Corporate Finance, 6th Edition PDF by Jonathan Berk and Peter Demarzo

By

Corporate Finance, Sixth Edition

By Jonathan Berk and Peter Demarzo

Corporate Finance, 6th Edition

Detailed Contents:

PART 1 INTRODUCTION 33

Chapter 1 The Corporation and Financial

Markets 34

1.1 The Four Types of Firms 35

Sole Proprietorships 35

Partnerships 36

Limited Liability Companies 37

Corporations 37

Tax Implications for Corporate Entities 38

■ Corporate Taxation Around the World 39

1.2 Ownership Versus Control of

Corporations 39

The Corporate Management Team 39

■ INTERVIEW with David Viniar 40

The Financial Manager 41

■ FINANCE IN TIMES OF DISRUPTION

The Dodd-Frank Act 42

The Goal of the Firm 42

The Firm and Society 42

Ethics and Incentives within Corporations 43

■ Shareholder versus Stakeholder Value 43

■ FINANCE IN TIMES OF DISRUPTION

The Dodd-Frank Act on Corporate Compensation 44

■ Citizens United v. Federal Election Commission 45

■ Airlines in Bankruptcy 46

1.3 The Stock Market 46

Primary and Secondary Stock Markets 47

Traditional Trading Venues 47

■ INTERVIEW with Adena T. Friedman 48

New Competition and Market Changes 49

Dark Pools 50

1.4 Fintech: Finance and Technology 51

Telecommunications 51

Security and Verification 51

Automation of Banking Services 52

Big Data and Machine Learning 52

Competition 53

Key Points and Equations 53 ■ Key

Terms 54 ■ Further Reading 55 ■

Problems 55

Chapter 2 Introduction to Financial

Statement Analysis 59

2.1 Firms’ Disclosure of Financial

Information 60

Preparation of Financial Statements 60

■ International Financial Reporting

Standards 60

■ INTERVIEW with Ruth Porat 61

Types of Financial Statements 62

2.2 The Balance Sheet 62

Assets 63

Liabilities 64

Stockholders’ Equity 65

Market Value Versus Book Value 65

Enterprise Value 66

2.3 The Income Statement 66

Earnings Calculations 67

2.4 The Statement of Cash Flows 68

Operating Activity 69

Investment Activity 70

Financing Activity 70

2.5 Other Financial Statement Information 71

Statement of Stockholders’ Equity 71

Management Discussion and Analysis 72

Notes to the Financial Statements 72

2.6 Financial Statement Analysis 73

Profitability Ratios 73

Liquidity Ratios 74

Working Capital Ratios 75

Interest Coverage Ratios 76

Leverage Ratios 77

Valuation Ratios 79

■ COMMON MISTAKE Mismatched Ratios 79

Operating Returns 80

The DuPont Identity 82

2.7 Financial Reporting in Practice 84

Enron 84

WorldCom 84

Sarbanes-Oxley Act 85

■ FINANCE IN TIMES OF DISRUPTION

Bernard Madoff’s Ponzi Scheme 86

Dodd-Frank Act 86

Foreign Regulation: Wirecard 86

Key Points and Equations 87 ■ Key

Terms 89 ■ Further Reading 90 ■

Problems 90 ■ Data Case 96

Chapter 3 Financial Decision Making and the

Law of One Price 99

3.1 Valuing Decisions 100

Analyzing Costs and Benefits 100

Using Market Prices to Determine Cash

Values 101

■ When Competitive Market Prices Are Not Available 103

3.2 Interest Rates and the Time Value of Money 103

The Time Value of Money 103

The Interest Rate: An Exchange Rate Across Time 103

3.3 Present Value and the NPV Decision Rule 106

Net Present Value 106

The NPV Decision Rule 107

NPV and Cash Needs 109

3.4 Arbitrage and the Law of One Price 110

Arbitrage 110

Law of One Price 111

3.5 No-Arbitrage and Security Prices 111

Valuing a Security with the Law of One Price 111

■ An Old Joke 115

The NPV of Trading Securities and Firm

Decision Making 115

Valuing a Portfolio 116

