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Ross
Westerfield
Jaffe

Corporate Finance gets you

Ross • Westerfield • Jaffe

CORPORATE FINANCE

moving in the right direction
Succeed in your corporate finance course with help from this
experienced author team and a text that provides modern
theory and cutting-edge examples in corporate finance.
• New end-of-chapter mini-cases and questions focus on
common company situations that embody important
corporate finance topics.
• Expanded theory and research, including new content on
risk analysis, behavioral finance, and real options capital
budgeting.
MD DALIM 871603 9/17/06 CYAN MAG YELO BLACK

• New problems have been added to the ends of most
chapters.
• New 4-color design.
For more information on the book, its features, and the
supplements package, please see the Preface or visit
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eighth
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CORPORATE FINANCE

ISBN 978-0-07-310590-1
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The McGraw-Hill/Irwin Series in Finance, Insurance, and Real Estate
Stephen A. Ross
Franco Modigliani Professor of Finance and Economics
Sloan School of Management
Massachusetts Institute of Technology
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Corporate Finance
Eighth Edition

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

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

Jeffrey Jaffe
Wharton School of Business
University of Pennsylvania

Boston Burr Ridge, IL Dubuque, IA New York San Francisco St. Louis
Bangkok Bogotá Caracas Kuala Lumpur Lisbon London Madrid Mexico City
Milan Montreal New Delhi Santiago Seoul Singapore Sydney Taipei Toronto

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CORPORATE FINANCE
Published by McGraw-Hill/Irwin, a business unit of The McGraw-Hill Companies, Inc., 1221
Avenue of the Americas, New York, NY, 10020. Copyright © 2008 by The McGraw-Hill Companies, Inc.
All rights reserved. No part of this publication may be reproduced or distributed in any form or by any

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Some ancillaries, including electronic and print components, may not be available to customers outside the United States.
This book is printed on acid-free paper.
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Library of Congress Cataloging-in-Publication Data
Ross, Stephen A.
Corporate finance / Stephen A. Ross, Randolph W. Westerfield, Jeffrey Jaffe. -- 8th ed.
p. cm. -- (The McGraw-Hill/Irwin series in finance, insurance, and real estate)
Includes index.
ISBN-13: 978-0-07-310590-1 (alk. paper)
ISBN-10: 0-07-310590-2 (alk. paper)

1. Corporations--Finance. I. Westerfield, Randolph. II. Jaffe, Jeffrey F., 1946- III. Title.
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About the Authors

STEPHEN A. ROSS Sloan School of Management, Massachusetts Institute of Technology Stephen A. Ross is the Franco Modigliani Professor of Financial Economics at the
Sloan School of Management, Massachusetts Institute of Technology. One of the most
widely published authors in finance and economics, Professor Ross is recognized for his
work in developing the arbitrage pricing theory, as well as for having made substantial contributions to the discipline through his research in signaling, agency theory, option pricing,
and the theory of the term structure of interest rates, among other topics. A past president

of the American Finance Association, he currently serves as an associate editor of several
academic and practitioner journals. He is a trustee of CalTech and Freddie Mac.

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

RANDOLPH W. WESTERFIELD

JEFFREY F. JAFFE Wharton School of Business, University of Pennsylvania Jeffrey
F. Jaffe has been a frequent contributor to the finance and economics literatures in such
journals as the Quarterly Economic Journal, The Journal of Finance, The Journal of Financial and Quantitative Analysis, The Journal of Financial Economics, and The Financial
Analysts Journal. His best-known work concerns insider trading, where he showed both
that corporate insiders earn abnormal profits from their trades and that regulation has little
effect on these profits. He has also made contributions concerning initial public offerings,
regulation of utilities, the behavior of marketmakers, the fluctuation of gold prices, the
theoretical effect of inflation on interest rates, the empirical effect of inflation on capital
asset prices, the relationship between small-capitalization stocks and the January effect,
and the capital structure decision.

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Preface

T

he teaching and the practice 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, private equity and venture capital, and the disappearing dividend. 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 few 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 Eighth Edition
With the eight edition of Corporate Finance, we have done extensive updating and reworking throughout the text. Among the more noticeable changes are opening vignettes
for each chapter. Most of these present familiar companies in situations covered by the
chapter, thereby motivating the discussion. The end-of-chapter material has been expanded
considerably. We now have two separate sets of questions, one that focuses on concepts and
critical ideas and another that is more problem oriented. The total number of questions has
grown significantly. Finally, almost every chapter now ends with a mini-case that places
the student in the position of needing to apply chapter concepts in a common real-world
situation. These cases are suitable for a variety of pedagogical purposes, ranging from
homework to group assignments to in-class discussions.
In addition to these changes and overall updating, a number of chapters have significant new material. Following are some of the more notable additions and upgrades:
Chapter 1:

Expanded discussion of goal of the firm and agency problems. New material
on Sarbanes-Oxley.
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viii


Preface

Chapter 3:
Chapter 5:
Chapter 7:
Chapter 8:
Chapter 9:
Chapter 12:
Chapter 18:
Chapter 19:
Chapter 20:
Chapter 22:
Chapter 27:
Chapter 29:
Chapter 31:

Completely rewritten to cover financial statements analysis and long-term
financial planning.
New discussion of bond price information, including the NASD TRACE
system.
New discussion of alternative definitions of project cash flows.
Reorganized, with improved discussion of decision trees.
New discussion of geometric versus arithmetic returns.
Expanded discussion on actual cost of capital estimation.
New material on several dividend-related subjects.
New material on Dutch auction IPOs.
New material on bond price quotes and make-whole call provisions.
Expanded discussion on applications of options analysis in corporate finance.
New material on financial electronic data interchange and the Check Clearing
Act for the 21st Century.

Completely rewritten with new material on a variety of merger-related
topics.
Completely rewritten for clarity.

