Fundamentals of Corporate Finance, Thirteenth Edition
By Stephen A. Ross, Randolph W. Westerfield and Bradford D. Jordan
Contents:
PART 1 Overview of Corporate Finance
CHAPTER 1
INTRODUCTION TO CORPORATE FINANCE 1
1.1 Finance: A Quick Look 2
Finance: The Five Main Areas 2
Corporate Finance 2
Investments 2
Financial Institutions 3
International Finance 3
Fintech 3
Why Study Finance? 3
Marketing and Finance 3
Accounting and Finance 3
Management and Finance 4
Technology and Finance 4
You and Finance 5
1.2 Corporate Finance and the Financial Manager 5
What is Corporate Finance? 5
The Financial Manager 6
Financial Management Decisions 7
Capital Budgeting 7
Capital Structure 7
Working Capital Management 7
Conclusion 8
1.3 Forms of Business Organization 8
Sole Proprietorship 8
Partnership 8
Corporation 9
A Corporation by Another Name . . . 10
Benefit Corporation 11
1.4 The Goal of Financial Management 11
Possible Goals 12
The Goal of Financial Management 12
A More General Goal 13
Sarbanes-Oxley 13
1.5 The Agency Problem and Control of the
Corporation 14
Agency Relationships 14
Management Goals 14
Do Managers Act in the Stockholders’ Interests? 15
Managerial Compensation 15
Control of the Firm 16
Conclusion 17
Stakeholders 17
1.6 Financial Markets and the Corporation 18
Cash Flows to and from the Firm 18
Primary versus Secondary Markets 19
Primary Markets 19
Secondary Markets 19
Dealer versus Auction Markets 19
Trading in Corporate Securities 20
Listing 20
1.7 Summary and Conclusions 21
CHAPTER 2
FINANCIAL STATEMENTS, TAXES, AND CASH FLOW 24
2.1 The Balance Sheet 25
Assets: The Left Side 25
Liabilities and Owners’ Equity: The Right Side 25
Net Working Capital 26
Liquidity 27
Debt versus Equity 28
Market Value versus Book Value 28
2.2 The Income Statement 29
GAAP and the Income Statement 30
Noncash Items 31
Time and Costs 31
2.3 Taxes 33
Corporate Tax Rates 33
Average versus Marginal Tax Rates 33
2.4 Cash Flow 35
Cash Flow from Assets 35
Operating Cash Flow 35
Capital Spending 36
Change in Net Working Capital 37
Conclusion 37
A Note about “Free” Cash Flow 37
Cash Flow to Creditors and Stockholders 38
Cash Flow to Creditors 38
Cash Flow to Stockholders 38
An Example: Cash Flows for Dole Cola 38
Operating Cash Flow 38
Net Capital Spending 40
Change in NWC and Cash Flow from Assets 40
Cash Flow to Stockholders and Creditors 40
2.5 Summary and Conclusions 41
Part 2 Financial Statements and Long-Term Financial Planning
CHAPTER 3
WORKING WITH FINANCIAL STATEMENTS 51
3.1 Cash Flow and Financial Statements:
A Closer Look 52
Sources and Uses of Cash 52
The Statement of Cash Flows 54
3.2 Standardized Financial Statements 56
Common-Size Statements 56
Common-Size Balance Sheets 56
Common-Size Income Statements 57
Common-Size Statements of Cash Flows 58
Common-Base Year Financial Statements: Trend
Analysis 58
Combined Common-Size and Base Year Analysis 58
3.3 Ratio Analysis 59
Short-Term Solvency, or Liquidity, Measures 60
Current Ratio 60
The Quick (or Acid-Test) Ratio 61
Other Liquidity Ratios 62
Long-Term Solvency Measures 62
Total Debt Ratio 63
A Brief Digression: Total Capitalization versus Total
Assets 63
Times Interest Earned 64
Cash Coverage 64
Asset Management, or Turnover, Measures 64
Inventory Turnover and Days’ Sales in Inventory 64
Receivables Turnover and Days’ Sales in
Receivables 65
Asset Turnover Ratios 66
Profitability Measures 67
Profit Margin 67
Return on Assets 67
Return on Equity 68
Market Value Measures 69
Price-Earnings Ratio 69
Price-Sales Ratio 69
Market-to-Book Ratio 70
Enterprise Value-EBITDA Multiple 71
A Note on Ratio Analysis 71
Conclusion 71
3.4 The DuPont Identity 72
A Closer Look at ROE 73
An Expanded DuPont Analysis 75
3.5 Using Financial Statement Information 76
Why Evaluate Financial Statements? 76
Internal Uses 77
External Uses 77
Choosing a Benchmark 77
Time Trend Analysis 77
Peer Group Analysis 78
