Principles of Finance 2e

Citation

Dahlquist, J., & Knight, R. (2026). Principles of Finance (2nd ed.). OpenStax, Rice University. Free official edition: https://openstax.org/details/books/principles-finance-2e

Chapter Summary

The book has 20 chapters. Its preface labels 14 of them "core" and six (Chapters 3, 4, 13, 14, 19 and 20) "extension" chapters that review prerequisite economics, accounting and statistics or add applied topics. Closely related chapters are grouped below with their exact titles.

Chapters 1–2: Introduction to Finance / Corporate Structure and Governance

Chapter 1 defines finance as the study of the trade-off between risk and expected return and divides it into business finance, investments, and financial markets and institutions. It explains the finance function inside a firm, the growing role of data and technology, careers such as financial and business analyst, primary and secondary markets and their participants, money- and capital-market instruments, and the idea that time affects value. Chapter 2 compares sole proprietorships, partnerships, corporations and hybrid forms, then covers shareholders and stakeholders, the board of directors and independent members, agency problems and ESG, investor relations and earnings calls, and the decision to expand internationally.

Chapter 3: Economic Foundations: Money and Rates

An extension chapter that reviews supply and demand, inflation, unemployment and GDP, the business cycle, nominal and real interest rates and risk premiums, exchange rates and translation exposure, and how to find and interpret economic data in the FRED database, using American Airlines to show why managers must watch the economy.

Chapters 4–6: Accrual Accounting Process / Financial Statements / Measures of Financial Health

Chapter 4 (an extension chapter) explains cash versus accrual accounting, double-entry bookkeeping and the accounting equation, revenue and expense recognition, capitalising versus expensing and depreciation methods, and the difference between profit and cash. Chapter 5 builds the income statement, balance sheet, statement of owner's equity and statement of cash flows for a small retailer, Clear Lake Sporting Goods, then computes operating and free cash flow, common-size statements and reviews SEC reporting and annual reports. Chapter 6 turns the statements into ratios: efficiency (turnover and days' sales), liquidity, solvency, market value (EPS, P/E, book value per share) and profitability, ending with the DuPont decomposition of return on equity.

Chapters 7–9: Time Value of Money I: Single Payment Value / Time Value of Money II: Equal Multiple Payments / Time Value of Money III: Unequal Multiple Payment Values

These three chapters build the book's central tool. Chapter 7 explains why a dollar today is worth more than a dollar later and solves for future value, present value, rates, growth and time, using equations, a financial calculator and Excel, with applications to inflation, risk and compounding frequency. Chapter 8 covers perpetuities, ordinary annuities and annuities due, loan amortisation schedules and stated versus effective rates, opening with a car loan whose real rate turned out to be almost double the advertised one. Chapter 9 extends the method to uneven cash flows, which prepares the ground for project evaluation.

Chapters 10–11: Bonds and Bond Valuation / Stocks and Stock Valuation

Chapter 10 describes bond features and types, prices bonds as the present value of coupons and principal, explains premium and discount bonds and yields, the yield curve and term structure, interest-rate, default and other risks, bond ratings and laddering, and solves bond problems in Excel. Chapter 11 values stocks with multiples (P/E, P/B, P/S, P/CF), dividend discount models including the Gordon growth and two-stage models, a discounted cash flow model for firms that pay no dividends, and preferred stock, and closes with operational and informational efficiency and the weak, semi-strong and strong forms of market efficiency.

Chapter 12: Historical Performance of US Markets

The chapter surveys US money, bond and equity markets (including IPOs and SPACs), the history and measurement of inflation, and long-run returns on government and corporate bonds and on stocks by style and size, concluding that stocks have earned the highest average returns but have had negative annual returns roughly a quarter of the time.

Chapters 13–14: Statistical Analysis in Finance / Regression Analysis in Finance

Two extension chapters review statistics with financial examples: measures of centre (including geometric and weighted means), spread and position, frequency, normal and exponential distributions, expected values and portfolio weights, and data visualisation; then correlation, least-squares regression, prediction intervals and the use of regression to estimate a stock's beta. Both include short introductions to the R statistical software.

