Fundamentals of Corporate Finance PDF

 Page i Page ii The McGraw-Hill/Irwin Series in Finance, Insurance, and Real Estate Stephen A. Ross Franco Modigliani Professor of Finance and...

 Page i Page ii The McGraw-Hill/Irwin Series in Finance, Insurance, and Real Estate Stephen A. Ross Franco Modigliani Professor of Finance and Economics Sloan School of Management, Massachusetts Institute of Technology, Consulting Editor Financial Management Block, Hirt, and Danielsen Foundations of Financial Management Fifteenth Edition Brealey, Myers, and Allen Principles of Corporate Finance Eleventh Edition Brealey, Myers, and Allen Principles of Corporate Finance, Concise Second Edition Brealey, Myers, and Marcus Fundamentals of Corporate Finance Eighth Edition Brooks FinGame Online 5.0 Bruner Case Studies in Finance: Managing for Corporate Value Creation Seventh Edition Cornett, Adair, and Nofsinger Finance: Applications and Theory Third Edition Cornett, Adair, and Nofsinger M: Finance Third Edition DeMello Cases in Finance Second Edition Grinblatt (editor) Stephen A. Ross, Mentor: Infl uence through Generations Grinblatt and Titman Financial Markets and Corporate Strategy Second Edition Higgins Analysis for Financial Management Eleventh Edition Kellison Theory of Interest Third Edition Ross, Westerfield, and Jaffe Corporate Finance Tenth Edition Ross, Westerfield, Jaffe, and Jordan Corporate Finance: Core Principles and Applications Fourth Edition Ross, Westerfield, and Jordan Essentials of Corporate Finance Eighth Edition Ross, Westerfield, and Jordan Fundamentals of Corporate Finance Eleventh Edition Shefrin Behavioral Corporate Finance: Decisions that Create Value First Edition White Financial Analysis with an Electronic Calculator Sixth Edition Investments Bodie, Kane, and Marcus Essentials of Investments Ninth Edition Bodie, Kane, and Marcus Investments Tenth Edition Hirt and Block Fundamentals of Investment Management Tenth Edition Jordan, Miller, and Dolvin Fundamentals of Investments: Valuation and Management Seventh Edition Stewart, Piros, and Heisler Running Money: Professional Portfolio Management First Edition Sundaram and Das Derivatives: Principles and Practice Second Edition Financial Institutions and Markets Rose and Hudgins Bank Management and Financial Services Ninth Edition Rose and Marquis Financial Institutions and Markets Eleventh Edition Saunders and Cornett Financial Institutions Management: A Risk Management Approach Eighth Edition Saunders and Cornett Financial Markets and Institutions Sixth Edition International Finance Eun and Resnick International Financial Management Seventh Edition Real Estate Brueggeman and Fisher Real Estate Finance and Investments Fourteenth Edition Ling and Archer Real Estate Principles: A Value Approach Fourth Edition Financial Planning and Insurance Allen, Melone, Rosenbloom, and Mahoney Retirement Plans: 401(k)s, IRAs, and Other Deferred Compensation Approaches Eleventh Edition Altfest Personal Financial Planning First Edition Harrington and Niehaus Risk Management and Insurance Second Edition Kapoor, Dlabay, and Hughes Focus on Personal Finance: An Active Approach to Help You Achieve Financial Literacy Fifth Edition Kapoor, Dlabay, and Hughes Personal Finance Eleventh Edition Walker and Walker Personal Finance: Building Your Future First Edition Page iii  To our families and friends with Page v love and gratitude. S.A.R. R.W.W. B.D.J.  Page vi About the Authors STEPHEN A. ROSS Sloan School of Management, Massachusetts Institute of Technology Stephen A. Ross is the Franco Modigliani Professor of Finance and Economics at the Sloan School of Management, Massachusetts Institute of Technology. One of the most widely published authors in finance and economics, Professor Ross is recognized for his work in developing the Arbitrage Pricing Theory and his substantial contributions to the discipline through his research in signaling, agency theory, option pricing, and the theory of the term structure of interest rates, among other topics. A past president of the American Finance Association, he currently serves as an associate editor of several academic and practitioner journals. He is a trustee of CalTech. RANDOLPH W. WESTERFIELD Marshall School of Business, University of Southern California Randolph W. Westerfield is Dean Emeritus and is the Charles B. Thornton Professor in Finance Emeritus of the University of Southern California’s Marshall School of Business. Professor Westerfield came to USC from the Wharton School, University of Pennsylvania, where he was the chairman of the finance department and a member of the finance faculty for 20 years. He is a member of the board of trustees of Oaktree Capital mutual funds. His areas of expertise include corporate financial policy, investment management, and stock market price behavior. BRADFORD D. JORDAN Gatton College of Business and Economics, University of Kentucky Bradford D. Jordan is professor of finance and holder of the Richard W. and Janis H. Furst Endowed Chair in Finance at the University of Kentucky. He has a long-standing interest in both applied and theoretical issues in corporate finance and has extensive experience teaching all levels of corporate finance and financial management policy. Professor Jordan has published numerous articles on issues such as cost of capital, capital structure, and the behavior of security prices. He is a past president of the Southern Finance Association, and he is coauthor of Fundamentals of Investments: Valuation and Management, 7e, a leading investments text, also published by McGraw-Hill/Irwin.  Page vii Preface from the Authors When the three of us decided to write a book, we were united by one strongly held principle: Corporate finance should be developed in terms of a few integrated, powerful ideas. We believed that the subject was all too often presented as a collection of loosely related topics, unified primarily by virtue of being bound together in one book, and we thought there must be a better way. One thing we knew for certain was that we didn’t want to write a “me-too” book. So, with a lot of help, we took a hard look at what was truly important and useful. In doing so, we were led to eliminate topics of dubious relevance, downplay purely theoretical issues, and minimize the use of extensive and elaborate calculations to illustrate points that are either intuitively obvious or of limited practical use. As a result of this process, three basic themes became our central focus in writing Fundamentals of Corporate Finance: AN EMPHASIS ON INTUITION We always try to separate and explain the principles at work on a common sense, intuitive level before launching into any specifics. The underlying ideas are discussed first in very general terms and then by way of examples that illustrate in more concrete terms how a financial manager might proceed in a given situation. A UNIFIED VALUATION APPROACH We treat net present value (NPV) as the basic concept underlying corporate finance. Many texts stop well short of consistently integrating this important principle. The most basic and important notion, that NPV represents the excess of market value over cost, often is lost in an overly mechanical approach that emphasizes computation at the expense of comprehension. In contrast, every subject we cover is firmly rooted in valuation, and care is taken throughout to explain how particular decisions have valuation effects. A MANAGERIAL FOCUS Students shouldn’t lose sight of the fact that financial management concerns management. We emphasize the role of the financial manager as decision maker, and we stress the need for managerial input and judgment. We consciously avoid “black box” approaches to finance, and,  where appropriate, the approximate, pragmatic nature of financial analysis is made explicit, possible pitfalls are described, and limitations are discussed. In retrospect, looking back to our 1991 first edition IPO, we had the same hopes and fears as any entrepreneurs. How would we be received in the market? At the time, we had no idea that 23 years later, we would be working on an eleventh edition. We certainly never dreamed that in those years we would work with friends and colleagues from around the world to create country-specific Australian, Canadian, and South African editions, an International edition, Chinese, French, Polish, Portuguese, Thai, Russian, Korean, and Spanish language editions, and an entirely separate book, Essentials of Corporate Finance, now in its eighth edition. Today, as we prepare to once more enter the market, our goal is to stick with the basic principles that have brought us this far. However, based on the enormous amount of feedback we have received from you and your colleagues, we have made this edition and its package even more flexible than previous editions. We offer flexibility in coverage, as customized editions of this text can be crafted in any combination through McGraw-Hill’s CREATE system, and flexibility in pedagogy, by providing a wide variety of features in the book to help students to learn about corporate finance. We also provide flexibility in package options by offering the Page viii most extensive collection of teaching, learning, and technology aids of any corporate finance text. Whether you use only the textbook, or the book in conjunction with our other products, we believe you will find a combination with this edition that will meet your current as well as your changing course needs. Stephen A. Ross Randolph W. Westerfield Bradford D. Jordan  Page ix Coverage This book was designed and developed explicitly for a first course in business or corporate finance, for both finance majors and non-majors alike. In terms of background or prerequisites, the book is nearly self-contained, assuming some familiarity with basic algebra and accounting concepts, while still reviewing important accounting principles very early on. The organization of this text has been developed to give instructors the flexibility they need. The following grid presents, for each chapter, some of the most significant features as well as a few selected chapter highlights of the 11th edition of Fundamentals. Of course, in every chapter, opening vignettes, boxed features, in-chapter illustrated examples using real companies, and end-of- chapter material have been thoroughly updated as well. Page x Page xi Page xii Page xiii  Page xiv Page xv In-Text Study Features To meet the varied needs of its intended audience, Fundamentals of Corporate Finance is rich in valuable learning tools and support. CHAPTER-OPENING VIGNETTES Vignettes drawn from real-world events introduce students to the chapter concepts. CHAPTER LEARNING OBJECTIVES This feature maps out the topics and learning goals in every chapter. Each end-of-chapter problem and test bank question is linked to a learning objective, to help you organize your assessment