Corporate finance 3rd by ross wester jaffe and jordan

BRIEF CONTENTSCHAPTER THREE Financial Statements Analysis and Financial Models 44 Budgeting 267 PART THREE RISK AND RETURN CHAPTER ELEVEN Return and Risk: The Capital Asset Pricing Mod

C O R P O R AT E F I N A N C E

C O R E P R I N C I P L E S & A P P L I C AT I O N S

The McGraw-Hill/Irwin Series in Finance, Insurance, and Real Estate

Stephen A Ross

Franco Modigliani Professor of Finance

and Economics

Sloan School of Management

Massachusetts Institute of Technology

Block, Hirt, and Danielsen

Foundations of Financial Management

Fourteenth Edition

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Case Studies in Finance: Managing for

Corporate Value Creation

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Finance: Applications and Theory

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Financial Markets and Corporate Strategy

Kester, Ruback, and Tufano

Case Problems in Finance

Twelfth Edition Ross, Westerfi eld, and Jaffe

Corporate Finance

Ninth Edition Ross, Westerfi eld, Jaffe, and Jordan

Corporate Finance: Core Principles and Applications

Third Edition Ross, Westerfi eld, and Jordan

Essentials of Corporate Finance

Seventh Edition Ross, Westerfi eld, and Jordan

Fundamentals of Corporate Finance

Ninth Edition Shefrin

Behavioral Corporate Finance: Decisions that Create Value

First Edition White

Financial Analysis with an Electronic Calculator

Investments

Ninth Edition Hirt and Block

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Ninth Edition Hirschey and Nofsinger

Investments: Analysis and Behavior

Second Edition Jordan and Miller

Fundamentals of Investments: Valuation and Management

Fifth Edition Stewart, Piros, and Heisler

Running Money: Professional Portfolio Management

First Edition Sundaram and Das

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First Edition

FINANCIAL INSTITUTIONS AND MARKETS

Rose and Hudgins

Bank Management and Financial Services

Eighth Edition

Rose and Marquis

Financial Institutions and Markets

Eleventh Edition Saunders and Cornett

Financial Institutions Management: A Risk Management Approach

Seventh Edition Saunders and Cornett

Financial Markets and Institutions

Fourth Edition

INTERNATIONAL FINANCE

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Ninth Edition

Randolph W Westerfi eld

Marshall School of Business University of Southern California

CORPORATE FINANCE: CORE PRINCIPLES & APPLICATIONS

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ISBN 978-0-07-353068-0 MHID 0-07-353068-9

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Library of Congress Cataloging-in-Publication Data

Corporate fi nance : core principles & applications / Stephen A Ross [et al.] — 3rd ed.

p cm — (The McGraw-Hill/Irwin series in fi nance, insurance, and real estate) Includes index.

ISBN-13: 978-0-07-353068-0 (alk paper) ISBN-10: 0-07-353068-9 (alk paper)

1 Corporations–Finance I Ross, Stephen A

HG4026.C643 2011 658.15 —dc22

2010026731

To our family and friends with love

and gratitude

— S.A.R R.W.W J.F.J B.D.J

of the most widely published authors in fi nance and economics, Professor Ross

is recognized for his work in developing the Arbitrage Pricing Theory, as well as for having made 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 currently serves as an associate editor of several academic and practitioner journals He is a trustee of CalTech

Randolph W Westerfi eld

MARSHALL SCHOOL OF BUSINESS, UNIVERSITY OF SOUTHERN CALIFORNIA

Randolph W Westerfi eld is Dean Emeritus of the University of Southern California’s Marshall School of Business and is the Charles B Thornton Profes-sor in Finance Professor Westerfi eld came to USC from the Wharton School, University of Pennsylvania, where he was the chairman of the fi nance department and member of the fi nance faculty for 20 years He is a member of several pub-lic company boards of directors including Health Management Associates, Inc., William Lyon Homes, and the Nicholas Applegate Growth Fund His areas of expertise include corporate fi nancial policy, investment management, and stock market price behavior

ABOUT THE AUTHORS

Jeffrey F Jaffe

WHARTON SCHOOL OF BUSINESS, UNIVERSITY OF PENNSYLVANIA

Jeffrey F Jaffe has been a frequent contributor to fi nance and economic

litera-ture 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

prof-its from their trades and that regulation has little effect on these profi ts He has

also made contributions concerning initial public offerings, the regulation of

utili-ties, the behavior of market makers, the fl uctuation of gold prices, the theoretical

effect of infl ation on the interest rate, the empirical effect of infl ation 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 Richard W and

Janis H Furst Endowed Chair in Finance at the University of Kentucky He has a

long-standing interest in both applied and theoretical issues in corporate fi nance

and has extensive experience teaching all levels of corporate fi nance and fi nancial

management policy Professor Jordan has published numerous articles in leading

journals on issues such as initial public offerings, capital structure, and the

behav-ior of security prices He is a past president of the Southern Finance Association,

and he is coauthor of Fundamentals of Investments: Valuation and Management ,

5e, a leading investments text, also published by McGraw-Hill/Irwin

IN THE BEGINNING…

It was probably inevitable that the four of us would

collabo-rate on this project Over the last 20 or so years, we have been

working as two separate “RWJ” teams In that time, we

man-aged (much to our own amazement) to coauthor two widely

adopted undergraduate texts and an equally successful

grad-uate text, all in the corporate fi nance area These three books

have collectively totaled more than 25 editions (and counting),

plus a variety of country-specifi c editions and international

editions, and they have been translated into at least a dozen

foreign languages

Even so, we knew that there was a hole in our lineup at the

graduate (MBA) level We’ve continued to see a need for a

concise, up-to-date, and to-the-point product, the majority of

which can be realistically covered in a typical single term or

course As we began to develop this book, we realized (with

wry chuckles all around) that, between the four of us, we have

been teaching and researching fi nance principles for well

over a century From our own very extensive experience with

this material, we recognized that corporate fi nance

introduc-tory classes often have students with extremely diverse

edu-cational and professional backgrounds We also recognized

that this course is increasingly being delivered in alternative

formats ranging from traditional semester-long classes to

highly compressed modules, to purely online courses, taught

both synchronously and asynchronously

OUR APPROACH

To achieve our objective of reaching out to the many

differ-ent types of studdiffer-ents and the varying course environmdiffer-ents,

we worked to distill the subject of corporate fi nance down to

its core, while maintaining a decidedly modern approach We

have always maintained that corporate fi nance can be viewed

as the working of a few very powerful intuitions We also know

that understanding the “why” is just as important, if not more

so, than understanding the “how.” Throughout the

develop-ment of this book, we continued to take a hard look at what

is truly relevant and useful In doing so, we have worked to

downplay purely theoretical issues and minimize the use of

ex-tensive and elaborate calculations to illustrate points that are

either intuitively obvious or of limited practical use

Perhaps more than anything, this book gave us the chance

to pool all that we have learned about what really works in

a corporate fi nance text We have received an enormous

amount of feedback over the years Based on that feedback,

the two key ingredients that we worked to blend together here

are the careful attention to pedagogy and readability that we have developed in our undergraduate books and the strong emphasis on current thinking and research that we have always stressed in our graduate book

From the start, we knew we didn’t want this text to be cyclopedic Our goal instead was to focus on what students really need to carry away from a principles course After much debate and consultation with colleagues who regularly teach this material, we settled on a total of 20 chapters Chapter length is typically 30 pages, so most of the book (and, thus, most of the key concepts and applications) can be realistically covered in a single term or module Writing a book that strictly focuses on core concepts and applications necessarily in- volves some picking and choosing, with regard to both topics and depth of coverage Throughout, we strike a balance by introducing and covering the essentials, while leaving more specialized topics to follow-up courses