We have also worked to improve the supplements to the text, with the goal of providing far and away the most comprehensive student and instructor support at this level. For
example, we now provide fully detailed step-by-step solutions to end-of-chapter problems
(and spreadsheets for each one as well). The testbank has grown significantly in terms of
the number of questions, and we have worked to provide a wider variety of questions and
question types. The PowerPoint set also has grown.
The book’s Online Learning Center (OLC) delivers several new and very rich student
study aids. There is self-study software with at least 100 questions per chapter. Narrated
PowerPoint slides actually talk students through the material. Our Interactive FinSims contain simulations of key finance concepts in which students are asked to provide values for
key variables. These digital assets provide completely new avenues for students to explore
and ways for them to comprehend the subject on a deeper level.
For a complete look at the new and updated eighth edition features, please see the next
section.

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Pedagogy

In this
this edition
edition of
ofCorporate
Corporate Finance,
Finance, we
have updated and improved our features
to present material in a way that makes
it coherent and easy to understand. In
addition, Corporate
Corporate Finance
Finance isis rich
rich in
valuable learning tools and support, to
help students succeed in learning the
fundamentals of financial management.

CHAPTER

10

Return and Risk
The Capital Asset Pricing Model (CAPM)

Chapter Opening
Vignettes
Each chapter begins with a “roadmap” that

describes the objectives of the chapter and
how
it connects with
concepts already learned
Chapter
Opening
in previous chapters. Real company examples
Vignettes
that will be discussed are highlighted in these
Each
chapter begins with a “roadmap” that
sections.
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 these sections.

Expected returns on common stocks can vary quite a
bit. One important determinant is the industry in which a
company operates. For example, according to recent estimates from Ibbotson Associates, the median expected
return for department stores, which includes companies
such as Sears and Kohls, is 11.63 percent, whereas
computer service companies such as Microsoft and
Oracle have a median expected return of 15.46 percent.
Air transportation companies such as Delta and Southwest have a median expected return that is even higher:
17.93 percent.

These estimates raise some obvious questions.
First, why do these industry expected returns differ so

much, and how are these specific numbers calculated?
Also, does the higher return offered by airline stocks
mean that investors should prefer these to, say,
department store stocks? As we will see in this chapter,
the Nobel Prize–winning answers to these questions
form the basis of our modern understanding of risk and
return.

10.1 Individual Securities
In the first part of Chapter 10, we will examine the characteristics of individual securities.
In particular, we will discuss:
1. Expected return: This is the return that an individual expects a stock to earn over the
next period. Of course, because this is only an expectation, the actual return may be
either higher or lower. An individual’s expectation may simply be the average return
per period a security has earned in the past. Alternatively, it may be based on a
detailed analysis of a firm’s prospects, on some computer-based model, or on special
(or inside) information.
2. Variance and standard deviation: There are many ways to assess the volatility of a
security’s return. One of the most common is variance, which is a measure of the
squared deviations of a security’s return from its expected return. Standard deviation
is the square root of the variance.
3. Covariance and correlation: Returns on individual securities are related to one
another. Covariance is a statistic measuring the interrelationship between two
securities. Alternatively, this relationship can be restated in terms of the correlation
between the two securities. Covariance and correlation are building blocks to an
understanding of the beta coefficient.
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Chapter 24 Warrants and Convertibles

Table 24.2
The Case for and
against Convertible
Bonds (CBs)

Convertible bonds
(CBs)
Compared to:
Straight bonds

Common stock

705

If Firm Subsequently
Does Poorly

If Firm Subsequently
Prospers

No conversion because of low
stock price.


Conversion because of high
stock price.

CBs provide cheap financing because coupon rate is lower.

CBs provide expensive financing
because bonds are converted,
which dilutes existing equity.
CBs provide expensive financing CBs provide cheap financing
because firm could have issued
because firm issues stock at
common stock at high prices.
high prices when bonds are
converted.

Summary Compared with equity, the firm is better off having issued convertible debt if
the underlying stock subsequently does well. The firm is worse off having issued convertible debt if the underlying stock subsequently does poorly. We cannot predict future stock
price in an efficient market. Thus, we cannot argue that issuing convertibles is better or
worse than issuing equity. The preceding analysis is summarized in Table 24.2.
Modigliani–Miller (MM) pointed out that, abstracting from taxes and bankruptcy
costs, the firm is indifferent to whether it issues stock or issues debt. The MM relationship
is a quite general one. Their pedagogy could be adjusted to show that the firm is indifferent
to whether it issues convertibles or issues other instruments. To save space (and the patience of students) we have omitted a full-blown proof of MM in a world with convertibles.
However, our results are perfectly consistent with MM. Now we turn to the real-world view
of convertibles.

The “Free Lunch” Story

EXAMPLE 24.4


The preceding discussion suggests that issuing a convertible bond is no better and no worse
than issuing other instruments. Unfortunately, many corporate executives fall into the trap
of arguing that issuing convertible debt is actually better than issuing alternative instruments. This is a free lunch type of explanation, of which we are quite critical.
Are Convertibles Always Better? The stock price of RW Company is $20. Suppose this
company can issue subordinated debentures at 10 percent. It can also issue convertible bonds at
6 percent with a conversion value of $800. The conversion value means that the holders can convert
a convertible bond into 40 (ϭ $800͞$20) shares of common stock.
A company treasurer who believes in free lunches might argue that convertible bonds should
be issued because they represent a cheaper source of financing than either subordinated bonds or
common stock. The treasurer will point out that if the company does poorly and the price does not
rise above $20, the convertible bondholders will not convert the bonds into common stock. In this
case the company will have obtained debt financing at below-market rates by attaching worthless
equity kickers. On the other hand, if the firm does well and the price of its common stock rises to
$25 or above, convertible holders will convert. The company will issue 40 shares. The company will
receive a bond with face value of $1,000 in exchange for issuing 40 shares of common stock, implying a conversion price of $25. The company will have issued common stock at $25 per share, or
20 percent above the $20 common stock price prevailing when the convertible bonds were issued.
This enables it to lower its cost of equity capital. Thus, the treasurer happily points out, regardless
of whether the company does well or poorly, convertible bonds are the cheapest form of financing.
(continued)

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

Examples
Separate called-out examples are integrated throughout
the chapters. Each example illustrates an intuitive or
mathematical application in a step-by-step format. There

is enough detail in the explanations so the student doesn’t
have to look elsewhere for additional information.

