Essentialos of corporate finance 9e by ross jordan

EssEntials

9e

of Corporate Finance

Ross

Westerfeld

Jordan


Essentials of
Corporate Finance

i


The McGraw-Hill/Irwin Series in Finance, Insurance, and Real Estate
Stephen A. Ross, Consulting Editor
Franco Modigliani Professor of Finance and Economics
Sloan School of Management, Massachusetts Institute of Technology

FINANCIAL MANAGEMENT
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Essentials of
Corporate Finance
Ninth Edition
Stephen A. Ross
Massachusetts Institute of Technology
Randolph W. Westerfield
University of Southern California
Bradford D. Jordan
University of Kentucky


ESSENTIALS OF CORPORATE FINANCE, NINTH EDITION
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Names: Ross, Stephen A., author. | Westerfield, Randolph W., author. |
   Jordan, Bradford D., author.
Title: Essentials of corporate finance / Stephen A. Ross, Massachusetts
   Institute of Technology, Randolph W. Westerfield, University of Southern
   California, Bradford D. Jordan, University of Kentucky.
Description: Ninth edition. | New York, NY : McGraw-Hill/Irwin, [2015]
Identifiers: LCCN 2015046933 | ISBN 9781259277214 (alk. paper) | ISBN
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About the Authors
Stephen A. Ross
Sloan School of Management, Franco Modigliani Professor of Financial Economics,
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 and his substantial contributions to the discipline through his research in signaling, agency theory, option pricing, and the theory of the term structure of interest rates, among
other topics. A past president of the American Finance Association, he currently serves as an associate editor of several academic and practitioner journals. He is a trustee of CalTech.

Randolph W. Westerfield

Marshall School of Business, University of Southern California
Randolph W. Westerfield is Dean Emeritus of the University of Southern California’s Marshall
School of Business and is the Charles B. Thornton Professor of Finance Emeritus. He came to
USC from the Wharton School, University of Pennsylvania, where he was the chairman of the
finance department and a member of the finance faculty for 20 years. He is a member of the Board
of Trustees of Oaktree Capital Management. His areas of expertise include corporate financial
policy, investment management, and stock market price behavior.

Bradford D. Jordan
Gatton College of Business and Economics, University of Kentucky
Bradford D. Jordan is Professor of Finance and holder of the Richard W. and Janis H. Furst Endowed Chair in Finance at the University of Kentucky. He has a long-standing interest in both
applied and theoretical issues in corporate finance and has extensive experience teaching all levels
of corporate finance and financial management policy. Professor Jordan has published numerous
articles on issues such as the cost of capital, capital structure, and the behavior of security prices.
He is a past president of the Southern Finance Association, and he is coauthor of Fundamentals of
Investments: Valuation and Management, 7th edition, a leading investments text, also published
by McGraw-Hill Education.

v


From the Authors
W

hen we first wrote Essentials of Corporate Finance, we thought there might be a
small niche for a briefer book that really focused on what students with widely varying backgrounds and interests needed to carry away from an introductory finance course.
We were wrong. There was a huge niche! What we learned is that our text closely matches
the needs of instructors and faculty at hundreds of schools across the country. As a result,
the growth we have experienced through the first eight editions of Essentials has far exceeded anything we thought possible.

With the ninth edition of Essentials of Corporate Finance, we have continued to refine
our focus on our target audience, which is the undergraduate student taking a core course in
business or corporate finance. This can be a tough course to teach. One reason is that the class
is usually required of all business students, so it is not uncommon for a majority of the students to be nonfinance majors. In fact, this may be the only finance course many of them will
ever have. With this in mind, our goal in Essentials is to convey the most important concepts
and principles at a level that is approachable for the widest possible audience.

To achieve our goal, we have worked to distill the subject down to its bare essentials
(hence, the name of this book), while retaining a decidedly modern approach to finance.
We have always maintained that the subject of corporate finance can be viewed as the
workings of a few very powerful intuitions. We also think that understanding the “why” is
just as important, if not more so, than understanding the “how”—especially in an introductory course. Based on the gratifying market feedback we have received from our previous
editions, as well as from our other text, Fundamentals of Corporate Finance (now in its
eleventh edition), many of you agree.

By design, this book is not encyclopedic. As the table of contents indicates, we have
a total of 18 chapters. Chapter length is about 30 pages, so the text is aimed squarely at a
single-term course, and most of the book can be realistically covered in a typical semester or quarter. Writing a book for a one-term course necessarily means some picking and
choosing, with regard to both topics and depth of coverage. Throughout, we strike a balance by introducing and covering the essentials (there’s that word again!) while leaving
some more specialized topics to follow-up courses.
The other things we have always stressed, and have continued to improve with this
edition, are readability and pedagogy. Essentials is written in a relaxed, conversational
style that invites the students to join in the learning process rather than being a passive
information absorber. We have found that this approach dramatically increases students’
willingness to read and learn on their own. Between larger and larger class sizes and the
ever-growing demands on faculty time, we think this is an essential (!) feature for a text in
an introductory course.
Throughout the development of this book, we have 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.

vi



As a result of this process, three basic themes emerge as our central focus in writing
Essentials of Corporate Finance:
An Emphasis on Intuition  We always try to separate and explain the principles at work on

a commonsense, intuitive level before launching into any specifics. The underlying ideas
are discussed first in very general terms and then by way of examples that illustrate in more
concrete terms how a financial manager might proceed in a given situation.

A Unified Valuation Approach  We treat net present value (NPV) as the basic concept

underlying corporate finance. Many texts stop well short of consistently integrating this
important principle. The most basic and important notion, that NPV represents the excess
of market value over cost, often is lost in an overly mechanical approach that emphasizes
computation at the expense of comprehension. In contrast, every subject we cover is firmly
rooted in valuation, and care is taken throughout to explain how particular decisions have
valuation effects.

A Managerial Focus  Students shouldn’t lose sight of the fact that financial management

concerns management. We emphasize the role of the financial manager as decision maker,
and we stress the need for managerial input and judgment. We consciously avoid “black
box” approaches to finance, and, where appropriate, the approximate, pragmatic nature
of financial analysis is made explicit, possible pitfalls are described, and limitations are
discussed.

Today, as we prepare to once again enter the market, our goal is to stick with and build
on the principles that have brought us this far. However, based on an enormous amount of
feedback we have received from you and your colleagues, we have made this edition and
its package even more flexible than previous editions. We offer flexibility in coverage and
pedagogy by providing a wide variety of features in the book to help students learn about
corporate finance. We also provide flexibility in package options by offering the most
extensive collection of teaching, learning, and technology aids of any corporate finance
text. Whether you use just the textbook, or the book in conjunction with other products, we
believe you will find a combination with this edition that will meet your needs.




Stephen A. Ross
Randolph W. Westerfield
Bradford D. Jordan

vii


Organization of the Text
W

e designed Essentials of Corporate Finance to be as flexible and modular as possible. There are a total of nine parts, and, in broad terms, the instructor is free to decide the particular sequence. Further, within each part, the first chapter generally contains
an overview and survey. Thus, when time is limited, subsequent chapters can be omitted.
Finally, the sections placed early in each chapter are generally the most important, and later
sections frequently can be omitted without loss of continuity. For these reasons, the instructor has great control over the topics covered, the sequence in which they are covered, and
the depth of coverage.

Just to get an idea of the breadth of coverage in the ninth edition of Essentials, the following grid presents for each chapter some of the most significant new features, as well as a few

selected chapter highlights. Of course, in every chapter, figures, opening vignettes, boxed features, and in-chapter illustrations and examples using real companies have been thoroughly
updated as well. In addition, the end-of-chapter material has been completely revised.

Chapters

Selected Topics

Benefits to Users

PART ONE

Overview of Financial Management

Chapter 1

New opener discussing The Men’s
Wearhouse
Updated Finance Matters box on
corporate ethics

Describes ethical issues in the context of mortgage fraud,
offshoring, and tax havens.

Updated information on executive and
celebrity compensation

Highlights important development regarding the very current
question of appropriate executive compensation.

Updated Work the Web box on stock

quotes
Goal of the firm and agency problems

Stresses value creation as the most fundamental aspect of
management and describes agency issues that can arise.

Ethics, financial management, and
executive compensation

Brings in real-world issues concerning conflicts of interest
and current controversies surrounding ethical conduct and
management pay.

