PRINCIPLES OF CORP FINANCE.pdf

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eleventh edition Principles of Principles of a Modern Masterpiece Corporate Te integrated solutions for Principles of Corporate Finance, eleventh edition have been specifically designed to help improve student performance. Resources within Connect® Finance provide unlimited opportunities for students to practice solving FinanCe eleventh edition FinanCe Corporate financial problems and apply what they’ve learned. Brealey, Myers, and Allen’s world-leading content, combined with a complete digital solution, will help students achieve higher outcomes in the course. BEYOND THE PAGE New! “Beyond the Page” Interactive Content and Applications put Principles of corporate finance additional resources and hands‐on applications just a click away. Brealey Students will learn more about key concepts as they go beyond the page with additional examples, applications, spreadsheet programs, Myers MD DALIM #1216378 11/18/12 CYAN MAG YELO BLK and other opportunities to explore topics in more depth. For more information on Connect® Finance and changes to the eleventh edition, allen please visit the text website at www.mhhe.com/bma Brealey Myers allen ISBN 978-0-07-803476-3 MHID 0-07-803476-0 9 0 0 0 0 EAN 9 780078 034763 TM www.mhhe.com  ® Get Connected. finance The integrated solutions for Brealey, Myers, and Allen’s Principles of Corporate Finance 11e have been proven to help you achieve your course goals of improving student readiness, enhancing student engagement, and increasing their comprehension of content. Self-Quiz and Study PROVEN EFFECTIVE Whether accessing online homework, quizzes, and tests or utilizing an interactive eBook, McGraw-Hill’s Connect Finance provides a complete digital solution. Connect’s seamless partnership with the text’s content allows instructors and students to go beyond the print world, and into the digital realm with complete confidence. Connect Finance’s Self-Quiz McGraw-Hill’s Finance Prep Courses are available for math, and Study takes students statistics, accounting, and economics. These courses are comprised through a practice test, then of animated tutorial modules with quiz questions that save recommends readings, study instructors time in class and get students up to speed on the basics tools, and additional practice. so they will be ready for more complex finance topics. No need for you to set up Self-Quiz and Study allows students to evaluate their performance an assignment for them— through a practice test and then receive recommendations for students can access this specific readings from the text, supplemental study material, and content on their own. practice work that will improve their mastery of each learning objective. Connect Finance helps students learn by providing Detailed Feedback, complete step-by-step solutions for every problem, and instructors decide when students receive the solutions. Detailed Feedback FEATURES Finance Prep Courses Connect Finance helps students learn by Do your students struggle with prerequisite providing complete step-by-step solutions for material from accounting, math, statistics, every problem, and you decide when students and economics? With the Finance Prep receive the solutions. These solutions can then Courses, students will view a video to refresh be accessed before an exam so students can them on these topics, and then answer use them as a study tool for their tests. questions to test their understanding. This product gives you more time in class to cover finance topics, and ensures that students do not get left behind. Brealey_Frnt_Endsheets.indd 1 11/20/12 8:54 PM ISBN: 0-07-803476-0 Front endsheets Author: Brealey, Meyers, Allen Color: 4c Title: Principles of Corporate Finance, 11e Pages: 2,3  ® Get Connected. finance The integrated solutions for Brealey, Myers, and Allen’s Principles of Corporate Finance 11e have been proven to help you achieve your course goals of improving student readiness, enhancing student engagement, and increasing their comprehension of content. Self-Quiz and Study PROVEN EFFECTIVE Whether accessing online homework, quizzes, and tests or utilizing an interactive eBook, McGraw-Hill’s Connect Finance provides a complete digital solution. Connect’s seamless partnership with the text’s content allows instructors and students to go beyond the print world, and into the digital realm with complete confidence. Connect Finance’s Self-Quiz McGraw-Hill’s Finance Prep Courses are available for math, and Study takes students statistics, accounting, and economics. These courses are comprised through a practice test, then of animated tutorial modules with quiz questions that save recommends readings, study instructors time in class and get students up to speed on the basics tools, and additional practice. so they will be ready for more complex finance topics. No need for you to set up Self-Quiz and Study allows students to evaluate their performance an assignment for them— through a practice test and then receive recommendations for students can access this specific readings from the text, supplemental study material, and content on their own. practice work that will improve their mastery of each learning objective. Connect Finance helps students learn by providing Detailed Feedback, complete step-by-step solutions for every problem, and instructors decide when students receive the solutions. Detailed Feedback FEATURES Finance Prep Courses Connect Finance helps students learn by Do your students struggle with prerequisite providing complete step-by-step solutions for material from accounting, math, statistics, every problem, and you decide when students and economics? With the Finance Prep receive the solutions. These solutions can then Courses, students will view a video to refresh be accessed before an exam so students can them on these