FUNDAMENTALS OF

Corporate Finance
SECOND EDITION


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FUNDAMENTALS OF

Corporate Finance
SECOND EDITION

Jonathan Berk

Peter DeMarzo

Jarrad Harford

STANFORD UNIVERSITY

STANFORD UNIVERSITY

UNIVERSITY OF WASHINGTON

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Library of Congress Cataloging-in-Publication Data
Berk, Jonathan B., 1962–
Fundamentals of corporate finance / Jonathan Berk, Peter DeMarzo, Jarrad Harford.—2nd ed.
p. cm.
ISBN 978-0-13-214823-8

1. Corporations—Finance. I. DeMarzo, Peter M. II. Harford, Jarrad V. T. III. Title.
HG4026.B464 2012
658.15—dc22
2010050580

10 9 8 7 6 5 4 3 2 1

ISBN 10:
ISBN 13:

0-132-14823-4
978-0-13-214823-8


Brief Contents
PART 1

Introduction
CHAPTER 1
CHAPTER 2

PART 2

Corporate Finance and the Financial Manager 2
Introduction to Financial Statement Analysis 23

Interest Rates and Valuing Cash Flows
CHAPTER
CHAPTER
CHAPTER

CHAPTER
CHAPTER

PART 3

1

3
4
5
6
7

61

Time Value of Money: An Introduction 62
Time Value of Money: Valuing Cash Flow Streams
Interest Rates 117
Bonds 144
Stock Valuation 182

Valuation and the Firm

83

209

CHAPTER 8 Investment Decision Rules 210
CHAPTER 9 Fundamentals of Capital Budgeting 247
CHAPTER 10 Stock Valuation: A Second Look 282


PART 4

Risk and Return

315

CHAPTER 11 Risk and Return in Capital Markets 316
CHAPTER 12 Systematic Risk and the Equity Risk Premium
CHAPTER 13 The Cost of Capital 381

PART 5

Long-Term Financing

409

CHAPTER 14 Raising Equity Capital
CHAPTER 15 Debt Financing 438

PART 6

345

410

Capital Structure and Payout Policy

459


CHAPTER 16 Capital Structure 460
CHAPTER 17 Payout Policy 498

PART 7

Financial Planning and Forecasting

533

CHAPTER 18 Financial Modeling and Pro Forma Analysis
CHAPTER 19 Working Capital Management 564
CHAPTER 20 Short-Term Financial Planning 591

PART 8

Special Topics

534

621

CHAPTER 21 Option Applications and Corporate Finance
CHAPTER 22 Mergers and Acquisitions 648
CHAPTER 23 International Corporate Finance 679

622

vii



Detailed Contents
PART 1
CHAPTER 1

Introduction

1

Corporate Finance and the Financial
Manager 2
◗ INTERVIEW WITH Leslie Tillquist,
PA Consulting Group 3

1.1 Why Study Finance? 4
1.2 The Four Types of Firms 4
Sole Proprietorships 5
Partnerships 5
Limited Liability Companies 6
Corporations 6
Tax Implications for Corporate Entities 7
1.3 The Financial Manager 9
◗ Corporate Taxation Around the World 9
Making Investment Decisions 10
Making Financing Decisions 10
Managing Short-Term Cash Needs 10
The Goal of the Financial Manager 11
1.4 The Financial Manager’s Place in the
Corporation 11
The Corporate Management Team 11
Ethics and Incentives in Corporations 12

1.5 The Stock Market 14
The Largest Stock Markets 14
Primary Versus Secondary Markets 14
Physical Stock Markets 15
Over-the-Counter Stock Markets 15
◗ NYSE, AMEX, DJIA, S&P 500: Awash in
Acronyms 16
Listing Standards 16
Other Financial Markets 17
1.6 Financial Institutions 17
The Financial Cycle 17
Types of Financial Institutions 18
Role of Financial Institutions 18
Summary 19 ◗ Problems 21

CHAPTER 2

viii

Introduction to Financial Statement
Analysis 23
◗ INTERVIEW WITH Hiral Tolia, CBIZ Valuation
Group, LLC 24

2.1 Firms’ Disclosure of Financial Information 25
Preparation of Financial Statements 25
Types of Financial Statements 25
◗ International Financial Reporting Standards
26
2.2 The Balance Sheet 26

Assets 27
Liabilities 28
Stockholders’ Equity 28
2.3 Balance Sheet Analysis 30
Market-to-Book Ratio 30
Debt-Equity Ratio 30
Enterprise Value 31
Other Balance Sheet Information 32
2.4 The Income Statement 33
Earnings Calculations 33
2.5 Income Statement Analysis 35
Profitability Ratios 35
Asset Efficiency 36
Working Capital Ratios 36
EBITDA 37
Leverage Ratios 37
Investment Returns 37
The DuPont Identity 38
Valuation Ratios 39
◗ COMMON MISTAKE Mismatched Ratios
40
2.6 The Statement of Cash Flows 42
Operating Activity 42
Investment Activity 44
Financing Activity 44
2.7 Other Financial Statement Information 45
Management Discussion and Analysis 45
Statement of Stockholders’ Equity 46
Notes to the Financial Statements 46
2.8 Financial Reporting in Practice 46

Enron 46
The Sarbanes-Oxley Act 47
◗ Practitioner INTERVIEW WITH
Sue Frieden, Ernst & Young 48
The Financial Statements: A Useful Starting Point
49
Summary 49 ◗ Critical
Thinking 52 ◗ Problems 52 ◗ Data Case 58


Detailed Contents

PART 2
CHAPTER 3

Interest Rates and Valuing
Cash Flows 61
Time Value of Money: An
Introduction 62
◗ INTERVIEW WITH Nicole Wickswat,
Intel Corporation 63

3.1 Cost-Benefit Analysis 64
Role of the Financial Manager 64
Quantifying Costs and Benefits 64
◗ When Competitive Market Prices Are Not
Available 66

◗ COMMON MISTAKE Discounting One Too
Many Times 92

4.3 Annuities 92
Present Value of an Annuity 92
Future Value of an Annuity 95
4.4 Growing Cash Flows 96
Growing Perpetuity 96
Growing Annuity 98
4.5 Solving for Variables Other Than Present Value
or Future Value 99
Solving for the Cash Flows 100
Rate of Return 102
Solving for the Number of Periods 104

3.2 Market Prices and the Valuation Principle 66
The Valuation Principle 67
Why There Can Be Only One Competitive Price
for a Good 67
◗ Your Personal Financial Decisions 68

Summary 106 ◗ Critical
Thinking 108 ◗ Problems 108 ◗ Data Case 113
CHAPTER 4 APPENDIX Using a Financial
Calculator 114
Specifying Decimal Places 114
Toggling Between the Beginning and End of a
Period 114
Set the Number of Periods per Year 114
General TVM Buttons 114
Solving for the Future Value of an Annuity
(Example 4.5) 115
Solving for the Rate of Return 115


