Principles of corporate finance 7ed mcgraw−hill

Financial assets include not only bank loans but also shares of stock, bonds, and a dizzying variety of specialized securities.5 The financial manager stands between the firm’s operation

PREFACE

This book describes the theory and practice of

corpo-rate finance We hardly need to explain why financial

managers should master the practical aspects of their

job, but we should spell out why down-to-earth,

red-blooded managers need to bother with theory

Managers learn from experience how to cope

with routine problems But the best managers are

also able to respond to change To do this you need

more than time-honored rules of thumb; you must

understand why companies and financial markets

behave the way they do In other words, you need a

theory of finance.

Does that sound intimidating? It shouldn’t

Good theory helps you grasp what is going on in

the world around you It helps you to ask the right

questions when times change and new problems

must be analyzed It also tells you what things you

do not need to worry about Throughout this book

we show how managers use financial theory to

solve practical problems

Of course, the theory presented in this book is not

perfect and complete—no theory is There are some

famous controversies in which financial economists

cannot agree on what firms ought to do We have not

glossed over these controversies We set out the main

arguments for each side and tell you where we stand

Once understood, good theory is common sense.Therefore we have tried to present it at a common-sense level, and we have avoided proofs and heavymathematics There are no ironclad prerequisites forreading this book except algebra and the English lan-guage An elementary knowledge of accounting, sta-tistics, and microeconomics is helpful, however

C H A N G E S I N T H E S E V E N T H E D I T I O N

This book is written for students of financial agement For many readers, it is their first look at theworld of finance Therefore in each edition we strive

man-to make the book simpler, clearer, and more fun man-toread But the book is also used as a reference andguide by practicing managers around the world.Therefore we also strive to make each new editionmore comprehensive and authoritative

We believe this edition is better for both the dent and the practicing manager Here are some ofthe major changes:

stu-We have streamlined and simplified the tion of major concepts, with special attention toChapters 1 through 12, where the fundamental con-cepts of valuation, risk and return, and capital bud-geting are introduced In these chapters we coveronly the most basic institutional material At the

exposi-same time we have rewritten Chapter 14 as a

free-standing introduction to the nature of the

corpora-tion, to the major sources of corporate financing, and

to financial markets and institutions Some readers

will turn first to Chapter 14 to see the contexts in

which financial decisions are made

We have also expanded coverage of important

topics For example, real options are now introduced

in Chapter 10—you don’t have to master

option-pricing theory in order to grasp what real options are

and why they are important Later in the book, after

Chapter 20 (Understanding Options) and Chapter 21

(Valuing Options), there is a brand-new Chapter 22

on real options, which covers valuation methods and

a range of practical applications

Other examples of expanded coverage include

be-havioral finance (Chapter 13) and new international

evidence on the market-risk premium (Chapter 7) We

have also reorganized the chapters on financial

plan-ning and working capital management In fact we

have revised and updated every chapter in the book

This edition’s international coverage is

panded and woven into the rest of the text For

ex-ample, international investment decisions are now

introduced in Chapter 6, right alongside domestic

investment decisions Likewise the cost of capital

for international investments is discussed in

Chap-ter 9, and inChap-ternational differences in security issue

procedures are reviewed in Chapter 15 Chapter 34

looks at some of the international differences in

fi-nancial architecture and ownership There is,

how-ever, a separate chapter on international risk

man-agement, which covers foreign exchange rates and

markets, political risk, and the valuation of capital

investments in different currencies There is also a

new international index

The seventh edition is much more Web-friendly

than the sixth Web references are highlighted in the

text, and an annotated list of useful websites has

been added to each part of the book

Of course, as every first-grader knows, it is easier

to add than to subtract, but we have pruned ciously Some readers of the sixth edition may miss afavorite example or special topic But new readersshould find that the main themes of corporate fi-nance come through with less clutter

judi-M A K I N G L E A R N I N G E A S I E R

Each chapter of the book includes an introductorypreview, a summary, and an annotated list of sug-gestions for further reading There is a quick andeasy quiz, a number of practice questions, and a fewchallenge questions Many questions use financialdata on actual companies accessible by the readerthrough Standard & Poor’s Educational Version ofMarket Insight In total there are now over a thou-sand end-of-chapter questions All the questions re-fer to material in the same order as it occurs in thechapter Answers to the quiz questions may befound at the end of the book, along with a glossaryand tables for calculating present values and pric-ing options

We have expanded and revised the mini-casesand added specific questions for each mini-case toguide the case analysis Answers to the mini-casesare available to instructors on this book’s website

(www.mhhe.com/bm7e).

Parts 1 to 3 of the book are concerned with tion and the investment decision, Parts 4 to 8 withlong-term financing and risk management Part 9 fo-cuses on financial planning and short-term financialdecisions Part 10 looks at mergers and corporatecontrol and Part 11 concludes We realize that manyteachers will prefer a different sequence of topics.Therefore, we have ensured that the text is modular,

valua-so that topics can be introduced in a variety of orders.For example, there will be no difficulty in reading thematerial on financial statement analysis and short-term decisions before the chapters on valuation andcapital investment

We should mention two matters of style now to

prevent confusion later First, the most important

fi-nancial terms are set out in boldface type the first

time they appear; less important but useful terms are

given in italics Second, most algebraic symbols

rep-resenting dollar values are shown as capital letters

Other symbols are generally lowercase letters Thus

the symbol for a dividend payment is “DIV,” and the

symbol for a percentage rate of return is “r.”

S U P P L E M E N T S

In this edition, we have gone to great lengths to

en-sure that our supplements are equal in quality and

authority to the text itself

Instructor’s Manual

ISBN 0072467886

The Instructor’s Manual was extensively revised and

updated by C R Krishnaswamy of Western

Michi-gan University It contains an overview of each

chap-ter, teaching tips, learning objectives, challenge

ar-eas, key terms, and an annotated outline that

provides references to the PowerPoint slides

Test Bank

ISBN 0072468025

The Test Bank was also updated by C R

Krish-naswamy, who included well over 1,000 new

multiple-choice and short answer/discussion questions based

on the revisions of the authors The level of difficulty is

varied throughout, using a label of easy, medium, or

difficult

PowerPoint Presentation System

Matt Will of the University of Indianapolis

pre-pared the PowerPoint Presentation System, which

contains exhibits, outlines, key points, and

sum-maries in a visually stimulating collection of slides

Found on the Student CD-ROM, the Instructor’s

CD-ROM, and our website, the slides can be edited,

printed, or rearranged in any way to fit the needs of

your course

Financial Analysis Spreadsheet Templates(F.A.S.T.)

Mike Griffin of KMT Software created the templates

in Excel They correlate with specific concepts in thetext and allow students to work through financialproblems and gain experience using spreadsheets.Each template is tied to a specific problem in the text

Solutions ManualISBN 0072468009The Solutions Manual, prepared by Bruce Swensen,Adelphi University, contains solutions to all practicequestions and challenge questions found at the end

of each chapter Thoroughly checked for accuracy,this supplement is available to be purchased by yourstudents

Study GuideISBN 0072468017The new Study Guide was carefully revised by

V Sivarama Krishnan of Cameron University andcontains useful and interesting keys to learning It in-cludes an introduction to each chapter, key concepts,examples, exercises and solutions, and a completechapter summary

VideosISBN 0072467967The McGraw-Hill/Irwin Finance Video Series is acomplete video library designed to bring addedpoints of discussion to your class Within this profes-sionally developed series, you will find examples ofhow real businesses face today’s hottest topics, likemergers and acquisitions, going public, and careers

in finance

Student CD-ROMPackaged with each text is a CD-ROM for studentsthat contains many features designed to enhance theclassroom experience Three learning modules fromthe new Finance Tutor Series are included on the CD:Time Value of Money Tutor, Stock and Bond Valuation

Tutor, and Capital Budgeting Tutor In each module,

students answer questions and solve problems that

not only assess their general understanding of the

subject but also their ability to apply that

understand-ing in real-world business contexts In “Practice

Mode,” students learn as they go by receiving

in-depth feedback on each response before proceeding to

the next question Even better, the program

antici-pates common misunderstandings, such as incorrect

calculations or assumptions, and then provides

feed-back only to the student making that specific mistake

Students who want to assess their current knowledge

may select “Test Mode,” where they read an extensive

evaluation report after they have completed the test

Also included are the PowerPoint presentation

system, Financial Analysis Spreadsheet Templates

(F.A.S.T.), video clips from our Finance Video Series,

and many useful Web links

Instructor’s CD-ROM

ISBN 0072467959

We have compiled many of our instructor

supple-ments in electronic format on a CD-ROM designed

to assist with class preparation The CD-ROM

in-cludes the Instructor’s Manual, the Solutions

Man-ual, a computerized Test Bank, PowerPoint slides,

video clips, and Web links

Online Learning Center

(www.mhhe.com/bm7e)

This site contains information about the book and the

authors, as well as teaching and learning materials

for the instructor and the student, including:

PageOut: The Course Website Development

Center and PageOut Lite

www.pageout.net

This Web page generation software, free to adopters,

is designed for professors just beginning to explore

website options In just a few minutes, even the most

novice computer user can have a course website

Simply type your material into the template

pro-vided and PageOut Lite instantly converts it to

HTML—a universal Web language Next, chooseyour favorite of three easy-to-navigate designs andyour Web home page is created, complete with on-line syllabus, lecture notes, and bookmarks You caneven include a separate instructor page and an as-signment page

PageOut offers enhanced point-and-click featuresincluding a Syllabus Page that applies real-worldlinks to original text material, an automated gradebook, and a discussion board where instructors andtheir students can exchange questions and post an-nouncements

