Ebook Copeland''s financial theory and corporate policy: Part 2

Ebook Copeland''s financial theory and corporate policy: Part 2 presents the following content: Efficient capital markets: evidence; capital budgeting under uncertainty: the multiperiod case; capital structure and the cost of capital: theory; capital structure: empirical evidence and applications; dividend policy: theory; dividend policy: empirical evidence and applications; the economics of leasing; applied issues in corporate finance; mergers, restructuring, and corporate control: theory; mergers and restructuring: tests and applications; exchange rate systems and parity conditions; international financial management: tests and implications. Please refer to the documentation for more details.

PART II Corporate Policy: Theory, Evidence, and Applications T HE FIRST PART OF THE text covers most of what has come to be recognized as a unified theory of decision making under uncertainty as applied to the field of finance The theory of finance, as presented in the first half of the text, is applicable to a wide range of finance topics The theoretical foundations are prerequisite to almost any of the traditional subject areas in finance curricula; e.g., portfolio management, corporation finance, commercial banking, money and capital markets, financial institutions, security analysis, international finance, investment banking, speculative markets, insurance, and case studies in finance Since all these topics require a thorough understanding of decision making under uncertainty, all use the theory of finance The second half of this text focuses, for the most part, on applications of the theory of finance to a corporate setting The fundamental issues are: Does financing matter? Does the type of financing (debt or equity) have any real effect on the value of the firm? Does the form of financial payment (dividends or capital gains) have any effect on the value of claims held by various classes of security holders? Because these issues are usually discussed in the context of corporate finance they may seem to be narrow This is not the case First of all, the definition of a corporation is very broad The class of corporations includes not only manufacturing firms but also commercial banks, savings and loan associations, many brokerage houses, some investment banks, and even the major security exchanges Second, the debt equity decision applies to all individuals as well as all corporations Therefore although the language is narrow, the issues are very broad indeed They affect almost every economic entity in the private sector of the economy 357 358 CORPORATE POLICY: THEORY, EVIDENCE, AND APPLICATIONS As we shall see, the theoretical answer to the question "Does financing matter?" is often a loud and resounding "Maybe." Often the answer depends on the assumptions of the model employed to study the problem Under different sets of assumptions, different and even opposite answers are possible This is extremely disquieting to the student of finance Therefore we have presented empirical evidence related to each of the theoretical hypotheses Frequently, but not always, the preponderance of evidence supports a single conclusion It is important to keep in mind that hypotheses cannot be tested by the realism of the assumptions used to derive them What counts for a positive science is the development of theories that yield valid and meaningful predictions about observed phenomena On the first pass, what counts is whether or not the hypothesis is consistent with the evidence at hand Further testing involves deducing new facts capable of being observed but not previously known, then checking those deduced facts against additional empirical evidence As students of finance, which seeks to be a positive science, we must not only understand the theory, but also study the empirical evidence in order to determine which hypothesis is validated Chapter 11 is devoted to various empirical studies related to the efficient market hypothesis Most of the evidence is consistent with the weak and semistrong forms of market efficiency but inconsistent with the strong form In certain situations, individuals with inside information appear to be able to earn abnormal returns In particular, corporate insiders can beat the market when trading in the securities of their firm Also, block traders can earn abnormal returns when they trade at the block price, as can purchasers of new equity issues The last two situations will surely lead to further research because current theory cannot explain why, in the absence of barriers to entry, there appear to be inexplicable abnormal rates of return Chapter 12 returns to the theoretical problem of how to evaluate multiperiod investments in a world with uncertainty It shows the set of assumptions necessary in order to extend the simple one-period CAPM rules into a multiperiod world It also discusses two interesting applied issues: the abandonment problem, and the technique for discounting uncertain costs Chapter 13 explores the theory of capital structure and the cost of capital This is the first of the corporate policy questions that relate to whether or not the value of the firm is affected by the type of financing it chooses Also, we define a cost of capital that is consistent with the objective of maximizing the wealth of the current shareholders of the firm This helps to complete, in a consistent fashion, the theory of project selection Capital budgeting decisions that are consistent with shareholder wealth maximization require use of the correct technique (the NPV criterion), the correct definition of cash flows (operating cash flows after taxes), and the correct cost of capital definition Chapter 14 discusses empirical evidence on whether or not the debt-to-equity ratio (i.e., the type of financing) affects the value of the firm This is one of the most difficult empirical issues in finance Although not conclusive, the evidence is consistent with increases in the value of the firm resulting from increasing debt (up to some range) in the capital structure However, much work remains to be done in this area Chapter 14 also provides a short example of how to actually compute the cost of capital CORPORATE POLICY: THEORY, EVIDENCE, AND APPLICATIONS 359 Chapter 15 looks at the relationship between dividend policy and the value of the firm There are several competing theories However, the dominant argument seems to be that the value of an all-equity firm depends on the expected returns from current and future investment and not on the form in which the returns are paid out If investment is held constant, it makes no difference whether the firm pays out high or low dividends On the other hand, a firm's announcement of increase in dividend payout may be interpreted as a signal by shareholders that the firm anticipates permanently higher levels of return from investment, and of course, higher returns on investment will result in higher share prices Chapter 16 presents empirical evidence on the relationship between dividend policy and the value of the firm that, for the most part, seems to be consistent with the theory—namely, that dividend policy does not affect shareholders' wealth The chapter also applies the valuation models (presented in Chapter 15) to an example Chapter 17 uses the subject of leasing to bring together a number of further applications of capital structure and cost of capital issues We also illustrate how option pricing can help clarify the nature of an operating lease under which the lessee may exercise a contractual right to cancel (with some notice and with moderate penalties) Chapter 18 discusses several applied topics of interest to chief financial officers pension-fund management, executive compensation, leveraged buyouts, ESOP's and interest rate swaps Chapters 19 