■ FINANCE IN TIMES OF DISRUPTION

Liquidity and the Informational Role of

Prices 117

■ Arbitrage in Markets 118

Where Do We Go from Here? 119

Key Points and Equations 120 ■ Key

Terms 121 ■ Further Reading 121 ■

Problems 121 ■ Data Case 125

Appendix The Price of Risk 126

Risky Versus Risk-Free Cash Flows 126

Arbitrage with Transactions Costs 131

PART 2 TIME, MONEY, AND

INTEREST RATES 135

Chapter 4 The Time Value of Money 136

4.1 The Timeline 137

4.2 The Three Rules of Time Travel 138

Rule 1: Comparing and Combining Values 138

Rule 2: Moving Cash Flows Forward in Time 139

Rule 3: Moving Cash Flows Back in Time 140

■ Rule of 72 141

Applying the Rules of Time Travel 142

4.3 Valuing a Stream of Cash Flows 144

4.4 Calculating the Net Present Value 146

■ USING EXCEL Calculating Present Values

in Excel 148

4.5 Perpetuities and Annuities 149

Perpetuities 149

■ Historical Examples of Perpetuities 149

Annuities 151

■ COMMON MISTAKE Discounting One

Too Many Times 151

■ Formula for an Annuity Due 154

Growing Cash Flows 155

4.6 Using an Annuity Spreadsheet or

Calculator 159

■ Annuity Calculator 161

4.7 Non-Annual Cash Flows 162

4.8 Solving for the Cash Payments 163

4.9 The Internal Rate of Return 166

■ USING EXCEL Excel’s IRR Function 169

Key Points and Equations 170 ■ Key

Terms 171 ■ Further Reading 172 ■

Problems 172 ■ Data Case 178

Appendix Solving for the Number of Periods 179

Chapter 5 Interest Rates 181

5.1 Interest Rate Quotes and Adjustments 182

The Effective Annual Rate 182

■ COMMON MISTAKE Using the

Wrong Discount Rate in the Annuity

Formula 183

Annual Percentage Rates 184

5.2 Application: Discount Rates and Loans 186

5.3 The Determinants of Interest Rates 187

■ FINANCE IN TIMES OF DISRUPTION

Teaser Rates and Subprime Loans 188

Inflation and Real Versus Nominal

Rates 188

Investment and Interest Rate Policy 190

The Yield Curve and Discount Rates 191

The Yield Curve and the Economy 192

■ COMMON MISTAKE Using the Annuity

Formula When Discount Rates Vary by

Maturity 192

■ INTERVIEW with Dr. Janet Yellen 194

5.4 Risk and Taxes 195

Risk and Interest Rates 196

After-Tax Interest Rates 197

5.5 The Opportunity Cost of Capital 198

■ COMMON MISTAKE States Dig a Multi-

Trillion Dollar Hole by Discounting at the

Wrong Rate 199

Key Points and Equations 200 ■ Key

Terms 201 ■ Further Reading 201 ■

Problems 201 ■ Data Case 206

Appendix Continuous Rates and Cash Flows 207

Discount Rates for a Continuously

Compounded APR 207

Continuously Arriving Cash Flows 207

Chapter 6 Valuing Bonds 209

6.1 Bond Cash Flows, Prices, and Yields 210

Bond Terminology 210

Zero-Coupon Bonds 210

■ FINANCE IN TIMES OF DISRUPTION

Negative Bond Yields 212

Coupon Bonds 213

6.2 Dynamic Behavior of Bond Prices 215

Discounts and Premiums 215

Time and Bond Prices 216

Interest Rate Changes and Bond Prices 218

■ Clean and Dirty Prices for Coupon

Bonds 219

6.3 The Yield Curve and Bond Arbitrage 221

Replicating a Coupon Bond 221

Valuing a Coupon Bond Using Zero-Coupon

Yields 222

Coupon Bond Yields 223

Treasury Yield Curves 224

6.4 Corporate Bonds 224

Corporate Bond Yields 225

■ Are Treasuries Really Default-Free

Securities? 225

Bond Ratings 227

Corporate Yield Curves 228

6.5 Sovereign Bonds 228

■ FINANCE IN TIMES OF DISRUPTION The

Credit Crisis and Bond Yields 229

■ FINANCE IN TIMES OF DISRUPTION

European Sovereign Debt Yields: A

Puzzle 231

■ INTERVIEW with Carmen M. Reinhart 232

