Corporate finance core principles and applications 3rd ed Ross Jaffe Jordan

C O R P O R AT E F I N A N C E
C O R E P R I N C I P L E S & A P P L I C AT I O N S

ros30689_fm_i-xxxiv.indd i

8/19/10 12:59 PM


The McGraw-Hill/Irwin Series in Finance, Insurance, and Real Estate
Stephen A. Ross
Franco Modigliani Professor of Finance
and Economics
Sloan School of Management
Massachusetts Institute of Technology
Consulting Editor
FINANCIAL MANAGEMENT
Adair
Excel Applications for Corporate Finance
First Edition
Block, Hirt, and Danielsen
Foundations of Financial Management
Fourteenth Edition
Brealey, Myers, and Allen
Principles of Corporate Finance
Tenth Edition
Brealey, Myers, and Allen
Principles of Corporate Finance, Concise
Second Edition
Brealey, Myers, and Marcus
Fundamentals of Corporate Finance

Sixth Edition
Brooks
FinGame Online 5.0
Bruner
Case Studies in Finance: Managing for
Corporate Value Creation
Sixth Edition
Chew
The New Corporate Finance: Where Theory
Meets Practice
Third Edition
Cornett, Adair, and Nofsinger
Finance: Applications and Theory
First Edition
DeMello
Cases in Finance
Second Edition
Grinblatt (editor)
Stephen A. Ross, Mentor: Influence through
Generations
Grinblatt and Titman
Financial Markets and Corporate Strategy
Second Edition
Higgins
Analysis for Financial Management
Ninth Edition
Kellison
Theory of Interest
Third Edition

ros30689_fm_i-xxxiv.indd ii

Kester, Ruback, and Tufano
Case Problems in Finance
Twelfth Edition

Rose and Marquis
Financial Institutions and Markets
Eleventh Edition

Ross, Westerfield, and Jaffe
Corporate Finance
Ninth Edition

Saunders and Cornett
Financial Institutions Management: A Risk
Management Approach
Seventh Edition

Ross, Westerfield, Jaffe, and Jordan
Corporate Finance: Core Principles and
Applications
Third Edition
Ross, Westerfield, and Jordan
Essentials of Corporate Finance
Seventh Edition
Ross, Westerfield, and Jordan
Fundamentals of Corporate Finance
Ninth Edition
Shefrin

Behavioral Corporate Finance: Decisions
that Create Value
First Edition
White
Financial Analysis with an Electronic
Calculator
Sixth Edition
INVESTMENTS
Bodie, Kane, and Marcus
Essentials of Investments
Eighth Edition
Bodie, Kane, and Marcus
Investments
Ninth Edition
Hirt and Block
Fundamentals of Investment Management
Ninth Edition
Hirschey and Nofsinger
Investments: Analysis and Behavior
Second Edition
Jordan and Miller
Fundamentals of Investments: Valuation
and Management
Fifth Edition
Stewart, Piros, and Heisler
Running Money: Professional Portfolio
Management
First Edition
Sundaram and Das
Derivatives: Principles and Practice

First Edition
FINANCIAL INSTITUTIONS AND MARKETS

Saunders and Cornett
Financial Markets and Institutions
Fourth Edition
INTERNATIONAL FINANCE
Eun and Resnick
International Financial Management
Fifth Edition
Kuemmerle
Case Studies in International
Entrepreneurship: Managing and Financing
Ventures in the Global Economy
First Edition
Robin
International Corporate Finance
First Edition
REAL ESTATE
Brueggeman and Fisher
Real Estate Finance and Investments
Fourteenth Edition
Ling and Archer
Real Estate Principles: A Value Approach
Third Edition
FINANCIAL PLANNING AND INSURANCE
Allen, Melone, Rosenbloom, and Mahoney
Retirement Plans: 401(k)s, IRAs, and Other
Deferred Compensation Approaches
Tenth Edition

Altfest
Personal Financial Planning
First Edition
Harrington and Niehaus
Risk Management and Insurance
Second Edition
Kapoor, Dlabay, and Hughes
Focus on Personal Finance: An Active
Approach to Help You Develop Successful
Financial Skills
Third Edition
Kapoor, Dlabay, and Hughes
Personal Finance
Ninth Edition

Rose and Hudgins
Bank Management and Financial Services
Eighth Edition

18/08/10 7:44 PM


THIRD EDITION

C O R P O R AT E F I N A N C E
C O R E P R I N C I P L E S & A P P L I C AT I O N S
Stephen A. Ross
Sloan School of Management
Massachusetts Institute of Technology

Randolph W. Westerfield
Marshall School of Business
University of Southern California

Jeffrey F. Jaffe
Wharton School of Business
University of Pennsylvania

Bradford D. Jordan
Gatton College of Business and Economics
University of Kentucky

ros30689_fm_i-xxxiv.indd iii

18/08/10 7:44 PM


CORPORATE FINANCE: CORE PRINCIPLES & APPLICATIONS
Published by McGraw-Hill/Irwin, a business unit of The McGraw-Hill Companies, Inc., 1221 Avenue of
the Americas, New York, NY, 10020. Copyright © 2011, 2009, 2007 by The McGraw-Hill Companies, Inc.
All rights reserved. No part of this publication may be reproduced or distributed in any form or by any means,
or stored in a database or retrieval system, without the prior written consent of The McGraw-Hill Companies,
Inc., including, but not limited to, in any network or other electronic storage or transmission, or broadcast for
distance learning.
Some ancillaries, including electronic and print components, may not be available to customers outside the
United States.
This book is printed on acid-free paper.
1 2 3 4 5 6 7 8 9 0 RJE/RJE 1 0 9 8 7 6 5 4 3 2 1 0
ISBN 978-0-07-353068-0
MHID 0-07-353068-9