New proxy fight example involving
Starboard Value and Darden Restaurants
New takeover battle discussion
involving Jos. A. Bank and The Men’s
Wearhouse

PART TWO

Understanding Financial Statements and Cash Flow

Chapter 2

New opener discussing large energy
company write-offs due to falling oil prices

viii

Cash flow vs. earnings

Clearly defines cash flow and spells out the differences
between cash flow and earnings.

Market values vs. book values

Emphasizes the relevance of market values over book values.

Updated Work the Web box on SEC
filings

Discusses the information that public companies are required
to file with the SEC, and how to find that information.


Chapters

Selected Topics

Benefits to Users

Chapter 3

Additional explanation of alternative
formulas for sustainable and internal
growth rates

Expanded explanation of growth rate formulas clears up
a common misunderstanding about these formulas and

the circumstances under which alternative formulas are
correct.

Updated opener on PE ratios
Updated examples on Lowe’s vs. Home
Depot and Yahoo! vs. Google
Updated Work the Web box on financial
ratios

Discusses how to find and analyze profitability ratios.

PART THREE

Valuation of Future Cash Flows

Chapter 4

First of two chapters on time value of
money

Relatively short chapter introduces just the basic ideas
on time value of money to get students started on this
traditionally difficult topic.

Updated Finance Matters box on
collectibles
Chapter 5

Second of two chapters on time value
of money

Covers more advanced time value topics with numerous
examples, calculator tips, and Excel spreadsheet exhibits.
Contains many real-world examples.

Updated opener on professional
athletes’ salaries

Provides a real-world example why it’s important to properly
understand how to value costs incurred today versus future
cash inflows.

Updated Work the Web box on student
loan payments

PART FOUR

Valuing Stocks and Bonds

Chapter 6

New opener on negative interest on
various sovereign bonds

Discusses the importance of interest rates and how they
relate to bonds.

Bond valuation

Thorough coverage of bond price/yield concepts.

Updated bond features example using
ExxonMobil issue
Interest rates and inflation

Highly intuitive discussion of inflation, the Fisher effect, and
the term structure of interest rates.

New “fallen angels” example using
Petrobas issue
“Clean” vs. “dirty” bond prices and
accrued interest

Clears up the pricing of bonds between coupon payment
dates and also bond market quoting conventions.

Updated Treasury quotes exhibit and
discussion
Updated historic interest rates figure
FINRA’s TRACE system and transparency
in the corporate bond market

Up-to-date discussion of new developments in fixed
income with regard to price, volume, and transactions
reporting.

“Make-whole” call provisions

Up-to-date discussion of relatively new type of call provision
that has become very common.

Updated Treasury yield curve exhibit

ix


Chapters

Selected Topics

Benefits to Users

Chapter 7

Stock valuation

Thorough coverage of constant and nonconstant growth
models.

Updated opener on difference in
dividend payouts
Updated discussion of the NYSE,
including its acquisition by ICE

Up-to-date description of major stock market operations.

Updated Finance Matters box on the
OTCBB and the Pink Sheets markets

PART FIVE

Capital Budgeting

Chapter 8

Updated opener on GE’s
“Ecomagination” program

Illustrates the growing importance of “green” business.

First of two chapters on capital
budgeting

Relatively short chapter introduces key ideas on an intuitive
level to help students with this traditionally difficult topic.

NPV, IRR, MIRR, payback, discounted
payback, and accounting rate of
return

Consistent, balanced examination of advantages and
disadvantages of various criteria.

Project cash flow

Thorough coverage of project cash flows and the relevant
numbers for a project analysis.

New opener on project failures and
successes

Shows the importance of properly evaluating net present
value.

Scenario and sensitivity “what-if”
analyses

Illustrates how to actually apply and interpret these tools in a
project analysis.

Chapter 9

PART SIX

Risk and Return

Chapter 10

Updated opener on stock market
performance

Discusses the relationship between risk and return as it
relates to personal investing.

Capital market history

Extensive coverage of historical returns, volatilities, and risk
premiums.

Market efficiency

Efficient markets hypothesis discussed along with common
misconceptions.

Geometric vs. arithmetic returns

Discusses calculation and interpretation of geometric returns.
Clarifies common misconceptions regarding appropriate use
of arithmetic vs. geometric average returns.

Diversification, systematic, and
unsystematic risk

Illustrates basics of risk and return in a straightforward
fashion.

Chapter 11

Updated opener on stock price
reactions to announcements
Updated beta coefficients exhibit and
associated discussion

PART SEVEN

Long-Term Financing

Chapter 12

Cost of capital estimation

Develops the security market line with an intuitive approach
that bypasses much of the usual portfolio theory and
statistics.

Intuitive development of the WACC and a complete, webbased illustration of cost of capital for a real company.

Updated WACC calculations for
Eastman

x

Geometric vs. arithmetic growth rates

Both approaches are used in practice. Clears up issues
surrounding growth rate estimates.

New section on company valuation with
the WACC

Explores the difference between valuing a project and
valuing a company.


Chapters

Selected Topics

Benefits to Users

Chapter 13

Basics of financial leverage

Illustrates effect of leverage on risk and return.

Optimal capital structure

Describes the basic trade-offs leading to an optimal capital
structure.

Updated Finance Matters box on recent
pre-pack bankruptcies

Chapter 14

Chapter 15

Financial distress and bankruptcy

Briefly surveys the bankruptcy process.

Updated opener with Qualcomm
dividend announcement

Raises questions about why raising dividends and
repurchasing stock would please investors.

Updated figures on aggregate
dividends, stock repurchases, and

proportion of firms paying dividends

Brings students the latest thinking and evidence on dividend
policy.

Dividends and dividend policy

Describes dividend payments and the factors favoring higher
and lower payout policies. Includes recent survey results on
setting dividend policy.

Updated examples and Finance
Matters box covering buyback activity

Explores the reasons that buybacks are gaining in popularity
now, following the recent recession.

IPO valuation

Extensive, up-to-date discussion of IPOs, including the
1999–2000 period and the recent Facebook IPO.

Dutch auctions

Explains uniform price (“Dutch”) auctions using Google IPO
as an example.

New subsection on crowdfunding

Discusses the JOBS Act and crowdfunding.

Updated tables and figures on IPO
initial returns and number of offerings

PART EIGHT

Short-Term Financial Management

Chapter 16

Operating and cash cycles

Stresses the importance of cash flow timing.

Short-term financial planning

Illustrates the creation of cash budgets and the potential
need for financing.

New Finance Matters box discussing
operating and cash cycles

Explores how comparing the cash cycles of companies can
reveal whether a company is performing well.

Cash collection and disbursement

Examination of systems used by firms to handle cash inflows
and outflows.

Credit management

Analysis of credit policy and implementation.

Inventory management

Brief overview of important inventory concepts.

Chapter 17

PART NINE

Topics in Business Finance

Chapter 18

New opener on impact of U.S. dollar
appreciation

Raises questions about how currency appreciation affects
the broader economy.

Foreign exchange

Covers essentials of exchange rates and their
determination.

International capital budgeting

Shows how to adapt the basic DCF approach to handle

exchange rates.

Updated discussion of exchange rates
and political risk

Discusses hedging and issues surrounding sovereign risk.

xi


Learning Solutions
I

n addition to illustrating relevant concepts and presenting up-to-date coverage, Essentials of Corporate Finance strives to present the material in a way that makes it engaging
and easy to understand. To meet the varied needs of the intended audience, Essentials of
Corporate Finance is rich in valuable learning tools and support.

Each feature can be categorized by the benefit to the student:
■ Real financial decisions
■ Application tools
■ Study aids

REAL FINANCIAL DECISIONS
We have included two key features that help students
connect chapter concepts to how decision makers
use this material in the real world.

▼ CHAPTER-OPENING VIGNETTES
Each chapter begins with a contemporary real-world event to
introduce students to chapter concepts.

