Contents

PART J _ .INTRODUCTION ; j

Chapter 1 The Corporation 2

1.1 The FourTypes of Firms 3Sole Proprietorships 3

Partnerships 4

Limited Liability Companies 5

Corporations 5-

Tax Implications for Corporate Entities 6

B INTERVIEW with David Viniar 7

B Corporate Taxation Around the World

8

1.2 Ownership Versus Control ofCorporations 8The Corporate Management Team 9The Financial Manager 9The Goal of the Firm 10Ethics and Incentives withinCorporations 10B FINANCIAL CRISIS Lehman

Brothers Bankruptcy 13 /

1.3 The Stock Market 13Primary and Secondary StockMarkets 13

The Largest Stock Markets 14

NYSE 14B INTERVIEW with Jean-Frangois

Theodore 15

NASDAQ 16

-- Summary 16 a Key Terms 17 s Further.. Reading 17 a Problems 17

Chapter 2 Introduction to FinancialStatement Analysis 19

2.1 Firms' Disclosure of FinancialInformation 20Preparation of Financial Statements 20

• International Financial Reporting

Standards 20

B INTERVIEW with Sue Frieden 21

Types of Financial Statements 22

2.2 The Balance Sheet 22Assets 23

Liabilities 24

Shareholders' Equity 25

2.3 Balance Sheet Analysis 26Market-to-Book Ratio 26

Debt-Equity Ratio 26

Enterprise Value 27

Other Balance Sheet Information 28

2.4 The Income Statement 28Earnings Calculations 28

2.5 Income Statement Analysis 30Profitability Ratios 30 '

Working Capital Ratios 31

EBITDA 31

Leverage (Gearing) Ratios 32

Investment Returns 32

The DuPont Identity 32

Valuation Ratios 33

H COMMON MISTAKE Mismatched

Ratios 33

2.6 The Statement of Cash Flows 35Operating Activity 36

Investment Activity 36

Financing Activity 36

2.7 Other Financial StatementInformation 37Management Discussion and Analysis38

Statement of Changes in Shareholders'Equity 38

Notes to the Financial Statements 38

2.8 Financial Reporting in Practice 39Enron 39

WorldCom 39Sarbanes-Oxley Act 40@ FINANCIAL CRISIS Bernard

Madoff's Ponzi Scheme 41Difficulties in International FinancialStatement Analysis 41

