Fundamentals of Corporate Finance 8th Edition


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Fundamentals of Corporate Finance 8th Edition

  1. 1. Standard Edition FUNDAMENTALS OF CORPORATE FINANCE ros3062x_fm_Standard.indd i 2/9/07 6:01:58 PM
  2. 2. The McGraw-Hill/Irwin Series in Finance, Insurance, and Real Estate Stephen A. Ross Franco Modigliani Professor of Finance and Economics Sloan School of Management Massachusetts Institute of Technology Consulting Editor Financial Management Adair Excel Applications for Corporate Finance First Edition Benninga and Sarig Corporate Finance: A Valuation Approach Block and Hirt Foundations of Financial Management Twelfth Edition Brealey, Myers, and Allen Principles of Corporate Finance Eighth Edition Brealey, Myers, and Marcus Fundamentals of Corporate Finance Fifth Edition Brooks FinGame Online 4.0 Bruner Case Studies in Finance: Managing for Corporate Value Creation Fifth Edition Chew The New Corporate Finance: Where Theory Meets Practice Third Edition Chew and Gillan Corporate Governance at the Crossroads: A Book of Readings First Edition DeMello Cases in Finance Second Edition Grinblatt and Titman Financial Markets and Corporate Strategy Second Edition Helfert Techniques of Financial Analysis: A Guide to Value Creation Eleventh Edition Higgins Analysis for Financial Management Eighth Edition Kester, Ruback, and Tufano Case Problems in Finance Twelfth Edition Ross, Westerfield, and Jaffe Corporate Finance Eighth Edition ros3062x_fm_Standard.indd ii Ross, Westerfield, Jaffe, and Jordan Corporate Finance: Core Principles and Applications First Edition Ross, Westerfield, and Jordan Essentials of Corporate Finance Fifth Edition Ross, Westerfield, and Jordan Fundamentals of Corporate Finance Eighth Edition Shefrin Behavioral Corporate Finance: Decisions that Create Value First Edition Saunders and Cornett Financial Institutions Management: A Risk Management Approach Fifth Edition Saunders and Cornett Financial Markets and Institutions: An Introduction to the Risk Management Approach Third Edition International Finance White Financial Analysis with an Electronic Calculator Sixth Edition Eun and Resnick International Financial Management Fourth Edition Kuemmerle Case Studies in International Entrepreneurship: Managing and Financing Ventures in the Global Economy First Edition Investments Real Estate Adair Excel Applications for Investments First Edition Brueggeman and Fisher Real Estate Finance and Investments Thirteenth Edition Corgel, Ling, and Smith Real Estate Perspectives: An Introduction to Real Estate Fourth Edition Ling and Archer Real Estate Principles: A Value Approach Second Edition Bodie, Kane, and Marcus Essentials of Investments Sixth Edition Bodie, Kane, and Marcus Investments Seventh Edition Hirt and Block Fundamentals of Investment Management Eighth Edition Hirschey and Nofsinger Investments: Analysis and Behavior First Edition Jordan and Miller Fundamentals of Investments: Valuation and Management Fourth Edition Financial Institutions and Markets Rose and Hudgins Bank Management and Financial Services Seventh Edition Rose and Marquis Money and Capital Markets: Financial Institutions and Instruments in a Global Marketplace Ninth Edition Financial Planning and Insurance Allen, Melone, Rosenbloom, and Mahoney Pension Planning: Pension, Profit-Sharing, and Other Deferred Compensation Plans Ninth Edition Altfest Personal Financial Planning First Edition Harrington and Niehaus Risk Management and Insurance Second Edition Kapoor, Dlabay, and Hughes Focus on Personal Finance: An active approach to help you develop successful financial skills First Edition Kapoor, Dlabay, and Hughes Personal Finance Eighth Edition 2/9/07 6:01:59 PM
  3. 3. Standard Edition Eighth Edition FUNDAMENTALS OF CORPORATE FINANCE Stephen A. Ross Massachusetts Institute of Technology Randolph W. Westerfield University of Southern California Bradford D. Jordan University of Kentucky Boston Burr Ridge, IL Dubuque, IA New York San Francisco St. Louis Bangkok Bogotá Caracas Kuala Lumpur Lisbon London Madrid Mexico City Milan Montreal New Delhi Santiago Seoul Singapore Sydney Taipei Toronto iii ros3062x_fm_Standard.indd iii 2/9/07 6:01:59 PM
  4. 4. FUNDAMENTALS OF CORPORATE FINANCE Published by McGraw-Hill/Irwin, a business unit of The McGraw-Hill Companies, Inc., 1221 Avenue of the Americas, New York, NY, 10020. Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of The McGraw-Hill Companies, Inc., including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning. Some ancillaries, including electronic and print components, may not be available to customers outside the United States. This book is printed on acid-free paper. 1 2 3 4 5 6 7 8 9 0 WCK/WCK 0 9 8 7 ISBN MHID ISBN MHID ISBN MHID 978-0-07-353062-8 (standard edition) 0-07-353062-X (standard edition) 978-0-07-328211-4 (alternate edition) 0-07-328211-1 (alternate edition) 978-0-07-328212-1 (annotated instructor’s edition) 0-07-328212-X (annotated instructor’s edition) Editorial director: Brent Gordon Executive editor: Michele Janicek Developmental editor II: Jennifer Rizzi Senior marketing manager: Julie Phifer Senior media producer: Victor Chiu Lead project manager: Christine A. Vaughan Lead production supervisor: Carol A. Bielski Senior designer: Kami Carter Lead media project manager: Cathy L. Tepper Cover design: Kiera Cunningham Pohl Cover image: © Corbis Images Typeface: 10/12 Times Roman Compositor: ICC Macmillan Inc. Printer: Quebecor World Versailles Inc. Library of Congress Cataloging-in-Publication Data Ross, Stephen A. Fundamentals of corporate finance/Stephen A. Ross, Randolph W. Westerfield, Bradford D. Jordan. -- 8th ed., Standard ed. p. cm. -- (The McGraw-Hill/Irwin series in finance, insurance and real estate) Includes index. ISBN-13: 978-0-07-353062-8 (standard edition : alk. paper) ISBN-10: 0-07-353062-X (standard edition : alk. paper) ISBN-13: 978-0-07-328211-4 (alternate edition : alk. paper) ISBN-10: 0-07-328211-1 (alternate edition : alk. paper) [etc.] 1. Corporations--Finance. I. Westerfield, Randolph. II. Jordan, Bradford D. HG4026.R677 2008 658.15--dc22 2007002136 Copyright_page_FM.indd iv III. Title. 2/9/07 6:25:23 PM
  5. 5. To our families and friends with love and gratitude. S.A.R. R.W.W. B.D.J. v ros3062x_fm_Standard.indd v 2/9/07 6:02:00 PM
  6. 6. About the Authors 3 STEPHEN A. ROSS Sloan School of Management, Franco Modigliani Professor of Finance and Economics, Massachusetts Institute of Technology Stephen A. Ross is the Franco Modigliani Professor of Finance and Economics at the Sloan School of Management, Massachusetts Institute of Technology. One of the most widely published authors in finance and economics, Professor Ross is recognized for his work in developing the Arbitrage Pricing Theory and his substantial contributions to the discipline through his research in signaling, agency theory, option pricing, and the theory of the term structure of interest rates, among other topics. A past president of the American Finance Association, he currently serves as an associate editor of several academic and practitioner journals. He is a trustee of CalTech and Freddie Mac. RANDOLPH W. WESTERFIELD Marshall School of Business, University of Southern California Randolph W. Westerfield is Dean Emeritus of the University of Southern California’s Marshall School of Business and is the Charles B. Thornton Professor of Finance. He came to USC from the Wharton School, University of Pennsylvania, where he was the chairman of the finance department and a member of the finance faculty for 20 years. He is a member of several public company boards of directors including Health Management Associates, Inc., and the Nicholas Applegate growth fund. His areas of expertise include corporate financial policy, investment management, and stock market price behavior. BRADFORD D. JORDAN Gatton College of Business and Economics, University of Kentucky Bradford D. Jordan is Professor of Finance and holder of the Richard W. and Janis H. Furst Endowed Chair in Finance at the University of Kentucky. He has a long-standing interest in both applied and theoretical issues in corporate finance and has extensive experience teaching all levels of corporate finance and financial management policy. Professor Jordan has published numerous articles on issues such as cost of capital, capital structure, and the behavior of security prices. He is a past president of the Southern Finance Association, and he is coauthor of Fundamentals of Investments: Valuation and Management, 4e, a leading investments text, also published by McGraw-Hill/Irwin. vi ros3062x_fm_Standard.indd vi 2/9/07 6:02:00 PM
  7. 7. Preface from the Authors When the three of us decided to write a book, we were united by one strongly held principle: Corporate finance should be developed in terms of a few integrated, powerful ideas. We believed that the subject was all too often presented as a collection of loosely related topics, unified primarily by virtue of being bound together in one book, and we thought there must be a better way. One thing we knew for certain was that we didn’t want to write a “me-too” book. So, with a lot of help, we took a hard look at what was truly important and useful. In doing so, we were led to eliminate topics of dubious relevance, downplay purely theoretical issues, and minimize the use of extensive and elaborate calculations to illustrate points that are either intuitively obvious or of limited practical use. As a result of this process, three basic themes became our central focus in writing Fundamentals of Corporate Finance: AN EMPHASIS ON INTUITION We always try to separate and explain the principles at work on a commonsense, intuitive level before launching into any specifics. The underlying ideas are discussed first in very general terms and then by way of examples that illustrate in more concrete terms how a financial manager might proceed in a given situation. A UNIFIED VALUATION APPROACH We treat net present value (NPV) as the basic concept underlying corporate finance. Many texts stop well short of consistently integrating this important principle. The most basic and important notion, that NPV represents the excess of market value over cost, often is lost in an overly mechanical approach that emphasizes computation at the expense of comprehension. In contrast, every subject we cover is firmly rooted in valuation, and care is taken throughout to explain how particular decisions have valuation effects. A MANAGERIAL FOCUS Students shouldn’t lose sight of the fact that financial management concerns management. We emphasize the role of the financial manager as decision maker, and we stress the need for managerial input and judgment. We consciously avoid “black box” approaches to finance, and, where appropriate, the approximate, pragmatic nature of financial analysis is made explicit, possible pitfalls are described, and limitations are discussed. In retrospect, looking back to our 1991 first edition IPO, we had the same hopes and fears as any entrepreneurs. How would we be received in the market? At the time, we had no idea that just 16 years later, we would be working on an eighth edition. We certainly never dreamed that in those years we would work with friends and colleagues from around the world to create country-specific Australian, Canadian, and South African editions, an International edition, Chinese, French, Polish, Portuguese, Thai, Russian, Korean, and Spanish language editions, and an entirely separate book, Essentials of Corporate Finance, now in its fifth edition. Today, as we prepare to once more enter the market, our goal is to stick with the basic principles that have brought us this far. However, based on an enormous amount of feedback we have received from you and your colleagues, we have made this edition and its package even more flexible than previous editions. We offer flexibility in coverage, by continuing to offer a variety of editions, and flexibility in pedagogy, by providing a wide variety of features in the book to help students to learn about corporate finance. We also provide flexibility in package options by offering the most extensive collection of teaching, learning, and technology aids of any corporate finance text. Whether you use just the textbook, or the book in conjunction with our other products, we believe you will find a combination with this edition that will meet your current as well as your changing needs. Stephen A. Ross Randolph W. Westerfield Bradford D. Jordan vii ros3062x_fm_Standard.indd vii 2/9/07 6:02:03 PM