PA RT F OU R

6

FINANCE M ATTER S
Exotic Bonds

B

onds come in many flavors. The unusual types are called
“exotics” and can range from the fairly simple to the truly
esoteric. Take the case of mortgage-backed securities (MBSs).
MBSs are a type of securitized financial instrument. In securitization, cash flows from financial assets are pooled together
into securities, and the securities are sold to investors. With
an MBS, banks or mortgage brokers who originate mortgages
sell the mortgages to a trust. The trust pools the mortgages
and sells bonds to investors. Bondholders receive payments
based on the mortgage payments made by homeowners.
During 2008, problems with MBSs skyrocketed due to the
precipitous drop in real estate values and the sharply increased default rates on the underlying mortgages.
The reverse convertible is a relatively new type of
structured note. One type generally offers a high coupon
rate, but the redemption at maturity can be paid in cash at
par value or paid in shares of stock. For example, one recent
General Motors (GM) reverse convertible had a coupon rate
of 16 percent, which is a very high coupon rate in today’s interest rate environment. However, at maturity, if GM’s stock
declined sufficiently, bondholders would receive a fixed
number of GM shares that were worth less than par value.
So, while the income portion of the bond return would be

high, the potential loss in par value could easily erode the
extra return.

CAT bonds are issued to cover insurance companies
against natural catastrophes. The type of natural catastrophe is outlined in the bond. For example, about 30 percent
of all CAT bonds protect against a North Atlantic hurricane.
The way these issues are structured is that the borrowers
can suspend payment temporarily (or even permanently) if
they have significant hurricane-related losses. These CAT
bonds may seem like pretty risky investments, but, to date,
only four have not been paid in full. For example, because of
Hurricane Katrina, CAT bondholders lost $190 million. CAT
bondholders also lost $300 million due to the 2011 tsunami
in Japan. During 2011, two other CAT bond issues, each
worth $100 million, were triggered due to an unusually active tornado season.
Perhaps the most unusual bond (and certainly the most
ghoulish) is the “death bond.” Companies such as Stone
Street Financial purchase life insurance policies from individuals who are expected to die within the next 10 years.
They then sell bonds that are paid off from the life insurance
proceeds received when the policyholders die. The return
on the bonds to investors depends on how long the policyholders live. A major risk is that if medical treatment advances quickly, it will raise the life expectancy of the
policyholders, thereby decreasing the return to the
bondholder.

Valuing Stocks and Bonds

Interest Rates and
Bond Valuation

L

ate 2014 and early 2015 proved to be a very unusual period for
bonds. For example, in the last week of February 2015, the

German government issued new five-year bonds with a yield to
maturity of negative .08 percent. In other words, investors were willing to put up money today and receive less money in the future! You

LEARNING OBJECTIVES
After studying this chapter, you should
be able to:

LO 1

Identify important bond features
and types of bonds.

LO 2

Describe bond values and why
they fluctuate.

LO 3

Discuss bond ratings and what
they mean.

LO 4

Evaluate the impact of inflation on
interest rates.

would actually be better off burying your money in the backyard for
the next five years. Germany wasn’t alone: Finland, the Netherlands,
France, Belgium, Austria, and Italy all had government bonds outstanding with a negative return.
So what happened? Central banks were in a race to the bottom, lowering interest rates in an attempt to improve their domestic
economies.
This chapter takes what we have learned about the time value

LO 5

Explain the term structure of
interest rates and the determinants
of bond yields.

of money and shows how it can be used to value one of the most
common of all financial assets, a bond. It then discusses bond features, bond types, and the
operation of the bond market.
What we will see is that bond prices depend critically on interest rates, so we will go on
to discuss some very fundamental issues regarding interest rates. Clearly, interest rates are
important to everybody because they underlie what businesses of all types—small and
large—must pay to borrow money.

BOND MARKETS
▲ FINANCE 6.5
MATTERS
BOXES
Bonds are bought and sold in enormous quantities every day. You may be surprised to
Excel
Most
chapters

include
at least
Master
learn
that the trading
volume inone
bonds Finance
on a typical day is many, many times larger than
coverage online
the trading volume in stocks (by trading volume, we simply mean the amount of money
­Matters box, which
takes a chapter issue and
that changes hands). Here is a finance trivia question: What is the largest securities
market
in the world?
Most
people now
would guess
the New York Stock Exchange. In fact,
shows how it is
being
used
right
in everythe largest securities market in the world in terms of trading volume is the U.S. Treasury
market.
day financial decision
making.

How Bonds Are Bought and Sold

xii

186

As we mentioned all the way back in Chapter 1, most trading in bonds takes place over the
counter, or OTC. Recall that this means that there is no particular place where buying and
selling occur. Instead, dealers around the country (and around the world) stand ready to
buy and sell. The various dealers are connected electronically.
One reason the bond markets are so big is that the number of bond issues far exceeds
the number of stock issues. There are two reasons for this. First, a corporation would typically have only one common stock issue outstanding (there are exceptions to this that we
discuss in our next chapter). However, a single large corporation could easily have a dozen

Please visit us at essentialsofcorporatefinance.blogspot.com for the latest developments in the world of corporate finance.

O

ur goal in this chapter is to introduce you to bonds. We begin by showing how
the techniques we developed in Chapters 4 and 5 can be applied to bond valuation. From there, we go on to discuss bond features and how bonds are bought and
sold. One important thing we learn is that bond values depend, in large part, on interest rates. Thus, we close out the chapter with an examination of interest rates and
their behavior.
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APPLICATION TOOLS
Because there is more than one way to solve problems in corporate finance, we include many sections
that encourage students to learn or brush up on different problem-solving methods, including financial

calculator and Excel spreadsheet skills.

▼ CHAPTER CASES
Located at the end of most chapters, these cases focus ­on
­hypothetical company situations that embody corporate
­finance topics. Each case presents a new scenario, data, and
a dilemma. Several questions at the end of each case require
students to analyze and focus on all of the material they
learned from the chapters in that part. Great for homework or
in-class exercises and discussions!

204

▼ WORK THE WEB
These in-chapter boxes show students how to
research financial issues using the web and how
to use the information they find to make business
decisions. All the Work the Web boxes also include
interactive follow-up questions and exercises.
188

part 4

W

Valuing Stocks and Bonds

RK THE WEB

B

ond quotes have become more available with the rise of the web. One site where you can find
current bond prices (from TRACE) is finra-markets.morningstar.com/BondCenter. We went to
the site and entered “AZO” for AutoZone, the well-known auto parts company. We found a total of
eight bond issues outstanding. Here you see the information we pulled up.

part 4

Valuing Stocks and Bonds

CHAPTER CASE
Financing S&S Air’s Expansion Plans with a Bond Issue

M

QUESTIONS
1.

The security of the bond—that is, whether the
bond has collateral.

7. Any positive covenants. Also, discuss several possible positive covenants S&S Air might consider.

2.

The seniority of the bond.

3.

The presence of a sinking fund.

4.

A call provision with specified call dates and call
prices.

8. Any negative covenants. Also, discuss several
possible negative covenants S&S Air might
consider.

5.

A deferred call accompanying the preceding call
provision.

6.

A make-whole call provision.

chapter 6

Most of the information is self-explanatory. The price and yield columns show the price and yield
to maturity of the issues based on their most recent sales. If you need more information about a
particular issue, clicking on it will give you more details such as coupon dates and call dates.

QUESTIONS
1. Go to this website and find the last bond shown in the accompanying table. When was
this bond issued? What was the size of the bond issue? What were the yield to maturity
and price when the bond was issued?
2. When you search for Chevron bonds (CVX), you will find bonds for several companies

listed. Why do you think Chevron has bonds issued with different corporate names?

The Federal Reserve
Bank of St. Louis
maintains dozens of
online files containing
macroeconomic data as
well as rates on U.S.
Treasury issues. Go to
research.stlouisfed.org/
fred2/.

The very last ordinary bond listed, in this case the 2/15/2045, is often called the “bellwether” bond. This bond’s yield is the one that is usually reported in the evening news. So,
for example, when you hear that long-term interest rates rose, what is really being said is
that the yield on this bond went up (and its price went down).
If you examine the yields on the various issues in Figure 6.3, you clearly see that they
vary by maturity. Why this occurs and what it might mean is one of the things we discuss
in our next section.