Summary 42 a Key Terms 43 a

Further Reading 44 a Problems 44

Data Case 49

• V l l l

Contents

PART 18 TOOLS

Chapter 3 Arbitrage and Financial

Decision Making 52

3.1 Valuing Decisions 53

Analyzing Costs and Benefits 53Using Market Prices to Determine CashValues 54

I I When Competitive Market Prices AreNot Available 56

3.2 Interest Rates and theTime Value

of Money 56

The/Time Value of Money 56

The Interest Rate: An Exchange RateAcross Time 56

3.3 Present Value and the NPV Decision

Rule 59

Net Present Value 59

The NPV Decision Rule 60

NPV and Cash Needs 62

3.4 Arbitrage and the Law of One Price. 63

Arbitrage 63

H NASDAQ SOES Bandits 64

Law of One Price 64 f

3.5 No-Arbitrage and Security Prices

• 65

Valuing a Security with the Law of One

Price 65

B An Old Joke 65

The NPV of Trading Securities and Firm

Decision Making 68

Valuing a Portfolio 69

H Stock Index Arbitrage 70 £

H FINANCIAL CRISIS Liquidity and the

Informational Role of Prices 71

Where Do We Go from Here? 71

Summary 72 a Key Terms 73 n Further

Reading 73 Q Problems 74

Appendix The Price of Risk 77

Arbitrage with Transactions Costs 83

Summary 84 a Key Terms 84 nProblems 84

Chapter 4 The Time Value of Money 86

4.1 TheTimeline 87

4.2 TheThree Rules of TimeTravel 88

Rule 1: Comparing and Combining Values88

Rule 2: Moving Cash Flows Forward inTime 89

Rule 3: Moving Cash Flows Back in Time90

Applying the Rules of TimeTravel 92

4.3 Valuing a Stream of Cash Flows 94

4.4 Calculating the Net Present Value 97

4.5 Perpetuities, Annuities, and OtherSpecial Cases 98Perpetuities 98

B Historical Examples of Perpetuities ' 99

Annuities 100

• COMMON MISTAKE Discounting OneToo Many Times 101

Growing Cash Flows 104

4.6 Solving Problems with a

Spreadsheet Program 108

4.7 Solving for Variables OtherThan

Present Value or Future Value 110

Solving for the Cash Flows 111

Internal Rate of Return 113

Solving for the Number of Periods 116

• COMMON MISTAKE Excel's NPV andIRR Functions 117

B Rule of 72 118

Summary 119 • Key Terms 120 a

Further Reading 120 a Problems 121

Data Case 126

Chapter 5 Interest Rates 128

5.1 Interest Rate Quotes and

Adjustments 129

The Effective Annual Rate 129

• COMMON MISTAKE Using the WrongDiscount Rate in the Annuity Formula130

Annual Percentage Rates 131

5.2 Application: Discount Rates and

Loans 133

Contents

5.3 The Determinants of Interest Rates134a FINANCIAL CRISIS Teaser Rates and

Subprime Loans 135Inflation and Real Versus Nominal Rates135Investment and Interest Rate Policy 136The Yield Curve and Discount Rates 137• INTERVIEW with Frederic S. Mishkin

139The Yield Curve and the Economy 140B COMMON MISTAKE Using the

Annuity Formula When Discount RatesVary by Maturity 140

5.4 RiskanUTaxes 142Risk and Interest Rates 143After-Tax Interest Rates 144

5.5 The Opportunity Cost of Capital 145Summary 146 a Key Terms 147 aFurther Reading 147 m Problems 148

Appendix Continuous Rates and Cash Flows153

Chapter 6 Investment Decision Rules 156

6.1 NPV and Stand-Alone Projects 157Applying the NPV Rule 157The NPV Profile and IRR 157Alternative Rules Versus the NPV Rule158B INTERVIEW with Dick Grannis 159

6.2 The Internal Rate of Return Rule 160Applying the IRR Rule 160Pitfall #1: Delayed Investments 160

' Pitfall #2: Multiple IRRs 161'• ( Pitfall #3: Nonexistent IRR 163

B COMMON MISTAKE IRR Versus theIRR Rule 163

6.3 The Payback Rule 164Applying the Payback Rule 164Payback Rule Pitfalls in Practice 165H Why Do Rules Other Than the NPV

Rule Persist? 165

6.4 Choosing Between Projects 166NPV Rule and Mutually ExclusiveInvestments 166IRR Rule and Mutually ExclusiveInvestments 167The Incremental IRR 168

H When Can Returns Be Compared? 170B COMMON MISTAKE IRR and Project

Financing 171

6.5 Project Selection with ResourceConstraints 171Evaluating Projects with DifferentResource Requirements 171Profitability Index 172Shortcomings of the Profitability Index 174Summary 174 a Key Terms 175 BFurther Reading 175 B Problems 175Data Case 181

Chapter 7 Fundamentals of CapitalBudgeting 182

7.1 Forecasting Earnings 183Revenue and Cost Estimates 183Incremental Earnings Forecast 184Indirect Effects on Incremental Earnings186B COMMON MISTAKE The Opportunity

Cost of an Idle Asset 187Sunk Costs and Incremental Earnings 188B The Sunk Cost Fallacy 188Real-World Complexities 189

7.2 Determining Free Cash Flow andNPV 190Calculating Free Cash Flow from Earnings190Calculating Free Cash Flow Directly 192Calculating the NPV 193

7.3 Choosing Among Alternatives 194Evaluating Manufacturing Alternatives 194Comparing Free Cash Flows for Cisco'sAlternatives 195

7.4 Further Adjustments to Free CashFlow 195B FINANCIAL CRISIS The American

Recovery and Reinvestment Act of2009 200

7.5 Analyzing the Project 200Break-Even Analysis 200Sensitivity Analysis 201B INTERVIEW with David Holland 203Scenario Analysis 204Summary 205 a Key Terms 206 aFurther Reading 206 a Problems 206Data Case 213

Appendix MACRS Depreciation 215

Contents

Chapter 8 Valuing Bonds 217

8.1 Bond Cash Flows, Prices, andYields218Bond Terminology 218

Zero-Coupon Bonds 218

B FINANCIAL CRISIS Pure Discount

Bonds Trading at a Premium 220

Coupon Bonds 221

8.2 Dynamic Behavior of Bond Prices223Discounts and Premiums 223Time and Bond Prices 224Interest Rate Changes and Bond Prices226/

B Clean and Dirty Prices for CouponBonds 227

8.3 The Yield Curve and Bond Arbitrage229

Replicating a Coupon Bond 229Valuing a Coupon Bond Using Zero-Coupon Yields 230Coupon Bond Yields 231Treasury Yield Curves 232

