Corporate Finance TWELFTH EDITION Richard A. Brealey .
Principles ofCorporateFinanceTWELFTH EDITIONRichard A. BrealeyProfessor of FinanceLondon Business SchoolStewart C. MyersRobert C. Merton (1970) Professor of FinanceSloan School of ManagementMassachusetts Institute of TechnologyFranklin AllenProfessor of Finance and EconomicsImperial College London andNippon Life Professor of FinanceThe Wharton SchoolUniversity of PennsylvaniaMi
ContentsPreface vii2-4I Part One: ValueSummary 39 Problem Sets 40 Finance on the Web 4511-1Introduction to CorporateFinance 1Corporate Investment and FinancingDecisions 2Investment Decisions/Financing Decisions/WhatIs a Corporation?fThe Role of the FinancialManager1-2The Financial Goal of the Corporation 7Shareholders Want Managers to Maximize MarketValue/A Fundamental Result/The InvestmentTrade-OffiShould Managers Look After theInterests ofTheir Shareholders?ZAgency Problemsand Corporate Governance1-3Preview of Coming Attractions13Summary 14 Problem Sets 14 - Appendix: WhyMaximizing Shareholder Value Makes Sense 172How to Caiculate PresentValues 192-1Future Values and Present Values 19Calcidating Future Values/Calculating PresentValues/Valuing an Investment Opportunity/NetPresent Value/Risk and Present Value/PresentValues and Rates of Return/Calculating PresentValues When There Are Multiple Cash FIows/TheOpportunity Cost of Capital2-22-3Looking for Shortcuts—Perpetuities andAnnuities 27How to Value Perpetuities/How to Value Annuities/Valuing Annuities Due/Calculating ArnualPayments/Future Value ofan AnnuityMore Shortcuts—Growing Perpetuities andAnnuities 34Growing Perpetuities/Growing Annuities3How Interest Is Paid and QuotedContinuous CompoundingValuing Bonds36463-1 Using the Present Value Formula to ValueBonds 47A Short Trip to Paris to Value a Government Bond/Back to the United States: Semiannual Couponsand Bond Prices3-2How Bond Prices Vary with Interest Rates 50Duration and Volatility3-3The Term Structure of Interest Rates 54Spot Rates, Bond Prices, and the Law ofOne Price/Measuring the Term Structure/Why the Discount Factor Declines asFuturity Increases—and a Digression onMoney Machines3-4Explaining the Term Structure 58Expectations Theory of the TermStructure/Introducing Risk/Inflation and TermStructure3-5Real and Nominal Rates of Interest 60Indexed Bonds and the Real Rate of Interest/WhatDetermines the Real Rate of lnterest?/Inflation andNominal Interest Rates3-6The Risk of Default 64Corporate Bonds and Default Risk/SovereignBonds and Default RiskSummary 70 - Further Reading 71 Problem Sets 71Finance on the Web 754The Value of Common Stocks4-1How Common Stocks Are Traded 76Trading Results for GE4-2How Common Stocks Are Valued 78Vcduation by Comparables/Stock Prices andDividends76VIV
XXContents4-3Estimating the Cost of Equity Capital 85Using the DCF Model to Set Gas and ElectricityPrices/Dangers Lurk in Constant-Growth Formulas4-4The Link Between Stock Price and Earnings perShare 90Calculating the Present Value of GrowthOpportunities for Fledgling Electronics4-5Valuing a Business by Discounted Cash Flow 93Valuing the Concatenator Business/ValuationFormat/Estimating Horizon Value/A Further RealityCheck/Free Cash Flow, Dividends, and RepurchasesRule 3: Treat Inflation Consistently/Rule 4:Separate Investment and Financing Decisions6-2Example—IM&C's Fertilizer Project 139Separating Investment and Financing Decisions/Investments in Working Capital/A Further Note onDepreciation/A Final Comment on Taxes/ProjectAnalysis/Calculating NPV in Other Countries andCurrencies6-3Using the NPV Rule to Choose amongProjects 146Problem 1: The Investment Timing Decision/Problem 2: The Choice between Long- and ShortLived Equipment/Problem 3: When to Replace anOld Machine/Problem 4: Cost ofExcess CapacitySummary 98 Problem Sets 99 Finance on the Web 103Mini-Case: Reeby Sports 1045Net Present Value and OtherInvestment Criteria 1055-1A Review of the Basics 105Net Present Value 's Competitors/Three Points toRemember about NPV/NPV Depends on CashFlow, Not on Book Returns5-2Payback 109Discounted Payback5-3Internal (or Discounted-Cash-Flow) Rate ofReturn 111Calculating the IRR/The IRR Rule/Pitfall I—Leriding or Borrowing?