and 20 consider the widespread phenomenon of mergers They begin with the proposition that without synergy, value additivity holds in mergers as it does in other types of capital budgeting analysis Mergers not affect value unless the underlying determinants of value—the patterns of future cash flows or the applicable capitalization factors are changed by combining firms Empirical tests of mergers indicate that the shareholders of acquired firms benefit, on the average, but the shareholders of acquiring firms experience neither significant benefit nor harm Chapters 21 and 22 conclude the book by placing finance in its increasingly important international setting A framework for analyzing the international financial decisions of business firms is developed by summarizing the applicable fundamental propositions The Fisher effect, which states that nominal interest rates reflect anticipated rates of inflation, is carried over to its international implications This leads to the Interest Rate Parity Theorem, which states that the current forward exchange rate for a country's currency in relation to the currency of another country will reflect the present interest rate differentials between the two countries The Purchasing Power Parity Theorem states that the difference between the current spot exchange rate and the future spot exchange rate of a country's currency in relation to the currency of another country will reflect the ratio of the rates of price changes of their internationally traded goods We point out that exchange risk is a "myth" in the sense that departures from fundamental parity theorems reflect changes in underlying demand and supply conditions that would cause business risks even if international markets were not involved The fundamental relations provide the principles to guide firms in adjusting their policies to the fluctuations in the exchange rate values of the currencies in which their business is conducted The only valid statement is that the current price embodies all knowledge, all expectations and all discounts that infringe upon the market C W J Granger and Morgenstern, Predictability of Stock Market Prices, Heath Lexington Books, Lexington, Mass., 1970, 20 Efficient Capital Markets: Evidence Empirical evidence for or against the hypothesis that capital markets are efficient takes many forms This chapter is arranged in topical order rather than chronological order, degree of sophistication, or type of market efficiency being tested Not all the articles mentioned completely support the efficient market hypothesis However, most agree that capital markets are efficient in the weak and semistrong forms but not in the strong form The majority of the studies are very recent, dating from the late 1960s and continuing up to the most recently published papers Usually capital market efficiency has been tested in the large and sophisticated capital markets of developed countries Therefore one must be careful to limit any conclusions to the appropriate arena from which they are drawn Research into the efficiency of capital markets is an ongoing process, and the work is being extended to include assets other than common stock as well as smaller and less sophisticated marketplaces A EMPIRICAL MODELS USED FOR RESIDUAL ANALYSIS Before discussing the empirical tests of market efficiency it is useful to review the three basic types of empirical models that are frequently employed The differences between them are important The simplest model, called the market model, simply argues that 361 362 EFFICIENT CAPITAL MARKETS: EVIDENCE returns on security j are linearly related to returns on a "market" portfolio Mathematically, the market model is described by Rit = a; + ki Rint + Cit (11.1) The market model is not supported by any theory It assumes that the slope and intercept terms are constant over the time period during which the model is fit to the available data This is a strong assumption, particularly if the time series is long The second model uses the capital asset pricing theory It requires the intercept term to be equal to the risk-free rate, or the rate of return on the minimum variance zero-beta portfolio, both of which change over time This CAPM-based methodology is written [Rnz, — R ft ][1j + E ft Rit = R ft (7.32) Note, however, that systematic risk is assumed to remain constant over the interval of estimation The use of the CAPM for residual analysis was explained at the end of Chapter 10 Finally, we sometimes see the empirical market line, which was explained in Chapter and is written as Rjt j1 ) 0t Lfljt jt• (7.36) Although related to the CAPM, it does not require the intercept term to equal the risk-free rate Instead, both the intercept, ')i ot , and the slope, j)s,„ are the best linear estimates taken from cross-section data each time period (typically each month) urthermore, it has the advantage that no parameters are assumed to be constant over time All three models use the residual term, cit , as a measure of risk-adjusted abnormal performance However, only one of the models, the second, relies exactly on the theoretical specification of the Sharpe-Lintner capital asset pricing model In each of the empirical studies discussed, we shall mention the empirical technique by name because the market model is not subject to Roll's critique (discussed in Chapter 7), whereas the CAPM and the empirical market line are Thus residual analysis that employs the CAPM or the empirical market line may be subject to criticism B ACCOUNTING INFORMATION Market efficiency requires that security prices instantaneously and fully reflect all available relevant information But what information is relevant? And how fast security prices really react to new information? The answers to these questions are of particular interest to corporate officers who report the performance of their firm to the public; to the accounting profession, which audits these reports; and to the Securities and Exchange Commission, which regulates securities information The market value of assets is the present value of their cash flows discounted at the appropriate risk-adjusted rate Investors should care only about the cash flow ACCOUNTING INFORMATION 363 Table 11.1 FIFO versus LIFO Revenue Cost of goods sold Operating income Taxes at 40% Net income eps (100 shares) Cash flow per share LIFO FIFO 100 90 10 06 96 100 25 75 30 45 45 70 Inventory at Cost Fourth item 90 —> LIFO Third item 60 Second item 40 First item 25 —> FIFO implications of various corporate decisions However, corporations report accounting definitions of earnings, not cash flow, and frequently the two are not related Does an efficient market look at the effect of managerial decisions on earnings per share (eps) or cash flow? This is not an unimportant question, because frequently managers are observed to maximize eps rather than cash flow because they believe that the market value of the company depends on reported eps, when in fact (as we shall see) it does not Inventory accounting provides a good example of a situation where managerial decisions have opposite effects on eps and cash flow During an inflationary economy the cost of producing the most recent inventory continues to rise On the books, inventory is recorded at cost so that in the example given in Table 11.1 the fourth item added to the inventory costs more to produce than the first If management elects to use first-in-first-out (FIFO) accounting, it will record a cost of goods sold of $25 against a revenue of $100 when an item is sold from inventory This results in eps of $.45 On the other hand, if LIFO (last-in-first-out) is used, eps is $.06 The impact of the two accounting treatments on cash flow is in exactly the opposite direction Because the goods were manufactured in past time periods, the actual costs of production are sunk costs and