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Twelfth Edition
ISBN 978-1-259-91894-0
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CORPORATE FINANCE
Twelfth Edition
Ross
Westerfield
Jaffe
Jordan
Corporate Finance
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Corporate Finance
TWELFTH EDITION
Stephen A. Ross
Randolph W. Westerfield
Marshall School of Business
University of Southern California
Jeffrey Jaffe
Wharton School of Business
University of Pennsylvania
Bradford D. Jordan
Gatton College of Business and Economics
University of Kentucky
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CORPORATE FINANCE, TWELFTH EDITION
Published by McGraw-Hill Education, 2 Penn Plaza, New York, NY 10121. Copyright ©2019 by McGraw-Hill
Education. All rights reserved. Printed in the United States of America. Previous editions ©2016, 2013, and
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Library of Congress Cataloging-in-Publication Data
Ross, Stephen A., author.
Corporate finance / Stephen A. Ross [and three others].
Twelfth edition. | New York, NY : McGraw-Hill Education, [2019]
LCCN 2018026320 | ISBN 9781259918940 (student edition)
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To Stephen A. Ross and family
Our great friend, colleague, and coauthor Steve Ross passed away on
March 3, 2017, while we were working on this edition of Corporate
Finance. Steve’s influence on our textbook is seminal, deep, and
enduring, and we will miss him greatly. On the foundation of Steve’s
lasting and invaluable contributions, we pledge to continue our efforts
to provide the best possible textbook for today—and tomorrow.
R.W.W. J.F.J B.D.J.
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About the Authors
STEPHEN A. ROSS Sloan School of Management, Massachusetts Institute of Technology
Stephen A. Ross was the Franco Modigliani Professor of Finance and Economics at the
Sloan School of Management, Massachusetts Institute of Technology. One of the most
widely published authors in finance and economics, Professor Ross was widely recognized
for his work in developing the Arbitrage Pricing Theory and his substantial contributions
to the discipline through his research in signaling, agency theory, option pricing, and the
theory of the term structure of interest rates, among other topics. A past president of the
American Finance Association, he also served as an associate editor of several academic
and practitioner journals. He was a trustee of CalTech. He died suddenly in March of 2017.
RANDOLPH W. WESTERFIELD Marshall School of Business, University of Southern California
Randolph W. Westerfield is Dean Emeritus of the University of Southern California’s
Marshall School of Business and is the Charles B. Thornton Professor of Finance Emeritus.
Professor Westerfield came to USC from the Wharton School, University of Pennsylvania,
where he was the chairman of the finance department and member of the finance faculty
for 20 years. He is a member of the Board of Trustees of Oak Tree Capital Mutual Funds.
His areas of expertise include corporate financial policy, investment management, and
stock market price behavior.
JEFFREY F. JAFFE Wharton School of Business, University of Pennsylvania Jeffrey F. Jaffe
has been a frequent contributor to the finance and economics literatures in such journals as the Quarterly Economic Journal, The Journal of Finance, The Journal of Financial
and Quantitative Analysis, The Journal of Financial Economics, and The Financial Analysts
Journal. His best-known work concerns insider trading, where he showed both that corporate insiders earn abnormal profits from their trades and that regulation has little effect on
these profits. He also has made contributions concerning initial public offerings, regulation
of utilities, the behavior of market makers, the fluctuation of gold prices, the theoretical
effect of inflation on interest rates, the empirical effect of inflation on capital asset prices,
the relationship between small-capitalization stocks and the January effect, and the capital
structure decision.
BRADFORD D. JORDAN Gatton College of Business and Economics, University of Kentucky
Bradford D. Jordan is Professor of Finance and holder of the duPont Endowed Chair
in Banking and Financial Services. He has a long-standing interest in both applied and
theoretical issues in corporate finance and has extensive experience teaching all levels of
corporate finance and financial management policy. Professor Jordan has published numerous articles on issues such as cost of capital, capital structure, and the behavior of security
prices. He is a past president of the Southern Finance Association and is coauthor of
Fundamentals of Investments: Valuation and Management, 8th edition, a leading investments
text, also published by McGraw-Hill Education.
vii
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Preface
T
he teaching and the practice of corporate finance are more challenging and exciting
than ever before. The last decade has seen fundamental changes in financial markets
and financial instruments. In the early years of the 21st century, we still see announcements in the financial press about takeovers, junk bonds, financial restructuring, initial
public offerings, bankruptcies, and derivatives. In addition, there are the new recognitions
of “real” options, private equity and venture capital, subprime mortgages, bailouts, and
credit spreads. As we have learned in the recent global credit crisis and stock market collapse, the world’s financial markets are more integrated than ever before. Both the theory
and practice of corporate finance have been moving ahead with uncommon speed, and our
teaching must keep pace.
These developments have placed new burdens on the teaching of corporate finance.
On one hand, the changing world of finance makes it more difficult to keep materials up to
date. On the other hand, the teacher must distinguish the permanent from the temporary
and avoid the temptation to follow fads. Our solution to this problem is to emphasize the
modern fundamentals of the theory of finance and make the theory come to life with contemporary examples. Increasingly, many of these examples are outside the United States.
All too often, the beginning student views corporate finance as a collection of unrelated topics that are unified largely because they are bound together between the covers of
one book. We want our book to embody and reflect the main principle of finance: Namely,
good financial decisions will add value to the firm and to shareholders and bad financial
decisions will destroy value. The key to understanding how value is added or destroyed is
cash flows. To add value, firms must generate more cash than they use. We hope this simple
principle is manifest in all parts of this book.
The Intended Audience of This Book
This book has been written for the introductory courses in corporate finance at the MBA
level and for the intermediate courses in many undergraduate programs. Some instructors
will find our text appropriate for the introductory course at the undergraduate level as well.
We assume that most students either will have taken, or will be concurrently enrolled in,
courses in accounting, statistics, and economics. This exposure will help students understand
some of the more difficult material. However, the book is self-contained, and a prior knowledge of these areas is not essential. The only mathematics prerequisite is basic algebra.
New to 12th Edition
THE TAX CUTS AND JOBS ACT (TCJA) IS INCORPORATED THROUGHOUT
There are six primary areas of change and they will be reflected in the 12th edition:
1. Corporate tax. The new, flat-rate 21 percent corporate rate is discussed and compared
to the old progressive system. The new rate is used throughout the text in examples
and problems. Entities other than C corporations still face progressive taxation, so the
discussion of marginal versus average tax rates remains relevant and is retained.
viii
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2. Bonus depreciation. For a limited time, businesses can take a 100 percent depreciation charge the first year for most non-real estate, MACRS-qualified investments. This
“bonus depreciation” ends in a few years and MACRS returns, so the MACRS material remains relevant and is retained. The impact of bonus depreciation is illustrated in
various problems.
3. Limitations on interest deductions. The amount of interest that may be deducted for
tax purposes is limited. Interest that cannot be deducted can be carried forward to
future tax years (but not carried back; see next).
4. Carrybacks. Net operating loss (NOL) carrybacks have been eliminated and NOL
carryforward deductions are limited in any one tax year.
5. Dividends-received tax break. The tax break on dividends received by a corporation has
been reduced, meaning that the portion subject to taxation has increased.
6. Repatriation. The distinction between U.S. and non-U.S. profits essentially has been
eliminated. All “overseas” assets, both liquid and illiquid, are subject to a one-time
“deemed” tax.
With the 12th edition, we’ve also included coverage of
●● Inversions.
●● Negative interest rates.
●● NYSE market operations.
●● Direct listings and cryptocurrency initial coin offerings (ICOs).
●● Regulation CF.
●● Brexit.
●● Repatriation.
●● Changes in lease accounting.
In addition, each chapter has been updated and, where relevant, “internationalized.” We try
to capture the excitement of corporate finance with current examples, chapter vignettes,
and openers. Spreadsheet applications are spread throughout.
ix
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Pedagogy
In this edition of Corporate Finance, we have updated and improved our features to
present material in a way that makes it coherent and easy to understand. In addition,
Corporate Finance is rich in valuable learning tools and support to help students
succeed in learning the fundamentals of financial management.
Chapter Opening Vignettes
Each chapter begins with a contemporary vignette that highlights the concepts in
the chapter and their relevance to real-world examples.
10
PART III: RISK
Lessons from Market History
With the S&P 500 Index returning about 19 percent and
These examples show that there were tremendous
the NASDAQ Composite Index up about 28 percent in
potential profits to be made during 2017, but there was
2017, stock market performance overall was very good.
also the risk of losing money—and lots of it. So what
In particular, investors in biopharmaceutical company
should you, as a stock market investor, expect when you
Madrigal Pharmaceuticals, Inc., had to be happy about the
invest your own money? In this chapter, we study more
516 percent gain in that stock and investors in genomic
than eight decades of market history to find out.
therapy company Sangamo Therapeutics had to feel pretty
good following that company’s 438 percent gain. Of
course, not all stocks increased in value during the year.
Stock in Sears Holdings fell 61 percent during the year and
Please visit us at rwjcorporatefinance.blogspot.com for
the latest developments in the world of corporate finance.
stock in Under Armour dropped 48 percent.
ExcelMaster Icons
Topics covered in the comprehensive
ExcelMaster supplement (in Connect) are
indicated by ALLOCATED
an icon
in the margin.
COSTS
172
■■■
PART II Valuation and Capital Budgeting
Frequently a particular expenditure benefits a number of projects. Accountants allocate
this cost across the different projects when determining income. However, for capital
budgeting purposes, this allocated cost should be viewed as a cash outflow of a project
only if it is an incremental cost of the project.
10.1 Returns
DOLLAR RETURNS
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Master
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How did the market
do today? Find out at
finance.yahoo.com.
Suppose the Video Concept Company has several thousand shares of stock outstanding
and you are a shareholder. Further suppose that you purchased some of the shares of
stock in the company at the beginning of the year; it is now year-end and you want to
figure out how well you have done on your investment. The return you get on an investment in stocks, like that in bonds or any other investment, comes in two forms.
As the owner of stock in the Video Concept Company, you are a part owner of the
company. If the company is profitable, it generally could distribute some of its profits to
the shareholders. Therefore, as the owner of shares of stock, you could receive some cash,
called a dividend, during the year. This cash is the income component of your return. In
addition to the dividends, the other part of your return is the capital gain—or, if it is negative, the capital loss (negative capital gain)—on the investment.
