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Unformatted text preview: Alternate Edition Fundamentals of Corporate Finance Stephen A. Ross Massachusettes Institute of Technology Randolph W. Westerfield University of Southern California Bradford D. Jordan University of Kentucky Fifth Edition | v v Boston Burr Ridge, IL Dubuque, IA Madison, WI New York San Francisco St. Louis Bangkok Bogotá Caracas Lisbon London Madrid Mexico City Milan New Delhi Seoul Singapore Sydney Taipei Toronto | e-Text Main Menu | Textbook Table of Contents | Study Guide Table of Contents Dedication To our families and friends with love and gratitude. S.A.R. R.W.W. B.D.J. McGraw-Hill Higher Education A Division of The McGraw-Hill Companies FUNDAMENTALS OF CORPORATE FINANCE Copyright © 2000, 1998, 1995, 1993, 1991 by The McGraw-Hill Companies, Inc. All rights reserved. Printed in the United States of America. Except as permitted under the United States Copyright Act of 1976, no part of this publication may be reproduced or distributed in any form or by any means, or stored in a data base or retrieval system, without the prior written permission of the publisher. This book is printed on acid-free paper. domestic international 1 2 3 4 5 6 7 8 9 0 VNH/VNH 9 0 9 8 7 6 5 4 3 2 1 0 9 1 2 3 4 5 6 7 8 9 0 VNH/VNH 9 0 9 8 7 6 5 4 3 2 1 0 9 ISBN 0-07-231289-0 (standard edition) ISBN 0-07-366128-7 (alternate edition) ISBN 0-07-231290-4 (annotated instructors edition) Vice president/Editor-in-chief: Michael W. Junior Publisher: Craig S. Beytien Senior sponsoring editor: Randall Adams Developmental editor: Michele Janicek Senior marketing manager: Katie Rose Matthews Senior project manager: Jean Lou Hess Senior production supervisor: Lori Koetters Senior designer: Michael Warrell Cover illustrator: David Tillinghast Supplement coordinator: Becky Szura Compositor: Carlisle Communications, Ltd. Typeface: 10/12 Times Roman Printer: Von Hoffmann Press, Inc. Library of Congress Cataloging-in-Publication Data Ross, Stephen A. Fundamentals of corporate finance / Stephen A. Ross, Randolph W. Westerfield, Bradford D. Jordan.5th ed. p. cm.(Irwin/McGraw-Hill series in finance, insurance, and real estate.) Includes index. ISBN (invalid) 0-07-232389-0 (standard) 1. CorporationsFinance. I. Westerfield, Randolph. II. Jordan, Bradford D. III. Title. IV. Series. HG4026.R677 2000 658.15dc21 99-27707 International Edition ISBN 0-07-116831-1; alternate edition ISBN 0-07-116981-4 Copyright © 2000. Exclusive rights by The McGraw-Hill Companies, Inc. for manufacture and export. This book cannot be re-exported from the country to which it is consigned by McGraw-Hill. The International Edition is not available in North America. | v v | e-Text Main Menu | Textbook Table of Contents | Study Guide Table of Contents Irwin/McGraw-Hill Series in Finance, Insurance, and Real Estate Franco Modigliani Professor of Finance and Economics, Sloan School of Management, Massachusetts Institute of Technology Financial Management Investments Benninga and Sarig Corporate Finance: A Valuation Approach Block and Hirt Foundations of Financial Management Ninth Edition Brealey and Myers Principles of Corporate Finance Sixth Edition Brealey, Myers, and Marcus Fundamentals of Corporate Finance Second Edition Brooks FinGame Online 3.0 Bruner Case Studies in Finance: Managing for Corporate Value Creation Third Edition Chew The New Corporate Finance: Where Theory Meets Practice Second Edition Graduate Management Admissions Council, Robert F. Bruner, Kenneth Eades, and Robert Harris Finance Interactive: Pre-MBA Series 2000 Second Edition Essentials of Finance: With an Accounting Review Fully interactive CD-ROM derived from Finance Interactive 1997 Pre-MBA Edition Grinblatt and Titman Financial Markets and Corporate Strategy Helfert Techniques of Financial Analysis: A Guide to Value Creation Tenth Edition Higgins Analysis for Financial Management Fifth Edition Kester, Fruhan, Piper, and Ruback Case Problems in Finance Eleventh Edition Nunnally and Plath Cases in Finance Second Edition Ross, Westerfield, and Jaffe Corporate Finance Fifth Edition Ross, Westerfield, and Jordan Essentials of Corporate Finance Second Edition Ross, Westerfield, and Jordan Fundamentals of Corporate Finance Fifth Edition Smith The Modern Theory of Corporate Finance Second Edition White Financial Analysis with an Electronic Calculator Fourth Edition Bodie, Kane, and Marcus Essentials of Investments Third Edition Bodie, Kane, and Marcus Investments Fourth Edition Cohen, Zinbarg, and Zeikel Investment Analysis and Portfolio Management Fifth Edition Corrado and Jordan Fundamentals of Investments: Valuation and Management Farrell Portfolio Management: Theory and Applications Second Edition Hirt and Block Fundamentals of Investment Management Sixth Edition Jarrow Modelling Fixed Income Securities and Interest Rate Options Shimko The Innovative Investor Excel Version | v v Consulting Editor Stephen A. Ross | e-Text Main Menu Financial Institutions and Markets Levi International Finance Third Edition Levich International Financial Markets: Prices and Policies Stonehill and Eiteman Finance: An International Perspective Real Estate Berston California Real Estate Principles Seventh Edition Brueggeman and Fisher Real Estate Finance and Investments Tenth Edition Corgel, Smith, and Ling Real Estate Perspectives: An Introduction to Real Estate Third Edition Lusht Real Estate Valuation: Principles and Applications Sirmans Real Estate Finance Second Edition Financial Planning and Insurance Cornett and Saunders Fundamentals of Financial Institutions Management Johnson Financial Institutions and Markets: A Global Perspective Rose Commercial Bank Management Third Edition Rose Money and Capital Markets: Financial Institutions and Instruments in a Global Marketplace Seventh Edition Rose and Kolari Financial Institutions: Understanding and Managing Financial Services Fifth Edition Santomero and Babbel Financial Markets, Instruments, and Institutions Saunders Financial Institutions Management: A Modern Perspective Third Edition International Finance Allen, Melone, Rosenbloom, and VanDerhei Pension Planning: Pension, Profit-Sharing, and Other Deferred Compensation Plans Eighth Edition Crawford Life and Health Insurance Law Eighth Edition (LOMA) Harrington and Niehaus Risk Management and Insurance Hirsch Casualty Claim Practice Sixth Edition