Problems with Financial Statement Analysis 83
3.6 Summary and Conclusions 84
CHAPTER 4
LONG-TERM FINANCIAL PLANNING AND GROWTH 96
4.1 What Is Financial Planning? 98
Growth as a Financial Management Goal 98
Dimensions of Financial Planning 98
What Can Planning Accomplish? 99
Examining Interactions 99
Exploring Options 99
Avoiding Surprises 99
Ensuring Feasibility and Internal Consistency 100
Conclusion 100
4.2 Financial Planning Models: A First Look 100
A Financial Planning Model: The Ingredients 100
Sales Forecast 101
Pro Forma Statements 101
Asset Requirements 101
Financial Requirements 101
The Plug 101
Economic Assumptions 102
A Simple Financial Planning Model 102
4.3 The Percentage of Sales Approach 103
The Income Statement 103
The Balance Sheet 104
A Particular Scenario 106
An Alternative Scenario 107
4.4 External Financing and Growth 109
EFN and Growth 111
Financial Policy and Growth 113
The Internal Growth Rate 113
The Sustainable Growth Rate 114
Determinants of Growth 114
A Note about Sustainable Growth Rate
Calculations 116
4.5 Some Caveats Regarding Financial Planning
Models 118
4.6 Summary and Conclusions 119
PART 3 of Future Cash Flows
CHAPTER 5
INTRODUCTION TO VALUATION: THE TIME VALUE OF MONEY 130
5.1 Future Value and Compounding 131
Investing for a Single Period 131
Investing for More Than One Period 131
A Note about Compound Growth 137
5.2 Present Value and Discounting 138
The Single-Period Case 138
Present Values for Multiple Periods 139
5.3 More about Present and Future Values 142
Present versus Future Value 142
Determining the Discount Rate 143
Finding the Number of Periods 146
5.4 Summary and Conclusions 150
CHAPTER 6
DISCOUNTED CASH FLOW VALUATION 156
6.1 Future and Present Values of Multiple Cash
Flows 157
Future Value with Multiple Cash Flows 157
Present Value with Multiple Cash Flows 159
A Note about Cash Flow Timing 163
6.2 Valuing Level Cash Flows: Annuities and
Perpetuities 164
Present Value for Annuity Cash Flows 164
Annuity Tables 165
Finding the Payment 167
Finding the Rate 168
Future Value for Annuities 170
A Note about Annuities Due 171
Perpetuities 172
Growing Annuities and Perpetuities 174
6.3 Comparing Rates: The Effect of Compounding 174
Effective Annual Rates and Compounding 175
Calculating and Comparing Effective Annual Rates 175
EARs and APRs 177
Taking It to the Limit: A Note about Continuous
Compounding 178
6.4 Loan Types and Loan Amortization 180
Pure Discount Loans 180
Interest-Only Loans 181
Amortized Loans 181
6.5 Summary and Conclusions 186
CHAPTER 7
INTEREST RATES AND BOND VALUATION 201
7.1 Bonds and Bond Valuation 202
Bond Features and Prices 202
Bond Values and Yields 202
Interest Rate Risk 206
Finding the Yield to Maturity: More Trial and Error 207
7.2 More about Bond Features 212
Is it Debt or Equity? 212
Long-Term Debt: The Basics 212
The Indenture 213
Terms of a Bond 214
Security 214
Seniority 215
Repayment 215
The Call Provision 215
Protective Covenants 216
7.3 Bond Ratings 217
7.4 Some Different Types of Bonds 218
Government Bonds 218
Zero Coupon Bonds 219
Floating-Rate Bonds 220
Other Types of Bonds 221
Sukuk 222
7.5 Bond Markets 224
How Bonds Are Bought and Sold 225
Bond Price Reporting 225
A Note about Bond Price Quotes 229
7.6 Inflation and Interest Rates 229
Real versus Nominal Rates 229
The Fisher Effect 230
Inflation and Present Values 231
7.7 Determinants of Bond Yields 232
The Term Structure of Interest Rates 232
Bond Yields and the Yield Curve: Putting it all
Together 235
Conclusion 236
7.8 Summary and Conclusions 236
CHAPTER 8
STOCK VALUATION 245
8.1 Common Stock Valuation 246
Cash Flows 246
Some Special Cases 248
Zero Growth 248
Constant Growth 248
Nonconstant Growth 251
Two-Stage Growth 253
Components of the Required Return 254
Stock Valuation Using Multiples 255
8.2 Some Features of Common and Preferred Stocks 257
Common Stock Features 257
Shareholder Rights 257
Proxy Voting 258