8.4 Corporate Bonds 233

Corporate Bond Yields 233

Bond Ratings 235

• INTERVIEW with Lisa.-Black 236

Corporate Yield Curves 237

• FINANCIAL CRISIS The Credit Crisisand Bond Yields 238

Summary 239 a Key Terms 240 •

Further Reading 240 m Problems 240

Data Case 245

Appendix Forward Interest Rates 247Key Terms 250 a Problems 250

Chapter 9 Valuing Stocks 251

9.1 The Dividend-Discount Model 252A One-Year Investor 252

Dividend Yields, Capital Gains, and Total

Returns 253

B The Mechanics of a Short Sale 254

A Multiyear Investor 255

The Dividend-Discount Model Equation256

9.2 Applying the Dividend-DiscountModel 256Constant Dividend Growth 256

Dividends Versus Investment and Growth257

• John Burr Williams' Theory ofInvestment Value 258

Changing Growth Rates 260

• INTERVIEW with Marilyn Fedak 262Limitations of the Dividend-DiscountModel 262

9.3 Total Payout and Free Cash FlowValuation Models 263Share Repurchases and the Total PayoutModel 263

The Discounted Free Cash Flow Model265

9.4 Valuation Based on ComparableFirms 269Valuation Multiples 269

Limitations of Multiples 271

Comparison with Discounted Cash FlowMethods 272 •

Stock Valuation Techniques: The Final Word273

9.5 Information, Competition, andStock Prices 274Information in Stock Prices 274Competition and Efficient Markets 275Lessons for Investors and CorporateManagers 278The Efficient Markets Hypothesis VersusNo Arbitrage 279

• FINANCIAL CRISIS Kenneth ColeProductions—What Happened? 279

Summary 280 a Key Terms 282 a

Further Reading 282 e Problems 283

Data Case 288

Chapter 10 Capital Markets and the

Pricing of Risk 292

10.1 A First Look at Risk and Return -293

10.2 Common Measures of Risk andReturn 295Probability Distributions 295

Expected Return 295

Variance and Standard Deviation 296

10.3 Historical Returns of Stocks andBonds 298Computing Historical Returns 298

Xll Contents

Average Annual Returns 300The Variance and Volatility of Returns 301Estimation Error: Using Past Returns toPredict the Future 303• Arithmetic Average Returns Versus

Compound Annual Returns 305

10.4 The HistoricalTrade-Off BetweenRisk and Return 305The Returns of Large Portfolios 306The Returns of Individual Stocks 307

10.5 Common Versus Independent Risk308Theft Versus Earthquake Insurance: AnExample 308The Role of Diversification 309

10.6 Diversification in Stock Portfolios311Firm-Specific Versus Systematic Risk 311No Arbitrage and the Risk Premium 313B FINANCIAL CRISIS Diversification

Benefits During Market Crashes 314m COMMON MISTAKE A Fallacy of

Long-Run Diversification 316

10.7 Measuring Systematic Risk 316Identifying Systematic Risk: The .MarketPortfolio 316Sensitivity to Systematic Risk:, Beta 317

10.8 Beta and the Cost of Capital 319_; Estimating the Risk Premium 319

B COMMON MISTAKE Beta VersusVolatility 319

B INTERVIEW with Randall Lert 320The Capital Asset Pricing Model 322Summary 322 a Key Terms 324 aFurther Reading 324 a Problems 324Data Case 328

Chapter 11 Optimal Portfolio Choice

and the Capital Asset Pricing

Model 330

11.1 The Expected Return of a Portfolio331

11.2 The Volatility of aTwo-StockPortfolio 332Combining Risks 332Determining Covariance and Correlation333

• COMMON MISTAKE ComputingVariance, Covariance, and Correlation inExcel 335

Computing a Portfolio's Variance andVolatility 336

11.3 The Volatility of a Large Portfolio338Large Portfolio Variance 338Diversification with an Equally WeightedPortfolio 339Diversification with General Portfolios 341

11.4 Risk Versus Return: Choosing anEfficient Portfolio 341Efficient Portfolios with Two Stocks 342The Effect of Correlation 344Short Sales 345Efficient Portfolios with Many Stocks 346H NOBEL PRIZES Harry Markowitz and

James Tobin 347

11.5 Risk-Free Saving and Borrowing349Investing in Risk-Free Securities 349Borrowing and Buying Stocks on Margin350Identifying the Tangent Portfolio 351

11.6 The Efficient Portfolio and RequiredReturns 353Portfolio Improvement: Beta and theRequired Return 353Expected Returns and the EfficientPortfolio 355

11.7 The Capital Asset Pricing Model357The CAPM Assumptions 357Supply, Demand, and the Efficiency of theMarket Portfolio 358Optimal Investing: The Capital Market Line358

11.8 Determining the Risk Premium 359Market Risk and Beta 359B NOBEL PRIZE William Sharpe on the

CAPM 361The Security Market Line 362Beta of a Portfolio 362Summary of the Capital Asset PricingModel 364Summary 364 a Key Terms 367 •Further Reading 367 a Problems 367Data Case 373