A C K N O W L E D G M E N T S

We have a long list of people to thank for their ful criticism of earlier editions and for assistance inpreparing this one They include Aleijda de Cazen-ove Balsan, John Cox, Kedrum Garrison, RobertPindyck, and Gretchen Slemmons at MIT; StefaniaUccheddu at London Business School; LyndaBorucki, Marjorie Fischer, Larry Kolbe, James A.Read, Jr., and Bente Villadsen at The Brattle Group,Inc.; John Stonier at Airbus Industries; and Alex Tri-antis at the University of Maryland We would alsolike to thank all those at McGraw-Hill/Irwin whoworked on the book, including Steve Patterson, Pub-lisher; Rhonda Seelinger, Executive Marketing Man-ager; Sarah Ebel, Senior Developmental Editor; JeanLou Hess, Senior Project Manager; Keith McPherson,Design Director; Joyce Chappetto, Supplement Co-ordinator; and Michael McCormick, Senior Produc-tion Supervisor

help-We want to express our appreciation to those structors whose insightful comments and sugges-tions were invaluable to us during this revision:

in-Noyan Arsen Koc University Penny Belk Loughborough University Eric Benrud University of Baltimore Peter Berman University of New Haven Jean Canil University of Adelaide Robert Everett Johns Hopkins University

Winfried Hallerbach Erasmus University, Rotterdam

Milton Harris University of Chicago

Mark Griffiths Thunderbird, American School of

International Management

Jarl Kallberg NYU, Stern School of Business

Steve Kaplan University of Chicago

Ken Kim University of Wisconsin—Milwaukee

C R Krishnaswamy Western Michigan University

Ravi Jaganathan Northwestern University

David Lovatt University of East Anglia

Joe Messina San Francisco State University

Dag Michalson Bl, Oslo

Peter Moles University of Edinburgh

Claus Parum Copenhagen Business School

Narendar V Rao Northeastern University

Tom Rietz University of Iowa

Robert Ritchey Texas Tech University

Mo Rodriguez Texas Christian University

John Rozycki Drake University

Brad Scott Webster University

Bernell Stone Brigham Young University

Shrinivasan Sundaram Ball State University Avanidhar Subrahmanyam UCLA

Stephen Todd Loyola University—Chicago David Vang St Thomas University John Wald Rutgers University Jill Wetmore Saginaw Valley State University Matt Will Johns Hopkins University

Art Wilson George Washington University

This list is almost surely incomplete We know howmuch we owe to our colleagues at the London Busi-ness School and MIT’s Sloan School of Manage-ment In many cases, the ideas that appear in thisbook are as much their ideas as ours Finally, werecord the continuing thanks due to our wives, Di-ana and Maureen, who were unaware when they

married us that they were also marrying The

Princi-ples of Corporate Finance.

Richard A Brealey Stewart C Myers

F I N A N C E A N D

T H E F I N A N C I A L

M A N A G E R

THIS BOOK ISabout financial decisions made by corporations We should start by saying what thesedecisions are and why they are important.

Corporations face two broad financial questions: What investments should the firm make? andHow should it pay for those investments? The first question involves spending money; the second in-volves raising it

The secret of success in financial management is to increase value That is a simple statement, butnot very helpful It is like advising an investor in the stock market to “Buy low, sell high.” The prob-lem is how to do it

There may be a few activities in which one can read a textbook and then do it, but financial agement is not one of them That is why finance is worth studying Who wants to work in a field wherethere is no room for judgment, experience, creativity, and a pinch of luck? Although this book can-not supply any of these items, it does present the concepts and information on which good financialdecisions are based, and it shows you how to use the tools of the trade of finance

man-We start in this chapter by explaining what a corporation is and introducing you to the

responsi-bilities of its financial managers We will distinguish real assets from financial assets and capital

in-vestment decisions from financing decisions We stress the importance of financial markets, both

na-tional and internana-tional, to the financial manager

Finance is about money and markets, but it is also about people The success of a corporationdepends on how well it harnesses everyone to work to a common end The financial manager mustappreciate the conflicting objectives often encountered in financial management Resolving con-flicts is particularly difficult when people have different information This is an important themewhich runs through to the last chapter of this book In this chapter we will start with some defini-tions and examples

3

Not all businesses are corporations Small ventures can be owned and managed by

a single individual These are called sole proprietorships In other cases several ple may join to own and manage a partnership.1However, this book is about corpo-

peo-rate finance So we need to explain what a corporation is.

Almost all large and medium-sized businesses are organized as corporations.For example, General Motors, Bank of America, Microsoft, and General Electric arecorporations So are overseas businesses, such as British Petroleum, Unilever,Nestlé, Volkswagen, and Sony In each case the firm is owned by stockholders whohold shares in the business

When a corporation is first established, its shares may all be held by a smallgroup of investors, perhaps the company’s managers and a few backers In this

case the shares are not publicly traded and the company is closely held Eventually,

when the firm grows and new shares are issued to raise additional capital, its

shares will be widely traded Such corporations are known as public companies.

1.1 WHAT IS A CORPORATION?

1 Many professional businesses, such as accounting and legal firms, are partnerships Most large vestment banks started as partnerships, but eventually these companies and their financing needs grew too large for them to continue in this form Goldman Sachs, the last of the leading investment-bank part- nerships, issued shares and became a public corporation in 1998.

in-Most well-known corporations in the United States are public companies In manyother countries, it’s common for large companies to remain in private hands.

By organizing as a corporation, a business can attract a wide variety of vestors Some may hold only a single share worth a few dollars, cast only a sin-gle vote, and receive a tiny proportion of profits and dividends Shareholdersmay also include giant pension funds and insurance companies whose invest-ment may run to millions of shares and hundreds of millions of dollars, and whoare entitled to a correspondingly large number of votes and proportion of prof-its and dividends

in-Although the stockholders own the corporation, they do not manage it

In-stead, they vote to elect a board of directors Some of these directors may be drawn

from top management, but others are non-executive directors, who are not ployed by the firm The board of directors represents the shareholders It ap-points top management and is supposed to ensure that managers act in the share-holders’ best interests

em-This separation of ownership and management gives corporations permanence.2

Even if managers quit or are dismissed and replaced, the corporation can survive,and today’s stockholders can sell all their shares to new investors without dis-rupting the operations of the business

Unlike partnerships and sole proprietorships, corporations have limited ity,which means that stockholders cannot be held personally responsible for thefirm’s debts If, say, General Motors were to fail, no one could demand that itsshareholders put up more money to pay off its debts The most a stockholder canlose is the amount he or she has invested

liabil-Although a corporation is owned by its stockholders, it is legally distinct from

them It is based on articles of incorporation that set out the purpose of the business,

how many shares can be issued, the number of directors to be appointed, and so

on These articles must conform to the laws of the state in which the business is corporated.3For many legal purposes, the corporation is considered as a resident

in-of its state As a legal “person,” it can borrow or lend money, and it can sue or besued It pays its own taxes (but it cannot vote!)

Because the corporation is distinct from its shareholders, it can do things thatpartnerships and sole proprietorships cannot For example, it can raise money byselling new shares to investors and it can buy those shares back One corporationcan make a takeover bid for another and then merge the two businesses

There are also some disadvantages to organizing as a corporation Managing a

corporation’s legal machinery and communicating with shareholders can betime-consuming and costly Furthermore, in the United States there is an impor-tant tax drawback Because the corporation is a separate legal entity, it is taxedseparately So corporations pay tax on their profits, and, in addition, sharehold-ers pay tax on any dividends that they receive from the company The UnitedStates is unusual in this respect To avoid taxing the same income twice, mostother countries give shareholders at least some credit for the tax that the com-pany has already paid.4

2 Corporations can be immortal but the law requires partnerships to have a definite end A partnership agreement must specify an ending date or a procedure for wrapping up the partnership’s affairs A sole proprietorship also will have an end because the proprietor is mortal.

3 Delaware has a well-developed and supportive system of corporate law Even though they may do tle business in that state, a high proportion of United States corporations are incorporated in Delaware.

lit-4 Or companies may pay a lower rate of tax on profits paid out as dividends.

To carry on business, corporations need an almost endless variety of real assets.

Many of these assets are tangible, such as machinery, factories, and offices; others are

intangible, such as technical expertise, trademarks, and patents All of them need to

be paid for To obtain the necessary money, the corporation sells claims on its real

sets and on the cash those assets will generate These claims are called financial

as-sets or securities For example, if the company borrows money from the bank, the

bank gets a written promise that the money will be repaid with interest Thus the

bank trades cash for a financial asset Financial assets include not only bank loans but

also shares of stock, bonds, and a dizzying variety of specialized securities.5

The financial manager stands between the firm’s operations and the financial (or

capital) markets,where investors hold the financial assets issued by the firm.6The

financial manager’s role is illustrated in Figure 1.1, which traces the flow of cash

from investors to the firm and back to investors again The flow starts when the firm

sells securities to raise cash (arrow 1 in the figure) The cash is used to purchase real

assets used in the firm’s operations (arrow 2) Later, if the firm does well, the real

assets generate cash inflows which more than repay the initial investment (arrow 3)

Finally, the cash is either reinvested (arrow 4a) or returned to the investors who

pur-chased the original security issue (arrow 4b) Of course, the choice between arrows

4a and 4b is not completely free For example, if a bank lends money at stage 1, the

bank has to be repaid the money plus interest at stage 4b.

Our diagram takes us back to the financial manager’s two basic questions First,

what real assets should the firm invest in? Second, how should the cash for the

in-vestment be raised? The answer to the first question is the firm’s inin-vestment, or

cap-ital budgeting, decision The answer to the second is the firm’s financing decision.

