CORPORATE FINANCE potx

Franco Modigliani Professor of Finance and EconomicsSloan School of Management Massachusetts Institute of Technology Benninga and Sarig Corporate Finance: A Valuation Approach Block and

e i g h t h

e d i t i o n

ISBN 978-0-07-310590-1 MHID 0-07-310590-2 Part of

ISBN 978-0-07-333718-0 MHID 0-07-333718-8

common company situations that embody important corporate finance topics.

risk analysis, behavioral finance, and real options capital budgeting.

chapters.

For more information on the book, its features, and the supplements package, please see the Preface or visit www.mhhe.com/rwj.

Corporate Finance gets you

moving in the right direction

Corporate Finance

Franco Modigliani Professor of Finance and Economics

Sloan School of Management

Massachusetts Institute of Technology

Benninga and Sarig

Corporate Finance: A Valuation Approach

Block and Hirt

Foundations of Financial Management

Twelfth Edition

Brealey, Myers, and Allen

Principles of Corporate Finance

Eighth Edition

Brealey, Myers, and Marcus

Fundamentals of Corporate Finance

Chew and Gillan

Corporate Governance at the Crossroads: A Book

Grinblatt and Titman

Financial Markets and Corporate Strategy

Kester, Ruback, and Tufano

Case Problems in Finance

Twelfth Edition

Ross, Westerfi eld, and Jaffe

Corporate Finance

Eighth Edition

Ross, Westerfi eld, Jaffe, and Jordan

Corporate Finance: Core Principles

and Applications

First Edition

Ross, Westerfi eld, and Jordan

Essentials of Corporate Finance

Fifth Edition

Ross, Westerfi eld, and Jordan

Fundamentals of Corporate Finance

Hirt and Block

Fundamentals of Investment Management

Eighth Edition

Hirschey and Nofsinger

Investments: Analysis and Behavior

First Edition

Jordan and Miller

Fundamentals of Investments: Valuation

and Management

Fourth Edition

Financial Institutions and Markets

Rose and Hudgins

Bank Management and Financial Services

Seventh Edition

Rose and Marquis

Money and Capital Markets: Financial Institutions

and Instruments in a Global Marketplace

Ninth Edition

Saunders and Cornett

Financial Institutions Management: A Risk

Management Approach

Fifth Edition

Saunders and Cornett

Financial Markets and Institutions: An Introduction

to the Risk Management Approach

Third Edition

International Finance

Eun and Resnick

International Financial Management

Fourth Edition

Kuemmerle

Case Studies in International Entrepreneurship:

Managing and Financing Ventures in the Global Economy

First Edition

Real Estate

Brueggeman and Fisher

Real Estate Finance and Investments

Thirteenth Edition

Corgel, Ling, and Smith

Real Estate Perspectives: An Introduction

to Real Estate

Fourth Edition

Ling and Archer

Real Estate Principles: A Value Approach

Second Edition

Financial Planning and Insurance

Allen, Melone, Rosenbloom, and Mahoney

Pension Planning: Pension, Profi t-Sharing,

and Other Deferred Compensation Plans

Ninth Edition

Altfest

Personal Financial Planning

First Edition

Harrington and Niehaus

Risk Management and Insurance

Second Edition

Kapoor, Dlabay, and Hughes

Focus on Personal Finance: An Active Approach

to Help You Develop Successful Financial Skills

First Edition

Kapoor, Dlabay, and Hughes

Personal Finance

Eighth Edition

Randolph W Westerfi eld

Marshall School of BusinessUniversity of Southern California

Published by McGraw-Hill/Irwin, a business unit of The McGraw-Hill Companies, Inc., 1221

Avenue of the Americas, New York, NY, 10020 Copyright © 2008 by The McGraw-Hill Companies, Inc

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or broadcast for distance learning.

Some ancillaries, including electronic and print components, may not be available to customers outside the United States.

This book is printed on acid-free paper.

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ISBN 978-0-07-310590-1

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Ross, Stephen A.

p cm (The McGraw-Hill/Irwin series in fi nance, insurance, and real estate)

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To our family and friends with love and gratitude.

STEPHEN A ROSS Sloan School of Management, Massachusetts Institute of ogy Stephen A Ross is the Franco Modigliani Professor of Financial Economics at the

Technol-Sloan School of Management, Massachusetts Institute of Technology One of the most widely published authors in fi nance and economics, Professor Ross is recognized for his work in developing the arbitrage pricing theory, as well as for having made substantial con-tributions to the discipline through his research in signaling, agency theory, option pricing, and the theory of the term structure of interest rates, among other topics A past president

of the American Finance Association, he currently serves as an associate editor of several academic and practitioner journals He is a trustee of CalTech and Freddie Mac

California Randolph W Westerfi eld is Dean Emeritus of the University of Southern California’s Marshall School of Business and is the Charles B Thornton Professor of Finance

Pennsylvania, where he was the chairman of the fi nance department and member of the

fi nance faculty for 20 years He is a member of several public company boards of directors, including Health Management Associates, Inc., William Lyon Homes, and the Nicholas Applegate Growth Fund His areas of expertise include corporate fi nancial policy, invest-ment management, and stock market price behavior

F Jaffe has been a frequent contributor to the fi nance and economics literatures in such

journals as the Quarterly Economic Journal, The Journal of Finance, The Journal of nancial and Quantitative Analysis, The Journal of Financial Economics, and The Financial Analysts Journal His best-known work concerns insider trading, where he showed both

Fi-that corporate insiders earn abnormal profi ts from their trades and Fi-that regulation has little effect on these profi ts He has also made contributions concerning initial public offerings, regulation of utilities, the behavior of marketmakers, the fl uctuation of gold prices, the theoretical effect of infl ation on interest rates, the empirical effect of infl ation on capital asset prices, the relationship between small-capitalization stocks and the January effect, and the capital structure decision

vi

excit-ing than ever before The last decade has seen fundamental changes in fi nancial markets and fi nancial instruments In the early years of the 21st century, we still see announcements in the fi nancial press about such matters as takeovers, junk bonds, fi nancial restructuring, initial public offerings, bankruptcy, and derivatives In addition, there is the new recognition of “real” options, private equity and venture capital, and the disappear-ing dividend The world’s fi nancial markets are more integrated than ever before Both the theory and practice of corporate fi nance have been moving ahead with uncommon speed, and our teaching must keep pace