Vice president and editor-in-chief: Brent Gordon
Publisher: Douglas Reiner
Executive editor: Michele Janicek
Director of development: Ann Torbert
Development editor II: Elizabeth Hughes
Vice president and director of marketing: Robin J. Zwettler
Senior marketing manager: Melissa S. Caughlin
Vice president of editing, design, and production: Sesha Bolisetty
Lead project manager: Christine A. Vaughan
Senior buyer: Carol A. Bielski
Senior designer: Mary Kazak Sander
Media project manager: Ron Nelms
Cover and interior design: Pam Verros
Cover image: Toyohiro Yamada, Tohoku Color Agency
Typeface: 10/12 Times New Roman
Compositor: MPS Limited, A Macmillan Company
Printer: R. R. Donnelley
Library of Congress Cataloging-in-Publication Data
Corporate finance : core principles & applications / Stephen A. Ross . . . [et al.]. — 3rd ed.
p. cm. — (The McGraw-Hill/Irwin series in finance, insurance, and real estate)
Includes index.
ISBN-13: 978-0-07-353068-0 (alk. paper)
ISBN-10: 0-07-353068-9 (alk. paper)
1. Corporations–Finance. I. Ross, Stephen A.
HG4026.C643 2011
658.15 —dc22
2010026731

www.mhhe.com

ros30689_fm_i-xxxiv.indd iv

18/08/10 7:44 PM


To our family and friends with love
and gratitude.
—S.A.R.

ros30689_fm_i-xxxiv.indd v

R.W.W.

J.F.J.

B.D.J.

18/08/10 7:44 PM


ABOUT THE AUTHORS

Stephen A. Ross
SLOAN SCHOOL OF MANAGEMENT, MASSACHUSETTS INSTITUTE
OF TECHNOLOGY

Stephen A. Ross is the Franco Modigliani Professor of Financial 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, as well as

for having made substantial contributions to the discipline through his research
in signaling, agency theory, option pricing, and the theory of the term structure
of interest rates, among other topics. A past president of the American Finance
Association, he currently serves as an associate editor of several academic and
practitioner journals. He is a trustee of CalTech.

Randolph W. Westerfield
MARSHALL SCHOOL OF BUSINESS, UNIVERSITY OF SOUTHERN CALIFORNIA

Randolph W. Westerfield is Dean Emeritus of the University of Southern
California’s Marshall School of Business and is the Charles B. Thornton Professor in Finance. Professor Westerfield came to USC from the Wharton School,
University of Pennsylvania, where he was the chairman of the finance department
and member of the finance faculty for 20 years. He is a member of several public company boards of directors including Health Management Associates, Inc.,
William Lyon Homes, and the Nicholas Applegate Growth Fund. His areas of
expertise include corporate financial policy, investment management, and stock
market price behavior.

ros30689_fm_i-xxxiv.indd vi

18/08/10 7:44 PM


Jeffrey F. Jaffe
WHARTON SCHOOL OF BUSINESS, UNIVERSITY OF PENNSYLVANIA

Jeffrey F. Jaffe has been a frequent contributor to finance and economic literature in such journals as the Quarterly Economic Journal, The Journal of Finance,
The Journal of Financial and Quantitative Analysis, The Journal of Financial
Economics, and The Financial Analysts Journal. His best known work concerns
insider trading, where he showed both that corporate insiders earn abnormal profits from their trades and that regulation has little effect on these profits. He has
also made contributions concerning initial public offerings, the regulation of utilities, the behavior of market makers, the fluctuation of gold prices, the theoretical

effect of inflation on the interest rate, the empirical effect of inflation on capital
asset prices, the relationship between small capitalization stocks and the January
effect, and the capital structure decision.

Bradford D. Jordan
GATTON COLLEGE OF BUSINESS AND ECONOMICS, UNIVERSITY OF KENTUCKY

Bradford D. Jordan is Professor of Finance and holder of the Richard W. and
Janis H. Furst Endowed Chair in Finance at the University of Kentucky. He has a
long-standing interest in both applied and theoretical issues in corporate finance
and has extensive experience teaching all levels of corporate finance and financial
management policy. Professor Jordan has published numerous articles in leading
journals on issues such as initial public offerings, capital structure, and the behavior of security prices. He is a past president of the Southern Finance Association,
and he is coauthor of Fundamentals of Investments: Valuation and Management,
5e, a leading investments text, also published by McGraw-Hill/Irwin.

ros30689_fm_i-xxxiv.indd vii

8/19/10 12:59 PM


FROM THE AUTHORS
IN THE BEGINNING…
It was probably inevitable that the four of us would collaborate on this project. Over the last 20 or so years, we have been
working as two separate “RWJ” teams. In that time, we managed (much to our own amazement) to coauthor two widely
adopted undergraduate texts and an equally successful graduate text, all in the corporate finance area. These three books
have collectively totaled more than 25 editions (and counting),
plus a variety of country-specific editions and international
editions, and they have been translated into at least a dozen
foreign languages.

Even so, we knew that there was a hole in our lineup at the
graduate (MBA) level. We’ve continued to see a need for a
concise, up-to-date, and to-the-point product, the majority of
which can be realistically covered in a typical single term or
course. As we began to develop this book, we realized (with
wry chuckles all around) that, between the four of us, we have
been teaching and researching finance principles for well
over a century. From our own very extensive experience with
this material, we recognized that corporate finance introductory classes often have students with extremely diverse educational and professional backgrounds. We also recognized
that this course is increasingly being delivered in alternative
formats ranging from traditional semester-long classes to
highly compressed modules, to purely online courses, taught
both synchronously and asynchronously.

