Corporate Finance, Fifth Edition PDF by Jonathan Berk and Peter Demarzo

By

Corporate Finance, Fifth Edition

By Jonathan Berk and Peter Demarzo

Corporate Finance, Fifth Edition

Detailed Contents

PART 1 INTRODUCTION 31

Chapter 1 The Corporation and Financial

Markets 32

1.1 The Four Types of Firms 33

Sole Proprietorships 33

Partnerships 34

Limited Liability Companies 35

Corporations 35

Tax Implications for Corporate Entities 36

■■ Corporate Taxation Around the

World 37

1.2 Ownership Versus Control of

Corporations 37

The Corporate Management Team 37

■■ INTERVIEW with David Viniar 38

The Financial Manager 39

■■ GLOBAL FINANCIAL CRISIS The

Dodd-Frank Act 40

The Goal of the Firm 40

The Firm and Society 41

Ethics and Incentives within

Corporations 41

■■ GLOBAL FINANCIAL CRISIS The Dodd-

Frank Act on Corporate Compensation

and Governance 42

■■ Citizens United v. Federal Election

Commission 42

■■ Airlines in Bankruptcy 44

1.3 The Stock Market 44

Primary and Secondary Stock Markets 45

Traditional Trading Venues 45

■■ INTERVIEW with Frank Hatheway 46

New Competition and Market

Changes 47

Dark Pools 48

1.4 Fintech: Finance and Technology 49

Telecommunications 49

Security and Verification 49

Automation of Banking Services 50

Big Data and Machine Learning 50

Competition 51

MyLab Finance 51 Key Terms 52

Further Reading 53  Problems 53

Chapter 2 Introduction to Financial

Statement Analysis 57

2.1 Firms’ Disclosure of Financial

Information 58

Preparation of Financial Statements 58

■■ International Financial Reporting

Standards 58

■■ INTERVIEW with Ruth Porat 59

Types of Financial Statements 60

2.2 The Balance Sheet 60

Assets 61

Liabilities 62

Stockholders’ Equity 63

Market Value Versus Book Value 63

Enterprise Value 64

2.3 The Income Statement 64

Earnings Calculations 65

2.4 The Statement of Cash Flows 66

Operating Activity 67

Investment Activity 68

Financing Activity 68

2.5 Other Financial Statement Information 69

Statement of Stockholders’ Equity 69

Management Discussion and Analysis 70

Notes to the Financial Statements 70

2.6 Financial Statement Analysis 71

Profitability Ratios 71

Liquidity Ratios 72

Working Capital Ratios 73

Interest Coverage Ratios 74

Leverage Ratios 75

Valuation Ratios 77

■■ COMMON MISTAKE Mismatched

Ratios 77

Operating Returns 78

The DuPont Identity 80

2.7 Financial Reporting in Practice 82

Enron 82

WorldCom 82

Sarbanes-Oxley Act 83

■■ GLOBAL FINANCIAL CRISIS Bernard

Madoff’s Ponzi Scheme 84

Dodd-Frank Act 84

MyLab Finance 85 Key Terms 86

Further Reading 87 Problems 87

Data Case 94

Chapter 3 Financial Decision Making and the

Law of One Price 95

3.1 Valuing Decisions 96

Analyzing Costs and Benefits 96

Using Market Prices to Determine Cash

Values 97

■■ When Competitive Market Prices Are Not

Available 99

3.2 Interest Rates and the Time Value of

Money 99

The Time Value of Money 99

The Interest Rate: An Exchange Rate Across

Time 99

3.3 Present Value and the NPV Decision

Rule 102

Net Present Value 102

The NPV Decision Rule 103

NPV and Cash Needs 105

3.4 Arbitrage and the Law of One Price 106

Arbitrage 106

Law of One Price 107

3.5 No-Arbitrage and Security Prices 107

Valuing a Security with the Law of One

Price 107

■■ An Old Joke 111

The NPV of Trading Securities and Firm

Decision Making 111

Valuing a Portfolio 112

■■ GLOBAL FINANCIAL CRISIS Liquidity

and the Informational Role of Prices 113

■■ Arbitrage in Markets 114

Where Do We Go from Here? 115

Appendix The Price of Risk 122

Risky Versus Risk-Free Cash Flows 122

Arbitrage with Transactions Costs 127

MyLab Finance 116 Key Terms 117

Further Reading 117 Problems 117

Data Case 121

PART 2 TIME, MONEY, AND

INTEREST RATES 131

Chapter 4 The Time Value of Money 132

4.1 The Timeline 133

4.2 The Three Rules of Time Travel 134

Rule 1: Comparing and Combining

Values 134

Rule 2: Moving Cash Flows Forward in

Time 135

Rule 3: Moving Cash Flows Back in Time 136

■■ Rule of 72 137

Applying the Rules of Time Travel 138

4.3 Valuing a Stream of Cash Flows 140

4.4 Calculating the Net Present Value 143

■■ USING EXCEL Calculating Present Values

in Excel 144

4.5 Perpetuities and Annuities 145

Perpetuities 145

■■ Historical Examples of Perpetuities 146

■■ COMMON MISTAKE Discounting One

Too Many Times 148

Annuities 148

■■ Formula for an Annuity Due 151

Growing Cash Flows 151

4.6 Using an Annuity Spreadsheet or

Calculator 156

4.7 Non-Annual Cash Flows 158

4.8 Solving for the Cash Payments 159

4.9 The Internal Rate of Return 162

■■ USING EXCEL Excel’s IRR Function 165

Appendix Solving for the Number of Periods 175

MyLab Finance 166 Key Terms 167

Further Reading 168 Problems 168

Data Case 174

Chapter 5 Interest Rates 177

5.1 Interest Rate Quotes and Adjustments 178

The Effective Annual Rate 178

■■ COMMON MISTAKE Using the

Wrong Discount Rate in the Annuity

Formula 179

Annual Percentage Rates 180

5.2 Application: Discount Rates and Loans 182

