Corporate finance, 6th ed – ross, westerfield, and jaffe (1)

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Corporate finance, 6th ed – ross, westerfield, and jaffe (1)

  1. 1. Finance Corporate Fiance Volume 1 David Whitehurst UMIST abc McGraw-Hill/IrwinMcGraw−Hill PrimisISBN: 0−390−32000−5Text:Corporate Finance, Sixth EditionRoss−Westerfield−Jaffe
  2. 2. This book was printed on recycled paper.Financehttp://www.mhhe.com/primis/online/Copyright ©2003 by The McGraw−Hill Companies, Inc. All rightsreserved. Printed in the United States of America. Except aspermitted under the United States Copyright Act of 1976, no partof this publication may be reproduced or distributed in any formor by any means, or stored in a database or retrieval system,without prior written permission of the publisher.This McGraw−Hill Primis text may include materials submitted toMcGraw−Hill for publication by the instructor of this course. Theinstructor is solely responsible for the editorial content of suchmaterials.111 FINA ISBN: 0−390−32000−5
  3. 3. FinanceVolume 1Ross−Westerfield−Jaffe • Corporate Finance, Sixth Edition Front Matter 1 Preface 1 I. Overview 8 Introduction 8 1. Introduction to Corporate Finance 9 2. Accounting Statements and Cash Flow 29 II. Value and Capital Budgeting 51 Introduction 51 3. Financial Markets and Net Present Value: First Principles of Finance (Adv.) 52 4. Net Present Value 72 5. How to Value Bonds and Stocks 108 6. Some Alternative Investment Rules 146 7. Net Present Value and Capital Budgeting 175 8. Strategy and Analysis in Using Net Present Value 206 III. Risk 225 Introduction 225 9. Capital Market Theory: An Overview 226 10. Return and Risk: The Capital−Asset−Pricing Model 248 11. An Alternative View of Risk and Return: The Arbitrage Pricing Theory 291 12. Risk, Cost of Capital, and Capital Budgeting 313 IV. Capital Structure and Dividend Policy 343 Introduction 343 13. Corporate−Financing Decisions and Efficient Capital Markets 345 14. Long−Term Financing: An Introduction 377 15. Capital Structure: Basic Concepts 396 16. Capital Structure: Limits to the Use of Debt 428 17. Valuation and Capital Budgeting for the Levered Firm 474 18. Dividend Policy: Why Does It Matter? 501 V. Long−Term Financing 539 Introduction 539 19. Issuing Securities to the Public 540 iii
  4. 4. 20. Long−Term Debt 56921. Leasing 592VI. Options, Futures, and Corporate Finance 617Introduction 61722. Options and Corporate Finance: Basic Concepts 61823. Options and Corporate Finance: Extensions and Applications 65624. Warrants and Convertibles 68025. Derivatives and Hedging Risk 701VII. Financial Planning and Short−Term Finance 736Introduction 73626. Corporate Financial Models and Long−Term Planning 73727. Short−Term Finance and Planning 75128. Cash Management 77629. Credit Management 803VIII. Special Topics 820Introduction 82030. Mergers and Acquisitions 82131. Financial Distress 85932. International Corporate Finance 877 iv
  5. 5. Ross−Westerfield−Jaffe: Front Matter Preface © The McGraw−Hill 1Corporate Finance, Sixth Companies, 2002Edition Preface The teaching and the practicing of corporate finance are more challenging and exciting than ever before. The last decade has seen fundamental changes in financial markets and financial instruments. In the early years of the 21st century, we still see announcements in the financial press about such matters as takeovers, junk bonds, financial restructuring, ini- tial public offerings, bankruptcy, and derivatives. In addition, there is the new recognition of “real” options (Chapters 21 and 22), private equity and venture capital (Chapter 19), and the disappearing dividend (Chapter 18). The world’s financial markets are more integrated than ever before. Both the theory and practice of corporate finance have been moving ahead with uncommon speed, and our teaching must keep pace. These developments place new burdens on the teaching of corporate finance. On one hand, the changing world of finance makes it more difficult to keep materials up to date. On the other hand, the teacher must distinguish the permanent from the temporary and avoid the temptation to follow fads. Our solution to this problem is to emphasize the mod- ern fundamentals of the theory of finance and make the theory come to life with contem- porary examples. Increasingly, many of these examples are outside the United States. All too often, the beginning student views corporate finance as a collection of unrelated topics that are unified largely because they are bound together between the covers of one book. As in the previous editions, our aim is to present corporate finance as the working of a small number of integrated and powerful institutions.THE INTENDED AUDIENCE OF THIS BOOK This book has been written for the introductory courses in corporate finance at the MBA level, and for the intermediate courses in many undergraduate programs. Some instructors will find our text appropriate for the introductory course at the undergraduate level as well. We assume that most students either will have taken, or will be concurrently enrolled in, courses in accounting, statistics, and economics. This exposure will help students understand some of the more difficult material. However, the book is self-contained, and a prior knowl- edge of these areas is not essential. The only mathematics prerequisite is basic algebra.NEW TO THE SIXTH EDITION Following are the key revisions and updates to this edition: • A complete update of all cost of capital discussions to emphasize its usefulness in capital budgeting, primarily in Chapters 12 and 17.