Classes of Stock 258
Other Rights 259
Dividends 259
Preferred Stock Features 260
Stated Value 260
Cumulative and Noncumulative Dividends 260
Is Preferred Stock Really Debt? 260
8.3 The Stock Markets 261
Dealers and Brokers 261
Organization of the NYSE 262
Members 262
Operations 263
Floor Activity 263
Nasdaq Operations 264
ECNs 266
Stock Market Reporting 266
8.4 Summary and Conclusions 268
PART 4 Capital Budgeting
CHAPTER 9
NET PRESENT VALUE AND OTHER
INVESTMENT CRITERIA 278
9.1 Net Present Value 279
The Basic Idea 279
Estimating Net Present Value 280
9.2 The Payback Rule 283
Defining the Rule 283
Analyzing the Rule 285
Redeeming Qualities of the Rule 285
Summary of the Rule 286
9.3 The Discounted Payback 287
9.4 The Average Accounting Return 289
9.5 The Internal Rate of Return 291
Problems with the IRR 295
Nonconventional Cash Flows 295
Mutually Exclusive Investments 297
Investing or Financing? 299
Redeeming Qualities of the IRR 300
The Modified Internal Rate of Return (MIRR) 301
Method 1: The Discounting Approach 301
Method 2: The Reinvestment Approach 301
Method 3: The Combination Approach 302
MIRR or IRR: Which Is Better? 302
9.6 The Profitability Index 302
9.7 The Practice of Capital Budgeting 303
9.8 Summary and Conclusions 306
CHAPTER 10
MAKING CAPITAL INVESTMENT DECISIONS 318
10.1 Project Cash Flows: A First Look 319
Relevant Cash Flows 319
The Stand-Alone Principle 319
10.2 Incremental Cash Flows 320
Sunk Costs 320
Opportunity Costs 320
Side Effects 321
Net Working Capital 321
Financing Costs 321
Other Issues 322
10.3 Pro Forma Financial Statements and Project Cash
Flows 322
Getting Started: Pro Forma Financial Statements 322
Project Cash Flows 323
Project Operating Cash Flow 323
Project Net Working Capital and Capital
Spending 324
Projected Total Cash Flow and Value 324
10.4 More about Project Cash Flow 325
A Closer Look at Net Working Capital 325
Depreciation 328
Modified ACRS Depreciation (MACRS) 328
Bonus Depreciation 329
Book Value versus Market Value 330
An Example: The Majestic Mulch and Compost Company
(MMCC) 331
Operating Cash Flows 332
Change in NWC 333
Capital Spending 334
Total Cash Flow and Value 334
Conclusion 334
10.5 Alternative Definitions of Operating Cash Flow 335
The Bottom-Up Approach 336
The Top-Down Approach 336
The Tax Shield Approach 336
Conclusion 337
10.6 Some Special Cases of Discounted Cash Flow
Analysis 337
Evaluating Cost-Cutting Proposals 337
Setting the Bid Price 339
Evaluating Equipment Options with Different Lives 341
10.7 Summary and Conclusions 343
CHAPTER 11
PROJECT ANALYSIS AND EVALUATION 356
11.1 Evaluating NPV Estimates 357
The Basic Problem 357
Projected versus Actual Cash Flows 357
Forecasting Risk 357
Sources of Value 358
11.2 Scenario and Other What-If Analyses 359
Getting Started 359
Scenario Analysis 360
Sensitivity Analysis 362
Simulation Analysis 364
11.3 Break-Even Analysis 364
Fixed and Variable Costs 365
Variable Costs 365
Fixed Costs 366
Total Costs 366
Accounting Break-Even 367
Accounting Break-Even: A Closer Look 369
Uses for the Accounting Break-Even 369
11.4 Operating Cash Flow, Sales Volume, and
Break-Even 370
Accounting Break-Even and Cash Flow 370
The Base Case 371
Calculating the Break-Even Level 371
Payback and Break-Even 371
Sales Volume and Operating Cash Flow 372
Cash Flow, Accounting, and Financial Break-Even
Points 372
Accounting Break-Even Revisited 373
Cash Break-Even 373
Financial Break-Even 373
Conclusion 374
11.5 Operating Leverage 375
The Basic Idea 375
Implications of Operating Leverage 375
Measuring Operating Leverage 375
Operating Leverage and Break-Even 377
11.6 Capital Rationing 378
Soft Rationing 378
Hard Rationing 378
11.7 Summary and Conclusions 379
PART 5 Risk and Return
CHAPTER 12
SOME LESSONS FROM CAPITAL MARKET HISTORY 388
12.1 Returns 389
Dollar Returns 389
Percentage Returns 391
12.2 The Historical Record 393
A First Look 393
A Closer Look 395