5.3 The Determinants of Interest Rates 183

■■ GLOBAL FINANCIAL CRISIS Teaser Rates

and Subprime Loans 184

Inflation and Real Versus Nominal

Rates 184

Investment and Interest Rate Policy 185

The Yield Curve and Discount Rates 186

The Yield Curve and the Economy 188

■■ COMMON MISTAKE Using the Annuity

Formula When Discount Rates Vary by

Maturity 188

■■ INTERVIEW with Dr. Janet Yellen 190

5.4 Risk and Taxes 191

Risk and Interest Rates 192

After-Tax Interest Rates 193

5.5 The Opportunity Cost of Capital 194

■■ COMMON MISTAKE States Dig a Multi-

Trillion Dollar Hole by Discounting at the

Wrong Rate 195

Appendix Continuous Rates and Cash Flows 204

Discount Rates for a Continuously

Compounded APR 204

Continuously Arriving Cash Flows 204

MyLab Finance 196 Key Terms 197

Further Reading 197 Problems 197

Data Case 202

Chapter 6 Valuing Bonds 207

6.1 Bond Cash Flows, Prices, and Yields 208

Bond Terminology 208

Zero-Coupon Bonds 208

■■ GLOBAL FINANCIAL CRISIS Negative

Bond Yields 210

Coupon Bonds 211

6.2 Dynamic Behavior of Bond Prices 213

Discounts and Premiums 213

Time and Bond Prices 214

Interest Rate Changes and Bond Prices 216

■■ Clean and Dirty Prices for Coupon

Bonds 217

6.3 The Yield Curve and Bond Arbitrage 219

Replicating a Coupon Bond 219

Valuing a Coupon Bond Using Zero-Coupon

Yields 220

Coupon Bond Yields 221

Treasury Yield Curves 222

6.4 Corporate Bonds 222

Corporate Bond Yields 223

■■ Are Treasuries Really Default-Free

Securities? 223

Bond Ratings 225

Corporate Yield Curves 226

6.5 Sovereign Bonds 226

■■ GLOBAL FINANCIAL CRISIS The Credit

Crisis and Bond Yields 227

■■ GLOBAL FINANCIAL CRISIS European

Sovereign Debt Yields: A Puzzle 229

■■ INTERVIEW with Carmen M. Reinhart 230

Appendix Forward Interest Rates 240

Computing Forward Rates 240

Computing Bond Yields from Forward

Rates 241

Forward Rates and Future Interest

Rates 242

MyLab Finance 231 Key Terms 232

Further Reading 233 Problems 233

Data Case 237 Case Study 238

PART 3 VALUING PROJECTS AND

FIRMS 245

Chapter 7 Investment Decision Rules 246

7.1 NPV and Stand-Alone Projects 247

Applying the NPV Rule 247

The NPV Profile and IRR 247

Alternative Rules Versus the

NPV Rule 248

■■ INTERVIEW with Dick Grannis 249

7.2 The Internal Rate of Return Rule 250

Applying the IRR Rule 250

Pitfall #1: Delayed Investments 250

Pitfall #2: Multiple IRRs 251

■■ COMMON MISTAKE IRR Versus the IRR

Rule 253

Pitfall #3: Nonexistent IRR 253

7.3 The Payback Rule 254

Applying the Payback Rule 254

Payback Rule Pitfalls in Practice 255

■■ Why Do Rules Other Than the NPV Rule Persist? 256

7.4 Choosing between Projects 256

NPV Rule and Mutually Exclusive

Investments 256

IRR Rule and Mutually Exclusive

Investments 257

The Incremental IRR 258

■■ When Can Returns Be Compared? 259

■■ COMMON MISTAKE IRR and Project

Financing 261

7.5 Project Selection with Resource

Constraints 261

Evaluating Projects with Different Resource

Requirements 261

Profitability Index 262

Shortcomings of the Profitability Index 264

Appendix Computing the NPV Profile Using Excel’s

Data Table Function 272

MyLab Finance 264 Key Terms 265

Further Reading 265 Problems 265

Data Case 271

Chapter 8 Fundamentals of Capital

Budgeting 273

8.1 Forecasting Earnings 274

Revenue and Cost Estimates 274

Incremental Earnings Forecast 275

Indirect Effects on Incremental Earnings 277

■■ COMMON MISTAKE The Opportunity

Cost of an Idle Asset 278

Sunk Costs and Incremental Earnings 279

■■ COMMON MISTAKE The Sunk Cost

Fallacy 279

Real-World Complexities 280

8.2 Determining Free Cash Flow and NPV 281

Calculating Free Cash Flow from

Earnings 281

Calculating Free Cash Flow Directly 283

Calculating the NPV 284

■■ USING EXCEL Capital Budgeting Using

Excel 285

8.3 Choosing among Alternatives 286

Evaluating Manufacturing Alternatives 286

Comparing Free Cash Flows for Cisco’s

Alternatives 287

8.4 Further Adjustments to Free Cash Flow 287

■■ INTERVIEW with David Holland 292

8.5 Analyzing the Project 293

Break-Even Analysis 293

■■ COMMON MISTAKE Corporate Tax Rates

and Investment 294

Sensitivity Analysis 294

Scenario Analysis 296

■■ USING EXCEL Project Analysis Using

Excel 297

Appendix MACRS Depreciation 309

MyLab Finance 299 Key Terms 300

Further Reading 300

Problems 301 Data Case 307

Chapter 9 Valuing Stocks 311

9.1 The Dividend-Discount Model 312

A One-Year Investor 312

Dividend Yields, Capital Gains, and Total

Returns 313

■■ The Mechanics of a Short Sale 314

A Multiyear Investor 315

The Dividend-Discount Model

Equation 316

9.2 Applying the Dividend-Discount Model 316

Constant Dividend Growth 316

Dividends Versus Investment and

Growth 317

■■ John Burr Williams’s Theory of Investment

Value 318

Changing Growth Rates 320

Limitations of the Dividend-Discount

Model 322

9.3 Total Payout and Free Cash Flow Valuation

Models 322

Share Repurchases and the Total Payout

Model 322

