Corporate Finance, Sixth Edition
Jonathan Berk and Peter Demarzo
Detailed Contents
PART 1 INTRODUCTION 1
Chapter 1 The Corporation and Financial
Markets 2
1.1 The Four Types of Firms 3
Sole Proprietorships 3
Partnerships 4
Limited Liability Companies 5
Corporations 5
Tax Implications for Corporate Entities 6
■ Corporate Taxation Around the
World 7
1.2 Ownership Versus Control of
Corporations 7
The Corporate Management Team 7
■ INTERVIEW with David Viniar 8
The Financial Manager 9
■ FINANCE IN TIMES OF DISRUPTION
The Dodd-Frank Act 10
The Goal of the Firm 10
The Firm and Society 10
Ethics and Incentives within
Corporations 11
■ Shareholder versus Stakeholder
Value 11
■ FINANCE IN TIMES OF DISRUPTION
The Dodd-Frank Act on Corporate
Compensation 12
■ Citizens United v. Federal Election
Commission 13
■ Airlines in Bankruptcy 14
1.3 The Stock Market 14
Primary and Secondary Stock Markets 15
Traditional Trading Venues 15
■ INTERVIEW with Adena T. Friedman 16
New Competition and Market
Changes 17
Dark Pools 18
1.4 Fintech: Finance and Technology 19
Telecommunications 19
Security and Verification 19
Automation of Banking Services 20
Big Data and Machine Learning 20
Competition 21
Key Points and Equations 21 ■ Key
Terms 22 ■ Further Reading 23 ■
Problems 23
Chapter 2 Introduction to Financial
Statement Analysis 27
2.1 Firms’ Disclosure of Financial
Information 28
Preparation of Financial Statements 28
■ International Financial Reporting
Standards 28
■ INTERVIEW with Ruth Porat 29
Types of Financial Statements 30
2.2 The Balance Sheet 30
Assets 31
Liabilities 32
Stockholders’ Equity 33
Market Value Versus Book Value 33
Enterprise Value 34
2.3 The Income Statement 34
Earnings Calculations 35
2.4 The Statement of Cash Flows 36
Operating Activity 37
Investment Activity 38
Financing Activity 38
2.5 Other Financial Statement Information 39
Statement of Stockholders’ Equity 39
Management Discussion and Analysis 40
Notes to the Financial Statements 40
2.6 Financial Statement Analysis 41
Profitability Ratios 41
Liquidity Ratios 42
Working Capital Ratios 43
Interest Coverage Ratios 44
Leverage Ratios 45
Valuation Ratios 47
■ COMMON MISTAKE Mismatched
Ratios 47
Operating Returns 48
The DuPont Identity 50
2.7 Financial Reporting in Practice 52
Enron 52
WorldCom 52
Sarbanes-Oxley Act 53
■ FINANCE IN TIMES OF DISRUPTION
Bernard Madoff’s Ponzi Scheme 54
Dodd-Frank Act 54
Foreign Regulation: Wirecard 54
Key Points and Equations 55 ■ Key
Terms 57 ■ Further Reading 58 ■
Problems 58 ■ Data Case 64
Chapter 3 Financial Decision Making and the
Law of One Price 67
3.1 Valuing Decisions 68
Analyzing Costs and Benefits 68
Using Market Prices to Determine Cash
Values 69
■ When Competitive Market Prices Are Not
Available 71
3.2 Interest Rates and the Time Value of
Money 71
The Time Value of Money 71
The Interest Rate: An Exchange Rate Across
Time 71
3.3 Present Value and the NPV Decision Rule 74
Net Present Value 74
The NPV Decision Rule 75
NPV and Cash Needs 77
3.4 Arbitrage and the Law of One Price 78
Arbitrage 78
Law of One Price 79
3.5 No-Arbitrage and Security Prices 79
Valuing a Security with the Law of One
Price 79
■ An Old Joke 83
The NPV of Trading Securities and Firm
Decision Making 83
Valuing a Portfolio 84
■ FINANCE IN TIMES OF DISRUPTION
Liquidity and the Informational Role of
Prices 85
■ Arbitrage in Markets 86
Where Do We Go from Here? 87
Key Points and Equations 88 ■ Key
Terms 89 ■ Further Reading 89 ■
Problems 89 ■ Data Case 93
Appendix The Price of Risk 94
Risky Versus Risk-Free Cash Flows 94
Arbitrage with Transactions Costs 99
PART 2 TIME, MONEY, AND
INTEREST RATES 103
Chapter 4 The Time Value of Money 104
4.1 The Timeline 105
4.2 The Three Rules of Time Travel 106
Rule 1: Comparing and Combining
Values 106
Rule 2: Moving Cash Flows Forward in
Time 107
Rule 3: Moving Cash Flows Back in Time 108
■ Rule of 72 109
Applying the Rules of Time Travel 110
4.3 Valuing a Stream of Cash Flows 112
4.4 Calculating the Net Present Value 114
■ USING EXCEL Calculating Present Values
in Excel 116
4.5 Perpetuities and Annuities 117
Perpetuities 117
■ Historical Examples of Perpetuities 117
■ COMMON MISTAKE Discounting One
Too Many Times 119
Annuities 119
■ Formula for an Annuity Due 122
Growing Cash Flows 123
4.6 Using an Annuity Spreadsheet or
Calculator 127
■ Annuity Calculator 129
4.7 Non-Annual Cash Flows 130
4.8 Solving for the Cash Payments 131
4.9 The Internal Rate of Return 134
■ USING EXCEL Excel’s IRR Function 137
Key Points and Equations 138 ■ Key
Terms 139 ■ Further Reading 140 ■
Problems 140 ■ Data Case 146
Appendix Solving for the Number of Periods 147
