Essentials of corporate finance 8e by ross jordan

essentials of Corporate Finance 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 Eleventh Edition Brealey, Myers, and Allen Principles of Corporate Finance, Concise Second Edition Brealey, Myers, and Marcus Fundamentals of Corporate Finance Seventh Edition Brooks FinGame Online 5.0 Bruner Case Studies in Finance: Managing for Corporate Value Creation Seventh Edition Cornett, Adair, and Nofsinger Finance: Applications and Theory Second Edition Cornett, Adair, and Nofsinger M: Finance Second 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 Tenth Edition Ross, Westerfield, Jaffe, and Jordan Corporate Finance: Core Principles and Applications Third Edition Ross, Westerfield, and Jordan Essentials of Corporate Finance Eighth Edition Ross, Westerfield, and Jordan Fundamentals of Corporate Finance Tenth Edition Shefrin Behavioral Corporate Finance: Decisions that Create Value First Edition White Financial Analysis with an Electronic Calculator Sixth Edition INVESTMENTS Bodie, Kane, and Marcus Essentials of Investments Ninth Edition Bodie, Kane, and Marcus Investments Ninth Edition Hirt and Block Fundamentals of Investment Management Tenth Edition Jordan, Miller, and Dolvin 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 Second edition FINANCIAL INSTITUTIONS AND MARKETS Rose and Hudgins Bank Management and Financial Services Ninth Edition Rose and Marquis Financial Institutions and Markets Eleventh 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 REAL ESTATE Brueggeman and Fisher Real Estate Finance and Investments Fourteenth Edition Ling and Archer Real Estate Principles: A Value Approach Fourth 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 Kapoor, Dlabay, and Hughes Focus on Personal Finance: An active approach to help you develop successful financial skills Fourth Edition Kapoor, Dlabay, and Hughes Personal Finance Tenth Edition Walker and Walker Personal Finance: Building Your Future First Edition essentials of Corporate Finance EIGHTH EDITION Stephen A Ross Massachusetts Institute of Technology Randolph W Westerfield University of Southern California Bradford D Jordan University of Kentucky ESSENTIALS OF CORPORATE FINANCE, EIGHTH EDITION Published by McGraw-Hill/Irwin, a business unit of The McGraw-Hill Companies, Inc., 1221 Avenue of the Americas, New York, NY, 10020 Copyright © 2014 by The McGraw-Hill Companies, Inc All rights reserved Printed in the United States of America Previous editions © 2011, 2008, and 2007 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 QVR/QVR ISBN 978-0-07-803475-6 MHID 0-07-803475-2 Senior Vice President, Products & Markets: Kurt L Strand Vice President, General Manager, Products & Markets: Brent Gordon Vice President, Content Production & Technology Services: Kimberly Meriwether David Managing Director: Douglas Reiner Executive Brand Manager: Chuck Synovec Executive Director of Development: Ann Torbert Development Editor II : Jennifer Lohn Director of Digital Content: Doug Ruby Digital Development Editor: Meg B Maloney Executive Marketing Manager: Melissa S Caughlin Lead Project Manager: Christine A Vaughan Content Project Manager: Emily Kline Senior Buyer: Carol A Bielski Cover/Interior Designer: Pam Verros Cover Image: © Nikolai Larin/Getty Images Media Project Manager: Joyce J Chappetto Typeface: 10/12 Times Roman Compositor: MPS Limited Printer: Quad/Graphics All credits appearing on page or at the end of the book are considered to be an extension of the copyright page Library of Congress Cataloging-in-Publication Data Ross, Stephen A Essentials of corporate finance / Stephen A Ross, Randolph W Westerfield, Bradford D Jordan 8th ed p cm Includes index ISBN-13: 978-0-07-803475-6 (alk paper) ISBN-10: 0-07-803475-2 (alk paper) Corporations Finance I Westerfield, Randolph W II Jordan, Bradford D III Title HG4026.R676 2014 658.15 dc23 2012041243 The Internet addresses listed in the text were accurate at the time of publication The inclusion of a website does not indicate an endorsement by the authors or McGraw-Hill, and McGraw-Hill does not guarantee the accuracy of the information presented at these sites www.mhhe.com About the Authors Stephen A Ross Sloan School of Management, Franco Modigliani Professor of Finance and Economics, Massachusetts Institute of Technology Stephen A Ross is the Franco Modigliani Professor of Finance and Economics at the Sloan School of Management, Massachusetts Institute of Technology One of the most widely published authors in finance and economics, Professor Ross is recognized for his work in developing the Arbitrage Pricing Theory and his substantial contributions to the discipline through his research in signaling, agency theory, option pricing, and the theory of the term structure of interest rates, among other topics A past president of the American Finance Association, he currently serves as an associate editor of several academic and practitioner journals He is a trustee of CalTech Randolph W Westerfield Marshall School of Business, University of Southern California Bradford D Jordan Gatton College of Business and Economics, University of Kentucky Randolph W Westerfield is Dean Emeritus of the University of Southern California’s Marshall School of Business and is the Charles B Thornton Professor of Finance He came to USC from the Wharton School, University of Pennsylvania, where he was the chairman of the finance department and a member of the finance faculty for 20 years He has been a member of several public company boards of directors, including Health Management Associates, Inc., and Oak Tree Finance, LLC His areas of expertise include corporate financial policy, investment management, and stock market price behavior Bradford D Jordan is Professor of Finance and holder of the Richard W and Janis H Furst Endowed Chair in Finance at the University of Kentucky He has a long-standing interest in both applied and theoretical issues in corporate finance and has extensive experience teaching all levels of corporate finance and financial management policy Professor Jordan published numerous articles on issues such as the cost of capital, capital structure, and the behavior of security prices He is a past president of the Southern Finance Association, and he is coauthor of Fundamentals of Investments: Valuation and Management, 6th edition, a leading investments text, also published by McGraw-Hill/Irwin v From the Authors W hen we first wrote Essentials of Corporate Finance, we thought there might be a small niche for a briefer book that really focused on what students with widely varying backgrounds and interests needed to carry away from an introductory finance course We were wrong There was a huge niche! What we learned is that our text closely matches the needs of instructors and faculty at hundreds of schools across the country As a result, the growth we have experienced through the first seven editions of Essentials has far exceeded anything we thought possible With the eighth edition of Essentials of Corporate Finance, we have continued to refine our focus on our target audience, which is the undergraduate student taking a core course in business or corporate finance This can be a tough course to teach One reason is that the class is usually required of all business students, so it is not uncommon for a majority of the students to be nonfinance majors In fact, this may be the only finance course many of them will ever have With this in mind, our goal in Essentials is to convey the most important concepts and principles at a level that is approachable for the widest possible audience To achieve our goal, we have worked to distill the subject