The Discounted Free Cash Flow Model 324

9.4 Valuation Based on Comparable Firms 328

Valuation Multiples 328

Limitations of Multiples 330

Comparison with Discounted Cash Flow

Methods 331

Stock Valuation Techniques: The Final

Word 332

■■ Kenneth Cole Productions—What

Happened? 333

■■ Cryptocurrencies and Price Bubbles 334

■■ INTERVIEW with Susan Athey 336

9.5 Information, Competition, and Stock

Prices 337

Information in Stock Prices 337

Competition and Efficient Markets 338

Lessons for Investors and Corporate

Managers 340

The Efficient Markets Hypothesis Versus No

Arbitrage 342

MyLab Finance 342 Key Terms 344

Further Reading 344 Problems 345

Data Case 350

PART 4 RISK AND RETURN 353

Chapter 10 Capital Markets and the Pricing of

Risk 354

10.1 Risk and Return: Insights from 92 Years of

Investor History 355

10.2 Common Measures of Risk and Return 358

Probability Distributions 358

Expected Return 358

Variance and Standard Deviation 359

10.3 Historical Returns of Stocks and Bonds 361

Computing Historical Returns 361

Average Annual Returns 363

The Variance and Volatility of Returns 365

Estimation Error: Using Past Returns to Predict

the Future 366

■■ Arithmetic Average Returns Versus Compound

Annual Returns 368

10.4 The Historical Tradeoff Between Risk and

Return 368

The Returns of Large Portfolios 369

The Returns of Individual Stocks 370

10.5 Common Versus Independent Risk 371

Theft Versus Earthquake Insurance: An

Example 371

The Role of Diversification 372

10.6 Diversification in Stock Portfolios 373

Firm-Specific Versus Systematic Risk 374

No Arbitrage and the Risk Premium 375

■■ GLOBAL FINANCIAL CRISIS Diversification

Benefits During Market Crashes 377

■■ COMMON MISTAKE A Fallacy of Long-

Run Diversification 378

10.7 Measuring Systematic Risk 379

Identifying Systematic Risk: The Market

Portfolio 379

Sensitivity to Systematic Risk: Beta 379

10.8 Beta and the Cost of Capital 382

Estimating the Risk Premium 382

■■ COMMON MISTAKE Beta Versus

Volatility 382

The Capital Asset Pricing Model 384

MyLab Finance 384  Key Terms 386

Further Reading 386  Problems 386

Data Case 391

Chapter 11 Optimal Portfolio Choice and the

Capital Asset Pricing Model 393

11.1 The Expected Return of a Portfolio 394

11.2 The Volatility of a Two-Stock Portfolio 395

Combining Risks 395

Determining Covariance and

Correlation 396

■■ COMMON MISTAKE Computing

Variance, Covariance, and Correlation

in Excel 398

Computing a Portfolio’s Variance and

Volatility 399

11.3 The Volatility of a Large Portfolio 401

Large Portfolio Variance 401

Diversification with an Equally Weighted

Portfolio 402

■■ INTERVIEW with Anne Martin 404

Diversification with General Portfolios 405

11.4 Risk Versus Return: Choosing an Efficient

Portfolio 405

Efficient Portfolios with Two Stocks 406

The Effect of Correlation 408

Short Sales 409

Efficient Portfolios with Many Stocks 410

■■ NOBEL PRIZE Harry Markowitz and James

Tobin 411

11.5 Risk-Free Saving and Borrowing 413

Investing in Risk-Free Securities 413

Borrowing and Buying Stocks on

Margin 414

Identifying the Tangent Portfolio 415

11.6 The Efficient Portfolio and Required

Returns 417

Portfolio Improvement: Beta and the Required

Return 417

Expected Returns and the Efficient

Portfolio 419

11.7 The Capital Asset Pricing Model 421

The CAPM Assumptions 421

Supply, Demand, and the Efficiency of the

Market Portfolio 422

Optimal Investing: The Capital Market

Line 422

11.8 Determining the Risk Premium 423

Market Risk and Beta 423

■■ NOBEL PRIZE William Sharpe on the

CAPM 425

The Security Market Line 426

Beta of a Portfolio 426

Summary of the Capital Asset Pricing

Model 428

Appendix The CAPM with Differing Interest

Rates 440

The Efficient Frontier with Differing Saving

and Borrowing Rates 440

The Security Market Line with Differing

Interest Rates 440

MyLab Finance 428  Key Terms 431

Further Reading 431  Problems 432

Data Case 438

Chapter 12 Estimating the Cost of Capital 443

12.1 The Equity Cost of Capital 444

12.2 The Market Portfolio 445

Constructing the Market Portfolio 445

Market Indexes 445

■■ Value-Weighted Portfolios and

Rebalancing 446

The Market Risk Premium 447

12.3 Beta Estimation 449

Using Historical Returns 449

Identifying the Best-Fitting Line 451

Using Linear Regression 452

■■ Why Not Estimate Expected Returns

Directly? 453

12.4 The Debt Cost of Capital 453

Debt Yields Versus Returns 453

■■ COMMON MISTAKE Using the Debt Yield

as Its Cost of Capital 454

Debt Betas 455

12.5 A Project’s Cost of Capital 456

All-Equity Comparables 456

Levered Firms as Comparables 457

The Unlevered Cost of Capital 457

Industry Asset Betas 459

12.6 Project Risk Characteristics and

Financing 461

Differences in Project Risk 461

■■ COMMON MISTAKE Adjusting for

Execution Risk 463

Financing and the Weighted Average Cost of

Capital 463

■■ INTERVIEW with Shelagh Glaser 464

■■ COMMON MISTAKE Using a Single Cost