irrelevant to current decision making Therefore current cash flows are revenues less taxes The cost of goods sold is a noncash charge Therefore, with FIFO, cash flow per share is $.70, whereas with LIFO it is $.96 LIFO provides more cash flow because taxes are lower If investors really value cash flow and not eps, we should expect to see stock prices rise when firms announce a switch from FIFO to LIFO accounting during inflationary periods Sunder [1973, 1975] collected a sample of 110 firms that switched from FIFO to LIFO between 1946 and 1966 and 22 firms that switched from LIFO to FIFO His procedure was to look at the pattern of cumulative average residuals from the CAPM A residual return is the difference between the actual return and the return estimated by the model: e j, = R j, — E(R sit ) The usual technique is to estimate a ft over an interval surrounding the economic event of interest Taking monthly data, Sunder used all observations of returns except for 364 EFFICIENT CAPITAL MARKETS: EVIDENCE those occurring plus or minus 12 months around the announcement of the inventoryaccounting change He then used the estimated ,6";„ the actual risk-free rate, and the actual market return during the 24-month period around the announcement date to predict the expected return.' Differences between estimated and actual returns were then averaged across all companies for each month The average abnormal return in a given month is N AR E = — e., N 1=1 where N = the number of companies The cumulative average return (CAR) is the sum of average abnormal returns over all months from the start of the data up to and including the current month, T: CAR = E=t AR E , where T = the number of months being summed (T = 1, 2, , M), M = the total number of months in the sample If there were no abnormal change in the value of the firm associated with the switch from FIFO to LIFO, we should observe no pattern in the residuals They would fluctuate around zero and on the average would equal zero In other words, we would have a fair game Figure 11.1 shows Sunder's results Assuming that risk does not change during the 24-month period, the cumulative average residuals for the firms switching to LIFO rise by 5.3% during the 12 months prior to the announcement of the accounting change This is consistent with the fact that shareholders actually value cash flow, not eps However, it does not necessarily mean that a switch to LIFO causes higher value Almost all studies of this type, which focus on a particular phenomenon, suffer from what has come to be known as postselection bias In this case, firms may decide to switch to LIFO because they are already doing well and their value may have risen for that reason, not because of the switch in accounting method Either way, Sunder's results are inconsistent with the fact that shareholders look only at changes in eps in order to value common stock He finds no evidence that the switch to LIFO lowered value even though it did lower eps More recently Ricks [1982] studied a set of 354 NYSE- and AMEX-listed firms that switched to LIFO in 1974 He computed their earnings "as if" they never switched and found that the firms that switched to LIFO had an average 47% increase in their as-if earnings, whereas a matched sample of no-change firms had an average 2% decrease Ricks also found that the abnormal returns of the switching firms were significantly lower than the matched sample of no-change firms These results are inconsistent with those reported by Sunder The studies above indicate that investors in efficient markets attempt to evaluate news about the effect of managerial decisions on cash flows not on eps This fact has Sunder used a moving-average beta technique in his second study [1975] However, it did not substantially change his results ACCOUNTING INFORMATION 125 125 110 firms switching to LIFO 075 075 22 firms' switching from LIFO • • • •••• •• •• ••••••••• — •••• •• 72 025 - vir • —.025 —.025 —.075 — 075 365 4D 0.• • • • •• L I —.125 —12 —7 —2 13 I I —.0125 —12 —7 —2 13 Months from the date of change Months from the date of change Figure 11.1 Cumulative average residuals for 24 months around the accounting change (From S Sunder, "Relationship between Accounting Changes and Stock Prices: Problems of Measurement and Some Empirical Evidence," reprinted from Empirical Research in Accounting: Selected Studies, 1973, 18.) direct implications for the accounting treatment of mergers and acquisitions Two types of accounting treatment are possible: pooling or purchase In a pooling arrangement the income statements and balance sheets of the merging firms are simply added together On the other hand, when one company purchases another, the assets of the acquired company are added to the acquiring company's balance sheet along with an item called goodwill Goodwill is the difference between the purchase price and the book value of the acquired company's assets Regulations require that goodwill be written off as a charge against earnings after taxes in a period not to exceed 40 years Because the writeoff is after taxes, there is no effect on cash flows, but reported eps decline The fact that there is no difference in cash flows between pooling and purchase and the fact that cash flows, not eps, are the relevant information used by investors to value the firm should convey to management the message that the accounting treatment of mergers and acquisitions is a matter of indifference.' Yet many managements prefer pooling, presumably because they not like to see eps decline owing to the writeoff of goodwill No economically rational basis for this type of behavior can be cited In a recent empirical study tiong, Kaplan, and Mandelker [1978] tested the effect of pooling and purchase techniques on stock prices of acquiring firms Using monthly Prior to the 1986 Tax Reform Act, the Internal Revenue Service (IRS) allowed the book value of the assets of the acquired firm to be written up upon purchase This reduced the amount of goodwill created, but even more important, it created a depreciation tax shield that did not exist in a pooling arrangement Therefore cash flows for purchase were often higher than pooling In these cases purchase was actually preferable to pooling, at least from the point of view of the acquiring firm 366 EFFICIENT CAPITAL MARKETS: EVIDENCE data between 1954 and 1964, they compared a sample of 122 firms that used pooling and 37 that used purchase The acquired firm had to be at least 3% of the net asset value of the acquiring firm Mergers were excluded from the sample if another merger took place within 18 months, if the acquiring firm was not NYSE listed, or if the merger terms were not based on an exchange of shares (This last criterion rules out taxable mergers.) Using the simple time-series market model given below, they calculated cumulative abnormal residuals: ln = oci + ln + ui„ where = return on the jth security in time period t, o ; = an intercept term assumed to be constant over the entire time period, 16'; = systematic risk assumed to be constant over the entire time period, Rmt = market return in time period t, nit = abnormal return for the jth security in time period t When the cumulative average residuals were centered around the month of the actual merger, the patterns revealed no evidence of abnormal performance for the sample of 122 poolings This is shown in Fig 11.2 Therefore there is no evidence that "dirty pooling" raises the stock prices of acquiring firms Investors are not fooled by the accounting convention These results are just as important for acquiring firms that had to write off goodwill against their after-tax earnings because they used the purchase technique As shown in Fig 11.3, there is no evidence of negative abnormal returns, which is what we would expect if investors looked at eps Instead, there is weak evidence that shareholders of acquiring firms experienced positive abnormal returns when the purchase technique was used This is consistent with the hypothesis that investors value cash flows and that they disregard reported eps The empirical studies of Sunder [1973, 1975], and Hong, Kaplan, and Mandelker [1978] provide evidence on what is meant by relevant accounting information Cumulative abnormal residual 04— 02 — 0•• ••• • • • • °•• v.: —.02 —.0 —50 —40 —30 —20 —10 • • • • • • • • •:••• 10 20 30 40 50 60 Figure 11.2 Cumulative abnormal residuals for 122 poolings with market value greater than book value in the month relative to merger (From H Hong, R S Kaplan, and G Mandelker, "Pooling vs Purchase: The Effects of Accounting for Mergers on Stock Prices," reprinted with permission of Accounting Review, January 1978, 42.) 