down to its bare essentials (hence, the name of this book), while retaining a decidedly modern approach to finance We have always maintained that the subject of corporate finance can be viewed as the working of a few very powerful intuitions We also think that understanding the “why” is just as important, if not more so, than understanding the “how,” especially in an introductory course Based on the gratifying market feedback we have received from our previous editions, as well as from our other text, Fundamentals of Corporate Finance (now in its tenth edition), many of you agree By design, this book is not encyclopedic As the table of contents indicates, we have a total of 18 chapters Chapter length is about 30 pages, so the text is aimed squarely at a single-term course, and most of the book can be realistically covered in a typical semester or quarter Writing a book for a one-term course necessarily means some picking and choosing, with regard to both topics and depth of coverage Throughout, we strike a balance by introducing and covering the essentials (there’s that word again!) while leaving some more specialized topics to follow-up courses The other things we have always stressed, and have continued to improve with this edition, are readability and pedagogy Essentials is written in a relaxed, conversational style that invites the students to join in the learning process rather than being a passive information absorber We have found that this approach dramatically increases students’ willingness to read and learn on their own Between larger and larger class sizes and the ever-growing demands on faculty time, we think this is an essential (!) feature for a text in an introductory course Throughout the development of this book, we have continued to take a hard look at what is truly relevant and useful In doing so, we have worked to downplay purely theoretical issues and minimize the use of extensive and elaborate calculations to illustrate points that are either intuitively obvious or of limited practical use As a result of this process, three basic themes emerge as our central focus in writing Essentials of Corporate Finance: An Emphasis on Intuition We always try to separate and explain the principles at work on a commonsense, intuitive level before launching into any specifics The underlying vi ideas are discussed first in very general terms and then by way of examples that illustrate in more concrete terms how a financial manager might proceed in a given situation A Unified Valuation Approach We treat net present value (NPV) as the basic concept underlying corporate finance Many texts stop well short of consistently integrating this important principle The most basic and important notion, that NPV represents the excess of market value over cost, often is lost in an overly mechanical approach that emphasizes computation at the expense of comprehension In contrast, every subject we cover is firmly rooted in valuation, and care is taken throughout to explain how particular decisions have valuation effects A Managerial Focus Students shouldn’t lose sight of the fact that financial management concerns management We emphasize the role of the financial manager as decision maker, and we stress the need for managerial input and judgment We consciously avoid “black box” approaches to finance, and, where appropriate, the approximate, pragmatic nature of financial analysis is made explicit, possible pitfalls are described, and limitations are discussed Today, as we prepare to once again enter the market, our goal is to stick with and build on the principles that have brought us this far However, based on an enormous amount of feedback we have received from you and your colleagues, we have made this edition and its package even more flexible than previous editions We offer flexibility in coverage and pedagogy by providing a wide variety of features in the book to help students learn about corporate finance We also provide flexibility in package options by offering the most extensive collection of teaching, learning, and technology aids of any corporate finance text Whether you use just the textbook, or the book in conjunction with other products, we believe you will find a combination with this edition that will meet your current as well as your changing needs Stephen A Ross Randolph W Westerfield Bradford D Jordan vii Organization of the Text W e designed Essentials of Corporate Finance to be as flexible and modular as possible There are a total of nine parts, and, in broad terms, the instructor is free to decide the particular sequence Further, within each part, the first chapter generally contains an overview and survey Thus, when time is limited, subsequent chapters can be omitted Finally, the sections placed early in each chapter are generally the most important, and later sections frequently can be omitted without loss of continuity For these reasons, the instructor has great control over the topics covered, the sequence in which they are covered, and the depth of coverage Just to get an idea of the breadth of coverage in the eighth edition of Essentials, the following grid presents for each chapter some of the most significant new features, as well as a few selected chapter highlights Of course, in every chapter, figures, opening vignettes, boxed features, and in-chapter illustrations and examples using real companies have been thoroughly updated as well In addition, the end-of-chapter material has been completely revised Chapters Selected Topics Benefits to Users PART ONE Overview of Financial Management Chapter Updated opener on “Say on Pay.” Highlights important development regarding the very current question of appropriate executive compensation Updated corporate ethics box Describes ethical issues in the context of recent insider trading scandals Goal of the firm and agency problems Stresses value creation as the most fundamental aspect of management and describes agency issues that can arise Ethics, financial management, and executive compensation Brings in real-world issues concerning conflicts of interest and current controversies surrounding ethical conduct and management pay PART TWO Understanding Financial Statements and Cash Flow Chapter Cash flow vs earnings Clearly defines cash flow and spells out the differences between cash flow and earnings Market values vs book values Emphasizes the relevance of market values over book values New box on tax rates Discusses controversy surrounding tax rates paid by Warren Buffett, Greg Mankiw, and Mitt Romney viii Chapters Selected Topics Benefits to Users Chapter Additional explanation of alternative formulas for sustainable and internal growth rates Expanded explanation of growth rate formulas clears up a common misunderstanding about these formulas and the circumstances under which alternative formulas are correct New ratio discussion Introduces and discusses the EBITDA/enterprise value ratio PART THREE Valuation of Future Cash Flows Chapter First of two chapters on time value of money Relatively short chapter introduces just the basic ideas on time value of money to get students started on this traditionally difficult topic Chapter Second of two chapters on time value of money Covers more advanced time value topics with numerous examples, calculator tips, and Excel spreadsheet exhibits Contains many real-world examples PART FOUR Valuing Stocks and Bonds Chapter New opener on bond ratings Discusses the downgrade of U.S Treasury debt from AAA to AA Bond valuation Thorough coverage of bond price/yield concepts Interest rates and inflation Highly intuitive discussion of inflation, the Fisher effect, and the term structure of interest