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A first course in corporate finance

A First Course in
Corporate Finance
Preview, Sunday 5th February, 2006


A First Course in Corporate Finance
© 2003–2006 by Ivo Welch. All rights reserved.
Cartoons are copyright and courtesy of Mike Baldwin. See http://www.cornered.com/.
ISBN: no number yet.
Library of Congress: no number yet.
Book Website: http://welch.econ.brown.edu/book
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Printed: Sunday 5th February, 2006 (from bookc.tex).

Warning: This book is in development.
It is not error-free.


A First Course in
Corporate Finance
Preview, Sunday 5th February, 2006

Ivo Welch
Professor of Finance and Economics
Yale University


There are a large number of individuals who have helped me with this book. They will eventually be thanked here.
Until then, some random collection: Rick Antle. Donna Battista. Randolph Beatty. Wolfgang Bühler. Kangbin Chua.
Diego Garcia. Stan Garstka. Roger Ibbotson. Ludovic Phalippou. Matthew Spiegel. John Strong. Julie Yufe. Many
anonymous victim students using earlier error-ridden drafts. Most importantly, Mary-Clare McEwing helped me
improve the book.
Most of the review comments on early version of this book were very good, and I have tried hard to use them all.
Thanks to the reviewers, who really gave a lot of their valuable time and thoughts to help me.

Tony Bernardo
Bill Christie
Jennifer Conrad
Josh Coval
Amy Dittmar
Richard Fendler

Diego Garcia
Sharon Garrison

James Gatti
Simon Gervais
Tom Geurtz
Robert Hansen
Milt Harris
Ronald Hoffmeister
Kurt Jesswin

Mark Klock

Tim Sullivan

Angeline Lavin

Chris Stivers

Joseph McCarthy

Mark Stohs

Michael Pagano

John Strong

Mitch Petersen

Joel Vanden

Sarah Peck

Jaime Zender

Robert Ritchey

Miranda (Mei) Zhang

Bruce Rubin

A list of articles upon which the ideas in the book are based, and a list of articles that describe current ongoing
academic research will eventually appear on the book’s website.

Warning: This book is in development.
It is not error-free.

Dedicated to my parents, Arthur and Charlotte.

last file change: Jan 23, 2006 (07:01h)


i

A Quick Adoption Checklist For Instructors
This is the recommended checklist for this book (AFCICF) while the book is in beta test mode. This
checklist will not apply after AFCICF is published (with full supplementary materials) by AddisonWesley-Pearson.
✓ Read this prologue and one or two sample chapters to determine whether you like the AFCICF
approach. (Although not representative, I recommend that you also read the epilogue.)
If you do like the AFCICF approach, then please continue. If you do not like AFCICF (or the chapters
you read), please email ivo_welch@brown.edu why you did not like it. I promise I will not shoot
the messenger: I want to learn how to do it better.

✓ Continue to assign whatever other finance textbook you were planning to use, just add AFCICF.
Use it as a supplementary text, or assign just a few chapters.
• Although AFCICF is a full-service textbook for an introductory finance course, it should also work
well as a complement to an existing textbook. Your students should relatively easily benefit from
having access to both, because this book is both different from and similar to the competition. I
believe that relative to relying only on your old textbook, AFCICF will not increase, but decrease
your student’s confusion and workload.
• Take the low risk route and see how well AFCICF works! (Take the Pepsi challenge!) Keeping your
old textbook is also your insurance against using a novel textbook. And it will make students less
critical of the remaining shortcomings in AFCICF, such as the limited number of exercises (and
their occasionally erroneous solutions). Perhaps most importantly, AFCICF does not yet have full
supplementary materials. It will when Addison-Wesley will publish it, but until then, the auxiliary
materials from other textbooks may help.
• For now, students can download the book chapters, so there is no printing cost involved. Affordability should not be a concern.
• It should be a relatively simple matter to link AFCICF chapters into your curriculum, because
the chapters are kept relatively straightforward and succinct.

You cannot go wrong if you try out at least a few chapters of AFCICF in this manner.
✓ You can receive permission to post the electronic AFCICF on your class website. (The website
must be secured to allow only university-internal distribution.) Students can carry the files on
their notebook computers with them.
✓ You can ask your copy center to print and bind the version on your website. You can also obtain
a nicely printed and bound version for $40 from lulu.com.
• Although versions on the AFCICF website at http://welch.econ.brown.edu/book will always have
some improvements, it is a good idea for each class to agree on one definitive reference version.

✓ If you are using AFCICF and you are looking for lecture notes, feel free to “steal” and adapt my
lecture notes (linked at http://welch.econ.brown.edu/book) to your liking. You can change and
modify the lecture notes anyway you like, without copyright restrictions.
✓ Of course, I hope that the majority of your students (and you) will prefer reading AFCICF instead
of your old textbook. At the end of the course, please ask your students which textbook they
found more helpful. Please email your conclusions and impressions to ivo.welch@yale.edu. Any
suggestions for improvement are of course also very welcome. Any feedback would be appreciated,
but it would be particularly helpful for me to learn in what respects they prefer their other textbook.


ii

To The Instructor
This book is
intentionally different.

Most corporate financce textbooks cover a similar canon of concepts, and this textbook is no
exception. A quick glance at the Table of Contents will show you that most—though not all—of
the topics in A First Course in Corporate Finance overlap with those in traditional finance
textbooks. But this does not mean that this book is not different. Although I cover similar
conceptual territory, there are also important departures.
Approach Innovations
So, here is my view of how this book differs from what is currently out there. I do not claim
that other traditional textbooks do not teach any of what I will list, but I do maintain that my
emphasis on these points is much stronger than what you will find elsewhere.

Conversational Tone.

Conversational Tone The tone is informal and conversational, which (I hope) makes the subject more accessible.

The method of
instruction is
“step-by-step numerical
examples.”

Numerical-Example Based I learn best by numerical example, and firmly believe that students
do, too. Whenever I want to understand an idea, I try to construct numerical examples
for myself (the simpler, the better). I do not particularly care for long algebra or complex
formulas, precise though they may be. I do not much like many diagrams with long textual
descriptions but no specific examples, either—I often find them too vague, and I am never
sure whether I have really grasped the whole mechanism by which the concept works.
Therefore, I wanted to write a textbook that relies on numerical examples as its primary
tutorial method.
This approach necessitates a rearrangement of the tutorial textbook progression. Most
conventional finance textbooks start with a bird’s eye view and then work their way down.
The fundamental difference of this book is that it starts with a worm’s eye view and
works its way up. The organization is built around critical question like “What would it be
worth?,” which is then answered in numerical step-by-step examples from first principles.
Right under numerical computations are the corresponding symbolic formulas. In my
opinion, this structure clarifies the meaning of these formulas, and is better than either
an exclusively textual or algebraic exposition. I believe that the immediate duality of
numerics with formulas will ultimately help students understand the material on a higher
level and with more ease. (Of course, this book also provides some overviews, and ordinary
textbooks also provide some numerical examples.)

