Corporate Finance, Sixth Edition
By Jonathan Berk and Peter Demarzo
Detailed Contents:
PART 1 INTRODUCTION 33
Chapter 1 The Corporation and Financial
Markets 34
1.1 The 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 Ownership Versus Control of
Corporations 39
The Corporate Management Team 39
■ INTERVIEW with David Viniar 40
The Financial Manager 41
■ FINANCE IN TIMES OF DISRUPTION
The Dodd-Frank Act 42
The Goal of the Firm 42
The Firm and Society 42
Ethics and Incentives within Corporations 43
■ Shareholder versus Stakeholder Value 43
■ FINANCE IN TIMES OF DISRUPTION
The Dodd-Frank Act on Corporate Compensation 44
■ Citizens United v. Federal Election Commission 45
■ Airlines in Bankruptcy 46
1.3 The Stock Market 46
Primary and Secondary Stock Markets 47
Traditional Trading Venues 47
■ INTERVIEW with Adena T. Friedman 48
New Competition and Market Changes 49
Dark Pools 50
1.4 Fintech: Finance and Technology 51
Telecommunications 51
Security and Verification 51
Automation of Banking Services 52
Big Data and Machine Learning 52
Competition 53
Key Points and Equations 53 ■ Key
Terms 54 ■ Further Reading 55 ■
Problems 55
Chapter 2 Introduction to Financial
Statement Analysis 59
2.1 Firms’ Disclosure of Financial
Information 60
Preparation of Financial Statements 60
■ International Financial Reporting
Standards 60
■ INTERVIEW with Ruth Porat 61
Types of Financial Statements 62
2.2 The Balance Sheet 62
Assets 63
Liabilities 64
Stockholders’ Equity 65
Market Value Versus Book Value 65
Enterprise Value 66
2.3 The Income Statement 66
Earnings Calculations 67
2.4 The Statement of Cash Flows 68
Operating Activity 69
Investment Activity 70
Financing Activity 70
2.5 Other Financial Statement Information 71
Statement of Stockholders’ Equity 71
Management Discussion and Analysis 72
Notes to the Financial Statements 72
2.6 Financial Statement Analysis 73
Profitability Ratios 73
Liquidity Ratios 74
Working Capital Ratios 75
Interest Coverage Ratios 76
Leverage Ratios 77
Valuation Ratios 79
■ COMMON MISTAKE Mismatched Ratios 79
Operating Returns 80
The DuPont Identity 82
2.7 Financial Reporting in Practice 84
Enron 84
WorldCom 84
Sarbanes-Oxley Act 85
■ FINANCE IN TIMES OF DISRUPTION
Bernard Madoff’s Ponzi Scheme 86
Dodd-Frank Act 86
Foreign Regulation: Wirecard 86
Key Points and Equations 87 ■ Key
Terms 89 ■ Further Reading 90 ■
Problems 90 ■ Data Case 96
Chapter 3 Financial Decision Making and the
Law of One Price 99
3.1 Valuing Decisions 100
Analyzing Costs and Benefits 100
Using Market Prices to Determine Cash
Values 101
■ When Competitive Market Prices Are Not Available 103
3.2 Interest Rates and the Time Value of Money 103
The Time Value of Money 103
The Interest Rate: An Exchange Rate Across Time 103
3.3 Present Value and the NPV Decision Rule 106
Net Present Value 106
The NPV Decision Rule 107
NPV and Cash Needs 109
3.4 Arbitrage and the Law of One Price 110
Arbitrage 110
Law of One Price 111
3.5 No-Arbitrage and Security Prices 111
Valuing a Security with the Law of One Price 111
■ An Old Joke 115
The NPV of Trading Securities and Firm
Decision Making 115
Valuing a Portfolio 116
■ FINANCE IN TIMES OF DISRUPTION
Liquidity and the Informational Role of
Prices 117
■ Arbitrage in Markets 118
Where Do We Go from Here? 119
Key Points and Equations 120 ■ Key
Terms 121 ■ Further Reading 121 ■
Problems 121 ■ Data Case 125
Appendix The Price of Risk 126
Risky Versus Risk-Free Cash Flows 126
Arbitrage with Transactions Costs 131
PART 2 TIME, MONEY, AND
INTEREST RATES 135
Chapter 4 The Time Value of Money 136
4.1 The Timeline 137
4.2 The Three Rules of Time Travel 138
Rule 1: Comparing and Combining Values 138
Rule 2: Moving Cash Flows Forward in Time 139
Rule 3: Moving Cash Flows Back in Time 140
■ Rule of 72 141
Applying the Rules of Time Travel 142
4.3 Valuing a Stream of Cash Flows 144
4.4 Calculating the Net Present Value 146
■ USING EXCEL Calculating Present Values
in Excel 148
4.5 Perpetuities and Annuities 149
Perpetuities 149
■ Historical Examples of Perpetuities 149
Annuities 151
■ COMMON MISTAKE Discounting One
Too Many Times 151
■ Formula for an Annuity Due 154
Growing Cash Flows 155
4.6 Using an Annuity Spreadsheet or
Calculator 159
■ Annuity Calculator 161
4.7 Non-Annual Cash Flows 162
4.8 Solving for the Cash Payments 163
4.9 The Internal Rate of Return 166
■ USING EXCEL Excel’s IRR Function 169
Key Points and Equations 170 ■ Key
Terms 171 ■ Further Reading 172 ■
Problems 172 ■ Data Case 178
Appendix Solving for the Number of Periods 179
Chapter 5 Interest Rates 181
5.1 Interest Rate Quotes and Adjustments 182
