Fundamentals of corporate finance 8th ed standard ed stephen a ross

Financial ManagementAdair Excel Applications for Corporate Finance First Edition Benninga and Sarig Corporate Finance: A Valuation Approach Block and Hirt Foundations of Financial Manage

FUNDAMENTALS OF

CORPORATE FINANCE

Financial Management

Adair

Excel Applications for Corporate Finance

First Edition

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

Fifth Edition

Brooks

FinGame Online 4.0

Bruner

Case Studies in Finance: Managing for

Corporate Value Creation

Chew and Gillan

Corporate Governance at the Crossroads:

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 Eighth Edition

Excel Applications for Investments First Edition

Bodie, Kane, and Marcus

Essentials of Investments Sixth Edition

Bodie, Kane, and Marcus

Investments Seventh Edition

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

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 duction to the Risk Management Approach Third Edition

Intro-International Finance Eun and Resnick

International Financial Management Fourth Edition

Kuemmerle

Case Studies in International ship: Managing and Financing Ventures in the Global Economy

Entrepreneur-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

fi nancial skills First Edition

Kapoor, Dlabay, and Hughes

Personal Finance Eighth Edition

Stephen A Ross

Franco Modigliani Professor of Finance and Economics

Sloan School of Management

Massachusetts Institute of Technology

Consulting Editor

FUNDAMENTALS OF

CORPORATE FINANCE

Stephen A Ross

Massachusetts Institute of Technology

Randolph W Westerfi eld

University 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 All rights reserved No part of this publication may be reproduced or distributed in

any form or by any means, or stored in a database or retrieval system, without the prior written consent of The McGraw-Hill Companies, Inc.,

including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning.

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

This book is printed on acid-free paper.

1 2 3 4 5 6 7 8 9 0 WCK/WCK 0 9 8 7

ISBN 978-0-07-353062-8 (standard edition)

MHID 0-07-353062-X (standard edition)

ISBN 978-0-07-328211-4 (alternate edition)

MHID 0-07-328211-1 (alternate edition)

ISBN 978-0-07-328212-1 (annotated instructor’s edition)

MHID 0-07-328212-X (annotated instructor’s edition)

Editorial director: Brent Gordon

Executive editor: Michele Janicek

Developmental editor II: Jennifer Rizzi

Senior marketing manager: Julie Phifer

Senior media producer: Victor Chiu

Lead project manager: Christine A Vaughan

Lead production supervisor: Carol A Bielski

Senior designer: Kami Carter

Lead media project manager: Cathy L Tepper

Cover design: Kiera Cunningham Pohl

Cover image: © Corbis Images

Typeface: 10/12 Times Roman

Compositor: ICC Macmillan Inc.

Printer: Quebecor World Versailles Inc.

Library of Congress Cataloging-in-Publication Data

Ross, Stephen A.

Fundamentals of corporate fi nance/Stephen A Ross, Randolph W Westerfi eld,

Bradford D Jordan 8th ed., Standard ed.

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

Includes index.

ISBN-13: 978-0-07-353062-8 (standard edition : alk paper)

ISBN-10: 0-07-353062-X (standard edition : alk paper)

ISBN-13: 978-0-07-328211-4 (alternate edition : alk paper)

ISBN-10: 0-07-328211-1 (alternate edition : alk paper)

S.A.R R.W.W B.D.J.

fi nance and economics, Professor Ross is recognized for his work in developing the Arbitrage Pricing Theory and his substantial contribu- tions 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 Asso- ciation, he currently serves as an associate editor of several academic and practitioner journals He is a trustee of CalTech and Freddie Mac

RANDOLPH W WESTERFIELD

Marshall School of Business, University of Southern California

Randolph W Westerfi eld is Dean Emeritus of the University of ern California’s Marshall School of Business and is the Charles B

South-Thornton Professor of Finance.

He came to USC from the Wharton School, University of vania, where he was the chairman of the fi nance department and a 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., and the Nicholas Applegate growth fund His areas of expertise include corporate fi nancial policy, investment management, and stock market price behavior.

Pennsyl-BRADFORD D JORDAN

Gatton College of Business and Economics, University of Kentucky

Bradford D Jordan is Professor of Finance and holder of the Richard

W and Janis H Furst Endowed Chair in Finance at the University of Kentucky He has a long-standing interest in both applied and theoret- ical issues in corporate fi nance and has extensive experience teaching all levels of corporate fi nance and fi nancial management policy Pro- fessor Jordan has published numerous articles on issues such as cost

of capital, capital structure, and the behavior of security prices He is

a past president of the Southern Finance Association, and he is

coau-thor of Fundamentals of Investments: Valuation and Management, 4e,

a leading investments text, also published by McGraw-Hill/Irwin.

vi

When the three of us decided to write a book, we were united by one strongly held principle: Corporate

fi nance should be developed in terms of a few integrated, powerful ideas We believed that the subject was

all too often presented as a collection of loosely related topics, unifi ed primarily by virtue of being bound

together in one book, and we thought there must be a better way.

One thing we knew for certain was that we didn’t want to write a “me-too” book So, with a lot of help,

we took a hard look at what was truly important and useful In doing so, we were led to eliminate topics

of dubious relevance, downplay purely theoretical issues, and minimize the use of extensive and elaborate

calculations to illustrate points that are either intuitively obvious or of limited practical use.

As a result of this process, three basic themes became our central focus in writing Fundamentals of Corporate Finance:

AN EMPHASIS ON INTUITION

We always try to separate and explain the principles at work on a commonsense, intuitive level before

launch-ing into any specifi cs The underlylaunch-ing ideas are discussed fi rst in very general terms and then by way of

ex-amples that illustrate in more concrete terms how a fi nancial manager might proceed in a given situation.

A UNIFIED VALUATION APPROACH

We treat net present value (NPV) as the basic concept underlying corporate fi nance Many texts stop well

short of consistently integrating this important principle The most basic and important notion, that NPV

represents the excess of market value over cost, often is lost in an overly mechanical approach that

em-phasizes computation at the expense of comprehension In contrast, every subject we cover is fi rmly

root-ed in valuation, and care is taken throughout to explain how particular decisions have valuation effects.

A MANAGERIAL FOCUS

Students shouldn’t lose sight of the fact that fi nancial management concerns management We emphasize the

role of the fi nancial manager as decision maker, and we stress the need for managerial input and judgment

We consciously avoid “black box” approaches to fi nance, and, where appropriate, the approximate, pragmatic

nature of fi nancial analysis is made explicit, possible pitfalls are described, and limitations are discussed.

In retrospect, looking back to our 1991 fi rst edition IPO, we had the same hopes and fears as any preneurs How would we be received in the market? At the time, we had no idea that just 16 years later, we

entre-would be working on an eighth edition We certainly never dreamed that in those years we entre-would work with

friends and colleagues from around the world to create country-specifi c Australian, Canadian, and South African

editions, an International edition, Chinese, French, Polish, Portuguese, Thai, Russian, Korean, and Spanish

language editions, and an entirely separate book, Essentials of Corporate Finance, now in its fi fth edition.

Today, as we prepare to once more enter the market, our goal is to stick with the basic principles that have brought us this far However, based on an enormous amount of feedback we have received from you and your

colleagues, we have made this edition and its package even more fl exible than previous editions We offer

fl exibility in coverage, by continuing to offer a variety of editions, and fl exibility in pedagogy, by providing a wide

variety of features in the book to help students to learn about corporate fi nance We also provide fl exibility in

package options by offering the most extensive collection of teaching, learning, and technology aids of any

cor-porate fi nance text Whether you use just the textbook, or the book in conjunction with our other products, we

believe you will fi nd a combination with this edition that will meet your current as well as your changing needs

Stephen A Ross Randolph W Westerfi eld Bradford D Jordan

vii

Preface from the Authors

Coverage

viii

This book was designed and developed explicitly for a fi rst course in business or corporate fi nance, for

both fi nance majors and non-majors alike In terms of background or prerequisites, the book is nearly

self- contained, assuming some familiarity with basic algebra and accounting concepts, while still

review-ing important accountreview-ing principles very early on The organization of this text has been developed to give

instructors the fl exibility they need

Just to get an idea of the breadth of coverage in the eighth edition of Fundamentals, the following grid

presents, for each chapter, some of the most signifi cant new features as well as a few selected chapter

highlights Of course, in every chapter, opening vignettes, boxed features, in-chapter illustrated examples

using real companies, and end-of-chapter material have been thoroughly updated as well.

PART 1 Overview of Corporate Finance

Chapter 1

Introduction to Corporate

Finance

New section: Sarbanes–Oxley.

aspect of management and describes agency issues that can arise.

Ethics, fi nancial management, and executive compensation.

Brings in real-world issues concerning confl icts

of interest and current controversies surrounding ethical conduct and management pay.

Chapter 2

Financial Statements, Taxes,

and Cash Flow

Mini-case: Cash Flows and Financial

Statements at Sunset Boards, Inc.

Cash fl ow vs earnings.

Market values vs book values.

New case written for this edition reinforces key cash fl ow concepts in a small-business setting.

Clearly defi nes cash fl ow and spells out the differences between cash fl ow and earnings.

Emphasizes the relevance of market values over book values.

PART 2 Financial Statements and Long-Term Financial Planning

equa-tion to better explore the interrelaequa-tion ships between operating and fi nancial performance.

New material: Du Pont analysis for

real companies using data from S&P

Market Insight.

New analysis shows students how to get and use real-world data, thereby applying key chapter ideas.

Ratio and fi nancial statement analysis using smaller fi rm data.

