Corporate Finance: The Core, 4th Edition PDF by Jonathan Berk and Peter Demarzo

By

Corporate Finance: The Core, Fourth Edition

By Jonathan Berk and Peter Demarzo

Corporate Finance The Core 4th Edition

Detailed Contents

1 INTRO DUCTION

Chapter 1 T he Corporation 34

1.1 T he Four Types of Firms 35

Sole Proprietorships 35

Partnerships 36

Limited Liability Companies 37

Corporations 37

Tax Implications for Corporate Entities 38

■■ Corporate Taxation Around the World 39

1.2 O wnership Versus Control of Corporations 39

The Corporate Management Team 39

■■ Interview with David Viniar 40

The Financial Manager 41

■■ GLOBAL FINANCIAL CRISIS

The Dodd-Frank Act 42

The Goal of the Firm 42

The Firm and Society 43

Ethics and Incentives within Corporations 43

■■ GLOBAL FINANCIAL CRISIS The Dodd-Frank Act on Corporate Compensation and Governance 44

■■ Citizens United v. Federal Election Commission 44

■■ Airlines in Bankruptcy 46

1.3 T he Stock Market 46

Primary and Secondary Stock Markets 47

Traditional Trading Venues 47

■■ INTERVIEW with Frank Hatheway 48

New Competition and Market Changes 49

Dark Pools 50

MyFinanceLab 51 n Key Terms 51 n Further Reading 52 n Problems 52

Chapter 2 I ntroduction to Financial

Statement Analysis 55

2.1 Firms’ Disclosure of Financial Information 56

Preparation of Financial Statements 56

■■ International Financial Reporting Standards 56

■■ INTERVIEW with Ruth Porat 57

Types of Financial Statements 58

2.2 T he Balance Sheet 58

Assets 59

Liabilities 60

Stockholders’ Equity 61

Market Value Versus Book Value 61

Enterprise Value 62

2.3 T he Income Statement 62

Earnings Calculations 63

2.4 T he Statement of Cash Flows 64

Operating Activity 65

Investment Activity 66

Financing Activity 66

2.5 O ther Financial Statement

Information 67

Statement of Stockholders’ Equity 67

Management Discussion and

Analysis 68

Notes to the Financial

Statements 68

2.6 Financial Statement Analysis 69

Profitability Ratios 69

Liquidity Ratios 70

Working Capital Ratios 71

Interest Coverage Ratios 72

Leverage Ratios 73

Valuation Ratios 75

■■ COMMON MISTAKE

Mismatched Ratios 75

Operating Returns 76

The DuPont Identity 78

2.7 Financial Reporting in Practice 80

Enron 80

WorldCom 80

Sarbanes-Oxley Act 81

■■ GLOBAL FINANCIAL CRISIS

Bernard Madoff’s Ponzi Scheme 82

Dodd-Frank Act 82

MyFinanceLab 83 n Key Terms 84 n

Further Reading 85 n Problems 85 n

Data Case 92

Chapter 3 Financial Decision Making

and the Law of One Price 93

3.1 Valuing Decisions 94

Analyzing Costs and Benefits 94

Using Market Prices to Determine Cash

Values 95

■■ When Competitive Market Prices

Are Not Available 97

3.2 I nterest Rates and the Time Value

of Money 97

The Time Value of Money 97