of Capital in Multi-Divisional Firms 465

12.7 Final Thoughts on Using the CAPM 466

Appendix Practical Considerations When Forecasting

Beta 475

Time Horizon 475

The Market Proxy 475

Beta Variation and Extrapolation 475

Outliers 476

■■ COMMON MISTAKE Changing the Index

to Improve the Fit 477

■■ USING EXCEL Estimating Beta Using

Excel 478

Other Considerations 479

MyLab Finance 467  Key Terms 469

Further Reading 469  Problems 470

Data Case 474

Chapter 13 Investor Behavior and Capital

Market Efficiency 481

13.1 Competition and Capital Markets 482

Identifying a Stock’s Alpha 482

Profiting from Non-Zero Alpha Stocks 483

13.2 Information and Rational Expectations 484

Informed Versus Uninformed Investors 484

Rational Expectations 485

13.3 The Behavior of Individual Investors 486

Underdiversification and Portfolio Biases 486

Excessive Trading and Overconfidence 487

Individual Behavior and Market Prices 489

13.4 Systematic Trading Biases 489

Hanging on to Losers and the Disposition

Effect 489

■■ NOBEL PRIZE Prospect Theory, Mental

Accounting, and Nudges 490

Investor Attention, Mood, and

Experience 490

Herd Behavior 491

Implications of Behavioral Biases 491

13.5 The Efficiency of the Market Portfolio 492

Trading on News or Recommendations 492

■■ NOBEL PRIZE The 2013 Prize: An

Enigma? 494

The Performance of Fund Managers 494

The Winners and Losers 497

13.6 Style-Based Techniques and the Market

Efficiency Debate 498

Size Effects 498

■■ INTERVIEW with Jonathan Clements 500

Momentum 502

■■ Market Efficiency and the Efficiency of the

Market Portfolio 503

Implications of Positive-Alpha Trading

Strategies 503

13.7 Multifactor Models of Risk 505

Using Factor Portfolios 505

Smart Beta 506

Long-Short Portfolios 506

Selecting the Portfolios 507

The Cost of Capital with Fama-French-Carhart

Factor Specification 508

13.8 Methods Used in Practice 510

Financial Managers 510

Investors 511

Appendix Building a Multifactor Model 521

MyLab Finance 512 ■ Key Terms 514 ■

Further Reading 514 ■ Problems 515

PART 5 CAPITAL STRUCTURE 523

Chapter 14 Capital Structure in a Perfect

Market 524

14.1 Equity Versus Debt Financing 525

Financing a Firm with Equity 525

Financing a Firm with Debt and Equity 526

The Effect of Leverage on Risk and Return 527

14.2 Modigliani-Miller I: Leverage, Arbitrage, and

Firm Value 529

MM and the Law of One Price 529

Homemade Leverage 529

■■ MM and the Real World 530

The Market Value Balance Sheet 531

Application: A Leveraged Recapitalization 532

14.3 Modigliani-Miller II: Leverage, Risk, and the

Cost of Capital 534

Leverage and the Equity Cost of

Capital 534

Capital Budgeting and the Weighted Average

Cost of Capital 535

■■ COMMON MISTAKE Is Debt Better Than

Equity? 538

Computing the WACC with Multiple

Securities 538

Levered and Unlevered Betas 538

■■ NOBEL PRIZE Franco Modigliani and

Merton Miller 540

14.4 Capital Structure Fallacies 541

Leverage and Earnings per Share 541

■■ GLOBAL FINANCIAL CRISIS Bank Capital

Regulation and the ROE Fallacy 543

Equity Issuances and Dilution 544

14.5 MM: Beyond the Propositions 545

MyLab Finance 546 ■ Key Terms 547 ■

Further Reading 547 ■ Problems 548 ■

Data Case 552

Chapter 15 Debt and Taxes 555

15.1 The Interest Tax Deduction 556

15.2 Valuing the Interest Tax Shield 558

The Interest Tax Shield and Firm

Value 558

■■ Pizza and Taxes 559

The Interest Tax Shield with Permanent

Debt 559

The Weighted Average Cost of Capital with

Taxes 560

■■ The Repatriation Tax: Why Some Cash-

Rich Firms Borrowed 561

The Interest Tax Shield with a Target Debt-

Equity Ratio 562

15.3 Recapitalizing to Capture the Tax

Shield 564

The Tax Benefit 564

The Share Repurchase 565

No Arbitrage Pricing 565

Analyzing the Recap: The Market Value

Balance Sheet 566

15.4 Personal Taxes 567

Including Personal Taxes in the Interest Tax

Shield 567

Determining the Actual Tax Advantage of

Debt 570

Valuing the Interest Tax Shield with Personal

Taxes 571

■■ COMMON MISTAKE How to Save for

Retirement 572

15.5 Optimal Capital Structure with Taxes 573

Do Firms Prefer Debt? 573

Limits to the Tax Benefit of Debt 576

Growth and Debt 577

■■ INTERVIEW with Andrew Balson 578

Other Tax Shields 579

The Low Leverage Puzzle 579

■■ Employee Stock Options 581

MyLab Finance 581 ■ Key Terms 582 ■

Further Reading 582 ■ Problems 583 ■

Data Case 587

Chapter 16 Financial Distress, Managerial

Incentives, and Information 589

16.1 Default and Bankruptcy in a Perfect

Market 590

Armin Industries: Leverage and the Risk of

Default 590

Bankruptcy and Capital Structure 591

16.2 The Costs of Bankruptcy and Financial

Distress 592

The Bankruptcy Code 593

Direct Costs of Bankruptcy 593

Indirect Costs of Financial Distress 594

■■ GLOBAL FINANCIAL CRISIS The Chrysler

Prepack 597

16.3 Financial Distress Costs and Firm

Value 598

Armin Industries: The Impact of Financial

Distress Costs 598

Who Pays for Financial Distress Costs? 598