OUR APPROACH
To achieve our objective of reaching out to the many different types of students and the varying course environments,
we worked to distill the subject of corporate finance down to
its core, while maintaining a decidedly modern approach. We
have always maintained that corporate finance can be viewed
as the working of a few very powerful intuitions. We also know
that understanding the “why” is just as important, if not more
so, than understanding the “how.” Throughout the development of this book, we continued to take a hard look at what
is truly relevant and useful. In doing so, we have worked to
downplay purely theoretical issues and minimize the use of extensive and elaborate calculations to illustrate points that are
either intuitively obvious or of limited practical use.
Perhaps more than anything, this book gave us the chance
to pool all that we have learned about what really works in
a corporate finance text. We have received an enormous
amount of feedback over the years. Based on that feedback,
the two key ingredients that we worked to blend together here

ros30689_fm_i-xxxiv.indd viii

are the careful attention to pedagogy and readability that we
have developed in our undergraduate books and the strong
emphasis on current thinking and research that we have
always stressed in our graduate book.
From the start, we knew we didn’t want this text to be encyclopedic. Our goal instead was to focus on what students
really need to carry away from a principles course. After much
debate and consultation with colleagues who regularly teach
this material, we settled on a total of 20 chapters. Chapter
length is typically 30 pages, so most of the book (and, thus,
most of the key concepts and applications) can be realistically
covered in a single term or module. Writing a book that strictly
focuses on core concepts and applications necessarily involves some picking and choosing, with regard to both topics
and depth of coverage. Throughout, we strike a balance by
introducing and covering the essentials, while leaving more
specialized topics to follow-up courses.
As in our other books, we treat net present value (NPV) as
the underlying and unifying concept in corporate finance. Many
texts stop well short of consistently integrating this basic principle. The simple, intuitive, and very powerful notion that NPV
represents the excess of market value over cost often is lost in
an overly mechanical approach that emphasizes computation
at the expense of comprehension. In contrast, every subject we
cover is firmly rooted in valuation, and care is taken throughout
to explain how particular decisions have valuation effects.
Also, students shouldn’t lose sight of the fact that financial
management is about management. We emphasize the role
of the financial manager as decision maker, and we stress
the need for managerial input and judgment. We consciously

avoid “black box” approaches to decisions, and where appropriate, the approximate, pragmatic nature of financial analysis
is made explicit, possible pitfalls are described, and limitations
are discussed.

NEW TO THE 3RD EDITION
With our first two editions of Corporate Finance: Core
Principles & Applications, we had the same hopes and fears
as any entrepreneurs. How would we be received in the market? Based on the very gratifying feedback we received, we
learned that many of you agreed with us concerning the need
for a focused, concise treatment of the major principles of corporate finance.
In developing the third edition, one of the things we focused on was extensive updating. We wanted to be as current
as possible throughout the book. As a result, we revamped,

18/08/10 7:44 PM


rewrote, or replaced essentially all of the chapter opening vignettes, in-chapter real-world examples, and The Real World
readings. We updated facts and figures throughout the book,
and we revised and expanded the already extensive end-ofchapter material.
A list of the most important revisions to the third edition
is below:
Overall:

Completely rewritten Chapter on Financial
Statements and Financial Models
Revised and updated data and figures
More Excel examples
All new chapter openers
All new problems at ends of chapters
Many new boxes

New chapter on Raising Capital
Completely rewritten International Corporate
Finance chapter
Updated real examples
Mergers and Acquisitions moved to online

Chapter 1:

New materials on corporate governance and
regulation, including Sarbanes-Oxley

Chapter 3:

Improved discussion of financial ratios
e.g. EBITDA and EV
More examples

Chapter 4:

New spreadsheet applications

Chapter 9:

New material on the full payout model

Chapter 10:

New material on global equity risk premiums
Update to 2009
New material on the global market collapse

Chapter 12:

New material on how to estimate the WACC
Updated examples

Chapter 13:

More material on bubbles
Changed Chapter title to underscore behavioral
challenges

Chapter 15:

Updated data on capital structure

ros30689_fm_i-xxxiv.indd ix

Our attention to updating and improving also extended to
the extensive collection of support and enrichment materials
that accompany the text. Working with many dedicated and
talented colleagues and professionals, we continue to provide
supplements that are unrivaled at the graduate level (a complete description appears in the following pages). Whether
you use just the textbook, or the book in conjunction with other
products, we believe you will be able to find a combination
that meets your current as well as your changing needs.

—Stephen A. Ross
—Randolph W. Westerfield
—Jeffrey F. Jaffe

—Bradford D. Jordan

18/08/10 7:44 PM


PEDAGOGY
Chapter Opening Case

Corporate Finance: Core
Principles & Applications
is rich in valuable learning
tools and support to help
students succeed in learning
the fundamentals of financial
management.

Each chapter begins with a recent real-world event to
introduce students to chapter concepts.
CHAPTER

4

Discounted Cash Flow
Valuation

OPENING CASE
PART TWO Valuation and Capital Budgeting

W

hat do Chris Iannetta, John Lackey, and Matt Holliday have in common? All
three are star athletes who signed big-money contracts during late 2009 or
early 2010. Their contract values were reported as $8.35 million, $82.5 million, and $120 million, respectively. But reported numbers can be misleading.
For example, catcher Chris Ianetta re-signed with the Colorado Rockies. His

deal called for salaries of $1.75 million, $2.55 million, and $3.55 million over the next three years,
respectively, with a contract buyout of $500,000 or a salary of $5,000,000 in four years. Not bad,
especially for someone who makes a living using the “tools of ignorance” (jock jargon for a catcher’s
equipment).
A closer look at the numbers shows that Chris, John, and Matt did pretty well, but nothing like the
quoted figures. Using Matt’s contract as an example, the value was reported to be $120 million, but it
was actually payable over several years. The terms called for a salary of $17 million per year for seven
years, then a club option for $17 million in 2017 or a club buyout of $1 million. However, of the $17 million annual salary, $2 million each year was to be deferred and paid annually from 2020 to 2029. Since
the payments are spread out over time, we must consider the time value of money, which means his
contract was worth less than reported. How much did he really get? This chapter gives you the “tools
of knowledge” to answer this question.

