Financial Theory and Corporate Policy/ THOMAS E COPELAND Professor of Finance University of California at Los Angeles Firm Consultant, Finance McKinsey & Company, Inc J FRED WESTON Cordner Professor of Managerial Economics and Finance University of California at Los Angeles • •• ADDISON-WESLEY PUBLISHING COMPANY Reading, Massachusetts • Menlo Park, California • New York Don Mills, Ontario • Wokingham, England • Amsterdam Bonn • Sydney • Singapore • Tokyo • Madrid • San Juan This book is dedicated to our wives, Casey and June, who have provided their loving support; and to the pioneers in the development of the modern theory of finance: Hirshleifer, Arrow, Debreu, Miller, Modigliani, Markowitz, Sharpe, Lintner, Jensen, Fama, Roll, Black, Scholes, Merton, Ross, and others cited in the pages that follow Without their intellectual leadership this text could not exist Library of Congress Cataloging-in-Publication Data Copeland, Thomas E., 1946– Financial theory and corporate policy Includes bibliographies and index Corporations—Finance I Weston, J Fred (John Fred), 1916– II Title HG4011.C833 1988 658.1'5 87-12595 ISBN 0-201-10648-5 Many of the designations used by manufacturers and sellers to distinguish their products are claimed as trademarks Where those designations appear in this book, and Addison-Wesley was aware of a trademark claim, the designations have been printed in initial caps or all caps Copyright © 1988 by Addison-Wesley Publishing Company, Inc All rights reserved No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher Printed in the United States of America Published simultaneously in Canada ABCDEFGHIJ–DO-898 Preface In this third edition we seek to build on our experiences and the suggestions of users of the two previous editions The feedback that we have received from all sources confirms our original judgment that there is a need for a book like Financial Theory and Corporate Policy Therefore, we will continue to emphasize our original objectives for the book Primarily, our aim is to provide a bridge to the more theoretical articles and treatises on finance theory For doctoral students the book provides a framework of conceptual knowledge, enabling the students to understand what the literature on financial theory is trying to and how it all fits together For MBAs it provides an in-depth experience with the subject of finance Our aim here is to equip the MBA for his or her future development as a practicing executive We seek to prepare the MBA for reading the significant literature of the past, present, and future This will help the practicing financial executive keep up to date with developments in finance theory, particularly as they affect the financial executive's own thinking processes in making financial decisions As before, our emphasis is on setting forth clearly and succinctly the most important concepts in finance theory We have given particular attention to testable propositions and to the literature that has developed empirical tests of important elements of finance theory In addition, we have emphasized applications so that the nature and uses of finance theory can be better understood A PURPOSE AND ORGANIZATION Over the past 30 years a branch of applied microeconomics has been developed and specialized into what is known as modern finance theory The historical demarcation point was roughly 1958, when Markowitz and Tobin were working on the theory of portfolio selection and Modigliani and Miller were working on capital structure and valuation Prior to 1958, finance was largely a descriptive field of endeavor Since then major theoretical thrusts have transformed the field into a positive science As evidence of the changes that have taken place we need only look at the types of people who teach in the schools of business Fifty years ago the faculty were drawn from the ranks of business and government They were respected and experienced statesmen within their fields Today, finance faculty are predominantly academicians in the traditional sense of the word The majority of them have no business experience except for consulting Their interest iii iV PREFACE and training is in developing theories to explain economic behavior, then testing them with the tools provided by statistics and econometrics Anecdotal evidence and individual business experience have been superseded by the analytic approach of modern finance theory The rapid changes in the field of finance have profound implications for management education As usual, the best students (and the best managers) possess rare intuition, initiative, common sense, strong reading and writing skills, and the ability to work well with others But those with the greatest competitive advantage also have strong technical training in the analytical and quantitative skills of management Modern finance theory emphasizes these skills It is to the students and faculty who seek to employ them that this textbook is addressed The six seminal and internally consistent theories upon which modern finance is founded are: (1) utility theory, (2) state-preference theory, (3) mean-variance theory and the capital asset pricing model, (4) arbitrage pricing theory, (5) option pricing theory, and (6) the Modigliani-Miller theorems They are discussed in Chapters through and in Chapter 13 Their common theme is "How individuals and society allocate scarce resources through a price system based on the valuation of risky assets?" Utility theory establishes the basis of rational decision making in the face of risky alternatives It focuses on the question "How people make choices?" The objects of choice are described by state-preference theory, mean-variance portfolio theory, arbitrage pricing, and option pricing theory When we combine the theory of choice with the objects of choice, we are able to determine how risky alternatives are valued When correctly assigned, asset prices provide useful signals to the economy for the necessary task of resource allocation Finally, the Modigliani-Miller theory asks the question "Does the method of financing have any effect on the value of assets, particularly the firm?" The answer to this question has important implications for the firm's choice of capital structure (debt-to-equity mix) and dividend policy It is important to keep in mind that what counts for a positive science is the development of theories that yield valid and meaningful predictions about observed phenomena The critical first test is whether the hypothesis is consistent with the evidence at hand Further testing involves deducing new facts capable of being observed but not previously known, then checking those deduced facts against additional empirical evidence As students of finance, we must not only understand the theory, but also review the empirical evidence to determine which hypotheses have been validated Consequently, every effort has been made to summarize the empirical evidence related to the theory of finance Chapter discusses empirical evidence on the capital asset pricing model and the arbitrage pricing theory Chapter includes studies of how alternative option pricing models perform Chapter 9, newly