International Financial Reporting Standards Edition. Stanford University. Stanford University. University of Washington

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1 ' J nternational Financial Reporting Standards Edition Stanford University Stanford University University of Washington PEARSON Prentice Hall Boston San Francisco New York London Toronto Sydney Tokyo Singapore Madrid Mexico City Munich Paris Cape Town Hong Kong Montreal

>*-,, H, 1Corporate Finance and the Financial Manager Z 6 NTERVEW WTH Leslie Tillquist, PA Consulting Group 3 1.1 Why Study Finance? 4 1.

2 >*-,, H, 1Corporate Finance and the Financial Manager Z 6 NTERVEW WTH Leslie Tillquist, PA Consulting Group Why Study Finance? The Four Types of Firms 5 Sole Proprietorships 5 Partnerships 6 Limited Liability Companies 6 Corporations 6 Tax mplications for Corporate Entities 8 Corporate Taxation around the World The Financial Manager 11 Making nvestment Decisions 11 Making Financing Decisions 11 Managing Short-Term Cash Needs 11 The Goal of the Financial Manager The Financial Manager's Place in the Corporation 12 The Corporate Management Team 13 Ethics and ncentives in Corporations 14 Shareholder Activism and Voting Rights The Stock Market 16 The Largest Stock Markets 16 NYSE 16 NASDAQ 17 $ NYSE, AMEX, DJA, S&P 500: Awash in Acronyms Summary 191 Problems 21 ntroduction to Financial Statement Analysis 23 NTERVEW WTH Hira Tolia, CBZ Valuation Group, LLC 24 Firms' Disclosure of Financial nformation 25 nternational Financial Reporting Standards 26 Preparation of Financial Statements 26 Types of Financial Statements The Balance Sheet 26 Assets 27 Liabilities 28 Stockholders'Equity Balance Sheet Analysis 30 Market-to-Book Ratio 30 Debt-Equity Ratio 30 Enterprise Value 31 Other Balance Sheet nformation The ncome Statement 33 Earnings Calculations ncome Statement Analysis 35 Profitability Ratios 35 Asset Efficiency 36 Working Capital Ratios 37 EBTDA 37 Leverage Ratios 37 nvestment Returns 38 The DuPont dentity 38 Valuation Ratios 40 COMMON MSTAKE: Mismatched Ratios The Statement of Cash Flows 43 Operating Activity 44 nvestment Activity 44 Financing Activity Other Financial Statement nformation 46 Management Discussion and Analysis 46 Statement of Stockholders' Equity 46 Notes to the Financial Statements Financial Reporting in Practice 47 Enron 47 WorldCom 47 The Sarbannes-Oxley Act 48 & PRACTTONER NTERVEW WTH Sue Frieden, Ernst & Young 49 The Financial Statements: A Useful Starting Point 50 Hmyfinancelabl Summary 511 Review Questions 53 Problems 54 Data Case 59 X

3 Detailed Contents k nterest Rates and Valuing The Valuation Principle: The Foundation of Financial Decision Making 62 NTERVEW WTH Matt Herriot, Oxford & Hill Home Products 63 Managerial Decision Making 64 Your Personal Financial Decisions 65 Cost-Benefit Analysis 65 Valuation Principle 67 When Competitive Market Prices Are Not Available 68 The Time Value of Money and nterest Rates 69 The Time Value of Money 69 The nterest Rate: Converting Cash Across Time 70 The NPV Decision Rule 73 Net Present Value 74 The NPV Decision Rule 74 NPV and Cash Needs 76 The Law of One Price Arbitrage 78 Arbitrage 78 Law of One Price An Old Joke 79 Transactions Costs Hmyfinaneelabl Summary 811 Review Questions 821 Problems 83 NPV and the Time Value of Honey 86 NTERVEW WTH Jonathan Jagolinzer, Ameriprise Financial Services The Timeline 88 Constructing a Timeline 88 dentifying Dates on a Timeline 89 Distinguishing Cash nflows from Outflows 89 Representing Various Time Periods Valuing Cash Flows at Different Points in Time 90 Rule 1: Comparing and Combining Values 90 COMMON MSTAKE: Summing Cash Flows Across Time 90 Rule 2: Compounding 91 & Rule of Rule 3: Discounting 93 Applying the Rules of Valuing Cash Flows 94 & Using a Financial Calculator: Solving for Present and Future Values Valuing a Stream of Cash Flows The Net Present Value of a Stream of Cash Flows Perpetuities, Annuities, and Other Special Cases 101 Perpetuities 101 Historical Examples of Perpetuities 103 COMMON MSTAKE: Discounting One Too Many Times 104 Annuities 104 Growing Cash Flows Solving for Variables Other Than Present Value or Future Value 110 Solving for the Cash Flows 111 nternal Rate Return 113 Solving for the Number of Periods 117 Solving for N Using Logarithms 117 llmyfinancelabl Summary 1191 Review Questions 1211 Problems 1211 Data Case 127 Chapter 4 Appendix: Using a Financial Calculator nterest Rates 32 NTERVEW WTH Jason Moore, Bradford & Marzec, LLC nterest Rate Quotes and Adjustments 134 The Effective Annual Rate 135 Adjusting the Discount Rate to Different Time Periods 135 Annual Percentage Rates 137 COMMON MSTAKE: Using the EAR in the Annuity Formula Application: Discount Rates and Loans Computing Loan Payments 140 Computing the Outstanding Loan Balance The Determinants of nterest Rates nflation and Real Versus Nominal Rates