Kapoor, Dlabay, and Hughes Personal Finance Fifth Edition Kellison Theory of Interest Second Edition Lang Strategy for Personal Finance Fifth Edition Skipper International Risk and Insurance: An Environmental-Managerial Approach Williams, Smith, and Young Risk Management and Insurance Eighth Edition Eun and Resnick International Financial Management Kester and Luehrman Case Problems in International Finance Second Edition | Textbook Table of Contents | Study Guide Table of Contents About the Authors Stephen A. Ross Randolph W. Westerfield Bradford D. Jordan Massachusetts Institute of Technology University of Southern California University of Kentucky Randolph W. Westerfield is Dean of the Marshall School of Business at University of Southern California and holder of the Robert R. Dockson Deans Chair of Business Administration. From 1988 to 1993, Professor Westerfield served as the chairman of the Schools finance and business economics department and 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 member of the finance faculty for 20 years. His areas of expertise include corporate financial policy, investment management and analysis, mergers and acquisitions, and stock market price behavior. Professor Westerfield has served as a member of the Continental Bank trust committee, supervising all activities of the trust department. He has been consultant to a number of corporations, including AT&T, Mobil Oil and Pacific Enterprises, as well as to the United Nations, the U.S. Department of Justice and Labor, and the State of California. Bradford D. Jordan is Professor of Finance and Gatton Research Fellow in the Carol Martin Gatton College of Business and Economics 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. | v v Stephen Ross is presently 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, a director of the College Retirement Equity Fund (CREF), and Freddie Mac. He is also the cochairman of Roll and Ross Asset Management Corporation. | e-Text Main Menu | Textbook Table of Contents | Study Guide Table of Contents Preface From the Authors . . . W HEN THE THREE OF US DECIDED TO A Managerial Focus Students shouldnt lose sight WRITE A BOOK, 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 nine years later, we would be working on a fifth 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, Polish, Portuguese, and Spanish language editions, and an entirely separate book, Essentials of Corporate Finance, now in its second 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 other products, we believe you will find a combination with this edition that will meet your current as well as your changing needs. we were united by one strongly held principle: Corporate finance should be developed in terms of a few integrated, powerful ideas. We felt 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 didnt 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 common sense, 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. Stephen A. Ross Randolph W. Westerfield Bradford D. Jordan | v v v | e-Text Main Menu | Textbook Table of Contents | Study Guide Table of Contents Setting a Clear Course 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 principles, while still reviewing important accounting principles very early on. The organization of this text has been developed to give instructors the flexibility they need. T As with the previous edition of the book, we are offering a Standard Edition with 21 chapters, and an Alternate Edition with 25 chapters Considers the goals of the corporation, the corporate form of organization, the agency problem, and, briefly, financial markets Succinctly discusses cash flow versus accounting income, market value versus book value, taxes, and a review of financial statements This part can be omitted entirely if desired without affecting the flow of the other chapters Contains a thorough discussion of the sustainable growth rate as a planning tool Standard and Alternate Editions Table of Contents Part One Overview of Corporate Finance 1 2 Introduction to Corporate Finance Financial Statements, Taxes, and Cash Flow Part Two Financial Statements and Long-Term Financial Planning 3 4 Working with Financial Statements Long-Term Financial Planning and Growth Part Three Valuation of Future Cash Flows 5 First of two chapters covering time value of money, allowing for a building-block approach to this concept HIS BOOK WAS DESIGNED 6 7 8 Introduction to Valuation: The Time Value of Money Discounted Cash Flow Valuation Interest Rates and Bond Valuation Stock Valuation Part Four Capital Budgeting 9 10 Contains an extensive discussion on NPV estimates Gives students a feel for typical rates of return on risky assets Discusses the expected return/risk trade-off, and develops the security market line in a highly intuitive way that bypasses much of the usual portfolio theory and statistics 11 Net Present Value and Other Investment Criteria Making Capital Investment Decisions Project Analysis and Evaluation Part Five Risk and Return 12 13 Some Lessons from Capital Market History Return, Risk, and the Security Market Line | v v vi | e-Text Main Menu | Textbook Table of Contents | Study Guide Table of Contents Part Six Cost of Capital and Long-Term Financial Policy Cost of Capital Raising Capital Financial Leverage and Capital Structure Policy Dividends and Dividend Policy 14 15 16 17 Provides a modern, up-to-date discussion of IPOs and the cost of going public This chapter can be omitted without a loss in continuity Part Seven Short-Term Financial Planning and Management Presents a general survey of short-term financial management, which is useful when time does not permit a more in-depth treatment Short-Term Finance and Planning Cash and Liquidity Management Appendix 19ADetermining the Target Cash Balance Credit and Inventory Management Appendix 20AMore on Credit Policy Analysis 18 19 20 Choose this edition if you are interested in covering the following additional topics! Alternate EditionAdditional Chapters Part Eight Topics in Corporate Finance International Corporate Finance Risk Management: An Introduction to Financial Engineering Options and Corporate Securities Mergers and Acquisitions Leasing Appendix A Mathematical Tables Appendix B Key Equations Appendix C Answers to Selected End-of-Chapter Problems 21 22 23 24 25 Same chapter as in the Standard Edition This