For example, suppose we are considering the cash flows of the investment in
Figure 10.1, showing that you purchased 100 shares of stock at the beginning of the year
at a price of $37 per share. Your total investment, then, was:
C0 = $37 × 100 = $3,700
299
EXAMPLE
6.5
Allocated Costs The Voetmann Consulting Corp. devotes one wing of its suite of offices to a
library requiring a cash outflow of $100,000 a year in upkeep. A proposed capital budgeting
project is expected to generate revenue equal to 5 percent of the overall firm’s sales. An
executive at the firm, David Pedersen, argues that $5,000 (= .05 × $100,000) should be viewed
as the proposed project’s share of the library’s costs. Is this appropriate for capital budgeting?
The answer is no. One must ask what the difference is between the cash flows of the entire
firm with the project and the cash flows of the entire firm without the project. The firm will spend
$100,000 on library upkeep whether or not the proposed project is accepted. Because acceptance of the proposed project does not affect this cash flow, the cash flow should be ignored
when calculating the NPV of the project. Suppose the project has a positive NPV without the
allocated costs but is rejected because of the allocated costs. In this case, the firm is losing
potential value that it could have gained otherwise.
6.2 The Baldwin Company: An Example
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We next consider the example of a proposed investment in machinery and related items.
Our example involves the Baldwin Company and colored bowling balls.
The Baldwin Company, originally established 16 years ago to make footballs, is now
a leading producer of tennis balls, baseballs, footballs, and golf balls. Nine years ago, the
company introduced “High Flite,” its first line of high-performance golf balls. Baldwin
management has sought opportunities in whatever businesses seem to have some potential
for cash flow. Recently W. C. Meadows, vice president of the Baldwin Company, identified another segment of the sports ball market that looked promising and that he felt was
not adequately served by larger manufacturers. That market was for brightly colored bowling balls, and he believed many bowlers valued appearance and style above performance.
He also believed that it would be difficult for competitors to take advantage of the opportunity because of both Baldwin’s cost advantages and its highly developed marketing skills.
As a result, the Baldwin Company investigated the marketing potential of brightly
colored bowling balls. Baldwin sent a questionnaire to consumers in three markets: Philadelphia, Los Angeles, and New Haven. The results of the three questionnaires were much
better than expected and supported the conclusion that the brightly colored bowling balls
could achieve a 10 to 15 percent share of the market. Of course, some people at Baldwin
complained about the cost of the test marketing, which was $250,000. (As we shall see
later, this is a sunk cost and should not be included in project evaluation.)
In any case, the Baldwin Company is now considering investing in a machine to
produce bowling balls. The bowling balls would be manufactured in a warehouse owned
by the firm and located near Los Angeles. This warehouse, which is vacant, and the land
can be sold for $150,000 after taxes.
Working with his staff, Meadows is preparing an analysis of the proposed new product. He summarizes his assumptions as follows: The cost of the bowling ball machine is
$100,000 and it is expected to last five years. At the end of five years, the machine will be
xii
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240
■■■
PART II
Valuation and Capital Budgeting
Figure 8.2
Interest Rate Risk
and Time to Maturity
2,000
Bond value ($)
$1,768.62
30-year bond
1,500
1,000
$1,047.62
1-year bond
$916.67
278
■■■
$502.11
500
5
10
15
Interest rate (%)
20
Value of a Bond with a 10 Percent Coupon Rate for Different Interest Rates and Maturities
Time to Maturity
Interest Rate
1 Year
30 Years
5%
$1,047.62
$1,768.62
10
1,000.00
1,000.00
15
956.52
671.70
20
916.67
502.11
tells us that a relatively small change in interest rates will lead to a substantial change
in the bond’s value. In comparison, the 1-year bond’s price is relatively insensitive to
interest rate changes.
Intuitively, shorter-term bonds have less interest rate sensitivity because the $1,000
face amount is received so quickly. The present value of this amount isn’t greatly affected
by a small change in interest rates if the amount is received in, say, one year. However,
even a small change in the interest rate, once compounded for, say, 30 years, can have a
significant effect on present value. As a result, the present value of the face amount will
be much more volatile with a longer-term bond.
The other thing to know about interest rate risk is that, like many things in finance
and economics, it increases at a decreasing rate. A 10-year bond has much greater interest
rate risk than a 1-year bond has. However, a 30-year bond has only slightly greater interest
rate risk than a 10-year bond.
The reason that bonds with lower coupons have greater interest rate risk is essenEXAMPLE
tially the same. As we discussed earlier, the value of a bond depends on the present
9.5
value of both its coupons and its face amount. If two bonds with different coupon
rates have the same maturity, the value of the lower-coupon bond is proportionately
more dependent on the face amount to be received at maturity. As a result, its value
will fluctuate more as interest rates change. Put another way, the bond with the higher
Examples
Separate called-out examples are integrated
throughout the chapters. Each example
illustrates an intuitive or mathematical application in a step-by-step format. There is
enough detail in the explanations so students don’t have to look elsewhere for
additional information.
PART II Valuation and Capital Budgeting
Figures and Tables
In this case, total return works out to be:
R = $1/$20 + .10
= .05 + .10
This text makes extensive
use of real data and
= .15, or 15%
This stock has an expected return of 15 percent.
presents
them
in various
figures
and
ExWe can verify
this answer
by calculating the
price in one
year, Ptables.
, using 15 percent
as the required expected return. Because the dividend expected to be received in one year
planations
in the
andexpected
end-to
is $1 and the expected
growth narrative,
rate of dividends isexamples,
10 percent, the dividend
be received in two years, D , is $1.10. Based on the dividend growth model, the stock
price in one year will
be:
of-chapter
problems
will refer to many of these
P = D /(R − g)
exhibits.
= $1.10/(.15 − .10)
1
2
1
2
= $1.10/.05
= $22
Notice that this $22 is $20 × 1.1, so the stock price has grown by 10 percent, as it should.
This means the capital gains yield is 10 percent, which equals the growth rate in dividends.
What is the investor’s total expected return? If you pay $20 for the stock today, you
will get a $1 dividend at the end of the year, and you will have a $22 − 20 = $2 gain.
Your dividend yield is $1/$20 = .05, or 5 percent. Your capital gains yield is $2/$20 =
.10, or 10 percent, so your total expected return would be 5 percent + 10 percent = 15
percent, as we calculated above.
To get a feel for actual numbers in this context, consider that, according to the 2017
Value Line Investment Survey, Procter & Gamble’s dividends were expected to grow by
6.5 percent over the next 5 or so years, compared to a historical growth rate of 6.0 percent
over the preceding 5 years and 8.5 percent over the preceding 10 years. In 2017, the
projected dividend for the coming year was given as $2.85. The stock price at that time
was $94.40 per share. What is the expected return investors require on P&G? Here, the
dividend yield is 3.0 (= $2.85/$94.40) percent and the capital gains yield is 6.5 percent,
giving a total required return of 9.5 percent on P&G stock.
Calculating the Required Return Pagemaster Enterprises, the company examined in
Example 9.4, has 1,000,000 shares of stock outstanding. The stock is selling at $10. What is the
required return on the stock?
The payout ratio is the ratio of dividends/earnings. Because Pagemaster’s retention ratio is
40 percent, the payout ratio, which is 1 – Retention ratio, is 60 percent. Recall both that Pagemaster reported earnings of $2,000,000 and that the firm’s growth rate is 6.4 percent.
Earnings a year from now will be $2,128,000 (= $2,000,000 × 1.064), implying that dividends will be $1,276,800 (= .60 × $2,128,000). Dividends per share will be $1.28
(= $1,276,800/1,000,000). Given that g = .064, we calculate R from Equation 9.9 as follows:
$1.28
.192 = ______ + .064
$10.00
A HEALTHY SENSE OF SKEPTICISM
It is important to emphasize that our approach merely estimates g; our approach does
not determine g precisely. We mentioned earlier that our estimate of g is based on a
number of assumptions. We assumed that the return on reinvestment of future retained
In Their Own Words
ROBERT C. HIGGINS ON SUSTAINABLE
GROWTH
Most financial officers know intuitively that it takes
money to make money. Rapid sales growth requires
increased assets in the form of accounts receivable,
inventory, and fixed plant, which, in turn, require money
to pay for assets. They also know that if their company
does not have the money when needed, it can literally
“grow broke.” The sustainable growth equation states
these intuitive truths explicitly.
Sustainable growth is often used by bankers and other
external analysts to assess a company’s creditworthiness.
They are aided in this exercise by several sophisticated
computer software packages that provide detailed analyses of the company’s past financial performance, including its annual sustainable growth rate.
Bankers use this information in several ways. Quick
comparison of a company’s actual growth rate to its sustainable rate tells the banker what issues will be at the
top of management’s financial agenda. If actual growth
consistently exceeds sustainable growth, management’s
problem will be where to get the cash to finance growth.
The banker thus can anticipate interest in loan products.
Conversely, if sustainable growth consistently exceeds
actual, the banker had best be prepared to talk about
investment products because management’s problem will
be what to do with all the cash that keeps piling up in
the till.
Bankers also find the sustainable growth equation
useful for explaining to financially inexperienced small
business owners and overly optimistic entrepreneurs
that, for the long-run viability of their business, it is necessary to keep growth and profitability in proper
balance.
Finally, comparison of actual to sustainable growth
rates helps a banker understand why a loan applicant
needs money and for how long the need might continue.
In one instance, a loan applicant requested $100,000 to
pay off several insistent suppliers and promised to repay
in a few months when he collected some accounts receivable that were coming due. A sustainable growth analysis
revealed that the firm had been growing at four to six
times its sustainable growth rate and that this pattern
was likely to continue in the foreseeable future. This
alerted the banker that impatient suppliers were only a
symptom of the much more fundamental disease of
overly rapid growth, and that a $100,000 loan would
likely prove to be only the down payment on a much
larger, multiyear commitment.
SOURCE: Robert C. Higgins is the Marguerite Reimers Professor of
Finance, Emeritus, at the Foster School of Business at the University of
Washington. He pioneered the use of sustainable growth as a tool for
financial analysis.
“In Their Own Words” Boxes
Located throughout the chapters, this unique series consists of articles written by distinguished
scholars or practitioners about key topics in the
text. Boxes include essays by Edward I. Altman,
Robert S. Hansen, Robert C. Higgins, Michael C.
