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Fundamentals of CORPORATE FINANCE
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The McGraw-Hill Education Series in Finance, Insurance, and Real Estate
Financial Management Block, Hirt, and Danielsen Foundations of Financial Management Sixteenth Edition Brealey, Myers, and Allen Principles of Corporate Finance Twelfth Edition Brealey, Myers, and Allen Principles of Corporate Finance, Concise Second Edition Brealey, Myers, and Marcus Fundamentals of Corporate Finance Ninth Edition Brooks FinGame Online 5.0 Bruner, Eades, and Schill Case Studies in Finance: Managing for Corporate Value Creation Eighth Edition Cornett, Adair, and Nofsinger Finance: Applications and Theory Fourth Edition Cornett, Adair, and Nofsinger M: Finance Fourth Edition DeMello Cases in Finance Third Edition Grinblatt (editor) Stephen A. Ross, Mentor: Influence through Generations Grinblatt and Titman Financial Markets and Corporate Strategy Second Edition Higgins Analysis for Financial Management Twelfth Edition Ross, Westerfield, Jaffe, and Jordan Corporate Finance Eleventh Edition Ross, Westerfield, Jaffe, and Jordan Corporate Finance: Core Principles and Applications Fifth Edition
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Ross, Westerfield, and Jordan Essentials of Corporate Finance Ninth Edition Ross, Westerfield, and Jordan Fundamentals of Corporate Finance Twelfth Edition Shefrin Behavioral Corporate Finance: Decisions that Create Value Second Edition
Investments Bodie, Kane, and Marcus Essentials of Investments Tenth Edition Bodie, Kane, and Marcus Investments Eleventh Edition Hirt and Block Fundamentals of Investment Management Tenth Edition Jordan, Miller, and Dolvin Fundamentals of Investments: Valuation and Management Eighth Edition Stewart, Piros, and Heisler Running Money: Professional Portfolio Management First Edition Sundaram and Das Derivatives: Principles and Practice Second Edition
Financial Institutions and Markets Rose and Hudgins Bank Management and Financial Services Ninth Edition Rose and Marquis Financial Institutions and Markets Eleventh Edition Saunders and Cornett Financial Institutions Management: A Risk Management Approach Ninth Edition Saunders and Cornett Financial Markets and Institutions Seventh Edition
International Finance Eun and Resnick International Financial Management Eighth Edition
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Real Estate Brueggeman and Fisher Real Estate Finance and Investments Sixteenth Edition Ling and Archer Real Estate Principles: A Value Approach Fifth Edition
Financial Planning and Insurance Allen, Melone, Rosenbloom, and Mahoney Retirement Plans: 401(k)s, IRAs, and Other Deferred Compensation Approaches Twelfth Edition Altfest Personal Financial Planning Second Edition Harrington and Niehaus Risk Management and Insurance Second Edition Kapoor, Dlabay, Hughes, and Hart Focus on Personal Finance: An Active Approach to Help You Achieve Financial Literacy Sixth Edition Kapoor, Dlabay, Hughes, and Hart Personal Finance Twelfth Edition Walker and Walker Personal Finance: Building Your Future Second Edition
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Fundamentals of CORPORATE FINANCE
Twelfth Edition
Stephen A. Ross
Randolph W. Westerfield University of Southern California, Emeritus
Bradford D. Jordan University of Kentucky
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FUNDAMENTALS OF CORPORATE FINANCE, TWELFTH EDITION
Published by McGraw-Hill Education, 2 Penn Plaza, New York, NY 10121. Copyright © 2019 by McGraw-Hill Education. All rights reserved. Printed in the United States of America. Previous editions © 2016, 2013, and 2010. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of McGraw-Hill Education, including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning.
Some ancillaries, including electronic and print components, may not be available to customers outside the United States.
This book is printed on acid-free paper.
1 2 3 4 5 6 7 8 9 LWI 21 20 19 18
ISBN 978-1-259-91895-7
MHID 1-259-91895-5
Director, Finance: Chuck Synovec Product Developers: Michele Janicek, Jennifer Upton Senior Marketing Manager: Trina Maurer Content Project Managers: Daryl Horrocks, Jill Eccher, Karen Jocefowicz Buyer: Susan K. Culbertson Design: Matt Diamond Content Licensing Specialist: Beth Thole Cover Image: ©Jose A. Bernat Bacete/Getty Images Compositor: MPS Limited
All credits appearing on page or at the end of the book are considered to be an extension of the copyright page.
Library of Congress Cataloging-in-Publication Data
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Ross, Stephen A., author. | Westerfield, Randolph W., author. | Jordan, Bradford D., author.
Fundamentals of corporate finance/Stephen A. Ross, Massachusetts Institute of Technology,
Randolph W. Westerfield, University of Southern California, Emeritus, Bradford D. Jordan,
University of Kentucky. Twelfth edition. | New York, NY : McGraw-Hill Education, [2019] | Series: The McGraw-Hill Education series in finance, insurance, and
real estate LCCN 2017031339 | ISBN 9781259918957 (alk. paper) LCSH: Corporations—Finance. LCC HG4026 .R677 2019 | DDC 658.15—dc23 LC record available at https://lccn.loc.gov/2017031339
The Internet addresses listed in the text were accurate at the time of publication. The inclusion of a website does not indicate an endorsement by the authors or McGraw-Hill Education, and McGraw-Hill Education does not guarantee the accuracy of the information presented at these sites.
mheducation.com/highered
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http://mheducation.com/highered
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To Stephen A. Ross and family
Our great friend, colleague, and coauthor Steve Ross passed away on March 3, 2017, while we were working on this edition of Fundamentals of Corporate Finance. Steve’s influence on our textbook is seminal, deep, and enduring, and we will miss him greatly. We are confident that on the foundation of Steve’s lasting and invaluable contributions, our textbook will continue to reach the highest level of excellence that we all aspire to.
R.W.W. B.D.J.
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About the Authors
STEPHEN A. ROSS
Stephen A. Ross was the Franco Modigliani Professor of Finance and Economics at the Sloan School of Management, Massachusetts Institute of Technology. One of the most widely published authors in finance and economics, Professor Ross was widely recognized for his work in developing the Arbitrage Pricing Theory and his substantial contributions to the discipline through his research in signaling, agency theory, option pricing, and the theory of the term structure of interest rates, among other topics. A past president of the American Finance Association, he also served as an associate editor of several academic and practitioner journals. He was a trustee of CalTech. He died suddenly in March of 2017.
RANDOLPH W. WESTERFIELD
Marshall School of Business, University of Southern California
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Randolph W. Westerfield is Dean Emeritus and the Charles B. Thornton Professor in Finance Emeritus of the University of Southern California’s Marshall School of Business. Professor Westerfield came to USC from the Wharton School, University of Pennsylvania, where he was the chairman of the finance department and a member of the finance faculty for 20 years. He is a member of the board of trustees of Oaktree Capital mutual funds. His areas of expertise include corporate financial policy, investment management, and stock market price behavior.
BRADFORD D. JORDAN
Gatton College of Business and Economics, University of Kentucky
Bradford D. Jordan is Professor of Finance and holder of the duPont Endowed Chair in Banking and Financial Services at the University of Kentucky. He has a long-standing interest in both applied and theoretical issues in corporate finance and has extensive experience teaching all levels of corporate finance and financial management policy. Professor Jordan has published numerous articles on issues such as cost of capital, capital structure, and the behavior of security prices. He is a past president of the Southern Finance Association, and he is coauthor of Fundamentals of Investments: Valuation and Management, 8e, a leading investments text, also published by McGraw-Hill.
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Preface from the Authors
When the three of us decided to write a book, we were united by one strongly held principle: Corporate finance should be developed in terms of a few integrated, powerful ideas. We believed that the subject was all too often presented as a collection of loosely related topics, unified primarily by virtue of being bound together in one book, and we thought there must be a better way.
One thing we knew for certain was that we didn’t want to write a “me- too” book. So, with a lot of help, we took a hard look at what was truly important and useful. In doing so, we were led to eliminate topics of dubious relevance, downplay purely theoretical issues, and minimize the use of extensive and elaborate calculations to illustrate points that are either intuitively obvious or of limited practical use.