Capital investment and financing decisions are typically separated, that is,

ana-lyzed independently When an investment opportunity or “project” is identified,

the financial manager first asks whether the project is worth more than the capital

required to undertake it If the answer is yes, he or she then considers how the

proj-ect should be financed

But the separation of investment and financing decisions does not mean that the

financial manager can forget about investors and financial markets when analyzing

capital investment projects As we will see in the next chapter, the fundamental

fi-nancial objective of the firm is to maximize the value of the cash invested in the firm

by its stockholders Look again at Figure 1.1 Stockholders are happy to contribute

cash at arrow 1 only if the decisions made at arrow 2 generate at least adequate

re-turns at arrow 3 “Adequate” means rere-turns at least equal to the rere-turns available to

investors outside the firm in financial markets If your firm’s projects consistently

generate inadequate returns, your shareholders will want their money back.

Financial managers of large corporations also need to be men and women of the

world They must decide not only which assets their firm should invest in but also

where those assets should be located Take Nestlé, for example It is a Swiss company,

but only a small proportion of its production takes place in Switzerland Its 520 or so

1.2 THE ROLE OF THE FINANCIAL MANAGER

5

We review these securities in Chapters 14 and 25.

6

You will hear financial managers use the terms financial markets and capital markets almost

synony-mously But capital markets are, strictly speaking, the source of long-term financing only Short-term

fi-nancing comes from the money market “Short-term” means less than one year We use the term financial

markets to refer to all sources of financing.

factories are located in 82 countries Nestlé’s managers must therefore know how toevaluate investments in countries with different currencies, interest rates, inflationrates, and tax systems.

The financial markets in which the firm raises money are likewise international.The stockholders of large corporations are scattered around the globe Shares aretraded around the clock in New York, London, Tokyo, and other financial centers.Bonds and bank loans move easily across national borders A corporation thatneeds to raise cash doesn’t have to borrow from its hometown bank Day-to-daycash management also becomes a complex task for firms that produce or sell in dif-ferent countries For example, think of the problems that Nestlé’s financial man-agers face in keeping track of the cash receipts and payments in 82 countries

We admit that Nestlé is unusual, but few financial managers can close their eyes

to international financial issues So throughout the book we will pay attention todifferences in financial systems and examine the problems of investing and raisingmoney internationally

(1) (2)

(4b)

(4a)

(3)

Financial manager

Financial markets (investors holding financial assets)

Firm's operations (a bundle

of real assets)

F I G U R E 1 1

Flow of cash between financial markets

and the firm’s operations Key: (1) Cash

raised by selling financial assets to

investors; (2) cash invested in the firm’s

operations and used to purchase real

assets; (3) cash generated by the firm’s

operations; (4a) cash reinvested;

(4b) cash returned to investors.

1.3 WHO IS THE FINANCIAL MANAGER?

In this book we will use the term financial manager to refer to anyone responsible

for a significant investment or financing decision But only in the smallest firms is

a single person responsible for all the decisions discussed in this book In mostcases, responsibility is dispersed Top management is of course continuously in-volved in financial decisions But the engineer who designs a new production fa-cility is also involved: The design determines the kind of real assets the firm willhold The marketing manager who commits to a major advertising campaign isalso making an important investment decision The campaign is an investment in

an intangible asset that is expected to pay off in future sales and earnings

Nevertheless there are some managers who specialize in finance Their roles are

summarized in Figure 1.2 The treasurer is responsible for looking after the firm’s

cash, raising new capital, and maintaining relationships with banks, stockholders,and other investors who hold the firm’s securities

For small firms, the treasurer is likely to be the only financial executive Larger

corporations also have a controller, who prepares the financial statements,

man-ages the firm’s internal accounting, and looks after its tax obligations You can seethat the treasurer and controller have different functions: The treasurer’s main re-sponsibility is to obtain and manage the firm’s capital, whereas the controller en-sures that the money is used efficiently

Still larger firms usually appoint a chief financial officer (CFO) to oversee both the

treasurer’s and the controller’s work The CFO is deeply involved in financial policy

and corporate planning Often he or she will have general managerial responsibilities

beyond strictly financial issues and may also be a member of the board of directors

The controller or CFO is responsible for organizing and supervising the capital

budgeting process However, major capital investment projects are so closely tied

to plans for product development, production, and marketing that managers from

these areas are inevitably drawn into planning and analyzing the projects If the

firm has staff members specializing in corporate planning, they too are naturally

involved in capital budgeting

Because of the importance of many financial issues, ultimate decisions often rest

by law or by custom with the board of directors For example, only the board has

the legal power to declare a dividend or to sanction a public issue of securities

Boards usually delegate decisions for small or medium-sized investment outlays,

but the authority to approve large investments is almost never delegated

Chief Financial Officer (CFO) Responsible for:

Financial policy Corporate planning

Controller Responsible for:

Preparation of financial statements Accounting

Senior financial managers in large corporations.

1.4 SEPARATION OF OWNERSHIP AND MANAGEMENT

In large businesses separation of ownership and management is a practical

neces-sity Major corporations may have hundreds of thousands of shareholders There

is no way for all of them to be actively involved in management: It would be like

running New York City through a series of town meetings for all its citizens

Au-thority has to be delegated to managers

The separation of ownership and management has clear advantages It allows

share ownership to change without interfering with the operation of the business It

allows the firm to hire professional managers But it also brings problems if the

man-agers’ and owners’ objectives differ You can see the danger: Rather than attending

to the wishes of shareholders, managers may seek a more leisurely or luxurious

working lifestyle; they may shun unpopular decisions, or they may attempt to build

an empire with their shareholders’ money

Such conflicts between shareholders’ and managers’ objectives create principal– agent problems The shareholders are the principals; the managers are their agents.

Shareholders want management to increase the value of the firm, but managers may

have their own axes to grind or nests to feather Agency costs are incurred when

(1) managers do not attempt to maximize firm value and (2) shareholders incur costs

to monitor the managers and influence their actions Of course, there are no costswhen the shareholders are also the managers That is one of the advantages of a soleproprietorship Owner–managers have no conflicts of interest

Conflicts between shareholders and managers are not the only principal–agentproblems that the financial manager is likely to encounter For example, just asshareholders need to encourage managers to work for the shareholders’ interests,

so senior management needs to think about how to motivate everyone else in thecompany In this case senior management are the principals and junior manage-ment and other employees are their agents

Agency costs can also arise in financing In normal times, the banks and holders who lend the company money are united with the shareholders in want-ing the company to prosper, but when the firm gets into trouble, this unity of pur-pose can break down At such times decisive action may be necessary to rescue thefirm, but lenders are concerned to get their money back and are reluctant to see thefirm making risky changes that could imperil the safety of their loans Squabblesmay even break out between different lenders as they see the company heading forpossible bankruptcy and jostle for a better place in the queue of creditors

bond-Think of the company’s overall value as a pie that is divided among a number ofclaimants These include the management and the shareholders, as well as the com-pany’s workforce and the banks and investors who have bought the company’s debt.The government is a claimant too, since it gets to tax corporate profits

All these claimants are bound together in a complex web of contracts and derstandings For example, when banks lend money to the firm, they insist on aformal contract stating the rate of interest and repayment dates, perhaps placingrestrictions on dividends or additional borrowing But you can’t devise writtenrules to cover every possible future event So written contracts are incomplete andneed to be supplemented by understandings and by arrangements that help toalign the interests of the various parties

un-Principal–agent problems would be easier to resolve if everyone had the sameinformation That is rarely the case in finance Managers, shareholders, and lendersmay all have different information about the value of a real or financial asset, and

it may be many years before all the information is revealed Financial managers

need to recognize these information asymmetries and find ways to reassure investors

that there are no nasty surprises on the way

Here is one example Suppose you are the financial manager of a company thathas been newly formed to develop and bring to market a drug for the cure of toeti-tis At a meeting with potential investors you present the results of clinical trials,show upbeat reports by an independent market research company, and forecastprofits amply sufficient to justify further investment But the potential investorsare still worried that you may know more than they do What can you do to con-vince them that you are telling the truth? Just saying “Trust me” won’t do the trick

Perhaps you need to signal your integrity by putting your money where your

mouth is For example, investors are likely to have more confidence in your plans

if they see that you and the other managers have large personal stakes in the new

enterprise Therefore your decision to invest your own money can provide

infor-mation to investors about the true prospects of the firm

In later chapters we will look more carefully at how corporations tackle the

problems created by differences in objectives and information Figure 1.3

summa-rizes the main issues and signposts the chapters where they receive most attention

Differences in information

Stock prices and returns (13)

Issues of shares and other securities

(15, 18, 23)

Dividends (16)

Financing (18)

Different objectives Managers vs stockholders (2, 12, 33, 34)

Top management vs operating management (12)

Stockholders vs banks and other lenders (18)

F I G U R E 1 3

Differences in objectives and information can complicate financial decisions We address these issues at several points in this book (chapter numbers in parentheses).