Students should have a
method of thinking, not
just formulas.

Problem Solving An important goal of this book is to teach students how to approach new
problems that they have not seen before. Our goal should be send students into the real
world with the analytical tools that allow them to disect new problems, and not just with a
chest full of formulas. I believe that if students adopt the numerical example method—the
“start simple and then generalize” method—they should be able to solve all sorts of new
problems. It should allow them to figure out and perhaps even generalize the formulas
that they learn in this book. Similarly, if students can learn how to verify others’ complex
new claims with simple examples first, it will often help them to determine whether the
emperor is wearing clothes.

We build a foundation
first—so we are deeper!

Deeper, Yet Easier I believe that formulaic memorization is ultimately not conducive to learning. In my opinion, such an alternative “canned formula” approach is akin to a house
without a foundation. Yes, it may be quicker to build. It may work for a while. But there
is always the risk of collapse. Shoring up the house later is also more costly than building
it right to begin with.
Giving students the methods of how to think about problems and then showing them
how to develop the formulas themselves will make finance seem easier and simpler in
the end, even if the coverage is conceptually deeper. In my case, when I haved learned
new subjects, I have often found it especially frustrating if I understand a subject just
a little but I also suspect that the pieces are really not all in place. A little knowledge


iii
can also be dangerous. If I do not understand where a formula comes from, how would I
know whether I can or cannot use it in a new situation? And I believe that even average
students can understand the basic ideas in finance and with it where the formulas have
come from.
Brevity Sometimes, less is more.
This book is intentionally concise, even though it goes into more theoretical detail than
other books! Institutional descriptions are short. Only the concepts are explained in great
detail.

Brevity is important.
The book focus is on
explanations, not
institutions.

My view is that when students are exposed to too much material, they won’t read it, they
won’t remember it, and they won’t know what is really important and what is not. Ten
years after our students graduate, they should still solidly remember the fundamental
ideas of finance, be able to look up the details when they need them, and be able to solve
new (financial) problems. Many institutional details will have changed, anyway—it is the
ideas, concepts, and tools that will last longer.
Self-Contained for Clarity Finance is a subject that every student can comprehend, regardless
of background. It is no more difficult than economics or basic physics. But, it is often
a problem that many students come into class with a patchwork on knowledge. We, the
instructors, then often erroneously believe the students have all the background covered.
Along the way, such students get lost. It is easy to mistake such them for “poor students,”
especially if there is no reference source, where they can quickly fill in the missing parts.

Self-contained means
students can backtrack.

In this book, I try to make each topic’s development as self-contained as possible. I
try to explain everything from first principles, but in a way that every student can find
interesting. For example, even though the necessary statistical background is integrated
in the book for the statistics novice, the statistics-savvy student also should find value
in reading it. This is because statistics is different in our finance context than when it is
taught for its own sake in a statistics course.
Closer Correspondence with the Contemporary Curriculum I believe that most finance core
courses taught today follow a curriculum that is closer in spirit to this book—and more
logical—than it is to the order in older, traditional finance textbooks. In the places where
this book covers novel material (see below), I hope that you will find that the new material
has merit—and if you agree, that covering it is much easier with this book than with earlier
books.

Less Chapter Reordering.

Topical Innovations
The book also offers a number of topical and expositional innovations. Here is a selection:
Progression to Risk and Uncertainty The book starts with a perfect risk-free world, then adds
horizon-dependent interest rates, uncertainty under risk neutrality, imperfect market frictions (e.g., taxes), uncertainty under risk-aversion, and finally uncertainty under risk aversion and with taxes (e.g., WACC and APV).
Frictions (Ch6):
PV0 =

 
Perfect World (Ch2):
CF2
CF1
+
+ ...
PV0 =
1+r
(1 + r )2







 




Often Meaningless.
 Various Modifications.





Corporate Taxes (Ch18):

Uncertainty (Ch5):
PV0 =

E (CF2 )
E (CF1 )
+
+ ...
1 + E (˜
r1 )
1 + E (˜
r0,2 )

 


 
 

Horizon-Dependent Rates (Ch4):
CF1
CF2
PV0 =
+
+ ...
1 + r0,1
1 + r0,2

First, no risk; then
risk-neutral attitudes to
risk; then risk-averse
attitudes to risk.





E (CF1,FM )
+
PV0 =
1 + E (˜
r1,EQ ) + (1 − τ) · E (˜
r1,DT )
...





 


 
 

Risk-Aversion (Part III):
PV0 =

E (CF1 )
+ ...
1 + r1,F + [E (˜
r1,M ) − r1,F ] · βi,M


iv
Each step builds on concepts learned earlier. I believe it is an advantage to begin simply
and then gradually add complexity. The unique roles of the more difficult concepts of risk
measurement, risk-aversion, and risk-aversion compensation then become much clearer.
(There are some forward hints in the text that describe how the model will change when
the world becomes more complex.)
Drive home “default
risk.”

A Strong Distinction between Expected and Promised Cash Flows I have always been shocked
by how many graduating students think that a Boston Celtics bond quotes 400 basis points
in interest above a comparable Treasury bond because of the risk-premium, which they
can calculate using the CAPM formula. Learning to avoid this fundamental error is more
important than fancy theories: the main reason why the Boston Celtics bond promises 400
extra basis points is, of course, primarily its default risk (compensation for non-payment),
not a risk-premium (compensation for risk-averse investors that comes from the correlation with the market rate of return). And for bonds, the latter is usually an order of
magnitude smaller than the former. The CAPM can definitely not be used to find the 400
basis points. Although many instructors mention this difference at some point, 5 minutes of default risk discussion is often lost in 5 hours worth of CAPM discussion. But if
students do not understand the basic distinction, the 5 hours of CAPM discussion are not
only wasted but will have made matters worse!
Traditional textbooks have not helped, because they have not sufficiently emphasized the
distinction. In contrast, in this book, default risk is clearly broken out. The difference
between quoted (promised) and expected returns, and quoted default compensation and
risk compensation are important themes carried throughout.

