Corporate Finance: The Core, Fourth Edition
By Jonathan Berk and Peter Demarzo
Detailed Contents:
1 INTRODUCTION
Chapter 1 T he Corporation 34
1.1 T he Four Types of Firms 35
Sole Proprietorships 35
Partnerships 36
Limited Liability Companies 37
Corporations 37
Tax Implications for Corporate Entities 38
■■ Corporate Taxation Around the World 39
1.2 O wnership Versus Control of Corporations 39
The Corporate Management Team 39
■■ Interview with David Viniar 40
The Financial Manager 41
■■ GLOBAL FINANCIAL CRISIS
The Dodd-Frank Act 42
The Goal of the Firm 42
The Firm and Society 43
Ethics and Incentives within Corporations 43
■■ GLOBAL FINANCIAL CRISIS The Dodd-Frank Act on Corporate Compensation and Governance 44
■■ Citizens United v. Federal Election Commission 44
■■ Airlines in Bankruptcy 46
1.3 T he Stock Market 46
Primary and Secondary Stock Markets 47
Traditional Trading Venues 47
■■ INTERVIEW with Frank Hatheway 48
New Competition and Market Changes 49
Dark Pools 50
MyFinanceLab 51 n Key Terms 51 n Further Reading 52 n Problems 52
Chapter 2 I ntroduction to Financial
Statement Analysis 55
2.1 Firms’ Disclosure of Financial Information 56
Preparation of Financial Statements 56
■■ International Financial Reporting Standards 56
■■ INTERVIEW with Ruth Porat 57
Types of Financial Statements 58
2.2 T he Balance Sheet 58
Assets 59
Liabilities 60
Stockholders’ Equity 61
Market Value Versus Book Value 61
Enterprise Value 62
2.3 T he Income Statement 62
Earnings Calculations 63
2.4 T he Statement of Cash Flows 64
Operating Activity 65
Investment Activity 66
Financing Activity 66
2.5 O ther Financial Statement
Information 67
Statement of Stockholders’ Equity 67
Management Discussion and
Analysis 68
Notes to the Financial
Statements 68
2.6 Financial Statement Analysis 69
Profitability Ratios 69
Liquidity Ratios 70
Working Capital Ratios 71
Interest Coverage Ratios 72
Leverage Ratios 73
Valuation Ratios 75
■■ COMMON MISTAKE
Mismatched Ratios 75
Operating Returns 76
The DuPont Identity 78
2.7 Financial Reporting in Practice 80
Enron 80
WorldCom 80
Sarbanes-Oxley Act 81
■■ GLOBAL FINANCIAL CRISIS
Bernard Madoff’s Ponzi Scheme 82
Dodd-Frank Act 82
MyFinanceLab 83 n Key Terms 84 n
Further Reading 85 n Problems 85 n
Data Case 92
Chapter 3 Financial Decision Making
and the Law of One Price 93
3.1 Valuing Decisions 94
Analyzing Costs and Benefits 94
Using Market Prices to Determine Cash
Values 95
■■ When Competitive Market Prices
Are Not Available 97
3.2 I nterest Rates and the Time Value
of Money 97
The Time Value of Money 97
The Interest Rate: An Exchange Rate
Across Time 97
3.3 P resent Value and the NPV Decision Rule 100
Net Present Value 100
The NPV Decision Rule 101
NPV and Cash Needs 103
3.4 A rbitrage and the Law of One Price 104
Arbitrage 104
Law of One Price 105
3.5 N o-Arbitrage and Security Prices 105
Valuing a Security with the Law of One Price 105
■■ An Old Joke 109
The NPV of Trading Securities
and Firm Decision Making 109
Valuing a Portfolio 110
■■ GLOBAL FINANCIAL CRISIS
Liquidity and the Informational Role of Prices 111
■■ Arbitrage in Markets 112
Where Do We Go from Here? 113
MyFinanceLab 114 n Key Terms 115 n
Further Reading 115 n Problems 115
A ppendix T he Price of Risk 119
Risky Versus Risk-Free Cash Flows 119
Arbitrage with Transactions Costs 124
PART 2 TI ME, MONEY, AND INTERESTRATE S
Chapter 4 T he Time Value of Money 130
4.1 T he Timeline 131
4.2 T he Three Rules of Time Travel 132
Rule 1: Comparing and Combining
Values 132
Rule 2: Moving Cash Flows Forward in Time 133
