Fundamentals of corporate finance bealey, richard

BREALEY MYERS MARCUS fundamentals of New horizons in corporate finance Fundamentals of Corporate Finance opens students’ eyes to new horizons in corporate finance via a modern approach and contemporary examples Rich in pedagogy, CORPORATE FINANCE the text provides students with a solid framework of theory and application to use well after they complete the course The seventh edition has been fully updated to reflect recent events, including the financial crisis This edition is also replete with worked examples and illustrative boxes, forging connections between concepts and the real world to create a base of knowledge that will last a lifetime Fundamentals of Corporate Finance, 7e is available with Connect PlusTM Finance, McGraw-Hill’s online assignment and assessment solution With Connect PlusTM Finance, students can take self-graded practice quizzes, homework assignments, or tests, making the learning process more accessible and efficient An integrated, printable eBook is also included in the package, allowing for anytime, anywhere access to the textbook Visit the Online Learning Center at www.mhhe.com/bmm7e for more information on Connect PlusTM Finance and for additional student and instructor resources CourseSmart E-Book CourseSmart enables access to a printable e-book and mirrors the traditional textbook experience with the ability to highlight and take notes in the text Curious? Go to www.coursesmart.com to try one chapter of the e-book, free of charge, before purchase seventh edition ISBN 978-0-07-803464-0 MHID 0-07-803464-7 0 0 EAN 780078 034640 www.mhhe.com fundamentals of CORPORATE FINANCE seventh edition BREALEY MYERS MARCUS Rev Confirming Pages SEVENTH EDITION Fundamentals of Corporate Finance bre34647_FM_i-xxxi.indd i 19/08/11 3:04 PM Rev Confirming Pages THE McGRAW-HILL/IRWIN SERIES IN FINANCE, INSURANCE AND REAL ESTATE Stephen A Ross Franco Modigliani Professor of Finance and Economics Sloan School of Management Massachusetts Institute of Technology Consulting Editor Financial Management Block, Hirt, and Danielsen Foundations of Financial Management Fourteenth Edition Brealey, Myers, and Allen Principles of Corporate Finance Tenth Edition Brealey, Myers, and Allen Principles of Corporate Finance, Concise Second Edition Ross, Westerfield and Jordan Essentials of Corporate Finance Seventh Edition Ross, Westerfield, and Jordan Fundamentals of Corporate Finance Ninth Edition Shefrin Behavioral Corporate Finance: Decisions that Create Value First Edition Brealey, Myers, and Marcus Fundamentals of Corporate Finance Seventh Edition White Financial Analysis with an Electronic Calculator Sixth Edition Brooks FinGame Online 5.0 Investments Bruner Case Studies in Finance: Managing for Corporate Value Creation Sixth Edition Cornett, Adair, and Nofsinger Finance: Applications and Theory Second Edition Cornett, Adair, and Nofsinger M: Finance First Edition DeMello Cases in Finance Second Edition Grinblatt (editor) Stephen A Ross, Mentor: Influence through Generations Grinblatt and Titman Financial Markets and Corporate Strategy Second Edition Higgins Analysis for Financial Management Tenth Edition Kellison Theory of Interest Third Edition Ross, Westerfield, and Jaffe Corporate Finance Ninth Edition Ross, Westerfield, Jaffe, and Jordan Corporate Finance: Core Principles and Applications Third Edition bre34647_FM_i-xxxi.indd ii Bodie, Kane, and Marcus Essentials of Investments Eighth Edition Bodie, Kane, and Marcus Investments Ninth Edition Hirt and Block Fundamentals of Investment Management Tenth Edition Hirschey and Nofsinger Investments: Analysis and Behavior Second Edition Jordan and Miller Fundamentals of Investments: Valuation and Management Sixth Edition Stewart, Piros, and Heisler Running Money: Professional Portfolio Management First Edition Sundaram and Das Derivatives: Principles and Practice First edition Saunders and Cornett Financial Institutions Management: A Risk Management Approach Seventh Edition Saunders and Cornett Financial Markets and Institutions Fifth Edition International Finance Eun and Resnick International Financial Management Sixth Edition Robin International Corporate Finance First Edition Real Estate Brueggeman and Fisher Real Estate Finance and Investments Fourteenth Edition Ling and Archer Real Estate Principles: A Value Approach Third Edition Financial Planning and Insurance Allen, Melone, Rosenbloom, and Mahoney Retirement Plans: 401(k)s, IRAs, and Other Deferred Compensation Approaches Tenth Edition Altfest Personal Financial Planning First Edition Harrington and Niehaus Risk Management and Insurance Second Edition Financial Institutions and Markets Kapoor, Dlabay, and Hughes Focus on Personal Finance: An active approach to help you develop successful financial skills Third Edition Rose and Hudgins Bank Management and Financial Services Eighth Edition Kapoor, Dlabay, and Hughes Personal Finance Tenth Edition Rose and Marquis Financial Institutions and Markets Eleventh Edition 19/08/11 3:04 PM Rev Confirming Pages SEVENTH EDITION Fundamentals of Corporate Finance Richard A Brealey London Business School Stewart C Myers Sloan School of Management Massachusetts Institute of Technology Alan J Marcus Carroll School of Management Boston College bre34647_FM_i-xxxi.indd iii 19/08/11 3:04 PM Rev Confirming Pages FUNDAMENTALS OF CORPORATE FINANCE Published by McGraw-Hill/Irwin, a business unit of The McGraw-Hill Companies, Inc., 1221 Avenue of the Americas, New York, NY, 10020 Copyright © 2012, 2009, 2007, 2004, 2001, 1999, 1995 by The McGraw-Hill Companies, Inc All rights reserved No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of The McGraw-Hill Companies, Inc., including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning Some ancillaries, including electronic and print components, may not be available to customers outside the United States This book is printed on acid-free paper QDB/QDB ISBN 978-0-07-803464-0 MHID 0-07-803464-7 Vice president and editor-in-chief: Brent Gordon Publisher: Douglas Reiner Executive editor: Michele Janicek Executive director of development: Ann Torbert Development editor II: Karen L Fisher Vice president and director of marketing: Robin J Zwettler Marketing director: Brad Parkins Senior marketing manager: Melissa S Caughlin Vice president of editing, design, and production: Sesha Bolisetty Senior project manager: Dana M Pauley Buyer II: Debra R Sylvester Designer: Matt Diamond Senior photo research coordinator: Keri Johnson Photo researcher: Michelle Buhr Senior media project manager: Susan Lombardi Media project manager: Ron Nelms Typeface: 10.5/12 Times Roman Compositor: Laserwords Private Limited Printer: Quad/Graphics Library of Congress Cataloging-in-Publication Data Brealey, Richard A Fundamentals of corporate finance / Richard A Brealey, Stewart C Myers, Alan J Marcus.—7th ed p cm.—(The McGraw-Hill/Irwin series in finance, insurance and real estate) Includes index ISBN-13: 978-0-07-803464-0 (alk paper) ISBN-10: 0-07-803464-7 (alk paper) Corporations–Finance I Myers, Stewart C II Marcus, Alan J III Title HG4026.B6668 2012 Proudly sourced and uploaded by [StormRG] 658.15—dc22 Kickass Torrents | TPB | ET | h33t 2011017399 www.mhhe.com bre34647_FM_i-xxxi.indd iv 19/08/11 3:04 PM Rev Confirming Pages To Our Wives bre34647_FM_i-xxxi.indd v 19/08/11 3:04 PM Rev Confirming Pages About the Authors Richard A Brealey Professor of Finance at the London Business School He is the former president of the European Finance Association and a former director of the American Finance Association He is a fellow of the British Academy and has served as a special adviser to the Governor of the Bank of England and as director of a number of financial institutions Professor Brealey is also the author (with Professor Myers and Franklin Allen) of this book’s sister text, Principles of Corporate Finance Stewart C Myers Gordon Y Billard Professor of Finance at MIT’s Sloan School of Management He is past president of the American Finance Association and a research associate of the National Bureau of Economic Research His research has focused on financing decisions, valuation methods, the cost of capital, and financial aspects of government regulation of business Dr Myers is a director of The Brattle Group, Inc., and is active as a financial consultant He is also the author (with Professor Brealey and Franklin Allen) of this book’s sister text, Principles of Corporate Finance Alan J Marcus Mario Gabelli Professor of Finance in the Carroll School of Management at Boston College His main research interests are in derivatives and securities markets He is co-author (with Zvi Bodie and Alex Kane) of the texts Investments and Essentials of Investments Professor Marcus has served as a research fellow at the National Bureau of Economic Research Professor Marcus also spent years at Freddie Mac, where he helped to develop mortgage pricing and credit risk models He currently serves on the Research Foundation Advisory Board of the CFA Institute vi bre34647_FM_i-xxxi.indd vi 19/08/11 3:04 PM Rev Confirming Pages Preface This book is about corporate finance It focuses on how companies invest in real assets, how they raise the money to pay for these investments, and how those assets ultimately affect the value of the firm It also provides a broad introduction to the financial landscape, discussing, for example, the major players in financial markets, the role of financial institutions in the economy, and how securities are traded and valued by investors The book offers a framework for systematically thinking about most of the important financial problems that both firms and individuals are likely to confront Financial management is important, interesting, and challenging It is important because today’s capital investment decisions may determine the businesses that the firm is in 10, 20, or more years ahead Also, a firm’s success or failure depends in large part on its ability to find the capital that it needs Finance is interesting for several reasons Financial decisions often involve huge sums of money Large investment projects or acquisitions may involve billions of dollars Also, the financial community is international and fast-moving, with colorful heroes and a sprinkling of unpleasant villains Finance is challenging Financial decisions are rarely cut and dried, and the financial markets in which companies operate are changing rapidly Good managers can cope with routine problems, but only the best managers can respond to change To handle new problems, you need more than rules of thumb; you need to understand why companies and financial markets behave as they and when common practice may not be best practice Once you have a consistent framework for making financial decisions, complex problems become more manageable This book provides that framework It is not an encyclopedia of finance It focuses instead on setting out the basic principles of financial management and applying them to the main decisions faced by the financial manager It explains why the firm’s owners would like the manager to increase firm value and shows how managers choose between investments that may pay off at different points of time or have different degrees of risk It also describes the main features of financial markets and discusses why companies may prefer a particular source of finance We organize the book around the key concepts of modern finance These concepts, properly explained, simplify the subject They are also practical The tools of financial management are easier to grasp and use effectively when presented