Chapter 5 Interest Rates 149
5.1 Interest Rate Quotes and Adjustments 150
The Effective Annual Rate 150
■ COMMON MISTAKE Using the
Wrong Discount Rate in the Annuity
Formula 151
Annual Percentage Rates 152
5.2 Application: Discount Rates and Loans 154
5.3 The Determinants of Interest Rates 155
■ FINANCE IN TIMES OF DISRUPTION
Teaser Rates and Subprime Loans 156
Inflation and Real Versus Nominal
Rates 156
Investment and Interest Rate Policy 158
The Yield Curve and Discount Rates 159
The Yield Curve and the Economy 160
■ COMMON MISTAKE Using the Annuity
Formula When Discount Rates Vary by
Maturity 160
■ INTERVIEW with Dr. Janet Yellen 162
5.4 Risk and Taxes 163
Risk and Interest Rates 164
After-Tax Interest Rates 165
5.5 The Opportunity Cost of Capital 166
■ COMMON MISTAKE States Dig a Multi-
Trillion Dollar Hole by Discounting at the
Wrong Rate 167
Key Points and Equations 168 ■ Key
Terms 169 ■ Further Reading 169 ■
Problems 169 ■ Data Case 174
Appendix Continuous Rates and Cash Flows 175
Discount Rates for a Continuously
Compounded APR 175
Continuously Arriving Cash Flows 175
Chapter 6 Valuing Bonds 177
6.1 Bond Cash Flows, Prices, and Yields 178
Bond Terminology 178
Zero-Coupon Bonds 178
■ FINANCE IN TIMES OF DISRUPTION
Negative Bond Yields 180
Coupon Bonds 181
6.2 Dynamic Behavior of Bond Prices 183
Discounts and Premiums 183
Time and Bond Prices 184
Interest Rate Changes and Bond Prices 186
■ Clean and Dirty Prices for Coupon
Bonds 187
6.3 The Yield Curve and Bond Arbitrage 189
Replicating a Coupon Bond 189
Valuing a Coupon Bond Using Zero-Coupon
Yields 190
Coupon Bond Yields 191
Treasury Yield Curves 192
6.4 Corporate Bonds 192
Corporate Bond Yields 193
■ Are Treasuries Really Default-Free
Securities? 193
Bond Ratings 195
Corporate Yield Curves 196
6.5 Sovereign Bonds 196
■ FINANCE IN TIMES OF DISRUPTION The
Credit Crisis and Bond Yields 197
■ FINANCE IN TIMES OF DISRUPTION
European Sovereign Debt Yields: A
Puzzle 199
■ INTERVIEW with Carmen M. Reinhart 200
Key Points and Equations 201 ■ Key
Terms 202 ■ Further Reading 203 ■
Problems 203 ■ Data Case 207 ■ Case
Study 208
Appendix Forward Interest Rates 210
Computing Forward Rates 210
Computing Bond Yields from Forward
Rates 211
Forward Rates and Future Interest
Rates 212
PART 3 VALUING PROJECTS AND
FIRMS 215
Chapter 7 Investment Decision Rules 216
7.1 NPV and Stand-Alone Projects 217
Applying the NPV Rule 217
The NPV Profile and IRR 217
Alternative Rules Versus the
NPV Rule 218
■ INTERVIEW with Dick Grannis 219
7.2 The Internal Rate of Return Rule 220
Applying the IRR Rule 220
Pitfall #1: Delayed Investments 220
Pitfall #2: Multiple IRRs 221
■ COMMON MISTAKE IRR Versus the IRR
Rule 223
Pitfall #3: Nonexistent IRR 223
7.3 The Payback Rule 224
Applying the Payback Rule 224
Payback Rule Pitfalls in Practice 225
■ Why Do Rules Other Than the NPV Rule
Persist? 226
7.4 Choosing between Projects 226
NPV Rule and Mutually Exclusive
Investments 226
IRR Rule and Mutually Exclusive
Investments 227
The Incremental IRR 228
■ COMMON MISTAKE Manipulating the
IRR with Financing 229
■ When Can Returns Be Compared? 231
7.5 Project Selection with Resource
Constraints 231
Evaluating Projects with Different Resource
Requirements 231
Profitability Index 232
Shortcomings of the Profitability
Index 234
Key Points and Equations 234 ■ Key
Terms 235 ■ Further Reading 235 ■
Problems 235 ■ Data Case 241
Appendix Computing the NPV Profile Using Excel’s
Data Table Function 242
Chapter 8 Fundamentals of Capital
Budgeting 243
8.1 Forecasting Earnings 244
Revenue and Cost Estimates 244
Incremental Earnings Forecast 245
Indirect Effects on Incremental Earnings 247
■ COMMON MISTAKE The Opportunity
Cost of an Idle Asset 248
Sunk Costs and Incremental Earnings 249
■ COMMON MISTAKE The Sunk Cost
Fallacy 249
Real-World Complexities 250
8.2 Determining Free Cash Flow and NPV 251
Calculating Free Cash Flow from
Earnings 251
Calculating Free Cash Flow Directly 253
Calculating the NPV 254
■ USING EXCEL Capital Budgeting Using
Excel 255
8.3 Choosing among Alternatives 256
Evaluating Manufacturing Alternatives 256
Comparing Free Cash Flows for Cisco’s
Alternatives 257
8.4 Further Adjustments to Free Cash Flow 257
■ INTERVIEW with David Holland 262
8.5 Analyzing the Project 263
Break-Even Analysis 263
■ COMMON MISTAKE Corporate Tax Rates
and Investment 264
Sensitivity Analysis 264
■ USING EXCEL Project Analysis Using
Excel 266
Scenario Analysis 267
Key Points and Equations 269 ■ Key
Terms 270 ■ Further Reading 270 ■
Problems 271 ■ Data Case 277
Appendix MACRS Depreciation 279
