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Part Ⅰ Overview1

Chapter 1 Introduction to Corporate Finance2

Executive Summary2

1.1 What Is Corporate Finance?3

The Balance-Sheet Model of the Firm3

Capital Structure4

The Financial Manager5

1.2 Corporate Securities as Contingent Claims on Total Firm Value9

1.3 The Corporate Firm10

The Sole Proprietorship10

The Partnership10

The Corporation11

Case Study: Making the Decision to Become a Corporation: The Case of PLM International, Inc.12

1.4 Goals of the Corporate Firm14

Agency Costs and the Set-of-Contracts Perspective14

Managerial Goals15

Separation of Ownership and Control15

Do Shareholders Control Managerial Behavior?16

1.5 Financial Markets17

The Primary Market: New Issues17

Secondary Markets18

Exchange Trading of Listed Stocks18

Listing18

1.6 Outline of the Text19

Chapter 2 Accounting Statements and Cash Flow21

Executive Summary21

2.1 The Balance Sheet21

Accounting Liquidity22

Debt versus Equity23

Value versus Cost23

2.2 The Income Statement24

Generally Accepted Accounting Principles25

Noncash Items25

Time and Costs25

2.3 Net Working Capital26

2.4 Financial Cash Flow26

2.5 The Accounting Statement of Cash Flows29

Cash Flow from Operating Activities29

Cash Flow from Investing Activities30

Cash Flow from Financing Activities30

2.6 Summary and Conclusions31

Appendix 2A Financial Statement Analysis34

Appendix 2B U.S. Federal Tax Rates42

Chapter 3 Financial Planning and Growth44

Executive Summary44

3.1 What Is Financial Planning?44

3.2 A Financial-Planning Model: The Ingredients45

3.3 The Percentage Sales Method47

The Income Statement48

The Balance Sheet49

3.4 What Determines Growth?51

3.5 Some Caveats of Financial-Planning Models54

3.6 Summary and Conclusions55

Part Ⅱ Value and Capital Budgeting59

Chapter 4 Net Present Value60

Executive Summary60

4.1 The One-Period Case60

4.2 The Multiperiod Case63

Future Value and Compounding63

The Power of Compounding: A Digression67

Present Value and Discounting68

The Algebraic Formula71

4.3 Compounding Periods72

Distinction between Stated Annual Interest Rate and Effective Annual Interest Rate73

Compounding over Many Years73

Continuous Compounding (Advanced)74

4.4 Simplifications75

Perpetuity75

Growing Perpetuity77

Annuity79

Growing Annuity83

Case Study: Making the Decision to Convert Lottery Prize Winnings: The Case of the Singer Asset Finance Company85

4.5 What Is a Firm Worth?86

4.6 Summary and Conclusions87

Appendix 4A Net Present Value: First Principles of Finance94

Chapter 5 How to Value Bonds and Stocks106

Executive Summary106

5.1 Definition and Example of a Bond106

5.2 How to Value Bonds106

Pure Discount Bonds106

Level-Coupon Bonds107

Consols109

5.3 Bond Concepts110

Interest Rates and Bond Prices110

Yield to Maturity110

Bond Market Reporting111

5.4 The Present Value of Common Stocks112

Dividends versus Capital Gains112

Valuation of Different Types of Stocks113

5.5 Estimates of Parameters in the Dividend-Discount Model116

Where Does g Come From?116

Where Does r Come From?118

A Healthy Sense of Skepticism118

5.6 Growth Opportunities119

Growth in Earnings and Dividends versus Growth Opportunities121

Dividends or Earnings: Which to Discount?122

The No-Dividend Firm122

5.7 The Dividend-Growth Model and the NPVGO Model (Advanced)123

The Dividend-Growth Model123

The NPVGO Model123

Summation125

5.8 Price-Earnings Ratio125

5.9 Stock Market Reporting127

5.10 Summary and Conclusions128

Appendix 5A The Term Structure of Interest Rates,Spot Rates, and Yield to Maturity134

Chapter 6 Some Alternative Investment Rules144

Executive Summary144

6.1 Why Use Net Present Value?144

6.2 The Payback Period Method146

Defining the Rule146

Problems with the Payback Method147

Managerial Perspective148

Summary of Payback148

6.3 The Discounted Payback Period Method149

6.4 The Average Accounting Return Method149

Defining the Rule149

Analyzing the Average Accounting Return Method151

6.5 The Internal Rate of Return152

6.6 Problems with the IRR Approach154

Definition of Independent and Mutually Exclusive Projects154

Two General Problems Affecting Both Independent and Mutually Exclusive Projects 154 Problems Specific to Mutually Exclusive Projects159