Rule 3: Moving Cash Flows Back in Time 134
■■ Rule of 72 135
Applying the Rules of Time Travel 136
4.3 Valuing a Stream of Cash Flows 138
4.4 Calculating the Net Present Value 141
■■ USING EXCEL Calculating Present Values in Excel 142
4.5 P erpetuities and Annuities 143 Perpetuities 143
■■ Historical Examples of Perpetuities 144
■■ COMMON MISTAKE Discounting One
Too Many Times 146
Annuities 146
■■ Formula for an Annuity Due 149
Growing Cash Flows 149
4.6 Using an Annuity Spreadsheet or Calculator 154
4.7 N on-Annual Cash Flows 156
4.8 Solving for the Cash Payments 157
4.9 T he Internal Rate of Return 160
■■ USING EXCEL Excel’s IRR Function 163
MyFinanceLab 164 n Key Terms 165 n
Further Reading 166 n Problems 166 n Data Case 172
A ppendix Solving for the Number of Periods 173
Chapter 5 I nterest Rates 175
5.1 I nterest Rate Quotes and Adjustments 176
The Effective Annual Rate 176
■■ COMMON MISTAKE Using the Wrong Discount Rate in the Annuity Formula 177
Annual Percentage Rates 178
5.2 Application: Discount Rates and Loans 180
5.3 The Determinants of Interest Rates 181
■■ GLOBAL FINANCIAL CRISIS Teaser Rates and Subprime Loans 182
Inflation and Real Versus Nominal Rates 182
Investment and Interest Rate Policy 183
The Yield Curve and Discount Rates 184
The Yield Curve and the Economy 186
■■ COMMON MISTAKE Using the Annuity Formula When Discount Rates Vary by Maturity 186
■■ INTERVIEW with Kevin M. Warsh 188
5.4 Risk and Taxes 189
Risk and Interest Rates 190
After-Tax Interest Rates 191
5.5 The Opportunity Cost of Capital 192
■■ COMMON MISTAKE States Dig
a $3 Trillion Hole by Discounting at the Wrong Rate 193
My Finance Lab 194 n Key Terms 195 n Further Reading 195 n Problems 195 n Data Case 200
appendix Continuous Rates and Cash Flows 202
Discount Rates for a Continuously Compounded APR 202
Continuously Arriving Cash Flows 202
Chapter 6 Valuing Bonds 205
6.1 Bond Cash Flows, Prices,
and Yields 206
Bond Terminology 206
Zero-Coupon Bonds 206
■■ GLOBAL FINANCIAL CRISIS
Negative Bond Yields 208
Coupon Bonds 209
6.2 Dynamic Behavior of Bond Prices 211
Discounts and Premiums 211
Time and Bond Prices 212
Interest Rate Changes and Bond Prices 214
■■ Clean and Dirty Prices for Coupon Bonds 215
6.3 The Yield Curve and Bond Arbitrage 217
Replicating a Coupon Bond 217
Valuing a Coupon Bond Using
Zero-Coupon Yields 218
Coupon Bond Yields 219
Treasury Yield Curves 220
6.4 Corporate Bonds 220
Corporate Bond Yields 221
■■ Are Treasuries Really Default-Free Securities? 221
Bond Ratings 223
Corporate Yield Curves 224
6.5 Sovereign Bonds 224
■■ GLOBAL FINANCIAL CRISIS The Credit Crisis and Bond Yields 225
■■ GLOBAL FINANCIAL CRISIS European Sovereign Debt Yields: A Puzzle 227
■■ INTERVIEW with Carmen M. Reinhart 228
My Finance Lab 229 n Key Terms 230 n
Further Reading 231 n Problems 231 n
Data Case 235 n Case Study 236
A ppendix Forward Interest Rates 238
Computing Forward Rates 238
Computing Bond Yields from Forward
Rates 239
PART 3 VALUING PROJECTS AND FIRMS
Chapter 7 investment Decision Rules 244
7.1 NP V and Stand-Alone Projects 245
Applying the NPV Rule 245
The NPV Profile and IRR 245
Alternative Rules Versus the NPV Rule 246
■■ INTERVIEW with Dick Grannis 247
7.2 The Internal Rate of Return Rule 248
Applying the IRR Rule 248
Pitfall #1: Delayed Investments 248
Pitfall #2: Multiple IRRs 249
■■ COMMON MISTAKE
IRR Versus the IRR Rule 251
Pitfall #3: Nonexistent IRR 251
7.3 The Payback Rule 252
Applying the Payback Rule 252
Payback Rule Pitfalls in Practice 253
