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Corporate Finance, Global Edition

Corporate Finance, Global Edition

Jonathan Berk | Peter DeMarzo

(2016)

Additional Information

Book Details

Abstract

For MBA/graduate students taking a course in corporate finance.

 

An Emphasis on Core Financial Principles to Elevate Individuals’ Financial Decision Making

Using the unifying valuation framework based on the Law of One Price, top researchers Jonathan Berk and Peter DeMarzo have set the new canon for corporate finance textbooks. Corporate Finance, Fourth Edition blends coverage of time-tested principles and the latest advancements with the practical perspective of the financial manager, so students have the knowledge and tools they need to make sound financial decisions in their careers.

 

For a streamlined book specifically tailored to the topics covered in the first one-semester course, Corporate Finance: The Core is also available by Jonathan Berk and Peter DeMarzo.

 

MyFinanceLabTM not included. Students, if MyFinanceLab is recommended/mandatory component of the course, please ask your instructor for the correct ISBN and course ID. MyFinanceLab should only be purchased when required by an instructor.

Table of Contents

Section Title Page Action Price
Cover\r Cover
Title Page\r 3
Copyright Page 4
Detailed Contents\r 5
PART 1 INTRODUCTION 33
Chapter 1 The Corporation 34
1.1 The Four Types of Firms 35
Sole Proprietorships 35
Partnerships 36
Limited Liability Companies 37
Corporations 37
Tax Implications for Corporate Entities\r 38
Corporate Taxation Around the World 39
1.2 Ownership Versus Control of Corporations\r 39
The Corporate Management Team 39
INTERVIEW with David Viniar 40
The Financial Manager 41
GLOBAL FINANCIAL CRISIS The Dodd-Frank Act 42
The Goal of the Firm 42
The Firm and Society 43
Ethics and Incentives within Corporations 43
GLOBAL FINANCIAL CRISIS The Dodd-Frank Act on Corporate Compensation and Governance 44
Citizens United v. Federal Election Commission 44
Airlines in Bankruptcy 46
1.3 The Stock Market 46
Primary and Secondary Stock Markets 47
Traditional Trading Venues 47
INTERVIEW with Frank Hatheway 48
New Competition and Market Changes\r 49
Dark Pools 50
MyFinanceLab 51
Key Terms 51
Further Reading 52
Problems 52
Chapter 2 Introduction to Financial Statement Analysis 55
2.1 Firms’ Disclosure of Financial Information\r 56
Preparation of Financial Statements 56
International Financial Reporting Standards 56
INTERVIEW with Ruth Porat 57
Types of Financial Statements 58
2.2 The Balance Sheet 58
Assets 59
Liabilities 60
Stockholders’ Equity 61
Market Value Versus Book Value 61
Enterprise Value 62
2.3 The Income Statement 62
Earnings Calculations 63
2.4 The Statement of Cash Flows 64
Operating Activity 65
Investment Activity 66
Financing Activity 66
2.5 Other Financial Statement Information\r 67
Statement of Stockholders’ Equity 67
Management Discussion and Analysis\r 68
Notes to the Financial Statements 68
2.6 Financial Statement Analysis 69
Profitability Ratios 69
Liquidity Ratios 70
Working Capital Ratios 71
Interest Coverage Ratios 72
Leverage Ratios 73
Valuation Ratios 75
COMMON MISTAKE Mismatched Ratios 75
Operating Returns 76
The DuPont Identity 78
2.7 Financial Reporting in Practice 80
Enron 80
WorldCom 80
Sarbanes-Oxley Act 81
GLOBAL FINANCIAL CRISIS Bernard Madoff’s Ponzi Scheme 82
Dodd-Frank Act 82
MyFinanceLab 83
Key Terms 84
Further Reading 85
Problems 85
Data Case 92
Chapter 3 Financial Decision Making and the Law of One Price 93
3.1 Valuing Decisions 94
Analyzing Costs and Benefits 94
Using Market Prices to Determine Cash Values 95
When Competitive Market Prices Are Not Available 97
3.2 Interest Rates and the Time Value of Money 97
The Time Value of Money 97
The Interest Rate: An Exchange Rate Across Time 97
3.3 Present Value and the NPV Decision Rule 100
Net Present Value 100
The NPV Decision Rule 101
NPV and Cash Needs 103
3.4 Arbitrage and the Law of One Price 104
Arbitrage 104
Law of One Price 105
3.5 No-Arbitrage and Security Prices 105
Valuing a Security with the Law of One Price 105
An Old Joke 109
The NPV of Trading Securities and Firm Decision Making 109
Valuing a Portfolio 110
GLOBAL FINANCIAL CRISIS Liquidity and the Informational Role of Prices 111
Arbitrage in Markets 112
Where Do We Go from Here? 113
MyFinanceLab 114
Key Terms 115
Further Reading 115
Problems 115
Appendix The Price of Risk 119
Risky Versus Risk-Free Cash Flows 119
Arbitrage with Transactions Costs 124
PART 2 TIME, MONEY, AND INTEREST RATES\r 129