  8. 8. viii PA RT 1 Part Title Goes Here on Verso Page Coverage This book was designed and developed explicitly for a first course in business or corporate finance, for both finance majors and non-majors alike. In terms of background or prerequisites, the book is nearly self-contained, assuming some familiarity with basic algebra and accounting concepts, while still reviewing important accounting principles very early on. The organization of this text has been developed to give instructors the flexibility they need. Just to get an idea of the breadth of coverage in the eighth edition of Fundamentals, the following grid presents, for each chapter, some of the most significant new features as well as a few selected chapter highlights. Of course, in every chapter, opening vignettes, boxed features, in-chapter illustrated examples using real companies, and end-of-chapter material have been thoroughly updated as well. Chapters PART 1 Selected Topics of Interest Benefits to You Overview of Corporate Finance Chapter 1 Introduction to Corporate Finance New section: Sarbanes–Oxley. Brings in real-world issues concerning conflicts of interest and current controversies surrounding ethical conduct and management pay. Mini-case: Cash Flows and Financial Statements at Sunset Boards, Inc. New case written for this edition reinforces key cash flow concepts in a small-business setting. Cash flow vs. earnings. Clearly defines cash flow and spells out the differences between cash flow and earnings. Market values vs. book values. PART 2 Stresses value creation as the most fundamental aspect of management and describes agency issues that can arise. Ethics, financial management, and executive compensation. Chapter 2 Financial Statements, Taxes, and Cash Flow Goal of the firm and agency problems. Emphasizes the relevance of market values over book values. Financial Statements and Long-Term Financial Planning Chapter 3 Working with Financial Statements New ratios: PEG, price-to-sales, and Tobin’s Q. Expanded Du Pont analysis. New section expands the basic Du Pont equation to better explore the interrelationships between operating and financial performance. New material: Du Pont analysis for real companies using data from S&P Market Insight. Ratio and financial statement analysis using smaller firm data. Chapter 4 Long-Term Financial Planning and Growth New analysis shows students how to get and use real-world data, thereby applying key chapter ideas. Uses firm data from RMA to show students how to actually get and evaluate financial statements benchmarks. Expanded discussion on sustainable growth calculations. New case written for this edition illustrates the importance of financial planning in a small firm. Mini-case: Planning for Growth at S&S Air. Explanation of alternative formulas for sustainable and internal growth rates. Thorough coverage of sustainable growth as a planning tool. Explanation of growth rate formulas clears up a common misunderstanding about these formulas and the circumstances under which alternative formulas are correct. Provides a vehicle for examining the interrelationships between operations, financing, and growth. viii ros3062x_fm_Standard.indd viii 2/9/07 6:02:03 PM
  9. 9. Chapters PART 3 Selected Topics of Interest Benefits to You Valuation of Future Cash Flows Chapter 5 Introduction to Valuation: The Time Value of Money First of two chapters on time value of money. Relatively short chapter introduces just the basic ideas on time value of money to get students started on this traditionally difficult topic. Chapter 6 Discounted Cash Flow Valuation New section: Growing annuities and perpetuities. Second of two chapters on time value of money. New minicase: The MBA Decision. Covers more advanced time value topics with numerous examples, calculator tips, and Excel spreadsheet exhibits. Contains many real-world examples. Chapter 7 Interest Rates and Bond Valuation New section: Inflation and present values. “Clean” vs. “dirty” bond prices and accrued interest. Clears up the pricing of bonds between coupon payment dates and also bond market quoting conventions. NASD’s new TRACE system and transparency in the corporate bond market. Up-to-date discussion of new developments in fixed income with regard to price, volume, and transactions reporting. “Make-whole” call provisions. Up-to-date discussion of a relatively new type of call provision that has become very common. New minicase: Stock Valuation at Ragan, Inc. Minicase: Financing S&S Air’s Expansion Plans with a Bond Issue. New case written for this edition examines the debt issuance process for a small firm. Stock valuation. Thorough coverage of constant and nonconstant growth models. NYSE and NASDAQ Market Operations. Up-to-date description of major stock market operations Chapter 8 Stock Valuation PART 4 Capital Budgeting Chapter 9 Net Present Value and Other Investment Criteria Relatively short chapter introduces key ideas on an intuitive level to help students with this traditionally difficult topic. NPV, IRR, payback, discounted payback, and accounting rate of return. Chapter 10 Making Capital Investment Decisions New section: Modified internal rate of return (MIRR). New minicase: Bullock Gold Mining. First of three chapters on capital budgeting. Consistent, balanced examination of advantages and disadvantages of various criteria. Projected cash flow. Thorough coverage of project cash flows and the relevant numbers for a project analysis. Emphasizes the equivalence of various formulas, thereby removing common misunderstandings. Considers important applications of chapter tools. Alternative cash flow definitions. Special cases of DCF analysis. Chapter 11 Project Analysis and Evaluation Minicase: Conch Republic Electronics. Sources of value. Scenario and sensitivity “what-if” analyses. Break-even analysis. Case analyzes capital budgeting issues and complexities. Stresses the need to understand the economic basis for value creation in a project. Illustrates how to actually apply and interpret these tools in a project analysis. Covers cash, accounting, and financial break-even levels. ix ros3062x_fm_Standard.indd ix 2/9/07 6:02:05 PM
  10. 10. x PA RT 1 Coverage Chapters PART 5 Part Title Goes Here on Verso Page (continued) Selected Topics of Interest Benefits to You Risk and Return Chapter 12 Some Lessons from Capital Market History New minicase: A Job at S&S Air. Expanded discussion of geometric vs. arithmetic returns. Discusses calculation and interpretation of geometric returns. Clarifies common misconceptions regarding appropriate use of arithmetic vs. geometric average returns. Capital market history. Market efficiency. Chapter 13 Return, Risk, and the Security Market Line Chapter 14 Options and Corporate Finance PART 6 Extensive coverage of historical returns, volatilities, and risk premiums. Efficient markets hypothesis discussed along with common misconceptions. New minicase: The Beta for American Standard. Diversification, systematic and unsystematic risk. Beta and the security market line. Illustrates basics of risk and return in a straightforward fashion. Minicase: S&S Air’s Convertible Bond. New discussion in ESO backdating. Stock options, employee stock options, and real options. Option-embedded securities. New case written for this edition examines security issuance issues for a small firm. Discusses the basics of these important option types. Describes the different types of option found in corporate securities. Develops the security market line with an intuitive approach that bypasses much of the usual portfolio theory and statistics. Cost of Capital and Long-Term Financial Policy Chapter 15 Cost of Capital New section: Internal equity and flotation costs. Geometric vs. arithmetic growth rates. Cost of capital estimation. Both approaches are used in practice. Clears up issues surrounding growth rate estimates. Contains a complete, Web-based illustration of cost of capital for a real company. Chapter 16 Raising Capital Explains uniform price auctions using recent Google IPO as an example. IPO valuation. Chapter 17 Financial Leverage and Capital Structure Policy New minicase: S&S Air Goes Public. Dutch auction IPOs. IPO “quiet periods.” Rights vs. warrants. Extensive, up-to-date discussion of IPOs, including the 1999–2000 period. Explains the SEC’s quiet period rules. Clarifies the option-like nature of rights prior to their expiration dates. New section: The pecking-order theory of capital structure. New minicase: Stephenson Real Estate Capitalization. Basics of financial leverage. Optimal capital structure. Financial distress and bankruptcy. Illustrates effect of leverage on risk and return. Describes the basic trade-offs leading to an optimal capital structure. Briefly surveys the bankruptcy process. x ros3062x_fm_Standard.indd x 2/9/07 6:02:08 PM
  11. 11. Chapters Selected Topics of Interest New case written for this edition analyzes cost of capital estimation for a non-public firm. New survey results show the most important (and least important) factors considered by financial managers in setting dividend policy. Effect of new tax laws. Discusses implications of new, lower dividend, and capital gains rates. Dividends and dividend policy. PART 7 New minicase: Electronic Timing, Inc. Minicase: Piepkorn Manufacturing Working Capital Management. Very recent survey evidence on dividend policy. Chapter 18 Dividends and Dividend Policy Benefits to You Describes dividend payments and the factors favoring higher and lower payout policies. Short-Term Financial Planning and Management Chapter 19 Short-Term Finance and Planning Operating and cash cycles. Stresses the importance of cash flow timing. Short-term financial planning. Illustrates creation of cash budgets and potential need for financing. Chapter 20 Cash and Liquidity Management New material on Check Clearing Act of the 21st century. New minicase: Cash Management at Webb Corporation. Float management. Thorough coverage of float management and potential ethical issues. Cash collection and disbursement. PART 8 New minicase: Credit Policy at Howlett Industries. New case written for this edition evaluates working capital issues for a small firm. Credit management. Analysis of credit policy and implementation. Inventory management. Chapter 21 Credit and Inventory Management Examination of systems used by firms to handle cash inflows and outflows. Brief overview of important inventory concepts. Topics in Corporate Finance Chapter 22 International Corporate Finance New minicase: S&S Air Goes International. Foreign exchange. Covers essentials of exchange rates and their determination. International capital budgeting. Shows how to adapt basic DCF approach to handle exchange rates. Exchange rate and political risk. Discusses hedging and issues surrounding sovereign risk. xi ros3062x_fm_Standard.indd xi 2/9/07 6:02:10 PM
