FUNDAMENTALS OF CORPORATE FINANCE

[Pages:11]Tenth Edition

FUNDAMENTALS OF CORPORATE FINANCE

Stephen A. Ross

Massachusetts Institute of Technology

Randolph W. Westerfield

University of Southern California

Bradford D.Jordan

University of Kentucky

McGraw-Hill Irwin

CHAPTER!

INTRODUCTION TO CORPORATE FINANCE 1

1.1 Corporate Finance and the Financial Manager 2

What Is Corporate Finance? 2

The Financial Manager 2

Financial Management Decisions 2

Capital Budgeting 2

Capital Structure 3

Working Capital Management 4

Conclusion 4

1.2 Forms of Business Organization 4

Sole Proprietorship 4

Partnership 5

Corporation 5

A Corporation by Another Name . . . 7

1.3 The Goal of Financial Management 7

Possible Goals 8

The Goal of Financial Management 8

A More General Goal 9

Sarbanes-Oxley 9

1.4 The Agency Problem and Control

of the Corporation 10

Agency Relationships 10

Management Goals 10

Do Managers Act in the Stockholders! Interests? 11

Managerial Compensation 11

Control of the Firm 12

Conclusion 12

Stakeholders 12

1.5 Financial Markets and the Corporation 13

Cash Flows to and from the Firm 14

Primary versus Secondary Markets 14

Primary Markets 14

Secondary Markets 15

1

Dealer versus Auction Markets 15

Trading in Corporate Securities 15

Listing 16

1.6 Summary and Conclusions 16

CHAPTER 2

FINANCIAL STATEMENTS, TAXES, AND CASH FLOW 20

2.1 The Balance Sheet 21 Assets: The Left Side 21 Liabilities and Owners' Equity: The Right Side 21 Net Working Capital 22 Liquidity 23 Debt versus Equity 24 Market Value versus Book Value 24

2.2 The Income Statement 25 GAAP and the Income Statement 26 Noncash Items 27 Time and Costs 27

2.3 Taxes 29 Corporate Tax Rates 30 Average versus Marginal Tax Rates 30

2.4 Cash Flow 32 Cash Flow from Assets 32 Operating Cash Flow 33 Capital Spending 33 Change in Net Working Capital 34 Conclusion 34 A Note about "Free" Cash Flow 35 Cash Flow to Creditors and Stockholders 35 Cash Flow to Creditors 35 Cash Flow to Stockholders 35 An Example: Cash Flows for Dole Cola 37 Operating Cash Flow 37 Net Capital Spending 38 Change in NWC and Cash Flow from Assets 38 Cash Flow to Stockholders and Creditors 38

2.5 Summary and Cohclusions 39

CHAPTER 3

WORKING WITH FINANCIAL STATEMENTS 48

3.1 Cash Flow and Financial Statements: A Closer Look 49 Sources and Uses of Cash 49 The Statement of Cash Flows 51

3.2 Standardized Financial Statements 53 Common-Size Statements 53 Common-Size Balance Sheets 53 Common-Size Income Statements 54 Common-Size Statements of Cash Flows 55 Common-Base Year Financial Statements: Trend Analysis 55 Combined Common-Size and Base Year Analysis 55 xxxi

3.3 Ratio Analysis 56 Short-Term Solvency, or Liquidity, Measures 57 Current Ratio 57 The Quick (or Acid-Test) Ratio 58 Other Liquidity Ratios 59 Long-Term Solvency Measures 59 Total Debt Ratio 59 A Brief Digression: Total Capitalization versus Total Assets 60 Times Interest Earned 60 Cash Coverage 61 Asset Management, or Turnover, Measures 61 Inventory Turnover and Days' Sales in Inventory 61 Receivables Turnover and Days' Sales in -Receivables 62 Asset Turnover Ratios 63 Profitability Measures 63 Profit Margin 64 Return on Assets 64 Return on Equity 64 Market Value Measures 65 Price-Earnings Ratio 65 Price-Sales Ratio 65 Market-to-Book Ratio 66 Enterprise Value-EBITDA Ratio 66 Conclusion 67

3.4 The DuPont Identity 68 A Closer Look at ROE 68 An Expanded DuPont Analysis 69

3.5 Using Financial Statement Information 71 Why Evaluate Financial Statements? 71 Internal Uses 72 External Uses 72 Choosing a Benchmark 72 Time Trend Analysis 72 Peer Group Analysis 72 Problems with Financial Statement Analysis 77

