Quantitative Corporate Finance, 3rd Edition PDF by John B Guerard Jr., Anureet Saxena and Mustafa N Gültekin

By

Quantitative Corporate Finance, Third Edition

By John B. Guerard Jr., Anureet Saxena And Mustafa N. Gültekin

Quantitative Corporate Finance, Third Edition

Contents:

1 Introduction: Capital Formation, Risk, and the Corporation . . . . . 1

1.1 Financial Mathematics and Theory . . . . . . . . . . . . . . . . . . . . . 1

1.2 Growth and Survival of the Firm . . . . . . . . . . . . . . . . . . . . . . 3

1.3 Risk and Uncertainty Inherent in Finance . . . . . . . . . . . . . . . . 3

1.4 Types of Business Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

1.5 Financial Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

1.6 Division of Risk, Income, and Control . . . . . . . . . . . . . . . . . . 5

1.7 Profitability and Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

1.8 Areas Covered in This Book . . . . . . . . . . . . . . . . . . . . . . . . . 9

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

2 The Corporation and Other Forms of Business Organization . . . . . 13

2.1 The Sole or Single Proprietorship . . . . . . . . . . . . . . . . . . . . . . 14

2.2 The Partnership . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

2.3 The Limited Partnership . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

2.4 The Corporation, Its Basic Characteristics . . . . . . . . . . . . . . . . 18

2.4.1 Chartering the Corporation . . . . . . . . . . . . . . . . . . . 20

2.4.2 Administrative Organization . . . . . . . . . . . . . . . . . . 23

2.5 Major Rights of the Shareholders . . . . . . . . . . . . . . . . . . . . . . 25

2.6 The Advantages of the Corporate Form . . . . . . . . . . . . . . . . . 27

2.7 The Corporation in 2020: Trying to Maintain Economic Growth in the COVID-19 Pandemic with the Payroll

Protection Plan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29

3 The Corporation Balance Sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31

3.1 The Balance Sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31

3.2 Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32

3.3 Liabilities and Stockholder Equity . . . . . . . . . . . . . . . . . . . . . 37

3.4 Book Value of Common Stock . . . . . . . . . . . . . . . . . . . . . . . 42

3.5 Summary and Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . 53

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53

4 The Annual Operating Statements: The Income Statement and Cash Flow Statement . . . . . . . . .. . . 55

4.1 Form and Content of the Income Statement . . . . . . . . . . . . . . . 56

4.2 Retained Earnings vs Dividends . . . . . . . . . . . . . . . . . . . . . . . 61

4.3 Income Statement in the World of Business: IBM, Boeing, and Dominion Energy . . . . . . . . . . . . . . . 62

4.4 Annual Cash Flow Statement . . . . . . . . . . . . . . . . . . . . . . . . . 66

4.5 US Firm Cash Flow Analysis, 1971–2020 . . . . . . . . . . . . . . . . 74

4.6 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75

5 Financing Current Operations and Efficiency Ratio Analysis . . . . . 77

5.1 Working Capital Concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . 77

5.2 Snapshots of Financial Ratios . . . . . . . . . . . . . . . . . . . . . . . . 79

5.3 The Calculations of Financial Ratios and Their Implications for Stockholder Wealth Maximization . . . . . . . . . 84

5.3.1 The Dupont Analysis Return on Invested Capital . . . . . . . . . . . . . . .. . . 84

5.3.2 Current Ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87

5.3.3 Sales to Total Assets . . . . . . . . . . . . . . . . . . . . . . . . 88

5.3.4 The Altman Z Model . . . . . . . . . . . . . . . . . . . . . . . 89

5.4 The Time Series of WRDS Ratios in the United States, 1970–2020 . . . . . . . . . . . 90

5.5 Industry Production of Financial Ratios . . . . . . . . . . . . . . . . . 90

5.6 Limitations of Ratio Analysis . . . . . . . . . . . . . . . . . . . . . . . . . 92

5.7 A Summary of Ratio Analysis . . . . . . . . . . . . . . . . . . . . . . . . 99

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100

6 Financing Current Operations and the Cash Budget . . . . . . . . . . . . 101

6.1 Sources of Short-Term Financing . . . . . . . . . . . . . . . . . . . . . . 103