topics, and then answer use them as a study tool for their tests. questions to test their understanding. This product gives you more time in class to cover finance topics, and ensures that students do not get left behind. Brealey_Frnt_Endsheets.indd 1 11/20/12 8:54 PM ISBN: 0-07-803476-0 Front endsheets Author: Brealey, Meyers, Allen Color: 4c Title: Principles of Corporate Finance, 11e Pages: 2,3  Get Engaged. eBooks Connect Plus includes a media-rich eBook that allows you to share your notes with your students. Your students can insert and review their own notes, highlight the text, search for specific information, and interact with media resources. Using an eBook with Connect Plus gives your students a complete digital solution that allows them to access their materials from any computer. End-of-Chapter and Test Bank Content Connect Finance includes both static and algorithmic versions of end of chapter problems and static test bank questions. Brealey_Frnt_Endsheets.indd 2 11/20/12 8:54 PM ISBN: 0-07-803476-0 Front endsheets Author: Brealey, Meyers, Allen Color: 4c Title: Principles of Corporate Finance, 11e Pages: 4  Get Engaged. eBooks Connect Plus includes a media-rich eBook that allows you to share your notes with your students. Your students can insert and review their own notes, highlight the text, search for specific information, and interact with media resources. Using an eBook with Connect Plus gives your students a complete digital solution that allows them to access their materials from any computer. End-of-Chapter and Test Bank Content Connect Finance includes both static and algorithmic versions of end of chapter problems and static test bank questions. Brealey_Frnt_Endsheets.indd 2 11/20/12 8:54 PM ISBN: 0-07-803476-0 Front endsheets Author: Brealey, Meyers, Allen Color: 4c Title: Principles of Corporate Finance, 11e Pages: 4  Rev.confirming pages Principles of Corporate Finance bre34760_fm_i-xxviii.indd i 12/5/12 7:37 AM  Rev.confirming pages 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 Ross, Westerfield, and Jordan Saunders and Cornett Essentials of Corporate Finance Financial Institutions Management: Block, Hirt, and Danielsen Eighth Edition A Risk Management Approach Foundations of Financial Management Seventh Edition Fourteenth Edition Ross, Westerfield, and Jordan Fundamentals of Corporate Finance Saunders and Cornett Brealey, Myers, and Allen Tenth Edition Financial Markets and Institutions Principles of Corporate Finance Fifth Edition Eleventh Edition Shefrin Behavioral Corporate Finance: Brealey, Myers, and Allen Decisions that Create Value Principles of Corporate Finance, Concise International Finance First Edition Second Edition Eun and Resnick White Brealey, Myers, and Marcus International Financial Management Financial Analysis with an Electronic Fundamentals of Corporate Finance Sixth Edition Calculator Seventh Edition Sixth Edition Brooks Real Estate FinGame Online 5.0 Investments Brueggeman and Fisher Bruner Real Estate Finance and Investments Case Studies in Finance: Managing for Bodie, Kane, and Marcus Fourteenth Edition Corporate Value Creation Essentials of Investments Seventh Edition Ninth Edition Ling and Archer Cornett, Adair, and Nofsinger Real Estate Principles: A Value Approach Bodie, Kane, and Marcus Fourth Edition Finance: Applications and Theory Investments Second Edition Ninth Edition Cornett, Adair, and Nofsinger Financial Planning Hirt and Block M: Finance and Insurance Fundamentals of Investment Second Edition Management Allen, Melone, Rosenbloom, DeMello Tenth Edition and Mahoney Cases in Finance Retirement Plans: 401(k)s, IRAs, Jordan and Miller Second Edition and Other Deferred Compensation Fundamentals of Investments: Valuation Grinblatt (editor) and Management Approaches Stephen A. Ross, Mentor: Influence through Sixth Edition Tenth Edition Generations Altfest Stewart, Piros, and Heisler Grinblatt and Titman Running Money: Professional Portfolio Personal Financial Planning Financial Markets and Corporate Strategy Management First Edition Second Edition First Edition Harrington and Niehaus Higgins Sundaram and Das Risk Management and Insurance Analysis for Financial Management Derivatives: Principles and Practice Second Edition Tenth Edition First Edition Kapoor, Dlabay, and Hughes Kellison Focus on Personal Finance: An Active Theory of Interest Approach to Help You Develop Successful Third Edition Financial Institutions Financial Skills and Markets Fourth Edition Ross, Westerfield, and Jaffe Corporate Finance Rose and Hudgins Kapoor, Dlabay, and Hughes Tenth Edition Bank Management and Financial Services Personal Finance Ninth Edition Tenth Edition Ross, Westerfield, Jaffe, and Jordan Corporate Finance: Core Principles Rose and Marquis Walker and Walker and Applications Financial Institutions and Markets Personal Finance: Building Your Future Third Edition Eleventh Edition First Edition bre34760_fm_i-xxviii.indd ii 12/5/12 7:37 AM  Rev.confirming pages Principles of Corporate Finance ELEVENTH EDITION Richard A. Brealey Professor of Finance London Business School Stewart C. Myers Robert C. Merton (1970) Professor of Finance Sloan School of Management Massachusetts Institute of Technology Franklin Allen Nippon Life Professor of Finance The Wharton School University of Pennsylvania bre34760_fm_i-xxviii.indd iii 12/5/12 7:37 AM  Rev.confirming pages PRINCIPLES OF CORPORATE FINANCE, ELEVENTH EDITION Published by McGraw-Hill/Irwin, a business unit of The McGraw-Hill Companies, Inc., 1221 Avenue of the Americas, New York, NY, 10020. Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved. Printed in the United States of America. Previous editions © 2011, 2008, and 2006. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of The McGraw-Hill Companies, Inc., including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning. Some ancillaries, including electronic and print components, may not be available to customers outside the United States. This book is printed on acid-free paper. 