Corporate Finance The McGraw-Hill/Irwin Series in Finance, Insurance, and Real Estate Stephen A. Ross Franco Modigliani Professor of Finance and Economics Sloan School of Management Massachusetts Institute of Technology Consulting Editor FINANCIAL MANAGEMENT Ross, Westerfield, and Jordan Saunders and Cornett Essentials of Corporate Finance Financial Markets and Institutions Block, Hirt, and Danielsen Eighth Edition Sixth Edition Foundations of Financial Management Fifteenth Edition Ross, Westerfield, and Jordan Fundamentals of Corporate Finance INTERNATIONAL FINANCE Brealey, Myers, and Allen Eleventh Edition Eun and Resnick Principles of Corporate Finance Eleventh Edition Shefrin International Financial Management Behavioral Corporate Finance: Decisions that Seventh Edition Brealey, Myers, and Allen Create Value Principles of Corporate Finance, Concise First Edition REAL ESTATE Second Edition White Brueggeman and Fisher Brealey, Myers, and Marcus Financial Analysis with an Electronic Calculator Real Estate Finance and Investments Fundamentals of Corporate Finance Sixth Edition Fourteenth Edition Eighth Edition Ling and Archer Brooks INVESTMENTS Real Estate Principles: A Value Approach FinGame Online 5.0 Bodie, Kane, and Marcus Fourth Edition Bruner Essentials of Investments Case Studies in Finance: Managing for Corporate Ninth Edition FINANCIAL PLANNING Value Creation Bodie, Kane, and Marcus AND INSURANCE Seventh Edition Investments Allen, Melone, Rosenbloom, and Mahoney Cornett, Adair, and Nofsinger Tenth Edition Retirement Plans: 401(k)s, IRAs, and Other Finance: Applications and Theory Hirt and Block Deferred Compensation Approaches Third Edition Fundamentals of Investment Management Eleventh Edition Cornett, Adair, and Nofsinger Tenth Edition Altfest M: Finance Jordan, Miller, and Dolvin Personal Financial Planning Third Edition Fundamentals of Investments: Valuation First Edition DeMello and Management Harrington and Niehaus Cases in Finance Seventh Edition Risk Management and Insurance Second Edition Stewart, Piros, and Heisler Second Edition Grinblatt (editor) Running Money: Professional Portfolio Kapoor, Dlabay, Hughes, and Hart Stephen A. Ross, Mentor: Influence through Management Focus on Personal Finance: An Active Approach to Generations First Edition Help You Achieve Financial Literacy Grinblatt and Titman Sundaram and Das Fifth Edition Financial Markets and Corporate Strategy Derivatives: Principles and Practice Kapoor, Dlabay, and Hughes Second Edition Second Edition Personal Finance Higgins Eleventh Edition Analysis for Financial Management FINANCIAL INSTITUTIONS Walker and Walker Eleventh Edition AND MARKETS Personal Finance: Building Your Future Kellison Rose and Hudgins First Edition Theory of Interest Bank Management and Financial Services Third Edition Ninth Edition Ross, Westerfield, Jaffe, and Jordan Rose and Marquis Corporate Finance Financial Institutions and Markets Eleventh Edition Eleventh Edition Ross, Westerfield, Jaffe, and Jordan Saunders and Cornett Corporate Finance: Core Principles Financial Institutions Management: A Risk and Applications Management Approach Fourth Edition Eighth Edition Corporate Finance ELEVENTH EDITION Stephen A. Ross Sloan School of Management Massachusetts Institute of Technology Randolph W.
Westerfield Marshall School of Business University of Southern California Jeffrey Jaffe Wharton School of Business University of Pennsylvania Bradford D. Jordan Gatton College of Business and Economics University of Kentucky Brief Contents Part I OVERVIEW 1 Introduction to Corporate Finance 1 2 Financial Statements and Cash Flow 20 3 Financial Statements Analysis and Financial Models 44 Part II VALUATION AND CAPITAL BUDGETING 4 Discounted Cash Flow Valuation 87 5 Net Present Value and Other Investment Rules 135 6 Making Capital Investment Decisions 171 7 Risk Analysis, Real Options, and Capital Budgeting 208 8 Interest Rates and Bond Valuation 238 9 Stock Valuation 273 Part III RISK 10 Risk and Return: Lessons from Market History 302 11 Return and Risk: The Capital Asset Pricing Model (CAPM) 331 12 An Alternative View of Risk and Return: The Arbitrage Pricing Theory 374 13 Risk, Cost of Capital, and Valuation 396 Part IV CAPITAL STRUCTURE AND DIVIDEND POLICY 14 Efficient Capital Markets and Behavioral Challenges 431 15 