Principles of Finance PDF Download – Dahlquist and Knight (2e, OpenStax) BBA / BS Finance

Principles of Finance 2e is the OpenStax textbook for the core finance course in an undergraduate business program, written by senior contributing authors Julie Dahlquist and Rainford Knight with six contributing authors, and you can download it free as a PDF from the official OpenStax site. Its 20 chapters begin with what finance is and how corporations are governed, review the economics, accounting and statistics a finance student needs, and then cover financial statements, ratios, time value of money, bonds, stocks, market history, risk and return, capital budgeting, cost of capital, forecasting, working capital and risk management.

The book is built for the finance course in BBA and BS Finance programs, and it works with a financial calculator or Excel throughout. This page gives a summary, key points, a tip, a common mistake and two practice questions for every chapter, plus a study plan that follows the book’s own core and extension chapters, so you know what to read first before you open the official book.

Book Overview

Chapter List

Chapter 1: Introduction to Finance

Difficulty: Easy · Key topics: business finance, investments, financial markets and institutions, risk and return, finance function, financial planning, budgeting, primary and secondary markets, dealers and brokers, money and capital markets

The opening chapter defines finance as the study of how money is managed, moved and raised, and divides it into business finance, investments, and financial markets and institutions. It explains the risk and return trade-off, then shows what the finance function does inside a firm: planning, forecasting and budgeting. The chapter looks at the role of data, careers such as financial analyst and business analyst, primary and secondary markets, the roles of dealers, brokers and intermediaries, microeconomics and macroeconomics, money and capital market instruments, and the link between time and value.

Key Points:

• Finance is the study of the management, movement and raising of money, and at its core it is about the trade-off between risk and expected return.
• Business finance covers working capital management, capital budgeting and capital structure, with the aim of maximizing the wealth of shareholders.
• The primary market sells new securities and the secondary market trades used ones; a trade of Amazon stock between investors sends no cash to Amazon.
• Dealers trade from their own portfolio and earn the bid-ask spread, brokers match buyers and sellers for a commission, and intermediaries such as banks create new products.
• Money markets hold short-term, low-risk, liquid securities with maturities under one year; capital markets hold longer-term bonds and stocks.
• Book values record what has happened, while market values look forward and reflect expected future cash flows.

Memory Tip: Remember the three areas as “run it, buy it, trade it”: business finance runs the firm, investments buy assets, and financial markets and institutions are where they trade.

Common Mistake: Thinking that finance and accounting are the same. The chapter says accounting creates the financial statements, while finance uses them to plan, forecast and decide.

Important Questions:

• What are the three main areas of finance? Business finance, investments, and financial markets and institutions.
• What is the difference between a dealer and a broker? A dealer buys and sells from its own portfolio and profits from the bid-ask spread, while a broker brings buyers and sellers together and earns a commission.

Chapter 2: Corporate Structure and Governance

Difficulty: Easy · Key topics: sole proprietorship, partnership, corporation, LLC and LLP, stakeholders, board of directors, audit committee, agency problems, ESG, investor relations, GAAP versus IFRS

This chapter compares the four main business forms: sole proprietorships, partnerships, corporations and hybrids such as the LLC and LLP. It separates shareholders from the wider group of stakeholders and describes the board of directors, its audit committee, and the value of independent and diverse directors. It then explains agency problems between owners, managers, creditors and other stakeholders, introduces ESG ratings, and describes how investor relations teams use SEC filings, earnings calls and press releases. The last section contrasts domestic and global firms, GAAP and IFRS, and EDGAR.

Key Points:

• A corporation is a legal entity separate from its owners, so shareholders can lose only the money they invested.
• A company becomes a corporation by filing articles of incorporation, also called a corporate charter, with the state.
• Common shareholders vote and control management, while preferred shareholders have no votes and receive a fixed dividend.
• An agency problem arises when an agent (the manager) pursues personal goals instead of the interests of the principal (the owner).
• An independent director has no material interest in the company other than the directorship and uses information sources apart from management.
• ESG stands for environmental, social and governance; third-party ESG ratings are increasingly used by investors.
• Public companies file the annual Form 10-K, quarterly Form 10-Qs and current Form 8-Ks with the SEC through EDGAR.

Memory Tip: Link each form to its liability. A sole proprietor and a general partner are the business, so they are personally exposed, while a corporation stands apart from its owners and limits their loss.

Common Mistake: Using “shareholder” and “stakeholder” as the same word. Every shareholder is a stakeholder, but employees, customers and governments are stakeholders without owning any stock.

Important Questions:

• What is an agency problem? It is a conflict of interest in which the manager, acting as agent, uses the position for personal goals instead of serving the shareholders, who are the principals.
• Why do firms want independent board members? Independent directors have no material ties to the company and their own sources of information, so they can oversee management objectively.

Chapter 3: Economic Foundations: Money and Rates

Difficulty: Easy · Key topics: supply and demand, equilibrium price, inflation and CPI, unemployment, GDP, business cycle, nominal and real interest rates, risk premium, exchange rates, FRED data

This chapter gives the economics a finance student needs. It starts with demand, supply and the equilibrium price, using a pizza example to show how shifts in either curve move the price. It then turns to macroeconomics: inflation measured by the consumer price index, unemployment, and gross domestic product. It describes the expansion, peak, contraction and trough of the business cycle, explains nominal and real interest rates and risk premiums, and shows how spot exchange rates and currency exposure work. It ends with FRED data and how to read levels, percentage changes and indexes.

Key Points:

• The law of demand says quantity demanded falls as price rises; the equilibrium price is where quantity demanded equals quantity supplied.
• The CPI tracks a fixed basket of goods in eight categories, and the 1970s and early 1980s were the only period of double-digit US inflation.
• To count as unemployed, a person must be jobless, actively seeking work and able to take a job.
• GDP is the market value of all final goods and services produced in a year, and consumption is about two-thirds of US GDP.
• The real interest rate equals the nominal interest rate minus the inflation rate, so a 6% savings rate with 2% inflation earns about 4% in real terms.
• Lenders add a risk premium to compensate for lending to riskier borrowers than the US government.
• When it costs more dollars to buy a peso, the peso has appreciated; the dollar has depreciated against it.