12.3 Average Returns: The First Lesson 400
Calculating Average Returns 400
Average Returns: The Historical Record 400
Risk Premiums 401
The First Lesson 401
12.4 The Variability of Returns: The Second Lesson 402
Frequency Distributions and Variability 402
The Historical Variance and Standard Deviation 403
The Historical Record 404
Normal Distribution 405
The Second Lesson 407
2008: A Year to Remember 407
Using Capital Market History 408
More on the Stock Market Risk Premium 409
12.5 More about Average Returns 411
Arithmetic versus Geometric Averages 411
Calculating Geometric Average Returns 411
Arithmetic Average Return or Geometric Average
Return? 414
12.6 Capital Market Efficiency 415
Price Behavior in an Efficient Market 415
The Efficient Markets Hypothesis 416
Some Common Misconceptions about the EMH 417
The Forms of Market Efficiency 418
12.7 Summary and Conclusions 419
CHAPTER 13
RETURN, RISK, AND THE SECURITY MARKET LINE 427
13.1 Expected Returns and Variances 428
Expected Return 428
Calculating the Variance 430
13.2 Portfolios 431
Portfolio Weights 432
Portfolio Expected Returns 432
Portfolio Variance 433
13.3 Announcements, Surprises, and Expected
Returns 435
Expected and Unexpected Returns 435
Announcements and News 435
13.4 Risk: Systematic and Unsystematic 437
Systematic and Unsystematic Risk 437
Systematic and Unsystematic Components of
Return 437
13.5 Diversification and Portfolio Risk 438
The Effect of Diversification: Another Lesson from Market
History 438
The Principle of Diversification 439
Diversification and Unsystematic Risk 440
Diversification and Systematic Risk 441
13.6 Systematic Risk and Beta 441
The Systematic Risk Principle 442
Measuring Systematic Risk 442
Portfolio Betas 444
13.7 The Security Market Line 445
Beta and the Risk Premium 445
The Reward-to-Risk Ratio 446
The Basic Argument 447
The Fundamental Result 448
The Security Market Line 450
Market Portfolios 450
The Capital Asset Pricing Model 450
13.8 The SML and the Cost of Capital: A Preview 453
The Basic Idea 453
The Cost of Capital 453
13.9 Summary and Conclusions 454
Part 6 Cost of Capital and Long-Term Financial Policy
CHAPTER 14
COST OF CAPITAL 465
14.1 The Cost of Capital: Some Preliminaries 466
Required Return versus Cost of Capital 466
Financial Policy and Cost of Capital 467
14.2 The Cost of Equity 467
The Dividend Growth Model Approach 467
Implementing the Approach 468
Estimating g 468
Advantages and Disadvantages of the
Approach 469
The SML Approach 469
Implementing the Approach 470
Advantages and Disadvantages of the
Approach 470
14.3 The Costs of Debt and Preferred Stock 471
The Cost of Debt 471
The Cost of Preferred Stock 471
14.4 The Weighted Average Cost of Capital 472
The Capital Structure Weights 472
Taxes and the Weighted Average Cost of Capital 473
Calculating the WACC for Eastman Chemical 474
Eastman’s Cost of Equity 475
Eastman’s Cost of Debt 477
Eastman’s WACC 478
Solving the Warehouse Problem and Similar Capital
Budgeting Problems 480
Performance Evaluation: Another Use of the
WACC 482
14.5 Divisional and Project Costs of Capital 483
The SML and the WACC 483
Divisional Cost of Capital 484
The Pure Play Approach 484
The Subjective Approach 485
14.6 Company Valuation with the WACC 486
14.7 Flotation Costs and the Average Cost
of Capital 489
The Basic Approach 489
Flotation Costs and NPV 490
Internal Equity and Flotation Costs 492
14.8 Summary and Conclusions 492
CHAPTER 15
RAISING CAPITAL 502
15.1 Entrepreneurship: Early-Stage Financing and Venture
Capital 503
Entrepreneurship 503
Venture Capital 503
Some Venture Capital Realities 505
Venture Capital Firms 506
Crowdfunding 507
Initial Coin Offerings (ICOS) 507
Conclusion 508
15.2 Selling Securities to the Public: The Basic
Procedure 508
15.3 Alternative Issue Methods 511
15.4 Underwriters 512
Choosing an Underwriter 512
Types of Underwriting 512
Firm Commitment Underwriting 512