Chapter 1 Introduction to Corporate Finance

5

In Their Own Words

“In Their Own Words” Boxes
Located
throughout
the chapters,
this unique
series consists
“In Their
Own
Words”
Boxes

of articles written by distinguished scholars or practitioners
Located throughout the chapters, this unique series consists
about key topics in the text. Boxes include essays by Edward
of articles written by distinguished scholars or practitioners
I. Altman, Anthony Bourdain, Robert S. Hansen, Robert C.
about key topics in the text. Boxes include essays by Edward
Higgins, Michael C. Jensen, Richard M. Levich, Merton Miller,
I. Altman, Anthony Bourdain, Robert S. Hansen, Robert C.
and Jay R. Ritter.
Higgins, Michael C. Jensen, Richard M. Levich, Merton Miller,

and Jay R. Ritter.

SKILLS NEEDED FOR THE CHIEF
FINANCIAL OFFICERS OF
eFINANCE.COM

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

Chief strategist: CFOs will need to use real-time financial
information to make crucial decisions fast.

Chief communicator: Gaining the confidence of Wall
Street and the media will be essential.

Chief deal maker: CFOs must be adept at venture capital, mergers and acquisitions, and strategic partnerships.

SOURCE: BusinessWeek, August 28, 2000, p. 120.

The interplay of the firm’s activities 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 (assets) 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 easy to observe cash flows directly. Much of the information we obtain is in the form of accounting statements, and

h f h
k f fi
i l
l i i
h fl i f
i f
i

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2.2 The Income Statement
The income statement measures performance over a specific period—say a year. The accounting definition of income is:
Revenue Ϫ Expenses ϵ Income

Key Terms
Students will note that important words
are highlighted in boldface type the first
time they appear.

If the balance sheet is like a snapshot, the income statement is like a video recording of
what the people did between two snapshots. Table 2.2 gives the income statement for the
U.S. Composite Corporation for 2007.
The income statement usually includes several sections. The operations section reports

the firm’s revenues and expenses from principal operations. One number of particular importance is earnings before interest and taxes (EBIT), which summarizes earnings before
taxes and financing costs. Among other things, the nonoperating section of the income
statement includes all financing costs, such as interest expense. Usually a second section
reports as a separate item the amount of taxes levied on income. The last item on the
income statement is the bottom line, or net income. Net income is frequently expressed per
share of common stock—that is, earnings per share.
When analyzing an income statement, the financial manager should keep in mind
GAAP, noncash items, time, and costs.

25.5 Interest Rate Futures Contracts
In this section we consider interest rate futures contracts. Our examples deal with futures
contracts on Treasury bonds because of their high popularity. We first price Treasury bonds
and Treasury bond forward contracts. Differences between futures and forward contracts
are explored. Hedging examples are provided next.

Pricing of Treasury Bonds
As mentioned earlier in the text, a Treasury bond pays semiannual interest over its life. In
addition, the face value of the bond is paid at maturity. Consider a 20-year, 8 percent coupon bond that was issued on March 1. The first payment is to occur in six months—that is,
on September 1. The value of the bond can be determined as follows:
Pricing of Treasury Bond
$1,040
$40
$40
$40
$40
________
________
. . . ϩ _________
PTB ϭ ______
ϩ _________

1 ϩ R1 ϩ (1 ϩ R2)2 ϩ (1 ϩ R3)3 ϩ
(1 ϩ R39)39 (1 ϩ R40)40

(25.1)

Because an 8 percent coupon bond pays interest of $80 a year, the semiannual coupon
is $40. Principal and the semiannual coupons are both paid at maturity. As we mentioned in
a previous chapter, the price of the Treasury bond, PTB, is determined by discounting each
payment on a bond at the appropriate spot rate. Because the payments are semiannual, each
spot rate is expressed in semiannual terms. That is, imagine a horizontal term structure
where the effective annual yield is 12 percent for all maturities. Because each spot rate, R,
is expressed in semiannual terms, each spot rate is 1.12 − 1 ϭ 5.83%. Coupon payments

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

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End-of-Chapter Material
The end-of-chapter material reflects and builds upon the


35

concepts learned from the chapter and study features.

go under financing activities, but unfortunately that is not how the accounting is handled.
The reason is that interest is deducted as an expense when net income is computed. As a
consequence, a primary difference between the accounting cash flow and the financial cash
flow of the firm (see Table 2.5) is interest expense.

Summary
and
Conclusions

Summary and Conclusions

Besides introducing you to corporate accounting, the purpose of this chapter has been to teach you
how to determine cash flow from the accounting statements of a typical company.
1. Cash flow is generated by the firm and paid to creditors and shareholders. It can be classified as:
a. Cash flow from operations.
b. Cash flow from changes in fixed assets.
c. Cash flow from changes in working capital.

The summary provides a quick review of key concepts in the chapter.

2. Calculations of cash flow are not difficult, but they require care and particular attention to detail in
properly accounting for noncash expenses such as depreciation and deferred taxes. It is especially
important that you do not confuse cash flow with changes in net working capital and net income.

Questions

and Problems
BASIC
(Questions 1–10)

1.

Liquidity True or false: All assets are liquid at some price. Explain.

2.

Accounting and Cash Flows Why might the revenue and cost figures shown on a standard
income statement not represent the actual cash inflows and outflows that occurred during a
period?

3.

Accounting Statement of Cash Flows Looking at the accounting statement of cash flows,
what does the bottom line number mean? How useful is this number for analyzing a company?

4.

Cash Flows How do financial cash flows and the accounting statement of cash flows differ?
Which is more useful for analyzing a company?

5.

Book Values versus Market Values Under standard accounting rules, it is possible for a
company’s liabilities to exceed its assets. When this occurs, the owners’ equity is negative. Can
this happen with market values? Why or why not?


6.

Cash Flow from Assets Why is it not necessarily bad for the cash flow from assets to be
negative for a particular period?

7.

Operating Cash Flow Why is it not necessarily bad for the operating cash flow to be negative for a particular period?

8.

Net Working Capital and Capital Spending Could a company’s change in net working
capital be negative in a given year? (Hint: Yes.) Explain how this might come about. What
about net capital spending?