Explanatory Web Links

p

EXAMPLE

4.12

These Web links are provided in the
margins of the text. They are specifically
selected to accompany text material and
provide students and instructors with
a quick way to check for additional

information using the Internet.

If the stated annual rate of interest, 8 percent, is compounded quarterly, what is the effective annual
rate?
Using (4.7), we have
m

4

.08 ⫺ 1 ⫽ .0824 ⫽ 8.24%
⫺ 1 ⫽ 1 ⫹ ___
4

(

)

Referring back to our earlier example where C0 ⫽ $1,000 and r ⫽ 10%, we can generate the following table:

C0

COMPOUNDING
FR E Q U E N C Y ( m )

C1

$1,000
1,000
1,000
1,000

Yearly (m ⫽ 1)
Semiannually (m ⫽ 2)
Quarterly (m ⫽ 4)
Daily (m ⫽ 365)

$1,100.00
1,102.50
1,103.81
1,105.16

ros30689_fm_i-xxxiv.indd x

y

Online bond calculators
are available at
personal.fidelity.com;
interest rate information
is available at money.
cnn.com/markets/
bondcenter and www.
bankrate.com.

This is just the amount of the discount.
What would the Xanth bond sell for if interest rates had dropped by 2 percent instead of
rising by 2 percent? As you might guess, the bond would sell for more than $1,000. Such a
bond is said to sell at a premium and is called a premium bond.
This case is just the opposite of that of a discount bond. The Xanth bond now has a
coupon rate of 8 percent when the market rate is only 6 percent. Investors are willing to

pay a premium to get this extra coupon amount. In this case, the relevant discount rate
is 6 percent, and there are nine years remaining. The present value of the $1,000 face
amount is:

Examples

Compounding Frequencies

( 1 ⫹ __mr )

,

Annuity present value  $20  (1  1兾1.109)兾.10
 $20  5.7590
 $115.18

E FFE C T I V E A N N U A L
R AT E 
r m
1  _
m  1

(

)

.10
.1025
.10381
.10516

Separate numbered and titled examples are extensively
integrated into the chapters. These examples provide
detailed applications and illustrations of the text
material in a step-by-step format. Each example is
completely self-contained, so students don’t have to
search for additional information.

8/19/10 12:59 PM


Figure 4.11 illustrates the relationship among annual, semiannual, and continuous compounding. Semiannual compounding gives rise to both a smoother curve and a higher ending value than does annual compounding. Continuous compounding has both the smoothest
curve and the highest ending value of all.

Figures and Tables

FIGURE 4.11

THE REAL WORLD

4

Interest
earned

3
2

4

Interest
earned

3

Dollars

4
Dollars

This text makes extensive use of real data
presented in various figures and tables.
Explanations in the narrative, examples,
and end-of-chapter problems refer to
many of these exhibits.

Dollars

Annual, Semiannual, and
Continuous Compounding

2

0

1

2
3
Years

4

5

0

Annual compounding

Interest
earned

2
1

1

1

3

1

2
3
Years

4

5

Semiannual compounding

0

1

2
3
Years

4

5

Continuous compounding

JACKPOT!
If you or someone you know is a regular lottery player, you probably already understand that you are 20 times more
likely to get struck by lightning than you are to win a big lottery jackpot. What are your odds of winning? Below you
will find a table with your chances of winning the Mega Millions Lottery compared to other events.
Odds of winning a Mega Millions jackpot
Odds of being killed by a venomous spider
Odds of being killed by a dog bite
Odds of being killed by lightning
Odds of being killed by drowning
Odds of being killed falling from a bed or other furniture
Odds of being killed in a car crash

The Real World

1:135,145,920*
1:57,018,763
1:11,403,753
1:6,479,405
1:690,300
1:388,411
1:6,029

By exploring information found in recent
publications and building upon concepts
learned in each chapter, these boxes work
through real-world issues relevant to the
surrounding text.

*Source: Virginia Lottery Web site. All other odds from the National Safety Council.

Sweepstakes may have different odds than lotteries, but these odds may not be much better. Probably the
largest advertised potential grand prize ever was Pepsi’s “Play for a Billion,” which, you guessed it, had a $1 billion
(billion!) prize. Not bad for a day’s work, but you still have to read the fine print. It turns out that the winner would
be paid $5 million per year for the next 20 years, $10 million per year for years 21 through 39, and a lump sum
$710 million in 40 years. From what you have learned, you know the value of the sweepstakes wasn’t even close to
$1 billion. In fact, at an interest rate of 10 percent, the present value is about $70.7 million.
In January 2010, a 59-year-old man and his 57-year-old wife in New York won the $162 million Mega Millions
jackpot. They were given the option of receiving the jackpot as $6.231 million immediately and $6.231 million per
year for the next 25 years, or $102 million immediately. So, what discount rate does this imply? After some computational effort, we find the interest rate is about 4.15 percent. Unfortunately for the winners, nearly $1 million was
placed in an escrow account over a dispute about the mismanagement of funds at a homeless shelter the couple
had previously operated.
Some lotteries make your decision a little tougher. The Ontario Lottery will pay you either $2,000 a week for the
rest of your life or $1.3 million now. (That’s in Canadian dollars or “loonies,” by the way.) Of course, there is the

chance you might die in the near future, so the lottery guarantees that your heirs will collect the $2,000 weekly
payments until the twentieth anniversary of the first payment, or until you would have turned 91, whichever comes
first. This payout scheme complicates your decision quite a bit. If you live for only the 20-year minimum, the breakeven interest rate between the two options is about 5.13 percent per year, compounded weekly. If you expect to
live longer than the 20-year minimum, you might be better off accepting $2,000 per week for life. Of course, if you
manage to invest the $1.3 million lump sum at a rate of return of about 8 percent per year (compounded weekly),
you can have your cake and eat it too because the investment will return $2,000 at the end of each week forever!
Taxes complicate the decision in this case because the lottery payments are all on an aftertax basis. Thus, the rates
of return in this example would have to be aftertax as well.