1.5 TOPICS COVERED IN THIS BOOK

We have mentioned how financial managers separate investment and financing

de-cisions: Investment decisions typically precede financing decisions That is also how

we have organized this book Parts 1 through 3 are almost entirely devoted to

differ-ent aspects of the investmdiffer-ent decision The first topic is how to value assets, the

sec-ond is the link between risk and value, and the third is the management of the

capi-tal investment process Our discussion of these topics occupies Chapters 2 through 12

As you work through these chapters, you may have some basic questions about

financing For example, What does it mean to say that a corporation has “issued

shares”? How much of the cash contributed at arrow 1 in Figure 1.1 comes from

shareholders and how much from borrowing? What types of debt securities do

firms actually issue? Who actually buys the firm’s shares and debt—individual

in-vestors or financial institutions? What are those institutions and what role do they

play in corporate finance and the broader economy? Chapter 14, “An Overview of

Corporate Financing,” covers these and a variety of similar questions This

chap-ter stands on its own bottom—it does not rest on previous chapchap-ters You can read

it any time the fancy strikes You may wish to read it now

Chapter 14 is one of three in Part 4, which begins the analysis of corporate

financ-ing decisions Chapter 13 reviews the evidence on the efficient markets hypothesis,

which states that security prices observed in financial markets accurately reflect

un-derlying values and the information available to investors Chapter 15 describes how

debt and equity securities are issued

Part 5 continues the analysis of the financing decision, covering dividend policy

and the mix of debt and equity financing We will describe what happens when

firms land in financial distress because of poor operating performance or excessiveborrowing We will also consider how financing decisions may affect decisionsabout the firm’s investment projects.

Part 6 introduces options Options are too advanced for Chapter 1, but by ter 20 you’ll have no difficulty Investors can trade options on stocks, bonds, currencies,

Chap-and commodities Financial managers find options lurking in real assets—that is, real options—and in the securities the firms may issue Having mastered options, we pro-

ceed in Part 7 to a much closer look at the many varieties of long-term debt financing

An important part of the financial manager’s job is to judge which risks the firmshould take on and which can be eliminated Part 8 looks at risk management, bothdomestically and internationally

Part 9 covers financial planning and short-term financial management We address

a variety of practical topics, including short- and longer-term forecasting, channels forshort-term borrowing or investment, management of cash and marketable securities,and management of accounts receivable (money lent by the firm to its customers).Part 10 looks at mergers and acquisitions and, more generally, at the control andgovernance of the firm We also discuss how companies in different countries arestructured to provide the right incentives for management and the right degree ofcontrol by outside investors

Part 11 is our conclusion It also discusses some of the things that we don’t know

about finance If you can be the first to solve any of these puzzles, you will be tifiably famous

jus-SUMMARY

.mhhe.com/bm7e In Chapter 2 we will begin with the most basic concepts of asset valuation However,

we should first sum up the principal points made in this introductory chapter.Large businesses are usually organized as corporations Corporations havethree important features First, they are legally distinct from their owners and paytheir own taxes Second, corporations provide limited liability, which means thatthe stockholders who own the corporation cannot be held responsible for the firm’sdebts Third, the owners of a corporation are not usually the managers

The overall task of the financial manager can be broken down into (1) the ment, or capital budgeting, decision and (2) the financing decision In other words, thefirm has to decide (1) what real assets to buy and (2) how to raise the necessary cash

invest-In small companies there is often only one financial executive, the treasurer.However, most companies have both a treasurer and a controller The treasurer’sjob is to obtain and manage the company’s financing, while the controller’s job is

to confirm that the money is used correctly In large firms there is also a chief nancial officer or CFO

fi-Shareholders want managers to increase the value of the company’s stock agers may have different objectives This potential conflict of interest is termed aprincipal–agent problem Any loss of value that results from such conflicts istermed an agency cost Of course there may be other conflicts of interest For ex-ample, the interests of the shareholders may sometimes conflict with those of thefirm’s banks and bondholders These and other agency problems become morecomplicated when agents have more or better information than the principals.The financial manager plays on an international stage and must understandhow international financial markets operate and how to evaluate overseas invest-ments We discuss international corporate finance at many different points in thechapters that follow

Man-Financial managers read The Wall Street Journal (WSJ), The Man-Financial Times (FT), or both daily You

should too The Financial Times is published in Britain, but there is a North American edition.

The New York Times and a few other big-city newspapers have good business and financial

sec-tions, but they are no substitute for the WSJ or FT The business and financial sections of most

United States dailies are, except for local news, nearly worthless for the financial manager.

The Economist, Business Week, Forbes, and Fortune contain useful financial sections, and

there are several magazines that specialize in finance These include Euromoney, Corporate

Fi-nance, Journal of Applied Corporate FiFi-nance, Risk, and CFO Magazine This list does not include

research journals such as the Journal of Finance, Journal of Financial Economics, Review of

Fi-nancial Studies, and FiFi-nancial Management In the following chapters we give specific

refer-ences to pertinent research.

FURTHER READING

QUIZ

tan-gible assets such as (b) and intantan-gible assets such as (c) In order to pay for these assets,

they sell (d ) assets such as (e) The decision about which assets to buy is usually termed

the ( f ) or (g) decision The decision about how to raise the money is usually termed the

(h) decision.” Now fit each of the following terms into the most appropriate space:

financing, real, bonds, investment, executive airplanes, financial, capital budgeting, brand names.

controller?

main implications of this separation?

P R E S E N T V A L U E

A N D T H E

O P P O R T U N I T Y COST OF CAPITAL

COMPANIES INVEST IN a variety of real assets These include tangible assets such as plant and chinery and intangible assets such as management contracts and patents The object of the invest-ment, or capital budgeting, decision is to find real assets that are worth more than they cost In thischapter we will take the first, most basic steps toward understanding how assets are valued.

ma-There are a few cases in which it is not that difficult to estimate asset values In real estate, for ample, you can hire a professional appraiser to do it for you Suppose you own a warehouse The oddsare that your appraiser’s estimate of its value will be within a few percent of what the building wouldactually sell for.1After all, there is continuous activity in the real estate market, and the appraiser’sstock-in-trade is knowledge of the prices at which similar properties have recently changed hands.Thus the problem of valuing real estate is simplified by the existence of an active market in which allkinds of properties are bought and sold For many purposes no formal theory of value is needed Wecan take the market’s word for it

ex-But we need to go deeper than that First, it is important to know how asset values are reached in

an active market Even if you can take the appraiser’s word for it, it is important to understand why

that warehouse is worth, say, $250,000 and not a higher or lower figure Second, the market for most

corporate assets is pretty thin Look in the classified advertisements in The Wall Street Journal: It is

not often that you see a blast furnace for sale

Companies are always searching for assets that are worth more to them than to others That house is worth more to you if you can manage it better than others But in that case, looking at theprice of similar buildings will not tell you what the warehouse is worth under your management Youneed to know how asset values are determined In other words, you need a theory of value

ware-This chapter takes the first, most basic steps to develop that theory We lead off with a simple merical example: Should you invest to build a new office building in the hope of selling it at a profitnext year? Finance theory endorses investment if net present value is positive, that is, if the new

nu-building’s value today exceeds the required investment It turns out that net present value is positive

in this example, because the rate of return on investment exceeds the opportunity cost of capital

So this chapter’s first task is to define and explain net present value, rate of return, and tunity cost of capital The second task is to explain why financial managers search so assiduously

oppor-for investments with positive net present values Is increased value today the only possible

finan-cial objective? And what does “value” mean for a corporation?

Here we will come to the fundamental objective of corporate finance: maximizing the current

mar-ket value of the firm’s outstanding shares We will explain why all shareholders should endorse this

objective, and why the objective overrides other plausible goals, such as “maximizing profits.”

Finally, we turn to the managers’ objectives and discuss some of the mechanisms that help to align

the managers’ and stockholders’ interests We ask whether attempts to increase shareholder valueneed be at the expense of workers, customers, or the community at large

In this chapter, we will stick to the simplest problems to make basic ideas clear Readers with ataste for more complication will find plenty to satisfy them in later chapters

13

1

Needless to say, there are some properties that appraisers find nearly impossible to value—for example, nobody knows the tential selling price of the Taj Mahal or the Parthenon or Windsor Castle.

po-Your warehouse has burned down, fortunately without injury to you or your ployees, leaving you with a vacant lot worth $50,000 and a check for $200,000 fromthe fire insurance company You consider rebuilding, but your real estate advisersuggests putting up an office building instead The construction cost would be

em-$300,000, and there would also be the cost of the land, which might otherwise besold for $50,000 On the other hand, your adviser foresees a shortage of office spaceand predicts that a year from now the new building would fetch $400,000 if yousold it Thus you would be investing $350,000 now in the expectation of realizing

$400,000 a year hence You should go ahead if the present value (PV) of the

ex-pected $400,000 payoff is greater than the investment of $350,000 Therefore, youneed to ask, What is the value today of $400,000 to be received one year from now,and is that present value greater than $350,000?

Calculating Present Value

The present value of $400,000 one year from now must be less than $400,000 After

all, a dollar today is worth more than a dollar tomorrow, because the dollar today can

be invested to start earning interest immediately This is the first basic principle offinance Thus, the present value of a delayed payoff may be found by multiplying

the payoff by a discount factor which is less than 1 (If the discount factor were

more than 1, a dollar today would be worth less than a dollar tomorrow.) If C1notes the expected payoff at period 1 (one year hence), then

de-Present value (PV)
discount factor  C1

This discount factor is the value today of $1 received in the future It is usually

ex-pressed as the reciprocal of 1 plus a rate of return:

The rate of return r is the reward that investors demand for accepting delayed

payment

Now we can value the real estate investment, assuming for the moment that the

$400,000 payoff is a sure thing The office building is not the only way to obtain

$400,000 a year from now You could invest in United States government securitiesmaturing in a year Suppose these securities offer 7 percent interest How muchwould you have to invest in them in order to receive $400,000 at the end of theyear? That’s easy: You would have to invest $400,000/1.07, which is $373,832.2Therefore, at an interest rate of 7 percent, the present value of $400,000 one yearfrom now is $373,832

Let’s assume that, as soon as you’ve committed the land and begun tion on the building, you decide to sell your project How much could you sell itfor? That’s another easy question Since the property will be worth $400,000 in ayear, investors would be willing to pay $373,832 for it today That’s what it would

cost them to get a $400,000 payoff from investing in government securities Of

course, you could always sell your property for less, but why sell for less than the

market will bear? The $373,832 present value is the only feasible price that

satis-fies both buyer and seller Therefore, the present value of the property is also its

market price

To calculate present value, we discount expected payoffs by the rate of return

offered by equivalent investment alternatives in the capital market This rate of

return is often referred to as the discount rate, hurdle rate, or opportunity cost

of capital.It is called the opportunity cost because it is the return foregone by

in-vesting in the project rather than inin-vesting in securities In our example the

op-portunity cost was 7 percent Present value was obtained by dividing $400,000

by 1.07:

Net Present Value

The building is worth $373,832, but this does not mean that you are $373,832

bet-ter off You committed $350,000, and therefore your net present value (NPV) is

$23,832 Net present value is found by subtracting the required investment:

NPV
PV  required investment
373,832  350,000
$23,832

In other words, your office development is worth more than it costs—it makes a

net contribution to value The formula for calculating NPV can be written as

remembering that C0, the cash flow at time 0 (that is, today), will usually be a

neg-ative number In other words, C0is an investment and therefore a cash outflow In

our example, C0
$350,000

A Comment on Risk and Present Value

We made one unrealistic assumption in our discussion of the office development:

Your real estate adviser cannot be certain about future values of office buildings.

