## Fundamentals of Corporate Finance, Thirteenth Edition

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

**Contents:**

PART 1 Overview of Corporate Finance

CHAPTER 1

INTRODUCTION TO CORPORATE FINANCE 1

1.1 Finance: A Quick Look 2

Finance: The Five Main Areas 2

Corporate Finance 2

Investments 2

Financial Institutions 3

International Finance 3

Fintech 3

Why Study Finance? 3

Marketing and Finance 3

Accounting and Finance 3

Management and Finance 4

Technology and Finance 4

You and Finance 5

1.2 Corporate Finance and the Financial Manager 5

What is Corporate Finance? 5

The Financial Manager 6

Financial Management Decisions 7

Capital Budgeting 7

Capital Structure 7

Working Capital Management 7

Conclusion 8

1.3 Forms of Business Organization 8

Sole Proprietorship 8

Partnership 8

Corporation 9

A Corporation by Another Name . . . 10

Benefit Corporation 11

1.4 The Goal of Financial Management 11

Possible Goals 12

The Goal of Financial Management 12

A More General Goal 13

Sarbanes-Oxley 13

1.5 The Agency Problem and Control of the

Corporation 14

Agency Relationships 14

Management Goals 14

Do Managers Act in the Stockholders’ Interests? 15

Managerial Compensation 15

Control of the Firm 16

Conclusion 17

Stakeholders 17

1.6 Financial Markets and the Corporation 18

Cash Flows to and from the Firm 18

Primary versus Secondary Markets 19

Primary Markets 19

Secondary Markets 19

Dealer versus Auction Markets 19

Trading in Corporate Securities 20

Listing 20

1.7 Summary and Conclusions 21

CHAPTER 2

FINANCIAL STATEMENTS, TAXES, AND CASH FLOW 24

2.1 The Balance Sheet 25

Assets: The Left Side 25

Liabilities and Owners’ Equity: The Right Side 25

Net Working Capital 26

Liquidity 27

Debt versus Equity 28

Market Value versus Book Value 28

2.2 The Income Statement 29

GAAP and the Income Statement 30

Noncash Items 31

Time and Costs 31

2.3 Taxes 33

Corporate Tax Rates 33

Average versus Marginal Tax Rates 33

2.4 Cash Flow 35

Cash Flow from Assets 35

Operating Cash Flow 35

Capital Spending 36

Change in Net Working Capital 37

Conclusion 37

A Note about “Free” Cash Flow 37

Cash Flow to Creditors and Stockholders 38

Cash Flow to Creditors 38

Cash Flow to Stockholders 38

An Example: Cash Flows for Dole Cola 38

Operating Cash Flow 38

Net Capital Spending 40

Change in NWC and Cash Flow from Assets 40

Cash Flow to Stockholders and Creditors 40

2.5 Summary and Conclusions 41

Part 2 Financial Statements and Long-Term Financial Planning

CHAPTER 3

WORKING WITH FINANCIAL STATEMENTS 51

3.1 Cash Flow and Financial Statements:

A Closer Look 52

Sources and Uses of Cash 52

The Statement of Cash Flows 54

3.2 Standardized Financial Statements 56

Common-Size Statements 56

Common-Size Balance Sheets 56

Common-Size Income Statements 57

Common-Size Statements of Cash Flows 58

Common-Base Year Financial Statements: Trend

Analysis 58

Combined Common-Size and Base Year Analysis 58

3.3 Ratio Analysis 59

Short-Term Solvency, or Liquidity, Measures 60

Current Ratio 60

The Quick (or Acid-Test) Ratio 61

Other Liquidity Ratios 62

Long-Term Solvency Measures 62

Total Debt Ratio 63

A Brief Digression: Total Capitalization versus Total

Assets 63

Times Interest Earned 64

Cash Coverage 64

Asset Management, or Turnover, Measures 64

Inventory Turnover and Days’ Sales in Inventory 64

Receivables Turnover and Days’ Sales in

Receivables 65

Asset Turnover Ratios 66

Profitability Measures 67

Profit Margin 67

Return on Assets 67

Return on Equity 68

Market Value Measures 69

Price-Earnings Ratio 69

Price-Sales Ratio 69

Market-to-Book Ratio 70

Enterprise Value-EBITDA Multiple 71

A Note on Ratio Analysis 71

Conclusion 71

3.4 The DuPont Identity 72

A Closer Look at ROE 73

An Expanded DuPont Analysis 75

3.5 Using Financial Statement Information 76

Why Evaluate Financial Statements? 76

Internal Uses 77

External Uses 77

Choosing a Benchmark 77

Time Trend Analysis 77

Peer Group Analysis 78

Problems with Financial Statement Analysis 83

3.6 Summary and Conclusions 84

CHAPTER 4

LONG-TERM FINANCIAL PLANNING AND GROWTH 96

4.1 What Is Financial Planning? 98

Growth as a Financial Management Goal 98

Dimensions of Financial Planning 98

What Can Planning Accomplish? 99

Examining Interactions 99

Exploring Options 99

Avoiding Surprises 99

Ensuring Feasibility and Internal Consistency 100