4 Detailed Contents xi nvestment and nterest Rate Policy 145 H How s nflation Actually Calculated? 146 The Yield Curve and Discount Rates 146 COMMON MSTAKE: Using the Annuity Formula When Discount Rates Vary 149 The Yield Curve and the Economy The Opportunity Cost of Capital 152 nterest Rates, Discount Rates, and the Cost of Capital 153 [Hniyfuiancelab[ Summary 154 Review Questions 1561 Problems Bonds NTERVEW WTH Patrick Brown, Citigroup Global Market Bond Terminology Zero-Coupon Bonds 165 Zero-Coupon Bond Cash Flows 165 Yield to Maturity of a Zero-Coupon Bond 166 Risk-Free nterest Rates Coupon Bonds 168 Coupon Bond Cash Flows 169 & The U.S. Treasury Market 170 Yield to Maturity of a Coupon Bond 170 Finding Bond Prices on the Web 172 Coupon Bond Price Quotes Why Bond Prices Change 173 nterest Rate Changes and Bond Prices 174 Time and Bond Prices 176 nterest Rate Risk and Bond Prices 178 Bond Prices in Practice 180 Clean and Dirty Prices for Coupon Bonds Corporate Bonds 182 Credit Risk 182 Corporate Bond Yields 183 Bond Ratings 183 PRACTTONER NTERVEW WTH Lisa Black, Teachers nsurance and Annuity Association 185 Corporate Yield Curves 186 Bond Ratings and the Subprime Crisis 187 [myfuiancelabl Summary 1881 Review Questions 1901 Problems 190 Data Case 193 Chapter 6 Appendix A: Solving for the Yield to Maturity of a Bond Using a Financial Calculator 195 Part Chapter 6 Appendix B: The Yield Curve and the Law of One Price 196 ntegrate Case ZOO nvestment Decision Rules NTERVEW WTH Katherine Pagelsdorf, Pearson Education 205 Using the NPV Rule 206 Organizing the Cash Flows and Computing the NPV 206 The NPV Profile 207 Measuring Sensitivity with RR 207 Alternative Rules Versus the NPV Rule 208 Alternative Decision Rules 208 The Payback Rule 209 The nternal Rate of Return Rule 210 COMMON MSTAKE: RR Versus the RR Rule 214 Why Do Rules Other Than the NPV Rule Persist? 214 Modified nternal Rate of Return 215 Choosing Between Projects 217 Differences in Scale 218 PRACTTONER NTERVEW WTH Dick Grannis, Qualcomm, nc. 221 Timing of the Cash Flows 223 Evaluating Projects with Different Lives 224 mportant Considerations When Using the Equivalent Annual Annuity 226 Choosing Among Projects When Resources Are Limited 227 Evaluating Projects with Different Resource Requirements 227 Putting t All Together 230 SJmyflnancdabl Summary 2321 Review Questions 2331 Problems 2331 Data Case 238 Chapter 7 Appendix: Using Excel to Make an NPV Profile Fundamentals of Capital Budgeting 242 NTERVEW WTH James King, Limitless LLC 243