Chapter 4 The Time Value of Money 130
4.1 The Timeline 131
4.2 The Three Rules of Time Travel 132
Rule 1: Comparing and Combining Values 132
Rule 2: Moving Cash Flows Forward in Time 133
Rule 3: Moving Cash Flows Back in Time 134
Rule of 72 135
Applying the Rules of Time Travel 136
4.3 Valuing a Stream of Cash Flows 138
4.4 Calculating the Net Present Value 141
USING EXCEL Calculating Present Values in Excel 142
4.5 Perpetuities and Annuities 143
Perpetuities 143
Historical Examples of Perpetuities 144
COMMON MISTAKE Discounting One Too Many Times 146
Annuities 146
Formula for an Annuity Due 149
Growing Cash Flows 149
4.6 Using an Annuity Spreadsheet or Calculator\r 154
4.7 Non-Annual Cash Flows 156
4.8 Solving for the Cash Payments 157
4.9 The Internal Rate of Return 160
USING EXCEL Excel’s IRR Function\r 163
MyFinanceLab 164
Key Terms 165
Further Reading 166
Problems 166
Data Case 172
Appendix Solving for the Number of Periods 173
Chapter 5 Interest Rates 175
5.1 Interest Rate Quotes and Adjustments\r 176
The Effective Annual Rate 176
COMMON MISTAKE Using the Wrong Discount Rate in the Annuity Formula 177
Annual Percentage Rates 178
5.2 Application: Discount Rates and Loans 180
5.3 The Determinants of Interest Rates 181
GLOBAL FINANCIAL CRISIS Teaser Rates and Subprime Loans 182
Inflation and Real Versus Nominal Rates 182
Investment and Interest Rate Policy 183
The Yield Curve and Discount Rates 184
The Yield Curve and the Economy 186
COMMON MISTAKE Using the Annuity Formula When Discount Rates Vary by Maturity 186
INTERVIEW with Kevin M. Warsh 188
5.4 Risk and Taxes 189
Risk and Interest Rates 190
After-Tax Interest Rates 191
5.5 The Opportunity Cost of Capital 192
COMMON MISTAKE States Dig a $3 Trillion Hole by Discounting at the Wrong Rate 193
MyFinanceLab 194
Key Terms 195
Further Reading 195
Problems 195
Data Case 200
Appendix Continuous Rates and Cash Flows 202
Discount Rates for a Continuously Compounded APR 202
Continuously Arriving Cash Flows 202
Chapter 6 Valuing Bonds 205
6.1 Bond Cash Flows, Prices, and Yields 206
Bond Terminology 206
Zero-Coupon Bonds 206
GLOBAL FINANCIAL CRISIS Negative Bond Yields 208
Coupon Bonds 209
6.2 Dynamic Behavior of Bond Prices 211
Discounts and Premiums 211
Time and Bond Prices 212
Interest Rate Changes and Bond Prices 214
Clean and Dirty Prices for Coupon Bonds 215
6.3 The Yield Curve and Bond Arbitrage\r 217
Replicating a Coupon Bond 217
Valuing a Coupon Bond Using Zero-Coupon Yields 218
Coupon Bond Yields 219
Treasury Yield Curves 220
6.4 Corporate Bonds 220
Corporate Bond Yields 221
Are Treasuries Really Default-Free Securities? 221
Bond Ratings 223
Corporate Yield Curves 224
6.5 Sovereign Bonds 224
GLOBAL FINANCIAL CRISIS The Credit Crisis and Bond Yields 225
GLOBAL FINANCIAL CRISIS European Sovereign Debt Yields: A Puzzle 227
INTERVIEW with Carmen M. Reinhart 228
MyFinanceLab 229
Key Terms 230
Further Reading 231
Problems 231
Data Case 235
Case Study 236
Appendix Forward Interest Rates 238
Computing Forward Rates 238
Computing Bond Yields from Forward Rates 239
PART 3 VALUING PROJECTS AND FIRMS 243
Chapter 7 Investment Decision Rules 244
7.1 NPV and Stand-Alone Projects 245
Applying the NPV Rule 245
The NPV Profile and IRR 245
Alternative Rules Versus the NPV Rule 246
INTERVIEW with Dick Grannis 247
7.2 The Internal Rate of Return Rule 248
Applying the IRR Rule 248
Pitfall 248
Pitfall 249
COMMON MISTAKE IRR Versus the IRR Rule 251
Pitfall 251
7.3 The Payback Rule 252
Applying the Payback Rule 252
Payback Rule Pitfalls in Practice 253
Why Do Rules Other Than the NPV Rule Persist? 254
7.4 Choosing Between Projects 254
NPV Rule and Mutually Exclusive Investments 254
IRR Rule and Mutually Exclusive Investments 255
The Incremental IRR 256
When Can Returns Be Compared? 257
COMMON MISTAKE IRR and Project Financing 259
7.5 Project Selection with Resource Constraints\r 259
Evaluating Projects with Different Resource Requirements\r 259
Profitability Index 260
Shortcomings of the Profitability Index\r 262
MyFinanceLab 262
Key Terms 263
Further Reading 263
Problems 263
Data Case 269
Appendix Computing the NPV Profile Using Excel’s Data Table Function\r 270
Chapter 8 Fundamentals of Capital Budgeting\r 271
8.1 Forecasting Earnings 272
Revenue and Cost Estimates 272
Incremental Earnings Forecast 273
Indirect Effects on Incremental Earnings\r 275
COMMON MISTAKE The Opportunity Cost of an Idle Asset 276
Sunk Costs and Incremental Earnings\r 277
COMMON MISTAKE The Sunk Cost Fallacy 277
Real-World Complexities 278
