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Chapter 12 Questions & Problems: 8, 9, 10 Chapter 13 Questions & Problems: 1, 3, 5, 18, 19Fundamentals of
Corporate Finance
Tenth
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Fundamentals of
Corporate Finance
Tenth
EDITION
Richard A. Brealey
London Business School
Stewart C. Myers
Sloan School of Management,
Massachusetts Institute of Technology
Alan J. Marcus
Carroll School of Management,
Boston College
FUNDAMENTALS OF CORPORATE FINANCE, TENTH EDITION
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Brealey, Richard A., author. | Myers, Stewart C., author. | Marcus, Alan J., author.
Fundamentals for corporate finance / Richard A. Brealey, London
Business School, Stewart C. Myers, Sloan School of Management,
Massachusetts Institute of Technology, Alan J. Marcus, Carroll School of
Management, Boston College.
Tenth Edition. | Dubuque, IA : McGraw-Hill Education, [2019] |
Revised edition of Fundamentals of corporate finance, [2018] | Includes
bibliographical references and index.
LCCN 2018047649 | ISBN 9781260013962 (student edition : alk. paper)
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Dedication
To Our Families
About
The Authors
Richard A. Brealey
Professor of Finance at the London Business School
Professor Brealey is the former president of the European Finance Association and
a former director of the American Finance Association. He is a fellow of the British
Academy and has served as Special Adviser to the Governor of the Bank of England
and as director of a number of financial institutions. Professor Brealey is also the
author (with Professor Myers and Franklin Allen) of this book’s sister text, Principles
of Corporate Finance (McGraw-Hill Education).
Courtesy of Richard A. Brealey
Stewart C. Myers
Gordon Y Billard Professor of Finance at MIT’s Sloan School of Management
Dr. Myers is past president of the American Finance Association and a research
associate of the National Bureau of Economic Research. His research has focused on
financing decisions, valuation methods, the cost of capital, and financial aspects of
government regulation of business. Dr. Myers is a director of The Brattle Group, Inc.
and is active as a financial consultant. He is also the author (with Professor Brealey
and Franklin Allen) of this book’s sister text, Principles of Corporate Finance
(McGraw-Hill Education).
Courtesy of Stewart C. Myers
Alan J. Marcus
Mario Gabelli Professor of Finance in the Carroll School of Management at Boston
College
Professor Marcus’s main research interests are in derivatives and securities m
­ arkets.
He is co-author (with Zvi Bodie and Alex Kane) of the texts Investments and
Essentials of Investments (McGraw-Hill Education). Professor Marcus has served as
a research fellow at the National Bureau of Economic Research. Professor Marcus
also spent two years at Freddie Mac, where he helped to develop mortgage pricing
and credit risk models. He currently serves on the Research Foundation Advisory
Board of the CFA Institute.
Courtesy of Alan J. Marcus
vi
Preface
This book is an introduction to corporate finance. It focuses on how companies invest
in real assets, how they raise the money to pay for the investments, and how those
assets ultimately affect the value of the firm. It also provides a broad overview of the
financial landscape, discussing, for example, the major players in financial markets,
the role of financial institutions in the economy, and how securities are traded and
valued by investors. The book offers a framework for systematically thinking about
most of the important financial problems that both firms and individuals are likely to
confront.
Financial management is important, interesting, and challenging. It is important
because today’s capital investment decisions may determine the businesses that the
firm is in 10, 20, or more years ahead. Needless to say, a firm’s success or failure
also depends, in large part, on its ability to find the capital that it requires.
Finance is interesting for several reasons. Financial decisions often involve huge
sums of money. Large investment projects or acquisitions may involve billions of dollars. Also, the financial community is international and fast-moving, with colorful
heroes and a sprinkling of unpleasant villains.
Finance is challenging. Financial decisions are rarely cut and dried, and the financial markets in which companies operate are changing rapidly. Good managers can
cope with routine problems, but only the best managers can respond to change. To
handle new problems, you need more than rules of thumb; you need to understand
why companies and financial markets behave as they do and when common practice
may not be best practice. Once you have a consistent framework for making financial
decisions, complex problems become more manageable.
This book provides that framework. It is not an encyclopedia of finance. It
focuses instead on setting out the basic principles of financial management and
applying them to the main decisions faced by the financial manager. It explains
how managers can make choices between investments that may pay off at different
points of time or have different degrees of risk. It also describes the main features
of financial markets and discusses why companies may prefer a particular source
of finance.
We organize the book around the key concepts of modern finance. These concepts,
properly explained, simplify the subject. They are also practical. The tools of financial
management are easier to grasp and use effectively when presented in a consistent
conceptual framework. This text provides that framework.
Modern financial management is not “rocket science.” It is a set of ideas that can be
made clear by words, graphs, and numerical examples. The ideas provide the “why”
behind the tools that good financial managers use to make investment and financing
decisions.
We wrote this book to make financial management clear, useful, and fun for the
beginning student. We set out to show that modern finance and good financial practice
go together, even for the financial novice.
Fundamentals and Principles of Corporate Finance
This book is derived in part from its sister text Principles of Corporate Finance. The
spirit of the two books is similar. Both apply modern finance to give students a working ability to make financial decisions. However, there are also substantial differences
between the two books.
vii
viii
Preface
First, we provide in Fundamentals much more detailed discussion of the principles and mechanics of the time value of money. This material underlies almost all of
this text, and we spend a lengthy chapter providing extensive practice with this key
concept.
Second, we use numerical examples in this text to a greater degree than in Principles.
Each chapter presents several detailed numerical examples to help the reader become
familiar and comfortable with the material.
Third, we have streamlined the treatment of most topics. Whereas Principles has
34 chapters, Fundamentals has only 25. The relative brevity of Fundamentals necessitates a broader-brush coverage of some topics, but we feel that this is an advantage
for a beginning audience.
Fourth, we assume little in the way of background knowledge. While most users
will have had an introductory accounting course, we review the concepts of accounting that are important to the financial manager in Chapter 3.
Principles is known for its relaxed and informal writing style, and we continue
this tradition in Fundamentals. In addition, we use as little mathematical notation as
possible. Even when we present an equation, we usually write it in words rather than
symbols. This approach has two advantages. It is less intimidating, and it focuses
attention on the underlying concept rather than the formula.
Organizational Design
Fundamentals is organized in eight parts.
Part 1 (Introduction) provides essential background material. In the first chap-
ter, we discuss how businesses are organized, the role of the financial manager,
and the financial markets in which the manager operates. We explain how shareholders with many disparate goals might all agree that they want managers to
take actions that increase the value of their investment, and we introduce the
concept of the opportunity cost of capital and the trade-off that the firm needs
to make when assessing investment proposals. We also describe some of the
mechanisms that help to align the interests of managers and shareholders. Of
course, the task of increasing shareholder value does not justify corrupt and
unscrupulous behavior. We, therefore, discuss some of the ethical issues that
confront managers.
Chapter 2 surveys and sets out the functions of financial markets and institutions.
This chapter also reviews the crisis of 2007–2009. The events of those years illustrate
clearly why and how financial markets and institutions matter.
A large corporation is a team effort, so the firm produces financial statements to
help the players monitor its progress. Chapter 3 provides a brief overview of these
financial statements and introduces two key distinctions—between market and book
values and between cash flows and profits. This chapter also discusses some of the
shortcomings in accounting practice. The chapter concludes with a summary of federal taxes.
Chapter 4 provides an overview of financial statement analysis. In contrast to most
introductions to this topic, our discussion is motivated by considerations of valuation
and the insight that financial ratios can provide about how management has added to
the firm’s value.
Part 2 (Value) is concerned with valuation. In Chapter 5, we introduce the concept of
the time value of money, and because most readers will be more familiar with their
own financial affairs than with the big leagues of finance, we motivate our discussion
by looking first at some personal financial decisions. We show how to value long-lived
Preface
ix
streams of cash flows and work through the valuation of perpetuities and annuities.
Chapter 5 also contains a short concluding section on inflation and the distinction
between real and nominal returns.
Chapters 6 and 7 introduce the basic features of bonds and stocks and give students a chance to apply the ideas of Chapter 5 to the valuation of these securities.
We show how to find the value of a bond given its yield, and we show how prices
of bonds fluctuate as interest rates change. We look at what determines stock prices
and how stock valuation formulas can be used to infer the return that investors
expect. Finally, we see how investment opportunities are reflected in the stock price
and why analysts focus on the price-earnings multiple. Chapter 7 also introduces
the concept of market efficiency. This concept is crucial to interpreting a stock’s
valuation; it also provides a framework for the later treatment of the issues that
arise when firms issue securities or make decisions concerning dividends or capital
structure.
The remaining chapters of Part 2 are concerned with the company’s investment
decision. In Chapter 8, we introduce the concept of net present value and show how
to calculate the NPV of a simple investment project. We then consider more complex
investment proposals, including choices between alternative projects, machine replacement decisions, and decisions of when to invest. We also look at other measures of an
investment’s attractiveness—its internal rate of return, profitability index, and payback
period. We show how the profitability index can be used to choose between investment projects when capital is scarce. The appendix to Chapter 8 shows how to sidestep
some of the pitfalls of the IRR rule.
The first step in any NPV calculation is to decide what to discount. Therefore, in
Chapter 9, we work through a realistic example of a capital budgeting analysis, showing how the manager needs to recognize the investment in working capital and how
taxes and depreciation affect cash flows.