Key Points and Equations 233 ■ Key

Terms 234 ■ Further Reading 235 ■

Problems 235 ■ Data Case 239 ■ Case

Study 240

Appendix Forward Interest Rates 242

Computing Forward Rates 242

Computing Bond Yields from Forward

Rates 243

Forward Rates and Future Interest

Rates 244

PART 3 VALUING PROJECTS AND

FIRMS 247

Chapter 7 Investment Decision Rules 248

7.1 NPV and Stand-Alone Projects 249

Applying the NPV Rule 249

The NPV Profile and IRR 249

Alternative Rules Versus the

NPV Rule 250

■ INTERVIEW with Dick Grannis 251

7.2 The Internal Rate of Return Rule 252

Applying the IRR Rule 252

Pitfall #1: Delayed Investments 252

Pitfall #2: Multiple IRRs 253

■ COMMON MISTAKE IRR Versus the IRR

Rule 255

Pitfall #3: Nonexistent IRR 255

7.3 The Payback Rule 256

Applying the Payback Rule 256

Payback Rule Pitfalls in Practice 257

■ Why Do Rules Other Than the NPV Rule

Persist? 258

7.4 Choosing between Projects 258

NPV Rule and Mutually Exclusive

Investments 258

IRR Rule and Mutually Exclusive

Investments 259

The Incremental IRR 260

■ COMMON MISTAKE Manipulating the

IRR with Financing 261

■ When Can Returns Be Compared? 263

7.5 Project Selection with Resource

Constraints 263

Evaluating Projects with Different Resource

Requirements 263

Profitability Index 264

Shortcomings of the Profitability

Index 266

Key Points and Equations 266 ■ Key

Terms 267 ■ Further Reading 267 ■

Problems 267 ■ Data Case 273

Appendix Computing the NPV Profile Using Excel’s

Data Table Function 274

Chapter 8 Fundamentals of Capital

Budgeting 275

8.1 Forecasting Earnings 276

Revenue and Cost Estimates 276

Incremental Earnings Forecast 277

Indirect Effects on Incremental Earnings 279

■ COMMON MISTAKE The Opportunity

Cost of an Idle Asset 280

Sunk Costs and Incremental Earnings 281

■ COMMON MISTAKE The Sunk Cost

Fallacy 281

Real-World Complexities 282

8.2 Determining Free Cash Flow and NPV 283

Calculating Free Cash Flow from

Earnings 283

Calculating Free Cash Flow Directly 285

Calculating the NPV 286

■ USING EXCEL Capital Budgeting Using

Excel 287

8.3 Choosing among Alternatives 288

Evaluating Manufacturing Alternatives 288

Comparing Free Cash Flows for Cisco’s

Alternatives 289

8.4 Further Adjustments to Free Cash Flow 289

■ INTERVIEW with David Holland 294

8.5 Analyzing the Project 295

Break-Even Analysis 295

■ COMMON MISTAKE Corporate Tax Rates

and Investment 296

Sensitivity Analysis 296

■ USING EXCEL Project Analysis Using

Excel 298

Scenario Analysis 299

Key Points and Equations 301 ■ Key

Terms 302 ■ Further Reading 302 ■

Problems 303 ■ Data Case 309

Appendix MACRS Depreciation 311

Chapter 9 Valuing Stocks 313

9.1 The Dividend-Discount Model 314

A One-Year Investor 314

Dividend Yields, Capital Gains, and Total

Returns 315

■ The Mechanics of a Short Sale 316

A Multiyear Investor 317

The Dividend-Discount Model

Equation 318

9.2 Applying the Dividend-Discount Model 318

Constant Dividend Growth 318

Dividends Versus Investment and

Growth 319

■ John Burr Williams’s Theory of Investment

Value 320

Changing Growth Rates 322

Limitations of the Dividend-Discount

Model 324

9.3 Total Payout and Free Cash Flow Valuation

Models 324

Share Repurchases and the Total Payout

Model 324

The Discounted Free Cash Flow Model 326

9.4 Valuation Based on Comparable Firms 330

Valuation Multiples 330

Limitations of Multiples 332

Comparison with Discounted Cash Flow

Methods 333