9.

Cash Flow to Stockholders and Creditors Could a company’s cash flow to stockholders
be negative in a given year? (Hint: Yes.) Explain how this might come about. What about cash
flow to creditors?

10.

Firm Values Referring back to the CBS Records example at the beginning of the chapter,
note that we suggested that CBS Records’ stockholders probably didn’t suffer as a result of the
reported loss. What do you think was the basis for our conclusion?

1.

Building a Balance Sheet Culligan, Inc., has current assets of $5,000, net fixed assets of

$23,000, current liabilities of $4,300, and long-term debt of $13,000. What is the value of the
shareholders’ equity account for this firm? How much is net working capital?

2.

Building an Income Statement Ragsdale, Inc., has sales of $527,000, costs of $280,000,
depreciation expense of $38,000, interest expense of $15,000, and a tax rate of 35 percent.

Questions and Problems
www.mhhe.com/rwj

Concept
Questions

Because solving problems is so critical to a student’s learning, new
questions and problems have been added, and existing questions
and problems have been revised. All problems have also been
thoroughly reviewed and accuracy-checked.
Problems have been grouped according to level of difficulty with
the levels listed in the margin: Basic, Intermediate, and Challenge.
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.

S&P Problems

S&P
Problems


Included in the end-of-chapter material are problems directly
incorporating the Educational Version of Market Insight, a
service based on Standard & Poor’s renowned Compustat
database. These problems provide you with an easy method
of including current real-world data in your course.

www.mhhe.com/rwj

CHALLENGE
(Questions 15–17)

15. Convertible Calculations You have been hired to value a new 25-year callable, convertible
bond. The bond has a 6.80 percent coupon rate, payable annually. The conversion price is $150,
and the stock currently sells for $44.75. The stock price is expected to grow at 12 percent per
year. The bond is callable at $1,200; but based on prior experience, it won’t be called unless the
conversion value is $1,300. The required return on this bond is 10 percent. What value would
you assign to this bond?
16. Warrant Value Superior Clamps, Inc., has a capital structure consisting of 4 million shares of
common stock and 500,000 warrants. Each warrant gives its owner the right to purchase one
share of newly issued common stock for an exercise price of $20. The warrants are European
and will expire one year from today. The market value of the company’s assets is $88 million,
and the annual variance of the returns on the firm’s assets is 0.04. Treasury bills that mature in
one year yield a continuously compounded interest rate of 7 percent. The company does not
pay a dividend. Use the Black–Scholes model to determine the value of a single warrant.

www.mhhe.com/edumarketinsight
1.

Marginal and Average Tax Rates Download the annual income statements for Sharper

Image (SHRP). Looking back at Table 2.3, what is the marginal income tax rate for Sharper
Image? Using the total income tax and the pretax income numbers, calculate the average tax
rate for Sharper Image. Is this number greater than 35 percent? Why or why not?

2.

Net Working Capital Find the annual balance sheets for American Electric Power (AEP)
and HJ Heinz (HNZ). Calculate the net working capital for each company. Is American Electric Power’s net working capital negative? If so, does this indicate potential financial difficulty
for the company? What about Heinz?

3.

Per Share Earnings and Dividends Find the annual income statements for Harley-Davidson (HDI), Hawaiian Electric Industries (HE), and Time Warner (TWX). What are the earnings
per share (EPS Basic from operations) for each of these companies? What are the dividends
per share for each company? Why do these companies pay out a different portion of income in
the form of dividends?

Excel Problems
Indicated by the Excel icon in the margin, these problems can be
found at the end of almost all chapters. Located on the book’s
Web site (see Online Resources), Excel templates have been
created for each of these problems, where students can use the
data in the problem to work out the solution using Excel skills.

End-of-Chapter Cases
Located at the end of almost every chapter, these mini-cases
focus on common company situations that embody important
corporate finance topics. Each case presents a new scenario,
data, and a dilemma. Several questions at the end of each case
require students to analyze and focus on all of the material

they learned in that chapter.

Mini Case

Chapter 2 Financial Statements and Cash Flow

Cash Flows at Warf Computers, Inc.
Warf Computers, Inc., was founded 15 years ago by Nick Warf, a computer programmer. The
small initial investment to start the company was made by Nick and his friends. Over the years,
this same group has supplied the limited additional investment needed by the company in the
form of both equity and short- and long-term debt. Recently the company has developed a virtual keyboard (VK). The VK uses sophisticated artificial intelligence algorithms that allow the
user to speak naturally and have the computer input the text, correct spelling and grammatical
errors, and format the document according to preset user guidelines. The VK even suggests
alternative phrasing and sentence structure, and it provides detailed stylistic diagnostics. Based
on a proprietary, very advanced software/hardware hybrid technology, the system is a full generation beyond what is currently on the market. To introduce the VK, the company will require
significant outside investment.
Nick has made the decision to seek this outside financing in the form of new equity
investments and bank loans. Naturally, new investors and the banks will require a detailed
financial analysis. Your employer, Angus Jones & Partners, LLC, has asked you to examine the
financial statements provided by Nick. Here are the balance sheet for the two most recent years
and the most recent income statement:

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Comprehensive Teaching
Corporate Finance has many options in terms of the textbook, instructor supplements, student
supplements, and multimedia products. Mix and match to create a package that is perfect for your
course.

Instructor Supplements
Instructor’s CD-ROM ISBN-10: 0-07-325735-4 / ISBN-13: 978-0-07-325735-4
This CD contains all the necessary supplements—Instructor’s Manual, Test Bank, Computerized Test Bank, and
PowerPoint—all in one useful product in an electronic format.
•

Instructor’s Manual
Prepared by Steven Dolvin, Butler University and Joseph Smolira, Belmont University.
This is a great place to find new lecture ideas. The IM has three main sections. The first section contains a chapter
outline and other lecture materials. The annotated outline for each chapter includes lecture tips, real-world tips,
ethics notes, suggested PowerPoint slides, and, when appropriate, a video synopsis. Detailed solutions for all
end-of-chapter problems appear in section two.