added to this edition, discusses the theory and evidence on futures markets Chapter 11 covers evidence on the efficient markets hypothesis Chapter 14 reviews evidence on capital structure; Chapter 16 on dividend policy; Chapter 20 on mergers and acquisitions; and Chapter 22 on international finance Finally, in addition to the theory and empirical evidence there is always the PREFACE V practical question of how to apply the concepts to difficult and complex realworld problems Toward this end, Chapters and are devoted to capital budgeting, Chapter 14 shows how to estimate the cost of capital for a large, publicly held corporation, and Chapter 16 determines the value of the same company Chapter 18, another change in this edition, emphasizes the theory and evidence on topics of interest to chief financial officers: pension fund management, interest rate swaps, and leveraged buyouts Throughout the text we attempt, wherever feasible, to give examples of how to apply the theory Among other things we show how the reader can estimate his or her own utility function, calculate portfolio means and variances, set up a cross-hedge to reduce the variance of equity returns, value a call option, determine the terms of a merger or acquisition, use international exchange rate relationships In sum, we believe that a sound foundation in finance theory requires not only a complete presentation of the theoretical concepts, but also a review of the empirical evidence that either supports or refutes the theory as well as enough examples to allow the practitioner to apply the validated theory B CHANGES IN THE THIRD EDITION We have tried to move all the central paradigms of finance theory into the first half of the book In the second edition this motivated our shifting the option pricing material into Chapter In this third edition we decided to add a completely new chapter on futures markets—Chapter It covers traditional material on pricing both commodity and financial futures, as well as newer issues: why futures markets exist, why there are price limits in some markets but not others, and empirical evidence on normal backwardation and contango In the materials on portfolio theory we have added a section on how to use T-bond futures contracts for cross-hedging In Chapter we have updated the literature review on the Capital Asset Pricing Model and the Arbitrage Pricing Model Chapter contains new evidence on option pricing The materials on capital structure (Chapters 13 and 14) and on dividend policy (Chapters 15 and 16) have been completely rewritten to summarize the latest thinking in these rapidly changing areas of research Chapter 18 is completely new Many topics of importance to chief financial officers are applications of finance theory Pension fund management, interest rate swaps, and leveraged buyouts are the examples developed in this chapter Chapters 19 and 20 on mergers and acquisitions, restructuring, and corporate control represent up-to-date coverage of the burgeoning literature Similarly, Chapters 21 and 22 reflect the latest thinking in the field of international financial management We made numerous other minor changes In general, we sought to reflect all of the new important literature of finance theory—published articles and treatises as well as working papers Our aim was to keep the book as close as possible to the frontiers of the "state-of-the-art" in the literature of finance theory Vi PREFACE C SUGGESTED USE IN CURRICULUM At UCLA we use the text as a second course in finance for MBA students and as the first finance course for doctoral students We found that requiring all finance majors to take a theory-of-finance course before proceeding to upperlevel courses eliminated a great deal of redundancy For example, a portfolio theory course that uses the theory of finance as a prerequisite does not have to waste time with the fundamentals Instead, after a brief review, most of the course can be devoted to more recent developments and applications Because finance theory has developed into a cohesive body of knowledge, it underlies almost all of what had formerly been thought of as disparate topics The theory of finance, as presented in this text, is prerequisite to security analysis, portfolio theory, money and capital markets, commercial banking, speculative markets, investment banking, international finance, insurance, case courses in corporation finance, and quantitative methods of finance The theory of finance can be, and is, applied in all of these courses That is why, at UCLA at least, we have made it a prerequisite to all the aforementioned course offerings The basic building blocks that will lead to the most advantageous use of this text include algebra and elementary calculus; basic finance skills such as discounting, the use of cash flows, pro-forma income statements and balance sheets; elementary statistics; and an intermediate-level microeconomics course Consequently, the book would be applicable as a second semester (or quarter) in finance This could occur at the junior or senior undergraduate year, for MBAs during the end of their first year or beginning of their second year, or as an introductory course for Ph.D students D USE OF THE SOLUTIONS MANUAL The end-of-chapter problems and questions ask the students not only to feed back what they have just learned, but also to take the concepts and extend them beyond the material covered directly in the body of the text Consequently, we hope that the solutions manual will be employed almost as if it were a supplementary text It should not be locked up in the faculty member's office, as so many instructor's manuals are It is not an instructor's manual in a narrow sense Rather, it is a solutions manual, intended for use by the students Anyone (without restriction) can order it from the publisher We order it, through our bookstore, as a recommended supplemental reading Understanding of the theory is increased by efforts to apply it Consequently, most of the end-of-chapter problems are oriented toward applications of the theory They require analytical thinking as well as a thorough understanding of the theory If the solutions manual is used, as we hope it will be, then students who learn how to apply their understanding of the theory to the end-of-chapter problems will at the same time be learning how to apply the theory to real-world tasks PREFACE Vii E ACKNOWLEDGMENTS We have received help from many persons on the three editions of the book We especially benefited from the insightful corrections, clarifications, and suggestions of Eugene Fama, Herb Johnson, and Kuldeep Shastri Nai-fu Chen and Ronald Bibb wrote Appendixes B and D, respectively Ron Masulis rewrote Chapter We also wish to acknowledge the help of the following: Ed Altman, Enrique Arzac, Dan Asquith, Warren Bailey, Gerry Bierwag, Diran Bodenhorn, Jim Brandon, Michael Brennan, William Carleton, Don Chance, Nai-fu Chen, Don Chew, Kwang S Chung, Halimah Clark, Peter Clark, S Kerry Cooper, Larry Dann, Harry and Linda E DeAngelo, Dirk Davidson, David Eiteman, Chapman Findlay, Kenneth French, Dan Galai, Robert Geske, Mark Grinblatt, C W Haley, Ronald