Stock Valuation Techniques: The Final

Word 334

■ Kenneth Cole Productions—What

Happened? 335

■ Cryptocurrencies and Price Bubbles 336

■ INTERVIEW with Susan Athey 338

9.5 Information, Competition, and Stock

Prices 339

Information in Stock Prices 339

Competition and Efficient Markets 340

Lessons for Investors and Corporate

Managers 342

■ INTERVIEW with Fahmi Quadir 344

The Efficient Markets Hypothesis Versus No

Arbitrage 345

Key Points and Equations 345 ■ Key

Terms 347 ■ Further Reading 347 ■

Problems 348 ■ Data Case 353

PART 4 RISK AND RETURN 355

Chapter 10 Capital Markets and the Pricing

of Risk 356

10.1 Risk and Return: Insights from 96 Years of

Investor History 357

10.2 Common Measures of Risk and Return 360

Probability Distributions 360

Expected Return 360

Variance and Standard Deviation 361

10.3 Historical Returns of Stocks and Bonds 363

Computing Historical Returns 363

Average Annual Returns 365

The Variance and Volatility of Returns 367

Estimation Error: Using Past Returns to Predict

the Future 368

■ Arithmetic Average Returns Versus

Compound Annual Returns 370

10.4 The Historical Tradeoff Between Risk and

Return 370

The Returns of Large Portfolios 371

The Returns of Individual Stocks 372

10.5 Common Versus Independent Risk 373

Theft Versus Earthquake Insurance: An

Example 373

The Role of Diversification 374

10.6 Diversification in Stock Portfolios 375

Firm-Specific Versus Systematic Risk 376

No Arbitrage and the Risk Premium 377

■ FINANCE IN TIMES OF DISRUPTION

Diversification Benefits During Market

Crashes 379

■ COMMON MISTAKE A Fallacy of Long-

Run Diversification 380

10.7 Measuring Systematic Risk 381

Identifying Systematic Risk: The Market

Portfolio 381

Sensitivity to Systematic Risk: Beta 381

10.8 Beta and the Cost of Capital 384

Estimating the Risk Premium 384

■ COMMON MISTAKE Beta Versus

Volatility 384

The Capital Asset Pricing Model 386

Key Points and Equations 386 ■ Key

Terms 388 ■ Further Reading 388 ■

Problems 388 ■ Data Case 393

Chapter 11 Optimal Portfolio Choice and the

Capital Asset Pricing Model 395

11.1 The Expected Return of a Portfolio 396

11.2 The Volatility of a Two-Stock Portfolio 397

Combining Risks 397

Determining Covariance and

Correlation 398

■ COMMON MISTAKE Computing

Variance, Covariance, and Correlation

in Excel 400

Computing a Portfolio’s Variance and

Volatility 401

11.3 The Volatility of a Large Portfolio 403

Large Portfolio Variance 403

Diversification with an Equally Weighted

Portfolio 404

■ INTERVIEW with Anne Martin 406

Diversification with General Portfolios 407

11.4 Risk Versus Return: Choosing an Efficient

Portfolio 407

Efficient Portfolios with Two Stocks 408

The Effect of Correlation 410

Short Sales 411

Efficient Portfolios with Many Stocks 412

■ NOBEL PRIZE Harry Markowitz and James

Tobin 413

11.5 Risk-Free Saving and Borrowing 415

Investing in Risk-Free Securities 415

Borrowing and Buying Stocks on

Margin 416

Identifying the Tangent Portfolio 417

11.6 The Efficient Portfolio and Required

Returns 419

Portfolio Improvement: Beta and the Required

Return 419

Expected Returns and the Efficient

Portfolio 421

11.7 The Capital Asset Pricing Model 423

The CAPM Assumptions 423

Supply, Demand, and the Efficiency of the

Market Portfolio 424

Optimal Investing: The Capital Market

Line 424

11.8 Determining the Risk Premium 425

Market Risk and Beta 425

■ NOBEL PRIZE William Sharpe on the