Appendix The CAPM with Differing InterestRates 375

Contents

Chapter 12 Estimating the Cost of Capital

377

12.1 The Equity Cost of Capital 378

12.2 The Market Portfolio 379Constructing the Market Portfolio 379

Market Indexes 379

M Value-Weighted Portfolios and

Rebalancing 380

The Market Risk Premium 381

12.3 Beta Estimation 383Using Historical Returns 383Identifying the Best-Fitting Line 385Using Linear Regression 386B Why Not Estimate Expected Returns

Directly? 387

12.4 The Debt Cost of Capital 387

Debt Yields 387

9 COMMON MISTAKE Using the Debt

Yield as Its Cost of Capital 388

Debt Betas 389

12.5 A Project's Cost of Capital 390

All-Equity Comparables 390

Levered Firms as Comparables 391

The Unlevered Cost of Capital 391

Industry Asset Betas 393'

12.6 Project Risk Characteristics andFinancing 395Differences in Project Risk 395

3 COMMON MISTAKE Adjusting forExecution Risk 397

Financing and the Weighted Average Costof Capital 397

*12.7 FinalThoughts on Using the CAPM *

399B INTERVIEW with Shelagh Glaser

400

Summary 401 • Key Terms 402 a

Further Reading 403 e Problems 403

Data Case 407

Appendix Practical Considerations WhenForecasting Beta 408B COMMON MISTAKE Changing the

Index to Improve the Fit 411

Key Terms 411 a Data Case 411

Chapter 13 Investor Behavior and Capital

Market Efficiency 412

13.1 Competition and Capital Markets413Identifying a Stock's Alpha 413

Profiting from Non-Zero Alpha Stocks 414

13.2 Information and RationalExpectations 415

Informed Versus Uninformed Investors415Rational Expectations 416

13.3 The Behavior of IndividualInvestors 417Underdiversification and Portfolio Biases417

Excessive Trading and Overconfidence 418

• INTERVIEW with Jonathan Clements420

Individual Behavior and Market Prices 421

13.4 SystematicTrading Biases 421Hanging on to Losers and the DispositionEffect 421

• NOBEL PRIZE Kahneman andTversky's Prospect Theory 422

Investor Attention, Mood, and Experience422

Herd Behavior 423

Implications of Behavioral Biases 423

13.5 The Efficiency of the MarketPortfolio 424Trading on News or Recommendations

424

The Performance of Fund Managers 426

The Winners and Losers 427

13.6 Style-Based Anomalies and theMarket Efficiency Debate 429

-Size Effects 429

Momentum 432

Implications of Positive-Alpha TradingStrategies 432

• Market Efficiency and the Efficiency ofthe Market Portfolio 433

13.7 Multifactor Models of Risk 435Using Factor Portfolios 435Selecting the Portfolios 436The Cost of Capital with Fama-French-Carhart Factor Specification 437

13.8 Methods Used in Practice 439

Contents

Summary 440 a Key Terms 442 BFurther Reading 442 n Problems 443

Appendix Building a Multifactor Model 448

; PARTV CAPITAL STRUCTURE j

Chapter 14 Capital Structure in a Perfect

Market 450

14.1 Equity Versus Debt Financing 451Financing a Firm with Equity 451

Financing a Firm with Debt and Equity452

The Effect of Leverage on Risk and Return453 ;

