LibraryPirate S E C O N D E D I T I O N CORPORATE FINANCE F U N D A M E N T A L S O F Robert Parrino Lamar Savings Centennial Professor of Finance University of Texas at Austin David S Kidwell Profess.
dd Page iii 8/5/11 2:09:24 PM user-f396 user-f396 LibraryPirate SECOND EDITION F U N D A M E N T A L S O F CORPORATE FINANCE Robert Parrino Lamar Savings Centennial Professor of Finance University of Texas at Austin David S Kidwell Professor of Finance and Dean Emeritus University of Minnesota Thomas W Bates Department Chair and Associate Professor of Finance Arizona State University John Wiley & Sons, Inc ry.indd Page 728 8/3/11 2:11:36 PM user-f396 F-396 LibraryPirate This page intentionally left blank dd Page i 8/5/11 2:09:19 PM user-f396 user-f396 LibraryPirate This online teaching and learning environment integrates the entire digital textbook with the most effective instructor and student resources WRÀWHYHU\OHDUQLQJVW\OH With WileyPLUS: Students achieve concept mastery in a rich, structured environment that’s available 24/7 Instructors personalize and manage their course more effectively with assessment, assignments, grade tracking, and more manage time better study smarter save money From multiple study paths, to self-assessment, to a wealth of interactive visual and audio resources, WileyPLUS gives you everything you need to personalize the teaching and learning experience » F i n d o u t h ow t o M A K E I T YO U R S » dd Page ii 8/5/11 2:09:22 PM user-f396 user-f396 LibraryPirate ALL THE HELP, RESOURCES, AND PERSONAL SUPPORT YOU AND YOUR STUDENTS NEED! 2-Minute Tutorials and all of the resources you & your students need to get started www.wileyplus.com/firstday Student support from an experienced student user Ask your local representative for details! 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of America dd Page v 8/5/11 2:09:24 PM user-f396 user-f396 LibraryPirate Dedication ROBERT PARRINO To my parents, whose life-long support and commitment to education inspired me to become an educator and to my wife, Emily, for her unending support DAVID KIDWELL To my parents, Dr William and Margaret Kidwell for their endless support of my endeavors, to my son, David Jr., of whom I am very proud, and to my wife Jillinda who is the joy of my life THOMAS BATES To my wife, Emi, and our daughters Abigail and Lillian Your support, patience, fun, and friendship make me a better educator, scholar, and person ABO U T T HE A U T HO RS dd Page vi 8/9/11 1:08:38 PM user-f396 F-396 LibraryPirate ROBERT PARRINO Lamar Savings Centennial Professor of Finance McCombs School of Business, University of Texas at Austin A member of the faculty at University of Texas since 1992, Dr Parrino teaches courses in regular degree and executive education programs at the University of Texas, as well as in customized executive education courses for industrial, financial, and professional firms He has also taught at the University of Chicago, University of Rochester, and IMADEC University in Vienna Dr Parrino has received numerous awards for teaching excellence at University of Texas from students, faculty, and the Texas Ex’s (alumni association) Dr Parrino has been involved in advancing financial education outside of the classroom in a variety of ways As a Chartered Financial Analyst (CFA) charterholder he has been very active with the CFA Institute, having been a member of the candidate curriculum committee, served as a regular speaker at the annual Financial Analysts Seminar, spoken at over 20 Financial Analyst Society meetings, and as a past member of the planning committee for the CFA Institute’s Annual Meeting In addition, Dr Parrino is the founding director of the Hicks, Muse, Tate & Furst Center for Private Equity Finance at the University of Texas Dr Parrino was Vice President for Financial Education of the Financial Management Association (FMA) from 2008 to 2010 and has been elected to serve as an academic director of the FMA from 2011 to 2013 Dr Parrino is also co-founder of the Financial Research Association and is Associate Editor of the Journal of Corporate Finance and the Journal of Financial Research Dr Parrino’s research includes work on corporate governance, financial policies, restructuring, and mergers and acquisitions, as well as research on private equity markets He has published his research in a number of journals, including the Journal of Finance, Journal of Financial Economics, Journal of Financial and Quantitative Analysis, Journal of Law and Economics, Journal of Portfolio Management, and Financial Management Dr Parrino has won a number of awards for his research Dr Parrino has experience in the application of corporate finance concepts in a variety of business situations Since entering the academic profession he has been retained as an advisor on valuation issues concerning businesses with enterprise values ranging to more than $1 billion and has consulted in areas such as corporate financing, compensation, and corporate governance Dr Parrino is currently on the advisory council of Virgo capital, a private equity firm, and was previously President of Sprigg Lane Financial, Inc., a financial consulting firm with offices in Charlottesville, Virginia and New York City While at Sprigg Lane, he was on the executive, banking, and portfolio committees of the holding company that owns Sprigg Lane Before joining Sprigg Lane, Dr Parrino was on the Corporate Business Planning and Development staff at Marriott Corporation At Marriott, he conducted fundamental business analyses and preliminary financial valuations of new business development opportunities and potential acquisitions Dr Parrino holds a B.S in chemical engineering from Lehigh University, an MBA degree from The College of William and Mary, and M.S and Ph.D degrees in applied economics and finance, respectively, from University of Rochester dd Page vii 8/5/11 2:09:25 PM user-f396 user-f396 LibraryPirate DAVID S KIDWELL THOMAS W BATES Professor of Finance and Dean Emeritus Curtis L Carlson School of Management, University of Minnesota Department Chair and Associate Professor of Finance W P Carey School of Business, Arizona State University Dr Kidwell has over 30 years experience in financial education, as a teacher, researcher, and administrator He has served as Dean of the Carlson School at the University of Minnesota and of the School of Business Administration at the University of Connecticut Prior to joining the University of Connecticut, Dr Kidwell held endowed chairs in banking and finance at Tulane University, the University of Tennessee, and Texas Tech University He was also on the faculty at the Krannert Graduate School of Management, Purdue University where he was twice voted the outstanding undergraduate teacher of the year Dr Bates is the Chair of the Department of Finance and Dean’s Council of 100 Distinguished Scholar at the W P Carey School of Business, Arizona State University He has also taught courses in finance at the University of Delaware, the Ivey School of Business at the University of Western Ontario, and the University of Arizona where he received the Scrivner teaching award During his career as an educator, Professor Bates has taught corporate finance to students in undergraduate, MBA, executive MBA, and Ph.D programs, as well as in custom corporate educational courses An expert on the U.S financial system, Dr Kidwell is the author of more than 80 articles dealing with the U.S financial system and capital markets He has published his research in the leading journals, including Journal of Finance, Journal of Financial Economics, Journal of Financial and Quantitative Analysis, Financial Management, and Journal of Money, Credit, and Banking Dr Kidwell has also participated in a number of research grants funded by the National Science Foundation to study the efficiency of U.S capital markets, and to study the impact of government regulations upon the delivery of consumer financial services Professor Bates is a regular contributor to the academic finance literature in such journals as The Journal of Finance, Journal of Financial Economics, and Financial Management His research addresses a variety of issues in corporate finance including the contracting environment in mergers and acquisitions, corporate liquidity decisions and cash holdings, and the governance of corporations In practice, Dr Bates has worked with companies and legal firms as an advisor on issues related to the valuation of companies and corporate governance Dr Bates received a B.A in Economics from Guilford College and his doctorate in finance from the University of Pittsburgh Dr Kidwell has been a management consultant for Coopers & Lybrand and a sales engineer for Bethlehem Steel Corporation He currently serves on the Board of Directors and is the Chairman of the Audit and Risk Committee of the Schwan Food Company Dr Kidwell is the past Secretary-Treasurer of the Board of Directors of AACSB, the International Association for Management Education and is a past member of the Boards of the Minnesota Council for Quality, the Stonier Graduate School of Banking, and Minnesota Center for Corporate Responsibility