Uses fi rm data from RMA to show students

how to actually get and evaluate fi nancial statements benchmarks.

Mini-case: Planning for Growth at S&S Air.

New case written for this edition illustrates the importance of fi nancial planning in a small fi rm.

Explanation of alternative formulas for sustainable and internal growth rates.

Explanation of growth rate formulas clears

up a common misunderstanding about these formulas and the circumstances under which alternative formulas are correct.

Thorough coverage of sustainable growth as a planning tool.

Provides a vehicle for examining the ships between operations, fi nancing, and growth.

PART 3 Valuation of Future Cash Flows Chapter 5

Introduction to Valuation:

The Time Value of Money

First of two chapters on time value of money.

Relatively short chapter introduces just the basic ideas on time value of money to get stu- dents started on this traditionally diffi cult topic.

New minicase: The MBA Decision.

Covers more advanced time value topics with numerous examples, calculator tips, and Excel spreadsheet exhibits Contains many real-world examples.

Chapter 7

Interest Rates and Bond Valuation

New section: Infl ation and present values.

“Clean” vs “dirty” bond prices and accrued interest.

Clears up the pricing of bonds between coupon payment dates and also bond market quoting conventions.

NASD’s new TRACE system and transparency in the corporate bond market.

Up-to-date discussion of new developments

in fi xed income with regard to price, volume, and transactions reporting.

of call provision that has become very common

Chapter 8

Stock Valuation

New minicase: Stock Valuation at Ragan, Inc.

Minicase: Financing S&S Air’s Expansion

Plans with a Bond Issue.

New case written for this edition examines the debt issuance process for a small fi rm.

non-constant growth models.

New minicase: Bullock Gold Mining.

First of three chapters on capital budgeting.

Relatively short chapter introduces key ideas

on an intuitive level to help students with this traditionally diffi cult topic.

NPV, IRR, payback, discounted payback, and accounting rate of return.

Consistent, balanced examination of tages and disadvantages of various criteria.

advan-Chapter 10

Making Capital Investment Decisions

Projected cash fl ow.

Alternative cash fl ow defi nitions.

Special cases of DCF analysis.

Thorough coverage of project cash fl ows and the relevant numbers for a project analysis.

Emphasizes the equivalence of various formulas, thereby removing common misunderstandings.

Considers important applications of chapter tools.

Chapter 11

Project Analysis and Evaluation

Minicase: Conch Republic Electronics.

Coverage (continued)

PART 5 Risk and Return

Chapter 12

Some Lessons from

Capital Market History

New minicase: A Job at S&S Air.

Expanded discussion of geometric vs

arithmetic returns.

Capital market history.

Market effi ciency.

Discusses calculation and interpretation of geometric returns Clarifi es common mis- conceptions regarding appropriate use of arithmetic vs geometric average returns.

Extensive coverage of historical returns, volatilities, and risk premiums.

Effi cient markets hypothesis discussed along with common misconceptions.

Chapter 13

Return, Risk, and the

Security Market Line

New minicase: The Beta for American

Standard.

Diversifi cation, systematic and unsystematic risk.

Beta and the security market line.

Illustrates basics of risk and return in a straightforward fashion

Develops the security market line with an intuitive approach that bypasses much of the usual portfolio theory and statistics.

Chapter 14

Options and Corporate

Finance

Minicase: S&S Air’s Convertible Bond.

New discussion in ESO backdating.

Stock options, employee stock options, and real options.

New section: Internal equity and fl otation costs.

Geometric vs arithmetic growth rates.

Cost of capital estimation.

Both approaches are used in practice Clears

up issues surrounding growth rate estimates.

Contains a complete, Web-based illustration

of cost of capital for a real company.

Chapter 16

Raising Capital

New minicase: S&S Air Goes Public.

Dutch auction IPOs.

IPO “quiet periods.”

Rights vs warrants.

IPO valuation.

Explains uniform price auctions using recent Google IPO as an example.

Explains the SEC’s quiet period rules.

Clarifi es the option-like nature of rights prior

to their expiration dates.

Extensive, up-to-date discussion of IPOs, including the 1999–2000 period.

Chapter 17

Financial Leverage and

Capital Structure Policy

New section:The pecking-order theory of capital structure.

New minicase:Stephenson Real Estate Capitalization.

Basics of fi nancial leverage.

Optimal capital structure.

Financial distress and bankruptcy.

Illustrates effect of leverage on risk and return.

Describes the basic trade-offs leading to an optimal capital structure.

Briefl y surveys the bankruptcy process.

x

Chapter 18

Dividends and Dividend Policy

New minicase: Electronic Timing, Inc.

Minicase: Piepkorn Manufacturing

Working Capital Management.

Very recent survey evidence on dividend policy.

Effect of new tax laws.

Dividends and dividend policy.

New case written for this edition analyzes cost of capital estimation for a non-public

fi rm.

New survey results show the most important (and least important) factors considered by

fi nancial managers in setting dividend policy.

Discusses implications of new, lower dend, and capital gains rates.

divi-Describes dividend payments and the factors favoring higher and lower payout policies.

PART 7 Short-Term Financial Planning and Management Chapter 19

Short-Term Finance and Planning

Operating and cash cycles.

Short-term fi nancial planning.

Stresses the importance of cash fl ow timing.

Illustrates creation of cash budgets and potential need for fi nancing.

Cash collection and disbursement.

Thorough coverage of fl oat management and potential ethical issues.

Examination of systems used by fi rms to handle cash infl ows and outfl ows.

Analysis of credit policy and implementation.

Brief overview of important inventory concepts.

xi

PART 8 Topics in Corporate Finance Chapter 22

International Corporate Finance

New minicase: S&S Air Goes

Interna-tional

determination.

handle exchange rates.

sovereign risk.

In-Text Study Features

In addition to illustrating pertinent concepts and presenting up-to-date coverage, Fundamentals of

Cor-porate Finance strives to present the material in a way that makes it coherent and easy to understand

To meet the varied needs of its intended audience, Fundamentals of Corporate Finance is rich in valuable

learning tools and support.

CHAPTER-OPENING VIGNETTES

Vignettes drawn from real-world events introduce students to the chapter concepts Questions about these

vignettes are posed to the reader to ensure understanding of the concepts in the end-of-chapter material For

examples, see Chapter 4, page 89; Chapter 5, page 21.

PEDAGOGICAL USE OF COLOR

This learning tool continues to be an

important feature of Fundamentals of

Corporate Finance In almost every

chapter, color plays an extensive, schematic, and largely self-evident role

non-A guide to the functional use of color

is found on the endsheets of both the Annotated Instructor’s Edition (AIE) and student version For examples of this technique, see Chapter 5, page 130.

IN THEIR OWN

WORDS BOXES

This series of boxes are the

popular articles updated

from previous editions

written by a distinguished

scholar or practitioner

on key topics in the text

Boxes include essays by

Merton Miller on capital

structure, Fischer Black

on dividends, and Roger

Ibbotson on capital

market history A

com-plete list of “In Their Own

Words” boxes appears on

page xxxvii.

xii

This approach works just fi ne However, we will often encounter situations in which the

number of cash fl ows is quite large For example, a typical home mortgage calls for monthly

payments over 30 years, for a total of 360 payments If we were trying to determine the

present value of those payments, it would be useful to have a shortcut.

Because the cash fl ows of an annuity are all the same, we can come up with a handy

variation on the basic present value equation The present value of an annuity of C dollars

per period for t periods when the rate of return or interest rate is r is given by:

Annuity present value  C  ( 1  Present value factor r )

Sustainable growth is often used by bankers and other external analysts to assess a company’s credit worthiness They are aided in this exercise by several sophisticated computer software packages that provide detailed analyses of the company’s past fi nancial performance, including its annual sustainable growth rate.

Bankers use this information in several ways Quick comparison of a company’s actual growth rate to its sustainable rate tells the banker what issues will be at the top of management’s fi nancial agenda If actual growth consistently exceeds sustainable growth, management’s problem will be where to get the cash to

fi nance growth The banker thus can anticipate interest in loan products Conversely, if sustainable growth consistently exceeds actual, the banker had best be prepared to talk about investment products, because management’s problem will be what to do with all the cash that keeps piling up in the till.

ENHANCED! REAL-WORLD EXAMPLES

Actual events are integrated throughout the text, tying chapter concepts to real life through

illus-tration and reinforcing the relevance of the material Some examples tie into the chapter opening

vignette for added reinforcement See example in Chapter 5, page 135.

WORK THE WEB

These boxes in the chapter

material show students how

to research fi nancial issues

using the Web and how to

use the information they fi nd

to make business decisions

See examples in Chapter 4,

page 103; Chapter 5,

page 140.

SPREADSHEET STRATEGIES

This feature either introduces students to Excel or helps them brush up on their Excel spread- sheet skills, particularly as they relate to corporate fi nance This feature appears in self-contained sections and shows students how to set up spreadsheets

to analyze common fi nancial problems—a vital part of every business student’s education

For examples, see Chapter 5, page 139; Chapter 6, page 153.

Calculating company growth rates can involve detailed research, and a major part of a stock analyst’s job is to

estimate them One place to fi nd earnings and sales growth rates on the Web is Yahoo! Finance at fi nance.yahoo.

com We pulled up a quote for Minnesota Mining & Manufacturing (MMM, or 3M as it is known) and followed the

“Analyst Estimates” link Here is an abbreviated look at the results:

As shown, analysts expect, on average, revenue (sales) of $22.77 billion in 2006, growing to $24.27 billion

in 2007, an increase of 6.6 percent We also have the following table comparing MMM to some benchmarks:

Using a Spreadsheet for Time Value of Money Calculations More and more, businesspeople from many different areas (not just fi nance and accounting) rely on spreadsheets

to do all the different types of calculations that come up in the real world As a result, in this section, we will show you how to use a spreadsheet to handle the various time value of money problems we presented in this chapter

We will use Microsoft Excel™, but the commands are similar for other types of software We assume you are already familiar with basic spreadsheet operations.