of knowledge and comprehension. PEDAGOGICAL USE OF COLOR This learning tool continues to be an important feature of Fundamentals of Corporate Finance. In almost every chapter, color plays an extensive, nonschematic, and largely self-evident role. A guide to the functional use of color is on the endsheets of the text. IN THEIR OWN WORDS BOXES This series of boxes are the popular articles updated from previous editions Page xvi written by a distinguished scholar or practitioner on key topics in the text. Boxes include essays by Merton Miller on capital structure, Fischer Black on dividends, and Roger Ibbotson on capital market history. A complete list of “In Their Own Words” boxes appears on page xlv. WORK THE WEB BOXES These boxes show students how to research financial issues using the Web and then how to use the information they find to make business decisions. Work the Web boxes also include interactive follow-up questions and exercises. REAL-WORLD EXAMPLES Page xvii Actual events are integrated throughout the text, tying chapter concepts to real life through illustration and reinforcing the relevance of the material. Some examples tie into the chapter-opening vignette for added reinforcement. SPREADSHEET STRATEGIES This feature introduces students to Excel and shows them how to set up spreadsheets in order to analyze common financial problems—a vital part of every business student’s education. CALCULATOR HINTS Brief calculator tutorials appear in selected chapters to help students learn or brush up on their financial calculator skills. These complement the Spreadsheet Strategies. CONCEPT BUILDING Chapter sections are intentionally kept short to promote a step-by-step, Page xviii building block approach to learning. Each section is then followed by a series of short concept questions that highlight the key ideas just presented. Students use these questions to make sure they can identify and understand the most important concepts as they read. SUMMARY TABLES These tables succinctly restate key principles, results, and equations. They appear whenever it is useful to emphasize and summarize a group of related concepts. For an example, see Chapter 3, page 69. LABELED EXAMPLES Separate numbered and titled examples are extensively integrated into the chapters. These examples provide detailed applications and illustrations of the text material in a step-by-step format. Each example is completely self-contained so students don’t have to search for additional information. Based on our classroom testing, these examples are among the most useful learning aids because they provide both detail and explanation. KEY TERMS Key Terms are printed in bold type and defined within the text the first time Page xix they appear. They also appear in the margins with definitions for easy location and identification by the student. EXPLANATORY WEB LINKS These Web links are provided in the margins of the text. They are specifically selected to accompany text material and provide students and instructors with a quick way to check for additional information using the Internet. KEY EQUATIONS Called out in the text, key equations are identified by an equation number. The list in Appendix B shows the key equations by chapter, providing students with a convenient reference. HIGHLIGHTED CONCEPTS Throughout the text, important ideas are pulled out and presented in a highlighted box—signaling to students that this material is particularly relevant and critical for their understanding. For examples, Chapter 10, page 313; Chapter 13, page 434. EXCEL MASTER Icons in the margin identify concepts and skills covered in our unique, RWJ-created Excel Master program. For more training in Excel functions for finance, and for more practice, log on to McGraw- Hill’s Connect Finance for Fundamentals of Corporate Finance to access the Excel Master files. This pedagogically superior tool will help get your students the practice they need to succeed—and to exceed expectations. CHAPTER SUMMARY AND CONCLUSIONS Every chapter ends with a concise, but thorough, summary of the important ideas Page xx —helping students review the key points and providing closure to the chapter. CHAPTER REVIEW AND SELF-TEST PROBLEMS Appearing after the Summary and Conclusions, each chapter includes a Chapter Review and Self- Test Problem section. These questions and answers allow students to test their abilities in solving key problems related to the chapter content and provide instant reinforcement. CONCEPTS REVIEW AND CRITICAL THINKING QUESTIONS This successful end-of-chapter section facilitates your students’ knowledge of key principles, as well as intuitive understanding of the chapter concepts. A number of the questions relate to the chapter- opening vignette—reinforcing student critical thinking skills and the learning of chapter material. END-OF-CHAPTER QUESTIONS AND PROBLEMS Page xxi Students learn better when they have plenty of opportunity to practice; therefore, FCF, 11e, provides extensive end-of-chapter questions and problems. The end-of-chapter support greatly exceeds typical introductory textbooks. The questions and problems are separated into three learning levels: Basic, Intermediate, and Challenge. Answers to selected end-of-chapter material appear in Appendix C. Also, most problems are available in McGraw-Hill’s Connect—see page xxiv for details. END-OF-CHAPTER CASES Located at the end of the book’s chapters, these minicases focus on real-life company situations that embody important corporate finance topics. Each case presents a new scenario, data, and a dilemma. Several questions at the end of each case require students to analyze and focus on all of the material they learned from each chapter. WEB EXERCISES (ONLINE ONLY) For instructors interested in integrating even more online resources and problems into their course, these Web activities show students how to learn from the vast amount of financial resources available on the Internet. In the 11th edition of Fundamentals, these Web exercises are available to students and instructors through Connect. Page xxii Comprehensive Teaching and Learning Package This edition of Fundamentals has several options in terms of the textbook, instructor supplements, student supplements, and multimedia products. Mix and match to create a package that is perfect for your course! TEXTBOOK Customize your version of Fundamentals 11e through McGraw-Hill’s Create platform. Teach the chapters you want in the order you want—your rep can show you how! INSTRUCTOR RESOURCES Keep all the supplements in one place! Your Connect Library contains all the necessary supplements — Instructor’s Manual, Solutions, Test Bank, Computerized Test Bank, and PowerPoint—all in one easy-to-find, easy-to-use, integrated place: your Connect Finance course. Instructor’s Manual (IM) Prepared by Denver Travis, Eastern Kentucky University A great place to find new lecture ideas! The annotated outline for each chapter includes lecture tips, real-world tips, ethics notes, suggested PowerPoint slides, and, when appropriate, a video synopsis. Solutions Manual (SM) Prepared by Brad Jordan, University of Kentucky, and Joseph Smolira, Belmont University The Fundamentals Solutions Manual provides detailed solutions to the extensive end-of-chapter material, including concept review questions, quantitative problems, and cases.  Test Bank Prepared by Kay Johnson Over 100 questions and problems per chapter ! Each chapter includes questions that test the understanding of key terms in the book; questions patterned after learning objectives, concept questions, chapter opening vignettes, boxes, and highlighted phrases; multiple-choice problems patterned after end-of-chapter questions at a variety of skill levels; and essay questions to test problem-solving skills and more advanced understanding of concepts. Computerized Test Bank (Windows) Create your own tests in a snap! These additional questions are found in a computerized test bank utilizing McGraw-Hill’s EZ Test testing software to quickly create customized exams. This user- friendly program allows instructors to sort questions by format; edit existing questions or add new ones; and scramble questions for multiple versions of the same test. PowerPoint Presentations Prepared by Denver Travis, Eastern Kentucky University The PowerPoint slides for the 11th edition have been revised to include a wealth of instructor material, including lecture tips, real-world examples, and international notes. Each presentation now also includes slides dedicated entirely to ethics notes that relate to the chapter topics. In addition, the PPTs provide exhibits and examples both from the book and from outside sources. Applicable slides have Web links that take you directly to specific Internet sites, or a spreadsheet link to show an example in Excel. Go to the Notes Page xxiii Page function for more tips and information while presenting the slides to your class. STUDENT RESOURCES Student resources for this edition can be found through the Library tab in your Connect Finance course. If you aren’t using Connect, visit us at http://connect.mheducation.com to learn more, and ask your professor about using it in your course for access to a great group of supplement resources! Excel Resources For those seeking additional practice, students can access Excel template problems and Excel Master, designed by Brad Jordan and Joe Smolira. Narrated PowerPoint Slides The Narrated PowerPoints provide real-world examples accompanied by step-by-step instructions and explanations for solving problems presented in the chapter. The Concept Checks from the text  are also integrated into the slides to reinforce the key topics in the chapter. Designed specifically to appeal to the different learning methods of students, the slides provide a visual and audio explanation of topics and problems. Click on the slide and listen to the accompanying narration! TEACHING SUPPORT Along with having access to all of the student resource materials through the Connect Library tab, you also have password-protected access to the Instructor’s Manual, solutions to end-of-chapter problems and cases, Instructor’s PowerPoint, Excel Template Solutions, video clips, and video projects and questions. HOW THE MARKET WORKS Students receive free access to this Web-based portfolio simulation with a hypothetical brokerage account to buy and sell stocks and mutual funds. Students can use the real data found at this site in conjunction with the chapters on investments. They can also compete against students in their class, and around the United States to run the most successful portfolio. This site is powered by Stock- Trak, the leading provider of investment simulation services to the academic community. AVAILABLE FOR PURCHASE & PACKAGING FinGame Online 5.0 By LeRoy Brooks, John Carroll University (ISBN 10: 0077219880/ISBN 13: 9780077219888) Just $15.00 when packaged with this text. In this comprehensive simulation game, students control a hypothetical company over numerous periods of operation. The game is now tied to the text by exercises found on the Connect Student Library. As students make major financial and operating decisions for their company, they will develop and enhance their skills in financial management and financial accounting statement analysis. FINANCIAL ANALYSIS WITH AN Page xxiv ELECTRONIC CALCULATOR, SIXTH EDITION by Mark A. White, University of Virginia, McIntire School of Commerce (ISBN 10: 0073217093/ISBN 13: 9780073217093) The information and procedures in this supplementary text enable students to master the use of financial calculators and develop a working knowledge of financial mathematics and problem solving. Complete instructions are included for solving all major problem types on four popular models: HP 10B and 12C, TI BA II Plus, and TI-84. Hands-on problems with detailed solutions allow students to practice the skills outlined in the text and obtain instant reinforcement. Financial Analysis with an Electronic Calculator is a self-contained supplement to the introductory financial management course. MCGRAW-HILL’S CONNECT FINANCE LESS MANAGING. MORE TEACHING. GREATER LEARNING. McGraw-Hill’s Connect Finance is an online assignment and assessment solution that connects students with the tools and resources they’ll need to achieve success. McGraw-Hill’s Connect Finance helps prepare students for their future by enabling faster learning, more efficient studying, and higher retention of knowledge. MCGRAW-HILL’S CONNECT FINANCE FEATURES Connect Finance offers a number of powerful tools and features to make managing assignments easier, so faculty can spend more time teaching. With Connect Finance, students can engage with their coursework anytime and anywhere, making the learning process more accessible and efficient. Connect Finance offers you the features described below. Simple Assignment Management With Connect Finance, creating assignments is easier than ever, so you can spend more time teaching and less time managing. The assignment management function enables you to: Create and deliver assignments easily with selectable end-of-chapter questions and test bank items. Streamline lesson planning, student progress reporting, and assignment grading to make classroom management more efficient than ever. Go paperless with the eBook and online submission and grading of student assignments. Smart Grading When it comes to studying, time is precious. Connect Finance helps students learn more efficiently by providing feedback and practice material when they need it, where they need it. When it comes to teaching, your time also is precious. The grading function enables you to: Have assignments scored automatically, giving students immediate feedback on their work and side-by-side comparisons with correct answers. Access and review each response; manually change grades or leave comments for students to review. Reinforce classroom concepts with practice tests and instant quizzes. Instructor Library The Connect Finance Instructor Library is your repository for additional Page xxv resources to improve student engagement in and out of class. You can select and use any asset that enhances your lecture. The Connect Finance Instructor Library includes all of the instructor supplements for this text. Student Study Center The Connect Finance Student Study Center is the place for students to access additional resources. The Student Study Center: Offers students quick access to lectures, practice materials, eBooks, and more. Provides instant practice material and study questions, easily accessible on the go. Student Progress Tracking Connect Finance keeps instructors informed about how each student, section, and class is performing, allowing for more productive use of lecture and office hours. The progress-tracking function enables you to: View scored work immediately and track individual or group performance with assignment and grade reports. Access an instant view of student or class performance relative to learning objectives. Collect data and generate reports required by many accreditation organizations, such as AACSB. Continually evolving, McGraw-Hill Connect has been redesigned to provide the only true adaptive learning experience delivered within a simple and easy-to-navigate environment, placing students at the very center. Performance Analytics—Now available for both instructors and students, easy-to-decipher data illuminates course performance. Students always know how they’re doing in class, while  instructors can view student and section performance at-a-glance. Mobile—Available on tablets, students can now access assignments, quizzes, and results on-the- go, while instructors can assess student and section performance anytime, anywhere. Personalized Learning—Squeezing the most out of study time, the adaptive engine in Connect creates a highly personalized learning path for each student by identifying areas of weakness, and surfacing learning resources to assist in the moment of need. This seamless integration of reading, practice, and assessment, ensures that the focus is on the most important content for that individual student at that specific time, while promoting long-term retention of the material. http://connect.mheducation.com DIAGNOSTIC AND ADAPTIVE LEARNING OF CONCEPTS: LEARNSMART Students want to make the best use of their study time. The LearnSmart adaptive self-study technology within Connect Finance provides students with a seamless combination of practice, assessment, and remediation for every concept in the textbook. LearnSmart’s intelligent software adapts to every student response and automatically delivers concepts that advance students’ understanding while reducing time devoted to the concepts already mastered. The result for every student is the fastest path to mastery of the chapter Page xxvi concepts. LearnSmart: Applies an intelligent concept engine to identify the relationships between concepts and to serve new concepts to each student only when he or she is ready. Adapts automatically to each student, so students spend less time on the topics they understand and practice more those they have yet to master. Provides continual reinforcement and remediation, but gives only as much guidance as students need. Integrates diagnostics as part of the learning experience. Enables you to assess which concepts students have efficiently learned on their own, thus freeing class time for more applications and discussion. SMARTBOOK Smartbook is an extension of LearnSmart— an adaptive eBook that helps students focus their study time more effectively. As students read, Smartbook assesses comprehension and dynamically highlights where they need to study more. For more information about Connect, go to http://connect.mheducation.com, or contact your local McGraw-Hill sales representative. TEGRITY CAMPUS: LECTURES 24/7 Tegrity Campus is a service that makes class time available 24/7 by automatically capturing every lecture in a searchable format for students to review when they study and complete assignments. With a simple one-click start-and-stop process, you capture all computer screens and corresponding audio. Students can replay any part of the class with easy-to-use browser-based viewing on a PC or Mac. Educators know that the more students can see, hear, and experience class resources, the better they learn. In fact, studies prove it. With Tegrity Campus, students quickly recall key moments by using Tegrity Campus’s unique search feature. This search helps students efficiently find what they need, when they need it, across an entire semester of class recordings. Help turn all your students’ study time into learning moments immediately supported by your lecture. To learn more about Tegrity, watch a 2-minute Flash demo at www.tegrity.com. MCGRAW-HILL CUSTOMER CARE CONTACT INFORMATION At McGraw-Hill, we understand that getting the most from new technology can be challenging. That’s why our services don’t stop after you purchase our products. You can chat with our Product Specialists 24 hours a day to get product training online. Or you can search our knowledge bank of Frequently Asked Questions on our support website. For Customer Support, call 800-331-5094, or visit mpss.mhhe.com. One of our Technical Support Analysts will be able to assist you in a timely fashion. Assurance of Learning Ready Assurance of Learning is an important element of many accreditation standards. Fundamentals of Corporate Finance, 11e, is designed specifically to support your assurance of learning initiatives. Each chapter in the book begins with a list of numbered learning objectives that appear throughout the chapter, as well as in the end-of-chapter problems and exercises. Every test bank question is also linked to one of these objectives, in addition to Page xxvii level of difficulty, topic area, Bloom’s Taxonomy level, and AACSB skill area. Connect, McGraw-Hill’s online homework solution, and EZ Test, McGraw-Hill’s easy-to-use test bank software, can search the test bank using these and other categories, providing an engine for targeted Assurance of Learning analysis and assessment. AACSB Statement McGraw-Hill Education is a proud corporate member of AACSB International. Understanding the importance and value of AACSB Accreditation, Fundamentals of Corporate Finance, 11e, has sought to recognize the curricula guidelines detailed in the AACSB standards for business accreditation by connecting selected questions in the test bank to the general knowledge and skill guidelines found in the AACSB standards. The statements contained in Fundamentals of Corporate Finance, 11e, are provided only as a guide for the users of this text. The AACSB leaves content coverage and assessment within the purview of individual schools, the mission of the school, and the faculty. While Fundamentals of Corporate Finance, 11e, and the teaching package make no claim of any specific AACSB qualification or evaluation, we have, within the test bank, labeled selected questions according to the eight general knowledge and skills areas.  