3.6 Summary and Conclusions 78

CHAPTER 4

LONG-TERM FINANCIAL PLANNING AND GROWTH 90

4.1 What Is Financial Planning? 92 Growth as a Financial Management Goal 92 Dimensions of Financial Planning 92 What Can Planning Accomplish? 93 Examining Interactions 93 Exploring Options 93 Avoiding Surprises 93 Ensuring Feasibility and Internal Consistency 94 Conclusion 94

4.2 Financial Planning Models: A First Look 94 A Financial Planning Model: The Ingredients 94 Sales Forecast 94 Pro Forma Statements 95 Asset Requirements 95 Financial Requirements 95 The Plug 95 Economic Assumptions 96 A Simple Financial Planning Model 96

4.3 The Percentage of Sales Approach 97 The Income Statement 97 The Balance Sheet 98 A Particular Scenario 700 An Alternative Scenario 707

4.4 External Financing and Growth 704 EFN and Growth 704 Financial Policy and Growth 706 The Internal Growth Rate 106 The Sustainable Growth Rate 107 Determinants of Growth 108

A Note about Sustainable Growth Rate Calculations 7 70 4.5 Some Caveats regarding Financial Planning Models 7 7 7 4.6 Summary and Conclusions 712

CHAPTER 5

INTRODUCTION TO VALUATION: THE TIME VALUE OF MONEY 722

5.1 Future Value and Compounding 723 Investing for a Single Period 723 Investing for More Than One Period 723 A Note about Compound Growth 729

5.2 Present Value and Discounting 730 The Single-Period Case 730 Present Values for Multiple Periods 737

5.3 More about Present and Future Values 733 Present versus Future Value 734 Determining the Discount Rate, 734 Finding the Number of Periods 738

5.4 Summary and Conclusions 747

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CHAPTER 6

DISCOUNTED CASH FLOW VALUATION 747

6.1 Future and Present Values of Multiple Cash Flows 748 Future Value with Multiple Cash Flows 748 Present Value with Multiple Cash Flows 757 A Note about Cash Flow Timing 754

6.2 Valuing Level Cash Flows: Annuities and Perpetuities 755 Present Value for Annuity Cash Flows 755 Annuity Tables 156 Finding the Payment 158 Finding the Rate 159 Future Value for Annuities 767 A Note about Annuities Due -162 Perpetuities 763 Growing Annuities and Perpetuities 765

6.3 Comparing Rates: The Effect of Compounding 765 Effective Annual Rates and Compounding 766 Calculating and Comparing Effective Annual Rates 766 EARS and APRS 768 Taking It to the Limit: A Note about Continuous Compounding 770

6.4 Loan Types and Loan Amortization 7 77 Pure Discount Loans 7 77 Interest-Only Loans 7 72 Amortized Loans 7 72

6.5 Summary and Conclusions 7 77

CHAPTER 7

INTEREST RATES A N D BOND VALUATION 792

7.1 Bonds and Bond Valuation 793 Bond Features and Prices 193 Bond Values and Yields 793 Interest Rate Risk 797 Finding the Yield to Maturity: More Trial and Error 798

7.2 More about Bond Features 203 Is It Debt or Equity? 203 Long-Term Debt: The Basics 203 The Indenture 205 Terms of a Bond 205 Security 206 Seniority 206 Repayment 206 The Call Provision 207 Protective Covenants 207

7.3 Bond Ratings 208 7.4 Some Different Types of Bonds 209

Government Bonds 209 Zero Coupon Bonds 270 Floating-Rate Bonds 27 7

Other Types of Bonds 272 Sukuk 274 7.5 Bond Markets 275 How Bonds Are Bought and Sold 276 Bond Price Reporting 276 A Note about Bond Price Quotes 277 7.6 Inflation and Interest Rates 279 Real versus Nominal Rates 279 The Fisher Effect 220 Inflation and Present Values 227 7.7 Determinants of Bond Yields 222 The Term Structure of Interest Rates 222 Bond Yields and the Yield Curve: Putting It All Together 223 Conclusion 225 7.8 Summary and Conclusions 226

CHAPTER 8

STOCK VALUATION 234

8.1 Common Stock Valuation 235 Cash Flows 235 Some Special Cases 237 Zero Growth 237 Constant Growth 237 Nonconstant Growth 240 Two-Stage Growth 242 Components of the Required Return 243 Stock Valuation Using Multiples 244

8.2 Some Features of Common and Preferred Stocks 246 Common Stock Features 246 Shareholder Rights 246 Proxy Voting 247 Classes of Stock 247 Other Rights 248 Dividends 248 Preferred Stock Features 249 Stated Value 249 Cumulative and Noncumulative Dividends 249 Is Preferred Stock Really Debt? 249