Redeeming Qualities of IRR163

A Test163

6.7 The Profitability Index164

Calculation of Profitability Index164

6.8 The Practice of Capital Budgeting166

6.9 Summary and Conclusions168

Chapter 7 Net Present Value and Capital Executive Summary178

7.1 Incremental Cash Flows178

Cash Flows--Not Accounting Income178

Sunk Costs179

Opportunity Costs179

Side Effects179

Allocated Costs180

7.2 The Baldwin Company: An Example180

An Analysis of the Project182

Which Set of Books?184

A Note on Net Working Capital185

Interest Expense186

7.3 The Boeing 777: A Real-World Example186

7.4 Inflation and Capital Budgeting189

Interest Rates and Inflation189

Cash Flow and Inflation191

Discounting: Nominal or Real?191

7.5 Investments of Unequal Lives: The Equivalent Annual Cost Method193

The General Decision to Replace (Advanced)195

7.6 Summary and Conclusions197

Minicases: Goodweek Tires,Inc.206

I. Q., Inc.207

Jimmy's Hot Dog Stands208

Appendix 7A Depreciation209

Chapter 8 Risk Analysis, Real Options, and Capital Budgeting211

Executive Summary211

8.1 Decision Trees211

8.2 Sensitivity Analysis, Scenario Analysis,and Break-Even Analysis213

Sensitivity Analysis and Scenario Analysis214

Break-Even Analysis216

8.3 Monte Carlo Simulation219

8.4 Real Options223

The Option to Expand223

The Option to Abandon224

Timing Options226

8.5 Summary and Conclusions227

Part Ⅲ Risk233

Chapter 9 Capital Market Theory: An Overview234

Executive Summary234

9.1 Returns235

Dollar Returns235

Percentage Returns237

9.2 Holding-Period Returns239

9.3 Return Statistics244

9.4 Average Stock Returns and Risk-Free Returns246

9.5 Risk Statistics247

Variance247

Normal Distribution and Its Implications for Standard Deviation248

9.6 Summary and Conclusions249

Appendix 9A The Historical Market Risk Premium: The Very Long Run253

Chapter 10 Return and Risk: The Capital-Asset-Pricing Model (CAPM)255

Executive Summary255

10.1 Individual Securities255

10.2 Expected Return, Variance, and Covariance256

Expected Return and Variance256

Covariance and Correlation258

10.3 The Return and Risk for Portfolios261

The Example of Supertech and Slowpoke261

The Expected Return on a Portfolio261

Variance and Standard Deviation of a Portfolio262

10.4 The Efficient Set for Two Assets265

10.5 The Efficient Set for Many Securities270

Variance and Standard Deviation in a Portfolio of Many Assets271

10.6 Diversification: An Example272

Risk and the Sensible Investor275

10.7 Riskless Borrowing and Lending276

The Optimal Portfolio278

10.8 Market Equilibrium280

Definition of the Market-Equilibrium Portfolio280

Definition of Risk When Investors Hold the Market Portfolio281

The Formula for Beta283

A Test283

10.9 Relationship between Risk and Expected Return (CAPM)284

Expected Return on Market284

Expected Return on Individual Security284

10.10 Summary and Conclusions287

Appendix 10A Is Beta Dead?295

Chapter 11 An Alternative View of Risk and Return:The Arbitrage Pricing Theory297

