Fundamentals Of Corporate Finance - Higher Education Pearson

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Fundamentals ofCorporate FinanceFIFTH RD UNIVERSITYSTANFORD UNIVERSITYUNIVERSITY OF WASHINGTONA01 BERK1597 05 SE FM.indd 11/22/20 9:41 PM

Please contact https://support.pearson.com/getsupport/s with any queries on this content.Cover Image: 3alexd/E /Getty ImagesMicrosoft and/or its respective suppliers make no representations about the suitability of the information contained in thedocuments and related graphics published as part of the services for any purpose. All such documents and related graphicsare provided “as is” without warranty of any kind. Microsoft and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all warranties and conditions of merchantability, whetherexpress, implied or statutory, fitness for a particular purpose, title and non-infringement. In no event shall Microsoft and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resultingfrom loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or inconnection with the use or performance of information available from the services.The documents and related graphics contained herein could include technical inaccuracies or typographical errors.Changes are periodically added to the information herein. Microsoft and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time. Partial screen shots may beviewed in full within the software version specified.Microsoft and Windows are registered trademarks of the Microsoft Corporation in the U.S.A. and other countries. Thisbook is not sponsored or endorsed by or affiliated with the Microsoft Corporation.Copyright 2021, 2018, 2015 by Jonathan B. Berk, Peter M. DeMarzo and Jarrad V.T. Harford. All Rights Reserved. Manufactured in the United States of America. This publication is protected by copyright, and permission should be obtainedfrom the publisher prior to any prohibited reproduction, storage in a retrieval system, or transmission in any form or byany means, electronic, mechanical, photocopying, recording, or otherwise. For information regarding permissions, requestforms, and the appropriate contacts within the Pearson Education Global Rights and Permissions department, please s of third-party content appear on the appropriate page within the text. Photographs in this text courtesyof the following: p. 11 Anna Hoychuk/Shutterstock; p.15 Gary/Fotolia; p. 17 Frank Hatheway; p. 25 Yahoo Inc.; p. 29Ruth Porat; p. 83 Xavier Subias/Age fotostock/Alamy Stock Photo; p. 146 Kevin M.Warsh; p. 161: Courtesy Heritage Auctions, Inc. 1999–2006; p. 180 Lisa Black; p. 199 finance.yahoo.com/quote/NKE?p NKE.; p. 233 Microsoft Corporation;p. 246 Dick Grannis; p. 264 Microsoft Corporation; p. 277 Microsoft Corporation; p. 278 Denys Prykhodov/Shutterstock; p. 286 David Holland; p. 288 Microsoft Corporation; p. 289 Microsoft Corporation; p. 309 https://finance.yahoo.com/quote/NKE?p NKE.; p. 315 Douglas Kehring; p. 348: Microsoft Corporation; p. 377 Microsoft Corporation; p. 388 Microsoft Corporation; p. 422 Shelagh Glaser; p. 437 Kevin Laws; p. 559 John Connors; p. 662 Tasos Katopodis/GettyImages; p. 665 Cristina99/Fotolia; p. 675: /optionscalculator; p. 719Chetianu/Fotolia.PEARSON, ALWAYS LEARNING, and MYLAB are exclusive trademarks owned by Pearson Education, Inc. or its affiliates inthe U.S. and/or other countries.Unless otherwise indicated herein, any third-party trademarks, logos, or icons that may appear in this work are theproperty of their respective owners, and any references to third-party trademarks, logos, icons, or other trade dress arefor demonstrative or descriptive purposes only. Such references are not intended to imply any sponsorship, endorsement,authorization, or promotion of Pearson’s products by the owners of such marks, or any relationship between the ownerand Pearson Education, Inc., or its affiliates, authors, licensees, or distributors.Library of Congress Cataloging-in-Publication DataNames: Berk, Jonathan B.- author. DeMarzo, Peter M., author. Harford, Jarrad V. T., author.Title: Fundamentals of corporate finance / Jonathan Berk, StanfordUniversity, Peter DeMarzo, Stanford University, Jarrad Harford,University of Washington.Description: Fifth edition. New York, NY : Pearson Education, Inc.,[2021] Includes index.Identifiers: LCCN 2019020474 ISBN 9780135811597Subjects: LCSH: Corporations—Finance.Classification: LCC HG4026 .B464 2021 DDC 658.15—dc23LC record available at CodeISBN 10:0-13-581159-7ISBN 13: 978-0-13-581159-7A01 BERK1597 05 SE FM.indd 21/22/20 9:41 PM

