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**Unformatted text preview: **CORPORATE FINANCE CONTENT
CHAPTER 1 Introduction PART I VALUE AND CAPITAL BUDGETING
CHAPTER 2 The Time Value of Money and Net Present Value
CHAPTER 3 Stock and Bond Valuation: Annuities and Perpetuities CHAPTER 4 A First Encounter with Capital Budgeting Rules CHAPTER 5 Time-Varying Rates of Return and the Yield Curve CHAPTER 6 Uncertainty, Default, and Risk PART II RISK AND RETURN CHAPTER 7 A First Look at Investments CHAPTER 8 Investor Choice: Risk and Reward CHAPTER 9 The Capital Asset Pricing Model PART III VALUE AND MARKET EFFICIENCY
IN AN IMPERFECT MARKET CHAPTER 10 Market Imperfections
CHAPTER 11 Perfect and Efficient Markets, and Classical and Behavioral Finance PART IV REAL-WORLD APPLICATION CHAPTER 12 Capital Budgeting Applications and Pitfalls
CHAPTER 13 From Financial Statements to Economic Cash Flows
CHAPTER 14 Valuation from Comparables and Some Financial Ratios PART V CAPITAL STRUCTURE AND PAYOUT POLICY CHAPTER 15 Corporate Claims
CHAPTER 16 Capital Structure and Capital Budgeting in a Perfect Market
CHAPTER 17 The Weighted Cost of Capital and Adjusted Present Value
in an Imperfect Market with Taxes
CHAPTER 18 More Market Imperfections Influencing Capital Structure
CHAPTER 19 Equity Payouts: Dividends and Share Repurchases PART VI PROJECTING THE FUTURE CHAPTER 20 Pro Forma Financial Statements PART VII ADDITIONAL TOPICS
CHAPTER 21 Capital Structure Dynamics
CHAPTER 22 Capital Structure Patterns in the United States
CHAPTER 23 Investment Banking and Mergers & Acquisitions
CHAPTER 24 Corporate Governance
CHAPTER 25 International Finance
CHAPTER 26 Options and Risk Management Contents
CHAPTER 1 Introduction
1.1 The Goal of Finance: Relative Valuation
ANECDOTE The Joy of Cooking: Positive Prestige Flows and Restaurant
Failures
1.2 Investments, Projects, and Firms
1.3 Firms versus Individuals PART I VALUE AND CAPITAL BUDGETING CHAPTER 2 The Time Value of Money and Net Present Value
Our Basic Scenario: Perfect Markets, Certainty, Constant Interest
2.1
Rates
2.2
Loans and Bonds
2.3
Returns, Net Returns, and Rates of Return
ANECDOTE Interest Rates over the Millennia
2.4
The Time Value of Money, Future Value, and Compounding
ANECDOTE Life Expectancy and Credit
How Bad Are Mistakes? Adding or Compounding Interest Rates?
2.5
Present Values, Discounting, and Capital Budgeting
2.6
Net Present Value
. . CHAPTER 3 Stock and Bond Valuation: Annuities and Perpetuities
3.1
Perpetuities
ANECDOTE The Oldest Institutions and Perpetuities
Annuities
ANECDOTE Fibonacci and the Invention of Net Present Value
3.3
The Four Formulas Summarized Appendix: Advanced Material
3.4
Projects With Different Lives and Rental Equivalents
Perpetuity and Annuity Derivations
3.5 CHAPTER 4 A First Encounter with Capital Budgeting Rules
Net Present Value
4.1
How Bad Are Mistakes? Errors in Cash Flows versus Errors in the Cost of
Capital
The Internal Rate of Return (IRR)
4.2
The Profitability Index
4.3
The Payback Capital Budgeting Rule
4.4
How Do Chief Financial Officers (CFOs) Decide?
4.5 CHAPTER 5 Time-Varying Rates of Return and the Yield Curve
Working With Time-Varying Rates of Return
5.1
Inflation
5.2
ANECDOTE The German Hyperinflation of 1922
5.3
Time-Varying Interest Rates: U.S. Treasuries and the Yield Curve
ANECDOTE Macroeconomic Implications of Different Yield Curve Shapes
How Bad Are Mistakes? Paper Losses
5.4
Why is the (Nominal) Yield Curve Usually Upward Sloping?