EXPLANATORY WEB LINKS ►

These web links are provided in the margins of the text.
6.5 Treasury Quotes
TheyEXAMPLE
are specifically
selected to accompany text material
Locate the Treasury issue in Figure 6.3 maturing in August 2022. What is its coupon rate? What is
and itsprovide
instructors
with a quick way to

bid price? Whatstudents
was the previousand
day’s asked
price?
The bond listed as 8/15/2022 is the one we seek. Its coupon rate is 1.625 percent of face
check
additional
Internet.
value.for
The bid
price is 97.8281, orinformation
97.8281 percent of faceusing
value. Thethe
ask price
is 97.8438, which is
down by .0781 from the previous day. This means that the ask price on the previous day was equal
to 97.8438 + .0781 = 97.9219.

A Note on Bond Price Quotes If you buy a bond between coupon payment dates,
the price you pay is usually more than the price you are quoted. The reason is that standard
convention in the bond market is to quote prices net of “accrued interest,” meaning that

ros77216_ch06_165-204.indd 188

Although Chris is aware of the bond features, he is
uncertain as to the costs and benefits of some features,
so he isn’t clear on how each feature would affect the
coupon rate of the bond issue. You are Renata’s assistant, and she has asked you to prepare a memo to Chris
describing the effect of each of the following bond features on the coupon rate of the bond. She would also
like you to list any advantages or disadvantages of each

feature.

ark Sexton and Todd Story, the owners of S&S Air,
have decided to expand their operations. They instructed their newly hired financial analyst, Chris Guthrie,
to enlist an underwriter to help sell $20 million in new
10-year bonds to finance construction. Chris has entered
into discussions with Renata Harper, an underwriter from
the firm of Crowe & Mallard, about which bond features
S&S Air should consider and what coupon rate the issue
will likely have.

9. A conversion feature (note that S&S Air is not a
publicly traded company).
10. A floating rate coupon.

187

Interest Rates and Bond Valuation

or more note and bond issues outstanding. Beyond this, federal, state, and local borrowing
is enormous. For example, even a small city would usually have a wide variety of notes and
bonds outstanding, representing money borrowed to pay for things like roads, sewers, and
schools. When you think about how many small cities there are in the United States, you
begin to get the picture!
Because the bond market is almost entirely OTC, it has historically had little or no
transparency. A financial market is transparent if it is possible to easily observe its prices
and trading volume. On the New York Stock Exchange, for example, it is possible to see
the price and quantity for every single transaction. In contrast, in the bond market, historically it was not possible to observe either. Transactions are privately negotiated between
parties, and there is little or no centralized reporting of transactions.
Although the total volume of trading in bonds far exceeds that in stocks, only a very

small fraction of the total bond issues that exist actually trade on a given day. This means
that getting up-to-date prices on individual bonds is often difficult or impossible, particularly for smaller corporate or municipal issues. Instead, a variety of sources of estimated
prices exist and are very commonly used.

Bond Price Reporting
In 2002, transparency in the corporate bond market began to improve dramatically. Under
new regulations, corporate bond dealers are now required to report trade information
through what is known as the Trade Reporting and Compliance Engine (TRACE). A
nearby Work the Web box shows how to get TRACE prices.
As we mentioned before, the U.S. Treasury market is the largest securities market in
ros77216_ch06_165-204.indd 204
the world. As with bond markets in general, it is an OTC market, so there is limited transparency. However, unlike the situation with bond markets in general, trading in Treasury
issues, particularly recently issued ones, is very heavy. Each day, representative prices for
outstanding Treasury issues are reported.
Figure 6.3 shows a portion of the daily Treasury note and bond listings from The Wall
Street Journal online. The only difference between a Treasury note and a Treasury bond is
that notes have 10 years or less to maturity at the time of issuance. The entry that begins
“5/15/2030” is highlighted. Reading from left to right, the “5/15/2030” tells us that the
bond’s maturity is May 15, 2030. The 6.250 is the bond’s coupon rate. Treasury bonds all
make semiannual payments and have a face value of $1,000, so this bond will pay $31.25
per six months until it matures.
The next two pieces of information are the bid and asked prices. In general, in any
OTC or dealer market, the bid price represents what a dealer is willing to pay for a security,
and the asked price (or just “ask” price) is what a dealer is willing to take for it. The difference between the two prices is called the bid-ask spread (or just “spread”), and it repre1/5/16 5:15 PM
sents the dealer’s profit.
Treasury prices are quoted as a percentage of face value. The bid price, or what a
dealer is willing to pay for the bond, on the 5/15/2030 bond is 149.4063. With a $1,000
face value, this quote represents $1,494.063. The asked price, or the price at which the
dealer is willing to sell the bond, is 149.4688, or $1,494.688.
The next number quoted is the change in the asked price from the previous day, mea-

To learn more about
TRACE, a. 7.60%
b.  Weight of stock = .5691
c. .825
d.  Weight of stock = 200%
19. Reward-to-risk ratios:
Market = 7.00%
Y: 6.25%
Z: 7.29%
21. 9.25%; 10.10%
23. J: .4571
E(R) = 11.57%
27. C = $169,821.43
Rf = $70,178.57
CHAPTER 12

1. 11.23%
3. 11.28%
5. 4.52%
7. a. 5.74%
b. 3.73%
9. a. 9.18%
11. .34
13. 8.36%
15. 9.08%
17. a.  Y and Z
b.  X and Z
c. Incorrectly accepted: Y
Incorrectly rejected: X

9. .3620
1
21. Cost < $46,357,615.89
23. a. 5.32%
b. 11.47%
CHAPTER 13

1. a.  $1.22; $1.88; $2.25
b.  $1.13; $1.95; $2.42
3. a.  4.61%; 7.09%; 8.50%
b.  4.25%; 7.36%; 9.14%
c. 2.99%; 4.61%; 5.53%
2.76%; 4.79%; 5.94%

5. $26.30; $7,890,000; $7,890,000
7. $52; $52

Answers to Selected End-of-Chapter Problems

9. a. $2,203.13
b. $2,517.50
c.  Sell 75 shares
11. a. 9.60%
b. 11.19%
c. 15.15%
d.  9.60%; 9.60%
13. $5,244,000
15. .58; .47
CHAPTER 14

1. $12,852
3. $85.71
5. a.  New shares = 70,000; Par value = $.50
b.  New shares = 7,000; Par value = $5.00
7. $31.50; $30.15
11. Par value = $.50; Dividend per share last year = $1.33
13. a. $58.04
b. $58.04
CHAPTER 15

1. $4,250; −$500
3. 1,980,847 shares
5. 2,702,703 shares
CHAPTER 16

1. a. No change
b. No change
c. No change
d.Decrease
e.Decrease
f.Decrease
g. No change
h.Decrease
i.Increase
j.Decrease
k.Decrease
l. No Change
m.Decrease
n.Decrease

o.Decrease
3. a. Increase
b. Increase
c. Decrease
d.  No Change
e. Decrease
f.  No Change
5. a.  $623; $630; $653; $763
b.  $525; $615; $660; $718
c.  $720; $645; $645; $807
7. 21.42%
9. $2,112.50; $2,439.00; $2,741.75; $2,769.50
11. $221,100; $361,850; $276,350
13. a. 6.29%
b. $465,080.96
15. Average payables = $27,919.18
Average receivables = $71,804.93

625


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626

appendix C

CHAPTER 17

1. $95,000; $70,700
3. $4,200; −$5,100; −$900

5. $5,920
7. $104,816.44
9. a.  19 days
b. $1,795,890.41
11. d.  20.13%; 44.59%; 13.01%; 44.32%
13. 2,744.15
CHAPTER 18

1. a.  Z 335.98

b.  €1.2452
c. $6,226,000
d.  Singapore dollar
e.  Mexican peso
f. SFr/€ = $1.2022
g.  Kuwait dinar; Vietnam dong

Answers to Selected End-of-Chapter Problems

3. a.  ¥ 118.37; premium
b.  A$1.1831; discount
5. a.  ¥/£ = 185.13
b.  arbitrage profit per $ = $.0209
7. Invest in U.S. = $30,171,325.11
Invest in Great Britain = $29,726,585.36
9. Current = $233,343.56
+10% = $621,221.41
−10% = −$240,729.38
Breakeven = $1.2367; −5.19%
11. −2.03%

13. $65.32
15. a.  Equity = $22,916.67
b.  Equity = $21,153.85
c.  Equity = $25,462.96


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Using the HP-10B
and TI BA II Plus
Financial Calculators
This appendix is intended to help you use your Hewlett-Packard
HP-10B or Texas Instruments BA II Plus financial calculator to
solve problems encountered in the introductory finance course. It
describes the various calculator settings and provides keystroke solutions for nine selected problems from this book. Please see your
owner’s manual for more complete instructions. For more examples
and problem-solving techniques, please see Financial Analysis with
an Electronic Calculator, 6th edition, by Mark A. White (New York:
McGraw-Hill, 2007).