To Natasha and Hannah for all the joy youbring to my life. —J. B.To Kaui, Pono, Koa, and Kai for all the loveand laughter. —P. D.To Katrina, Evan, and Cole for your love andsupport. —J. H.A01 BERK1597 05 SE FM.indd 31/22/20 9:41 PM

A01 BERK1597 05 SE FM.indd 41/22/20 9:41 PM

Brief ContentsPART 1PART 2PART 3PART 4PART 5PART 6PART 7PART 8A01 BERK1597 05 SE FM.indd 5Introduction  1CHAPTER 1Corporate Finance and the Financial Manager 3CHAPTER 2Introduction to Financial Statement Analysis 27Interest Rates and Valuing Cash FlowsCHAPTER 3Time Value of Money: An IntroductionCHAPTER 4Time Value of Money: Valuing Cash Flow StreamsCHAPTER 5Interest Rates 131CHAPTER 6BondsCHAPTER 7Stock Valuation717393159197Valuation and the Firm225CHAPTER 8Investment Decision Rules 227CHAPTER 9Fundamentals of Capital Budgeting 265CHAPTER 10Stock Valuation: A Second LookRisk and Return303335CHAPTER 11Risk and Return in Capital MarketsCHAPTER 12Systematic Risk and the Equity Risk Premium337CHAPTER 13The Cost of Capital369405Long-Term Financing 433CHAPTER 14Raising Equity CapitalCHAPTER 15Debt Financing 467435Capital Structure and Payout PolicyCHAPTER 16Capital StructureCHAPTER 17Payout Policy495497537Financial Planning and ForecastingCHAPTER 18Financial Modeling and Pro Forma AnalysisCHAPTER 19Working Capital Management 603CHAPTER 20Short-Term Financial Planning 629571573Special Topics 659CHAPTER 21Option Applications and Corporate Finance 661CHAPTER 22Mergers and Acquisitions 687CHAPTER 23International Corporate Finance717v1/22/20 9:41 PM

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Detailed ContentsPART 1CHAPTER 1Introduction1Corporate Finance and theFinancial Manager 31.1 Why Study Finance? 41.2 The Four Types of Firms 4Sole Proprietorships 5Partnerships 6Limited Liability Companies 6Corporations 6Tax Implications for Corporate Entities 8 Corporate Taxation Around the World 81.3 The Financial Manager 10Making Investment Decisions 10 GLOBAL FINANCIAL CRISIS The Dodd-Frank Act 10Making Financing Decisions 11Managing Short-Term Cash Needs 11The Goal of the Financial Manager 11 Shareholder Value Versus StakeholderValue 121.4 The Financial Manager’s Place in theCorporation 12The Corporate Management Team 12Ethics and Incentives in Corporations 13 GLOBAL FINANCIAL CRISIS The Dodd-Frank Act on Corporate Compensationand Governance 14 Citizens United v. Federal ElectionCommission 14Role of Financial Institutions 21Summary 23 Problems 24CHAPTER 2Introduction to FinancialStatement Analysis 272.1 Firms’ Disclosure of Financial InformationPreparation of Financial Statements 28 I nternational Financial ReportingStandards 28 INTERVIEW WITH Ruth Porat 29Types of Financial Statements 302.2 The Balance Sheet 30Assets 31Liabilities 32Stockholders’ Equity 32Market Value Versus Book ValueMarket-to-Book Ratio 34Enterprise Value 3428332.3 The Income Statement 36Earnings Calculations 36EBITDA 372.4 The Statement of Cash FlowsOperating Activity 38Investment Activity 41Financing Activity 41382.5 Other Financial Statement Information 41Statement of Stockholders’ Equity 42Management Discussion and Analysis 42Notes to the Financial Statements 421.5 The Stock Market 15The Largest Stock Markets 15Primary Versus Secondary Markets 16Traditional Trading Venues 16 INTERVIEW WITH Frank Hatheway 17New Competition and Market Changes 18Dark Pools 19Listing Standards 19Other Financial Markets 19 NYSE, BATS, DJIA, S&P 500: Awash inAcronyms 202.6 Financial Statement Analysis 42Profitability Ratios 43Liquidity Ratios 44Asset Efficiency 44Working Capital Ratios 44Interest Coverage Ratios 46Leverage Ratios 46Valuation Ratios 48 COMMON MISTAKE MismatchedRatios 48Operating Returns 49The DuPont Identity 501.6 Financial Institutions 20The Financial Cycle 20Types of Financial Institutions 212.7 Financial Reporting in PracticeEnron 54The Sarbanes-Oxley Act 5454viiA01 BERK1597 05 SE FM.indd 71/22/20 9:41 PM

