Corporate Finance


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
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Corporate Finance
ELEVENTH EDITION

Stephen A. Ross
Sloan School of Management
Massachusetts Institute of Technology

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

Jeffrey Jaffe
Wharton School of Business
University of Pennsylvania

Bradford D. Jordan

Gatton College of Business and Economics
University of Kentucky


Brief Contents
Part I
OVERVIEW
1

Introduction to Corporate Finance

2

Financial Statements and Cash Flow

20

3

Financial Statements Analysis and Financial Models

44

1

Part II
VALUATION AND CAPITAL BUDGETING
4

Discounted Cash Flow Valuation


5

Net Present Value and Other Investment Rules

135

6

Making Capital Investment Decisions

171

7

Risk Analysis, Real Options, and Capital Budgeting

208

8

Interest Rates and Bond Valuation

238

9

Stock Valuation

273


87

Part III
RISK
10 Risk and Return: Lessons from Market History

302

11 Return and Risk: The Capital Asset Pricing Model (CAPM)

331

12 An Alternative View of Risk and Return: The Arbitrage Pricing Theory

374

13 Risk, Cost of Capital, and Valuation

396

Part IV
CAPITAL STRUCTURE AND DIVIDEND POLICY
14 Efficient Capital Markets and Behavioral Challenges

431

15 Long-Term Financing: An Introduction

471


16 Capital Structure: Basic Concepts

490

17 Capital Structure: Limits to the Use of Debt

522

18 Valuation and Capital Budgeting for the Levered Firm

555

19 Dividends and Other Payouts

577

Part V
LONG-TERM FINANCING

xxiv

20 Raising Capital

617

21 Leasing

652



Part VI
OPTIONS, FUTURES, AND CORPORATE FINANCE
22 Options and Corporate Finance

677

23 Options and Corporate Finance: Extensions and Applications

722

24 Warrants and Convertibles

746

25 Derivatives and Hedging Risk

767

Part VII
SHORT-TERM FINANCE
26 Short-Term Finance and Planning

799

27 Cash Management

829

28 Credit and Inventory Management


851

Part VIII
SPECIAL TOPICS
29 Mergers, Acquisitions, and Divestitures

880

30 Financial Distress

923

31 International Corporate Finance

939

Appendix A: Mathematical Tables

966

Appendix B: Solutions to Selected End-of-Chapter Problems

975

Appendix C: Using the HP 10B and TI BA II Plus
Financial Calculators

978


Glossary

982

Name Index

999

Subject Index

1001

xxv


Contents
PART I Overview

2.7

Chapter 1
Introduction to Corporate Finance
1.1
1.2

1.3
1.4

1.5


What Is Corporate Finance?
The Balance Sheet Model of the Firm
The Financial Manager
The Corporate Firm
The Sole Proprietorship
The Partnership
The Corporation
A Corporation by Another Name . . .
The Importance of Cash Flows
The Goal of Financial Management
Possible Goals
The Goal of Financial Management
A More General Goal
The Agency Problem and Control
of the Corporation
Agency Relationships
Management Goals
Do Managers Act in the Stockholders’ Interests?
Stakeholders
Regulation
The Securities Act of 1933 and the Securities
Exchange Act of 1934
Sarbanes-Oxley
Summary and Conclusions
Concept Questions

1
1
1
3

4
4
4
5
7
8
11
11
12
12

Financial Statements Analysis
and Financial Models
3.1

3.2

3.3

16
17
18
18

3.5

Financial Statements and Cash Flow

20


3.6

2.1

20
21
22
22
23
24
25
25
26
26
26
28
29
32
32
33

3.4

Chapter 2

2.2

2.3
2.4
2.5

2.6

xxvi

The Balance Sheet
Liquidity
Debt versus Equity
Value versus Cost
The Income Statement
Generally Accepted Accounting Principles
Noncash Items
Time and Costs
Taxes
Corporate Tax Rates
Average versus Marginal Tax Rates
Net Working Capital
Cash Flow of the Firm
The Accounting Statement of Cash Flows
Cash Flow from Operating Activities
Cash Flow from Investing Activities

33
34
35
36
36
41
42

Chapter 3


13
13
14
14
16
16

1.6

Cash Flow from Financing Activities
Cash Flow Management
Summary and Conclusions
Concept Questions
Questions and Problems
Excel Master It! Problem
Mini Case: Cash Flows at Warf Computers, Inc.

Financial Statements Analysis
Standardizing Statements
Common-Size Balance Sheets
Common-Size Income Statements
Ratio Analysis
Short-Term Solvency or Liquidity Measures
Long-Term Solvency Measures
Asset Management or Turnover Measures
Profitability Measures
Market Value Measures
The DuPont Identity
A Closer Look at ROE

Problems with Financial Statement Analysis
Financial Models
A Simple Financial Planning Model
The Percentage of Sales Approach
External Financing and Growth
EFN and Growth
Financial Policy and Growth
A Note about Sustainable
Growth Rate Calculations
Some Caveats Regarding Financial
Planning Models
Summary and Conclusions
Concept Questions
Questions and Problems
Excel Master It! Problem
Mini Case: Ratios and Financial Planning at
East Coast Yachts

44
44
44
45
46
48
49
50
52
54
55
58

58
60
61
61
63
67
68
70
74
75
76
76
78
83
84

PART II Valuation and
Capital Budgeting
Chapter 4
Discounted Cash Flow Valuation

87

4.1
4.2

87
91
91


Valuation: The One-Period Case
The Multiperiod Case
Future Value and Compounding


4.3

4.4

4.5
4.6

The Power of Compounding: A Digression
Present Value and Discounting
Finding the Number of Periods
The Algebraic Formula
Compounding Periods
Distinction between Annual Percentage Rate
and Effective Annual Rate
Compounding over Many Years
Continuous Compounding
Simplifications
Perpetuity
Growing Perpetuity
Annuity
Growing Annuity
Loan Amortization
What Is a Firm Worth?
Summary and Conclusions
Concept Questions

Questions and Problems
Excel Master It! Problem
Mini Case: The MBA Decision
Appendix 4A: Net Present Value:
First Principles of Finance
Appendix 4B: Using Financial Calculators

