FUNDAMENTALS OF CORPORATE FINANCE - GBV
Tenth EditionFUNDAMENTALS OFCORPORATE FINANCEStephen A. RossMassachusetts Institute of TechnologyRandolph W. WesterfieldUniversity of Southern CaliforniaBradford D.JordanUniversity of KentuckyMcGraw-HillIrwin
CHAPTER!CHAPTER 2INTRODUCTION TO CORPORATE FINANCE 1FINANCIAL STATEMENTS, TAXES,AND CASH FLOW 201.11.21.31.41.511.6Corporate Finance and the Financial Manager 2What Is Corporate Finance? 2The Financial Manager 2Financial Management Decisions 2Capital Budgeting 2Capital Structure 3Working Capital Management 4Conclusion 4Forms of Business Organization 4Sole Proprietorship 4Partnership 5Corporation 5A Corporation by Another Name . . . 7The Goal of Financial Management 7Possible Goals 8The Goal of Financial Management 8A More General Goal 9Sarbanes-Oxley 9The Agency Problem and Controlof the Corporation 10Agency Relationships 10Management Goals 10Do Managers Act in the Stockholders! Interests? 11Managerial Compensation 11Control of the Firm 12Conclusion 12Stakeholders 12Financial Markets and the Corporation 13Cash Flows to and from the Firm 14Primary versus Secondary Markets 14Primary Markets 14Secondary Markets 15Dealer versus Auction Markets 15Trading in Corporate Securities 15Listing 16Summary and Conclusions 163.1Cash Flow and Financial Statements:A Closer Look 49Sources and Uses of Cash 49The Statement of Cash Flows 512.22.32.42.53.2CHAPTER 3WORKING WITH FINANCIAL STATEMENTS2.148The Balance Sheet 21Assets: The Left Side 21Liabilities and Owners' Equity: The Right Side 21Net Working Capital 22Liquidity 23Debt versus Equity 24Market Value versus Book Value 24The Income Statement 25GAAP and the Income Statement 26Noncash Items 27Time and Costs 27Taxes 29Corporate Tax Rates 30Average versus Marginal Tax Rates 30Cash Flow 32Cash Flow from Assets 32Operating Cash Flow 33Capital Spending 33Change in Net Working Capital 34Conclusion 34A Note about "Free" Cash Flow 35Cash Flow to Creditors and Stockholders 35Cash Flow to Creditors 35Cash Flow to Stockholders 35An Example: Cash Flows for Dole Cola 37Operating Cash Flow 37Net Capital Spending 38Change in NWC and Cash Flow from Assets 38Cash Flow to Stockholders and Creditors 38Summary and Cohclusions 39Standardized Financial Statements 53Common-Size Statements 53Common-Size Balance Sheets 53Common-Size Income Statements 54Common-Size Statements of Cash Flows 55Common-Base Year Financial Statements:Trend Analysis 55Combined Common-Size and Base Year Analysis 55xxxi
3.33.43.53.6Ratio Analysis 56Short-Term Solvency, or Liquidity, Measures 57Current Ratio 57The Quick (or Acid-Test) Ratio 58Other Liquidity Ratios 59Long-Term Solvency Measures 59Total Debt Ratio 59A Brief Digression: Total Capitalization versusTotal Assets 60Times Interest Earned 60Cash Coverage 61Asset Management, or Turnover, Measures 61Inventory Turnover and Days' Sales in Inventory 61Receivables Turnover and Days' Sales in-Receivables 62Asset Turnover Ratios 63Profitability Measures 63Profit Margin 64Return on Assets 64Return on Equity 64Market Value Measures 65Price-Earnings Ratio 65Price-Sales Ratio 65Market-to-Book Ratio 66Enterprise Value-EBITDA Ratio 66Conclusion 67The DuPont Identity 68A Closer Look at ROE 68An Expanded DuPont Analysis 69Using Financial Statement Information 71Why Evaluate Financial Statements? 71Internal Uses 72External Uses 72Choosing a Benchmark 72Time Trend Analysis 72Peer Group Analysis 72Problems with Financial Statement Analysis 77Summary and Conclusions 78CHAPTER 5INTRODUCTION TO VALUATION: THE TIMEVALUE OF MONEY7225.1Future Value and Compounding 723Investing for a Single Period 723Investing for More Than One Period 723A Note about Compound Growth 729CHAPTER 4LONG-TERM FINANCIAL PLANNINGAND GROWTH 904.14.24.34.44.54.65.25.35.4What Is Financial Planning? 92Growth as a Financial Management Goal 92Dimensions of Financial Planning 92What Can Planning Accomplish? 