viiiDetailed ContentsDodd-Frank Act 55 GLOBAL FINANCIAL CRISISMadoff’s Ponzi Scheme 56The Financial Statements: A Useful StartingPoint 56Summary 57 Critical Thinking 59 Problems 60 Data Case 68PART 2CHAPTER 3Interest Rates andValuing Cash Flows 71Time Value of Money: AnIntroduction 733.1 Cost-Benefit Analysis 74Role of the Financial Manager 74Quantifying Costs and Benefits 743.2 Market Prices and the Valuation Principle 76The Valuation Principle 76Why There Can Be Only One Competitive Price fora Good 77 Your Personal Financial Decisions 783.3 The Time Value of Money and InterestRates 78The Time Value of Money 78The Interest Rate: Converting Cash AcrossTime 79Timelines 823.4 Valuing Cash Flows at Different Points inTime 83Rule 1: Comparing and Combining Values 83 COMMON MISTAKE Summing Cash FlowsAcross Time 83Rule 2: Compounding 84 Rule of 72 85Rule 3: Discounting 86 Using a Financial Calculator 88Summary 88 Critical Thinking 89 Problems 89CHAPTER 4Time Value of Money: ValuingCash Flow Streams 934.1 Valuing a Stream of Cash Flows 94Applying the Rules of Valuing Cash Flows to aCash Flow Stream 94 Using a Financial Calculator: Solving forPresent and Future Values of Cash FlowStreams 974.2 Perpetuities 98Perpetuities 98A01 BERK1597 05 SE FM.indd 8 Historical Examples of Perpetuities 100 COMMON MISTAKE Discounting One TooBernardMany Times1014.3 Annuities 101Present Value of an Annuity 101Future Value of an Annuity 1044.4 Growing Cash Flows 105Growing Perpetuity 106Growing Annuity 1084.5 Solving for Variables Other Than Present Valueor Future Value 109Solving for the Cash Flows 109Rate of Return 112Solving for the Number of Periods 1154.6 Non-Annual Cash Flows 116The Big Picture 117Summary 118 Critical Thinking 119 Problems 119 Data Case 125CHAPTER 4 APPENDIX Using a FinancialCalculator 127CHAPTER 5Interest Rates1315.1 Interest Rate Quotes and Adjustments 132The Effective Annual Rate 132Adjusting the Discount Rate to Different TimePeriods 133Annual Percentage Rates 134 COMMON MISTAKE Using the EAR in theAnnuity Formula 1355.2 Application: Discount Rates and Loans 137Computing Loan Payments 137 GLOBAL FINANCIAL CRISIS Teaser Ratesand Subprime Loans 139Computing the Outstanding Loan Balance 1395.3 The Determinants of Interest Rates 140Inflation and Real Versus Nominal Rates 141Investment and Interest Rate Policy 142 How Is Inflation Actually Calculated? 143The Yield Curve and Discount Rates 144 INTERVIEW WITH Dr. Janet Yellen 146 COMMON MISTAKE Using the AnnuityFormula When Discount Rates Vary 147The Yield Curve and the Economy 1475.4 The Opportunity Cost of Capital 150 Interest Rates, Discount Rates, and the Costof Capital 151 COMMON MISTAKE States Dig a 3 TrillionHole by Discounting at the Wrong Rate 152Summary 152 Critical Thinking 154 Problems 1541/22/20 9:41 PM