  6. 6. 2 Ross−Westerfield−Jaffe: Front Matter Preface © The McGraw−Hill Corporate Finance, Sixth Companies, 2002 Edition Preface vii • A new appendix on performance evaluation and EVA in Chapter 12. • A new section on liquidity and the cost of capital in Chapter 12. • New evidence on efficient markets and CAPM in Chapter 13. • New treatment on why firms choose different capital structures and dividend poli- cies: the case of Qualcomm in Chapters 16 and 18. • A redesign and rewrite of options and derivatives chapters into a new Part VI. • Extension of options theory to mergers and acquisitions in Chapter 22. • An expanded discussion of real options and their importance to capital budgeting in Chapter 23. • New material on carveouts, spinoffs, and tracking stocks in Chapter 30. • Many new end-of-chapter problems throughout all chapters. ATTENTION TO PEDAGOGY Executive Summary Each chapter begins with a “roadmap” that describes the objectives of the chapter and how it connects with concepts already learned in previous chapters. Real company examples that will be discussed are highlighted in this section. Case Study There are 10 case studies that are highlighted in the Sixth Edition that present situations with real companies and how they rationalized the decisions they made to solve various problems. They provide extended examples of the material covered in the chapter. The cases are highlighted in the detailed Table of Contents. In Their Own Words Boxes Located throughout the Sixth Edition, this unique series consists of articles written by dis- tinguished scholars or practitioners on key topics in the text. Concept Questions Included after each major section in a chapter, Concept Questions point to essential mater- ial and allow students to test their recall and comprehension before moving forward. Key Terms Students will note that important words are highlighted in boldface type the first time they appear. They are also listed at the end of the chapter, along with the page number on which they first appear, as well as in the glossary at the end of the book. Demonstration Problems We have provided worked-out examples throughout the text to give students a clear under- standing of the logic and structure of the solution process. These examples are clearly called out in the text. Highlighted Concepts Throughout the text, important ideas are pulled out and presented in a copper box—signal- ing to students that this material is particularly relevant and critical for their understanding. Numbered Equations Key equations are numbered and listed on the back end sheets for easy reference. The end of-chapter material reflects and builds on the concepts learned from the chap- ter and study features:
  7. 7. Ross−Westerfield−Jaffe: Front Matter Preface © The McGraw−Hill 3 Corporate Finance, Sixth Companies, 2002 Editionviii Preface Summary and Conclusions The numbered summary provides a quick review of key concepts in the chapter. List of Key Terms A list of the boldfaced key terms with page numbers is included for easy reference. Suggested Readings Each chapter is followed by a short, annotated list of books and articles to which interest- ed students can refer for additional information. Questions and Problems Because solving problems is so critical to a student’s learning, they have been revised, thor- oughly reviewed, and accuracy-checked. The problem sets are graded for difficulty, moving from easier problems intended to build confidence and skill to more difficult problems designed to challenge the enthusiastic student. Problems have been grouped according to the concepts they test on. Additionally, we have tried to make the problems in the critical “con- cept” chapters, such as those on value, risk, and capital structure, especially challenging and interesting. We provide answers to selected problems in Appendix B at the end of the book. Minicase This end-of-chapter feature, located in Chapters 12 and 30, parallels the Case Study feature found in various chapters. These Minicases apply what is learned in a number of chapters to a real-world type of scenario. After presenting the facts, the student is given guidance in rationalizing a sound business decision.SUPPLEMENTS PACKAGE As with the text, developing supplements of