The Interest Rate: An Exchange Rate

Across Time 97

3.3 P resent Value and the NPV Decision

Rule 100

Net Present Value 100

The NPV Decision Rule 101

NPV and Cash Needs 103

3.4 A rbitrage and the Law of One Price 104

Arbitrage 104

Law of One Price 105

3.5 N o-Arbitrage and Security

Prices 105

Valuing a Security with the Law

of One Price 105

■■ An Old Joke 109

The NPV of Trading Securities

and Firm Decision Making 109

Valuing a Portfolio 110

■■ GLOBAL FINANCIAL CRISIS

Liquidity and the Informational

Role of Prices 111

■■ Arbitrage in Markets 112

Where Do We Go from Here? 113

MyFinanceLab 114 n Key Terms 115 n

Further Reading 115 n Problems 115

A ppendix T he Price of Risk 119

Risky Versus Risk-Free Cash Flows 119

Arbitrage with Transactions Costs 124

PART 2 TI ME, MONEY, AND INTERESTRATE S

Chapter 4 T he Time Value of Money 130

4.1 T he Timeline 131

4.2 T he Three Rules of Time Travel 132

Rule 1: Comparing and Combining

Values 132

Rule 2: Moving Cash Flows Forward in Time 133

Rule 3: Moving Cash Flows Back in Time 134

■■ Rule of 72 135

Applying the Rules of Time Travel 136

4.3 Valuing a Stream of Cash Flows 138

4.4 Calculating the Net Present Value 141

■■ USING EXCEL Calculating Present Values in Excel 142

4.5 P erpetuities and Annuities 143 Perpetuities 143

■■ Historical Examples of Perpetuities 144

■■ COMMON MISTAKE Discounting One

Too Many Times 146

Annuities 146

■■ Formula for an Annuity Due 149

Growing Cash Flows 149

4.6 Using an Annuity Spreadsheet

or Calculator 154

4.7 N on-Annual Cash Flows 156

4.8 Solving for the Cash Payments 157

4.9 T he Internal Rate of Return 160

■■ USING EXCEL Excel’s IRR Function 163

MyFinanceLab 164 n Key Terms 165 n

Further Reading 166 n Problems 166 n Data Case 172

A ppendix Solving for the Number of Periods 173

Chapter 5 I nterest Rates 175

5.1 I nterest Rate Quotes and Adjustments 176

The Effective Annual Rate 176

■■ COMMON MISTAKE Using the Wrong Discount Rate in the Annuity Formula 177

Annual Percentage Rates 178

5.2 Application: Discount Rates and Loans 180

5.3 The Determinants of Interest Rates 181

■■ GLOBAL FINANCIAL CRISIS Teaser Rates and Subprime Loans 182

Inflation and Real Versus Nominal Rates 182

Investment and Interest Rate Policy 183

The Yield Curve and Discount Rates 184

The Yield Curve and the Economy 186

■■ COMMON MISTAKE Using the Annuity Formula When Discount Rates Vary by Maturity 186

■■ INTERVIEW with Kevin M. Warsh 188

5.4 Risk and Taxes 189

Risk and Interest Rates 190

After-Tax Interest Rates 191

5.5 The Opportunity Cost of Capital 192

■■ COMMON MISTAKE States Dig

a $3 Trillion Hole by Discounting at the Wrong Rate 193

My Finance Lab 194 n Key Terms 195 n Further Reading 195 n Problems 195 n Data Case 200

