Financial markets and corporate strategy grinblatt titman

Front Matter • About the Authors • Foreword Add View pp • Preface I Financial Markets and Financial Instruments Add View pg • Introduction Add View 27 pp • Raising Capital Add View 39 pp • Debt Financing Add View 26 pp • Equity Financing II Valuing Financial Assets Add View pp • Introduction Add View 33 pp • Portfolio Tools • Mean-Variance Analysis and the Capital Asset Pricing Add View 45 pp Model Add View 39 pp • Factor Models and the Arbitrage Pricing Theory Add View 43 pp • Pricing Derivatives Add View 42 pp • Options III Valuing Real Assets Add View pp • Introduction Add View 28 pp • Discounting and Valuation Add View 41 pp • 10 Investing in Risk-Free Projects Add View 52 pp • 11 Investing in Risky Projects Add View 38 pp • 12 Allocating Capital and Corporate Strategy • 13 Corporate Taxes and the Impact of Financing on Real Add View 37 pp Asset Valuation IV Capital Structure Add View pp • Introduction Add View 31 pp • 14 How Taxes Affect Financing Choices Add View 26 pp • 15 How Taxes Affect Dividends and Share Repurchases • 16 Bankruptcy Costs and Debt Holder-Equity Holder Add View 38 pp Conflicts Add View 30 pp • 17 Capital Structure and Corporate Strategy V Incentives, Information, and Corporate Control Add View pp • Introduction Add View pg Add View pg • 18 How Managerial Incentives Affect Financial Decisions • 19 The Information Conveyed by Financial Decisions Add View 46 pp • 20 Mergers and Acquisitions VI Risk Management Add View pp • Introduction Add View 34 pp • 21 Risk Management and Corporate Strategy Add View 45 pp • 22 The Practice of Hedging Add View 38 pp • 23 Interest Rate Risk Management Back Matter Add View pp • End Papers Add View pp • Appendix A Add View 16 pp • Index Add View 29 pp Add View 35 pp Grinblatt−Titman: Financial Markets and Corporate Strategy, Second Edition Back Matter © The McGraw−Hill Companies, 2002 End Papers Practical Insights for Financial Managers Practical Insights is a unique feature of this text (found at the end of each part) that contains guidelines to help you identify the important issues faced by financial managers The following table shows the tasks of financial managers (e.g., Allocating Capital for Real Investment, Financing the Firm, Knowing Whether and How to Hedge Risk, and Allocating Funds for Financial Investments) and the key Practical Insights relevant to each of these tasks For example, to locate Practical Insights on Allocating Capital for Real Investments, you would look under that task, determine which Practical Insight applies to the issue you wish to know more about, and then reference the far left-hand column to determine which Part it is located under The Practical Insights feature enables the book to serve as a reference as well as a primer on finance We hope you find it useful Allocating Capital for Real Investment Part I Financial Markets and Financial Instruments Part II Valuing Financial Assets Part III Valuing Real Assets Financing the Firm Be familiar with the various sources of financing Understand the legal and institutional environment for financing Know how projects affect the risk of the firm: • Individual projects • Acquisitions Know how to value the financial instruments considered for financing Knowing Whether and How to Hedge Risk Allocating Funds for Financial Investments Understand the financial instruments that can be used for hedging Understand the financial instruments available for investment and the markets in which they trade Be familiar with the market environment in which hedging takes place Know how to value a hedging instrument Derive a proper mix of individual assets Compute discount rates or risk associated with portfolio of financial assets that tracks the real asset cash flows Know what forecasts of cash flows should do: • Estimate mean • Sometimes adjust for risk Determine whether investments are fairly valued Understand risk and return of financial investments and mixtures of various financial investments Understand how taxes affect the costs of various financial instruments (see also Part IV) Estimate a portfolio of financial assets that track cash flows Understand pitfalls in various methods of obtaining present value Analyze how financing and taxes affect valuation Identify where value in projects comes from: • Estimated cash flows • Growth opportunities Part IV Capital Structure Analyze how financing and taxes affect capital allocation decisions Determine an optimal debt/equity ratio Know how financing affects real investment decisions Know how financing affects operating decisions Part V Incentives, Information, and Corporate Control Consider effects of delegated decisions: • Incentives • Asymmetric information Part VI Risk Management Determine whether to focus capital on a few projects or diversify Determine the proper mix of asset classes Understand the relation between financing and managerial incentives Understand the information communicated by financing decisions Understand how value is created by hedging Design and implement a hedging strategy Grinblatt−Titman: Financial Markets and Corporate Strategy, Second Edition Back Matter End Papers © The McGraw−Hill Companies, 2002 Excellence makes its mark “Integrating capital structure and corporate financial decisions with corporate strategy has been a central area of research in finance and economics for more than a decade and it has clearly changed the way we think about these matters What is remarkable about this book is that it can take this relatively new material and so comfortably and seamlessly knit it together with more traditional approaches to give the reader such a clear understanding of corporate finance Anyone who wants to probe more deeply into financial decision making and understand its relation to corporate strategy should read this text Nor is this a book that will gather dust when the course is over; it will become part of every reader’s tool kit and they will turn back to it often I know that I will.” Stephen A Ross, Yale University “Financial Markets and Corporate Strategy is a thorough, authoritative, yet readable text that covers the material in a modern and analytically cohesive manner It’s the first book I go to when I need to look something up.” James Angel, Georgetown University “An increasingly standard text for advanced finance courses the book should be on every top financial executive’s bookshelf.” Campbell Harvey, Duke University “Grinblatt and Titman is indispensable for the student who wants to gain a deep understanding of financial markets and valuation, and wants to learn how to carry this understanding to real-world decisions It presents concepts lucidly yet with rigor, and integrates theory with institutional sophistication Every serious student of finance, from the untried undergraduate to the battle-scarred practitioner, from the hungry MBA student to the cerebral academician, should own a copy—no, two copies—for the office and at home.” David Hirshleifer, Ohio State University “Perhaps the most modern, cutting-edge textbook around Well worth a close look for anyone teaching finance, be it for an introductory, intermediate, or advanced course.” Ivo Welch, Yale University Grinblatt−Titman: Financial Markets and Corporate Strategy, Second Edition Front Matter © The McGraw−Hill Companies, 2002 About the Authors About the Authors Mark Grinblatt, University of California at Los Angeles Mark Grinblatt is Professor of Finance at UCLA’s Anderson School, where he began his career in 1981 after graduate work at Yale University He is also a director on the board of Salomon Swapco, Inc., a consultant to numerous firms, and an associate editor of the Journal of Financial and Quantitative Analysis and the Review of Financial Studies From 1987 to 1989, Professor Grinblatt was a visiting professor at the Wharton School, and, while on leave from UCLA in 1989 and 1990, he was a vicepresident for Salomon Brothers, Inc., valuing complex derivatives for the fixed income arbitrage trading group in the firm In 1999 and 2000, Professor Grinblatt was a visiting fellow at Yale’s International Center for Finance Professor Grinblatt is a noted teacher at UCLA, having been awarded teacher of the year for UCLA’s Fully Employed MBA Program by a vote of the students This award was based on his teaching of a course designed around early drafts of this textbook Professor Grinblatt’s areas of expertise include investments, performance evaluation of fund managers, fixed income markets, corporate finance, and derivatives Sheridan Titman, University of Texas—Austin Sheridan Titman holds the Walter W McAllister Centennial Chair in Financial Services at the University of Texas He is also a research associate of the National Bureau of Economic Research Professor Titman began his academic career in 1980 at UCLA, where he served as the department chair for the finance group and as the vice-chairman of the UCLA management school faculty He designed executive education programs in corporate financial strategy at UCLA and the Hong Kong University of Science and Technology, based on material developed for this textbook In the 1988–89 academic year Professor Titman worked in Washington, D.C., as the special assistant to the Assistant Secretary of the Treasury for Economic Policy, where he analyzed proposed legislation related to the stock and futures markets, leveraged buyouts and takeovers Between 1992 and 1994, he served as a founding professor of the School of Business and Management at the Hong Kong University of Science and Technology, where his duties included the vice chairmanship of the faculty and chairmanship of the faculty appointments committee From 1994 to 1997 he was the John J Collins, S.J Chair in International Finance at Boston College Professor Titman has served on the editorial boards of the leading academic finance journals, was an editor of the Review of Financial Studies, and a past director of the American Finance Association and the Western Finance Association He is the founding managing editor of the International Review of Finance and current director of the Asia Pacific Finance Association and the Financial Management Association He has won a number of awards for his research excellence, including the Batterymarch fellowship in 1985, which was given to the most promising assistant professors of finance, and the Smith Breeden prize for the best paper published in the Journal of Finance in 1997 v Grinblatt−Titman: Financial Markets and Corporate Strategy, Second Edition Front Matter © The McGraw−Hill Companies, 2002 Foreword Foreword After an introduction to corporate finance, students generally experience the subject as fragmenting into a variety of specialized areas, such as investments, derivatives markets, and fixed income, to name a few What is often overlooked is the opportunity to introduce these topics as integral components of corporate finance and corporate decision making Before now, it was difficult to convey this important connection between corporate finance and financial markets By doing just that, this book simultaneously serves as a basis of and a