As we have seen, you can solve for any one of the following four potential unknowns: future value, present value, the discount rate, or the number of periods With a spreadsheet, there is a separate formula for each In Excel, these are shown in a nearby box.

In these formulas, pv and fv are present and future value, nper is the number of periods, and rate is the discount, or interest, rate.

Two things are a little tricky here First, unlike a

fi nancial calculator, the spreadsheet requires that the rate be entered as a decimal Second, as with most

fi nancial calculators, you have to put a negative sign

on either the present value or the future value to solve for the rate or the number of periods For the same reason, if you solve for a present value, the answer will have

a negative sign unless you input a negative future value The same is true when you compute a future value.

To illustrate how you might use these formulas, we will go back to an example in the chapter If you invest

$25,000 at 12 percent per year, how long until you have $50,000? You might set up a spreadsheet like this:

SPREADSHEET STRATEGIES

Future value  FV (rate,nper,pmt,pv) Present value  PV (rate,nper,pmt,fv) Discount rate  RATE (nper,pmt,pv,fv) Number of periods  NPER (rate,pmt,pv,fv)

1

3

5

7 8

have been added in selected

chapters to help students learn

or brush up on their fi nancial

cal-culator skills These complement

the just-mentioned Spreadsheet

Strategies For examples, see

Chapter 5, page 136; Chapter 6,

page 152.

CONCEPT BUILDING

Chapter sections are intentionally kept short to promote a step-by-step, building block approach to learning Each section is then followed by a series of short concept questions that highlight the key ideas just presented Students use these questions to make sure they can identify and understand the most important concepts as they read See Chapter 5, page 133; Chapter 6, page 154 for examples.

SUMMARY TABLES

These tables succinctly restate key principles, results, and equations They appear whenever it is useful

to emphasize and summarize a group of related concepts For examples, see Chapter 6, page 163.

LABELED EXAMPLES

Separate numbered and titled

examples are extensively integrated

into the chapters as indicated below

These examples provide detailed

applications and illustrations of

the text material in a step-by-step

format Each example is

com-pletely self-contained so students

don’t have to search for additional

information Based on our

class-room testing, these examples are

among the most useful learning aids

because they provide both detail

and explanation See Chapter 6,

page 163; Chapter 7, page 196.

Cash Flows Using a Financial Calculator

To calculate the present value of multiple cash fl ows with a fi nancial calculator, we will simply discount the vidual cash fl ows one at a time using the same technique we used in our previous chapter, so this is not really new However, we can show you a shortcut We will use the numbers in Example 6.3 to illustrate.

indi-To begin, of course we fi rst remember to clear out the calculator! Next, from Example 6.3, the fi rst cash fl ow

is $200 to be received in one year and the discount rate is 12 percent, so we do the following:

Next we value the second cash fl ow We need to change N to 2 and FV to 400 As long as we haven’t changed anything else, we don’t have to reenter I/Y or clear out the calculator, so we have:

Preferred stock (or preference stock) is an important example of a perpetuity When a

corporation sells preferred stock, the buyer is promised a fi xed cash dividend every period (usually every quarter) forever This dividend must be paid before any dividend can be paid

to regular stockholders—hence the term preferred.

Suppose the Fellini Co wants to sell preferred stock at $100 per share A similar issue

of preferred stock already outstanding has a price of $40 per share and offers a dividend

of $1 every quarter What dividend will Fellini have to offer if the preferred stock is going to sell?

The issue that is already out has a present value of $40 and a cash fl ow of $1 every quarter forever Because this is a perpetuity:

Present value  $40  $1  (1兾r)

r  2.5%

To be competitive, the new Fellini issue will also have to offer 2.5 percent per quarter; so if

the present value is to be $100, the dividend must be such that:

Present value  $100  C  (1兾.025)

C  $2.50 (per quarter)

HIGHLIGHTED CONCEPTS

Throughout the text, important

ideas are pulled out and presented

in a highlighted box—signaling

to students that this material is

particularly relevant and critical for

their understanding See Chapter 4,

page 107.

KEY EQUATIONS

Called out in the text, key equations are identifi ed by an equation number The list in Appendix B

shows the key equations by chapter, providing students with a convenient reference For examples,

see Chapter 4, page 97; Chapter 5, page 123.

EXPLANATORY WEB LINKS

These Web links are provided in the margins of the text They are specifi cally selected

to accompany text material and provide students and instructors with a quick way to

check for additional information using the Internet See Chapter 4, page 91; Chapter 5,

page 123.

appear in the margins with defi nitions for easy location and identifi cation by the student See

Chapter 4, page 91; Chapter 7, page 199 for examples.

Amazon.com, the big online retailer, is another example At one time, Amazon’s motto seemed to be “growth at any cost.” Unfortunately, what really grew rapidly for the com- pany were losses Amazon refocused its business, explicitly sacrifi cing growth in the hope

of achieving profi tability The plan seems to be working as Amazon.com turned a profi t for the fi rst time in the third quarter of 2003.

As we discussed in Chapter 1, the appropriate goal is increasing the market value of the owners’ equity Of course, if a fi rm is successful in doing this, then growth will usually result Growth may thus be a desirable consequence of good decision making, but it is not

an end unto itself We discuss growth simply because growth rates are so commonly used

in the planning process As we will see, growth is a convenient means of summarizing various aspects of a fi rm’s fi nancial and investment policies Also, if we think of growth as growth in the market value of the equity in the fi rm, then goals of growth and increasing the market value of the equity in the fi rm are not all that different.

You can fi nd growth rates under the research links at

www.investor.reuters.com

and fi nance.yahoo.com.

Given values for all four of these, there is only one growth rate that can be achieved

This is an important point, so it bears restating:

If a fi rm does not wish to sell new equity and its profi t margin, dividend policy,

fi nancial policy, and total asset turnover (or capital intensity) are all fi xed, then there is only one possible growth rate.

As we described early in this chapter, one of the primary benefi ts of fi nancial planning

is that it ensures internal consistency among the fi rm’s various goals The concept of the sustainable growth rate captures this element nicely Also, we now see how a fi nancial planning model can be used to test the feasibility of a planned growth rate If sales are to grow at a rate higher than the sustainable growth rate, the fi rm must increase profi t margins, increase total asset turnover, increase fi nancial leverage, increase earnings retention, or sell new shares.

These questions and answers allow students to test their abilities in solving key problems related to the chapter content and provide instant reinforce- ment See Chapter 5, page 141;

Chapter 6, page 177.

CONCEPTS REVIEW AND

CRITICAL THINKING

QUESTIONS

This successful end-of-chapter

section facilitates your students’

knowledge of key principles, as

well as intuitive understanding of

the chapter concepts A number

of the questions relate to the

chapter-opening vignette—

reinforcing student

critical-think-ing skills and the learncritical-think-ing of

chapter material For examples,

see Chapter 6, page 180;

Chapter 7, page 228.

CHAPTER REVIEW AND SELF-TEST PROBLEMS 5.1 Calculating Future Values Assume you deposit $10,000 today in an account that

pays 6 percent interest How much will you have in fi ve years?

5.2 Calculating Present Values Suppose you have just celebrated your 19th birthday

A rich uncle has set up a trust fund for you that will pay you $150,000 when you turn

30 If the relevant discount rate is 9 percent, how much is this fund worth today?

5.3 Calculating Rates of Return You’ve been offered an investment that will double

your money in 10 years What rate of return are you being offered? Check your

answer using the Rule of 72.

5.4 Calculating the Number of Periods You’ve been offered an investment that

will pay you 9 percent per year If you invest $15,000, how long until you have

$30,000? How long until you have $45,000?

ANSWERS TO CHAPTER REVIEW AND SELF-TEST PROBLEMS 5.1 We need to calculate the future value of $10,000 at 6 percent for fi ve years The

future value factor is:

1.06 5  1.3382

The future value is thus $10,000  1.3382  $13,382.26

5.2 We need the present value of $150,000 to be paid in 11 years at 9 percent The

discount factor is:

1 兾1.09 11  1兾2.5804  3875

The present value is thus about $58,130

CONCEPTS REVIEW AND CRITICAL THINKING QUESTIONS

1 Annuity Factors There are four pieces to an annuity present value What are they?

2 Annuity Period As you increase the length of time involved, what happens to the

present value of an annuity? What happens to the future value?

3 Interest Rates What happens to the future value of an annuity if you increase the

rate r? What happens to the present value?

4 Present Value What do you think about the Tri-State Megabucks lottery discussed

in the chapter advertising a $500,000 prize when the lump sum option is $250,000?

Is it deceptive advertising?

5 Present Value If you were an athlete negotiating a contract, would you want a

big signing bonus payable immediately and smaller payments in the future, or vice versa? How about looking at it from the team’s perspective?

6 Present Value Suppose two athletes sign 10-year contracts for $80 million In one

case, we’re told that the $80 million will be paid in 10 equal installments In the other case, we’re told that the $80 million will be paid in 10 installments, but the installments will increase by 5 percent per year Who got the better deal?

7 APR and EAR Should lending laws be changed to require lenders to report EARs

instead of APRs? Why or why not?

