eighteen sockets mortised in it. These were 1
inch square. I had made the tools with square shanks so as to insure
their proper position. These mortises must be absolutely in line and
of equal depth. These objects were accomplished as follows: A cast-
iron angle-bar with planed surfaces was first bolted on the table of
the drilling-machine, and for drilling the holes the bar of steel was
kept in contact with this angle-bar. A uniform depth was insured by
employing a bottoming-drill with a collar formed on the shank. The
drilling was finished when this collar rubbed on the steel bar.
I had this work done by Mr. Joseph Banks, whose shop was in a
large building at the corner of Second Avenue and Twenty-second
Street. Mr. A. S. Cameron, the inventor and manufacturer of the
celebrated Cameron steam-pumps, was then an apprentice in that
shop. Mr. Banks was an excellent mechanic, and I was greatly
indebted to him for the accuracy of the work that I procured. He
devised an expanding-drill to cut a groove at the bottom of these
sockets, in which the chips from the slotting-tool made in squaring
the holes would come off. The finishing slotting-tool I designed
myself. I had noticed in all slotting-machines that came under my
observation at that time that the tool would spring off a little at the
commencement of the cut, so that a full square angle was never
obtained. To avoid this defect and to size the slots equally I made a
slotting-tool to cut on opposite sides. The cutting edges were each
about ¹⁄₈ inch long and the corners rounded. The bar for the tool-
holders had to be set three times on account of its length. It was set
in contact with the same angle-bar, which was bolted on this table
parallel with its transverse feed. This finishing-tool being once set,
the upper and lower faces of all the sockets were thus readily
finished in perfect line and with square edges. The tool being then
turned at right angles to its first position, for which purpose its shank
had been planed square, finished the sides of the sockets. These
were identical in every respect, and any tool could go anywhere.
The springs behind the hammers were prepared with great care. I
had large bars of spring steel reduced under a tilt-hammer to a
section ³⁄₈ inch square. These were coiled with only ¹⁄₄ inch space
between the coils, so that in case a spring broke within the hammer
it could not get out of place. These springs were exceptionally
durable. We took off the back cross-bar occasionally—perhaps once
a month—to examine for broken springs, and sometimes we found
one, which was replaced with a new one because we assumed that
it was fatigued, but the hammers worked just as well with broken
springs as they did with whole ones. The springs, having
considerable initial compression, did not become loose.
It seems proper to add that, except the help from Mr. Banks, I did
not in designing the machine or organizing the work receive
assistance or suggestion from anyone.
With these details I bid a final good-by to you, my old
schoolmaster. I have a warm place in my heart for you. You set me
my first lessons in mechanics. Your life was short. You were not
ordained to cut much of a figure in the world. But you were faithful.
You always did your work and did it well.
CHAPTER II
The Evolution and Manufacture of the Central Counterpoise Governor. Introduction