rates “Clean” vs “dirty” bond prices and accrued interest Clears up the pricing of bonds between coupon payment dates and also bond market quoting conventions FINRA’s TRACE system and transparency in the corporate bond market Up-to-date discussion of new developments in fixed income with regard to price, volume, and transactions reporting “Make-whole” call provisions Up-to-date discussion of relatively new type of call provision that has become very common Stock valuation Thorough coverage of constant and nonconstant growth models New section on stock valuation Covers valuation using multiples NYSE and Nasdaq Market operations Up-to-date description of major stock market operations Chapter PART FIVE Capital Budgeting Chapter Updated opener on GE’s “Ecomagination” program Illustrates the growing importance of “green” business First of two chapters on capital budgeting Relatively short chapter introduces key ideas on an intuitive level to help students with this traditionally difficult topic NPV, IRR, MIRR, payback, discounted payback, accounting rate of return Consistent, balanced examination of advantages and disadvantages of various criteria Project cash flow Thorough coverage of project cash flows and the relevant numbers for a project analysis Scenario and sensitivity “what-if” analyses Illustrates how to actually apply and interpret these tools in a project analysis Chapter ix SUBJE CT Calculatoredge, 140 Call premium, 180 Call protected bond, 180 Call provision, 180–181 Capital Asset Pricing Model (CAPM), 375–376 Capital budgeting, 5, 238–239, 276; see also Internal rate of return (IRR); Net present value (NPV); Payback rule additional considerations in, 297–300 average accounting return, 247–248 capital rationing, 299–300 contingency planning, 297–299 example analysis, 287–290 financial management decisions, hard rationing, 300 managerial options and, 297–299 net working capital, 278 percentage of CFOs using a technique, 260–261 practice of, 259–261 profitability index, 258–259 size, timing, and risk of future cash flows, strategic options, 299 summary of investment criteria, 261 techniques in practice, 260 WACC and, 399–400 Capital expenditures, 530 Capital gain/loss, 215, 312, 458 Capital gains yield, 215, 217 Capital intensity ratio, 62 Capital investment, 260 Capital investment decisions, 275 capital rationing, 299–300 depreciation, 284–285 evaluating NPV estimates, 291–293 example analysis, 287–291 incremental cash flows, 277–279 managerial options, 297–200 net working capital, 293–284 pro forma financial statements, 279–282 project cash flows, 276, 280–287 scenario and what-if analyses, 293–297 tax shield approach, 282 Capital market efficiency, 337–340 efficient markets hypothesis, 338–339 forms of, 340 price behavior, 337 Capital market history average return (1926–2011), 321–323 average returns, standard deviations, and frequency distributions (1926–2011), 327 bear market (2008), 329–330 frequency distribution on common stocks (1926–2011), 323 geometric vs arithmetic average returns (1926–2011), 335–336 historical record (1926–2011), 315–320 large-company stocks, 315, 317–319, 322 lessons from, 310–311 INDE X 633 long-term corporate bonds, 316–317, 319, 322 long-term U.S government bonds, 316–317, 319–320 small-company stocks, 316–319, 322 standard deviation, 326–327 stock market risk premium, 332–333 technical trading rules, 331 U.S Treasury bills, 316–317, 319–320, 322 use of, 330–331 variability of returns, 323–343 year-to-year inflation (1926–2011), 321 Capital rationing, 299–300 hard rationing, 300 soft rationing, 299–300 Capital spending, 35–36, 39, 289 Capital structure, 5; see also Financial leverage; Optimal capital structure business and financial risk, 426–427 corporate taxes, 429–432 cost of equity capital, 426–429 financial management decisions, 5–6, 420–421 interest tax shield, 430 leverage and, 419 M&M Proposition I, 426, 430–431 M&M Proposition II, 427–428 managerial recommendations, 436 observed structures, 437–438 optimal capital structure, 421, 433–436 static theory of, 433–434 target capital structure, 390 U.S industries, 437 Capital structure weights, 396–397 Capped coupon rate, 186 Captive finance company, 563 Carrying costs, 524–525 flexible/restrictive policy, 524–525 Cases Beta for FLIR Systems, The, 387 Bullock Gold Mining, 274 Cash Flows and Financial Statements at Sunset Boards, Inc., 51 Conch Republic Electronics, 309 Cost of Capital for Hubbard Computer, Inc., 418 Electronic Timing, Inc., 480 Financing S&S Air’s Expansion Plans with a Bond Issue, 206 Job at S&S Air, A, 348–349 McGee Cake Company, 21 Peipkorn Manufacturing Working Capital Management, Part 1, 546 Peipkorn Manufacturing Working Capital Management, Part 2, 581 Ratios and Financial Planning at S&S Air, Inc., 95–96 S&S Air Goes International, 605 S&S Air Goes Public, 512 S&S Air’s Mortgage, 165 Stephenson Real Estate Recapitalization, 450 Stock Valuation at Ragan, Inc., 237 634 SU B J E C T I N D E X Cash; see also Cash management activities that increase/decrease, 515 benefits of holding, 547–548 investing idle cash, 555–557 reasons for holding, 547–548 sources/uses of, 515 tracing cash, 514–516 Cash balance, 530–531, 548 Cash budget, 529–531 cash balance, 530–531 cash outflows, 530 sales and cash collections, 529–530 Cash collection, 551–552 components of collection time, 551 costs and, 284 lockboxes, 552–554 sales and, 529 Cash concentration, 552 Cash coverage ratio, 59–60 Cash cycle, 517 calculation of, 519–521 defining of, 516–518 industry comparisons of, 522 interpretation of, 521–523 Cash disbursements, 553–555 controlled disbursement account, 555 controlling disbursements, 554–555 increasing disbursement float, 554 zero-balance accounts, 555 Cash discount, 560–561 Cash dividends, 452–453 standard method of payment, 453 stock repurchases vs., 461–463 Cash flow, 22, 34–40 after-tax cash flow, 279 cash flow from assets, 35–37, 39 level cash flows, 132–141 project cash flows, 276 relevant cash flows, 276 stand-alone principle, 276 stock valuation, 208–209 summary, 38 timing of, 130–131 to and from firm, 15–16 Cash flow from assets, 35–38 capital spending, 36, 39 change in net working capital, 35–37, 39 example of, 38–40 free cash flow, 37 operating cash flow, 35–36 Cash flow identity, 35, 37–38 Cash flow time line, 517 Cash flow to bondholders, 37 Cash flow to creditors, 37–38, 40 Cash flow to stockholders, 37–38, 40 Cash Flows and Financial Statements at Sunset Boards, Inc (case), 51 Cash management benefits of holding cash, 547–548 cash collection and concentration, 551–553 ethical and legal questions, 550 float and, 546–551 investing idle cash, 555–558 managing disbursements, 553–555 precautionary motive, 547 reasons to hold cash, 547–548 short-term securities, 556–557 speculative motive, 547 temporary cash surpluses, 556 transaction motive, 547 Cash manager, 518 Cash-out, 524 Cash outflows, 530 capital expenditures, 530 long-term financing expenses, 530 payments of accounts payable, 530 wages, taxes, and other expenses, 530 Cash ratio, 58 Cash reserves, short-term borrowing and, 527 CAT bonds, 187 Certificates of deposit (CDs), 557 Change in net working capital, 35–37 Chapter 11, 440–441 Check Clearing Act for the 21st Century (Check 21), 550–551 Check kiting, 550 Chicago Stock Exchange, 17 Classes of stock, 219–220 Classified boards, 219 Clean price, 191 Cleanup period, 532 Clearing, 548 Clientele effect, 460 CNN Money, 368 Coca-Cola, 398 CoCo bonds, 186 Collar, 186 Collateral, 179 Collected balance, 548 Collectibles as investments, 111 Collection effort, 565 Collection float, 548–549 Collection policy, 558, 564–565 aging schedule, 565 collection effort, 565 monitoring receivables, 