As in our other books, we treat net present value (NPV) as the underlying and unifying concept in corporate fi nance Many texts stop well short of consistently integrating this basic prin- ciple The simple, intuitive, and very powerful notion that NPV represents the excess of market value over cost often is lost in

an overly mechanical approach that emphasizes computation

at the expense of comprehension In contrast, every subject we cover is fi rmly rooted in valuation, and care is taken throughout

to explain how particular decisions have valuation effects

Also, students shouldn’t lose sight of the fact that fi nancial management is about management We emphasize the role

of the fi nancial manager as decision maker, and we stress the need for managerial input and judgment We consciously avoid “black box” approaches to decisions, and where appro- priate, the approximate, pragmatic nature of fi nancial analysis

is made explicit, possible pitfalls are described, and limitations are discussed

NEW TO THE 3RD EDITION

With our fi rst two editions of Corporate Finance: Core Principles & Applications , we had the same hopes and fears

as any entrepreneurs How would we be received in the ket? Based on the very gratifying feedback we received, we learned that many of you agreed with us concerning the need for a focused, concise treatment of the major principles of cor- porate fi nance

In developing the third edition, one of the things we cused on was extensive updating We wanted to be as current

fo-as possible throughout the book As a result, we revamped,

FROM THE AUTHORS

rewrote, or replaced essentially all of the chapter opening

vi-gnettes, in-chapter real-world examples, and The Real World

readings We updated facts and fi gures throughout the book,

and we revised and expanded the already extensive

end-of-chapter material

A list of the most important revisions to the third edition

is below:

Overall: Completely rewritten Chapter on Financial

Statements and Financial Models Revised and updated data and fi gures More Excel examples

All new chapter openers All new problems at ends of chapters Many new boxes

New chapter on Raising Capital Completely rewritten International Corporate Finance chapter

Updated real examples Mergers and Acquisitions moved to online

Chapter 1: New materials on corporate governance and

regulation, including Sarbanes-Oxley

Chapter 3: Improved discussion of fi nancial ratios

e.g EBITDA and EV More examples

Chapter 4: New spreadsheet applications

Chapter 9: New material on the full payout model

Chapter 10: New material on global equity risk premiums

Update to 2009 New material on the global market collapse

Chapter 12: New material on how to estimate the WACC

Updated examples

Chapter 13: More material on bubbles

Changed Chapter title to underscore behavioral challenges

Chapter 15: Updated data on capital structure

Our attention to updating and improving also extended to the extensive collection of support and enrichment materials that accompany the text Working with many dedicated and talented colleagues and professionals, we continue to provide supplements that are unrivaled at the graduate level (a com- plete description appears in the following pages) Whether you use just the textbook, or the book in conjunction with other products, we believe you will be able to fi nd a combination that meets your current as well as your changing needs

— Stephen A Ross — Randolph W Westerfi eld

— Jeffrey F Jaffe — Bradford D Jordan

Corporate Finance: Core

Principles & Applications

is rich in valuable learning

tools and support to help

students succeed in learning

the fundamentals of fi nancial

This is just the amount of the discount

What would the Xanth bond sell for if interest rates had dropped by 2 percent instead of rising by 2 percent? As you might guess, the bond would sell for more than $1,000 Such a

bond is said to sell at a premium and is called a premium bond

This case is just the opposite of that of a discount bond The Xanth bond now has a coupon rate of 8 percent when the market rate is only 6 percent Investors are willing to

is 6 percent, and there are nine years remaining The present value of the $1,000 face amount is:

Online bond calculators are available at personal.fi delity.com ; interest rate information

is available at money.

cnn.com/markets/

bondcenter and www.

bankrate.com

Explanatory Web Links

These Web links are provided in the

margins of the text They are specifi cally

selected to accompany text material and

provide students and instructors with

a quick way to check for additional

information using the Internet

PEDAGOGY

W hat do Chris Iannetta, John Lackey, and Matt Holliday have in common? All

three are star athletes who signed big-money contracts during late 2009 or early 2010 Their contract values were reported as $8.35 million, $82.5 mil- lion, and $120 million, respectively But reported numbers can be misleading

For example, catcher Chris Ianetta re-signed with the Colorado Rockies His deal called for salaries of $1.75 million, $2.55 million, and $3.55 million over the next three years, respectively, with a contract buyout of $500,000 or a salary of $5,000,000 in four years Not bad, especially for someone who makes a living using the “tools of ignorance” (jock jargon for a catcher’s equipment)

A closer look at the numbers shows that Chris, John, and Matt did pretty well, but nothing like the quoted figures Using Matt’s contract as an example, the value was reported to be $120 million, but it was actually payable over several years The terms called for a salary of $17 million per year for seven years, then a club option for $17 million in 2017 or a club buyout of $1 million However, of the $17 mil- lion annual salary, $2 million each year was to be deferred and paid annually from 2020 to 2029 Since the payments are spread out over time, we must consider the time value of money, which means his contract was worth less than reported How much did he really get? This chapter gives you the “tools

of knowledge” to answer this question

Chapter Opening Case

Each chapter begins with a recent real-world event to introduce students to chapter concepts

Examples

Separate numbered and titled examples are extensively integrated into the chapters These examples provide detailed applications and illustrations of the text material in a step-by-step format Each example is completely self-contained, so students don’t have to search for additional information

 1

$1,000 1,000 1,000

Yearly (m ⫽ 1) Semiannually (m ⫽ 2) Quarterly (m ⫽ 4) Daily (m ⫽ 365)

$1,100.00 1,102.50 1,105.16

.10 1025 10381

Figure 4.11 illustrates the relationship among annual, semiannual, and continuous pounding Semiannual compounding gives rise to both a smoother curve and a higher end- ing value than does annual compounding Continuous compounding has both the smoothest curve and the highest ending value of all

Annual compounding

1 2 3 4 Interest earned

Years

Semiannual compounding

1 2 3 4

Interest earned

Annual, Semiannual, and

Figures and Tables

This text makes extensive use of real data

presented in various fi gures and tables

Explanations in the narrative, examples,

and end-of-chapter problems refer to

many of these exhibits

*Source: Virginia Lottery Web site All other odds from the National Safety Council.

1:135,145,920*

1:57,018,763 1:6,479,405 1:690,300

1:6,029

Sweepstakes may have different odds than lotteries, but these odds may not be much better Probably the largest advertised potential grand prize ever was Pepsi’s “Play for a Billion,” which, you guessed it, had a $1 billion

be paid $5 million per year for the next 20 years, $10 million per year for years 21 through 39, and a lump sum

$710 million in 40 years From what you have learned, you know the value of the sweepstakes wasn’t even close to

$1 billion In fact, at an interest rate of 10 percent, the present value is about $70.7 million

In January 2010, a 59-year-old man and his 57-year-old wife in New York won the $162 million Mega Millions jackpot They were given the option of receiving the jackpot as $6.231 million immediately and $6.231 million per year for the next 25 years, or $102 million immediately So, what discount rate does this imply? After some compu- tational effort, we find the interest rate is about 4.15 percent Unfortunately for the winners, nearly $1 million was had previously operated

Some lotteries make your decision a little tougher The Ontario Lottery will pay you either $2,000 a week for the rest of your life or $1.3 million now (That’s in Canadian dollars or “loonies,” by the way.) Of course, there is the payments until the twentieth anniversary of the first payment, or until you would have turned 91, whichever comes first This payout scheme complicates your decision quite a bit If you live for only the 20-year minimum, the break- even interest rate between the two options is about 5.13 percent per year, compounded weekly If you expect to manage to invest the $1.3 million lump sum at a rate of return of about 8 percent per year (compounded weekly), Taxes complicate the decision in this case because the lottery payments are all on an aftertax basis Thus, the rates

of return in this example would have to be aftertax as well

The Real World

By exploring information found in recent publications and building upon concepts learned in each chapter, these boxes work through real-world issues relevant to the surrounding text

S P R E A D S H E E T T E C H N I Q U E S

H o w t o C a l c u l a t e P r e s e n t V a l u e s w i t h

M u l t i p l e F u t u r e C a s h F l o w s U s i n g a

S p r e a d s h e e t

We can set up a basic spreadsheet to calculate the present values of the individual cash flows as follows

Notice that we have simply calculated the present values one at a time and added them up:

1 3 5 7 9

What is the present value of $200 in one year, $400 the next year, $600 the next year, and

$800 the last year if the discount rate is 12 percent?

