a first coursein corporate finance

a first coursein corporate finance

A First Course in Corporate Finance Preview, Monday 26 th September, 2005 A First Course in Corporate Finance © 2003, 2004 by Ivo Welch. All rights reserved. Cartoons are copyright and courtesy of Mike Baldwin. See http://www.cornered.com/. ISBN: no number yet. Library of Congress: no number yet. Book Website: http://welch.econ.brown.edu/book Typesetting System: pdflatex. Cover Font Y&Y Lucida Casual 15, 36, 43pt. Main Body Font Y&Y Lucida 11pt. Other Fonts Y&Y Lucida variations See http://www.yandy.com/ Most graphics were created in R, open-source and free: www.r-project.org. The referenced spreadsheets are Excel and OpenOffice (free). Printed: Monday 26 th September, 2005 (bookc). Warning: This book is in development. It is not error-free. A First Course in Corporate Finance Preview, Monday 26 th September, 2005 Ivo Welch Professor of Finance and Economics Yale University There are a large number of individuals who have helped me with this book. They will eventually be thanked here. Until then, some random collection: Rick Antle. Donna Battista. Randolph Beatty. Wolfgang Bühler. Kangbin Chua. Diego Garcia. Stan Garstka. Roger Ibbotson. Ludovic Phalippou. Matthew Spiegel. John Strong. Julie Yufe. Many anonymous victim students using earlier error-ridden drafts. Most importantly, Mary-Clare McEwing helped me improve the book. Most of the review comments on early version of this book were very good, and I have tried hard to use them all. Thanks to the reviewers, who really gave a lot of their valuable time and thoughts to help me. Tony Bernardo Bill Christie Jennifer Conrad Josh Coval Amy Dittmar Richard Fendler Diego Garcia Sharon Garrison James Gatti Simon Gervais Tom Geurtz Robert Hansen Milt Harris Ronald Hoffmeister Kurt Jesswin Mark Klock Angeline Lavin Joseph McCarthy Michael Pagano Sarah Peck Robert Ritchey Bruce Rubin Tim Sullivan Chris Stivers Mark Stohs John Strong Joel Vanden Jaime Zender Miranda (Mei) Zhang Warning: This book is in development. It is not error-free. Dedicated to my parents, Arthur and Charlotte. last file change: Aug 23, 2005 (09:13h) i A Quick Adoption Checklist For Instructors This checklist will not apply after AFCICF is published (with full supplementary materials) by Addison-Wesley- Pearson. The recommended checklist for this book (AFCICF) while in beta test mode: ✓ Read this prologue and one or two sample chapters to determine whether you like the AFCICF approach. Although not representative, I recommend that you also read the epilogue. • If you do like the AFCICF approach, then please continue. If you do not like AFCICF (or the chapters you read), please email ivo.welch@yale.edu why you did not like it. I promise I will not shoot the messenger: I want to learn how to do it better. ✓ You can continue to assign whatever other finance textbook you were planning to use, but now please add AFCICF. • AFCICF is a full-service textbook for an introductory finance course. However, this does not mean that it cannot also work as a complement to your previous textbook. The fact that it is so different from the competition means that you and your students can benefit from a test, in which you assign both books for one year. Relative to relying on only your old textbook, AFCICF will not increase, but decrease your student confusion and workload. See how well AFCICF works! (Take the Pepsi challenge!) I hope that the majority of your students (and you) will prefer reading AFCICF instead of your old textbook. • I believe it should also be a relatively simple matter for you to plug AFCICF into your current class: The chapters are succinct and should map easily into your curriculum. Having the old textbook is also your insurance against using a novel textbook. And it will make students less critical of the remaining shortcomings in AFCICF, such as the limited number of exercises (and their occasionally erroneous solutions). Perhaps most importantly, AFCICF does not yet have full supplementary materials. It will, but until then, the auxiliary materials from older textbook may help. • For now, the printing cost for AFCICF adds only around $25 to student cost, so affordability should not be a concern. You can go wrong if you try out at least a few chapters of AFCICF in this manner. ✓ You can receive permission to post AFCICF on your class website. (The website must be secured to allow only university-internal distribution). ✓ Ask your copy center to print and bind the version on your website. (If need be, I can send you nicely bound copies at $50/book. Your copy center can probably do it for $25/book.) • Although versions on the AFCICF website at http://welch.econ.brown.edu/book will be better than the version you download, it is good for you and your students to have one definitive refer- ence