Memory Tip: An interest rate is the rental price of money, so think of nominal as the price on the sticker and real as the price after inflation takes its share.

Common Mistake: Treating a change in price and a change in quantity demanded as the same thing. A price change moves along the demand curve, while a change in something else shifts the whole curve.

Important Questions:

• How do you calculate the real interest rate? Subtract the inflation rate from the nominal interest rate; for example, 6% nominal minus 2% inflation gives about 4% real.
• What happens to the equilibrium price when supply increases? The supply curve shifts right, so the equilibrium price falls and the equilibrium quantity rises.

Chapter 4: Accrual Accounting Process

Difficulty: Medium · Key topics: cash versus accrual accounting, accounting equation, double-entry, debits and credits, revenue and expense recognition, capitalizing, depreciation, profit versus cash flow

This chapter is the accounting prerequisite for finance. It compares cash-basis and accrual-basis accounting and says who should use each. It builds the accounting equation and double-entry system with T-accounts, debits and credits. The revenue recognition and expense recognition principles are explained with the running example of Chris’s summer landscaping business. The chapter then asks when to capitalize an item instead of expensing it, and compares straight-line, units-of-production and double-declining-balance depreciation, before separating profit or loss from cash flow.

Key Points:

• Cash-basis accounting records a transaction only when cash moves, while accrual-basis accounting records revenue when earned and expenses when incurred.
• Most publicly traded companies must use accrual accounting under SEC rules, and they follow GAAP or IFRS.
• Double-entry accounting means every transaction touches at least two accounts and total debits must equal total credits.
• Revenue is recognized only when goods or services have been delivered; expenses are recorded in the period in which they are incurred, which is the matching principle.
• A fixed asset is capitalized and recorded at its full cost, including shipping, taxes and installation, then depreciated over its useful life.
• Double-declining-balance doubles the straight-line rate, so a five-year asset uses 40 percent of its remaining book value instead of 20 percent of cost.
• Net income is revenue minus expenses, but a revenue is not always cash in and an expense is not always cash out.

Memory Tip: Remember “earned, not paid” for accrual accounting. Ask whether the work was done, not whether the money has arrived.

Common Mistake: Believing that a profitable company must have plenty of cash. The chapter explains that profit and cash flow differ, which is why the statement of cash flows exists.

Important Questions:

• What is the difference between cash-basis and accrual-basis accounting? Cash-basis records transactions only when cash is received or paid; accrual-basis records revenues when earned and expenses when incurred, whatever the timing of cash.
• Why is a fixed asset depreciated instead of expensed all at once? The expense recognition principle requires the cost to be spread over the years in which the asset helps earn revenue.

Chapter 5: Financial Statements

Difficulty: Medium · Key topics: income statement, gross profit, operating income, EBITDA, classified balance sheet, retained earnings, statement of owner’s equity, statement of cash flows, free cash flow, common-size statements, 10-K and 10-Q

Using the fictional Clear Lake Sporting Goods, this chapter builds each statement in turn. The income statement moves from sales to gross profit, operating income, net income and EBITDA. The classified balance sheet follows the accounting equation, and the chapter links the two statements through retained earnings and separates expenses from payables. It adds the statement of owner’s equity and the statement of cash flows with operating, investing and financing activities, then operating cash flow, free cash flow, common-size statements, accounting periods, annual reports and SEC filings.

Key Points:

• The income statement covers a period of time, while the balance sheet is a snapshot at one date.
• Sales less cost of goods sold gives gross profit; deducting operating costs gives operating income; deducting interest, taxes and other items gives net income.
• EBITDA is earnings before interest, taxes, depreciation and amortization, so it removes noncash items from the profit figure.
• Under GAAP, balance sheet assets are carried at historical cost, so land and buildings do not show current market value.
• Net income flows into retained earnings; a firm cannot pay dividends beyond the retained earnings it has.
• Free cash flow is operating cash flow minus capital expenditures, and it shows cash left for debt repayment, dividends and growth.
• A common-size income statement divides each line by net sales, and a common-size balance sheet divides each line by total assets.

Memory Tip: Think of the income statement as a video of a period and the balance sheet as a photograph of one day; the cash flow statement is the receipt that shows where the cash actually went.

Common Mistake: Treating an expense and a payable as the same. An expense belongs on the income statement when incurred, while a payable is a liability on the balance sheet until the bill is paid.

Important Questions:

• What are the three sections of the statement of cash flows? Operating activities, investing activities and financing activities.
• Why use common-size statements? Restating every line as a percentage lets you compare periods, divisions and companies of different sizes, including against industry averages.

Chapter 6: Measures of Financial Health

Difficulty: Medium · Key topics: ratio analysis, efficiency ratios, operating cycle, liquidity ratios, solvency ratios, times interest earned, EPS, P/E ratio, book value per share, profit margin, ROA, ROE, DuPont method

This chapter teaches ratio analysis with Clear Lake Sporting Goods’ two years of statements. It first explains why ratios help and where they mislead, since past results do not guarantee the future. It then groups ratios into efficiency measures (receivables turnover, asset turnover, inventory turnover, days’ sales in inventory), liquidity measures (current, quick and cash ratios), solvency measures (debt-to-assets, debt-to-equity, times interest earned), market value measures (EPS, P/E, book value per share), and profitability measures, ending with the DuPont breakdown of return on equity.