in a consistent conceptual framework This text provides that framework Modern financial management is not “rocket science.” It is a set of ideas that can be made clear by words, graphs, and numerical examples The ideas provide the “why” behind the tools that good financial managers use to make investment and financing decisions We wrote this book to make financial management clear, useful, interesting, and fun for the beginning student We set out to show that modern finance and good financial practice go together, even for the financial novice Fundamentals and Principles of Corporate Finance This book is derived in part from its sister text Principles of Corporate Finance The spirit of the two books is similar Both apply modern finance to give students a working ability to make financial decisions However, there are also substantial differences between the two books First, we provide much more detailed discussion of the principles and mechanics of the time value of money This material underlies almost all of this text, and we spend a lengthy chapter providing extensive practice with this key concept vii bre34647_FM_i-xxxi.indd vii 19/08/11 3:04 PM Rev Confirming Pages viii Preface Second, we use numerical examples in this text to a greater degree than in Principles Each chapter presents several detailed numerical examples to help the reader become familiar and comfortable with the material Third, we have streamlined the treatment of most topics Whereas Principles has 34 chapters, Fundamentals has only 25 The relative brevity of Fundamentals necessitates a broader-brush coverage of some topics, but we feel that this is an advantage for a beginning audience Fourth, we assume little in the way of background knowledge While most users will have had an introductory accounting course, we review the concepts of accounting that are important to the financial manager in Chapter Principles is known for its relaxed and informal writing style, and we continue this tradition in Fundamentals In addition, we use as little mathematical notation as possible Even when we present an equation, we usually write it in words rather than symbols This approach has two advantages It is less intimidating, and it focuses attention on the underlying concept rather than the formula Organizational Design Fundamentals is organized in eight parts Part (Introduction) provides essential background material In the first chapter we discuss how businesses are organized, the role of the financial manager, and the financial markets in which the manager operates We explain how shareholders want managers to take actions that increase the value of their investment, and we introduce the concept of the opportunity cost of capital and the trade-off that the firm needs to make when assessing investment proposals We also describe some of the mechanisms that help to align the interests of managers and shareholders Of course, the task of increasing shareholder value does not justify corrupt and unscrupulous behavior We therefore discuss some of the ethical issues that confront managers Chapter surveys and sets out the functions of financial markets and institutions This chapter also reviews the crisis of 2007–2009 The events of those years illustrate clearly why and how financial markets and institutions matter A large corporation is a team effort, and so the firm produces financial statements to help the players monitor its progress Chapter provides a brief overview of these financial statements and introduces two key distinctions—between market and book values and between cash flows and profits This chapter also discusses some of the shortcomings in accounting practice The chapter concludes with a summary of federal taxes Chapter provides an overview of financial statement analysis In contrast to most introductions to this topic, our discussion is motivated by considerations of valuation and the insight that financial ratios can provide about how management has added to the firm’s value Part (Value) is concerned with valuation In Chapter we introduce the concept of the time value of money, and, since most readers will be more familiar with their own financial affairs than with the big leagues of finance, we motivate our discussion by looking first at some personal financial decisions We show how to value long-lived streams of cash flows and work through the valuation of perpetuities and annuities Chapter also contains a short concluding section on inflation and the distinction between real and nominal returns Chapters and introduce the basic features of bonds and stocks and give students a chance to apply the ideas of Chapter to the valuation of these securities We show how to find the value of a bond given its yield, and we show how prices of bonds fluctuate as interest rates change We look at what determines stock prices and how stock valuation formulas can be used to infer the return that investors expect Finally, we see how investment opportunities are reflected in the stock price and why analysts focus on the price-earnings multiple Chapter also introduces the concept of market efficiency This concept is crucial to interpreting a stock’s valuation; it also provides a bre34647_FM_i-xxxi.indd viii 19/08/11 3:04 PM Rev Confirming Pages Preface ix framework for the later treatment of the issues that arise when firms issue securities or make decisions concerning dividends or capital structure The remaining chapters of Part are concerned with the company’s investment decision In Chapter we introduce the concept of net present value and show how to calculate the NPV of a simple investment project We then consider more complex investment proposals, including choices between alternative projects, machine replacement decisions, and decisions of when to invest We also look at other measures of an investment’s attractiveness—its internal rate of return, payback period, and profitability index We show how the profitability index can be used to choose between investment projects when capital is scarce The appendix to Chapter shows how to sidestep some of the pitfalls of the IRR rule The first step in any NPV calculation is to decide what to discount Therefore, in Chapter we work through a realistic example of a capital budgeting analysis, showing how the manager needs to recognize the investment in working capital and how taxes and depreciation affect cash flows We start Chapter 10 by looking at how companies organize the investment process and ensure everyone works toward a common goal We then go on to look at various techniques to help managers identify the key assumptions in their estimates, such as sensitivity analysis, scenario analysis, and break-even analysis We explain the distinction between accounting break-even and NPV break-even We conclude the chapter by describing how managers try to build future flexibility into projects so that they can capitalize on good luck and mitigate the consequences of bad luck Part (Risk) is concerned with the cost of capital Chapter 11 starts with a historical survey of returns on bonds and stocks and goes on to distinguish between the specific risk and market risk of individual stocks Chapter 12 shows how to measure market risk and discusses the relationship between risk and expected return Chapter 13 introduces the weighted-average cost of capital and provides a practical illustration of how to estimate it Part (Financing) begins our discussion of the financing decision Chapter 14 provides an overview of the securities that firms issue and their relative importance as sources of finance In Chapter 15 we look at how firms issue securities, and we follow a firm from its first need for venture capital, through its initial public offering, to its continuing need to raise debt or equity Part (Debt and Payout Policy) focuses on the two classic long-term financing decisions In Chapter 16 we ask how much the firm should borrow and we summarize bankruptcy procedures that occur when firms can’t pay their debts In Chapter 17 we study how firms should set dividend and payout policy In each case we start with Modigliani and Miller’s (MM’s) observation that in well-functioning markets the decision should not matter, but we use this observation to help the reader understand why financial managers in practice pay attention to these decisions Part (Financial Analysis and Planning) starts with long-term financial planning in Chapter 18, where we look at how the financial manager considers the combined effects of investment and financing decisions on the firm as a whole We also show how measures of internal and sustainable growth help managers check that the firm’s planned growth is consistent with its financing plans Chapter 19 is an introduction to short-term financial planning It shows how managers ensure that the firm will have enough cash to pay its bills over the coming year, and describes the principal sources of short-term borrowing Chapter 20 addresses working capital management It describes the basic steps of credit management, the principles of inventory management, and how firms handle payments efficiently and put cash to work as quickly as possible Part (Special Topics) covers several important but somewhat more advanced topics—mergers (Chapter 21), international financial management (Chapter 22), options (Chapter 23), and risk management (Chapter 24) Some of these topics are touched on in earlier chapters For example, we introduce the idea of options in Chapter 10, when we bre34647_FM_i-xxxi.indd ix 19/08/11 3:04 PM Confirming Pages IND-13 Subject Index importance to companies, 32–33 information provided by on commodity prices, 45 on company values, 46 on cost of capital, 46–47 on interest rates, 45–46 money market, 36 options market, 37–38 over-the-counter market, 36 stock market, 35–36 Financial plan, 503 balancing item, 507–508 depreciation in, 512–513 Financial planning; see also Short-term financial planning alternative business plans, 504 to avoid surprises, 503 big-picture focus, 504 case, 525 to establish goals, 504 external financing and growth, 515–518 long-term focus, 504 long-term links to short-term, 528–531 planning horizon, 504 reasons for contingency planning, 505 forcing consistency, 505 options to consider, 505 and strategic plans, 504 Financial planning models assumption in percentage of sales models, 513–514 components functions, 506 inputs, 506 outputs, 506 consistency between assumptions and plans, 508 danger of complexities, 515 and growth rate changes, 512 improved model, 508–512 limits to, 515 percentage of sales models, 507–508 pitfalls in design, 512–513 purpose, 506 role of, 514–515 Financial ratios benchmarks for performance, 100 case, 110–111 comparisons with past, 100–101 in credit analysis, 563–565 in financial plan, 506, 507 at Home Depot over time, 100–101 interpreting, 98–101 leverage ratios, 92–94 limitations, 79–80 liquidity ratios, 95–97 for major industry groups, 98, 99 bre34647_ndx_IND-IND28.indd IND13 payout ratio, 97 plowback ratio, 97 profitability ratios, 86–89 role of, 101–102 default risk, 102 transparency, 103 to understand value added, 80–81 Financial risk definition, 450 increased by debt, 453 Financial slack dark side of, 466–467 and debt policy, 466–467 definition, 465 at L A Gear, 532 threat of financial distress, 466–467 valued by managers, 465 Financial statements; see also specific statements cross-border, 68 Enron, 103 filed with SEC, 54 for financial plan, 506 for financial planning model, 508–512 pro forma, 506, 507 users of, 53 websites for, 56 Financial system, 33 Financing cash flows as basic source, 445 company options, 33–35 