Part Ⅰ Overview 1
Chapter 1 Introduction to Corporate Finance 2
Executive Summary 2
1.1 What Is Corporate Finance? 3
The Balance-Sheet Model of the Firm 3
Capital Structure 4
The Financial Manager 5
1.2 Corporate Securities as Contingent Claims on Total Firm Value 9
1.3 The Corporate Firm 10
The Sole Proprietorship 10
The Partnership 10
The Corporation 11
Case Study: Making the Decision to Become a Corporation: The Case of PLM International, Inc. 12
1.4 Goals of the Corporate Firm 14
Agency Costs and the Set-of-Contracts Perspective 14
Managerial Goals 15
Separation of Ownership and Control 15
Do Shareholders Control Managerial Behavior? 16
1.5 Financial Markets 17
The Primary Market: New Issues 17
Secondary Markets 18
Exchange Trading of Listed Stocks 18
Listing 18
1.6 Outline of the Text 19
Chapter 2 Accounting Statements and Cash Flow 21
Executive Summary 21
2.1 The Balance Sheet 21
Accounting Liquidity 22
Debt versus Equity 23
Value versus Cost 23
2.2 The Income Statement 24
Generally Accepted Accounting Principles 25
Noncash Items 25
Time and Costs 25
2.3 Net Working Capital 26
2.4 Financial Cash Flow 26
2.5 The Accounting Statement of Cash Flows 29
Cash Flow from Operating Activities 29
Cash Flow from Investing Activities 30
Cash Flow from Financing Activities 30
2.6 Summary and Conclusions 31
Appendix 2A Financial Statement Analysis 34
Appendix 2B U.S. Federal Tax Rates 42
Chapter 3 Financial Planning and Growth 44
Executive Summary 44
3.1 What Is Financial Planning? 44
3.2 A Financial-Planning Model: The Ingredients 45
3.3 The Percentage Sales Method 47
The Income Statement 48
The Balance Sheet 49
3.4 What Determines Growth? 51
3.5 Some Caveats of Financial-Planning Models 54
3.6 Summary and Conclusions 55
Part Ⅱ Value and Capital Budgeting 59
Chapter 4 Net Present Value 60
Executive Summary 60
4.1 The One-Period Case 60
4.2 The Multiperiod Case 63
Future Value and Compounding 63
The Power of Compounding: A Digression 67
Present Value and Discounting 68
The Algebraic Formula 71
4.3 Compounding Periods 72
Distinction between Stated Annual Interest Rate and Effective Annual Interest Rate 73
Compounding over Many Years 73
Continuous Compounding (Advanced) 74
4.4 Simplifications 75
Perpetuity 75
Growing Perpetuity 77
Annuity 79
Growing Annuity 83
Case Study: Making the Decision to Convert Lottery Prize Winnings: The Case of the Singer Asset Finance Company 85
4.5 What Is a Firm Worth? 86
4.6 Summary and Conclusions 87
Appendix 4A Net Present Value: First Principles of Finance 94
Chapter 5 How to Value Bonds and Stocks 106
Executive Summary 106
5.1 Definition and Example of a Bond 106
5.2 How to Value Bonds 106
Pure Discount Bonds 106
Level-Coupon Bonds 107
Consols 109
5.3 Bond Concepts 110
Interest Rates and Bond Prices 110
Yield to Maturity 110
Bond Market Reporting 111
5.4 The Present Value of Common Stocks 112
Dividends versus Capital Gains 112
Valuation of Different Types of Stocks 113
5.5 Estimates of Parameters in the Dividend-Discount Model 116
Where Does g Come From? 116
Where Does r Come From? 118
A Healthy Sense of Skepticism 118
5.6 Growth Opportunities 119
Growth in Earnings and Dividends versus Growth Opportunities 121
Dividends or Earnings: Which to Discount? 122
The No-Dividend Firm 122
5.7 The Dividend-Growth Model and the NPVGO Model (Advanced) 123
The Dividend-Growth Model 123
The NPVGO Model 123
Summation 125
5.8 Price-Earnings Ratio 125
5.9 Stock Market Reporting 127
5.10 Summary and Conclusions 128
Appendix 5A The Term Structure of Interest Rates,Spot Rates, and Yield to Maturity 134
Chapter 6 Some Alternative Investment Rules 144
Executive Summary 144
6.1 Why Use Net Present Value? 144
6.2 The Payback Period Method 146
Defining the Rule 146
Problems with the Payback Method 147
Managerial Perspective 148
Summary of Payback 148
6.3 The Discounted Payback Period Method 149
6.4 The Average Accounting Return Method 149
Defining the Rule 149
Analyzing the Average Accounting Return Method 151