Key Points:

• The four main ratio families are liquidity, solvency, efficiency and profitability, and the chapter adds market value ratios for public firms.
• The current ratio is current assets divided by current liabilities; the quick ratio removes inventory and prepaid expenses; the cash ratio uses only cash and equivalents.
• The debt-to-assets ratio shows how much of the assets were financed by debt, and times interest earned divides operating income (EBIT) by interest expense.
• GAAP requires public companies to report basic and diluted earnings per share on the face of the income statement.
• The P/E ratio is share price divided by EPS, and it can be trailing (past earnings) or forward (estimated earnings).
• The DuPont method splits ROE into profit margin, total asset turnover and the equity multiplier (leverage).
• Clear Lake’s ROE of 26.4% looks strong against an industry average of 12.56%, but a ratio is only meaningful in context.

Memory Tip: Remember DuPont as “margin times turnover times leverage”: how much you keep from each sale, how hard the assets work, and how much of the funding is borrowed.

Common Mistake: Assuming a higher turnover or a higher ratio is always better. The chapter notes that very high inventory turnover can mean stock is too low to meet demand.

Important Questions:

• How do the current, quick and cash ratios differ? All divide by current liabilities, but the current ratio uses all current assets, the quick ratio excludes inventory and prepaids, and the cash ratio counts only cash and cash equivalents.
• What does the DuPont method show? It breaks return on equity into profit margin, total asset turnover and an equity multiplier, so you can see what drives the return.

Chapter 7: Time Value of Money I: Single Payment Value

Difficulty: Medium · Key topics: time value of money, lump sum, future value, present value, compounding, discount rate, timelines, financial calculator keys, Excel FV and PV, inflation, Fisher effect, rule of 72, opportunity cost

This chapter introduces the idea that money received sooner is worth more than the same amount later because it can earn interest. It treats the lump sum as the building block of all cash flows, shows single-period and multi-period future values, and explains how compounding and the interest rate change the result. It then solves for future value, present value, number of periods and interest rate using timelines, the five calculator keys (N, I/Y, PV, FV, PMT) and Excel. It closes with applications: inflation, nominal versus real rates, compounding frequency, the rule of 72, risk and opportunity cost.

Key Points:

• Future value is what a present amount grows to at a given rate; present value is the future amount discounted back to today.
• $1,000 at 4% for one year becomes $1,040, and $1,000 at 3% for four years becomes $1,125.51 because interest earns interest.
• The five TVM keys on a financial calculator are N, I/Y, PV, FV and PMT; for a lump sum, PMT is zero.
• Under the cash flow sign convention, outflows are negative and inflows are positive, so a $1,000 deposit is entered as −1,000.
• The Fisher effect links the nominal rate, the real rate and expected inflation; a negative real rate erodes the purchasing power of savings.
• The rule of 72 estimates the years to double money as 72 divided by the rate expressed as a whole number.

Memory Tip: Remember “compound up, discount down”. Moving a lump sum forward in time grows it, and moving it back to today shrinks it.

Common Mistake: Entering the present value and future value with the same sign in a calculator or Excel. The chapter explains that one must be an outflow and the other an inflow, or the answer is wrong.

Important Questions:

• Why is a dollar today worth more than a dollar tomorrow? Money today can be invested to earn interest, so it grows into a larger future value.
• What is the rule of 72? It is a shortcut: divide 72 by the annual interest rate (in percent) to estimate how many years it takes for money to double.

Chapter 8: Time Value of Money II: Equal Multiple Payments

Difficulty: Medium · Key topics: perpetuity, preferred stock, ordinary annuity, annuity due, structured settlements, retirement planning, loan amortization, stated and effective rates, calculator and Excel solutions

This chapter extends time value of money from one payment to a stream of equal payments. It begins with perpetuities, valuing a constant stream such as a preferred stock dividend by dividing it by the required rate of return. It then covers the present and future value of annuities, the one-period difference between an ordinary annuity and an annuity due, and uses in lotteries, settlements and retirement. Loan amortization shows how each fixed payment splits into interest and principal, and stated versus effective rates reveal the true cost of credit card style compounding.

Key Points:

• A perpetuity pays forever, so it cannot be compounded into a future value, but its present value is the payment divided by the required rate of return.
• A growing perpetuity has payments that rise by a set rate, unlike a constant perpetuity.
• An ordinary annuity pays at the end of each period; an annuity due pays at the start, so it has exactly one extra period of interest.
• A lottery that pays the first check immediately, such as $120,000 a year, is an annuity due, and a lump sum is its discounted value.
• Loan amortization is the schedule that shows how each equal payment is split between interest and principal on a fixed-rate loan.
• A credit card rate of 1.5% per month is not 18% a year, because the effective annual rate includes compounding within the year.
• Excel and calculator solutions use the PMT, PV, FV, N and rate inputs, and the chapter says to use four decimal places for TVM factors.

Memory Tip: For annuity due, think “due means now”. The first payment is made right away, so every payment earns one more period of interest.

Common Mistake: Multiplying a monthly rate by 12 and calling it the annual rate. The chapter shows that monthly compounding makes the effective rate higher than the stated rate.

Important Questions:

• How do you value a constant perpetuity? Divide the fixed periodic payment by the required rate of return, which is the market rate and not the stated rate on the share; Shaw Inc.’s $2.00 preferred dividend is 4% of a $50 stated value, but its price depends on the required return.
• What is the difference between an ordinary annuity and an annuity due? An ordinary annuity pays at the end of each period and an annuity due pays at the beginning, which adds one period of interest.

Chapter 9: Time Value of Money III: Unequal Multiple Payment Values

Difficulty: Medium · Key topics: mixed stream, uneven cash flows, future value of a mixed stream, present value of a mixed stream, capital investment, cash flow lists on a financial calculator, Excel NPV and FV

The last time value of money chapter handles cash flows that change in size. When payments are unequal, the annuity shortcuts no longer work, so the chapter treats each cash flow as its own lump sum and adds the results. It shows a seven-year savings plan with extra deposits in years 4 and 6, and a lottery windfall used to fund withdrawals of $17,000, $17,500 and $18,000. It then repeats both problems with the cash flow worksheet of the TI BA II Plus Professional calculator and with Microsoft Excel.