extraordinary quality and utility was the pri- mary objective. Each component in the supplement package underwent extensive review and revision.FOR THE INSTRUCTOR Instructor’s Manual (0-07-233882-2) Prepared by John Stansfield, University of Missouri, Columbia, this instructor’s tool has been thoroughly revised and updated. Each chapter includes a list of transparencies/ PowerPoint slides, a brief chapter outline, an introduction, and an annotated outline. The annotated outline contains references to the transparencies/PowerPoint slides, additional explanations and examples, and teaching tips. PowerPoint Presentation System (0-07-233883-0) This presentation system was developed in conjunction with the Instructor’s Manual by the same author, allowing for a complete and integrated teaching package. These slides contain useful outlines, summaries, and exhibits from the text. If you have PowerPoint installed on your PC, you have the ability to edit, print, or rearrange the complete transparency presen- tation to meet your specific needs. Test Bank (0-07-233885-7) The Test Bank, prepared by David Burnie, Western Michigan University, includes an aver- age of 35 multiple-choice questions and problems per chapter, and 5 essay questions per
  8. 8. 4 Ross−Westerfield−Jaffe: Front Matter Preface © The McGraw−Hill Corporate Finance, Sixth Companies, 2002 Edition Preface ix chapter. Each question is labeled with the level of difficulty. About 30–40 percent of these problems are new or revised. Computerized Testing Software (0-07-233881-4) This software includes an easy-to-use menu system which allows quick access to all the powerful features available. The Keyword Search option lets you browse through the ques- tion bank for problems containing a specific word or phrase. Password protection is avail- able for saved tests or for the entire database. Questions can be added, modified, or deleted. Available in Windows version. Solutions Manual (0-07-233884-9) The Solutions Manual, prepared by John A. Helmuth, University of Michigan, contains worked-out solutions for all of the problems, and has been thoroughly reviewed for accu- racy. The Solutions Manual is also available to be purchased for your students. Instructor CD-ROM (0-07-246238-8) You can receive all of the supplements in an electronic format! The Instructor’s Manual, PowerPoint, Test Bank, and Solutions Manual are all together on one convenient CD. The interface provides the instructor with a self-contained program that allows him or her to arrange the visual resources into his or her own presentation and add additional files as well. Videos (0-07-250741-1) These finance videos 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. Questions to accompany these videos can be found on the book’s Online Learning Center. FOR THE STUDENTS Standard & Poor’s Educational Version of Market Insight. If you purchased a new book, you will have received a free passcode card that will give you access to the same company and industry data that industry experts use. See www.mhhe.com/edumarketinsight for details on this exclusive partnership! PowerWeb If you purchased a new book, free access to PowerWeb—a dynamic supplement specific to your corporate finance course—is also available. Included are three levels of resource materials: articles from journals and magazines from the past year, weekly updates on cur- rent issues, and links to current news of the day. Also available is a series of study aids, such as quizzes, web links, and interactive exercises. See www.dushkin.com/powerweb for more details and access to this valuable resource. Student Problem Manual (0-07-233880-6) Written by Robert Hanson, Eastern Michigan University, the Student Problem Manual is a direct companion to the text. It is uniquely designed to involve the student in the learning process. Each chapter contains a Mission Statement, an average of 20 fill-in-the-blank Concept Test questions and answers, and an average of 15 problems and worked-out solu- tions. This product can be purchased separately or packaged with the text. Online Learning Center Visit the full web resource now available with the Sixth Edition at www.mhhe.com/rwj. The Information Center includes information on this new edition, and links for special offers.