■■ Why Do Rules Other Than the NPV
Rule Persist? 254
7.4 Choosing Between Projects 254
NPV Rule and Mutually Exclusive
Investments 254
IRR Rule and Mutually Exclusive Investments 255
The Incremental IRR 256
■■ When Can Returns Be Compared? 257
■■ COMMON MISTAKE
IRR and Project Financing 259
7.5 Project Selection with Resource Constraints 259
Evaluating Projects with Different Resource Requirements 259
Profitability Index 260
Shortcomings of the Profitability Index 262
My Finance Lab 262 n Key Terms 263 n
Further Reading 263 n Problems 263 n Data Case 269
Appendix Computing the NPV Profile Using
Excel’s Data Table Function 270
Chapter 8 Fundamentals of Capital Budgeting 271
8.1 Forecasting Earnings 272
Revenue and Cost Estimates 272
Incremental Earnings Forecast 273
Indirect Effects on Incremental Earnings 275
■■ COMMON MISTAKE The Opportunity
Cost of an Idle Asset 276
Sunk Costs and Incremental Earnings 277
■■ COMMON MISTAKE
The Sunk Cost Fallacy 277
Real-World Complexities 278
8.2 Determining Free Cash Flow and NPV 279
Calculating Free Cash Flow from Earnings 279
Calculating Free Cash Flow Directly 281
Calculating the NPV 282
■■ USING EXCEL Capital Budgeting
Using a Spreadsheet Program 283
8.3 Choosing Among Alternatives 284
Evaluating Manufacturing Alternatives 284
Comparing Free Cash Flows for Cisco’s Alternatives 285
8.4 Further Adjustments to Free Cash Flow 286
■■ GLOBAL FINANCIAL CRISIS
The American Recovery and Reinvestment Act of 2009 290
8.5 Analyzing the Project 290
Break-Even Analysis 290
Sensitivity Analysis 291
■■ INTERVIEW with
David Holland 293
Scenario Analysis 294
■■ USING EXCEL Project Analysis Using Excel 295
My Finance Lab 296 n Key Terms 298 n
Further Reading 298 n Problems 298 n Data Case 305
Appendix MACRS Depreciation 307
Chapter 9 Valuing Stocks 309
9.1 The Dividend-Discount Model 310
A One-Year Investor 310
Dividend Yields, Capital Gains, and Total Returns 311
■■ The Mechanics of a Short Sale 312
A Multiyear Investor 313
The Dividend-Discount Model Equation 314
9.2 Applying the Dividend-Discount Model 314
Constant Dividend Growth 314
Dividends Versus Investment
and Growth 315
■■ John Burr Williams’ Theory
of Investment Value 316
Changing Growth Rates 318
Limitations of the Dividend-Discount Model 320
9.3 Total Payout and Free Cash Flow
Valuation Models 320
Share Repurchases and the Total Payout Model 320
The Discounted Free Cash Flow Model 322
9.4 Valuation Based on Comparable Firms 326
Valuation Multiples 326
Limitations of Multiples 328
Comparison with Discounted Cash Flow
Methods 329
Stock Valuation Techniques: The Final Word 330
■■ INTERVIEW with Douglas Kehring 331
9.5 I nformation, Competition, and Stock Prices 332
Information in Stock Prices 332
Competition and Efficient Markets 333
Lessons for Investors and Corporate
Managers 335
■■ Kenneth Cole Productions—What Happened? 337
The Efficient Markets Hypothesis Versus
No Arbitrage 338
My Finance Lab 338 n Key Terms 340 n
Further Reading 340 n Problems 341 n
Data Case 346
4 RISK AND RETURN
Chapter 10 Capital Markets and the Pricing of Risk 350
10.1 Risk and Return: Insights from 89 Years of Investor History 351
10.2 Common Measures of Risk
and Return 354
Probability Distributions 354
Expected Return 354
Variance and Standard Deviation 355
10.3 Historical Returns of Stocks and Bonds 357
Computing Historical Returns 357
Average Annual Returns 359
The Variance and Volatility of
Returns 361
Estimation Error: Using Past Returns
to Predict the Future 362
■■ Arithmetic Average Returns Versus