As a result of this process, three basic themes became our central focus in writing Fundamentals of Corporate Finance:
AN EMPHASIS ON INTUITION We always try to separate and explain the principles at work on a commonsense, intuitive level before launching into any specifics. The underlying ideas are discussed first in very general terms and then by way of examples that illustrate in more concrete terms how a financial manager might proceed in a given situation.
A UNIFIED VALUATION APPROACH We treat net present value (NPV) as the basic concept underlying corporate finance. Many texts stop well short of consistently integrating this important principle. The most basic and important notion, that NPV represents the excess of market value over cost, often is lost in an overly mechanical approach that emphasizes computation at the expense of comprehension. In contrast, every subject we cover is firmly rooted in valuation, and care is taken throughout to explain how particular decisions have valuation effects.
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A MANAGERIAL FOCUS Students shouldn’t lose sight of the fact that financial management concerns management. We emphasize the role of the financial manager as decision maker, and we stress the need for managerial input and judgment. We consciously avoid “black box” approaches to finance, and, where appropriate, the approximate, pragmatic nature of financial analysis is made explicit, possible pitfalls are described, and limitations are discussed.
In retrospect, looking back to our 1991 first edition IPO, we had the same hopes and fears as any entrepreneurs. How would we be received in the market? At the time, we had no idea that 26 years later, we would be working on a twelfth edition. We certainly never dreamed that in those years we would work with friends and colleagues from around the world to create country-specific Australian, Canadian, and South African editions, an International edition, Chinese, French, Polish, Portuguese, Thai, Russian, Korean, and Spanish language editions, and an entirely separate book, Essentials of Corporate Finance, now in its ninth edition.
Today, as we prepare to once more enter the market, our goal is to stick with the basic principles that have brought us this far. However, based on the enormous amount of feedback we have received from you and your colleagues, we have made this edition and its package even more flexible than previous editions. We offer flexibility in coverage, as customized editions of this text can be crafted in any combination through McGraw-Hill’s CREATE system, and flexibility in pedagogy, by providing a wide variety viii of features in the book to help students to learn about corporate finance. We also provide flexibility in package options by offering the most extensive collection of teaching, learning, and technology aids of any corporate finance text. Whether you use only the textbook, or the book in conjunction with our other products, we believe you will find a combination with this edition that will meet your current as well as your changing course needs.
Stephen A. Ross Randolph W. Westerfield
Bradford D. Jordan
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THE TAX CUTS AND JOBS ACT (TCJA) IS INCORPORATED THROUGHOUT ROSS FUNDAMENTALS OF CORPORATE FINANCE, 12E.
There are six primary areas of change and will be reflected in the 12th edition:
1. Corporate tax. The new, flat-rate 21 percent corporate rate is discussed and compared to the old progressive system. The new rate is used throughout the text in examples and problems. Entities other than C corporations still face progressive taxation, so the discussion of marginal versus average tax rates remains relevant and is retained.
2. Bonus depreciation. For a limited time, businesses can take a 100 percent depreciation charge the first year for most non-real estate, MACRS-qualified investments. This “bonus depreciation” ends in a few years and MACRS returns, so the MACRS material remains relevant and is retained. The impact of bonus depreciation is illustrated in various problems.
3. Limitations on interest deductions. The amount of interest that may be deducted for tax purposes is limited. Interest that cannot be deducted can be carried forward to future tax years (but not carried back; see next).
4. Carrybacks. Net operating loss (NOL) carrybacks have been eliminated and NOL carryforward deductions are limited in any one tax year.
5. Dividends received tax break. The tax break on dividends received by a corporation has been reduced, meaning that the portion subject to taxation has increased.
6. Repatriation. The distinction between U.S. and non-U.S. profits has been essentially eliminated. All “overseas” assets, both liquid and illiquid, are subject to a one-time “deemed” tax.
With the 12e we’ve also included coverage of:
Clawbacks and deferred compensation Inversions Negative interest rates
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NYSE market operations Direct Listings and Cryptocurrency Initial Coin Offerings (ICOs) Regulation CF Brexit Repatriation Changes in lease accounting
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Coverage
This book was designed and developed explicitly for a first course in business or corporate finance, for both finance majors and non-majors alike. In terms of background or prerequisites, the book is nearly self- contained, assuming some familiarity with basic algebra and accounting concepts, while still reviewing important accounting principles very early on. The organization of this text has been developed to give instructors the flexibility they need.
The following grid presents, for each chapter, some of the most significant features as well as a few selected chapter highlights of the 12th edition of Fundamentals. Of course, in every chapter, opening vignettes, boxed features, in-chapter illustrated examples using real companies, and end-of-chapter material have been thoroughly updated as well.
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In-Text Study Features
To meet the varied needs of its intended audience, Fundamentals of Corporate Finance is rich in valuable learning tools and support.
CHAPTER-OPENING VIGNETTES Vignettes drawn from real-world events introduce students to the chapter concepts.
PEDAGOGICAL USE OF COLOR This learning tool continues to be an important feature of Fundamentals of Corporate Finance. In almost every chapter, color plays an extensive, nonschematic, and largely self-evident
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role. A guide to the functional use of color is on pages xlv-xlvi of this front matter.
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IN THEIR OWN WORDS BOXES This series of boxes features popular articles on key topics in the text written by distinguished scholars and practitioners. Boxes include essays by Merton Miller on capital structure, Fischer Black on dividends, and Roger Ibbotson on capital market history. A complete list of “In Their Own Words” boxes appears on page xliv.
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REAL-WORLD EXAMPLES Actual events are integrated throughout the text, tying chapter
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concepts to real life through illustration and reinforcing the relevance of the material. Some examples tie into the chapter- opening vignette for added reinforcement.
SPREADSHEET STRATEGIES This feature introduces students to Excel and shows them how to set up spreadsheets in order to analyze common financial problems-a vital part of every business student’s education.
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CALCULATOR HINTS Brief calculator tutorials appear in selected chapters to help students learn or brush up on their financial calculator skills. These complement the Spreadsheet Strategies. xviii
CONCEPT BUILDING Chapter sections are intentionally kept short to promote a step- by-step, building block approach to learning. Each section is then followed by a series of short concept questions that highlight the key ideas just presented. Students use these questions to make sure they can identify and understand the most important concepts as they read.
SUMMARY TABLES These tables succinctly restate key principles, results, and equations. They appear whenever it is useful to emphasize and summarize a group of related concepts. For an example, see Chapter 3, page 68.
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LABELED EXAMPLES Separate numbered and titled examples are extensively integrated into the chapters. These examples provide detailed applications and illustrations of the text material in a step-by-step format. Each example is completely self-contained so students don’t have to search for additional information. Based on our classroom testing, these examples are among the most useful learning aids because they provide both detail and explanation.
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KEY TERMS Key Terms are printed in bold type and defined within the text the first time they appear. They also appear in the margins with definitions for easy location and identification by the student.
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HIGHLIGHTED CONCEPTS Throughout the text, important ideas are pulled out and presented in a highlighted box-signaling to students that this material is particularly relevant and critical for their understanding. For
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examples, Chapter 10, page 313; Chapter 13, page 434.
EXCEL MASTER Icons in the margin identify concepts and skills covered in our unique, RWJ-created Excel Master program. For more training in Excel functions for finance, and for more practice, log on to McGraw-Hill’s Connect Finance for Fundamentals of Corporate Finance to access the Excel Master files. This pedagogically superior tool will help get your students the practice they need to succeed—and to exceed expectations. xx
CHAPTER SUMMARY AND CONCLUSIONS Every chapter ends with a concise, but thorough, summary of the important ideas–helping students review the key points and providing closure to the chapter.
CHAPTER REVIEW AND SELF-TEST PROBLEMS Appearing after the Summary and Conclusions, each chapter includes a Chapter Review and Self-Test Problem section. These
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questions and answers allow students to test their abilities in solving key problems related to the chapter content and provide instant reinforcement.
CONCEPTS REVIEW AND CRITICAL THINKING QUESTIONS This successful end-of-chapter section facilitates your students’ knowledge of key principles, as well as their intuitive understanding of the chapter concepts. A number of the questions relate to the chapter-opening vignette–reinforcing student critical thinking skills and the learning of chapter material.
