Corporate Finance

1069 Pages·2015·15.728 MB·English

by  Ross, Westerfield, Jaffe

SEVENTH CANADIAN EDITION
C O R P O R A T E
F I N A N C E
Stephen A. Ross
Sloan School of Management, Massachusetts Institute of Technology
Randolph W. Westerf ield
Marshall School of Business, University of Southern California
Jeffrey F. Jaffe
Wharton School of Business, University of Pennsylvania
Gordon S. Roberts
Schulich School of Business, York University
Corporate Finance
Seventh Canadian edition
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Library and Archives Canada Cataloguing in Publication
Ross, Stephen A., author
Corporate finance/Stephen A. Ross (Sloan School of Management, Massachusetts Institute of Technology),
Randolph W. Westerfield (Marshall School of Business, University of Southern California), JeffreY F. Jaffe
(Wharton School of Business, University of Pennsylvania), Gordon S. Roberts (Schulich School of Business,
York University). — Seventh Canadian edition.
Revision of: Corporate finance/Stephen A. Ross … [et al.]. — 6th Canadian ed. — Toronto: McGraw-Hill Ryerson,
(c)2011. Includes bibliographical references and index. ISBN 978-0-07-133957-5 (bound)
1. Corporations—Finance—Textbooks. 2. Corporations—Canada— Finance—Textbooks. I. Westerfield,
Randolph, author II. Jaffe, Jeffrey F., 1946-, author III. Roberts, Gordon S. (Gordon Sam), 1945-, author IV. Title.
HG4026.R64 2014 658.15 C2014-905417-3
A B O U T T H E A U T H O R S
STEPHEN A. ROSS Sloan School of Management, JEFFREY F. JAFFE Wharton School of Business,
Massachusetts Institute of Technology Stephen Ross University of Pennsylvania Jeffrey F. Jaffe has been a
is the Franco Modigliani Professor of Financial frequent contributor to finance and economic lit-
Economics at the Sloan School of Management, erature in such journals as the Quarterly Economic
Massachusetts Institute of Technology. One of the Journal, The Journal of Finance, The Journal of
most widely published authors in finance and eco- Financial and Quantitative Analysis, The Journal
nomics, Professor Ross is recognized for his work of Financial Economics, and The Financial Analysts
in developing the arbitrage pricing theory, as well Journal. His best-known work concerns insider
as for having made substantial contributions to the trading, where he showed both that corporate insid-
discipline through his research in signalling, agency ers earn abnormal profits from their trades and that
theory, option pricing, and the theory of the term regulation has little effect on these profits. He has
structure of interest rates, among other topics. A also made contributions concerning initial public
past president of the American Finance Association, offerings, regulation of utilities, the behaviour of
he currently serves as an associate editor of several marketmakers, the fluctuation of gold prices, the
academic and practitioner journals. He is a trustee theoretical effect of inflation on the interest rate,
of CalTech and a director of the College Retirement the empirical effect of inflation on capital asset
Equity Fund (CREF), Freddie Mac, and Algorithmics prices, the relationship between small capitaliza-
Inc. He is also the co-chairman of Roll and Ross tion stocks and the January effect, and the capital
Asset Management Corporation. structure decision.
RANDOLPH W. WESTERFIELD Marshall School of GORDON S. ROBERTS Schulich School of Business,
Business, University of Southern California Randolph York University Gordon Roberts is Canadian Imperial
W. Westerfield is Dean of the University of Southern Bank of Commerce Professor of Financial Services
California’s Marshall School of Business and holder at the Schulich School of Business, York University.
of the Robert R. Dockson Dean’s Chair of Business A winner of numerous teaching awards, his exten-
Administration. sive experience includes finance classes for under-
He came to USC from the Wharton School, graduate and MBA students, executives, and bankers
University of Pennsylvania, where he was the chair- in Canada and internationally. Professor Roberts
man of the finance department and a member of the conducts research in corporate finance and bank-
finance faculty for 20 years. He is a member of sev- ing. He has served on the editorial boards of sev-
eral public company boards of directors, including eral Canadian and international academic journals.
Health Management Associates Inc., William Lyon Professor Roberts has been a consultant to a number
Homes, and the Nicholas Applegate growth fund. His of regulatory bodies responsible for the oversight of
areas of expertise include corporate financial policy, financial institutions and utilities.
investment management, and stock market price
behaviour.