ANECDOTE Inflation-Neutral Bonds
5.5
Corporate Insights about Time-Varying Costs of Capital
from the Yield Curve 5.6
5.7
5.8
5.9
5.10
5.11
5.12 Extracting Forward Interest Rates
Shorting and Locking in Forward Interest Rates
Bond Duration
Duration Similarity
Duration Hedging
Continuous Compounding
Institutional Knowledge: Compounding, Price Quotes, and STRIPS CHAPTER 6 Uncertainty, Default, and Risk
6.1
An Introduction to Statistics
ANECDOTE The Ruin of the First Financial System
6.2
Interest Rates and Credit Risk(Default Risk)
ANECDOTE A Short History of Bankruptcy 6.3
6.4 Uncertainty in Capital Budgeting
Splitting Uncertain Project Payoffs intoDebt and Equity
ANECDOTE Limited Liability
How Bad Are Mistakes? Discounting Promised Cash Flows with the Promised
Cost of Capital PART II RISK AND RETURN
CHAPTER 7 A First Look at Investments
7.1 Stocks, Bonds, and Cash, 1970–2007
7.2 A Brief Overview of Equity-Related Market Institutions
ANECDOTE Trading Volume in the Tech Bubble
CHAPTER 8 Investor Choice: Risk and Reward
8.1
Measuring Risk and Reward
8.2
Portfolios, Diversification, and Investor Preferences
8.3
How to Measure Risk Contribution
8.4
Expected Rates of Return and Market Betas for (Weighted) Portfolios
and Firms
8.5
Spreadsheet Calculations for Risk and Reward 8.6
8.7
8.8
8.9 An Investor’s Specific Trade-Off Between Risk and Reward
A Shortcut Formula for the Risk of a Portfolio
Graphing the Mean-Variance Efficient Frontier
Adding a Risk-Free Asset CHAPTER 9 The Capital Asset Pricing Model
9.1
What You Already Know and What You Want to Know
9.2
The Capital Asset Pricing Model (CAPM)—A Cookbook Recipe Approach
9.3
The CAPM Cost of Capital in the PresentValue Formula
9.4
Estimating the CAPM Inputs
ANECDOTE Was the 20th Century Really the “American Century?”
9.5
Empirical Evidence: Is the CAPM theRight Model?
How Bad Are Mistakes? How Robust is the CAPM? . PART III 9.6 Application: Certainty Equivalence 9.7
9.8 Theory: The CAPM Basis
Theory: CAPM Alternatives!? VALUE AND MARKET EFFICIENCY
IN AN IMPERFECT MARKET CHAPTER 10 Market Imperfections
10.1 Causes and Consequences of Imperfect Markets
10.2 Opinions, Disagreements, and Insider Information
ANECDOTE Sumerian Debt Contracts
10.3 Market Depth and Transaction Costs
ANECDOTE Real Estate Agents: Who Works for Whom?
10.4 Taxes
10.5 Entrepreneurial Finance
10.6 Deconstructing Quoted Rates of Return—Liquidity and Tax Premiums
10.7 Multiple Effects: How to Work Novel Problems CHAPTER 11 Perfect and Efficient Markets, and Classical and Behavioral Finance
11.1 Market Efficiency
ANECDOTE “Trading Places” and Citrus
Futures
11.2 Classifications of Market Efficiency Beliefs and Behavioral Finance
ANECDOTE How to Get Squeezed and Lose Money Even When
You Are Right
11.3 The Random Walk and the Signal-to-Noise Ratio
ANECDOTE Great Mathematicians and Gambling: The Origin of the
Random Walk
11.4 True Arbitrage and Risk(y) Arbitrage
11.5 Investment Consequences
ANECDOTE Are Women Better Investors Than Men?
ANECDOTE The Three Top Investment Books of 1996
11.6 Corporate Consequences 11.7 Event Studies Can Measure Instant Value Impacts
ANECDOTE The Effects of Sanctions on South Africa PART IV REAL-WORLD APPLICATION CHAPTER 12 Capital Budgeting Applications and Pitfalls
So Many Returns: The Internal Rate of Return, the Cost of Capital,
the Hurdle Rate, and the Expected Rate of Return
12.2 Promised, Expected, Typical, or Most Likely?
12.3 Badly Blended Costs of Capital
ANECDOTE Risk and Conglomeration
How Bad Are Mistakes? Do Projects Really Need Their Own Costs of
Capital?
