Fundamentals of Corporate Finance

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1 GlobAl edition Fundamentals of Corporate Finance ThIrd edition Jonathan Berk Peter DeMarzo Jarrad Harford

Use the Financial Calculator to solve math problems right in MyFinanceLab!

flow, net present value, and internal rate of return.

Tutorials include lessons on calculator functions such as IRR and bond valuation.

Each problem has algorithmically generated values and allows students to solve the problem as they would in Excel.

2 Use the Financial Calculator to solve math problems right in MyFinanceLab! The Financial Calculator is available as a smartphone application as well as on a computer and includes important functions such as cash flow, net present value, and internal rate of return. Fifteen helpful tutorials show instructors and students the many ways to use the Financial Calculator in MyFinanceLab. Tutorials include lessons on calculator functions such as IRR and bond valuation. Select end-of-chapter problems are now available in MyFinanceLab as simulated Excel problems. Each problem has algorithmically generated values and allows students to solve the problem as they would in Excel. Each problem is autograded and has both Excel and problem-specific Learning Aids. Pearson etext in MyFinanceLab incorporates author solution videos of every in-text example, spreadsheets, animations, and other tools into easy-to-navigate chapters. Did your textbook come with a MyFinanceLab Student Access Kit? If so, go to to register using the code. If not, you can purchase access to MyFinanceLab online at

3 Fundamentals of Corporate Finance, Global Edition Table of Contents Cover IFC Title Copyright Contents PART 1 Introduction CHAPTER 1 Corporate Finance and the Financial Manager 1.1 Why Study Finance? 1.2 The Types of Firms Sole Proprietorships Partnerships Limited Liability Companies Features of Corporations Tax Implications for Corporate Entities Corporate Taxation Around the World 1.3 The Financial Manager Making Investment Decisions The Dodd-Frank Act Making Financing Decisions Cash for Treasury Management The Goal of the Firm Shareholder Value Versus Stakeholder Value 1.4 The Financial Managers Place in the Corporation The Corporate Management Team Ethics and Incentives Within Corporations The Dodd-Frank Act on Corporate Compensation and Governance Citizens United v. Federal Election Commission 1.5 The Stock Market The Largest Stock Markets Primary and Secondary Markets NYSE INTERVIEW WITH Jean-François Théodore Over-the-Counter Stock Markets Listing Standards Other Financial Markets SE, AMEX, DJIA, S&P 500: Awash in Acronyms 1.6 Financial Institutions The Financial Cycle Types of Financial Institutions Role of Financial Institutions

4 CHAPTER 2 Introduction to Financial Statement Analysis 2.1 Firms Disclosure of Financial Information Preparation of Financial Statements International Financial Reporting Standards INTERVIEW WITH Sue Frieden Types of Financial Statements 2.2 The Balance Sheet or Statement of Financial Position Assets Liabilities Shareholders Equity Market Value Versus Book Value Market-to-Book Ratio Enterprise Value 2.3 The Income Statement Earnings Calculations EBITDA 2.4 The Statement of Cash Flows Operating Activity Investment Activity Financing Activity 2.5 Other Financial Statement Information Statement of Changes in Shareholders Equity Management Discussion and Analysis Notes to the Financial Statements 2.6 Financial Statement Analysis Profitability Ratios Liquidity Ratios Asset Efficiency Working Capital Ratios Interest Coverage Ratios Leverage (Gearing) Ratios Valuation Ratios COMMON MISTAKE Mismatched Ratios Investment Returns The DuPont Identity 2.7 Financial Reporting in Practice Enron The Sarbanes-Oxley Act Dodd-Frank Act Global Financial Crisis Bernard Madoffs Ponzi Scheme The Financial Statements: A Useful Starting Point PART 2 Interest Rates and Valuing Cash Flows