5 xii Detailed Contents 8.1 The Capital Budgeting Process Forecasting ncremental Earnings 246 Operating Expenses Versus Capital Expenditures 246 ncremental Revenue and Cost Estimates 246 Taxes 247 ncremental Earnings Forecast Determining ncremental Free Cash Flow 250 Calculating Free Cash Flow from Earnings 251 Calculating Free Cash Flow Directly 255 Calculating the NPV Other Effects on ncremental Free Cash Flows 256 Opportunity Costs 256 COMMON MSTAKE: The Opportunity Cost of an dle Asset 257 Project Externalities 257 Sunk Costs 257 COMMON MSTAKE: The Sunk Cost Fallacy 258 Adjusting Free Cash Flow 258 Replacement Decisions Analyzing the Project 262 Sensitivity Analysis 262 Break-Even Analysis 263 Scenario Analysis Real Options in Capital Budgeting 266 Option to Delay 266 Option to Expand 266 Option to Abandon 266 gmyfuiancelabi Summary 2671 Review Questions 2691 Problems 2691 Data Case 275 Chapter 8 Appendix A: MACRS Depreciation 277 Chapter 8: Appendix B: Using Excel for Capital Budgeting Valuing Stocks 282 NTERVEW WTH Christopher Brigham, Loomis Sayles & Company Stock Basics The Dividend-Discount Model 286 A One-Year nvestor 286 Dividend Yields, Capital Gains, and Total Returns 287 A Multiyear nvestor 288 Dividend-Discount Model Equation Estimating Dividends in the Dividend-Discount Model 290 Constant Dividend Growth 290 Dividends Versus nvestment and Growth 291 PRACTTONER NTERVEW WTH Marilyn Fedak, AllianceBernstein 294 Changing Growth Rates 295 Limitations of the Dividend-Discount Model Total Payout and Free Cash Flow Valuation Models 298 Share Repurchases and the Total Payout Model 298 The Discounted Free Cash Flow Model Valuation Based on Comparable Firms 303 Valuation Multiples 304 Limitations of Multiples 306 Comparison with Discounted Cash Flow Methods 307 Stock Valuation Techniques: The Final Word nformation, Competition, and Stock Prices 309 nformation in Stock Prices 309 Competition and Efficient Markets 311 Lessons for nvestors and Corporate Managers 314 The Efficient Markets Hypothesis Versus No Arbitrage 314 lllniyffflancelabl Summary 3151 Review Questions 3181 Problems 3181 Data Case 324 Chapter 9 Appendix: Using Excel to Build a Dividend-Discount Model 326 Part 3 ntegrative Case 328 Risk and Return in Capital Market ! NTERVEW WTH Jon Kirchoff, 3M A First Look at Risk and Return Historical Risks and Returns of Stocks 338 Computing Historical Returns 338

