CORPORATE

FINANCE

FOURTH EDITION

JONATHAN BERK

STANFORD UNIVERSITY

PETER DEMARZO

STANFORD UNIVERSITY

Pearson

Detailed Contents

PART 1 INTRODUCTION

Chapter 1 The Corporation 2

1.1 The FourTypes 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 • GLOBAL FINANCIAL CRISIS

The Dodd-Frank Act 10 The Goal of the Firm 10 The Firm and Society 11 Ethics and Incentives with in Corporations 11 • GLOBAL FINANCIAL CRISIS

The Dodd-Frank Act on Corporate Compensation and Governance 12

• Citizens United v. Federal Election Commission 12

• Airlines in Bankruptcy 14 1.3 The Stock Market 14

Prima ry and Secondary Stock Markets 15 Traditional Trading Venues 15 • INTERVIEW with

Frank Hatheway 16 New Competition and Market Changes 17 Dark Pools 18 MyFinanceLab 19 • Key Terms 19 • Further Reading 20 • Problems 20

2.2

2.3

2.4

2.5

2.6

2.7

Chapter 2 Introduction to Financial Statement Analysis 23

2.1 Firms' Disclosure of Financial Information 24 Preparation of Financial Statements 24

• International Financial Reporting Standards 24

• INTERVIEW with Ruth Porat 25 Types of Financial Statements 26 The Balance Sheet 26 Assets 27 Liabilities 28 Stockholders' Equity 29 Market Value Versus Book Value 29 Enterprise Value 30 The Income Statement 30 Earnings Calculations 31 The Statement of Cash Flows 32 Operating Activity 33 Investment Activity 34 Financing Activity 34 Other Financial Statement Information 35 Statement of Stockholders' Equity 35 Management Discussion and Analysis 36 Notes to the Financial Statements 36 Financial Statement Analysis 37 Profitability Ratios 37 Liquidity Ratios 38 Working Capital Ratios 39 Interest Coverage Ratios 40 Leverage Ratios 41 Valuation Ratios 43 • COMMON MISTAKE

Mismatched Ratios 43 Operating Returns 44 The Du Pont Identity 46 Financial Reporting in Practica 48 Enron 48 WorldCom 48 Sarbanes-Oxley Act 49 • GLOBAL FINANCIAL CRISIS

Bernard Madoff's Ponzi Scheme 50 Dodd-Frank Act 50 MyFinanceLab 51 • Key Terms 52 • Further Reading 53 • Problems 53 • Data Case 60

vi Contents

Chapter 3 Financial Decision Making and the Law of One Price 61

3.1 Valuing Decisions 62 Analyzing Costs and Benefits 62 Using Market Prices to Determine Cash Values 63 • When Competitive Market Prices

Are Not Available 65 3.2 Interest Rates and the Time Value

of Money 65 The Time Value of Money 65 The Interest Rate: An Exchange Rate AcrossTime 65

3.3 Present Value and the NPV Decision Rule 68 Net Present Value 68 The NPV Decision Rule 69 NPV and Cash Needs 71

3.4 Arbitrage and the Law of One Price 72 Arbitrage 72 Law of One Price 73

3.5 No-Arbitrage and Security Prices 73 Valuing a Security with the Law of One Price 73 • An Old Joke 77 The NPV of Trading Securities and Firm Decision Making 77 Valuing a Portfolio 78 • GLOBAL FINANCIAL CRISIS

Liquidity and the Informational Role of Prices 79

• Arbitrage in Markets 80 Where Do We Go from Here? 81 MyFinanceLab 82 • Key Terms 83 • Further Reading 83 • Problems 83

Appendix The Price of Risk 87 Risky Versus Risk-Free Cash Flows 87 Arbitrage with Transactions Costs 92

PART 2 TIME, MONEY, AND INTEREST RATES

Chapter 4 The Time Value of Money 98

4.1 The Timeline 99 4.2 The Three Rules ofTimeTravel 100

Rule 1: Comparing and Combining Values 100

Rule 2: Moving Cash Flows Forward in Time 101 Rule 3: Moving Cash Flows Back in Time 102 • Rule of 72 103 Applying the Rules of Time Travel 104

4.3 Valuing a Stream of Cash Flows 106 4.4 Calculating the Net Present Value 109

• USING EXCEL Calculating Present Values in Excel 110

4.5 Perpetuities and Annuities 111 Perpetuities 111 • Historical Examples of Perpetuities 112 • COMMON MI STAKE Discounting One

Too Many Times 114 Annuities 114 • Formula for an Annuity Due 117 Growing Cash Flows 117

4.6 Using an Annuity Spreadsheet or Calculator 122

4.7 Non-Annual Cash Flows 124 4.8 Solving for the Cash Payments 125 4.9 The Internal Rate of Return 128

• USING EXCEL Excel's IRR Function 131

MyFinanceLab 132 • Key Terms 133 • Further Reading 134 • Problems 134 • Data Case 140

Appendix Solving for the Number of Periods 141

Chapter 5 interest Rates 143

5.1 Interest Rate Quotes and Adjustments 144 The Effective Annual Rate 144 • COMMON MISTAKE Using the Wrong

Discount Rate in the Annuity Formu­la 145

Annual Percentage Rates 146 5.2 Application: Discount Rates

and Loans 148 5.3 The Determinants of Interest

Rates 149 • GLOBAL FINANCIAL CRISIS Teaser

Rates and Subprime Loans 150 Inflation and Real Versus Nominal Rates 150 Investment and Interest Rate Policy 151 TheYield Curve and Discount Rates 152