We start Chapter 10 by looking at how companies organize the investment
process and ensure everyone works toward a common goal. We then go on to
look at various techniques to help managers identify the key assumptions in their
estimates, such as sensitivity analysis, scenario analysis, and break-even analysis.
We explain the distinction between accounting break-even and NPV break-even.
We conclude the chapter by describing how managers try to build future flexibility into projects so that they can capitalize on good luck and mitigate the consequences of bad luck.
Part 3 (Risk) is concerned with the cost of capital. Chapter 11 starts with a historical
survey of returns on bonds and stocks and goes on to distinguish between the specific
risk and market risk of individual stocks. Chapter 12 shows how to measure market
risk and discusses the relationship between risk and expected return. Chapter 13 introduces the weighted-average cost of capital and provides a practical illustration of how
to estimate it.
Part 4 (Financing) begins our discussion of the financing decision. Chapter 14 provides an overview of the securities that firms issue and their relative importance as
sources of finance. In Chapter 15, we look at how firms issue securities, and we follow
a firm from its first need for venture capital, through its initial public offering, to its
continuing need to raise debt or equity.
Part 5 (Debt and Payout Policy) focuses on the two classic long-term financ-
ing decisions. In Chapter 16, we ask how much the firm should borrow, and we
summarize bankruptcy procedures that occur when firms can’t pay their debts. In
x
Preface
Chapter 17, we study how firms should set dividend and payout policy. In each
case, we start with Modigliani and Miller’s (MM’s) observation that in wellfunctioning markets, the decision should not matter, but we use this initial observation to help the reader understand why financial managers in practice do pay
attention to these decisions.
Part 6 (Financial Analysis and Planning) starts with long-term financial planning in Chapter 18, where we look at how the financial manager considers the combined effects of investment and financing decisions on the firm as a whole. We also
show how measures of internal and sustainable growth help managers check that
the firm’s planned growth is consistent with its financing plans. Chapter 19 is an
introduction to short-term financial planning. It shows how managers ensure that
the firm will have enough cash to pay its bills over the coming year. Chapter 20
addresses working capital management. It describes the basic steps of credit management, the principles of inventory management, and how firms handle payments
efficiently and put cash to work as quickly as possible. It also describes how firms
invest temporary surpluses of cash and how they can borrow to offset any temporary
deficiency. Chapter 20 is conceptually straightforward, but it contains a large dollop
of institutional material.
Part 7 (Special Topics) covers several important but somewhat more advanced
t­ opics—mergers (Chapter 21), international financial management (Chapter 22),
options (Chapter 23), and risk management (Chapter 24). Some of these topics
are touched on in earlier chapters. For example, we introduce the idea of options
in Chapter 10, when we show how companies build flexibility into capital projects. However, Chapter 23 generalizes this material, explains at an elementary
level how options are valued, and provides some examples of why the financial
manager needs to be concerned about options. International finance is also not
confined to Chapter 22. As one might expect from a book that is written by
an international group of authors, examples from different countries and financial systems are scattered throughout the book. However, Chapter 22 tackles
the specific problems that arise when a corporation is confronted by different
currencies.
Part 8 (Conclusion) contains a concluding chapter (Chapter 25), in which we review
the most important ideas covered in the text. We also introduce some interesting questions that either were unanswered in the text or are still puzzles to the finance profession. Thus, the last chapter is an introduction to future finance courses as well as a
conclusion to this one.
Routes through the Book
There are about as many effective ways to organize a course in corporate finance as
there are teachers. For this reason, we have ensured that the text is modular so that topics can be introduced in different sequences.
We like to discuss the principles of valuation before plunging into financial planning. Nevertheless, we recognize that many instructors will prefer to move directly
from Chapter 4 (Measuring Corporate Performance) to Chapter 18 (Long-Term
Financial Planning) in order to provide a gentler transition from the typical prerequisite
accounting course. We have made sure that Part 6 (Financial Analysis and Planning)
can easily follow Part 1.
Similarly, we like to discuss working capital only after the student is familiar with
the basic principles of valuation and financing, but we recognize that here also
Preface
xi
many instructors prefer to reverse our order. There should be no difficulty in taking
Chapter 20 out of order.
When we discuss project valuation in Part 2, we stress that the opportunity cost of
capital depends on project risk. But we do not discuss how to measure risk or how
return and risk are linked until Part 3. This ordering can easily be modified. For example, the chapters on risk and return can be introduced before, after, or midway through
the material on project valuation.
Changes in the Tenth Edition
Users of previous editions of this book will not find dramatic changes in either
the material or the ordering of topics. But, throughout, we have made the book
more up to date and easier to read. Here are some of the ways that we have
done this.
Beyond the Page The Beyond the Page digital extensions and applications provide
additional examples, anecdotes, spreadsheet programs, and more thoroughgoing
explanations of some topics. This material is very easily accessed on the web. In this
edition, we have updated them and added a number of additional applications and
made them easier to access. For example, the applications are seamlessly available
with a click on the e-version of the book, but they are also readily accessible in the
traditional hard copy of the text using the shortcut URLs provided in the margins of
relevant pages.
Improving the Flow A major part of our effort in revising this text was spent on
improving the flow. Often this has meant a word change here or a redrawn diagram
there, but sometimes we have made more substantial changes. One example is the discussion of discounted cash flow analysis in Chapter 9. Rather than presenting a series
of disconnected examples, we now illustrate the many aspects of cash flow analysis in
one integrated application. The material is substantially unchanged, but we think that
the flow is much improved.
Updating Major updates in this edition revolved around the implications of recent
tax reform legislation. The Tax Cuts and Jobs Act of 2017 mandated substantial
changes in corporate and personal tax rates as well as in the tax treatment of depreciation and investment income. All of these changes potentially affect firms’ capital
budgeting and financing decisions.
Of course, in each new edition we also try to ensure that any statistics are as up to
date as possible. For example, since the previous edition, we have available an extra
2 years of data on security returns. These show up in the figures in Chapter 11 of
the long-run returns on stocks, bonds, and bills. Measures of EVA, data on security
ownership, dividend payments, and stock repurchases are just a few of the other cases
where data have been brought up to date.
New Illustrative Boxes The text contains a number of boxes with illustrative real-world examples. Many of these are new. Look, for example, at the
box in Chapter 2 that describes prediction markets and what they had to
say about the 2016 presidential election. Or look at the box in Chapter 15 that
shows how the JOBS Act of 2012 cleared the way for companies to use crowdfunding to raise up to $50 million from small investors who wish to invest in
start-up firms.
xii
Preface
More Worked Examples We have added more worked examples in the text, many of
them taken from real companies.
Specific Chapter Changes in the Tenth Edition
Here are a few of the additions to chapter material:
Chapter 1 contains updated and timely examples of real capital expenditure decisions by major corporations.
Chapter 2 includes a discussion of prediction markets in the most recent presidential election.
Chapter 3 includes updated discussions of recent changes in tax law.
Chapter 6 includes a new Finance in Practice box to show how to find bond information on the web.
Chapter 7 provides new evidence on efficient markets and some of the anomalies
literature.
Chapter 9 now illustrates cash flow analysis in one integrated, extended
example. It also discusses and provides several examples of the impact of
accelerated depreciation and immediate expensing on the value of a capital
investment.
Chapter 14 now includes more coverage of alternative sources of cash as well as
extended treatment of the variety of corporate debt.
Chapter 16 reconsiders the present value of interest tax shields at the new, lower,
corporate tax rate.
Chapter 20 introduces the components of working capital and the determinants of
the cash cycle. It then looks briefly at each of the components including shortterm debt. It provides updated discussions on recent trends in the United States
concerning investments in working capital.
Chapter 21 features numerous updates to our coverage of the market for corporate
control, for example, GE’s divestment of major sectors of the firm, recent activist investor initiatives, and tax inversion strategies in the wake of recent changes
to tax law.
Assurance of Learning
Assurance of learning is an important element of many accreditation standards.
Fundamentals of Corporate Finance, Tenth Edition, is designed specifically to support your assurance-of-learning initiatives. Each chapter in the book begins with
a list of numbered learning objectives, which are referred to in the end-of-chapter problems and exercises. Every test bank question is also linked to one of these
objectives, in addition to level of difficulty, topic area, Bloom’s Taxonomy level, and
AACSB skill area. Connect, McGraw-Hill’s online homework solution, and EZ Test,
McGraw-Hill’s easy-to-use test bank software, can search the test bank by these and
other categories, providing an engine for targeted assurance-of-learning analysis
and assessment.
AACSB Statement
McGraw-Hill Education is a proud corporate member of AACSB International.
Understanding the importance and value of AACSB accreditation, Fundamentals of
Corporate Finance, Tenth Edition, has sought to recognize the curricula guidelines
detailed in the AACSB standards for business accreditation by connecting selected
questions in the test bank to the general knowledge and skill guidelines found in the
AACSB standards.
Preface
xiii
The statements contained in Fundamentals of Corporate Finance, Tenth Edition,
are provided only as a guide for the users of this text. The AACSB leaves content
coverage and assessment within the purview of individual schools, the mission of the
school, and the faculty. While Fundamentals of Corporate Finance, Tenth Edition, and
the teaching package make no claim of any specific AACSB qualification or evaluation, we have, within the test bank, labeled selected questions according to the six
general knowledge and skills areas.
