a first coursein corporate finance

A First Course in
Corporate Finance
Preview, Monday 26
th
September, 2005
A First Course in Corporate Finance
© 2003, 2004 by Ivo Welch. All rights reserved.
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The referenced spreadsheets are Excel and OpenOffice (free).
Printed: Monday 26
th
September, 2005 (bookc).
Warning: This book is in development.
It is not error-free.
A First Course in
Corporate Finance
Preview, Monday 26
th
September, 2005
Ivo Welch
Professor of Finance and Economics
Yale University
There are a large number of individuals who have helped me with this book. They will eventually be thanked here.
Until then, some random collection: Rick Antle. Donna Battista. Randolph Beatty. Wolfgang Bühler. Kangbin Chua.
Diego Garcia. Stan Garstka. Roger Ibbotson. Ludovic Phalippou. Matthew Spiegel. John Strong. Julie Yufe. Many

anonymous victim students using earlier error-ridden drafts. Most importantly, Mary-Clare McEwing helped me
improve the book.
Most of the review comments on early version of this book were very good, and I have tried hard to use them all.
Thanks to the reviewers, who really gave a lot of their valuable time and thoughts to help me.
Tony Bernardo
Bill Christie
Jennifer Conrad
Josh Coval
Amy Dittmar
Richard Fendler
Diego Garcia
Sharon Garrison
James Gatti
Simon Gervais
Tom Geurtz
Robert Hansen
Milt Harris
Ronald Hoffmeister
Kurt Jesswin
Mark Klock
Angeline Lavin
Joseph McCarthy
Michael Pagano
Sarah Peck
Robert Ritchey
Bruce Rubin
Tim Sullivan
Chris Stivers
Mark Stohs
John Strong

Joel Vanden
Jaime Zender
Miranda (Mei) Zhang
Warning: This book is in development.
It is not error-free.
Dedicated to my parents, Arthur and Charlotte.
last file change: Aug 23, 2005 (09:13h)
i
A Quick Adoption Checklist For Instructors
This checklist will not apply after AFCICF is published (with full supplementary materials) by Addison-Wesley-
Pearson. The recommended checklist for this book (AFCICF) while in beta test mode:
✓ Read this prologue and one or two sample chapters to determine whether you like the AFCICF approach.
Although not representative, I recommend that you also read the epilogue.
• If you do like the AFCICF approach, then please continue. If you do not like AFCICF (or the chapters you
read), please email why you did not like it. I promise I will not shoot the messenger: I
want to learn how to do it better.
✓ You can continue to assign whatever other finance textbook you were planning to use, but now please add
AFCICF.
• AFCICF is a full-service textbook for an introductory finance course. However, this does not
mean that it cannot also work as a complement to your previous textbook. The fact that it is
so different from the competition means that you and your students can benefit from a test, in
which you assign both books for one year. Relative to relying on only your old textbook, AFCICF
will not increase, but decrease your student confusion and workload. See how well AFCICF works!
(Take the Pepsi challenge!) I hope that the majority of your students (and you) will prefer reading
AFCICF instead of your old textbook.
• I believe it should also be a relatively simple matter for you to plug AFCICF into your current
class: The chapters are succinct and should map easily into your curriculum. Having the old
textbook is also your insurance against using a novel textbook. And it will make students less
critical of the remaining shortcomings in AFCICF, such as the limited number of exercises (and
their occasionally erroneous solutions). Perhaps most importantly, AFCICF does not yet have full

supplementary materials. It will, but until then, the auxiliary materials from older textbook may
help.
• For now, the printing cost for AFCICF adds only around $25 to student cost, so affordability
should not be a concern.
You can go wrong if you try out at least a few chapters of AFCICF in this manner.
✓ You can receive permission to post AFCICF on your class website. (The website must be secured to allow only
university-internal distribution).
✓ Ask your copy center to print and bind the version on your website. (If need be, I can send you nicely bound
copies at $50/book. Your copy center can probably do it for $25/book.)
• Although versions on the AFCICF website at will be better
than the version you download, it is good for you and your students to have one definitive refer-
ence version.
✓ If you are using AFCICF and you are looking for lecture notes, feel free to “steal” and adapt my lecture notes
(linked at to your liking. (Please avoid the homeworks for now. Like some
of the Q&A in AFCICF, the homeworks are not solid.)
✓ At the end of the course, please ask your students which textbook they found more helpful. Please email
your conclusions and impressions to Any suggestions for improvement are of course
also very welcome.
ii
To The Instructor: Differences and Innovations
The main concepts of finance are found in all textbooks, and this textbook is no exception.This book is
intentionally different.
Thus, most—though not all—of the concepts and subjects in A First Course in Corporate
Finance overlap with more traditional finance textbooks. This text’s content is evolutionary,
not revolutionary. Only its presentation is a revolutionary departure from traditional finance
textbooks. Here is my view of how this book differs from what is currently out there:
Conversational Tone The tone is conversational, which (I hope) makes the subject more ac-Conversational Tone.
cessible.
Numerical Example Based I learn best by numerical example, and firmly believe that studentsThe method of
instruction is

“step-by-step numerical
examples.”
do, too. Whenever I want to understand an idea, I try to construct numerical examples
for myself (the simpler, the better). I do not particularly care for long algebra or complex
formulas, precise though they may be. I do not much like many diagrams with long textual
descriptions, either—I often find them too vague, and I am never sure whether I have really
grasped the whole mechanism by which the concept works. Therefore, I wanted to write
a textbook that relies on numerical examples as its primary tutorial method.
This approach necessitates a rearrangement of the tutorial textbook progression. Most
conventional finance textbooks start with a bird’s eye view and then work their way down.
The fundamental difference of this book is that it starts with a worm’s eye view and works
its way up. In caricature form, the format of other textbooks is “institutional background,
hand-waving, formulas, figures, recipe application.” The format of this textbook is the
posing of a critical question like “what would it be worth?,” which is then explained in
numerical step-by-step examples from first principles. Right under the numerical compu-
tations are the corresponding formulas. In my opinion, this structure clarifies the meaning
of these formulas, and is better than either a textual exposition or an algebraic exposition.
I believe that the immediate duality of numerics with formulas ultimately helps students
understand the material on a higher level and with more ease. (Of course, this book also
provides some overviews, and ordinary textbooks also provide some numerical examples.)
This “forward development” approach also goes well with a book that has a conversa-
tional, more interactive flavor.
Brevity Sometimes, less is more.Brevity is important.
The book focus is on
explanations, not
institutions.
This book is intentionally concise, even though it goes into a lot more theoretical detail
than other books! Institutional descriptions are short; only the concepts are explained in
great detail.
My view is that when students are exposed to too much material, they won’t read it, they