version. ✓ If you are using AFCICF and you are looking for lecture notes, feel free to “steal” and adapt my lecture notes (linked at http://welch.econ.brown.edu/book) to your liking. (Please avoid the homeworks for now. Like some of the Q&A in AFCICF, the homeworks are not solid.) ✓ At the end of the course, please ask your students which textbook they found more helpful. Please email your conclusions and impressions to ivo.welch@yale.edu. Any suggestions for improvement are of course also very welcome. ii To The Instructor: Differences and Innovations The main concepts of finance are found in all textbooks, and this textbook is no exception.This book is intentionally different. Thus, most—though not all—of the concepts and subjects in A First Course in Corporate Finance overlap with more traditional finance textbooks. This text’s content is evolutionary, not revolutionary. Only its presentation is a revolutionary departure from traditional finance textbooks. Here is my view of how this book differs from what is currently out there: Conversational Tone The tone is conversational, which (I hope) makes the subject more ac-Conversational Tone. cessible. Numerical Example Based I learn best by numerical example, and firmly believe that studentsThe method of instruction is “step-by-step numerical examples.” do, too. Whenever I want to understand an idea, I try to construct numerical examples for myself (the simpler, the better). I do not particularly care for long algebra or complex formulas, precise though they may be. I do not much like many diagrams with long textual descriptions, either—I often find them too vague, and I am never sure whether I have really grasped the whole mechanism by which the concept works. Therefore, I wanted to write a textbook that relies on numerical examples as its primary tutorial method. This approach necessitates a rearrangement of the tutorial textbook progression. Most conventional finance textbooks start with a bird’s eye view and then work their way down. The fundamental difference of this book is that it starts with a worm’s eye view and works its way up. In caricature form, the format of other textbooks is “institutional background, hand-waving, formulas, figures, recipe application.” The format of this textbook is the posing of a critical question like “what would it be worth?,” which is then explained in numerical step-by-step examples from first principles. Right under the numerical compu- tations are the corresponding formulas. In my opinion, this structure clarifies the meaning of these formulas, and is better than either a textual exposition or an algebraic exposition. I believe that the immediate duality of numerics with formulas ultimately helps students understand the material on a higher level and with more ease. (Of course, this book also provides some overviews, and ordinary textbooks also provide some numerical examples.) This “forward development” approach also goes well with a book that has a conversa- tional, more interactive flavor. Brevity Sometimes, less is more.Brevity is important. The book focus is on explanations, not institutions. This book is intentionally concise, even though it goes into a lot more theoretical detail than other books! Institutional descriptions are short; only the concepts are explained in great detail. My view is that when students are exposed to too much material, they won’t read it, they won’t remember it, and they won’t know what is really important and what is not. Ten years after our students graduate, they should still solidly remember the fundamental ideas and be able to look up the details when they need them. Aside, many institutional details will have changed—it is the concepts that will last longer. Self-Contained for Clarity Finance is a subject that every smart student can comprehend, re-Self-contained means students can backtrack. gardless of background. It is no more difficult than economics or basic physics. The real problem is that many students come into class without much prerequisite knowledge, which we, the instructors, often erroneously believe they have. It is easy to mistake such “lost students” as “dumb students,” especially if there is no reference source where lost students can quickly fill in the missing parts. In this book, I try to make each topic’s development as self-contained as possible. I try to explain everything from first principles, but in a way that every student can find interesting. For example, even though the necessary statistical background is integrated in the book for the statistics novice, the statistics-savvy student also should find value in reading it. This is because it is different in our finance context than when it is taught for its own sake in a statistics course. Because this book tries to be as self-contained as possible, students who