PROBLEMS

We have found that many students learn better when they have plenty

of opportunity to practice; therefore,

we provide extensive end-of-chapter questions and problems The end- of-chapter support greatly exceeds typical introductory textbooks

The questions and problems are segregated into three learning levels: Basic, Intermediate, and Challenge

All problems are fully annotated so that students and instructors can readily identify particular types

Answers to selected end-of-chapter material appear in Appendix C

Also, all problems are available

in McGraw-Hill’s Homework Manager—see page xxi for details

See Chapter 6, page 181; Chapter 7, page 229.

WEB EXERCISES

These end-of-chapter activities show students how to use and learn

from the vast amount of fi nancial resources available on the Internet

See examples in Chapter 6, page 190; Chapter 7, page 233.

1 Interpreting Bond Yields Is the yield to maturity on a bond the same thing

as the required return? Is YTM the same thing as the coupon rate? Suppose today a 10 percent coupon bond sells at par Two years from now, the required return on the same bond is 8 percent What is the coupon rate on the bond then?

The YTM?

2 Interpreting Bond Yields Suppose you buy a 7 percent coupon, 20-year bond

today when it’s fi rst issued If interest rates suddenly rise to 15 percent, what pens to the value of your bond? Why?

3 Bond Prices Carpenter, Inc., has 8 percent coupon bonds on the market that have

10 years left to maturity The bonds make annual payments If the YTM on these bonds is 9 percent, what is the current bond price?

4 Bond Yields Linebacker Co has 7 percent coupon bonds on the market with nine

years left to maturity The bonds make annual payments If the bond currently sells for $1,080, what is its YTM?

5 Coupon Rates Hawk Enterprises has bonds on the market making annual

payments, with 16 years to maturity, and selling for $870 At this price, the bonds yield 7.5 percent What must the coupon rate be on the bonds?

6 Bond Prices Cutler Co issued 11-year bonds a year ago at a coupon rate of

7.8 percent The bonds make semiannual payments If the YTM on these bonds is 8.6 percent, what is the current bond price?

7 Bond Yields Ngata Corp issued 12-year bonds 2 years ago at a coupon rate of

9.2 percent The bonds make semiannual payments If these bonds currently sell for 104 percent of par value, what is the YTM?

8 Coupon Rates Wimbley Corporation has bonds on the market with 14.5 years to

maturity, a YTM of 6.8 percent, and a current price of $1,136.50 The bonds make semiannual payments What must the coupon rate be on these bonds?

BASIC

(Questions 1–14)

WEB EXERCISES 7.1 Bond Quotes You can fi nd the current bond quotes for many companies at www.

nasdbondinfo.com Go to the site and fi nd the bonds listed for Georgia Pacifi c

What is the shortest-maturity bond listed for Georgia Pacifi c? What is the maturity bond? What are the credit ratings for each bond? Do each of the bonds have the same credit rating? Why do you think this is?

longest-7.2 Yield Curves You can fi nd information regarding the most current bond yields at

money.cnn.com Graph the yield curve for U.S Treasury bonds What is the general shape of the yield curve? What does this imply about the expected future infl ation?

Now graph the yield curve for AAA, AA, and A rated corporate bonds Is the rate yield curve the same shape as the Treasury yield curve? Why or why not?

corpo-7.3 Default Premiums The St Louis Federal Reserve Board has fi les listing historical

interest rates on their Web site: www.stls.frb.org Find the link for “FRED II” data, then “Interest Rates.” You will fi nd listings for Moody’s Seasoned Aaa Corporate Bond Yield and Moody’s Seasoned Baa Corporate Bond Yield A default premium can be calculated as the difference between the Aaa bond yield and the Baa bond yield

Calculate the default premium using these two bond indexes for the most recent 36 months Is the default premium the same for every month? Why do you think this is?

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 from each chapter See examples in

Chapter 6, page 191; Chapter 7, page 233.

MINICASE

The MBA Decision

Ben Bates graduated from college six years ago with a fi nance

undergraduate degree Although he is satisfi ed with his

cur-rent job, his goal is to become an investment banker He feels

that an MBA degree would allow him to achieve this goal

After examining schools, he has narrowed his choice to either

Wilton University or Mount Perry College Although

intern-ships are encouraged by both schools, to get class credit for

the internship, no salary can be paid Other than internships,

neither school will allow its students to work while enrolled

in its MBA program.

Ben currently works at the money management fi rm of

Dewey and Louis His annual salary at the fi rm is $50,000 per

year, and his salary is expected to increase at 3 percent per

year until retirement He is currently 28 years old and expects

to work for 35 more years His current job includes a fully

paid health insurance plan, and his current average tax rate is

26 percent Ben has a savings account with enough money to

cover the entire cost of his MBA program.

The Ritter College of Business at Wilton University is one

of the top MBA programs in the country The MBA degree

requires two years of full-time enrollment at the university

The annual tuition is $60,000, payable at the beginning of

each school year Books and other supplies are estimated to

cost $2,500 per year Ben expects that after graduation from

Wilton, he will receive a job offer for about $95,000 per year,

with a $15,000 signing bonus The salary at this job will

increase at 4 percent per year Because of the higher salary,

his average income tax rate will increase to 31 percent.

The Bradley School of Business at Mount Perry College

began its MBA program 16 years ago The Bradley School is

smaller and less well known than the Ritter College Bradley offers an accelerated one-year program, with a tuition cost of

$75,000 to be paid upon matriculation Books and other plies for the program are expected to cost $3,500 Ben thinks that he will receive an offer of $78,000 per year upon gradua- tion, with a $10,000 signing bonus The salary at this job will increase at 3.5 percent per year His average tax rate at this level of income will be 29 percent.

sup-Both schools offer a health insurance plan that will cost

$3,000 per year, payable at the beginning of the year Ben also estimates that room and board expenses will cost $20,000 per year at both schools The appropriate discount rate is 6.5 percent.

1 How does Ben’s age affect his decision to get an MBA?

2 What other, perhaps nonquantifi able, factors affect Ben’s decision to get an MBA?

3 Assuming all salaries are paid at the end of each year, what is the best option for Ben from a strictly fi nancial standpoint?

4 Ben believes that the appropriate analysis is to calculate the future value of each option How would you eva- luate this statement?

5 What initial salary would Ben need to receive to make him indifferent between attending Wilton University and staying in his current position?

6 Suppose, instead of being able to pay cash for his MBA, Ben must borrow the money The current borrowing rate is 5.4 percent How would this affect his decision?

Comprehensive Teaching

and Learning Package

This edition of Fundamentals has more options than ever in terms of the textbook, instructor supplements,

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

TEXTBOOK

As with the previous editions, we are offering two versions of this text, both of which are packaged with an exciting student CD-ROM (see description under “Student Supplements”),

• Standard Edition (22 Chapters)

• Alternate Edition (26 Chapters)

INSTRUCTOR SUPPLEMENTS

Annotated Instructor’s Edition (AIE) ISBN 007328212X All your teaching resources are tied together here! This handy resource contains extensive references to the Instructor’s Manual regarding lecture tips, ethics notes, Internet references, international notes, and the availability of teaching PowerPoint slides The lecture tips vary in content and purpose—providing an alternative perspective on a subject, suggesting important points to be stressed, giving further examples,

or recommending other readings The ethics notes present background on topics that motivate room discussion of fi nance-related ethical issues Other annotations include notes for the Real-World Tips, Concept Questions, Self-Test Problems, End-of-Chapter Problems, Videos, and answers to the end-of- chapter problems.

class-Instructor’s CD-ROM ISBN 0073282138 Keep all the supplements in one place! This CD contains all the necessary supplements— Instructor’s Manual, Solutions, Test Bank, Computerized Test Bank, and PowerPoint—all in one useful product in an electronic format.

• Instructor’s Manual (IM)

prepared by Kent Ragan, Missouri State University and Joseph Smolira, Belmont University

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 designed for use with the Annotated Instructor’s Edition

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.

Also included are ready-made quizzes to hand out in class

xix

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 Kent Ragan, Missouri State 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 spread- sheet link to show an example in Excel You can also go to the Notes Page function for more tips in presenting the slides If you already have PowerPoint installed on your PC, you have the ability to edit, print, or rearrange the complete presentation to meet your specifi c needs.

Videos (DVD Format) ISBN 0073282111

Current set of videos on hot topics! McGraw-Hill/Irwin produced a series of fi nance videos that are

10-minute case studies on topics such as Financial Markets, Careers, Rightsizing, Capital Budgeting, EVA

(Economic Value Added), Mergers and Acquisitions, and International Finance.

ONLINE SUPPORT

Online learning center 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:

• Student Support

A great resource for those seeking additional practice, students can access self-grading quizzes, Excel template problems, electronic fl ashcards, self-study software, Web Exercises, links to Corpo- rate Finance Online questions, Finance Around the World problems, timely articles, and much more to help master the fundamentals of corporate fi nance!

• Teaching Support

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 prob- lems and Excel, Instructor’s PowerPoint, Excel Template Solutions, Video clips, Video projects and questions, and teaching notes to Corporate Finance Online, a Web extension with additional exer- cises and projects for your course.

• McGraw-Hill Investments Trader

Students receive free access to this Web-based portfolio simulation with a hypothetical $100,000 brokerage account to buy and sell stocks and mutual funds Students can use the real data found at this site in conjunction with the chapters on investments They can also compete against students around the United States This site is powered by Stock-Trak, the leading provider of investment simulation services to the academic community.

• Interactive FinSims

Each module highlights a key concept of corporate fi nance from the book and simulates how to solve

it, asking the student to input certain variables This hands-on approach guides students through

dif-fi cult and important corporate dif-fi nance topics.

