A First Course in
Preview, Monday 9th
Professor of Finance and Economics
Far and away, the most important contributor to this book was Mary-Clare McEwing. As editor, she helped me
improve the substance of the book tremendously.
There are also a large number of other individuals who have helped me with this book. Among them were Rick
Antle, Donna Battista, Randolph Beatty, Wolfgang Bühler, Kangbin Chua, Diego Garcia, Stan Garstka, Roger Ibbotson,
Ludovic Phalippou, Matthew Spiegel, John Strong, Julie Yufe, and many anonymous (victim) students who had to use
earlier error-ridden drafts.
The reviewers of earlier drafts of the book spent an enormous amount of time and provided me with many great
ideas. I owe them my deep gratitude for their engagement:
Miranda (Mei) Zhang
A list of articles upon which the ideas in the book are based, and a list of articles that describe current ongoing
academic research will eventually appear on the book’s website.
Warning: This book is in development.
It is not error-free.
Dedicated to my parents, Arthur and Charlotte.
Last ﬁle change: Jul 19, 2006 (11:13h)
A Quick Adoption Checklist For Instructors
This is the recommended checklist for this book (AFCIc) while the book is in beta test mode. This
checklist will not apply after AFCIc is published (with full supplementary materials) by Addison-
Read this prologue and one or two sample chapters to determine whether you like the AFCIc
approach. (Although not representative, I recommend that you also read the epilogue.)
If you do like the AFCIc approach, then please continue. If you do not like AFCIc (or the chapters
you read), please email firstname.lastname@example.org why you did not like it. I promise I will not shoot
the messenger: I want to learn how to do it better.
Continue to assign whatever other ﬁnance textbook you were planning to use, just add AFCIc. Use
it as a supplementary text, or assign just a few chapters.
• Although AFCIc is a full-service textbook for an introductory ﬁnance course, it should also work
well as a complement to an existing textbook. Your students should relatively easily beneﬁt from
having access to both, because this book is both diﬀerent from and similar to the competition. I
believe that relative to relying only on your old textbook, AFCIc will not increase, but decrease
your student’s confusion and workload.
• Take the low risk route and see how well AFCIc works! (Take the Pepsi challenge!) Keeping your
old textbook is also your insurance against using a novel textbook. And it will make students
less critical of the remaining shortcomings in AFCIc, such as the limited number of exercises (and
their occasionally erroneous solutions). Perhaps most importantly, AFCIc does not yet have full
supplementary materials. It will when Addison-Wesley will publish it, but until then, the auxiliary
materials from other textbooks may help.
• For now, students can download the book chapters, so there is no printing cost involved. Af-
fordability should not be a concern.
• It should be a relatively simple matter to link AFCIc chapters into your curriculum, because the
chapters are kept relatively straightforward and succinct.
You cannot go wrong if you try out at least a few chapters of AFCIc in this manner.
You can receive permission to post the electronic AFCIc on your class website. (The website must
be secured to allow only university-internal distribution.) Students can carry the ﬁles on their
notebook computers with them.
You can ask your copy center to print and bind the version on your website. You can also obtain
a nicely printed and bound version for $40 from lulu.com.
• Although versions on the AFCIc website at http://welch.econ.brown.edu/book will always have
some improvements, it is a good idea for each class to agree on one deﬁnitive reference version.
If you are using AFCIc and you are looking for lecture notes, feel free to “steal” and adapt my
lecture notes (linked at http://welch.econ.brown.edu/book) to your liking. You can change and
modify the lecture notes anyway you like, without copyright restrictions.
Of course, I hope that the majority of your students (and you) will prefer reading AFCIc instead
of your old textbook. At the end of the course, please ask your students which textbook they
found more helpful. Please email your conclusions and impressions to email@example.com. Any
suggestions for improvement are of course also very welcome. Any feedback would be appreciated,
but it would be particularly helpful for me to learn in what respects they prefer their other textbook.
To The Instructor
Most corporate ﬁnance textbooks cover a similar canon of concepts, and this textbook is noThis book is
intentionally diﬀerent. exception. A quick glance at the Table of Contents will show you that most—though not all—of
the topics in A First Course in Corporate Finance overlap with those in traditional ﬁnance
textbooks. But this does not mean that this book is not diﬀerent. Although I cover similar
conceptual territory, there are also important departures.
Innovations in Approach
Here is my view of how this book diﬀers from what is currently out there. I do not claim
that other traditional textbooks do not teach any of what I will list, but I do maintain that my
emphasis on these points is much stronger than what you will ﬁnd elsewhere.
Conversational Tone: The tone is more informal and conversational, which (I hope) makes theConversational Tone.
subject more accessible.
Numerical-Example Based: I learn best by numerical example, and ﬁrmly believe that studentsThe method of
do, too. Whenever I want to understand an idea, I try to construct numerical examples
for myself (the simpler, the better). I do not particularly care for long algebra or complex
formulas, precise though they may be. I do not much like many diagrams with long textual
descriptions but no speciﬁc examples, either—I often ﬁnd them too vague, and I am never
sure whether I have really grasped the whole mechanism by which the concept works.
Therefore, I wanted to write a textbook that relies on numerical examples as its primary
This approach necessitates a rearrangement of the tutorial textbook progression. Most
conventional ﬁnance textbooks start with a bird’s eye view and then work their way down.
The fundamental diﬀerence of this book is that it starts with a worm’s eye view and
works its way up. The organization is built around critical question like “What would it be
worth?,” which is then answered in numerical step-by-step examples from ﬁrst principles.
Right under numerical computations are the corresponding symbolic formulas. In my
opinion, this structure clariﬁes the meaning of these formulas, and is better than either
an exclusively textual or algebraic exposition. I believe that the immediate duality of
numerics with formulas will ultimately help students understand the material on a higher
level and with more ease. (Of course, this book also provides some overviews, and ordinary
textbooks also provide some numerical examples.)
Problem Solving: An important goal of this book is to teach students how to approach newStudents should have
a method of thinking,
not just formulas.
problems that they have not seen before. Our goal should be send students into the real
world with the analytical tools that allow them to disect new problems, and not just with a
chest full of formulas. I believe that if students adopt the numerical example method—the
“start simple and then generalize” method—they should be able to solve all sorts of new
problems. It should allow them to ﬁgure out and perhaps even generalize the formulas
that they learn in this book. Similarly, if students can learn how to verify others’ complex
new claims with simple examples ﬁrst, it will often help them to determine whether the
emperor is wearing clothes.
Deeper, Yet Easier: I believe that formulaic memorization is ultimately not conducive to learn-We build a foundation
ﬁrst—so we are
ing. In my opinion, such an alternative “canned formula” approach is akin to a house
without a foundation. I believe that shoring up a poorly built house later is more costly
than building it right to begin with.