The $400,000 represents the best forecast, but it is not a sure thing.

If the future value of the building is risky, our calculation of NPV is wrong

Investors could achieve $400,000 with certainty by buying $373,832 worth of

United States government securities, so they would not buy your building

for that amount You would have to cut your asking price to attract investors’

interest

Here we can invoke a second basic financial principle: A safe dollar is worth more

than a risky one Most investors avoid risk when they can do so without sacrificing

return However, the concepts of present value and the opportunity cost of capital

still make sense for risky investments It is still proper to discount the payoff by the

rate of return offered by an equivalent investment But we have to think of expected

payoffs and the expected rates of return on other investments.3

NPV
C0 C1

1 r

PV
discount factor  C1
1 r1  C1
400,0001.07
$373,832

3

We define “expected” more carefully in Chapter 9 For now think of expected payoff as a realistic

fore-cast, neither optimistic nor pessimistic Forecasts of expected payoffs are correct on average.

Not all investments are equally risky The office development is more riskythan a government security but less risky than a start-up biotech venture Supposeyou believe the project is as risky as investment in the stock market and that stockmarket investments are forecasted to return 12 percent Then 12 percent becomesthe appropriate opportunity cost of capital That is what you are giving up by notinvesting in equally risky securities Now recompute NPV:

The value of the office building depends on the timing of the cash flows andtheir uncertainty The $400,000 payoff would be worth exactly that if it could berealized instantaneously If the office building is as risk-free as government se-curities, the one-year delay reduces value to $373,832 If the building is as risky

as investment in the stock market, then uncertainty further reduces value by

$16,689 to $357,143

Unfortunately, adjusting asset values for time and uncertainty is often morecomplicated than our example suggests Therefore, we will take the two effectsseparately For the most part, we will dodge the problem of risk in Chapters 2through 6, either by treating all cash flows as if they were known with certainty or

by talking about expected cash flows and expected rates of return without ing how risk is defined or measured Then in Chapter 7 we will turn to the prob-lem of understanding how financial markets cope with risk

worry-Present Values and Rates of Return

We have decided that construction of the office building is a smart thing to do,since it is worth more than it costs—it has a positive net present value To calcu-late how much it is worth, we worked out how much one would need to pay toachieve the same payoff by investing directly in securities The project’s presentvalue is equal to its future income discounted at the rate of return offered bythese securities

We can say this in another way: Our property venture is worth undertakingbecause its rate of return exceeds the cost of capital The rate of return on the in-vestment in the office building is simply the profit as a proportion of the initialoutlay:

The cost of capital is once again the return foregone by not investing in securities.

If the office building is as risky as investing in the stock market, the return foregone

is 12 percent Since the 14 percent return on the office building exceeds the 12 cent opportunity cost, you should go ahead with the project

per-Return
investmentprofit
400,000350,000 350,000
143, about 14%

PV
400,0001.12
$357,143

Here then we have two equivalent decision rules for capital investment:4

• Net present value rule Accept investments that have positive net present values.

• Rate-of-return rule Accept investments that offer rates of return in excess of

their opportunity costs of capital.5

The Opportunity Cost of Capital

The opportunity cost of capital is such an important concept that we will give one

more example You are offered the following opportunity: Invest $100,000 today,

and, depending on the state of the economy at the end of the year, you will receive

one of the following payoffs:

4 You might check for yourself that these are equivalent rules In other words, if the return

50,000/350,000 is greater than r, then the net present value  350,000  [400,000/(1  r)] must be greater

than 0.

5 The two rules can conflict when there are cash flows in more than two periods We address this

prob-lem in Chapter 5.

6 We are assuming that the probabilities of slump and boom are equal, so that the expected (average)

outcome is $110,000 For example, suppose the slump, normal, and boom probabilities are all 1/3 Then

the expected payoff C
(80,000  110,000  140,000)/3
$110.000.

$80,000 $110,000 $140,000

You reject the optimistic (boom) and the pessimistic (slump) forecasts That gives

an expected payoff of C1
110,000,6a 10 percent return on the $100,000 investment

But what’s the right discount rate?

You search for a common stock with the same risk as the investment Stock X

turns out to be a perfect match X’s price next year, given a normal economy, is

fore-casted at $110 The stock price will be higher in a boom and lower in a slump, but

to the same degrees as your investment ($140 in a boom and $80 in a slump) You

conclude that the risks of stock X and your investment are identical

Stock X’s current price is $95.65 It offers an expected rate of return of 15 percent:

This is the expected return that you are giving up by investing in the project rather

than the stock market In other words, it is the project’s opportunity cost of capital

To value the project, discount the expected cash flow by the opportunity cost of

capital:

This is the amount it would cost investors in the stock market to buy an expected cash

flow of $110,000 (They could do so by buying 1,000 shares of stock X.) It is, therefore,

also the sum that investors would be prepared to pay you for your project

To calculate net present value, deduct the initial investment:

The project is worth $4,350 less than it costs It is not worth undertaking.

Notice that you come to the same conclusion if you compare the expected ect return with the cost of capital:

proj-The 10 percent expected return on the project is less than the 15 percent return vestors could expect to earn by investing in the stock market, so the project is notworthwhile

in-Of course in real life it’s impossible to restrict the future states of the economy

to just “slump,” “normal,” and “boom.” We have also simplified by assuming aperfect match between the payoffs of 1,000 shares of stock X and the payoffs to theinvestment project The main point of the example does carry through to real life,however Remember this: The opportunity cost of capital for an investment project

is the expected rate of return demanded by investors in common stocks or other curities subject to the same risks as the project When you discount the project’s ex-pected cash flow at its opportunity cost of capital, the resulting present value is theamount investors (including your own company’s shareholders) would be willing

se-to pay for the project Any time you find and launch a positive-NPV project (a ect with present value exceeding its required cash outlay) you have made yourcompany’s stockholders better off

proj-A Source of Confusion

Here is a possible source of confusion Suppose a banker approaches “Your company

is a fine and safe business with few debts,” she says “My bank will lend you the

$100,000 that you need for the project at 8 percent.” Does that mean that the cost ofcapital for the project is 8 percent? If so, the project would be above water, with PV at

8 percent
110,000/1.08
$101,852 and NPV
101,852  100,000
$1,852.That can’t be right First, the interest rate on the loan has nothing to do with the risk

of the project: It reflects the good health of your existing business Second, whether youtake the loan or not, you still face the choice between the project, which offers an ex-pected return of only 10 percent, or the equally risky stock, which gives an expectedreturn of 15 percent A financial manager who borrows at 8 percent and invests at

10 percent is not smart, but stupid, if the company or its shareholders can borrow at

8 percent and buy an equally risky investment offering 15 percent That is why the

15 percent expected return on the stock is the opportunity cost of capital for the project

So far our discussion of net present value has been rather casual Increasing value

sounds like a sensible objective for a company, but it is more than just a rule of

thumb You need to understand why the NPV rule makes sense and why managerslook to the bond and stock markets to find the opportunity cost of capital

In the previous example there was just one person (you) making 100 percent of

the investment and receiving 100 percent of the payoffs from the new office

build-ing In corporations, investments are made on behalf of thousands of shareholders

with varying risk tolerances and preferences for present versus future income

Could a positive-NPV project for Ms Smith be a negative-NPV proposition for Mr

Jones? Could they find it impossible to agree on the objective of maximizing the

market value of the firm?