Understand accounting
without being an
accounting textbook.

Financials from a Finance Perspective Finance students need to solidly understand the relationship between financial statements and NPV. They need to understand the basic relationships in order to construct pro formas. Yet, when I was writing this book, I could not
find good, concise, and self-contained explanations of the important aspects and logic of
accounting statements from a finance perspective. Consequently, this book offers such a
chapter. It does not just show students some financial statements and names the financial items; instead, it makes students understand how the NPV cash flows are embedded
in the accounting statements.
A fundamental understanding of financials is also necessary to understand comparables:
for example, students must know that capital expenditures must be subtracted out if
depreciation is not. (Indeed, the common use of EBITDA without a capital expenditures
adjustment is often wrong. If we do not subtract out the pro-rated expense cost, we
should subtract out the full expenses. Factories and the cash flows they produce do not
fall from heaven.)
Pro Formas In any formal financial setting, professionals propose new projects—whether it is
the expansion of a factory building within a corporation, or a new business for presentation to venture capitalists—through pro formas. A good pro forma is a combination
of financial expertise, business expertise, and intuition. Both art and science go into its
construction. The book’s final chapter, our capstone towards which the book works, is
the creation of such a pro forma. It combines all the ingredients from earlier chapters—
capital budgeting, taxes, the cost of capital, capital structure, and so on.
Robustness The book looks at the robustness of our methods—the relative importance of
errors and mistakes—and what first-order problems students should worry about and
what second-order problems they can reasonably neglect.
A Newer Perspective on Capital Structure The academic perspective about capital structure
has recently changed. A $1 million house that was originally financed by a 50% mortgage
and then doubles in value now has only a 25% debt ratio. In analogous fashion, Chapter 20
shows how stock price movements have drastically changed the debt ratio of IBM from
2001 to 2003. Students can immediately eyeball the relative importance of market influences, issuing and other financial activities. The corporate market value changes are an
important and robust factor determining capital structure—at least equal in magnitude


v
to factors suggested in academic theories involving the pecking order or tradeoffs. Moreover, we now know that most new equity shares appear in the context of M&A activity and
as executive compensation, not in the context of public equity offerings. Part IV of our
book explains what the known first-order determinants of capital structure are, what the
(important) second-order determinants are, and what the factors still under investigation
are.
Many Other Topical Improvements For example, the yield curve gets its own chapter even
before uncertainty is described in much detail, so that students understand that projects
over different time horizons can offer different rates of return even in the absence of risk.
There is a self-contained chapter on comparables as a valuation technique—a technique
that many of our students will regularly have to use after they graduate. The corporate
governance chapter has a perspective that is darker than it is in other textbooks. WACC,
APV, and direct pro forma construction all incorporate the tax advantage of debt into
valuation. This is bread-and-butter for CFOs. This book offers a clear explanation of how
these methods usually come to similar results (and when not!). Throughout the book, I
try to be open and honest about where our knowledge is solid and where it is shaky—and
how sensitive our estimates are to the errors we inevitably commit.

...and many more.

Although most of our curriculums are similar in their coverage of the basics, time constraints
usually force us to exclude some topics. Your preferences as to what to cut may differ from
mine. For example, I find the financials part very important, because this is what most of
our graduates will do when they become analysts, brokers, or consultants. However, you may
instead prefer to talk more about international finance. It is of course impossible to satisfy
everyone—and instructors have always chosen their own favorites, adding and deleting topics
as they see fit.

Webchapters will allow
a-la-carte choice.

This book tries to accomodate some choice. Some chapters are available on the Web site (“Web
Chapters”) accompanying this book. Chapter style and formatting are unmistakably identical
to the book itself. Every instructor can therefore choose his/her own favorite selection and
ask students to download it. These chapters are free and access is easy. The menu right now
contains the following chapters:
Real Options Real options are briefly covered in Chapter 7 in the text, but not in great detail.
This web chapter shows how to use spreadsheets, time-series analysis, Monte Carlo simulation, and optimization to determine the value of a plant that can shut down and reopen
(for a cost) as output prices fluctuate.
Option and Derivative Pricing This is a difficult subject to cover in an introductory course,
because it really requires a minimum of 4-6 class sessions to do it well. This chapter
tries to help you cover the basics in 2-3 class sessions. It explains option contracts, static
arbitrage relations (including put-call parity), dynamic arbitrage and the Black-Scholes
formula, and binomial trees.
International Finance This chapter explains the role of currency translations and international
market segmentation for both investments and corporate budgeting purposes.
Ethics This chapter is experimental—and provocative. There is neither a particular set of mustcover topics nor a template on how to present this material. Your choices and views may
differ from mine. However, I believe that ethical considerations are too important for
them never to be raised.
Capital Structure Event Studies This chapter describes the evidence (up-to-2003!) of how the
stock market reacts to the announcements of new debt offerings, new equity offerings,
and dividend payments.
The title of the book is optimistic. A one-quarter course cannot cover the vast field that our
profession has created over the last few decades. The book requires at least a one semester
course, or, better yet, a full two-quarter sequence in finance—although the latter may prefer
the “general survey” version of this book, which goes into more detail in the investments part.


vi
I hope that this book will become your first choice in finance textbooks. If you do not like it,
please drop me an email to let me know where it falls short. I would love to learn from you.
(And even if I do disagree, chances are that your comments will influence my next revision.)
Side Note: If you use this book or some chapters therefrom, please permit me to use and post your homework
and exam questions with answers. (Of course, this is not a requirement, only a plea for help.) My intent is for
the Website to become collaborative: you will be able to see what other faculty do, and they can see what you
do. The copyright will of course remain with you.

To The Student
Prerequisites
This book and the
subject itself are tough,
but they are not
forbidding, even to an
average student. The
main prerequisite is
mathematical aptitude,
but not mathematical
sophistication.

What do you need to understand this book? You do not need any specific background in finance. You do need to be thoroughly comfortable with arithmetic and generally comfortable
with algebra. You do need mathematical aptitude, but no knowledge of advanced mathematical constructs, such as calculus. Knowledge of statistics would be very helpful, but I will
explain the relevant concepts when the need arises. You should own a $20 scientific calculator. (Financial calculators are not bad but also not necessary.) You should learn how to
operate a spreadsheet (such as Excel in Microsoft’s Office or the free OpenCalc spreadsheet in
OpenOffice). The financial world is moving rapidly away from financial calculators and toward
computer spreadsheets—it is easier to work with information on a large screen with a 2,000
MHz processor than on a small 2-line display with a 2MHz processor. Because I have tried hard
to keep the book self-contained and to explain everything from first principles, you should not
need to go hunting for details in statistics, economics, or accounting textbooks. But this is not
to say that you do not need to take courses in these disciplines: they have way more to offer
than just background knowledge for a finance textbook.