  12. 12. xii PA RT 1 Part Title Goes Here on Verso Page In-Text Study Features In addition to illustrating pertinent concepts and presenting up-to-date coverage, Fundamentals of Corporate Finance strives to present the material in a way that makes it coherent and easy to understand. To meet the varied needs of its intended audience, Fundamentals of Corporate Finance is rich in valuable learning tools and support. CHAPTER-OPENING VIGNETTES Vignettes drawn from real-world events introduce students to the chapter concepts. Questions about these vignettes are posed to the reader to ensure understanding of the concepts in the end-of-chapter material. For examples, see Chapter 4, page 89; Chapter 5, page 21. This approach works just fine. However, we will often encounter situations in which the number of cash flows is quite large. For example, a typical home mortgage calls for monthly payments over 30 years, for a total of 360 payments. If we were trying to determine the present value of those payments, it would be useful to have a shortcut. Because the cash flows of an annuity are all the same, we can come up with a handy variation on the basic present value equation. The present value of an annuity of C dollars per period for t periods when the rate of return or interest rate is r is given by: 1 Ϫ Present value factor Annuity present value ϭ C ϫ ____________________ r [6.1] 1 Ϫ [1͞(1 ϩ r)t] ______________ ϭCϫ r ( { ) } PEDAGOGICAL USE OF COLOR This learning tool continues to be an important feature of Fundamentals of Corporate Finance. In almost every chapter, color plays an extensive, nonschematic, and largely self-evident role. A guide to the functional use of color is found on the endsheets of both the Annotated Instructor’s Edition (AIE) and student version. For examples of this technique, see Chapter 5, page 130. IN THEIR OWN WORDS BOXES This series of boxes are the popular articles updated from previous editions written by a distinguished scholar or practitioner on key topics in the text. Boxes include essays by Merton Miller on capital structure, Fischer Black on dividends, and Roger Ibbotson on capital market history. A complete list of “In Their Own Words” boxes appears on page xxxvii. IN THEIR OWN WORDS . . . Robert C. Higgins on Sustainable Growth Most financial officers know intuitively that it takes money to make money. Rapid sales growth requires increased assets in the form of accounts receivable, inventory, and fixed plant, which, in turn, require money to pay for assets. They also know that if their company does not have the money when needed, it can literally “grow broke.” The sustainable growth equation states these intuitive truths explicitly. Sustainable growth is often used by bankers and other external analysts to assess a company’s credit worthiness. They are aided in this exercise by several sophisticated computer software packages that provide detailed analyses of the company’s past financial performance, including its annual sustainable growth rate. Bankers use this information in several ways. Quick comparison of a company’s actual growth rate to its sustainable rate tells the banker what issues will be at the top of management’s financial agenda. If actual growth consistently exceeds sustainable growth, management’s problem will be where to get the cash to finance growth. The banker thus can anticipate interest in loan products. Conversely, if sustainable growth consistently exceeds actual, the banker had best be prepared to talk about investment products, because management’s problem will be what to do with all the cash that keeps piling up in the till. xii ros3062x_fm_Standard.indd xii 2/9/07 6:02:13 PM
  13. 13. CHAPTER 1 WORK THE WEB Chapter Title Goes Here on Recto Page ORK THE WEB These boxes in the chapter material show students how to research financial issues using the Web and how to use the information they find to make business decisions. See examples in Chapter 4, page 103; Chapter 5, page 140. xiii WORK THE WEB Calculating company growth rates can involve detailed research, and a major part of a stock analyst’s job is to estimate them. One place to find earnings and sales growth rates on the Web is Yahoo! Finance at com. We pulled up a quote for Minnesota Mining & Manufacturing (MMM, or 3M as it is known) and followed the “Analyst Estimates” link. Here is an abbreviated look at the results: As shown, analysts expect, on average, revenue (sales) of $22.77 billion in 2006, growing to $24.27 billion in 2007, an increase of 6.6 percent. We also have the following table comparing MMM to some benchmarks: ENHANCED! REAL-WORLD EXAMPLES Actual events are integrated throughout the text, tying chapter concepts to real life through illustration and reinforcing the relevance of the material. Some examples tie into the chapter opening vignette for added reinforcement. See example in Chapter 5, page 135. SPREADSHEET STRATEGIES Using a Spreadsheet for Time Value of Money Calculations More and more, businesspeople from many different areas (not just finance and accounting) rely on spreadsheets to do all the different types of calculations that come up in the real world. As a result, in this section, we will show you how to use a spreadsheet to handle the various time value of money problems we presented in this chapter. We will use Microsoft Excel™, but the commands are similar for other types of software. We assume you are already familiar with basic spreadsheet operations. As we have seen, you can solve for any one of the following four potential unknowns: future value, present value, the discount rate, or the number of periods. With a spreadsheet, there is a separate formula for each. In Excel, these are shown in a nearby box. In these formulas, pv and fv are present and future To Find Enter This Formula value, nper is the number of periods, and rate is the Future value ϭ FV (rate,nper,pmt,pv) discount, or interest, rate. Present value ϭ PV (rate,nper,pmt,fv) Two things are a little tricky here. First, unlike a financial calculator, the spreadsheet requires that the Discount rate ϭ RATE (nper,pmt,pv,fv) rate be entered as a decimal. Second, as with most Number of periods ϭ NPER (rate,pmt,pv,fv) financial calculators, you have to put a negative sign on either the present value or the future value to solve for the rate or the number of periods. For the same reason, if you solve for a present value, the answer will have a negative sign unless you input a negative future value. The same is true when you compute a future value. To illustrate how you might use these formulas, we will go back to an example in the chapter. If you invest $25,000 at 12 percent per year, how long until you have $50,000? You might set up a spreadsheet like this: A 1 2 3 4 5 6 7 8 9 10 11 12 13 14 B C D E F G SPREADSHEET STRATEGIES This feature either introduces students to Excel or helps them brush up on their Excel spreadsheet skills, particularly as they relate to corporate finance. This feature appears in self-contained sections and shows students how to set up spreadsheets to analyze common financial problems—a vital part of every business student’s education. For examples, see Chapter 5, page 139; Chapter 6, page 153. H Using a spreadsheet for time value of money calculations If we invest $25,000 at 12 percent, how long until we have $50,000? We need to solve for the unknown number of periods, so we use the formula NPER(rate, pmt, pv, fv). Present value (pv): Future value (fv): Rate (rate): $25,000 $50,000 0.12 Periods: 6.1162554 The formula entered in cell B11 is =NPER(B9,0,-B7,B8); notice that pmt is zero and that pv has a negative sign on it. Also notice that rate is entered as a decimal, not a percentage. xiii ros3062x_fm_Standard.indd xiii 2/9/07 6:02:14 PM
  14. 14. CALCULATOR HINTS CALCULATOR HINTS These brief calculator tutorials have been added in selected chapters to help students learn or brush up on their financial calculator skills. These complement the just-mentioned Spreadsheet Strategies. For examples, see Chapter 5, page 136; Chapter 6, page 152. How to Calculate Present Values with Multiple Future Cash Flows Using a Financial Calculator To calculate the present value of multiple cash flows with a financial calculator, we will simply discount the individual cash flows one at a time using the same technique we used in our previous chapter, so this is not really new. However, we can show you a shortcut. We will use the numbers in Example 6.3 to illustrate. To begin, of course we first remember to clear out the calculator! Next, from Example 6.3, the first cash flow is $200 to be received in one year and the discount rate is 12 percent, so we do the following: Enter 1 12 N I/Y 200 PMT PV FV Ϫ178.57 Solve for Now, you can write down this answer to save it, but that’s inefficient. All calculators have a memory where you can store numbers. Why not just save it there? Doing so cuts way down on mistakes because you don’t have to write down and/or rekey numbers, and it’s much faster. Next we value the second cash flow. We need to change N to 2 and FV to 400. As long as we haven’t changed anything else, we don’t have to reenter I/Y or clear out the calculator, so we have: Enter 2 N Solve for 400 I/Y PMT PV FV Ϫ318.88 You save this number by adding it to the one you saved in our first calculation, and so on for the remaining two calculations. As we will see in a later chapter, some financial calculators will let you enter all of the future cash flows at once, but we’ll discuss that subject when we get to it. CONCEPT BUILDING Chapter sections are intentionally kept short to promote a step-by-step, building block approach to learning. Each section is then followed by a series of short concept questions that highlight the key ideas just presented. Students use these questions to make sure they can identify and understand the most important concepts as they read. See Chapter 5, page 133; Chapter 6, page 154 for examples. SUMMARY TABLES These tables succinctly restate key principles, results, and equations. They appear whenever it is useful to emphasize and summarize a group of related concepts. For examples, see Chapter 6, page 163. LABELED EXAMPLES Separate numbered and titled examples are extensively integrated into the chapters as indicated below. These examples provide detailed applications and illustrations of the text material in a step-by-step format. Each example is completely self-contained so students don’t have to search for additional information. Based on our classroom testing, these examples are among the most useful learning aids because they provide both detail and explanation. See Chapter 6, page 163; Chapter 7, page 196. Preferred Stock EXAMPLE 6.7 Preferred stock (or preference stock) is an important example of a perpetuity. When a corporation sells preferred stock, the buyer is promised a fixed cash dividend every period (usually every quarter) forever. This dividend must be paid before any dividend can be paid to regular stockholders—hence the term preferred. Suppose the Fellini Co. wants to sell preferred stock at $100 per share. A similar issue of preferred stock already outstanding has a price of $40 per share and offers a dividend of $1 every quarter. What dividend will Fellini have to offer if the preferred stock is going to sell? The issue that is already out has a present value of $40 and a cash flow of $1 every quarter forever. Because this is a perpetuity: Present value ϭ $40 ϭ $1 ϫ (1͞r) r ϭ 2.5% To be competitive, the new Fellini issue will also have to offer 2.5 percent per quarter; so if the present value is to be $100, the dividend must be such that: Present value ϭ $100 ϭ C ϫ (1͞.025) C ϭ $2.50 (per quarter) xiv ros3062x_fm_Standard.indd xiv 2/9/07 6:02:18 PM
