Fundamentals of Corporate Finance

928 Pages·3·99.413 MB·English

by  Jonathan Berk, Jarrad Harford, David Stanseland, Andras Marosi

To my family, friends, colleagues, and God for all the love, support,
and encouragement, and to our country, Canada, where we can take
for granted all the freedoms that are sought after, but often denied,
around the world.
—David Stangeland
To my family for all their love and support.
—András Marosi
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Brief Contents
Introduction
PART 1
1
CHAPTER 1 Corporate Finance and the Financial Manager 2
CHAPTER 2 Introduction to Financial Statement Analysis 27
Interest Rates and Valuing Cash Flows
PART 2
71
CHAPTER 3 The Valuation Principle: The Foundation of Financial
Decision Making 72
CHAPTER 4 The Time Value of Money 95
CHAPTER 5 Interest Rates 134
CHAPTER 6 Bonds 162
CHAPTER 7 Valuing Stocks 202
Investment Decisions
PART 3
259
CHAPTER 8 Investment Decision Rules 260
CHAPTER 9 Fundamentals of Capital Budgeting 301
Return, Risk, and the Cost of Capital
PART 4
347
CHAPTER 10 Risk and Return in Capital Markets 348
CHAPTER 11 Systematic Risk and the Equity Risk Premium 381
CHAPTER 12 Determining the Cost of Capital 425
CHAPTER 13 Risk and the Pricing of Options 454
Financing Decisions
PART 5
483
CHAPTER 14 Raising Equity Capital 484
CHAPTER 15 Debt Financing 519
CHAPTER 16 Capital Structure 549
CHAPTER 17 Payout Policy 592
Financial Planning and Forecasting
PART 6
629
CHAPTER 18 Financial Modelling and Pro Forma Analysis 630
CHAPTER 19 Working Capital Management 661
CHAPTER 20 Short-Term Financial Planning 688
Special Topics
PART 7
719
CHAPTER 21 Risk Management 720
CHAPTER 22 International Corporate Finance 750
CHAPTER 23 Leasing 787
CHAPTER 24 Mergers and Acquisitions 814
CHAPTER 25 Corporate Governance 848
v
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Detailed Contents
PART 1 PREPARATION OF FINANCIAL STATEMENTS 28
INTERNATIONAL FINANCIAL REPORTING
Introduction
1 STANDARDS 29
2.2 The Statement of Financial Position
1 Corporate Finance and the or Balance Sheet 29
Financial Manager Assets 31
2
Liabilities 31
Shareholders’ Equity 32
Market Value versus Book Value 32
1.1 Why Study Finance? 3
Market-to-Book Ratio 33
1.2 The Three Types of Firms 3 Enterprise Value 34
Sole Proprietorships 4
2.3 The Statement of Comprehensive Income
Partnerships 5
and Income Statement 35
Corporations 5
Earnings Calculations 35
Tax Implications for Corporate Entities 7
EBITDA 37
CORPORATE TAXATION AROUND THE
2.4 The Statement of Cash Flows 37
WORLD 9
Operating Activity 39
1.3 The Financial Manager 10 Investment Activity 40
Making Investment Decisions 11 Financing Activity 40
Making Financing Decisions 11
2.5 Other Financial Statement Information 41
Managing Short-Term Cash Needs 11
Statement of Shareholders’ Equity 41
The Goal of the Financial Manager 11
Management Discussion and Analysis 42
1.4 The Financial Manager’s Place in the Notes to the Financial Statements 42
Corporation 12
2.6 Financial Statement Analysis 42
The Corporate Management Team 12
Profitability Ratios 42
Ethics and Incentives in Corporations 13
Liquidity Ratios 43
1.5 The Stock Market 16 Asset Efficiency 45
The Largest Stock Markets 16 Working Capital Ratios 45
NYSE 18 Interest Coverage Ratios 46
New Competition and Market Changes 18 Leverage Ratios 47
Listing Standards 19 Valuation Ratios 48
Other Financial Markets 19
COMMON MISTAKE MISMATCHED RATIOS 49
1.6 Financial Institutions 19 Operating Returns 50
The Financial Cycle 19 The DuPont Identity 51
Types of Financial Institutions 20 2.7 Financial Reporting in Practice 55
Role of Financial Institutions 21
Enron 55
The Sarbanes-Oxley Act 55
MyLabFinance  SUMMARY 21 • PROBLEMS 23
The Financial Statements: A Useful Starting
Point 57
MyLab Finance SUMMARY 58 • REVIEW
2 Introduction to Financial Statement
QUESTIONS 61 • PROBLEMS 61 • DATA CASE 69
Analysis
27
2.1 Firms’ Disclosure of Financial Information 28
Types of Financial Statements 28
vii
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viii Detailed Contents
PART 2 4 The Time Value of Money 95
Interest Rates and Valuing
Cash Flows 4.1 Valuing a Stream of Cash Flows 96
71
Applying the Rules of Valuing Cash
Flows 96
3 The Valuation Principle: 4.2 Perpetuities and Annuities 101
The Foundation of Financial Perpetuities 101
Decision Making 72 HISTORICAL EXAMPLES OF PERPETUITIES 102
COMMON MISTAKE DISCOUNTING ONE TOO
MANY TIMES 103
3.1 Cost-Benefit Analysis 73
Annuities 104
Role of the Financial Manager 73
USING A FINANCIAL CALCULATOR OR EXCEL:
YOUR PERSONAL FINANCIAL DECISIONS 73
SOLVING FOR PRESENT AND FUTURE VALUES
Quantifying Costs and Benefits 74
OF CASH FLOW STREAMS 106
Role of Competitive Market Prices 74
4.3 Solving for Variables Other Than Present Value
3.2 Market Prices and the Valuation Principle 75
or Future Value 110
The Valuation Principle 76
Solving for the Cash Flows 110
Why There Can Be Only One Competitive
Rate of Return 112
Price for a Good 77
Solving for n, the Number of Periods 115
3.3 The Time Value of Money and Interest
SOLVING FOR N USING LOGARITHMS 116
Rates 78
The Time Value of Money 78 4.4 Growing Cash Flows 118
The Interest Rate: Converting Cash across
Time 79 MyLab Finance SUMMARY 122 • REVIEW
Timelines 82 QUESTIONS 123 • PROBLEMS 124 • DATA CASE 129
Constructing a Timeline 82
CHAPTER 4 APPENDIX: USING A FINANCIAL
Identifying Dates on a Timeline 82
CALCULATOR 131
Distinguishing Cash Inflows from
Outflows 83
Representing Various Time Periods 83
3.4 Valuing Cash Flows at Different Points in 5 Interest Rates
134
Time 83
COMMON MISTAKE SUMMING CASH FLOWS
ACROSS TIME 84
5.1 Interest Rate Quotes and Adjustments 135
Rule 1: Comparing and Combining
The Effective Annual Rate 135
Values 84
Adjusting the Effective Annual Rate to
Rule 2: Compounding 84
an Effective Rate over Different Time
RULE OF 72 85
Periods 136
Rule 3: Discounting 86 Annual Percentage Rates 137
USING A FINANCIAL CALCULATOR 88 COMMON MISTAKE USING THE APR OR EAR
IN THE ANNUITY FORMULA 140
MyLab Finance SUMMARY 89 • REVIEW
5.2 Application: Discount Rates and Loans 140
QUESTION 91 • PROBLEMS 91
Computing Loan Payments 140
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Detailed Contents ix
Computing Canadian Mortgage Payments 143 CHAPTER 6 APPENDIX A: SOLVING FOR THE
Computing the Outstanding Loan Balance 143 YIELD TO MATURITY OF A BOND USING A
5.3 The Determinants of Interest Rates 144 FINANCIAL CALCULATOR 196
Inflation and Real versus Nominal Rates 145 CHAPTER 6 APPENDIX B: THE YIELD CURVE
Investment and Interest Rate Policy 146 AND THE LAW OF ONE PRICE 197
The Yield Curve and Discount Rates 147
CHAPTER 6 APPENDIX C: INTEREST RATE RISK
COMMON MISTAKE USING THE ANNUITY
MEASUREMENT: DURATION ONLINE
FORMULA WHEN DISCOUNT RATES VARY 150
The Yield Curve and the Economy 150
5.4 The Opportunity Cost of Capital 153
7 Valuing Stocks
INTEREST RATES, DISCOUNT RATES, AND 202
THE COST OF CAPITAL 153
MyLab Finance SUMMARY 155 • REVIEW
QUESTIONS 157 • PROBLEMS 157 7.1 Stock Basics 203
Stock Market Reporting: Stock Quotes 203
Common Stock 205
Preferred Stock 206
7.2 The Dividend-Discount Model 206
6 Bonds
162 A One-Year Investor 207
Dividend Yields, Capital Gains, and Total
Returns 207
A Multi-Year Investor 209
6.1 Bond Terminology 163 Dividend-Discount Model Equation 210
6.2 Zero-Coupon Bonds 164 7.3 Estimating Dividends in the Dividend-Discount
Zero-Coupon Bond Cash Flows 164 Model 211
Price and Yield to Maturity of a Constant Dividend Growth 211
Zero-Coupon Bond 164 Dividends versus Investment and
Risk-Free Interest Rates 166 Growth 212
GLOBAL FINANCIAL CRISIS: NEGATIVE Changing Growth Rates 215
BOND YIELDS 167 COMMON MISTAKE THE FIRST DIVIDEND 216
6.3 Coupon Bonds 169 Value Drivers and the Dividend-Discount
Model 217
Coupon Bond Cash Flows 169
Price and Yield to Maturity of a Coupon 7.4 Limitations of the Dividend-Discount
Bond 170 Model 218
Coupon Bond Price Quotes 171 Uncertain Dividend Forecasts 218
6.4 Why Bond Prices Change 173 Non-Dividend-Paying Stocks 219
7.5 Share Repurchases and the Total Payout
FINDING BOND PRICES ON THE WEB 173
Interest Rate Changes and Model 220
Bond Prices 174 7.6 The Discounted Free Cash Flow Model 221
Time and Bond Prices 176
7.7 Valuation Based on Comparable Firms 226
Interest Rate Risk and Bond Prices 178
Bond Prices in Practice 179 Valuation Multiples 227
Limitations of Multiples 230
6.5 Corporate Bonds 182
Comparison with Discounted Cash Flow
Credit Risk 182
Methods 231
Corporate Bond Yields 183
Stock Valuation Techniques: The Final
Bond Ratings 183
Word 232
Corporate and Provincial Yield Curves 185
7.8 Information, Competition, and Stock Prices 234
THE CREDIT CRISIS AND BOND YIELDS 188
Information in Stock Prices 234
Competition and Efficient Markets 236
MyLab Finance SUMMARY 189 • REVIEW
Lessons for Investors and Corporate
QUESTIONS 191 • PROBLEMS 191 • DATA CASE 195 Managers 239
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x Detailed Contents
The Efficient Markets Hypothesis versus No MyLab Finance • SUMMARY 289 • REVIEW
Arbitrage 240 QUESTIONS 290 • PROBLEMS 291 • DATA CASE 297
7.9 Individual Biases and Trading 240 CHAPTER 8 APPENDIX: USING EXCEL TO MAKE
Excessive Trading and Overconfidence 240 AN NPV PROFILE 299
Hanging on to Losers and the Disposition
Effect 241
Investor Attention, Mood, and
Experience 242 9 Fundamentals of Capital
Budgeting
301
MyLab Finance SUMMARY 243 • REVIEW
QUESTIONS 247 • PROBLEMS 247 • DATA CASE 255
PART 2 INTEGRATIVE CASE 257 9.1 The Capital Budgeting Process 302
9.2 Forecasting Incremental Earnings 303
Revenue and Cost Estimates 303
PART 3
COMMON MISTAKE USING THE WRONG CCA
Investment Decisions ASSET CLASS 305
259
Incremental Revenue and Cost
Estimates 306
8 Investment Decision Rules 260 9.3 Determining Incremental Free Cash Flow 309
Calculating Free Cash Flow from
Earnings 309
Calculating Free Cash Flow Directly 313
8.1 The NPV Rule 261 Calculating the NPV 314
Net Present Value 261 9.4 Other Effects on Incremental Free Cash
Making Decisions: The NPV Rule 262
Flows 315
8.2 Using the NPV Rule 263 Opportunity Costs 315
Organizing the Cash Flows and Computing
COMMON MISTAKE THE OPPORTUNITY COST OF
the NPV 263
AN IDLE ASSET 315
The NPV Profile 264
Project Externalities 316
Measuring Sensitivity with IRR 264
Sunk Costs 316
Alternative Rules versus the NPV Rule 265
COMMON MISTAKE THE SUNK COST
USING EXCEL: COMPUTING NPV AND IRR 266
FALLACY 317
8.3 Alternative Decision Rules 267 Adjusting Free Cash Flow 317
The Payback Rule 268 Replacement Decisions 323
The Internal Rate of Return Rule 269
9.5 Analyzing the Project 325
COMMON MISTAKE IRR VERSUS THE Sensitivity Analysis 325
IRR RULE 272 Break-Even Analysis 327
Scenario Analysis 327
WHY DO RULES OTHER THAN THE NPV RULE
PERSIST? 273 9.6 Real Options in Capital Budgeting 329
Option to Delay 330
8.4 Choosing Between Projects 274
Option to Expand 330
Differences in Scale 274
Option to Abandon 330
Timing of the Cash Flows 281
8.5 Evaluating Projects with Different Lives 282 MyLab Finance SUMMARY 331 • REVIEW
Important Considerations When Using the QUESTIONS 332 • PROBLEMS 333 • DATA CASE 338
Equivalent Annual Annuity 284
CHAPTER 9 APPENDIX: USING EXCEL
8.6 Choosing Among Projects When Resources Are
FOR CAPITAL BUDGETING 340
Limited 285
PART 3 INTEGRATIVE CASE 345
Evaluating Projects with Different Resource
Requirements 285
8.7 Putting It All Together 288
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Detailed Contents xi
11.2 The Volatility of a Portfolio 385
Diversifying Risks 385
PART 4 Measuring Stocks’ Co-movement:
Correlation 386
Return, Risk, and the
USING EXCEL: CALCULATING THE CORRELATION
Cost of Capital BETWEEN TWO SETS OF RETURNS 390
347 Computing a Portfolio’s Variance and
Standard Deviation 390
Risk versus Return: Choosing an Efficient
10 Risk and Return in Capital
Portfolio with Two Stocks 392
Markets 348 The Effect of Correlation 395
The Volatility of a Large Portfolio 395
NOBEL PRIZE HARRY MARKOWITZ 396
10.1 A First Look at Risk and Return 349
11.3 Measuring Systematic Risk 397
10.2 Historical Risks and Returns of Stocks 351
Role of the Market Portfolio 397
Computing Historical Returns 351
Stock Market Indexes as the Market
Average Annual Returns 355
Portfolio 398
The Variance and Volatility of Returns 357
INDEX FUNDS AND EXCHANGE TRADED
ARITHMETIC AVERAGE RETURNS VERSUS
FUNDS 399
COMPOUND ANNUAL RETURNS 358
Market Risk and Beta 399
COMMON MISTAKE MISTAKES WHEN
COMMON MISTAKE STANDARD DEVIATION
COMPUTING STANDARD DEVIATION 360
VERSUS BETA 401
USING EXCEL: COMPUTING THE STANDARD Estimating Beta from Historical Returns 403
DEVIATION OF HISTORICAL RETURNS 360
USING EXCEL: CALCULATING A STOCK’S
The Normal Distribution 361
BETA 405
10.3 The Historical Trade-Off between Risk and
11.4 Putting It All Together: The Capital Asset
Return 363
Pricing Model 406
The Returns of Large Portfolios 363
The CAPM Equation Relating Risk to
The Returns of Individual Stocks 363
Expected Return 407
10.4 Common versus Independent Risk 365
WHY NOT ESTIMATE EXPECTED RETURNS
Theft versus Earthquake Insurance: An
DIRECTLY? 408
Example 365
The Security Market Line 409
Types of Risk 366
The CAPM and Portfolios 409
10.5 Diversification in Stock Portfolios 367 Summary of the Capital Asset Pricing
Unsystematic versus Systematic Risk 367 Model 412
Diversifiable Risk and the Risk Premium 370 The Big Picture 412
The Importance of Systematic Risk 370 Problems with the CAPM in Practice 412
COMMON MISTAKE A FALLACY OF LONG-RUN NOBEL PRIZE WILLIAM SHARPE 413
DIVERSIFICATION 371
MyLab Finance SUMMARY 414 • REVIEW
MyLab Finance SUMMARY 373 • REVIEW QUESTIONS 416 • PROBLEMS 416
QUESTIONS 374 • PROBLEMS 375 • DATA CASE 379
CHAPTER 11 APPENDIX: ALTERNATIVE MODELS
OF SYSTEMATIC RISK 422
11 Systematic Risk and the Equity
Risk Premium 381 12 Determining the Cost of Capital 425
11.1 The Expected Return of a Portfolio 382
Portfolio Weights 382 12.1 A First Look at the Weighted Average
Portfolio Returns 382 Cost of Capital 426
Expected Portfolio Return 384
The Firm’s Capital Structure 426
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xii Detailed Contents
Opportunity Cost and the Overall Cost of 13.3 Factors Affecting Option Prices 466
Capital 427 Strike Price and Stock Price 466
Weighted Averages and the Overall Cost of Option Prices and the Expiration Date 466
Capital 427 Option Prices and the Risk-Free Rate 466
Weighted Average Cost of Capital Option Prices and Volatility 466
Calculations 428
13.4 The Binomial Option Pricing Model 468
12.2 The Firm’s Costs of Debt and Equity The Two-State Single-Period Model: An
Capital 430 Example 468
Cost of Debt Capital 430 The Binomial Pricing Formula 469
COMMON MISTAKE USING THE COUPON RATE 13.5 The Black-Scholes Option Pricing
AS THE COST OF DEBT 431 Formula 470
Cost of Preferred Stock Capital 432
13.6 Put-Call Parity 472
Cost of Common Stock Capital 432
Portfolio Insurance 472
12.3 A Second Look at the Weighted Average
13.7 Options and Corporate Finance 475
Cost of Capital 435
WACC Equation 435 MyLab Finance SUMMARY 477 • REVIEW
Weighted Average Cost of Capital in
QUESTIONS 479 • PROBLEMS 479 • DATA CASE 481
Practice 436
Methods in Practice 436
12.4 Using the WACC to Value a Project 439
Key Assumptions 440
PART 5
WACC Method Application: Extending the
Life of Facilities at BCE 440 Financing Decisions
483
Summary of the WACC Method 441
12.5 Project-Based Costs of Capital 442
14 Raising Equity Capital
484
COMMON MISTAKE USING A SINGLE COST OF
CAPITAL IN MULTIDIVISIONAL FIRMS 442
Cost of Capital for a New Acquisition 442
Divisional Costs of Capital 443
14.1 Equity Financing for Private Companies 485
12.6 When Raising External Capital Is Costly 445
Sources of Funding 485
Crowdfunding: The Wave of the Future? 488
MyLab Finance SUMMARY 446 • REVIEW
Securities and Valuation 489
QUESTIONS 448 • PROBLEMS 449 • DATA CASE 452 Exiting an Investment in a Private
Company 491
14.2 Taking Your Firm Public: The Initial Public
13 Risk and the Pricing of Options Offering 492
454
Advantages and Disadvantages of Going
Public 492
Primary and Secondary IPO Offerings 494
Other IPO Types 499
13.1 Option Basics 455
Option Contracts 455 GOOGLE’S IPO 502
Stock Option Quotations 456
14.3 IPO Puzzles 503
Options on Other Financial Securities 458
Underpriced IPOs 503
OPTIONS ARE FOR MORE THAN JUST “Hot” and “Cold” IPO Markets 503
STOCKS 459
GLOBAL FINANCIAL CRISIS 2008–2009: A VERY
13.2 Option Payoffs and Profits at Expiration 459 COLD IPO MARKET 505
The Long Position in an Option Contract 459 High Cost of Issuing an IPO 506
The Short Position in an Option Contract 461 Poor Post-IPO Long-Run Stock
Profit from Holding an Option to Performance 507
Expiration 463
14.4 Raising Additional Capital: The Seasoned
Short Sales 464
Equity Offering 507
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