Fundamentals of Corporate Finance PDF by Bradford D. Jordan, Randolph W Westerfield, and Stephen Ross

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Fundamentals of Corporate Finance
by Bradford D. Jordan, Randolph W Westerfield, and Stephen Ross
Fundamentals of Corporate Finance

Contents

PART 1 Overview of Corporate Finance
CHAPTER 1
INTRODUCTION TO CORPORATE FINANCE 1
1.1 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
1.2 Forms of Business Organization 4
Sole Proprietorship 4
Partnership 5
Corporation 5
A Corporation by Another Name . . . 7
1.3 The Goal of Financial Management 7
Possible Goals 8
The Goal of Financial Management 8
A More General Goal 9
Sarbanes-Oxley 9
1.4 The Agency Problem and Control of the
Corporation 10
Agency Relationships 10
Management Goals 10
Do Managers Act in the Stockholders’ Interests? 11
Managerial Compensation 11
Control of the Firm 13
Conclusion 13
Stakeholders 13
1.5 Financial Markets and the Corporation 14
Cash Flows to and from the Firm 14
Primary versus Secondary Markets 15
Primary Markets 15
Secondary Markets 15
Dealer versus Auction Markets 15
Trading in Corporate Securities 16
Listing 16
1.6 Summary and Conclusions 16
CHAPTER 2
FINANCIAL STATEMENTS, TAXES, AND CASH FLOW 20
2.1 The Balance Sheet 21
Assets: The Left Side 21
Liabilities and Owners’ Equity: The Right Side 21
Net Working Capital 22
Liquidity 23
Debt versus Equity 24
Market Value versus Book Value 24
2.2 The Income Statement 25
GAAP and the Income Statement 26
Noncash Items 27
Time and Costs 27
2.3 Taxes 29
Corporate Tax Rates 29
Average versus Marginal Tax Rates 30
2.4 Cash Flow 32
Cash Flow from Assets 32
Operating Cash Flow 33
Capital Spending 33
Change in Net Working Capital 34
Conclusion 34
A Note about “Free” Cash Flow 34
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 37
Change in NWC and Cash Flow from Assets 38
Cash Flow to Stockholders and Creditors 38
2.5 Summary and Conclusions 39
 
PART 2 Financial Statements and Long-Term Financial Planning
CHAPTER 3
WORKING WITH FINANCIAL STATEMENTS 49
3.1 Cash Flow and Financial Statements:
A Closer Look 50
Sources and Uses of Cash 50
The Statement of Cash Flows 52
3.2 Standardized Financial Statements 54
Common-Size Statements 54
Common-Size Balance Sheets 54
Common-Size Income Statements 55
Common-Size Statements of Cash Flows 56
Common-Base Year Financial Statements:
Trend Analysis 56
Combined Common-Size and Base Year Analysis 56
3.3 Ratio Analysis 57
Short-Term Solvency, or Liquidity, Measures 58
Current Ratio 58
The Quick (or Acid-Test) Ratio 59
Other Liquidity Ratios 60
Long-Term Solvency Measures 60
Total Debt Ratio 60
A Brief Digression: Total Capitalization versus
Total Assets 61
Times Interest Earned 61
Cash Coverage 62
Asset Management, or Turnover, Measures 62
Inventory Turnover and Days’ Sales in Inventory 62
Receivables Turnover and Days’ Sales in
Receivables 63
Asset Turnover Ratios 64
Profitability Measures 64
Profit Margin 65
Return on Assets 65
Return on Equity 65
Market Value Measures 66
Price-Earnings Ratio 66
Price-Sales Ratio 66
Market-to-Book Ratio 67
Enterprise Value-EBITDA Ratio 67
Conclusion 68
3.4 The DuPont Identity 69
A Closer Look at ROE 69
An Expanded DuPont Analysis 71
3.5 Using Financial Statement Information 73
Why Evaluate Financial Statements? 73
Internal Uses 73
External Uses 73
Choosing a Benchmark 74
Time Trend Analysis 74
Peer Group Analysis 74
Problems with Financial Statement Analysis 78
3.6 Summary and Conclusions 80
CHAPTER 4
LONG-TERM FINANCIAL PLANNING AND GROWTH 91
4.1 What Is Financial Planning? 93
Growth as a Financial Management Goal 93
Dimensions of Financial Planning 93
What Can Planning Accomplish? 94
Examining Interactions 94
Exploring Options 94
Avoiding Surprises 94
Ensuring Feasibility and Internal Consistency 95
Conclusion 95
4.2 Financial Planning Models: A First Look 95
A Financial Planning Model: The Ingredients 95
Sales Forecast 96
