CHAPTER 3
Analysis of Financial Statements 87
Box: Intrinsic Value and Analysis of Financial Statements 88
Financial Analysis 88
Liquidity Ratios 89
Asset Management Ratios 92
Box: The Price is Right! (Or Wrong!) 93
Debt Management Ratios 95
Profitability Ratios 98
Box: The World Might be Flat, but Global Accounting is Bumpy!
The Case of IFRS versus FASB 99
Market Value Ratios 100
Trend Analysis, Common Size Analysis, and Percentage Change Analysis 102
Tying the Ratios Together: The Du Pont Equation 106
Comparative Ratios and Benchmarking 107
Uses and Limitations of Ratio Analysis 108
Box: Ratio Analysis on the Web 109
Looking beyond the Numbers 110
Summary 110
CHAPTER 4
Time Value of Money 123
Box: Corporate Valuation and the Time Value of Money 124
Time Lines 125
Future Values 125
Box: Hints on Using Financial Calculators 129
Box: The Power of Compound Interest 132 Present Values 133
Finding the Interest Rate, I 136
Finding the Number of Years, N 137 Annuities 138 Future Value of an Ordinary Annuity 138 Future Value of an Annuity Due 141
Present Value of Ordinary Annuities and Annuities
Due 141
Box: Variable Annuities: Good or Bad? 144
Finding Annuity Payments, Periods, and Interest Rates 144
Perpetuities 146
Box: Using the Internet for Personal Financial Planning 147
Uneven, or Irregular, Cash Flows 148
Future Value of an Uneven Cash Flow Stream 151
Solving for I with Irregular Cash Flows 152
Semiannual and Other Compounding Periods 153
Box: Truth in Lending: What Loans Really Cost 156
Fractional Time Periods 157
Amortized Loans 158
Growing Annuities 159
Box: An Accident Waiting to Happen: Option Reset
Adjustable Rate Mortgages 160
Summary 162
Web Extensions
4A: The Tabular Approach
4B: Derivation of Annuity Formulas
4C: Continuous Compounding
CHAPTER 5
Bonds, Bond Valuation, and Interest Rates 173
Box: Intrinsic Value and the Cost of Debt 174
Who Issues Bonds? 174
Key Characteristics of Bonds 175
Box: Betting With or Against the U.S. Government:
The Case of Treasury Bond Credit Default Swaps 176
Bond Valuation 180
Changes in Bond Values over Time 184
Box: Drinking Your Coupons 187
Bonds with Semiannual Coupons 187
Bond Yields 188
The Pre-Tax Cost of Debt: Determinants of Market
Interest Rates 191
The Real Risk-Free Rate of Interest, r* 192
The Inflation Premium (IP) 193
The Nominal, or Quoted, Risk-Free Rate of Interest,
r RF
195
The Default Risk Premium (DRP) 195
Box: Insuring with Credit Default Swaps: Let the Buyer Beware! 197
Box: Might the U.S. Treasury Bond Be Downgraded? 199
Box: Are Investors Rational? 201
The Liquidity Premium (LP) 201
The Maturity Risk Premium (MRP) 201
The Term Structure of Interest Rates 204
Financing with Junk Bonds 205
Bankruptcy and Reorganization 206
Summary 207
Web Extensions
5A: A Closer Look at Zero Coupon Bonds
5B: A Closer Look at TIPS: Treasury InflationProtected Securities
5C: A Closer Look at Bond Risk: Duration
5D: The Pure Expectations Theory and Estimation of Forward Rates
PART 3 Stocks and Options 215
CHAPTER 6
Risk, Return, and the Capital Asset Pricing Model 217
Box: Intrinsic Value, Risk, and Return 219
Returns on Investments 219
Stand-Alone Risk 220
Box: What Does Risk Really Mean? 227
Box: The Trade-off between Risk and Return 229
Risk in a Portfolio Context 231
Box: How Risky Is a Large Portfolio of Stocks? 236
Box: The Benefits of Diversifying Overseas 239
Calculating Beta Coefficients 243
The Relationship between Risk and Return 246
Box: Another Kind of Risk: The Bernie Madoff Story 252
Some Concerns about Beta and the CAPM 253
Some Concluding Thoughts: Implications for Corporate Managers and Investors 253
Summary 255
Web Extensions
6A: Continuous Probability Distributions
6B: Estimating Beta with a Financial Calculator
CHAPTER 7
Stocks, Stock Valuation, and Stock Market Equilibrium 267
Box: Corporate Valuation and Stock Prices 268
Legal Rights and Privileges of Common Stockholders 268
Types of Common Stock 269
The Market Stock Price versus Intrinsic Value 270
Stock Market Reporting 272
Valuing Common Stocks 273
Valuing a Constant Growth Stock 276
Expected Rate of Return on a Constant Growth
Stock 279
Valuing Nonconstant Growth Stocks 281
Stock Valuation by the Free Cash Flow Approach
285 Market Multiple Analysis 285
Preferred Stock 286
Stock Market Equilibrium 287
The Efficient Markets Hypothesis 290
Box: Rational Behavior versus Animal Spirits, Herding, and Anchoring Bias 293
Summary 294
Web Extensions
7A: Derivation of Valuation Equations
CHAPTER 8
