Fundamentals Of Corporate Finance Volume 1 David Whitehurst

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FinanceFundamentals of Corporate FinanceVolume 1David WhitehurstUMISTabcMcGraw-Hill/IrwinMcGraw Hill PrimisISBN: 0 390 31999 6Text:Fundamentals of Corporate Finance, SixthEdition, Alternate EditionRoss et al.

This book was printed on recycled yright 2003 by The McGraw Hill Companies, Inc. All rightsreserved. Printed in the United States of America. Except aspermitted under the United States Copyright Act of 1976, no partof this publication may be reproduced or distributed in any formor by any means, or stored in a database or retrieval system,without prior written permission of the publisher.This McGraw Hill Primis text may include materials submitted toMcGraw Hill for publication by the instructor of this course. Theinstructor is solely responsible for the editorial content of suchmaterials.111FINAISBN: 0 390 31999 6

FinanceVolume 1Ross et al. Fundamentals of Corporate Finance, Sixth Edition, Alternate EditionFront Matter1Preface1I. Overview of Corporate Finance331. Introduction to Corporate Finance2. Financial Statements, Taxes, and Cash Flow3355II. Financial Statements and Long Term Financial Planning833. Working with Financial Statements4. Long Term Financial Planning and Growth83126III. Valuation of Future Cash Flows1585. Introduction to Valuation: The Time Value of Money6. Discounted Cash Flow Valuation7. Interest Rates and Bond Valuation8. Stock Valuation158187231273IV. Capital Budgeting3019. Net Present Value and Other Investment Criteria10. Making Capital Investment Decisions11. Project Analysis and Evaluation301340378V. Risk and Return40812. Some Lessons from Capital Market History13. Return, Risk, and the Security Market Line14. Options and Corporate Finance408443481VI. Cost of Capital and Long Term Financial Policy51915. Cost of Capital16. Raising Capital17. Financial Leverage and Capital Structure Policy18. Dividends and Dividend Policy519553594632VII. Short Term Financial Planning and Management66419. Short Term Finance and Planning20. Cash and Liquidity Management21. Credit and Inventory Management664700734iii

VIII. Topics in Corporate Finance77322. International Corporate Finance23. Risk Management: An Introduction to Financial Engineering24. Option Valuation25. Mergers and Acquisitions26. Leasing773803832865896iv

Ross et al.: Fundamentalsof Corporate Finance, SixthEdition, Alternate EditionFront Matter The McGraw HillCompanies, 2002PrefaceAlternate EditionFundamentals ofCorporate FINANCE1

2Ross et al.: Fundamentalsof Corporate Finance, SixthEdition, Alternate EditionFront MatterPreface The McGraw HillCompanies, 2002

Ross et al.: Fundamentalsof Corporate Finance, SixthEdition, Alternate EditionFront Matter The McGraw HillCompanies, 2002PrefaceAlternate EditionFundamentals ofCorporate FINANCESixth E ditionStephen A. RossMassachusetts Institute of TechnologyRandolph W. WesterfieldUniversity of Souther n Califor niaBradford D. JordanUniversity of KentuckyBoston Burr Ridge, IL Dubuque, IA Madison, WI New York San Francisco St. LouisBangkok Bogotá Caracas Kuala Lumpur Lisbon London Madrid Mexico CityMilan Montreal New Delhi Santiago Seoul Singapore Sydney Taipei Toronto3