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END-OF-CHAPTER QUESTIONS AND PROBLEMS Students learn better when they have plenty of opportunity to practice; therefore, Fundamentals, 12e, provides extensive end-
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of-chapter questions and problems. The end-of-chapter support greatly exceeds typical introductory textbooks. The questions and problems are separated into three learning levels: Basic, Intermediate, and Challenge. Answers to selected end-of-chapter material appear in Appendix C. Also, most problems are available in McGraw-Hill’s Connect–see page xxiv for details.
END-OF-CHAPTER CASES Located at the end of the book’s chapters, these minicases focus on real-life company situations that embody important corporate finance topics. Each case presents a new scenario, data, and a dilemma. Several questions at the end of each case require students to analyze and focus on all of the material they learned from each chapter.
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WEB EXERCISES (ONLINE ONLY) For instructors interested in integrating even more online resources and problems into their course, these web activities show students how to learn from the vast amount of financial resources available on the internet. In the 12th edition of Fundamentals, these web exercises are available to students and instructors through Connect.
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Comprehensive Teaching and Learning Package
This edition of Fundamentals has several options in terms of the textbook, instructor supplements, student supplements, and multimedia products. Mix and match to create a package that is perfect for your course!
TEXTBOOK Customize your version of Fundamentals 12e through McGraw-Hill’s Create platform. Teach the chapters you want in the order you want— your rep can show you how!
INSTRUCTOR RESOURCES Keep all the supplements in one place! Your Connect Library contains all the necessary supplements—Teaching Resource Manual, Solutions, Test Bank, Computerized Test Bank, and PowerPoint—all in one easy- to-find, easy-to-use, integrated place: Your Connect Finance course.
Teaching Resource Manual (TRM) The TRM is a full-service implementation guide designed to support you in the delivery of your curriculum and assist you in integrating Connect.
Solutions Manual (SM) Prepared by Brad Jordan, University of Kentucky, and Joe Smolira, Belmont University The Fundamentals Solutions Manual provides detailed solutions to the extensive end-of-chapter material, including concept review questions, quantitative problems, and cases.
Test Bank Prepared by Kay Johnson Over 100 questions and problems per chapter! Each chapter includes questions that test the understanding of key terms in the
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book; questions patterned after learning objectives, concept questions, chapter opening vignettes, boxes, and highlighted phrases; multiple-choice problems patterned after end-of-chapter questions at a variety of skill levels; and essay questions to test problem-solving skills and more advanced understanding of concepts.
Computerized Test Bank TestGen is a complete, state-of-the-art test generator and editing application software that allows instructors to quickly and easily select test items from McGraw Hill’s test bank content. The instructors can then organize, edit, and customize questions and answers to rapidly generate tests for paper or online administration. Questions can include stylized text, symbols, graphics, and equations that are inserted directly into questions using built-in mathematical templates. TestGen’s random generator provides the option to display different text or calculated number values each time questions are used. With both quick-and-simple test creation and flexible and robust editing tools, TestGen is a complete test generator system for today’s educators.
Excel Simulations Expanded for this edition! With 180 Excel simulation questions now included in Connect, RWJ is the unparalleled leader in offering students the opportunity to practice using the Excel functions they will use throughout their careers in finance.
Corporate Finance Videos New for this edition, brief and engaging conceptual videos (and accompanying questions) help students to master the building blocks of the Corporate Finance course.
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PowerPoint Presentations The PowerPoint slides for the 12th edition have been revised to include a wealth of instructor material, including lecture tips, real- world examples, and international notes. Each presentation also includes slides dedicated entirely to ethics notes that relate to the chapter topics.
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STUDENT RESOURCES Student resources for this edition can be found through the Library tab in your Connect Finance course. If you aren’t using Connect, visit us at http://connect.mheducation.com to learn more, and ask your professor about using it in your course for access to a great group of supplement resources!
Excel Resources For those seeking additional practice, students can access Excel template problems and Excel Master, designed by Brad Jordan and Joe Smolira.
Narrated Lecture Videos Updated for this edition, the Narrated Lecture videos provide real- world examples accompanied by step-by-step instructions and explanations for solving problems presented in the chapter. The Concept Checks from the text are also integrated into the slides to reinforce the key topics in the chapter. Designed specifically to appeal to the different learning methods of students, the slides provide a visual and audio explanation of topics and problems.
TEACHING SUPPORT Along with having access to all of the student resource materials through the Connect Library tab, you also have password-protected access to the Instructor’s Manual, solutions to end-of-chapter problems and cases, Instructor’s PowerPoint, Excel Template Solutions, video clips, and video projects and questions.
HOW THE MARKET WORKS Students receive free access to this web-based portfolio simulation with a hypothetical brokerage account to buy and sell stocks and mutual funds. Students can use the real data found at this site in conjunction with the chapters on investments. They can also compete against students in their class and around the United States to run the most successful portfolio. This site is powered by Stock-Trak, the leading provider of investment simulation services to the academic community.
AVAILABLE FOR PURCHASE & PACKAGING FinGame Online 5.0
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http://connect.mheducation.com
By LeRoy Brooks, John Carroll University (ISBN 10: 0077219880/ISBN 13: 9780077219888) Just $15.00 when packaged with this text. In this comprehensive simulation game, students control a hypothetical company over numerous periods of operation. The game is now tied to the text by exercises found on the Connect Student Library. As students make major financial and operating decisions for their company, they will develop and enhance their skills in financial management and financial accounting statement analysis. xxiv
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FINANCIAL ANALYSIS WITH AN ELECTRONIC CALCULATOR, SIXTH EDITION by Mark A. White, University of Virginia, McIntire School of Commerce (ISBN 10: 0073217093/ISBN 13: 9780073217093) The information and procedures in this supplementary text enable students to master the use of financial calculators and develop a working knowledge of financial mathematics and problem solving. Complete instructions are included for solving all major problem types on four popular models: HP 10B and 12C, TI BA II Plus, and TI-84. Hands-on
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problems with detailed solutions allow students to practice the skills outlined in the text and obtain instant reinforcement. Financial Analysis with an Electronic Calculator is a self-contained supplement to the introductory financial management course.
MCGRAW-HILL CUSTOMER CARE CONTACT INFORMATION At McGraw-Hill, we understand that getting the most from new technology can be challenging. That’s why our services don’t stop after you purchase our products. You can chat with our Product Specialists 24 hours a day to get product training online. Or you can search our knowledge bank of Frequently Asked Questions on our support website. For Customer Support, call 800-331-5094, or visit mpss.mhhe.com. One of our Technical Support Analysts will be able to assist you in a timely fashion.
Assurance of Learning Ready Assurance of Learning is an important element of many accreditation standards. Fundamentals of Corporate Finance, 12e, is designed specifically to support your assurance of learning initiatives. Each chapter in the book begins with a list of numbered learning objectives that appear throughout the chapter, as well as in the end-of-chapter problems and exercises. Every test bank question is also linked to one of these objectives, in addition to level of difficulty, topic area, Bloom’s Taxonomy level, and AACSB skill area. Connect, McGraw-Hill’s online homework solution, and EZ Test, McGraw-Hill’s easy-to-use test bank software, can search the test bank using these and other categories, providing an engine for targeted Assurance of Learning analysis and assessment.
AACSB Statement McGraw-Hill Education is a proud corporate member of AACSB International. Understanding the importance and value of AACSB Accreditation, Fundamentals of Corporate Finance, 12e, has sought to recognize the curricula guidelines detailed in the AACSB standards for business accreditation by connecting selected questions in the test bank to the general knowledge and skill guidelines found in the AACSB standards.
The statements contained in Fundamentals of Corporate Finance, 12e, are provided only as a guide for the users of this text. The AACSB leaves content coverage and assessment within the purview of individual schools, the mission of the school, and the faculty. While Fundamentals of
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Corporate Finance, 12e, and the teaching package make no claim of any specific AACSB qualification or evaluation, we have, within the test bank, labeled selected questions according to the eight general knowledge and skills areas.