practical reference for all further study and experience in financial management The central corporate financial questions address which projects to accept and how to finance them This text recognizes that to provide a framework to answer these questions, along with the associated issues of corporate finance and corporate strategy that they raise, requires a deep understanding of the financial markets The book begins by describing the financing instruments available to the firm and how they are priced It then develops the logic, the models, and the intuitions of modern financial decision making from portfolio theory through options and on to tax effects The treatment focuses on project evaluation and the uses of capital and financial vi structure, and it is enriched with a wealth of real world examples The questions raised by managerial incentives and differences in the information held by management and the financial markets are also taken up in detail, supplementing the familiar treatment of the tradeoffs between taxes and bankruptcy costs Lastly, and wholly appropriately, financial decision making is shown to be an essential part of the overall challenge of risk management Integrating capital structure and corporate financial decisions with corporate strategy has been a central area of research in finance and economics for the last two decades, and it has clearly changed the way we think about these matters What is remarkable about this book is that it can take this relatively new material and so comfortably and seamlessly knit it together with more traditional approaches to give the reader such a clear understanding of corporate finance Anyone who wants to probe more deeply into financial decision making and understand its relation to corporate strategy should read this text Nor is this a book that will gather dust when the course is over; it will become part of every reader’s tool kit and they will turn back to it often I know that I will Stephen A Ross Grinblatt−Titman: Financial Markets and Corporate Strategy, Second Edition Front Matter Preface © The McGraw−Hill Companies, 2002 Preface Textbooks can influence the lives of people We know this firsthand As high school students, each of us read a textbook that ignited our interests in the field of economics This text, Economics by Paul Samuelson, resulted in our separate decisions to study economics in college, which, in turn, led to graduate school in this field There, each of us had the great fortune to study under some exceptional teachers (including the author of the foreward to this text) who stimulated our interest in finance Satisfying, rewarding careers have blessed us ever since To Paul Samuelson and his textbook, we owe a debt of gratitude As young assistant professors at UCLA in the early 1980s, we discovered that teaching a comprehensive course in finance could be a valuable way to learn about the field of finance Our course preparations invariably sparked discussion and debates about points made in the textbooks used to teach our classes, which helped to jumpstart our scholarly writing and professional careers These discussions and debates eventually evolved into a long-term research collaboration in many areas of finance, reflected in our coauthorship of numerous published research papers over the past two decades and culminating in our ultimate collaboration—this textbook We began writing the first edition of this textbook in early 1988 It took almost 10 years to complete this effort because we did not want to write an ordinary textbook Our goal was to write a book that would break new ground in both the understanding and explanation of finance and its practice We wanted to write a book that would influence the way people think about, teach, and practice finance It would be a book that would elevate the level of discussion and analysis in the classroom, in the corporate boardroom, and in the conference rooms of Wall Street firms We wanted a book that would sit on the shelves of financial executives as a useful reference manual, long after the executives had studied the text and received a degree About the Second Edition The success of the first edition of Financial Markets and Corporate Strategy was heartening The market for this text has expanded every year, and it is well known around the world as the cutting-edge textbook in corporate finance The book is used in a vii Grinblatt−Titman: Financial Markets and Corporate Strategy, Second Edition viii Front Matter Preface © The McGraw−Hill Companies, 2002 Preface variety of courses, including both introductory core courses and advanced electives Some schools have even designed their curricula around this text We have developed a second edition based on the comments of many reviewers and colleagues, producing what we think is a more reader-friendly book The most consistent comment from users of the first edition was a request for a chapter on the key ingredients of valuation: accounting, cash flows, and basic discounting This ultimately led to an entirely new chapter in the text, Chapter In almost every chapter, examples were updated, vignettes were changed, numbers were modified, statements were checked for currency, clarity, and historical accuracy, and exercises and examples were either modified or expanded Even the introductions to the various parts of the text were modified For example, data on capital budgeting techniques in use were liberally sprinkled into the introduction to Part III The new edition also includes a number of additions that we hope will broaden its appeal These include: • • • • • • • • • • • • • • • • • • a discussion of Germany’s Neuer Markt, designed for stocks of new growth companies in Chapter a discussion of the Internet company boom and bust and the reasons for it in Chapter a short section on private equity in Chapter a discussion of the collapse of Long Term Capital Management (LTCM) and the risks associated with arbitrage in Chapter a discussion about the lessons learned from the fate of LTCM in Chapter a new section about market frictions and their implications for derivative securities pricing and the management of derivatives portfolios in Chapter an expanded section on covered interest rate parity in Chapter more in-depth discussion of the equivalent annual benefit approach in Chapter 10 an expanded discussion of the distinction between firm betas and project betas, and several new explanations for why these might differ, in Chapter 11 a discussion of Amgen and why growth companies with near horizon research costs and deferred profitability of projects generated by that research tend to have high betas, in Chapter 11 an expanded discussion of pitfalls when using comparisons with the riskadjusted discount rate method in Chapter 11 a completely fresh approach to the understanding of WACC adjusted cost of capital formulas in Chapter 13 step-by-step recipes for doing a valuation with the risk-adjusted discount rate method in Chapters 11 and 13 a rewritten discussion of the tax benefits of internal financing in Chapter 15 a new section on project financing in Chapter 16 a revised discussion of the Miller-Rock dividend signalling model in Chapter 19 an analysis of California’s 2000–01 electricity crisis in Chapter 21 a retrospective on how merger activity has changed since the 1st edition in Chapter 21 With the second edition, and with all future editions, our goal is to make the book ever more practical, pedagogically effective, and current All suggestions and comments continue to be welcome Grinblatt−Titman: Financial Markets and Corporate Strategy, Second Edition Front Matter Preface Preface © The McGraw−Hill Companies, 2002 ix The Need for This Text The changes witnessed since the early 1980s in both the theory of finance and its practice make the pedagogy of finance never more challenging than it is today Since the early 1980s, the level of sophistication needed by financial managers has increased substantially Managers now have access to a myriad of financing alternatives as well as futures and other derivative securities that, if used correctly, can increase value and decrease the risk exposure of their firms Markets have also become more competitive and less forgiving of bad judgment Although the amount of wealth created in financial markets in these past years has been unprecedented, the wealth lost by finance professionals in a number of serious mishaps has received even more attention Today, there is a unique opportunity for the financial manager Clearly, the returns to having even a slight edge in the ability to evaluate and structure corporate investments and financial securities have never been so high Yet, while the possibilities seem so great, the world of finance has never seemed so complex As our understanding of financial markets has grown more sophisticated, so has the practice of trading and valuing financial securities in these markets At the same time, our understanding of how corporations can create value through their financial decisions has also advanced, suggesting that financial management is on the verge of a similar transformation to that seen in the financial markets We believe that successful corporate managers will be those who can take advantage of the growing sophistication of the financial markets The key to this will be the ability to take the lessons learned from the financial markets and apply them to the world of corporate financial management and strategy The knowledge and tools that will enable the financial manager to transfer this knowledge from the markets arena to the corporate arena are found within this text Intended Audience This book provides an in-depth analysis of financial theory, empirical work, and practice It is primarily designed as a text for a second course in corporate finance for MBAs and advanced undergraduates The text can stand alone or in tandem with cases Because the book is self-contained, we also envision this as a textbook for a first course in finance for highly motivated students with some previous finance background The book’s applications are intuitive, largely nontechnical, and geared toward helping the corporate manager formulate policies and financial strategies that maximize firm value However, the formulation of corporate strategy requires an understanding of corporate securities and how they are valued The depth with which we explore how to value financial securities also makes about half of this book appropriate for the Wall Street professional, including those on the sales and trading side The Underlying Philosophy We believe that finance is not a set of topics or a set of formulas Rather, it is the consistent application of a few sensible rules and themes We have searched long and hard for the threads that weave finance theory together, on both the corporate and investment side, and have tried to integrate the approach to finance used here by repeating these common rules and themes whenever possible A common theme that appears throughout the book is that capital assets must be valued in a way that rules out the possibility of riskless arbitrage We illustrate how