The answer to both questions is no; Smith and Jones will always agree if both have

access to capital markets We will demonstrate this result with a simple example

How Capital Markets Reconcile Preferences for Current

vs Future Consumption

Suppose that you can look forward to a stream of income from your job Unless you

have some way of storing or anticipating this income, you will be compelled to

con-sume it as it arrives This could be inconvenient or worse If the bulk of your income

comes late in life, the result could be hunger now and gluttony later This is where the

capital market comes in The capital market allows trade between dollars today and

dollars in the future You can therefore eat moderately both now and in the future

We will now illustrate how the existence of a well-functioning capital market

allows investors with different time patterns of income and desired

consump-tion to agree on whether investment projects should be undertaken Suppose

that there are two investors with different preferences A is an ant, who wishes

to save for the future; G is a grasshopper, who would prefer to spend all his

wealth on some ephemeral frolic, taking no heed of tomorrow Now suppose

that each is confronted with an identical opportunity—to buy a share in a

$350,000 office building that will produce a sure-fire $400,000 at the end of the

year, a return of about 14 percent The interest rate is 7 percent A and G can

bor-row or lend in the capital market at this rate

A would clearly be happy to invest in the office building Every hundred dollars

that she invests in the office building allows her to spend $114 at the end of the year,

while a hundred dollars invested in the capital market would enable her to spend

only $107

But what about G, who wants money now, not in one year’s time? Would he

pre-fer to forego the investment opportunity and spend today the cash that he has in

hand? Not as long as the capital market allows individuals to borrow as well as to

lend Every hundred dollars that G invests in the office building brings in $114 at

the end of the year Any bank, knowing that G could look forward to this sure-fire

income, would be prepared to lend him $114/1.07
$106.54 today Thus, instead

of spending $100 today, G can spend $106.54 if he invests in the office building and

then borrows against his future income

This is illustrated in Figure 2.1 The horizontal axis shows the number of

dol-lars that can be spent today; the vertical axis shows spending next year Suppose

that the ant and the grasshopper both start with an initial sum of $100 If they

invest the entire $100 in the capital market, they will be able to spend 100  1.07

$107 at the end of the year The straight line joining these two points (the

in-nermost line in the figure) shows the combinations of current and future

con-sumption that can be achieved by investing none, part, or all of the cash at the

7 percent rate offered in the capital market (The interest rate determines the

slope of this line.) Any other point along the line could be achieved by spending

part of the $100 today and investing the balance.7For example, one could choose

to spend $50 today and $53.50 next year However, A and G would each reject

such a balanced consumption schedule

The burgundy arrow in Figure 2.1 shows the payoff to investing $100 in a share

of your office project The rate of return is 14 percent, so $100 today transmutes to

$114 next year

The sloping line on the right in Figure 2.1 (the outermost line in the figure)

shows how A’s and G’s spending plans are enhanced if they can choose to invest their $100 in the office building A, who is content to spend nothing today, can in- vest $100 in the building and spend $114 at the end of the year G, the spendthrift,

also invests $100 in the office building but borrows 114/1.07
$106.54 against thefuture income Of course, neither is limited to these spending plans In fact, theright-hand sloping line shows all the combinations of current and future expendi-ture that an investor could achieve from investing $100 in the office building andborrowing against some fraction of the future income

You can see from Figure 2.1 that the present value of A’s and G’s share in the office building is $106.54 The net present value is $6.54 This is the distance be-

7

The exact balance between present and future consumption that each individual will choose depends

on personal preferences Readers who are familiar with economic theory will recognize that the choice can be represented by superimposing an indifference map for each individual The preferred combina- tion is the point of tangency between the interest-rate line and the individual’s indifference curve In other words, each individual will borrow or lend until 1 plus the interest rate equals the marginal rate

of time preference (i.e., the slope of the indifference curve) A more formal graphical analysis of ment and the choice between present and future consumption is on the Brealey–Myers website at

invest-www://mhhe.com/bm/7e.

Dollars now

A invests $100 in office building and consumes $114 next year.

106.54

114

107 Dollars next year

G invests $100 in office building, borrows $106.54, and consumes that amount now 100

F I G U R E 2 1

The grasshopper (G) wants consumption

now The ant (A) wants to wait But each

is happy to invest A prefers to invest at

14 percent, moving up the burgundy arrow,

rather than at the 7 percent interest rate

G invests and then borrows at 7 percent,

thereby transforming $100 into $106.54 of

immediate consumption Because of the

investment, G has $114 next year to pay

off the loan The investment’s NPV is

106.54  100
6.54.

tween the $106.54 present value and the $100 initial investment Despite their

dif-ferent tastes, both A and G are better off by investing in the office block and then

using the capital markets to achieve the desired balance between consumption

today and consumption at the end of the year In fact, in coming to their

invest-ment decision, both would be happy to follow the two equivalent rules that we

proposed so casually at the end of Section 2.1 The two rules can be restated as

follows:

• Net present value rule Invest in any project with a positive net present value.

This is the difference between the discounted, or present, value of the future

cash flow and the amount of the initial investment

• Rate-of-return rule Invest as long as the return on the investment exceeds the

rate of return on equivalent investments in the capital market

What happens if the interest rate is not 7 percent but 14.3 percent? In this case

the office building would have zero NPV:

NPV
400,000/1.143  350,000
$0Also, the return on the project would be 400,000/350,000  1
143, or 14.3 per-

cent, exactly equal to the rate of interest in the capital market In this case our two

rules would say that the project is on a knife edge Investors should not care

whether the firm undertakes it or not

It is easy to see that with a 14.3 percent interest rate neither A nor G would gain

anything by investing in the office building A could spend exactly the same

amount at the end of the year, regardless of whether she invests her money in the

office building or in the capital market Equally, there is no advantage in G

in-vesting in an office block to earn 14.3 percent and at the same time borrowing at

14.3 percent He might just as well spend whatever cash he has on hand

In our example the ant and the grasshopper placed an identical value on the

of-fice building and were happy to share in its construction They agreed because they

faced identical borrowing and lending opportunities Whenever firms discount

cash flows at capital market rates, they are implicitly assuming that their

share-holders have free and equal access to competitive capital markets

It is easy to see how our net present value rule would be damaged if we did

not have such a well-functioning capital market For example, suppose that G

could not borrow against future income or that it was prohibitively costly for

him to do so In that case he might well prefer to spend his cash today rather

than invest it in an office building and have to wait until the end of the year

be-fore he could start spending If A and G were shareholders in the same

enter-prise, there would be no simple way for the manager to reconcile their different

objectives

No one believes unreservedly that capital markets are perfectly competitive

Later in this book we will discuss several cases in which differences in taxation,

transaction costs, and other imperfections must be taken into account in financial

decision making However, we will also discuss research which indicates that, in

general, capital markets function fairly well That is one good reason for relying on

net present value as a corporate objective Another good reason is that net present

value makes common sense; we will see that it gives obviously silly answers less

frequently than its major competitors But for now, having glimpsed the problems

of imperfect markets, we shall, like an economist in a shipwreck, simply assume our

life jacket and swim safely to shore

Our justification of the present value rule was restricted to two periods and to acertain cash flow However, the rule also makes sense for uncertain cash flows thatextend far into the future The argument goes like this:

1 A financial manager should act in the interests of the firm’s owners, itsstockholders Each stockholder wants three things:

a To be as rich as possible, that is, to maximize current wealth

b To transform that wealth into whatever time pattern of consumption he

or she desires

c To choose the risk characteristics of that consumption plan

2 But stockholders do not need the financial manager’s help to achieve thebest time pattern of consumption They can do that on their own, providingthey have free access to competitive capital markets They can also choosethe risk characteristics of their consumption plan by investing in more orless risky securities

3 How then can the financial manager help the firm’s stockholders? There isonly one way: by increasing the market value of each stockholder’s stake inthe firm The way to do that is to seize all investment opportunities thathave a positive net present value

Despite the fact that shareholders have different preferences, they are mous in the amount that they want to invest in real assets This means that theycan cooperate in the same enterprise and can safely delegate operation of that en-terprise to professional managers These managers do not need to know anythingabout the tastes of their shareholders and should not consult their own tastes Theirtask is to maximize net present value If they succeed, they can rest assured thatthey have acted in the best interest of their shareholders

unani-This gives us the fundamental condition for successful operation of a moderncapitalist economy Separation of ownership and control is essential for most cor-porations, so authority to manage has to be delegated It is good to know that man-agers can all be given one simple instruction: Maximize net present value

Other Corporate Goals

Sometimes you hear managers speak as if the corporation has other goals For ample, they may say that their job is to maximize profits That sounds reasonable.After all, don’t shareholders prefer to own a profitable company rather than an un-profitable one? But taken literally, profit maximization doesn’t make sense as a cor-porate objective Here are three reasons:

ex-1 “Maximizing profits” leaves open the question, Which year’s profits?Shareholders might not want a manager to increase next year’s profits atthe expense of profits in later years

2 A company may be able to increase future profits by cutting its dividendand investing the cash That is not in the shareholders’ interest if thecompany earns only a low return on the investment

3 Different accountants may calculate profits in different ways So you mayfind that a decision which improves profits in one accountant’s eyes willreduce them in the eyes of another

2.3 A FUNDAMENTAL RESULT

We have explained that managers can best serve the interests of shareholders by

investing in projects with a positive net present value But this takes us back to the

principal–agent problem highlighted in the first chapter How can shareholders

(the principals) ensure that management (their agents) don’t simply look after their

own interests? Shareholders can’t spend their lives watching managers to check

that they are not shirking or maximizing the value of their own wealth However,

there are several institutional arrangements that help to ensure that the

sharehold-ers’ pockets are close to the managsharehold-ers’ heart

A company’s board of directors is elected by the shareholders and is supposed

to represent them Boards of directors are sometimes portrayed as passive

stooges who always champion the incumbent management But when company

performance starts to slide and managers do not offer a credible recovery plan,

boards do act In recent years the chief executives of Eastman Kodak, General

Motors, Xerox, Lucent, Ford Motor, Sunbeam, and Lands End were all forced to

step aside when each company’s profitability deteriorated and the need for new

strategies became clear

If shareholders believe that the corporation is underperforming and that the

board of directors is not sufficiently aggressive in holding the managers to task,

they can try to replace the board in the next election If they succeed, the new board

will appoint a new management team But these attempts to vote in a new board

are expensive and rarely successful Thus dissidents do not usually stand and fight

but sell their shares instead

Selling, however, can send a powerful message If enough shareholders bail out,

the stock price tumbles This damages top management’s reputation and

compen-sation Part of the top managers’ paychecks comes from bonuses tied to the

com-pany’s earnings or from stock options, which pay off if the stock price rises but are

worthless if the price falls below a stated threshold This should motivate

man-agers to increase earnings and the stock price

If managers and directors do not maximize value, there is always the threat

of a hostile takeover The further a company’s stock price falls, due to lax

man-agement or wrong-headed policies, the easier it is for another company or

group of investors to buy up a majority of the shares The old management team

is then likely to find themselves out on the street and their place is taken by a

fresh team prepared to make the changes needed to realize the company’s

value

These arrangements ensure that few managers at the top of major United States

corporations are lazy or inattentive to stockholders’ interests On the contrary, the

pressure to perform can be intense

2.4 DO MANAGERS REALLY LOOK AFTER

THE INTERESTS OF SHAREHOLDERS?

