## Corporate Finance, Twelfth Edition

By Stephen A. Ross, Randolph W. Westerfield, Jeffrey Jaffe and Bradford D. Jordan

**Contents:**

PART I Overview

Chapter 1

Introduction to Corporate Finance 1

1.1 What Is Corporate Finance? 1

The Balance Sheet Model of the Firm 1

The Financial Manager 3

1.2 The Corporate Firm 4

The Sole Proprietorship 4

The Partnership 4

The Corporation 5

A Corporation by Another Name . . . 7

1.3 The Importance of Cash Flows 8

Identification of Cash Flows 8

Timing of Cash Flows 9

Risk of Cash Flows 10

1.4 The Goal of **Financial Management** 10

Possible Goals 10

The Goal of the Financial Manager 11

A More General Goal 12

1.5 The Agency Problem and Control

of the Corporation 12

Agency Relationships 13

Management Goals 13

Do Managers Act in the Stockholders’

Interests? 14

Stakeholders 15

1.6 Regulation 16

The Securities Act of 1933 and the

Securities Exchange Act of 1934 16

Sarbanes-Oxley 17

Summary and Conclusions 18

Concept Questions 18

Chapter 2

Financial Statements and Cash Flow 20

2.1 The Balance Sheet 20

Liquidity 21

Debt versus Equity 22

Value versus Cost 22

2.2 The Income Statement 23

Generally Accepted Accounting

Principles 24

Noncash Items 25

Time and Costs 25

2.3 Taxes 26

Corporate and personal Tax Rates 26

Average versus Marginal Tax Rates 26

2.4 Net Working Capital 27

2.5 Cash Flow of the Firm 28

2.6 The Accounting Statement of Cash Flows 31

Cash Flow from Operating Activities 31

Cash Flow from Investing Activities 32

Cash Flow from Financing Activities 32

2.7 Cash Flow Management 33

Summary and Conclusions 34

Concept Questions 34

Questions and Problems 35

Excel Master It! Problem 39

Mini Case: Cash Flows at Warf

Computers, Inc. 40

Chapter 3

Financial Statements Analysis and Financial Models 42

3.1 Financial Statements Analysis 42

Standardizing Statements 42

Common-Size Balance Sheets 43

Common-Size Income Statements 44

3.2 Ratio Analysis 46

Short-Term Solvency or Liquidity Measures 47

Long-Term Solvency Measures 48

Asset Management or Turnover Measures 50

Profitability Measures 52

Market Value Measures 53

3.3 The DuPont Identity 56

A Closer Look at ROE 56

Problems with Financial Statement Analysis 58

3.4 Financial Models 59

A Simple Financial Planning Model 59

The Percentage of Sales Approach 61

3.5 External Financing and Growth 65

The Relationship Between EFN

and Growth 66

Financial Policy and Growth 68

A Note about Sustainable Growth

Rate Calculations 72

3.6 Some Caveats Regarding Financial

Planning Models 73

Summary and Conclusions 74

Concept Questions 74

Questions and Problems 76

Excel Master It! Problem 81

Mini Case: Ratios and Financial Planning at East Coast Yachts 82

PART II Valuation and

Capital Budgeting

Chapter 4

Discounted Cash Flow Valuation 85

4.1 Valuation: The One-Period Case 85

4.2 The Multiperiod Case 89

Future Value and Compounding 89

The Power of Compounding: A Digression 92

Present Value and Discounting 93

Finding the Number of Periods 96

The Algebraic Formula 99

4.3 Compounding Periods 100

Distinction between Annual Percentage

Rate and Effective Annual Rate 101

Compounding over Many Years 102

Continuous Compounding 102

4.4 Simplifications 104

Perpetuity 104

Growing Perpetuity 106

Annuity 107

Growing Annuity 113

4.5 Loan Amortization 114

4.6 What Is a Firm Worth? 118

Summary and Conclusions 120

Concept Questions 121

Questions and Problems 121

Excel Master It! Problem 131

Mini Case: The MBA Decision 132

