What constitutes fair behavior by companies? One survey asked a number of individuals to state whether they regarded a particular action as acceptable or unfair. Before we tell you how they responded, think how you would rate each of the following actions:
Selected material from Fundamentals of Corporate Finance Third Edition Richard A. Brealey Bank of England and London Business School Stewart C. Myers Sloan School of Management Massachusetts Institute of Technology Alan J. Marcus Wallace E. Carroll School of Management Boston College with additional material from Fundamentals of Corporate Finance, Alternate Fifth Edition Essentials of Corporate Finance, Second Edition Stephen A. Ross, Massachusetts Institute of Technology Randolph W. Westerfield, University of Southern California Bradford D. Jordan, University of Kentucky UNIVERSITY OF PHOENIX Boston Burr Ridge, IL Dubuque, IA Madison, WI New York San Francisco St. Louis Bangkok Bogotá Caracas Lisbon London Madrid Mexico City Milan New Delhi Seoul Singapore Sydney Taipei Toronto Selected material from FUNDAMENTALS OF CORPORATE FINANCE, Third Edition with additional material from FUNDAMENTALS OF CORPORATE FINANCE, Alternate Fifth Edition ESSENTIALS OF CORPORATE FINANCE, Second Edition Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Printed in the United States of America. Ex- cept as permitted under the United States Copyright Act of 1976, no part of this publication may be reproduced or distrib- uted in any form or by any means, or stored in a data base retrieval system, without prior written permission of the pub- lisher. This book contains select material from: Fundamentals of Corporate Finance, Third Edition by Richard A. Brealey, Stewart C. Myers, and Alan J. Marcus. Copyright © 2001, 1999, 1995, by The McGraw-Hill Companies, Inc. Fundamentals of Corporate Finance, Alternate Fifth Edition by Stephen A. Ross, Randolph W. Westerfield, and Bradford D. Jordan. Copyright © 2000, 1998, 1995, 1993, 1991 by The McGraw-Hill Companies, Inc. Essentials of Corporate Finance, Second Edition by Stephen A. Ross, Randolph W. Westerfield, and Bradford D. Jordan. Copyright © 1999 by The McGraw-Hill Companies, Inc. Previous edition © 1996 by Richard D. Irwin, a Times Mirror Higher Education Group, Inc. company. All reprinted with permission of the publisher. ISBN 0-07-553109-7 Sponsoring Editor: Christian Perlee Production Editor: Nina Meyer iii Contents SECTION 1 1 How to Value Perpetuities 50 How to Value Annuities 51 Annuities Due 54 Future Value of an Annuity 57 Inflation and the Time Value of Money 61 Real versus Nominal Cash Flows 61 Inflation and Interest Rates 63 Valuing Real Cash Payments 65 Real or Nominal? 67 Effective Annual Interest Rates 67 Summary 69 Related Web Links 69 Key Terms 70 Quiz 70 Practice Problems 72 Challenge Problems 75 Solutions to Self-Test Questions 77 Minicase 79 Financial Planning 81 What Is Financial Planning? 82 Financial Planning Focuses on the Big Picture 83 Financial Planning Is Not Just Forecasting 84 Three Requirements for Effective Planning 84 Financial Planning Models 86 Components of a Financial Planning Model 87 An Example of a Planning Model 88 An Improved Model 89 Planners Beware 93 Pitfalls in Model Design 93 The Assumption in Percentage of Sales Models 94 The Role of Financial Planning Models 95 External Financing and Growth 96 Summary 100 Related Web Links 101 Key Terms 101 Quiz 101 Practice Problems 102 Challenge Problems 106 Solutions to Self-Test Questions 106 The Firm and the Financial Manager 3 Organizing a Business 4 Sole Proprietorships 4 Partnerships 5 Corporations 5 Hybrid Forms of Business Organization 6 The Role of the Financial Manager 7 The Capital Budgeting Decision 8 The Financing Decision 9 Financial Institutions and Markets 10 Financial Institutions 10 Financial Markets 11 Other Functions of Financial Markets and Institutions 12 Who Is the Financial Manager? 13 Careers in Finance 15 Goals of the Corporation 17 Shareholders Want Managers to Maximize Market Value 17 Ethics and Management Objectives 19 Do Managers Really Maximize Firm Value? 