•

Test Bank
Prepared by Patricia Ryan, Colorado State University.
Here’s a great format for a better testing process. The Test Bank has well over 100 questions per chapter that closely
link with the text material and provides a variety of question formats (multiple-choice questions/problems and
essay questions) and levels of difficulty (basic, intermediate, and challenge) to meet every instructor’s testing needs.
Problems are detailed enough to make them intuitive for students, and solutions are provided for the instructor.

•


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

•

PowerPoint Presentation System
Prepared by Steven Dolvin, Butler University.
Customize our content for your course. This presentation has been thoroughly revised to include more lectureoriented slides, as well as exhibits and examples both from the book and from outside sources. Applicable
slides have Web links that take you directly to specific Internet sites, or a spreadsheet link to show an example
in Excel. You can also go to the Notes Page function for more tips on presenting the slides. If you already
have PowerPoint installed on your PC, you can edit, print, or rearrange the complete presentation to meet your
specific needs.

Solutions Manual ISBN-10: 0-07-325737-0 / ISBN-13: 978-0-07-325737-2
Prepared by Joseph Smolira, Belmont University.
This manual contains detailed, worked-out solutions for all of the problems in the end-of-chapter material. It has also
been reviewed for accuracy by multiple sources. The Solutions Manual is also available for purchase by your students.
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and Learning Package
Videos ISBN-10: 0-07-326174-2 / ISBN-13: 978-0-07-326174-4

Now available in DVD format: a current set of videos about hot topics! McGraw-Hill/Irwin has produced a series
of finance videos that are 10-minute case studies of topics such as financial markets, careers, rightsizing, capital
budgeting, EVA (economic value added), mergers and acquisitions, and foreign exchange. Discussion questions for
these videos, as well as video clips, are available in the Instructor’s Center at www.mhhe.com/rwj.

Digital Solutions
Online Learning Center (OLC): Online Support at www.mhhe.com/rwj
The Online Learning Center (OLC) contains FREE access to additional Web-based study and teaching aids created
for this text, such as the following.

Student Support
•

New! Self-Study Software
With this self-study program, students can test their knowledge of one chapter or a number of chapters by using
self-grading questions written specifically for this text. There are at least 100 questions per chapter. Students
can set a timer function to simulate a test environment, or they can choose to have answers pop up as they finish
each question. Questions were prepared by Kay Johnson, Penn State University–Erie.

•

New! Narrated PowerPoint Examples
Created by Kay Johnson, Penn State University–Erie, exclusively for students. Each chapter’s slides follow the
chapter topics and provide steps and explanations showing how to solve key problems. Because each student
learns differently, a quick click on each slide will “talk through” its contents with you!

•

New! Interactive FinSims
Created by Eric Sandburg, Interactive Media, each module highlights a key concept of the book and simulates

how to solve its problems, asking the student to input certain variables. This hands-on approach guides students
through difficult and important corporate finance topics.

•

Excel Templates
Corresponding to most end-of-chapter problems, each template allows the student to work through the problem
using Excel. Each end-of-chapter problem with a template is indicated by an Excel icon in the margin beside it.

•

More
Be sure to check out the other helpful features on the OLC, including links to Corporate Finance Online study
problems, and Finance around the World.

Teaching Support
Along with having access to all of the same material your students can view on the book’s OLC, you also have passwordprotected access to the Instructor’s Manual, solutions to end-of-chapter problems, Instructor’s PowerPoint, Excel
Template Solutions, video clips, video projects and questions, and teaching notes to Corporate Finance Online.
OLCs can be delivered in multiple ways—through the textbook Web site (www.mhhe.com/rwj), through
PageOut, or within a course management system like Blackboard, WebCT, TopClass, or eCollege. Ask your campus
representative for more details.
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Standard & Poor’s Educational Version of Market Insight
McGraw-Hill/Irwin and the Institutional Market Services division of Standard & Poor’s are pleased to announce
an exclusive partnership that offers instructors and students FREE access to the educational version of Standard &
Poor’s Market Insight with each new textbook. The educational version of Market Insight is a rich online resource
that provides six years of fundamental financial data for over 1,000 companies in the database. S&P–specific
problems can be found at the end of almost all chapters in this text and ask students to solve a problem by using
research found on this site. For more details, please see the bound-in card inside the front cover of this text or visit
www.mhhe.com/edumarketinsight.

Corporate Finance Online
As part of the OLC, instructors and students will also have access to Corporate Finance Online, found on the
opening page. Corporate Finance Online is an exclusive Web tool from McGraw-Hill/Irwin. The site provides over
54 exercises for 27 key corporate finance topics, allowing students to complete challenging exercises and discussion
questions that draw on recent articles, company reports, government data, and other Web-based resources. For
instructors there are also password-protected teaching notes to assist with classroom integration of the material.

PageOut at www.pageout.net
FREE to adopters, this Web page generation software is designed to help you create your own course Web site
without hassle. In just a few minutes even the most novice computer user can have a functioning course Web site.
Simply type your material into the template provided and PageOut instantly converts it to HTML. Next, choose
your favorite of three easy-to-navigate designs and your class Web home page is created, complete with online
syllabus, lecture notes, and bookmarks. You can even include a separate instructor page and an assignment page.
PageOut offers enhanced point-and-click features, including a Syllabus Page that applies a real-world link to
original text material, an automatic grade book, and a discussion board where you and your students can exchange
questions and post announcements. Ask your campus representative to show you a demo.

Options Available for Purchase & Packaging
You may also package either version of the text with a variety of additional learning tools that are available for
your students.


Student Problem Manual ISBN-10: 0-07-326173-4 / ISBN-13: 978-0-07-326173-7
Prepared 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 can be packaged with this text.

Solutions Manual
ISBN-10: 0-07-325737-0 / ISBN-13: 978-0-07-325737-2
Prepared by Joseph Smolira, Belmont University.
This manual contains detailed, worked-out solutions for all of the problems in the end-of-chapter material. It has
also been reviewed for accuracy by multiple sources. The Solutions Manual is also available for purchase by your
students.
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The Wall Street Journal
If you order this package, your students can subscribe to The Wall Street Journal—both print and online versions—
for 15 weeks at a specially priced rate of $20.00 in addition to the price of the text. Students will receive a “How to
Use the WSJ” handbook plus a card explaining how to start the subscription to both versions.