of Mr. Richards.
hen the stone-dressing machine was started a

difficulty presented itself. The governor was in
constant motion a short distance up and down,
causing the engine to oscillate, running alternately too
fast and too slow. There was nothing that should have
caused this action, so far as I could observe. The load
on the engine was constant. However the work done on the stone
may have varied, the work of the engine was to lift the hammers, and
these, being lifted successively, presented a uniform resistance. The
oscillation was not very great, as nearly as I can remember about 12
per cent. of the speed; which would give to each hammer a variation
of thirty-six blows per minute. This, however, produced a waving
surface on the stone. The more rapid the blow, the stronger it was
and the deeper the cut. These waves were slight, only about ¹⁄₅₀ of
an inch variation in depth, but yet it was not possible for our rubbing-
machine to grind them off without great loss of time. So we had to
employ three or four stone-cutters to chisel off these ridges, which
were about 4 inches apart.
It was evident that this oscillation must be stopped. I tried to
remedy it by changing the pressure of the steam, and then by
changing the pulleys so as to run the engine faster, the speed of the
governor, however, necessarily remaining the same. But these had
no effect. Having exhausted my own stock of ignorance on the
subject, I applied to professional experts for more, and I got it. Three
persons, who I supposed ought to know, and who probably did know,
all that was then known on the subject, gave me the same advice. It
was that I should get a larger engine and a great deal larger fly-
wheel. This advice did not seem to me reasonable. I knew that the
engine was large enough, because while the governor was in the
lowest position, in which it did not open the throttle entirely by any
means, the machine ran too fast. They then told me I must have a
heavier fly-wheel at any rate, and they explained to me that the fly-
wheel performed two offices—one to carry the crank over its dead
centers with an approximately uniform motion, and the other to give
the governor time to act. I replied that the engine passed its dead
centers with absolute uniformity then, as nearly as I could see, and
as was shown by the surface of the stone, and consequently for that
purpose the fly-wheel I had must be sufficient. The oscillations were
regular, occupying about 30 revolutions of the machine, or 6 seconds
of time, and had no connection with the dead centers, and I did not
see why the governor should require any time to act. They told me
that all governors required time to act, of course.
I then examined the governor more critically, and made up my
mind that its action was hindered by friction in the driving-joints at the
top of the spindle. These joints were about 4 inches apart, on
opposite sides of the spindle, and were of a character in which the
force transmitted through them to drive the balls produced a pinch
between the broad faces of the joints. The governor could not act
until by change of its speed it had accumulated force enough to
overcome this pinch, and then it moved too far. Again I applied to my
authorities for some way of getting rid of this friction. They told me
that was easy enough. All I had to do was to put a yoke on the
governor spindle, through which the governor arms were threaded
and by which the driving pressure was applied close to the balls. So
for the first time I took their advice and had a yoke put on the
governor. I could not discover that this helped the matter at all. The
improvement was too trifling to be noticed. I also saw clearly enough
why this was so. The pressure applied was lighter than that applied
through the joints, but it was also applied at a correspondingly
increased distance from the axis, so that the effect in retarding the
action of the governor was substantially the same.
I saw that if I got any relief I must find a way to it myself. So I
began studying the subject of governors. My engineering library at
that time consisted of Haswell’s Engineers’ Pocket Book. What little
book-knowledge I had respecting mechanics I had learned from
Haswell. I turned to Haswell and read what he had to say about
governors. I learned that they were conical pendulums and made
half as many revolutions in a minute as the vibrations of a pendulum
whose length was equal to the height of the cone, the base of which
was the plane in which the center of oscillation of the balls and arms
revolved, and its apex the point of intersection of the axes of the
arms, if produced upward, and that their revolutions varied inversely
as the square root of the height of this cone. I did not see that this
got me out of my difficulty at all. I then referred to the subject of
centrifugal force, with which I had made some acquaintance before,
and I read this champion mind-muddler: “All bodies moving around a
center or fixed point have a tendency to fly off in a straight line. This
is termed centrifugal force.” This did not help me any more, nor
interest me much at that time.
But I read further that the centrifugal force of a body revolving in
any given circle varies as the square of the speed. “Thus a body
making 10 revolutions per minute will exert four times as much