How to Calculate Present Values with
Multiple Future Cash Flows Using a
Spreadsheet

SPREADSHEET TECHNIQUES

We can set up a basic spreadsheet to calculate the present values of the individual cash flows as follows.
Notice that we have simply calculated the present values one at a time and added them up:

Spreadsheet Techniques

A

B

C

D

E

1

Using a spreadsheet to value multiple future cash flows

2

This feature helps students to improve their Excel
spreadsheet skills, particularly as they relate to
corporate finance. This feature appears in selfcontained sections and shows students how to set up
spreadsheets to analyze common financial problems—a
vital part of every business student’s education. For
even more help using Excel, students have access to
Excel Master, an in-depth online tutorial.

3
4
5
6
7
8
9

What is the present value of $200 in one year, $400 the next year, $600 the next year, and
$800 the last year if the discount rate is 12 percent?

10
11
12
13
14

15
16
17
18
19
20
21
22

Rate:

0.12

Year

Cash flows

1
2
3
4

$200
$400
$600
$800
Total PV:

Present values
$178.57

$318.88
$427.07
$508.41
$1,432.93

Formula used
=PV($B$7,A10,0,⫺B10)
=PV($B$7,A11,0,⫺B11)
=PV($B$7,A12,0,⫺B12)
=PV($B$7,A13,0,⫺B13)
=SUM(C10:C13)

Notice the negative signs inserted in the PV formulas. These just make the present values have
positive signs. Also, the discount rate in cell B7 is entered as $B$7 (an "absolute" reference)
because it is used over and over. We could have just entered ".12" instead, but our approach is more
flexible.

This real rate is the same as we had before. If we take another look at the Fisher effect, we
can rearrange things a little as follows:
1  R  (1  r)  (1  h)
Rrhrh

[5.3]

What this tells us is that the nominal rate has three components. First, there is the real rate
on the investment, r. Next, there is the compensation for the decrease in the value of the
money originally invested because of inflation, h. The third component represents compensation for the fact that the dollars earned on the investment are also worth less because of
the inflation.
This third component is usually small, so it is often dropped. The nominal rate is then
approximately equal to the real rate plus the inflation rate:

R 艐 rh

ros30689_fm_i-xxxiv.indd xi

Numbered Equations
Key equations are numbered within the
text and listed on the back end sheets for
easy reference.

[5.4]

8/19/10 12:59 PM


END-OF-CHAPTER
MATERIAL
The end-of-chapter material
reflects and builds on the
concepts learned from the
chapter and study features.

Summary and Conclusions
Each chapter ends with a numbered and concise, but
thorough, summary of the important ideas presented
in the chapter—helping students review the key points
and providing closure.
SUMMARY AND CONCLUSIONS
This chapter has explored bonds, bond yields, and interest rates. We saw that:
1. Determining bond prices and yields is an application of basic discounted cash flow principles.
2. Bond values move in the direction opposite that of interest rates, leading to potential gains or

losses for bond investors.
3. Bonds have a variety of features spelled out in a document called the indenture.
4. Bonds are rated based on their default risk. Some bonds, such as Treasury bonds, have no risk
of default, whereas so-called junk bonds have substantial default risk.
5. A wide variety of bonds exist, many of which contain exotic or unusual features.
6. Almost all bond trading is OTC, with little or no market transparency in many cases. As a result,
bond price and volume information can be difficult to find for some types of bonds.
7. Bond yields and interest rates reflect the effect of six different things: the real interest rate and
five premiums that investors demand as compensation for inflation, interest rate risk, default
risk, taxability, and lack of liquidity.

CONCEPT QUESTIONS

Concept Questions

1. Treasury Bonds Is it true that a U.S. Treasury security is risk-free?
2. Interest Rate Risk Which has greater interest rate risk, a 30-year Treasury bond or a 30-year
BB corporate bond?
3. Treasury Pricing With regard to bid and ask prices on a Treasury bond, is it possible for the bid
price to be higher? Why or why not?
4. Yield to Maturity Treasury bid and ask quotes are sometimes given in terms of yields, so there
would be a bid yield and an ask yield. Which do you think would be larger? Explain.
5. Call Provisions A company is contemplating a long-term bond issue. It is debating whether
or not to include a call provision. What are the benefits to the company from including a call
provision? What are the costs? How do these answers change for a put provision?
6. Coupon Rate How does a bond issuer decide on the appropriate coupon rate to set on its
bonds? Explain the difference between the coupon rate and the required return on a bond.

This end-of-chapter section facilitates your
students’ knowledge of key principles, as well

as their intuitive understanding of the chapter
concepts. The questions reinforce students’
critical-thinking skills and provide a review of
chapter material.

7. Real and Nominal Returns Are there any circumstances under which an investor might be
more concerned about the nominal return on an investment than the real return?
8. Bond Ratings Companies pay rating agencies such as Moody’s and S&P to rate their bonds,
and the costs can be substantial. However, companies are not required to have their bonds
rated in the first place; doing so is strictly voluntary. Why do you think they do it?
9. Bond Ratings

U.S. Treasury bonds are not rated. Why? Often, junk bonds are not rated. Why?

Questions and Problems
Because solving problems is so critical to
students’ learning, we provide extensive end-ofchapter questions and problems. The questions
and problems are segregated into three learning
levels: Basic, Intermediate, and Challenge. All
problems are fully annotated so that students
and instructors can readily identify particular
types. Also, most of the problems are available
in McGraw-Hill’s Connect—see the next
section of this preface for more details.

ros30689_fm_i-xxxiv.indd xii

QUESTIONS AND PROBLEMS
1. Stock Values The Starr Co. just paid a dividend of $2.15 per share on its stock. The dividends
are expected to grow at a constant rate of 4 percent per year, indefinitely. If investors require a

12 percent return on the stock, what is the current price? What will the price be in three years?
In 15 years?