6.2 Trade Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104

6.3 Bank Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105

6.4 Other Forms of Short-Term Financing . . . . . . . . . . . . . . . . . . 110

6.5 Quantitative Working Capital Models: Cash Management . . . . 112

6.6 The Cash Budget . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 118

7 Capital and New Issue Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119

7.1 The Secondary Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120

7.2 The Primary Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122

7.3 The Originating House . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123

7.3.1 The Underwriting Group . . . . . . . . . . . . . . . . . . . . . 124

7.3.2 The Selling Group . . . . . . . . . . . . . . . . . . . . . . . . . 124

7.3.3 Other Aspects of Investment Banking . . . . . . . . . . . 124

7.4 Initial Public Offerings (IPOs) . . . . . . . . . . . . . . . . . . . . . . . . 125

7.4.1 Expansion of a Privately Held Firm into a Public Corporation . . . . . . . . . . . . 126

7.4.2 The Problem of Control . . . . . . . . . . . . . . . . . . . . . 127

7.4.3 Promotion of a Subsidiary by Parent Corporations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127

7.5 Formation of a Joint Subsidiary by Two or More Parent Companies . . . . . . . . . .  . . . 129

7.6 The SEC and the Flotation of New Issues . . . . . . . . . . . . . . . . 129

7.6.1 Secondary Floatations . . . . . . . . . . . . . . . . . . . . . . . 131

7.7 Issuing Securities Through Rights . . . . . . . . . . . . . . . . . . . . . 131

7.8 Stock Tenders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133

7.9 Costs of Floating an Issue . . . . . . . . . . . . . . . . . . . . . . . . . . . 134

7.10 Regulation of the Capital Markets . . . . . . . . . . . . . . . . . . . . . 135

7.11 The Capital Market as a Source of Funds . . . . . . . . . . . . . . . . 141

7.12 The Debate on the Optimal Organization of the Capital Market . . . . . . . . . . . . 143

7.13 Capital Markets and Long-Term Economic Growth . . . . . . . . . 144

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145

8 The Equity of the Corporation: Common and Preferred Stock . . . . 149

8.1 Common Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 149

8.2 Rewards of Common Shareholders . . . . . . . . . . . . . . . . . . . . . 150

8.3 The Corporate Sector: A Net Exporter of Funds . . . . . . . . . . . 153

8.4 Corporate Exports and the Maximization of Stockholder Wealth . . . .  . . . . . . . 155

8.5 Definitions of the Value of Common Shares . . . . . . . . . . . . . . 158

8.5.1 Book Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159

8.5.2 Market Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159

8.5.3 Intrinsic or “Normal” Value . . . . . . . . . . . . . . . . . . 160

8.6 Stock Splits and Stock Dividends . . . . . . . . . . . . . . . . . . . . . . 161

8.7 Stock Prices and Dividends: An Example of Valuation . . . . . . 162

8.7.1 Noncash-Paying Growth Shares . . . . . . . . . . . . . . . . 165

8.7.2 Valuing a Dividend-Paying Super-Growth Stock . . . 167

8.7.3 Super Growth Cannot Be Infinite . . . . . . . . . . . . . . . 169

8.7.4 The Paradox of the Low Current Return

on Growth Options . . . . . . . . . . . . . . . . . . . . . . . . . 170

8.8 Risk and Returns to Growth Investments . . . . . . . . . . . . . . . . 170

8.8.1 The Cost of Capital to a Growth Firm . . . . . . . . . . . 171

8.8.2 The Cost of Common Stock Financing: The Norm. . . . . . . . . . . . . . . . . . . 171

8.9 Preferred Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 172

8.9.1 Features of Preferred Stock . . . . . . . . . . . . . . . . . . . 173

8.9.2 Rational for Preferred Stock Financing . . . . . . . . . . . 174

8.9.3 Convertible Preferred . . . . . . . . . . . . . . . . . . . . . . . 174

8.9.4 Protective Features on Preferred Shares . . . . . . . . . . 176

8.9.5 Floating New Common Equity Issues . . . . . . . . . . . 177

8.10 Advantage of New Share Financing . . . . . . . . . . . . . . . . . . . . 177

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178

9 Long-Term Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 181

9.1 Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 181

9.1.1 Mortgage Agreement . . . . . . . . . . . . . . . . . . . . . . . 182