These developments place new burdens on the teaching of corporate fi nance On one hand, the changing world of fi nance makes it more diffi cult to keep materials up to date On the other hand, the teacher must distinguish the permanent from the temporary and avoid the temptation to follow fads Our solution to this problem is to emphasize the modern fundamentals of the theory of fi nance and make the theory come to life with contemporary examples Increasingly, many of these examples are outside the United States All too often the beginning student views corporate fi nance as a collection of unrelated topics that are unifi ed largely because they are bound together between the covers of one book As in the previous editions, our aim is to present corporate fi nance as the working of a few integrated and powerful institutions

The Intended Audience of This Book

This book has been written for the introductory courses in corporate fi nance at the MBA level and for the intermediate courses in many undergraduate programs Some instructors will fi nd our text appropriate for the introductory course at the undergraduate level as well

We assume that most students either will have taken, or will be concurrently enrolled in, courses in accounting, statistics, and economics This exposure will help students understand some of the more diffi cult material However, the book is self-contained, and a prior knowl-edge of these areas is not essential The only mathematics prerequisite is basic algebra

New to the Eighth Edition

With the eight edition of Corporate Finance, we have done extensive updating and

re-working throughout the text Among the more noticeable changes are opening vignettes for each chapter Most of these present familiar companies in situations covered by the chapter, thereby motivating the discussion The end-of-chapter material has been expanded considerably We now have two separate sets of questions, one that focuses on concepts and critical ideas and another that is more problem oriented The total number of questions has grown signifi cantly Finally, almost every chapter now ends with a mini-case that places the student in the position of needing to apply chapter concepts in a common real-world situation These cases are suitable for a variety of pedagogical purposes, ranging from homework to group assignments to in-class discussions

In addition to these changes and overall updating, a number of chapters have signifi cant new material Following are some of the more notable additions and upgrades:

on Sarbanes-Oxley

Chapter 3: Completely rewritten to cover fi nancial statements analysis and long-term

fi nancial planning

system

Chapter 12: Expanded discussion on actual cost of capital estimation

Chapter 18: New material on several dividend-related subjects

Chapter 19: New material on Dutch auction IPOs

Chapter 20: New material on bond price quotes and make-whole call provisions

Chapter 22: Expanded discussion on applications of options analysis in corporate fi nance

Chapter 27: New material on fi nancial electronic data interchange and the Check Clearing

topics

Chapter 31: Completely rewritten for clarity

We have also worked to improve the supplements to the text, with the goal of ing far and away the most comprehensive student and instructor support at this level For example, we now provide fully detailed step-by-step solutions to end-of-chapter problems (and spreadsheets for each one as well) The testbank has grown signifi cantly in terms of the number of questions, and we have worked to provide a wider variety of questions and question types The PowerPoint set also has grown

provid-The book’s Online Learning Center (OLC) delivers several new and very rich student study aids There is self-study software with at least 100 questions per chapter Narrated PowerPoint slides actually talk students through the material Our Interactive FinSims con-tain simulations of key fi nance concepts in which students are asked to provide values for key variables These digital assets provide completely new avenues for students to explore and ways for them to comprehend the subject on a deeper level

For a complete look at the new and updated eighth edition features, please see the next section

viii Preface

have updated and improved our features

to present material in a way that makes

it coherent and easy to understand In

valuable learning tools and support, to help students succeed in learning the fundamentals of fi nancial management.

Pedagogy

Chapter Opening

Vignettes

Each chapter begins with a “roadmap” that

describes the objectives of the chapter

and how it connects with concepts already

learned in previous chapters Real company

examples that will be discussed are

highlighted in these sections.

have updated and improved our features

to present material in a way that makes

it coherent and easy to understand In

valuable learning tools and support, to help students succeed in learning the fundamentals of fi nancial management.

Pedagogy

Chapter Opening

Vignettes

Each chapter begins with a “roadmap” that

describes the objectives of the chapter and

how it connects with concepts already learned

in previous chapters Real company examples

that will be discussed are highlighted in these

sections.

Return and Risk

The Capital Asset Pricing Model (CAPM)

Expected returns on common stocks can vary quite a bit One important determinant is the industry in which a company operates For example, according to recent es- timates from Ibbotson Associates, the median expected return for department stores, which includes companies such as Sears and Kohls, is 11.63 percent, whereas Oracle have a median expected return of 15.46 percent

Air transportation companies such as Delta and west have a median expected return that is even higher:

South-17.93 percent.

These estimates raise some obvious questions

First, why do these industry expected returns differ so much, and how are these specific numbers calculated?

Also, does the higher return offered by airline stocks mean that investors should prefer these to, say, department store stocks? As we will see in this chapter, the Nobel Prize–winning answers to these questions form the basis of our modern understanding of risk and return.

C H A P T E R

10

279

10.1 Individual Securities

In the first part of Chapter 10, we will examine the characteristics of individual securities

In particular, we will discuss:

1 Expected return: This is the return that an individual expects a stock to earn over the

next period Of course, because this is only an expectation, the actual return may be either higher or lower An individual’s expectation may simply be the average return per period a security has earned in the past Alternatively, it may be based on a detailed analysis of a firm’s prospects, on some computer-based model, or on special (or inside) information.

2 Variance and standard deviation: There are many ways to assess the volatility of a

security’s return One of the most common is variance, which is a measure of the squared deviations of a security’s return from its expected return Standard deviation

is the square root of the variance.

3 Covariance and correlation: Returns on individual securities are related to one

another Covariance is a statistic measuring the interrelationship between two securities Alternatively, this relationship can be restated in terms of the correlation between the two securities Covariance and correlation are building blocks to an understanding of the beta coefficient.

Figures and TablesThis text makes extensive use of real data and presents them in various fi gures and tables Explanations in the narrative, examples, and end-of-chapter problems will refer to many of these exhibits.

ExamplesSeparate called-out examples are integrated throughout the chapters Each example illustrates an intuitive or mathematical application in a step-by-step format There

is enough detail in the explanations so the student doesn’t have to look elsewhere for additional information.

