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Fundamentals of Corporate Finance Alternate Edition / Edition 9

Fundamentals of Corporate Finance Alternate Edition / Edition 9

by Stephen A. Ross


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Product Details

ISBN-13: 2900077246128
Publisher: McGraw-Hill Companies,Inc.
Publication date: 02/24/2009
Edition description: Older Edition
Pages: 992
Product dimensions: 6.50(w) x 1.50(h) x 9.50(d)

About the Author

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 longstanding interest in both applied and theoretical issues in corporate finance and has extensive experience teaching all levels of corporate finance and financial management policy.

Randolph W.Westerfield is Dean Emeritus of the University of Southern California's Marshall School of Business and is the Charles B. Thornton Professor of Finance. He 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.

Stephen Ross is presently 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, a director of the College Retirement Equity Fund (CREF), and Freddie Mac. He is also the co-chairman of Roll and Ross Asset Management Corporation.

Table of Contents

Overview of Corporate Finance
Introduction to Corporate Finance     1
Corporate Finance and the Financial Manager     2
What Is Corporate Finance?     2
The Financial Manager     2
Financial Management Decisions     2
Capital Budgeting     2
Capital Structure     3
Working Capital Management     4
Conclusion     4
Forms of Business Organization     4
Sole Proprietorship     5
Partnership     5
Corporation     6
A Corporation by Another Name...     7
The Goal of Financial Management     8
Possible Goals     8
The Goal of Financial Management     9
A More General Goal     9
The Agency Problem and Control of the Corporation     10
Agency Relationships     10
Management Goals     10
Do Managers Act in the Stockholders' Interests?     12
Managerial Compensation     12
Control of the Firm     13
Conclusion     14
Stakeholders     14
Financial Markets and the Corporation     14
Cash Flows to and from the Firm     14
Primary versus Secondary Markets     15
Primary Markets     15
Secondary Markets     16
Summary and Conclusions     17
Financial Statements, Taxes, and Cash Flow     20
The Balance Sheet     21
Assets: The Left-Hand Side     21
Liabilities and Owners' Equity: The Right-Hand Side     21
Net Working Capital     22
Liquidity     23
Debt versus Equity     24
Market Value versus Book Value     24
The Income Statement     25
GAAP and the Income Statement     26
Noncash Items     27
Time and Costs     27
Taxes     29
Corporate Tax Rates     29
Average versus Marginal Tax Rates     29
Cash Flow     31
Cash Flow from Assets     32
Operating Cash Flow     32
Capital Spending     33
Change in Net Working Capital     33
Conclusion     34
A Note on "Free" Cash Flow     34
Cash Flow to Creditors and Stockholders     34
Cash Flow to Creditors     34
Cash Flow to Stockholders     35
An Example: Cash Flows for Dole Cola     36
Operating Cash Flow     36
Net Capital Spending     31
Change in NWC and Cash Flow from Assets     37
Cash Flow to Stockholders and Creditors     38
Summary and Conclusions     39
Financial Statements and Long-Term Financial Planning
Working with Financial Statements     48
Cash Flow and Financial Statements: A Closer Look     49
Sources and Uses of Cash     49
The Statement of Cash Flows     51
Standardized Financial Statements     53
Common-Size Statements     53
Common-Size Balance Sheets     54
Common-Size Income Statements     54
Common-Size Statements of Cash Flows     55
Common-Base Year Financial Statements: Trend Analysis     55
Combined Common-Size and Base-Year Analysis     56
Ratio Analysis     56
Short-Term Solvency, or Liquidity, Measures     57
Current Ratio     58
The Quick (or Acid-Test) Ratio     59
Other Liquidity Ratios     59
Long-Term Solvency Measures     60
Total Debt Ratio     60
A Brief Digression: Total Capitalization versus Total Assets     61
Times Interest Earned     61
Cash Coverage     61
Asset Management, or Turnover, Measures     62
Inventory Turnover and Days' Sales in Inventory     62
