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 Munich Paris Cape Town Hong Kong Montreal

_ j PARTI INTRODUCTION 1 Chapter 1 The Corporation 3 Income Statement Analysis 62 Common Mistake: Mismatched Ratios 30 29 1.1 The Four Types of Firms 4 Sole Proprietorships 4 Partnerships 5 B Interview with David Viniar 6 Limited Liability Companies 7 Corporations 7 Tax Implications for Corporate Entities 8 1.2 Ownership Versus Control of Corporations 9 The Corporate Management Team 10 Ownership and Control of Corporations 10 E3 Shareholder Activism and Voting Rights 12 1.3 The Stock Market 12 The Largest Stock Markets 13 NYSE 13 Nasdaq 13 Summary 15 Key Terms 15 Further Reading 16 Problems 16 Chapter 2 Introduction to Financial Statement Analysis 19 2.1 The Disclosure of Financial Information 20 Preparation of Financial Statements 20 O International Financial Reporting Standards 20 Types of Financial Statements 21 2.2 The Balance Sheet 21 Assets 21 Liabilities 23 Stockholders' Equity 24 Balance Sheet Analysis 25 2.3 The income Statement 27 Earnings Calculations 27 2.4 The Statement of Cash Flows 32 Operating Activity 32 Investment Activity 33 Financing Activity 33 2.5 Other Financial Statement Information 34 a Interview with Sue Frieden 35 Management Discussion and Analysis 36 Statement of Stockholders' Equity 36 Notes to the Financial Statements 36 2.6 Accounting Manipulation 37 Enron 37 WorldCom 38 Sarbanes-Oxley Act 38 Summary 38 Key Terms 40 Further Reading 40 Problems 41 Data Case 45 3 Arbitrage and Financial Decision Making 47 3.1 Valuing Costs and Benefits 48 Using Market Prices to Determine Cash Values 48 When Competitive Market Prices Are Not Available 50 3.2 Interest Rates and the Time Value of Money 51 The Time Value of Money 51 The Interest Rate: An Exchange Rate Across Time 51 3.3 Present Value and the NPV Decision Rule 54 Net Present Value 54 The NPV Decision Rule 55 NPV and Individual Preferences 57

3.4 Arbitrage and the Law of One Price 59 a An Old Joke 60 Arbitrage 60 Law of One Price 60 3.5 No-Arbitrage and Security Prices 61 Valuing a Security 61 Determining the No-Arbitrage Price 62 Q Nasdaq SOES Bandits 63 Determining the Interest Rate from Bond Prices 64 The NPV of Trading Securities 64 Valuing a Portfolio 66 Stock Index Arbitrage 66 3.6 The Price of Risk 67 Risky Versus Risk-Free Cash Flows 68 Risk Aversion and the Risk Premium 68 The No-Arbitrage Price of a Risky Security 69 Risk Premiums Depend on Risk 70 Risk Is Relative to the Overall Market 70 Risk, Return, and Market Prices 72 3.7 Arbitrage with Transactions Costs 73 Summary 75 Key Terms 76 Further Reading 76 Problems 76 PART II TOOLS 81 Chapter 4 The Time Value of 4.1 The Timeline 84 4.2 The Three Rules of Time Travel 85 Comparing and Combining Values 85 Moving Cash Flows Forward in Time 86 Moving Cash Flows Back in Time 87 Applying the Rules of Time Travel 88 4.3 The Power of Compounding: An Application 90 4.4 Valuing a Stream of Cash Flows 91 4.5 The Net Present Value of a Stream of Cash Flows 94 4.6 Perpetuities, Annuities, and Other Special Cases 95 Perpetuities 95 D Historical Examples of Perpetuities 97 Q Common Mistake: Discounting One Too Many Times 98 Annuities 98 Growing Cash Flows 101 4.7 Solving Problems with a Spreadsheet Program 106 4.8 Solving for Variables Other Than Present Value or Future Value 108 Solving for the Cash Flows 109 Internal Rate of Return 111 Solving for the Number of Periods 114 Q Common Mistake: Excels NPV and IRR Functions 115 Rule of 72 116 Summary 117 Key Terms 118 Further Reading 118 - Problems 119 Data Case 123 Chapter 5 interest Rates 125 5.1 Interest Rate Quotes and Adjustments 126 The Effective Annual Rate 126 Adjusting the Discount Rate to Different Time Periods 126 Annual Percentage Rates 127 Application: Discount Rates and Loans 130 5.2 The Determinants of interest Rates 131 Inflation and Real Versus Nominal Rates 131 Investment and Interest Rate Policy 132 The Yield Curve and Discount Rates 133 D Common Mistake: Using the Annuity Formula When Discount Rates Vary 135 The Yield Curve and the Economy 136 5.3 Risk and Taxes 138 Risk and Interest Rates 138 After-Tax Interest Rates 139