6.5 The Internal Rate of Return 152
6.6 Problems with the IRR Approach 154
Definition of Independent and Mutually Exclusive Projects 154
Two General Problems Affecting Both Independent and Mutually Exclusive Projects 154 Problems Specific to Mutually Exclusive Projects 159
Redeeming Qualities of IRR 163
A Test 163
6.7 The Profitability Index 164
Calculation of Profitability Index 164
6.8 The Practice of Capital Budgeting 166
6.9 Summary and Conclusions 168
Chapter 7 Net Present Value and Capital Executive Summary 178
7.1 Incremental Cash Flows 178
Cash Flows--Not Accounting Income 178
Sunk Costs 179
Opportunity Costs 179
Side Effects 179
Allocated Costs 180
7.2 The Baldwin Company: An Example 180
An Analysis of the Project 182
Which Set of Books? 184
A Note on Net Working Capital 185
Interest Expense 186
7.3 The Boeing 777: A Real-World Example 186
7.4 Inflation and Capital Budgeting 189
Interest Rates and Inflation 189
Cash Flow and Inflation 191
Discounting: Nominal or Real? 191
7.5 Investments of Unequal Lives: The Equivalent Annual Cost Method 193
The General Decision to Replace (Advanced) 195
7.6 Summary and Conclusions 197
Minicases: Goodweek Tires,Inc. 206
I. Q., Inc. 207
Jimmy's Hot Dog Stands 208
Appendix 7A Depreciation 209
Chapter 8 Risk Analysis, Real Options, and Capital Budgeting 211
Executive Summary 211
8.1 Decision Trees 211
8.2 Sensitivity Analysis, Scenario Analysis,and Break-Even Analysis 213
Sensitivity Analysis and Scenario Analysis 214
Break-Even Analysis 216
8.3 Monte Carlo Simulation 219
8.4 Real Options 223
The Option to Expand 223
The Option to Abandon 224
Timing Options 226
8.5 Summary and Conclusions 227
Part Ⅲ Risk 233
Chapter 9 Capital Market Theory: An Overview 234
Executive Summary 234
9.1 Returns 235
Dollar Returns 235
Percentage Returns 237
9.2 Holding-Period Returns 239
9.3 Return Statistics 244
9.4 Average Stock Returns and Risk-Free Returns 246
9.5 Risk Statistics 247
Variance 247
Normal Distribution and Its Implications for Standard Deviation 248
9.6 Summary and Conclusions 249
Appendix 9A The Historical Market Risk Premium: The Very Long Run 253
Chapter 10 Return and Risk: The Capital-Asset-Pricing Model (CAPM) 255
Executive Summary 255
10.1 Individual Securities 255
10.2 Expected Return, Variance, and Covariance 256
Expected Return and Variance 256
Covariance and Correlation 258
10.3 The Return and Risk for Portfolios 261
The Example of Supertech and Slowpoke 261
The Expected Return on a Portfolio 261
Variance and Standard Deviation of a Portfolio 262
10.4 The Efficient Set for Two Assets 265
10.5 The Efficient Set for Many Securities 270
Variance and Standard Deviation in a Portfolio of Many Assets 271
10.6 Diversification: An Example 272
Risk and the Sensible Investor 275
10.7 Riskless Borrowing and Lending 276
The Optimal Portfolio 278
10.8 Market Equilibrium 280
Definition of the Market-Equilibrium Portfolio 280
Definition of Risk When Investors Hold the Market Portfolio 281
The Formula for Beta 283
A Test 283
10.9 Relationship between Risk and Expected Return (CAPM) 284
Expected Return on Market 284
Expected Return on Individual Security 284
10.10 Summary and Conclusions 287
Appendix 10A Is Beta Dead? 295
Chapter 11 An Alternative View of Risk and Return:The Arbitrage Pricing Theory 297
Executive Summary 297
11.1 Factor Models: Announcements, Surprises, and Expected Returns 298
11.2 Risk: Systematic and Unsystematic 299
11.3 Systematic Risk and Betas 300
11.4 Portfolios and Factor Models 303
Portfolios and Diversification 305
11.5 Betas and Expected Returns 307
The Linear Relationship 307
The Market Portfolio and the Single Factor 309
11.6 The Capital-Asset-Pricing Model and the Arbitrage Pricing Theory 310
Differences in Pedagogy 310
Differences in Application 310
11.7 Empirical Approaches to Asset Pricing 311
Empirical Models 311
Style Portfolios 313
11.8 Summary and Conclusions 313
Chapter 12 Risk, Cost of Capital, and Capital Budgeting 318
Executive Summary 318
12.1 The Cost of Equity Capital 318