Basic
(Questions 1–9)

2. Stock Values The next dividend payment by ZYX, Inc., will be $2.85 per share. The dividends
are anticipated to maintain a 4.5 percent growth rate, forever. If ZYX stock currently sells for
$84 per share, what is the required return?
3. Stock Values For the company in the previous problem, what is the dividend yield? What is the
expected capital gains yield?
4. Stock Values Mickelson Corporation will pay a $2.90 per share dividend next year. The
company pledges to increase its dividend by 4.75 percent per year, indefinitely. If you require
an 11 percent return on your investment, how much will you pay for the company’s stock
today?
5. Stock Valuation Shelter, Inc., is expected to maintain a constant 5.2 percent growth rate in its
dividends, indefinitely. If the company has a dividend yield of 4.4 percent, what is the required
return on the company’s stock?
6. Stock Valuation Suppose you know that a company’s stock currently sells for $73 per share
and the required return on the stock is 12 percent. You also know that the total return on the
stock is evenly divided between a capital gains yield and a dividend yield. If it’s the company’s
policy to always maintain a constant growth rate in its dividends, what is the current dividend
per share?

8/19/10 12:59 PM


What’s On the Web?

W H AT ’ S O N T H E W E B ?

1. Bond Quotes You can find current bond prices at cxa.marketwatch.com/finra/BondCenter.
You want to find the bond prices and yields for bonds issued by Georgia Pacific. You can enter
the ticker symbol “GP” to do a search. What is the shortest maturity bond issued by Georgia
Pacific that is outstanding? What is the longest maturity bond? What is the credit rating for
Georgia Pacific’s bonds? Do all of the bonds have the same credit rating? Why do you think
this is?

Excel Problems

13. Nonconstant Dividends South Side Corporation is expected to pay the following dividends
over the next four years: $10, $8, $5, and $3. Afterward, the company pledges to maintain a constant 5 percent growth rate in dividends forever. If the required return on the stock is 13 percent,
what is the current share price?

Indicated by the Excel icon in the margin,
these problems are integrated in the
Questions and Problems section of almost
all chapters. Located on the book’s Web site,
Excel templates have been created for each
of these problems. Students can use the data
in the problem to work out the solution using
Excel skills.

14. Differential Growth Hughes Co. is growing quickly. Dividends are expected to grow at a
30 percent rate for the next three years, with the growth rate falling off to a constant 7 percent
thereafter. If the required return is 10 percent and the company just paid a $2.40 dividend, what
is the current share price?
15. Differential Growth Janicek Corp. is experiencing rapid growth. Dividends are expected to
grow at 27 percent per year during the next three years, 17 percent over the following year,
and then 7 percent per year indefinitely. The required return on this stock is 12 percent, and the
stock currently sells for $65 per share. What is the projected dividend for the coming year?

16. Negative Growth Antiques R Us is a mature manufacturing firm. The company just paid a
$12 dividend, but management expects to reduce the payout by 4 percent per year, indefinitely. If
you require a 9 percent return on this stock, what will you pay for a share today?

ros30689_fm_i-xxxiv.indd xiii

CLOSING CASE

S T O C K V A L U AT I O N AT R A G A N E N G I N E S
Larissa has been talking with the company’s directors about the future of East Coast Yachts. To this
point, the company has used outside suppliers for various key components of the company’s yachts,
including engines. Larissa has decided that East Coast Yachts should consider the purchase of an
engine manufacturer to allow East Coast Yachts to better integrate its supply chain and get more
control over engine features. After investigating several possible companies, Larissa feels that the
purchase of Ragan Engines, Inc., is a possibility. She has asked Dan Ervin to analyze Ragan’s value.
Ragan Engines, Inc., was founded nine years ago by a brother and sister—Carrington and
Genevieve Ragan—and has remained a privately owned company. The company manufactures
marine engines for a variety of applications. Ragan has experienced rapid growth because of a
proprietary technology that increases the fuel efficiency of its engines with very little sacrifice in
performance. The company is equally owned by Carrington and Genevieve. The original agreement
between the siblings gave each 125,000 shares of stock.

These end-of-chapter activities show
students how to use and learn from the vast
amount of financial resources available on
the Internet.

End-of-Chapter Cases
Located at the end of each chapter,
these mini-cases focus on common

company situations that embody
important corporate finance topics.
Each case presents a new scenario,
data, and a dilemma. Several questions
at the end of each case require students
to analyze and focus on all of the
material they learned in that chapter.

8/19/10 12:59 PM


COMPREHENSIVE TEACHING
DIGITAL SOLUTIONS
Online Learning Center (OLC): Online Support at www.mhhe.com/rwj
The Online Learning Center (OLC) contains FREE access to Web-based study and
teaching aids created for this text, all in one place!

INSTRUCTOR SUPPORT

ros30689_fm_i-xxxiv.indd xiv

■

Instructor’s Manual
prepared by David Diehl, Aurora University, and Joseph Smolira, Belmont
University
A great place to find new lecture ideas. The IM has three main sections. The first
section contains a chapter outline and other lecture materials. The annotated outline
for each chapter includes lecture tips, real-world tips, ethics notes, suggested
PowerPoint slides, and, when appropriate, a video synopsis. Detailed solutions for

all end-of-chapter problems appear in section three.

■

Test Bank
prepared by Bruce Costa, University of Montana
Great format for a better testing process. The Test Bank has 75–100 questions per
chapter that closely link with the text material and provide a variety of question
formats (multiple-choice questions problems and essay questions) and levels of difficulty (basic, intermediate, and challenge) to meet every instructor’s testing needs.
Problems are detailed enough to make them intuitive for students and solutions are
provided for the instructor.

■

Computerized Test Bank
Create your own tests in a snap! These additional questions are found in a computerized test bank utilizing McGraw-Hill’s EZ Test testing software to quickly create
customized exams. This user-friendly program allows instructors to sort questions
by format; edit existing questions or add new ones; and scramble questions for
multiple versions of the same test.