CALCULATOR SETTINGS
Most calculator errors in the introductory finance course are the result
of inappropriate settings. Before beginning a calculation, you should
ask yourself the following questions:
1.
2.
3.
4.

Did I clear the financial registers?

Is the compounding frequency set to once per period?
Is the calculator in END mode?
Did I enter negative numbers using the  +/−  key?

Clearing the Registers
All calculators have areas of memory, called registers, where variables and intermediate results are stored. There are two sets of financial registers, the time value of money (TVM) registers and the
cash flow (CF) registers. These must be cleared before beginning
a new calculation. On the Hewlett-Packard HP-10B, pressing
{CLEAR ALL} clears both the TVM and the CF registers.1 To clear
the TVM registers on the BA II Plus, press  2nd   {CLR TVM}. Press 
2nd   {CLR Work} from within the cash flow worksheet to clear the
CF registers.

Compounding Frequency
Both the HP-10B and the BA II Plus are hardwired to assume monthly
compounding, that is, compounding 12 times per period. Because very
few problems in the introductory finance course make this assumption,
you should change this default setting to once per period. On the HP10B, press 1    {P/YR}. To verify that the default has been changed,
press the
key, then press and briefly hold the INPUT  key.2 The
display should read “1P_Yr”.
1 The
key is colored orange and serves as a Shift key for the functions in
curly brackets.
2 This is the same keystroke used to clear all registers; pretty handy, eh?

D

On the BA II Plus, you can specify both payment frequency and
compounding frequency, although they should normally be set to the

same number. To set both to once per period, press the key sequence
2nd   {P/Y} 1  ENTER , then press  ↓   1  ENTER . Pressing
2nd   {QUIT} returns you to standard calculator mode.

END Mode and Annuities Due
In most problems, payment is made at the end of a period, and this is
the default setting (end mode) for both the HP-10B and the BA II Plus.
Annuities due assume payments are made at the beginning of each period (begin mode). On the HP-10B, pressing    {BEG/END} toggles
between begin and end mode. Press the key sequence  2nd   {BGN} 
2nd   {SET}  2nd   {QUIT} to accomplish the same task on the BA II
Plus. Both calculators will indicate on the display that your calculator
is set for begin mode.

Sign Changes
Sign changes are used to identify the direction of cash inflows and
outflows. Generally, cash inflows are entered as positive numbers and cash outflows are entered as negative numbers. To enter
a negative number on either the HP-10B or the BA II Plus, first
press the appropriate digit keys and then press the change sign key, 
+/− . Do not use the minus sign key,  − , as its effects are quite
unpredictable.

SAMPLE PROBLEMS
This section provides keystroke solutions for selected problems from
the text illustrating the nine basic financial calculator skills.

1. Future Value or Present Value of a Single Sum
Compute the future value of $2,250 at a 17 percent annual rate for
30 years.
HP-10B
–2,250.00 PV

BA II PLUS
–2,250.00 PV

30.00 N

30.00 N

17.00 I/YR

17.00 I/Y

FV 249,895.46

CPT

FV 249,895.46

The future value is $249,895.46.

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628

appendix D

Using the HP-10B and TI BA II Plus Financial Calculators

2. Present Value or Future Value of an Ordinary
Annuity
Betty’s Bank offers you a $20,000, seven-year term loan at 11 percent
annual interest. What will your annual loan payment be?
HP-10B
–20,000.00 PV

BA II PLUS
–20,000.00 PV

7.00 N

7.00 N

11.00 I/YR

PMT 4,244.31

11.00 I/Y

CPT

PMT 4,244.31

Your annual loan payment will be $4,244.31.

3. Finding an Unknown Interest Rate
Assume that the total cost of a college education will be $75,000 when
your child enters college in 18 years. You presently have $7,000 to
invest. What rate of interest must you earn on your investment to cover

the cost of your child’s college education?
HP-10B
–7,000.00 PV

BA II PLUS
–7,000.00 PV

18.00 N
75,000.00 FV

I/YR 14.08

Because the bonds make semiannual payments, we must halve the
coupon payment (8.25 ÷ 2 = 4.125 ==> $41.25), halve the YTM
(7.10 ÷ 2 ==> 3.55), and double the number of periods (10 years remaining × 2 = 20 periods). Then, the current bond price is $1,081.35.

6. Simple Bond Yields to Maturity
Vasicek Co. has 12.5 percent coupon bonds on the market with eight
years left to maturity. The bonds make annual payments. If one of
these bonds currently sells for $1,145.68, what is its YTM?
HP-10B

BA II PLUS

–1,145.68 PV

8.00 N

I/YR 9.79

CPT

7. Cash Flow Analysis
What are the IRR and NPV of the following set of cash flows? Assume a discount rate of 10 percent.

18.00 N

CPT

Year

Cash Flow

0
1
2
3

−$1,300
400
300
1,200

I/Y 14.08

HP-10B

BA II PLUS

HP-10B

–1,300.00

CFj

400.00

CFj

1.00
300.00

–12,000.00 PV

1.00

1.40 I/Y

1,200.00

1.40 I/YR

374.00 PMT

CPT

N 42.90

1.00

BA II PLUS

CF
2ND {CLR Work}
↓

–1,300.00 ENTER

{Nj}

CFj
{Nj}

CFj
{Nj}

{IRR/YR} 17.40
10.00 I/YR

The loan will be paid off in 42.90 months.

{NPV} 213.15

IRR

5. Simple Bond Pricing

HP-10B

BA II PLUS

41.25 PMT

41.25 PMT
1,000.00 FV

20.00 N

20.00 N

3.55 I/YR

PV −1,081.35

400.00 ENTER

↓

1.00 ENTER

↓

300.00 ENTER

↓

1.00 ENTER

↓

1,200.00 ENTER

↓

1.00 ENTER

↓

CPT 17.40
NPV

Mullineaux Co. issued 11-year bonds one year ago at a coupon rate of
8.25 percent. The bonds make semiannual payments. If the YTM on
these bonds is 7.10 percent, what is the current bond price?

1,000.00 FV

I/Y 9.79

The bond has a yield to maturity of 9.79 percent.

75,000.00 FV

One of your customers is delinquent on his accounts payable balance.
You’ve mutually agreed to a repayment schedule of $374 per month.
You will charge 1.4 percent per month interest on the overdue balance.
If the current balance is $12,000, how long will it take for the account
to be paid off?

N 42.90

1,000.00 FV

8.00 N

4. Finding an Unknown Number of Periods

374.00 PMT

125.00 PMT

1,000.00 FV

You must earn an annual interest rate of at least 14.08 percent to cover
the expected future cost of your child’s education.

–12,000.00 PV

–1,145.68 PV

125.00 PMT

3.55 I/Y

CPT

PV −1,081.35

10.00 ENTER

↓

CPT 213.15

The project has an IRR of 17.40 percent and an NPV of $213.15.