won’t remember it, and they won’t know what is really important and what is not. Ten
years after our students graduate, they should still solidly remember the fundamental
ideas and be able to look up the details when they need them. Aside, many institutional
details will have changed—it is the concepts that will last longer.
Self-Contained for Clarity Finance is a subject that every smart student can comprehend, re-Self-contained means
students can backtrack.
gardless of background. It is no more difficult than economics or basic physics. The real
problem is that many students come into class without much prerequisite knowledge,
which we, the instructors, often erroneously believe they have. It is easy to mistake such
“lost students” as “dumb students,” especially if there is no reference source where lost
students can quickly fill in the missing parts.
In this book, I try to make each topic’s development as self-contained as possible. I
try to explain everything from first principles, but in a way that every student can find
interesting. For example, even though the necessary statistical background is integrated
in the book for the statistics novice, the statistics-savvy student also should find value in
reading it. This is because it is different in our finance context than when it is taught for
its own sake in a statistics course.
Because this book tries to be as self-contained as possible, students who have failed to
understand a particular lecture or topic (or who simply miss class) can now be referred
iii
back to read a self-contained chapter. My experience is that having a textbook that relates
closely to the curriculum significantly reduces the need to back up and re-lecture on topics
when enough students have become confused. My experience tells me that this reduces
the planned time necessary to cover topics by about 10%.
Closer Correspondence with the Curriculum I believe that most finance core courses follow Less Chapter Reordering.
a curriculum that is much closer in spirit to this book—and more logical—than it is to the
order in traditional finance textbooks. In the places where this book covers novel material
(see below), I hope that you will find that it has merit—and if you agree, that covering the
topic is much easier with this book than with another book.
Topical Innovation The book offers a good number of specific topical and expositional inno-

vations. Here is a selection:
Progression to Risk and Uncertainty The book starts with a risk-free world, then adds First, no risk; then
risk-neutral attitudes to
risk; then risk-averse
attitudes to risk.
horizon dependent interest rates, then uncertainty under risk neutrality, then fric-
tions (e.g., taxes), then uncertainty under risk-aversion, and finally uncertainty un-
der risk aversion and with taxes (e.g., WACC and APV). Each step builds on concepts
learned earlier. I believe it is an advantage to begin simple and then complicate up,
e.g., to first teach uncertainty and default risk in terms of the much simpler concept
of expected values (elaborated in my next point). The unique role of the more dif-
ficult concepts of risk measurement, risk-aversion, and risk-aversion compensation,
then becomes much clearer (there are forward hints to how it will change when we
will make the world more complex).
Distinction Between Compensation for Default Risk and Risk Aversion I have always beenDrive home “default
risk.”
shocked by how many graduating students think that a Boston Celtics bond quotes
400 basis points in interest above a comparable Treasury bond because of the risk-
premium, which can be calculated using the CAPM formula. Learning to avoid this
fundamental error is more important than fancy theories: the reason why the Boston
Celtics bond quotes 400 extra basis points is primarily its default risk (compensa-
tion for non-payment), not a risk-premium (compensation for risk-aversion). And for
bonds, the latter is usually an order of magnitude smaller than the former. Although
many instructors mention this difference at some point, 5 minutes of default risk
discussion is often lost in 5 hours worth of CAPM discussion. But if students do
not understand the basic distinction, the 5 hours of CAPM discussion are not only
wasted, they will have made matters worse!
Traditional textbooks have not helped, because they have not emphasized the dis-
tinction. In contrast, in this book, default risk is clearly broken out. The difference
between quoted (promised) and expected returns, and default probabilities and de-

fault risk are important themes carried through.
Financials from a Finance Perspective Students need to solidly understand the relation- Understand accounting
without being an
accounting textbook.
ship between financial statements and NPV, and they need to understand the basic
thought process to construct pro formas. Alas, I could not find good, concise, and
self-contained explanations of the important aspects and logic of accounting state-
ments from a finance perspective—rather than from the sometimes minutiae-oriented
accounting perspective. Consequently, AFCICF offers a good chapter on financials.
A fundamental understanding of financials is also necessary to understand compara-
bles: for example, students must know that capital expenditures must be subtracted
out if depreciation is not. Therefore, the common use of EBITDA without a capital
expenditures adjustment is often wrong.
Pro Forma The final chapter, towards which the book works at, is the creation of a pro
forma. It combines all the ingredients from earlier chapters—capital budgeting,
taxes, the cost of capital, capital structure, etc.
iv
Better Exposition of Valuation with Corporate Taxes WACC, APV, and direct pro-formaExplain Pro-Forma,
WACC, and APV better.
construction all incorporate the tax advantage of debt into valuation. This is bread-
and-butter for a CFO. This book offers a clear explanation of how these methods
usually come to similar results (and when not!).
Robustness The book covers the robustness of our methods—the relative importance of
errors and mistakes—and what first-order problems students should worry about
and what second-order problems they can reasonably neglect.
Capital Structure The academic perspective about capital structure has recently changed
quite significantly. The empirical capital structure related chapters make it very clear
where debt/equity ratios really come from.
Many Other Topical Improvements For example, the yield curve gets its own chapter and many more.
even before uncertainty is described in much detail, so that students understand that