■

PowerPoint Presentation System
prepared by David Diehl, Aurora University
Customize our content for your course. This presentation has been thoroughly
revised to include more lecture-oriented slides, as well as exhibits and examples
both from the book and from outside sources. Applicable slides have Web links
that take you directly to specific Internet sites, or a spreadsheet link to show an
example in Excel. You can also go to the Notes Page function for more tips in
presenting the slides. This customizable format gives you the ability to edit, print,

or rearrange the complete presentation to meet your specific needs.

18/08/10 7:44 PM


AND LEARNING PACKAGE
Videos
Also available in DVD format. Current set of videos on hot topics! McGraw-Hill/Irwin
has produced a series of finance videos that are 10-minute case studies on topics such as
Financial Markets, Careers, Rightsizing, Capital Budgeting, EVA (Economic Value Added),
Mergers and Acquisitions, and Foreign Exchange. Discussion questions for these videos, as
well as video clips, are available in the Instructor’s Center at www.mhhe.com/rwj.

STUDENT SUPPORT
■

Narrated PowerPoint Examples
These in-depth slides are designed exclusively for students as part of the premium
content package of this book. Each chapter’s slides follow the chapter topics and provide steps and explanations showing how to solve key problems. Because each student
learns differently, a quick click on each slide will “talk through” its contents with you!

■

Interactive FinSims
Created by Eric Sandburg, Interactive Media, each module highlights a key concept
of the book and simulates how to solve its problems, asking the student to input
certain variables. This hands-on approach guides students through difficult and
important corporate finance topics.

■

Excel Master
Created by Brad Jordan and Joe Smolira, this extensive Excel tutorial is fully
integrated with the text. Learn Excel and corporate finance at the same time. For
more details about this exciting new feature see the inside cover of this book!

McGraw-Hill Investments Trader
Students receive free access to this Web-based portfolio simulation with a hypothetical
$100,000 brokerage account to buy and sell stocks and mutual funds. Students can use
the real data found at this site in conjunction with the chapters on investments. They
can also compete against other students around the United States. Please click on the
corresponding link found in the OLC for more details. This site is powered by Stock-Trak,
the leading provider of investment simulation services to the academic community.
■

And More!
Be sure to check out the other helpful features found on the OLC, including selfgrading quizzes and end-of-chapter problem Excel templates.

PACKAGE OPTIONS AVAILABLE
FOR PURCHASE & PACKAGING
You may also package either version of the text with a variety of additional learning tools
that are available for your students.

ros30689_fm_i-xxxiv.indd xv

18/08/10 7:44 PM


Solutions Manual
(ISBN 10: 0077316363/ISBN 13: 9780077316365)

Prepared by Joseph Smolira, Belmont University, this manual contains detailed, workedout solutions for all of the problems in the end-of-chapter material. It has also been
reviewed for accuracy by multiple sources. The Solutions Manual is also available for
purchase for your students.

FinGame Online 5.0
by LeRoy Brooks, John Carroll University
(ISBN 10: 0077219880/ISBN 13: 9780077219888)
Just $15.00 when packaged with this text. In this comprehensive simulation game,
students control a hypothetical company over numerous periods of operation. The game is
now tied to the text by exercises found on the Online Learning Center. As students make
major financial and operating decisions for their company, they will develop and enhance
their skills in financial management and financial accounting statement analysis.

Financial Analysis with an Electronic Calculator, Sixth Edition
by Mark A. White, University of Virginia, McIntire School of Commerce
(ISBN 10: 0073217093/ISBN 13: 9780073217093)
The information and procedures in this supplementary text enable students to master the
use of financial calculators and develop a working knowledge of financial mathematics
and problem solving. Complete instructions are included for solving all major problem
types on three popular models: HP 10B and 12C, TI BA II Plus, and TI-84. Hands-on
problems with detailed solutions allow students to practice the skills outlined in the text
and obtain instant reinforcement. Financial Analysis with an Electronic Calculator is a
self-contained supplement to the introductory financial management course.

McGRAW-HILL CONNECT FINANCE
Less Managing. More Teaching. Greater Learning.
McGraw-Hill’s Connect Finance is an online assignment and assessment solution that
connects students with the tools and resources they’ll need to achieve success.
Connect helps prepare students for their future by enabling faster learning, more
efficient studying, and higher retention of knowledge.

McGraw-Hill Connect Finance Features Connect Finance offers a number of
powerful tools and features to make managing assignments easier, so faculty can spend
more time teaching. With Connect Finance, students can engage with their coursework
anytime and anywhere, making the learning process more accessible and efficient.
Connect Finance offers you the features described below.

ros30689_fm_i-xxxiv.indd xvi

18/08/10 7:44 PM


Simple assignment management With Connect Finance, creating assignments is
easier than ever, so you can spend more time teaching and less time managing. The
assignment management function enables you to:
■

■

■

Create and deliver assignments easily with selectable end-of-chapter questions and
test bank items.
Streamline lesson planning, student progress reporting, and assignment grading to
make classroom management more efficient than ever.
Go paperless with online submission and grading of student assignments.

Smart grading When it comes to studying, time is precious. Connect Finance helps
students learn more efficiently by providing feedback and practice material when they
need it, where they need it. When it comes to teaching, your time is also precious. The
grading function enables you to:

■

■

■

Have assignments scored automatically, giving students immediate feedback on
their work and side-by-side comparisons with correct answers.
Access and review each response; manually change grades or leave comments for
students to review.
Reinforce classroom concepts with practice tests and instant quizzes.

Instructor library The Connect Finance Instructor Library is your repository for
additional resources to improve student engagement in and out of class. You can select
and use any asset that enhances your lecture.
Student study center The Connect Finance Student Study Center is the place for
students to access additional resources. The Student Study Center:
■
■

Offers students quick access to lectures, practice materials, and more.
Provides instant practice material and study questions, easily accessible on the go.