Pro Forma Statements 96
Asset Requirements 96
Financial Requirements 96
The Plug 96
Economic Assumptions 97
A Simple Financial Planning Model 97
4.3 The Percentage of Sales Approach 98
The Income Statement 98
The Balance Sheet 99
A Particular Scenario 101
An Alternative Scenario 102
4.4 External Financing and Growth 105
EFN and Growth 105
Financial Policy and Growth 107
The Internal Growth Rate 107
The Sustainable Growth Rate 108
Determinants of Growth 109
A Note about Sustainable Growth Rate
Calculations 111
4.5 Some Caveats Regarding Financial Planning
Models 112
4.6 Summary and Conclusions 113
 
PART 3 Valuation of Future Cash Flows

CHAPTER 5
INTRODUCTION TO VALUATION: THE TIME
VALUE OF MONEY 124
5.1 Future Value and Compounding 125
Investing for a Single Period 125
Investing for More Than One Period 125
A Note about Compound Growth 131
5.2 Present Value and Discounting 132
The Single-Period Case 132
Present Values for Multiple Periods 133
5.3 More about Present and Future Values 136
Present versus Future Value 136
Determining the Discount Rate 137
Finding the Number of Periods 140
5.4 Summary and Conclusions 144
CHAPTER 6
DISCOUNTED CASH FLOW VALUATION 149
6.1 Future and Present Values of Multiple Cash Flows 150
Future Value with Multiple Cash Flows 150
Present Value with Multiple Cash Flows 153
A Note about Cash Flow Timing 156
6.2 Valuing Level Cash Flows: Annuities and
Perpetuities 157
Present Value for Annuity Cash Flows 157
Annuity Tables 158
Finding the Payment 160
Finding the Rate 161
Future Value for Annuities 163
A Note about Annuities Due 164
Perpetuities 165
Growing Annuities and Perpetuities 167
6.3 Comparing Rates: The Effect of Compounding 167
Effective Annual Rates and Compounding 168
Calculating and Comparing Effective Annual Rates 168
EARs and APRs 170
Taking It to the Limit: A Note about
Continuous Compounding 172
6.4 Loan Types and Loan Amortization 173
Pure Discount Loans 173
Interest-Only Loans 174
Amortized Loans 174
6.5 Summary and Conclusions 179
CHAPTER 7
INTEREST RATES AND BOND VALUATION 195
7.1 Bonds and Bond Valuation 196
Bond Features and Prices 196
Bond Values and Yields 196
Interest Rate Risk 200
Finding the Yield to Maturity: More Trial and Error 201
7.2 More about Bond Features 206
Is It Debt or Equity? 206
Long-Term Debt: The Basics 206
The Indenture 208
Terms of a Bond 208
Security 209
Seniority 209
Repayment 209
The Call Provision 210
Protective Covenants 210
7.3 Bond Ratings 211
7.4 Some Different Types of Bonds 212
Government Bonds 212
Zero Coupon Bonds 213
Floating-Rate Bonds 214
Other Types of Bonds 215
Sukuk 216
7.5 Bond Markets 218
How Bonds Are Bought and Sold 220
Bond Price Reporting 220
A Note about Bond Price Quotes 223
7.6 Inflation and Interest Rates 223
Real versus Nominal Rates 223
The Fisher Effect 224
Inflation and Present Values 225
7.7 Determinants of Bond Yields 226
The Term Structure of Interest Rates 226
Bond Yields and the Yield Curve: Putting It
All Together 229
Conclusion 230
7.8 Summary and Conclusions 230
CHAPTER 8
STOCK VALUATION 239
8.1 Common Stock Valuation 240
Cash Flows 240
Some Special Cases 242
Zero Growth 242
Constant Growth 242
Nonconstant Growth 245
Two-Stage Growth 247
Components of the Required Return 248
Stock Valuation Using Multiples 249
8.2 Some Features of Common and Preferred Stocks 251
Common Stock Features 251
Shareholder Rights 251
Proxy Voting 252
Classes of Stock 252
Other Rights 253
Dividends 253
Preferred Stock Features 254
Stated Value 254
Cumulative and Noncumulative Dividends 254
Is Preferred Stock Really Debt? 254
8.3 The Stock Markets 255
Dealers and Brokers 255
Organization of the NYSE 256
Members 256
Operations 257
Floor Activity 257
NASDAQ Operations 258
ECNs 260
Stock Market Reporting 260
8.4 Summary and Conclusions 262
 
PART 4 Capital Budgeting
CHAPTER 9
NET PRESENT VALUE AND OTHER INVESTMENT
CRITERIA 272
9.1 Net Present Value 273
The Basic Idea 273