932 AUTHOR INDEX Taylor, R., 633 Tehranian, H., 671 Teichroew, D., 35 Telser, L., 307, 309, 317 Tepper, I., 650 Thompson, R., 388, 389, 390, 587, 633, 727728, 755 Thorpe, K E., 690 Titman, S., 382, 383, 499, 511, 518, 519, 581 Tobin, J., 96, 822 Treynor, J., 193, 196, 383, 646 Triffin, R., 785, 787 Trueman, B., 561, 563 Tversky, A., 102 Ungerer, H., 787 Vanderwicken, P., 614 Van Home, J C., 61, 428 Vermaelen, T., 581, 597, 598, 599, 600 Vertinsky, I., 336 Vickers, D., 383 Vickrey, D., 382 Vickson, R G., 95 Von Neumann, J., 77, 102 Waegelein, J., 671 Wakeman, L., 516, 626, 657-658, 739 Walker, C E., 69 Walter, J E., 83, 84, 544 Walther, C H., 824 Warner, J., 499, 500, 512, 739, 756 Wart, J R., 95 Watts, R., 369, 510, 584, 585, 586, 668 Weil, R., 385 Weinberger, A., 494 Weingartner, H M., 58, 59, 60 Weinstein, M., 380, 500, 515, 516 Weitzman, M., 430 Wessels, R., 518, 519 West, R., 597 Westerfield, R., 653 Weston, J F., 420-427, 517, 630, 631, 686, 707, 734, 763 Whaley, R., 275 Whitmore, G A., 95 Whittaker, J G., 829 Wier, P., 733-734 Williams, J., 212 Williamson, E., 20, 685 Wolfson, M., 370 Woods, D., 597 Woodward, S., 68 Woolridge, J R., 382, 586, 587 Working, H., 309 Yawitz, J B., 494 Young, A., 597 Young, P., 787 Ziemba, W T., 95, 336 Zimmerman, J., 510 Subject Index Abandonment value, 419-429 Abnormal performance, 362, 364, 384 Abnormal performance index, 367-368 Abnormal return, 351 in mergers, 729 Absolute risk aversion, 89, 920 Accounting information, 607-608 definition of profit, 23, 40, 441 LIFO vs FIFO, 24, 363 lease accounting, 616-618 purchase vs pooling, 25, 365, 678 Accounting rate of return, 28 Acquisitions programs, 727-728 Actuarial assumptions of pension plans, 644645 Actuarial value of a gamble, 85-86 Adjustment process under flexible foreign exchange rates, 782, 785 Agency costs, 20, 472, 662 effect on capital structure, 509-512 incentive effect, 728 of debt, 509 of external equity, 510 theory of mergers, 687-688 Allocational efficiency, 330, 349 American options, calls, 241, 252, 254, 324 puts, 277-279, 323, 419, 631 Annual equivalent value, 51 Annuities, 843-848 continuously growing, 853-854 present value of growing stream, 21 Antitakeover defenses, amendments, 679, 736-737 structural, 740-742 Antitrust, 730-734 ARA See Absolute risk aversion Arbitrage, 314-316 international, 796-800, 818 quality spread, 657 tax, 581 Arbitrage opportunities, 225 Arbitrage portfolios, 219-220, 225 Arbitrage Pricing Theory, 193, 219-228, 320, 411, 443 empirical tests, 228-230 Arbitrage profits, 115-116, 316, 578 ARR See Accounting rate of return Arrow-Debreu securities, 111 Auction market, double, 340 Autoregressive process, stationary, 313 Average, 148 Axioms of cardinal utility, 79-80 Backwardation, normal, 317-318, 321-322, 324 Balance of payments, 788-790 Bankruptcy, 22, 498-500, 696, 699 Benchmark, future, 386 Benefit function, 333 Benefits, vested, 640 Beta, 198, 201, 222, 225 levered equity, 457, 459 unlevered, 457, 459 zero-beta, 206 Bethlehem Steel case, cost of capital, 526-531 valuation, 602-607 Bias, misspecification, 887 of regression, 886 postselection, 364 Bilateral exchange, 13 Binomial distribution, 264-265 Binomial model of one-period riskless interest rate, 659 Binomial option pricing, 257-267 comparison with Black-Scholes OPM, 272 Bird-in-hand fallacy, 553-554 Black-Scholes option pricing model, 267-269, 309, 311, 426 comparison with binomial, 272 cost of risky debt, 466 derivation, 296-299 933 934 SUBJECT INDEX Block trading, 370-375 Bond indenture provisions, 508-509, 512-514, 743-744 Bond rating agencies, 514-516 Bondholder wealth expropriation, 507-509, 519, 600, 694, 743 744 Bonds, callable, 478-480 consol, 37, 844 convertible, 473-478 junk, 676 new issues, 380 zero coupon, 66 Bonus plans, 666-667 Book value leverage, 447 Borrowing and lending opportunities, 19 Breakdown of separation, 14 Brownian motion, 296 Buy-and-hold strategy, 349 Buyback, premium, 679, 738 Buyer and seller premiums in mergers, 718 Buying a call, a put, 245-246 Buying on margin, 259 Cady-Roberts decision, 376 Calculus, fundamental theorem, 923-924 Call options, 241, 252, 254, 324 Call premium, 478, 531-532 Callable debt, 478-480, 531-532 Cancellable leases, 629-631 CAPM See Capital Asset Pricing Model Capital Asset Pricing Model, 124, 187, 193, 197, 204, 362, 401, 417, 455, 476, 589 continuous time version, 465-466 empirical tests, 212-217 ex ante form, 212 ex post form, 213, 217-218 extensions of, 205-212 and futures prices, 318-319 international, 810-813 and market efficiency, 350 properties of, 198-202 Roll's critique, 218-219 two-factor model, 207 Capital budgeting, 25-41, 46-65 constrained, 55-61 linear programming solutions, 58-61 and term structure of interest rates, 70-71 under inflation, 61-65 and use of state-contingent claims, 135-139 Capital gains, dividends, versus, 20-22, 689-690 short-term, 308 tax rate, 557 Capital leases, 616 Capital Market Line, 9-10, 11, 19, 181, 183, 194, 195, 197, 333 Capital markets, efficiency, 331, 338 equilibrium, 15 frictionless, 219, 252 perfect, 125, 330, 790 Capital rationing, 56 multiperiod constraints, 58-61 Capital shares of a dual fund, 387 Capital structure, application of SPM, 140-144 effect of agency costs, 509-512 empirical evidence, 516-523 optimal, 499, 621 pecking order theory, 507, 519, 520 Cardinal utility, 79-81 function, 908 Cash flows, 21-25 for capital budgeting, 36-41, 441, 442 discounted, 25 expected, 26 free cash flows, 38, 39, 441, 604 for leasing, 622 Cash tender offers, 723-724 Casino Society, 676 Central tendency, measure of, 149 Certainty equivalent, for spot price of a commodity, 319 valuation formula, 203, 403-406 wealth, 87, 91 Chain rule of differential calculus, 905-906 Choice, axioms of, 79-80 objects of, 15 theory of, 15, 77 Citizens Utilities Company, 594 Clearinghouse for futures contracts, 303 Clientele effects, debt, 559, 582-583 dividend, 563, 578-582 Coefficient, correlation, 159-161 Collateralized debt, 511 Collusion, 688 Committed lines of credit, 480-481 Comparability, axioms of choice, 79 interpersonal comparison of utility functions, 84 Comparative advantage, 779 Comparison of binomial and Black-Scholes OPMs, 272 Compensation plans, 665-672 SUBJECT INDEX Competition in acquisitions market, 720 Complete markets, 112, 125 Completeness, axioms of choice, 79 Compound interest, 898 formula, 842 Compound option model, 281 Compound sum of annuity, 846 Compounding, continuous, 851-854, 902-903 semiannual, 850 Concentration, industrial, 688 Confidence intervals, 884 Conglomerate mergers, 678, 691-708 performance, 707-708 Consistency, axioms of choice, 79 Consistent foreign exchange rates, 782-783 Consol bonds, 37, 844 Constant payment annuities, 843-846 Constant elasticity of variance, 281, 287 Constant scale replication, 49-51, 54-55 Constrained capital budgeting, 55-61 Constrained optimization, 914-916 Consumer surplus, 454 Consumption, international opportunity set, 811 optimal pattern, 11 and production decision, 10 Contango, 318, 324 