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CORPORATE FINANCE

An Introduction

The Prentice Hall Series in Finance

Alexander/Sharpe/Bailey

Fundamentals of Investments

Bear/Moldonado-Bear

Free Markets, Finance, Ethics, and

Law

Berk/DeMarzo

Corporate Finance*

Berk/DeMarzo

Corporate Finance: The Core*

Berk/DeMarzo/Harford

Fundamentals of Corporate

Finance*

Bierman/Smidt

The Capital Budgeting Decision:

Economic Analysis of Investment

Projects

Bodie/Merton/Cleeton

Financial Economics

Click/Coval

The Theory and Practice

of International Financial

Management

Copeland/Weston/Shastri

Financial Theory and Corporate

Policy

Cox/Rubinstein

Options Markets

Dorfman

Introduction to Risk Management

and Insurance

Dietrich

Financial Services and Financial

Institutions: Value Creation in

Theory and Practice

Dufey/Giddy

Cases in International Finance

Eakins

Finance in .learn

Eiteman/Stonehill/Moffett

Multinational Business Finance

Emery/Finnerty/Stowe

Corporate Financial Management

Fabozzi

Bond Markets: Analysis and

Strategies

Fabozzi/Modigliani

Capital Markets: Institutions and

Instruments

* denotes titles Log ontowww.myÞnancelab.comto learn moreFabozzi/Modigliani/Jones/Ferri

Foundations of Financial Markets

and Institutions

Finkler

Financial Management for

Public, Health, and Not-for-ProÞt

Organizations

Francis/Ibbotson

Investments: A Global Perspective

Fraser/Ormiston

Understanding Financial

Statements

Geisst

Investment Banking in the

Financial System

Gitman

Principles of Managerial Finance*

Gitman

Principles of Managerial

FinanceÑBrief Edition*

Gitman/Joehnk

Fundamentals of Investing*

Gitman/Madura

Introduction to Finance

Guthrie/Lemon

Mathematics of Interest Rates and

Finance

Haugen

The InefÞcient Stock Market:

What Pays Off and Why

Haugen

Modern Investment Theory

Haugen

The New Finance: Overreaction,

Complexity, and Uniqueness

Holden

Excel Modeling and Estimation

in the Fundamentals of Corporate

Finance

Holden

Excel Modeling and Estimation in

the Fundamentals of Investments

Holden

Excel Modeling and Estimation in

Investments

Holden

Excel Modeling and Estimation in

Corporate Finance

Hughes/MacDonald

International Banking: Text and

CasesHull

Fundamentals of Futures and

Options Markets

Hull

Options, Futures, and Other

Derivatives

Hull

Risk Management and Financial

Institutions

Keown/Martin/Petty/Scott

Financial Management: Principles

and Applications

Keown/Martin/Petty/Scott

Foundations of Finance: The

Logic and Practice of Financial

Management

Keown

Personal Finance: Turning Money

into Wealth

Kim/Nofsinger

Corporate Governance

Levy/Post

Investments

May/May/Andrew

Effective Writing: A Handbook for

Finance People

Madura

Personal Finance

Marthinsen

Risk Takers: Uses and Abuses of

Financial Derivatives

McDonald

Derivatives Markets

McDonald

Fundamentals of Derivatives

Markets

Megginson

Corporate Finance Theory

Melvin

International Money and Finance

Mishkin/Eakins

FinancialMarketsandInstitutions

Moffett

Cases in International Finance

Moffett/Stonehill/Eiteman

Fundamentals of Multinational

Finance

Nofsinger

Psychology of InvestingOgden/Jen/OÕConnor

Advanced Corporate Finance

Pennacchi

Theory of Asset Pricing

Rejda

Principles of Risk Management

and Insurance

Schoenebeck

Interpreting and Analyzing

Financial Statements

Scott/Martin/Petty/Keown/

Thatcher

Cases in Finance

Seiler

Performing Financial Studies: A

Methodological Cookbook

Shapiro

Capital Budgeting and Investment

Analysis

Sharpe/Alexander/Bailey

Investments

Solnik/McLeavey

Global Investments

Stretcher/Michael

Cases in Financial Management

Titman/Martin

Valuation: The Art and Science of

Corporate Investment Decisions

Trivoli

Personal Portfolio Management:

Fundamentals and Strategies

Van Horne

Financial Management and Policy

Van Horne

Financial Market Rates and Flows

Van Horne/Wachowicz

Fundamentals of Financial

Management

Vaughn

Financial Planning for the

Entrepreneur

Welch

Corporate Finance:

An Introduction*

Weston/Mitchel/Mulherin

Takeovers, Restructuring, and

Corporate Governance

Winger/Frasca

Personal Finance

CORPORATE FINANCE

An Introduction

Ivo Welch

BROWNUNIVERSITY

PRENTICEHALL

New York Boston San Francisco

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Editor in Chief: Donna Battista

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Text and Cover Designer: Leslie Haimes

Production Coordination, Composition, and Art: Windfall Software, using ZzTEX Cover and Text Image: © La Fleur Studio/Images.com Copyright © 2009 Pearson Education, Inc. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the

publisher. Printed in the United States of America. For information on obtaining permission for use of

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Department, 501 Boylston Street, Suite 900, Boston, MA 02116, fax your request to 617-671-3447, or e-mail at http://www.pearsoned.com/legal/permissions.htm.

Many of the designations used by manufacturers and sellers to distinguish their products are claimed as

trademarks. Where those designations appear in this book, and the publisher was aware of a trademark claim, the designations have been printed in initial caps or all caps. Library of Congress Cataloging-in-Publication Data

Welch, Ivo.

Corporate Þnance : an introduction / Ivo Welch. p. cm.

Includes bibliographical references and index.

ISBN-13: 978-0-321-27799-2 (alk. paper)

ISBN-10: 0-321-27799-6 (alk. paper)

1. CorporationsÐFinance. I. Title.

HG4026.W434 2009

650.15Ñdc22

2008024981

12345678910ÑCRKÑ12 11 10 09 08

www.pearsonhighered.comISBN-10: 0-321-27799-6

ISBN-13: 978-0-321-27799-2

About the Author

a position he has held since 2004. He previously held the same appointment at UCLAÕs Anderson School of Management (from

1989 to 2000) and Yale UniversityÕs School of Management (from

Columbia University, and both his MBA (1989) and PhD (1991) in Þnance from the University of Chicago. His work has been featured in many academic journals, as well as the popular press. More information about the author can be found at the bookÕs Web site (www.prenhall.com/welch) and at the authorÕs personal website (http://welch.econ.brown.edu).

To my parents, Arthur and Charlotte Welch

and to my wife, Lily

Preface

M ost corporate Þnance textbooks cover a similar canon of concepts, and myThe author raises some thought-provoking questions beyond those found in most books of this genre.

ÑMarianne Plunkert

University of

Colorado, Denver

book is no exception. A quick glance at the table of contents will show you that mostÑthough not allÑof the topics inCorporate Finance: An Introductionoverlap with those in traditional Þnancetextbooksandsyllabi.Thatsaid, this book is intentionally different. Although I cover similar territory, I also introduce many innovations in approach and emphasis. I hope that once you have seen them, there will be no going back.

INNOVATIONS IN APPROACH

The underlying philosophy of this book is based on a belief that any talented student can understand Þnance. I believe that our concepts are no more difÞcult than those in standard texts covering the principles of economics and that our mathematics is no more difÞcult than that in high school. I believe that Þnance is easiest when explained from basic principles and only gradually ramped up in complexity. I also believe

I really like the

approach starting from an ideal, simple market to more realistic and complex market conditions... [this is] one of the best written and easiest to understand texts

Ihaveeverreadin

Þnance.

ÑKuo Tseng

California State

University, Fresno

that although it is important for students to learn how to solve traditional textbook problems, it is as important for them to learn how to think about and approach new problems that they will encounter in the real world.