Estimating Net Present Value 274
9.2 The Payback Rule 277
Defining the Rule 277
Analyzing the Rule 279
Redeeming Qualities of the Rule 279
Summary of the Rule 280
9.3 The Discounted Payback 281
9.4 The Average Accounting Return 283
9.5 The Internal Rate of Return 285
Problems with the IRR 289
Nonconventional Cash Flows 289
Mutually Exclusive Investments 291
Investing or Financing? 293
Redeeming Qualities of the IRR 294
The Modified Internal Rate of Return (MIRR) 295
Method #1: The Discounting Approach 295
Method #2: The Reinvestment Approach 295
Method #3: The Combination Approach 296
MIRR or IRR: Which Is Better? 296
9.6 The Profitability Index 296
9.7 The Practice of Capital Budgeting 297
9.8 Summary and Conclusions 300
CHAPTER 10
MAKING CAPITAL INVESTMENT DECISIONS 312
10.1 Project Cash Flows: A First Look 313
Relevant Cash Flows 313
The Stand-Alone Principle 313
10.2 Incremental Cash Flows 314
Sunk Costs 314
Opportunity Costs 314
Side Effects 315
Net Working Capital 315
Financing Costs 315
Other Issues 316
10.3 Pro Forma Financial Statements and Project
Cash Flows 316
Getting Started: Pro Forma Financial Statements 316
Project Cash Flows 317
Project Operating Cash Flow 317
Project Net Working Capital and Capital Spending 318
Projected Total Cash Flow and Value 318
10.4 More about Project Cash Flow 319
A Closer Look at Net Working Capital 319
Depreciation 322
Modified ACRS Depreciation (MACRS) 322
Bonus Depreciation 323
Book Value versus Market Value 323
An Example: The Majestic Mulch and Compost
Company (MMCC) 325
Operating Cash Flows 325
Change in NWC 326
Capital Spending 328
Total Cash Flow and Value 328
Conclusion 328
10.5 Alternative Definitions of Operating
Cash Flow 329
The Bottom-Up Approach 330
The Top-Down Approach 330
The Tax Shield Approach 330
Conclusion 331
10.6 Some Special Cases of Discounted Cash
Flow Analysis 331
Evaluating Cost-Cutting Proposals 331
Setting the Bid Price 333
Evaluating Equipment Options with Different
Lives 335
10.7 Summary and Conclusions 337
CHAPTER 11
PROJECT ANALYSIS AND EVALUATION 350
11.1 Evaluating NPV Estimates 351
The Basic Problem 351
Projected versus Actual Cash Flows 351
Forecasting Risk 351
Sources of Value 352
11.2 Scenario and Other What-If Analyses 353
Getting Started 353
Scenario Analysis 354
Sensitivity Analysis 356
Simulation Analysis 357
11.3 Break-Even Analysis 358
Fixed and Variable Costs 358
Variable Costs 358
Fixed Costs 360
Total Costs 360
Accounting Break-Even 361
Accounting Break-Even: A Closer Look 363
Uses for the Accounting Break-Even 363
11.4 Operating Cash Flow, Sales Volume, and
Break-Even 364
Accounting Break-Even and Cash Flow 364
The Base Case 364
Calculating the Break-Even Level 365
Payback and Break-Even 365
Sales Volume and Operating Cash Flow 366
Cash Flow, Accounting, and Financial Break-Even
Points 366
Accounting Break-Even Revisited 367
Cash Break-Even 367
Financial Break-Even 367
Conclusion 368
11.5 Operating Leverage 369
The Basic Idea 369
Implications of Operating Leverage 369
Measuring Operating Leverage 369
Operating Leverage and Break-Even 371
11.6 Capital Rationing 372
Soft Rationing 372
Hard Rationing 372
11.7 Summary and Conclusions 373
 
PART 5 Risk and Return
 
CHAPTER 12
SOME LESSONS FROM CAPITAL MARKET HISTORY 382
12.1 Returns 383
Dollar Returns 383
Percentage Returns 385
12.2 The Historical Record 387
A First Look 387
A Closer Look 389
12.3 Average Returns: The First Lesson 393
Calculating Average Returns 393
Average Returns: The Historical Record 393
Risk Premiums 394
The First Lesson 394
12.4 The Variability of Returns:
The Second Lesson 395
Frequency Distributions and Variability 395
The Historical Variance and Standard
Deviation 396
The Historical Record 397
Normal Distribution 399
The Second Lesson 400
2008: A Year to Remember 400
Using Capital Market History 402
More on the Stock Market Risk Premium 402
12.5 More about Average Returns 404
Arithmetic versus Geometric Averages 404