Key Points:

• A mixed stream is a set of cash flows that vary in amount from one period to the next, so annuity shortcuts cannot be used.
• The future value of a mixed stream is the sum of each cash flow compounded forward to the end date.
• The present value of a mixed stream is the sum of each cash flow discounted back to today at the same rate.
• In the chapter’s savings example, $2,000 a year plus $10,000 in year 4 and $3,000 in year 6, at 7%, grows to about $35,062.26.
• Capital investment decisions rest on this method because they compare a large up-front cost with uneven future cash inflows.
• Cash flow is the actual cash moving in and out of a business, not accounting income based on accruals.

Memory Tip: Think “one at a time, then add”. Move each uneven cash flow to the same point in time on a timeline before you sum them.

Common Mistake: Forgetting the zero. If a year has no cash flow, you must still enter it in the calculator or Excel list, or every later cash flow is placed in the wrong period.

Important Questions:

• Why can you not use the annuity formula for a mixed stream? The annuity formula needs equal payments, so each unequal cash flow must be valued separately and the values added.
• How do you find the present value of a mixed stream? Discount each cash flow to today at the required rate and add the present values together.

Chapter 10: Bonds and Bond Valuation

Difficulty: Medium · Key topics: coupon rate, par value, yield to maturity, government, corporate and convertible bonds, discount and premium bonds, bond pricing, yield curve, interest rate risk, default risk, bond ratings, bond laddering

This chapter explains bonds as fixed-income securities that pay periodic coupons and return par value at maturity. It names the three main types, government, corporate and convertible, and shows why bond prices move opposite to interest rates. Pricing is done in four steps: lay out the cash flows, choose the discount rate, discount the coupon annuity and the face value, then add. The chapter then solves price, yield, maturity and coupon rate with a calculator and Excel, reads the yield curve, and covers interest rate risk, default risk, rating agencies, capital gains and bond laddering.

Key Points:

• A bond holder receives two cash flows: periodic coupon payments and the par (face) value at maturity.
• Bond prices and interest rates move in opposite directions, except for floating-rate notes whose coupons reset.
• The coupon rate only sets the payment amount, while the yield to maturity is the market discount rate used to price the bond.
• A 4% semiannual bond with 15 years left and a 5% yield is worth $895.35, and a 20-year 6% bond with a 4% yield is worth $1,271.81.
• A bond trades at a discount when its coupon is below market yields and at a premium when its coupon is above them.
• The yield curve plots yields against maturity; its level and slope describe the term structure of interest rates.
• A bond ladder spreads money across bonds that mature at regular intervals to reduce risk and keep cash coming in.

Memory Tip: Picture a seesaw with the yield on one end and the price on the other. When one goes up, the other must go down.

Common Mistake: Confusing the coupon rate with the yield to maturity. The coupon rate fixes the payments printed on the bond, while the yield is the rate you use to discount them.

Important Questions:

• What are the four steps to price a bond? Identify the amount and timing of cash flows, determine the discount rate, find the present value of the principal and of the coupon annuity, and add the two present values.
• Why do bond prices fall when interest rates rise? A fixed-rate bond pays a set coupon, so when new bonds offer higher yields the older bond must sell for less to give buyers a competitive return.

Chapter 11: Stocks and Stock Valuation

Difficulty: Medium · Key topics: P/E and P/B ratios, P/S and P/CF multiples, equity and enterprise value multiples, dividend discount models, Gordon growth model, discounted cash flow, preferred stock, efficient markets

This chapter shows several ways to value common stock. It starts with multiples: price-to-earnings, price-to-book, price-to-sales, price-to-cash-flow, and the difference between equity and enterprise value multiples. It then builds the dividend discount models: zero growth, constant growth (the Gordon growth model), and variable or two-stage growth, with worked prices found by equation, calculator and Excel. The discounted cash flow model is used for young firms that pay no dividends, preferred stock is valued like a perpetuity, and the last section explains operational and informational market efficiency.

Key Points:

• The P/E ratio divides market price by earnings per share, and the P/B ratio compares market value with book value to judge relative over- or undervaluation.
• Comparable company analysis (comps) values a firm using the multiples of similar businesses in the same industry.
• The Gordon growth model values a stock as the next dividend divided by the required return minus the growth rate.
• The zero growth model has the same formula as a perpetuity: annual dividend divided by the required rate of return.
• The DCF model discounts a firm’s expected cash flows plus a terminal value and suits young companies that pay no dividends.
• Preferred stock has a fixed dividend and no maturity; a $1,000 par, 5% preferred at a 10% discount rate is worth $500.
• Market efficiency has three forms of the hypothesis: weak (past prices), semi-strong (public information) and strong (all information).

Memory Tip: For the Gordon model, remember “next dividend over the gap”. The gap is the required return minus the growth rate, and it must stay positive.

Common Mistake: Using the Gordon growth model for a firm with a short or erratic dividend record. The chapter says the DDM works best for companies with long, consistent dividends.

Important Questions:

• What is the constant growth dividend discount model? It values a stock at the next year’s dividend divided by the required return less the constant dividend growth rate.
• What are the three forms of market efficiency? Weak form reflects past prices and volume, semi-strong form reflects all public information, and strong form reflects all information, public and private.

Chapter 12: Historical Performance of US Markets

Difficulty: Medium · Key topics: money markets, Treasury and corporate bonds, indenture, equity markets, IPO and SPAC, market and limit orders, expected versus actual inflation, bond and stock returns, Dow and S&P 500

This chapter tours the US financial markets and then reads their history from charts. It describes money markets, Treasury, corporate and municipal bond markets, and the equity market, including exchanges, the over-the-counter market, IPOs, SPACs and how market and limit orders are executed. It then explains how expected and actual inflation redistribute wealth and how the CPI is measured. The last sections compare the returns on Treasury bonds, Baa corporate bonds and stocks over past decades and show that higher average returns come with larger and more frequent losses.