Jensen, Merton Miller, and Jay R. Ritter.
xiii
3.6 Some Caveats Regarding Financial
Planning Models
ros18947_fm_i-xxxii.indd 13
Financial planning models do not always ask the right questions. A primary reason is that
they tend to rely on accounting relationships and not financial relationships. In particular,
the three basic elements of firm value tend to get left out—namely, cash flow size, risk,
and timing.
Because of this, financial planning models sometimes do not produce output that
gives the user many meaningful clues about what strategies will lead to increases in value.
Instead, they divert the user’s attention to questions concerning the association of, say,
9/11/18 3:34 PM
CHAPTER 4
Spreadsheet Applications
■■■
97
Using a Spreadsheet for Time Value of Money Calculations
PART I Overview
Annual and
quarterly financial
statements for
most public U.S.
corporations can be
found in the EDGAR
database at
www.sec.gov.
■■■
SPREADSHEET APPLICATIONS
Now integrated into select chapters, Spreadsheet Applications boxes reintroduce students
to Excel, demonstrating how to set up spreadsheets in order to analyze common financial
problems—a vital part of every business student’s education. (For even more spreadsheet
example problems, check out ExcelMaster
in Connect).
22
Discounted Cash Flow Valuation
the least liquid kind of assets. Tangible fixed assets include property, plant, and equipment.
These assets do not convert to cash from normal business activity, and they are not usually used to pay expenses such as payroll.
Some fixed assets are intangible. Intangible assets have no physical existence but can be
very valuable. Examples of intangible assets are the value of a trademark or the value of a patent. The more liquid a firm’s assets, the less likely the firm is to experience problems meeting
short-term obligations. The probability that a firm will avoid financial distress can be linked to
the firm’s liquidity. Unfortunately, liquid assets frequently have lower rates of return than fixed
assets; for example, cash generates no investment income. To the extent a firm invests in liquid
assets, it sacrifices an opportunity to invest in potentially more profitable investment vehicles.
DEBT VERSUS EQUITY
Liabilities are obligations of the firm that require a payout of cash within a stipulated period.
Many liabilities involve contractual obligations to repay a stated amount plus interest over
a period. Liabilities are debts and are frequently associated with fixed cash burdens, called
debt service, that put the firm in default of a contract if they are not paid. Stockholders’ equity
is a claim against the firm’s assets that is residual and not fixed. In general terms, when the
firm borrows, it gives the bondholders first claim on the firm’s cash flow.1 Bondholders can
sue the firm if the firm defaults on its bond contracts. This may lead the firm to declare
itself bankrupt. Stockholders’ equity is the difference between assets and liabilities:
Assets − Liabilities ≡ Stockholders’ equity
This is the stockholders’ share in the firm stated in accounting terms. The accounting
CHAPTER 25 Derivatives and Hedging Risk
■■■
771
value of stockholders’ equity increases when retained earnings are added. This occurs
when the firm retains part of its earnings instead of paying them out as dividends.
Moon Chemical. Because there is a crude oil futures contract for every month, selecting the
correct futures contract is not difficult. Many other commodities have only five contracts per
The home page year, frequently necessitating buying contracts one month away from the month of production.
VALUE VERSUS COST
for the Financial
The accounting value of a firm’s assets is frequently referred to as the carrying value or
Accounting
As mentioned
earlier,
Moon
Chemical
in hedging
the risk
of fluctuating
oil
the book
value
of the
assets.is2 interested
Under generally
accepted
accounting
principles
(GAAP),
Standards Board
prices because it cannot pass any cost increases on to the consumer. Suppose, alternatively, 3
audited financial statements of firms in the United States carry assets at cost. The terms
(FASB) is that Moon Chemical was not selling petrochemicals on a fixed contract to the U.S. government.
carrying value and book value are misleading and cause many readers of financial statewww.fasb.org.
Instead, imagine that the petrochemicals were to be sold to private industry at currently prevailments to believe the firm’s assets are recorded at true market values. Market value is the
ing prices. The price of petrochemicals should move directly with oil prices because oil is a
price at which willing buyers and sellers would trade the assets. It would be only a coinmajor component of petrochemicals. Because cost increases are likely to be passed on to the
cidence if accounting value and market value were the same. In fact, management’s job
consumer, Moon Chemical would probably not want to hedge in this case. Instead, the firm is
is to create value for the firm that exceeds its cost.
likely to choose Strategy 1, buying the oil as it is needed. If oil prices increase between April 1
Many
peopleChemical,
use the balance
sheet,
each become
may wish
to extract is difand, say, September
1, Moon
of course,
will but
findthe
thatinformation
its inputs have
quite
ferent.
banker maymarket,
look atitsa revenues
balance sheet
for evidence
liquidity and working
costly. However,
in aAcompetitive
are likely
to rise, of
as accounting
well.
while
a supplier
may note
the size of aaccounts
payable and
the general
Strategy capital,
2 is called
a long
hedgealso
because
one purchases
futures contract
to reduce
risk. promptness
of one
payments.
of financial
statements,
managers
and investors,
want to
In other words,
takes aMany
long users
position
in the futures
market.including
In general,
a firm institutes
a
knowitthe
value of the
not
its cost.
is not found
onactual
the balance sheet.
long hedge when
is committed
to firm,
a fixed
sales
price.This
Oneinformation
class of situations
involves
written contracts with customers, such as the one Moon Chemical had with the U.S. government.
Alternatively, a firm may find that it cannot easily pass on costs to consumers or does not want
to pass on these
costs. For example, a group of students opened a small meat market called
1
Bondholders are investors in the firm’s debt. They are creditors of the firm. In this discussion, the term bondholder means the
What’s Your Beef
nearas the
University of Pennsylvania in the late 1970s.6 This was a time of
same thing
creditor.
2
Confusion
oftenespecially
arises becausefood
manyprices.
financial Knowing
accounting that
terms their
have the
same meaning.
Forwere
example,
the following terms
volatile consumer
prices,
fellow
students
parusually refer to the same thing: assets minus liabilities, net worth, stockholders’ equity, owners’ equity, book equity, and equity
ticularly budget-conscious,
the owners vowed to keep food prices constant regardless of price
capitalization.
movements in3Generally,
either direction.
They
accomplished
this
by
purchasing
futures
contracts
in
various
the U.S. GAAP require assets to be carried at the lower of cost or market value. In most instances, cost is lower
than market value. However, in some cases when a fair market value can be readily determined, the assets have their value
agricultural commodities.
More and more, businesspeople from many different areas (not only finance and accounting) rely on spreadsheets to do all the different types of calculations that come up in the real world. In this section, we will
show you how to use a spreadsheet to handle the various time value of money problems we present in this
chapter. We will use Microsoft Excel™, but the commands are similar for other types of software. We assume
you are already familiar with basic spreadsheet operations.
As we have seen, you can solve for any one
of the following four potential unknowns: future
To Find
Enter This Formula
value, present value, the discount rate, or the numFuture value
= FV (rate,nper,pmt,pv)
ber of periods. The box at right lists formulas that
Present value
= PV (rate,nper,pmt,fv)
can be used in Excel to solve for each input in the
Discount rate
= RATE (nper,pmt,pv,fv)
time value of money equation.
Number of periods
= NPER (rate,pmt,pv,fv)
In these formulas, pv and fv are present value
and future value, nper is the number of periods,
and rate is the discount, or interest, rate.
Two things are a little tricky here. First, unlike a financial calculator, the spreadsheet requires that the rate
be entered as a decimal. Second, as with most financial calculators, you have to put a negative sign on
either the present value or the future value to solve for the rate or the number of periods. For the same
reason, if you solve for a present value, the answer will have a negative sign unless you input a negative
future value. The same is true when you compute a future value.
To illustrate how you might use these formulas, we will go back to an example in the chapter. If you invest
$25,000 at 12 percent per year, how long until you have $50,000? You might set up a spreadsheet like this:
A
1
2
3
4
5
6
7
8
9
10
11
12
13
14
B
C
D
E
F
G
H
Using a spreadsheet for time value of money calculations
If we invest $25,000 at 12 percent, how long until we have $50,000? We need to solve
for the unknown number of periods, so we use the formula NPER(rate,pmt,pv,fv).
Present value (pv):
Future value (fv):
Rate (rate):
$25,000
$50,000
.12
Periods: 6.1162554
The formula entered in cell B11 is =NPER(B9,0,-B7,B8); notice that pmt is zero and that pv
has a negative sign on it. Also notice that rate is entered as a decimal, not a percentage.
EXAMPLE
4.9
Waiting for Godot You’ve been saving up to buy the Godot Company. The total cost will be
$10 million. You currently have about $2.3 million. If you can earn 5 percent on your money,
how long will you have to wait? At 16 percent, how long must you wait?
At 5 percent, you’ll have to wait a long time. From the present value equation:
$2.3 million = $10 million/1.05t
1.05t = 4.35
t ≅ 30 years
At 16 percent, things are a little better. Verify for yourself that it will take about 10 years.
Explanatory Website Links
These web links are specifically selected to accompany text material and provide students and
instructors with a quick reference to additional
information on the Internet.
adjusted to the fair market value.
25.5 Interest Rate Futures Contracts
In this section, we consider interest rate futures contracts. Our examples deal with futures
contracts on Treasury bonds because of their high popularity. We first price Treasury
bonds and Treasury bond forward contracts. Differences between futures and forward
contracts are explored. Hedging examples are provided next.
PRICING OF TREASURY BONDS
As mentioned earlier in the text, a Treasury bond pays semiannual interest over its life.
In addition, the face value of the bond is paid at maturity. Consider a 20-year, 8 percent
coupon bond that was issued on March 1. The first payment is to occur in six months—that
is, on September 1. The value of the bond can be determined as follows:
Pricing of Treasury Bond
$1,040
$40
$40
$40
$40
________
________
__________
__________
PTB = ______
1 + R1 + (1 + R2)2 + (1 + R3)3 + ˙ ˙ ˙ + (1 + R39)39 + (1 + R40)40
(25.1)
Numbered Equations
Key equations are numbered and listed on the back
endsheets for easy reference.