Compound Annual Returns 364
10.4 T he Historical Trade-Off Between Risk and Return 364
The Returns of Large Portfolios 365
The Returns of Individual Stocks 366
10.5 Common Versus Independent Risk 367
Theft Versus Earthquake Insurance:
An Example 367
The Role of Diversification 368
10.6 Diversification in Stock Portfolios 369
Firm-Specific Versus Systematic Risk 370
No Arbitrage and the Risk Premium 371
■■ GLOBAL FINANCIAL CRISIS
Diversification Benefits During
Market Crashes 373
■■ COMMON MISTAKE A Fallacy
of Long-Run Diversification 374
10.7 Measuring Systematic Risk 375
Identifying Systematic Risk: The Market
Portfolio 375
Sensitivity to Systematic Risk: Beta 375
10.8 Beta and the Cost of Capital 378
Estimating the Risk Premium 378
■■ COMMON MISTAKE
Beta Versus Volatility 378
The Capital Asset Pricing Model 380
MyFinanceLab 380 n Key Terms 382 n
Further Reading 382 n Problems 382 n
Data Case 387
Chapter 11 O ptimal Portfolio Choice
and the Capital Asset Pricing
Model 389
11.1 T he Expected Return of a Portfolio 390
11.2 T he Volatility of a Two-Stock Portfolio 391
Combining Risks 391
Determining Covariance
and Correlation 392
■■ COMMON MISTAKE
Computing Variance, Covariance,
and Correlation in Excel 394
Computing a Portfolio’s Variance
and Volatility 395
11.3 T he Volatility of a Large Portfolio 397
Large Portfolio Variance 397
Diversification with an Equally Weighted
Portfolio 398
■■ INTERVIEW with John Powers 400
Diversification with General
Portfolios 401
11.4 R isk Versus Return: Choosing an Efficient Portfolio 401
Efficient Portfolios with Two Stocks 402
The Effect of Correlation 404
Short Sales 405
Efficient Portfolios with Many
Stocks 406
■■ NOBEL PRIZES Harry Markowitz
and James Tobin 407
11.5 R isk-Free Saving and Borrowing 409
Investing in Risk-Free Securities 409
Borrowing and Buying Stocks
on Margin 410
Identifying the Tangent Portfolio 411
11.6 T he Efficient Portfolio and Required
Returns 413
Portfolio Improvement: Beta
and the Required Return 413
Expected Returns and the Efficient
Portfolio 415
11.7 T he Capital Asset Pricing Model 417
The CAPM Assumptions 417
Supply, Demand, and the Efficiency
of the Market Portfolio 418
Optimal Investing: The Capital
Market Line 418
11.8 Determining the Risk Premium 419
Market Risk and Beta 419
■■ NOBEL PRIZE William Sharpe
on the CAPM 421
The Security Market Line 422
Beta of a Portfolio 422
Summary of the Capital Asset
Pricing Model 424
MyFinanceLab 424 n Key Terms 427 n
Further Reading 427 n Problems 428 n
Data Case 434
A ppendix The CAPM with Differing
Interest Rates 436
The Efficient Frontier with Differing Saving
and Borrowing Rates 436
The Security Market Line with Differing
Interest Rates 436
Chapter 12 E stimating the Cost
of Capital 439
12.1 T he Equity Cost of Capital 440
12.2 T he Market Portfolio 441
Constructing the Market Portfolio 441
Market Indexes 441
■■ Value-Weighted Portfolios and
Rebalancing 442
The Market Risk Premium 443
12.3 Beta Estimation 445
Using Historical Returns 445
Identifying the Best-Fitting Line 447
Using Linear Regression 448
■■ Why Not Estimate Expected Returns
Directly? 449
12.4 T he Debt Cost of Capital 449
Debt Yields Versus Returns 449
■■ COMMON MISTAKE Using the Debt
Yield as Its Cost of Capital 450
Debt Betas 451
12.5 A Project’s Cost of Capital 452
All-Equity Comparables 452
Levered Firms as Comparables 453
The Unlevered Cost of Capital 453
Industry Asset Betas 455
12.6 P roject Risk Characteristics
and Financing 457
Differences in Project Risk 457
■■ COMMON MISTAKE Adjusting
