Finance
Corporate Fiance

Volume 1

David Whitehurst
UMIST

abc

McGraw-Hill/Irwin

McGraw−Hill Primis
ISBN: 0−390−32000−5
Text:
Corporate Finance, Sixth Edition
Ross−Westerfield−Jaffe


This book was printed on recycled paper.
Finance

/>Copyright ©2003 by The McGraw−Hill Companies, Inc. All rights
reserved. Printed in the United States of America. Except as
permitted under the United States Copyright Act of 1976, no part
of this publication may be reproduced or distributed in any form
or by any means, or stored in a database or retrieval system,
without prior written permission of the publisher.
This McGraw−Hill Primis text may include materials submitted to
McGraw−Hill for publication by the instructor of this course. The

instructor is solely responsible for the editorial content of such
materials.

111

FINA

ISBN: 0−390−32000−5


Finance

Volume 1
Ross−Westerfield−Jaffe • Corporate Finance, Sixth Edition
Front Matter

1

Preface

1

I. Overview

8

Introduction
1. Introduction to Corporate Finance
2. Accounting Statements and Cash Flow


8
9
29

II. Value and Capital Budgeting

51

Introduction
3. Financial Markets and Net Present Value: First Principles of Finance
(Adv.)
4. Net Present Value
5. How to Value Bonds and Stocks
6. Some Alternative Investment Rules
7. Net Present Value and Capital Budgeting
8. Strategy and Analysis in Using Net Present Value

51
52
72
108
146
175
206

III. Risk

225

Introduction

9. Capital Market Theory: An Overview
10. Return and Risk: The Capital−Asset−Pricing Model
11. An Alternative View of Risk and Return: The Arbitrage Pricing
Theory
12. Risk, Cost of Capital, and Capital Budgeting

225
226
248
291
313

IV. Capital Structure and Dividend Policy

343

Introduction
13. Corporate−Financing Decisions and Efficient Capital Markets
14. Long−Term Financing: An Introduction
15. Capital Structure: Basic Concepts
16. Capital Structure: Limits to the Use of Debt
17. Valuation and Capital Budgeting for the Levered Firm
18. Dividend Policy: Why Does It Matter?

343
345
377
396
428
474

501

V. Long−Term Financing

539

Introduction
19. Issuing Securities to the Public

539
540

iii


20. Long−Term Debt
21. Leasing

569
592

VI. Options, Futures, and Corporate Finance

617

Introduction
22. Options and Corporate Finance: Basic Concepts
23. Options and Corporate Finance: Extensions and Applications
24. Warrants and Convertibles
25. Derivatives and Hedging Risk


617
618
656
680
701

VII. Financial Planning and Short−Term Finance

736

Introduction
26. Corporate Financial Models and Long−Term Planning
27. Short−Term Finance and Planning
28. Cash Management
29. Credit Management

736
737
751
776
803

VIII. Special Topics

820

Introduction
30. Mergers and Acquisitions
31. Financial Distress

32. International Corporate Finance

820
821
859
877

iv


Ross−Westerfield−Jaffe:
Corporate Finance, Sixth
Edition

Front Matter

© The McGraw−Hill
Companies, 2002

Preface

Preface

The teaching and the practicing of corporate finance are more challenging and exciting
than ever before. The last decade has seen fundamental changes in financial markets and
financial instruments. In the early years of the 21st century, we still see announcements in
the financial press about such matters as takeovers, junk bonds, financial restructuring, initial public offerings, bankruptcy, and derivatives. In addition, there is the new recognition
of “real” options (Chapters 21 and 22), private equity and venture capital (Chapter 19), and
the disappearing dividend (Chapter 18). The world’s financial markets are more integrated
than ever before. Both the theory and practice of corporate finance have been moving

ahead with uncommon speed, and our teaching must keep pace.
These developments place new burdens on the teaching of corporate finance. On one
hand, the changing world of finance makes it more difficult to keep materials up to date.
On the other hand, the teacher must distinguish the permanent from the temporary and
avoid the temptation to follow fads. Our solution to this problem is to emphasize the modern fundamentals of the theory of finance and make the theory come to life with contemporary examples. Increasingly, many of these examples are outside the United States. All
too often, the beginning student views corporate finance as a collection of unrelated topics
that are unified largely because they are bound together between the covers of one book.
As in the previous editions, our aim is to present corporate finance as the working of a
small number of integrated and powerful institutions.

THE INTENDED AUDIENCE OF THIS BOOK
This book has been written for the introductory courses in corporate finance at the MBA
level, and for the intermediate courses in many undergraduate programs. Some instructors
will find our text appropriate for the introductory course at the undergraduate level as well.
We assume that most students either will have taken, or will be concurrently enrolled in,
courses in accounting, statistics, and economics. This exposure will help students understand
some of the more difficult material. However, the book is self-contained, and a prior knowledge of these areas is not essential. The only mathematics prerequisite is basic algebra.

NEW TO THE SIXTH EDITION
Following are the key revisions and updates to this edition:
• A complete update of all cost of capital discussions to emphasize its usefulness in
capital budgeting, primarily in Chapters 12 and 17.

1


2

Ross−Westerfield−Jaffe:
Corporate Finance, Sixth

Edition

Front Matter

Preface

vii

Preface

•
•
•
•
•
•
•
•
•

© The McGraw−Hill
Companies, 2002

A new appendix on performance evaluation and EVA in Chapter 12.
A new section on liquidity and the cost of capital in Chapter 12.
New evidence on efficient markets and CAPM in Chapter 13.
New treatment on why firms choose different capital structures and dividend policies: the case of Qualcomm in Chapters 16 and 18.
A redesign and rewrite of options and derivatives chapters into a new Part VI.
Extension of options theory to mergers and acquisitions in Chapter 22.
An expanded discussion of real options and their importance to capital budgeting in

Chapter 23.
New material on carveouts, spinoffs, and tracking stocks in Chapter 30.
Many new end-of-chapter problems throughout all chapters.

ATTENTION TO PEDAGOGY
Executive Summary
Each chapter begins with a “roadmap” that describes the objectives of the chapter and how
it connects with concepts already learned in previous chapters. Real company examples
that will be discussed are highlighted in this section.

Case Study
There are 10 case studies that are highlighted in the Sixth Edition that present situations
with real companies and how they rationalized the decisions they made to solve various
problems. They provide extended examples of the material covered in the chapter. The
cases are highlighted in the detailed Table of Contents.

In Their Own Words Boxes
Located throughout the Sixth Edition, this unique series consists of articles written by distinguished scholars or practitioners on key topics in the text.