CAPM 427

The Security Market Line 428

Beta of a Portfolio 428

Summary of the Capital Asset Pricing

Model 430

Key Points and Equations 430 ■ Key

Terms 433 ■ Further Reading 433 ■

Problems 434 ■ Data Case 440

Appendix The CAPM with Differing Interest

Rates 442

The Efficient Frontier with Differing Saving

and Borrowing Rates 442

The Security Market Line with Differing

Interest Rates 442

Chapter 12 Estimating the Cost of Capital 445

12.1 The Equity Cost of Capital 446

12.2 The Market Portfolio 447

Constructing the Market Portfolio 447

Market Indexes 447

■ Value-Weighted Portfolios and

Rebalancing 448

The Market Risk Premium 449

12.3 Beta Estimation 451

Using Historical Returns 451

Identifying the Best-Fitting Line 453

Using Linear Regression 454

■ Why Not Estimate Expected Returns

Directly? 455

12.4 The Debt Cost of Capital 455

Debt Yields Versus Returns 455

■ COMMON MISTAKE Using the Debt Yield

as Its Cost of Capital 456

Debt Betas 457

12.5 A Project’s Cost of Capital 458

All-Equity Comparables 458

Levered Firms as Comparables 459

The Unlevered Cost of Capital 459

Industry Asset Betas 461

12.6 Project Risk Characteristics and

Financing 463

Differences in Project Risk 463

■ COMMON MISTAKE Adjusting for

Execution Risk 465

Financing and the Weighted Average Cost of

Capital 465

■ INTERVIEW with Shelagh Glaser 466

■ COMMON MISTAKE Using a Single Cost

of Capital in Multi-Divisional Firms 467

12.7 Final Thoughts on Using the CAPM 468

Key Points and Equations 469 ■ Key

Terms 471 ■ Further Reading 471 ■

Problems 472 ■ Data Case 476

Appendix Practical Considerations When Forecasting

Beta 477

Time Horizon 477

The Market Proxy 477

Beta Variation and Extrapolation 477

Outliers 478

■ COMMON MISTAKE Changing the Index

to Improve the Fit 479

■ USING EXCEL Estimating Beta Using

Excel 480

Other Considerations 481

Chapter 13 Investor Behavior and Capital

Market Efficiency 483

13.1 Competition and Capital Markets 484

Identifying a Stock’s Alpha 484

Profiting from Non-Zero Alpha Stocks 485

13.2 Information and Rational Expectations 486

Informed Versus Uninformed

Investors 486

Rational Expectations 487

13.3 The Behavior of Individual Investors 488

Underdiversification and Portfolio Biases 488

Excessive Trading and Overconfidence 489

Individual Behavior and Market Prices 491

13.4 Systematic Trading Biases 491

Hanging on to Losers and the Disposition

Effect 491

■ NOBEL PRIZE Prospect Theory, Mental

Accounting, and Nudges 492

Investor Attention, Mood, and

Experience 492

Herd Behavior 493

Implications of Behavioral Biases 493

13.5 The Efficiency of the Market Portfolio 494

Trading on News or Recommendations 494

■ NOBEL PRIZE The 2013 Prize: An

Enigma? 496

The Performance of Fund Managers 496

The Winners and Losers 499

13.6 Style-Based Techniques and the Market

Efficiency Debate 500

Size Effects 500

■ INTERVIEW with Jonathan Clements 502

Momentum 504

■ Market Efficiency and the Efficiency of the

Market Portfolio 505

Implications of Positive-Alpha Trading

Strategies 505

13.7 Multifactor Models of Risk 507

Using Factor Portfolios 507

Smart Beta 508

Long-Short Portfolios 508

Selecting the Portfolios 509

The Cost of Capital with Fama-French-Carhart

Factor Specification 510

13.8 Methods Used in Practice 512

Financial Managers 512

Investors 513

Key Points and Equations 514 ■ Key

Terms 516 ■ Further Reading 516 ■

Problems 517

Appendix Building a Multifactor Model 523