BusinessWeek
Your students can subscribe to 15 weeks of BusinessWeek for a specially priced rate of $8.25 in addition to the price
of the text. Students will receive a pass-code card shrink-wrapped with their new text. The card directs students

to a Web site where they enter the code and then gain access to BusinessWeek’s registration page to enter address
information and set up their print and online subscriptions.

Financial Times
Your students can subscribe to the Financial Times for 15 weeks at a specially priced rate of $10 in addition to the
price of the text by ordering this special package. Students will receive a subscription card shrink-wrapped with
their new text to fill in and send to the Financial Times to start receiving their subscription. Instructors, once you
order, make sure you contact your sales representative to receive a complimentary one-year subscription.

Excel Applications for Corporate Finance
ISBN-10: 0-07-298072-9 / ISBN-13: 978-0-07-298072-1
By Troy Adair, University of Michigan–Ann Arbor; can be packaged with the text at a discounted price.
This supplement teaches students how to build financial models in Excel and shows students how to use these
models to solve a variety of common corporate finance problems. For more information about this supplement,
visit www.mhhe.com/adair1e.

FinGame Online 4.0 ISBN-10: 0-07-292219-2 / ISBN-13: 978-0-07-292219-6
By LeRoy Brooks, John Carroll University.
Just $15.00 when packaged with this text. In this comprehensive simulation game, students control a hypothetical
company over numerous periods of operation. The game is now tied to the text by exercises found at the Online
Learning Center. As students make major financial and operating decisions for their company, they will develop
and enhance skills in financial management and financial accounting statement analysis.
Financial Analysis with an Electronic Calculator, Sixth Edition
ISBN-10: 0-07-321709-3 / ISBN-13: 978-0-07-321709-3
By Mark A.White, University of Virginia, McIntire School of Commerce.
The information and procedures in this supplementary text enable students to master the use of financial calculators
and develop a working knowledge of financial mathematics and problem solving. Complete instructions are included
for solving all major problem types on three popular models: HP 10-B and 12-C, TI BA II Plus, and TI-84. Handson problems with detailed solutions allow students to practice the skills outlined in the text and obtain instant
reinforcement. Financial Analysis with an Electronic Calculator is a self-contained supplement to the introductory
financial management course.


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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
Eighth Edition. Contributors to this edition include the following:
Janet Hamilton
Portland State University

Thomas Legg
University of Minnesota

Edward Morris
Lindenwood University

Robert Hauswald
American University

Joseph Meredith
Elon University

Betty Simkins

Oklahoma State University

Robert Krell
George Mason University

Vassil Mihov
Texas Christian University

Robert Wood
Tennessee Tech University

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:
R. Aggarwal
John Carroll University

William O. Brown
Claremont McKenna College

William Damon
Vanderbilt University

Christopher Anderson
University of Missouri–Columbia

Kirt Butler
Michigan State University

Sudip Datta
Bentley College


James J. Angel
Georgetown University

Bill Callahan
Southern Methodist University

Anand Desai
University of Florida

Nasser Arshadi
University of Missouri–St. Louis

Steven Carvell
Cornell University

Miranda Lam Detzler
University of Massachusetts–Boston

Kevin Bahr
Indudeep S. Chhachhi
University of Wisconsin–Milwaukee Western Kentucky University

David Distad
University of California–Berkeley

Robert Balik
Western Michigan University

Andreas Christofi

Monmouth University

Dennis Draper
University of Southern California

John W. Ballantine
Babson College

Jeffrey L. Coles
Arizona State University

Jean-Francois Dreyfus
New York University

Thomas Bankston
Angelo State University

Mark Copper
Wayne State University

Gene Drzycimski
University of Wisconsin–Oshkosh

Brad Barber
University of California–Davis

James Cotter
University of Iowa

Robert Duvic

The University of Texas at Austin

Michael Barry
Boston College

Jay Coughenour
University of Massachusetts–Boston

Demissew Ejara
University of Massachusetts–Boston

Swati Bhatt
Rutgers University

Arnold Cowan
Iowa State University

Roger Bolton
Williams College

Raymond Cox
Central Michigan University

Gordon Bonner
University of Delaware

John Crockett
George Mason University

Oswald Bowlin

Texas Technical University

Mark Cross
Louisiana Technical University

Robert Eldridge
Fairfield University
Gary Emery
University of Oklahoma
Theodore Eytan
City University of New York–Baruch
College

Ronald Braswell
Florida State University

Ron Crowe
Jacksonville University

Don Fehrs
University of Notre Dame
Steven Ferraro
Pepperdine University

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Acknowledgments

Andrew Fields
University of Delaware
Paige Fields
Texas A&M
Adlai Fisher
New York University
Michael Fishman
Northwestern University
Yee-Tien Fu
Stanford University
Bruno Gerard
University of Southern California
Frank Ghannadian
Mercer University–Atlanta

Prem Jain
Tulane University
Narayanan Jayaraman
Georgia Institute of Technology
Brad Jordan
University of Kentucky
Jarl Kallberg
New York University
Jonathan Karpoff
University of Washington


Dennis Logue
Dartmouth College
Michael Long
Rutgers University
Yulong Ma
Cal State–Long Beach
Ileen Malitz
Fairleigh Dickinson University
Terry Maness
Baylor University
Surendra Mansinghka
San Francisco State University
Michael Mazzco
Michigan State University