Grinblatt−Titman: Financial Markets and Corporate Strategy, Second Edition x Front Matter Preface © The McGraw−Hill Companies, 2002 Preface this powerful assumption can be used both to price financial securities like bonds and options and to evaluate investment projects To identify whether the pricing of an investment allows one to create wealth, it is generally necessary to construct a portfolio of financial assets that tracks the investment To understand how to construct such tracking portfolios, a part of the text is devoted to developing the mathematics of portfolios A second theme is that financial decisions are interconnected and, therefore, must be incorporated into the overall corporate strategy of the firm For example, a firm’s ability to generate positive net present value projects today depends on its past investment choices as well as its financing choices For the most part, the book takes a prescriptive perspective; in other words, it examines how financial decisions should be made to improve firm value However, the book also takes the descriptive perspective, developing theories that shed light on which financial decisions are made and why, and analyzing the impact of these decisions in financial markets At times, the book’s perspective combines aspects of the descriptive and prescriptive For example, the text analyzes why top management incentives may differ from value maximization and describes how these incentive problems can bias financial decisions as well as how to use financial contracts to alleviate incentive problems This is an up-to-date book, in terms of theoretical developments, empirical results, and practical applications Our detailed analysis of the debate about the applicability of the CAPM, for example (Chapters and 6), cannot be found in any existing corporate finance text The same is true of the book’s treatment of value management (Chapters 10 and 18), practiced by consulting firms like Stern Stewart and Co., BCG/Holt, and McKinsey and Co.; the text’s treatment of hedging with futures contracts and its impact on companies like Metallgesellschaft (Chapter 22); and of its treatment of interest rate risk and its impact on Orange County’s bankruptcy (Chapter 23) Pedagogical Features Our goal was to provide a text that is as simple and accessible as possible without superficially glossing over important details We also wanted a text that would be eminently practical Practicality is embedded from the start of each chapter, which begins with a real-world vignette to motivate the issues in the respective chapter As a pedagogical aid to help the reader understand what should be gleaned from each chapter, the vignettes are immediately preceded by a set of learning objectives, which itemize the chapter’s major lessons that the student should strive to master Learning Objectives After reading this chapter you should be able to: Describe the types of equity securities a firm can issue Provide an overview of the operation of secondary markets for equity Describe the role of institutions in secondary equity markets and in corporate governance Understand the process of going public Discuss the concept of informational efficiency Southern Company is one of the largest producers of electricity in the United States Before 2000, the company was a major player in both the regulated and unregulated electricity markets On September 27, 2000, Southern Energy, Inc (since renamed Mi C i ) h l d di i i fS h C b Grinblatt−Titman: Financial Markets and Corporate Strategy, Second Edition 866 Back Matter Index © The McGraw−Hill Companies, 2002 Name Index Eades, Kenneth, 544n Eckbo, B Espen, 18n, 680e, 681e, 722 Ederington, Louis, 49 Elliot, Gordon, 717, 718 Elton, Edward J., 191, 544 Elton, Edwin, 543 Erb, Claude, 186n Evanson, Paul, 668 Ezzell, John, 483, 484 Fabozzi, Frank, 48e Fama, Eugene, 75, 135, 161n, 164n, 166e, 208, 208n, 209 Faulhaber, Gerald, 85n Fazzari, Steven, 684 Feenberg, Daniel, 540 Finnerty, John, 586n Fisher, Irving, 521 Flannery, Mark J., 682n Flath, David, 589 Ford, Henry, II, 669 Foster, George, 683n Franchi, Dan, 684, 684n Frank, Murray, 544 Frank, Robert H., 652 Franks, Julian R., 560n, 708, 720 French, Kenneth, 164n, 166e, 208, 208n, 209 Frier, Ken, 751n Froot, Ken, 748n Frost, Peter, 16n Frye, Jack, 500 Galai, Dan, 569n Gallagher, T J., 768 Garfinkel, John, 85n Gates, Bill, 551, 552, 555, 634, 675, 757 Gaver, Jennifer J., 646n Gaver, Kenneth M., 646n Gebhardt, Gunther, 740 Geczy, Christopher, 83, 768, 768n Geneen, Harold, 696 Gertner, Robert, 576n, 610n Geske, Robert, 269n Ghosh, Chinmoy, 656n, 668 Giammarino, Ronald M., 722 Gibson, Rajna, 794n Gilovich, Thomas, 652 Gilson, Stuart, 637 Givoly, Dan, 522 Golub, Harvey, 633 Gompers, Paul, 83 Graham, John, 300, 509, 518, 522, 524 Green, Kevin, 51 Green, Richard, 585n Greeniaus, John, 701 Grimm, W T., 693e Grinblatt, Mark, 85n, 164n, 205n, 220n, 250n, 363n, 496, 544n, 671n, 735, 794, 864 Grossman, Sanford J., 639n, 700n, 705n, 724n Gruber, Martin, 191, 543, 544 Grullon, Gustovo, 533e Guedes, Jose, 588n Hall, Brian J., 645, 647 Hamada, Robert, 484, 485 Hammer, Armand, 627, 628, 630 Han, Bing, 363n Handa, Puneet, 157 Hanka, Gordon, 603 Hanley, Kathleen, 87 Hansen, Robert, 18n Harris, Robert S., 708, 720 Hart, Oliver D., 639n, 641n, 700n, 705n, 724n Hartley, Fred, 630 Harvey, Campbell, 186n, 300, 509, 864 Hasbrouck, Joel, 711 Haugen, Robert, 576n Haushalter, David, 769 Hawawini, Gabriel, 165e Hayes, Robert, 425n Hayn, Carla, 522 Hayt, Gregory S., 740n, 768n Healy, Paul, 664, 672n, 712 Heinkel, Robert, 635, 722 Helyar, John, 702n Hermalin, Benjamin, 635n Hess, Patrick, 544n Hirshleifer, David, 683, 864 Hoag, Susan E., 728n Hodder, James, 21n Holderness, Clifford, 636 Holmstrom, Bengt, 697 Hong, Harrison, 164n Hoshi, T., 22n, 583n, 685 Hotchkiss, Edith, 560n Howe, Jonathan, 767 Hsieh, David, 185, 208 Huang, Yen-Sheng, 720 Hubbard, Jeff, 546 Hubbard, R Glenn, 684 Hughes, Howard, 500, 500n, 509, 675 Hughes, Patricia, 671n Huson, Mark, 633 Hussein, Saddam, 183 Hwang, Chuan-Yang, 85n Iacocca, Lee, 257 Icahn, Carl, 631, 702 Ikenberry, David, 683 Ingersoll, Jonathan E., 436n Jagadeesh, Narasimhan, 85n Jagannathan, Ravi, 208, 544 James, Christopher, 682 Jarrell, Gregg A., 588n, 616n, 696n, 707, 710, 710n, 729 Jarrow, R., 165e Jegadeesh, Narasimhan, 166e, 220n, 794 Jenkinson, Tim, 82n Jensen, Michael, 80, 155, 163, 569n, 630, 640n, 641n, 645, 646, 707 Johnson, Bruce, 630n Johnson, H., 565n, 567n Johnson, Ross, 691 Jones, Jennifer, 661 Kalay, Avner, 37, 543 Kaplan, Steven, 467, 663n, 697, 713 Kashyap, Anil, 22n, 583n, 685 Kearney, A John, 748 Keim, Donald, 51, 165e, 545 Keloharju, Matti, 86 Kennedy, Robert D., 706 Kensinger, John, 586n Kerkorian, Kirk, 531, 531n, 532, 541, 620 Kester, W Carl, 19, 52 Khanna, Naveen, 611 Kim, E Han, 544n, 588n, 616n, 708, 709, 710 Klapper, Leora, 796 Kleidon, Allan, 164n Klein, Ben, 700n Koh, Francis, 86 Kole, Stacey, 635n Korajczyk, Robert, 207 Korwar, Ashok N., 681e Kothari, S P., 157, 164n Kuh, Edwin, 684 Kuwahara, Hiroto, 469n Lakonishok, Josef, 168, 168n, 683 Lamont, Owen, 588n Lang, Larry, 588, 610n, 669, 669n, 670e, 703, 710 Lanstein, Ronald, 157 La Porta, Rafael, 634n Lease, Ronald, 541 Lee, Charles, 164n Lee, Inmoo, 16e Leeson, Nick, 757 Lego, Paul, 633 Lehmann, Bruce N., 207 Lehn, Kenneth, 43n, 582, 634, 635, 703, 712 Leland, Hayne, 675n, 679e Lemmon, Michael, 524 Lenz, Randolph, 557 Lessard, Don, 748n Levine, Ross, 634n Levis, M., 164n Lewellen, Wilbur, 541 Lewent, Judy C., 748 Lewis, Michael, 229, 229n Lewis, Tracy R., 607n Liberty, Susan, 661 Lichtenberg, Frank R., 713, 714 Grinblatt−Titman: Financial Markets and Corporate Strategy, Second Edition Back Matter Index 867 Name Index Liebman, Jeffrey B., 645, 647 Lim, Terence, 164n Linn, Scott C., 681e Lintner, John, 131n Lippman, Steven A., 355n Litzenberger, Robert H., 545n, 669, 669n, 670e Ljungqvist, Alexander, 82n Lochhead, Scott, 16e Long, John B., Jr., 546 Long, Michael, 567n, 588n, 616n Lopez-de-Silanes, Florencio, 634n Lorenzo, Frank, 606, 606n, 702, 725 Lorsch, Jay, 629 Loughran, Tim, 78n, 79, 82, 83, 683 Lowenstein, Louis, 661n, 712 Lys, Thomas, 721 MacAuley, Frederick, 848n, 849, 850, 851 MacBeth, James, 161n, 291 MacKie-Mason, Jeffrey K., 522 Majluf, Nicholas S., 613, 676n, 679e Maksimovic, Vojislav, 165e, 601n, 607n Malitz, Ileen, 588n, 616n Malitz, Irene, 567n Margrabe, William, 803n Markowitz, Harry, 97, 98, 131 Marsh, Terry, 164n, 469n Marston, Richard C., 740n, 768n Martin, John, 586n Marx, Groucho, 85 Masulis, Ronald, 18n, 78n, 516n, 544n, 569n, 671n, 680e, 681, 681e Matsusaka, John, 696n, 710n Mauer, David, 588n Mayer, Colin, 708, 720 Mayers, David, 167n McConnell, John, 560n, 635n, 680e McDaniel, M., 581, 582 Means, G., 629 Meckling, William, 569n, 630 Mehran, Hamid, 639, 647 Mello, Antonio, 791, 792 Merton, Robert, 216 Merville, Larry J., 291 Meyer, John Robert, 684 Michaely, Roni, 85n, 533e, 546, 664, 683 Mikkelson, Wayne H., 585, 680e, 681e Miles, James, 483, 484, 651 Milken, Michael, 49, 50 Miller, Merton, 488n, 498, 500, 501, 502, 503, 504, 505, 505n, 506, 509, 525, 526, 527, 529, 529e, 530, 532, 535, 540, 541, 545n, 553, 554, 560, 664n, 679e, 692, 741, 742, 742n, 853 Minton, Bernadette, 768, 768n Mitchell, Mark, 697, 703, 712, 719 Moderhak, Robert, 753 Modest, David M., 207 © The McGraw−Hill Companies, 2002 Modigliani, Franco, 488n, 498, 500, 501, 502, 503, 504, 505, 505n, 506, 509, 525, 526, 527, 532, 535, 553, 554, 560, 692, 741, 742, 742n, 853 Moore, John, 641n Morck, Randall, 634, 635, 710 Moskowitz, Tobias, 164n Mullins, David W., Jr., 51, 664, 681e Murdoch, David, 727 Murphy, Kevin, 80, 630, 645, 646, 647, 648 Muscarella, Chris, 15n, 84 Myers, Stewart C., 564n, 584, 613, 676n, 679e Nammacher, Scott, 50 Nance, Deana R., 768, 768n Nanda, Vikram, 78n Narayanan, M P., 662n Nash, Rob, 582n Netter, Jeff, 582n, 707 Neuberger, Anthony, 809 Ofek, Eli, 588, 710 Ofer, Aharon, 522 Olsen, Chris, 683n Opler, Tim, 588n, 610, 610n, 713, 714 Palepu, Krishna, 664, 672n, 712 Parrino, Robert, 633 Parsons, John, 791, 792 Partch, Megan M., 680e, 681e Patel, Sandeep, 51 Perotti, Enrico, 605n Perrin, Charles R., 700 Petersen, Bruce, 684 Peterson, David, 540 Peterson, Pamela, 540 Pettit, Richardson, 541 Pettway, Richard H., 681e Phillips, Gordon M., 611 Pickens, T Boone, 695 Pinegar, Michael J., 681e Pinkerton, John, 18n Pontiff, Jeffrey, 636 Poterba, James, 546 Poulsen, Annette, 43n, 582, 582n, 610n, 707, 712, 729 Price, Lisa, 735, 736 Pringle, John, 768 Prowse, Stephen, 589 Pyle, David, 675n, 679e Quigg, Laura, 434 Radcliff, Robert C., 681e Raether, Paul, 701 Rajan, Raghuram, 584n, 616n Ramaswamy, Krishna, 545n Ravenscraft, David J., 711, 712 Redington, F M., 834n, 836 Regan, Dennis T., 652 Reid, Kenneth, 157 Ritter, Jay, 16e, 78e, 78n, 79, 82, 83, 86, 635, 683 Rivola, Pietra, 82 Roberts, Brian, 49 Robinson, Jack E., 602n Robinson, James, 633 Rock, Kevin, 85, 86, 664n, 679e Roe, Mark, 10, 632 Roll, Richard, 159, 160, 184n, 185, 207, 208, 208n, 818n Rose, Michael D., 639 Rosenberg, Barr, 157 Ross, Stephen A., 176, 184n, 185, 207, 208, 208n, 436n, 637, 672n, 679e, 794n, 864 Ruback, Richard, 384n, 707, 712 Rubin, Howie, 229 Rubinstein, Mark, 291 