9.1.2 Subordinate Mortgages . . . . . . . . . . . . . . . . . . . . . . 183

9.1.3 Net Working Capital Maintenance Requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 184

9.1.4 Restrictions on Creating New Debt . . . . . . . . . . . . . 184

9.2 Other Types of Long-Term Debt . . . . . . . . . . . . . . . . . . . . . . 185

9.2.1 Term Loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 186

9.2.2 Private Placements . . . . . . . . . . . . . . . . . . . . . . . . . 186

9.2.3 Equipment Trust Certificates . . . . . . . . . . . . . . . . . . 186

9.3 Long-Term Lease . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 187

9.4 Lease Accounting: Recent Changes . . . . . . . . . . . . . . . . . . . . 189

9.5 The Cost of Debt Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . 190

9.6 Level and Structure of the Interest Rates . . . . . . . . . . . . . . . . . 193

9.7 The Liquidity Preference Theory of the Term Structure . . . . . . 193

9.7.1 The Pure Expectations Theory of the Term Structure . . . . . . . . . . . . . . . . . . . . . . . 194

9.7.2 The Market Segmentation Theory of the Term Structure . . . . . . . .  . . . . . . . . . . 195

9.7.3 Setting the Rate on a New Issue . . . . . . . . . . . . . . . 196

9.8 The Call Feature on Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . 197

9.9 Convertible Bonds and Bonds with Warrants Attached . . . . . . 199

9.10 The Advantages and Disadvantages of Long-Term Debt . . . . . 202

9.11 Malkiel’s Bond Theorems . . . . . . . . . . . . . . . . . . . . . . . . . . . 202

9.12 Retirement of Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 205

9.12.1 Toward a More Conservative Capital Structure . . . . . 206

9.12.2 Decreasing the Level of Operations . . . . . . . . . . . . . 206

9.12.3 Methods for Retiring Specific Issues . . . . . . . . . . . . 208

9.12.4 Repurchase on the Open Market . . . . . . . . . . . . . . . 208

9.12.5 Repayment or Refunding at Maturity . . . . . . . . . . . . 209

9.12.6 Gradual Reduction of Debt Issue by Sinking Fund Purchase . . . . . . . .. . . . . 210

9.12.7 Reduction of Debt Through Serial Issues . . . . . . . . . 211

9.12.8 Debt Retirement and the Call Privilege . . . . . . . . . . . 212

9.12.9 Forced Conversion . . . . . . . . . . . . . . . . . . . . . . . . . 213

9.13 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 213

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 213

10 Debt, Equity, the Optimal Financial Structure, and the

Cost of Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 215

10.1 Definition of Leverage: Profits and Financial Risk . . . . . . . . . . 216

10.2 Illustrations of Leverage: Return and Risk . . . . . . . . . . . . . . . . 217

10.3 Surrogate Evidence on the Development of “Optimum” Financial Structure . . . . . . . . . . . . 220

10.4 The Pure Theory of the Optimal Financial Structure . . . . . . . . 221

10.5 Modigliani and Miller: Constant Capital Costs . . . . . . . . . . . . 224

10.6 The Optimal Capital Structure and the M&M Hypothesis . . . . . 228

10.7 Empirical Factors Influencing Financial Structures . . . . . . . . . . 229

10.8 Measures for Approximating Financial Risk . . . . . . . . . . . . . . 230

10.9 Outside Financing Capacity . . . . . . . . . . . . . . . . . . . . . . . . . . 234

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 237

11 Investing in Assets: Theory of Investment Decision-Making . . . . . . 239

11.1 Net Present Value and the Internal Rate of Return . . . . . . . . . . 240

11.2 Mutually Exclusive Projects . . . . . . . . . . . . . . . . . . . . . . . . . . 241

11.3 Difference in Project Size and Durations of Cash Flow . . . . . . 244

11.4 Lowest Annualized Total Costs . . . . . . . . . . . . . . . . . . . . . . . 247

11.5 The Irrational Fixed Capital Budget . . . . . . . . . . . . . . . . . . . . 247

11.6 Real Investments and the Cost of Funds . . . . . . . . . . . . . . . . . 248

11.7 The Adjusted Present Value (APV) Model . . . . . . . . . . . . . . . 251

11.7.1 Estimating Cash Flows . . . . . . . . . . . . . . . . . . . . . . 254

11.7.2 Gathering Information . . . . . . . . . . . . . . . . . . . . . . . 255

11.7.3 Financial Statement: Pitfalls . . . . . . . . . . . . . . . . . . 255

11.7.4 Anatomy of Core Financial Statements . . . . . . . . . . . 256