Contingent claims, 110 Contingent immunization, 494 Contingent projects, 26 Continuous compounding, 851-854, 902-903 Continuous stochastic processes, 252, 268 Continuously growing annuities, 853-854 Control, corporate, 679 Convenience yield, 317, 322 Convertibility (in foreign exchange), 781 Convertible debt, 473-478 Corporate control, 679 Corporate governance, 734-744 Corporate restructuring, 677-680, 757 Correlation, coefficient, 159-161 perfect, 159-160, 162-165 serial, 889-892 Cost of capital, 22, 25 debt, 39, 470, 527 equity, 39, 448-450, 458, 525, 530 example calculation, 526-531 market-determined opportunity cost of capital, 31 risk-adjusted for capital budgeting, 461 935 short-term liabilities, 530 warrants, 476 weighted average, 29, 39, 402, 444-446, 450, 470 Cost of the gamble, 87 Costly information, 343-346 Costs of storage, 317 Covariance, 156, 159, 174, 187, 193, 198 risk, 188, 202 serial, 348 Covenants, 509, 512-514, 743-744 Covered interest arbitrage, 796-800 Cramer's rule, 870-871, 873 Credit, committed lines, 480-481 Cross hedging, 474 with futures contracts, 176-178 Cumulative average residuals, 363, 364 Cumulative probability of unit normal variable, 269-270 Currency swaps, 830 Daily settlement of futures contracts, 304 Dead weight losses, 498 Debt, capacity and mergers, 701-707 clienteles, 559, 582-583 collateralized, 511 convertible, 473-478 cost of long term, 527 defeasance, 533-534 fixed rate, 660 market value of, 602 maturity structure and duration, 471, 494 new issues, 380 ratio, 446 refunding, 531-534 risky, 248, 462, 470 secured, 511 variable rate, 264, 660 Default risk premium, 230 Defeasance, 533-534 Defined benefit pension plans, 641 Defined contribution pension plans, 641 Definite integrals, 922 Degrees of freedom, 884 Derivatives, 903 higher order, 907-910 Descartes' rule of signs, 34 Determinants of a matrix, 866-868 Deviation, mean absolute, 153 standard, 150 Differential efficiency theory of mergers, 683 Differentials, 910-911 936 SUBJECT INDEX Differentiation, partial, 911 rules of, 903-904 Dilution factor, 476 Diminishing marginal returns, Direct costs of bankruptcy, 499 Direct financing leases, 617 Disclosure regulation, mergers, 727 Discount or premium in mergers, 761 Discount rate, actuarial, 645 multiperiod, 402 risk-adjusted, 401, 410 Dispersion, measures of, 149-153 Displaced diffusion model, 281 Diversifiable risk, 118, 188 Diversification effect, 728 Diversification, international, 810 Divestitures, 678, 690 Dividends, 20 announcement effects, 584-588 capital gains, versus, 20-23 clienteles, 563, 578-582 covenants, 514 irrelevance, 545, 547 payout, 577 with personal and corporate taxes, 556-560 specially designated, 588 stock, 570 surprise, 567 and value, 588 Dominance, second order, 100-101 stochastic, 92-95, 169, 251 Double auction market, 340 Dual-class stock firms, 742-743 Dual problem, 59 Dual purpose funds, 387-390 Duration, in capital budgeting, 51-55 of debt, 489-495 matching, 657 Durbin-Watson d-statistic, 890-892 table, 891 Earnings per share, 24-25 growth maximization, 550-551 Earnings surprise, 567 Economic basis for international transactions, 779 Economic Recovery Tax Act of 1981, 690 Economies of scale, 684 Efficiency, allocational, 330-349 informational, 321 of a linear regression estimate, 886 marginal efficiency of investment schedule, 438 market efficiency and CAPM, 350 merger theories, 683-686 operational, 14, 331, 383 semi-strong form, 332, 383 strong form, 332, 376 weak form, 332, 348, 350 Efficient capital markets hypothesis, 15, 331, 338, 720 Efficient index portfolio, 224 Efficient portfolios, 181, 195 Efficient set, 169, 170, 172, 179, 333 Empirical investigations of exchange risk, 817818 Empirical market line, 216-217, 362 Employment Retirement Income Security Act, 638, 641-642, 645, 648 EMS See European Monetary System End-of-period payoff, 110 Equilibrium price of risk, 183 Equilibrium relationships, international, 790803 intertemporal, 809 testing equilibrium pricing models, 818 Equity, agency cost of external, 510 cost of, 39, 448-450, 458, 525, 530 market value, 602 new issues, 377-380, 506 required return on, 204 Equity carve-out, 679, 750-751 ERISA See Employment Retirement Income Security Act Errors in variables, 887-889 European Monetary System, 786-788 European options, calls, 241, 252, 254 puts, 279 Ex ante form of CAPM, 212 Ex ante test of OPM, 285 Ex dividend, 255, 578 Ex post form of CAPM, 213, 217-218 Ex post test of OPM, 285 Exchange economy, 4, 11, 180 bilateral exchange, 13 Exchange offers, 519-523, 662, 680 Exchange opportunities, 19 Exchange rates, 791 consistent, 782-783 fixed, 780-781 flexible, 782, 783-788 forecasting, 822-823 Exchange ratio in mergers, 757-763 SUBJECT INDEX Exchange risk, 809, 813 empirical investigation, 817-818 "real," 814-817 Executive compensation plans, 665-672 Executive stock option plans, 667-671 Exercise of stock options, sequential, 668 Exercise price, 241, 322 uncertain, 282 Expansion, 677-678 Expectations, heterogeneous, 211-212, 260 homogeneous, 181, 194, 219, 507 rational, 339-343 Expectations theory of futures prices, 314, 322 Expected utility, 17, 86 of an information set, 333 maximization, 168, 194 Expected value, 147 Exponential functions, 898-899 Exponential utility functions, 104, 909 Expropriation of bondholder wealth, 507-509, 519, 600, 743-744 Factor analysis in APT, 229 Factor loadings and sensitivities, 223, 225 Factorial notation, 265 Factors in Purchasing Power Parity Theorem, 793 Fair game, 212, 346-347, 348, 349, 364 FASB Statement No 8, 830-832 FASB Statement No 13, 616 FASB Statement No 35, 641 FASB Statement No 36, 641 FASB Statement No 52, 830-832 FASB Statement No 76, 533 FIFO inventory accounting, 24, 363 Filter rules, 349 Financial gains from conglomerate mergers, 691 Financial leases, 615, 619, 622 Financial synergy, 684-685 Financial theories of conglomerate firms, 692 Finite supernormal growth model, 551, 601602 for all-equity firm, 554-555 Firm commitment offering, 378 First-order stochastic dominance, 92 Fisher effect, 62 Fisher relation, international, 793-795 Fisher separation theorem, 11-12, 15, 18, 32, 124, 126, 180 Breakdown of separation, 14 Fixed exchange rates, 780-781 Fixed-rate debt, 660 937 Flexibility, value in capital budgeting, 429 Flexible exchange rates, 782, 783-788 Floating rate debt, 264, 660 Flotation costs, 534-536 Forecasting foreign exchange rates, 822-823 Foreign currency translation, 830-832 Foreign exchange exposure, empirical studies, 823-824 management, 790, 824-829 Foreign exchange rates, 791 consistent, 782-783 fixed, 780-781 flexible, 782, 783-788 forecasting, 822-823 Foreign exchange risk, 809, 813 empirical investigation, 817-818 "real," 814-817 Foreign exchange swaps, 660 Foreign tax credits, 518 Formal merger, 717 Forward contract, 300, 302 synthetic, 322-323 Forward Parity Theorem, 802-803 Forward price, 322-323 Forward rate of interest, 66-68 Forward speculation, international, 819-822 FPT See Forward Parity Theorem Free cash flows, 38, 39, 441, 604 Free rider problem in tender offers, 735 Frictionless markets, 194, 219, 252 Fully aggregating markets, 343, 377 Functions, cardinal utility, 908 exponential, 898-899 exponential utility, 104, 909 inverse, 895-896 limit of, 901-903 linear, 896-897 logarithmic, 900-901 logarithmic utility, 86, 120, 909 monotonically increasing or decreasing, 910 power utility, 90, 909 quadratic utility, 89-90, 153, 909 Fundamental theorem of calculus, 923-924 Future benchmark technique, 386 Future interest rates, 66-68 Future value of annuity, 846 table, 858 Future value formula, 842 Future value table, 856 Futures contracts, 301 commodities, 317-319 cross hedging, 176-178 financial, 314-317 Futures market, 342 938 SUBJECT INDEX Futures prices, 307, 310, 314 and CAPM, 318-319 expected, 312 Gain from leverage, 443, 451-453, 517 