appendix Continuous Rates and Cash Flows 202

Discount Rates for a Continuously Compounded APR 202

Continuously Arriving Cash Flows 202

Chapter 6 Valuing Bonds 205

6.1 Bond Cash Flows, Prices,

and Yields 206

Bond Terminology 206

Zero-Coupon Bonds 206

■■ GLOBAL FINANCIAL CRISIS

Negative Bond Yields 208

Coupon Bonds 209

6.2 Dynamic Behavior of Bond Prices 211

Discounts and Premiums 211

Time and Bond Prices 212

Interest Rate Changes and Bond Prices 214

■■ Clean and Dirty Prices for Coupon Bonds 215

6.3 The Yield Curve and Bond Arbitrage 217

Replicating a Coupon Bond 217

Valuing a Coupon Bond Using

Zero-Coupon Yields 218

Coupon Bond Yields 219

Treasury Yield Curves 220

6.4 Corporate Bonds 220

Corporate Bond Yields 221

■■ Are Treasuries Really Default-Free Securities? 221

Bond Ratings 223

Corporate Yield Curves 224

6.5 Sovereign Bonds 224

■■ GLOBAL FINANCIAL CRISIS The Credit Crisis and Bond Yields 225

■■ GLOBAL FINANCIAL CRISIS European Sovereign Debt Yields: A Puzzle 227

■■ INTERVIEW with Carmen M. Reinhart 228

My Finance Lab 229 n Key Terms 230 n

Further Reading 231 n Problems 231 n

Data Case 235 n Case Study 236

A ppendix Forward Interest Rates 238

Computing Forward Rates 238

Computing Bond Yields from Forward

Rates 239

PART 3 VALUING PROJECTS AND FIRMS

Chapter 7  investment Decision Rules 244

7.1 NP V and Stand-Alone Projects 245

Applying the NPV Rule 245

The NPV Profile and IRR 245

Alternative Rules Versus the NPV Rule 246

■■ INTERVIEW with Dick Grannis 247

7.2 The Internal Rate of Return Rule 248

Applying the IRR Rule 248

Pitfall #1: Delayed Investments 248

Pitfall #2: Multiple IRRs 249

■■ COMMON MISTAKE

IRR Versus the IRR Rule 251

Pitfall #3: Nonexistent IRR 251

7.3 The Payback Rule 252

Applying the Payback Rule 252

Payback Rule Pitfalls in Practice 253

■■ Why Do Rules Other Than the NPV

Rule Persist? 254

7.4 Choosing Between Projects 254

NPV Rule and Mutually Exclusive

Investments 254

IRR Rule and Mutually Exclusive

Investments 255

The Incremental IRR 256

■■ When Can Returns Be Compared? 257

■■ COMMON MISTAKE

IRR and Project Financing 259

7.5 Project Selection with Resource

Constraints 259

Evaluating Projects with Different Resource Requirements 259

Profitability Index 260

Shortcomings of the Profitability Index 262

My Finance Lab 262 n Key Terms 263 n

Further Reading 263 n Problems 263 n Data Case 269

Appendix Computing the NPV Profile Using

Excel’s Data Table Function 270

Chapter 8 Fundamentals of Capital Budgeting 271

8.1 Forecasting Earnings 272

Revenue and Cost Estimates 272

Incremental Earnings Forecast 273

Indirect Effects on Incremental Earnings 275

■■ COMMON MISTAKE The Opportunity

Cost of an Idle Asset 276

Sunk Costs and Incremental Earnings 277

■■ COMMON MISTAKE

The Sunk Cost Fallacy 277

Real-World Complexities 278