8.2 Determining Free Cash Flow and NPV 279
Calculating Free Cash Flow from Earnings 279
Calculating Free Cash Flow Directly 281
Calculating the NPV 282
USING EXCEL Capital Budgeting Using a Spreadsheet Program 283
8.3 Choosing Among Alternatives 284
Evaluating Manufacturing Alternatives 284
Comparing Free Cash Flows for Cisco’s Alternatives 285
8.4 Further Adjustments to Free Cash Flow 286
GLOBAL FINANCIAL CRISIS The American Recovery and Reinvestment Act of 2009\r 290
8.5 Analyzing the Project 290
Break-Even Analysis 290
Sensitivity Analysis 291
INTERVIEW with David Holland 293
Scenario Analysis 294
USING EXCEL Project Analysis Using Excel 295
MyFinanceLab 296
Key Terms 298
Further Reading 298
Problems 298
Data Case 305
Appendix MACRS Depreciation 307
Chapter 9 Valuing Stocks 309
9.1 The Dividend-Discount Model 310
A One-Year Investor 310
Dividend Yields, Capital Gains, and Total Returns 311
The Mechanics of a Short Sale 312
A Multiyear Investor 313
The Dividend-Discount Model Equation 314
9.2 Applying the Dividend-Discount Model 314
Constant Dividend Growth 314
Dividends Versus Investment and Growth 315
John Burr Williams’ Theory of Investment Value 316
Changing Growth Rates 318
Limitations of the Dividend-Discount Model 320
9.3 Total Payout and Free Cash Flow Valuation Models\r 320
Share Repurchases and the Total Payout Model 320
The Discounted Free Cash Flow Model 322
9.4 Valuation Based on Comparable Firms 326
Valuation Multiples 326
Limitations of Multiples 328
Comparison with Discounted Cash Flow Methods 329
Stock Valuation Techniques: The Final Word 330
INTERVIEW with Douglas Kehring 331
9.5 Information, Competition, and Stock Prices 332
Information in Stock Prices 332
Competition and Efficient Markets 333
Lessons for Investors and Corporate Managers\r 335
Kenneth Cole Productions—What Happened? 337
The Efficient Markets Hypothesis Versus No Arbitrage 338
MyFinanceLab 338
Key Terms 340
Further Reading 340
Problems 341
Data Case 346
PART 4 RISK AND RETURN 349
Chapter 10 Capital Markets and the Pricing of Risk 350
10.1 Risk and Return: Insights from 89 Years of Investor History 351
10.2 Common Measures of Risk and Return\r 354
Probability Distributions 354
Expected Return 354
Variance and Standard Deviation 355
10.3 Historical Returns of Stocks and Bonds 357
Computing Historical Returns 357
Average Annual Returns 359
The Variance and Volatility of Returns 361
Estimation Error: Using Past Returns to Predict the Future 362
Arithmetic Average Returns Versus Compound Annual Returns 364
10.4 The Historical Trade-Off Between Risk and Return 364
The Returns of Large Portfolios 365
The Returns of Individual Stocks 366
10.5 Common Versus Independent Risk 367
Theft Versus Earthquake Insurance: An Example 367
The Role of Diversification 368
10.6 Diversification in Stock Portfolios 369
Firm-Specific Versus Systematic Risk 370
No Arbitrage and the Risk Premium 371
GLOBAL FINANCIAL CRISIS Diversification Benefits During Market Crashes 373
COMMON MISTAKE A Fallacy of Long-Run Diversification 374
10.7 Measuring Systematic Risk 375
Identifying Systematic Risk: The Market Portfolio 375
Sensitivity to Systematic Risk: Beta 375
10.8 Beta and the Cost of Capital 378
Estimating the Risk Premium 378
COMMON MISTAKE Beta Versus Volatility 378
The Capital Asset Pricing Model 380
MyFinanceLab 380
Key Terms 382
Further Reading 382
Problems 382
Data Case 387
Chapter 11 Optimal Portfolio Choice and the Capital Asset Pricing Model 389
11.1 The Expected Return of a Portfolio 390
11.2 The Volatility of a Two-Stock Portfolio\r 391
Combining Risks 391
Determining Covariance and Correlation 392
COMMON MISTAKE Computing Variance, Covariance, and Correlation in Excel 394
Computing a Portfolio’s Variance and Volatility 395
11.3 The Volatility of a Large Portfolio 397
Large Portfolio Variance 397
Diversification with an Equally Weighted Portfolio 398
INTERVIEW with John Powers 400
Diversification with General Portfolios 401
11.4 Risk Versus Return: Choosing an Efficient Portfolio\r 401
Efficient Portfolios with Two Stocks 402
The Effect of Correlation 404
Short Sales 405
Efficient Portfolios with Many Stocks 406
NOBEL PRIZES Harry Markowitz and James Tobin 407
11.5 Risk-Free Saving and Borrowing 409
Investing in Risk-Free Securities 409
Borrowing and Buying Stocks on Margin 410
Identifying the Tangent Portfolio 411
11.6 The Efficient Portfolio and Required Returns 413
Portfolio Improvement: Beta and the Required Return 413
Expected Returns and the Efficient Portfolio 415
11.7 The Capital Asset Pricing Model 417