Dr Kidwell has also served as an Examiner for the 1995 Malcolm Baldrige National Quality Award, on the Board of Directors of the Juran Center for Leadership in Quality, and on the Board of the Minnesota Life Insurance Company Dr Kidwell holds an undergraduate degree in mechanical engineering from California State University at San Diego, an MBA with a concentration in finance from California State University at San Francisco, and a Ph.D in finance from the University of Oregon dd Page viii 8/5/11 2:09:26 PM user-f396 user-f396 LibraryPirate Preface We have written Fundamentals of Corporate Finance for use in an introductory course in corporate finance at the undergraduate level It is also suitable for advanced undergraduate, executive development, and traditional or executive MBA courses when supplemented with cases and outside readings The main chapters in the book assume that students are well-versed in algebra and that they have taken courses in principles of economics and financial accounting Optional chapters covering important economic and financial accounting concepts are included for students and instructors seeking such coverage Balance Between Conceptual Understanding and Computational Skills We wrote this corporate finance text for one very important reason We want to provide students and instructors with a book that strikes the best possible balance between helping students develop an intuitive understanding of key financial concepts and providing them with problem-solving and decision-making skills In our experience, teaching students at all levels and across a range of business schools, we have found that students who understand the intuition underlying the basic concepts of finance are better able to develop the critical judgment necessary to apply financial tools to a broad range of real-world situations An introductory corporate finance course should provide students with a strong understanding of both the concepts and tools that will help them in their subsequent business studies and their personal and professional lives Market research supports our view Many faculty members who teach the introductory corporate finance course to undergraduates express a desire for a book that bridges the gap between conceptually-focused and computationally-focused books This text is designed to bridge this gap Specifically, the text develops the fundamental concepts underlying corporate finance in an intuitive manner while maintaining a strong emphasis on developing computational skills It also takes the students one step further by emphasizing the use of intuition and analytical skills in decision making Our ultimate goal has been to write a book and develop associated learning tools that help our colleagues succeed in the classroom—materials that are genuinely helpful in the learning process Our book offers a level of rigor that is appropriate for finance majors and yet presents the content in a manner that both finance and non-finance students find accessible and want to read Writing a book that is both rigorous and accessible has been one of our key objectives, and both faculty and student reviews of the first edition, as well as pre-publication chapters from this second edition, suggest that we have achieved this objective We have also tried to provide solutions to many of the challenges facing finance faculty in the current environment, who are asked to teach ever-increasing numbers of students with limited resources Faculty members need a book and associated learning tools that help them effectively leverage their time The organization of this book and the supplemental materials, along with the innovative WileyPLUS Web-based interface, which offers extensive problem solving opportunities and other resources for students, provide such leverage to an extent not found with other textbooks ndd Page 737 8/8/11 10:44:23 AM user-f396 F-396 LibraryPirate Subject Index Inside directors, 17 Insider trading, 299–300 Insolvency, 88 Institutional investors, 555 Insurable interest, 502 Insurance, company-owned life, 502–503 Insurance companies, 35, 36 Intangible assets, 2, 3, 54, 345 amortization of, 62 capital structures of companies with, 527 cash flows associated with, 345–346 Intensity of use conflict, 539, 540 Interest: compound, 128–130 deferred payment of, 521 on Eurocredit loans, 693–694 future value interest factor, 128, 131–132, 179 simple, 128–130, 185 and taxes, 418, 514–518 total simple, 130 Interest expense, 73, 623 Interest on interest, 128–129, 131–133 Interest rates, 38–44 annual percentage rate, 185–188, 198 for annuities, 174–177 for bank loans, 494–495 and bond prices, 246–248, 253–255 caps on, 267 comparing, 186–187 and cost of debt, 416 cyclical and long-term trends in, 42–44 disclosure of, 187–188 effective annual, see Effective annual interest rate (EAR) equilibrium, 38, 39 Fed’s role in setting, 24–25 finding, 148–149 impact of inflation on loans, 40–42 lending and borrowing, 26 and market value of liabilities, 58 nominal, 38 and options associated with securities, 654 prime, 494–495 quoted, 185, 186 real, 38–40, 259 risk-free rate of interest for options, 649 structure of, 255–259 term structure of, 258–259 Interest rate factor, 188–189 Interest rate per period, 186 Interest rate risk, 252, 259 with bonds, 252–255 options in management of, 662 Intermediation, financial, 34, 35 Internal accounting controls, 17 Internal auditors, 9, 10 Internal growth rate (IGR), 628–629 Internally generated funds, use of, 526 Internal rate of return (IRR), 318–328 agreement of NPV and, 321–322 calculating, 319–321 disagreement of NPV and, 322–325 modified, 325–327 NPV vs., 327–328 as practitioners’ method of choice, 329 Internal Revenue Service (IRS), 358, 536, 580 International Accounting Standards Board (IASB), 51 International banking, 692–694 International finance management, 671–695 basic principles of, 676 capital budgeting in, 685–688 factors affecting, 673–675 foreign exchange markets, 677–685 and globalization, 672–673 global money and capital markets in, 689–691 goals of, 675–676 international banking, 692–694 and rise of multinational corporations, 673 International Financial Reporting Standards (IFRS), 51 International GAAP, 51–52 Intrinsic value, 33, 588 Inventory, 444 accounting for, 54 as current asset, 53, 54 forecasting, 365 just-in-time, 456 management of, 455–456 profitability and, Inventory carrying costs, 450 Inventory turnover, 89–91, 446, 447 Investing activities, on statement of cash flows, 65 Investments: as cash outflows, 63 costs and benefits of, by entrepreneurs, 477 evaluating opportunities for, 614–615 follow-on, 656 in long-term assets, 69–70 in multinational corporations, 673 in net working capital, 68–69 options to defer, 655–656 real investment policy, 506 through private equity funds, 493–494 Investment banks, 28–29 distribution by, 29, 483 origination by, 28, 481–482 in private placements, 492 services of, 28–29, 481–483 and subprime mortgages, 268 underwriting by, 29, 482–483 Investment funds, 36 Investment-grade bonds, 257 Investment period, 202 Investment plan, 608, 609 Investment policies, 523, 539, 612 Investment projects: classification of, 304 with different lives, 365–367 Investment strategies, for working capital, 450–451 Investment value, 581, 587, 588 Investopedia, 168, 350 Investors: angel, 474 benefits of dividends for, 555 business plan for, 578–579 cash flows to, 67–71 effects of financial restructuring for, 507–508, 512 financial, 580 importance of cash flow to, institutional, 555 and need for dividends, 554–555 specialization of, 572 IPOs, see Initial public offerings IRR, see Internal rate of return IRS, see Internal Revenue Service Issuance costs: for bonds, 417, 490, 491, 518 for stock, 518, 526 Italy, 674 J “Janitor’s insurance,” 502–503 Japan, business in, 675 Jobs, Steve, 287, 472 Jones, Barbara S., 20 Junk bonds, 257 Just-in-time inventory management, 456 K Keiretsu, 675 Key person discount, 596–597 L Labor market, managerial, 15 Land of the Lost (movie), Langone, Ken, 669 Last in, first out (LIFO), 54 Las Vegas, Nevada, 641, 655 Laws See also Regulation for business ethics, 20 and managers’ decision making, 16 Leases (rental agreements), 535 capital, 536, 538 operating, 536 types of, 535–536 Leasing, 535–544 evaluating opportunities for, 540–543 lessee and lessor conflicts, 539–540 motivations for, 536–539 types of leases, 535–536 Lee, Spike, 474 Legal persons, corporations as, Legal systems, foreign, 674 Lenders See also Loans mortgage, 267–269 payoff functions for, 659–661 stockholder-lender agency costs, 524–526 venture capitalists, 474, 477, 479 Lender-savers, 26 Lending margin, 694 Lending rates, 26 Lessees, 535, 539–540 Lessors, 535 conflicts with lessee, 539–540 value of asset to, 535–536 Level cash flows, 167–182 annuities, 167–182 annuities due, 181–182 perpetuities, 179–180 Leverage See also Financial leverage and choice of capital structure, 528–529 and cost of assets, 512, 513 and cost of debt, 510n.6, 512, 513 and cost of equity, 510, 512, 513 and interest tax shield, 515, 517 operating, 388–391, 511–512, 676 and return on equity, 103 Leveraged buyouts, 1–2, 493 