have failed to understand a particular lecture or topic (or who simply miss class) can now be referred iii back to read a self-contained chapter. My experience is that having a textbook that relates closely to the curriculum significantly reduces the need to back up and re-lecture on topics when enough students have become confused. My experience tells me that this reduces the planned time necessary to cover topics by about 10%. Closer Correspondence with the Curriculum I believe that most finance core courses follow Less Chapter Reordering. a curriculum that is much closer in spirit to this book—and more logical—than it is to the order in traditional finance textbooks. In the places where this book covers novel material (see below), I hope that you will find that it has merit—and if you agree, that covering the topic is much easier with this book than with another book. Topical Innovation The book offers a good number of specific topical and expositional inno- vations. Here is a selection: Progression to Risk and Uncertainty The book starts with a risk-free world, then adds First, no risk; then risk-neutral attitudes to risk; then risk-averse attitudes to risk. horizon dependent interest rates, then uncertainty under risk neutrality, then fric- tions (e.g., taxes), then uncertainty under risk-aversion, and finally uncertainty un- der risk aversion and with taxes (e.g., WACC and APV). Each step builds on concepts learned earlier. I believe it is an advantage to begin simple and then complicate up, e.g., to first teach uncertainty and default risk in terms of the much simpler concept of expected values (elaborated in my next point). The unique role of the more dif- ficult concepts of risk measurement, risk-aversion, and risk-aversion compensation, then becomes much clearer (there are forward hints to how it will change when we will make the world more complex). Distinction Between Compensation for Default Risk and Risk Aversion I have always beenDrive home “default risk.” shocked by how many graduating students think that a Boston Celtics bond quotes 400 basis points in interest above a comparable Treasury bond because of the risk- premium, which can be calculated using the CAPM formula. Learning to avoid this fundamental error is more important than fancy theories: the reason why the Boston Celtics bond quotes 400 extra basis points is primarily its default risk (compensa- tion for non-payment), not a risk-premium (compensation for risk-aversion). And for bonds, the latter is usually an order of magnitude smaller than the former. Although many instructors mention this difference at some point, 5 minutes of default risk discussion is often lost in 5 hours worth of CAPM discussion. But if students do not understand the basic distinction, the 5 hours of CAPM discussion are not only wasted, they will have made matters worse! Traditional textbooks have not helped, because they have not emphasized the dis- tinction. In contrast, in this book, default risk is clearly broken out. The difference between quoted (promised) and expected returns, and default probabilities and de- fault risk are important themes carried through. Financials from a Finance Perspective Students need to solidly understand the relation- Understand accounting without being an accounting textbook. ship between financial statements and NPV, and they need to understand the basic thought process to construct pro formas. Alas, I could not find good, concise, and self-contained explanations of the important aspects and logic of accounting state- ments from a finance perspective—rather than from the sometimes minutiae-oriented accounting perspective. Consequently, AFCICF offers a good chapter on financials. A fundamental understanding of financials is also necessary to understand compara- bles: for example, students must know that capital expenditures must be subtracted out if depreciation is not. Therefore, the common use of EBITDA without a capital expenditures adjustment is often wrong. Pro Forma The final chapter, towards which the book works at, is the creation of a pro forma. It combines all the ingredients from earlier chapters—capital budgeting, taxes, the cost of capital, capital structure, etc. iv Better Exposition of Valuation with Corporate Taxes WACC, APV, and direct pro-formaExplain Pro-Forma, WACC, and APV better. construction all incorporate the tax advantage of debt into valuation. This is bread- and-butter for a CFO. This book offers a clear explanation of how these methods usually come to similar results (and when not!). Robustness The book covers the robustness of our methods—the relative importance of errors and mistakes—and what first-order problems students should worry about and what second-order problems they can reasonably neglect. Capital Structure The academic perspective about capital structure