94
95
98
101
102
103
104
104
106
106
108
109
115
116
120
122
123
123
133
134

Questions and Problems
Excel Master It! Problem

Mini Case: Bullock Gold Mining

Chapter 6
Making Capital Investment Decisions
6.1

6.2

6.3

134
134

Chapter 5
Net Present Value and Other
Investment Rules
5.1
5.2

5.3
5.4
5.5

5.6
5.7

Why Use Net Present Value?
The Payback Period Method
Defining the Rule
Problems with the Payback Method

Managerial Perspective
Summary of Payback
The Discounted Payback Period Method
The Internal Rate of Return
Problems with the IRR Approach
Definition of Independent and Mutually
Exclusive Projects
Two General Problems Affecting Both
Independent and Mutually Exclusive Projects
Problems Specific to Mutually Exclusive Projects
Redeeming Qualities of IRR
A Test
The Profitability Index
Calculation of Profitability Index
The Practice of Capital Budgeting
Summary and Conclusions
Concept Questions

6.4

135
135
138
138
139
140
141
141
141
145


6.5

145
145
149
154
154
155
155
157
159
160

162
169
170

171

Incremental Cash Flows: The Key
to Capital Budgeting
Cash Flows—Not Accounting Income
Sunk Costs
Opportunity Costs
Side Effects
Allocated Costs
The Baldwin Company: An Example
An Analysis of the Project
Which Set of Books?

A Note about Net Working Capital
A Note about Depreciation
Interest Expense
Alternative Definitions
of Operating Cash Flow
The Top-Down Approach
The Bottom-Up Approach
The Tax Shield Approach
Conclusion
Some Special Cases of Discounted
Cash Flow Analysis
Evaluating Cost-Cutting Proposals
Setting The Bid Price
Investments of Unequal Lives: The Equivalent
Annual Cost Method
Inflation and Capital Budgeting
Interest Rates and Inflation
Cash Flow and Inflation
Discounting: Nominal or Real?
Summary and Conclusions
Concept Questions
Questions and Problems
Excel Master It! Problems
Mini Cases: Bethesda Mining Company
Goodweek Tires, Inc.

171
171
172
173

173
174
174
177
179
179
180
181
181
182
182
183
184
184
184
186
188
190
190
192
192
195
195
197
205
205
206

Chapter 7
Risk Analysis, Real Options,

and Capital Budgeting
7.1

Sensitivity Analysis, Scenario Analysis,
and Break-Even Analysis
Sensitivity Analysis and Scenario Analysis

208
208
208

xxvii


7.2

7.3

7.4

Break-Even Analysis
Monte Carlo Simulation
Step 1: Specify the Basic Model
Step 2: Specify a Distribution
for Each Variable in the Model
Step 3: The Computer Draws
One Outcome
Step 4: Repeat the Procedure
Step 5: Calculate NPV
Real Options

The Option to Expand
The Option to Abandon
Timing Options
Decision Trees
Summary and Conclusions
Concept Questions
Questions and Problems
Excel Master It! Problem
Mini Case: Bunyan Lumber, LLC

212
216
216
216
219
219
220
220
221
222
224
225
227
228
228
235
236

Chapter 9
Stock Valuation

9.1
9.2

9.3
9.4
9.5

Chapter 8
Interest Rates and Bond Valuation
8.1

8.2

8.3

8.4

8.5

xxviii

Bonds and Bond Valuation
Bond Features and Prices
Bond Values and Yields
Interest Rate Risk
Finding the Yield to Maturity:
More Trial and Error
Zero Coupon Bonds
Government and
Corporate Bonds

Government Bonds
Corporate Bonds
Bond Ratings
Bond Markets
How Bonds Are Bought and Sold
Bond Price Reporting
A Note on Bond Price Quotes
Inflation and Interest Rates
Real versus Nominal Rates
Inflation Risk and Inflation-Linked Bonds
The Fisher Effect
Determinants of Bond Yields
The Term Structure of Interest Rates
Bond Yields and the Yield Curve:
Putting It All Together
Conclusion
Summary and Conclusions
Concept Questions
Questions and Problems
Excel Master It! Problem
Mini Case: Financing East Coast Yachts’s
Expansion Plans With A Bond Issue

238
238
238
239
242
244
246

248
248
249
251
252
252
253
256
257
257
258
259
261
261
263
265
265
265
266
270
271

The Present Value of Common Stocks
Dividends versus Capital Gains
Valuation of Different Types of Stocks
Estimates of Parameters in the
Dividend Discount Model
Where Does g Come From?
Where Does R Come From?
A Healthy Sense of Skepticism

Dividends or Earnings: Which to Discount?
The No-Dividend Firm
Comparables
Price-to-Earnings Ratio
Enterprise Value Ratios
Valuing Stocks Using Free Cash Flows
The Stock Markets
Dealers and Brokers
Organization of the NYSE
Types of Orders
NASDAQ Operations
Stock Market Reporting
Summary and Conclusions
Concept Questions
Questions and Problems
Excel Master It! Problem
Mini Case: Stock Valuation at Ragan Engines

273
273
273
274
278
278
280
281
282
282
283
283

286
287
288
289
289
292
292
293
294
295
295
299
300

PART III Risk
Chapter 10
Risk and Return: Lessons
from Market History
10.1
10.2
10.3
10.4
10.5

10.6

10.7

302


Returns
302
Dollar Returns
302
Percentage Returns
304
Holding Period Returns
306
Return Statistics
312
Average Stock Returns
and Risk-Free Returns
314
Risk Statistics
314
Variance
314
Normal Distribution and Its Implications
for Standard Deviation
317
More on Average Returns
318
Arithmetic versus Geometric Averages
318
Calculating Geometric Average Returns
318
Arithmetic Average Return or Geometric
Average Return?
320
The U.S. Equity Risk Premium: Historical

and International Perspectives
320


10.8

2008: A Year of Financial Crisis
Summary and Conclusions
Concept Questions
Questions and Problems
Excel Master It! Problem
Mini Case: A Job at East Coast Yachts

323
325
325
326
328
329

12.3
12.4
12.5

Chapter 11
Return and Risk: The Capital Asset
Pricing Model (CAPM)
11.1
11.2


11.3
11.4
11.5
11.6

11.7
11.8

11.9

331

Individual Securities
331
Expected Return, Variance,
and Covariance
332
Expected Return and Variance
332
Covariance and Correlation
334
The Return and Risk for Portfolios
337
The Expected Return on a Portfolio
337
Variance and Standard Deviation of a Portfolio 338
The Efficient Set for Two Assets
341
The Efficient Set for Many Securities
346

