Fundamentals Of CORPORATE FINANCE Eleventh Edition Stephen .
Fundamentals ofCORPORATEFINANCEEleventh EditionStephen A. RossMassachusetts Institute of TechnologyRandolph W. WesterfeldUniversity of Southern California, EmeritusBradford D. JordanUniversity of KentuckyMcGrawHillEducation
ContentsPART 1Overview of Corporate FinanceCHARTER 1CHARTER 2INTRODUCTION TO CORPORATE FINANCE 11.1 Corporate Finance and the Financial Manager 2What Is Corporate Finance? 2The Financial Manager 2Financial Management Decisions 2Capital Budgeting 2Capital Structure 3Working Capital Management 4Conclusion 41.2 Forms of Business Organization 4Sole Proprietorship 4Partnership 5Corporation 5A Corporation by Another Name . 71.3 The Goal of Financial Management 7Possible Goals 8The Goal of Financial Management 8A More General Goal 9Sarbanes-Oxley 91.4 The Agency Problem and Control of theCorporation 10Agency Relationships 10Management Goals 10Do Managers Act in the Stockholders' Interests? 11Managerial Compensatlon 11Control of the Firm 12Conclusion 12Stakeholders 121.5 Financial 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 161.6 Summary and Conclusions 16FINANCIAL STATEMENTS, TAXES,AND CASH FLOW 202.1 The 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 242.2 The Income Statement 25GAAP and the Income Statement 26Noncash Items 27Time and Costs 272.3 Taxes 29Corporate Tax Rates 29Average versus Marginal Tax Rates 302.4 Cash Flow 32Cash Flow from Assets 32Operating Cash Flow 33Capital Spending 33Change in Net Working Capital 34Conclusion 34A Note about "Free" Cash Flow 34Cash 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 37Change in NWC and Cash Flow from Assets 38Cash Flow to Stockholders and Creditors 382.5 Summary and Conclusions 39PART 2Financial Statements and Long-CHARTER 3WORKING WITH FINANCIAL STATEMENTS 493.1Cash Flow and Financial Statements:A Closer Look 50Sources and Uses of Cash 50The Statement of Cash Flows 52Financial Flanning3.2Standardized Financial Statements 54Common-Size Statements 54Common-Size Balance Sheets 54Common-Size Income Statements 55Common-Size Statements of Cash Flows 56xxxiii
CONTENTSxxxiv3.33.43.53.6Common-Base Year Financial Statements:Trend Analysis 56Combined Common-Size and Base Year Analysis 56Ratio Analysis 57Short-Term Solvency, or Liquidity, Measures 58Current Ratio 58The Quick (or Acid-Test) Ratio 59Other Liquidity Ratios 60Long-Term Solvency Measures 60Total Debt Ratio 60A Brief Digression: Total Capitalization versus TotalAssets 61Times internst Earned 61Cash Coverage 62Asset Management, or Turnover, Measures 62Inventory Turnover and Days' Sales in Inventory 62Receivabies Turnover and Days' Sales inReceivabies 63Asset Turnover Ratios 64Profitability Measures 64Profit Margin 65Return on Assets 65Return on Equity 65Market Value Measures 66Price-Eamings Ratio 66Price-Sales Ratio 66Market-to-Book Ratio 67Enterprise Value-EBITDA Ratio 67Conclusion 68The DuPont Identity 69A Closer Look at Roe 69An Expanded Dupont Analysis 71Using Financial Statement Information 73Why Evaluate Financial Statements? 73Internal Uses 73External Uses 73Choosing a Benchmark 74Time Trend Analysis 74Peer Group Analysis 74Problems with Financial Statement Analysis 78Summary and Conclusions 80PART 3LONG-TERM FINANCIAL FLANNINGAND GROWTH 914.1 What Is Financial Flanning? 93Growth as a Financial Management Goal 93Dimensions of Financial Flanning 93What Can Flanning Accomplish? 94Examining Interactions 94Exploring Options 94Avoiding Surprises 94Ensuring Feasibility and Internal Consistency 95Conclusion 954.2 Financial Flanning Models: A First Look 95A Financial Flanning Model: The Ingredients 95Sales Forecast 96Pro Forma Statements 96Asset Requirements 96Financial Requirements 96The Plug 96Economic Assumptions 97A Simple Financial Flanning Model 974.3 The Percentage of Sales Approach 98The Income Statement 98The Balance Sheet 99A Particular Scenario 101An Alternative Scenario 1024.4 External Financing and Growth 105EFN and Growth 105Financial Policy and Growth 107The Internal Growth Rate 107The Sustainable Growth Rate 108Determinants of Growth 109A Note about Sustainable Growth RateCalculations 1114.5 Some Caveats Regarding Financial FlanningModels 1124.6 Summary and Conclusions 113Valuation of Future Cash FlowsCHARTER 5INTRODUCTION TO VALUATION: THE TIME VALUEOF MONEY 1245.1CHARTER 4Future Value and Compounding 125Investing for a Single Period 125Investing for More Than One Period 125A Note about Compound Growth 1315.25.35.4Present Value and Discounting 132The Single-Period Case 132Present Values for Multiple Periods 133More about Present and Future Values 136Present versus Future Value 136Determining the Discount Rate 137Finding the Number of Periods 140Summary and Conclusions 144
CONTENTSCHARTER 6DISCOUNTED CASH FLOW VALVATION6.16.26.36.46.5i49Future and Present Values of MultipleCash Flows 150Future Value with Multiple Cash Flows 150Present Value with Multiple Cash Flows 153A Note about Cash Flow Timing 156Valuing Level Cash Flows: Annuitiesand Perpetuities 157Present Value for Annuity Cash Flows 157Annuity Tables 158Finding the Payment 160Finding the Rate 161Future Value for Annuities 163A Note about Annuities Due 164Perpetuities 165Growing Annuities and Perpetuities 167Comparing Rates: The Effect of Compounding 167Effective Annual Rates and Compounding 168Calculating and Comparing Effective AnnualRates 168EARs and APRs 170Taking It to the Limit: A Note about ContinuousCompounding 172Loan Types and Loan Amortization 173Pure Discount Loans 1 73Interest-Only Loans 174Amortized Loans 7 74Summary and Conclusions 179CHARTER 7INTEREST RATES AND BOND VALVATION7.17.27.37.4195Bonds and Bond Valuation 196Bond Features and Prices 196Bond Values and Yields 196Interest Rate Risk 200Finding the Yield to Maturity: More Trial and Error 201More about Bond Features 206Is It Debt or Equity? 206Long-Term Debt: The Basics 206The Indenture 208Terms ofa Bond 208Security 209Seniority 209Repayment 209The Call Provision 210Protective Covenants 210Bond Ratings 217Some Different Types of Bonds 212Government Bonds 212Zero Coupon Bonds 2137.57.67.77.8Floating-Rate Bonds 214Other Types of Bonds 215Sukuk 216Bond Markets 218How Bonds are Bought and Sold 220Bond Price Reporting 220A Note about Bond Price Quotes 223Inflation and Interest Rates 223Real versus Nominal Rates 223The Fisher Effect 224Inflation and Present Values 225Determinants of Bond Yields 226The Term Structure of Interest Rates 226Bond Yields and the Yield Curve: Putting It AllTogether 229Conclusion 230Summary and Conclusions 230CHARTER 8STOCK VALUATION 2398.1 Common Stock Valuation 240Cash Flows 240Some Special Cases 242Zero Growth 242Constant Growth 242Nonconstant Growth 245Two-Stage Growth 247Components of the Required Return 248Stock Valuation Using Multiples 2498.2 Some Features of Common and PreferredStocks 251Common Stock Features 251Shareholder Rights 251Proxy Voting 252Classes of Stock 252Other Rights 253Dividends 253Preferred Stock Features 254Stated Value 254Cumulative and Noncumulative Dividends 254Is Preferred Stock Really Debt? 2548.3 The Stock Markets 255Dealers and Brokers 255Organization of the NYSE 256Members 256Operations 257Floor Activity 257NASDAQ Operations 258ECNs 260Stock Market Reporting 2608.4 Summary and Conclusions 262
xxxviPART 4CONTENTSCapital Budget! ngCHARTER 9NET PRESENT VALUE AND OTHER INVESTMENTCRITERIA 2729.1 Net Present Value 273The Basic Idea 273Estimating Net Present Value 2749.2 The Payback Rule 277Defining the Rule 277Analyzing the Rule 279Redeeming Qualities of the Rule 279Summary of the Rule 2809.3 The Discounted Payback 2819.4 The Average Accounting Return 2839.5 The Internal Rate of Return 285Problems with The IRR 289Nonconventional Cash Flows 289Mutually Exclusive Investments 291Investing or Financing? 293Redeeming Qualities of the IRR 294The Modified Internal Rate of Return (MIRR) 295Method #1: The Discounting Approach 295Method #2; The Reinvestment Approach 295Method #3; The Combination Approach 296MIRR or IRR: Which Is Better? 2969.6 The Profitability Index 2969.7 The Practice of Capital Budgeting 2979.8 Summary and Conclusions 300CHARTER 10MAKING CAPITAL INVESTMENT DECISIONS 31210.1 Project Cash Flows: A First Look 313Relevant Cash Flows 313The Stand-Alone Principle 31310.2 Incremental Cash Flows 314SunkCosts 314Opportunity Costs 314Side Effects 315Net Working Capital 315Financing Costs 315Otherlssues 31610.3 Pro Forma Financial Statements and Project CashFlows 316Gelting Started: Pro Forma FinancialStatements 316Project Cash Flows 317Project Operating Cash Flow 317Project Net Working Capital and CapitalSpending 318Projected Total Cash Flow and Value 31810.4 More about Project Cash Flow 319A Closer Look at Net Working Capital 319Depreciation 322Modified ACRS Depreciation (MACRS) 322Book Value versus Market Value 323An Example: The Majestic Mulch and CompostCompany (MMCC) 325Operating Cash Flows 325Change in NWC 326Capital Spending 328Total Cash Flow and Value 328Conclusion 32810.5 Alternative Definitions of OperatingCash Flow 329The Bottom-Up Approach 330The Top-Down Approach 330The Tax Shield Approach 330Conclusion 33110.6 Some Special Cases of Discounted Cash FlowAnalysis 331Evaluating Cost-Cutting Proposais 331Setting the Bid Price 333Evaluating Equipment Optionswith Different Lives 33510.7 Summary and Conclusions 337CHARTER 11PROJECT ANALYSIS AND EVALUATION 35011.1 Evaluating NPV Estimates 351The Basic Problem 351Projected versus Actual Cash Flows 351Forecasting Risk 351Sources of Value 35211.2 Scenario and Other What-If Analyses 353Getting Started 353Scenario Analysis 354Sensitivity Analysis 356Simulation Analysis 35711.3 Break-Even Analysis 358Fixed and Variable Costs 358Variable Costs 358Fixed Costs 360Total Costs 360Accounting Break-Even 361Accounting Break-Even: A Closer Look 363Uses for the Accounting Break-Even 36311.4 Operating Cash Flow, Sales Volume,and Break-Even 364Accounting Break-Even and Cash Flow 364The Base Case 364
CONTENTSCalculating the Break-Even Level 365Payback and Break-Even 365Sales Volume and Operating Cash Flow 366Cash Flow, Accounting, and Financial Break-EvenPoints 366Accounting Break-Even Revisited 367Cash Break-Even 367Financial Break-Even 367Conclusion 368PART 5xxxvii11.5 Operating Leverage 369The Basic Idea 369Implications of Operating Leverage 369Measuring Operating Leverage 369Operating Leverage and Break-Even 37111.6 Capital Rationing 372Soft Rationing 372Hard Rationing 37211.7 Summary and Conclusions 373Risk and ReturnCHAPTER 12SOME LESSONS FROM CAPITAL MARKETHISTORY 38212.1 Returns 383Dollar Returns 383Percentage Returns 38512.2 The Historical Record 387A First Look 387A Closer Look 38912.3 Average Returns: The First Lesson 393Calculating Average Returns 393Average Returns: The Historical Record 393Risk Premiums 393The First Lesson 39412.4 The Variability of Returns: The SecondLesson 395Frequency Distributions and Variability 395The Historical Variance and StandardDeviation 396The Historical Record 397Normal Distribution 399The Second Lesson 4002008: The Bear Growled and InvestorsHowled 400Using Capital Market History 402More on the Stock Market Risk Premium 40212.5 More about Average Returns 404Arithmetic versus Geometrie Averages 404Calculating Geometrie Average Returns 404Arithmetic Average Return or Geometrie AverageReturn? 40712.6 Capital Market Efficiency 408Price Behavior in an Efficient Market 408The Efficient Markets Hypothesis 409Some Common Misconceptions aboutthe EMH 410The Forms of Market Efficiency 41112.7 Summary and Conclusions 412CHAPTER 13RETURN, RISK, AND THE SECURITY MARKETLINE 42013.1 Expected Returns and Variances 421Expected Return 421Calculating the Variance 42313.2 Portfolios 424Portfolio Weights 425Portfolio Expected Returns 425Portfolio Variance 42613.3 Announcements, Surprises, and ExpectedReturns 428Expected and Unexpected Returns 428Announcements and News 42813.4 Risk: Systematic and Unsystematic 430Systematic and Unsystematic Risk 430Systematic and Unsystematic Componentsof Return 43013.5 Diversification and Portfolio Risk 431The Effect of Diversification: Another Lesson fromMarket History 431The Principle of Diversification 432Diversification and Unsystematic Risk 433Diversification and Systematic Risk 43413.6 Systematic Risk and Beta 434The Systematic Risk Principle 435Measuring Systematic Risk 435Portfolio Betas 43713.7 The Security Market Line 438Beta and the Risk Premium 438The Reward-to-Risk Ratio 439The Basic Argument 440The Fundamental Result 442The Security Market Line 443Market Portfolios 443The Capital Asset Pricing Model 44313.8 The SML and the Cost of Capital: A Preview 446The Basic Idea 446The Cost of Capital 44613.9 Summary and Conclusions 447
xxxviiiPART 6CONTENTSCost of Capital and Long-Term Financial PolicyCHARTER#COST OF CAPITAL 45814.1 The Cost of Capital: Some Preliminaries 459Required Return versus Cost of Capital 459Financial Policy and Cost of Capital 46014.2 The Cost of Equity 460The Dividend Growth Model Approach 460Implementing the Approach 461Estimating G 461Advantages and Disadvantages of the Approach 462The SML Approach 462Implementing the Approach 463Advantages and Disadvantages of the Approach 46314.3 The Costs of Debt and Preferred Stock 464The Cost of Debt 464The Cost of Preferred Stock 46514.4 The Weighted Average Cost of Capital 466The Capital Structure Weights 466laxes and the Weighted Average Costof Capital 467Calculating the WACC for Eastman Chemical 468Eastman's Cost of Equity 468Eastman's Cost of Debt 470Eastman's WACC 471Solving the Warehouse Problem and Similar CapitalBudgeting Problems 472Performance Evaluation: Another Use of theWACC 47514.5 Oivisional and Project Costs of Capital 476The SML and the WACC 476Oivisional Cost of Capital 477The Pure Play Approach 477The Subjective Approach 47814.6 Company Valvation With The WACC 47914.7 Flotation Costs and the Average Cost ofCapital 482The Basic Approach 482Flotation Costs and NPV 483Internal Equity and Flotation Costs 48514.8 Summary and Conclusions 485CHARTER 15RAISING CAPITAL 49515.1 The Financing Life Cycle of a Firm: Early-StageFinancing and Venture Capital 496Venture Capital 496Some Venture Capital Realities 497Choosing a Venture Capitalist 497Conclusion 49715.2 Selling Securities to the Public: The BasicProcedura 498Crowdfunding 49915.3 Alternative Issue Methods 49915.4 Underwriters 501Choosing an Underwriter 502Types of Underwriting 502Firm Commitment Underwriting 502Best Efforts Underwriting 503Dutch Auction Underwriting 503The Aftermarket 503The Green Shoe Provision 504Lockup Agreements 504The Quiet Period 50415.5 IPOs and Underpricing 505IPO Underpricing: The 1999-2000 Experience 505Evidence on Underpricing 607Why Does Underpricing Exist? 51015.6 New Equity Sales and the Value of the Firm 51115.7 The Costs of Issuing Securities 512The Costs of Selling Stock to the Public 512The Costs of Going Public: A Gase Study 51515.8 Rights 517The Mechanics of a Rights Ottering 517Number of Rights Needed to Purchase a Share 518The Value of a Right 519Ex Rights 520The Underwriting Arrangements 522Effects on Shareholders 52215.9 Dilution 523Dilution of Proportionale Ownership 523Dilution of Value: Book versus Market Values 523A Misconception 524The Correct Arguments 52415.10 Issuing Long-Term Debt 52515.11 Shelf Registration 52615.12 Summary and Conclusions 527CHARTER 16FINANCIAL LEVERAGE AND CAPITAL STRUCTUREPOLICY 53416.1 The Capital Structure Question 535Firm Value and Stock Value: An Example 535Capital Structure and the Cost of Capital 53616.2 The Effect of Financial Leverage 537The Basics of Financial Leverage 537Financial Leverage, EPS, and ROE:An Example 537EPS versus EBIT 538Corporate Borrowing and Homemade Leverage 540
CONTENTS16.3 Capital Structure and the Cost of EquityCapital 541M&M Proposition I: The Pie Model 541The Cost of Equity and Financial Leverage:M&M Proposition II 542Business and Financial Risk 54416.4 M&M Propositions I and II with CorporateTaxes 545The Interest Tax Shield 546Taxes and M&M Proposition I 546Taxes, the WACC, and Proposition II 547Conclusion 54816.5 Bankruptcy Costs 550Direct Bankruptcy Costs 551Indirect Bankruptcy Costs 55116.6 Optimal Capital Structure 552The Static Theory of Capital Structure 552Optimal Capital Structure and the Costof Capital 553Optimal Capital Structure: A Recap 554Capital Structure: Some ManagerialRecommendations 556Taxes 556Financial Distress 55616.7 The Pie Again 556The Extended Pie Model 557Marketed Claims versus NonmarketedClaims 55816.8 The Pecking-Order Theory 558Internal Financing and the Pecking Order 558Implications of the Pecking Order 55916.9 Observed Capital Structures 56016.10 A Quick Look at the Bankruptcy Process 562Liquidation and Reorganization 562Bankruptcy Liquidation 562Bankruptcy Reorganization 563Financial Management and the BankruptcyProcess 565Agreements to Avoid Bankruptcy 56516.11 Summary and Conclusions 56617.217.317.417.517.617.717.8CHAPTER 17DIVIDENDS AND PAYOUT POLICY57417.1 Cash Dividends and Dividend Payment 575Cash Dividends 575Standard Method of Cash Dividend Payment 57517.9xxxixDividend Payment: A Chronology 576More about the Ex-Dividend Date 576Does Dividend Policy Matter? 578An Illustration of the Irrelevance of DividendPolicy 578Current Policy: Dividends Set Equalto Cash Flow 579Alternative Policy: Initial Dividend GreaterThan Cash Flow 579Homemade Dividends 579A Test 580Real-World Factors Favoring a Low DividendPayout 581Taxes 581Flotation Costs 581Dividend Restrictions 581Real-World Factors Favoring a High DividendPayout 582Desire for Current Income 582Tax and Other Benefits from High Dividends 583Corporate Investors 583Tax-Exempt Investors 583Conclusion 583A Resolution of Real-World Factors? 583Information Content of Dividends 584The Clientele Effect 585Stock Repurchases: An Alternative to CashDividends 585Cash Dividends versus Repurchase 587Real-World Considerations in a Repurchase 588Share Repurchase and EPS 589What We Know and Do Not Know about Dividendand Payout Policies 589Dividends and Dividend Payers 589Corporations Smooth Dividends 592Putting It All Together 592Some Survey Evidence on Dividends 594Stock Dividends and Stock Splits 596Some Details about Stock Splits and StockDividends 596Example of a Small Stock Dividend 596Example of a Stock Split 597Example of a Large Stock Dividend 597Value of Stock Splits and Stock Dividends 597The Benchmark Case 597Populär Trading Range 598Reverse Splits 598Summary and Conclusions 599
CONTENTSxlPART 7Short-Term Financial Flanning andCHAPTER 18SHORT-TERM FINANCE AND FLANNING 60618.1 Tracing Cash and Net Working Capital 60718.2 The Operating Cycle and the Cash Cycle 608Defining the Operating and Cash Cycles 609The Operating Cycle 609The Cash Cycle 609The Operating Cycle and the Firm's OrganizationalChart 611Calculating the Operating and Cash Cycles 611The Operating Cycle 612The Cash Cycle 613Interpreting the Cash Cycle 61418.3 Some Aspects of Short-Term Financial Policy 614The Size of the Firm's Investment in CurrentAssets 615Alternative Financing Policies for Current Assets 616An Ideal Case 616Different Policies for Financing Current Assets 616Which Financing Policy Is Best? 619Current Assets and Liabilities in Practice 62018.4 The Cash Budget 621Sales and Cash Collections 621Cash Outflows 622The Cash Balance 62218.5 Short-Term Borrowing 623Unsecured Loans 624Compensating Balances 624Cost ofa Compensating Balance 624Letters of Credit 625Secured Loans 625Accounts Receivabie Financing 625Inventory Loans 626Other Sources 62618.6 A Short-Term Financial Plan 62
Fundamentals of CORPORATE FINANCE Eleventh Edition Stephen A. Ross Massachusetts Institute of Technology Randolph W. Westerfeld University of Southern California, Emeritus Bradford D. Jordan University of Kentucky Mc Graw Hill Education
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