Page xxviii Acknowledgments To borrow a phrase, writing an introductory finance textbook is easy—all you do is sit down at a word processor and open a vein. We never would have completed this book without the incredible amount of help and support we received from literally hundreds of our colleagues, students, editors, family members, and friends. We would like to thank, without implicating, all of you. Clearly, our greatest debt is to our many colleagues (and their students) who, like us, wanted to try an alternative to what they were using and made the decision to change. Needless to say, without this support, we would not be publishing an 11th edition! A great many of our colleagues read the drafts of our first and subsequent editions. The fact that this book has so little in common with our earliest drafts, along with the many changes and improvements we have made over the years, is a reflection of the value we placed on the many comments and suggestions that we received. To the following reviewers, then, we are grateful for their many contributions: Ibrahim Affeneh Jan Ambrose Mike Anderson Sung C. Bae Robert Benecke Gary Benesh Scott Besley Sanjai Bhaghat Vigdis Boasson Elizabeth Booth Denis Boudreaux Jim Boyd William Brent Ray Brooks Charles C. Brown Lawrence Byerly Steve Byers Steve Caples Asim Celik Christina Cella Mary Chaffin Fan Chen Raju Chenna Barbara J. Childs Charles M. Cox Natalya Delcoure Michael Dorigan David A. Dumpe Michael Dunn Alan Eastman Adrian C. Edwards Uchenna Elike Steve Engel Angelo V. Esposito James Estes Cheri Etling Thomas H. Eyssell Dave Fehr Michael Ferguson Deborah Ann Ford Jim Forjan Micah Frankel Jennifer R. Frazier Deborah M. Giarusso Devra Golbe A. Steven Graham Mark Graham Darryl E. J. Gurley Wendy D. Habegger Karen Hallows David Harraway John M. Harris, Jr. R. Stevenson Hawkey Delvin D. Hawley Eric Haye Robert C. Higgins Karen Hogan Matthew Hood Steve Isberg James Jackson Pankaj Jain James M. Johnson Randy Jorgensen Daniel Jubinski Jarl G. Kallberg Ashok Kapoor Terry Keasler Howard Keen David N. Ketcher Jim Keys Kee Kim Deborah King Robert Kleinman Ladd Kochman Sophie Kong David Kuipers Morris A. Lamberson Qin Lan Dina Layish Chun Lee Adam Y. C. Lei George Lentz John Lightstone Jason Lin Scott Lowe Robert Lutz Qingzhong Ma Pawan Madhogarhia Timothy Manuel David G. Martin Dubos J. Masson Mario Mastrandrea Leslie Mathis John McDougald Bob McElreath Bahlous Mejda Page xxix Gordon Melms Richard R. Mendenhall Wayne Mikkelson Lalatendu Misra Karlyn Mitchell Sunil Mohanty Scott Moore Belinda Mucklow Barry Mulholland Frederick H. Mull Michael J. Murray Randy Nelson Oris Odom Keith Osher Bulent Parker Megan Partch Samuel Penkar Pamela P. Peterson Robert Phillips Greg Pierce Steve Pilloff Robert Puelz George A. Racette Charu G. Raheja Narendar V. Rao Russ Ray Ron Reiber Thomas Rietz Jay R. Ritter Ricardo J. Rodriguez Stu Rosenstein Kenneth Roskelley Ivan Roten Philip Russel Gary Sanger Travis Sapp Martha A. Schary Robert Schwebach Roger Severns Michael Sher Dilip K. Shome Neil W. Sicherman Timothy Smaby Ahmad Sohrabian Michael F. Spivey Vic Stanton Charlene Sullivan Alice Sun George S. Swales, Jr. Lee Swartz Philip Swensen Philip Swicegood Brian Tarrant Rhonda Tenkku John G. Thatcher Harry Thiewes A. Frank Thompson Joseph Trefzger George Turk Michael R. Vetsuypens Joe Walker Jun Wang James Washam Alan Weatherford Gwendolyn Webb Marsha Weber Jill Wetmore Mark White Susan White Annie Wong Colbrin Wright David J. Wright Steve B. Wyatt Tung-Hsiao Yang Morris Yarmish Michael Young Mei Zhang J. Kenton Zumwalt Tom Zwirlein Several of our most respected colleagues contributed original essays for this edition, which are entitled “In Their Own Words,” and appear in selected chapters. To these individuals we extend a special thanks: Edward I. Altman New York University Robert C. Higgins University of Washington Roger Ibbotson Yale University, Ibbotson Associates Erik Lie University of Iowa Robert C. Merton Harvard University Jay R. Ritter University of Florida Richard Roll California Institute of Technology Fischer Black Jeremy Siegel University of Pennsylvania Hersh Shefrin Santa Clara University Bennett Stewart Stern Stewart & Co. Samuel C. Weaver Lehigh University Merton H. Miller We are lucky to have had skilled and experienced instructors developing the supplement material for this edition. Thank you to Eric McLaughlin for his work thoroughly revising and updating the PowerPoint presentations and for organizing and distributing the wealth of annotated instructor notes from the book into these teaching materials. We greatly appreciate the contributions of Joe Smolira, Belmont University, who worked closely with us to develop the Solutions Manual and to create Excel Templates for many of the end-of-chapter problems. Thank you also to Kay Johnson for thorough updating, revising, and tagging of every problem in Page xxx the test bank. Thanks to Denver Travis for expertly developing and reviewing the PowerPoint slides and Instructor’s Manual for the eleventh edition. The following University of Kentucky students did outstanding work on this edition of Fundamentals: Andrew Beeli and Steve Hailey. To them fell the unenviable task of technical proofreading, and in particular, careful checking of each calculation throughout the text and Instructor’s Manual. Finally, in every phase of this project, we have been privileged to have had the complete and unwavering support of a great organization, McGraw-Hill Education. We especially thank the sales group. The suggestions they provide, their professionalism in assisting potential adopters, and the service they provide to current users have been a major factor in our success. We are deeply grateful to the select group of professionals who served as our development team on this edition: Chuck Synovec, Executive Brand Manager; Jennifer Upton, Product Developer; Melissa Caughlin, Executive Marketing Manager; Kathryn Wright, Core Project Manager; Matt Diamond, Designer; Bruce Gin, Assessment Project Manager. Others at McGraw-Hill/Irwin, too numerous to list here, have improved the book in countless ways. Throughout the development of this edition, we have taken great care to discover and eliminate errors. Our goal is to provide the best textbook available on the subject. To ensure that future editions are error-free, we gladly offer $10 per arithmetic error to the first individual reporting it as a modest token of our appreciation. More than this, we would like to hear from instructors and students alike. Please write and tell us how to make this a better text. Forward your comments to: Dr. Brad Jordan, c/o Editorial—Finance, McGraw-Hill Education, 1333 Burr Ridge Parkway, Burr Ridge, IL 60527. Stephen A. Ross Randolph W. Westerfield Bradford D. Jordan  Page xxxi Brief Contents PART 1 Overview of Corporate Finance CHAPTER 1 INTRODUCTION TO CORPORATE FINANCE CHAPTER 2 FINANCIAL STATEMENTS, TAXES, AND CASH FLOW PART 2 Financial Statements and Long-Term Financial Planning CHAPTER 3 WORKING WITH FINANCIAL STATEMENTS CHAPTER 4 LONG-TERM FINANCIAL PLANNING AND GROWTH PART 3 Valuation of Future Cash Flows CHAPTER 5 INTRODUCTION TO VALUATION: THE TIME VALUE OF MONEY CHAPTER 6 DISCOUNTED CASH FLOW VALUATION CHAPTER 7 INTEREST RATES AND BOND VALUATION CHAPTER 8 STOCK VALUATION PART 4 Capital Budgeting CHAPTER 9 NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA CHAPTER 10 MAKING CAPITAL INVESTMENT DECISIONS CHAPTER 11 PROJECT ANALYSIS AND EVALUATION PART 5 Risk and Return CHAPTER 12 SOME LESSONS FROM CAPITAL MARKET HISTORY CHAPTER 13 RETURN, RISK, AND THE SECURITY MARKET LINE PART 6 Cost of Capital and Long-Term Financial Policy CHAPTER 14 COST OF CAPITAL CHAPTER 15 RAISING CAPITAL CHAPTER 16 FINANCIAL LEVERAGE AND CAPITAL STRUCTURE POLICY CHAPTER 17 DIVIDENDS AND PAYOUT POLICY Page xxxii PART 7 Short-Term Financial Planning and Management CHAPTER 18 SHORT-TERM FINANCE AND PLANNING CHAPTER 19 CASH AND LIQUIDITY MANAGEMENT CHAPTER 20 CREDIT AND INVENTORY MANAGEMENT PART 8 Topics in Corporate Finance CHAPTER 21 INTERNATIONAL CORPORATE FINANCE CHAPTER 22 BEHAVIORAL FINANCE: IMPLICATIONS FOR FINANCIAL MANAGEMENT CHAPTER 23 ENTERPRISE RISK MANAGEMENT CHAPTER 24 OPTIONS AND CORPORATE FINANCE CHAPTER 25 OPTION VALUATION CHAPTER 26 MERGERS AND ACQUISITIONS CHAPTER 27 LEASING  Contents PART 1 Overview of Corporate Finance CHAPTER 1 INTRODUCTION TO CORPORATE FINANCE 1.1 Corporate Finance and the Financial Manager What Is Corporate Finance? The Financial Manager Financial Management Decisions Capital Budgeting Capital Structure Working Capital Management Conclusion 1.2 Forms of Business Organization Sole Proprietorship Partnership Corporation A Corporation by Another Name... 1.3 The Goal of Financial Management Possible Goals The Goal of Financial Management A More General Goal Sarbanes-Oxley 1.4 The Agency Problem and Control of the Corporation Agency Relationships Management Goals Do Managers Act in the Stockholders’ Interests? Managerial Compensation Control of the Firm Conclusion Stakeholders 1.5 Financial Markets and the Corporation Cash Flows to and from the Firm Primary versus Secondary Markets Primary Markets Secondary Markets  Dealer versus Auction Markets Trading in Corporate Securities Listing 1.6 Summary and Conclusions CHAPTER 2 FINANCIAL STATEMENTS, TAXES, AND CASH FLOW 2.1 The Balance Sheet Assets: The Left Side Liabilities and Owners’ Equity: The Right Side Net Working Capital Liquidity Debt versus Equity Market Value versus Book Value 2.2 The Income Statement GAAP and the Income Statement Noncash Items Time and Costs 2.3 Taxes Corporate Tax Rates Average versus Marginal Tax Rates 2.4 Cash Flow Cash Flow from Assets Operating Cash Flow Capital Spending Change in Net Working Capital Conclusion A Note about “Free” Cash Flow Cash Flow to Creditors and Stockholders Cash Flow to Creditors Cash Flow to Stockholders An Example: Cash Flows for Dole Cola Operating Cash Flow Net Capital Spending Change in NWC and Cash Flow from Assets Cash Flow to Stockholders and Creditors 2.5 Summary and Conclusions PART 2 Financial Statements and Long-Term Financial Planning CHAPTER 3 WORKING WITH FINANCIAL STATEMENTS 3.1 Cash Flow and Financial Statements: A Closer Look  Sources and Uses of Cash The Statement of Cash Flows 3.2 Standardized Financial Statements Common-Size Statements Common-Size Balance Sheets Common-Size Income Statements Common-Size Statements of Cash Flows Common-Base Year Financial Statements: Trend Analysis Combined Common-Size and Base Year Analysis 3.3 Ratio Analysis Short-Term Solvency, or Liquidity, Measures Current Ratio The Quick (or Acid-Test) Ratio Other Liquidity Ratios Long-Term Solvency Measures Total Debt Ratio A Brief Digression: Total Capitalization versus Total Assets Times Interest Earned Cash Coverage Asset Management, or Turnover, Measures Inventory Turnover and Days’ Sales in Inventory Receivables Turnover and Days’ Sales in Receivables Asset Turnover Ratios Profitability Measures Profit Margin Return on Assets Return on Equity Market Value Measures Price–Earnings Ratio Price–Sales Ratio Market-to-Book Ratio Enterprise Value–EBITDA Ratio Conclusion 3.4 The DuPont Identity A Closer Look at Roe An Expanded Dupont Analysis 3.5 Using Financial Statement Information Why Evaluate Financial Statements?  