for Execution Risk 459
Financing and the Weighted Average Cost
of Capital 459
■■ INTERVIEW with Shelagh Glaser 460
■■ COMMON MISTAKE
Using a Single Cost of Capital
in Multi-Divisional Firms 461
12.7 Final Thoughts on Using
the CAPM 462
MyFinanceLab 463 n Key Terms 465 n
Further Reading 465 n Problems 466 n
Data Case 470
A ppendix Practical Considerations When
Forecasting
Beta 471
Time Horizon 471
The Market Proxy 471
Beta Variation and Extrapolation 471
Outliers 472
■■ COMMON MISTAKE Changing
the Index to Improve the Fit 473
■■ USING EXCEL Estimating Beta
Using Excel 474
Other Considerations 475
Chapter 13 I nvestor Behavior and Capital
Market Efficiency 477
13.1 Competition and Capital
Markets 478
Identifying a Stock’s Alpha 478
Profiting from Non-Zero Alpha
Stocks 479
13.2 Information and Rational Expectations 480
Informed Versus Uninformed Investors 480
Rational Expectations 481
13.3 T he Behavior of Individual
Investors 482
Underdiversification and Portfolio Biases 482
Excessive Trading and Overconfidence 483
Individual Behavior and Market Prices 485
13.4 Systematic Trading Biases 485
Hanging on to Losers and the
Disposition Effect 485
■■ NOBEL PRIZE Kahneman and
Tversky’s
Prospect Theory 486
Investor Attention, Mood,
and Experience 486
Herd Behavior 487
Implications of Behavioral
Biases 487
13.5 T he Efficiency of the Market
P
ortfolio 488
Trading on News or
Recommendations
488
■■ NOBEL PRIZE The 2013 Prize:
An Enigma? 490
The Performance of Fund
Managers 490
The Winners and Losers 493
13.6 Style-Based Techniques and the Market
Efficiency Debate 494
Size Effects 494
■■ INTERVIEW with
Jonathan Clements 496
Momentum 498
■■ Market Efficiency and the Efficiency
of the Market Portfolio 499
Implications of Positive-Alpha Trading
Strategies 499
13.7 Multifactor Models of Risk 501
Using Factor Portfolios 502
Selecting the Portfolios 503
The Cost of Capital with Fama-French-
Carhart Factor Specification 504
13.8 Methods Used in Practice 506
Financial Managers 506
Investors 507
MyFinanceLab 508 n Key Terms 510 n
Further Reading 510 n Problems 511
A ppendix Building a Multifactor Model 517
PART 5 CAPITA L STRUCTURE Chapter 14 Capital Structure in a Perfect
Market 520
14.1 E quity Versus Debt Financing 521
Financing a Firm with Equity 521
Financing a Firm with Debt
and Equity 522
The Effect of Leverage on Risk
and Return 523
14.2 Modigliani-Miller I: Leverage, Arbitrage,
and Firm Value 525
MM and the Law of One Price 525
Homemade Leverage 525
■■ MM and the Real World 526
The Market Value Balance Sheet 527
Application: A Leveraged
Recapitalization
528
14.3 Modigliani-Miller II: Leverage, Risk,
and the Cost of Capital 530
Leverage and the Equity Cost
of Capital 530
Capital Budgeting and the Weighted
Average
Cost of Capital 531
■■ COMMON MISTAKE
Is Debt Better Than Equity? 534
Computing the WACC with Multiple
Securities
534
Levered and Unlevered Betas 534
■■ NOBEL PRIZE Franco Modigliani
and Merton Miller 536
14.4 Capital Structure Fallacies 537
Leverage and Earnings per Share 537
■■ GLOBAL FINANCIAL CRISIS
Bank Capital Regulation and
the ROE Fallacy 539
Equity Issuances and Dilution 540
14.5 MM: Beyond the Propositions 541
MyFinanceLab 542 n Key Terms 543 n
Further Reading 543 n Problems 544 n
Data Case 548
Chapter 15 Debt and Taxes 551
15.1 T he Interest Tax Deduction 552
15.2 Valuing the Interest Tax Shield 554
The Interest Tax Shield and Firm
Value
554
■■ Pizza and Taxes 555
The Interest Tax Shield with Permanent
Debt 555
The Weighted Average Cost of Capital
with Taxes 556