Chapter 9 Valuing Stocks 281
9.1 The Dividend-Discount Model 282
A One-Year Investor 282
Dividend Yields, Capital Gains, and Total
Returns 283
■ The Mechanics of a Short Sale 284
A Multiyear Investor 285
The Dividend-Discount Model
Equation 286
9.2 Applying the Dividend-Discount Model 286
Constant Dividend Growth 286
Dividends Versus Investment and
Growth 287
■ John Burr Williams’s Theory of Investment
Value 288
Changing Growth Rates 290
Limitations of the Dividend-Discount
Model 292
9.3 Total Payout and Free Cash Flow Valuation
Models 292
Share Repurchases and the Total Payout
Model 292
The Discounted Free Cash Flow Model 294
9.4 Valuation Based on Comparable Firms 298
Valuation Multiples 298
Limitations of Multiples 300
Comparison with Discounted Cash Flow
Methods 301
Stock Valuation Techniques: The Final
Word 302
■ Kenneth Cole Productions—What
Happened? 303
■ Cryptocurrencies and Price Bubbles 304
■ INTERVIEW with Susan Athey 306
9.5 Information, Competition, and Stock
Prices 307
Information in Stock Prices 307
Competition and Efficient Markets 308
Lessons for Investors and Corporate
Managers 310
■ INTERVIEW with Fahmi Quadi 312
The Efficient Markets Hypothesis Versus No
Arbitrage 313
Key Points and Equations 313 ■ Key
Terms 315 ■ Further Reading 315 ■
Problems 316 ■ Data Case 321
PART 4 RISK AND RETURN 323
Chapter 10 Capital Markets and the Pricing
of Risk 324
10.1 Risk and Return: Insights from 96 Years of
Investor History 325
10.2 Common Measures of Risk and Return 328
Probability Distributions 328
Expected Return 328
Variance and Standard Deviation 329
10.3 Historical Returns of Stocks and Bonds 331
Computing Historical Returns 331
Average Annual Returns 333
The Variance and Volatility of Returns 335
Estimation Error: Using Past Returns to Predict
the Future 336
■ Arithmetic Average Returns Versus
Compound Annual Returns 338
10.4 The Historical Tradeoff Between Risk and
Return 338
The Returns of Large Portfolios 339
The Returns of Individual Stocks 340
10.5 Common Versus Independent Risk 341
Theft Versus Earthquake Insurance: An
Example 341
The Role of Diversification 342
10.6 Diversification in Stock Portfolios 343
Firm-Specific Versus Systematic Risk 344
No Arbitrage and the Risk Premium 345
■ FINANCE IN TIMES OF DISRUPTION
Diversification Benefits During Market
Crashes 347
■ COMMON MISTAKE A Fallacy of Long-
Run Diversification 348
10.7 Measuring Systematic Risk 349
Identifying Systematic Risk: The Market
Portfolio 349
Sensitivity to Systematic Risk: Beta 349
10.8 Beta and the Cost of Capital 352
Estimating the Risk Premium 352
■ COMMON MISTAKE Beta Versus
Volatility 352
The Capital Asset Pricing Model 354
Key Points and Equations 354 ■ Key
Terms 356 ■ Further Reading 356 ■
Problems 356 ■ Data Case 361
Chapter 11 Optimal Portfolio Choice and the
Capital Asset Pricing Model 363
11.1 The Expected Return of a Portfolio 364
11.2 The Volatility of a Two-Stock Portfolio 365
Combining Risks 365
Determining Covariance and
Correlation 366
■ COMMON MISTAKE Computing
Variance, Covariance, and Correlation
in Excel 368
Computing a Portfolio’s Variance and
Volatility 369
11.3 The Volatility of a Large Portfolio 371
Large Portfolio Variance 371
Diversification with an Equally Weighted
Portfolio 372
■ INTERVIEW with Anne Martin 374
Diversification with General Portfolios 375
11.4 Risk Versus Return: Choosing an Efficient
Portfolio 375
Efficient Portfolios with Two Stocks 376
The Effect of Correlation 378
Short Sales 379
Efficient Portfolios with Many Stocks 380
■ NOBEL PRIZE Harry Markowitz and James
Tobin 381
11.5 Risk-Free Saving and Borrowing 383
Investing in Risk-Free Securities 383
Borrowing and Buying Stocks on
Margin 384
Identifying the Tangent Portfolio 385
11.6 The Efficient Portfolio and Required
Returns 387
Portfolio Improvement: Beta and the Required
Return 387
Expected Returns and the Efficient
Portfolio 389
11.7 The Capital Asset Pricing Model 391
The CAPM Assumptions 391
Supply, Demand, and the Efficiency of the
Market Portfolio 392
Optimal Investing: The Capital Market
Line 392
11.8 Determining the Risk Premium 393
Market Risk and Beta 393
■ NOBEL PRIZE William Sharpe on the
CAPM 395
The Security Market Line 396
Beta of a Portfolio 396
Summary of the Capital Asset Pricing
Model 398
Key Points and Equations 398 ■ Key
Terms 401 ■ Further Reading 401 ■
Problems 402 ■ Data Case 408
Appendix The CAPM with Differing Interest
Rates 410
The Efficient Frontier with Differing Saving
and Borrowing Rates 410
The Security Market Line with Differing
Interest Rates 410
Chapter 12 Estimating the Cost of Capital 413