Because an 8 percent coupon bond pays interest of $80 a year, the semiannual coupon
is $40. Principal and the semiannual coupon are both paid at maturity. As we mentioned
in a previous chapter, the price of the Treasury bond, PTB, is determined by discounting
each payment on the bond at the appropriate spot rate. Because the payments are semiannual, each spot rate is expressed in semiannual terms. That is, imagine a horizontal term
structure where the effective annual yield is 8 percent for all maturities. Because each
6
Ordinarily, an unusual firm name in this textbook is a tip-off that it is fictional. This, however, is a true story.
xiv
ros18947_fm_i-xxxii.indd 14
9/11/18 3:34 PM
The end-of-chapter material reflects and builds upon the concepts learned from the chapter and study features.
790
■■■
PART VI
Options, Futures, and Corporate Finance
Summary and Conclusions
1. Firms hedge to reduce risk. This chapter showed a number of hedging strategies.
2. A forward contract is an agreement by two parties to sell an item for cash at a later date.
The price is set at the time the agreement is signed. However, cash changes hands on the
date of delivery. Forward contracts are generally not traded on organized exchanges.
3. Futures contracts are also agreements for future delivery. They have certain advantages,
such as liquidity, that forward contracts do not. An unusual feature of futures contracts
is the mark-to-the-market convention. If the price of a futures contract falls on a particular day, every buyer of the contract must pay money to the clearinghouse. Every seller of
the contract receives money from the clearinghouse. Everything is reversed if the price
rises. The mark-to-the-market convention prevents defaults on futures contracts.
4. We divided hedges into two types: short hedges and long hedges. An individual or firm
that sells a futures contract to reduce risk is instituting a short hedge. Short hedges are
generally appropriate for holders of inventory. An individual or firm that buys a futures
contract to reduce risk is instituting a long hedge. Long hedges are typically used by firms
with contracts to sell finished goods at a fixed price.
5. An interest rate futures contract employs a bond as the deliverable instrument. Because
of their popularity, we worked with Treasury bond futures contracts. We showed that
Treasury bond futures contracts can be priced using the same type of net present value
analysis that is used to price Treasury bonds themselves.
6. Many firms face interest rate risk. They can reduce this risk by hedging with interest rate
futures contracts. As with other commodities, a short hedge involves the sale of a futures
contract. Firms that are committed to buying mortgages or other bonds are likely to institute
short hedges. A long hedge involves the purchase of a futures contract. Firms that have
agreed to sell mortgages or other bonds at a fixed price are likely to institute long hedges.
7. Duration measures the average maturity of all the cash flows of a bond. Bonds with high
duration have high price variability. Firms frequently try to match the duration of their
assets with the duration of their liabilities.
8. Swaps are agreements to exchange cash flows over time. The first major type is an interest rate swap in which one pattern of coupon payments, say, fixed payments, is exchanged
for another, say, coupons that float with LIBOR. The second major type is a currency
swap, in which an agreement is struck to swap payments denominated in one currency
for payments in another currency over time.
Concept Questions
1. Hedging Strategies If a firm is selling futures contracts on lumber as a hedging strategy,
what must be true about the firm’s exposure to lumber prices?
2. Hedging Strategies If a firm is buying call options on pork belly futures as a hedging
strategy, what must be true about the firm’s exposure to pork belly prices?
3. Forwards and Futures What is the difference between a forward contract and a futures
contract? Why do you think that futures contracts are much more common? Are there any
circumstances under which you might prefer to use forwards instead of futures? Explain.
4. Hedging Commodities Bubbling Crude Corporation, a large Texas oil producer, would
like to hedge against adverse movements in the price of oil because this is the firm’s
primary source of revenue. What should the firm do? Provide at least two reasons why it
Summary and Conclusions
The summary provides a quick review of key concepts
in the chapter.
Questions and Problems
Because solving problems is so critical to a student’s
learning, new questions and problems have been
added and existing questions and problems have
been revised. All problems also have been thoroughly
reviewed and checked for accuracy.
Problems have been grouped according to level
of difficulty with the levels listed in the margin: Basic,
124
■■■
PART II Valuation and
Capital Budgeting
CHAPTER
4 Discounted Cash Flow Valuation
■■■
131
Intermediate,
and
Challenge.
18. Value
Interest
Well-known
financial
Andrew
Tobias
that hevalue
can earn
73. Present
of aRates
Growing
Perpetuity
Whatwriter
is the
equation
for argues
the present
of a 177
percent per year buying wine by the case. Specifically, he assumes that he will consume
growing perpetuity
with a payment tried
of C one periodmake
from today the
if the payments
grow
Additionally,
one $10 we
bottle ofhave
fine Bordeaux per weekto
for the next 12 weeks.
He problems
can either pay $10
by C eachper
period?
week or buy a case of 12 bottles today. If he buys the case, he receives a 10 percent
and, rule
by doing
so, earns
the time
177 percent.
Assume
he buystothe
wine with
and conRule of 72discount
A useful
of thumb
for the
it takes
an investment
double
in the74.critical
“concept”
chapters,
such
as
those
on
sumes the firstisbottle
today. of
Do72.”
you To
agree
analysis?
see a72
problem
discrete compounding
the “Rule
usewith
the his
Rule
of 72, Do
youyou
divide
by thewith
his numbers?
rate to determine
the number of periods it takes for a value today to double. For examvalue, risk,
and
capital
structure,
especially
challengple,19.
if theCalculating
rate is 6 percent,
Rule of 72
it willcustomers
take 72/6
12 yearson
to his
double.
Number the
of Periods
Onesays
of your
is =
delinquent
accounts
This is approximately
equal
to the
actualagreed
answerto of
11.90 years.
The Rule
of 72
payable balance.
You’ve
mutually
a repayment
schedule
of $400
peralso
month.
be applied
to determine
what rate
neededinterest
to double
money
in abalance.
specifiedIf period.
You will
charge 1.1 percent
perismonth
on the
overdue
the current
ing and can
interesting.
is $16,450, howfor
long
will rates
it takeand
for periods.
the account
to be rate
paid isoff?
This is a balance
useful approximation
many
At what
the Rule of
72 exact?
20. Calculating EAR Friendly’s Quick Loans, Inc., offers you “three for four or I knock
We
provide
answers
toyouselected
problems
inyourisApon your
door.” This
and of
repay
$4The
when
youofget69.3
pay75. Rule of 69.3
A corollary
to means
the Rule
ofget72$3is today
the Rule
69.3.
Rule
check except
in one for
week
(or else).
What’s
Friendly’scontinuously.
earns on thisProve
lending
exactly correct
rounding
when
ratesthe
areEAR
compounded
thebusiness?forIfend
you wereof
brave
enoughbook.
tointerest.
ask, what APR would Friendly’s say you were
pendix BRuleatof 69.3
the
the
continuously
compounded
paying?
INTERMEDIATE
(Questions 21–50)
Excel Master It! Problems
Included in the end-of-chapter material are problems directly incorporating Excel, and new tips and
techniques taught in the chapter’s ExcelMaster
supplement.
Excel Master It! Problem
Excel
Master
coverage online
compounded annually, what rate should the bank set if it wants to match First Simple
Bank over an investment horizon of 10 years?
Years until retirement
30
Calculating
You
are year
planning to save for$90,000
retirement over the next 30 years.
AmountAnnuities
to withdraw
each
To do
this,toyou
will invest
$850 per month in a stock account
and $350 per month
Years
withdraw
in retirement
20
in a Investment
bond account.
The
return
of
the
stock
account
is
expected
to be 10 percent per
rate
8%
year, and the bond account will earn 6 percent per year. When you retire, you will
combine your money into an account with an annual return of 7 percent. How much
canfriend
you withdraw
each
month
accountwill
assuming
25-year
withdrawal
Because your
is planning
ahead,
thefrom
first your
withdrawal
not takea place
until
one
period?She wants to make equal annual deposits into her account for her retireyear after she retires.
ment fund.24. Calculating Rates of Return Suppose an investment offers to quadruple your money in
months
(don’t
believe
it). What
rate year
of return
quarter
being on
offered?
a. If she 12
starts
making
these
deposits
in one
and per
makes
her are
lastyou
deposit
the
25. sheCalculating
Rates
of Return
tryingannually
to choosetobetween
different
day
retires, what
amount
must You’re
she deposit
be abletwo
to make
the investments,
desired
both ofinwhich
have up-front costs of $65,000. Investment G returns $125,000 in 6 years.
withdrawals
retirement?
Investment
H
returns
$205,000
in
10
years.
Which
of
these
investments
has
the
higher
b. Suppose your friend has inherited a large sum of money. Rather than making equal
annualreturn?
payments, she has decided to make one lump-sum deposit today to cover her
retirement
needs.
What amount
she have
to deposit
today?
26. Growing
Perpetuities
Markdoes
Weinstein
has been
working
on an advanced technology in
laseryour
eye friend’s
surgery. His
technology
be available
in the
near term.
anticipates
c. Suppose
employer
will will
contribute
to the
account
each He
year
as part his
annual cash
flow from plan.
the technology
to beyour
$175,000,
years from
of the first
company’s
profit-sharing
In addition,
friend received
expects two
a distributoday.a Subsequent
cashyears
flowsfrom
will grow
3.8 percent
in must
perpetuity.
What is the
tion from
family trustannual
several
now. atWhat
amount
she deposit
present
value
of
the
technology
if
the
discount
rate
is
9.7
percent?
annually now to be able to make the desired withdrawals in retirement? The
details
are:
27. Perpetuities
A prestigious investment bank designed a new security that pays a
Indicated by the Excel icon in the margin, these
problems can be found at the end of almost all
chapters. Located in Connect Finance for Corporate Finance, 12e, Excel templates have been created for each of these problems, where students
can use the data in the problem to work out the
solution using Excel skills.
quarterly dividend of $2.25 in perpetuity. The first dividend occurs one quarter from
today. What is the price of the security if the APR is 3.8 percent compounded
Employer’s annual contribution
$ 1,500
quarterly?
Years until trust fund distribution
20
Amount of trust fund distribution
$25,000
132
Located at the end of almost every chapter, these
mini cases focus on common company situations
that embody important corporate finance topics.
Each case presents a new scenario, data, and a dilemma. Several questions at the end of each case
require students to analyze and focus on all of the
material they learned in that chapter.
may still need to draw a time line. Consider a classic retirement problem. A friend is celebrating her birthday
and wants
to start
for herInterest
anticipated
Shepays
has5.3
thepercent
following
22. Simple
Interest
versussaving
Compound
Firstretirement.
Simple Bank
simple
interest
its investment
accounts.
years to retirement
andon
retirement
spending
goals:If First Complex Bank pays interest on its accounts
23.