■■ The Repatriation Tax: Why Some
Cash-
Rich Firms Borrow 557
The Interest Tax Shield with a Target Debt-
Equity Ratio 558
15.3 R ecapitalizing to Capture the Tax
Shield 560
The Tax Benefit 560
The Share Repurchase 561
No Arbitrage Pricing 561
Analyzing the Recap: The Market Value
Balance Sheet 562
15.4 P ersonal Taxes 563
Including Personal Taxes in the Interest
Tax Shield 563
Valuing the Interest Tax Shield
with Personal Taxes 566
Determining the Actual Tax Advantage
of Debt 567
■■ Cutting the Dividend Tax Rate 567
15.5 O ptimal Capital Structure
with T
axes 568
Do Firms Prefer Debt? 568
Limits to the Tax Benefit of Debt 571
■■ INTERVIEW with
Andrew Balson 572
Growth and Debt 573
Other Tax Shields 574
The Low Leverage Puzzle 574
■■ Employee Stock Options 576
MyFinanceLab 576 n Key Terms 577 n
Further Reading 577 n Problems 578 n
Data Case 582
Chapter 16 Financial Distress, Managerial
Incentives,
and Information
583
16.1 Default and Bankruptcy in a Perfect
Market 584
Armin Industries: Leverage and the Risk
of Default 584
Bankruptcy and Capital Structure 585
16.2 T he Costs of Bankruptcy and Financial
Distress 586
The Bankruptcy Code 587
Direct Costs of Bankruptcy 587
Indirect Costs of Financial
Distress 588
■■ GLOBAL FINANCIAL CRISIS
The Chrysler Prepack 591
16.3 Financial Distress Costs and Firm
Value 592
Armin Industries: The Impact of Financial
Distress Costs 592
Who Pays for Financial Distress
Costs? 592
16.4 O ptimal Capital Structure: The Trade-
Off Theory 594
The Present Value of Financial
Distress Costs 594
Optimal Leverage 595
16.5 E xploiting Debt Holders: The Agency
Costs of Leverage 597
Excessive Risk-Taking and Asset
Substitution
597
Debt Overhang and Under-Investment 598
■■ GLOBAL FINANCIAL CRISIS
Bailouts, Distress Costs, and Debt
Overhang 599
Agency Costs and the Value
of Leverage 600
The Leverage Ratchet Effect 601
Debt Maturity and Covenants 602
■■ Why Do Firms Go Bankrupt? 602
16.6 Motivating Managers: The Agency
Benefits
of Leverage 603
Concentration of Ownership 604
Reduction of Wasteful Investment 604
■■ Excessive Perks and Corporate
Scandals 605
■■ GLOBAL FINANCIAL CRISIS
Moral Hazard, Government Bailouts,
and the Appeal of Leverage 606
Leverage and Commitment 607
16.7 A gency Costs and the Trade-Off
Theory 607
The Optimal Debt Level 608
Debt Levels in Practice 609
16.8 A symmetric Information and Capital
Structure 609
Leverage as a Credible Signal 609
Issuing Equity and Adverse
Selection 611
■■ NOBEL PRIZE The 2001 Nobel Prize
in Economics 613
Implications for Equity Issuance 613
Implications for Capital Structure 614
16.9 Capital Structure: The Bottom Line 617
MyFinanceLab 618 n Key Terms 620 n
Further Reading 620 n Problems 620
Chapter 17 P ayout Policy 629
17.1 Distributions to Shareholders 630
Dividends 630
Share Repurchases 632
17.2 Comparison of Dividends and Share
Repurchases 633
Alternative Policy 1: Pay Dividend
with Excess Cash 633
Alternative Policy 2: Share Repurchase
(No Dividend) 634
■■ COMMON MISTAKE Repurchases
and the Supply of Shares 636
Alternative Policy 3: High Dividend
(Equity Issue) 636
Modigliani-Miller and Dividend Policy
Irrelevance 637
■■ COMMON MISTAKE The Bird
in the Hand Fallacy 638
Dividend Policy with Perfect Capital
Markets 638
17.3 T he Tax Disadvantage
of Dividends 638
Taxes on Dividends and Capital Gains 639
Optimal Dividend Policy
with Taxes 640
17.4 Dividend Capture and Tax
Clienteles 642
The Effective Dividend Tax Rate 642
Tax Differences Across Investors 643
Clientele Effects 644
INTERVIEW with
John Connors 645