XI 5.4 The Opportunity Cost of Capital 140 Summary 141 Key Terms 142 Further Reading 142 Problems 143 Chapter 5 Appendix: Continuous Rate and Cash Flows 147 Chapter 6 Investment Decision Rules 149 6.1 NPV and Stand-Alone Projects 150 NPV Rule 150 Measuring Sensitivity with IRR 150 Alternative Rules Versus NPV Rule 150 6.2 Alternative Decision Rules 151 The Payback Rule 151 The Internal Rate of Return Rule 152 Economic Profit or EVA 156 E3 Interview with Joel M. Stern 157 m Why Do Rules Other Than the NPV Rule Persist? 160 6.3 Mutually Exclusive investment Opportunities 161 Differences in Scale 161 Timing of the Cash Flows 164 Incremental IRR Rule 164 6.4 Project Selection with Resource Constraints 166 Evaluation of Projects with Different Resource Requirements 166 Profitability Index 167 Shortcomings of the Profitability Index 168 Summary 168 Key Terms 169 Further Reading 169 Problems 170 Data Case 173 PART II! BASIC VALUATION 175 Chapter 7 Fundamentals of Capita! Budgeting 7.1 Forecasting Earnings 178 Revenue and Cost Estimates 178 Interview with Dick Grannis 179 Incremental Earnings Forecast 180 Indirect Effects on Incremental Earnings 182 SB Common Mistake: The Opportunity Cost of an Idle Asset 183 Sunk Costs and Incremental Earnings 184 Real-World Complexities 184 Q The Sunk Cost Fallacy 185 7.2 Determining Free Cash Flow and NPV 186 Calculating the Free Cash Flow from Earnings 186 Calculating Free Cash Flow Directly 188 Calculating the NPV 189 Choosing Among Alternatives 190 Further Adjustments to Free Cash Flow 191 7.3 Analyzing the Project 196 Break-Even Analysis 196 Sensitivity Analysis 197 Scenario Analysis 198 Summary 200 Key Terms 201 Further Reading 201 Problems 201 Data Case 207 Chapter 7 Appendix: MACRS Depreciation 209 Chapters Valuing Bonds 211 8.1 Bond Cash Flows, Prices, and Yields 212 Bond Terminology 212 Zero-Coupon Bonds 212 Coupon Bonds 214 8.2 Dynamic Behavior of Bond Prices 217 Discounts and Premiums 217 Time and Bond Prices 218 H Clean and Dirty Prices for Coupon Bonds 221 Interest Rate Changes and Bond Prices 221 8.3 The Yield Curve and Bond Arbitrage 224 Replicating a Coupon Bond 224 Valuing a Coupon Bond Using Zero-Coupon Yields 225

Xll Contents Coupon Bond Yields 226 Treasury Yield Curves 227 8.4 Corporate Bonds 228 Corporate Bond Yields 228 Interview with Lisa Black 230 Bond Ratings 231 Corporate Yield Curves 231 Summary 233 Key Terms 235 Further Reading 235 Problems 235 Data Case 239 Chapter 8 Appendix: Forward Interest Rates 241 Chapter 9 Valuing Stocks 245 9.1 Stock Prices, Returns, and the Investment Horizon 246 A One-Year Investor 246 Dividend Yields, Capital Gains, and Total Returns 247 A Multiyear Investor 248 9.2 The Dividend-Discount Model 249 Constant Dividend Growth 249 Dividends Versus Investment and Growth 250 Changing Growth Rates 252 D Interview with Marilyn Fedak 253 Limitations of the Dividend-Discount Model 255 O John Burr Williams's Theory of Investment Value 255 9.3 Total Payout and Free Cash Flow Valuation Models 256 Share Repurchases and the Total Payout Model The Discounted Free Cash Flow Model 258 256 9.4 Valuation Based on Comparable Firms 261 Valuation Multiples 262 Limitations of Multiples 264 Comparison with Discounted Cash Flow Methods 264 Stock Valuation Techniques: The Final Word 265 9.5 Information, Competition, and Stock Prices 266 Information in Stock Prices 266 Competition and Efficient Markets 268 Lessons for Investors and Corporate Managers 271 The Efficient Markets Hypothesis Versus No Arbitrage 271 Summary 272 Key Terms 274 Further Reading 274 Problems 275 Data Case 279 PART IV RISK AND RETURN 281 10 Capita! Markets and the Pricing of Risk 283 10.1 A First Look at Risk and Return 284 10.2 Common Measures of Risk and Return 286 Probability Distributions 286 Expected Return 286 Variance and Standard Deviation 287 10.3 Historical Returns of Stocks and Bonds 289 Computing Historical Returns 289 Average Annual Returns 292 The Variance and Volatility of Returns 293 Using Past Returns to Predict the Future: Estimation Error 294 Arithmetic Average Returns Versus Compound Annual Returns 296 10.4 The Historical Tradeoff Between Risk and Return 297 The Returns of Large Portfolios 297 The Returns of Individual Stocks 298 10.5 Common Versus independent Risk 299 10.6 Diversification in Stock Portfolios 303 Firm-Specific Versus Systematic Risk 303