Rummel, Robert W., 500n Rydqvist, Kristian, 82, 83 Safieddine, Assem, 709 Samwick, Andrew A., 647 Sarig, Oded, 522 Sarin, Atulya, 670, 710 Schallheim, James, 524 Scharfstein, David, 22n, 576n, 583n, 608n, 609n, 610n, 611n, 685, 748n Scherer, F M., 711, 712 Schipper, Katherine, 650, 681e Schlarbaum, Garry, 541, 680e Scholes, Myron, 155, 157n, 163, 215, 216, 298, 540, 541, 545n Schrand, Catherine, 768, 768n Schultz, Paul, 71, 75n Schwartz, Eduardo, 250n, 430, 585n, 794n Schwert, G William, 728 Sculley, John, 633 Sefcik, Stephen, 567n Senbet, Lemma, 576n Sengupta, Kunal, 605n Servaes, Henri, 635n, 710 Shanken, Jay, 164n Shapiro, Alan, 601n Sharpe, Steven, 603 Sharpe, William, 131, 131n Shaw, Wayne, 85n Sherman, Ann E., 82n Shevlin, Terry, 683n Shleifer, Andrei, 168, 251n, 634, 634n, 635, 637, 702, 703, 710 Shoven, John, 534, 577n Siegel, Donald, 713, 714 Sloan, Richard G., 164n Smith, Abbie, 650, 681e, 714 Grinblatt−Titman: Financial Markets and Corporate Strategy, Second Edition 868 Back Matter © The McGraw−Hill Companies, 2002 Index Name Index Smith, Clifford, 581, 588n, 646n, 680e, 744n, 753n, 768, 768n Smith, Kimberly, 645, 646 Smithson, Charles W., 768, 768n Soter, Dennis, 668 Spielberg, Steven, 637 Spier, Kathy E., 605n Spindt, Paul, 87 Stafford, Erik, 697, 712, 719 Stanley, Kenneth, 541 Starks, Laura, 633 Stein, Jeremy, 164n, 467, 662n, 713, 748n Stiglitz, Joseph, 573n Stohs, Mark, 588n Stoll, Hans, 261 Story, Edward, 74n Stulz, Rene, 565n, 588, 610n, 640n, 641n, 703, 710, 744n Subrahmanyam, Avanidhai, 683 Summers, Lawrence H., 601, 702 Swaminathan, Bhaskaran, 164n Swary, Itzhak, 664 435, 496, 522, 544n, 576n, 588n, 589n, 598n, 601n, 608n, 610, 610n, 616n, 671n, 709, 735, 760n, 864 Tobin, James, 131, 711 Torous, Walter, 560n Travlos, Nickolaos G., 708, 720 Tschoegl, Adrian, 21n Tuckman, Bruce, 93 Tufano, Peter, 53n, 769 Tehranian, Hassan, 647 Telmer, Chris, 796 Teoh, Siew Hong, 661 Thaler, Richard, 664, 683 Thomas, Jacob, 683n Tice, Sheri, 611 Tinic, Seha, 84 Titman, Sheridan, 166e, 205n, 209n, 432, Waegelein, James F., 647 Walkling, Ralph, 703, 720 Wall, Larry D., 768 Walter, Terry, 86 Wang, Zhenyn, 208 Warga, Arthur, 509n Warner, Jerold, 560, 581 Wasley, Charles, 157 Urich, Thomas J., 191 Uttal, Bro, 79n Vermaelen, Theo, 667, 683 Verrechia, Robert, 645n Vetsuypens, Michael, 15n, 84, 85 Vincent, Linda, 721 Vishny, Robert, 168, 168n, 251n, 634, 634n, 635, 637, 703, 710 Vishwanathan, S., 751n Viskanta, Tadas, 186n Volcker, Paul, 740n Watts, Ross, 588n, 646n Wei, K C John, 205n Weinstein, Mark, 50, 85n Weisbach, Michael, 635n Weiss, Andrew, 573n Weiss, Lawrence, 560 Welch, Ivo, 85n, 86, 509n, 661, 671n, 864 Wessels, Roberto, 522, 588n, 589n, 616n Weston, J Fred, 728n Whitmore, Kay, 633 Wilhelm, William, 82n, 86n, 87 Williams, Joseph, 157n Wilson, Richard, 48e Wizman, Thierry, 509n Wolff, Eric, 51 Womack, Kent, 664, 683 Wong, T J., 661 Woolridge, J Randall, 651, 656n, 668 Wrigley, William, Jr., 89 Wu, Gordon, 688 Yang, Jerry, 634 Yawitz, Jess, 49 Zervos, Sara, 634n Zhao, Quanshui, 16e Ziemba, William, 164n, 165e Zimmerman, Jerold, 661 Zingales, Luigi, 611, 616n Zweibel, Jeffrey, 613n Grinblatt−Titman: Financial Markets and Corporate Strategy, Second Edition Back Matter © The McGraw−Hill Companies, 2002 Index Subject Index Absolute priority rule, 559 Accelerated depreciation, 524 Accounting cash flow, 303–305 Accounting rate of return, 358 Accounts receivable, 310–311 Accrued interest, 59–62 Acquiring firm, 692 Acquisitions See Mergers and acquisitions Adjustable-rate preferred stock, 70 Adjusted cost of capital formula, 481–482 Adjusted present value (APV) method, 461, 467–468 certainty equivalent method, 472–473 debt capacity, 469 price/earnings ratio approach, 475 ratio comparison approach, 475 real options approach, 473–474 risk-adjusted discount rate method, 470 sources of shareholder value, 468–469 versatility and usability, 470–475 ADRs, 73 Adverse selection, 674–678 Agency costs, 645 Agency problem, 643–645 Agents, 643 American Depository Receipts (ADRs), 73 American options, 258 binomial valuation of, 274–278 forward price version of BlackScholes model, 290–291 put-call parity, 264–268 Amortization, 36, 44–47 EBITDA, 306 good will, 721–722 Annualized rates, 322 Annuities, 316–321 Annuity bonds, 44–45 Annuity rates, 363–368 Annuity term structure, 363 Anti-takeover defenses, 727–729 Any-or-all offer, 724 APT See Arbitrage pricing theory (APT) APV method See Adjusted present value (APV) method Arbitrage Black-Scholes model, 284 derivatives, 230–231 futures, 783–784 Miller-Modigliani dividend irrelevancy theorem, 536 Modigliani-Miller Theorem, 503–504, 505 net present value (NPV), 333–335 put-call parity, 263–264, 265–266 secret share accumulations by risk arbitrageurs, 725 term structure of interest rates is always flat, 842 tracking and, 197–199 verifying existence, 202–203 Arbitrage opportunity, 176 Arbitrage pricing theory (APT), 176–177, 199, 209 APT risk return equation, 200–201 assumptions, 199 certainty equivalent method, 407 empirical tests, 206–209, 398–399 factor betas, 206 factor risk premiums, 206 firm-specific risk, 199–200, 203–206 risk-adjusted discount rate method implementation, 386–390 risk-expected return for securities with firm-specific risk, 203–206 verifying arbitrage existence, 202–203 Arithmetic sample mean, 419–421 Asset allocation, 98 Asset-backed securities, 52 Asset betas, 465 Asset covenants, 36–37 Asset substitution problem, 563, 569 government-insured debt, 572 short-term versus long-term debt, 584–585 At the money, 225 Balance sheets, 310–311 all-equity-financed firms, 379–380 partially financed with debt firm, 380 right-hand side as portfolio, 380–381 risk of components with taxdeductible debt interest, 463–465 Balloon payment, 43 Bank Holding Company Act of 1956, 10 Banking Act of 1933 (Glass-Steagall Act), Bankruptcy Chapter bankruptcy, 559 Chapter 11 bankruptcy, 559–560, 580 connection with liquidation, 599 direct costs, 558, 560–561 indirect bankruptcy costs See Indirect bankruptcy costs minimizing debt holder-equity holder incentive problems, 580–587 Modigliani-Miller Theorem, 506–509 Banks and banking assets of the 10 largest banks in the world, 21 869 Grinblatt−Titman: Financial Markets and Corporate Strategy, Second Edition 870 Back Matter Index © The McGraw−Hill Companies, 2002 Subject Index Banks and banking (cont.) commercial banks, Germany, 19 investment banks, 4, 10–11 Japan, 20–21 loans See Loans monitoring capital structure, 642–643 United Kingdom, 23–24 universal banking, 10, 19 Bargaining with the government, 606 Bargaining with unions, 605–606 Barriers to entry, 424 Basis, 698, 699, 720 hedging, 794 Basis risk, 794–795, 809 Basket options, 802 Basket swaps, 796 Bearer bonds, 54 Benchmark rate, 31–33 Best-efforts offering, 15 Betas, 147–149 asset betas, 465 Capital Asset Pricing Model (CAPM), 155–157 cash flow beta, 404–405 cash flow horizon and beta risk, 397–398 certainty equivalent method See Certainty equivalent method comparison method, 391–394, 399–402 equity betas, 465 factor betas See Factor betas (factor sensitivities) return betas, 405 risk-adjusted discount rate method, 377–378 risk-adjusted discount rate method implementation, 386 target beta level, 774 zero-beta returns, 155 Bid-ask spread, 10 Bidder incentive programs, 703 Bid price, 10 “Big Bang,” 22–23 Bilateral monopolies, 605 Bill, 47 Binomial derivative pricing models, 234–245, 247–248 Binomial process, 235 Binomial valuation of American options, 274–278 Binomial valuation of European options, 271–274 Black-Scholes formula, 279–280 Black-Scholes model empirical biases, 291–292 forward price, 287–291 price sensitivity to stock price, volatility, interest rates and expiration time, 284–287 valuation, 278–280 volatility, 280–283 Bloomberg adjustment, 157 Board terms staggered, 727–728 Bond equivalent yield, 58 Bond indentures, 35–39 Bonding mechanism, 39 Bond market conventions, 57–63 Bond ratings, 36, 47–49 Bonds, 35 accrued interest, 59–62 annuity bonds, 44–45 asset covenants, 36–37 bearer bonds, 54 binomial model tracking, 235–237 bonding mechanism, 39 cash flow pattern, 43–47 collateral trust bond, 39 convertible bonds, 585 covenants (bond indentures), 35–39 deferred-coupon bonds, 44–45 discount bonds, 47 dividend covenants, 37 dual-coupon bond, 47 dual-currency bonds, 51–52 duration, 826–829 DV01, 820–823 Eurobonds See Eurobonds Euroyen bonds, 18 features, 36 financial ratio covenants, 37–39 financing covenants, 37 high-yield bonds (junk bonds), 49–51, 53 increasing-rate notes (IRNs), 53 maturity, 47 municipal bonds, 60, 519–521 oil-linked bonds, 52 options, 39–43 price based, 47 prices, 36, 43, 57–63 price/yield relationship, 57–59 primary and secondary markets, 56–57 settlement date, 58–59 sinking fund provisions, 39, 40 Treasury Inflation Protected Securities (TIPS), 52 type based on asset claims in default, 39 yields to maturity, 57–59, 62–63 Book building process, 81 Book return on equity, 389 Brennan-Schwartz method, 430 Brokers, 74 Bullet bonds, 44–46 Callability, 41–42 Call options, 71 American options See American options European options See European options put-call parity See Put-call parity value as function of volatility, 283 value at expiration, 223–225, 259–261 Cap, 33 Capacity expansion valuation, 438–443 Capital, 2–3 cost of See Cost of capital external capital, 4–5 finance defined, financial intermediaries, 3–4 Germany, 19–20 hedging, 748–749, 751–754 internal capital, 4–5 international markets, 18 Japan, 20–22 legal environment, 8–10 markets See Capital markets misallocation in mergers and acquisitions, 706 public and private sources, 6–8, 19 trends, 25–26 United Kingdom, 22–24 Capital Asset Pricing Model (CAPM), 130–131, 151, 155, 169 applications of, 132 assumptions, 151 beta, 155–157 certainty equivalent method, 406–407 conclusions, 152 cross-sectional tests of the CAPM, 160–167 empirical tests, 158–168, 398–399 implications for optimal investment, 154 market model, 179–180 market portfolio, 152–154 market risk premium, 158 risk-adjusted discount rate method implementation, 384–390 risk-free returns, 155 zero-beta returns, 155 Capital budgeting, 330 Capital constraints, 338–339 Capital gains tax, 719–720 Capital leases, 34 tax advantages, 523 Capital market line (CML), 138–143 Capital markets, emerging capital markets, 53 U.S capital market, 5–6 Capital structure, 382 competitive strategy, 607–611 corporate taxes affect on, 509–511 debt holder–equity holder conflicts, 614–615 dynamic capital structure considerations, 611–615 empirical evidence, 616–617 Grinblatt−Titman: Financial Markets and Corporate Strategy, Second Edition Back Matter Index 871 Subject Index event studies, 680–681 individual investors can “undo,” 505–506 liquidation policy, 576 managerial control, 639–643 mergers and acquisitions, 722 Miller equilibrium, 529–530 Modigliani-Miller Theorem See Modigliani-Miller Theorem negative taxable earnings, 515–518 payout policy, 551–552 personal taxes affect on, 512–518, 529–530 stakeholder theory, 597–604 Tax Reform Act of 1986 effect on, 522 CAPM See Capital Asset Pricing Model (CAPM) CAR, 777–778 Carve-outs, 650–651 Cash, 310–311 investment