Concept Questions
Included after each major section in a chapter, Concept Questions point to essential material and allow students to test their recall and comprehension before moving forward.

Key Terms
Students will note that important words are highlighted in boldface type the first time they
appear. They are also listed at the end of the chapter, along with the page number on which
they first appear, as well as in the glossary at the end of the book.

Demonstration Problems
We have provided worked-out examples throughout the text to give students a clear understanding of the logic and structure of the solution process. These examples are clearly
called out in the text.


Highlighted Concepts
Throughout the text, important ideas are pulled out and presented in a copper box—signaling to students that this material is particularly relevant and critical for their understanding.

Numbered Equations
Key equations are numbered and listed on the back end sheets for easy reference.
The end of-chapter material reflects and builds on the concepts learned from the chapter and study features:


Ross−Westerfield−Jaffe:
Corporate Finance, Sixth
Edition

viii

Front Matter

Preface

© The McGraw−Hill
Companies, 2002

Preface

Summary and Conclusions
The numbered summary provides a quick review of key concepts in the chapter.

List of Key Terms
A list of the boldfaced key terms with page numbers is included for easy reference.


Suggested Readings
Each chapter is followed by a short, annotated list of books and articles to which interested students can refer for additional information.

Questions and Problems
Because solving problems is so critical to a student’s learning, they have been revised, thoroughly reviewed, and accuracy-checked. The problem sets are graded for difficulty, moving
from easier problems intended to build confidence and skill to more difficult problems
designed to challenge the enthusiastic student. Problems have been grouped according to the
concepts they test on. Additionally, we have tried to make the problems in the critical “concept” chapters, such as those on value, risk, and capital structure, especially challenging and
interesting. We provide answers to selected problems in Appendix B at the end of the book.

Minicase
This end-of-chapter feature, located in Chapters 12 and 30, parallels the Case Study feature
found in various chapters. These Minicases apply what is learned in a number of chapters
to a real-world type of scenario. After presenting the facts, the student is given guidance in
rationalizing a sound business decision.

SUPPLEMENTS PACKAGE
As with the text, developing supplements of extraordinary quality and utility was the primary objective. Each component in the supplement package underwent extensive review
and revision.

FOR THE INSTRUCTOR
Instructor’s Manual (0-07-233882-2)
Prepared by John Stansfield, University of Missouri, Columbia, this instructor’s tool has
been thoroughly revised and updated. Each chapter includes a list of transparencies/
PowerPoint slides, a brief chapter outline, an introduction, and an annotated outline. The
annotated outline contains references to the transparencies/PowerPoint slides, additional
explanations and examples, and teaching tips.

PowerPoint Presentation System (0-07-233883-0)
This presentation system was developed in conjunction with the Instructor’s Manual by the

same author, allowing for a complete and integrated teaching package. These slides contain
useful outlines, summaries, and exhibits from the text. If you have PowerPoint installed on
your PC, you have the ability to edit, print, or rearrange the complete transparency presentation to meet your specific needs.

Test Bank (0-07-233885-7)
The Test Bank, prepared by David Burnie, Western Michigan University, includes an average of 35 multiple-choice questions and problems per chapter, and 5 essay questions per

3


4

Ross−Westerfield−Jaffe:
Corporate Finance, Sixth
Edition

Front Matter

Preface

© The McGraw−Hill
Companies, 2002

Preface

ix

chapter. Each question is labeled with the level of difficulty. About 30–40 percent of these
problems are new or revised.


Computerized Testing Software (0-07-233881-4)
This software includes an easy-to-use menu system which allows quick access to all the
powerful features available. The Keyword Search option lets you browse through the question bank for problems containing a specific word or phrase. Password protection is available for saved tests or for the entire database. Questions can be added, modified, or deleted.
Available in Windows version.

Solutions Manual (0-07-233884-9)
The Solutions Manual, prepared by John A. Helmuth, University of Michigan, contains
worked-out solutions for all of the problems, and has been thoroughly reviewed for accuracy. The Solutions Manual is also available to be purchased for your students.

Instructor CD-ROM (0-07-246238-8)
You can receive all of the supplements in an electronic format! The Instructor’s Manual,
PowerPoint, Test Bank, and Solutions Manual are all together on one convenient CD. The
interface provides the instructor with a self-contained program that allows him or her to
arrange the visual resources into his or her own presentation and add additional files as well.

Videos (0-07-250741-1)
These finance videos are 10-minute case studies on topics such as Financial Markets,
Careers, Rightsizing, Capital Budgeting, EVA (Economic Value Added), Mergers and
Acquisitions, and International Finance. Questions to accompany these videos can be
found on the book’s Online Learning Center.

FOR THE STUDENTS
Standard & Poor’s Educational Version of Market Insight. If you purchased a new book,
you will have received a free passcode card that will give you access to the same company
and industry data that industry experts use. See www.mhhe.com/edumarketinsight for
details on this exclusive partnership!

PowerWeb
If you purchased a new book, free access to PowerWeb—a dynamic supplement specific to
your corporate finance course—is also available. Included are three levels of resource

materials: articles from journals and magazines from the past year, weekly updates on current issues, and links to current news of the day. Also available is a series of study aids,
such as quizzes, web links, and interactive exercises. See www.dushkin.com/powerweb for
more details and access to this valuable resource.

Student Problem Manual (0-07-233880-6)
Written by Robert Hanson, Eastern Michigan University, the Student Problem Manual is a
direct companion to the text. It is uniquely designed to involve the student in the learning
process. Each chapter contains a Mission Statement, an average of 20 fill-in-the-blank
Concept Test questions and answers, and an average of 15 problems and worked-out solutions. This product can be purchased separately or packaged with the text.

Online Learning Center
Visit the full web resource now available with the Sixth Edition at www.mhhe.com/rwj. The
Information Center includes information on this new edition, and links for special offers.


Ross−Westerfield−Jaffe:
Corporate Finance, Sixth
Edition

x

Front Matter

Preface

© The McGraw−Hill
Companies, 2002

Preface


The Instructor Center includes all of the teaching resources for the book, and the Student
Center includes free online study materials—such as quizzes, study outlines, and spreadsheets—developed specifically for this edition. A feedback form is also available for your
questions and comments.