investments over different time horizons can offer different rates of return. There
is a self-contained chapter on comparables as a valuation technique—which many of
our students will regularly have to do after they graduate. And the book tries to be
open and honest about where our knowledge is solid and where it is shaky—and how
sensitive our estimates are to the errors we inevitably commit.
Web Chapters and Flexible Topic Choice Although most of our curriculums are the same,Webchapters will allow
a-la-carte choice.
covering necessary basics, there are some topics which may or may not appeal to ev-
eryone. Your preferences may differ from mine. For example, I find the financials part
very important, because this is what most of our graduates will do when they become
analysts, brokers, or consultants. However, you may instead prefer to talk more about
international finance than I. It is of course impossible to satisfy everyone—and instructors
have always chosen their own favorites, adding and deleting topics themselves.
Still, this book tries to help. Some chapters will not be in the printed book, but will
be available only on the Web site (“Web chapters”). Chapter style and formatting are
unmistakably identical to the book itself. Every instructor can therefore choose his/her
own favorite selection and ask students to download it. The existing web chapters are
posted. Among them are
Real Options Real options are briefly covered in Chapter 7 now, but not in great detail.
This web chapter shows how to use spreadsheets, time-series analysis, Monte Carlo
simulation, and optimization to determine the value of a plant that can shut down
and reopen (for a cost) as output prices fluctuate.
Option and Derivative Pricing This is a difficult subject to cover in an introductory course,
because it really requires a minimum of 4-6 class sessions to do it well. This chapter
tries to help you cover the basics in 2-3 class sessions. It explains option contracts,
static arbitrage relations (including put-call parity), dynamic arbitrage and the Black-
Scholes formula, and binomial trees.
International Finance This chapter explains the role of currency translations and interna-
tional market segmentation for both investments and corporate budgeting purposes.
Ethics This chapter is experimental—and provocative. There is neither a particular set

of must-cover topics, nor is there a template on how to present this material. You
may disagree with my choices.
v
All the material in this book has been covered in one full semester course for M.B.A. students Warning: The title is
optimistic.
at the Yale School of Management. However, it is a tight fit, even for graduate students as
talented as those at Yale. It would be impossible to cover all the material in a one quarter
course—although I deem all of it essential. However, a two-quarter course sequence (usually
one investments and one corporate finance course) should be able to cover the material, even
in an undergraduate context. For planning purposes, most chapters should consume either
one or two class sessions.
Is this textbook too clear, and does it thereby eliminate the need for an instructor? If you believe
this to be true, then you are too familiar with the material and you underestimate how difficult
finance is for new students. Neither the book alone nor lectures alone are usually enough. If
we get lucky, the two together will work. Redundancy is important to the learning experience.
Indeed, in my own classes, I ask the students to read the book before class, not after. Having a
good idea of what is coming, student ask questions in the classroom that tend to become more
informed. Of course, if you find that the book makes it easier to teach finance, you can always
speed up and cover more material!
Side Note: If you use this book, please permit me to use and post your homework and exam questions with
answers. (Of course, this is not a requirement, only a plea for help.) My intent is for the Website to become
collaborative: you will be able to see what other faculty do, and they can see what you do. The copyright will of
course remain with you.
To The Student
Prerequisites
What do you need to understand this book? You do not need any specific background in fi- This book and the
subject itself are tough,
but they are not
forbidding, even to an
average student. The

main prerequisite is
mathematical aptitude,
but not mathematical
sophistication.
nance. You do need to be thoroughly comfortable with arithmetic and generally comfortable
with algebra. You do need mathematical aptitude, but no knowledge of advanced mathematical
constructs, such as calculus. (Knowledge of statistics would be helpful, but I will explain the
relevant concepts when the need arises.) You should own a $20 scientific calculator. (Financial
calculators are not bad but also not necessary.) You should learn how to operate a spread-
sheet (such as Excel in Microsoft’s office or the OpenCalc spreadsheet in the excellent and free
OpenOffice at www.openoffice.org). The financial world is moving rapidly away from finan-
cial calculators and toward computer spreadsheets—it is easier to work with information on a
large screen with a 2,000 MHz processor than on a small 2-line display with a 2MHz processor.
Because I have tried hard to keep the book self-contained and to explain everything from first
principles, you should not need to go hunting for details in statistics, economics, or accounting
textbooks. This is not to say that you do not need to take courses in these disciplines: they
have way more to offer than just background knowledge for a finance textbook.
One word of caution: the biggest problem for a novice of any field, but especially of finance, Jargon can trip up the
reader.
is jargon: the specialized terminology known only to the initiated. Worse, in finance, much
jargon is ambiguous. Different people may use different terms for the same thing, and the
same term may mean different things to different people. You have been warned! This book
attempts to point out such ambiguous usage. Luckily, the bark of jargon is usually worse than
its bite. It is only a temporary barrier to entry into the field of finance.
How to Read The Book
vi
This textbook is concise. Its intent is to communicate the essential material in a straightforwardThis book is concise,
focusing on the essence
of arguments.
(and thus compact), but also conversational (and thus more interactive) and accessible fashion.

There are already many finance textbooks with well over a thousand pages. Much of the content
of these textbooks is interesting and useful but not essential to an understanding of finance.
(I personally find some of this extra content distracting.)
The book is organized into four parts: the basics consist of return computations and capitalThe layout of the book.
budgeting. Next are corporate financials, investments (asset pricing), and financing (capital
structure). Major sections within chapters end with questions that ask you to review the points
just made with examples or questions similar to those just covered. You should not proceed
beyond a section without completing these questions (and in “closed book” format)! Many,
but not all, questions are easy and/or straightforward replications of problems that you will
have just encountered in the chapter. Others are more challenging. Each chapter ends with
answers to these review questions. Do not move on until you have mastered these review
questions.
There are “annotations” on the left side of most paragraphs throughout the text. Suggestion:This is an annotation.
use the remaining white space in the margin to scribble your own notes, preferably in pencil
so that you can revise them.
Especially important concepts that you should memorize are in red boxes:These are other notices.
Important: This is an important point to remember.
Interesting, related points that either interrupt the flow of an argument, or that are not abso-
lutely necessary are marked
Side Note: This is an interesting related note, not crucial for understanding the material. It is usually not
excessively technical.
More detailed technical points are “digging-deeper notes,” which should be of interest only to
the student who is interested in pursuing finance beyond the introductory course:
Digging Deeper: If you are really interested, here is a curious fact or a derivation that most likely relies on
excessive algebra.
Both can be safely omitted from reading without compromising understanding. Sometimes, an
appendix contains further advanced material.
A final warning: I have a strange sense of humor. Please do not be easily turned off.Sense of Humor
Other Readings
This book cannot do it all. It is important for you to keep up with current financial devel-Advice: Follow current