Executive Summary297

11.1 Factor Models: Announcements, Surprises, and Expected Returns298

11.2 Risk: Systematic and Unsystematic299

11.3 Systematic Risk and Betas300

11.4 Portfolios and Factor Models303

Portfolios and Diversification305

11.5 Betas and Expected Returns307

The Linear Relationship307

The Market Portfolio and the Single Factor309

11.6 The Capital-Asset-Pricing Model and the Arbitrage Pricing Theory310

Differences in Pedagogy310

Differences in Application310

11.7 Empirical Approaches to Asset Pricing311

Empirical Models311

Style Portfolios313

11.8 Summary and Conclusions313

Chapter 12 Risk, Cost of Capital, and Capital Budgeting318

Executive Summary318

12.1 The Cost of Equity Capital318

12.2 Estimation of Beta321

Real-World Betas323

Stability of Beta323

Using an Industry Beta324

12.3 Determinants of Beta326

Cyclically of Revenues326

Operating Leverage327

Financial Leverage and Beta328

12.4 Extensions of the Basic Model330

The Firm versus the Project: Vive la Difference330

The Cost of Capital with Debt331

12.5 Estimating International Paper's Cost of Capital333

Cost of Equity and Debt333

Determining rWACC334

12.6 Reducing the Cost of Capital334

What Is Liquidity?335

Liquidity, Expected Returns, and the Cost of Capital335

Liquidity and Adverse Selection336

What the Corporation Can Do336

12.7 Summary and Conclusions338

Minicase: AlliedProducts341

Appendix 12A Economic Value Added and the Measurement of Financial Performance343

Part Ⅳ Capital Structure and Dividend Policy347

Chapter 13 Corporate-Financing Decisions and Efficient Capital Markets349

Executive Summary349

13.1 Can Financing Decisions Create Value?349

13.2 A Description of Efficient Capital Markets351

Foundations of Market Efficiency352

13.3 The Different Types of Efficiency354

The Weak Form355

The Semistrong and Strong Forms356

Some Common Misconceptions about the Efficient-Market Hypothesis357

13.4 The Evidence358

The Weak Form358

The Semistrong Form360

The Strong Form363

13.5 The Behavioral Challenge to Market Efficiency364

13.6 Empirical Challenges to Market Efficiency366

13.7 Reviewing the Differences370

Representativeness371

Conservatism371

13.8 Implications for Corporate Finance371

1. Accounting Choices, Financial Choices,and Market Efficiency372

2. The Timing Decision373

3. Speculation and Efficient Markets375

4. Information in Market Prices377

13.9 Summary and Conclusions378

Chapter 14 Long-Term Financing:An Introduction384

Executive Summary384

14.1 Common Stock384

Par and No-Par Stock384

Authorized versus Issued Common Stock385

Capital Surplus385

Retained Earnings385

Market Value, Book Value, and Replacement Value386

Shareholders' Rights387

Dividends388

Classes of Stock388

14.2 Corporate Long-Term Debt: The Basics389

Interest versus Dividends389

Is It Debt or Equity?390

Basic Features of Long-Term Debt390

Different Types of Debt390

Repayment391

Seniority391

Security391

Indenture391

14.3 Preferred Stock392

Stated Value392

Cumulative and Noncumulative Dividends392

Is Preferred Stock Really Debt?393

The Preferred-Stock Puzzle393

14.4 Patterns of Financing394

14.5 Recent Trends in Capital Structure398

Which Are Best: Book or Market Values?398

14.6 Summary and Conclusions399

Chapter 15 Capital Structure: Basic Concepts402

Executive Summary402

15.1 The Capital-Structure Question and the Pie Theory402

15.2 Maximizing Firm Value versus Maximizing Stockholder Interests403

15.3 Financial Leverage and Firm Value: An Example405

Leverage and Returns to Shareholders405

The Choice between Debt and Equity407

A Key Assumption409

15.4 Modigliani and Miller: Proposition II (No Taxes)409

Risk to Equityholders Rises with Leverage409

Proposition II: Required Return to Equityholders Rises with Leverage410

Example Illustrating Proposition I and Proposition II412

MM: An Interpretation416

15.5 Taxes419

The Basic Insight419

The Quirk in the Tax Code419

Present Value of the Tax Shield420

Value of the Levered Firm421

Expected Return and Leverage under Corporate Taxes422

The Weighted Average Cost of Capital rWACC and Corporate Taxes424

Stock Price and Leverage under Corporate Taxes424

15.6 Summary and Conclusions426

Chapter 16 Capital Structure: Limits to the Use of Debt433

Executive Summary433

16.1 Costs of Financial Distress433

Bankruptcy Risk or Bankruptcy Cost?433

16.2 Description of Financial Distress Costs436

Direct Costs of Financial Distress: Legal and Administrative Costs of Liquidation or Reorganization436