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Acknowledgments
To borrow a phrase, writing an introductory finance textbook is easy—all you do is sit down at a word processor and open a vein. We never would have completed this book without the incredible amount of help and support we received from literally hundreds of our colleagues, students, editors, family members, and friends. We would like to thank, without implicating, all of you.
Clearly, our greatest debt is to our many colleagues (and their students) who, like us, wanted to try an alternative to what they were using and made the decision to change. Needless to say, without this support, we would not be publishing a 12th edition!
A great many of our colleagues read the drafts of our first and subsequent editions. The fact that this book has so little in common with our earliest drafts, along with the many changes and improvements we have made over the years, is a reflection of the value we placed on the many comments and suggestions that we received. To the following reviewers, then, we are grateful for their many contributions:
Ibrahim Affeneh Jan Ambrose Mike Anderson Sung C. Bae Robert Benecke Gary Benesh Scott Besley Sanjai Bhaghat Vigdis Boasson Elizabeth Booth Denis Boudreaux Jim Boyd William Brent
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Ray Brooks Charles C. Brown Lawrence Byerly Steve Byers Steve Caples Asim Celik Christina Cella Mary Chaffin Fan Chen Raju Chenna Barbara J. Childs Charles M. Cox Natalya Delcoure Michael Dorigan David A. Dumpe Michael Dunn Alan Eastman Adrian C. Edwards Uchenna Elike Steve Engel Angelo V. Esposito James Estes Cheri Etling Thomas H. Eyssell Dave Fehr Michael Ferguson Deborah Ann Ford Jim Forjan Micah Frankel Jennifer R. Frazier Deborah M. Giarusso Devra Golbe A. Steven Graham Mark Graham Darryl E. J. Gurley Wendy D. Habegger Karen Hallows David Harraway John M. Harris, Jr.
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R. Stevenson Hawkey Delvin D. Hawley Eric Haye Robert C. Higgins Karen Hogan Matthew Hood Steve Isberg James Jackson Pankaj Jain James M. Johnson Randy Jorgensen Daniel Jubinski Jarl G. Kallberg Ashok Kapoor Terry Keasler Howard Keen David N. Ketcher Jim Keys Kee Kim Deborah King Robert Kleinman Ladd Kochman Sophie Kong David Kuipers Morris A. Lamberson Qin Lan Dina Layish Chun Lee Adam Y. C. Lei George Lentz John Lightstone Jason Lin Scott Lowe Robert Lutz Qingzhong Ma Pawan Madhogarhia Timothy Manuel David G. Martin Dubos J. Masson
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Mario Mastrandrea Leslie Mathis xxviii John McDougald Bob McElreath Bahlous Mejda Gordon Melms Richard R. Mendenhall Wayne Mikkelson Lalatendu Misra Karlyn Mitchell Sunil Mohanty Scott Moore Belinda Mucklow Barry Mulholland Frederick H. Mull Michael J. Murray Randy Nelson Oris Odom Keith Osher Bulent Parker Megan Partch Samuel Penkar Pamela P. Peterson Robert Phillips Greg Pierce Steve Pilloff Robert Puelz George A. Racette Charu G. Raheja Narendar V. Rao Russ Ray Ron Reiber Thomas Rietz Jay R. Ritter Ricardo J. Rodriguez Stu Rosenstein Kenneth Roskelley Ivan Roten
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Philip Russel Gary Sanger Travis Sapp Martha A. Schary Robert Schwebach Roger Severns Michael Sher Dilip K. Shome Neil W. Sicherman Timothy Smaby Ahmad Sohrabian Michael F. Spivey Vic Stanton Charlene Sullivan Alice Sun George S. Swales, Jr. Lee Swartz Philip Swensen Philip Swicegood Brian Tarrant Rhonda Tenkku John G. Thatcher Harry Thiewes A. Frank Thompson Joseph Trefzger George Turk Michael R. Vetsuypens Joe Walker Jun Wang James Washam Alan Weatherford Gwendolyn Webb Marsha Weber Jill Wetmore Mark White Susan White Annie Wong Colbrin Wright David J. Wright
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Steve B. Wyatt Tung-Hsiao Yang Morris Yarmish Michael Young Mei Zhang J. Kenton Zumwalt Tom Zwirlein
Several of our most respected colleagues contributed original essays for this edition, which are entitled “In Their Own Words,” and appear in selected chapters. To these individuals we extend a special thanks:
Edward I. Altman New York University Robert C. Higgins University of Washington Roger Ibbotson Yale University, Ibbotson Associates Erik Lie University of Iowa Robert C. Merton Harvard University, Massachusetts Institute of Technology Jay R. Ritter University of Florida Richard Roll California Institute of Technology Fischer Black Jeremy Siegel University of Pennsylvania Hersh Shefrin Santa Clara University Bennett Stewart Stern Stewart & Co. Samuel C. Weaver Lehigh University Merton H. Miller
We are lucky to have had skilled and experienced instructors developing
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the supplement material for this edition. We greatly appreciate the contributions of Joe Smolira, Belmont University, who worked closely with us to develop the Solutions Manual, the new and improved
xxix Instructor’s Guide, and to create Excel templates for many of the end-of- chapter problems. Thank you also to Kay Johnson for thorough updating, revising, and tagging of every problem in the test bank.
The following proofers did outstanding work on this edition of Fundamentals: Emily Bello and Steve Hailey. To them fell the unenviable task of technical proofreading, and in particular, careful checking of each calculation throughout the text and Instructor’s Manual.
Finally, in every phase of this project, we have been privileged to have had the complete and unwavering support of a great organization, McGraw-Hill Education. We especially thank the sales group. The suggestions they provide, their professionalism in assisting potential adopters, and the service they provide to current users have been a major factor in our success.
We are deeply grateful to the select group of professionals who served as our development team on this edition: Chuck Synovec, Director; Jennifer Upton, Senior Product Developer; Trina Maurer, Senior Marketing Manager; Matt Diamond, Designer; Jill Eccher, Core Project Manager. Others at McGraw-Hill/Irwin, too numerous to list here, have improved the book in countless ways.
Throughout the development of this edition, we have taken great care to discover and eliminate errors. Our goal is to provide the best textbook available on the subject. To ensure that future editions are error-free, we gladly offer $10 per arithmetic error to the first individual reporting it as a modest token of our appreciation. More than this, we would like to hear from instructors and students alike. Please write and tell us how to make this a better text. Forward your comments to: Dr. Brad Jordan, c/o Editorial—Finance, McGraw-Hill Education, 1333 Burr Ridge Parkway, Burr Ridge, IL 60527.
Stephen A. Ross Randolph W. Westerfield
Bradford D. Jordan
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PART 1
CHAPTER 1
CHAPTER 2
PART 2
CHAPTER 3
CHAPTER 4
PART 3
CHAPTER 5
CHAPTER 6 CHAPTER 7
CHAPTER 8
PART 4
CHAPTER 9
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Brief Contents
Overview of Corporate Finance
INTRODUCTION TO CORPORATE FINANCE FINANCIAL STATEMENTS, TAXES, AND CASH FLOW
Financial Statements and Long-Term Financial Planning
WORKING WITH FINANCIAL STATEMENTS LONG-TERM FINANCIAL PLANNING AND GROWTH
Valuation of Future Cash Flows
INTRODUCTION TO VALUATION: THE TIME VALUE OF MONEY DISCOUNTED CASH FLOW VALUATION INTEREST RATES AND BOND VALUATION STOCK VALUATION
Capital Budgeting
NET PRESENT VALUE AND OTHER
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CHAPTER 10
CHAPTER 11
PART 5
CHAPTER 12
CHAPTER 13
PART 6
CHAPTER 14 CHAPTER 15 CHAPTER 16
CHAPTER 17
PART 7
CHAPTER 18 CHAPTER 19 CHAPTER 20
PART 8
CHAPTER 21 CHAPTER 22
INVESTMENT CRITERIA MAKING CAPITAL INVESTMENT DECISIONS PROJECT ANALYSIS AND EVALUATION
Risk and Return
SOME LESSONS FROM CAPITAL MARKET HISTORY RETURN, RISK, AND THE SECURITY MARKET LINE
Cost of Capital and Long-Term Financial Policy
COST OF CAPITAL RAISING CAPITAL FINANCIAL LEVERAGE AND CAPITAL STRUCTURE POLICY DIVIDENDS AND PAYOUT POLICY
xxxi
Short-Term Financial Planning and Management
SHORT-TERM FINANCE AND PLANNING CASH AND LIQUIDITY MANAGEMENT CREDIT AND INVENTORY MANAGEMENT
Topics in Corporate Finance
INTERNATIONAL CORPORATE FINANCE BEHAVIORAL FINANCE: IMPLICATIONS FOR FINANCIAL MANAGEMENT
48
CHAPTER 23 CHAPTER 24 CHAPTER 25 CHAPTER 26 CHAPTER 27
ENTERPRISE RISK MANAGEMENT OPTIONS AND CORPORATE FINANCE OPTION VALUATION MERGERS AND ACQUISITIONS LEASING
49
PART 1
1.1
1.2
1.3
1.4
xxxii
Contents
Overview of Corporate Finance
CHAPTER 1 INTRODUCTION TO CORPORATE FINANCE
Corporate Finance and the Financial Manager What Is Corporate Finance? The Financial Manager Financial Management Decisions
Capital Budgeting Capital Structure Working Capital Management Conclusion
Forms of Business Organization Sole Proprietorship Partnership Corporation A Corporation by Another Name . . .