3.3 The Time Value of Money and Interest Rates
68
The Time Value of Money 69
The Interest Rate: Converting Cash Across Time
70
Timelines 72
3.4 Valuing Cash Flows at Different Points in Time
73
Rule 1: Comparing and Combining Values 73
◗ COMMON MISTAKE Summing Cash Flows
Across Time 74
Rule 2: Compounding 74
◗ Rule of 72 76
Rule 3: Discounting 76
◗ Using a Financial Calculator 78
Summary 78 ◗ Critical
Thinking 80 ◗ Problems 80

CHAPTER 4

Time Value of Money: Valuing Cash
Flow Streams 83
◗ INTERVIEW WITH Gregory Goin, McFee
Financial Group 84

4.1 Valuing a Stream of Cash Flows 85
Applying the Rules of Valuing Cash Flows to a
Cash Flow Stream 85
◗ Using a Financial Calculator: Solving for

Present and Future Values of Cash Flow
Streams 88
4.2 Perpetuities 89
Perpetuities 89
◗ Historical Examples of Perpetuities 91

ix

CHAPTER 5

Interest Rates

117

◗ INTERVIEW WITH Jason Moore, Bradford
& Marzec, LLC 118
5.1 Interest Rate Quotes and Adjustments 119
The Effective Annual Rate 119
Adjusting the Discount Rate to Different Time
Periods 120
Annual Percentage Rates 121
◗ COMMON MISTAKE Using the EAR
in the Annuity Formula 122
5.2 Application: Discount Rates and Loans 124
Computing Loan Payments 124
Computing the Outstanding Loan Balance 126
5.3 The Determinants of Interest Rates 127
Inflation and Real Versus Nominal Rates 127
Investment and Interest Rate Policy 128
◗ How Is Inflation Actually Calculated? 130

The Yield Curve and Discount Rates 130
◗ Practitioner INTERVIEW WITH Frederic S.
Mishkin, Columbia University 132
◗ COMMON MISTAKE Using the Annuity
Formula When Discount Rates Vary 133
The Yield Curve and the Economy 133


x

Detailed Contents
5.4 The Opportunity Cost of Capital 136
◗ Interest Rates, Discount Rates, and the Cost
of Capital 137
Summary 138
◗ Critical Thinking 139 ◗ Problems 140

CHAPTER 6

Bonds

144

◗ INTERVIEW WITH Andrew DeWitt, PIMCO
145
6.1 Bond Terminology 146
6.2 Zero-Coupon Bonds 147
Zero-Coupon Bond Cash Flows 148
Yield to Maturity of a Zero-Coupon Bond 148
Risk-Free Interest Rates 149

6.3 Coupon Bonds 151
Coupon Bond Cash Flows 151
◗ The U.S. Treasury Market 152
Yield to Maturity of a Coupon Bond 152
◗ Finding Bond Prices on the Web 154
Coupon Bond Price Quotes 155
6.4 Why Bond Prices Change 156
Interest Rate Changes and Bond Prices 156
Time and Bond Prices 158
Interest Rate Risk and Bond Prices 160
◗ Clean and Dirty Prices for Coupon Bonds
162
Bond Prices in Practice 163
6.5 Corporate Bonds 164
Credit Risk 164
◗ Practitioner INTERVIEW WITH Lisa Black,
Teachers Insurance and Annuity Association
165
Corporate Bond Yields 166
Bond Ratings 166
Corporate Yield Curves 166
◗ The Credit Crisis and Bond Yields 168
Summary 170
◗ Critical Thinking 171 ◗ Problems 172
◗ Data Case 175
CHAPTER 6 APPENDIX A Solving for the Yield
to Maturity of a Bond Using a Financial
Calculator 177
CHAPTER 6 APPENDIX B The Yield Curve
and the Law of One Price 178


CHAPTER 7

Stock Valuation

182

◗ INTERVIEW WITH Christopher Ellis-Ferrara,
AllianceBernstein 183
7.1 Stock Basics 184
Stock Market Reporting: Stock Quotes 184

Common Stock 185
Preferred Stock 186
7.2 The Mechanics of Stock Trades 187
7.3 The Dividend-Discount Model 188
A One-Year Investor 188
Dividend Yields, Capital Gains, and Total Returns
189
A Multiyear Investor 190
Dividend-Discount Model Equation 191
7.4 Estimating Dividends in the Dividend-Discount
Model 192
Constant Dividend Growth 192
Dividends Versus Investment and Growth 193
Changing Growth Rates 195
◗ COMMON MISTAKE Forgetting to “Grow”
This Year’s Dividend 196
Value Drivers and the Dividend-Discount Model
198

7.5 Limitations of the Dividend-Discount Model
198
Uncertain Dividend Forecasts 198
Non-Dividend-Paying Stocks 199
7.6 Share Repurchases and the Total Payout Model
200
7.7 Putting It All Together 201
Summary 202
◗ Critical Thinking 204 ◗ Problems 204
PART 2 INTEGRATIVE CASE 207

PART 3

Valuation and the Firm

CHAPTER 8

Investment Decision Rules

209
210

◗ INTERVIEW WITH Scott Ladner, Parsons
Brinckerhoff 211
8.1 The NPV Decision Rule 212
Net Present Value 212
The NPV Decision Rule 213
8.2 Using the NPV Rule 214
Organizing the Cash Flows and Computing the
NPV 214

The NPV Profile 215
Measuring Sensitivity with IRR 216
Alternative Rules Versus the NPV Rule 216
8.3 Alternative Decision Rules 216
◗ USING EXCEL Computing NPV and IRR 217
The Payback Rule 218
The Internal Rate of Return Rule 219
◗ COMMON MISTAKE IRR Versus the IRR Rule
223


Detailed Contents
Break-Even Analysis 267
◗ Practitioner INTERVIEW WITH
David Holland, Sports and Entertainment
Solutions 268
Scenario Analysis 269

Modified Internal Rate of Return 223
◗ Why Do Rules Other Than the NPV Rule
Persist? 224
8.4 Choosing Between Projects 226
Differences in Scale 227
◗ Practitioner INTERVIEW WITH
Dick Grannis, QUALCOMM 230
Timing of the Cash Flows 231
8.5 Evaluating Projects with Different Lives 232
Important Considerations When Using the
Equivalent Annual Annuity 234


xi

9.6 Real Options in Capital Budgeting 270
Option to Delay 270
Option to Expand 270
Option to Abandon 270
Summary 271
◗ Critical Thinking 273 ◗ Problems 273
◗ Data Case 279

8.6 Choosing Among Projects When Resources Are
Limited 235
Evaluating Projects with Different Resource
Requirements 235

CHAPTER 9 APPENDIX MACRS Depreciation
280

8.7 Putting It All Together 238
Summary 239
◗ Critical Thinking 240 ◗ Problems 241
◗ Data Case 246

CHAPTER 9

Fundamentals of Capital Budgeting
247
◗ INTERVIEW WITH Kelly Cox, Boeing
Corporation 248