expenditures and availability of, 684–685 Cash flow, 302 accounting cash flow, 303–305 changes following leveraged buyouts, 713–714 conditional expected cash flows, 409 corporate taxes effect on, 509–510 discounted cash flow See Discounted cash flow (DCF) discounting in bankruptcy, 563–564 early cash flow streams, 345, 352–353 to equity holders, 488–490 expected cash flow See Expected cash flow factor betas, 805 financing cash flows, 303 forecasts, 308–311 horizon and beta risk, 397–398 incremental cash flows, 307–308, 331 internal rate of return (IRR), 345, 351–354 later cash flow stream, 345, 351–352 Modigliani-Miller Theorem, 501–502 negative cash flows, 393–394 nominal cash flows, 315 real assets, 302–311 real cash flows, 315 value additivity and present value of cash flow streams, 315 Cash flow at risk (CAR), 777–778 Cash flow beta, 397–398, 404–405, 805 Cash flow hedging, 743–744, 774, 808–809 Cash flow pattern, 36, 43–47 Cash flow statements, 309–310 Certainty equivalent, 372 forward prices, 413–414 Certainty equivalent method, 372 adjusted present value (APV) method, 472–473 © The McGraw−Hill Companies, 2002 arbitrage pricing theory (APT), 407 Capital Asset Pricing Model (CAPM), 406–407 defining, 403–404 identifying, 404–405 providing certainty equivalents without knowing it, 413 risk-free scenario method, 408–413 tracking portfolios, 407–408 Chapter bankruptcy, 559 Chapter 11 bankruptcy, 559–560, 580 Charitable foundations, Chinese walls, Classical tax system, 539 Clearinghouse, 227 Closed-end mutual funds, 636 CML, 138–143 CMOs, 229 Collared floating loan rate, 33 Collateralized mortgage obligations (CMOs), 229 Collateral trust bond, 39 Commercial banks, Commercial paper, 33, 34–35 accrued interest, 60 Commercial paper rate, 32 Common factors, 176 Common stock, 69–70 volume of issuances, 72 Comparison approach, 378, 384–391 comparable lines of business, 399–403 empirical failures of CAPM and APT, 398–399 growth opportunities as source of high betas, 392–394 multiperiod risk-adjusted discount rates, 394–398 project betas not the same as firm betas, 391–392 taxes, 466–467 weighted average cost of capital (WACC) method, 487–488 Compensation of management, 587 executive compensation, 643–651, 749–751 mergers and acquisitions, 650–651 Competitive analysis approach, 423, 451–454 Competitive offering, 16 Competitive strategy, 607–611 Compounding, 314 Compounding-based bias, 419–421 Compound option, 269 Conditional expected cash flows, 409 Conditional tender offers, 723–724 Confidentiality of information, Conglomerate (diversifying) acquisition, 695–697 Contingent immunization, 838 Continuous-time models, 278 Contracts forward contracts See Forward contracts futures See Futures contracts management compensation, 587 relative performance contract, 648 Convenience yields, 785–795 Conversion premium, 43 Conversion price, 43 Convertibility, 42 Convertible bonds, 585 Convertible preferred stock, 70 Convex curvature, 58 Convexity, 819, 839–845 Corporate bonds See Bonds Corporate ownership and control, 629–634 Corporate strategy, 598 Correlations, 109–110, 115 factor models, 190 market model, 180–181 mean-standard deviation diagram, 117–119 Cost of capital, 132, 333 adjusted cost of capital formula, 481–482 as function of leverage ratio, 383–384 marginal cost of capital, 486 marginal weighted average cost of capital, 486–487 risk-adjusted discount rate method, 378, 386–390 statistics, 418–421 unlevered cost of capital, 462–467 Cost of debt, 383–384 weighted average cost of capital (WACC) method, 477–479, 482–483 Cost of equity, 383–384 weighted average cost of capital (WACC) method, 476, 479, 482–483 Counterparties, 221 Coupon, 36 duration, 826–827 Coupon rate, 36 Coupon yields, 62–63 Covariances, 107–110 contrasting with betas, 149 factor models, 188–192 many-stock portfolios, 114–115 as marginal variance, 120–122 Covenants asset covenants, 36–37 bond indentures, 35–39 dividend covenants, 37 financial ratio covenants, 37–39 financing covenants, 37 loan covenants, 33, 566–567 protective covenants, 582 Covered interest rate priority relation, 234 Covered option strategy, 799–803 Grinblatt−Titman: Financial Markets and Corporate Strategy, Second Edition 872 Back Matter Index © The McGraw−Hill Companies, 2002 Subject Index Cramdown, 560 Credit rating importance, 602–603 Credit rationing, 573–575 Credit spread, 30 Cross-border acquisitions, 698 Cross-hedging, 809 Cross-sectional regression, 161 Cross-sectional tests of the CAPM, 160–163 results, 164–167 Cum-dividend value, 277 Cumulative, 70 Currency caps and floors, 802–803 dual-currency bonds, 51–52 Currency forward rates, 232–234 Currency futures, 217–218 Currency risk, 761–767 hedging, 781–782 Currency swaps, 54, 222–223 hedging, 798–799 Currency trading, 217 Current value, 659–660 Customer confidence, 615 Dealer markets for equity, 75 Debenture, 39 Debt, costs of issues, 15–16 default-free debt, 381–382, 477 dynamic perpetual risk-free debt, 483 effect on risk, 382–384 firm value, 510–511 government-insured debt, 572 non-recourse debt, 490 personal taxes, effect on debt and equity rates of return, 512–515 protective covenants, 582 Debt capacity, 462, 469 Debt financing, 29–30, 63–64 accrued interest, 59–62 adverse selection, 677 asset-backed securities, 52 bank loans, 31–33 bankruptcy See Bankruptcy bonds See Bonds commercial paper, 34–35 competitive effects, 607–611 corporate bonds See Bonds effect on comparisons, 379–384 emerging capital markets, 53 Euromarkets, 53–55 firm size, 589 firms with more taxable earnings, 522 information content of debt-equity choice, 671–678 investment choice influences, 588 investment levels, 640–642 leases, 34 measures, 497–498 mergers and acquisitions, 699 pace of innovation, 53 price/earnings ratios, 446–451 primary and secondary markets, 55–57 ratios of select U.S corporations, 499 risk-adjusted discount rate method implementation, 384–386 settlement dates, 58–59 shareholder control and, 639–640 Treasury Inflation Protected Securities (TIPS), 52 weighted average cost of capital (WACC) method, 477–479, 480–485 Debt holder–equity holder conflicts capital structure, 614–615 Chapter 11 bankruptcy, 580 hedging, 756 indirect bankruptcy costs, 561–579 minimizing, 580–587 Debtor-in-possession (DIP) financing, 580 Debt overhang problem, 563–567 short-term versus long-term debt, 584 Debt ratios, 383–384, 640–641 Debt tax shield (TX), 464 discount rate, 471–472 hedging, 747 weighted average cost of capital (WACC) method, 476 Default-free debt, 381–382 weighted average cost of capital (WACC) method, 477 Default premium, 561 Defaults, 30 Defenses to takeovers, 727–729 Deferred-coupon bonds, 44–45 Deferred taxes, 311 Delta, 284 Delta hedging, 799, 803–804 Demeaned returns, 105 Depreciation accelerated depreciation, 524 EBITDA, 306 economic depreciation, 341, 523 Depth, 75 Deregulation capital markets generally, 10, 25 Germany, 20 Japan, 22 United Kingdom, 22 Derivatives, 113, 215–216, 252 forwards See Forwards futures See Futures long-term capital management (LTCM), 251–252 market friction, 251–252 mortgage-backed securities, 228–229 options See Options pricing See Pricing derivatives real assets, 228 swaps, 221–223 usage, 767–769 DIP financing, 580 Direct bankruptcy costs, 558, 560–561 Direct issuance, 18 Direct lease, 34 Disciplinary takeover, 695 management incentives, 701–703 Discount, 240 Discount bonds, 47 Discounted cash flow (DCF ), 330, 425 to equity holders, 488–491 net present value (NPV), 332–335 Discounted cash flow (DCF ) method, 330 Discount rates, 302 discounted cash flow and net present value, 332–333 nominal discount rates, 315 real discount rates, 315–316 risk-adjusted discount rate method See Risk-adjusted discount rate method risky debt tax shields, 471–472 Discrete models, 278 Distribution, 12 joint distribution, 107 Distribution policy in frictionless markets, 534–538 investment distortions, 547–551 payout policy, 551–552 taxes and transaction costs, 538–542 Diversification, 98, 181–183 Diversifying acquisition, 695–697 Dividend covenants, 37 Dividend discount model, 320, 388–390 Dividend growth forecasts, 388–390 Dividend payout ratio, 533 Dividend policies, 532, 534 debt overhang problem, 566 expected stock returns, 542–546 investment incentives, 668–670 optimal payout policy, 537–538 taxes, 539–541 Dividends announcements, 664–671 Black-Scholes model, 280 cum-dividend value, 277 debt overhang problem, 567 forecasting, 308–309 Miller-Modigliani dividend irrelevancy theorem, 532, 535–537 rations, 533–534 versus share repurchases, 667–668 Dividend signaling model, 664–668 Dividend tax, 540–541 financing choices, 546–547 investment choices, 547–551 Dividend yields, 534, 535 cross-sectional relation with stock returns, 544–546 Grinblatt−Titman: Financial Markets and Corporate Strategy, Second Edition Back Matter Index © The McGraw−Hill Companies, 2002 873 Subject Index Dollar value of one basis point decrease See DV01 Dominated portfolios, 134 Down state, 235 Dual-class common stock, 69 Dual-coupon bond, 47 Dual-currency bonds, 51–52 Due diligence, Duration, 826–834 DV01, 820–825 convexity, 839–845 duration, 830–834 immunization, 837 term structure DV01, 847 Dynamic capital structure theory, 611–615 Dynamic debt capacity, 469 Dynamic perpetual risk-free debt, 483 Early cash flow streams, 345, 352–353 Earnings-based compensation, 649–650 Earnings before interest, taxes, depreciation, and amortization (EBITDA), 306 Earnings before interest and taxes (EBIT), 303 forecasting, 309 unlevered cash flow, 305–307 Earnings before taxes, 309 Earnings manipulation, 660–661 Earnings stream, 514 ECNs, 74–75 Economic depreciation, 341, 523 Economic risk, 763 hedging, 766–767 Economic Value Added (EVA), 330, 341–343 Economies of scale, 424 Economies of scope, 425–426 Effective duration, 832 Effective marginal tax rates, 518 Efficient frontier, 135–136 risky assets, 143–145 Efficient markets hypothesis, 75 Embedded options, 228 Emerging capital markets, 53 Equipment trust certificate, 39 Equity, balance sheet equity, 311 costs of issues, 15–16 personal taxes effect on debt and equity rates of return, 512–515 pricing, 81, 82–87 private equity, 77 Equity betas, 465 Equity financing, 68–69, 88 cost of, 383–384 debt holder–equity holder conflicts See Debt holder–equity holder conflicts globalization of equity markets, 72–73 “going public.” See “Going public” indirect bankruptcy costs See Indirect bankruptcy costs informational efficiency and capital allocation, 75–77 information content of debt-equity choice, 671–678 monitoring role, 643 ownership of U.S equities, 72 private equity, 77 secondary markets for equity, 73–75 types of equity securities, 69–72 underpricing, 82–87 weighted average cost of capital (WACC) method, 476, 479, 482–483 Equivalent annual benefit, 341 Equivalent rates, 322–324 Eurobonds, 54 accrued interest, 60 Eurodollar bonds, 18 Eurocurrency loans, 54–55 Eurodollar bonds, 18 Eurodollar deposits, 55 accrued interest, 60 Euro-floating rate notes (FRNs), 60 Euromarkets, 18 debt financing, 53–55 European options, 258 binomial valuation, 271–274 put-call parity, 267–268 Euroyen bonds, 18 EVA, 330, 341–343 Event studies, 