6 Detailed Contents xiii Average Annual Returns 341 The Variance and Volatility of Returns 343 P Arithmetic Average Returns Versus Compound Annual Returns 344 Common Mistake 345 The Normal Distribution The Historical Tradeoff Between Risk and Returns 348 The Returns of Large Portfolios 349 The Returns of ndividual Stocks Common Versus ndependent Risk 350 Theft Versus Earthquake nsurance: An Example 350 Types of Risk Diversification in Stock Portfolios 352 Unsystematic Versus Systematic Risk 352 Diversifiable Risk and the Risk Premium 355 The mportance of Systematic Risk 355 COMMON MSTAKE: A Fallacy of Long-Run Diversification llgmyrinancelabl Summary 3571 Review Questions 3591 Problems 360 Systematic Risk and the Equity Risk Premium 362, NTERVEW WTH Alexander Morgan, Pantheon Ventures The Expected Return of a Portfolio 364 Portfolio Weights 364 Portfolio Returns 365 Expected Portfolio Return The Volatility of a Portfolio 368 Diversifying Risks 368 Measuring Stocks' Comovement: Correlation 370 Computing a Portfolio's Variance and Standard Deviation 373 The Volatility of a Large Portfolio 374 NOBEL PRZE: Harry Markowitz Measuring Systematic Risk 375 Role of the Market Portfolio 376 Stock Market ndexes as the Market Portfolio 377 % ndex Funds 377 Market Risk and Beta 378 COMMON MSTAKE: Mixing Standard Deviation and Beta 379 Estimating Beta from Historical Returns Putting it All Together: The Capital Asset Pricing Model 384 The CAPM Equation Relating Risk to Expected Return 384 Why Not Estimate Expected Returns Directly? 384 The Security Market Line 386 The CAPM and Portfolios 387 Summary of the Capital Asset Pricing Model 389 NOBEL PRZE: William Sharpe 389 The Big Picture 390 lumyfinancelabl Summary 3901 Review Questions 3921 Problems 392 Chapter 11 Appendix: Alternative Models of Systematic Risk Determining the Cost of Capital 399 NTERVEW WTH Priscilla Srbu, GualcomnVs Strategic Finance Group A First Look at the Weighted Average Cost of Capital 401 The Firm's Capital Structure 401 Opportunity Cost and the Overall Cost of Capital 402 Weighted Averages and the Overall Cost of Capital 402 Weighted Average Cost of Capital Calculations The Firm's Costs of Debt and Equity Capital 405 Cost of Debt Capital 405 COMMON MSTAKE: Using the Coupon Rate as the Cost of Debt 406 Cost of Preferred Stock Capital 406 Cost of Common Stock Capital A Second Look at the Weighted Average Cost of Capital 409 WACC Equation 409 Weighted Average Cost of Capital in Practice 410 Methods in Practice Using the WACC to Value a Project 412 Key Assumptions 413 WACC Method Application: Extending the Life of an Alcoa Mine 414

7 XV Detailed Contents Summary of the WACC Method Project-Based Costs of Capital 415 Cost of Capital for a New Acquisition Divisional Costs of Capital When Raising External Capital s Costly 417 jjmyfinancelabl Summary Review Questions 4219 Problems Data Case 424 Part 4 ntegrative Case 426 PART S Long -Term Financing 42? 13 Raising Equity Capital 428 NTERVEW WTH Sandra Pfeiler, Goldman Sachs Equity Financing for Private Companies 430 Sources of Funding 430 Securities and Valuation 433 Exiting an nvestment in a Private Company Taking Your Firm Public: The nitial Public Offering 435 Advantages and Disadvantages of Going Public 435 Primary and Secondary PO Offerings Other PO Types 441 Google's PO PO Puzzles 444 Underpriced POs 445 "Hot" and "Cold" PO Markets 445 High Cost of ssuing an PO 446 Poor Post-PO Long-Run Stock Performance Raising Additional Capital: The Seasoned Equity Offering 448 SEO Process 448 SEO Price Reaction 451 SEO Costs 452 jjmyfinancelabl Summary Review Questions Problems Debt Financing 458 NTERVEW WTH Bryan Milner, Wells Fargo Foothill Corporate Debt 460 Private Debt 460 U Debt Financing at Hertz: Bank Loans 461 P Debt Financing at Hertz: Private Placements Public Debt 462 & Debt Financing at Hertz: Public Debt Bond Covenants 466 Types of Covenants 466 Advantages of Covenants 467 Application: Hertz's Covenants Repayment Provisions 467 Call Provisions 467 Sinking Funds 470 Convertible Provisions 470 Summary 4731 Review Questions 4741 Problems 475 Chapter 14 Appendix: Using a Financial Calculator to Calculate Yield to Call 476 Part 5 ntegrative Case 477 Capital Structure and Capital Structure 482 P NTERVEW WTH Christopher Cvijic, Morgan Stanley Capital Structure Choices 484 Capital Structure Choices Across ndustries 484 Capital Structure Choices Within ndustries Capital Structure in Perfect Capital Markets 486 Application: Financing a New Business 487 Leverage and Firm Value 488 The Effect of Leverage on Risk and Return 490 Homemade Leverage 492 Leverage and the Cost of Capital 492 & COMMON MSTAKE: Capital Structure Fallacies 494 MM and the Real World 495 NOBEL PRZE: Franco Modigliani and Merton Miller Debt and Taxes 496 The nterest Tax Deduction and Firm Value 496