increasingly important topic is presented at a level appropriate for an introductory class Index | v v vii | e-Text Main Menu | Textbook Table of Contents | Study Guide Table of Contents Pedagogy to Guide You pertinent concepts and presenting up-to-date coverage, Fundamentals of Corporate Finance strives to present the material in a way that makes it coherent and easy to understand. To meet the varied needs of the intended audience, Fundamentals of Corporate Finance is rich in valuable learning tools and support. I N ADDITION TO ILLUSTRATING These are from real-world events and introduce students to the chapter concepts. Questions about these vignettes are posed to the reader to ensure understanding of the concepts in the end-of-chapter material. Check out these engaging applications and their related questions. For examples, see Chapter 5, pages 118 and 137; Chapter 6, pages 140 and 169; and Chapter 10, pages 278 and 311. Chapter-Opening Vignettes N EARLY I 1998, General Motors announced plans to launch the Cadillac Escalade, its first truck under the Cadillac brand name and its first luxury sport-utility vehicle (SUV). GMs decision was primarily a reaction to the runaway success of new luxury SUVs such as Fords Lincoln Navigator and Mercedes-Benzs new M-class. These vehicles were exceptionally profitable; for example, each of the 18,500 Lincoln Navigators that sold in the four months after their introduction in June 1997 generated well over $10,000 in profit for Ford. GM had previously been unwilling to build a luxury SUV, but these profit margins were too large to ignore. To answer the next three questions, refer back to the case of the Cadillac Escalade we discussed to open the chapter. 8. In evaluating the Escalade, under what circumstances might GM have concluded that erosion of the Denali line was irrelevant? 9. GM was not the only manufacturer looking at the big sport-utility category. Chrysler, however, initially decided not to go ahead with an entry (Chrysler later reversed course on this issue). Why might one company decide to proceed when another would not? 10. In evaluating the Escalade, what do you think GM needs to assume regarding the enormous profit margins that exist in this market? Is it likely they will be maintained when GM and others enter this market? | v v viii | e-Text Main Menu | Textbook Table of Contents | Study Guide Table of Contents This learning tool continues to be an important feature of Fundamentals of Corporate Finance. In almost every chapter, color plays an extensive, nonschematic, and largely self-evident role. A guide to the functional use of color is found on the endsheets of both the Annotated Instructor s Edition (AIE) and student version. For examples of this technique, see Chapter 3, page 52; Chapter 9, page 264; and Chapter 12, page 370. Pedagogical Use of Color NPV ($) Figure 9.8 NPV profiles for mutually exclusive investments 70 60 50 Project B 40 30 26.34 Crossover point Project A 20 NPVB > NPVA 10 IRRA = 24% NPVA > NPVB 0 5 10 10 11.1% 15 25 20 R (%) 30 IRRB = 21% To see why Investment A is not necessarily the better of the two investments, weve calculated the NPV of these investments for different required returns: Discount Rate 0% 5% 10% 15% 20% 25% NPV(A) NPV(B) $60.00 43.13 29.06 17.18 7.06 1.63 $70.00 47.88 29.79 14.82 2.31 8.22 Enhanced! Real-World Examples These are integrated throughout the text tying chapter concepts to real life through illustration, reinforcing the relevance of the material. Some examples tie into the Chapter-Opening Vignette for added reinforcement. See Chapter 2, page 28; Chapter 5, page 124; and Chapter 8, page 229. To give another example, H. Wayne Huizenga wants you to own a piece of the National Hockey Leagues Florida Panthers. If you buy a share of the Class A stock, you get the right to cast a vote, but that vote wont count for much. To make sure Huizenga doesnt violate NHL bylaws, which require league approval of any change in team control, Huizenga created 255,000 shares of another class of stock (Class B) just for himself. Each of those shares carries 10,000 votes. In principle, the New York Stock Exchange does not allow companies to create classes of publicly traded common stock with unequal voting rights. Exceptions (e.g., Ford) appear to have been made. In addition, many non-NYSE companies have dual classes of common stock. | v v ix | e-Text Main Menu | Textbook Table of Contents | Study Guide Table of Contents New! In Their Own Words Boxes This edition has two series of In Their Own Words boxes. The series in blue boxes are the popular articles updated from previous editions written by a distinguished scholar or practitioner on key topics in the text. Boxes include essays by Merton Miller on capital structure, Fischer Black on dividends, and Roger Ibbotson on capital market history. A complete list of In Their Own Words boxes appears on page xxxii. The series in green boxes features recent college graduates with business degrees who are now important members of the workforce. Their jobs range from finance to marketing to sales to information systems. These boxes help students realize the career opportunities available to them with a business degree. They also feature recent graduates giving helpful advice for success after college. See Chapter 1, page 10; Chapter 4, page 99; and Chapter 13, page 389. THICS IS A TOPIC that has been receiving increased interest in the business community. Much of this discussion has been led by philosophers and has focused on moral principles. Rather than review these issues, I want to discuss a complementary (but often ignored) set of issues from an economists viewpoint. Markets impose potentially substantial costs on individuals and institutions that engage in unethical behavior. These market forces thus provide important incentives that foster ethical behavior in the business community. At its core, economics is the study of making choices. I thus want to examine ethical behavior simply as one choice facing an individual. Economic analysis suggests that in considering an action, you identify its expected costs and benefits. If the estimated benefits exceed the estimated costs, you take the action; if not, you dont. To focus this discussion, lets consider the following specific choice: Suppose you have a contract to deliver a product of a ifi d li W ld b di li In Their Own Words . . . E doubt a firms claims about product quality. Where quality is more uncertain, customers are only willing to pay lower prices. Such firms thus have particularly strong incentives to adopt financial policies that imply a lower probability of insolvency. Therefore such firms should have lower leverage, enter fewer leases, and engage in more hedging. Third, the expected costs are higher if information about cheating is rapidly and widely distributed to potential future customers. Thus information services like Consumer Reports, which monitor and report on product quality, help deter cheating. By lowering the costs for potential customers to monitor quality, such services raise the expected costs of cheating. Finally, the costs imposed on a firm that is caught cheating depend on the markets assessment of the ethical breach. Some actions viewed as clear transgressions by some might be viewed as justifiable behavior by others. Ethical standards also vary across markets. For example, a payment that if disclosed in the United States would be labeled a bribe might be i d t d db i ti i t id ld In Their Own Words . . . Clifford W. Smith Jr. on Market Incentives for Ethical Behavior Recipe for Success: Go Cross-Functional INANCE. The word in itself brings to mind images of frantic brokers on the floor of a stock exchange, people who speak in what seems like another language complete with alphabet soup acronyms such as LBO, IPO, LIBOR, and NASDAQ, and a profession that keeps the makers of pain relievers in business. In much the same way that the image of the bean-counting, pencil-pushing accountant has gone the way of the dinosaur, so too has the misconception that the only opportunities available to finance majors are careers on Wall Street. In my case, finance has opened the door to a challenging career in corporate finance with General Mills, Inc. After getting an initial look at General Mills through a summer internship, I felt very confident in the many challenges that lay ahead. At General Mills, the finance organization is rotationally based, giving each individual the opportunity to see the business from many different perspectives. In this dynamic environment, the company seeks to develop financial professionals that have a broad sense about the business as a whole, rather than their department in isolation. By developing this background, members of the finance organization bl f i d ii i F of the coin, receiving a request from a product sales manager, or one of the representatives from a sales region or account, would not be considered outside of the realm of possibility. Finally, I also work closely with the other division trade analysts to examine issues common to all divisions. My career in the finance organization has the potential to take me many different places. In adhering to their philosophy of well-rounded, business-minded financial professionals, my rotations could take me to a position within a marketing division, analyzing growth and directing the business according to clear financial goals, or possibly to an operations division such as purchasing or distribution, looking at generating productivity improvements and driving costs out of our production processes, or maybe within some of our corporate functions such as treasury operations, financial reporting, or mergers and acquisitions. The possibility also exists to take a more hands-on approach to the business and lead the financial group at one of our production facilities. I can offer a few words of wisdom to those of you still making decisions about where you want your degree to take you. First, find a way to work on crossfunctional projects within the business school, or even l Bl i d dd | v v x | e-Text Main Menu | Textbook Table of Contents | Study Guide Table of Contents This feature either introduces students to Excel or helps them brush up on their Excel spreadsheet skills, particularly as they relate to corporate finance. This feature appears in self-contained sections and shows students how to set up spreadsheets to analyze common financial problemsa vital part of every business students education. For examples, see Chapter 5, page 134; Chapter 6, page 146; and Chapter 7, page 187. New! Spreadsheet Strategies Spreadsheet Strategies How to Calculate Present Values with Multiple Future Cash Flows Using a Spreadsheet Just as we did in our previous chapter, we can set up a basic spreadsheet to calculate the present values of the individual cash flows as follows. Notice that we have simply calculated the present values one at a time and added them up: A B C D E 1 Using a spreadsheet to value multiple future cash flows 2 3 4 5 6 7 8 9 What is the present value of $200 in one year, $400 the next year, $600 the next year, and $800 the last year if the discount rate is 12 percent? Rate: Cash flows 1 2 3 4 10 11 12 13 14 15 16 17 18 19 20 21 22 0.12 Year $200 $400 $600 $800 Total PV: Present values $178.57 $318.88 $427.07 $508.41 $1,432.93 Formula used =PV($B$7, =PV($B$7, =PV($B$7, =PV($B$7, A10,0,B10) A11,0,B11) A12,0,B12) A13,0,B13) =SUM(C10:C13) Notice the negative signs inserted in the PV formulas. These just make the present values have positive signs. Also, the discount rate in cell b7 is entered as $B$7 (an "absolute" reference) because it is used over and over. We could have just entered ".12" instead, but our approach is more flexible. Chapter sections are intentionally kept short to promote a step-by-step, building block approach to learning. Each section is then followed by a series of short concept questions that highlight the key ideas just presented. Students use these questions to make sure they can identify and understand the most important concepts as they read. See Chapter 5, page 127; Chapter 8, page 232; and Chapter 12, page 371 for examples. Concept Building Concept Questions 8.2a What rights do stockholders have? 8.2b What is a proxy? 8.2c Why is preferred stock called preferred? | v v xi | e-Text Main Menu | Textbook Table of Contents | Study Guide Table of Contents These tables succinctly restate key principles, results and equations. They appear whenever it is useful to emphasize and summarize a group of related concepts. For examples, see Chapter 2, page 35; Chapter 6, page 155; and Chapter 7, page 186. Summary Tables I. The cash flow identity Cash flow from assets II. Cash flow from assets Cash flow from assets where Operating cash flow Net capital spending Change in NWC Table 2.5 Cash flow to creditors (bondholders) Cash flow to stockholders (owners) Cash flow summary Trans. 