12.2 Estimation of Beta 321
Real-World Betas 323
Stability of Beta 323
Using an Industry Beta 324
12.3 Determinants of Beta 326
Cyclically of Revenues 326
Operating Leverage 327
Financial Leverage and Beta 328
12.4 Extensions of the Basic Model 330
The Firm versus the Project: Vive la Difference 330
The Cost of Capital with Debt 331
12.5 Estimating International Paper's Cost of Capital 333
Cost of Equity and Debt 333
Determining rWACC 334
12.6 Reducing the Cost of Capital 334
What Is Liquidity? 335
Liquidity, Expected Returns, and the Cost of Capital 335
Liquidity and Adverse Selection 336
What the Corporation Can Do 336
12.7 Summary and Conclusions 338
Minicase: AlliedProducts 341
Appendix 12A Economic Value Added and the Measurement of Financial Performance 343
Part Ⅳ Capital Structure and Dividend Policy 347
Chapter 13 Corporate-Financing Decisions and Efficient Capital Markets 349
Executive Summary 349
13.1 Can Financing Decisions Create Value? 349
13.2 A Description of Efficient Capital Markets 351
Foundations of Market Efficiency 352
13.3 The Different Types of Efficiency 354
The Weak Form 355
The Semistrong and Strong Forms 356
Some Common Misconceptions about the Efficient-Market Hypothesis 357
13.4 The Evidence 358
The Weak Form 358
The Semistrong Form 360
The Strong Form 363
13.5 The Behavioral Challenge to Market Efficiency 364
13.6 Empirical Challenges to Market Efficiency 366
13.7 Reviewing the Differences 370
Representativeness 371
Conservatism 371
13.8 Implications for Corporate Finance 371
1. Accounting Choices, Financial Choices,and Market Efficiency 372
2. The Timing Decision 373
3. Speculation and Efficient Markets 375
4. Information in Market Prices 377
13.9 Summary and Conclusions 378
Chapter 14 Long-Term Financing:An Introduction 384
Executive Summary 384
14.1 Common Stock 384
Par and No-Par Stock 384
Authorized versus Issued Common Stock 385
Capital Surplus 385
Retained Earnings 385
Market Value, Book Value, and Replacement Value 386
Shareholders' Rights 387
Dividends 388
Classes of Stock 388
14.2 Corporate Long-Term Debt: The Basics 389
Interest versus Dividends 389
Is It Debt or Equity? 390
Basic Features of Long-Term Debt 390
Different Types of Debt 390
Repayment 391
Seniority 391
Security 391
Indenture 391
14.3 Preferred Stock 392
Stated Value 392
Cumulative and Noncumulative Dividends 392
Is Preferred Stock Really Debt? 393
The Preferred-Stock Puzzle 393
14.4 Patterns of Financing 394
14.5 Recent Trends in Capital Structure 398
Which Are Best: Book or Market Values? 398
14.6 Summary and Conclusions 399
Chapter 15 Capital Structure: Basic Concepts 402
Executive Summary 402
15.1 The Capital-Structure Question and the Pie Theory 402
15.2 Maximizing Firm Value versus Maximizing Stockholder Interests 403
15.3 Financial Leverage and Firm Value: An Example 405
Leverage and Returns to Shareholders 405
The Choice between Debt and Equity 407
A Key Assumption 409
15.4 Modigliani and Miller: Proposition II (No Taxes) 409
Risk to Equityholders Rises with Leverage 409
Proposition II: Required Return to Equityholders Rises with Leverage 410
Example Illustrating Proposition I and Proposition II 412
MM: An Interpretation 416
15.5 Taxes 419
The Basic Insight 419
The Quirk in the Tax Code 419
Present Value of the Tax Shield 420
Value of the Levered Firm 421
Expected Return and Leverage under Corporate Taxes 422
The Weighted Average Cost of Capital rWACC and Corporate Taxes 424
Stock Price and Leverage under Corporate Taxes 424
15.6 Summary and Conclusions 426
Chapter 16 Capital Structure: Limits to the Use of Debt 433
Executive Summary 433
16.1 Costs of Financial Distress 433
Bankruptcy Risk or Bankruptcy Cost? 433
16.2 Description of Financial Distress Costs 436
Direct Costs of Financial Distress: Legal and Administrative Costs of Liquidation or Reorganization 436
Indirect Costs of Financial Distress 437
Agency Costs 438
16.3 Can Costs of Debt Be Reduced? 441
Protective Covenants 441
Consolidation of Debt 442