678–680 evidence, 680–684 Excess returns, 158 market-adjusted excess return, 679 Exchangeability, 42 Exchange offers, 681 Exchange option, 431 Exchange rate changes, 761–767 Exchanges, 73–74 Exchange-traded options, 225–227 Ex-date, 59 Ex-dividend date, 266 stock price movements, 543–544 Ex-dividend value, 277 Executive compensation, 643–651 hedging, 749–751 Exercise commencement date, 259 Expanding capacity valuation, 438–443 Expected cash flow, 371 conditional expected cash flows, 409 tracking portfolios, 376 Expected returns (mean return), 103–104 relation with risk, 146–151 tracking portfolios, 198, 376 weighted average cost of capital (WACC) method, 478–479 Expense forecasts, 308–309 Expiration date, 223 Explicit interest, 314 Exposures, 773 External capital, 4–5 Face value, 36 Factor analysis, 184–185 arbitrage pricing theory (APT), 207 Factor betas (factor sensitivities), 176, 187–188, 206 arbitrage pricing theory, 206 covariances, 189–190 hedging, 805–807 prespecification of, from theoretical relations, 776 Factor models, 176–177, 209 correlations, 190 covariances, 188–192 diversification, 181–183 estimating factors, 184–186 market model See Market model mean-variance analysis, 191 multifactor models, 183–184 tracking portfolios, 192–195 variances, 188–192 Factor portfolios, 184–185 pure factor portfolios See Pure factor portfolios tracking portfolios, 376 Factor risk, 176, 181 Factor risk premiums, 206 Factor sensitivities See Factor betas (factor sensitivities) Fair price amendments, 727 Fallen angels, 50 Feasible portfolios, 101 Feasible set, 133–134, 136–137 Fed funds rate, 32, 33 Financial acquisitions, 695, 697 Financial distress benefits of with committed stakeholders, 604–606 and reputation, 601–603 Financial distress costs, 562 estimating, 600–601 hedging, 745–747 signaling model based on tax gain/financial distress cost tradeoff, 671–674 Financial intermediaries, 3–4 Financial leases (capital leases), 34 tax advantages, 523 Financially distressed firms, 558 Financial ratio covenants, 37–39 Financial statements balance sheets See Balance sheets cash flow forecasts, 308–311 Financial synergies, 696, 703–704 Financing cash flows, 303 Financing covenants, 37 Firm characteristics, 185–186 Firm commitment offering, 15 Grinblatt−Titman: Financial Markets and Corporate Strategy, Second Edition 874 Back Matter Index © The McGraw−Hill Companies, 2002 Subject Index Firm-specific risk, 176 arbitrage pricing theory (APT), 199–200, 203–206 diversification, 181–183 Firm value debt, 510–511 performance-based pay, 647–648 shareholdings by management, 635–636 Fixed-income investments, 30 Fixed-price method, 81 Flat price, 59 Flipover rights plans, 728 Floating rates, 31–33 Floor, 33 currency, 802–803 Follow-up merger, 726 Foreign exchange risk management, 761–767 Forward contracts, 216 certainty equivalents, 413–414 hedging, 779–782, 788–795 put-call parity, 262–264 valuing, 231–232 Forward delta, 803–804 Forward prices, 216, 783–784 Black-Scholes model, 287–291 certainty equivalent, 413–414 information in, 781 Forward rate discount, 233 Forwards, 216–221 valuation, 231–234 Fourth market, 74 Free-rider problem, 565, 722–727 financial institution mitigation, 632 Frictionless markets, 135 distribution policy in, 534–538 Friendly takeover, 694 FRNs, 60 Full price, 59 Futures, 216–221 derivative valuation, 242–245 hedging, 751–752, 783 Futures contracts, 216 hedging, 783–785, 788–795 Futures markets, 216 Future value formulas, 313–314 GDP, 184 Geometric mean, 398, 419–421 Germany, 19–20 Glass-Steagall Act, Globalization capital, 25 equity markets, 72–73 international acquisitions, 698 Going concern value, 576 “Going public,” 77–78 benefits, 79–80 costs, 80 demand- and supply-side explanations for IPO cycles, 78–79 process, 81–82 Gold mining risk management, 769 Good will amortization, 721–722 Gordon Growth Model, 388 Government bargaining, 606 Great Britain, 22–24 Greenmail, 727 “Green-Shoe option,” 12 Gross domestic product (GDP), 184 Gross return, 400 Growing perpetuity, 320 Growth opportunities, 392 Growth options, 392 Hamada formula, 467 Hedge ratio, 774 Hedging, 739–740 capital, 748–749, 751–754 cash flow, 743–744, 774, 808–809 convenience yields, 785–795 credit rate change exposure, 761 debt tax shields (TX), 747 decision making, 751–754 DV01, 823–824, 832–834 economic risk, 766–767 exchange rate changes, 766–767 executive compensation, 749–751 factor-based, 805–807 financial distress costs, 745–747 interest rates, 845–850 investor’s hedging choice, 741 long-dated commitments with shortmaturing futures or forward contracts, 788–795 mean-variance analysis, 810–812 measuring risk exposure, 774–778 minimum variance portfolios, 810–812 Modigliani-Miller Theorem, 740–742 motivation to hedge affects what is hedged, 754 options, 799–804 organization of hedging activities, 755 reasons for, 743–754 regression, 807–810 short-term commitments with maturity-matched forward contracts, 779–782 short-term commitments with maturity-matched futures contracts, 783–785 stakeholder effects, 756–757 stakeholder theory, 745–747 swaps, 795–799 taxes, 744–745 usage, 755–756, 767–769 value creation, 744 value hedging, 774 High-yield bonds (junk bonds), 49–51, 53 Hold up problem, 584 Homogeneous beliefs, 151 Horizontal mergers, 700 Hostile takeovers, 694 bidding strategies, 722–727 trends, 697–698 Hot issue periods, 78 Human capital, 167 Hurdle rate, 345, 353–354 Immunization, 819, 834–839 convexity, 840 Impaired creditors, 559 Implicit interest, 314 Implied volatility, 282 versus strike price, 292 Imputation systems, 539 Income statements, 309 Increasing-rate notes (IRNs), 53 Incremental cash flows, 307–308, 331 Indirect bankruptcy costs, 558, 561–562 asset substitution problem See Asset substitution problem debt holder responses to shareholder incentives, 570–575 debt overhang problem, 563–567, 584 equity holder incentives, 562–563 reluctance to liquidate problem, 563, 575–579 shortsighted investment problem, 563, 567–569 taking higher risks, 569–570 underinvestment problem, 563–567 Inflation, 315–316 currency risk, 764–765 interest rate decomposition, 760–761 tax gain from leverage, 521 Inflation-adjusted cash flows (real cash flows), 315 Information confidentiality, content of debt-equity choice, 671–678 on dividend and share repurchases, 664–671 forward prices, 781 of management superior to shareholders, 658–660 Informational efficiency, 75–77 underpricing, 85–87 Initial public offering (IPO), 15 Inside information, Insider trading, Insurance, portfolio, 269–271 Insurance companies, Interest accrued interest, 59–62 compounding, 314 EBIT See Earnings before interest and taxes (EBIT) Grinblatt−Titman: Financial Markets and Corporate Strategy, Second Edition Back Matter Index © The McGraw−Hill Companies, 2002 875 Subject Index EBITDA, 306 explicit interest, 314 implicit interest, 314 open interest, 219 simple interest, 321 Interest coverage ratio, 37 Interest-only securities (IOs), 229 Interest rate risk management, 758–761, 819, 850 convexity, 839–845 dollar value of one basis point decrease (DV01) See DV01 duration, 826–834 hedging, 845–850 immunization, 834–839, 840 Interest rates adjustable-rate preferred stock, 70 annualized rates, 322 Black-Scholes model, 286 covered interest rate priority relation, 234 equivalent rates, 322–324 floating rates, 31–33 forecasting, 308–309 risk hedging, 796–798 risk management See Interest rate risk management Interest rate swaps, 60, 221–222 hedging, 796–798 Internal capital, 4–5 Internal rate of return (IRR), 345, 359 cash flows, 345, 351–354 examples, 346–349 mutually exclusive projects, 355–357 net present value (NPV), 346–349 numerical iteration of, 345–346 term structure issues, 350–351 Internal rate of return method, 345 International acquisitions, 698 In the money, 225 Intrinsic value, 658 trade-off with current value, 659–660 Inventory, 310–311 Investment banks, 4, 10–11 Investment Company Act of 1940, 10 Investment-grade rating, 48, 49 Investments cash, availability of and effect on investment expenditures, 684–685 debt financing, 588, 640–642 dividend policies, 668–670 leveraging an investment, 104 management decisions, 636–639 shareholder policies, 547–551 shortsighted investment choices, 662–663 Investor clienteles, 541 IOs, 229 IPO, 15 demand- and supply-side explanations for IPO cycles, 78–79 underpricing, 82–87 IRNs, 53 IRR See Internal rate of return (IRR) Japan, 20–22 cash flow and investment, 685 debt holder–equity holder conflicts, 589 Joint distributions, 107 Junior bonds, 36 Junk bonds, 49–51, 53 Keiretsu, 21 Later cash flow stream, 345, 351–352 Layoffs, 343–344 LBOs See Leveraged buyouts (LBOs) LEAPS, 226 Leases, 34 tax advantages, 523–525 Legal environment, capital, 8–10 Lessees, 34 tax advantages, 523 Lessors, 34 tax advantages, 523 Leverage See Debt financing Leveraged buyouts (LBOs), 43 empirical evidence on gains from, 712–714 management incentives, 701–703 trends, 697–698 Leveraged lease, 34 Leveraged recapitalization, 43 Leverage ratios, 382–384, 640–641 Leveraging an investment, 104 Liability management, 758 Liability streams, 758–761 LIBID, 32 LIBOR, 32, 33 LIBOR term structure, 363 Limit order, 74 Line of credit, 31 Liquidation, 70 connection with bankruptcy, 599 Liquidation costs, 576 imposed on stakeholders, 599 Liquidation value, 576 Loan commitment, 31 Loan covenants, 33 underinvestment problem, 566–567 Loans, 31–33 Eurocurrency loans, 54–55 Lock-box, 37 Long position, 100 call option value at expiration, 262 Long-term capital management (LTCM), 251–252 Long-term risk-free rates, 395–397 Long-term share price maximization, 658–660 LTCM, 251–252 MacAuley duration, 847–849 Macroeconomic variables, 176 arbitrage pricing theory (APT), 207–208 factors, 185–186 Management capital structure, 613, 639–643 compensation See Compensation of management earnings manipulation, 660–661 executive compensation, 643–651, 749–751 hedging influences, 749–751, 757 incentives in mergers and acquisitions, 701–703 incentives when managers have better information than shareholders, 658–660 influences on incentives, 629–630 investment decisions, 636–639 outside shareholders, 638–639 separation of ownership and control, 629–634 shareholder control of managers, 630–632 shareholdings by, 634–636 shortsighted investment choices, 662–663 takeover defenses, 727–729 value-based, 650 Management buyout (MBO), 701 Manufacturing project delay valuation, 435–438 Many-stock portfolios, 101–102 minimum variance portfolio, 124–125 returns, 104 variances, 114–115 Margin accounts, 220 Marginal cost of capital, 486 Marginal variances, 120–122 versus total variance, 149 Marginal weighted average cost of capital, 486–487 Market-adjusted excess return, 679 Market capitalization, 152 Marketing, 81 Market making, 10 Market model, 177 covariances, 188–189 diversifiable risk and fallacious CAPM intuition, 179–180 regression, 177–178 residual correlation, 180–181 variance decomposition, 178–179 Grinblatt−Titman: Financial Markets and Corporate Strategy, Second Edition 876 Back Matter Index © The McGraw−Hill Companies, 2002 Subject Index Market order, 74 Market portfolio, 152–154 tracking portfolios, 