ixDetailed ContentsCHAPTER 6Bonds1596.1 Bond Terminology 1606.2 Zero-Coupon Bonds 161Zero-Coupon Bond Cash Flows 162Yield to Maturity of a Zero-Coupon Bond 162 GLOBAL FINANCIAL CRISIS Negative BondYields 163Risk-Free Interest Rates 1646.3 Coupon Bonds 165Coupon Bond Cash Flows 165 The U.S. Treasury Market 166Yield to Maturity of a Coupon Bond 167 Finding Bond Prices on the Web 169Coupon Bond Price Quotes 1706.4 Why Bond Prices Change 170Interest Rate Changes and Bond Prices 170Time and Bond Prices 173Interest Rate Risk and Bond Prices 174 Clean and Dirty Prices for Coupon Bonds 177Bond Prices in Practice 1776.5 Corporate Bonds 178Credit Risk 179 Are Treasuries Really Default-FreeSecurities? 179 INTERVIEW WITH Lisa Black 180Corporate Bond Yields 180Bond Ratings 181Corporate Yield Curves 181 The Credit Crisis and Bond Yields 183Summary 185 Critical Thinking 186 Problems 186 Data Case 190CHAPTER 6 APPENDIX A Solving for theYield to Maturity of a Bond Using a FinancialCalculator 192CHAPTER 6 APPENDIX B The Yield Curve andthe Law of One Price 193CHAPTER 7Stock Valuation 1977.1 Stock Basics 198Stock Market Reporting: Stock Quotes 198Common Stock 199Preferred Stock 2007.2 The Mechanics of Stock Trades2017.3 The Dividend-Discount Model 202A One-Year Investor 202Dividend Yields, Capital Gains, and TotalReturns 203A Multiyear Investor 204Dividend-Discount Model Equation 205A01 BERK1597 05 SE FM.indd 97.4 Estimating Dividends in the Dividend-DiscountModel 206Constant Dividend Growth 206Dividends Versus Investment and Growth 207Changing Growth Rates 209 COMMON MISTAKE Forgetting to “Grow”This Year’s Dividend 210Value Drivers and the Dividend-Discount Model 2127.5 Limitations of the Dividend-Discount Model 212Uncertain Dividend Forecasts 212Non-Dividend-Paying Stocks 2137.6 Share Repurchases and the Total PayoutModel 2147.7 Putting It All Together 215Summary 216 Critical ThinkingProblems 218PART 2 INTEGRATIVE CASEPART 3CHAPTER 8218 222Valuation and theFirm 225Investment Decision Rules 2278.1 The NPV Decision Rule 228Net Present Value 228The NPV Decision Rule 2298.2 Using the NPV Rule 230Organizing the Cash Flows and Computing theNPV 230The NPV Profile 231Measuring Sensitivity with IRR 232Alternative Rules Versus the NPV Rule 2328.3 Alternative Decision Rules 232 USING EXCEL Computing NPV andIRR 233The Payback Rule 234The Internal Rate of Return Rule 235 COMMON MISTAKE IRR Versus the IRRRule 239Modified Internal Rate of Return 239 Why Do Rules Other Than the NPV RulePersist? 2408.4 Choosing Among Projects 242Differences in Scale 243 INTERVIEW WITH Dick GrannisTiming of the Cash Flows 2472468.5 Evaluating Projects with DifferentLives 248Important Considerations When Using the Equivalent Annual Annuity 2501/22/20 9:41 PM