16.4 Integration of Tax Effects and Financial Distress Costs 442
Pie Again 444
16.5 Signaling 445
16.6 Shirking, Perquisites, and Bad Investments: A Note on Agency Cost of Equity 447
Effect of Agency Costs of Equity on Debt-Equity Financing 449
Free Cash Flow 449
16.7 The Pecking-Order Theory 450
Rules of the Pecking Order 452
Implications 452
16.8 Growth and the Debt-Equity Ratio 453
No-Growth 454
Growth 454
16.9 Personal Taxes 456
The Miller Model 458
16.10 How Firms Establish Capital Structure 461
16.11 Summary and Conclusions 464
Appendix 16A Some Useful Formulas of Financial Structure 472
Appendix 16B The Miller Model and the Graduated Income Tax 473
Chapter 17 Valuation and Capital Budgeting for the Levered Firm 477
Executive Summary 477
17.1 Adjusted-Present-Value Approach 477
17.2 Flow-to-Equity Approach 479
Step 1: Calculating Levered Cash Flow (LCF) 479
Step 2: Calculating rs 480
Step 3: Valuation 480
17.3 Weighted-Average-Cost-of-Capital Method 480
17.4 A Comparison of the APV, FTE, and WACC Approaches 481
A Suggested Guideline 482
17.5 Capital Budgeting When the Discount Rate Must Be Estimated 485
17.6 APV Example 486
17.7 Beta and Leverage 490
The Project Is Not Scale-Enhancing 491
17.8 Summary and Conclusions 492
Appendix 17A The Adjusted-Present-Value Approach to Valuing Leveraged Buyouts 497
Chapter 18 Dividends and Other Payouts 502
Executive Summary 502
18.1 Different Types of Dividends 502
18.2 Standard Method of Cash Dividend Payment 503
18.3 The Benchmark Case: An Illustration of the Irrelevance of Dividend Policy 504
Current Policy: Dividends Set Equal to Cash Flow 505
Alternative Policy: Initial Dividend Is Greater than Cash Flow 505
The Indifference Proposition 506
Homemade Dividends 507
A Test 508
Dividends and Investment Policy 509
18.4 Repurchase of Stock 509
Dividend versus Repurchase: Conceptual Example 511
Dividends versus Repurchases: Real-World Considerations 512
18.5 Personal Taxes, Issuance Costs,and Dividends 513
Firms without Sufficient Cash to Pay a Dividend 513
Firms with Sufficient Cash to Pay a Dividend 514
Summary on Personal Taxes 516
18.6 Real-World Factors Favoring a High-Dividend Policy 517
Desire for Current Income 517
Behavioral Finance 517
Agency Costs 519
Information Content of Dividends and Dividend Signaling 519
18.7 The Clientele Effect: A Resolution of Real-World Factors? 522
18.8 What We Know and Do Not Know about Dividend Policy 523
Corporate Dividends Are Substantial 523
Fewer Companies Pay Dividends 525
Corporations Smooth Dividends 526
Payouts Provide Information to the Market 527
A Sensible Payout Policy 527
Case Study: How Firms Make the Decision to Pay Dividends: The Case of Apple Computer 528
18.9 Summary and Conclusions 531
Appendix 18A Stock Dividends and Stock Splits 535
Part Ⅴ Long-Term Financing 539
Chapter 19 Issuing Securities to the Public 540
Executive Summary 540
19.1 The Public Issue 540
The Basic Procedure for a New Issue 540
19.2 Alternative Issue Methods 541
19.3 The Cash Offer 543
Investment Banks 545
The Offering Price 547
Underpricing: A Possible Explanation 548
19.4 The Announcement of New Equity and the Value of the Firm 550
19.5 The Cost of New Issues 551
19.6 Rights 553
The Mechanics of a Rights Offering 554
Subscription Price 554
Number of Rights Needed to Purchase a Share 555
Effect of Rights Offering on Price of Stock 555
Effects on Shareholders 557
The Underwriting Arrangements 557
19.7 The Rights Puzzle 557
19.8 Shelf Registration 559
19.9 The Private Equity Market 560
Private Placement 560
The Private Equity Firm 561
Suppliers of Venture Capital 561
Stages of Financing 563
Case Study: The Decision to Do an Initial Public Offering (IPO): The Case of Medstone International, Inc. 564
19.10 Summary and Conclusions 566
Chapter 20 Long-Term Debt 569
Executive Summary 569
20.1 Long-Term Debt: A Review 569
20.2 The Public Issue of Bonds 570
The Basic Terms 571
Security 572
Protective Covenants 573
The Sinking Fund 573
The Call Provision 574