4Ross et al.: Fundamentalsof Corporate Finance, SixthEdition, Alternate EditionFront MatterPrefaceDedicationTo our families and friends with love and gratitude.S.A.R.R.W.W.B.D.J.McGraw-Hill Higher EducationA Division of The McGraw-Hill CompaniesFUNDAMENTALS OF CORPORATE FINANCEPublished by McGraw-Hill/Irwin, a business unit of The McGraw-Hill Companies, Inc. 1221Avenue of the Americas, New York, NY, 10020. Copyright 2003, 2000, 1998, 1995, 1993,1991 by The McGraw-Hill Companies, Inc. All rights reserved. No part of this publication may bereproduced or distributed in any form or by any means, or stored in a database or retrieval system,without the prior written consent of The McGraw-Hill Companies, Inc., including, but not limited to, inany network or other electronic storage or transmission, or broadcast for distance learning.Some ancillaries, including electronic and print components, may not be available to customers outsidethe United States.This book is printed on acid-free paper.1 2 3 4 5 6 7 8 9 0 VNH/VNH 0 9 8 7 6 5 4 3 2ISBN 0-07-246974-9 (standard edition)ISBN 0-07-246982-X (alternate edition)ISBN 0-07-246987-0 (annotated instructor’s edition)Executive editor: Stephen M. PattersonSponsoring editor: Michele JanicekDevelopmental editor II: Erin RileyExecutive marketing manager: Rhonda SeelingerSenior project manager: Jean Lou HessProduction supervisor: Rose HepburnSenior designer: Pam VerrosProducer, Media technology: Melissa KansaSenior supplement producer: Carol LorethPhoto research coordinator: Judy KausalInterior design: Maureen McCutcheonCover and interior illustration: Jacek Stachowski/SIS Typeface: 10/12 Times RomanCompositor: GAC / IndianapolisPrinter: Von Hoffmann Press, Inc.Library of Congress Cataloging-in-Publication Data: 2002100736INTERNATIONAL EDITION ISBN 0-07-115102-8Copyright 2003. Exclusive rights by The McGraw-Hill Companies, Inc. for manufacture andexport. This book cannot be re-exported from the country to which it is sold by McGraw-Hill.The International Edition is not available in North America. The McGraw HillCompanies, 2002

Ross et al.: Fundamentalsof Corporate Finance, SixthEdition, Alternate EditionFront MatterPreface The McGraw HillCompanies, 20025The McGraw-Hill/Irwin Series in Finance, Insurance, and Real EstateConsulting Editor Stephen A. RossFinancial ManagementBenninga and SarigCorporate Finance: A Valuation ApproachBlock and HirtFoundations of Financial ManagementTenth EditionBrealey and MyersPrinciples of Corporate FinanceSixth EditionBrealey, Myers, and MarcusFundamentals of Corporate FinanceThird EditionBrooksFinGame Online 3.0BrunerCase Studies in Finance: Managing forCorporate Value CreationFourth EditionChewThe New Corporate Finance: Where TheoryMeets PracticeThird EditionGrinblatt and TitmanFinancial Markets and Corporate StrategySecond EditionHelfertTechniques of Financial Analysis: A Guideto Value CreationEleventh EditionHigginsAnalysis for Financial ManagementSixth EditionKester, Fruhan, Piper, and RubackCase Problems in FinanceEleventh EditionNunnally and PlathCases in FinanceSecond EditionRoss, Westerfield, and JaffeCorporate FinanceSixth EditionRoss, Westerfield, and JordanEssentials of Corporate FinanceThird EditionRoss, Westerfield, and JordanFundamentals of Corporate FinanceSixth EditionSmithThe Modern Theory of Corporate FinanceSecond EditionFranco Modigliani Professor of Finance and EconomicsSloan School of ManagementMassachusetts Institute of TechnologyWhiteFinancial Analysis with an ElectronicCalculatorFourth EditionSaunders and CornettFinancial Markets and Institutions:A Modern PerspectiveInternational FinanceInvestmentsBodie, Kane, and MarcusEssentials of InvestmentsFourth EditionBodie, Kane, and MarcusInvestmentsFifth EditionCohen, Zinbarg, and ZeikelInvestment Analysis and PortfolioManagementFifth EditionCorrado and JordanFundamentals of Investments: Valuationand ManagementSecond EditionFarrellPortfolio Management: Theory andApplicationsSecond EditionHirt and BlockFundamentals of Investment ManagementSeventh EditionFinancial Institutions and MarketsCornett and SaundersFundamentals of Financial InstitutionsManagementRoseCommercial Bank ManagementFifth EditionRoseMoney and Capital Markets: FinancialInstitutions and Instruments in a GlobalMarketplaceSeventh EditionSantomero and BabbelFinancial Markets, Instruments, andInstitutionsSecond EditionSaundersFinancial Institutions Management:A Modern PerspectiveThird EditionBeim and CalomirisEmerging Financial MarketsEun and ResnickInternational Financial ManagementSecond EditionLevichInternational Financial Markets:Prices and PoliciesSecond EditionReal EstateBrueggeman and FisherReal Estate Finance and InvestmentsEleventh EditionCorgel, Ling, and SmithReal Estate Perspectives: An Introduction toReal EstateFourth EditionFinancial Planning and InsuranceAllen, Melone, Rosenbloom, andVanDerheiPension Planning: Pension, Profit-Sharing,and Other Deferred Compensation PlansNinth EditionCrawfordLife and Health Insurance LawEighth Edition (LOMA)Harrington and NiehausRisk Management and InsuranceHirschCasualty Claim PracticeSixth EditionKapoor, Dlabay, and HughesPersonal FinanceSixth EditionSkipperInternational Risk and Insurance: AnEnvironmental-Managerial ApproachWilliams, Smith, and YoungRisk Management and InsuranceEighth Edition