/Pitfall 2—Multiple Rates ofReturn/Pitfall 3—Mutually Exclusive Projects/Pitfall4—What Happens When There Is More than OneOpportunity Cost of Capital?/The Verdict on IRR5-4Choosing Capital Investments When ResourcesAre Limited 119An Easy Problem in Capital Rationing/Uses ofCapital Rationing ModelsSummary 123 Further Reading 124 - Problem Sets125 Mini-Case: Vegetron's CFO Calls Again 1296Making Investment Decisions withthe Net Present Value Rule 1326-1Applying the Net Present Value Rule 132Rule 1: Only Cash Flow Is Relevant/Rule 2:Estimate Cash Flows on an Incremental Basis/Summary 151 Problem Sets 152 Mini-Case: NewEconomy Transport (A) and (B) 159I Part Two: Risk7Introduction to Risk andReturn 1627-1Over a Century of Capital Market History inOne Easy Lesson 162Arithmetic Ave rage s and Compound AnnualReturns/Using Historical Evidence to EvaluateToday's Cost of Capital/Dividend Yields and theRisk Premium7-2Measuring Portfolio Risk 169Variance and Standard Deviation/Measuring Variability/How DiversificationReduces Risk7-3Calculating Portfolio Risk 176General Formula for Computing Portfolio Risk/DoI Really Have to Add up 25 Million Boxes ?7-4How Individual Securities Affect PortfolioRisk 180Market Risk Is Measured by Beta/Why SecurityBetas Determine Portfolio Risk7-5Diversification and Value AdditivitySummary 185 Further Reading 186Problem Sets 186 Finance on the Web 191184
Contents8Portfolio Theory and the CapitalAsset Pricing Model 1928-1Harry Markowitz and the Birth of PortfolioTheory 192Combining Stocks into PortfoliosAVe IntroduceBorrowing and Lending8-28-38-4The Relationship Between Risk andReturn 199Some Estimates of Expected Returns/Review oftheCapital Asset Pricing Model/What Ifa Stock DidNot Lie on the Security Market Line?Validity and Role of the Capital Asset PricingModel 202Tests ofthe Capital Asset Pricing Model/Assumptions behind the Capital Asset Pricing ModelSome Alternative Theories 206Arbitrage Pricing Theory/A Comparison oftheCapital Asset Pricing Model and Arbitrage PricingTheory/The Three-Factor ModelSummary 211 Further Reading 212 ProblemSets 212 Finance on the Web 218 Mini-Case: Johnand Marsha on Portfolio Selection 2199Risk and the Cost of Capital2219-1Company and Project Costs of Capital 222Perfect Pitch and the Cost of Capital/Debt and theCompany Cost of Capital9-2Measuring the Cost of Equity 225Estimating Beta/The Expected Return on UnionPacific Corporation's Common Stock/UnionPacific's After-Tax Weighted-Average Cost ofCapital/Union Pacific's Asset Beta9-3Analyzing Project Risk 229What Determines Asset Betas?/Don't Be Fooled byDiversifiable Risk/Avoid Fudge Factors in DiscountRates/Discount Rates for International Projects9-4Certainty Equivalents—Another Way to Adjustfor Risk 235Valuation by Certainty Equivalents/When to Use aSingle Risk-Adjusted Discount Rate for Long-LivedAssets/A Common Mistake/When You CannotUse a Single Risk-Adjusted Discount Rate forLong-Lived AssetsxxiSummary 241 Further Reading 242 Problem Sets242 Finance on the Web 246 Mini-Case: The JonesFamily, Incorporated 247I Part Three: Best Practices in CapitalBudgeting10 Project Analysis24910-1 The Capital Investment Process 250Project Authorizations—and the Problem ofBiasedForecasts/Postaudits10-2 Sensitivity Analysis 252Value of Information/Limits to SensitivityAnalysis/Scenario Analysis/Break-EvenAnalysis/Operating Leverage and the Break-EvenPoint10-3 Monte Carlo Simulation 259Simulating the Electric Scooter Project10-4 Real Options and Decision Trees 262The Option to Expand/The Option toAbandon/Production Options/Timing Options/More on Decision Trees/Pro and ConDecision TreesSummary 270 Further Reading 271Problem Sets 271 Mini-Case: Waldo County 277IIInvestment, Strategy,and Economic Rents 27911-1 Look First to Market Values 279The Cadillac and the Movie Star11-2 Economic Rents and CompetitiveAdvantage 28411-3 Marvin Enterprises Decides to Exploit a NewTechnology—an Example 288Forecasting Prices ofGargle Blasters/The Valueof Marvin 's New Expansion/Alternative ExpansionPlans/The Value of Marvin Stock/The Lessons ofMarvin EnterprisesSummary 295 Further Reading 295- Problem Sets 295Mini-Case: Ecsy-Cola 300