8. Loan Amortization
Prepare an amortization schedule for a three-year loan of $24,000.
The interest rate is 16 percent per year, and the loan calls for equal
annual payments. How much interest is paid in the third year? How
much total interest is paid over the life of the loan?
To prepare a complete amortization schedule, you must amortize
each payment one at a time:


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HP-10B

BA II PLUS



−24,000.00 PV



16.00

{AMORT} =

3,840.00 <== Interest



=



= −17,153.81 <== Balance

2.00 INPUT

=



16.00 I/Y

{AMORT} =



=



=

3.00 N

CPT



PMT 10,686.19

2ND {AMORT} 2ND {CLR Work}



↓

1.00 ENTER

2,744.61 <== Interest 1.00

1.00 ENTER

↓ −17,153.81 <== Balance

7,941.58 <== Principal




↓
↓

1,473.96 <== Interest

↓

9,212.23 <== Principal

2.00 ENTER

↓

= −9,212.23 <== Balance


3.00 INPUT

–24,000.00 PV

6,846.19 <== Principal

{AMORT} =







PMT 10,686.19

1.00 INPUT

I/YR

3.00 N



629

Using the HP-10B and TI BA II Plus Financial Calculators

appendix D

0.00 <== Balance

6,846.19 <== Principal
3,840.00 <== Interest

2.00 ENTER

↓ −9,212.23 <== Balance




↓
↓

↓

3.00 ENTER

↓

3.00 ENTER

↓
↓



↓
↓




7,941.58 <== Principal
2,744.61 <== Interest

0.00 <== Balance
9,212.23 <== Principal
1,473.96 <== Interest

Interest of $1,473.96 is paid in the third year.
Enter both a beginning and an ending period to compute the total amount of interest or principal paid over a particular period of time.
HP-10B

BA II PLUS



−24,000.00 PV



16.00

3.00 N





1.00



–24,000.00 PV



16.00 I/Y
3.00 N

PMT 10,686.19



3.00

I/YR

INPUT

{AMORT} = 8,058.57 <== Interest



= 24,000.00 <== Principal



=

0.00 <== Balance

CPT



PMT 10,686.19

2ND {AMORT} 2ND {CLR Work}
↓

1.00 ENTER
3.00 ENTER

↓



↓ 24,000.00 <== Principal
↓ 8,058.57 <== Interest



Total interest of $8,058.57 is paid over the life of the loan.

0.00 <== Balance

HP-10B

9. Interest Rate Conversions

4.00

{P/YR}

Find the effective annual rate, EAR, corresponding to a 7 percent annual percentage rate, APR, compounded quarterly.

7.00

{NOM%}

BA II PLUS
2ND {IConv}
7.00 ENTER

↓ ↓

{EFF%} 7.19

4.00 ENTER

↑
The effective annual rate equals 7.19 percent.

CPT 7.19


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Name Index
B
Beckman, Theodore N., 563
Benioff, Marc, 495
Bernanke, Ben, 150
Block, S. B., 258
Brav, A., 471, 474–475
Briloff, Abraham, 80
Brin, Sergey, 495

Buffett, Warren, 33

H
Harvey, C. R., 258, 471, 474–475

D
DeAngelo, H., 472
DeAngelo, L., 472
Dimson, Elroy, 332

K
Keynes, John Maynard, 551

E
Elton, E. J., 362
F
Ford, Henry, 310
G
Graham, J. R., 258, 471, 474–475
Gruber, M. J., 362

630

I
Ibbotson, R. G., 314, 496–497
J
Jaffe, J. F., 393
Jordan, B. D., 393

M

Mankiw, N. Gregory, 33
Marsh, Paul, 332
Mehra, Rajnish, 332
Michaely, R., 471, 474–475
Moore, J. S., 258
O
Obama, Barack, 33
P
Page, Larry, 495

R
Reichert, A. K., 258
Ritter, Jay R., 486, 496–499, 503
Roberts, Brian, 218
Romney, Mitt, 33
Ross, S. A., 393
S
Santayana, George, 310
Sindelar, J. L, 496, 497, 498
Sinquefield, Rex, 314
Stanley, M. T., 258
Statman, Meir, 362
Staunton, Michael, 332
T
Trump, Donald, 445
W
Westerfield, R. W., 393
Z
Zaslav, David, 13
Zimmer, George, 1, 13

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Subject Index
A
Abbott Laboratories (ABT), 442
ABC approach, 571–572
ABN AMBRO, 171
Abnormal returns, 505
Absolute priority rule
(APR), 444
Absolute purchasing power parity,
593–594
Accelerated cost recovery system
(ACRS), 283
Accounting, finance and, 3
Accounting insolvency, 443
Accounts payable, 534
Accounts payable period, 522
Accounts receivable
financing, 536
Accounts receivable period, 521
Acid-test ratio, 57
Adobe Systems, 205
Aftertax cash flow, 278
Aftermarket, 494
Agency cost, 12
Agency problem, 12
control of corporation, 12–15

stockholders’ vs. managers
interests, 13–14
Agency relationships, 12
Aging schedule, 569
Alibaba, 495
Allen System Group, 446
Amazon.com, 532
American Depository Receipt
(ADR), 587
American Electric Power
(AEP), 442
America Online (AOL), 291
AmeriServ Food Distribution,
Inc., 182
Amortization, 59
Amortization schedule,
147–148
Amortized loans, 146
Announcements and news,
358–359

Annual percentage rate
(APR), 142
effective annual rate (EAR) and,
141–144
financial calculators and, 133
spreadsheets and, 144
Annuity, 131–132
annuity payments, 134
financial calculator, 133

finding payment, 134
finding rate, 136
future values for, 137–138
number of payments, 135
PV for annuity cash flows,
132–133
spreadsheet strategies,
134–135
summary of calculations, 139
Annuity due, 137–138
Annuity tables, 133
Apple, 526
Arithmetic average return, 333
Arrearage, 219
Articles of incorporation, 8
Asked price, 187
Asset management, 59–61
days’ sales in inventory, 59–60
days’ sales in receivables, 60
inventory turnover, 59–60
payables turnover, 61
receivables turnover, 60
total asset turnover, 61
Asset-specific risks, 360
Asset utilization ratios, 59, 64
Assets, 22–23
Auction markets, 16–17
AutoZone, 198
Availability delay, 554–555
Average accounting return

(AAR), 245–246
advantages/disadvantages
of, 246
average accounting return rule,
246
defined, 245

Average collection period (ACP), 60
Average returns, 320–322
arithmetic vs. geometric
averages, 333
calculation of, 320, 333–335
geometric average returns,
calculation of, 333–334
historical record (1926–2014),
320–321, 326
risk premiums, 321
Average tax rate, 31
marginal tax rates vs., 31
for various industries, 32
B
Balance sheet, 22–26, 56
assets, 23
common-size balance sheets,
53–54
debt vs. equity, 25
example, 24
liabilities and owners’ equity,
23–24
liquidity, 25

market value vs. book value,
25–26
net working capital, 24
Banker’s acceptance, 566
Bankruptcy, 443
Bankruptcy Abuse Prevention and
Consumer Protection Act of
2005 (BAPCPA), 445
Bankruptcy costs, 435–437
direct costs, 436
financial distress costs, 436
indirect costs, 436–438
Bankruptcy process, 443–447
agreements to avoid, 447
financial management and,
446–447
liquidation and reorganization,
443–444
prepackaged bankruptcy, 445
reorganization, 444–445
strategic bankruptcies, 447
631


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632

Subject Index

Banks, credit information, 568

BASF, 388
BATS Exchange, 224
Bearer form, 178
BellSouth, 171
Benchmark, choice of, 74–79
Berkshire Hathaway Corporation,
33
Best case, 294
Best efforts underwriting,
493
Beta, risk premium, 368–369
Beta coefficient, 365–366
portfolio betas, 367
for selected companies, 365
total risk vs., 366
Beta for FLIR Systems (case),
387
Bid-ask spread, 187
Bid price, 187
Big Mac Index, 595
Blanket inventory lien, 537
BMW, 600
Board of directors, 217
Boeing, 532
Bond markets, 186–189
bond price quotes, 188–189
bond price reporting,
187–188
buying and selling bonds,
186–187

U.S. Treasury quotes, 189
Bond ratings, 180–182
Bond types, 182–185
convertible bond, 185
exotic bonds, 185–186
floating-rate bonds, 184–185
government bonds, 182–183
put bond, 185
structured notes, 185
zero coupon bonds, 183–184
Bond valuation. see Bonds and
bond valuation
Bond yields
determinants of, 192–195
financial calculator, 173–174
term structure of interest rates,
192–193
yield curve and, 193–195
Bondholders, 23

Bonds and bond valuation, 23,
166–176
call provision, 179–180
debt vs. equity, 176
features and prices, 166, 175
financial calculator,
173–174
indenture, 177
interest rate risk, 169–171
long-term debt, 176–177

protective covenants, 180
repayment, 179
security, 178–179
semiannual coupons, 169
seniority, 179
spreadsheet strategies, 174–175
terms of a bond, 178
values and yields, 166–169
yield to maturity, 171–172
Book building, 493
Book value, 25
market value vs., 25–26, 285
Borrower, 175
Brackets, 489
Break-even EBIT, 428
Broker, 220
Bullock Gold Mining (case), 273
Business ethics, 10
Business failure, 443
Business finance, 2
defined, 4
financial management decisions,
5–6
financial manager and, 4–6
working capital management, 6,
518, 558
Business organization
corporation, 7–9
forms of, 6–9
partnership, 7

sole proprietorship, 6–7
Business risk, 432
Buybacks, 464
Bylaws, 8
C
Call premium, 179
Call protected bond, 179
Call provision, 179
Cannibalism, 277