ACKNOWLEDGMENTS
The plan for developing this edition began with a number of our colleagues who had an interest in the book and regularly teach the MBA introductory course. We integrated their comments and recommendations throughout the Sixth Edition. Contributors to this edition include:
R. Aggarwal, John Carroll University
Christopher Anderson, University of
Missouri–Columbia
James J. Angel, Georgetown University
Kevin Bahr, University of Wisconsin–Milwaukee

Richard Miller, Wesleyan University
Naval Modani, University of Central Florida

Michael Barry, Boston College
William O. Brown, Claremont McKenna College
Bill Callahan, Southern Methodist University

Ingmar Nyman, Hunter College
Venky Panchapagesan, Washington
University–St. Louis

Steven Carvell, Cornell University

Bulent Parker, University of Wisconsin–Madison
Christo Pirinsky, Ohio State University

Indudeep S. Chhachhi, Western Kentucky
University

Jeffrey L. Coles, Arizona State University
Raymond Cox, Central Michigan University
John Crockett, George Mason University
Robert Duvic, The University of Texas at Austin
Steven Ferraro, Pepperdine University
Adlai Fisher, New York University
Yee-Tien Fu, Stanford University
Bruno Gerard, University of Southern California
Frank Ghannadian, Mercer University–Atlanta
John A. Helmuth, University of
Michigan–Dearborn
Edith Hotchkiss, Boston College
Charles Hu, Claremont McKenna College
Raymond Jackson, University of
Massachusetts–Dartmouth
Narayanan Jayaraman, Georgia Institute of
Technology
Dolly King, University of Wisconsin–Milwaukee
Ronald Kudla, The University of Akron
Dilip Kumar Patro, Rutgers University
Youngsik Kwak, Delaware State University
Youngho Lee, Howard University
Yulong Ma, Cal State—Long Beach

Robert Nachtmann, University of Pittsburgh
Edward Nelling, Georgia Tech
Gregory Niehaus, University of South Carolina

Jeffrey Pontiff, University of Washington
N. Prabhala, Yale University

Mao Qiu, University of Utah–Salt Lake City
Latha Ramchand, University of Houston
Gabriel Ramirez, Virginia Commonwealth
University
Stuart Rosenstein, University of Colorado at
Denver
Bruce Rubin, Old Dominion University
Jaime Sabal, New York University
Andy Saporoschenko, University of Akron
William Sartoris, Indiana University
Faruk Selcuk, University of Bridgeport
Sudhir Singh, Frostburg State University
John S. Strong, College of William and Mary
Michael Sullivan, University of Nevada–Las Vegas
Andrew C. Thompson, Virginia Polytechnic
Institute
Karin Thorburn, Dartmouth College
Satish Thosar, University of
Massachusetts–Dorchester
Oscar Varela, University of New Orleans
Steven Venti, Dartmouth College
Susan White, University of Texas–Austin

Over the years, many others have contributed their time and expertise to the development and
writing of this text. We extend our thanks once again for their assistance and countless insights:

5


6


Ross−Westerfield−Jaffe:
Corporate Finance, Sixth
Edition

Front Matter

Preface

© The McGraw−Hill
Companies, 2002

xi

Preface

James J. Angel, Georgetown University
Nasser Arshadi, University of Missouri–St. Louis
Robert Balik, Western Michigan University
John W. Ballantine, Babson College
Thomas Bankston, Angelo State University
Swati Bhatt, Rutgers University
Roger Bolton, Williams College
Gordon Bonner, University of Delaware
Brad Borber, University of California–Davis
Oswald Bowlin, Texas Technical University
Ronald Braswell, Florida State University
Kirt Butler, Michigan State University
Andreas Christofi, Pennsylvania State
University–Harrisburg

James Cotter, University of Iowa
Jay Coughenour, University of
Massachusetts–Boston
Arnold Cowan, Iowa State University
Mark Cross, Louisiana Technical University
Ron Crowe, Jacksonville University
William Damon, Vanderbilt University
Sudip Datta, Bentley College
Anand Desai, University of Florida
Miranda Lam Detzler, University of
Massachusetts–Boston
David Distad, University of California–Berkeley
Dennis Draper, University of Southern California
Jean-Francois Dreyfus, New York University
Gene Drzycimski, University of
Wisconsin–Oshkosh
Robert Eldridge, Fairfield University
Gary Emery, University of Oklahoma
Theodore Eytan, City University of New
York–Baruch College
Don Fehrs, University of Notre Dame
Andrew Fields, University of Delaware
Paige Fields, Texas A&M
Michael Fishman, Northwestern University
Michael Goldstein, University of Colorado
Indra Guertler, Babson College
James Haltiner, College of William and Mary

Hugh Hunter, Eastern Washington University
James Jackson, Oklahoma State University

Prem Jain, Tulane University
Brad Jordan, University of Kentucky
Jarl Kallberg, New York University
Jonathan Karpoff, University of Washington
Paul Keat, American Graduate School of
International Management
Brian Kluger, University of Cincinnati
Narayana Kocherlakota, University of Iowa
Nelson Lacey, University of Massachusetts
Gene Lai, University of Rhode Island
Josef Lakonishok, University of Illinois
Dennis Lasser, SUNY–Binghamton
Paul Laux, Case Western Reserve University
Bong-Su Lee, University of Minnesota
James T. Lindley, University of Southern
Mississippi
Dennis Logue, Dartmouth College
Michael Long, Rutgers University
Ileen Malitz, Fairleigh Dickinson University
Terry Maness, Baylor University
Surendra Mansinghka, San Francisco State
University
Michael Mazzco, Michigan State University
Robert I. McDonald, Northwestern University
Hugh McLaughlin, Bentley College
Larry Merville, University of Texas–Richardson
Joe Messina, San Francisco State University
Roger Mesznik, City College of New
York–Baruch College
Rick Meyer, University of South Florida

Richard Mull, New Mexico State University
Jim Musumeci, Southern Illinois
University–Carbondale
Peder Nielsen, Oregon State University
Dennis Officer, University of Kentucky
Joseph Ogden, State University of New York
Ajay Patel, University of Missouri–Columbia
Glenn N. Pettengill, Emporia State University

Delvin Hawley, University of Mississippi
Hal Heaton, Brigham Young University

Pegaret Pichler, University of Maryland
Franklin Potts, Baylor University
Annette Poulsen, University of Georgia

John Helmuth, Rochester Institute of Technology
Michael Hemler, University of Notre Dame
Stephen Heston, Washington University
Andrea Heuson, University of Miami

Latha Ramchand, University of Houston
Narendar Rao, Northeastern Illinois University
Steven Raymar, Indiana University
Stuart Rosenstein, Southern Illinois University


Ross−Westerfield−Jaffe:
Corporate Finance, Sixth
Edition


xii

Front Matter

Preface

© The McGraw−Hill
Companies, 2002

Preface

Patricia Ryan, Drake University
Anthony Sanders, Ohio State University
James Schallheim, University of Utah