composition of, 371 by corporations, debt vs equity, effects of investment decisions on, 699 of Federal Express, 4–5 forms of, 33 by Home Depot, 60 for investment and growth, 97 MM irrelevance propositions, 693 multiple sources and WACC 378 of U.S corporations, 42 and value of the firm, 79 Financing decisions, Apple Inc., 32–33 case, 439–440 cash payments at different dates, 113 common stock, 404–407 compared to investment decisions, 7, 399 convertible securities, 415–416 corporate debt, 409–415 definition, effect on debt ratios, 402 examples, by Federal Express, and financial slack, 465–467 general cash offer, 431–434 in history, 24–25 initial public offering, 426–431 investors, 6–7 kinds of financing, means of, 6–7 patterns of corporate finance, 400–404 and payout policy, 487 pecking order theory, 464–465 preferred stock, 407–408 private placement, 434–435 real vs financial assets, separate from investment decisions, 270 task of financial managers, 10–11 trade-off theory, 463–464 value creation with, 400 venture capital, 424–425 Financing requirements, 505 Fire insurance, 335 Firm commitment, 427 First Call, 201n First Data Corporation, 175 First-stage financing, 424 Fisher, L., 482n Five Cs of credit, 563 Fixed assets, 56 on balance sheet, 54 investment in, 274–275 Fixed costs, 295 and operating leverage, 303–305 potential advantages, 303 Fixed-income market, 36 Fixed-income securities, 578–579 Fixed-rate debt, 681, 682 Flexible production facilities, 308 Flight to quality, 580 Float definition, 574–575 reducing, 578 Floating interest rates, 36, 409 Floating-rate bonds, 177, 681, 682 Floating-rate portfolio, 682 Floating-rate preferred stock, 408 Flotation costs, 429–430 Food companies, macro risk, 336 Forbes, 212 Ford Motor Company, 6, 330, 332–333, 336, 347, 350, 359, 365, 369, 384n, 385, 399, 402, 413, 480, 481, 548–549, 586, 610 investment and financing decisions, Forecast bias, resolving, 293–294 Forecasting ensuring consistency in, 293 in financial plan, 506 operating cash flow, 387–388 versus planning, 505 sources of cash, 530–541 uses of cash, 541 Forelle, C., 660 Forward contracts characteristics, 680–681 definition, 680 and futures contracts, 680 risk reduction with, 680–681 Fraud; see also Corporate scandals Allied Crude Vegetable Oil Refining Company, 547 Bernard Madoff, 15 charges for Goldman Sachs, 16 Freddie Mac, 18, 47, 66, 169 Free cash flow definition, 65, 387 for Home Depot, 65 managers with, 466 motive for takeover, 595 parts of, 65 in valuing entire businesses, 388–389 Free-cash-flow theory of takeovers, 609 Free credit, value of, 120–121 Frock, Roger, 462n Fudge factors, 362 Fundamental analysis, 210 Fundamental analysts, 210 Funded debt, 409 Futures, 676 Futures contracts characteristics, 676–677 commodity futures, 679–680 definition, 676 financial futures, 679–680 and forward contracts, 680 for iron ore prices, 684 margin account, 676n mechanics of trading, 677–679 margin requirement, 678 marked to market, 678–679 spot price, 679 versus options, 676 problems with, 684–685 profits on, 676 real estate, 684 for risk reduction, 676–680 standardized, 680 Futures market Chicago Mercantile Exchange, 24, 35, 684 New York Mercantile Exchange, 37, 46, 684 prediction markets, 37 requirements for success, 684 Future value of annuity, 133–135 of annuity due, 137 of annuity vs annuity due, 137 calculating, 115–116 and compound interest, 114–117 definition, 114 of multiple cash flows, 124–125, 128 in present value calculations, 117–118 of retirement savings, 135 spreadsheet solution, 122–123 Future value tables, 116, 135, A-2, A-5 04/08/11 6:50 PM Confirming Pages IND-14 G Gantchev, Nickolay, 429n Gasoline prices, 141 Gates, Bill, 131–132, 143–144, 423 Genentech, 426, 592 General cash offer costs of, 433 definition, 432 market reaction, 433–434 rights issue, 432 seasoned offering, 431–432 and shelf registration, 432–433 General Dynamics, General Electric, 179, 189, 192, 319, 598 Generally accepted accounting principles, 57, 66, 103 and International Financial Reporting Standards, 68 General Mills, 336 General Motors, 18, 160, 179, 336, 404, 487, 548, 595 Geothermal Corporation cost of capital, 372–373 WACC, 379–380 Global Crossing, 67 Goals from financial planning, 504 long-term, 504 mutually consistent, 505 Going-concern value, 190 Goldman Sachs, 10, 15, 21, 41, 175, 431 and housing crisis, 16 and SEC, 16 Goodwill, 55 Google Finance, 56 Google Inc., 37, 83, 84, 85, 86, 88, 205, 206, 368, 402, 480, 646, 647–648, 650–651, 656, 657, 666 auction IPO, 431 founding of, 423 initial public offering of 2004, 204 Gordon, Myron, 198 Gordon growth model, 198 Government, Troubled Asset Relief Program, 487 Government bonds amount publicly held, 160 rate of return vs yield to maturity, 168–169 sales of, 159 Gradley, Richard, 21 Graham, J R., 66, 323n, 465n, 485, 530n Grand Union, 476 Greenbacks, 24 Greenmail transactions, 483 Greenspan, Alan, 215n Greenwood, R., 482n bre34647_ndx_IND-IND28.indd IND14 Subject Index Growth from external financing, 515–518 limited by opportunities, 97 Growth company, 190 Growth rate and changes in financial planning, 512 internal, 517 sustainable, 518 Growth stocks, 191, 358 determining dividend growth, 203–205 reasons for buying, 202 valuing, 205 Growth vs no-growth company, 190–191 Gulf oil spill of 2010, 486 H H J Heinz Company, 350, 359, 385 Hard rationing, 249 Harvard Industries, 476 Harvey, C R., 66, 323n, 465n, 485, 530n Haushalter, G D., 673n Healy, P., 482n, 486, 611 Hedge funds, 16 definition and functions, 39 vulture funds, 39 Hedging and CAPM, 695 financial instruments for, 671 with forward contracts, 680–681 with futures contracts, 676–680 innovations in derivatives, 683–684 versus investor choices, 672 with options, 674–675 problems with derivatives, 684–685 reasons for, 672–673 sensible strategy for, 673 with swaps, 681–683 types of derivatives, 673 value of tools for, 699 as zero-sum game, 672 Helyar, J., 607n Herman Miller Corporation, 537 Hewlett-Packard, 611 Hickey, Robert, 413 High-price and high-margin strategy, 91 High-yield bonds, 174–175 Histogram, 324, 325 Historical cost, 57, 190 versus mark-to-market accounting, 67 Hollywood Videos, 598 Home Depot, 19, 81, 83, 85, 86, 87–88, 90, 91, 93, 94, 95, 96, 97, 98, 100, 101, 106, 107, 368, 393 balance sheet, 54–57 cash coverage ratio, 94 debt ratio, 97–101 economic value added, 84–85 efficiency measures, 88–90 financial statements, 54–60, 63–64 free cash flow, 65 income statement, 59–60 market capitalization, 81 market value added, 81–82 return on assets, 90–91 statement of cash flow, 63–64 summary of performance, 99 sustainable growth rate, 97–98 times interest earned ratio, 94 total capitalization, 84 Honeywell Corporation, 598 Horizontal merger, 592 Horizon value, 388–389 Hostile takeovers, 591 examples, 604–605 poison pills, 605–607 shark repellent, 606 Host Marriott Corporation, 413 Households holdings of corporate bonds in 2010, 42 holdings of equities 2010, 42, 406 House price fluctuations, 684 Housing crisis and Goldman Sachs, 16 subprime mortgages, 25, 47 Human assets, 593 Hurdle rate, 14, 46 I IBES, 201n IBM, 37, 318, 329, 335, 336–337, 350, 359, 385, 480, 593, 602, 616, 667 Icahn, Carl, 19, 604 Idle cash, 574 invested in money market, 578–580 Illiquid assets, 95 ImClone Systems, 595 Implicit annual interest rate, 561 Implicit cost of debt, 385–386, 453 Income subject to corporate tax, 68–69 subject to personal tax, 69–70 Income statement accrual accounting, 63 capital expenditures on, 63 common-size, 60 cost of capital excluded, 84 definition, 59 earnings on, 59–60 effect of transactions, 62–63 expense items, 59 Home Depot, 69–70 profit vs cash flow, 60–63 pro forma, 508–512 Income stocks, 191 determining dividend growth, 203–205 reasons for buying, 203 Incremental cash flows allocated overhead costs, 268 forecasting, 266 ignoring sunk costs, 266–267 including opportunity cost, 267 indirect effects, 266 recognizing investment in working capital, 267–268 terminal cash flow, 268 Indexed bonds during American Revolution, 173n definition, 173 TIPS, 173 Index funds, 43 Index mutual funds, 43–44 Indirect costs of bankruptcy, 460–461 Individual investments, 113 Industries, debt ratios, 446 Inefficiencies, eliminated by mergers, 595–596 Inflation base period, 140 and consumer price index, 140 definition, 139 effect on Bill Gates, 143–144 effect on cash flow, 269–270 effect on depreciation, 277 and nominal vs real interest rates, 172–174 and time value of money and interest rates, 141–142 real or nominal present value calculations, 144 real vs nominal cash flows, 139–141 valuing real cash payments, 143–144 Inflation indexed debt, 25 Inflation rate and interest rates, 142 in U.S 1900–2010, 140 Information content of dividends, 486–487 Information value in sensitivity analysis, 297 Initial public offering Apple Inc., 35–36 Apple IPO and Massachusetts, 427n arranging, 427 bookbuilding method, 430–431 case, 439–440 definition, 35, 186, 423–424, 426 direct costs, 429–430 Federal Express, 4, 186 financing decision, 04/08/11 6:50 PM Confirming Pages IND-15 Subject Index flotation costs, 429–430 Google Inc., 204, 423 issue price, 427 Microsoft, 423 and open auctions, 430–431 overpricing, 429 as primary offering, 426 prospectus, 427 versus remaining privately owned, 426 and SEC registration, 427 underpricing, 427–429 underwriters, 427, 431 underwriters’ spread, 427 Visa, 430 Innovation by Apple Inc., 33 in derivatives market, 683–684 Inputs to financial plan, 506 Insolvency, 404, 481n Installment plan, 126 Institutional investors, 18–19, 42 proxy contests, 604 Insurance companies holdings of corporate bonds in 2010, 42 holdings of equities in 2010, 42, 406 long-term financing by, 41 reinsurance, 43n risk reduction by, 43 Intangible assets, 3, on balance sheet, 55 and going-concern value, 190 investment in, 113 lacking abandonment value, 307 Intel Corporation, 7, 57, 117, 393, 425, 426, 530 Interest compound, 114–117 versus coupon rate, 165 simple, 114 tax-deductible, 69 Interest coverage, 94 Interest-free reserves, 412n Interest payments, 64n, 509, 541 on before-tax income, 409 floating, 36 and interest coverage, 94 on Treasury bonds, 160 Interest rate quotes, 138 Interest rate risk, 165–166 Interest rates on bank loans, 546 and bond prices, 126 comparing, 138 and compound interest, 114–117 discount basis quotes, 579 discount rate, 118 floating, 409 floating-rate bonds, 177 floating-rate preferred stock, 408 on government bonds, 159 hedging fluctuations in, 679 bre34647_ndx_IND-IND28.indd IND15 information on, 45–46 long-term bonds, 45 long- vs short-term bonds, 172 market vs coupon, 164 per period, 561 present value calculation, 123–124 prime rate, 509 real vs nominal, 141–142, 172– 174, 269 TED spread, 546 ten-year Treasury bonds, 1900–2009, 164 on trade credit, 561 varying bond prices, 163–165 Interest rate swaps, 681–682 Interest tax shield, 85n, 456–457, 609 definition, 455 perpetual, 455–456 as valuable asset, 455–456 value of shareholders’ equity, 456 and value of the firm, 455 Internal growth rate definition, 518 determinants, 518 Internally generated funds, 465 companies relying on, 402 definition, 400 reliance on, 403 Internal rate of return and discount rate, 242–243 financial calculator solution, 245 for long-lived projects, 241–243 modified, 248, 260 versus opportunity cost of capital, 243 pitfalls cost of capital, 244 multiple rates of return, 247–248 mutually exclusive projects, 244–246 mutually exclusive projects with different outlays, 246–247 Internal rate of return rule, 240–248 agreement with net present value rule, 243 for choosing between mutually exclusive