Contents vii

TheYield Curve and the Economy 154 • COMMON MISTAKE Using the

Annuity Formula When Discount Rates Vary by Maturity 154

• INTERVIEW with Kevin M.Warsh 156

5.4 RiskandTaxes 157 Risk and Interest Rates 158 After-Tax Interest Rates 159

5.5 The Opportunity Cost of Capital 160 • COMMON MISTAKE States Dig

a $3Trillion Hole by Discounting at the Wrong Rate 161

MyFinanceLab 162 • Key Terms 163 a Further Reading 163 a Problems 163 a Data Case 168

Appendix Continuous Rates and Cash Flows 170 Discount Rates for a Continuously Compounded APR 170 Continuously Arriving Cash Flows 170

Chapter 6 Valuing Bonds 173

6.1 Bond Cash Flows, Prices, andYields 174 BondTerminology 174 Zero-Coupon Bonds 174 • GLOBAL FINANCIAL CRISIS

Negative BondYields 176 Coupon Bonds 177

6.2 Dynamic Behavior of Bond Prices 179 Discounts and Premiums 179 Time and Bond Prices 180 Interest Rate Changes and Bond Prices 182 • Clean and Dirty Prices for Coupon

Bonds 183 6.3 TheYield Curve and Bond

Arbitrage 185 Replicating a Coupon Bond 185 Valuing a Coupon Bond Using Zero-Coupon Yields 186 Coupon BondYields 187 Treasury Yield Curves 188

6.4 Corporate Bonds 188 Corporate BondYields 189 • AreTreasuries Really Default-Free

Securities? 189 Bond Ratings 191 Corporate Yield Curves 192

6.5 Sovereign Bonds 192 • GLOBAL FINANCIAL CRISIS The

Credit Crisis and BondYields 193 • GLOBAL FINANCIAL CRISIS

European Sovereign DebtYields: A Puzzle 195

• INTERVIEW with Carmen M. Reinhart 196

MyFinanceLab 197 • Key Terms 198 Further Reading 199 • Problems 199 Data Case 203 • Case Study 204

Appendix Forward Interest Rates 206 Computing Forward Rates 206 Computing BondYields from Forward

Rates 207

PART 3 VALUING PROJECTS AND FIRNIS

Chapter 7 Investment Decision Rules 212

7.1 NPV and Stand-Alone Projects 213 Applying the NPV Rule 213 The NPV Profile and IRR 213 Alternative Rules Versus the NPV Rule 214 • INTERVIEW with Dick Grannis 215

7.2 The Internal Rate of Retum Rule 216 Applying the IRR Rule 216 Pitfall #1: Delayed Investments 216 Pitfall #2: Multiple IRRs 217 • COMMON MISTAKE

IRR Versus the IRR Rule 219 Pitfall #3: Nonexistent IRR 219

7.3 The Payback Rule 220 Applying the Payback Rule 220 Payback Rule Pitfalls in Practice 221 • Why Do Rules OtherThan the NPV

Rule Persist? 222 7.4 Choosing Between Projects 222

NPV Rule and Mutually Exclusive Investments 222 IRR Rule and Mutually Exclusive Investments 223 The Incremental IRR 224 • When Can Returns Be

Compared? 225 • COMMON MISTAKE

IRR and Project Financing 227

viii Contents

7.5 Project Selection with Resource Constraints 227 Evaluating Projects with Different Resource Requirements 227 Profitability Index 228 Shortcomings of the Profitability Index 230 MyFinanceLab 230 • Key Terms 231 • Further Reading 231 • Problems 231 • Data Gase 237

Appendix Computing the NPV Profile Using Excel's Data Table Function 238

Chapter 8 Fundamentals of Capital Budgeting 239

8.1 Forecasting Earnings 240 Revenue and Cost Estimates 240 Incremental Earnings Forecast 241 Indirect Effects on Incremental Earnings 243 • COMMON MISTAKE The Opportunity

Cost of an Idle Asset 244 Sunk Costs and Incremental Earnings 245 • COMMON MISTAKE

The Sunk Cost Fallacy 245 Real-World Complexities 246

8.2 Determining Free Cash Flow and NPV 247 Calculating Free Cash Flow from Earnings 247 Calculating Free Cash Flow Directly 249 Calculating the NPV 250 • USING EXCEL Capital Budgeting

Using a Spreadsheet Program 251 8.3 Choosing Among Alternatives 252

Evaluating Manufacturing Alternatives 252 Comparing Free Cash Flows for Cisco's Alternatives 253

8.4 Further Adjustments to Free Cash Flow 254 • GLOBAL FINANCIAL CRISIS

The American Recovery and Reinvestment Act of 2009 258

8.5 Analyzing the Project 258 Break-Even Analysis 258 Sensitivity Analysis 259 • INTERVIEW with David Holland 261 Scenario Analysis 262 • USING EXCEL Project Analysis

Using Excel 263

MyFinanceLab 264 • Key Terms 266 • Further Reading 266 • Problems 266 • Data Case 273