12.4 The Economics of Project Interactions
12.5 Evaluating Projects Incrementally
12.6
12.7
12.8
12.9 Real Options
Behavioral Biases
ANECDOTE Small Business Failures
Incentive (Agency) Biases
ANECDOTE Fiduciary Responsibility, or the Fox Guarding the Henhouse
An NPV Checklist Appendix: Valuing Some More Real Options
12.10 Decision Trees: One Set of Parameters
12.11 Projects with Different Parameters CHAPTER 13 From Financial Statements to Economic Cash Flows
13.1 Financial Statements
ANECDOTE Trashy Accounting at Waste Management
13.2 A Bottom-Up Example—Long-Term Accruals (Depreciation)
ANECDOTE Solid Financial Analysis
13.3 A Bottom-Up Example—Deferred Taxes
13.4 A Bottom-Up Example—Short-Term Accruals and Working Capital
ANECDOTE Working Capital Management
13.5 Earnings Management
13.6 Extracting Economic Cash Flows from PepsiCo’s Financials CHAPTER 14 Valuation from Comparables and Some Financial Ratios
14.1 Comparables and Net Present Value
The Price/Earnings (P/E)
14.2 Ratio
14.3 Problems with Price/Earnings Ratios
How Bad Are Mistakes? Averaging P/E Ratios and the 1/X Domain Problem
ANECDOTE Which P/E Ratio to Believe?
14.4 Other Financial Ratios PART V CAPITAL STRUCTURE AND PAYOUT POLICY CHAPTER 15 Corporate Claims
15.1 The Basic Building Blocks
15.2 Liabilities
ANECDOTE Judge Lifland and Eastern Airlines’ Creditors
ANECDOTE Are Convertibles Debt or Equity?
15.3 Equity (Stock)
15.4 Tracking IBM’s Capital Structure From 2001 to 2003 CHAPTER 16 Capital Structure and Capital Budgeting in a Perfect Market
16.1 Conceptual Basics—Maximization of Equity Value or Firm Value?
16.2 Modigliani and Miller: The Informal Way
16.3 Modigliani and Miller: The Formal Way
16.4 The Weighted Average Cost of Capital (WACC)
How Bad Are Mistakes? If all Securities are Riskier, is the Firm Riskier?
How Bad Are Mistakes? Can the Equity’s Cost of Capital be Lower than
the Rate that the Firm is Paying to its Creditors?
16.5 The Big Picture: How to Think of Debt and Equity
Nonfinancial and Operational Liabilities and the Marginal Cost of
16.6 Capital CHAPTER 17 The Weighted Cost of Capital and Adjusted Present Value
in an Imperfect Market with Taxes
17.1 Relative Taxation of Debt and Equity 17.2
17.3 17.4
17.5
17.6 Firm Value Under Different Capital Structures
ANECDOTE The RJR Buyout Tax Loophole
Formulaic Valuation Methods: APV and WACC
How Bad Are Mistakes? Applying APV and WACC to the Current
Cash Flows
A Sample Application of Tax-Adjusted Valuation Techniques
The Tax Subsidy on PepsiCo’s Financial Statement
Contemplating Corporate Taxes
ANECDOTE Stanley Works and Foreign Domiciles Appendix: Advanced Material
17.7 The Discount Factor on Tax Obligations and Tax Shelters CHAPTER 18 More Market Imperfections Influencing Capital Structure
18.1 What Matters?
18.2 The Role of Personal Income Taxes and Clientele Effects
ANECDOTE Tax Reductions for the Needy? For-Profit Companies
with No Tax Obligations
Operating Policy: Behavior in Bad Times (Financial
18.3 Distress)
ANECDOTE Fear and Relief
18.4 Operating Policy: Agency Issues and Behavior in Good Times
ANECDOTE Airlines, Unions, and Shareholders
18.5 Bondholder Expropriation
18.6 Inside Information and Adverse Selection
18.7 Transaction Costs and Behavioral Issues
18.8 Static Capital Structure Summary
18.9 The Effect of Leverage on Costs of Capital and Quoted Bond Yields
18.10 Valuation Formulas with Many Market Imperfections
18.11 Capital Structure Dynamics CHAPTER 19 Equity Payouts: Dividends and Share Repurchases
19.1 Background
19.2 Perfect-Market Irrelevance
19.3 Dividends and Share Repurchases
ANECDOTE Pre-Bush Tax Cuts: Ralph Nader and Microsoft
19.4 Empirical Evidence 19.5 PART VI Survey Evidence
. Summary . Key Terms Solve Now! Solutions . . Problems PROJECTING THE FUTURE CHAPTER 20 Pro Forma Financial Statements
20.1 The Goal and Logic
20.2 The Template
20.3 The Length of the Detailed Projection Period
20.4 The Detailed Projection Phase
20.5 The Terminal Value
How Bad Are Mistakes? How Robust Is Your Valuation?