Calculating Geometric Average Returns 404
Arithmetic Average Return or Geometric
Average Return? 407
12.6 Capital Market Efficiency 408
Price Behavior in an Efficient Market 408
The Efficient Markets Hypothesis 409
Some Common Misconceptions about
the EMH 410
The Forms of Market Efficiency 411
12.7 Summary and Conclusions 412
CHAPTER 13
RETURN, RISK, AND THE SECURITY MARKET LINE 420
13.1 Expected Returns and Variances 421
Expected Return 421
Calculating the Variance 423
13.2 Portfolios 424
Portfolio Weights 425
Portfolio Expected Returns 425
Portfolio Variance 426
13.3 Announcements, Surprises, and Expected
Returns 428
Expected and Unexpected Returns 428
Announcements and News 428
13.4 Risk: Systematic and Unsystematic 430
Systematic and Unsystematic Risk 430
Systematic and Unsystematic Components
of Return 430
13.5 Diversification and Portfolio Risk 431
The Effect of Diversification: Another Lesson
from Market History 431
The Principle of Diversification 432
Diversification and Unsystematic Risk 433
Diversification and Systematic Risk 434
13.6 Systematic Risk and Beta 434
The Systematic Risk Principle 435
Measuring Systematic Risk 435
Portfolio Betas 437
13.7 The Security Market Line 438
Beta and the Risk Premium 438
The Reward-to-Risk Ratio 439
The Basic Argument 440
The Fundamental Result 442
The Security Market Line 443
Market Portfolios 443
The Capital Asset Pricing Model 443
13.8 The SML and the Cost of Capital: A Preview 446
The Basic Idea 446
The Cost of Capital 446
13.9 Summary and Conclusions 447
 
PART 6 Cost of Capital and Long-Term Financial Policy
CHAPTER 14
COST OF CAPITAL 458
14.1 The Cost of Capital: Some Preliminaries 459
Required Return versus Cost of Capital 459
Financial Policy and Cost of Capital 460
14.2 The Cost of Equity 460
The Dividend Growth Model Approach 460
Implementing the Approach 461
Estimating g 461
Advantages and Disadvantages of the Approach 462
The SML Approach 462
Implementing the Approach 463
Advantages and Disadvantages of the Approach 463
14.3 The Costs of Debt and Preferred Stock 464
The Cost of Debt 464
The Cost of Preferred Stock 464
14.4 The Weighted Average Cost of Capital 465
The Capital Structure Weights 465
Taxes and the Weighted Average Cost of Capital 466
Calculating the WACC for Eastman Chemical 467
Eastman’s Cost of Equity 468
Eastman’s Cost of Debt 470
Eastman’s WACC 471
Solving the Warehouse Problem and Similar
Capital Budgeting Problems 473
Performance Evaluation: Another Use of the WACC 475
14.5 Divisional and Project Costs of Capital 476
The SML and the WACC 476
Divisional Cost of Capital 477
The Pure Play Approach 477
The Subjective Approach 478
14.6 Company Valuation with the WACC 479
14.7 Flotation Costs and the Average Cost of Capital 482
The Basic Approach 482
Flotation Costs and NPV 483
Internal Equity and Flotation Costs 485
14.8 Summary and Conclusions 485
CHAPTER 15
RAISING CAPITAL 495
15.1 The Financing Life Cycle of a Firm: Early-Stage
Financing and Venture Capital 496
Venture Capital 496
Some Venture Capital Realities 497
Choosing a Venture Capitalist 497
Conclusion 497
15.2 Selling Securities to the Public: The Basic
Procedure 498
Crowdfunding 499
Initial Coin Offerings (ICOs) 500
15.3 Alternative Issue Methods 501
15.4 Underwriters 502
Choosing an Underwriter 502
Types of Underwriting 502
Firm Commitment Underwriting 502
Best Efforts Underwriting 503
Dutch Auction Underwriting 503
The Aftermarket 504
The Green Shoe Provision 504
Lockup Agreements 504
The Quiet Period 504
Direct Listing 505
15.5 IPOs and Underpricing 505
IPO Underpricing: The 1999–2000 Experience 505
Evidence on Underpricing 510
The Partial Adjustment Phenomenon 510
Why Does Underpricing Exist? 511
15.6 New Equity Sales and the Value of the Firm 513
15.7 The Costs of Issuing Securities 513
The Costs of Selling Stock to the Public 514
The Costs of Going Public: A Case Study 516
15.8 Rights 518