376 Market risk, 178 Market risk premium, 158 Market share, 610–611 Market-to-book ratio, 158, 164–167 Marking to market, 220 hedging, 783 Material information, 81 Mathematical tables, 854–862 Maturity, 36 Maturity date (settlement date), 58–59, 216 MBO, 701 Mean-beta diagram, 148 Mean returns, 103–104 derivative valuation, 239–240 relation with risk, 146–151 tracking portfolios, 198, 376 weighted average cost of capital (WACC) method, 478–479 Mean-standard deviation diagram defined, 115 feasible means, 119–120 feasible set, 133–134, 136–137 historical returns, 140 negative correlation, 118–119 negative weighted portfolio, 117 positive correlation, 117–118 positive weighted portfolio, 115–117 versus securities market line, 147–148 standard deviation, 119–120 Mean-variance analysis, 98, 130–131, 169 applications of, 132 assumptions, 133–135 Capital Asset Pricing Model See Capital Asset Pricing Model (CAPM) efficient portfolios, 145 essentials, 132–135 factor models, 191 hedging, 810–812 value-weighted market index, 160 Mean-variance efficient portfolios, 133 efficient frontier, 135–136, 143–145 risk and return, 146–151 two-fund separation, 136–138 Mean-variance optimizers, 98 Mergers and acquisitions, 691–692 accounting implications, 720–722 capital structure, 722 compensation of management, 650–651 defenses, 727–729 disadvantages, 705–707 empirical evidence on gains from leveraged buyouts (LBOs), 712–714 empirical evidence on takeover gains for non-LBO takeovers, 707–712 financial acquisitions, 695, 697 financial synergies, 703–704 financing acquisitions, 719–722 history, 692–694 hostile takeovers See Hostile takeovers information effects, 722 management incentives, 701–703 operating synergies, 699–701, 704–705 sources of takeover gains, 698–705 tax implications, 719–720 tax motivations, 698–699, 704–705 trends, 697–698 types, 694–697 valuing acquisitions, 714–719 Miller equilibrium, 529–530 Miller-Modigliani dividend irrelevancy theorem, 532, 535–537 Mines and minerals risk management, 769 valuations, 426–432 Minimum variance portfolios, 120, 123–125 hedging, 810–812 MIPS, 71 Modified duration, 831 Modigliani-Miller Theorem, 501 assumptions, 504–505 cash flows, 501–502 proof, 502–504 risk management, 740–742 risky debt, 506–509 Momentum, 158, 164–167 Money market hedge, 782 Monopolies, 605 Monthly income preferred securities (MIPS), 71 Mortgage-backed securities, 228–229 Mortgage bond, 39 Mortgage passthroughs, 228 Mortgages accrued interest, 60 amortization, 46 collateralized mortgage obligations (CMOs), 229 Multifactor models, 183–184 covariances, 189–190 Multiperiod binomial derivative valuation, 245–248 Municipal bonds accrued interest, 60 taxes, 519–521 Mutual funds, closed-end mutual funds, 636 Investment Company Act of 1940, 10 open-ended mutual funds, 636 Mutually exclusive projects, 330 comparison approach, 402–403 internal rate of return, 355–357 Negative amortization, 45 Negative cash flows, 393–394 Negotiable, 30 Negotiated offering, 16 Net present value (NPV), 330–332, 359 capital constraints, 338–339 debt tax shield (TX), 471–472 discounted cash flow, 332–333 internal rate of return (IRR), 346–349 layoffs, 343–344 positive net present value sources, 424–426 product price cuts, 343–344 project evaluation, 333–336, 340–341 value additivity, 336–338 Net present value (NPV) criterion, 330 Net profitability rate, 339 Net working capital, 37 Nominal cash flows, 315 Nominal discount rates, 315 Nominal exchange rates, 763, 765 Non-debt tax shields, 515 Nondiversifiable risk, 178 Nonfinancial stakeholders, 558, 596, 598 Nonnegotiable, 30 Non-recourse debt (project financing), 490, 586 Nonrevolving loan commitment, 31 Notes, 47 structured notes, 229–230 Notional amount, 221 NPV See Net present value (NPV) Numerical iteration, 345–346 Numerical methods, 248–250 Offer for sale by tender, 24, 219 OID, 47 Oil and gas risk management, 769 Oil futures, 219 stack hedge error, 791–792 Oil-linked bonds, 52 Oil price risk, 779–781, 804 One-factor model See Market model One-period binomial trees, 236 On-the-run Treasuries, 32 Open-ended mutual funds, 636 Open interest, 219 Operating leases, 34 tax advantages, 523 Operating leverage, 392 Operating synergies, 695 mergers and acquisitions, 699–701, 704–705 Options, 36, 223–228, 257–258, 292 American options See American options basket options, 802 Black-Scholes model See BlackScholes model bonds, 39–43 call options See Call options Grinblatt−Titman: Financial Markets and Corporate Strategy, Second Edition Back Matter Index 877 Subject Index description, 258–259 European options See European options expiration, 259–261 growth options, 392 hedging, 799–804 markets, 258–259 put-call parity See Put-call parity put options See Put options volatility, 280–283, 285 Original issue discount (OID), 47 Origination, 12 OTC, 56 equities, 73 Out of the money, 225 Outside shareholders, 638–639 Overallotment option (Green-Shoe option), 12 Oversubscribed offering, 81 Over the counter (OTC), 56 Over-the-counter (OTC) market equities, 73 Par bonds, 47 Par rates, 363–368 Partial hedging, 748–749 Par value, 43 Par yield curves, 363 Passthroughs, 229 Payback method, 358 Pay-for-performance, 645–650 hedging, 749–751 Payment-in-kind bonds, 44 Pecking order of financial choices, 552 capital structure, 612–613 Pension funds, Perfect tracking portfolios, 230 Perpetuities, 316–321 Perpetuity bonds (consol), 44–46 PIK (payment-in-kind) bonds, 44 Plowback ratio, 389 Plowback ratio formula, 389 Poison put bond, 43 Poison pills, 727–728 Pooling of interests accounting, 720–722 Portfolio betas, 148–149 Portfolio insurance, 269–271 Portfolios, 97–99, 126 correlations See Correlations covariances See Covariances defined, 97 dominated portfolios, 134 factor portfolios See Factor portfolios feasible portfolios, 101 many-stock portfolios See Manystock portfolios market portfolio, 152–154, 376 mean-standard deviation diagram See Mean-standard deviation diagram © The McGraw−Hill Companies, 2002 mean-variance efficient portfolios See Mean-variance efficient portfolios minimum variance portfolios, 120, 123–125, 810–812 perfect tracking portfolios, 230 pure factor portfolios See Pure factor portfolios returns, 102–104 standard deviation See Standard deviation tangency portfolios See Tangency portfolios tracking portfolios See Tracking portfolios two-stock portfolios See Two-stock portfolios value-weighted portfolio, 152 variances See Variances weights, 99–102, 115–117 Portfolio-weighted average method, 102 POs, 229 PPE, 310–311 Predation, 609–610 Preferred stock, 70–71 adverse selection, 677–678 taxes, 518–519 volume of issuances, 72 Premium bonds, 47 Present value duration, 847–850 Present value (PV), 302, 324 annuities and perpetuities, 316–321 betas, 401–402 certainty equivalent method, 404–405, 406 certainty equivalents from future prices, 414 estimation error and denominatorbased biases, 418–419 generalizing, 313–314 inflation, 315–316 interest rate hedging when term structure not flat, 847–850 multiperiod settings, 312–315 risk-adjusted discount rate method See Risk-adjusted discount rate method risk-free scenario method, 409–410 simple interest, 321 single period returns, 312 time horizons and compounding frequencies, 321–324 tracking errors, 375 value additivity, 315, 336–338 Price/earnings ratio method, 444 adjusted present value (APV) method, 475 Price/earnings ratios, 444–450 Pricing bonds, 36, 57–63 conversion price, 43 Pricing derivatives, 230–234 binomial pricing models, 234–245, 247–248 financial service industry techniques, 248–250 multiperiod binomial valuation, 245–248 numerical methods of the financial services industry, 248–250 risk-free rate, 250 Pricing equities, 81 underpricing, 82–87 Primary issue, 15 Primary market for corporate bonds, 56 Primary market for U.S Treasury Securities, 56 Primary offerings, Prime rate, 32, 33 Principal, 30 Principal-agent relationship, 643 Principal-only securities (POs), 229 Principals, 643 Private equity, 77 Private placements, 7–8 Private sources of capital, 6–8 Germany, 19 Productivity, 713–714 Product price cuts net present value (NPV), 343–344 Profitability index, 338–339 Project evaluation internal rate of return (IRR), 355–357 net present value (NPV), 333–336, 340–341 value additivity, 336–338 Project financing, 490, 586 Property, plant and equipment (PPE), 310–311 Proprietary trading, 10 Prospectus, 9, 13–14 Protective covenants, 581–583 Proxy fights, 631 Pseudo-American value, 279 Public sources of capital, 6–8 Germany, 19 United Kingdom, 24 Purchase of assets, 720 Pure discount bonds See Zero-coupon bonds (pure discount bonds) Pure factor portfolios, 195–197 decomposing into weights, 198–199 tracking returns of a security, 197–198 Putability, 42 Put-call parity, 261 American options, 264–268 corporate securities as options, 268–269 European options, 267–268 forward contracts, 262–264 hedging, 802 minimum value for a call, 264 portfolio insurance, 269–271 Grinblatt−Titman: Financial Markets and Corporate Strategy, Second Edition 878 Back Matter Index © The McGraw−Hill Companies, 2002 Subject Index Put-call parity formula, 261 Put options, 223–225 American options See American options European options See European options put-call parity See Put-call parity value at expiration, 259–261 PV See Present value (PV) Quality, 601–602 Raiders, 701 Rate of return, 358 Ratio comparison approach, 423, 443–444, 452–454 adjusted present value (APV) method, 475 investments hidden in multibusiness firms, 445–446 leverage differences, 450–451 price/earnings ratios, 444–450 Ratio method, 102 Real asset cash flows, 302–311 Real cash flows, 315 Real discount rates, 315–316 Real estate investment trusts (REITs), 444 Real exchange rates, 763, 765 Real investments, 301 Real options, 490–491 Real options approach, 423, 452–454 adjusted present value (APV) method, 473–474 valuing strategic options, 426–443 Recovery rate, 479 Refundable bonds, 42 Registration statements, 8–9, 81 Regression beta estimate, 156–157 cross-sectional regression, 161 hedging, 807–810 market model, 177–178 risk exposure estimates, 775–776 R-squared, 178–179 Regression method, 775 REITs, 444 Relative performance contract, 648 Reluctance to liquidate problem, 563, 575–579 Reorganization plan, 559 Repos, 56 accrued interest, 60 Repurchase agreements (repos/RPs) of U.S securities, 56 accrued interest, 60 Repurchase of shares See Share repurchases Reputation, 601–603 Residual correlation, 180–181 Restructuring, 77 Retail price, 10 Return betas, 405 Return on assets, 358 Returns, 98, 102–104 accounting rate of return, 358 book return on equity, 389 covariances, 115 demeaned returns, 105 excess returns, 158, 679 expected returns See Expected returns (mean return) gross return, 400 internal rate of return See Internal rate of return (IRR) mean returns See Mean returns pure factor portfolio tracking, 197–198 rate of return, 358 risk return equation, APT, 200–201 stock See Stock returns variances, 105 Revolver, 31 Rights offerings, 17–18 Risk debt’s effect on, 382–384 diversification, 181–183 Economic Value Added (EVA), 330, 341–343 factor risk, 176, 181, 206 firm-specific risk See Firm-specific