The CAPM Assumptions 417
Supply, Demand, and the Efficiency of the Market Portfolio 418
Optimal Investing: The Capital Market Line 418
11.8 Determining the Risk Premium 419
Market Risk and Beta 419
NOBEL PRIZE William Sharpe on the CAPM 421
The Security Market Line 422
Beta of a Portfolio 422
Summary of the Capital Asset Pricing Model 424
MyFinanceLab 424
Key Terms 427
Further Reading 427
Problems 428
Data Case 434
Appendix The CAPM with Differing Interest Rates 436
The Efficient Frontier with Differing Saving and Borrowing Rates 436
The Security Market Line with Differing Interest Rates 436
Chapter 12 Estimating the Cost of Capital\r 439
12.1 The Equity Cost of Capital 440
12.2 The Market Portfolio 441
Constructing the Market Portfolio 441
Market Indexes 441
Value-Weighted Portfolios and Rebalancing 442
The Market Risk Premium 443
12.3 Beta Estimation 445
Using Historical Returns 445
Identifying the Best-Fitting Line 447
Using Linear Regression 448
Why Not Estimate Expected Returns Directly? 449
12.4 The Debt Cost of Capital 449
Debt Yields Versus Returns 449
COMMON MISTAKE Using the Debt Yield as Its Cost of Capital 450
Debt Betas 451
12.5 A Project’s Cost of Capital 452
All-Equity Comparables 452
Levered Firms as Comparables 453
The Unlevered Cost of Capital 453
Industry Asset Betas 455
12.6 Project Risk Characteristics and Financing\r 457
Differences in Project Risk 457
COMMON MISTAKE Adjusting for Execution Risk 459
Financing and the Weighted Average Cost of Capital 459
INTERVIEW with Shelagh Glaser 460
COMMON MISTAKE Using a Single Cost of Capital in Multi-Divisional Firms 461
12.7 Final Thoughts on Using the CAPM 462
MyFinanceLab 463
Key Terms 465
Further Reading 465
Problems 466
Data Case 470
Appendix Practical Considerations When Forecasting Beta\r 471
Time Horizon 471
The Market Proxy 471
Beta Variation and Extrapolation 471
Outliers 472
COMMON MISTAKE Changing the Index to Improve the Fit 473
USING EXCEL Estimating Beta Using Excel 474
Other Considerations 475
Chapter 13 Investor Behavior and Capital Market Efficiency 477
13.1 Competition and Capital Markets 478
Identifying a Stock’s Alpha 478
Profiting from Non-Zero Alpha Stocks 479
13.2 Information and Rational Expectations\r 480
Informed Versus Uninformed Investors\r 480
Rational Expectations 481
13.3 The Behavior of Individual Investors\r 482
Underdiversification and Portfolio Biases\r 482
Excessive Trading and Overconfidence\r 483
Individual Behavior and Market Prices\r 485
13.4 Systematic Trading Biases 485
Hanging on to Losers and the Disposition Effect 485
NOBEL PRIZE Kahneman and Tversky’s Prospect Theory 486
Investor Attention, Mood, and Experience 486
Herd Behavior 487
Implications of Behavioral Biases 487
13.5 The Efficiency of the Market Portfolio\r 488
Trading on News or Recommendations\r 488
NOBEL PRIZE The 2013 Prize: An Enigma? 490
The Performance of Fund Managers 490
The Winners and Losers 493
13.6 Style-Based Techniques and the Market Efficiency Debate 494
Size Effects 494
INTERVIEW with Jonathan Clements 496
Momentum 498
Market Efficiency and the Efficiency of the Market Portfolio 499
Implications of Positive-Alpha Trading Strategies 499
13.7 Multifactor Models of Risk 501
Using Factor Portfolios 502
Selecting the Portfolios 503
The Cost of Capital with Fama-French-Carhart Factor Specification 504
13.8 Methods Used in Practice 506
Financial Managers 506
Investors 507
MyFinanceLab 508
Key Terms 510
Further Reading 510
Problems 511
Appendix Building a Multifactor Model 517
PART 5 CAPITAL STRUCTURE 519
Chapter 14 Capital Structure in a Perfect Market 520
14.1 Equity Versus Debt Financing 521
Financing a Firm with Equity 521
Financing a Firm with Debt and Equity 522
The Effect of Leverage on Risk and Return 523
14.2 Modigliani-Miller I: Leverage, Arbitrage, and Firm Value 525
MM and the Law of One Price 525
Homemade Leverage 525
MM and the Real World 526
The Market Value Balance Sheet 527
Application: A Leveraged Recapitalization\r 528
14.3 Modigliani-Miller II: Leverage, Risk, and the Cost of Capital 530
Leverage and the Equity Cost of Capital 530
Capital Budgeting and the Weighted Average Cost of Capital\r 531
COMMON MISTAKE Is Debt Better Than Equity? 534
Computing the WACC with Multiple Securities\r 534
Levered and Unlevered Betas 534
NOBEL PRIZE Franco Modigliani and Merton Miller 536
14.4 Capital Structure Fallacies 537
Leverage and Earnings per Share 537
GLOBAL FINANCIAL CRISIS Bank Capital Regulation and the ROE Fallacy 539
Equity Issuances and Dilution 540
14.5 MM: Beyond the Propositions 541