xDetailed Contents8.6 Choosing Among Projects When Resources AreLimited 251Evaluating Projects with Different ResourceRequirements 2518.7 Putting It All Together 254Summary 255 Critical Thinking 256 Problems 257 Data Case 263CHAPTER 8 APPENDIX Creating the NPVProfile Using Excel's Data Table Function 264CHAPTER 9Fundamentals of CapitalBudgeting 2659.1 The Capital Budgeting Process 2669.2 Forecasting Incremental Earnings 267Operating Expenses Versus CapitalExpenditures 267Incremental Revenue and Cost Estimates 268Taxes 269Incremental Earnings Forecast 2699.3 Determining Incremental Free Cash Flow 271Converting from Earnings to Free CashFlow 272Calculating Free Cash Flow Directly 275Calculating the NPV 276 USING EXCEL Capital B udgeting Using a Spreadsheet Program 2779.4 Other Effects on Incremental Free CashFlows 278Opportunity Costs 278 COMMON MISTAKE The Opportunity Costof an Idle Asset 278Project Externalities 278Sunk Costs 279 COMMON MISTAKE The Sunk CostFallacy 279Adjusting Free Cash Flow 280Replacement Decisions 2829.5 Analyzing the Project 283Sensitivity Analysis 283Break-Even Analysis 284 INTERVIEW WITH David Holland 286Scenario Analysis 287 USING EXCEL Project Analysis UsingExcel 2889.6 Real Options in Capital Budgeting 289Option to Delay 290Option to Expand 290Option to Abandon 290Summary 291 Critical Thinking 292 Problems 292 Data Case 300CHAPTER 9 APPENDIX MACRSDepreciation 301A01 BERK1597 05 SE FM.indd 10CHAPTER 10Stock Valuation: A SecondLook 30310.1 The Discounted Free Cash Flow ModelValuing the Enterprise 304Implementing the Model 305Connection to Capital Budgeting 30630410.2 Valuation Based on Comparable FirmsValuation Multiples 308Limitations of Multiples 313Comparison with Discounted Cash FlowMethods 31430810.3 Stock Valuation Techniques: A Final Word 314 INTERVIEW WITH Douglas Kehring 31510.4 Information, Competition, and StockPrices 316Information in Stock Prices 316Competition and Efficient Markets 318 Forms of Market Efficiency 318Lessons for Investors and CorporateManagers 320 Nobel Prize The 2013 Prize: AnEnigma? 321The Efficient Markets Hypothesis Versus NoArbitrage 32110.5 Individual Biases and Trading 322Excessive Trading and Overconfidence 322Hanging On to Losers and the DispositionEffect 322Investor Attention, Mood, and Experience 324Summary 325 Critical Thinking 326 Problems 326 Data Case 331PART 3 INTEGRATIVE CASEPART 4CHAPTER 11333Risk and Return 335Risk and Return in CapitalMarkets 33711.1 A First Look at Risk and Return33811.2 Historical Risks and Returns of Stocks 340Computing Historical Returns 341Average Annual Returns 343 Arithmetic Average Returns Versus Compound Annual Returns 345The Variance and Volatility of Returns 346 COMMON MISTAKE Mistakes WhenComputing Standard Deviation 348 USING EXCEL Computing the Standard Deviation of Historical Returns 348The Normal Distribution 34911.3 The Historical Tradeoff Between Risk andReturn 3511/22/20 9:41 PM

xiDetailed ContentsThe Returns of Large Portfolios 351The Returns of Individual Stocks 351The Big Picture 394Summary 394 Critical ThinkingProblems 39611.4 Common Versus Independent Risk 353Theft Versus Earthquake Insurance: AnExample 353Types of Risk 35311.5 Diversification in Stock Portfolios 355Unsystematic Versus Systematic Risk 355 GLOBAL FINANCIAL CRISIS DiversificationBenefits During Market Crashes 356Diversifiable Risk and the Risk Premium 358The Importance of Systematic Risk 358 COMMON MISTAKE A Fallacy of Long-RunDiversification 359Summary 360 Critical Thinking 361 Problems 362 Data Case 365CHAPTER 12Systematic Risk and the EquityRisk Premium 36912.1 The Expected Return of a PortfolioPortfolio Weights 370Portfolio Returns 370Expected Portfolio Return 37237012.2 The Volatility of a Portfolio 373Diversifying Risks 373Measuring Stocks’ Co-Movement:Correlation 375 USING EXCEL Calculating the CorrelationBetween Two Sets of Returns 377Computing a Portfolio’s Variance and StandardDeviation 377The Volatility of a Large Portfolio 379 Nobel Prize Harry Markowitz 38012.3 Measuring Systematic Risk 381Role of the Market Portfolio 381Stock Market Indexes as the MarketPortfolio 382Market Risk and Beta 382 Index Funds 383 COMMON MISTAKE Mixing StandardDeviation and Beta 385Estimating Beta from Historical Returns 386 USING EXCEL Calculating a Stock’s Beta 38812.4 Putting It All Together: The Capital Asset PricingModel 388The CAPM Equation Relating Risk to ExpectedReturn 388 Why Not Estimate Expected ReturnsDirectly? 389 Nobel Prize William Sharpe 390The Security Market Line 391The CAPM and Portfolios 393Summary of the Capital Asset Pricing Model 394A01 BERK1597 05 SE FM.indd 11396 CHAPTER 12 APPENDIX Alternative Models ofSystematic Risk 401CHAPTER 13The Cost of Capital40513.1 A First Look at the Weighted Average Cost ofCapital 406The Firm’s Capital Structure 406Opportunity Cost and the Overall Cost ofCapital 406Weighted Averages and the Overall Cost ofCapital 407Weighted Average Cost of CapitalCalculations 40813.2 The Firm’s Costs of Debt and Equity Capital 409Cost of Debt Capital 409 COMMON MISTAKE Using the Coupon Rateas the Cost of Debt 410Cost of Preferred Stock Capital 411Cost of Common Stock Capital 41213.3 A Second Look at the Weighted Average Cost ofCapital 414WACC Equation 414Weighted Average Cost of Capital inPractice 415Methods in Practice 41613.4 Using the WACC to Value a Project 417Key Assumptions 418WACC Method Application: Extending the Life ofan AT&T Facility 419Summary of the WACC Method 42013.5 Project-Based Costs of Capital 420 COMMON MISTAKE Using a Single Cost ofCapital in Multi-Divisional Firms 420Cost of Capital for a New Acquisition 421Divisional Costs of Capital 421 INTERVIEW WITH Shelagh Glaser 42213.6 When Raising External Capital Is Costly 423Summary 424 Critical Thinking 426 Problems 426 Data Case 429PART 4 INTEGRATIVE CASEPART 5CHAPTER 14431Long-TermFinancing 433Raising Equity Capital43514.1 Equity Financing for Private Companies 436Sources of Funding436 INTERVIEW WITH Kevin Laws 4371/22/20 9:41 PM