centrifugal force as will be exerted by the same body making 5
revolutions per minute.” The governor on my engine was making 50
revolutions per minute, and in thinking the matter over it occurred to
me that if the governor could be run as fast as my machine, namely,
at 300 revolutions per minute, the centrifugal force of one pound
would be as great as that exerted by 36 pounds at 50 revolutions per
minute. I cried, “Eureka! I have found it.” One-pound balls in place of
36-pound balls would be easily driven. I told my experts of the great
find that I had made, and they laughed at me. They told me I ought
to know that the momentum of the balls increased in the same ratio
with their centrifugal force, MV² being the expression common to
both, so, in the same circle, while the centrifugal force of the balls at
300 revolutions per minute would be 36 times greater than at 50
revolutions, it would require also 36 times the force to drive them,
and that I would gain nothing by my proposed change, but instead I
would have to rotate also the weight that I would need to use to hold
the small balls down, and the last case would be worse than the first.
This staggered me, and I pondered awhile what I should do.
I had a friend living near by on Fourteenth Street, west of Seventh
Avenue—a Mr. Thompson, a mathematician and the author of a
series of mathematical books then largely used. So I called upon him
and stated my trouble and asked his advice. He illuminated the
subject to me as follows: “You seem to be a persevering young man;
keep hard at it and you will solve the difficulty by and by.”
In my despair I just had before me this one thought: The friction
must be cured at any rate. After a time I thought that if I made a long
joint at the top embracing the center of gyration of the counterpoise,
so that the pressure required to drive the balls and counterpoise
would be applied at some distance from the axis of the spindle and
for that reason would be much lighter, and also would be normal to
the surface of the joint-pin instead of being a pinch between opposite
faces, the difficulty would be cured, as the force to overcome the
friction would be exerted at the ends of levers 50 or 100 times the
radius of the pin. I felt so sure of this that I risked making a governor
with a single joint at the apex of the cone, as originally employed by
Watt, thus making the governor more sensitive, as the height of the
cone would not be changed at both ends, still fortunately holding to
my little balls and high speed, though I cannot tell why. The joint at
the top I made 6 inches in length.
When this governor was started, the trouble absolutely vanished.
The engine ran with perfect uniformity while the load was constant. I
use the adjective “perfect” advisedly, for the governor slide was as
motionless on the spindle as if it were screwed tight, and the
governor proved to be the most sensitive possible index of the
variations of speed. When the belt was thrown off to the loose pulley
the engine ran idle. The counterpoise then rose promptly but gently
to its fixed highest position, and stood there motionless until the belt
was thrown on and the hammers were started, when it moved as
gently but promptly down to its lower position and stood there again
motionless so long as the hammers were running. We could not
detect by the eye the variation in speed that caused this action of the
governor. The heaviest load on the engine, however, was dragging
rapidly the two tables loaded with stone. This caused the governor to
settle still further, but always the motion of the engine seemed to be
the same so far as I could detect. The surface produced on the stone
left nothing to be desired. The machine cut true planes, free from
any windage, and the surfaces were left so smooth that the rubbing-
machine had but little to do, and kept up with the cutting-machine
very easily. The governor fascinated everybody who witnessed its
operation.
The First Porter Governor.
I first made the drawing for the governor with the weight hanging
to the slide. Mr. John McLaren, a machinist who had done good work
for me, when I showed it to him said, “Why don’t you turn your
weight upside down and put it between the arms?” I was not long in
acting upon this suggestion, and that made the Porter governor
complete. I had it described and illustrated in the Scientific American.
They took a photograph of it as photographs were taken in those
days—that is, they sent their artist up to make a sketch of it, and this
sketch (shown here) and description will be found in the Scientific
American of October 9, 1858. This governor has never been
changed by me except in the shape of the counterpoise.
I believed the mathematics of my advisers to be sound, and that
the perfect action of the governor was obtained entirely by the long
driving-joint, which I supposed would have enabled the 36-lb. balls at
50 revolutions per minute to do just as well as 1-lb. balls at 300
revolutions, but I never tried the experiment.
In that belief I remained for 50 years. Now, at the age of over 80
years, after long rest from business activities, in revising these
reminiscences for publication, the idea has first occurred to me, and
has grown into a conviction, that my advisers were wrong here as
they had been in every other respect. They overlooked the fact that