“In Their Own Words” Boxes

Located throughout the chapters, this unique series consists

of articles written by distinguished scholars or practitioners

about key topics in the text Boxes include essays by Edward

I Altman, Anthony Bourdain, Robert S Hansen, Robert C

Higgins, Michael C Jensen, Richard M Levich, Merton Miller,

and Jay R Ritter.

Figures and TablesThis text makes extensive use of real data and presents them in various fi gures and tables Explanations in the narrative, examples, and end-of-chapter problems will refer to many of these exhibits.

ExamplesSeparate called-out examples are integrated throughout the chapters Each example illustrates an intuitive or mathematical application in a step-by-step format There

is enough detail in the explanations so the student doesn’t have to look elsewhere for additional information.

“In Their Own Words” Boxes

Located throughout the chapters, this unique series consists

of articles written by distinguished scholars or practitioners

about key topics in the text Boxes include essays by Edward

I Altman, Anthony Bourdain, Robert S Hansen, Robert C

Higgins, Michael C Jensen, Richard M Levich, Merton Miller,

and Jay R Ritter.

If Firm Subsequently Does Poorly

If Firm Subsequently Prospers

Convertible bonds (CBs)

No conversion because of low stock price.

Conversion because of high stock price.

Compared to:

be-cause coupon rate is lower.

CBs provide expensive fi nancing because bonds are converted, which dilutes existing equity.

because fi rm could have issued common stock at high prices.

CBs provide cheap fi nancing high prices when bonds are converted.

Table 24.2

The Case for and against Convertible Bonds (CBs)

Are Convertibles Always Better? The stock price of RW Company is $20 Suppose this

company can issue subordinated debentures at 10 percent It can also issue convertible bonds at

6 percent with a conversion value of $800 The conversion value means that the holders can convert

a convertible bond into 40 (
$800兾$20) shares of common stock.

A company treasurer who believes in free lunches might argue that convertible bonds should

be issued because they represent a cheaper source of fi nancing than either subordinated bonds or rise above $20, the convertible bondholders will not convert the bonds into common stock In this case the company will have obtained debt fi nancing at below-market rates by attaching worthless equity kickers On the other hand, if the fi rm does well and the price of its common stock rises to receive a bond with face value of $1,000 in exchange for issuing 40 shares of common stock, imply- ing a conversion price of $25 The company will have issued common stock at $25 per share, or

20 percent above the $20 common stock price prevailing when the convertible bonds were issued

This enables it to lower its cost of equity capital Thus, the treasurer happily points out, regardless

of whether the company does well or poorly, convertible bonds are the cheapest form of fi nancing.

(continued)

the underlying stock subsequently does well The fi rm is worse off having issued ible debt if the underlying stock subsequently does poorly We cannot predict future stock worse than issuing equity The preceding analysis is summarized in Table 24.2.

convert-Modigliani–Miller (MM) pointed out that, abstracting from taxes and bankruptcy costs, the fi rm is indifferent to whether it issues stock or issues debt The MM relationship

to whether it issues convertibles or issues other instruments To save space (and the tience of students) we have omitted a full-blown proof of MM in a world with convertibles

pa-of convertibles.

The “Free Lunch” Story

The preceding discussion suggests that issuing a convertible bond is no better and no worse

of arguing that issuing convertible debt is actually better than issuing alternative ments This is a free lunch type of explanation, of which we are quite critical.

The interplay of the firm’s activities with the financial markets is illustrated in ure 1.4 The arrows in Figure 1.4 trace cash flow from the firm to the financial markets and sells debt and equity shares to investors in the financial markets This results in cash flows

Fig-from the financial markets to the firm (A) This cash is invested in the investment ties (assets) of the firm (B) by the firm’s management The cash generated by the firm (C)

activi-dividends; the bondholders who lent funds to the firm receive interest and, when the initial

some is paid to the government as taxes (D).

Over time, if the cash paid to shareholders and bondholders (F) is greater than the cash raised in the financial markets (A), value will be created.

di-rectly Much of the information we obtain is in the form of accounting statements, and

h f h k f fi i l l i i h fl i f i f i

In Their Own Words

SKILLS NEEDED FOR THE CHIEF FINANCIAL OFFICERS OF eFINANCE.COM

Chief strategist: CFOs will need to use real-time financial

information to make crucial decisions fast.

Chief deal maker: CFOs must be adept at venture

capi-tal, mergers and acquisitions, and strategic partnerships.

Chief risk officer: Limiting risk will be even more

im-portant as markets become more global and hedging instruments become more complex.

Chief communicator: Gaining the confidence of Wall

Street and the media will be essential.

SOURCE: BusinessWeek, August 28, 2000, p 120.

Key Terms

Students will note that important words

are highlighted in boldface type the fi rst

time they appear

Numbered EquationsKey equations are numbered and listed on the back end sheets for easy reference.

xii

counting definition of income is:

Revenue  Expenses ⬅ Income

If the balance sheet is like a snapshot, the income statement is like a video recording of U.S Composite Corporation for 2007.

The income statement usually includes several sections The operations section reports the firm’s revenues and expenses from principal operations One number of particular im- portance is earnings before interest and taxes (EBIT), which summarizes earnings before taxes and financing costs Among other things, the nonoperating section of the income statement includes all financing costs, such as interest expense Usually a second section reports as a separate item the amount of taxes levied on income The last item on the income statement is the bottom line, or net income Net income is frequently expressed per share of common stock—that is, earnings per share.

When analyzing an income statement, the financial manager should keep in mind GAAP, noncash items, time, and costs.

25.5 Interest Rate Futures Contracts

In this section we consider interest rate futures contracts Our examples deal with futures and Treasury bond forward contracts Differences between futures and forward contracts are explored Hedging examples are provided next.