564–565 Collection time, 551–552 Commercial draft, 562 Commercial loan officer, Commercial Metals Company, 15 Commercial paper, 533, 557 Committed line of credit, 532 Common equity, 23 Common-size balance sheets, 54–55 Common-size income statements, 55–56 SUBJE CT Common-size statement, 54 Common stock, 218; see also Stock valuation classes of stock, 219–220 dividends, 220 features of, 218–230 other rights, 220 proxy voting, 219 shareholder rights, 218–219 Competition, collection period, 560 Competitive firm cash offer, 487 Compound interest, 99–100, 102 Compounding, 99 effective annual rates and, 141–142 Compounding periods, 141–146 Concentration banks, 553 Conch Republic Electronics (case), 309 Consol, 139 Consolidated financial statements, 79 Constant growth, stock valuation, 210, 217 Consumer credit, 558 Consumer demand, collection period, 560 Consumer price index (CPI), 316, 327 Continental Airlines, 442–443 Contingency planning, 297–299 option to abandon, 298 option to expand, 297–298 option to wait, 298–299 Continuous equity offerings, 507 Control of firm, 14–15 Controlled disbursement account, 555 Controller, 518 Conventional factoring, 532 Convertible bond, 186 Corporate board of directors, 218–219 Corporate borrowing, 424–425 Corporate compensation, Corporate ethics, 11 Corporate finance, Corporate investors, high dividends, 459 Corporate securities, trading in, 17–18 Corporate tax rates, 31–32 Corporate taxes, capital structure and, 429–431 Corporation, agency problem, 12–13 cash flows to and from firm, 15–16 control of firm, 12–15 financial management goal, 10 financial markets and, 15–18 international corporations, management goals, 13 shareholder’s vs manager’s interests, 13–15 stakeholders, 15 Cost, profitability, and standardization, 560 Cost accounting, Cost of capital, 377, 388–390 divisional and project costs, 406–409 Eastman’s example, 401–403 INDE X financial policy and, 390 introduction to, 389–390 optimal capital structure and, 434–436 required return vs., 389–390 Cost of Capital for Hubbard Computer, Inc (case), 418 Cost of debt, 395 Eastman example, 403–404 Cost of equity, 391–394 capital structure and, 426–431 dividend growth model approach, 391–393 Eastman example, 401–403 financial leverage and (M&M Proposition II), 427–428 M&M Proposition I, 426–427 SML approach, 393–394 Cost of preferred stock, 395–396 Costs inventory costs, 567 of issuing securities, 501 Countrywide Financial, 292 Coupon, 167 Coupon rate, 167 Covered interest arbitrage, 593–594 Credit analysis, 558, 563–564 credit evaluation and scoring, 564 credit information, 563–564 Credit cost curve, 562 Credit evaluation and scoring, 564 Credit information, 563–564 banks, 564 customer’s payment history, 564 financial statements, 563 Credit instrument, 561–562 Credit manager, 518 Credit period, 559–560 factors that influence, 560 Credit policy collection policy, 558 components of, 558 credit analysis, 558 terms of sale, 558 Credit ratings, 183 Credit risk, 197 collection period, 560 Credit scoring, 564 Creditor, 176–177 Cross-rate, 583, 587–588 Crossover (5B) bonds, 182 Cumulative dividends, 221 Cumulative voting, 218 Currency appreciation/depreciation, 593 Currency swaps, 584 Current assets, 23, 514 alternative financing policies, 525–527 financing of, 523 in proactive, 528 size of firm’s investment in, 523–524 635 636 SU B J E C T I N D E X Current income, 459 Current liabilities, 23, 514, 528 Current ratio, 57–58 Current yield, 173 Customer type, collection period, 560 Cyclical activities, 556 Date of payment, 454 Date of record, 454 Days’ sales in inventory, 60 Days’ sales in receivables, 61, 520 Dealer, 222 Dealer markets, 17 Death bond, 187 Debenture, 177, 179 Debt; see also Bankruptcy costs cost of debt, 395 equity vs., 25–26, 177 long-term debt, 177–178 preferred stock as, 221 Debt-equity ratio, 59, 420 Debt securities, 176, 179–180 Debtor, 176 Declaration date, 453–454 Deed of trust, 178 Default, 197 Default-free, pure discount bonds, 193 Default risk, short-term securities, 557 Default risk premium, 197 Deferred call provision, 180 Deflation, 192 Depreciation, 29, 284–287 modified ACRS (MACRS) depreciation, 285–286 Depreciation tax shield, 282 Derived-demand inventories, 572–574 just-in-time inventory, 574 materials requirements planning (MRP), 573 Designated market maker (DMM), 223 Dim sum bonds, 584 Direct bankruptcy costs, 432 Direct costs, 503–504 Direct expenses, 501 Direct placement, 487 Direct rights offer, 487 Directors, 218 Dirty price, 191 Disbursement float, 548, 554 Discount, 105 Discount an announcement, 360 Discount bond, 169 Discount factor, 106 Discount rate, 106, 377, 388–389 determination of, 109–112 single-period investment, 109–110 Discounted cash flow (DCF) return, 250 Discounted cash flow (DCF) valuation, 106, 122–123, 240, 261 internal rate of return (IRR), 249–258 modified internal rate of return (MIRR), 257–258 net present value (NPV), 240–242 profitability index (PI), 258–259 Discounting, 105–108 Disney, 275 Distribution, 452 Diversifiable risk, 363, 365 Diversification, 351, 376 effect of, 362 portfolio risk and, 362–365 principle of, 363 systematic risk, 364–365 unsystematic risk and, 363–364 Dividend, 34, 220, 452 survey evidence on, 470–471 Dividend growth, stock valuation, 211 Dividend growth model, 211–212 Dividend growth model approach, 391–393 advantages/disadvantages of, 392–393 estimating g, 392 implementation of, 391 Dividend payout, 69, 453 chronology of, 453–454 corporations smoothing, 467–468 dividend payers, 465–467 pros and cons of, 470 Dividend payout ratio, 70 Dividend policy, 72, 451–452 cash dividends, 452–453 clientele effects, 460 corporations smoothing, 467–468 dividend payment, 453–454 dividends and dividend payers, 465–467 high payout factors, 459 irrelevance of, 456–458 low payout factors, 458–459 pros/cons of, 470 summary of findings on, 468–470 survey responses on decisions, 471 Dividend restrictions, 458–459 Dividend yield, 215, 217, 453 Dividends per share, 28, 453 Divisional cost of capital, 407 DMM’s post (designated market makers), 224 Dodd-Frank Wall Street Reform and Consumer Protection Act, Dollar returns, 311–313 Double taxation, Dow Jones Industrial Average, top 12 one-day percentage changes, 329 Dribble programs, 507 Dun & Bradstreet, 564 SUBJE CT DuPont identity, 67–69 asset use efficiency, 67 expanded analysis, 68 extended DuPont chart, 69 financial leverage, 67 operating efficiency, 67 for Yahoo! and Google, 67 Dutch auction cash offer, 487 Dutch auction underwriting, 489, 491 Early stage financing, 482 Earnings, 28 Earnings before interest and taxes (EBIT), 35 Earnings management, 31 Earnings per share (EPS), 28, 63 EBIT vs., 422–424 financial leverage, 421–422 share repurchase and, 464 Earnings retention, 69 Eastman Chemical calculating WACC for, 400, 404–405 cost of debt, 403–404 cost of equity, 401–403 Eastman Kodak, 419 EBIT (earnings before interest and taxes) break-even EBIT, 424 EPS vs., 422–423 EBITD (earnings before interest, taxes, and depreciation), 60 EBITDA ratio, 64 ECNs (electronic communications networks), 225–226 Economic order quantity (EOQ), 571 Economic order quantity (EOQ) model, 568–572 carrying costs, 569–570 extensions to, 572 inventory depletion, 569 reorder points, 572 safety stocks, 572 shortage costs, 570 total costs, 570–571 Economic value added (EVA), 398 EDGAR database, 24, 30, 62 E.F Hutton, 550 Effective annual rate (EAR), 141–142 annual percentage rate (APR) and, 144 calculating and comparing, 142–143 compounding, 141–142 financial calculators and, 145 spreadsheets and, 145 Effective tax rates, 458 Efficient capital market, 337 price behavior in, 337–338 Efficient market hypothesis (EMH), 