projects, 259–260 definition, 241 discount rate, 241, 242 and opportunity cost of capital, 240–241 summary on, 250 Internal Revenue Service, 68, 69, 274, 277, 612 International Monetary Fund, 48 Internet, bill payment by, 575–576 Intrinsic value of common stock, 192–194 definition, 192 and fundamental analysis, 210 and market value, 696 Inventories carrying costs, 536 composition of, 571 costs of holding, 571 as current asset, 531 and economic value added, 537 level divisions, 534n relative liquidity, 530n shortage costs, 536–537 types of, 559 Inventory financing example of fraud, 547 and field warehousing, 548 Inventory management carrying costs, 571 composition of inventories, 571 economic order quantity, 572 essential features, 572 just-in-time systems, 573 and production to order, 573 storage costs, 571 Inventory period definition, 534 estimating, 534 Inventory turnover versus profit margin, 91 for selected industries, 92 Inventory turnover ratio, 88–89 Investment banks, 10, 20, 22 bridge loans, 40n in financial crisis of 2007–2009, 47–48 functions, 40–41 investments by, 41 largest, 41 underwriters, 427, 431 underwriting, 41 Investment decisions, 3; see also Capital budgeting decisions; Financial investment criteria characteristics, compared to financing decisions, considering options, 505 examples, by Federal Express, 4–5 fundamental trade-off, 13–14 in history, 24–25 long-term consequences, new, 503 opportunity cost of capital, 14 and payout policy, 487 separate from financing decisions, 270 side effects on financing, 699 terminology for, warped, 462 Investment expenditures, recognizing, 265 Investment grade bonds, 174–175 Investment grade companies, 45–46 Investment income, tax treatment, 70 Investment management departments, 22 Investment risk and dispersion of possible outcomes, 324 measures of dispersion, 324–325 Investments annuities, 128–130 compound interest, 114–117 costs of, 227 by dividends, 113 flow of, 34 future value, 190 historical performance, 319–322 in intangible assets, 113 least and most risky, 352 limited opportunity for, 97 liquidity of, 44–45 need for borrowing, 159 paying for, 113 perpetuities, 127–128 rates of return, 14 relative risks, 229 risky, 12, 14 in tangible assets, 113 Investment strategies of hedge funds, 39 Investment timing decision, 234, 235, 236 Investment trade-off opportunity cost of capital, 14 and value maximization, 13–14 Investors, 6–7 and asymmetric information, 464 behavioral finance attitudes toward risk, 214 beliefs about probabilities, 215 and blue-sky laws, 427 in CAPM, 356–358 choices without hedging, 672 and company cost of capital, 376 concern of macro risks, 336 deceived by Enron, 413–414 differing time horizons, 194–197 diversification, 43 early repayment demand, 410–411 earnings reported to, 66 effect of dividend change, 478–487 fear of default, 698 fundamental analysts, 210 in initial public offerings, 35 04/08/11 6:50 PM Confirming Pages IND-16 Investors—Cont irrational exuberance, 215, 696 overconfidence, 215 reaction to price cycles, 209 required return, 371 senior vs junior, 415 technical analysts, 206 use of financial statements, 54 valuing liquidity, 698 venture capital firms, 425–426 wide choice of securities, 319 worst year for bonds, 322 Iowa Electronic Markets, 37 IPO; see Initial public offering Iridium failure, Iron ore futures, 684 Irrational exuberance, 215, 696 Issue costs, 433 Issued and outstanding shares, 405 Issued but not outstanding stock, 405 Issue price, 427 J J D Edwards & Company, 605 Jarrell, G., 487n JCPenney, 83, 84 Jensen, Michael C., 466, 482n, 609n Jinghua Yan, 210 Jobs, Steven, 423 Johnson, J., 516, 604n Johnson, Ross, 607–608, 609 Johnson & Johnson, 83, 84, 189, 190, 191, 192, 350, 359, 385, 425 Jorwar, A N., 434n JPMorgan Chase, 40, 47, 175, 176, 431, 580 dividend cut, 486, 487 Junior investors, 415 Junk bond market default rates, 608 and Drexel Burnham Lambert, 610 and takeover business, 608 Junk bonds, 46, 174–175, 411 Just-in-time systems, 573 K Kahn, V M., 566 Kaplan, S., 609 Kellogg, 336 Keown, A., 210 Kinko’s, 4, 401 Kohlberg Kravis Roberts, RJR Nabisco LBO, 607–608, 609–610 Kolasinski, Adam, 357 Kozlowski, Dennis, 17 Kraft Foods, 592 bre34647_ndx_IND-IND28.indd IND16 Subject Index L L A Gear, 530 bankruptcy, 532 capital structure, 532 Labor costs, 541 Lamont, O A., 611 Large-firm vs small-firm stocks, 358 Lazard, 41 LBO; see Leveraged buyouts Lease, 413 Leasing, 699 Lee, Dorothy K., 413 Legal capital, 481 Legal requirements, 18 Lehman Brothers, 8, 24, 25, 47 bankruptcy, 460, 477, 549 default by, 580 repo agreements, 67 Level cash flows future value of annuities, 133–135 valuing annuities, 129–133 valuing perpetuities, 127–128 Leveraged buyouts, 93 case, 616 cash cow company targets, 609 compared to other acquisitions, 607 decline and recovery, 609–610 definition, 607 ending in bankruptcy, 609 free-cash-flow theory, 609 and incentives, 609 junk bond market, 608 management buyouts, 607 private equity, 607 RJR Nabisco, 607–608, 609–610 and stakeholders, 609 and taxes, 608–609 Leverage ratios cash coverage ratio, 94 debt equity ratio, 93 debt ratio, 93–94 and equity financing, 95 function, 92 ignoring short-term debt, 93 times interest earned ratio, 94 Levi Strauss & Company, 426 Liabilities on balance sheet, 54–57, 189 book vs market value, 57–58 matching maturities, 529–530 Lie, E., 660 Life insurance companies, 20 Limited liability, 8, 10 Limited liability companies, 9–10 Limited liability partnerships, 9–10 Limited partnerships, venture capitalists, 425 Limit order book, 187 Line of credit, 545–546 Liquid assets, 54, 95–96 Liquidation creditor preference for, 477 definition, 475 versus reorganization, 476–477 Liquidation value, 190, 191 Liquid bonds, 175 Liquidity advantages of, 530n of assets, 95 of cash holdings, 574 corporate vs government securities, 580 corporate vs Treasury bonds, 698 definition, 44, 95 explaining value of, 698 measures of, 95–97 of money market, 579 provided by financial institutions, 44–45 of structured investment vehicles, 95 Liquidity ratios cash ratio, 96–97 current ratio, 96 less desirable characteristics, 95 net working capital to total assets, 96 quick ratio, 96 Litigation bankruptcy as protection from, 477 malpractice suits, 10 Live Nation, 703 Loan covenants, 463 Loans, amortizing, 132–133; see also Bank loans Lochhead, Scott, 429n Lock-box system, 574–575 Lockheed Corporation, 266–267, 302–303 Long-term bonds, 172 Long-term debt, 36 Long-term debt-equity ratio, 93 Long-term debt ratio, 93 and sustainable growth rate, 98 Long-term finance, 399; see also Corporate finance Long-term financial planning focus of, 504 links to short-term planning advantage of liquidity, 530–531 kinds of approaches, 529 time horizons, 528 total capital requirements, 528–530 Long-term financial planning decisions, 527 Long-term financing, 41 Long-term liabilities, 55, 58 Long-term loans repayment provisions, 410–411 Long-term Treasury bonds, 320 Long- vs short-lived equipment choice, 235, 236–238 Loss carryback, 69 Loss of degree of freedom, 328n Lotteries, 131 Lowe’s, 19, 83, 100, 106 M Machine tool manufacturers, market risk, 336 Macro risks; see Market risks Madoff, Bernard, 15 Maintenance, 392 Majority voting, 407 Makkula, Mike, 32 Malkiel, Burton G., 212n Malpractice suits, 10 Management of corporations, 603 cost of mergers to, 600–601 means of changing carve-outs, 610 divestiture, 610 leveraged buyouts, 607–610 proxy contests, 603–604 spin-offs, 610 takeovers, 604–607 as off-balance-sheet liability, 696–697 replacing, 595–596 Management buyouts definition, 607 payoff from incentives, 609 Managers adding value, 79 agency problems, 16–19 and asymmetric information, 464 dishonest, 103 eliminating conflicts of interest, 293 ethics of value maximization, 14–15 with free cash flow, 466 threat of takeover, 612 use of WACC, 371 and value maximization, 16–19 value of financial slack for, 465 views of debt policy, 465–467 views on dividends, 485 Manhattan Island purchase, 116 Manufacturing, flexible production facilities, 308 Manville Corporation, 477 Margin account, 676n Marginal tax rates, 70 Margin requirement, 678 Marked to market, 678–679 Marketable securities, 531 Market anomalies earnings announcement puzzle, 212, 213 new issue puzzle, 212–213 Market capitalization, 206 definition, 81 Federal Express, 188 for selected companies, 84 04/08/11 6:50 PM Confirming Pages IND-17 Subject Index Market for corporate control, 591, 602–610 agency costs, 603 definition, 603 and separation of ownership and management, 603 ways of changing management divestitures, 610 leveraged buyouts, 607–610 proxy contests, 603–604 takeovers, 604–607 Market index, 319 Market order, 186–187 Market portfolio, 323 and CAPM, 354–359 definition, 346 expected rate of return, 353–354 market risk premium, 353–354 mutual fund risks, 351–352 risk and return, 352–359 and security market line, 355–356 Market price, 229 Market risk premium calculating, 353–354 definition, 352 measuring, 382 for past century, 352 Market risks, 43, 692 airlines, 336 definition, 334 machine tool manufacturers, 336 as macro risks, 336 measuring betas, 346–349 portfolio betas, 350–352 and total risk, 350 not eliminated by diversification, 346 versus specific risks, 333–334, 345 spreadsheet solution, 348 Market-to-book ratio, 206 definition, 83 examples, 83 for selected companies, 191–192 Market value, 229 basis of company cost of capital, 376–377 versus book value, 57–59, 189–191 in calculating WACC, 380–381 company examples, 46 and debt ratios, 93 of equity, 404 excluded from balance sheet, 88 fluctuations, 83 impact of merger on, 597 and intrinsic value, 696 measure of capital structure, 380–381 bre34647_ndx_IND-IND28.indd IND17 measuring, 81–84 for selected companies, 189 Market value added definition, 81 examples, 83 measuring, 81–84 Market-value balance sheet, 58–59, 205–206 Market vs coupon rate, 164 Markowitz, Harry, 702 Mark-to-market accounting, 67 Marriott Corporation, bondholder problems, 413 Marriott International Inc., 413 Marsh, Paul R., 319, 320, 321, 324, 325, 327, 328 Martin, K J., 596 Marvel Entertainment, 703 Masonite, 609 Massachusetts, and Apple IPO, 427n Massachusetts Bay Colony, 24 MasterCard, 576 Masulis, Ronald W., 434n, 472 Matching maturities, 529–530 Maturities, 409–410 of commercial paper, 548 limited in money market, 578–579 matching, 529–530 Maturity date, 36 Maturity premium, 320 Maximizing value; see Value maximization McCain, John, 37 McConnell, J J., 596 McDonald’s, 189, 192, 201–202, 329, 350, 359, 385, 524 McGuire, William W., 660 McNichols, Maureen F., 563–565 Mellon Financial Corporation, 594 Memorex, 476 Merchant banks, 40n Merck & Company, 554, 592 Mergers banking, 594 benefits and costs, 610–612 and deregulation, 611 wave of 1990s, 610–611 case, 616 conglomerate, 593 Daimler-Chrysler, 593 definition, 598 versus divestitures, 610 dubious reasons for bootstrap game, 596–597 diversification, 596 evaluation of cash financing, 599–601 stock financing, 601–602 warnings on, 602 explaining waves of, 697–698 horizontal, 592 LBOs, 607–610 mechanics of and antitrust law, 598–599 form of acquisition, 598 and popular opposition, 598–599 tender offer, 598 pharmaceutical industry, 595 and price-earnings ratio, 597 questions preceding, 599–601 cost to management, 600–601 cost to shareholders, 600–601 economic gain, 600 recent, 591, 592 RJR Nabisco, 24–25 sensible motives for combining complementary resources, 595 to create synergies, 593–594 economics of vertical integration, 594–595 economies of scale, 594 eliminating inefficiencies, 595–596 use of surplus funds, 595 takeovers, 604–607 in U.S., 