Conclusion 100

4.2 Financial Planning Models: A First Look 100

A Financial Planning Model: The Ingredients 100

Sales Forecast 101

Pro Forma Statements 101

Asset Requirements 101

Financial Requirements 101

The Plug 101

Economic Assumptions 102

A Simple Financial Planning Model 102

4.3 The Percentage of Sales Approach 103

The Income Statement 103

The Balance Sheet 104

A Particular Scenario 106

An Alternative Scenario 107

4.4 External Financing and Growth 109

EFN and Growth 111

Financial Policy and Growth 113

The Internal Growth Rate 113

The Sustainable Growth Rate 114

Determinants of Growth 114

A Note about Sustainable Growth Rate

Calculations 116

4.5 Some Caveats Regarding Financial Planning

Models 118

4.6 Summary and Conclusions 119

PART 3 of Future Cash Flows

CHAPTER 5

INTRODUCTION TO VALUATION: THE TIME VALUE OF MONEY 130

5.1 Future Value and Compounding 131

Investing for a Single Period 131

Investing for More Than One Period 131

A Note about Compound Growth 137

5.2 Present Value and Discounting 138

The Single-Period Case 138

Present Values for Multiple Periods 139

5.3 More about Present and Future Values 142

Present versus Future Value 142

Determining the Discount Rate 143

Finding the Number of Periods 146

5.4 Summary and Conclusions 150

CHAPTER 6

DISCOUNTED CASH FLOW VALUATION 156

6.1 Future and Present Values of Multiple Cash

Flows 157

Future Value with Multiple Cash Flows 157

Present Value with Multiple Cash Flows 159

A Note about Cash Flow Timing 163

6.2 Valuing Level Cash Flows: Annuities and

Perpetuities 164

Present Value for Annuity Cash Flows 164

Annuity Tables 165

Finding the Payment 167

Finding the Rate 168

Future Value for Annuities 170

A Note about Annuities Due 171

Perpetuities 172

Growing Annuities and Perpetuities 174

6.3 Comparing Rates: The Effect of Compounding 174

Effective Annual Rates and Compounding 175

Calculating and Comparing Effective Annual Rates 175

EARs and APRs 177

Taking It to the Limit: A Note about Continuous

Compounding 178

6.4 Loan Types and Loan Amortization 180

Pure Discount Loans 180

Interest-Only Loans 181

Amortized Loans 181

6.5 Summary and Conclusions 186

CHAPTER 7

INTEREST RATES AND BOND VALUATION 201

7.1 Bonds and Bond Valuation 202

Bond Features and Prices 202

Bond Values and Yields 202

Interest Rate Risk 206

Finding the Yield to Maturity: More Trial and Error 207

7.2 More about Bond Features 212

Is it Debt or Equity? 212

Long-Term Debt: The Basics 212

The Indenture 213

Terms of a Bond 214

Security 214

Seniority 215

Repayment 215

The Call Provision 215

Protective Covenants 216

7.3 Bond Ratings 217

7.4 Some Different Types of Bonds 218

Government Bonds 218

Zero Coupon Bonds 219

Floating-Rate Bonds 220

Other Types of Bonds 221

Sukuk 222

7.5 Bond Markets 224

How Bonds Are Bought and Sold 225

Bond Price Reporting 225

A Note about Bond Price Quotes 229

7.6 Inflation and Interest Rates 229

Real versus Nominal Rates 229

The Fisher Effect 230

Inflation and Present Values 231

7.7 Determinants of Bond Yields 232

The Term Structure of Interest Rates 232

Bond Yields and the Yield Curve: Putting it all

Together 235

Conclusion 236

7.8 Summary and Conclusions 236

CHAPTER 8

STOCK VALUATION 245

8.1 Common Stock Valuation 246

Cash Flows 246

Some Special Cases 248

Zero Growth 248

Constant Growth 248

Nonconstant Growth 251

Two-Stage Growth 253

Components of the Required Return 254

Stock Valuation Using Multiples 255

8.2 Some Features of Common and Preferred Stocks 257

Common Stock Features 257

Shareholder Rights 257

Proxy Voting 258

Classes of Stock 258

Other Rights 259

Dividends 259

Preferred Stock Features 260

Stated Value 260

Cumulative and Noncumulative Dividends 260

Is Preferred Stock Really Debt? 260

8.3 The Stock Markets 261

Dealers and Brokers 261

Organization of the NYSE 262

Members 262

Operations 263

Floor Activity 263

Nasdaq Operations 264

ECNs 266

Stock Market Reporting 266

8.4 Summary and Conclusions 268

PART 4 **Capital Budgeting**

CHAPTER 9

NET PRESENT VALUE AND OTHER

INVESTMENT CRITERIA 278

9.1 Net Present Value 279

The Basic Idea 279

Estimating Net Present Value 280

9.2 The Payback Rule 283

Defining the Rule 283

Analyzing the Rule 285

Redeeming Qualities of the Rule 285

Summary of the Rule 286

9.3 The Discounted Payback 287

9.4 The Average Accounting Return 289