338 common misconceptions about, 339–340 semistrong form, 339 Electronic communications networks (ECNs), 225 Electronic data interchange (EDI), 550 INDE X Electronic Timing, Inc (case), 480 Electronic trading, 223 Embedded debt cost, 395 Enron Corporation bankruptcy, 11–12 Enterprise value, 64 Equity, 22–23 debt vs., 177 new equity sales and value of firm, 500 Equity carve-out, 497 Equity multiplier, 59, 67 Equity securities, 176 Erickson Air-Crane, 503 Erosion, 278 Estimation risk, 292 Ethical issues, in cash management, 550 eToys, 492 Euro Disney, 298 Eurobonds, 583 Eurocurrency, 583 Ex-dividend date, 453–455 price behavior around, 455 Excess return, 322 Exchange rate, 585–588 cross-rates and triangle arbitrage, 587–588 interest rates and, 593–595 Exchange rate quotations, 585–586 Exchange rate risk, 595–598 long-run exposure, 596 management of, 598 short-run exposure, 595–596 translation exposure, 597 Executive compensation, 1, 13 Exit strategy, 484 Exotic bonds, 187 Expected growth rate (g), 392 Expected return, 352, 358–359 calculation of, 353 portfolio expected return, 355–357 systematic risk and, 373 unexpected returns and, 358–359 variance and, 351–353 Expected risk premium, 352 Expenses, 27–28 Experian, 564 External financing, 70 Extra cash dividend, 452–453 Face value, 167 Facebook, 481, 490 Factoring receivables, 532 Fair value accounting, 26 Fallen angels, 183 Federal Bankruptcy Reform Act of 1978, 440 Federal Reserve Bank of St Louis, 189 Fiduciary responsibility, 460 Field warehouse financing, 533 File price range, 497–498 637 638 SU B J E C T I N D E X Finance accounting and, 3–4 corporate finance, financial institutions, four basic areas of, international finance, investments, 2–3 management and, marketing and, overview of, 2–4 personal financial decisions, reasons for study, 3–4 Finance.yahoo.com, 14, 70, 226 Financial Accounting Standards Board (FASB), 26, 31 Statement Number 52, 597 Financial advisers, Financial analysts, Financial assets mix of holdings, risks and rewards of, Financial calculator, 103–104 annuity present values, 134 EARs and ARPs, 145 future value, 103–104 number of periods, 113 present value, 107 present value of multiple cash flows, 129–130 unknown rates, 111 websites of, 115, 140 Financial distress, capital structure and, 436 Financial distress costs, 433 Financial institutions, Financial leverage, 25, 67 corporate borrowing and homemade leverage, 424–426 effect of, 421–426 EPS and ROE, 421–422 EPS vs EBIT, 422–424 impact of, 421–424 Financial leverage ratios, 59 Financial management bankruptcy process, 442–443 goal of, 10–12 international aspects of, 582–583 introduction to, maximizing current value per share, 10 maximizing value of existing owner’s equity, 11, 15 profit maximization, 10 Financial management decisions capital budgeting, capital structure, working capital management, Financial manager, business finance and, 4–6 financial management decisions, 5–6 inventory policy, 566 working capital management, Financial markets cash flows to and from firm, 15–16 corporation and, 15–18 primary vs secondary markets, 16–18 Financial policy, 72 cost of capital and, 390 Financial ratios, 52, 56; see also Ratio analysis summary of, 65 Financial risk, 429 Financial statement analysis, 74–81 choosing a benchmark, 75–79 external uses, 74 internal uses, 73 peer group analysis, 75–76 problems with, 79–81 selected financial information (example), 77–79 time-trend analysis, 75 Financial statements, 22; see also Ratio analysis common-size balance sheets, 54 common-size income statements, 55–56 credit information, 563 pro forma statements, 279–282 standardized statements, 53–56 using information of, 74–81 working with, 52–53 Financing costs, 278 Financing life cycle of a firm, 482–484 early stage financing, 482–483 venture capital, 482–484 Financing S&S Air’s Expansion Plans with a Bond Issue (case), 206 Finished goods, 566 Firm commitment cash offer, 487 Firm commitment underwriting, 488 Firm’s book, 548 Firm’s organizational chart, 518–519 First-stage financing, 482 Fisher effect, 192–193 Five Cs of credit, 564 capacity, 564 capital, 564 character, 564 collateral, 564 conditions, 564 Fixed assets, 23, 25 Fixed costs, 29 Flat-rate tax, 33 Float, 548 collection float, 548–549 disbursement float, 548 EDI and Check 21, 550–551 net float, 548–549 Float management, 549–550 availability delay, 550 mailing time, 550 processing delay, 550 Floating a new issue, 501 SUBJE CT Floating-rate bonds, 185–186 Floor brokers, 223 Flotation costs, 501 low dividend payout, 458 Follow-on offering, 487 Forecasting risk, 292 sources of value, 293 Foreign bonds, 583 Foreign exchange market, 584–585 forward trade, 588 spot trade, 588 types of participants in, 584–585 types of transactions, 588–589 Form 10-K, 68 Forward exchange rate, 588 Forward PE ratio, 216 Forward trade, 588 Free cash flow, 37 Frequency distribution normal distribution, 327–329 return on common stocks (1926–2011), 323, 327 variability and, 323–324 Full price, 191 Future value (FV), 98–101 annuities, 138 calculating with financial calculator, 103 cash flow timing, 130–131 compound interest, 102 compounding and, 98–104 interest on interest, 99–102 multiperiod investing, 98–99 multiple cash flows, 123–126 present value vs., 108–109 single period investing, 98 Future value interest factor, 99, 101 Galleon Group, 11 Gap, Inc., 80 General cash offer, 485 General Electric (GE), 79, 238, 506 General Motors (GM), 187 General partners, 7–8 General partnership, General Theory of Employment, Interest, and Money (Keynes), 547 Generally Accepted Accounting Principles (GAAP), 26, 31 income statement and, 28–29 Geometric average return, 334 arithmetic average returns vs., 335–336 calculation of, 334–335 Gifts, 584 Globalization, 583 Go or no-go decisions, 298 Goldman Sachs Group, Inc., 9, 481 Google, 67–68, 489, 491 Government bonds, 183–184 INDE X Green Shoe provision, 490, 501 Growing perpetuity, 210, 213 Growth, determinants of, 71–72 Growth stocks, 209, 332 Hard rationing, 300 Harley-Davidson, Inc., 226 Hewlett Packard, 292 Historical cost, 26 Historical record; see Capital market history Home Depot, 66 Homemade leverage, 424–425 Hybrid market, 223 Hybrid securities, 177 IASB, 31 Income, 27 Income statement, 27–31 common-size income statements, 55–56 earnings management, 31 GAAP and, 28–29 noncash items, 29 time and costs, 29–30 Incremental cash flows, 276–279 financing costs, 278 net working capital, 278 opportunity costs, 277–278 other issues, 279 side effects, 278 sunk costs, 277 Indenture, 178 Indirect bankruptcy costs, 433 Indirect costs, 503 Indirect expenses, 501 Inflation Fisher effect, 192–193 historical average return, standard deviation, and frequency distribution (1926–2011), 327 interest rates and, 191–193 real vs nominal rates, 191–192 year-to-year inflation (1926–2011), 321 Inflation-linked bond, 186 Inflation premium, 194 Initial public offering (IPO), 481, 487; see also Selling securities to the public biggest first-day gains, 496 cost of issuing securities, 501–505 evidence on underpricing, 492–494, 498–499 file price range, 497–498 global underpricing, 495 long-term debt, 505–506 partial adjustment phenomenon, 497–498 underpricing, 491–492 underpricing (1999–2000) experience, 494–497 Innovation, 360 Inside information, 337 Inside quotes, 225 639 640 SU B J E C T I N D E X Insider trading, 11 Insurance companies, Intangible assets, 23, 25 Intel, 18 Interest expense, 36 Interest on interest, 99 Interest-only loans, 146–147 Interest rate parity (IRP), 594–595 Interest rate risk, 170–172 time to maturity and, 171 Interest rate risk premium, 195 Interest rate swaps, 584 Interest rates, 166 exchange rates and, 593–595 