The Goal of Financial Management Possible Goals The Goal of Financial Management A More General Goal Sarbanes-Oxley
The Agency Problem and Control of the Corporation Agency Relationships Management Goals Do Managers Act in the Stockholders’ Interests?
Managerial Compensation Control of the Firm Conclusion
Stakeholders
50
1.5
1.6
2.1
2.2
2.3
2.4
Financial Markets and the Corporation Cash Flows to and from the Firm Primary versus Secondary Markets
Primary Markets Secondary Markets Dealer versus Auction Markets Trading in Corporate Securities Listing
Summary and Conclusions
CHAPTER 2 FINANCIAL STATEMENTS, TAXES, AND CASH FLOW
The Balance Sheet Assets: The Left Side Liabilities and Owners’ Equity: The Right Side Net Working Capital Liquidity Debt versus Equity Market Value versus Book Value
The Income Statement GAAP and the Income Statement Noncash Items Time and Costs
Taxes Corporate Tax Rates Average versus Marginal Tax Rates
Cash Flow Cash Flow from Assets
Operating Cash Flow Capital Spending Change in Net Working Capital Conclusion A Note about “Free” Cash Flow
Cash Flow to Creditors and Stockholders Cash Flow to Creditors Cash Flow to Stockholders
An Example: Cash Flows for Dole Cola Operating Cash Flow Net Capital Spending
51
2.5
PART 2
3.1
3.2
3.3
Change in NWC and Cash Flow from Assets Cash Flow to Stockholders and Creditors
Summary and Conclusions
Financial Statements and Long-Term Financial Planning
CHAPTER 3 WORKING WITH FINANCIAL STATEMENTS
Cash Flow and Financial Statements: A Closer Look Sources and Uses of Cash The Statement of Cash Flows
Standardized Financial Statements Common-Size Statements
Common-Size Balance Sheets Common-Size Income Statements Common-Size Statements of Cash Flows
xxxiii Common-Base Year Financial Statements: Trend Analysis Combined Common-Size and Base Year Analysis
Ratio Analysis Short-Term Solvency, or Liquidity, Measures
Current Ratio The Quick (or Acid-Test) Ratio Other Liquidity Ratios
Long-Term Solvency Measures Total Debt Ratio A Brief Digression: Total Capitalization versus Total Assets Times Interest Earned Cash Coverage
Asset Management, or Turnover, Measures Inventory Turnover and Days’ Sales in Inventory Receivables Turnover and Days’ Sales in Receivables Asset Turnover Ratios
Profitability Measures Profit Margin Return on Assets
52
3.4
3.5
3.6
4.1
4.2
Return on Equity Market Value Measures
Price-Earnings Ratio Price-Sales Ratio Market-to-Book Ratio Enterprise Value-EBITDA Ratio
Conclusion The DuPont Identity A Closer Look at ROE An Expanded DuPont Analysis
Using Financial Statement Information Why Evaluate Financial Statements?
Internal Uses External Uses
Choosing a Benchmark Time Trend Analysis Peer Group Analysis
Problems with Financial Statement Analysis Summary and Conclusions
CHAPTER 4 LONG-TERM FINANCIAL PLANNING AND GROWTH
What Is Financial Planning? Growth as a Financial Management Goal Dimensions of Financial Planning What Can Planning Accomplish?
Examining Interactions Exploring Options Avoiding Surprises Ensuring Feasibility and Internal Consistency Conclusion
Financial Planning Models: A First Look A Financial Planning Model: The Ingredients
Sales Forecast Pro Forma Statements Asset Requirements Financial Requirements The Plug Economic Assumptions
53
4.3
4.4
4.5 4.6
PART 3
5.1
5.2
5.3
5.4
A Simple Financial Planning Model The Percentage of Sales Approach The Income Statement The Balance Sheet A Particular Scenario An Alternative Scenario
External Financing and Growth EFN and Growth Financial Policy and Growth
The Internal Growth Rate The Sustainable Growth Rate Determinants of Growth
A Note about Sustainable Growth Rate Calculations Some Caveats Regarding Financial Planning Models Summary and Conclusions
Valuation of Future Cash Flows
CHAPTER 5 INTRODUCTION TO VALUATION: THE TIME VALUE OF MONEY
Future Value and Compounding Investing for a Single Period Investing for More Than One Period A Note about Compound Growth
Present Value and Discounting The Single-Period Case Present Values for Multiple Periods
More about Present and Future Values Present versus Future Value Determining the Discount Rate Finding the Number of Periods
Summary and Conclusions xxxiv
CHAPTER 6 DISCOUNTED CASH FLOW VALUATION
54
6.1
6.2
6.3
6.4
6.5
7.1
7.2
Future and Present Values of Multiple Cash Flows Future Value with Multiple Cash Flows Present Value with Multiple Cash Flows A Note about Cash Flow Timing
Valuing Level Cash Flows: Annuities and Perpetuities Present Value for Annuity Cash Flows
Annuity Tables Finding the Payment Finding the Rate
Future Value for Annuities A Note about Annuities Due Perpetuities Growing Annuities and Perpetuities
Comparing Rates: The Effect of Compounding Effective Annual Rates and Compounding Calculating and Comparing Effective Annual Rates EARs and APRs Taking It to the Limit: A Note about Continuous Compounding
Loan Types and Loan Amortization Pure Discount Loans Interest-Only Loans Amortized Loans
Summary and Conclusions
CHAPTER 7 INTEREST RATES AND BOND VALUATION
Bonds and Bond Valuation Bond Features and Prices Bond Values and Yields Interest Rate Risk Finding the Yield to Maturity: More Trial and Error
More about Bond Features Is It Debt or Equity? Long-Term Debt: The Basics The Indenture
Terms of a Bond Security Seniority Repayment
55
7.3 7.4
7.5
7.6
7.7
7.8
8.1
8.2
The Call Provision Protective Covenants
Bond Ratings Some Different Types of Bonds Government Bonds Zero Coupon Bonds Floating-Rate Bonds Other Types of Bonds Sukuk
Bond Markets How Bonds Are Bought and Sold Bond Price Reporting A Note about Bond Price Quotes
Inflation and Interest Rates Real versus Nominal Rates The Fisher Effect Inflation and Present Values
Determinants of Bond Yields The Term Structure of Interest Rates Bond Yields and the Yield Curve: Putting It All Together Conclusion
Summary and Conclusions
CHAPTER 8 STOCK VALUATION
Common Stock Valuation Cash Flows Some Special Cases
Zero Growth Constant Growth Nonconstant Growth Two-Stage Growth
Components of the Required Return Stock Valuation Using Multiples
Some Features of Common and Preferred Stocks Common Stock Features
Shareholder Rights Proxy Voting Classes of Stock
56
8.3
8.4
PART 4
9.1
9.2
9.3 9.4 9.5
Other Rights Dividends
Preferred Stock Features Stated Value Cumulative and Noncumulative Dividends Is Preferred Stock Really Debt?