Leverage ratios, 89, 93–97 737 ndd Page 738 8/8/11 10:44:23 AM user-f396 738 F-396 LibraryPirate Subject Index iabilities, 52–55 on balance sheet, 52–55 in balance sheet identity, 411–412 on common-size balance sheets, 84, 85 current, 53–54, 69, 443 for different forms of business, 572 in financial planning models, 619 limited, long-term, 55, 64 market value of, 58 and organizational form, 573–574 retiring, 63 IBOR (London Interbank Offer Rate), 690 ife cycles (business), 286 ife insurance, company-owned, 502–503 ife insurance companies, 36 ife of a business: for different business forms, 572, 573 in valuation of business, 588 IFO (last in, first out), 54 imited liability, 7, 276 imited liability companies (LLCs), 8, 571, 572 capital for, 573 characteristics of, 572 financial liabilities of, 574 life of, 573 partnership agreements in, 573 private equity funds as, 493 taxes as C-corporations, 574n.1 imited liability partnerships (LLPs), imited partners, 7, 493 imited partnerships, capital for, 572, 573 characteristics of, 572 financial liabilities of, 573 life of, 573 private equity funds as, 493 inear programming, 402 ine of best fit, 225–226 ines of credit, 461–462 intner, John, 563 iquidating dividend, 547 iquidation value of a business, 582–583 iquidity, 30, 444 marketability vs., 30 in money markets, 31 of seasoned vs unseasoned stocks, 481 iquidity discounts, 585n.3 iquidity position, 87–88 iquidity ratios, 87–90 isted stocks, 272 LCs, see Limited liability companies LPs (limited liability partnerships), oans See also Bank loans amortizing, 172 estimating current cost of, 418 from factors, 462–463 from family and friends, 474 impact of inflation on, 40–42 interest rates on, 148–149 mortgage, 267–269 no documentation, 269 pricing model for, 495–496 prime-rate, 494–495 risk-free, 659n.5 secured loans, 462 securitization of, 267 short-term, 461–462, 496 true cost of, 186–187 unsecured, 462 when starting a business, 474, 494–496 Loan pricing model, 495–496 Lockbox systems, 457–458 London Interbank Offer Rate (LIBOR), 690 London Stock Exchange, 31, 272, 673, 677 Long-term assets: on balance sheet, 54–55 cash flow invested in, 69–70 funding of, 460 See also Raising capital Long-term debt: book value and market value for, 58 cost of, 415–420 in financial planning models, 619 financing with, 459–460 as source of cash, 64 Long-term equity, 64 Long-term funding strategy, 460 Long-term liabilities, 55, 64 Long-term solvency ratios, 93 See also Leverage ratios Lowest-cost method of sale, 489 Lumpy assets, 623–625 M MACRS (Modified Accelerated Cost Recovery System), 357–361 Maintenance conflict, 539–540 Management See also Financial management of current assets, venture capitalists’ involvement in, 479 Management team: in business plan, 579 and private equity investment, 494 Managers See also Financial managers agency relationship of stockholders and, 14 aligning interests of stockholders and, 14–16, 555–556 compensation of, 15 competition among, 16 control of firm by, 13–14 financial analysis for, 83 incentives for, 15, 16 payoff function for, 660–661 shift in behavior of, 18 specialization of, 572 as stakeholders, and stockholder-lender agency costs, 524 and stockholder-manager agency costs, 523 stock price affected by decisions of, 12, 13 views of stock repurchases, 563 waste of money by, 518 Managerial labor market, 15 Mandatory contingent projects, 304 Manning, Robert, 198 Manufacturing companies, revenues of, 60 Marginal tax rate, 72–73, 344, 356, 357, 364 Markets See also Financial markets bond, 239–240, 690–691 broker, 273 dealer, 273 direct search, 273 efficiency of, 33–34, 272–273, 415 foreign exchange, 677–685 historical performance of, 211–214 informal, 677 options, 32 stock, 225, 270–276 Marketability, 30, 255, 595 Marketability discount, 584–585 Marketability risk premium (MRP), 255 Marketable securities, 53, 444 Market analysis, in business plan, 579 Market approaches to business valuation, 584–588 income approaches vs., 588 multiples analysis, 584–588 transactions analysis, 584, 588 Market capitalization, 272 Market economies, 675 Market extension projects, 434 Marketing and sales, in business plan, 579 Market operational efficiency, 33 Market portfolio, 225 Market rate of interest, 244 Market risk, 225 See also Systematic risk Market risk premium, 228, 410, 422 Market-to-book ratio, 100–101 Market value (MV), 50, 57 of assets, 57–58, 411–412 book value vs., 57–58 of common stock, 56 of liabilities, 58 of stockholders’ equity, 58 in WACC, 428 Market-value balance sheet, 58–60 Market-value ratios, 89, 100–101 Marking to market, 57 MAT (term to maturity), 495 Matching maturities, see Maturity matching strategy Matching principle, 51, 67–68 Material information, 299 Mature companies, valuation of, 595–596 Maturity: fixed, 290–291 yield to, 241, 248–249, 251 Maturity date (bonds), 245 Maturity matching strategy, 459, 460 Maximizing shareholder wealth, 676 Maximizing stock value, 12 MBSs (mortgage-backed securities), 267–269 Mean, 208–209 Mega Millions lottery game, 125 Merchandising companies, 60 Mergers, 272, 341 Metering of services, 540 Mezzanine financing, 477 Michigan State University, 199 Microsoft Excel, 127 for bond prices/yields, 245 business valuation templates, 585 Cash Flow Template, 575 and changes in assumptions, 388 for free cash flow, 348, 364 for internal rate of return, 321 and leverage model, 512 loan amortization tables, 174 for Monte Carlo simulations, 398 and multistage-growth dividend model, 426 for net present value, 312 for time value of money, 138 Miller, Merton, 506, 514, 554 Minneapolis Fed, 495 Minority ownership interest, 596 MIRR (modified internal rate of return), 325–327 Mixed (supernormal) growth dividend model, 286–289, 424–426 M&M propositions, see Modigliani and ndd Page 739 8/8/11 10:44:24 AM user-f396 F-396 LibraryPirate Subject Index Modified Accelerated Cost Recovery System (MACRS), 357–361 Modified internal rate of return (MIRR), 325–327 Modigliani, Franco, 506, 514, 554 Modigliani and Miller (M&M) propositions, 506–514 proposition 1, 506–509 proposition 2, 509–513 Money, value of, 40n.6 See also Foreign exchange rates; Time value of money Money center banks, 28 in foreign exchange market, 677 in private placements, 492 Money markets, 31, 32, 689–691 Monte Carlo simulations, 398 Mortgage-backed securities (MBSs), 267–269 Mortgage brokers, 267 Mortgage market, subprime, 267–269, 280 Motley Fool, 277 MRP (marketability risk premium), 255 MSN Money Central, 86, 227, 270, 422, 424 Multinational corporations, 673, 674 See also International finance management Multiples analysis, 584–588, 595, 596 Multiple cash flows, 160–166 future value of, 160–163 present value of, 163–166 Multistage-growth dividend model, 424–426 Mutual funds, 36 Mutually exclusive projects, 304, 312 with different lives, 365–367 IRR vs NPV methods for, 324–325 MV, see Market value N NAICS (North American Industry Classification System), 106 NASA, 656 NASD (National Association of Securities Dealers), 272 NASDAQ, 8, 31, 272, 273, 562 NASDAQ Composite Index, 211, 274 National Association of Insurance Commissioners, 503 National Association of Securities Dealers (NASD), 272 National Association of Securities Dealers Automated Quotation system, see NASDAQ Nationalization, 686 National Venture Capital Association (NVCA), 475 NCF, see Net cash flow Negative correlation, 220 Negotiated sales, 489–490 Net cash flow (NCF), 308, 314 See also Incremental after-tax free cash flows Net income, 60–62 cash flow to investors vs., 67–70 and decrease in revenue, 511 differing from cash flows, 510n.7 dollar value of, 529 and operating leverage, 511–512 on statement of cash flows, 64, 65 Net plant and equipment, 54 Net present value (NPV): agreement of IRR and, 321–322 calculation of, 309–312 disagreement of IRR and, 322–325 of free cash flow, 352–353 in international finance, 676 IRR vs., 327–328 of leasing opportunities, 540–543 payback period vs., 317 of projects with different lives, 365–366 and replacing of assets, 368–369 in risk analysis, 395–397 and use of existing assets, 370 Net present value (NPV) method, 306–313 calculation of NPV, 309–312 for cash flows, 347 concept of, 306 expected cash flows in, 362 for financial vs real assets, 306 framework for, 307–309 as practitioners’ method of choice, 329 and value creation, 307–309 and value of options, 655–658 Net proceeds (bonds), 417 Net profit margins, 97–98 of discount retailers, 81–82 in DuPont system of analysis, 102 Net sales, 85 Net working capital (NWC), 4, cash flow invested in, 68–69 on financial statements, 53–54 in working capital management, 443, 450–451 Net worth, 52n.2 See also Stockholders’ equity New businesses, see Business formation New product projects, 434 New York Board of Trade, 32 New York Stock Exchange (NYSE), as auction market, 273 as capital market, 31 corporate bonds on, 239 financial market classifications for, 30 as foreign exchange market, 677 overcompensation by, 669–670 as public market, 31 and reverse stock splits, 562 as secondary market, 271, 272 transparency of, 240 Wall Street Journal listings for, 274–275 Web site, 8, 272, 275 New York University, 693 