The Mechanics of a Rights Offering 518
Number of Rights Needed to Purchase a Share 519
The Value of a Right 520
Ex Rights 521
The Underwriting Arrangements 523
Effects on Shareholders 523
15.9 Dilution 524
Dilution of Proportionate Ownership 524
Dilution of Value: Book versus Market Values 524
A Misconception 525
The Correct Arguments 525
15.10 Issuing Long-Term Debt 526
15.11 Shelf Registration 527
15.12 Summary and Conclusions 528
CHAPTER 16
FINANCIAL LEVERAGE AND CAPITAL
STRUCTURE POLICY 534
16.1 The Capital Structure Question 535
Firm Value and Stock Value: An Example 535
Capital Structure and the Cost of Capital 536
16.2 The Effect of Financial Leverage 537
The Basics of Financial Leverage 537
Financial Leverage, EPS, and ROE: An Example 537
EPS versus EBIT 538
Corporate Borrowing and Homemade Leverage 540
16.3 Capital Structure and the Cost of Equity Capital 541
M&M Proposition I: The Pie Model 541
The Cost of Equity and Financial Leverage:
M&M Proposition II 542
Business and Financial Risk 544
16.4 M&M Propositions I and II with Corporate Taxes 545
The Interest Tax Shield 546
Taxes and M&M Proposition I 546
Taxes, the WACC, and Proposition II 547
Conclusion 548
16.5 Bankruptcy Costs 550
Direct Bankruptcy Costs 551
Indirect Bankruptcy Costs 551
16.6 Optimal Capital Structure 552
The Static Theory of Capital Structure 552
Optimal Capital Structure and the Cost of Capital 553
Optimal Capital Structure: A Recap 554
Capital Structure: Some Managerial
Recommendations 556
Taxes 556
Financial Distress 556
16.7 The Pie Again 556
The Extended Pie Model 557
Marketed Claims versus Nonmarketed Claims 558
16.8 The Pecking-Order Theory 558
Internal Financing and the Pecking Order 558
Implications of the Pecking Order 559
16.9 Observed Capital Structures 560
16.10 A Quick Look at the Bankruptcy Process 562
Liquidation and Reorganization 562
Bankruptcy Liquidation 562
Bankruptcy Reorganization 563
Financial Management and the Bankruptcy
Process 565
Agreements to Avoid Bankruptcy 565
16.11 Summary and Conclusions 566
CHAPTER 17
DIVIDENDS AND PAYOUT POLICY 574
17.1 Cash Dividends and Dividend Payment 575
Cash Dividends 575
Standard Method of Cash Dividend Payment 575
Dividend Payment: A Chronology 576
More about the Ex-Dividend Date 576
17.2 Does Dividend Policy Matter? 578
An Illustration of the Irrelevance of Dividend Policy 578
Current Policy: Dividends Set Equal to
Cash Flow 578
Alternative Policy: Initial Dividend Greater than
Cash Flow 579
Homemade Dividends 579
A Test 580
17.3 Real-World Factors Favoring a Low Dividend
Payout 581
Taxes 581
Flotation Costs 581
Dividend Restrictions 581
17.4 Real-World Factors Favoring a High
Dividend Payout 582
Desire for Current Income 582
Tax and Other Benefits from High Dividends 583
Corporate Investors 583
Tax-Exempt Investors 583
Conclusion 583
17.5 A Resolution of Real-World Factors? 583
Information Content of Dividends 584
The Clientele Effect 585
17.6 Stock Repurchases: An Alternative to
Cash Dividends 585
Cash Dividends versus Repurchase 586
Real-World Considerations in a Repurchase 588
Share Repurchase and EPS 588
17.7 What We Know and Do Not Know about Dividend
and Payout Policies 589
Dividends and Dividend Payers 589
Corporations Smooth Dividends 591
Putting It All Together 592
Some Survey Evidence on Dividends 594
17.8 Stock Dividends and Stock Splits 596
Some Details about Stock Splits and Stock
Dividends 596
Example of a Small Stock Dividend 596
Example of a Stock Split 597
Example of a Large Stock Dividend 597
Value of Stock Splits and Stock
Dividends 597
The Benchmark Case 597
Popular Trading Range 598
Reverse Splits 598
17.9 Summary and Conclusions 599
 
PART 7 Short-Term Financial Planning and Management
CHAPTER 18
SHORT-TERM FINANCE AND PLANNING 606
18.1 Tracing Cash and Net Working Capital 607
18.2 The Operating Cycle and the Cash Cycle 608
Defining the Operating and Cash Cycles 609
The Operating Cycle 609
The Cash Cycle 609