The Effective Annual Rate 182
■ COMMON MISTAKE Using the
Wrong Discount Rate in the Annuity
Formula 183
Annual Percentage Rates 184
5.2 Application: Discount Rates and Loans 186
5.3 The Determinants of Interest Rates 187
■ FINANCE IN TIMES OF DISRUPTION
Teaser Rates and Subprime Loans 188
Inflation and Real Versus Nominal
Rates 188
Investment and Interest Rate Policy 190
The Yield Curve and Discount Rates 191
The Yield Curve and the Economy 192
■ COMMON MISTAKE Using the Annuity
Formula When Discount Rates Vary by
Maturity 192
■ INTERVIEW with Dr. Janet Yellen 194
5.4 Risk and Taxes 195
Risk and Interest Rates 196
After-Tax Interest Rates 197
5.5 The Opportunity Cost of Capital 198
■ COMMON MISTAKE States Dig a Multi-
Trillion Dollar Hole by Discounting at the
Wrong Rate 199
Key Points and Equations 200 ■ Key
Terms 201 ■ Further Reading 201 ■
Problems 201 ■ Data Case 206
Appendix Continuous Rates and Cash Flows 207
Discount Rates for a Continuously
Compounded APR 207
Continuously Arriving Cash Flows 207
Chapter 6 Valuing Bonds 209
6.1 Bond Cash Flows, Prices, and Yields 210
Bond Terminology 210
Zero-Coupon Bonds 210
■ FINANCE IN TIMES OF DISRUPTION
Negative Bond Yields 212
Coupon Bonds 213
6.2 Dynamic Behavior of Bond Prices 215
Discounts and Premiums 215
Time and Bond Prices 216
Interest Rate Changes and Bond Prices 218
■ Clean and Dirty Prices for Coupon
Bonds 219
6.3 The Yield Curve and Bond Arbitrage 221
Replicating a Coupon Bond 221
Valuing a Coupon Bond Using Zero-Coupon
Yields 222
Coupon Bond Yields 223
Treasury Yield Curves 224
6.4 Corporate Bonds 224
Corporate Bond Yields 225
■ Are Treasuries Really Default-Free
Securities? 225
Bond Ratings 227
Corporate Yield Curves 228
6.5 Sovereign Bonds 228
■ FINANCE IN TIMES OF DISRUPTION The
Credit Crisis and Bond Yields 229
■ FINANCE IN TIMES OF DISRUPTION
European Sovereign Debt Yields: A
Puzzle 231
■ INTERVIEW with Carmen M. Reinhart 232
Key Points and Equations 233 ■ Key
Terms 234 ■ Further Reading 235 ■
Problems 235 ■ Data Case 239 ■ Case
Study 240
Appendix Forward Interest Rates 242
Computing Forward Rates 242
Computing Bond Yields from Forward
Rates 243
Forward Rates and Future Interest
Rates 244
PART 3 VALUING PROJECTS AND
FIRMS 247
Chapter 7 Investment Decision Rules 248
7.1 NPV and Stand-Alone Projects 249
Applying the NPV Rule 249
The NPV Profile and IRR 249
Alternative Rules Versus the
NPV Rule 250
■ INTERVIEW with Dick Grannis 251
7.2 The Internal Rate of Return Rule 252
Applying the IRR Rule 252
Pitfall #1: Delayed Investments 252
Pitfall #2: Multiple IRRs 253
■ COMMON MISTAKE IRR Versus the IRR
Rule 255
Pitfall #3: Nonexistent IRR 255
7.3 The Payback Rule 256
Applying the Payback Rule 256
Payback Rule Pitfalls in Practice 257
■ Why Do Rules Other Than the NPV Rule
Persist? 258
7.4 Choosing between Projects 258
NPV Rule and Mutually Exclusive
Investments 258
IRR Rule and Mutually Exclusive
Investments 259
The Incremental IRR 260
■ COMMON MISTAKE Manipulating the
IRR with Financing 261
■ When Can Returns Be Compared? 263
7.5 Project Selection with Resource
Constraints 263
Evaluating Projects with Different Resource
Requirements 263
Profitability Index 264
Shortcomings of the Profitability
Index 266
Key Points and Equations 266 ■ Key
Terms 267 ■ Further Reading 267 ■
Problems 267 ■ Data Case 273
Appendix Computing the NPV Profile Using Excel’s
Data Table Function 274
Chapter 8 Fundamentals of Capital
Budgeting 275
8.1 Forecasting Earnings 276
Revenue and Cost Estimates 276
Incremental Earnings Forecast 277
Indirect Effects on Incremental Earnings 279
■ COMMON MISTAKE The Opportunity
Cost of an Idle Asset 280
Sunk Costs and Incremental Earnings 281
■ COMMON MISTAKE The Sunk Cost
Fallacy 281
Real-World Complexities 282
8.2 Determining Free Cash Flow and NPV 283
Calculating Free Cash Flow from
Earnings 283
Calculating Free Cash Flow Directly 285
Calculating the NPV 286
■ USING EXCEL Capital Budgeting Using
Excel 287
8.3 Choosing among Alternatives 288
Evaluating Manufacturing Alternatives 288
Comparing Free Cash Flows for Cisco’s
Alternatives 289
8.4 Further Adjustments to Free Cash Flow 289
■ INTERVIEW with David Holland 294
8.5 Analyzing the Project 295
Break-Even Analysis 295
■ COMMON MISTAKE Corporate Tax Rates
and Investment 296
Sensitivity Analysis 296
■ USING EXCEL Project Analysis Using
Excel 298
Scenario Analysis 299
Key Points and Equations 301 ■ Key
Terms 302 ■ Further Reading 302 ■
Problems 303 ■ Data Case 309
Appendix MACRS Depreciation 311
Chapter 9 Valuing Stocks 313
9.1 The Dividend-Discount Model 314
A One-Year Investor 314