11.7.5 Definition of Cash Flows . . . . . . . . . . . . . . . . . . . . 259

11.8 CFO Practice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 261

11.9 Current Costs of the “Optimum” Financial Mix . . . . . . . . . . . . 263

11.10 The Effect of Taxes on the Financial Structure . . . . . . . . . . . . 264

11.11 Costing the Components of the Financial Mix . . . . . . . . . . . . . 265

11.11.1 Cost of Trade Credit . . . . . . . . . . . . . . . . . . . . . . . . 265

11.11.2 Cost of Bank Credit . . . . . . . . . . . . . . . . . . . . . . . . 266

11.11.3 Cost of Long-Term Debt . . . . . . . . . . . . . . . . . . . . . 266

11.11.4 Cost of Preferred Stock . . . . . . . . . . . . . . . . . . . . . . 266

11.11.5 The Cost of Retained Earnings . . . . . . . . . . . . . . . . 268

11.11.6 Other Internal Funds-Depreciation, Depletion, etc. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 269

11.12 Investments Under Negative Interest Rates and Hyperinflation . . . . . . . . . . . . . . . . . . 269

11.12.1 Negative Interest Rates . . . . . . . . . . . . . . . . . . . . . . 269

11.12.2 Hyperinflationary Regime . . . . . . . . . . . . . . . . . . . . 271

11.13 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 271

Appendix A: Application of APV . . . . . . . . . . . . . . . . . . . . . . . . . . . 272

Basic Extensions of Valuation Theory . . . . . . . . . . . . . . . . . . 275

Application of APV . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 276

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 289

12 Regression Analysis and Estimating Regression Models . . . . . . . . . 291

12.1 Estimating an Ordinary Least Squares Regression Line . . . . . . 291

12.2 Autocorrelation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 296

12.3 Estimating Multiple Regression Lines . . . . . . . . . . . . . . . . . . . 299

12.4 Influential Observations and Possible Outliers and the Application of Robust Regression . . . . . . . . . . . . . 301

12.5 The Conference Board Composite Index of Leading Economic Indicators and Real US GDP Growth: A Regression

Example Including Much of the Pandemic Period . . . . . . . . . . 303

12.6 The Conference Board Composite Index of Leading Economic Indicators and the US Unemployment Rate:

Another Regression Example Including Much of the Pandemic Period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 318

12.7 Summary and Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . 320

Appendices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 321

Appendix A: Influential Observations and Outlier Detection . . . . . . . . . . . . . . . . . 321

The US Leading Economic Indicators . . . . . . . . . . . . . . . . . . . 323

Appendix C: Identifying Influential Observations in a Regression . . . . . . . . . . . . . .  . . 325

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 329

13 Time Series Modeling and the Forecasting Effectiveness of the US Leading Economic Indicators . .  . . . . . 331

13.1 Basic Statistical Properties of Economic Series . . . . . . . . . . . . 332

13.1.1 The Autoregressive and Moving Average Processes . . . . . . . . . . . .  . . . . 335

13.2 ARMA Model Identification in Practice . . . . . . . . . . . . . . . . . 342

13.3 Estimating an ARIMA RWD for US GDP, 1959Q2–2020Q3 . . . . . . . . . . . . .. . . . . . . . . 346

13.3.1 Estimating an ARIMA RWD for DLGDP, 1959Q2–2020Q3. . . . . . . . . . . . . . . . . . . . . . . . . . 351

13.4 Estimating a Transfer Function Time Series Model of US GDP with the US Leading Economic Indicator

Time Series as Its Input . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 354

13.5 Forecasting Effectiveness of Time Series Modeling Using Autometrics to Estimate Outliers and Breaks:

Studies of the US Real GDP, 1959–2020 . . . . . . . . . . . . . . . . 358

13.6 Automatic Time Series Modeling of the Unemployment Rate Using Leading Economic Indicators (LEI) . . . . . . . . . . . . 365

13.7 Summary and Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . 382

Appendix A: Granger Causality Modeling of the Change in the US Unemployment Rate with First-Differenced Changes in the LEI Time

Series . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 383

Append B: Autometrics and Saturation Variables . . . . . . . . . . . . . . . . 395