Variance and Standard Deviation in a
Portfolio of Many Assets
347
Diversification
349
The Anticipated and Unanticipated
Components of News
349
Risk: Systematic and Unsystematic
349
The Essence of Diversification
350
Riskless Borrowing and Lending
352
The Optimal Portfolio
354
Market Equilibrium
355
Definition of the Market Equilibrium Portfolio 355
Definition of Risk When Investors
Hold the Market Portfolio
356
The Formula for Beta
358
A Test
359
Relationship between Risk and Expected
Return (CAPM)
359
Expected Return on Market

359
Expected Return on Individual Security
360
Summary and Conclusions
363
Concept Questions
364
Questions and Problems
365
Excel Master It! Problem
371
Mini Case: A Job At East Coast
Yachts, Part 2
372
Appendix 11A: Is Beta Dead?
373

Chapter 12
An Alternative View of Risk and Return:
The Arbitrage Pricing Theory
374
12.1
12.2

Introduction
Systematic Risk and Betas

374
374


12.6

Portfolios and Factor Models
Portfolios and Diversification
Betas, Arbitrage, and Expected Returns
The Linear Relationship
The Market Portfolio and the Single Factor
The Capital Asset Pricing Model
and the Arbitrage Pricing Theory
Differences in Pedagogy
Differences in Application
Empirical Approaches to Asset Pricing
Empirical Models
Style Portfolios
Summary and Conclusions
Concept Questions
Questions and Problems
Excel Master It! Problem
Mini Case: The Fama–French Multifactor
Model and Mutual Fund Returns

377
379
382
382
383
384
384
384
386

386
387
389
389
390
394
395

Chapter 13
Risk, Cost of Capital,
and Valuation
13.1
13.2

The Cost of Capital
Estimating the Cost of Equity
Capital with the CAPM
The Risk-Free Rate
Market Risk Premium
13.3 Estimation of Beta
Real-World Betas
Stability of Beta
Using an Industry Beta
13.4 Determinants of Beta
Cyclicality of Revenues
Operating Leverage
Financial Leverage and Beta
13.5 The Dividend Discount
Model Approach
Comparison of DDM and CAPM

13.6 Cost of Capital for Divisions
and Projects
13.7 Cost of Fixed Income Securities
Cost of Debt
Cost of Preferred Stock
13.8 The Weighted Average
Cost of Capital
13.9 Valuation with R WACC
Project Evaluation and the RWACC
Firm Valuation with the RWACC
13.10 Estimating Eastman Chemical’s
Cost of Capital
13.11 Flotation Costs and the Weighted
Average Cost of Capital
The Basic Approach
Flotation Costs and NPV

396
396
397
400
400
401
402
402
403
405
405
406
406

407
408
409
411
411
412
413
414
414
415
418
420
420
421

xxix


Internal Equity and Flotation Costs
Summary and Conclusions
Concept Questions
Questions and Problems
Mini Case: Cost of Capital for Swan Motors
Appendix 13A: Economic Value Added and
the Measurement of Financial
Performance

422
423
423

425
429

15.2

430

15.4
15.5
15.6
15.7

PART IV Capital Structure
and Dividend Policy

15.3

Chapter 14
Efficient Capital Markets
and Behavioral Challenges
14.1
14.2
14.3

14.4

14.5

14.6
14.7

14.8

Can Financing Decisions Create Value?
A Description of Efficient Capital Markets
Foundations of Market Efficiency
The Different Types of Efficiency
The Weak Form
The Semistrong and Strong Forms
Some Common Misconceptions about the
Efficient Market Hypothesis
The Evidence
The Weak Form
The Semistrong Form
The Strong Form
The Behavioral Challenge
to Market Efficiency
Rationality
Independent Deviations from Rationality
Arbitrage
Empirical Challenges to Market Efficiency
Reviewing the Differences
Implications for Corporate Finance
1. Accounting Choices, Financial Choices,
and Market Efficiency
2. The Timing Decision
3. Speculation and Efficient Markets
4. Information in Market Prices
Summary and Conclusions
Concept Questions
Questions and Problems

Mini Case: Your 401(k) Account at
East Coast Yachts

431
431
433
435
436
436
437
439
440
440
442
444
445
445
447
448
449
454
456

15.1

xxx

Some Features of Common
and Preferred Stocks
Common Stock Features

Preferred Stock Features

Capital Structure: Basic Concepts
16.1
16.2
16.3

16.4

16.5

469

Long-Term Financing: An Introduction 471
471
471
474

475
476
476
478
481
481
481
482
483
483
485
486

486
487
487

Chapter 16

456
457
458
460
462
463
467

Chapter 15

Corporate Long-Term Debt
Is It Debt or Equity?
Long-Term Debt: The Basics
The Indenture
Some Different Types of Bonds
Floating-Rate Bonds
Other Types of Bonds
Bank Loans
International Bonds
Patterns of Financing
Recent Trends in Capital Structure
Which Are Best: Book or Market Values?
Summary and Conclusions
Concept Questions

Questions and Problems

490

The Capital Structure Question
and the Pie Theory
490
Maximizing Firm Value versus
Maximizing Stockholder Interests
491
Financial Leverage and Firm Value:
An Example
493
Leverage and Returns to Shareholders
493
The Choice between Debt and Equity
495
A Key Assumption
497
Modigliani and Miller: Proposition II
(No Taxes)
497
Risk to Equityholders Rises with Leverage
497
Proposition II: Required Return to
Equityholders Rises with Leverage
498
MM: An Interpretation
504
Taxes

506
The Basic Insight
506
Present Value of the Tax Shield
508
Value of the Levered Firm
508
Expected Return and Leverage
under Corporate Taxes
510
The Weighted Average Cost
of Capital, RWACC, and Corporate Taxes
512
Stock Price and Leverage under
Corporate Taxes
513
Summary and Conclusions
515
Concept Questions
515
Questions and Problems
516
Mini Case: Stephenson Real Estate Recapitalization 521

Chapter 17
Capital Structure: Limits to
the Use of Debt
17.1

Costs of Financial Distress

Bankruptcy Risk or Bankruptcy Cost?