  15. 15. KEY TERMS Key Terms are printed in bold type and defined within the text the first time they appear. They also appear in the margins with definitions for easy location and identification by the student. See Chapter 4, page 91; Chapter 7, page 199 for examples. EXPLANATORY WEB LINKS These Web links are provided in the margins of the text. They are specifically selected to accompany text material and provide students and instructors with a quick way to check for additional information using the Internet. See Chapter 4, page 91; Chapter 5, page 123. p y y g p p, the big online retailer, is another example. At one time, Amazon’s motto seemed to be “growth at any cost.” Unfortunately, what really grew rapidly for the company were losses. Amazon refocused its business, explicitly sacrificing growth in the hope of achieving profitability. The plan seems to be working as turned a profit for the first time in the third quarter of 2003. As we discussed in Chapter 1, the appropriate goal is increasing the market value of the owners’ equity. Of course, if a firm is successful in doing this, then growth will usually result. Growth may thus be a desirable consequence of good decision making, but it is not an end unto itself. We discuss growth simply because growth rates are so commonly used in the planning process. As we will see, growth is a convenient means of summarizing various aspects of a firm’s financial and investment policies. Also, if we think of growth as growth in the market value of the equity in the firm, then goals of growth and increasing the market value of the equity in the firm are not all that different. You can find growth rates under the research links at and KEY EQUATIONS Called out in the text, key equations are identified by an equation number. The list in Appendix B shows the key equations by chapter, providing students with a convenient reference. For examples, see Chapter 4, page 97; Chapter 5, page 123. HIGHLIGHTED CONCEPTS Throughout the text, important ideas are pulled out and presented in a highlighted box—signaling to students that this material is particularly relevant and critical for their understanding. See Chapter 4, page 107. y q y Given values for all four of these, there is only one growth rate that can be achieved. This is an important point, so it bears restating: If a firm does not wish to sell new equity and its profit margin, dividend policy, financial policy, and total asset turnover (or capital intensity) are all fixed, then there is only one possible growth rate. As we described early in this chapter, one of the primary benefits of financial planning is that it ensures internal consistency among the firm’s various goals. The concept of the sustainable growth rate captures this element nicely. Also, we now see how a financial planning model can be used to test the feasibility of a planned growth rate. If sales are to grow at a rate higher than the sustainable growth rate, the firm must increase profit margins, increase total asset turnover, increase financial leverage, increase earnings retention, or sell new shares. xv ros3062x_fm_Standard.indd xv 2/9/07 6:02:20 PM
  16. 16. CHAPTER SUMMARY AND CONCLUSIONS Every chapter ends with a concise, but thorough, summary of the important ideas—helping students review the key points and providing closure to the chapter. See Chapter 4, page 111; Chapter 5, page 141. CHAPTER REVIEW AND SELF-TEST PROBLEMS 5.1 5.2 5.3 5.4 Calculating Future Values Assume you deposit $10,000 today in an account that pays 6 percent interest. How much will you have in five years? Calculating Present Values Suppose you have just celebrated your 19th birthday. A rich uncle has set up a trust fund for you that will pay you $150,000 when you turn 30. If the relevant discount rate is 9 percent, how much is this fund worth today? Calculating Rates of Return You’ve been offered an investment that will double your money in 10 years. What rate of return are you being offered? Check your answer using the Rule of 72. Calculating the Number of Periods You’ve been offered an investment that will pay you 9 percent per year. If you invest $15,000, how long until you have $30,000? How long until you have $45,000? CHAPTER REVIEW AND SELF-TEST PROBLEMS Appearing after the Summary and Conclusion, each chapter includes a Chapter Review and Self-Test Problem section. These questions and answers allow students to test their abilities in solving key problems related to the chapter content and provide instant reinforcement. See Chapter 5, page 141; Chapter 6, page 177. ANSWERS TO CHAPTER REVIEW AND SELF-TEST PROBLEMS 5.1 5.2 We need to calculate the future value of $10,000 at 6 percent for five years. The future value factor is: 1.065 ϭ 1.3382 The future value is thus $10,000 ϫ 1.3382 ϭ $13,382.26. We need the present value of $150,000 to be paid in 11 years at 9 percent. The discount factor is: 1͞1.0911 ϭ 1͞2.5804 ϭ .3875 The present value is thus about $58,130. CONCEPTS REVIEW AND CRITICAL THINKING QUESTIONS This successful end-of-chapter section facilitates your students’ knowledge of key principles, as well as intuitive understanding of the chapter concepts. A number of the questions relate to the chapter-opening vignette— reinforcing student critical-thinking skills and the learning of chapter material. For examples, see Chapter 6, page 180; Chapter 7, page 228. CONCEPTS REVIEW AND CRITICAL THINKING QUESTIONS 1. 2. 3. 4. 5. 6. 7. Annuity Factors There are four pieces to an annuity present value. What are they? Annuity Period As you increase the length of time involved, what happens to the present value of an annuity? What happens to the future value? Interest Rates What happens to the future value of an annuity if you increase the rate r? What happens to the present value? Present Value What do you think about the Tri-State Megabucks lottery discussed in the chapter advertising a $500,000 prize when the lump sum option is $250,000? Is it deceptive advertising? Present Value If you were an athlete negotiating a contract, would you want a big signing bonus payable immediately and smaller payments in the future, or vice versa? How about looking at it from the team’s perspective? Present Value Suppose two athletes sign 10-year contracts for $80 million. In one case, we’re told that the $80 million will be paid in 10 equal installments. In the other case, we’re told that the $80 million will be paid in 10 installments, but the installments will increase by 5 percent per year. Who got the better deal? APR and EAR Should lending laws be changed to require lenders to report EARs instead of APRs? Why or why not? xvi ros3062x_fm_Standard.indd xvi 2/9/07 6:02:22 PM
  17. 17. QUESTIONS AND PROBLEMS 1. 2. 3. 4. 5. 6. 7. 8. Interpreting Bond Yields Is the yield to maturity on a bond the same thing as the required return? Is YTM the same thing as the coupon rate? Suppose today a 10 percent coupon bond sells at par. Two years from now, the required return on the same bond is 8 percent. What is the coupon rate on the bond then? The YTM? Interpreting Bond Yields Suppose you buy a 7 percent coupon, 20-year bond today when it’s first issued. If interest rates suddenly rise to 15 percent, what happens to the value of your bond? Why? Bond Prices Carpenter, Inc., has 8 percent coupon bonds on the market that have 10 years left to maturity. The bonds make annual payments. If the YTM on these bonds is 9 percent, what is the current bond price? Bond Yields Linebacker Co. has 7 percent coupon bonds on the market with nine years left to maturity. The bonds make annual payments. If the bond currently sells for $1,080, what is its YTM? Coupon Rates Hawk Enterprises has bonds on the market making annual payments, with 16 years to maturity, and selling for $870. At this price, the bonds yield 7.5 percent. What must the coupon rate be on the bonds? Bond Prices Cutler Co. issued 11-year bonds a year ago at a coupon rate of 7.8 percent. The bonds make semiannual payments. If the YTM on these bonds is 8.6 percent, what is the current bond price? Bond Yields Ngata Corp. issued 12-year bonds 2 years ago at a coupon rate of 9.2 percent. The bonds make semiannual payments. If these bonds currently sell for 104 percent of par value, what is the YTM? Coupon Rates Wimbley Corporation has bonds on the market with 14.5 years to maturity, a YTM of 6.8 percent, and a current price of $1,136.50. The bonds make semiannual payments. What must the coupon rate be on these bonds? ros3062x_Ch07.indd 229 BASIC (Questions 1–14) END-OF-CHAPTER QUESTIONS AND PROBLEMS We have found that many students learn better when they have plenty of opportunity to practice; therefore, we provide extensive end-of-chapter questions and problems. The endof-chapter support greatly exceeds typical introductory textbooks. The questions and problems are segregated into three learning levels: Basic, Intermediate, and Challenge. All problems are fully annotated so that students and instructors can readily identify particular types. Answers to selected end-of-chapter material appear in Appendix C. Also, all problems are available in McGraw-Hill’s Homework Manager—see page xxi for details. See Chapter 6, page 181; Chapter 7, page 229. 2/8/07 4:36:33 AM WEB EXERCISES These end-of-chapter activities show students how to use and learn from the vast amount of financial resources available on the Internet. See examples in Chapter 6, page 190; Chapter 7, page 233. WEB EXERCISES 7.1 7.2 7.3 Bond Quotes You can find the current bond quotes for many companies at www. Go to the site and find the bonds listed for Georgia Pacific. What is the shortest-maturity bond listed for Georgia Pacific? What is the longestmaturity bond? What are the credit ratings for each bond? Do each of the bonds have the same credit rating? Why do you think this is? Yield Curves You can find information regarding the most current bond yields at Graph the yield curve for U.S. Treasury bonds. What is the general shape of the yield curve? What does this imply about the expected future inflation? Now graph the yield curve for AAA, AA, and A rated corporate bonds. Is the corporate yield curve the same shape as the Treasury yield curve? Why or why not? Default Premiums The St. Louis Federal Reserve Board has files listing historical interest rates on their Web site: Find the link for “FRED II” data, then “Interest Rates.” You will find listings for Moody’s Seasoned Aaa Corporate Bond Yield and Moody’s Seasoned Baa Corporate Bond Yield. A default premium can be calculated as the difference between the Aaa bond yield and the Baa bond yield. Calculate the default premium using these two bond indexes for the most recent 36 months. Is the default premium the same for every month? Why do you think this is? xvii ros3062x_fm_Standard.indd xvii 2/9/07 6:02:24 PM
  18. 18. NEW END-OF-CHAPTER CASES Located at the end of the book’s chapters, these minicases focus on real-life company situations that embody important corporate finance topics. Each case presents a new scenario, data, and a dilemma. Several questions at the end of each case require students to analyze and focus on all of the material they learned from each chapter. See examples in Chapter 6, page 191; Chapter 7, page 233. The MBA Decision Ben Bates graduated from college six years ago with a finance undergraduate degree. Although he is satisfied with his current job, his goal is to become an investment banker. He feels that an MBA degree would allow him to achieve this goal. After examining schools, he has narrowed his choice to either Wilton University or Mount Perry College. Although internships are encouraged by both schools, to get class credit for the internship, no salary can be paid. Other than internships, neither school will allow its students to work while enrolled in its MBA program. Ben currently works at the money management firm of Dewey and Louis. His annual salary at the firm is $50,000 per year, and his salary is expected to increase at 3 percent per year until retirement. He is currently 28 years old and expects to work for 35 more years. His current job includes a fully paid health insurance plan, and his current average tax rate is 26 percent. Ben has a savings account with enough money to cover the entire cost of his MBA program. The Ritter College of Business at Wilton University is one of the top MBA programs in the country. The MBA degree requires two years of full-time enrollment at the university. The annual tuition is $60,000, payable at the beginning of each school year. Books and other supplies are estimated to cost $2,500 per year. Ben expects that after graduation from Wilton, he will receive a job offer for about $95,000 per year, with a $15,000 signing bonus. The salary at this job will increase at 4 percent per year. Because of the higher salary, his average income tax rate will increase to 31 percent. The Bradley School of Business at Mount Perry College began its MBA program 16 years ago. The Bradley School is smaller and less well known than the Ritter College. Bradley offers an accelerated one-year program, with a tuition cost of $75,000 to be paid upon matriculation. Books and other supplies for the program are expected to cost $3,500. Ben thinks that he will receive an offer of $78,000 per year upon graduation, with a $10,000 signing bonus. The salary at this job will increase at 3.5 percent per year. His average tax rate at this level of income will be 29 percent. Both schools offer a health insurance plan that will cost $3,000 per year, payable at the beginning of the year. Ben also estimates that room and board expenses will cost $20,000 per year at both schools. The appropriate discount rate is 6.5 percent. 