Dividend Yields, Capital Gains, and Total
Returns 315
■ The Mechanics of a Short Sale 316
A Multiyear Investor 317
The Dividend-Discount Model
Equation 318
9.2 Applying the Dividend-Discount Model 318
Constant Dividend Growth 318
Dividends Versus Investment and
Growth 319
■ John Burr Williams’s Theory of Investment
Value 320
Changing Growth Rates 322
Limitations of the Dividend-Discount
Model 324
9.3 Total Payout and Free Cash Flow Valuation
Models 324
Share Repurchases and the Total Payout
Model 324
The Discounted Free Cash Flow Model 326
9.4 Valuation Based on Comparable Firms 330
Valuation Multiples 330
Limitations of Multiples 332
Comparison with Discounted Cash Flow
Methods 333
Stock Valuation Techniques: The Final
Word 334
■ Kenneth Cole Productions—What
Happened? 335
■ Cryptocurrencies and Price Bubbles 336
■ INTERVIEW with Susan Athey 338
9.5 Information, Competition, and Stock
Prices 339
Information in Stock Prices 339
Competition and Efficient Markets 340
Lessons for Investors and Corporate
Managers 342
■ INTERVIEW with Fahmi Quadir 344
The Efficient Markets Hypothesis Versus No
Arbitrage 345
Key Points and Equations 345 ■ Key
Terms 347 ■ Further Reading 347 ■
Problems 348 ■ Data Case 353
PART 4 RISK AND RETURN 355
Chapter 10 Capital Markets and the Pricing
of Risk 356
10.1 Risk and Return: Insights from 96 Years of
Investor History 357
10.2 Common Measures of Risk and Return 360
Probability Distributions 360
Expected Return 360
Variance and Standard Deviation 361
10.3 Historical Returns of Stocks and Bonds 363
Computing Historical Returns 363
Average Annual Returns 365
The Variance and Volatility of Returns 367
Estimation Error: Using Past Returns to Predict
the Future 368
■ Arithmetic Average Returns Versus
Compound Annual Returns 370
10.4 The Historical Tradeoff Between Risk and
Return 370
The Returns of Large Portfolios 371
The Returns of Individual Stocks 372
10.5 Common Versus Independent Risk 373
Theft Versus Earthquake Insurance: An
Example 373
The Role of Diversification 374
10.6 Diversification in Stock Portfolios 375
Firm-Specific Versus Systematic Risk 376
No Arbitrage and the Risk Premium 377
■ FINANCE IN TIMES OF DISRUPTION
Diversification Benefits During Market
Crashes 379
■ COMMON MISTAKE A Fallacy of Long-
Run Diversification 380
10.7 Measuring Systematic Risk 381
Identifying Systematic Risk: The Market
Portfolio 381
Sensitivity to Systematic Risk: Beta 381
10.8 Beta and the Cost of Capital 384
Estimating the Risk Premium 384
■ COMMON MISTAKE Beta Versus
Volatility 384
The Capital Asset Pricing Model 386
Key Points and Equations 386 ■ Key
Terms 388 ■ Further Reading 388 ■
Problems 388 ■ Data Case 393
Chapter 11 Optimal Portfolio Choice and the
Capital Asset Pricing Model 395
11.1 The Expected Return of a Portfolio 396
11.2 The Volatility of a Two-Stock Portfolio 397
Combining Risks 397
Determining Covariance and
Correlation 398
■ COMMON MISTAKE Computing
Variance, Covariance, and Correlation
in Excel 400
Computing a Portfolio’s Variance and
Volatility 401
11.3 The Volatility of a Large Portfolio 403
Large Portfolio Variance 403
Diversification with an Equally Weighted
Portfolio 404
■ INTERVIEW with Anne Martin 406
Diversification with General Portfolios 407
11.4 Risk Versus Return: Choosing an Efficient
Portfolio 407
Efficient Portfolios with Two Stocks 408
The Effect of Correlation 410
Short Sales 411
Efficient Portfolios with Many Stocks 412
■ NOBEL PRIZE Harry Markowitz and James
Tobin 413
11.5 Risk-Free Saving and Borrowing 415
Investing in Risk-Free Securities 415
Borrowing and Buying Stocks on
Margin 416
Identifying the Tangent Portfolio 417
11.6 The Efficient Portfolio and Required
Returns 419
Portfolio Improvement: Beta and the Required
Return 419
Expected Returns and the Efficient
Portfolio 421
11.7 The Capital Asset Pricing Model 423
The CAPM Assumptions 423
Supply, Demand, and the Efficiency of the
Market Portfolio 424
Optimal Investing: The Capital Market
Line 424
11.8 Determining the Risk Premium 425
Market Risk and Beta 425
■ NOBEL PRIZE William Sharpe on the
CAPM 427
The Security Market Line 428
Beta of a Portfolio 428
Summary of the Capital Asset Pricing
Model 430
Key Points and Equations 430 ■ Key
Terms 433 ■ Further Reading 433 ■
Problems 434 ■ Data Case 440
Appendix The CAPM with Differing Interest
Rates 442
The Efficient Frontier with Differing Saving
and Borrowing Rates 442
The Security Market Line with Differing
Interest Rates 442
Chapter 12 Estimating the Cost of Capital 445
12.1 The Equity Cost of Capital 446
12.2 The Market Portfolio 447
Constructing the Market Portfolio 447
