CORPORATE FINANCE An Introduction PDF
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CORPORATE FINANCE An Introduction The Prentice Hall Series in Finance Alexander/Sharpe/Bailey Fabozzi/Modigliani/Jones/Ferri Hull Ogden/Jen/O’Connor FundamentalsofInvestments FoundationsofFinancialMarkets FundamentalsofFuturesand AdvancedCorporateFinance andInstitutions OptionsMarkets Bear/Moldonado-Bear Pennacchi FreeMarkets,Finance,Ethics,and Finkler Hull TheoryofAssetPricing Law FinancialManagementfor Options,Futures,andOther Public,Health,andNot-for-Profit Derivatives Rejda Berk/DeMarzo Organizations PrinciplesofRiskManagement CorporateFinance* Hull andInsurance Francis/Ibbotson RiskManagementandFinancial Berk/DeMarzo Investments:AGlobalPerspective Institutions Schoenebeck InterpretingandAnalyzing CorporateFinance:TheCore* Fraser/Ormiston Keown/Martin/Petty/Scott FinancialStatements Berk/DeMarzo/Harford Understanding Financial FinancialManagement:Principles FundamentalsofCorporate Statements andApplications Scott/Martin/Petty/Keown/ Thatcher Finance* Geisst Keown/Martin/Petty/Scott CasesinFinance Bierman/Smidt InvestmentBankinginthe FoundationsofFinance:The TheCapitalBudgetingDecision: FinancialSystem LogicandPracticeofFinancial Seiler PerformingFinancialStudies:A EconomicAnalysisofInvestment Gitman Management MethodologicalCookbook Projects PrinciplesofManagerialFinance* Keown Shapiro Bodie/Merton/Cleeton Gitman PersonalFinance:TurningMoney CapitalBudgetingandInvestment FinancialEconomics Principles of Managerial intoWealth Analysis Finance—BriefEdition* Kim/Nofsinger Click/Coval Sharpe/Alexander/Bailey The Theory and Practice Gitman/Joehnk CorporateGovernance Investments ofInternationalFinancial FundamentalsofInvesting* Levy/Post Management Gitman/Madura Investments Solnik/McLeavey GlobalInvestments IntroductiontoFinance Copeland/Weston/Shastri May/May/Andrew FinancialTheoryandCorporate Guthrie/Lemon EffectiveWriting:AHandbookfor Stretcher/Michael Policy MathematicsofInterestRatesand FinancePeople CasesinFinancialManagement Finance Titman/Martin Cox/Rubinstein Madura OptionsMarkets Haugen PersonalFinance Valuation:TheArtandScienceof TheInefficientStockMarket: CorporateInvestmentDecisions Dorfman WhatPaysOffandWhy Marthinsen Trivoli IntroductiontoRiskManagement RiskTakers:UsesandAbusesof andInsurance Haugen FinancialDerivatives PersonalPortfolioManagement: ModernInvestmentTheory FundamentalsandStrategies Dietrich McDonald FinancialServicesandFinancial Haugen DerivativesMarkets VanHorne TheNewFinance:Overreaction, FinancialManagementandPolicy Institutions:ValueCreationin Complexity,andUniqueness McDonald TheoryandPractice VanHorne FundamentalsofDerivatives Holden Markets FinancialMarketRatesandFlows Dufey/Giddy ExcelModelingandEstimation CasesinInternationalFinance VanHorne/Wachowicz intheFundamentalsofCorporate Megginson FundamentalsofFinancial Finance CorporateFinanceTheory Eakins Management Financein.learn Holden Melvin Vaughn ExcelModelingandEstimationin InternationalMoneyandFinance Eiteman/Stonehill/Moffett FinancialPlanningforthe theFundamentalsofInvestments MultinationalBusinessFinance Mishkin/Eakins Entrepreneur Holden FinancialMarketsandInstitutions Emery/Finnerty/Stowe ExcelModelingandEstimationin Welch CorporateFinancialManagement Investments Moffett CorporateFinance: CasesinInternationalFinance AnIntroduction* Fabozzi Holden BondMarkets:Analysisand ExcelModelingandEstimationin Moffett/Stonehill/Eiteman Weston/Mitchel/Mulherin Strategies CorporateFinance FundamentalsofMultinational Takeovers,Restructuring,and Finance CorporateGovernance Fabozzi/Modigliani Hughes/MacDonald CapitalMarkets:Institutionsand InternationalBanking:Textand Nofsinger Winger/Frasca Instruments Cases PsychologyofInvesting