Receivables Turnover and Days' Sales in Receivables     63
Asset Turnover Ratios     64
Profitability Measures     64
Profit Margin     65
Return on Assets     65
Return on Equity     65
Market Value Measures     66
Price-Earnings Ratio     66
Market-to-Book Ratio     61
Conclusion     68
The Du Pont Identity     68
A Closer Look at ROE     68
An Expanded Du Pont Analysis     70
Using Financial Statement Information     71
Why Evaluate Financial Statements?     72
Internal Uses     72
External Uses     12
Choosing a Benchmark     72
Time-Trend Analysis     72
Peer Group Analysis     73
Problems with Financial Statement Analysis     77
Summary and Conclusions     78
Long-Term Financial Planning and Growth     90
What Is Financial Planning?     91
Growth as a Financial Management Goal      91
Dimensions of Financial Planning     92
What Can Planning Acccomplish?     93
Examining Interactions     93
Exploring Options     93
Avoiding Surprises     93
Ensuring Feasibility and Internal Consistency     93
Conclusion     94
Financial Planning Models: A First Look     94
A Financial Planning Model: The Ingredients     94
Sales Forecast     94
Pro Forma Statements     94
Asset Requirements     95
Financial Requirements     95
The Plug     95
Economic Assumptions     95
A Simple Financial Planning Model     95
The Percentage of Sales Approach     97
The Income Statement     97
The Balance Sheet     98
A Particular Scenario     99
An Alternative Scenario     100
External Financing and Growth     102
EFN and Growth     104
Financial Policy and Growth     106
The Internal Growth Rate     106
The Sustainable Growth Rate     107
Determinants of Growth     108
A Note on Sustainable Growth Rate Calculations      109
Some Caveats Regarding Financial Planning Models     111
Summary and Conclusions     111
Valuation of Future Cash Flows
Introduction to Valuation: The Time Value of Money     124
Future Value and Compounding     125
Investing for a Single Period     125
Investing for More Than One Period     125
A Note on Compound Growth     131
Present Value and Discounting     132
The Single-Period Case     132
Present Values for Multiple Periods     133
More on Present and Future Values     136
Present versus Future Value     136
Determining the Discount Rate     137
Finding the Number of Periods     141
Summary and Conclusions     144
Discounted Cash Flow Valuation     149
Future and Present Values of Multiple Cash Flows     150
Future Value with Multiple Cash Flows     150
Present Value with Multiple Cash Flows     153
A Note on Cash Flow Timing     156
Valuing Level Cash Flows: Annuities and Perpetuities     157
Present Value for Annuity Cash Flows     157
Annuity Tables     159
Finding the Payment     160
Finding the Rate      162
Future Value for Annuities     163
A Note on Annuities Due     164
Perpetuities     165
Comparing Rates: The Effect of Compounding     167
Effective Annual Rates and Compounding     167
Calculating and Comparing Effective Annual Rates     168
EARs and APRs     170
Taking It to the Limit: A Note on Continuous Compounding     171
Loan Types and Loan Amortization     172
Pure Discount Loans     172
Interest-Only Loans     173
Amortized Loans     173
Summary and Conclusions     178
Interest Rates and Bond Valuation     192
Bonds and Bond Valuation     193
Bond Features and Prices     193
Bond Values and Yields     193
Interest Rate Risk     197
Finding the Yield to Maturity: More Trial and Error     198
More on Bond Features     203
Is It Debt or Equity?     203
Long-Term Debt: The Basics     203
The Indenture     205
Terms of a Bond     205
Security     206
Seniority     206
Repayment     206
The Call Provision      207
Protective Covenants     207
Bond Ratings     208
Some Different Types of Bonds     209
Government Bonds     209
Zero Coupon Bonds     210
Floating-Rate Bonds     211
Other Types of Bonds     212
Bond Markets     214
How Bonds Are Bought and Sold     214
Bond Price Reporting     216
A Note on Bond Price Quotes     219
Inflation and Interest Rates     219
Real versus Nominal Rates     219
The Fisher Effect     220
Determinants of Bond Yields     221
