Standard Edition FUNDAMENTALS OF CORPORATE FINANCE ros3062x_fm_Standard.indd i 2/9/07 6:01:58 PM The McGraw-Hill/Irwin Series in Finance, Insurance, and Real Estate Stephen A Ross Franco Modigliani Professor of Finance and Economics Sloan School of Management Massachusetts Institute of Technology Consulting Editor Financial Management Adair Excel Applications for Corporate Finance First Edition Benninga and Sarig Corporate Finance: A Valuation Approach Block and Hirt Foundations of Financial Management Twelfth Edition Brealey, Myers, and Allen Principles of Corporate Finance Eighth Edition Brealey, Myers, and Marcus Fundamentals of Corporate Finance Fifth Edition Brooks FinGame Online 4.0 Bruner Case Studies in Finance: Managing for Corporate Value Creation Fifth Edition Chew The New Corporate Finance: Where Theory Meets Practice Third Edition Chew and Gillan Corporate Governance at the Crossroads: A Book of Readings First Edition DeMello Cases in Finance Second Edition Grinblatt and Titman Financial Markets and Corporate Strategy Second Edition Helfert Techniques of Financial Analysis: A Guide to Value Creation Eleventh Edition Higgins Analysis for Financial Management Eighth Edition Kester, Ruback, and Tufano Case Problems in Finance Twelfth Edition Ross, Westerfield, and Jaffe Corporate Finance Eighth Edition ros3062x_fm_Standard.indd ii Ross, Westerfield, Jaffe, and Jordan Corporate Finance: Core Principles and Applications First Edition Ross, Westerfield, and Jordan Essentials of Corporate Finance Fifth Edition Ross, Westerfield, and Jordan Fundamentals of Corporate Finance Eighth Edition Shefrin Behavioral Corporate Finance: Decisions that Create Value First Edition Saunders and Cornett Financial Institutions Management: A Risk Management Approach Fifth Edition Saunders and Cornett Financial Markets and Institutions: An Introduction to the Risk Management Approach Third Edition International Finance White Financial Analysis with an Electronic Calculator Sixth 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Capital Markets: Financial Institutions and Instruments in a Global Marketplace Ninth Edition Financial Planning and Insurance Allen, Melone, Rosenbloom, and Mahoney Pension Planning: Pension, Profit-Sharing, and Other Deferred Compensation Plans Ninth Edition Altfest Personal Financial Planning First Edition Harrington and Niehaus Risk Management and Insurance Second Edition Kapoor, Dlabay, and Hughes Focus on Personal Finance: An active approach to help you develop successful financial skills First Edition Kapoor, Dlabay, and Hughes Personal Finance Eighth Edition 2/9/07 6:01:59 PM Standard Edition Eighth 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 Boston Burr Ridge, IL Dubuque, IA New York San Francisco St Louis Bangkok Bogotá Caracas Kuala Lumpur Lisbon London Madrid Mexico City Milan Montreal New Delhi Santiago Seoul Singapore Sydney Taipei Toronto iii ros3062x_fm_Standard.indd iii 2/9/07 6:01:59 PM FUNDAMENTALS OF CORPORATE FINANCE Published by McGraw-Hill/Irwin, a business unit of The McGraw-Hill Companies, Inc., 1221 Avenue of the Americas, New York, NY, 10020 Copyright © 2008 by The McGraw-Hill Companies, Inc All rights reserved No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of The McGraw-Hill Companies, Inc., including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning Some ancillaries, including electronic and print components, may not be available to customers outside the United States This book is printed on acid-free paper WCK/WCK ISBN MHID ISBN MHID ISBN MHID 978-0-07-353062-8 (standard edition) 0-07-353062-X (standard edition) 978-0-07-328211-4 (alternate edition) 0-07-328211-1 (alternate edition) 978-0-07-328212-1 (annotated instructor’s edition) 0-07-328212-X (annotated instructor’s edition) Editorial director: Brent Gordon Executive editor: Michele Janicek Developmental editor II: Jennifer Rizzi Senior marketing manager: Julie Phifer Senior media producer: Victor Chiu Lead project manager: Christine A Vaughan Lead production supervisor: Carol A Bielski Senior designer: Kami Carter Lead media project manager: Cathy L Tepper Cover design: Kiera Cunningham Pohl Cover image: © Corbis Images Typeface: 10/12 Times Roman Compositor: ICC Macmillan Inc Printer: Quebecor World Versailles Inc Library of Congress Cataloging-in-Publication Data Ross, Stephen A Fundamentals of corporate finance/Stephen A Ross, Randolph W Westerfield, Bradford D Jordan 8th ed., Standard ed p cm (The McGraw-Hill/Irwin series in finance, insurance and real estate) Includes index ISBN-13: 978-0-07-353062-8 (standard edition : alk paper) ISBN-10: 0-07-353062-X (standard edition : alk paper) ISBN-13: 978-0-07-328211-4 (alternate edition : alk paper) ISBN-10: 0-07-328211-1 (alternate edition : alk paper) [etc.] Corporations Finance I Westerfield, Randolph II Jordan, Bradford D HG4026.R677 2008 658.15 dc22 2007002136 www.mhhe.com Copyright_page_FM.indd iv III Title 2/9/07 6:25:23 PM To our families and friends with love and gratitude S.A.R R.W.W B.D.J v ros3062x_fm_Standard.indd v 2/9/07 6:02:00 PM About the Authors STEPHEN A ROSS Sloan School of Management, Franco Modigliani Professor of Finance and Economics, Massachusetts Institute of Technology Stephen A Ross is the Franco Modigliani Professor of Finance and Economics at the Sloan School of Management, Massachusetts Institute of Technology One of the most widely published authors in finance and economics, Professor Ross is recognized for his work in developing the Arbitrage Pricing Theory and his substantial contributions to the discipline through his research in signaling, agency theory, option pricing, and the theory of the term structure of interest rates, among other topics A past president of the American Finance Association, he currently serves as an associate editor of several academic and practitioner journals He is a trustee of CalTech and Freddie Mac RANDOLPH W WESTERFIELD Marshall School of Business, University of Southern California Randolph W Westerfield is Dean Emeritus of the University of Southern California’s Marshall School of Business and is the Charles B Thornton Professor of Finance He came to USC from the Wharton