B R I E F C O N T E N T S
PART 1 16 Capital Structure: Basic Concepts 465
17 Capital Structure: Limits to the Use of Debt 496
Overview 1
Appendix 17A Some Useful Formulas of
1 Introduction to Corporate Finance 1 Financial Structure Connect
Appendix 1A Taxes 28 Appendix 17B The Miller Model and the
Appendix 1B Finance Professional Careers Connect Graduated Income Tax Connect
2 Accounting Statements and Cash Flow 33 18 Valuation and Capital Budgeting for the
Levered Firm 533
Appendix 2A Financial Statement Analysis 49
Appendix 2B Statement of Cash Flows 60 Appendix 18A The Adjusted Present Value
Approach to Valuing Leveraged Buyouts Connect
3 Financial Planning and Growth 65
19 Dividends and Other Payouts 555
PART 2
PART 5
Value and Capital Budgeting 83
Long-Term Financing 592
4 Financial Markets and Net Present Value:
First Principles of Finance 83 20 Issuing Equity Securities to the Public 592
5 The Time Value of Money 104 21 Long-Term Debt 618
Appendix 5A Using Financial Calculators Connect 22 Leasing 643
6 How to Value Bonds and Stocks 146 Appendix 22A Adjusted Present Value
Approach to Leasing Connect
Appendix 6A The Term Structure of Interest Rates 179
7 Net Present Value and Other Investment Rules 191
PART 6
8 Net Present Value and Capital Budgeting 223
Options, Futures, and Corporate Finance 669
Appendix 8A Capital Cost Allowance 255
Appendix 8B Derivation of the Present Value 23 Options and Corporate Finance: Basic Concepts 669
of the Capital Cost Allowance Tax Shield Formula 259 24 Options and Corporate Finance:
9 Risk Analysis, Real Options, and Extensions and Applications 709
Capital Budgeting 261
25 Warrants and Convertibles 733
26 Derivatives and Hedging Risk 754
PART 3
Risk 286 PART 7
10 Risk and Return: Lessons from Market History 286 Financial Planning and Short-Term Finance 790
Appendix 10A The U.S. Equity Risk Premium:
27 Short-Term Finance and Planning 790
Historical and International Perspectives Connect
28 Cash Management 818
11 Risk and Return: The Capital Asset
29 Credit Management 837
Pricing Model 309
Appendix 29A Inventory Management Connect
Appendix 11A Is Beta Dead? Connect
12 An Alternative View of Risk and Return:
PART 8
The Arbitrage Pricing Theory 350
13 Risk, Return, and Capital Budgeting 372 Special Topics 857
Appendix 13A Economic Value Added and
30 Mergers and Acquisitions 857
the Measurement of Financial Performance 407
31 Financial Distress 896
PART 4 Appendix 31A Predicting Corporate
Bankruptcy: The Z-Score Model Connect
Capital Structure and Dividend Policy 412 32 International Corporate Finance 910
14 Corporate Financing Decisions and Efficient Appendix A: Mathematical Tables Connect
Capital Markets 412 Appendix B: Answers to Selected
15 Long-Term Financing: An Introduction 448 End-of-Chapter Problems Connect
C O N T E N T S
Preface 1.7 Outline of the Text 26
1.8 Summary and Conclusions 27
PART 1
Appendix 1A Taxes 28
Overview 1 Appendix 1B Finance Professional Careers Connect
CHAPTER 1
CHAPTER 2
Introduction to Corporate Finance 1
Accounting Statements and Cash Flow 33
Executive Summary 1
Executive Summary 33
1.1 What Is Corporate Finance? 2
2.1 The Statement of Financial Position 33
The Balance-Sheet Model of the Firm 2
Liquidity 34
Capital Structure 3
Debt versus Equity 34
The Financial Manager 4
Value versus Cost 35
Identification of Cash Flows 6
Concept Questions 36
Timing of Cash Flows 6
2.2 Statement of Comprehensive Income 36
Risk of Cash Flows 7
International Financial Reporting
Concept Questions 7
Standards 36
1.2 Corporate Securities as Contingent Non-cash Items 37
Claims on Total Firm Value 8
Time and Costs 37
Concept Questions 9
Concept Questions 38
1.3 The Corporate Firm 9
2.3 Net Working Capital 38
The Sole Proprietorship 9
Concept Questions 38
The Partnership 10
2.4 Financial Cash Flow 39
The Corporation 11
Concept Questions 41
The Income Trust 12
2.5 Summary and Conclusions 42
Concept Questions 12
Minicase: Cash Flows at Warf Computers Ltd. 48
1.4 Goals of the Corporate Firm 12
Appendix 2A Financial Statement Analysis 49
Agency Costs and the Set-of-Contracts