The Term Structure of Interest Rates     221
Bond Yields and the Yield Curve: Putting It All Together     223
Conclusion     225
Summary and Conclusions     226
Stock Valuation     233
Common Stock Valuation     234
Cash Flows     234
Some Special Cases     236
Zero Growth     236
Constant Growth     236
Nonconstant Growth     239
Components of the Required Return     241
Some Features of Common and Preferred Stocks     243
Common Stock Features      243
Shareholder Rights     243
Proxy Voting     244
Classes of Stock     245
Other Rights     245
Dividends     245
Preferred Stock Features     246
Stated Value     246
Cumulative and Noncumulative Dividends     246
Is Preferred Stock Really Debt?     241
The Stock Markets     247
Dealers and Brokers     247
Organization of the NYSE     248
Members     248
Operations     249
Floor Activity     249
NASDAQ Operations     250
NASDAQ Participants     251
Stock Market Reporting     252
Summary and Conclusions     254
Capital Budgeting
Net Present Value and Other Investment Criteria     261
Net Present Value     262
The Basic Idea     262
Estimating Net Present Value     263
The Payback Rule     266
Defining the Rule     266
Analyzing the Rule     267
Redeeming Qualities of the Rule     268
Summary of the Rule     269
The Discounted Payback     269
The Average Accounting Return      272
The Internal Rate of Return     274
Problems with the IRR     278
Nonconventional Cash Flows     278
Mutually Exclusive Investments     280
Redeeming Qualities of the IRR     282
The Profitability Index     283
The Practice of Capital Budgeting     284
Summary and Conclusions     286
Making Capital Investment Decisions     295
Project Cash Flows: A First Look     296
Relevant Cash Flows     296
The Stand-Alone Principle     296
Incremental Cash Flows     296
Sunk Costs     297
Opportunity Costs     297
Side Effects     298
Net Working Capital     298
Financing Costs     298
Other Issues     299
Pro Forma Financial Statements and Project Cash Flows     299
Getting Started: Pro Forma Financial Statements     299
Project Cash Flows     300
Project Operating Cash Flow     301
Project Net Working Capital and Capital Spending     301
Projected Total Cash Flow and Value     301
More on Project Cash Flow     302
A Closer Look at Net Working Capital      302
Depreciation     305
Modified ACRS Depreciation (MACRS)     305
Book Value versus Market Value     307
An Example: The Majestic Mulch and Compost Company (MMCC)     308
Operating Cash Flows     309
Change in NWC     309
Capital Spending     310
Total Cash Flow and Value     310
Conclusion     312
Alternative Definitions of Operating Cash Flow     312
The Bottom-Up Approach     313
The Top-Down Approach     313
The Tax Shield Approach     314
Conclusion     314
Some Special Cases of Discounted Cash Flow Analysis     314
Evaluating Cost-Cutting Proposals     315
Setting the Bid Price     316
Evaluating Equipment Options with Different Lives     319
Summary and Conclusions     321
Project Analysis and Evaluation     330
Evaluating NPV Estimates     331
The Basic Problem     331
Projected versus Actual Cash Flows     331
Forecasting Risk     331
Sources of Value     332
Scenario and Other What-If Analyses     333
Getting Started     333
Scenario Analysis     334
Sensitivity Analysis     336
Simulation Analysis     337
Break-Even Analysis     337
Fixed and Variable Costs     338
Variable Costs     338
Fixed Costs     339
Total Costs     339
Accounting Break-Even     341
Accounting Break-Even: A Closer Look     342
Uses for the Accounting Break-Even     343
Operating Cash Flow, Sales Volume, and Break-Even     344
Accounting Break-Even and Cash Flow     344
The Base Case     344
Calculating the Break-Even Level     344
Payback and Break-Even     345
Sales Volume and Operating Cash Flow     345
Cash Flow, Accounting, and Financial Break-Even Points     346
Accounting Break-Even Revisited     346
Cash Break-Even     346
Financial Break-Even     341
Conclusion     347
Operating Leverage     349
The Basic Idea     349
Implications of Operating Leverage     349
Measuring Operating Leverage     349
Operating Leverage and Break-Even     351
Capital Rationing     352