xxiiContents12 Agency Problems,Compensation, and PerformanceMeasurement 30212-1 Incentives and Compensation 302Agency Problems in Capital Budgeting/Agency Problems and Risk Taking/Monitoring/Management Compensation/IncentiveCompensationJMonitoring Pay for Performance12-2 Measuring and Rewarding Performance:Residual Income and EVA 311Pros and Cons of EVA12-3 Biases in Accounting Measures ofPerformance 314Example: Measuring the Profitability ofthe NodheadSupermarkei/Measuring Economic Profitability/Do the Biases Wash Out in the Long Run ?/WhatCan We Do about Biases in Accounting ProfitabilityMeasures?/Earnings and Earnings TargetsSummary 320 Further Reading 321 Problem Sets 322I Part Four: Financing Decisions andMarket Efficiency13 Efficient Marketsand Behavioral Finance32713-1 We Always Come Back to NPV 328Differences between Investment and FinancingDecisions13-2 What Is an Efficient Market? 329A Startling Discovery: Price Changes Are Random/Competition and the Efficient Market Hypothesis/Efficient Markets: The Evidence13-3 The Evidence Against Market Efficiency 336Do Investors Respond Slowly to New Information?/Bubbles and Market EfficiencySeen One Stock, Seen Them. All/What Jf MarketsAre Not Efficient? Implications for the FinancialManagerSummary 349 Further Reading 350Problem Sets 351 Finance on the Web 35414 An Overview ofCorporate Financing35514-1 Patterns of Corporate Financing 355Do Firms Rely Too Much on Internal Funds?/HowMuch Do Firms Borrow?14-2 Common Stock 358Voting Procedures/Dual-Class Shares and PrivateBenefits/Equity in Disguise/Preferred Stock14-3 Debt 363Debt Comes in Many Forms/A Debt by Any OtherName/Variety's the Very Spiee of Life14-4 Financial Markets and Institutions 366Financial Markets/Financial Intermediaries/Investment Funds/Financial Institutions14-5 The Role of Financial Markets andIntermediaries 372The Payment Mechanism/Borrowing and Lending/Pooling Risk/Information Provided by FinancialMarkets/The Financial Crisis of2007-2009Summary 376 Further Reading 376Problem Sets 377 Finance on the Web 37815 How Corporations IssueSecurities 37915-1 Venture Capital 379The Venture Capital Market15-2 The Initial Public Offering 384Arranging an Initial Public Offering/The Sale ofMarvin Stock/The Underwriters/Costs of a NewIssue/Underpricing oflPOs/Hot New-Issue Periods13-4 Behavioral Finance 340Sentiment/Limits to Arbitrage/Incentive Problemsand the Subprime Crisis15-3 Alternative Issue Procedures for IPOs 392Types ofAuction: A Digression13-5 The Five Lessons of Market Efficiency 344Lesson I: Markets Have No Memory/Lesson 2:Trust Market Prices/Lesson 3: Read the Entrails/Lesson 4: The Do-It-Yourself Alternative/Lesson S. 15-4 Security Sales by Public Companies 394General Cash Ojfers/lnternational SecurityIssues/The Costs of a General Cash Offer/MarketReaction to Stock Issues/Rights Issues
Contents15-5 Private Placements and Public Issues399xxiii i—Summary 400 Further Reading 400Problem Sets 401 Finance on the Web 405Appendix: Marvin's New-Issue Prospectus 40617-3 The Weighted-Average Cost of Capital 448Two Warnings/Rates of Return on LeveredEquity—The Traditional Position/Today's Unsatisfied Clienteies Are ProbablyInterested in Exotic Securities/Imperfections andOpportunitiesI Part Five: Payout Policy and CapitalStructure17-4 A Final Word on the After-TaxWeighted-Average Cost of Capital 45216 Payout PolicySummary 453 Further Reading 453 Problem Sets 454Mini-Case: Claxton Drywall Comes to the Rescue 45841016-1 Facts About Payout 411How Firms Pay Dividends/How Firms RepurchaseStock16-2 The Information Content of Dividends andRepurchases 413The Information Content of 'Share Repurchases16-3 Dividends or Repurchases? The PayoutControversy 416Payout Policy Is Irrelevant in Perfect CapitalMarkets/Dividends or Repurchases? An Example/Stock Repurchases and DCF Models ofSharePrice/Dividends and Share Issues16-4 The Rightists 421Payout