Pricing of Treasury Bonds

As mentioned earlier in the text, a Treasury bond pays semiannual interest over its life In addition, the face value of the bond is paid at maturity Consider a 20-year, 8 percent cou- pon bond that was issued on March 1 The fi rst payment is to occur in six months—that is,

on September 1 The value of the bond can be determined as follows:

Pricing of Treasury Bond

P TB
$40

1  R 1  $40

(1  R 2 ) 2  $40(1  R 3 ) 3   _$40

(1  R 39 ) 39  _$1,040(1  R 40 ) 40 (25.1)

Because an 8 percent coupon bond pays interest of $80 a year, the semiannual coupon

is $40 Principal and the semiannual coupons are both paid at maturity As we mentioned in

a previous chapter, the price of the Treasury bond, P TB, is determined by discounting each payment on a bond at the appropriate spot rate Because the payments are semiannual, each spot rate is expressed in semiannual terms That is, imagine a horizontal term structure

where the effective annual yield is 12 percent for all maturities Because each spot rate, R,

is expressed in semiannual terms, each spot rate is 1 12 −
5.83% Coupon payments 1

Because solving problems is so critical to a student’s learning, new questions and problems have been added, and existing questions and problems have been revised All problems have also been thoroughly reviewed and accuracy-checked.

Problems have been grouped according to level of diffi culty with the levels listed in the margin: Basic, Intermediate, and Challenge.

Additionally, we have tried to make the problems in the critical “concept” chapters, such as those on value, risk, and capital structure, especially challenging and interesting.

We provide answers to selected problems in Appendix B

at the end of the book.

S&P ProblemsIncluded in the end-of-chapter material are problems directly incorporating the Educational Version of Market Insight, a service based on Standard & Poor’s renowned Compustat database These problems provide you with an easy method

of including current real-world data in your course.

Excel ProblemsIndicated by the Excel icon in the margin, these problems can be found at the end of almost all chapters Located on the book’s Web site (see Online Resources), Excel templates have been created for each of these problems, where students can use the data in the problem to work out the solution using Excel skills.

End-of-Chapter Cases

Located at the end of almost every chapter, these mini-cases

focus on common company situations that embody important

corporate fi nance topics Each case presents a new scenario,

data, and a dilemma Several questions at the end of each case

require students to analyze and focus on all of the material

they learned in that chapter

Chapter 2 Financial Statements and Cash Flow 35

go under financing activities, but unfortunately that is not how the accounting is handled

consequence, a primary difference between the accounting cash flow and the financial cash flow of the firm (see Table 2.5) is interest expense.

Chapter 2 Financial Statements and Cash Flow 35

Besides introducing you to corporate accounting, the purpose of this chapter has been to teach you how to determine cash flow from the accounting statements of a typical company.

1 Cash flow is generated by the firm and paid to creditors and shareholders It can be classified as:

a Cash flow from operations.

b Cash flow from changes in fixed assets.

c Cash flow from changes in working capital.

2 Calculations of cash flow are not difficult, but they require care and particular attention to detail in

properly accounting for noncash expenses such as depreciation and deferred taxes It is especially important that you do not confuse cash flow with changes in net working capital and net income.

Summary and Conclusions

Concept Questions

1 Liquidity True or false: All assets are liquid at some price Explain.

2 Accounting and Cash Flows Why might the revenue and cost figures shown on a standard

period?

3 Accounting Statement of Cash Flows Looking at the accounting statement of cash flows,

what does the bottom line number mean? How useful is this number for analyzing a company?

4 Cash Flows How do financial cash flows and the accounting statement of cash flows differ?

Which is more useful for analyzing a company?

5 Book Values versus Market Values Under standard accounting rules, it is possible for a

company’s liabilities to exceed its assets When this occurs, the owners’ equity is negative Can this happen with market values? Why or why not?

6 Cash Flow from Assets Why is it not necessarily bad for the cash flow from assets to be

negative for a particular period?

7 Operating Cash Flow Why is it not necessarily bad for the operating cash flow to be

nega-tive for a particular period?

8 Net Working Capital and Capital Spending Could a company’s change in net working

about net capital spending?

9 Cash Flow to Stockholders and Creditors Could a company’s cash flow to stockholders

flow to creditors?

10 Firm Values Referring back to the CBS Records example at the beginning of the chapter,

reported loss What do you think was the basis for our conclusion?

Questions and Problems

1 Building a Balance Sheet Culligan, Inc., has current assets of $5,000, net fixed assets of

shareholders’ equity account for this firm? How much is net working capital?

2 Building an Income Statement Ragsdale, Inc., has sales of $527,000, costs of $280,000,

BASIC (Questions 1–10)

www.mhhe.com/edumarketinsight

Image (SHRP) Looking back at Table 2.3, what is the marginal income tax rate for Sharper rate for Sharper Image Is this number greater than 35 percent? Why or why not?

and HJ Heinz (HNZ) Calculate the net working capital for each company Is American tric Power’s net working capital negative? If so, does this indicate potential financial difficulty for the company? What about Heinz?

Harley-David-son (HDI), Hawaiian Electric Industries (HE), and Time Warner (TWX) What are the earnings per share (EPS Basic from operations) for each of these companies? What are the dividends per share for each company? Why do these companies pay out a different portion of income in the form of dividends?

S&P Problems

Cash Flows at Warf Computers, Inc.

Warf Computers, Inc., was founded 15 years ago by Nick Warf, a computer programmer The small initial investment to start the company was made by Nick and his friends Over the years, this same group has supplied the limited additional investment needed by the company in the form of both equity and short- and long-term debt Recently the company has developed a vir- tual keyboard (VK) The VK uses sophisticated artificial intelligence algorithms that allow the errors, and format the document according to preset user guidelines The VK even suggests alternative phrasing and sentence structure, and it provides detailed stylistic diagnostics Based

on a proprietary, very advanced software/hardware hybrid technology, the system is a full eration beyond what is currently on the market To introduce the VK, the company will require significant outside investment.

gen-Nick has made the decision to seek this outside financing in the form of new equity investments and bank loans Naturally, new investors and the banks will require a detailed financial analysis Your employer, Angus Jones & Partners, LLC, has asked you to examine the and the most recent income statement:

15 Convertible Calculations You have been hired to value a new 25-year callable, convertible

bond The bond has a 6.80 percent coupon rate, payable annually The conversion price is $150, year The bond is callable at $1,200; but based on prior experience, it won’t be called unless the you assign to this bond?

16 Warrant Value Superior Clamps, Inc., has a capital structure consisting of 4 million shares of

common stock and 500,000 warrants Each warrant gives its owner the right to purchase one and will expire one year from today The market value of the company’s assets is $88 million, one year yield a continuously compounded interest rate of 7 percent The company does not pay a dividend Use the Black–Scholes model to determine the value of a single warrant.