Best Efforts Underwriting 513
Dutch Auction Underwriting 513
The Aftermarket 514
The Green Shoe Provision 514
Lockup Agreements 514
The Quiet Period 515
Direct Listing 515
15.5 IPOS and Underpricing 515
IPO Underpricing: The 1999–2000 Experience 516
Evidence on Underpricing 519
The Partial Adjustment Phenomenon 520
Why Does Underpricing Exist? 521
15.6 New Equity Sales and the Value of the Firm 522
15.7 The Costs of Issuing Securities 523
The Costs of Selling Stock to the Public 523
The Costs of Going Public: A Case Study 524
15.8 Rights 525
The Mechanics of a Rights Offering 525
Number of Rights Needed to Purchase a Share 526
The Value of a Right 527
Ex Rights 528
The Underwriting Arrangements 530
Effects on Shareholders 530
15.9 Dilution 531
Dilution of Proportionate Ownership 531
Dilution of Value: Book versus Market Values 531
A Misconception 532
The Correct Arguments 532
15.10 Issuing Long-Term Debt 533
15.11 Shelf Registration 534
15.12 Summary and Conclusions 535
CHAPTER 16
FINANCIAL LEVERAGE AND CAPITAL STRUCTURE
POLICY 541
16.1 The Capital Structure Question 542
Firm Value and Stock Value: An Example 542
Capital Structure and the Cost of Capital 543
16.2 The Effect of Financial Leverage 544
The Basics of Financial Leverage 544
Financial Leverage, EPS, and ROE: An Example 544
EPS versus EBIT 545
Corporate Borrowing and Homemade Leverage 547
16.3 Capital Structure and the Cost of Equity Capital 548
M&M Proposition I: The Pie Model 548
The Cost of Equity and Financial Leverage:
M&M Proposition II 549
Business and Financial Risk 551
16.4 M&M Propositions I and II with Corporate Taxes 552
The Interest Tax Shield 553
Taxes and M&M Proposition I 553
Taxes, the WACC, and Proposition II 554
Conclusion 555
16.5 Bankruptcy Costs 557
Direct Bankruptcy Costs 558
Indirect Bankruptcy Costs 558
16.6 Optimal Capital Structure 559
The Static Theory of Capital Structure 559
Optimal Capital Structure and the Cost of Capital 560
Optimal Capital Structure: A Recap 561
Capital Structure: Some Managerial
Recommendations 563
Taxes 563
Financial Distress 563
16.7 The Pie Again 563
The Extended Pie Model 564
Marketed Claims versus Nonmarketed Claims 565
16.8 The Pecking-Order Theory 565
Internal Financing and the Pecking Order 565
Implications of the Pecking Order 566
16.9 Observed Capital Structures 567
16.10 A Quick Look at the Bankruptcy Process 569
Liquidation and Reorganization 569
Bankruptcy Liquidation 569
Bankruptcy Reorganization 570
Financial Management and the Bankruptcy
Process 571
Agreements to Avoid Bankruptcy 572
16.11 Summary and Conclusions 572
CHAPTER 17
DIVIDENDS AND PAYOUT POLICY 580
17.1 Cash Dividends and Dividend Payment 581
Cash Dividends 581
Standard Method of Cash Dividend Payment 581
Dividend Payment: A Chronology 582
More about the Ex-dividend Date 582
17.2 Does Dividend Policy Matter? 584
An Illustration of the Irrelevance of Dividend Policy 584
Current Policy: Dividends Set Equal to Cash Flow 584
Alternative Policy: Initial Dividend Greater Than Cash
Flow 585
Homemade Dividends 585
A Test 586
17.3 Real-World Factors Favoring a Low Dividend
Payout 587
Taxes 587
Flotation Costs 587
Dividend Restrictions 587
17.4 Real-World Factors Favoring a High Dividend
Payout 588
Desire for Current Income 588
Tax and Other Benefits from High Dividends 589
Corporate Investors 589
Tax-Exempt Investors 589
Conclusion 589
17.5 A Resolution of Real-World Factors? 589
Information Content of Dividends 590
The Clientele Effect 591
17.6 Stock Repurchases: An Alternative to Cash
Dividends 591
Cash Dividends versus Repurchase 592
Real-World Considerations in a Repurchase 594
Share Repurchase and EPS 594
17.7 What We Know and Do Not Know about Dividend and
Payout Policies 595
Dividends and Dividend Payers 595
Corporations Smooth Dividends 597
Putting It All Together 598
Some Survey Evidence on Dividends 600
17.8 Stock Dividends and Stock Splits 602