2.7 Operating cash flow Net capital spending Change in net working capital (NWC) Earnings before interest and taxes (EBIT) Depreciation Taxes Ending net fixed assets Beginning net fixed assets Depreciation Ending NWC Beginning NWC III. Cash flow to creditors (bondholders) Cash flow to creditors Interest paid Net new borrowing IV. Cash flow to stockholders (owners) Cash flow to stockholders Dividends paid Net new equity raised Separate numbered and titled examples are extensively integrated into the chapters as indicated below. These examples provide detailed applications and illustrations of the text material in a step-by-step format. Each example is completely self-contained so students dont have to search for additional information. Based on our classroom testing, these examples are among the most useful learning aids because they provide both detail and explanation. See Chapter 2, page 30; Chapter 6, page 149; and Chapter 9, page 250. Labeled Examples Example 2.4 Trans. 2.5 Marginal vs. Average Corporate Tax Rates Deep in the Heart of Taxes Algernon, Inc., has a taxable income of $85,000. What is its tax bill? What is its average tax rate? Its marginal tax rate? From Table 2.3, we see that the tax rate applied to the first $50,000 is 15 percent; the rate applied to the next $25,000 is 25 percent, and the rate applied after that up to $100,000 is 34 percent. So Algernon must pay .15 $50,000 .25 25,000 .34 (85,000 75,000) $17,150. The average tax rate is thus $17,150/85,000 20.18%. The marginal rate is 34 percent because Algernons taxes would rise by 34 cents if it had another dollar in taxable income. Throughout the text, important ideas are pulled out and presented in a green boxsignaling to students that this material is particularly relevant and critical for their understanding. See Chapter 7, page 205; Chapter 9, page 253; and Chapter 12, page 396. Highlighted Concepts Based on the discounted payback rule, an investment is acceptable if its discounted payback is less than some prespecified number of years. | v v xii | e-Text Main Menu | Textbook Table of Contents | Study Guide Table of Contents Chapter Review and Self-Test Problems Appearing after the Summary and Conclusions, each chapter includes a Chapter Review and Self-Test Problem section. These questions and answers allow students to test their abilities in solving key problems related to the chapter content and provide instant reinforcement. See Chapter 2, page 39; Chapter 7, page 343; and Chapter 14, page 439. Chapter Review and Self-Test Problem 2.1 Cash Flow for Mara Corporation This problem will give you some practice working with financial statements and figuring cash flow. Based on the following information for Mara Corporation, prepare an income statement for 1999 and balance sheets for 1998 and 1999. Next, following our U.S. Corporation examples in Answer to Chapter Review and Self-Test Problem 2.1 In preparing the balance sheets, remember that shareholders equity is the residual. With this in mind, Maras balance sheets are as follows: MARA CORPORATION Balance sheets as of December 31, 1998 and 1999 1998 Current assets Net fixed assets Total assets 1999 $2,205 7,344 $ 2,429 7,650 $9,549 $10,079 1998 Current liabilities $1,003 Long-term debt 3,106 Equity 5,440 Total liabilities and $9,549 shareholders equity 1999 $ 1,225 2,085 6,769 $10,079 The income statement is straightforward: Concepts Review and Critical Thinking Questions This successful endof-chapter section introduced in the Fourth Edition facilitates students knowledge of key principles, and their intuitive understanding of chapter concepts. A number of the questions relate to the Chapter-Opening Vignettereinforcing student critical-thinking skills and the learning of chapter material. For examples, see Chapter 3, page 79; Chapter 6, page 169; and Chapter 14, page 440. Concepts Review and Critical Thinking Questions 1. 2. 3. 4. In evaluating an annuity present value, there are four pieces. What are they? As you increase the length of time involved, what happens to the present value of an annuity? What happens to the future value? What happens to the future value of an annuity if you increase the rate r? What happens to the present value? What do you think about the Tri-State Megabucks lottery discussed in the chapter advertising a $500,000 prize when the lump-sum option is $250,000? Is it deceptive advertising? | v v xiii | e-Text Main Menu | Textbook Table of Contents | Study Guide Table of Contents End-of-Chapter Questions and Problems We have found that many students learn better when they have plenty of opportunity to practice; therefore, we provide extensive end-of-chapter questions and problems. The end-of-chapter support greatly exceeds what is typical in an introductory textbook. The questions and problems are segregated into three learning levels: Basic, Intermediate, and Challenge. All problems are fully annotated so that students and instructors can readily identify particular types. Throughout the text, we have worked to supply interesting problems that illustrate real-world applications of chapter material. Answers to selected end-of-chapter material appear in Appendix C. See Chapter 5, page 137; Chapter 6, page 170; and Chapter 15, page 482. Basic (Questions 128) Questions and Problems 1. @ 10%: PV @ 18%: PV @ 24%: PV $2,699.95 $2,251.68 $1,990.57 Intermediate (Questions 2959) 29. Simple Interest versus Compound Interest First Simple Bank pays 8 percent simple interest on its investment accounts. If First Complex Bank pays interest on its accounts compounded annually, what rate should the bank set if it wants to match First Simple Bank over an investment horizon of 10 years? 