PART 5 CAPITAL STRUCTURE 525

Chapter 14 Capital Structure in a Perfect

Market 526

14.1 Equity Versus Debt Financing 527

Financing a Firm with Equity 527

Financing a Firm with Debt and Equity 528

The Effect of Leverage on Risk and Return 529

14.2 Modigliani-Miller I: Leverage, Arbitrage, and

Firm Value 531

MM and the Law of One Price 531

Homemade Leverage 531

■ MM and the Real World 532

The Market Value Balance Sheet 533

Application: A Leveraged Recapitalization 534

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

Cost of Capital 536

Leverage and the Equity Cost of

Capital 536

Capital Budgeting and the Weighted Average

Cost of Capital 537

■ COMMON MISTAKE Is Debt Better Than

Equity? 540

Computing the WACC with Multiple

Securities 540

Levered and Unlevered Betas 540

■ NOBEL PRIZE Franco Modigliani and

Merton Miller 542

14.4 Capital Structure Fallacies 543

Leverage and Earnings per Share 543

■ FINANCE IN TIMES OF DISRUPTION

Bank Capital Regulation and the ROE

Fallacy 545

Equity Issuances and Dilution 546

14.5 MM: Beyond the Propositions 547

Key Points and Equations 548 ■ Key

Terms 549 ■ Further Reading 549 ■

Problems 550

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

Key Points and Equations 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

■ FINANCE IN TIMES OF DISRUPTION 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

■ FINANCE IN TIMES OF DISRUPTION

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

■ FINANCE IN TIMES OF DISRUPTION

Moral Hazard, 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

■ NOBEL PRIZE The Cost of Bank Runs 623

16.9 Capital Structure: The Bottom Line 623

Key Points and Equations 624 ■ Key

Terms 626 ■ Further Reading 626 ■

Problems 627

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 644

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

■ COMMON MISTAKE Mischaracterizing Buybacks 660

17.6 Signaling with Payout Policy 660

Dividend Smoothing 660

Dividend Signaling 661

■ Can a Dividend Cut be Good News? 662

Signaling and Share Repurchases 663

17.7 Stock Dividends, Splits, and Spin-Offs 665

Stock Dividends and Splits 665

Spin-Offs 666

■ Berkshire Hathaway’s A & B Shares 667

Key Points and Equations 668 ■ Key

Terms 670 ■ Further Reading 670 ■

Problems 671 ■ Data Case 675

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

■ FINANCE IN TIMES OF DISRUPTION

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

Key Points and Equations 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

Key Points and Equations 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

■ FINANCE IN TIMES OF DISRUPTION

Credit Default Swaps 785

Pricing Risky Debt 786

Agency Conflicts 787

Key Points and Equations 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

■ FINANCE IN TIMES OF DISRUPTION 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

Key Points and Equations 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

Factors Affecting the Timing of

Investment 838

■ Why Are There Empty Lots in Built-Up

Areas of Big Cities? 839

Investment Options and Firm Risk 840

■ FINANCE IN TIMES OF DISRUPTION

Uncertainty, Investment, and the Option

to Delay 841

22.4 Growth and Abandonment Options 842

Valuing Growth Potential 842

■ Growth Options and COVID 844

The Option to Expand 844

The Option to Abandon 845

■ INTERVIEW with Kenneth C. Frazier 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