School, University of Pennsylvania, where he was the chairman of the finance department and a member of the finance faculty for 20 years He is a member of several public company boards of directors including Health Management Associates, Inc., and the Nicholas Applegate growth fund His areas of expertise include corporate financial policy, investment management, and stock market price behavior BRADFORD D JORDAN Gatton College of Business and Economics, University of Kentucky Bradford D Jordan is Professor of Finance and holder of the Richard W and Janis H Furst Endowed Chair in Finance at the University of Kentucky He has a long-standing interest in both applied and theoretical issues in corporate finance and has extensive experience teaching all levels of corporate finance and financial management policy Professor Jordan has published numerous articles on issues such as cost of capital, capital structure, and the behavior of security prices He is a past president of the Southern Finance Association, and he is coauthor of Fundamentals of Investments: Valuation and Management, 4e, a leading investments text, also published by McGraw-Hill/Irwin vi ros3062x_fm_Standard.indd vi 2/9/07 6:02:00 PM Preface from the Authors When the three of us decided to write a book, we were united by one strongly held principle: Corporate finance should be developed in terms of a few integrated, powerful ideas We believed that the subject was all too often presented as a collection of loosely related topics, unified primarily by virtue of being bound together in one book, and we thought there must be a better way One thing we knew for certain was that we didn’t want to write a “me-too” book So, with a lot of help, we took a hard look at what was truly important and useful In doing so, we were led to eliminate topics of dubious relevance, downplay purely theoretical issues, and minimize the use of extensive and elaborate calculations to illustrate points that are either intuitively obvious or of limited practical use As a result of this process, three basic themes became our central focus in writing Fundamentals of Corporate Finance: AN EMPHASIS ON INTUITION We always try to separate and explain the principles at work on a commonsense, intuitive level before launching into any specifics The underlying ideas are discussed first in very general terms and then by way of examples that illustrate in more concrete terms how a financial manager might proceed in a given situation A UNIFIED VALUATION APPROACH We treat net present value (NPV) as the basic concept underlying corporate finance Many texts stop well short of consistently integrating this important principle The most basic and important notion, that NPV represents the excess of market value over cost, often is lost in an overly mechanical approach that emphasizes computation at the expense of comprehension In contrast, every subject we cover is firmly rooted in valuation, and care is taken throughout to explain how particular decisions have valuation effects A MANAGERIAL FOCUS Students shouldn’t lose sight of the fact that financial management concerns management We emphasize the role of the financial manager as decision maker, and we stress the need for managerial input and judgment We consciously avoid “black box” approaches to finance, and, where appropriate, the approximate, pragmatic nature of financial analysis is made explicit, possible pitfalls are described, and limitations are discussed In retrospect, looking back to our 1991 first edition IPO, we had the same hopes and fears as any entrepreneurs How would we be received in the market? At the time, we had no idea that just 16 years later, we would be working on an eighth edition We certainly never dreamed that in those years we would work with friends and colleagues from around the world to create country-specific Australian, Canadian, and South African editions, an International edition, Chinese, French, Polish, Portuguese, Thai, Russian, Korean, and Spanish language editions, and an entirely separate book, Essentials of Corporate Finance, now in its fifth edition Today, as we prepare to once more enter the market, our goal is to stick with the basic principles that have brought us this far However, based on an enormous amount of feedback we have received from you and your colleagues, we have made this edition and its package even more flexible than previous editions We offer flexibility in coverage, by continuing to offer a variety of editions, and flexibility in pedagogy, by providing a wide variety of features in the book to help students to learn about corporate finance We also provide flexibility in package options by offering the most extensive collection of teaching, learning, and technology aids of any corporate finance text Whether you use just the textbook, or the book in conjunction with our other products, we believe you will find a combination with this edition that will meet your current as well as your changing needs Stephen A Ross Randolph W Westerfield Bradford D Jordan vii ros3062x_fm_Standard.indd vii 2/9/07 6:02:03 PM viii PA RT Part Title Goes Here on Verso Page Coverage This book was designed and developed explicitly for a first course in business or corporate finance, for both finance majors and non-majors alike In terms of background or prerequisites, the book is nearly self-contained, assuming some familiarity with basic algebra and accounting concepts, while still reviewing important accounting principles very early on The organization of this text has been developed to give instructors the flexibility they need Just to get an idea of the breadth of coverage in the eighth edition of Fundamentals, the following grid presents, for each chapter, some of the most significant new features as well as a few selected chapter highlights Of course, in every chapter, opening vignettes, boxed features, in-chapter illustrated examples using real companies, and end-of-chapter material have been thoroughly updated as well Chapters PART Selected Topics of Interest Overview of Corporate Finance Chapter Introduction to Corporate Finance Chapter Financial Statements, Taxes, and Cash Flow PART Benefits to You New section: Sarbanes–Oxley Goal of the firm and agency problems Stresses value creation as the most fundamental aspect of management and describes agency issues that can arise Ethics, financial management, and executive compensation Brings in real-world issues concerning conflicts of interest and current controversies surrounding ethical conduct and management pay Mini-case: Cash Flows and Financial Statements at Sunset Boards, Inc New case written for this edition reinforces key cash flow concepts in a small-business setting Cash flow vs earnings Clearly defines cash flow and spells out the differences between cash flow and earnings Market values vs book values Emphasizes the relevance of market values over book values Financial Statements and Long-Term Financial Planning Chapter Working with Financial Statements Chapter Long-Term Financial Planning and Growth New ratios: PEG, price-to-sales, and Tobin’s Q Expanded Du Pont analysis New section expands the basic Du Pont equation to better explore the interrelationships between operating and financial performance New material: Du Pont analysis for real companies using data from S&P Market Insight New analysis shows students how to get and use real-world data, thereby applying key chapter ideas Ratio and financial statement analysis using smaller firm data Uses firm data from RMA to show students how to actually get and evaluate financial statements benchmarks Expanded discussion on sustainable growth calculations New case written for this edition illustrates the importance of financial planning in a small firm Mini-case: Planning for Growth at S&S Air Explanation of alternative formulas for sustainable and internal growth rates Thorough coverage of sustainable growth as a planning tool Explanation of growth rate formulas clears up a common misunderstanding about these formulas and the circumstances under which alternative formulas are correct Provides a vehicle for examining the interrelationships between operations, financing, and growth viii ros3062x_fm_Standard.indd viii 2/9/07 6:02:03 PM Chapters PART Selected Topics of Interest Benefits to You Valuation of Future Cash Flows Chapter Introduction to Valuation: The Time Value of Money First of two chapters on time value of money Relatively short chapter introduces just the basic ideas on time value of money to get students started on this traditionally difficult topic Chapter Discounted Cash Flow Valuation New section: Growing annuities and perpetuities Second of two chapters on time value of money New minicase: The MBA Decision Covers more advanced time value topics with numerous examples, calculator tips, and Excel spreadsheet exhibits Contains many real-world examples Chapter Interest Rates and Bond Valuation New section: Inflation and present values “Clean” vs “dirty” bond prices and accrued interest Clears up the pricing of bonds between coupon payment dates and also bond market quoting conventions NASD’s new TRACE system and transparency in the corporate bond market Up-to-date discussion of new developments in fixed income with regard to price, volume, and transactions reporting “Make-whole” call provisions Up-to-date discussion of a relatively new type of call provision that has become very common New minicase: Stock Valuation at Ragan, Inc Minicase: Financing S&S Air’s Expansion Plans with a Bond Issue New case written for this edition examines the debt issuance process for a small firm Stock valuation Thorough coverage of constant and nonconstant growth models NYSE and NASDAQ Market Operations Up-to-date description of major stock market operations Chapter Stock Valuation PART Capital Budgeting Chapter Net Present Value and Other Investment Criteria Chapter 10 Making Capital Investment Decisions New section: Modified internal rate of return (MIRR) New minicase: Bullock Gold Mining First of three chapters on capital budgeting Relatively short chapter introduces key ideas on an intuitive level to help students with this traditionally difficult topic NPV, IRR, payback, discounted payback, and accounting rate of return Consistent, balanced examination of advantages and disadvantages of various criteria Projected cash flow Thorough coverage of project cash flows and the relevant numbers for a project analysis Emphasizes the equivalence of various formulas, thereby removing common misunderstandings Considers important applications of chapter tools Alternative cash flow definitions Special cases of DCF analysis Chapter 11 Project Analysis and Evaluation Minicase: Conch Republic Electronics Sources of value Scenario and sensitivity “what-if” analyses Break-even analysis Case analyzes capital budgeting issues and complexities Stresses the need to understand the economic basis for value creation in a project Illustrates how to actually apply and interpret these tools in a project analysis Covers cash, accounting, and financial break-even levels ix ros3062x_fm_Standard.indd ix 2/9/07 6:02:05 PM Travis Sapp Martha A Schary Robert Schwebach Roger Severns Dilip K Shome Neil W Sicherman Timothy Smaby Michael F Spivey Vic Stanton Charlene Sullivan George S Swales, Jr Philip Swensen Philip Swicegood John G Thatcher Harry Thiewes A Frank Thompson Joseph Trefzger Michael R Vetsuypens Joe Walker Jun Wang James Washam Alan Weatherford Marsha Weber Jill Wetmore Mark White Annie Wong David J Wright Steve B Wyatt Tung-Hsiao Yang Morris Yarmish Michael Young Mei Zhang J Kenton Zumwalt Tom Zwirlein Several of our most respected colleagues contributed original essays for this edition, which are entitled “In Their Own Words,” and appear in selected chapters To these individuals we extend a special thanks: Edward I Altman New York University Fischer Black Robert C Higgins University of Washington Roger Ibbotson Yale University, Ibbotson Associates Erik Lie University of Iowa Robert C Merton Harvard University Merton H Miller Jay R Ritter University of Florida Richard Roll University of California at Los Angeles Jeremy Siegel University of Pennsylvania Bennett Stewart Stern Stewart & Co Samuel C Weaver Lehigh University We owe a special thanks to Kent Ragan of Missouri State University Kent worked on the many supplements that accompany this