Using a spreadsheet to value multiple future cash flows

Spreadsheet Techniques

This feature helps students to improve their Excel

spreadsheet skills, particularly as they relate to

corporate fi nance This feature appears in

self-contained sections and shows students how to set up

spreadsheets to analyze common fi nancial problems—a

vital part of every business student’s education For

even more help using Excel, students have access to

Excel Master, an in-depth online tutorial

Numbered Equations

Key equations are numbered within the text and listed on the back end sheets for easy reference

This real rate is the same as we had before If we take another look at the Fisher effect, we

can rearrange things a little as follows:

R  r  h  r  h

What this tells us is that the nominal rate has three components First, there is the real rate

money originally invested because of infl ation, h The third component represents

compen-sation for the fact that the dollars earned on the investment are also worth less because of

the infl ation

This third component is usually small, so it is often dropped The nominal rate is then approximately equal to the real rate plus the infl ation rate:

Summary and Conclusions

Each chapter ends with a numbered and concise, but thorough, summary of the important ideas presented

in the chapter—helping students review the key points and providing closure

END-OF-CHAPTER

MATERIAL

The end-of-chapter material

refl ects and builds on the

concepts learned from the

chapter and study features

S U M M A R Y A N D C O N C L U S I O N S

This chapter has explored bonds, bond yields, and interest rates We saw that:

1 Determining bond prices and yields is an application of basic discounted cash fl ow principles

2 Bond values move in the direction opposite that of interest rates, leading to potential gains or

losses for bond investors

3 Bonds have a variety of features spelled out in a document called the indenture

4 Bonds are rated based on their default risk Some bonds, such as Treasury bonds, have no risk

of default, whereas so-called junk bonds have substantial default risk

5 A wide variety of bonds exist, many of which contain exotic or unusual features

6 Almost all bond trading is OTC, with little or no market transparency in many cases As a result,

bond price and volume information can be diffi cult to fi nd for some types of bonds

7 Bond yields and interest rates refl ect the effect of six different things: the real interest rate and

fi ve premiums that investors demand as compensation for infl ation, interest rate risk, default risk, taxability, and lack of liquidity

$84 per share, what is the required return?

3 Stock Values For the company in the previous problem, what is the dividend yield? What is the expected capital gains yield?

4 Stock Values Mickelson Corporation will pay a $2.90 per share dividend next year The company pledges to increase its dividend by 4.75 percent per year, indefi nitely If you require

an 11 percent return on your investment, how much will you pay for the company’s stock today?

5 Stock Valuation Shelter, Inc., is expected to maintain a constant 5.2 percent growth rate in its dividends, indefi nitely If the company has a dividend yield of 4.4 percent, what is the required return on the company’s stock?

6 Stock Valuation Suppose you know that a company’s stock currently sells for $73 per share and the required return on the stock is 12 percent You also know that the total return on the stock is evenly divided between a capital gains yield and a dividend yield If it’s the company’s per share?

Basic

(Questions 1–9)

C O N C E P T Q U E S T I O N S

1 Treasury Bonds Is it true that a U.S Treasury security is risk-free?

2 Interest Rate Risk Which has greater interest rate risk, a 30-year Treasury bond or a 30-year

BB corporate bond?

3 Treasury Pricing With regard to bid and ask prices on a Treasury bond, is it possible for the bid

price to be higher? Why or why not?

4 Yield to Maturity Treasury bid and ask quotes are sometimes given in terms of yields, so there

would be a bid yield and an ask yield Which do you think would be larger? Explain

5 Call Provisions A company is contemplating a long-term bond issue It is debating whether

or not to include a call provision What are the benefi ts to the company from including a call provision? What are the costs? How do these answers change for a put provision?

6 Coupon Rate How does a bond issuer decide on the appropriate coupon rate to set on its

bonds? Explain the difference between the coupon rate and the required return on a bond

7 Real and Nominal Returns Are there any circumstances under which an investor might be

more concerned about the nominal return on an investment than the real return?

8 Bond Ratings Companies pay rating agencies such as Moody’s and S&P to rate their bonds,

and the costs can be substantial However, companies are not required to have their bonds rated in the fi rst place; doing so is strictly voluntary Why do you think they do it?

9 Bond Ratings U.S Treasury bonds are not rated Why? Often, junk bonds are not rated Why?

Questions and Problems

Because solving problems is so critical to

students’ learning, we provide extensive

end-of-chapter questions and problems The questions

and problems are segregated into three learning

levels: Basic, Intermediate, and Challenge All

problems are fully annotated so that students

and instructors can readily identify particular

types Also, most of the problems are available

in McGraw-Hill’s Connect—see the next

section of this preface for more details

What’s On the Web?

These end-of-chapter activities show students how to use and learn from the vast amount of fi nancial resources available on the Internet

W H AT ’ S O N T H E W E B ?

You want to fi nd the bond prices and yields for bonds issued by Georgia Pacifi c You can enter the ticker symbol “GP” to do a search What is the shortest maturity bond issued by Georgia Pacifi c that is outstanding? What is the longest maturity bond? What is the credit rating for Georgia Pacifi c’s bonds? Do all of the bonds have the same credit rating? Why do you think this is?

over the next four years: $10, $8, $5, and $3 Afterward, the company pledges to maintain a stant 5 percent growth rate in dividends forever If the required return on the stock is 13 percent, what is the current share price?

30 percent rate for the next three years, with the growth rate falling off to a constant 7 percent thereafter If the required return is 10 percent and the company just paid a $2.40 dividend, what

is the current share price?

grow at 27 percent per year during the next three years, 17 percent over the following year, and then 7 percent per year indefi nitely The required return on this stock is 12 percent, and the stock currently sells for $65 per share What is the projected dividend for the coming year?

$12 dividend, but management expects to reduce the payout by 4 percent per year, indefi nitely If you require a 9 percent return on this stock, what will you pay for a share today?

S T O C K V A L U AT I O N AT R A G A N E N G I N E S

Larissa has been talking with the company’s directors about the future of East Coast Yachts To this including engines Larissa has decided that East Coast Yachts should consider the purchase of an control over engine features After investigating several possible companies, Larissa feels that the purchase of Ragan Engines, Inc., is a possibility She has asked Dan Ervin to analyze Ragan’s value

Ragan Engines, Inc., was founded nine years ago by a brother and sister—Carrington and marine engines for a variety of applications Ragan has experienced rapid growth because of a proprietary technology that increases the fuel effi ciency of its engines with very little sacrifi ce in between the siblings gave each 125,000 shares of stock

Excel Problems

Indicated by the Excel icon in the margin,

these problems are integrated in the

Questions and Problems section of almost

all chapters Located on the book’s Web site,

Excel templates have been created for each

of these problems Students can use the data

in the problem to work out the solution using

Excel skills

End-of-Chapter Cases

Located at the end of each chapter, these mini-cases focus on common company situations that embody important corporate fi nance 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

DIGITAL SOLUTIONS

Online Learning Center (OLC): Online Support at www.mhhe.com/rwj

The Online Learning Center (OLC) contains FREE access to Web-based study and teaching aids created for this text, all in one place!