93Examining Interactions 93Exploring Options 93Avoiding Surprises 93Ensuring Feasibility and Internal Consistency 94Conclusion 94Financial Planning Models: A First Look 94A Financial Planning Model: The Ingredients 94Sales Forecast 94Pro Forma Statements 95Asset Requirements 95Financial Requirements 95The Plug 95Economic Assumptions 96A Simple Financial Planning Model 96The Percentage of Sales Approach 97The Income Statement 97The Balance Sheet 98A Particular Scenario 700An Alternative Scenario 707External Financing and Growth 704EFN and Growth 704Financial Policy and Growth 706The Internal Growth Rate 106The Sustainable Growth Rate 107Determinants of Growth 108A Note about Sustainable Growth RateCalculations 7 70Some Caveats regarding FinancialPlanning Models 7 7 7Summary and Conclusions 712Present Value and Discounting 730The Single-Period Case 730Present Values for Multiple Periods 737More about Present and Future ValuesPresent versus Future Value 734Determining the Discount Rate, 734Finding the Number of Periods 738Summary and Conclusions 747733
rI «CHAPTER 6DISCOUNTED CASH FLOW VALUATION6.16.26.36.46.57477.5Future and Present Values of Multiple Cash Flows 748Future Value with Multiple Cash Flows 748Present Value with Multiple Cash Flows 757A Note about Cash Flow Timing 754Valuing Level Cash Flows: Annuities andPerpetuities 755Present Value for Annuity Cash Flows 755Annuity Tables 156Finding the Payment 158Finding the Rate 159Future Value for Annuities 767A Note about Annuities Due -162Perpetuities 763Growing Annuities and Perpetuities 765Comparing Rates: The Effect of Compounding 765Effective Annual Rates and Compounding 766Calculating and Comparing Effective Annual Rates 766EARS and APRS 768Taking It to the Limit: A Note about ContinuousCompounding 770Loan Types and Loan Amortization 7 77Pure Discount Loans 7 77Interest-Only Loans 7 72Amortized Loans 7 72Summary and Conclusions 7 77CHAPTER 7INTEREST RATES A N D BOND VALUATION7.17.27.37.47.77.8CHAPTER 8STOCK VALUATION 2348.18.2792Bonds and Bond Valuation 793Bond Features and Prices 193Bond Values and Yields 793Interest Rate Risk 797Finding the Yield to Maturity: More Trial and ErrorMore about Bond Features 203Is It Debt or Equity? 203Long-Term Debt: The Basics 203The Indenture 205Terms of a Bond 205Security 206Seniority 206Repayment 206The Call Provision 207Protective Covenants 207Bond Ratings 208Some Different Types of Bonds 209Government Bonds 209Zero Coupon Bonds 270Floating-Rate Bonds 27 77.6Other Types of Bonds 272Sukuk 274Bond Markets 275How Bonds Are Bought and Sold 276Bond Price Reporting 276A Note about Bond Price Quotes 277Inflation and Interest Rates 279Real versus Nominal Rates 279The Fisher Effect 220Inflation and Present Values 227Determinants of Bond Yields 222The Term Structure of Interest Rates 222Bond Yields and the Yield Curve: Putting It AllTogether 223Conclusion 225Summary and Conclusions 2267988.38.4Common Stock Valuation 235Cash Flows 235Some Special Cases 237Zero Growth 237Constant Growth 237Nonconstant Growth 240Two-Stage Growth 242Components of the Required Return 243Stock Valuation Using Multiples 244Some Features of Common and PreferredStocks 246Common Stock Features 246Shareholder Rights 246Proxy Voting 247Classes of Stock 247Other Rights 248Dividends 248Preferred Stock Features 249Stated Value 249Cumulative and Noncumulative Dividends 249Is Preferred Stock Really Debt? 249The Stock Markets 250Dealers and Brokers 250Organization of the NYSE 257Members 251Operations 252Floor Activity 252NASDAQ Operations 253ECNs 254Stock Market Reporting 254Summary and Conclusions 256