book, including the Instructor’s Manual and PowerPoint Presentation System Kent also worked with us to develop the Annotated Instructor’s Edition of the text which, along with the Instructor’s Manual, contains a wealth of teaching notes We also thank Joseph C Smolira of Belmont University for his work on this edition Joe worked closely with us to develop portions of the Instructor’s Manual, along with the many vignettes and real-world examples we have added to this edition We owe a special thank you to Thomas H Eyssell of the University of Missouri Tom has continued his exceptional work on our supplements by creating the Student Problem Manual for this edition In addition, we would like to thank Kay Johnson, Penn State University—Erie, for creating the self-study questions, as well as revising, reorganizing, and expanding the very extensive testbank available with Fundamentals and creating the Student PowerPoints The following University of Kentucky doctoral students did outstanding work on this edition of Fundamentals: Hinh Khieu, T J Phillips, and Qun Wu To them fell the unenviable task of technical proofreading, and in particular, careful checking of each calculation throughout the text and Instructor’s Manual Finally, in every phase of this project, we have been privileged to have had the complete and unwavering support of a great organization, McGraw-Hill/Irwin We especially thank the McGraw-Hill/Irwin sales xxiv ros3062x_fm_Standard.indd xxiv 2/9/07 6:02:29 PM organization The suggestions they provide, their professionalism in assisting potential adopters, and the service they provide to current adopters have been a major factor in our success We are deeply grateful to the select group of professionals who served as our development team on this edition: Michele Janicek, Executive Sponsoring Editor; Jennifer Rizzi, Development Editor II; Julie Phifer, Marketing Manager; Christine Vaughan, Lead Project Manager; Kami Carter, Senior Designer; and Carol Bielski, Lead Production Supervisor Others at McGraw-Hill/Irwin, too numerous to list here, have improved the book in countless ways Throughout the development of this edition, we have taken great care to discover and eliminate errors Our goal is to provide the best textbook available on the subject To ensure that future editions are error-free, we gladly offer $10 per arithmetic error to the first individual reporting it as a modest token of our appreciation More than this, we would like to hear from instructors and students alike Please write and tell us how to make this a better text Forward your comments to: Dr Brad Jordan, c/o Editorial—Finance, McGraw-Hill/Irwin, 1333 Burr Ridge Parkway, Burr Ridge, IL 60527 or visit us online at www.mhhe.com/rwj Stephen A Ross Randolph W Westerfield Bradford D Jordan xxv ros3062x_fm_Standard.indd xxv 2/9/07 6:02:29 PM Brief Contents PART Overview of Corporate Finance CHAPTER INTRODUCTION TO CORPORATE FINANCE CHAPTER FINANCIAL STATEMENTS, TAXES, AND CASH FLOW 21 PART Financial Statements and Long-Term Financial Planning CHAPTER WORKING WITH FINANCIAL STATEMENTS 48 CHAPTER LONG-TERM FINANCIAL PLANNING AND GROWTH PART Valuation of Future Cash Flows CHAPTER INTRODUCTION TO VALUATION: THE TIME VALUE OF MONEY CHAPTER DISCOUNTED CASH FLOW VALUATION CHAPTER INTEREST RATES AND BOND VALUATION CHAPTER STOCK VALUATION PART Capital Budgeting CHAPTER NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA CHAPTER 10 MAKING CAPITAL INVESTMENT DECISIONS CHAPTER 11 PROJECT ANALYSIS AND EVALUATION PART Risk and Return CHAPTER 12 SOME LESSONS FROM CAPITAL MARKET HISTORY CHAPTER 13 RETURN, RISK, AND THE SECURITY MARKET LINE CHAPTER 14 OPTIONS AND CORPORATE FINANCE PART Cost of Capital and Long-Term Financial Policy CHAPTER 15 COST OF CAPITAL 479 CHAPTER 16 RAISING CAPITAL 513 CHAPTER 17 FINANCIAL LEVERAGE AND CAPITAL STRUCTURE POLICY CHAPTER 18 DIVIDENDS AND DIVIDEND POLICY PART Short-Term Financial Planning and Management CHAPTER 19 SHORT-TERM FINANCE AND PLANNING CHAPTER 20 CASH AND LIQUIDITY MANAGEMENT CHAPTER 21 CREDIT AND INVENTORY MANAGEMENT PART Topics in Corporate Finance CHAPTER 22 INTERNATIONAL CORPORATE FINANCE 89 121 146 192 234 264 302 337 368 403 439 551 590 624 657 689 726 xxvi ros3062x_fm_Standard.indd xxvi 2/9/07 6:02:29 PM Contents PART Overview of Corporate Finance CHAPTER INTRODUCTION TO CORPORATE FINANCE 1.1 1.2 1.3 1.4 1.5 1.6 CHAPTER Corporate Finance and the Financial Manager What Is Corporate Finance? The Financial Manager Financial Management Decisions Capital Budgeting Capital Structure Working Capital Management Conclusion Forms of Business Organization Sole Proprietorship Partnership Corporation A Corporation by Another Name The Goal of Financial Management Possible Goals The Goal of Financial Management A More General Goal Sarbanes–Oxley 10 The Agency Problem and Control of the Corporation 11 Agency Relationships 11 Management Goals 11 Do Managers Act in the Stockholders’ Interests? 12 Managerial Compensation 12 Control of the Firm 12 Conclusion 13 Stakeholders 14 Financial Markets and the Corporation 14 Cash Flows to and from the Firm 14 Primary versus Secondary Markets 14 Primary Markets 15 Secondary Markets 15 Dealer versus Auction Markets 15 Trading in Corporate Securities 16 Listing 16 Summary and Conclusions 17 PART 2.1 2.2 2.3 2.4 2.5 The Balance Sheet 22 Assets: The Left Side 22 Liabilities and Owners’ Equity: The Right Side 22 Net Working Capital 23 Liquidity 24 Debt versus Equity 25 Market Value versus Book Value 25 The Income Statement 26 GAAP and the Income Statement 27 Noncash Items 28 Time and Costs 28 Taxes 30 Corporate Tax Rates 30 Average versus Marginal Tax Rates 30 Cash Flow 32 Cash Flow from Assets 33 Operating Cash Flow 33 Capital Spending 34 Change in Net Working Capital 34 Conclusion 35 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 Summary and Conclusions 39 Financial Statements and Long-Term Financial Planning CHAPTER WORKING WITH FINANCIAL STATEMENTS 48 3.1 FINANCIAL STATEMENTS, TAXES, AND CASH FLOW 21 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 xxvii ros3062x_fm_Standard.indd xxvii 2/9/07 6:02:30 PM xxviii 3.3 3.4 3.5 3.6 Contents Combined Common-Size and Base Year Analysis 55 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 Conclusion 66 The Du Pont Identity 67 A Closer Look at ROE 67 An Expanded Du Pont Analysis 69 Using Financial Statement Information 71 Why Evaluate Financial Statements? 