Key Points:

• Money market securities are short term (under one year), very low risk and liquid, and commercial paper is an unsecured short-term corporate security.
• An indenture is the legal contract for a bond, and a debenture is an unsecured corporate bond.
• An IPO is the first time a firm offers stock to the public, and the firm receives proceeds only in the primary market, not in later secondary trading.
• A market order trades at the current price, while a limit order sets the price at which the investor will buy or sell.
• Inflation redistributes wealth: lenders with fixed-rate loans are repaid in less valuable dollars and borrowers gain.
• From 1980 to 1999, Baa corporate bonds earned an average of 12.07% a year, 1.86% more than Treasury bonds.
• Stocks gave the highest average returns of the assets studied, yet equity markets lost money in about 25% of years.

Memory Tip: Remember the ladder of risk and reward: money market, then bonds, then stocks. Each step up has had higher average returns and bigger swings.

Common Mistake: Believing that a default-free Treasury bond has a steady return. The chapter shows that Treasury bond returns changed widely from year to year as interest rates moved.

Important Questions:

• What is the difference between the primary and secondary markets? The primary market sells new securities and the issuer receives the cash, while the secondary market trades used securities between investors.
• How have stocks performed compared with bonds historically? Stocks earned the highest average annual returns but with more risk, including negative returns in about a quarter of years.

Chapter 13: Statistical Analysis in Finance

Difficulty: Medium · Key topics: mean, median, mode, geometric and weighted mean, standard deviation, variance, z-scores, quartiles, outliers, normal and exponential distributions, expected value, portfolio weights, graphs, R software

This chapter teaches the statistics used in finance. It starts with measures of center: arithmetic, geometric and weighted means, median and mode, and when each is the right choice. It then covers spread through standard deviation and variance, and position through z-scores, quartiles, percentiles and the interquartile range for spotting outliers. Frequency, normal and exponential distributions follow, along with portfolio weights, expected return and the empirical rule. The final sections choose graphs for univariate and bivariate data and introduce basic commands in the free R software.

Key Points:

• The median is a better measure of the center than the mean when a data set has outliers, such as one very large salary.
• A weighted mean gives each value a weight, as when you find the average price per share of a stock bought at different prices.
• Standard deviation and variance measure spread, and variance is the square of the standard deviation: 12.5 gives 156.25.
• A z-score is the number of standard deviations a value lies above or below the mean.
• The first quartile is the 25th percentile, the third quartile is the 75th, and the interquartile range is Q3 minus Q1.
• The normal distribution is described by its mean and standard deviation, while the exponential distribution models the time until an event such as a default.
• Expected value is a probability-weighted average, and it is used to find the expected return of an investment or a portfolio.

Memory Tip: For spread, link volatility to risk. A stock with a wider swing in yearly returns has a larger standard deviation, so Stock B in the chapter is riskier than Stock A.

Common Mistake: Using the arithmetic mean to average growth rates. The chapter presents the geometric mean for that purpose, because returns compound by multiplication.

Important Questions:

• When is the median better than the mean? When the data set has outliers or extreme values, because the median is not pulled toward them.
• How is a z-score calculated and what does it tell you? Subtract the mean from the data value and divide by the standard deviation; it shows how many standard deviations the value is from the mean.

Chapter 14: Regression Analysis in Finance

Difficulty: Hard · Key topics: correlation coefficient, significance test, least squares, residuals, regression assumptions, slope and intercept, beta, predictions, prediction intervals, R lm command

This chapter moves from describing one variable to relating two. It begins with the correlation coefficient r, which measures the strength and direction of a linear relationship, and how to test whether it is significant. It then fits a straight line by the method of least squares, explains residuals and the assumptions behind the test, and shows how to calculate and interpret the slope and intercept with a calculator, Excel or R. Finance applications include index relationships and beta, followed by predictions and prediction intervals, and the lm command in R.

Key Points:

• The correlation coefficient r always lies between −1 and +1; values near either end show a stronger linear relationship, and the sign shows the direction.
• Start with a scatter plot, compute r, and check its significance before building a regression model.
• The method of least squares picks the line that minimizes the squared differences between observed and predicted y-values.
• A residual is the observed y-value minus the predicted y-value from the regression equation.
• The slope shows the average change in y for each one-unit rise in x; the intercept has meaning only if x equal to zero is sensible and within the data range.
• A stock’s beta, the slope against a benchmark such as the S&P 500, measures systematic risk: above 1.0 means more volatile than the benchmark.
• Predict only for x-values inside the original data range, and use a prediction interval because a single prediction is only a point estimate.

Memory Tip: Say “plot, correlate, then regress”. If the picture and r show no real relationship, you should not build a prediction model.

Common Mistake: Treating a high correlation as proof that one variable causes the other, or extrapolating far beyond the observed data. The chapter limits predictions to the range of the collected x-values.

Important Questions:

• What does a beta greater than 1 mean? The stock has been more volatile than the benchmark, such as the S&P 500, so it carries more systematic risk.
• How do you interpret the slope of a regression line? It is the average change in the dependent variable for each one-unit increase in the independent variable.

Chapter 15: How to Think about Investing

Difficulty: Medium · Key topics: realized return, dividend and capital gain yield, effective annual rate, volatility, firm-specific risk, diversification, systematic risk, CAPM, beta, Sharpe and Treynor ratios, Jensen’s alpha

The chapter treats risk and return as the two Rs of finance. It calculates the realized return on one stock, using a Target purchase and a Delta Airlines holding, then converts a holding period return into an effective annual rate and measures risk as the standard deviation of returns. It shows that holding many stocks removes firm-specific risk but not market risk, and uses that idea to build the capital asset pricing model with the risk-free rate, market risk premium and beta. Sharpe, Treynor and Jensen measures judge managers, and Excel handles the calculations.