21 Snippets of History 25 Summary 25 Related Web Links 28 Key Terms 28 Quiz 28 Practice Problems 29 Solutions to Self-Test Questions 31 The Time Value of Money 33 Future Values and Compound Interest 34 Present Values 38 Finding the Interest Rate 44 Multiple Cash Flows 46 Future Value of Multiple Cash Flows 46 Present Value of Multiple Cash Flows 49 Level Cash Flows: Perpetuities and Annuities 50 Financial Statement Analysis 133 Financial Ratios 134 Leverage Ratios 138 Liquidity Ratios 139 Efficiency Ratios 141 Profitability Ratios 143 The Du Pont System 145 Other Financial Ratios 146 Using Financial Ratios 147 Choosing a Benchmark 147 Measuring Company Performance 150 The Role of Financial Ratios 151 Summary 153 Related Web Links 155 Key Terms 155 Quiz 155 Practice Problems 157 Challenge Problem 158 Solutions to Self-Test Questions 159 Minicase 160 IV CONTENTS Accounting and Finance 111 The Balance Sheet 112 Book Values and Market Values 115 The Income Statement 117 Profits versus Cash Flow 118 The Statement of Cash Flows 119 Accounting for Differences 121 Taxes 123 Corporate Tax 123 Personal Tax 125 Summary 126 Related Web Links 127 Key Terms 127 Quiz 127 Practice Problems 128 Challenge Problem 131 Solutions to Self-Test Questions 131 APPENDIX A 109 SECTION 2 163 Working Capital Management and Short-Term Planning 165 Working Capital 167 The Components of Working Capital 167 Working Capital and the Cash Conversion Cycle 168 The Working Capital Trade-Off 171 Links between Long-Term and Short-Term Financing 172 Tracing Changes in Cash and Working Capital 175 Cash Budgeting 177 Forecast Sources of Cash 177 Forecast Uses of Cash 179 The Cash Balance 179 A Short-Term Financing Plan 180 Options for Short-Term Financing 180 Evaluating the Plan 184 Sources of Short-Term Financing 185 Bank Loans 185 Commercial Paper 186 Secured Loans 186 The Cost of Bank Loans 187 Simple Interest 187 Discount Interest 188 Interest with Compensating Balances 189 Summary 190 Related Web Links 191 Key Terms 191 Quiz 191 Practice Problems 192 Challenge Problem 194 Solutions to Self-Test Questions 195 Minicase 197 Cash and Inventory Management 201 Cash Collection, Disbursement, and Float 202 Float 203 Valuing Float 204 CONTENTS V Managing Float 205 Speeding Up Collections 206 Controlling Disbursements 209 Electronic Funds Transfer 210 Inventories and Cash Balances 211 Managing Inventories 212 Managing Inventories of Cash 215 Uncertain Cash Flows 216 Cash Management in the Largest Corporations 217 Investing Idle Cash: The Money Market 218 Summary 219 Related Web Links 220 Key Terms 220 Quiz 220 Practice Problems 221 Challenge Problem 224 Solutions to Self-Test Questions 224 Credit Management and Collection 227 Terms of Sale 229 Credit Agreements 231 Credit Analysis 232 Financial Ratio Analysis 233 Numerical Credit Scoring 233 When to Stop Looking for Clues 234 The Credit Decision 236 Credit Decisions with Repeat Orders 23 7 Some General Principles 23 8 Collection Policy 239 Bankruptcy 240 Bankruptcy Procedures 24 1 The Choice between Liquidation and Reorganization 24 2 Summary 244 Related Web Links 24 5 Key Terms 24 5 Quiz 24 5 Practice Problems 24 6 Challenge Problems 24 8 Solutions to Self-Test Questions 24 9 Minicase 250 Valuing Bonds 255 Bond Characteristics 256 Reading the Financial Pages 257 Bond Prices and Yields 25 9 How Bond Prices Vary with Interest Rates 260 Yield to Maturity versus Current Yield 261 Rate of Return 265 Interest Rate Risk 267 The Yield Curve 268 Nominal and Real Rates of Interest 268 Default Risk 270 Valuations in Corporate Bonds 273 Summary 27 3 Related Web Links 274 Key Terms 274 Quiz 274 Practice Problems 275 Challenge Problems 277 Solutions to Self-Test Questions 277 Valuing Stocks 279 Stocks and the Stock Market 280 Reading the Stock Market Listings 281 Book Values, Liquidation Values, and Market Values 283 Valuing Common Stocks 287 Today’s Price and Tomorrow’s Price 287 The Dividend Discount Model 288 Simplifying the Dividend Discount Model 291 The Dividend Discount Model with No Growth 291 The Constant-Growth Dividend Discount Model 292 Estimating Expected Rates of Return 293 Nonconstant Growth 295 Growth Stocks and Income Stocks 296 The Price-Earnings Ratio 298 What Do Earnings Mean? 298 Valuing Entire Businesses 301 Summary 301 Related Web Links 302 Key Terms 302 Quiz 302 Practice Problems 303 Challenge Problems 306 Solutions to Self-Test