■ Test Bank

prepared by Bruce Costa, University of Montana Great format for a better testing process The Test Bank has 75–100 questions per chapter that closely link with the text material and provide a variety of question formats (multiple-choice questions problems and essay questions) and levels of dif-

fi culty (basic, intermediate, and challenge) to meet every instructor’s testing needs

Problems are detailed enough to make them intuitive for students and solutions are provided for the instructor

■ Computerized Test Bank

Create your own tests in a snap! These additional questions are found in a erized test bank utilizing McGraw-Hill’s EZ Test testing software to quickly create customized exams This user-friendly program allows instructors to sort questions

comput-by format; edit existing questions or add new ones; and scramble questions for multiple versions of the same test

■ PowerPoint Presentation System

prepared by David Diehl, Aurora University Customize our content for your course This presentation has been thoroughly revised to include more lecture-oriented slides, as well as exhibits and examples both from the book and from outside sources Applicable slides have Web links that take you directly to specifi c Internet sites, or a spreadsheet link to show an example in Excel You can also go to the Notes Page function for more tips in presenting the slides This customizable format gives you the ability to edit, print,

or rearrange the complete presentation to meet your specifi c needs

COMPREHENSIVE TEACHING

Videos

Also available in DVD format Current set of videos on hot topics! McGraw-Hill/Irwin

has produced a series of fi nance videos that are 10-minute case studies on topics such as

Financial Markets, Careers, Rightsizing, Capital Budgeting, EVA (Economic Value Added),

Mergers and Acquisitions, and Foreign Exchange Discussion questions for these videos, as

well as video clips, are available in the Instructor’s Center at www.mhhe.com/rwj

STUDENT SUPPORT

■ Narrated PowerPoint Examples

These in-depth slides are designed exclusively for students as part of the premium content package of this book Each chapter’s slides follow the chapter topics and pro-vide steps and explanations showing how to solve key problems Because each student learns differently, a quick click on each slide will “talk through” its contents with you!

■ Interactive FinSims

Created by Eric Sandburg, Interactive Media, each module highlights a key concept

of the book and simulates how to solve its problems, asking the student to input certain variables This hands-on approach guides students through diffi cult and important corporate fi nance topics

■ Excel Master

Created by Brad Jordan and Joe Smolira, this extensive Excel tutorial is fully integrated with the text Learn Excel and corporate fi nance at the same time For more details about this exciting new feature see the inside cover of this book!

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ACKNOWLEDGMENTS

To borrow a phrase, writing a fi nance textbook

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col-be publishing this text

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Las Vegas

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We owe a special thanks to Joseph Smolira

of Belmont University for his work on this book

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The following doctoral students did ing work on this edition: Dane Makhoul and Tim Riley To them fell the unenviable task of technical proofreading, and in particular, careful check- ing of each calculation throughout the text and Instructor’s Manual

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We are deeply grateful to the select group of professionals who served as our development team on this edition: Michele Janicek, Executive Editor; Elizabeth Hughes, Development Editor;

Melissa Caughlin, Marketing Manager; Christine Vaughan, Lead Project Manager; Mary Sander, Designer; Heather Burbridge, Senior Manager,

EDP; and Brian Nacik, Media Project Manager Others at

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Mark, Lynne, and Susan, for their forbearance and help

Throughout the development of this edition, we have taken

great care to discover and eliminate errors Our goal is to

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our appreciation More than this, we would like to hear from

instructors and students alike Please write and tell us how to make this a better text Forward your comments to: Dr Brad Jordan, c/o Editorial–Finance, McGraw-Hill/Irwin, 1333 Burr Ridge Parkway, Burr Ridge, IL 60527, or visit us online at www.

mhhe.com/rwj

— Stephen A Ross — Randolph W Westerfi eld

— Jeffrey F Jaffe — Bradford D Jordan

BRIEF CONTENTS

CHAPTER THREE Financial Statements Analysis and Financial

Models 44

Budgeting 267 PART THREE RISK AND RETURN

CHAPTER ELEVEN Return and Risk: The Capital Asset Pricing

Model (CAPM) 321 CHAPTER TWELVE Risk, Cost of Capital, and Capital Budgeting 363

CHAPTER THIRTEEN Effi cient Capital Markets and Behavioral

Challenges 395 CHAPTER FOURTEEN Capital Structure: Basic Concepts 430 CHAPTER FIFTEEN Capital Structure: Limits to the Use of Debt 459

CHAPTER SEVENTEEN Options and Corporate Finance 527 CHAPTER EIGHTEEN Short-Term Finance and Planning 568

CHAPTER TWENTY ONE Mergers and Acquisitions (Web only)

Financial Calculators 677

CHAPTER ONE Introduction to Corporate Finance 1

1.1 What Is Corporate Finance? 1

The Balance Sheet Model of the Firm 2 The Financial Manager 3

1.2 The Corporate Firm 4

The Sole Proprietorship 4 The Partnership 4 The Corporation 5

A Corporation by Another Name 7

1.3 The Importance of Cash Flows 7 1.4 The Goal of Financial Management 10

Possible Goals 10 The Goal of Financial Management 11

A More General Goal 12

1.5 The Agency Problem and Control

of the Corporation 12

Agency Relationships 13 Management Goals 13

Do Managers Act in the Stockholders’

Interests? 14 Stakeholders 15

1.6 Regulation 15

The Securities Act of 1933 and the Securities Exchange Act of 1934 16

Summary and Conclusions 17

Closing Case: East Coast Yachts 19 CHAPTER TWO

Financial Statements and Cash Flow 20

2.1 The Balance Sheet 20

Accounting Liquidity 21 Debt versus Equity 22 Value versus Cost 22

2.2 The Income Statement 23

Generally Accepted Accounting Principles 24

Noncash Items 24 Time and Costs 25

Cash Flow from Operating Activities 31

Cash Flow from Investing Activities 32

Cash Flow from Financing Activities 33

Summary and Conclusions 34

Closing Case: Cash Flows at East Coast Yachts 42

CHAPTER THREE Financial Statements Analysis and Financial Models 44

3.1 Financial Statements Analysis 44

Standardizing Statements 45 Common-Size Balance Sheets 45 Common-Size Income Statements 46

Profi tability Measures 53 Market Value Measures 54

3.3 The Du Pont Identity 57

A Closer Look at ROE 57

Problems with Financial Statement Analysis 59

3.4 Financial Models 61

A Simple Financial Planning Model 61

The Percentage of Sales Approach 62

3.5 External Financing and Growth 66

EFN and Growth 67

Financial Policy and Growth 69

A Note about Sustainable Growth Rate Calculations 72

3.6 Some Caveats Regarding Financial Planning Models 73

Summary and Conclusions 74

Closing Case: Ratios and Financial Planning

at East Coast Yachts 81

CHAPTER FOUR

Discounted Cash Flow Valuation 84

4.1 Valuation: The One-Period Case 84

4.2 The Multiperiod Case 88

Future Value and Compounding 88

The Power of Compounding: A Digression 91

Present Value and Discounting 92

The Algebraic Formula 96

4.3 Compounding Periods 97

Distinction between Stated Annual Interest Rate

and Effective Annual Rate 99

Compounding over Many Years 101

Growing Annuity 111

4.5 Loan Types and Loan Amortization 113

Pure Discount Loans 113

Interest-Only Loans 113

Amortized Loans 114

4.6 What Is a Firm Worth? 117

Summary and Conclusions 119

Closing Case: The MBA Decision 131

CHAPTER FIVE Interest Rates and Bond Valuation 133

5.1 Bonds and Bond Valuation 133

Bond Features and Prices 134 Bond Values and Yields 134 Interest Rate Risk 137 Finding the Yield to Maturity: More Trial and Error 139