8.3 The Stock Markets 250 Dealers and Brokers 250 Organization of the NYSE 257 Members 251 Operations 252 Floor Activity 252 NASDAQ Operations 253 ECNs 254 Stock Market Reporting 254

8.4 Summary and Conclusions 256

CHAPTER 9

NET PRESENT VALUE A N D OTHER INVESTMENT CRITERIA 266

9.1 Net Present Value 267 The Basic Idea 267 Estimating Net Present Value 268

9.2 The Payback Rule 277 Defining the Rule 277 Analyzing the Rule 272 Redeeming Qualities of the Rule 273 Summary of the Rule 274

9.3 The Discounted Payback 274 9.4 The Average Accounting Return 277 9.5 The Internal Rate of Return 279

Problems with the IRR 283 Nonconventional Cash Flows 283 Mutually Exclusive Investments 285 Investing or Financing? 287

Redeeming Qualities of the IRR 288 The Modified Internal Rate of Return (MIRR) 289

Method # 7; The Discounting Approach 289 Method #2: The Reinvestment Approach 289 Method #3: The Combination Approach 289 MIRR or IRR: Which Is Better? 290 9.6 The Profitability Index 290 9.7 The Practice of Capital Budgeting 297 9.8 Summary and Conclusions 294

CHAPTER 10

MAKING CAPITAL INVESTMENT DECISIONS 305

10.1 Project Cash Flows: A First Look 306 Relevant Cash Flows 306 The Stand-Alone Principle 306

10.2 Incremental Cash Flows 307 Sunk Costs 307 Opportunity Costs 307 Side Effects 308 Net Working Capital 308 Financing Costs 308 Other Issues 309

10.3 Pro Forma Financial Statements and Project Cash Flows 309 Getting Started: Pro Forma Financial Statements 309 Project Cash Flows 370 Project Operating Cash Flow 310 Project Net Working Capital and Capital Spending 311 Projected Total Cash Flow and Value 37 7

10.4 More about Project Cash Flow 372 A Closer Look at Net Working Capital 372 Depreciation 375 Modified ACRS Depreciation (MACRS) 315 Book Value versus Market Value 316 An Example: The Majestic Mulch and Compost Company (MMCC) 378 Operating Cash Flows 318 Change in NWC 318 Capital Spending 321 Total Cash Flow and Value 321 Conclusion 321

10.5 Alternative Definitions of Operating Cash Flow 322 The Bottom-Up Approach 323 The Top-Down Approach 323 The Tax Shield Approach 323 Conclusion 324

10.6 Some Special Cases of Discounted Cash Flow Analysis 324 Evaluating Cost-Cutting Proposals 324 Setting the Bid Price 326 Evaluating Equipment Options with Different Lives 328

10.7 Summary and Conclusions 330

CHAPTER 11

PROJECT ANALYSIS A N D EVALUATION 343

11.1 Evaluating NPV Estimates 344 The Basic Problem 344 Projected versus Actual Cash Flows 344 Forecasting Risk 344 Sources of Value 345

11.2 Scenario and Other What-lf Analyses 346 Getting Started 346 Scenario Analysis 347 Sensitivity Analysis 349 Simulation Analysis 350

11.3 Break-Even Analysis 357 Fixed and Variable Costs 357 Variable Costs 351 Fixed Costs 353 Total Costs 353 Accounting Break-Even 354 Accounting Break-Even: A Closer Look 355 Uses for the Accounting Break-Even 356

11.4 Operating Cash Flow, Sales Volume, and Break-Even 357 Accounting Break-Even and Cash Flow 357 The Base Case 357

?$333

Calculating the Break-Even Level 358 Payback and Break-Even 358 Sales Volume and Operating Cash Flow 358 Cash Flow, Accounting, and Financial Break-Even Points 359 Accounting Break-Even Revisited 359 Cash Break-Even 360 Financial Break-Even 360 Conclusion 360

11.5 Operating Leverage 362 The Basic Idea 362 Implications of Operating Leverage 362 Measuring Operating Leverage 362 Operating Leverage and Break-Even 364