Student progress tracking Connect Finance keeps instructors informed about how
each student, section, and class is performing, allowing for more productive use of lecture
and office hours. The progress-tracking function enables you to:
■

■

View scored work immediately and track individual or group performance with
assignment and grade reports.
Access an instant view of student or class performance relative to learning
objectives.

Lecture capture through Tegrity Campus For an additional charge Lecture Capture
offers new ways for students to focus on the in-class discussion, knowing they can revisit
important topics later. This can be delivered through Connect or separately. See below for
more details.

ros30689_fm_i-xxxiv.indd xvii

18/08/10 7:44 PM


In short, Connect Finance offers you and your students powerful tools and features that
optimize your time and energies, enabling you to focus on course content, teaching, and
student learning. Connect Finance also offers a wealth of content resources for both
instructors and students. This state-of-the-art, thoroughly tested system supports you in
preparing students for the world that awaits.
For more information about Connect, go to www.mcgrawhillconnect.com, or contact
your local McGraw-Hill sales representative.

TEGRITY CAMPUS: LECTURES 24/7
Tegrity Campus is a service that makes class time available 24/7
by automatically capturing every lecture in a searchable format
for students to review when they study and complete assignments. With a simple one-click
start-and-stop process, you capture all computer screens and corresponding audio. Students
can replay any part of any class with easy-to-use browser-based viewing on a PC or Mac.
Educators know that the more students can see, hear, and experience class resources,

the better they learn. In fact, studies prove it. With Tegrity Campus, students quickly
recall key moments by using Tegrity Campus’s unique search feature. This search helps
students efficiently find what they need, when they need it, across an entire semester
of class recordings. Help turn all your students’ study time into learning moments
immediately supported by your lecture.
To learn more about Tegrity watch a 2-minute Flash demo at http://tegritycampus.
mhhe.com.

McGRAW-HILL CUSTOMER CARE CONTACT INFORMATION
At McGraw-Hill, we understand that getting the most from new technology can be
challenging. That’s why our services don’t stop after you purchase our products. You can
e-mail our Product Specialists 24 hours a day to get product-training online. Or you can
search our knowledge bank of Frequently Asked Questions on our support Web site. For
Customer Support, call 800-331-5094, e-mail , or visit
www.mhhe.com/support. One of our Technical Support Analysts will be able to assist
you in a timely fashion.

ros30689_fm_i-xxxiv.indd xviii

18/08/10 7:44 PM


ACKNOWLEDGMENTS

To borrow a phrase, writing a finance textbook
is easy—all you do is sit down at a word processor and open a vein. We never would have completed this book without the incredible amount
of help and support we received from our colleagues, students, editors, family members, and
friends. We would like to thank, without implicating, all of you.
Clearly, our greatest debt is to our many colleagues (and their students). Needless to say,
without this support and feedback we would not

be publishing this text.
To the following reviewers we are grateful for
their many contributions:
Dean Baim, Pepperdine University
Madhulina Bandyopadhyay, University of
Wisconsin, Milwaukee
Peter Basciano, Augusta State University
Elizabeth Booth, Michigan State University
Christa Bouwman, Case Western Reserve
University
Bruce Costa, University of Montana
Isabelle Delalex, Pace University
David Diehl, Aurora University
Robert Duvic, University of Texas at Austin
Yee-Tien Fu, Stanford University
Janet Hamilton, Portland State University
Corrine Hasbany, Rivier College
Rodrigo Hernandez, Radford University
Vanessa Holmes, Penn State Worthington,
Scranton
Gary Kayakachoian, University of Rhode Island
Gregory Kivenzor, Oregon State University
V. Sivarama Krishnan, University of Central
Oklahoma
Sanjay Kudrimoti, Salem State College
Douglas Lamdin, University of Maryland
Baltimore County
Michael Madaris, William Carey University
Robert Nash, Wake Forest University
Ali Ozbeki, Oakland University

Deniz Ozenbas, Montclair State University
Chein-Chih Peng, Morehead State University

Jong Rhim, University of Southern Indiana
Atul Saxena, Georgia Gwinnett College
James Scott, Missouri State University
Michael Sullivan, University of Nevada,
Las Vegas
Alex Tang, Morgan State University
Antoinette Tessmer, Michigan State University
Charles Wellens, North Idaho College
J. Douglas Wellington, Husson University
Jill Wetmore, Saginaw Valley State University
Casey Whilhelm, North Idaho College
We owe a special thanks to Joseph Smolira
of Belmont University for his work on this book.
Joe worked closely with us to develop portions
of the Instructor’s Manual, along with the many
vignettes and real-world examples. In addition,
we would like to thank David Diehl, Aurora
University, for his work on the PowerPoint and
Instructor’s Manual, and Bruce Costa, University of Montana, for his revision of the Test
Bank.
The following doctoral students did outstanding work on this edition: Dane Makhoul and Tim
Riley. To them fell the unenviable task of technical
proofreading, and in particular, careful checking of each calculation throughout the text and
Instructor’s Manual.
Finally, in every phase of this project, we
have been privileged to have had the complete
and unwavering support of a great organization, McGraw-Hill/Irwin. We especially thank

the McGraw-Hill/Irwin sales organization. The
suggestions they provide, their professionalism
in assisting potential adopters, and the service
they provide have been a major factor in our
success.
We are deeply grateful to the select group of
professionals who served as our development
team on this edition: Michele Janicek, Executive
Editor; Elizabeth Hughes, Development Editor;
Melissa Caughlin, Marketing Manager; Christine
Vaughan, Lead Project Manager; Mary Sander,
Designer; Heather Burbridge, Senior Manager,

ACKNOWLEDGMENTS

ros30689_fm_i-xxxiv.indd xix

xix

18/08/10 7:44 PM