5.2 More on Bond Features 141

Long-Term Debt: The Basics 143 The Indenture 144

Terms of a Bond 144 Security 145 Seniority 145 Repayment 145 The Call Provision 146 Protective Covenants 146 5.3 Bond Ratings 147

5.4 Some Different Types of Bonds 148

Government Bonds 148 Zero Coupon Bonds 149 Floating-Rate Bonds 150 Other Types of Bonds 151

5.5 Bond Markets 151

How Bonds Are Bought and Sold 152 Bond Price Reporting 152

A Note on Bond Price Quotes 155

5.6 Infl ation and Interest Rates 155

Real versus Nominal Rates 155 The Fisher Effect 156

5.7 Determinants of Bond Yields 157

The Term Structure of Interest Rates 157 Bond Yields and the Yield Curve: Putting It All Together 159

Conclusion 161

Summary and Conclusions 161

Closing Case: Financing East Coast Yachts’ Expansion Plans with a Bond Issue 166

CHAPTER SIX Stock Valuation 168

6.1 The Present Value of Common Stocks 168

Dividends versus Capital Gains 168 Valuation of Different Types of Stocks 170

Case 1 (Zero Growth) 170 Case 2 (Constant Growth) 170 Case 3 (Differential Growth) 171

6.2 Estimates of Parameters in the Dividend Discount

6.4 Price-Earnings Ratio 180

6.5 Some Features of Common and Preferred Stocks 182

Common Stock Features 182

Shareholder Rights 182 Proxy Voting 183 Classes of Stock 183 Other Rights 184 Dividends 184

Preferred Stock Features 185

Stated Value 185 Cumulative and Noncumulative Dividends 185

Is Preferred Stock Really Debt? 185 6.6 The Stock Markets 186

Dealers and Brokers 186 Organization of the NYSE 186

Members 186 Operations 187 Floor Activity 187

NASDAQ Operations 188

ECNs 189

Stock Market Reporting 189

Summary and Conclusions 192

Closing Case: Stock Valuation at Ragan Engines 197

CHAPTER SEVEN

Net Present Value and Other Investment

Rules 199

7.1 Why Use Net Present Value? 199

7.2 The Payback Period Method 202

Defi ning the Rule 202 Problems with the Payback Method 203

Problem 1: Timing of Cash Flows within the Payback Period 203

Problem 2: Payments after the Payback Period 203 Problem 3: Arbitrary Standard for Payback Period 204

Managerial Perspective 204 Summary of Payback 204

7.3 The Discounted Payback Period Method 205 7.4 The Average Accounting Return Method 205

Defi ning the Rule 205

Step 1: Determining Average Net Income 206 Step 2: Determining Average Investment 207 Step 3: Determining AAR 207

Analyzing the Average Accounting Return Method 207

7.5 The Internal Rate of Return 207 7.6 Problems with the IRR Approach 210

Defi nition of Independent and Mutually Exclusive Projects 210

Two General Problems Affecting Both Independent and Mutually Exclusive Projects 211

Problem 1: Investing or Financing? 212 Problem 2: Multiple Rates of Return 212 NPV Rule 213

Modified IRR 213 The Guarantee against Multiple IRRs 214 General Rules 214

Problems Specifi c to Mutually Exclusive Projects 215

The Scale Problem 215 The Timing Problem 217

Redeeming Qualities of IRR 219

A Test 219

7.7 The Profi tability Index 220

Calculation of Profi tability Index 220

Application of the Profitability Index 220 7.8 The Practice of Capital Budgeting 222 Summary and Conclusions 224

Closing Case: Bullock Gold Mining 235 CHAPTER EIGHT

Making Capital Investment Decisions 236

8.1 Incremental Cash Flows 236

Cash Flows—Not Accounting Income 236 Sunk Costs 237

Opportunity Costs 237 Side Effects 238 Allocated Costs 238

8.2 The Baldwin Company: An Example 239

An Analysis of the Project 240

Investments 240 Income and Taxes 241 Salvage Value 242

Cash Flow 243 Net Present Value 243

Which Set of Books? 243

A Note on Net Working Capital 243

A Note on Depreciation 244

Interest Expense 245

8.3 Infl ation and Capital Budgeting 245

Discounting: Nominal or Real? 246

8.4 Alternative Defi nitions of Operating Cash Flow 248

The Bottom-Up Approach 249

The Top-Down Approach 249

The Tax Shield Approach 249

Conclusion 250

8.5 Investments of Unequal Lives: The Equivalent Annual

Cost Method 250

The General Decision to Replace 252

Summary and Conclusions 254

Closing Cases: Expansion at East Coast Yachts 265

Break-Even Analysis 269

Sensitivity Analysis and Scenario Analysis 270

Revenues 270 Costs 271

Break-Even Analysis 273

Accounting Profit 273 Present Value 275 9.3 Monte Carlo Simulation 276

Step 1: Specify the Basic Model 276 Step 2: Specify a Distribution for Each Variable

in the Model 276 Step 3: The Computer Draws One Outcome 278 Step 4: Repeat the Procedure 278

Step 5: Calculate NPV 278 9.4 Real Options 279

The Option to Expand 279

The Option to Abandon 280

Timing Options 282

Summary and Conclusions 283

Closing Case: Bunyan Lumber, LLC 291

CHAPTER TEN Risk and Return Lessons from Market History 293

10.1 Returns 293

Dollar Returns 293 Percentage Returns 295

10.2 Holding Period Returns 297 10.3 Return Statistics 303 10.4 Average Stock Returns and Risk-Free Returns 304

10.5 Risk Statistics 306

Variance 306 Normal Distribution and Its Implications for Standard Deviation 307

10.6 The U.S Equity Risk Premium: Historical and International Perspectives 3 0 8

10.7 2008: A Year of Financial Crisis 311 10.8 More on Average Returns 312

Arithmetic versus Geometric Averages 312 Calculating Geometric Average Returns 313 Arithmetic Average Return or Geometric Average Return? 314

Summary and Conclusions 315

Closing Case: A Job at East Coast Yachts, Part 1 319

CHAPTER ELEVEN Return and Risk: The Capital Asset Pricing Model (CAPM) 321

11.1 Individual Securities 321 11.2 Expected Return, Variance, and Covariance 322

Expected Return and Variance 322 Covariance and Correlation 323

11.3 The Return and Risk for Portfolios 326

The Expected Return on a Portfolio 326 Variance and Standard Deviation of a Portfolio 327

The Variance 327 Standard Deviation of a Portfolio 327 The Diversification Effect 328

An Extension to Many Assets 329 11.4 The Effi cient Set 329

The Two-Asset Case 329 The Effi cient Set for Many Securities 333

11.5 Riskless Borrowing and Lending 334

The Optimal Portfolio 336

11.6 Announcements, Surprises, and Expected

Returns 338

Expected and Unexpected Returns 338 Announcements and News 339

11.7 Risk: Systematic and Unsystematic 340

Systematic and Unsystematic Risk 340 Systematic and Unsystematic Components

of Return 340

11.8 Diversifi cation and Portfolio Risk 341

The Effect of Diversifi cation: Another Lesson from Market History 341

The Principle of Diversifi cation 341 Diversifi cation and Unsystematic Risk 343 Diversifi cation and Systematic Risk 343