the angular velocity of the driving-joint increased equally with that of
the balls, so that the ratio between them would remain constant. The
law that the driving force required increases as the square of the
speed imparted applies only to the original source of power, as, to
the force of the steam exerted in the cylinder of an engine, the
motion of the piston remaining the same, and to the transmitting
belts or gears whose speed also remains the same. At all these
points the force exerted must increase as the square of the speed
imparted; but this does not apply to the pressure exerted in the
governor joint. Its speed does not remain the same, but increases
with that of the balls. So, while the centrifugal force of the balls,
changes in which produce the vertical movements of the
counterpoise, varies as the square of the speed, the force required
to be exerted in this joint to drive the balls, and which produces the
friction to retard these movements, does not increase at all,
whatever the speed of revolution may be. This fact, unobserved by
me or any one else so far as I ever heard, has all the time been the
secret, a pretty open secret when once seen, of the surprising
combination of sensitiveness and stability in the action of this
governor which has led to its general use, and at which I myself have
never ceased to wonder because I was ignorant of its cause. This,
however, was not the only time that I builded better than I knew.
I can imagine some persons, after having read the above
explanation, to say, some of them perhaps flippantly, and some
possibly sneeringly, “To a properly educated engineer this is obvious
at a glance.” I think it will be so hereafter, but has it been so hitherto?
If any one will produce the record of its observation I will cheerfully
yield to him the priority and will congratulate him upon it.
Some things, however, make me doubt if this observation has ever
been made. At the London Exhibition of 1862 this governor attracted
much attention from its novel appearance, rapid rotation and
remarkable action. Many engineers spoke to me about it. In their
conversation I observed two things: first, no one ever asked me a
question, but every one explained its action to me; and second, while
each had an explanation of his own to make, they all agreed in a
fundamental respect. Their minds ran in the same groove. They
considered the governor only in its theoretical action. No one ever
took notice of the incident of friction, which was the controlling factor.
An improved governor was in their view one contrived in some way
to free the governor from the limitation to its action, which is imposed
by the law of the conical pendulum, and every one explained to me
how my governor was adapted to do this.
The following illustrates this universal view among English
engineers:
In the Appendix to the 10th edition of Rankine’s “Manual of the
Steam-engine and other Prime Movers,” published in 1882, one
reads as follows: “Isochronous governors. The ordinary
governor is not isochronous; for when, in order to adapt the opening
of the regulating-valve to different loads, it rotates with its revolving
pendulums at different angles to the vertical axis, the altitude of the
cone assumes different values, corresponding to different speeds.
The following are expedients for diminishing or removing this defect.
1. Loaded Governor (Porter’s).—From the balls of the common
governor, whose collective weight is (say) A, let there be hung by a
pair of links of lengths equal to the pendulum arms, a load, B,
capable of sliding up and down the spindle, and having its center of
gravity on the axis of rotation. Then the centrifugal force is that due
to A alone, and the effect of gravity that due to A + 2B; consequently
the altitude for a given speed is increased in the ratio A + 2B : A, as
compared with that of a simple revolving pendulum; and a given
absolute variation of altitude in moving the regulating-valve produces
a smaller proportionate variation of speed than in the common
governor.”
That is the whole of it. Respecting this I have to say:
1st. The vertical motion of the counterpoise (variation of altitude), if
the links had also a single joint at the bottom, could not be either
more or less than twice that of the balls, which equal lengths of the
arms and links give also in the common governor, so in this respect
the governor is no improvement.
2d. No notice is taken of the small size of the balls or of the speed
of rotation.
3d. Professor Rankine is not responsible for this absurd piece of
reasoning.
4th. It only shows how far the English engineering mind has been
from considering the subject of hindrance to the governor action from
friction.
My governor works within the law of the conical pendulum. I never
dreamed of attempting in this form of governor to avoid it. In fact it is
this law which gives to the governor its action. A change of speed is
necessary to produce a motion of the counterpoise. But as the
governor was designed by me, this change of speed is very small,
probably no more than is required for stability, and is not sensible in
any way except in the motion of the counterpoise itself, which is
simultaneous with the most minute changes of speed.
Quite a variety of modifications of this governor are being made in
this country, but I think not elsewhere. The makers have been kind