Appendix 4A: Net Present Value: First

Principles of Finance 132

Appendix 4B: Using Financial Calculators 132

Chapter 5

Net Present Value and Other

Investment Rules 133

5.1 Why Use Net Present Value? 133

5.2 The Payback Period Method 136

Defining the Rule 136

Problems with the Payback Method 137

Managerial Perspective 138

Summary of Payback 139

5.3 The Discounted Payback Period Method 139

5.4 The Internal Rate of Return 139

5.5 Problems with the IRR Approach 143

Definition of Independent and Mutually

Exclusive Projects 143

Two General Problems Affecting Both

Independent and Mutually

Exclusive Projects 143

The Modified Internal Rate of Return (MIRR) 146

Problems Specific to Mutually

Exclusive Projects 148

Redeeming Qualities of IRR 153

A Test 153

5.6 The Profitability Index 153

Calculation of Profitability Index 154

5.7 The Practice of Capital Budgeting 155

Summary and Conclusions 157

Concept Questions 158

Questions and Problems 160

Excel Master It! Problem 167

Mini Case: Bullock Gold Mining 168

Chapter 6

Making Capital Investment Decisions 169

6.1 Incremental Cash Flows: The Key

to Capital Budgeting 169

Cash Flows—Not Accounting Income 169

Sunk Costs 170

Opportunity Costs 171

Side Effects 171

Allocated Costs 172

6.2 The Baldwin Company: An Example 172

An Analysis of the Project 175

Which Set of Books? 177

A Note about Net Working Capital 177

A Note about Depreciation 178

Interest Expense 179

6.3 Alternative Definitions of Operating

Cash Flow 179

The Top-Down Approach 180

The Bottom-Up Approach 180

The Tax Shield Approach 181

Conclusion 182

6.4 Some Special Cases of Discounted

Cash Flow Analysis 182

Evaluating Cost-Cutting Proposals 182

Setting the Bid Price 184

Investments of Unequal Lives: The

Equivalent Annual Cost Method 186

6.5 Inflation and Capital Budgeting 187

Interest Rates and Inflation 187

Cash Flow and Inflation 189

Discounting: Nominal or Real? 190

Summary and Conclusions 192

Concept Questions 193

Questions and Problems 194

Excel Master It! Problems 203

Mini Case: Bethesda Mining Company 203

Chapter 7

Risk Analysis, Real Options, and Capital Budgeting 205

7.1 Sensitivity Analysis, Scenario Analysis,

and Break-Even Analysis 205

Sensitivity Analysis and Scenario Analysis 206

Break-Even Analysis 209

7.2 Monte Carlo Simulation 213

Step 1: Specify the Basic Model 213

Step 2: Specify a Distribution for Each Variable in the Model 214

Step 3: The Computer Draws One Outcome 216

Step 4: Repeat the Procedure 217

Step 5: Calculate NPV 217

7.3 Real Options 218

The Option to Expand 218

The Option to Abandon 219

Timing Options 221

7.4 Decision Trees 222

Summary and Conclusions 224

Concept Questions 225

Questions and Problems 226

Excel Master It! Problem 232

Mini Case: Bunyan Lumber, LLC 233

Chapter 8

Interest Rates and Bond Valuation 235

8.1 Bonds and Bond Valuation 235

Bond Features and Prices 235

Bond Values and Yields 236

Interest Rate Risk 239

Finding the Yield to Maturity: More Trial and Error 241

Zero Coupon Bonds 243

8.2 Government and Corporate Bonds 245

Government Bonds 245

Corporate Bonds 246

Bond Ratings 248

8.3 Bond Markets 249

How Bonds Are Bought and Sold 249

Bond Price Reporting 250

A Note on Bond Price Quotes 253

8.4 Inflation and Interest Rates 254

Real versus Nominal Rates 254

Inflation Risk and Inflation-Linked Bonds 255

The Fisher Effect 256

8.5 Determinants of Bond Yields 258

The Term Structure of Interest Rates 258

Bond Yields and the Yield Curve:

Putting It All Together 260

Conclusion 262

Summary and Conclusions 262

Concept Questions 262

Questions and Problems 263

Excel Master It! Problem 267

Mini Case: Financing East Coast

Yachts’s Expansion Plans with a Bond Issue 268

Chapter 9

Stock Valuation 270

9.1 The Present Value of Common Stocks 270

Dividends versus Capital Gains 270

Valuation of Different Types of Stocks 271

9.2 Estimates of Parameters in

the Dividend Discount Model 275

Where Does g Come From? 275

Where Does R Come From? 277

A Healthy Sense of Skepticism 278

Dividends or Earnings: Which

to Discount? 279

The No-Dividend Firm 279

9.3 Comparables 280

Price-Earnings Ratio 280

Enterprise Value Ratios 282

9.4 Valuing Stocks Using Free Cash Flows 284

9.5 The Stock Markets 285

Dealers and Brokers 285

Organization of the NYSE 286

Types of Orders 289

NASDAQ Operations 289

Stock Market Reporting 290

Summary and Conclusions 291

Concept Questions 292

Questions and Problems 293

Excel Master It! Problem 296

Mini Case: Stock Valuation

at Ragan Engines 297

PART III Risk

Chapter 10

Lessons from Market History 299

10.1 Returns 299

Dollar Returns 299

Percentage Returns 301

10.2 Holding Period Returns 303

10.3 Return Statistics 309

10.4 Average Stock Returns and

Risk-Free Returns 310

10.5 Risk Statistics 312

Variance 312

Normal Distribution and Its Implications

for Standard Deviation 314

10.6 More on Average Returns 315

Arithmetic versus Geometric Averages 315

Calculating Geometric Average Returns 315

Arithmetic Average Return or Geometric

Average Return? 317

10.7 The U.S. Equity Risk Premium: Historical

and International Perspectives 317

10.8 2008: A Year of Financial Crisis 320

Summary and Conclusions 321

Concept Questions 322

Questions and Problems 322

Excel Master It! Problem 325

Mini Case: A Job at East Coast Yachts 326

Chapter 11

Return, Risk, and the Capital Asset Pricing Model 328

11.1 Individual Securities 328

11.2 Expected Return, Variance, and Covariance 329

Expected Return and Variance 329

Covariance and Correlation 330

11.3 The Return and Risk for Portfolios 334

The Expected Return on a Portfolio 334

Variance and Standard Deviation

of a Portfolio 335

11.4 The Efficient Set for Two Assets 338

11.5 The Efficient Set for Many Securities 342

Variance and Standard Deviation

in a Portfolio of Many Assets 344

11.6 Diversification 345

The Anticipated and Unanticipated

Components of News 345

Risk: Systematic and Unsystematic 346

The Essence of Diversification 347

The Effect of Diversification: Another

Lesson from Market History 348

11.7 Riskless Borrowing and Lending 349

The Optimal Portfolio 351

11.8 Market Equilibrium 353

Definition of the Market Equilibrium

Portfolio 353

Definition of Risk When Investors Hold

the Market Portfolio 354

The Formula for Beta 356

A Test 357

11.9 Relationship between Risk and Expected

Return (CAPM) 357

Expected Return on the Market 357

Expected Return on an Individual Security 358

Summary and Conclusions 361