Market Indexes 447
■ Value-Weighted Portfolios and
Rebalancing 448
The Market Risk Premium 449
12.3 Beta Estimation 451
Using Historical Returns 451
Identifying the Best-Fitting Line 453
Using Linear Regression 454
■ Why Not Estimate Expected Returns
Directly? 455
12.4 The Debt Cost of Capital 455
Debt Yields Versus Returns 455
■ COMMON MISTAKE Using the Debt Yield
as Its Cost of Capital 456
Debt Betas 457
12.5 A Project’s Cost of Capital 458
All-Equity Comparables 458
Levered Firms as Comparables 459
The Unlevered Cost of Capital 459
Industry Asset Betas 461
12.6 Project Risk Characteristics and
Financing 463
Differences in Project Risk 463
■ COMMON MISTAKE Adjusting for
Execution Risk 465
Financing and the Weighted Average Cost of
Capital 465
■ INTERVIEW with Shelagh Glaser 466
■ COMMON MISTAKE Using a Single Cost
of Capital in Multi-Divisional Firms 467
12.7 Final Thoughts on Using the CAPM 468
Key Points and Equations 469 ■ Key
Terms 471 ■ Further Reading 471 ■
Problems 472 ■ Data Case 476
Appendix Practical Considerations When Forecasting
Beta 477
Time Horizon 477
The Market Proxy 477
Beta Variation and Extrapolation 477
Outliers 478
■ COMMON MISTAKE Changing the Index
to Improve the Fit 479
■ USING EXCEL Estimating Beta Using
Excel 480
Other Considerations 481
Chapter 13 Investor Behavior and Capital
Market Efficiency 483
13.1 Competition and Capital Markets 484
Identifying a Stock’s Alpha 484
Profiting from Non-Zero Alpha Stocks 485
13.2 Information and Rational Expectations 486
Informed Versus Uninformed
Investors 486
Rational Expectations 487
13.3 The Behavior of Individual Investors 488
Underdiversification and Portfolio Biases 488
Excessive Trading and Overconfidence 489
Individual Behavior and Market Prices 491
13.4 Systematic Trading Biases 491
Hanging on to Losers and the Disposition
Effect 491
■ NOBEL PRIZE Prospect Theory, Mental
Accounting, and Nudges 492
Investor Attention, Mood, and
Experience 492
Herd Behavior 493
Implications of Behavioral Biases 493
13.5 The Efficiency of the Market Portfolio 494
Trading on News or Recommendations 494
■ NOBEL PRIZE The 2013 Prize: An
Enigma? 496
The Performance of Fund Managers 496
The Winners and Losers 499
13.6 Style-Based Techniques and the Market
Efficiency Debate 500
Size Effects 500
■ INTERVIEW with Jonathan Clements 502
Momentum 504
■ Market Efficiency and the Efficiency of the
Market Portfolio 505
Implications of Positive-Alpha Trading
Strategies 505
13.7 Multifactor Models of Risk 507
Using Factor Portfolios 507
Smart Beta 508
Long-Short Portfolios 508
Selecting the Portfolios 509
The Cost of Capital with Fama-French-Carhart
Factor Specification 510
13.8 Methods Used in Practice 512
Financial Managers 512
Investors 513
Key Points and Equations 514 ■ Key
Terms 516 ■ Further Reading 516 ■
Problems 517
Appendix Building a Multifactor Model 523
PART 5 CAPITAL STRUCTURE 525
Chapter 14 Capital Structure in a Perfect
Market 526
14.1 Equity Versus Debt Financing 527
Financing a Firm with Equity 527
Financing a Firm with Debt and Equity 528
The Effect of Leverage on Risk and Return 529
14.2 Modigliani-Miller I: Leverage, Arbitrage, and
Firm Value 531
MM and the Law of One Price 531
Homemade Leverage 531
■ MM and the Real World 532
The Market Value Balance Sheet 533
Application: A Leveraged Recapitalization 534
14.3 Modigliani-Miller II: Leverage, Risk, and the
Cost of Capital 536
Leverage and the Equity Cost of
Capital 536
Capital Budgeting and the Weighted Average
Cost of Capital 537
■ COMMON MISTAKE Is Debt Better Than
Equity? 540
Computing the WACC with Multiple
Securities 540
Levered and Unlevered Betas 540
■ NOBEL PRIZE Franco Modigliani and
Merton Miller 542
14.4 Capital Structure Fallacies 543
Leverage and Earnings per Share 543
■ FINANCE IN TIMES OF DISRUPTION
Bank Capital Regulation and the ROE
Fallacy 545
Equity Issuances and Dilution 546
14.5 MM: Beyond the Propositions 547
Key Points and Equations 548 ■ Key
Terms 549 ■ Further Reading 549 ■
Problems 550
Chapter 15 Debt and Taxes 555
15.1 The Interest Tax Deduction 556
15.2 Valuing the Interest Tax Shield 558
The Interest Tax Shield and Firm
Value 558
■ Pizza and Taxes 559
The Interest Tax Shield with Permanent
Debt 559
The Weighted Average Cost of Capital with
Taxes 560
■ The Repatriation Tax: Why Some Cash-
Rich Firms Borrowed 561
The Interest Tax Shield with a Target Debt-
Equity Ratio 562
15.3 Recapitalizing to Capture the Tax
Shield 564
The Tax Benefit 564
The Share Repurchase 565
No Arbitrage Pricing 565
Analyzing the Recap: The Market Value
Balance Sheet 566
15.4 Personal Taxes 567