coverage of financial
topics elsewhere!
opments. Frequent reading of the financial section of a major newspaper (such as the New
York Times [N.Y.T.]), the Wall Street Journal [W.S.J.], or the Financial Times [F.T.] can help,
as can regular consumption of good business magazines, such as The Economist or Business
Week. (See the website at
for more useful resource links.)
Although this is not a book on “how to read and understand the newspaper,” you should be
able to understand most of the contents of the financial pages after consuming this textbook.
You should also know how to cruise the web—sites such as Yahoo!Finance contain a wealth of
useful financial information, which we shall also use extensively in this book.
TABLE OF CONTENTS vii
Table of Contents
I Investments and Returns 1
Chapter 1: Introduction 5
1·1 The Goal of Finance: Relative Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
1·2 Learning How to Approach New Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
1·3 The Main Parts of This Book . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
Chapter 2: The Time Value of Money 9
2·1 Basic Definitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
2·1.A. Investments, Projects, and Firms 10
2·1.B. Loans and Bonds 11
2·1.C. U.S. Treasuries 12
2·2 Returns, Net Returns, and Rates of Return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
2·3 The Time Value of Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
2·3.A. The Future Value of Money 15
2·3.B. Compounding 15
2·3.C. Confusion: Interest Rates vs. Interest Quotes 19
2·4 Capital Budgeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
2·4.A. Discount Factor and Present Value (PV) 21

2·4.B. Net Present Value (NPV) 24
2·5 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
Chapter 3: More Time Value of Money 31
3·1 Separating Investment Decisions and Present Values From Other Considerations . . . . . 32
3·1.A. Does It Matter When You Need Cash? 32
3·1.B. Corporate Valuation: Growth as Investment Criteria? 33
3·1.C. The Value today is just “All Inflows” or just “All Outflows” 34
3·2 Perpetuities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
3·2.A. The Simple Perpetuity Formula 36
3·2.B. The Growing Perpetuity Formula 38
3·2.C. A Growing Perpetuity Application: Stock Valuation with Gordon Growth Models 39
3·3 The Annuity Formula . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
3·3.A. An Annuity Application: Fixed-Rate Mortgage Payments 41
3·3.B. An Annuity Example: A Level-Coupon Bond 42
3·4 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
a Advanced Appendix: Proofs of Perpetuity and Annuity Formulas . . . . . . . . . . . . . . . 48
viii TABLE OF CONTENTS
Chapter 4: Investment Horizon, The Yield Curve, and (Treasury) Bonds 49
4·1 Time-Varying Rates of Return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
4·2 Annualized Rates of Return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
4·3 The Yield Curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54
4·3.A. An Example: The Yield Curve in May 2002 54
4·3.B. Compounding With The Yield Curve 56
4·3.C. Yield Curve Shapes 57
4·4 Present Values With Time-Varying Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . 58
4·4.A. Valuing A Coupon Bond With A Particular Yield Curve 59
4·5 Why is the Yield Curve not Flat? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61
4·5.A. The Effect of Interest Rate Changes on Short-Term and Long-Term Treasury Bond Values 62
4·6 The Yield To Maturity (YTM) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64
4·7 Optional Bond Topics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66

4·7.A. Extracting Forward Interest Rates 66
4·7.B. Shorting and Locking in Forward Interest Rates 68
4·7.C. Bond Duration 70
4·7.D. Continuous Compounding 74
4·8 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75
Chapter 5: Uncertainty, Default, and Risk 79
5·1 An Introduction to Statistics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80
5·1.A. Random Variables and Expected Values 80
5·1.B. Risk Neutrality (and Risk Aversion Preview) 82
5·2 Interest Rates and Credit Risk (Default Risk) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84
5·2.A. Risk-Neutral Investors Demand Higher Promised Rates 84
5·2.B. A More Elaborate Example With Probability Ranges 85
5·2.C. Preview: Risk-Averse Investors Have Demanded Higher Expected Rates 87
5·3 Uncertainty in Capital Budgeting, Debt, and Equity . . . . . . . . . . . . . . . . . . . . . . . . 89
5·3.A. Present Value With State-Contingent Payoff Tables 89
5·3.B. Splitting Project Payoffs into Debt and Equity 92
5·4 Robustness: How Bad are Your Mistakes? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101
5·4.A. Short-Term Projects 101
5·4.B. Long-Term Projects 102
5·5 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103
a Appendix: A Short Glossary of Some Bonds and Rates . . . . . . . . . . . . . . . . . . . . . . 106
Chapter 6: Dealing With Imperfect Markets 109
6·1 Causes and Consequences of Imperfect Markets . . . . . . . . . . . . . . . . . . . . . . . . . . 110
6·1.A. Perfect Market Assumptions 110
6·1.B. Value in Imperfect Markets 111
6·1.C. Perfect, Competitive, and Efficient Markets 111
6·2 The Effect of Disagreements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115
6·2.A. Expected Return Differences vs. Promised Return Differences 115
6·2.B. Corporate Finance vs. Entrepreneurial or Personal Finance? 116
6·2.C. Covenants, Collateral, and Credit Rating Agencies 117

6·3 Market Depth and Transaction Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121
6·3.A. Typical Costs When Trading Real Goods—Houses 121
6·3.B. Typical Costs When Trading Financial Goods—Stocks 122
6·3.C. Transaction Costs in Returns and Net Present Values 124
6·3.D. Liquidity 125
6·4 An Introduction to The Tax Code . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126
6·4.A. The Basics of (Federal) Income Taxes 126
6·4.B. Before-Tax vs. After-Tax Expenses 128
TABLE OF CONTENTS ix
6·4.C. Average and Marginal Tax Rates 129
6·4.D. Dividend and Capital Gains Taxes 130
6·4.E. Other Taxes 131
6·4.F. What You Need To Know About Tax Principles In Our Book 131
6·5 Working With Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 132
6·5.A. Taxes in Rates of Returns 132
6·5.B. Tax-Exempt Bonds and the Marginal Investor 133
6·5.C. Taxes in NPV 134
6·5.D. Tax Timing 136
6·6 Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137
6·6.A. Defining the Inflation Rate 137
6·6.B. Real and Nominal Interest Rates 138
6·6.C. Handling Inflation in Net Present Value 140
6·6.D. Interest Rates and Inflation Expectations 141
6·7 Multiple Effects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143
6·7.A. How to Work Problems You Have Not Encountered 143
6·7.B. Taxes on Nominal Returns? 144
6·8 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146
Chapter 7: Capital Budgeting (NPV) Applications and Advice 153
7·1 The Economics of Project Interactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 154
7·1.A. The Ultimate Project Selection Rule 154