71 Internal Uses 71 External Uses 71 Choosing a Benchmark 71 Time Trend Analysis 71 Peer Group Analysis 72 Problems with Financial Statement Analysis 76 Summary and Conclusions 77 PART LONG-TERM FINANCIAL PLANNING AND GROWTH 89 4.1 4.2 4.3 4.4 4.5 4.6 What Is Financial Planning? 90 Growth as a Financial Management Goal 90 Dimensions of Financial Planning 91 What Can Planning Accomplish? 92 Examining Interactions 92 Exploring Options 92 Avoiding Surprises 92 Ensuring Feasibility and Internal Consistency 92 Conclusion 92 Financial Planning Models: A First Look 93 A Financial Planning Model: The Ingredients 93 Sales Forecast 93 Pro Forma Statements 93 Asset Requirements 94 Financial Requirements 94 The Plug 94 Economic Assumptions 94 A Simple Financial Planning Model 94 The Percentage of Sales Approach 96 The Income Statement 96 The Balance Sheet 97 A Particular Scenario 99 An Alternative Scenario 100 External Financing and Growth 101 EFN and Growth 101 Financial Policy and Growth 105 The Internal Growth Rate 105 The Sustainable Growth Rate 105 Determinants of Growth 107 A Note about Sustainable Growth Rate Calculations 108 Some Caveats Regarding Financial Planning Models 110 Summary and Conclusions 111 Valuation of Future Cash Flows CHAPTER INTRODUCTION TO VALUATION: THE TIME VALUE OF MONEY 121 5.1 CHAPTER Future Value and Compounding 122 Investing for a Single Period 122 Investing for More Than One Period 122 A Note about Compound Growth 128 ros3062x_fm_Standard.indd xxviii 5.2 5.3 5.4 Present Value and Discounting 129 The Single-Period Case 129 Present Values for Multiple Periods 130 More about Present and Future Values 133 Present versus Future Value 133 Determining the Discount Rate 134 Finding the Number of Periods 138 Summary and Conclusions 141 2/9/07 6:02:31 PM Contents CHAPTER DISCOUNTED CASH FLOW VALUATION 6.1 6.2 6.3 6.4 6.5 146 Future and Present Values of Multiple Cash Flows 147 Future Value with Multiple Cash Flows 147 Present Value with Multiple Cash Flows 150 A Note about Cash Flow Timing 153 Valuing Level Cash Flows: Annuities and Perpetuities 154 Present Value for Annuity Cash Flows 154 Annuity Tables 156 Finding the Payment 157 Finding the Rate 159 Future Value for Annuities 161 A Note about Annuities Due 162 Perpetuities 162 Growing Annuities and Perpetuities 164 Comparing Rates: The Effect of Compounding Effective Annual Rates and Compounding 165 Calculating and Comparing Effective Annual Rates 166 EARs and APRs 168 Taking It to the Limit: A Note about Continuous Compounding 169 Loan Types and Loan Amortization 171 Pure Discount Loans 171 Interest-Only Loans 171 Amortized Loans 172 Summary and Conclusions 177 7.5 7.6 7.7 7.8 165 STOCK VALUATION 8.1 CHAPTER 7.1 7.2 7.3 7.4 192 Bonds and Bond Valuation 193 Bond Features and Prices 193 Bond Values and Yields 193 Interest Rate Risk 197 Finding the Yield to Maturity: More Trial and Error 198 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 Bond Ratings 208 Some Different Types of Bonds 209 Government Bonds 209 ros3062x_fm_Standard.indd xxix Zero-Coupon Bonds 210 Floating-Rate Bonds 211 Other Types of Bonds 212 Bond Markets 214 How Bonds Are Bought and Sold 214 Bond Price Reporting 216 A Note about Bond Price Quotes 219 Inflation and Interest Rates 219 Real versus Nominal Rates 219 The Fisher Effect 220 Inflation and Present Values 221 Determinants of Bond Yields 222 The Term Structure of Interest Rates 222 Bond Yields and the Yield Curve: Putting It All Together 225 Conclusion 226 Summary and Conclusions 227 CHAPTER 8.2 INTEREST RATES AND BOND VALUATION xxix 8.3 8.4 234 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 Some Features of Common and Preferred Stocks 245 Common Stock Features 245 Shareholder Rights 245 Proxy Voting 246 Classes of Stock 247 Other Rights 247 Dividends 248 Preferred Stock Features 248 Stated Value 248 Cumulative and Noncumulative Dividends 248 Is Preferred Stock Really Debt? 249 The Stock Markets 249 Dealers and Brokers 250 Organization of the NYSE 250 Members 250 Operations 251 Floor Activity 251 NASDAQ Operations 252 NASDAQ Participants 253 Stock Market Reporting 254 Summary and Conclusions 256 2/9/07 6:02:32 PM xxx Contents PART Capital Budgeting CHAPTER 10.4 NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA 264 9.1 9.2 9.3 9.4 9.5 9.6 9.7 9.8 Net Present Value 265 The Basic Idea 265 Estimating Net Present Value 266 The Payback Rule 269 Defining the Rule 269 Analyzing the Rule 270 Redeeming Qualities of the Rule 271 Summary of the Rule 272 The Discounted Payback 272 The Average Accounting Return 275 The Internal Rate of Return 277 Problems with the IRR 281 Nonconventional Cash Flows 281 Mutually Exclusive Investments 283 Redeeming Qualities of the IRR 285 The Modified Internal Rate of Return (MIRR) 286 Method #1: The Discounting Approach 286 Method #2: The Reinvestment Approach 286 Method #3: The Combination Approach 286 MIRR or IRR: Which Is Better? 287 The Profitability Index 287 The Practice of Capital Budgeting 288 Summary and Conclusions 291 10.5 10.6 10.7 More about Project Cash Flow 309 A Closer Look at Net Working Capital 309 Depreciation 312 Modified ACRS Depreciation (MACRS) 312 Book Value versus Market Value 313 An Example: The Majestic Mulch and Compost Company (MMCC) 315 Operating Cash Flows 315 Change in NWC 315 Capital Spending 317 Total Cash Flow and Value 317 Conclusion 318 Alternative Definitions of Operating Cash Flow 318 The Bottom-Up Approach 319 The Top-Down Approach 320 The Tax Shield Approach 320 Conclusion 321 Some Special Cases of Discounted Cash Flow Analysis 321 Evaluating Cost-Cutting Proposals 321 Setting the Bid Price 323 Evaluating Equipment Options with Different Lives 325 Summary and Conclusions 327 CHAPTER 11 PROJECT ANALYSIS AND EVALUATION CHAPTER 10 MAKING CAPITAL INVESTMENT DECISIONS 10.1 10.2 10.3 11.1 302 Project Cash Flows: A First Look 303 Relevant Cash Flows 303 The Stand-Alone Principle 303 Incremental Cash Flows 303 Sunk Costs 304 Opportunity