Questions 307 SECTION 3 253 VI CONTENTS Introduction to Risk, Return, and the Opportunity Cost of Capital 311 Rates of Return: A Review 312 Seventy-Three Years of Capital Market History 313 Market Indexes 314 The Historical Record 314 Using Historical Evidence to Estimate Today’s Cost of Capital 317 Measuring Risk 318 Variance and Standard Deviation 318 A Note on Calculating Variance 322 Measuring the Variation in Stock Returns 322 Risk and Diversification 324 Diversification 324 Asset versus Portfolio Risk 325 Market Risk versus Unique Risk 330 Thinking about Risk 331 Message 1: Some Risks Look Big and Dangerous but Really Are Diversifiable 331 Message 2: Market Risks Are Macro Risks 332 Message 3: Risk Can Be Measured 333 Summary 334 Related Web Links 334 Key Terms 334 Quiz 335 Practice Problems 336 Solutions to Self-Test Questions 338 SECTION 4 339 Net Present Value and Other Investment Criteria 341 Net Present Value 343 A Comment on Risk and Present Value 344 Valuing Long-Lived Projects 345 Other Investment Criteria 349 Internal Rate of Return 349 A Closer Look at the Rate of Return Rule 350 Calculating the Rate of Return for Long-Lived Projects 351 A Word of Caution 352 Payback 352 Book Rate of Return 355 Investment Criteria When Projects Interact 356 Mutually Exclusive Projects 356 Investment Timing 357 Long- versus Short-Lived Equipment 359 Replacing an Old Machine 361 Mutually Exclusive Projects and the IRR Rule 361 Other Pitfalls of the IRR Rule 363 Capital Rationing 365 Soft Rationing 365 Hard Rationing 366 Pitfalls of the Profitability Index 3667 Summary 367 Related Web Links 368 Key Terms 368 Quiz 368 Practice Problems 369 Challenge Problems 373 Solutions to Self-Test Questions 373 Using Discounted Cash-Flow Analysis to Make Investment Decisions 377 Discount Cash Flows, Not Profits 379 Discount Incremental Cash Flows 381 Include All Indirect Effects 381 Forget Sunk Costs 382 Include Opportunity Costs 382 Recognize the Investment in Working Capital 383 Beware of Allocated Overhead Costs 384 Discount Nominal Cash Flows by the Nominal Cost of Capital 385 Separate Investment and Financing Decisions 386 Calculating Cash Flow 387 Capital Investment 387 Investment in Working Capital 387 Cash Flow from Operations 388 Example: Blooper Industries 390 Calculating Blooper’s Project Cash Flows 391 Calculating the NPV of Blooper’s Project 392 Further Notes and Wrinkles Arising from Blooper’s Project 393 Summary 397 Related Web Links 398 Key Terms 398 Quiz 398 CONTENTS VII Practice Problems 200 Challenge Problems 402 Solutions to Spreadsheet Model Questions 403 Solutions to Self-Test Questions 404 Minicase 405 Risk, Return, and Capital Budgeting 407 Measuring Market Risk 408 Measuring Beta 409 Betas for MCI WorldCom and Exxon 411 Portfolio Betas 412 Risk and Return 414 Why the CAPM Works 416 The Security Market Line 417 How Well Does the CAPM Work? 419 Using the CAPM to Estimate Expected Returns 420 Capital Budgeting and Project Risk 422 Company versus Project Risk 422 Determinants of Project Risk 423 Don’t Add Fudge Factors to Discount Rates 424 Summary 425 Related Web Links 426 Key Terms 426 Quiz 426 Practice Problems 427 Challenge Problem 432 Solutions to Self-Test Questions 432 The Cost of Capital 435 Geothermal’s Cost of Capital 436 Calculating the Weighted-Average Cost of Capital 438 Calculating Company Cost of Capital as a Weighted Average 440 Market versus Book Weights 441 Taxes and the Weighted-Average Cost of Capital 442 What If There Are Three (or More) Sources of Financing? 443 Wrapping Up Geothermal 444 Checking Our Logic 445 Measuring Capital Structure 446 Calculating Required Rates of Return 447 The Expected Return on Bonds 448 The Expected Return on Common Stock 448 The Expected Return on Preferred Stock 449 Big Oil’s Weighted-Average Cost of Capital 450 Real Oil Company WACCs 450 Interpreting the Weighted-Average Cost of Capital 451 When You Can and Can’t Use WACC 451 Some Common Mistakes 452 How Changing Capital Structure Affects Expected Returns 452 What Happens When the Corporate Tax Rate Is Not Zero 453 Flotation Costs and the Cost of Capital 454 Summary 454 Related Web Links 455 Key Terms 455 Quiz 455 Practice Problems 456 Challenge Problems 458 Solutions to Self-Test Questions 