Fisher effect, 192–193 inflation and, 191–193 real vs nominal rates, 191–192 relative interest rates, 527 term structure of, 193–196 U.S rates (1800–2011), 194 Interest tax shield, 430 Internal financing, 70 Internal growth, 69 Internal growth rate, 70–71, 73 Internal rate of return (IRR), 249–258, 261, 377 advantages/disadvantages of, 256–257 calculation of, 251–252 IRR rule, 249 modified internal rate of return (MIRR), 257–258 mutually exclusive investments, 254–256 nonconventional cash flows, 252–253 problems with, 252–254 spreadsheet calculation of, 252 Internal Revenue Service (IRS), International corporations, 9, 582 International currency symbols, 585 International finance, terminology of, 583–584 International Financial Reporting Standards (IFRS), 31 Internet bubble, 496 Inventory, 25, 81 Inventory costs, 567 Inventory loan, 533 Inventory management, 566–567 financial manager, 566 inventory costs, 567 inventory policy, 566 inventory types, 566 Inventory management techniques, 567–574 ABC approach, 567–568 derived-demand inventories, 572–574 economic order quantity (EOQ) model, 568–572 Inventory period, 517, 519, 560 Inventory policy, 566 Inventory turnover, 60, 519 Inventory types, 566 Investments, mutually exclusive investments, 254–256 returns, 311–315 stocks and bonds, summary of investment criteria, 261 Invoice, 559 Invoice price, 191 Jacobs Engineering Group, Job at S&S Air, A (case), 348–349 Johnson & Johnson, 438 Joint stock companies, JPMorgan Chase & Co., 481 Junior debt, 180 Junk bonds, 182–183 Just-in-time (JIT) inventory, 574 Kanban systems, 574 Keiretsu, 574 Key employee retention plans (KERPs), 441 Kiting, 550 Ledger balance, 548 Lee Enterprises, 442 Legacy effect, 469 Legal bankruptcy, 439 Lehman Brothers, 440–441 Lender, 176 Letter of comment, 485 Level coupon bond, 167 Leverage ratios, 59 Liabilities, 22–25 Life cycle theory, 468 Limited liability company (LLC), Limited partners, 7–8 Limited partnership, 7–8 Line of credit, 532 Liquidating dividends, 453 Liquidation, 439 Liquidity, 24–25 Liquidity measures, 57–58 Liquidity premium, 195, 197 Listing, 18 Listing requirements, 228 Loan agreement, 178 Loan amortization, 146–150 using a spreadsheet, 149 Loan contract, 178 Loan types, 146–150 amortized loans, 146 interest-only loans, 146 pure discount loans, 146 Lockboxes, 552–554 Lockup agreement, 490 London Interbank Offer Rate (LIBOR), 584 London Stock Exchange (LSE), 18 Alternative Investment Market (AIM), 12 SUBJE CT Long-run exposure, exchange rate risk, 596 Long-term debt, 177–178 features of a Macy’s bond, 178 indenture, 178 issuing of, 505–506 Long-term financial decisions, 514 Long-term financing, Long-term financing expenses, 530 Long-term investments, Long-term liabilities, 23 Long-term solvency measures, 59–60 cash coverage, 59–60 debt-equity ratio, 59 equity multiplier, 59 times interest earned, 59 total debt ratio, 59 Low-grade corporate bonds, 182 Lowe’s, 66 M&M Proposition I, 426 the pie model, 426 taxes and, 430–431 M&M Proposition II, 427 cost of equity and financial leverage, 427–428 Mailing time, 550 Make-whole call provision, 180–181 Management, finance and, Management goals, 13 Managerial compensation, 11 Managerial options, 297 Managers recommendations for capital structure, 436 shareholder’s vs own interests, 13–15 Marginal tax rate, 32 Market efficiency, forms of, 340 Market portfolios, 374 Market risk, 365 Market risk premium, 374 Market risks, 361, 376 Market-to-book ratio, 64 Market value, 22, 26–27 book value vs., 26–27, 286 Market value measures, 63–65 earnings per share (EPS), 63 EBITDA ratio, 64 enterprise value, 64 market-to-book ratio, 64 price-earnings ratio (PE), 63 price-sales ratio, 64 Marketability, short-term securities, 557 Marketing, finance and, Marketing analysts, Marketing manager, 518 Martha Stewart Omnimedia, 496 Matching principle, 28 Materials requirements planning (MRP), 573 INDE X Maturity, 167 short-term securities, 556–557 Maturity factoring, 532 Maturity hedging, short-term borrowing and, 527 Maturity risk premium, 195 Maximizing current value per share, 10 Maximizing value of existing owner’s equity, 11, 15 McDonald’s, 591 McGee Cake Company (case), 21 Member, 222 Merrill Lynch, 488 Mezzanine level financing, 483 Microcaps, 228 Microsoft, 18 Minority shareholders, 218–219 Modified ACRs (MARCS) depreciation, 285–287 example of, 287–290 Modified internal rate of return (MIRR), 257–258, 261 combination approach, 257–258 discounting approach, 257 IRR vs., 258 reinvestment approach, 257 Money market, 555 Money market preferred stock, 558 Money market securities, 547 types of, 557–558 Moneychimp website, 115 Moody’s, 181–182 Morgan Stanley, 481, 490 Mortgage-backed securities (MBSs), 187 Mortgage securities, 179 Mortgage trust indenture, 179 Motley Fool, 210 Multiperiod investing compounding, 98–99 present values for, 106 Multinationals, 582 Multiple cash flows financial calculator, 129–130 future value (FV), 123–126 present value (PV), 126–129 spreadsheet for, 131 Multiple rates of return, 254 Multiples, stock valuation using, 216–217 Mutually exclusive investment, 254–256 Mutually exclusive investment decisions, 254 Nanocaps, 228 NASDAQ (NASD Automated Quotations System), 17, 222 operations of, 228 National Association of Securities Dealers (NASD), 17 Negative covenants, 181 Negotiated offer, 488 Net cash inflow, 530–531 Net float, 548–549 Net income, 28 641 642 SU B J E C T I N D E X Net present value (NPV), 238, 240, 261–262 basic idea of, 239–240 estimating of, 240–241 evaluating estimates, 291–293 mutually exclusive investments, 255 net present value rule, 241–242 spreadsheet calculation, 242–243 Net present value profile, 251 Net working capital, 24–25, 514 in capital budgeting, 279 change in, 36–37, 289 project cash flow, 283–284 tracing cash and, 514–516 New York Stock Exchange (NYSE), 17, 222–225 floor activity, 224 members, 222–223 operations, 223 organization of, 222–225 News, 359–360 Nominal interest rates, 193 Nominal rates, 145, 191 Noncash items, 29 Noncommitted line of credit, 532 Nonconstant growth, stock valuation, 213, 217 Nonconventional cash flows, IRR and, 252–253 Noncumulative dividends, 221 Nondiversifiable risk, 363, 365 NoNo bonds, 186 Normal distribution, 327–329 North American Industry Classification System (NAICS), 76 Note, 177, 179 NPV; see Net present value (NPV) NYSE Euronext, 223 NYSE Group, Inc., 223 Offshoring, 11 Open account, 561 Open market purchases, 461 Operating cash flow, 35–36, 280–281 example analysis, 288 tax shield approach, 282 Operating cycle, 517, 560 calculation of, 519–521 defining of, 516–518 firm’s organizational chart, 518–519 Operating efficiency, 52, 67 Oppenheimer Capital, 503 Opportunity cost, 277 Optimal capital structure, 421, 433–436 cost of capital and, 434–436 financial distress, 436 managerial recommendations, 436 static theory of, 433–434 taxes, 436 Optimal credit policy, 562–563 organizing the credit function, 562–563 total credit cost curve, 562 Option to abandon, 298 Option to expand, 297–298 Option to wait, 298–299 Order book, 227 Order costs, 524 Order flow, 223 Organizational chart, 6, 518–519 Outsourcing, 11 Over-the-counter, (OTC), 17 Over-the-Counter Bulletin Board (OTCBB), 228 Over-the-counter collection, 552 Overallotment option, 490 Oversubscribed issue, 498 Overvalued asset, 374 Owners’ equity, 23–25 Pacific Gas and Electric (PG&E), 507 Palm, Inc., 292, 497 Par value, 167 Par value bond, 167 Partial adjustment phenomenon, 497–498 Partnership, 7–8 Partnership agreement, Payables manager, 518 Payables period, 520 Payables turnover, 61, 520 Payback period, 243, 282 Payback rule, 243–246, 261 advantages/disadvantages of, 246 analyzing the rule, 