Costs 304 Side Effects 304 Net Working Capital 305 Financing Costs 305 Other Issues 305 Pro Forma Financial Statements and Project Cash Flows 306 Getting Started: Pro Forma Financial Statements 306 Project Cash Flows 307 Project Operating Cash Flow 307 Project Net Working Capital and Capital Spending 308 Projected Total Cash Flow and Value 308 ros3062x_fm_Standard.indd xxx 11.2 11.3 337 Evaluating NPV Estimates 338 The Basic Problem 338 Projected versus Actual Cash Flows 338 Forecasting Risk 338 Sources of Value 339 Scenario and Other What-If Analyses 340 Getting Started 340 Scenario Analysis 341 Sensitivity Analysis 343 Simulation Analysis 344 Break-Even Analysis 344 Fixed and Variable Costs 345 Variable Costs 345 Fixed Costs 346 Total Costs 346 Accounting Break-Even 348 Accounting Break-Even: A Closer Look 348 Uses for the Accounting Break-Even 350 2/9/07 6:02:33 PM Contents 11.4 Operating Cash Flow, Sales Volume, and BreakEven 350 Accounting Break-Even and Cash Flow 351 The Base Case 351 Calculating the Break-Even Level 351 Payback and Break-Even 352 Sales Volume and Operating Cash Flow 352 Cash Flow, Accounting, and Financial Break-Even Points 352 Accounting Break-Even Revisited 353 Cash Break-Even 353 Financial Break-Even 354 Conclusion 354 PART 11.5 11.6 11.7 Operating Leverage 355 The Basic Idea 355 Implications of Operating Leverage 356 Measuring Operating Leverage 356 Operating Leverage and Break-Even 357 Capital Rationing 358 Soft Rationing 358 Hard Rationing 359 Summary and Conclusions 359 Risk and Return CHAPTER 12 CHAPTER 13 SOME LESSONS FROM CAPITAL MARKET HISTORY 368 RETURN, RISK, AND THE SECURITY MARKET LINE 403 12.1 13.1 12.2 12.3 12.4 12.5 12.6 12.7 Returns 369 Dollar Returns 369 Percentage Returns 371 The Historical Record 373 A First Look 373 A Closer Look 375 Average Returns: The First Lesson 379 Calculating Average Returns 379 Average Returns: The Historical Record 379 Risk Premiums 380 The First Lesson 380 The Variability of Returns: The Second Lesson 381 Frequency Distributions and Variability 381 The Historical Variance and Standard Deviation 382 The Historical Record 384 Normal Distribution 384 The Second Lesson 386 Using Capital Market History 386 More about Average Returns 387 Arithmetic versus Geometric Averages 387 Calculating Geometric Average Returns 388 Arithmetic Average Return or Geometric Average Return? 390 Capital Market Efficiency 391 Price Behavior in an Efficient Market 391 The Efficient Markets Hypothesis 392 Some Common Misconceptions about the EMH 393 The Forms of Market Efficiency 395 Summary and Conclusions 396 ros3062x_fm_Standard.indd xxxi xxxi 13.2 13.3 13.4 13.5 13.6 13.7 Expected Returns and Variances 404 Expected Return 404 Calculating the Variance 406 Portfolios 407 Portfolio Weights 408 Portfolio Expected Returns 408 Portfolio Variance 409 Announcements, Surprises, and Expected Returns 411 Expected and Unexpected Returns 411 Announcements and News 411 Risk: Systematic and Unsystematic 413 Systematic and Unsystematic Risk 413 Systematic and Unsystematic Components of Return 413 Diversification and Portfolio Risk 414 The Effect of Diversification: Another Lesson from Market History 414 The Principle of Diversification 415 Diversification and Unsystematic Risk 416 Diversification and Systematic Risk 417 Systematic Risk and Beta 417 The Systematic Risk Principle 418 Measuring Systematic Risk 418 Portfolio Betas 420 The Security Market Line 421 Beta and the Risk Premium 421 The Reward-to-Risk Ratio 422 The Basic Argument 423 The Fundamental Result 424 The Security Market Line 426 Market Portfolios 426 The Capital Asset Pricing Model 426 2/9/07 6:02:34 PM xxxii xxxii 13.8 13.9 Contents PA RT Part Title Goes Here on Verso Page The SML and the Cost of Capital: A Preview The Basic Idea 428 The Cost of Capital 429 Summary and Conclusions 429 428 14.4 14.5 CHAPTER 14 OPTIONS AND CORPORATE FINANCE 14.1 14.2 14.3 439 14.6 Options: The Basics 440 Puts and Calls 440 Stock Option Quotations 440 Option Payoffs 444 Fundamentals of Option Valuation 446 Value of a Call Option at Expiration 446 The Upper and Lower Bounds on a Call Option’s Value 446 The Upper Bound 447 The Lower Bound 447 A Simple Model: Part I 448 The Basic Approach 448 A More Complicated Case 449 Four Factors Determining Option Values 450 Valuing a Call Option 451 A Simple Model: Part II 451 The Fifth Factor 452 A Closer Look 453 PART 14.7 14.8 Cost of Capital and Long-Term Financial Policy CHAPTER 15 COST OF CAPITAL 15.1 15.2 15.3 15.4 Employee Stock Options 454 ESO Features 454 ESO Repricing 455 ESO Backdating 455 Equity as a Call Option on the Firm’s Assets 456 Case I: The Debt Is Risk-Free 457 Case II: The Debt Is Risky 457 Options and Capital Budgeting 459 The Investment Timing Decision 459 Managerial Options 461 Contingency Planning 462 Options in Capital Budgeting: An Example 463 Strategic Options 464 Conclusion 464 Options and Corporate Securities 465 Warrants 465 The Difference between Warrants and Call Options 465 Earnings Dilution 466 Convertible Bonds 466 Features of a Convertible Bond 466 Value of a Convertible Bond 466 Other Options 468 The Call Provision on a Bond 468 Put Bonds 469 Insurance and Loan Guarantees 469 Summary and Conclusions 470 479 The Cost of Capital: Some Preliminaries 480 Required Return versus Cost of Capital 480 Financial Policy and Cost of Capital 480 The Cost of Equity 481 The Dividend Growth Model Approach 481 Implementing the Approach 481 Estimating g 482 Advantages and Disadvantages of the Approach The SML Approach 483 Implementing the Approach 484 Advantages and Disadvantages of the Approach The Costs of Debt and Preferred Stock 485 The Cost of Debt 485 The Cost of Preferred Stock 486 The Weighted Average Cost of Capital 487 The Capital Structure Weights 487 ros3062x_fm_Standard.indd xxxii 15.5 483 484 15.6 15.7 Taxes and the Weighted Average Cost of Capital 488 Calculating the WACC for Eastman Chemical 489 Eastman’s Cost of Equity 489 Eastman’s Cost of Debt 491 Eastman’s WACC 492 Solving the Warehouse Problem and Similar Capital Budgeting Problems 494 Performance Evaluation: Another Use of the WACC 496 Divisional and Project Costs of Capital 497 The SML and the WACC 