Alex Tang, Morgan State University
Richard Taylor, Arkansas State University
Timothy Thompson, Northwestern University

Mary Jean Scheuer, California State University
at Northridge
Lemma Senbet, University of Maryland

Charles Trzcinka, State University of New
York–Buffalo
Haluk Unal, University of Maryland–College Park

Kuldeep Shastri, University of Pittsburgh
Scott Smart, Indiana University

Jackie So, Southern Illinois University
John Stansfield, Columbia College

Avinash Verma, Washington University
Lankford Walker, Eastern Illinois University
Ralph Walkling, Ohio State University
F. Katherine Warne, Southern Bell College

A. Charlene Sullivan, Purdue University
Timothy Sullivan, Bentley College

Robert Whitelaw, New York University
Berry Wilson, Georgetown University

R. Bruce Swensen, Adelphi University
Ernest Swift, Georgia State University

Thomas Zorn, University of Nebraska–Lincoln
Kent Zumwalt, Colorado State University

For their help on the Sixth Edition, we would like to thank Linda De Angelo, Dennis
Draper, Kim Dietrich, Alan Shapiro, Harry De Angelo, Aris Protopapadakis, Anath
Madhevan, and Suh-Pyng Ku, all of the Marshall School of Business at the University of
Southern California. We also owe a debt of gratitude to Edward I. Altman, of New York
University; Robert S. Hansen, of Virginia Tech; and Jay Ritter, of the University of Florida,
who have provided several thoughtful comments and immeasurable help.
Over the past three years, readers have provided assistance by detecting and reporting
errors. Our goal is to offer the best textbook available on the subject, so this information
was invaluable as we prepared the Sixth Edition. We want to ensure that all future editions
are error-free and therefore we will offer $10 per arithmetic error to the first individual

reporting it. Any arithmetic error resulting in subsequent errors will be counted double. All
errors should be reported using the Feedback Form on the Corporate Finance Online
Learning Center at www.mhhe.com/rwj.
In addition, Sandra Robinson and Wendy Wat have given significant assistance in
preparing the manuscript.
Finally, we wish to thank our families and friends, Carol, Kate, Jon, Jan, Mark, and
Lynne for their forbearance and help.
Stephen A. Ross
Randolph W. Westerfield
Jeffrey F. Jaffe

7


8

Ross−Westerfield−Jaffe:
Corporate Finance, Sixth
Edition

I. Overview

Introduction

1 Introduction to Corporate Finance 2
2 Accounting Statements and Cash Flow 22

T

O engage in business the financial managers of a firm must find answers to three

kinds of important questions. First, what long-term investments should the firm take
on? This is the capital budgeting decision. Second, how can cash be raised for the required investments? We call this the financing decision. Third, how will the firm manage its day-to-day cash and financial affairs? These decisions involve short-term finance
and concern net working capital.
In Chapter 1 we discuss these important questions, briefly introducing the basic
ideas of this book and describing the nature of the modern corporation and why it has
emerged as the leading form of the business firm. Using the set-of-contracts perspective,
the chapter discusses the goals of the modern corporation. Though the goals of shareholders and managers may not always be the same, conflicts usually will be resolved in
favor of the shareholders. Finally, the chapter reviews some of the salient features of
modern financial markets. This preliminary material will be familiar to students who
have some background in accounting, finance, and economics.
Chapter 2 examines the basic accounting statements. It is review material for students with an accounting background. We describe the balance sheet and the income
statement. The point of the chapter is to show the ways of converting data from accounting statements into cash flow. Understanding how to identify cash flow from accounting statements is especially important for later chapters on capital budgeting.

PART I

Overview

© The McGraw−Hill
Companies, 2002


I. Overview

1. Introduction to Corporate
Finance

© The McGraw−Hill
Companies, 2002

CHAPTER


1

Ross−Westerfield−Jaffe:
Corporate Finance, Sixth
Edition

Introduction to
Corporate Finance
EXECUTIVE SUMMARY

T

he Video Product Company designs and manufactures very popular software for
video game consoles. The company was started in 1999, and soon thereafter its game
“Gadfly” appeared on the cover of Billboard magazine. Company sales in 2000 were
over $20 million. Video Product’s initial financing of $2 million came from Seed Ltd., a
venture-capital firm, in exchange for a 15-percent equity stake in the company. Now the financial management of Video Product realizes that its initial financing was too small. In the
long run Video Product would like to expand its design activity to the education and business areas. It would also like to significantly enhance its website for future Internet sales.
However, at present the company has a short-run cash flow problem and cannot even buy
$200,000 of materials to fill its holiday orders.
Video Product’s experience illustrates the basic concerns of corporate finance:
1. What long-term investment strategy should a company take on?
2. How can cash be raised for the required investments?
3. How much short-term cash flow does a company need to pay its bills?
These are not the only questions of corporate finance. They are, however, among the most
important questions and, taken in order, they provide a rough outline of our book.
One way that companies raise cash to finance their investment activities is by selling
or “issuing” securities. The securities, sometimes called financial instruments or claims,
may be roughly classified as equity or debt, loosely called stocks or bonds. The difference

between equity and debt is a basic distinction in the modern theory of finance. All securities of a firm are claims that depend on or are contingent on the value of the firm.1 In Section
1.2 we show how debt and equity securities depend on the firm’s value, and we describe
them as different contingent claims.
In Section 1.3 we discuss different organizational forms and the pros and cons of the
decision to become a corporation.
In Section 1.4 we take a close look at the goals of the corporation and discuss why maximizing shareholder wealth is likely to be the primary goal of the corporation. Throughout
the rest of the book, we assume that the firm’s performance depends on the value it creates
for its shareholders. Shareholders are better off when the value of their shares is increased
by the firm’s decisions.
A company raises cash by issuing securities to the financial markets. The market value
of outstanding long-term corporate debt and equity securities traded in the U.S. financial
markets is in excess of $25 trillion. In Section 1.5 we describe some of the basic features of
the financial markets. Roughly speaking, there are two basic types of financial markets: the
money markets and the capital markets. The last section of the chapter provides an outline
of the rest of the book.

1
We tend to use the words firm, company, and business interchangeably. However, there is a difference between
a firm and a corporation. We discuss this difference in Section 1.3.