TABLE 5.4 An example of an
annuity table, showing the
present value today of $1 a year
received for each of t years
Unique Features
Interest Rate per Year
Number
of Years
5%
6%
7%
8%
9%
10%
1
2
3
4
5
10
20
30
0.9524
1.8594
2.7232
3.5460
4.3295
7.7217
12.4622
15.3725
0.9434
1.8334
2.6730
3.4651
4.2124
7.3601
11.4699
13.7648
0.9346
1.8080
2.6243
3.3872
4.1002
7.0236
10.5940
12.4090
0.9259
1.7833
2.5771
3.3121
3.9927
6.7101
9.8181
11.2578
0.9174
1.7591
2.5313
3.2397
3.8897
6.4177
9.1285
10.2737
0.9091
1.7355
2.4869
3.1699
3.7908
6.1446
8.5136
9.4269
Remembering formulas is about as difficult as remembering other people’s birthdays. But as long as you bear in mind that an annuity is equivalent to the difference
between an immediate and a delayed perpetuity, you shouldn’t have any difficulty.
You can use a calculator or spreadsheet to work out annuity factors (we show you
how momentarily), or you can use a set of annuity tables. Table 5.4 is an abridged
annuity table (an extended version is shown in Table A.3 at the end of the book).
Check that you can find the 3-year annuity factor for an interest rate of 10%.
Compare Table 5.4 with Table 5.3, which presented the present value of a single
cash flow. In both tables, present values fall as we move across the rows to higher discount rates. But in contrast to those in Table 5.3, present values in Table 5.4 increase
as we move down the columns, reflecting the greater number of payments made by
longer annuities.
What makes Fundamentals of Corporate Finance
such a powerful learning tool?
5.6
Self-Test
If the interest rate is 8%, what is the 4-year discount factor? What is the 4-year
annuity factor? What is the relationship between these two numbers? Explain.
Integrated Examples
Numbered and titled examples are
integrated in each chapter. Students
can learn how to solve specific
problems step-by-step as well as gain
insight into general principles by
seeing how to approach and analyze
different problems.
Example
5.8 ⊲
Winning Big at the Lottery
In August 2017, a Massachusetts woman bought a Powerball lottery ticket and won a record
$758.7 million. We suspect that she received unsolicited congratulations, good wishes, and
requests for money from dozens of more or less worthy charities, relations, and newly
devoted friends. In response, she could fairly point out that the prize wasn’t really worth
$758.7 million. That sum was to be paid in 30 annual installments of about $23 million each.
Assuming that the first payment occurred at the end of 1 year, what was the present value of
the prize? The interest rate at the time was about 2.7%.
The present value of these payments is simply the sum of the present values of each
annual payment. But rather than valuing the payments separately, it is much easier to treat
them as a 30-year annuity. To value this annuity, we multiply $23 million by the 30-year annuity factor:
PV = 23 × 30-year annuity factor
1
1
= 23 × __ − _______
r r (1 + r)30
[
]
At an interest rate of 2.7%, the annuity factor is
[
]
1
1
____
− ___________ = 20.3829
.027 .027(1.027)30
Spreadsheet Solutions Boxes
These boxes provide the student with
detailed examples of how to use Excel
spreadsheets when applying financial
concepts. The boxes include questions
that apply to the spreadsheet, and their
solutions are given at the end of the
applicable chapter. These spreadsheets
are available for download in Connect.
Spreadsheet Solutions
=PRICE(settlement date, maturity date, annual coupon
rate, yield to maturity, redemption value as percent of
face value, number of coupon payments per year)
(If you can’t remember the formula, just remember that you
can go to the Formulas tab in Excel, and from the Financial
tab pull down the PRICE function, which will prompt you for
the necessary inputs.) For our 2.25% coupon bond, we
would enter the values shown in the spreadsheet below.
A
1
2
3
4
5
6
7
8
9
Excel Exhibits
Selected exhibits are set as Excel
spreadsheets. The accompanying
files are available for instructors
and students in Connect.
Bond Valuation
Excel and most other spreadsheet programs provide builtin functions to compute bond values and yields. They typically ask you to input both the date you buy the bond
(called the settlement date) and the maturity date of the
bond.
The Excel function for bond value is:
B
2.25% annual
coupon bond,
maturing Feb 2021
Alternatively, we could simply enter the following function in
Excel:
=PRICE(DATE(2018,2,15), DATE(2021,2,15), .0225, .02391, 100, 1)
The DATE function in Excel, which we use for both the settlement
and
maturity
dates,
uses
the
format
DATE(year,month,day).
Notice that the coupon rate and yield to maturity are
expressed as decimals, not percentages. In most cases,
redemption value will be 100 (i.e., 100% of face value), and the
resulting price will be expressed as a percent of face value.
Occasionally, however, you may encounter bonds that pay off
at a premium or discount to face value. One example would
be callable bonds, which give the company the right to buy
back the bonds at a premium before maturity.
C
Formula in column B
D
E
F
2.25% semiannual
6% annual
coupon bond,
coupon bond,
maturing Feb 2021
30-year maturity
Settlement date
15-Feb-2018
=DATE(2018,2,15)
15-Feb-2018
Maturity date
15-Feb-2021
=DATE(2021,2,15)
15-Feb-2021
Annual coupon rate
0.0225
0.0225
Chapter
5 The Time Value of Money
Yield to maturity
0.02391
0.02391
Redemption value
100
100
(% of face value)
10 Coupon payments
1
2
per year 5.3 Using a spreadsheet to find the present value of multiple cash flows
SPREADSHEET
11
A
B
C
D
12
1 Finding the present value of multiple cash flows using a spreadsheet
13 Bond price (% of par)
99.596 =PRICE(B5,B6,B7,B8,B9,B10)
99.594
2
3
4
5
6
7
8
9
10
11
12
13
14
Time until CF
0
1
2
15-Feb-2018
15-Feb-2021
0.06
0.07
100
135
1
E
87.591
Cash flow Present value Formula in Col C
Alternative formula for Col C
8000
$8,000.00 =PV($B$10, A4, 0, −B4) =B4/(1 + $B$10)^A4
4000
$3,703.70 =PV($B$10, A5, 0, −B5) =B5/(1 + $B$10)^A5
The solid curve in Figure 6.6 plots the price of a 30-year maturity,
6% coupon
^
4000bond over
$3,429.36
=PV($B$10,
A6, 0,
+ $B$10)
A6 does not
time assuming
that its yield
to−B6)
maturity=B6/(1
is currently
4% and
change. The price declines gradually until the maturity date, when it finally reaches
face value.
In each period,
the price decline offsets
the coupon income by just
$15,133.06
=SUM(C4:C6)
=SUM(C4:C6)
enough to reduce total return to 4%. The dashed curve in Figure 6.6 shows the
corresponding price path for a bond with a 2% coupon that sells at a discount to
Discount rate:
0.08
face value. In this case, the coupon income would provide less than a competitive
rate of return, so the bond sells below face value. Its price gradually approaches
Notice that the time until each
is foundand
in column
A. gain each year brings its total return up to the
facepayment
value, however,
the price
interest
rate.
Once we enter the formula market
for present
value
in cell C4, we can copy it to cells C5 and C6.
The present value for other interest rates can be found by changing the entry in cell B10.
SUM
6.5 The Yield Curve
178
values (column C) therefore appear as positive numbers. Column E shows an alternaWhentoyou
a packagewhere
of coupon
the final
repay-directly. This
tive
thebuy
usea bond,
of theyou
PVbuyfunction,
we payments
calculateplus
present
values
ment of us
face
But sometimes
is inconvenient
to buy things in packages. For
allows
tovalue.
see exactly
what weit are
doing.
example, perhaps you do not need a regular income and would prefer to buy just the
The
Beyond
the
Page
icon
will
take
you
to
an
application
that
shows
how each of
final repayment. That’s not a problem. The Treasury is prepared to split its bonds into
the examples in this chapter can be solved using a spreadsheet.
5.5 Level Cash Flows: Perpetuities and Annuities
Frequently, you may need to value a stream of equal cash flows. For example, a home
mortgage might require the homeowner to make equal monthly payments for the life of the
loan. For a 30-year loan, this would result in 360 equal payments. A 4-year car loan might
Finance in Practice Boxes
These are excerpts that appear in most
chapters, often from the financial
174
Part Two Value
Finance
in Practice Ethical Disputes in Finance
press, providing real-life illustrations
But sometimes raids can enhance shareholder value. For
Short-Selling
of the chapter’s topics, such as ethical
Investors who take short positions are betting that securities example, in 2012 and 2013, Relational Investors teamed up
FIGURE 6.5 Plot of bond will fall in price. Usually they do this by borrowing the security, with the California State Teachers’ Retirement System (CSTRS,
choices in finance, disputes about
selling it for cash, and
then waiting in the hope that they will a pension fund) to try to force Timken Co. to split into two
1,800
prices as a function of the
be able to buy it back cheaply. In 2007, hedge fund manager separate companies, one for its steel business and one for its
interest rate. The price of long- John Paulson took a huge short position in mortgage-backed industrial bearings business. Relational and CSTRS believed
stock valuation, financial planning,
1,600
term bonds is more sensitive to securities. The bet paid off, and that
When
interesttrade
rate equals
the 2.25%
coupon
that Timken’s
combination
of unrelated businesses was unfoyearthe
Paulson’s
and inefficient. Timken management responded that
billion for his fund.
rate, both bonds sell for cused
face value.
changes in the interest rate thanmade a profit of $1 1,400
and credit analysis.
Was Paulson’s trade unethical? Some believe not only that breakup would “deprive our shareholders of long-run value—
*
†
is the price of short-term bonds.
Bond price ($)
he was profiting from the misery that resulted from the crash all in an attempt to create illusory short-term gains through
1,200
in mortgage-backed securities, but that his short trades financial engineering.” But Timken’s stock price rose at the
accentuated the collapse. It is certainly true that short-sellers prospect of a breakup, and a nonbinding shareholder vote on
1,000 For example, following the crash of Relational’s proposal attracted a 53% majority. Finally, in 2014
have never been popular.
3-year bond
1929, one commentator compared short-selling to the ghoul- Timken spun off its steel business in a new corporation,
ishness of “creatures800
who, at all great earthquakes and fires, Timken Steel.
How do you draw the ethical line in such examples? Was
spring up to rob broken homes and injured and dead
Relational Investors a “raider” (sounds bad) or an “activist
humans.”
600
Short-selling in the stock market is the Wall Street Walk on investor” (sounds good)? Breaking up a portfolio of businesses can create difficult adjustments and job losses. Some
steroids. Not only do400
short-sellers sell all the shares 30-year
they may bond
have previously owned, but they borrow more shares and sell stakeholders lose. But shareholders and the overall economy
them too, hoping to buy them back for less when the stock can gain if businesses are managed more efficiently.
200
price falls. Poorly performing companies are natural targets
for short-sellers, and the companies’ incumbent managers Tax Avoidance
naturally complain, often0bitterly. Governments sometimes lis- In 2012 it was revealed that during the 14 years that Starbucks
0
1
2
3
4
5
6
7
8
9
10
11
12
13
14
ten to such complaints. For example, in 2008 the U.S. govern- had operated in the United Kingdom, it paid hardly any taxes.
outrage
led (%)
to a boycott of Starbucks shops, and the
Interest
rate
ment temporarily banned short sales of financial stocks in an Public
company
responded
by
promising
that
it
would
voluntarily
attempt to halt their decline.
But defendants of short-selling argue that selling securi- pay to the taxman about $16 million more than it was required
ties that one believes are overpriced is no less legitimate than to pay by law. Several months later, a U.S. Senate committee
buying those that appear underpriced. The object of a well- investigating tax avoidance by U.S. technology firms reported
functioning market is to set the correct stock prices, not that Apple had used a “highly questionable” web of offshore
always higher prices. Why impede short-selling if it conveys entities to avoid billions of dollars of U.S. taxes.
Multinational companies, such as Starbucks and Apple,
truly bad news, puts pressure on poor performers, and helps
could reduce their tax bills using legal techniques with exotic
corporate governance work?
interest rate risk
You can use a financial calculator to calculate the yield tonames
payments
of $11.25.
Therefore,“Double
we can
findand
the semiannual
such as the
“Dutch Sandwich,”
Irish,”
The risk in bond prices due
to Corporate
“Check-the-Box.”
But the public outcry over the revelations
maturity
on our 2.25%
yield as follows:
RaidersTreasury bond. The inputs are:
suggested
that
many
believed
that
use
of
these
techniques,
fluctuations in interest rates. In the movie Pretty Woman, Richard Gere plays the role of
an asset stripper, Edward Lewis. He buys companies, takes though legal, was unethical. If they were unethical, that leaves
do companies decide which tax
them apart, and
he paid forFV
the an awkward question: How
n
i
PV
PMT
FV
n sells the
i bits for more
PV than PMT
package. In the movie Wall Street, Gordon Gekko schemes are ethical and which are not? Can a company act in
BEYOND THE PAGE total
buys a failing airline, Blue Star, in order to break it up and shareholders’ interest if it voluntarily pays more taxes than it
obligated to pay?
995.938
1000 is legally
Inputs
6
995.938 11.25
1000
How changesInputssell the bits. 3Real corporate raiders
may not22.5
be as ruthless
Financial Calculator Boxes
and Exercises
In a continued effort to help students
Interest
Rate RiskUsing a Financial Calculator to Compute Bond Yield
grasp the critical concept of the time
Financial
Calculator
We
have
just
seen that bond prices fluctuate as interest rates change. In other words,
value of money, many pedagogical
bonds are subject to interest rate risk. Bond investors cross their fingers that market
tools have been added throughout
interest rates will fall, so that the price of their bond will rise. If they are unlucky and
the market interest rate rises, the value of their investment falls.
the first section of the text. Financial
A change in interest rates has only a modest impact on the present value of near-term
Calculator boxes provide examples
cash flows but a much greater impact on the value of distant cash flows. Therefore, any
change has a greater impact on the price of long-term bonds than the price of shortfor solving a variety of problems,
as Edward Lewis or2.392
Gordon Gekko, but they do target
in interest rates
Compute
Compute
1.19556
termwhose
bonds.
For
assets
can example,
be profitably compare
split up andthe two curves in Figure 6.5. The blue line shows
with directions for the most popular affect long- and companies
redeployed.
how
theyou
value
of the
2.25%
coupon bond
varies
with the
interest
Theyield,
green
short-term Now
bondscompute
i and
should
get 3-year,
an answer
of 2.392%,
This yield
to maturity,
of course,
is arate.
6-month
not an
This has led some to complain that raiders seek to carve
financial calculators.
which is
a tickshows
above
the
yield
reported
in
6.1.
annual
one. varies.
Bond dealers
typically
the semiline
how
the
pricethem
ofTable
awith
30-year,
2.25%
bond
Youwould
can see
thatannualize
the 30-year
upjust
established
companies,
often
leaving
heavy
* We need not go into the mechanics of short sales here, but note that the seller
is obligated to buy back the security, even if its price skyrockets far above what
he or she sold it for. As the saying goes, “He who sells what isn’t his’n, buys it
back or goes to prison.”
mhhe.com/brealey10e
of Paulson’s
told in G. Zuckerman,
The Greatest
Ever
Let’sdebt
now
redo this
calculation
that
the cou-† The story
annual
ratetrade
by isdoubling
it, so the
yield Trade
to maturity
would be
burdens,
basically
in order tobut
getrecognize
rich quick. One
German
bond is more sensitive to interest rate fluctuations
than the
bond.
This
should not
(New York: Broadway Business,
2009). 3-year
The trade was
controversial
for reasons
politician
has likened themInstead
to “swarms
of locusts
that fall
on
pons are
paid semiannually.
of three
annual
coupon
quoted
asScan
1.19556
× 2 = 2.391%,
which exactly
matches the
short-selling.
the nearby
Page icon
you.
you
buymove
a six
3-year
bondbeyond
and
rates
then
rise, Beyond
you the
will
be “Goldman
stuck Sachs
with a bad
companies,
devour all
they If
can,
andmakes
then
on.”semiannual
causes
a ruckus”
learn more.
payments
ofsurprise
$22.50,
the
bond
value
intoTable
6.1.
BEYOND THE PAGE
deal—you could have got a better interest rate if you had waited. However, think how
much worse it would be if the loan had been for 30 years rather than 3 years. The longer
the loan,
the more
you have lost by accepting what turns out to be a low interest rate.
BEYOND
PAGE
had reached 138.05% of face value and the yield had fallen to 2.5%. Anyone fortunate enough
BEYOND THETHE
PAGE
This
showsSachs
up intoa have
bigger
decline
in the
price
ofprice
the would
longer-term
bond.
Of course,
there −
bought
the bond
at the
issue
have made
a capital
gain of $1,380.50
BondGoldman
pricing
It is not always easy to know what is ethical behavior, and there can be many gray
mhhe.com/brealey10e
causes
a
ruckus
financial
isusing
a flip
side to this
effect,
whichboxyou
can three
also
see from
Figure
6.5.
When
rates
$963.80
= nearby
$416.70.
Inpresents
addition,
on ethical
August
15 the
bondin made
its Think
first interest
coupon
areas. The
controversies
finance.
about payment of
calculators
$21.875
(this
is the
semiannual
payment
onwould
the 4.375%
coupon
bond with a face value of
fall, the longer-term
bond
responds
with
greater
increase
inthe
price.
mhhe.com/brealey10e
where
you
stand
on these
issues aand
where you
draw
ethical line.
Which is the
longer-term bond?
Self-Test Questions
Provided in each chapter, these
helpful questions enable students to
check their understanding as they
read. Answers are worked out at the
end of each chapter.
mhhe.com/brealey10e
20
rate of return
Total income per period
per dollar invested.
6.4
$1,000). Our lucky investor would therefore have earned a 7-month rate of return of 45.5%:
Self-Test
coupon income + price change
Rate of return = _____________________
investment
(6.2)
$21.875 + $416.70
= ______________ = .455 = 45.5%
$963.80
Suddenly,
government
did4%
not seem
boring overnight
as before. ■ to 2%.
Suppose that the
market
interest bonds
rate is
and quite
thensodrops
Calculate the present values of the 2.25%, 3-year bond and of the 2.25%,
30-year bond both before and after this change in interest rates. Assume annual
coupon payments.
that your answers correspond with Figure 6.5. Use
6.6Confirm
Self-Test
your financial calculator or a spreadsheet. You can find a box on bond pricing
using Excel laterSuppose
in this chapter.
that you purchased 8% coupon, 10-year bonds for $1,324.44 when they
were yielding 4% (we assume annual coupon payments). One year later, you
receive the annual coupon payment of $80, but the yield to maturity has risen to
6%. Confirm that the rate of return on your bond over the year is less than the
original 4% yield to maturity.
6.3 Yield to Maturity
Suppose you are considering the purchase of a 3-year bond with a coupon rate of 10%.
adviser
a price between
for the bond.
How
do youand
calculate
rate during
of
Is therequotes
any connection
the yield
to maturity
the rate the
of return
a particular period? Yes: If the bond’s yield to maturity remains unchanged during the
return
theand
bond offers?
Bond prices
Your
BEYOND
THEinvestment
PAGE
approaching
maturity
mhhe.com/brealey10e
period, the bond price changes with time so that the total return on the bond is equal to
the yield to maturity. The rate of return will be less than the yield to maturity if interest
rates rise, and it will be greater than the yield to maturity if interest rates fall.
FIGURE 6.5 Plot of bond
prices as a function of the
interest rate. The price of longterm bonds is more sensitive to
changes in the interest rate than
is the price of short-term bonds.
1,800
1,600
When the interest rate equals the 2.25% coupon
rate, both bonds sell for face value.
Bond price ($)
1,400
1,200
1,000
3-year bond
800
600
30-year bond
400
200
0
1
2
3
4
5
6
7
8
Interest rate (%)
9
10
11
12
13
14
Interest Rate Risk
192
“Beyond the Page” Interactive
Content and Applications
Additional resources and hands-on
applications are just a click away.
Students can tap or click the icons
in the e-version or use the direct
web links to learn more about key
concepts and try out calculations,
tables, and figures when they go
“Beyond the Page.”
0
Part Two
interest rate risk
The risk in bond prices due to
fluctuations in interest rates.
BEYOND THE PAGE
How changes
in interest rates
affect long- and
short-term bonds
mhhe.com/brealey10e
BEYOND THE PAGE
Which is the
longer-term bond?
mhhe.com/brealey10e
Value
We have just seen that bond prices fluctuate as interest rates change. In other words,
bonds are subject to interest rate risk. Bond investors cross their fingers that market
interest32.rates
will
fall,
so that the price of their bond will rise. If they are unlucky and
Credit
Risk.
(LO6-5)
the marketa. interest
rate
of issued
theirbonds
investment
falls.
Many years
ago,rises,
Castles the
in thevalue
Sand Inc.
at face value
at a yield to maturity of
7%.
Now,
with
8 yearshas
left until
the bonds,on
thethe
company
has run
into hard
A change in interest rates
onlythea maturity
modestofimpact
present
value
of near-term
times and the yield to maturity on the bonds has increased to 15%. What is now the price of
cash flows but
a much greater impact on the value of distant cash flows. Therefore, any
the bond? (Assume semiannual coupon payments.)
change hasb. aSuppose
greater
impact
on
the
price
of
long-term
bonds
than
the
price
that investors believe that Castles can make good on the promised coupon pay- of shortbut that the company
willthe
go bankrupt
when the
matures
the blue
principal
term bonds. ments
For example,
compare
two curves
in bond
Figure
6.5.andThe
line shows
comes due. The expectation is that investors will receive only 80% of face value at maturity.
how the value
of the 3-year, 2.25% coupon bond varies with the interest rate. The green
If they buy the bond today, what yield to maturity do they expect to receive?
line shows
how the price of a 30-year, 2.25% bond varies. You can see that the 30-year
33. Credit Risk. Suppose that Casino Royale has issued bonds that mature in 1 year. They currently
bond is more
to interest
rateisfluctuations
than
thewill
3-year
This should not
offer sensitive
a yield of 20%.
However, there
a 50% chance that
Casino
defaultbond.
and bondholders
will
is the bond
expectedand
yieldrates
on thethen
bonds?rise,
(LO6-5)
surprise you. receive
If younothing.
buy aWhat
3-year
you will be stuck with a bad
34. Credit
Bond
A is
10-yearinterest
U.S. Treasury
Bondhad
B is waited.
a 10-year corporate
bond.
deal—you
couldRisk.
have
got
a abetter
ratebond.
if you
However,
think how
True or false? (LO6-3 and LO6-5)
much worse
it would be if the loan had been for 30 years rather than 3 years. The longer
a. If you hold bond A to maturity, your return will be equal to the yield to maturity.
the loan, the
youbond
have
by accepting
what
turnstoout
to be
low
interest
rate.
b. Ifmore
you hold
B tolost
maturity,
your return will
be equal
or less
thanathe
yield
to
This shows up
in a bigger decline in the price of the longer-term bond. Of course, there
maturity.
c.
If
you
hold
bond
A
for
5
years
and
then
sell
it,
your
return
could
be
greater
than
the
yield
to
is a flip side to this effect, which you can also see from Figure 6.5. When interest rates
maturity.
fall, the longer-term bond responds with a greater increase in price.
35. Credit Risk. A bond’s credit rating provides a guide to its risk. Suppose that long-term bonds
rated Aa currently offer yields to maturity of 7.5%. A-rated bonds sell at yields of 7.8%. Suppose that a 10-year bond with a coupon rate of 7.6% is downgraded by Moody’s from an Aa to
A rating. (LO6-5)
a. Is the bond likely to sell above or below par value before the downgrade?
b. Is the bond likely to sell above or below par value after the downgrade?
6.4
Self-Test
36. Credit
Risk.
Sludge
Corporation
has two
bonds
with
a face value
of $2 mil-to 2%.
Suppose
that
the
market
interest
rate
isoutstanding,
4% and each
then
drops
overnight
lion. Bond A is a senior bond; bond B is subordinated. Sludge has suffered a severe downturn in
Calculate
theandpresent
values
of only
the$3 2.25%,
3-year
bond
and
thecan2.25%,
demand,
its assets are
now worth
million. If the
company
defaults,
whatof
payoff
30-yearthebond
before
and
after this change in interest rates. Assume annual
holdersboth
of bond
B expect?
(LO6-5)
coupon
payments.
Confirm
that
your
answers
correspond
with
Figure
6.5. Use
37. Credit Risk. Slush Corporation has two bonds outstanding, each with a face value of $2 million. Bond calculator
A is secured onor
theacompany’s
head officeYou
building;
your financial
spreadsheet.
canbond
findB ais unsecured.
box on Slush
bondhaspricing
suffered a severe downturn in demand. Its head office building is worth $1 million, but its
using Excel
later
in are
this
chapter.
remaining
assets
now
worth only $2 million. If the company defaults, what payoff can the
holders of bond B expect? (LO6-5)
Web Exercises
Select chapters include Web Exercises
that allow students to utilize the
Internet to apply their knowledge
and skills with real-world companies.
6.3 Yield to Maturity
WEB EXERCISES
Suppose you are considering the purchase of a 3-year bond with a coupon rate of 10%.
1. Log on toadviser
www.investopedia.com
to find
calculator
for working
bond prices.
Your investment
quotes a price
fora simple
the bond.
How
do yououtcalculate
the rate of
(Start by clicking the Investing link and then look for another link to Calculators.) Check
return the whether
bond offers?
a change in yield has a greater effect on the price of a long-term or a short-term bond.
164
Minicases
Integrated minicases allow students
to apply their knowledge to relatively
complex, practical problems and
­typical real-world scenarios.
2.
When we plotted the yield curve in Figure 6.7, we used the prices of Treasury strips. You can
find current prices of strips by logging on to The Wall Street Journal website (www.wsj.com)
and clicking on Markets, Market Data, and then Rates. Try plotting the yields on stripped coupons against maturity. Do they currently increase or decline with maturity? Can you explain
why? You can also use The Wall Street Journal site to compare the yields on nominal Treasury
bonds with those on TIPS. Suppose that you are confident that inflation will be 3% per year.
Which bonds are the better buy?
3.
In Figure 6.9, we showed how bonds with greater credit risk have promised higher yields to
maturity. This yield spread goes up when the economic outlook is particularly uncertain. You can
check how much extra yield lower-grade bonds offer today by logging on to the Federal Reserve
Economic Database (FRED) at the St. Louis Fed website (fred.stlouisfed.org). Search for
Corporate Bonds and compare the yields on Aaa and Baa bonds. How does the current spread
in yields compare with the spread in November 2008 at the height of the financial crisis?
Part Two Value
MINICASE
Old Alfred Road, who is well-known to drivers on the Maine
Turnpike, has reached his 70th birthday and is ready to retire. Mr.
Road has no formal training in finance but has saved his money and
invested carefully.
Mr. Road owns his home—the mortgage is paid off—and does
not want to move. He is a widower, and he wants to bequeath the
house and any remaining assets to his daughter.
He has accumulated savings of $180,000, conservatively
invested. The investments are yielding 9% interest. Mr. Road also
has $12,000 in a savings account at 5% interest. He wants to keep the
savings account intact for unexpected expenses or emergencies.
Mr. Road’s basic living expenses now average about $1,500 per
month, and he plans to spend $500 per month on travel and hobbies. To maintain this planned standard of living, he will have to
rely on his investment portfolio. The interest from the portfolio is
$16,200 per year (9% of $180,000), or $1,350 per month.
Mr. Road will also receive $750 per month in Social Security
payments for the rest of his life. These payments are indexed for
inflation. That is, they will be automatically increased in proportion to changes in the consumer price index.
Mr. Road’s main concern is with inflation. The inflation rate
has been below 3% recently, but a 3% rate is unusually low by historical standards. His Social Security payments will increase with
inflation, but the interest on his investment portfolio will not.
What advice do you have for Mr. Road? Can he safely spend all
the interest from his investment portfolio? How much could he
withdraw at year-end from that portfolio if he wants to keep its real
value intact?
Suppose Mr. Road will live for 20 more years and is willing to
use up all of his investment portfolio over that period. He also
wants his monthly spending to increase along with inflation over
that period. In other words, he wants his monthly spending to stay
the same in real terms. How much can he afford to spend per
month?
Assume that the investment portfolio continues to yield a 9%
rate of return and that the inflation rate will be 4%.
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Acknowledgments
We take this opportunity to thank all of the individuals who helped us prepare this and previous editions. We want
to express our appreciation to those instructors whose insightful comments and suggestions were invaluable to us
during this revision.
Marlena Akhbari
Wright State University
Fan Chen
University of Mississippi
John Fay
Santa Clara University
Timothy Alzheimer
Montana State University
Nicole Choi
Washington State
University–Pullman
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University
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Arkansas
xx
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University of Montana
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Columbus State Community
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University
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Pennsylvania
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Technology
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xxi
In addition, we would like to thank the dedicated experts who have helped with updates to our instructor materials
and online content in Connect and LearnSmart, including Andrew Hession-Kunz, Matt Will, Marc-Anthony Isaacs,
and Nicholas Racculia. Their efforts are much appreciated as they will help both students and instructors. We also
appreciate help from Aleijda de Cazenove Balsan and Malcolm Taylor.
We are grateful to the talented staff at McGraw-Hill Education, especially Allison McCabe-Carroll, Senior
Product Developer; Chuck Synovec, Director, Finance; Kevin Moran, Director, Digital Content; Fran Simon and
Jamie Koch, Content Project Managers; Matthew Diamond, Senior Designer; Trina Mauer, Senior Marketing
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Finally, as was the case with the last nine editions, we cannot overstate the thanks due to our families.
Richard A. Brealey
Stewart C. Myers
Alan J. Marcus
xxii
Contents
in Brief
Part One
Introduction
Part Two
Value
1
Goals and Governance of the Corporation
2
Financial Markets and Institutions
3
Accounting and Finance
4
Measuring Corporate Performance
5
The Time Value of Money
6
Valuing Bonds
2
32
56
86
118
166
7
Valuing Stocks 196
8
Net Present Value and Other Investment Criteria
9
Using Discounted Cash-Flow Analysis to Make Investment Decisions 274
238
10
Project Analysis
11
Introduction to Risk, Return, and the Opportunity Cost of Capital 332
12
Risk, Return, and Capital Budgeting
13
The Weighted-Average Cost of Capital and Company Valuation
14
Introduction to Corporate Financing
15
How Corporations Raise Venture Capital and Issue Securities 440
16
Debt Policy
Debt and Payout
Policy
17
Payout Policy
Part Six
18
Long-Term Financial Planning
19
Short-Term Financial Planning 550
Part Three
Risk
Part Four
Financing
Part Five
Financial Analysis
and Planning
Part Seven
Special Topics
304
392
420
466
504
20 Working Capital Management
21
362
528
572
Mergers, Acquisitions, and Corporate Control 612
22 International Financial Management
23 Options
640
666
24 Risk Management 694
Part Eight
Conclusion
25 What We Do and Do Not Know about Finance 714
Appendix: Present Value and Future Value Tables A-1
Glossary G-1
Index IND-1
xxiii
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Contents
Part One
Introduction
Chapter 1
Goals and Governance of the Corporation 2
Chapter 3
Accounting and Finance
1.1
3.1
Investment and Financing Decisions 4
The Investment (Capital Budgeting) Decision 6
The Financing Decision
1.2
6
What Is a Corporation?
1.4
1.5
8
63
9
3.3
The Statement of Cash Flows 67
Free Cash Flow 69
Goals of the Corporation 12
3.4
Accounting Practice and Malpractice
Shareholders Want Managers to Maximize Market Value 12
3.5
Taxes
Agency Problems, Executive Compensation,
and Corporate Governance 15
Corporate Governance
Summary
1.7
Careers in Finance 21
1.8
Preview of Coming Attractions
1.9
Snippets of Financial History
Questions and Problems
18
Chapter 4
Measuring Corporate Performance 86
22
23
26
Chapter 2
Financial Markets and Institutions 32
2.1
The Importance of Financial Markets
and Institutions 34
2.2
The Flow of Savings to Corporations 35
4.1
How Financial Ratios Relate to Shareholder
Value 88
4.2
Measuring Market Value and Market Value
Added 89
4.3
Economic Value Added and Accounting
Rates of Return 91
Accounting Rates of Return 93
Problems with EVA and Accounting Rates of Return 95
37
4.4
Measuring Efficiency 96
4.5
Analyzing the Return on Assets:
The Du Pont System 98
Other Financial Markets 38
The Du Pont System 98
Financial Intermediaries 40
4.6
Financial Institutions 42
Total Financing of U.S. Corporations
Transporting Cash across Time
Risk Transfer and Diversification
44
45
45
46
The Payment Mechanism
Measuring Financial Leverage 100
Leverage and the Return on Equity 102
Functions of Financial Markets and Intermediaries 45
Liquidity
4.7
Measuring Liquidity
4.8
Interpreting Financial Ratios 104
4.9
The Role of Financial Ratios 108
Summary
47
Information Provided by Financial Markets
The Crisis of 2007–2009
75
Questions and Problems 76
Summary 25
The Stock Market
Personal Tax 74
17
The Ethics of Maximizing Value
70
73
Corporate Tax 73
16
1.6
2.4
The Income Statement
Income versus Cash Flow 64
Who Is the Financial Manager? 10
Executive Compensation
2.3
56
58
Book Values and Market Values 61
3.2
Other Forms of Business Organization
1.3
The Balance Sheet
103
109
Questions and Problems 110
47
Minicase 116
49
Summary 51
Questions and Problems
52
xxv
xxvi
Contents
Part Two
Value
Chapter 5
The Time Value of Money 118
Summary
5.1
Future Values and Compound Interest 120
5.2
Present Values
5.3
Chapter 7
Valuing Stocks 196
123
Finding the Interest Rate
127
7.1
Multiple Cash Flows 128
5.4
7.2
129
Reducing the Chore of the Calculations: Part 1
131
Using Financial Calculators to Solve Simple
Time-Value-of-Money Problems 131
7.3
How to Value Annuities
The Dividend Discount Model 206
135
7.4
Case 2: The Dividend Discount Model with Constant
Growth 209
140
Case 3: The Dividend Discount Model
with Nonconstant Growth 214
Annuities Due 143
5.6
Reducing the Chore of the Calculations: Part 2
144
Using Financial Calculators to Solve Annuity Problems 144
Using Spreadsheets to Solve Annuity Problems
5.7
Effective Annual Interest Rates 145
5.8
Inflation and the Time Value of Money 147
Real versus Nominal Cash Flows
Inflation and Interest Rates
Real or Nominal?
7.5
147
7.6
6.1
7.7
224
Behavioral Finance 227
Summary
153
228
Questions and Problems 229
Minicase 236
Chapter 8
Net Present Value and Other Investment
Criteria 238
166
The Bond Market
168
168
8.1
Interest Rates and Bond Prices 170
172
Valuing Long-Lived Projects 242
Choosing between Alternative Projects 244
Yield to Maturity 174
8.2
Calculating the Yield to Maturity
6.4
Bond Rates of Return
6.5
The Yield Curve 178
Net Present Value 240
A Comment on Risk and Present Value 241
Interest Rate Risk 174
176
The Internal Rate of Return Rule 245
A Closer Look at the Rate of Return Rule 246
176
Nominal and Real Rates of Interest
6.6
Market Anomalies and Behavioral Finance
Bubbles and Market Efficiency 226
How Bond Prices Vary with Interest Rates
6.3
220
Market Anomalies 224
151
164
Bond Characteristics
6.2
There Are No Free Lunches on Wall Street
Random Walks and Efficient Markets 221
152
Questions and Problems
Chapter 6
Valuing Bonds
218
218
Repurchases and the Dividend Discount Model 219
Summary 152
Minicase
Valuing a Business by Discounted Cash Flow
Valuing the Concatenator Business
145
149
Valuing Real Cash Payments
Simplifying the Dividend Discount Model 209
Case 1: The Dividend Discount Model with No Growth 209
135
136
Future Value of an Annuity
Valuing Common Stocks 203
Price and Intrinsic Value 204
Level Cash Flows: Perpetuities and Annuities
How to Value Perpetuities
Market Values, Book Values, and
Liquidation Values 201
Valuation by Comparables 203
Using Spreadsheets to Solve Simple
Time-Value-of-Money Problems 132
5.5
Stocks and the Stock Market 198
Reading Stock Market Listings 199
Future Value of Multiple Cash Flows 128
Present Value of Multiple Cash Flows
187
Questions and Problems 188
Calculating the Rate of Return for Long-Lived Projects 246
A Word of Caution 248
181
Some Pitfalls with the Internal Rate of Return Rule 248
Corporate Bonds and the Risk of Default 182
Protecting against Default Risk 185
Not All Corporate Bonds Are Plain Vanilla
8.3
The Profitability Index
253
Capital Rationing 254
187
Pitfalls of the Profitability Index 254
xxvii
Contents
8.4
The Payback Rule 255
Discounted Payback
8.5
Calculating the NPV of Blooper’s Mine 287
Further Notes and Wrinkles Arising from Blooper’s Project 288
256
More Mutually Exclusive Projects
256
Problem 1: The Investment Timing Decision
257
Problem 2: The Choice between Long- and Short-Lived
Equipment 258
Problem 3: When to Replace an Old Machine
8.6
260
A Last Look 261
Summary 262
Questions and Problems
Minicase
293
Questions and Problems 294
Minicase 302
Chapter 10
Project Analysis 304
10.1 How Firms Organize the Investment Process to Draw on
Their Competitive Strengths 306
263
270
The Capital Budget 306
Appendix: More on the IRR Rule 271
Problems and Some Solutions 307
Using the IRR to Choose between Mutually Exclusive
Projects 271
Using the Modified Internal Rate of Return When There Are
Multiple IRRs 271
Chapter 9
Using Discounted Cash-Flow Analysis to Make
Investment Decisions 274
9.1
Summary
Identifying Cash Flows
276
Discount Cash Flows, Not Profits
Discount Nominal Cash Flows
by the Nominal Cost of Capital
308
Sensitivity Analysis 309
Scenario Analysis 312
10.4 Break-Even Analysis 312
Accounting Break-Even Analysis 313
NPV Break-Even Analysis 314
Operating Leverage 317
A Second Real Option: The Option to Abandon 321
A Third Real Option: The Timing Option 321
281
282
283
A Fourth Real Option: Flexible Production Facilities 322
9.2
Corporate Income Taxes
9.3
An Example—Blooper Industries 283
Questions and Problems 324
Forecasting Blooper’s Cash Flows
Minicase 330
Part Three
Summary
284
323
Risk
Chapter 11
Introduction to Risk, Return, and the
Opportunity Cost of Capital 332
11.1 Rates of Return: A Review
334
11.2 A Century of Capital Market History 335
Market Indexes
335
340
Variance and Standard Deviation
340
A Note on Calculating Variance 343
Measuring the Variation in Stock Returns 343
11.4 Risk and Diversification
345
Message 1: Some Risks Look Big and Dangerous
but Really Are Diversifiable 353
Message 2: Market Risks Are Macro Risks 354
Message 3: Risk Can Be Measured 355
356
12.1 Measuring Market Risk 364
Measuring Beta 364
Betas for Ford and PG&E 367
Total Risk and Market Risk 367
Portfolio Betas 369
346
Market Risk versus Specific Risk
Chapter 12
Risk, Return, and Capital Budgeting 362
12.2 What Can You Learn from Beta? 369
345
Asset versus Portfolio Risk
353
Questions and Problems 357
Using Historical Evidence to Estimate Today’s Cost
of Capital 338
11.3 Measuring Risk
11.5 Thinking about Risk
Summary
335
The Historical Record
Diversification
319
The Option to Expand 319
278
Separate Investment and Financing Decisions
10.3 Some “What-If” Questions
10.5 Real Options and the Value of Flexibility
276
Discount Incremental Cash Flows
10.2 Reducing Forecast Bias 307
352
The Portfolio Beta Determines the Risk of a Diversified
Portfolio 372
xxviii
Contents
12.3 Risk and Return 373
The NPV of Geothermal’s Expansion 400
Why the CAPM Makes Sense
The Security Market Line
Checking Our Logic 401
375
376
13.3 Interpreting the Weighted-Average Cost of Capital 402
Using the CAPM to Estimate Expected Returns
How Well Does the CAPM Work?
377
377
Some Common Mistakes 402
12.4 The CAPM and the Opportunity Cost of Capital 380
The Company Cost of Capital
382
What Determines Project Risk?
383
13.4 Practical Problems: Measuring Capital Structure 403
Summary 383
13.5 More Practical Problems: Estimating
Expected Returns 405
384
Chapter 13
The Weighted-Average Cost of Capital and
Company Valuation 392
13.1 Geothermal’s Cost of Capital 394
The Expected Return on Common Stock 406
The Expected Return on Preferred Stock 407
Adding It All Up 408
13.6 Valuing Entire Businesses 409
Calculating Company Cost of Capital
as a Weighted Average 396
Use Market Weights, Not Book Weights
The Expected Return on Bonds 405
Real-Company WACCs 408
13.2 The Weighted-Average Cost of Capital 395
Calculating the Value of the Deconstruction Business 410
Summary
398
Taxes and the Weighted-Average Cost of Capital
398
411
Questions and Problems 412
Minicase 417
What If There Are Three (or More)
Sources of Financing? 400
Part Four
How Changing Capital Structure Affects Expected
Returns 403
What Happens When the Corporate Tax Rate Is
Not Zero 403
382
Don’t Add Fudge Factors to Discount Rates
Questions and Problems
When You Can and Can’t Use WACC 402
Financing
Chapter 14
Introduction to Corporate Financing
14.1 Creating Value with Financing Decisions
14.2 Patterns of Corporate Financing 422
Are Firms Issuing Too Much Debt?
14.3 Common Stock
Classes of Stock
427
Arranging a Public Issue 446
The Underwriters 450
429
15.3 General Cash Offers by Public Companies
451
General Cash Offers and Shelf Registration 452
430
Debt Comes in Many Forms
431
Innovation in the Debt Market
14.6 Convertible Securities 435
433
Costs of the General Cash Offer 452
Market Reaction to Stock Issues 453
15.4 The Private Placement 454
Summary
Summary 436
Questions and Problems
Venture Capital Companies 443
Other New-Issue Procedures 450
428
14.4 Preferred Stock 429
14.5 Corporate Debt
15.1 Venture Capital 442
15.2 The Initial Public Offering 445
425
Ownership of the Corporation
Voting Procedures
424
420
422
Chapter 15
How Corporations Raise Venture Capital and
Issue Securities 440
437
454
Questions and Problems 455
Minicase 460
Appendix: Hotch Pot’s New-Issue Prospectus 461
xxix
Contents
Part Five
Chapter 16
Debt Policy
Debt and Payout Policy
Minicase 499
Appendix: Bankruptcy Procedures 501
466
16.1 How Borrowing Affects Value in a Tax-Free
Economy 468
MM’s Argument—A Simple Example
Chapter 17
Payout Policy
469
How Borrowing Affects Earnings per Share
How Borrowing Affects Risk and Return
470
472
Stock Repurchases 509
16.3 Debt, Taxes, and the Weighted-Average
Cost of Capital 478
17.2 The Information Content of Dividends and
Repurchases 509
478
How Interest Tax Shields Contribute to the Value of
Stockholders’ Equity 480
Corporate Taxes and the Weighted-Average Cost of Capital 480
The Implications of Corporate Taxes for Capital Structure 482
Bankruptcy Costs
482
483
Financial Distress without Bankruptcy
488
17.5 Why Dividends May Reduce Value 517
Summary
489
Is There a Theory of Optimal Capital Structure?
490
Summary 491
519
Questions and Problems 520
Minicase 526
492
Financial Analysis and Planning
Chapter 18
Long-Term Financial Planning
Chapter 19
Short-Term Financial Planning 550
528
18.1 What Is Financial Planning? 530
Why Build Financial Plans?
18.3 A Long-Term Financial Planning Model
for Dynamic Mattress 532
Pitfalls in Model Design 537
538
531
19.2 Tracing Changes in Cash 554
19.3 Cash Budgeting 556
Preparing the Cash Budget 556
19.4 Dynamic’s Short-Term Financial Plan 559
Evaluating the Plan 561
A Note on Short-Term Financial Planning Models 562
Summary 542
549
553
Reasons to Hold Cash 554
Dynamic Mattress’s Financing Plan 560
18.4 External Financing and Growth 539
Questions and Problems
Tax Strategies
531
Components of a Financial Planning Model
Choosing a Plan
19.1 Links between Long-Term and Short-Term Financing 552
530
18.2 Financial Planning Models
Minicase
Dividends and Share Issues 514
17.6 Payout Policy and the Life Cycle of the Firm 518
The Two Faces of Financial Slack
Part Six
Repurchases and the Dividend Discount Model 513
Taxes and Payout—A Summary 518
487
Questions and Problems
Dividends or Repurchases? An Example 511
Taxation of Dividends and Capital Gains
under Current Tax Law 518
485
16.5 Explaining Financing Choices 487
A Pecking Order Theory
17.3 Dividends or Repurchases? The Payout
Controversy 511
17.4 Why Dividends May Increase Value 515
Costs of Bankruptcy Vary with Type of Asset 484
The Trade-Off Theory
How Firms Pay Dividends 507
Stock Dividends and Stock Splits 508
No Magic in Financial Leverage 476
16.4 Costs of Financial Distress
17.1 How Corporations Pay Out Cash to Shareholders 506
Limitations on Dividends 507
16.2 Debt and the Cost of Equity 474
Debt and Taxes at River Cruises
504
543
Summary
564
Questions and Problems 564
Minicase 569
xxx
Contents
Chapter 20
Working Capital Management 572
Other Payment Systems 592
Electronic Funds Transfer 593
International Cash Management 594
20.1 Working Capital 574
Components of Working Capital
20.5 Investing Idle Cash: The Money Market 595
574
Working Capital and the Cash Cycle
Money Market Investments 595
574
20.2 Accounts Receivable and Credit Policy
Calculating the Yield on Money Market Investments 596
577
Yields on Money Market Investments 597
Terms of Sale 578
Credit Agreements
The International Money Market 597
579
20.6 Managing Current Liabilities: Short-Term Debt 598
Credit Analysis 580
The Credit Decision
Collection Policy
Bank Loans 598
581
Commercial Paper 599
586
20.3 Inventory Management
587
Summary
20.4 Cash Management 590
Check Handling and Float
Part Seven
Minicase 610
591
Special Topics
Chapter 21
Mergers, Acquisitions, and Corporate
Control 612
21.1 Sensible Motives for Mergers
21.10 The Benefits and Costs of Mergers 633
Merger Waves 633
Summary
614
Minicase 639
Economies of Vertical Integration
616
Combining Complementary Resources
Mergers as a Use for Surplus Funds
Chapter 22
International Financial Management 640
617
618
Eliminating Inefficiencies 618
Industry Consolidation
22.1 Foreign Exchange Markets 642
618
Spot Exchange Rates 642
Taxes and Cross-Border Mergers
21.2 Dubious Reasons for Mergers
619
Forward Exchange Rates 644
619
22.2 Some Basic Relationships
Diversification 619
The Bootstrap Game
645
Exchange Rates and Inflation 645
619
Real and Nominal Exchange Rates 648
21.3 The Mechanics of a Merger 621
Inflation and Interest Rates 648
The Form of Acquisition 621
Mergers, Antitrust Law, and Popular Opposition
621
The Forward Exchange Rate and the Expected
Spot Rate 650
Interest Rates and Exchange Rates 651
21.4 Evaluating Mergers 622
Mergers Financed by Cash
622
Mergers Financed by Stock
624
22.3 Hedging Currency Risk 652
Transaction Risk 652
Economic Risk 653
625
Another Warning
634
Questions and Problems 635
Economies of Scale 616
A Warning
600
Questions and Problems 602
22.4 International Capital Budgeting 654
625
21.5 The Market for Corporate Control 626
Net Present Values for Foreign Investments 654
21.6 Method 1: Proxy Contests
Political Risk 656
21.7 Method 2: Takeovers
626
627
21.8 Method 3: Leveraged Buyouts 629
Barbarians at the Gate?