6Ross et al.: Fundamentalsof Corporate Finance, SixthEdition, Alternate EditionFront MatterPreface The McGraw HillCompanies, 2002ABOUT THE AUTHORSStephen A. RossRandolph W. WesterfieldBradford D. JordanSloan School of Management,Franco Modigliani Professor ofFinance and Economics,Massachusetts Institute ofTechnologyMarshall School of Business, Deanof the School of BusinessAdministration and holder of theRobert R. Dockson Dean’s Chair ofBusiness Administration, Universityof Southern CaliforniaCarol Martin Gatton College ofBusiness and Economics, NationalCity Bank Professor of Finance,University of KentuckyStephen Ross is presently the FrancoModigliani Professor of Finance andEconomics at the Sloan School ofManagement, Massachusetts Instituteof Technology. One of the most widelypublished authors in finance andeconomics, Professor Ross isrecognized for his work in developingthe Arbitrage Pricing Theory and hissubstantial contributions to thediscipline through his research insignaling, agency theory, optionpricing, and the theory of the termstructure of interest rates, among othertopics. A past president of the AmericanFinance Association, he currentlyserves as an associate editor of severalacademic and practitioner journals.He is a trustee of CalTech, a director ofthe College Retirement Equity Fund(CREF), and Freddie Mac. He is alsothe co-chairman of Roll and Ross AssetManagement Corporation.viRandolph W. Westerfield is Dean of theUniversity of Southern CaliforniaSchool of Business Administration andholder of the Robert R. DocksonDean’s Chair of BusinessAdministration.He came to USC from The WhartonSchool, University of Pennsylvania,where he was the chairman of thefinance department and member of thefinance faculty for 20 years. He was thesenior research associate at the RodneyL. White Center for Financial Researchat Wharton. His areas of expertiseinclude corporate financial policy,investment management and analysis,mergers and acquisitions, and stockmarket price behavior.Professor Westerfield serves as amember of the Board of Directors ofHealth Management Associates(NYSE: HMA), William Lyon Homes,Inc. (NYSE: WLS), the LordFoundation, and the AACSBInternational. He has been consultant toa number of corporations, includingAT&T, Mobil Oil, and PacificEnterprises, as well as to the UnitedNations, the U.S. Department of Justiceand Labor, and the State of California.Bradford D. Jordan is Professor ofFinance and the National City BankProfessor at the University ofKentucky. He has a long-standinginterest in both applied and theoreticalissues in corporate finance and hasextensive experience teaching all levelsof corporate finance and financialmanagement policy. Professor Jordanhas published numerous articles onissues such as cost of capital, capitalstructure, and the behavior of securityprices. He is a past president of theSouthern Finance Association, and he iscoauthor (with Charles J. Corrado) ofFundamentals of Investments:Valuation and Management, a leadinginvestments text, also published byMcGraw-Hill/Irwin.