1. How does Ben’s age affect his decision to get an MBA? 2. What other, perhaps nonquantifiable, factors affect Ben’s decision to get an MBA? 3. Assuming all salaries are paid at the end of each year, what is the best option for Ben from a strictly financial standpoint? 4. Ben believes that the appropriate analysis is to calculate the future value of each option. How would you evaluate this statement? 5. What initial salary would Ben need to receive to make him indifferent between attending Wilton University and staying in his current position? 6. Visit us at MINICASE Suppose, instead of being able to pay cash for his MBA, Ben must borrow the money. The current borrowing rate is 5.4 percent. How would this affect his decision? xviii ros3062x_fm_Standard.indd xviii 2/9/07 6:02:26 PM
  19. 19. Comprehensive Teaching and Learning Package CHAPTER 1 Chapter Title Goes Here on Recto Page xix This edition of Fundamentals has more options than ever in terms of the textbook, instructor supplements, student supplements, and multimedia products. Mix and match to create a package that is perfect for your course! TEXTBOOK As with the previous editions, we are offering two versions of this text, both of which are packaged with an exciting student CD-ROM (see description under “Student Supplements”), • Standard Edition (22 Chapters) • Alternate Edition (26 Chapters) INSTRUCTOR SUPPLEMENTS Annotated Instructor’s Edition (AIE) ISBN 007328212X All your teaching resources are tied together here! This handy resource contains extensive references to the Instructor’s Manual regarding lecture tips, ethics notes, Internet references, international notes, and the availability of teaching PowerPoint slides. The lecture tips vary in content and purpose—providing an alternative perspective on a subject, suggesting important points to be stressed, giving further examples, or recommending other readings. The ethics notes present background on topics that motivate classroom discussion of finance-related ethical issues. Other annotations include notes for the Real-World Tips, Concept Questions, Self-Test Problems, End-of-Chapter Problems, Videos, and answers to the end-ofchapter problems. Instructor’s CD-ROM ISBN 0073282138 Keep all the supplements in one place! This CD contains all the necessary supplements—Instructor’s Manual, Solutions, Test Bank, Computerized Test Bank, and PowerPoint—all in one useful product in an electronic format. • Instructor’s Manual (IM) prepared by Kent Ragan, Missouri State University and Joseph Smolira, Belmont University A great place to find new lecture ideas! The IM has three main sections. The first section contains a chapter outline and other lecture materials designed for use with the Annotated Instructor’s Edition. The annotated outline for each chapter includes lecture tips, real-world tips, ethics notes, suggested PowerPoint slides, and, when appropriate, a video synopsis. Detailed solutions for all end-of-chapter problems appear in section two. • Test Bank prepared by Kay Johnson, Penn State University—Erie Great format for a better testing process! All questions closely link with the text material. Each chapter is divided into four parts. Part I contains questions that test the understanding of the key terms in the book. Part II includes questions patterned after the learning objectives, concept questions, chapteropening vignettes, boxes, and highlighted phrases. Part III contains multiple-choice and true/false problems patterned after the end-of-chapter questions, in basic, intermediate, and challenge levels. Part IV provides essay questions to test problem-solving skills and more advanced understanding of concepts. Also included are ready-made quizzes to hand out in class. xix ros3062x_fm_Standard.indd xix 2/9/07 6:02:27 PM
  20. 20. • Computerized Test Bank (Windows) Create your own tests in a snap! These additional questions are found in a computerized test bank utilizing McGraw-Hill’s EZ Test testing software to quickly create customized exams. This user-friendly program allows instructors to sort questions by format; edit existing questions or add new ones; and scramble questions for multiple versions of the same test. • PowerPoint Presentation System prepared by Kent Ragan, Missouri State University Customize our content for your course! This presentation has been thoroughly revised to include more lecture-oriented slides, as well as exhibits and examples both from the book and from outside sources. Applicable slides have Web links that take you directly to specific Internet sites, or a spreadsheet link to show an example in Excel. You can also go to the Notes Page function for more tips in presenting the slides. If you already have PowerPoint installed on your PC, you have the ability to edit, print, or rearrange the complete presentation to meet your specific needs. Videos (DVD Format) ISBN 0073282111 Current set of videos on hot topics! McGraw-Hill/Irwin produced a series of finance videos that are 10-minute case studies on topics such as Financial Markets, Careers, Rightsizing, Capital Budgeting, EVA (Economic Value Added), Mergers and Acquisitions, and International Finance. ONLINE SUPPORT Online learning center at The Online Learning Center (OLC) contains FREE access to additional Web-based study and teaching aids created for this text, such as: • Student Support A great resource for those seeking additional practice, students can access self-grading quizzes, Excel template problems, electronic flashcards, self-study software, Web Exercises, links to Corporate Finance Online questions, Finance Around the World problems, timely articles, and much more to help master the fundamentals of corporate finance! • Teaching Support Along with having access to all of the same material your students can view on the book’s OLC, you also have password protected access to the Instructor’s Manual, solutions to end-of-chapter problems and Excel, Instructor’s PowerPoint, Excel Template Solutions, Video clips, Video projects and questions, and teaching notes to Corporate Finance Online, a Web extension with additional exercises and projects for your course. • McGraw-Hill Investments Trader Students receive free access to this Web-based portfolio simulation with a hypothetical $100,000 brokerage account to buy and sell stocks and mutual funds. Students can use the real data found at this site in conjunction with the chapters on investments. They can also compete against students around the United States. This site is powered by Stock-Trak, the leading provider of investment simulation services to the academic community. xx ros3062x_fm_Standard.indd xx 2/9/07 6:02:27 PM
  21. 21. ENHANCED CARTRIDGES Enhanced WebCT and Blackboard course cartridges allow instructors to manage their course and administer online examinations. Some of the new features include: • Narrated PowerPoint Each chapter’s slides follow the chapter topics and provide steps and explanations for how to solve those topics using real-life examples. Knowing that each student learns differently, a quick click on each slide and the slide will “talk through” its contents with students! Students can view these slides via computer or download them onto their video iPod (see details below). • Interactive FinSims Each module highlights a key concept of corporate finance from the book and simulates how to solve it, asking the student to input certain variables. This hands-on approach guides students through difficult and important corporate finance topics. • iPod Content Harness the power of one of the most popular technology tools students use today, the Apple iPod®. Our innovative approach enables students to download Narrated PowerPoints and quizzes right into their iPod and take learning materials with them wherever they go. This makes review and study time as easy as putting on headphones! • Chapter Overviews Concise recap of what students should learn from each chapter. A great reading prep assignment. • Pretest and Posttest Question Banks Administer comprehensive and chapter-specific pretest and posttests to evaluate student understanding. • Online Glossary Key terms and their definitions in a ready to use format. Distribute to students for a study tool, or mix and match to create a quiz. Ask your McGraw-Hill representative for more details about Enhanced Cartridges today! McGraw-Hill’s Homework Manager and Homework Manager Plus Are you looking for a way to spend less time grading and to have more flexibility with the problems you assign as homework and tests? McGraw-Hill’s Homework Manager is an exciting new package option developed for this text! Homework Manager is a Web-based tool for instructors and students for delivering, answering, and grading end-of-chapter problems and tests, and providing a limitless supply of self-graded practice for students. All of the book’s end-of-chapter Questions and Problems are loaded into Homework Manager, and instructors can choose to assign the exact problems as stated in the book, or algorithmic versions of them so each student has a unique set of variables for the problems. You create the assignments and control parameters such as do you want your students to receive hints, is this a graded assignment or practice, etc. The test bank is also available in Homework Manager, giving you the ability to use those questions for online tests. Both the problems and the tests are automatically graded and the results are stored in a private grade book, which is created when you set up your class. Detailed results let you see at a glance how each student does on an assignment or an individual problem—you can even see how many tries it xxi ros3062x_fm_Standard.indd xxi 2/9/07 9:54:28 PM