PersonalFinance *denotes titlesLogontowww.myfinancelab.comtolearnmore CORPORATE FINANCE An Introduction Ivo Welch BROWNUNIVERSITY PRENTICEHALL NewYork Boston SanFrancisco London Toronto Sydney Tokyo Singapore Madrid MexicoCity Munich Paris CapeTown HongKong Montreal EditorinChief:DonnaBattista ExecutiveDevelopmentEditor:MaryClareMcEwing ManagingEditor:JeffHolcomb SeniorProductionSupervisor:KathrynDinovo SupplementsSupervisor:HeatherMcNally DirectorofMedia:SusanSchoenberg SeniorMediaProducer:BethanyTidd AssociateMediaProducer:MiguelLeonarte MarketingAssistant:IanGold SeniorAuthorSupport/TechnologySpecialist:JoeVetere SeniorPrepressSupervisor:CarolineFell RightsandPermissionsAdvisor:DanaWeightman SeniorManufacturingBuyer:CarolMelville SeniorMediaBuyer:GinnyMichaud SeniorDesigner:BarbaraAtkinson TextandCoverDesigner:LeslieHaimes ProductionCoordination,Composition,andArt:WindfallSoftware,usingZzTEX CoverandTextImage:©LaFleurStudio/Images.com Copyright © 2009 Pearson Education, Inc. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher.PrintedintheUnitedStatesofAmerica.Forinformationonobtainingpermissionforuseof materialinthiswork,pleasesubmitawrittenrequesttoPearsonEducation,Inc.,RightsandContracts Department,501BoylstonStreet,Suite900,Boston,MA02116,faxyourrequestto617-671-3447,or e-mailathttp://www.pearsoned.com/legal/permissions.htm. Manyofthedesignationsusedbymanufacturersandsellerstodistinguishtheirproductsareclaimedas trademarks.Wherethosedesignationsappearinthisbook,andthepublisherwasawareofatrademark claim,thedesignationshavebeenprintedininitialcapsorallcaps. LibraryofCongressCataloging-in-PublicationData Welch,Ivo. Corporatefinance:anintroduction/IvoWelch. p. cm. Includesbibliographicalreferencesandindex. ISBN-13:978-0-321-27799-2(alk.paper) ISBN-10:0-321-27799-6(alk.paper) 1.Corporations–Finance. I.Title. HG4026.W4342009 650.15—dc22 2008024981 1 2 3 4 5 6 7 8 9 10—CRK—12 11 10 09 08 www.pearsonhighered.com ISBN-10:0-321-27799-6 ISBN-13:978-0-321-27799-2 About the Author IvoWelchisProfessorofFinancialEconomicsatBrownUniversity, a position he has held since 2004. He previously held the same appointment at UCLA’s Anderson School of Management (from 1989 to 2000) and Yale University’s School of Management (from 2000to2004).HereceivedhisBAincomputersciencein1985from Columbia University, and both his MBA (1989) and PhD (1991) in financefromtheUniversityofChicago.Hisworkhasbeenfeatured in many academic journals, as well as the popular press. More information about the author can be found at the book’s Web site (www.prenhall.com/welch) and at the author’s personal website (http://welch.econ.brown.edu). To my parents, Arthur and Charlotte Welch and to my wife, Lily Preface Theauthorraisessome Mostcorporatefinancetextbookscoverasimilarcanonofconcepts,andmy thought-provoking book is no exception. A quick glance at the table of contents will show questionsbeyondthose you that most—though not all—of the topics in Corporate Finance: An foundinmostbooksof Introductionoverlapwiththoseintraditionalfinancetextbooksandsyllabi.Thatsaid, thisgenre. —MariannePlunkert thisbookisintentionallydifferent.AlthoughIcoversimilarterritory,Ialsointroduce University of many innovations in approach and emphasis. I hope that once you have seen them, Colorado,Denver therewillbenogoingback. INNOVATIONS IN APPROACH Theunderlyingphilosophyofthisbookisbasedonabeliefthatanytalentedstudent can understand finance. I believe that our concepts are no more difficult than those instandardtextscoveringtheprinciplesofeconomicsandthatourmathematicsisno moredifficultthanthatinhighschool.Ibelievethatfinanceiseasiestwhenexplained I really like the from basic principles and only gradually ramped up in complexity. I also believe approach starting that although it is important for students to learn how to solve traditional textbook fromanideal,simple problems,itisasimportantforthemtolearnhowtothinkaboutandapproachnew market to more problemsthattheywillencounterintherealworld. realisticandcomplex marketconditions . . . [thisis]oneofthebest A LOGICAL PROGRESSION writtenandeasiest tounderstandtexts Thebookstartswithsimplescenariosinwhichalltheinputsareclearandprogresses Ihaveeverreadin to more complex, real-world scenarios for which the solutions become more diffi- finance. cult.Withinthisarchitecture, chaptersbuildorganicallyonconceptslearnedearlier. —KuoTseng CaliforniaState Thisincrementalprogressionallowsstudentstoreusewhattheyhavelearnedandto University,Fresno understandtheeffectofeachnewchangeinandofitself. One theme that binds the book together is the progression from the perfect- market,law-of-one-priceidealworld(onwhichmostfinanceformulasarebased)to an imperfect market (in which formulas may need adjustment, explicitly or implic- itly).Thelayoutonpagesxiv–xvshowcasesthebuildingblocksofthisapproach. NUMERICAL EXAMPLE LEADING TO FORMULA Ilikethisapproach I learn best by numerical example, and I believe that students do, too. Whenever verymuch.Thisis,in I want to understand an idea, I try to construct numerical examples for myself— fact,theoptimalway the simpler, the better. Therefore, this book relies on simple numerical examples tolearn. as its primary tutorial method. Instead of a “bird’s eye” view of the formula first —RichardFendler Georgia State and application second, students will start with a “worm’s eye” view and work their University way up—from simple numbers, to more complex examples, and finally to abstract formulas.Eachstepiseasy.Atfirstglance,youmaythinkthismaybeless“executive” or perhaps not as well-suited to students with only a cursory interest in finance. I assureyouthatneitheroftheseisthecase. vi PREFACE vii Criticalquestionssuchas, “Whatwouldthisprojectbeworth?”areansweredin Withoutadoubt,this numerical step-by-step examples (printed in black), and right under the computa- isthegreateststrength ofthetext. tions are the corresponding symbolic formulas (printed in red). I believe that the —SharonGarrison pairingofnumericswithformulaswillultimatelyhelpstudentsunderstandthema- University of terialonahigherlevelandwithmoreease.Thelayoutonpagesxvi—xviiprovidesa Arizona smallsampleofthe“numbersfirst”approachthatIusethroughoutthebook. Theuseof . . . simple numericalexamples PROBLEM SOLVING throughout . . . to explain essential A corollary to the numbers-first approach is my belief that formulaic memorization conceptsandformulas is a last resort. Such a rote approach leaves the house without a foundation. Instead isoutstanding. ofgivingstudentscannedformulas,Itrytoshowthemhowtosolveproblemsthem- —EffiBenmelech HarvardUniversity selves.Mygoalistoteachstudentshowtodissectnewproblemswithasetofanalytical toolsthatwillstandthemingoodsteadintheirfuturecareers. SELF-CONTAINED FOR CLARITY Manystudentscomeintoclasswithapatchworkofbackgroundknowledge.Alongthe Ithink[the]approach way,holesintheirbackgroundscausesomeofthemtogetlost.Ihavethereforetriedto of integrating necessarymaterialis keepthisbookself-contained.Forexample,allnecessarystatisticalconceptsareinte- perfect.Ithelpsremind gratedinChapter8(InvestorChoice:RiskandReward),andallnecessaryaccounting students[about]what conceptsareexplainedinChapter13(FromFinancialStatementstoEconomicCash theyneedtoknowand Flows). shouldbolstertheir confidence. —AngelaLavin UniversityofSouth Dakota INNOVATIONS IN CONTENT AND PERSPECTIVE This book also offers numerous topical and expositional innovations, of which the followingisalimitedselection. A STRONG DISTINCTION BETWEEN EXPECTED AND PROMISED CASH FLOWS Iclearlydistinguishbetweenthepremiumtocompensatefordefault(creditrisk)—a conceptintroducedinChapter6(Uncertainty,Default,andRisk)—andtheriskpre- mium,whichisintroducedinChapter9(TheCapitalAssetPricingModel).Students shouldnolongermakethemistakeofthinkingthattheyhavetakencareofcreditrisk whentheydiscountapromisedcashflowwithaCAPMexpectedrateofreturn. ROBUSTNESS Throughout, I describe what finance practitioners can know clearly and what they Muchmorehonest canonlyguessat(withvaryingdegreesofaccuracy).Intheapplicationofanumber thanotherintroduc- torybooks. of financial tools, I point out which of the guessed uncertainties are likely to have —AdamGehr importantrepercussionsandwhichareminorinconsequence.Ialsotrytobehonest DePaulUniversity aboutwhereouracademicknowledgeissolidandwhereitisshaky. viii PREFACE A SPOTLIGHT ON THE PITFALLS OF CAPITAL BUDGETING IreallylovetheNPV A self-contained chapter (Chapter 12: Capital Budgeting Applications and Pitfalls) Checklist.Thisalone describes real-world difficulties and issues in applying capital budgeting techniques, makes the book rangingfromexternalitiestorealoptions,toagencyissues,tobehavioraldistortions, stand high above andsoon.Thechapterendswithan“NPVChecklist.” thecompetition. —JoeWalker FINANCIALS FROM A FINANCE PERSPECTIVE University of Alabama, Aself-containedaccountingchapter(Chapter13:FromFinancialStatementstoEco- Birmingham nomicCashFlows)explainshowearningsandeconomiccashflowsrelate.Whenstu- Thebestdiscussion dentsunderstandthelogicofcorporatefinancialstatements,theyavoidanumberof relatingaccountingto commonmistakesthathavecreptintofinancialcashflowcalculations“bytradition.” thefinancialinputsfor Inaddition,asynthesizingchapteronproformas(Chapter20:ProFormaFinancial valuationatthislevel Statements)combinesalltheingredientsfrompreviouschapters—capitalbudgeting, thatIhaveeverseen. —RobertHansen taxes,thecostofcapital,capitalstructure,andsoon.Manystudentswillbeaskedin TulaneUniversity theirfuturejobstoconstructproformas, andourcorporatefinancecurriculumhas notalwayspreparedthemwellenoughtoexecutesuchassignmentsappropriatelyand thoughtfully. COMPARABLES A chapter on comparables (Chapter 14: Valuation from Comparables and Some Fi- nancialRatios),usuallynotfoundinothercorporatefinancetextbooks,showsthatif usedproperly,thecomparablesvaluationmethodisagoodcousintoNPV. AN UPDATED PERSPECTIVE ON CAPITAL STRUCTURE The[capitalstructure] The academic perspective on capital structure has been changing. Here are a few of materialiscurrent themorenovelpointsofemphasisinthisbook: andpractical—much Corporate claims do not just have cash flow rights but important control rights as betterdonethanother . booksIhaveseen. well. This fact has many implications—that is, for the Modigliani-Miller perfect- —RichardFendler marketbenchmark. Georgia State Corporate liabilities are broader than just financial debt; in fact, on average, about University . two-thirdsoffirms’liabilitiesarenonfinancial.Thevalueofthefirmisthusthesum ofitsfinancialdebtandequityplusitsnonfinancialdebt(oftenlinkedtooperations). Again,thiscanbeimportantinanumberofapplications. Adverseselectioncausesapeckingorder,butsodoothereffects.Thus,thepecking . orderdoesnotnecessarilyimplyadverseselection. The debate about trade-off theory today has moved to how slowly it happens— . whetherittakes5yearsor500yearsforafirmtoreadjust. Historicalstockreturnsareamajordeterminantofwhichfirmstodayhavehighdebt . ratiosandwhichhavelowdebtratios.AsimpleinspectionoftheevolutionofIBM’s capitalstructurefrom2001to2003inChapter15makesthisplainlyobvious. Capital structure may not be a corporate control device. On the contrary, equity- . heavycapitalstructurescouldbetheresultofabreakdownofcorporatecontrol. Preferredequityandconvertibleshavebecomerareamongpubliclytradedcorpora- . tionsoverthepastdecade. PREFACE ix A unique synthesizing figure (Figure 18.5) in Chapter 18 (More Market Imperfec- . tionsInfluencingCapitalStructure)providesaconceptualbasisforthinkingabout capitalstructureinimperfectmarkets.ItshowshowAPVandothernon-tax-related imperfectionshangtogether. BASIC ORGANIZATION CorporateFinance:AnIntroductioncoversallthetopicsoftheusualcorporatefinance curriculum.However, asnotedabove, theorganizingprincipleofmovingfromper- fect to imperfect markets unifies the core chapters. This progression from financial “utopia”tothecomplexrealworldisespeciallyapparentinthefirstthreepartsofthe bookandisrevisitedmultipletimesinPartVoncapitalstructure. Part I: Value and Capital Budgeting shows how to work with rates of return and . . . Thetransition how to decide whether to take or reject projects in a perfect market under risk from perfect to imperfectmarkets neutrality. Five chapters lay out the basics of the time value of money, net present makes a lot of value,valuationofperpetuitiesandannuities,capitalbudgeting,interestrates,and sense . . . and is theconceptofuncertaintyintheabsenceofriskaversion. consistentwiththe overall theme of PartII:RiskandReturnintroducesriskaversionandshowshowitcreatesarelation thebook, whichis between risk and expected returns in a perfect market. It also provides a historical startingwithsimple backdrop of rates of return on various asset classes and some institutional back- conceptsandgradually ground.Itthenproceedstothekeyconceptsofrisk,reward,anddiversificationfrom introducing more complex, realistic aninvestor’sperspective,andculminateswithadiscussionoftheCapitalAssetPric- elements.I . . . liketo ingModel. structuremylectures PartIII:ValueandMarketEfficiencyinanImperfectMarketdescribeswhathappens accordingtosimilar logic. iftheperfectmarketassumptionsdonotholdinourmessierrealworld.Although —EvgenyLyandres the perfect market assumptions form the basis of most finance formulas (such as BostonUniversity NPV and the CAPM) and have facilitated the development of finance into a mod- ernscience,theyareprincipallyconceptual,notreal.Thus,inthispart,twochapters examinetherealityofinformationdifferences,noncompetitivemarkets,transaction costs, and taxes. The differences between efficient and inefficient markets, and be- tweenrationalandbehavioralfinance,arealsoexplained. PartIV:Real-WorldApplication puts the theory to work in three chapters. It shows that although the financial concepts may be simple, their application can be com- plex.Thispartexamineawideswathofissuesandpitfallstoconsiderwhenputting NPVandIRRtowork,looksatfinancialstatementanalysisfromafinanceperspec- tive,andconsidersthevaluationtechniqueofcomparables. PartV:CapitalStructureandPayoutPolicyconsidersthecapitalstructurethatfirms should choose. It starts again with a perfect-market theme and then shows in five chaptershowthisshouldplayoutinanimperfectworldofcorporatetaxesandother issues.Somemarketimperfectionsshouldpushfirmstowardmoreequityandothers towardmoredebt. Part VI: Projecting the Future shows how to think about the construction of pro formas.Inacertainsense,itiswhatmuchofcorporatefinanceisallabout. x PREFACE PartVII:AdditionalTopics contains six chapters for which the length of many cor- porate finance courses has little time. For those interested, there are treatments of capital structure dynamics, capital structure patterns in the United States, invest- mentbankingandM&A,corporategovernance,internationalfinance,andoptions. Moreover,thebook’swebsite(www.prenhall.com/welch)hasachapteronquantita- tiverealoptionimplementation.
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