1 2 3 4 5 6 7 8 9 0 DOW/DOW 1 0 9 8 7 6 5 4 3 ISBN 978-0-07-803476-3 MHID 0-07-803476-0 Senior Vice President, Products & Markets: Kurt L. Strand Vice President, General Manager, Products & Markets: Brent Gordon Vice President, Content Production & Technology Services: Kimberly Meriwether David Managing Director: Douglas Reiner Executive Brand Manager: Michele Janicek Executive Brand Manager: Chuck Synovec Executive Director of Development: Ann Torbert Development Editor: Noelle Bathurst Director of Digital Content: Doug Ruby Digital Development Editor: Meg M. Maloney Executive Marketing Manager: Melissa S. Caughlin Content Project Manager: Rachel Townsend Senior Buyer: Michael R. McCormick Designer: Laurie J. Entringer Cover Image: © Jean-Francois Schmit; iStockphoto Media Project Manager: Ron Nelms Typeface: 10/12 Minion Pro Regular Compositor: Laserwords Private Limited Printer: R. R. Donnelley All credits appearing on page or at the end of the book are considered to be an extension of the copyright page. Library of Congress Cataloging-in-Publication Data Brealey, Richard A. Principles of corporate finance/Richard A. Brealey, Stewart C. Myers, Franklin Allen.—11th ed. p. cm.—(The McGraw-Hill/Irwin series in finance, insurance, and real estate) Includes index. ISBN 978-0-07-803476-3 (alk. paper)—ISBN 0-07-803476-0 (alk. paper) 1. Corporations—Finance. I. Myers, Stewart C. II. Allen, Franklin, 1956-III. Title. HG4026.B667 2014 658.15—dc23 2012039928 The Internet addresses listed in the text were accurate at the time of publication. The inclusion of a website does not indicate an endorsement by the authors or McGraw-Hill, and McGraw-Hill does not guarantee the accuracy of the information presented at these sites. www.mhhe.com bre34760_fm_i-xxviii.indd iv 12/5/12 7:37 AM  Rev.confirming pages To Our Parents bre34760_fm_i-xxviii.indd v 12/5/12 7:37 AM  Rev.confirming pages About the Authors ◗ Richard A. Brealey ◗ Stewart C. Myers ◗ Franklin Allen Professor of Finance at the London Robert C. Merton (1970) Professor Nippon Life Professor of Finance Business School. He is the former of Finance at MIT’s Sloan School of at the Wharton School of the president of the European Finance Management. He is past president University of Pennsylvania. He is Association and a former director of the American Finance Asso- past president of the American of the American Finance Associa- ciation and a research associate of Finance Association, Western tion. He is a fellow of the British the National Bureau of Economic Finance Association, and Society Academy and has served as a spe- Research. His research has focused for Financial Studies. His research cial adviser to the Governor of the on financing decisions, valuation has focused on financial innova- Bank of England and director of a methods, the cost of capital, and tion, asset price bubbles, comparing number of financial institutions. financial aspects of government financial systems, and financial Other books written by Professor regulation of business. Dr. Myers is crises. He is a scientific adviser at Brealey include Introduction to Risk a director of Entergy Corporation Sveriges Riksbank (Sweden’s central and Return from Common Stocks. and The Brattle Group, Inc. He is bank). active as a financial consultant. vi bre34760_fm_i-xxviii.indd vi 12/5/12 7:37 AM  Rev.confirming pages Preface ◗ This book describes the theory and practice of corporate finance. We hardly need to explain why financial manag- ers have to master the practical aspects of their job, but we Chapter 1 has grown over the years as major new devel- opments in the financial world seem to demand some reference and comment. In this edition we have sought to should spell out why down-to-earth managers need to bother make the chapter a more focused introduction to corporate with theory. finance. It concentrates on the decisions that corporations Managers learn from experience how to cope with routine need to make and the financial objectives that govern these problems. But the best managers are also able to respond to decisions. It also introduces five basic themes that return change. To do so you need more than time-honored rules of again and again throughout the book. thumb; you must understand why companies and financial Chapter 3 introduces bond valuation. We rewrote and markets behave the way they do. In other words, you need a simplified some of the material, such as the discussion of theory of finance. duration. The last section of the chapter includes an intro- Does that sound intimidating? It shouldn’t. Good theory duction to default risk. The tribulations of the eurozone helps you to grasp what is going on in the world around you. and the default by the Greek government on its bonds are It helps you to ask the right questions when times change and reminders that default is not just a concern for holders of new problems need to be analyzed. It also tells you which corporate debt. So we discuss briefly the risk of default for things you do not need to worry about. Throughout this book both corporate and sovereign borrowers. (We discuss cor- we show how managers use financial theory to solve practical porate debt and default risk in more detail in Chapter 23.) problems. Chapter 4 is concerned with the valuation of common Of course, the theory presented in this book is not perfect stocks. We start by explaining how individual stocks are val- and complete—no theory is. There are some famous contro- ued and go on to look at the problem of valuing the entire versies where financial economists cannot agree. We have not company. These days many firms do not pay dividends and glossed over these disagreements. We set out the arguments for use excess cash to repurchase stock. In this