  9. 9. Ross−Westerfield−Jaffe: Front Matter Preface © The McGraw−Hill 5 Corporate Finance, Sixth Companies, 2002 Editionx Preface The Instructor Center includes all of the teaching resources for the book, and the Student Center includes free online study materials—such as quizzes, study outlines, and spread- sheets—developed specifically for this edition. A feedback form is also available for your questions and comments.ACKNOWLEDGMENTS The plan for developing this edition began with a number of our colleagues who had an inter- est in the book and regularly teach the MBA introductory course. We integrated their com- ments and recommendations throughout the Sixth Edition. Contributors to this edition include: R. Aggarwal, John Carroll University Richard Miller, Wesleyan University Christopher Anderson, University of Naval Modani, University of Central Florida Missouri–Columbia Robert Nachtmann, University of Pittsburgh James J. Angel, Georgetown University Edward Nelling, Georgia Tech Kevin Bahr, University of Wisconsin–Milwaukee Gregory Niehaus, University of South Carolina Michael Barry, Boston College Ingmar Nyman, Hunter College William O. Brown, Claremont McKenna College Venky Panchapagesan, Washington Bill Callahan, Southern Methodist University University–St. Louis Steven Carvell, Cornell University Bulent Parker, University of Wisconsin–Madison Indudeep S. Chhachhi, Western Kentucky Christo Pirinsky, Ohio State University University Jeffrey Pontiff, University of Washington Jeffrey L. Coles, Arizona State University N. Prabhala, Yale University Raymond Cox, Central Michigan University Mao Qiu, University of Utah–Salt Lake City John Crockett, George Mason University Latha Ramchand, University of Houston Robert Duvic, The University of Texas at Austin Gabriel Ramirez, Virginia Commonwealth Steven Ferraro, Pepperdine University University Adlai Fisher, New York University Stuart Rosenstein, University of Colorado at Yee-Tien Fu, Stanford University Denver Bruno Gerard, University of Southern California Bruce Rubin, Old Dominion University Frank Ghannadian, Mercer University–Atlanta Jaime Sabal, New York University John A. Helmuth, University of Andy Saporoschenko, University of Akron Michigan–Dearborn William Sartoris, Indiana University Edith Hotchkiss, Boston College Faruk Selcuk, University of Bridgeport Charles Hu, Claremont McKenna College Sudhir Singh, Frostburg State University Raymond Jackson, University of John S. Strong, College of William and Mary Massachusetts–Dartmouth Michael Sullivan, University of Nevada–Las Vegas Narayanan Jayaraman, Georgia Institute of Andrew C. Thompson, Virginia Polytechnic Technology Institute Dolly King, University of Wisconsin–Milwaukee Karin Thorburn, Dartmouth College Ronald Kudla, The University of Akron Satish Thosar, University of Dilip Kumar Patro, Rutgers University Massachusetts–Dorchester Youngsik Kwak, Delaware State University Oscar Varela, University of New Orleans Youngho Lee, Howard University Steven Venti, Dartmouth College Yulong Ma, Cal State—Long Beach Susan White, University of Texas–Austin Over the years, many others have contributed their time and expertise to the development and writing of this text. We extend our thanks once again for their assistance and countless insights:
  10. 10. 6 Ross−Westerfield−Jaffe: Front Matter Preface © The McGraw−Hill Corporate Finance, Sixth Companies, 2002 Edition Preface xi James J. Angel, Georgetown University Hugh Hunter, Eastern Washington University Nasser Arshadi, University of Missouri–St. Louis James Jackson, Oklahoma State University Robert Balik, Western Michigan University Prem Jain, Tulane University John W. Ballantine, Babson College Brad Jordan, University of Kentucky Thomas Bankston, Angelo State University Jarl Kallberg, New York University Swati Bhatt, Rutgers University Jonathan Karpoff, University of Washington Roger Bolton, Williams College Paul Keat, American Graduate School of Gordon Bonner, University of Delaware International Management Brad Borber, University of California–Davis Brian Kluger, University of Cincinnati Oswald Bowlin, Texas Technical University Narayana Kocherlakota, University of Iowa Ronald Braswell, Florida State University Nelson Lacey, University of Massachusetts Kirt Butler, Michigan State University Gene Lai, University of Rhode Island Andreas Christofi, Pennsylvania State Josef Lakonishok, University of Illinois University–Harrisburg Dennis Lasser, SUNY–Binghamton James Cotter, University of Iowa Paul Laux, Case Western Reserve University Jay Coughenour, University of Bong-Su Lee, University of Minnesota Massachusetts–Boston James T. Lindley, University of Southern Arnold Cowan, Iowa State University Mississippi Mark Cross, Louisiana Technical University Dennis Logue, Dartmouth College Ron Crowe, Jacksonville University Michael Long, Rutgers University William Damon, Vanderbilt University Ileen Malitz, Fairleigh Dickinson University Sudip Datta, Bentley College Terry Maness, Baylor University Anand Desai, University of Florida Surendra Mansinghka, San Francisco State Miranda Lam Detzler, University of University Massachusetts–Boston Michael Mazzco, Michigan State University David Distad, University of California–Berkeley Robert I. McDonald, Northwestern University Dennis Draper, University of Southern California Hugh McLaughlin, Bentley College Jean-Francois Dreyfus, New York University Larry Merville, University of Texas–Richardson Gene Drzycimski, University of Joe Messina, San Francisco State University Wisconsin–Oshkosh Roger Mesznik, City College