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FUNDAMENTALS OF CORPORATE FINANCE - GBV

INTRODUCTION TO CORPORATE FINANCE 1 1 1 Corporate Finance and the Financial

Corporate Finance

Ross, Westerfield, and Jordan Fundamentals of Corporate Finance Ninth Edition

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Selected material from

Fundamentals of Corporate Finance

Third Edition

Richard A. Brealey

Bank of England and London Business School

Stewart C. Myers

Sloan School of Management

Massachusetts Institute of Technology

Alan J. Marcus

Wallace E. Carroll School of Management

Boston College

with additional material from Fundamentals of Corporate Finance,Alternate Fifth Edition

Essentials of Corporate Finance, Second Edition

Stephen A. Ross,

Massachusetts Institute of Technology

Randolph W. Westerfield,University of Southern California

Bradford D. Jordan, University of Kentucky

UNIVERSITY OF PHOENIX

Boston Burr Ridge, IL Dubuque, IA Madison, WI New York San Francisco St. Louis Bangkok Bogotá Caracas Lisbon London Madrid Mexico City Milan New Delhi Seoul Singapore Sydney Taipei Toronto

Selected material from

FUNDAMENTALS OF CORPORATE FINANCE, Third Edition

with additional material from FUNDAMENTALS OF CORPORATE FINANCE, Alternate Fifth Edition

ESSENTIALS OF CORPORATE FINANCE, Second Edition

cept as permitted under the United States Copyright Act of 1976, no part of this publication may be reproduced or distrib-

uted in any form or by any means, or stored in a data base retrieval system, without prior written permission of the pub-

lisher.

This book contains select material from:

Fundamentals of Corporate Finance, Third Edition by Richard A. Brealey, Stewart C. Myers, and Alan J. Marcus. Copyright

Fundamentals of Corporate Finance, Alternate Fifth Edition by Stephen A. Ross, Randolph W. Westerfield, and Bradford D.

Essentials of Corporate Finance, Second Edition by Stephen A. Ross, Randolph W. Westerfield, and Bradford D. Jordan.

Higher Education Group, Inc. company.

All reprinted with permission of the publisher.