• iPod Content

Harness the power of one of the most popular technology tools students use today, the Apple iPod ® Our innovative approach enables students to download Narrated PowerPoints and quizzes right into their iPod and take learning materials with them wherever they go This makes review and study time

as easy as putting on headphones!

• Chapter Overviews

Concise recap of what students should learn from each chapter A great reading prep assignment.

• Pretest and Posttest Question Banks

Administer comprehensive and chapter-specifi c pretest and posttests to evaluate student understanding.

• Online Glossary

Key terms and their defi nitions in a ready to use format Distribute to students for a study tool, or mix and match to create a quiz.

Ask your McGraw-Hill representative for more details about Enhanced Cartridges today!

McGraw-Hill’s Homework Manager and Homework Manager Plus

Are you looking for a way to spend less time grading and to have more fl exibility with the problems you assign as homework and tests? McGraw-Hill’s Homework Manager is an exciting new package option de- veloped for this text! Homework Manager is a Web-based tool for instructors and students for delivering, answering, and grading end-of-chapter problems and tests, and providing a limitless supply of self-graded practice for students.

All of the book’s end-of-chapter Questions and Problems are loaded into Homework Manager, and instructors can choose to assign the exact problems as stated in the book, or algorithmic versions of them

so each student has a unique set of variables for the problems You create the assignments and control parameters such as do you want your students to receive hints, is this a graded assignment or practice, etc The test bank is also available in Homework Manager, giving you the ability to use those questions for online tests Both the problems and the tests are automatically graded and the results are stored in a private grade book, which is created when you set up your class Detailed results let you see at a glance how each student does on an assignment or an individual problem—you can even see how many tries it

There is also an enhanced version of McGraw-Hill’s Homework Manager through the Homework ager Plus package option If you order the text packaged with Homework Manager Plus, your students

Man-will receive Homework Manager as described above, but with an integrated online text included When

students are in Homework Manager and need more help to solve a problem, there will be a link that takes

them to the section of the text online that explains the concept they are struggling with All of McGraw-Hill’s

media assets, such as videos, narrated lectures, and additional online quizzing, are also integrated at the

appropriate places of the online text to provide students with a full learning experience If you order this

special package, students will receive the Homework Manager Plus card packaged with their text, which

gives them access to all of these products.

McGraw-Hill’s Homework Manager is powered by Brownstone.

AVAILABLE FOR PURCHASE & PACKAGING

Student Problem Manual ISBN 0073282154

prepared by Thomas Eyssell, University of Missouri —St Louis

Need additional reinforcement of the concepts? This valuable resource provides students with

addi-tional problems for practice Each chapter begins with Concepts for Review, followed by Chapter

High-lights These re-emphasize the key terms and concepts in the chapter A short Concept Test, averaging

10 questions and answers, appears next Each chapter concludes with additional problems for the

student to review Answers to these problems appear at the end of the Student Problem Manual.

BusinessWeek Subscription

Your students can subscribe to BusinessWeek for a specially priced rate of $20.00 in addition to the

price of the text Students will receive a passcode card shrink-wrapped with their new text by ordering

this special package The card directs students to a Web site where they enter the code and then gain

access to BusinessWeek’s registration page to enter address info and set up their print and online

sub-scription for a 15-week period

Financial Times Subscription

Your students can subscribe to the Financial Times for 15 weeks at a specially priced rate of $10 in

addition to the price of the text by ordering this special package Students will receive a subscription

card shrink-wrapped with their new text to fi ll in and send to the Financial Times to start receiving their

subscription Instructors, once you order, make sure you contact your sales representative to receive a

complimentary one-year subscription.

To borrow a phrase, writing an introductory fi nance textbook is easy—all you do is sit down at a word processor and open a vein We never would have completed this book without the incredible amount of help and support we received from literally hundreds of our colleagues, students, editors, family members, and friends We would like to thank, without implicating, all of you.

Clearly, our greatest debt is to our many colleagues (and their students) who, like us, wanted to try an alternative to what they were using and made the decision to change Needless to say, without this sup- port, we would not be publishing an eighth edition!

A great many of our colleagues read the drafts of our fi rst and subsequent editions The fact that this book has so little in common with our earliest drafts, along with the many changes and improvements we have made over the years, is a refl ection of the value we placed on the many comments and suggestions that we received To the following reviewers, then, we are grateful for their many contributions:

xxiii

Ibrahim Affeneh Sung C Bae Robert Benecke Gary Benesh Scott Besley Sanjai Bhaghat Vigdis W Boasson Elizabeth Booth Denis Boudreaux William Brent Ray Brooks Charles C Brown Mary Chaffi n Fan Chen Raju Chenna Barbara J Childs Charles M Cox Natalya Delcoure Michael Dorigan David A Dumpe Michael Dunn Alan Eastman Adrian C Edwards Steve Engel Angelo V Esposito Cheri Etling Thomas H Eyssell Michael Ferguson Deborah Ann Ford Jim Forjan Micah Frankel

Jennifer R Frazier Deborah M Giarusso Devra Golbe

A Steven Graham Darryl E J Gurley Wendy D Habegger David Harraway John M Harris, Jr.

R Stevenson Hawkey Delvin D Hawley Robert C Higgins Karen Hogan Steve Isberg James Jackson Pankaj Jain James M Johnson Randy Jorgensen Jarl G Kallberg Terry Keasler David N Ketcher Jim Keys Kee Kim Robert Kleinman David Kuipers Morris A Lamberson Qin Lan

Adam Y.C Lei George Lentz John Lightstone Jason Lin Robert Lutz

Pawan Madhogarhia Timothy Manuel David G Martin Dubos J Masson John McDougald Bob McElreath Gordon Melms Richard R Mendenhall Wayne Mikkelson Lalatendu Misra Karlyn Mitchell Sunil Mohanty Scott Moore Frederick H Mull Michael J Murray Randy Nelson Bulent Parker Megan Partch Samuel Penkar Pamela P Peterson Robert Phillips George A Racette Charu G Raheja Narendar V Rao Russ Ray Ron Reiber Thomas Rietz Jay R Ritter Ricardo J Rodriguez Kenneth Roskelley Gary Sanger

Robert Schwebach Roger Severns Dilip K Shome Neil W Sicherman Timothy Smaby Michael F Spivey Vic Stanton Charlene Sullivan George S Swales, Jr.

Philip Swensen

Harry Thiewes

A Frank Thompson Joseph Trefzger Michael R Vetsuypens Joe Walker

Jun Wang James Washam Alan Weatherford Marsha Weber Jill Wetmore

David J Wright Steve B Wyatt Tung-Hsiao Yang Morris Yarmish Michael Young Mei Zhang

J Kenton Zumwalt Tom Zwirlein

We owe a special thanks to Kent Ragan of Missouri State University Kent worked on the many

supple-ments that accompany this book, including the Instructor’s Manual and PowerPoint Presentation System

Kent also worked with us to develop the Annotated Instructor’s Edition of the text which, along with the

Instructor’s Manual, contains a wealth of teaching notes

We also thank Joseph C Smolira of Belmont University for his work on this edition Joe worked closely with us to develop portions of the Instructor’s Manual, along with the many vignettes and real-world

examples we have added to this edition We owe a special thank you to Thomas H Eyssell of the

Universi-ty of Missouri Tom has continued his exceptional work on our supplements by creating the Student

Prob-lem Manual for this edition In addition, we would like to thank Kay Johnson, Penn State University—Erie,

for creating the self-study questions, as well as revising, reorganizing, and expanding the very extensive

testbank available with Fundamentals and creating the Student PowerPoints.

The following University of Kentucky doctoral students did outstanding work on this edition of mentals: Hinh Khieu, T J Phillips, and Qun Wu To them fell the unenviable task of technical proofreading,

Funda-and in particular, careful checking of each calculation throughout the text Funda-and Instructor’s Manual.

Finally, in every phase of this project, we have been privileged to have had the complete and unwavering support of a great organization, McGraw-Hill/Irwin We especially thank the McGraw-Hill/Irwin sales

Edward I Altman

New York University

Fischer Black Robert C Higgins

University of Washington

Roger Ibbotson

Yale University, Ibbotson Associates

University of Florida

Richard Roll

University of California at Los Angeles

Several of our most respected colleagues contrib uted original essays for this edition, which are entitled “In

Their Own Words,” and appear in selected chapters To these individuals we extend a special thanks:

We are deeply grateful to the select group of professionals who served as our development team on this edition: Michele Janicek, Executive Sponsoring Editor; Jennifer Rizzi, Development Editor II; Julie Phifer, Marketing Manager; Christine Vaughan, Lead Proj ect Manager; Kami Carter, Senior Designer; and Carol Bielski, Lead Production Supervisor Others at McGraw-Hill/Irwin, too numerous to list here, have improved the book in countless ways.

Throughout the development of this edition, we have taken great care to discover and eliminate errors Our goal is to provide the best textbook available on the subject To ensure that future editions are error-free, we gladly offer $10 per arithmetic error to the fi rst individual reporting it as a modest token of our appreci ation More than this, we would like to hear from instructors and students alike Please write and tell us how to make this a better text Forward your comments to: Dr Brad Jordan, c/o Editorial—Finance, McGraw-Hill/Irwin, 1333 Burr Ridge Parkway, Burr Ridge, IL 60527 or visit us online at www.mhhe.com/rwj.