Financial Options and Applications in Corporate Finance 305
Box: The Intrinsic Value of Stock Options 306
Overview of Financial Options 306
Composite, or Weighted Average, Cost of Capital, WACC 358
Box: Global Variations in the Cost of Capital 361
Factors That Affect the WACC 361
Adjusting the Cost of Capital for Risk 363
Privately Owned Firms and Small Businesses 366
Four Mistakes to Avoid 367
Summary 368
Web Extensions
9A: The Required Return Assuming Nonconstant Dividends and Stock Repurchases
CHAPTER 10
The Basics of Capital Budgeting: Evaluating Cash Flows 379
Box: Corporate Valuation and Capital Budgeting 381
An Overview of Capital Budgeting 381
Net Present Value (NPV) 383
Internal Rate of Return (IRR) 387
Box: Why NPV Is Better Than IRR 389
Multiple Internal Rates of Return 390
Reinvestment Rate Assumptions 392
Modified Internal Rate of Return (MIRR) 393
NPV Profiles 396
Profitability Index (PI) 400
Payback Period 401
Conclusions on Capital Budgeting Methods 403
Decision Criteria Used in Practice 405
Other Issues in Capital Budgeting 405
Summary 411
Web Extensions
10A: The Accounting Rate of Return (ARR)
CHAPTER 11
Cash Flow Estimation and Risk Analysis 423
Box: Corporate Valuation, Cash Flows, and Risk Analysis 424
Conceptual Issues 424
Analysis of an Expansion Project 429
Risk Analysis in Capital Budgeting 435
Measuring Stand-Alone Risk 436
Sensitivity Analysis 436
Scenario Analysis 439
Monte Carlo Simulation 442
Box: Are Bank Stress Tests Stressful Enough? 445
Project Risk Conclusions 446
Box: Capital Budgeting Practices in the Asian/Pacific Region 447
Replacement Analysis 448
Real Options 449
Phased Decisions and Decision Trees 451 Summary 454 Appendix 11A Tax Depreciation 468
473
Box: Corporate Valuation and Financial Planning 474
Overview of Financial Planning 474
Sales Forecast 476
Additional Funds Needed (AFN) Method 478
Forecasted Financial Statements Method 482
Forecasting When the Ratios Change 496
Summary 499
Web Extensions
12A: Advanced Techniques for Forecasting Financial Statements Accounts
CHAPTER 13 Corporate Valuation, Value-Based Management and Corporate Governance 511
Box: Corporate Valuation: Putting the Pieces Together 512
Overview of Corporate Valuation 513 The Corporate Valuation Model 514
521
Managerial Behavior and Shareholder Wealth 530
Corporate Governance 531
Box: Let’s Go to Miami! IBM’s 2009 Annual Meeting 533
Box: Would the U.S. Government Be an Effective Board Director? 536
Box: Shareholder Reactions to the Crisis 538
Box: The Sarbanes-Oxley Act of 2002 and Corporate Governance 540
Box: International Corporate Governance 542
Employee Stock Ownership Plans (ESOPs) 543
Procedures for Cash Distributions 562
Cash Distributions and Firm Value 564
Clientele Effect 567
Information Content, or Signaling, Hypothesis 568
Implications for Dividend Stability 569
Box: Will Dividends Ever Be the Same? 570
Setting the Target Distribution Level: The Residual Distribution Model 570
The Residual Distribution Model in Practice 572
A Tale of Two Cash Distributions: Dividends versus Stock Repurchases 573
The Pros and Cons of Dividends and Repurchases 582
Box: Dividend Yields around the World 584
Other Factors Influencing Distributions 584
Summarizing the Distribution Policy Decision 585
Stock Splits and Stock Dividends 587
Box: Talk about a Split Personality! 588
Dividend Reinvestment Plans 590
Summary 591
CHAPTER 15
Capital Structure Decisions 599
Box: Corporate Valuation and Capital Structure 600
A Preview of Capital Structure Issues 600
Business Risk and Financial Risk 603
Capital Structure Theory 609
Box: Yogi Berra on the MM Proposition 611
Capital Structure Evidence and Implications 618
Box: Taking a Look at Global Capital Structures 620
Estimating the Optimal Capital Structure 621
Anatomy of a Recapitalization 625
Box: Deleveraging 630
Summary 630
Web Extensions
15A: Degree of Leverage
PART 7 Managing Global Operations 639
CHAPTER 16
Working Capital Management 641
Box: Corporate Valuation and Working Capital Management 642
Current Asset Holdings 643
Current Assets Financing Policies 644
The Cash Conversion Cycle 648
Box: Some Firms Operate with Negative Working Capital! 653
The Cash Budget 654
Cash Management and the Target Cash Balance 657
Box: The CFO Cash Management Scorecard 658
Cash Management Techniques 659
Inventory Management 661
Box: Supply Chain Management 662
Receivables Management 663
Box: Supply Chain Finance 665
Accruals and Accounts Payable (Trade Credit) 667
Short-Term Marketable Securities 670
