combat the deepening global economic and financial crisis. When the economy is
growing rapidly and inflation threatens, the Fed raises interest rates, as it did six
times in 1999 and early 2000. The Fed gave four reasons for the rate hikes: healthy
financial markets, a persistent strength in domestic demand, firmer foreign
economies, and a tight labor market. Currently, in early 2002, we are in a period of
recession, and the Fed has cut rates eleven times since mid-2000.
- During recessions, short-term rates decline more sharply than long-term rates.
This occurs because (a) the Fed operates mainly in the short-term sector, so its in-
tervention has the strongest effect there, and (b) long-term rates reflect the average
expected inflation rate over the next 20 to 30 years, and this expectation generally
does not change much, even when the current inflation rate is low because of a re-
cession or high because of a boom. So, short-term rates are more volatile than
long-term rates.
Other than inflationary expectations, name some additional factors that influ-
ence interest rates, and explain the effects of each.
How does the Fed stimulate the economy? How does the Fed affect interest
rates? Does the Fed have complete control over U.S. interest rates; that is, can it
set rates at any level it chooses?
Organization of the Book
The primary goal of a manager should be to maximize the value of his or her firm.
To achieve this goal, managers must have a general understanding of how busi-
nesses are organized, how financial markets operate, how interest rates are deter-
mined, how the tax system operates, and how accounting data are used to evaluate
a business’s performance. In addition, managers must have a good understanding of
such fundamental concepts as the time value of money, risk measurement, asset
valuation, and techniques for evaluating specific investment opportunities. This
background information is essential for anyone involved with the kinds of decisions
that affect the value of a firm’s securities.
The book’s organization reflects these considerations. Part One contains the basic
building blocks of finance, beginning here in Chapter 1 with an overview of corporate
finance and the financial markets. Then, in Chapters 2 and 3, we cover two of the
most important concepts in finance—the time value of money and the relationship be-
tween risk and return.
Part Two covers the valuation of securities and projects. Chapter 4 focuses on
bonds, and Chapter 5 considers stocks. Both chapters describe the relevant institu-
tional details, then explain how risk and time value jointly determine stock and bond
prices. Then, in Chapter 6, we explain how to measure the cost of capital, which is the
rate of return that investors require on capital used to fund a company’s projects.
Chapter 7 goes on to show how we determine whether a potential project will add
value to the firm, while Chapter 8 shows how to estimate the size and risk of the cash
flows that a project will produce.
Part Three addresses the issue of corporate valuation. Chapter 9 describes the key
financial statements, discusses what these statements are designed to do, and then ex-
plains how our tax system affects earnings, cash flows, stock prices, and managerial de-
cisions. Chapter 10 shows how to use financial statements to identify a firm’s strengths
and weaknesses, and Chapter 11 develops techniques for forecasting future financial
46 CHAPTER 1 An Overview of Corporate Finance and the Financial Environment
44 An Overview of Corporate Finance and the Financial Environment