xiiDetailed ContentsSummary 485 Critical Thinking 487 Problems 487 Data Case 489 Crowdfunding: The Wave of the Future?439Securities and Valuation 439Exiting an Investment in a Private Company 44114.2 Taking Your Firm Public: The Initial PublicOffering 442Advantages and Disadvantages of Going Public 442Primary and Secondary IPO Offerings 442Other IPO Types 448 Google’s IPO 449 An Alternative to the Traditional IPO: Spotify'sDirect Listing 45114.3 IPO Puzzles 451Underpriced IPOs 452“Hot” and “Cold” IPO Markets 453 GLOBAL FINANCIAL CRISIS 2008–2009:A Very Cold IPO Market 454High Cost of Issuing an IPO 454Poor Post-IPO Long-Run Stock Performance 45514.4 Raising Additional Capital: The Seasoned EquityOffering 456SEO Process 456SEO Price Reaction 458SEO Costs 459Summary 460 Critical Thinking 461 Problems 461 Data Case 464CHAPTER 15Debt Financing 46715.1 Corporate Debt 468Private Debt 468 Debt Financing at Hertz: Bank Loans 468 Debt Financing at Hertz: PrivatePlacements 469Public Debt 469 Debt Financing at Hertz: Public Debt 47115.2 Other Types of Debt 473Sovereign Debt 473Municipal Bonds 474 Detroit’s Art Museum at Risk 475Asset-Backed Securities 475 GLOBAL FINANCIAL CRISIS CDOs,Subprime Mortgages, and the FinancialCrisis 47615.3 Bond Covenants 478Types of Covenants 478Advantages of Covenants 478Application: Hertz’s Covenants 47915.4 Repayment Provisions 479Call Provisions 479 New York City Calls Its MunicipalBonds 481Sinking Funds 482Convertible Provisions 482A01 BERK1597 05 SE FM.indd 12CHAPTER 15 APPENDIX Using a Financial Calculator to Calculate Yield to Call 490PART 5 INTEGRATIVE CASEPART 6CHAPTER 16491Capital Structure andPayout Policy 495Capital Structure49716.1 Capital Structure Choices 498Capital Structure Choices Across Industries 498Capital Structure Choices Within Industries 49816.2 Capital Structure in Perfect Capital Markets 500Application: Financing a New Business 501Leverage and Firm Value 502The Effect of Leverage on Risk and Return 503Homemade Leverage 505Leverage and the Cost of Capital 505 COMMON MISTAKE Capital StructureFallacies 506 GLOBAL FINANCIAL CRISIS Bank CapitalRegulation and the ROE Fallacy 508MM and the Real World 509 Nobel Prize Franco Modigliani and MertonMiller 50916.3 Debt and Taxes 510The Interest Tax Deduction and Firm Value 510Value of the Interest Tax Shield 511The Interest Tax Shield with Permanent Debt 513Leverage and the WACC with Taxes 514Debt and Taxes: The Bottom Line 51416.4 The Costs of Bankruptcy and FinancialDistress 515Direct Costs of Bankruptcy 516 Bankruptcy Can Be Expensive 516Indirect Costs of Financial Distress 51616.5 Optimal Capital Structure: The TradeoffTheory 517Differences Across Firms 517Optimal Leverage 51816.6 Additional Consequences of Leverage: AgencyCosts and Information 519Agency Costs 519 Airlines Use Financial Distress to TheirAdvantage 520 GLOBAL FINANCIAL CRISIS Moral Hazardand Government Bailouts 521 Financial Distress and Rolling the Dice,Literally 522Debt and Information 5221/22/20 9:41 PM