edition we pro- each side and tell you where we stand. vide more guidance on valuing these companies. Much of this book is concerned with understanding what Chapter 6 explains how to calculate the present value of financial managers do and why. But we also say what finan- new investments. We cover the same material in this chap- cial managers should do to increase company value. Where ter as in previous editions, but we include a longer discus- theory suggests that financial managers are making mistakes, sion of the differences between cash flows and accounting we say so, while admitting that there may be hidden reasons profits. We think that this will provide readers with a for their actions. In brief, we have tried to be fair but to pull clearer understanding of how to derive cash-flow forecasts. no punches. The financial manager spends a large part of his time inter- This book may be your first view of the world of modern acting with financial institutions and markets. In Chap- finance theory. If so, you will read first for new ideas, for an ter 14 we expand our discussion of these institutions. We understanding of how finance theory translates into practice, describe the main forms of institutions, we look at their and occasionally, we hope, for entertainment. But eventually economic role, and we use the crisis of 2007–2009 to you will be in a position to make financial decisions, not just review what happens when financial institutions and mar- study them. At that point you can turn to this book as a refer- kets cease to function well. ence and guide. We substantially rewrote Chapter 16, which looks at payout policy. We review both how much companies should pay out and whether they should do so by means of a dividend pay- ◗ Changes in the Eleventh Edition ment or stock repurchase. We also return to an issue that we introduced in Chapter 4 and look in more detail at how to We are proud of the success of previous editions of Principles, value a company when repurchases are important. and we have done our best to make the eleventh edition even Chapter 24, which previously looked at the different kinds better. of long-term debt, now also looks at short-term debt such What is new in the eleventh edition? Of course, a large part as bank loans. Many of the issues about debt design of the changes in any edition consist of adding some updated such as the role of covenants apply to both short- and long- data here and a new example there. However, we have rewrit- term debt. ten and refreshed several basic chapters. Content remains In earlier editions we discussed bank debt in the chapter much the same, but we think that the revised chapters are sim- on working capital management. One advantage of moving pler and flow better. this discussion to Chapter 24 is that we have the luxury in vii bre34760_fm_i-xxviii.indd vii 12/5/12 7:38 AM  Rev.confirming pages viii Preface Chapter 30 of being able to look more broadly at working Additional examples include: capital. For example, we now include a discussion of the Chapter 2 Do you need to learn how to use a financial cash conversion cycle and show how it is affected by man- calculator? The “Beyond the Page” financial calculator agement decisions. application shows how to do so. The first edition of this book appeared in 1981. Basic prin- Chapter 3 Would you like to calculate a bond’s duration, ciples are the same now as then, but the last three decades see how it predicts the effect of small interest rate changes have also generated important changes in theory and practice. on bond price, calculate the duration of a common stock, Research in finance has focused less on what financial manag- or learn how to adjust for convexity? The duration applica- ers should do, and more on understanding and interpreting tion for Figure 3.2 allows you to do so. what they do in practice. In other words, finance has become Chapter 9 How about measuring the betas of the Fama- more positive and less normative. For example, we now have French three-factor model for U.S. stocks? The “Beyond careful surveys of firms’ capital investment practices and pay- the Page” beta estimation application does this. out and financing policies. We review these surveys and look Chapter 15 There was not space in the chapter to include at how they cast light on competing theories. a real IPO prospectus, but you can go “Beyond the Page” to Many financial decisions seem less clear-cut than they were learn more. 20 or 30 years ago. It no longer makes sense to ask whether high Chapter 19 The book briefly describes the flow-to-equity payouts are always good or always bad, or whether companies method for valuing businesses, but using the method should always borrow less or more. The right answer is, “It can be tricky. We provide an application that guides you depends.” Therefore we set out pros and cons of different policies. through the procedure. We ask, “What questions should the financial manager ask when Chapter 20 The Black-Scholes “Beyond the Page” appli- setting financial policy?” You will, for example, see this shift in cation provides an option calculator. It also shows how to emphasis when we discuss payout decisions in Chapter 16. estimate the option’s sensitivity to changes in the inputs. This edition builds on other changes from earlier editions. Chapter 28 Would you like to view the most recent We recognize that financial managers work more than ever in financial statements for different U.S. companies and cal- an international environment and therefore need to be famil- culate their financial ratios? There is an application that iar with international differences in financial management and will do this for you. in financial markets and institutions. Chapters 27 (Managing We believe that the opportunity to add additional content and International Risks) and 33 (Governance and Corporate Con- applications