7·1.B. Project Pairs and Externalities 155
7·1.C. One More Project: Marginal Rather Than Average Contribution 157
7·2 Comparing Projects With Different Lives and Rental Equivalents . . . . . . . . . . . . . . . . 162
7·3 Expected, Typical, and Most Likely Scenarios . . . . . . . . . . . . . . . . . . . . . . . . . . . . 164
7·4 Future Contingencies and Real Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165
7·5 Mental Biases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 167
7·6 Incentive (Agency) Biases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 168
7·7 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 172
Chapter 8: Other Important Capital Budgeting Topics 175
8·1 Profitability Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176
8·2 The Internal Rate of Return (IRR) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 177
8·2.A. Definition 177
8·2.B. Problems with IRR 178
8·3 So Many Returns: The Internal Rate of Return, the Cost of Capital, the Hurdle Rate, and
the Expected Rate of Return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180
8·4 Other Capital Budgeting Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 181
8·4.A. The Problems of Payback 181
8·4.B. More Rules 182
8·5 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 183
x TABLE OF CONTENTS
II Corporate Financials 185
Chapter 9: Understanding Financial Statements 189
9·1 Financial Statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 190
9·1.A. The Contents of Financials 191
9·1.B. PepsiCo’s 2001 Financials 192
9·1.C. Why Finance and Accounting Think Differently 198
9·2 The Bottom-Up Example — Long-Term Accruals (Depreciation) . . . . . . . . . . . . . . . . . 200
9·2.A. Doing Accounting 200
9·2.B. Doing Finance 203
9·2.C. Translating Accounting into Finance 205

9·3 The Hypothetical Bottom-Up Example — Short-Term Accruals . . . . . . . . . . . . . . . . . 208
9·3.A. Working Capital 208
9·3.B. Earnings Management 210
9·4 Completing the Picture: PepsiCo’s Financials . . . . . . . . . . . . . . . . . . . . . . . . . . . . 212
9·5 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 217
A Appendix: Supplementary Financials — Coca Cola . . . . . . . . . . . . . . . . . . . . . . . . . 218
a. Coca Cola’s Financials From EdgarScan 219
b. Coca Cola’s Financials From Yahoo!Finance 220
B Appendix: Abbreviated PepsiCo Income Statement and Cash Flow Statement . . . . . . . . 221
Chapter 10:Valuation From Comparables 227
10·1 Comparables vs. NPV . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 228
10·2 The Price-Earnings (PE) Ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 229
10·2.A. Definition 229
10·2.B. Why P/E Ratios differ 230
10·2.C. P/E Ratio Application Example: Valuing Beverage Companies 236
10·3 Problems With P/E Ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 237
10·3.A. Selection of Comparison Firms 238
10·3.B. (Non-) Aggregation of Comparables 239
10·3.C. A Major Blunder: Never Average P/E ratios 240
10·3.D. Computing Trailing Twelve Month (TTM) Figures 242
10·3.E. Leverage Adjustments For P/E Ratios 243
10·4 Other Financial Ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 247
10·4.A. Value-Based Ratios 247
10·4.B. Non-Value-Based Ratios Used in Corporate Analyses 248
10·5 Closing Thoughts: Comparables or NPV? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 253
10·6 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 254
A Advanced Appendix: A Formula For Unlevering P/E ratios . . . . . . . . . . . . . . . . . . . . 255
TABLE OF CONTENTS xi
III Risk and the Opportunity Cost of Capital / Abbre-
viated Investments 259

Chapter 11:A First Look at Investments 263
11·1 Stocks, Bonds, and Cash, 1970–2004 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 264
11·1.A. Graphical Representation of Historical Stock Market Returns 265
11·1.B. Comparative Investment Performance 268
11·1.C. Comovement, Beta, and Correlation 272
11·2 Visible and General Historical Stock Regularities . . . . . . . . . . . . . . . . . . . . . . . . . . 274
11·3 History or Opportunities? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 275
11·4 Eggs and Baskets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 276
11·4.A. The Overall Basket 276
11·4.B. The Marginal Risk Contribution 277
11·4.C. The Market Equilibrium 277
11·5 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 278
A Appendix: Some Background Information About Equities Market Microstructure . . . . . . 279
a. Brokers 279
b. Exchanges and Non-Exchanges 279
c. How Securities Appear and Disappear 280
Chapter 12:Investor Choice: Risk and Reward 283
12·1 Measuring Risk and Reward . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 284
12·1.A. Possible Investment Opportunity Returns 284
12·1.B. Measuring Reward: The Expected Rate of Return 285
12·1.C. Measuring Risk: The Standard Deviation of the Rate of Return 286
12·2 Portfolios, Diversification, and Aggregate Investor Preferences . . . . . . . . . . . . . . . . . 287
12·2.A. Aggregate Investor Preferences 289
12·3 How To Measure Risk Contribution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 290
12·3.A. Own Risk is not a Good Measure for Portfolio Risk Contribution 290
12·3.B. Beta is a Good Measure for Portfolio Risk Contribution 293
12·3.C. Computing Betas from Rates of Returns 296
12·3.D. Beta and Correlation 298
12·3.E. Typical Stock Betas and Interpreting Their Meanings 299
12·4 Expected Rates of Return and Betas of (Weighted) Portfolios and Firms . . . . . . . . . . . . 300

12·5 Practical Application . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 303
12·5.A. Spreadsheets 303
12·5.B. Some Notes on the Statistical Formulas 303
12·6 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 305
Chapter 13:The Capital Asset Pricing Model 307
13·1 What We Already Know And Where We Want To Go . . . . . . . . . . . . . . . . . . . . . . . . 308
13·2 The Capital-Asset Pricing Model (CAPM) — A Cookbook Recipe Approach . . . . . . . . . . 309
13·2.A. The Security Markets Line (SML) 310
13·2.B. Non-CAPM Worlds and Non-Linear SMLs 313
13·2.C. Empirical Reality 316
13·3 Using the CAPM Cost of Capital in the NPV Context:
Revisiting The Default Premium and Risk Premium . . . . . . . . . . . . . . . . . . . . . . . . 318
13·4 Estimating CAPM Inputs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 320
13·4.A. The Equity Premium