Giving students the methods of how to think about problems and then showing them
how to develop the formulas themselves will make ﬁnance seem easier and simpler in the
end, even if the coverage is conceptually deeper. In my case, when I haved learned new
subjects, I have often found it especially frustrating if I understand a subject just a little
but I also suspect that the pieces are really not all in place. A little knowledge can also
be dangerous. If I do not understand where a formula comes from, how would I know
whether I can or cannot use it in a new situation? And I believe that even average students
can understand the basic ideas of ﬁnance and where the formulas come from.
Brevity: Sometimes, less is more. Brevity is important.
The book focus is on
This book is intentionally concise, even though it goes into more theoretical detail than
other books! Institutional descriptions are short. Only the concepts are explained in great
My view is that when students are exposed to too much material, they won’t read it, they
won’t remember it, and they won’t know what is really important and what is not. Ten
years after our students graduate, they should still solidly remember the fundamental
ideas of ﬁnance, be able to look up the details when they need them, and be able to solve
new (ﬁnancial) problems. Many institutional details will have changed, anyway—it is the
ideas, concepts, and tools that will last longer.
Self-Contained for Clarity: Finance is a subject that every student can comprehend, regardless Self-contained means
of background. It is no more diﬃcult than economics or basic physics. But, it is often
a problem that many students come into class with a patchwork on knowledge. We, the
instructors, then often erroneously believe the students have all the background covered.
Along the way, such students get lost. It is easy to mistake such them for “poor students,”
especially if there is no reference source, where they can quickly ﬁll in the missing parts.
In this book, I try to make each topic’s development self-contained. This means that I
try to explain everything from ﬁrst principles, but in a way that every student can ﬁnd
interesting. For example, even though the necessary statistical background is integrated
in the book for the statistics novice, the statistics-savvy student also should ﬁnd value
in reading it. This is because statistics is diﬀerent in our ﬁnance context than when it is
taught for its own sake in a statistics course.
Closer Correspondence with the Contemporary Curriculum: I believe that most ﬁnance core Less Chapter
Reordering.courses taught today follow a curriculum that is closer in spirit to this book—and more
logical—than it is to the order in older, traditional ﬁnance textbooks. In the places where
this book covers novel material (see below), I hope that you will ﬁnd that the new material
has merit—and if you agree, that covering it is much easier with this book than with earlier
Innovations in Particular Topics
The book also oﬀers a number of topical and expositional innovations. Here is a selection:
Progression to Risk and Uncertainty: The book starts with a perfect risk-free world, then adds First, no risk; then
to risk; then
risk-averse attitudes to
horizon-dependent interest rates, uncertainty under risk neutrality, imperfect market fric-
tions (e.g., taxes), uncertainty under risk-aversion, and ﬁnally uncertainty under risk aver-
sion and with taxes (e.g., WACC and APV).
Perfect World (Ch2):
1 + r
(1 + r)2
+ · · ·
Horizon-Dependent Rates (Ch4):
1 + r0,1
1 + r0,2
+ · · ·
1 + E(˜r1)
1 + E(˜r0,2)
+· · ·
Risk-Aversion (Part III):
1 + r1,F + [E(˜r1,M) − r1,F] · βi,M
+· · ·
Corporate Taxes (Ch18):
1 + E(˜r1,EQ) + (1 − τ) · E(˜r1,DT)
+ · · ·
Each step builds on concepts learned earlier. I believe it is an advantage to begin simply
and then gradually add complexity. The unique roles of the more diﬃcult concepts of risk
measurement, risk-aversion, and risk-aversion compensation then become much clearer.
(There are some forward hints in the text that describe how the model will change when
the world becomes more complex.)
A Strong Distinction between Expected and Promised Cash Flows: I have always been shockedDrive home “default
risk.” by how many graduating students think that a Boston Celtics bond quotes 400 basis points
in interest above a comparable Treasury bond because of the risk-premium, which they
can calculate using the CAPM formula. Learning to avoid this fundamental error is more
important than fancy theories: the main reason why the Boston Celtics bond promises 400
extra basis points is, of course, primarily its default risk (compensation for non-payment),
not a risk-premium (compensation for risk-averse investors that comes from the corre-
lation with the market rate of return). And for bonds, simple ICAPM-like equilibrium
models suggest that the latter should be an order of magnitude smaller than the former.
The CAPM itself can deﬁnitely not be used to claim a 400 basis point risk premmium.
Although many instructors mention this diﬀerence at some point, 5 minutes of default
risk discussion is often lost in 5 hours worth of CAPM discussion. But if students do not
understand the basic distinction, the 5 hours of CAPM discussion are not just wasted but
have only made matters worse.
Traditional textbooks have not helped, because they have not suﬃciently emphasized the
distinction. In contrast, in this book, default risk is clearly broken out. The diﬀerence
between quoted (promised) and expected returns, and quoted default compensation and
risk compensation are important themes carried throughout.
Financials from a Finance Perspective: Finance students need to solidly understand the re-Understand
being an accounting
lationship between ﬁnancial statements and NPV. Although it is not bad if they also
understand all the accounting nooks and crannies, it is more important that they under-
stand the basic logic and relationship between ﬁnance and accounting. It is essential if
they want to construct pro formas. Yet, when I was writing this book, I could not ﬁnd
good, concise, and self-contained explanations of the important aspects and logic of ac-
counting statements from a ﬁnance perspective. Consequently, this book oﬀers such a
chapter. It does not just show students some ﬁnancial statements and names the ﬁnan-
cial items; instead, it makes students understand how the NPV cash ﬂows are embedded
in the accounting statements.
A fundamental understanding of ﬁnancials is also necessary to understand comparables:
for example, students must know that capital expenditures must be subtracted out if
depreciation is not. (Indeed, the common use of EBITDA without a capital expenditures
adjustment is often wrong. If we do not subtract out the pro-rated expense cost, we
should subtract out the full expenses. Factories and the cash ﬂows they produce do not
fall from heaven.)
Pro Formas: In any formal ﬁnancial setting, professionals propose new projects—whether it
is the expansion of a factory building within a corporation, or a new business for presen-
tation to venture capitalists—through pro formas. A good pro forma is a combination
of ﬁnancial expertise, business expertise, and intuition. Both art and science go into its
construction. The book’s ﬁnal chapter, the capstone towards which the book works, is
the creation of such a pro forma. It combines all the ingredients from earlier chapters—
capital budgeting, taxes, the cost of capital, capital structure, and so on.
Robustness: The book discusses the robustness of methods—the relative importance of er-
rors and mistakes—and what ﬁrst-order problems students should worry about and what
second-order problems they can reasonably neglect.