Perspective 13 Appendix 2B Statement of Cash Flows 60
Managerial Goals 13
Separation of Ownership and Control 14 CHAPTER 3
In Their Own Words: B. Espen Eckbo
on corporate governance 16 Financial Planning and Growth 65
Concept Questions 18
Executive Summary 65
1.5 Financial Institutions, Financial Markets,
3.1 What Is Financial Planning? 65
and the Corporation 18
Concept Questions 66
Financial Institutions 18
Money Versus Capital Markets 20 3.2 A Financial Planning Model: The
Ingredients 66
Primary Versus Secondary Markets 20
Listing 21 3.3 The Percentage of Sales Method 67
Foreign Exchange Market 22 The Statement of Comprehensive Income 69
Concept Questions 23 The Statement of Financial Position 70
In Their Own Words: Robert C. Higgins on
1.6 Trends in Financial Markets and
sustainable growth 72
Management 23
In Their Own Words: Maria Strömqvist on 3.4 What Determines Growth? 73
hedge funds and the financial crisis of 2008 24 Concept Questions 76
Concept Question 26 Some Caveats on Financial Planning Models 76
vi Contents
3.5 Summary and Conclusions 77 5.4 Simplifications 121
Minicase: Ratios and Financial Planning Perpetuity 121
at East Coast Yachts 81 Growing Perpetuity 122
Annuity 124
PART 2 Mortgages 126
Using Annuity Formulas 127
Value and Capital Budgeting 83
Growing Annuity 130
Concept Questions 131
CHAPTER 4
5.5 What Is a Firm Worth? 131
Financial Markets and Net Present Value: 5.6 Summary and Conclusions 133
First Principles of Finance 83 Minicase: The MBA Decision 145
Appendix 5A Using Financial Calculators Connect
Executive Summary 83
4.1 The Financial Market Economy 84
The Anonymous Market 85 CHAPTER 6
Market Clearing 85
How to Value Bonds and Stocks 146
Concept Questions 86
4.2 Making Consumption Choices over Time 86 Executive Summary 146
Concept Questions 88 6.1 Definition and Example of a Bond 146
4.3 The Competitive Market 89 6.2 How to Value Bonds 146
How Many Interest Rates Are There in a Pure Discount Bonds 146
Competitive Market? 89 Level-Coupon Bonds 147
Concept Questions 90 A Note on Bond Price Quotes 149
4.4 The Basic Principle 90 Consols 150
Concept Question 90 Concept Questions 150
4.5 Practising the Principle 90 6.3 Bond Concepts 150
A Lending Example 91 Interest Rates and Bond Prices 150
A Borrowing Example 92 Yield to Maturity 151
Concept Questions 93 The Present Value Formulas for Bonds 152
4.6 Illustrating the Investment Decision 94 Holding-Period Return 152
Concept Questions 97 Concept Questions 152
4.7 Corporate Investment Decision Making 97 6.4 The Present Value of Common Stocks 152
Concept Question 99 Dividends versus Capital Gains 152
4.8 Summary and Conclusions 100 Valuation of Different Types of Stocks 153
6.5 Estimates of Parameters in the
Dividend Discount Model 157
CHAPTER 5
Where Does g Come From? 157
Where Does r Come From? 158
The Time Value of Money 104
A Healthy Sense of Skepticism 158
Executive Summary 104
6.6 Growth Opportunities 159
5.1 The One-Period Case 104 NPVGOs of Real Companies 160
Concept Questions 107 Growth in Earnings and Dividends versus
5.2 The Multiperiod Case 107 Growth Opportunities 162
Future Value and Compounding 107 Dividends or Earnings: Which to Discount? 162
The Power of Compounding: A Digression 111 The No-Dividend Firm 163
Present Value and Discounting 112 6.7 The Dividend Growth Model and
Finding the Number of Periods 115 the NPVGO Model (Advanced) 163
The Algebraic Formula 116 The Dividend Growth Model 164
Concept Questions 116 The NPVGO Model 164
5.3 Compounding Periods 116 Summary 165
Compounding over Many Years 118 6.8 Comparables 165
Concept Questions 119 Price–Earnings Ratio 166
Continuous Compounding (Advanced) 119 Concept Questions 167
Contents vii
6.9 Valuing the Entire Firm 168 Sunk Costs 224
6.10 Stock Market Reporting 169 Opportunity Costs 224
6.11 Summary and Conclusions 170 Side Effects 225
Minicase: Stock Valuation at Ragan Engines 178 Allocated Costs 225
Concept Questions 225
Appendix 6A The Term Structure of Interest Rates 179
8.2 The Majestic Mulch and Compost
Company: An Example 226
CHAPTER 7
An Analysis of the Project 228
Which Set of Books? 229
Net Present Value and Other