Soft Rationing     352
Hard Rationing     352
Summary and Conclusions     353
Risk and Return
Some Lessons from Capital Market History     361
Returns     362
Dollar Returns     362
Percentage Returns     364
The Historical Record     366
A First Look     367
A Closer Look     368
Average Returns: The First Lesson     372
Calculating Average Returns     372
Average Returns: The Historical Record     372
Risk Premiums     373
The First Lesson     373
The Variability of Returns: The Second Lesson     374
Frequency Distributions and Variability     374
The Historical Variance and Standard Deviation     375
The Historical Record     377
Normal Distribution     377
The Second Lesson     379
Using Capital Market History     379
More on Average Returns     380
Arithmetic versus Geometric Averages     380
Calculating Geometric Average Returns     381
Arithmetic Average Return or Geometric Average Return?     382
Capital Market Efficiency     383
Price Behavior in an Efficient Market     383
The Efficient Markets Hypothesis     385
Some Common Misconceptions about the EMH     385
The Forms of Market Efficiency     387
Summary and Conclusions     388
Return, Risk, and the Security Market Line     394
Expected Returns and Variances     395
Expected Return     395
Calculating the Variance     397
Portfolios     398
Portfolio Weights     399
Portfolio Expected Returns     399
Portfolio Variance     400
Announcements, Surprises, and Expected Returns     402
Expected and Unexpected Returns     402
Announcements and News     403
Risk: Systematic and Unsystematic     404
Systematic and Unsystematic Risk     404
Systematic and Unsystematic Components of Return     405
Diversification and Portfolio Risk     406
The Effect of Diversification: Another Lesson from Market History     406
The Principle of Diversification     407
Diversificaton and Unsystematic Risk     408
Diversification and Systematic Risk     408
Systematic Risk and Beta     409
The Systematic Risk Principle      409
Measuring Systematic Risk     410
Portfolio Betas     411
The Security Market Line     412
Beta and the Risk Premium     412
The Reward-to-Risk Ratio     413
The Basic Argument     414
The Fundamental Result     416
The Security Market Line     417
Market Portfolios     417
The Capital Asset Pricing Model     418
The SML and the Cost of Capital: A Preview     420
The Basic Idea     420
The Cost of Capital     420
Summary and Conclusions     421
Options and Corporate Finance     430
Options: The Basics     431
Puts and Calls     431
Stock Option Quotations     431
Option Payoffs     433
Fundamentals of Option Valuation     436
Value of a Call Option at Expiration     436
The Upper and Lower Bounds on a Call Option's Value     437
The Upper Bound     437
The Lower Bound     437
A Simple Model: Part I     438
The Basic Approach     439
A More Complicated Case     439
Four Factors Determining Option Values      440
Valuing a Call Option     441
A Simple Model: Part II     441
The Fifth Factor     442
A Closer Look     443
Employee Stock Options     444
ESO Features     444
ESO Repricing     445
Equity as a Call Option on the Firm's Assets     445
The Debt Is Risk-Free     446
The Debt Is Risky     446
Options and Capital Budgeting     448
The Investment Timing Decision     448
Managerial Options     450
Contingency Planning     451
Options in Capital Budgeting: An Example     452
Strategic Options     453
Conclusion     453
Options and Corporate Securities     454
Warrants     454
The Difference between Warrants and Call Options     454
Earnings Dilution     455
Convertible Bonds     455
Features of a Convertible Bond     455
Value of a Convertible Bond     455
Other Options     457
The Call Provision on a Bond     457
Put Bonds     458
Insurance and Loan Guarantees     458
Summary and Conclusions      459
Cost of Capital and Long-Term Financial Policy
Cost of Capital     468
The Cost of Capital: Some Preliminaries     469
Required Return versus Cost of Capital     469
Financial Policy and Cost of Capital     469
The Cost of Equity     470
The Dividend Growth Model Approach     470
Implementing the Approach     470
Estimating g     471