Short-Term Financing 672
Short-Term Bank Loans 672
Commercial Paper 676
Use of Security in Short-Term Financing 677
Summary 678
Web Extensions
16A: Secured Short-Term Financing
CHAPTER 17
Multinational Financial Management 691
Box: Corporate Valuation in a Global Context 692
Multinational, or Global, Corporations 692
Multinational versus Domestic Financial Management 693
Exchange Rates 694
Exchange Rates and International Trade 698
The International Monetary System and Exchange Rate Policies 699
Trading in Foreign Exchange 703
Interest Rate Parity 704
Purchasing Power Parity 706
Box: Hungry for a Big Mac? Go To Malaysia! 708
Inflation, Interest Rates, and Exchange Rates 709
International Money and Capital Markets 710
Box: Greasing the Wheels of International Business 711
Box: Stock Market Indices around the World 713
Multinational Capital Budgeting 714
Box: Consumer Finance in China 715
International Capital Structures 718
Multinational Working Capital Management 720 Summary 723
Box: Off–Balance Sheet Financing: Is It Going to Disappear? 740 Evaluation by the Lessee 740
Evaluation by the Lessor 745
Other Issues in Lease Analysis 747
Box: What You Don’t Know Can Hurt You! 748
Box: Lease Securitization 750
Other Reasons for Leasing 751
Summary 753
Web Extensions
18A: Leasing Feedback
18B: Percentage Cost Analysis
18C: Leveraged Leases
CHAPTER 19
Hybrid Financing: Preferred Stock, Warrants, and Convertibles 759
Preferred Stock 761
Box: The Romance Had No Chemistry, But It Had a Lot of Preferred Stock! 762
Warrants 765
Convertible Securities 770
A Final Comparison of Warrants and Convertibles 777
Reporting Earnings When Warrants or Convertibles
Are Outstanding 778
Summary 779
Web Extensions
19A: Calling Convertible Issues
CHAPTER 20
Initial Public Offerings, Investment Banking, and Financial
Restructuring 787
The Financial Life Cycle of a Start-up Company 788
The Decision to Go Public 789
The Process of Going Public: An Initial Public Offering 791
Equity Carve-outs: A Special Type of IPO 799
Other Ways to Raise Funds in the Capital Markets
800
Box: Bowie Bonds Ch-Ch-Change Asset
Securitization 803
Investment Banking Activities and Their Role in the Global Economic Crisis 803
Box: Investment Banks and the Global Economic Crisis 805
The Decision to Go Private 806
Managing the Maturity Structure of Debt 808
Refunding Operations 810
Box: TVA Ratchets Down Its Interest Expenses 813
Managing the Risk Structure of Debt with Project Financing 815
Summary 817
Web Extensions
20A: Rights Offerings
PART 9 Special Topics 825
CHAPTER 21
Mergers, LBOs, Divestitures, and Holding Companies 827
Rationale for Mergers 828
Types of Mergers 830
Level of Merger Activity 831
Hostile versus Friendly Takeovers 832
Merger Regulation 833
Overview of Merger Analysis 834
The Adjusted Present Value (APV) Approach 835
The Free Cash Flow to Equity (FCFE) Approach 838
Illustration of the Three Valuation Approaches for a Constant Capital Structure 840
Setting the Bid Price 845
Analysis When There Is a Permanent Change in Capital Structure 847
Taxes and the Structure of the Takeover Bid 849
Box: Tempest in a Teapot? 850
Financial Reporting for Mergers 852
Analysis for a “True Consolidation” 855
The Role of Investment Bankers 855
Who Wins: The Empirical Evidence 857
Box: Merger Mistakes 858
Corporate Alliances 858
Leveraged Buyouts 859
Divestitures 859
Holding Companies 860
Summary 862
Web Extensions
21A: Projecting Consistent Debt and Interest Expenses
CHAPTER 22
Bankruptcy, Reorganization, and Liquidation 869
Financial Distress and Its Consequences 870
Issues Facing a Firm in Financial Distress 871
Settlements without Going through Formal Bankruptcy 872
Federal Bankruptcy Law 874
Reorganization in Bankruptcy 875
Liquidation in Bankruptcy 885
Box: A Nation of Defaulters? 888
Other Motivations for Bankruptcy 889
Some Criticisms of Bankruptcy Laws 889
Summary 890
Web Extensions
22A: Multiple Discriminant Analysis
CHAPTER 23
Derivatives and Risk Management 899
Box: Corporate Valuation and Risk Management
900
Reasons to Manage Risk 901
Background on Derivatives 903
Derivatives in the News 904
Other Types of Derivatives 907
Corporate Risk Management 913
Box: Enterprise Risk Management and Value at Risk 916
Using Derivatives to Reduce Risks 917
Box: Risk Management in the Cyber Economy 920
Summary 924
Web Extensions
23A: Risk Management with Insurance
PART 10 Advanced Issues 929
CHAPTER 24
Portfolio Theory, Asset Pricing Models, and
Behavioral Finance 931