risk internal rate of return See Internal rate of return (IRR) long-term risk-free rates, 395–397 market model, 179–180 market risk premium, 158 net present value See Net present value (NPV) relation with expected return, 146–151 short-term risk-free rates, 395–397 systematic (market) risk, 158, 178 unsystematic (nonmarket) risk, 178 weighted average cost of capital (WACC) method, 477–479 Risk-adjusted discount rate method, 371, 377 adjusted present value (APV) method, 470 betas, 399–402 cash flow valuations, 490–491 defining and implementing with given betas, 377–378 implementing, 384–391 multiperiod risk-adjusted discount rates, 394–398 mutually exclusive projects, 402–403 statistical issues in estimating cost of capital, 418–421 tracking portfolios, 379 Risk aversion, 105 derivative valuation, 239–240 Risk bearing, 12 Risk exposure measurement, 774–778 Risk-free debt, 381–382 static perpetual risk-free debt, 464–465 Risk-free scenario method, 408–413 Risk management, 739 foreign exchange, 761–767 hedging See Hedging interest rates See Interest rate risk management mines and mining, 769 Modigliani-Miller Theorem, 740–742 oil and gas, 769 Risk neutral, 105 Risk-neutral probabilities, 240 Risk-neutral valuation method, 240 Risk-neutral valuation of derivatives, 239–245 Risk premiums, 140 factors, 206 market risk premium, 158 pure factor portfolios, 196–197 Risk profile, 739 Risk return equation, APT, 200–201 Rolling stock, 792 Rosenberg adjustment, 157 RPs, 56 accrued interest, 60 R-squared regression, 178–179 Rule 144A, Rule 415, 16 Rule of 70, 313 Rules of Fair Practice, 12 Sale and leaseback, 34 Sales forecasts, 308–309 Scallop effect, 63 Seasoned offering (SEO), 15 SEC, Secondary issue, 15 Secondary markets, corporate bonds, 56–57 equity, 73–75 U.S Treasury securities, 56–57 Secret share accumulations, 725 Secured bonds, 36, 39 Securities, See also specific types of securities asset-backed securities, 52 debt financing See Debt financing equity financing See Equity financing event studies, 681 mortgage-backed securities, 228–229 put-call parity, 268–269 Securities Act of 1933, 8–9 Securities and Exchange Commission (SEC), Grinblatt−Titman: Financial Markets and Corporate Strategy, Second Edition Back Matter Index © The McGraw−Hill Companies, 2002 879 Subject Index Securities Exchange Act of 1934, 8–9 Securities market line, 147–148 Securitization, 26 Self-financing, 143 Sell short, 56 portfolio weights, 100 Senior, Senior bonds, 36 SEO, 15 Settlement date, 58–59 forwards, 216 Shareholder control and leverage, 639–640 Shareholder control of managers, 630–632 Shareholder information inferior to management, 658–660 Shareholder value, 468–469 Shareholdings by management, 634–636 Share price maximization, 658–660 Share repurchases, 533–534 announcements, 664–671 versus dividends, 667–668 optimal payout policy, 537–538 tax consequences, 540 Shelf offering, 16 Short position, 100 value in call and put options at expiration, 260–262 Short sales, 56 portfolio weights, 100 Shortsighted investment problem, 563, 567–569 Short squeeze, 100 Short-term risk-free rates, 395–397 Short-term share price maximization, 658–660 Signals, 657 dividend signaling model, 664–668 empirical evidence, 678–685 model based on tax gain/financial distress cost trade-off, 671–674 theories and implications, 679 Simple interest, 321 Simulation, 250 estimating VAR and CAR using, 778 risk exposure measurements, 775–776, 778 Simulation method, 775 Sinking fund provisions, 39, 40 Smile effect, 291 Specialist, 74 Spin-offs, 650–651 Spot delta, 803–804 Spot market, 779 Spot price, 220 convenience yield risk, 793–794 forward price computations, 288–289 Spot rates, 232, 363–368 Spot term structure, 363 Staggered board terms, 727–728 Stakeholder theory, 597–604 capital structure, 613–614 hedging, 745–747 Standard deviation, 106–107 estimating VAR and CAR from, 777–778 firm-specific, 182 historical returns, 140 mean-standard deviation diagram, 119–120 two-stock portfolios, 111–114 Standby basis, 17 Static capital structure theory, 612 Static debt capacity, 469 Static perpetual risk-free debt, 464–465 Stepping up the basis, 698, 699, 720 Stock common stock, 69–70, 72 many-stock portfolios See Manystock portfolios preferred stock See Preferred stock Stock-based compensation, 649 Stock exchanges, responses to pure capital structure changes, 680 Stock returns cross-sectional relation with dividend yields, 544–546 dividend policies, 542–546 mergers and acquisitions, 707–710 Straight-coupon bonds (bullet bonds), 44–46 Strategic acquisition, 694–695, 697 Strategic options, 423 valuing with real options methodology, 426–443 Strategy competitive strategy, 607–611 corporate strategy, 598 covered option strategy, 799–803 Strike price, 223 implied volatility versus, 292 Structured notes, 229–230 Subordinated claims, 36 Subscription price, 17 Supermajority rules, 727–728 Swap maturity, 221 Swaps, 221–223 basket swaps, 796 hedging, 795–799 Swap spread, 797 Syndicate desk, 56 Synergies financial synergies, 696, 703–704 mergers and acquisitions, 699–701, 703–705 operating synergies, 695, 699–701, 704–705 valuing, 715–719 Systematic (market) risk, 178 premium, 158 Tailing the hedge, 784 Takeover premium, 692 Tangency portfolios, 138–143 hedging, 811–812 market portfolios as, 153–154 relevant risk, 146–147 Target beta level, 774 Target firm, 692 Tax Equity and Fiscal Responsibility Act of 1982, 698 Taxes, 501, 525 adjusted present value method See Adjusted present value (APV) method capital gains tax, 719–720 classical tax system, 539 comparison approach, 466–467 corporate taxes affect on capital structure, 509–511 debt tax shield See Debt tax shield (TX) deferred taxes, 311 distribution policies, 538–542 dividend policies, 539–541 dividend tax See Dividend tax EBIT See Earnings before interest and taxes (EBIT) EBITDA, 306 effective marginal tax rates, 518 empirical implications, 522 hedging, 744–745 imputation systems, 539 inflation, 521 investment distortions, 547–551 leasing, 523–525 mergers and acquisitions, 698–699, 704–705, 719–720 Miller equilibrium, 529–530 Modigliani-Miller Theorem See Modigliani-Miller Theorem municipal bonds, 519–521 negative earnings, 515–518 non-debt tax shields, 515 personal taxes effect on capital structure, 512–518, 529–530 personal taxes effect on investment policies, 547–551 personal taxes payout policy, 551–552 preferred stock, 518–519 signaling model based on tax gain/financial distress cost tradeoff, 671–674 Tax Reform Act of 1986, 522, 699 weighted average cost of capital method See Weighted average cost of capital (WACC) method Grinblatt−Titman: Financial Markets and Corporate Strategy, Second Edition 880 Back Matter Index © The McGraw−Hill Companies, 2002 Subject Index Tax Reform Act of 1986 capital structure, 522 mergers and acquisitions, 699 Technical default, 581 Technology capital, 25 valuing flexibility in production technology, 440–443 Tender offers, 694 conditional tender offers, 723–724 Term structure DV01, 847 Term structure of interest rates (yield curve), 330, 363–368 Third market, 74 Time series regression, 160 Time-series tests of the CAPM, 163 results, 164–167 TIPS, 52 Tobin’s q, 711 Tombstone ad, 12 Track, 149 Tracking portfolios, 149–151 certainty equivalent method, 407–408 derivative valuation, 237–239, 242 expected returns, 198 factor models, 192–195 forward contracts, 414 perfect tracking portfolios, 230 put-call parity, 263 real asset valuation, 373–377 risk-adjusted discount rate method, 379 Tranches, 229 Transaction costs distribution policies, 538–542 Modigliani-Miller Theorem, 505 Transaction risk, 761–762 Translation risk, 762–763 Treasury bills, 32, 33 primary and secondary markets, 56 Treasury bonds, 32 accrued interest, 60–61 primary and secondary markets, 56 Treasury Inflation Protected Securities (TIPS), 52 Treasury notes, 32, 33 accrued interest, 60–61 primary and secondary markets, 56 Treasury rate, 32 Treasury strips, 58 True lease, 525 Two-fund separation, 136–138 Two-stock portfolios, 99–101 minimum variance portfolio, 123–124 returns, 103–104 standard deviation, 111–114 variances, 110–114 Two-tiered offers, 726–727 TX See Debt tax shield (TX) UA, 464 Unconditional (any-or-all) offer, 724 Underinvestment problem, 563–567 Underlying asset, 215 Underwriters, top global underwriters, 11 underpricing, 84–87 Underwriting agreement, 12–15 Underwriting arrangement types, 15–18 Underwriting process, 11–12 Underwriting spread, 12 Underwriting syndicate, Union bargaining, 605–606 United Kingdom, 22–24 Unit offering, 71 Universal banking, 10 Germany, 19 Unleveraged price/earnings ratio, 450–451 Unlevered assets (UA), 464 Unlevered cash flows, 303–308 Unlevered cost of capital, 462–467 Unlevered earnings, 449 Unsecured creditors, 39 Unsystematic (nonmarket) risk, 178 Up state, 235 U.S capital market, 5–6 U.S equity ownership, 72 Vacant land valuations, 432–435 Valuation Black-Scholes valuation, 278–280 capacity expansion valuation, 438–443 of derivatives See Pricing derivatives Valuation by components, 461 Value additivity, 315 present values and net present values, 336–338 Value at risk (VAR), 777–778 Value-based management, 650 Value hedging, 774 Value-weighted market index, 160 Value-weighted portfolio, 152 Valuing acquisitions, 714–719 VAR, 777–778 Variances, 104–106 beta versus as measure of risk, 149 covariances See Covariances factor models, 188–192 many-stock portfolios, 114–115 marginal variances, 120–122, 149 market model decomposition, 178–179 minimum variance portfolio, 123–125 two-stock portfolios, 110–114 Venture capital, 77 Venture capital firm, Vertical mergers, 700 Volatility, 279 Black-Scholes model, 280–283 implied volatility, 282, 292 risk exposure measurements, 776–777 Warrants, 71, 227–228 Weighted average cost of capital (WACC) method, 461, 475–476 comparison approach, 487–488 cost of debt, 477–479, 482–483 cost of equity, 476, 479, 482–483 debt financing, 480–485 debt tax shields (TX), 476 individual project evaluation, 485–488 unlevered cost of capital distinguished, 462–463 Weights decomposing pure factor portfolios into, 198–199 derivative valuation, 241 portfolios, 99–102, 115–117 Well-diversified portfolios, 178 Winner’s curse, 86 Writing an option, 227 Yield-beta, 846–847 Yields to maturity, 57–59, 62–63 discounted cash flow and net present value, 332 Zerfix bond, 44 Zero-beta returns, 155 Zero-cost instruments, 223 valuation, 232 Zero-coupon bonds (pure discount bonds), 44–46 convexity, 843–845 discounted cash flow and net present value, 332 duration, 826 ... (continued) Grinblatt Titman: Financial Markets and Corporate Strategy, Second Edition 14 EXHIBIT 1.6 Part I I Financial Markets and Financial Instruments Raising Capital Financial Markets and Financial. .. generate Grinblatt Titman: Financial Markets and Corporate Strategy, Second Edition Part I I Financial Markets and Financial Instruments © The McGraw−Hill Companies, 2002 Raising Capital Financial Markets. .. Parkway, Burr Ridge, IL 60521) Mark Grinblatt Sheridan Titman Grinblatt Titman: Financial Markets and Corporate Strategy, Second Edition PART I I Financial Markets and Financial Instruments Introduction