A LOGICAL PROGRESSION

The book starts with simple scenarios in which all the inputs are clear and progresses to more complex, real-world scenarios for which the solutions become more difÞ- cult. Within this architecture, chapters buildorganically on concepts learned earlier. This incremental progression allows students to reuse what they have learned and to understand the effect of each new change in and of itself. One theme that binds the book together isthe progression from the perfect- market, law-of-one-price ideal world (on which most Þnance formulas are based) to an imperfect market (in which formulas may need adjustment, explicitly or implic- itly). The layout on pages xivÐxv showcases the building blocks of this approach.

NUMERICAL EXAMPLE LEADING TO FORMULA

I learn best by numerical example, and I believe that students do, too. WheneverI like this approach very much. This is, in fact, the optimal way to learn.

ÑRichard Fendler

Georgia State

University

I want to understand an idea, I try to construct numerical examples for myselfÑ the simpler, the better. Therefore, this book relies on simple numerical examples as its primary tutorial method. Instead of a ÒbirdÕs eyeÓ view of the formula Þrst and application second, students will start with a ÒwormÕs eyeÓ view and work their way upÑfrom simple numbers, to more complex examples, and Þnally to abstract formulas. Each step is easy. At Þrst glance, you may think this may be less ÒexecutiveÓ or perhaps not as well-suited to students with only a cursory interest in Þnance. I assure you that neither of these is the case. vi

PREFACEvii

Critical questions such as, ÒWhat would this project be worth?Ó are answered inWithout a doubt, this

is the greatest strength of the text.

ÑSharon Garrison

University of

Arizona

numerical step-by-step examples (printed in black), and right under the computa- tions are the corresponding symbolic formulas (printed in red). I believe that the pairing of numerics with formulas will ultimately help students understand the ma- terial on a higher level and with more ease. The layout on pages xviÑxvii provides a small sample of the Ònumbers ÞrstÓ approach that I use throughout the book.

Theuseof...simple

numerical examples throughout...to explain essential concepts and formulas is outstanding.

ÑEfÞ Benmelech

Harvard University

PROBLEM SOLVING

A corollary to the numbers-Þrst approach is my belief that formulaic memorization is a last resort. Such a rote approach leaves the house without a foundation. Instead of giving students canned formulas, I try to show them how to solve problems them- tools that will stand them in good stead in their future careers.

SELF-CONTAINED FOR CLARITY

Manystudentscomeintoclasswithapatchworkofbackgroundknowledge.AlongtheI think [the] approach of integrating necessary material is perfect. It helps remind students [about] what they need to know and should bolster their conÞdence.

ÑAngela Lavin

University of South

Dakota

keep this book self-contained. For example, all necessary statistical concepts are inte- grated in Chapter 8 (Investor Choice: Risk and Reward), and all necessary accounting concepts are explained in Chapter 13 (From Financial Statements to Economic Cash

Flows).

INNOVATIONS IN CONTENT AND PERSPECTIVE

This book also offers numerous topical and expositional innovations, of which the following is a limited selection. A STRONG DISTINCTION BETWEEN EXPECTED AND PROMISEDCASH FLOWS I clearly distinguish between the premium to compensate for default (credit risk)Ña concept introduced in Chapter 6 (Uncertainty, Default, and Risk)Ñand the risk pre- mium, which is introduced in Chapter 9 (The Capital Asset Pricing Model). Students should no longer make the mistake of thinking that they have taken care of credit risk when they discount a promised cash ßow with a CAPM expected rate of return.

ROBUSTNESS

Throughout, I describe what Þnance practitioners can know clearly and what theyMuch more honest than other introduc- tory books.

ÑAdam Gehr

DePaul University

can only guess at (with varying degrees of accuracy). In the application of a number of Þnancial tools, I point out which of the guessed uncertainties are likely to have important repercussions and which are minor in consequence. I also try to be honest about where our academic knowledge is solid and where it is shaky. viiiPREFACE

A SPOTLIGHT ON THE PITFALLS OF CAPITAL BUDGETING

A self-contained chapter (Chapter 12:Capital Budgeting Applications and Pitfalls)I really love the NPV

Checklist. This alone

makes the bookquotesdbs_dbs1.pdfusesText_1