Internal Uses External Uses Choosing a Benchmark Time Trend Analysis Peer Group Analysis Problems with Financial Statement Analysis 3.6 Summary and Conclusions CHAPTER 4 LONG-TERM FINANCIAL PLANNING AND GROWTH 4.1 What Is Financial Planning? Growth as a Financial Management Goal Dimensions of Financial Planning What Can Planning Accomplish? Examining Interactions Exploring Options Avoiding Surprises Ensuring Feasibility and Internal Consistency Conclusion 4.2 Financial Planning Models: A First Look A Financial Planning Model: The Ingredients Sales Forecast Pro Forma Statements Asset Requirements Financial Requirements The Plug Economic Assumptions A Simple Financial Planning Model 4.3 The Percentage of Sales Approach The Income Statement The Balance Sheet A Particular Scenario An Alternative Scenario 4.4 External Financing and Growth EFN and Growth Financial Policy and Growth The Internal Growth Rate The Sustainable Growth Rate Determinants of Growth A Note about Sustainable Growth Rate Calculations  4.5 Some Caveats Regarding Financial Planning Models 4.6 Summary and Conclusions PART 3 Valuation of Future Cash Flows CHAPTER 5 INTRODUCTION TO VALUATION: THE TIME VALUE OF MONEY 5.1 Future Value and Compounding Investing for a Single Period Investing for More Than One Period A Note about Compound Growth 5.2 Present Value and Discounting The Single-Period Case Present Values for Multiple Periods 5.3 More about Present and Future Values Present versus Future Value Determining the Discount Rate Finding the Number of Periods 5.4 Summary and Conclusions CHAPTER 6 DISCOUNTED CASH FLOW VALUATION 6.1 Future and Present Values of Multiple Cash Flows Future Value with Multiple Cash Flows Present Value with Multiple Cash Flows A Note about Cash Flow Timing 6.2 Valuing Level Cash Flows: Annuities and Perpetuities Present Value for Annuity Cash Flows Annuity Tables Finding the Payment Finding the Rate Future Value for Annuities A Note about Annuities Due Perpetuities Growing Annuities and Perpetuities 6.3 Comparing Rates: The Effect of Compounding Effective Annual Rates and Compounding Calculating and Comparing Effective Annual Rates EARs and APRs Taking It to the Limit: A Note about Continuous Compounding 6.4 Loan Types and Loan Amortization Pure Discount Loans  Interest-Only Loans Amortized Loans 6.5 Summary and Conclusions CHAPTER 7 INTEREST RATES AND BOND VALUATION 7.1 Bonds and Bond Valuation Bond Features and Prices Bond Values and Yields Interest Rate Risk Finding the Yield to Maturity: More Trial and Error 7.2 More about Bond Features Is It Debt or Equity? Long-Term Debt: The Basics The Indenture Terms of a Bond Security Seniority Repayment The Call Provision Protective Covenants 7.3 Bond Ratings 7.4 Some Different Types of Bonds Government Bonds Zero Coupon Bonds Floating-Rate Bonds Other Types of Bonds Sukuk 7.5 Bond Markets How Bonds are Bought and Sold Bond Price Reporting A Note about Bond Price Quotes 7.6 Inflation and Interest Rates Real versus Nominal Rates The Fisher Effect Inflation and Present Values 7.7 Determinants of Bond Yields The Term Structure of Interest Rates Bond Yields and the Yield Curve: Putting It All Together Conclusion 7.8 Summary and Conclusions  CHAPTER 8 STOCK VALUATION 8.1 Common Stock Valuation Cash Flows Some Special Cases Zero Growth Constant Growth Nonconstant Growth Two-Stage Growth Components of the Required Return Stock Valuation Using Multiples 8.2 Some Features of Common and Preferred Stocks Common Stock Features Shareholder Rights Proxy Voting Classes of Stock Other Rights Dividends Preferred Stock Features Stated Value Cumulative and Noncumulative Dividends Is Preferred Stock Really Debt? 8.3 The Stock Markets Dealers and Brokers Organization of the NYSE Members Operations Floor Activity NASDAQ Operations ECNs Stock Market Reporting 8.4 Summary and Conclusions PART 4 Capital Budgeting CHAPTER 9 NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA 9.1 Net Present Value The Basic Idea Estimating Net Present Value 9.2 The Payback Rule Defining the Rule  Analyzing the Rule Redeeming Qualities of the Rule Summary of the Rule 9.3 The Discounted Payback 9.4 The Average Accounting Return 9.5 The Internal Rate of Return Problems with The IRR Nonconventional Cash Flows Mutually Exclusive Investments Investing or Financing? Redeeming Qualities of the IRR The Modified Internal Rate of Return (MIRR) Method #1: The Discounting Approach Method #2: The Reinvestment Approach Method #3: The Combination Approach MIRR or IRR: Which Is Better? 9.6 The Profitability Index 9.7 The Practice of Capital Budgeting 9.8 Summary and Conclusions CHAPTER 10 MAKING CAPITAL INVESTMENT DECISIONS 10.1 Project Cash Flows: A First Look Relevant Cash Flows The Stand-Alone Principle 10.2 Incremental Cash Flows Sunk Costs Opportunity Costs Side Effects Net Working Capital Financing Costs Other Issues 10.3 Pro Forma Financial Statements and Project Cash Flows Getting Started: Pro Forma Financial Statements Project Cash Flows Project Operating Cash Flow Project Net Working Capital and Capital Spending Projected Total Cash Flow and Value 10.4 More about Project Cash Flow A Closer Look at Net Working Capital Depreciation  Modified ACRS Depreciation (MACRS) Book Value versus Market Value An Example: The Majestic Mulch and Compost Company (MMCC) Operating Cash Flows Change in NWC Capital Spending Total Cash Flow and Value Conclusion 10.5 Alternative Definitions of Operating Cash Flow The Bottom-Up Approach The Top-Down Approach The Tax Shield Approach Conclusion 10.6 Some Special Cases of Discounted Cash Flow Analysis Evaluating Cost-Cutting Proposals Setting the Bid Price Evaluating Equipment Options with Different Lives 10.7 Summary and Conclusions CHAPTER 11 PROJECT ANALYSIS AND EVALUATION 11.1 Evaluating NPV Estimates The Basic Problem Projected versus Actual Cash Flows Forecasting Risk Sources of Value 11.2 Scenario and Other What-If Analyses Getting Started Scenario Analysis Sensitivity Analysis Simulation Analysis 11.3 Break-Even Analysis Fixed and Variable Costs Variable Costs Fixed Costs Total Costs Accounting Break-Even Accounting Break-Even: A Closer Look Uses for the Accounting Break-Even 11.4 Operating Cash Flow, Sales Volume, and Break-Even  Accounting Break-Even and Cash Flow The Base Case Calculating the Break-Even Level Payback and Break-Even Sales Volume and Operating Cash Flow Cash Flow, Accounting, and Financial Break-Even Points Accounting Break-Even Revisited Cash Break-Even Financial Break-Even Conclusion 11.5 Operating Leverage The Basic Idea Implications of Operating Leverage Measuring Operating Leverage Operating Leverage and Break-Even 11.6 Capital Rationing Soft Rationing Hard Rationing 11.7 Summary and Conclusions PART 5 Risk and Return CHAPTER 12 SOME LESSONS FROM CAPITAL MARKET HISTORY 12.1 Returns Dollar Returns Percentage Returns 12.2 The Historical Record A First Look A Closer Look 12.3 Average Returns: The First Lesson Calculating Average Returns Average Returns: The Historical Record Risk Premiums The First Lesson 12.4 The Variability of Returns: The Second Lesson Frequency Distributions and Variability The Historical Variance and Standard Deviation The Historical Record Normal Distribution The Second Lesson  2008: The Bear Growled and Investors Howled Using Capital Market History More on the Stock Market Risk Premium 12.5 More about Average Returns Arithmetic versus Geometric Averages Calculating Geometric Average Returns Arithmetic Average Return or Geometric Average Return? 12.6 Capital Market Efficiency Price Behavior in an Efficient Market The Efficient Markets Hypothesis Some Common Misconceptions about the EMH The Forms of Market Efficiency 12.7 Summary and Conclusions CHAPTER 13 RETURN, RISK, AND THE SECURITY MARKET LINE 13.1 Expected Returns and Variances Expected Return Calculating the Variance 13.2 Portfolios Portfolio Weights Portfolio Expected Returns Portfolio Variance 13.3 Announcements, Surprises, and Expected Returns Expected and Unexpected Returns Announcements and News 13.4 Risk: Systematic and Unsystematic Systematic and Unsystematic Risk Systematic and Unsystematic Components of Return 13.5 Diversification and Portfolio Risk The Effect of Diversification: Another Lesson from Market History The Principle of Diversification Diversification and Unsystematic Risk Diversification and Systematic Risk 13.6 Systematic Risk and Beta The Systematic Risk Principle Measuring Systematic Risk Portfolio Betas 13.7 The Security Market Line  Beta and the Risk Premium The Reward-to-Risk Ratio The Basic Argument The Fundamental Result The Security Market Line Market Portfolios The Capital Asset Pricing Model 13.8 The SML and the Cost of Capital: A Preview The Basic Idea The Cost of Capital 13.9 Summary and Conclusions PART 6 Cost of Capital and Long-Term Financial Policy CHAPTER 14 COST OF CAPITAL 14.1 The Cost of Capital: Some Preliminaries Required Return versus Cost of Capital Financial Policy and Cost of Capital 14.2 The Cost of Equity The Dividend Growth Model Approach Implementing the Approach Estimating G Advantages and Disadvantages of the Approach The SML Approach Implementing the Approach Advantages and Disadvantages of the Approach 14.3 The Costs of Debt and Preferred Stock The Cost of Debt The Cost of Preferred Stock 14.4 The Weighted Average Cost of Capital The Capital Structure Weights Taxes and the Weighted Average Cost of Capital Calculating the WACC for Eastman Chemical Eastman’s Cost of Equity Eastman’s Cost of Debt Eastman’s WACC Solving the Warehouse Problem and Similar Capital Budgeting Problems Performance Evaluation: Another Use of the WACC 14.5 Divisional and Project Costs of Capital The SML and the WACC  Divisional Cost of Capital The Pure Play Approach The Subjective Approach 14.6 Company Valuation With The WACC 14.7 Flotation Costs and the Average Cost of Capital The Basic Approach Flotation Costs and NPV Internal Equity and Flotation Costs 14.8 Summary and Conclusions CHAPTER 15 RAISING CAPITAL 15.1 The Financing Life Cycle of a Firm: Early-Stage Financing and Venture Capital Venture Capital Some Venture Capital Realities Choosing a Venture Capitalist Conclusion 15.2 Selling Securities to the Public: The Basic Procedure Crowdfunding 15.3 Alternative Issue Methods 15.4 Underwriters Choosing an Underwriter Types of Underwriting Firm Commitment Underwriting Best Efforts Underwriting Dutch Auction Underwriting The Aftermarket The Green Shoe Provision Lockup Agreements The Quiet Period 15.5 IPOs and Underpricing IPO Underpricing: The 1999–2000 Experience Evidence on Underpricing Why Does Underpricing Exist? 