497 Divisional Cost of Capital 498 The Pure Play Approach 498 The Subjective Approach 499 Flotation Costs and the Weighted Average Cost of Capital 501 The Basic Approach 501 Flotation Costs and NPV 502 Internal Equity and Flotation Costs 504 Summary and Conclusions 504 2/9/07 6:02:35 PM Contents CHAPTER 16 RAISING CAPITAL 513 16.1 The Financing Life Cycle of a Firm: Early-Stage Financing and Venture Capital 514 Venture Capital 514 Some Venture Capital Realities 515 Choosing a Venture Capitalist 515 Conclusion 516 16.2 Selling Securities to the Public: The Basic Procedure 516 16.3 Alternative Issue Methods 517 16.4 Underwriters 519 Choosing an Underwriter 520 Types of Underwriting 520 Firm Commitment Underwriting 520 Best Efforts Underwriting 520 Dutch Auction Underwriting 521 The Aftermarket 521 The Green Shoe Provision 522 Lockup Agreements 522 The Quiet Period 522 16.5 IPOs and Underpricing 523 IPO Underpricing: The 1999–2000 Experience 523 Evidence on Underpricing 525 Why Does Underpricing Exist? 526 16.6 New Equity Sales and the Value of the Firm 529 16.7 The Costs of Issuing Securities 530 The Costs of Selling Stock to the Public 530 The Costs of Going Public: The Case of Symbion 532 16.8 Rights 534 The Mechanics of a Rights Offering 534 Number of Rights Needed to Purchase a Share 535 The Value of a Right 536 Ex Rights 538 The Underwriting Arrangements 539 Effects on Shareholders 539 16.9 Dilution 540 Dilution of Proportionate Ownership 540 Dilution of Value: Book versus Market Values 540 A Misconception 541 The Correct Arguments 542 16.10 Issuing Long-Term Debt 542 16.11 Shelf Registration 543 16.12 Summary and Conclusions 544 FINANCIAL LEVERAGE AND CAPITAL STRUCTURE POLICY 551 The Capital Structure Question ros3062x_fm_Standard.indd xxxiii Firm Value and Stock Value: An Example 552 Capital Structure and the Cost of Capital 553 17.2 The Effect of Financial Leverage 553 The Basics of Financial Leverage 553 Financial Leverage, EPS, and ROE: An Example 554 EPS versus EBIT 555 Corporate Borrowing and Homemade Leverage 556 17.3 Capital Structure and the Cost of Equity Capital 558 M&M Proposition I: The Pie Model 558 The Cost of Equity and Financial Leverage: M&M Proposition II 559 Business and Financial Risk 561 17.4 M&M Propositions I and II with Corporate Taxes 562 The Interest Tax Shield 563 Taxes and M&M Proposition I 563 Taxes, the WACC, and Proposition II 564 Conclusion 565 17.5 Bankruptcy Costs 567 Direct Bankruptcy Costs 568 Indirect Bankruptcy Costs 568 17.6 Optimal Capital Structure 569 The Static Theory of Capital Structure 569 Optimal Capital Structure and the Cost of Capital 570 Optimal Capital Structure: A Recap 571 Capital Structure: Some Managerial Recommendations 573 Taxes 573 Financial Distress 573 17.7 The Pie Again 573 The Extended Pie Model 574 Marketed Claims versus Nonmarketed Claims 575 17.8 The Pecking-Order Theory 575 Internal Financing and the Pecking Order 575 Implications of the Pecking Order 576 17.9 Observed Capital Structures 577 17.10 A Quick Look at the Bankruptcy Process 579 Liquidation and Reorganization 579 Bankruptcy Liquidation 579 Bankruptcy Reorganization 580 Financial Management and the Bankruptcy Process 581 Agreements to Avoid Bankruptcy 582 17.11 Summary and Conclusions 582 CHAPTER 18 CHAPTER 17 17.1 xxxiii 552 DIVIDENDS AND DIVIDEND POLICY 18.1 590 Cash Dividends and Dividend Payment Cash Dividends 591 591 2/9/07 6:02:36 PM xxxiv 18.2 18.3 18.4 18.5 Contents Standard Method of Cash Dividend Payment 592 Dividend Payment: A Chronology 592 More about the Ex-Dividend Date 593 Does Dividend Policy Matter? 594 An Illustration of the Irrelevance of Dividend Policy 595 Current Policy: Dividends Set Equal to Cash Flow 595 Alternative Policy: Initial Dividend Greater Than Cash Flow 595 Homemade Dividends 596 A Test 596 Real-World Factors Favoring a Low Payout 597 Taxes 597 Expected Return, Dividends, and Personal Taxes 598 Flotation Costs 599 Dividend Restrictions 599 Real-World Factors Favoring a High Payout 599 Desire for Current Income 600 Uncertainty Resolution 600 Tax and Legal Benefits from High Dividends 601 Corporate Investors 601 Tax-Exempt Investors 601 Conclusion 601 A Resolution of Real-World Factors? 602 Information Content of Dividends 602 The Clientele Effect 603 PART SHORT-TERM FINANCE AND PLANNING 19.3 18.7 18.8 18.9 Establishing a Dividend Policy 604 Residual Dividend Approach 604 Dividend Stability 606 A Compromise Dividend Policy 607 Some Survey Evidence on Dividends 608 Stock Repurchase: An Alternative to Cash Dividends 609 Cash Dividends versus Repurchase 610 Real-World Considerations in a Repurchase 611 Share Repurchase and EPS 612 Stock Dividends and Stock Splits 612 Some Details about Stock Splits and Stock Dividends 613 Example of a Small Stock Dividend 613 Example of a Stock Split 613 Example of a Large Stock Dividend 614 Value of Stock Splits and Stock Dividends 614 The Benchmark Case 614 Popular Trading Range 614 Reverse Splits 615 Summary and Conclusions 616 Short-Term Financial Planning and Management CHAPTER 19 19.1 19.2 18.6 19.4 624 Tracing Cash and Net Working Capital 625 The Operating Cycle and the Cash Cycle 626 Defining the Operating and Cash Cycles 627 The Operating Cycle 627 The Cash Cycle 627 The Operating Cycle and the Firm’s Organizational Chart 629 Calculating the Operating and Cash Cycles 629 The Operating Cycle 630 The Cash Cycle 631 Interpreting the Cash Cycle 632 Some Aspects of Short-Term Financial Policy 632 The Size of the Firm’s Investment in Current Assets 633 Alternative Financing Policies for Current Assets 634 An Ideal Case 634 Different Policies for Financing Current Assets 634 Which Financing Policy Is Best? 637 Current Assets and Liabilities in Practice 638 ros3062x_fm_Standard.indd xxxiv 19.5 19.6 19.7 The Cash Budget 639 Sales and Cash Collections 639 Cash Outflows 640 The Cash Balance 640 Short-Term Borrowing 641 Unsecured Loans 642 Compensating Balances 642 Cost of a Compensating Balance 642 Letters of Credit 643 Secured Loans 643 Accounts Receivable Financing 643 Inventory Loans 644 Other Sources 644 A Short-Term Financial Plan 645 Summary and Conclusions 646 CHAPTER 20 CASH AND LIQUIDITY MANAGEMENT 20.1 657 Reasons for Holding Cash 658 The Speculative and Precautionary Motives The Transaction Motive 658 658 2/9/07 6:02:37 PM Contents 20.2 20.3 20.4 20.5 20.6 20A Compensating Balances 658 Costs of Holding Cash 658 Cash Management versus Liquidity Management 659 Understanding Float 659 Disbursement Float 659 Collection Float and Net Float 660 Float Management 661 Measuring Float 661 Some Details 662 Cost of the Float 662 Ethical and Legal Questions 664 Electronic Data Interchange and Check 21: The End of Float? 