Gamble, actuarial value, 85-86 cost, 87 expected utility, 91 Going private, 661-665, 680, 752 Gold standard, 780-781 Golden parachute, 679 Goodwill in mergers, 25, 365 Gordon growth model, 21, 535, 552, 848 Government National Mortgage Association, 313 Greenmail, 679 Gross investment, 23 Growing payment annuities, 847 continuously growing, 853-854 Growth stock, 550 Heat exchange equation, 299 Hedge portfolios, 275-276, 284, 286, 297 Hedge ratio, 258, 263, 277 Hedging, 176-178, 308 against inflation, 230 cross-hedging, 176-178, 472 perfect, 163 probability, 259 risk-free hedge portfolio, 258, 260, 262, 263, 275-276, 278 risk-free hedged position using options, 245 Herfindahl index, 688-689 Heterogeneous expectations, 211-212, 260 Higher order derivatives, 907-910 Homemade leverage, 444 Homogeneous expectations, 117, 181, 194, 219, 507 Horizontal mergers, 678 Hubris hypothesis, 687-688 Human capital, 209 Hypothesis testing, 881-884 IAPM See International asset pricing model Idiosyncratic risk, 227 IFR See International Fisher Relation IMF See International Monetary Fund Immunization, 492-494, 656 Implied delivery option, 303 Improper integrals, 924-925 Incentive hypothesis, 670 Incentive signaling, 501 Incentive stock options, 668-671 Income shares of a dual fund, 387 Indefinite integrals, 921 Indenture provisions of debt, 508, 512-514, 743-744 Independence, axioms of choice, 79 of returns, 159 Independent projects, 26 Index of industrial production, 230 Index portfolios, 218 efficient, 224 Indifference curves, 3-5, 78, 97-98, 166, 333 Indirect costs of bankruptcy, 500 Indivisibilities, 684 Inefficient management theory of mergers, 683 Infinite constant growth model, 551 Inflation, and capital budgeting, 61-65 hedging against, 230 unanticipated, 223-230 Inflation risk, international, 814 Information, costly, 343-346 effects in block trades, 371 hypothesis of mergers, 686-687 structure, 332 value of, 332-339 Information averaging markets, 343 Informational efficiency, 321 Initial margin, 305 Insider trading, 376-377, 728-729 Instantaneous variance, 274 Instrumental variables, 889 Integrals, definite, 922 improper, 924-925 indefinite, 921 Integration, rules of, 921-922 Interest rate futures, 314 Interest Rate Parity Theorem, 795-800 Interest rate swaps, 656-661 international, 829-830 Interest rates, risk-adjusted discount rate, 401, 410 risk-free rate, 117, 362 term structure of, 260, 658 Internal rate of return, capital budgeting, 29 and duration problem, 53 versus NPV method, 31-36 International arbitrage, 796-800 relationships, 818 International asset pricing model, 810-813 testing difficulties, 812-813 International diversification, 810 SUBJECT INDEX International equilibrium relationships, 790 intertemporal, 809 testing equilibrium pricing models, 818 International finance, economic basis for international transactions, 779 significance, 777 International Fisher Relation, 793-795 International forward speculation, 819-822 International Monetary Fund, 785-788 International transactions, 788 Interpersonal comparison of utility functions, 84 In-the-money, 271 Intrinsic value hypothesis, 340 Inventory accounting, 24, 363 Inverse correlation, 163 Inverse functions, 895-896 Inverse of a square matrix, 869-870 Inversion, matrix, 865-866, 869-870 Investment and mergers, 682 Investment, gross, 23 replacement, 38 Investment decision, 17, 26, 621 optimal, 125 separation from financing decision, 40 Investment opportunity set, Investment rate, 551 Investment schedule, marginal efficiency, 438 Investment tax credits, 518 IRPT See Interest Rate Parity Theorem IRR See Internal rate of return ISO See Incentive stock options Ito's lemma, 297 Joint hypotheses, 218 Joint probability, 420 Joint tests of market efficiency and model validity, 283 Joint ventures, 678 Jump process, 268 mixed-diffusion model, 280 pure, 280 Junk bonds, 676 Keogh accounts, 560 Lagrange multiplier, 872, 914-916 Law of one price, 791 LBO See Leveraged buyouts Leaseback, 513, 615 Leases, accounting for, 616-618 939 cancellable, 629-631 capital, 616 cash flows, 622 direct financing, 617 FASB No 13, 613 leveraged, 617, 627-629 operating, 615-617, 619, 629-631 sale-leaseback, 513, 615 sales type, 617 service, 615-617, 619, 629-631 strict financial, 615, 619, 622 tax treatment, 616 Leasing, 511 Left-out variables, 886-887 Letter stock, 388 Leverage, book value vs replacement value vs reproduction value, 447 gain from, 443, 451-453, 517 homemade, 444 personal, 444 Leveraged buyouts, 661-665, 680 Leveraged leases, 617, 627-629 Levered equity beta, 457, 459 Levered firm, value, 442, 602 LIBOR See London Interbank Offer Rate LIFO inventory accounting, 24, 363 Limit of a function, 901-903 Linear functions, 896-897 Linear programming solutions to multi-period constraints in capital budgeting, 58-61 Linear regression, 873-876 Linear risk tolerance utility function, 123 Lines of credit, committed, 480-481 Liquidation value, 419 Liquidity premium, 68-69, 317, 370 Location, measures of, 147-149 Logarithmic functions, 900-901 utility, 86, 120, 909 Logarithms, natural, 852 table, 860 Lognormal distribution, 210 London Interbank Offer Rate, 656 Long-range strategic planning, 685 MacLaurin Series, 916-921 Maintenance margin, 305 call, 307 Management incentive schemes, 502 Managerialism, 687-688 Margin, buying on, 259 call, 306 initial, 305 940 SUBJECT INDEX maintenance, 305 requirements, 307 Marginal efficiency of investment schedule, 438 Marginal rate of substitution, 6, 12, 96, 98, 166, 168, 183 Marginal rate of transformation, 8, 12, 166, 167, 183 Marginal utility of consumption, Marked to market, 304 Market efficiency, 15, 330 Market extension mergers, 678 Market line, capital, 9-10, 11, 19, 181, 183, 194, 195, 197 empirical, 216-217 security, 197, 198, 217 Market model, 361-362 Market portfolio, 118, 180, 193, 196, 198, 207, 222 Market power theory of mergers, 688-689 Market price of risk, 203, 210, 404 Market risk premium, 897 Market segmentation hypothesis, 69-70 Market value weights, 529 Markets, assumptions for perfect, 790 complete, 112 information averaging vs fully aggregating, 343, 377 Markov matrix, 334 Markowitz risk premium, 87, 91-92 Martingale, 346-347, 408 Matrix, definition of variance, 174 inversion, 865-866 Markov, 334 transposition, 866 Maturity structure of debt, 471-472 application of duration, 494 Maximization, of expected utility of wealth, 82, 95, 168, 194 of shareholder wealth, 18, 20, 24, 25, 31 of utility, 10 Mean, 96, 147, 148 of a binomial distribution, 265 marginal rate of substitution between mean and variance, 98 of a two-asset portfolio, 155 Mean absolute deviation, 153 Mean square error criterion, 886 Measurability, axioms of choice, 79, 81 Measurement error, 887-888 Measures, central tendency, 149 dispersion, 149-153 location, 147-149 Median, 148 Merger analysis, methodology, 763-769 Merger effects on monopoly, 732 Merger performance in the United Kingdom, 724 Merger performance tests, 724-725 Merger policies in valuation framework, 763769 Merger studies, empirical results, 754 Merger terms, 757-763 Mergers, 23 accounting treatment, 25, 365 and bondholder wealth, 694, 743-744 definition, 677 discount or premium, 761 early empirical studies, 718 formal, 717 goodwill, 25, 365 and investment, 682 theories, 682-690 Methodology for merger analysis, 763-769 Mezzanine level financing, 662 Miller and Modigliani See Modigliani and Miller model Minimum tax, 518 Minimum variance, opportunity set, 165-166, 167, 170, 194 portfolio, 161-162, 871-873 zero-beta portfolio, 206, 362 Minority shareholders, 664 Misspecification bias, 887 Mixed diffusion jump model, 280 Mixed stable strategy, 345 Mode, 148 Model of conglomerate mergers, Scott, 696701 Modigliani and Miller model, 443, 464, 468, 498-499, 507, 526, 551, 601-602, 619 Monitoring costs, 20, 25 Monopoly, 688 merger effects on, 