MyFinanceLab 542
Key Terms 543
Further Reading 543
Problems 544
Data Case 548
Chapter 15 Debt and Taxes 551
15.1 The Interest Tax Deduction 552
15.2 Valuing the Interest Tax Shield 554
The Interest Tax Shield and Firm Value\r 554
Pizza and Taxes 555
The Interest Tax Shield with Permanent Debt 555
The Weighted Average Cost of Capital with Taxes 556
The Repatriation Tax: Why Some Cash-Rich Firms Borrow\r 557
The Interest Tax Shield with a Target Debt-Equity Ratio\r 558
15.3 Recapitalizing to Capture the Tax Shield 560
The Tax Benefit 560
The Share Repurchase 561
No Arbitrage Pricing 561
Analyzing the Recap: The Market Value Balance Sheet 562
15.4 Personal Taxes 563
Including Personal Taxes in the Interest Tax Shield 563
Valuing the Interest Tax Shield with Personal Taxes 566
Determining the Actual Tax Advantage of Debt 567
Cutting the Dividend Tax Rate 567
15.5 Optimal Capital Structure with Taxes\r 568
Do Firms Prefer Debt? 568
Limits to the Tax Benefit of Debt 571
INTERVIEW with Andrew Balson 572
Growth and Debt 573
Other Tax Shields 574
The Low Leverage Puzzle 574
Employee Stock Options 576
MyFinanceLab 576
Key Terms 577
Further Reading 577
Problems 578
Data Case 582
Chapter 16 Financial Distress, Managerial Incentives, and Information\r 583
16.1 Default and Bankruptcy in a Perfect Market 584
Armin Industries: Leverage and the Risk of Default 584
Bankruptcy and Capital Structure 585
16.2 The Costs of Bankruptcy and Financial Distress 586
The Bankruptcy Code 587
Direct Costs of Bankruptcy 587
Indirect Costs of Financial Distress 588
GLOBAL FINANCIAL CRISIS The Chrysler Prepack 591
16.3 Financial Distress Costs and Firm Value 592
Armin Industries: The Impact of Financial Distress Costs 592
Who Pays for Financial Distress Costs? 592
16.4 Optimal Capital Structure: The Trade-Off Theory\r 594
The Present Value of Financial Distress Costs 594
Optimal Leverage 595
16.5 Exploiting Debt Holders: The Agency Costs of Leverage 597
Excessive Risk-Taking and Asset Substitution\r 597
Debt Overhang and Under-Investment\r 598
GLOBAL FINANCIAL CRISIS Bailouts, Distress Costs, and Debt Overhang 599
Agency Costs and the Value of Leverage 600
The Leverage Ratchet Effect 601
Debt Maturity and Covenants 602
Why Do Firms Go Bankrupt? 602
16.6 Motivating Managers: The Agency Benefits of Leverage\r 603
Concentration of Ownership 604
Reduction of Wasteful Investment 604
Excessive Perks and Corporate Scandals\r 605
GLOBAL FINANCIAL CRISIS Moral Hazard, Government Bailouts, and the Appeal of Leverage 606
Leverage and Commitment 607
16.7 Agency Costs and the Trade-Off Theory 607
The Optimal Debt Level 608
Debt Levels in Practice 609
16.8 Asymmetric Information and Capital Structure 609
Leverage as a Credible Signal 609
Issuing Equity and Adverse Selection 611
NOBEL PRIZE The 2001 Nobel Prize in Economics 613
Implications for Equity Issuance 613
Implications for Capital Structure 614
16.9 Capital Structure: The Bottom Line 617
MyFinanceLab 618
Key Terms 620
Further Reading 620
Problems 620
Chapter 17 Payout Policy 629
17.1 Distributions to Shareholders 630
Dividends 630
Share Repurchases 632
17.2 Comparison of Dividends and Share Repurchases 633
Alternative Policy 1: Pay Dividend with Excess Cash 633
Alternative Policy 2: Share Repurchase (No Dividend) 634
COMMON MISTAKE Repurchases and the Supply of Shares 636
Alternative Policy 3: High Dividend (Equity Issue) 636
Modigliani-Miller and Dividend Policy Irrelevance\r 637
COMMON MISTAKE The Bird in the Hand Fallacy 638
Dividend Policy with Perfect Capital Markets\r 638
17.3 The Tax Disadvantage of Dividends 638
Taxes on Dividends and Capital Gains 639
Optimal Dividend Policy with Taxes 640
17.4 Dividend Capture and Tax Clienteles\r 642
The Effective Dividend Tax Rate 642
Tax Differences Across Investors 643
Clientele Effects 644
INTERVIEW with John Connors 645
17.5 Payout Versus Retention of Cash 647
Retaining Cash with Perfect Capital Markets\r 648
Taxes and Cash Retention 649
Adjusting for Investor Taxes 650
Issuance and Distress Costs 651
Agency Costs of Retaining Cash 652
17.6 Signaling with Payout Policy 654
Dividend Smoothing 654
Dividend Signaling 655
Royal & SunAlliance’s Dividend Cut 656
Signaling and Share Repurchases 656
17.7 Stock Dividends, Splits, and Spin-Offs 658
Stock Dividends and Splits 658
Spin-Offs 660
Berkshire Hathaway’s A & B Shares 661
MyFinanceLab 662
Key Terms 663
Further Reading 664
Problems 664
Data Case 668
PART 6 ADVANCED VALUATION 671
Chapter 18 Capital Budgeting and Valuation with Leverage 672