Summary and Conclusions 352

Closing Case: A Job at East Coast Yachts, Part 2 361

CHAPTER TWELVE

Risk, Cost of Capital, and Capital Budgeting 363

12.1 The Cost of Equity Capital 363

12.2 Estimating the Cost of Equity Capital with

12.3 Estimation of Beta 368

Real-World Betas 369 Stability of Beta 369 Using an Industry Beta 370

12.4 Beta and Covariance 372

Beta and Covariance 372

12.5 Determinants of Beta 373

Cyclicality of Revenues 373 Operating Leverage 373 Financial Leverage and Beta 373

12.6 Dividend Discount Model 375

Comparison of DDM and CAPM 375 Can a Low-Dividend or a No-Dividend Stock Have a High Cost of Capital? 376

12.7 Cost of Capital for Divisions and Projects 377 12.8 Cost of Fixed Income Securities 378

Cost of Debt 378 Cost of Preferred Stock 379

12.9 The Weighted Average Cost of Capital 380 12.10 Estimating Eastman Chemical’s Cost

of Capital 383 Eastman’s Cost of Equity 383 Eastman’s Cost of Debt 384 Eastman’s WACC 385 12.11 Flotation Costs and the Weighted Average Cost

of Capital 385

The Basic Approach 385 Flotation Costs and NPV 386 Internal Equity and Flotation Costs 387

Summary and Conclusions 387

Closing Case: The Cost of Capital for Goff Computer, Inc 394

AND DIVIDEND POLICY

CHAPTER THIRTEEN Effi cient Capital Markets and Behavioral Challenges 395

13.1 Can Financing Decisions Create Value? 395

13.2 A Description of Effi cient Capital Markets 397

Foundations of Market Effi ciency 399

Rationality 399 Independent Deviations from Rationality 399 Arbitrage 400

13.3 The Different Types of Effi ciency 400

The Weak Form 400 The Semistrong and Strong Forms 401 Some Common Misconceptions about the Effi cient Market Hypothesis 402

The Efficacy of Dart Throwing 403 Price Fluctuations 403

Stockholder Disinterest 403 13.4 The Evidence 403

The Weak Form 404

The Semistrong Form 405

Event Studies 406 The Record of Mutual Funds 407

The Strong Form 408

13.5 The Behavioral Challenge to Market

Effi ciency 409

Rationality 409 Independent Deviations from Rationality 409

Arbitrage 410 13.6 Empirical Challenges to Market Effi ciency 410

13.7 Reviewing the Differences 416

Representativeness 416

Conservatism 416

13.8 Implications for Corporate Finance 417

1 Accounting Choices, Financial Choices,

and Market Effi ciency 417

2 The Timing Decision 417

3 Speculation and Effi cient Markets 420

4 Information in Market Prices 420

Summary and Conclusions 422

Closing Case: Your 401(K) Account at East Coast

Yachts 428

CHAPTER FOURTEEN

Capital Structure: Basic Concepts 430

14.1 The Capital Structure Question and the Pie

Leverage and Returns to Shareholders 433

The Choice between Debt and Equity 435

A Key Assumption 437

14.4 Modigliani and Miller: Proposition II

(No Taxes) 437

Risk to Equityholders Rises with Leverage 437

Proposition II: Required Return to Equityholders

Rises with Leverage 438

MM: An Interpretation 443

14.5 Taxes 444

The Basic Insight 444

Present Value of the Tax Shield 446

Value of the Levered Firm 446

Expected Return and Leverage under Corporate

Taxes 448

and Corporate Taxes 449 Stock Price and Leverage under Corporate Taxes 449

Summary and Conclusions 451

Closing Case: Stephenson Real Estate Recapitalization 458

CHAPTER FIFTEEN Capital Structure: Limits to the Use

of Debt 459

15.1 Costs of Financial Distress 459

Direct Bankruptcy Costs 460 Indirect Bankruptcy Costs 460 Agency Costs 461

Summary of Selfish Strategies 463 15.2 Can Costs of Debt Be Reduced? 464

Protective Covenants 464 Consolidation of Debt 465

15.3 Integration of Tax Effects and Financial Distress Costs 465

Pie Again 465

15.4 Signaling 468 15.5 Shirking, Perquisites, and Bad Investments: A Note

on Agency Cost of Equity 469

Effect of Agency Costs of Equity on Debt-Equity Financing 471 Free Cash Flow 471

15.6 The Pecking-Order Theory 472

Rules of the Pecking Order 473

Rule #1 Use Internal Financing 473 Rule #2 Issue Safe Securities First 474

Implications 474

15.7 Growth and the Debt-Equity Ratio 475

No Growth 475 Growth 475

15.8 How Firms Establish Capital Structure 477 15.9 A Quick Look at the Bankruptcy Process 481

Liquidation and Reorganization 482

Bankruptcy Liquidation 482 Bankruptcy Reorganization 483

Financial Management and the Bankruptcy Process 483

Agreements to Avoid Bankruptcy 484

Summary and Conclusions 484

Closing Case: McKenzie Corporation’s Capital Budgeting 489

CHAPTER SIXTEEN

Dividends and Other Payouts 490

16.1 Different Types of Dividends 490

16.2 Standard Method of Cash Dividend Payment 491

16.3 The Benchmark Case: An Illustration of the

Irrelevance of Dividend Policy 493

Current Policy: Dividends Set Equal to Cash Flow 493 Alternative Policy: Initial Dividend Is Greater than Cash Flow 494

The Indifference Proposition 494 Homemade Dividends 494

A Test 496 Dividends and Investment Policy 497

Firms without Suffi cient Cash to Pay a Dividend 501 Firms with Suffi cient Cash to Pay a Dividend 502 Summary on Personal Taxes 503

16.6 Real-World Factors Favoring a High-Dividend Policy 503

Desire for Current Income 503 Behavioral Finance 504 Agency Costs 505 Information Content of Dividends and Dividend Signaling 506

16.7 The Clientele Effect: a Resolution of Real-World

Factors? 507 16.8 What We Know and Do Not Know about Dividend

Policy 508

Dividends and Dividend Payers 508 Corporations Smooth Dividends 510 Payouts Provide Information to the Market 511 Putting It All Together 511

Some Survey Evidence on Dividends 514

16.9 Stock Dividends and Stock Splits 515

Some Details on Stock Splits and Stock Dividends 515

Example of a Small Stock Dividend 515 Example of a Stock Split 516

Example of a Large Stock Dividend 516

Value of Stock Splits and Stock Dividends 516

The Benchmark Case 516 Popular Trading Range 517

Reverse Splits 517

Summary and Conclusions 518

Closing Case: Electronic Timing, Inc 525

CHAPTER SEVENTEEN Options and Corporate Finance 527

17.1 Options 527 17.2 Call Options 528

The Value of a Call Option at Expiration 528

17.3 Put Options 529

The Value of a Put Option at Expiration 529

17.4 Selling Options 531 17.5 Option Quotes 532 17.6 Combinations of Options 533 17.7 Valuing Options 536

Bounding the Value of a Call 536

Lower Bound 536 Upper Bound 536

The Factors Determining Call Option Values 536

Exercise Price 536 Expiration Date 537 Stock Price 537 The Key Factor: The Variability of the Underlying Asset 538

The Interest Rate 539

A Quick Discussion of Factors Determining Put Option Values 539

17.8 An Option Pricing Formula 540

A Two-State Option Model 541

Determining the Delta 541 Determining the Amount of Borrowing 542 Risk-Neutral Valuation 542