Including Personal Taxes in the Interest Tax
Shield 567
Determining the Actual Tax Advantage of
Debt 570
Valuing the Interest Tax Shield with Personal
Taxes 571
■ COMMON MISTAKE How to Save for
Retirement 572
15.5 Optimal Capital Structure with Taxes 573
Do Firms Prefer Debt? 573
Limits to the Tax Benefit of Debt 576
Growth and Debt 577
■ INTERVIEW with Andrew Balson 578
Other Tax Shields 579
The Low Leverage Puzzle 579
■ Employee Stock Options 581
Key Points and Equations 581 ■ Key
Terms 582 ■ Further Reading 582 ■
Problems 583 ■ Data Case 587
Chapter 16 Financial Distress, Managerial
Incentives, and Information 589
16.1 Default and Bankruptcy in a Perfect Market 590
Armin Industries: Leverage and the Risk of Default 590
Bankruptcy and Capital Structure 591
16.2 The Costs of Bankruptcy and Financial
Distress 592
The Bankruptcy Code 593
Direct Costs of Bankruptcy 593
Indirect Costs of Financial Distress 594
■ FINANCE IN TIMES OF DISRUPTION The Chrysler Prepack 597
16.3 Financial Distress Costs and Firm Value 598
Armin Industries: The Impact of Financial
Distress Costs 598
Who Pays for Financial Distress Costs? 598
16.4 Optimal Capital Structure: The Tradeoff Theory 600
The Present Value of Financial Distress Costs 600
Optimal Leverage 601
16.5 Exploiting Debt Holders: The Agency Costs of Leverage 603
Excessive Risk-Taking and Asset Substitution 603
Debt Overhang and Under-Investment 604
■ FINANCE IN TIMES OF DISRUPTION
Bailouts, Distress Costs, and Debt Overhang 605
Agency Costs and the Value of Leverage 606
The Leverage Ratchet Effect 607
Debt Maturity and Covenants 608
■ Why Do Firms Go Bankrupt? 609
16.6 Motivating Managers: The Agency Benefits of Leverage 609
Concentration of Ownership 610
Reduction of Wasteful Investment 610
■ Excessive Perks and Corporate Scandals 611
■ FINANCE IN TIMES OF DISRUPTION
Moral Hazard, Bailouts, and the Appeal of
Leverage 612
Leverage and Commitment 612
■ NOBEL PRIZE Contract Theory 613
16.7 Agency Costs and the Tradeoff Theory 613
The Optimal Debt Level 614
Debt Levels in Practice 615
16.8 Asymmetric Information and Capital
Structure 615
Leverage as a Credible Signal 615
Issuing Equity and Adverse Selection 617
■ NOBEL PRIZE Markets with
Asymmetric Information and Adverse
Selection 619
Implications for Equity Issuance 619
Implications for Capital Structure 620
■ NOBEL PRIZE The Cost of Bank Runs 623
16.9 Capital Structure: The Bottom Line 623
Key Points and Equations 624 ■ Key
Terms 626 ■ Further Reading 626 ■
Problems 627
Chapter 17 Payout Policy 635
17.1 Distributions to Shareholders 636
Dividends 636
Share Repurchases 638
17.2 Comparison of Dividends and Share
Repurchases 639
Alternative Policy 1: Pay Dividend with
Excess Cash 639
Alternative Policy 2: Share Repurchase
(No Dividend) 640
■ COMMON MISTAKE Repurchases and the
Supply of Shares 642
Alternative Policy 3: High Dividend
(Equity Issue) 642
Modigliani-Miller and Dividend Policy
Irrelevance 643
■ COMMON MISTAKE The Bird in the Hand
Fallacy 644
Dividend Policy with Perfect Capital
Markets 644
17.3 The Tax Disadvantage of Dividends 644
Taxes on Dividends and Capital
Gains 644
Optimal Dividend Policy with Taxes 646
17.4 Dividend Capture and Tax Clienteles 648
The Effective Dividend Tax Rate 648
Tax Differences Across Investors 649
Clientele Effects 650
■ INTERVIEW with John Connors 651
17.5 Payout Versus Retention of Cash 653
Retaining Cash with Perfect Capital Markets 654
Taxes and Cash Retention 655
Adjusting for Investor Taxes 656
Issuance and Distress Costs 657
Agency Costs of Retaining Cash 658
■ COMMON MISTAKE Mischaracterizing Buybacks 660
17.6 Signaling with Payout Policy 660
Dividend Smoothing 660
Dividend Signaling 661
■ Can a Dividend Cut be Good News? 662
Signaling and Share Repurchases 663
17.7 Stock Dividends, Splits, and Spin-Offs 665
Stock Dividends and Splits 665
Spin-Offs 666
■ Berkshire Hathaway’s A & B Shares 667
Key Points and Equations 668 ■ Key
Terms 670 ■ Further Reading 670 ■
Problems 671 ■ Data Case 675
PART 6 ADVANCED VALUATION 677
Chapter 18 Capital Budgeting and Valuation with Leverage 678
18.1 Overview of Key Concepts 679
18.2 The Weighted Average Cost of Capital Method 680
■ INTERVIEW with Zane Rowe 681
Using the WACC to Value a Project 682
Summary of the WACC Method 683
Implementing a Constant Debt-Equity Ratio 684
18.3 The Adjusted Present Value Method 686
The Unlevered Value of the Project 686
Valuing the Interest Tax Shield 687
Summary of the APV Method 688
18.4 The Flow-to-Equity Method 690
Calculating the Free Cash Flow to Equity 690
Valuing Equity Cash Flows 691