E(
˜
r
M
) − r
F

320
13·4.B. The Risk-Free Rate and Multi-Year Considerations (r
F
) 323
13·4.C. Investment Projects’ Market Betas (β
i,M
) 324
13·4.D. Betas For Publicly Traded Firms 326

xii TABLE OF CONTENTS
13·4.E. Betas From Comparables and Leverage Adjustments:
Equity Beta vs. Asset Beta 326
13·4.F. Betas Based on Economic Intuition 329
13·4.G. Robustness: How Bad are Mistakes in CAPM Inputs? 329
13·5 Value Creation and Destruction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 331
13·5.A. Does Risk-Reducing Corporate Diversification (or Hedging) Create Value? 331
13·5.B. Avoiding Cost-of-Capital Mixup Blunders That Destroy Value 333
13·5.C. Differential Costs of Capital — Theory and Practice! 335
13·6 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 337
A Appendix: Valuing Goods Not Priced at Fair Value via Certainty Equivalence . . . . . . . . 339
a. Finding The True Value of A Good That is Not Fairly Priced 339
b. An Application of the Certainty Equivalence Method 342
Chapter 14:The Optimal Portfolio 347
14·1 An Investor’s Risk vs Reward Tradeoff . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 348
14·1.A. A Short-Cut Formula For the Risk of a Portfolio 349
14·1.B. Graphing the Mean-Variance Efficient Frontier 350
14·1.C. Adding a Risk-Free Rate 355
14·2 The Efficient Frontier and the CAPM Formula . . . . . . . . . . . . . . . . . . . . . . . . . . . . 361
14·3 Simplifications and Perspective . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 363
14·4 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 365
14·5 Advanced Appendix: More than Two Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . 366
Chapter 15:Efficient Markets, Classical Finance, and Behavioral Finance 371
15·1 Arbitrage and Great Bets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 372
15·2 Market Efficiency and Behavioral Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 373
15·2.A. Basic Definition and Requirements 373
15·2.B. Classifications Of Market Efficiency Beliefs 375
15·2.C. The Fundamentals Based Classification 375
15·2.D. The Traditional Classification 377
15·3 Efficient Market Consequences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 378

15·3.A. Stock Prices and Random Walks 379
15·3.B. Are Fund Managers Just Monkeys on Typewriters? 384
15·3.C. Corporate Consequences 386
15·3.D. Event Studies Can Measure Instant Value Impacts 387
15·4 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 394
TABLE OF CONTENTS xiii
IV Financing Choices / Capital Structure 397
Chapter 16:Corporate Financial Claims 401
16·1 The Basic Building Blocks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 402
16·1.A. Bonds 402
16·1.B. Ordinary Equity (Common Stock) 403
16·1.C. Debt and Equity as State-Contingent Claims 404
16·2 More Financial Claims . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 405
16·2.A. Call Options and Warrants 405
16·2.B. Preferred Equity (Stock) 409
16·2.C. Convertible Bonds 409
16·2.D. Other Bond Features 412
16·3 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 414
Chapter 17:Idealized Capital Structure and Capital Budgeting 419
17·1 Conceptual Basics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 420
17·1.A. The Firm, The Charter, and The Capital Structure 420
17·1.B. Maximization of Equity Value or Firm Value? 420
17·2 Modigliani and Miller (M&M), The Informal Way . . . . . . . . . . . . . . . . . . . . . . . . . . 422
17·3 Modigliani and Miller (M&M), The Formal Way In Perfect Markets . . . . . . . . . . . . . . . . 424
17·4 Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 428
17·5 The Weighted Cost of Capital (WACC) in a Perfect M&M World . . . . . . . . . . . . . . . . . 429
17·5.A. The Numerical Example 429
17·5.B. The WACC Formula (Without Taxes) 432
17·5.C. The Big Picture: How to Think of Debt and Equity 433
17·6 A Major Blunder: If all securities are more risky, is the firm more risky? . . . . . . . . . . . 435

17·7 Using the CAPM and WACC Cost of Capital in the NPV Formula . . . . . . . . . . . . . . . . . 436
17·8 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 437
A Advanced Appendix: Compatibility of Beta, the WACC, and the CAPM Formulas in a Perfect
World. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 438
Chapter 18:Corporate Taxes and A Tax Advantage of Debt 441
18·1 Capital Budgeting If Equity and Debt Were Equally Taxed . . . . . . . . . . . . . . . . . . . . 442
18·2 Differential Taxation in The U.S. Tax Code . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 443
18·3 Firm Value Under Different Capital Structures . . . . . . . . . . . . . . . . . . . . . . . . . . . 444
18·3.A. Future Corporate Income Taxes and Owner Returns 444
18·3.B. The Discount Factor on Tax Obligations and Tax Shelters 445
18·4 Formulaic Valuation Methods: APV and WACC . . . . . . . . . . . . . . . . . . . . . . . . . . . 451
18·4.A. Adjusted Present Value (APV): Theory 451
18·4.B. APV: Application to a 60/40 Debt Financing Case 453
18·4.C. Tax-Adjusted Weighted Average Cost of Capital (WACC) Valuation: Theory 453
18·4.D. A Major Blunder: Applying APV and WACC to the Current Cash Flows 456
18·5 A Sample Application of Tax-Adjusting Valuation Techniques . . . . . . . . . . . . . . . . . 457
18·5.A. Direct Valuations from Pro Forma Financials 458
18·5.B. APV 458
18·5.C. WACC 459
18·6 The Tax Subsidy on PepsiCo’s Financial Statement . . . . . . . . . . . . . . . . . . . . . . . . 462
18·7 Odds and Ends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 463
18·7.A. Which Valuation Method is Best? 463
18·7.B. A Quick-and-Dirty Heuristic Tax-Savings Rule 464
18·7.C. Can Investment and Financing Decisions Be Separate? 464
18·7.D. Using Our Tax Formulas 465
18·7.E. Other Capital Structure Related Tax Avoidance Schemes 466
xiv TABLE OF CONTENTS
18·8 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 468
Chapter 19:Other Capital Structure Considerations 473
19·1 The Role of Personal Income Taxes and Clientele Effects . . . . . . . . . . . . . . . . . . . . . 474