The Black–Scholes Model 543

17.9 Stocks and Bonds as Options 547

The Firm Expressed in Terms of Call Options 548

The Stockholders 548 The Bondholders 549

The Firm Expressed in Terms of Put Options 550

The Stockholders 550 The Bondholders 550

A Resolution of the Two Views 550

A Note on Loan Guarantees 552

17.10 Options and Corporate Decisions: Some

Applications 552

Mergers and Diversifi cation 553

Options and Capital Budgeting 554

17.11 Investment in Real Projects and Options 556

Summary and Conclusions 558

Closing Case: Exotic Cuisines Employee Stock

Options 567

CHAPTER EIGHTEEN

Short-Term Finance and Planning 568

18.1 Tracing Cash and Net Working Capital 569

18.2 The Operating Cycle and the Cash Cycle 570

Defi ning the Operating and Cash Cycles 571

The Operating Cycle 571 The Cash Cycle 571

The Operating Cycle and the Firm’s Organization Chart 573

Calculating the Operating and Cash Cycles 574

The Operating Cycle 574 The Cash Cycle 575

Interpreting the Cash Cycle 576

18.3 Some Aspects of Short-Term Financial Policy 577

The Size of the Firm’s Investment in Current Assets 577

Alternative Financing Policies for Current Assets 578

An Ideal Case 578 Different Policies for Financing Current Assets 580

Which Financing Policy Is Best? 582

Current Assets and Liabilities in Practice 583

18.4 The Cash Budget 583

Sales and Cash Collections 583

Cash Outfl ows 584

The Cash Balance 585

18.5 Short-Term Borrowing 585

Unsecured Loans 586

Compensating Balances 586 Cost of a Compensating Balance 586 Letters of Credit 587

19.1 The Financing Life Cycle of a Firm: Early-Stage Financing and Venture Capital 602

Venture Capital 602 Some Venture Capital Realities 603 Choosing a Venture Capitalist 603 Conclusion 603

19.2 Selling Securities to the Public: The Basic Procedure 603

19.3 Alternative Issue Methods 606 19.4 Underwriters 607

Choosing an Underwriter 607 Types of Underwriting 607

Firm Commitment Underwriting 607 Best Efforts Underwriting 607 Dutch Auction Underwriting 608

The Green Shoe Provision 608 The Aftermarket 609

Lockup Agreements 609 The Quiet Period 609

19.5 IPOs and Underpricing 609

Evidence on Underpricing 610 IPO Underpricing: The 1999–2000 Experience 611 Why Does Underpricing Exist? 614

19.6 What CFOs Say about the IPO Process 616 19.7 CEOs and the Value of the Firm 617 19.8 The Cost of Issuing Securities 618 19.9 Rights 622

The Mechanics of a Rights Offering 622 Subscription Price 623

Number of Rights Needed to Purchase a Share 623 Effect of Rights Offering on Price of Stock 623 Effects on Shareholders 625

The Underwriting Arrangements 625 The Rights Puzzle 626

19.10 Dilution 626

Dilution of Proportionate Ownership 626 Dilution of Value: Book versus Market Values 626

A Misconception 627 The Correct Arguments 628

19.11 Issuing Long-Term Debt 628

19.12 Shelf Registration 629

Summary and Conclusions 630

Closing Case: East Coast Yachts Goes Public 634

20.3 Purchasing Power Parity 643

Absolute Purchasing Power Parity 643 Relative Purchasing Power Parity 645

The Basic Idea 645 The Result 645 Currency Appreciation and Depreciation 647 20.4 Interest Rate Parity, Unbiased Forward Rates, and the

International Fisher Effect 647

Covered Interest Arbitrage 647 Interest Rate Parity 648 Forward Rates and Future Spot Rates 649 Putting It All Together 650

Uncovered Interest Parity 650 The International Fisher Effect 650 20.5 International Capital Budgeting 651

Method 1: The Home Currency Approach 652 Method 2: The Foreign Currency Approach 652 Unremitted Cash Flows 653

20.6 Exchange Rate Risk 653

Short-Run Exposure 653 Long-Run Exposure 654 Translation Exposure 655 Managing Exchange Rate Risk 656

20.7 Political Risk 656 Summary and Conclusions 657

Closing Case: East Coast Yachts Goes International 662

CHAPTER TWENTY ONE Mergers and Acquisitions (Web only)

APPENDIX A Mathematical Tables 663 APPENDIX B

Solutions to Selected End-of-Chapter Problems 672

APPENDIX C Using the HP 10B and TI BA II Plus Financial Calculators 677

NAME INDEX 681 COMPANY INDEX 683 SUBJECT INDEX 685

THE REAL WORLD BOXES CHAPTER 1 Sarbanes-Oxley 16

CHAPTER 2 Putting a Spin on Cash Flows 32

CHAPTER 3 What’s in a Ratio? 60

CHAPTER 5 Beauty Is in the Eye of the Bondholder 150

CHAPTER 6 How Fast Is Too Fast? 176

The Wild, Wild West of Stock Trading 190

CHAPTER 9 When Things Go Wrong 270

CHAPTER 11 Beta, Beta, Who’s Got the Beta? 348

CHAPTER 12 The Cost of Capital, Texas Style 382

CHAPTER 13 Can Stock Market Investors Add and Subtract? 412

CHAPTER 16 Stock Buybacks: No End in Sight 504

CHAPTER 18 A Look at Operating and Cash Cycles 572

CHAPTER 19 IPO Underpricing around the World 612

Anatomy of an IPO 620

In 2008 and 2009, the U.S government set up the $700 billion Troubled Asset Relief Program

(TARP) to help companies avoid bankruptcy due to the severe financial turmoil The loans to companies such as Bank of America and General Motors created unique governance prob- lems One such that received special attention was executive compensation In June 2009, Kenneth Feinberg was appointed as a Special Master for Compensation (better known as the “ Pay Czar ” ) and given broad powers over executive compensation for firms participating in the

TARP program

In October 2009, Mr Feinberg capped the salaries at the seven largest TARP companies at

$500,000 This group ’ s annualized total pay would be 50 percent lower than a year before through

reduced bonuses and options Interestingly, 80 of the 136 employees affected actually had their base

salaries increased, including an average base salary increase of about 87 percent at Citigroup

Some outside experts argued that the pay cuts were overstated Many employees continued to receive seven-figure pay packages, including one who received $9.9 million Of the 136 employees

whose paychecks were reviewed, 29 were on track to collect total 2009 pay of at least $5 million The

discrepancy arose because the pay cut calculation depended in part on departures of certain highly

paid employees from the previous year

The Pay Czar ’ s role in setting compensation limits is an unusual case in the U.S of direct ment involvement in corporate decisions Understanding how a corporation sets executive pay, and

govern-the role of shareholders in that process, takes us into issues involving govern-the corporate form of

organiza-tion, corporate goals, and corporate control, all of which we cover in this chapter

1 1 W H AT I S C O R P O R AT E F I N A N C E ?