ISBN 0-07-553109-7

Sponsoring Editor: Christian Perlee

Production Editor: Nina Meyer

iii

SECTION 11 How to Value Perpetuities 50

How to Value Annuities 51

Annuities Due 54

Future Value of an Annuity 57

Inflation and the Time Value of Money 61

Real versus Nominal Cash Flows 61

Inflation and Interest Rates 63

Valuing Real Cash Payments 65

Real or Nominal? 67

Effective Annual Interest Rates 67

Summary 69

Key Terms 70

Quiz 70

Practice Problems 72

Challenge Problems 75

Solutions to Self-Test Questions 77

Minicase 79

Financial Planning 81

What Is Financial Planning? 82

Financial Planning Focuses on the Big Picture 83

Financial Planning Is Not Just Forecasting 84

Three Requirements for Effective Planning 84

Financial Planning Models 86

Components of a Financial Planning Model 87

An Example of a Planning Model 88

An Improved Model 89

Planners Beware 93

Pitfalls in Model Design 93

The Assumption in Percentage of Sales Models 94

The Role of Financial Planning Models 95

External Financing and Growth 96

Summary 100

Key Terms 101

Quiz 101

Practice Problems 102

Challenge Problems 106

Solutions to Self-Test Questions 106

The Firm and the Financial

Manager 3

Organizing a Business 4

Sole Proprietorships 4

Partnerships 5

Corporations 5

Hybrid Forms of Business Organization 6

The Role of the Financial Manager 7

The Capital Budgeting Decision 8

The Financing Decision 9

Financial Institutions and Markets 10

Financial Institutions 10

Financial Markets 11

Other Functions of Financial Markets and

Institutions 12

Who Is the Financial Manager? 13

Careers in Finance 15

Goals of the Corporation 17

Shareholders Want Managers to Maximize

Market Value 17

Ethics and Management Objectives 19

Do Managers Really Maximize Firm Value? 21

Snippets of History 25

Summary 25

Key Terms 28

Quiz 28

Practice Problems 29

Solutions to Self-Test Questions 31

The Time Value of Money 33

Future Values and Compound Interest 34

Present Values 38

Finding the Interest Rate 44

Multiple Cash Flows 46

Future Value of Multiple Cash Flows 46

Present Value of Multiple Cash Flows 49

Level Cash Flows: Perpetuities and Annuities 50

Financial Statement Analysis 133

Financial Ratios 134

Leverage Ratios 138

Liquidity Ratios 139

Efficiency Ratios 141

Profitability Ratios 143

The Du Pont System 145

Other Financial Ratios 146

Using Financial Ratios 147

Choosing a Benchmark 147

Measuring Company Performance 150

The Role of Financial Ratios 151

Summary 153

Key Terms 155

Quiz 155

Practice Problems 157

Challenge Problem 158

Solutions to Self-Test Questions 159

Minicase 160

IV CONTENTS

Accounting and Finance 111

The Balance Sheet 112

Book Values and Market Values 115

The Income Statement 117

Profits versus Cash Flow 118

The Statement of Cash Flows 119

Accounting for Differences 121

Taxes 123

Corporate Tax 123

Personal Tax 125

Summary 126

Key Terms 127

Quiz 127

Practice Problems 128

Challenge Problem 131

Solutions to Self-Test Questions 131

APPENDIX A109

SECTION 2163

Working Capital Management and

Short-Term Planning 165

Working Capital 167

The Components of Working Capital 167

Working Capital and the Cash Conversion Cycle 168

The Working Capital Trade-Off 171

Links between Long-Term and Short-Term

Financing 172

Tracing Changes in Cash and Working Capital 175

Cash Budgeting 177

Forecast Sources of Cash 177

Forecast Uses of Cash 179

The Cash Balance 179

A Short-Term Financing Plan 180

Options for Short-Term Financing 180

Evaluating the Plan 184

Sources of Short-Term Financing 185

Bank Loans 185

Commercial Paper 186

Secured Loans 186

The Cost of Bank Loans 187

Simple Interest 187

Discount Interest 188

Interest with Compensating Balances 189

Summary 190

Key Terms 191

Quiz 191

Practice Problems 192

Challenge Problem 194

Solutions to Self-Test Questions 195

Minicase 197

Cash and Inventory Management 201

Cash Collection, Disbursement, and Float 202

Float 203

Valuing Float 204

CONTENTS V

Managing Float 205

Speeding Up Collections 206

Controlling Disbursements 209

Electronic Funds Transfer 210

Inventories and Cash Balances 211

Managing Inventories 212

Managing Inventories of Cash 215

Uncertain Cash Flows 216

Cash Management in the Largest Corporations 217

Investing Idle Cash: The Money Market 218

Summary 219

Key Terms 220

Quiz 220

Practice Problems 221

Challenge Problem 224

Solutions to Self-Test Questions 224

Credit Management and Collection 227

Terms of Sale 229

Credit Agreements 231Credit Analysis 232

Financial Ratio Analysis 233

Numerical Credit Scoring 233

When to Stop Looking for Clues 234

The Credit Decision 236

Credit Decisions with Repeat Orders237

Some General Principles

238

Collection Policy 239

Bankruptcy 240

Bankruptcy Procedures241

The Choice between Liquidation and

Reorganization

242

Summary 244

Key Terms

245
Quiz 245

Practice Problems

246

Challenge Problems

248

Solutions to Self-Test Questions

249

Minicase 250

Valuing Bonds 255

Bond Characteristics 256

Reading the Financial Pages 257

Bond Prices and Yields259

How Bond Prices Vary with Interest Rates 260

Yield to Maturity versus Current Yield 261

Rate of Return 265

Interest Rate Risk 267

The Yield Curve 268

Nominal and Real Rates of Interest 268

Default Risk 270

Valuations in Corporate Bonds 273

Summary273

Key Terms 274

Quiz 274

Practice Problems 275

Challenge Problems 277

Solutions to Self-Test Questions 277

Valuing Stocks 279

Stocks and the Stock Market 280

Reading the Stock Market Listings 281

Book Values, Liquidation Values, and Market

Values 283

Valuing Common Stocks 287

Today's Price and Tomorrow's Price 287