12.1 The Equity Cost of Capital 414
12.2 The Market Portfolio 415
Constructing the Market Portfolio 415
Market Indexes 415
■ Value-Weighted Portfolios and
Rebalancing 416
The Market Risk Premium 417
12.3 Beta Estimation 419
Using Historical Returns 419
Identifying the Best-Fitting Line 421
Using Linear Regression 422
■ Why Not Estimate Expected Returns
Directly? 423
12.4 The Debt Cost of Capital 423
Debt Yields Versus Returns 423
■ COMMON MISTAKE Using the Debt Yield
as Its Cost of Capital 424
Debt Betas 425
12.5 A Project’s Cost of Capital 426
All-Equity Comparables 426
Levered Firms as Comparables 427
The Unlevered Cost of Capital 427
Industry Asset Betas 429
12.6 Project Risk Characteristics and
Financing 431
Differences in Project Risk 431
■ COMMON MISTAKE Adjusting for
Execution Risk 433
Financing and the Weighted Average Cost of
Capital 433
■ INTERVIEW with Shelagh Glaser 434
■ COMMON MISTAKE Using a Single Cost
of Capital in Multi-Divisional Firms 435
12.7 Final Thoughts on Using the CAPM 436
Key Points and Equations 437 ■ Key
Terms 439 ■ Further Reading 439 ■
Problems 440 ■ Data Case 444
Appendix Practical Considerations When Forecasting
Beta 445
Time Horizon 445
The Market Proxy 445
Beta Variation and Extrapolation 445
Outliers 446
■ COMMON MISTAKE Changing the Index
to Improve the Fit 447
■ USING EXCEL Estimating Beta Using
Excel 448
Other Considerations 449
Chapter 13 Investor Behavior and Capital
Market Efficiency 451
13.1 Competition and Capital Markets 452
Identifying a Stock’s Alpha 452
Profiting from Non-Zero Alpha Stocks 453
13.2 Information and Rational Expectations 454
Informed Versus Uninformed
Investors 454
Rational Expectations 455
13.3 The Behavior of Individual Investors 456
Underdiversification and Portfolio Biases 456
Excessive Trading and Overconfidence 457
Individual Behavior and Market Prices 459
13.4 Systematic Trading Biases 459
Hanging on to Losers and the Disposition
Effect 459
■ NOBEL PRIZE Prospect Theory, Mental
Accounting, and Nudges 460
Investor Attention, Mood, and
Experience 460
Herd Behavior 461
Implications of Behavioral Biases 461
13.5 The Efficiency of the Market Portfolio 462
Trading on News or Recommendations 462
■ NOBEL PRIZE The 2013 Prize: An
Enigma? 464
The Performance of Fund Managers 464
The Winners and Losers 467
13.6 Style-Based Techniques and the Market
Efficiency Debate 468
Size Effects 468
■ INTERVIEW with Jonathan Clements 470
Momentum 472
■ Market Efficiency and the Efficiency of the
Market Portfolio 473
Implications of Positive-Alpha Trading
Strategies 473
13.7 Multifactor Models of Risk 475
Using Factor Portfolios 475
Smart Beta 476
Long-Short Portfolios 476
Selecting the Portfolios 477
The Cost of Capital with Fama-French-Carhart
Factor Specification 478
13.8 Methods Used in Practice 480
Financial Managers 480
Investors 481
Key Points and Equations 482 ■ Key
Terms 484 ■ Further Reading 484 ■
Problems 485
Appendix Building a Multifactor Model 491
PART 5 CAPITAL STRUCTURE 493
Chapter 14 Capital Structure in a Perfect
Market 494
14.1 Equity Versus Debt Financing 495
Financing a Firm with Equity 495
Financing a Firm with Debt and Equity 496
The Effect of Leverage on Risk and Return 497
14.2 Modigliani-Miller I: Leverage, Arbitrage, and
Firm Value 499
MM and the Law of One Price 499
Homemade Leverage 499
■ MM and the Real World 500
The Market Value Balance Sheet 501
Application: A Leveraged Recapitalization 502
14.3 Modigliani-Miller II: Leverage, Risk, and the
Cost of Capital 504
Leverage and the Equity Cost of
Capital 504
Capital Budgeting and the Weighted Average
Cost of Capital 505
■ COMMON MISTAKE Is Debt Better Than
Equity? 508
Computing the WACC with Multiple
Securities 508
Levered and Unlevered Betas 508
■ NOBEL PRIZE Franco Modigliani and
Merton Miller 510
14.4 Capital Structure Fallacies 511
Leverage and Earnings per Share 511
■ FINANCE IN TIMES OF DISRUPTION
Bank Capital Regulation and the ROE
Fallacy 513
Equity Issuances and Dilution 514
14.5 MM: Beyond the Propositions 515
Key Points and Equations 516 ■ Key
Terms 517 ■ Further Reading 517 ■
Problems 518
Chapter 15 Debt and Taxes 523
15.1 The Interest Tax Deduction 524
15.2 Valuing the Interest Tax Shield 526
The Interest Tax Shield and Firm
Value 526
■ Pizza and Taxes 527
The Interest Tax Shield with Permanent
Debt 527
The Weighted Average Cost of Capital with
Taxes 528
■ The Repatriation Tax: Why Some Cash-
Rich Firms Borrow 529
The Interest Tax Shield with a Target Debt-
Equity Ratio 530
15.3 Recapitalizing to Capture the Tax
Shield 532
The Tax Benefit 532
The Share Repurchase 533
No Arbitrage Pricing 533