Suppose you decide to start a fi rm to make tennis balls To do this you hire managers

to buy raw materials, and you assemble a workforce that will produce and sell fi nished

tennis balls In the language of fi nance, you make an investment in assets such as inventory,

machinery, land, and labor The amount of cash you invest in assets must be matched by an

equal amount of cash raised by fi nancing When you begin to sell tennis balls, your fi rm

will generate cash This is the basis of value creation The purpose of the fi rm is to create value for you, the owner The value is refl ected in the framework of the simple balance sheet model of the fi rm

The Balance Sheet Model of the Firm

Suppose we take a fi nancial snapshot of the fi rm and its activities at a single point in time

Figure 1.1 shows a graphic conceptualization of the balance sheet, and it will help duce you to corporate fi nance

The assets of the fi rm are on the left side of the balance sheet These assets can be

thought of as current and fi xed Fixed assets are those that will last a long time, such as

buildings Some fi xed assets are tangible, such as machinery and equipment Other fi xed

assets are intangible, such as patents and trademarks The other category of assets, current assets , comprises those that have short lives, such as inventory The tennis balls that your

fi rm has made, but has not yet sold, are part of its inventory Unless you have overproduced, they will leave the fi rm shortly

Before a company can invest in an asset, it must obtain fi nancing, which means that it must raise the money to pay for the investment The forms of fi nancing are represented

on the right side of the balance sheet A fi rm will issue (sell) pieces of paper called debt (loan agreements) or equity shares (stock certifi cates) Just as assets are classifi ed as long- lived or short-lived, so too are liabilities A short-term debt is called a current liability

Short-term debt represents loans and other obligations that must be repaid within one year

Long-term debt is debt that does not have to be repaid within one year Shareholders’ equity represents the difference between the value of the assets and the debt of the fi rm In this sense, it is a residual claim on the fi rm’s assets

From the balance sheet model of the fi rm, it is easy to see why fi nance can be thought of

as the study of the following three questions:

1 In what long-lived assets should the fi rm invest? This question concerns the left side

of the balance sheet Of course the types and proportions of assets the fi rm needs tend to be set by the nature of the business We use the term capital budgeting to describe the process of making and managing expenditures on long-lived assets

F I G U R E 1 1

The Balance Sheet

Model of the Firm

Long-term debt

Current assets

Fixed assets

1 Tangible fixed assets

2 Intangible fixed assets

Net working capital

Current liabilities

Shareholders’

equity

Total Value of Assets = Total Value of the Firm to Investors

2 How can the fi rm raise cash for required capital expenditures? This question concerns the right side of the balance sheet The answer to this question involves the fi rm’s capital structure , which represents the proportions of the fi rm’s

fi nancing from current liabilities, long-term debt, and equity

3 How should short-term operating cash fl ows be managed? This question concerns the upper portion of the balance sheet There is often a mismatch between the timing of cash infl ows and cash outfl ows during operating activities Furthermore, the amount and timing of operating cash fl ows are not known with certainty Financial manag-ers must attempt to manage the gaps in cash fl ow From a balance sheet perspective, short-term management of cash fl ow is associated with a fi rm’s net working capital Net working capital is defi ned as current assets minus current liabilities From a

fi nancial perspective, short-term cash fl ow problems come from the mismatching

of cash infl ows and outfl ows This is the subject of short-term fi nance

The Financial Manager

In large fi rms, the fi nance activity is usually associated with a top offi cer of the fi rm,

such as the vice president and chief fi nancial offi cer, and some lesser offi cers Figure 1.2

Financial Accounting Manager

Financial Planning

Capital Expenditures

F I G U R E 1 2

Hypothetical Organization Chart

depicts a general organizational structure emphasizing the fi nance activity within the fi rm

Reporting to the chief fi nancial offi cer are the treasurer and the controller The treasurer is responsible for handling cash fl ows, managing capital expenditure decisions, and making

fi nancial plans The controller handles the accounting function, which includes taxes, cost and fi nancial accounting, and information systems

1 2 T H E C O R P O R AT E F I R M

The fi rm is a way of organizing the economic activity of many individuals A basic problem

of the fi rm is how to raise cash The corporate form of business—that is, organizing the

fi rm as a corporation—is the standard method for solving problems encountered in ing large amounts of cash However, businesses can take other forms In this section we consider the three basic legal forms of organizing fi rms, and we see how fi rms go about the task of raising large amounts of money under each form

The Sole Proprietorship

A sole proprietorship is a business owned by one person Suppose you decide to start a business to produce mousetraps Going into business is simple: You announce to all who will listen, “Today, I am going to build a better mousetrap.”

Most large cities require that you obtain a business license Afterward, you can begin to hire as many people as you need and borrow whatever money you need At year-end all the profi ts and the losses will be yours

Here are some factors that are important in considering a sole proprietorship:

1 The sole proprietorship is the cheapest business to form No formal charter is required, and few government regulations must be satisfi ed for most industries

2 A sole proprietorship pays no corporate income taxes All profi ts of the business are taxed as individual income

3 The sole proprietorship has unlimited liability for business debts and obligations

No distinction is made between personal and business assets

4 The life of the sole proprietorship is limited by the life of the sole proprietor

5 Because the only money invested in the fi rm is the proprietor’s, the equity money that can be raised by the sole proprietor is limited to the proprietor’spersonal wealth

The Partnership

Any two or more people can get together and form a partnership Partnerships fall into two categories: (1) general partnerships and (2) limited partnerships

In a general partnership all partners agree to provide some fraction of the work and

cash and to share the profi ts and losses Each partner is liable for all of the debts of the partnership A partnership agreement specifi es the nature of the arrangement The partnership agreement may be an oral agreement or a formal document setting forth the understanding

Limited partnerships permit the liability of some of the partners to be limited to the

amount of cash each has contributed to the partnership Limited partnerships usually require that (1) at least one partner be a general partner and (2) the limited partners do not participate in managing the business Here are some things that are important when considering a partnership:

1 Partnerships are usually inexpensive and easy to form Written documents are required in complicated arrangements Business licenses and fi ling fees may

be necessary

For current issues

facing CFOs, see

2 General partners have unlimited liability for all debts The liability of limited partners is usually limited to the contribution each has made to the partnership

If one general partner is unable to meet his or her commitment, the shortfall must be made up by the other general partners

3 The general partnership is terminated when a general partner dies or withdraws (but this is not so for a limited partner) It is diffi cult for a partnership to transfer ownership without dissolving Usually all general partners must agree However, limited partners may sell their interest in a business

4 It is diffi cult for a partnership to raise large amounts of cash Equity contributions are usually limited to a partner’s ability and desire to contribute to the partner-ship Many companies, such as Apple Computer, start life as a proprietorship or partnership, but at some point they choose to convert to corporate form

5 Income from a partnership is taxed as personal income to the partners

6 Management control resides with the general partners Usually a majority vote is required on important matters, such as the amount of profi t to be retained in the business

It is diffi cult for large business organizations to exist as sole proprietorships or ships The main advantage to a sole proprietorship or partnership is the cost of getting

partner-started Afterward, the disadvantages, which may become severe, are (1) unlimited liability,

(2) limited life of the enterprise, and (3) diffi culty of transferring ownership These three

disadvantages lead to (4) diffi culty in raising cash

The Corporation

Of the forms of business enterprises, the corporation is by far the most important It is a

distinct legal entity As such, a corporation can have a name and enjoy many of the legal

powers of natural persons For example, corporations can acquire and exchange property

Corporations can enter contracts and may sue and be sued For jurisdictional purposes the

corporation is a citizen of its state of incorporation (it cannot vote, however)

Starting a corporation is more complicated than starting a proprietorship or partnership

The incorporators must prepare articles of incorporation and a set of bylaws The articles

of incorporation must include the following:

1 Name of the corporation

2 Intended life of the corporation (it may be forever)

3 Business purpose

4 Number of shares of stock that the corporation is authorized to issue, with a statement of limitations and rights of different classes of shares

5 Nature of the rights granted to shareholders

6 Number of members of the initial board of directors

The bylaws are the rules to be used by the corporation to regulate its own existence,

and they concern its shareholders, directors, and offi cers Bylaws range from the

brief-est possible statement of rules for the corporation’s management to hundreds of pages

of text

In its simplest form, the corporation comprises three sets of distinct interests: the holders (the owners), the directors, and the corporation offi cers (the top management)

Traditionally, the shareholders control the corporation’s direction, policies, and activities

The shareholders elect a board of directors, who in turn select top management Members

of top management serve as corporate offi cers and manage the operations of the corporation

in the best interest of the shareholders In closely held corporations with few shareholders,