  22. 22. took them to solve it. If you order this special package, students will receive a Homework Manager User’s Guide and an access code packaged with their text. There is also an enhanced version of McGraw-Hill’s Homework Manager through the Homework Manager Plus package option. If you order the text packaged with Homework Manager Plus, your students will receive Homework Manager as described above, but with an integrated online text included. When students are in Homework Manager and need more help to solve a problem, there will be a link that takes them to the section of the text online that explains the concept they are struggling with. All of McGraw-Hill’s media assets, such as videos, narrated lectures, and additional online quizzing, are also integrated at the appropriate places of the online text to provide students with a full learning experience. If you order this special package, students will receive the Homework Manager Plus card packaged with their text, which gives them access to all of these products. McGraw-Hill’s Homework Manager is powered by Brownstone. AVAILABLE FOR PURCHASE & PACKAGING Student Problem Manual ISBN 0073282154 prepared by Thomas Eyssell, University of Missouri—St. Louis Need additional reinforcement of the concepts? This valuable resource provides students with additional problems for practice. Each chapter begins with Concepts for Review, followed by Chapter Highlights. These re-emphasize the key terms and concepts in the chapter. A short Concept Test, averaging 10 questions and answers, appears next. Each chapter concludes with additional problems for the student to review. Answers to these problems appear at the end of the Student Problem Manual. BusinessWeek Subscription Your students can subscribe to BusinessWeek for a specially priced rate of $20.00 in addition to the price of the text. Students will receive a passcode card shrink-wrapped with their new text by ordering this special package. The card directs students to a Web site where they enter the code and then gain access to BusinessWeek’s registration page to enter address info and set up their print and online subscription for a 15-week period. Financial Times Subscription Your students can subscribe to the Financial Times for 15 weeks at a specially priced rate of $10 in addition to the price of the text by ordering this special package. Students will receive a subscription card shrink-wrapped with their new text to fill in and send to the Financial Times to start receiving their subscription. Instructors, once you order, make sure you contact your sales representative to receive a complimentary one-year subscription. xxii ros3062x_fm_Standard.indd xxii 2/9/07 6:02:28 PM
  23. 23. Acknowledgments To borrow a phrase, writing an introductory finance textbook is easy—all you do is sit down at a word processor and open a vein. We never would have completed this book without the incredible amount of help and support we received from literally hundreds of our colleagues, students, editors, family members, and friends. We would like to thank, without implicating, all of you. Clearly, our greatest debt is to our many colleagues (and their students) who, like us, wanted to try an alternative to what they were using and made the decision to change. Needless to say, without this support, we would not be publishing an eighth edition! A great many of our colleagues read the drafts of our first and subsequent editions. The fact that this book has so little in common with our earliest drafts, along with the many changes and improvements we have made over the years, is a reflection of the value we placed on the many comments and suggestions that we received. To the following reviewers, then, we are grateful for their many contributions: Ibrahim Affeneh Sung C. Bae Robert Benecke Gary Benesh Scott Besley Sanjai Bhaghat Vigdis W. Boasson Elizabeth Booth Denis Boudreaux William Brent Ray Brooks Charles C. Brown Mary Chaffin Fan Chen Raju Chenna Barbara J. Childs Charles M. Cox Natalya Delcoure Michael Dorigan David A. Dumpe Michael Dunn Alan Eastman Adrian C. Edwards Steve Engel Angelo V. Esposito Cheri Etling Thomas H. Eyssell Michael Ferguson Deborah Ann Ford Jim Forjan Micah Frankel Jennifer R. Frazier Deborah M. Giarusso Devra Golbe A. Steven Graham Darryl E. J. Gurley Wendy D. Habegger David Harraway John M. Harris, Jr. R. Stevenson Hawkey Delvin D. Hawley Robert C. Higgins Karen Hogan Steve Isberg James Jackson Pankaj Jain James M. Johnson Randy Jorgensen Jarl G. Kallberg Terry Keasler David N. Ketcher Jim Keys Kee Kim Robert Kleinman David Kuipers Morris A. Lamberson Qin Lan Adam Y.C. Lei George Lentz John Lightstone Jason Lin Robert Lutz Pawan Madhogarhia Timothy Manuel David G. Martin Dubos J. Masson John McDougald Bob McElreath Gordon Melms Richard R. Mendenhall Wayne Mikkelson Lalatendu Misra Karlyn Mitchell Sunil Mohanty Scott Moore Frederick H. Mull Michael J. Murray Randy Nelson Bulent Parker Megan Partch Samuel Penkar Pamela P. Peterson Robert Phillips George A. Racette Charu G. Raheja Narendar V. Rao Russ Ray Ron Reiber Thomas Rietz Jay R. Ritter Ricardo J. Rodriguez Kenneth Roskelley Gary Sanger xxiii ros3062x_fm_Standard.indd xxiii 2/9/07 6:02:28 PM
  24. 24. Travis Sapp Martha A. Schary Robert Schwebach Roger Severns Dilip K. Shome Neil W. Sicherman Timothy Smaby Michael F. Spivey Vic Stanton Charlene Sullivan George S. Swales, Jr. Philip Swensen Philip Swicegood John G. Thatcher Harry Thiewes A. Frank Thompson Joseph Trefzger Michael R. Vetsuypens Joe Walker Jun Wang James Washam Alan Weatherford Marsha Weber Jill Wetmore Mark White Annie Wong David J. Wright Steve B. Wyatt Tung-Hsiao Yang Morris Yarmish Michael Young Mei Zhang J. Kenton Zumwalt Tom Zwirlein Several of our most respected colleagues contributed original essays for this edition, which are entitled “In Their Own Words,” and appear in selected chapters. To these individuals we extend a special thanks: Edward I. Altman New York University Fischer Black Robert C. Higgins University of Washington Roger Ibbotson Yale University, Ibbotson Associates Erik Lie University of Iowa Robert C. Merton Harvard University Merton H. Miller Jay R. Ritter University of Florida Richard Roll University of California at Los Angeles Jeremy Siegel University of Pennsylvania Bennett Stewart Stern Stewart & Co. Samuel C. Weaver Lehigh University We owe a special thanks to Kent Ragan of Missouri State University. Kent worked on the many supplements that accompany this book, including the Instructor’s Manual and PowerPoint Presentation System. Kent also worked with us to develop the Annotated Instructor’s Edition of the text which, along with the Instructor’s Manual, contains a wealth of teaching notes. We also thank Joseph C. Smolira of Belmont University for his work on this edition. Joe worked closely with us to develop portions of the Instructor’s Manual, along with the many vignettes and real-world examples we have added to this edition. We owe a special thank you to Thomas H. Eyssell of the University of Missouri. Tom has continued his exceptional work on our supplements by creating the Student Problem Manual for this edition. In addition, we would like to thank Kay Johnson, Penn State University—Erie, for creating the self-study questions, as well as revising, reorganizing, and expanding the very extensive testbank available with Fundamentals and creating the Student PowerPoints. The following University of Kentucky doctoral students did outstanding work on this edition of Fundamentals: Hinh Khieu, T. J. Phillips, and Qun Wu. To them fell the unenviable task of technical proofreading, and in particular, careful checking of each calculation throughout the text and Instructor’s Manual. Finally, in every phase of this project, we have been privileged to have had the complete and unwavering support of a great organization, McGraw-Hill/Irwin. We especially thank the McGraw-Hill/Irwin sales xxiv ros3062x_fm_Standard.indd xxiv 2/9/07 6:02:29 PM
  25. 25. organization. The suggestions they provide, their professionalism in assisting potential adopters, and the service they provide to current adopters have been a major factor in our success. We are deeply grateful to the select group of professionals who served as our development team on this edition: Michele Janicek, Executive Sponsoring Editor; Jennifer Rizzi, Development Editor II; Julie Phifer, Marketing Manager; Christine Vaughan, Lead Project Manager; Kami Carter, Senior Designer; and Carol Bielski, Lead Production Supervisor. Others at McGraw-Hill/Irwin, too numerous to list here, have improved the book in countless ways. Throughout the development of this edition, we have taken great care to discover and eliminate errors. Our goal is to provide the best textbook available on the subject. To ensure that future editions are error-free, we gladly offer $10 per arithmetic error to the first individual reporting it as a modest token of our appreciation. More than this, we would like to hear from instructors and students alike. Please write and tell us how to make this a better text. Forward your comments to: Dr. Brad Jordan, c/o Editorial—Finance, McGraw-Hill/Irwin, 1333 Burr Ridge Parkway, Burr Ridge, IL 60527 or visit us online at Stephen A. Ross Randolph W. Westerfield Bradford D. Jordan xxv ros3062x_fm_Standard.indd xxv 2/9/07 6:02:29 PM
  27. 27. Contents PART 1 Overview of Corporate Finance CHAPTER 1 INTRODUCTION TO CORPORATE FINANCE 1.1 1.2 1.3 1.4 1.5 1.6 CHAPTER 2 1 Corporate Finance and the Financial Manager 2 What Is Corporate Finance? 2 The Financial Manager 2 Financial Management Decisions 2 Capital Budgeting 2 Capital Structure 3 Working Capital Management 4 Conclusion 4 Forms of Business Organization 4 Sole Proprietorship 5 Partnership 5 Corporation 6 A Corporation by Another Name . . . 7 The Goal of Financial Management 8 Possible Goals 8 The Goal of Financial Management 8 A More General Goal 9 Sarbanes–Oxley 10 The Agency Problem and Control of the Corporation 11 Agency Relationships 11 Management Goals 11 Do Managers Act in the Stockholders’ Interests? 12 Managerial Compensation 12 Control of the Firm 12 Conclusion 13 Stakeholders 14 Financial Markets and the Corporation 14 Cash Flows to and from the Firm 14 Primary versus Secondary Markets 14 Primary Markets 15 Secondary Markets 15 Dealer versus Auction Markets 15 Trading in Corporate Securities 16 Listing 16 Summary and Conclusions 17 PART 2 2.1 2.2 2.3 2.4 2.5 The Balance Sheet 22 Assets: The Left Side 22 Liabilities and Owners’ Equity: The Right Side 22 Net Working Capital 23 Liquidity 24 Debt versus Equity 25 Market Value versus Book Value 25 The Income Statement 26 GAAP and the Income Statement 27 Noncash Items 28 Time and Costs 28 Taxes 30 Corporate Tax Rates 30 Average versus Marginal Tax Rates 30 Cash Flow 32 Cash Flow from Assets 33 Operating Cash Flow 33 Capital Spending 34 Change in Net Working Capital 34 Conclusion 35 A Note about “Free” Cash Flow 35 Cash Flow to Creditors and Stockholders 35 Cash Flow to Creditors 35 Cash Flow to Stockholders 35 An Example: Cash Flows for Dole Cola 37 Operating Cash Flow 37 Net Capital Spending 38 Change in NWC and Cash Flow from Assets 38 Cash Flow to Stockholders and Creditors 38 Summary and Conclusions 39 Financial Statements and Long-Term Financial Planning CHAPTER 3 WORKING WITH FINANCIAL STATEMENTS 48 3.1 FINANCIAL STATEMENTS, TAXES, AND CASH FLOW 21 Cash Flow and Financial Statements: A Closer Look 49 Sources and Uses of Cash 49 The Statement of Cash Flows 51 3.2 Standardized Financial Statements 53 Common-Size Statements 53 Common-Size Balance Sheets 53 Common-Size Income Statements 54 Common-Size Statements of Cash Flows 55 Common–Base Year Financial Statements: Trend Analysis 55 xxvii ros3062x_fm_Standard.indd xxvii 2/9/07 6:02:30 PM
  28. 28. xxviii 3.3 3.4 3.5 3.6 Contents Combined Common-Size and Base Year Analysis 55 Ratio Analysis 56 Short-Term Solvency, or Liquidity, Measures 57 Current Ratio 57 The Quick (or Acid-Test) Ratio 58 Other Liquidity Ratios 59 Long-Term Solvency Measures 59 Total Debt Ratio 59 A Brief Digression: Total Capitalization versus Total Assets 60 Times Interest Earned 60 Cash Coverage 61 Asset Management, or Turnover, Measures 61 Inventory Turnover and Days’ Sales in Inventory 61 Receivables Turnover and Days’ Sales in Receivables 62 Asset Turnover Ratios 63 Profitability Measures 63 Profit Margin 64 Return on Assets 64 Return on Equity 64 Market Value Measures 65 Price–Earnings Ratio 65 Price–Sales Ratio 65 Market-to-Book Ratio 66 Conclusion 66 The Du Pont Identity 67 A Closer Look at ROE 67 An Expanded Du Pont Analysis 69 Using Financial Statement Information 71 Why Evaluate Financial Statements? 71 Internal Uses 71 External Uses 71 Choosing a Benchmark 71 Time Trend Analysis 71 Peer Group Analysis 72 Problems with Financial Statement Analysis 76 Summary and Conclusions 77 PART 3 LONG-TERM FINANCIAL PLANNING AND GROWTH 89 4.1 4.2 4.3 4.4 4.5 4.6 What Is Financial Planning? 90 Growth as a Financial Management Goal 90 Dimensions of Financial Planning 91 What Can Planning Accomplish? 92 Examining Interactions 92 Exploring Options 92 Avoiding Surprises 92 Ensuring Feasibility and Internal Consistency 92 Conclusion 92 Financial Planning Models: A First Look 93 A Financial Planning Model: The Ingredients 93 Sales Forecast 93 Pro Forma Statements 93 Asset Requirements 94 Financial Requirements 94 The Plug 94 Economic Assumptions 94 A Simple Financial Planning Model 94 The Percentage of Sales Approach 96 The Income Statement 96 The Balance Sheet 97 A Particular Scenario 99 An Alternative Scenario 100 External Financing and Growth 101 EFN and Growth 101 Financial Policy and Growth 105 The Internal Growth Rate 105 The Sustainable Growth Rate 105 Determinants of Growth 107 A Note about Sustainable Growth Rate Calculations 108 Some Caveats Regarding Financial Planning Models 110 Summary and Conclusions 111 Valuation of Future Cash Flows CHAPTER 5 INTRODUCTION TO VALUATION: THE TIME VALUE OF MONEY 121 5.1 CHAPTER 4 Future Value and Compounding 122 Investing for a Single Period 122 Investing for More Than One Period 122 A Note about Compound Growth 128 ros3062x_fm_Standard.indd xxviii 5.2 5.3 5.4 Present Value and Discounting 129 The Single-Period Case 129 Present Values for Multiple Periods 130 More about Present and Future Values 133 Present versus Future Value 133 Determining the Discount Rate 134 Finding the Number of Periods 138 Summary and Conclusions 141 2/9/07 6:02:31 PM
