CORPORATE FINANCE.pdf - CORPORATE FINANCE CONTENT CHAPTER 1 Introduction PART I VALUE AND CAPITAL BUDGETING CHAPTER 2 The Time Value of Money and Net

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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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