Hanoian, Iraj Heravi, David Hirshleifer, Tom Ho, Chi-Cheng Hsia, William C Hunter, Ashok Korwar, Clement Krouse, Steven Lippman, Stephen Magee, Dubos Masson, Bill Margrabe, Charles Martin, Ronald Masulis, David Mayers, Guy Mercier, Edward Miller, Merton Miller, Timothy J Nantell, Ron Necoechea, Jorge:Nielson, R Richardson Pettit, Richard Pettway, Richard Roll, Shigeki Sakakibara, Eduardo Schwartz, Jim Scott, Jandhyala Sharma, Kilman Shin, Ron Shrieves-, Keith Smith, Dennis Soter, Joel Stern, Sheridan Titman, Brett Trueman, Jim Wansley, Marty Weingartner, Richard West, Randy Westerfield, Robert Whaley, Stuart Wood, and Bill Ziemba For their considerable help in preparation of the text, we thank Susan Hoag and Marilyn McElroy We also express appreciation for the cooperation of the Addison-Wesley staff: Steve Mautner, Herb Merritt, and their associates There are undoubtedly errors in the final product, both typographical and conceptual as well as differences of opinion We invite readers to send suggestions, comments, criticisms, and corrections to the authors at the Anderson Graduate School of Management, University of California, Los Angeles, CA 90024 Any form of communication will be welcome Los Angeles, California T.E.C J.F.W Contents PART I THE THEORY OF FINANCE 1 Introduction: Capital Markets, Consumption, and Investment Introduction Consumption and Investment without Capital Markets Consumption and Investment with Capital Markets Marketplaces and Transactions Costs 13 Transactions Costs and the Breakdown of Separation 14 Summary 15 Problem Set 15 References 16 Investment Decisions: The Certainty Case Introduction 17 Fisher Separation 18 The Agency Problem 20 Maximization of Shareholders' Wealth 20 Techniques for Capital Budgeting 25 Comparison of Net Present Value with Internal Rate of Return 31 Cash Flows for Capital Budgeting Purposes 36 Summary and Conclusion 41 Problem Set 41 References 44 More Advanced Capital Budgeting Topics Introduction 46 Capital Budgeting Techniques in Practice 47 Projects with Different Lives 49 Constrained Capital Budgeting Problems 55 Capital Budgeting Procedures under Inflation 61 46 The Term Structure of Interest Rates 65 Summary and Conclusions 71 Problem Set 72 References 74 The Theory of Choice: Utility Theory Given Uncertainty Five Axioms of Choice under Uncertainty 79 Developing Utility Functions 80 Establishing a Definition of Risk Aversion 85 17 77 Comparison of Risk Aversion in the Small and in the Large 90 Stochastic Dominance 92 Using Mean and Variance as Choice Criteria 96 ix X CONTENTS A Mean-Variance Paradox 99 Recent Thinking and Empirical Evidence 102 Summary 103 Problem Set 103 References 107 State-Preference Theory Uncertainty and Alternative Future States 110 Definition of Pure Securities 111 Complete Capital Market 111 Derivation of Pure Security Prices 113 No Arbitrage Profit Condition 115 Economic Determinants of Security Prices 116 Optimal Portfolio Decisions 119 Portfolio Optimality Conditions and Portfolio Separation 122 Firm Valuation, the Fisher Separation Principle, and Optimal Investment Decisions 124 109 Summary 128 Problem Set 129 References 131 Appendix A to Chapter 5: Forming a Portfolio of Pure Securities 133 Appendix B to Chapter 5: Use of Prices for State-Contingent Claims in Capital Budgeting 135 Appendix C to Chapter 5: Application of the SPM in Capital Structure Decisions 140 Objects of Choice: Mean-Variance Uncertainty Measuring Risk and Return for a Single Asset 146 Measuring Portfolio Risk and Return 153 Optimal Portfolio Choice: The Efficient Set with Two Risky Assets (and No Risk-Free Asset) 166 The Efficient Set with One Risky and One Risk-Free Asset 171 Optimal Portfolio Choice: Many Assets 173 Portfolio Diversification and Individual Asset Risk 184 Summary 188 Problem Set 188 References 192 Market Equilibrium: CAPM and APT Introduction 193 The Efficiency of the Market Portfolio 194 Derivation of the CAPM 195 Properties of the CAPM 198 Use of the CAPM for Valuation: SinglePeriod Models, Uncertainty 202 Applications of the CAPM for Corporate Policy 204 Extensions of the CAPM 205 193 Empirical Tests of the CAPM 212 The Problem of Measuring Performance: Roll's Critique 217 The Arbitrage Pricing Theory 219 Empirical Tests of the Arbitrage Pricing Theory 228 Summary 231 Problem Set 231 References 235 Pricing Contingent Claims: Option Pricing Theory and Evidence Introduction 240 A Description of the Factors That Affect Prices of European Options 241 145 Combining Options, A Graphic Presentation 245 Equity as a Call Option 248 240 932 AUTHOR INDEX Taylor, R., 633 Tehranian, H., 671 Teichroew, D., 35 Telser, L., 307, 309, 317 Tepper, I., 650 Thompson, R., 388, 389, 390, 587, 633, 727728, 755 Thorpe, K E., 690 Titman, S., 382, 383, 499, 511, 518, 519, 581 Tobin, J., 96, 822 Treynor, J., 193, 196, 383, 646 Triffin, R., 785, 787 Trueman, B., 561, 563 Tversky, A., 102 Ungerer, H., 787 Vanderwicken, P., 614 Van Home, J C., 61, 428 Vermaelen, T., 581, 597, 598, 599, 600 Vertinsky, I., 336 Vickers, D., 383 Vickrey, D., 382 Vickson, R G., 95 Von Neumann, J., 77, 102 Waegelein, J., 671 Wakeman, L., 516, 626, 657-658, 739 Walker, C E., 69 Walter, J E., 83, 84, 544 Walther, C H., 824 Warner, J., 499, 500, 512, 739, 756 Wart, J R., 95 Watts, R., 369, 510, 584, 585, 586, 668 Weil, R., 385 Weinberger, A., 494 Weingartner, H M., 58, 59, 60 Weinstein, M., 380, 500, 515, 516 Weitzman, M., 430 Wessels, R., 518, 519 West, R., 597 Westerfield, R., 653 Weston, J F., 420-427, 517, 630, 631, 686, 707, 734, 763 Whaley, R., 275 Whitmore, G A., 95 Whittaker, J G., 829 Wier, P., 733-734 Williams, J., 212 Williamson, E., 20, 685 Wolfson, M., 370 Woods, D., 597 Woodward, S., 68 Woolridge, J R., 382, 586, 587 Working, H., 309 Yawitz, J B., 494 Young, A., 597 Young, P., 787 Ziemba, W T., 95, 336 Zimmerman, J., 510 Subject Index Abandonment value, 419-429 Abnormal performance, 362, 364, 384 Abnormal performance index, 367-368 Abnormal return, 351 in mergers, 729 Absolute risk aversion, 89, 920 Accounting information, 607-608 definition of profit, 23, 40, 441 LIFO vs FIFO, 24, 363 lease accounting, 616-618 purchase vs pooling, 25, 365, 678 Accounting rate of return, 28 Acquisitions programs, 727-728 Actuarial assumptions of pension plans, 644645 Actuarial value of a gamble, 85-86 Adjustment process under flexible foreign exchange rates, 782, 785 Agency costs, 20, 472, 662 effect on capital structure, 509-512 incentive effect, 728 of debt, 509 of external equity, 510 theory of mergers, 687-688 Allocational efficiency, 330, 349 American options, calls, 241, 252, 254, 324 puts, 277-279, 323, 419, 631 Annual equivalent value, 51 Annuities, 843-848 continuously growing, 853-854 present value of growing stream, 21 Antitakeover defenses, amendments, 679, 736-737 structural, 740-742 Antitrust, 730-734 ARA See Absolute risk aversion Arbitrage, 314-316 international, 796-800, 818 quality spread, 657 tax, 581 Arbitrage opportunities, 225 Arbitrage portfolios, 219-220, 225 Arbitrage Pricing Theory, 193, 219-228, 320, 411, 443 empirical tests, 228-230 Arbitrage profits, 115-116, 316, 578 ARR See Accounting rate of return Arrow-Debreu