5 CHAPTER 3 Time Value of Money: An Introduction 3.1 Cost-Benefit Analysis Role of the Financial Manager Quantifying Costs and Benefits 3.2 Market Prices and the Valuation Principle The Valuation Principle Why There Can Be Only One Competitive Price for a Good Your Personal Financial Decisions 3.3 The Time Value of Money and Interest Rates The Time Value of Money The Interest Rate: Converting Cash Across Time Timelines 3.4 Valuing Cash Flows at Different Points in Time Rule 1: Comparing and Combining Values COMMON MISTAKE Summing Cash Flows Across Time Rule 2: Compounding Rule of 72 Rule 3: Discounting Using a Financial Calculator CHAPTER 4 Time Value of Money: Valuing Cash Flow Streams 4.1 Valuing a Stream of Cash Flows Applying the Rules of Valuing Cash Flows to a Cash Flow Stream Using a Financial Calculator: Solving for Present and Future Values of Cash Flow Streams 4.2 Perpetuities Perpetuities Historical Examples of Perpetuities COMMON MISTAKE Discounting One Too Many Times 4.3 Annuities Present Value of an Annuity Future Value of an Annuity 4.4 Growing Cash Flows Growing Perpetuity Growing Annuity 4.5 Solving for Variables Other Than Present Value or Future Value Solving for the Cash Flows Rate of Return Solving for the Number of Periods 4.6 Non-Annual Cash Flows Summing It Up

6 Chapter 4 Appendix Using a Financial Calculator CHAPTER 5 Interest Rates 5.1 Interest Rate Quotes and Adjustments The Effective Annual Rate Adjusting the Discount Rate to Different Time Periods Annual Percentage Rates COMMON MISTAKE Using the EAR in the Annuity Formula 5.2 Application: Discount Rates and Loans Computing Loan Payments GLOBAL FINANCIAL CRISIS Teaser Rates and Subprime Loans Computing the Outstanding Loan Balance 5.3 The Determinants of Interest Rates Inflation and Real Versus Nominal Rates Investment and Interest Rate Policy How Is Inflation Actually Calculated? The Yield Curve and Discount Rates INTERVIEW WITH Kevin M. Warsh COMMON MISTAKE Using the Annuity Formula When Discount Rates Vary The Yield Curve and the Economy 5.4 The Opportunity Cost of Capital Interest Rates, Discount Rates, and the Cost of Capital CHAPTER 6 Bonds 6.1 Bond Terminology 6.2 Zero-Coupon Bonds Zero-Coupon Bond Cash Flows Yield to Maturity of a Zero-Coupon Bond GLOBAL FINANCIAL CRISIS Pure Discount Bonds Trading at a Premium Risk-Free Interest Rates 6.3 Coupon Bonds Coupon Bond Cash Flows The U.S. Treasury Market Yield to Maturity of a Coupon Bond Finding Bond Prices on the Web Coupon Bond Price Quotes 6.4 Why Bond Prices Change Interest Rate Changes and Bond Prices Time and Bond Prices Interest Rate Risk and Bond Prices Clean and Dirty Prices for Coupon Bonds Bond Prices in Practice 6.5 Corporate Bonds

7 Credit Risk Are Treasuries Really Default-Free Securities? INTERVIEW WITH Lisa Black Corporate Bond Yields Bond Ratings Corporate Yield Curves The Credit Crisis and Bond Yields Chapter 6 Appendix A Solving for the Yield to Maturity of a Bond Using a Financial Calculator Chapter 6 Appendix B The Yield Curve and the Law of One Price CHAPTER 7 Stock Valuation 7.1 Stock Basics Stock Market Reporting: Stock Quotes Common Stock Preferred Stock 7.2 The Mechanics of Stock Trades 7.3 The Dividend-Discount Model A One-Year Investor Dividend Yields, Capital Gains, and Total Returns A Multiyear Investor Dividend-Discount Model Equation 7.4 Estimating Dividends in the Dividend-Discount Model Constant Dividend Growth Dividends Versus Investment and Growth Changing Growth Rates COMMON MISTAKE Forgetting to Grow This Years Dividend Value Drivers and the Dividend-Discount Model 7.5 Limitations of the Dividend-Discount Model Uncertain Dividend Forecasts Non-Dividend-Paying Stocks 7.6 Share Repurchases and the Total Payout Model 7.7 Putting It All Together PART 2 INTEGRATIVE CASE PART 3 Valuation and the Firm CHAPTER 8 Investment Decision Rules 8.1 The NPV Decision Rule Net Present Value The NPV Decision Rule