Michael Goldstein
University of Colorado

Paul Keat
American Graduate School of
International Management

Indra Guertler
Babson College

Dolly King
University of Wisconsin–Milwaukee

Hugh McLaughlin
Bentley College


James Haltiner
College of William and Mary

Brian Kluger
University of Cincinnati

Larry Merville
University of Texas–Richardson

Delvin Hawley
University of Mississippi

Narayana Kocherlakota
University of Iowa

Joe Messina
San Francisco State University

Hal Heaton
Brigham Young University

Ronald Kudla
The University of Akron

John A. Helmuth
University of Michigan–Dearborn

Youngsik Kwak
Delaware State University


Roger Mesznik
City College of New York–Baruch
College

John Helmuth
Rochester Institute of Technology

Nelson Lacey
University of Massachusetts

Michael Hemler
University of Notre Dame

Gene Lai
University of Rhode Island

Stephen Heston
Washington University

Josef Lakonishok
University of Illinois

Andrea Heuson
University of Miami

Dennis Lasser
State University of New York–
Binghamton


Edith Hotchkiss
Boston College
Charles Hu
Claremont McKenna College
Hugh Hunter
Eastern Washington University
James Jackson
Oklahoma State University

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Raymond Jackson
University of Massachusetts–
Dartmouth

xix

Paul Laux
Case Western Reserve University
Bong-Su Lee
University of Minnesota
Youngho Lee
Howard University
James T. Lindley
University of Southern Mississippi

Robert I. McDonald
Northwestern University

Rick Meyer

University of South Florida
Richard Miller
Wesleyan University
Naval Modani
University of Central Florida
Richard Mull
New Mexico State University
Jim Musumeci
Southern Illinois University–
Carbondale
Robert Nachtmann
University of Pittsburgh
Edward Nelling
Georgia Tech
Gregory Niehaus
University of South Carolina

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xx

Acknowledgments

Peder Nielsen
Oregon State University

Stuart Rosenstein
East Carolina University


Ernest Swift
Georgia State University

Ingmar Nyman
Hunter College

Bruce Rubin
Old Dominion University

Alex Tang
Morgan State University

Dennis Officer
University of Kentucky

Patricia Ryan
Drake University

Richard Taylor
Arkansas State University

Joseph Ogden
State University of New York

Jaime Sabal
New York University

Andrew C. Thompson
Virginia Polytechnic Institute


Venky Panchapagesan
Washington University–St. Louis

Anthony Sanders
Ohio State University

Timothy Thompson
Northwestern University

Bulent Parker
University of Wisconsin–Madison

Andy Saporoschenko
University of Akron

Karin Thorburn
Dartmouth College

Ajay Patel
University of Missouri–Columbia

William Sartoris
Indiana University

Dilip Kumar Patro
Rutgers University

James Schallheim
University of Utah


Satish Thosar
University of Massachusetts–
Dorchester

Gary Patterson
University of South Florida

Mary Jean Scheuer
California State University at
Northridge

Glenn N. Pettengill
Emporia State University
Pegaret Pichler
University of Maryland
Christo Pirinsky
Ohio State University
Jeffrey Pontiff
University of Washington
Franklin Potts
Baylor University
Annette Poulsen
University of Georgia
N. Prabhala
Yale University
Mao Qiu
University of Utah–Salt Lake City
Latha Ramchand
University of Houston

Gabriel Ramirez
Virginia Commonwealth University
Narendar Rao
Northeastern Illinois University
Steven Raymar
Indiana University

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

Faruk Selcuk
University of Bridgeport

Oscar Varela
University of New Orleans

Lemma Senbet
University of Maryland

Steven Venti
Dartmouth College

Kuldeep Shastri
University of Pittsburgh

Avinash Verma

Washington University

Sudhir Singh
Frostburg State University

Lankford Walker
Eastern Illinois University

Scott Smart
Indiana University

Ralph Walkling
Ohio State University

Jackie So
Southern Illinois University

F. Katherine Warne
Southern Bell College

John Stansfield
Columbia College

Susan White
University of Texas–Austin

John S. Strong
College of William and Mary

Robert Whitelaw

New York University

A. Charlene Sullivan
Purdue University

Berry Wilson
Georgetown University

Michael Sullivan
University of Nevada–Las Vegas

Thomas Zorn
University of Nebraska–Lincoln

Timothy Sullivan
Bentley College

Kent Zumwalt
Colorado State University

R. Bruce Swensen
Adelphi University

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Acknowledgments

xxi


For their help on the Eighth Edition, we would like to thank Linda De Angelo, Dennis
Draper, Kim Dietrich, Harry De Angelo, Aris Protopapadakis, Suh-Pyng Ku, and Mark
Westerfield all of the Marshall School of Business at the University of Southern California;
Jordan Strauss Esq.; Stephen Dolvin, Butler University, for his work on the Instructor’s
Manual and PowerPoint; Patricia Ryan, Colorado State University, for her work on the Test
Bank; Robert Hanson, Eastern Michigan University, for his work on the Student Problem
Manual; Joe Smolira, Belmont University, for his work on the solutions and text; and Kay
Johnson, Penn State University–Erie, for her work on the self-study software and narrated
Student PowerPoint. We also owe a debt of gratitude to Bradford D. Jordan of the University
of Kentucky; Edward I. Altman of New York University; Robert S. Hansen of Virginia
Tech; and Jay R. Ritter of the University of Florida, who have provided several thoughtful
comments and immeasurable help.
We thank Allissa Day, Hinh Khieu, Pankaj Maskara, and Theodore Phillips, Jr., for their
extensive proofing and problem-checking efforts.
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 Eighth Edition. We want to ensure that all future editions are
error-free—and therefore we 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.
Many talented professionals at McGraw-Hill/Irwin have contributed to the development
of Corporate Finance, Eighth Edition. We would especially like to thank Michele Janicek,
Jennifer Rizzi, Julie Phifer, Christine Vaughan, Kami Carter, Gina Hangos, Jennifer Wilson,
and Beckey Szura.
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

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Brief Contents
18

PA R T I
Overview
Financial Statements and Cash Flow

3

Financial Statements Analysis
and Long-Term Planning 43

510

PA R T V
Long-Term Financing

1 Introduction to Corporate Finance 1
2

Dividends and Other Payouts


21

19

Issuing Securities to the Public

20

Long-Term Debt

21

Leasing

549

580

606

P A R T II
Valuation and Capital Budgeting P A R T VI
4 Discounted Cash Flow Valuation 89
Options, Futures,
5 How to Value Bonds and Stocks 129
and Corporate Finance
6 Net Present Value and Other Investment Rules 161
7