9.5 The Internal Rate of Return 291

Problems with the IRR 295

Nonconventional Cash Flows 295

Mutually Exclusive Investments 297

Investing or Financing? 299

Redeeming Qualities of the IRR 300

The Modified Internal Rate of Return (MIRR) 301

Method 1: The Discounting Approach 301

Method 2: The Reinvestment Approach 301

Method 3: The Combination Approach 302

MIRR or IRR: Which Is Better? 302

9.6 The Profitability Index 302

9.7 The Practice of Capital Budgeting 303

9.8 Summary and Conclusions 306

CHAPTER 10

MAKING CAPITAL INVESTMENT DECISIONS 318

10.1 Project Cash Flows: A First Look 319

Relevant Cash Flows 319

The Stand-Alone Principle 319

10.2 Incremental Cash Flows 320

Sunk Costs 320

Opportunity Costs 320

Side Effects 321

Net Working Capital 321

Financing Costs 321

Other Issues 322

10.3 Pro Forma Financial Statements and Project Cash

Flows 322

Getting Started: Pro Forma Financial Statements 322

Project Cash Flows 323

Project Operating Cash Flow 323

Project Net Working Capital and Capital

Spending 324

Projected Total Cash Flow and Value 324

10.4 More about Project Cash Flow 325

A Closer Look at Net Working Capital 325

Depreciation 328

Modified ACRS Depreciation (MACRS) 328

Bonus Depreciation 329

Book Value versus Market Value 330

An Example: The Majestic Mulch and Compost Company

(MMCC) 331

Operating Cash Flows 332

Change in NWC 333

Capital Spending 334

Total Cash Flow and Value 334

Conclusion 334

10.5 Alternative Definitions of Operating Cash Flow 335

The Bottom-Up Approach 336

The Top-Down Approach 336

The Tax Shield Approach 336

Conclusion 337

10.6 Some Special Cases of Discounted Cash Flow

Analysis 337

Evaluating Cost-Cutting Proposals 337

Setting the Bid Price 339

Evaluating Equipment Options with Different Lives 341

10.7 Summary and Conclusions 343

CHAPTER 11

PROJECT ANALYSIS AND EVALUATION 356

11.1 Evaluating NPV Estimates 357

The Basic Problem 357

Projected versus Actual Cash Flows 357

Forecasting Risk 357

Sources of Value 358

11.2 Scenario and Other What-If Analyses 359

Getting Started 359

Scenario Analysis 360

Sensitivity Analysis 362

Simulation Analysis 364

11.3 Break-Even Analysis 364

Fixed and Variable Costs 365

Variable Costs 365

Fixed Costs 366

Total Costs 366

Accounting Break-Even 367

Accounting Break-Even: A Closer Look 369

Uses for the Accounting Break-Even 369

11.4 Operating Cash Flow, Sales Volume, and

Break-Even 370

Accounting Break-Even and Cash Flow 370

The Base Case 371

Calculating the Break-Even Level 371

Payback and Break-Even 371

Sales Volume and Operating Cash Flow 372

Cash Flow, Accounting, and Financial Break-Even

Points 372

Accounting Break-Even Revisited 373

Cash Break-Even 373

Financial Break-Even 373

Conclusion 374

11.5 Operating Leverage 375

The Basic Idea 375

Implications of Operating Leverage 375

Measuring Operating Leverage 375

Operating Leverage and Break-Even 377

11.6 Capital Rationing 378

Soft Rationing 378

Hard Rationing 378

11.7 Summary and Conclusions 379

PART 5 Risk and Return

CHAPTER 12

SOME LESSONS FROM CAPITAL MARKET HISTORY 388

12.1 Returns 389

Dollar Returns 389

Percentage Returns 391

12.2 The Historical Record 393

A First Look 393

A Closer Look 395

12.3 Average Returns: The First Lesson 400

Calculating Average Returns 400

Average Returns: The Historical Record 400

Risk Premiums 401

The First Lesson 401

12.4 The Variability of Returns: The Second Lesson 402

Frequency Distributions and Variability 402

The Historical Variance and Standard Deviation 403

The Historical Record 404

Normal Distribution 405

The Second Lesson 407

2008: A Year to Remember 407

Using Capital Market History 408

More on the Stock Market Risk Premium 409

12.5 More about Average Returns 411

Arithmetic versus Geometric Averages 411

Calculating Geometric Average Returns 411

Arithmetic Average Return or Geometric Average

Return? 414

12.6 Capital Market Efficiency 415

Price Behavior in an Efficient Market 415

The Efficient Markets Hypothesis 416

Some Common Misconceptions about the EMH 417

The Forms of Market Efficiency 418

12.7 Summary and Conclusions 419

CHAPTER 13

RETURN, RISK, AND THE SECURITY MARKET LINE 427

13.1 Expected Returns and Variances 428

Expected Return 428

Calculating the Variance 430

13.2 Portfolios 431

Portfolio Weights 432

Portfolio Expected Returns 432

Portfolio Variance 433