14.2 Modigliani-Miller I: Leverage,Arbitrage, and Firm Value 455MM and the Law of One Price 455

Homemade Leverage 455

9 MM and the Real World 456

The Market Value Balance Sheet 457

Application: A Leveraged Recapitalization458

14.3 Modigliani-Miller II: Leverage, Risk,and the Cost of Capital 460Leverage and the Equity Cost of Capital460

Capital Budgeting and the WeightedAverage Cost of Capital 461

S COMMON MISTAKE Is Debt BetterThan Equity? 464

Computing the WACC with MultipleSecurities 464Levered and Unlevered Betas 464

14.4 Capital Structure Fallacies 466

Leverage and Earnings per Share 466

Equity Issuances and Dilution 469

14.5 M M : Beyond the Propositions 469

B NOBEL PRIZES Franco Modiglianiand Merton Miller 470

Summary 471 a Key Terms 472 a

Further Reading 472 a Problems 473

Data Case 477

Chapter 15 Debt and Taxes 478

15.1 The InterestTax Deduction 479

15.2 Valuing the InterestTax Shield 481The InterestTax Shield and Firm Value 481

The InterestTax Shield with PermanentDebt 482

B Pizza and Taxes 483The Weighted Average Cost of Capitalwith Taxes 483

The InterestTax Shield with a Target Debt-Equity Ratio 484

15.3 Recapitalizing to Capture theTax

Shield 486

The Tax Benefit 486

The Share Repurchase 487

No Arbitrage Pricing 487

Analyzing the Recap: The Market ValueBalance Sheet 488

15.4 Personal Taxes 489Including Personal Taxes in the InterestTaxShield 489

Valuing the InterestTax Shield withPersonal Taxes 492

Determining the Actual'Tax Advantageof Debt 493

• Cutting the Dividend Tax Rate 494

15.5 Optimal Capital Structure with

Taxes 494

Do Firms Prefer Debt? 494

Limits to theTax Benefit of Debt 497

H INTERVIEW with Andrew Balson 498

Growth and Debt 499

Other Tax Shields 500

The Low Leverage Puzzle 500

• Employee Stock Options 502

Summary 502 a Key Terms 503 B

Further Reading 503 a Problems 504

Data Case 508

Chapter 16 Financial Distress, Managerial

Incentives, and Information 509

16.1 Default and Bankruptcy in a PerfectMarket 510Armin Industries: Leverage and the Risk ofDefault 510

Bankruptcy and Capital Structure 511

16.2 The Costs of Bankruptcy andFinancial Distress 512The Bankruptcy Code 513Direct Costs of Bankruptcy 513Indirect Costs of. Financial Distress 514IB FINANCIAL CRISIS The Chrysler

Prepack 517

Contents

16.3 Financial Distress Costs and FirmValue 518Armin Industries: The Impact of FinancialDistress Costs 518Who Pays for Financial Distress Costs?518

16.4 Optimal Capital Structure:TheTrade-OffTheory 520The Present Value of Financial DistressCosts 520Optimal Leverage 521

16.5 Exploiting Debt Holders:TheAgency Costs of Leverage 523Excessive Risk-Taking and AssetSubstitution 523Debt Overhang and Under-lnvestment524D FINANCIAL CRISIS Bailouts, Distress

Costs, and Debt Overhang 525Agency Costs and the Value of Leverage526Debt Maturity and Covenants 5270 FINANCIAL CRISIS Moral Hazard and

the Government Bailout 528

16.6 Motivating Managers: The AgencyBenefits of Leverage 528Concentration of Ownership 528Reduction of Wasteful Investment 529Q Excessive Perks and Corporate

Scandals 530Leverage and Commitment 531

16.7 Agency Costs and the Trade-OffTheory 532The Optimal Debt Level 532Debt Levels in Practice 533

16.8 Asymmetric Information andCapital Structure 533Leverage as a Credible Signal 534Issuing Equity and Adverse Selection535H NOBEL PRIZE The 2001 Nobel Prize

in Economics 536Implications for Equity Issuance 537Implications for Capital Structure 539

16.9 Capital Structure:The Bottom Line541

Summary 542 n Key Terms 543 aFurther Reading 543 a Problems 544

Chapter 17 Payout Policy 551

17.1 Distributions to Shareholders 552Dividends 552Share Repurchases 554

17.2 Comparison of Dividends andShare Repurchases 555Alternative Policy 1: Pay Dividend withExcess Cash 555Alternative Policy 2: Share Repurchase (NoDividend) 556• COMMON MISTAKE Repurchases

and the Supply of Shares 557Alternative Policy 3: High Dividend (EquityIssue) 558Modigliani-Miller and Dividend PolicyIrrelevance 559B COMMON MISTAKE The Bird in the

Hand Fallacy 560Dividend Policy with Perfect CapitalMarkets 560

17.3 TheTax Disadvantage of Dividends560Taxes on Dividends and Capital Gains 561Optimal Dividend Policy with Taxes 562

17.4 Dividend Capture and Tax Clienteles564The Effective Dividend Tax Rate 564Tax Differences Across Investors 565Clientele Effects 566

17.5 Payout Versus Retention of Cash569Retaining Cash with Perfect CapitalMarkets 569

Taxes and Cash Retention 570

Adjusting for Investor Taxes 571

Issuance and Distress Costs 572

Agency Costs of Retaining Cash 573

17.6 Signaling with Payout Policy 575Dividend Smoothing 575Dividend Signaling 576B Royal & SunAlliance's Dividend Cut

577Signaling and Share Repurchases 577

17.7 Stock Dividends, Splits, and Spin-Offs 579Stock Dividends and Splits 579B INTERVIEW with John Connors 580

Contents

H Berkshire Hathaway's A & B Shares582

Spin-Offs 582

Summary 584 a Key Terms 585 a

Further Reading 585 a Problems 586

Data Case 590

PART VT VALUATION " "

Chapter 18 Capital Budgeting and

Valuation with Leverage 594

18.1 Overview of Key Concepts 595

18.2 TheWejghted Average Cost ofCapital Method 596Using the WACC to Value a Project 597Summary of the WACC Method 598Implementing a Constant Debt-EquityRatio 599