17.5 P ayout Versus Retention of Cash 647
Retaining Cash with Perfect Capital Markets 648
Taxes and Cash Retention 649
Adjusting for Investor Taxes 650
Issuance and Distress Costs 651
Agency Costs of Retaining Cash 652
17.6 Signaling with Payout Policy 654
Dividend Smoothing 654
Dividend Signaling 655
Royal & SunAlliance’s
Dividend Cut 656
Signaling and Share Repurchases 656
17.7 Stock Dividends, Splits,
and Spin-Offs 658
Stock Dividends and Splits 658
Spin-Offs 660
Berkshire Hathaway’s
A & B Shares 661
MyFinanceLab 662 n Key Terms 663 n
Further Reading 664 n Problems 664 n
Data Case 668
PART 6 A DVANCED VALUATION
Chapter 18 Capital Budgeting and
Valuation with Leverage 672
18.1 O verview of Key Concepts 673
18.2 T he Weighted Average Cost
of Capital Method 674
INTERVIEW with Zane Rowe 675
Using the WACC to Value a Project 676
Summary of the WACC Method 677
Implementing a Constant Debt-Equity
Ratio 678
18.3 T he Adjusted Present Value Method 680
The Unlevered Value of the Project 680
Valuing the Interest Tax Shield 681
Summary of the APV Method 682
18.4 T he Flow-to-Equity Method 684
Calculating the Free Cash Flow
to Equity 684
Valuing Equity Cash Flows 685
What Counts as “Debt”? 686
Summary of the Flow-to-Equity
Method 686
18.5 P roject-Based Costs
of Capital 687
Estimating the Unlevered Cost
of Capital 688
Project Leverage and the Equity Cost
of Capital 688
Determining the Incremental Leverage
of a Project 690
COMMON MISTAKE
Re-Levering the WACC 690
18.6 AP V with Other Leverage
Policies 692
Constant Interest Coverage
Ratio 692
Predetermined Debt Levels 693
A Comparison of Methods 695
18.7 O ther Effects of Financing 695
Issuance and Other Financing
Costs 695
Security Mispricing 696
Financial Distress and Agency Costs 697
GLOBAL FINANCIAL CRISIS
Government Loan Guarantees 698
18.8 A dvanced Topics in Capital Budgeting 698
Periodically Adjusted Debt 699
Leverage and the Cost of Capital 701
The WACC or FTE Method with Changing Leverage 703
Personal Taxes 704
MyFinanceLab 706 n Key Terms 708 n
Further Reading 708 n Problems 709 n
Data Case 715
ppendix Foundations and Further Details 717
Deriving the WACC Method 717
The Levered and Unlevered Cost of
Capital 718
Solving for Leverage and Value
Simultaneously 719
The Residual Income and Economic Value
Added Valuation Methods 721
Chapter 19 Valuation and Financial
Modeling: A Case Study 723
19.1 Valuation Using Comparables 724
19.2 T he Business Plan 726
Operational Improvements 726
Capital Expenditures: A Needed Expansion 727
Working Capital Management 728
Capital Structure Changes: Levering Up 728
19.3 Building the Financial Model 729
Forecasting Earnings 729
INTERVIEW with
Joseph L. Rice, III 730
Working Capital Requirements 732
Forecasting Free Cash Flow 733
USING EXCEL
Summarizing Model Outputs 735
The Balance Sheet and Statement
of Cash Flows (Optional) 736
USING EXCEL
Auditing Your Financial Model 738
19.4 E stimating the Cost of Capital 739
CAPM-Based Estimation 739
Unlevering Beta 740
Ideko’s Unlevered Cost of Capital 740
19.5 Valuing the Investment 741
The Multiples Approach to Continuation Value 742
The Discounted Cash Flow Approach
to Continuation Value 743
COMMON MISTAKE Continuation
Values and Long-Run Growth 745
APV Valuation of Ideko’s Equity 745
A Reality Check 746
■■ COMMON MISTAKE
Missing Assets or Liabilities 746
IRR and Cash Multiples 747
19.6 Sensitivity Analysis 748
MyFinanceLab 749 n Key Terms 750 n
Further Reading 750 n Problems 751
A ppendix Compensating Management 753
Glossary 755
Index 775