13.3 Announcements, Surprises, and Expected

Returns 435

Expected and Unexpected Returns 435

Announcements and News 435

13.4 Risk: Systematic and Unsystematic 437

Systematic and Unsystematic Risk 437

Systematic and Unsystematic Components of

Return 437

13.5 Diversification and Portfolio Risk 438

The Effect of Diversification: Another Lesson from Market

History 438

The Principle of Diversification 439

Diversification and Unsystematic Risk 440

Diversification and Systematic Risk 441

13.6 Systematic Risk and Beta 441

The Systematic Risk Principle 442

Measuring Systematic Risk 442

Portfolio Betas 444

13.7 The Security Market Line 445

Beta and the Risk Premium 445

The Reward-to-Risk Ratio 446

The Basic Argument 447

The Fundamental Result 448

The Security Market Line 450

Market Portfolios 450

The Capital Asset Pricing Model 450

13.8 The SML and the Cost of Capital: A Preview 453

The Basic Idea 453

The Cost of Capital 453

13.9 Summary and Conclusions 454

Part 6 Cost of Capital and Long-Term Financial Policy

CHAPTER 14

COST OF CAPITAL 465

14.1 The Cost of Capital: Some Preliminaries 466

Required Return versus Cost of Capital 466

Financial Policy and Cost of Capital 467

14.2 The Cost of Equity 467

The Dividend Growth Model Approach 467

Implementing the Approach 468

Estimating g 468

Advantages and Disadvantages of the

Approach 469

The SML Approach 469

Implementing the Approach 470

Advantages and Disadvantages of the

Approach 470

14.3 The Costs of Debt and Preferred Stock 471

The Cost of Debt 471

The Cost of Preferred Stock 471

14.4 The Weighted Average Cost of Capital 472

The Capital Structure Weights 472

Taxes and the Weighted Average Cost of Capital 473

Calculating the WACC for Eastman Chemical 474

Eastman’s Cost of Equity 475

Eastman’s Cost of Debt 477

Eastman’s WACC 478

Solving the Warehouse Problem and Similar Capital

Budgeting Problems 480

Performance Evaluation: Another Use of the

WACC 482

14.5 Divisional and Project Costs of Capital 483

The SML and the WACC 483

Divisional Cost of Capital 484

The Pure Play Approach 484

The Subjective Approach 485

14.6 Company Valuation with the WACC 486

14.7 Flotation Costs and the Average Cost

of Capital 489

The Basic Approach 489

Flotation Costs and NPV 490

Internal Equity and Flotation Costs 492

14.8 Summary and Conclusions 492

CHAPTER 15

RAISING CAPITAL 502

15.1 Entrepreneurship: Early-Stage Financing and Venture

Capital 503

Entrepreneurship 503

Venture Capital 503

Some Venture Capital Realities 505

Venture Capital Firms 506

Crowdfunding 507

Initial Coin Offerings (ICOS) 507

Conclusion 508

15.2 Selling Securities to the Public: The Basic

Procedure 508

15.3 Alternative Issue Methods 511

15.4 Underwriters 512

Choosing an Underwriter 512

Types of Underwriting 512

Firm Commitment Underwriting 512

Best Efforts Underwriting 513

Dutch Auction Underwriting 513

The Aftermarket 514

The Green Shoe Provision 514

Lockup Agreements 514

The Quiet Period 515

Direct Listing 515

15.5 IPOS and Underpricing 515

IPO Underpricing: The 1999–2000 Experience 516

Evidence on Underpricing 519

The Partial Adjustment Phenomenon 520

Why Does Underpricing Exist? 521

15.6 New Equity Sales and the Value of the Firm 522

15.7 The Costs of Issuing Securities 523

The Costs of Selling Stock to the Public 523

The Costs of Going Public: A Case Study 524

15.8 Rights 525

The Mechanics of a Rights Offering 525

Number of Rights Needed to Purchase a Share 526

The Value of a Right 527

Ex Rights 528

The Underwriting Arrangements 530

Effects on Shareholders 530

15.9 Dilution 531

Dilution of Proportionate Ownership 531

Dilution of Value: Book versus Market Values 531

A Misconception 532

The Correct Arguments 532

15.10 Issuing Long-Term Debt 533

15.11 Shelf Registration 534

15.12 Summary and Conclusions 535

CHAPTER 16

FINANCIAL LEVERAGE AND CAPITAL STRUCTURE

POLICY 541

16.1 The Capital Structure Question 542

Firm Value and Stock Value: An Example 542

Capital Structure and the Cost of Capital 543

16.2 The Effect of Financial Leverage 544

The Basics of Financial Leverage 544

Financial Leverage, EPS, and ROE: An Example 544

EPS versus EBIT 545

Corporate Borrowing and Homemade Leverage 547

16.3 Capital Structure and the Cost of Equity Capital 548

M&M Proposition I: The Pie Model 548

The Cost of Equity and Financial Leverage:

M&M Proposition II 549

Business and Financial Risk 551

16.4 M&M Propositions I and II with Corporate Taxes 552

The Interest Tax Shield 553

Taxes and M&M Proposition I 553

Taxes, the WACC, and Proposition II 554

Conclusion 555

16.5 Bankruptcy Costs 557

Direct Bankruptcy Costs 558

Indirect Bankruptcy Costs 558

16.6 Optimal Capital Structure 559

The Static Theory of Capital Structure 559

Optimal Capital Structure and the Cost of Capital 560

Optimal Capital Structure: A Recap 561

Capital Structure: Some Managerial

Recommendations 563

Taxes 563

Financial Distress 563

16.7 The Pie Again 563

The Extended Pie Model 564

Marketed Claims versus Nonmarketed Claims 565

16.8 The Pecking-Order Theory 565

Internal Financing and the Pecking Order 565

Implications of the Pecking Order 566

16.9 Observed Capital Structures 567

16.10 A Quick Look at the Bankruptcy Process 569

Liquidation and Reorganization 569

Bankruptcy Liquidation 569

Bankruptcy Reorganization 570

Financial Management and the Bankruptcy

Process 571

Agreements to Avoid Bankruptcy 572

16.11 Summary and Conclusions 572

CHAPTER 17

DIVIDENDS AND PAYOUT POLICY 580

17.1 Cash Dividends and Dividend Payment 581

Cash Dividends 581

Standard Method of Cash Dividend Payment 581

Dividend Payment: A Chronology 582

More about the Ex-dividend Date 582

17.2 Does Dividend Policy Matter? 584

An Illustration of the Irrelevance of Dividend Policy 584

Current Policy: Dividends Set Equal to Cash Flow 584

Alternative Policy: Initial Dividend Greater Than Cash

Flow 585

Homemade Dividends 585

A Test 586

17.3 Real-World Factors Favoring a Low Dividend

Payout 587

Taxes 587

Flotation Costs 587

Dividend Restrictions 587

17.4 Real-World Factors Favoring a High Dividend

Payout 588

Desire for Current Income 588

Tax and Other Benefits from High Dividends 589

Corporate Investors 589

Tax-Exempt Investors 589

Conclusion 589

17.5 A Resolution of Real-World Factors? 589

Information Content of Dividends 590

The Clientele Effect 591

17.6 Stock Repurchases: An Alternative to Cash

Dividends 591

Cash Dividends versus Repurchase 592

Real-World Considerations in a Repurchase 594

Share Repurchase and EPS 594

17.7 What We Know and Do Not Know about Dividend and

Payout Policies 595

Dividends and Dividend Payers 595

Corporations Smooth Dividends 597

Putting It All Together 598

Some Survey Evidence on Dividends 600

17.8 Stock Dividends and Stock Splits 602

Some Details about Stock Splits and Stock

Dividends 602

Example of a Small Stock Dividend 602

Example of a Stock Split 603

Example of a Large Stock Dividend 603

Value of Stock Splits and Stock Dividends 603

The Benchmark Case 603

Popular Trading Range 604

Reverse Splits 604

17.9 Summary and Conclusions 605

Part 7 Short-Term Financial Planning and Management

CHAPTER 18

SHORT-TERM FINANCE AND PLANNING 612

18.1 Tracing Cash and Net Working Capital 613

18.2 The Operating Cycle and the Cash Cycle 614

Defining the Operating and Cash Cycles 615

The Operating Cycle 615

The Cash Cycle 615

The Operating Cycle and the Firm’s Organizational

Chart 616

Calculating the Operating and Cash Cycles 617

The Operating Cycle 617

The Cash Cycle 618

Interpreting the Cash Cycle 619

18.3 Some Aspects of Short-Term Financial Policy 620

The Size of the Firm’s Investment in Current

Assets 620

Alternative Financing Policies for Current Assets 621

An Ideal Case 623

Different Policies for Financing Current Assets 623

Which Financing Policy Is Best? 625

Current Assets and Liabilities in Practice 626

18.4 The Cash Budget 627

Sales and Cash Collections 627