Box: Corporate Valuation and Risk 932
Efficient Portfolios 932
Choosing the Optimal Portfolio 936
The Basic Assumptions of the Capital Asset Pricing Model 939
The Capital Market Line and the Security Market Line 940
Calculating Beta Coefficients 944
Box: Skill or Luck? 945
Empirical Tests of the CAPM 952
Arbitrage Pricing Theory 954
The Fama-French Three-Factor Model 957
An Alternative Theory of Risk and Return:
Behavioral Finance 961
Summary 963
CHAPTER 25
Real Options 971
Valuing Real Options 972
The Investment Timing Option: An Illustration 973
The Growth Option: An Illustration 982
Concluding Thoughts on Real Options 986
Summary 989
Web Extensions
25A: The Abandonment Real Option
25B: Risk-Neutral Valuation
CHAPTER 26
Analysis of Capital Structure Theory 995
Box: Corporate Valuation and Capital Structure Decisions 996
Capital Structure Theory: Arbitrage Proofs of the Modigliani-Miller Models 996
Introducing Personal Taxes: The Miller Model 1006
Criticisms of the MM and Miller Models 1010
An Extension of the MM Model: Nonzero Growth and a Risky Tax Shield 1011
Risky Debt and Equity as an Option 1015
Capital Structure Theory: Our View 1019
Summary 1021
Appendix A Solutions to Self-Test Problems .......................... 1029
Appendix B Answers to End-of-Chapter Problems ..................... 1063
Appendix C Selected Equations and Data ............................. 1071
Appendix D Values of the Areas under the Standard Normal Distribution Function ................................... 1085 Glossary ........................................................... 1087
Name Index ........................................................ 1113 Subject Index ...................................................... 1119
CHAPTERS
PART 1 Fundamental Concepts of Corporate Finance
Chapter 1 An Overview of Financial Management and the Financial Environment
Chapter 2 Financial Statements, Cash Flow, and Taxes
Chapter 3 Analysis of Financial Statements
CHAPTER 1 An Overview of Financial Management and the Financial Environment
In a global beauty contest for companies, the winner is … Apple. Or at least Apple is the most admired company in the world, according to Fortune magazine’s annual survey. The others in the global top ten are Berkshire Hathaway, Toyota, Google, Johnson & Johnson, Procter & Gamble, FedEx, Southwest Airlines, General Electric, and Microsoft. What do these companies have that separates them from the rest of the pack? According to a survey of executives, directors, and security analysts, these companies have very high average scores across nine attributes: (1) innovativeness, (2) quality of management, (3) long-term investment value, (4) social responsibility, (5) employee talent, (6) quality of products and services, (7) financial soundness, (8) use of corporate assets, and (9) effectiveness in doing business globally. After culling weaker
companies, the final rankings are then determined by over 3,700 experts from a wide variety of industries. What do these companies have in common? First, they have an incredible focus on using technology to understand their customers, reduce costs, reduce inventory, and speed up product delivery. Second, they continually innovate and invest in ways to differentiate their products. Some are known for game-changing products, such as Apple’s touch screen iPhone or Toyota’s hybrid Prius. Others continually introduce small improvements, such as Southwest Airline’s streamlined boarding procedures. In addition to their acumen with technology and customers, they are also on the leading edge when it comes to training employees and providing a workplace in which people can thrive. In a nutshell, these companies reduce costs by having innovative production processes, they create value for customers by providing high- quality products and services, and they create value for employees by training and fostering an environment that allows employees to utilize all of their skills and talents. Do investors benefit from this focus on processes, customers, and employees? During the most recent 5-year period,
these ten companies posted an average annual stock return of 6.9%, which is not too shabby when compared with the −4.1% average annual return of the S&P 500. These superior returns are due to superior cash flow generation. But, as you will see throughout this book, a company can generate cash flow only if it also creates value for its customers, employees, and suppliers.
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