Quantitative Corporate Finance, Third Edition
By John B. Guerard Jr., Anureet Saxena And Mustafa N. Gültekin
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