such as these will increasingly widen the type of trol around the World) are exclusively devoted to international material that can be made available and help the reader to issues. We have also found more and more opportunities in decide how deeply he or she wishes to explore a topic. other chapters to draw cross-border comparisons or use non- U.S. examples. We hope that this material will both provide a better understanding of the wider financial environment and be useful to our many readers around the world. ◗ Making Learning Easier As every first-grader knows, it is easier to add than to sub- Each chapter of the book includes an introductory preview, a tract. To make way for new topics we needed to make some summary, and an annotated list of suggested further reading. judicious pruning. We will not tell you where we cut out mate- The list of possible candidates for further reading is now volu- rial, because we hope that the deletions will be invisible. minous. Rather than trying to list every important article, we The biggest change in this edition largely listed survey articles or general books. We give more BEYOND THE PAGE is not to the printed text but to the specific references in footnotes. Beyond the Page digital extensions Each chapter is followed by a set of basic problems, inter- Principles of corporate finance and applications (see Pedagogical mediate problems on both numerical and conceptual topics, Features, below). These pieces are an and a few challenge problems. Answers to the odd-numbered integral part of the e-versions of the basic problems appear in the Appendix at the end of the book. book, but they are also easily acces- We included a “Finance on the Web” section in chapters sible via the Web using the QR codes where it makes sense to do so. This section now houses a number and shortcut URLs provided. They of Web Projects, along with new Data Analysis problems. These mhhe.com/bma provide additional examples, applica- exercises seek to familiarize the reader with some useful websites tions, spreadsheet programs, and opportunities to explore top- and to explain how to download and process data from the Web. ics in more depth. The book also contains 12 end-of-chapter Mini-Cases. These The QR codes are easy to use. First, use your smartphone to include specific questions to guide the case analyses. Answers to download any QR-enabled barcode reader from your provider’s the mini-cases are available to instructors on the book’s website. marketplace. Focus your smartphone’s camera on any code in Spreadsheet programs such as Excel are tailor-made for many the book, and you’ll be able to access the online chapter content financial calculations. Several chapters include boxes that intro- instantly. Try the code above now! duce the most useful financial functions and provide some short bre34760_fm_i-xxviii.indd viii 12/5/12 7:38 AM  Rev.confirming pages Preface ix practice questions. We show how to use the Excel function key Omar Benkato Ball State University to locate the function and then enter the data. We think that this Eric Benrud University of Baltimore approach is much simpler than trying to remember the formula Ronald Benson University of Maryland, University College for each function. Peter Berman University of New Haven We conclude the book with a glossary of financial terms. Tom Boulton Miami University of Ohio The 34 chapters in this book are divided into 11 parts. Edward Boyer Temple University Parts 1 to 3 cover valuation and capital investment decisions, Alon Brav Duke University including portfolio theory, asset pricing models, and the cost Jean Canil University of Adelaide of capital. Parts 4 to 8 cover payout policy, capital structure, Robert Carlson Bethany College options (including real options), corporate debt, and risk Chuck Chahyadi Eastern Illinois University management. Part 9 covers financial analysis, planning, and Fan Chen University of Mississippi working-capital management. Part 10 covers mergers and Celtin Ciner University of North Carolina, Wilmington acquisitions, corporate restructuring, and corporate gover- John Cooney Texas Tech University nance around the world. Part 11 concludes. Charles Cuny Washington University, St. Louis We realize that instructors will wish to select topics and may John Davenport Regent University prefer a different sequence. We have therefore written chapters Ray DeGennaro University of Tennessee, Knoxville so that topics can be introduced in several logical orders. For Adri DeRidder Gotland University example, there should be no difficulty in reading the chapters William Dimovski Deakin University, Melbourne on financial analysis and planning before the chapters on valua- David Ding Nanyang Technological University tion and capital investment. Robert Duvic University of Texas at Austin Alex Edmans University of Pennsylvania Susan Edwards Grand Valley State University ◗ Acknowledgments Riza Emekter Robert Morris University Robert Everett Johns Hopkins University We have a long list of people to thank for their helpful criti- Dave Fehr Southern New Hampshire University cism of earlier editions and for assistance in preparing this Donald Flagg University of Tampa one. They include Faiza Arshad, Aleijda de Cazenove Balsan, Frank Flanegin Robert Morris University Kedran Garrison, Robert Pindyck, Sara Salem, and Gretchen Zsuzanna Fluck Michigan State University Slemmons at MIT; Elroy Dimson, Paul Marsh, Mike Staunton, Connel Fullenkamp Duke University and Stefania Uccheddu at London Business School; Lynda Mark Garmaise University of California, Los Angeles Borucki, Michael Barhum, Marjorie Fischer, Larry Kolbe, Sharon Garrison University of Arizona Michael Vilbert, Bente Villadsen, and Fiona Wang at The Christopher Geczy University of Pennsylvania Brattle Group, Inc.; Alex Triantis at the University of Mary- George Geis University of