Stephen A Ross Randolph W Westerfi eld Bradford D Jordan

Brief Contents

PART 1 Overview of Corporate Finance

CHAPTER 1 INTRODUCTION TO CORPORATE FINANCE 1

CHAPTER 2 FINANCIAL STATEMENTS, TAXES, AND CASH FLOW 21

PART 2 Financial Statements and Long-Term Financial Planning

CHAPTER 3 WORKING WITH FINANCIAL STATEMENTS 48

CHAPTER 4 LONG-TERM FINANCIAL PLANNING AND GROWTH 89

PART 3 Valuation of Future Cash Flows

CHAPTER 5 INTRODUCTION TO VALUATION: THE TIME VALUE OF MONEY 121

CHAPTER 6 DISCOUNTED CASH FLOW VALUATION 146

CHAPTER 7 INTEREST RATES AND BOND VALUATION 192

CHAPTER 8 STOCK VALUATION 234

PART 4 Capital Budgeting

CHAPTER 9 NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA 264

CHAPTER 10 MAKING CAPITAL INVESTMENT DECISIONS 302

CHAPTER 11 PROJECT ANALYSIS AND EVALUATION 337

PART 5 Risk and Return

CHAPTER 12 SOME LESSONS FROM CAPITAL MARKET HISTORY 368

CHAPTER 13 RETURN, RISK, AND THE SECURITY MARKET LINE 403

CHAPTER 14 OPTIONS AND CORPORATE FINANCE 439

PART 6 Cost of Capital and Long-Term Financial Policy

CHAPTER 15 COST OF CAPITAL 479

CHAPTER 16 RAISING CAPITAL 513

CHAPTER 17 FINANCIAL LEVERAGE AND CAPITAL STRUCTURE POLICY 551

CHAPTER 18 DIVIDENDS AND DIVIDEND POLICY 590

PART 7 Short-Term Financial Planning and Management

CHAPTER 19 SHORT-TERM FINANCE AND PLANNING 624

CHAPTER 20 CASH AND LIQUIDITY MANAGEMENT 657

CHAPTER 21 CREDIT AND INVENTORY MANAGEMENT 689

PART 8 Topics in Corporate Finance

CHAPTER 22 INTERNATIONAL CORPORATE FINANCE 726

xxvi

CHAPTER 1

INTRODUCTION TO CORPORATE FINANCE 1

1.1 Corporate Finance and the Financial Manager 2

What Is Corporate Finance? 2 The Financial Manager 2 Financial Management Decisions 2

Capital Budgeting 2 Capital Structure 3 Working Capital Management 4 Conclusion 4

1.2 Forms of Business Organization 4

Sole Proprietorship 5 Partnership 5 Corporation 6

A Corporation by Another Name 7

1.3 The Goal of Financial Management 8

Possible Goals 8 The Goal of Financial Management 8

A More General Goal 9 Sarbanes–Oxley 10

1.4 The Agency Problem and Control of the

Corporation 11

Agency Relationships 11 Management Goals 11

Do Managers Act in the Stockholders’ Interests? 12

Managerial Compensation 12 Control of the Firm 12 Conclusion 13

Stakeholders 14

1.5 Financial Markets and the Corporation 14

Cash Flows to and from the Firm 14 Primary versus Secondary Markets 14

Primary Markets 15 Secondary Markets 15 Dealer versus Auction Markets 15 Trading in Corporate Securities 16 Listing 16

CHAPTER 2

FINANCIAL STATEMENTS, TAXES, AND CASH FLOW 21

2.1 The Balance Sheet 22

Assets: The Left Side 22 Liabilities and Owners’ Equity: The Right Side 22 Net Working Capital 23

Liquidity 24 Debt versus Equity 25 Market Value versus Book Value 25

GAAP and the Income Statement 27 Noncash Items 28

Time and Costs 28

Corporate Tax Rates 30 Average versus Marginal Tax Rates 30

Cash Flow from Assets 33

Operating Cash Flow 33 Capital Spending 34 Change in Net Working Capital 34 Conclusion 35

A Note about “Free” Cash Flow 35

Cash Flow to Creditors and Stockholders 35

Cash Flow to Creditors 35 Cash Flow to Stockholders 35

An Example: Cash Flows for Dole Cola 37

Operating Cash Flow 37 Net Capital Spending 38 Change in NWC and Cash Flow from Assets 38 Cash Flow to Stockholders and Creditors 38

PART 1 Overview of Corporate Finance

PART 2 Financial Statements and Long-Term Financial Planning

CHAPTER 3

WORKING WITH FINANCIAL STATEMENTS 48

3.1 Cash Flow and Financial Statements: A Closer

Common–Base Year Financial Statements: Trend

Analysis 55

xxvii

Combined Common-Size and Base Year

Analysis 55

3.3 Ratio Analysis 56

Short-Term Solvency, or Liquidity, Measures 57

Current Ratio 57

The Quick (or Acid-Test) Ratio 58

Other Liquidity Ratios 59

Long-Term Solvency Measures 59

Total Debt Ratio 59

A Brief Digression: Total Capitalization versus Total

Assets 60

Times Interest Earned 60

Cash Coverage 61

Asset Management, or Turnover, Measures 61

Inventory Turnover and Days’ Sales in Inventory 61

Receivables Turnover and Days’ Sales in

Receivables 62

Asset Turnover Ratios 63

Profi tability Measures 63

3.4 The Du Pont Identity 67

A Closer Look at ROE 67

An Expanded Du Pont Analysis 69

3.5 Using Financial Statement Information 71

Why Evaluate Financial Statements? 71

Internal Uses 71

External Uses 71

Choosing a Benchmark 71

Time Trend Analysis 71

Peer Group Analysis 72

Problems with Financial Statement Analysis 76

3.6 Summary and Conclusions 77

CHAPTER 4

LONG-TERM FINANCIAL PLANNING AND GROWTH 89

4.1 What Is Financial Planning? 90

Growth as a Financial Management Goal 90 Dimensions of Financial Planning 91 What Can Planning Accomplish? 92

Examining Interactions 92 Exploring Options 92 Avoiding Surprises 92 Ensuring Feasibility and Internal Consistency 92

Conclusion 92

4.2 Financial Planning Models: A First Look 93

A Financial Planning Model: The Ingredients 93

Sales Forecast 93 Pro Forma Statements 93 Asset Requirements 94 Financial Requirements 94 The Plug 94

Economic Assumptions 94

A Simple Financial Planning Model 94

4.3 The Percentage of Sales Approach 96

The Income Statement 96 The Balance Sheet 97

A Particular Scenario 99

An Alternative Scenario 100

4.4 External Financing and Growth 101

EFN and Growth 101 Financial Policy and Growth 105

The Internal Growth Rate 105 The Sustainable Growth Rate 105 Determinants of Growth 107

A Note about Sustainable Growth Rate

Calculations 108

4.5 Some Caveats Regarding Financial Planning Models 110

PART 3 Valuation of Future Cash Flows

CHAPTER 5

INTRODUCTION TO VALUATION: THE TIME

VALUE OF MONEY 121

Investing for a Single Period 122

Investing for More Than One Period 122

A Note about Compound Growth 128

5.2 Present Value and Discounting 129

The Single-Period Case 129 Present Values for Multiple Periods 130

5.3 More about Present and Future Values 133

Present versus Future Value 133 Determining the Discount Rate 134 Finding the Number of Periods 138

CHAPTER 6

DISCOUNTED CASH FLOW VALUATION 146

6.1 Future and Present Values of Multiple Cash

Flows 147

Future Value with Multiple Cash Flows 147 Present Value with Multiple Cash Flows 150

A Note about Cash Flow Timing 153

6.2 Valuing Level Cash Flows: Annuities and

Perpetuities 154

Present Value for Annuity Cash Flows 154

Annuity Tables 156 Finding the Payment 157 Finding the Rate 159

Future Value for Annuities 161

A Note about Annuities Due 162 Perpetuities 162

Growing Annuities and Perpetuities 164

6.3 Comparing Rates: The Effect of Compounding 165

Effective Annual Rates and Compounding 165

Calculating and Comparing Effective Annual

Rates 166 EARs and APRs 168

Taking It to the Limit: A Note about Continuous

Compounding 169

6.4 Loan Types and Loan Amortization 171

Pure Discount Loans 171 Interest-Only Loans 171 Amortized Loans 172

CHAPTER 7

INTEREST RATES AND BOND VALUATION 192

7.1 Bonds and Bond Valuation 193

Bond Features and Prices 193 Bond Values and Yields 193 Interest Rate Risk 197 Finding the Yield to Maturity: More Trial and Error 198

7.2 More about Bond Features 203

Is It Debt or Equity? 203 Long-Term Debt: The Basics 203 The Indenture 205

Terms of a Bond 205 Security 206 Seniority 206 Repayment 206 The Call Provision 207 Protective Covenants 207

7.4 Some Different Types of Bonds 209

Government Bonds 209

Zero-Coupon Bonds 210 Floating-Rate Bonds 211 Other Types of Bonds 212

How Bonds Are Bought and Sold 214 Bond Price Reporting 216

A Note about Bond Price Quotes 219

7.6 Infl ation and Interest Rates 219

Real versus Nominal Rates 219 The Fisher Effect 220

Infl ation and Present Values 221

7.7 Determinants of Bond Yields 222

The Term Structure of Interest Rates 222

Bond Yields and the Yield Curve: Putting It All

Together 225 Conclusion 226

CHAPTER 8

STOCK VALUATION 234

Cash Flows 235 Some Special Cases 237

Zero Growth 237 Constant Growth 237 Nonconstant Growth 240 Two-Stage Growth 242

Components of the Required Return 243

8.2 Some Features of Common and Preferred Stocks 245

Common Stock Features 245

Shareholder Rights 245 Proxy Voting 246 Classes of Stock 247 Other Rights 247 Dividends 248