NGOs (nongovernmental organizations), 379 NOA (nonoperating assets), 588–589 No documentation (no-doc) loans, 269 Nominal, use of term, 41n.7 Nominal cost of capital, 354 Nominal dollars, 353–355 Nominal rate of interest, 38, 676 Noncash expenses, 62, 68 Noncash revenues, 68 Nonconvertible bonds, cost of issuing, 490, 491 Nonconvertible preferred stock, 276 Nondiversifiable risk, 223 See also Systematic risk Nongovernmental organizations (NGOs), 379 Noninvestment-grade bonds, 257 Nonoperating assets (NOA), 588–589 NOPAT (incremental net operating profits after tax), 345–348, 352 Normal distribution, 208–210 Normal trading range, 562 North American Industry Classification System (NAICS), 106 Notes payable, as current liability, 53 Not-for-Profit Corporation Law (New York), 670 739 NPV method, see Net present value method NPV profile, 321–323, 325 NVCA (National Venture Capital Association), 475 NWC, see Net working capital NYSE, see New York Stock Exchange NYSE Euronext, 272 O Odd lots (of shares), 561–562 Offer price, 273, 489 Oil industry, options to defer in, 655–656 OMX Group, 272 One-period model (stock valuation), 277–278 Ongoing reviews of projects, 329 Open-market repurchases, 553, 554, 558 Operating activities: cash flow from, 68, 70–71 on statement of cash flows, 64, 65 Operating cycle, 446–448 accounts receivable in, 452–454 inventory management in, 455–456 Operating leases, 536 Operating leverage, 388–391 Accounting DOL, 389–391 Cash Flow DOL, 389, 391 in international finance, 676 and net income, 511–512 Operating profits, see Accounting profits Operating shortage costs, 450 Operations: in business plan, 579 options to change, 656–657 Operational efficiency, market, 33 Op Ex, see Incremental operating expenses Opportunity costs, 242, 305, 351 Opportunity cost of capital, 305 Opportunity loss, 485 Optimal capital structure, 505–506, 520, 676 Options, 641–663 agency costs of, 658–661 and compensation, 669–670 financial, 643–654 real, 655–658 and risk management, 662 value of, 646–654 Optional contingent projects, 304 Options markets, 32 Option payoff function, 643–646 Options to abandon projects, 657 Options to change operations, 656–657 Options to defer investment, 655–656 Options to make follow-on investments, 656 Option writers, 32 Ordinary annuities, 167 Organizational form, see Forms of business organization “Organized” markets, 31 See also Exchanges Origination, 28, 481–482 OTC markets, see Over-the-counter market(s) Otellini, Paul, 301 Out-of-pocket costs, 417 direct bankruptcy costs as, 521 economies of scale in, 491 with IPOs, 486 Outright sales, leases vs., 536 Outside directors, 17 Overall cost of capital, 410–415 See also Weighted average cost of capital (WACC) estimating, 413–415 ndd Page 740 8/8/11 10:44:24 AM user-f396 740 F-396 LibraryPirate Subject Index Overcompensation, 669–670 Over-the-counter (OTC) market(s), 31, 239, 240, 272 Owners: agency conflict between managers and, 14 cash flows between stakeholders and, decisions in interest of, double taxation of, Owners’ equity, 52n.2 See also Stockholders’ equity Ownership: control vs., 13–14 separation of control and, 573 and stock repurchases, 551 transfer of, 572 Ownership interest, 573, 596 Ownership rights, with common stock, 55 Ownership structure, in business plan, 579 P Partnerships, characteristics of, 572 life of, 573 limited liability, maximizing stock value for, 12 taxation of, Partnership agreements, 572, 573 Par value, 56, 240 Par-value bonds, 244 Payables, see Accounts payable Payable date, 550 Payback period, 313–317 in capital budgeting, 315–316 computing, 313–315 discounted, 316–317 NPV method vs., 317 Payments: annuity, 170–172 cash collection cycles for, 457 as cash outflows, 63 coupon, 240 dividend, 548–551, 558–559 end-of-month, 453 frequency of bond, 245 Payoff functions: and agency conflicts, 658–661 for options, 643–646 Payout policy, 546, 609, 612 PCs (professional corporations), Pecking order theory, 526–528 Peer group analysis, 106–107 Pension funds, 36 P/E ratio, see Price-earnings ratio Percent of sales model, 613–615 Performance analysis, 108–111 Permanent debt, 416 Permanent working capital, 459, 460 Perpetuities, 167, 179–180 common stock as, 276 growing, 183–184 preferred stock as, 291 present value of, 281 Perpetuity model: for stock valuation, 278–279, 427 for tax benefit of debt financing, 515–516 Personal investment, by entrepreneurs, 477 Per-unit contribution, 392 PI (profitability index), 399–402 PIPE (private investments in public equity), 494 Planet Ventures II, LP fund, 569 Popeil, Ron, 607n.1 Portfolios, 214 CAPM and returns on, 230–231 market, 225 with more than one asset, 217–222 replicating, 650–652 risk and diversification of, 214–224 single-asset, 215–217 Positive correlation, 220, 222 Positive time preference for consumption, 38 Posts, 273 Postaudit reviews, 329 Preferred stock, 56–57, 276 convertible, 654 cost of equity for, 426–428 as debt vs equity, 276 with fixed maturity, 290–291 nonconvertible, 276 as perpetuities, 179, 180, 291 valuation of, 290–291 for venture capitalists, 477 Preliminary prospectus, 481 Premiums: call, 644 call interest, 256 control, 596 default risk, 256, 495 forward, 683–684 inflation, 41–42 marketability risk, 255 market risk, 228, 410, 422 Premium bonds, 244 Prepaid expenses, 68 Present value (PV), 33, 140–147 See also Net present value applying formula for, 142–144 of cash flows, 506 of exercise price, 648 with financial calculators, 145–146 future value vs., 142, 146–147 of multiple cash flows, 163–166 relations among time, discount rate, and, 144–145 Present value equation, 142, 163–164 Present value factor, 140, 145, 168–169 Present value of an annuity (PVA), 167–177 for annuities due, 182 with financial calculator, 169–170 interest rate, 174–177 loan amortization schedule, 172–174 monthly/yearly payments, 170–172 present value factors, 168–169 Pretax cost of debt, 418, 419, 509n.5 Pretax earnings, 351 Pretax operating cash flow, 382 See also EBIT plus depreciation and amortization (EBITDA) Pretax operating cash flow (EBITDA) break-even point, 391–393 Price-earnings (P/E) ratio, 100, 275, 584, 585, 587 Price/revenue ratio, 584, 585, 587 Price risk, 31, 273, 482, 662 Pricing: of bank loans, 495–496 of Eurocredit loans, 693–694 of IPOs, 485–488 of leases, 540 Pricing call, 483 Primary markets, 30 Prime rate of interest, 494–495 Principal (agency), 14, 523 Principal (amount), 129, 240, 241 deferred payment of, 521 in future value analysis, 127, 128 Private equity firms, 493–494 Private equity funds, 493 Private information, 34 Private investments in public equity (PIPE), 494 Privately held companies: business valuation for, 594–595 dividend payment process for, 550, 551 financial statements of, 594–595 transactions analysis for, 588 Privately held corporations, 8, 12 Private markets, 32 private equity firms, 493–494 private investments in public equity, 494 private placements, 32, 492–493 public markets vs., 492 raising capital in, 491–494 Private placements, 32, 492–493 Products and services, in business plan, 579 Product extension projects, 434 Production, globalization of, 673 Productive assets, 2–3 See also Long-term assets financing of, purchasing, 4, for venture capital funding, 475 Productivity ratios, 87 Professional corporations (PCs), Professional partnerships, Profits, 631 See also Accounting (operating) profits; Net income incremental net operating profits after tax, 345–348, 352 maximization of, 11–12 of multinational companies, 671 Profitability: and amount of debt, 528 and inventory level, Profitability index (PI), 399–402 Profitability ratios, 89, 97–99 Profit margins: asset turnover vs., 102–103 net, 81–82, 97–98, 102 Pro forma financial statements, 613–615 balance sheet, 614–615, 617–622 final, 621–622 income statement, 613, 616–617 preliminary, 619–621 Progressive tax system, 356 Project costs, 308, 309 Project economics, 381–398 break-even analysis, 391–395 cost structure and project risk, 381–388 operating leverage, 388–391 risk analysis, 395–398 Project risk, 381–388 analysis of, 395–398 determining, 309 scenario analysis, 396–397 sensitivity analysis, 395–396 sensitivity of EBITDA to revenue changes, 382–385 sensitivity of EBIT to revenue changes, 385–388 simulation analysis, 387–398 variable and fixed costs’ effect on, 381–388 Promised yield (bonds), 249 ndd Page 741 8/8/11 10:44:25 AM user-f396 F-396 LibraryPirate Subject Index Pro-rata basis (dividends), 546 Public accounting firm scandals, see Accounting firm scandals Public announcement (dividend payment), 548, 549 Public companies See also Initial public offerings (IPOs) business valuation for, 594–595 dividend payment process for, 548–550 dividend payments vs stock repurchases by, 558–559 financial statements of, 594 new regulations for, 17 PIPE transactions by, 494 transparency of, 480 Public corporations, See also Corporations Public information, 34 Public markets, 8, 31–33 See also Initial public offerings private markets vs., 492 as wholesale markets, 491 Public offerings, 479 See also Initial public offerings; Securities registered, 488 See also General cash offers seasoned, 479, 481 Purchasing power, 40, 