enough to invent the name “the central counterpoise governor.” For
this I feel greatly obliged, as I should be mortified to find my name
attached to any of them. Their action is always more or less
unsatisfactory, sometimes very much so. But I do not think it likely
that the secret of the remarkable action of the Porter governor has
been detected by any of these people.
I am glad that this was not explained to me at first; if it had been I
might not have thought of the single long driving-joint, which is a
valuable feature.
When the stone-dressing machine proved to be valueless, as
already described, I found myself out of business; but the governor
had attracted so much attention and had been so favorably received
that I thought I could establish a business of manufacturing these
governors, and I am proud to say that the gentlemen already
associated with me and who had lost their money in the
abandonment of the stone-dressing machine were so decidedly of
the same opinion, and I had won their confidence to such an extent,
that they furnished the money to enable me to establish this
manufacture.
I rented a shop on the second floor of a triangular building on
Thirteenth Street, at the junction of Hudson Street and Ninth Avenue,
owned by Mr. Herring, the safe-manufacturer, the lower part of which
was occupied by him for his own business. This was a large room
and had light on three sides.
I proceeded to equip this shop with the necessary tools, some of
which I purchased of Mr. Freeland, then considered the best
toolmaker in the United States, and who had gone to England and
worked for some years as a journeyman in the celebrated Whitworth
Works, in Manchester, for the purpose of learning everything that
was known there. Those which Mr. Freeland could not supply I
obtained from Geo. S. Lincoln & Co., of Hartford, Conn.
During the time these tools were building I was waited upon by Mr.
Chas. B. Richards, who was then removing from Hartford to New
York to establish himself as a designer of machinery, and who
brought me a letter from Geo. S. Lincoln & Co. I was at that time
engaged in scheming as well as I could a machine for drilling the
arms and balls and counterweight and spindle of my governor, and
immediately employed Mr. Richards to assist me in getting out the
drawings for this machine. This he did quite to my satisfaction, and
the machine was made by Geo. S. Lincoln & Co., Mr. Pratt, for so
many years head of the firm of Pratt & Whitney, afterwards the Pratt
& Whitney Company, being then their foreman; so that all my tools
from that concern were made by Mr. Pratt. He also cut for me superb
iron patterns for the governor gears.
This machine always interested me very much. It solved every
problem which was involved in the perfect and rapid performance of
these operations. It had two parallel spindles running horizontally in
the same plane, one fixed and the other adjustable. Distance pieces
laid between the spindle heads insured the equal length of the arms
of all governors of the same size. The table was made with a back to
it, so that, a parallel block being laid on the table behind the arms,
these were always brought in position parallel with its back. The
arms were supported on blocks of proper height. These provisions
insured that the joint-holes, which were drilled simultaneously,
should intersect the axes of the arms and of the balls and spindle at
right angles. This machine fitted up all the governors that I ever
made. I gradually built up an excellent business in their manufacture,
on account of the extreme pains taken to produce perfect work, so
that the governors always gave the highest satisfaction.
I think of only one instance to the contrary. I sold a governor to Mr.
Winslow, of Troy, afterwards of the firm of Corning & Winslow, the
first manufacturers of Bessemer steel rails in this country under the
inspiration of Mr. Alexander L. Holley. Soon after this governor had
been shipped I received a letter from Mr. Winslow telling me that the
governor would not answer at all, and I should come and see about
it. I found the governor had been placed on a second-hand Burden
engine, which was a well-known type of horizontal engine at that
time, made in Brooklyn. The engine had been built to make 50
revolutions per minute, but being a great deal too large for their use
they had reduced the speed to 25 revolutions per minute, and the
complaint was that every time the crank passed its centers the
governor dropped to its seat. I told them what I thought the difficulty
was; that any one could see that the engine very nearly stopped as
the crank passed its centers, and the governor had to drop. To show
them this action, I disconnected the governor from the valve and
throttled the engine by hand, and showed them that the governor,
when not connected with the throttle-valve, rose and dropped on
every stroke, in the same way as when connected. They asked me
what I was going to do about it. I told them I should do nothing about
it; that I presumed they might possibly get a governor somewhere
that would stand that alternation of speed without winking, but they
had better send mine back, because it was not made for any such
service.
Charles B. Richards
A.D. 1858
The following is an amusing illustration, doubtless an extreme one,