Jargon can trip up the
reader.

One word of caution: the biggest problem for a novice of any field, but especially of finance,
is jargon: the specialized terminology known only to the initiated. Worse, in finance, much
jargon is ambiguous. Different people may use different terms for the same thing, and the
same term may mean different things to different people. You have been warned! This book
attempts to point out such ambiguous usage. Luckily, the bark of jargon is usually worse than
its bite. It is only a temporary barrier to entry into the field of finance.
How to Read The Book

This book is concise,
focusing on the essence
of arguments.

This textbook is concise. I wants to communicate the essential material in a straightforward
(and thus compact), but also conversational (and thus more interactive) and accessible fashion.
There are already many finance textbooks with over a thousand pages. Much of the content of
these textbooks is interesting and useful but not essential to an understanding of finance. (I
personally find some of this extra content distracting.)

The layout of the book.

The book is organized into four parts: the basics consist of return computations and capital
budgeting. Next are corporate financials, then investments (asset pricing), and financing (capital
structure). Major sections within chapters end with questions that ask you to review the points
just made with examples or questions similar to those just covered. You should not proceed
beyond a section without completing these questions (and in “closed book” format)! Many,
but not all, questions are easy and/or straightforward replications of problems that you will
have just encountered in the chapter. Others are more challenging. Each chapter ends with
answers to these review questions. Do not move on until you have mastered these review
questions. (The published version of this book will contain many more student questions, and
there will be a separate student testbank.)


vii
There are “annotations” on the left side of most paragraphs throughout the text. Suggestion:
use the remaining white space in the margin to scribble your own notes, preferably in pencil
so that you can revise them.

This is an annotation.

Especially important concepts that you should memorize are in red boxes:

These are other notices.

Important: This is an important point to remember.

Interesting, related points that either interrupt the flow of an argument, or that are not absolutely necessary are marked
Side Note:
This is an interesting related note, not crucial for understanding the material. It is usually not
excessively technical.

More detailed technical points are “digging-deeper notes,” which should be of interest only to
the student who is interested in pursuing finance beyond the introductory course:
Digging Deeper:
excessive algebra.

If you are really interested, here is a curious fact or a derivation that most likely relies on

Both can be safely omitted from reading without compromising understanding. Sometimes, an
appendix contains further advanced material.
A final warning: I have a strange sense of humor. Please do not be easily turned off.

Sense of Humor

Other Readings
This book cannot do it all. It is important for you to keep up with current financial developments. Frequent reading of the financial section of a major newspaper (such as the New
York Times [N.Y.T.]), the Wall Street Journal [W.S.J.], or the Financial Times [F.T.] can help,
as can regular consumption of good business magazines, such as The Economist or Business
Week. (See the website at http://welch.econ.brown.edu/book for more useful resource links.)
Although this is not a book on “how to read and understand the newspaper,” you should be
able to understand most of the contents of the financial pages after consuming this textbook.
You should also know how to cruise the web—sites such as Yahoo!Finance contain a wealth of
useful financial information. Yahoo!Finance is also used extensively in this book.

Advice: Follow current
coverage of financial
topics elsewhere!


viii


TABLE OF CONTENTS

ix

(This particular printout is of a version that contains questions and notes to reviewers, and the
book itself ends early—covering only the more polished and edited chapters. However, the following table of contents corresponds to the complete and standard version of the book. Consequently,
the page numbers are not correct. A parenthesized chapter title means that the chapter has not
yet been completed.)

Table of Contents

I

Investments and Returns

1

Chapter 1: A Short Introduction
1·1
1·2
1·3

5

The Goal of Finance: Relative Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Learning How to Approach New Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
The Main Parts of This Book . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Chapter 2: The Time Value of Money
2·1

2·2
2·3

2·4

2·5

9

Basic Definitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2·1.A.

Investments, Projects, and Firms

2·1.B.

Loans and Bonds

2·1.C.

U.S. Treasuries

3·2

11
12

Returns, Net Returns, and Rates of Return . . . . . . . . . . . . . . . . . . . . . . . . . . . .
The Time Value of Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2·3.A.

The Future Value of Money

2·3.B.

Compounding

2·3.C.

Confusion: Interest Rates vs. Interest Quotes

12
15

15

15
19

Capital Budgeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2·4.A.

Discount Factor and Present Value (PV)

2·4.B.

Net Present Value (NPV)

21

21

23

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

27

31

Separating Investment Decisions and Present Values From Other Considerations . . . .
3·1.A.

Does It Matter When You Need Cash?

3·1.B.

Corporate Valuation: Growth as Investment Criteria?

3·1.C.

The Value today is just “All Inflows” or just “All Outflows”

32

32
33
34

Perpetuities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3·2.A.

The Simple Perpetuity Formula

3·2.B.

The Growing Perpetuity Formula

3·2.C.

A Growing Perpetuity Application: Individual Stock Valuation with Gordon Growth Models

3·3

10

10

Chapter 3: More Time Value of Money
3·1

6
7
8

36

36
37

39

The Annuity Formula . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

41


x

TABLE OF CONTENTS
3·3.A.

An Annuity Application: Fixed-Rate Mortgage Payments

3·3.B.

An Annuity Example: A Level-Coupon Bond

41

42

3·4

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

45

a

Advanced Appendix: Proofs of Perpetuity and Annuity Formulas . . . . . . . . . . . . . .

48

Chapter 4: Investment Horizon, The Yield Curve, and (Treasury) Bonds

49

4·1
4·2
4·3

4·4

Time-Varying Rates of Return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Annualized Rates of Return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
The Yield Curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
4·3.A.

An Example: The Yield Curve in May 2002

4·3.B.

Compounding With The Yield Curve

4·3.C.

Yield Curve Shapes

4·5

Valuing A Coupon Bond With A Particular Yield Curve

5·2

5·3

5·4

61

62

The Yield To Maturity (YTM) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Optional Bond Topics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
4·7.A.

Extracting Forward Interest Rates

4·7.B.

Shorting and Locking in Forward Interest Rates

4·7.C.