Appendix MACRS Depreciation 275

Chapter 9 Valuing Stocks 277

9.1 The Dividend-Discount Model 278 A One-Year Investor 278 Dividend Yields, Capital Gains, and Total Returns 279 • The Mechanics of a Short Sale 280 A Multiyear Investor 281 The Dividend-Discount Model Equation 282

9.2 Applying the Dividend-Discount Model 282 Constant Dividend Growth 282 Dividende Versus Investment and Growth 283 • John Burr Williams' Theory

of Investment Value 284 Changing Growth Rates 286 Limitations of the Dividend-Discount Model 288

9.3 Total Payout and Free Cash Flow Valuation Models 288 Share Repurchases and the Total Payout Model 288 The Discounted Free Cash Flow Model 290

9.4 Valuation Based on Comparable Firms 294 Valuation Multiples 294 Limitations of Multiples 296 Comparison with Discounted Cash Flow Methods 297 Stock Valuation Techniques: The Final Word 298 • INTERVIEW with Douglas Kehring 299

9.5 Information, Competition, and Stock Prices 300 Information in Stock Prices 300 Competition and Efficient Markets 301 Lessons for Investors and Corporate Managers 303 • Kenneth Cole Productions—What

Happened? 305 The Efficient Markets Hypothesis Versus No Arbitrage 306 MyFinanceLab 306 • Key Terms 308 • Further Reading 308 • Problems 309 • Data Case 314

Contents ix

PART 4 RISK AND RETURN

Chapter 10 Capital Markets and the Pricing ofRisk 318

10.1 Risk and Return: Insights from 89Years of Investor History 319

10.2 Common Measures of Risk and Return 322 Probability Distributions 322 Expected Return 322 Variance and Standard Deviation 323

10.3 Historical Returns of Stocks and Bonds 325 Computing Historical Returns 325 Average Annual Returns 327 The Variance and Volatility of Returns 329 Estimation Error: Using Rast Returns to Predict the Future 330 • Arithmetic Average Returns Versus

Compound Annual Returns 332 10.4 The Historical Trade-Off Between Risk

and Return 332 The Returns of Large Portfolios 333 The Returns of Individual Stocks 334

10.5 Common Versus Independent Risk 335 Theft Versus Earthquake Insurance: An Example 335 The Role of Diversification 336

10.6 Diversification in Stock Portfolios 337 Firm-Specific Versus Systematic Risk 338 No Arbitrage and the Risk Premium 339 • GLOBAL FINANCIAL CRISIS

Diversification Benefits Düring Market Crashes 341

• COMMON MISTAKE A Fallacy of Long-Run Diversification 342

10.7 Measuring Systematic Risk 343 Identifying Systematic Risk: The Market Portfolio 343 Sensitivity to Systematic Risk: Beta 343

10.8 Beta and the Co st of Capital 346 Estimating the Risk Premium 346 • COMMON MISTAKE

Beta Versus Volatility 346 The Capital Asset Pricing Model 348 MyFinanceLab 348 • Key Terms 350 • Further Reading 350 • Problems 350 • Data Case 355

Chapter 11 Optimal Portfolio Choice and the Capital Asset Pricing Model 357

11.1 The Expected Return of a Portfolio 358

11.2 The Volatility of aTwo-Stock Portfolio 359 Combining Risks 359 Determining Covariance and Correlation 360 • COMMON MISTAKE

Computing Variance, Covariance, and Correlation in Excel 362

Computing a Portfolio's Variance and Volatility 363

11.3 The Volatility of a Large Portfolio 365 Large Portfolio Variance 365 Diversification with an Equally Weighted Portfolio 366 • INTERVIEW with John Powers 368 Diversification with General Portfolios 369

11.4 Risk Versus Retum: Choosing an Efficient Portfolio 369 Efficient Portfolios withTwo Stocks 370 The Effect of Correlation 372 Short Sales 373 Efficient Portfolios with Many Stocks 374 • NOBEL PRIZES Harry Markowitz

and JamesTobin 375 11.5 Risk-Free Saving and Borrowing 377

Investing in Risk-Free Securities 377 Borrowing and Buying Stocks on Margin 378 Identifying theTangent Portfolio 379

11.6 The Efficient Portfolio and Required Returns 381 Portfolio Improvement: Beta and the Required Return 381 Expected Returns and the Efficient Portfolio 383

11.7 The Capital Asset Pricing Model 385 The CAPM Assumptions 385 Supply, Demand, and the Efficiency of the Market Portfolio 386 Optimal Investing:The Capital Market Line 386

11.8 Determining the Risk Premium 387 Market Risk and Beta 387 • NOBEL PRIZE William Sharpe

on the CAPM 389

X Contents

The Security Market Line 390 Beta of a Portfolio 390 Summary of the Capital Asset Pricing Model 392 MyFinanceLab 392 • Key Terms 395 • Further Reading 395 • Problems 396 • Data Gase 402

Appendix The CAPM with Differing Interest Rates 404 The Efficient Frontier with Differing Saving and Borrowing Rates 404 The Security Market Line with Differing Interest Rates 404

Chapter 12 Estimating the Cost of Capital 407

12.1 The Equity Cost of Capital 408 12.2 The Market Portfolio 409

Constructing the Market Portfolio 409 Market Indexes 409 • Value-Weighted Portfolios and