Making Capital Investment Decisions

8

Risk Analysis, Real Options,
and Capital Budgeting 229

PA R T
Risk
9

197

III

Risk and Return: Lessons from Market History

256

22

Options and Corporate Finance

630

23

Options and Corporate Finance: Extensions
and Applications 671


24

Warrants and Convertibles

25

Derivatives and Hedging Risk

695
714

P A R T VII
Short-Term Finance

10

Return and Risk: The Capital Asset Pricing
Model (CAPM) 279

11

An Alternative View of Risk and Return:
The Arbitrage Pricing Theory 320

27 Cash Management 771

12

Risk, Cost of Capital, and Capital Budgeting 342


28 Credit Management 795

26

Short-Term Finance and Planning

P A R T IV
Capital Structure
and Dividend Policy

P A R T VIII
Special Topics

13

30

Financial Distress

31

International Corporate Finance

745

29 Mergers and Acquisitions 812

Corporate Financing Decisions and Efficient
Capital Markets 368


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 488

853
867

405
Appendix A: Mathematical Tables

423
455

895

Appendix B: Solutions to Selected End-of-Chapter
Problems 905

Name Index

909

Subject Index 911

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Contents
PA R T

I

2.4
2.5
2.6

Overview

Chapter 1
Introduction to Corporate Finance
1.1


1.2

1.3

1.4

1.5

What Is Corporate Finance?
The Balance Sheet Model of the Firm
Capital Structure
The Financial Manager
The Corporate Firm
The Sole Proprietorship
The Partnership
The Corporation
A Corporation by Another Name . . .
The Goal of Financial Management
Possible Goals
The Goal of Financial Management
A More General Goal
The Agency Problem and Control
of the Corporation
Agency Relationships
Management Goals
Do Managers Act in the Stockholders’ Interests?
Stakeholders
Financial Markets
The Primary Market: New Issues
Secondary Markets

Exchange Trading of Listed Stocks
Listing
Summary and Conclusions
Concept Questions
S&P Problems

1
1
1
3
3
7
7
8
9
10
11
11
12
12
13
13
13
14
15
15
16
16
17
17

19
19
20

Financial Statements Analysis
and Long-Term Planning
3.1

3.2

3.3

3.4

Chapter 2
2.1

2.2

2.3

The Balance Sheet
Liquidity
Debt versus Equity
Value versus Cost
The Income Statement
Generally Accepted Accounting Principles
Noncash Items
Time and Costs
Taxes

Corporate Tax Rates
Average versus Marginal Tax Rates

21
22
23
23
24
25
25
26
26
27
27

29
29
32
33
33
33
35
35
35
40

Chapter 3

3.5


Financial Statements and Cash Flow 21

Net Working Capital
Financial Cash Flow
The Accounting Statement of Cash Flows
Cash Flow from Operating Activities
Cash Flow from Investing Activities
Cash Flow from Financing Activities
Summary and Conclusions
Concept Questions
Questions and Problems
S&P Problems

3.6

3.7

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

Using Financial Statement Information
Choosing a Benchmark
Problems with Financial Statement Analysis
Long-Term Financial Planning
A Simple Financial Planning Model
The Percentage of Sales Approach
External Financing and Growth
EFN and Growth
Financial Policy and Growth
A Note about Sustainable Growth
Rate Calculations
Some Caveats Regarding Financial
Planning Models
Summary and Conclusions
Concept Questions
Questions and Problems
S&P Problems

43
43
43
44
45
45
47
49
50
52
53
54

54
57
58
58
63
64
64
66
70
70
73
76
77
79
79
80
86

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xxiv

Contents


PA R T

II Valuation and

5.6

Capital Budgeting
Chapter 4
Discounted Cash Flow Valuation

89

4.1
4.2

89
93
93
96
97
101
102

4.3

4.4

4.5

Valuation: The One-Period Case

The Multiperiod Case
Future Value and Compounding
The Power of Compounding: A Digression
Present Value and Discounting
The Algebraic Formula
Compounding Periods
Distinction between Stated Annual
Interest Rate and Effective Annual Rate
Compounding over Many Years
Continuous Compounding
Simplifications
Perpetuity
Growing Perpetuity
Annuity
Growing Annuity
What Is a Firm Worth?
Summary and Conclusions
Concept Questions
Questions and Problems
S&P Problems

104
104
105
106
107
108
110
115
116

117
118
119
127

Growth Opportunities
Growth in Earnings and Dividends
versus Growth Opportunities
Dividends or Earnings: Which to Discount?
The No-Dividend Firm
5.7 The Dividend Growth Model
and the NPVGO Model
The Dividend Growth Model
The NPVGO Model
Summation
5.8 Price–Earnings Ratio
5.9 Stock Market Reporting
Summary and Conclusions
Concept Questions
Questions and Problems
S&P Problems
Appendix 5A The Term Structure of
Interest Rates, Spot Rates,
and Yield to Maturity

5.1
5.2

5.3


5.4

5.5

Definition and Example of a Bond
How to Value Bonds
Pure Discount Bonds
Level Coupon Bonds
Consols
Bond Concepts
Interest Rates and Bond Prices
Yield to Maturity
Bond Market Reporting
The Present Value of Common Stocks
Dividends versus Capital Gains
Valuation of Different Types of Stocks
Estimates of Parameters in the Dividend
Growth Model
Where Does g Come From?
Where Does R Come From?
A Healthy Sense of Skepticism

Net Present Value and Other
Investment Rules
6.1
6.2

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129
129
129
130
132
133
133
134
134
136
136
137
140
141
142
143

146
146
147
147
148
148
149
150
151
153
154
154
159


160

Chapter 6

Chapter 5
How to Value Bonds and Stocks

144

6.3
6.4

6.5
6.6

6.7
6.8

Why Use Net Present Value?
The Payback Period Method
Defining the Rule
Problems with the Payback Method
Managerial Perspective
Summary of Payback
The Discounted Payback Period Method
The Average Accounting Return Method
Defining the Rule
Analyzing the Average Accounting
Return Method

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

161
161
163
163
164
165
166
166
166
166
168
169
171
171
171
175

180
180
181
181
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