Key Points and Equations 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

■ FINANCE IN TIMES OF DISRUPTION

Worldwide IPO Deals in

2008–2009 890

Cost of an IPO 890

Long-Run Underperformance 891

23.4 SPACs: A New Way to Go Public 892

The SPAC Process 893

Analyzing a Deal 894

SPAC Performance 896

23.5 The Seasoned Equity Offering 897

The Mechanics of an SEO 897

Price Reaction 898

Issuance Costs 899

Key Points and Equations 900 ■ Key

Terms 901 ■ Further Reading 902 ■

Problems 903 ■ Data Case 907

Chapter 24 Debt Financing 909

24.1 Corporate Debt 910

Public Debt 910

Private Debt 914

24.2 Other Types of Debt 915

Sovereign Debt 915

■ Green Bonds 916

Municipal Bonds 917

■ Detroit’s Art Museum at Risk 917

Asset-Backed Securities 918

■ FINANCE IN TIMES OF DISRUPTION

CDOs, Subprime Mortgages, and the

Financial Crisis 918

24.3 Bond Covenants 920

24.4 Repayment Provisions 921

Call Provisions 921

■ New York City Calls Its Municipal

Bonds 923

Sinking Funds 925

Convertible Provisions 925

Key Points and Equations 927 ■ Key

Terms 928 ■ Further Reading 929 ■

Problems 929

Chapter 25 Leasing 931

25.1 The Basics of Leasing 932

Examples of Lease Transactions 932

Lease Payments and Residual Values 933

Leases Versus Loans 934

■ Calculating Auto Lease Payments 935

End-of-Term Lease Options 935

Other Lease Provisions 937

25.2 Accounting, Tax, and Legal Consequences of

Leasing 937

Lease Accounting 938

■ Operating Leases at Alaska Air

Group 939

The Tax Treatment of Leases 940

Leases and Bankruptcy 941

■ Synthetic Leases 942

25.3 The Leasing Decision 942

Cash Flows for a True Tax Lease 943

Lease Versus Buy (An Unfair

Comparison) 944

Lease Versus Borrow (The Right

Comparison) 945

Evaluating a True Tax Lease 947

Evaluating a Non-Tax Lease 948

25.4 Reasons for Leasing 948

Valid Arguments for Leasing 949

■ INTERVIEW with Mark Long 952

Suspect Arguments for Leasing 953

Key Points and Equations 953 ■ Key

Terms 954 ■ Further Reading 955 ■

Problems 955

PART 9 SHORT-TERM FINANCING 959

Chapter 26 Working Capital

Management 960

26.1 Overview of Working Capital 961

The Cash Cycle 961

Firm Value and Working Capital 963

26.2 Trade Credit 964

Trade Credit Terms 964

Trade Credit and Market Frictions 964

Managing Float 965

26.3 Receivables Management 966

Determining the Credit Policy 966

Monitoring Accounts Receivable 967

26.4 Payables Management 969

Determining Accounts Payable Days

Outstanding 969

Stretching Accounts Payable 970

26.5 Inventory Management 970

Benefits of Holding Inventory 971

Costs of Holding Inventory 971

■ FINANCE IN TIMES OF DISRUPTION

Supply Chains during COVID-19 972

26.6 Cash Management 973

Motivation for Holding Cash 973

Alternative Investments 974

■ FINANCE IN TIMES OF DISRUPTION

Hoarding Cash 974

Key Points and Equations 976 ■ Key

Terms 977 ■ Further Reading 977 ■

Problems 978 ■ Data Case 981

Chapter 27 Shor t-Term Financial Planning 983

27.1 Forecasting Short-Term Financing

Needs 984

Seasonalities 984

Negative Cash Flow Shocks 987

Positive Cash Flow Shocks 988

27.2 The Matching Principle 989

Permanent Working Capital 989

Temporary Working Capital 989

Financing Policy Choices 990

27.3 Short-Term Financing with Bank Loans 991

Single, End-of-Period Payment Loan 991

Line of Credit 991

Bridge Loan 992

Common Loan Stipulations and Fees 992

27.4 Short-Term Financing with Commercial

Paper 994

■ FINANCE IN TIMES OF DISRUPTION

Short-Term Financing Costs during

Crises 995

27.5 Short-Term Financing with Secured

Financing 996

Accounts Receivable as Collateral 996

Inventory as Collateral 996

■ A Seventeenth-Century Financing

Solution 997

■ Loan Guarantees: The Ex-Im Bank

Controversy 998

Sales as Collateral 999

Key Points and Equations 1000 ■ Key

Terms 1001 ■ Further Reading 1001 ■

Problems 1001

PART 10 SPECIAL TOPICS 1005

Chapter 28 Mergers and Acquisitions 1006

28.1 Background and Historical Trends 1007

Merger Waves 1007

Types of Mergers 1009

28.2 Market Reaction to a Takeover 1009