15.6 New Equity Sales and the Value of the Firm 15.7 The Costs of Issuing Securities The Costs of Selling Stock to the Public The Costs of Going Public: A Case Study 15.8 Rights The Mechanics of a Rights Offering  Number of Rights Needed to Purchase a Share The Value of a Right Ex Rights The Underwriting Arrangements Effects on Shareholders 15.9 Dilution Dilution of Proportionate Ownership Dilution of Value: Book versus Market Values A Misconception The Correct Arguments 15.10 Issuing Long-Term Debt 15.11 Shelf Registration 15.12 Summary and Conclusions CHAPTER 16 FINANCIAL LEVERAGE AND CAPITAL STRUCTURE POLICY 16.1 The Capital Structure Question Firm Value and Stock Value: An Example Capital Structure and the Cost of Capital 16.2 The Effect of Financial Leverage The Basics of Financial Leverage Financial Leverage, EPS, and ROE: An Example EPS versus EBIT Corporate Borrowing and Homemade Leverage 16.3 Capital Structure and the Cost of Equity Capital M&M Proposition I: The Pie Model The Cost of Equity and Financial Leverage: M&M Proposition II Business and Financial Risk 16.4 M&M Propositions I and II with Corporate Taxes The Interest Tax Shield Taxes and M&M Proposition I Taxes, the WACC, and Proposition II Conclusion 16.5 Bankruptcy Costs Direct Bankruptcy Costs Indirect Bankruptcy Costs 16.6 Optimal Capital Structure The Static Theory of Capital Structure Optimal Capital Structure and the Cost of Capital  Optimal Capital Structure: A Recap Capital Structure: Some Managerial Recommendations Taxes Financial Distress 16.7 The Pie Again The Extended Pie Model Marketed Claims versus Nonmarketed Claims 16.8 The Pecking-Order Theory Internal Financing and the Pecking Order Implications of the Pecking Order 16.9 Observed Capital Structures 16.10 A Quick Look at the Bankruptcy Process Liquidation and Reorganization Bankruptcy Liquidation Bankruptcy Reorganization Financial Management and the Bankruptcy Process Agreements to Avoid Bankruptcy 16.11 Summary and Conclusions CHAPTER 17 DIVIDENDS AND PAYOUT POLICY 17.1 Cash Dividends and Dividend Payment Cash Dividends Standard Method of Cash Dividend Payment Dividend Payment: A Chronology More about the Ex-Dividend Date 17.2 Does Dividend Policy Matter? An Illustration of the Irrelevance of Dividend Policy Current Policy: Dividends Set Equal to Cash Flow Alternative Policy: Initial Dividend Greater Than Cash Flow Homemade Dividends A Test 17.3 Real-World Factors Favoring a Low Dividend Payout Taxes Flotation Costs Dividend Restrictions 17.4 Real-World Factors Favoring a High Dividend Payout Desire for Current Income Tax and Other Benefits from High Dividends Corporate Investors  Tax-Exempt Investors Conclusion 17.5 A Resolution of Real-World Factors? Information Content of Dividends The Clientele Effect 17.6 Stock Repurchases: An Alternative to Cash Dividends Cash Dividends versus Repurchase Real-World Considerations in a Repurchase Share Repurchase and EPS 17.7 What We Know and Do Not Know about Dividend and Payout Policies Dividends and Dividend Payers Corporations Smooth Dividends Putting It All Together Some Survey Evidence on Dividends 17.8 Stock Dividends and Stock Splits Some Details about Stock Splits and Stock Dividends Example of a Small Stock Dividend Example of a Stock Split Example of a Large Stock Dividend Value of Stock Splits and Stock Dividends The Benchmark Case Popular Trading Range Reverse Splits 17.9 Summary and Conclusions PART 7 Short-Term Financial Planning and Management CHAPTER 18 SHORT-TERM FINANCE AND PLANNING 18.1 Tracing Cash and Net Working Capital 18.2 The Operating Cycle and the Cash Cycle Defining the Operating and Cash Cycles The Operating Cycle The Cash Cycle The Operating Cycle and the Firm’s Organizational Chart Calculating the Operating and Cash Cycles The Operating Cycle The Cash Cycle Interpreting the Cash Cycle 18.3 Some Aspects of Short-Term Financial Policy The Size of the Firm’s Investment in Current Assets  Alternative Financing Policies for Current Assets An Ideal Case Different Policies for Financing Current Assets Which Financing Policy Is Best? Current Assets and Liabilities in Practice 18.4 The Cash Budget Sales and Cash Collections Cash Outflows The Cash Balance 18.5 Short-Term Borrowing Unsecured Loans Compensating Balances Cost of a Compensating Balance Letters of Credit Secured Loans Accounts Receivable Financing Inventory Loans Other Sources 18.6 A Short-Term Financial Plan 18.7 Summary and Conclusions CHAPTER 19 CASH AND LIQUIDITY MANAGEMENT 19.1 Reasons for Holding Cash The Speculative and Precautionary Motives The Transaction Motive Compensating Balances Costs of Holding Cash Cash Management versus Liquidity Management 19.2 Understanding Float Disbursement Float Collection Float and Net Float Float Management Measuring Float Some Details Cost of the Float Ethical and Legal Questions Electronic Data Interchange and Check 21: The End of Float? 19.3 Cash Collection and Concentration Components of Collection Time  Cash Collection Lockboxes Cash Concentration Accelerating Collections: An Example 19.4 Managing Cash Disbursements Increasing Disbursement Float Controlling Disbursements Zero-Balance Accounts Controlled Disbursement Accounts 19.5 Investing Idle Cash Temporary Cash Surpluses Seasonal or Cyclical Activities Planned or Possible Expenditures Characteristics of Short-Term Securities Maturity Default Risk Marketability Taxes Some Different Types of Money Market Securities 19.6 Summary and Conclusions 19A Determining the Target Cash Balance The Basic Idea The Bat Model The Opportunity Costs The Trading Costs The Total Cost The Solution Conclusion The Miller–Orr Model: A More General Approach The Basic Idea Using the Model Implications of the BAT and Miller–Orr Models Other Factors Influencing the Target Cash Balance CHAPTER 20 CREDIT AND INVENTORY MANAGEMENT 20.1 Credit and Receivables Components of Credit Policy The Cash Flows from Granting Credit The Investment in Receivables 20.2 Terms of the Sale  The Basic Form The Credit Period The Invoice Date Length of the Credit Period Cash Discounts Cost of the Credit Trade Discounts The Cash Discount and the ACP Credit Instruments 20.3 Analyzing Credit Policy Credit Policy Effects Evaluating a Proposed Credit Policy NPV of Switching Policies A Break-Even Application 20.4 Optimal Credit Policy The Total Credit Cost Curve Organizing the Credit Function 20.5 Credit Analysis When Should Credit Be Granted? A One-Time Sale Repeat Business Credit Information Credit Evaluation and Scoring 20.6 Collection Policy Monitoring Receivables Collection Effort 20.7 Inventory Management The Financial Manager and Inventory Policy Inventory Types Inventory Costs 20.8 Inventory Management Techniques The ABC Approach The Economic Order Quantity Model Inventory Depletion The Carrying Costs The Restocking Costs The Total Costs Extensions to the EOQ Model Safety Stocks  Reorder Points Managing Derived-Demand Inventories Materials Requirements Planning Just-in-Time Inventory 20.9 Summary and Conclusions 20A More about Credit Policy Analysis Two Alternative Approaches The One-Shot Approach The Accounts Receivable Approach Discounts and Default Risk NPV of the Credit Decision A Break-Even Application PART 8 Topics in Corporate Finance CHAPTER 21 INTERNATIONAL CORPORATE FINANCE 21.1 Terminology 21.2 Foreign Exchange Markets and Exchange Rates Exchange Rates Exchange Rate Quotations Cross-Rates and Triangle Arbitrage Types of Transactions 21.3 Purchasing Power Parity Absolute Purchasing Power Parity Relative Purchasing Power Parity The Basic Idea The Result Currency Appreciation and Depreciation 21.4 Interest Rate Parity, Unbiased Forward Rates, and the International Fisher Effect Covered Interest Arbitrage Interest Rate Parity Forward Rates and Future Spot Rates Putting It All Together Uncovered Interest Parity The International Fisher Effect 21.5 International Capital Budgeting Method 1: The Home Currency Approach Method 2: The Foreign Currency Approach Unremitted Cash Flows 21.6 Exchange Rate Risk  Short-Run Exposure Long-Run Exposure Translation Exposure Managing Exchange Rate Risk 21.7 Political Risk 21.8 Summary and Conclusions CHAPTER 22 BEHAVIORAL FINANCE: IMPLICATIONS FOR FINANCIAL MANAGEMENT 22.1 Introduction to Behavioral Finance 22.2 Biases Overconfidence Overoptimism Confirmation Bias 22.3 Framing Effects Loss Aversion House Money 22.4 Heuristics The Affect Heuristic The Representativeness Heuristic Representativeness and Randomness The Gambler’s Fallacy 22.5 Behavioral Finance and Market Efficiency Limits to Arbitrage The 3Com/Palm Mispricing The Royal Dutch/Shell Price Ratio Bubbles and Crashes The Crash of 1929 The Crash of October 1987 The Nikkei Crash The “Dot-Com” Bubble and Crash 22.6 Market Efficiency and the Performance of Professional Money Managers 22.7 Summary and Conclusions CHAPTER 23 ENTERPRISE RISK MANAGEMENT 23.1 Insurance 23.2 Managing Financial Risk The Risk Profile Reducing Risk Exposure Hedging Short-Run Exposure  Cash Flow Hedging: A Cautionary Note Hedging Long-Term Exposure Conclusion 23.3 Hedging with Forward Contracts Forward Contracts: The Basics The Payoff Profile Hedging with Forwards A Caveat Credit Risk Forward Contracts in Practice 23.4 Hedging with Futures Contracts Trading in Futures Futures Exchanges Hedging with Futures 23.5 Hedging with Swap Contracts Currency Swaps Interest Rate Swaps Commodity Swaps The Swap Dealer Interest Rate Swaps: An Example 23.6 Hedging with Option Contracts Option Terminology Options versus Forwards Option Payoff Profiles Option Hedging Hedging Commodity Price Risk with Options Hedging Exchange Rate Risk with Options Hedging Interest Rate Risk with Options A Preliminary Note Interest Rate Caps Other Interest Rate Options Actual Use of Derivatives 23.7 Summary and Conclusions CHAPTER 24 OPTIONS AND CORPORATE FINANCE 24.1 Options: The Basics Puts and Calls Stock Option Quotations Option Payoffs 24.2 Fundamentals of Option Valuation  Value of a Call Option at Expiration The Upper and Lower Bounds on a Call Option’s Value The Upper Bound The Lower Bound A Simple Model: Part I The Basic Approach A More Complicated Case Four Factors Determining Option Values 24.3 Valuing a Call Option A Simple Model: Part II The Fifth Factor A Closer Look 24.4 Employee Stock Options ESO Features ESO Repricing ESO Backdating 24.5 Equity as a Call Option on the Firm’s Assets Case I: The Debt Is Risk-Free Case II: The Debt Is Risky 24.6 Options and Capital Budgeting The Investment Timing Decision Managerial Options Contingency Planning Options in Capital Budgeting: An Example Strategic Options Conclusion 24.7 Options and Corporate Securities Warrants The Difference between Warrants and Call Options Earnings Dilution Convertible Bonds Features of a Convertible Bond Value of a Convertible Bond Other Options The Call Provision on a Bond Put Bonds Insurance and Loan Guarantees 24.8 Summary and Conclusions CHAPTER 25 OPTION VALUATION  25.1 Put–Call Parity Protective Puts An Alternative Strategy The Result Continuous Compounding: A Refresher Course 25.2 The Black–Scholes Option Pricing Model The Call Option Pricing Formula Put Option Valuation A Cautionary Note 25.3 More about Black–Scholes Varying the Stock Price Varying the Time to Expiration Varying the Standard Deviation Varying the Risk-Free Rate Implied Standard Deviations 25.4 Valuation of Equity and Debt in a Leveraged Firm Valuing the Equity in a Leveraged Firm Options and the Valuation of Risky Bonds 25.5 Options and Corporate