Rebalancing 410 The Market Risk Premium 411

12.3 Beta Estimation 413 Using Historical Returns 413 Identifying the Best-Fitting Line 415 Using Linear Regression 416 • Why Not Estimate Expected Returns

Directly? 417 12.4 The Bebt Cost of Capital 417

DebtYields Versus Returns 417 • COMMON MISTAKE Using the Debt

Yield as Its Cost of Capital 418 Debt Betas 419

12.5 A Project's Cost of Capital 420 All-Equity Comparables 420 Levered Firms as Comparables 421 The Unlevered Cost of Capital 421 Industry Asset Betas 423

12.6 Project Risk Characteristics and Financing 425 Differences in Project Risk 425 • COMMON MISTAKE Adjusting

for Execution Risk 427 Financing and the Weighted Average Cost of Capital 427 • INTERVIEW with Shelagh Glaser 428 • COMMON MISTAKE

Using a Single Cost of Capital in Multi-Divisional Firms 429

12.7 Final Thoughts on Using the CAPM 430 MyFinanceLab 431 • Key Terms 433 • Further Reading 433 • Problems 434 • Data Case 438

Appendix Practica! Considerations When Forecasting Beta 439 Time Horizon 439 The Market Proxy 439 Beta Variation and Extrapolation 439 Outliers 440 • COMMON MISTAKE Changing

the Index to Improve the Fit 441 • USING EXCEL Estimating Beta

Using Excel 442 Other Considerations 443

Chapter 13 Investor Behavior and Capital Market Efficiency 445

13.1 Competition and Capital Markets 446 Identifying a Stock's Alpha 446 Profiting from Non-Zero Alpha Stocks 447

13.2 Information and Rational Expectations 448 Informed Versus Uninformed Investors 448 Rational Expectations 449

13.3 The Behavior of Individual Investors 450 Underdiversification and Portfolio Biases 450 ExcessiveTrading and Overconfidence 451 Individual Behavior and Market Prices 453

13.4 SystematicTrading Biases 453 Flanging on to Losers and the Disposition Effect 453 • NOBEL PRIZE Kahneman and

Tversky's ProspectTheory 454 Investor Attention, Mood, and Experience 454 Herd Behavior 455 Implications of Behavioral Biases 455

13.5 The Efficiency of the Market Portfolio 456 Trading on News or Recommendations 456 • NOBEL PRIZE The 2013 Prize:

An Enigma? 458

Contents xi

The Performance of Fund Managers 458 The Winners and Losers 461

13.6 Style Based Techniques and the Market Efficiency Debate 462 Size Effects 462 • INTERVIEW with 14.4

Jonathan Clements 464 Momentum 466 • Market Efficiency and the Efficiency

of the Market Portfolio 467 Implications of Positive-Alpha Trading Strategies 467 145

13.7 Multifactor Models of Risk 469 Using Factor Portfolios 470 Selecting the Portfolios 471 The Cost of Capital with Fama-French-Carhart Factor Specification 472

13.8 Methods Used in Practice 474 Chapter 15 Financial Managers 474 15 1

Investors 475 15.2 MyFinanceLab 476 • Key Terms 478 • Further Reading 478 • Problems 479

Appendix Building a Multifactor Model 485

PART 5 CAPITAL STRUCTURE

Chapter 14 Capital Structure in a Perfect Market 488

14.1 Equity Versus Debt Financing 489 Financing a Firm with Equity 489 Financing a Firm with Debt and Equity 490 The Effect of Leverage on Risk and Return 491

14.2 Modigliani-Miller I: Leverage, Arbitrage, and Firm Value 493 MM and the Law of One Price 493 Homemade Leverage 493 • MM and the Real World 494 The Market Value Balance Sheet 495 Application: A Leveraged Recapitalization 496

14.3 Modigliani-Miller II: Leverage, Risk, and the Cost of Capital 498 Leverage and the Equity Cost of Capital 498 Capital Budgeting and the Weighted Average Cost of Capital 499 • COMMON MISTAKE

Is Debt BetterThan Equity? 502

15.3

15.4

15.5

Computing the WACC with Multiple Securities 502 Levered and Unlevered Betas 502 • NOBEL PRIZE Franco Modigliani

and Merton Miller 504 Capital Structure Fallacies 505 Leverage and Earnings per Share 505 • GLOBAL FINANCIAL CRISIS

Bank Capital Regulation and the ROE Fallacy 507

Equity Issuances and Dilution 508 MM: Beyond the Propositions 509 MyFinanceLab 510 • Key Terms 511 • Further Reading 511 • Problems 512 * Data Case 516

Debt and Taxes 519

The InterestTax Deduction 520 Valuing the InterestTax Shield 522 The InterestTax Shield and Firm Value 522 • Pizza and Taxes 523 The InterestTax Shield with Permanent Debt 523 The Weighted Average Cost of Capital with Taxes 524 • The Repatriation Tax: Why Some