1962–2009, 591, 592 vertical, 592 Merrill Lynch, 25, 41n, 47, 431, 592 Merton, Robert, 655, 694, 695, 702 Michaely, R., 485 Microsoft Corporation, 19, 189, 191, 329, 350, 359, 385, 437, 445, 446, 480, 530 cash dividend, 491–492 founding of, 423 MidAmerica Energy, 279 Middle-of-the-road policy for financing, 529 Midyear cash flow convention, 276n Mikkelson, W H., 434n Milken, Michael, 610 Miller, Merton H., 446, 488, 693, 696, 702 Minimum operating cash balance, 541 Minuit, Peter, 116, 117 Mitchell, M., 611n MM debt-irrelevance proposition, 450 MM dividend-irrelevance proposition assumptions behind, 490–491 description, 488–490 MM proposition I, 693 cost of equity, 452 definition, 450 on shareholder risk, 450–451 simplifying assumption, 447 and value of the firm, 446–448 MM proposition II, 693 debt-equity ratio, 453–454 definition, 452 Modified accelerated cost recovery system, 278 Modified internal rate of return, 248 with multiple rates of return, 260 Modigliani, Franco, 446, 488, 693, 696 Money; see also Time value of money greenbacks, 24 in 17th century America, 24 Money management, 22 Money market, 36 certificates of deposit, 579 commercial paper, 579 corporate vs government securities, 580 default risk, 580 definition, 578 fixed-income securities, 578–579 interest rates, 579 limited maturities, 578–579 liquidity of, 579 recent market turmoil, 580 repurchase agreements, 579 Treasury bills, 579 yields, 580 Moody’s Investors Service Inc., 174, 411, 413, 563, 579 Moore, Gordon, 117 Morgan Stanley, 10, 21 Morrison, A D., 16 Mortgage amortization, 132–133 Mortgage-backed securities, 47 toxic, 48 Mortgage pass-through certificates, 414–415 Mortgages, present value analysis, 132–133 Motorola, 604 Mullins, D W., 434n Multiple cash flows future value, 124–125 present value, 126–127 spreadsheet solution, 128 Multiple discriminant analysis, 565 Multiple internal rate of returns, 260 Multiple rates of return, 247–248 Municipal bonds, 174n Murphy, T., 573n Mutual funds, 22 closed end, 38n, 696 consistently successful, 212 versus exchange traded funds, 44 functions, 38–39 holders of corporate bonds in 2010, 42 holdings of corporate equities, 406 holdings of equities in 2010, 42 number of, 39 open end, 38n risks, 351–352 04/08/11 6:50 PM Confirming Pages IND-18 Mutually exclusive projects, 244–246 with different outlays, 246 internal rate of return rule for, 259–260 Myers, S C., 387n, 434n, 458n N Najluf, N S., 434n Nardelli, Robert, 19 NASDAQ, 35, 36, 186 number of stocks traded, 319 NASDAQ Composite Index, 696 NASDAQ 100 index, 44 NASDAQ stock index, rise and decline of, 213 National Association of Security Dealers Automated Quotation system, 186n National Semiconductor, 703 NBC Universal, 592, 703 Negative-risk assets, 332 Neiman Marcus, 106 Net asset value, 38n Net common equity, 405–406 Net current assets, 55 Net income versus cash flow, 63 and internal growth rate, 517 Net present value, 228, 377 break-even point, 300 calculating, 229, 276, 692 definition, 229 examples, 228–229 financial calculator solution, 245 to measure worth of project, 263 negative, 265 negative in accounting break-even analysis, 300 new computer system, 232 office block project, 230–231 and opportunity cost of capital, 229 in profitability index, 248 recognizing investment expenditures, 265 and sensitivity analysis, 296 steps in calculating, 232 timing option, 307–308 Net present value break-even analysis, 300–301 Net present value profile, 241 and IRR, 242–243 Net present value rule agreement with internal rate of return rule, 243 to choose among projects investment timing decision, 235–236 long- vs short-lived equipment, 236–238 replacement of old equipment, 238–29 bre34647_ndx_IND-IND28.indd IND18 Subject Index to choose between two projects, 234 definition, 229 vs payback rule, 239 and rate of return rule, 241 summary on, 250 value of, 692 valuing long-lived projects, 230–234 Net working capital, 55, 65; see also Working capital entries definition, 96, 267, 533 function of sales, 513–514 Net worth, 407 New issue puzzle, 212–213 Newmont Mining, 329, 332–333, 350, 351, 359, 365, 385 New products development of, effect on existing products, 266 investment in, 293 Newspage Corporation, 175 New York Mercantile Exchange, 37, 45, 684 New York Stock Exchange, 8–9, 11, 36, 185, 186 changes since 2007, 35 formation of, 24 number of stocks traded, 319 trading volume, 620 New York Stock Exchange Composite Index, 206–207 New York Stock Exchange stocks, 357 No-dividend companies, 480 No-growth dividend discount model, 197 No-growth perpetuity, 197 Nominal cash flows, 139–141, 269–270 Nominal cost of capital, 269–270 Nominal dollars, 141 Nominal interest rate, 141–142, 172–174, 269 Nominal rate of return, 318 Nonconstant growth stocks estimating McDonald’s value, 201–202 investment horizon, 201–202 terminal value, 201 valuation errors, 202 value of dividends, 200–202 Nondiversifiable risks, 692 Non-profit organizations holdings of corporate equities, 406 Normal growth, 330–332 Normal growth plan, 504 NPV; see Net present value entries Numerical credit scoring FICO score, 563n financial ratios for, 563–565 five Cs of credit, 563 Z-score model, 565 O Obama, Barack, 37 Off-balance-sheet assets and liabilities, 66–67 Olin Corporation, 679 One-at-a-time sensitivity analysis, 297 Open account, 562 Open auction issue, 430–431 Open-end fund, 38n Open-market repurchase, 482–483 Operating cash balance, 541 Operating cash flow, 275–276 of cost-cutting projects, 271–272 dealing with depreciation, 272 example, 273 forecasting, 387–388 formula, 271 Operating income after-tax, 85 calculating, 87 effect on earnings per share, 450 in management buyouts, 609 for selected companies, 84 Operating leverage, 303–305, 451n and project risk, 361 Operating profit margin, 90 Operating risk definition, 450 effect of debt, 450–451 Opportunity cost in accounting break-even analysis, 300 definition, 267 of holding cash, 573 Opportunity cost of capital, 14, 31, 46–47, 84, 229, 322, 359, 692; see also Cost of capital additional, 515 to discount future cash flows, 263 effect on shareholders, 373–374 estimating, 263 ignored by Lockheed, 302 versus internal rate of return, 243 and project risk, 317 relation to return, 240–241 Optimal capital structure, 445, 459 Option(s) to abandon, 307 considered in financial planning, 505 to expand decision tree, 306 example, 305–306 Option ARM loan, 47n Option premium, 646, 648 Options annual volume, 645 backdating scandal, 660 calls and puts, 646–649 on convertible bonds, 645 on financial assets callable bonds, 661 convertible bonds, 659–661 executive stock options, 659 warrants, 659 payoff and profit, 650–651 versus payoff from holding stock, 652 protective put, 650 put-call parity, 651 on real assets, 657–658 and risk characteristics of portfolio, 650 for risk reduction, 674–675 types traded, 645 Options market, 37–38 Option theory, 693–694 Option to abandon, 307, 658 Option to expand, 305–306, 658 Option-valuation models Black-Scholes model, 655, 657, 659 simple model, 656 Option values determinants, 652–655 models for, 655–657 upper and lower limits, 652 Oracle Corporation, 18–19, 480, 659 bid for PeopleSoft, 605–607 Orange, M., 516, 604n Ordinary income, 70 Ordinary least squares regression, 349n Outputs of financial plan, 506 Outside directors, 407 Outsourcing vs vertical integration, 595 Overconfidence, 215 Overhead costs, 268 Overpricing, 429 Over-the-counter market, 36 Overvalued stocks, 434 P Pacific Capital Bancorp, 186 Pacific Gas & Electric, 409, 549 Page, Parry, 423 Palepu, K., 482n, 486, 611 Palm, 611 Pandora, Inc., 438 Partch, M M., 434n Partnership definition, types of, 9–10 unlimited liability, Par value of bonds, 160 of common stock, 405 of outstanding shares, 481 Paulson, John, 39n 04/08/11 6:50 PM Confirming Pages IND-19 Subject Index Payback period, 239–240 discounted, 239 summary on, 250 Payback rule, 228 advantage of simplicity, 240 cutoff period, 239 definition, 239 length of payback periods, 239–240 problems with, 239 reasons for using, 240 Pay lag, 582 Payment date, 481 Payment mechanism, 45 Payment systems checks, 574–575 electronic funds transfer, 576–578 United States, 576 Payoff on hedging instruments, 671 on options, 649, 650–561 Payoff diagram, 649 Payout policy, 479 and capital budgeting, 487 case, 499–500 controversy assumptions behind MM proposition, 490–491 effects of changes, 487–488 MM dividend-irrelevance proposition, 488–490 decisions on, 485–487 and financing decisions, 487 high vs low, 491–493 implication of tax rates, 493 and investment decisions, 487 managerial views, 485 means used cash dividends, 480–481 stock dividends, 481–482 stock repurchase, 482–484 stock splits, 482 and overall cash flow, 490–491 reasons for dividend value decrease, 492–493 reasons for dividend value increase, 491–492 Payout ratio, 97 definition, 203 Pecking order theory of capital structure asymmetric information, 464 definition, 465 external financing, 465 internal financing, 465 Peets Coffee & Tea, 586 Penn Central Railroad, 24 Pension Benefit Guarantee Corporation, 475n Pension funds definition and function, 39–40 holdings of corporate bonds in 2010, 42 bre34647_ndx_IND-IND28.indd IND19 holdings of equities in 2010, 42, 406 monitors of company performance, 18 not taxed, 70 Pension plans assets in 2010, 40 defined-benefit, 39n, 40n defined-contribution, 39 Pensions, 413 Pentagon Law of Large Projects, 234 PeopleSoft, 605–607 PepsiCo, 189, 192, 473, 599 Percentage capital gain, 318 Percentage of sales models assumptions in, 513–514 balancing item, 507–508 complications, 513–514 definition, 507 Percentage return, 318 Percentages squared, 326 Performance measures, 85 Permanent working capital requirement, 530n Perpetuities definition, 127 no-growth, 197 preferred stock dividends as, 378 present value, 198 valuing, 127–128 Perpetuity formula, 383–384, 455–456 Personal tax average rate, 70 on capital gains, 70 on dividend income, 70 marginal rates, 70 on ordinary income, 70 Petersen, M A., 571n Pfizer Inc., 7, 329, 350, 359, 369, 385, 473, 592, 667 Pharmaceutical industry mergers, 595 Pinkerton, J., 210 Pinkowitz, L., 530–531 Planet Hollywood, 476 Planning horizon, 504 Plowback ratio, 97, 518 definition, 203 Plug; see Balancing item Poison pill, 605–607 Ponzi, Charles, 15n Ponzi scheme, 15 Portfolio betas, 350–352 Portfolio risk and economic scenarios, 330–332 example, 332–333 macro risks, 336 Portfolios diversification, 329–330 floating-rate, 682 performance of, 320–322 risk characteristics and options, 650 Positive-NPV projects, 694–695 and discount rate, 306 plausibility, 294 what-if questions, 294–295 Postpetition creditors, 477 Postretirment benefits, 413 Powerball lottery, 131, 137 Power Computing Corporation, 32 Prediction markets, 37 Preferred stock, 378 convertible, 416 definition, 407 dividends, 408 expected rate of return, 383–384 floating-rate, 408 lack of voting privileges, 408 and net worth, 407 tax advantage, 408 Premium bond, 167 price changes, 170 Prepackaged bankruptcies, 475n Present value of annuity, 129–130, 136–137 calculating, 117–123 of cash flow, 264 of cost of machinery, 236 definition, 117 determination questions, 694–695 discounted cash flow calculation, 118 discount factor, 119 effect of interest rates, 165 examples, 120–121 financial calculator solution, 121 finding interest rates, 123–124 formula, 118 and future value, 117–118 in future value of annuity, 134 as intrinsic value, 192 investment timing decision, 235 of lottery winnings, 131 mortgage payments, 132–133 of multiple cash flows, 126–127, 128 new computer system, 232 office block project, 230–231 of