Preferred Stock Features 248

Stated Value 248 Cumulative and Noncumulative Dividends 248

Is Preferred Stock Really Debt? 249

8.3 The Stock Markets 249

Dealers and Brokers 250 Organization of the NYSE 250

Members 250 Operations 251 Floor Activity 251

NASDAQ Operations 252

NASDAQ Participants 253

Stock Market Reporting 254

PART 4 Capital Budgeting

CHAPTER 9

NET PRESENT VALUE AND OTHER INVESTMENT

CRITERIA 264

9.1 Net Present Value 265

The Basic Idea 265

Estimating Net Present Value 266

9.2 The Payback Rule 269

Defi ning the Rule 269

Analyzing the Rule 270

Redeeming Qualities of the Rule 271

Summary of the Rule 272

9.4 The Average Accounting Return 275

9.5 The Internal Rate of Return 277

Problems with the IRR 281

Nonconventional Cash Flows 281

Mutually Exclusive Investments 283

Redeeming Qualities of the IRR 285

The Modifi ed Internal Rate of Return (MIRR) 286

Method #1: The Discounting Approach 286

Method #2: The Reinvestment Approach 286

Method #3: The Combination Approach 286

MIRR or IRR: Which Is Better? 287

9.6 The Profi tability Index 287

9.7 The Practice of Capital Budgeting 288

9.8 Summary and Conclusions 291

CHAPTER 10

MAKING CAPITAL INVESTMENT DECISIONS 302

10.1 Project Cash Flows: A First Look 303

Relevant Cash Flows 303

The Stand-Alone Principle 303

10.2 Incremental Cash Flows 303

Getting Started: Pro Forma Financial Statements 306

Project Cash Flows 307

Project Operating Cash Flow 307

Project Net Working Capital and Capital

Spending 308

Projected Total Cash Flow and Value 308

10.4 More about Project Cash Flow 309

A Closer Look at Net Working Capital 309 Depreciation 312

Modifi ed ACRS Depreciation (MACRS) 312 Book Value versus Market Value 313

An Example: The Majestic Mulch and Compost

Company (MMCC) 315

Operating Cash Flows 315 Change in NWC 315 Capital Spending 317 Total Cash Flow and Value 317

10.6 Some Special Cases of Discounted Cash Flow Analysis 321

Evaluating Cost-Cutting Proposals 321 Setting the Bid Price 323

Evaluating Equipment Options with

Sources of Value 339

11.2 Scenario and Other What-If Analyses 340

Getting Started 340 Scenario Analysis 341 Sensitivity Analysis 343 Simulation Analysis 344

11.3 Break-Even Analysis 344

Fixed and Variable Costs 345

Variable Costs 345 Fixed Costs 346 Total Costs 346

Accounting Break-Even 348 Accounting Break-Even: A Closer Look 348 Uses for the Accounting Break-Even 350

11.4 Operating Cash Flow, Sales Volume, and

Break-Even 350

Accounting Break-Even and Cash Flow 351

The Base Case 351 Calculating the Break-Even Level 351 Payback and Break-Even 352

Sales Volume and Operating Cash Flow 352

Cash Flow, Accounting, and Financial Break-Even

11.6 Capital Rationing 358

Soft Rationing 358 Hard Rationing 359

11.7 Summary and Conclusions 359

PART 5 Risk and Return

12.2 The Historical Record 373

A First Look 373

A Closer Look 375

12.3 Average Returns: The First Lesson 379

Calculating Average Returns 379 Average Returns: The Historical Record 379 Risk Premiums 380

The First Lesson 380

12.4 The Variability of Returns: The Second

Lesson 381

Frequency Distributions and Variability 381

The Historical Variance and Standard

Deviation 382 The Historical Record 384 Normal Distribution 384 The Second Lesson 386 Using Capital Market History 386

12.5 More about Average Returns 387

Arithmetic versus Geometric Averages 387

Calculating Geometric Average

Returns 388

Arithmetic Average Return or Geometric Average

Return? 390

12.6 Capital Market Effi ciency 391

Price Behavior in an Effi cient Market 391 The Effi cient Markets Hypothesis 392

Some Common Misconceptions about the

EMH 393 The Forms of Market Effi ciency 395

12.7 Summary and Conclusions 396

13.2 Portfolios 407

Portfolio Weights 408 Portfolio Expected Returns 408 Portfolio Variance 409

13.3 Announcements, Surprises, and Expected Returns 411

Expected and Unexpected Returns 411 Announcements and News 411

13.4 Risk: Systematic and Unsystematic 413

Systematic and Unsystematic Risk 413

Systematic and Unsystematic Components of

Return 413

13.5 Diversifi cation and Portfolio Risk 414

The Effect of Diversifi cation: Another Lesson from

Market History 414 The Principle of Diversifi cation 415 Diversifi cation and Unsystematic Risk 416 Diversifi cation and Systematic Risk 417

13.6 Systematic Risk and Beta 417

The Systematic Risk Principle 418 Measuring Systematic Risk 418 Portfolio Betas 420

13.7 The Security Market Line 421

Beta and the Risk Premium 421

The Reward-to-Risk Ratio 422 The Basic Argument 423 The Fundamental Result 424

The Security Market Line 426

Market Portfolios 426 The Capital Asset Pricing Model 426

13.8 The SML and the Cost of Capital: A Preview 428

The Basic Idea 428

The Cost of Capital 429

13.9 Summary and Conclusions 429

CHAPTER 14

OPTIONS AND CORPORATE FINANCE 439

14.1 Options: The Basics 440

Puts and Calls 440

Stock Option Quotations 440

Option Payoffs 444

14.2 Fundamentals of Option Valuation 446

Value of a Call Option at Expiration 446

The Upper and Lower Bounds on a Call Option’s

Value 446

The Upper Bound 447

The Lower Bound 447

A Simple Model: Part I 448

The Basic Approach 448

A More Complicated Case 449

Four Factors Determining Option

Values 450

14.3 Valuing a Call Option 451

A Simple Model: Part II 451

The Fifth Factor 452

A Closer Look 453

14.4 Employee Stock Options 454

ESO Features 454 ESO Repricing 455 ESO Backdating 455

14.5 Equity as a Call Option on the Firm’s Assets 456

Case I: The Debt Is Risk-Free 457 Case II: The Debt Is Risky 457

14.6 Options and Capital Budgeting 459

The Investment Timing Decision 459 Managerial Options 461

Contingency Planning 462 Options in Capital Budgeting: An Example 463 Strategic Options 464

Insurance and Loan Guarantees 469

14.8 Summary and Conclusions 470

PART 6 Cost of Capital and Long-Term Financial Policy

CHAPTER 15

COST OF CAPITAL 479

15.1 The Cost of Capital: Some Preliminaries 480

Required Return versus Cost of Capital 480

Financial Policy and Cost of Capital 480

15.2 The Cost of Equity 481

The Dividend Growth Model Approach 481

Implementing the Approach 481

Estimating g 482

Advantages and Disadvantages of the Approach 483

The SML Approach 483

Implementing the Approach 484

Advantages and Disadvantages of the Approach 484

15.3 The Costs of Debt and Preferred Stock 485

The Cost of Debt 485

The Cost of Preferred Stock 486

15.4 The Weighted Average Cost of Capital 487

The Capital Structure Weights 487

Taxes and the Weighted Average Cost of Capital 488 Calculating the WACC for Eastman Chemical 489

Eastman’s Cost of Equity 489 Eastman’s Cost of Debt 491 Eastman’s WACC 492

Solving the Warehouse Problem and Similar Capital

Budgeting Problems 494

Performance Evaluation: Another Use of the

WACC 496

15.5 Divisional and Project Costs of Capital 497

The SML and the WACC 497 Divisional Cost of Capital 498 The Pure Play Approach 498 The Subjective Approach 499

15.6 Flotation Costs and the Weighted Average Cost of Capital 501

The Basic Approach 501 Flotation Costs and NPV 502 Internal Equity and Flotation Costs 504

15.7 Summary and Conclusions 504

CHAPTER 16

RAISING CAPITAL 513

16.1 The Financing Life Cycle of a Firm: Early-Stage

Financing and Venture Capital 514

Venture Capital 514 Some Venture Capital Realities 515 Choosing a Venture Capitalist 515 Conclusion 516

16.2 Selling Securities to the Public: The Basic

Procedure 516 16.3 Alternative Issue Methods 517

16.4 Underwriters 519

Choosing an Underwriter 520 Types of Underwriting 520

Firm Commitment Underwriting 520 Best Efforts Underwriting 520 Dutch Auction Underwriting 521

The Aftermarket 521 The Green Shoe Provision 522 Lockup Agreements 522 The Quiet Period 522

16.5 IPOs and Underpricing 523

IPO Underpricing: The 1999–2000 Experience 523 Evidence on Underpricing 525

Why Does Underpricing Exist? 526

16.6 New Equity Sales and the Value of the Firm 529

16.7 The Costs of Issuing Securities 530

The Costs of Selling Stock to the Public 530 The Costs of Going Public: The Case of Symbion 532

16.8 Rights 534

The Mechanics of a Rights Offering 534 Number of Rights Needed to Purchase a Share 535 The Value of a Right 536

Ex Rights 538 The Underwriting Arrangements 539 Effects on Shareholders 539

16.9 Dilution 540

Dilution of Proportionate Ownership 540 Dilution of Value: Book versus Market Values 540