Cash-Rich Firms Borrow 525 The InterestTax Shield with aTarget Debt-Equity Ratio 526 Recapitalizing to Capture theTax Shield 528 TheTax Benefit 528 The Share Repurchase 529 No Arbitrage Pricing 529 Analyzing the Recap:The Market Value Balance Sheet 530 Personal Taxes 531 Including Personal Taxes in the Interest Tax Shield 531 Valuing the InterestTax Shield with Personal Taxes 534 Determining the ActualTax Advantage of Debt 535 • Cutting the Dividend Tax Rate 535 Optimal Capital Structure with Taxes 536 Do Firms Prefer Debt? 536 Limits to theTax Benefit of Debt 539 • INTERVIEW with

Andrew Balson 540

Contents

16.7

16.8

Growth and Debt 541 OtherTax Shields 542 The Low Leverage Puzzle 542 • Employee Stock Options 544 MyFinanceLab 544 • Key Terms 545 • Further Reading 545 • Problems 546 • Data Gase 550

pter 16 Financial Distress, Managerial Incentives, and Information 551

16.1 Default and Bankruptcy in a Perfect Market 552 Armin Industries: Leverage and the Risk of Default 552 Bankruptcy and Capital Structure 553

16.2 The Costs of Bankruptcy and Financial Distress 554 The Bankruptcy Code 555 Direct Costs of Bankruptcy 555 16.9 Indirect Costs of Financial Distress 556 • GLOBAL FINANCIAL CRISIS

The Chrysler Prepack 559 16.3 Financial Distress Costs and Firm

Value 560 Chapter 17 Armin Industries:The Impact of Financial 17.1 Distress Costs 560 Who Pays for Financial Distress Costs? 560

16.4 Optimal Capital Structure: The 172

Trade-OffTheory 562 The Present Value of Financial Distress Costs 562 Optimal Leverage 563

16.5 Exploiting Debt Holders:The Agency Costs of Leverage 565 Excessive Risk-Taking and Asset Substitution 565 Debt Overhang and Under-Investment 566 • GLOBAL FINANCIAL CRISIS

Bailouts, Distress Costs, and Debt Overhang 567

Agency Costs and the Value of Leverage 568 The Leverage Ratchet Effect 569 Debt Maturity and Covenants 570 172

• Why Do Firms Go Bankrupt? 570 16.6 Motivating Managers: The Agency

Benefits of Leverage 571 Concentration of Ownership 572

Reduction of Wasteful Investment 572 • Excessive Perks and Corporate

Scandals 573 • GLOBAL FINANCIAL CRISIS

Moral Hazard, Government Bailouts, and the Appeal of Leverage 574

Leverage and Commitment 575 Agency Costs and theTrade-Off Theory 575 The Optimal Debt Level 576 Debt Levels in Practice 577 Asymmetrie Information and Capital Structure 577 Leverage as a Credible Signal 577 Issuing Equity and Adverse Selection 579 • NOBEL PRIZE The 2001 Nobel Prize

in Economics 581 Implications for Equity Issuance 581 Implications for Capital Structure 582 Capital Structure: The Bottom Line 585 MyFinanceLab 586 • Key Terms 588 Further Reading 588 • Problems 588

Payout Policy 597

Distributions to Shareholders 598 Dividende 598 Share Repurchases 600 Comparison of Dividende and Share Repurchases 601 Alternative Policy 1: Pay Dividend with Excess Cash 601 Alternative Policy 2: Share Repurchase (No Dividend) 602 • COMMON MISTAKE Repurchases

and the Supply of Shares 604 Alternative Policy 3: High Dividend (Equity Issue) 604 Modigliani-Miller and Dividend Policy Irrelevance 605 • COMMON MISTAKE The Bird

in the Hand Fallacy 606 Dividend Policy with Perfect Capital Markets 606 TheTax Disadvantage of Dividends 606 Taxes on Dividends and Capital Gains 607 Optimal Dividend Policy with Taxes 608

Contents xiii

17.4 Dividend Capture and Tax Clienteies 610 The Effective Dividend Tax Rate 610 Tax Differences Across Investors 611 Clientele Effects 612 185

• INTERVIEW with John Connors 613 17.5 Payout Versus Retention of Cash 615

Retaining Cash with Perfect Capital Markets 616 Taxes and Cash Retention 617 Adjusting for InvestorTaxes 618 Issuance and Distress Costs 619 Agency Costs of Retaining Cash 620

17.6 Signaling with Payout Policy 622 Dividend Smoothing 622 Dividend Signaling 623 • Royal & SunAlliance's

Dividend Cut 624 Signaling and Share Repurchases 624

18 7 17.7 Stock Dividende, Splits, and Spin-Offs 626 Stock Dividends and Splits 626 Spin-Offs 628 • Berkshire Hathaway's

A & B Shares 629 MyFinanceLab 630 • Key Terms 631 • "'®-® Further Reading 632 m Problems 632 • Data Case 636

18.6

PART 6 ADVANCED VALUATION

Chapter 18 Capital Budgeting and Valuation with Leverage 640

18.1 Overview of Key Concepts 641 18.2 The Weighted Average Cost

of Capital Method 642 • INTERVIEW with Zane Rowe 643 Using the WACC to Value a Project 644 Summary of the WACC Method 645 Implementing a Constant Debt-Equity Ratio 646

18.3 TheAdjustedPresent Value Method 648 The Unlevered Value of the Project 648 Valuing the InterestTax Shield 649 Summary of the APV Method 650