732 Monotonically increasing or decreasing functions, 910 Multicollinearity, 889 Multiple rates of return with IRR method, 3336 Multiple regression, 877-893 Mutual funds, 383-385 Mutually exclusive projects, 26 SUBJECT INDEX Natural logarithms, 852 logarithmic functions, 900-901 table, 860 Negotiated premium buyback, 738 Net asset value of a dual fund, 387 Net cash flow, 29 Net dividend surprise, 567 Net monetary position exposure, 824-829 Net Present Value method, 28-29, 849-850 with constant scale replication, 49-51, 54-55 vs IRR method, 31-36 New issues, bonds, 380 equity, 377-380, 506 underwritten vs rights, 534 New York Mercantile Exchange, 303 New York Stock Exchange index futures contract, 316 Nondiversifiable risk, 118, 202 Nonmarketable assets, 209-210 Nonrecourse loan, 627 Normal backwardation, 317-318, 321-322, 324 Normal distribution, 96, 99, 153-155, 194, 222, 411 cumulative probability, 269-270 normally distributed returns, 208 NPV See Net Present Value method Objects of choice, 15 Oil well pump problem, 33 One price, law of, 791 Open interest, 305 Operating leases, 615, 616, 617, 619 cancellable, 629-631 Operational efficiency, 14, 331, 383 Opportunity cost of capital, 22, 28, 31, 35, 36 Opportunity set, investment, minimum variance, 165-166, 167, 170, 194 with n risky assets, 178 production, 3, 6, 8, 10, 11 Optimal capital structure, 499, 621 Optimal consumption pattern, 11 Optimal investment rule, 125 Optimal portfolio decisions, 119-121, 173 Optimal production decisions, 11, 19 Optimization, 911-916 Option pricing models, 127, 240 binomial, 257-267 Black-Scholes, 267-269, 309 comparison of binomial and Black-Scholes, 272 compeand option model, 281 941 and cost of risky debt, 464-466 displaced diffusion model, 281 empirical evidence, 283-289 extensions, 280-283 implications for capital structure, 507 and mergers, 701-707 Option to exchange one asset for another, 282 Options, American, 241, 277-279, 323, 324, 419, 631 calls, 241 European, 241, 279 executive stock option plans, 667-671 on futures, 324 implied delivery, 303 tax-timing, 308 truncated, 282 Orange juice futures, 306 Ordinary least squares, 877-881 Orthogonal portfolios, 218 Orthogonal transformation, 225 Out-of-the-money, 266, 271 Output, unanticipated changes in real, 223 Ownership and control, 20 Pascal's triangle, 264-265 Pareto, stable Paretian hypothesis, 208 Partial differentiation, 911 Payback method of capital budgeting, 27-28 Payoff, end-of-period, 110 PBGC See Pension Benefit Guaranty Corporation Pecking order theory of capital structure, 507, 519, 520 Penrose effect, 56 Pension Benefit Guaranty Corporation, 642, 648, 654 Pension fund management, 638-656 Perfect capital markets, 125, 330 assumptions for, 790 Perfect hedge, 163 Perfect substitute for debt, 622 Perfectly correlated, assets, 162-165 returns, 159-160, 169 Perpetuities, 441 Personal income tax rate, 557 Personal leverage, 444 Poison pill, 679 Poisson process, 280 Pooling, accounting treatment for mergers, 25, 365, 678 Portfolio, arbitrage, 219-220, 225 942 SUBJECT INDEX beta of, 201 decisions, 119-121 diversification, 184-188 efficient, 181, 195 efficient index, 224 index, 218 market, 118, 180, 193, 196, 198, 207, 218, 222 mean and variance of 2-asset, 155-159 mean return of, 173 minimum variance, 161-162, 871-873 minimum variance zero-beta, 206 optimal, 173 orthogonal, 218 risk-free hedge, 258, 260, 262, 263, 275, 284, 286, 297 separation, 122-124 variance of, 161, 173-174, 184 zero-beta, 218 Postselection bias, 364 Power utility function, 90, 909 PPPT See Purchasing Power Parity Theorem Pratt-Arrow measure of risk premium, 89, 9192 Preferred habitats, 70 Preferred stock, 475, 480 Premium, liquidity, 68-69 in mergers, 718, 761 risk, 87 Premium buybacks, 679, 738 Present value, formula, 843 index, 56, 58 table, 857 Present value of an annuity, 844 table, 859 Present value of a growing annuity stream, 21, 848 Price limits, 306, 307, 321 Price of risk, 183, 198, 203, 210 Price pressure, 370 Priced factors in APM, 229 Price/earnings ratio, differential in mergers, 691 Primitive securities, 111, 113-115, 133-134 price, 119 Probability, joint, 420 Producer's surplus, 454 Product extension mergers, 678 Production, consumption decision, 10 index of industrial, 230 opportunity set, 3, 6, 8, 10, 11 optimal decision, 11, 19 Profit, accounting definition, 23, 40, 441 cash flow definition, 23 economic definition, 22-25 no arbitrage profit condition, 115-116 Programming, linear, 58-61 Projects, contingent, 26 different lives, 49-55 different scale, 56-58 independent, 26 mutually exclusive, 26 Proportional expansion of scale, 53 Protective covenants, 509, 512-514, 743-744 Proxy contests, 679, 739-740 Public offerings of equity, 377-380 Purchase accounting treatment for mergers, 25, 265, 678 Purchasing Power Parity Theorem, 791-793, 813-818 violations, 817 Pure arbitrage, 316 Pure jump process, 280 Pure security, 111, 113-115, 133-134 price, 119 Put-call parity, 249-251, 322, 464, 647 formula, 250 Put options, 277-279, 323, 419, 631 q-ratio, 686-687 Quadratic formula, 34-35 Quadratic programming, 170 Quadratic utility function, 89-90, 153, 909 Quality spread arbitrage, 657 Quantity of risk, 198 Random walk, 312, 346-348 Range, 149-150 semi-interquartile, 150 Ranking, axioms of choice, 79-80, 81 Rate of return, 18 accounting, 28 expected, 117 multiple, 33-36 real rate of return relation, 800-803 risk-free, 117 Rational expectations hypothesis, 339-343 Rational expectations signaling equilibrium, 503 SUBJECT INDEX Real exchange risk, 814-817 Real Rate of Return Relation, 800-803 Recursive valuation formula, 545-546 Refunding decisions, 531-534 Regression, linear, 873-876 multiple, 877-893 Regret, 334 Reinvestment rate assumption, 32 Relative risk aversion, 89 Replacement cost uncertainty, 630 Replacement investment, 38 Replacement value leverage, 447 Reproduction value leverage, 447 Repurchase of shares, 22, 522, 571, 596-600, 680 from corporate insiders, 739 single block, 739 Required rate of return on equity, 204 Restructuring, corporate, 677-680, 757 theories, 690-691 Retention ratio, 551 Returns, abnormal, 351 on assets, 28 on equity, 21 independent, 159 on investment, 28 perfectly correlated, 159-160, 162-165 portfolio, 173 required on equity, 204 Reverse stock split, 662 Reward to variability ratio, 384 Rights offerings, 534 Risk, diversifiable, 118 empirical investigation of exchange risk, 817-818 equilibrium price of, 183 foreign exchange, 809, 813 idiosyncratic, 227 inflation, international, 814 market price of, 198, 203, 210, 404 quantity, in CAPM, 198 "real" foreign exchange risk, 814-817 systematic, 220, 225, 416, 457 systematic vs unsystematic, 198-199 undiversifiable, 118, 202 Risk-adjusted abnormal performance, 362, 364, 384 Risk-adjusted discount rate, 401, 410, 461 Risk-adjusted rate of return valuation formula, 203 943 Risk-aversion, 260 absolute, 89 comparison in the small and in the large, 90-92 definition, 85-90 relative, 89 Risk-free asset, 171, 179, 194 no riskless asset, 205-208 Risk-free hedged position, 245, 258, 260, 262, 263, 275-276, 278, 284, 297 Risk-free rate, 117, 362 Risk lover, 86 Risk neutral, 86 Risk premium, 87, 221 default, 230 Pratt-Arrow measure, 89, 91-92 Riskless arbitrage, 314 self-financing, 316 Risky debt, 248, 462 Robinson Crusoe economy, 4-9, 11, 183 Roll's critique of CAPM, 218-219 RRA See Relative risk aversion RRR See Real Rate of Return Relation Rules of differentiation, 903-904 Rules of integration, 921-922 Sale-leaseback agreements, 513, 615 Sales-type leases, 617 SAR See Stock appreciation rights Scale, projects of different, 56-58 Scott's model of conglomerate mergers, 696701 SDR See Special Drawing Rights Second-order condition, 913 Second-order stochastic dominance, 93, 100101 Secured debt, 511 Security Market Line, 197, 198, 350, 403, 417, 455, 461, 