xm No Arbitrage and the Risk Premium 305 B Common Mistake: A Fallacy of Long-Run Diversification 306 10.7 Estimating the Expected Return 307 Measuring Systematic Risk 308 Estimating the Risk Premium 310 10.8 Risk and the Cost of Capital 311 10.9 Capital Market Efficiency 313 Notions of Efficiency 313 Empirical Evidence on Capital Market Competition 313 0 Interview with Randall Lert 314 Summary 315 Key Terms 317 Further Reading 317 Problems 318 Data Case 321 Chapter 11 Optimal Portfolio Choice 323 11.1 The Expected Return of a Portfolio 324 11.2 The Volatility of a Two-Stock Portfolio 325 Combining Risks 326 Determining Covariance and Correlation 326 G3 Computing the Variance, Covariance, and Correlation in Microsoft Excel 330 Computing a Portfolio's Variance and Volatility 330 11.3 The Volatility of a Large Portfolio 332 Diversification with an Equally Weighted Portfolio of Many Stocks 332 Diversification with General Portfolios 334 11.4 Risk Versus Return: Choosing an Efficient Portfolio 335 Efficient Portfolios with Two Stocks 335 The Effect of Correlation 338 Short Sales 339 D The Mechanics of a Short Sale 340 Risk Versus Return: Many Stocks 341 11.5 Risk-Free Saving and Borrowing 345 Investing in Risk-Free Securities 345 Borrowing and Buying Stocks on Margin 346 Identifying the Tangent Portfolio 347 11.6 The Efficient Portfolio and the Cost of Capital 349 How to Improve a Portfolio: Beta and the Required Return 349 Expected Returns and the Efficient Portfolio 351 Cost of Capital 352 H Nobel Prizes: Harry Markowitz and James Tobin 353 E3 Interview with Jonathan Clements 354 Summary 355 Key Terms 357 Further Reading 358 Problems 358 Data Case 361 Chapter 12 The Capital Asset Pricing Model 363 12.1 The Efficiency of the Market Portfolio 364 The CAPM Assumptions 364 Security Demand Must Equal Supply 365 Optimal Investing: The Capital Market Line 366 12.2 Determining the Risk Premium 368 Market Risk and Beta 368 The Security Market Line 370 Alpha 373 Summary of the Capital Asset Pricing Model 374 12.3 The Market Portfolio 375 Value-Weighted Portfolios 375 Common Stock Market Indexes 377 O Interview with John Bogle 378 12.4 Determining Beta 380 Estimating Beta from Historical Returns 380