9


10

Ross−Westerfield−Jaffe:
Corporate Finance, Sixth
Edition

I. Overview


© The McGraw−Hill
Companies, 2002

1. Introduction to Corporate
Finance

Chapter 1

3

Introduction to Corporate Finance

1.1 WHAT IS CORPORATE FINANCE?
Suppose you decide to start a firm to make tennis balls. To do this, you hire managers to
buy raw materials, and you assemble a workforce that will produce and sell finished tennis
balls. In the language of finance, you make an investment in assets such as inventory, machinery, land, and labor. The amount of cash you invest in assets must be matched by an
equal amount of cash raised by financing. When you begin to sell tennis balls, your firm
will generate cash. This is the basis of value creation. The purpose of the firm is to create
value for you, the owner. The firm must generate more cash flow than it uses. The value is
reflected in the framework of the simple balance-sheet model of the firm.

The Balance-Sheet Model of the Firm
Suppose we take a financial snapshot of the firm and its activities at a single point in time.
Figure 1.1 shows a graphic conceptualization of the balance sheet, and it will help introduce you to corporate finance.
The assets of the firm are on the left-hand side of the balance sheet. These assets can
be thought of as current and fixed. Fixed assets are those that will last a long time, such as
buildings. Some fixed assets are tangible, such as machinery and equipment. Other fixed
assets are intangible, such as patents, trademarks, and the quality of management. The other
category of assets, current assets, comprises those that have short lives, such as inventory.

The tennis balls that your firm has made but has not yet sold are part of its inventory. Unless
you have overproduced, they will leave the firm shortly.
Before a company can invest in an asset, it must obtain financing, which means that it
must raise the money to pay for the investment. The forms of financing are represented on
the right-hand side of the balance sheet. A firm will issue (sell) pieces of paper called debt

■ F I G U R E 1.1 The Balance-Sheet Model of the Firm

Current assets

Net
working
capital

Current liabilities

Long-term debt
Fixed assets
1. Tangible fixed
assets
2. Intangible fixed
assets

Total value of assets

Shareholders’ equity

Total value of the firm
to investors
Left side, total value of assets. Right side, total value of the firm to investors,

which determines how the value is distributed.


Ross−Westerfield−Jaffe:
Corporate Finance, Sixth
Edition

4

I. Overview

Part I

1. Introduction to Corporate
Finance

© The McGraw−Hill
Companies, 2002

Overview

(loan agreements) or equity shares (stock certificates). Just as assets are classified as longlived or short-lived, so too are liabilities. A short-term debt is called a current liability.
Short-term debt represents loans and other obligations that must be repaid within one year.
Long-term debt is debt that does not have to be repaid within one year. Shareholders’ equity represents the difference between the value of the assets and the debt of the firm. In this
sense it is a residual claim on the firm’s assets.
From the balance-sheet model of the firm it is easy to see why finance can be thought
of as the study of the following three questions:
1. In what long-lived assets should the firm invest? This question concerns the lefthand side of the balance sheet. Of course, the type and proportions of assets the firm needs
tend to be set by the nature of the business. We use the terms capital budgeting and capital expenditures to describe the process of making and managing expenditures on longlived assets.
2. How can the firm raise cash for required capital expenditures? This question concerns the right-hand side of the balance sheet. The answer to this involves the firm’s capital structure, which represents the proportions of the firm’s financing from current and

long-term debt and equity.
3. How should short-term operating cash flows be managed? This question concerns
the upper portion of the balance sheet. There is often a mismatch between the timing of cash
inflows and cash outflows during operating activities. Furthermore, the amount and timing
of operating cash flows are not known with certainty. The financial managers must attempt
to manage the gaps in cash flow. From a balance-sheet perspective, short-term management
of cash flow is associated with a firm’s net working capital. Net working capital is defined
as current assets minus current liabilities. From a financial perspective, the short-term cash
flow problem comes from the mismatching of cash inflows and outflows. It is the subject
of short-term finance.

Capital Structure
Financing arrangements determine how the value of the firm is sliced up. The persons or
institutions that buy debt from the firm are called creditors.2 The holders of equity shares
are called shareholders.
Sometimes it is useful to think of the firm as a pie. Initially, the size of the pie will depend
on how well the firm has made its investment decisions. After a firm has made its investment
decisions, it determines the value of its assets (e.g., its buildings, land, and inventories).
The firm can then determine its capital structure. The firm might initially have raised
the cash to invest in its assets by issuing more debt than equity; now it can consider changing that mix by issuing more equity and using the proceeds to buy back some of its debt.
Financing decisions like this can be made independently of the original investment decisions. The decisions to issue debt and equity affect how the pie is sliced.
The pie we are thinking of is depicted in Figure 1.2. The size of the pie is the value of
the firm in the financial markets. We can write the value of the firm, V, as
VϭBϩS
where B is the value of the debt and S is the value of the equity. The pie diagrams consider two ways of slicing the pie: 50 percent debt and 50 percent equity, and 25 percent
2
We tend to use the words creditors, debtholders, and bondholders interchangeably. In later chapters we
examine the differences among the kinds of creditors. In algebraic notation, we will usually refer to the firm’s
debt with the letter B (for bondholders).


11


12

Ross−Westerfield−Jaffe:
Corporate Finance, Sixth
Edition

I. Overview

Chapter 1

© The McGraw−Hill
Companies, 2002

1. Introduction to Corporate
Finance

5

Introduction to Corporate Finance

■ F I G U R E 1.2 Two Pie Models of the Firm
25% debt

50% debt

50% equity


Capital structure 1

75% equity

Capital structure 2

debt and 75 percent equity. The way the pie is sliced could affect its value. If so, the goal
of the financial manager will be to choose the ratio of debt to equity that makes the value
of the pie—that is, the value of the firm, V—as large as it can be.

The Financial Manager
In large firms the finance activity is usually associated with a top officer of the firm, such
as the vice president and chief financial officer, and some lesser officers. Figure 1.3 depicts
a general organizational structure emphasizing the finance activity within the firm. Reporting to the chief financial officer are the treasurer and the controller. The treasurer is responsible for handling cash flows, managing capital-expenditures decisions, and making
financial plans. The controller handles the accounting function, which includes taxes, cost
and financial accounting, and information systems.
We think that the most important job of a financial manager is to create value from the
firm’s capital budgeting, financing, and liquidity activities. How do financial managers create value?
1. The firm should try to buy assets that generate more cash than they cost.
2. The firm should sell bonds and stocks and other financial instruments that raise more
cash than they cost.
Thus the firm must create more cash flow than it uses. The cash flows paid to bondholders and stockholders of the firm should be higher than the cash flows put into the firm
by the bondholders and stockholders. To see how this is done, we can trace the cash flows
from the firm to the financial markets and back again.
The interplay of the firm’s finance with the financial markets is illustrated in Figure
1.4. The arrows in Figure 1.4 trace cash flow from the firm to the financial markets and back
again. Suppose we begin with the firm’s financing activities. To raise money the firm sells
debt and equity shares to investors in the financial markets. This results in cash flows from
the financial markets to the firm (A). This cash is invested in the investment activities of the
firm (B) by the firm’s management. The cash generated by the firm (C) is paid to shareholders and bondholders (F). The shareholders receive cash in the form of dividends; the

bondholders who lent funds to the firm receive interest and, when the initial loan is repaid,
principal. Not all of the firm’s cash is paid out. Some is retained (E), and some is paid to
the government as taxes (D).
Over time, if the cash paid to shareholders and bondholders (F) is greater than the cash
raised in the financial markets (A), value will be created.
Identification of Cash Flows Unfortunately, it is not all that easy to observe cash flows
directly. Much of the information we obtain is in the form of accounting statements, and