522
522
522


17.2

17.3
17.4
17.5
17.6

17.7
17.8
17.9

Description of Financial Distress Costs
Direct Costs of Financial Distress: Legal
and Administrative Costs of Liquidation
or Reorganization
Indirect Costs of Financial Distress
Agency Costs
Can Costs of Debt Be Reduced?
Protective Covenants
Consolidation of Debt
Integration of Tax Effects
and Financial Distress Costs
Pie Again

Signaling
Shirking, Perquisites, and Bad
Investments: A Note on
Agency Cost of Equity
Effect of Agency Costs of Equity
on Debt–Equity Financing
Free Cash Flow
The Pecking-Order Theory
Rules of the Pecking Order
Implications
Personal Taxes
The Basics of Personal Taxes
The Effect of Personal Taxes on Capital Structure
How Firms Establish Capital Structure
Summary and Conclusions
Concept Questions
Questions and Problems
Mini Case: Mckenzie Corporation’s
Capital Budgeting
Appendix 17A: Some Useful Formulas of
Financial Structure
Appendix 17B: The Miller Model and the
Graduated Income Tax

524
524
526
527
530
530

531

18.1
18.2

18.3
18.4
18.5
18.6

Adjusted Present Value Approach
Flow to Equity Approach
Step 1: Calculating Levered
Cash Flow (LCF)
Step 2: Calculating RS
Step 3: Valuation
Weighted Average Cost
of Capital Method
A Comparison of the APV, FTE,
and WACC Approaches
A Suggested Guideline
Valuation When the Discount Rate
Must Be Estimated
APV Example

Beta and Leverage
The Project Is Not Scale Enhancing
Summary and Conclusions
Concept Questions
Questions and Problems

Mini Case: The Leveraged Buyout
of Cheek Products, Inc.
Appendix 18A: The Adjusted Present
Value Approach to
Valuing Leveraged Buyouts

532
533
534

Chapter 19

536

19.1
19.2

538
538
539
540
541
542
542
542
544
549
549
550
553

554
554

Chapter 18
Valuation and Capital Budgeting
for the Levered Firm

18.7

555
555
557
557
558
558
558
559
560
562
564

Dividends and Other Payouts
Different Types of Payouts
Standard Method of Cash
Dividend Payment
19.3 The Benchmark Case: An Illustration
of the Irrelevance of Dividend Policy
Current Policy: Dividends Set Equal
to Cash Flow
Alternative Policy: Initial Dividend Is Greater

Than Cash Flow
The Indifference Proposition
Homemade Dividends
A Test
Dividends and Investment Policy
19.4 Repurchase of Stock
Dividend versus Repurchase:
Conceptual Example
Dividends versus Repurchases:
Real-World Considerations
19.5 Personal Taxes, Dividends,
and Stock Repurchases
Firms without Sufficient Cash to Pay
a Dividend
Firms with Sufficient Cash to Pay a Dividend
Summary of Personal Taxes
19.6 Real-World Factors Favoring
a High-Dividend Policy
Desire for Current Income
Behavioral Finance
Agency Costs
Information Content of Dividends
and Dividend Signaling
19.7 The Clientele Effect: A Resolution
of Real-World Factors?
19.8 What We Know and Do Not Know
about Dividend Policy
Corporate Dividends are Substantial
Fewer Companies Pay Dividends
Corporations Smooth Dividends

Some Survey Evidence about Dividends
19.9 Putting It All Together
19.10 Stock Dividends and Stock Splits

567
569
570
570
571
575
576

577
577
578
580
580
581
581
582
583
583
584
585
586
587
587
588
591
591

591
592
593
594
596
598
598
599
600
601
603
605

xxxi


Some Details about Stock Splits
and Stock Dividends
Value of Stock Splits and Stock Dividends
Reverse Splits
Summary and Conclusions
Concept Questions
Questions and Problems
Mini Case: Electronic Timing, Inc.

605
607
608
609
609

611
615

PART V Long-Term
Financing
Chapter 20
Raising Capital
Early-Stage Financing
and Venture Capital
Venture Capital
Stages of Financing
Some Venture Capital Realities
Venture Capital Investments
and Economic Conditions
20.2 The Public Issue
20.3 Alternative Issue Methods
20.4 The Cash Offer
Investment Banks
The Offering Price
Underpricing: A Possible Explanation
20.5 The Announcement of New Equity
and the Value of the Firm
20.6 The Cost of New Issues
The Costs of Going Public: A Case Study
20.7 Rights
The Mechanics of a Rights Offering
Subscription Price
Number of Rights Needed to Purchase
a Share
Effect of Rights Offering on Price of Stock

Effects on Shareholders
The Underwriting Arrangements
20.8 The Rights Puzzle
20.9 Dilution
Dilution of Proportionate Ownership
Stock Price Dilution
Book Value
Earnings Per Share
Conclusion
20.10 Shelf Registration
20.11 Issuing Long-Term Debt
Summary and Conclusions
Concept Questions
Questions and Problems
Mini Case: East Coast Yachts Goes Public

617

20.1

xxxii

617
618
619
620
621
621
622
624

627
628
629
631
632
634
635
635
635
637
637
639
639
640
641
641
641
642
643
643
643
644
645
645
648
650

Chapter 21
Leasing
21.1


Types of Leases
The Basics
Operating Leases
Financial Leases
21.2 Accounting and Leasing
21.3 Taxes, the IRS, and Leases
21.4 The Cash Flows of Leasing
21.5 A Detour for Discounting
and Debt Capacity with
Corporate Taxes
Present Value of Riskless Cash Flows
Optimal Debt Level and Riskless Cash Flows
21.6 NPV Analysis of the
Lease-versus-Buy Decision
The Discount Rate
21.7 Debt Displacement
and Lease Valuation
The Basic Concept of Debt Displacement
Optimal Debt Level in the Xomox Example
21.8 Does Leasing Ever Pay? The Base Case
21.9 Reasons for Leasing
Good Reasons for Leasing
Bad Reasons for Leasing
21.10 Some Unanswered Questions
Are the Uses of Leases
and Debt Complementary?
Why Are Leases Offered by Both
Manufacturers and Third-Party Lessors?
Why Are Some Assets Leased More

Than Others?
Summary and Conclusions
Concept Questions
Questions and Problems
Mini Case: The Decision to Lease or Buy at
Warf Computers
Appendix 21A: APV Approach to Leasing

652
652
652
653
653
654
656
657
659
659
660
661
661
662
662
663
665
666
666
669
670
670

670
671
671
672
673
675
676

PART VI Options, Futures,
and Corporate Finance
Chapter 22
Options and Corporate Finance
22.1
22.2
22.3
22.4
22.5