354, 355 Pure-play comparables, 433 Put-call parity, 652–653 Put options, 644 early exercise of, 648n.2 exercising, 645 as “insurance,” 662 real, 655 Put premium, 644 PV, see Present value PVA, see Present value of an annuity Q Quick ratio, 88–89 Quoted interest rate, 185, 186 R r (real cost of capital), 354 Raising capital, 472–497 with bank loans, 494–496 by bootstrapping, 473–474, 492 business plan in, 578–579 for cash-constrained companies, 578–579 with company owned life insurance, 502–503 with general cash offers, 488–491 with initial public offerings, 479–488 for multinational companies, 672 in private markets, 491–494 for starting business, 473–474 from venture capitalists, 474–479 Range of returns, 210–211 Rapidly-growing companies, valuation of, 595–596 Rate of return: accounting, 318 book value, 318 internal, 318–328 modified internal, 325–327 and risk, 201–202 risk-free, 216, 227–228, 421 Raw materials inventories, 444 Real, use of term, 41n.7 Real assets, 25, 305, 306 Real cost of capital (r), 354 Real investment policy, 506 Realization principle, 50–51 Realized rate of inflation, 41 Realized yield (bonds), 252 Real options, 642, 655–658 to abandon projects, 657 to change operations, 656–657 to defer investment, 655–656 to make follow-on investments, 656 and NPV analysis, 657–658 value of, 658 Real rate of interest, 38–40, 259 Receipts, 63 Receivables, see Accounts receivable Recessions, 43 Reconciliation, 65, 614 Record date, 550 Redemption (bonds), 245 Registered public offerings, 488 See also General cash offers Regression analysis, 225–226 Regular cash dividends, 547, 558 Regulation, 16–18 See also Laws consumer protection acts, 187–188 managers’ decisions influenced by, 16 of private equity firms, 494 reforms in, 16–18 requiring capital expenditures, 303 Reinvestment of residual cash flows, Renewal of assets, 303 Rental agreements, 535 Reorder costs, 455 Repatriation of earnings restrictions, 685–686 Replacement cost, 581–582 Replacement cost valuation approach, 581–582 Replacement of assets, 303, 368–369 Replicating portfolios, 650–652 “Report to the Congress on College Credit Card Agreements,” 199 Required return, 509n.5 See also Cost of debt; Cost of equity Resale of securities, with private placements, 492–493 Residual cash flows, Resource constraints, 305 Restricted securities, 494 Restrictions, on leased assets, 540 Restrictive current asset investment strategy, 450 Restructuring, financial, 507, 508 Retained earnings: cash vs., 56 events affecting, 63 in financial planning models, 619 statement of, 63, 66–67 Retained earnings account, 56 Retention (plowback) ratio, 617 Return on assets (ROA): in DuPont system of analysis, 101–103 EBIT, 98, 99 for multiple-asset portfolios, 217–222 for single-asset portfolios, 215–217 Return on equity (ROE), 87, 99 in DuPont system of analysis, 103 maximization of, 104, 105 M&M proposition in calculation of, 512, 513 Return on investment, 201–207 See also Rate of return on bonds, 422 See also Yields, bond calculating, 205–206 741 on IPOs, 485–486 quantitative measures of, 202–207 and rate of interest, 38 for single-asset portfolios, 215–217 and standard deviation, 210–211 on stocks, 422 and systematic risk, 224 for venture capitalists, 479 Revenue(s): deferred, 68 in FCF calculation, 346, 347, 352–353 forecasting, 379 on income statement, 60 incremental net, 363 matching expenses and, 51 noncash, 68 recognition of, 50–51, 67–68 Revenue changes: EBITDA sensitivity to, 382–385 EBIT sensitivity to, 385–388 fixed costs and, 382 Reverse stock splits, 562 Review of projects, 329 Revolving credit, 461 Rights: to assets, 535, 539 with common stock, 55 Right to buy (leased assets), 540 Risk See also specific types avoiding, 11 with cash flows, 12 and choice of capital structure, 528 with debt financing, and diversification, 214–224 and expected return, 229, 231 and financial planning models, 615 and flight to quality, 492 with international bank lending, 692–693 measures of, 207–214 with portfolio having more than one asset, 218–222 and rate of return, 201–202 with seasoned vs unseasoned securities, 481 with single-asset portfolios, 215–217 and stockholder-manager agency costs, 523 and structure of interest rates, 255–257 with underwriting, 29 with venture capital funding, 475, 477 Risk analysis, 395–398 Risk-free bonds, 659n.5 Risk-free loans, 659n.5 Risk-free rate of interest (options), 648, 649 Risk-free rate of return, 216, 227–228, 421 Riskglossary.com, 290 Risk management, 662 Risk Management Association, 106 Risk managers, 9, 10 ROA, see Return on assets Road show, 482–483 ROE, see Return on equity Rollover pricing, 694 Round lots (of shares), 561–562 Rule 144A, 492–493 Rule of 72, 150 Russia, 18–19, 43 S , see Standard deviation 2, see Variance ndd Page 742 8/8/11 10:44:25 AM user-f396 742 F-396 LibraryPirate Subject Index ales: of assets, 361 and leases, 536, 539–543 and working capital, 623, 624 allie Mae, 198 alvage rights, 535 alvage value, 360, 361 amurai bonds, 690 arbanes-Oxley Act (2002), 16–18, 48, 494 avings and loan industry, 525 caling, 84, 87 candals, accounting firm, 16, 122–123 cenario analysis, 396–397 chultz, Howard, 606 chumer, Charles E., 267 -corporations, 8, 571, 572 easonal working capital, 458–460 easoned public offerings, 479, 481 See also Securities Seat-of-the-pants” forecasts, 611 EC, see Securities and Exchange Commission econdary markets, 30, 271–273 corporate bonds transactions in, 239 efficiency of, 272–273 transactions in, 271–272 types of, 273 econd Valuation Principle, 580–581 ecured loans, 462 ecurities See also Bonds; Stocks derivative, 32, 643 in direct financing, 27–29 fixed-income, 240–241 historical returns on, 211–214 issuing, 63, 417, 490–491, 518, 526 marketability of, 255 marketable, 53, 444 and market efficiency, 33–34 mortgage-backed, 267–269 options associated with, 653–654 public offering of, 479–480 See also Initial public offerings restricted, 494 seasoned vs unseasoned, 481 treasury, 256, 258, 421, 495 and types of financial markets, 30–32 unregistered, 32, 492–493 U.S government, 227 ecurities Act (1933), 16 ecurities and Exchange Commission (SEC), 8, 50, 549 and Arthur Andersen scandal, 122–123 compliance and ethics directors required by, 10 cost of compliance with, 480 depreciation expense reporting for, 61, 62 EDGAR database of, 49, 611 external auditors required by, 10 filing of financial statements with, 588, 594 financial statements in documents filed with, 356 general cash offer registration statements for, 488 and IFRS adoption, 51 IPO requirements for, 479, 481 PIPE registration with, 494 and private equity firms, 494 private placements limited by, 492–493 public markets regulated by, 31–33 registering securities with, 28, 481–483 shelf registrations allowed by, 490 and Martha Stewart trading case, 299, 300 Securitization of mortgage loans, 267 Security Market Line (SML), 228–229, 431–432, 650 Seed money, 474 Seendripu, Kishore, 380, 381 Selling groups, 482 Semiannual compounding (bonds), 246–248, 416–417 Semistrong-form, efficient market hypothesis, 34 Sensitivity analysis, 395–396 September 11, 2001 terrorist attack, 58 Service companies, 60 Service contracts, 540 Settlement date (bonds), 245 SGR (sustainable growth rate), 629–631 Shanghai Stock Exchange, 272 Shareholders’ equity, 52n.2 See also Stockholders’ equity Sharpe, William, 217 Sharpe Ratio, 217 Shelf registration, 490 She’s Gotta Have It (film), 474 Shortage costs, 450 Short-term assets, 460 See also Working capital Short-term financing sources, 461–463 Short-term funding strategy, 460 Short-term liabilities, book value and market value for, 58 Short-term liquidity ratios, 87–90 Short-term solvency ratios, 88 SIBOR (Singapore Interbank Offer Rate), 690 SIC (Standard Industrial Classification) System, 106 Simple interest, 128–130, 129, 185 Simulation analysis, 397–398 Singapore Interbank Offer Rate (SIBOR), 690 Single-asset portfolios, returns for, 215–217 Sinking fund provisions, 276 Size factor, 87 Small Business Administration, 571 SML, see Security Market Line Social communication, 675 Sole proprietorships, 6–7 capital for, 572, 573 characteristics of, 572 financial liabilities of, 573–574 life of, 573 taxation of, Sovereign nations, 675n.1 Soviet Union, 675 S&P 500, see Standard & Poor’s 500 Index Special dividends, 547 Specialists, 273 Specialization (venture capitalist’s), 477 Speculation, foreign exchange, 685 Speculative-grade bonds, 257 Spin-offs, 524 Spitzer, Eliot, 670 Spot rate, 680–682 Spread: bid-ask, 680–681 of borrowing and lending rates, 26 on securities, 273 Spreadsheet programs, 138 See also Microsoft Excel Staged funding (venture capital), 477 Stakeholders, 2, Stand-alone principle, 344–345 Standard deviation (), 207–211, 208 for portfolios with more than one asset, 221, 223 Standard Industrial Classification (SIC) System, 106 Standardized financial statements, 84 Standard & Poor’s (S&P) 500 Index, 211, 213, 225–227, 274, 328, 479 Starting a business, see Business formation Stateless corporations, 673 Statement of cash flows, 63–67 Statement of retained earnings, 63, 66–67 Stewart, Martha, 299, 300 Stillwagoner, Peggy, 503 Stocks See also