458 Minicase 459 SECTION 5 463 Project Analysis 465 How Firms Organize the Investment Process 466 Stage 1: The Capital Budget 467 Stage 2: Project Authorizations 467 Problems and Some Solutions 468 Some “What-If ” Questions 469 Sensitivity Analysis 469 Scenario Analysis 472 Break-Even Analysis 473 Accounting Break-Even Analysis 474 NPV Break-Even Analysis 475 Operating Leverage 478 Flexibility in Capital Budgeting 481 Decision Trees 481 The Option to Expand 482 Abandonment Options 483 Flexible Production Facilities 484 Investment Timing Options 484 Summary 485 Related Web Links 485 Key Terms 485 VIII CONTENTS Quiz 485 Practice Problems 486 Challenge Problems 489 Solutions to Self-Test Questions 489 Minicase 491 An Overview of Corporate Financing 493 Common Stock 494 Book Value versus Market Value 496 Dividends 497 Stockholders’ Rights 497 Voting Procedures 497 Classes of Stock 498 Corporate Governance in the United States and Elsewhere 498 Preferred Stock 499 Corporate Debt 500 Debt Comes in Many Forms 501 Innovation in the Debt Market 504 Convertible Securities 507 Patterns of Corporate Financing 508 Do Firms Rely Too Heavily on Internal Funds? 508 External Sources of Capital 510 Summary 511 Related Web Links 512 Key Terms 512 Quiz 512 Practice Problems 513 Solutions to Self-Test Questions 514 How Corporations Issue Securities 517 Venture Capital 519 The Initial Public Offering 520 Arranging a Public Issue 521 The Underwriters 526 Who Are the Underwriters? 526 General Cash Offers by Public Companies 528 General Cash Offers and Shelf Registration 528 Costs of the General Cash Offer 529 Market Reaction to Stock Issues 530 The Private Placement 531 Summary 532 Related Web Links 533 Key Terms 533 Quiz 534 Practice Problems 534 Challenge Problem 536 Solutions to Self-Test Questions 537 Minicase 537 Appendix: Hotch Pot’s New Issue Prospectus 539 Leasing 547 Leasing versus Buying 548 Operating Leases 548 Financial Leases 549 Tax-Oriented Leases 549 Leveraged Leases 550 Sale and Leaseback Agreements 550 Accounting and Leasing 550 Taxes, the IRS, and Leases 552 The Cash Flows from Leasing 553 The Incremental Cash Flows 553 A Note on Taxes 554 Lease or Buy? 555 A Preliminary Analysis 555 Three Potential Pitfalls 555 NPV Analysis 556 A Misconception 556 Leverage and Capital Structure 559 The Capital Structure Question 560 The Effect of Financial Leverage 560 The Impact of Financial Leverage 560 Financial Leverage, EPS, and ROE: An Example 561 EPS versus EBIT 561 APPENDIX B 545 CONTENTS IX Mergers, Acquisitions, and Corporate Control 567 22.1 The Market for Corporate Control 569 Method 1: Proxy Contests 569 Method 2: Mergers and Acquisitions 570 Method 3: Leveraged Buyouts 571 Method 4: Divestitures and Spin-offs 571 22.2 Sensible Motives for Mergers 572 Economies of Scale 573 Economies of Vertical Integration 573 Combining Complementary Resources 574 Mergers as a Use for Surplus Funds 574 22.3 Dubious Reasons for Mergers 575 Diversification 575 The Bootstrap Game 575 22.4 Evaluating Mergers 577 Mergers Financed by Cash 577 Mergers Financed by Stock 579 A Warning 580 Another Warning 580 22.5 Merger Tactics 582 Who Gets the Gains? 584 22.6 Leveraged Buyouts 585 Barbarians at the Gate? 587 22.7 Mergers and the Economy 588 Merger Waves 588 Do Mergers Generate Net Benefits? 589 22.8 Summary 590 Related Web Links 592 Key Terms 592 Quiz 592 Practice Problems 593 Challenge Problems 594 Solutions to Self-Test Questions 595 Minicase 595 International Financial Management 597 23.1 Foreign Exchange Markets 598 23.2 Some Basic Relationships 602 Exchange Rates and Inflation 602 Inflation and Interest Rates 606 Interest Rates and Exchange Rates 608 The Forward Rate and the Expected Spot Rate 609 Some Implications 610 23.3 Hedging Exchange Rate Risk 612 23.4 International Capital Budgeting 613 Net Present Value Analysis 613 The Cost of Capital for Foreign Investment 615 Avoiding Fudge Factors 616 23.5 Summary 617 Related Web Links 618 Key Terms 618 Quiz 618 Practice Problems 619 Challenge Problem 621 Solutions to Self-Test Questions 621 Minicase 623 Glossary 635 SECTION 6 565 APPENDIX C 625 [...]