The Stock Markets Dealers and Brokers Organization of the NYSE
Members Operations Floor Activity
NASDAQ Operations ECNs
Stock Market Reporting Summary and Conclusions
xxxv
Capital Budgeting
CHAPTER 9 NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA
Net Present Value The Basic Idea Estimating Net Present Value
The Payback Rule Defining the Rule Analyzing the Rule Redeeming Qualities of the Rule Summary of the Rule
The Discounted Payback The Average Accounting Return The Internal Rate of Return Problems with the IRR
Nonconventional Cash Flows Mutually Exclusive Investments
57
9.6 9.7 9.8
10.1
10.2
10.3
10.4
Investing or Financing? Redeeming Qualities of the IRR The Modified Internal Rate of Return (MIRR)
Method #1: The Discounting Approach Method #2: The Reinvestment Approach Method #3: The Combination Approach MIRR or IRR: Which Is Better?
The Profitability Index The Practice of Capital Budgeting Summary and Conclusions
CHAPTER 10 MAKING CAPITAL INVESTMENT DECISIONS
Project Cash Flows: A First Look Relevant Cash Flows The Stand-Alone Principle
Incremental Cash Flows Sunk Costs Opportunity Costs Side Effects Net Working Capital Financing Costs Other Issues
Pro Forma Financial Statements and Project Cash Flows Getting Started: Pro Forma Financial Statements Project Cash Flows
Project Operating Cash Flow Project Net Working Capital and Capital Spending
Projected Total Cash Flow and Value More about Project Cash Flow A Closer Look at Net Working Capital Depreciation
Modified ACRS Depreciation (MACRS) Bonus Depreciation Book Value versus Market Value
An Example: The Majestic Mulch and Compost Company (MMCC)
Operating Cash Flows Change in NWC
58
10.5
10.6
10.7
11.1
11.2
11.3
11.4
Capital Spending Total Cash Flow and Value Conclusion
Alternative Definitions of Operating Cash Flow The Bottom-Up Approach The Top-Down Approach The Tax Shield Approach Conclusion
Some Special Cases of Discounted Cash Flow Analysis Evaluating Cost-Cutting Proposals Setting the Bid Price Evaluating Equipment Options with Different Lives
Summary and Conclusions
CHAPTER 11 PROJECT ANALYSIS AND EVALUATION
Evaluating NPV Estimates The Basic Problem Projected versus Actual Cash Flows Forecasting Risk Sources of Value
Scenario and Other What-If Analyses Getting Started Scenario Analysis Sensitivity Analysis Simulation Analysis
Break-Even Analysis Fixed and Variable Costs
Variable Costs Fixed Costs Total Costs
Accounting Break-Even Accounting Break-Even: A Closer Look Uses for the Accounting Break-Even
Operating Cash Flow, Sales Volume, and Break-Even Accounting Break-Even and Cash Flow
xxxvi The Base Case Calculating the Break-Even Level
59
11.5
11.6
11.7
PART 5
12.1
12.2
12.3
12.4
Payback and Break-Even Sales Volume and Operating Cash Flow Cash Flow, Accounting, and Financial Break-Even Points
Accounting Break-Even Revisited Cash Break-Even Financial Break-Even Conclusion
Operating Leverage The Basic Idea Implications of Operating Leverage Measuring Operating Leverage Operating Leverage and Break-Even
Capital Rationing Soft Rationing Hard Rationing
Summary and Conclusions
Risk and Return
CHAPTER 12 SOME LESSONS FROM CAPITAL MARKET HISTORY
Returns Dollar Returns Percentage Returns
The Historical Record A First Look A Closer Look
Average Returns: The First Lesson Calculating Average Returns Average Returns: The Historical Record Risk Premiums The First Lesson
The Variability of Returns: The Second Lesson Frequency Distributions and Variability The Historical Variance and Standard Deviation The Historical Record Normal Distribution
60
12.5
12.6
12.7
13.1
13.2
13.3
13.4
13.5
13.6
The Second Lesson 2008: A Year to Remember Using Capital Market History More on the Stock Market Risk Premium
More about Average Returns Arithmetic versus Geometric Averages Calculating Geometric Average Returns Arithmetic Average Return or Geometric Average Return?
Capital Market Efficiency Price Behavior in an Efficient Market The Efficient Markets Hypothesis Some Common Misconceptions about the EMH The Forms of Market Efficiency
Summary and Conclusions
CHAPTER 13 RETURN, RISK, AND THE SECURITY MARKET LINE
Expected Returns and Variances Expected Return Calculating the Variance
Portfolios Portfolio Weights Portfolio Expected Returns Portfolio Variance
Announcements, Surprises, and Expected Returns Expected and Unexpected Returns Announcements and News
Risk: Systematic and Unsystematic Systematic and Unsystematic Risk Systematic and Unsystematic Components of Return
Diversification and Portfolio Risk The Effect of Diversification: Another Lesson from Market History The Principle of Diversification Diversification and Unsystematic Risk Diversification and Systematic Risk
Systematic Risk and Beta The Systematic Risk Principle Measuring Systematic Risk
61
13.7
13.8
13.9
PART 6
14.1
14.2
14.3
14.4
Portfolio Betas The Security Market Line Beta and the Risk Premium
The Reward-to-Risk Ratio The Basic Argument The Fundamental Result
The Security Market Line Market Portfolios The Capital Asset Pricing Model
The SML and the Cost of Capital: A Preview The Basic Idea The Cost of Capital
Summary and Conclusions xxxvii
Cost of Capital and Long-Term Financial Policy
CHAPTER 14 COST OF CAPITAL
The Cost of Capital: Some Preliminaries Required Return versus Cost of Capital Financial Policy and Cost of Capital
The Cost of Equity The Dividend Growth Model Approach
Implementing the Approach Estimating g Advantages and Disadvantages of the Approach
The SML Approach Implementing the Approach Advantages and Disadvantages of the Approach
The Costs of Debt and Preferred Stock The Cost of Debt The Cost of Preferred Stock
The Weighted Average Cost of Capital The Capital Structure Weights Taxes and the Weighted Average Cost of Capital Calculating the WACC for Eastman Chemical
62
14.5
14.6 14.7
14.8
15.1
15.2
15.3 15.4
Eastman’s Cost of Equity Eastman’s Cost of Debt Eastman’s WACC
Solving the Warehouse Problem and Similar Capital Budgeting Problems Performance Evaluation: Another Use of the WACC
Divisional and Project Costs of Capital The SML and the WACC Divisional Cost of Capital The Pure Play Approach The Subjective Approach
Company Valuation with the WACC Flotation Costs and the Average Cost of Capital The Basic Approach Flotation Costs and NPV Internal Equity and Flotation Costs
Summary and Conclusions
CHAPTER 15 RAISING CAPITAL
The Financing Life Cycle of a Firm: Early-Stage Financing and Venture Capital Venture Capital Some Venture Capital Realities Choosing a Venture Capitalist Conclusion
Selling Securities to the Public: The Basic Procedure Crowdfunding Initial Coin Offerings (ICOs)
Alternative Issue Methods Underwriters Choosing an Underwriter Types of Underwriting
Firm Commitment Underwriting Best Efforts Underwriting Dutch Auction Underwriting
The Aftermarket The Green Shoe Provision Lockup Agreements
63
15.5
15.6 15.7
15.8
15.9
15.10 15.11 15.12
16.1
16.2
The Quiet Period Direct Listing
IPOs and Underpricing IPO Underpricing: The 1999–2000 Experience Evidence on Underpricing The Partial Adjustment Phenomenon Why Does Underpricing Exist?