Policy, Investment Policy, and Management/nccMfiyga16-5 Taxes and the Radical Left 422Empirical Evidence on Dividends and Taxes/Alternative Tax Systems/Taxes and Payout—ASummary16-6 Payout Policy and the Life Cycle of the Firm 426Payout and Corporate GovernanceSummary 429 Further Reading 430 Problem Sets 43017 Does Debt Policy Matter?43617-1 The Effect of Financial Leverage in aCompetitive Tax-Free Economy 437Enter Modigliani and Miller/The Law ofConservation ofValue/An Example of Proposition I17-2 Financial Risk and Expected Returns 442Proposition 2/How Changing Capital StructureAffects Beta/Watch Out for Hidden Leverage18 How Much Should aCorporation Borrow?46018-1 Corporate Taxes 461How Do Interest Tax Shields Contribute to theValue of Stockholders' Equity ?/Recasting Johnson& Johnson's Capital Structure/MM and Taxes18-2 Corporate and Personal Taxes 46418-3 Costs of Financial Distress 467Bankruptcy Costs/Evidence on Bankruptcy Costs/Direct versus Indirect Costs of Bankruptcy/Financial Distress without Bankruptcy/Debt andIncentives/Risk Shifting: The First Game/Refusingto Contribute Equity Capital: The Second Game/And Three More Games, Briefly/What the GamesCost/Costs of Distress Vary with Type of Asset/The Trade-Off Theory of Capital Structure18-4 The Pecking Order of Financing Choices 479Debt and Equity Issues with AsymmetrieInformation/Implications ofthe Pecking Order/TheTrade-Off Theory vs. the Pecking-Order Theory—Some Evidence/The Bright Side and the Dark Sideof Financial SlackJls There a Theory of OptimalCapital Structure?Summary 485 Further Reading 486 Problem Sets 486Finance on the Web 49019 Financing and Valuation49119-1 The After-Tax Weighted-Average Cost ofCapital 491Review of Assumptions/Mistakes People Make inUsing the Weighted-Average Formula
xxivContents19-2 Valuing Businesses 496Valuing Rio Corporation/Estimating HorizonValue/WACC v.v. the Flow-to-Equity Method19-3 Using WACC In Practice 501Some Tricks ofthe Trade/Adjusting WACC when DebtRatios and Business Risks Differ/Unlevering andRelevering Betas/The lmportance of Rebalancing/TheModigliani-Miller Formida, Plus Some Final Advice19-4 Adjusted Present Value 508APVfor the Perpetual Crusher/Other FinancingSide Effects/APV for Businesses/APV forInternational Investments19-5 Your Questions Answered21-4 Black-Scholes in Action 561Executive Stock Options/Warrants/PortfolioInsurance/Calculating Implied Volatilities21-5 Option Values at a Glance 56421-6 The Option Menagerie 566Summary 567 Further Reading 567Problem Sets 567 Finance on the Web 571Mini-Case: Bruce Honiball's Invention 571512Summary 514 Further Reading 515Problem Sets 515 Finance on the Web 520Appendix: Discounting Safe, Nominal Cash Flows 521I Part Six: Options20 Understanding Options52520-1 Calls, Puts, and Shares 526Call Options and Position Diagrams/Put Options/Selling Calls and Puts/Position Diagrams Are NotProfit Diagrams20-2 Financial Alchemy with Options 530Spotting the Option20-3 What Determines Option Values? 536Risk and Option ValuesSummary 541 Further Reading 541Problem Sets 542 Finance on the Web 54621 Valuing Options21-3 The Black-Scholes Formula 557Using the Black-Scholes Formula/The Risk ofan Option/The Black-Scholes Formula and theBinomial Method54722 Real Options57322-1 The Value of Follow-On InvestmentOpportunities 573Questions and Answers about Blitzen's Mark II/Other Expansion Options22-2 The Timing Option 577Valuing the Malted. Herring Option/OptimalTiming for Real Estate Development22-3 The Abandonment Option 580Bad News for the Perpetual Crusher/AbandonmentValue and Project Life/Temporary Abandonment22-4 Flexible Production and ProcurementAircraft Purchase Options58322-5 Investment in Pharmaceutical R&D 58722-6 Valuing Real Options 589A Conceptual Problem?/What about Taxes?/Practical ChallengesSummary 591 Further Reading 592 Problem Sets 592I Part Seven: Debt Financing21-1 A Simple Option-Valuation Model 548Why Discounted Cash Flow Won't Work forOptions/Constructing Option Equivalents fromCommon Stocks and Borrowing/Valuing theGoogle Put Option23-1 Yields on Corporate Debt 597What Determines the Yield Spread?21-2 The Binomial Method for Valuing Options 552Example: The Two-Step Binomial Method/TheGeneral Binomial Method/The Binomial Methodand Decision Trees23-2 The Option to Default 602How the Default Option Affects a Bond's Risk andYield/A Digression: Valuing Government FinancialGuarantees23 Credit Risk and the Valueof Corporate Debt 597