Analyzing the Recap: The Market Value
Balance Sheet 534
15.4 Personal Taxes 535
Including Personal Taxes in the Interest Tax
Shield 535
Determining the Actual Tax Advantage of
Debt 538
Valuing the Interest Tax Shield with Personal
Taxes 539
■ COMMON MISTAKE How to Save for
Retirement 540
15.5 Optimal Capital Structure with Taxes 541
Do Firms Prefer Debt? 541
Limits to the Tax Benefit of Debt 544
Growth and Debt 545
■ INTERVIEW with Andrew Balson 546
Other Tax Shields 547
The Low Leverage Puzzle 547
■ Employee Stock Options 549
Key Points and Equations 549 ■ Key
Terms 550 ■ Further Reading 550 ■
Problems 551 ■ Data Case 555
Chapter 16 Financial Distress, Managerial
Incentives, and Information 557
16.1 Default and Bankruptcy in a Perfect
Market 558
Armin Industries: Leverage and the Risk of
Default 558
Bankruptcy and Capital Structure 559
16.2 The Costs of Bankruptcy and Financial
Distress 560
The Bankruptcy Code 561
Direct Costs of Bankruptcy 561
Indirect Costs of Financial Distress 562
■ FINANCE IN TIMES OF DISRUPTION The
Chrysler Prepack 565
16.3 Financial Distress Costs and Firm
Value 566
Armin Industries: The Impact of Financial
Distress Costs 566
Who Pays for Financial Distress
Costs? 566
16.4 Optimal Capital Structure: The Tradeoff
Theory 568
The Present Value of Financial Distress
Costs 568
Optimal Leverage 569
16.5 Exploiting Debt Holders: The Agency Costs of
Leverage 571
Excessive Risk-Taking and Asset
Substitution 571
Debt Overhang and Under-Investment 572
■ FINANCE IN TIMES OF DISRUPTION
Bailouts, Distress Costs, and Debt
Overhang 573
Agency Costs and the Value of Leverage 574
The Leverage Ratchet Effect 575
Debt Maturity and Covenants 576
■ Why Do Firms Go Bankrupt? 577
16.6 Motivating Managers: The Agency Benefits of
Leverage 577
Concentration of Ownership 578
Reduction of Wasteful Investment 578
■ Excessive Perks and Corporate
Scandals 579
■ FINANCE IN TIMES OF DISRUPTION
Moral Hazard, Bailouts, and the Appeal of
Leverage 580
Leverage and Commitment 580
■ NOBEL PRIZE Contract Theory 581
16.7 Agency Costs and the Tradeoff Theory 581
The Optimal Debt Level 582
Debt Levels in Practice 583
16.8 Asymmetric Information and Capital
Structure 583
Leverage as a Credible Signal 583
Issuing Equity and Adverse Selection 585
■ NOBEL PRIZE Markets with
Asymmetric Information and Adverse
Selection 587
Implications for Equity Issuance 587
Implications for Capital Structure 588
■ NOBEL PRIZE The Cost of Bank
Runs 591
16.9 Capital Structure: The Bottom Line 591
Key Points and Equations 592 ■ Key
Terms 594 ■ Further Reading 594 ■
Problems 595
Chapter 17 Payout Policy 603
17.1 Distributions to Shareholders 604
Dividends 604
Share Repurchases 606
17.2 Comparison of Dividends and Share
Repurchases 607
Alternative Policy 1: Pay Dividend with
Excess Cash 607
Alternative Policy 2: Share Repurchase
(No Dividend) 608
■ COMMON MISTAKE Repurchases and the
Supply of Shares 610
Alternative Policy 3: High Dividend
(Equity Issue) 610
Modigliani-Miller and Dividend Policy
Irrelevance 611
■ COMMON MISTAKE The Bird in the Hand
Fallacy 612
Dividend Policy with Perfect Capital
Markets 612
17.3 The Tax Disadvantage of Dividends 612
Taxes on Dividends and Capital
Gains 612
Optimal Dividend Policy with Taxes 614
17.4 Dividend Capture and Tax Clienteles 616
The Effective Dividend Tax Rate 616
Tax Differences Across Investors 617
Clientele Effects 618
■ INTERVIEW with John Connors 619
17.5 Payout Versus Retention of Cash 621
Retaining Cash with Perfect Capital
Markets 622
Taxes and Cash Retention 623
Adjusting for Investor Taxes 624
Issuance and Distress Costs 625
Agency Costs of Retaining Cash 626
■ COMMON MISTAKE Mischaracterizing
Buybacks 628
17.6 Signaling with Payout Policy 628
Dividend Smoothing 628
Dividend Signaling 629
■ Can a Dividend Cut be Good
News? 630
Signaling and Share Repurchases 631
17.7 Stock Dividends, Splits, and Spin-Offs 633
Stock Dividends and Splits 633
Spin-Offs 634
■ Berkshire Hathaway’s A & B Shares 635
Key Points and Equations 636 ■ Key
Terms 638 ■ Further Reading 638 ■
Problems 639 ■ Data Case 643
PART 6 ADVANCED VALUATION 645
Chapter 18 Capital Budgeting and Valuation
with Leverage 646
18.1 Overview of Key Concepts 647
18.2 The Weighted Average Cost of Capital
Method 648
■ INTERVIEW with Zane Rowe 649
Using the WACC to Value a Project 650
Summary of the WACC Method 651
Implementing a Constant Debt-Equity
Ratio 652
18.3 The Adjusted Present Value Method 654
The Unlevered Value of the Project 654
Valuing the Interest Tax Shield 655
Summary of the APV Method 656
18.4 The Flow-to-Equity Method 658
Calculating the Free Cash Flow to