Capital asset pricing model
(CAPM), 373
Capital budgeting, 5, 237; see also
Internal rate of return (IRR);
Net present value (NPV);
Payback rule
additional considerations in,
296–299
average accounting return,
245–246
capital rationing, 298–299
contingency planning, 296–298
financial management
decisions, 5
hard rationing, 299
managerial options and, 296–298
net working capital, 277,
282–283
practice of, 257–259
profitability index, 256–257

size, timing, and risk of future
cash flows, 5
strategic options, 298
summary of investment
criteria, 259
techniques in practice, 258
WACC and, 399–400
Capital expenditures, 534
Capital gains yield, 213
Capital intensity ratio, 61
Capital investment decisions, 274
capital rationing, 298–299
depreciation, 283–285
evaluating NPV estimates,
290–292
example analysis, 286–290
incremental cash flows, 276–278
managerial options, 296
net working capital, 282–283
pro forma financial statements,
278–279
project cash flows, 275, 279–281
scenario and what-if analyses,
292–296
tax shield approach, 281
Capital market efficiency, 336–339
efficient markets hypothesis,
337–339
forms of, 339
price behavior, 336

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Capital market history
arithmetic vs. geometric
averages, 333–335
average return, 333
stock market risk premium,
331–332
technical trading rules, 330
2008 bear market, 328–329
use of, 329–330
Capital One, 205
Capital rationing, 298–299
hard rationing, 299
soft rationing, 298
Capital spending, 34–35, 38, 288
project net working capital, 280
Capital structure, 6, 424; see also
Financial leverage; Optimal
capital structure
business and financial risk, 432
corporate taxes, 433–435
cost of equity capital, 430–432
financial management decisions,
5–6
homemade leverage, 428–429
interest tax shield, 433–434

leverage and, 428–429
M&M Proposition I, 430
M&M Proposition II, 430–432
managerial recommendations,
440
observed structures, 441–443
optimal capital structure, 424
static theory of, 437–438
target capital structure, 390
U.S. industries, 441
Capital structure decision, 424n
Capital structure weights, 397
Captive finance company, 567
Carrying costs, 528, 571, 573–575
flexible/restrictive policy, 529
Cases
The Beta for FLIR Systems, 387
Bullock Gold Mining, 273
Cash Flows and Financial
Statements at Sunset Boards,
Inc., 50
Conch Republic Electronics, 308
Cost of Capital for Layton
Motors, 422
Electronic Timing, Inc., 484

Subject Index

Financing S&S Air’s Expansion
Plans with a Bond Issue, 204

A Job at S&S Air, 347–348
McGee Cake Company, 21
Piepkorn Manufacturing
Working Capital Management,
Part 1, 549
Piepkorn Manufacturing
Working Capital Management,
Part 2, 585
Ratios and Financial Planning at
S&S Air, Inc., 95–96
S&S Air Goes International, 611
S&S Air Goes Public, 517
S&S Air’s Mortgage, 164
Stephenson Real Estate
Recapitalization, 454
Stock Valuation at Ragan,
Inc., 235
Cash; see also Cash management
activities that increase/
decrease, 520
benefits of holding, 551–552
investing idle cash, 559–562
reasons for holding, 551
seasonal cash demands, 560
sources/uses of, 520
tracing cash, 519–520
Cash balance, 534–535
Cash budget, 533–535
cash balance, 534–535
cash outflows, 534

sales and cash collections, 533
Cash collection, 555–557
components of collection time,
555–556
costs and, 283
lockboxes, 556
sales and, 533–534
Cash concentration, 556–557
Cash coverage ratio, 59
Cash cycle, 522, 524–525
calculation of, 523–525
defining of, 521
industry comparisons of, 526
interpretation of, 525–527
operating cycle and, 521–527
Cash disbursements, 557–559
controlled disbursement
account, 559

633

controlling disbursements,
558–559
increasing disbursement
float, 558
management of, 557
zero-balance accounts, 559
Cash discount, 564
Cash dividends, 456–459
standard method of payment, 457

stock repurchases vs., 464–466
Cash flow, 33–37
aftertax cash flow, 278
cash flow from assets, 34–36
incremental cash flow, 275
level cash flows, 131–137
nonconventional cash flows,
250–252
project cash flows, 239
relevant cash flows, 275
stand-alone principle, 275
stock valuation, 206–207
summary, 37
timing of, 139
to and from firm, 15–16
Cash flow from assets, 34–36
capital spending, 35
change in net working capital,
35, 38–39
example of, 37–39
free cash flow, 36
operating cash flow, 34–35
Cash flow time line, 522
Cash flow to creditors, 36, 39
Cash flow to stockholders,
36–37, 39
Cash Flows and Financial
Statements at Sunset Boards,
Inc. (case), 50
Cash management

benefits of holding cash,
551–552
cash collection and
concentration, 555–557
ethical and legal questions, 554
float and, 552–555
investing idle cash, 559–560
managing disbursements, 557–559
money market securities, 561–562
planned or possible expenditures,
560


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634

Subject Index

Cash management—Cont.
precautionary motive, 551
reasons to hold cash, 551–552
short-term securities, 560–561
speculative motive, 551
temporary cash surpluses, 560
transaction motive, 551
Cash-out, 528
Cash outflows, 534
capital expenditures, 534
long-term financing expenses, 534
payments of accounts

payable, 534
wages, taxes, and other
expenses, 534
Cash ratio, 58
Cash reserves, 531
CAT bonds, 186
Certificates of deposit (CDs), 561
Check Clearing for the 21st
Century, 554–555
Chief financial officer (CFO), 4
Cisco, 532
Citizens Financial, 291
Classified boards, 217
Clean price, 189
Cleanup period, 536
Clientele effect, 464
Coca–Cola, 171, 586
Collar, 185
Collateral, 178, 568
Collateral value, 564
Collectibles, 111
Collection effort, 569
Collection float, 552
Collection policy, 562, 568–569
aging schedule, 569
collection effort, 569
monitoring receivables, 568–569
Collection time, 555–556
Combination approach, 255–256
Comcast, 218

Commercial draft, 566
Commercial paper, 537, 561
Committed lines of credit, 536
Common equity, 23
Common-size balance sheets, 53–54
Common-size income statements,
54–55
Common-size statements, 53

Common stock, 216; see also
Stock valuation
classes of stock, 217–218
dividends, 218
features of, 216–218
frequency distribution of returns
(1926–2014), 322
other rights, 218
proxy voting, 217
shareholder rights, 216–217
Company valuation, with WACC,
410–412
Comparables (comps), 214–215
Competition, 564
Competitive offer, 492
Compound interest, 99, 102
Compounding, 99
effective annual rates and,
140–141
future value and, 98–104
Concentration banks, 557

Conch Republic Electronics
(case), 308
Consols, 138
Consumer demand, 564
Continental Airlines, 446
Contingency planning, 296
option to abandon, 297
option to expand, 296–297
option to wait, 297
Control of the firm, 13–14
Controlled disbursement
account, 559
Controller, 4
Conventional factoring, 536
Convertible bond, 185
Corporate ethics, 11
Corporate finance, 2
Corporate investors, 463
Corporate securities, trading in, 17
Corporate tax rates, 30–31
Corporate taxes, capital structure
and, 433–435
Corporation, 7–9
agency problem, 12
cash flows to and from firm, 15
control of firm, 13–14
dividend smoothing, 471–472
financial management goal, 9–10
financial markets and, 15–17

international corporations, 9
management goals, 12
shareholder’s vs. manager’s
interests, 13–15
stakeholders, 15
Cost of capital, 375
divisional and project costs,
406–410
Eastman’s example, 400–406
financial policy and, 390
optimal capital structure and,
438–440
required return vs., 389–390
SML and, 375
summary of calculations, 400
Cost of Capital for Layton Motors
(case), 422
Cost of debt, 394–396
Eastman example, 403–404
Cost of equity, 391–394
capital structure and, 430–432
dividend growth model
approach, 391–393
Eastman example, 402–403
financial leverage and (M&M
Proposition II), 430–432
M&M Proposition I, 430
SML approach, 393–394
Cost of goods sold (CoGS), 69
Cost of preferred stock, 395