Key Points:

• Total return is the dividend yield plus the capital gain yield; a Target share bought at $128.74 and sold at $176.53 with $2.68 in dividends is an example.
• A Delta Airlines investment rising from $11.19 to $40.21 over ten years gave a 259.34% holding period return, which is converted to an effective annual rate.
• In finance, risk is the volatility of returns, usually measured by their standard deviation.
• Adding stocks to a portfolio cuts firm-specific (unsystematic) risk, but systematic (market) risk cannot be diversified away.
• Beta measures how much a stock moves with the market: a beta of 1 moves in step, and Delta’s beta of 1.39 means more systematic risk than average.
• The CAPM says expected return equals the risk-free rate plus beta times the market risk premium, so only systematic risk is rewarded.
• The Sharpe ratio divides excess return by total risk (standard deviation), the Treynor ratio divides it by beta, and Jensen’s alpha is actual return minus the CAPM expected return.

Memory Tip: Remember “Sharpe is total, Treynor is beta”. Both divide a risk premium, but Sharpe uses all of the risk and Treynor uses only the market part.

Common Mistake: Expecting investors to be paid for all the volatility of a stock. The chapter explains that the firm-specific part can be diversified away, so only systematic risk earns a premium.

Important Questions:

• What is the difference between firm-specific risk and systematic risk? Firm-specific risk comes from events at one company and can be diversified away; systematic risk affects the whole market and cannot.
• What does the CAPM say about expected return? A security’s required return equals the risk-free rate plus its beta times the market risk premium.

Chapter 16: How Companies Think about Investing

Difficulty: Medium · Key topics: capital budgeting, payback period, net present value, NPV profile, internal rate of return, profitability index, discounted payback, MIRR, mutually exclusive projects, unequal lives, capital rationing

This chapter is about capital budgeting, the way a firm decides which major projects to take. Using Sam’s Sporting Goods and a $16,000 embroidery machine, it shows the payback period, net present value, NPV profile and internal rate of return, listing the strengths and weaknesses of each. It then adds the profitability index, discounted payback and modified IRR. Choosing between projects covers mutually exclusive projects, projects with different lives (replacement chain and equal annuity approaches) and ranking projects when capital is limited. The last section builds NPV, IRR and NPV profiles in Excel.

Key Points:

• The payback period is the time needed to recover the initial investment; it is simple but ignores the time value of money.
• NPV is the present value of cash inflows minus the present value of outflows; accept a project if NPV is positive and reject it if negative.
• In the embroidery machine example, a 9% discount rate gives an NPV of $2,836, and a higher discount rate lowers the NPV.
• IRR is the discount rate that makes NPV equal zero; accept a project if its IRR is greater than the firm’s cost of attracting capital.
• The profitability index divides the present value of benefits by the present value of cost, and MIRR fixes the reinvestment assumption and has only one solution.
• Mutually exclusive projects cannot both be done, so the firm chooses one; projects with different lives are compared with the replacement chain or equal annuity approach.
• Excel’s NPV function ignores the time-zero outflow, but the IRR function includes all cash flows.

Memory Tip: Remember “NPV in dollars, IRR in percent”. NPV tells you how much value a project adds, while IRR tells you the rate of return it earns.

Common Mistake: Relying on payback alone. The chapter shows two projects with the same five-year payback that are not equally good, because payback ignores both timing and cash flows after the payback date.

Important Questions:

• What is the NPV decision rule? Accept a project with a positive NPV and reject one with a negative NPV, because a positive NPV adds value for shareholders.
• How do you compare projects with different lives? Use the replacement chain approach (repeat the short project until lives match) or the equal annuity approach (convert each NPV to an annual amount assuming the project repeats forever).

Chapter 17: How Firms Raise Capital

Difficulty: Hard · Key topics: capital structure, cost of capital, WACC, after-tax cost of debt, cost of equity, CAPM, constant dividend growth, net debt, leverage, interest tax shield, financial distress, trade-off theory, preferred stock, flotation costs, convertible bonds

This chapter explains how a firm pays for its assets. It starts with the balance sheet view of capital: debt and equity, and why every source has an opportunity cost. It then estimates the cost of debt from yield to maturity with the tax adjustment, and the cost of equity with CAPM and the constant dividend growth model, using Bluebonnet Industries. These costs are weighted into the WACC, including the use of net debt. The chapter compares levered and unlevered firms, the interest tax shield, financial distress and trade-off theory, and closes with preferred shares, new stock issues and convertible debt.

Key Points:

• Capital structure is the mix of debt, preferred stock and common stock that finances a firm’s assets, and each source has a cost because investors give up other opportunities.
• WACC is the average of the costs of debt, preferred stock and common equity, weighted by their market-value proportions, and the weights must total 100%.
• Interest is tax-deductible, so the after-tax cost of debt is lower than the yield to maturity; Bluebonnet’s bonds yield 6.312%.
• The cost of equity must be estimated: Bluebonnet’s CAPM estimate is 13.4% and the constant dividend growth estimate is 14.24%.
• In perfect markets with no taxes, leverage does not change firm value; with corporate taxes, the interest tax shield adds value.
• Trade-off theory balances the tax shield against the higher chance and cost of financial distress as debt rises.
• Issuing new stock carries flotation costs and makes it the most expensive source of financing; a convertible bond lets the holder swap for a fixed number of shares.

Memory Tip: Think of trade-off theory as a seesaw: the tax benefit of debt pushes one end up, and the fear of distress pushes the other, so the best capital structure sits where they balance.

Common Mistake: Treating the yield paid to bondholders as the firm’s true cost of debt. The chapter shows that the tax deduction on interest makes the after-tax cost lower.

Important Questions:

• How is WACC calculated? Multiply the after-tax cost of debt, the cost of preferred stock and the cost of common equity by their weights in the capital structure and add the results.
• What is the interest tax shield? It is the reduction in taxes because interest on debt is tax-deductible, calculated as the corporate tax rate times the interest paid.