8.2 Determining Free Cash Flow

and NPV 279

Calculating Free Cash Flow

from Earnings 279

Calculating Free Cash Flow

Directly 281

Calculating the NPV 282

■■ USING EXCEL Capital Budgeting

Using a Spreadsheet Program 283

8.3 Choosing Among Alternatives 284

Evaluating Manufacturing

Alternatives 284

Comparing Free Cash Flows for Cisco’s

Alternatives 285

8.4 Further Adjustments to Free

Cash Flow 286

■■ GLOBAL FINANCIAL CRISIS

The American Recovery and

Reinvestment

Act of 2009 290

8.5 Analyzing the Project 290

Break-Even Analysis 290

Sensitivity Analysis 291

■■ INTERVIEW with

David Holland 293

Scenario Analysis 294

■■ USING EXCEL Project Analysis Using Excel 295

My Finance Lab 296 n Key Terms 298 n

Further Reading 298 n Problems 298 n Data Case 305

Appendix MACRS Depreciation 307

Chapter 9 Valuing Stocks 309

9.1 The Dividend-Discount Model 310

A One-Year Investor 310

Dividend Yields, Capital Gains, and Total Returns 311

■■ The Mechanics of a Short Sale 312

A Multiyear Investor 313

The Dividend-Discount Model Equation 314

9.2 Applying the Dividend-Discount Model 314

Constant Dividend Growth 314

Dividends Versus Investment

and Growth 315

■■ John Burr Williams’ Theory

of Investment Value 316

Changing Growth Rates 318

Limitations of the Dividend-Discount Model 320

9.3 Total Payout and Free Cash Flow

Valuation Models 320

Share Repurchases and the Total Payout Model 320

The Discounted Free Cash Flow Model 322

9.4 Valuation Based on Comparable Firms 326

Valuation Multiples 326

Limitations of Multiples 328

Comparison with Discounted Cash Flow

Methods 329

Stock Valuation Techniques: The Final Word 330

■■ INTERVIEW with Douglas Kehring 331

9.5 I nformation, Competition, and Stock Prices 332

Information in Stock Prices 332

Competition and Efficient Markets 333

Lessons for Investors and Corporate

Managers 335

■■ Kenneth Cole Productions—What Happened? 337

The Efficient Markets Hypothesis Versus

No Arbitrage 338

My Finance Lab 338 n Key Terms 340 n

Further Reading 340 n Problems 341 n

Data Case 346

4 RISK AND RETURN

Chapter 10 Capital Markets and the Pricing of Risk 350

10.1 Risk and Return: Insights from 89 Years of Investor History 351

10.2 Common Measures of Risk

and Return 354

Probability Distributions 354

Expected Return 354

Variance and Standard Deviation 355

10.3 Historical Returns of Stocks and Bonds 357

Computing Historical Returns 357

Average Annual Returns 359

The Variance and Volatility of

Returns 361

Estimation Error: Using Past Returns

to Predict the Future 362

■■ Arithmetic Average Returns Versus

Compound Annual Returns 364

10.4 T he Historical Trade-Off Between Risk and Return 364

The Returns of Large Portfolios 365

The Returns of Individual Stocks 366

10.5 Common Versus Independent Risk 367

Theft Versus Earthquake Insurance:

An Example 367

The Role of Diversification 368

10.6 Diversification in Stock Portfolios 369

Firm-Specific Versus Systematic Risk 370

No Arbitrage and the Risk Premium 371

■■ GLOBAL FINANCIAL CRISIS

Diversification Benefits During

Market Crashes 373

■■ COMMON MISTAKE A Fallacy

of Long-Run Diversification 374

10.7 Measuring Systematic Risk 375

Identifying Systematic Risk: The Market

Portfolio 375

Sensitivity to Systematic Risk: Beta 375

10.8 Beta and the Cost of Capital 378

Estimating the Risk Premium 378

■■ COMMON MISTAKE

Beta Versus Volatility 378

The Capital Asset Pricing Model 380

MyFinanceLab 380 n Key Terms 382 n

Further Reading 382 n Problems 382 n

Data Case 387

Chapter 11 O ptimal Portfolio Choice

and the Capital Asset Pricing

Model 389

11.1 T he Expected Return of a Portfolio 390

11.2 T he Volatility of a Two-Stock Portfolio 391

Combining Risks 391

Determining Covariance

and Correlation 392

■■ COMMON MISTAKE

Computing Variance, Covariance,

and Correlation in Excel 394

Computing a Portfolio’s Variance

and Volatility 395

11.3 T he Volatility of a Large Portfolio 397

Large Portfolio Variance 397

Diversification with an Equally Weighted

Portfolio 398

■■ INTERVIEW with John Powers 400

Diversification with General

Portfolios 401

11.4 R isk Versus Return: Choosing an Efficient Portfolio 401

Efficient Portfolios with Two Stocks 402

The Effect of Correlation 404

Short Sales 405

Efficient Portfolios with Many

Stocks 406

■■ NOBEL PRIZES Harry Markowitz

and James Tobin 407

11.5 R isk-Free Saving and Borrowing 409

Investing in Risk-Free Securities 409

Borrowing and Buying Stocks

on Margin 410

Identifying the Tangent Portfolio 411

11.6 T he Efficient Portfolio and Required

Returns 413

Portfolio Improvement: Beta

and the Required Return 413

Expected Returns and the Efficient

Portfolio 415

11.7 T he Capital Asset Pricing Model 417

The CAPM Assumptions 417

Supply, Demand, and the Efficiency

of the Market Portfolio 418

Optimal Investing: The Capital

Market Line 418

11.8 Determining the Risk Premium 419

Market Risk and Beta 419

■■ NOBEL PRIZE William Sharpe

on the CAPM 421

The Security Market Line 422

Beta of a Portfolio 422

Summary of the Capital Asset

Pricing Model 424

MyFinanceLab 424 n Key Terms 427 n

Further Reading 427 n Problems 428 n

Data Case 434

A ppendix The CAPM with Differing

Interest Rates 436

The Efficient Frontier with Differing Saving

and Borrowing Rates 436

The Security Market Line with Differing

Interest Rates 436

Chapter 12 E stimating the Cost

of Capital 439

12.1 T he Equity Cost of Capital 440

12.2 T he Market Portfolio 441

Constructing the Market Portfolio 441

Market Indexes 441

■■ Value-Weighted Portfolios and

Rebalancing 442

The Market Risk Premium 443

12.3 Beta Estimation 445

Using Historical Returns 445

Identifying the Best-Fitting Line 447

Using Linear Regression 448

■■ Why Not Estimate Expected Returns

Directly? 449

12.4 T he Debt Cost of Capital 449

Debt Yields Versus Returns 449

■■ COMMON MISTAKE Using the Debt

Yield as Its Cost of Capital 450

Debt Betas 451

12.5 A Project’s Cost of Capital 452

All-Equity Comparables 452

Levered Firms as Comparables 453

The Unlevered Cost of Capital 453

Industry Asset Betas 455

12.6 P roject Risk Characteristics

and Financing 457

Differences in Project Risk 457

■■ COMMON MISTAKE Adjusting

for Execution Risk 459

Financing and the Weighted Average Cost

of Capital 459

■■ INTERVIEW with Shelagh Glaser 460

■■ COMMON MISTAKE

Using a Single Cost of Capital

in Multi-Divisional Firms 461

12.7 Final Thoughts on Using

the CAPM 462

MyFinanceLab 463 n Key Terms 465 n

Further Reading 465 n Problems 466 n

Data Case 470

A ppendix Practical Considerations When

Forecasting

Beta 471

Time Horizon 471

The Market Proxy 471

Beta Variation and Extrapolation 471

Outliers 472

■■ COMMON MISTAKE Changing

the Index to Improve the Fit 473

■■ USING EXCEL Estimating Beta

Using Excel 474

Other Considerations 475

Chapter 13 I nvestor Behavior and Capital

Market Efficiency 477

13.1 Competition and Capital

Markets 478

Identifying a Stock’s Alpha 478

Profiting from Non-Zero Alpha

Stocks 479

13.2 Information and Rational Expectations 480

Informed Versus Uninformed Investors 480

Rational Expectations 481

13.3 T he Behavior of Individual

Investors 482

Underdiversification and Portfolio Biases 482

Excessive Trading and Overconfidence 483

Individual Behavior and Market Prices 485

13.4 Systematic Trading Biases 485

Hanging on to Losers and the

Disposition Effect 485

■■ NOBEL PRIZE Kahneman and

Tversky’s

Prospect Theory 486

Investor Attention, Mood,

and Experience 486

Herd Behavior 487

Implications of Behavioral

Biases 487

13.5 T he Efficiency of the Market

P

ortfolio 488

Trading on News or

Recommendations

488

■■ NOBEL PRIZE The 2013 Prize:

An Enigma? 490

The Performance of Fund

Managers 490

The Winners and Losers 493

13.6 Style-Based Techniques and the Market

Efficiency Debate 494

Size Effects 494

■■ INTERVIEW with

Jonathan Clements 496

Momentum 498

■■ Market Efficiency and the Efficiency

of the Market Portfolio 499

Implications of Positive-Alpha Trading

Strategies 499

13.7 Multifactor Models of Risk 501

Using Factor Portfolios 502

Selecting the Portfolios 503

The Cost of Capital with Fama-French-

Carhart Factor Specification 504

13.8 Methods Used in Practice 506

Financial Managers 506

Investors 507

MyFinanceLab 508 n Key Terms 510 n

Further Reading 510 n Problems 511

A ppendix Building a Multifactor Model 517

PART 5 CAPITA L STRUCTURE                    Chapter 14 Capital Structure in a Perfect