Concept Questions 361

Questions and Problems 362

Excel Master It! Problem 368

Mini Case: A Job at East Coast Yachts, Part 2 369

Appendix 11A: Is Beta Dead? 370

Chapter 12

An Alternative View of Risk

and Return 371

12.1 Systematic Risk and Betas 371

12.2 Portfolios and Factor Models 374

Portfolios and Diversification 377

12.3 Betas, Arbitrage, and Expected Returns 379

The Linear Relationship 379

The Market Portfolio and the

Single Factor 380

12.4 The Capital Asset Pricing Model

and the Arbitrage Pricing Theory 381

Differences in Pedagogy 381

Differences in Application 381

12.5 Empirical Approaches to Asset Pricing 383

Empirical Models 383

Style Portfolios 384

Summary and Conclusions 385

Concept Questions 386

Questions and Problems 387

Excel Master It! Problem 391

Mini Case: The Fama-French Multifactor

Model and Mutual Fund Returns 391

Chapter 13

Risk, Cost of Capital, and Valuation 393

13.1 The Cost of Capital 393

13.2 Estimating the Cost of Equity Capital

with the CAPM 394

The Risk-Free Rate 397

Market Risk Premium 397

13.3 Estimation of Beta 398

Real-World Betas 399

Stability of Beta 399

Using an Industry Beta 401

13.4 Determinants of Beta 402

Cyclicality of Revenues 402

Operating Leverage 402

Financial Leverage and Beta 403

13.5 The Dividend Discount Model Approach 404

Comparison of DDM and CAPM 405

13.6 Cost of Capital for Divisions

and Projects 406

13.7 Cost of Fixed Income Securities 408

Cost of Debt 408

Cost of Preferred Stock 409

13.8 The Weighted Average Cost of Capital 410

13.9 Valuation with WACC 411

Project Evaluation and the WACC 412

Firm Valuation with the WACC 412

13.10 Estimating Eastman Chemical’s

Cost of Capital 415

13.11 Flotation Costs and the Weighted

Average Cost of Capital 417

The Basic Approach 417

Flotation Costs and NPV 418

Internal Equity and Flotation Costs 419

Summary and Conclusions 420

Concept Questions 420

Questions and Problems 422

Mini Case: Cost of Capital for

Swan Motors 426

Appendix 13A: Economic Value Added

and the Measurement of

Financial Performance 427

PART IV Capital Structure

and Dividend Policy

Chapter 14

Efficient Capital Markets

and Behavioral Challenges 428

14.1 Can Financing Decisions Create Value? 428

14.2 A Description of Efficient Capital Markets 430

Foundations of Market Efficiency 432

14.3 The Different Types of Efficiency 433

The Weak Form 433

The Semistrong and Strong Forms 434

Some Common Misconceptions about

the Efficient Market Hypothesis 436

14.4 The Evidence 437

The Weak Form 437

The Semistrong Form 438

The Strong Form 441

14.5 The Behavioral Challenge

to Market Efficiency 442

Rationality 442

Independent Deviations from Rationality 444

Arbitrage 445

14.6 Empirical Challenges to Market

Efficiency 446

14.7 Reviewing the Differences 451

14.8 Implications for Corporate Finance 453

- Accounting Choices, Financial Choices, and Market Efficiency 453
- The Timing Decision 454
- Speculation and Efficient Markets 455
- Information in Market Prices 457