9.1 The Capital Budgeting Process 249
9.2 Forecasting Incremental Earnings 250
Operating Expenses Versus Capital Expenditures
250
Incremental Revenue and Cost Estimates 251
Taxes 252
Incremental Earnings Forecast 252
9.3 Determining Incremental Free Cash Flow 254
Converting from Earnings to Free Cash Flow
255
Calculating Free Cash Flow Directly 258
Calculating the NPV 259
9.4 Other Effects on Incremental Free Cash Flows
260
Opportunity Costs 260
◗ COMMON MISTAKE The Opportunity Cost
of an Idle Asset 260
Project Externalities 260
Sunk Costs 261
◗ COMMON MISTAKE The Sunk Cost Fallacy
261
Adjusting Free Cash Flow 262
Replacement Decisions 264
9.5 Analyzing the Project 265
Sensitivity Analysis 265

CHAPTER 10

Stock Valuation: A Second Look
282

◗ INTERVIEW WITH David Mandell, William
Blair & Company 283

10.1 The Discounted Free Cash Flow Model 284
Valuing the Enterprise 284
Implementing the Model 285
Connection to Capital Budgeting 286
10.2 Valuation Based on Comparable Firms 288
Valuation Multiples 288
Limitations of Multiples 293
Comparison with Discounted Cash Flow Methods
294
Stock Valuation Techniques: The Final Word 294
◗ Practitioner INTERVIEW WITH
Marilyn Fedak, AllianceBernstein 295
10.3 Information, Competition, and Stock Prices
296
Information in Stock Prices 296
Competition and Efficient Markets 298
Forms of Market Efficiency 298
Lessons for Investors and Corporate Managers
300
The Efficient Markets Hypothesis Versus No
Arbitrage 301
10.4 Individual Biases and Trading 302
Excessive Trading and Overconfidence 302
Hanging On to Losers and the Disposition Effect
302
Investor Attention, Mood, and Experience 303
Summary 305

◗ Critical Thinking 306 ◗ Problems 306
◗ Data Case 310
PART 3 INTEGRATIVE CASE 312


xii

Detailed Contents

PART 4
CHAPTER 11

Risk and Return

Computing a Portfolio’s Variance and Standard
Deviation 354
The Volatility of a Large Portfolio 356
◗ NOBEL PRIZE Harry Markowitz 357

315

Risk and Return in Capital Markets
316
◗ INTERVIEW WITH Sunita S. Mohanty,
Absolute Return for Kids 317

11.1 A First Look at Risk and Return 318
11.2 Historical Risks and Returns of Stocks 320
Computing Historical Returns 321
Average Annual Returns 323

◗ Arithmetic Average Returns Versus
Compound Annual Returns 325
The Variance and Volatility of Returns 326
◗ COMMON MISTAKE Mistakes When
Computing Standard Deviation 328
◗ USING EXCEL Computing the Standard
Deviation of Historical Returns 328
The Normal Distribution 329
11.3 The Historical Tradeoff Between Risk and
Return 331
The Returns of Large Portfolios 331
The Returns of Individual Stocks 332
11.4 Common Versus Independent Risk 332
Theft Versus Earthquake Insurance: An Example
332
Types of Risk 333

12.3 Measuring Systematic Risk 358
Role of the Market Portfolio 358
Stock Market Indexes as the Market Portfolio
359
Market Risk and Beta 359
◗ Index Funds 360
◗ COMMON MISTAKE Mixing Standard
Deviation and Beta 362
Estimating Beta from Historical Returns 363
◗ USING EXCEL Calculating a Stock’s Beta
365
12.4 Putting It All Together: The Capital Asset
Pricing Model 366

The CAPM Equation Relating Risk to Expected
Return 366
◗ Why Not Estimate Expected Returns
Directly? 367
◗ NOBEL PRIZE William Sharpe
The Security Market Line 368
The CAPM and Portfolios 370
Summary of the Capital Asset Pricing Model
371
The Big Picture 371
Summary 372
◗ Critical Thinking 373 ◗ Problems 373

11.5 Diversification in Stock Portfolios 334
Unsystematic Versus Systematic Risk 334
Diversifiable Risk and the Risk Premium 337
The Importance of Systematic Risk 337
◗ COMMON MISTAKE A Fallacy of Long-Run
Diversification 339
Summary 339
◗ Critical Thinking 341 ◗ Problems 342

CHAPTER 12

Systematic Risk and the Equity Risk
Premium 345
◗ INTERVIEW WITH Alexander Morgan,
Pantheon Ventures 346

12.1 The Expected Return of a Portfolio 347

Portfolio Weights 347
Portfolio Returns 347
Expected Portfolio Return 349
12.2 The Volatility of a Portfolio 350
Diversifying Risks 350
Measuring Stocks’ Co-movement: Correlation
352
◗ USING EXCEL Calculating the Correlation
Between Two Sets of Returns 354

CHAPTER 12 APPENDIX Alternative Models
of Systematic Risk 378

CHAPTER 13

The Cost of Capital

381

◗ INTERVIEW WITH John Drum, KPMG LLP
382
13.1 A First Look at the Weighted Average Cost of
Capital 383
The Firm’s Capital Structure 383
Opportunity Cost and the Overall Cost of Capital
384
Weighted Averages and the Overall Cost of
Capital 384
Weighted Average Cost of Capital Calculations
384

13.2 The Firm’s Costs of Debt and Equity Capital
386
Cost of Debt Capital 386
◗ COMMON MISTAKE Using the Coupon Rate
as the Cost of Debt 387


Detailed Contents
Cost of Preferred Stock Capital 388
Cost of Common Stock Capital 388
13.3 A Second Look at the Weighted Average Cost
of Capital 390
WACC Equation 391
Weighted Average Cost of Capital in Practice
391
Methods in Practice 392
13.4 Using the WACC to Value a Project 394
Key Assumptions 394
WACC Method Application: Extending the Life of
a DuPont Facility 395
Summary of the WACC Method 396
13.5 Project-Based Costs of Capital 396
Cost of Capital for a New Acquisition 397
Divisional Costs of Capital 397
◗ Practitioner INTERVIEW WITH
Shelagh Glaser, Intel 398
13.6 When Raising External Capital Is Costly 399
Summary 401
◗ Critical Thinking 402 ◗ Problems 403
◗ Data Case 406

PART 4 INTEGRATIVE CASE 408

PART 5
CHAPTER 14

Long-Term Financing
Raising Equity Capital

409

14.4 Raising Additional Capital: The Seasoned Equity
Offering 429
SEO Process 429
SEO Price Reaction 431
SEO Costs 432
Summary 433
◗ Critical Thinking 434 ◗ Problems 434

CHAPTER 15

14.3 IPO Puzzles 425
Underpriced IPOs 425
“Hot” and “Cold” IPO Markets 427
◗ 2008–2009: A Very Cold IPO Market 427
High Cost of Issuing an IPO 428
Poor Post-IPO Long-Run Stock Performance
429

438


15.1 Corporate Debt 440
Private Debt 440
◗ Debt Financing at Hertz: Bank Loans 440
◗ Debt Financing at Hertz: Private Placements
441
Public Debt 441
◗ Debt Financing at Hertz: Public Debt 443
15.2 Bond Covenants 445
Types of Covenants 445
Advantages of Covenants 445
Application: Hertz’s Covenants 446
15.3 Repayment Provisions 446
Call Provisions 446
Sinking Funds 449
Convertible Provisions 449
Summary 452
◗ Critical Thinking 453 ◗ Problems 453