Long-Term Financing: An Introduction 471 16 Capital Structure: Basic Concepts 490 17 Capital Structure: Limits to the Use of Debt 522 18 Valuation and Capital Budgeting for the Levered Firm 555 19 Dividends and Other Payouts 577 Part V LONG-TERM FINANCING 20 Raising Capital 617 21 Leasing 652 xxiv Part VI OPTIONS, FUTURES, AND CORPORATE FINANCE 22 Options and Corporate Finance 677 23 Options and Corporate Finance: Extensions and Applications 722 24 Warrants and Convertibles 746 25 Derivatives and Hedging Risk 767 Part VII SHORT-TERM FINANCE 26 Short-Term Finance and Planning 799 27 Cash Management 829 28 Credit and Inventory Management 851 Part VIII SPECIAL TOPICS 29 Mergers, Acquisitions, and Divestitures 880 30 Financial Distress 923 31 International Corporate Finance 939 Appendix A: Mathematical Tables 966 Appendix B: Solutions to Selected End-of-Chapter Problems 975 Appendix C: Using the HP 10B and TI BA II Plus Financial Calculators 978 Glossary 982 Name Index 999 Subject Index 1001 xxv Contents PART I Overview 2.7 Cash Flow from Financing Activities Cash Flow Management 33 34 Chapter 1 Summary and Conclusions 35 Concept Questions 36 Introduction to Corporate Finance 1 Questions and Problems 36 1.1 What Is Corporate Finance? 1 Excel Master It! Problem 41 The Balance Sheet Model of the Firm 1 Mini Case: Cash Flows at Warf Computers, Inc. 42 The Financial Manager 3 Chapter 3 1.2 The Corporate Firm 4 The Sole Proprietorship 4 Financial Statements Analysis The Partnership 4 and Financial Models 44 The Corporation 5 3.1 Financial Statements Analysis 44 A Corporation by Another Name .3 The Importance of Cash Flows 8 Common-Size Balance Sheets 45 1.4 The Goal of Financial Management 11 Common-Size Income Statements 46 Possible Goals 11 3.2 Ratio Analysis 48 The Goal of Financial Management 12 Short-Term Solvency or Liquidity Measures 49 A More General Goal 12 Long-Term Solvency Measures 50 1.5 The Agency Problem and Control Asset Management or Turnover Measures 52 of the Corporation 13 Profitability Measures 54 Agency Relationships 13 Market Value Measures 55 Management Goals 14 3.3 The DuPont Identity 58 Do Managers Act in the Stockholders’ Interests? 14 A Closer Look at ROE 58 Stakeholders 16 Problems with Financial Statement Analysis 60 1.4 Financial Models 61 The Securities Act of 1933 and the Securities A Simple Financial Planning Model 61 Exchange Act of 1934 16 The Percentage of Sales Approach 63 Sarbanes-Oxley 17 3.5 External Financing and Growth 67 Summary and Conclusions 18 EFN and Growth 68 Concept Questions 18 Financial Policy and Growth 70 A Note about Sustainable Chapter 2 Growth Rate Calculations 74 Financial Statements and Cash Flow 20 3.6 Some Caveats Regarding Financial 2.1 The Balance Sheet 20 Planning Models 75 Liquidity 21 Summary and Conclusions 76 Debt versus Equity 22 Concept Questions 76 Value versus Cost 22 Questions and Problems 78 2.2 The Income Statement 23 Excel Master It! Problem 83 Generally Accepted Accounting Principles 24 Mini Case: Ratios and Financial Planning at Noncash Items 25 East Coast Yachts 84 Time and Costs 25 2.3 Taxes 26 PART II Valuation and Corporate Tax Rates 26 Capital Budgeting Average versus Marginal Tax Rates 26 2.4 Net Working Capital 28 Chapter 4 2.5 Cash Flow of the Firm 29 Discounted Cash Flow Valuation 87 2.6 The Accounting Statement of Cash Flows 32 4.1 Valuation: The One-Period Case 87 Cash Flow from Operating Activities 32 4.2 The Multiperiod Case 91 Cash Flow from Investing Activities 33 Future Value and Compounding 91 xxvi The Power of Compounding: A Digression 94 Questions and Problems 162 Present Value and Discounting 95 Excel Master It! Problem 169 Finding the Number of Periods 98 Mini Case: Bullock Gold Mining 170 The Algebraic Formula 101 4.3 Compounding Periods 102 Chapter 6 Distinction between Annual Percentage Rate Making Capital Investment Decisions 171 and Effective Annual Rate 103 Compounding over Many Years 104 6.1 Incremental Cash Flows: The Key Continuous Compounding 104 to Capital Budgeting 171 4.4 Simplifications 106 Cash Flows—Not Accounting Income 171 Perpetuity 106 Sunk Costs 172 Growing Perpetuity 108 Opportunity Costs 173 Annuity 109 Side Effects 173 Growing Annuity 115 Allocated Costs 174 4.2 The Baldwin Company: An Example 174 4.6 What Is a Firm Worth? 