Detailed Contents16.7 Capital Structure: Putting It All Together 524Summary 525 Critical Thinking 527 Problems 527CHAPTER 16 APPENDIX The BankruptcyCode 535CHAPTER 17Payout Policy53717.1 Cash Distributions to ShareholdersDividends 539Share Repurchases 54053817.2 Dividends Versus Share Repurchases in a Perfect Capital Market 541Alternative Policy 1: Pay a Dividend with ExcessCash 542Alternative Policy 2: Share Repurchase(No Dividend) 542 COMMON MISTAKE Repurchases and theSupply of Shares 544Alternative Policy 3: High Dividend (EquityIssue) 544Modigliani-Miller and Dividend PolicyIrrelevance 545 COMMON MISTAKE The Bird in the HandFallacy 546Dividend Policy with Perfect CapitalMarkets 54617.3 The Tax Disadvantage of Dividends 547Taxes on Dividends and CapitalGains 547Optimal Dividend Policy with Taxes 547Tax Differences Across Investors 55017.4 Payout Versus Retention of Cash 552Retaining Cash with Perfect CapitalMarkets 552Retaining Cash with Imperfect CapitalMarkets 55317.5 Signaling with Payout Policy 556Dividend Smoothing 556Dividend Signaling 557 Royal & SunAlliance’s Dividend Cut 558Signaling and Share Repurchases 558 INTERVIEW WITH John Connors 55917.6 Stock Dividends, Splits, and Spin-Offs 560Stock Dividends and Splits 560 Berkshire Hathaway’s A andB Shares 561Spin-Offs 56117.7 Advice for the Financial Manager 562Summary 563 Critical Thinking 565 Problems 565 Data Case 568PART 6 INTEGRATIVE CASEA01 BERK1597 05 SE FM.indd 13570PART 7CHAPTER 18xiiiFinancial Planning andForecasting 571Financial Modeling and ProForma Analysis 57318.1 Goals of Long-Term Financial Planning 574Identify Important Linkages 574Analyze the Impact of Potential BusinessPlans 574Plan for Future Funding Needs 57418.2 Forecasting Financial Statements: The Percentof Sales Method 575Percent of Sales Method 575Pro Forma Income Statement 576Pro Forma Balance Sheet 577 COMMON MISTAKE ConfusingStockholders’ Equity with RetainedEarnings 578Making the Balance Sheet Balance: Net NewFinancing 578Choosing a Forecast Target 58018.3 Forecasting a Planned Expansion 580KMS Designs’ Expansion: FinancingNeeds 581KMS Designs’ Expansion: Pro Forma IncomeStatement 582 COMMON MISTAKE Treating Forecastsas Fact 584Forecasting the Balance Sheet 58418.4 Growth and Firm Value 585Sustainable Growth Rate and ExternalFinancing 58618.5 Valuing the Expansion 589Forecasting Free Cash Flows 589 COMMON MISTAKE Confusing Totaland Incremental Net WorkingCapital 591KMS Designs’ Expansion: Effect on FirmValue 591Optimal Timing and the Option to Delay 594Summary 595 Critical Thinking 596 Problems 596CHAPTER 18 APPENDIX The Balance Sheetand Statement of Cash Flows 600CHAPTER 19Working CapitalManagement 60319.1 Overview of Working Capital 604The Cash Cycle 604Working Capital Needs by Industry 606Firm Value and Working Capital 6071/22/20 9:41 PM