Summary and Conclusions 459

Concept Questions 460

Questions and Problems 463

Mini Case: Your 401(k) Account at

East Coast Yachts 466

Chapter 15

Long-Term Financing 468

15.1 Some Features of Common

and Preferred Stocks 468

Common Stock Features 468

Preferred Stock Features 471

15.2 Corporate Long-Term Debt 472

Is It Debt or Equity? 473

Long-Term Debt: The Basics 473

The Indenture 475

15.3 Some Different Types of Bonds 478

Floating-Rate Bonds 478

Other Types of Bonds 478

15.4 Bank Loans 479

15.5 International Bonds 480

15.6 Patterns of Financing 480

15.7 Recent Trends in Capital Structure 482

Which Are Best: Book or Market

Values? 482

Summary and Conclusions 483

Concept Questions 484

Questions and Problems 485

Chapter 16

Capital Structure 487

16.1 The Capital Structure Question

and the Pie Theory 487

16.2 Maximizing Firm Value versus

Maximizing Stockholder Interests 488

16.3 Financial Leverage and Firm Value:

An Example 490

Leverage and Returns to Shareholders 490

The Choice between Debt and Equity 492

A Key Assumption 494

16.4 Modigliani and Miller: Proposition II

(No Taxes) 494

Risk to Equityholders Rises with

Leverage 494

Proposition II: Required Return to

Equityholders Rises with Leverage 495

MM: An Interpretation 501

16.5 Taxes 503

The Basic Insight 503

Present Value of the Tax Shield 505

Value of the Levered Firm 506

Expected Return and Leverage

under Corporate Taxes 508

The Weighted Average Cost of Capital,

WACC, and Corporate Taxes 509

Stock Price and Leverage under

Corporate Taxes 510

Summary and Conclusions 512

Concept Questions 512

Questions and Problems 513

Mini Case: Stephenson Real Estate

Recapitalization 518

Chapter 17

Capital Structure 519

17.1 Costs of Financial Distress 519

Bankruptcy Risk or Bankruptcy Cost? 519

17.2 Description of Financial Distress Costs 521

Direct Costs of Financial Distress: Legal

and Administrative Costs of Liquidation

or Reorganization 521

Indirect Costs of Financial Distress 523

Agency Costs 524

17.3 Can Costs of Debt Be Reduced? 527

Protective Covenants 527

Consolidation of Debt 528

17.4 Integration of Tax Effects and Financial

Distress Costs 529

Pie Again 530

17.5 Signaling 531

17.6 Shirking, Perquisites, and Bad Investments:

A Note on Agency Cost of Equity 533

Effect of Agency Costs of Equity

on Debt-Equity Financing 535

Free Cash Flow 535

17.7 The Pecking-Order Theory 536

Rules of the Pecking Order 537

Implications 538

17.8 Personal Taxes 539

The Basics of Personal Taxes 539

The Effect of Personal Taxes on

Capital Structure 539

17.9 How Firms Establish Capital

Structure 540

Summary and Conclusions 545

Concept Questions 546

Questions and Problems 546

Mini Case: McKenzie Corporation’s

Capital Budgeting 549

Appendix 17A: Some Useful Formulas

of Financial Structure 550

Appendix 17B: The Miller Model and the

Graduated Income Tax 550

Chapter 18

Valuation and Capital Budgeting

for the Levered Firm 551

18.1 Adjusted Present Value Approach 551

18.2 Flow to Equity Approach 553

Step 1: Calculating Levered Cash

Flow (LCF) 553

Step 2: Calculating RS 554

Step 3: Valuation 554

18.3 Weighted Average Cost

of Capital Method 554

18.4 A Comparison of the APV, FTE,

and WACC Approaches 555

A Suggested Guideline 556

18.5 Valuation When the Discount Rate

Must Be Estimated 558

18.6 APV Example 560

18.7 Beta and Leverage 563

The Project Is Not Scale Enhancing 565

Summary and Conclusions 566

Concept Questions 566

Questions and Problems 567

Mini Case: The Leveraged Buyout

of Cheek Products, Inc. 571

Appendix 18A: The Adjusted Present Value

Approach to Valuing

Leveraged Buyouts 572

Chapter 19

Dividends and Other Payouts 573

19.1 Different Types of Payouts 573

19.2 Standard Method of Cash

Dividend Payment 574

19.3 The Benchmark Case: An Illustration

of the Irrelevance of Dividend Policy 576

Current Policy: Dividends Set Equal

to Cash Flow 576

Alternative Policy: Initial Dividend

Is Greater Than Cash Flow 576

The Indifference Proposition 577

Homemade Dividends 577

A Test 578

Dividends and Investment Policy 579

19.4 Repurchase of Stock 579

Dividend versus Repurchase: Conceptual

Example 581

Dividends versus Repurchases:

Real-World Considerations 582

19.5 Personal Taxes, Dividends,

and Stock Repurchases 583

Firms without Sufficient Cash to Pay

a Dividend 583

Firms with Sufficient Cash to Pay

a Dividend 584

Summary of Personal Taxes 586

19.6 Real-World Factors Favoring

a High-Dividend Policy 587

Desire for Current Income 587

Behavioral Finance 587

Agency Costs 588

Information Content of Dividends

and Dividend Signaling 589

19.7 The Clientele Effect: A Resolution

of Real-World Factors? 591

19.8 What We Know and Do Not Know

about Dividend Policy 593

Corporate Dividends Are Substantial 593

Fewer Companies Pay Dividends 594

Corporations Smooth Dividends 595

Some Survey Evidence about Dividends 597

19.9 Putting It All Together 598

19.10 Stock Dividends and Stock Splits 600

Some Details about Stock Splits

and Stock Dividends 600

Value of Stock Splits and Stock Dividends 602

Reverse Splits 603

Summary and Conclusions 604

Concept Questions 604

Questions and Problems 606

Mini Case: Electronic Timing, Inc. 610

PART V Long‐Term

Financing

Chapter 20

Raising Capital 612

20.1 Early-Stage Financing and

Venture Capital 612

Venture Capital 613

Stages of Financing 614

Some Venture Capital Realities 615

Venture Capital Investments and

Economic Conditions 616

20.2 The Public Issue 616

Direct Listing 617

Crowdfunding 617

Initial Coin Offerings (ICOs) 619

20.3 Alternative Issue Methods 620

20.4 The Cash Offer 621

Investment Banks 623

The Offering Price 625

Underpricing: A Possible Explanation 625

Evidence on Underpricing 627

The Partial Adjustment Phenomenon 628

20.5 The Announcement of New Equity

and the Value of the Firm 629

20.6 The Cost of New Issues 630

The Costs of Going Public: A Case

Study 632

20.7 Rights 634

The Mechanics of a Rights Offering 634

Subscription Price 634

Number of Rights Needed to Purchase

a Share 635

Effect of Rights Offering on Price

of Stock 635

Effects on Shareholders 636

The Underwriting Arrangements 637

20.8 The Rights Puzzle 638

20.9 Dilution 639

Dilution of Percentage Ownership 639

Dilution of Stock Price 639

Dilution of Book Value 640

Dilution of Earnings Per Share 641

Conclusion 641

20.10 Shelf Registration 641

20.11 Issuing Long-Term Debt 642

Summary and Conclusions 643

Concept Questions 643

Questions and Problems 645

Mini Case: East Coast Yachts

Goes Public 648

Chapter 21

Leasing 649

21.1 Types of Leases 649

The Basics 649

Operating Leases 650

Financial Leases 650

21.2 Accounting and Leasing 651

21.3 Taxes, the IRS, and Leases 653

21.4 The Cash Flows of Leasing 654

A Note about Taxes 656

21.5 A Detour for Discounting and Debt

Capacity with Corporate Taxes 656

Present Value of Riskless Cash Flows 656

Optimal Debt Level and Riskless

Cash Flows 656

21.6 NPV Analysis of the Lease-versus-Buy

Decision 658

The Discount Rate 658

21.7 Debt Displacement and Lease Valuation 659

The Basic Concept of Debt

Displacement 659

Optimal Debt Level in the Xomox

Example 660

21.8 Does Leasing Ever Pay? The Base

Case 662

21.9 Reasons for Leasing 663

Good Reasons for Leasing 663

Bad Reasons for Leasing 666

21.10 Some Unanswered Questions 667

Are the Uses of Leases and Debt

Complementary? 667

Why Are Leases Offered by Both

Manufacturers and Third-Party Lessors? 667

Why Are Some Assets Leased More

Than Others? 667

Summary and Conclusions 668

Concept Questions 668

Questions and Problems 669

Mini Case: The Decision to Lease or

Buy at Warf Computers 672

Appendix 21A: APV Approach to Leasing 672

PART VI Options, Futures,

and Corporate Finance

Chapter 22

Options and Corporate Finance 673

22.1 Options 673

22.2 Call Options 674

The Value of a Call Option at Expiration 674

22.3 Put Options 675

The Value of a Put Option at Expiration 676

22.4 Selling Options 677

22.5 Option Quotes 678

22.6 Combinations of Options 679

22.7 Valuing Options 682

Bounding the Value of a Call 683

The Factors Determining Call

Option Values 684

A Quick Discussion of Factors

Determining Put Option Values 687

22.8 An Option Pricing Formula 687

A Two-State Option Model 688

The Black-Scholes Model 690

22.9 Stocks and Bonds as Options 695

The Firm Expressed in Terms

of Call Options 696

The Firm Expressed in Terms

of Put Options 697

A Resolution of the Two Views 698

A Note about Loan Guarantees 699

22.10 Options and Corporate Decisions:

Some Applications 700

Mergers and Diversification 700

Options and Capital Budgeting 702

22.11 Investment in Real Projects

and Options 704

Summary and Conclusions 707

Concept Questions 707

Questions and Problems 708

Excel Master It! Problem 715

Mini Case: Clissold Industries Options 716

Chapter 23

Options and Corporate Finance:

Extensions and Applications 718

23.1 Executive Stock Options 718

Why Options? 718

Valuing Executive Compensation 719

23.2 Valuing a Start-Up 722

23.3 More about the Binomial Model 725

Heating Oil 725

23.4 Shutdown and Reopening Decisions 731

Valuing a Gold Mine 731

The Abandonment and Opening

Decisions 732

Valuing the Simple Gold Mine 734

Summary and Conclusions 738

Concept Questions 738

Questions and Problems 739

Mini Case: Exotic Cuisines’ Employee

Stock Options 741

Chapter 24

Warrants and Convertibles 742

24.1 Warrants 742

24.2 The Difference between Warrants

and Call Options 743

How the Firm Can Hurt Warrant Holders 746

24.3 Warrant Pricing and the

Black-Scholes Model 746

24.4 Convertible Bonds 747

24.5 The Value of Convertible Bonds 748

Straight Bond Value 748

Conversion Value 749

Option Value 750

24.6 Reasons for Issuing Warrants

and Convertibles 751

Convertible Debt versus Straight Debt 751

Convertible Debt versus Common Stock 752

The “Free Lunch” Story 753

The “Expensive Lunch” Story 754

A Reconciliation 754

24.7 Why Are Warrants and Convertibles

Issued? 754

Matching Cash Flows 754

Risk Synergy 755

Agency Costs 755

Backdoor Equity 756

24.8 Conversion Policy 756

Summary and Conclusions 757

Concept Questions 758

Questions and Problems 759

Mini Case: S&S Air’s Convertible Bond 761

Chapter 25

Derivatives and Hedging Risk 763

25.1 Derivatives, Hedging, and Risk 763

25.2 Forward Contracts 764

25.3 Futures Contracts 765

25.4 Hedging 769

25.5 Interest Rate Futures Contracts 771

Pricing of Treasury Bonds 771

Pricing of Forward Contracts 772

Futures Contracts 773

Hedging in Interest Rate Futures 774

25.6 Duration Hedging 778

The Case of Zero Coupon Bonds 778

The Case of Two Bonds with the Same

Maturity but with Different Coupons 779

Duration 780

Matching Liabilities with Assets 782

25.7 Swaps Contracts 784

Interest Rate Swaps 785

Currency Swaps 786

Credit Default Swaps 787

Exotics 787

25.8 Actual Use of Derivatives 788

Summary and Conclusions 790

Concept Questions 790

Questions and Problems 792

Mini Case: Williamson Mortgage, Inc. 794

PART VII Short‐Term

Finance

Chapter 26

Short-Term Finance and Planning 795

26.1 Tracing Cash and Net Working Capital 796

26.2 The Operating Cycle and the Cash Cycle 797

Defining the Operating and Cash Cycles 798

The Operating Cycle and the Firm’s

Organization Chart 799

Calculating the Operating and

Cash Cycles 800

Interpreting the Cash Cycle 803

A Look at Operating and Cash Cycles 803

26.3 Some Aspects of Short-Term

Financial Policy 804

The Size of the Firm’s Investment in

Current Assets 804

Alternative Financing Policies for

Current Assets 807

Which Is Best? 809

26.4 Cash Budgeting 810

Cash Outflow 811

The Cash Balance 811

26.5 The Short-Term Financial Plan 812

Unsecured Loans 812

Secured Loans 812

Other Sources 813

Summary and Conclusions 813

Concept Questions 814

Questions and Problems 814

Excel Master It! Problem 822

Mini Case: Keafer Manufacturing

Working Capital Management 823

Chapter 27

Cash Management 825

27.1 Reasons for Holding Cash 825

The Speculative and Precautionary

Motives 825

The Transaction Motive 826

Compensating Balances 826

Costs of Holding Cash 826

Cash Management versus Liquidity

Management 826

27.2 Understanding Float 827

Disbursement Float 827

Collection Float and Net Float 828

Float Management 829

Electronic Data Interchange and

Check 21: The End of Float? 832

27.3 Cash Collection and Concentration 833

Components of Collection Time 833

Cash Collection 834

Lockboxes 834

Cash Concentration 835

Accelerating Collections: An Example 836

27.4 Managing Cash Disbursements 838

Increasing Disbursement Float 838

Controlling Disbursements 839

27.5 Investing Idle Cash 840

Temporary Cash Surpluses 840

Characteristics of Short-Term Securities 841

Some Different Types of Money

Market Securities 841

Summary and Conclusions 842

Concept Questions 843

Questions and Problems 844

Mini Case: Cash Management

at Richmond Corporation 846

Appendix 27A: Determining the Target

Cash Balance 846

Appendix 27B: Adjustable Rate Preferred

Stock, Auction Rate Preferred

Stock, and Floating-Rate

Certificates of Deposit 846

Chapter 28

Credit and Inventory Management 847

28.1 Credit and Receivables 847