Ross et al.: Fundamentalsof Corporate Finance, SixthEdition, Alternate EditionFront Matter The McGraw HillCompanies, 2002Preface7PREFACEfrom the AuthorsWhen the three of us decided to write a book,we were united by one strongly held principle: Corporate finance should be developedin terms of a few integrated, powerful ideas.We believed that the subject was all too often presentedas a collection of loosely related topics, unified primarily by virtue of being bound together in one book, andwe thought there must be a better way.One thing we knew for certain was that we didn’twant to write a “me-too” book. So, with a lot of help,we took a hard look at what was truly important anduseful. In doing so, we were led to eliminate topics ofdubious relevance, downplay purely theoretical issues,and minimize the use of extensive and elaborate calculations to illustrate points that are either intuitively obvious or of limited practical use.As a result of this process, three basic themes became our central focus in writing Fundamentals ofCorporate Finance:An Emphasis on Intuition We always try to separateand explain the principles at work on a common sense,intuitive level before launching into any specifics. Theunderlying ideas are discussed first in very generalterms and then by way of examples that illustrate inmore concrete terms how a financial manager mightproceed in a given situation.A Unified Valuation Approach We treat net presentvalue (NPV) as the basic concept underlying corporatefinance. Many texts stop well short of consistently integrating this important principle. The most basic and important notion, that NPV represents the excess of marketvalue over cost, often is lost in an overly mechanical approach that emphasizes computation at the expense ofcomprehension. In contrast, every subject we cover isfirmly rooted in valuation, and care is taken throughoutto explain how particular decisions have valuationeffects.A Managerial Focus Students shouldn’t lose sight ofthe fact that financial management concerns management. We emphasize the role of the financial manager asdecision maker, and we stress the need for managerialinput and judgment. We consciously avoid “black box”approaches to finance, and, where appropriate, the approximate, pragmatic nature of financial analysis ismade explicit, possible pitfalls are described, and limitations are discussed.In retrospect, looking back to our 1991 first editionIPO, we had the same hopes and fears as any entrepreneurs. How would we be received in the market? At thetime, we had no idea that just 10 years later, we would beworking on a sixth edition. We certainly never dreamedthat in those years we would work with friends and colleagues from around the world to create country-specificAustralian, Canadian, and South African editions, an International edition, Chinese, Polish, Portuguese, andSpanish language editions, and an entirely separate book,Essentials of Corporate Finance, now in its third edition.Today, as we prepare to once more enter the market,our goal is to stick with the basic principles that havebrought us this far. However, based on an enormousamount of feedback we have received from you and yourcolleagues, we have made this edition and its packageeven more flexible than previous editions. We offer flexibility in coverage, by continuing to offer a variety ofeditions, and flexibility in pedagogy, by providing awide variety of features in the book to help students tolearn about corporate finance. We also provide flexibilityin package options by offering the most extensive collection of teaching, learning, and technology aids of anycorporate finance text. Whether you use just the textbook, or the book in conjunction with other products, webelieve you will find a combination with this edition thatwill meet your current as well as your changing needs.Stephen A. RossRandolph W. WesterfieldBradford D. Jordanvii