The Operating Cycle and the Firm’s Organizational
Chart 611
Calculating the Operating and Cash Cycles 611
The Operating Cycle 612
The Cash Cycle 613
Interpreting the Cash Cycle 614
18.3 Some Aspects of Short-Term Financial Policy 614
The Size of the Firm’s Investment in Current Assets 615
Alternative Financing Policies for Current Assets 616
An Ideal Case 616
Different Policies for Financing Current Assets 616
Which Financing Policy Is Best? 619
Current Assets and Liabilities in Practice 620
18.4 The Cash Budget 621
Sales and Cash Collections 621
Cash Outflows 622
The Cash Balance 622
18.5 Short-Term Borrowing 623
Unsecured Loans 624
Compensating Balances 624
Cost of a Compensating Balance 624
Letters of Credit 625
Secured Loans 625
Accounts Receivable Financing 625
Inventory Loans 626
Other Sources 626
18.6 A Short-Term Financial Plan 627
18.7 Summary and Conclusions 628
CHAPTER 19
CASH AND LIQUIDITY MANAGEMENT 640
19.1 Reasons for Holding Cash 641
The Speculative and Precautionary Motives 641
The Transaction Motive 641
Compensating Balances 641
Costs of Holding Cash 641
Cash Management versus Liquidity Management 642
19.2 Understanding Float 642
Disbursement Float 642
Collection Float and Net Float 643
Float Management 644
Measuring Float 644
Some Details 645
Cost of the Float 645
Ethical and Legal Questions 647
Electronic Data Interchange and Check 21:
The End of Float? 648
19.3 Cash Collection and Concentration 649
Components of Collection Time 649
Cash Collection 649
Lockboxes 649
Cash Concentration 651
Accelerating Collections: An Example 652
19.4 Managing Cash Disbursements 653
Increasing Disbursement Float 653
Controlling Disbursements 654
Zero-Balance Accounts 654
Controlled Disbursement Accounts 655
19.5 Investing Idle Cash 655
Temporary Cash Surpluses 655
Seasonal or Cyclical Activities 655
Planned or Possible Expenditures 655
Characteristics of Short-Term Securities 656
Maturity 656
Default Risk 656
Marketability 656
Taxes 656
Some Different Types of Money Market Securities 657
19.6 Summary and Conclusions 658
19A Determining the Target Cash Balance 662
The Basic Idea 663
The BAT Model 664
The Opportunity Costs 665
The Trading Costs 665
The Total Cost 666
The Solution 666
Conclusion 667
The Miller-Orr Model: A More General Approach 668
The Basic Idea 668
Using the Model 668
Implications of the BAT and Miller-Orr Models 669
Other Factors Influencing the Target
Cash Balance 670
CHAPTER 20
CREDIT AND INVENTORY MANAGEMENT 673
20.1 Credit and Receivables 674
Components of Credit Policy 674
The Cash Flows from Granting Credit 674
The Investment in Receivables 675
20.2 Terms of the Sale 675
The Basic Form 676
The Credit Period 676
The Invoice Date 676
Length of the Credit Period 676
Cash Discounts 677
Cost of the Credit 678
Trade Discounts 678
The Cash Discount and the ACP 678
Credit Instruments 679
20.3 Analyzing Credit Policy 679
Credit Policy Effects 679
Evaluating a Proposed Credit Policy 680
NPV of Switching Policies 680
A Break-Even Application 682
20.4 Optimal Credit Policy 682
The Total Credit Cost Curve 682
Organizing the Credit Function 683
20.5 Credit Analysis 684
When Should Credit Be Granted? 684
A One-Time Sale 684
Repeat Business 685
Credit Information 686
Credit Evaluation and Scoring 686
20.6 Collection Policy 687
Monitoring Receivables 687
Collection Effort 688
20.7 Inventory Management 688
The Financial Manager and Inventory Policy 688
Inventory Types 689
Inventory Costs 689
20.8 Inventory Management Techniques 690
The ABC Approach 690
The Economic Order Quantity Model 690
Inventory Depletion 692
The Carrying Costs 692
The Restocking Costs 692
The Total Costs 693
Extensions to the EOQ Model 695
Safety Stocks 695
Reorder Points 695
Managing Derived-Demand Inventories 695
Materials Requirements Planning 695
Just-in-Time Inventory 697
20.9 Summary and Conclusions 697
20.A More about Credit Policy Analysis 704
Two Alternative Approaches 704