18.3 The Adjusted Present Value Method601The Unlevered Value of the Project 601

Valuing the InterestTax Shield 602

Summary of the APV Method 603

18.4 The Flow-to-Equity Method 604Calculating the Free Cash Flow/to Equity605

Valuing Equity Cash Flows 606

Summary of the Flow-to-Equity Method606• What Counts as "Debt"? 607

18.5 Project-Based Costs of Capital 608

Estimating the Unlevered Cost of Capital608

Project Leverage and the Equity Cost ofCapital 609

" ' .Determining the Incremental Leverage ofa Project 610

H COMMON MISTAKE Re-Levering theWACC 611

18.6 APV with Other Leverage Policies612Constant Interest Coverage Ratio 613

Predetermined Debt Levels 614

A Comparison of Methods 615

18.7 Other Effects of Financing 616

Issuance and Other Financing Costs 616

Security Mispricing 617

Financial Distress' and Agency Costs 618

B FINANCIAL CRISIS Government LoanGuarantees 618

18.8 Advanced Topics in CapitalBudgeting 619Periodically Adjusted Debt 619

Leverage and the Cost of Capital 622

The WACC or FTE Method with Changing

Leverage 623

Personal Taxes 625

Summary 627 • Key Terms 628 a

Further Reading 628 a Problems 629

Data Case 635

Appendix Foundations and Further Details637

Chapter 19 Valuation and Financial

Modeling: A Case Study 641

19.1 Valuation Using Comparables 642

19.2 The Business Plan 644Operational Improvements 644

Capital Expenditures: A Needed

Expansion 645

Working Capital Management 646

Capital Structure Changes: Levering Up646

19.3 Building the Financial Model 647Forecasting Earnings 647

Working Capital Requirements 649

Forecasting Free Cash Flow 650

The Balance Sheet and Statement of CashFlows (Optional) 652

19.4 Estimating the Cost of Capital 654* CAPM-Based Estimation 654

Unlevering Beta 655

Ideko's Unlevered Cost of Capital 656

19.5 Valuing the Investment 657The Multiples Approach to ContinuationValue 657

The Discounted Cash Flow Approach toContinuation Value 658

APV Valuation of Ideko's Equity 660

B COMMON MISTAKE Continuation

Values and Long-Run Growth 660

H COMMON MISTAKE Missing Assets

or Liabilities 662

A Reality Check 662

IRR and Cash Multiples 663

Contents xvii

• INTERVIEW with Joseph L. Rice, III664

19.6 Sensitivity Analysis 665Summary 666 a Key Terms 666 HFurther Reading 666 a Problems 667

Appendix Compensating Management 669

PART V8J OPTIONS

Chapter 20 Financial Options 672

20.1 Option Basics 673Understanding Option Contracts 673

Interpreting Stock Option Quotations673

Options on Other Financial Securities675

20.2 Option Payoffs at Expiration 676Long Position in an Option Contract 676

Short Position in an Option Contract 677

Profits for Holding an Option to Expiration678

Returns for Holding an Option toExpiration 680

Combinations of Options 681

20.3 Put-Call Parity 684''

20.4 Factors Affecting Option Prices686Strike Price and Stock Price 686

Arbitrage Bounds on Option Prices 686

Option Prices and the Exercise Date 687

Option Prices and Volatility 687

20.5 Exercising Options Early 688 'Non-Dividend-Paying Stocks 688

Dividend-Paying Stocks 690

20.6 Options and Corporate Finance693Equity as a Call Option 693

Debt as an Option Portfolio 693

Credit Default Swaps 694

H FINANCIAL CRISIS Credit Default

Swaps 695

Pricing Risky Debt 695

Agency Conflicts 697

Summary 697 a Key Terms 698 a

Further Reading 699 a Problems 699

Data Case 702

Chapter 21 Option Valuation 704

21.1 The Binomial Option Pricing Model705A Two-State Single-Period Model 705

The Binomial Pricing Formula 707

A Multiperiod Model 709

Making the Model Realistic 712

21.2 The Black-Scholes Option PricingModel 713The Black-Scholes Formula 713

Implied Volatility 718

• FINANCIAL CRISIS The VIX Index719

The Replicating Portfolio 720

• COMMON MISTAKE ValuingEmployee Stock Options 722

21.3 Risk-Neutral Probabilities 723A Risk-Neutral Two-State Model 723Implications of the Risk-Neutral World 723Risk-Neutral Probabilities and OptionPricing 724

21.4 Risk and Return of an Option 726

21.5 Corporate Applications of OptionPricing 728Beta of Risky Debt 728

8 NOBEL PRIZE The 1997 Nobel Prize

in Economics 729

Agency Costs of Debt 731Summary 732 a Key Terms 733 aFurther Reading 734 a. Problems 734