Cash Outflows 628

The Cash Balance 628

18.5 Short-Term Borrowing 630

Unsecured Loans 630

Compensating Balances 630

Cost of a Compensating Balance 630

Letters of Credit 631

Secured Loans 631

Accounts Receivable Financing 631

Inventory Loans 632

Other Sources 633

18.6 A Short-Term Financial Plan 633

18.7 Summary and Conclusions 634

CHAPTER 19

CASH AND LIQUIDITY MANAGEMENT 646

19.1 Reasons for Holding Cash 647

The Speculative and Precautionary Motives 647

The Transaction Motive 647

Compensating Balances 647

Costs of Holding Cash 647

Cash Management versus Liquidity Management 648

19.2 Understanding Float 648

Disbursement Float 648

Collection Float and Net Float 649

Float Management 650

Measuring Float 650

Some Details 651

Cost of the Float 652

Ethical and Legal Questions 653

Electronic Data Interchange and Check 21: The End of

Float? 654

19.3 Cash Collection and Concentration 655

Components of Collection Time 655

Cash Collection 655

Lockboxes 655

Cash Concentration 657

Accelerating Collections: An Example 658

19.4 Managing Cash Disbursements 659

Increasing Disbursement Float 660

Controlling Disbursements 660

Zero-Balance Accounts 660

Controlled Disbursement Accounts 661

19.5 Investing Idle Cash 661

Temporary Cash Surpluses 661

Seasonal or Cyclical Activities 661

Planned or Possible Expenditures 661

Characteristics of Short-Term Securities 662

Maturity 662

Default Risk 662

Marketability 662

Taxes 663

Some Different Types of Money Market Securities 663

19.6 Summary and Conclusions 664

CHAPTER 20

CREDIT AND INVENTORY MANAGEMENT 679

20.1 Credit and Receivables 679

Components of Credit Policy 680

The Cash Flows from Granting Credit 680

The Investment in Receivables 681

20.2 Terms of the Sale 681

The Basic Form 681

The Credit Period 682

The Invoice Date 682

Length of the Credit Period 682

Cash Discounts 683

Cost of the Credit 684

Trade Discounts 684

The Cash Discount and the ACP 684

Credit Instruments 685

20.3 Analyzing Credit Policy 685

Credit Policy Effects 685

Evaluating a Proposed Credit Policy 686

NPV of Switching Policies 686

A Break-Even Application 688

20.4 Optimal Credit Policy 688

The Total Credit Cost Curve 688

Organizing the Credit Function 689

20.5 Credit Analysis 690

When Should Credit Be Granted? 690

A One-Time Sale 690

Repeat Business 691

Credit Information 692

Credit Evaluation and Scoring 692

20.6 Collection Policy 693

Monitoring Receivables 693

Collection Effort 694

20.7 Inventory Management 694

The Financial Manager and Inventory Policy 694

Inventory Types 695

Inventory Costs 695

20.8 Inventory Management Techniques 696

The ABC Approach 696

The Economic Order Quantity Model 696

Inventory Depletion 698

The Carrying Costs 698

The Restocking Costs 698

The Total Costs 699

Extensions to the EOQ Model 701

Safety Stocks 701

Reorder Points 701

Managing Derived-Demand Inventories 701

Materials Requirements Planning 701

Just-in-Time Inventory 703

20.9 Summary and Conclusions 703

Part 8 Topics in Corporate Finance

CHAPTER 21

INTERNATIONAL CORPORATE FINANCE 717

21.1 Terminology 718

21.2 Foreign Exchange Markets and Exchange Rates 719

Exchange Rates 720

Exchange Rate Quotations 720

Cross-Rates and Triangle Arbitrage 720

Types of Transactions 723

21.3 Purchasing Power Parity 724

Absolute Purchasing Power Parity 724

Relative Purchasing Power Parity 726

The Basic Idea 726

The Result 726

Currency Appreciation and Depreciation 727

21.4 Interest Rate Parity, Unbiased Forward Rates, and the

International Fisher Effect 728

Covered Interest Arbitrage 728