Equity 658
Valuing Equity Cash Flows 659
■ What Counts as “Debt”? 660
Summary of the Flow-to-Equity Method 660
18.5 Project-Based Costs of Capital 661
Estimating the Unlevered Cost of
Capital 662
Project Leverage and the Equity Cost of
Capital 662
Determining the Incremental Leverage of a
Project 664
■ COMMON MISTAKE Re-Levering the
WACC 664
18.6 APV with Other Leverage Policies 666
Constant Interest Coverage Ratio 666
Predetermined Debt Levels 667
A Comparison of Methods 669
18.7 Other Effects of Financing 669
Issuance and Other Financing Costs 669
Security Mispricing 670
Financial Distress and Agency Costs 671
■ FINANCE IN TIMES OF DISRUPTION
Government Loan Guarantees 672
18.8 Advanced Topics in Capital Budgeting 672
Periodically Adjusted Debt 673
Leverage and the Cost of Capital 675
The WACC or FTE Method with Changing
Leverage 677
Personal Taxes 678
Key Points and Equations 680 ■ Key
Terms 682 ■ Further Reading 682 ■
Problems 683 ■ Data Case 689
Appendix Foundations and Further Details 691
Deriving the WACC Method 691
The Levered and Unlevered Cost of
Capital 692
Solving for Leverage and Value
Simultaneously 693
The Residual Income and Economic Value
Added Valuation Methods 695
Chapter 19 Valuation and Financial Modeling:
A Case Study 697
19.1 Valuation Using Comparables 698
19.2 The Business Plan 700
Operational Improvements 700
Capital Expenditures: A Needed
Expansion 701
Working Capital Management 702
Capital Structure Changes: Levering Up 702
19.3 Building the Financial Model 703
Forecasting Earnings 703
■ INTERVIEW with Joseph L.
Rice, III 704
Working Capital Requirements 706
Forecasting Free Cash Flow 707
■ USING EXCEL Summarizing Model
Outputs 709
The Balance Sheet and Statement of Cash
Flows (Optional) 710
■ USING EXCEL Auditing Your Financial
Model 712
19.4 Estimating the Cost of Capital 713
CAPM-Based Estimation 713
Unlevering Beta 714
Ideko’s Unlevered Cost of Capital 714
19.5 Valuing the Investment 715
The Multiples Approach to Continuation
Value 716
The Discounted Cash Flow Approach to
Continuation Value 717
■ COMMON MISTAKE Continuation Values
and Long-Run Growth 719
APV Valuation of Ideko’s Equity 719
A Reality Check 720
■ COMMON MISTAKE Missing Assets or
Liabilities 721
IRR and Cash Multiples 721
19.6 Sensitivity Analysis 722
Key Points and Equations 723 ■ Key
Terms 724 ■ Further Reading 724 ■
Problems 725
Appendix Compensating Management 727
PART 7 OPTIONS 729
Chapter 20 Financial Options 730
20.1 Option Basics 731
Understanding Option Contracts 731
Interpreting Stock Option Quotations 731
Options on Other Financial
Securities 733
20.2 Option Payoffs at Expiration 734
Long Position in an Option Contract 734
Short Position in an Option
Contract 735
Profits for Holding an Option to
Expiration 737
Returns for Holding an Option to
Expiration 738
Combinations of Options 739
20.3 Put-Call Parity 742
20.4 Factors Affecting Option Prices 745
Strike Price and Stock Price 745
Arbitrage Bounds on Option Prices 745
Option Prices and the Exercise Date 745
Option Prices and Volatility 746
20.5 Exercising Options Early 747
Non-Dividend-Paying Stocks 747
Dividend-Paying Stocks 749
20.6 Options and Corporate Finance 751
Equity as a Call Option 751
Debt as an Option Portfolio 752
Credit Default Swaps 752
■ FINANCE IN TIMES OF DISRUPTION
Credit Default Swaps 753
Pricing Risky Debt 754
Agency Conflicts 755
Key Points and Equations 756 ■ Key
Terms 757 ■ Further Reading 757 ■
Problems 757 ■ Data Case 762
Chapter 21 Option Valuation 763
21.1 The Binomial Option Pricing Model 764
A Two-State Single-Period Model 764
The Binomial Pricing Formula 766
A Multiperiod Model 767
Making the Model Realistic 771
21.2 The Black-Scholes Option Pricing
Model 772
The Black-Scholes Formula 772
■ INTERVIEW with Myron S. Scholes 773
Implied Volatility 778
■ FINANCE IN TIMES OF DISRUPTION The
VIX Index 779
The Replicating Portfolio 780
21.3 Risk-Neutral Probabilities 782
A Risk-Neutral Two-State Model 782
Implications of the Risk-Neutral
World 782
Risk-Neutral Probabilities and Option
Pricing 783
21.4 Risk and Return of an Option 785
21.5 Corporate Applications of Option
Pricing 787
Beta of Risky Debt 787
■ COMMON MISTAKE Valuing Employee
Stock Options 790
■ NOBEL PRIZE Pricing Financial
Options 791
Agency Costs of Debt 791
Key Points and Equations 792 ■ Key
Terms 794 ■ Further Reading 794 ■
Problems 794
Chapter 22 Real Options 799
22.1 Real Versus Financial Options 800
22.2 Decision Tree Analysis 800
Representing Uncertainty 801
Real Options 802
Solving Decision Trees 802
22.3 The Option to Delay: Investment as a Call
Option 803