Excel Problems
End-of-Chapter Cases
Future Value What is the future value in 11 years of $1,000 invested in an account
with an APR of 8.9 percent:
a. Compounded annually?
b. Compounded semiannually?
c. Compounded monthly?
d. Compounded continuously?
Excel is a great tool for solving problems, but with many time value of money problems, you
e. Why does the future value increase as the compounding period shortens?
21.
■■■
Mini Case
PART II
Valuation and Capital Budgeting
THE MBA DECISION
Ben Bates graduated from college six years ago with a finance undergraduate degree. Although
he is satisfied with his current job, his goal is to become an investment banker. He feels that an
MBA degree would allow him to achieve this goal. After examining schools, he has narrowed
his choice to either Wilton University or Mount Perry College. Although internships are encouraged by both schools, to get class credit for the internship, no salary can be paid. Other than
internships, neither school will allow its students to work while enrolled in its MBA program.
Ben currently works at the money management firm of Dewey and Louis. His annual salary
at the firm is $65,000 per year, and his salary is expected to increase at 3 percent per year until
retirement. He is currently 28 years old and expects to work for 40 more years. His current job
includes a fully paid health insurance plan, and his current average tax rate is 26 percent. Ben
has a savings account with enough money to cover the entire cost of his MBA program.
The Ritter College of Business at Wilton University is one of the top MBA programs in
the country. The MBA degree requires two years of full-time enrollment at the university. The
annual tuition is $70,000, payable at the beginning of each school year. Books and other supplies are estimated to cost $3,000 per year. Ben expects that after graduation from Wilton, he
will receive a job offer for about $110,000 per year, with a $20,000 signing bonus. The salary
at this job will increase at 4 percent per year. Because of the higher salary, his average income
tax rate will increase to 31 percent.
The Bradley School of Business at Mount Perry College began its MBA program 16 years
ago. The Bradley School is smaller and less well known than the Ritter College. Bradley offers
an accelerated, one-year program, with a tuition cost of $85,000 to be paid upon matriculation.
Books and other supplies for the program are expected to cost $4,500. Ben thinks that he will
receive an offer of $92,000 per year upon graduation, with an $18,000 signing bonus. The
salary at this job will increase at 3.5 percent per year. His average tax rate at this level of
income will be 29 percent.
Both schools offer a health insurance plan that will cost $3,000 per year, payable at the
beginning of the year. Ben also estimates that room and board expenses will cost $2,000 more
per year at both schools than his current expenses, payable at the beginning of each year. The
appropriate discount rate is 4.7 percent.
xv
ros18947_fm_i-xxxii.indd 15
1. How does Ben’s age affect his decision to get an MBA?
2. What other, perhaps nonquantifiable, factors affect Ben’s decision to get an MBA?
3. Assuming all salaries are paid at the end of each year, what is the best option for Ben—
from a strictly financial standpoint?
4. Ben believes that the appropriate analysis is to calculate the future value of each option.
How would you evaluate this statement?
5. What initial salary would Ben need to receive to make him indifferent between attending 9/11/18
Wilton University and staying in his current position?
3:34 PM
Comprehensive Teaching
and Learning Package
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connect.mheducation.com to find:
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Instructor’s Manual
Prepared by Steven D. Dolvin, Butler University
This is a great place to find new lecture ideas. The IM has three main sections. The
first section contains a chapter outline and other lecture materials. The annotated
xvi
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outline for each chapter includes lecture tips, real-world tips, ethics notes, suggested
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system for today’s educators.
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Customize our content for your course. This presentation has been thoroughly revised
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to specific Internet sites, or a spreadsheet link to show an example in Excel. You also
can go to the Notes Page function for more tips on presenting the slides. If you already
have PowerPoint installed on your PC, you can edit, print, or rearrange the complete
presentation to meet your specific needs.
Excel Simulations
Expanded for this edition! With 180 Excel simulation questions now included in
Connect, RWJJ is the unparalleled leader in offering students the opportunity to practice using the Excel functions they will use throughout their careers in finance.
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xvii
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●●
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Excel Templates
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work through the problem using Excel. Each end-of-chapter problem with a template is
indicated by an Excel icon in the margin beside it.
ExcelMaster
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by chapter sections.
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ISBN-10: 0-07-721988-0 / ISBN-13: 978-0-07-721988-8
By LeRoy Brooks, John Carroll University.
$15.00 when packaged with this text. In this comprehensive simulation game, students control a hypothetical company over numerous periods of operation. As students make major
financial and operating decisions for their company, they will develop and enhance skills in
financial management and financial accounting statement analysis.
xviii
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Acknowledgments
Andras Danis
Georgia Institute of Technology
Abu Jalai
Suffolk University
Ronald M. Shapiro
Rutgers University
Sugata Das
Montana State University–Billings
Robert James
Boston College
Stephen V. Smith
Drexel University
Lowell D’Souza
Northeastern University
Victoria Javine
University of Alabama
Mete Tepe
Virginia Tech
Eric Eller
Loras College
Roger Klee
Cleveland State University
Gary P. Tripp
Southern New Hampshire University
Melissa B. Frye
University of Central Florida
Wendy Liu
University of Kentucky
Emre Unlu
University of Nebraska
Melody J. Gunter
Florida State University
Jeremy Marcq
Tufts University and Harvard University
Kainan Wang
University of Toledo
Atul Gupta
Bentley University
Narasimha Mohan
Baldwin Wallace University
Arthur J. Wilson
George Washington University
Janet Hamilton
Portland State University
Hongsong Neuhauser
Elizabethtown College
John Hartman
University of California–Santa Barbara
Francis Blaise Roncagli
Cleveland State University
xix
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Brief Contents
Part I
OVERVIEW
1
Introduction to Corporate Finance
1
2
Financial Statements and Cash Flow
20
3
Financial Statements Analysis and Financial Models
42
Part II
VALUATION AND CAPITAL BUDGETING
4
Discounted Cash Flow Valuation
85
5
Net Present Value and Other Investment Rules
133
6
Making Capital Investment Decisions
169
7
Risk Analysis, Real Options, and Capital Budgeting
205
8
Interest Rates and Bond Valuation
235
9
Stock Valuation
270
Part III
RISK
10 Lessons from Market History
299
11 Return, Risk, and the Capital Asset Pricing Model
328
12 An Alternative View of Risk and Return
371
13 Risk, Cost of Capital, and Valuation
393
Part IV
CAPITAL STRUCTURE AND DIVIDEND POLICY
14 Efficient Capital Markets and Behavioral Challenges
428
15 Long-Term Financing
468
16 Capital Structure
487
17 Capital Structure
519
18 Valuation and Capital Budgeting for the Levered Firm
551
19 Dividends and Other Payouts
573
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Part V
LONG-TERM FINANCING
20 Raising Capital
612
21 Leasing
649
Part VI
OPTIONS, FUTURES, AND CORPORATE FINANCE
22 Options and Corporate Finance
673
23 Options and Corporate Finance: Extensions and Applications
718
24 Warrants and Convertibles
742
25 Derivatives and Hedging Risk
763
Part VII
SHORT-TERM FINANCE
26 Short-Term Finance and Planning
795
27 Cash Management
825
28 Credit and Inventory Management
847
Part VIII
SPECIAL TOPICS
29 Mergers, Acquisitions, and Divestitures
876
30 Financial Distress
919
31 International Corporate Finance
935
Appendix A: Mathematical Tables
963
Appendix B: Solutions to Selected End-of-Chapter Problems
972
Appendix C: Using the HP 10B and TI BA II Plus
Financial Calculators
975
Glossary
979
Name Index
987
Subject Index
989
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Contents
PART I Overview
2.3
Chapter 1
Introduction to Corporate Finance
1
1.1
1
1
3
4
4
4
5
7
8
8
9
10
10
10
11
12
1.2
1.3
1.4
1.5
1.6
What Is Corporate Finance?
The Balance Sheet Model of the Firm
The Financial Manager
The Corporate Firm
The Sole Proprietorship
The Partnership
The Corporation
A Corporation by Another Name . . .
The Importance of Cash Flows
Identification of Cash Flows
Timing of Cash Flows
Risk of Cash Flows
The Goal of Financial Management
Possible Goals
The Goal of the Financial Manager
A More General Goal
The Agency Problem and Control
of the Corporation
Agency Relationships
Management Goals
Do Managers Act in the Stockholders’
Interests?
Stakeholders
Regulation
The Securities Act of 1933 and the
Securities Exchange Act of 1934
Sarbanes-Oxley
Summary and Conclusions
Concept Questions
12
13
13
14
15
16
16
17
18
18
Financial Statements and Cash Flow
20
2.1
20
21
22
22
23
2.2
2.7
Chapter 3
Financial Statements Analysis
and Financial Models
3.1
3.2
3.3
3.4
Chapter 2
The Balance Sheet
Liquidity
Debt versus Equity
Value versus Cost
The Income Statement
Generally Accepted Accounting
Principles
Noncash Items
Time and Costs
2.4
2.5
2.6
24
25
25
Taxes
26
Corporate and personal Tax Rates
26
Average versus Marginal Tax Rates
26
Net Working Capital
27
Cash Flow of the Firm
28
The Accounting Statement of Cash Flows 31
Cash Flow from Operating Activities
31
Cash Flow from Investing Activities
32
Cash Flow from Financing Activities
32
Cash Flow Management
33
Summary and Conclusions
34
Concept Questions
34
Questions and Problems
35
Excel Master It! Problem
39
Mini Case: Cash Flows at Warf
Computers, Inc.