Some Details about Stock Splits and Stock
Dividends 602
Example of a Small Stock Dividend 602
Example of a Stock Split 603
Example of a Large Stock Dividend 603
Value of Stock Splits and Stock Dividends 603
The Benchmark Case 603
Popular Trading Range 604
Reverse Splits 604
17.9 Summary and Conclusions 605
Part 7 Short-Term Financial Planning and Management
CHAPTER 18
SHORT-TERM FINANCE AND PLANNING 612
18.1 Tracing Cash and Net Working Capital 613
18.2 The Operating Cycle and the Cash Cycle 614
Defining the Operating and Cash Cycles 615
The Operating Cycle 615
The Cash Cycle 615
The Operating Cycle and the Firm’s Organizational
Chart 616
Calculating the Operating and Cash Cycles 617
The Operating Cycle 617
The Cash Cycle 618
Interpreting the Cash Cycle 619
18.3 Some Aspects of Short-Term Financial Policy 620
The Size of the Firm’s Investment in Current
Assets 620
Alternative Financing Policies for Current Assets 621
An Ideal Case 623
Different Policies for Financing Current Assets 623
Which Financing Policy Is Best? 625
Current Assets and Liabilities in Practice 626
18.4 The Cash Budget 627
Sales and Cash Collections 627
Cash Outflows 628
The Cash Balance 628
18.5 Short-Term Borrowing 630
Unsecured Loans 630
Compensating Balances 630
Cost of a Compensating Balance 630
Letters of Credit 631
Secured Loans 631
Accounts Receivable Financing 631
Inventory Loans 632
Other Sources 633
18.6 A Short-Term Financial Plan 633
18.7 Summary and Conclusions 634
CHAPTER 19
CASH AND LIQUIDITY MANAGEMENT 646
19.1 Reasons for Holding Cash 647
The Speculative and Precautionary Motives 647
The Transaction Motive 647
Compensating Balances 647
Costs of Holding Cash 647
Cash Management versus Liquidity Management 648
19.2 Understanding Float 648
Disbursement Float 648
Collection Float and Net Float 649
Float Management 650
Measuring Float 650
Some Details 651
Cost of the Float 652
Ethical and Legal Questions 653
Electronic Data Interchange and Check 21: The End of
Float? 654
19.3 Cash Collection and Concentration 655
Components of Collection Time 655
Cash Collection 655
Lockboxes 655
Cash Concentration 657
Accelerating Collections: An Example 658
19.4 Managing Cash Disbursements 659
Increasing Disbursement Float 660
Controlling Disbursements 660
Zero-Balance Accounts 660
Controlled Disbursement Accounts 661
19.5 Investing Idle Cash 661
Temporary Cash Surpluses 661
Seasonal or Cyclical Activities 661
Planned or Possible Expenditures 661
Characteristics of Short-Term Securities 662
Maturity 662
Default Risk 662
Marketability 662
Taxes 663
Some Different Types of Money Market Securities 663
19.6 Summary and Conclusions 664
CHAPTER 20
CREDIT AND INVENTORY MANAGEMENT 679
20.1 Credit and Receivables 679
Components of Credit Policy 680
The Cash Flows from Granting Credit 680
The Investment in Receivables 681
20.2 Terms of the Sale 681
The Basic Form 681
The Credit Period 682
The Invoice Date 682
Length of the Credit Period 682
Cash Discounts 683
Cost of the Credit 684
Trade Discounts 684
The Cash Discount and the ACP 684
Credit Instruments 685
20.3 Analyzing Credit Policy 685
Credit Policy Effects 685
Evaluating a Proposed Credit Policy 686
NPV of Switching Policies 686
A Break-Even Application 688
20.4 Optimal Credit Policy 688
The Total Credit Cost Curve 688
Organizing the Credit Function 689
20.5 Credit Analysis 690
When Should Credit Be Granted? 690
A One-Time Sale 690
Repeat Business 691
Credit Information 692
Credit Evaluation and Scoring 692
20.6 Collection Policy 693
Monitoring Receivables 693
Collection Effort 694
20.7 Inventory Management 694
The Financial Manager and Inventory Policy 694
Inventory Types 695
Inventory Costs 695
20.8 Inventory Management Techniques 696
The ABC Approach 696
The Economic Order Quantity Model 696
Inventory Depletion 698
The Carrying Costs 698
The Restocking Costs 698
The Total Costs 699
Extensions to the EOQ Model 701