60. Discount Interest Loans This question illustrates what is known as discount interest. Imagine you are discussing a loan with a somewhat unscrupulous lender. You want to borrow $12,000 for one year. The interest rate is 12 percent. You and the lender agree that the interest on the loan will be .12 $12,000 $1,440. So the lender deducts this interest amount from the loan up front and gives you $10,560. In this case, we say that the discount is $1,440. Whats wrong here? 6.05% Third year: $800.00 Life of loan: $4,800.00 Challenge (Questions 6075) EAR 13.64% Present Value and Multiple Cash Flows Stellato Shaved Ice Co. has identified an investment project with the following cash flows. If the discount rate is 10 percent, what is the present value of these cash flows? What is the present value at 18 percent? At 24 percent? | v v xiv | e-Text Main Menu | Textbook Table of Contents | Study Guide Table of Contents Supplements for the Journey has more options than ever in terms of the textbook, instructor supplements, student supplements, and multimedia products. Mix and match to create a package that is perfect for your course! HIS EDITION OF FUNDAMENTALS T The Textbook As with the previous edition, we are offering four versions of this text, all packaged with an exciting new student CD-ROM (see description under Student Supplements): Standard Edition (21 Chapters) 0072319380 Alternate Edition (25 Chapters) 0072319372 The Wall Street Journal Edition of the Standard Edition 0072319399 The Wall Street Journal Edition of the Alternate Edition 0072319402 For the Instructor Annotated Instructors Edition (AIE) ISBN 0072319364 All your teaching resources are tied together here! This handy resource contains extensive references to the Instructor s Manual regarding lecture tips, ethics notes, internet references, international notes, and the availability of solutions and teaching transparencies. The lecture tips vary in content and purposeproviding an alternative perspective on a subject, suggesting important points to be stressed, giving further examples, or Instructors Manual recommending other readings. The ethics notes present background on topics that can be used to motivate classroom discussion of finance-related ethical issues. Other annotations include: notes for the Real-World Tips; Concept Questions; Self-Test Problems; End-ofChapter Problems; Videos; and answers to the end-ofchapter problems. ISBN 0072312947, prepared by Thomas H. Eyssell, University of MissouriSt. Louis A great place to find new lecture ideas! The IM contains three main sections. The first section contains a chapter outline and other lecture materials designed for use with the Annotated Instructor s Edition. There is an annotated outline for each chapter, and included in the outlines are lecture tips, real-world tips, ethics notes, suggested overhead transparencies, and when appropriate, a video synopsis. Also included are detailed solutions for all end-of-chapter problems with selected transparency masters. | v v xv | e-Text Main Menu | Textbook Table of Contents | Study Guide Table of Contents 0072312955, prepared by David R. Kuipers, Texas Tech University New format for a better testing process! The Fifth and highlighted phrases. Part III contains multipleEdition Test Bank has been thoroughly reorganized to choice and true/false problems patterned after the endmore closely link with the text. Each chapter is divided of-chapter questions, in basic, intermediate, and chalinto four parts: Part I contains questions that test the unlenge levels. Part IV provides essay questions to test derstanding of the key terms in the book. Part II inproblem-solving skills and more advanced understandcludes questions patterned after the learning objectives, ing of concepts. concept questions, Chapter-Opening Vignettes, boxes, Test Bank Computerized Testing Software ISBN 0072312971 (Windows) ISBN 0072313080 (Mac) Create your own tests in a snap! This software includes an easy-to-use menu system that allows quick access to all the powerful features available. The Keyword Search option lets you browse through the question bank for problems containing a specific word or phrase. Password protection is available for saved tests or for the entire database. Questions can be added, modified, or deleted. TeleTest Need help creating tests? Call us! Irwin/McGraw-Hills free customized exam preparation service! Simply choose your desired questions from the Test Bank and ISBN 0072313110 Add visuals to your lectures! Offering both Teaching and Solutions Transparencies, this package includes over 350 acetates for use with this text. The majority of the acetates are supplemental exhibits and examples, in addition to selected figures and tables from the text. Selected solutions transparencies for end-of-chapter problems are also availablewith portions of each solutions transparency blank, designed specifically for interactive classroom problem-solving. call 1-800-338-3987 to order your test. Test and answer keys are printed on a laser printer according to the specifications provided and mailed to you. Transparency Acetates PowerPoint Presentation System The transparency package, separated by chapters, contains the teaching transparencies first, followed by the solutions transparencies. A complete list of transparencies appears in the Instructor s Manual, with annotations for the transparencies located in the margins of the AIE. ISBN 0072313099, prepared by Thomas H. Eyssell, University of MissouriSt. Louis. Customize our content for your course! This presentation system allows you to show the transparencies in color format using your PC and a computer projector. Packaged with the PowerPoint Viewer, you can display the entire transparency package that accompanies this ISBN 0072312963 Keep all the supplements in one place! This CD contains all the necessary supplementsInstructor s edition. If you already have PowerPoint installed on your PC, you have the ability to edit, print, or rearrange the complete transparency presentation to meet your specific needs. New! Instructor CD-ROM Manual, Test Bank, and PowerPointall in one useful product in an electronic format. | v v xvi | e-Text Main Menu | Textbook Table of Contents | Study Guide Table of Contents ISBN 007231303X Completely new set of videos on hot topics! Irwin/ McGraw-Hill produced a new series of finance videos that are 10-minute case studies on topics such as New! Videos Financial Markets, Careers, Rightsizing, Capital Budgeting, EVA (Economic Value Added), Mergers and Acquisitions, and International Finance. For the Student The Wall Street Journal Edition ISBN 0072319399 (Standard WSJ Edition) ISBN 0072319402 (Alternate WSJ Edition) Great way to bring in more current events! Through a unique arrangement with Dow Jones, the price of this version of the student text includes a 10-week subscription to The Wall Street Journal. This business