Options
Call Options
The Value of a Call Option at Expiration
Put Options
The Value of a Put Option at Expiration
Selling Options
Option Quotes

677
677
678
678

679
679
681
682


22.6
22.7

Combinations of Options
Valuing Options
Bounding the Value of a Call
The Factors Determining Call Option Values
A Quick Discussion of Factors Determining
Put Option Values
22.8 An Option Pricing Formula
A Two-State Option Model
The Black–Scholes Model
22.9 Stocks and Bonds as Options
The Firm Expressed In Terms of
Call Options
The Firm Expressed in Terms of Put Options
A Resolution of the Two Views
A Note about Loan Guarantees
22.10 Options and Corporate Decisions:
Some Applications
Mergers and Diversification
Options and Capital Budgeting
22.11 Investment in Real Projects
and Options

Summary and Conclusions
Concept Questions
Questions and Problems
Excel Master It! Problem
Mini Case: Clissold Industries Options

683
686
686
688
691
691
692
694
699
700
701
702
703

23.1
23.2
23.3
23.4

Executive Stock Options
Why Options?
Valuing Executive Compensation
Valuing a Start-Up
More about the Binomial Model

Heating Oil
Shutdown and Reopening Decisions
Valuing a Gold Mine
The Abandonment and Opening Decisions
Valuing the Simple Gold Mine
Summary and Conclusions
Concept Questions
Questions and Problems
Mini Case: Exotic Cuisines’
Employee Stock Options

24.4
24.5

24.6

24.7

704
704
706
708
711
711
712
719
720

24.8


Derivatives and Hedging Risk
722
722
722
723
726
729
729
735
735
736
738
742
742
743
745

25.1
25.2
25.3
25.4
25.5

25.6

25.7

Chapter 24
Warrants and Convertibles
24.1

24.2

Warrants
The Difference between Warrants
and Call Options
How the Firm Can Hurt Warrant Holders

Warrant Pricing and the
Black–Scholes Model
Convertible Bonds
The Value of Convertible Bonds
Straight Bond Value
Conversion Value
Option Value
Reasons for Issuing Warrants
and Convertibles
Convertible Debt versus Straight Debt
Convertible Debt versus Common Stock
The “Free Lunch” Story
The “Expensive Lunch” Story
A Reconciliation
Why Are Warrants and
Convertibles Issued?
Matching Cash Flows
Risk Synergy
Agency Costs
Backdoor Equity
Conversion Policy
Summary and Conclusions
Concept Questions

Questions and Problems
Mini Case: S&S Air’s Convertible Bond

750
752
752
752
753
754
755
755
756
757
758
758
758
758
759
759
760
760
761
762
763
765

Chapter 25

Chapter 23
Options and Corporate Finance:

Extensions and Applications

24.3

746
746
747
750

25.8

Derivatives, Hedging, and Risk
Forward Contracts
Futures Contracts
Hedging
Interest Rate Futures Contracts
Pricing of Treasury Bonds
Pricing of Forward Contracts
Futures Contracts
Hedging in Interest Rate Futures
Duration Hedging
The Case of Zero Coupon Bonds
The Case of Two Bonds with the Same
Maturity but with Different Coupons
Duration
Matching Liabilities with Assets
Swaps Contracts
Interest Rate Swaps
Currency Swaps
Credit Default Swaps

Exotics
Actual Use of Derivatives
Summary and Conclusions
Concept Questions
Questions and Problems
Mini Case: Williamson Mortgage, Inc.

767
767
768
769
773
775
775
776
777
778
782
782
783
784
786
788
789
790
791
791
792
794
794

796
798

xxxiii


PART VII Short-Term
Finance

27.4

Chapter 26
Short-Term Finance and Planning
26.1
26.2

26.3

26.4
26.5

Tracing Cash and Net Working Capital
The Operating Cycle
and the Cash Cycle
Defining the Operating and Cash Cycles
The Operating Cycle and the
Firm’s Organization Chart
Calculating the Operating and Cash Cycles
Interpreting the Cash Cycle
A Look at Operating and Cash Cycles

Some Aspects of Short-Term
Financial Policy
The Size of the Firm’s Investment
in Current Assets
Alternative Financing Policies for Current Assets
Which Is Best?
Cash Budgeting
Cash Outflow
The Cash Balance
The Short-Term Financial Plan
Unsecured Loans
Secured Loans
Other Sources
Summary and Conclusions
Concept Questions
Questions and Problems
Excel Master It! Problem
Mini Case: Keafer Manufacturing Working
Capital Management

799
800
801
802
804
804
807
807
808
809

810
812
814
815
816
816
816
817
817
818
818
819
827

27.1

27.2

27.3

xxxiv

Chapter 28
Credit and Inventory Management
28.1

28.2

28.3


828
28.4

Chapter 27
Cash Management

27.5

829

Reasons for Holding Cash
829
The Speculative and Precautionary Motives
829
The Transaction Motive
830
Compensating Balances
830
Costs of Holding Cash
830
Cash Management versus Liquidity Management 830
Understanding Float
831
Disbursement Float
831
Collection Float and Net Float
832
Float Management
833
Electronic Data Interchange and Check 21:

The End of Float?
836
Cash Collection and Concentration
837
Components of Collection Time
837
Cash Collection
838
Lockboxes
838

Cash Concentration
839
Accelerating Collections: An Example
840
Managing Cash Disbursements
842
Increasing Disbursement Float
842
Controlling Disbursements
843
Investing Idle Cash
844
Temporary Cash Surpluses
844
Characteristics of Short-Term Securities
845
Some Different Types of Money Market Securities 845
Summary and Conclusions
846

Concept Questions
847
Questions and Problems
848
Mini Case: Cash Management at
Richmond Corporation
850
Appendix 27A: Determining the
Target Cash Balance
850
Appendix 27B: Adjustable Rate Preferred
Stock, Auction Rate Preferred
Stock, and Floating-Rate
Certificates of Deposit
850

28.5

28.6
28.7

28.8

Credit and Receivables
Components of Credit Policy
The Cash Flows from Granting Credit
The Investment in Receivables
Terms of the Sale
The Basic Form
The Credit Period