xivDetailed Contents19.2 Trade Credit 608Trade Credit Terms609Trade Credit and Market Frictions 609 COMMON MISTAKE Using APR Instead of EARto C ompute the Cost of Trade Credit 610Managing Float 61119.3 Receivables Management 612Determining the Credit Policy 612 The 5 C’s of Credit 612Monitoring Accounts Receivable 61419.4 Payables Management 616Determining Accounts Payable DaysOutstanding 616Stretching Accounts Payable 61719.5 Inventory Management 618Benefits of Holding Inventory 618Costs of Holding Inventory 619 Inventory Management Adds to the BottomLine at Gap 61919.6 Cash Management 620Motivation for Holding Cash 620Alternative Investments 620 Hoarding Cash 622Summary 622 Critical Thinking 624 Problems 624 Data Case   627CHAPTER 20Short-Term FinancialPlanning 62920.1 Forecasting Short-Term Financing Needs 630Application: Springfield Snowboards, Inc. 630Negative Cash Flow Shocks 630Positive Cash Flow Shocks 631Seasonalities 631The Cash Budget 63320.2 The Matching Principle 635Permanent Working Capital 635Temporary Working Capital 635Permanent Versus Temporary WorkingCapital 635Financing Policy Choices 63620.3 Short-Term Financing with Bank Loans 638Single, End-of-Period Payment Loan 638Line of Credit 638Bridge Loan 639Common Loan Stipulations and Fees 63920.4 Short-Term Financing with CommercialPaper 641 Short-Term Financing and the Financial Crisisof the Fall of 2008 64120.5 Short-Term Financing with SecuredFinancing 643Accounts Receivable as Collateral 643A01 BERK1597 05 SE FM.indd 14 A Seventeenth-Century FinancingSolution 643Inventory as Collateral 644 Loan Guarantees: The Ex-Im BankControversy 64420.6 Putting It All Together: Creating a Short-TermFinancial Plan 646Summary 647 Critical Thinking 648 Problems 649PART 7 INTEGRATIVE CASEPART 8CHAPTER 21Special Topics653659Option Applications andCorporate Finance 66121.1 Option Basics 662Option Contracts 662Stock Option Quotations 663Options on Other Financial Securities 665 Options Are for More Than Just Stocks 66521.2 Option Payoffs at Expiration 665The Long Position in an Option Contract 666The Short Position in an Option Contract 667Profits for Holding an Option to Expiration 669Returns for Holding an Option to Expiration 67121.3 Factors Affecting Option Prices 672Strike Price and Stock Price 672Option Prices and the Exercise Date 672Option Prices and the Risk-Free Rate 673Option Prices and Volatility 67321.4 The Black-Scholes Option PricingFormula 67421.5 Put-Call Parity 675Portfolio Insurance 67621.6 Options and Corporate Finance 679Summary 681 Critical Thinking 682 Problems 682 Data Case 684CHAPTER 22Mergers and Acquisitions22.1 Background and Historical TrendsMerger Waves 689Types of Mergers 69022.2 Market Reaction to a Takeover68768869022.3 Reasons to Acquire 691Economies of Scale and Scope 691Vertical Integration 692Expertise 692Monopoly Gains 692Efficiency Gains 693Tax Savings from Operating Losses 6931/22/20 9:41 PM

Detailed ContentsDiversification 694Earnings Growth 695Managerial Motives to Merge 696Hedging with Forward Contracts 724Cash-and-Carry and the Pricing of CurrencyForwards 726Hedging Exchange Rate Risk withOptions 72822.4 The Takeover Process 697Valuation 697The Offer 698Merger “Arbitrage” 700Tax and Accounting Issues 701Board and Shareholder Approval 70223.3 Internationally Integrated Capital Markets 730 COMMON MISTAKE Forgetting to Flip theExchange Rate 73223.4 Valuation of Foreign Currency Cash Flows 732Application: Ityesi,

Fundamentals of Corporate Finance FIFTH EDITION Jonathan Berk STANFORD UNIVERSITY Peter DeMarzo . and Pearson Education, Inc., or its affiliates, authors, licensees, or distributors. . CHAPTER 19 Working Capital Management 603 CHAPTER 20 Short-Term Financial Planning 629

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