Bond Duration

4·7.D.

Continuous Compounding

64
66

66
68

70
74

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Chapter 5: Uncertainty, Default, and Risk
5·1

58

59

The Effect of Interest Rate Changes on Short-Term and Long-Term Treasury Bond Values

4·8

57

Why is the Yield Curve not Flat? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
4·5.A.

4·6
4·7

54

56

Present Values With Time-Varying Interest Rates . . . . . . . . . . . . . . . . . . . . . . . .
4·4.A.

50
51
54

79

An Introduction to Statistics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
5·1.A.

Random Variables and Expected Values

5·1.B.

Risk Neutrality (and Risk Aversion Preview)

75

80

80
82

Interest Rates and Credit Risk (Default Risk) . . . . . . . . . . . . . . . . . . . . . . . . . . .
5·2.A.

Risk-Neutral Investors Demand Higher Promised Rates

5·2.B.

A More Elaborate Example With Probability Ranges

5·2.C.

Preview: Risk-Averse Investors Have Demanded Higher Expected Rates

85
87

Uncertainty in Capital Budgeting, Debt, and Equity . . . . . . . . . . . . . . . . . . . . . . .
5·3.A.

Present Value With State-Contingent Payoff Tables

5·3.B.

Splitting Project Payoffs into Debt and Equity

84

84

89

89

92

Robustness: How Bad are Your Mistakes? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100
5·4.A.

Short-Term Projects

100

5·4.B.

Long-Term Projects

100

5·5

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101

a

Appendix: A Short Glossary of Some Bonds and Rates . . . . . . . . . . . . . . . . . . . . . 105

Chapter 6: Dealing With Imperfect Markets
6·1

6·2

6·3

109

Causes and Consequences of Imperfect Markets . . . . . . . . . . . . . . . . . . . . . . . . . 110
6·1.A.

Perfect Market Assumptions

6·1.B.

Value in Imperfect Markets

6·1.C.

Perfect, Competitive, and Efficient Markets

110
111
111

The Effect of Disagreements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115
6·2.A.

Expected Return Differences vs. Promised Return Differences

6·2.B.

Corporate Finance vs. Entrepreneurial or Personal Finance?

6·2.C.

Covenants, Collateral, and Credit Rating Agencies

115
116

117

Market Depth and Transaction Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121
6·3.A.

Typical Costs When Trading Real Goods—Houses

121


TABLE OF CONTENTS

6·4

6·5

6·6

6·7

6·8

xi

6·3.B.

Typical Costs When Trading Financial Goods—Stocks

122

6·3.C.

Transaction Costs in Returns and Net Present Values

124

6·3.D.

Liquidity

125

An Introduction to The Tax Code . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126
6·4.A.

The Basics of (Federal) Income Taxes

6·4.B.

Before-Tax vs. After-Tax Expenses

6·4.C.

Average and Marginal Tax Rates

6·4.D.

Dividend and Capital Gains Taxes

6·4.E.

Other Taxes

6·4.F.

What You Need To Know About Tax Principles In Our Book

126

128
129
129

130
131

Working With Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 132
6·5.A.

Taxes in Rates of Returns

6·5.B.

Tax-Exempt Bonds and the Marginal Investor

6·5.C.

Taxes in NPV

6·5.D.

Tax Timing

132
132

133
135

Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 136
6·6.A.

Defining the Inflation Rate

6·6.B.

Real and Nominal Interest Rates

6·6.C.

Handling Inflation in Net Present Value

6·6.D.

Interest Rates and Inflation Expectations

136
137
139
140

Multiple Effects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 142
6·7.A.

How to Work Problems You Have Not Encountered

6·7.B.

Taxes on Nominal Returns?

142

143

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145

Chapter 7: Capital Budgeting (NPV) Applications and Advice
7·1

7·2
7·3
7·4
7·5
7·6
7·7

The Economics of Project Interactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 152
7·1.A.

The Ultimate Project Selection Rule

7·1.B.

Project Pairs and Externalities

7·1.C.

One More Project: Marginal Rather Than Average Contribution

152

153

Comparing Projects With Different Lives and
Expected, Typical, and Most Likely Scenarios
Future Contingencies and Real Options . . .
Mental Biases . . . . . . . . . . . . . . . . . . .
Incentive (Agency) Biases . . . . . . . . . . . .
Summary . . . . . . . . . . . . . . . . . . . . . .

Rental Equivalents .
. . . . . . . . . . . . .
. . . . . . . . . . . . .
. . . . . . . . . . . . .
. . . . . . . . . . . . .
. . . . . . . . . . . . .

Chapter 8: Other Important Capital Budgeting Topics
8·1
8·2

8·3
8·4

8·5

151

155

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160
162
163
165
166
170

173

Profitability Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174
The Internal Rate of Return (IRR) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175
8·2.A.

Definition

8·2.B.

Problems with IRR

175
176

So Many Returns: The Internal Rate of Return, the Cost of Capital, the Hurdle Rate, and
the Expected Rate of Return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178
Other Capital Budgeting Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179
8·4.A.

The Problems of Payback

8·4.B.

More Rules

179

180

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 181


xii

TABLE OF CONTENTS

II

Corporate Financials

183

Chapter 9: Understanding Financial Statements
9·1

Financial Statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 188
9·1.A.

The Contents of Financials

9·1.B.

PepsiCo’s 2001 Financials

9·1.C.

Why Finance and Accounting Think Differently

9·2

189
195
196

The Bottom-Up Example — Long-Term Accruals (Depreciation) . . . . . . . . . . . . . . . 198
9·2.A.

Doing Accounting

9·2.B.

Doing Finance

9·2.C.

Translating Accounting into Finance

9·3

198

201
202

The Hypothetical Bottom-Up Example — Short-Term Accruals . . . . . . . . . . . . . . . . 205
9·3.A.

Working Capital

9·3.B.

Earnings Management

9·4
9·5

205
207

Completing the Picture: PepsiCo’s Financials . . . . . . . . . . . . . . . . . . . . . . . . . . . 209
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 214

A

B

187

Appendix: Supplementary Financials — Coca Cola . . . . . . . . . . . . . . . . . . . . . . . 215
a.

Coca Cola’s Financials From EdgarScan

b.

Coca Cola’s Financials From Yahoo!Finance

216
217

Appendix: Abbreviated PepsiCo Income Statement and Cash Flow Statement . . . . . . . 218

Chapter 10: Valuation From Comparables
10·1
10·2

10·3

10·4

223

Comparables vs. NPV . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 224
The Price-Earnings (PE) Ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225
10·2.A.