related topics, e.g.: Stock valuation common, see Common stock convertible preferred, 654 cost of equity for, see Cost of equity cost of issuing, 490, 491 dividends from, 560–562 dollar value of earnings per share, 529 financial statements and performance of, 48–49 growth, 280, 286–289 historical returns on, 211–214 issuance costs for, 518, 526 listed, 272 odd vs round lots of, 561–562 preferred, see Preferred stock Treasury, 56 yields, 275, 291 Stock dividends, 560–562 Stock exchanges, see Exchanges Stockholders: agency conflicts with, 14, 19 cash flows available to, 591–594 dividends and claims of, 546–547 FCF as focus of, 344 financial analysis for, 82 interests of management and, 14–16, 555–556 limited liability of, manager monitoring by, 16 payoff functions for, 659–661 for S-corporations, 572 stock repurchases vs dividends for, 551 Stockholders’ equity: on balance sheet, 52 in balance sheet identity, 411–412 book value and market value of, 58 and cash flow, 59 maximizing, 12 Stockholder-lender agency costs, 524–526 Stockholder-manager agency costs, 523 Stockholder of record, 550 Stock market, 271–276 as benchmark for systematic risk, 225 flash crash, 270 reading listings for, 274–275 Stock market indexes, 211–214 Stock prices See also Stock valuation from balance sheet, 58 current listing of, 424 and dividend announcements, 550, 557–558 ex-dividend date and drop in, 549–550 future, 284–286 growth stocks, 280, 286–289 major factors affecting, 13 and management decisions, 12, 13 in market valuation approaches, 584 maximizing, 12 and ownership vs control of firm, 14 and size of dividends, 555–556 ndd Page 743 8/8/11 10:44:26 AM user-f396 F-396 LibraryPirate Subject Index Stock repurchases, 545, 551 dividends vs., 551–552, 558–559 managers’ views on, 563 process for, 553–554 targeted, 553, 554 taxes on, 552 Stock splits, 561–562 Stock valuation, 270–293 common stock, 276–280 computing future stock prices, 284–286 constant-growth dividend model, 281–284, 286 and insider trading, 299–300 in international finance, 676 mixed growth dividend model, 286–289 preferred stock, 290–291 relationship between R and g, 285, 286 of seasoned vs unseasoned stocks, 481 simplifying assumptions in, 281–289 and stock markets, 271–276 zero-growth dividend model, 281 Straight-line depreciation, 55, 61–62, 358 Strategic buyers, 478 Strategic investors, 580 Strategic plan, 303, 608–609 Strategic planning, 608 Strike price, see Exercise price Strong-form, efficient market hypothesis, 33–34 Student debt, 198–199 StudyFinance.com, 163 Subchapter S corporations, Subprime mortgage market, 267–269, 280 Sunk costs, 351 SuperDOT trading system, 273 Supernormal growth dividend model, 286–289, 424–426 Suppliers: indirect bankruptcy costs from, 522 as stakeholders, Supply curve, 680 Sustainability, 378–379 Sustainable Agriculture Code, 379 Sustainable growth rate (SGR), 629–631 Sustainable Living Plan, 378–379 Syndicates, underwriting, 482, 483 Syndication, 477 Synergies, value of, 580–581, 587 Systematic risk, 223–228 associated with stock, 422 beta, 226–230 compensation for bearing, 227–228, 410 and cost of capital, 413 line of best fit, 225–226 measuring, 225–227 nature of business and, 432 Systematic volatility, 432–433 T t (firm’s marginal tax rate), 344 Takeovers, 16 Tangible assets, 2, 54, 345 capital structures of companies with, 527 cash flows associated with, 345–346 depreciation of, 55 Targeted stock repurchases, 553, 554 Taxes See also Income taxes; related topics, e.g.: Earnings before interest and taxes (EBIT) accelerating depreciation for, 61 accrued, 53 capital gains, 556 deferred, 68 and depreciation, 356–359 for different forms of business, 572 on dividends, 73, 549, 552, 556 and excess compensation, 595 in foreign countries, 674 and interest, 418, 514–518 in international finance, 676 on leased assets, 536–537 on life insurance policies, 502, 503 on limited liability companies, 574n.1 on limited liability partnerships, and organizational form, 574 on owners of corporations, on partnerships, on sale of assets, 361 on sole proprietorships, on stock repurchases, 552 on Subchapter S corporations, Tax rates: average, 72–73, 356, 357 and depreciation of free cash flows, 355–359 marginal, 72–73, 344, 356, 357, 364 progressive, 356 and real interest rate, 40 Tax Reform Act (1986), 72, 357 TDM (time to double your money), 150 TeachMeFinance.com, 125 Technology, real interest rate and, 40 Tender offers, 553, 554 Terminal value (TV), 325–327, 589 Terminal-year FCF, 359–362 Term loans, 495, 496 Terms of sale, 452–454 Term structure of interest rates, 258–259 Term to maturity (MAT), 495 Thin market, 239 Three-period model (stock valuation), 279 Tillman, Anthony, 502 Tillman, Felipe, 502 Time interest earned, 96 Time lines: for calculating NPV, 308 for time value of money, 126 Time periods, in future value equation, 149–150 Time preference for consumption: positive, 38 and rate of interest, 38 and time value of money, 125–126 Time to double your money (TDM), 150 Time-trend analysis, 89 Time value of money, 124–153, 125 applying future value formula, 132–137 applying present value formula, 142–144 compound growth rates, 150–152 compounding, 132–137 finding interest rate, 148–149 future value, 127–139 future value equation, 129–131 future value factor, 131–132 future value vs present value, 142, 146–147 growth rates, 149–152 in international finance, 676 investment growth rates, 149–152 and positive time preference for consumption, 125–126 present value, 140–147 present value equation, 142 743 relations among time, discount rate, and present value, 144–145 Rule of 72, 150 time lines illustrating, 126 and value of call options, 647–648 Time zero, 126, 146, 147 Tokyo Stock Exchange, 31, 272, 673, 677 Toronto Stock Exchange, 272 Total asset turnover, 92–93, 102 Total debt ratio, 94, 95 Total equity risk, 510–511 Total holding period return, 202–203 Total simple interest (TSI), 130 Total volatility, 432 “Tracking stock,” 433n.9 Trade credit, 444–445 cost of, 453 as short-term financing, 461 terms of sale, 452–454 Trade-off theory, 520, 526–528 Trading range argument, 561–562 Transactions analysis, 584, 588 Transaction costs, 30, 33 direct bankruptcy costs as, 521 of dividends, 556–557 indirect bankruptcy costs as, 522 for leasing, 537 for shares in public vs private companies, 595 Transaction costs argument (stock splits), 562 Transfer of ownership, forms of business and, 572 Transnational corporations, 673 See also International finance management Transparency, 19n.8 and company-owned life insurance, 503 of financial markets, 240 of public companies, 480 Treasurer, 9, 10 Treasury securities, 256, 258, 421, 495 Treasury stock, 56 Trend analysis, 83, 106 Trial-and-error IRR calculation, 319–321 True (intrinsic) value, 33, 588 Truth-in-Lending Act (1968), 185, 187, 188 Truth-in-Savings Act, 187 Truth in Securities Act, 16 TSI (total simple interest), 130 TV (terminal value), 325–327, 589 Two-period model (stock valuation), 278 U U.K GAAP, 51 Uncertainty, see Risk Unconventional cash flows, 322–324 Underinvestment problem, 525, 660 Underlying assets (options), 643, 646–649 current value of, 646–648 volatility of the value of, 648 Underpricing, 485–486 Underwriter’s compensation, 29 Underwriting, 29 for competitive vs negotiated sales, 489 as investment banking service, 481–483 Underwriting spread, 29, 482, 486, 491 Underwriting syndicates, 482, 483 United Kingdom, 675 United States: bond coupon interest in, 246 corporate tax system in, 355–357 inflation and real interest rate in, 43 ndd Page 744 8/8/11 10:44:26 AM user-f396 744 F-396 LibraryPirate Subject Index U.S Department of Commerce, 106, 686 U.S Department of the Treasury, 72 U.S dollar, 689 U.S Federal Reserve Bank, 421, 462 U.S Justice Department, 123 U.S Small Business Administration, 393 U.S Treasury bills, 211–214, 216, 255, 422 U.S Treasury bonds, 241, 422 United States Saving Bonds, 241 Unit sales: in break-even analysis, 391–395 in EBIT, 386 in EBITDA, 384–385 University of Notre Dame du Lac, 199 University of Southern California, 199 University of Tennessee, 199 Unregistered securities, 32, 492–493 Unsecured loans, 462 Unsystematic risk, 223, 225, 227, 410 V Valuation: of bonds, see Bond valuation of business, see Business valuation of financial options, 646–654 of inventory, 54 of stocks, see Stock valuation of young vs mature companies, 595–596 Valuation date, 580 Value: of asset to lessor, 535–536 book, see Book value dollar value of earnings per share, 529 dollar value of net income, 529 enterprise, 506, 585–586 face, 240 fair market, 581, 582, 587 of firm, see Firm value future, see Future value going-concern, 582 intrinsic, 33, 588 investment, 581, 587, 588 liquidation, 582–583 market, see Market value of money, 40n.6 See also Time value of money net present, see Net present value par, 56, 240 present, see Present value salvage, 360, 361 of synergies, 580–581, 587 terminal, 325–327, 589 of underlying assets, 646–648 Value additivity, 653 Value creation, 302, 307–309 Value proposition, 476 Vanilla bonds, 240, 489 Variable costs (VC), 363 in calculating EBIT, 385–388 in calculating EBITDA, 382–385 and project risk, 