An Investment Option 803
Factors Affecting the Timing of
Investment 806
■ Why Are There Empty Lots in Built-Up
Areas of Big Cities? 807
Investment Options and Firm Risk 808
■ FINANCE IN TIMES OF DISRUPTION
Uncertainty, Investment, and the Option
to Delay 809
22.4 Growth and Abandonment Options 810
Valuing Growth Potential 810
■ Growth Options and COVID 812
The Option to Expand 812
The Option to Abandon 813
■ INTERVIEW with Kenneth C. Frazier 814
22.5 Investments with Different Lives 816
■ Equivalent Annual Benefit Method 817
22.6 Optimally Staging Investments 818
22.7 Rules of Thumb 821
The Profitability Index Rule 822
The Hurdle Rate Rule 822
■ The Option to Repay a Mortgage 824
22.8 Key Insights from Real Options 825
Key Points and Equations 825 ■ Key
Terms 827 ■ Further Reading 827 ■
Problems 827
PART 8 LONG-TERM FINANCING
833
Chapter 23 Raising Equity Capital 834
23.1 Equity Financing for Private Companies 835
Sources of Funding 835
■ Crowdfunding: The Wave of the
Future? 836
■ INTERVIEW with Kevin Laws 837
Venture Capital Investing 840
Venture Capital Financing Terms 842
■ COMMON MISTAKE Misinterpreting
Start-Up Valuations 842
■ From Launch to Liquidity 844
Exiting an Investment in a Private
Company 846
23.2 The Initial Public Offering 846
Advantages and Disadvantages of Going
Public 846
Types of Offerings 847
The Mechanics of an IPO 849
■ Google’s IPO 849
■ An Alternative to the Traditional IPO:
Spotify’s Direct Listing 854
23.3 IPO Puzzles 854
Underpricing 854
Cyclicality and Recent Trends 857
■ FINANCE IN TIMES OF DISRUPTION
Worldwide IPO Deals in
2008–2009 858
Cost of an IPO 858
Long-Run Underperformance 859
23.4 SPACs: A New Way to Go Public 860
The SPAC Process 861
Analyzing a Deal 862
SPAC Performance 864
23.5 The Seasoned Equity Offering 865
The Mechanics of an SEO 865
Price Reaction 866
Issuance Costs 867
Key Points and Equations 868 ■ Key
Terms 869 ■ Further Reading 870 ■
Problems 871 ■ Data Case 875
Chapter 24 Debt Financing 877
24.1 Corporate Debt 878
Public Debt 878
Private Debt 882
24.2 Other Types of Debt 883
Sovereign Debt 883
■ Green Bonds 884
Municipal Bonds 885
■ Detroit’s Art Museum at Risk 885
Asset-Backed Securities 886
■ FINANCE IN TIMES OF DISRUPTION
CDOs, Subprime Mortgages, and the
Financial Crisis 886
24.3 Bond Covenants 888
24.4 Repayment Provisions 889
Call Provisions 889
■ New York City Calls Its Municipal
Bonds 891
Sinking Funds 893
Convertible Provisions 893
Key Points and Equations 895 ■ Key
Terms 896 ■ Further Reading 897 ■
Problems 897
Chapter 25 Leasing 899
25.1 The Basics of Leasing 900
Examples of Lease Transactions 900
Lease Payments and Residual Values 901
Leases Versus Loans 902
■ Calculating Auto Lease Payments 903
End-of-Term Lease Options 903
Other Lease Provisions 905
25.2 Accounting, Tax, and Legal Consequences of
Leasing 905
Lease Accounting 906
■ Operating Leases at Alaska Air
Group 907
The Tax Treatment of Leases 908
Leases and Bankruptcy 909
■ Synthetic Leases 910
25.3 The Leasing Decision 910
Cash Flows for a True Tax Lease 911
Lease Versus Buy (An Unfair
Comparison) 912
Lease Versus Borrow (The Right
Comparison) 913
Evaluating a True Tax Lease 915
Evaluating a Non-Tax Lease 916
25.4 Reasons for Leasing 916
Valid Arguments for Leasing 917
■ INTERVIEW with Mark Long 920
Suspect Arguments for Leasing 921
Key Points and Equations 921 ■ Key
Terms 922 ■ Further Reading 923 ■
Problems 923
PART 9 SHORT-TERM FINANCING
927
Chapter 26 Working Capital
Management 928
26.1 Overview of Working Capital 929
The Cash Cycle 929
Firm Value and Working Capital 931
26.2 Trade Credit 932
Trade Credit Terms 932
Trade Credit and Market Frictions 932
Managing Float 933
26.3 Receivables Management 934
Determining the Credit Policy 934
Monitoring Accounts Receivable 935
26.4 Payables Management 937
Determining Accounts Payable Days
Outstanding 937
Stretching Accounts Payable 938
26.5 Inventory Management 938
Benefits of Holding Inventory 939
Costs of Holding Inventory 939
■ FINANCE IN TIMES OF DISRUPTION
Supply Chains during COVID-19 940
26.6 Cash Management 941
Motivation for Holding Cash 941
Alternative Investments 942
■ FINANCE IN TIMES OF DISRUPTION
Hoarding Cash 942
Key Points and Equations 944 ■ Key
Terms 945 ■ Further Reading 945 ■
Problems 946 ■ Data Case 949
Chapter 27 Shor t-Term Financial Planning 951
27.1 Forecasting Short-Term Financing
Needs 952
Seasonalities 952
Negative Cash Flow Shocks 955
Positive Cash Flow Shocks 956
27.2 The Matching Principle 957
Permanent Working Capital 957
Temporary Working Capital 957
Financing Policy Choices 958
27.3 Short-Term Financing with Bank Loans 959