19·1.A. Background: The Tax Code For Security Owners 474
19·1.B. The Principle Should Be “Joint Tax Avoidance” 475
19·1.C. Tax Clienteles 476
19·2 Operating Policy Distortions: Behavior in Bad Times . . . . . . . . . . . . . . . . . . . . . . . 482
19·2.A. Direct and Indirect Bankruptcy Costs 484
19·2.B. Operational Distortions of Incentives 486
19·2.C. Strategic Considerations 488
19·3 Operating Policy Distortions: Behavior in Good Times . . . . . . . . . . . . . . . . . . . . . . 489
19·3.A. Agency Issues 489
19·4 Bondholder Expropriation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 490
19·4.A. Project Risk Changes 491
19·4.B. Issuance of Bonds of Similar Priority 492
19·4.C. Counteracting Forces 493
19·5 Inside Information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 496
19·6 Transaction Costs and Behavioral Explanations . . . . . . . . . . . . . . . . . . . . . . . . . . 499
19·7 Corporate Payout Policy: Dividends and Share Repurchases . . . . . . . . . . . . . . . . . . . 500
19·8 Synthesis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 503
19·8.A. Cost of Capital Calculations 503
19·8.B. Interactions 503
19·8.C. Reputation and Capital Structure Recommendations 504
19·9 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 505
Chapter 20:Capital Dynamics 509
20·1 Tracking IBM’s Capital Structure From 2001 to 2003 . . . . . . . . . . . . . . . . . . . . . . . 510
20·1.A. Debt 511
20·1.B. Long-Term Debt 512
20·1.C. Current Liabilities 514
20·1.D. Other Liabilities 514
20·1.E. Equity 517
20·1.F. Observations 518
20·2 The Dynamics of Capital Structure and Firm Scale . . . . . . . . . . . . . . . . . . . . . . . . . 519

20·3 The Managerial Perspective . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 521
20·3.A. The Holistic View 521
20·3.B. Meaningful Questions 522
20·3.C. Financial Flexibility and Cash Management 523
20·3.D. Market Pressures Towards the Optimal Capital Structure? 524
20·4 Some Process Information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 525
20·4.A. The Pecking Order (and Financing Pyramid) 525
20·4.B. Debt and Debt-Hybrid Offerings 527
20·4.C. Seasoned Equity Offerings 529
20·4.D. Initial Public Offerings 530
20·4.E. Raising Funds Through Other Claims and Means 532
20·4.F. The Influence of Stock Returns 532
20·5 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 534
A Appendix: Standard&Poor’s 04/24/2005 Bond Report on IBM’s 2032 5.875% Coupon Bond536
TABLE OF CONTENTS xv
Chapter 21:Empirical Evidence on Capital Structure Dynamics 537
21·1 Layers of Causality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 538
21·2 The Relative Importance of Capital Structure Mechanisms . . . . . . . . . . . . . . . . . . . . 538
21·2.A. Net Issuing Activity 539
21·2.B. Firm Value Changes 540
21·3 Deeper Causality — Capital Structure Influences . . . . . . . . . . . . . . . . . . . . . . . . . . 542
21·3.A. A Large-Scale Empirical Study 542
21·3.B. Theory vs. Empirics 544
21·3.C. Evidence on Equity Payouts: Dividends and Equity Repurchasing 545
21·3.D. Forces Acting Through the Equity Payout Channel 546
21·4 Survey Evidence From CFOs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 547
21·5 Leverage Ratios By Firm Size, Profitability, and Industry . . . . . . . . . . . . . . . . . . . . . 549
21·6 Perspective . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 552
21·7 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 553
A Appendix: A List of Some Recent Empirical Capital-Structure Related Publications . . . . 554

Chapter 22:Financial Market Responses to Capital Structure Changes 557
22·1 Value Changes at Announcements (Event Studies) . . . . . . . . . . . . . . . . . . . . . . . . . 557
22·2 Equity Issuing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 558
22·2.A. The Average Response 558
22·2.B. The Cross-sectional Evidence 562
22·2.C. Earlier Studies 563
22·2.D. Theoretical Perspective 564
22·3 Debt Issuing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 565
22·3.A. The Average Response 565
22·3.B. The Cross-sectional Evidence 567
22·3.C. Earlier Studies 567
22·3.D. Theoretical Perspective 568
22·4 Dividend Payment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 569
22·4.A. The Average Response 569
22·4.B. The Cross-sectional Evidence 571
22·4.C. Earlier Studies 573
22·4.D. Theoretical Perspective 573
22·5 Interpreting The Empirical Event Study Evidence . . . . . . . . . . . . . . . . . . . . . . . . . . 574
22·6 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 576
Chapter 23:Investment Banking 579
23·1 Investment Bankers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 580
23·1.A. Underwriting Functions 580
23·1.B. The Top Underwriters 581
23·2 The Underwriting Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 584
23·2.A. Direct Issuing Costs 584
23·2.B. Underwriter Selection 585
23·2.C. Sum-Total Issuing Costs — The Financial Market Reaction 586
23·3 Mergers and Acquisitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 589
23·3.A. M&A Participants, Deal Characteristics, and Advisory Fees 591
23·4 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 593

xvi TABLE OF CONTENTS
Chapter 24:Corporate Governance 595
24·1 Less Fact, More Fiction: In Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 596
24·2 Managerial Temptations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 597
24·2.A. Illegal Temptations 597
24·2.B. Legal Temptations 599
24·2.C. The Incentive of the Entrepreneur to Control Temptations 601
24·3 Equity Protection . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 604
24·3.A. Subsequent Equity Offerings 604
24·3.B. The Corporate Board 605
24·3.C. The Role of Votes 606
24·3.D. Large Shareholders 611
24·3.E. The Legal Environment 613
24·3.F. Ethics, Publicity, and Reputation 614
24·3.G. Conclusion 616
24·4 Debt Protection . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 617
24·5 The Effectiveness of Corporate Governance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 618
24·5.A. An Opinion: What Works and What Does not Work 618
24·5.B. Where are we going? 619
24·6 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 622
V Putting It All Together – Pro Formas 625
Chapter 25:Pro Forma Financial Statements 627
25·1 The Goal and Logic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 628
25·1.A. The Template 628
25·2 The Detailed vs. Terminal Time Break . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 630
25·3 The Detailed Projection Phase . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 632
25·3.A. Method 1: Direct Extrapolation of Historical Cash Flows 632
25·3.B. Method 2: Pro Forma Projections With Detailed Modeling of Financials 633
25·3.C. Policy and Calculations off the Pro Forma Components 638
25·4 Pro Forma Terminal Values . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 639