Safety Stocks 701
Reorder Points 701
Managing Derived-Demand Inventories 701
Materials Requirements Planning 701
Just-in-Time Inventory 703
20.9 Summary and Conclusions 703
Part 8 Topics in Corporate Finance
CHAPTER 21
INTERNATIONAL CORPORATE FINANCE 717
21.1 Terminology 718
21.2 Foreign Exchange Markets and Exchange Rates 719
Exchange Rates 720
Exchange Rate Quotations 720
Cross-Rates and Triangle Arbitrage 720
Types of Transactions 723
21.3 Purchasing Power Parity 724
Absolute Purchasing Power Parity 724
Relative Purchasing Power Parity 726
The Basic Idea 726
The Result 726
Currency Appreciation and Depreciation 727
21.4 Interest Rate Parity, Unbiased Forward Rates, and the
International Fisher Effect 728
Covered Interest Arbitrage 728
Interest Rate Parity 729
Forward Rates and Future Spot Rates 730
Putting It All Together 730
Uncovered Interest Parity 731
The International Fisher Effect 731
21.5 International Capital Budgeting 732
Method 1: The Home Currency Approach 732
Method 2: The Foreign Currency Approach 733
Unremitted Cash Flows 734
21.6 Exchange Rate Risk 734
Short-Run Exposure 734
Long-Run Exposure 735
Translation Exposure 736
Managing Exchange Rate Risk 737
21.7 Political Risk 737
The Tax Cuts and Jobs Act of 2017 737
Managing Political Risk 738
21.8 Summary and Conclusions 739
CHAPTER 22
BEHAVIORAL FINANCE: IMPLICATIONS FOR
FINANCIAL MANAGEMENT 746
22.1 Introduction to Behavioral Finance 747
22.2 Biases 747
Overconfidence 747
Overoptimism 748
Confirmation Bias 748
22.3 Framing Effects 749
Loss Aversion 749
House Money 750
22.4 Heuristics 752
The Affect Heuristic 752
The Representativeness Heuristic 753
Representativeness and Randomness 753
The Gambler’s Fallacy 754
22.5 Behavioral Finance and Market Efficiency 755
Limits to Arbitrage 756
The 3Com/Palm Mispricing 756
The Royal Dutch/Shell Price Ratio 757
Bubbles and Crashes 758
The Crash of 1929 758
The Crash of October 1987 759
The Nikkei Crash 761
The “Dot-Com” Bubble and Crash 761
22.6 Market Efficiency and the Performance of Professional
Money Managers 763
22.7 Summary and Conclusions 766
CHAPTER 23
ENTERPRISE RISK MANAGEMENT 769
23.1 Insurance 770
23.2 Managing Financial Risk 772
The Risk Profile 772
Reducing Risk Exposure 772
Hedging Short-Run Exposure 774
Cash Flow Hedging: A Cautionary Note 774
Hedging Long-Term Exposure 775
Conclusion 775
23.3 Hedging with Forward Contracts 776
Forward Contracts: The Basics 776
The Payoff Profile 776
Hedging with Forwards 777
A Caveat 777
Credit Risk 778
Forward Contracts in Practice 778
23.4 Hedging with Futures Contracts 778
Trading in Futures 779
Futures Exchanges 779
Hedging with Futures 779
23.5 Hedging with Swap Contracts 782
Currency Swaps 782
Interest Rate Swaps 783
Commodity Swaps 783
The Swap Dealer 783
Interest Rate Swaps: An Example 784
23.6 Hedging with Option Contracts 785
Option Terminology 785
Options versus Forwards 785
Option Payoff Profiles 785
Option Hedging 786
Hedging Commodity Price Risk with Options 787
Hedging Exchange Rate Risk with Options 788
Hedging Interest Rate Risk with Options 788
A Preliminary Note 788
Interest Rate Caps 789
Other Interest Rate Options 789
Actual Use of Derivatives 789
23.7 Summary and Conclusions 791
CHAPTER 24
OPTIONS AND CORPORATE FINANCE 796
24.1 Options: The Basics 797
Puts and Calls 797
Stock Option Quotations 798
Option Payoffs 799
24.2 Fundamentals of Option Valuation 802
Value of a Call Option at Expiration 802
The Upper and Lower Bounds on a Call Option’s
Value 803
The Upper Bound 803
The Lower Bound 803
A Simple Model: Part I 805
The Basic Approach 805
A More Complicated Case 805
Four Factors Determining Option Values 806
24.3 Valuing a Call Option 807
A Simple Model: Part II 807
The Fifth Factor 808
A Closer Look 809
24.4 Employee Stock Options 810
ESO Features 811
ESO Repricing 811
ESO Backdating 812
24.5 Equity as a Call Option on the Firm’s Assets 813