◗ INTERVIEW WITH Sandra Pfeiler, Goldman
Sachs 411

14.2 Taking Your Firm Public: The Initial Public
Offering 416
Advantages and Disadvantages of Going Public
416
Primary and Secondary IPO Offerings 417
Other IPO Types 422
◗ Google’s IPO 425

Debt Financing


◗ INTERVIEW WITH Eric Hassberger, Strategic
Hotels & Resorts 439

410

14.1 Equity Financing for Private Companies 412
Sources of Funding 412
Securities and Valuation 414
Exiting an Investment in a Private Company 416

xiii

CHAPTER 15 APPENDIX Using a Financial
Calculator to Calculate Yield to Call 455
PART 5 INTEGRATIVE CASE 456

PART 6
CHAPTER 16

Capital Structure and Payout
Policy 459
Capital Structure

460

◗ INTERVIEW WITH Christopher Cvijic,
Morgan Stanley 461
16.1 Capital Structure Choices 462
Capital Structure Choices Across Industries

462
Capital Structure Choices Within Industries 462
16.2 Capital Structure in Perfect Capital Markets
464
Application: Financing a New Business 465
Leverage and Firm Value 466


xiv

Detailed Contents
◗ COMMON MISTAKE Repurchases
and the Supply of Shares 506
Alternative Policy 3: High Dividend (Equity Issue)
506
Modigliani-Miller and Dividend Policy Irrelevance
507
◗ COMMON MISTAKE The Bird in the Hand
Fallacy 508
Dividend Policy with Perfect Capital Markets 508

The Effect of Leverage on Risk and Return 467
Homemade Leverage 469
Leverage and the Cost of Capital 469
◗ COMMON MISTAKE Capital Structure
Fallacies 470
MM and the Real World 472
◗ NOBEL PRIZE Franco Modigliani and Merton
Miller 472
16.3 Debt and Taxes 473

The Interest Tax Deduction and Firm Value 473
Value of the Interest Tax Shield 474
The Interest Tax Shield with Permanent Debt
476
Leverage and the WACC with Taxes 477
Debt and Taxes: The Bottom Line 477
16.4 The Costs of Bankruptcy and Financial Distress
479
Direct Costs of Bankruptcy 479
◗ Bankruptcy Can Be Expensive 479
Indirect Costs of Financial Distress 479
16.5 Optimal Capital Structure: The Tradeoff Theory
480
Differences Across Firms 481
Optimal Leverage 481
16.6 Additional Consequences of Leverage: Agency
Costs and Information 482
Agency Costs 483
◗ Airlines Use Financial Distress to Their
Advantage 483
◗ Financial Distress and Rolling the Dice,
Literally 484
Debt and Information 485

17.3 The Tax Disadvantage of Dividends 509
Taxes on Dividends and Capital Gains 509
Optimal Dividend Policy with Taxes 509
Tax Differences Across Investors 512
17.4 Payout Versus Retention of Cash 514
Retaining Cash with Perfect Capital Markets

514
Retaining Cash with Imperfect Capital Markets
515
17.5 Signaling with Payout Policy 518
Dividend Smoothing 518
Dividend Signaling 519
◗ Royal & SunAlliance’s Dividend Cut 520
Signaling and Share Repurchases 520
◗ Practitioner INTERVIEW WITH
John Connors, Microsoft (Retired) 521
17.6 Stock Dividends, Splits, and Spin-Offs 522
Stock Dividends and Splits 522
◗ Berkshire Hathaway’s A and B Shares 523
Spin-Offs 523
17.7 Advice for the Financial Manager 524
Summary 525
◗ Critical Thinking 527 ◗ Problems 527
◗ Data Case 529

16.7 Capital Structure: Putting It All Together 487
Summary 488
◗ Critical Thinking 490 ◗ Problems 490
CHAPTER 16 APPENDIX The Bankruptcy Code
497

CHAPTER 17

Payout Policy

498


◗ INTERVIEW WITH Nitin Garg, Intuit 499
17.1 Cash Distributions to Shareholders 500
Dividends 501
Share Repurchases 502
17.2 Dividends Versus Share Repurchases in a
Perfect Capital Market 503
Alternative Policy 1: Pay a Dividend with Excess
Cash 504
Alternative Policy 2: Share Repurchase (No
Dividend) 504

PART 6 INTEGRATIVE CASE 531

PART 7
CHAPTER 18

Financial Planning
and Forecasting 533
Financial Modeling and Pro Forma
Analysis 534
◗ INTERVIEW WITH David Hollon,
Goldman Sachs 535

18.1 Goals of Long-Term Financial Planning 536
Identify Important Linkages 536
Analyze the Impact of Potential Business Plans
536
Plan for Future Funding Needs 536
18.2 Forecasting Financial Statements: The Percent

of Sales Method 537


Detailed Contents
Percent of Sales Method 537
Pro Forma Income Statement 538
Pro Forma Balance Sheet 539
◗ COMMON MISTAKE Confusing
Stockholders’ Equity with Retained
Earnings 540
Making the Balance Sheet Balance: Net New
Financing 540
Choosing a Forecast Target 542
18.3 Forecasting a Planned Expansion 542
KMS Designs’ Expansion: Financing Needs 543
KMS Designs’ Expansion: Pro Forma Income
Statement 544
◗ COMMON MISTAKE Treating Forecasts
as Fact 546
Forecasting the Balance Sheet 546
18.4 Growth and Firm Value 547
Sustainable Growth Rate and External Financing
548
18.5 Valuing the Expansion 551
Forecasting Free Cash Flows 551
◗ COMMON MISTAKE Confusing Total
and Incremental Net Working Capital 553
KMS Designs’ Expansion: Effect on Firm Value
553
Optimal Timing and the Option to Delay 556

Summary 557
◗ Critical Thinking 558 ◗ Problems 558
CHAPTER 18 APPENDIX The Balance Sheet
and Statement of Cash Flows 562

CHAPTER 19

Working Capital Management
564
◗ INTERVIEW WITH Waleed Husain, Comcast
565

19.1 Overview of Working Capital 566
The Cash Cycle 566
Working Capital Needs by Industry 568
Firm Value and Working Capital 569
19.2 Trade Credit 570
Trade Credit Terms 571
Trade Credit and Market Frictions 571
◗ COMMON MISTAKE Using APR Instead
of EAR to Compute the Cost of Trade
Credit 572
Managing Float 573
19.3 Receivables Management 574
Determining the Credit Policy 574
◗ The 5 C’s of Credit 574
Monitoring Accounts Receivable 576

xv


19.4 Payables Management 578
Determining Accounts Payable Days Outstanding
578
Stretching Accounts Payable 579
19.5 Inventory Management 580
Benefits of Holding Inventory 580
Costs of Holding Inventory 581
◗ Inventory Management Adds to the Bottom
Line at Gap 581
19.6 Cash Management 582
Motivation for Holding Cash 582
Alternative Investments 582
◗ Cash Balances 584
Summary 584
◗ Critical Thinking 586 ◗ Problems 586
◗ Data Case 589