A Newer Perspective on Capital Structure: The academic perspective about capital structure
has recently changed. A $1 million house that was originally ﬁnanced by a 50% mortgage
and then doubles in value now has only a 25% debt ratio. In analogous fashion, Chapter 20
shows how stock price movements have drastically changed the debt ratio of IBM from
2001 to 2003. Students can immediately eyeball the relative importance of market inﬂu-
ences, issuing and other ﬁnancial activities. The corporate market value changes are an
important and robust factor determining capital structure—at least equal in magnitude
to factors suggested in academic theories involving the pecking order or trade-oﬀs. More-
over, we now know that most new equity shares appear in the context of MA activity and
as executive compensation, not in the context of public equity oﬀerings. Part IV of our
book explains what the known ﬁrst-order determinants of capital structure are, what the
(important) second-order determinants are, and what the factors still under investigation
Many Other Topical Improvements: For example, the yield curve gets its own (optional) chap- ...and many more.
ter even before uncertainty is described in much detail, so that students understand that
projects over diﬀerent time horizons can oﬀer diﬀerent rates of return even in the absence
of risk. There is a self-contained chapter on comparables as a valuation technique—a
technique that many of our students will regularly have to use after they graduate. The
corporate governance chapter has a perspective that is darker than it is in other textbooks.
WACC, APV, and direct pro forma construction all incorporate the tax advantage of debt
into valuation. This is bread-and-butter for CFOs. This book oﬀers a clear explanation
of how these methods usually come to similar results (and when not!). Throughout the
book, I try to be open and honest about where our knowledge is solid and where it is
shaky—and how sensitive our estimates are to the errors we inevitably commit.
Although most of our curriculums are similar in their coverage of the basics, time constraints Webchapters will allow
a-la-carte choice.usually force us to exclude some topics. Your preferences as to what to cut may diﬀer from
mine. For example, I ﬁnd the ﬁnancials part very important, because this is what most of
our graduates will do when they become analysts, brokers, or consultants. However, you may
instead prefer to talk more about international ﬁnance. It is of course impossible to satisfy
everyone—and instructors have always chosen their own favorites, adding and deleting topics
as they see ﬁt.
This book tries to accommodate some choice. Some chapters are available on the Web site (“Web
Chapters”) accompanying this book. Chapter style and formatting are unmistakably identical
to the book itself. Every instructor can therefore choose his/her own favorite selection and
ask students to download it. These chapters are free and access is easy. The menu right now
contains the following chapters:
Real Options: Real options are brieﬂy covered in Chapter 7 in the text, but not in great detail.
This web chapter shows how to use spreadsheets, time-series analysis, Monte Carlo simu-
lation, and optimization to determine the value of a plant that can shut down and reopen
(for a cost) as output prices ﬂuctuate.
Option and Derivative Pricing: This is a diﬃcult subject to cover in an introductory course,
because it really requires a minimum of 4-6 class sessions to do it well. This chapter
tries to help you cover the basics in 2 class sessions. It explains option contracts, static
arbitrage relations (including put-call parity), dynamic arbitrage and the Black-Scholes
formula, and binomial trees.
International Finance: This chapter explains the role of currency translations and international
market segmentation for both investments and corporate budgeting purposes.
Ethics: This chapter is experimental—and provocative. There is neither a particular set of
must-cover topics nor a template on how to present this material. Your choices and views
may diﬀer from mine. However, I believe that ethical considerations are too important
for them never to be raised.
Capital Structure Event Studies: This chapter describes the evidence (up-to-2003!) of how the
stock market reacts to the announcements of new debt oﬀerings, new equity oﬀerings,
and dividend payments.
The title of the book is optimistic. A one-quarter course cannot cover the vast ﬁeld that our
profession has created over the last few decades. The book requires at least a one semester
course, or, better yet, a full two-quarter sequence in ﬁnance—although I would recommend
that the latter type of course sequence use the “general survey” version of this book, which
goes into more detail in the investments part.
I hope that this book will become your ﬁrst choice in ﬁnance textbooks. If you do not like it,
please drop me an email to let me know where it falls short. I would love to learn from you.
(And even if I disagree, chances are that your comments will inﬂuence my next revision.)
If you use this book or some chapters therefrom, please permit me to use and post your homework and exam
questions with answers. (Of course, this is not a requirement, only a plea for help.) My intent is for the Website
to become collaborative: you will be able to see what other faculty do, and they can see what you do. The
copyright will of course remain with you.
To The Student
What do you need to understand this book? You do not need any speciﬁc background inThis book and the
subject itself are
tough, but they are not
forbidding, even to an
average student. The
main prerequisite is
but not mathematical
ﬁnance. You do need to be thoroughly comfortable with arithmetic and generally comfortable
with algebra. You do need mathematical aptitude, but no knowledge of advanced mathematical
constructs, such as calculus. Knowledge of statistics would be very helpful, but the book will
explain the relevant concepts when the need arises. You should own a $20 scientiﬁc calculator.
A ﬁnancial calculator is not necessary and barely useful. Instead, you should learn how to
operate a spreadsheet (such as Excel in Microsoft’s Oﬃce or the free OpenCalc spreadsheet in
OpenOﬃce). The ﬁnancial world is moving rapidly away from ﬁnancial calculators and toward
computer spreadsheets—it is easier to work with information on a large screen with a 2,000
MHz processor than on a small 2-line display with a 2MHz processor. Because I have tried hard
to keep the book self-contained and to explain everything from ﬁrst principles, you should not
need to go hunting for details in statistics, economics, or accounting textbooks. But this is not
to say that you do not need to take courses in these disciplines: they have way more to oﬀer
than just background knowledge for a ﬁnance textbook.
One word of caution: the biggest problem for a novice of any ﬁeld, but especially of ﬁnance,Jargon can trip up the
reader. is jargon: the specialized terminology known only to the initiated. Worse, in ﬁnance, much
jargon is ambiguous. Diﬀerent people may use diﬀerent terms for the same thing, and the
same term may mean diﬀerent things to diﬀerent people. You have been warned! This book
attempts to point out such ambiguous usage. Luckily, the bark of jargon is usually worse than
its bite. It is only a temporary barrier to entry into the ﬁeld of ﬁnance.
How to Read The Book
This textbook tries to be concise. It wants to communicate the essential material in a straight-This book is concise,
focusing on the
essence of arguments.
forward (and thus compact), but also conversational (and thus more interactive) and accessible
fashion. There are already many ﬁnance textbooks with over a thousand pages. Much of the
content of these textbooks is interesting and useful but not essential to an understanding of
ﬁnance. (I personally ﬁnd some of this extra content distracting.)
The book is organized into four parts: the basics consist of return computations and capitalThe layout of the book.
budgeting. Next are corporate ﬁnancials, then investments (asset pricing), and ﬁnancing (capital
structure). Major sections within chapters end with questions that ask you to review the points
just made with examples or questions similar to those just covered. You should not proceed
beyond a section without completing these questions (and in “closed book” format)! Many,
but not all, questions are easy and/or straightforward replications of problems that you will
have just encountered in the chapter. Others are more challenging. Each chapter ends with
answers to these review questions. Do not move on until you have mastered these review
questions. (The published version of this book will contain many more student questions, and
there will be a separate student testbank.)