8 8.2 Using the NPV Rule Organizing the Cash Flows and Computing the NPV The NPV Profile Measuring Sensitivity with IRR Alternative Rules Versus the NPV Rule 8.3 Alternative Decision Rules USING EXCEL Computing NPV and IRR The Payback Rule The Internal Rate of Return Rule COMMON MISTAKE IRR Versus the IRR Rule Modified Internal Rate of Return Why Do Rules Other Than the NPV Rule Persist? 8.4 Choosing Between Projects Differences in Scale INTERVIEW WITH Dick Grannis Timing of the Cash Flows 8.5 Evaluating Projects with Different Lives Important Considerations When Using the Equivalent Annual Annuity 8.6 Choosing Among Projects When Resources Are Limited Evaluating Projects with Different Resource Requirements 8.7 Putting It All Together CHAPTER 9 Fundamentals of Capital Budgeting 9.1 The Capital Budgeting Process 9.2 Forecasting Incremental Earnings Operating Expenses Versus Capital Expenditures Incremental Revenue and Cost Estimates Taxes Incremental Earnings Forecast 9.3 Determining Incremental Free Cash Flow Converting from Earnings to Free Cash Flow Calculating Free Cash Flow Directly Calculating the NPV USING EXCEL Capital Budgeting Using a Spreadsheet Program 9.4 Other Effects on Incremental Free Cash Flows Opportunity Costs COMMON MISTAKE The Opportunity Cost of an Idle Asset Project Externalities Sunk Costs COMMON MISTAKE The Sunk Cost Fallacy Adjusting Free Cash Flow Replacement Decisions 9.5 Analyzing the Project

9 Sensitivity Analysis Break-Even Analysis INTERVIEW WITH David Holland Scenario Analysis USING EXCEL Project Analysis Using Excel 9.6 Real Options in Capital Budgeting Option to Delay Option to Expand Option to Abandon CHAPTER 9 APPENDIX MACRS Depreciation CHAPTER 10 Stock Valuation: A Second Look 10.1 The Discounted Free Cash Flow Model Valuing the Enterprise Implementing the Model Connection to Capital Budgeting 10.2 Valuation Based on Comparable Firms Valuation Multiples Limitations of Multiples Comparison with Discounted Cash Flow Methods 10.3 Stock Valuation Techniques: The Final Word INTERVIEW WITH Marilyn Fedak 10.4 Information, Competition, and Stock Prices Information in Stock Prices Competition and Efficient Markets Forms of Market Efficiency Lessons for Investors and Corporate Managers The Efficient Markets Hypothesis Versus No Arbitrage 10.5 Individual Biases and Trading Excessive Trading and Over confidence Hanging On to Losers and the Disposition Effect Investor Attention, Mood, and Experience PART 3 INTEGRATIVE CASE PART 4 Risk and Return CHAPTER 11 Risk and Return in Capital Markets 11.1 A First Look at Risk and Return 11.2 Historical Risks and Returns of Stocks Computing Historical Returns

10 Average Annual Returns Arithmetic Average Returns Versus Compound Annual Returns The Variance and Volatility of Returns COMMON MISTAKE Mistakes When Computing Standard Deviation USING EXCEL Computing the Standard Deviation of Historical Returns The Normal Distribution 11.3 The Historical Tradeoff Between Risk and Return The Returns of Large Portfolios The Returns of Individual Stocks 11.4 Common Versus Independent Risk Theft Versus Earthquake Insurance: An Example Types of Risk 11.5 Diversification in Stock Portfolios Unsystematic Versus Systematic Risk Diversifiable Risk and the Risk Premium The Importance of Systematic Risk COMMON MISTAKE A Fallacy of Long-Run Diversification CHAPTER 12 Systematic Risk and the Equity Risk Premium 12.1 The Expected Return of a Portfolio Portfolio Weights Portfolio Returns Expected Portfolio Return 12.2 T he Volatility of a Portfolio Diversifying Risks Measuring Stocks Co-Movement: Correlation USING EXCEL Calculating the Correlation Between Two Sets of Returns Computing a Portfolios Variance and Standard Deviation The Volatility of a Large Portfolio Nobel Prize Harry Markowitz 12.3 Measuring Systematic Risk Role of the Market Portfolio Stock Market Indexes as the Market Portfolio Market Risk and Beta Index Funds COMMON MISTAKE Mixing Standard Deviation and Beta Estimating Beta from Historical Returns USING EXCEL Calculating a Stocks Beta 12.4 Putting It All Together: The Capital Asset Pricing Model The CAPM Equation Relating Risk to Expected Return Why Not Estimate Expected Returns Directly? Nobel Prize William Sharpe The Security Market Line