Chapter 22 Real Options 738

22.1 Real Versus Financial Options 739

22.2 Decision Tree Analysis 739Mapping Uncertainties on a Decision Tree740

Real Options 741

22.3 The Option to Delay an InvestmentOpportunity 742Investment as a Call Option 742

Factors Affecting the Timing of Investment744

B FINANCIAL CRISIS Uncertainty,Investment, and the Option to Delay747

22.4 Growth and Abandonment Options747Valuing Growth Potential 747

Contents

S Why Are There Empty Lots in Built-Up• Areas of Big Cities? 748

The Option to Expand 750

B INTERVIEW with Scott Mathews

751

The Option to Abandon 752

22.5 Applications to Multiple Projects754Comparing Mutually ExclusiveInvestments with Different Lives 754• Equivalent Annual Benefit Method

756

Staging Mutually Dependent Investments756

22.6 Rules of/Thumb 759The Profitability Index Rule 760

The Hurdle Rate Rule 760

B The Option to Repay a Mortgage 762

22.7 Key Insights from Real Options762Summary 763 m Key Terms 764 aFurther Reading 764 a Problems 765

| PART VIII ;LONG-TERI^F|NAMONG j

Chapter 23 Raising Equity Capital 770

23.1 Equity Financing for PrivateCompanies 771Sources of Funding 771Outside Investors .774Exiting an Investment in a PrivateCompany 776

23.2 The Initial Public Offering 776Advantages and Disadvantages of Going

- Public 776- - Types of Offerings 777

The Mechanics of an IPO 779B Google's IPO 779.

23.3 IPO Puzzles 784Underpricing 784

Cyclically 787

• FINANCIAL CRISIS Worldwide IPO

Deals in 2008-2009 788

Cost of an IPO 788

Long-Run Underperformance 789

23.4 The Seasoned Equity Offering 790The Mechanics of an SEO 790

Price Reaction 791

Issuance Costs 793

Summary 793 • Key Terms 794 •Further Reading 794 a Problems 795

Chapter 24 Debt Financing 798

24.1 Corporate Debt 799Public Debt 799

Private Debt 803

24.2 OtherTypes of Debt 804Sovereign Debt 804 .

Municipal Bonds 806

Asset-Backed Securities 806

B FINANCIAL CRISIS CDOs, SubprimeMortgages, and the Financial Crisis

808

24.3 Bond Covenants 807

24.4 Repayment Provisions 810Call Provisions 810 -B New York City Calls Its Municipal

Bonds 812

Sinking Funds 814

Convertible Provisions 814

Summary 816 o Key Terms 817 a

Further Reading 818 a Problems 818

Data Case 819

Chapter 25 Leasing 821

25.1 The Basics of Leasing 822Examples of Lease Transactions 822Lease Payments and Residual Values823Leases Versus Loans 824B Calculating Auto Lease Payments 825

»' End-of-Term Lease Options 825

* Other Lease Provisions 827

25.2 Accounting,Tax, and LegalConsequences of Leasing 827B Operating Leases at Alaska Air Group

828

Lease Accounting 828

The Tax Treatment of Leases 830

Leases and Bankruptcy 831

H Synthetic Leases 832

25.3 The Leasing Decision 832Cash Flows for a True Tax Lease 833

Lease Versus Buy (An Unfair Comparison)834

Lease Versus Borrow (The Right

Contents

Comparison) 835

Evaluating a True Tax Lease 837

Evaluating a Non-Tax Lease 838

25.4 Reasons for Leasing 838Valid Arguments for Leasing 839

Suspect Arguments for Leasing 841

Summary 842 a Key Terms 842 a

Further Reading 843 m Problems 843

JPARTJXSHOJT-TERivi FINAWCING

Chapter 26 Working Capital Management

848

26.1 Overview of Working Capital 849The Cash Cycle 849Firm Value and Working Capital 851

26.2 Trade Credit 851Trade Credit Terms 852Trade Credit and Market Frictions 852Managing Float 853

26.3 Receivables Management 854.Determining the Credit Policy 854

Monitoring Accounts Receivable 855

26.4 Payables Management 857Determining Accounts Payable DaysOutstanding 857Stretching Accounts Payable 858

26.5 Inventory Management 858Benefits of Holding Inventory 859Costs of Holding Inventory 859

26.6 Cash Management 860Motivation for Holding Cash 860Alternative Investments 861B FINANCIAL CRISIS Cash Balances

861

Summary 863 • Key Terms 863 •Further Reading 864 • Problems 864Data Case 867

Chapter 27 Short-Term Financial Planning

869

27.1 Forecasting Short-Term FinancingNeeds 870Seasonalities 870

Negative Cash Flow Shocks 872

Positive Cash Flow Shocks 873

27.2 The Matching Principle 875Permanent Working Capital 875

Temporary Working Capital 875

Financing Policy Choices 876

27.3 Short-Term Financing with BankLoans 877Single, End-of-Period Payment Loan 877Line of Credit 877Bridge Loan 878Common Loan Stipulations and Fees 878