Virginia land; Adam Kolasinski at the University of Washington; Simon Stuart Gillan University of Delaware Gervais at Duke University; Michael Chui at China Interna- Felix Goltz Edhec Business School tional Capital Corporation; Pedro Matos at the University Ning Gong Melbourne Business School of Southern California; Yupana Wiwattanakantang at Hitot- Levon Goukasian Pepperdine University subashi University; Nickolay Gantchev, Tina Horowitz, and Gary Gray Pennsylvania State University Chenying Zhang at the University of Pennsylvania; Julie Wulf C. J. Green Loughborough University at Harvard University; Jinghua Yan at Tykhe Capital; Roger Mark Griffiths Thunderbird, American School of Stein at Moody’s Investor Service; Bennett Stewart at EVA International Management Dimensions; and James Matthews at Towers Perrin. Re-Jin Guo University of Illinois, Chicago We want to express our appreciation to those instructors whose insightful comments and suggestions were invaluable Ann Hackert Idaho State University to us during the revision process: Winfried Hallerbach Erasmus University, Rotterdam Milton Harris University of Chicago Ibrahim Affaneh Indiana University of Pennsylvania Mary Hartman Bentley College Neyaz Ahmed University of Maryland Glenn Henderson University of Cincinnati Alexander Amati Rutgers University, New Brunswick Donna Hitscherich Columbia University Anne Anderson Lehigh University Ronald Hoffmeister Arizona State University Noyan Arsen Koc University James Howard University of Maryland, College Park Anders Axvarn Gothenburg University George Jabbour George Washington University John Banko University of Florida, Gainesville Ravi Jagannathan Northwestern University Michael Barry Boston College Abu Jalal Suffolk University Jan Bartholdy ASB, Denmark Nancy Jay Mercer University Penny Belk Loughborough University Thadavillil (Nathan) Jithendranathan University of Saint Thomas bre34760_fm_i-xxviii.indd ix 12/5/12 7:38 AM  Rev.confirming pages x Preface Kathleen Kahle University of Arizona Richard Simonds Michigan State University Jarl Kallberg NYU, Stern School of Business Bernell Stone Brigham Young University Ron Kaniel Duke University John Strong College of William & Mary Steve Kaplan University of Chicago Avanidhar Subrahmanyam University of California, Eric Kelley University of Arizona Los Angeles Arif Khurshed Manchester Business School Tim Sullivan Bentley College Ken Kim University of Wisconsin, Milwaukee Shrinivasan Sundaram Ball State University Jiro Eduoard Kondo Northwestern University Chu-Sheng Tai Texas Southern University Kellogg School of Management Tom Tallerico Dowling College C. R. Krishnaswamy Western Michigan University Stephen Todd Loyola University, Chicago George Kutner Marquette University Walter Torous University of California, Los Angeles Dirk Laschanzky University of Iowa Emery Trahan Northeastern University Scott Lee Texas A&M University Gary Tripp Southern New Hampshire University Bob Lightner San Diego Christian College Ilias Tsiakas University of Warwick David Lins University of Illinois, Urbana Narendar V. Rao Northeastern University Brandon Lockhart University of Nebraska, Lincoln David Vang St. Thomas University David Lovatt University of East Anglia Steve Venti Dartmouth College Greg Lucado University of the Sciences in Philadelphia Joseph Vu DePaul University Debbie Lucas Northwestern University John Wald Rutgers University Brian Lucey Trinity College, Dublin Chong Wang Naval Postgraduate School Suren Mansinghka University of California, Irvine Faye Wang University of Illinois, Chicago Ernst Maug Mannheim University Kelly Welch University of Kansas George McCabe University of Nebraska Jill Wetmore Saginaw Valley State University Eric McLaughlin California State University, Pomona Patrick Wilkie University of Virginia Joe Messina San Francisco State University Matt Will University of Indianapolis Tim Michael University of Houston, Clear Lake David Williams Texas A&M University, Commerce Dag Michalson Bl, Oslo Art Wilson George Washington University Franklin Michello Middle Tennessee State University Shee Wong University of Minnesota, Duluth Peter Moles University of Edinburgh Bob Wood Tennessee Tech University Katherine Morgan Columbia University Fei Xie George Mason University James Nelson East Carolina University Minhua Yang University of Central Florida James Owens West Texas A&M University David Zalewski Providence College Darshana Palkar Minnesota State University, Mankato Chenying Zhang University of Pennsylvania Claus Parum Copenhagen Business School Dilip Patro Rutgers University This list is surely incomplete. We know how much we owe to John Percival University of Pennsylvania our colleagues at the London Business School, MIT’s Sloan Birsel Pirim University of Illinois, Urbana School of Management, and the University of Pennsylvania’s Latha Ramchand University of Houston Wharton School. In many cases, the ideas that appear in this Rathin Rathinasamy Ball State University book are as much their ideas as ours. Raghavendra Rau Purdue University We would also like to thank all those at McGraw-Hill/ Joshua Raugh University of Chicago Irwin who worked on the book, including Michele Janicek Charu Reheja Wake Forest University and Chuck Synovec, Executive Brand Managers; Noelle Thomas Rhee California State University, Long Beach Bathurst, Development Editor; Melissa Caughlin, Executive Tom Rietz University of Iowa Marketing Manager; Jennifer Jelinski, Marketing Specialist; Robert Ritchey Texas Tech University Rachel Townsend, Content Project Manager; Laurie Entringer, Michael Roberts University of Pennsylvania Designer; and Michael McCormick, Senior Buyer. Mo Rodriguez Texas Christian University Finally, we record the continuing thanks due to our wives, John Rozycki Drake University Diana, Maureen, and Sally, who were unaware when they mar- Frank Ryan San Diego State