Cash Discounts
Credit Instruments
Analyzing Credit Policy
Credit Policy Effects
Evaluating a Proposed Credit Policy
Optimal Credit Policy
The Total Credit Cost Curve
Organizing the Credit Function
Credit Analysis
When Should Credit Be Granted?
Credit Information
Credit Evaluation and Scoring
Collection Policy
Monitoring Receivables
Collection Effort
Inventory Management
The Financial Manager and Inventory Policy
Inventory Types
Inventory Costs
Inventory Management Techniques
The ABC Approach
The Economic Order Quantity Model
Extensions to the EOQ Model
Managing Derived-Demand Inventories

851
851
852
852
852

853
853
853
855
856
857
857
857
859
860
861
861
862
863
864
864
864
865
865
866
866
866
867
867
868
872
872


Summary and Conclusions

Concept Questions
Questions and Problems
Mini Case: Credit Policy at Braam Industries
Appendix 28A: More about Credit
Policy Analysis

879

Chapter 29
Mergers, Acquisitions, and Divestitures 880

29.2
29.3

29.4

29.5

29.6

29.7
29.8
29.9

29.10
29.11
29.12
29.13

The Basic Forms of Acquisitions

Merger or Consolidation
Acquisition of Stock
Acquisition of Assets
A Classification Scheme
A Note about Takeovers
Synergy
Sources of Synergy
Revenue Enhancement
Cost Reduction
Tax Gains
Reduced Capital Requirements
Two Financial Side Effects of
Acquisitions
Earnings Growth
Diversification
A Cost to Stockholders
from Reduction in Risk
The Base Case
Both Firms Have Debt
How Can Shareholders Reduce Their Losses
from the Coinsurance Effect?
The NPV of a Merger
Cash
Common Stock
Cash versus Common Stock
Friendly versus Hostile Takeovers
Defensive Tactics
Deterring Takeovers before Being in Play
Deterring a Takeover after the Company Is in Play
Have Mergers Added Value?

Returns to Bidders
Target Companies
The Managers versus the Stockholders
The Tax Forms of Acquisitions
Accounting for Acquisitions
Going Private and Leveraged Buyouts
Divestitures
Sale
Spin-Off
Carve-Out
Tracking Stocks

880
880
881
881
882
882
883
884
884
885
887
889
890
890
891
892
892
892

894
894
894
896
897
898
900
900
901
903
905
906
906
908
910
911
912
912
912
913
913

914
914
915
921

Chapter 30
Financial Distress


PART VIII Special Topics

29.1

Summary and Conclusions
Concept Questions
Questions and Problems
Mini Case: The Birdie Golf—Hybrid Golf Merger

874
875
876
879

30.1
30.2
30.3

30.4

30.5
30.6

What Is Financial Distress?
What Happens in Financial Distress?
Bankruptcy Liquidation
and Reorganization
Bankruptcy Liquidation
Bankruptcy Reorganization
Private Workout or Bankruptcy:

Which Is Best?
The Marginal Firm
Holdouts
Complexity
Lack of Information
Prepackaged Bankruptcy
Predicting Corporate Bankruptcy:
The Z-Score Model
Summary and Conclusions
Concept Questions
Questions and Problems

923
923
925
927
927
929
932
932
933
933
933
933
935
936
937
937

Chapter 31

International Corporate Finance
31.1
31.2
31.3
31.4

31.5

31.6

Terminology
Foreign Exchange Markets
and Exchange Rates
Exchange Rates
Purchasing Power Parity
Absolute Purchasing Power Parity
Relative Purchasing Power Parity
Interest Rate Parity, Unbiased
Forward Rates, and the
International Fisher Effect
Covered Interest Arbitrage
Interest Rate Parity
Forward Rates and Future Spot Rates
Putting It All Together
International Capital Budgeting
Method 1: The Home Currency Approach
Method 2: The Foreign Currency Approach
Unremitted Cash Flows
The Cost of Capital for International Firms
Exchange Rate Risk

Short-Term Exposure
Long-Term Exposure
Translation Exposure
Managing Exchange Rate Risk

939
940
940
941
946
946
947
949
949
950
951
952
953
954
955
955
956
956
956
957
958
959

xxxv



31.7

xxxvi

Political Risk
Summary and Conclusions
Concept Questions
Questions and Problems
Excel Master It! Problem
Mini Case: East Coast Yachts Goes
International

959
960
961
962
965
965

Appendix A: Mathematical Tables
Appendix B: Solutions to Selected End-of-Chapter Problems
Appendix C: Using the HP 10B and TI BA II Plus
Financial Calculators
Glossary
Name Index
Subject Index

966
975

978
982
999
1001


CORPORATE FINANCE 2
No

1

2

3

4

5

Contents (syllabus)
Chapter 1: Risk and Return in Corporate
Finance
1.1 Risk
1.2 Returns (Profits)
1.3 The relationship between risk and return in
financial decisions

Chapter 2: The effect of financial leverage on
risk and return
2.1 Operating leverage

2.2 Financial leverage
2.3 Total leverage
2.4 Overview of risk
2.5 Business and financial risks
Chapter 3: Sources of Funds
3.1 Overview
3.2 Financial market and Funding Instruments
3.3 Asset Structure and Funding Strategy
Chapter 4: Capital structure
4.1 Financial structure and capital structure
4.2 The relationship between capital structure
and firm value
4.3.1 Optimal capital structure theory
4.3.2 MM preposition (theorem)
4.3.3 Other theorems
Chapter 5: Dividend policy
5.1 Dividends
5.2 Dividend policy
5.3 Relationship between dividend policy and
firm value

Corporate Finance (11th
Edition)
Chapter 10: Risk and Return –
Lessons from Market History
Chapter 11: Return and Risk –
Capital Asset Pricing Model
(CAPM)
Chapter 12: An Alternative
View of Risk and Return – The

Arbitrage Pricing Theory
Chapter 13: Risk, Cost of
Capital and Valuation

Chapter 15: Long-term
Financing
Chapter 20: Raising Capital
Chapter 21: Leasing
Chapter 16: Capital Structure –
Basic Concepts
Chapter 17: Capital Structure –
Limits to the Use of Debt

Chapter 19: Dividend and Other
Payouts


CORPORATE FINANCE 2
No

6

7

Contents (syllabus)
Chapter 6: Financial analysis
6.1 Overview of Financial Analysis
6.2 Content of Financial Analysis
6.3.1 Financial Indicators
6.3.2 The Dupont Identity

Chapter 7: Financial planning
7.1 Definition and role of financial planning
7.2 Classification of financial planning
7.3 Establishment of financial planning
7.4 What can planning accomplish?
7.5 Short-term financial planning
7.6 Long-term financial planning

Corporate Finance (11th
Edition)
Chapter 3: Financial Statements
Analysis and Financial Models

Chapter 2: Financial Statements
and Cash Flow
Chapter 15: Long-term
Financing
Chapter 20: Raising Capital
Chapter 21: Leasing
Chapter 26: Short – Term
Finance and Planning
Chapter 27: Cash Management
Chapter 28: Credit and
Inventory Management


10

PART III: RISK


Risk and Return
LESSONS FROM MARKET HISTORY
With the S&P 500 Index returning about 14 percent and
the NASDAQ Composite Index up about 13 percent in
2014, stock market performance overall was very good.
In particular, investors in outpatient diagnostic imaging
services company RadNet, Inc., had to be happy about the
411 percent gain in that stock, and investors in biopharmaceutical company Achillon Pharmaceuticals had to feel pretty
good following that company’s 269 percent gain. Of course,
not all stocks increased in value during the year. Stock in

Transocean Ltd. fell 63 percent during the year, and stock in
Avon Products dropped 44 percent.
These examples show that there were tremendous
potential profits to be made during 2014, but there was also
the risk of losing money—and lots of it. So what should you,
as a stock market investor, expect when you invest your own
money? In this chapter, we study more than eight decades of
market history to find out.

10.1 Returns
DOLLAR RETURNS
Excel
Master

coverage online

How did the market
do today? Find out at
finance.yahoo.com.


Suppose the Video Concept Company has several thousand shares of stock outstanding
and you are a shareholder. Further suppose that you purchased some of the shares of stock
in the company at the beginning of the year; it is now year-end and you want to figure
out how well you have done on your investment. The return you get on an investment in
stocks, like that in bonds or any other investment, comes in two forms.
As the owner of stock in the Video Concept Company, you are a part owner of the
company. If the company is profitable, it generally could distribute some of its profits to
the shareholders. Therefore, as the owner of shares of stock, you could receive some cash,
called a dividend, during the year. This cash is the income component of your return. In
addition to the dividends, the other part of your return is the capital gain—or, if it is
negative, the capital loss (negative capital gain)—on the investment.
For example, suppose we are considering the cash flows of the investment in
Figure 10.1, showing that you purchased 100 shares of stock at the beginning of the year
at a price of $37 per share. Your total investment, then, was:
C0 5 $37 3 100 5 $3,700

302


CHAPTER 10

Figure 10.1
Dollar Returns

Risk and Return

$4,218
Inflows


Dividends
Ending
market
value

$4,033
0
Initial
investment

303

TOTAL

$185

Time

■■■

1

Outflows
2$3,700

Suppose that over the year the stock paid a dividend of $1.85 per share. During the year,
then, you received income of:
Div 5 $1.85 3 100 5 $185
Suppose, finally, that at the end of the year the market price of the stock is $40.33 per
share. Because the stock increased in price, you had a capital gain of:

Gain 5 ($40.33 2 $37) 3 100 5 $333
The capital gain, like the dividend, is part of the return that shareholders require to maintain their investment in the Video Concept Company. Of course, if the price of Video Concept
stock had dropped in value to, say, $34.78, you would have recorded this capital loss:
Loss 5 ($34.78 2 $37) 3 100 5 −$222
The total dollar return on your investment is the sum of the dividend income and the
capital gain or loss on the investment:
Total dollar return 5 Dividend income 1 Capital gain (or loss)
(From now on we will refer to capital losses as negative capital gains and not distinguish
them.) In our first example, the total dollar return is given by:
Total dollar return 5 $185 1 $333 5 $518
Notice that if you sold the stock at the end of the year, your total amount of cash would be
the initial investment plus the total dollar return. In the preceding example you would have:
Total cash if stock is sold 5 Initial investment 1 Total dollar return
5 $3,700 1 $518
5 $4,218
As a check, notice that this is the same as the proceeds from the sale of stock plus
the dividends:
Proceeds from stock sale 1 Dividends
5 $40.33 3 100 1 $185
5 $4,033 1 $185
5 $4,218
Suppose, however, that you hold your Video Concept stock and don’t sell it at yearend. Should you still consider the capital gain as part of your return? Does this violate our
previous present value rule that only cash matters?


304

■■■

PART III


Risk

The answer to the first question is a strong yes, and the answer to the second
question is an equally strong no. The capital gain is every bit as much a part of your
return as the dividend, and you should certainly count it as part of your total return.
That you have decided to hold onto the stock and not sell, or realize the gain or the
loss, in no way changes the fact that, if you wanted, you could get the cash value of
the stock. After all, you could always sell the stock at year-end and immediately buy
it back. The total amount of cash you would have at year-end would be the $518 gain
plus your initial investment of $3,700. You would not lose this return when you bought
back 100 shares of stock. In fact, you would be in exactly the same position as if you
had not sold the stock (assuming, of course, that there are no tax consequences and no
brokerage commissions from selling the stock).

PERCENTAGE RETURNS

Go to
www.marketwatch
.com/markets for a
Java applet that shows
today’s returns by
market sector.

It is more convenient to summarize the information about returns in percentage terms than
in dollars because the percentages apply to any amount invested. The question we want to
answer is this: How much return do we get for each dollar invested? To find this out, let t
stand for the year we are looking at, let Pt be the price of the stock at the beginning of the
year, and let Divt11 be the dividend paid on the stock during the year. Consider the cash
flows in Figure 10.2.

In our example, the price at the beginning of the year was $37 per share and the dividend paid during the year on each share was $1.85. Hence, the percentage income return,
sometimes called the dividend yield, is:
Dividend yield 5 Divt11yPt
5 $1.85y$37
5 .05
5 5%

Figure 10.2
Percentage Returns

TOTAL

$42.18
Inflows

$1.85

Dividends
Ending
market
value

$40.33
Time

t

t11

Outflows

2$37
Dividends paid

Change in market
value over period
Beginning market value

Percentage return 5 at end of period

1

Dividends paid
 Market value
1
1 1 Percentage return 5 at end of period at end of period
Beginning market value


CHAPTER 10

Risk and Return

■■■

305

The capital gain (or loss) is the change in the price of the stock divided by the initial
price. Letting Pt11 be the price of the stock at year-end, we can compute the capital gain
as follows:
Capital gain 5 (Pt11 2 Pt)yPt

5 ($40.33 2 $37)y$37
5 $3.33y$37
5 .09
5 9%
Combining these two results, we find that the total return on the investment in Video
Concept stock over the year, which we will label Rt11, was:
Divt+1
(Pt+1 − Pt)
__________
Rt+1 = ______
Pt +
Pt
= 5% + 9%
= 14%
From now on, we will refer to returns in percentage terms.
To give a more concrete example, stock in Keurig Green Mountain (GMCR), of coffee
making by the cup fame, began 2014 at $75.54 per share. Keurig Green Mountain paid dividends of $1.00 during 2014, and the stock price at the end of the year was $132.40. What was
the return on GMCR for the year? For practice, see if you agree that the answer is 76.60 percent.
Of course, negative returns occur as well. For example, again in 2014, GameStop’s stock price
at the end of the year was $33.80 per share, and dividends of $1.32 were paid. The stock began
the year at $49.26 per share. Verify that the loss was 28.70 percent for the year.

EXAMPLE

10.1

Calculating Returns Suppose a stock begins the year with a price of $25 per share and ends with
a price of $35 per share. During the year, it paid a $2 dividend per share. What are its dividend yield,
its capital gains yield, and its total return for the year? We can imagine the cash flows in Figure 10.3.
P1 − P0

Div
R1 = ____1  + ______
P0
P0
$35 − 25 $12
$2
= ____ + _________ = ____
$25
$25
$25
= 8% + 40%
= 48%

Figure 10.3 Cash Flow—An Investment Example
$37

Dividends (Div1)

$2

Cash inflows

Ending
price per
share (P1)

$35
Time

0


TOTAL

1

Cash outflows
2$25 (P0)
(continued)


306

■■■

PART III

Risk

Thus, the stock’s dividend yield, its capital gains yield, and its total return are 8 percent, 40 percent,
and 48 percent, respectively.
Suppose you had $5,000 invested. The total dollar return you would have received on an investment in the stock is $5,000 3 .48 5 $2,400. If you know the total dollar return on the stock, you do
not need to know how many shares you would have had to purchase to figure out how much money
you would have made on the $5,000 investment. You just use the total dollar return.

10.2 Holding Period Returns
Excel
Master

coverage online


A famous set of studies dealing with rates of return on common stocks, bonds, and
Treasury bills is found in Ibbotson SBBI 2015 Classic U.S. Yearbook.1 It presents yearby-year historical rates of return for the following five important types of financial instruments in the United States:
1. Large-company common stocks: This common stock portfolio is based on the
Standard & Poor’s (S&P) Composite Index. At present the S&P Composite includes
500 of the largest (in terms of market value) companies in the United States.
2. Small-company common stocks: This is a portfolio corresponding to the bottom
fifth of stocks traded on the New York Stock Exchange in which stocks are ranked
by market value (i.e., the price of the stock multiplied by the number of shares outstanding).
3. Long-term corporate bonds: This is a portfolio of high-quality corporate bonds with
20-year maturities.
4. Long-term U.S. government bonds: This is based on U.S. government bonds with
maturities of 20 years.
5. U.S. Treasury bills: This is based on Treasury bills with a one-month maturity.
None of the returns are adjusted for taxes or transaction costs. In addition to the yearby-year returns on financial instruments, the year-to-year change in the consumer price
index is computed. This is a basic measure of inflation. We can calculate year-by-year real
returns by subtracting annual inflation.
Before looking closely at the different portfolio returns, we graphically present the
returns and risks available from U.S. capital markets in the 89-year period from 1926 to
2014. Figure 10.4 shows the growth of $1 invested at the beginning of 1926. Notice that the
vertical axis is logarithmic, so that equal distances measure the same percentage change. The
figure shows that if $1 was invested in large-company common stocks and all dividends were
reinvested, the dollar would have grown to $5,316.85 by the end of 2014. The biggest growth
was in the small stock portfolio. If $1 was invested in small stocks in 1926, the investment
would have grown to $27,419.32. However, when you look carefully at Figure 10.4, you can
see great variability in the returns on small stocks, especially in the earlier part of the period.
A dollar in long-term government bonds was very stable as compared with a dollar in common stocks. Figures 10.5 to 10.8 plot each year-to-year percentage return as a vertical bar
drawn from the horizontal axis for large-company common stocks, small-company stocks,
long-term bonds and Treasury bills, and inflation, respectively.

Ibbotson SBBI 2015 Classic Yearbook (Chicago: Morningstar).


1


CHAPTER 10

Risk and Return

■■■

307

Figure 10.4 Wealth Indexes of Investments in the U.S. Capital Markets (Year-End 1925 5 $1.00)
$1,000,000
$27,419.32
$10,000

$5,316.85
Small-company stocks

$1,000

Large-company stocks

$100

$10

$135.18


$20.58

Long-term
government bonds

$13.10
Treasury bills

Inflation

$1
1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

$0
Redrawn from Stocks, Bonds, Bills and Inflation: 2015 Yearbook,™ annual updates to the work by Roger G. Ibbotson and Rex A. Sinquefield (Chicago:
Morningstar). All rights reserved.

Figure 10.4 gives the growth of a dollar investment in the stock market from 1926
through 2014. In other words, it shows what the value of the investment would have been
if the dollar had been left in the stock market and if each year the dividends from the
previous year had been reinvested in more stock. If Rt is the return in year t (expressed
in decimals), the value you would have at the end of year T is the product of 1 plus the
return in each of the years:
Value 5 (1 1 R1) 3 (1 1 R2) 3 · · · 3 (1 1 Rt) 3 · · · 3 (1 1 RT)
Go to
bigcharts.
marketwatch.com
to see both intraday
and long-term charts.


For example, if the returns were 11 percent, 25 percent, and 9 percent in a three-year
period, an investment of $1 at the beginning of the period would be worth:
(1 1 R1) 3 (1 1 R2) 3 (1 1 R3) 5 ($1 1 .11) 3 ($1 2 .05) 3 ($1 1 .09)
5 $1.11 3 $.95 3 $1.09
5 $1.15
at the end of the three years. Notice that .15 or 15 percent is the total return. This includes
the return from reinvesting the first-year dividends in the stock market for two more years
and reinvesting the second-year dividends for the final year. The 15  percent is called
a three-year holding period return. Table 10.1 gives the annual returns each year for
selected investments from 1926 to 2014. From this table, you can determine holding period
returns for any combination of years.