There are “annotations” on the left side of most paragraphs throughout the text. Suggestion: This is an annotation.
use the remaining white space in the margin to scribble your own notes, preferably in pencil
so that you can revise them.
IMPORTANT: Especially important concepts that you should memorize are typeset like this.
“Side notes” and “digging deeper” notes can be safely omitted from reading without compro-
Interesting, related points that either interrupt the ﬂow of an argument or that are not absolutely necessary
are marked like this. They are not crucial for understanding the material. They are usually not excessively
“Digging-deeper notes” are more detailed technical points. They should be of interest only to the student who is
interested in pursuing ﬁnance beyond the introductory course. They are often just curious facts or derivations
that rely on excessive algebra.
Sometimes, an appendix contains further advanced material.
A ﬁnal warning: I have a strange sense of humor. Please do not be easily turned oﬀ. Sense of Humor
This book cannot do it all. It is important for you to keep up with current ﬁnancial devel- Advice: Follow current
coverage of ﬁnancial
opments. Frequent reading of the ﬁnancial section of a major newspaper (such as the New
York Times [N.Y.T.]), the Wall Street Journal [W.S.J.], or the Financial Times [F.T.] can help,
as can regular consumption of good business magazines, such as The Economist or Business
Week. (See the website at http://welch.econ.brown.edu/book for more useful resource links.)
Although this is not a book on “how to read and understand the newspaper,” you should be
able to understand most of the contents of the ﬁnancial pages after consuming this textbook.
You should also know how to cruise the web—sites such as Yahoo!Finance contain a wealth of
useful ﬁnancial information. Yahoo!Finance is also used extensively in this book.
Table of Contents
I Investments and Returns 1
Chapter 1: A Short Introduction 5
1·1 The Goal of Finance: Relative Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
1·2 How do Chief Financial Oﬃcers (CFOs) Decide? . . . . . . . . . . . . . . . . . . . . . . . . . 7
1·3 Learning How to Approach New Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
1·4 The Main Parts of This Book . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Chapter 2: The Time Value of Money 11
2·1 Basic Background and Deﬁnitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
2·1.A. Investments, Projects, and Firms 12
2·1.B. Loans and Bonds 14
2·1.C. U.S. Treasuries 14
2·2 Returns, Net Returns, and Rates of Return . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
2·3 The Time Value of Money, Future Value, and Compounding . . . . . . . . . . . . . . . . . 17
2·3.A. The Future Value (FV) of Money 18
2·3.B. Compounding and Future Value 18
2·3.C. How Bad Are Mistakes?
Interest Rates vs. Interest Quotes Confusion 21
2·4 Capital Budgeting, Present Values, and Net Present Values . . . . . . . . . . . . . . . . . . 23
2·4.A. Discount factors and present value (PV) 23
2·4.B. Net Present Value (NPV) 27
2·5 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
Chapter 3: More Time Value of Money 35
3·1 Separating Investment Decisions and Present Values From Other Considerations . . . . 36
3·1.A. Does It Matter When You Need Cash? 36
3·1.B. Are Faster Growing Firms Better Bargains? 37
3·1.C. Firm Value Today is “All Inﬂows” and “All Outﬂows” 38
3·2 Perpetuities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
3·2.A. The Simple Perpetuity Formula 39
3·2.B. The Growing Perpetuity Formula 41
3·2.C. Application: Stock Valuation with A Gordon Growth Model 42
3·3 The Annuity Formula . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
3·3.A. Application: Fixed-Rate Mortgage Payments 44
3·3.B. Application: A Level-Coupon Bond 45
3·3.C. Application: Projects With Diﬀerent Lives and Rental Equivalents 48
3·4 Summary of Special Cash Flow Stream Formulas . . . . . . . . . . . . . . . . . . . . . . . . 50
3·5 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52
A Perpetuity and Annuity Derivations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55
Web Chapters na
Chapter : International Finance see website
Chapter : Ethics see website
Chapter : IPOs in Detail see website
Chapter : Options see website
Chapter : Empirical Corporate Finance see website
Investments and Returns
(A part of all versions of the book.)
What You Want to Learn in this Part
The two primary goals of this ﬁrst part of the book is to explain how to work with rates of
return, and how to decide whether to take or reject investment projects.
• Chapter 1 describes what this book is about. Most of ﬁnance is about “relative valuation”
(valuing one opportunity relative to others). At the end of the book, everything will come
together in the ﬁnal “pro forma” chapter. This chapter also tells you more about the
book’s approach. Its method is to start with “simple” scenarios and then build on them.
What you learn in earlier chapters lays the ground work for later chapters. After all, any
tool that works in more complex scenarios also has to work in simpler ones.
• In Chapter 2, you start with the simplest possible scenario. The market is perfect: there
are no taxes, transaction costs, disagreements, or limits as to the number of sellers and
buyers in the market. There is no uncertainty: you know everything. All rates of return in
the economy are the same: a one-year investment pays the same and perfectly known rate
of return per annum as a ten-year investment. Under these assumptions, you learn how
one-year returns translate into multi-year returns; and when you should take a project
and when you should reject it. The chapter introduces the most important concept of
Typical questions: If you earn 5% per year, how much will you earn over 10
years? If you earn 100% over 10 years, how much will you earn per year? What
is the value of a project that will deliver $1,000,000 in 10 years? Should you buy
this project if it cost you $650,000?
• In Chapter 3, you learn how to value particular kinds of projects—annuities and perpetu-
ities—if the economy-wide interest rate remains constant.
Typical questions: What is the monthly mortgage payment for a $300,000 mort-
gage if the interest rate is 4% per annum?
• In Chapter 4, you abandon the assumption that returns are the same regardless of invest-
ment horizon. For example, one-year investments may pay 2% per annum, while ten-year
investments may pay 5% per annum. Having time-varying rates of return is a more real-
istic scenario than the previous chapter’s constant interest rate scenario. However, the
question that you want to answer are the same questions as those in Chapter 2. (The
chapter then also explains some more advanced aspects of bonds.)
Typical questions: If you earn 5% in the ﬁrst year and 10% in the second year,
how much will you earn over both years? What is the meaning of a 4% annualized
interest rate? What is the meaning of a 4% yield-to-maturity? How can you value
projects if appropriate rates of return depend on investment horizon?
• In Chapter 5, you abandon the assumption that you have perfect omniscience. To be able
to study uncertainty, you must ﬁrst learn basic statistics. The chapter then explains an
important assumption about your risk preferences that makes this easy: risk-neutrality.