120 An Analysis of the Project 177 Summary and Conclusions 122 Which Set of Books? 179 Concept Questions 123 A Note about Net Working Capital 179 Questions and Problems 123 A Note about Depreciation 180 Excel Master It! Problem 133 Interest Expense 181 Mini Case: The MBA Decision 134 6.3 Alternative Definitions Appendix 4A: Net Present Value: of Operating Cash Flow 181 First Principles of Finance 134 The Top-Down Approach 182 Appendix 4B: Using Financial Calculators 134 The Bottom-Up Approach 182 The Tax Shield Approach 183 Chapter 5 Conclusion 184 Net Present Value and Other 6.4 Some Special Cases of Discounted Investment Rules 135 Cash Flow Analysis 184 Evaluating Cost-Cutting Proposals 184 5.1 Why Use Net Present Value? 135 Setting The Bid Price 186 5.2 The Payback Period Method 138 Investments of Unequal Lives: The Equivalent Defining the Rule 138 Annual Cost Method 188 Problems with the Payback Method 139 6.5 Inflation and Capital Budgeting 190 Managerial Perspective 140 Interest Rates and Inflation 190 Summary of Payback 141 Cash Flow and Inflation 192 5.3 The Discounted Payback Period Method 141 Discounting: Nominal or Real? 192 5.4 The Internal Rate of Return 141 Summary and Conclusions 195 5.5 Problems with the IRR Approach 145 Concept Questions 195 Definition of Independent and Mutually Questions and Problems 197 Exclusive Projects 145 Excel Master It! Problems 205 Two General Problems Affecting Both Mini Cases: Bethesda Mining Company 205 Independent and Mutually Exclusive Projects 145 Goodweek Tires, Inc. 206 Problems Specific to Mutually Exclusive Projects 149 Redeeming Qualities of IRR 154 Chapter 7 A Test 154 Risk Analysis, Real Options, 5.6 The Profitability Index 155 and Capital Budgeting 208 Calculation of Profitability Index 155 5.7 The Practice of Capital Budgeting 157 7.1 Sensitivity Analysis, Scenario Analysis, Summary and Conclusions 159 and Break-Even Analysis 208 Concept Questions 160 Sensitivity Analysis and Scenario Analysis 208 xxvii Break-Even Analysis 212 Chapter 9 7.2 Monte Carlo Simulation 216 Step 1: Specify the Basic Model 216 Stock Valuation 273 Step 2: Specify a Distribution 9.1 The Present Value of Common Stocks 273 for Each Variable in the Model 216 Dividends versus Capital Gains 273 Step 3: The Computer Draws Valuation of Different Types of Stocks 274 One Outcome 219 9.2 Estimates of Parameters in the Step 4: Repeat the Procedure 219 Dividend Discount Model 278 Step 5: Calculate NPV 220 Where Does g Come From? 278 7.3 Real Options 220 Where Does R Come From? 280 The Option to Expand 221 A Healthy Sense of Skepticism 281 The Option to Abandon 222 Dividends or Earnings: Which to Discount? 282 Timing Options 224 The No-Dividend Firm 282 7.3 Comparables 283 Summary and Conclusions 227 Price-to-Earnings Ratio 283 Concept Questions 228 Enterprise Value Ratios 286 Questions and Problems 228 9.4 Valuing Stocks Using Free Cash Flows 287 Excel Master It! Problem 235 9.5 The Stock Markets 288 Mini Case: Bunyan Lumber, LLC 236 Dealers and Brokers 289 Organization of the NYSE 289 Types of Orders 292 Chapter 8 NASDAQ Operations 292 Interest Rates and Bond Valuation 238 Stock Market Reporting 293 Summary and Conclusions 294 8.1 Bonds and Bond Valuation 238 Concept Questions 295 Bond Features and Prices 238 Questions and Problems 295 Bond Values and Yields 239 Excel Master It! Problem 299 Interest Rate Risk 242 Mini Case: Stock Valuation at Ragan Engines 300 Finding the Yield to Maturity: More Trial and Error 244 Zero Coupon Bonds 246 8.2 Government and PART III Risk Corporate Bonds 248 Government Bonds 248 Chapter 10 Corporate Bonds 249 Risk and Return: Lessons Bond Ratings 251 from Market History 302 8.3 Bond Markets 252 How Bonds Are Bought and Sold 252 10.1 Returns 302 Bond Price Reporting 253 Dollar Returns 302 A Note on Bond Price Quotes 256 Percentage Returns 304 8.4 Inflation and Interest Rates 257 10.2 Holding Period Returns 306 Real versus Nominal Rates 257 10.3 Return Statistics 312 Inflation Risk and Inflation-Linked Bonds 258 10.4 Average Stock Returns The Fisher Effect 259 and Risk-Free Returns 314 8.5 Determinants of Bond Yields 261 10.5 Risk Statistics 314 The Term Structure of Interest Rates 261 Variance 314 Bond Yields and the Yield Curve: Normal Distribution and Its Implications Putting It All Together 263 for Standard Deviation 317 Conclusion 265 10.