  29. 29. Contents CHAPTER 6 DISCOUNTED CASH FLOW VALUATION 6.1 6.2 6.3 6.4 6.5 146 Future and Present Values of Multiple Cash Flows 147 Future Value with Multiple Cash Flows 147 Present Value with Multiple Cash Flows 150 A Note about Cash Flow Timing 153 Valuing Level Cash Flows: Annuities and Perpetuities 154 Present Value for Annuity Cash Flows 154 Annuity Tables 156 Finding the Payment 157 Finding the Rate 159 Future Value for Annuities 161 A Note about Annuities Due 162 Perpetuities 162 Growing Annuities and Perpetuities 164 Comparing Rates: The Effect of Compounding Effective Annual Rates and Compounding 165 Calculating and Comparing Effective Annual Rates 166 EARs and APRs 168 Taking It to the Limit: A Note about Continuous Compounding 169 Loan Types and Loan Amortization 171 Pure Discount Loans 171 Interest-Only Loans 171 Amortized Loans 172 Summary and Conclusions 177 7.5 7.6 7.7 7.8 165 STOCK VALUATION 8.1 CHAPTER 7 7.1 7.2 7.3 7.4 192 Bonds and Bond Valuation 193 Bond Features and Prices 193 Bond Values and Yields 193 Interest Rate Risk 197 Finding the Yield to Maturity: More Trial and Error 198 More about Bond Features 203 Is It Debt or Equity? 203 Long-Term Debt: The Basics 203 The Indenture 205 Terms of a Bond 205 Security 206 Seniority 206 Repayment 206 The Call Provision 207 Protective Covenants 207 Bond Ratings 208 Some Different Types of Bonds 209 Government Bonds 209 ros3062x_fm_Standard.indd xxix Zero-Coupon Bonds 210 Floating-Rate Bonds 211 Other Types of Bonds 212 Bond Markets 214 How Bonds Are Bought and Sold 214 Bond Price Reporting 216 A Note about Bond Price Quotes 219 Inflation and Interest Rates 219 Real versus Nominal Rates 219 The Fisher Effect 220 Inflation and Present Values 221 Determinants of Bond Yields 222 The Term Structure of Interest Rates 222 Bond Yields and the Yield Curve: Putting It All Together 225 Conclusion 226 Summary and Conclusions 227 CHAPTER 8 8.2 INTEREST RATES AND BOND VALUATION xxix 8.3 8.4 234 Common Stock Valuation 235 Cash Flows 235 Some Special Cases 237 Zero Growth 237 Constant Growth 237 Nonconstant Growth 240 Two-Stage Growth 242 Components of the Required Return 243 Some Features of Common and Preferred Stocks 245 Common Stock Features 245 Shareholder Rights 245 Proxy Voting 246 Classes of Stock 247 Other Rights 247 Dividends 248 Preferred Stock Features 248 Stated Value 248 Cumulative and Noncumulative Dividends 248 Is Preferred Stock Really Debt? 249 The Stock Markets 249 Dealers and Brokers 250 Organization of the NYSE 250 Members 250 Operations 251 Floor Activity 251 NASDAQ Operations 252 NASDAQ Participants 253 Stock Market Reporting 254 Summary and Conclusions 256 2/9/07 6:02:32 PM
  30. 30. xxx Contents PART 4 Capital Budgeting CHAPTER 9 10.4 NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA 264 9.1 9.2 9.3 9.4 9.5 9.6 9.7 9.8 Net Present Value 265 The Basic Idea 265 Estimating Net Present Value 266 The Payback Rule 269 Defining the Rule 269 Analyzing the Rule 270 Redeeming Qualities of the Rule 271 Summary of the Rule 272 The Discounted Payback 272 The Average Accounting Return 275 The Internal Rate of Return 277 Problems with the IRR 281 Nonconventional Cash Flows 281 Mutually Exclusive Investments 283 Redeeming Qualities of the IRR 285 The Modified Internal Rate of Return (MIRR) 286 Method #1: The Discounting Approach 286 Method #2: The Reinvestment Approach 286 Method #3: The Combination Approach 286 MIRR or IRR: Which Is Better? 287 The Profitability Index 287 The Practice of Capital Budgeting 288 Summary and Conclusions 291 10.5 10.6 10.7 More about Project Cash Flow 309 A Closer Look at Net Working Capital 309 Depreciation 312 Modified ACRS Depreciation (MACRS) 312 Book Value versus Market Value 313 An Example: The Majestic Mulch and Compost Company (MMCC) 315 Operating Cash Flows 315 Change in NWC 315 Capital Spending 317 Total Cash Flow and Value 317 Conclusion 318 Alternative Definitions of Operating Cash Flow 318 The Bottom-Up Approach 319 The Top-Down Approach 320 The Tax Shield Approach 320 Conclusion 321 Some Special Cases of Discounted Cash Flow Analysis 321 Evaluating Cost-Cutting Proposals 321 Setting the Bid Price 323 Evaluating Equipment Options with Different Lives 325 Summary and Conclusions 327 CHAPTER 11 PROJECT ANALYSIS AND EVALUATION CHAPTER 10 MAKING CAPITAL INVESTMENT DECISIONS 10.1 10.2 10.3 11.1 302 Project Cash Flows: A First Look 303 Relevant Cash Flows 303 The Stand-Alone Principle 303 Incremental Cash Flows 303 Sunk Costs 304 Opportunity Costs 304 Side Effects 304 Net Working Capital 305 Financing Costs 305 Other Issues 305 Pro Forma Financial Statements and Project Cash Flows 306 Getting Started: Pro Forma Financial Statements 306 Project Cash Flows 307 Project Operating Cash Flow 307 Project Net Working Capital and Capital Spending 308 Projected Total Cash Flow and Value 308 ros3062x_fm_Standard.indd xxx 11.2 11.3 337 Evaluating NPV Estimates 338 The Basic Problem 338 Projected versus Actual Cash Flows 338 Forecasting Risk 338 Sources of Value 339 Scenario and Other What-If Analyses 340 Getting Started 340 Scenario Analysis 341 Sensitivity Analysis 343 Simulation Analysis 344 Break-Even Analysis 344 Fixed and Variable Costs 345 Variable Costs 345 Fixed Costs 346 Total Costs 346 Accounting Break-Even 348 Accounting Break-Even: A Closer Look 348 Uses for the Accounting Break-Even 350 2/9/07 6:02:33 PM
  31. 31. Contents 11.4 Operating Cash Flow, Sales Volume, and BreakEven 350 Accounting Break-Even and Cash Flow 351 The Base Case 351 Calculating the Break-Even Level 351 Payback and Break-Even 352 Sales Volume and Operating Cash Flow 352 Cash Flow, Accounting, and Financial Break-Even Points 352 Accounting Break-Even Revisited 353 Cash Break-Even 353 Financial Break-Even 354 Conclusion 354 PART 5 11.5 11.6 11.7 xxxi Operating Leverage 355 The Basic Idea 355 Implications of Operating Leverage 356 Measuring Operating Leverage 356 Operating Leverage and Break-Even 357 Capital Rationing 358 Soft Rationing 358 Hard Rationing 359 Summary and Conclusions 359 Risk and Return CHAPTER 12 CHAPTER 13 SOME LESSONS FROM CAPITAL MARKET HISTORY 368 RETURN, RISK, AND THE SECURITY MARKET LINE 403 12.1 13.1 12.2 12.3 12.4 12.5 12.6 12.7 Returns 369 Dollar Returns 369 Percentage Returns 371 The Historical Record 373 A First Look 373 A Closer Look 375 Average Returns: The First Lesson 379 Calculating Average Returns 379 Average Returns: The Historical Record 379 Risk Premiums 380 The First Lesson 380 The Variability of Returns: The Second Lesson 381 Frequency Distributions and Variability 381 The Historical Variance and Standard Deviation 382 The Historical Record 384 Normal Distribution 384 The Second Lesson 386 Using Capital Market History 386 More about Average Returns 387 Arithmetic versus Geometric Averages 387 Calculating Geometric Average Returns 388 Arithmetic Average Return or Geometric Average Return? 390 Capital Market Efficiency 391 Price Behavior in an Efficient Market 391 The Efficient Markets Hypothesis 392 Some Common Misconceptions about the EMH 393 The Forms of Market Efficiency 395 Summary and Conclusions 396 ros3062x_fm_Standard.indd xxxi 13.2 13.3 13.4 13.5 13.6 13.7 Expected Returns and Variances 404 Expected Return 404 Calculating the Variance 406 Portfolios 407 Portfolio Weights 408 Portfolio Expected Returns 408 Portfolio Variance 409 Announcements, Surprises, and Expected Returns 411 Expected and Unexpected Returns 411 Announcements and News 411 Risk: Systematic and Unsystematic 413 Systematic and Unsystematic Risk 413 Systematic and Unsystematic Components of Return 413 Diversification and Portfolio Risk 414 The Effect of Diversification: Another Lesson from Market History 414 The Principle of Diversification 415 Diversification and Unsystematic Risk 416 Diversification and Systematic Risk 417 Systematic Risk and Beta 417 The Systematic Risk Principle 418 Measuring Systematic Risk 418 Portfolio Betas 420 The Security Market Line 421 Beta and the Risk Premium 421 The Reward-to-Risk Ratio 422 The Basic Argument 423 The Fundamental Result 424 The Security Market Line 426 Market Portfolios 426 The Capital Asset Pricing Model 426 2/9/07 6:02:34 PM
  32. 32. xxxii xxxii 13.8 13.9 ContentsT 1 PA R Part Title Goes Here on Verso Page The SML and the Cost of Capital: A Preview The Basic Idea 428 The Cost of Capital 429 Summary and Conclusions 429 428 14.4 14.5 CHAPTER 14 OPTIONS AND CORPORATE FINANCE 14.1 14.2 14.3 439 14.6 Options: The Basics 440 Puts and Calls 440 Stock Option Quotations 440 Option Payoffs 444 Fundamentals of Option Valuation 446 Value of a Call Option at Expiration 446 The Upper and Lower Bounds on a Call Option’s Value 446 The Upper Bound 447 The Lower Bound 447 A Simple Model: Part I 448 The Basic Approach 448 A More Complicated Case 449 Four Factors Determining Option Values 450 Valuing a Call Option 451 A Simple Model: Part II 451 The Fifth Factor 452 A Closer Look 453 PART 6 14.7 14.8 Cost of Capital and Long-Term Financial Policy CHAPTER 15 COST OF CAPITAL 15.1 15.2 15.3 15.4 Employee Stock Options 454 ESO Features 454 ESO Repricing 455 ESO Backdating 455 Equity as a Call Option on the Firm’s Assets 456 Case I: The Debt Is Risk-Free 457 Case II: The Debt Is Risky 457 Options and Capital Budgeting 459 The Investment Timing Decision 459 Managerial Options 461 Contingency Planning 462 Options in Capital Budgeting: An Example 463 Strategic Options 464 Conclusion 464 Options and Corporate Securities 465 Warrants 465 The Difference between Warrants and Call Options 465 Earnings Dilution 466 Convertible Bonds 466 Features of a Convertible Bond 466 Value of a Convertible Bond 466 Other Options 468 The Call Provision on a Bond 468 Put Bonds 469 Insurance and Loan Guarantees 469 Summary and Conclusions 470 479 The Cost of Capital: Some Preliminaries 480 Required Return versus Cost of Capital 480 Financial Policy and Cost of Capital 480 The Cost of Equity 481 The Dividend Growth Model Approach 481 Implementing the Approach 481 Estimating g 482 Advantages and Disadvantages of the Approach The SML Approach 483 Implementing the Approach 484 Advantages and Disadvantages of the Approach The Costs of Debt and Preferred Stock 485 The Cost of Debt 485 The Cost of Preferred Stock 486 The Weighted Average Cost of Capital 487 The Capital Structure Weights 487 ros3062x_fm_Standard.indd xxxii 15.5 483 484 15.6 15.7 Taxes and the Weighted Average Cost of Capital 488 Calculating the WACC for Eastman Chemical 489 Eastman’s Cost of Equity 489 Eastman’s Cost of Debt 491 Eastman’s WACC 492 Solving the Warehouse Problem and Similar Capital Budgeting Problems 494 Performance Evaluation: Another Use of the WACC 496 Divisional and Project Costs of Capital 497 The SML and the WACC 497 Divisional Cost of Capital 498 The Pure Play Approach 498 The Subjective Approach 499 Flotation Costs and the Weighted Average Cost of Capital 501 The Basic Approach 501 Flotation Costs and NPV 502 Internal Equity and Flotation Costs 504 Summary and Conclusions 504 2/9/07 6:02:35 PM