of the degree in which the lay mind may be incapable of mechanical
perception. My governors were usually set on the engine bed of
horizontal engines near the shaft, and were connected with the
throttle-valve over the cylinder by means of a bell-crank lever and a
long rod. One day a gentleman called to make a personal
examination of the governor and its manufacture, with a view to
investing in the business. I showed him a governor in action on the
testing platform, and a woodcut on my circular which represented the
governor in its position, as above described, with a short piece of the
connecting-rod attached to the lever. He looked at this cut intently for
some time, and then, putting his finger on the broken-off end of the
little rod, said, “Ah, I see; the steam enters there.” I made no reply,
and he was so much pleased with his own penetration that he
invested at once.
I know of only one case in which this governor needed the help of
a dash-pot or controlling vessel. In the great plate-mill of the Otis
Works, in Cleveland, when the enormous mass of steel struck the
rolls, the governor dropped sharply to its seat, and jumped as
sharply to the upper limit of its action when this mass was shot out.
Mr. Wellman, their general manager, suggested to me an elegant
arrangement of air-chambers at the top and bottom of a cylinder,
which permitted free motion to the governor through its whole range
of action, but cushioned it on confined air at the ends.
For several years I made the counterpoise of the governor in the
form of a vase. The present form with hemispherical top was
suggested by Mr. Whitworth in 1866, and shown by me in the Paris
Exposition of 1867. It has three advantages. It is more readily turned
with a circular tool-rest, and it contains more metal and looks more
mechanical.
I exhibited the governor in operation at a fair of the American
Institute held on Fourteenth Street between Sixth and Seventh
avenues, New York City (where the armory of the Twelfth Regiment
now stands), making an arrangement with an exhibitor of an engine
for that purpose. I remember that Mr. George H. Reynolds, then an
engineer in the works of Mr. Delamater at the foot of West Thirteenth
Street, as he passed it with a friend a day or two after it was started,
remarked in my hearing, “It will take a horse-power to drive that
governor.” It would not do to let any such nonsense get around as
the opinion of an engineer, so the next morning the governor was
driven by a belt ⁵⁄₈ of an inch wide, and continued to be so through
the fair. I was sorry afterwards that I did not use a half-inch belt,
which would have driven it just as well, and indeed I think even a
narrower belt would have done, as the foot of the spindle was of
hardened steel, a segment of a sphere, running in a puddle of oil in a
hardened step cupped to a larger radius.
The funniest application of the governor I ever made was the
following: The Civil War had just broken out, and every Yankee was
making some warlike invention. The most ridiculous of all was a
centrifugal gun. A company was formed for its manufacture. The
shot, about an inch in diameter, was fed in at the center of a swiftly
revolving wheel and thrown out through a barrel at the periphery,
with a velocity that, it was estimated by the inventor, would carry it
about two miles. This velocity was to be got up in about one second.
The governor would not act quickly enough, and the engine was
stopped. The parties heard of my governor, and ordered one,
offering to pay for it in a tempting amount of their stock. I preferred
the cash and got it. The governor filled the bill, the shot was
delivered, the velocity of revolution not falling sensibly, but we judged
by the sharp fall of the counterpoise that it required not less than
twenty horse-powers to do it.
The gun was tried on the bank of the Hudson, the Palisades
opposite being the target. The inventor declared that every shot hit
the mark, but some evil-minded persons insisted that they fell into
the water within a quarter of a mile of the shore from which they
were fired.
About the same time the absurdity of sending into the field a tank
of water, a boiler, an engine and the gun, on separate wheels,
connected by pipes or belting, which would be ruined by the least
damage to anything, began to dawn on the enthusiasts, and the
thing was abandoned.
I furnished one of my first governors to Mr. James Horner to
regulate a rolling-mill near Boonton, N. J., a sale which is worth
recording. This mill was employed in rolling steel pretty high in
carbon into rods for making gimlets, and the three-high train had not
yet issued from the brain of Mr. Fritz. The rolling was slow work. The
resistance brought down the speed of the engine before the
governor could act, and they could have only one pass in the rolls at
a time. The workmen had to carry the end of the rod around and
insert it in the next groove after it had run out of the former one. The
rod would be black before it was finished, and often it was difficult to
get it finished at all. I do not know of any change that so much