Together, statistics and risk-neutrality lay the groundwork for discussing the role of un-
certainty in ﬁnance. (In Part III of the book, you will learn what happens if investors are
Uncertainty means that a project may not return the promised amount. Because of such
default, the stated rate of return must be higher than the expected rate of return. Although
you are interested in the latter, it is almost always only the former that you are quoted
(promised). It is important that you always draw a sharp distinction between promised
(stated) rates of return, and expected rates of return. This chapter also explains what
debt and equity are, claims that have a meaningful diﬀerence under uncertainty.
Typical questions: If there is a 2% chance that your borrower will not return
the money, how much extra in interest should you charge? From an investment
perspective, what is the diﬀerence between debt and equity? How bad is the
role of inevitable mis-estimates in your calculations? If your cost of capital
(borrowing from the bank) is 10% and your savings interest rate (saving in the
bank) is 5%, should you take a project that will oﬀer a 7% rate of return?
• In Chapter 6, you abandon the perfect market assumptions and focus on the four impor-
tant frictions: disagreement, non-competitive markets, transaction costs, and taxes. This
chapter also explains the principles of the tax code, and the role of inﬂation. Though
not welcome, these frictions matter, so you must know how they matter and how to do
ﬁnance when they matter.
Typical questions: What are typical transaction costs, and how do you work
with them? Why are capital gains better than ordinary income? If you have to
pay 40% income taxes on interest receipts, the inﬂation rate is 2% per annum,
and your investment promises 5% per annum, how much more can you buy in
goods tomorrow if you invest? If you can earn 5% in taxable bonds, and 3%
in tax-exempt municipal bonds, which is the better investment for you? If the
inﬂation rate is 5% per year, and the interest rate is 10% per year, how much
more in goods can you actually buy if you save your money?
• Chapter 7 goes over a number of important issues that you should pay attention to when
you have to make investment decisions.
Typical questions: How should you think of projects that have side eﬀects—
for example, projects that pollute the air? How should you think of sunk costs?
What is a “real option”? How do you value contingencies and your own ﬂexibility
to change course in the future? How should your assessment of the value change
if someone else makes up the cash ﬂow estimates? How do humans—you—tend
to mis-estimate future cash ﬂows.
• Chapter 8 discusses other capital budgeting rules, ﬁrst and foremost the proﬁtability
index and the internal rate of return.
Typical question: If your project costs $100, and returns $50 next year and $100
in ten years, what is your project’s internal rate of return?
A Short Introduction
The First Draft
efore you set out for your journey into the world of ﬁnance, this chapter outlines in very
broad strokes what this book is all about.
6 Chapter 1
A SHORT INTRODUCTION
1·1 The Goal of Finance: Relative Valuation
Finance is such an important part of modern life that almost everyone can beneﬁt from under-
standing it better. What you may ﬁnd surprising is that the ﬁnancial problems facing PepsiCo or
Microsoft are not really diﬀerent from those facing an average investor, small business owner,
entrepreneur, or family. On the most basic level, these problems are about how to allocate
money. The choices are many: money can be borrowed or saved; money can be invested into
projects, undertaken with partners or with the aid of a lender; projects can be avoided alto-
gether if they do not appear valuable enough. Finance is about how best to decide among these
alternatives—and this textbook will explain how.
There is one principal theme that carries through all of ﬁnance. It is value. It is the questionTheme Number One:
Value! Make Decisions
Based on Value.
“What is a project, a stock, or a house worth?” To make smart decisions, you must be able to
assess value—and the better you can assess value, the smarter your decisions will be.
The goal of a good corporate manager should be to take all projects that add value, and avoidCorporate managers
need to know how to
value—and so do you.
those that would subtract value. Sounds easy? If it only were so. Valuation is often very
It is not the formulas that are diﬃcult—even the most complex formulas in this book containThe math is not hard.
just a few symbols, and the overwhelming majority of ﬁnance formulas only use the four major
operations (addition, subtraction, multiplication, and division). Admittedly, even if the formu-
las are not sophisticated, there are a lot of them, and they have an intuitive economic meaning
that requires experience to grasp—which is not a trivial task. But if you managed to pass high-
school algebra, if you are motivated, and if you keep an open mind, you positively will be able
to handle the math. It is not the math that is the real diﬃculty in valuation.
Instead, the diﬃculty is the real world! It is deciding how you should judge the future—whetherThe tough aspect
about valuation is the
your Gizmo will be a hit or a bust, whether the economy will enter a recession or not, where you
will ﬁnd alternative markets, and how interest rates or the stock market will move. This book
explains how to use your forecasts in the best way, but it mostly remains up to you to make
smart forecasts. (The book however does explain how solid economic intuition can often help,
but forecasting remains a diﬃcult and often idiosyncratic task.) There is also a ray of light
here: If valuation were easy, a computer could do your job of being a manager. This will never
happen. Valuation will always remain a matter of both art and science, that requires judgment
and common sense. The formulas and ﬁnance in this book are only the necessary toolbox to
convert your estimates of the future into what you need today to make good decisions.
To whet your appetite, much in this book is based in some form or another on the law of oneThe law of one price.
price. This is the fact that two identical items at the same venue should sell for the same price.
Otherwise, why would anyone buy the more expensive one? This law of one price is the logic
upon which almost all of valuation is based. If you can ﬁnd other projects that are identical—
at least along all dimensions that matter—to the project that you are considering, then your
project should be worth the same and sell for the same price. If you put too low a value on
your project, you might pass up on a project that is worth more than your best alternative uses
of money. If you put too high a value on your project, you might take a project that you could
buy cheaper elsewhere.
Note how value is deﬁned in relative terms. This is because it is easier to determine whetherValue is easier relative.
your project is better, worse, or similar to its best alternatives than it is to put an absolute value
on your project. The closer the alternatives, the easier it is to put a value on your project. It is
easier to compare and therefore value a new Toyota Camry—because you have good alternatives
such as Honda Accords and one-year used Toyota Camry—than it is to compare the Camry
against a Plasma TV, a vacation, or pencils. It is against the best and closest alternatives that
you want to estimate your own project’s value. These alternatives create an “opportunity cost”
that you suﬀer if you take your project instead of the alternatives.
1·2 HOW DO CHIEF FINANCIAL OFFICERS (CFOS) DECIDE? 7
Many corporate projects in the real world have close comparables that make such relative Relative value often
works well in the
valuation feasible. For example, say you want to put a value on a new factory that you would
build in Rhode Island. You have many alternatives: you could determine the value of a similar
factory in Massachusetts instead; or you could determine the value of a similar factory in
Mexico; or you could determine how much it would cost you to just purchase the net output of
the factory from another company; or you could determine how much money you could earn if
you invest your money instead into the stock market or deposit it into a savings account. If you
understand how to estimate your factory’s value relative to your other opportunities, you then
know whether you should build it or not. But not all projects are easy to value in relative terms.
For example, what would be the value of building a tunnel across the Atlantic, of controlling
global warming, or of terraforming Mars? There are no easy alternative projects to compare
these to, so any valuation would inevitably be haphazard.