securities, 111 Auction market, double, 340 Autoregressive process, stationary, 313 Average, 148 Axioms of cardinal utility, 79-80 Backwardation, normal, 317-318, 321-322, 324 Balance of payments, 788-790 Bankruptcy, 22, 498-500, 696, 699 Benchmark, future, 386 Benefit function, 333 Benefits, vested, 640 Beta, 198, 201, 222, 225 levered equity, 457, 459 unlevered, 457, 459 zero-beta, 206 Bethlehem Steel case, cost of capital, 526-531 valuation, 602-607 Bias, misspecification, 887 of regression, 886 postselection, 364 Bilateral exchange, 13 Binomial distribution, 264-265 Binomial model of one-period riskless interest rate, 659 Binomial option pricing, 257-267 comparison with Black-Scholes OPM, 272 Bird-in-hand fallacy, 553-554 Black-Scholes option pricing model, 267-269, 309, 311, 426 comparison with binomial, 272 cost of risky debt, 466 derivation, 296-299 933 934 SUBJECT INDEX Block trading, 370-375 Bond indenture provisions, 508-509, 512-514, 743-744 Bond rating agencies, 514-516 Bondholder wealth expropriation, 507-509, 519, 600, 694, 743 744 Bonds, callable, 478-480 consol, 37, 844 convertible, 473-478 junk, 676 new issues, 380 zero coupon, 66 Bonus plans, 666-667 Book value leverage, 447 Borrowing and lending opportunities, 19 Breakdown of separation, 14 Brownian motion, 296 Buy-and-hold strategy, 349 Buyback, premium, 679, 738 Buyer and seller premiums in mergers, 718 Buying a call, a put, 245-246 Buying on margin, 259 Cady-Roberts decision, 376 Calculus, fundamental theorem, 923-924 Call options, 241, 252, 254, 324 Call premium, 478, 531-532 Callable debt, 478-480, 531-532 Cancellable leases, 629-631 CAPM See Capital Asset Pricing Model Capital Asset Pricing Model, 124, 187, 193, 197, 204, 362, 401, 417, 455, 476, 589 continuous time version, 465-466 empirical tests, 212-217 ex ante form, 212 ex post form, 213, 217-218 extensions of, 205-212 and futures prices, 318-319 international, 810-813 and market efficiency, 350 properties of, 198-202 Roll's critique, 218-219 two-factor model, 207 Capital budgeting, 25-41, 46-65 constrained, 55-61 linear programming solutions, 58-61 and term structure of interest rates, 70-71 under inflation, 61-65 and use of state-contingent claims, 135-139 Capital gains, dividends, versus, 20-22, 689-690 short-term, 308 tax rate, 557 Capital leases, 616 Capital Market Line, 9-10, 11, 19, 181, 183, 194, 195, 197, 333 Capital markets, efficiency, 331, 338 equilibrium, 15 frictionless, 219, 252 perfect, 125, 330, 790 Capital rationing, 56 multiperiod constraints, 58-61 Capital shares of a dual fund, 387 Capital structure, application of SPM, 140-144 effect of agency costs, 509-512 empirical evidence, 516-523 optimal, 499, 621 pecking order theory, 507, 519, 520 Cardinal utility, 79-81 function, 908 Cash flows, 21-25 for capital budgeting, 36-41, 441, 442 discounted, 25 expected, 26 free cash flows, 38, 39, 441, 604 for leasing, 622 Cash tender offers, 723-724 Casino Society, 676 Central tendency, measure of, 149 Certainty equivalent, for spot price of a commodity, 319 valuation formula, 203, 403-406 wealth, 87, 91 Chain rule of differential calculus, 905-906 Choice, axioms of, 79-80 objects of, 15 theory of, 15, 77 Citizens Utilities Company, 594 Clearinghouse for futures contracts, 303 Clientele effects, debt, 559, 582-583 dividend, 563, 578-582 Coefficient, correlation, 159-161 Collateralized debt, 511 Collusion, 688 Committed lines of credit, 480-481 Comparability, axioms of choice, 79 interpersonal comparison of utility functions, 84 Comparative advantage, 779 Comparison of binomial and Black-Scholes OPMs, 272 Compensation plans, 665-672 SUBJECT INDEX Competition in acquisitions market, 720 Complete markets, 112, 125 Completeness, axioms of choice, 79 Compound interest, 898 formula, 842 Compound option model, 281 Compound sum of annuity, 846 Compounding, continuous, 851-854, 902-903 semiannual, 850 Concentration, industrial, 688 Confidence intervals, 884 Conglomerate mergers, 678, 691-708 performance, 707-708 Consistency, axioms of choice, 79 Consistent foreign exchange rates, 782-783 Consol bonds, 37, 844 Constant payment annuities, 843-846 Constant elasticity of variance, 281, 287 Constant scale replication, 49-51, 54-55 Constrained capital budgeting, 55-61 Constrained optimization, 914-916 Consumer surplus, 454 Consumption, international opportunity set, 811 optimal pattern, 11 and production decision, 10 Contango, 318, 324 Contingent claims, 110 Contingent immunization, 494 Contingent projects, 26 Continuous compounding, 851-854, 902-903 Continuous stochastic processes, 252, 268 Continuously growing annuities, 853-854 Control, corporate, 679 Convenience yield, 317, 322 Convertibility (in foreign exchange), 781 Convertible debt, 473-478 Corporate control, 679 Corporate governance, 734-744 Corporate restructuring, 677-680, 757 Correlation, coefficient, 159-161 perfect, 159-160, 162-165 serial, 889-892 Cost of capital, 22, 25 debt, 39, 470, 527 equity, 39, 448-450, 458, 525, 530 example calculation, 526-531 market-determined opportunity cost of capital, 31 risk-adjusted for capital budgeting, 461 935 short-term liabilities, 530 warrants, 476 weighted average, 29, 39, 402, 444-446, 450, 470 Cost of the gamble, 87 Costly information, 343-346 Costs of storage, 317 Covariance, 156, 159, 174, 187, 193, 198 risk, 188, 202 serial, 348 Covenants, 509, 512-514, 743-744 Covered interest arbitrage, 796-800 Cramer's rule, 870-871, 873 Credit, committed lines, 480-481 Cross hedging, 474 with futures contracts, 176-178 Cumulative average residuals, 363, 364 Cumulative probability of unit normal variable, 269-270 Currency swaps, 830 Daily settlement of futures contracts, 304 Dead weight losses, 498 Debt, capacity and mergers, 701-707 clienteles, 559, 582-583 collateralized, 511 convertible, 473-478 cost of long term, 527 defeasance, 533-534 fixed rate, 660 market value of, 602 maturity structure and duration, 471, 494 new issues, 380 ratio, 446 refunding, 531-534 risky, 248, 462, 470 secured, 511 variable rate, 264, 660 Default risk premium, 230 Defeasance, 533-534 Defined benefit pension plans, 641 Defined contribution pension plans, 641 Definite integrals, 922 Degrees of freedom, 884 Derivatives, 903 higher order, 907-910 Descartes' rule of signs, 34 Determinants of a matrix, 866-868 Deviation, mean absolute, 153 standard, 150 Differential efficiency theory of mergers, 683 Differentials, 910-911 936 SUBJECT INDEX Differentiation, partial, 911 rules of, 903-904 Dilution factor, 476 Diminishing marginal returns, Direct costs of bankruptcy, 499 Direct financing leases, 617 Disclosure regulation, mergers, 727 Discount or premium in mergers, 761 Discount rate, actuarial, 645 multiperiod, 402 risk-adjusted, 401, 410 Dispersion, measures of, 149-153 Displaced diffusion model, 281 Diversifiable risk, 118, 188 Diversification effect, 728 Diversification, international, 810 Divestitures, 678, 690 Dividends, 20 announcement effects, 584-588 capital gains, versus, 20-23 clienteles, 563, 578-582 covenants, 514 irrelevance, 545, 547 payout, 577 with personal and corporate taxes, 556-560 specially designated, 588 stock, 570 surprise, 567 and