of New Robert Eldridge, Fairfield University York–Baruch College Gary Emery, University of Oklahoma Rick Meyer, University of South Florida Theodore Eytan, City University of New Richard Mull, New Mexico State University York–Baruch College Jim Musumeci, Southern Illinois Don Fehrs, University of Notre Dame University–Carbondale Andrew Fields, University of Delaware Peder Nielsen, Oregon State University Paige Fields, Texas A&M Dennis Officer, University of Kentucky Michael Fishman, Northwestern University Joseph Ogden, State University of New York Michael Goldstein, University of Colorado Ajay Patel, University of Missouri–Columbia Indra Guertler, Babson College Glenn N. Pettengill, Emporia State University James Haltiner, College of William and Mary Pegaret Pichler, University of Maryland Delvin Hawley, University of Mississippi Franklin Potts, Baylor University Hal Heaton, Brigham Young University Annette Poulsen, University of Georgia John Helmuth, Rochester Institute of Technology Latha Ramchand, University of Houston Michael Hemler, University of Notre Dame Narendar Rao, Northeastern Illinois University Stephen Heston, Washington University Steven Raymar, Indiana University Andrea Heuson, University of Miami Stuart Rosenstein, Southern Illinois University
  11. 11. Ross−Westerfield−Jaffe: Front Matter Preface © The McGraw−Hill 7 Corporate Finance, Sixth Companies, 2002 Editionxii Preface Patricia Ryan, Drake University Alex Tang, Morgan State University Anthony Sanders, Ohio State University Richard Taylor, Arkansas State University James Schallheim, University of Utah Timothy Thompson, Northwestern University Mary Jean Scheuer, California State University Charles Trzcinka, State University of New at Northridge York–Buffalo Lemma Senbet, University of Maryland Haluk Unal, University of Maryland–College Park Kuldeep Shastri, University of Pittsburgh Avinash Verma, Washington University Scott Smart, Indiana University Lankford Walker, Eastern Illinois University Jackie So, Southern Illinois University Ralph Walkling, Ohio State University John Stansfield, Columbia College F. Katherine Warne, Southern Bell College A. Charlene Sullivan, Purdue University Robert Whitelaw, New York University Timothy Sullivan, Bentley College Berry Wilson, Georgetown University R. Bruce Swensen, Adelphi University Thomas Zorn, University of Nebraska–Lincoln Ernest Swift, Georgia State University Kent Zumwalt, Colorado State University For their help on the Sixth Edition, we would like to thank Linda De Angelo, Dennis Draper, Kim Dietrich, Alan Shapiro, Harry De Angelo, Aris Protopapadakis, Anath Madhevan, and Suh-Pyng Ku, all of the Marshall School of Business at the University of Southern California. We also owe a debt of gratitude to Edward I. Altman, of New York University; Robert S. Hansen, of Virginia Tech; and Jay Ritter, of the University of Florida, who have provided several thoughtful comments and immeasurable help. Over the past three years, readers have provided assistance by detecting and reporting errors. Our goal is to offer the best textbook available on the subject, so this information was invaluable as we prepared the Sixth Edition. We want to ensure that all future editions are error-free and therefore we will offer $10 per arithmetic error to the first individual reporting it. Any arithmetic error resulting in subsequent errors will be counted double. All errors should be reported using the Feedback Form on the Corporate Finance Online Learning Center at www.mhhe.com/rwj. In addition, Sandra Robinson and Wendy Wat have given significant assistance in preparing the manuscript. Finally, we wish to thank our families and friends, Carol, Kate, Jon, Jan, Mark, and Lynne for their forbearance and help. Stephen A. Ross Randolph W. Westerfield Jeffrey F. Jaffe
  12. 12. 8 Ross−Westerfield−Jaffe: I. Overview Introduction © The McGraw−Hill Corporate Finance, Sixth Companies, 2002 Edition PART I Overview 1 Introduction to Corporate Finance 2 2 Accounting Statements and Cash Flow 22 T O engage in business the financial managers of a firm must find answers to three kinds of important questions. First, what long-term investments should the firm take on? This is the capital budgeting decision. Second, how can cash be raised for the re- quired investments? We call this the financing decision. Third, how will the firm man- age its day-to-day cash and financial affairs? These decisions involve short-term finance and concern net working capital. In Chapter 1 we discuss these important questions, briefly introducing the basic ideas of this book and describing the nature of the modern corporation and why it has emerged as the leading form of the business firm. Using the set-of-contracts perspective, the chapter discusses the goals of the modern corporation. Though the goals of share- holders and managers may not always be the same, conflicts usually will be resolved in favor of the shareholders. Finally, the chapter reviews some of the salient features of modern financial markets. This preliminary material will be familiar to students who have some background in accounting, finance, and economics. Chapter 2 examines the basic accounting statements. It is review material for stu- dents with an accounting background. We describe the balance sheet and the income statement. The point of the chapter is to show the ways of converting data from ac- counting statements into cash flow. Understanding how to identify cash flow from ac- counting statements is especially important for later chapters on capital budgeting.