Ross−Westerfield−Jaffe:
Corporate Finance, Sixth
Edition

6

I. Overview

Part I

© The McGraw−Hill
Companies, 2002

1. Introduction to Corporate
Finance

Overview

■ F I G U R E 1.3 Hypothetical Organization Chart
Board of Directors


Chairman of the Board and
Chief Executive Officer (CEO)

President and Chief
Operations Officer (COO)

Vice President and Chief
Financial Officer (CFO)

Treasurer

Controller

Cash Manager

Credit Manager

Tax Manager

Cost Accounting
Manager

Capital
Expenditures

Financial
Planning

Financial
Accounting

Manager

Data Processing
Manager

much of the work of financial analysis is to extract cash flow information from accounting
statements. The following example illustrates how this is done.

E XAMPLE
The Midland Company refines and trades gold. At the end of the year it sold 2,500
ounces of gold for $1 million. The company had acquired the gold for $900,000 at
the beginning of the year. The company paid cash for the gold when it was purchased. Unfortunately, it has yet to collect from the customer to whom the gold
was sold. The following is a standard accounting of Midland’s financial circumstances at year-end:

13


14

Ross−Westerfield−Jaffe:
Corporate Finance, Sixth
Edition

I. Overview

© The McGraw−Hill
Companies, 2002

1. Introduction to Corporate
Finance


Chapter 1

7

Introduction to Corporate Finance

I N T HEIR O WN W ORDS
Skills Needed for the Chief Financial Officers of eFinance.com
Chief strategist: CFOs will need to use real-time financial information to make crucial decisions fast.
Chief dealmaker: CFOs must be adept at venture capital, mergers and acquisitions, and strategic partnerships.

Chief communicator: Gaining the confidence of Wall
Street and the media will be essential.
Source: Business Week, August 28, 2000, p. 120.

Chief risk officer: Limiting risk will be even more
important as markets become more global and hedging instruments become more complex.

THE MIDLAND COMPANY
Accounting View
Income Statement
Year Ended December 31

Sales
ϪCosts
______
Profit

$1,000,000

Ϫ900,000
__________
$ 100,000

By generally accepted accounting principles (GAAP), the sale is recorded even
though the customer has yet to pay. It is assumed that the customer will pay soon.
From the accounting perspective, Midland seems to be profitable. However, the
perspective of corporate finance is different. It focuses on cash flows:
THE MIDLAND COMPANY
Corporate Finance View
Income Statement
Year Ended December 31

Cash inflow
Cash outflow

$
0
Ϫ
900,000
__________
Ϫ$900,000

The perspective of corporate finance is interested in whether cash flows are being
created by the gold-trading operations of Midland. Value creation depends on cash
flows. For Midland, value creation depends on whether and when it actually receives $1 million.
Timing of Cash Flows The value of an investment made by the firm depends on the timing of cash flows. One of the most important assumptions of finance is that individuals prefer to receive cash flows earlier rather than later. One dollar received today is worth more
than one dollar received next year. This time preference plays a role in stock and bond prices.

E XAMPLE

The Midland Company is attempting to choose between two proposals for new
products. Both proposals will provide additional cash flows over a four-year period
and will initially cost $10,000. The cash flows from the proposals are as follows:


8

I. Overview

Part I

© The McGraw−Hill
Companies, 2002

1. Introduction to Corporate
Finance

Overview

■ F I G U R E 1.4 Cash Flows between the Firm and the Financial
Markets

Firm issues securities (A)
Firm invests
in assets
(B)

Financial
markets
Retained cash flows (E)


Current assets
Fixed assets

Short-term debt
Long-term debt
Equity shares

Dividends and
debt payments (F)

Cash flow
from firm (C)
Taxes

Ross−Westerfield−Jaffe:
Corporate Finance, Sixth
Edition

Government
(D)

Total value of assets

(A)
(B)
(C)
(D)
(E)
(F)


Total value of the firm
to investors in
the financial markets

Firm issues securities to raise cash (the financing decision).
Firm invests in assets (capital budgeting).
Firm’s operations generate cash flow.
Cash is paid to government as taxes.
Retained cash flows are reinvested in firm.
Cash is paid out to investors in the form of interest and dividends.

Year

New Product A

New Product B

1
2
3
4

$

0
0
0
20,000
_______


$ 4,000
4,000
4,000
4,000
_______

Total

$20,000

$16,000

At first it appears that new product A would be best. However, the cash flows from
proposal B come earlier than those of A. Without more information we cannot decide which set of cash flows would create the most value to the bondholders and
shareholders. It depends on whether the value of getting cash from B up front outweighs the extra total cash from A. Bond and stock prices reflect this preference for
earlier cash, and we will see how to use them to decide between A and B.
Risk of Cash Flows The firm must consider risk. The amount and timing of cash flows
are not usually known with certainty. Most investors have an aversion to risk.

E XAMPLE
The Midland Company is considering expanding operations overseas. It is evaluating Europe and Japan as possible sites. Europe is considered to be relatively safe,
whereas operating in Japan is seen as very risky. In both cases the company would
close down operations after one year.

15


Ross−Westerfield−Jaffe:
Corporate Finance, Sixth

Edition

I. Overview

© The McGraw−Hill
Companies, 2002

1. Introduction to Corporate
Finance

Chapter 1

9

Introduction to Corporate Finance

After doing a complete financial analysis, Midland has come up with the following cash flows of the alternative plans for expansion under three equally likely
scenarios—pessimistic, most likely, and optimistic:

Europe
Japan

Pessimistic

Most Likely

Optimistic

$75,000
0


$100,000
150,000

$125,000
200,000

If we ignore the pessimistic scenario, perhaps Japan is the best alternative. When
we take the pessimistic scenario into account, the choice is unclear. Japan appears
to be riskier, but it also offers a higher expected level of cash flow. What is risk and
how can it be defined? We must try to answer this important question. Corporate
finance cannot avoid coping with risky alternatives, and much of our book is devoted to developing methods for evaluating risky opportunities.
QUESTIONS
CONCEPT

16

?