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 399

14 Risk and Return of Equity, the Capital Asset Pricing Model,

and Stock Selection for Efficient Portfolio Construction . . . . . . . . . 403

14.1 Calculating Holding Period Returns . . . . . . . . . . . . . . . . . . . . 404

14.2 An Introduction to Modern Portfolio Theory and Betas . . . . . . 411

14.3 Expected Returns Versus Historic Mean Returns . . . . . . . . . . . 420

14.4 Fundamental Analysis and Stock Selection . . . . . . . . . . . . . . . 421

14.5 Modern Portfolio Theory and GPRD: An Example of Markowitz Analysis . . . . . . . . . . . . . . 423

14.6 Further Estimations of a Composite Equity Valuation

Model: The Roles of Analyst Forecasts and Momentum in Stock Selection . . . . . . . . . . . . . . . 427

14.6.1 REG8 Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 432

14.6.2 REG9 Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 432

14.6.3 REG10 Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . 432

14.7 Summary and Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . 434

Appendices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 434

Appendix 1: The Three-Asset Case . . . . . . . . . . . . . . . . . . . . 434

Appendix 2: ICs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 437

Appendix 3: Matrix Algebra . . . . . . . . . . . . . . . . . . . . . . . . . 452

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 455

15 Multifactor Risk Models and Portfolio Construction and Management . . . . . .  . . . . . . . . 461

15.1 The Barra System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 462

15.2 Barra Model Mathematics . . . . . . . . . . . . . . . . . . . . . . . . . . . 463

15.3 The Barra Multifactor Model and Analysts’ Forecasts, Revisions, and Breadth . . . . . . . . .  . 467

15.4 Early Alternative Multi-Beta Risk Models . . . . . . . . . . . . . . . . 471

15.5 APT Approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 473

15.6 Applying the Blin and Blender APT Model . . . . . . . . . . . . . . 476

15.7 Applying the Blin and Blender APT Model, BARRA, and Axioma: The McKinley Capital Management (MCM)

Horse Race Tests . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 478

15.8 Why Use the Axioma Statistical Model? . . . . . . . . . . . . . . . . . 479

15.9 Alpha Alignment Factor . . . . . . . . . . . . . . . . . . . . . . . . . . . . 481

15.10 Financial Anomalies in Global Portfolio Management: Evidence Through COVID-19 . .  . . . . . . . 485

15.11 Summary and Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . 486

Appendices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 487

Appendix 1: US-E3 Descriptor Definitions . . . . . . . . . . . . . . . 487

Appendix 2: Factor Alignment Problems and Quantitative

Portfolio Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 496

Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 499

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 499

16 Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 505

16.1 The Malkiel–Quandt Notation . . . . . . . . . . . . . . . . . . . . . . . . 510

16.2 The Binominal Option Pricing Model . . . . . . . . . . . . . . . . . . . 513

16.3 The More Traditional Black and Scholes Option Pricing Model Derivation . . . . . . . . . . . . . 516

16.4 Black and Scholes Model Calculation . . . . . . . . . . . . . . . . . . . 519

16.5 The OPM and Corporate Liabilities . . . . . . . . . . . . . . . . . . . . 521

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 524

17 Real Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 527

17.1 The Option to Delay a Project . . . . . . . . . . . . . . . . . . . . . . . . 528

17.2 Implications of Viewing the Right to Delay a Project as an Option . . . . . . . . . . . . . . . . . 529

17.3 Abandonment Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 529

17.4 Options in Investment Analysis/Capital Budgeting . . . . . . . . . 535

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 535

18 Mergers and Acquisitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 537

18.1 Noneconomic Motives for Combinations . . . . . . . . . . . . . . . . 538

18.2 Holding Companies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 539

18.3 A Merger History of the United States . . . . . . . . . . . . . . . . . . 540

18.4 Using an Accounting Basis . . . . . . . . . . . . . . . . . . . . . . . . . . 545

18.5 The Economic Basis for Acquisitions . . . . . . . . . . . . . . . . . . . 546

18.6 Theories of Conglomerate Mergers . . . . . . . . . . . . . . . . . . . . . 547

18.7 Combinations Correcting Economic or Financial Imbalances . . . . . . . . . . . . 552

18.8 Combinations Increasing Market Dominance . . . . . . . . . . . . . 553

18.9 Combinations for Tax Advantages . . . . . . . . . . . . . . . . . . . . . 554

18.10 The Larson–Gonedes Exchange Ratio Model . . . . . . . . . . . . . 555

18.11 Valuation of a Merger Candidate . . . . . . . . . . . . . . . . . . . . . . 559