665 Cash Collection and Concentration 666 Components of Collection Time 666 Cash Collection 666 Lockboxes 666 Cash Concentration 668 Accelerating Collections: An Example 669 Managing Cash Disbursements 670 Increasing Disbursement Float 670 Controlling Disbursements 671 Zero-Balance Accounts 671 Controlled Disbursement Accounts 672 Investing Idle Cash 672 Temporary Cash Surpluses 672 Seasonal or Cyclical Activities 672 Planned or Possible Expenditures 672 Characteristics of Short-Term Securities 673 Maturity 673 Default Risk 673 Marketability 673 Taxes 673 Some Different Types of Money Market Securities 674 Summary and Conclusions 675 Determining the Target Cash Balance 679 The Basic Idea 679 The BAT Model 680 The Opportunity Costs 681 The Trading Costs 682 The Total Cost 682 The Solution 683 Conclusion 684 The Miller–Orr Model: A More General Approach 684 The Basic Idea 684 Using the Model 684 Implications of the BAT and Miller–Orr Models 686 Other Factors Influencing the Target Cash Balance 686 ros3062x_fm_Standard.indd xxxv xxxv CHAPTER 21 CREDIT AND INVENTORY MANAGEMENT 21.1 21.2 21.3 21.4 21.5 21.6 21.7 21.8 689 Credit and Receivables 690 Components of Credit Policy 690 The Cash Flows from Granting Credit 690 The Investment in Receivables 691 Terms of the Sale 691 The Basic Form 692 The Credit Period 692 The Invoice Date 692 Length of the Credit Period 692 Cash Discounts 693 Cost of the Credit 694 Trade Discounts 694 The Cash Discount and the ACP 694 Credit Instruments 695 Analyzing Credit Policy 695 Credit Policy Effects 695 Evaluating a Proposed Credit Policy 696 NPV of Switching Policies 696 A Break-Even Application 698 Optimal Credit Policy 698 The Total Credit Cost Curve 698 Organizing the Credit Function 699 Credit Analysis 700 When Should Credit Be Granted? 700 A One-Time Sale 700 Repeat Business 701 Credit Information 702 Credit Evaluation and Scoring 702 Collection Policy 703 Monitoring Receivables 703 Collection Effort 704 Inventory Management 704 The Financial Manager and Inventory Policy 705 Inventory Types 705 Inventory Costs 705 Inventory Management Techniques 706 The ABC Approach 706 The Economic Order Quantity Model 707 Inventory Depletion 707 The Carrying Costs 709 The Shortage Costs 709 The Total Costs 709 Extensions to the EOQ Model 711 Safety Stocks 711 Reorder Points 711 Managing Derived-Demand Inventories 711 Materials Requirements Planning 713 Just-in-Time Inventory 713 2/9/07 6:02:38 PM xxxvi 21.9 21A Contents Summary and Conclusions 713 More about Credit Policy Analysis Two Alternative Approaches 719 The One-Shot Approach 720 PART The Accounts Receivable Approach Discounts and Default Risk 721 NPV of the Credit Decision 722 A Break-Even Application 723 719 Topics in Corporate Finance CHAPTER 22 INTERNATIONAL CORPORATE FINANCE 22.1 22.2 22.3 22.4 720 22.5 726 Terminology 727 Foreign Exchange Markets and Exchange Rates 728 Exchange Rates 729 Exchange Rate Quotations 729 Cross-Rates and Triangle Arbitrage 730 Types of Transactions 732 Purchasing Power Parity 733 Absolute Purchasing Power Parity 733 Relative Purchasing Power Parity 735 The Basic Idea 735 The Result 735 Currency Appreciation and Depreciation 736 Interest Rate Parity, Unbiased Forward Rates, and the International Fisher Effect 737 Covered Interest Arbitrage 737 Interest Rate Parity 738 Forward Rates and Future Spot Rates 739 Putting It All Together 739 Uncovered Interest Parity 740 The International Fisher Effect 740 ros3062x_fm_Standard.indd xxxvi 22.6 22.7 22.8 International Capital Budgeting 741 Method 1: The Home Currency Approach 741 Method 2: The Foreign Currency Approach 742 Unremitted Cash Flows 743 Exchange Rate Risk 743 Short-Run Exposure 743 Long-Run Exposure 744 Translation Exposure 745 Managing Exchange Rate Risk 746 Political Risk 746 Summary and Conclusions 747 APPENDIX A MATHEMATICAL TABLES APPENDIX B KEY EQUATIONS A-1 B-1 APPENDIX C ANSWERS TO SELECTED END-OF-CHAPTER PROBLEMS C-1 Index I-1 2/9/07 6:02:39 PM In Their Own Words Boxes CHAPTER CHAPTER 15 Robert C Higgins University of Washington On Sustainable Growth Bennett Stewart On EVA CHAPTER Samuel C Weaver Lehigh University On Cost of Capital and Hurdle Rates at the Hershey Company Edward I Altman On Junk Bonds New York University Stern Stewart & Co CHAPTER 16 CHAPTER 10 Samuel C Weaver Lehigh University On Capital Budgeting at the Hershey Company Jay R Ritter University of Florida On IPO Underpricing around the World CHAPTER 17 CHAPTER 12 Roger Ibbotson Yale University On Capital Market History Jeremy Siegel University of Pennsylvania On Stocks for the Long Run Richard Roll University of California at Los Angeles On Market Efficiency Merton H Miller On Capital Structure: M&M 30 Years Later CHAPTER 18 Fischer Black On Why Firms Pay Dividends CHAPTER 14 Erik Lie University of Iowa On Option Backdating Robert C Merton Harvard University On Applications of Option Analysis xxxvii ros3062x_fm_Standard.indd xxxvii 2/9/07 6:02:40 PM Standard Edition FUNDAMENTALS OF CORPORATE FINANCE ros3062x_fm_Standard.indd xxxix 2/9/07 6:02:40 PM ... acid-free paper WCK/WCK ISBN MHID ISBN MHID ISBN MHID 97 8-0 -0 7-3 5306 2-8 (standard edition) 0-0 7-3 53062-X (standard edition) 97 8-0 -0 7-3 2821 1-4 (alternate edition) 0-0 7-3 2821 1-1 (alternate edition) ... ISBN-13: 97 8-0 -0 7-3 5306 2-8 (standard edition : alk paper) ISBN-10: 0-0 7-3 53062-X (standard edition : alk paper) ISBN-13: 97 8-0 -0 7-3 2821 1-4 (alternate edition : alk paper) ISBN-10: 0-0 7-3 2821 1-1 ... (alternate edition) 0-0 7-3 2821 1-1 (alternate edition) 97 8-0 -0 7-3 2821 2-1 (annotated instructor’s edition) 0-0 7-3 28212-X (annotated instructor’s edition) Editorial director: Brent Gordon Executive editor: