# Cash flow

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FREQUENTLY USED SYMBOLS

ACP Average collection period ADR American Depository Receipt APR Annual percentage rate AR Accounts receivable b Beta coefficient, a measure of an asset’s market risk

bL Levered beta bU Unlevered beta

BEP Basic earning power BVPS Book value per share CAPM Capital Asset Pricing Model CCC Cash conversion cycle CF Cash flow; CFt is the cash flow in Period t

CFPS Cash flow per share CR Conversion ratio CV Coefficient of variation Δ Difference, or change (uppercase delta)

Dps Dividend of preferred stock Dt Dividend in Period t

DCF Discounted cash flow D/E Debt-to-equity ratio DPS Dividends per share

DRIP Dividend reinvestment plan DRP Default risk premium DSO Days sales outstanding EAR Effective annual rate, EFF% EBIT Earnings before interest and taxes; net operating income

EBITDA Earnings before interest, taxes, depreciation, and amortization EPS Earnings per share EVA Economic Value Added

F (1) Fixed operating costs (2) Flotation cost

FCF Free cash flow FVN Future value for Year N

FVAN Future value of an annuity for N years g Growth rate in earnings, dividends, and stock prices I Interest rate; also denoted by r

I/YR Interest rate key on some calculators INT Interest payment in dollars

IP Inflation premium IPO Initial public offering IRR Internal rate of return LP Liquidity premium M (1) Maturity value of a bond

(2) Margin (profit margin) M/B Market-to-book ratio

MIRR Modified Internal Rate of Return MRP Maturity risk premium MVA Market Value Added

n Number of shares outstanding N Calculator key denoting number of periods

N(di) Represents area under a standard normal distribution function NOPAT Net operating profit after taxes NOWC Net operating working capital

NPV Net present value P (1) Price of a share of stock in Period t; P0 = price of the stock today

(2) Sales price per unit of product sold Pc Conversion price

Pf Price of good in foreign country Ph Price of good in home country PN A stock’s horizon, or terminal, value P/E Price/earnings ratio

PMT Payment of an annuity PPP Purchasing power parity PV Present value

PVAN Present value of an annuity for N years Q Quantity produced or sold

QBE Breakeven quantity r (1) A percentage discount rate, or cost of capital; also denoted by i

(2) Nominal risk-adjusted required rate of return r̄ “r bar,” historic, or realized, rate of return r̂ “r hat,” an expected rate of return r* Real risk-free rate of return rd Before-tax cost of debt re Cost of new common stock (outside equity) rf Interest rate in foreign country rh Interest rate in home country ri Required return for an individual firm or security

rM Return for “the market” or for an “average” stock rNOM Nominal rate of interest; also denoted by iNOM

rps (1) Cost of preferred stock (2) Portfolio’s return

rPER Periodic rate of return rRF Rate of return on a risk-free security rs (1) Required return on common stock

(2) Cost of old common stock (inside equity) ρ Correlation coefficient (lowercase rho); also denoted by R when using historical data

ROA Return on assets ROE Return on equity RP Risk premium

RPM Market risk premium RR Retention rate S (1) Sales

(2) Estimated standard deviation for sample data (3) Intrinsic value of stock (i.e., all common equity)

SML Security Market Line ∑ Summation sign (uppercase sigma) σ Standard deviation (lowercase sigma) σ2 Variance t Time period T Marginal income tax rate

TVN A stock’s horizon, or terminal, value TIE Times interest earned

V Variable cost per unit VB Bond value VL Total market value of a levered firm Vop Value of operations Vps Value of preferred stock VU Total market value of an unlevered firm VC Total variable costs w Proportion or weight wd Weight of debt wps Weight of preferred stock ws Weight of common equity raised internally by retaining earnings wce Weight of common equity raised externally by issuing stock

WACC Weighted averaged cost of capital X Exercise price of option

YTC Yield to call YTM Yield to maturity

Financial Management: Theory and Practice THIRTEENTH EDITION

M ICHAE L C . EHRHARDT University of Tennessee

EUGENE F . B R I GHAM University of Florida

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Financial Management: Theory and Practice, Thirteen Edition

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Brief Contents

Preface xix

PART 1 Fundamental Concepts of Corporate Finance 1

CHAPTER 1 An Overview of Financial Management and the Financial Environment 3

Web Extensions 1A: An Overview of Derivatives 1B: A Closer Look at the Stock Markets

CHAPTER 2 Financial Statements, Cash Flow, and Taxes 47

Web Extensions 2A: The Federal Income Tax System for Individuals

CHAPTER 3 Analysis of Financial Statements 87

PART 2 Fixed Income Securities 121

CHAPTER 4 Time Value of Money 123

Web Extensions 4A: The Tabular Approach 4B: Derivation of Annuity Formulas 4C: Continuous Compounding

CHAPTER 5 Bonds, Bond Valuation, and Interest Rates 173

Web Extensions 5A: A Closer Look at Zero Coupon Bonds 5B: A Closer Look at TIPS: Treasury Inflation-Protected Securities 5C: A Closer Look at Bond Risk: Duration 5D: The Pure Expectations Theory and Estimation of Forward Rates

PART 3 Stocks and Options 215

CHAPTER 6 Risk, Return, and the Capital Asset Pricing Model 217

Web Extensions 6A: Continuous Probability Distributions 6B: Estimating Beta with a Financial Calculator

CHAPTER 7 Stocks, Stock Valuation, and Stock Market Equilibrium 267

Web Extensions 7A: Derivation of Valuation Equations

CHAPTER 8 Financial Options and Applications in Corporate Finance 305

PART 4 Projects and Their Valuation 333

CHAPTER 9 The Cost of Capital 335

Web Extensions 9A: The Required Return Assuming Nonconstant Dividends and Stock Repurchases

CHAPTER 10 The Basics of Capital Budgeting: Evaluating Cash Flows 379

Web Extensions 10A: The Accounting Rate of Return (ARR)

CHAPTER 11 Cash Flow Estimation and Risk Analysis 423

Web Extensions 11A: Certainty Equivalents and Risk-Adjusted Discount Rates

i i i

PART 5 Corporate Valuation and Governance 471

CHAPTER 12 Financial Planning and Forecasting Financial Statements 473

Web Extensions 12A: Advanced Techniques for Forecasting Financial Statements Accounts

CHAPTER 13 Corporate Valuation, Value-Based Management and Corporate Governance 511

PART 6 Cash Distributions and Capital Structure 557

CHAPTER 14 Distributions to Shareholders: Dividends and Repurchases 559

CHAPTER 15 Capital Structure Decisions 599

Web Extensions 15A: Degree of Leverage

PART 7 Managing Global Operations 639

CHAPTER 16 Working Capital Management 641

Web Extensions 16A: Secured Short-Term Financing

CHAPTER 17 Multinational Financial Management 691

PART 8 Tactical Financing Decisions 731

CHAPTER 18 Lease Financing 733

Web Extensions 18A: Leasing Feedback 18B: Percentage Cost Analysis 18C: Leveraged Leases

CHAPTER 19 Hybrid Financing: Preferred Stock, Warrants, and Convertibles 759

Web Extensions 19A: Calling Convertible Issues

CHAPTER 20 Initial Public Offerings, Investment Banking, and Financial Restructuring 787

Web Extensions 20A: Rights Offerings

PART 9 Special Topics 825

CHAPTER 21 Mergers, LBOs, Divestitures, and Holding Companies 827

Web Extensions 21A: Projecting Consistent Debt and Interest Expenses

CHAPTER 22 Bankruptcy, Reorganization, and Liquidation 869

Web Extensions 22A: Multiple Discriminant Analysis

CHAPTER 23 Derivatives and Risk Management 899

Web Extensions 23A: Risk Management with Insurance

PART 10 Advanced Issues 929

CHAPTER 24 Portfolio Theory, Asset Pricing Models, and Behavioral Finance 931

CHAPTER 25 Real Options 971

Web Extensions 25A: The Abandonment Real Option 25B: Risk-Neutral Valuation

CHAPTER 26 Analysis of Capital Structure Theory 995

iv Brief Contents

Appendixes

Appendix A Solutions to Self-Test Problems 1029

Appendix B Answers to End-of-Chapter Problems 1063

Appendix C Selected Equations and Data 1071

Appendix D Values of the Areas under the Standard Normal Distribution Function 1085

Glossary 1087 Name Index 1113 Subject Index 1119

Web Chapters CHAPTER 27 Providing and Obtaining Credit

CHAPTER 28 Advanced Issues in Cash Management and Inventory Control

CHAPTER 29 Pension Plan Management

CHAPTER 30 Financial Management in Not-for-Profit Businesses

Brief Contents v

Contents

Preface . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xix

PART 1 Fundamental Concepts of Corporate Finance 1

C H A P T E R 1 An Overview of Financial Management and the Financial Environment 3 The Five-Minute MBA 4

Box: Say Hello to the Global Economic Crisis! 5

The Corporate Life Cycle 5 Box: Columbus Was Wrong—the World Is Flat! And Hot, and Crowded! 6

The Primary Objective of the Corporation: Value Maximization 9 Box: Ethics for Individuals and Businesses 10

Box: Corporate Scandals and Maximizing Stock Price 13

An Overview of the Capital Allocation Process 13 Financial Securities 15 The Cost of Money 19 Financial Institutions 23 Financial Markets 27 Trading Procedures in Financial Markets 29 Types of Stock Market Transactions 30

Box: Rational Exuberance? 31

The Secondary Stock Markets 31 Box: Measuring the Market 33

Stock Market Returns 34 The Global Economic Crisis 36 The Big Picture 42 e-Resources 43 Summary 44 Web Extensions

1A: An Overview of Derivatives

1B: A Closer Look at the Stock Markets

C H A P T E R 2 Financial Statements, Cash Flow, and Taxes 47

Box: Intrinsic Value, Free Cash Flow, and Financial Statements 48

Financial Statements and Reports 48 The Balance Sheet 49

Box: Let’s Play Hide-and-Seek! 51

v i

The Income Statement 52 Statement of Stockholders’ Equity 53 Net Cash Flow 54 Statement of Cash Flows 55

Box: Financial Analysis on the WEB 56

Modifying Accounting Data for Managerial Decisions 59 Box: Financial Bamboozling: How to Spot It 63

MVA and EVA 67 Box: Sarbanes-Oxley and Financial Fraud 70

The Federal Income Tax System 71 Summary 76 Web Extensions

2A: The Federal Income Tax System for Individuals

C H A P T E R 3 Analysis of Financial Statements 87

Box: Intrinsic Value and Analysis of Financial Statements 88

Financial Analysis 88 Liquidity Ratios 89 Asset Management Ratios 92

Box: The Price is Right! (Or Wrong!) 93

Debt Management Ratios 95 Profitability Ratios 98

Box: The World Might be Flat, but Global Accounting is Bumpy! The Case of IFRS versus FASB 99

Market Value Ratios 100 Trend Analysis, Common Size Analysis, and Percentage Change Analysis 102 Tying the Ratios Together: The Du Pont Equation 106 Comparative Ratios and Benchmarking 107 Uses and Limitations of Ratio Analysis 108

Box: Ratio Analysis on the Web 109

Looking beyond the Numbers 110 Summary 110

PART 2 Fixed Income Securities 121

C H A P T E R 4 Time Value of Money 123

Box: Corporate Valuation and the Time Value of Money 124

Time Lines 125 Future Values 125

Box: Hints on Using Financial Calculators 129

Box: The Power of Compound Interest 132

Present Values 133

Contents vii

Finding the Interest Rate, I 136 Finding the Number of Years, N 137 Annuities 138 Future Value of an Ordinary Annuity 138 Future Value of an Annuity Due 141 Present Value of Ordinary Annuities and Annuities Due 141

Box: Variable Annuities: Good or Bad? 144

Finding Annuity Payments, Periods, and Interest Rates 144 Perpetuities 146

Box: Using the Internet for Personal Financial Planning 147

Uneven, or Irregular, Cash Flows 148 Future Value of an Uneven Cash Flow Stream 151 Solving for I with Irregular Cash Flows 152 Semiannual and Other Compounding Periods 153

Box: Truth in Lending: What Loans Really Cost 156

Fractional Time Periods 157 Amortized Loans 158 Growing Annuities 159

Box: An Accident Waiting to Happen: Option Reset Adjustable Rate Mortgages 160

Summary 162 Web Extensions

4A: The Tabular Approach

4B: Derivation of Annuity Formulas

4C: Continuous Compounding

C H A P T E R 5 Bonds, Bond Valuation, and Interest Rates 173

Box: Intrinsic Value and the Cost of Debt 174

Who Issues Bonds? 174 Key Characteristics of Bonds 175

Box: Betting With or Against the U.S. Government: The Case of Treasury Bond Credit Default Swaps 176

Bond Valuation 180 Changes in Bond Values over Time 184

Box: Drinking Your Coupons 187

Bonds with Semiannual Coupons 187 Bond Yields 188 The Pre-Tax Cost of Debt: Determinants of Market Interest Rates 191 The Real Risk-Free Rate of Interest, r* 192 The Inflation Premium (IP) 193 The Nominal, or Quoted, Risk-Free Rate of Interest, rRF 195 The Default Risk Premium (DRP) 195

Box: Insuring with Credit Default Swaps: Let the Buyer Beware! 197

viii Contents

Box: Might the U.S. Treasury Bond Be Downgraded? 199

Box: Are Investors Rational? 201

The Liquidity Premium (LP) 201 The Maturity Risk Premium (MRP) 201 The Term Structure of Interest Rates 204 Financing with Junk Bonds 205 Bankruptcy and Reorganization 206 Summary 207 Web Extensions

5A: A Closer Look at Zero Coupon Bonds

5B: A Closer Look at TIPS: Treasury Inflation-Protected Securities

5C: A Closer Look at Bond Risk: Duration

5D: The Pure Expectations Theory and Estimation of Forward Rates

PART 3 Stocks and Options 215

C H A P T E R 6 Risk, Return, and the Capital Asset Pricing Model 217

Box: Intrinsic Value, Risk, and Return 219

Returns on Investments 219 Stand-Alone Risk 220

Box: What Does Risk Really Mean? 227

Box: The Trade-off between Risk and Return 229

Risk in a Portfolio Context 231 Box: How Risky Is a Large Portfolio of Stocks? 236

Box: The Benefits of Diversifying Overseas 239

Calculating Beta Coefficients 243 The Relationship between Risk and Return 246

Box: Another Kind of Risk: The Bernie Madoff Story 252

Some Concerns about Beta and the CAPM 253 Some Concluding Thoughts: Implications for Corporate Managers and Investors 253 Summary 255 Web Extensions

6A: Continuous Probability Distributions

6B: Estimating Beta with a Financial Calculator

C H A P T E R 7 Stocks, Stock Valuation, and Stock Market Equilibrium 267

Box: Corporate Valuation and Stock Prices 268

Legal Rights and Privileges of Common Stockholders 268 Types of Common Stock 269 The Market Stock Price versus Intrinsic Value 270 Stock Market Reporting 272

Contents ix

Valuing Common Stocks 273 Valuing a Constant Growth Stock 276 Expected Rate of Return on a Constant Growth Stock 279 Valuing Nonconstant Growth Stocks 281 Stock Valuation by the Free Cash Flow Approach 285 Market Multiple Analysis 285 Preferred Stock 286 Stock Market Equilibrium 287 The Efficient Markets Hypothesis 290

Box: Rational Behavior versus Animal Spirits, Herding, and Anchoring Bias 293

Summary 294 Web Extensions

7A: Derivation of Valuation Equations

C H A P T E R 8 Financial Options and Applications in Corporate Finance 305

Box: The Intrinsic Value of Stock Options 306

Overview of Financial Options 306 Box: Financial Reporting for Employee Stock Options 309

The Single-Period Binomial Option Pricing Approach 310 The Single-Period Binomial Option Pricing Formula 314 The Multi-Period Binomial Option Pricing Model 316 The Black-Scholes Option Pricing Model (OPM) 319

Box: Taxes and Stock Options 324

The Valuation of Put Options 325 Applications of Option Pricing in Corporate Finance 326 Summary 328

PART 4 Projects and Their Valuation 333

C H A P T E R 9 The Cost of Capital 335

Box: Corporate Valuation and the Cost of Capital 336

The Weighted Average Cost of Capital 337 Basic Definitions 338 Cost of Debt, rd(1 − T) 340 Cost of Preferred Stock, rps 342

Box: GE and Warren Buffett: The Cost of Preferred Stock 343

Cost of Common Stock, rs 344 The CAPM Approach 345 Dividend-Yield-Plus-Growth-Rate, or Discounted Cash Flow (DCF), Approach 353 Over-Own-Bond-Yield-Plus-Judgmental-Risk-Premium Approach 355 Comparison of the CAPM, DCF, and Over-Own-Bond-Yield-Plus-Judgmental-Risk-

Premium Methods 356

x Contents

Adjusting the Cost of Equity for Flotation Costs 357 Composite, or Weighted Average, Cost of Capital, WACC 358

Box: Global Variations in the Cost of Capital 361

Factors That Affect the WACC 361 Adjusting the Cost of Capital for Risk 363 Privately Owned Firms and Small Businesses 366 Four Mistakes to Avoid 367 Summary 368 Web Extensions

9A: The Required Return Assuming Nonconstant Dividends and Stock Repurchases

C H A P T E R 1 0 The Basics of Capital Budgeting: Evaluating Cash Flows 379

Box: Corporate Valuation and Capital Budgeting 381

An Overview of Capital Budgeting 381 Net Present Value (NPV) 383 Internal Rate of Return (IRR) 387

Box: Why NPV Is Better Than IRR 389

Multiple Internal Rates of Return 390 Reinvestment Rate Assumptions 392 Modified Internal Rate of Return (MIRR) 393 NPV Profiles 396 Profitability Index (PI) 400 Payback Period 401 Conclusions on Capital Budgeting Methods 403 Decision Criteria Used in Practice 405 Other Issues in Capital Budgeting 405 Summary 411 Web Extensions

10A: The Accounting Rate of Return (ARR)

C H A P T E R 1 1 Cash Flow Estimation and Risk Analysis 423

Box: Corporate Valuation, Cash Flows, and Risk Analysis 424

Conceptual Issues 424 Analysis of an Expansion Project 429 Risk Analysis in Capital Budgeting 435 Measuring Stand-Alone Risk 436 Sensitivity Analysis 436 Scenario Analysis 439 Monte Carlo Simulation 442

Box: Are Bank Stress Tests Stressful Enough? 445

Project Risk Conclusions 446 Box: Capital Budgeting Practices in the Asian/Pacific Region 447

Contents xi

Replacement Analysis 448 Real Options 449 Phased Decisions and Decision Trees 451 Summary 454 Appendix 11A Tax Depreciation 468 Web Extensions

11A: Certainty Equivalents and Risk-Adjusted Discount Rates

PART 5 Corporate Valuation and Governance 471

C H A P T E R 1 2 Financial Planning and Forecasting Financial Statements 473

Box: Corporate Valuation and Financial Planning 474 Overview of Financial Planning 474 Sales Forecast 476 Additional Funds Needed (AFN) Method 478 Forecasted Financial Statements Method 482 Forecasting When the Ratios Change 496 Summary 499 Web Extensions

12A: Advanced Techniques for Forecasting Financial Statements Accounts

C H A P T E R 1 3 Corporate Valuation, Value-Based Management and Corporate

Governance 511 Box: Corporate Valuation: Putting the Pieces Together 512

Overview of Corporate Valuation 513 The Corporate Valuation Model 514 Value-Based Management 521 Managerial Behavior and Shareholder Wealth 530 Corporate Governance 531

Box: Let’s Go to Miami! IBM’s 2009 Annual Meeting 533

Box: Would the U.S. Government Be an Effective Board Director? 536

Box: Shareholder Reactions to the Crisis 538

Box: The Sarbanes-Oxley Act of 2002 and Corporate Governance 540

Box: International Corporate Governance 542

Employee Stock Ownership Plans (ESOPs) 543 Summary 546

PART 6 Cash Distributions and Capital Structure 557

C H A P T E R 1 4 Distributions to Shareholders: Dividends and Repurchases 559

Box: Uses of Free Cash Flow: Distributions to Shareholders 560

An Overview of Cash Distributions 560

xii Contents

Procedures for Cash Distributions 562 Cash Distributions and Firm Value 564 Clientele Effect 567 Information Content, or Signaling, Hypothesis 568 Implications for Dividend Stability 569

Box: Will Dividends Ever Be the Same? 570

Setting the Target Distribution Level: The Residual Distribution Model 570 The Residual Distribution Model in Practice 572 A Tale of Two Cash Distributions: Dividends versus Stock Repurchases 573 The Pros and Cons of Dividends and Repurchases 582

Box: Dividend Yields around the World 584

Other Factors Influencing Distributions 584 Summarizing the Distribution Policy Decision 585 Stock Splits and Stock Dividends 587

Box: Talk about a Split Personality! 588

Dividend Reinvestment Plans 590 Summary 591

C H A P T E R 1 5 Capital Structure Decisions 599

Box: Corporate Valuation and Capital Structure 600

A Preview of Capital Structure Issues 600 Business Risk and Financial Risk 603 Capital Structure Theory 609

Box: Yogi Berra on the MM Proposition 611

Capital Structure Evidence and Implications 618 Box: Taking a Look at Global Capital Structures 620

Estimating the Optimal Capital Structure 621 Anatomy of a Recapitalization 625

Box: Deleveraging 630

Summary 630 Web Extensions

15A: Degree of Leverage

PART 7 Managing Global Operations 639

C H A P T E R 1 6 Working Capital Management 641

Box: Corporate Valuation and Working Capital Management 642

Current Asset Holdings 643 Current Assets Financing Policies 644 The Cash Conversion Cycle 648

Box: Some Firms Operate with Negative Working Capital! 653

The Cash Budget 654

Contents xiii

Cash Management and the Target Cash Balance 657 Box: The CFO Cash Management Scorecard 658

Cash Management Techniques 659 Inventory Management 661

Box: Supply Chain Management 662

Receivables Management 663 Box: Supply Chain Finance 665

Accruals and Accounts Payable (Trade Credit) 667 Short-Term Marketable Securities 670 Short-Term Financing 672 Short-Term Bank Loans 672 Commercial Paper 676 Use of Security in Short-Term Financing 677 Summary 678 Web Extensions

16A: Secured Short-Term Financing

C H A P T E R 1 7 Multinational Financial Management 691

Box: Corporate Valuation in a Global Context 692

Multinational, or Global, Corporations 692 Multinational versus Domestic Financial Management 693 Exchange Rates 694 Exchange Rates and International Trade 698 The International Monetary System and Exchange Rate Policies 699 Trading in Foreign Exchange 703 Interest Rate Parity 704 Purchasing Power Parity 706

Box: Hungry for a Big Mac? Go To Malaysia! 708

Inflation, Interest Rates, and Exchange Rates 709 International Money and Capital Markets 710

Box: Greasing the Wheels of International Business 711

Box: Stock Market Indices around the World 713

Multinational Capital Budgeting 714 Box: Consumer Finance in China 715

International Capital Structures 718 Multinational Working Capital Management 720 Summary 723

PART 8 Tactical Financing Decisions 731

C H A P T E R 1 8 Lease Financing 733 Types of Leases 734

xiv Contents

Tax Effects 736 Financial Statement Effects 738

Box: Off–Balance Sheet Financing: Is It Going to Disappear? 740

Evaluation by the Lessee 740 Evaluation by the Lessor 745 Other Issues in Lease Analysis 747

Box: What You Don’t Know Can Hurt You! 748

Box: Lease Securitization 750

Other Reasons for Leasing 751 Summary 753 Web Extensions

18A: Leasing Feedback

18B: Percentage Cost Analysis

18C: Leveraged Leases

C H A P T E R 1 9 Hybrid Financing: Preferred Stock, Warrants, and Convertibles 759 Preferred Stock 761

Box: The Romance Had No Chemistry, But It Had a Lot of Preferred Stock! 762

Warrants 765 Convertible Securities 770 A Final Comparison of Warrants and Convertibles 777 Reporting Earnings When Warrants or Convertibles Are Outstanding 778 Summary 779 Web Extensions

19A: Calling Convertible Issues

C H A P T E R 2 0 Initial Public Offerings, Investment Banking, and Financial

Restructuring 787 The Financial Life Cycle of a Start-up Company 788 The Decision to Go Public 789 The Process of Going Public: An Initial Public Offering 791 Equity Carve-outs: A Special Type of IPO 799 Other Ways to Raise Funds in the Capital Markets 800

Box: Bowie Bonds Ch-Ch-Change Asset Securitization 803

Investment Banking Activities and Their Role in the Global Economic Crisis 803 Box: Investment Banks and the Global Economic Crisis 805

The Decision to Go Private 806 Managing the Maturity Structure of Debt 808 Refunding Operations 810

Box: TVA Ratchets Down Its Interest Expenses 813

Managing the Risk Structure of Debt with Project Financing 815 Summary 817 Web Extensions

20A: Rights Offerings

Contents xv

PART 9 Special Topics 825

C H A P T E R 2 1 Mergers, LBOs, Divestitures, and Holding Companies 827 Rationale for Mergers 828 Types of Mergers 830 Level of Merger Activity 831 Hostile versus Friendly Takeovers 832 Merger Regulation 833 Overview of Merger Analysis 834 The Adjusted Present Value (APV) Approach 835 The Free Cash Flow to Equity (FCFE) Approach 838 Illustration of the Three Valuation Approaches for a Constant Capital Structure 840 Setting the Bid Price 845 Analysis When There Is a Permanent Change in Capital Structure 847 Taxes and the Structure of the Takeover Bid 849

Box: Tempest in a Teapot? 850

Financial Reporting for Mergers 852 Analysis for a “True Consolidation” 855 The Role of Investment Bankers 855 Who Wins: The Empirical Evidence 857

Box: Merger Mistakes 858

Corporate Alliances 858 Leveraged Buyouts 859 Divestitures 859 Holding Companies 860 Summary 862 Web Extensions

21A: Projecting Consistent Debt and Interest Expenses

C H A P T E R 2 2 Bankruptcy, Reorganization, and Liquidation 869 Financial Distress and Its Consequences 870 Issues Facing a Firm in Financial Distress 871 Settlements without Going through Formal Bankruptcy 872 Federal Bankruptcy Law 874 Reorganization in Bankruptcy 875 Liquidation in Bankruptcy 885

Box: A Nation of Defaulters? 888

Other Motivations for Bankruptcy 889 Some Criticisms of Bankruptcy Laws 889 Summary 890 Web Extensions

22A: Multiple Discriminant Analysis

xvi Contents

C H A P T E R 2 3 Derivatives and Risk Management 899

Box: Corporate Valuation and Risk Management 900

Reasons to Manage Risk 901 Background on Derivatives 903 Derivatives in the News 904 Other Types of Derivatives 907 Corporate Risk Management 913

Box: Enterprise Risk Management and Value at Risk 916

Using Derivatives to Reduce Risks 917 Box: Risk Management in the Cyber Economy 920

Summary 924 Web Extensions

23A: Risk Management with Insurance

PART 10 Advanced Issues 929

C H A P T E R 2 4 Portfolio Theory, Asset Pricing Models, and Behavioral Finance 931

Box: Corporate Valuation and Risk 932

Efficient Portfolios 932 Choosing the Optimal Portfolio 936 The Basic Assumptions of the Capital Asset Pricing Model 939 The Capital Market Line and the Security Market Line 940 Calculating Beta Coefficients 944

Box: Skill or Luck? 945

Empirical Tests of the CAPM 952 Arbitrage Pricing Theory 954 The Fama-French Three-Factor Model 957 An Alternative Theory of Risk and Return: Behavioral Finance 961 Summary 963

C H A P T E R 2 5 Real Options 971 Valuing Real Options 972 The Investment Timing Option: An Illustration 973 The Growth Option: An Illustration 982 Concluding Thoughts on Real Options 986 Summary 989 Web Extensions

25A: The Abandonment Real Option

25B: Risk-Neutral Valuation

Contents xvii

C H A P T E R 2 6 Analysis of Capital Structure Theory 995

Box: Corporate Valuation and Capital Structure Decisions 996

Capital Structure Theory: Arbitrage Proofs of the Modigliani-Miller Models 996 Introducing Personal Taxes: The Miller Model 1006 Criticisms of the MM and Miller Models 1010 An Extension of the MM Model: Nonzero Growth and a Risky Tax Shield 1011 Risky Debt and Equity as an Option 1015 Capital Structure Theory: Our View 1019 Summary 1021

Appendix A Solutions to Self-Test Problems . . . . . . . . . . . . . . . . . . . . . . . . . . 1029 Appendix B Answers to End-of-Chapter Problems . . . . . . . . . . . . . . . . . . . . . …