University ried us that they were also marrying the Principles of Corpo- Marc Schauten Eramus University rate Finance. Brad Scott Webster University Nejat Seyhun University of Michigan Richard A. Brealey Jay Shanken Emory University Chander Shekhar University of Melbourne Stewart C. Myers Hamid Shomali Golden Gate University Franklin Allen bre34760_fm_i-xxviii.indd x 12/5/12 7:38 AM  Rev.confirming pages Guided Tour Pedagogical Features ◗ Chapter Overview Each chapter begins with a brief narrative and Part 1 Value outline to explain the concepts that will be covered in more depth. Useful websites related to material for each Part are provided on the book’s website at CHAPTER 1 www.mhhe.com/bma. Introduction to Corporate Finance T his book is about how corporations make financial decisions. We start by explaining what these decisions are and what they are seeking to accomplish. This chapter begins with specific examples of recent investment and financing decisions made by well-known cor- porations. The chapter ends by stating the financial goal of Corporations invest in real assets, which generate the corporation, which is to increase, and ideally to maximize, income. Some of these assets, such as plant and machin- its market value. We explain why this goal makes sense. The ery, are tangible; others, such as brand names and patents, middle of the chapter covers what a corporation is and what are intangible. Corporations finance their investments by bor- its financial managers do. rowing, by retaining and reinvesting cash flow, and by selling Financial managers add value whenever the corporation ◗ Finance in Practice Boxes FINANCE IN PRACTICE Relevant news articles from financial publications A Game of Political Chicken appear in various chapters throughout the text. ◗ In 2010 the U.S. Congress set a ceiling of $14.3 tril- Although there was general agreement that any Aimed at bringing real-world flavor into the lion on the amount that the federal government could increase in the debt ceiling should be accompanied by a deal to reduce the deficit, there was little meeting of borrow. However, government spending was fast out- classroom, these boxes provide insight into the running revenues, and, unless Congress voted to increase the debt ceiling, the U.S. government fore- minds as to how this should be achieved. Few observers believed that the United States would actually default casted that by August 2, 2011, it would run out of cash on its debt, but as the dispute dragged on, the unthink- business world today. to pay its bills. It would then face a stark choice between able became thinkable. Negotiations went down to the wire. On August 2, the day that the country was fore- drastic cuts in government spending or defaulting on its debt. Treasury Secretary Tim Geithner warned that casted to run out of borrowing power, President Obama “failure to raise the limit would precipitate a default by finally signed the Budget Control Act that increased the United States. Default would effectively impose a the debt ceiling by $900 billion. Two days later Stan- significant and long-lasting tax on all Americans and dard & Poor’s downgraded the long-term credit rating all American businesses and could lead to the loss of of the U.S. government from AAA to AA. millions of American jobs. Even a very short-term or “Secretary Geithner Sends Debt Limit Letter to Congress,” U.S. Department limited default would have catastrophic economic con- of the Treasury, January 6, 2011. http://www.treasury.gov/connect/blog/ sequences that would last for decades.” Pages/letter.aspx bre34760_ch01_001-017.indd 1 8/16/12 1:53 PM ◗ Numbered Examples EXAMPLE 2.1 Present Values with Multiple Cash Flows Your real estate adviser has come back with some revised forecasts. He suggests that you rent Numbered and titled examples are called out out the building for two years at $30,000 a year, and predicts that at the end of that time you will be able to sell the building for $840,000. Thus there are now two future cash flows—a cash flow of C1 5 $30,000 at the end of one year and a further cash flow of C2 5 (30,000 1 within chapters to further illustrate concepts. 840,000) 5 $870,000 at the end of the second year. The present value of your property development is equal to the present value of C1 plus Students can learn how to solve specific problems the present value of C2. Figure 2.5 shows that the value of the first year’s cash flow is C1/ (1 1 r) 5 30,000/1.12 5 $26,786 and the value of the second year’s flow is C2/(1 1 r)2 5 870,000/1.122 5 $693,559. Therefore our rule for adding present values tells us that the total step-by-step and apply key principles to answer present value of your investment is: concrete questions and scenarios. PV 5 C1 11r 1 C2 (1 1 r)2 5 30,000 1.12 1 870,000 1.122 5 26,786 1 693,559 5 $720,344 ◗ “Beyond the Page” Interactive BEYOND THE PAGE. BEYOND THE PAGE Content and Applications bre34760_ch02_018-044.indd 24 Introduction to financial calculators a Try It! More on duration 8/16/12 1:55 PM New to this edition! Additional resources and 8 hands-on applications are just a click away. bre34760_ch03_045-074.indd 67 t 8/16/12 1:56 PM Students can scan the in-text QR codes or use brealey.mhhe.com/c02 brealey.mhhe.com/c03 the direct Web address to learn more about key concepts and try out calculations, tables, and figures when they go “Beyond the Page.” xi bre34760_fm_i-xxviii.indd xi 12/5/12 7:38 AM  Rev.confirming pages Excel Treatment ◗ Spreadsheet Functions Boxes These boxes provide detailed USEFUL SPREADSHEET FUNCTIONS examples of how to use Excel Valuing Bonds spreadsheets when applying financial concepts. Questions ◗ Spreadsheet programs such as Excel provide built-in You must enter the yield and coupon as decimal functions to solve for a variety of bond valuation prob- values, for example, for 3% you would enter.03. that apply