CHALLENGE (Questions 15–17)

Comprehensive Teaching

Corporate Finance has many options in terms of the textbook, instructor supplements, student

supplements, and multimedia products Mix and match to create a package that is perfect for your

course.

Instructor Supplements

Instructor’s CD-ROM ISBN-10: 0-07-325735-4 / ISBN-13: 978-0-07-325735-4

This CD contains all the necessary supplements—Instructor’s Manual, Test Bank, Computerized Test Bank, and

PowerPoint—all in one useful product in an electronic format

Prepared by Steven Dolvin, Butler University and Joseph Smolira, Belmont University.

This is a great place to fi nd new lecture ideas The IM has three main sections The fi rst section contains a chapter

outline and other lecture materials The annotated outline for each chapter includes lecture tips, real-world tips,

ethics notes, suggested PowerPoint slides, and, when appropriate, a video synopsis Detailed solutions for all

end-of-chapter problems appear in section two

Prepared by Patricia Ryan, Colorado State University.

Here’s a great format for a better testing process The Test Bank has well over 100 questions per chapter that closely

link with the text material and provides a variety of question formats (multiple-choice questions/problems and

essay questions) and levels of diffi culty (basic, intermediate, and challenge) to meet every instructor’s testing needs

Problems are detailed enough to make them intuitive for students, and solutions are provided for the instructor

These additional questions are found in a computerized test bank utilizing McGraw-Hill’s EZ Test testing

software to quickly create customized exams This user-friendly program allows instructors to sort questions by

format; edit existing questions or add new ones; and scramble questions for multiple versions of the same test

• PowerPoint Presentation System

Prepared by Steven Dolvin, Butler University.

Customize our content for your course This presentation has been thoroughly revised to include more

lecture-oriented slides, as well as exhibits and examples both from the book and from outside sources Applicable

slides have Web links that take you directly to specifi c Internet sites, or a spreadsheet link to show an example

in Excel You can also go to the Notes Page function for more tips on presenting the slides If you already

have PowerPoint installed on your PC, you can edit, print, or rearrange the complete presentation to meet your

specifi c needs

Solutions Manual ISBN-10: 0-07-325737-0 / ISBN-13: 978-0-07-325737-2

Prepared by Joseph Smolira, Belmont University

This manual contains detailed, worked-out solutions for all of the problems in the end-of-chapter material It has also

been reviewed for accuracy by multiple sources The Solutions Manual is also available for purchase by your students

xiv

and Learning Package

Videos ISBN-10: 0-07-326174-2 / ISBN-13: 978-0-07-326174-4

Now available in DVD format: a current set of videos about hot topics! McGraw-Hill/Irwin has produced a series

of fi nance videos that are 10-minute case studies of topics such as fi nancial markets, careers, rightsizing, capital

budgeting, EVA (economic value added), mergers and acquisitions, and foreign exchange Discussion questions for

these videos, as well as video clips, are available in the Instructor’s Center at www.mhhe.com/rwj

Digital Solutions

Online Learning Center (OLC): Online Support at www.mhhe.com/rwj

The Online Learning Center (OLC) contains FREE access to additional Web-based study and teaching aids created

for this text, such as the following

Student Support

• New! Self-Study Software

With this self-study program, students can test their knowledge of one chapter or a number of chapters by using self-grading questions written specifi cally for this text There are at least 100 questions per chapter Students can set a timer function to simulate a test environment, or they can choose to have answers pop up as they fi nish each question Questions were prepared by Kay Johnson, Penn State University–Erie

• New! Narrated PowerPoint Examples

Created by Kay Johnson, Penn State University–Erie, exclusively for students Each chapter’s slides follow the chapter topics and provide steps and explanations showing how to solve key problems Because each student learns differently, a quick click on each slide will “talk through” its contents with you!

• New! Interactive FinSims

Created by Eric Sandburg, Interactive Media, each module highlights a key concept of the book and simulates how to solve its problems, asking the student to input certain variables This hands-on approach guides students through diffi cult and important corporate fi nance topics

Along with having access to all of the same material your students can view on the book’s OLC, you also have

password-protected access to the Instructor’s Manual, solutions to end-of-chapter problems, Instructor’s PowerPoint, Excel

Template Solutions, video clips, video projects and questions, and teaching notes to Corporate Finance Online

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research found on this site For more details, please see the bound-in card inside the front cover of this text or visit

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Corporate Finance Online

As part of the OLC, instructors and students will also have access to Corporate Finance Online, found on the

opening page Corporate Finance Online is an exclusive Web tool from McGraw-Hill/Irwin The site provides over

54 exercises for 27 key corporate fi nance topics, allowing students to complete challenging exercises and discussion

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instructors there are also password-protected teaching notes to assist with classroom integration of the material

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without hassle In just a few minutes even the most novice computer user can have a functioning course Web site

Simply type your material into the template provided and PageOut instantly converts it to HTML Next, choose

your favorite of three easy-to-navigate designs and your class Web home page is created, complete with online

syllabus, lecture notes, and bookmarks You can even include a separate instructor page and an assignment page

PageOut offers enhanced point-and-click features, including a Syllabus Page that applies a real-world link to

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You may also package either version of the text with a variety of additional learning tools that are available for

your students

Prepared by Robert Hanson, Eastern Michigan University.

The Student Problem Manual is a direct companion to the text It is uniquely designed to involve the student in

the learning process Each chapter contains a mission statement, an average of 20 fi ll-in-the-blank concept test

questions and answers, and an average of 15 problems and worked-out solutions This product can be purchased

separately or can be packaged with this text

Solutions Manual

ISBN-10: 0-07-325737-0 / ISBN-13: 978-0-07-325737-2

Prepared by Joseph Smolira, Belmont University.

This manual contains detailed, worked-out solutions for all of the problems in the end-of-chapter material It has

also been reviewed for accuracy by multiple sources The Solutions Manual is also available for purchase by your

students

xvi

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ISBN-10: 0-07-298072-9 / ISBN-13: 978-0-07-298072-1

By Troy Adair, University of Michigan–Ann Arbor; can be packaged with the text at a discounted price

This supplement teaches students how to build fi nancial models in Excel and shows students how to use these

models to solve a variety of common corporate fi nance problems For more information about this supplement,

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FinGame Online 4.0 ISBN-10: 0-07-292219-2 / ISBN-13: 978-0-07-292219-6

By LeRoy Brooks, John Carroll University.