Interest Rate Parity 729

Forward Rates and Future Spot Rates 730

Putting It All Together 730

Uncovered Interest Parity 731

The International Fisher Effect 731

21.5 International Capital Budgeting 732

Method 1: The Home Currency Approach 732

Method 2: The Foreign Currency Approach 733

Unremitted Cash Flows 734

21.6 Exchange Rate Risk 734

Short-Run Exposure 734

Long-Run Exposure 735

Translation Exposure 736

Managing Exchange Rate Risk 737

21.7 Political Risk 737

The Tax Cuts and Jobs Act of 2017 737

Managing Political Risk 738

21.8 Summary and Conclusions 739

CHAPTER 22

BEHAVIORAL FINANCE: IMPLICATIONS FOR

FINANCIAL MANAGEMENT 746

22.1 Introduction to Behavioral Finance 747

22.2 Biases 747

Overconfidence 747

Overoptimism 748

Confirmation Bias 748

22.3 Framing Effects 749

Loss Aversion 749

House Money 750

22.4 Heuristics 752

The Affect Heuristic 752

The Representativeness Heuristic 753

Representativeness and Randomness 753

The Gambler’s Fallacy 754

22.5 Behavioral Finance and Market Efficiency 755

Limits to Arbitrage 756

The 3Com/Palm Mispricing 756

The Royal Dutch/Shell Price Ratio 757

Bubbles and Crashes 758

The Crash of 1929 758

The Crash of October 1987 759

The Nikkei Crash 761

The “Dot-Com” Bubble and Crash 761

22.6 Market Efficiency and the Performance of Professional

Money Managers 763

22.7 Summary and Conclusions 766

CHAPTER 23

ENTERPRISE RISK MANAGEMENT 769

23.1 Insurance 770

23.2 Managing Financial Risk 772

The Risk Profile 772

Reducing Risk Exposure 772

Hedging Short-Run Exposure 774

Cash Flow Hedging: A Cautionary Note 774

Hedging Long-Term Exposure 775

Conclusion 775

23.3 Hedging with Forward Contracts 776

Forward Contracts: The Basics 776

The Payoff Profile 776

Hedging with Forwards 777

A Caveat 777

Credit Risk 778

Forward Contracts in Practice 778

23.4 Hedging with Futures Contracts 778

Trading in Futures 779

Futures Exchanges 779

Hedging with Futures 779

23.5 Hedging with Swap Contracts 782

Currency Swaps 782

Interest Rate Swaps 783

Commodity Swaps 783

The Swap Dealer 783

Interest Rate Swaps: An Example 784

23.6 Hedging with Option Contracts 785

Option Terminology 785

Options versus Forwards 785

Option Payoff Profiles 785

Option Hedging 786

Hedging Commodity Price Risk with Options 787

Hedging Exchange Rate Risk with Options 788

Hedging Interest Rate Risk with Options 788

A Preliminary Note 788

Interest Rate Caps 789

Other Interest Rate Options 789

Actual Use of Derivatives 789

23.7 Summary and Conclusions 791

CHAPTER 24

OPTIONS AND CORPORATE FINANCE 796

24.1 Options: The Basics 797

Puts and Calls 797

Stock Option Quotations 798

Option Payoffs 799

24.2 Fundamentals of Option Valuation 802

Value of a Call Option at Expiration 802

The Upper and Lower Bounds on a Call Option’s

Value 803

The Upper Bound 803

The Lower Bound 803

A Simple Model: Part I 805

The Basic Approach 805

A More Complicated Case 805

Four Factors Determining Option Values 806

24.3 Valuing a Call Option 807

A Simple Model: Part II 807

The Fifth Factor 808

A Closer Look 809

24.4 Employee Stock Options 810

ESO Features 811

ESO Repricing 811

ESO Backdating 812

24.5 Equity as a Call Option on the Firm’s Assets 813

Case I: The Debt Is Risk-Free 813

Case II: The Debt Is Risky 814

24.6 Options and Capital Budgeting 815

The Investment Timing Decision 816

Managerial Options 817

Contingency Planning 818

Options in Capital Budgeting: An Example 819

Strategic Options 820

Conclusion 820

24.7 Options and Corporate Securities 820

Warrants 821

The Difference between Warrants and Call

Options 821