■ What Counts as “Debt”? 692
Summary of the Flow-to-Equity Method 692
18.5 Project-Based Costs of Capital 693
Estimating the Unlevered Cost of Capital 694
Project Leverage and the Equity Cost of Capital 694
Determining the Incremental Leverage of a Project 696
■ COMMON MISTAKE Re-Levering the WACC 696
18.6 APV with Other Leverage Policies 698
Constant Interest Coverage Ratio 698
Predetermined Debt Levels 699
A Comparison of Methods 701
18.7 Other Effects of Financing 701
Issuance and Other Financing Costs 701
Security Mispricing 702
Financial Distress and Agency Costs 703
■ FINANCE IN TIMES OF DISRUPTION
Government Loan Guarantees 704
18.8 Advanced Topics in Capital Budgeting 704
Periodically Adjusted Debt 705
Leverage and the Cost of Capital 707
The WACC or FTE Method with Changing
Leverage 709
Personal Taxes 710
Key Points and Equations 712 ■ Key
Terms 714 ■ Further Reading 714 ■
Problems 715 ■ Data Case 721
Appendix Foundations and Further Details 723
Deriving the WACC Method 723
The Levered and Unlevered Cost of
Capital 724
Solving for Leverage and Value
Simultaneously 725
The Residual Income and Economic Value
Added Valuation Methods 727
Chapter 19 Valuation and Financial Modeling:
A Case Study 729
19.1 Valuation Using Comparables 730
19.2 The Business Plan 732
Operational Improvements 732
Capital Expenditures: A Needed
Expansion 733
Working Capital Management 734
Capital Structure Changes: Levering Up 734
19.3 Building the Financial Model 735
Forecasting Earnings 735
■ INTERVIEW with Joseph L.
Rice, III 736
Working Capital Requirements 738
Forecasting Free Cash Flow 739
■ USING EXCEL Summarizing Model
Outputs 741
The Balance Sheet and Statement of Cash
Flows (Optional) 742
■ USING EXCEL Auditing Your Financial
Model 744
19.4 Estimating the Cost of Capital 745
CAPM-Based Estimation 745
Unlevering Beta 746
Ideko’s Unlevered Cost of Capital 746
19.5 Valuing the Investment 747
The Multiples Approach to Continuation
Value 748
The Discounted Cash Flow Approach to
Continuation Value 749
■ COMMON MISTAKE Continuation Values
and Long-Run Growth 751
APV Valuation of Ideko’s Equity 751
A Reality Check 752
■ COMMON MISTAKE Missing Assets or
Liabilities 753
IRR and Cash Multiples 753
19.6 Sensitivity Analysis 754
Key Points and Equations 755 ■ Key
Terms 756 ■ Further Reading 756 ■
Problems 757
Appendix Compensating Management 759
PART 7 OPTIONS 761
Chapter 20 Financial Options 762
20.1 Option Basics 763
Understanding Option Contracts 763
Interpreting Stock Option Quotations 763
Options on Other Financial
Securities 765
20.2 Option Payoffs at Expiration 766
Long Position in an Option Contract 766
Short Position in an Option
Contract 767
Profits for Holding an Option to
Expiration 769
Returns for Holding an Option to
Expiration 770
Combinations of Options 771
20.3 Put-Call Parity 774
20.4 Factors Affecting Option Prices 777
Strike Price and Stock Price 777
Arbitrage Bounds on Option Prices 777
Option Prices and the Exercise Date 777
Option Prices and Volatility 778
20.5 Exercising Options Early 779
Non-Dividend-Paying Stocks 779
Dividend-Paying Stocks 781
20.6 Options and Corporate Finance 783
Equity as a Call Option 783
Debt as an Option Portfolio 784
Credit Default Swaps 784
■ FINANCE IN TIMES OF DISRUPTION
Credit Default Swaps 785
Pricing Risky Debt 786
Agency Conflicts 787
Key Points and Equations 788 ■ Key
Terms 789 ■ Further Reading 789 ■
Problems 789 ■ Data Case 794
Chapter 21 Option Valuation 795
21.1 The Binomial Option Pricing Model 796
A Two-State Single-Period Model 796
The Binomial Pricing Formula 798
A Multiperiod Model 799
Making the Model Realistic 803
21.2 The Black-Scholes Option Pricing
Model 804
The Black-Scholes Formula 804
■ INTERVIEW with Myron S. Scholes 805
Implied Volatility 810
■ FINANCE IN TIMES OF DISRUPTION The
VIX Index 811
The Replicating Portfolio 812
21.3 Risk-Neutral Probabilities 814
A Risk-Neutral Two-State Model 814
Implications of the Risk-Neutral
World 814
Risk-Neutral Probabilities and Option
Pricing 815
21.4 Risk and Return of an Option 817
21.5 Corporate Applications of Option
Pricing 819
Beta of Risky Debt 819
■ COMMON MISTAKE Valuing Employee
Stock Options 822
■ NOBEL PRIZE Pricing Financial
Options 823
Agency Costs of Debt 823
Key Points and Equations 824 ■ Key
Terms 826 ■ Further Reading 826 ■
Problems 826
Chapter 22 Real Options 831
22.1 Real Versus Financial Options 832
22.2 Decision Tree Analysis 832
Representing Uncertainty 833
Real Options 834
Solving Decision Trees 834
22.3 The Option to Delay: Investment as a Call
Option 835
An Investment Option 835
Factors Affecting the Timing of