18.4 The Flow-to-Equity Method 652 Calculating the Free Cash Flow to Equity 652

Appendix

Chapter 19

19.1 19.2

Valuing Equity Cash Flows 653 • What Counts as "Debt"? 654 Summary of the Flow-to-Equity Method 654 Project-Based Costs of Capital 655 Estimating the Unlevered Cost of Capital 656 Project Leverage and the Equity Cost of Capital 656 Determining the Incremental Leverage of a Project 658 • COMMON MISTAKE

Re-Levering the WACC 658 APV with Other Leverage Policies 660 Constant Interest Coverage Ratio 660 Predetermined Debt Levels 661 A Comparison of Methods 663 Other Effects of Financing 663 Issuance and Other Financing Costs 663 Security Mispricing 664 Financial Distress and Agency Costs 665 • GLOBAL FINANCIAL CRISIS

Government Loan Guarantees 666 Advanced Topics in Capital Budgeting 666 Periodically Adjusted Debt 667 Leverage and the Cost of Capital 669 The WACC or FTE Method with Changing Leverage 671 Personal Taxes 672 MyFinanceLab 674 • Key Terms 676 • Further Reading 676 • Problems 677 • Data Case 683 Föundations and Further Details 685 Deriving the WACC Method 685 The Levered and Unlevered Cost of Capital 686 Solving for Leverage and Value Simultaneously 687 The Residual Income and Economic Value Added Valuation Methods 689

Valuation and Financial Modeling: A Case Study 691

Valuation Using Comparables 692 The Business Plan 694 Operational Improvements 694 Capital Expenditures: A Needed

xiv Contents

Expansion 695 Working Capital Management 696 Capital Structure Changes: Levering Up 696

19.3 Building the Financial Model 697 Forecasting Earnings 697 • INTERVIEW with

Joseph L. Rice, III 698 Working Capital Requirements 700 Forecasting Free Cash Flow 701 • USING EXCEL

Summarizing Model Outputs 703 The Balance Sheet and Statement of Cash Flows (Optional) 704 • USING EXCEL

AuditingYour Financial Model 706 19.4 Estimating the Cost of Capital 707

CAPM-Based Estimation 707 Unlevering Beta 708 Ideko's Unlevered Cost of Capital 708

19.5 Valuing the Investment 709 The Multiples Approach to Continuation Value 710 The Discounted Cash Flow Approach to Continuation Value 711 • COMMON MISTAKE Continuation

Values and Long-Run Growth 713 APVValuation of Ideko's Equity 713 A Reality Check 714 • COMMON MISTAKE

Missing Assets or Liabilities 714 IRR and Cash Multiples 715

19.6 Sensitivity Analysis 716 MyFinanceLab 717 • Key Terms 718 • Further Reading 718 • Problems 719

Appendix Compensating Management 721

PART 7 OPTIONS

Chapter 20 Financial Options 724

20.1 Option Basics 725 Understanding Option Contracts 725 Interpreting Stock Option Quotations 725 Options on Other Financial Securities 727

20.2 Option Payoffs at Expiration 728 Long Position in an Option Contract 728 Short Position in an Option Contract 729 Profits for Holding an Option to Expiration 731 Returns for Holding an Option to Expiration 732 Combinations of Options 733

20.3 Put-Call Parity 736 20.4 Factors Affecting Option Prices 739

Strike Price and Stock Price 739 Arbitrage Bounds on Option Prices 739 Option Prices and the Exercise Date 739 Option Prices and Volatility 740

20.5 Exercising Options Early 741 Non-Dividend-Paying Stocks 741 Dividend-Paying Stocks 743

20.6 Options and Corporate Finance 745 Equity as a Call Option 745 Debt as an Option Portfolio 746 Credit Default Swaps 746 • GLOBAL FINANCIAL CRISIS

Credit Default Swaps 747 Pricing Risky Debt 748 Agency Conflicts 749 MyFinanceLab 750 • Key Terms 751 • Further Reading 751 • Problems 751 • Data Case 756

Chapter 21 Option Valuation 757

21.1 The Binomial Option Pricing Model 758 ATwo-State Single-Period Model 758 The Binomial Pricing Formula 760 A Multiperiod Model 761 Making the Model Realistic 765

21.2 The Black Scholas Option Pricing Model 766 The Black-Scholes Formula 766 • INTERVIEW with

Myron S. Scholes 767 Implied Volatility 772 • GLOBAL FINANCIAL CRISIS

TheVIX Index 773 The Replicating Portfolio 774

21.3 Risk-Neutral Probabilities 776 A Risk-NeutralTwo-State Model 776 Implications of the Risk-Neutral World 776 Risk-Neutral Probabilities and Option Pricing 777

21.4 Risk and Return of an Option 779 21.5 Corporate Applications of Option

Pricing 781 Beta of Risky Debt 781 • COMMON MISTAKE

Valuing Employee Stock Options 784 • NOBEL PRIZE The 1997 Nobel Prize

in Economics 785

Contents xv

Agency Costs of Debt 785 MyFinanceLab 786 • Key Terms 788 • Further Reading 788 • Problems 788