Costs
carrying costs, 573–574
cash collections and, 283
financial distress costs, 436
inventory costs, 571–572
of issuing securities, 505–509
shortage costs, 574
time and, 28–29
Coupon, 166
Coupon rate, 166
Covered interest arbitrage, 597–598
Credit analysis, 562, 567–568
credit evaluation and
scoring, 568
credit information, 567–568
Credit cost curve, 566
Credit information, 567–568
banks, 568
customer’s payment history, 568
financial statements, 567–568


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Credit instrument, 565–566
Credit period, 563
factors that influence, 564
length of, 563
Credit policy

collection policy, 562
components of, 562
credit analysis, 562
optimal credit policy, 566–567
terms of sale, 562
Credit reports, 568
Credit risk, 564
Credit scoring, 568
Creditor, 175
Cross-rates, 587, 590–592
Crowdfunding, 489–490
Cumulative dividend, 219
Cumulative voting, 216
Currency appreciation/
depreciation, 597
Currency swap, 588
Current assets, 23, 519
alternative financing policies,
529–531
in practice, 532
short-term financial policy, 527
size of firm’s investment in,
527–529
Current liabilities, 23, 519, 532
Current ratio, 56–57
Current yield, 172
Customer type, 564
Cyclical activities, 560
D
Date of payment, 458

Date of record, 458
Days’ sales in inventory, 59
Days’ sales in receivables, 60
Dealer, 220
Dealer vs. auction markets, 16–17
Dealers, 220
Debenture, 176, 178
Debt; see also Bankruptcy costs
cost of debt, 394–396
equity vs., 25, 176, 504
long-term debt, 176–177
preferred stock as, 219
Debt–equity ratio, 58, 424
Debt securities, 175

Subject Index

Debtor, 175
Declaration date, 457
Deed of trust, 177
Default risk, 561
Default risk premium, 194
Deferred call provision, 179
Dell, 526
Depreciation, 28, 283
modified ACRS (MACRS)
depreciation, 284–285
as noncash item, 28
Depreciation tax shield, 281
Derived-demand inventories,

576–578
just-in-time inventory, 578
materials requirements planning
(MRP), 577
Designated market makers
(DMMs), 221–222
Diebold, 526
Direct bankruptcy costs, 436
Dirty price, 189
Disbursement float, 552, 558
Discount bond, 168
Discount factor, 106
Discount rate, 106
determination of, 109–111
single-period investment, 109
Discounted cash flow (DCF)
valuation, 106, 122, 238
internal rate of return (IRR), 248
modified internal rate of return
(MIRR), 255
profitability index (PI),
256–257
Distribution, 456
Diversifiable risk, 363
Diversification, 360
effect of, 361
portfolio risk and, 361–364
principle of, 362
systematic risk, 363–364
unsystematic risk and,

362–363
Dividend, 216, 218, 456, 472
cash dividends, 456–457
characteristics of, 218
cumulative/noncumulative, 219
survey evidence on, 474–475
Dividend growth model, 209

635

Dividend growth model approach,
391–393
advantages/disadvantages of,
392–393
estimating g, 392
implementation of, 391
Dividend payout, 69, 457
chronology of, 457–458
corporations smoothing, 471–472
dividend payers, 469–471
pros and cons of, 474
Dividend policy, 71, 455–456
cash dividends, 456–459
clientele effects, 464
corporations smoothing,
471–472
dividends and dividend payers,
469–471
high payout factors, 462–463
irrelevance of, 460–461

low payout factors, 461–462
pros/cons of, 474
summary of findings on, 472
Dividend yield, 213, 457
Dividends per share, 27, 457
Divisional cost of capital, 408
DMM’s post, 222
Dollar returns, 310–311
Double taxation, 8
Dow Jones Industrial Average
(DJIA), 328
DuPont identity, 65–69
expanded analysis, 67–69
extended DuPont chart, 68
ROE and, 66
for Yahoo! and Google, 67
Dutch auction underwriting, 493
E
E. F. Hutton, 554
Earnings management, 30
Earnings per share (EPS),
27, 63, 425
EBIT vs., 426
financial leverage, 425–426
share repurchase and, 468
Eastman Chemical
calculating WACC for, 400–406
cost of debt, 403–404
cost of equity, 402–403

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636

Subject Index

EBIT (earnings before interest and
taxes), 34, 59
break-even EBIT, 428
EPS vs., 426–427
EBITD (earnings before interest,
taxes, and depreciation), 59
EBITDA (earnings before interest,
taxes, depreciation, and
amortization), 59
EBITDA ratio, 63–64
Economic order quantity
(EOQ), 575
Economic order quantity (EOQ)
model, 572–576
carrying costs, 573–574
extensions to, 576
inventory depletion, 573
reorder points, 576
safety stocks, 576
shortage costs, 574
total costs, 574–575
Economic value added (EVA), 398
The Economist, 595
Effective annual rate (EAR), 141

annual percentage rate (APR)
and, 142–144
calculating and comparing, 141
compounding, 140–141
financial calculators and, 144
spreadsheets and, 144
Efficient capital market, 336
price behavior in, 336–337
Efficient markets hypothesis
(EMH), 337
common misconceptions about,
338–339
semistrong form, 339
Electronic communications
networks (ECNs), 223
Electronic data interchange
(EDI), 554
Electronic Timing, Inc. (case), 484
Embedded debt cost, 395
Enron Corporation, 11
Enterprise value, 64–65
Equifax, 568
Equity, 22
debt vs., 25, 176
new equity sales and value of
firm, 504

Equity multiplier, 58
Equity securities, 175
Erosion, 277

Ethical and legal questions of
float, 554
Euro Disney, 297
Eurobonds, 587
Eurocurrency, 587
Ex-dividend date, 457–458
price behavior around, 458
Excess return, 321
Exchange rate, 589
cross-rates and triangle
arbitrage, 590–592
interest rates and, 597–599
quotations, 590
Exchange rate risk, 599–602
long-run exposure, 600
management of, 602
short-run exposure, 599–600
translation exposure, 601–602
Exit strategy, 488
Exotic bonds, 186
Expected return, 350–351
announcements and news,
358–359
calculation of, 351–352
portfolio expected return, 354–356
systematic risk and, 372
unexpected returns and, 358
variance and, 350–352
Experian, 568
External uses of financial

statements, 74
Extra cash dividend, 457
ExxonMobil, 177, 468, 553
F
Face value, 166
Facebook, 72
Factoring receivables, 536
Fallen angels, 182
Federal Bankruptcy Reform Act
of 1978
Chapter 7, 443
Chapter 11, 444–445
Field warehouse financing, 537
Finance
accounting and, 3
corporate finance, 2

financial institutions, 2–3
four basic areas of, 2–3
international finance, 4
investments, 2
management and, 3–4
marketing and, 3
overview of, 1–4
personal financial decisions, 4
reasons for study, 3–4
Financial Accounting Standards
Board (FASB), 30
Financial advisers, 2
Financial analysts, 3

Financial calculator, 103–104
annuity present values, 133
bond prices and yields, 173–174
future value, 103–104
present value of multiple cash
flows, 129–130
Financial distress costs, 436, 440
Financial EDI (electronic data
interchange), 554
Financial institutions, 2–3
Financial leverage, 25
corporate borrowing and
homemade leverage, 428–429
cost of equity and, 430–432
effect of, 425–429
EPS vs. EBIT, 426–427
EPS and ROE, 425–426
impact of, 425
Financial leverage ratios, 58
Financial management
bankruptcy process, 446–447
goal of, 9–11
international aspects of, 586
profit maximization, 9
Sarbanes–Oxley Act, 10–11
Financial management decisions,
5–6
capital budgeting, 5
capital structure, 6
working capital management, 6

Financial manager, 4–5
business finance and, 4–6
inventory policy, 570
Financial markets
cash flows to and from firm,
15–16
corporation and, 15–17