Chapters 15–16: How to Think about Investing / How Companies Think about Investing

Chapter 15 measures the return and volatility of individual assets and portfolios, explains diversification and the split between firm-specific and systematic risk, derives required returns from the capital asset pricing model and beta, and introduces the Sharpe ratio, Treynor measure and Jensen's alpha, with Excel calculations. Chapter 16 covers capital budgeting: payback, net present value, internal rate of return, profitability index, discounted payback and modified IRR, and how to choose among mutually exclusive projects, projects of different lives and scales, and under capital rationing.

Chapters 17–18: How Firms Raise Capital / Financial Forecasting

Chapter 17 explains capital structure and the cost of capital: after-tax cost of debt, estimating the cost of equity with the dividend growth model and CAPM, the weighted average cost of capital, capital structure irrelevance in perfect markets, the interest tax shield, financial distress and the trade-off theory of optimal structure, and preferred stock, flotation costs and convertible debt. Chapter 18 shows how to build a sales forecast and pro forma income statements, balance sheets and cash forecasts, link them in Excel, and use them to judge the value of growth.

Chapters 19–20: The Importance of Trade Credit and Working Capital in Planning / Risk Management and the Financial Manager

Chapter 19 (extension) defines working capital, the operating and cash conversion cycles, the cost of trade credit and cash discounts, cash, receivables and inventory management (including aging schedules and just-in-time inventory), and builds a cash budget in Excel. Chapter 20 (extension) explains why firms manage risk and how they hedge commodity price risk (long-term contracts, vertical integration, futures), exchange rate risk (transaction, translation and economic risk; natural hedges, forwards and options) and interest rate risk (duration and swaps).

Key Concepts

Chapters 1–2: Introduction to Finance / Corporate Structure and Governance

• Risk–return trade-off: the central idea of finance, that higher expected returns come with higher risk.
• Agency problem: conflicts of interest between shareholders (principals) and managers or directors (agents), and the costs of controlling them.
• Primary and secondary markets: markets where securities are first issued versus where existing securities are traded.

Chapter 3: Economic Foundations: Money and Rates

• Real interest rate: the nominal rate minus inflation.
• Business cycle: the repeated sequence of expansion, peak, contraction and trough.

Chapters 4–6: Accrual Accounting Process / Financial Statements / Measures of Financial Health

• Accrual accounting: recording revenues and expenses when earned or incurred rather than when cash moves.
• Free cash flow: operating cash flow minus capital expenditures, the cash available to pay lenders and shareholders.
• DuPont method: breaking return on equity into profit margin, total asset turnover and the equity multiplier.

Chapters 7–9: Time Value of Money I–III

• Time value of money: money available now is worth more than the same amount later because it can earn a return and future payments are uncertain.
• Annuity and perpetuity: a fixed stream of payments for a set period, and one that continues indefinitely.
• Effective interest rate: the true annual rate once compounding within the year is taken into account.

Chapters 10–11: Bonds and Bond Valuation / Stocks and Stock Valuation

• Bond price and yield: a bond's price is the present value of its cash flows, so price and yield move in opposite directions.
• Yield curve: a plot of yields against maturity that shows the term structure of interest rates.
• Dividend discount model: valuing a share as the present value of expected future dividends, as in the Gordon growth model.
• Market efficiency: the degree to which prices reflect available information, in weak, semi-strong or strong form.

Chapter 12: Historical Performance of US Markets

• Equity risk and return: stocks have produced the highest average returns among the asset classes studied, with more frequent losing years.
• Money market versus capital market: markets for short-term versus long-term securities.

Chapters 13–14: Statistical Analysis in Finance / Regression Analysis in Finance

• Standard deviation: the measure of spread used as the book's measure of investment risk.
• Beta (from regression): the slope of a stock's returns regressed on market returns, a measure of systematic risk.

Chapters 15–16: How to Think about Investing / How Companies Think about Investing

• Systematic versus firm-specific risk: market-wide risk that cannot be diversified away versus risk that can.
• Capital asset pricing model: required return equals the risk-free rate plus beta times the market risk premium.
• Net present value rule: accept a project if the present value of its inflows exceeds that of its outflows.

Chapters 17–18: How Firms Raise Capital / Financial Forecasting

• Weighted average cost of capital: the market-value-weighted average of the after-tax cost of debt and the cost of equity.
• Interest tax shield: the tax saving from deductible interest, which makes debt attractive up to the point where financial distress costs rise.
• Pro forma statements: forecast financial statements driven mainly by the sales forecast.