Definition

10·2.B.

Why P/E Ratios differ

10·2.C.

P/E Ratio Application Example: Valuing Beverage Companies

225
226
234

Problems With P/E Ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 235
10·3.A.

Selection of Comparison Firms

10·3.B.

(Non-) Aggregation of Comparables

10·3.C.

A Major Blunder: Never Average P/E ratios

10·3.D.

Computing Trailing Twelve Month (TTM) Figures

10·3.E.

Leverage Adjustments For P/E Ratios

236
237
238
240

241

Other Financial Ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 245
10·4.A.

Value-Based Ratios

10·4.B.

Non-Value-Based Ratios Used in Corporate Analyses

245
246

10·5
10·6

Closing Thoughts: Comparables or NPV? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 251
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 252

A

Advanced Appendix: A Formula For Unlevering P/E ratios . . . . . . . . . . . . . . . . . . . 253


TABLE OF CONTENTS

III

xiii

Risk and the Opportunity Cost of Capital / Abbre257
viated Investments

Chapter 11: A First Look at Investments
11·1

261

Stocks, Bonds, and Cash, 1970–2004 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 262
11·1.A.

Graphical Representation of Historical Stock Market Returns

11·1.B.

Comparative Investment Performance

11·1.C.

Comovement, Beta, and Correlation

11·2
11·3
11·4

262

266
270

Visible and General Historical Stock Regularities . . . . . . . . . . . . . . . . . . . . . . . . 272
History or Opportunities? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 273
Eggs and Baskets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 274
11·4.A.

The Overall Basket

11·4.B.

The Marginal Risk Contribution

11·4.C.

The Market Equilibrium

11·5

274
275

275

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 276

A

Appendix: Some Background Information About Equities Market Microstructure . . . . 277
a.

Brokers

b.

Exchanges and Non-Exchanges

c.

How Securities Appear and Disappear

277
277
278

Chapter 12: Investor Choice: Risk and Reward
12·1

12·2

Measuring Risk and Reward . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 282
12·1.A.

Possible Investment Opportunity Returns

12·1.B.

Measuring Reward: The Expected Rate of Return

12·1.C.

Measuring Risk: The Standard Deviation of the Rate of Return

12·4
12·5

12·6

282
282

Aggregate Investor Preferences

287

How To Measure Risk Contribution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 289
12·3.A.

Own Risk is not a Good Measure for Portfolio Risk Contribution

12·3.B.

Beta is a Good Measure for Portfolio Risk Contribution

12·3.C.

Computing Betas from Rates of Returns

12·3.D.

Beta and Correlation

12·3.E.

Typical Stock Betas and Interpreting Their Meanings

13·3
13·4

289

291

294

296
297

Expected Rates of Return and Betas of (Weighted) Portfolios and Firms . . . . . . . . . . 298
Practical Application . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 301
12·5.A.

Spreadsheets

12·5.B.

Some Notes on the Statistical Formulas

301
301

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 303

Chapter 13: The Capital Asset Pricing Model
13·1
13·2

283

Portfolios, Diversification, and Aggregate Investor Preferences . . . . . . . . . . . . . . . . 286
12·2.A.

12·3

281

305

What We Already Know And Where We Want To Go . . . . . . . . . . . . . . . . . . . . . . . 306
The Capital-Asset Pricing Model (CAPM) — A Cookbook Recipe Approach . . . . . . . . . 307
13·2.A.

The Security Markets Line (SML)

13·2.B.

Non-CAPM Worlds and Non-Linear SMLs

13·2.C.

Empirical Reality

308
309

312

Using the CAPM Cost of Capital in the NPV Context:
Revisiting The Default Premium and Risk Premium . . . . . . . . . . . . . . . . . . . . . . . 314
Estimating CAPM Inputs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 316
13·4.A.
13·4.B.

The Equity Premium E (˜
rM ) − r F

316

The Risk-Free Rate and Multi-Year Considerations (rF )

13·4.C.

Investment Projects’ Market Betas (βi,M )

13·4.D.

Betas For Publicly Traded Firms

322

320

319


xiv

TABLE OF CONTENTS
13·4.E.

Betas From Comparables and Leverage Adjustments:
Equity Beta vs. Asset Beta

322

13·4.F.

Betas Based on Economic Intuition

13·4.G.

Robustness: How Bad are Mistakes in CAPM Inputs?

13·5

325
325

Value Creation and Destruction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 327
13·5.A.

Does Risk-Reducing Corporate Diversification (or Hedging) Create Value?

13·5.B.

Avoiding Cost-of-Capital Mixup Blunders That Destroy Value

13·5.C.

Differential Costs of Capital — Theory and Practice!

13·6

327

329

330

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 333

A

Appendix: Valuing Goods Not Priced at Fair Value via Certainty Equivalence . . . . . . . 334
a.

Finding The True Value of A Good That is Not Fairly Priced

b.

An Application of the Certainty Equivalence Method

334

337

Chapter 14: The Optimal Portfolio
14·1

14·2
14·3
14·4
14·5

343

An Investor’s Risk vs Reward Tradeoff . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 344
14·1.A.

A Short-Cut Formula For the Risk of a Portfolio

14·1.B.

Graphing the Mean-Variance Efficient Frontier

14·1.C.

Adding a Risk-Free Rate

345
346

350

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355
357
359
360

Chapter 15: Efficient Markets, Classical Finance, and Behavioral Finance

365

15·1
15·2

15·3

15·4

The Efficient Frontier and the CAPM Formula . .
Simplifications and Perspective . . . . . . . . . .
Summary . . . . . . . . . . . . . . . . . . . . . . . .
Advanced Appendix: More than Two Securities

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Arbitrage and Great Bets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 366
Market Efficiency and Behavioral Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 367
15·2.A.

Basic Definition and Requirements

15·2.B.

Classifications Of Market Efficiency Beliefs

15·2.C.

The Fundamentals Based Classification

15·2.D.

The Traditional Classification

367
369

369

371

Efficient Market Consequences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 372
15·3.A.

Stock Prices and Random Walks

15·3.B.

Are Fund Managers Just Monkeys on Typewriters?

15·3.C.

Corporate Consequences

15·3.D.

Event Studies Can Measure Instant Value Impacts

372
377

380
381

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 388


TABLE OF CONTENTS

IV

xv

Financing Choices / Capital Structure

391

Chapter 16: Corporate Financial Claims
16·1

16·2

16·3

16·4

395

The Basic Building Blocks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 396
16·1.A.