perpetuities, 127–128, 198 projected cash flows, 300–301 of real cash payments, 143 and risk, 229 spreadsheet solution, 122–123, 233 of stream of future cash, 126–127 of Treasury bonds, 162, 163 using compound interest, 118 Present value of growth opportunities, 204–205 on market-value balance sheet, 206 Present value tables, 119, A-3, A-4 Present value tax shield, 455 Presidential futures prices, 37 Price(s) of assets, 692 of commodities, 679 corporate vs Treasury bonds, 698 of gasoline, 141 with inflation, 139–141 Price-earnings multiple, 188 Price-earnings ratio, 188 and company prospects, 205 and mergers, 597 for selected companies, 191–192 Primary issue, 35–36 Primary market, 35–36 definition, 186 Primary offerings, 186, 426 Prime rate, 509 Principal (par value), 160 Principals, 694 Principles-based accounting, 68 Private equity financing, 425 Privately owned businesses, 426 Private placement, 412 advantage, 434–435 definition, 434 and Rule 144a (SED), 434 Probabilities, beliefs about, 215 Probability theory, 215 Procter & Gamble, 204 debt issue, 414 Production cycle, 534 Production to order, 573 Product life cycle, 98 Product markets, competitive advantages in, 400 Products, sales of new vs existing, 266 Professional corporations, 10 Profit versus cash flow, 60–63, 264–265 cash vs accrual accounting, 61–62 from channel stuffing, 66 and depreciation, 60–61 determining factors, 190 economic value added, 84 expected, 567 from options, 650–651 taxation of, 69 Profitability, 79 Profitability index, 228, 248–250 with capital rationing, 249 definition, 248 and hard rationing, 249 pitfalls, 249 positive net present value, 248 and soft rationing, 249 summary on, 250 Profitability ratios asset turnover ratio, 88 inventory turnover, 88–89 receivables turnover, 89–90 return on assets, 87 return on equity, 87 04/08/11 6:50 PM Confirming Pages IND-20 Profit diagram, 649 Profit margin, 90 versus inventory turnover, 91 low vs high, 90–91 for selected industries, 92 Profit maximization and credit decision, 569 not well-defined, 12–13 Profit per dollar of assets, 85 Pro forma balance sheet, 507, 508 Pro forma income statement, 507 Pro formas, 506 second-stage, 509–510 Project analysis break-even analysis accounting, 298–300 net present value, 300–303 operating leverage, 303–305 case, 315 investment process analyzing competitive advantage, 294 capital budget, 292 consistent forecasts, 293 eliminating conflicts of interest, 293 project authorization, 292–293 reducing forecast bias, 293–294 real options flexible production facilities, 308 option to abandon, 307 option to expand, 305–307 timing, 307–308 what-if questions, 291, 294–298 scenario analysis, 297–298 sensitivity analysis, 295–297 Project authorization information capacity expansion, 293 maintenance cost reduction, 293 new product investments, 293 outlays required, 292–293 Project betas, 694–695 Project cash flows, 263 calculating net present value, 276 capital investment, 271 cash flow analysis, 274–276 changes in working capital, 273–274 dealing with depreciation, 272, 277–279 and financing, 270 forecasting working capital, 277 identifying, 264–268 allocated overhead costs, 268 incremental cash flows, 266–268 terminal cash flow, 268 mistakes in forecasting, 268 operating cash flow, 271–273 salvage value, 279 spreadsheet solution, 280 with zero net present value, 380 bre34647_ndx_IND-IND28.indd IND20 Subject Index Project cost of capital estimating, 360–361 and project risk, 360 Project risk and capital budgeting, 359–362 versus company risk, 359–360 project cost of capital, 360–362 common perceptions of, 362 and company cost of capital, 359–360 contemplating big risks as diversifiable, 335 market risks as macro risks, 336 risks as measurable, 336–337 determinants earnings variability, 361–362 operating leverage, 361 determination questions, 694–695 and diversification assets vs portfolio risk, 329–330 market vs specific risk, 333–334 estimating cost of capital, 322–323 with fear of default, 463 fudge factors in discount rate, 362 measuring benchmarks, 324 calculating variance, 327 standard deviation, 324–327 variance, 324–327 variation in stock returns, 327–329 opportunity cost of capital, 317 and security market line, 361 Property, plant, and equipment, 54 Prospectus definition, 427 example, 440–443 Protective covenants definition, 412 and Marriott Corporation, 413 Protective put, 650 Proxy access, 604 Proxy contest/fight, 407 costs of, 603–604 definition, 603 at PeopleSoft, 606 Public companies, 8–9 Public Company Accounting Oversight Board, 68, 103 Public placement, 412 Puerto Rico, 120 Put-call parity, 651 Put options definition, 647 payoff diagram, 649 profit diagram, 649 protective put, 650 for risk reduction, 674–675 selling, 647–649 Puttable bonds, 661 Q QQQs, 44 QUBES, 44 Quick ratio, 96 Qwest Communications, 67 R Rajan, R G., 571n Rajgopel, S., 66 Random walk theory, 208–209, 693 Rate of return rule, 241 Rates of return, 14; see also Accounting rates of return; Expected rate of return for bonds, 168–171 calculated for bonds, 166–168 in capital market history, 319–322 common stock, 1900–2010, 321 common stock fluctuations, 321 and cost of capital, 46–47, 317 and current yield, 167 with debt-equity mix, 375–376 definition, 169 differing, 371 estimating, 322–323 estimating cost of capital from history, 322–323 Ford Motor Company, 365 Geothermal example, 372 government bonds, 1900–2010, 321 histogram, 324, 325 on market portfolio, 346–352 maturity premium, 320 multiple, 247–248 Newmont Mining, 365 nominal, 318 and opportunity cost of capital, 47 percentage return, 318 real, 318 relation to opportunity cost of capital, 240–241 specific vs market risk, 345 Treasury bills, 1900–2010, 321 Treasury bills in 1981, 323–323 Treasury bills in 2011, 323 variable, 330 Walt Disney Company, 365 versus yield to maturity, 167–169 Raw materials, dependence on single source, 308 Real assets, 38 definition, risky vs safe, 694–695 Real cash flows, 139–141 Real dollars, 141 Real estate bubble, 213 Real estate futures, 684 Real interest rate, 142, 172–174, 269 Real options Allegheny Corporation, 658 definition, 307, 657 flexible production facilities, 308 option to abandon, 307, 658 option to expand, 305–307, 658 for risk management, 673 timing, 307–308 Real rate of return, 318 Real-time, gross settlement system, 577n Rebalancing capital structure, 456 Receivables, 89 aging schedule, 569–570 liquidity of, 530n Receivables turnover ratio, 89–90 Recession, 330–332 Recession of 2007–2009, 48 Record date, 481 Registration statement, 427 Regression line, 349n Regular dividends, 480 Regulatory requirements, 18 Reinhardt, U E., 303n Reinsurance, 43n Reinvestment, 33 Relaxed approach to financing, 529, 530 Rent, contingent, 303 Reorganization definition, 475 versus liquidation, 476–477 procedures, 475–476 Repayment provisions, 410–411 Replacement problem, 235, 238–239 Repurchase agreements Lehman Brothers, 67 in money market, 579 Reputation, and financial transactions, 15 Required external financing, 515–516 Required return, 371, 692 calculating, 374–375 Reserve accounts, misuse of, 66 Residual income, 84, 537 Resources, complementary, 595 Restrictive financing policy, 529 Restructuring and cost of capital, 452 effect on capital structure, 447–448 by Marriott Corporation, 413 and operating income, 450 04/08/11 6:50 PM Confirming Pages IND-21 Subject Index Retained earnings, 56n, 60 definition, 405 Retirement savings, 135 Retrenchment plan, 504 Return actual vs expected, 358 effect of debt, 450 on Treasury bonds, 161–162 Return on assets and credit scoring, 563 definition, 87 Du Pont formula, 90–91 at Home Depot, 87 Home Depot vs Lowe’s, 100–101 profit margin, 90 for selected industries, 92 Return on capital calculating, 85 definition, 85 for Home Depot, 85–86 for selected companies, 84 Return on equity, 517, 518 definition, 87 and financial leverage, 94–95 for Home Depot, 87 for software firms, 98 Revenue recognition, 66 Revenues, examples of, Rhie, Jung-Wu, 563–565 RHI Entertainment, 186 Rich, Jeffrey, 660 Rieker, M., 487 Rights issue, 431n, 432 Risk(s) asset vs portfolio, 330–333 attitudes toward, 214 in cost of capital, 317 diversifiable, 335, 692 hedging, 671 incremental, 332 market, 692 market vs specific, 333–334 measurable, 336–337 of New York Stock Exchange stocks, 334 not eliminated by hedging, 672 and operating leverage, 305 ordinary meaning of, 362 and present value, 229 selection of, 671 of various securities, 371 Risk and return CAPM, 354–359, 692, 695 effect of borrowing on, 450–451 least and most risky investments, 352 market risk premium, 352–354 security market line, 355–356 statistical problems, 695 Risk-averse, 12 Risk-free rate, 354 measuring, 382 Risk-free return on Treasury bills, 353 bre34647_ndx_IND-IND28.indd IND21 Risk management derivatives, 673 evidence on, 673 with forward contracts, 680–681 with futures contracts, 676–680 innovations in derivatives, 683–684 with options, 674–675 problems from derivatives, 684–685 reasons for hedging, 672–673 with swaps, 681–683 value of tools for, 699 Risk premium and beta, 353–354 in CAPM, 356–357 CAPM prediction, 357 on equally weighted index, 357n future, 323 and security market line, 356 United States, 323, 324 Risk reduction; see also Risk management with options, 674–675 versus speculation, 684 Risk-return trade-off, 330 Risk tolerant, 12 Risk transfer, 43–44 Ritter, Jay, 212n, 428n, 429n Ritz-Carlton Hotel, 593 RJR Nabisco LBO, 24–25, 413, 607–608, 609–610, 612 Road shows, 427 Rockefeller, John D., 702 Rodriguez, Albert, 21 Roll, R., 482n Ruback, R., 611 Rules-based accounting, 68 S Safeway, 593 Sales conditional, 562 credit agreements, 562 of new vs existing products, 266 on open accounts, 562 Sales department vs collection department, 570 Sales-to-assets ratio, 88 Sales volume, 298 break-even, 299 break-even point, 300 Salvage value, 274, 279 Sarbanes-Oxley Act, 18, 103, 427, 610 cost and burden of, 68 Savings flow in commercial banks, 40 pooled in hedge funds, 39 pooled in mutual funds, 38–39 pooled in pension funds, 39–40 Savings banks, 40n Scenario analysis, 505 definition, 297 example, 298 and simulation analysis, 297–298 Schiller, Robert, 215n Scholes, Myron, 655, 694, 702 Schrefflen, R., 573n Schwartz, S L., 213 Schwed, Fred, 702 Sealed Air Corporation, 445 capital structure changes, 466–467 Seasoned offering, 431–432 direct costs, 429 Secondary market, 36 definition, 186 Secondary offering, 426 Secondary transactions, 36 Second-stage financing, 425 Second-stage pro formas, 509–510 Secured debt, 411 Secured loans accounts receivable financing, 547 definition, 547 hazards of, 548 inventory financing, 547–548 Securities, 7; see also Bonds; Common stock; Corporate bonds; Preferred stock commercial paper, 36 electronic trading, 35 fixed-income, 578–579 mortgage-backed, 47 private placement, 434–435 relative safety or risk, 320 shelf registration, 433 short-term, 36 at true value, 400 valuation difficulties, 214 wide choice for investors, 319 Securities and Exchange Commission, 16, 18, 548 financial statements filed with, 654 and International Financial Reporting Standards, 68 on private placement, 434 and proxy access, 604 registration statements, 427 Rule 144a, 434 Security market line definition, 355–356 and project acceptance, 361 Security prices, 692–693 Self-liquidating loans, 546 Selling, Thomas I., 92 Semistrong-form efficiency, 211, 693 Senior investors, 415 Sensitivity analysis definition, 295 fixed costs, 295 limitations, 297 net present value, 296 one-at-a-time, 297 for project analysis, 295–296 unknown unknowns, 296 value of information, 297 variable costs, 295 