8Ross et al.: Fundamentalsof Corporate Finance, SixthEdition, Alternate EditionFront Matter The McGraw HillCompanies, 2002PrefaceCOVERAGEThis book was designed and developed explicitly for a first course in business or corporate finance, for bothfinance majors and non-majors alike. In terms of background or prerequisites, the book is nearly selfcontained, assuming some familiarity with basic algebra and accounting concepts, while still reviewing important accounting principles very early on. The organization of this text has been developed to giveinstructors the flexibility they need.As with the previous edition of thebook, we are offering a StandardEdition with 22 chapters and anAlternate Edition with 26chapters.Considers the goals of thecorporation, the corporate form oforganization, the agency problem,and, briefly, financial markets.S TA N D A R D A N D ALT ERN AT E EDIT ION S TABL E OF CON T EN T SPA RT ONEOver view of Corporate Finance1 In t ro d u ct i o n t o Cor p orat e Fin an ce2 Fi n a n ci a l St at em en t s , Ta xes , an d Cas h FlowSuccinctly discusses cash flowversus accounting income, marketvalue versus book value, taxes,and a review of financialstatements.PA RT TWOFinancial Statements and Long-Term Financial Planning3 Wo rk i n g w i t h Fin an cial St at em en t sContains a thorough discussionof the sustainable growth rate asa planning tool.First of two chapters coveringtime value of money, allowing fora building-block approach to thisconcept.4 L o n g -Te rm Fin an cial Plan n in g an d Gr owt hPA RT THREEValuation of Future Cash Flows5 In t ro d u ct i o n t o Valu at ion : T h e T im e Valu e of Mon ey6 D i s co u n t e d Cas h Flow Valu at ion7 In t ere s t R a t es an d Bon d Valu at ionContains an extensive discussionon NPV estimates.8 S t o c k Va l u at ionPA RT FOURUpdated to reflect market returnsand events through 2000.Discusses the expectedreturn/risk trade-off, anddevelops the security market linein a highly intuitive way thatbypasses much of the usualportfolio theory and statistics.New chapter! Introduces theimportant role of options incorporate finance by coveringstock options, employee stockoptions, real options and their rolein capital budgeting, and themany different types of optionsfound in corporate securities.viiiCapital Budgeting9 N e t P re s en t Valu e an d Ot h er In ves t m en t Cr it er ia10 Making Capital Investment Decisions1 1 P ro j e ct A n a lys is an d Evalu at ionPA RT FIVERisk and Return1 2 S o m e L es s on s f r om Cap it al Mar ket His t or y1 3 R et u rn , R i s k , an d t h e Secu r it y Mar ket L in e1 4 O p t i o n s a n d Cor p orat e Fin an ce

Ross et al.: Fundamentalsof Corporate Finance, SixthEdition, Alternate EditionFront MatterPreface The McGraw HillCompanies, 20029PA RT SIXCost of Capital and Long-Term Financial Policy15 C o s t o f C a p i t a l16 R a i s i n g C a p i t a l17 F i n a n ci a l L evera g e a n d C a p i t al St r u ct u r e Policy18 Dividends and Dividend PolicyPA RT SEVENIncludes a completely Web-basedillustration of the cost-of-capitalcalculation.Provides key developments in theIPO market such as the Internet“bubble,” the role of “lockup”agreements, and current thinkingon IPO underpricing.Short-Term Financial Planning and Management19 S h o rt -Te rm Fi n a n ce a n d P l a n n in g20 C a s h a n d L i q u i d i t y Ma n a g em e n tA p p en d i x 2 0 A D e t erm i n i n g t he Tar g et Cas h Balan cePresents a general survey ofshort-term financial management,which is useful when time doesnot permit a more in-depthtreatment.21 Credit and Inventor y ManagementA p p en d i x 2 1 A Mo re o n C re d i t Policy An alys isPA RT EIGHTTopics in Corporate Finance22 In t e rn a t i o n a l C o rp o ra t e Fi n a n ceA Ma t h em a t i c a l Ta b l e sCovers important issues ininternational finance, includingthe introduction of the euro.B Key E q u a t i o n sC A n swe rs t o S el e ct ed E n d -o f -Ch ap t er Pr ob lem sIndexesA LTE R N AT E E D I T I O N — A D D I T I O N A L CHAPT ERSPA RT EIGHTTopics in Corporate FinanceChoose this edition if you areinterested in covering thefollowing additional topics!Same chapter as in the StandardEdition.22 In t e rn a t i o n a l C o rp o ra t e Fi n a n ce23 R i s k Ma n a g em e n t : A n I n t ro d u c t ion t o Fin an cial En g in eer in g24 Option ValuationThis increasingly important topicis presented a

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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