The One-Shot Approach 704
The Accounts Receivable Approach 704
Discounts and Default Risk 706
NPV of the Credit Decision 706
A Break-Even Application 707
 
PART 8 Topics in Corporate Finance
CHAPTER 21
INTERNATIONAL CORPORATE FINANCE 711
21.1 Terminology 712
21.2 Foreign Exchange Markets and Exchange
Rates 713
Exchange Rates 714
Exchange Rate Quotations 715
Cross-Rates and Triangle Arbitrage 715
Types of Transactions 717
21.3 Purchasing Power Parity 718
Absolute Purchasing Power Parity 718
Relative Purchasing Power Parity 720
The Basic Idea 720
The Result 720
Currency Appreciation and Depreciation 721
21.4 Interest Rate Parity, Unbiased Forward Rates,
and the International Fisher Effect 722
Covered Interest Arbitrage 722
Interest Rate Parity 723
Forward Rates and Future Spot Rates 724
Putting It All Together 724
Uncovered Interest Parity 725
The International Fisher Effect 725
21.5 International Capital Budgeting 726
Method 1: The Home Currency Approach 726
Method 2: The Foreign Currency Approach 727
Unremitted Cash Flows 728
21.6 Exchange Rate Risk 728
Short-Run Exposure 728
Long-Run Exposure 729
Translation Exposure 730
Managing Exchange Rate Risk 731
21.7 Political Risk 731
The Tax Cuts and Jobs Act of 2017 731
Managing Political Risk 732
21.8 Summary and Conclusions 733
CHAPTER 22
BEHAVIORAL FINANCE: IMPLICATIONS FOR
FINANCIAL MANAGEMENT 740
22.1 Introduction to Behavioral Finance 741
22.2 Biases 741
Overconfidence 741
Overoptimism 742
Confirmation Bias 742
22.3 Framing Effects 743
Loss Aversion 743
House Money 744
22.4 Heuristics 746
The Affect Heuristic 746
The Representativeness Heuristic 747
Representativeness and Randomness 747
The Gambler’s Fallacy 748
22.5 Behavioral Finance and Market Efficiency 749
Limits to Arbitrage 750
The 3Com/Palm Mispricing 750
The Royal Dutch/Shell Price Ratio 751
Bubbles and Crashes 752
The Crash of 1929 752
The Crash of October 1987 753
The Nikkei Crash 755
The “Dot-Com” Bubble and Crash 755
22.6 Market Efficiency and the Performance of Professional
Money Managers 757
22.7 Summary and Conclusions 760
CHAPTER 23
ENTERPRISE RISK MANAGEMENT 763
23.1 Insurance 764
23.2 Managing Financial Risk 765
The Risk Profile 766
Reducing Risk Exposure 766
Hedging Short-Run Exposure 768
Cash Flow Hedging: A Cautionary Note 768
Hedging Long-Term Exposure 768
Conclusion 769
23.3 Hedging with Forward Contracts 769
Forward Contracts: The Basics 769
The Payoff Profile 770
Hedging with Forwards 770
A Caveat 771
Credit Risk 772
Forward Contracts in Practice 772
23.4 Hedging with Futures Contracts 772
Trading in Futures 772
Futures Exchanges 773
Hedging with Futures 773
23.5 Hedging with Swap Contracts 776
Currency Swaps 776
Interest Rate Swaps 776
Commodity Swaps 777
The Swap Dealer 777
Interest Rate Swaps: An Example 777
23.6 Hedging with Option Contracts 778
Option Terminology 779
Options versus Forwards 779
Option Payoff Profiles 779
Option Hedging 780
Hedging Commodity Price Risk with Options 781
Hedging Exchange Rate Risk with Options 781
Hedging Interest Rate Risk with Options 781
A Preliminary Note 781
Interest Rate Caps 783
Other Interest Rate Options 783
Actual Use of Derivatives 783
23.7 Summary and Conclusions 784
CHAPTER 24
OPTIONS AND CORPORATE FINANCE 790
24.1 Options: The Basics 791
Puts and Calls 791
Stock Option Quotations 792
Option Payoffs 793
24.2 Fundamentals of Option Valuation 796
Value of a Call Option at Expiration 796
The Upper and Lower Bounds on a Call Option’s Value 797
The Upper Bound 797
The Lower Bound 797
A Simple Model: Part I 799
The Basic Approach 799
A More Complicated Case 799
Four Factors Determining Option Values 800
24.3 Valuing a Call Option 801
A Simple Model: Part II 801
The Fifth Factor 802
A Closer Look 803
24.4 Employee Stock Options 804
ESO Features 805
ESO Repricing 805
ESO Backdating 806
24.5 Equity as a Call Option on the Firm’s Assets 807
Case I: The Debt Is Risk-Free 807
Case II: The Debt Is Risky 808