CHAPTER 20

Short-Term Financial Planning

591

◗ INTERVIEW WITH Teresa Wendt,
Lockheed Martin 592
20.1 Forecasting Short-Term Financing Needs 593
Application: Springfield Snowboards, Inc. 593
Negative Cash Flow Shocks 594
Positive Cash Flow Shocks 594
Seasonalities 595

The Cash Budget 596
20.2 The Matching Principle 598
Permanent Working Capital 598
Temporary Working Capital 598
Permanent Versus Temporary Working Capital
598
Financing Policy Choices 599
20.3 Short-Term Financing with Bank Loans 601
Single, End-of-Period Payment Loan 601
Line of Credit 601
Bridge Loan 602
Common Loan Stipulations and Fees 602
20.4 Short-Term Financing with Commercial Paper
604
◗ Short-Term Financing and the Financial
Crisis of the Fall of 2008 604
20.5 Short-Term Financing with Secured Financing
606
Accounts Receivable as Collateral 606
◗ A Seventeenth-Century Financing Solution
606
Inventory as Collateral 607
20.6 Putting It All Together: Creating a Short-Term
Financial Plan 609
Summary 610
◗ Critical Thinking 611 ◗ Problems 612
PART 7 INTEGRATIVE CASE 616


xvi


Detailed Contents

PART 8
CHAPTER 21

Special Topics

621

Option Applications and Corporate
Finance 622
◗ INTERVIEW WITH Deniz Gulunay, BP 623

21.1 Option Basics 624
Option Contracts 624
Stock Option Quotations 625
Options on Other Financial Securities 627
◗ Options Are for More Than Just Stocks 627
21.2 Option Payoffs at Expiration 627
The Long Position in an Option Contract 628
The Short Position in an Option Contract 629
Profits for Holding an Option to Expiration 631
Returns for Holding an Option to Expiration 633
21.3 Factors Affecting Option Prices 634
Strike Price and Stock Price 634
Option Prices and the Exercise Date 634
Option Prices and the Risk-Free Rate 635
Option Prices and Volatility 635
21.4 The Black-Scholes Option Pricing Formula

636
21.5 Put-Call Parity 638
Portfolio Insurance 638

22.4 The Takeover Process 659
Valuation 659
The Offer 660
Merger “Arbitrage” 662
Tax and Accounting Issues 663
Board and Shareholder Approval 664
22.5 Takeover Defenses 665
Poison Pills 665
Staggered Boards 666
White Knights 667
Golden Parachutes 667
Recapitalization 667
Other Defensive Strategies 667
Regulatory Approval 668
◗ Weyerhaeuser’s Hostile Bid for Willamette
Industries 668
22.6 Who Gets the Value Added from a Takeover?
669
The Free Rider Problem 669
Toeholds 670
The Leveraged Buyout 670
◗ The Leveraged Buyout of RJR-Nabisco by
KKR 672
The Freezeout Merger 673
Competition 673
Summary 674 ◗ Critical

Thinking 676 ◗ Problems 676

21.6 Options and Corporate Finance 641
Summary 643
◗ Critical Thinking 644 ◗ Problems 644
◗ Data Case 646

CHAPTER 22

Mergers and Acquisitions

648

◗ INTERVIEW WITH Kyle Finegan,
Croft & Bender LLC 649
22.1 Background and Historical Trends 650
Merger Waves 650
Types of Mergers 652
22.2 Market Reaction to a Takeover 652
22.3 Reasons to Acquire 653
Economies of Scale and Scope 653
Vertical Integration 654
Expertise 654
Monopoly Gains 654
Efficiency Gains 655
Tax Savings from Operating Losses 655
Diversification 656
Earnings Growth 657
Managerial Motives to Merge 658


CHAPTER 23

International Corporate Finance
679
◗ INTERVIEW WITH Rob Harvey, Cisco
Systems 680

23.1 Foreign Exchange 681
The Foreign Exchange Market 682
Exchange Rates 683
23.2 Exchange Rate Risk 683
Exchange Rate Fluctuations 684
Hedging with Forward Contracts 686
Cash-and-Carry and the Pricing of Currency
Forwards 687
Hedging Exchange Rate Risk with Options 691
23.3 Internationally Integrated Capital Markets
692
◗ COMMON MISTAKE Forgetting to Flip
the Exchange Rate 694
23.4 Valuation of Foreign Currency Cash Flows
694
Application: Ityesi, Inc. 695


Detailed Contents
The Law of One Price as a Robustness Check
697
23.5 Valuation and International Taxation 698
A Single Foreign Project with Immediate

Repatriation of Earnings 699
Multiple Foreign Projects and Deferral of Earnings
Repatriation 699
23.6 Internationally Segmented Capital Markets
700
Differential Access to Markets 700
Macro-Level Distortions 700
Implications of Internationally Segmented Capital
Markets 701
23.7 Capital Budgeting with Exchange Rate Risk
703
Application: Ityesi, Inc. 703
Conclusion 705
Summary 705
◗ Critical Thinking 707 ◗ Problems 707
◗ Data Case 711

xvii

CHAPTERS ON THE WEB
These Web Chapters are on MyFinanceLab at
www.myfinancelab.com

Leasing
WEB CHAPTER 2 Insurance and Risk
Management
WEB CHAPTER 3 Corporate Governance
WEB CHAPTER 1



About the Authors
Jonathan Berk

is the A.P. Giannini Professor
of Finance at the Graduate School of Business,
Stanford University, and is a Research Associate at the
National Bureau of Economic Research. Prior to
Stanford, he was the Sylvan Coleman Professor of
Finance at the Haas School of Business at the
University of California, Berkeley, where he taught the
introductory Corporate Finance course. Before earning his PhD from Yale University, he worked as an
associate at Goldman Sachs, where his education in
finance really began. His research has won a number
of awards including the TIAA-CREF Paul A.
Samuelson Award, the Smith Breeden Prize, Best
Paper of the Year in The Review of Financial Studies,
and the FAME Research Prize. His paper “A Critique of
Jonathan Berk, Peter DeMarzo, and Jarrad Harford
Size-Related Anomalies” was selected as one of the
two best papers ever published in The Review of
Financial Studies. In recognition of his influence on the practice of finance, he has
received the Bernstein-Fabozzi/Jacobs Levy Award, the Graham and Dodd Award of
Excellence, and the Roger F. Murray Prize. He served as an Associate Editor of the Journal
of Finance for eight years and is currently an Advisory Editor at the journal. Born in
Johannesburg, South Africa, Professor Berk is married, has two daughters, and is an avid
skier and biker.

Peter DeMarzo is the Mizuho Financial Group Professor of Finance and Senior
Associate Dean for Academic Affairs at Stanford Graduate School of Business. He is also
a Research Associate at the National Bureau of Economic Research. He currently teaches

MBA and PhD courses in Corporate Finance and Financial Modeling. Prior to Stanford,
he taught at the Haas School of Business and the Kellogg Graduate School of
Management, and he was a National Fellow at the Hoover Institution. Professor DeMarzo
received the Sloan Teaching Excellence Award at Stanford in 2004 and 2006 and the Earl
F. Cheit Outstanding Teaching Award at the University of California, Berkeley, in 1998.
Professor DeMarzo has served as an Associate Editor for The Review of Financial Studies,
Financial Management, and the B.E. Journals in Economic Analysis and Policy, as well
as a Director of the American Finance Association. He is currently President of the
Western Finance Association. Professor DeMarzo has received numerous awards for his
research including the Western Finance Association Corporate Finance Award and the
Barclays Global Investors/Michael Brennan Best Paper Award from The Review of
Financial Studies. Professor DeMarzo was born in Whitestone, New York, is married, and
has three sons. He and his family enjoy hiking, biking, and skiing.

xviii


About the Authors

xix

Jarrad Harford is the Marion B. Ingersoll Professor of Finance at the University of
Washington. Prior to Washington, Professor Harford taught at the Lundquist College of
Business at the University of Oregon. He received his PhD in Finance with a minor in
Organizations and Markets from the University of Rochester. Professor Harford has
taught the core undergraduate finance course, Business Finance, for over thirteen years,
as well as an elective in Mergers and Acquisitions, and “Finance for Non-financial
Executives” in the executive education program. He has won numerous awards for his
teaching, including the UW Finance Professor of the Year (2010), Interfraternity Council
Excellence in Teaching Award (2007 and 2008), ISMBA Excellence in Teaching Award

(2006), and the Wells Fargo Faculty Award for Undergraduate Teaching (2005). He is also
the Faculty Director of the UW Business School Undergraduate Honors Program.
Professor Harford serves as an Associate Editor for The Journal of Financial Economics,
Journal of Financial and Quantitative Analysis, and Journal of Corporate Finance.
Professor Harford was born in State College, Pennsylvania, is married, and has two sons.
He and his family enjoy traveling, hiking, and skiing.


Bridging Theory
and Practice
Study Aids with a Practical Focus

EXAMPLE 7.1

To be successful, students need to master the core
concepts and learn to identify and solve problems
that today’s practitioners face.

Stock Prices
and Returns

Suppose you expect Longs Drug Stores to pay an annual dividend of $0.56 per share in the coming year
and to trade for $45.50 per share at the end of the year. If investments with equivalent risk to Longs’ stock
have an expected return of 6.80%, what is the most you would pay today for Longs’ stock? What dividend
yield and capital gain rate would you expect at this price?

Solution

◗ The Valuation Principle is presented as the
foundation of all financial decision making: The

central idea is that a firm should take projects or
make investments that increase the value of the
firm. The tools of finance determine the impact of
a project or investment on the firm’s value by
comparing the costs and benefits in equivalent
terms. The Valuation Principle is first introduced
in Chapter 3, revisited in the part openers, and
integrated throughout the text.
◗ Guided Problem Solutions (GPS) are Examples
that accompany every important concept using a
consistent problem-solving methodology that
breaks the solution process into three steps:
Plan, Execute, and Evaluate. This approach aids
student comprehension, enhances their ability to
model the solution process when tackling problems on their own, and demonstrates the importance of interpreting the mathematical solution.

Problem

◗ Plan

We can use Eq. 7.1 to solve for the beginning price we would pay now 1 P0 2 given our expectations about
dividends 1 Div1 = $0.56 2 and future price 1 P1 = $45.50 2 and the return we need to expect to earn to
be willing to invest 1 rE = 0.068 2 . We can then use Eq. 7.2 to calculate the dividend yield and capital gain
rate.
◗ Execute
Using Eq. 7.1, we have
P0 =

Div1 + P1
$0.56 + $45.50

= $43.13
=
1 + rE
1.0680

Referring to Eq. 7.2, we see that at this price, Longs’ dividend yield is Div1/P0 = 0.56/43.13 = 1.30%.
The expected capital gain is $45.50 - $43.13 = $2.37 per share, for a capital gain rate of
2.37/43.13 = 5.50%.
◗ Evaluate
At a price of $43.13, Longs’ expected total return is 1.30% + 5.50% = 6.80%, which is equal to its
equity cost of capital (the return being paid by investments with equivalent risk to Longs’). This amount is
the most we would be willing to pay for Longs’ stock. If we paid more, our expected return would be less
than 6.8% and we would rather invest elsewhere.

Personal Finance

EXAMPLE 4.4

◗ Personal Finance GPS Examples showcase the
use of financial analysis in everyday life by setting problems in scenarios such as purchasing
a new car or house, and saving for retirement.

Present Value of
a Lottery Prize
Annuity

Problem
You are the lucky winner of the $30 million state lottery. You can take your prize money either as (a) 30 payments of $1 million per year (starting today), or (b) $15 million paid today. If the interest rate is 8%, which
option should you take?


Solution
◗ Plan
Option (a) provides $30 million in prize money but paid over time. To evaluate it correctly, we must convert
it to a present value. Here is the timeline:
0

1

2

29
...

$1 million

$1 million

$1 million

$1 million

Because the first payment starts today, the last payment will occur in 29 years (for a total of 30 payments).2
The $1 million at date 0 is already stated in present value terms, but we need to compute the present value
of the remaining payments. Fortunately, this case looks like a 29-year annuity of $1 million per year, so we
can use the annuity formula.
◗ Execute

◗ Common Mistake boxes alert students to
frequently made mistakes stemming from
misunderstanding core concepts and calculations—in the classroom and in the field.


COMMON
MISTAKE

We use the annuity formula:
PV 1 29@year annuity of +1 million at 8% annual interest 2 = +1 million *

= +1 million * 11.16
= +11.16 million today

Summing Cash Flows Across Time

Once you understand the time value of money, our first rule may
seem straightforward. However, it is very common, especially for those who have not studied
finance, to violate this rule, simply treating all
cash flows as comparable regardless of when
they are received. One example is in sports contracts. In 2007, Alex Rodriguez and the New York
Yankees were negotiating what was repeatedly
referred to as a “$275 million” contract. The
$275 million comes from simply adding up all

xx

1
1
≤
¢1 0.08
1.0829

the payments Rodriguez would receive over

the ten years of the contract and an additional ten years of deferred payments—
treating dollars received in 20 years the
same as dollars received today. The same
thing occurred when David Beckham signed
a “$250 million” contract with the LA Galaxy
soccer team.


Applications That Reflect
Real Practice
Applications That Reflect
Real Practice
INTERVIEW WITH

Nicole Wickswat
Intel Corporation

Fundamentals of Corporate Finance features actual
companies and practitioners in the field.