  33. 33. Contents CHAPTER 16 RAISING CAPITAL 513 16.1 The Financing Life Cycle of a Firm: Early-Stage Financing and Venture Capital 514 Venture Capital 514 Some Venture Capital Realities 515 Choosing a Venture Capitalist 515 Conclusion 516 16.2 Selling Securities to the Public: The Basic Procedure 516 16.3 Alternative Issue Methods 517 16.4 Underwriters 519 Choosing an Underwriter 520 Types of Underwriting 520 Firm Commitment Underwriting 520 Best Efforts Underwriting 520 Dutch Auction Underwriting 521 The Aftermarket 521 The Green Shoe Provision 522 Lockup Agreements 522 The Quiet Period 522 16.5 IPOs and Underpricing 523 IPO Underpricing: The 1999–2000 Experience 523 Evidence on Underpricing 525 Why Does Underpricing Exist? 526 16.6 New Equity Sales and the Value of the Firm 529 16.7 The Costs of Issuing Securities 530 The Costs of Selling Stock to the Public 530 The Costs of Going Public: The Case of Symbion 532 16.8 Rights 534 The Mechanics of a Rights Offering 534 Number of Rights Needed to Purchase a Share 535 The Value of a Right 536 Ex Rights 538 The Underwriting Arrangements 539 Effects on Shareholders 539 16.9 Dilution 540 Dilution of Proportionate Ownership 540 Dilution of Value: Book versus Market Values 540 A Misconception 541 The Correct Arguments 542 16.10 Issuing Long-Term Debt 542 16.11 Shelf Registration 543 16.12 Summary and Conclusions 544 FINANCIAL LEVERAGE AND CAPITAL STRUCTURE POLICY 551 The Capital Structure Question ros3062x_fm_Standard.indd xxxiii Firm Value and Stock Value: An Example 552 Capital Structure and the Cost of Capital 553 17.2 The Effect of Financial Leverage 553 The Basics of Financial Leverage 553 Financial Leverage, EPS, and ROE: An Example 554 EPS versus EBIT 555 Corporate Borrowing and Homemade Leverage 556 17.3 Capital Structure and the Cost of Equity Capital 558 M&M Proposition I: The Pie Model 558 The Cost of Equity and Financial Leverage: M&M Proposition II 559 Business and Financial Risk 561 17.4 M&M Propositions I and II with Corporate Taxes 562 The Interest Tax Shield 563 Taxes and M&M Proposition I 563 Taxes, the WACC, and Proposition II 564 Conclusion 565 17.5 Bankruptcy Costs 567 Direct Bankruptcy Costs 568 Indirect Bankruptcy Costs 568 17.6 Optimal Capital Structure 569 The Static Theory of Capital Structure 569 Optimal Capital Structure and the Cost of Capital 570 Optimal Capital Structure: A Recap 571 Capital Structure: Some Managerial Recommendations 573 Taxes 573 Financial Distress 573 17.7 The Pie Again 573 The Extended Pie Model 574 Marketed Claims versus Nonmarketed Claims 575 17.8 The Pecking-Order Theory 575 Internal Financing and the Pecking Order 575 Implications of the Pecking Order 576 17.9 Observed Capital Structures 577 17.10 A Quick Look at the Bankruptcy Process 579 Liquidation and Reorganization 579 Bankruptcy Liquidation 579 Bankruptcy Reorganization 580 Financial Management and the Bankruptcy Process 581 Agreements to Avoid Bankruptcy 582 17.11 Summary and Conclusions 582 CHAPTER 18 CHAPTER 17 17.1 xxxiii 552 DIVIDENDS AND DIVIDEND POLICY 18.1 590 Cash Dividends and Dividend Payment Cash Dividends 591 591 2/9/07 6:02:36 PM
  34. 34. xxxiv 18.2 18.3 18.4 18.5 Contents Standard Method of Cash Dividend Payment 592 Dividend Payment: A Chronology 592 More about the Ex-Dividend Date 593 Does Dividend Policy Matter? 594 An Illustration of the Irrelevance of Dividend Policy 595 Current Policy: Dividends Set Equal to Cash Flow 595 Alternative Policy: Initial Dividend Greater Than Cash Flow 595 Homemade Dividends 596 A Test 596 Real-World Factors Favoring a Low Payout 597 Taxes 597 Expected Return, Dividends, and Personal Taxes 598 Flotation Costs 599 Dividend Restrictions 599 Real-World Factors Favoring a High Payout 599 Desire for Current Income 600 Uncertainty Resolution 600 Tax and Legal Benefits from High Dividends 601 Corporate Investors 601 Tax-Exempt Investors 601 Conclusion 601 A Resolution of Real-World Factors? 602 Information Content of Dividends 602 The Clientele Effect 603 PART 7 SHORT-TERM FINANCE AND PLANNING 19.3 18.7 18.8 18.9 Establishing a Dividend Policy 604 Residual Dividend Approach 604 Dividend Stability 606 A Compromise Dividend Policy 607 Some Survey Evidence on Dividends 608 Stock Repurchase: An Alternative to Cash Dividends 609 Cash Dividends versus Repurchase 610 Real-World Considerations in a Repurchase 611 Share Repurchase and EPS 612 Stock Dividends and Stock Splits 612 Some Details about Stock Splits and Stock Dividends 613 Example of a Small Stock Dividend 613 Example of a Stock Split 613 Example of a Large Stock Dividend 614 Value of Stock Splits and Stock Dividends 614 The Benchmark Case 614 Popular Trading Range 614 Reverse Splits 615 Summary and Conclusions 616 Short-Term Financial Planning and Management CHAPTER 19 19.1 19.2 18.6 19.4 624 Tracing Cash and Net Working Capital 625 The Operating Cycle and the Cash Cycle 626 Defining the Operating and Cash Cycles 627 The Operating Cycle 627 The Cash Cycle 627 The Operating Cycle and the Firm’s Organizational Chart 629 Calculating the Operating and Cash Cycles 629 The Operating Cycle 630 The Cash Cycle 631 Interpreting the Cash Cycle 632 Some Aspects of Short-Term Financial Policy 632 The Size of the Firm’s Investment in Current Assets 633 Alternative Financing Policies for Current Assets 634 An Ideal Case 634 Different Policies for Financing Current Assets 634 Which Financing Policy Is Best? 637 Current Assets and Liabilities in Practice 638 ros3062x_fm_Standard.indd xxxiv 19.5 19.6 19.7 The Cash Budget 639 Sales and Cash Collections 639 Cash Outflows 640 The Cash Balance 640 Short-Term Borrowing 641 Unsecured Loans 642 Compensating Balances 642 Cost of a Compensating Balance 642 Letters of Credit 643 Secured Loans 643 Accounts Receivable Financing 643 Inventory Loans 644 Other Sources 644 A Short-Term Financial Plan 645 Summary and Conclusions 646 CHAPTER 20 CASH AND LIQUIDITY MANAGEMENT 20.1 657 Reasons for Holding Cash 658 The Speculative and Precautionary Motives The Transaction Motive 658 658 2/9/07 6:02:37 PM
  35. 35. Contents 20.2 20.3 20.4 20.5 20.6 20A Compensating Balances 658 Costs of Holding Cash 658 Cash Management versus Liquidity Management 659 Understanding Float 659 Disbursement Float 659 Collection Float and Net Float 660 Float Management 661 Measuring Float 661 Some Details 662 Cost of the Float 662 Ethical and Legal Questions 664 Electronic Data Interchange and Check 21: The End of Float? 665 Cash Collection and Concentration 666 Components of Collection Time 666 Cash Collection 666 Lockboxes 666 Cash Concentration 668 Accelerating Collections: An Example 669 Managing Cash Disbursements 670 Increasing Disbursement Float 670 Controlling Disbursements 671 Zero-Balance Accounts 671 Controlled Disbursement Accounts 672 Investing Idle Cash 672 Temporary Cash Surpluses 672 Seasonal or Cyclical Activities 672 Planned or Possible Expenditures 672 Characteristics of Short-Term Securities 673 Maturity 673 Default Risk 673 Marketability 673 Taxes 673 Some Different Types of Money Market Securities 674 Summary and Conclusions 675 Determining the Target Cash Balance 679 The Basic Idea 679 The BAT Model 680 The Opportunity Costs 681 The Trading Costs 682 The Total Cost 682 The Solution 683 Conclusion 684 The Miller–Orr Model: A More General Approach 684 The Basic Idea 684 Using the Model 684 Implications of the BAT and Miller–Orr Models 686 Other Factors Influencing the Target Cash Balance 686 ros3062x_fm_Standard.indd xxxv xxxv CHAPTER 21 CREDIT AND INVENTORY MANAGEMENT 21.1 21.2 21.3 21.4 21.5 21.6 21.7 21.8 689 Credit and Receivables 690 Components of Credit Policy 690 The Cash Flows from Granting Credit 690 The Investment in Receivables 691 Terms of the Sale 691 The Basic Form 692 The Credit Period 692 The Invoice Date 692 Length of the Credit Period 692 Cash Discounts 693 Cost of the Credit 694 Trade Discounts 694 The Cash Discount and the ACP 694 Credit Instruments 695 Analyzing Credit Policy 695 Credit Policy Effects 695 Evaluating a Proposed Credit Policy 696 NPV of Switching Policies 696 A Break-Even Application 698 Optimal Credit Policy 698 The Total Credit Cost Curve 698 Organizing the Credit Function 699 Credit Analysis 700 When Should Credit Be Granted? 700 A One-Time Sale 700 Repeat Business 701 Credit Information 702 Credit Evaluation and Scoring 702 Collection Policy 703 Monitoring Receivables 703 Collection Effort 704 Inventory Management 704 The Financial Manager and Inventory Policy 705 Inventory Types 705 Inventory Costs 705 Inventory Management Techniques 706 The ABC Approach 706 The Economic Order Quantity Model 707 Inventory Depletion 707 The Carrying Costs 709 The Shortage Costs 709 The Total Costs 709 Extensions to the EOQ Model 711 Safety Stocks 711 Reorder Points 711 Managing Derived-Demand Inventories 711 Materials Requirements Planning 713 Just-in-Time Inventory 713 2/9/07 6:02:38 PM
  36. 36. xxxvi 21.9 21A Contents Summary and Conclusions 713 More about Credit Policy Analysis Two Alternative Approaches 719 The One-Shot Approach 720 PART 8 The Accounts Receivable Approach Discounts and Default Risk 721 NPV of the Credit Decision 722 A Break-Even Application 723 719 Topics in Corporate Finance CHAPTER 22 INTERNATIONAL CORPORATE FINANCE 22.1 22.2 22.3 22.4 720 22.5 726 Terminology 727 Foreign Exchange Markets and Exchange Rates 728 Exchange Rates 729 Exchange Rate Quotations 729 Cross-Rates and Triangle Arbitrage 730 Types of Transactions 732 Purchasing Power Parity 733 Absolute Purchasing Power Parity 733 Relative Purchasing Power Parity 735 The Basic Idea 735 The Result 735 Currency Appreciation and Depreciation 736 Interest Rate Parity, Unbiased Forward Rates, and the International Fisher Effect 737 Covered Interest Arbitrage 737 Interest Rate Parity 738 Forward Rates and Future Spot Rates 739 Putting It All Together 739 Uncovered Interest Parity 740 The International Fisher Effect 740 ros3062x_fm_Standard.indd xxxvi 22.6 22.7 22.8 International Capital Budgeting 741 Method 1: The Home Currency Approach 741 Method 2: The Foreign Currency Approach 742 Unremitted Cash Flows 743 Exchange Rate Risk 743 Short-Run Exposure 743 Long-Run Exposure 744 Translation Exposure 745 Managing Exchange Rate Risk 746 Political Risk 746 Summary and Conclusions 747 APPENDIX A MATHEMATICAL TABLES APPENDIX B KEY EQUATIONS A-1 B-1 APPENDIX C ANSWERS TO SELECTED END-OF-CHAPTER PROBLEMS C-1 Index I-1 2/9/07 6:02:39 PM
  37. 37. In Their Own Words Boxes CHAPTER 4 CHAPTER 15 Robert C. Higgins University of Washington On Sustainable Growth Bennett Stewart On EVA CHAPTER 7 Samuel C. Weaver Lehigh University On Cost of Capital and Hurdle Rates at the Hershey Company Edward I. Altman On Junk Bonds New York University Stern Stewart & Co. CHAPTER 16 CHAPTER 10 Samuel C. Weaver Lehigh University On Capital Budgeting at the Hershey Company Jay R. Ritter University of Florida On IPO Underpricing around the World CHAPTER 17 CHAPTER 12 Roger Ibbotson Yale University On Capital Market History Jeremy Siegel University of Pennsylvania On Stocks for the Long Run Richard Roll University of California at Los Angeles On Market Efficiency Merton H. Miller On Capital Structure: M&M 30 Years Later CHAPTER 18 Fischer Black On Why Firms Pay Dividends CHAPTER 14 Erik Lie University of Iowa On Option Backdating Robert C. Merton Harvard University On Applications of Option Analysis xxxvii ros3062x_fm_Standard.indd xxxvii 2/9/07 6:02:40 PM
  38. 38. ros3062x_fm_Standard.indd xxxviii 2/9/07 6:02:40 PM
  39. 39. Standard Edition FUNDAMENTALS OF CORPORATE FINANCE ros3062x_fm_Standard.indd xxxix 2/9/07 6:02:40 PM
  40. 40. ros3062x_fm_Standard.indd xl 2/9/07 6:02:40 PM