Corporate Finance, Sixth Edition PDF by Jonathan Berk and Peter Demarzo

By

Corporate Finance, Sixth Edition

Jonathan Berk and Peter Demarzo

Corporate Finance

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

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