16.4 Optimal Capital Structure: The Tradeoff

Theory 600

The Present Value of Financial Distress

Costs 600

Optimal Leverage 601

16.5 Exploiting Debt Holders: The Agency Costs of

Leverage 603

Excessive Risk-Taking and Asset

Substitution 603

Debt Overhang and Under-

Investment 604

■■ GLOBAL FINANCIAL CRISIS Bailouts,

Distress Costs, and Debt Overhang 605

Agency Costs and the Value of Leverage 606

The Leverage Ratchet Effect 607

Debt Maturity and Covenants 608

■■ Why Do Firms Go Bankrupt? 609

16.6 Motivating Managers: The Agency Benefits of

Leverage 609

Concentration of Ownership 610

Reduction of Wasteful Investment 610

■■ Excessive Perks and Corporate

Scandals 611

■■ GLOBAL FINANCIAL CRISIS Moral Hazard,

Government Bailouts, and the Appeal

of Leverage 612

Leverage and Commitment 612

■■ NOBEL PRIZE Contract Theory 613

16.7 Agency Costs and the Tradeoff Theory 613

The Optimal Debt Level 614

Debt Levels in Practice 615

16.8 Asymmetric Information and Capital

Structure 615

Leverage as a Credible Signal 615

Issuing Equity and Adverse Selection 617

■■ NOBEL PRIZE Markets with Asymmetric

Information and Adverse Selection 619

Implications for Equity Issuance 619

Implications for Capital Structure 620

16.9 Capital Structure: The Bottom Line 623

MyLab Finance 624 ■ Key Terms 626 ■

Further Reading 626 ■ Problems 626

Chapter 17 Payout Policy 635

17.1 Distributions to Shareholders 636

Dividends 636

Share Repurchases 638

17.2 Comparison of Dividends and Share

Repurchases 639

Alternative Policy 1: Pay Dividend with

Excess Cash 639

Alternative Policy 2: Share Repurchase (No

Dividend) 640

■■ COMMON MISTAKE Repurchases and the

Supply of Shares 642

Alternative Policy 3: High Dividend (Equity

Issue) 642

Modigliani-Miller and Dividend Policy

Irrelevance 643

■■ COMMON MISTAKE The Bird in the Hand

Fallacy 644

Dividend Policy with Perfect Capital

Markets 644

17.3 The Tax Disadvantage of Dividends 644

Taxes on Dividends and Capital

Gains 645

Optimal Dividend Policy with

Taxes 646

17.4 Dividend Capture and Tax Clienteles 648

The Effective Dividend Tax Rate 648

Tax Differences Across Investors 649

Clientele Effects 650

■■ INTERVIEW with John Connors 651

17.5 Payout Versus Retention of Cash 653

Retaining Cash with Perfect Capital

Markets 654

Taxes and Cash Retention 655

Adjusting for Investor Taxes 656

Issuance and Distress Costs 657

Agency Costs of Retaining Cash 658

17.6 Signaling with Payout Policy 660

Dividend Smoothing 660

Dividend Signaling 661

■■ Royal & SunAlliance’s Dividend

Cut 662

Signaling and Share Repurchases 662

17.7 Stock Dividends, Splits, and Spin-Offs 664

Stock Dividends and Splits 664

Spin-Offs 666

■■ Berkshire Hathaway’s A & B Shares 667

MyLab Finance 668 ■ Key Terms 669 ■

Further Reading 669 ■ Problems 670 ■

Data Case 674

PART 6 ADVANCED VALUATION 677

Chapter 18 Capital Budgeting and Valuation

with Leverage 678

18.1 Overview of Key Concepts 679

18.2 The Weighted Average Cost of Capital

Method 680

■■ INTERVIEW with Zane Rowe 681

Using the WACC to Value a Project 682

Summary of the WACC Method 683

Implementing a Constant Debt-Equity

Ratio 684

18.3 The Adjusted Present Value Method 686

The Unlevered Value of the Project 686

Valuing the Interest Tax Shield 687

Summary of the APV Method 688

18.4 The Flow-to-Equity Method 690

Calculating the Free Cash Flow to Equity 690

Valuing Equity Cash Flows 691

■■ What Counts as “Debt”? 692

Summary of the Flow-to-Equity Method 692

18.5 Project-Based Costs of Capital 693

Estimating the Unlevered Cost of Capital 694

Project Leverage and the Equity Cost of

Capital 694

Determining the Incremental Leverage of a

Project 696

■■ COMMON MISTAKE Re-Levering the

WACC 696

18.6 APV with Other Leverage Policies 698

Constant Interest Coverage Ratio 698

Predetermined Debt Levels 699

A Comparison of Methods 701

18.7 Other Effects of Financing 701

Issuance and Other Financing Costs 701

Security Mispricing 702

Financial Distress and Agency Costs 703

■■ GLOBAL FINANCIAL CRISIS Government

Loan Guarantees 704

18.8 Advanced Topics in Capital Budgeting 704

Periodically Adjusted Debt 705

Leverage and the Cost of Capital 707

The WACC or FTE Method with Changing

Leverage 709

Personal Taxes 710

MyLab Finance 712 ■ Key Terms 714 ■

Further Reading 714 ■ Problems 715 ■

Data Case 721

Appendix Foundations and Further Details 723

Deriving the WACC Method 723

The Levered and Unlevered Cost of

Capital 724

Solving for Leverage and Value

Simultaneously 725

The Residual Income and Economic Value

Added Valuation Methods 727

Chapter 19 Valuation and Financial Modeling: A

Case Study 729

19.1 Valuation Using Comparables 730

19.2 The Business Plan 732

Operational Improvements 732

Capital Expenditures: A Needed

Expansion 733

Working Capital Management 734

Capital Structure Changes:

Levering Up 734

19.3 Building the Financial Model 735

Forecasting Earnings 735

■■ INTERVIEW with Joseph L.