Indirect Costs of Financial Distress437

Agency Costs438

16.3 Can Costs of Debt Be Reduced?441

Protective Covenants441

Consolidation of Debt442

16.4 Integration of Tax Effects and Financial Distress Costs442

Pie Again444

16.5 Signaling445

16.6 Shirking, Perquisites, and Bad Investments: A Note on Agency Cost of Equity447

Effect of Agency Costs of Equity on Debt-Equity Financing449

Free Cash Flow449

16.7 The Pecking-Order Theory450

Rules of the Pecking Order452

Implications452

16.8 Growth and the Debt-Equity Ratio453

No-Growth454

Growth454

16.9 Personal Taxes456

The Miller Model458

16.10 How Firms Establish Capital Structure461

16.11 Summary and Conclusions464

Appendix 16A Some Useful Formulas of Financial Structure472

Appendix 16B The Miller Model and the Graduated Income Tax473

Chapter 17 Valuation and Capital Budgeting for the Levered Firm477

Executive Summary477

17.1 Adjusted-Present-Value Approach477

17.2 Flow-to-Equity Approach479

Step 1: Calculating Levered Cash Flow (LCF)479

Step 2: Calculating rs480

Step 3: Valuation480

17.3 Weighted-Average-Cost-of-Capital Method480

17.4 A Comparison of the APV, FTE, and WACC Approaches481

A Suggested Guideline482

17.5 Capital Budgeting When the Discount Rate Must Be Estimated485

17.6 APV Example486

17.7 Beta and Leverage490

The Project Is Not Scale-Enhancing491

17.8 Summary and Conclusions492

Appendix 17A The Adjusted-Present-Value Approach to Valuing Leveraged Buyouts497

Chapter 18 Dividends and Other Payouts502

Executive Summary502

18.1 Different Types of Dividends502

18.2 Standard Method of Cash Dividend Payment503

18.3 The Benchmark Case: An Illustration of the Irrelevance of Dividend Policy504

Current Policy: Dividends Set Equal to Cash Flow505

Alternative Policy: Initial Dividend Is Greater than Cash Flow505

The Indifference Proposition506

Homemade Dividends507

A Test508

Dividends and Investment Policy509

18.4 Repurchase of Stock509

Dividend versus Repurchase: Conceptual Example511

Dividends versus Repurchases: Real-World Considerations512

18.5 Personal Taxes, Issuance Costs,and Dividends513

Firms without Sufficient Cash to Pay a Dividend513

Firms with Sufficient Cash to Pay a Dividend514

Summary on Personal Taxes516

18.6 Real-World Factors Favoring a High-Dividend Policy517

Desire for Current Income517

Behavioral Finance517

Agency Costs519

Information Content of Dividends and Dividend Signaling519

18.7 The Clientele Effect: A Resolution of Real-World Factors?522

18.8 What We Know and Do Not Know about Dividend Policy523

Corporate Dividends Are Substantial523

Fewer Companies Pay Dividends525

Corporations Smooth Dividends526

Payouts Provide Information to the Market527

A Sensible Payout Policy527

Case Study: How Firms Make the Decision to Pay Dividends: The Case of Apple Computer528

18.9 Summary and Conclusions531

Appendix 18A Stock Dividends and Stock Splits535

Part Ⅴ Long-Term Financing539

Chapter 19 Issuing Securities to the Public540

Executive Summary540

19.1 The Public Issue540

The Basic Procedure for a New Issue540

19.2 Alternative Issue Methods541

19.3 The Cash Offer543

Investment Banks545

The Offering Price547

Underpricing: A Possible Explanation548

19.4 The Announcement of New Equity and the Value of the Firm550

19.5 The Cost of New Issues551

19.6 Rights553

The Mechanics of a Rights Offering554

Subscription Price554

Number of Rights Needed to Purchase a Share555

Effect of Rights Offering on Price of Stock555

Effects on Shareholders557

The Underwriting Arrangements557

19.7 The Rights Puzzle557

19.8 Shelf Registration559

19.9 The Private Equity Market560

Private Placement560

The Private Equity Firm561

Suppliers of Venture Capital561

Stages of Financing563

Case Study: The Decision to Do an Initial Public Offering (IPO): The Case of Medstone International, Inc.564

19.10 Summary and Conclusions566

Chapter 20 Long-Term Debt569

Executive Summary569

20.1 Long-Term Debt: A Review569

20.2 The Public Issue of Bonds570

The Basic Terms571

Security572

Protective Covenants573

The Sinking Fund573

The Call Provision574