A Misconception 541 The Correct Arguments 542

16.10 Issuing Long-Term Debt 542

17.1 The Capital Structure Question 552

Firm Value and Stock Value: An Example 552 Capital Structure and the Cost of Capital 553

17.2 The Effect of Financial Leverage 553

The Basics of Financial Leverage 553

Financial Leverage, EPS, and ROE: An Example 554 EPS versus EBIT 555

Corporate Borrowing and Homemade Leverage 556

17.3 Capital Structure and the Cost of Equity Capital 558

M&M Proposition I: The Pie Model 558

The Cost of Equity and Financial Leverage: M&M

Proposition II 559 Business and Financial Risk 561

17.4 M&M Propositions I and II with Corporate Taxes 562

The Interest Tax Shield 563 Taxes and M&M Proposition I 563 Taxes, the WACC, and Proposition II 564 Conclusion 565

17.5 Bankruptcy Costs 567

Direct Bankruptcy Costs 568 Indirect Bankruptcy Costs 568

17.6 Optimal Capital Structure 569

The Static Theory of Capital Structure 569 Optimal Capital Structure and the Cost of Capital 570 Optimal Capital Structure: A Recap 571

Capital Structure: Some Managerial

Recommendations 573

Taxes 573 Financial Distress 573

17.7 The Pie Again 573

The Extended Pie Model 574 Marketed Claims versus Nonmarketed Claims 575

17.8 The Pecking-Order Theory 575

Internal Financing and the Pecking Order 575 Implications of the Pecking Order 576

17.9 Observed Capital Structures 577 17.10 A Quick Look at the Bankruptcy Process 579

Liquidation and Reorganization 579

Bankruptcy Liquidation 579 Bankruptcy Reorganization 580

Financial Management and the Bankruptcy

Process 581 Agreements to Avoid Bankruptcy 582

17.11 Summary and Conclusions 582

CHAPTER 18

DIVIDENDS AND DIVIDEND POLICY 590

18.1 Cash Dividends and Dividend Payment 591

Cash Dividends 591

Standard Method of Cash Dividend Payment 592

Dividend Payment: A Chronology 592

More about the Ex-Dividend Date 593

18.2 Does Dividend Policy Matter? 594

An Illustration of the Irrelevance of Dividend Policy 595

Current Policy: Dividends Set Equal to Cash Flow 595

Alternative Policy: Initial Dividend Greater Than Cash

18.4 Real-World Factors Favoring a High Payout 599

Desire for Current Income 600

18.5 A Resolution of Real-World Factors? 602

Information Content of Dividends 602

The Clientele Effect 603

18.6 Establishing a Dividend Policy 604

Residual Dividend Approach 604 Dividend Stability 606

A Compromise Dividend Policy 607 Some Survey Evidence on Dividends 608

18.7 Stock Repurchase: An Alternative to Cash Dividends 609

Cash Dividends versus Repurchase 610 Real-World Considerations in a Repurchase 611 Share Repurchase and EPS 612

18.8 Stock Dividends and Stock Splits 612

Some Details about Stock Splits and Stock

Dividends 613

Example of a Small Stock Dividend 613 Example of a Stock Split 613

Example of a Large Stock Dividend 614

Value of Stock Splits and Stock Dividends 614

The Benchmark Case 614 Popular Trading Range 614

Reverse Splits 615

18.9 Summary and Conclusions 616

PART 7 Short-Term Financial Planning and Management

CHAPTER 19

SHORT-TERM FINANCE AND PLANNING 624

19.1 Tracing Cash and Net Working Capital 625

19.2 The Operating Cycle and the Cash Cycle 626

Defi ning the Operating and Cash Cycles 627

The Operating Cycle 627

The Cash Cycle 627

The Operating Cycle and the Firm’s Organizational

Chart 629

Calculating the Operating and Cash Cycles 629

The Operating Cycle 630

The Cash Cycle 631

Interpreting the Cash Cycle 632

19.3 Some Aspects of Short-Term Financial Policy 632

The Size of the Firm’s Investment in Current

Assets 633

Alternative Financing Policies for Current Assets 634

An Ideal Case 634

Different Policies for Financing Current Assets 634

Which Financing Policy Is Best? 637

Current Assets and Liabilities in Practice 638

19.4 The Cash Budget 639

Sales and Cash Collections 639 Cash Outfl ows 640

The Cash Balance 640

19.5 Short-Term Borrowing 641

Unsecured Loans 642

Compensating Balances 642 Cost of a Compensating Balance 642 Letters of Credit 643

CASH AND LIQUIDITY MANAGEMENT 657

20.1 Reasons for Holding Cash 658

The Speculative and Precautionary Motives 658 The Transaction Motive 658

Compensating Balances 658 Costs of Holding Cash 658

Cash Management versus

Liquidity Management 659

20.2 Understanding Float 659

Disbursement Float 659 Collection Float and Net Float 660 Float Management 661

Measuring Float 661 Some Details 662 Cost of the Float 662 Ethical and Legal Questions 664

Electronic Data Interchange and Check 21: The End of

Float? 665

20.3 Cash Collection and Concentration 666

Components of Collection Time 666 Cash Collection 666

Lockboxes 666 Cash Concentration 668 Accelerating Collections: An Example 669

20.4 Managing Cash Disbursements 670

Increasing Disbursement Float 670 Controlling Disbursements 671

Zero-Balance Accounts 671 Controlled Disbursement Accounts 672

20.5 Investing Idle Cash 672

Temporary Cash Surpluses 672

Seasonal or Cyclical Activities 672 Planned or Possible Expenditures 672

Characteristics of Short-Term Securities 673

Maturity 673 Default Risk 673 Marketability 673 Taxes 673

Some Different Types of Money Market

Securities 674

20.6 Summary and Conclusions 675

20A Determining the Target Cash Balance 679

The Basic Idea 679 The BAT Model 680

The Opportunity Costs 681 The Trading Costs 682 The Total Cost 682 The Solution 683

Implications of the BAT and Miller–Orr Models 686

Other Factors Infl uencing the Target Cash

Balance 686

CHAPTER 21

CREDIT AND INVENTORY MANAGEMENT 689

21.1 Credit and Receivables 690

Components of Credit Policy 690 The Cash Flows from Granting Credit 690 The Investment in Receivables 691

21.2 Terms of the Sale 691

The Basic Form 692 The Credit Period 692

The Invoice Date 692 Length of the Credit Period 692

Cash Discounts 693

Cost of the Credit 694 Trade Discounts 694 The Cash Discount and the ACP 694

Credit Instruments 695

21.3 Analyzing Credit Policy 695

Credit Policy Effects 695 Evaluating a Proposed Credit Policy 696

NPV of Switching Policies 696

A Break-Even Application 698

21.4 Optimal Credit Policy 698

The Total Credit Cost Curve 698 Organizing the Credit Function 699

21.5 Credit Analysis 700

When Should Credit Be Granted? 700

A One-Time Sale 700 Repeat Business 701

Credit Information 702 Credit Evaluation and Scoring 702

21.6 Collection Policy 703

Monitoring Receivables 703 Collection Effort 704

The Financial Manager and Inventory Policy 705 Inventory Types 705

Inventory Costs 705

21.8 Inventory Management Techniques 706

The ABC Approach 706 The Economic Order Quantity Model 707

Inventory Depletion 707 The Carrying Costs 709 The Shortage Costs 709 The Total Costs 709

Extensions to the EOQ Model 711

Safety Stocks 711 Reorder Points 711

Managing Derived-Demand Inventories 711

Materials Requirements Planning 713

Just-in-Time Inventory 713

PART 8 Topics in Corporate Finance

21.9 Summary and Conclusions 713

21A More about Credit Policy Analysis 719

Two Alternative Approaches 719

The One-Shot Approach 720

The Accounts Receivable Approach 720

Discounts and Default Risk 721

NPV of the Credit Decision 722

Exchange Rate Quotations 729

Cross-Rates and Triangle Arbitrage 730

Types of Transactions 732

22.3 Purchasing Power Parity 733

Absolute Purchasing Power Parity 733

Relative Purchasing Power Parity 735

The Basic Idea 735

The Result 735

Currency Appreciation and Depreciation 736

22.4 Interest Rate Parity, Unbiased Forward Rates, and

the International Fisher Effect 737

Covered Interest Arbitrage 737

Interest Rate Parity 738

Forward Rates and Future Spot Rates 739

Putting It All Together 739

Uncovered Interest Parity 740

The International Fisher Effect 740

22.5 International Capital Budgeting 741

Method 1: The Home Currency Approach 741 Method 2: The Foreign Currency Approach 742 Unremitted Cash Flows 743

22.6 Exchange Rate Risk 743

Short-Run Exposure 743 Long-Run Exposure 744 Translation Exposure 745 Managing Exchange Rate Risk 746

22.7 Political Risk 746 22.8 Summary and Conclusions 747

In Their Own Words Boxes

Samuel C Weaver Lehigh University

On Capital Budgeting at the Hershey Company

CHAPTER 12

Roger Ibbotson Yale University

On Capital Market History

Jeremy Siegel University of Pennsylvania

On Stocks for the Long Run

Richard Roll University of California at Los Angeles

On Market Effi ciency

CHAPTER 14

Erik Lie University of Iowa

On Option Backdating

Robert C Merton Harvard University

On Applications of Option Analysis

CHAPTER 15

Bennett Stewart Stern Stewart & Co.

On EVA

Samuel C Weaver Lehigh University

On Cost of Capital and Hurdle Rates at the Hershey Company

CHAPTER 16

Jay R Ritter University of Florida

On IPO Underpricing around the World

FUNDAMENTALS OF

CORPORATE FINANCE