Fundamentals of Corporate Finance 12th Edition PDF by Stephen A. Ross, Randolph W. Westerfield, Bradford D. Jordan

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Fundamentals of Corporate Finance, Twelfth Edition

by Stephen A. Ross, Randolph W. Westerfield, Bradford D. Jordan

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

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

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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