2.5 SHOULD MANAGERS LOOK AFTER THE INTERESTS

OF SHAREHOLDERS?

We have described managers as the agents of the shareholders But perhaps this

begs the question, Is it desirable for managers to act in the selfish interests of their

shareholders? Does a focus on enriching the shareholders mean that managers

must act as greedy mercenaries riding roughshod over the weak and helpless? Do

they not have wider obligations to their employees, customers, suppliers, and thecommunities in which the firm is located?8

Most of this book is devoted to financial policies that increase a firm’s value.None of these policies requires gallops over the weak and helpless In most in-stances there is little conflict between doing well (maximizing value) and doinggood Profitable firms are those with satisfied customers and loyal employees;firms with dissatisfied customers and a disgruntled workforce are more likely tohave declining profits and a low share price

Of course, ethical issues do arise in business as in other walks of life, and fore when we say that the objective of the firm is to maximize shareholder wealth,

there-we do not mean that anything goes In part, the law deters managers from makingblatantly dishonest decisions, but most managers are not simply concerned withobserving the letter of the law or with keeping to written contracts In business andfinance, as in other day-to-day affairs, there are unwritten, implicit rules of behav-ior To work efficiently together, we need to trust each other Thus huge financialdeals are regularly completed on a handshake, and each side knows that the otherwill not renege later if things turn sour.9Whenever anything happens to weakenthis trust, we are all a little worse off.10

In many financial transactions, one party has more information than the other

It can be difficult to be sure of the quality of the asset or service that you are ing This opens up plenty of opportunities for financial sharp practice and outrightfraud, and, because the activities of scoundrels are more entertaining than those ofhonest people, airport bookstores are packed with accounts of financial fraudsters.The response of honest firms is to distinguish themselves by building long-termrelationships with their customers and establishing a name for fair dealing and fi-nancial integrity Major banks and securities firms know that their most valuableasset is their reputation They emphasize their long history and responsible be-havior When something happens to undermine that reputation, the costs can beenormous

buy-Consider the Salomon Brothers bidding scandal in 1991.11 A Salomon tradertried to evade rules limiting the firm’s participation in auctions of U.S Treasurybonds by submitting bids in the names of the company’s customers without thecustomers’ knowledge When this was discovered, Salomon settled the case bypaying almost $200 million in fines and establishing a $100 million fund for pay-ments of claims from civil lawsuits Yet the value of Salomon Brothers stock fell by

8 Some managers, anxious not to offend any group of stakeholders, have denied that they are ing profits or value We are reminded of a survey of businesspeople that inquired whether they at- tempted to maximize profits They indignantly rejected the notion, objecting that their responsibilities went far beyond the narrow, selfish profit motive But when the question was reformulated and they were asked whether they could increase profits by raising or lowering their selling price, they replied

maximiz-that neither change would do so The survey is cited in G J Stigler, The Theory of Price, 3rd ed (New

York: Macmillan Company, 1966).

9 In U.S law, a contract can be valid even if it is not written down Of course documentation is prudent, but contracts are enforced if it can be shown that the parties reached a clear understanding and agree- ment For example, in 1984, the top management of Getty Oil gave verbal agreement to a merger offer with Pennzoil Then Texaco arrived with a higher bid and won the prize Pennzoil sued—and won— arguing that Texaco had broken up a valid contract.

10 For a discussion of this issue, see A Schleifer and L H Summers, “Breach of Trust in Corporate

Takeovers,” Corporate Takeovers: Causes and Consequences (Chicago: University of Chicago Press, 1988).

11 This discussion is based on Clifford W Smith, Jr., “Economics and Ethics: The Case of Salomon

Broth-ers,” Journal of Applied Corporate Finance 5 (Summer 1992), pp 23–28.

far more than $300 million In fact the price dropped by about a third, representing

a $1.5 billion decline in the company’s market value

Why did the value of Salomon Brothers drop so dramatically? Largely because

investors were worried that Salomon would lose business from customers that

now distrusted the company The damage to Salomon’s reputation was far greater

than the explicit costs of the scandal and was hundreds or thousands of times more

costly than the potential gains Salomon could have reaped from the illegal trades

SUMMARY

In this chapter we have introduced the concept of present value as a way of

valu-ing assets Calculatvalu-ing present value is easy Just discount future cash flow by an

appropriate rate r, usually called the opportunity cost of capital, or hurdle rate:

Net present value is present value plus any immediate cash flow:

Remember that C0is negative if the immediate cash flow is an investment, that is,

if it is a cash outflow

The discount rate is determined by rates of return prevailing in capital markets

If the future cash flow is absolutely safe, then the discount rate is the interest rate

on safe securities such as United States government debt If the size of the future

cash flow is uncertain, then the expected cash flow should be discounted at the

ex-pected rate of return offered by equivalent-risk securities We will talk more about

risk and the cost of capital in Chapters 7 through 9

Cash flows are discounted for two simple reasons: first, because a dollar today

is worth more than a dollar tomorrow, and second, because a safe dollar is worth

more than a risky one Formulas for PV and NPV are numerical expressions of

these ideas The capital market is the market where safe and risky future cash flows

are traded That is why we look to rates of return prevailing in the capital markets

to determine how much to discount for time and risk By calculating the present

value of an asset, we are in effect estimating how much people will pay for it if they

have the alternative of investing in the capital markets

The concept of net present value allows efficient separation of ownership and

management of the corporation A manager who invests only in assets with

pos-itive net present values serves the best interests of each one of the firm’s owners,

regardless of differences in their wealth and tastes This is made possible by the

existence of the capital market which allows each shareholder to construct a

per-sonal investment plan that is custom tailored to his or her own requirements For

example, there is no need for the firm to arrange its investment policy to obtain

a sequence of cash flows that matches its shareholders’ preferred time patterns

of consumption The shareholders can shift funds forward or back over time

per-fectly well on their own, provided they have free access to competitive capital

markets In fact, their plan for consumption over time is limited by only two

things: their personal wealth (or lack of it) and the interest rate at which they can

borrow or lend The financial manager cannot affect the interest rate but can

Net present value 1NPV2
C0 C1

increase stockholders’ wealth The way to do so is to invest in assets having itive net present values.

pos-There are several institutional arrangements which help to ensure that agers pay close attention to the value of the firm:

man-• Managers’ actions are subject to the scrutiny of the board of directors

• Shirkers are likely to find that they are ousted by more energetic managers Thiscompetition may arise within the firm, but poorly performing companies arealso more likely to be taken over That sort of takeover typically brings in a freshmanagement team

• Managers are spurred on by incentive schemes, such as stock options, whichpay off big if shareholders gain but are valueless if they do not

Managers who focus on shareholder value need not neglect their wider tions to the community Managers play fair by employees, customers, and suppli-ers partly because they know that it is for the common good, but partly becausethey know that their firm’s most valuable asset is its reputation Of course, ethicalissues do arise in financial management and, whenever unscrupulous managersabuse their position, we all trust each other a little less

obliga-FURTHER

READING

QUIZ

The pioneering works on the net present value rule are:

I Fisher: The Theory of Interest, Augustus M Kelley, Publishers New York, 1965 Reprinted

from the 1930 edition.

J Hirshleifer: “On the Theory of Optimal Investment Decision,” Journal of Political Economy,

66:329–352 (August 1958).

For a more rigorous textbook treatment of the subject, we suggest:

E F Fama and M H Miller: The Theory of Finance, Holt, Rinehart and Winston New

York, 1972.

If you would like to dig deeper into the question of how managers can be motivated to maximize holder wealth, we suggest:

share-M C Jensen and W H Meckling: “Theory of the Firm: Managerial Behavior, Agency Costs,

and Ownership Structure,” Journal of Financial Economics, 3:305–360 (October 1976).

E F Fama: “Agency Problems and the Theory of the Firm,” Journal of Political Economy,

88:288–307 (April 1980).

year The symbol r is the discount rate.

dis-count factor? What is the disdis-count rate?

per-cent, and (c) 30 percent.

4. A merchant pays $100,000 for a load of grain and is certain that it can be resold at the

end of one year for $132,000.

or a negative NPV?

the same answer?

opportu-nity cost of capital for a risk-free asset? For a risky asset?

20 percent What would the ant (A) and grasshopper (G) do? Would they invest in the

office building? Would they borrow or lend? Suppose each starts with $100 How much

and when would each consume?

stock-holders For example, the manager might:

positive NPVs.

pattern of consumption.

But in well-functioning capital markets, shareholders will vote for only one of these

goals Which one? Why?

stock dropped by far more than it paid in fines and settlements of lawsuits Why?

PRACTICE QUESTIONS

is positive only if the rate of return exceeds the opportunity cost of capital.

5 percent and maturing in one year? Hint: What is the opportunity cost of capital?

Ig-nore taxes.

property The land and motel should be worth $1,500,000 next year Suppose that

com-mon stocks with the same risk as this investment offer a 10 percent expected return.

Would you construct the motel? Why or why not?

oppor-tunity cost of capital is 20 percent for all four investments.