value, 588 Dominance, second order, 100-101 stochastic, 92-95, 169, 251 Double auction market, 340 Dual-class stock firms, 742-743 Dual problem, 59 Dual purpose funds, 387-390 Duration, in capital budgeting, 51-55 of debt, 489-495 matching, 657 Durbin-Watson d-statistic, 890-892 table, 891 Earnings per share, 24-25 growth maximization, 550-551 Earnings surprise, 567 Economic basis for international transactions, 779 Economic Recovery Tax Act of 1981, 690 Economies of scale, 684 Efficiency, allocational, 330-349 informational, 321 of a linear regression estimate, 886 marginal efficiency of investment schedule, 438 market efficiency and CAPM, 350 merger theories, 683-686 operational, 14, 331, 383 semi-strong form, 332, 383 strong form, 332, 376 weak form, 332, 348, 350 Efficient capital markets hypothesis, 15, 331, 338, 720 Efficient index portfolio, 224 Efficient portfolios, 181, 195 Efficient set, 169, 170, 172, 179, 333 Empirical investigations of exchange risk, 817818 Empirical market line, 216-217, 362 Employment Retirement Income Security Act, 638, 641-642, 645, 648 EMS See European Monetary System End-of-period payoff, 110 Equilibrium price of risk, 183 Equilibrium relationships, international, 790803 intertemporal, 809 testing equilibrium pricing models, 818 Equity, agency cost of external, 510 cost of, 39, 448-450, 458, 525, 530 market value, 602 new issues, 377-380, 506 required return on, 204 Equity carve-out, 679, 750-751 ERISA See Employment Retirement Income Security Act Errors in variables, 887-889 European Monetary System, 786-788 European options, calls, 241, 252, 254 puts, 279 Ex ante form of CAPM, 212 Ex ante test of OPM, 285 Ex dividend, 255, 578 Ex post form of CAPM, 213, 217-218 Ex post test of OPM, 285 Exchange economy, 4, 11, 180 bilateral exchange, 13 Exchange offers, 519-523, 662, 680 Exchange opportunities, 19 Exchange rates, 791 consistent, 782-783 fixed, 780-781 flexible, 782, 783-788 forecasting, 822-823 Exchange ratio in mergers, 757-763 SUBJECT INDEX Exchange risk, 809, 813 empirical investigation, 817-818 "real," 814-817 Executive compensation plans, 665-672 Executive stock option plans, 667-671 Exercise of stock options, sequential, 668 Exercise price, 241, 322 uncertain, 282 Expansion, 677-678 Expectations, heterogeneous, 211-212, 260 homogeneous, 181, 194, 219, 507 rational, 339-343 Expectations theory of futures prices, 314, 322 Expected utility, 17, 86 of an information set, 333 maximization, 168, 194 Expected value, 147 Exponential functions, 898-899 Exponential utility functions, 104, 909 Expropriation of bondholder wealth, 507-509, 519, 600, 743-744 Factor analysis in APT, 229 Factor loadings and sensitivities, 223, 225 Factorial notation, 265 Factors in Purchasing Power Parity Theorem, 793 Fair game, 212, 346-347, 348, 349, 364 FASB Statement No 8, 830-832 FASB Statement No 13, 616 FASB Statement No 35, 641 FASB Statement No 36, 641 FASB Statement No 52, 830-832 FASB Statement No 76, 533 FIFO inventory accounting, 24, 363 Filter rules, 349 Financial gains from conglomerate mergers, 691 Financial leases, 615, 619, 622 Financial synergy, 684-685 Financial theories of conglomerate firms, 692 Finite supernormal growth model, 551, 601602 for all-equity firm, 554-555 Firm commitment offering, 378 First-order stochastic dominance, 92 Fisher effect, 62 Fisher relation, international, 793-795 Fisher separation theorem, 11-12, 15, 18, 32, 124, 126, 180 Breakdown of separation, 14 Fixed exchange rates, 780-781 Fixed-rate debt, 660 937 Flexibility, value in capital budgeting, 429 Flexible exchange rates, 782, 783-788 Floating rate debt, 264, 660 Flotation costs, 534-536 Forecasting foreign exchange rates, 822-823 Foreign currency translation, 830-832 Foreign exchange exposure, empirical studies, 823-824 management, 790, 824-829 Foreign exchange rates, 791 consistent, 782-783 fixed, 780-781 flexible, 782, 783-788 forecasting, 822-823 Foreign exchange risk, 809, 813 empirical investigation, 817-818 "real," 814-817 Foreign exchange swaps, 660 Foreign tax credits, 518 Formal merger, 717 Forward contract, 300, 302 synthetic, 322-323 Forward Parity Theorem, 802-803 Forward price, 322-323 Forward rate of interest, 66-68 Forward speculation, international, 819-822 FPT See Forward Parity Theorem Free cash flows, 38, 39, 441, 604 Free rider problem in tender offers, 735 Frictionless markets, 194, 219, 252 Fully aggregating markets, 343, 377 Functions, cardinal utility, 908 exponential, 898-899 exponential utility, 104, 909 inverse, 895-896 limit of, 901-903 linear, 896-897 logarithmic, 900-901 logarithmic utility, 86, 120, 909 monotonically increasing or decreasing, 910 power utility, 90, 909 quadratic utility, 89-90, 153, 909 Fundamental theorem of calculus, 923-924 Future benchmark technique, 386 Future interest rates, 66-68 Future value of annuity, 846 table, 858 Future value formula, 842 Future value table, 856 Futures contracts, 301 commodities, 317-319 cross hedging, 176-178 financial, 314-317 Futures market, 342 938 SUBJECT INDEX Futures prices, 307, 310, 314 and CAPM, 318-319 expected, 312 Gain from leverage, 443, 451-453, 517 Gamble, actuarial value, 85-86 cost, 87 expected utility, 91 Going private, 661-665, 680, 752 Gold standard, 780-781 Golden parachute, 679 Goodwill in mergers, 25, 365 Gordon growth model, 21, 535, 552, 848 Government National Mortgage Association, 313 Greenmail, 679 Gross investment, 23 Growing payment annuities, 847 continuously growing, 853-854 Growth stock, 550 Heat exchange equation, 299 Hedge portfolios, 275-276, 284, 286, 297 Hedge ratio, 258, 263, 277 Hedging, 176-178, 308 against inflation, 230 cross-hedging, 176-178, 472 perfect, 163 probability, 259 risk-free hedge portfolio, 258, 260, 262, 263, 275-276, 278 risk-free hedged position using options, 245 Herfindahl index, 688-689 Heterogeneous expectations, 211-212, 260 Higher order derivatives, 907-910 Homemade leverage, 444 Homogeneous expectations, 117, 181, 194, 219, 507 Horizontal mergers, 678 Hubris hypothesis, 687-688 Human capital, 209 Hypothesis testing, 881-884 IAPM See International asset pricing model Idiosyncratic risk, 227 IFR See International Fisher Relation IMF See International Monetary Fund Immunization, 492-494, 656 Implied delivery option, 303 Improper integrals, 924-925 Incentive hypothesis, 670 Incentive signaling, 501 Incentive stock options, 668-671 Income shares of a dual fund, 387 Indefinite integrals, 921 Indenture provisions of debt, 508, 512-514, 743-744 Independence, axioms of choice, 79 of returns, 159 Independent projects, 26 Index of industrial production, 230 Index portfolios, 218 efficient, 224 Indifference curves, 3-5, 78, 97-98, 166, 333 Indirect costs of bankruptcy, 500 Indivisibilities, 684 Inefficient management theory of mergers, 683 Infinite constant growth model, 551 Inflation, and capital budgeting, 61-65 hedging against, 230 unanticipated, 223-230 Inflation risk, international, 814 Information, costly, 343-346 effects in block trades, 371 hypothesis of mergers, 686-687 structure, 332 value of, 332-339 Information averaging markets, 343 Informational efficiency, 321 Initial margin, 305 Insider trading, 