Just $15.00 when packaged with this text In this comprehensive simulation game, students control a hypothetical

company over numerous periods of operation The game is now tied to the text by exercises found at the Online

Learning Center As students make major fi nancial and operating decisions for their company, they will develop

and enhance skills in fi nancial management and fi nancial accounting statement analysis

Financial Analysis with an Electronic Calculator, Sixth Edition

ISBN-10: 0-07-321709-3 / ISBN-13: 978-0-07-321709-3

By Mark A White, University of Virginia, McIntire School of Commerce.

The information and procedures in this supplementary text enable students to master the use of fi nancial calculators

and develop a working knowledge of fi nancial mathematics and problem solving Complete instructions are included

for solving all major problem types on three popular models: HP 10-B and 12-C, TI BA II Plus, and TI-84

Hands-on problems with detailed solutiHands-ons allow students to practice the skills outlined in the text and obtain instant

reinforcement Financial Analysis with an Electronic Calculator is a self-contained supplement to the introductory

fi nancial management course

The plan for developing this edition began with a number of our colleagues who had an interest in the book and

regularly teach the MBA introductory course.We integrated their comments and recommendations throughout the

Eighth Edition Contributors to this edition include the following:

Tennessee Tech University

Over the years, many others have contributed their time and expertise to the development and writing of this text

We extend our thanks once again for their assistance and countless insights:

xviii

Mary Jean Scheuer

California State University at Northridge

Southern Illinois University

John Stansfi eld

For their help on the Eighth Edition, we would like to thank Linda De Angelo, Dennis Draper, Kim Dietrich, Harry De Angelo, Aris Protopapadakis, Suh-Pyng Ku, and Mark Westerfi eld all of the Marshall School of Business at the University of Southern California;

Jordan Strauss Esq.; Stephen Dolvin, Butler University, for his work on the Instructor’s Manual and PowerPoint; Patricia Ryan, Colorado State University, for her work on the Test Bank; Robert Hanson, Eastern Michigan University, for his work on the Student Problem Manual; Joe Smolira, Belmont University, for his work on the solutions and text; and Kay Johnson, Penn State University–Erie, for her work on the self-study software and narrated Student PowerPoint We also owe a debt of gratitude to Bradford D Jordan of the University

of Kentucky; Edward I Altman of New York University; Robert S Hansen of Virginia Tech; and Jay R Ritter of the University of Florida, who have provided several thoughtful comments and immeasurable help

We thank Allissa Day, Hinh Khieu, Pankaj Maskara, and Theodore Phillips, Jr., for their extensive proofi ng and problem-checking efforts

Over the past three years readers have provided assistance by detecting and reporting errors Our goal is to offer the best textbook available on the subject, so this information was invaluable as we prepared the Eighth Edition We want to ensure that all future editions are error-free—and therefore we offer $10 per arithmetic error to the fi rst individual reporting it

Any arithmetic error resulting in subsequent errors will be counted double All errors should

be reported using the Feedback Form on the Corporate Finance Online Learning Center at www.mhhe.com/rwj

Many talented professionals at McGraw-Hill/Irwin have contributed to the development

of Corporate Finance, Eighth Edition We would especially like to thank Michele Janicek,

Jennifer Rizzi, Julie Phifer, Christine Vaughan, Kami Carter, Gina Hangos, Jennifer Wilson, and Beckey Szura

Finally, we wish to thank our families and friends, Carol, Kate, Jon, Jan, Mark, and Lynne, for their forbearance and help

Stephen A Ross

Jeffrey F Jaffe

P A R T I

Overview

1 Introduction to Corporate Finance 1

2 Financial Statements and Cash Flow 21

and Long-Term Planning 43

P A R T II

Valuation and Capital Budgeting

5 How to Value Bonds and Stocks 129

6 Net Present Value and Other Investment Rules 161

7 Making Capital Investment Decisions 197

8 Risk Analysis, Real Options,

and Capital Budgeting 229

P A R T III

Risk

9 Risk and Return: Lessons from Market History 256

10 Return and Risk: The Capital Asset Pricing

Model (CAPM) 279

11 An Alternative View of Risk and Return:

The Arbitrage Pricing Theory 320

12 Risk, Cost of Capital, and Capital Budgeting 342

P A R T IV

Capital Structure

and Dividend Policy

13 Corporate Financing Decisions and Effi cient

Capital Markets 368

14 Long-Term Financing: An Introduction 405

15 Capital Structure: Basic Concepts 423

16 Capital Structure: Limits to the Use of Debt 455

17 Valuation and Capital Budgeting for the

and Applications 671

25 Derivatives and Hedging Risk 714

Appendix A: Mathematical Tables 895 Appendix B: Solutions to Selected End-of-Chapter Problems 905

Name Index 909 Subject Index 911

xxii

P A R T I Overview

Chapter 1

Financial Statements and Cash Flow 21

Chapter 3

Financial Statements Analysis

A Note about Sustainable Growth

P A R T II Valuation and

Capital Budgeting Chapter 4

Distinction between Stated Annual

Chapter 5

Growth in Earnings and Dividends

Appendix 5A The Term Structure of

Interest Rates, Spot Rates,

Chapter 6

Net Present Value and Other

Analyzing the Average Accounting

Defi nition of Independent and Mutually

Two General Problems Affecting Both

Problems Specifi c to Mutually Exclusive Projects 175

8.3 Real Options 241

Risk and Return: Lessons

Arithmetic Average Return or Geometric

Appendix 9A The Historical Market

Risk Premium: The Very

Chapter 10

Return and Risk: The Capital

Chapter 8

Risk Analysis, Real Options,

Step 2: Specify a Distribution for Each

10.3 The Return and Risk for Portfolios 285

Variance and Standard Deviation of a Portfolio 286

Variance and Standard Deviation

Defi nition of Risk When Investors Hold

10.9 Relationship between Risk and Expected

An Alternative View of Risk

and Return: The Arbitrage

11.6 The Capital Asset Pricing Model

The Firm versus the Project:

12.5 Estimating Eastman Chemical’s Cost of Capital 355

Liquidity, Expected Returns, and the Cost of Capital 359

Appendix 12A Economic Value Added

and the Measurement

P A R T IV Capital Structure

and Dividend Policy

Chapter 13

Corporate Financing Decisions

13.1 Can Financing Decisions Create Value? 368

13.3 The Different Types of Effi ciency 373

Some Common Misconceptions

13.5 The Behavioral Challenge to Market Effi ciency 382

Representativeness 390 Conservatism 390

1 Accounting Choices, Financial Choices,

Repayment 412 Seniority 412 Security 412 Indenture 412

Stated Value 413

Chapter 15

15.1 The Capital Structure Question and the

15.3 Financial Leverage and Firm Value: An Example 426

15.4 Modigliani and Miller: Proposition II (No Taxes) 430

Proposition II: Required Return to

Expected Return and Leverage

The Weighted Average Cost of Capital,

Stock Price and Leverage under

Capital Structure: Limits to

Direct Costs of Financial Distress: Legal and Administrative Costs of Liquidation or Reorganization 458

Indirect Costs of Financial Distress 459

16.4 Integration of Tax Effects

16.6 Shirking, Perquisites, and Bad Investments:

Effect of Agency Costs of Equity on

The Effect of Personal Taxes on Capital Structure 478

Appendix 16A Some Useful Formulas

Appendix 16B The Miller Model and the

Chapter 17

Valuation and Capital Budgeting

Step 3: Valuation 491

17.4 A Comparison of the APV, FTE,

17.5 Capital Budgeting When the Discount Rate

18.3 The Benchmark Case: An Illustration

Current Policy: Dividends Set Equal to Cash Flow 513 Alternative Policy: Initial Dividend Is

Firms without Suffi cient Cash

18.6 Real-World Factors Favoring

Information Content of Dividends

18.7 The Clientele Effect: A Resolution

18.8 What We Know and Do Not Know

18.9 Stock Dividends and Stock Splits 537

Some Details about Stock Splits and Stock Dividends 537

19.4 The Announcement of New Equity

Number of Rights Needed to Purchase a Share 565

Security 583

20.6 Direct Placement Compared to Public Issues 599

21.5 A Detour for Discounting and

21.6 NPV Analysis of the Lease-versus-Buy

Decision 614

21.10 Some Unanswered Questions 623

Are the Uses of Leases and Debt

Complementary? 624

Why Are Leases Offered by Both

Why Are Some Assets Leased More

P A R T VI Options, Futures,

and Corporate Finance

A Quick Discussion of Factors

22.10 Options and Corporate Decisions:

Chapter 23

Options and Corporate Finance:

24.2 The Difference between Warrants

24.3 Warrant Pricing and the Black–Scholes Model 699

Chapter 25

The Case of Two Bonds with the Same

P A R T VII Short-Term

Finance Chapter 26

26.4 Some Aspects of Short-Term Financial Policy 752

The Size of the Firm’s Investment

Alternative Financing Policies

Other Factors Infl uencing the Target

Electronic Data Interchange and Check 21:

Appendix 27A Adjustable Rate Preferred

Stock, Auction Rate Preferred Stock, and Floating-Rate Certifi cates

The Value of New Information

28.3 Optimal Credit Policy 801

P A R T VIII Special Topics

Chapter 29

29.5 A Cost to Stockholders from Reduction

How Can Shareholders Reduce Their Losses

Cash 826

Deterring a Takeover after the Company

Sale 843 Spin-Off 844 Carve-Out 844

Appendix 30A Predicting Corporate

Bankruptcy: The Z-Score Model 866

Chapter 31

31.4 Interest Rate Parity, Unbiased Forward

Appendix B: Solutions to Selected

In July 1999, Carleton “Carly” Fiorina assumed the

position of CEO of Hewlett-Packard (HP) Investors

were pleased with her view of HP’s future: She promised

15 percent annual growth in sales and earnings, quite

a goal for a company with five consecutive years of

declining revenue Ms Fiorina also changed the way HP

was run Rather than continuing to operate as separate

product groups, which essentially meant the company

operated as dozens of minicompanies, Ms Fiorina

reorganized the company into just two divisions.

In 2002, HP announced that it would merge with

Compaq Computers However, in one of the more

acrimonious recent corporate battles, a group led by

Walter Hewlett, son of one of HP’s cofounders, fought the

merger Ms Fiorina ultimately prevailed, and the merger

took place With Compaq in the fold, the company began

a two-pronged strategy It would compete with Dell in the lower-cost, more commodity-like personal computer segment and with IBM in the more specialized, high-end computing market.

Unfortunately for HP’s shareholders, Ms Fiorina’s strategy did not work out as planned; in February 2005, under pressure from HP’s board of directors, Ms Fiorina resigned her position as CEO Evidently investors also felt a change in direction was a good idea; HP’s stock price jumped almost 7 percent the day the resignation was announced.

Understanding Ms Fiorina’s rise from corporate executive to chief executive officer, and finally to ex- employee, takes us into issues involving the corporate form of organization, corporate goals, and corporate control, all of which we discuss in this chapter.

1.1 What Is Corporate Finance?

Suppose you decide to start a firm to make tennis balls To do this you hire managers to buy raw materials, and you assemble a workforce that will produce and sell finished ten-nis balls In the language of finance, you make an investment in assets such as inventory, machinery, land, and labor The amount of cash you invest in assets must be matched by

an equal amount of cash raised by financing When you begin to sell tennis balls, your firm will generate cash This is the basis of value creation The purpose of the firm is to create value for you, the owner The value is reflected in the framework of the simple balance sheet model of the firm

The Balance Sheet Model of the Firm

Suppose we take a financial snapshot of the firm and its activities at a single point in time

Figure 1.1 shows a graphic conceptualization of the balance sheet, and it will help duce you to corporate finance

intro-The assets of the firm are on the left side of the balance sheet intro-These assets can be

thought of as current and fixed Fixed assets are those that will last a long time, such as

buildings Some fixed assets are tangible, such as machinery and equipment Other fixed

assets are intangible, such as patents and trademarks The other category of assets, current assets, comprises those that have short lives, such as inventory The tennis balls that your

firm has made, but has not yet sold, are part of its inventory Unless you have overproduced, they will leave the firm shortly