“As a Senior Strategic Analyst in Intel Corporation’s Data
Center Group, I strive to uphold the company’s finance charter by being ‘a full partner in business
decisions to maximize shareholder value,’” says Nicole Wickswat, a 2006 graduate of the University of
Oregon’s Business Honors Program with a degree in finance. “I work on a team with engineers and
marketing people, helping them develop products for data center and cloud computer environments that
are competitive, financially feasible, and provide the required return.”
Nicole analyzes the potential financial impact of her group’s business decisions, evaluating the return
to Intel on current and proposed products and making recommendations to management on whether they
continue to add value. “A good investment decision should be aligned with the strategic objectives of the
business,” she says. “We want the benefits to outweigh the associated costs, and we also take into

account product launch timing and a project’s incremental financial value. Then we take a comprehensive
view of the decision on the company as a whole, assessing the impact a decision would have on other
products and/or groups.”
Intel uses present value calculations within all business groups to compare the present values of
costs and benefits that happen at different points in time. This gives management a consistent metric to
compare different investments and projects, set priorities, and make tradeoffs where necessary to
allocate funds to the optimal investments. The analysis continues throughout the product life cycle. “We
assess the competitive landscape and determine whether the cost of adding or removing specific product
features will benefit us in terms of increased market segment share, volume, and/or average selling
price. We also look at whether adding the product feature negatively affects other groups or products and,
if so, incorporate that into the analysis.”
Nicole’s analysis helps the Data Center Group establish product cost targets that are aligned with
long-term profitability goals. “These cost targets play a key role in product development decisions
because they put pressure on engineers to design with profitability in mind and encourage us to get the
most value out of the product line.”

INTERVIEW WITH

University of Oregon, 2006

“A good investment
decision should be
aligned with the
strategic objectives
of the business.”

Shelagh Glaser
Shelagh Glaser is the

Finance Director for Intel’s Mobility Group, which provides

solutions for the mobile computing market. Prior to that she was
Group Controller for Sales & Marketing and co-Group Controller
for Digital Enterprise Group.
QUESTION: Does Intel set the discount rate at the corporate or
project level?
ANSWER: We typically set the discount rate at the corporate level. As

a company, Intel makes a broad set of products that sell into similar markets, so one hurdle rate makes sense for our core business. To justify an investment, every project has to earn or exceed
that level of return for our shareholders.

We may use a different discount
rate for mergers and acquisitions.
For example, recently we’ve done
more software acquisitions. That
industry is very different from semiconductors and has different risk factors, so we take those considerations into account to set the hurdle rate.

◗ Chapter-Opening Interviews with recent
college graduates now working in the field of
finance underscore the relevance of these
concepts to students who are encountering
them for the first time.

◗ Practitioner Interviews from notable professionals featured in many chapters highlight
leaders in the field and address the effects of
the financial crisis.

QUESTION: How does Intel compute the cost of capital for new
investment opportunities?
ANSWER: We reexamine our weighted average cost of capital
(WACC) each year to see that we have the right inputs and if any

have changed: What is the current market risk premium? Are we
using the right risk-free rate? How should we weight historical

The Credit Crisis and Bond Yields
The financial crisis that engulfed
the world’s economies in 2008 originated as a credit crisis that
first emerged in August 2007. At that time, problems in the mortgage market had led to the bankruptcy of several large mortgage
lenders. The default of these firms, and the downgrading of
many of the bonds backed by mortgages these firms had made,
caused many investors to reassess the risk of other bonds in
their portfolios. As perceptions of risk increased, and investors
attempted to move into safer U.S. Treasury securities, the prices
of corporate bonds fell and so their credit spreads rose relative
to Treasuries, as shown in Figure 6.7. Panel A of the figure shows

the yield spreads for long-term corporate bonds, where we can
see that spreads of even the highest-rated Aaa bonds increased
dramatically, from a typical level of 0.5% to over 2% by the fall
of 2008. Panel B shows a similar pattern for the rate banks had
to pay on short-term loans compared to the yields of short-term
Treasury bills. This increase in borrowing costs made it more
costly for firms to raise the capital needed for new investment,
slowing economic growth. The decline in these spreads in early
2009 was viewed by many as an important first step in mitigating the ongoing impact of the financial crisis on the rest of the
economy.

◗ General Interest boxes highlight timely material
from financial publications that shed light on
business problems and real-company practices.


xxi


Teaching Every Student
to Think Finance
Simplified Presentation
of Mathematics

notation

Because one of the hardest parts of learning finance
for non-majors is mastering the jargon, math, and
non-standardized notation, Fundamentals of
Corporate Finance systematically uses:
◗ Notation Boxes. Each chapter begins with a
Notation box that defines the variables and the
acronyms used in the chapter and serves as a
“legend” for students’ reference.

C

cash flow

Cn

cash flow at date n

FV

future value


FVn

future value on date n

g

growth rate

Chapter 4
APPENDIX

◗ Numbered and Labeled Equations. The first
time a full equation is given in notation form it is
numbered. Key equations are titled and revisited
in the summary and in end papers.

N

date of the last cash flow in a stream of
cash flows

P

initial principal or deposit, or equivalent
present value

PV

present value


r

interest rate or rate of return

Using a Financial Calculator

Specifying Decimal Places
Make sure you have plenty of decimal places displayed!
HP-10BII
DISP

4

TI BAII Plus Professional

◗ Timelines. Introduced in Chapter 3, timelines are
emphasized as the important first step in solving
every problem that involves cash flow.

2ND

4

ENTER

Toggling Between the Beginning and End of a Period
You should always make sure that your calculator is in end-of-period mode.
HP-10BII


◗ Financial Calculator instructions, including a
box in Chapter 4 on solving for future and present
values, and appendices to Chapters 4, 6, and 15
with keystrokes for HP-10BII and TI BAII Plus
Professional, highlight this problem-solving tool.
◗ Spreadsheet Tables. Select tables are available
on MyFinanceLab as Excel files, enabling students to change inputs and manipulate the
underlying calculations.

•

MAR
TI BAII Plus Professional
2ND

TABLE 18.2
KMS Designs’ Pro
Forma Income
Statement for 2011

◗ Using Excel boxes describe Excel techniques
and include screenshots to serve as a guide for
students using this technology.

PMT

1
2
3
4

5
6
7
8
9
10
11

Year
Income Statement ($000s)
Sales
Costs Except Depreciation
EBITDA
Depreciation
EBIT
Interest Expense (net)
Pretax Income
Income Tax (35%)
Net Income

2010

2011

Calculation

74,889
88,369 74,889 1.18
Ϫ58,413 Ϫ68,928 78% of Sales
16,476

19,441 Lines 3 4
Ϫ5,492 Ϫ6,480 7.333% of Sales
10,984
12,961 Lines 5 6
Ϫ306
Ϫ306 Remains the same
10,678
12,655 Lines 7 8
4,429 35% of Line 9
Ϫ3,737
8,226 Lines 9 10
6,941

USING
EXCEL

Here we discuss how to use Microsoft Excel to solve for NPV and IRR. We also identify some pitfalls to avoid
when using Excel.

Computing NPV
and IRR

Excel’s NPV function has the format NPV (rate, value1, value2, . . . ), where “rate” is the interest rate per
period used to discount the cash flows, and “value1”, “value2”, etc., are the cash flows (or ranges of cash
flows). The NPV function computes the present value of the cash flows assuming the first cash flow occurs
at date 1. Therefore, if a project’s first cash flow occurs at date 0, we cannot use the NPV function by itself
to compute the NPV. We can use the NPV function to compute the present value of the cash flows from
date 1 onward, and then we must add the date 0 cash flow to that result to calculate the NPV. The screenshot below shows the difference. The first NPV calculation (outlined in blue) is correct: we used the NPV
function for all of the cash flows occurring at time 1 and later and then added on the first cash flow occurring at time 0 since it is already in present value. The second calculation (outlined in green) is incorrect:
we used the NPV function for all of the cash flows, but the function assumed that the first cash flow occurs

in period 1 instead of immediately.