New Equity Sales and the Value of the Firm The Costs of Issuing Securities The Costs of Selling Stock to the Public The Costs of Going Public: A Case Study
Rights The Mechanics of a Rights Offering Number of Rights Needed to Purchase a Share The Value of a Right Ex Rights The Underwriting Arrangements Effects on Shareholders
Dilution Dilution of Proportionate Ownership Dilution of Value: Book versus Market Values
A Misconception The Correct Arguments
Issuing Long-Term Debt Shelf Registration Summary and Conclusions
CHAPTER 16 FINANCIAL LEVERAGE AND CAPITAL STRUCTURE POLICY
The Capital Structure Question Firm Value and Stock Value: An Example Capital Structure and the Cost of Capital
The Effect of Financial Leverage The Basics of Financial Leverage
xxxviii Financial Leverage, EPS, and ROE: An Example EPS versus EBIT
Corporate Borrowing and Homemade Leverage
64
16.3
16.4
16.5
16.6
16.7
16.8
16.9 16.10
16.11
17.1
Capital Structure and the Cost of Equity Capital M&M Proposition I: The Pie Model The Cost of Equity and Financial Leverage: M&M Proposition II Business and Financial Risk
M&M Propositions I and II with Corporate Taxes The Interest Tax Shield Taxes and M&M Proposition I Taxes, the WACC, and Proposition II Conclusion
Bankruptcy Costs Direct Bankruptcy Costs Indirect Bankruptcy Costs
Optimal Capital Structure The Static Theory of Capital Structure Optimal Capital Structure and the Cost of Capital Optimal Capital Structure: A Recap Capital Structure: Some Managerial Recommendations
Taxes Financial Distress
The Pie Again The Extended Pie Model Marketed Claims versus Nonmarketed Claims
The Pecking-Order Theory Internal Financing and the Pecking Order Implications of the Pecking Order
Observed Capital Structures A Quick Look at the Bankruptcy Process Liquidation and Reorganization
Bankruptcy Liquidation Bankruptcy Reorganization
Financial Management and the Bankruptcy Process Agreements to Avoid Bankruptcy
Summary and Conclusions
CHAPTER 17 DIVIDENDS AND PAYOUT POLICY
Cash Dividends and Dividend Payment Cash Dividends Standard Method of Cash Dividend Payment
65
17.2
17.3
17.4
17.5
17.6
17.7
17.8
Dividend Payment: A Chronology More about the Ex-Dividend Date
Does Dividend Policy Matter? An Illustration of the Irrelevance of Dividend Policy
Current Policy: Dividends Set Equal to Cash Flow Alternative Policy: Initial Dividend Greater than Cash Flow
Homemade Dividends A Test
Real-World Factors Favoring a Low Dividend Payout Taxes Flotation Costs Dividend Restrictions
Real-World Factors Favoring a High Dividend Payout Desire for Current Income Tax and Other Benefits from High Dividends
Corporate Investors Tax-Exempt Investors
Conclusion A Resolution of Real-World Factors? Information Content of Dividends The Clientele Effect
Stock Repurchases: An Alternative to Cash Dividends Cash Dividends versus Repurchase Real-World Considerations in a Repurchase Share Repurchase and EPS
What We Know and Do Not Know about Dividend and Payout Policies Dividends and Dividend Payers Corporations Smooth Dividends Putting It All Together Some Survey Evidence on Dividends
Stock Dividends and Stock Splits Some Details about Stock Splits and Stock Dividends
Example of a Small Stock Dividend Example of a Stock Split Example of a Large Stock Dividend
Value of Stock Splits and Stock Dividends The Benchmark Case Popular Trading Range
66
17.9
PART 7
18.1 18.2
18.3
18.4
18.5
Reverse Splits Summary and Conclusions
xxxix
Short-Term Financial Planning and Management
CHAPTER 18 SHORT-TERM FINANCE AND PLANNING
Tracing Cash and Net Working Capital The Operating Cycle and the Cash Cycle Defining the Operating and Cash Cycles
The Operating Cycle The Cash Cycle
The Operating Cycle and the Firm’s Organizational Chart Calculating the Operating and Cash Cycles
The Operating Cycle The Cash Cycle
Interpreting the Cash Cycle Some Aspects of Short-Term Financial Policy The Size of the Firm’s Investment in Current Assets Alternative Financing Policies for Current Assets
An Ideal Case Different Policies for Financing Current Assets
Which Financing Policy Is Best? Current Assets and Liabilities in Practice
The Cash Budget Sales and Cash Collections Cash Outflows The Cash Balance
Short-Term Borrowing Unsecured Loans
Compensating Balances Cost of a Compensating Balance Letters of Credit
Secured Loans Accounts Receivable Financing Inventory Loans
67
18.6 18.7
19.1
19.2
19.3
19.4
19.5
Other Sources A Short-Term Financial Plan Summary and Conclusions
CHAPTER 19 CASH AND LIQUIDITY MANAGEMENT
Reasons for Holding Cash The Speculative and Precautionary Motives The Transaction Motive Compensating Balances Costs of Holding Cash Cash Management versus Liquidity Management
Understanding Float Disbursement Float Collection Float and Net Float Float Management
Measuring Float Some Details Cost of the Float Ethical and Legal Questions
Electronic Data Interchange and Check 21: The End of Float? Cash Collection and Concentration Components of Collection Time Cash Collection Lockboxes Cash Concentration Accelerating Collections: An Example
Managing Cash Disbursements Increasing Disbursement Float Controlling Disbursements
Zero-Balance Accounts Controlled Disbursement Accounts
Investing Idle Cash Temporary Cash Surpluses
Seasonal or Cyclical Activities Planned or Possible Expenditures
Characteristics of Short-Term Securities Maturity Default Risk
68
19.6 19A
20.1
20.2
20.3
Marketability Taxes
Some Different Types of Money Market Securities Summary and Conclusions Determining the Target Cash Balance The Basic Idea The BAT Model
The Opportunity Costs The Trading Costs The Total Cost The Solution Conclusion
The Miller-Orr Model: A More General Approach The Basic Idea Using the Model
Implications of the BAT and Miller-Orr Models Other Factors Influencing the Target Cash Balance
CHAPTER 20 CREDIT AND INVENTORY MANAGEMENT
Credit and Receivables Components of Credit Policy The Cash Flows from Granting Credit The Investment in Receivables
xl Terms of the Sale The Basic Form The Credit Period
The Invoice Date Length of the Credit Period
Cash Discounts Cost of the Credit Trade Discounts The Cash Discount and the ACP
Credit Instruments Analyzing Credit Policy Credit Policy Effects Evaluating a Proposed Credit Policy
NPV of Switching Policies
69
20.4
20.5
20.6
20.7
20.8
20.9 20.A
A Break-Even Application Optimal Credit Policy The Total Credit Cost Curve Organizing the Credit Function
Credit Analysis When Should Credit Be Granted?