8 Detailed Contents Value of the nterest Tax Shield 498 The nterest Tax Shield with Permanent Debt 499 Leverage and the WACC with Taxes 500 Debt and Taxes: The Bottom Line The Costs of Bankruptcy and Financial Distress 502 Direct Costs of Bankruptcy 502 Bankruptcies Mean Big Money for Experts 502 ndirect Costs of Financial Distress Optimal Capital Structure: The Tradeoff Theory 504 Differences Across Firms 504 Optimal Leverage Additional Consequences of Leverage: Agency Costs and nformation 506 Agency Costs 506 Airlines Use Financial Distress to Their Advantage 507 Financial Distress and Rolling the Dice, Literally 508 Debt and nformation Capital Structure: Putting t All Together 511 Summary 5111 Review Questions 514 Problems 515 Chapter 15 Appendix: The Bankruptcy Code Payout Policy 522 ^ NTERVEW WTH Bill Bascom, intuit, nc Distributions to Shareholders 524 Dividends 525 Share Repurchases Dividends Versus Share Repurchases in a Perfect Capital Market 527 Alternative Policy 1: Pay a Dividend with Excess Cash 528 Alternative Policy 2: Share Repurchase (No Dividend) 529 & COMMON MSTAKE: Repurchases and the Supply of Shares 530 Alternative Policy 3: High Dividend (Equity ssue) 531 Modigliani-Miller and Dividend Policy rrelevance 531 COMMON MSTAKE: The Bird in the Hand Fallacy 532 Dividend Policy with Perfect Capital Markets The Tax Disadvantage of Dividends 533 Taxes on Dividends and Capital Gains 533 Optimal Dividend Policy with Taxes 535 Tax Differences Across nvestors Payout Versus Retention of Cash 539 Retaining Cash with Perfect Capital Markets 539 Retaining Cash with mperfect Capital Markets Signaling with Payout Policy 543 Dividend Smoothing 543 Dividend Signaling 545 Royal & SunAlliance's Dividend Cut 545 PRACTTONER NTERVEW WTH John Connors, Microsoft 546 Signaling and Share Repurchases Stock Dividends, Splits, and Spin-offs 548 Stock Dividends and Splits 548 Berkshire Hathaway's A and B Shares 548 Spin-offs Advice for the Financial Manager 549 mmyfinancelabl Summary Review Questions 5531 Problems Data Case 555 Part 6 ntergrative Case 557 Financial Planning and Forecasting Financial Modeling and Pro Forma Analysis 560 NTERVEW WTH David Hollon, Goldman Sachs Goals of Long-Term Financial Planning 562 dentify mportant Linkages 562 Analyze the mpact of Potential Business Plans 562 Plan for Future Funding Needs Forecasting Financial Statements: The Percent of Sales Method 563 Percent of Sales Method 563 Pro Forma ncome Statement 564 Pro Forma Balance Sheet 565 COMMON MSTAKE: Confusing Stockholders' with Retained Earnings 567 The Plug: Net New Financing 567