Separation of ownership and control and agency problems, 16–19 and agency theory, 694 definition, downside of, Shareholder risk, 450–451 Shareholders, 7, 8, 404–405 and agency theory, 694 and bankruptcy, 477 blockholders, 18–19 versus bondholders, 463 and control of firms, 603 cost of mergers to, 600–601 delegation of decision making, 11–12 dividend reinvestment plan, 479 effect of financial distress, 462 effect of leverage, 451 effect of opportunity cost of capital, 373–374 and ethics of value maximization, 14–16 income vs debtholders, 92 investments in Home Depot, 81–83 large number of, no-growth stock, 197 ownership of corporations, 406–407 in PeopleSoft proxy fight, 605–606 pressures on managers, 19 proxy contests, 603–604 rates of return for, 375–376 return on equity, 87 rights issues, 432 risk-averse, 12 risk tolerant, 12 and stock dividends, 481–482 and stock splits, 482 use of financial statements, 53 value maximization goal, 11–14 voting procedures majority or cumulative voting, 407 proxy contests, 407 Shareholders’ equity on balance sheet, 55–56 book vs market value, 58 and interest tax shield, 456 Shareholder value created at Home Depot, 86 and financing decisions, 80–81 and investment decisions, 80–81 maximizing, 79 Shark repellent, 606 Sharpe, William F., 345, 702 04/08/11 6:50 PM Confirming Pages IND-22 Shearson Lehman Hutton, 607 Shelf registration advantages, 433 definition, 433 financial manager use of, 433 Shivakumar, L., 213 Shortage costs, 536–537 Short sellers, 39 Short-term bonds, 172 Short-term debt, 93 Short-term financial planning, 504 case, 556–557 cash budgeting, 539–543 decisions, 527 links to long-term planning amount of liquidity, 530–531 time horizons, 528 total capital requirements, 528–530 sources of financing bank loans, 545–548 commercial paper, 548–549 tracing changes in cash and working capital, 537–539 working capital, 531–537 Short-term financing line of credit, 545–546 sources commercial paper, 548–549 regular bank loans, 545–546 secured loans, 547–548 Short-term financing plan evaluation, 544–545 example, 543–545 Short-term securities, 36, 559 versus cash, 573 Sidel, R., 487 Sight draft, 562 Simple interest, 114 Simulation analysis, 297–298 Sinking fund, 410 Skinner, Douglas, 485n Small Business Administration, 475n Small businesses, credit scoring, 566 Small-firm vs large-firm stocks, 358 Smith, Fred, 462 Soft rationing, 249 Sole proprietorships, Solera, Sherry, 21 Southern California Edison, 549 Special dividends, 480 Specialist in stock trading, 186 Specialist monitoring, 18 Special-purpose entities, Enron, 103, 413–414 Specific risk, 334 versus market risk, 333–334, 345 Speculation, 684 Speculative bubbles, 696, 698 Speculative grade bonds, 174–175 Spinning, 431 bre34647_ndx_IND-IND28.indd IND22 Subject Index Spin-offs, 610 by 3Com, 611 Spot price, 679 Spread, 160, 176, 427 Spreadsheets annuity present value, 137 Black-Scholes option pricing model, 657 bond valuation, 170–171 for calculating risk, 347 cash budget, 540 for financial planning, 511 future value calculation, 122–123 interest rates, 124 multiple cash flows, 128 present value calculation, 122–123 present value of cash flows, 233 short-term financing plan, 542–544 Squared deviations, 326 Stafford, E., 611n Stakeholders definition, 17 effect of financial distress, 462 in LBOs, 609 relation to companies, 17–18 Standard and Poor’s, 174–175, 329, 411, 563, 579 Standard and Poor’s Composite/500 Index, 43–44, 319, 346, 348, 351–352 Standard and Poor’s Depository Receipts, 43–44 Standard deviation, 334 calculating, 326 Consolidated Edison, 346 definition, 325 Dow Chemical, 346 of returns, 332 selected common stocks, 329 Standard deviation of returns, 328 Starbucks, 18, 330, 350, 359, 385 Start-ups business plan, 424 capital requirements, 423 Federal Express, first-stage financing, 424 initial public offerings, 426–430 second-stage financing, 425 venture capital for, 424–425 State laws blue-sky laws, 427 dividend restrictions, 481 Statement of account, 570 Statement of cash flow definition, 63 free cash flow, 65 of Home Depot, 63–64 items on, 63–65 Statement of shareholders’ equity, 54n Staunton, Mike, 320, 321, 324, 325, 327, 328 Stern Stewart & Company, 84, 537 Stertz, Bradley A., 593n Stewart, G Bennett, III, 537n Stickney, Clyde P., 92 Stock, 7; see also Common stock; Preferred stock aggressive, 346 amount traded in exchanges, 319 blockholders, 18–19 defensive, 346 exercise price, 646–647 factors affecting returns, 346 measuring variations in returns, 327–329 mergers financed by, 601–602 payoff from holding, 652 primary issue, 35–36 primary offerings, 186 in secondary market, 186 secondary transactions, 36 total market value, 42n Stockbroking firms, 22 Stock dividends, 481–482 Stock exchanges electronic communications networks, 186 limit order book, 187 NASDAQ, 186 New York Stock Exchange, 186 number of stocks traded, 319 Stockholders, 8; see also Shareholder entries Stock market, 31 consolidation, 33 crash of 1929, 24, 329 crash of 2007–2009, 24, 322 decline in 2002, 322 decline in 2008, 14 effects of macro uncertainties, 336–337 efficient market hypothesis, 211–212 as equity market, 36 functions, 35–36 fundamental analysts, 210 historical performance, 319–322 market anomalies earnings announcement puzzle, 212, 213 new issue puzzle, 212–213 and market risk, 43 primary, 186 primary market, 35–36 reaction to stock issues, 433–434 secondary, 186 secondary market, 36 technical analysts, 206 volatility in 1900–2010, 328 Stock market bubbles, 213–214 Stock market listings, 187–189 Stock options, 426, 660 Stock price(s) Amazon vs Con Ed, 190–191 announcement effect, 486 Apple Inc., 423 and asymmetric information, 464 and behavioral finance, 214–215 bid-ask spread, 187 book vs market value, 189–191 and call options, 646 and company values, 46 effect of acquisition news, 611 effect of new issues, 433–434 effect of repurchase on, 484 efficient market hypothesis, 211–212 ex-dividend, 481 fundamental analysis, 210 Google Inc., 423 Home Depot, 81 and intrinsic value, 192–194 liquidation value, 190 Microsoft, 423 and option valuation models, 655–657 overpricing, 429 par value, 405 and put options, 647 random walk, 208–209 reactions to news, 210 reasons for knowing, 185 and rights issues, 432 in selling calls or puts, 647–649 speculative bubbles, 696 technical analysis, 206–210 trading range, 482n underpricing, 427–429 and value of call option, 652–653 yardstick for performance, 426 Stock price quotations, 187–189 Stock repurchase, 405 by Apple Inc., 33 compared to dividends, 483–484 definition, 482 examples, 480 information content, 486–487 means of auction, 483 direct negotiation, 483 greenmail transactions, 483 open-market repurchase, 482–483 tender offer, 483 and share valuation, 484 in U.S 1980–2008, 480 Stock splits, 482 Storage costs, 571 Straight-line depreciation, 275–276 Strategic plans and capital budgeting, 504 purpose, 504 04/08/11 6:50 PM Confirming Pages IND-23 Subject Index Strategy matched with capital budget, 292 Stream of cash flows, 124 Strips definition, 171–172 measure of yield curve, 171–172 yield in May 2010, 172 Strong-form efficiency, 211, 693 Structured investment vehicles, 95 Stuyvesant, Peter, 24 Subordinated debt, 411 Subprime mortgage market, 698 Subprime mortgages, 25, 47, 66, 415 mark-to-market accounting, 67 Sunbeam Corporation, 66 Sunk costs, ignoring, 266–267 Sun Life Financial, 592 Sun Microsystems, 480 Surplus funds, merger as use for, 595 Sustainable growth rate, 203–204, 518 calculating, 97 definition, 97–98 variability in, 98 Swaps counterparties, 681 credit-default, 683–684 currency swaps, 682–683 definition, 681 interest rate swaps, 681–682 for risk reduction, 681–683 Sweep programs, 573–574 Synergies elusive, 594 mergers to create, 593–594 Systematic risk, 334 T Takeovers, 19 case, 616 effect of threat on managers, 612 free-cash-flow theory, 609 hostile, 604–607 Oracle and PeopleSoft, 605–607 poison pills, 605–607 by proxy contests, 603–604 shark repellent, 606 tender offer, 604 unsuccessful, 604 Tangible assets, 3, on balance sheet, 54 easy to sell, 307 heavy investment in, 227 investment in, 113 Target dividend, 485 Target payout ratio, 485 Target Stores, 536, 624 Taxable income, 70 bre34647_ndx_IND-IND28.indd IND23 Taxation advantage for partnerships, capital gains, 70, 493 capital structure and, 454–458 and changes in capital structure, 386–387 corporate tax, 68–69 and cost of capital, 371 depreciation deduction, 272 depreciation tax shield, 277–279 disadvantage for corporations, disadvantages in borrowing, 458 and dividend policy, 492, 493 double taxation, 9n on individual income, 70 interest tax shield, 455–456 and LBOs, 608–609 and municipal bonds, 174n personal tax, 69–70 and preferred stock dividends, 408 and WACC, 377 Tax payments, 541 Tax rates on corporations, 68 personal taxes, 70 Tax shield, 85n; see also Depreciation tax shield; Interest tax shield Technical analysis, 206–210 Technical analysts, 206 TED spread, 546 Tender offer, 483, 604 definition, 598 10K reports, 54 10Q reports, 54 Terminal cash flow vs incremental cash flow, 268 Terminal value, 201 Terms lag, 582 Terms of sale cash before delivery, 560 cash on delivery, 560 credit sales, 560–561 definition, 560 due lag, 582 end-of-month sales, 561 implicit annual interest rate, 561 pay lag, 582 terms lag, 582 trade credit interest rates, 561 Tesla Motors, 440n Texas Instruments, 703 Thaler, R H., 611 Com, 611 Ticketmaster, 703 Tiffany & Company, 536 Tight money policy, 163 Time deposits, 531 Time draft, 562 Time horizon of investors, 194–197 long-term financial planning, 504 long- vs short-term financial planning, 528 Time line for future value, 125 Times interest earned ratio, 94 Time value of money annuity due, 136–137 definition, 117 effective annual interest rate, 138–139 future value of annuity, 133–135 future values, 114–117 and inflation and interest rates, 141–142 real vs nominal calculations, 144 real vs nominal cash flows, 139–141 valuing real cash payments, 143–144 level cash flows, 127–135 multiple cash flows, 124–126, 128 present values, 114–124 Time Warner, Inc., 175, 610 Timing option, 307–308 TIPS; see Treasury Inflation Protected Securities Total capitalization, 84 for selected companies, 84 Total capital requirements finding best level of advantages of liquidity, 530 matching maturities, 529–530 permanent working capital requirement, 530 for long- vs short-term financing, 528–530 seasonal variations, 528 Total project cash flow, 276 Total return on bonds, 167 yield to maturity as measure of, 168 Total risk and market risk, 350 Trade acceptance, 562 Trade credit, 531 credit scoring for, 563–565 definition, 560 source of funds, 570 Trade-off theory of capital structure, 459, 463–464 Trading range, 482n Transaction costs, 573 Transactions effect on balance sheet, 62–63 effect on income statement, 62–63 Transparency, 103 Trans Union, 563n Trans World Airlines (TWA), 476 Treasurer, 10 Treasury bills, 531 historical returns, 325 least risky investment, 352 in money market, 579 performance since 1900, 320–322 rate of return 1981, 322–323 rate of return 2011, 323 safety of, 320 standard deviation of returns, 328 Treasury bonds, 159 auction in 2003, 160 auction sales, 431 compared to corporate bonds, 174 historical returns, 325 interest rates, 161–166 performance since 1900, 320–322 price fluctuations, 320 prices vs corporate bonds, 698 rate of return vs yield to maturity, 168–169 real interest rate, 172–173 standard deviation of returns, 328 strips, 171–172 trading of, 126 yield to maturity, 167 Treasury Department, purchase of toxic mortgage-backed securities, 48 