Bonds

16·1.B.

Ordinary Equity (Common Stock)

16·1.C.

Debt and Equity as State-Contingent Claims

396
397
397

More About Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400
16·2.A.

Bond Features

16·2.B.

Convertible Bonds

400
402

More About Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 405
16·3.A.

Preferred Equity (Stock)

16·3.B.

OPTIONAL: Call Options and Warrants

405
405

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 409

Chapter 17: Idealized Capital Structure and Capital Budgeting
17·1

17·2
17·3
17·4
17·5

413

Conceptual Basics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 414
17·1.A.

The Firm, The Charter, and The Capital Structure

17·1.B.

Maximization of Equity Value or Firm Value?

414

414

Modigliani and Miller (M&M), The Informal Way . . . . . . . . . . .
Modigliani and Miller (M&M), The Formal Way In Perfect Markets
Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
The Weighted Cost of Capital (WACC) in a Perfect M&M World . .
17·5.A.

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416
418
421
422

The Numerical Example In a Risk-Averse World Where Riskier Equity Must Offer Higher A
Expected Rate of Return

422

17·5.B.

The WACC Formula (Without Taxes)

17·5.C.

A Graphical Illustration

17·5.D.

A Major Blunder: If all securities are more risky, is the firm more risky?

425

426
430

17·6
17·7
17·8

The Big Picture: How to Think of Debt and Equity . . . . . . . . . . . . . . . . . . . . . . . . 431
Using the CAPM and WACC Cost of Capital in the NPV Formula . . . . . . . . . . . . . . . 432
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 433

A

Advanced Appendix: Compatibility of Beta, the WACC, and the CAPM Formulas in a
Perfect World. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 434

Chapter 18: Corporate Taxes and A Tax Advantage of Debt
18·1
18·2
18·3

Capital Budgeting If Equity and Debt Were Equally Taxed . . . . . . . . . . . . . . . . . . . 438
Differential Debt and Equity Taxation in The U.S. Tax Code . . . . . . . . . . . . . . . . . . 439
Firm Value Under Different Capital Structures . . . . . . . . . . . . . . . . . . . . . . . . . . 440
18·3.A.

18·4

18·5

18·6
18·7

437

Future Corporate Income Taxes and Owner Returns

440

Formulaic Valuation Methods: APV and WACC . . . . . . . . . . . . . . . . . . . . . . . . . . 442
18·4.A.

Adjusted Present Value (APV): Theory

18·4.B.

APV: Application to a 60/40 Debt Financing Case

18·4.C.

Tax-Adjusted Weighted Average Cost of Capital (WACC) Valuation: Theory

18·4.D.

A Major Blunder: Applying APV and WACC to the Current Cash Flows

442
444
444

447

A Sample Application of Tax-Adjusting Valuation Techniques . . . . . . . . . . . . . . . . 448
18·5.A.

Direct Valuations from Pro Forma Financials

18·5.B.

APV

18·5.C.

WACC

449

449
450

The Tax Subsidy on PepsiCo’s Financial Statement . . . . . . . . . . . . . . . . . . . . . . . 453
Odds and Ends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 454
18·7.A.

Which Valuation Method is Best?

18·7.B.

A Quick-and-Dirty Heuristic Tax-Savings Rule

454
455


xvi

TABLE OF CONTENTS
18·7.C.

Can Investment and Financing Decisions Be Separate?

18·7.D.

Using Our Tax Formulas

18·7.E.

Other Capital Structure Related Tax Avoidance Schemes

455

456
457

18·8

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 459

a

Advanced Appendix: The Discount Factor on Tax Obligations and Tax Shelters . . . . . 464

Chapter 19: Other Capital Structure Considerations
19·1

19·2

19·3

The Role of Personal Income Taxes and Clientele Effects . . . . . . . . . . . . . . . . . . . 470
19·1.A.

Background: The Tax Code For Security Owners

19·1.B.

The Principle Should Be “Joint Tax Avoidance”

19·1.C.

Tax Clienteles

19·5
19·6
19·7
19·8

19·9

470
471

472

Operating Policy Distortions: Behavior in Bad Times . . . . . . . . . . . . . . . . . . . . . . 480
19·2.A.

The Tradeoff in the Presence of Financial Distress Costs

19·2.B.

Direct Losses of Firm Value

480

481

19·2.C.

Operational Distortions of Incentives

19·2.D.

Strategic Considerations

484

486

Operating Policy Distortions: Behavior in Good Times . . . . . . . . . . . . . . . . . . . . . 487
19·3.A.

19·4

469

Agency Issues

487

Bondholder Expropriation

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 489

19·4.A.

Project Risk Changes

19·4.B.

Issuance of Bonds of Similar Priority

19·4.C.

Counteracting Forces

489
490

491

Inside Information . . . . . . . . . . . . . . . . . . . . . . . . . .
Transaction Costs and Behavioral Explanations . . . . . . . .
Corporate Payout Policy: Dividends and Share Repurchases
Further Considerations . . . . . . . . . . . . . . . . . . . . . . .
19·8.A.

Interactions

19·8.B.

Reputation and Capital Structure Recommendations

19·8.C.

Final Note: Cost of Capital Calculations

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20·2

20·3
20·4

20·5

20·6

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494
497
498
501

501
501

502

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 503

Chapter 20: Capital Dynamics
20·1

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509

Tracking IBM’s Capital Structure From 2001 to 2003 . . . . . . . . . . . . . . . . . . . . . . 510
20·1.A.

Debt

20·1.B.

Equity

20·1.C.

Assessing Capital Structure Changes

513
517
519

The Capital Structure of Other Firms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 520
20·2.A.

Very Large Firms

20·2.B.

Smaller Firms

520

520

The Dynamics of Capital Structure and Firm Scale . . . . . . . . . . . . . . . . . . . . . . . 524
The Managerial Perspective . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 526
20·4.A.

The Holistic View

20·4.B.

Meaningful Questions

20·4.C.

Financial Flexibility and Cash Management

20·4.D.

Market Pressures Towards the Optimal Capital Structure?

526
527
528
529

Some Process Information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 531
20·5.A.

The Pecking Order (and Financing Pyramid)

20·5.B.

Debt and Debt-Hybrid Offerings

531

532

20·5.C.

Seasoned Equity Offerings

20·5.D.

Initial Public Offerings

20·5.E.