Decisions: Some Applications Mergers and Diversification Options and Capital Budgeting 25.6 Summary and Conclusions CHAPTER 26 MERGERS AND ACQUISITIONS 26.1 The Legal Forms of Acquisitions Merger or Consolidation Acquisition of Stock Acquisition of Assets Acquisition Classifications A Note about Takeovers Alternatives to Merger 26.2 Taxes and Acquisitions Determinants of Tax Status Taxable versus Tax-Free Acquisitions 26.3 Accounting for Acquisitions The Purchase Method More about Goodwill 26.4 Gains from Acquisitions Synergy Revenue Enhancement  Marketing Gains Strategic Benefits Market Power Cost Reductions Economies of Scale Economies of Vertical Integration Complementary Resources Lower Taxes Net Operating Losses Unused Debt Capacity Surplus Funds Asset Write-Ups Reductions in Capital Needs Avoiding Mistakes A Note about Inefficient Management 26.5 Some Financial Side Effects of Acquisitions EPS Growth Diversification 26.6 The Cost of an Acquisition Case I: Cash Acquisition Case II: Stock Acquisition Cash versus Common Stock 26.7 Defensive Tactics The Corporate Charter Repurchase and Standstill Agreements Poison Pills and Share Rights Plans Going Private and Leveraged Buyouts Other Devices and Jargon of Corporate Takeovers 26.8 Some Evidence on Acquisitions: Does M&A Pay? 26.9 Divestitures and Restructurings 26.10 Summary and Conclusions CHAPTER 27 LEASING 27.1 Leases and Lease Types Leasing versus Buying Operating Leases Financial Leases Tax-Oriented Leases Leveraged Leases Sale and Leaseback Agreements  27.2 Accounting and Leasing 27.3 Taxes, the IRS, and Leases 27.4 The Cash Flows from Leasing The Incremental Cash Flows A Note about Taxes 27.5 Lease or Buy? A Preliminary Analysis Three Potential Pitfalls NPV Analysis A Misconception 27.6 A Leasing Paradox 27.7 Reasons for Leasing Good Reasons for Leasing Tax Advantages A Reduction of Uncertainty Lower Transactions Costs Fewer Restrictions and Security Requirements Dubious Reasons for Leasing Leasing and Accounting Income 100 Percent Financing Low Cost Other Reasons for Leasing 27.8 Summary and Conclusions APPENDIX A MATHEMATICAL TABLES APPENDIX B KEY EQUATIONS APPENDIX C ANSWERS TO SELECTED END-OF-CHAPTER PROBLEMS APPENDIX D USING THE HP 10B AND TI BA II PLUS FINANCIAL CALCULATORS INDEX i ii iii iv v vi vii viii ix x xi xii xiii xiv xv xvi xvii xviii xix xx xxi xxii xxiii xxiv xxv xxvi xxvii xxviii xxix xxx xxxi xxxii xlv xlvi 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 100 101 102 103 104 105 106 107 108 109 110 111 112 113 114 115 116 117 118 119 120 121 122 123 124 125 126 127 128 129 130 131 132 133 134 135 136 137 138 139 140 141 142 143 144 145 146 147 148 149 150 151 152 153 154 155 156 157 158 159 160 161 162 163 164 165 166 167 168 169 170 171 172 173 174 175 176 177 178 179 180 181 182 183 184 185 186 187 188 189 190 191 192 193 194 195 196 197 198 199 200 201 202 203 204 205 206 207 208 209 210 211 212 213 214 215 216 217 218 219 220 221 222 223 224 225 226 227 228 229 230 231 232 233 234 235 236 237 238 239 240 241 242 243 244 245 246 247 248 249 250 251 252 253 254 255 256 257 258 259 260 261 262 263 264 265 266 267 268 269 270 271 272 273 274 275 276 277 278 279 280 281 282 283 284 285 286 287 288 289 290 291 292 293 294 295 296 297 298 299 300 301 302 303 304 305 306 307 308 309 310 311 312 313 314 315 316 317 318 319 320 321 322 323 324 325 326 327 328 329 330 331 332 333 334 335 336 337 338 339 340 341 342 343 344 345 346 347 348 349 350 351 352 353 354 355 356 357 358 359 360 361 362 363 364 365 366 367 368 369 370 371 372 373 374 375 376 377 378 379 380 381 382 383 384 385 386 387 388 389 390 391 392 393 394 395 396 397 398 399 400 401 402 403 404 405 406 407 408 409 410 411 412 413 414 415 416 417 418 419 420 421 422 423 424 425 426 427 428 429 430 431 432 433 434 435 436 437 438 439 440 441 442 443 444 445 446 447 448 449 450 451 452 453 454 455 456 457 458 459 460 461 462 463 464 465 466 467 468 469 470 471 472 473 474 475 476 477 478 479 480 481 482 483 484 485 486 487 488 489 490 491 492 493 494 495 496 497 498 499 500 501 502 503 504 505 506 507 508 509 510 511 512 513 514 515 516 517 518 519 520 521 522 523 524 525 526 527 528 529 530 531 532 533 534 535 536 537 538 539 540 541 542 543 544 545 546 547 548 549 550 551 552 553 554 555 556 557 558 559 560 561 562 563 564 565 566 567 568 569 570 571 572 573 574 575 576 577 578 579 580 581 582 583 584 585 586 587 588 589 590 591 592 593 594 595 596 597 598 599 600 601 602 603 604 605 606 607 608 609 610 611 612 613 614 615 616 617 618 619 620 621 622 623 624 625 626 627 628 629 630 631 632 633 634 635 636 637 638 639 640 641 642 643 644 645 646 647 648 649 650 651 652 653 654 655 656 657 658 659 660 661 662 663 664 665 666 667 668 669 670 671 672 673 674 675 676 677 678 679 680 681 682 683 684 685 686 687 688 689 690 691 692 693 694 695 696 697 698 699 700 701 702 703 704 705 706 707 708 709 710 711 712 713 714 715 716 717 718 719 720 721 722 723 724 725 726 727 728 729 730 731 732 733 734 735 736 737 738 739 740 741 742 743 744 745 746 747 748 749 750 751 752 753 754 755 756 757 758 759 760 761 762 763 764 765 766 767 768 769 770 771 772 773 774 775 776 777 778 779 780 781 782 783 784 785 786 787 788 789 790 791 792 793 794 795 796 797 798 799 800 801 802 803 804 805 806 807 808 809 810 811 812 813 814 815 816 817 818 819 820 821 822 823 824 825 826 827 828 829 830 831 832 833 834 835 836 837 838 839 840 841 842 843 844 845 846 847 848 849 850 851 852 853 854 855 856 857 858 859 860 861 862 863 864 865 866 867 868 869 870 871 872 873 874 875 876 877 878 879 880 881 882 883 884 885 886 887 888 889 890 891 892 893 894 895 896 897 898 899 900 901 902 903 904 905 906 907 908 909 910 911 912 913 914 A-1 A-2 A-3 A-4 A-5 A-6 A-7 A-8 A-9 A-10 B-1 B-2 B-3 B-4 B-5 B-6 C-1 C-2 C-3 C-4 D-1 D-2 D-3 D-4 I-1 I-2 I-3 I-4 I-5 I-6 I-7 I-8 I-9 I-10 I-11 I-12 I-13 I-14 I-15 I-16 I-17 I-18 I-19 Page xlv  In Their Own Words Boxes CHAPTER 4 Robert C. Higgins University of Washington On Sustainable Growth CHAPTER 7 Edward I. Altman New York University On Junk Bonds and Leveraged Loans CHAPTER 10 Samuel C. Weaver Lehigh University On Capital Budgeting at the Hershey Company CHAPTER 12 Roger Ibbotson Yale University On Capital Market History Jeremy Siegel University of Pennsylvania On Stocks for the Long Run Richard Roll California Institute of Technology On Market Efficiency CHAPTER 14 Bennett Stewart Stern Stewart & Co. On EVA Samuel C. Weaver Lehigh University On Cost of Capital and Hurdle Rates at the Hershey Company CHAPTER 15 Jay R. Ritter University of Florida On IPO Underpricing around the World CHAPTER 16 Merton H. Miller On Capital Structure: M&M 30 Years Later CHAPTER 17 Fischer Black On Why Firms Pay Dividends CHAPTER 22 Hersh Shefrin Santa Clara University On Behavioral Finance CHAPTER 24 Erik Lie University of Iowa On Option Backdating Robert C. Merton Harvard University On Applications of Options Analysis Page xlvi Page 1  PART 1 Overview of Corporate Finance Introduction to 1 Corporate Finance GEORGE ZIMMER, FOUNDER of The Men’s Wearhouse, for years appeared in television ads promising “You’re going to like the way you look. I guarantee it.” But, in mid-2013, Zimmer evidently didn’t look so good to the company’s board of directors, which abruptly fired him. It was reported that Zimmer had a series of disagreements with the board, including a desire to take the company private. Evidently, Zimmer’s ideas did not “suit” the board. Understanding Zimmer’s journey from the founder of a clothing store that used a cigar box as a cash register, to corporate executive, and finally to ex-employee takes us into issues involving the corporate form of organization, corporate goals, and corporate control, all of which we discuss in this chapter. You’re going to learn a lot if you read it. We guarantee it. For updates on the latest happenings in finance, visit www.fundamentalsofcorporatefinance.blogspot.com. Learning Objectives After studying this chapter, you should understand: The basic types of financial management decisions and the  The basic types of financial management decisions and the LO1 role of the financial manager. LO2 The goal of financial management. LO3 The financial implications of the different forms of business organization. LO4 The conflicts of interest that can arise between managers and owners. To begin our study of modern corporate finance and financial management, we need to address two central issues. First, what is corporate finance and what is the role of the financial manager in the corporation? Second, what is the goal of financial management? To describe the financial management environment, we consider the corporate form of organization and discuss some conflicts that can arise within the corporation. We also take a brief look at financial markets in the United States. 1.1 Corporate Finance and the Financial Page 2 Manager In this section, we discuss where the financial manager fits in the corporation. We start by defining corporate finance and the financial manager’s job. WHAT IS CORPORATE FINANCE? Imagine that you were to start your own business. No matter what type you started, you would have to answer the following three questions in some form or another: 1. What long-term investments should you take on? That is, what lines of business will you be in and what sorts of buildings, machinery, and equipment will you need? 2. Where will you get the long-term financing to pay for your investment? Will you bring in other owners or will you borrow the money? 