20.6 Some Pro Formas
20.7 Alternative Assumptions and Sensitivity and Scenario Analyses
20.8 Proposing Capital Structure Change
20.9 Our Pro Forma in Hindsight
20.10 Caution—The Emperor’s New Clothes . PART VII ADDITIONAL TOPICS
CHAPTER 21 Capital Structure Dynamics
21.1 Capital Structure and Firm Scale
21.2 Theories of Capital Structure Levels, Changes, and Issuing Activity
21.3 Capital Market Pressures toward the Optimal Capital Structure
21.4 Working Capital Management and Financial Flexibility
ANECDOTE How Bond Ratings Doomed Trust-Preferred Securities
and Created ECAPS
21.5 Debt and Debt-Hybrid Offerings
21.6 Seasoned Equity Offerings
21.7 Initial Public Offerings (IPOs)
ANECDOTE The Analyst Recommends: Buy!
21.8 Raising Funds through Other Claims and Means
21.9 The Capital Market Response to Issue (and Dividend) Announcements
. . CHAPTER 22 Capital Structure Patterns in the United States
22.1 How to Measure Leverage
How Bad Are Mistakes? Financial Debt-to-Assets
22.2 Empirical Capital Structure Patterns
22.3 Mechanisms versus Causes
What are the Underlying Rationales for Capital Structure
22.4 Changes?
22.5 Survey Evidence from CFOs . CHAPTER 23 Investment Banking and Mergers & Acquisitions
23.1 The Investment Banking Business
ANECDOTE An Investment Banking Job?
23.2 Underwriting Services from the Firm’s Perspective
ANECDOTE Legal Monopolies: Bond Ratings
23.3 Mergers & Acquisitions (M&A) from the Firm’s Perspective
ANECDOTE RJR, Ego, and Overpayment CHAPTER 24 Corporate Governance
24.1 Separation of Ownership and Control
24.2 Managerial Temptations
ANECDOTE Board Courage at
Citigroup
24.3 The Role of Social Institutions
ANECDOTE The Fox Guarding the Henhouse: The NYSE
24.4 Debt: The Right of Creditors to Force Default
ANECDOTE Would You Lend Your Money to a Country or a State?
24.5 Equity: The Right of Shareholders to Vote
ANECDOTE Board Composition, Board Perpetuation, and Executive
Compensation (IBM)
ANECDOTE CalPERS Top-10 List
ANECDOTE Bribing Shareholders in Proxy Fights
24.6 The Design and Effectiveness of Corporate Governance Systems
ANECDOTE Investor Rights Outside the United States
ANECDOTE The Corporate Governance Consulting Industry CHAPTER 25 International Finance
25.1 Currencies and Exchange Rates 25.2
25.3
25.4
25.5 ANECDOTE Currency Arbitrage in the Middle Ages
ANECDOTE Yale’s Most Famous Economist
Investments in Foreign Financial Markets
ANECDOTE Purchasing Power Parity and the Big Mac Index
Capital Budgeting with Foreign Cash Flows
Corporate Currency Hedging
ANECDOTE Metallgesellschaft’s Hedging
Who Are You Working For? ANECDOTE Free Trade—Where Convenient
ANECDOTE Protesting World Bank Policies CHAPTER 26 Options and Risk Management
26.1 Options
ANECDOTE A Brief History of Options
ANECDOTE Geography and Options
ANECDOTE Environmental Options
26.2 Static No-Arbitrage Relationships
26.3 Valuing Options from Underlying Stock Prices
26.4 The Black-Scholes Inputs
26.5 Corporate Applications
ANECDOTE 223 years of Barings; 1 year of Leeson
ANECDOTE 2006 GAAP Change in the Treatment of Executive and
Employee Options 26.6
26.7
26.8
26.9 Epilogue Modeling the Stock Price Process as a Binomial Tree
The Option Hedge
Matching a Stock Price Distribution to a Binomial Tree
and Infinite-Level Pricing
Binomial Pricing and the Black-Scholes Formula E.1
E.2 Theory or
Practice?