has recently changed quite significantly. The empirical capital structure related chapters make it very clear where debt/equity ratios really come from. Many Other Topical Improvements For example, the yield curve gets its own chapter and many more. even before uncertainty is described in much detail, so that students understand that investments over different time horizons can offer different rates of return. There is a self-contained chapter on comparables as a valuation technique—which many of our students will regularly have to do after they graduate. And the book tries to be open and honest about where our knowledge is solid and where it is shaky—and how sensitive our estimates are to the errors we inevitably commit. Web Chapters and Flexible Topic Choice Although most of our curriculums are the same,Webchapters will allow a-la-carte choice. covering necessary basics, there are some topics which may or may not appeal to ev- eryone. Your preferences may differ from mine. For example, I find the financials part very important, because this is what most of our graduates will do when they become analysts, brokers, or consultants. However, you may instead prefer to talk more about international finance than I. It is of course impossible to satisfy everyone—and instructors have always chosen their own favorites, adding and deleting topics themselves. Still, this book tries to help. Some chapters will not be in the printed book, but will be available only on the Web site (“Web chapters”). Chapter style and formatting are unmistakably identical to the book itself. Every instructor can therefore choose his/her own favorite selection and ask students to download it. The existing web chapters are posted. Among them are Real Options Real options are briefly covered in Chapter 7 now, but not in great detail. This web chapter shows how to use spreadsheets, time-series analysis, Monte Carlo simulation, and optimization to determine the value of a plant that can shut down and reopen (for a cost) as output prices fluctuate. Option and Derivative Pricing This is a difficult subject to cover in an introductory course, because it really requires a minimum of 4-6 class sessions to do it well. This chapter tries to help you cover the basics in 2-3 class sessions. It explains option contracts, static arbitrage relations (including put-call parity), dynamic arbitrage and the Black- Scholes formula, and binomial trees. International Finance This chapter explains the role of currency translations and interna- tional market segmentation for both investments and corporate budgeting purposes. Ethics This chapter is experimental—and provocative. There is neither a particular set of must-cover topics, nor is there a template on how to present this material. You may disagree with my choices. v All the material in this book has been covered in one full semester course for M.B.A. students Warning: The title is optimistic. at the Yale School of Management. However, it is a tight fit, even for graduate students as talented as those at Yale. It would be impossible to cover all the material in a one quarter course—although I deem all of it essential. However, a two-quarter course sequence (usually one investments and one corporate finance course) should be able to cover the material, even in an undergraduate context. For planning purposes, most chapters should consume either one or two class sessions. Is this textbook too clear, and does it thereby eliminate the need for an instructor? If you believe this to be true, then you are too familiar with the material and you underestimate how difficult finance is for new students. Neither the book alone nor lectures alone are usually enough. If we get lucky, the two together will work. Redundancy is important to the learning experience. Indeed, in my own classes, I ask the students to read the book before class, not after. Having a good idea of what is coming, student ask questions in the classroom that tend to become more informed. Of course, if you find that the book makes it easier to teach finance, you can always speed up and cover more material! Side Note: If you use this book, please permit me to use and post your homework and exam questions with answers. (Of course, this is not a requirement, only a plea for help.) My intent is for the Website to become collaborative: you will be able to see what other faculty do, and they can see what you do. The copyright will of course remain with you. To The Student Prerequisites What do you need to understand this book? You do not need any specific background in fi- This book and the subject itself are tough, but they are not forbidding, even to an average student. The main prerequisite is mathematical aptitude, but not mathematical sophistication. nance. You do need to be thoroughly comfortable with arithmetic and