18.1 Overview of Key Concepts 673
18.2 The Weighted Average Cost of Capital Method 674
INTERVIEW with Zane Rowe 675
Using the WACC to Value a Project 676
Summary of the WACC Method 677
Implementing a Constant Debt-Equity Ratio 678
18.3 The Adjusted Present Value Method 680
The Unlevered Value of the Project 680
Valuing the Interest Tax Shield 681
Summary of the APV Method 682
18.4 The Flow-to-Equity Method 684
Calculating the Free Cash Flow to Equity 684
Valuing Equity Cash Flows 685
What Counts as “Debt”? 686
Summary of the Flow-to-Equity Method\r 686
18.5 Project-Based Costs of Capital 687
Estimating the Unlevered Cost of Capital 688
Project Leverage and the Equity Cost of Capital 688
Determining the Incremental Leverage of a Project 690
COMMON MISTAKE Re-Levering the WACC 690
18.6 APV with Other Leverage Policies 692
Constant Interest Coverage Ratio 692
Predetermined Debt Levels 693
A Comparison of Methods 695
18.7 Other Effects of Financing 695
Issuance and Other Financing Costs 695
Security Mispricing 696
Financial Distress and Agency Costs 697
GLOBAL FINANCIAL CRISIS Government Loan Guarantees 698
18.8 Advanced Topics in Capital Budgeting 698
Periodically Adjusted Debt 699
Leverage and the Cost of Capital 701
The WACC or FTE Method with Changing Leverage 703
Personal Taxes 704
MyFinanceLab 706
Key Terms 708
Further Reading 708
Problems 709
Data Case 715
Appendix Foundations and Further Details 717
Deriving the WACC Method 717
The Levered and Unlevered Cost of Capital 718
Solving for Leverage and Value Simultaneously\r 719
The Residual Income and Economic Value Added Valuation Methods 721
Chapter 19 Valuation and Financial Modeling: A Case Study 723
19.1 Valuation Using Comparables 724
19.2 The Business Plan 726
Operational Improvements 726
Capital Expenditures: A Needed Expansion\r 727
Working Capital Management 728
Capital Structure Changes: Levering Up 728
19.3 Building the Financial Model 729
Forecasting Earnings 729
INTERVIEW with Joseph L. Rice, III 730
Working Capital Requirements 732
Forecasting Free Cash Flow 733
USING EXCEL Summarizing Model Outputs 735
The Balance Sheet and Statement of Cash Flows (Optional) 736
USING EXCEL Auditing Your Financial Model 738
19.4 Estimating the Cost of Capital 739
CAPM-Based Estimation 739
Unlevering Beta 740
Ideko’s Unlevered Cost of Capital 740
19.5 Valuing the Investment 741
The Multiples Approach to Continuation Value 742
The Discounted Cash Flow Approach to Continuation Value 743
COMMON MISTAKE Continuation Values and Long-Run Growth 745
APV Valuation of Ideko’s Equity 745
A Reality Check 746
COMMON MISTAKE Missing Assets or Liabilities 746
IRR and Cash Multiples 747
19.6 Sensitivity Analysis 748
MyFinanceLab 749
Key Terms 750
Further Reading 750
Problems 751
Appendix Compensating Management 753
PART 7 OPTIONS 755
Chapter 20 Financial Options 756
20.1 Option Basics 757
Understanding Option Contracts 757
Interpreting Stock Option Quotations 757
Options on Other Financial Securities 759
20.2 Option Payoffs at Expiration 760
Long Position in an Option Contract 760
Short Position in an Option Contract 761
Profits for Holding an Option to Expiration 763
Returns for Holding an Option to Expiration 764
Combinations of Options 765
20.3 Put-Call Parity 768
20.4 Factors Affecting Option Prices 771
Strike Price and Stock Price 771
Arbitrage Bounds on Option Prices 771
Option Prices and the Exercise Date 771
Option Prices and Volatility 772
20.5 Exercising Options Early 773
Non-Dividend-Paying Stocks 773
Dividend-Paying Stocks 775
20.6 Options and Corporate Finance 777
Equity as a Call Option 777
Debt as an Option Portfolio 778
Credit Default Swaps 778
GLOBAL FINANCIAL CRISIS Credit Default Swaps 779
Pricing Risky Debt 780
Agency Conflicts 781
MyFinanceLab 782
Key Terms 783
Further Reading 783
Problems 783
Data Case\r 788
Chapter 21 Option Valuation 789
21.1 The Binomial Option Pricing Model\r 790
A Two-State Single-Period Model 790
The Binomial Pricing Formula 792
A Multiperiod Model 793
Making the Model Realistic 797
21.2 The Black-Scholes Option Pricing Model 798
The Black-Scholes Formula 798
INTERVIEW with Myron S. Scholes 799
Implied Volatility 804
GLOBAL FINANCIAL CRISIS The VIX Index 805
The Replicating Portfolio 806
21.3 Risk-Neutral Probabilities 808
A Risk-Neutral Two-State Model 808
Implications of the Risk-Neutral World 808
Risk-Neutral Probabilities and Option Pricing\r 809
21.4 Risk and Return of an Option 811
21.5 Corporate Applications of Option Pricing 813
Beta of Risky Debt 813
COMMON MISTAKE Valuing Employee Stock Options 816