10.4CHAPTER 9NET PRESENT VALUE A N D OTHER INVESTMENTCRITERIA 2669.19.29.39.49.59.69.79.8Net Present Value 267The Basic Idea 267Estimating Net Present Value 268The Payback Rule 277Defining the Rule 277Analyzing the Rule 272Redeeming Qualities of the Rule 273Summary of the Rule 274The Discounted Payback 274The Average Accounting Return 277The Internal Rate of Return 279Problems with the IRR 283Nonconventional Cash Flows 283Mutually Exclusive Investments 285Investing or Financing? 287Redeeming Qualities of the IRR 288The Modified Internal Rate of Return (MIRR) 289Method # 7; The Discounting Approach 289Method #2: The Reinvestment Approach 289Method #3: The Combination Approach 289MIRR or IRR: Which Is Better? 290The Profitability Index 290The Practice of Capital Budgeting 297Summary and Conclusions 294CHAPTER 10MAKING CAPITAL INVESTMENT DECISIONS30510.1 Project Cash Flows: A First Look 306Relevant Cash Flows 306The Stand-Alone Principle 30610.2 Incremental Cash Flows 307Sunk Costs 307Opportunity Costs 307Side Effects 308Net Working Capital 308Financing Costs 308Other Issues 30910.3 Pro Forma Financial Statements and ProjectCash Flows 309Getting Started: Pro Forma Financial Statements 309Project Cash Flows 370Project Operating Cash Flow 310Project Net Working Capital and Capital Spending 311Projected Total Cash Flow and Value 37 7More about Project Cash Flow 372A Closer Look at Net Working Capital 372Depreciation 375Modified ACRS Depreciation (MACRS) 315Book Value versus Market Value 316An Example: The Majestic Mulch and CompostCompany (MMCC) 378Operating Cash Flows 318Change in NWC 318Capital Spending 321Total Cash Flow and Value 321Conclusion 32110.5 Alternative Definitions of Operating Cash Flow 322The Bottom-Up Approach 323The Top-Down Approach 323The Tax Shield Approach 323Conclusion 32410.6 Some Special Cases of DiscountedCash Flow Analysis 324Evaluating Cost-Cutting Proposals 324Setting the Bid Price 326Evaluating Equipment Options with Different Lives 32810.7 Summary and Conclusions 330CHAPTER 11PROJECT ANALYSIS A N D EVALUATION11.1343Evaluating NPV Estimates 344The Basic Problem 344Projected versus Actual Cash Flows 344Forecasting Risk 344Sources of Value 34511.2 Scenario and Other What-lf Analyses 346Getting Started 346Scenario Analysis 347Sensitivity Analysis 349Simulation Analysis 35011.3 Break-Even Analysis 357Fixed and Variable Costs 357Variable Costs 351Fixed Costs 353Total Costs 353Accounting Break-Even 354Accounting Break-Even: A Closer Look 355Uses for the Accounting Break-Even 35611.4 Operating Cash Flow, Sales Volume, andBreak-Even 357Accounting Break-Even and Cash Flow 357The Base Case 357
333Calculating the Break-Even Level 358Payback and Break-Even 358Sales Volume and Operating Cash Flow 358Cash Flow, Accounting, and FinancialBreak-Even Points 359Accounting Break-Even Revisited 359Cash Break-Even 360Financial Break-Even 360Conclusion 36011.511.611.7CHAPTER 12SOME LESSONS FROM CAPITAL MARKET HISTORY12.1Operating Leverage 362The Basic Idea 362Implications of Operating Leverage 362Measuring Operating Leverage 362Operating Leverage and Break-Even 364Capital Rationing 364Soft Rationing 365Hard Rationing 365Summary and Conclusions 365CHAPTER 13374Returns 375Dollar Returns 375Percentage Returns 37712.2 The Historical Record 379A First Look 379A Closer Look 38712.3 Average Returns: The First Lesson 385Calculating Average Returns 385Average Returns: The Historical Record 385Risk Premiums 386The First Lesson 38612.4 The Variability of Returns: The Second Lesson 387Frequency Distributions and Variability 387The Historical Variance and Standard Deviation 388The Historical Record 390Normal Distribution 397The Second Lesson 3922008: The Bear Growled and Investors Howled 392Using Capital Market History 394More on the Stock Market Risk Premium 39412.5 More about Average Returns 396Arithmetic versus Geometric Averages 396Calculating Geometric Average Returns 396Arithmetic Average Return or Geometric AverageReturn? 39912.6 Capital Market Efficiency 400Price Behavior in an Efficient Market 400The Efficient Markets Hypothesis 407Some Common Misconceptions about the EMH 402The Forms of Market Efficiency 40312.7 Summary and Conclusions 404RETURN, RISK, A N D THE SECURITY MARKET LINE13.1472Expected Returns and Variances 473Expected Return 473Calculating the Variance 47513.2 Portfolios 476Portfolio Weights 477Portfolio Expected Returns 47 7Portfolio Variance 47813.3 Announcements, Surprises, and ExpectedReturns 420Expected and Unexpected Returns 420Announcements and News 42013.4 Risk: Systematic and Unsystematic 422Systematic and Unsystematic Risk 422Systematic and Unsystematic Components ofReturn 42213.5 Diversification and Portfolio Risk 423The Effect of Diversification: Another Lessonfrom Market History 423The Principle of Diversification 424Diversification and Unsystematic Risk 425Diversification and Systematic Risk 42613.6 Systematic Risk and Beta 426The Systematic Risk Principle 427Measuring Systematic Risk 427Portfolio Betas 42913.7 The Security Market Line 430Beta and the Risk Premium 430——The Reward-to-Risk Ratio431The Basic Argument 432The Fundamental Result 434The Security Market Line 435Market Portfolios 435The Capital Asset Pricing Model 43513.8 The SML and the Cost of Capital: A Preview 438The Basic Idea 438The Cost of Capital 43813.9 Summary and Conclusions 439
HE3O5B, V"CHAPTER 14COST OF CAPITAL449The Cost of Capital: Some Preliminaries 450Required Return versus Cost of Capital 450Financial Policy and Cost of Capital 45714.2 The Cost of Equity 457The Dividend Growth Model Approach 457Implementing the Approach 451Estimating g 452Advantages and Disadvantages of the Approach 453The SML Approach 453Implementing the Approach 454Advantages and Disadvantages of the Approach 45414.3 The Costs of Debt and Preferred Stock 455The Cost of Debt 455The Cost of Preferred Stock 45614.4 The Weighted Average Cost of Capital 457The Capital Structure Weights 457Taxes and the Weighted Average Cost of Capital 458Calculating the WACC for Eastman Chemical 45915.315.4Alternative Issue Methods 487Underwriters 489Choosing an Underwriter 490Types of Underwriting 490Firm Commitment Underwriting 490Best Efforts Underwriting 491Dutch Auction Underwriting 491The Aftermarket 497The Green Shoe Provision 492Lockup Agreements 492The Quiet Period 49215.5IPOs and Underpricing 493IPO Underpricing: The 1999-2000 Experience 493Evidence on Underpricing 493Why Does Underpricing Exist? 498New Equity Sales and the Value of the Firm 499The Costs of Issuing Securities 500The Costs of Selling Stock to the Public 500The Costs of Going Public: A Case Study 504Rights 504The Mechanics of a Rights Offering 504Number of Rights Needed to Purchase a Share 505The Value of a Right 506Ex Rights 508The Underwriting Arrangements 509Effects on Shareholders 509Dilution 570Dilution of Proportionate Ownership 570Dilution of Value: Book versus Market Values 570A Misconception 511The Correct Arguments 512Issuing Long-Term Debt 572Shelf Registration 573Summary and Conclusions 57414.1Eastman's Cost of Equity 459Eastman's Cost of Debt 461Eastman's WACC 462Solving the Warehouse Problem and Similar CapitalBudgeting Problems 462Performance Evaluation: Another Use of the WACC 46514.5 Divisional and Project Costs of Capital 466The SML and the WACC 467Divisional Cost of Capital 468The Pure Play Approach 468The Subjective Approach 46914.6 Flotation Costs and the Weighted Average Cost ofCapital 470Tfye Basic Approach 477Flotation Costs and NPV 472Internal Equity and Flotation Costs 47314.7 Summary and Conclusions 474CHAPTER 15RAISING TER 16FINANCIAL LEVERAGE AND CAPITALSTRUCTURE POLICY 52716.1483The Financing Life Cycle of a Firm: Early-StageFinancing and Venture Capital 484Venture Capital 484Some Venture Capital Realities 485Choosing a Venture Capitalist 485Conclusion 486Selling Securities to the Public: The BasicProcedure 486The Capital Structure Question 522Firm Value and Stock Value: An Example 522Capital Structure and the Cost of Capital 52316.2 The Effect of Financial Leverage 524The Basics of Financial Leverage 524Financial Leverage, EPS, and ROE: An Example 524EPS versus EBIT 525Corporate Borrowing and Homemade Leverage 52716.3 Capital Structure and the Cost of Equity Capital 528M&M Proposition I: The Pie Model 528
&'4: ' ''"r-16.416.516.616.716.816.916.1016.11The Cost of Equity and Financial Leverage: M&MProposition II 529Business and Financial Risk 537M&M Propositions I and II with Corporate Taxes 532The Interest Tax Shield 533Taxes and M&M Proposition I 533Taxes, the WACC, and Proposition II 534Conclusion 535Bankruptcy Costs 537Direct Bankruptcy Costs 538Indirect Bankruptcy Costs 538Optimal Capital Structure 539The Static Theory of Capital Structure 539Optimal Capital Structure and the Cost of Capital 540Optimal Capital Structure: A Recap 547Capital Structure: Some ManagerialRecommendations 543Taxes 543Financial Distress 543The Pie Again 543The Extended Pie Model 544Marketed Claims versus Nonmarketed Claims 545The Pecking-Order Theory 545Internal Financing and the Pecking Order 545Implications of the Pecking Order 546Observed Capital Structures 547A Quick Look at the Bankruptcy Process 549Liquidation and Reorganization 549Bankruptcy Liquidation 549Bankruptcy Reorganization 550Financial Management and the BankruptcyProcess ,557Agreements to Avoid Bankruptcy 552Summary and Conclusions 55317.217.317.417.517.6 17.717.8CHAPTER 17t DIVIDENDS AND PAYOUT POLICY56017.1 /Cash Dividends and Dividend Payment 567Cash Dividends 567Standard Method of Cash Dividend Payment 567Dividend Payment: A Chronology 562More about the Ex-Dividend Date 56217.9Does Dividend Policy Matter? 564An Illustration of the Irrelevance of Dividend Policy 564Current Policy: Dividends Set Equal to Cash Flow 565Alternative Policy: Initial Dividend Greater Than CashFlow 565Homemade Dividends 565A Test 566Real-World Factors Favoring a Low DividendPayout 567Taxes 567Flotation Costs 567Dividend Restrictions 567Real-World Factors Favoring a High DividendPayout 568Desire for Current Income 568Tax and Other Benefits from High Dividends 569Corporate Investors 569Tax-Exempt Investors 569Conclusion 569A Resolution of Real-World Factors? 569Information Content of Dividends 569The Clientele Effect 577Stock Repurchases: An Alternative to CashDividends 577Cash Dividends versus Repurchase 573Real-World Considerations in a Repurchase 574Share Repurchase and EPS 575What We Know and Do NotKnow about Dividend and Payout Policies 575Dividends and Dividend Payers 575Corporations Smooth Dividends 578Putting It All Together 578Some Survey Evidence on Dividends 580Stock Dividends and Stock Splits 582Some Details about Stock Splits and StockDividends 582Example of a Small Stock Dividend 582Example of a Stock Split 583Example of a Large Stock Dividend 583Value of Stock Splits and Stock Dividends 583The Benchmark Case 584Popular Trading Range 584Reverse Splits 584Summary and Conclusions 585
CHAPTER 18SHORT-TERM FINANCE AND PLANNING19-259318.118.2Tracing Cash and Net Working Capital 594The Operating Cycle and the Cash Cycle 595Defining the Operating and Cash Cycles 596The Operating Cycle 596The Cash Cycle 596The Operating Cycle and the Firm's OrganizationalChart 597Calculating the Operating and Cash Cycles 598The Operating Cycle 599The Cash Cycle 600Interpreting the Cash Cycle 60718.3 Some Aspects of Short-Term Financial Policy 607The Size of the Firm's Investment in Current Assets 602Alternative Financing Policies for Current Assets 603An Ideal Case 603Different Policies for Financing Current Assets 603Which Financing Policy Is Best? 606Current Assets and Liabilities in Practice 60718.4 The Cash Budget 608Sales And Cash Collections 608Cash Outflows 609The Cash Balance 60918.5 Short-Term Borrowing 670Unsecured Loans 67 7Compensating Balances 611Cost of a Compensating Balance 611Letters of Credit612Secured Loans 672Accounts Receivable Financing 612Inventory Loans 613Other Sources 673*18.6 A, Short-Term Financial Plan 67418.7 Summary and Conclusions 675CHAPTER 19CASH AND LIQUIDITY MANAGEMENT 62619.1Reasons for Holding Cash 627The Speculative and Precautionary Motives 627The Transaction Motive 627Compensating Balances 627Costs of Holding Cash 627Cash Management versus Liquidity Management 62819.319.4Understanding Float 628Disbursement Float 628Collection Float and Net Float 629Float Management 630Measuring F
FUNDAMENTALS OF CORPORATE FINANCE Stephen A. Ross Massachusetts Institute of Technology Randolph W. Westerfield University of Southern California Bradford D.Jordan University of Kentucky McGraw-Hill Irwin. CHAPTER! INTRODUCTION TO CORPORATE FINANCE 1 1.1 Corporate Finance and the Financial Manager 2
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