The Dividend Discount Model 288

Simplifying the Dividend Discount Model 291

The Dividend Discount Model with No Growth 291

The Constant-Growth Dividend Discount Model 292

Estimating Expected Rates of Return 293

Nonconstant Growth 295

Growth Stocks and Income Stocks 296

The Price-Earnings Ratio 298

What Do Earnings Mean? 298

Valuing Entire Businesses 301

Summary 301

Key Terms 302

Quiz 302

Practice Problems 303

Challenge Problems 306

Solutions to Self-Test Questions 307

SECTION 3253

VI CONTENTS

Introduction to Risk, Return, and the

Opportunity Cost of Capital 311

Rates of Return: A Review 312

Seventy-Three Years of Capital Market

History 313

Market Indexes 314

The Historical Record 314

Using Historical Evidence to Estimate Today's Cost of

Capital 317

Measuring Risk 318

Variance and Standard Deviation 318

A Note on Calculating Variance 322

Measuring the Variation in Stock Returns 322

Risk and Diversification 324

Diversification 324

Asset versus Portfolio Risk 325

Market Risk versus Unique Risk 330

Thinking about Risk 331

Message 1: Some Risks Look Big and Dangerous but

Really Are Diversifiable 331

Message 2: Market Risks Are Macro Risks 332

Message 3: Risk Can Be Measured 333

Summary 334

Key Terms 334

Quiz 335

Practice Problems 336

Solutions to Self-Test Questions 338

SECTION 4339

Net Present Value and Other Investment

Criteria 341

Net Present Value 343

A Comment on Risk and Present Value 344

Valuing Long-Lived Projects 345

Other Investment Criteria 349

Internal Rate of Return 349

A Closer Look at the Rate of Return Rule 350

Calculating the Rate of Return for Long-Lived

Projects 351

A Word of Caution 352

Payback 352

Book Rate of Return 355

Investment Criteria When Projects Interact 356

Mutually Exclusive Projects 356

Investment Timing 357

Long- versus Short-Lived Equipment 359

Replacing an Old Machine 361

Mutually Exclusive Projects and the IRR Rule 361

Other Pitfalls of the IRR Rule 363

Capital Rationing 365

Soft Rationing 365

Hard Rationing 366

Pitfalls of the Profitability Index 3667

Summary 367

Key Terms 368

Quiz 368

Practice Problems 369Challenge Problems 373

Solutions to Self-Test Questions 373

Using Discounted Cash-Flow Analysis to

Make Investment Decisions 377

Discount Cash Flows, Not Profits 379

DiscountIncrementalCash Flows 381

Include All Indirect Effects 381

Forget Sunk Costs 382

Include Opportunity Costs 382

Recognize the Investment in Working Capital 383

Beware of Allocated Overhead Costs 384

Discount Nominal Cash Flows by the Nominal Cost

of Capital 385

Separate Investment and Financing Decisions 386

Calculating Cash Flow 387

Capital Investment 387

Investment in Working Capital 387

Cash Flow from Operations 388

Example: Blooper Industries 390

Calculating Blooper's Project Cash Flows 391

Calculating the NPV of Blooper's Project 392

Further Notes and Wrinkles Arising from Blooper's

Project 393

Summary 397

Key Terms 398

Quiz 398

CONTENTS VII

Practice Problems 200

Challenge Problems 402

Solutions to Spreadsheet Model Questions 403

Solutions to Self-Test Questions 404

Minicase 405

Risk, Return, and Capital Budgeting 407

Measuring Market Risk 408

Measuring Beta 409

Betas for MCI WorldCom and Exxon 411

Portfolio Betas 412

Risk and Return 414

Why the CAPM Works 416

The Security Market Line 417

How Well Does the CAPM Work? 419

Using the CAPM to Estimate Expected Returns 420

Capital Budgeting and Project Risk 422

Company versus Project Risk 422

Determinants of Project Risk 423

Don't Add Fudge Factors to Discount Rates 424

Summary 425

Key Terms 426

Quiz 426

Practice Problems 427

Challenge Problem 432

Solutions to Self-Test Questions 432

The Cost of Capital 435

Geothermal's Cost of Capital 436

Calculating the Weighted-Average Cost of

Capital 438

Calculating Company Cost of Capital as a Weighted

Average 440

Market versus Book Weights 441

Taxes and the Weighted-Average Cost of Capital 442

What If There Are Three (or More) Sources of

Financing? 443

Wrapping Up Geothermal 444

Checking Our Logic 445

Measuring Capital Structure 446

Calculating Required Rates of Return 447

The Expected Return on Bonds 448

The Expected Return on Common Stock 448

The Expected Return on Preferred Stock 449

Big Oil's Weighted-Average Cost of Capital 450

Real Oil Company WACCs 450

Interpreting the Weighted-Average Cost of

Capital 451

When You Can and Can't Use WACC 451

Some Common Mistakes 452

How Changing Capital Structure Affects Expected

Returns 452

What Happens When the Corporate Tax Rate Is Not

Zero 453

Flotation Costs and the Cost of Capital 454

Summary 454

Key Terms 455

Quiz 455

Practice Problems 456

Challenge Problems 458

Solutions to Self-Test Questions 458

Minicase 459

SECTION 5463

Project Analysis 465

How Firms Organize the Investment Process 466

Stage 1: The Capital Budget 467

Stage 2: Project Authorizations 467

Problems and Some Solutions 468

Some "What-If" Questions 469

Sensitivity Analysis 469

Scenario Analysis 472

Break-Even Analysis 473

Accounting Break-Even Analysis 474NPV Break-Even Analysis 475

Operating Leverage 478

Flexibility in Capital Budgeting 481

Decision Trees 481

The Option to Expand 482

Abandonment Options 483

Flexible Production Facilities 484

Investment Timing Options 484

Summary485

Key Terms 485

VIII CONTENTS

Quiz 485

Practice Problems 486

Challenge Problems 489

Solutions to Self-Test Questions 489

Minicase 491

An Overview of Corporate

Financing 493

Common Stock 494

Book Value versus Market Value 496

Dividends 497

Stockholders'Rights 497

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