24.6 Options and Capital Budgeting 809
The Investment Timing Decision 810
Managerial Options 811
Contingency Planning 812
Options in Capital Budgeting: An Example 813
Strategic Options 814
Conclusion 814
24.7 Options and Corporate Securities 814
Warrants 815
The Difference between Warrants and Call
Options 815
Earnings Dilution 815
Convertible Bonds 816
Features of a Convertible Bond 816
Value of a Convertible Bond 816
Other Options 818
The Call Provision on a Bond 818
Put Bonds 818
Insurance and Loan Guarantees 819
24.8 Summary and Conclusions 820
CHAPTER 25
OPTION VALUATION 829
25.1 Put-Call Parity 830
Protective Puts 830
An Alternative Strategy 830
The Result 831
Continuous Compounding: A Refresher Course 832
25.2 The Black-Scholes Option Pricing Model 835
The Call Option Pricing Formula 835
Put Option Valuation 838
A Cautionary Note 839
25.3 More about Black-Scholes 840
Varying the Stock Price 840
Varying the Time to Expiration 843
Varying the Standard Deviation 844
Varying the Risk-Free Rate 845
Implied Standard Deviations 846
25.4 Valuation of Equity and Debt in a Leveraged Firm 848
Valuing the Equity in a Leveraged Firm 848
Options and the Valuation of Risky Bonds 849
25.5 Options and Corporate Decisions: Some
Applications 851
Mergers and Diversification 851
Options and Capital Budgeting 852
25.6 Summary and Conclusions 854
CHAPTER 26
MERGERS AND ACQUISITIONS 862
26.1 The Legal Forms of Acquisitions 863
Merger or Consolidation 863
Acquisition of Stock 864
Acquisition of Assets 864
Acquisition Classifications 865
A Note about Takeovers 865
Alternatives to Merger 866
26.2 Taxes and Acquisitions 866
Determinants of Tax Status 866
Taxable versus Tax-Free Acquisitions 867
26.3 Accounting for Acquisitions 867
The Purchase Method 867
More about Goodwill 868
26.4 Gains from Acquisitions 869
Synergy 869
Revenue Enhancement 870
Marketing Gains 870
Strategic Benefits 870
Increases in Market Power 871
Cost Reductions 871
Economies of Scale 871
Economies of Vertical Integration 871
Complementary Resources 872
Lower Taxes 872
Net Operating Losses 872
Unused Debt Capacity 872
Surplus Funds 872
Asset Write-Ups 873
Reductions in Capital Needs 873
Avoiding Mistakes 874
A Note about Inefficient Management 874
26.5 Some Financial Side Effects of Acquisitions 875
EPS Growth 875
Diversification 876
26.6 The Cost of an Acquisition 876
Case I: Cash Acquisition 877
Case II: Stock Acquisition 877
Cash versus Common Stock 878
26.7 Defensive Tactics 879
The Corporate Charter 879
Repurchase and Standstill Agreements 879
Poison Pills and Share Rights Plans 880
Going Private and Leveraged Buyouts 881
Other Devices and Jargon of Corporate Takeovers 881
26.8 Some Evidence on Acquisitions:
Does M&A Pay? 882
26.9 Divestitures and Restructurings 883
26.10 Summary and Conclusions 884
CHAPTER 27
LEASING 893
27.1 Leases and Lease Types 894
Leasing versus Buying 894
Operating Leases 895
Financial Leases 895
Tax-Oriented Leases 896
Leveraged Leases 896
Sale and Leaseback Agreements 896
27.2 Accounting and Leasing 896
27.3 Taxes, the IRS, and Leases 898
27.4 The Cash Flows from Leasing 899
The Incremental Cash Flows 899
A Note about Taxes 900
27.5 Lease or Buy? 900
A Preliminary Analysis 900
Three Potential Pitfalls 901
NPV Analysis 901
A Misconception 903
27.6 A Leasing Paradox 903
27.7 Reasons for Leasing 904
Good Reasons for Leasing 905
Tax Advantages 905
A Reduction of Uncertainty 906
Lower Transactions Costs 906
Fewer Restrictions and Security Requirements 906
Dubious Reasons for Leasing 906
Leasing and Accounting Income 906
100 Percent Financing 907
Low Cost 907
Other Reasons for Leasing 907
27.8 Summary and Conclusions 907
APPENDIX A
MATHEMATICAL TABLES A-1
APPENDIX B
KEY EQUATIONS B-1
APPENDIX C
ANSWERS TO SELECTED END-OF-CHAPTER
PROBLEMS C-1
APPENDIX D
USING THE HP 10B AND TI BA II
PLUS FINANCIAL CALCULATORS D-1
INDEX I-1

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