245 calculating payback, 244–245 defining the rule, 243–244 redeeming qualities of, 246 summary of, 246 Payday loans, 145 Payment date, 454 Peer group analysis, 75–76 Peipkorn Manufacturing Working Capital Management, Part (case), 546 Peipkorn Manufacturing Working Capital Management, Part (case), 581 Penny stocks, 228 Percentage returns, 313–314 Perishability and collateral value, 560 Perpetual bond, 177 Perpetuity, 139–140 preferred stock as, 141 summary of calculations, 140 Philip Morris, 81 Pink Sheets, 228 Plowback ratio, 70 Political risk, 598–599 Portfolio, 355–358 portfolio expected returns, 355–357 portfolio variance, 357–358 portfolio weights, 355 standard deviation, 358 SUBJE CT Portfolio betas, 367–369 Portfolio diversification, 364 Portfolio expected returns, 355–357 Portfolio management, 2–3 Portfolio risk, 362–365 diversification and, 362–365 Portfolio variance, 357–358 standard deviation and, 358 Portfolio weight, 355 Positive (affirmative) covenants, 181 Precautionary motive to hold cash, 547 Preemptive right, 220 Preferred stock, 59, 141, 221 cost of, 395–396 cumulative/noncumulative dividends, 221 as debt, 221 features of, 221 stated value, 221 Premium, 169 Premium bond, 169 Present value (PV), 105–108 annuity cash flows, 132–133 basic present value equation, 109 cash flow timing, 130–131 determining discount rate, 109–112 discounting, 105–108 finding number of periods, 112–113 future value vs., 108–109 multiple cash flows, 126–129 for multiple periods, 106–108 single-period case, 105–106 spreadsheet for, 131 Present value factor, 106 Present value interest factor, 106–107 Price appreciation, 215 Price-earnings ratio (PE), 63 benchmark PE ratio, 216 forward PE ratio, 216 Price-sales ratio, 64 Primary market, 16–17, 222 secondary markets vs., 16–18 Principal value, 179 Principle of diversification, 363 Private equity, 482 Private equity issues, 485 Private placements, 17, 506 Pro forma financial statements, 279 getting started with, 279–280 project cash flows, 279–282 Processing delay, 550 Production manager, 518 Profit margin, 62, 67, 72 Profit maximization, 10 Profitability index (PI), 258–259, 261 advantages/disadvantages of, 259 Profitability measures, 62–63, 65 profit margin, 62 INDE X return on assets, 63 return on equity, 63 Project cash flows, 276, 279–282 incremental cash flows, 276 net working capital and capital spending, 281, 283–284 operating cash flow, 280–281 pro forma financial statements, 279–282 relevant cash flows, 276 stand-alone principle, 276 total cash flow and value, 281–282 Projected risk premium, 352 Promissory note, 561 Prospectus, 484 Protective covenant, 181 Protonex Technologies, 12 Proxy, 219 Proxy fight, 14, 219 Proxy voting, 219 Public limited companies, Public offerings, 17 Purchasing manager, 518 Purchasing power parity (PPP), 589–593 absolute PPP, 589–590 currency appreciation/depreciation, 593 relative PPP, 591–592 Pure discount loans, 146 Pure play, 408 Pure play approach, 407–408 Put bond, 186 Put provision, 186 Quick (acid-test ratio), 58 Quiet period, 491 Quoted interest rate, 142 Rate of return, 110 Ratio analysis, 56–66 asset utilization or turnover measures, 60–62 long-term solvency measures, 59–60, 65 market value measures, 63–65 profitability measures, 62–63 short-term solvency/liquidity measures, 57–58, 65 summary of, 65 Ratios and Financial Planning at S&S Air, Inc (case), 95–96 Raw material, 566 Real vs nominal rates, 191–192 Real rates, 191 Receivables, 558 monitoring of, 564–565 Receivables period, 520, 560 Receivables turnover, 61, 520 Record date, 454 Red herring, 485 Registered form, 179 Registration statement, 484 643 644 SU B J E C T I N D E X Regular cash dividend, 453 Regular cash dividends, 452 Relative purchasing power parity, 591–592 Relevant cash flows, 276 Rembrandt bonds, 583 Reorder points, 572 Reorganization, 439 Repayment, 180 Repurchases, 461–463, 469 EPS and, 464 real-world considerations in, 463–464 Required return, 311, 388, 390 components of, 215–217 cost of capital vs., 389–390 Research in Motion, 72 Restructurings, 420 Retention ratio, 70 Return on assets (ROA), 63, 66–67, 248 growth and, 70–73 Return on book assets, 63 Return on book equity, 63 Return on equity (ROE), 63, 66 financial leverage and, 421–422 growth and, 70–73 Return on investment, 110, 311–315 average returns, 321–323 calculation of, 314–315 dollar returns, 311–313 historical record on, 315–321 percentage returns, 313–314 systematic and unsystematic components of, 361 variability of returns, 323–333 Return on net worth, 63 Revenues, 27 Reverse split, 472 Revolver, 532 Revolving credit arrangement, 532 Reward-to-risk ratio, 370, 373, 376 Rights offer, 485 Rights offering, 484 Risk in an investment, 311 business and financial risk, 428–429 diversifiable risk, 363 exchange rate risk, 595–598 forecasting risk, 292–293 political risk, 598–599 reward and, 311, 328 reward-to-risk ratio, 370, 373 systematic and unsystematic, 361 Risk and return, 350–351 reward-to-risk ratio, 370, 373 summary of concepts, 376 Risk-free return, 322 Risk premium, 322, 351–353 beta and, 369–370 stock market risk premium, 332–333 Road show, 489 Rule 415 (shelf registration), 506 Rule of 72, 110, 112 S&P monthly returns (2008), 330 S&S Air Goes International (case), 605 S&S Air Goes Public (case), 512 S&S Air’s Mortgage (case), 165 Safety reserves, costs of, 524 Safety stocks, 572 Sallie Mae, 151 Samurai bonds, 583 Sarbanes-Oxley Act (2002), 12 Scenario analysis, 294–295 Seasonal activities, 556 Seasonal businesses, 81 Seasoned equity offering (SEO), 487, 500 Second-stage financing, 483 Secondary market, 16–18, 222 auction markets, 17 dealer markets, 17 Secondary offering, 487 Section 363 bankruptcy, 441 Secured loans, 532 accounts receivable financing, 532–533 inventory loans, 533 Secured obligation, 180 Securities Act of 1933, 484 Securities and Exchange Commission (SEC), 17, 30, 68, 484 Securities Exchange Act of 1934, 484–485, 507 Rule 415 shelf registration, 506 selling securities to the public, 484–485 Securities Industry and Financial Markets Association (SIFMA) website, 180 Security analysis, Security analysts, Security market line (SML), 351, 369–373, 374–376, 389 basic argument, 371–372 basic idea of, 377 beta and risk premium, 369–370 Capital Asset Pricing Model, 374–375 cost of capital and, 376–377 fundamental result, 373–374 market portfolios, 374 reward-to-risk ratio, 370 WACC and, 406–407 Security market line (SML) approach advantages/disadvantages of, 394 implementation of, 393–395 Seed money, 483 Selling securities to the public alternative issue methods, 485–487 basic procedure of, 484–485 cost of issuing, 501–505 IPOs and underpricing, 491–499 SUBJE CT issuing long-term debt, 505–506 new equity sales and value of the firm, 500 shelf registration, 506–507 underwriters, 488–491 Semiannual coupons, 170 Semistrong form of market efficiency, 339–340 Senior debt, 180 Seniority, 180 Sensitivity analysis, 295–297 Series EE bonds, 97 Shareholder rights, 218–219 Shareholders’ equity, 23, 25 Sharpe ratio, 325 Shelf cash offer, 487 Shelf registration, 506–507 Short-run exposure, exchange rate risk, 595–596 Short-term borrowing, 532–533 appropriate amount of, 527 inventory loans, 533 other sources of funds, 53 secured loans, 532–533 unsecured loans, 532 Short-term debt, 177 Short-term finance, 514 Short-term financial decisions, 514 Short-term financial plan (example), 534 Short-term financial policy, 513–514; see also Cash budget aspects of, 523–534 best policy for, 527–528 compromise financing policy, 527 current assets, 525–527 practices of, 528 Short-term securities, 556–557 default risk, 557 marketability, 557 maturity, 556–557 taxability, 557 Short-term