Earnings Dilution 821

Convertible Bonds 822

Features of a Convertible Bond 822

Value of a Convertible Bond 822

Other Options 824

The Call Provision on a Bond 824

Put Bonds 824

Insurance and Loan Guarantees 825

24.8 Summary and Conclusions 826

CHAPTER 25

OPTION VALUATION 835

25.1 Put-Call Parity 836

Protective Puts 836

An Alternative Strategy 836

The Result 837

Continuous Compounding: A Refresher Course 838

25.2 The Black-Scholes Option Pricing Model 841

The Call Option Pricing Formula 841

Put Option Valuation 844

A Cautionary Note 845

25.3 More about Black-Scholes 846

Varying the Stock Price 846

Varying the Time to Expiration 849

Varying the Standard Deviation 851

Varying the Risk-Free Rate 851

Implied Standard Deviations 851

25.4 Valuation of Equity and Debt in a Leveraged Firm 854

Valuing the Equity in a Leveraged Firm 855

Options and the Valuation of Risky Bonds 856

25.5 Options and Corporate Decisions: Some

Applications 857

Mergers and Diversification 857

Options and Capital Budgeting 859

25.6 Summary and Conclusions 861

CHAPTER 26

MERGERS AND ACQUISITIONS 869

26.1 The Legal Forms of Acquisitions 870

Merger or Consolidation 870

Acquisition of Stock 871

Acquisition of Assets 871

Acquisition Classifications 872

A Note about Takeovers 872

Alternatives to Merger 873

26.2 Taxes and Acquisitions 873

Determinants of Tax Status 873

Taxable versus Tax-Free Acquisitions 874

26.3 Accounting for Acquisitions 874

The Purchase Method 874

More about Goodwill 875

26.4 Gains from Acquisitions 876

Synergy 876

Revenue Enhancement 877

Marketing Gains 877

Strategic Benefits 877

Increases in Market Power 878

Cost Reductions 878

Economies of Scale 878

Economies of Vertical Integration 878

Complementary Resources 879

Lower Taxes 879

Net Operating Losses 879

Unused Debt Capacity 879

Surplus Funds 879

Asset Write-Ups 880

Reductions in Capital Needs 880

Avoiding Mistakes 880

A Note about Inefficient Management 881

26.5 Some Financial Side Effects of Acquisitions 881

EPS Growth 881

Diversification 882

26.6 The Cost of an Acquisition 883

Case I: Cash Acquisition 884

Case II: Stock Acquisition 884

Cash versus Common Stock 885

26.7 Defensive Tactics 886

The Corporate Charter 886

Repurchase and Standstill Agreements 886

Poison Pills and Share Rights Plans 886

Going Private and Leveraged Buyouts 888

Other Devices and Jargon of Corporate Takeovers 888

26.8 Some Evidence on Acquisitions: Does M&A Pay? 889

26.9 Divestitures and Restructurings 890

26.10 Summary and Conclusions 891

CHAPTER 27

LEASING 900

27.1 Leases and Lease Types 901

Leasing versus Buying 901

Operating Leases 902

Financial Leases 902

Tax-Oriented Leases 902

Leveraged Leases 903

Sale and Leaseback Agreements 903

27.2 Accounting and Leasing 903

27.3 Taxes, the IRS, and Leases 905

27.4 The Cash Flows from Leasing 905

The Incremental Cash Flows 906

A Note about Taxes 906

27.5 Lease or Buy? 907

A Preliminary Analysis 907

Three Potential Pitfalls 908

NPV Analysis 908

A Misconception 910

27.6 A Leasing Paradox 910

27.7 Reasons for Leasing 911

Good Reasons for Leasing 912

Tax Advantages 912

A Reduction of Uncertainty 913

Lower Transactions Costs 913

Fewer Restrictions and Security Requirements 913

Dubious Reasons for Leasing 913

100 Percent Financing 913

Low Cost 914

Other Reasons for Leasing 914

27.8 Summary and Conclusions 914

Appendix A

Mathematical Tables A-1

Appendix B

Key Equations B-1

Appendix C

Answers To Selected End-Of-Chapter

Problems C-1

Appendix D

Using The Hp 10b And Ti Ba Ii

Plus Financial Calculators D-1

Index I-1