Chapters 19–20: Trade Credit and Working Capital / Risk Management

• Cash conversion cycle: the time between paying for inputs and collecting cash from customers.
• Cost of trade credit: the implied interest rate of forgoing a cash discount.
• Hedging versus speculating: using derivatives such as futures, forwards, options and swaps to reduce risk rather than to bet on price moves.

Critical Analysis

Strengths

• Built-in prerequisite review. Extension chapters on economics, accrual accounting, statistics and regression let instructors fill gaps in students' backgrounds without a second book, and the preface's core/extension table makes it easy to skip them when students are prepared.
• Strong calculation support. Time value of money, bonds, stocks, capital budgeting, forecasting and working capital are each worked with formulas, a TI BA II Plus Professional financial calculator and Excel, and the preface notes downloadable Excel files for several chapters; the statistics chapters add a brief introduction to R.
• Relatable cases from corporate, small-business and personal finance. "Why It Matters" openers range from American Airlines' fuel bill to one of the authors' own car loan negotiation and a young graduate's first investments, and running examples such as Clear Lake Sporting Goods and Sam's Sporting Goods make the statements and project decisions concrete.
• Links to professional study. Several chapters end with a note connecting the material to the CFA Institute's Level I learning outcome statements, and each chapter has multiple-choice and review questions, quantitative problems where relevant, and a video activity.

Limitations

• Introductory in depth. Option pricing models, payout policy as a topic in its own right, mergers and real options receive little or no treatment, and capital structure is covered in one chapter, so the book cannot replace a full corporate finance text in later courses.
• US focus. Market history, regulation (the SEC), tax examples and data are American; Chapter 12 is entirely about US markets.
• Uneven depth across chapters. Some summaries and sections are brief (for example, Chapter 9 is short compared with the other time value chapters), and tool-specific instructions tie the worked examples to one calculator model and to Excel.
• Solutions reserved for instructors. Sample answers to questions and problems are in the instructor resources, which limits self-checking for independent learners.

Where It Fits in the Course

In the Corporate Finance course list, this book and Ross, Westerfield and Jordan's Fundamentals of Corporate Finance are the introductory options. Ross and colleagues' book is generally described as a standard first corporate finance text; the OpenStax book covers similar ground (statements and ratios, time value, valuation, capital budgeting, cost of capital) free of charge and adds review chapters on accounting and statistics, which makes it a good first reading or a free alternative for students who need that support.

Berk and DeMarzo's Corporate Finance and Brealey, Myers, Allen and Edmans's Principles of Corporate Finance are the natural next steps; they go further into capital structure, payout, options and corporate control, which this book treats lightly or not at all. Atrill's Financial Management for Decision Makers is a graduate-level text generally described as aimed at managers and non-specialists; this book's Chapters 5–6 and 16–19 cover overlapping practical ground at an introductory level.

How to Use This Book

The book is aimed at the core undergraduate finance course for business majors, typically in the second year, and assumes only high-school algebra; a little accounting helps, but Chapter 4 supplies it. A financial calculator or spreadsheet is essential.

For a one-semester course, follow the preface's core path: Chapters 1–2, 5–12 and 15–18. Add Chapter 3 or 4 if students lack economics or accounting, Chapters 13–14 if they need statistics before the risk-and-return material, and Chapters 19–20 for working capital and risk management. Chapters 7–9 are the foundation for everything after them and should be practised until the calculations are routine; work each example three ways (formula, calculator, spreadsheet) as the book does. Use the multiple-choice questions for quick checks, the problems for practice, and the Excel-based sections in Chapters 10, 15, 16, 18 and 19 to build skills that carry into later courses and work.

Edition and Sources

This guide is based on Principles of Finance 2e (second edition, OpenStax, published June 2026; print ISBN 979-8-3197-3155-5), read in the official PDF from https://openstax.org/details/books/principles-finance-2e. It draws on the preface (including the core/extension teaching plan and the changes in the second edition), the full table of contents, and for all 20 chapters the "Why It Matters" introduction, every section heading with its learning outcomes, the key terms and the full end-of-chapter summary.