Raising Funds Through Other Claims and Means

20·5.F.

The Influence of Stock Returns

534

535
537

538

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 539


TABLE OF CONTENTS
A

xvii

Appendix: Standard&Poor’s 04/24/2005 Bond Report on IBM’s 2032 5.875% Coupon
Bond . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 541

Chapter 21: Empirical Evidence on Capital Structure Dynamics
21·1
21·2

21·3

543

Layers of Causality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 544
The Relative Importance of Capital Structure Mechanisms . . . . . . . . . . . . . . . . . . 544
21·2.A.

Net Issuing Activity

545

21·2.B.

Firm Value Changes

546

Deeper Causality — Capital Structure Influences . . . . . . . . . . . . . . . . . . . . . . . . 548
21·3.A.

A Large-Scale Empirical Study

21·3.B.

Theory vs. Empirics

21·3.C.

Evidence on Equity Payouts: Dividends and Equity Repurchasing

21·3.D.

Forces Acting Through the Equity Payout Channel

548

550
551

552

21·4
21·5
21·6
21·7
21·8

Survey Evidence From CFOs . . . . . . . . . . . . . . . . . . . . . . . . . .
Leverage Ratios By Firm Size, Profitability, and Industry . . . . . . . . .
Perspective . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
The Capital Market Response to Issue and Dividend Announcements
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

A

Appendix: A List of Some Recent Empirical Capital-Structure Related Publications . . . 562

Chapter 22: Investment Banking
22·1

22·2

22·3

23·3

23·4
23·5

23·6

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553
555
559
560
560

565

Underwriting Functions

22·1.B.

The Top Underwriters

566
567

The Underwriting Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 569
22·2.A.

Direct Issuing Costs

22·2.B.

Underwriter Selection

22·2.C.

Sum-Total Issuing Costs — The Financial Market Reaction

569
571
571

Mergers and Acquisitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 575
M&A Participants, Deal Characteristics, and Advisory Fees

577

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 579

Chapter 23: Corporate Governance
23·1
23·2

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Investment Bankers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 566
22·1.A.

22·3.A.

22·4

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581

Less Fact, More Fiction: In Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 582
Managerial Temptations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 583
23·2.A.

Illegal Temptations

23·2.B.

Legal Temptations

23·2.C.

The Incentive of the Entrepreneur to Control Temptations

583
585
588

Equity Protection . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 590
23·3.A.

Subsequent Equity Offerings

23·3.B.

The Corporate Board

590

591

23·3.C.

The Role of Votes

23·3.D.

Large Shareholders

23·3.E.

The Legal Environment

23·3.F.

Ethics, Publicity, and Reputation

23·3.G.

Conclusion

592
596
598
599

601

Debt Protection . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 602
The Effectiveness of Corporate Governance . . . . . . . . . . . . . . . . . . . . . . . . . . . . 603
23·5.A.

An Opinion: What Works and What Does not Work

23·5.B.

Where are we going?

603

604

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 607


xviii

V

TABLE OF CONTENTS

Putting It All Together – Pro Formas

609

Chapter 24: Creating Pro Forma Financial Statements
24·1

611

The Goal and Logic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 612
24·1.A.

24·2
24·3

The Template

612

The Detailed vs. Terminal Time Break . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 614
The Detailed Projection Phase . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 616
24·3.A.

Method 1: Direct Extrapolation of Historical Cash Flows

24·3.B.

Method 2: Pro Forma Projections With Detailed Modeling of Financials

24·3.C.

Policy and Calculations off the Pro Forma Components

24·4

617
618

623

Pro Forma Terminal Values . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 624
24·4.A.

The Cost of Capital

24·4.B.

The Cost of Capital Minus the Growth Rate of Cash Flows

24·5

624
626

Complete Pro Formas . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 628
24·5.A.

An Unbiased Pro Forma

628

24·5.B.

A Calibrated Pro Forma

630

24·6

Alternative Assumptions and Sensitivity Analysis . . . . . . . . . . . . . . . . . . . . . . . . 633
24·6.A.

Fiddle With Individual Items

24·6.B.

Do Not Forget Failure

24·6.C.

Assessing the Pro Forma

633

633
634

24·7
24·8
24·9
24·10

Proposing Capital Structure Change . .
Hindsight . . . . . . . . . . . . . . . . . . .
Caution — The Emperor’s New Clothes
Summary . . . . . . . . . . . . . . . . . . .

A

Appendix: In-a-Pinch Advice: Fixed vs. Variable Components . . . . . . . . . . . . . . . . 641

VI

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Appendices

A·2

A·3

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635
637
639
640

649

Chapter A: Epilogue
A·1

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653

Thoughts on Business and Finance Education . . . . . . . . . . . . . . . . . . . . . . . . . . 654
A·1.A.

Common Student Misconceptions

A·1.B.

Common Faculty Misconceptions

A·1.C.

Business School vs. Practice

A·1.D.

The Rankings

654
655

656

657

Finance: As A Discipline . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 658
A·2.A.

Art or Science?

A·2.B.

Will We Ever Fully Understand Finance?

658
658

Finance Research . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 659
A·3.A.

Accomplishments of Finance

A·3.B.

Interesting Current Academic Research

659

A·3.C.

Getting Involved in Academic Research

659

A·3.D.

Finance Degrees

A·3.E.

Academic Careers in Finance and Economics: A Ph.D.?

A·3.F.

Being a Professor — A Dream Job for the Lazy?

A·3.G.

Top Finance Journals

659

659

662

661

660


TABLE OF CONTENTS
A·4

xix

Bon Voyage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 663

Chapter B: More Resources
2·1
2·2
2·3
2·4

2·5

665

An NPV Checklist . . . . . . . . . . .
Prominently Used Data Websites .
Necessary Algebraic Background .
Laws of Probability, Portfolios, and
2·4.A.

Single Random Variables

2·4.B.

Portfolios

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Expectations

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666
668
669
671

671

673

Cumulative Normal Distribution Table . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 675

Chapter C: Sample Exams

679

3·1
3·2

A Sample Midterm . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 680
A Sample Final . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 681

a

Q&A: Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 685

Chapter A: Index
1·1

689

Main Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 689

Web Chapters

na

Chapter :

International Finance

see website

Chapter :

Ethics

see website

Chapter :

IPOs in Detail

see website

Chapter :

Options

see website

Chapter :

Empirical Corporate Finance

see website


xx

TABLE OF CONTENTS


Part I

Investments and Returns

(A part of all versions of the book.)

1


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