NOBEL PRIZE The 1997 Nobel Prize in Economics 817
Agency Costs of Debt 817
MyFinanceLab 818
Key Terms 820
Further Reading 820
Problems 820
Chapter 22 Real Options 825
22.1 Real Versus Financial Options 826
22.2 Decision Tree Analysis 826
Representing Uncertainty 827
Real Options 828
Solving Decision Trees 828
22.3 The Option to Delay: Investment as a Call Option 829
An Investment Option 829
Why Are There Empty Lots in Built-Up Areas of Big Cities? 832
Factors Affecting the Timing of Investment 833
Investment Options and Firm Risk 834
GLOBAL FINANCIAL CRISIS Uncertainty, Investment, and the Option to Delay 835
22.4 Growth and Abandonment Options 836
Valuing Growth Potential 836
The Option to Expand 838
INTERVIEW with Scott Mathews 839
The Option to Abandon 840
22.5 Investments with Different Lives 842
Equivalent Annual Benefit Method\r 843
22.6 Optimally Staging Investments 844
22.7 Rules of Thumb 847
The Profitability Index Rule 848
The Hurdle Rate Rule 848
The Option to Repay a Mortgage 850
22.8 Key Insights from Real Options 851
MyFinanceLab 851
Key Terms 853
Further Reading 853
Problems 853
PART 8 LONG-TERM FINANCING 859
Chapter 23 Raising Equity Capital 860
23.1 Equity Financing for Private Companies 861
Sources of Funding 861
Crowdfunding: The Wave of the Future? 862
INTERVIEW with Kevin Laws 863
Venture Capital Investing 866
Venture Capital Financing Terms 868
COMMON MISTAKE Misinterpreting Start-Up Valuations 868
From Launch to Liquidity 870
Exiting an Investment in a Private Company\r 872
23.2 The Initial Public Offering 872
Advantages and Disadvantages of Going Public 872
Types of Offerings 873
The Mechanics of an IPO 875
Google’s IPO 875
23.3 IPO Puzzles 880
Underpricing 880
Cyclicality 883
GLOBAL FINANCIAL CRISIS Worldwide IPO Deals in 2008–2009 884
Cost of an IPO 884
Long-Run Underperformance 885
23.4 The Seasoned Equity Offering 886
The Mechanics of an SEO 886
Price Reaction 888
Issuance Costs 889
MyFinanceLab 889
Key Terms 890
Further Reading 891
Problems 892
Data Case 895
Chapter 24 Debt Financing 897
24.1 Corporate Debt 898
Public Debt 898
Private Debt 902
24.2 Other Types of Debt 903
Sovereign Debt 903
Municipal Bonds 905
Detroit’s Art Museum at Risk 905
Asset-Backed Securities 906
GLOBAL FINANCIAL CRISIS CDOs, Subprime Mortgages, and the Financial Crisis 906
24.3 Bond Covenants 908
24.4 Repayment Provisions 909
Call Provisions 909
New York City Calls Its Municipal Bonds 911
Sinking Funds 913
Convertible Provisions 913
MyFinanceLab 915
Key Terms 916
Further Reading 917
Problems 917
Data Case 918
Chapter 25 Leasing 921
25.1 The Basics of Leasing 922
Examples of Lease Transactions 922
Lease Payments and Residual Values 923
Leases Versus Loans 924
Calculating Auto Lease Payments 925
End-of-Term Lease Options 925
Other Lease Provisions 927
25.2 Accounting, Tax, and Legal Consequences of Leasing 927
Lease Accounting 928
Operating Leases at Alaska Air Group 929
The Tax Treatment of Leases 930
Leases and Bankruptcy 931
Synthetic Leases 932
25.3 The Leasing Decision 932
Cash Flows for a True Tax Lease 933
Lease Versus Buy (An Unfair Comparison) 934
Lease Versus Borrow (The Right Comparison) 935
Evaluating a True Tax Lease 937
Evaluating a Non-Tax Lease 938
25.4 Reasons for Leasing 938
Valid Arguments for Leasing 939
INTERVIEW with Mark Long 941
Suspect Arguments for Leasing 942
MyFinanceLab 943
Key Terms 944
Further Reading 944
Problems 945
PART 9 SHORT-TERM FINANCING 949
Chapter 26 Working Capital Management 950
26.1 Overview of Working Capital 951
The Cash Cycle 951
Firm Value and Working Capital 953
26.2 Trade Credit 954
Trade Credit Terms 954
Trade Credit and Market Frictions 954
Managing Float 955
26.3 Receivables Management 956
Determining the Credit Policy 956
Monitoring Accounts Receivable 957
26.4 Payables Management 959
Determining Accounts Payable Days Outstanding 959
Stretching Accounts Payable 960
26.5 Inventory Management 960
Benefits of Holding Inventory 961
Costs of Holding Inventory 961
26.6 Cash Management 962
Motivation for Holding Cash 962
Alternative Investments 963
Hoarding Cash 963
MyFinanceLab 965
Key Terms 966
Further Reading 966
Problems 967
Data Case 970
Chapter 27 Short-Term Financial Planning 973
27.1 Forecasting Short-Term Financing Needs 974
Seasonalities 974
Negative Cash Flow Shocks 977
Positive Cash Flow Shocks 978
27.2 The Matching Principle 979
Permanent Working Capital 979
Temporary Working Capital 979
Financing Policy Choices 980
27.3 Short-Term Financing with Bank Loans 981
Single, End-of-Period Payment Loan 981