Market 520

14.1 E quity Versus Debt Financing 521

Financing a Firm with Equity 521

Financing a Firm with Debt

and Equity 522

The Effect of Leverage on Risk

and Return 523

14.2 Modigliani-Miller I: Leverage, Arbitrage,

and Firm Value 525

MM and the Law of One Price 525

Homemade Leverage 525

■■ MM and the Real World 526

The Market Value Balance Sheet 527

Application: A Leveraged

Recapitalization

528

14.3 Modigliani-Miller II: Leverage, Risk,

and the Cost of Capital 530

Leverage and the Equity Cost

of Capital 530

Capital Budgeting and the Weighted

Average

Cost of Capital 531

■■ COMMON MISTAKE

Is Debt Better Than Equity? 534

Computing the WACC with Multiple

Securities

534

Levered and Unlevered Betas 534

■■ NOBEL PRIZE Franco Modigliani

and Merton Miller 536

14.4 Capital Structure Fallacies 537

Leverage and Earnings per Share 537

■■ GLOBAL FINANCIAL CRISIS

Bank Capital Regulation and

the ROE Fallacy 539

Equity Issuances and Dilution 540

14.5 MM: Beyond the Propositions 541

MyFinanceLab 542 n Key Terms 543 n

Further Reading 543 n Problems 544 n

Data Case 548

Chapter 15 Debt and Taxes 551

15.1 T he Interest Tax Deduction 552

15.2 Valuing the Interest Tax Shield 554

The Interest Tax Shield and Firm

Value

554

■■ Pizza and Taxes 555

The Interest Tax Shield with Permanent

Debt 555

The Weighted Average Cost of Capital

with Taxes 556

■■ The Repatriation Tax: Why Some

Cash-

Rich Firms Borrow 557

The Interest Tax Shield with a Target Debt-

Equity Ratio 558

15.3 R ecapitalizing to Capture the Tax

Shield 560

The Tax Benefit 560

The Share Repurchase 561

No Arbitrage Pricing 561

Analyzing the Recap: The Market Value

Balance Sheet 562

15.4 P ersonal Taxes 563

Including Personal Taxes in the Interest

Tax Shield 563

Valuing the Interest Tax Shield

with Personal Taxes 566

Determining the Actual Tax Advantage

of Debt 567

■■ Cutting the Dividend Tax Rate 567

15.5 O ptimal Capital Structure

with T

axes 568

Do Firms Prefer Debt? 568

Limits to the Tax Benefit of Debt 571

■■ INTERVIEW with

Andrew Balson 572

Growth and Debt 573

Other Tax Shields 574

The Low Leverage Puzzle 574

■■ Employee Stock Options 576

MyFinanceLab 576 n Key Terms 577 n

Further Reading 577 n Problems 578 n

Data Case 582

Chapter 16 Financial Distress, Managerial

Incentives,

and Information

583

16.1 Default and Bankruptcy in a Perfect

Market 584

Armin Industries: Leverage and the Risk

of Default 584

Bankruptcy and Capital Structure 585

16.2 T he Costs of Bankruptcy and Financial

Distress 586

The Bankruptcy Code 587

Direct Costs of Bankruptcy 587

Indirect Costs of Financial

Distress 588

■■ GLOBAL FINANCIAL CRISIS

The Chrysler Prepack 591

16.3 Financial Distress Costs and Firm

Value 592

Armin Industries: The Impact of Financial

Distress Costs 592

Who Pays for Financial Distress

Costs? 592

16.4 O ptimal Capital Structure: The Trade-

Off Theory 594

The Present Value of Financial

Distress Costs 594

Optimal Leverage 595

16.5 E xploiting Debt Holders: The Agency

Costs of Leverage 597

Excessive Risk-Taking and Asset

Substitution

597

Debt Overhang and Under-Investment 598

■■ GLOBAL FINANCIAL CRISIS

Bailouts, Distress Costs, and Debt

Overhang 599

Agency Costs and the Value

of Leverage 600

The Leverage Ratchet Effect 601

Debt Maturity and Covenants 602

■■ Why Do Firms Go Bankrupt? 602

16.6 Motivating Managers: The Agency

Benefits

of Leverage 603

Concentration of Ownership 604

Reduction of Wasteful Investment 604

■■ Excessive Perks and Corporate

Scandals 605

■■ GLOBAL FINANCIAL CRISIS

Moral Hazard, Government Bailouts,

and the Appeal of Leverage 606

Leverage and Commitment 607

16.7 A gency Costs and the Trade-Off

Theory 607

The Optimal Debt Level 608

Debt Levels in Practice 609

16.8 A symmetric Information and Capital

Structure 609

Leverage as a Credible Signal 609

Issuing Equity and Adverse

Selection 611

■■ NOBEL PRIZE The 2001 Nobel Prize

in Economics 613

Implications for Equity Issuance 613

Implications for Capital Structure 614

16.9 Capital Structure: The Bottom Line 617

MyFinanceLab 618 n Key Terms 620 n

Further Reading 620 n Problems 620

Chapter 17 P ayout Policy 629

17.1 Distributions to Shareholders 630

Dividends 630

Share Repurchases 632

17.2 Comparison of Dividends and Share

Repurchases 633

Alternative Policy 1: Pay Dividend