Investment 838
■ Why Are There Empty Lots in Built-Up
Areas of Big Cities? 839
Investment Options and Firm Risk 840
■ FINANCE IN TIMES OF DISRUPTION
Uncertainty, Investment, and the Option
to Delay 841
22.4 Growth and Abandonment Options 842
Valuing Growth Potential 842
■ Growth Options and COVID 844
The Option to Expand 844
The Option to Abandon 845
■ INTERVIEW with Kenneth C. Frazier 846
22.5 Investments with Different Lives 848
■ Equivalent Annual Benefit Method 849
22.6 Optimally Staging Investments 850
22.7 Rules of Thumb 853
The Profitability Index Rule 854
The Hurdle Rate Rule 854
■ The Option to Repay a Mortgage 856
22.8 Key Insights from Real Options 857
Key Points and Equations 857 ■ Key
Terms 859 ■ Further Reading 859 ■
Problems 859
PART 8 LONG-TERM FINANCING 865
Chapter 23 Raising Equity Capital 866
23.1 Equity Financing for Private Companies 867
Sources of Funding 867
■ Crowdfunding: The Wave of the
Future? 868
■ INTERVIEW with Kevin Laws 869
Venture Capital Investing 872
Venture Capital Financing Terms 874
■ COMMON MISTAKE Misinterpreting
Start-Up Valuations 874
■ From Launch to Liquidity 876
Exiting an Investment in a Private
Company 878
23.2 The Initial Public Offering 878
Advantages and Disadvantages of Going
Public 878
Types of Offerings 879
The Mechanics of an IPO 881
■ Google’s IPO 881
■ An Alternative to the Traditional IPO:
Spotify’s Direct Listing 886
23.3 IPO Puzzles 886
Underpricing 886
Cyclicality and Recent Trends 889
■ FINANCE IN TIMES OF DISRUPTION
Worldwide IPO Deals in
2008–2009 890
Cost of an IPO 890
Long-Run Underperformance 891
23.4 SPACs: A New Way to Go Public 892
The SPAC Process 893
Analyzing a Deal 894
SPAC Performance 896
23.5 The Seasoned Equity Offering 897
The Mechanics of an SEO 897
Price Reaction 898
Issuance Costs 899
Key Points and Equations 900 ■ Key
Terms 901 ■ Further Reading 902 ■
Problems 903 ■ Data Case 907
Chapter 24 Debt Financing 909
24.1 Corporate Debt 910
Public Debt 910
Private Debt 914
24.2 Other Types of Debt 915
Sovereign Debt 915
■ Green Bonds 916
Municipal Bonds 917
■ Detroit’s Art Museum at Risk 917
Asset-Backed Securities 918
■ FINANCE IN TIMES OF DISRUPTION
CDOs, Subprime Mortgages, and the
Financial Crisis 918
24.3 Bond Covenants 920
24.4 Repayment Provisions 921
Call Provisions 921
■ New York City Calls Its Municipal
Bonds 923
Sinking Funds 925
Convertible Provisions 925
Key Points and Equations 927 ■ Key
Terms 928 ■ Further Reading 929 ■
Problems 929
Chapter 25 Leasing 931
25.1 The Basics of Leasing 932
Examples of Lease Transactions 932
Lease Payments and Residual Values 933
Leases Versus Loans 934
■ Calculating Auto Lease Payments 935
End-of-Term Lease Options 935
Other Lease Provisions 937
25.2 Accounting, Tax, and Legal Consequences of
Leasing 937
Lease Accounting 938
■ Operating Leases at Alaska Air
Group 939
The Tax Treatment of Leases 940
Leases and Bankruptcy 941
■ Synthetic Leases 942
25.3 The Leasing Decision 942
Cash Flows for a True Tax Lease 943
Lease Versus Buy (An Unfair
Comparison) 944
Lease Versus Borrow (The Right
Comparison) 945
Evaluating a True Tax Lease 947
Evaluating a Non-Tax Lease 948
25.4 Reasons for Leasing 948
Valid Arguments for Leasing 949
■ INTERVIEW with Mark Long 952
Suspect Arguments for Leasing 953
Key Points and Equations 953 ■ Key
Terms 954 ■ Further Reading 955 ■
Problems 955
PART 9 SHORT-TERM FINANCING 959
Chapter 26 Working Capital
Management 960
26.1 Overview of Working Capital 961
The Cash Cycle 961
Firm Value and Working Capital 963
26.2 Trade Credit 964
Trade Credit Terms 964
Trade Credit and Market Frictions 964
Managing Float 965
26.3 Receivables Management 966
Determining the Credit Policy 966
Monitoring Accounts Receivable 967
26.4 Payables Management 969
Determining Accounts Payable Days
Outstanding 969
Stretching Accounts Payable 970
26.5 Inventory Management 970
Benefits of Holding Inventory 971
Costs of Holding Inventory 971
■ FINANCE IN TIMES OF DISRUPTION
Supply Chains during COVID-19 972
26.6 Cash Management 973
Motivation for Holding Cash 973
Alternative Investments 974
■ FINANCE IN TIMES OF DISRUPTION
Hoarding Cash 974
Key Points and Equations 976 ■ Key
Terms 977 ■ Further Reading 977 ■
Problems 978 ■ Data Case 981
Chapter 27 Shor t-Term Financial Planning 983
27.1 Forecasting Short-Term Financing
Needs 984
Seasonalities 984
Negative Cash Flow Shocks 987
Positive Cash Flow Shocks 988
27.2 The Matching Principle 989
Permanent Working Capital 989
Temporary Working Capital 989
Financing Policy Choices 990
27.3 Short-Term Financing with Bank Loans 991
Single, End-of-Period Payment Loan 991
