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

.

.

.

.

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

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

Typesetting System: pdﬂatex.

Cover Font

Y&Y Lucida Casual

13-38pt.

Main Body Font

Y&Y Lucida

10pt.

Other Fonts

Y&Y Lucida variations

See http://www.tug.org/yandy/

Most graphics were created in R, open-source and free: www.r-project.org. Fonts were embedded using AFPL

ghostscript and Glyph Software’s xpdf.

The referenced spreadsheets are Excel (Microsoft) and OpenOﬃce (free).

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.)

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