381–388 Variance (2), 207–210, 208 in international finance, 676 for portfolios with two assets, 219–222 VC, see Variable costs Venture capital, 474–479 advice from lenders of, 479 cost of funding, 479 funding cycle for, 476–478 in private markets, 492 traditional funding vs., 475 Venture capital industry, 474, 475 Venture capitalists, 474, 477, 479 Verbal agreements, 461 Volatility: of bond prices, 253, 254 of EBIT, 390 of EBITDA, 390 and nature of business, 432 of portfolios, 218, 219 total vs systematic, 432–433 underpricing to reduce, 485 of the value of the underlying asset, 649 W WACC, see Weighted average cost of capital Waksal, Sam, 299, 300 Wall Street Journal, 34, 274–275, 422, 523, 584, 586, 672, 680, 681, 683 Warrants, 654 Weak-form, efficient market hypothesis, 34 Wealth, Wealth transfer, 524, 558 Webb, Dan, 670 Weighted average cost of capital (WACC), 414–434 alternatives to using, 433–434 calculating, 428–430 and capital structure, 506 cost of debt in, 415–420 cost of equity in, 421–428 effect of debt on, 517–519 in FCFF approach, 589–590 in international finance, 676 interpreting, 430 limitations as a discount rate, 430–433 minimizing, 514 and M&M proposition 2, 509 Weighted average first-day return (IPOs), 486 Whistleblower programs, 10 Wikipedia, 645 Working capital, 443 See also Incremental additions to working capital (Add WC) gross, 443 Investment strategies for, 450–451 net, 4, 6, 53–54, 68–69, 443, 450–451 permanent, 459, 460 seasonal, 458–460 on statement of cash flows, 65 and use of cash, 64 use of term, 443 Working capital accounts, 444–445, 618–619, 623, 624 Working capital efficiency, 444 Working capital management, 3, 441–465 accounts and trade-offs in, 444–445 accounts receivable, 452–454 cash conversion cycle in, 445–446, 448–449 cash management and budgeting, 456–458 decisions in, financing working capital, 458–463 in international finance, 676 inventory management, 455–456 investment strategies in, 450–451 operating cycle in, 446–448 terms and concepts in, 443–444 use of term, 444 Working capital trade-offs, 444–445, 451 Wozniak, Steve, 472 Y Yahoo! Finance, 52, 240, 270, 423, 424 Yankee bonds, 690 Yields, bond: and bond pricing, 244, 245 effective annual yield, 250–251 realized yield, 252 yield to maturity, 241, 248–249, 251 Yields, stock, 275, 291 Yield curve, 258–259 Yield to maturity (bonds), 241, 248–249, 251 Young companies, valuation of, 595–596 Yuan, 689 Z Zero coupon bonds, 148, 240–241, 246, 247, 255 Zero-growth dividend model, 281 Zuckerberg, Mark, 472 ndd Page 745 8/9/11 1:30:42 PM user-f396 F-396 LibraryPirate Company Index A Accel Partners, 472 Accenture, 122 Acme United, 274, 275 Adams Resource & Energy, 274, 275 AdCare Health Systems, 274, 275 Adeona Pharmaceuticals, 274, 275 Advanced Micro Devices (AMD), 215–217 Advanced Photonix, 274, 275 AdvanSource Biomaterials, 274, 275 Advantage Medical Services, Inc., 503 ADVENTRX Pharmaceuticals, 274, 275 Aerocentury, 274, 275 Aerosonic, 274, 275 AIG Corporation, 669, 670 AirTran Airways, 341 Alexco Resource, 274, 275 Allied Nevada Gold, 274, 275 Almaden Minerals, 274, 275 Amazon.com, 690 AMD (Advanced Micro Devices), 215–217 Ameriquest Mortgage Company, 269 Anheuser-Busch InBev, Apple, Inc., 28, 48, 213, 287, 350, 351, 472, 504 Archers Daniels Midland Company, 374 Arthur Andersen LLP, 122–123 AT&T, 271, 328 Aura Mira Energy Company Private Limited, 569, 570 AXA Group, 674 B Banco Santander S.A., 692 Bank of America Corporation, 26, 28, 193, 414, 419, 674, 692, 698–700 Bank of India, 698 Barclays, 692, 698 Berkshire Hathaway, Inc., 562 Best Buy, 455 Biogenesis Inc., 192 Blackstone Group, Blockbuster Inc., 200 BMW, 50, 142–143, 304, 609, 690, 697 BNP Paribas, 692 Boeing Company, 5, 54, 83, 411, 434, 656, 699 Boston Chicken, Inc., 625, 631 Boston Market Corporation, 625 Bplans, 579 BP p.l.c (British Petroleum), 280, 673, 674 Bradley Corporation, 298 BrightStar Corporation, 501 Bristol Myers, 299 British Petroleum, see BP p.l.c Burger King, 625 Busch Entertainment Corporation, 1, 493n.6 C Cadbury PLC, 159, 160 Callan Associates, 202 Cargill Company, 492 Carlson Companies, 492 Caterpillar, Inc., 405, 699 CCH Incorporated, 308, 392, 570, 571 Chevron Corporation, 328, 674 China National Petroleum, 674 Chipotle Mexican Grill, 478 Chrysler LLC, 601 Cisco Systems, Inc., 117, 328, 504 Citibank, 694, 698, 699 Citigroup, 28, 669, 692 Colnago, 177–179 Colonial Realty, 122 Compaq, 673 ConocoPhillips Company, 422 Conseco, Inc., 117 Credit Agricole, 692 CSX Corporation, 548 D Dairy Queen, 29 Daiwa Bank, 698, 700 Datsun, 203 Dean Foods Company, 498 Dell, Inc., 202–205, 236, 304, 344, 345, 441–443, 446–448, 456, 504, 656, 673 Deloitte Touche, 122 Delta Air Lines, Inc., 93 Deutsche Bank, 642, 692, 699, 700 Domino’s IP Holder LLC, 422, 423 The Dow Chemical Company, 502, 503 Dun & Bradstreet, 106 Dunkin‘ Donuts, 606 DuPont Company, 101 E Edison Electric Company, 671 eFunda, 185 Enron Corporation, 16, 18–20, 48, 122, 123 Ernst & Young, 122 Exxon Mobil Corporation, 218, 673, 674 F Facebook Incorporated, 472, 473 FedEx, 411, 543 Fidelity Investment Company, 256 Fitch, Inc., 256–257 FITCO, 376 Ford Motor Company, 83–84, 107, 319–322, 327, 328, 373, 601, 609, 610, 619, 645, 690, 698 Ford Motor Credit Company, 453 FPL Group, Inc., 415, 416, 555 G GE Capital Corporation, 26, 462 General Electric Company (GE), 225–227, 229, 671–672, 674, 697 General Motors Company, 84, 124, 518 Global Crossing, 16, 18 Global Partners, 500 The Goldman Sachs Group, Inc., 28, 670 Goodwill Industries International, Inc., 375 The Goodyear Tire & Rubber Company, 669 Google Inc., 20, 31, 211, 287, 500, 504 H Harrods Ltd., 697 Hartford Life, 502 Hatteras Hammocks®, 160 Hershey Company, 159 Hewlett-Packard Company (HP), 30, 127, 137, 455, 596, 691 Honda Motor Company, 193 Hoover’s, Inc., 611 HP, see Hewlett-Packard H&R Block, 90, 93, 95 HSBC Group Holdings, 692, 694 Hyundai Motor, 375 I IBM, 5, 152, 643, 644, 648, 649, 699 ImClone Systems, Inc., 299 Industrial and Commercial Bank of China, 692 Infosys Technologies Limited, 157 ING Group, 674, 692 Intel Corporation, 215–217, 301, 329, 504 International Finance Corporation, 569 ndd Page 746 8/9/11 1:30:54 PM user-f396 746 F-396 LibraryPirate Company Index apan Post Holdings, 674 PMorgan Chase & Co., 28, 419, 692, 698 K Kellogg Company, 328 Kia Motors, 699 Kingston, Inc., 334 Kirby Manufacturing, 463 Kmart, 51 Knight, Inc., 263 KPMG International, 122 Kraft Foods, 159, 160 Krispy Kreme Doughnuts, 485 aurel Electronics, Inc., 117 loyds Banking Group, 692 M Magna International, 561 Marriott Corporation, Inc., 524 Mason Corporation, 298 MaxLinear Inc (MXL), 380, 381 MBNA Corporation, 199 McDonalds Corporation, 478, 606, 625 Merrill Lynch & Co., Inc., 26 Microsoft Corporation, 31, 127, 138, 334, 472, 504 Mitsubishi, 675 Mitsubishi UFJ Financial Group, 692 Mitsui Group, 675 Mizuho Financial Group, 692 Moneychimp, 134 Moody’s Investors Service, 256–257 Morgan Construction Company, 638, 639 Morgan Stanley, 28, 37 MXL (MaxLinear Inc.), 380, 381 N Nalco Holding Company, 500 Nestlé, 159, 502 Netflix, 200, 219–223, 287 Newell Corporation, 636 New York Life Insurance Company, 168 Nike, Inc., 226, 227 Nissan Motor Company, 203, 375 Nordstrom, Inc., 106 Northern Manufacturing Company, 467 Northwest Airlines, 291 O Oakley, Inc., 498 Oracle, 504 P Pfizer Inc., 538 Piper Aircraft, Inc., 83 Pitney Bowes, Inc., 502 PlanWare, 579 Polo Ralph Lauren Corporation, 102, 103 Praxair, Inc., 545, 547 PricewaterhouseCoopers International Limited (PwC), 5, 122, 429 Procter & Gamble, 6, 117, 218, 285–286, 502 Public Service of New Mexico, 502 PwC, see PricewaterhouseCoopers Q Qualcomm, 504 R Regatta Inc., 263 Ronco Corporation, 607 The Royal Bank of Scotland International Limited, 692 Royal Dutch Shell plc, 673, 674, 697 Ryder System, Inc., 540 S San Diego Gas and Electric Company (SDG&E), 291 Sealed Air Corporation, 547, 554 Sharp Electronics Corporation, 127, 137 Shearson Lehman Hutton Inc., 255 Siemens International, 694 Sinopec Group, 674 SmartMoney, 143, 258 Southwest Airlines, Inc., 121, 219–223, 341 Spear, Leeds, and Kellogg Specialists LLC, 670 Standard & Poor’s, 106, 238, 256–257 Starbucks Corporation, 606–607 State Bank of India, 698 State Farm Mutual Automobile Insurance Company, 26 State Grid, 674 Stride Rite Corporation, 498 Sumitomo Corporation, 675 Sunbeam Corporation, 122 T Target Corporation, 81, 415 Texas Instruments, Inc., 127, 137, 434 3M Corporation, 36, 37 Tiffany & Company, 102, 103 Total S.A., 674 Toyota Motor Company, 84, 107, 456, 673, 674, 700 Treeplan, 398 TXU Corporation, 493 Tyco International, Ltd., 16, 18 U U-Haul, 540 Unilever PLC, 378–379 United Airlines Inc., 619 United Parcel Service (UPS), 411, 543 Universal Pictures, V Volkswagen AG, 696 W Wal-Mart Stores, Inc., 81, 90, 93, 102, 103, 106, 117, 502, 550, 551, 673, 674 Walt Disney Company, 409, 410 Waste Management, Inc., 122 Wells Fargo & Company, 427 Weyerhaeuser Company, 67 Whole Foods Markets, Inc., 102, 103 Winn-Dixie Stores, Inc., 502 WorldCom, 16, 18–20, 48, 518 Y Yahoo!, Inc., 52, 240, 270, 423, 424 _endsheetB2&B3.indd Page 8/11/11 7:30:00 PM user-f396 user-f396 LibraryPirate BUILDING INTUITION