with Excess Cash 633

Alternative Policy 2: Share Repurchase

(No Dividend) 634

■■ COMMON MISTAKE Repurchases

and the Supply of Shares 636

Alternative Policy 3: High Dividend

(Equity Issue) 636

Modigliani-Miller and Dividend Policy

Irrelevance 637

■■ COMMON MISTAKE The Bird

in the Hand Fallacy 638

Dividend Policy with Perfect Capital

Markets 638

17.3 T he Tax Disadvantage

of Dividends 638

Taxes on Dividends and Capital Gains 639

Optimal Dividend Policy

with Taxes 640

17.4 Dividend Capture and Tax

Clienteles 642

The Effective Dividend Tax Rate 642

Tax Differences Across Investors 643

Clientele Effects 644

■■ INTERVIEW with

John Connors 645

17.5 P ayout Versus Retention of Cash 647

Retaining Cash with Perfect Capital

Markets

648

Taxes and Cash Retention 649

Adjusting for Investor Taxes 650

Issuance and Distress Costs 651

Agency Costs of Retaining Cash 652

17.6 Signaling with Payout Policy 654

Dividend Smoothing 654

Dividend Signaling 655

■■ Royal & SunAlliance’s

Dividend Cut 656

Signaling and Share Repurchases 656

17.7 Stock Dividends, Splits,

and Spin-Offs 658

Stock Dividends and Splits 658

Spin-Offs 660

■■ Berkshire Hathaway’s

A & B Shares 661

MyFinanceLab 662 n Key Terms 663 n

Further Reading 664 n Problems 664 n

Data Case 668

PART 6 A DVANCED VALUATION

Chapter 18 Capital Budgeting and

Valuation with Leverage 672

18.1 O verview of Key Concepts 673

18.2 T he Weighted Average Cost

of Capital Method 674

■■ INTERVIEW with Zane Rowe 675

Using the WACC to Value a Project 676

Summary of the WACC Method 677

Implementing a Constant Debt-Equity

Ratio 678

18.3 T he Adjusted Present Value Method 680

The Unlevered Value of the Project 680

Valuing the Interest Tax Shield 681

Summary of the APV Method 682

18.4 T he Flow-to-Equity Method 684

Calculating the Free Cash Flow

to Equity 684

Valuing Equity Cash Flows 685

■■ What Counts as “Debt”? 686

Summary of the Flow-to-Equity

Method 686

18.5 P roject-Based Costs

of Capital 687

Estimating the Unlevered Cost

of Capital 688

Project Leverage and the Equity Cost

of Capital 688

Determining the Incremental Leverage

of a Project 690

■■ COMMON MISTAKE

Re-Levering the WACC 690

18.6 AP V with Other Leverage

Policies 692

Constant Interest Coverage

Ratio 692

Predetermined Debt Levels 693

A Comparison of Methods 695

18.7 O ther Effects of Financing 695

Issuance and Other Financing

Costs 695

Security Mispricing 696

Financial Distress and Agency Costs 697

■■ GLOBAL FINANCIAL CRISIS

Government Loan Guarantees 698

18.8 A dvanced Topics in Capital Budgeting 698

Periodically Adjusted Debt 699

Leverage and the Cost of Capital 701

The WACC or FTE Method with Changing Leverage 703

Personal Taxes 704

MyFinanceLab 706 n Key Terms 708 n

Further Reading 708 n Problems 709 n

Data Case 715

ppendix Foundations and Further Details 717

Deriving the WACC Method 717

The Levered and Unlevered Cost of

Capital 718

Solving for Leverage and Value

Simultaneously 719

The Residual Income and Economic Value

Added Valuation Methods 721

Chapter 19 Valuation and Financial

Modeling: A Case Study 723

19.1 Valuation Using Comparables 724

19.2 T he Business Plan 726

Operational Improvements 726

Capital Expenditures: A Needed

Expansion 727

Working Capital Management 728

Capital Structure Changes: Levering Up 728

19.3 Building the Financial Model 729

Forecasting Earnings 729

■■ INTERVIEW with

Joseph L. Rice, III 730

Working Capital Requirements 732

Forecasting Free Cash Flow 733

■■ USING EXCEL

Summarizing Model Outputs 735

The Balance Sheet and Statement

of Cash Flows (Optional) 736

■■ USING EXCEL

Auditing Your Financial Model 738

19.4 E stimating the Cost of Capital 739

CAPM-Based Estimation 739

Unlevering Beta 740

Ideko’s Unlevered Cost of

Capital 740

19.5 Valuing the Investment 741

The Multiples Approach to Continuation

Value 742

The Discounted Cash Flow Approach

to Continuation Value 743

■■ COMMON MISTAKE Continuation

Values and Long-Run Growth 745

APV Valuation of Ideko’s Equity 745

A Reality Check 746

■■ COMMON MISTAKE

Missing Assets or Liabilities 746

IRR and Cash Multiples 747

19.6 Sensitivity Analysis 748

MyFinanceLab 749 n Key Terms 750 n

Further Reading 750 n Problems 751

A ppendix Compensating Management 753

Glossary 755

Index 775

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