•
•
•
•

What are three basic questions of corporate finance?
Describe capital structure.
How is value created?
List the three reasons why value creation is difficult.

1.2 CORPORATE SECURITIES AS CONTINGENT CLAIMS ON

TOTAL FIRM VALUE
What is the essential difference between debt and equity? The answer can be found by thinking about what happens to the payoffs to debt and equity when the value of the firm changes.
The basic feature of a debt is that it is a promise by the borrowing firm to repay a fixed
dollar amount by a certain date.

E XAMPLE
The Officer Corporation promises to pay $100 to the Brigham Insurance Company
at the end of one year. This is a debt of the Officer Corporation. Holders of the debt
will receive $100 if the value of the Officer Corporation’s assets is equal to or more
than $100 at the end of the year.
Formally, the debtholders have been promised an amount F at the end of the
year. If the value of the firm, X, is equal to or greater than F at year-end, debtholders will get F. Of course, if the firm does not have enough to pay off the promised
amount, the firm will be “broke.” It may be forced to liquidate its assets for whatever they are worth, and the bondholders will receive X. Mathematically this
means that the debtholders have a claim to X or F, whichever is smaller. Figure 1.5
illustrates the general nature of the payoff structure to debtholders.
Suppose at year-end the Officer Corporation’s value is equal to $100. The firm has
promised to pay the Brigham Insurance Company $100, so the debtholders will get $100.
Now suppose the Officer Corporation’s value is $200 at year-end and the debtholders are promised $100. How much will the debtholders receive? It should be clear that
they will receive the same amount as when the Officer Corporation was worth $100.
Suppose the firm’s value is $75 at year-end and debtholders are promised $100.
How much will the debtholders receive? In this case the debtholders will get $75.


Ross−Westerfield−Jaffe:
Corporate Finance, Sixth
Edition

10

I. Overview


Part I

© The McGraw−Hill
Companies, 2002

1. Introduction to Corporate
Finance

Overview

■ F I G U R E 1.5 Debt and Equity as Contingent Claims
Payoff to
debtholders

Payoff to
equity shareholders

Payoffs to debtholders
and equity shareholders
Payoff to
equity
shareholders
F

F

F

Value

of the
firm
(X )

F

Value
of the
firm
(X )

Payoff to
debtholders
F

Value
of the
firm
(X )

F is the promised payoff to debtholders. X Ϫ F is the payoff to equity shareholders if X Ϫ F Ͼ 0. Otherwise the
payoff is 0.

The stockholders’ claim on firm value at the end of the period is the amount that remains after the debtholders are paid. Of course, stockholders get nothing if the firm’s value
is equal to or less than the amount promised to the debtholders.

E XAMPLE
The Officer Corporation will sell its assets for $200 at year-end. The firm has
promised to pay the Brigham Insurance Company $100 at that time. The stockholders will get the residual value of $100.
Algebraically, the stockholders’ claim is X Ϫ F if X Ͼ F and zero if X Յ F. This is depicted in Figure 1.5. The sum of the debtholders’ claim and the stockholders’ claim is always the value of the firm at the end of the period.

The debt and equity securities issued by a firm derive their value from the total value
of the firm. In the words of finance theory, debt and equity securities are contingent claims
on the total firm value.
When the value of the firm exceeds the amount promised to the debtholders, the shareholders obtain the residual of the firm’s value over the amount promised the debtholders,
and the debtholders obtain the amount promised. When the value of the firm is less than the
amount promised the debtholders, the shareholders receive nothing and the debtholders get
the value of the firm.
CONCEPT

QUESTIONS

?

• What is a contingent claim?
• Describe equity and debt as contingent claims.

1.3 THE CORPORATE FIRM
The firm is a way of organizing the economic activity of many individuals, and there are
many reasons why so much economic activity is carried out by firms and not by individuals.
The theory of firms, however, does not tell us much about why most large firms are corporations rather than any of the other legal forms that firms can assume.

17


18

Ross−Westerfield−Jaffe:
Corporate Finance, Sixth
Edition


I. Overview

Chapter 1

1. Introduction to Corporate
Finance

Introduction to Corporate Finance

© The McGraw−Hill
Companies, 2002

11

A basic problem of the firm is how to raise cash. The corporate form of business, that
is, organizing the firm as a corporation, is the standard method for solving problems encountered in raising large amounts of cash. However, businesses can take other forms. In
this section we consider the three basic legal forms of organizing firms, and we see how
firms go about the task of raising large amounts of money under each form.

The Sole Proprietorship
A sole proprietorship is a business owned by one person. Suppose you decide to start a
business to produce mousetraps. Going into business is simple: You announce to all who
will listen, “Today I am going to build a better mousetrap.”
Most large cities require that you obtain a business license. Afterward you can begin
to hire as many people as you need and borrow whatever money you need. At year-end all
the profits and the losses will be yours.
Here are some factors that are important in considering a sole proprietorship:
1. The sole proprietorship is the cheapest business to form. No formal charter is required,
and few government regulations must be satisfied for most industries.
2. A sole proprietorship pays no corporate income taxes. All profits of the business are

taxed as individual income.
3. The sole proprietorship has unlimited liability for business debts and obligations. No
distinction is made between personal and business assets.
4. The life of the sole proprietorship is limited by the life of the sole proprietor.
5. Because the only money invested in the firm is the proprietor’s, the equity money that
can be raised by the sole proprietor is limited to the proprietor’s personal wealth.

The Partnership
Any two or more persons can get together and form a partnership. Partnerships fall into
two categories: (1) general partnerships and (2) limited partnerships.
In a general partnership all partners agree to provide some fraction of the work and
cash and to share the profits and losses. Each partner is liable for the debts of the partnership. A partnership agreement specifies the nature of the arrangement. The partnership
agreement may be an oral agreement or a formal document setting forth the understanding.
Limited partnerships permit the liability of some of the partners to be limited to the
amount of cash each has contributed to the partnership. Limited partnerships usually require that (1) at least one partner be a general partner and (2) the limited partners do not
participate in managing the business. Here are some things that are important when considering a partnership:
1. Partnerships are usually inexpensive and easy to form. Written documents are required
in complicated arrangements, including general and limited partnerships. Business licenses and filing fees may be necessary.
2. General partners have unlimited liability for all debts. The liability of limited partners is
usually limited to the contribution each has made to the partnership. If one general partner is unable to meet his or her commitment, the shortfall must be made up by the other
general partners.
3. The general partnership is terminated when a general partner dies or withdraws (but this
is not so for a limited partner). It is difficult for a partnership to transfer ownership without dissolving. Usually, all general partners must agree. However, limited partners may
sell their interest in a business.