Advantages and Disadvantages of the Approach     472
The SML Approach     472
Implementing the Approach     473
Advantages and Disadvantages of the Approach     473
The Costs of Debt and Preferred Stock     474
The Cost of Debt     474
The Cost of Preferred Stock     475
The Weighted Average Cost of Capital     476
The Capital Structure Weights     476
Taxes and the Weighted Average Cost of Capital     477
Calculating the WACC for Eastman Chemical     478
Eastman's Cost of Equity     478
Eastman's Cost of Debt     480
Eastman's WACC     481
Solving the Warehouse Problem and Similar Capital Budgeting Problems     483
Performance Evaluation: Another Use of the WACC     485
Divisional and Project Costs of Capital     485
The SML and the WACC     485
Divisional Cost of Capital     486
The Pure Play Approach     487
The Subjective Approach     488
Flotation Costs and the Weighted Average Cost of Capital     489
The Basic Approach     489
Flotation Costs and NPV     490
Summary and Conclusions     492
Raising Capital     499
The Financing Life Cycle of a Firm: Early-Stage Financing and Venture Capital     500
Venture Capital     500
Some Venture Capital Realities     501
Choosing a Venture Capitalist     501
Conclusion     502
Selling Securities to the Public: The Basic Procedure     502
Alternative Issue Methods     503
Underwriters     505
Choosing an Underwriter     506
Types of Underwriting     506
Firm Commitment Underwriting     506
Best Efforts Underwriting     506
Dutch Auction Underwriting     507
The Aftermarket     507
The Green Shoe Provision     508
Lockup Agreements     508
The Quiet Period     508
IPOs and Underpricing      509
IPO Underpricing: The 1999-2000 Experience     509
Evidence on Underpricing     510
Why Does Underpricing Exist?     512
New Equity Sales and the Value of the Firm     515
The Costs of Issuing Securities     516
The Costs of Selling Stock to the Public     516
The Costs of Going Public: The Case of Symbion     518
Rights     520
The Mechanics of a Rights Offering     520
Number of Rights Needed to Purchase a Share     521
The Value of a Right     522
Ex Rights     524
The Underwriting Arrangements     524
Effects on Shareholders     525
Dilution     526
Dilution of Proportionate Ownership     526
Dilution of Value: Book versus Market Values     526
A Misconception     527
The Correct Arguments     528
Issuing Long-Term Debt     528
Shelf Registration     529
Summary and Conclusions     530
Financial Leverage and Capital Structure Policy     536
The Capital Structure Question     537
Firm Value and Stock Value: An Example     537
Capital Structure and the Cost of Capital      538
The Effect of Financial Leverage     538
The Basics of Financial Leverage     539
Financial Leverage, EPS, and ROE: An Example     539
EPS versus EBIT     540
Corporate Borrowing and Homemade Leverage     542
Capital Structure and the Cost of Equity Capital     543
M&M Proposition I: The Pie Model     544
The Cost of Equity and Financial Leverage: M&M Proposal II     544
Business and Financial Risk     546
M&M Propositions I and II with Corporate Taxes     547
The Interest Tax Shield     547
Taxes and M&M Proposition I     548
Taxes, the WACC, and Proposition II     549
Conclusion     550
Bankruptcy Costs     552
Direct Bankruptcy Costs     553
Indirect Bankruptcy Costs     553
Optimal Capital Structure     554
The Static Theory of Capital Structure     554
Optimal Capital Structure and the Cost of Capital     555
Optimal Capital Structure: A Recap     556
Capital Structure: Some Managerial Recommendations     558
Taxes     558
Financial Distress     558
The Pie Again     558
The Extended Pie Model      559
Marketed Claims versus Nonmarketed Claims     560
Observed Capital Structures     560
A Quick Look at the Bankruptcy Process     562
Liquidation and Reorganization     562
Bankruptcy Liquidation     562
Bankruptcy Reorganization     563
Financial Management and the Bankruptcy Process     564
Agreements to Avoid Bankruptcy     565
Summary and Conclusions     565
Dividends and Dividend Policy     572
Cash Dividends and Dividend Payment     573
Cash Dividends     573