18.12 Testing for Synergism: Do Mergers Enhance Stockholder Wealth? . . . . . .  . . . 561

18.13 Divestment and Spinoff . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 564

18.14 Summary and Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . 565

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 566

19 Liquidation, Failure, Bankruptcy, and Reorganization . . . . . . . . . . 569

19.1 Voluntary Liquidation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 571

19.2 A Liquidation Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 572

19.3 Remaining in Business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 573

19.4 Failure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 574

19.5 Informal Remedies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 575

19.6 Bankruptcy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 575

19.6.1 Bankruptcy Procedures . . . . . . . . . . . . . . . . . . . . . . 577

19.6.2 Priorities in Liquidation . . . . . . . . . . . . . . . . . . . . . 578

19.6.3 Reorganization . . . . . . . . . . . . . . . . . . . . . . . . . . . . 580

19.6.4 Analysis of the Reorganization . . . . . . . . . . . . . . . . 584

19.7 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 585

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 585

20 Corporation Growth and Economic Growth and Stability . . . . . . . 587

20.1 Factors in Economic Growth . . . . . . . . . . . . . . . . . . . . . . . . . 588

20.2 Savings and Real Investment . . . . . . . . . . . . . . . . . . . . . . . . . 589

20.3 Corporation Investment Spending and Economic Stability . . . . . . . . . . .  . . . . 590

20.4 Monetary Policy, the Cost of Capital, and the Firm Investment Process . . . . . . . . . . 592

20.5 Economic Growth and Firm Growth . . . . . . . . . . . . . . . . . . . . 593

20.6 Firm Growth and Economic Growth . . . . . . . . . . . . . . . . . . . . 594

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 595

21 International Business Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . 597

21.1 Currency Exchange Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . 597

21.2 International Diversification . . . . . . . . . . . . . . . . . . . . . . . . . . 602

21.3 International Stock Selection and Portfolio Construction and Optimization . . . . . . . .. . . . . 605

21.4 International Corporate Finance Decisions . . . . . . . . . . . . . . . 607

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 610

22 Management–Stockholder Relations: Is Optimal Behavior All That Is Necessary? .. . . . . . . . . . . 613

22.1 General Agreement and Potential Conflicts in Management and Control . . . . . . . . 614

22.2 Areas of Potential Conflict . . . . . . . . . . . . . . . . . . . . . . . . . . . 615

22.2.1 Managerial and Board of Directors Compensation . .  . . . . . . . . . . 615

22.2.2 Executive Compensation . . . . . . . . . . . . . . . . . . . . . 616

22.2.3 Board of Directors . . . . . . . . . . . . . . . . . . . . . . . . . 618

22.2.4 Stock Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 619

22.2.5 Bonuses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 620

22.2.6 Dividends, Buy Backs, and Retained Earnings . . . . . 621

22.2.7 Excessively Conservative Financial or Asset Structures . . . . . . .  . . . . 622

22.2.8 Liquidating or Selling the Firm . . . . . . . . . . . . . . . . 623

22.2.9 Risky Acquisitions . . . . . . . . . . . . . . . . . . . . . . . . . 624

22.3 Turning Agents into Owners . . . . . . . . . . . . . . . . . . . . . . . . . 624

22.4 The Diseconomies of Financial Scams . . . . . . . . . . . . . . . . . . 626

22.5 Insider Trading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 626

22.6 Conflict of Interests . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 627

22.7 Stockholder Remedies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 627

22.7.1 Sell His Shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . 627

22.7.2 Institute a Stockholder Suit . . . . . . . . . . . . . . . . . . . 628

22.7.3 Organize a Proxy Fight to Vote Out the Management . . . . . . . .  . . . . . 628

22.8 To Whom Is Management Responsible? . . . . . . . . . . . . . . . . . 629

22.9 Summary and Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . 630

Appendix A . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 630

From Raw to Normalized Score Definitions . . . . . . . . . . . . . . 634

Fama and French-Weighted Portfolios . . . . . . . . . . . . . . . . . . 636

A Return to Optimized Portfolio Construction and Management . . . . . . . . 640

The Interaction of Environmental Scores and Expected Return Models . . . . . . . . . . . . . 641

Summary of SRI/ESG Portfolio Construction and Analysis. . . . . . . . . . . . . . . . . . . 643

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 646

Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 651

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