generally comfortable with algebra. You do need mathematical aptitude, but no knowledge of advanced mathematical constructs, such as calculus. (Knowledge of statistics would be helpful, but I will explain the relevant concepts when the need arises.) You should own a $20 scientific calculator. (Financial calculators are not bad but also not necessary.) You should learn how to operate a spread- sheet (such as Excel in Microsoft’s office or the OpenCalc spreadsheet in the excellent and free OpenOffice at www.openoffice.org). The financial world is moving rapidly away from finan- cial calculators and toward computer spreadsheets—it is easier to work with information on a large screen with a 2,000 MHz processor than on a small 2-line display with a 2MHz processor. Because I have tried hard to keep the book self-contained and to explain everything from first principles, you should not need to go hunting for details in statistics, economics, or accounting textbooks. This is not to say that you do not need to take courses in these disciplines: they have way more to offer than just background knowledge for a finance textbook. One word of caution: the biggest problem for a novice of any field, but especially of finance, Jargon can trip up the reader. is jargon: the specialized terminology known only to the initiated. Worse, in finance, much jargon is ambiguous. Different people may use different terms for the same thing, and the same term may mean different things to different people. You have been warned! This book attempts to point out such ambiguous usage. Luckily, the bark of jargon is usually worse than its bite. It is only a temporary barrier to entry into the field of finance. How to Read The Book vi This textbook is concise. Its intent is to communicate the essential material in a straightforwardThis book is concise, focusing on the essence of arguments. (and thus compact), but also conversational (and thus more interactive) and accessible fashion. There are already many finance textbooks with well over a thousand pages. Much of the content of these textbooks is interesting and useful but not essential to an understanding of finance. (I personally find some of this extra content distracting.) The book is organized into four parts: the basics consist of return computations and capitalThe layout of the book. budgeting. Next are corporate financials, investments (asset pricing), and financing (capital structure). Major sections within chapters end with questions that ask you to review the points just made with examples or questions similar to those just covered. You should not proceed beyond a section without completing these questions (and in “closed book” format)! Many, but not all, questions are easy and/or straightforward replications of problems that you will have just encountered in the chapter. Others are more challenging. Each chapter ends with answers to these review questions. Do not move on until you have mastered these review questions. There are “annotations” on the left side of most paragraphs throughout the text. Suggestion:This is an annotation. use the remaining white space in the margin to scribble your own notes, preferably in pencil so that you can revise them. Especially important concepts that you should memorize are in red boxes:These are other notices. Important: This is an important point to remember. Interesting, related points that either interrupt the flow of an argument, or that are not abso- lutely necessary are marked Side Note: This is an interesting related note, not crucial for understanding the material. It is usually not excessively technical. More detailed technical points are “digging-deeper notes,” which should be of interest only to the student who is interested in pursuing finance beyond the introductory course: Digging Deeper: If you are really interested, here is a curious fact or a derivation that most likely relies on excessive algebra. Both can be safely omitted from reading without compromising understanding. Sometimes, an appendix contains further advanced material. A final warning: I have a strange sense of humor. Please do not be easily turned off.Sense of Humor Other Readings This book cannot do it all. It is important for you to keep up with current financial devel-Advice: Follow current coverage of financial topics elsewhere! opments. Frequent reading of the financial section of a major newspaper (such as the New York Times [N.Y.T.]), the Wall Street Journal [W.S.J.], or the Financial Times [F.T.] can help, as can regular consumption of good business magazines, such as The Economist or Business Week. (See the website at http://welch.econ.brown.edu/book for more useful resource links.) Although this is not a book on “how to read and understand the newspaper,” you should be able to understand most of the contents of the financial pages after consuming this textbook. You should also know how to cruise the web—sites such as Yahoo!Finance contain a wealth of useful financial information, which we shall also use extensively in this book. [...]