Throughout the book important finance principles and concepts are identified and emphasized in Building Intuition boxes These boxes restate an important finance concept that has been discussed in the main text, such as the importance of cash flows, and provide an intuitive example or explanation of the concept The Building Intuition boxes and the pages on which they appear are as follows: PAGE Cash Flows Matter Most to Investors Sound Investments are Those Where the Value of the Benefits Exceeds Their Cost Financing Decisions Affect the Value of the Firm The Timing of Cash Flows Affects Their Value 11 The Riskiness of Cash Flows Affects Their Value 12 The Financial Manager’s Goal Is to Maximize the Value of the Firm’s Stock 12 The Value of Money Changes with Time 126 Compounding Drives Much of the Earnings on Long-Term Investments 134 More Risk Means a Higher Expected Return 202 Diversified Portfolios are Less Risky 223 Systematic Risk Is the Risk That Matters 224 Investment Decisions Have Opportunity Costs 305 Capital Budgeting Is Forward Looking 342 Incremental After-Tax Free Cash Flows Are What Stockholders Care About in Capital Budgeting 344 We Discount Expected Cash Flows in an NPV Analysis 362 High Fixed Costs Mean Larger Fluctuations in Cash Flows and Profits 385 _endsheetB2&B3.indd Page 8/11/11 7:30:00 PM user-f396 user-f396 LibraryPirate PAGE Revenue Changes Drive Profit Volatility Through Operating Leverage 390 The Market Value of a Firm’s Assets Equals the Market Value of the Claims on Those Assets 412 A Firm’s Cost of Capital Is a Weighted Average of All of Its Financing Costs 414 The Current Cost of Long-Term Debt Is What Matters When Calculating WACC 416 Investors View Seasoned Securities as Less Risky Than Unseasoned Securities 481 The Optimal Capital Structure Minimizes the Cost of Financing a Firm’s Activities 506 Capital Structure Choices Do Not Affect Firm Value If They Do Not Affect the Value of the Free Cash Flows to Investors 506 The Cost of Equity Increases With Financial Leverage 510 People Behave Differently toward a Firm in Financial Distress, and This Increases Bankruptcy Costs 522 Leasing Is an Alternative Means of Financing the Acquisition of an Asset 535 Splitting the Rights to an Asset Between the Lessee and Lessor Can Create Costly Conflicts 539 Dividends Reduce the Stockholders’ Investment in a Firm 546 Dividend Announcements Send Signals to Investors 549 The Value of a Business Is Specific to a Point in Time 580 The Value of a Business Is Not the Same to All Investors 581 A Firm’s Strategy Drives Its Business Decisions 609 Payoff Functions for Options Are Not Linear 646 The Basic Principles of Finance Apply No Matter Where You Do Business 676 _endsheetF2&F3.indd Page 8/11/11 7:30:10 PM user-f396 user-f396 LibraryPirate Selected Abbreviations and Notation b5 Δ5 r5 s2 (s) x5 Add WC APR ARR b5 C5 Cap Exp CF CF Opns CFI CFLTA CFNWC CFOA CIP CO COGS CV D5 D&A DOL DPO DRP DSI DSO E(•) EAC EAR EAY EBIT EBITDA EBT EFN EOQ EROA F5 FC FCF FCFE FCFF beta (a measure of systematic risk) change (e.g., DP change in price level, DS change in sales level) correlation variance (standard deviation) fractional weight of investment or component of capital addition to working capital annual percentage rate accounting rate of return dividend payout ratio coupon payment (bond), call option value capital expenditures cash flow cash flow from operations cash flow to investors cash flow invested in long-term assets cash flow invested in net working capital cash flow from operating activity call interest premium crossover level of unit sales cost of goods sold coefficient of variation dividend (stock) depreciation and amortization degree of operating leverage days’ payables outstanding default risk premium days’ sales in inventory days’ sales outstanding expected value (E(R) expected return, etc.) equivalent annual cost effective annual rate (yield) earnings before interest and taxes earnings before interest, taxes, depreciation, and amortization earnings before taxes external funding needed economic order quantity EBIT return on assets face value (bond) fixed costs free cash flows free cash flow to equity free cash flow from the firm _endsheetF2&F3.indd Page 8/11/11 7:30:15 PM user-f396 user-f396 LibraryPirate FV FVAn FXR g5 i5 IGR IRR k5 m5 MAT MRP MV n5 NCF NCFOA NOPAT NPV NWC OC Op Ex p5 P5 P/E ratio PB PI PR PV PV annuity factor PVAn PVP r5 R5 ROA ROE S5 SGR t5 TV V5 VC WACC future value future value of an annuity foreign exchange or currency risk premium growth rate nominal rate of interest internal growth rate internal rate of return cost of capital (debt or equity) number of payments per year maturity adjustment to cost of a loan marketability risk premium market value number of periods net cash flow net cash flow from operating activities net operating profits after tax net present value net working capital operating cycle cash operating expenses probability price (P0 price at time zero, etc.), put option value price/earnings ratio payback period profitability index prime rate present value present value of annuity factor present value of an annuity present value of a perpetuity real rate of interest return (Rrf risk free, Ri, RPortfolio, etc.) return on assets return on equity Sharpe Ratio sustainable growth rate tax rate terminal value value (e.g.,VFirm VAssets VDebt VEquity) variable costs weighted average cost of capital _endsheetF4.indd Page 8/11/11 7:32:08 PM user-f396 user-f396 LibraryPirate Wiley Series in FINANCE SURVEY OF FINANCE Melicher, Introduction to Finance: Markets, Investments, and Financial Management 14e Fisher Investments, Fisher Investments on Energy Fisher Investments, Fisher Investments on Industrials MERGERS AND ACQUISITIONS Gaughan, Mergers, Acquisitions, and Corporate Restructurings 5e Gilson, Creating Value through Corporate Restructuring 2e Grossman, The Portable MBA in Finance and Accounting 4e Investments, Fisher Investments on Staples CORPORATE FINANCE VALUATION Cole, M&A Titans: The Pioneers Who Shaped Wall Street’s Mergers and Acquisitions Industry Parrino, Fundamentals of Corporate Finance 2e Arzac, Valuation: Mergers, Buyouts and Restructuring 2e Bruner, Deals from Hell: M&A Lessons that Rise Above the Ashes Clayman, Corporate Finance: A Practical Approach Damodaran, Investment Valuation: Tools and Techniques for Determining the Value of Any Asset PERSONAL FINANCE MANAGEMENT Bajelsmit, Personal Finance: Planning and Implementing Your Financial Goals Bajelsmit, Personal Finance 1e with Student Financial Planner Package McKinsey, Valuation University Edition 5e McKinsey, Valuation Workbook Stowe, Equity Asset Valuation Stimes, Equity Valuation, Risk and Investment: A Practitioner’s Roadmap FINANCIAL MARKETS AND INSTITUTIONS INTERNATIONAL FINANCE Kidwell, Financial Institutions, Markets, and Money 11e Shapiro, Multinational Financial Management 9e Acharya, Restoring Financial Stability: How to Repair a Failed System Shapiro, Foundations of Multinational Financial Management 6e Blackwell, Modern Financial Markets: Prices, Yields, and Risk Analysis INVESTMENTS Peck, Investment Ethics FIXED INCOME SECURITIES Veronesi, Fixed Income Securities: Valuation, Risk, and Risk Management Tuckman, Fixed Income Securities: Tools for Today’s Markets University Edition 3e Elton, Modern Portfolio Theory and Investment Analysis 8e Fabozzi, Fixed Income Analysis 2e McMillan, Investments: Principles of Portfolio and Equity Analysis FINANCIAL RISK MANAGEMENT Lawton, Investment Performance Management (CFA) Vaughan, Fundamentals of Risk and Insurance 10e Fisher Investments, Fisher Investments on Materials Lerner, Venture Capital, Private Equity, and the Financing of Entrepreneurship 1e Lerner, Venture Capital and Private Equity: A Casebook 5e Metrick, Venture Capital and the Finance of Innovation 2e Cumming, Venture Capital: Investment Strategies, Structures, and Policies ADVANCED APPLIED CORPORATE FINANCE Damodaran, Applied Corporate Finance 3e FINANCIAL THEORY Jones, Investments: Analysis and Management 11e Cuthbertson, Investments 2e VENTURE CAPITAL Fabozzi, Introduction to Financial Economics 1e Fabozzi, The Basics of Finance Fabozzi, Finance: Capital Markets, Financial Management, and Investment Management Kolb, Lessons from the Financial Crisis: Causes, Consequences, and our Economic Future Triana, Lecturing Birds on Flying: Can Mathematical Theories Destroy the Financial Markets? INVESTMENT BANKING Rosenbaum, Investments Banking: Valuation, Leveraged Buyouts, and Mergers and Acquisitions www.wiley.com/go/businesscatalog ... in other introductory corporate finance textbooks Chapter on Options and Corporate Finance Many other corporate finance textbooks have a chapter that introduces students to financial options and... 2011 to 2013 Dr Parrino is also co-founder of the Financial Research Association and is Associate Editor of the Journal of Corporate Finance and the Journal of Financial Research Dr Parrino? ??s research... ER 2.2 DIRECT FINANCING 27 The Financial System and the Level of Interest Rates 24 2.1 THE FINANCIAL SYSTEM 25 The Financial System at Work 26 through the Financial System 26 How Funds Flow A