... funds, universities, and charitable bodies 16 The Firm and the Financial Manager TABLE 1.2 Representative salaries for senior jobs in finance Career Banking President, medium-size bank Vice president, foreign exchange trading Controller Corporate finance Assistant treasurer Corporate controller Chief financial officer Investment banking Institutional brokers Vice president, institutional sales Managing... by banks, which keep an eagle eye on the progress of firms receiving their loans We do not want to leave the impression that corporate life is a series of squabbles and endless micromanagement It isn’t, because practical corporate finance has evolved to reconcile personal and corporate interests—to keep everyone working together to increase the value of the whole pie, not merely the size of each person’s... American offices, such as Argentina or Brazil Richard Gradley, Project Finance, Large Energy Company Emma Kuletsky, Customer Service Representative, Regional Bank After leaving college, I joined the finance department of a large energy company I spent my first year helping to analyze capital investment proposals I then moved to the project finance group, which is responsible for analyzing independent power... bring in new financial managers Sal studied finance, with an emphasis on financial markets and institutions Sally majored in accounting and became a CPA 5 years ago Who is more suited to be treasurer and who controller? Briefly explain CAREERS IN FINANCE SEE BOX In the United States well over 1 million people work in financial services, and many others work in the finance departments of corporations We... a strip mall and has financed its inventory with a bank loan Victor has little of his own money invested in the business Video shops usually command little customer loyalty 11 For example, the motto of the London Stock Exchange is “My word is my bond.” discussion is based on Clifford W Smith Jr., “Economics and Ethics: The Case of Salomon Brothers,” Journal of Applied Corporate Finance 5 (Summer 1992),... Analyst exam Since I did not study finance at college, this is quite challenging I hope eventually to move from a research role to become a portfolio manager builders, operators, suppliers, and so on, were all in place before we could arrange bank finance for the project Albert Rodriguez, Emerging Markets Group, Major New York Bank I joined the bank after majoring in finance I spent the first 6 months... by stockholders, who vote in a board of directors The directors appoint the corporation’s top executives and approve major financial decisions Comstock, Inc 3 T his material is an introduction to corporate finance We will discuss the various responsibilities of the corporation’s financial managers and show you how to tackle many of the problems that these managers are expected to solve We begin with... on This is where the mathematicians and the computer buffs thrive Investment banks, such as Merrill Lynch or Goldman Sachs, help companies sell their securities to investors They also have large corporate finance departments which assist firms in major reorganizations such as takeovers When firms issue securities or try to take over another firm, frequently a lot of money is at stake and the firms... in Boston Of course, many financial institutions have large businesses outside the United States Finance is a global business So you may spend some time working in a branch overseas or making the occasional trip to one of the other major financial centers, such as London, Tokyo, Hong Kong, or Singapore Finance professionals tend to be well paid Starting salaries for new graduates are in the region... that provide useful information about careers in finance Goals of the Corporation SHAREHOLDERS WANT MANAGERS TO MAXIMIZE MARKET VALUE For small firms, shareholders and management may be one and the same But for large companies, separation of ownership and management is a practical necessity For ex- 18 SECTION ONE TABLE 1.3 Internet sites for careers in finance Site URL Comment Wageweb Wall Street Journal . Selected material from FUNDAMENTALS OF CORPORATE FINANCE, Third Edition with additional material from FUNDAMENTALS OF CORPORATE FINANCE, Alternate Fifth. College with additional material from Fundamentals of Corporate Finance, Alternate Fifth Edition Essentials of Corporate Finance, Second Edition Stephen A.