Treasury Inflation Protected Securities, 25, 173 Treasury stock, 405 Triple-A bonds, 411 Tropicana, 609 Troubled Asset Relief Program, 487 True value, 400 Trust, in financial transactions, 15 Truth-in-lending laws, 138n Tyco International, 17 U Underpricing, 430 definition, 427 disadvantage, 428 and investor returns, 429 reasons for, 427–428 Underwriters best efforts basis, 427 and costs of general cash offer, 433 definition, 427 firm commitment, 427 largest in U.S., 431 road shows, 427 services performed by, 431 spinning by, 431 warrants for, 659 04/08/11 6:50 PM Confirming Pages IND-24 Underwriters’ spread, 427, 430 Unfunded debt, 409 Union Pacific, 6, 13–14 dividend dates, 481 dividend reinvestment plan, 479 investment and financing decisions, stock repurchase, 482 UnitedHealth Group Inc., 660 United States dividends/stock repurchase 1980–2008, 480 dot-com bubble, 213 inflation rate 1900–2010, 140 labeling corporations, 8n mergers 1962–2009, 591, 592 payment systems, 576 real estate bubble, 213 risk premium, 323, 324 tax system, 9n Universal Studios, 516, 604 Unlimited liability, Unocal, 599 US Airways Group Inc., 8n U.S Robotics, 611 V VA Linux, 431 Valuation by comparables, 191–192, 202 Valuation errors, 202 Value; see also Future value; Present value of call option at expiration, 646 created with financing decisions, 400 of entire businesses, 387–389 of no-growth stock, 197 of put option at expiration, 647 of real cash payments, 143–144 Value added and cost of capital, 84 financial ratios to understand, 80–81 by managers, 79 from real options, 306 Value Line Investment Survey, 98n Value maximization, ethics of, 14–16 goal of shareholders, 11–14 and investment trade-off, 13–14 and managers agency problems, 16–19 and blockholders, 18 and board of directors, 18 and compensation plans, 18–19 legal/regulatory requirements, 18 shareholder pressure, 19 specialist monitoring, 18 and stakeholders, 17–18 takeovers, 19 bre34647_ndx_IND-IND28.indd IND24 Subject Index opportunity cost of capital, 14 and profit maximization, 12–13 Value of the firm bases of, 465–466 and capital structure, 446–454, 697 components, 93 definition, 79 destroying, 79 and human assets, 593 impact of payout decisions, 489 and liquidation value, 190 market capitalization, 81–84 market-to-book ratio, 83 market vs asset values, 696–697 MM proposition I, 446–448 Value stocks, 358 Vanguard Explorer Fund, 38, 351 Vanguard 500 Index, 43 Vanguard Index fund, 354 Vanguard Index Trust 500, 352 Vanguard Total Stock Market index, 44 Van Kampen Merritt, 413 Variable costs, 295 linked to sales, 303 and operating leverage, 303–305 Variables in scenario analysis, 297–298 in sensitivity analysis, 297 trade-off between, 303 Variance, 324–327 calculating, 327 definition, 325 Venture capital, 33 and business plan, 424 definition, 424 first-stage financing, 424 second-stage financing, 425 Venture capital firms, 423, 425–426 Venture capitalists, 4, Verizon Communications, 227, 504, 505 Vertical integration economics of, 594–595 versus outsourcing, 595 Vertical merger, 592 Visa International initial public offering, 430 Vlasic, Bill, 593n Voting procedures with common stock, 407 lacking with preferred stock, 408 Vulture funds, 39 W WACC; see Weighted average cost of capital Wachovia, 25, 592, 703 Wall Street Journal, 160, 185, 199, 202, 204, 660 stock market listings, 187 Wall Street Walk, 19 Walmart, 6, 11, 83, 84, 85, 189, 192, 329, 350, 359, 385, 456, 480, 573, 624 investment and financing decisions, Walmart strategy, 91 Walt Disney Company, 329, 350, 359, 365, 385, 604, 703 Warrants, 415, 659 Washington Mutual, 404 Weak-form efficiency, 211, 693 Webb, Susan, 21 Weighted average cost of capital, 84n, 85n, 373–380 accuracy of, 379–380 calculating expected returns on bonds, 382 expected returns on common stock, 382–383 expected returns on preferred stock, 383–384 summary, 384 using market value, 380–381 calculating company cost of capital, 374–377 case, 394–396 corporate tax and debt policy, 456–458 definition, 377 Dow Chemical, 377–378 Ford Motor Company, 384n formula, 377 Geothermal Corporation, 379–380 interpreting common mistakes, 385–386 corporate taxes, 387 effect on returns with capital structure changes, 386–387 when unusable, 384–385 managerial use of, 371 measuring capital structure, 380–381 multiple sources of capital, 378 with preferred stock, 378 real-company, 384 for selected companies, 385 and taxes, 377–378 valuing entire businesses, 387–389 Weiss, L A., 460n Wells-Fargo, 586, 592, 703 Wendy’s International, 524 What-if questions, 291, 505 on cash balances, 543 crucial to capital budgeting, 295 function of, 294 scenario analysis, 297–298 sensitivity analysis, 295–297 Whole Foods Market, 599 Wickes Furniture, 609 Wildcat oil wells, 335 Wild Oats Markets, 599 Wilhelm, W J., Jr., 16 Williams Act of 1968, 605n Williamson, R., 530–531 Wilshire 5000 Market Index, 211 Window dressing, 67 Wind power project, 279 Winner’s curse, 428 Wire transfer, 577–578 Working capital, 559 additional investment in, 268 and cash conversion cycle, 533–536 cash flow from changes in, 273–274 changes in, 276 components changing with cycle of operations, 533–534 current assets, 531–532 current liabilities, 532–533 forecasting, 277 mistakes in forecasting, 268 permanent requirements, 530n recognizing investment in, 267–268 tracing changes in, 537–539 Working capital management, 536 accounts receivable credit policy, 560–571 case, 588 cash management, 573–578 inventory management, 571–573 investing idle cash, 578–580 and money market, 578–580 Working capital trade-off carrying costs, 536 costs and benefits of investment in, 536–537 shortage costs, 536–537 Workout, 475 WorldCom, 18, 67, 175, 427 Wozniak, Steven, 423 Wruck, K H., 466, 532 Wurgler, J., 482n Wyeth, 592 Wynn Resorts, 586 X Xerox Corporation, 66, 82, 83, 84 XTO Energy, 592 04/08/11 6:50 PM Confirming Pages IND-25 Subject Index Y Yahoo!, 19, 187 Yahoo! Finance, 56 Yield on corporate bonds, 142, 175 on money market investments corporate vs government securities, 580 default risk, 580 in recent market turmoil, 580 bre34647_ndx_IND-IND28.indd IND25 short- vs long-term bonds, 172 on TIPS in 2010, 173 Yield curve definition, 171 nominal vs real interest rate, 172–174 upward-sloping, 172 Yield spread, Treasury vs corporate bonds, 175–176 Yield to maturity, 160, 161 and current yield, 167 definition, 167 measure of total return interest rate fluctuations, 168 trial and error calculation, 168 promised vs expected, 177 versus rate of return, 168–169 selected corporate bonds, 175 for Treasury bonds, 167 Z Zack’s, 201n Zero-coupon bond, 120n, 177 Zero net present value, 242, 247 and project cash flows, 380 Zero-stage investment, 424 Zero-sum game, hedging as, 672 Zhao Quanshui, 429n Ziemba, W T., 213 Z-score model, 565 04/08/11 6:50 PM bre34647_ndx_IND-IND28.indd IND26 04/08/11 6:50 PM SOME USEFUL FACTS AND FORMULAS Return on Assets (16.1) Working Capital Management Return on assets equals the weighted average of the returns of the firm’s outstanding securities: Effective Annual Rate on Trade Credit (20.1) DuPont Formulas (4.5) Constant-Growth Dividend Discount Model (7.4) Return on assets asset turnover profit margin assets Return on equity asset turnover equity profit margin debt burden If the initial dividend is DIV1 (paid in year), and if the dividend grows thereafter at a constant rate of g, the present value rassets rdebt DIV1 of the dividend stream is P0 r – g (assuming no taxes) D E requity V V ( Effective annual rate 1 Capital Budgeting Future Value (5.1) Break-Even Point (10.3) The value to which a $1 investment will grow after t years with compound interest at an annual interest rate of r percent is FV (1 r)t The sales revenue necessary for the firm to break even (in terms of accounting profits) is Break-even revenue Present Value (5.2) The value today of $1 to be received in t years is PV (1 r)t fixed costs including depreciation additional profit from each additional dollar of sales Annuities (5.4) Operating Leverage (10.3) The present value of a stream of income of $1 per year for 1 t years is PV r r (1 r)t The future value of a stream of income of $1 per year for t years (1 r)t is FV r The degree of operating leverage, DOL, is the sensitivity of profits to changes in sales: Effective Annual Rate (5.6) Risk and Return The annually compounded rate on a loan given a stated APR and m compounding periods per year is Measures of Risk and Return (11.3, 12.1) Effective annual rate 1 APR m m 21 Real Versus Nominal Quantities (5.7) The purchasing power of a future cash flow in terms of today’s dollars is nominal cash flow Real value of cash flow at time t (1 inflation rate)t The growth of purchasing power from an investment is 1 nominal interest rate 21 1 inflation rate < nominal rate inflation rate DOL percentage change in profits fixed costs 511 percentage change in sales profits ) 365/extra days credit 21 International Finance (22.2) Value of Interest Tax Shields (16.2) Time Value of Money discount discounted price If a firm maintains a fixed amount of debt in perpetuity, then the present value of the tax savings equals Tc Debt Financial Planning Internal Growth Rate (18.4) The steady rate at which a firm can grow without issuing new debt or equity is equity Plowback ratio return on equity assets Sustainable Growth Rate (18.4) Interest rate parity: 1 rforeign fforeign/$ 5s 1 r$ foreign/$ where r is the interest rate, s is the spot exchange rate, and f is the forward exchange rate International Fisher effect: 1 rforeign 1 iforeign 1 r$ 1 i$ where r is the interest rate and i is the inflation rate Expectations theory: fforeign/$ E(sforeign/$) sforeign/$ sforeign/$ Purchasing power parity: 1 iforeign E(sforeign/$) 1 i$ sforeign/$ The steady rate at which a firm can grow without issuing new equity or changing leverage is Plowback ratio return on equity Cash Conversion Cycle (19.2) Inventory period receivables period accounts payable period Mean or expected return probability-weighted average of possible outcomes Variance s2 mean of squared deviations around the mean Standard deviation s ỴVariance Beta b Expected increase in stock return for an extra 1% increase in the return on the market index Capital Asset Pricing Model (12.2) The expected rate of return on a risky security equals the rate of return on risk-free assets plus a risk premium that depends on the security beta: Real interest rate r rf b(rm rf) Stock Valuation Capital Structure Dividend Discount Model (7.3) The value of a share of stock equals the present value of dividends paid until the horizon date, H, plus the present value of the anticipated sales price of the stock, PH P0 DIV1 11r DIV2 (1 r) 1 DIVH PH (1 r)H Weighted-Average Cost of Capital (13.2) D E WACC c rdebt(1 Tc)d requity V V where Tc is the corporate tax rate, D is debt, E is equity, and V D E bre34647_endsheet.indd ISBN: 0078034647 Author: Richard Brealey, Stewart Myers Title: Fundamentals of Corporate Finance, 7/e 23/06/11 7:39 AM back endsheets Color: color Pages: 2,3 ... Jordan Fundamentals of Corporate Finance Ninth Edition Shefrin Behavioral Corporate Finance: Decisions that Create Value First Edition Brealey, Myers, and Marcus Fundamentals of Corporate Finance. .. Principles of Corporate Finance Tenth Edition Brealey, Myers, and Allen Principles of Corporate Finance, Concise Second Edition Ross, Westerfield and Jordan Essentials of Corporate Finance Seventh... author (with Professor Myers and Franklin Allen) of this book’s sister text, Principles of Corporate Finance Stewart C Myers Gordon Y Billard Professor of Finance at MIT’s Sloan School of Management