XIV Contents Chapter 13 H Why Not Estimate Expected Returns Directly? 382 Using Linear Regression 382 12.5 Extending the CAPM 383 Saving Versus Borrowing Rates 384 Investor Information and Rational Expectations 386 12.6 The CAPM in Practice 388 13.1 Forecasting Beta 388 The Security Market Line 390 Evidence Regarding the CAPM 392 The Bottom Line on the CAPM 394 H Nobel Prize: William Sharpe on the CAPM 395 Summary 396 Key Terms 397 Further Reading 397 Problems 398 Data Case 400 Alternative Models of Systematic Risk The Efficiency of the Market Portfolio The Size Effect 402 Past Returns 406 402 13.2 implication of Positive Alphas 406 Proxy Error 407 Non-tradeable Wealth 407 D Common Mistake: Investing in Own Company Stock 408 13.3 Multifactor Models of Risk 409 Using Factor Portfolios 409 Building a Multifactor Model 411 Selecting the Portfolios 411 Interview with Rex A. Sinquefield 412 Calculating the Cost of Capital Using the Fama-French-Carhart Factor Specification 413 13.4 Characteristic Variable Models of Expected Returns 415 13.5 Methods Used in Practice 419 Summary 421 Key Terms 422 Further Reading 422 Problems 423 PARTV CAPITAL STRUCTURE 425 :er 14 Capital Structure in a Perfect Market 427 14.1 Equity Versus Debt Financing 428 Financing a Firm with Equity 428 Financing a Firm with Debt and Equity 429 The Effect of Leverage on Risk and Return 430 14.2 Modigliani-Miller I: Leverage, Arbitrage, and Firm Value 432 MM and the Law of One Price 432 Q MM and the Real World 433 Homemade Leverage 433 The Market Value Balance Sheet 435 Application: A Leveraged Recapitalization 436 14.3 Modigliani-Miller II: Leverage, Risk, and the Cost of Capital 437 Leverage and the Equity Cost of Capital 437 Capital Budgeting and the Weighted Average Cost of Capital 439 H Common Mistake: Is Debt Better Than Equity? 441 Computing the WACC with Multiple Securities 442 Levered and Unlevered Betas 442 Cash and Net Debt 444 D Microsoft's Dividend, Cash, and Beta 444 14.4 Capita! Structure Fallacies 445 Leverage and Earnings per Share 445 Equity, Issuances, and Dilution 448 14.5 MM: Beyond the Propositions 449 a Nobel Prize: Franco Modigliani and Merton Miller 450 Summary 451 Key Terms 452 Further Reading 452 - Problems 453 Data Case 456 Chapter 15 Debt and Taxes 459 15.1 The Interest Tax Deduction 460

15.2 Valuing the Interest Tax Shield 462 The Interest Tax Shield and Firm Value 462 The Interest Tax Shield with Permanent Debt 463 Pizza and Taxes 464 The Weighted Average Cost of Capital with Taxes 465 The Interest Tax Shield with a Target Debt-Equity Ratio 466 15.3 Recapitalizing to Capture the Tax Shield 468 The Tax Benefit 468 The Share Repurchase 468 No Arbitrage Pricing 469 Analyzing the Recap: The Market Value Balance Sheet 470 15.4 Personal Taxes 471 Including Personal Taxes in the Interest Tax Shield 471 Valuing the Interest Tax Shield with Personal Taxes 474 Determining the Actual Tax Advantage of Debt 475 0 Cutting the Dividend Tax Rate 475 15.5 Optimal Capital Structure with Taxes 476 Do Firms Prefer Debt? 476 Limits to the Tax Benefit of Debt 478 Growth and Debt 481 Other Tax Shields 481 The Low Leverage Puzzle 481 13 Employee Stock Options 482 H Interview with Andrew Balson 484 Summary 485 Key Terms 485 Further Reading 486 Problems 486 Data Case 490 Chapter 16 Financial Distress, Managerial Incentives, and information 491 16.1 Default and Bankruptcy in a Perfect Market 492 Armin Industries: Leverage and the Risk of Default 492 Bankruptcy and Capital Structure 493 16.2 The Cost of Bankruptcy and Financial Distress 494 The Bankruptcy Code 494 Direct Costs of Bankruptcy 495 Indirect Costs of Financial Distress 496 16.3 Financial Distress Costs and Firm Value 498 Armin Industries: The Impact of Financial Distress Costs 499 Who Pays for Financial Distress Costs? 500 16.4 Optimal Capital Structure: The Tradeoff Theory 501 Determinants of the Present Value of Financial Distress Costs 501 Optimal Leverage 501 16.5 Exploiting Debt Holders: The Agency Costs of Leverage 503 Over-investment 503 Under-investment 504 Cashing Out 505 Agency Costs and the Value of Leverage 505 Debt Maturity and Covenants 506 16.6 Motivating Managers: The Agency Benefits of Leverage 507 Concentration of Ownership 507 Reduction of Wasteful Investment 508 m Excessive Perks and Corporate Scandals 509 Leverage and Commitment 510 16.7 Agency Costs and the Tradeoff Theory 511 The Optimal Debt Level 511 Debt Levels in Practice 512 16.8 Asymmetric information and Capital Structure 512 Leverage as a Credible Signal 513 Issuing Equity and Adverse Selection 514 a Nobel Prize: The 2001 Nobel Prize in Economics 515 Implications for Equity Issuance 517 Implications for Capital Structure 517