28.3 Reasons to Acquire 1010

Economies of Scale and Scope 1011

Vertical Integration 1011

Expertise 1011

Monopoly Gains 1012

Efficiency Gains 1012

Tax Savings from Operating Losses 1013

Diversification 1014

Earnings Growth 1014

Managerial Motives to Merge 1016

28.4 Valuation and the Takeover Process 1017

Valuation 1017

The Offer 1018

Merger “Arbitrage” 1019

Tax and Accounting Issues 1020

Board and Shareholder Approval 1021

28.5 Takeover Defenses 1022

Poison Pills 1022

Staggered Boards 1023

White Knights 1024

Golden Parachutes 1025

Recapitalization 1025

Other Defensive Strategies 1025

Regulatory Approval 1026

■ Weyerhaeuser’s Hostile Bid for Willamette Industries 1026

28.6 Who Gets the Value Added from a Takeover? 1027

The Free Rider Problem 1027

Toeholds 1028

The Leveraged Buyout 1028

■ The Leveraged Buyout of RJR-Nabisco by KKR 1029

The Freezeout Merger 1031

Competition 1032

Key Points and Equations 1032 ■ Key

Terms 1034 ■ Further Reading 1034 ■

Problems 1034

Chapter 29 Corporate Governance 1037

29.1 Corporate Governance and Agency

Costs 1038

29.2 Monitoring by the Board of Directors and

Others 1039

Types of Directors 1039

Board Independence 1039

■ COMMON MISTAKE “Celebrity” Boards 1041

Board Size and Performance 1041

Other Monitors 1041

29.3 Compensation Policies 1042

Stock and Options 1042

Pay and Performance Sensitivity 1042

29.4 Managing Agency Conflict 1044

Direct Action by Shareholders 1044

■ Shareholder Activism at The New York

Times 1047

Management Entrenchment 1047

The Threat of Takeover 1048

29.5 Regulation 1048

The Sarbanes-Oxley Act 1048

■ INTERVIEW with Lawrence E. Harris 1049

The Cadbury Commission 1051

Dodd-Frank Act 1051

Insider Trading 1052

■ Martha Stewart and ImClone 1053

29.6 Corporate Governance Around the

World 1053

Protection of Shareholder Rights 1053

Controlling Owners and Pyramids 1053

The Stakeholder Model 1056

Cross-Holdings 1056

29.7 The Tradeoff of Corporate

Governance 1057

Key Points and Equations 1058 ■ Key

Terms 1059 ■ Further Reading 1060 ■

Problems 1060

Chapter 30 Risk Management 1061

30.1 Insurance 1062

The Role of Insurance: An Example 1062

Insurance Pricing in a Perfect Market 1062

The Value of Insurance 1064

The Costs of Insurance 1066

The Insurance Decision 1068

30.2 Commodity Price Risk 1068

Hedging with Vertical Integration and Storage 1069

Hedging with Long-Term Contracts 1069

Hedging with Futures Contracts 1071

■ COMMON MISTAKE Hedging Risk 1073

■ Differing Hedging Strategies 1074

Deciding to Hedge Commodity Price Risk 1074

■ FINANCE IN TIMES OF DISRUPTION

Negative Oil Prices 1075

30.3 Exchange Rate Risk 1075

Exchange Rate Fluctuations 1075

Hedging with Forward Contracts 1077

Cash-and-Carry and the Pricing of Currency Forwards 1078

■ FINANCE IN TIMES OF DISRUPTION

Arbitrage in Currency Markets? 1081

Hedging with Options 1082

30.4 Interest Rate Risk 1085

Interest Rate Risk Measurement: Duration 1086

Duration-Based Hedging 1087

■ The Savings and Loan Crisis 1091

Swap-Based Hedging 1091

Key Points and Equations 1095 ■ Key

Terms 1097 ■ Further Reading 1097 ■ Problems 1098

Chapter 31 International Corporate Finance 1103

31.1 Internationally Integrated Capital Markets 1104

31.2 Valuation of Foreign Currency Cash Flows 1105

WACC Valuation Method in Domestic Currency 1106

Using the Law of One Price as a Robustness Check 1108

31.3 Valuation and International Taxation 1109

The TCJA: A New Approach to International Taxation 1110

Harmonizing the Tax Treatment of Exports: GILTI and FDII 1110

Avoiding Base Erosion: BEAT 1112

31.4 Internationally Segmented Capital Markets 1112

Differential Access to Markets 1113

Macro-Level Distortions 1113

Implications 1114

31.5 Capital Budgeting with Exchange Risk 1116

■ INTERVIEW with Sally Johnson 1118

Key Points and Equations 1119 ■ Key

Terms 1119 ■ Further Reading 1120 ■

Problems 1120 ■ Data Case 1122

Glossary 1123

Index 1145

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