Thoughts on Business and Finance Education E.3
E.4 The Business School Rankings
Bon Voyage 1031 A.1
A.2
A.3 General Mathematical and Statistical
Background
Laws of Probability, Portfolios, and Expectations
Cumulative Normal Distribution Table Introduction
WHAT FINANCE IS ALL ABOUT F inance is such an important part of modern life that almost everyone can benefit from understanding it better. What you may find surprising is that the financial problems facing
PepsiCo or Microsoft are not really different from those facing an average investor, small
business owner, entrepreneur, or family. On the most basic level, these problems are about
how to allocate money. The choices are many: Money can be borrowed, saved, or lent.
Money can be invested into projects. Projects can be undertaken with partners or with the
aid of lenders. Projects can be avoided altogether if they do not appear to be valuable
enough. Finance is about how best to decide among these and other investment
alternatives—and this textbook will explain how. 1.1 THE GOAL OF FINANCE: RELATIVE VALUATION
There is one principal theme that carries through all of finance. It is value. What
exactly is a particular object worth? To make smart decisions, you must be able to
assess value—and the better you can assess value, the smarter your decisions will be.
The main reason why you need to estimate value is that you will want to buy objects whose values are above their costs and avoid those where it is the reverse. Sounds
easy? If it were only so. In practice, finding a good value (valuation) is often very difficult. But it is not the formulas that are difficult—even the most complex formulas in
this book contain just a few symbols, and the overwhelming majority of finance
formulas use only the five major operations (addition, subtraction, multiplication,
division, and exponentiation). Admittedly, even if the formulas themselves are not
sophisticated, there are a lot of them, and they have an intuitive economic meaning that
requires experience to grasp. But if you managed to pass high-school algebra, and . if you are motivated, you will be able to handle the math. It is not the math that is
the real difficulty in valuation.
Instead, the big difficulties lie in the real world, beyond finance theory. You
often have to decide how you should judge the future—whether your gizmo will be a
hit or a bust, whether the economy will enter a recession or not, where you will find
product markets, how you can advertise, how interest rates or the stock market will
move, and on and on. This book will explain what you should forecast and how you
should use your forecasts in the best way, but it mostly remains up to you to make
these forecasts. Putting this more positively, if forecasts and valuation were easy, a
computer could take over this job. This will never happen. Valuation will always
remain a matter of both art and science, which requires judgment and common
sense. The formulas and finance in this book are only the necessary tools to convert
your reasoned, informed, and intuitive estimates of the future into the information
that you need today to make good decisions. 1.1A THE LAW OF ONE PRICE
. . So how do you assess value? Most of finance and thus most of this book is based in
some form or another on the law of one price. It states that two identical items at the
same venue should sell for the same price. Otherwise, why would anyone buy the more
expensive item? This law of one price is the logic upon which virtually all valuation is
based. It is important that you realize that this means that value in finance is defined in
relative terms. The reason is that it is easier to determine whether an object is worth
more or less than equivalent alternatives than it is to put an absolute value on it.
For example, consider the value of a car—say, a 2007 Toyota Camry—that you
own. If you can find other cars that are identical—at least along all dimensions that
matter—to your Camry, then it should be worth the same and sell for the same price.
Fortunately, for a 2007 Toyota Camry, this is not too difficult. There are many other
2007 Toyota Camries, as well as 2006 Toyota Camries, 2008 Toyota Camries, and
2007 Honda Accords, that you can readily purchase. If there are 10 other exact
equivalents on the same block for sale, your valuation task is outright trivial.
What would happen if you make a mistake in valuing your Camry? If you put too
low a value on your car, you would sell it too cheaply. If you put too high a value on
your car, you would not be able to sell it. Naturally, you want to get the value right.
A related way of thinking about your Camry versus the alternatives is that your
Camry has an “opportunity cost.” Your ownership of the Camry is not free. Ignoring
transaction costs, your opportunity is to sell your car and purchase another Camry, or
Accord, or anything else with this money. Let’s say that the Accord is your alter-native,
and it is equivalent in all dimensions that matter. If someone were to offer to pay $1,000
above the Accord value for your Camry, the price would be above your opportunity
cost. You should then sell the Camry, buy the Accord, and gain $1,000.
The law of one price rarely applies perfectly. But it often applies “almost.” For
example, your Camry may have 65,334 miles on it, be green, and be located in Providence, RI. The comparable cars may have between 30,000 and 50,000 miles on them,
feature different colors, and be located in other spots on the East Coast. In this case,
the law of one price no longer works exactly. Instead, it should hold only approximately. That is, your car m...

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