11 The CAPM and Portfolios of the Capital Asset Pricing Model The Big Picture CHAPTER 12 APPENDIX Alternative Models of Systematic Risk with the CAPM in Practice Multi-Factor Models Fama-French-Carhart Factor Specification CHAPTER 13 The Cost of Capital 13.1 A First Look at the Weighted Average Cost of Capital The Firms Capital Structure Opportunity Cost and the Overall Cost of Capital Weighted Averages and the Overall Cost of Capital Weighted Average Cost of Capital Calculations 13.2 The Firms Costs of Debt and Equity Capital Cost of Debt Capital COMMON MISTAKE Using the Coupon Rateas the Cost of Debt Cost of Preferred Stock Capital Cost of Common Stock Capital 13.3 A Second Look at the Weighted Average Cost of Capital WACC Equation Weighted Average Cost of Capital in Practice Methods in Practice 13.4 Using the WACC to Value a Project Key Assumptions WACC Method Application: Extending the Life of a DuPont Facility of the WACC Method 13.5 Project-Based Costs of Capital Cost of Capital for a New Acquisition Divisional Costs of Capital INTERVIEW WITH Shelagh Glaser 13.6 When Raising External Capital Is Costly PART 4 INTEGRATIVE CASE PART 5 Long-Term Financing CHAPTER 14 Raising Equity Capital 14.1 Equity Financing for Private Companies Sources of Funding Securities and Valuation Exiting an Investment in a Private Company

12 14.2 Taking Your Firm Public: The Initial Public Offering Advantages and Disadvantages of Going Public Primary and Secondary IPO Offerings Other IPO Types Googles IPO 14.3 IPO Puzzles Underpriced IPOs Hot and Cold IPO Markets Global Financial Crisis : A Very Cold IPO Market High Cost of Issuing an IPO Poor Post-IPO Long-Run Stock Performance 14.4 Raising Additional Capital: The Seasoned Equity Offering SEO Process SEO Price Reaction SEO Costs CHAPTER 15 Debt Financing 15.1 Corporate Debt Private Debt Debt Financing at Hertz: Bank Loans Debt Financing at Hertz: Private Placements Public Debt Debt Financing at Hertz: Public Debt 15.2 Bond Covenants Types of Covenants Advantages of Covenants Application: Hertzs Covenants 15.3 Repayment Provisions Call Provisions New York City Calls Its Municipal Bonds Sinking Funds Convertible Provisions CHAPTER 15 APPENDIX Using a Financial Calculator to Calculate Yield to Call HP-10BII TI-BAII Plus Professional PART 5 INTEGRATIVE CASE PART 6 Capital Structure and Payout Policy CHAPTER 16 Capital Structure 16.1 Capital Structure Choices