376-377, 728-729 Instantaneous variance, 274 Instrumental variables, 889 Integrals, definite, 922 improper, 924-925 indefinite, 921 Integration, rules of, 921-922 Interest rate futures, 314 Interest Rate Parity Theorem, 795-800 Interest rate swaps, 656-661 international, 829-830 Interest rates, risk-adjusted discount rate, 401, 410 risk-free rate, 117, 362 term structure of, 260, 658 Internal rate of return, capital budgeting, 29 and duration problem, 53 versus NPV method, 31-36 International arbitrage, 796-800 relationships, 818 International asset pricing model, 810-813 testing difficulties, 812-813 International diversification, 810 SUBJECT INDEX International equilibrium relationships, 790 intertemporal, 809 testing equilibrium pricing models, 818 International finance, economic basis for international transactions, 779 significance, 777 International Fisher Relation, 793-795 International forward speculation, 819-822 International Monetary Fund, 785-788 International transactions, 788 Interpersonal comparison of utility functions, 84 In-the-money, 271 Intrinsic value hypothesis, 340 Inventory accounting, 24, 363 Inverse correlation, 163 Inverse functions, 895-896 Inverse of a square matrix, 869-870 Inversion, matrix, 865-866, 869-870 Investment and mergers, 682 Investment, gross, 23 replacement, 38 Investment decision, 17, 26, 621 optimal, 125 separation from financing decision, 40 Investment opportunity set, Investment rate, 551 Investment schedule, marginal efficiency, 438 Investment tax credits, 518 IRPT See Interest Rate Parity Theorem IRR See Internal rate of return ISO See Incentive stock options Ito's lemma, 297 Joint hypotheses, 218 Joint probability, 420 Joint tests of market efficiency and model validity, 283 Joint ventures, 678 Jump process, 268 mixed-diffusion model, 280 pure, 280 Junk bonds, 676 Keogh accounts, 560 Lagrange multiplier, 872, 914-916 Law of one price, 791 LBO See Leveraged buyouts Leaseback, 513, 615 Leases, accounting for, 616-618 939 cancellable, 629-631 capital, 616 cash flows, 622 direct financing, 617 FASB No 13, 613 leveraged, 617, 627-629 operating, 615-617, 619, 629-631 sale-leaseback, 513, 615 sales type, 617 service, 615-617, 619, 629-631 strict financial, 615, 619, 622 tax treatment, 616 Leasing, 511 Left-out variables, 886-887 Letter stock, 388 Leverage, book value vs replacement value vs reproduction value, 447 gain from, 443, 451-453, 517 homemade, 444 personal, 444 Leveraged buyouts, 661-665, 680 Leveraged leases, 617, 627-629 Levered equity beta, 457, 459 Levered firm, value, 442, 602 LIBOR See London Interbank Offer Rate LIFO inventory accounting, 24, 363 Limit of a function, 901-903 Linear functions, 896-897 Linear programming solutions to multi-period constraints in capital budgeting, 58-61 Linear regression, 873-876 Linear risk tolerance utility function, 123 Lines of credit, committed, 480-481 Liquidation value, 419 Liquidity premium, 68-69, 317, 370 Location, measures of, 147-149 Logarithmic functions, 900-901 utility, 86, 120, 909 Logarithms, natural, 852 table, 860 Lognormal distribution, 210 London Interbank Offer Rate, 656 Long-range strategic planning, 685 MacLaurin Series, 916-921 Maintenance margin, 305 call, 307 Management incentive schemes, 502 Managerialism, 687-688 Margin, buying on, 259 call, 306 initial, 305 940 SUBJECT INDEX maintenance, 305 requirements, 307 Marginal efficiency of investment schedule, 438 Marginal rate of substitution, 6, 12, 96, 98, 166, 168, 183 Marginal rate of transformation, 8, 12, 166, 167, 183 Marginal utility of consumption, Marked to market, 304 Market efficiency, 15, 330 Market extension mergers, 678 Market line, capital, 9-10, 11, 19, 181, 183, 194, 195, 197 empirical, 216-217 security, 197, 198, 217 Market model, 361-362 Market portfolio, 118, 180, 193, 196, 198, 207, 222 Market power theory of mergers, 688-689 Market price of risk, 203, 210, 404 Market risk premium, 897 Market segmentation hypothesis, 69-70 Market value weights, 529 Markets, assumptions for perfect, 790 complete, 112 information averaging vs fully aggregating, 343, 377 Markov matrix, 334 Markowitz risk premium, 87, 91-92 Martingale, 346-347, 408 Matrix, definition of variance, 174 inversion, 865-866 Markov, 334 transposition, 866 Maturity structure of debt, 471-472 application of duration, 494 Maximization, of expected utility of wealth, 82, 95, 168, 194 of shareholder wealth, 18, 20, 24, 25, 31 of utility, 10 Mean, 96, 147, 148 of a binomial distribution, 265 marginal rate of substitution between mean and variance, 98 of a two-asset portfolio, 155 Mean absolute deviation, 153 Mean square error criterion, 886 Measurability, axioms of choice, 79, 81 Measurement error, 887-888 Measures, central tendency, 149 dispersion, 149-153 location, 147-149 Median, 148 Merger analysis, methodology, 763-769 Merger effects on monopoly, 732 Merger performance in the United Kingdom, 724 Merger performance tests, 724-725 Merger policies in valuation framework, 763769 Merger studies, empirical results, 754 Merger terms, 757-763 Mergers, 23 accounting treatment, 25, 365 and bondholder wealth, 694, 743-744 definition, 677 discount or premium, 761 early empirical studies, 718 formal, 717 goodwill, 25, 365 and investment, 682 theories, 682-690 Methodology for merger analysis, 763-769 Mezzanine level financing, 662 Miller and Modigliani See Modigliani and Miller model Minimum tax, 518 Minimum variance, opportunity set, 165-166, 167, 170, 194 portfolio, 161-162, 871-873 zero-beta portfolio, 206, 362 Minority shareholders, 664 Misspecification bias, 887 Mixed diffusion jump model, 280 Mixed stable strategy, 345 Mode, 148 Model of conglomerate mergers, Scott, 696701 Modigliani and Miller model, 443, 464, 468, 498-499, 507, 526, 551, 601-602, 619 Monitoring costs, 20, 25 Monopoly, 688 merger effects on, 732 Monotonically increasing or decreasing functions, 910 Multicollinearity, 889 Multiple rates of return with IRR method, 3336 Multiple regression, 877-893 Mutual funds, 383-385 Mutually exclusive projects, 26 SUBJECT INDEX Natural logarithms, 852 logarithmic functions, 900-901 table, 860 Negotiated premium buyback, 738 Net asset value of a dual fund, 387 Net cash flow, 29 Net dividend surprise, 567 Net monetary position exposure, 824-829 Net Present Value method, 28-29, 849-850 with constant scale replication, 49-51, 54-55 vs IRR method, 31-36 New issues, bonds, 380 equity, 377-380, 506 underwritten vs rights, 534 New York Mercantile Exchange, 303 New York Stock Exchange index futures contract, 316 Nondiversifiable risk, 118, 202 Nonmarketable assets, 209-210 Nonrecourse loan, 627 Normal backwardation, 317-318, 321-322, 324 Normal distribution, 96, 99, 153-155, 194, 222, 411 cumulative probability, 269-270 normally distributed returns, 208 NPV See Net Present Value method Objects of choice, 15 Oil well pump problem, 33 One price, law of, 791 Open interest, 305 Operating leases, 615, 616, 617, 619 cancellable, 629-631 Operational efficiency, 14, 331, 383 Opportunity cost of capital, 22, 28, 31, 35, 36 Opportunity set, investment, minimum variance, 165-166, 167, 170, 194 with n risky assets, 178 production, 3, 6, 8, 10, 