Contentsxxv23-3 Bond Ratings and the Probability of Default 60823-4 Predicting the Probability of Default 609Credit Scoring/Market-Based Risk Models25-6 Leveraged Leases 66623-5 Value at RiskSummary 667 Further Reading 668 Problem Sets 66861325-5 When Do Financial Leases Pay? 665Leasing around the WorldSummary 614 Further Reading 615Problem Sets 615 Finance on the Web 617I Part Eight: Risk Management24 The Many Different Kindsof Debt 61824-1 Long-Term Bonds 619Bond Terms/Security and Seniority/Asset-BackedSecurities/Sinking Funds/Call Provisions/BondCovenants/Privately Placed Bonds/Foreign Bonds,Eurobonds, and Global Bonds24-2 Convertible Securities and Some UnusualBonds 630The Value of a Convertible at Maturity/Forcing Conversion/Why Do Companies IssueConvertibles?/Valuing Convertible Bonds/AVariation on Convertible Bonds: The BondWarrant Package/lnnovation in the Bond Market24-3 Bank Loans 636Commitment/Maturity/Rate of Interest/SyndicatedLoans/Security/Debt Covenants24-4 Commercial Paper and Medium-Term Notes 640Commercial Paper/Medium-Term NotesSummary 642 Further Reading 643 Problem Sets 643Mini-Case: The Shocking Demise of Mr. Thorndike 648Appendix: Project Finance 64925 Leasing65225-1 What Is a Lease? 65225-2 Why Lease? 653Sensible Reasons for Leasing/Some DubiousReasons for Leasing25-3 Operating Leases 657Example ofan Operating Lease/Lease or Buy?25-4 Valuing Financial Leases 660Example of a Financial Lease/Who Really Ownsthe Leased Asset?/Leasing and the InternalRevenue Service/A First Pass at Valuing a LeaseContract/The Story So Far26 Managing Risk67326-1 Why Manage Risk? 673Reducing the Risk of Cash Shortfalls or FinancialDistress/Agency Costs May Be Mitigated by RiskManagement/The Evidence on Risk Management26-2 Insurance 67626-3 Reducing Risk with Options 67826-4 Forward and Futures Contracts 679A Simple Forward Contract/Futures Exchanges/The Mechanics of Futures Trading/Tradingand Pricing Financial Futures Contracts/Spotand Futures Prices—Commodities/More aboutForward Contracts/Homemade Forward RateContracts26-5 Swaps 687Interest Rate Swaps/Currency Swaps/Some OtherSwaps26-6 How to Set Up a Hedge 691Hedging Interest Rate Risk/Hedge Ratios andBasis Risk26-7 Is "Derivative" A Four-Letter Word? 695Summary 697 Further Reading 698Problem Sets 698 Finance on the Web 704Mini-Case: Rensselaer Advisers 70427 Managing InternationalRisks 70727-1 The Foreign Exchange Market 70727-2 Some Basic Relationships 709Interest Rates and Exchange Rates/The ForwardPremium and Changes in Spot Rates/Changesin the Exchange Rate and Inflation Rates/InterestRates and Inflation Rates/Is Life Really ThatSimple?
H xxviContents27-3 Hedging Currency Risk 717Transaction Exposure and Economic Exposure27-4 Exchange Risk and International InvestmentDecisions 720The Cost of Capital for International Investments27-5 Political Risk 723Summary 725 Further Reading 726Problem Sets 726 Finance on the Web 730Mini-Case: Exacta, s.a. 730I Part N ine: Financial Flanning andWorking Capital Management28 Financial Analysis73228-1 Financial Ratios 73228-2 Financial Statements 73328-3 Home Depot's Financial Statements 7
Corporate Finance TWELFTH EDITION Richard A. Brealey Professor of Finance London Business School Stewart C. Myers Robert C. Merton (1970) Professor of Finance Sloan School of Management Massachusetts Institute of Technology Franklin Allen Professor of Finance and Economics Imperial College Lon
Finance Volume 1 Ross et al. Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition Front Matter 1 Preface 1 I. Overview of Corporate Finance 33 1. Introduction to Corporate Finance 33 2. Financial Statements, Taxes, and Cash Flow 55 II.
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