16.9 Capital Structure: The Bottom Line 520 Summary 521 Key Terms 523 Further Reading 523 Problems 523 Chapter 17 Payout Policy 531 17.1 Distributions to Shareholders 532 Dividends 532 Share Repurchases 534 17.2 Comparison of Dividends and Share Repurchases 535 Alternative Policy 1: Pay Dividend with Excess Cash 535 Alternative Policy 2: Share Repurchase (No Dividend) 537 (3 Common Mistake: Repurchases and the Supply of Shares 538 Alternative Policy 3: High Dividend (Equity Issue) 538 Modigliani-Miller and the Dividend Policy Irrelevance 539 IS Common Mistake: The Bird in Hand Fallacy 540 Dividend Policy with Perfect Capital Markets 541 17.3 The Tax Disadvantage of Dividends 541 Taxes on Dividends and Capital Gains 541 Optimal Dividend Policy with Taxes 542 17.4 Dividend Capture and Tax Clienteles 545 The Effective Dividend Tax Rate 545 Tax Differences Across Investors 546 Clientele Effects 547 17.5 Payout Versus Retention of Cash 549 Retaining Cash with Perfect Capital Markets 549 Taxes and Cash Retention 550 Adjusting for Investor Taxes 552 Issuance and Distress Costs 553 Agency Costs of Retaining Cash 553 17.6 Signaling with Payout Policy 555 Dividend Smoothing 555 Dividend Signaling 556 Q Royal & SunAlliance's Dividend Cut 557 Signaling and Share Repurchases 558 17.7 Stock Dividends, Splits, and Spin-offs 560 Stock Dividends and Splits 560 E Berkshire Hathaway's A & B Shares 561 E3 Interview with John Connors 562 Spin-offs 563 Summary 565 Key Terms 566 Further Reading 566 Problems 567 Data Case 570 PART VI VALUATION 573 Chapter 18 Capital Budgeting and ;e 575 18.1 Overview 576" 18.2 The Weighted Average Cost of Capital Method 577 Using the WACC to Value a Project 577 Summary of the WACC Method 579 Implementing a Constant Debt-Equity Ratio 580 18.3 The Adjusted Present Value Method 581 The Unlevered Value of the Project 582 Valuing the Interest Tax Shield 583 Summary of the APV Method 584 18.4 The Flow-to-Equity Method 585 Calculating the Free Cash Flow to Equity 586 Valuing Equity Cash Flows 587 Summary of the Flow-to-Equity Method 588 B What Counts as "Debt"? 589 18.5 Project-Based Costs of Capital 589 Estimating the Unlevered Cost of Capital 589 Project Leverage and the Equity Cost of Capital 590 Determining the Incremental Leverage of a Project 591

xvii E3 Common Mistake: Re-levering the WACC 592 18.6 APV with Other Leverage Policies 593 Constant Interest Coverage Ratio 594 Predetermined Debt Levels 595 A Comparison of Methods 596 18.7 Other Effects of Financing 597 Issuance and Other Financing Costs 597 B Airline Loan Guarantees after September 11,2001 598 Security Mispricing 598 Financial Distress and Agency Costs 599 18.8 Advanced Topics in Capital Budgeting 600 Periodically Adjusted Debt 601 Leverage and the Cost of Capital 603 The WACC or FTE Method with Changing Leverage 605 Personal Taxes 606 Summary 609 Key Terms 610 Further Reading 610 Problems 611 Data Case 617 Chapter 18 Appendix: Foundations and Further Details 619 Ideko's Unlevered Cost of Capital 638 19.5 Valuing the Investment 639 The Multiples Approach to Continuation Value 639 The Discounted Cash Flow Approach to Continuation Value 640 0 Common Mistake: Continuation Values and Long-Run Growth 643 APV Valuation of Ideko Equity 643 A Reality Check 644 a Common Mistake: Missing Assets or Liabilities 644 IRR and Cash Multiples 645 B Interview with Joseph L. Rice, III 646 19.6 Sensitivity Analysis 647 Summary 648 Key Terms 649 Further Reading 649 Problems 649 Chapter 19 Appendix: Compensating Management 652 Glossary G-1 Index 1-1 Chapter 19 Valuation and Financial Modeling: A Case Study 623 19.1 Valuation Using Comparables 624 19.2 The Business Plan 626 Operational Improvements 626 Capital Expenditures: A Needed Expansion 627 Working Capital Management 628 Capital Structure Changes: Levering Up 628 19.3 Building the Financial Model 629 Forecasting Earnings 629 Working Capital Requirements 631 Forecasting Free Cash Flow 633 The Balance Sheet and Statement of Cash Flows (Optional) 634 19.4 Estimating the Cost of Capital 636 CAPM-Based Estimation 636 Unlevering Beta 637