11 Optimal capital structure, 499, 621 Optimal consumption pattern, 11 Optimal investment rule, 125 Optimal portfolio decisions, 119-121, 173 Optimal production decisions, 11, 19 Optimization, 911-916 Option pricing models, 127, 240 binomial, 257-267 Black-Scholes, 267-269, 309 comparison of binomial and Black-Scholes, 272 compeand option model, 281 941 and cost of risky debt, 464-466 displaced diffusion model, 281 empirical evidence, 283-289 extensions, 280-283 implications for capital structure, 507 and mergers, 701-707 Option to exchange one asset for another, 282 Options, American, 241, 277-279, 323, 324, 419, 631 calls, 241 European, 241, 279 executive stock option plans, 667-671 on futures, 324 implied delivery, 303 tax-timing, 308 truncated, 282 Orange juice futures, 306 Ordinary least squares, 877-881 Orthogonal portfolios, 218 Orthogonal transformation, 225 Out-of-the-money, 266, 271 Output, unanticipated changes in real, 223 Ownership and control, 20 Pascal's triangle, 264-265 Pareto, stable Paretian hypothesis, 208 Partial differentiation, 911 Payback method of capital budgeting, 27-28 Payoff, end-of-period, 110 PBGC See Pension Benefit Guaranty Corporation Pecking order theory of capital structure, 507, 519, 520 Penrose effect, 56 Pension Benefit Guaranty Corporation, 642, 648, 654 Pension fund management, 638-656 Perfect capital markets, 125, 330 assumptions for, 790 Perfect hedge, 163 Perfect substitute for debt, 622 Perfectly correlated, assets, 162-165 returns, 159-160, 169 Perpetuities, 441 Personal income tax rate, 557 Personal leverage, 444 Poison pill, 679 Poisson process, 280 Pooling, accounting treatment for mergers, 25, 365, 678 Portfolio, arbitrage, 219-220, 225 942 SUBJECT INDEX beta of, 201 decisions, 119-121 diversification, 184-188 efficient, 181, 195 efficient index, 224 index, 218 market, 118, 180, 193, 196, 198, 207, 218, 222 mean and variance of 2-asset, 155-159 mean return of, 173 minimum variance, 161-162, 871-873 minimum variance zero-beta, 206 optimal, 173 orthogonal, 218 risk-free hedge, 258, 260, 262, 263, 275, 284, 286, 297 separation, 122-124 variance of, 161, 173-174, 184 zero-beta, 218 Postselection bias, 364 Power utility function, 90, 909 PPPT See Purchasing Power Parity Theorem Pratt-Arrow measure of risk premium, 89, 9192 Preferred habitats, 70 Preferred stock, 475, 480 Premium, liquidity, 68-69 in mergers, 718, 761 risk, 87 Premium buybacks, 679, 738 Present value, formula, 843 index, 56, 58 table, 857 Present value of an annuity, 844 table, 859 Present value of a growing annuity stream, 21, 848 Price limits, 306, 307, 321 Price of risk, 183, 198, 203, 210 Price pressure, 370 Priced factors in APM, 229 Price/earnings ratio, differential in mergers, 691 Primitive securities, 111, 113-115, 133-134 price, 119 Probability, joint, 420 Producer's surplus, 454 Product extension mergers, 678 Production, consumption decision, 10 index of industrial, 230 opportunity set, 3, 6, 8, 10, 11 optimal decision, 11, 19 Profit, accounting definition, 23, 40, 441 cash flow definition, 23 economic definition, 22-25 no arbitrage profit condition, 115-116 Programming, linear, 58-61 Projects, contingent, 26 different lives, 49-55 different scale, 56-58 independent, 26 mutually exclusive, 26 Proportional expansion of scale, 53 Protective covenants, 509, 512-514, 743-744 Proxy contests, 679, 739-740 Public offerings of equity, 377-380 Purchase accounting treatment for mergers, 25, 265, 678 Purchasing Power Parity Theorem, 791-793, 813-818 violations, 817 Pure arbitrage, 316 Pure jump process, 280 Pure security, 111, 113-115, 133-134 price, 119 Put-call parity, 249-251, 322, 464, 647 formula, 250 Put options, 277-279, 323, 419, 631 q-ratio, 686-687 Quadratic formula, 34-35 Quadratic programming, 170 Quadratic utility function, 89-90, 153, 909 Quality spread arbitrage, 657 Quantity of risk, 198 Random walk, 312, 346-348 Range, 149-150 semi-interquartile, 150 Ranking, axioms of choice, 79-80, 81 Rate of return, 18 accounting, 28 expected, 117 multiple, 33-36 real rate of return relation, 800-803 risk-free, 117 Rational expectations hypothesis, 339-343 Rational expectations signaling equilibrium, 503 SUBJECT INDEX Real exchange risk, 814-817 Real Rate of Return Relation, 800-803 Recursive valuation formula, 545-546 Refunding decisions, 531-534 Regression, linear, 873-876 multiple, 877-893 Regret, 334 Reinvestment rate assumption, 32 Relative risk aversion, 89 Replacement cost uncertainty, 630 Replacement investment, 38 Replacement value leverage, 447 Reproduction value leverage, 447 Repurchase of shares, 22, 522, 571, 596-600, 680 from corporate insiders, 739 single block, 739 Required rate of return on equity, 204 Restructuring, corporate, 677-680, 757 theories, 690-691 Retention ratio, 551 Returns, abnormal, 351 on assets, 28 on equity, 21 independent, 159 on investment, 28 perfectly correlated, 159-160, 162-165 portfolio, 173 required on equity, 204 Reverse stock split, 662 Reward to variability ratio, 384 Rights offerings, 534 Risk, diversifiable, 118 empirical investigation of exchange risk, 817-818 equilibrium price of, 183 foreign exchange, 809, 813 idiosyncratic, 227 inflation, international, 814 market price of, 198, 203, 210, 404 quantity, in CAPM, 198 "real" foreign exchange risk, 814-817 systematic, 220, 225, 416, 457 systematic vs unsystematic, 198-199 undiversifiable, 118, 202 Risk-adjusted abnormal performance, 362, 364, 384 Risk-adjusted discount rate, 401, 410, 461 Risk-adjusted rate of return valuation formula, 203 943 Risk-aversion, 260 absolute, 89 comparison in the small and in the large, 90-92 definition, 85-90 relative, 89 Risk-free asset, 171, 179, 194 no riskless asset, 205-208 Risk-free hedged position, 245, 258, 260, 262, 263, 275-276, 278, 284, 297 Risk-free rate, 117, 362 Risk lover, 86 Risk neutral, 86 Risk premium, 87, 221 default, 230 Pratt-Arrow measure, 89, 91-92 Riskless arbitrage, 314 self-financing, 316 Risky debt, 248, 462 Robinson Crusoe economy, 4-9, 11, 183 Roll's critique of CAPM, 218-219 RRA See Relative risk aversion RRR See Real Rate of Return Relation Rules of differentiation, 903-904 Rules of integration, 921-922 Sale-leaseback agreements, 513, 615 Sales-type leases, 617 SAR See Stock appreciation rights Scale, projects of different, 56-58 Scott's model of conglomerate mergers, 696701 SDR See Special Drawing Rights Second-order condition, 913 Second-order stochastic dominance, 93, 100101 Secured debt, 511 Security Market Line, 197, 198, 350, 403, 417, 455, 461, 463, 897 Self-financing riskless arbitrage, 316 Self-tender offer, 680 Seller and buyer premiums in merger, 718 Selling a call, a put, 245-246 Selling short, 159, 194, 208, 252 Sell-offs, 678-679, 744-746 Semiannual compounding, 850 Semi-interquartile range, 150 Semistrong form market efficiency, 332, 383 Semivariance, 152 Separation, breakdown, 14 Fisher principle, 11-12, 15, 18, 32, 124, 126, 180 944 SUBJECT INDEX of investment and financing decisions, 40 portfolio, 122-124 three-fund, 211 two-fund, 123, 209 Sequential exercise requirement, 668 Serial correlation, 889-892 Serial covariance, 348 Service leases, 615, 617 Share repurchase, 