9 XV Detailed Contents 17.3 Forecasting a Planned Expansion 568 KMS Design's Expansion: Financing Needs 569 KMS Design's Expansion: Pro Forma ncome Statement 570 Forecasting the Balance Sheet Valuing the Planned Expansion 573 Forecasting Free Cash Flows 573» COMMON MSTAKE: Confusing Total and ncremental New Working Capital 574 KMS Design's Expansion: Effect on Firm Value 575 Optimal Timing and the Option to Delay Growth and Firm Value 578 Sustainable Growth Rate and External Financing 579 iliinyrinancelab Summary Review Questions Problems 584 Chapter 17 Appendix: The Balance Sheet and Statement of Cash Flows Working Capital Management 590 NTERVEW WTH Waleed Husain, Comcast Overview of Working Capital 592 The Cash Cycle 592 Working Capital Needs by ndustry 595 Firm Value and Working Capital Trade Credit 597 Trade Credit Terms 597 Trade Credit and Market Frictions COMMON MSTAKE: Using APR nstead of EAR to Compute the Cost of Trade Credit 598 Managing Float Receivables Management 600 Determining the Credit Policy 600 The 5 C's of Credit 601 Monitoring Accounts Receivable Payables Management 604 Determining Accounts Payable Days Outstanding 605 Stretching Accounts Payable nventory Management 606 Benefits of Holding nventory 607 Costs of Holding nventory 607 nventory Management Adds to the Bottom Line at Gap Cash Management 608 Motivation for Holding Cash 609 Alternative nvestments 609 & Cash Balances 609 lljmyflnancelabl Summary 6111 Review Questions Problems Data Case Short-Term Financial Planning 618 & NTERVEW WTH Teresa Wendt, Lockheed Martin Forecasting Short-Term Financing Needs 620 Application: Springfield Snowboards, nc. 620 Seasonalities 621 Negative Cash Flow Shocks 623 Positive Cash Flow Shocks The Matching Principle 625 Permanent Working Capital 625 Temporary Working Capital 625 Permanent Versus Temporary Working Capital 625 Financing Policy Choices Short-Term Financing with Bank Loans 628 Single, End-of-Period Payment Loan 628 Line of Credit 628 Bridge Loan 629 Common Loan Stipulations and Fees Short-Term Financing with Commercial Paper Short-Term Financing with Secured Financing 633 Accounts Receivable as Collateral 633 f> A Seventeenth-Century Financing Solution 634 nventory as Collateral Putting t All Together: Creating a Short-Term Financial Plan 636 Summary Review Questions Problems 640 Part 7 ntegrative Case 643 Z 0 Special Topics 649 Option Applications and Corporate Finance 650 & NTERVEW WTH Dan Ross, Simon-Kucher & Partners 651

10 Detailed Contents XV 20.1 Option Basics 652 Option Contracts 652 Stock Option Quotations 654 Options on Other Financial Securities 655 Options Are for More Than Just Stocks Option Payoffs at Expiration 656 The Long Position in an Option Contract 656 The Short Position in an Option Contract 658 Profits for Holding an Option to Expiration 659 Returns for Holding an Option to Expiration Factors Affecting Option Prices 663 Strike Price and Stock Price 663 Option Prices and the Exercise Date 663 Option Prices and the Risk-Free Rate 664 Option Prices and Volatility The Black-Scholes Option Pricing Formula Put-Call Parity 667 Portfolio nsurance Options and Corporate Finance 670 lumyfinancelab] Summary Review Question's 673 i Problems Data Case 675 / Z l Risk Management 677 NTERVEW WiTH Randy Newsom, Real Sports nteractive nsurance 679 The Role of nsurance: An Example 680 nsurance Pricing in a Perfect Market 680 The Value of nsurance 682 The Costs of nsurance 684 The nsurance Decision Commodity Price Risk 687 Hedging with Vertical ntegration and Storage 687 & Hedging Strategy Leads to Promotion 688 Hedging with Long-Term Contracts 688 Hedging with Futures Contracts 690 COMMON MSTAKE: Mistakes When Hedging Risk 692 Deciding to Hedge Commodity Price Risk 692 Differing Hedging Strategies nterest Rate Risk 693 nterest Rate Risk Measurement: Duration 693 Duration-Based Hedging 694 The Savings and Loan Crisis 694 Swap-Based Hedging 695 Summary 6979 Review Questions Problems 698 nternational Corporate Finance 702 & NTERVEW WTH Sean West, Eurasia Group Foreign Exchange 705 The Foreign Exchange Market 706 Exchange Rates Exchange Rate Risk 708 Exchange Rate Fluctuations 708 Hedging with Forward Contracts 710 Cash-and-Carry and the Pricing of Currency Forwards 712 Hedging Exchange Rate Risk with Options nternationally ntegrated Capital Markets 716 D COMMON MSTAKES: Forgetting to Flip the Exchange Rate Valuation of Foreign Currency Cash Flows 719 Application: tyesi, nc. 719 The Law of One Price as a Robustness Check Valuation and nternational Taxation 723 A Single Foreign Project with mmediate Repatriation of Earnings 723 Multiple Foreign Projects and Deferral of Earnings Repatriation nternationally Segmented Capital Markets 724 Differential Access to Markets 724 Macro-Level Distortions 725 mplications of nternationally Segmented Capital Markets Capital Budgeting with Exchange Rate Risk 728 Application: tyesi, nc. 728 Conclusion 729 jinyfinancelabj Summary 7309 Review Questions Problems Data Case 736 Credits CR-1 ndex 1-1

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