Chapter 18: Financial Forecasting

Difficulty: Medium · Key topics: forecast, sales forecast, pro forma statements, common-size forecasting, variable and fixed costs, forecasted income statement and balance sheet, cash forecast, scenario analysis, sensitivity analysis, Excel

This chapter builds a financial forecast for Clear Lake Sporting Goods. It reviews what balance sheet and income statement items matter, then makes the sales forecast the first step because many costs follow sales. Pro forma statements are described: how long a forecast should be, how common-size percentages give a rough draft, and why variable and fixed costs must be separated. The chapter then forecasts the income statement and balance sheet and links them, adds a monthly cash forecast to find surpluses and shortages, assesses the value of growth with scenario and sensitivity analysis, and finishes in Excel.

Key Points:

• The sales forecast is done first because direct product costs, direct labor and commissions all depend on sales.
• Twelve months of past sales help reveal seasonality, but the past is only a baseline because customers, competitors and the economy change.
• Pro forma statements are forward-looking, and a typical forecast covers one year by month, followed by a monthly rolling forecast.
• Common-size percentages, such as cost of goods sold at 50% of sales, give a first draft that managers then adjust for variable and fixed costs.
• Many balance sheet accounts depend on the income statement; for example, accounts receivable is tied to sales.
• A cash forecast starts with the opening cash balance, adds inflows and subtracts outflows; Clear Lake’s policy is not to let cash fall below $35,000.
• Scenario analysis changes several assumptions together, while sensitivity analysis changes one input, such as sales, to see the effect on net income.

Memory Tip: Remember the order “sales, income statement, balance sheet, cash”. Each step feeds the next, so an error in sales runs through everything.

Common Mistake: Forecasting every line with last year’s percentage and calling it done. The chapter says common-size percentages are only a first draft, to be adjusted for fixed costs and expected changes.

Important Questions:

• Why is the sales forecast the first step in a financial forecast? Many costs, such as direct materials, direct labor and commissions, vary with sales, so most other forecast items depend on it.
• What is the difference between scenario and sensitivity analysis? Scenario analysis tests how a whole set of changed circumstances affects the forecast, while sensitivity analysis changes one input to see how much one output, such as net income, responds.

Chapter 19: The Importance of Trade Credit and Working Capital in Planning

Difficulty: Medium · Key topics: net working capital, operating cycle, cash conversion cycle, trade credit, cash discount, credit period, cash management, receivables aging, credit policy, inventory costs, cash budget

This chapter covers the short-term side of corporate finance. It defines working capital as current assets less current liabilities and shows how to calculate the operating cycle and the cash conversion cycle from inventory days, receivable days and payable days. It explains trade credit terms, cash discounts and the cost of passing up a discount, and why firms hold cash for transactions, precaution and speculation. Receivables management covers credit policy and aging schedules, inventory management weighs carrying, ordering and stockout costs, and the last section builds an annual operating budget and a cash budget in Excel.

Key Points:

• Net working capital is current assets minus current liabilities, and an often-cited rule of thumb is a current ratio of 2, though it varies by industry.
• The cash conversion cycle runs from paying for inventory to collecting from customers, offset by the days the firm takes to pay its suppliers; restaurants can even have a negative cycle.
• Trade credit lets a business buy now and pay later; Net 30 means the invoice is due within 30 days, and a cash discount rewards early payment.
• Firms hold cash for three motives: transactions, precaution against surprises, and speculation to seize opportunities.
• An accounts receivable aging schedule groups balances by age, and the older the receivable, the less likely it will be collected.
• Inventory has carrying costs, ordering costs and stockout costs, and just-in-time methods cut the investment in stock but raise the risk of stockouts.
• The cash budget is prepared last, after the sales budget and other budgets, and shows surpluses and deficits for planning short-term financing.

Memory Tip: Picture the cash cycle as a loop: cash goes out to inventory, comes back from customers, and the days you delay paying suppliers shorten the loop.

Common Mistake: Calling trade credit free money. The chapter says it is low cost only if you pay on time, and skipping an early-payment discount can be an expensive way to borrow.

Important Questions:

• What is the cash conversion cycle? It is the number of days between paying for resources and receiving cash from customers, found as inventory days plus receivable days minus payable days.
• Why do companies hold cash? To meet day-to-day transactions, to cover unexpected needs (precautionary motive) and to take advantage of investment opportunities (speculative motive).

Chapter 20: Risk Management and the Financial Manager

Difficulty: Hard · Key topics: hedging versus speculating, commodity price risk, vertical integration, futures contracts, exchange rate risk, forward contracts, natural hedge, call and put options, interest rate risk, duration, interest rate swap

The final chapter shows how a financial manager reduces uncertainty in cash flows, using Starbucks as the running example. It separates hedging from speculating and explains why riskier cash flows raise investors’ required return. Commodity price risk is managed with long-term contracts, vertical integration and futures contracts that use margin and marking to market. Exchange rate risk is split into transaction, translation and economic risk and managed with forwards, natural hedges and call and put options. The chapter ends with interest rate risk, duration, and how an interest rate swap works between two counterparties.

Key Points:

• Hedging reduces exposure to a risk, while speculating is betting on an uncertain future knowing that a loss is possible.
• The financial manager focuses on the size, timing and riskiness of cash flows, and investors demand a higher return for riskier cash flows.
• A futures contract is a standardized agreement to trade an asset on a future date at a price locked in today; margin and daily marking to market protect both sides.
• Transaction risk affects expected receipts or payments, translation risk is an accounting effect on the balance sheet, and economic risk affects sales and customers.
• An option gives the right but not the obligation to act: a call is the right to buy at the strike price, and a put is the right to sell.
• When interest rates rise, the present value of future cash flows falls, and duration measures this interest rate risk.
• In an interest rate swap, two counterparties exchange payment streams, for example a fixed rate for a floating rate.

Memory Tip: Remember “call to buy, put to sell”. A call option lets you call the asset to you, and a put option lets you put it on someone else.