Chapter 22 Real Options 793

22.1 22.2

22.3

22.4

22.5

22.6 22.7

22.8

Real Versus Financial Options 794 Decision Tree Analysis 794 Representing Uncertainty 795 Real Options 796 Solving Decision Trees 796 The Option to Delay: Investment as a Call Option 797 An Investment Option 797 • Why AreThere Empty Lots in Built-Up

Areas of Big Cities? 800 Factors Affecting theTiming of Investment 801 Investment Options and Firm Risk 802 • GLOBAL FINANCIAL CRISIS

Uncertainty, Investment, and the Option to Delay 803

Growth and Abandonment Options 804 Valuing Growth Potential 804 The Option to Expand 806 • INTERVIEW with

Scott Mathews 807 The Option to Abandon 808 Investments with Different Lives 810 • Equivalent Annual Benefit

Method 811 Optimally Staging Investments 812 Rules ofThumb 815 The Profitability Index Rule 816 The Hurdle Rate Rule 816 • The Option to Repay a Mortgage 818 Key Insights from Real Options 819 MyFinanceLab 819 • Key Terms 821 • Further Reading 821 • Problems 821

23.2

23.3

23.4

Chapter 24

24.1

24.2

PART 8 LONG-TERM FINANCING

Chapter 23 Raising Equity Capital 828

23.1 Equity Financing for Private Companies 829 Sources of Funding 829 • Crowdfunding: The Wave

of the Future? 830 * INTERVIEW with Kevin Laws 831

24.3 24.4

Venture Capital Investing 834 Venture Capital Financing Terms 836 • COMMON MISTAKE Misinterpreting

Start-Up Valuations 836 • From Laurich to Liquidity 838 Exiting an Investment in a Private Company 840 The Initial Public Offering 840 Advantages and Disadvantages of Going Public 840 Types of Offerings 841 The Mechanics of an IPO 843 • Google's IPO 843 IPO Puzzles 848 Underpricing 848 Cyclicality 851 • GLOBAL FINANCIAL CRISIS

Worldwide IPO Deals in 2008-2009 852

Cost of an IPO 852 Long-Run Underperformance 853 The Seasoned Equity Offering 854 The Mechanics of an SEO 854 Price Reaction 856 Issuance Costs 857 MyFinanceLab 857 • Key Terms 858 • Further Reading 859 • Problems 860 • Data Case 863

Debt Financing 865

Corporate Debt 866 Public Debt 866 Private Debt 870 OtherTypes of Debt 871 Sovereign Debt 871 Municipal Bonds 873 • Detroit's Art Museum at Risk 873 Asset-Backed Securities 874 • GLOBAL FINANCIAL CRISIS

CDOs, Subprime Mortgages, and the Financial Crisis 874

Bond Covenants 876 Repayment Provisions 877 Call Provisions 877 • New York City Calls Its Municipal

Bonds 879 Sinking Funds 881 Convertible Provisions 881 MyFinanceLab 883 • Key Terms 884 • Further Reading 885 • Problems 885 • Data Case 886

xvi Contents

Chapter 25 Leasing 889

25.1 The Basics of Leasing 890 Examples of LeaseTransactions 890 Laase Payments and Residual Values 891 Laases Versus Loans 892 • Calculating Auto Lease

Payments 893 End-of-Term Lease Options 893 Other Lease Provisions 895

25.2 Accounting,Tax, and Legal Consequences of Leasing 895 Lease Accounting 896 • Operating Leases at Alaska

Air Group 897 TheTaxTreatment of Leases 898 Leases and Bankruptcy 899 • Synthetic Leases 900

25.3 The Leasing Decision 900 Cash Flows for aTrueTax Lease 901 Lease Versus Buy (An Unfair Comparison) 902 Lease Versus Borrow (The Right Comparison) 903 Evaluating aTrueTax Lease 905 Evaluating a Non-Tax Lease 906

25.4 Reasons for Leasing 906 Valid Arguments for Leasing 907 • INTERVIEW with Mark Long 909 Suspect Arguments for Leasing 910 MyFinanceLab 911 • Key Terms 912 Further Reading 912 • Problems 913

PART 9 SHORT-TERM FINANCING

Chapter 26 Working Capital Management 918

26.1 Overview ofWorking Capital 919 The Cash Cycle 919 Firm Value and Working Capital 921

26.2 Trade Credit 922 Trade Credit Terms 922 Trade Credit and Market Frictions 922 Managing Float 923

26.3 Receivables Management 924 Determining the Credit Policy 924 Monitoring Accounts Receivable 925

26.4 Payables Management 927 Determining Accounts Payable Days Outstanding 927 Stretching Accounts Payable 928

26.5 Inventory Management 928 Benefits of Holding Inventory 929 Costs of Holding Inventory 929

26.6 Cash Management 930 Motivation for Holding Cash 930 Alternative Investments 931 • Hoarding Cash 931 MyFinanceLab 933 • Key Terms 934 m Further Reading 934 • Problems 935 m Data Case 938

Chapter 27 Short-Term Financial Flanning 941

27.1 Forecasting Short-Term Financing Needs 942 Seasonalities 942 Negative Cash Flow Shocks 945 Positive Cash Flow Shocks 946

27.2 The Matching Principle 947 Permanent Working Capital 947 Temporary Working Capital 947 Financing Policy Choices 948

27.3 Short-Term Financing with Bank Loans 949 Single, End-of-Period Payment Loan 949 Line of Credit 949 Bridge Loan 950 Common Loan Stipulations and Fees 950