Single, End-of-Period Payment Loan 959
Line of Credit 959
Bridge Loan 960
Common Loan Stipulations and Fees 960
27.4 Short-Term Financing with Commercial
Paper 962
■ FINANCE IN TIMES OF DISRUPTION
Short-Term Financing Costs during
Crises 963
27.5 Short-Term Financing with Secured
Financing 964
Accounts Receivable as Collateral 964
Inventory as Collateral 964
■ A Seventeenth-Century Financing
Solution 965
■ Loan Guarantees: The Ex-Im Bank
Controversy 966
Sales as Collateral 967
Key Points and Equations 968 ■ Key
Terms 969 ■ Further Reading 969 ■
Problems 969
PART 10 SPECIAL TOPICS 973
Chapter 28 Mergers and Acquisitions 974
28.1 Background and Historical Trends 975
Merger Waves 975
Types of Mergers 977
28.2 Market Reaction to a Takeover 977
28.3 Reasons to Acquire 978
Economies of Scale and Scope 979
Vertical Integration 979
Expertise 979
Monopoly Gains 980
Efficiency Gains 980
Tax Savings from Operating Losses 981
Diversification 982
Earnings Growth 982
Managerial Motives to Merge 984
28.4 Valuation and the Takeover Process 985
Valuation 985
The Offer 986
Merger “Arbitrage” 987
Tax and Accounting Issues 988
Board and Shareholder Approval 989
28.5 Takeover Defenses 990
Poison Pills 990
Staggered Boards 991
White Knights 992
Golden Parachutes 993
Recapitalization 993
Other Defensive Strategies 993
Regulatory Approval 994
■ Weyerhaeuser’s Hostile Bid for Willamette
Industries 994
28.6 Who Gets the Value Added from
a Takeover? 995
The Free Rider Problem 995
Toeholds 996
The Leveraged Buyout 996
■ The Leveraged Buyout of RJR-Nabisco by
KKR 997
The Freezeout Merger 999
Competition 1000
Key Points and Equations 1000 ■ Key
Terms 1002 ■ Further Reading 1002 ■
Problems 1002
Chapter 29 Corporate Governance 1005
29.1 Corporate Governance and Agency
Costs 1006
29.2 Monitoring by the Board of Directors and
Others 1007
Types of Directors 1007
Board Independence 1007
■ COMMON MISTAKE “Celebrity”
Boards 1009
Board Size and Performance 1009
Other Monitors 1009
29.3 Compensation Policies 1010
Stock and Options 1010
Pay and Performance Sensitivity 1010
29.4 Managing Agency Conflict 1012
Direct Action by Shareholders 1012
■ Shareholder Activism at The New York
Times 1015
Management Entrenchment 1015
The Threat of Takeover 1016
29.5 Regulation 1016
The Sarbanes-Oxley Act 1016
■ INTERVIEW with Lawrence E.
Harris 1017
The Cadbury Commission 1019
Dodd-Frank Act 1019
Insider Trading 1020
■ Martha Stewart and ImClone 1021
29.6 Corporate Governance Around the
World 1021
Protection of Shareholder Rights 1021
Controlling Owners and Pyramids 1021
The Stakeholder Model 1024
Cross-Holdings 1024
29.7 The Tradeoff of Corporate
Governance 1025
Key Points and Equations 1026 ■ Key
Terms 1027 ■ Further Reading 1028 ■
Problems 1028
Chapter 30 Risk Management 1029
30.1 Insurance 1030
The Role of Insurance: An Example 1030
Insurance Pricing in a Perfect Market 1030
The Value of Insurance 1032
The Costs of Insurance 1034
The Insurance Decision 1036
30.2 Commodity Price Risk 1036
Hedging with Vertical Integration and
Storage 1037
Hedging with Long-Term Contracts 1037
Hedging with Futures Contracts 1039
■ COMMON MISTAKE Hedging Risk 1041
■ Differing Hedging Strategies 1042
Deciding to Hedge Commodity Price
Risk 1042
■ FINANCE IN TIMES OF DISRUPTION
Negative Oil Prices 1043
30.3 Exchange Rate Risk 1043
Exchange Rate Fluctuations 1043
Hedging with Forward Contracts 1045
Cash-and-Carry and the Pricing of Currency
Forwards 1046
■ FINANCE IN TIMES OF DISRUPTION
Arbitrage in Currency Markets? 1049
Hedging with Options 1050
30.4 Interest Rate Risk 1053
Interest Rate Risk Measurement:
Duration 1054
Duration-Based Hedging 1055
■ The Savings and Loan Crisis 1059
Swap-Based Hedging 1059
Key Points and Equations 1063 ■ Key
Terms 1065 ■ Further Reading 1065 ■
Problems 1066
Chapter 31 International Corporate
Finance 1071
31.1 Internationally Integrated Capital
Markets 1072
31.2 Valuation of Foreign Currency Cash
Flows 1073
WACC Valuation Method in Domestic
Currency 1074
Using the Law of One Price as a Robustness
Check 1076
31.3 Valuation and International Taxation 1077
The TCJA: A New Approach to International
Taxation 1078
Harmonizing the Tax Treatment of Exports:
GILTI and FDII 1078
Avoiding Base Erosion: BEAT 1080
31.4 Internationally Segmented Capital
Markets 1080
Differential Access to Markets 1081
Macro-Level Distortions 1081
Implications 1082
31.5 Capital Budgeting with Exchange Risk 1084
■ INTERVIEW with Sally Johnson 1086
Key Points and Equations 1087 ■ Key
Terms 1087 ■ Further Reading 1088 ■
Problems 1088 ■ Data Case 1090
Glossary 1091
Index 1113