40
3.5
3.6
Financial Statements Analysis
Standardizing Statements
Common-Size Balance Sheets
Common-Size Income Statements
Ratio Analysis
Short-Term Solvency or Liquidity Measures
Long-Term Solvency Measures
Asset Management or Turnover Measures
Profitability Measures
Market Value Measures
The DuPont Identity
A Closer Look at ROE
Problems with Financial Statement Analysis
Financial Models
A Simple Financial Planning Model
The Percentage of Sales Approach
External Financing and Growth
The Relationship Between EFN
and Growth
Financial Policy and Growth
A Note about Sustainable Growth
Rate Calculations
Some Caveats Regarding Financial
Planning Models
Summary and Conclusions
Concept Questions
42
42
42
43
44
46
47
48
50
52
53
56
56
58
59
59
61
65
66
68
72
73
74
74
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Questions and Problems
Excel Master It! Problem
Mini Case: Ratios and Financial Planning
at East Coast Yachts
76
81
82
PART II Valuation and
Capital Budgeting
5.3
5.4
5.5
Chapter 4
Discounted Cash Flow Valuation
4.1
4.2
4.3
4.4
4.5
4.6
85
Valuation: The One-Period Case
85
The Multiperiod Case
89
Future Value and Compounding
89
The Power of Compounding: A Digression 92
Present Value and Discounting
93
Finding the Number of Periods
96
The Algebraic Formula
99
Compounding Periods
100
Distinction between Annual Percentage
Rate and Effective Annual Rate
101
Compounding over Many Years
102
Continuous Compounding
102
Simplifications
104
Perpetuity
104
Growing Perpetuity
106
Annuity
107
Growing Annuity
113
Loan Amortization
114
What Is a Firm Worth?
118
Summary and Conclusions
120
Concept Questions
121
Questions and Problems
121
Excel Master It! Problem
131
Mini Case: The MBA Decision
132
Appendix 4A: Net Present Value: First
Principles of Finance
132
Appendix 4B: Using Financial Calculators 132
5.6
5.7
5.1
5.2
Why Use Net Present Value?
The Payback Period Method
Defining the Rule
133
133
136
136
137
138
139
139
139
143
143
143
146
148
153
153
153
154
155
157
158
160
167
168
Chapter 6
Making Capital Investment Decisions
6.1
6.2
Chapter 5
Net Present Value and Other
Investment Rules
Problems with the Payback Method
Managerial Perspective
Summary of Payback
The Discounted Payback Period Method
The Internal Rate of Return
Problems with the IRR Approach
Definition of Independent and Mutually
Exclusive Projects
Two General Problems Affecting Both
Independent and Mutually
Exclusive Projects
The Modified Internal Rate of
Return (MIRR)
Problems Specific to Mutually
Exclusive Projects
Redeeming Qualities of IRR
A Test
The Profitability Index
Calculation of Profitability Index
The Practice of Capital Budgeting
Summary and Conclusions
Concept Questions
Questions and Problems
Excel Master It! Problem
Mini Case: Bullock Gold Mining
6.3
Incremental Cash Flows: The Key
to Capital Budgeting
Cash Flows—Not Accounting Income
Sunk Costs
Opportunity Costs
Side Effects
Allocated Costs
The Baldwin Company: An Example
An Analysis of the Project
Which Set of Books?
A Note about Net Working Capital
A Note about Depreciation
Interest Expense
Alternative Definitions of Operating
Cash Flow
The Top-Down Approach
The Bottom-Up Approach
The Tax Shield Approach
Conclusion
169
169
169
170
171
171
172
172
175
177
177
178
179
179
180
180
181
182
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6.4
6.5
Some Special Cases of Discounted
Cash Flow Analysis
Evaluating Cost-Cutting Proposals
Setting the Bid Price
Investments of Unequal Lives: The
Equivalent Annual Cost Method
Inflation and Capital Budgeting
Interest Rates and Inflation
Cash Flow and Inflation
Discounting: Nominal or Real?
Summary and Conclusions
Concept Questions
Questions and Problems
Excel Master It! Problems
Mini Case: Bethesda Mining Company
8.2
182
182
184
8.3
186
187
187
189
190
192
193
194
203
203
8.4
8.5
Chapter 7
Risk Analysis, Real Options,
and Capital Budgeting
7.1
7.2
7.3
7.4
Sensitivity Analysis, Scenario Analysis,
and Break-Even Analysis
Sensitivity Analysis and Scenario Analysis
Break-Even Analysis
Monte Carlo Simulation
Step 1: Specify the Basic Model
Step 2: Specify a Distribution for
Each Variable in the Model
Step 3: The Computer Draws One
Outcome
Step 4: Repeat the Procedure
Step 5: Calculate NPV
Real Options
The Option to Expand
The Option to Abandon
Timing Options
Decision Trees
Summary and Conclusions
Concept Questions
Questions and Problems
Excel Master It! Problem
Mini Case: Bunyan Lumber, LLC
205
205
206
209
213
213
214
216
217
217
218
218
219
221
222
224
225
226
232
233
Chapter 8
Interest Rates and Bond Valuation
235
8.1
235
235
236
239
Bonds and Bond Valuation
Bond Features and Prices
Bond Values and Yields
Interest Rate Risk
Finding the Yield to Maturity: More Trial
and Error
Zero Coupon Bonds
241
243
Government and Corporate Bonds
Government Bonds
Corporate Bonds
Bond Ratings
Bond Markets
How Bonds Are Bought and Sold
Bond Price Reporting
A Note on Bond Price Quotes
Inflation and Interest Rates
Real versus Nominal Rates
Inflation Risk and Inflation-Linked
Bonds
The Fisher Effect
Determinants of Bond Yields
The Term Structure of Interest Rates
Bond Yields and the Yield Curve:
Putting It All Together
Conclusion
Summary and Conclusions
Concept Questions
Questions and Problems
Excel Master It! Problem
Mini Case: Financing East Coast
Yachts’s Expansion Plans with
a Bond Issue
245
245
246
248
249
249
250
253
254
254
255
256
258
258
260
262
262
262
263
267
268
Chapter 9
Stock Valuation
270
9.1
270
270
271
9.2
9.3
9.4
9.5
The Present Value of Common Stocks
Dividends versus Capital Gains
Valuation of Different Types of Stocks
Estimates of Parameters in
the Dividend Discount Model
Where Does g Come From?
Where Does R Come From?
A Healthy Sense of Skepticism
Dividends or Earnings: Which
to Discount?
The No-Dividend Firm
Comparables
Price-Earnings Ratio
Enterprise Value Ratios
Valuing Stocks Using Free Cash Flows
The Stock Markets
Dealers and Brokers
Organization of the NYSE
Types of Orders
NASDAQ Operations
Stock Market Reporting
Summary and Conclusions
Concept Questions
Questions and Problems
275
275
277
278
279
279
280
280
282
284
285
285
286
289
289
290
291
292
293
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Excel Master It! Problem
Mini Case: Stock Valuation
at Ragan Engines
296
11.6
297
PART III Risk
Chapter 10
Lessons from Market History
10.1
10.2
10.3
10.4
10.5
10.6
10.7
10.8
11.7
299
Returns
299
Dollar Returns
299
Percentage Returns
301
Holding Period Returns
303
Return Statistics
309
Average Stock Returns and
Risk-Free Returns
310
Risk Statistics
312
Variance
312
Normal Distribution and Its Implications
for Standard Deviation
314
More on Average Returns
315
Arithmetic versus Geometric Averages
315
Calculating Geometric Average Returns
315
Arithmetic Average Return or Geometric
Average Return?
317
The U.S. Equity Risk Premium: Historical
and International Perspectives
317
2008: A Year of Financial Crisis
320
Summary and Conclusions
321
Concept Questions
322
Questions and Problems
322
Excel Master It! Problem
325
Mini Case: A Job at East Coast Yachts
326
Chapter 11
Return, Risk, and the Capital
Asset Pricing Model
11.1
11.2
11.3
11.4
11.5
Individual Securities
Expected Return, Variance,
and Covariance
Expected Return and Variance
Covariance and Correlation
The Return and Risk for Portfolios
The Expected Return on a Portfolio
Variance and Standard Deviation
of a Portfolio
The Efficient Set for Two Assets
The Efficient Set for Many Securities
Variance and Standard Deviation
in a Portfolio of Many Assets
11.8
11.9
Chapter 12
An Alternative View of Risk
and Return
12.1
12.2
12.3
328
328
329
329
330
334
334
335
338
342
344
Diversification
345
The Anticipated and Unanticipated
Components of News
345
Risk: Systematic and Unsystematic
346
The Essence of Diversification
347
The Effect of Diversification: Another
Lesson from Market History
348
Riskless Borrowing and Lending
349
The Optimal Portfolio
351
Market Equilibrium
353
Definition of the Market Equilibrium
Portfolio
353
Definition of Risk When Investors Hold
the Market Portfolio
354
The Formula for Beta
356
A Test
357
Relationship between Risk and Expected
Return (CAPM)
357
Expected Return on the Market
357
Expected Return on an Individual Security
358
Summary and Conclusions
361
Concept Questions
361
Questions and Problems
362
Excel Master It! Problem
368
Mini Case: A Job at East Coast
Yachts, Part 2
369
Appendix 11A: Is Beta Dead?
370
12.4
12.5
Systematic Risk and Betas
Portfolios and Factor Models
Portfolios and Diversification
Betas, Arbitrage, and Expected Returns
The Linear Relationship
The Market Portfolio and the
Single Factor
The Capital Asset Pricing Model
and the Arbitrage Pricing Theory
Differences in Pedagogy
Differences in Application
Empirical Approaches to Asset Pricing
Empirical Models
Style Portfolios
Summary and Conclusions
Concept Questions
Questions and Problems
Excel Master It! Problem
Mini Case: The Fama-French Multifactor
Model and Mutual Fund Returns
371
371
374
377
379
379
380
381
381
381
383
383
384
385
386
387
391
391
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Chapter 13
Risk, Cost of Capital, and Valuation
393
13.1
13.2
393
13.3
13.4
13.5
13.6
13.7
13.8
13.9
13.10
13.11
The Cost of Capital
Estimating the Cost of Equity Capital
with the CAPM
The Risk-Free Rate
Market Risk Premium
Estimation of Beta
Real-World Betas
Stability of Beta
Using an Industry Beta
Determinants of Beta
Cyclicality of Revenues
Operating Leverage
Financial Leverage and Beta
The Dividend Discount Model Approach
Comparison of DDM and CAPM
Cost of Capital for Divisions
and Projects
Cost of Fixed Income Securities
Cost of Debt
Cost of Preferred Stock
The Weighted Average Cost of Capital
Valuation with WACC
Project Evaluation and the WACC
Firm Valuation with the WACC
Estimating Eastman Chemical’s
Cost of Capital
Flotation Costs and the Weighted
Average Cost of Capital
The Basic Approach
Flotation Costs and NPV
Internal Equity and Flotation Costs
Summary and Conclusions
Concept Questions
Questions and Problems
Mini Case: Cost of Capital for
Swan Motors
Appendix 13A: Economic Value Added
and the Measurement of
Financial Performance
394
397
397
398
399
399
401
402
402
402
403
404
405
14.4
14.5
14.6
14.7
14.8
406
408
408
409
410
411
412
412
415
417
417
418
419
420
420
422
426
427
PART IV Capital Structure
and Dividend Policy
Efficient Capital Markets
and Behavioral Challenges
428
14.1
14.2
428
430
Foundations of Market Efficiency
The Different Types of Efficiency
The Weak Form
The Semistrong and Strong Forms
Some Common Misconceptions about
the Efficient Market Hypothesis
The Evidence
The Weak Form
The Semistrong Form
The Strong Form
The Behavioral Challenge
to Market Efficiency
Rationality
Independent Deviations from Rationality
Arbitrage
Empirical Challenges to Market
Efficiency
Reviewing the Differences
Implications for Corporate Finance
1. Accounting Choices, Financial Choices,
and Market Efficiency
2. The Timing Decision
3. Speculation and Efficient Markets
4. Information in Market Prices
Summary and Conclusions
Concept Questions
Questions and Problems
Mini Case: Your 401(k) Account at
East Coast Yachts
432
433
433
434
436
437
437
438
441
442
442
444
445
446
451
453
453
454
455
457
459
460
463
466
Chapter 15
Long-Term Financing
15.1
15.2
15.3
15.4
15.5
15.6
15.7
Chapter 14
Can Financing Decisions Create Value?