Common Mistake: Thinking that a company without foreign sales is safe from currency risk. The chapter explains that economic risk can reach even a firm that sells only in the United States if exchange rates change its competitors’ prices.

Important Questions:

• What is the difference between hedging and speculating? Hedging takes action to reduce exposure to a risk, while speculating tries to profit from an uncertain future and accepts the risk of loss.
• What are transaction, translation and economic risk? Transaction risk is the change in value of expected receipts or expenses, translation risk is the accounting effect of converting foreign assets to the home currency, and economic risk is the effect of exchange rates on sales and customers.

Download Principles of Finance PDF (Free)

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How to Study This Book

Start with the preface table, because the book labels its own chapters. Chapters 1, 2, 5, 6, 7, 8, 9, 10, 11, 12, 15, 16, 17 and 18 are marked Core, and Chapters 3, 4, 13, 14, 19 and 20 are marked Extension. The preface says that a one-semester course, or a class with a strong background in economics, accounting and statistics, should focus on the core chapters. The chapters are written to stand alone, but the core chapters build on each other, so follow the numbers when you can.

The three prerequisite chapters are there so you can fill gaps, not to be read blindly. Chapter 3 gives supply and demand, inflation, interest rates and exchange rates, Chapter 4 gives accrual accounting and depreciation, and Chapters 13 and 14 give statistics and regression. If you have not studied accounting, read Chapter 4 before Chapters 5 and 6, which use the Clear Lake Sporting Goods statements, and read Chapter 5 again before Chapter 18, which forecasts the same company.

Chapters 7, 8 and 9 are the mathematical heart of the book, and every later valuation chapter depends on them. Chapter 7 covers a single payment, Chapter 8 equal payments such as annuities and loans, and Chapter 9 unequal payments. Do not move on until you can solve a present value, a future value, a payment and an interest rate with the TI BA II Plus Professional calculator the book uses or with Excel. The preface says downloadable Excel files go with the time value of money chapters, but it cites some other chapter numbers that do not match its own table, so check the files on the official book page.

Chapters 10, 11 and 12 apply that mathematics to bonds, stocks and market history. Read Chapter 10 before Chapter 11, because preferred stock and the dividend discount models reuse perpetuity and bond ideas, and treat Chapter 12 as a data chapter with the most review questions in the book (21). Chapter 15 then adds risk and return, and it needs the standard deviation from Chapter 13 and the beta idea from Chapter 14, so read those two first if your statistics is weak.

Chapters 16 and 17 are the corporate finance core. Chapter 16 uses time value of money for payback, NPV and IRR, and Chapter 17 needs bond yields from Chapter 10, the dividend growth model from Chapter 11 and CAPM from Chapter 15 to estimate the weighted average cost of capital. If your course has limited time, these two chapters and Chapter 18 on forecasting give the most exam value after the time value of money.

Chapters 19 and 20 finish the book with short-term finance and risk management. Chapter 19 is easier and links to the operating cycle in Chapter 6, while Chapter 20 is the hardest conceptually, with futures, forwards, options and swaps. Learn the vocabulary and the payoff direction of calls and puts, because the chapter explains how these instruments are used to hedge and does not teach option pricing.

For practice, the book gives 217 multiple-choice questions, 148 review questions and 135 quantitative problems, plus Think It Through worked examples inside the sections, but the preface says answers are given only to instructors. Work the Think It Through examples first, then write your own answers and check them with your teacher or a study group. Know the limits as well. The book is built around US institutions and 2020 to 2021 examples, it has no chapter on dividend policy, it does not derive the efficient frontier, and it never mentions Pakistan or Islamic finance, so add local cases from your course.

Used In These Programs

This book is used for the Principles of Finance course in BBA and BS Finance. Browse all books tagged Finance or the whole BBA category in University Books.

Who Should Read This

Principles of Finance 2e is written for the core finance course of an undergraduate business program, and the preface says it suits students who are still early in the curriculum, such as second-year students. It fits you if you are in a BBA or BS Finance program and need time value of money, bonds, stocks, capital budgeting, cost of capital and forecasting in one free book. If your algebra is rusty, the Punjab board Key to Business Mathematics ICOM Part 1 is a good warm-up for Chapters 7 to 9, and ICOM students moving into a BBA can revise accounting with the Key to Principles of Accounting ICOM Part 1 before Chapters 4 to 6. It will not replace a derivatives or investment analysis text, because options and portfolios are introduced rather than developed, and it is not a full CFA preparation book, since only some chapters link to Level I learning outcomes.

Applicable Universities

This book is useful for students at Pakistani universities offering BBA, BS Finance and related business programs, including University of the Punjab, University of Karachi, Virtual University, COMSATS, Lahore School of Economics, IBA Karachi, and other HEC-recognized institutions.

FAQs

Related Books

• Key to Business Mathematics ICOM Part 1 – Punjab Board (the algebra and percentage skills behind the time value of money, Chapters 7 to 9)
• Key to Principles of Accounting ICOM Part 1 – Punjab Board (the accounts behind the statements and ratios, Chapters 4 to 6)
• Key to Business Statistics ICOM Part 2 – Punjab Board (averages, spread and regression for Chapters 13 and 14)
• Economics 1st Year ICOM Book – Punjab Board (supply, demand and interest rate basics behind Chapter 3)

Principles of Finance 2e gives BBA and BS Finance students one free book that runs from financial statements and ratios through time value of money, bonds, stocks, capital budgeting, cost of capital and risk management. Browse more BBA books or the whole University Books section.

Principles of Finance 2e, by Julie Dahlquist and Rainford Knight (senior contributing authors) with contributing authors Alan S. Adams, Curtis J. Bacon, Samantha T. Cooper, Michael P. Griffin, Kevin C. Higgins and Larry Musolino. OpenStax, Rice University. Free under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International licence (CC BY-NC-SA 4.0). Access for free at https://openstax.org/details/books/principles-finance-2e