630
21.9 Method 4: Divestitures, Spin-Offs,
and Carve-Outs 632
The Cost of Capital for Foreign Investment 657
Avoiding Fudge Factors 658
Summary
658
Questions and Problems 659
Minicase 664
xxxi
Contents
Chapter 23
Options 666
23.1 Calls and Puts
Chapter 24
Risk Management 694
668
Selling Calls and Puts
24.1 Why Hedge? 696
670
The Evidence on Risk Management 697
Payoff Diagrams Are Not Profit Diagrams 671
24.2 Reducing Risk with Options 698
Financial Alchemy with Options 672
24.3 Futures Contracts
Some More Option Magic
673
23.2 What Determines Option Values? 674
Upper and Lower Limits on Option Values
The Determinants of Option Value
Commodity and Financial Futures 702
674
24.4 Forward Contracts 703
675
24.5 Swaps 704
Option-Valuation Models 677
Interest Rate Swaps
23.3 Spotting the Option 680
Options on Real Assets
698
The Mechanics of Futures Trading 701
704
Currency Swaps 706
680
And Some Other Swaps 707
Options on Financial Assets 681
24.6 Innovation in the Derivatives Market 707
Summary 684
24.7 Is “Derivative” a Four-Letter Word?
Questions and Problems
685
Summary
707
708
Questions and Problems 709
Part Eight
Conclusion
Chapter 25
What We Do and Do Not Know about
Finance 714
Are There Important Exceptions to the
Efficient-Market Theory? 720
Is Management an Off-Balance-Sheet Liability?
25.1 What We Do Know: The Six Most Important
Ideas in Finance 716
Net Present Value (Chapter 5)
How Can We Resolve the Payout Controversy? 721
How Can We Explain Merger Waves? 721
716
Risk and Return (Chapters 11 and 12)
Efficient Capital Markets (Chapter 7)
What Is the Value of Liquidity? 722
716
Why Are Financial Systems Prone to Crisis? 722
717
MM’s Irrelevance Propositions (Chapters 16 and 17)
Option Theory (Chapter 23)
Agency Theory
717
25.3 A Final Word 723
Questions and Problems 723
717
718
Appendix A A-1
25.2 What We Do Not Know: Nine Unsolved Problems
in Finance 718
What Determines Project Risk and Present Value? 718
Risk and Return—Have We Missed Something?
720
How Can We Explain Capital Structure? 721
719
Glossary
G-1
Index IND-1
CHAPTER
1
Goals and
Governance of
the Corporation
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1-1
Give examples of the investment and financing decisions that
financial managers make.
1-2
Distinguish between real and financial assets.
1-3
Cite some of the advantages and disadvantages of organizing
a business as a corporation.
1-4
Describe the responsibilities of the CFO, treasurer, and
controller.
1-5
Explain why maximizing market value is the natural financial
goal of the corporation.
1-6
Understand what is meant by “agency problems,” and cite
some of the ways that corporate governance helps mitigate
them.
1-7
Understand why maximizing market value does not justify
behaving unethically.
R E L AT E D W E B S I T E S F O R T H I S C H A P T E R C A N B E
F O U N D I N C O N N E C T.
2
PA R T O N E
Introduction
To grow from small beginnings to a major corporation, FedEx needed to make good investment and financing decisions.
@Duy Phuong Nguyen/Alamy
T
o carry on business, a corporation needs an
almost endless variety of assets. Some assets are
tangible, for example, plant and machinery, office
buildings, and vehicles; others are intangible, for example, brand names and patents. Corporations finance
these assets by borrowing, by reinvesting profits back
into the firm, and by selling additional shares to the
firm’s shareholders.
Financial managers, therefore, face two broad questions. First, what investments should the corporation
make? Second, how should it pay for these investments?
Investment decisions spend money. Financing decisions
raise money for investment.
We start this chapter with examples of recent investment and financing decisions by major U.S. and foreign
corporations. We review what a corporation is and
describe the roles of its top financial managers. We then
turn to the financial goal of the corporation, which is usually expressed as maximizing value, or at least adding
value. Financial managers add value whenever the corporation can invest to earn a higher return than its shareholders can earn for themselves.
But managers are human beings; they cannot be perfect servants who always and everywhere maximize
value. We will consider the conflicts of interest that arise in
large corporations and how corporate governance helps
to align the interests of managers and shareholders.
If we ask managers to maximize value, can the corporation also be a good citizen? Won’t the managers be
tempted to try unethical or illegal financial tricks? They
sometimes may be tempted, but wise managers realize
that such tricks are not just dishonest; they almost
always destroy value, not increase it. More challenging for the financial manager are the gray areas where
the line between ethical and unethical financial actions
is hard to draw.
Finally, we look ahead to the rest of this book and look
back to some entertaining snippets of financial history.
3
4
Part One Introduction
1.1 Investment and Financing Decisions
Fred Smith is best known today as the founder of FedEx. But in 1965 he was still a
sophomore at Yale, where he wrote an economics term paper arguing that delivery
systems were not keeping up with increasing needs for speed and dependability.1 He
later joined his stepfather at a struggling equipment and maintenance firm for air carriers. He observed firsthand the difficulties of shipping spare parts on short notice. He
saw the need for an integrated air and ground delivery system with a central hub that
could connect a large number of points more efficiently than a point-to-point delivery
system. In 1971, at the age of 27, Smith founded Federal Express.
Like many start-up firms, Federal Express flirted again and again with failure.
Smith and his family had an inheritance of a few million dollars, but this was far from
enough. The young company needed to purchase and retrofit a small fleet of aging
Dassault Falcon jets; build a central-hub facility; and hire and train pilots, delivery,
and office staff. The initial source of capital was short-term bank loans. Because of the
company’s shaky financial position, the bank demanded that the planes be used as collateral and that Smith personally guarantee the loan with his own money.
In April 1973, the company went live with a fleet of 14 jets, servicing 25 U.S. cities
out of its Memphis hub. By then, the company had spent $25 million and was effectively flat broke, without enough funds to pay for its weekly delivery of jet fuel. In
desperation, it managed to acquire a bank loan for $23.7 million. This loan had to be
backed by a guarantee from General Dynamics, which in return acquired an option to
buy the company. (Today, General Dynamics must regret that it never exercised this
option.)
In November of that year, the company finally achieved some financial stability
when it raised $24.5 million from venture capitalists, investment firms that provide
funds and advice to young companies in return for a partial ownership share. Eventually, venture capitalists invested about $90 million in Federal Express.
In 1977, private firms were allowed for the first time to compete with the Postal
Service in package delivery. Federal Express responded by expanding its operations. It
acquired seven Boeing 727s, each with about seven times the capacity of the Falcon
jets. To pay for these new investments, Federal Express raised about $19 million by
selling shares of stock to the general public in an initial public offering (IPO). The new
stockholders became part-owners of the company in proportion to the number of
shares they purchased.
From this point on, success followed success, and the company invested heavily to
expand its air fleet as well as its supporting infrastructure. It introduced an automated
shipping system and a bar-coded tracking system. In 1994, it launched its fedex.com
website for online package tracking. It opened several new hubs across the United
States as well as in Canada, France, the Philippines, and China. In 2007, FedEx (as the
company was now called) became the world’s largest airline measured by number of
planes. FedEx also invested in other companies, capped by the acquisition of TNT
Express for $4.4 billion in 2016. By 2017, FedEx had 400,000 employees, annual revenue of $60 billion, and a stock market value of $67 billion. Its name had become a
verb—to “FedEx a package” was to ship it overnight.
Even in retrospect, FedEx’s success was hardly a sure thing. Fred Smith’s idea was
inspired, but its implementation was complex and difficult. FedEx had to make good
investment decisions. In the beginning, these decisions were constrained by lack of
financing. For example, used Falcon jets were the only option, give…
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