A Description of Efficient Capital Markets
14.3
Some Features of Common
and Preferred Stocks
Common Stock Features
Preferred Stock Features
Corporate Long-Term Debt
Is It Debt or Equity?
Long-Term Debt: The Basics
The Indenture
Some Different Types of Bonds
Floating-Rate Bonds
Other Types of Bonds
Bank Loans
International Bonds
Patterns of Financing
Recent Trends in Capital Structure
Which Are Best: Book or Market
Values?
Summary and Conclusions
Concept Questions
Questions and Problems
468
468
468
471
472
473
473
475
478
478
478
479
480
480
482
482
483
484
485
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Chapter 16
Capital Structure
16.1
16.2
16.3
16.4
16.5
The Capital Structure Question
and the Pie Theory
Maximizing Firm Value versus
Maximizing Stockholder Interests
Financial Leverage and Firm Value:
An Example
Leverage and Returns to Shareholders
The Choice between Debt and Equity
A Key Assumption
Modigliani and Miller: Proposition II
(No Taxes)
Risk to Equityholders Rises with
Leverage
Proposition II: Required Return to
Equityholders Rises with Leverage
MM: An Interpretation
Taxes
The Basic Insight
Present Value of the Tax Shield
Value of the Levered Firm
Expected Return and Leverage
under Corporate Taxes
The Weighted Average Cost of Capital,
WACC, and Corporate Taxes
Stock Price and Leverage under
Corporate Taxes
Summary and Conclusions
Concept Questions
Questions and Problems
Mini Case: Stephenson Real Estate
Recapitalization
17.6
487
487
490
490
492
494
495
501
503
503
505
506
508
Chapter 18
509
Valuation and Capital Budgeting
for the Levered Firm
510
512
512
513
18.3
17.1
519
519
521
17.4
17.5
18.1
18.2
518
519
17.3
17.9
494
Capital Structure
17.2
17.8
494
Chapter 17
Costs of Financial Distress
Bankruptcy Risk or Bankruptcy Cost?
Description of Financial Distress Costs
Direct Costs of Financial Distress: Legal
and Administrative Costs of Liquidation
or Reorganization
Indirect Costs of Financial Distress
Agency Costs
Can Costs of Debt Be Reduced?
Protective Covenants
Consolidation of Debt
Integration of Tax Effects and Financial
Distress Costs
Pie Again
Signaling
17.7
488
Shirking, Perquisites, and Bad Investments:
A Note on Agency Cost of Equity
533
Effect of Agency Costs of Equity
on Debt-Equity Financing
535
Free Cash Flow
535
The Pecking-Order Theory
536
Rules of the Pecking Order
537
Implications
538
Personal Taxes
539
The Basics of Personal Taxes
539
The Effect of Personal Taxes on
Capital Structure
539
How Firms Establish Capital
Structure
540
Summary and Conclusions
545
Concept Questions
546
Questions and Problems
546
Mini Case: McKenzie Corporation’s
Capital Budgeting
549
Appendix 17A: Some Useful Formulas
of Financial Structure
550
Appendix 17B: T
he Miller Model and the
Graduated Income Tax550
521
523
524
527
527
528
529
530
531
18.4
18.5
18.6
18.7
551
Adjusted Present Value Approach
551
Flow to Equity Approach
553
Step 1: Calculating Levered Cash
Flow (LCF)
553
Step 2: Calculating RS
554
Step 3: Valuation
554
Weighted Average Cost
of Capital Method
554
A Comparison of the APV, FTE,
and WACC Approaches
555
A Suggested Guideline
556
Valuation When the Discount Rate
Must Be Estimated
558
APV Example
560
Beta and Leverage
563
The Project Is Not Scale Enhancing
565
Summary and Conclusions
566
Concept Questions
566
Questions and Problems
567
Mini Case: The Leveraged Buyout
of Cheek Products, Inc.
571
Appendix 18A: The Adjusted Present Value
Approach to Valuing
Leveraged Buyouts
572
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Chapter 19
Dividends and Other Payouts
573
19.1
19.2
573
19.3
19.4
19.5
19.6
19.7
19.8
19.9
19.10
Different Types of Payouts
Standard Method of Cash
Dividend Payment
The Benchmark Case: An Illustration
of the Irrelevance of Dividend Policy
Current Policy: Dividends Set Equal
to Cash Flow
Alternative Policy: Initial Dividend
Is Greater Than Cash Flow
The Indifference Proposition
Homemade Dividends
A Test
Dividends and Investment Policy
Repurchase of Stock
Dividend versus Repurchase: Conceptual
Example
Dividends versus Repurchases:
Real-World Considerations
Personal Taxes, Dividends,
and Stock Repurchases
Firms without Sufficient Cash to Pay
a Dividend
Firms with Sufficient Cash to Pay
a Dividend
Summary of Personal Taxes
Real-World Factors Favoring
a High-Dividend Policy
Desire for Current Income
Behavioral Finance
Agency Costs
Information Content of Dividends
and Dividend Signaling
The Clientele Effect: A Resolution
of Real-World Factors?
What We Know and Do Not Know
about Dividend Policy
Corporate Dividends Are Substantial
Fewer Companies Pay Dividends
Corporations Smooth Dividends
Some Survey Evidence about Dividends
Putting It All Together
Stock Dividends and Stock Splits
Some Details about Stock Splits
and Stock Dividends
Value of Stock Splits and Stock Dividends
Reverse Splits
Summary and Conclusions
Concept Questions
Questions and Problems
Mini Case: Electronic Timing, Inc.
PART V Long‐Term
Financing
Chapter 20
574
Raising Capital
576
20.1
576
576
577
577
578
579
579
581
582
583
583
584
586
587
587
587
588
589
591
593
593
594
595
597
598
600
600
602
603
604
604
606
610
Early-Stage Financing and
Venture Capital
Venture Capital
Stages of Financing
Some Venture Capital Realities
Venture Capital Investments and
Economic Conditions
20.2 The Public Issue
Direct Listing
Crowdfunding
Initial Coin Offerings (ICOs)
20.3 Alternative Issue Methods
20.4 The Cash Offer
Investment Banks
The Offering Price
Underpricing: A Possible Explanation
Evidence on Underpricing
The Partial Adjustment Phenomenon
20.5 The Announcement of New Equity
and the Value of the Firm
20.6 The Cost of New Issues
The Costs of Going Public: A Case
Study
20.7 Rights
The Mechanics of a Rights Offering
Subscription Price
Number of Rights Needed to Purchase
a Share
Effect of Rights Offering on Price
of Stock
Effects on Shareholders
The Underwriting Arrangements
20.8 The Rights Puzzle
20.9 Dilution
Dilution of Percentage Ownership
Dilution of Stock Price
Dilution of Book Value
Dilution of Earnings Per Share
Conclusion
20.10 Shelf Registration
20.11 Issuing Long-Term Debt
Summary and Conclusions
Concept Questions
Questions and Problems
Mini Case: East Coast Yachts
Goes Public
612
612
613
614
615
616
616
617
617
619
620
621
623
625
625
627
628
629
630
632
634
634
634
635
635
636
637
638
639
639
639
640
641
641
641
642
643
643
645
648
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Chapter 21
22.3
Leasing
649
21.1
649
649
650
650
651
653
654
656
21.2
21.3
21.4
21.5
21.6
21.7
21.8
21.9
21.10
Types of Leases
The Basics
Operating Leases
Financial Leases
Accounting and Leasing
Taxes, the IRS, and Leases
The Cash Flows of Leasing
A Note about Taxes
A Detour for Discounting and Debt
Capacity with Corporate Taxes
Present Value of Riskless Cash Flows
Optimal Debt Level and Riskless
Cash Flows
NPV Analysis of the Lease-versus-Buy
Decision
The Discount Rate
Debt Displacement and Lease Valuation
The Basic Concept of Debt
Displacement
Optimal Debt Level in the Xomox
Example
Does Leasing Ever Pay? The Base
Case
Reasons for Leasing
Good Reasons for Leasing
Bad Reasons for Leasing
Some Unanswered Questions
Are the Uses of Leases and Debt
Complementary?
Why Are Leases Offered by Both
Manufacturers and Third-Party Lessors?
Why Are Some Assets Leased More
Than Others?