A Note on Net Working Capital 230
Investment Rules 191
Interest Expense 231
Executive Summary 191 Concept Questions 231
7.1 Why Use Net Present Value? 191 8.3 Inflation and Capital Budgeting 231
Concept Questions 193 Interest Rates and Inflation 231
7.2 The Payback Period Rule 193 Cash Flow and Inflation 232
Defining the Rule 193 Discounting: Nominal or Real? 233
Problems with the Payback Method 194 Concept Questions 235
Managerial Perspective 195
8.4 Alternative Definitions of Operating
Summary of Payback 195 Cash Flow 236
Concept Questions 195
The Bottom-Up Approach 236
7.3 The Discounted Payback Period Rule 196 The Top-Down Approach 237
7.4 The Average Accounting Return 196 The Tax Shield Approach 237
Defining the Rule 196 Conclusion 237
Analyzing the Average Accounting
8.5 Applying the Tax Shield Approach to
Return Method 198 the Majestic Mulch and Compost
Concept Questions 198 Company Project 237
7.5 The Internal Rate of Return 199 Present Value of the Tax Shield on Capital
Concept Question 201 Cost Allowance 239
7.6 Problems with the Internal Rate of Total Project Cash Flow versus Tax
Return Approach 201 Shield Approach 240
Definition of Independent and Mutually Concept Questions 240
Exclusive Projects 201 8.6 Investments of Unequal Lives: The
Two General Problems Affecting Both Equivalent Annual Cost Method 240
Independent and Mutually Exclusive The General Decision to Replace (Advanced) 242
Projects 202
Concept Question 246
Problems Specific to Mutually Exclusive
8.7 Summary and Conclusions 246
Projects 206
Minicase: Beaver Mining Company 253
Redeeming Qualities of the Internal
Minicase: Goodweek Tires Inc. 254
Rate of Return 211
A Test 211 Appendix 8A Capital Cost Allowance 255
Concept Questions 211 Appendix 8B Derivation of the Present Value
7.7 The Profitability Index 211 of Capital Cost Allowance Tax Shield Formula 259
Concept Questions 213
7.8 The Practice of Capital Budgeting 213 CHAPTER 9
7.9 Summary and Conclusions 215
Minicase: Bullock Gold Mining 222 Risk Analysis, Real Options,
and Capital Budgeting 261
CHAPTER 8 Executive Summary 261
9.1 Decision Trees 261
Net Present Value and Capital Budgeting 223
Concept Questions 263
Executive Summary 223 9.2 Sensitivity Analysis, Scenario Analysis,
8.1 Incremental Cash Flows 223 and Break-Even Analysis 263
Cash Flows—Not Accounting Income 223 Sensitivity Analysis and Scenario Analysis 263
viii Contents
Break-Even Analysis 266 10.7 2008: A Year of Financial Crisis 303
Concept Questions 269 10.8 Summary and Conclusions 304
Break-Even Analysis, Equivalent Annual Minicase: A Job at Deck Out My
Cost, and Capital Cost Allowance 269 Yacht Corporation 307
9.3 Monte Carlo Simulation 270 Appendix 10A The U.S. Equity Risk Premium:
Step 1: Specify the Basic Model 271 Historical and International Perspectives Connect
Step 2: Specify a Distribution for Each
Variable in the Model 271
CHAPTER 11
Step 3: The Computer Draws One Outcome 273
Step 4: Repeat the Procedure 273 Risk and Return: The Capital Asset
Step 5: Calculate Net Present Value 274 Pricing Model 309
9.4 Real Options 275
Executive Summary 309
The Option to Expand 275
11.1 Individual Securities 309
The Option to Abandon 276
Timing Options 277 11.2 Expected Return, Variance, and
Covariance 310
Real Options in the Real World 278
Expected Return and Variance 310
Concept Questions 279
Covariance and Correlation 312
9.5 Summary and Conclusions 279
11.3 The Risk and Return for Portfolios 315
Minicase: Bunyan Lumber, LLC 285
The Example of Supertech and Slowpoke 316
The Expected Return on a Portfolio 316
PART 3
Variance and Standard Deviation of a
Risk 286 Portfolio 317
Concept Questions 320
CHAPTER 10 11.4 The Efficient Set for Two Assets 320
Application to International Diversification 323
Risk and Return: Lessons from Concept Question 324
Market History 286 11.5 The Efficient Set for Many Securities 324
Variance and Standard Deviation in a
Executive Summary 286
Portfolio of Many Assets 325
10.1 Returns 287
Concept Questions 327
Dollar Earnings 287
11.6 Diversification: An Example 327
Percentage Returns or Rate of Return 288