A One-Time Sale Repeat Business
Credit Information Credit Evaluation and Scoring
Collection Policy Monitoring Receivables Collection Effort
Inventory Management The Financial Manager and Inventory Policy Inventory Types Inventory Costs
Inventory Management Techniques The ABC Approach The Economic Order Quantity Model
Inventory Depletion The Carrying Costs The Restocking Costs The Total Costs
Extensions to the EOQ Model Safety Stocks Reorder Points
Managing Derived-Demand Inventories Materials Requirements Planning Just-in-Time Inventory
Summary and Conclusions More about Credit Policy Analysis Two Alternative Approaches
The One-Shot Approach The Accounts Receivable Approach
Discounts and Default Risk NPV of the Credit Decision A Break-Even Application
70
PART 8
21.1 21.2
21.3
21.4
21.5
21.6
21.7
21.8
Topics in Corporate Finance
CHAPTER 21 INTERNATIONAL CORPORATE FINANCE
Terminology Foreign Exchange Markets and Exchange Rates Exchange Rates
Exchange Rate Quotations Cross-Rates and Triangle Arbitrage Types of Transactions
Purchasing Power Parity Absolute Purchasing Power Parity Relative Purchasing Power Parity
The Basic Idea The Result Currency Appreciation and Depreciation
Interest Rate Parity, Unbiased Forward Rates, and the International Fisher Effect Covered Interest Arbitrage Interest Rate Parity Forward Rates and Future Spot Rates Putting It All Together
Uncovered Interest Parity The International Fisher Effect
International Capital Budgeting Method 1: The Home Currency Approach Method 2: The Foreign Currency Approach Unremitted Cash Flows
Exchange Rate Risk Short-Run Exposure Long-Run Exposure Translation Exposure Managing Exchange Rate Risk
Political Risk The Tax Cuts and Jobs Act of 2017 Managing Political Risk
Summary and Conclusions
71
22.1 22.2
22.3
22.4
22.5
22.6
22.7
23.1 23.2
CHAPTER 22 BEHAVIORAL FINANCE: IMPLICATIONS FOR FINANCIAL MANAGEMENT
Introduction to Behavioral Finance Biases Overconfidence Overoptimism Confirmation Bias
xli Framing Effects Loss Aversion House Money
Heuristics The Affect Heuristic The Representativeness Heuristic Representativeness and Randomness The Gambler’s Fallacy
Behavioral Finance and Market Efficiency Limits to Arbitrage
The 3Com/Palm Mispricing The Royal Dutch/Shell Price Ratio
Bubbles and Crashes The Crash of 1929 The Crash of October 1987 The Nikkei Crash The “Dot-Com” Bubble and Crash
Market Efficiency and the Performance of Professional Money Managers Summary and Conclusions
CHAPTER 23 ENTERPRISE RISK MANAGEMENT
Insurance Managing Financial Risk The Risk Profile Reducing Risk Exposure Hedging Short-Run Exposure Cash Flow Hedging: A Cautionary Note
72
23.3
23.4
23.5
23.6
23.7
24.1
Hedging Long-Term Exposure Conclusion
Hedging with Forward Contracts Forward Contracts: The Basics The Payoff Profile Hedging with Forwards
A Caveat Credit Risk Forward Contracts in Practice
Hedging with Futures Contracts Trading in Futures Futures Exchanges Hedging with Futures
Hedging with Swap Contracts Currency Swaps Interest Rate Swaps Commodity Swaps The Swap Dealer Interest Rate Swaps: An Example
Hedging with Option Contracts Option Terminology Options versus Forwards Option Payoff Profiles Option Hedging Hedging Commodity Price Risk with Options Hedging Exchange Rate Risk with Options Hedging Interest Rate Risk with Options
A Preliminary Note Interest Rate Caps Other Interest Rate Options
Actual Use of Derivatives Summary and Conclusions
CHAPTER 24 OPTIONS AND CORPORATE FINANCE
Options: The Basics Puts and Calls Stock Option Quotations Option Payoffs
73
24.2
24.3
24.4
24.5
24.6
24.7
24.8
Fundamentals of Option Valuation Value of a Call Option at Expiration The Upper and Lower Bounds on a Call Option’s Value
The Upper Bound The Lower Bound
A Simple Model: Part I The Basic Approach A More Complicated Case
Four Factors Determining Option Values Valuing a Call Option A Simple Model: Part II The Fifth Factor A Closer Look
Employee Stock Options ESO Features ESO Repricing ESO Backdating
Equity as a Call Option on the Firm’s Assets Case I: The Debt Is Risk-Free Case II: The Debt Is Risky
Options and Capital Budgeting The Investment Timing Decision Managerial Options
Contingency Planning Options in Capital Budgeting: An Example Strategic Options Conclusion
Options and Corporate Securities Warrants
The Difference between Warrants and Call Options Earnings Dilution
Convertible Bonds Features of a Convertible Bond Value of a Convertible Bond
Other Options The Call Provision on a Bond Put Bonds Insurance and Loan Guarantees
Summary and Conclusions
74
25.1
25.2
25.3
25.4
25.5
25.6
26.1
26.2
xlii
CHAPTER 25 OPTION VALUATION
Put-Call Parity Protective Puts An Alternative Strategy The Result Continuous Compounding: A Refresher Course
The Black-Scholes Option Pricing Model The Call Option Pricing Formula Put Option Valuation A Cautionary Note
More about Black-Scholes Varying the Stock Price Varying the Time to Expiration Varying the Standard Deviation Varying the Risk-Free Rate Implied Standard Deviations
Valuation of Equity and Debt in a Leveraged Firm Valuing the Equity in a Leveraged Firm Options and the Valuation of Risky Bonds
Options and Corporate Decisions: Some Applications Mergers and Diversification Options and Capital Budgeting
Summary and Conclusions
CHAPTER 26 MERGERS AND ACQUISITIONS
The Legal Forms of Acquisitions Merger or Consolidation Acquisition of Stock Acquisition of Assets Acquisition Classifications A Note about Takeovers Alternatives to Merger
Taxes and Acquisitions Determinants of Tax Status
75
26.3
26.4
26.5
26.6
26.7
26.8 26.9 26.10
Taxable versus Tax-Free Acquisitions Accounting for Acquisitions The Purchase Method More about Goodwill
Gains from Acquisitions Synergy Revenue Enhancement
Marketing Gains Strategic Benefits Increases in Market Power
Cost Reductions Economies of Scale Economies of Vertical Integration Complementary Resources
Lower Taxes Net Operating Losses Unused Debt Capacity Surplus Funds Asset Write-Ups
Reductions in Capital Needs Avoiding Mistakes A Note about Inefficient Management
Some Financial Side Effects of Acquisitions EPS Growth Diversification
The Cost of an Acquisition Case I: Cash Acquisition Case II: Stock Acquisition Cash versus Common Stock
Defensive Tactics The Corporate Charter Repurchase and Standstill Agreements Poison Pills and Share Rights Plans Going Private and Leveraged Buyouts Other Devices and Jargon of Corporate Takeovers
Some Evidence on Acquisitions: Does M&A Pay? Divestitures and Restructurings Summary and Conclusions
76
27.1
27.2 27.3 27.4
27.5
27.6 27.7
27.8
CHAPTER 27 LEASING
Leases and Lease Types Leasing versus Buying Operating Leases Financial Leases
Tax-Oriented Leases Leveraged Leases Sale and Leaseback Agreements
Accounting and Leasing Taxes, the IRS, and Leases The Cash Flows from Leasing The Incremental Cash Flows A Note about Taxes
Lease or Buy? A Preliminary Analysis Three Potential Pitfalls NPV Analysis A Misconception
A Leasing Paradox Reasons for Leasing Good Reasons for Leasing
Tax Advantages A Reduction of Uncertainty Lower Transactions Costs Fewer Restrictions and Security Requirements
xliii Dubious Reasons for Leasing
Leasing and Accounting Income 100 Percent Financing Low Cost
Other Reasons for Leasing Summary and Conclusions
APPENDIX A MATHEMATICAL TABLES
APPENDIX B KEY EQUATIONS
77
APPENDIX C ANSWERS TO SELECTED END-OF-CHAPTER PROBLEMS
APPENDIX D USING THE HP 10B AND TI BA II PLUS FINANCIAL CALCULATORS D-1
INDEX
78
xliv
In Their Own Words Boxes
CHAPTER 4 Robert C. Higgins University of Washington On Sustainable Growth
CHAPTER 7 Edward I. Altman New York University On Junk Bonds and Leveraged Loans
CHAPTER 10 Samuel C. Weaver Lehigh University On Capital Budgeting at The Hershey Company
CHAPTER 12 Roger Ibbotson Yale University On Capital Market History
Jeremy Siegel University of Pennsylvania On Stocks for the Long Run
Richard Roll California Institute of Technology On Market Efficiency
CHAPTER 14 Bennett Stewart Stern Stewart & Co. On EVA
Samuel C. Weaver Lehigh University On Cost of Capital and Hurdle Rates at The Hershey Company
CHAPTER 15 Jay R. Ritter University of Florida On IPO Underpricing around the World
79
CHAPTER 16 Merton H. Miller On Capital Structure: M&M 30 Years Later
CHAPTER 17 Fischer Black On Why Firms Pay Dividends
CHAPTER 22 Hersh Shefrin Santa Clara University On Behavioral Finance
CHAPTER 24 Erik Lie University of Iowa On Option Backdating
Robert C. Merton Harvard University, Massachusetts Institute of Technology On Applications of Options Analysis
80
xlv
Pedagogical Use of Color Throughout the 12th edition of Fundamentals of Corporate Finance, we make color a functional dimension of the discussion. In almost every chapter, color plays an extensive and large