27.4 Short-Term Financing with Commercial Paper 952 • GLOBAL FINANCIAL CRISIS

Short-Term Financing in Fall 2008 953 27.5 Short-Term Financing with Secured

Financing 954 Accounts Receivable as Collateral 954 • A Seventeenth-Century Financing

Solution 954 Inventory as Collateral 955 • Loan GuaranteestThe Ex-Im Bank

Controversy 956 MyFinanceLab 957 • Key Terms 958 • Further Reading 958 • Problems 959

I

Contents xvii

PART 10 SPECIAL TOPICS Chapter 29 Corporate Govemance 993

Chapter 28 Mergers and Acquisitions 962

28.1 Background and Historical Trends 963 Merger Waves 963 Types of Mergers 965

28.2 Market Reactiontoa Takeover 965

28.3 Reasons to Acquire 966 Economies of Scale and Scope 967 Vertical Integration 967 Expertise 967 Monopoly Gains 968 Efficiency Gains 968 Tax Savings from Operating Losses 969 Diversification 970 Earnings Growth 970 Managerial Motives to Merge 971

28.4 Valuation and theTakeover Process 972 Valuation 973 The Offer 974 Merger "Arbitrage" 975 Tax and Accounting Issues 976 Board and Shareholder Approval 977

28.5 Takeover Defenses 978 Poison Pills 978 Staggered Boards 979 White Knights 980 Golden Parachutes 981 Recapitalization 981 Other Defensive Strategies 981 Regulatory Approval 982 • Weyerhaeuser's Hostile Bid

for Willamette Industries 982

28.6 Who Gets the Value Added from a Takeover? 983 The Free Rider Problem 983 Toeholds 984 The Leveraged Buyout 984 • The Leveraged Buyout of RJR-Nabisco

by KKR 985 The Freezeout Merger 987 Competition 988

MyFinanceLab 988 • Key Terms 990 • Further Reading 990 • Problems 990

29.1 Corporate Govemance and Agency Costs 994

29.2 Monitoring by the Board of Directors and Others 995 Types of Directors 995 Board Independence 995 Board Size and Performance 997 Other Monitors 997

29.3 Compensation Policies 998 Stock and Options 998 Pay and Performance Sensitivity 998

29.4 Managing Agency Conflict 1000 Direct Action by Shareholders 1000 • Shareholder Activism at The New

York Times 1001 Management Entrenchment 1002 The Threat of Takeover 1003

29.5 Regulation 1003 The Sarbanes-Oxley Act 1004 • INTERVIEW with

Lawrence E. Harris 1005 The Cadbury Commission 1006 Dodd-Frank Act 1007 Insider Trading 1007 • Martha Stewart and ImClone 1008

29.6 Corporate Govemance Around the World 1008 Protection of Shareholder Rights 1008 Controlling Owners and Pyramids 1009 The Stakeholder Model 1011 Cross-Holdings 1012

29.7 TheTrade-Off of Corporate Govemance 1013 MyFinanceLab 1013 • Key Terms 1015 • Further Reading 1015 • Problems 1015

Chapter 30 Risk Management 1017

30.1 Insurance 1018 The Role of Insurance: An Example 1018 Insurance Pricing in a Perfect Market 1018 The Value of Insurance 1020 The Costs of Insurance 1022 The Insurance Decision 1024

xviii Contents

30.2 Commodity Price Risk 1024 Hedging withVertical Integration and Storage 1025 Hedging with Long-Term Contracts 1025 Hedging with Futures Contracts 1027 • COMMON MISTAKE

Hedging Risk 1029 • Differing Hedging Strategies 1030 Deciding to Hedge Commodity Price Risk 1030

30.3 Exchange Rate Risk 1031 Exchange Rate Fluctuations 1031 Hedging with Forward Contracts 1032 Cash-and-Carry and the Pricing of Currency Forwards 1033 • GLOBAL FINANCIAL CRISIS

Arbitrage in Currency Markets? 1035 Hedging with Options 1037

30.4 Interest Rate Risk 1041 Interest Rate Risk Measurement: Duration 1041 Duration-Based Hedging 1043 Swap-Based Hedging 1046 • The Savings and Loan Crisis 1048 MyFinanceLab 1050 • Key Terms 1052 • Further Reading 1052 • Problems 1053

Chapter 31 International Corporate Finance 1059

31.2 Valuation of Foreign Currency Cash Flows 1061 WACC Valuation Method in Domestic Currency 1062 Using the Law of One Price as a Robustness Check 1064

31.3 Valuation and International Taxation 1065 Single Foreign Project with Immediate Repatriation of Earnings 1066 Multiple Foreign Projects and Deferral of Earnings Repatriation 1066

31.4 Internationally Segmented Capital Markets 1067 Differential Access to Markets 1067 Macro-Level Distortions 1068 Implications 1069

31.5 Capital Budgeting with Exchange Risk 1070 • INTERVIEW with Bill Barrett 1071

MyFinanceLab 1073 • Key Terms 1074 • Further Reading 1074 • Problems 1075 a Data Case 1077

Glossary 1079

31.1 Internationally Integrated Capital Markets 1060 Index 1099