Line of Credit 991
Bridge Loan 992
Common Loan Stipulations and Fees 992
27.4 Short-Term Financing with Commercial
Paper 994
■ FINANCE IN TIMES OF DISRUPTION
Short-Term Financing Costs during
Crises 995
27.5 Short-Term Financing with Secured
Financing 996
Accounts Receivable as Collateral 996
Inventory as Collateral 996
■ A Seventeenth-Century Financing
Solution 997
■ Loan Guarantees: The Ex-Im Bank
Controversy 998
Sales as Collateral 999
Key Points and Equations 1000 ■ Key
Terms 1001 ■ Further Reading 1001 ■
Problems 1001
PART 10 SPECIAL TOPICS 1005
Chapter 28 Mergers and Acquisitions 1006
28.1 Background and Historical Trends 1007
Merger Waves 1007
Types of Mergers 1009
28.2 Market Reaction to a Takeover 1009
28.3 Reasons to Acquire 1010
Economies of Scale and Scope 1011
Vertical Integration 1011
Expertise 1011
Monopoly Gains 1012
Efficiency Gains 1012
Tax Savings from Operating Losses 1013
Diversification 1014
Earnings Growth 1014
Managerial Motives to Merge 1016
28.4 Valuation and the Takeover Process 1017
Valuation 1017
The Offer 1018
Merger “Arbitrage” 1019
Tax and Accounting Issues 1020
Board and Shareholder Approval 1021
28.5 Takeover Defenses 1022
Poison Pills 1022
Staggered Boards 1023
White Knights 1024
Golden Parachutes 1025
Recapitalization 1025
Other Defensive Strategies 1025
Regulatory Approval 1026
■ Weyerhaeuser’s Hostile Bid for Willamette Industries 1026
28.6 Who Gets the Value Added from a Takeover? 1027
The Free Rider Problem 1027
Toeholds 1028
The Leveraged Buyout 1028
■ The Leveraged Buyout of RJR-Nabisco by KKR 1029
The Freezeout Merger 1031
Competition 1032
Key Points and Equations 1032 ■ Key
Terms 1034 ■ Further Reading 1034 ■
Problems 1034
Chapter 29 Corporate Governance 1037
29.1 Corporate Governance and Agency
Costs 1038
29.2 Monitoring by the Board of Directors and
Others 1039
Types of Directors 1039
Board Independence 1039
■ COMMON MISTAKE “Celebrity” Boards 1041
Board Size and Performance 1041
Other Monitors 1041
29.3 Compensation Policies 1042
Stock and Options 1042
Pay and Performance Sensitivity 1042
29.4 Managing Agency Conflict 1044
Direct Action by Shareholders 1044
■ Shareholder Activism at The New York
Times 1047
Management Entrenchment 1047
The Threat of Takeover 1048
29.5 Regulation 1048
The Sarbanes-Oxley Act 1048
■ INTERVIEW with Lawrence E. Harris 1049
The Cadbury Commission 1051
Dodd-Frank Act 1051
Insider Trading 1052
■ Martha Stewart and ImClone 1053
29.6 Corporate Governance Around the
World 1053
Protection of Shareholder Rights 1053
Controlling Owners and Pyramids 1053
The Stakeholder Model 1056
Cross-Holdings 1056
29.7 The Tradeoff of Corporate
Governance 1057
Key Points and Equations 1058 ■ Key
Terms 1059 ■ Further Reading 1060 ■
Problems 1060
Chapter 30 Risk Management 1061
30.1 Insurance 1062
The Role of Insurance: An Example 1062
Insurance Pricing in a Perfect Market 1062
The Value of Insurance 1064
The Costs of Insurance 1066
The Insurance Decision 1068
30.2 Commodity Price Risk 1068
Hedging with Vertical Integration and Storage 1069
Hedging with Long-Term Contracts 1069
Hedging with Futures Contracts 1071
■ COMMON MISTAKE Hedging Risk 1073
■ Differing Hedging Strategies 1074
Deciding to Hedge Commodity Price Risk 1074
■ FINANCE IN TIMES OF DISRUPTION
Negative Oil Prices 1075
30.3 Exchange Rate Risk 1075
Exchange Rate Fluctuations 1075
Hedging with Forward Contracts 1077
Cash-and-Carry and the Pricing of Currency Forwards 1078
■ FINANCE IN TIMES OF DISRUPTION
Arbitrage in Currency Markets? 1081
Hedging with Options 1082
30.4 Interest Rate Risk 1085
Interest Rate Risk Measurement: Duration 1086
Duration-Based Hedging 1087
■ The Savings and Loan Crisis 1091
Swap-Based Hedging 1091
Key Points and Equations 1095 ■ Key
Terms 1097 ■ Further Reading 1097 ■ Problems 1098
Chapter 31 International Corporate Finance 1103
31.1 Internationally Integrated Capital Markets 1104
31.2 Valuation of Foreign Currency Cash Flows 1105
WACC Valuation Method in Domestic Currency 1106
Using the Law of One Price as a Robustness Check 1108
31.3 Valuation and International Taxation 1109
The TCJA: A New Approach to International Taxation 1110
Harmonizing the Tax Treatment of Exports: GILTI and FDII 1110
Avoiding Base Erosion: BEAT 1112
31.4 Internationally Segmented Capital Markets 1112
Differential Access to Markets 1113
Macro-Level Distortions 1113
Implications 1114
31.5 Capital Budgeting with Exchange Risk 1116
■ INTERVIEW with Sally Johnson 1118
Key Points and Equations 1119 ■ Key
Terms 1119 ■ Further Reading 1120 ■
Problems 1120 ■ Data Case 1122
Glossary 1123
Index 1145