Components of Credit Policy 848

The Cash Flows from Granting Credit 848

The Investment in Receivables 848

28.2 Terms of the Sale 849

The Basic Form 849

The Credit Period 849

Cash Discounts 851

Credit Instruments 852

28.3 Analyzing Credit Policy 853

Credit Policy Effects 853

Evaluating a Proposed Credit Policy 853

28.4 Optimal Credit Policy 855

The Total Credit Cost Curve 856

Organizing the Credit Function 857

28.5 Credit Analysis 857

When Should Credit Be Granted? 857

Credit Information 859

Credit Evaluation and Scoring 860

28.6 Collection Policy 860

Monitoring Receivables 860

Collection Effort 861

28.7 Inventory Management 861

The Financial Manager and

Inventory Policy 862

Inventory Types 862

Inventory Costs 862

28.8 Inventory Management Techniques 863

The ABC Approach 863

The Economic Order Quantity Model 863

Extensions to the EOQ Model 868

Managing Derived-Demand Inventories 868

Summary and Conclusions 870

Concept Questions 871

Questions and Problems 872

Mini Case: Credit Policy at Braam

Industries 875

Appendix 28A: More about Credit Policy

Analysis 875

PART VIII Special Topics

Chapter 29

Mergers, Acquisitions, and

Divestitures 876

29.1 The Basic Forms of Acquisitions 876

Merger or Consolidation 876

Acquisition of Stock 877

Acquisition of Assets 877

A Classification Scheme 878

A Note about Takeovers 878

29.2 Synergy 879

29.3 Sources of Synergy 880

Revenue Enhancement 880

Cost Reduction 881

Tax Gains 883

Reduced Capital Requirements 885

29.4 Two Financial Side Effects

of Acquisitions 886

Earnings Growth 886

Diversification 887

29.5 A Cost to Stockholders

from Reduction in Risk 888

The Base Case 888

Both Firms Have Debt 888

How Can Shareholders Reduce Their

Losses from the Coinsurance Effect? 890

29.6 The NPV of a Merger 890

Cash 890

Common Stock 892

Cash versus Common Stock 893

29.7 Friendly versus Hostile Takeovers 894

29.8 Defensive Tactics 896

Deterring Takeovers before Being in Play 896

Deterring a Takeover after the Company

Is in Play 897

29.9 Have Mergers Added Value? 899

Returns to Bidders 901

Target Companies 902

The Managers versus the Stockholders 902

29.10 The Tax Forms of Acquisitions 904

29.11 Accounting for Acquisitions 906

29.12 Going Private and Leveraged Buyouts 907

29.13 Divestitures 908

Sale 908

Spin-Off 908

Carve-Out 909

Tracking Stocks 909

Summary and Conclusions 910

Concept Questions 910

Questions and Problems 911

Mini Case: The Birdie Golf-Hybrid

Golf Merger 917

Chapter 30

Financial Distress 919

30.1 What Is Financial Distress? 919

30.2 What Happens in Financial Distress? 921

30.3 Bankruptcy Liquidation and

Reorganization 923

Bankruptcy Liquidation 923

Bankruptcy Reorganization 925

30.4 Private Workout or Bankruptcy:

Which Is Best? 928

The Marginal Firm 929

Holdouts 929

Complexity 929

Lack of Information 929

30.5 Prepackaged Bankruptcy 929

30.6 Predicting Corporate Bankruptcy:

The Z-Score Model 931

Summary and Conclusions 932

Concept Questions 933

Questions and Problems 933

Chapter 31

International Corporate Finance 935

31.1 Terminology 936

31.2 Foreign Exchange Markets

and Exchange Rates 936

Exchange Rates 937

31.3 Purchasing Power Parity 942

Absolute Purchasing Power Parity 942

Relative Purchasing Power Parity 943

31.4 Interest Rate Parity, Unbiased

Forward Rates, and the

International Fisher Effect 945

Covered Interest Arbitrage 945

Interest Rate Parity 946

Forward Rates and Future Spot Rates 947

Putting It All Together 948

31.5 International Capital Budgeting 949

Method 1: The Home Currency Approach 950

Method 2: The Foreign Currency

Approach 951

Unremitted Cash Flows 951

The Cost of Capital for International

Firms 952

31.6 Exchange Rate Risk 952

Short-Term Exposure 952

Long-Term Exposure 953

Translation Exposure 954

Managing Exchange Rate Risk 955

31.7 Political Risk 955

The Tax Cuts and Jobs Act of 2017 955

Managing Political Risk 956

Summary and Conclusions 957

Concept Questions 957

Questions and Problems 959

Excel Master It! Problem 961

Mini Case: East Coast Yachts Goes

International 962

Appendix A: Mathematical Tables 963

Appendix B: Solutions to Selected

End-of-Chapter Problems 972

Appendix C: Using the HP 10B and TI BA II Plus

Financial Calculators 975

Glossary 979

Name Index 987

Subject Index 989