463, 897 Self-financing riskless arbitrage, 316 Self-tender offer, 680 Seller and buyer premiums in merger, 718 Selling a call, a put, 245-246 Selling short, 159, 194, 208, 252 Sell-offs, 678-679, 744-746 Semiannual compounding, 850 Semi-interquartile range, 150 Semistrong form market efficiency, 332, 383 Semivariance, 152 Separation, breakdown, 14 Fisher principle, 11-12, 15, 18, 32, 124, 126, 180 944 SUBJECT INDEX of investment and financing decisions, 40 portfolio, 122-124 three-fund, 211 two-fund, 123, 209 Sequential exercise requirement, 668 Serial correlation, 889-892 Serial covariance, 348 Service leases, 615, 617 Share repurchase, 22, 522, 571, 596-600, 680 from corporate insiders, 739 single block, 739 Shareholder wealth maximization, 18, 20, 24, 25, 31 Short sales, 159, 172, 194, 208, 252 Short-term capital gains, 308 Short-term liabilities, 530 Shutdown alternative, 429 Signaling hypotheses, 501-507, 520, 584, 671 of mergers, 686-687 Single block repurchases, 739 Single price law, of markets, 115 of securities, 187 Sinking fund requirements, 513 Slope estimate, 883 Social welfare function, 84 Sources and uses of funds statement, 23, 546547, 565 Special Drawing Rights, 786 Specially designated dividends, 588 Speculation, forward, international, 819-822 Speculative equilibrium hypothesis, 339 Speculators, 308 Spinoffs, 22, 678, 690-691, 746-750, 751 Splitoffs, 679 Splitups, 679 SPM See State Preference Model Spot prices, 302, 307, 310, 323 expected, 311 Spread, 247 Stable Paretian hypothesis, 208, 411 Standard and Poor's 500 index futures contract, 316 Standard deviation, 150, 159 Standard error of slope term, 884 Standard errors of estimate, 882 Standardization of futures contracts, 303 Standstill agreements, 679, 738 State-contingent claims, 110-111 applied to capital budgeting, 135-139 State of nature, 110 State Preference Model, 110, 127 application to capital structure, 140 State probabilities, 117 Stationary autoregressive process, 313 Stochastic dominance, 92-95, 169, 251 second order, 100-101 Stochastic process, continuous, 252, 268 subordinated hypothesis, 208 Stock appreciation rights, 667-671 Stock dividends, 23, 570 Stock index futures, 316 Stock option plans, 667-671 Stock repurchase, 22, 522, 571, 596-600, 680 from corporate insider, 739 single block, 739 Stock split, reverse, 662 Storage costs, 317 Straddle, 247 tax, 308 Straps, 247 Strategic planning, 685 Strict financial leases, 615, 619, 622 Striking price, 241 Strip financing, 662 Strips, 247 Strong form market efficiency, 332, 376 Strong independence, axioms of choice, 79 Student's t-distribution, 882 table, 885 Subjective price of risk, 166 Submartingale, 346-347, 349 Substitution, marginal rate of, 6, 12, 96, 98, 166, 168, 183 Supermajority voting provisions, 679 Supernormal growth model, 551, 554-555, 601-602 Surplus, consumers and producers, 454 Surprise, earnings and net dividend, 567 Swaps, 519-523 currency, 830 foreign exchange, 660 interest rate, 656-661 international interest rate, 829-830 Synergy, 684, 717 in conglomerate mergers, 692 Synthetic forward contracts, 322-323 Synthetic futures, 323 Systematic risk, 198-199, 202, 220, 225, 416, 457 of a commodity, 319 Tables, area under the normal curve, 290 Durbin-Watson d-statistic, 891 future value, 856 future value of an annuity, 858 natural logarithms, 860 SUBJECT INDEX present value, 857 present value of an annuity, 859 t-statistics, 885 Target debt ratio, 446 Target dividend payout, 577 Tax arbitrage, 581 Taxes, capital gains rate, 557 carrybacks and carryforwards, 518 considerations in merger, 689-690 credits, 518 hypothesis of mergers, 671 lease treatment, 616 minimum, 518 personal rate, 557 personal vs corporate, 451 rates, 39 straddles, 308 Tax-timing option, 308 Taylor Series, 916-921 Technical trading rules, 349-350 Tender offers, 678, 722, 723 free rider problem, 735 to go private, 662 to repurchase shares, 596-600 self-tender, 680 Term structure of interest rates, 65-71, 260, 658 Terms of mergers, 757-763 Texas Gulf Sulphur Case, 376 Theories of merger and acquisition activity, 682-690 Theory of choice, 15 Three-fund separation, 211 Trade credit, 530 Trading rule tests, international, 818-819 Trading rules, 339 Transactions costs, 13, 14 Transformation, marginal rate of, 8, 12, 166, 167, 183 Transitivity, axioms of choice, 79 Translation of foreign currency, 830-832 Treasury bill futures market, 316 Treynor index, 384 Truncated options, 282 t-statistics, 882 table, 885 Two-factor model, 207 Two-fund separation, 123, 181, 209, 508 Unanimity principle, 19 Unanticipated changes in real output, 223 Unanticipated inflation, 223, 230 Unbiased expectations hypothesis, 66-68 945 Undervaluation theory of mergers, 686-687 Underwritten new issues, 534 Undiversifiable risk, 118, 202 Unit normal distribution, 155 United States international transactions, 788 Unlevered beta, 457, 459 Unlevered firm value, 440, 442, 451 Unsystematic risk, 198-199 Utility, cardinal, 79-80 expected, 17, 80-82, 86, 92-93 expected utility criterion, 109 expected utility of an information set, 333 of expected wealth, 86 of a gamble, 91 marginal, 84 total, 166 Utility curves, 3-5 Utility functions, 18, 80-85 cardinal, 908 exponential, 104, 909 interpersonal comparison of, 84 linear risk-tolerance, 123 logarithmic, 86, 120, 909 order preserving, 81 power, 90, 909 quadratic, 89-90, 153, 909 social welfare, 84 Utility maximization, 10, 168, 194 Utility theory, 77, 102 Valuation, of all-equity firm with growth, 548-553 certainty equivalent formula, 203 example calculation, 602-607 finite supernormal growth model, 551, 601602 infinite constant growth model, 551 recursive formula, 545-546 risk-adjusted rate of return formula, 203 Valuation framework for mergers, 763-769 Value, of assets in place, 550 of future growth, 550 of information, 332-339 of levered firm, 442 liquidation, 419 net asset value of dual funds, 387 of unlevered firm, 440, 442, 451 Value additivity principle, 26, 32-33, 848-850 Value Line Investor Survey, 385-387 index futures contract, 316 Variable rate loans, 264 Variance, 150, 155 of binomial distribution, 265 946 SUBJECT INDEX constant elasticity of, 281, 287 of expected spot price, 311 of futures price, 312 instantaneous, 274 marginal rate of substitution between mean and, 96 matrix definition, 174 minimum variance opportunity set, 165-166, 167, 170, 194 minimum variance portfolio, 161-162, 871873 minimum variance zero-beta portfolio, 206, 362 of a portfolio, 161, 173-174, 184 of a two-asset portfolio, 155 Variance-covariance matrix, 872 Venture capitalists, 663 Vertical integration, 685 Vertical mergers, 678 Vested benefits, 640 Voluntary selloffs, 744-746 Voluntary spinoffs, 746-750 WACC See Weighted average cost of capital Warrants, 473-476 Weak form market efficiency, 332, 348, 350 Wealth expropriation, bondholder, 507-509, 519, 600, 743-744 Weekend effect, 390-392 Weighted average cost of capital, 29, 39, 402, 444-446, 450, 458, 470, 499, 517, 526531, 602 Williams Act of 1968, 726-727 Working capital, 41 Year-end effect, 390-392 Yield curve, twists in, 230 Yield to maturity, 65-66 Zero-beta, 220 Zero-beta portfolio, 206, 218, 362 Zero coupon bonds, 66, 248, 253, 464 ... +31 .2% +26 .3 +21 .4 +25 .1 +25 .9 -17.7% -16.3 -20 .7 -26 .8 -35.7 - 8.9% - 4.0 - 5.5 -11.7 -13.1 +26 .5% +17.4 + 12. 2 +14 .2 +10.5 +10.1% + 7.5 + 6 .2 + 3 .2 + 2. 9 -17,1% -23 .1% -27 .8 -26 .2 -28 .5 -27 .0 -29 .1... + 12. 7 + 5 .2 - 0 .2 - 2. 8 +19.8% +16.1 + 9 .2 + 2. 4 + 4.0 +25 .6% +30.8 +27 .6 +23 .1 +39.9 +50 .2% +37.4 +20 .8 +13 .2 + 8.4 -1.9% +0.7 +2. 7 -0.9 -4 .2 +33.7% +29 .0 +25 .5 +18.5 +19.9 +25 .2% -k 2. 2 +26 .7... 1)1 + ( 12. 25) t) Finally, taking the ratio of ( 12. 24) and ( 12. 25), we have - 1) COV(Vt- 1, ( 12. 26) 2( 1 7// t- 1) Et and from ( 12. 20), cov[E, _ t ), -1 ] = cov(k_ ,, Et- 2( k t) ( 12. 27) t- Therefore