  13. 13. Ross−Westerfield−Jaffe: I. Overview 1. Introduction to Corporate © The McGraw−Hill 9 Corporate Finance, Sixth Finance Companies, 2002 Edition1 Introduction toCHAPTER Corporate Finance EXECUTIVE SUMMARY T he Video Product Company designs and manufactures very popular software for video game consoles. The company was started in 1999, and soon thereafter its game “Gadfly” appeared on the cover of Billboard magazine. Company sales in 2000 were over $20 million. Video Product’s initial financing of $2 million came from Seed Ltd., a venture-capital firm, in exchange for a 15-percent equity stake in the company. Now the fi- nancial management of Video Product realizes that its initial financing was too small. In the long run Video Product would like to expand its design activity to the education and busi- ness areas. It would also like to significantly enhance its website for future Internet sales. However, at present the company has a short-run cash flow problem and cannot even buy $200,000 of materials to fill its holiday orders. Video Product’s experience illustrates the basic concerns of corporate finance: 1. What long-term investment strategy should a company take on? 2. How can cash be raised for the required investments? 3. How much short-term cash flow does a company need to pay its bills? These are not the only questions of corporate finance. They are, however, among the most important questions and, taken in order, they provide a rough outline of our book. One way that companies raise cash to finance their investment activities is by selling or “issuing” securities. The securities, sometimes called financial instruments or claims, may be roughly classified as equity or debt, loosely called stocks or bonds. The difference between equity and debt is a basic distinction in the modern theory of finance. All securi- ties of a firm are claims that depend on or are contingent on the value of the firm.1 In Section 1.2 we show how debt and equity securities depend on the firm’s value, and we describe them as different contingent claims. In Section 1.3 we discuss different organizational forms and the pros and cons of the decision to become a corporation. In Section 1.4 we take a close look at the goals of the corporation and discuss why max- imizing shareholder wealth is likely to be the primary goal of the corporation. Throughout the rest of the book, we assume that the firm’s performance depends on the value it creates for its shareholders. Shareholders are better off when the value of their shares is increased by the firm’s decisions. A company raises cash by issuing securities to the financial markets. The market value of outstanding long-term corporate debt and equity securities traded in the U.S. financial markets is in excess of $25 trillion. In Section 1.5 we describe some of the basic features of the financial markets. Roughly speaking, there are two basic types of financial markets: the money markets and the capital markets. The last section of the chapter provides an outline of the rest of the book. 1 We tend to use the words firm, company, and business interchangeably. However, there is a difference between a firm and a corporation. We discuss this difference in Section 1.3.
  14. 14. 10 Ross−Westerfield−Jaffe: I. Overview 1. Introduction to Corporate © The McGraw−Hill Corporate Finance, Sixth Finance Companies, 2002 Edition Chapter 1 Introduction to Corporate Finance 3 1.1 WHAT IS CORPORATE FINANCE? Suppose you decide to start a firm to make tennis balls. To do this, you hire managers to buy raw materials, and you assemble a workforce that will produce and sell finished tennis balls. In the language of finance, you make an investment in assets such as inventory, ma- chinery, land, and labor. The amount of cash you invest in assets must be matched by an equal amount of cash raised by financing. When you begin to sell tennis balls, your firm will generate cash. This is the basis of value creation. The purpose of the firm is to create value for you, the owner. The firm must generate more cash flow than it uses. The value is reflected in the framework of the simple balance-sheet model of the firm. The Balance-Sheet Model of the Firm Suppose we take a financial snapshot of the firm and its activities at a single point in time. Figure 1.1 shows a graphic conceptualization of the balance sheet, and it will help intro- duce you to corporate finance. The assets of