... or similar to its best alternatives than it is to put an absolute value on your project The closer the alternatives, the easier it is put a value on your project It is easier to compare and therefore value a new Toyota Camry—because you have good alternatives such as Honda Accords and one-year used Toyota Camry—than it is to compare the Camry against a Plasma TV, a vacation, or pencils It is against... Fully Understand Finance? 672 672 Finance Research 673 A 3 .A Interesting Current Academic Research 673 A 3.C Getting Involved in Academic Research 673 A 3.D Finance Degrees A 3.E Academic Careers in Finance and Economics: A Ph.D.? A 3.F Being a Professor — A Dream Job for the Lazy? A 3.G A 4 Accomplishments of Finance A 3.B Top Finance Journals 673 673 674... physical For example, a company may have a project called “customer relations,” with real cash outflows today and uncertain future inflows You (a student) are a project: you pay for education and will earn a salary in the future In addition, some of the payoffs from education are metaphysical rather than physical If knowledge provides you with pleasure, either today or in the future, education yields a value... have to understand how capital structure, taxes and other considerations influence the cost of capital, the final part of the book You will learn what is easy and what is hard You will learn what is science and what is art And you will learn the limits to financial analysis Let’s set sail CHAPTER 2 The Time Value of Money (Net) Present Values last file change: Sep 24, 2005 (15:16h) last major edit: Mar... Future Corporate Income Taxes and Owner Returns 444 18·3.B The Discount Factor on Tax Obligations and Tax Shelters 18·4 445 Formulaic Valuation Methods: APV and WACC 451 18·4 .A Adjusted Present Value (APV): Theory 451 18·4.B APV: Application to a 60/40 Debt Financing Case 453 18·4.C Tax-Adjusted Weighted Average Cost of Capital (WACC) Valuation: Theory 18·4.D A Major Blunder: Applying... and closest alternatives that you want to estimate your own project’s value These alternatives create an “opportunity cost” that you suffer if you take your project instead of the alternatives file=introduction.tex: RP 7 Section 1·2 Learning How to Approach New Problems Many corporate projects in the real world have close comparables that make such relative valuation feasible For example, say you want... value that should be regarded as a positive cash flow Of course, for some students, the distaste of learning should be factored in as a cost (equivalent cash outflow)—but I trust that you are not one of them All such nonfinancial flows must be appropriately translated into cash equivalents if you want to arrive at a good project valuation! In finance, firms are basically collections of projects A firm can be... value, the smarter your decisions will be Corporate managers need to know how to value—and so do you The goal of a good corporate manager should be to take all projects that add value, and avoid those that would subtract value Sounds easy? If it only were so Valuation is often very difficult The math is not hard It is not the formulas that are difficult—even the most complex formulas in this book contain... not appear valuable enough Finance is about how best to decide among these alternatives—and this textbook will explain how Theme Number One: Value! Make Decisions Based on Value There is one principal theme that carries through all of finance It is value It is the question “What is a project, a stock, or a house worth?” To make smart decisions, you must be able to assess value—and the better you can assess... Treasury originally issued 10 years ago, and 10 seconds later sell a 3-year Treasury issued 6 years ago—buyers and sellers in Treasuries are easily found, and transaction costs are very low In 2001, average trading volume in Treasuries was about $300 billion per trading day (about 255 per year) Therefore, the annual trading volume in U.S Treasuries of about $70 trillion totaled about five to ten times the . 217 A Appendix: Supplementary Financials — Coca Cola . . . . . . . . . . . . . . . . . . . . . . . . . 218 a. Coca Cola’s Financials From EdgarScan 219 b. Coca Cola’s Financials From Yahoo !Finance. Pro-Forma, WACC, and APV better. construction all incorporate the tax advantage of debt into valuation. This is bread- and-butter for a CFO. This book offers a clear explanation of how these methods usually. 126 6·4 .A. The Basics of (Federal) Income Taxes 126 6·4.B. Before-Tax vs. After-Tax Expenses 128 TABLE OF CONTENTS ix 6·4.C. Average and Marginal Tax Rates 129 6·4.D. Dividend and Capital Gains Taxes