impressed me at the time as did that which followed the putting of
my governor on this engine. The full speed was kept up, the billets
seemed to rush through the rolls, two and even three passes could
be in them at the same time, and the rods were still at a dull red heat
when finished.
This success induced me to make a raid on Pittsburg. I found
there very different conditions. They then rolled nothing but iron, so
far as I saw or heard. In the first mill I visited, after I had discussed
the subject with one of the proprietors, an old man came up to me
and said, “Do you see that chair? I have sat in that chair twenty-four
years.” The chair corroborated his story. “I watch the rolls; when a
bar enters them, I turn on more steam; when it goes out I shut it off.
If you put in a governor that will do as well, I shall be discharged. I
don’t know how to do anything else; I have a family dependent on
me, and I don’t know what I should do.” I did not hesitate long about
what I should do. I could not improve on the old man’s action. He
regulated the speed perfectly. The only result of my success would
be to beggar him. Superseding hand labor by machinery I did not in
this particular case care to be responsible for. I concluded that the
Pittsburg way was good enough for them, and took the next train for
home.
The first governor I sold was to Mr. William Moller for his sugar-
refinery on Vandam Street. The engine to be regulated was an old-
fashioned beam-engine. The governor was to be set on a bracket
that we had to bolt to the wall, and a pulley some 3 feet or more in
diameter had to be made in halves and put on the shaft. To make
sure that no mistake would be made, I went down myself to make a
gauge of that shaft. I took a ³⁄₈-inch steel rod bent to span the shaft,
and made of this an outside gauge with great care. Now this was not
what I wanted, but I did not know it. I wanted an inside gauge,
representing the diameter of the shaft, and what I did make was
useful only to compare the two.
I returned highly satisfied with my work, leaving the real gauge to
be made in the shop, where it could not be compared with the shaft.
What might reasonably have been expected to happen did happen.
In some unaccountable way something happened to my gauge, and
when we went to install the governor we found the pulley had been
bored ¹⁄₄ inch too small. We had to work hard all night, and got
through only just in time for the engine to start at its usual hour in the
morning. If I had sent a man who knew his business to make this
gauge I should have avoided a lot of trouble, but I should not have
learned anything.
In preparing for the establishment of the governor manufacture I
visited the works of Geo. S. Lincoln & Co., in Hartford, and saw twist-
drills in use, cutting chips instead of scraping. They attracted my
attention and I inquired about them, and was told that they made
them themselves. They kindly took me into the smith-shop and had
one made for me to witness the operation. The smith heated a round
bar of steel and swaged channels in it on opposite sides. They had
quite a set of top and bottom swages for different-sized channels. He
then took another heat on the bar and twisted it by hand, giving a
gradually increasing twist, which at the end was quite rapid. An
increasing twist was obtained in this way. The drill was held in a vise,
so that only the projecting end of it could receive the amount of twist
then being imparted. The drill had to be moved in the vise of course
a number of times. The channels were smoothed out with files, and
when the drill was turned in the lathe sharp cutting edges were
developed, which needed only to be backed off by grinding. I took
one of these drills home with me to serve as a pattern and equipped
my shop with them. They were of the highest use to me. The small
ones drilled the holes for the governor joints, and the large ones

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Management 11th Edition

4 Bond Valuation 118 Box: Corporate Valuation and Stock

7 Accounting for Financial Tying the Ratios Together: The Du Pont

Own-Bond-Yield-Plus-Judgmental-Risk- Employee Stock Ownership Plans

Project Risk Conclusions 520 16 Capital Structure decisions:

Current Asset Holdings 791 The Payments Pattern Approach to

Issues Facing a Firm in Financial Holding Companies 1007

Glossary 1085 Web Extension 10-A The Required

The Next Level: Intermediate Financial

Now it is time to move on. In Intermediate Financial Management, we first re-

Corporate Valuation as a Unifying Theme

Design of the Book

Beginning of Chapter Questions

Major Changes in the Eleventh Edition

Significant Changes in Selected Chapters

Chapter 10: Determining the Cost of Capital

Chapter 21: Working Capital Management

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Our plans were suddenly ruined. A change in the method of facing

The Evolution and Manufacture of the Central Counterpoise Governor. Introduction

hen the stone-dressing machine was started a

The following is an amusing illustration, doubtless an extreme one,

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