27.4 Short-Term Financing withCommercial Paper 880• FINANCIAL CRISIS Short-Term

Financing in Fall 2008 881

27.5 Short-Term Financing with SecuredFinancing 882Accounts Receivable as Collateral 882• A Seventeenth-Century Financing

Solution 882 -Inventory as Collateral 883Summary 885 • Key Terms 885 oFurther Reading 886 • Problems 886

i_ PART X SPECIALTOPJCS ; , : ; |

Chapter 28 Mergers and Acquisitions 890

28.1 Background and Historical Trends891Merger Waves 891Types of Mergers 892

28.2 Market Reaction to a Takeover 893

28.3 Reasons to Acquire 894Economies of Scale and Scope 895Vertical Integration 895Expertise 895Monopoly Gains 896Efficiency Gains 896Tax Savings from Operating Losses 897Diversification 897Earnings Growth 898Managerial Motives to Merge 899

28.4 The Takeover Process 900Valuation 901The Offer 901Merger "Arbitrage" 903Tax and Accounting Issues 904Board and Shareholder Approval 905

XX Contents

28.5 Takeover Defenses 906Poison Pills 906

Staggered Boards 907

White Knights 908

Golden Parachutes 908

Recapitalization 908

Other Defensive Strategies 909

Regulatory Approval 909

B Weyerhaeuser's Hostile Bid for

Willamette Industries 910

28.6 Who Gets the Value Added from aTakeover? 910The Free Rider Problem 910

Toeholds >911

The Leveraged Buyout 912

B The Leveraged Buyout of RJR-Nabisco

by KKR 914

The Freezeout Merger 914

Competition 915

Summary 915 a Key Terms 916 nFurther Reading 917 m Problems 917

Chapter 29 Corporate Governance 920

29.1 Corporate Governance and AgencyCosts 921

29.2 Monitoring by the Board ofDirectors and Others 922Types of Directors 922

Board Independence 922

Board Size and Performance 924

Other Monitors 924

29.3 Compensation Policies 925Stock and Options 925

Pay and Performance Sensitivity 925

29.4 Managing Agency Conflict 927"Direct Action by Shareholders 927

• Shareholder Activism at The New York

Times 928

Management Entrenchment 929

The Threat of Takeover 930

29.5 Regulation 930The Sarbanes-Oxley Act 931

B INTERVIEW with Lawrence E. Harris

932

The Cadbury Commission 933

Insider Trading 934

• Martha Stewart and ImClone 934

29.6 Corporate Governance Around theWorld 935Protection of Shareholder Rights 935

Controlling Owners and Pyramids 935

The Stakeholder Model 937

Cross-Holdings 938

29.7 The Trade-Off of CorporateGovernance 939Summary 939 a Key Terms 940 aFurther Reading 941 • Problems 941

Chapter 30 Risk Management 942

30.1 Insurance 943The Role of Insurance: An Example 943

Insurance Pricing in a Perfect Market 944

The Value of Insurance 945

The Costs of Insurance 947

The Insurance Decision 949

30.2 Commodity Price Risk 949Hedging with Vertical Integration andStorage 950

Hedging with Long-Term Contracts 950

Hedging with Futures Contracts 952

a COMMON MISTAKE Hedging Risk954

B Differing Hedging Strategies 955Deciding to Hedge Commodity Price Risk955

30.3 Exchange Rate Risk 956Exchange Rate Fluctuations 956Hedging with Forward Contracts 957Cash-and-Carry and the Pricing ofCurrency Forwards 958a FINANCIAL CRISIS Arbitrage in

Currency Markets? 960

Hedging with Options 962

30.4 Interest Rate Risk 966Interest Rate Risk Measurement: Duration966

Duration-Based Hedging 968

H The Savings and Loan Crisis 971

Swap-Based Hedging 972

Summary 975 a Key Terms 977 nFurther Reading 977 • Problems 978

Contents

Chapter 31 International Corporate

Finance 983

31.1 Internationally Integrated CapitalMarkets 984

31.2 Valuation of Foreign Currency CashFlows 985WACC Valuation Method in DomesticCurrency 986

Using the Law of One Price as aRobustness Check 988

31.3 Valuation and International Taxation989Single Foreign Project with ImmediateRepatriation of Earnings 990

Multiple Foreign Projects and Deferral ofEarnings Repatriation 990

m INTERVIEW with Bill Barrett 991

31.4 Internationally Segmented CapitalMarkets 992Differential Access to Markets 992

Macro-Level Distortions 992

Implications 993

31.5 Capital Budgeting with ExchangeRisk 995

Summary 997 s Key Terms 998 a

Further Reading 998 a Problems 998

Data Case 1001

Glossary G-1

Index 1-1

Credits C-1