13 Capital Structure Choices Across Industries Capital Structure Choices Within Industries 16.2 Capital Structure in Perfect Capital Markets Application: Financing a New Business Leverage and Firm Value The Effect of Leverage on Risk and Return Homemade Leverage Leverage and the Cost of Capital COMMON MISTAKE Capital Structure Fallacies GLOBAL FINANCIAL CRISIS Bank Capital Regulation and the ROE Fallacy MM and the Real World NOBEL PRIZE Franco Modigliani and Merton Miller 16.3 Debt and Taxes The Interest Tax Deduction and Firm Value Value of the Interest Tax Shield The Interest Tax Shield with Permanent Debt Leverage and the WACC with Taxes Debt and Taxes: The Bottom Line 16.4 The Costs of Bankruptcy and Financial Distress Direct Costs of Bankruptcy Bankruptcy Can Be Expensive Indirect Costs of Financial Distress 16.5 Optimal Capital Structure: The Tradeoff Theory Differences Across Firms Optimal Leverage 16.6 Additional Consequences of Leverage: Agency Costs and Information Agency Costs Airlines Use Financial Distress to Their Advantage GLOBAL FINANCIAL CRISIS Moral Hazard and Government Bailouts Financial Distress and Rolling the Dice,Literally Debt and Information 16.7 Capital Structure: Putting It All Together CHAPTER 16 APPENDIX The Bankruptcy Codel CHAPTER 17 Payout Policy 17.1 Cash Distributions to Shareholders Dividends Share Repurchases 17.2 Dividends Versus Share Repurchases in a Perfect Capital Market Alternative Policy 1: Pay a Dividend with Excess Cash Alternative Policy 2: Share Repurchase (No Dividend) COMMON MISTAKE Repurchases and the Supply of Shares Alternative Policy 3: High Dividend (Equity Issue) Modigliani-Miller and Dividend Policy Irrelevance

14 COMMON MISTAKE The Bird in the Hand Fallacy Dividend Policy with Perfect Capital Markets 17.3 The Tax Disadvantage of Dividends Taxes on Dividends and Capital Gains Optimal Dividend Policy with Taxes Tax Differences Across Investors 17.4 Payout Versus Retention of Cash Retaining Cash with Perfect Capital Markets Retaining Cash with Imperfect Capital Markets 17.5 Signaling with Payout Policy Dividend Smoothing Dividend Signaling Royal & SunAlliances Dividend Cut Signaling and Share Repurchases INTERVIEW WITH John Connors 17.6 Stock Dividends, Splits, and Spin-Offs Stock Dividends and Splits Berkshire Hathaways A and B Shares Spin-Offs 17.7 Advice for the Financial Manager PART 6 INTEGRATIVE CASE PART 7 Financial Planning and Forecasting CHAPTER 18 Financial Modeling and Pro Forma Analysis 18.1 Goals of Long-Term Financial Planning Identify Important Linkages Analyze the Impact of Potential Business Plans Plan for Future Funding Needs 18.2 Forecasting Financial Statements: The Percent of Sales Method Percent of Sales Method Pro Forma Income Statement Pro Forma Balance Sheet COMMON MISTAKE Confusing Stockholders Equity with Retained Earnings Making the Balance Sheet Balance: Net New Financing Choosing a Forecast Target 18.3 Forecasting a Planned Expansion KMS Designs Expansion: Financing Needs KMS Designs Expansion: Pro Forma Income Statement COMMON MISTAKE Treating Forecastsas Fact Forecasting the Balance Sheet 18.4 Growth and Firm Value Sustainable Growth Rate and External Financing

15 18.5 Valuing the Expansion Forecasting Free Cash Flows COMMON MISTAKE Confusing Total and Incremental Net Working Capital KMS Designs Expansion: Effect on Firm Value Optimal Timing and the Option to Delay CHAPTER 18 APPENDIX The Balance Sheet and Statement of Cash Flows CHAPTER 19 Working Capital Management 19.1 Overview of Working Capital The Cash Cycle Working Capital Needs by Industry Firm Value and Working Capital 19.2 Trade Credit Trade Credit Terms Trade Credit and Market Frictions COMMON MISTAKE Using APR Instead of EAR to Compute the Cost of Trade Credit Managing Float 19.3 Receivables Management Determining the Credit Policy The 5 Cs of Credit Monitoring Accounts Receivable 19.4 Payables Management Determining Accounts Payable Days Outstanding Stretching Accounts Payable 19.5 Inventory Management Benefits of Holding Inventory Costs of Holding Inventory Inventory Management Adds to the Bottom Line at Gap 19.6 Cash Management Motivation for Holding Cash Alternative Investments Cash Balances CHAPTER 20 Short-Term Financial Planning 20.1 Forecasting Short-Term Financing Needs Application: Springfield Snowboards, Inc. Negative Cash Flow Shocks Positive Cash Flow Shocks Seasonalities The Cash Budget 20.2 The Matching Principle