Ross−Westerfield−Jaffe:
Corporate Finance, Sixth
Edition


12

I. Overview

Part I

1. Introduction to Corporate
Finance

© The McGraw−Hill
Companies, 2002

Overview

4. It is difficult for a partnership to raise large amounts of cash. Equity contributions are
usually limited to a partner’s ability and desire to contribute to the partnership. Many
companies, such as Apple Computer, start life as a proprietorship or partnership, but at
some point they choose to convert to corporate form.
5. Income from a partnership is taxed as personal income to the partners.
6. Management control resides with the general partners. Usually a majority vote is required on important matters, such as the amount of profit to be retained in the business.
It is very difficult for large business organizations to exist as sole proprietorships or
partnerships. The main advantage is the cost of getting started. Afterward, the disadvantages, which may become severe, are (1) unlimited liability, (2) limited life of the enterprise, and (3) difficulty of transferring ownership. These three disadvantages lead to (4) the
difficulty of raising cash.

The Corporation
Of the many forms of business enterprises, the corporation is by far the most important. It
is a distinct legal entity. As such, a corporation can have a name and enjoy many of the legal powers of natural persons. For example, corporations can acquire and exchange property. Corporations can enter into contracts and may sue and be sued. For jurisdictional purposes, the corporation is a citizen of its state of incorporation. (It cannot vote, however.)
Starting a corporation is more complicated than starting a proprietorship or partnership. The incorporators must prepare articles of incorporation and a set of bylaws. The articles of incorporation must include the following:
1.
2.

3.
4.

Name of the corporation.
Intended life of the corporation (it may be forever).
Business purpose.
Number of shares of stock that the corporation is authorized to issue, with a statement
of limitations and rights of different classes of shares.
5. Nature of the rights granted to shareholders.
6. Number of members of the initial board of directors.
The bylaws are the rules to be used by the corporation to regulate its own existence, and
they concern its shareholders, directors, and officers. Bylaws range from the briefest possible statement of rules for the corporation’s management to hundreds of pages of text.
In its simplest form, the corporation comprises three sets of distinct interests: the shareholders (the owners), the directors, and the corporation officers (the top management).
Traditionally, the shareholders control the corporation’s direction, policies, and activities.
The shareholders elect a board of directors, who in turn selects top management. Members
of top management serve as corporate officers and manage the operation of the corporation
in the best interest of the shareholders. In closely held corporations with few shareholders
there may be a large overlap among the shareholders, the directors, and the top management. However, in larger corporations the shareholders, directors, and the top management
are likely to be distinct groups.
The potential separation of ownership from management gives the corporation several
advantages over proprietorships and partnerships:
1. Because ownership in a corporation is represented by shares of stock, ownership can be readily transferred to new owners. Because the corporation exists independently of those who
own its shares, there is no limit to the transferability of shares as there is in partnerships.

19


20

Ross−Westerfield−Jaffe:

Corporate Finance, Sixth
Edition

I. Overview

Chapter 1

1. Introduction to Corporate
Finance

Introduction to Corporate Finance

© The McGraw−Hill
Companies, 2002

13

2. The corporation has unlimited life. Because the corporation is separate from its owners,
the death or withdrawal of an owner does not affect its legal existence. The corporation
can continue on after the original owners have withdrawn.
3. The shareholders’ liability is limited to the amount invested in the ownership shares. For
example, if a shareholder purchased $1,000 in shares of a corporation, the potential loss
would be $1,000. In a partnership, a general partner with a $1,000 contribution could
lose the $1,000 plus any other indebtedness of the partnership.
Limited liability, ease of ownership transfer, and perpetual succession are the major advantages of the corporation form of business organization. These give the corporation an
enhanced ability to raise cash.
There is, however, one great disadvantage to incorporation. The federal government
taxes corporate income. This tax is in addition to the personal income tax that shareholders
pay on dividend income they receive. This is double taxation for shareholders when compared to taxation on proprietorships and partnerships.


CASE STUDY:

Making the Decision to Become a Corporation:
The Case of PLM International, Inc.3

I

n 1972, several entrepreneurs agreed to start a company they called PLM (Professional Lease Management, Inc.).Their idea was to sponsor, syndicate, and manage public and private limited partnerships with the purpose of acquiring and leasing transportation equipment.They created an operating subsidiary called FSI (Financial Services, Inc.) to be the general partner of each of the
partnerships. PLM had limited success in its early years, but during the period 1981 to 1986 more
than 27 public partnerships were formed. Each partnership was set up to acquire and lease transportation equipment, such as aircraft, tractors and trailers, cargo containers, and railcars, to transportation companies.
Until the Tax Reform Act of 1986, PLM enjoyed considerable success with its partnerships. It
became one of the largest equipment-leasing firms in the United States.The partnerships appealed
to high-tax-bracket individuals because unlike corporations, partnerships are not taxed. The partnerships were set up to be self-liquidating (i.e., all excess cash flow was to be distributed to the
partners), and no reinvestment could take place. No ready market for the partnership units existed,
and each partnership invested in a narrow class of transportation equipment. PLM’s success depended on creating tax-sheltered cash flow from accelerated depreciation and investment tax credits. However, the 1986 Tax Reform Act had a devastating impact on tax-sheltered limited partnerships. The act substantially flattened personal tax rates, eliminated the investment tax credit,
shortened depreciation schedules, and established an alternative minimum tax rate.The act caused
PLM to think about different types of equipment-leasing organizational forms.What was needed was
an organization form that could take advantage of potential growth and diversification opportunities and that wasn’t based entirely upon tax sheltering.
In 1987 PLM, with the advice and assistance of the now-bankrupt Drexel Burnham Lambert investment banking firm, terminated its partnerships and converted consenting partnerships to a new
umbrella corporation called PLM International.After much legal maneuvering, PLM International publicly announced that a majority of the partnerships had consented to the consolidation and incorporation. (A majority vote was needed for voluntary termination and some partnerships decided not to incorporate.) On February 2, 1988, PLM International’s common stock began trading on the American
Stock Exchange (AMEX) at about $8 per share. However, PLM International did not perform well, despite its conversion to a corporation. In April 2000, its stock was trading at only $5 per share.
3

The S–4 Registration Statement, PLM International, Inc., filed with the Securities and Exchange Commission,
Washington, D.C., August 1987, gives further details.