25·4.A. The Cost of Capital 639
25·4.B. The Cost of Capital Minus the Growth Rate of Cash Flows 641
25·5 Complete Pro Formas . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 643
25·5.A. An Unbiased Pro Forma 643
25·5.B. A Calibrated Pro Forma 645
25·6 Alternative Assumptions and Sensitivity Analysis . . . . . . . . . . . . . . . . . . . . . . . . . 648
25·6.A. Fiddle With Individual Items 648
25·6.B. Do Not Forget Failure 648
25·6.C. Assessing the Fudge Factor 649
25·7 Proposing Capital Structure Change . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 650
25·8 Hindsight . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 652
25·9 Caution — The Emperor’s New Clothes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 654
25·10 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 655
A Appendix: In-a-Pinch Advice: Fixed vs. Variable Components . . . . . . . . . . . . . . . . . . 656
TABLE OF CONTENTS xvii
VI Appendices 665
Chapter A:Epilogue 667
A·1 Thoughts on Business and Finance Education . . . . . . . . . . . . . . . . . . . . . . . . . . . . 668
A·1.A. Common Student Misconceptions 668
A·1.B. Common Faculty Misconceptions 669
A·1.C. Business School vs. Practice 670
A·1.D. The Rankings 671
A·2 Finance: As A Discipline . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 672
A·2.A. Art or Science? 672
A·2.B. Will We Ever Fully Understand Finance? 672
A·3 Finance Research . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 673
A·3.A. Accomplishments of Finance 673
A·3.B. Interesting Current Academic Research 673
A·3.C. Getting Involved in Academic Research 673
A·3.D. Finance Degrees 673

A·3.E. Academic Careers in Finance and Economics: A Ph.D.? 674
A·3.F. Being a Professor — A Dream Job for the Lazy? 675
A·3.G. Top Finance Journals 676
A·4 Bon Voyage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 677
Chapter B: More Resources 679
2·1 An NPV Checklist . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 680
2·2 Prominently Used Data Websites . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 682
2·3 Necessary Algebraic Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 683
2·4 Laws of Probability, Portfolios, and Expectations . . . . . . . . . . . . . . . . . . . . . . . . . . 685
2·4.A. Single Random Variables 685
2·4.B. Portfolios 687
2·5 Cumulative Normal Distribution Table . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 689
Chapter C:Sample Exams 693
3·1 A Sample Midterm . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 694
3·2 A Sample Final . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 695
a Q&A: Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 699
Chapter A:Index 703
1·1 Main Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 703
xviii TABLE OF CONTENTS
Web Chapters na
Chapter : International Finance see website
Chapter : Ethics see website
Chapter : IPOs in Detail see website
Chapter : Options see website
Chapter : Empirical Corporate Finance see website
Part I
Investments and Returns
(A part of all versions of the book.)
1

3
What You Want to Accomplish in this Part
Aside from teaching the necessary background, the two primary goals of this first part of the
book is to explain how to work with rates of return, and how to decide whether to take or reject
investment projects.
The method of our book is to start with “simple” scenarios and then build on them. For any
tool to work in a more complex scenario, it has to also work in the simpler scenario, so what
you learn in earlier chapters lays the ground work for later chapters.
• In Chapter 1, you will learn where this book is going. Most of our goal is “relative valu-
ation” (valuing one opportunity relative to others), and everything will come together to
be of use only in our final “pro forma” chapter. It will also tell you more about the book’s
approach—its “method of thinking.”
• In Chapter 2, you will start with the simplest possible scenario. There are no taxes, trans-
action costs, disagreements, or limits as to the number of sellers and buyers in the market.
You know everything, and all rates of return in the economy are the same. A one-year
investment pays the same and perfectly known rate of return per annum as a ten-year in-
vestment. You want to know how one-year returns translate into multi-year returns; and
when you should take a project and when you should reject it. The chapter introduces
the most important concept of “present value.”
Typical questions: If you earn 5% per year, how much will you earn over 10
years? If you earn 100% over 10 years, how much will you earn per year? What
is the value of a project that will deliver $1,000,000 in 10 years? Should you buy
this project if it cost you $650,000?
• In Chapter 3, you will learn how to value particular kinds of projects—annuities and
perpetuities—if the economy-wide interest rate remains constant.
Typical questions: What is the monthly mortgage payment for a $300,000 mort-
gage if the interest rate is 4% per annum?
• In Chapter 4, you will abandon the assumption that returns are the same regardless of
investment horizon. For example, one-year investments may pay 2% per annum, while ten-
year investments may pay 5% per annum. Having time-varying rates of return is a more

realistic scenario than the previous chapter’s constant interest rate scenario. However,
the question that you want to answer are the same questions as those in Chapter 2. (The
chapter then also explains some more advanced aspects of bonds.)
Typical questions: If you earn 5% in the first year and 10% in the second year,
how much will you earn over both years? What is the meaning of a 4% annualized
interest rate? What is the meaning of a 4% yield-to-maturity? How can you value
projects if appropriate rates of return depend on investment horizon?
• In Chapter 5, you will abandon the assumption that you have perfect omniscience. To be
able to study uncertainty, you must begin with statistics. The chapter then explains an
important assumption about your risk preferences that makes this easy: risk-neutrality.
This lays the ground for discussing the role of uncertainty in finance. (Later, in Part III,
you will learn what to do if investors are risk-averse.)
Uncertainty means that a project may not return the promised amount—the stated rate
of return would be higher than the expected rate of return. Although you are interested in
the latter, it is almost always only the former that you are quoted (promised). You must
always draw a sharp distinction between promised (stated) rates of return, and expected
rates of return. This chapter also explains the difference between debt and equity, which
is only meaningful under uncertainty.