daily newspaper s coverage of financial topics, both domestic and global, is unparalleled by any other business periodical. If you ordered this special edition for your students, they will find a subscription card in their books. Irwin/McGraw-Hill is pleased to offer this as part of the Ross/Westerfield/Jordan package. Please contact your sales representative for ordering information. New! Self-Study Software CD-ROM Packaged free with every new copy of the book! This CD-ROM for students contains many features to help students learn corporate finance: Self-Study Software. (Software prepared by Leland Mansuetti and Keith Weidkamp, questions prepared by Randy D. Jorgensen, Creighton University.) With the self-study program, students can test their knowledge on one chapter or a number of chapters by answering questions written specifically for this text. There are at least 100 questions per chapter. With the Skill Builder program, students can brush up on their problem-solving capabilities. This pro- gram generates an infinite number of problems based on formulas in the chapters, so students can solve the same problem again and again until they have mastered it. FAST Templates (prepared by KMT Software, Inc.). These Financial Analysis Spreadsheet Templates (FAST) provides students with templates tied to the specific problems in the text. Students gain experience working with spreadsheets and solving financial problems. PowerPoint slides. The same PowerPoint program available to instructors as described above is also available to students on this CD. ISBN 0072313013, prepared by Thomas H. Eyssell, University of Student Problem Manual MissouriSt. Louis. Need additonal reinforcement of the concepts? This valuable resource provides students with additional problems for practice. Each chapter begins with Concepts for Review, followed by Chapter Highlights. These re-emphasize the key terms and concepts in the Ready Notes chapter. A short Concept Test, averaging 10 questions and answers, appears next. Each chapter concludes with additional problems for the student to review. Answers to these problems appear at the end of the Student Problem Manual. ISBN 0072313005 Improved listening and attention = improved retention! This innovative student supplement, first introduced by Irwin, provides students with an inexpensive notetaking system that contains a reduced copy of every transparency in the acetate package. With a copy of each transparency in front of them, students can listen and record your comments about each point instead of hurriedly copying the transparency into their notebooks. Ask your Irwin/McGraw-Hill representative about packaging options. | v v xvii | e-Text Main Menu | Textbook Table of Contents | Study Guide Table of Contents Financial Analysis with an Electronic Calculator, Fourth Edition ISBN 007229738, prepared by Mark A. White, University of VirginiaMcIntire School of Commerce. Need help with your financial calculator? The information and procedures in this supplementary text enable students to master the use of financial calculators and develop a working knowledge of financial mathematics and problem-solving. Complete instructions are included for solving all major problem types on three popular models: HP 10-B, TI BA II Plus, and Sharp EL 733 A. Hands-on problems with detailed solutions allow students to practice the skills outlined in the text and obtain instant reinforcement. Financial Analysis with an Electronic Calculator is a self-contained supplement to the introductory financial management course. Technology Products coordinated by Thomas H. Eyssell, University of MissouriSt. Louis. Invaluable resource! This home page includes a variety that are posted on the site. Also, they can learn about of features: the companies you read about in the book by linking to their homepages. Teaching Support The basic page includes basic On-line Learning Center The On-line Learning product and author information, an instructor resource Center (OLC) under the Instructor Resource heading section to find current events in finance and teaching is a password-protected site for adopters of the book tips, and a student resources section with quizzes and only. This site includes the instructor s supplements other interesting links related to corporate finance. in an easy on-line format. Go to this site to register for Student Support Students can continue testing their the password. knowledge of corporate finance by taking quizzes RWJ Home Page Finance Resources Access Network (FRAN) Make us your resource for all of your courses! Looking for additional support for corporate finance or one of your other courses? Check out the Irwin/ McGraw-Hill F.I.R.E. supersite. Coordinated by faculty members McGraw-Hill Learning Architecture around the country, this continuously updated site provides you with current events, teaching tips, and lots of other resources that you just cant find in a book. Make the most of the Internet! This new and unique Web-based learning system gives instructors ownership over online course administration, study aids and activities, and Internet links to featured companies in many of the McGraw-Hill texts. You can now place course materials online, facilitating the assignment of quizzes and homeworkeven the tracking of student progressall from the comfort of your own computer. The system also works to break down traditional instructor/student communication barriers by providing students with an e-mail forum for course topics in addition to auto-graded tests and lecture slide reviews. Preview us at Create a web page for your course using our resources! This Web page generation software, free to adopters, is designed to help professors develop a Web page for their courses. In just a few minutes, a rich Web page will be created. Simply type your material into the template provided and PageOut! instantly converts it to HTMLa universal Web language. Next, choose your favorite of 16 easy-to-navigate designs and your Web homepage is created complete with online syllabus, lecture notes, and bookmarks. You can even include a separate instructor page and an assignment page. PageOut! offers enhanced point-and-click features including a Syllabus Page that applies real-world links to original text material, an automated grade book, and a discussion board where instructors and students can exchange