11.6 Capital Rationing 364 Soft Rationing 365 Hard Rationing 365

11.7 Summary and Conclusions 365

CHAPTER 12

SOME LESSONS FROM CAPITAL MARKET HISTORY 374

12.1 12.2 12.3 12.4

12.5 12.6 12.7

Returns 375 Dollar Returns 375 Percentage Returns 377 The Historical Record 379 A First Look 379 A Closer Look 387 Average Returns: The First Lesson 385 Calculating Average Returns 385 Average Returns: The Historical Record 385 Risk Premiums 386 The First Lesson 386 The Variability of Returns: The Second Lesson 387 Frequency Distributions and Variability 387 The Historical Variance and Standard Deviation 388 The Historical Record 390 Normal Distribution 397 The Second Lesson 392 2008: The Bear Growled and Investors Howled 392 Using Capital Market History 394 More on the Stock Market Risk Premium 394 More about Average Returns 396 Arithmetic versus Geometric Averages 396 Calculating Geometric Average Returns 396 Arithmetic Average Return or Geometric Average Return? 399 Capital Market Efficiency 400 Price Behavior in an Efficient Market 400 The Efficient Markets Hypothesis 407 Some Common Misconceptions about the EMH 402 The Forms of Market Efficiency 403 Summary and Conclusions 404

CHAPTER 13

RETURN, RISK, A N D THE SECURITY MARKET LINE 472

13.1 Expected Returns and Variances 473

Expected Return 473

Calculating the Variance 475

13.2 Portfolios 476

Portfolio Weights 477

Portfolio Expected Returns 47 7

Portfolio Variance 478

13.3 Announcements, Surprises, and Expected Returns 420

Expected and Unexpected Returns 420

Announcements and News 420

13.4 Risk: Systematic and Unsystematic 422

Systematic and Unsystematic Risk 422

Systematic and Unsystematic Components of

Return 422

13.5 Diversification and Portfolio Risk 423

The Effect of Diversification: Another Lesson

from Market History 423

The Principle of Diversification 424

Diversification and Unsystematic Risk 425

Diversification and Systematic Risk 426

13.6 Systematic Risk and Beta 426

The Systematic Risk Principle 427

Measuring Systematic Risk 427

Portfolio Betas 429

13.7 The Security Market Line 430

Beta and the Risk Premium 430

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The Reward-to-Risk Ratio 431

The Basic Argument 432

The Fundamental Result 434

The Security Market Line 435

Market Portfolios 435

The Capital Asset Pricing Model 435

13.8 The SML and the Cost of Capital: A Preview 438

The Basic Idea 438

The Cost of Capital 438

13.9 Summary and Conclusions 439

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CHAPTER 14

COST OF CAPITAL 449

14.1 The Cost of Capital: Some Preliminaries 450 Required Return versus Cost of Capital 450 Financial Policy and Cost of Capital 457

14.2 The Cost of Equity 457 The Dividend Growth Model Approach 457 Implementing the Approach 451 Estimating g 452 Advantages and Disadvantages of the Approach 453 The SML Approach 453 Implementing the Approach 454 Advantages and Disadvantages of the Approach 454

14.3 The Costs of Debt and Preferred Stock 455 The Cost of Debt 455 The Cost of Preferred Stock 456

14.4 The Weighted Average Cost of Capital 457 The Capital Structure Weights 457 Taxes and the Weighted Average Cost of Capital 458 Calculating the WACC for Eastman Chemical 459

Eastman's Cost of Equity 459 Eastman's Cost of Debt 461 Eastman's WACC 462 Solving the Warehouse Problem and Similar Capital Budgeting Problems 462 Performance Evaluation: Another Use of the WACC 465 14.5 Divisional and Project Costs of Capital 466 The SML and the WACC 467 Divisional Cost of Capital 468 The Pure Play Approach 468 The Subjective Approach 469 14.6 Flotation Costs and the Weighted Average Cost of Capital 470 Tfye Basic Approach 477 Flotation Costs and NPV 472 Internal Equity and Flotation Costs 473 14.7 Summary and Conclusions 474

CHAPTER 15

RAISING CAPITAL 483

15.1 The Financing Life Cycle of a Firm: Early-Stage Financing and Venture Capital 484 Venture Capital 484 Some Venture Capital Realities 485 Choosing a Venture Capitalist 485 Conclusion 486