Rice, III 736

Working Capital Requirements 738

Forecasting Free Cash Flow 739

■■ USING EXCEL Summarizing Model

Outputs 741

The Balance Sheet and Statement of Cash

Flows (Optional) 742

■■ USING EXCEL Auditing Your Financial

Model 744

19.4 Estimating the Cost of Capital 745

CAPM-Based Estimation 745

Unlevering Beta 746

Ideko’s Unlevered Cost of Capital 746

19.5 Valuing the Investment 747

The Multiples Approach to Continuation

Value 748

The Discounted Cash Flow Approach to

Continuation Value 749

■■ COMMON MISTAKE Continuation Values

and Long-Run Growth 751

APV Valuation of Ideko’s Equity 751

A Reality Check 752

■■ COMMON MISTAKE Missing Assets or

Liabilities 753

IRR and Cash Multiples 753

19.6 Sensitivity Analysis 754

MyLab Finance 755 ■ Key Terms 756 ■

Further Reading 756 ■ Problems 757

Appendix Compensating Management 759

PART 7 OPTIONS 761

Chapter 20 Financial Options 762

20.1 Option Basics 763

Understanding Option Contracts 763

Interpreting Stock Option Quotations 763

Options on Other Financial

Securities 765

20.2 Option Payoffs at Expiration 766

Long Position in an Option Contract 766

Short Position in an Option Contract 767

Profits for Holding an Option to

Expiration 769

Returns for Holding an Option to

Expiration 770

Combinations of Options 771

20.3 Put-Call Parity 774

20.4 Factors Affecting Option Prices 777

Strike Price and Stock Price 777

Arbitrage Bounds on Option Prices 777

Option Prices and the Exercise Date 777

Option Prices and Volatility 778

20.5 Exercising Options Early 779

Non-Dividend-Paying Stocks 779

Dividend-Paying Stocks 781

20.6 Options and Corporate Finance 783

Equity as a Call Option 783

Debt as an Option Portfolio 784

Credit Default Swaps 784

■■ GLOBAL FINANCIAL CRISIS Credit

Default Swaps 785

Pricing Risky Debt 786

Agency Conflicts 787

MyLab Finance 788 ■ Key Terms 789 ■

Further Reading 789 ■ Problems 789 ■

Data Case 794

Chapter 21 Option Valuation 795

21.1 The Binomial Option Pricing Model 796

A Two-State Single-Period Model 796

The Binomial Pricing Formula 798

A Multiperiod Model 799

Making the Model Realistic 803

21.2 The Black-Scholes Option Pricing

Model 804

The Black-Scholes Formula 804

■■ INTERVIEW with Myron S. Scholes 805

Implied Volatility 810

■■ GLOBAL FINANCIAL CRISIS The VIX

Index 811

The Replicating Portfolio 812

21.3 Risk-Neutral Probabilities 814

A Risk-Neutral Two-State Model 814

Implications of the Risk-Neutral World 814

Risk-Neutral Probabilities and Option

Pricing 815

21.4 Risk and Return of an Option 817

21.5 Corporate Applications of Option

Pricing 819

Beta of Risky Debt 819

■■ COMMON MISTAKE Valuing Employee

Stock Options 822

■■ NOBEL PRIZE Pricing Financial

Options 823

Agency Costs of Debt 823

MyLab Finance 824 ■ Key Terms 826 ■

Further Reading 826 ■ Problems 826

Chapter 22 Real Options 831

22.1 Real Versus Financial Options 832

22.2 Decision Tree Analysis 832

Representing Uncertainty 833

Real Options 834

Solving Decision Trees 834

22.3 The Option to Delay: Investment as a Call

Option 835

An Investment Option 835

■■ Why Are There Empty Lots in Built-Up

Areas of Big Cities? 838

Factors Affecting the Timing of

Investment 839

Investment Options and Firm Risk 840

■■ GLOBAL FINANCIAL CRISIS Uncertainty,

Investment, and the Option to Delay 841

22.4 Growth and Abandonment Options 842

Valuing Growth Potential 842

The Option to Expand 844

■■ INTERVIEW with Scott Mathews 845

The Option to Abandon 846

22.5 Investments with Different Lives 848

■■ Equivalent Annual Benefit Method 849

22.6 Optimally Staging Investments 850

22.7 Rules of Thumb 853

The Profitability Index Rule 854

The Hurdle Rate Rule 854

■■ The Option to Repay a Mortgage 856

22.8 Key Insights from Real Options 857

MyLab Finance 857 ■ Key Terms 859 ■

Further Reading 859 ■ Problems 859

PART 8 LONG-TERM FINANCING

865

Chapter 23 Raising Equity Capital 866

23.1 Equity Financing for Private Companies 867

Sources of Funding 867

■■ Crowdfunding: The Wave of the

Future? 868

■■ INTERVIEW with Kevin Laws 869

Venture Capital Investing 872

Venture Capital Financing Terms 874

■■ COMMON MISTAKE Misinterpreting

Start-Up Valuations 874

■■ From Launch to Liquidity 876

Exiting an Investment in a Private

Company 878

23.2 The Initial Public Offering 878

Advantages and Disadvantages of Going

Public 878

Types of Offerings 879

The Mechanics of an IPO 881

■■ Google’s IPO 881

■■ An Alternative to the Traditional IPO:

Spotify’s Direct Listing 886

23.3 IPO Puzzles 886

Underpricing 886

Cyclicality and Recent Trends 889

■■ GLOBAL FINANCIAL CRISIS Worldwide

IPO Deals in 2008–2009 890

Cost of an IPO 890

Long-Run Underperformance 891

23.4 The Seasoned Equity Offering 892

The Mechanics of an SEO 892

Price Reaction 894

Issuance Costs 895

MyLab Finance 895 ■ Key Terms 896 ■

Further Reading 897 ■ Problems 898 ■

Data Case 901

Chapter 24 Debt Financing 903

24.1 Corporate Debt 904

Public Debt 904

Private Debt 908

24.2 Other Types of Debt 909

Sovereign Debt 909

Municipal Bonds 911

■■ Detroit’s Art Museum at Risk 911

Asset-Backed Securities 912

■■ GLOBAL FINANCIAL CRISIS CDOs,

Subprime Mortgages, and the Financial

Crisis 912

24.3 Bond Covenants 914

24.4 Repayment Provisions 915

Call Provisions 915

■■ New York City Calls Its Municipal

Bonds 917

Sinking Funds 919

Convertible Provisions 919

MyLab Finance 921 ■ Key Terms 922 ■

Further Reading 923 ■ Problems 923 ■

Data Case 924

Chapter 25 Leasing 927

25.1 The Basics of Leasing 928

Examples of Lease Transactions 928

Lease Payments and Residual Values 929

Leases Versus Loans 930

■■ Calculating Auto Lease Payments 931

End-of-Term Lease Options 931

Other Lease Provisions 933

25.2 Accounting, Tax, and Legal Consequences of

Leasing 933

Lease Accounting 934

■■ Operating Leases at Alaska Air

Group 935

The Tax Treatment of Leases 936

Leases and Bankruptcy 937

■■ Synthetic Leases 938

25.3 The Leasing Decision 938

Cash Flows for a True Tax Lease 939

Lease Versus Buy (An Unfair

Comparison) 940

Lease Versus Borrow (The Right

Comparison) 941

Evaluating a True Tax Lease 943

Evaluating a Non-Tax Lease 944

25.4 Reasons for Leasing 944

Valid Arguments for Leasing 945

■■ INTERVIEW with Mark Long 948

Suspect Arguments for Leasing 949

MyLab Finance 949 ■ Key Terms 950 ■

Further Reading 951 ■ Problems 951

PART 9 SHORT-TERM FINANCING

955

Chapter 26 Working Capital

Management 956

26.1 Overview of Working Capital 957

The Cash Cycle 957

Firm Value and Working Capital 959

26.2 Trade Credit 960

Trade Credit Terms 960

Trade Credit and Market Frictions 960

Managing Float 961

26.3 Receivables Management 962

Determining the Credit Policy 962

Monitoring Accounts Receivable 963

26.4 Payables Management 965

Determining Accounts Payable Days

Outstanding 965

Stretching Accounts Payable 966

26.5 Inventory Management 966

Benefits of Holding Inventory 967

Costs of Holding Inventory 967

26.6 Cash Management 968

Motivation for Holding Cash 968

Alternative Investments 969

■■ Hoarding Cash 969

MyLab Finance 971 ■ Key Terms 972 ■

Further Reading 972 ■ Problems 973 ■

Data Case 976

Chapter 27 Shor t-Term Financial

Planning 979

27.1 Forecasting Short-Term Financing

Needs 980

Seasonalities 980

Negative Cash Flow Shocks 983

Positive Cash Flow Shocks 984

27.2 The Matching Principle 985

Permanent Working Capital 985

Temporary Working Capital 985

Financing Policy Choices 986

27.3 Short-Term Financing with Bank Loans 987

Single, End-of-Period Payment Loan 987

Line of Credit 987

Bridge Loan 988

Common Loan Stipulations and Fees 988

27.4 Short-Term Financing with Commercial

Paper 990

■■ GLOBAL FINANCIAL CRISIS Short-Term

Financing in Fall 2008 991

27.5 Short-Term Financing with Secured

Financing 992

Accounts Receivable as Collateral 992

■■ A Seventeenth-Century Financing

Solution 992

Inventory as Collateral 993

■■ Loan Guarantees: The Ex-Im Bank

Controversy 994

MyLab Finance 995 ■ Key Terms 996 ■

Further Reading 996 ■ Problems 997

PART 10 SPECIAL TOPICS 999

Chapter 28 Mergers and Acquisitions 1000

28.1 Background and Historical Trends 1001

Merger Waves 1001

Types of Mergers 1003

28.2 Market Reaction to a Takeover 1003

28.3 Reasons to Acquire 1004

Economies of Scale and Scope 1005

Vertical Integration 1005