Risk and the Sensible Investor 329
Concept Questions 290
Concept Questions 330
10.2 Holding-Period Returns 290
11.7 Risk-Free Borrowing and Lending 330
Concept Questions 293
The Optimal Portfolio 332
10.3 Return Statistics 294 Concept Questions 334
Concept Question 294
11.8 Market Equilibrium 334
10.4 Average Stock Returns and Risk-Free Definition of the Market Equilibrium Portfolio 334
Returns 295
Definition of Risk When Investors Hold
Concept Questions 297 the Market Portfolio 335
10.5 Risk Statistics 297 The Formula for Beta 337
Variance and Standard Deviation 298 A Test 337
Normal Distribution and Its Implications Concept Questions 338
for Standard Deviation 298 11.9 Relationship between Risk and Expected
Value at Risk 299 Return (Capital Asset Pricing Model) 338
Further Perspective on Returns and Risk 300 Expected Return on Market 338
Concept Questions 301 Expected Return on Individual Security 339
10.6 More on Average Returns 301 Concept Questions 342
Arithmetic versus Geometric Averages 301 11.10 Summary and Conclusions 342
Calculating Geometric Average Returns 301 Minicase: A Job at Deck Out My Yacht,
Part 2 349
Arithmetic Average Return or Geometric
Average Return? 303 Appendix 11A Is Beta Dead? Connect
Contents ix
CHAPTER 12 The Cost of Debt 384
The Cost of Preferred Stock 385
An Alternative View of Risk and Return: The Weighted Average Cost of Capital 385
The Arbitrage Pricing Theory 350 The Capital Structure Weights 386
Taxes and the Weighted Average Cost
Executive Summary 350
of Capital 386
12.1 Factor Models: Announcements,
Concept Questions 388
Surprises, and Expected Returns 351
13.5 Estimating the Cost of Capital for
Concept Questions 352
Suncor Energy 391
12.2 Risk: Systematic and Unsystematic 352
Concept Question 393
Concept Questions 353
13.6 Flotation Costs and the Weighted
12.3 Systematic Risk and Betas 353
Average Cost of Capital 393
Concept Questions 356
The Basic Approach 393
12.4 Portfolios and Factor Models 356 Flotation Costs and Net Present Value 395
Portfolios and Diversification 358 Internal Equity and Flotation Costs 395
Concept Questions 360
13.7 Reducing the Cost of Capital 396
12.5 Betas and Expected Returns 360
What Is Liquidity? 396
The Linear Relationship 360
Liquidity, Expected Returns, and the
The Market Portfolio and the Single Factor 361 Cost of Capital 397
Concept Question 362 Liquidity and Adverse Selection 397
12.6 The Capital Asset Pricing Model and What the Corporation Can Do 398
the Arbitrage Pricing Theory 362
Concept Questions 398
Differences in Pedagogy 362
13.8 Summary and Conclusions 399
Differences in Application 363
Minicase: The Cost of Capital for Goff
Concept Questions 364
Communications Inc. 406
12.7 Parametric Approaches to Asset Pricing 364
Appendix 13A Economic Value Added and
Empirical Models 364
the Measurement of Financial Performance 407
Style Portfolios 366
Concept Questions 366
PART 4
12.8 Summary and Conclusions 367
Capital Structure and Dividend Policy 412
Minicase: The Fama–French Multifactor
Model and Mutual Fund Returns 371
CHAPTER 14
CHAPTER 13
Corporate Financing Decisions and
Efficient Capital Markets 412
Risk, Return, and Capital Budgeting 372
Executive Summary 412
Executive Summary 372
14.1 Can Financing Decisions Create Value? 412
13.1 The Cost of Equity Capital 373
Concept Questions 375 Concept Question 414
13.2 Estimation of Beta 375 14.2 A Description of Efficient Capital Markets 414
Concept Questions 377 Foundations of Market Efficiency 416
Beta Estimation in Practice 377 Concept Question 418
Stability of Beta 378 14.3 The Different Types of Efficiency 418
Using an Industry Beta 379 The Weak Form 418
Concept Questions 380 The Semistrong and Strong Forms 419
13.3 Determinants of Beta 380 Some Common Misconceptions About
Cyclicality of Revenues 380 the Efficient Market Hypothesis 421
Operating Leverage 380 Concept Questions 422
Financial Leverage and Beta 382 14.4 The Evidence 422
Concept Questions 383 The Weak Form 422
13.4 Extensions of the Basic Model 383 The Semistrong Form 424
The Firm versus the Project: The Strong Form 427
Vive la différence 383 Concept Questions 428