NPV Function: Leaving Out Date 0

NPV Function: Ignoring Blank Cells
Another pitfall with the NPV function is that cash flows that are left blank are treated differently from cash
flows that are equal to zero. If the cash flow is left blank, both the cash flow and the period are ignored.
For example, the second set of cash flows below is equivalent to the first—we have simply left the cash
flow for date 2 blank instead of entering a “0.” However, the NPV function ignores the blank cell at date 2
and assumes the cash flow is 10 at date 1 and 110 at date 2, which is clearly not what is intended and

xxii


Practice Finance
to Learn Finance
Here is what you should know after reading this chapter. MyFinanceLab will help
you identify what you know, and where to go when you need to practice.

Key Points and Equations

Terms

MyFinanceLab Study
Plan 4.1

4.1 Valuing a Stream of Cash Flows
◗ The present value of a cash flow stream is:
C1
C2

CN
+
+ g +
PV = C0 +
(4.3)
11 + r2
11 + r22
11 + r2N
4.2 Perpetuities
◗ A perpetuity is a stream of equal cash flows C paid every
period, forever. The present value of a perpetuity is:
PV 1 C in perpetuity 2 =

C
r

Online Practice
Opportunities

consol, p. 89
perpetuity, p. 89

MyFinanceLab Study
Plan 4.2

(4.4)

4.3 Annuities
annuity, p. 92
◗ An annuity is a stream of equal cash flows C paid every

period for N periods. The present value of an annuity is:
1
1
C * a1 (4.5)
b
r
11 + r2N
◗ The future value of an annuity at the end of the annuity
is:
1
C * 1 11 + r2N - 12
(4.6)
r

MyFinanceLab Study
Plan 4.3
Interactive Annuity
Calculator
Financial Calculator
Tutorials: Calculating
the Present Value of an
Annuity and Solving
for the Future Value of
an Annuity

Working problems is the proven way to cement and
demonstrate an understanding of finance.
◗ Concept Check questions at the end of each
section enable students to test their understanding and target areas in which they need further
review.

◗ End-of-chapter problems written personally
by Jonathan Berk, Peter DeMarzo, and Jarrad
Harford offer instructors the opportunity to
assign first-rate materials to students for homework and practice with the confidence that the
problems are consistent with the chapter content. All end-of-chapter problems are available in
MyFinanceLab, the fully integrated homework
and tutorial system. Both the problems and solutions, which were also written by the authors,
have been class-tested and accuracy checked to
ensure quality. Excel icons indicate the availability of instructor solutions and student templates
in the Textbook Resources tab of MyFinanceLab.

End-of-Chapter Materials
Reinforce Learning
Testing understanding of central concepts is crucial to learning finance.
◗ MyFinanceLab Chapter Summary presents the key points and conclusions from each chapter,
provides a list of key terms with page numbers, and indicates online practice opportunities.
◗ Data Cases present in-depth scenarios in a business setting with questions designed to guide
students’ analysis. Many questions involve the use of Internet resources.
◗ Integrative Cases occur at the end of most parts and present a capstone extended problem for
each part with a scenario and data for students to analyze based on that subset of chapters.

Data
Case

Assume today is August 1, 2010. Natasha Kingery is 30 years old and has a Bachelor of
Science degree in computer science. She is currently employed as a Tier 2 field service
representative for a telephony corporation located in Seattle, Washington, and earns
$38,000 a year that she anticipates will grow at 3% per year. Natasha hopes to retire at age
65 and has just begun to think about the future.
Natasha has $75,000 that she recently inherited from her aunt. She invested this

money in ten-year Treasury bonds. She is considering whether she should further her
education and would use her inheritance to pay for it.
She has investigated a couple of options and is asking for your help as a financial
planning intern to determine the financial consequences associated with each option.
Natasha has already been accepted to two programs and could start either one soon.
One alternative that Natasha is considering is attaining a certification in network
design. This certification would automatically promote her to a Tier 3 field service representative in her company. The base salary for a Tier 3 representative is $10,000 more than
the salary of a Tier 2 representative, and she anticipates that this salary differential will
grow at a rate of 3% a year for as long as she keeps working. The certification program
requires the completion of 20 Web-based courses and a score of 80% or better on an exam
at the end of the course work. She has learned that the average amount of time necessary
to finish the program is one year. The total cost of the program is $5,000, due when she

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Preface
Finance professors are united by their commitment to shaping future generations
of financial professionals as well as instilling financial awareness and skills in non-majors.
Our goal with Fundamentals of Corporate Finance is to provide an accessible presentation for both finance and non-finance majors. We know from experience that countless
undergraduate students have felt that corporate finance is challenging. It is tempting to
make finance seem accessible by de-emphasizing the core principles and instead concentrating on the results. In our over 45 years of combined teaching experience, we have
found that emphasizing the core concepts in finance—which are clear and intuitive at
heart—is what makes the subject matter accessible. What makes the subject challenging
is that it is often difficult for a novice to distinguish between these core ideas and other
intuitively appealing approaches that, if used in financial decision making, will lead to
incorrect decisions.
The 2007–2009 financial crisis was fueled in part by many practitioners’ poor decision making when they did not understand—or chose to ignore—the core concepts that
underlie finance and the pedagogy in this book. With this point in mind, we present
finance as one unified whole based on two simple, powerful ideas: (1) valuation drives

decision making—the firm should take projects for which the value of the benefits
exceeds the value of the costs, and (2) in a competitive market, market prices (rather than
individual preferences) determine values. We combine these two ideas with what we call
the Valuation Principle, and from it we establish all of the key ideas in corporate finance.

New to This Edition
In general terms, in our work on the second edition we took great care to update all text
discussions and figures, tables, and facts to reflect key developments in the field and to
provide the clearest presentation possible. Specific highlights include the following:
◗ Reorganized Flow of Topics in Chapters 3 and 4. Mastering the tools for discounting

cash flows is central to students’ success in the introductory course. As always,
mastery comes with practice and by approaching complex topics in manageable
units. We begin our step-by-step look at the time value of money in Chapter 3, which
provides intuition for time value concepts, introduces the Valuation Principle, and
presents rules for valuing cash flows. Chapter 4 addresses cash flow valuation for
multi-period investments.
◗ New Two-Pronged Approach to Stock Valuation. Immediately following bond
valuation, Chapter 7 opens with key background coverage of stock quotes and the
mechanics of stock trades and then presents the dividend-discount model. We delay
the discussion of the discounted cash flow model until after we have covered capital
budgeting. In Chapter 10, we introduce the discounted cash flow model by building
on concepts already developed in the capital budgeting chapters. Chapter 10 also
discusses market efficiency and includes a new discussion of investor behavior.
◗ New and Updated Interviews. A number of new and updated practitioner and recent
graduate interviews support the book’s practical perspective and incorporate timely
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