Before a company can invest in an asset, it must obtain financing, which means that

it must raise the money to pay for the investment The forms of financing are represented

on the right side of the balance sheet A firm will issue (sell) pieces of paper called debt (loan agreements) or equity shares (stock certificates) Just as assets are classified as long- lived or short-lived, so too are liabilities A short-term debt is called a current liability

Short-term debt represents loans and other obligations that must be repaid within one year

Long-term debt is debt that does not have to be repaid within one year Shareholders’ equity represents the difference between the value of the assets and the debt of the firm In this sense, it is a residual claim on the firm’s assets

From the balance sheet model of the firm, it is easy to see why finance can be thought

of as the study of the following three questions:

1 In what long-lived assets should the firm invest? This question concerns the left side

of the balance sheet Of course the types and proportions of assets the firm needs

tend to be set by the nature of the business We use the term capital budgeting to

describe the process of making and managing expenditures on long-lived assets

2 How can the firm raise cash for required capital expenditures? This question cerns the right side of the balance sheet The answer to this question involves the

con-firm’s capital structure, which represents the proportions of the con-firm’s financing

from current and long-term debt and equity

3 How should short-term operating cash flows be managed? This question concerns the upper portion of the balance sheet There is often a mismatch between the timing of

Long-term debt

Current assets

Fixed assets

1 Tangible fixed assets

2 Intangible fixed assets

Net working capital

The Balance Sheet

Model of the Firm

Chapter 1 Introduction to Corporate Finance 3

cash inflows and cash outflows during operating activities Furthermore, the amount and timing of operating cash flows are not known with certainty Financial manag-ers must attempt to manage the gaps in cash flow From a balance sheet perspective,

short-term management of cash flow is associated with a firm’s net working capital

Net working capital is defined as current assets minus current liabilities From a financial perspective, short-term cash flow problems come from the mismatching of cash inflows and outflows This is the subject of short-term finance

Capital Structure

Financing arrangements determine how the value of the firm is sliced up The people

holders of equity shares are called shareholders.

Sometimes it is useful to think of the firm as a pie Initially the size of the pie will depend on how well the firm has made its investment decisions After a firm has made its investment decisions, it determines the value of its assets (e.g., its buildings, land, and inventories)

The firm can then determine its capital structure The firm might initially have raised the cash to invest in its assets by issuing more debt than equity; now it can consider chang-ing that mix by issuing more equity and using the proceeds to buy back (pay off) some of its debt Financing decisions like this can be made independently of the original investment decisions The decisions to issue debt and equity affect how the pie is sliced

The pie we are thinking of is depicted in Figure 1.2 The size of the pie is the value of

the firm in the financial markets We can write the value of the firm, V, as

where B is the market value of the debt and S is the market value of the equity The pie

diagrams consider two ways of slicing the pie: 50 percent debt and 50 percent equity, and

25 percent debt and 75 percent equity The way the pie is sliced could affect its value If so, the goal of the financial manager will be to choose the ratio of debt to equity that makes the

value of the pie—that is, the value of the firm, V—as large as it can be.

The Financial Manager

In large firms, the finance activity is usually associated with a top officer of the firm, such

as the vice president and chief financial officer, and some lesser officers Figure 1.3 picts a general organizational structure emphasizing the finance activity within the firm

de-Reporting to the chief financial officer are the treasurer and the controller The treasurer is

the differences among the kinds of creditors In algebraic notation, we will usually refer to the firm’s debt with

the letter B (for bondholders).

responsible for handling cash flows, managing capital expenditure decisions, and making financial plans The controller handles the accounting function, which includes taxes, cost and financial accounting, and information systems.

The most important job of a financial manager is to create value from the firm’s capital budgeting, financing, and net working capital activities How do financial managers create value? The answer is that the firm should:

1 Try to buy assets that generate more cash than they cost

2 Sell bonds and stocks and other financial instruments that raise more cash than they cost

Thus, the firm must create more cash flow than it uses The cash flows paid to bondholders and stockholders of the firm should be greater than the cash flows put into the firm by the bondholders and stockholders To see how this is done, we can trace the cash flows from the firm to the financial markets and back again

Financial Accounting Manager

Financial Planning

Capital Expenditures

Figure 1.3

Hypothetical

Organization Chart

Chapter 1 Introduction to Corporate Finance 5

The interplay of the firm’s activities with the financial markets is illustrated in ure 1.4 The arrows in Figure 1.4 trace cash flow from the firm to the financial markets and back again Suppose we begin with the firm’s financing activities To raise money, the firm sells debt and equity shares to investors in the financial markets This results in cash flows

Fig-from the financial markets to the firm (A) This cash is invested in the investment ties (assets) of the firm (B) by the firm’s management The cash generated by the firm (C)

activi-is paid to shareholders and bondholders (F) The shareholders receive cash in the form of

dividends; the bondholders who lent funds to the firm receive interest and, when the initial

loan is repaid, principal Not all of the firm’s cash is paid out Some is retained (E), and some is paid to the government as taxes (D).

Over time, if the cash paid to shareholders and bondholders (F) is greater than the cash raised in the financial markets (A), value will be created.

Identification of Cash Flows Unfortunately, it is not easy to observe cash flows rectly Much of the information we obtain is in the form of accounting statements, and much of the work of financial analysis is to extract cash flow information from accounting statements The following example illustrates how this is done

di-In Their Own Words

SKILLS NEEDED FOR THE CHIEF

FINANCIAL OFFICERS OF

eFINANCE.COM

Chief strategist: CFOs will need to use real-time financial

information to make crucial decisions fast

Chief deal maker: CFOs must be adept at venture

capi-tal, mergers and acquisitions, and strategic partnerships

Chief risk officer: Limiting risk will be even more

im-portant as markets become more global and hedging instruments become more complex

Chief communicator: Gaining the confidence of Wall

Street and the media will be essential

SOURCE: BusinessWeek, August 28, 2000, p 120.

Total Value of Assets

Firm invests

in assets (B) Current assets Fixed assets

Cash for securities issued by the firm (A)

Retained cash flows (E )

Government (D)

Cash flow from firm (C)

Dividends and debt payments (F )

Financial markets Short-term debt Long-term debt Equity shares

Total Value of the Firm

to Investors in the Financial Markets

Figure 1.4

Cash Flows between

the Firm and the

Financial Markets