15.2 Selling Securities to the Public: The Basic Procedure 486

15.3 Alternative Issue Methods 487 15.4 Underwriters 489

Choosing an Underwriter 490 Types of Underwriting 490

Firm Commitment Underwriting 490 Best Efforts Underwriting 491 Dutch Auction Underwriting 491 The Aftermarket 497 The Green Shoe Provision 492 Lockup Agreements 492 The Quiet Period 492 15.5 IPOs and Underpricing 493 IPO Underpricing: The 1999-2000 Experience 493 Evidence on Underpricing 493 Why Does Underpricing Exist? 498 15.6 New Equity Sales and the Value of the Firm 499 15.7 The Costs of Issuing Securities 500 The Costs of Selling Stock to the Public 500 The Costs of Going Public: A Case Study 504 15.8 Rights 504 The Mechanics of a Rights Offering 504 Number of Rights Needed to Purchase a Share 505 The Value of a Right 506 Ex Rights 508 The Underwriting Arrangements 509 Effects on Shareholders 509 15.9 Dilution 570 Dilution of Proportionate Ownership 570 Dilution of Value: Book versus Market Values 570 A Misconception 511 The Correct Arguments 512 15.10 Issuing Long-Term Debt 572 15.11 Shelf Registration 573 15.12 Summary and Conclusions 574

CHAPTER 16

FINANCIAL LEVERAGE AND CAPITAL STRUCTURE POLICY 527

16.1 The Capital Structure Question 522 Firm Value and Stock Value: An Example 522 Capital Structure and the Cost of Capital 523

16.2 The Effect of Financial Leverage 524 The Basics of Financial Leverage 524 Financial Leverage, EPS, and ROE: An Example 524 EPS versus EBIT 525 Corporate Borrowing and Homemade Leverage 527

16.3 Capital Structure and the Cost of Equity Capital 528 M&M Proposition I: The Pie Model 528

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The Cost of Equity and Financial Leverage: M&M Proposition II 529 Business and Financial Risk 537 16.4 M&M Propositions I and II with Corporate Taxes 532 The Interest Tax Shield 533 Taxes and M&M Proposition I 533 Taxes, the WACC, and Proposition II 534 Conclusion 535 16.5 Bankruptcy Costs 537 Direct Bankruptcy Costs 538 Indirect Bankruptcy Costs 538 16.6 Optimal Capital Structure 539 The Static Theory of Capital Structure 539 Optimal Capital Structure and the Cost of Capital 540 Optimal Capital Structure: A Recap 547 Capital Structure: Some Managerial Recommendations 543

Taxes 543 Financial Distress 543 16.7 The Pie Again 543 The Extended Pie Model 544 Marketed Claims versus Nonmarketed Claims 545 16.8 The Pecking-Order Theory 545 Internal Financing and the Pecking Order 545 Implications of the Pecking Order 546 16.9 Observed Capital Structures 547 16.10 A Quick Look at the Bankruptcy Process 549 Liquidation and Reorganization 549 Bankruptcy Liquidation 549 Bankruptcy Reorganization 550 Financial Management and the Bankruptcy Process ,557 Agreements to Avoid Bankruptcy 552 16.11 Summary and Conclusions 553

CHAPTER 17

t DIVIDENDS AND PAYOUT POLICY 560

17.1 /Cash Dividends and Dividend Payment 567 Cash Dividends 567 Standard Method of Cash Dividend Payment 567 Dividend Payment: A Chronology 562 More about the Ex-Dividend Date 562

17.2 Does Dividend Policy Matter? 564 An Illustration of the Irrelevance of Dividend Policy 564 Current Policy: Dividends Set Equal to Cash Flow 565 Alternative Policy: Initial Dividend Greater Than Cash Flow 565 Homemade Dividends 565 A Test 566

17.3 Real-World Factors Favoring a Low Dividend Payout 567 Taxes 567 Flotation Costs 567 Dividend Restrictions 567

17.4 Real-World Factors Favoring a High Dividend Payout 568 Desire for Current Income 568 Tax and Other Benefits from High Dividends 569 Corporate Investors 569 Tax-Exempt Investors 569 Conclusion 569

17.5 A Resolution of Real-World Factors? 569 Information Content of Dividends 569 The Clientele Effect 577

17.6 Stock Repurchases: An Alternative to Cash ? Dividends 577 Cash Dividends versus Repurchase 573 Real-World Considerations in a Repurchase 574 Share Repurchase and EPS 575

17.7 What We Know and Do Not Know about Dividend and Payout Policies 575 Dividends and Dividend Payers 575 Corporations Smooth Dividends 578 Putting It All Together 578 Some Survey Evidence on Dividends 580

17.8 Stock Dividends and Stock Splits 582 Some Details about Stock Splits and Stock Dividends 582 Example of a Small Stock Dividend 582 Example of a Stock Split 583 Example of a Large Stock Dividend 583 Value of Stock Splits and Stock Dividends 583 The Benchmark Case 584 Popular Trading Range 584 Reverse Splits 584

17.9 Summary and Conclusions 585

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