Case I: The Debt Is Risk-Free 813
Case II: The Debt Is Risky 814
24.6 Options and Capital Budgeting 815
The Investment Timing Decision 816
Managerial Options 817
Contingency Planning 818
Options in Capital Budgeting: An Example 819
Strategic Options 820
Conclusion 820
24.7 Options and Corporate Securities 820
Warrants 821
The Difference between Warrants and Call
Options 821
Earnings Dilution 821
Convertible Bonds 822
Features of a Convertible Bond 822
Value of a Convertible Bond 822
Other Options 824
The Call Provision on a Bond 824
Put Bonds 824
Insurance and Loan Guarantees 825
24.8 Summary and Conclusions 826
CHAPTER 25
OPTION VALUATION 835
25.1 Put-Call Parity 836
Protective Puts 836
An Alternative Strategy 836
The Result 837
Continuous Compounding: A Refresher Course 838
25.2 The Black-Scholes Option Pricing Model 841
The Call Option Pricing Formula 841
Put Option Valuation 844
A Cautionary Note 845
25.3 More about Black-Scholes 846
Varying the Stock Price 846
Varying the Time to Expiration 849
Varying the Standard Deviation 851
Varying the Risk-Free Rate 851
Implied Standard Deviations 851
25.4 Valuation of Equity and Debt in a Leveraged Firm 854
Valuing the Equity in a Leveraged Firm 855
Options and the Valuation of Risky Bonds 856
25.5 Options and Corporate Decisions: Some
Applications 857
Mergers and Diversification 857
Options and Capital Budgeting 859
25.6 Summary and Conclusions 861
CHAPTER 26
MERGERS AND ACQUISITIONS 869
26.1 The Legal Forms of Acquisitions 870
Merger or Consolidation 870
Acquisition of Stock 871
Acquisition of Assets 871
Acquisition Classifications 872
A Note about Takeovers 872
Alternatives to Merger 873
26.2 Taxes and Acquisitions 873
Determinants of Tax Status 873
Taxable versus Tax-Free Acquisitions 874
26.3 Accounting for Acquisitions 874
The Purchase Method 874
More about Goodwill 875
26.4 Gains from Acquisitions 876
Synergy 876
Revenue Enhancement 877
Marketing Gains 877
Strategic Benefits 877
Increases in Market Power 878
Cost Reductions 878
Economies of Scale 878
Economies of Vertical Integration 878
Complementary Resources 879
Lower Taxes 879
Net Operating Losses 879
Unused Debt Capacity 879
Surplus Funds 879
Asset Write-Ups 880
Reductions in Capital Needs 880
Avoiding Mistakes 880
A Note about Inefficient Management 881
26.5 Some Financial Side Effects of Acquisitions 881
EPS Growth 881
Diversification 882
26.6 The Cost of an Acquisition 883
Case I: Cash Acquisition 884
Case II: Stock Acquisition 884
Cash versus Common Stock 885
26.7 Defensive Tactics 886
The Corporate Charter 886
Repurchase and Standstill Agreements 886
Poison Pills and Share Rights Plans 886
Going Private and Leveraged Buyouts 888
Other Devices and Jargon of Corporate Takeovers 888
26.8 Some Evidence on Acquisitions: Does M&A Pay? 889
26.9 Divestitures and Restructurings 890
26.10 Summary and Conclusions 891
CHAPTER 27
LEASING 900
27.1 Leases and Lease Types 901
Leasing versus Buying 901
Operating Leases 902
Financial Leases 902
Tax-Oriented Leases 902
Leveraged Leases 903
Sale and Leaseback Agreements 903
27.2 Accounting and Leasing 903
27.3 Taxes, the IRS, and Leases 905
27.4 The Cash Flows from Leasing 905
The Incremental Cash Flows 906
A Note about Taxes 906
27.5 Lease or Buy? 907
A Preliminary Analysis 907
Three Potential Pitfalls 908
NPV Analysis 908
A Misconception 910
27.6 A Leasing Paradox 910
27.7 Reasons for Leasing 911
Good Reasons for Leasing 912
Tax Advantages 912
A Reduction of Uncertainty 913
Lower Transactions Costs 913
Fewer Restrictions and Security Requirements 913
Dubious Reasons for Leasing 913
100 Percent Financing 913
Low Cost 914
Other Reasons for Leasing 914
27.8 Summary and Conclusions 914
Appendix A
Mathematical Tables A-1
Appendix B
Key Equations B-1
Appendix C
Answers To Selected End-Of-Chapter
Problems C-1
Appendix D
Using The Hp 10b And Ti Ba Ii
Plus Financial Calculators D-1
Index I-1