to the spreadsheet lems. You can find these functions by pressing fx on the Settlement is the date that payment for the secu- Excel toolbar. If you then click on the function that you rity is made. Maturity is the maturity date. You follow for additional practice. wish to use, Excel will ask you for the inputs that it needs. can enter these dates directly using the Excel date At the bottom left of the function box there is a Help function; for example, you would enter 15 Feb 2009 facility with an example of how the function is used. as DATE(2009,02,15). Alternatively, you can enter Here is a list of useful functions for valuing bonds, these dates in a cell and then enter the cell address together with some points to remember when entering in the function. data: In the functions for PRICE and YLD you need to PRICE: The price of a bond given its yield to scroll down in the function box to enter the fre- maturity. quency of coupon payments. Enter 1 for annual YLD: The yield to maturity of a bond given its price. payments or 2 for semiannual. DURATION: The duration of a bond. The functions for PRICE and YLD ask for an entry MDURATION: The modified duration (or volatil- for “basis.” We suggest you leave this blank. (See ity) of a bond. the Help facility for an explanation.) Note: SPREADSHEET QUESTIONS You can enter all the inputs in these functions directly as numbers or as the addresses of cells that The following questions provide an opportunity to contain the numbers. practice each of these functions. 1. (PRICE) In February 2009, Treasury 8.5s of 2020 yielded 3.2976%. What was their price? If the yield rose to 4%, what would happen to the price? 2. (YLD) On the same day Treasury 3.5s of 2018 were priced at 107.46875%. What was their yield to maturity? Suppose that the price was 110.0%. What would happen to the yield? 3. (DURATION) What was the duration of the Treasury 8.5s? How would duration change if the yield rose to 4%? Can you explain why? 4. (MDURATION) What was the modified duration of the Treasury 8.5s? How would modified duration differ if the coupon were only 7.5%? ◗ Excel Exhibits Select tables are set as 1 (1) bre34760_ch03_045-074.indd 68 (2) (3) (4) (5) (7) (6) 8/16/12 1:56 PM 2 Product of spreadsheets, and the corre- 3 Deviation Deviation Squared deviations sponding Excel files are also 4 from from average deviation from average 5 Market Anchovy Q average Anchovy Q from average returns available on the book’s website 6 Month return return market return return market return (cols 4 3 5) 2 8% 2 11% 2 10 2 13 at www.mhhe.com/bma. 7 1 100 130 8 2 4 8 2 6 4 12 9 3 12 19 10 17 100 170 10 4 26 2 13 28 2 15 64 120 11 5 2 3 0 1 0 0 12 6 8 6 6 4 36 24 13 Average 2 2 Total 304 456 14 Variance 5 sm2 5 304/6 5 50.67 15 Covariance 5 sim 5 456/6 5 76 16 Beta (b) 5 sim/sm2 5 76/50.67 5 1.5 ◗ TABLE 7.7 Calculating the variance of the market returns and the covariance between the returns on the market and those of Anchovy Queen. Beta is the ratio of the variance to the covariance (i.e., b = sim/s2m). xii bre34760_fm_i-xxviii.indd xii 12/5/12 7:38 AM  Rev.confirming pages End-of-Chapter Features ◗ Problem Sets Select problems are available in McGraw-Hill’s Connect PROBLEM For the eleventh edition, topic labels have Finance. Please see the preface for more information. SETS been added to each end-of-chapter problem BASIC 1. Future values At an interest rate of 12%, the six-year discount factor is.507. How many dol- to enable easy assignment creation for lars is $.507 worth in six years if invested at 12%? 2. Discount factors If the PV of $139 is $125, what is the discount factor? instructors and reinforcement for students. 3. Present values If the cost of capital is 9%, what is the PV of $374 paid in year 9? These end-of-chapter problems give students 4. Present values A project produces a cash flow of $432 in year 1, $137 in year 2, and $797 in year 3. If the cost of capital is 15%, what is the project’s PV? hands-on practice with the key concepts. The 5. Futures values If you invest $100 at an interest rate of 15%, how much will you have at the end of eight years? content is organized by level of difficulty: 6. Perpetuities An investment costs $1,548 and pays $138 in perpetuity. If the interest rate is 9%, what is the NPV? Basic, Intermediate, and Challenge. Answers to the odd-numbered basic problems are included at the back of the book. INTERMEDIATE 15. Prices and yields A 10-year German government bond (bund) has a face value of €100 and a coupon rate of 5% paid annually. Assume that the interest rate (in euros) is equal to 6% per year. What is the bond’s PV? 16. Prices and yields A 10-year U.S. Treasury bond with a face value of $10,000 pays a coupon of 5.5% (2.75% of face value every six months). The semiannually compounded interest rate is 5.2% (a six-month discount rate of 5.2/2 5 2.6%). a. What is the present value of the bond? b. Generate a graph or table showing how the bond’s present value changes for semiannually compounded interest rates between 1% and 15%. 17. Prices and yields A six-year government bond makes annual coupon payments of 5% and offers a yield of 3% annually compounded. Suppose that one year later the bond still yields 3%. What return has the bondholder earned over the 12-month period? Now suppose that the bond yields 2% at the end of the year. What return would the bondholder earn in this case? d ld b d ld d b d ld bre34760_ch02_018-044.indd 39 10/19/12 10:56 AM CHALLENGE 31. Prices and yields Write a spreadsheet program to construct a series of bond tables that show the present value of a bond given the coupon rate, maturity, and yield to maturity. Assume that coupon payments are semiannual and yields are compounded semiannually. 32. Price and spot interest rates Find the arbitrage opportunity (opportunities?). Assume for simplicity that coupons are paid annually. In each case the f