questions and post announcements. PageOut! Lite is a simple, more accessible, albeit limited, version of PageOut! Any textbook adoption of 200 copies or more will receive one-on-one time with a Product Spet, who will help set up a custom course PageOut! Web site. | v v PageOut! | e-Text Main Menu | Textbook Table of Contents | Study Guide Table of Contents Acknowledgments O BORROW A PHRASE, writing an introductory finance textbook is easyall you do is sit down at a word processor and open a vein. We never would have completed this book without the incredible amount of help and support we received from literally hundreds of our colleagues, students, editors, family members, and friends. We would like to thank, without implicating, all of you. Clearly, our greatest debt is to our many colleagues (and their students) who, like us, wanted to try an alternative to what they were using and made the decision to change. Needless to say, without this support, we would not be publishing a fifth edition! A great many of our colleagues read the drafts of our first and subsequent editions. The fact that this book has so little in common with our earliest drafts along with the many changes and improvements we have made over the years is a reflection of the value we placed on the many comments and suggestions that we received. To the following reviewers, then, we are grateful for their many contributions: T Robert Benecke Scott Besley Sanjai Bhaghat William Brent Ray Brooks Charles C. Brown Mary Chaffin Charles M. Cox Michael Dorigan Michael Dunn Steve Engel Cheri Etling Adrian C. Edwards Thomas H. Eyssell Michael Ferguson Deborah Ann Ford Jim Forjan Micah Frankel Jennifer R. Frazier A. Steven Graham Darryl E. J. Gurley David Harraway John M. Harris, Jr. R. Stevenson Hawkey Delvin D. Hawley Robert C. Higgins Steve Isberg James Jackson James M. Johnson Randy Jorgensen Jarl G. Kallberg David N. Ketcher Jim Keys Robert Kleinman David Kuipers Morris A. Lamberson John Lightstone Jason Lin Robert Lutz Timothy Manuel David G. Martin Dubos J. Masson Gordon Melms Richard R. Mendenhall Wayne Mikkelson Lalatendu Misra Karlyn Mitchell Michael J. Murray Megan Partch Samuel Penkar Pamela P. Peterson Robert Phillips George A. Racette Narendar V. Rao Russ Ray Ron Reiber Jay R. Ritter Ricardo J. Rodriguez Gary Sanger Martha A. Schary Robert Schwebach Roger Severns Dilip K. Shome Neil W. Sicherman Timothy Smaby Charlene Sullivan George S. Swales, Jr. John G. Thatcher Harry Thiewes A. Frank Thompson Joseph Trefzger Michael R. Vetsuypens Joe Walker James Washam Alan Weatherford Marsha Weber Jill Wetmore Mark White Annie Wong David J. Wright Steve B. Wyatt Michael Young J. Kenton Zumwalt Tom Zwirlein Several of our most respected colleagues contributed original essays, 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 Michael C. Jensen Harvard University Robert C. Merton Harvard University Merton H. Miller University of Chicago Jay R. Ritter University of Florida Richard Roll University of California at Los Angeles Clifford W. Smith, Jr. University of Rochester Charles W. Smithson CIBC Wood Grundy Samuel C. Weaver Hershey Foods Corporation | v v xix | e-Text Main Menu | Textbook Table of Contents | Study Guide Table of Contents xx Acknowledgments We also owe special thanks to the recent graduates and future leaders who contributed their own In Their Own Words boxes: Jennifer Bloomberg Western International Media Angela Fisher ALLTEL Information Services Kurt Johnson General Mills, Inc. Kerry McDermott Freedman, Billings, and Ramsey & Company Chris OCull Deloitte & Touche LLP Tal Plotkin DeWalt Industrial Power Tools | v v We owe a special, and continuing, debt to Thomas H. Eyssell of the University of Missouri. As in the past, Tom has done yeomans work on the many supplements that accompany this book, including the Instructor s Manual, Student Problem Manual, Transparency Acetates, PowerPoint Presentation System, and Ready Notes. Tom 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, international notes, ethics notes, and lecture tips. Also, Tom hosts the official RWJ Home Page (at Our home page will have Toms tip of the week along with suggestions from adopters around the world. Stop by and say hello! We also thank Randy D. Jorgensen of the Creighton University for his efforts. Randy worked closely with us to develop the many vignettes and realworld examples we have added to this edition. He also created the questions on the Self-Study CD-ROM. David R. Kuipers of Texas Tech University did a great job completely revising, reorganizing, and extending the very extensive testbank. The following University of Kentucky doctoral students did outstanding work on this edition of Fundamentals: Ernest M. Biktimirov, Daniel J. Bradley, John K. Paglia, Ivan C. Roten, and Joseph C. Smolira. 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 unwa- | e-Text Main Menu | vering support a great organization, Irwin/McGrawHill. We especially thank the Irwin/McGraw-Hill sales 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. Of this group, we should particularly recognize the dedicated Finance Spets, including Lorna Brown, Martina Downey, Art Levine, Nick Miggans, Nancy Peterson, and Maryellen Krammer. We are deeply grateful to the select group of professionals who served as our development team on this edition: Randall Adams, Senior Sponsoring Editor; Michele Janicek, Development Editor; Katie Rose Matthews, Senior Marketing Manager; Craig Beytien, Publisher; Jean Lou Hess, Senior Project Manager; Michael Warrell, Design Manager; and Lori Koetters, Production Supervisor. At the risk of playing favorites, we have to especially recognize Michele and Katie. Not many authors experience the true luxury of having a great development editor and a great marketing manager at the same time! Of course, you never forget your first editor (especially ours), so we thank Mike Junior, now Vice President/Editor-in-Chief, for his enthusiasm and support over the years. Others at Irwin/McGrawHill, 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 will 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 EditorialFinance, Irwin/McGraw-Hill, 1333 Burr Ridge Parkway, Burr Ridge, IL 60521. Textbook Table of Contents Stephen A. Ross Randolph W. Westerfield Bradford D. Jordan | Study Guide Table of Contents ...
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