1·2 How do Chief Financial Oﬃcers (CFOs) Decide?
Table 1.1: CFO Valuation Techniques
Method CFO Usage Recommended
Internal Rate of Return (IRR) (76%) Often Chapter 8
Net Present Value (NPV) (75%) Almost Always Chapter 2
Payback Period (57%) Rarely Chapter 8
Earning Multiples (P/E Ratios) (39%) With Caution Chapter 10
Discounted Payback (30%) Rarely Chapter 8
Accounting Rate of Return (20%) Rarely Chapter 10
Proﬁtability Index (12%) Often Chapter 8
Reﬁnements Useful in NPV and IRR
Sensitivity Analysis? (52%) Highly Chapter 7
Real Options Incorporated? (27%) Highly Chapter 7
Simulation Analysis (or VaR)? (14%) Highly Chapter 7
Adjusted Present Value (11%) Highly Chapter 18
Cost of Capital — An Input Into NPV and Needed for IRR
CAPM (73%) With Caution Chapter 13
Historical Average Returns (39%) Rarely Chapter 12
Modiﬁed CAPM (34%) With Caution Chapter 13
Backed out from Gorden Model (16%) Occasionally Chapter 3
Whatever Investors Tell Us (14%) Occasionally Chapter 2
Rarely means “usually no, and often used incorrectly.”
This book will explain the most important valuation techniques. But how important are these The Survey.
techniques in the real world? Fortunately, we have a good idea. In a survey in 2001, Graham
and Harvey (from Duke University) surveyed 392 managers, primarily Chief Financial Oﬃcers
(CFOs), asking them what techniques they use when deciding on projects or acquisition. The
results are listed in Table 1.1. Naturally, these are also the techniques that take the most space
in this book. Until I explain them formally, let me try to give you a brief, informal explanation
of what these techniques are.
8 Chapter 1
A SHORT INTRODUCTION
The main techniques.
• The gold standard of valuation is the “Net Present Value” (NPV) method. It tries to trans-
late all present and future project cash ﬂows into one equivalent value today. The project
is worth taking only if this value is positive. You will spend much of your time learning
the intricacies of NPV.
• The “Internal Rate of Return” (IRR) method and its variant, the “Proﬁtability Index,” try
to determine if the investment rate of return is higher or lower than the cost of capital.
For example, if a project would earn 30% and you can ﬁnance this project with capital
obtained at a rate of return of 10%, IRR suggests that you take this project. For many
projects, IRR comes up with the same recommendation as NPV.
• The “Payback Period” method and its variant, “Discounted Payback,” ask how long it takes
before a project earns back its investment—and both are usually bad methods to judge
projects. (The survey also found that payback is especially popular among managers who
do not have an MBA and who are more advanced in years.)
• The “Earnings multiples” method tries to compare your project directly to others that
you already know about. If your project costs less and earns more than these alternative
opportunities, then the multiples approach usually suggests you take it. It can often be
used, but only with extreme caution.
• The “Accounting Rate of Return” method judges projects by their accounting performance.
This is rarely a good idea. (You will learn that ﬁnancial accounting is not designed to
always accurately reﬂect ﬁrm value.)
Both NPV and IRR are simple ideas, but they rely on inputs that can be diﬃcult to obtain.Input Methods.
Table 1.1 also describes CFOs’ use of some highly recommended techniques that try to help. A
“Sensitivity Analysis” asks what happens if you change your input estimates and/or forecasts.
If you are not 100% sure—and you will rarely be 100% sure—this is always a prudent exercise.
Spreadsheets were designed to facilitate such scenario analyses. “Real options” are embedded
projects that give you a lot of future possibilities. Their valuation is as important as it is diﬃcult.
“Simulations” are a form of automated sensitivity analysis. And “Adjusted Present Value” is a
way to take corporate income taxes into account.
One input that is of special interest to us ﬁnance types is the cost of capital. It is an opportunityThe Cost of Capital
cost—where else could you invest money instead? The standard to ﬁnd the cost of capital is
the “Capital-Asset Pricing Model,” more commonly abbreviated as CAPM. It tries to tell you
the appropriate expected rate of return of a project, given its contribution to most investors’
portfolio risk. It is a nice and consistent model, but not without problems. Still, the CAPM
and some of its generalizations are often the best methods we have. Interestingly, CAPM use
is more common in large ﬁrms and ﬁrms in which the CFO has an MBA.
1·3 Learning How to Approach New Problems
This book is not just about teaching ﬁnance. It also wants to teach you how to approach novelTheme Number Two:
Learn how to approach
problems. That is, it would rather not merely ﬁll your memory with a collection of formulas and
facts—which you could promptly forget after the ﬁnal exam. Instead, you should understand
why it is that you are doing what you are doing, and how you can logically deduce it for yourself
when you do not have this book around. The goal is to eliminate the deus ex machina—the god
that was lowered onto the stage to magically and illogically solve all intractable problems in
Greek tragedies. You should understand where the formulas in this book come from, and how
you can approach new problems by developing your own formulas. Learning how to logically
progress when tackling tough problems is useful, not only in ﬁnance, but also in many other
disciplines and in your life more generally.
1·4 THE MAIN PARTS OF THIS BOOK 9
The method of approaching new problems in this book is to think in terms of the simplest Always start simple
and uncomplicated!possible example ﬁrst, even if it may sometimes seem too banal a problem or a step that you
would rather brush aside. Some students may even be put oﬀ by doing the basics, wanting
to move immediately on to the truly interesting, philosophical, or complex problems right
away. However, you should try to avoid the temptation of skipping the simpler problems, the
foundation. Indeed, arrogance about the basics is often more a sign of insecurity and poor
understanding than it is a sign of solid understanding—and even after many years of studying
the subject, I am always surprised about the many novel insights that I still get from pondering
even the most basic problems. I have studied ﬁnance for almost two decades now, and this is
an introductory textbook—and yet I still learned a lot thinking about basic issues while writing
this textbook. There was plenty of “simple” material that I had thought I understood, which I
then realized I had not.
Now, working up from simple examples is done in this book by the method of numerical ex- Numerics work well.
ample. You should translate the numerics onto algebra only after you have understood the
simplest numerical form. Start simple even if you want to understand complex problems. This
will take the sting out of the many formulas that ﬁnance will throw at you. Here is an example
of how this book will proceed. If you will receive $150 next year if you give me $100 today, you
probably already know that the rate of return is 50%. How did you get this? You subtracted
$100 from $150, and divided by your original investment of $100:
$150 − $100
= 50% (1.1)
The next step is to make an algebraic formula out of this. Name the two inputs, say, CFt=1 and
CFt=0 for cash ﬂow at time 1 and cash ﬂow at time 0. Call your result a rate of return and name
it r. To explain the correspondence between formulas and numerics, in this book, the formula
is placed under the numerics, so you will read
$150 − $100
CFt=1 − CFt=0
Looks silly? Perhaps—but this is how I ﬁnd it easiest to learn. Now you can ask much more
interesting and complex questions, such as what you would end up with if you started with
$200 and earned 50% rate of return two years in a row, what the eﬀect of inﬂation and imperfect
competition would be on your rate of return, etc. There will be dozens of other complications
to this formula in this book. But, we are getting ahead of ourselves. Trust me: This book will
cover a lot of theory—but the theory is not diﬃcult when properly defanged. Most of it is just
common sense, sometimes put into formulas.
1·4 The Main Parts of This Book
Here is where this book is now going: This book has four
parts, plus a synthesis
pro forma chapter.1. The ﬁrst part covers how your ﬁrm should make investment decisions, one project at a
time. It covers the basics: rates of returns, the time value of money, and capital budgeting.
It explains why we often rely on “perfect markets” when we estimate value.
2. The second part explains how corporate ﬁnancial statements work, and how they relate
to ﬁrm value.
3. The third part covers “investments.” The novel part here is the consideration of how one
investment inﬂuences the risk of other investments. For example, a coin bet on heads is
risky. A coin bet on tails is risky. Half a coin bet on heads and half a coin bet on tails has
zero risk. This part explains how ordinary investors should look at a portfolio of bets in
overall terms. It then relates this investor problem to what the consequences are in terms
10 Chapter 1
A SHORT INTRODUCTION
of the corporate cost of capital—that is, the opportunity cost of capital that your ﬁrm’s
investors incur if they give their money to your corporation rather to another one.
4. The fourth part covers how your projects should be ﬁnanced. Should you ﬁnd partners to
join you, or should you borrow money? The former is called equity ﬁnancing, the latter
is called debt ﬁnancing. This part also describes how ﬁrms have historically ﬁnanced
themselves and how investment banking works. It closes with the subject of corporate
governance—how ﬁrm owners assure that their ﬁrm’s employees and other owners will
not steal all their money.
The book ends with a keystone chapter—a pro forma analysis of a real company, here PepsiCo.The synthesis chapter
is not only the
standard way of
communication, but it
also requires you
A pro forma is a projection of the future for the purpose of valuing the company today. In
virtually every corporation, new corporate propositions have to be put into a pro forma. This
is how new business ideas are pitched—to the CFO, the board, the venture capitalist, or the
investment bank. Pro formas bring together virtually everything that you learn in this book.
To do one well, you have to understand how to work with returns and net present values, the
subject of the part I of the book. You have to understand how to work with ﬁnancial statements,
part II of the book. You have to understand how to estimate the ﬁrm’s cost of capital, part III
of the book. You have to understand how capital structure, taxes and other considerations
inﬂuence the cost of capital, part IV of the book. You have to learn how to create a pro forma
analysis, part V of the book. In the process, you will understand what problems are easy and
what problems are hard. You will learn what is science and what is art. And you will learn the
limits to ﬁnancial analysis.
Let’s set sail.
3 Key Terms
CFO; Chief Financial Oﬃcer; Law Of One Price.
The Time Value of Money
(Net) Present Values
fter covering some basic deﬁnitions, we begin with the concept of a rate of return—the
cornerstone of ﬁnance. You can always earn interest by depositing your money today into
the bank. This means that money today is more valuable than the same amount of money next
year. This concept is called the time value of money—$1 in present value is better than $1 in
Investors like you are just one side of the ﬁnancial markets. They give money today in order
to receive money in the future. The other side are the ﬁrms. The process ﬁrms use to decide
what to do with the money—which projects to take and which projects to pass up—is called
capital budgeting. You will learn that there is one best method. The ﬁrm should translate all
future cash ﬂows—both inﬂows and outﬂows—into their equivalent present values today, and
then add them up to ﬁnd the net present value. The ﬁrm should take all projects that have
positive net present values and reject all projects that have negative net present values.
This all sounds more complex than it is, so we better get started.
12 Chapter 2
THE TIME VALUE OF MONEY
2·1 Basic Background and Deﬁnitions
Most ﬁnancial concepts are easiest to understand if we assume what ﬁnance experts call aYou must know what a
perfect market is. In
addition, this chapter
has some more
• There are no taxes.
• There are no transaction costs.
• There are no diﬀerences in opinions. This does not mean that there is no risk. For example,
if we can all agree that the throw of a die will come up heads with a probability of 50%,
then we are still in a perfect market. If, however, your information tells you that the die
is biased with a 51% chance of heads, while I believe it is biased with a 51% chance of tails,
then the market is no longer perfect.
• There are so many buyers and sellers (investors and ﬁrms) that no individual matters.
In this chapter, we will make two further assumptions: there is no risk and no inﬂation. Of
course, this ﬁnancial utopia is unrealistic. However, the tools that you are learning in this
chapter will also work in later chapters, in which the world becomes not only progressively
more realistic but also more diﬃcult. But it must be that any general tool for use in a more
complex world should also work in our simpliﬁed world here—otherwise, it would be a ﬂawed
With the deﬁnition of a perfect market out of the way, we are almost ready to get started. WeWhat we do next.
only still need to agree on some common language, for example, what we mean by a project, a
ﬁrm, a bond, or a stock.
2·1.A. Investments, Projects, and Firms
As far as ﬁnance is concerned, every project is a set of ﬂows of money (cash ﬂows). MostTo value projects,
make sure to use all
costs and beneﬁts,
opportunity costs and
projects require an up front cash outﬂow (an investment or expense or cost) and are followed
by a series of later cash inﬂows (payoﬀs or revenues or returns). It does not matter whether
the cash ﬂows come from garbage hauling or diamond sales. Cash is cash. However, it is
important that all costs and beneﬁts are included as cash values. If you have to spend a lot
of time hauling trash, which you ﬁnd distasteful, then you have to translate your dislike into
equivalent cash negatives. Similarly, if you want to do a project “for the fun of it,” you must
translate your “fun” into a cash positive. The discipline of ﬁnance takes over after all positives
and negatives (inﬂows and outﬂows) from the project “black box” have been translated into
their appropriate monetary cash values.
This does not mean that the operations of the ﬁrm are unimportant—things like revenues, man-The black box is not
trivial. ufacturing, inventory, marketing, payables, working capital, competition, etc. These business
factors are all of the utmost importance in making the cash ﬂows happen, and a good (ﬁnan-
cial) manager must understand these. After all, even if all you care about is cash ﬂows, it is
impossible to understand them well if you have no idea where they come from and how they
can change in the future.
2·1 BASIC BACKGROUND AND DEFINITIONS 13
Projects need not be physical. For example, a company may have a project called “customer These examples show
that cash ﬂows must
relations,” with real cash outﬂows today and uncertain future inﬂows. You (a student) are a
project: You pay for education (a cash outﬂow) and will earn a salary in the future (a cash
inﬂow). If you value the prestige or cachet that the degree will oﬀer, you should also put a cash
value on this. It counts as another cash inﬂow. In addition, some of the payoﬀs from education
are metaphysical rather than physical. If knowledge provides you with pleasure, either today
or in the future, education yields a value that should be regarded as a positive cash ﬂow. Of
course, for some students, the distaste of learning should be factored in as a cost (equivalent
cash outﬂow)—but I trust that you are not one of them. All such nonﬁnancial ﬂows must be
appropriately translated into cash equivalents if you want to arrive at a good project valuation!
A ﬁrm can be viewed as a collection of projects. Similarly, so can a family. Your family may In ﬁnance, ﬁrms are
basically collections of
own a house, a car, have tuition payments, education investments, and so on—a collection of
projects. This book assumes that the value of a ﬁrm is the value of all its projects’ net cash
ﬂows, and nothing else. It is now your goal to learn how to determine projects’ values, given
appropriate cash ﬂows.
There are two important speciﬁc kinds of projects that you may consider investing in—bonds Stocks and bonds are
just projects with
inﬂows and outﬂows.
and stocks, also called debt and equity. As you will learn later, you can think of a stock as the
equivalent of investing to become an owner, although with limited liability. You can think of
the bond as the equivalent of lending money. For a given company, an investment in a bond
is usually less risky—but it also usually has less upside. Together, if you own all outstanding
bonds, loans, other obligations, and stock in a company, you own the ﬁrm:
Entire Firm = All Outstanding Stocks + All Outstanding Obligations (2.1)
This sum is sometimes called the enterprise value. Our book will spend a lot of time dis-
cussing these two forms of ﬁnancing—but for now, you can consider both of them just simple
investment projects: You put money in, and they pay money out. For many stock and bond
investments that you can buy and sell in the ﬁnancial markets, we believe that most investors
enjoy very few, if any, non-cash-based beneﬁts.
Q 2.1 In computing the cost of your M.B.A., should you take into account the loss of salary
while going to school? Cite a few nonmonetary beneﬁts that you reap as a student, too, and try
to attach monetary value to them.
Q 2.2 If you purchase a house and live in it, what are your inﬂows and outﬂows?
Anecdote: The Joy of Cooking: Positive Prestige Flows and Restaurant Failures
In New York City, two out of every ﬁve new restaurants close within one year. Nationwide, the best estimates
suggest that about 90% of all restaurants close within two years. If successful, the average restaurant earns
a return of about 10% per year. One explanation for why so many entrepreneurs are continuing to open up
restaurants, despite seemingly low ﬁnancial rates of return, is that restauranteurs so much enjoy owning a
restaurant that they are willing to buy the prestige of owning a restaurant. If this is the case, then to value
the restaurant, you must factor in how much the restauranteur is willing to pay for the prestige of owning a
restaurant, just as you would factor in the revenues that restaurant patrons generate. (But there is also an
alternative reason why so many restaurants fail, described on Page 184.)
14 Chapter 2
THE TIME VALUE OF MONEY
2·1.B. Loans and Bonds
We will begin with the study of plain bonds because they are easiest to understand. You shouldWhy bonds ﬁrst?
view a bond as just another type of investment project—money goes in, and money comes
out. The beauty is that you know what the cash ﬂows will be. For stocks and other projects,
the complications created by having to guess future cash ﬂows can quickly become daunting.
Therefore, it makes sense to ﬁrst understand the project “plain bond” well before proceeding
to other kinds of projects. Besides, much more capital in the economy is tied up in bonds and
loans than is tied up in stock, so understanding bonds well is very useful in itself.
A loan is the commitment of a borrower to pay a predetermined amount of cash at one or moreFinance jargon: loan,
bond, ﬁxed income,
predetermined times in the future (the ﬁnal one being called maturity), usually in exchange for
cash up front today. Loosely speaking, the diﬀerence between the money lent and the money
paid back is the interest that the lender earns. A bond is a particular kind of loan, so named
because it “binds” the borrower to pay money. Thus, “buying a bond” is the same as “extending
a loan.” Bond buying is the process of giving cash today and receiving a promise for money in
the future. Similarly, instead of “taking a loan,” you can just say that you are “giving a bond,”
“issuing a bond,” or “selling a bond.” Loans and bonds are also sometimes called ﬁxed income
instruments, because they “promise” a ﬁxed income to the holder of the bond.
Is there any diﬀerence between buying a bond for $1,000 and putting $1,000 into a bank savingsBond: Deﬁned by
payment next year.
Savings: Deﬁned by
payment this year.
account? Yes, a small one. The bond is deﬁned by its future promised payoﬀs—say, $1,100
next year—and the bond’s value and price today are based on these future payoﬀs. But as the
bond owner, you know exactly how much you will receive next year. An investment in a bank
savings account is deﬁned by its investment today. The interest rate can and will change every
day, and next year you will end up with an amount that depends on future interest rates, for
example, $1,080 (if interest rates decrease) or $1,120 (if interest rates increase).
If you want, you can think of a savings account as consecutive 1-day bonds: When you depositA bank savings
account is like a
sequence of 1-day
money, you buy a 1-day bond, for which you know the interest rate this one day in advance,
and the money automatically gets reinvested tomorrow into another bond with whatever the
interest rate will be tomorrow. Incidentally, retirement plans also come in two such forms:
Deﬁned beneﬁt plans are like bonds and are deﬁned by how much you will get when you retire;
and deﬁned contribution plans are like bank deposit accounts and are deﬁned by how much
money you are putting into your retirement account today—in the real world, you won’t know
exactly how much money you will have when you retire.
You should already know that the net return on a loan is called interest, and that the rateInterest and
of return on a loan is called the interest rate—though we will soon ﬁrm up your knowledge
about interest rates. One diﬀerence between interest payments and noninterest payments is
that the former usually has a maximum payment, whereas the latter can have unlimited upside
potential. Not every rate of return is an interest rate. For example, an investment in a lottery
ticket is not a loan, so it does not oﬀer an interest rate, just a rate of return. In real life, its
payoﬀ is uncertain—it could be anything from zero to an unlimited amount. The same applies
to stocks and many corporate projects. Many of our examples use the phrase “interest rate,”
even though the examples almost always work for any other rates of return, too.
2·1.C. U.S. Treasuries
Bonds are relatively simple projects, and bonds issued by the U.S. government—called Treasuries—Start with the simplest
and most important
are perhaps the simplest of them all. This is because Treasuries cannot fail to pay. They
promise to pay U.S. dollars, and the United States has the right to print more U.S. dollars if it
were ever to run out. Thus, for Treasuries, there is absolutely no uncertainty about repayment.
This is convenient because it makes it easier to learn ﬁnance—but you should study them not
just because they are convenient tutorial examples.