Standard Method of Cash Dividend Payment     574
Dividend Payment: A Chronology     574
More on the Ex-Dividend Date     575
Does Dividend Policy Matter?     576
An Illustration of the Irrelevance of Dividend Policy     576
Current Policy: Dividends Set Equal to Cash Flow     576
Alternative Policy: Initial Dividend Greater than Cash Flow     577
Homemade Dividends     577
A Test     578
Real-World Factors Favoring a Low Payout     578
Taxes     578
Expected Return, Dividends, and Personal Taxes     580
Flotation Costs      580
Dividend Restrictions     580
Real-World Factors Favoring a High Payout     581
Desire for Current Income     581
Uncertainty Resolution     582
Tax and Legal Benefits from High Dividends     582
Corporate Investors     582
Tax-Exempt Investors     582
Conclusion     583
A Resolution of Real-World Factors?     583
Information Content of Dividends     583
The Clientele Effect     584
Establishing a Dividend Policy     585
Residual Dividend Approach     585
Dividend Stability     587
A Compromise Dividend Policy     587
Some Survey Evidence on Dividends     589
Stock Repurchase: An Alternative to Cash Dividends     590
Cash Dividends versus Repurchase     591
Real-World Considerations in a Repurchase     592
Share Repurchase and EPS     593
Stock Dividends and Stock Splits     593
Some Details on Stock Splits and Stock Dividends     593
Example of a Small Stock Dividend     594
Example of a Stock Split     594
Example of a Large Stock Dividend     595
Value of Stock Splits and Stock Dividends      595
The Benchmark Case     595
Popular Trading Range     595
Reverse Splits     596
Summary and Conclusions     597
Short-Term Financial Planning and Management
Short-Term Finance and Planning     605
Tracing Cash and Net Working Capital     606
The Operating Cycle and the Cash Cycle     607
Defining the Operating and Cash Cycles     608
The Operating Cycle     608
The Cash Cycle     608
The Operating Cycle and the Firm's Organizational Chart     610
Calculating the Operating and Cash Cycles     610
The Operating Cycle     611
The Cash Cycle     612
Interpreting the Cash Cycle     613
Some Aspects of Short-Term Financial Policy     613
The Size of the Firm's Investment in Current Assets     614
Alternative Financing Policies for Current Assets     615
An Ideal Case     615
Different Policies for Financing Current Assets     615
Which Financing Policy Is Best?     618
Current Assets and Liabilities in Practice     619
The Cash Budget     619
Sales and Cash Collections     620
Cash Outflows      621
The Cash Balance     621
Short-Term Borrowing     622
Unsecured Loans     623
Compensating Balances     623
Cost of a Compensating Balance     623
Letters of Credit     624
Secured Loans     624
Accounts Receivable Financing     624
Inventory Loans     625
Other Sources     625
A Short-Term Financial Plan     626
Summary and Conclusions     627
Cash and Liquidity Management     637
Reasons for Holding Cash     638
The Speculative and Precautionary Motives     638
The Transaction Motive     638
Compensating Balances     638
Costs of Holding Cash     638
Cash Management versus Liquidity Management     639
Understanding Float     639
Disbursement Float     639
Collection Float and Net Float     640
Float Management     641
Measuring Float     641
Some Details     642
Cost of the Float     643
Ethical and Legal Questions     645
Electronic Data Interchange: The End of Float?     645
Cash Collection and Concentration      646
Components of Collection Time     646
Cash Collection     646
Lockboxes     647
Cash Concentration     648
Accelerating Collections: An Example     648
Managing Cash Disbursements     651
Increasing Disbursement Float     651
Controlling Disbursements     651
Zero-Balance Accounts     651
Controlled Disbursement Accounts     652
Investing Idle Cash     652
Temporary Cash Surpluses     653
Seasonal or Cyclical Activities     653
Planned or Possible Expenditures     653
Characteristics of Short-Term Securities     654
Maturity     654
Default Risk     654
Marketability     654
Taxes     654
Some Different Types of Money Market Securities     654
Summary and Conclusions     655