22, 522, 571, 596-600, 680 from corporate insiders, 739 single block, 739 Shareholder wealth maximization, 18, 20, 24, 25, 31 Short sales, 159, 172, 194, 208, 252 Short-term capital gains, 308 Short-term liabilities, 530 Shutdown alternative, 429 Signaling hypotheses, 501-507, 520, 584, 671 of mergers, 686-687 Single block repurchases, 739 Single price law, of markets, 115 of securities, 187 Sinking fund requirements, 513 Slope estimate, 883 Social welfare function, 84 Sources and uses of funds statement, 23, 546547, 565 Special Drawing Rights, 786 Specially designated dividends, 588 Speculation, forward, international, 819-822 Speculative equilibrium hypothesis, 339 Speculators, 308 Spinoffs, 22, 678, 690-691, 746-750, 751 Splitoffs, 679 Splitups, 679 SPM See State Preference Model Spot prices, 302, 307, 310, 323 expected, 311 Spread, 247 Stable Paretian hypothesis, 208, 411 Standard and Poor's 500 index futures contract, 316 Standard deviation, 150, 159 Standard error of slope term, 884 Standard errors of estimate, 882 Standardization of futures contracts, 303 Standstill agreements, 679, 738 State-contingent claims, 110-111 applied to capital budgeting, 135-139 State of nature, 110 State Preference Model, 110, 127 application to capital structure, 140 State probabilities, 117 Stationary autoregressive process, 313 Stochastic dominance, 92-95, 169, 251 second order, 100-101 Stochastic process, continuous, 252, 268 subordinated hypothesis, 208 Stock appreciation rights, 667-671 Stock dividends, 23, 570 Stock index futures, 316 Stock option plans, 667-671 Stock repurchase, 22, 522, 571, 596-600, 680 from corporate insider, 739 single block, 739 Stock split, reverse, 662 Storage costs, 317 Straddle, 247 tax, 308 Straps, 247 Strategic planning, 685 Strict financial leases, 615, 619, 622 Striking price, 241 Strip financing, 662 Strips, 247 Strong form market efficiency, 332, 376 Strong independence, axioms of choice, 79 Student's t-distribution, 882 table, 885 Subjective price of risk, 166 Submartingale, 346-347, 349 Substitution, marginal rate of, 6, 12, 96, 98, 166, 168, 183 Supermajority voting provisions, 679 Supernormal growth model, 551, 554-555, 601-602 Surplus, consumers and producers, 454 Surprise, earnings and net dividend, 567 Swaps, 519-523 currency, 830 foreign exchange, 660 interest rate, 656-661 international interest rate, 829-830 Synergy, 684, 717 in conglomerate mergers, 692 Synthetic forward contracts, 322-323 Synthetic futures, 323 Systematic risk, 198-199, 202, 220, 225, 416, 457 of a commodity, 319 Tables, area under the normal curve, 290 Durbin-Watson d-statistic, 891 future value, 856 future value of an annuity, 858 natural logarithms, 860 SUBJECT INDEX present value, 857 present value of an annuity, 859 t-statistics, 885 Target debt ratio, 446 Target dividend payout, 577 Tax arbitrage, 581 Taxes, capital gains rate, 557 carrybacks and carryforwards, 518 considerations in merger, 689-690 credits, 518 hypothesis of mergers, 671 lease treatment, 616 minimum, 518 personal rate, 557 personal vs corporate, 451 rates, 39 straddles, 308 Tax-timing option, 308 Taylor Series, 916-921 Technical trading rules, 349-350 Tender offers, 678, 722, 723 free rider problem, 735 to go private, 662 to repurchase shares, 596-600 self-tender, 680 Term structure of interest rates, 65-71, 260, 658 Terms of mergers, 757-763 Texas Gulf Sulphur Case, 376 Theories of merger and acquisition activity, 682-690 Theory of choice, 15 Three-fund separation, 211 Trade credit, 530 Trading rule tests, international, 818-819 Trading rules, 339 Transactions costs, 13, 14 Transformation, marginal rate of, 8, 12, 166, 167, 183 Transitivity, axioms of choice, 79 Translation of foreign currency, 830-832 Treasury bill futures market, 316 Treynor index, 384 Truncated options, 282 t-statistics, 882 table, 885 Two-factor model, 207 Two-fund separation, 123, 181, 209, 508 Unanimity principle, 19 Unanticipated changes in real output, 223 Unanticipated inflation, 223, 230 Unbiased expectations hypothesis, 66-68 945 Undervaluation theory of mergers, 686-687 Underwritten new issues, 534 Undiversifiable risk, 118, 202 Unit normal distribution, 155 United States international transactions, 788 Unlevered beta, 457, 459 Unlevered firm value, 440, 442, 451 Unsystematic risk, 198-199 Utility, cardinal, 79-80 expected, 17, 80-82, 86, 92-93 expected utility criterion, 109 expected utility of an information set, 333 of expected wealth, 86 of a gamble, 91 marginal, 84 total, 166 Utility curves, 3-5 Utility functions, 18, 80-85 cardinal, 908 exponential, 104, 909 interpersonal comparison of, 84 linear risk-tolerance, 123 logarithmic, 86, 120, 909 order preserving, 81 power, 90, 909 quadratic, 89-90, 153, 909 social welfare, 84 Utility maximization, 10, 168, 194 Utility theory, 77, 102 Valuation, of all-equity firm with growth, 548-553 certainty equivalent formula, 203 example calculation, 602-607 finite supernormal growth model, 551, 601602 infinite constant growth model, 551 recursive formula, 545-546 risk-adjusted rate of return formula, 203 Valuation framework for mergers, 763-769 Value, of assets in place, 550 of future growth, 550 of information, 332-339 of levered firm, 442 liquidation, 419 net asset value of dual funds, 387 of unlevered firm, 440, 442, 451 Value additivity principle, 26, 32-33, 848-850 Value Line Investor Survey, 385-387 index futures contract, 316 Variable rate loans, 264 Variance, 150, 155 of binomial distribution, 265 946 SUBJECT INDEX constant elasticity of, 281, 287 of expected spot price, 311 of futures price, 312 instantaneous, 274 marginal rate of substitution between mean and, 96 matrix definition, 174 minimum variance opportunity set, 165-166, 167, 170, 194 minimum variance portfolio, 161-162, 871873 minimum variance zero-beta portfolio, 206, 362 of a portfolio, 161, 173-174, 184 of a two-asset portfolio, 155 Variance-covariance matrix, 872 Venture capitalists, 663 Vertical integration, 685 Vertical mergers, 678 Vested benefits, 640 Voluntary selloffs, 744-746 Voluntary spinoffs, 746-750 WACC See Weighted average cost of capital Warrants, 473-476 Weak form market efficiency, 332, 348, 350 Wealth expropriation, bondholder, 507-509, 519, 600, 743-744 Weekend effect, 390-392 Weighted average cost of capital, 29, 39, 402, 444-446, 450, 458, 470, 499, 517, 526531, 602 Williams Act of 1968, 726-727 Working capital, 41 Year-end effect, 390-392 Yield curve, twists in, 230 Yield to maturity, 65-66 Zero-beta, 220 Zero-beta portfolio, 206, 218, 362 Zero coupon bonds, 66, 248, 253, 464 ... taxes.' Then sources of funds are revenues, Rev, and sale of new equity (on m shares at S dollars per share) Uses of funds are wages, salaries, materials, and services, W &S; investment, I; and. .. above discussion, we shall assume that managers always make decisions that maximize the wealth of the firm 's shareholders To so, they must find and select the best set of investment projects to... common theme is "How individuals and society allocate scarce resources through a price system based on the valuation of risky assets?" Utility theory establishes the basis of rational decision making