Summary and Conclusions
Concept Questions
Questions and Problems
Mini Case: The Decision to Lease or
Buy at Warf Computers
Appendix 21A: APV Approach to Leasing
656
656
656
658
658
659
659
660
662
663
663
666
667
667
667
667
668
668
669
672
672
Chapter 22
Options and Corporate Finance
673
22.1
22.2
673
674
674
675
676
677
678
679
682
683
684
687
687
688
690
695
696
697
698
699
700
700
702
704
707
707
708
715
716
Chapter 23
Options and Corporate Finance:
Extensions and Applications
23.1
23.2
23.3
23.4
PART VI Options, Futures,
and Corporate Finance
Options
Call Options
The Value of a Call Option at Expiration
Put Options
The Value of a Put Option at Expiration
22.4 Selling Options
22.5 Option Quotes
22.6 Combinations of Options
22.7 Valuing Options
Bounding the Value of a Call
The Factors Determining Call
Option Values
A Quick Discussion of Factors
Determining Put Option Values
22.8 An Option Pricing Formula
A Two-State Option Model
The Black-Scholes Model
22.9 Stocks and Bonds as Options
The Firm Expressed in Terms
of Call Options
The Firm Expressed in Terms
of Put Options
A Resolution of the Two Views
A Note about Loan Guarantees
22.10 Options and Corporate Decisions:
Some Applications
Mergers and Diversification
Options and Capital Budgeting
22.11 Investment in Real Projects
and Options
Summary and Conclusions
Concept Questions
Questions and Problems
Excel Master It! Problem
Mini Case: Clissold Industries Options
Executive Stock Options
Why Options?
Valuing Executive Compensation
Valuing a Start-Up
More about the Binomial Model
Heating Oil
Shutdown and Reopening Decisions
Valuing a Gold Mine
The Abandonment and Opening
Decisions
Valuing the Simple Gold Mine
Summary and Conclusions
Concept Questions
Questions and Problems
Mini Case: Exotic Cuisines’ Employee
Stock Options
718
718
718
719
722
725
725
731
731
732
734
738
738
739
741
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Chapter 24
Warrants and Convertibles
742
24.1
24.2
742
24.3
24.4
24.5
24.6
24.7
24.8
Warrants
The Difference between Warrants
and Call Options
How the Firm Can Hurt Warrant Holders
Warrant Pricing and the
Black-Scholes Model
Convertible Bonds
The Value of Convertible Bonds
Straight Bond Value
Conversion Value
Option Value
Reasons for Issuing Warrants
and Convertibles
Convertible Debt versus Straight Debt
Convertible Debt versus Common Stock
The “Free Lunch” Story
The “Expensive Lunch” Story
A Reconciliation
Why Are Warrants and Convertibles
Issued?
Matching Cash Flows
Risk Synergy
Agency Costs
Backdoor Equity
Conversion Policy
Summary and Conclusions
Concept Questions
Questions and Problems
Mini Case: S&S Air’s Convertible Bond
25.8
743
746
746
747
748
748
749
750
751
751
752
753
754
754
754
754
755
755
756
756
757
758
759
761
Chapter 26
Short-Term Finance and Planning
795
26.1
26.2
796
797
798
26.3
26.4
763
25.1
25.2
25.3
25.4
25.5
763
764
765
769
771
771
772
773
774
778
778
25.6
25.7
Derivatives, Hedging, and Risk
Forward Contracts
Futures Contracts
Hedging
Interest Rate Futures Contracts
Pricing of Treasury Bonds
Pricing of Forward Contracts
Futures Contracts
Hedging in Interest Rate Futures
Duration Hedging
The Case of Zero Coupon Bonds
The Case of Two Bonds with the Same
Maturity but with Different Coupons
Duration
Matching Liabilities with Assets
Swaps Contracts
Interest Rate Swaps
779
780
782
784
785
786
787
787
788
790
790
792
794
PART VII Short‐Term
Finance
Chapter 25
Derivatives and Hedging Risk
Currency Swaps
Credit Default Swaps
Exotics
Actual Use of Derivatives
Summary and Conclusions
Concept Questions
Questions and Problems
Mini Case: Williamson Mortgage, Inc.
26.5
Tracing Cash and Net Working Capital
The Operating Cycle and the Cash Cycle
Defining the Operating and Cash Cycles
The Operating Cycle and the Firm’s
Organization Chart
Calculating the Operating and
Cash Cycles
Interpreting the Cash Cycle
A Look at Operating and Cash Cycles
Some Aspects of Short-Term
Financial Policy
The Size of the Firm’s Investment in
Current Assets
Alternative Financing Policies for
Current Assets
Which Is Best?
Cash Budgeting
Cash Outflow
The Cash Balance
The Short-Term Financial Plan
Unsecured Loans
Secured Loans
Other Sources
Summary and Conclusions
Concept Questions
Questions and Problems
Excel Master It! Problem
Mini Case: Keafer Manufacturing
Working Capital Management
799
800
803
803
804
804
807
809
810
811
811
812
812
812
813
813
814
814
822
823
Chapter 27
Cash Management
825
27.1
825
Reasons for Holding Cash
The Speculative and Precautionary
Motives
The Transaction Motive
825
826
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27.2
27.3
27.4
27.5
Compensating Balances
826
Costs of Holding Cash
826
Cash Management versus Liquidity
Management
826
Understanding Float
827
Disbursement Float
827
Collection Float and Net Float
828
Float Management
829
Electronic Data Interchange and
Check 21: The End of Float?
832
Cash Collection and Concentration
833
Components of Collection Time
833
Cash Collection
834
Lockboxes
834
Cash Concentration
835
Accelerating Collections: An Example
836
Managing Cash Disbursements
838
Increasing Disbursement Float
838
Controlling Disbursements
839
Investing Idle Cash
840
Temporary Cash Surpluses
840
Characteristics of Short-Term Securities
841
Some Different Types of Money
Market Securities
841
Summary and Conclusions
842
Concept Questions
843
Questions and Problems
844
Mini Case: Cash Management
at Richmond Corporation
846
Appendix 27A: Determining the Target
Cash Balance
846
Appendix 27B: Adjustable Rate Preferred
Stock, Auction Rate Preferred
Stock, and Floating-Rate
Certificates of Deposit
846
28.5
28.6
28.7
28.8
PART VIII Special Topics
Chapter 29
Mergers, Acquisitions, and
Divestitures
29.1
Chapter 28
Credit and Inventory Management
847
28.1
847
848
848
848
849
849
849
851
852
853
853
853
855
856
857
28.2
28.3
28.4
Credit and Receivables
Components of Credit Policy
The Cash Flows from Granting Credit
The Investment in Receivables
Terms of the Sale
The Basic Form
The Credit Period
Cash Discounts
Credit Instruments
Analyzing Credit Policy
Credit Policy Effects
Evaluating a Proposed Credit Policy
Optimal Credit Policy
The Total Credit Cost Curve
Organizing the Credit Function
Credit Analysis
857
When Should Credit Be Granted?
857
Credit Information
859
Credit Evaluation and Scoring
860
Collection Policy
860
Monitoring Receivables
860
Collection Effort
861
Inventory Management
861
The Financial Manager and
Inventory Policy
862
Inventory Types
862
Inventory Costs
862
Inventory Management Techniques
863
The ABC Approach
863
The Economic Order Quantity Model
863
Extensions to the EOQ Model
868
Managing Derived-Demand Inventories
868
Summary and Conclusions
870
Concept Questions
871
Questions and Problems
872
Mini Case: Credit Policy at Braam
Industries
875
Appendix 28A: More about Credit Policy
Analysis875
29.2
29.3
29.4
29.5
The Basic Forms of Acquisitions
Merger or Consolidation
Acquisition of Stock
Acquisition of Assets
A Classification Scheme
A Note about Takeovers
Synergy
Sources of Synergy
Revenue Enhancement
Cost Reduction
Tax Gains
Reduced Capital Requirements
Two Financial Side Effects
of Acquisitions
Earnings Growth
Diversification
A Cost to Stockholders
from Reduction in Risk
The Base Case
Both Firms Have Debt
How Can Shareholders Reduce Their
Losses from the Coinsurance Effect?
876
876
876
877
877
878
878
879
880
880
881
883
885
886
886
887
888
888
888
890
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29.6
The NPV of a Merger
Cash
Common Stock
Cash versus Common Stock
29.7 Friendly versus Hostile Takeovers
29.8 Defensive Tactics
Deterring Takeovers before Being in Play
Deterring a Takeover after the Company
Is in Play
29.9 Have Mergers Added Value?
Returns to Bidders
Target Companies
The Managers versus the Stockholders
29.10 The Tax Forms of Acquisitions
29.11 Accounting for Acquisitions
29.12 Going Private and Leveraged Buyouts
29.13 Divestitures
Sale
Spin-Off
Carve-Out
Tracking Stocks
Summary and Conclusions
Concept Questions
Questions and Problems
Mini Case: The Birdie Golf-Hybrid
Golf Merger
890
890
892
893
894
896
896
897
899
901
902
902
904
906
907
908
908
908
909
909
910
910
911
917
Chapter 31
International Corporate Finance
935
31.1
31.2
936
31.3
31.4
31.5
31.6
Chapter 30
Financial Distress
919
30.1
30.2
30.3
919
921
30.4
30.5
30.6
What Is Financial Distress?
What Happens in Financial Distress?
Bankruptcy Liquidation and
Reorganization
Bankruptcy Liquidation
Bankruptcy Reorganization
Private Workout or Bankruptcy:
Which Is Best?
The Marginal Firm
Holdouts
Complexity
Lack of Information
Prepackaged Bankruptcy
Predicting Corporate Bankruptcy:
The Z-Score Model
Summary and Conclusions
Concept Questions
Questions and Problems
923
923
925
928
929
929
929
929
929
931
932
933
933
31.7
Terminology
Foreign Exchange Markets
and Exchange Rates
Exchange Rates
Purchasing Power Parity
Absolute Purchasing Power Parity
Relative Purchasing Power Parity
Interest Rate Parity, Unbiased
Forward Rates, and the
International Fisher Effect
Covered Interest Arbitrage
Interest Rate Parity
Forward Rates and Future Spot Rates
Putting It All Together
International Capital Budgeting
Method 1: The Home Currency Approach
Method 2: The Foreign Currency
Approach
Unremitted Cash Flows
The Cost of Capital for International
Firms
Exchange Rate Risk
Short-Term Exposure
Long-Term Exposure
Translation Exposure
Managing Exchange Rate Risk
Political Risk
The Tax Cuts and Jobs Act of 2017
Managing Political Risk
Summary and Conclusions
Concept Questions
Questions and Problems
Excel Master It! Problem
Mini Case: East Coast Yachts Goes
International
Appendix A: Mathematical Tables
Appendix B: Solutions to Selected
End-of-Chapter Problems
Appendix C: Using the HP 10B and TI BA II Plus
Financial Calculators
Glossary
Name Index
Subject Index
936
937
942
942
943
945
945
946
947
948
949
950
951
951
952
952
952
953
954
955
955
955
956
957
957
959
961
962
963
972
975
979
987
989
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