Initial Cash Cash Flow Investment Flow, C0 in Year 1, C1

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you can take only one Which one? Hint: What is the firm’s objective: to earn a high

rate of return or to increase firm value?

land appraised at $50,000 We concluded that this investment had a positive NPV of

$7,143 at a discount rate of 12 percent.

Suppose E Coli Associates, a firm of genetic engineers, offers to purchase the land for $60,000, $30,000 paid immediately and $30,000 after one year United States gov- ernment securities maturing in one year yield 7 percent.

offer or start on the office building? Explain.

a 10 percent return on their loans to E Coli Assume that the other investors have correctly assessed the risks that E Coli will not be able to pay Should you accept

E Coli’s offer?

There are four immediate alternatives.

Cajun restaurant in Duluth Gerald had arranged a one-year bank loan for

$900,000, at 10 percent, but asks for a loan from Norman at 7 percent.

market The opportunity at hand would cost $1 million and is forecasted to be worth $1.1 million after one year.

Which of these investments have positive NPVs? Which would you advise Norman

to take?

for investment decisions.

offers Norman a $600,000 personal loan at 8 percent (Norman is a long-time customer

of the bank and has an excellent credit history.) Suppose Norman borrows the money, invests $1 million in real estate opportunity (d) and puts the rest of his money in op- portunity (c), the stock market Is this a smart move? Explain.

money.”

profits That’s what shareholders really want.”

view and maximize today’s price What I would prefer is to keep it on a gently rising trend.”

is a young executive who wants to save for the future They are both stockholders in Airbus, which is investing over $12 billion to develop the A380, a new super-jumbo airliner This investment’s payoff is many years in the future Assume the investment

is positive-NPV for Mr Jones Explain why it should also be positive-NPV for Ms Smith.

$200,000 available to support consumption in periods 0 (now) and 1 (next year) He EXCEL

wants to consume exactly the same amount in each period The interest rate is 8

per-cent There is no risk.

risk-free The interest rate stays at 8 percent What should he do, and how much can he

consume in each period?

capi-tal markets What does “well-functioning” mean? Can you think of circumstances in

which maximizing value would not be in all shareholders’ interests?

value of the corporation?

Dollars, year 0, millions

Owner's preferred consumption pattern

F I G U R E 2 2

See Challenge Question 2.

CHALLENGE QUESTIONS

governments First, governments must consider the time preferences of the community

as a whole rather than those of a few wealthy investors Second, governments must

have a longer horizon than individuals, for governments are the guardians of future

generations What do you think?

market and the solid curved line represents the opportunities for investment in plant

and machinery The company’s only asset at present is $2.6 million in cash.

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$4 million which can be paid out to the shareholders.

When you have finished, answer the following questions:

investment plan?

Rotterdam one year hence Unfortunately the net cash flow from selling the tanker load will be very sensitive to the growth rate of the world economy:

$8 million $12 million $16 million

equally likely.

proba-ble states like slump, normal, and boom But we’ll keep that simplification for one more example.

Your company has identified two more projects, B and C Each will require a $5 lion outlay immediately The possible payoffs at year 1 are, in millions:

You have identified the possible payoffs to investors in three stocks, X, Y, and Z:

Current Price Payoff at Year 1

EXCEL

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percentage differences, slump versus normal and boom versus normal, for stocks

X, Y, and Z Match up to the percentage differences in B’s and C’s payoffs.

they add to the total market value of your company’s shares?

H O W T O

C A L C U L A T E PRESENT VALUES

IN CHAPTER 2we learned how to work out the value of an asset that produces cash exactly one yearfrom now But we did not explain how to value assets that produce cash two years from now or inseveral future years That is the first task for this chapter We will then have a look at some shortcutmethods for calculating present values and at some specialized present value formulas In particular

we will show how to value an investment that makes a steady stream of payments forever (a

perpe-tuity) and one that produces a steady stream for a limited period (an annuity) We will also look at

in-vestments that produce a steadily growing stream of payments

The term interest rate sounds straightforward enough, but we will see that it can be defined in ious ways We will first explain the distinction between compound interest and simple interest Then

var-we will discuss the difference betvar-ween the nominal interest rate and the real interest rate This ference arises because the purchasing power of interest income is reduced by inflation

dif-By then you will deserve some payoff for the mental investment you have made in learning aboutpresent values Therefore, we will try out the concept on bonds In Chapter 4 we will look at the val-uation of common stocks, and after that we will tackle the firm’s capital investment decisions at apractical level of detail

33

Do you remember how to calculate the present value (PV) of an asset that produces

a cash flow (C1) one year from now?

The discount factor for the year-1 cash flow is DF1, and r1is the opportunity cost

of investing your money for one year Suppose you will receive a certain cash

in-flow of $100 next year (C1⫽ 100) and the rate of interest on one-year U.S Treasury

notes is 7 percent (r1⫽ 07) Then present value equals

The present value of a cash flow two years hence can be written in a similar

way as

C2is the year-2 cash flow, DF2is the discount factor for the year-2 cash flow, and r2

is the annual rate of interest on money invested for two years Suppose you get

an-other cash flow of $100 in year 2 (C2⫽ 100) The rate of interest on two-year

Trea-sury notes is 7.7 percent per year (r2⫽ 077); this means that a dollar invested in

two-year notes will grow to 1.0772⫽ $1.16 by the end of two years The present

value of your year-2 cash flow equals

PV⫽ DF1⫻ C1⫽ C1

1⫹ r1

3.1 VALUING LONG-LIVED ASSETS

Valuing Cash Flows in Several Periods

One of the nice things about present values is that they are all expressed in currentdollars—so that you can add them up In other words, the present value of cash

flow A ⫹ B is equal to the present value of cash flow A plus the present value of cash flow B This happy result has important implications for investments that

produce cash flows in several periods

We calculated above the value of an asset that produces a cash flow of C1in year 1,

and we calculated the value of another asset that produces a cash flow of C2in year 2.Following our additivity rule, we can write down the value of an asset that produces

cash flows in each year It is simply

We can obviously continue in this way to find the present value of an extendedstream of cash flows:

This is called the discounted cash flow (or DCF) formula A shorthand way to

write it is

where ⌺ refers to the sum of the series To find the net present value (NPV) we add

the (usually negative) initial cash flow, just as in Chapter 2:

Why the Discount Factor Declines as Futurity Increases—

And a Digression on Money Machines

If a dollar tomorrow is worth less than a dollar today, one might suspect that a lar the day after tomorrow should be worth even less In other words, the discountfactor DF2should be less than the discount factor DF1 But is this necessarily so, when there is a different interest rate r tfor each period?

dol-Suppose r1is 20 percent and r2is 7 percent Then

Apparently the dollar received the day after tomorrow is not necessarily worth less

than the dollar received tomorrow

But there is something wrong with this example Anyone who could borrowand lend at these interest rates could become a millionaire overnight Let us seehow such a “money machine” would work Suppose the first person to spot theopportunity is Hermione Kraft Ms Kraft first lends $1,000 for one year at 20 per-cent That is an attractive enough return, but she notices that there is a way to earn

DF2⫽ 111.0722⫽ 87

DF1⫽ 11.20⫽ 83

an immediate profit on her investment and be ready to play the game again She

reasons as follows Next year she will have $1,200 which can be reinvested for a

further year Although she does not know what interest rates will be at that time,

she does know that she can always put the money in a checking account and be

sure of having $1,200 at the end of year 2 Her next step, therefore, is to go to her

bank and borrow the present value of this $1,200 At 7 percent interest this

pres-ent value is

Thus Ms Kraft invests $1,000, borrows back $1,048, and walks away with a profit

of $48 If that does not sound like very much, remember that the game can be

played again immediately, this time with $1,048 In fact it would take Ms Kraft

only 147 plays to become a millionaire (before taxes).1

Of course this story is completely fanciful Such an opportunity would not last

long in capital markets like ours Any bank that would allow you to lend for one

year at 20 percent and borrow for two years at 7 percent would soon be wiped out

by a rush of small investors hoping to become millionaires and a rush of

million-aires hoping to become billionmillion-aires There are, however, two lessons to our story

The first is that a dollar tomorrow cannot be worth less than a dollar the day after

tomorrow In other words, the value of a dollar received at the end of one year

(DF1) must be greater than the value of a dollar received at the end of two years

(DF2) There must be some extra gain2from lending for two periods rather than

one: (1 ⫹ r2)2must be greater than 1 ⫹ r1

Our second lesson is a more general one and can be summed up by the precept

“There is no such thing as a money machine.”3In well-functioning capital markets,

any potential money machine will be eliminated almost instantaneously by

in-vestors who try to take advantage of it Therefore, beware of self-styled experts

who offer you a chance to participate in a sure thing

Later in the book we will invoke the absence of money machines to prove several

useful properties about security prices That is, we will make statements like “The

prices of securities X and Y must be in the following relationship—otherwise there

would be a money machine and capital markets would not be in equilibrium.”

Ruling out money machines does not require that interest rates be the same for

each future period This relationship between the interest rate and the maturity of

the cash flow is called the term structure of interest rates We are going to look at

term structure in Chapter 24, but for now we will finesse the issue by assuming that

the term structure is “flat”—in other words, the interest rate is the same regardless

of the date of the cash flow This means that we can replace the series of interest

rates r1, r2, , r t , etc., with a single rate r and that we can write the present value

1 That is, 1,000 ⫻ (1.04813) 147 ⫽ $1,002,000.

2The extra return for lending two years rather than one is often referred to as a forward rate of return Our

rule says that the forward rate cannot be negative.

3The technical term for money machine is arbitrage There are no opportunities for arbitrage in

well-functioning capital markets.