Determining the Target Cash Balance     660
The Basic Idea     660
The BAT Model     660
The Opportunity Costs     662
The Trading Costs     662
The Total Cost     663
The Solution     663
Conclusion      665
The Miller-Orr Model: A More General Approach     665
The Basic Idea     665
Using the Model     665
Implications of the BAT and Miller-Orr Models     666
Other Factors Influencing the Target Cash Balance     667
Credit and Inventory Management     670
Credit and Receivables     671
Components of Credit Policy     671
The Cash Flows from Granting Credit     671
The Investment in Receivables     672
Terms of the Sale     672
The Basic Form     672
The Credit Period     673
The Invoice Dote     673
Length of the Credit Period     673
Cash Discounts     674
Cost of the Credit     675
Trade Discounts     675
The Cash Discount and the ACP     675
Credit Instruments     676
Analyzing Credit Policy     676
Credit Policy Effects     676
Evaluating a Proposed Credit Policy     677
NPV of Switching Policies     677
A Break-Even Application     679
Optimal Credit Policy     679
The Total Credit Cost Curve     679
Organizing the Credit Function      680
Credit Analysis     681
When Should Credit Be Granted?     681
A One-Time Sale     681
Repeat Business     682
Credit Information     683
Credit Evaluation and Scoring     683
Collection Policy     684
Monitoring Receivables     684
Collection Effort     685
Inventory Management     685
The Financial Manager and Inventory Policy     686
Inventory Types     686
Inventory Costs     686
Inventory Management Techniques     687
The ABC Approach     687
The Economic Order Quantity Model     688
Inventory Depletion     688
The Carrying Costs     689
The Shortage Costs     690
The Total Costs     690
Extensions to the EOQ Model     692
Safety Stocks     692
Reorder Points     692
Managing Derived-Demand Inventories     694
Materials Requirements Planning     694
Just-in-Time Inventory     694
Summary and Conclusions     695
More on Credit Policy Analysis     700
Two Alternative Approaches      700
The One-Shot Approach     700
The Accounts Receivable Approach     701
Discounts and Default Risk     702
NPV of the Credit Decision     703
A Break-Even Application     703
Topics in Corporate Finance
International Corporate Finance     709
Terminology     710
Foreign Exchange Markets and Exchange Rates     711
Exchange Rates     712
Exchange Rate Quotations     712
Cross-Rates and Triangle Arbitrage     713
Types of Transactions     715
Purchasing Power Parity     716
Absolute Purchasing Power Parity     716
Relative Purchasing Power Parity     717
The Basic Idea     718
The Result     718
Currency Appreciation and Depreciation     719
Interest Rate Parity, Unbiased Forward Rates, and the International Fisher Effect     719
Covered Interest Arbitrage     720
Interest Rate Parity     721
Forward Rates and Future Spot Rates     722
Putting It All Together     722
Uncovered Interest Parity     722
The International Fisher Effect     722
International Capital Budgeting      723
The Home Currency Approach     724
The Foreign Currency Approach     725
Unremitted Cash Flows     725
Exchange Rate Risk     726
Short-Run Exposure     726
Long-Run Exposure     726
Translation Exposure     727
Managing Exchange Rate Risk     728
Political Risk     729
Summary and Conclusions     729
Risk Management: An Introduction to Financial Engineering     736
Hedging and Price Volatility     737
Price Volatility: A Historical Perspective     737
Interest Rate Volatility     738
Exchange Rate Volatility     738
Commodity Price Volatility     739
The Impact of Financial Risk: The U.S. Savings and Loan Industry     739
Managing Financial Risk     740
The Risk Profile     742
Reducing Risk Exposure     742
Hedging Short-Run Exposure     743
Cash Flow Hedging: A Cautionary Note     744
Hedging Long-Term Exposure     744
Conclusion     745
Hedging with Forward Contracts     745
Forward Contracts: The Basics     745
The Payoff Profile     746
Hedging with Forwards     746
A Caveat     747
Credit Risk     748
Forward Contracts in Practice     748
Hedging with Futures Contracts     748
Trading in Futures     748