Line of Credit 981
Bridge Loan 982
Common Loan Stipulations and Fees 982
27.4 Short-Term Financing with Commercial Paper 984
GLOBAL FINANCIAL CRISIS Short-Term Financing in Fall 2008 985
27.5 Short-Term Financing with Secured Financing 986
Accounts Receivable as Collateral 986
A Seventeenth-Century Financing Solution 986
Inventory as Collateral 987
Loan Guarantees: The Ex-Im Bank Controversy 988
MyFinanceLab 989
Key Terms 990
Further Reading 990
Problems 991
PART 10 SPECIAL TOPICS 993
Chapter 28 Mergers and Acquisitions 994
28.1 Background and Historical Trends 995
Merger Waves 995
Types of Mergers 997
28.2 Market Reaction to a Takeover 997
28.3 Reasons to Acquire 998
Economies of Scale and Scope 999
Vertical Integration 999
Expertise 999
Monopoly Gains 1000
Efficiency Gains 1000
Tax Savings from Operating Losses 1001
Diversification 1002
Earnings Growth 1002
Managerial Motives to Merge 1003
28.4 Valuation and the Takeover Process 1004
Valuation 1005
The Offer 1006
Merger “Arbitrage” 1007
Tax and Accounting Issues 1008
Board and Shareholder Approval 1009
28.5 Takeover Defenses 1010
Poison Pills 1010
Staggered Boards 1011
White Knights 1012
Golden Parachutes 1013
Recapitalization 1013
Other Defensive Strategies 1013
Regulatory Approval 1014
Weyerhaeuser’s Hostile Bid for Willamette Industries 1014
28.6 Who Gets the Value Added from a Takeover? 1015
The Free Rider Problem 1015
Toeholds 1016
The Leveraged Buyout 1016
The Leveraged Buyout of RJR-Nabisco by KKR 1017
The Freezeout Merger 1019
Competition 1020
MyFinanceLab 1020
Key Terms 1022
Further Reading 1022
Problems 1022
Chapter 29 Corporate Governance 1025
29.1 Corporate Governance and Agency Costs 1026
29.2 Monitoring by the Board of Directors and Others 1027
Types of Directors 1027
Board Independence 1027
Board Size and Performance 1029
Other Monitors 1029
29.3 Compensation Policies 1030
Stock and Options 1030
Pay and Performance Sensitivity 1030
29.4 Managing Agency Conflict 1032
Direct Action by Shareholders 1032
Shareholder Activism at The New York Times 1033
Management Entrenchment 1034
The Threat of Takeover 1035
29.5 Regulation 1035
The Sarbanes-Oxley Act 1036
INTERVIEW with Lawrence E. Harris 1037
The Cadbury Commission 1038
Dodd-Frank Act 1039
Insider Trading 1039
Martha Stewart and ImClone 1040
29.6 Corporate Governance Around the World 1040
Protection of Shareholder Rights 1040
Controlling Owners and Pyramids 1041
The Stakeholder Model 1043
Cross-Holdings 1044
29.7 The Trade-Off of Corporate Governance 1044
MyFinanceLab 1045
Key Terms 1047
Further Reading 1047
Problems 1047
Chapter 30 Risk Management 1049
30.1 Insurance 1050
The Role of Insurance: An Example 1050
Insurance Pricing in a Perfect Market 1050
The Value of Insurance 1052
The Costs of Insurance 1054
The Insurance Decision 1056
30.2 Commodity Price Risk 1056
Hedging with Vertical Integration and Storage 1057
Hedging with Long-Term Contracts 1057
Hedging with Futures Contracts 1059
COMMON MISTAKE Hedging Risk 1061
Differing Hedging Strategies 1062
Deciding to Hedge Commodity Price Risk 1062
30.3 Exchange Rate Risk 1063
Exchange Rate Fluctuations 1063
Hedging with Forward Contracts 1064
Cash-and-Carry and the Pricing of Currency Forwards 1065
GLOBAL FINANCIAL CRISIS Arbitrage in Currency Markets? 1067
Hedging with Options 1069
30.4 Interest Rate Risk 1073
Interest Rate Risk Measurement: Duration 1073
Duration-Based Hedging 1075
Swap-Based Hedging 1078
The Savings and Loan Crisis 1080
MyFinanceLab\r 1082
Key Terms\r 1084
Further Reading 1084
Problems 1085
Chapter 31 International Corporate Finance 1091
31.1 Internationally Integrated Capital Markets\r 1092
31.2 Valuation of Foreign Currency Cash Flows 1093
WACC Valuation Method in Domestic Currency 1094
Using the Law of One Price as a Robustness Check 1096
31.3 Valuation and International Taxation 1097
Single Foreign Project with Immediate Repatriation of Earnings 1098
Multiple Foreign Projects and Deferral of Earnings Repatriation 1098
31.4 Internationally Segmented Capital Markets 1099
Differential Access to Markets 1099
Macro-Level Distortions 1100
Implications 1101
31.5 Capital Budgeting with Exchange Risk 1102
INTERVIEW with Bill Barrett 1103
MyFinanceLab\r 1105
Key Terms\r 1106
Further Reading\r 1106
Problems\r 1107
Data Case 1109
Glossary 1111
Index 1131
A\r 1131
B\r 1133
C\r 1135
D\r 1139
E\r 1141
F\r 1144
G\r 1146
H\r 1147
I\r 1147
J\r 1149
K\r 1150
L\r 1150
M\r 1151
N\r 1153
O\r 1154
P\r 1155
Q\r 1158
R\r 1158
S\r 1160
T\r 1164
U\r 1165
V\r 1166
W\r 1166
X\r 1167
Y\r 1167
Z\r 1167