Expertise 1005

Monopoly Gains 1006

Efficiency Gains 1006

Tax Savings from Operating Losses 1007

Diversification 1008

Earnings Growth 1008

Managerial Motives to Merge 1010

28.4 Valuation and the Takeover Process 1011

Valuation 1011

The Offer 1012

Merger “Arbitrage” 1013

Tax and Accounting Issues 1014

Board and Shareholder Approval 1015

28.5 Takeover Defenses 1016

Poison Pills 1016

Staggered Boards 1017

White Knights 1018

Golden Parachutes 1019

Recapitalization 1019

Other Defensive Strategies 1019

Regulatory Approval 1020

■■ Weyerhaeuser’s Hostile Bid for Willamette

Industries 1020

28.6 Who Gets the Value Added from

a Takeover? 1021

The Free Rider Problem 1021

Toeholds 1022

The Leveraged Buyout 1022

■■ The Leveraged Buyout of RJR-Nabisco

by KKR 1023

The Freezeout Merger 1025

Competition 1026

MyLab Finance 1026 ■ Key Terms

1028 ■ Further Reading 1028

■ Problems 1028

Chapter 29 Corporate Governance 1031

29.1 Corporate Governance and Agency

Costs 1032

29.2 Monitoring by the Board of Directors

and Others 1033

Types of Directors 1033

Board Independence 1033

■■ COMMON MISTAKE “Celebrity”

Boards 1035

Board Size and Performance 1035

Other Monitors 1035

29.3 Compensation Policies 1036

Stock and Options 1036

Pay and Performance Sensitivity 1036

29.4 Managing Agency Conflict 1038

Direct Action by Shareholders 1038

■■ Shareholder Activism at The New York

Times 1041

Management Entrenchment 1041

The Threat of Takeover 1042

29.5 Regulation 1042

The Sarbanes-Oxley Act 1042

■■ INTERVIEW with Lawrence E.

Harris 1043

The Cadbury Commission 1044

Dodd-Frank Act 1045

Insider Trading 1046

■■ Martha Stewart and ImClone 1047

29.6 Corporate Governance Around the

World 1047

Protection of Shareholder Rights 1047

Controlling Owners and Pyramids 1047

The Stakeholder Model 1050

Cross-Holdings 1050

29.7 The Tradeoff of Corporate

Governance 1051

MyLab Finance 1052 ■ Key Terms 1053 ■

Further Reading 1054 ■ Problems 1054

Chapter 30 Risk Management 1055

30.1 Insurance 1056

The Role of Insurance: An Example 1056

Insurance Pricing in a Perfect Market 1056

The Value of Insurance 1058

The Costs of Insurance 1060

The Insurance Decision 1062

30.2 Commodity Price Risk 1062

Hedging with Vertical Integration and

Storage 1063

Hedging with Long-Term Contracts 1063

Hedging with Futures Contracts 1065

■■ COMMON MISTAKE Hedging Risk 1067

■■ Differing Hedging Strategies 1068

Deciding to Hedge Commodity Price

Risk 1068

30.3 Exchange Rate Risk 1069

Exchange Rate Fluctuations 1069

Hedging with Forward Contracts 1070

Cash-and-Carry and the Pricing of Currency

Forwards 1072

■■ GLOBAL FINANCIAL CRISIS Arbitrage in

Currency Markets? 1075

Hedging with Options 1076

30.4 Interest Rate Risk 1079

Interest Rate Risk Measurement:

Duration 1080

Duration-Based Hedging 1081

■■ The Savings and Loan Crisis 1085

Swap-Based Hedging 1085

MyLab Finance 1089 ■ Key Terms 1091 ■

Further Reading 1091 ■ Problems 1092

Chapter 31 International Corporate

Finance 1097

31.1 Internationally Integrated Capital

Markets 1098

31.2 Valuation of Foreign Currency Cash

Flows 1099

WACC Valuation Method in Domestic

Currency 1100

Using the Law of One Price as a Robustness

Check 1102

31.3 Valuation and International Taxation 1103

The TCJA: A New Approach to International

Taxation 1104

Harmonizing the Tax Treatment of Exports:

GILTI and FDII 1104

Avoiding Base Erosion: BEAT 1106

31.4 Internationally Segmented Capital

Markets 1106

Differential Access to Markets 1107

Macro-Level Distortions 1107

Implications 1108

31.5 Capital Budgeting with Exchange Risk 1110

■■ INTERVIEW with Bill Barrett 1112

MyLab Finance 1113 Key Terms 1113

Further Reading 1114 Problems 1114

Data Case 1116

Glossary 1119

Index 1139

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