solvency ratios, 57–58 cash ratio, 58 current ratio, 57–58 quick (acid-test ratio), 58 Short-term tax exempts, 557 Shortage costs, 524–525, 567 Sight draft, 562 Simple interest, 99–100 Single-period investing, 98 Single-period present value, 105–106 discount rate, 109–110 Sinking fund, 180 Sirius XM Radio, 14 Size of account, collection period, 560 Small-company stock, 327, 332 Society for Worldwide Interbank Financial Telecommunications (SWIFT), 584 Soft rationing, 299 Sole proprietorship, INDE X Sources of cash, 515 Special dividends, 453 Specialists, 223 Speculative motive to hold cash, 547 Spin-off, 497 Spot exchange rate, 588 Spot trade, 588 Spread, 188, 488, 501, 504 Stafford loans, 151 Staggered boards, 219 Stakeholder, 15 Stalking horse, 441 Stand-alone principle, 276 Standard and Poor’s (S&P), 181–182 Standard deviation, 324, 327 calculation of, 326 historical variance and, 324 on mutual funds, 325 portfolio variance and, 355, 358 Standard Industrial Classification (SIC) code, 75 Standard Register, 81 Standby rights offer, 487 Stanley Works, 11 Stated interest rate, 142 Statement of cash flows, 35 Static theory of capital structure, 433 Stephenson Real Estate Recapitalization (case), 450 Stern Stewart & Co., 398 Stifel Nicolaus Weisel, 503 Stock buybacks, 461, 464 Stock dividend, 471–473 benchmark case, 472 popular trading range, 472 value of, 472 Stock markets, 222–226 dealers and brokers, 222 ECNs, 225–226 NASDAQ operations, 225–226 NYSE, 222–225 Pink Sheets and OTC Bulletin Board, 228 risk premiums for 17 countries (1900–2010), 332–333 stock market reporting, 226 Stock-out, 524 Stock price delayed reaction, 338 efficient market reaction, 338 overreaction and corrections, 338 reaction to new information, 338 Stock repurchase, 461 cash dividends vs., 461–463 EPS and, 464 real world considerations in, 463–464 Stock split, 471 benchmark case, 472 reverse splits, 472–473 trading range, 472 645 646 SU B J E C T I N D E X Stock valuation, 208–217 cash flows, 208–209 constant growth dividend, 210 dividend growth, 211 dividend growth model, 211–212 growth stocks, 209 nonconstant growth dividend, 213–214 required return components, 215–216 summary of, 217 supernormal growth, 214–215 use of multiples, 216–217 zero growth dividend, 210 Stock Valuation at Ragan, Inc (case), 237 Stockbrokers, 2–3 Stockholder, Stockholder wealth maximization, 11, 15 Stockholders’ equity, 23 Stocks and bonds, Straight-line depreciation, 29 Straight voting, 218 Strategic options, 299 Strong form efficient, 340 Structured notes, 186 Student loan payments, 151 Subordinated debt, 180 Sunk cost, 277 Super Bowl indicator, 331 Supernormal growth, stock valuation, 214 Supplemental liquidity providers (SLPs), 223 Supply chain management (SCM), 574 Surprise, 360 Sustainable growth, 69 Sustainable growth rate, 71, 73 dividend policy, 72 financial policy, 72 note on calculations, 73 profit margin, 72 total asset turnover, 72 Swaps, 584 Syndicate, 488 Systematic risk, 361, 365, 376 beta and, 365–369 diversification, 364–365 expected returns and, 373 measurement of, 366 systematic risk principle, 365 Systematic risk principle, 365, 376 Takeover, 14 Tangible assets, 23 Target capital structure, 421 Targeted repurchase, 462 Tax deductions, 33 Tax-exempt investors, high dividends, 459–460 Tax loopholes, 33 Tax Reform Act of 1986, 284 Tax shield approach, 282 Taxability premium, 197 Taxes, 22, 31–34 average vs marginal tax rates, 32 capital structure and, 436 corporate tax rates, 31 corporate taxes and capital structure, 429–431 dividend income, 34 low dividend payout, 458 M&M Proposition I, 430–431 short-term securities, 557 weighted average cost of capital, 397–398 Technical analysis, 340 Technical insolvency, 439 Technical trading rules, 331 Temporary cash surpluses, 556 Tender offer, 462 Term loans, 506 Term structure of interest rates, 193–196 Terms of sale, 558–562 basic form, 559 credit period, 559–560 3Com, Inc., 497 Ticker symbol, 14 Tilly’s, 492 Time and costs, 29–30 Time draft, 562 Time line, 123–124 Time to maturity, interest rate risk, 171 Time-trend analysis, 75 Time value of money, 98 determining discount rate, 109–112 finding number of periods, 112–113 future value and compounding, 98–104 present value and discounting, 105–108 present value vs future value, 108–109 spreadsheet for calculations, 113–114 summary of calculations, 114 Time Warner, 292 Times interest earned, 59 TIPS (Treasury Inflation Protection Securities), 186 Tokyo Stock Exchange (TSE), 18 Tombstone, 485–486 Total asset turnover, 62, 67, 72 Total debt ratio, 59 Total return, 376 Total risk, 376 beta vs., 366–367 Toys ‘R’ Us, 398 Trade acceptance, 562 Trade credit, 533, 558 Trade Reporting and Compliance Engine (TRACE), 188 Trading, in corporate securities, 17 Trading costs, 524 Trading range, 472 Transaction motive to hold cash, 547 Translation exposure, 597 Translation gains/losses, 597 SUBJE CT Transparency, 188 Treasury bills (T-bills), 146, 557 Treasury yield curve, 196 Treynor index, 370 Triangle arbitrage, 587–588 Triple Crown Winner indicator, 331 Trust deed, 179 Trust receipt, 533 Turnover ratios, 60–62 Tyco, 12 Underpricing, 501 Underpricing of IPOs, 491–492 evidence on, 492–493 explanations for, 498–499 global phenomenon of, 495 years (1999–2000) experience, 494–497 Underwriters, 488–491 choice of, 488 Underwriting aftermarket, 490 best efforts, 489 Dutch auction, 489–490 firm commitment, 488–489 green shoe provision, 490 lockup agreements, 490–491 quiet period, 491 types of, 488–490 Unfunded debt, 177 Uniform price auction, 489 Unique risk, 365 Unique risks, 361, 376 U.S Treasury bills, 146, 557 U.S Treasury bonds, 166, 190 U.S Treasury market, 187 U.S Treasury quotes, 190 Unlimited liability, Unseasoned new issue, 487 Unsecured loans, 532 Unsystematic risk, 361, 376 diversification and, 363–364 Uses of cash, 515 Valuation, time value of money, 97–98 Value, sources of, 293 Value added, 239 Value Line Investment Survey, 81, 368 Value of the firm, new equity sales and, 500 Variability of returns frequency distributions and variability, 323–324 historical variance and standard deviation, 324–325 INDE X Variable costs, 29 Variance, 324 calculation of, 326, 353–354 historical variance, 324 portfolio variance, 357–358 Venture capital (VC), 482–484 choice of, 483–484 realities of, 483 Vulture capitalists, 482 Wages, taxes, and other expenses, 530 Walmart, 72 Walt Disney “Sleeping Beauty” bonds, 172 Warrants, 488 Weak form efficient, 340 Weighted average cost of capital (WACC), 388, 397–405 capital budgeting problems, 399–400 capital structure weights, 396–397 Eastman Chemical example, 400–405 oil industry valuations, 401 pure play approach, 408 SML and, 406–407 subjective approach, 408–409 taxes and, 397–399 What-if analyses, 293–295 Winner’s curse, 499 Work-in-progress inventory, 566 Working capital, Working capital management, 514, 546 Workouts, 443 World Wrestling Federation (WWF), 496 WorldCom, 12 Worst case, 295 Yahoo!, 67–68 Yahoo! Finance, 368 Yandex, 491 Yankee bonds, 583 Yield, 167, 174–175 Yield curve, 196 Yield to maturity (YTM), 167 finding the yield, 172–173 Zero-balance account, 555 Zero coupon bond, 184–185 Zero growth, stock valuation, 210 647 ... Westerfield, and Jordan Essentials of Corporate Finance Eighth Edition Ross, Westerfield, and Jordan Fundamentals of Corporate Finance Tenth Edition Shefrin Behavioral Corporate Finance: Decisions.. .essentials of Corporate Finance 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,... Stephen A Ross Sloan School of Management, Franco Modigliani Professor of Finance and Economics, Massachusetts Institute of Technology Stephen A Ross is the Franco Modigliani Professor of Finance