3. How will you manage your everyday financial activities such as collecting from customers and paying suppliers? These are not the only questions by any means, but they are among the most important. Corporate finance, broadly speaking, is the study of ways to answer these three questions. Accordingly, we’ll be looking at each of them in the chapters ahead. THE FINANCIAL MANAGER A striking feature of large corporations is that the owners (the stockholders) are usually not directly involved in making business decisions, particularly on a day-to-day basis. Instead, the corporation employs managers to represent the owners’ interests and make decisions on their behalf. In a large corporation, the financial manager would be in charge of answering the three questions we raised in the preceding section. The financial management function is usually associated with a top officer of the firm, such as a vice president of finance or some other chief financial officer (CFO). Figure 1.1 is a simplified organizational chart that highlights the finance activity in a large firm. As shown, the vice president of finance coordinates the activities of the treasurer and the controller. The controller’s office handles cost and financial accounting, tax payments, and management information systems. The treasurer’s office is responsible for managing the firm’s cash and credit, its financial planning, and its capital expenditures. These treasury activities are all related to the three general questions raised earlier, and the chapters ahead deal primarily with these issues. Our study thus bears mostly on activities usually associated with the treasurer’s office. For current issues facing CFOs, see ww2.cfo.com. FINANCIAL MANAGEMENT DECISIONS As the preceding discussion suggests, the financial manager must be concerned with three basic types of questions. We consider these in greater detail next. Capital Budgeting The first question concerns the firm’s long-term investments. The process of planning and managing a firm’s long-term investments is called capital budgeting. In capital budgeting, the financial manager tries to identify investment opportunities that are worth more to the firm than they cost to acquire. Loosely speaking, this means that the value of the cash flow generated by an asset exceeds the cost of that asset. capital budgeting The process of planning and managing a firm’s long-term investments. The types of investment opportunities that would typically be considered depend in part on the nature of the firm’s business. For example, for a large retailer such as Walmart, deciding whether to open another store would be an important capital budgeting decision. Similarly, for a software company such as Oracle or Microsoft, the decision to develop and market a new spreadsheet program would be a major capital budgeting decision. Some decisions, such as what type of computer system to purchase, might not depend so much on a particular line of business. FIGURE 1.1 Page 3 A Sample Simplified Organizational Chart  Regardless of the specific nature of an opportunity under consideration, financial managers must be concerned not only with how much cash they expect to receive, but also with when they expect to receive it and how likely they are to receive it. Evaluating the size, timing, and risk of future cash flows is the essence of capital budgeting. In fact, as we will see in the chapters ahead, whenever we evaluate a business decision, the size, timing, and risk of the cash flows will be by far the most important things we will consider. Capital Structure The second question for the financial manager concerns ways in which the firm obtains and manages the long-term financing it needs to support its long-term investments. A firm’s capital structure (or financial structure) is the specific mixture of long-term debt and equity the firm uses to finance its operations. The financial manager has two concerns in this area. First, how much should the firm borrow? That is, what mixture of debt and equity is best? The mixture chosen will affect both the risk and the value of the firm. Second, what are the least expensive sources of funds for the firm? capital structure The mixture of debt and equity maintained by a firm. If we picture the firm as a pie, then the firm’s capital structure determines how that pie is sliced—in other words, Page 4 what percentage of the firm’s cash flow goes to creditors and what percentage goes to shareholders. Firms have a great deal of flexibility in choosing a financial structure. The question of whether one structure is better than any other for a particular firm is the heart of the capital structure issue. In addition to deciding on the financing mix, the financial manager has to decide exactly how and where to raise the money. The expenses associated with raising long-term financing can be considerable, so different possibilities must be carefully evaluated. Also, corporations borrow money from a variety of lenders in a number of different, and sometimes exotic, ways. Choosing among lenders and among loan types is another job handled by the financial manager. Working Capital Management The third question concerns working capital management. The term working capital refers to a firm’s short-term assets, such as inventory, and its short-term liabilities, such as money owed to suppliers. Managing the firm’s working capital is a day-to-day activity that ensures that the firm has sufficient resources to continue its operations and avoid costly interruptions. This involves a number of activities related to the firm’s receipt and disbursement of cash. working capital A firm’s short-term assets and liabilities. Some questions about working capital that must be answered are the following: (1) How much cash and inventory should we keep on hand? (2) Should we sell on credit? If so, what terms will we offer, and to whom will we extend them? (3) How will we obtain any needed short-term financing? Will we purchase on credit, or will we borrow in the short term and pay cash? If we borrow in the short term, how and where should we do it? These are just a small sample of the issues that arise in managing a firm’s working capital. Conclusion The three areas of corporate financial management we have described—capital budgeting, capital structure, and working capital management—are very broad categories. Each includes a rich variety of topics, and we have indicated only a few questions that arise in the different areas. The chapters ahead contain greater detail. Concept Questions 1.1a What is the capital budgeting decision? 1.1b What do you call the specific mixture of long-term debt and equity that a firm chooses to use? 1.1c Into what category of financial management does cash management fall? 1.2 Forms of Business Organization Large firms in the United States, such as Ford and Microsoft, are almost all organized as corporations. We examine the three different legal forms of business organization—sole proprietorship, partnership, and corporation— to see why this is so. Each form has distinct advantages and disadvantages for the life of the business, the ability of the business to raise cash, and taxes. A key observation is that as a firm grows, the advantages of the corporate form may come to outweigh the disadvantages. SOLE PROPRIETORSHIP A sole proprietorship is a business owned by one person. This is the simplest type of business to start and is the least regulated form of organization. Depending on where you live, you might be able to start a proprietorship by doing little more than getting a business license and opening your doors. For this reason, there are more proprietorships than any other type of business, and many businesses that later become large corporations start out as small proprietorships. sole proprietorship A business owned by a single individual.  The owner of a sole proprietorship keeps all the profits. That’s the good news. The bad news is that the owner has Page 5 unlimited liability for business debts. This means that creditors can look beyond business assets to the proprietor’s personal assets for payment. Similarly, there is no distinction between personal and business income, so all business income is taxed as personal income. The life of a sole proprietorship is limited to the owner’s life span, and the amount of equity that can be raised is limited to the amount of the proprietor’s personal wealth. This limitation often means that the business is unable to exploit new opportunities because of insufficient capital. Ownership of a sole proprietorship may be difficult to transfer because this transfer requires the sale of the entire business to a new owner. PARTNERSHIP A partnership is similar to a proprietorship except that there are two or more owners (partners). In a general partnership, all the partners share in gains or losses, and all have unlimited liability for all partnership debts, not just some particular share. The way partnership gains (and losses) are divided is described in the partnership agreement. This agreement can be an informal oral agreement, such as “let’s start a lawn mowing business,” or a lengthy, formal written document. partnership A business formed by two or more individuals or entities. In a limited partnership, one or more general partners will run the business and have unlimited liability, but there will be one or more limited partners who will not actively participate in the business. A limited partner’s liability for business debts is limited to the amount that partner contributes to the partnership. This form of organization is common in real estate ventures, for example. The advantages and disadvantages of a partnership are basically the same as those of a proprietorship. Partnerships based on a relatively informal agreement are easy and inexpensive to form. General partners have unlimited liability for partnership debts, and the partnership terminates when a general partner wishes to sell out or dies. All income is taxed as personal income to the partners, and the amount of equity that can be raised is limited to the partners’ combined wealth. Ownership of a general partnership is not easily transferred because a transfer requires that a new partnership be formed. A limited partner’s interest can be sold without dissolving the partnership, but finding a buyer may be difficult. Because a partner in a general partnership can be held responsible for all partnership debts, having a written agreement is very important. Failure to spell out the rights and duties of the partners frequently leads to misunderstandings later on. Also, if you are a limited partner, you must not become deeply involved in business decisions unless you are willing to assume the obligations of a general partner. The reason is that if things go badly, you may be deemed to be a general partner even though you say you are a limited partner. Based on our discussion, the primary disadvantages of sole proprietorships and partnerships as forms of business organization are (1) unlimited liability for business debts on the part of the owners, (2) limited life of the business, and (3) difficulty of transferring ownership. These three disadvantages add up to a single, central problem: the ability of such businesses to grow can be seriously limited by an inability to raise cash for investment. CORPORATION The corporation is the most important form (in terms of size) of business organization in the United States. A corporation is a legal “person,” separate and distinct from its owners, and it has many of the rights, duties, and privileges of an actual person. Corporations can borrow money and own property, can sue and be sued, and can enter into contracts. A corporation can even be a general partner or a limited partner in a partnership, and a corporation can own stock in another corporation. corporation A business created as a distinct legal entity composed of one or more individuals or entities. Not surprisingly, starting a corporation is somewhat more complicated than starting the other forms of business Page 6 organization. Forming a corporation involves preparing articles of incorporation (or a charter) and a set of bylaws. The articles of incorporation must contain a number of things, including the corporation?