Futures Exchanges     749
Hedging with Futures     749
Hedging with Swap Contracts     751
Currency Swaps     751
Interest Rate Swaps     752
Commodity Swaps     752
The Swap Dealer     752
Interest Rate Swaps: An Example     753
Hedging with Option Contracts     754
Option Terminology     754
Options versus Forwards     754
Option Payoff Profiles     755
Option Hedging     755
Hedging Commodity Price Risk with Options     756
Hedging Exchange Rate Risk with Options     757
Hedging Interest Rate Risk with Options     757
A Preliminary Note     758
Interest Rate Caps     758
Other Interest Rate Options     758
Summary and Conclusions     759
Option Valuation     764
Put-Call Parity     765
Protective Puts     765
An Alternative Strategy      765
The Result     765
Continuous Compounding: A Refresher Course     767
The Black-Scholes Option Pricing Model     770
The Call Option Pricing Formula     770
Put Option Valuation     773
A Cautionary Note     774
More on Black-Scholes     775
Varying the Stock Price     776
Varying the Time to Expiration     778
Varying the Standard Deviation     780
Varying the Risk-Free Rate     780
Implied Standard Deviations     781
Valuation of Equity and Debt in a Leveraged Firm     783
Valuing the Equity in a Leveraged Firm     783
Options and the Valuation of Risky Bonds     784
Options and Corporate Decisions: Some Applications     786
Mergers and Diversification     786
Options and Capital Budgeting     787
Summary and Conclusions     789
Mergers and Acquisitions     797
The Legal Forms of Acquisitions     798
Merger or Consolidation     798
Acquisition of Stock     799
Acquisition of Assets     800
Acquisition Classifications     800
A Note on Takeovers      800
Alternatives to Merger     801
Taxes and Acquisitions     801
Determinants of Tax Status     802
Taxable versus Tax-Free Acquisitions     802
Accounting for Acquisitions     802
The Purchase Method     803
Pooling of Interests     803
More on Goodwill     803
Gains from Acquisition     804
Synergy     804
Revenue Enhancement     806
Marketing Gains     806
Strategic Benefits     806
Market Power     806
Cost Reductions     807
Economies of Scale     807
Economies of Vertical Integration     807
Complementary Resources     807
Lower Taxes     808
Net Operating Losses     808
Unused Debt Capacity     808
Surplus Funds     808
Asset Write-Ups     809
Reductions in Capital Needs     809
Avoiding Mistakes     809
A Note on Inefficient Management     810
Some Financial Side Effects of Acquisitions     810
EPS Growth     810
Diversification     811
The Cost of an Acquisition      812
Cash Acquisition     813
Stock Acquisition     813
Cash versus Common Stock     814
Defensive Tactics     814
The Corporate Charter     815
Repurchase and Standstill Agreements     815
Poison Pills and Share Rights Plans     815
Going Private and Leveraged Buyouts     816
Other Devices and Jargon of Corporate Takeovers     816
Some Evidence on Acquisitions: Does M&A Pay?     818
Divestitures and Restructurings     818
Summary and Conclusions     819
Leasing     826
Leases and Lease Types     827
Leasing versus Buying     827
Operating Leases     828
Financial Leases     828
Tax-Oriented Leases     829
Leveraged Leases     829
Sale and Leaseback Agreements     829
Accounting and Leasing     829
Taxes, the IRS, and Leases     832
The Cash Flows from Leasing     832
The Incremental Cash Flows     833
A Note on Taxes     834
Lease or Buy?     834
A Preliminary Analysis     834
Three Potential Pitfalls     835
NPV Analysis     835
A Misconception     835
A Leasing Paradox     837
Reasons for Leasing     838
Good Reasons for Leasing     838
Tax Advantages     839
A Reduction of Uncertainty     840
Lower Transactions Costs     840
Fewer Restrictions and Security Requirements     840
Dubious Reasons for Leasing     840
Leasing and Accounting Income     840
100 Percent Financing     841
Low Cost     841
Other Reasons for Leasing     841
Summary and Conclusions     841
Mathematical Tables     A-1
Key Equations     B-1
Answers to Selected End-of-Chapter Problems C
Index     I-1

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