16 Permanent Working Capital Temporary Working Capital Permanent Versus Temporary Working Capital Financing Policy Choices 20.3 Short-Term Financing with Bank Loans Single, End-of-Period Payment Loan Line of Credit Bridge Loan Common Loan Stipulations and Fees 20.4 Short-Term Financing with Commercial Paper Short-Term Financing and the Financial Crisis of the Fall of Short-Term Financing with Secured Financing Accounts Receivable as Collateral A Seventeenth-Century Financing Solution Inventory as Collateral 20.6 Putting It All Together: Creating a Short-Term Financial Plan PART 7 INTEGRATIVE CASE PART 8 Special Topics CHAPTER 21 Option Applications and Corporate Finance 21.1 Option Basics Option Contracts Stock Option Quotations Options on Other Financial Securities Options Are for More Than Just Stocks 21.2 Option Payoffs at Expiration The Long Position in an Option Contract The Short Position in an Option Contract Profits for Holding an Option to Expiration Returns for Holding an Option to Expiration 21.3 Factors Affecting Option Prices Strike Price and Stock Price Option Prices and the Exercise Date Option Prices and the Risk-Free Rate Option Prices and Volatility 21.4 The Black-Scholes Option Pricing Formula 21.5 Put-Call Parity Portfolio Insurance 21.6 Options and Corporate Finance

17 CHAPTER 22 Mergers and Acquisitions 22.1 Background and Historical Trends Merger Waves Types of Mergers 22.2 Market Reaction to a Takeover 22.3 Reasons to Acquire Economies of Scale and Scope Vertical Integration Expertise Monopoly Gains Efficiency Gains Tax Savings from Operating Losses Diversification Earnings Growth Managerial Motives to Merge 22.4 The Takeover Process Valuation The Offer Merger Arbitrage Tax and Accounting Issues Board and Shareholder Approval 22.5 Takeover Defenses Poison Pills Staggered Boards White Knights Golden Parachutes Recapitalization Other Defensive Strategies Regulatory Approval Weyerhaeusers Hostile Bid for Willamette Industries 22.6 Who Gets the Value Added from a Takeover? The Free Rider Problem Toeholds The Leveraged Buyout The Leveraged Buyout of RJR-Nabisco by KKR The Freezeout Merger Competition CHAPTER 23 International Corporate Finance 23.1 Foreign Exchange The Foreign Exchange Market Exchange Rates 23.2 Exchange Rate Risk Exchange Rate Fluctuations

18 Index Numbers A B C D E F G H I J K L M N O P Q Hedging with Forward Contracts Cash-and-Carry and the Pricing of Currency Forwards Hedging Exchange Rate Risk with Options 23.3 Internationally Integrated Capital Markets COMMON MISTAKE Forgetting to Flip the Exchange Rate 23.4 Valuation of Foreign Currency Cash Flows Application: Ityesi, Inc. The Law of One Price as a Robustness Check 23.5 Valuation and International Taxation A Single Foreign Project with Immediate Repatriation of Earnings Multiple Foreign Projects and Deferral of Earnings Repatriation 23.6 Internationally Segmented Capital Differential Access to Markets Macro-Level Distortions Implications of Internationally Segmented Capital Markets 23.7 Capital Budgeting with Exchange Rate Risk Application: Ityesi, Inc. Conclusion

19 R S T U V W Y Z

CORPORATE FINANCE: THE CORE

CORPORATE FINANCE: THE CORE JONATHAN' BERK UNIVERSITY OF CALIFORNIA, BERKHI.EY PETER DEMARZO STANFORD UNIVE RSITY Boston San Francisco New York London Toronto Sydney Tokyo Singapore Madrid Mexico City