Preface ix

efficiency. This concept is crucial to interpreting a stock’s valuation; it also provides a framework for the later treatment of the issues that arise when firms issue securities or make decisions concerning dividends or capital structure.

The remaining chapters of Part 2 are concerned with the company’s investment decision. In Chapter 8 we introduce the concept of net present value and show how to calculate the NPV of a simple investment project. We then consider more com- plex investment proposals, including choices between alternative projects, machine replacement decisions, and decisions of when to invest. We also look at other mea- sures of an investment’s attractiveness—its internal rate of return, payback period, and profitability index. We show how the profitability index can be used to choose between investment projects when capital is scarce. The appendix to Chapter 8 shows how to sidestep some of the pitfalls of the IRR rule.

The first step in any NPV calculation is to decide what to discount. Therefore, in Chapter 9 we work through a realistic example of a capital budgeting analysis, show- ing how the manager needs to recognize the investment in working capital and how taxes and depreciation affect cash flows.

We start Chapter 10 by looking at how companies organize the investment process and ensure everyone works toward a common goal. We then go on to look at various techniques to help managers identify the key assumptions in their estimates, such as sensitivity analysis, scenario analysis, and break-even analysis. We explain the dis- tinction between accounting break-even and NPV break-even. We conclude the chap- ter by describing how managers try to build future flexibility into projects so that they can capitalize on good luck and mitigate the consequences of bad luck.

Part 3 (Risk)  is concerned with the cost of capital. Chapter 11 starts with a historical survey of returns on bonds and stocks and goes on to distinguish between the specific risk and market risk of individual stocks. Chapter 12 shows how to measure market risk and discusses the relationship between risk and expected return. Chapter 13 intro- duces the weighted-average cost of capital and provides a practical illustration of how to estimate it.

Part 4 (Financing)  begins our discussion of the financing decision. Chapter 14 pro- vides an overview of the securities that firms issue and their relative importance as sources of finance. In Chapter 15 we look at how firms issue securities, and we follow a firm from its first need for venture capital, through its initial public offering, to its continuing need to raise debt or equity.

Part 5 (Debt and Payout Policy)  focuses on the two classic long-term financing decisions. In Chapter 16 we ask how much the firm should borrow, and we summa- rize bankruptcy procedures that occur when firms can’t pay their debts. In Chapter 17 we study how firms should set dividend and payout policy. In each case we start with Modigliani and Miller’s (MM’s) observation that in well-functioning markets the decision should not matter, but we use this observation to help the reader understand why financial managers in practice do pay attention to these decisions.

Part 6 (Financial Analysis and Planning)  starts with long-term financial plan- ning in Chapter 18, where we look at how the financial manager considers the combined effects of investment and financing decisions on the firm as a whole. We also show how measures of internal and sustainable growth help managers check that the firm’s planned growth is consistent with its financing plans. Chapter 19 is an introduction to short-term financial planning. It shows how managers ensure that the firm will have enough cash to pay its bills over the coming year, and describes the principal sources of short-term borrowing. Chapter 20 addresses working capital management. It describes the basic steps of credit management, the principles of inventory management, and how firms handle payments efficiently and put cash to work as quickly as possible.

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x Preface

Part 7 (Special Topics)   covers several important but somewhat more advanced topics—mergers (Chapter 21), international financial management (Chapter 22), options (Chapter 23), and risk management (Chapter 24). Some of these topics are touched on in earlier chapters. For example, we introduce the idea of options in Chapter 10, when we show how companies build flexibility into capital projects. How- ever, Chapter 23 generalizes this material, explains at an elementary level how options are valued, and provides some examples of why the financial manager needs to be concerned about options. International finance is also not confined to Chapter 22. As one might expect from a book that is written by an international group of authors, examples from different countries and financial systems are scattered throughout the book. However, Chapter 22 tackles the specific problems that arise when a corpora- tion is confronted by different currencies.

Part 8 (Conclusion)   contains a concluding chapter (Chapter 25), in which we review the most important ideas covered in the text. We also introduce some interest- ing questions that either were unanswered in the text or are still puzzles to the finance profession. Thus the last chapter is an introduction to future finance courses as well as a conclusion to this one.

Routes through the Book There are about as many effective ways to organize a course in corporate finance as there are teachers. For this reason, we have ensured that the text is modular, so that topics can be introduced in different sequences.

We like to discuss the principles of valuation before plunging into financial plan- ning. Nevertheless, we recognize that many instructors will prefer to move directly from Chapter 4 (Measuring Corporate Performance) to Chapter 18 (Long-Term Finan- cial Planning) in order to provide a gentler transition from the typical prerequisite accounting course. We have made sure that Part 6 (Financial Analysis and Planning) can easily follow Part 1.

Similarly, we like to discuss working capital after the student is familiar with the basic principles of valuation and financing, but we recognize that here also many instructors prefer to reverse our order. There should be no difficulty in taking Chapter 20 out of order.

When we discuss project valuation in Part 2, we stress that the opportunity cost of capital depends on project risk. But we do not discuss how to measure risk or how return and risk are linked until Part 3. This ordering can easily be modified. For exam- ple, the chapters on risk and return can be introduced before, after, or midway through the material on project valuation.

Changes in the Eighth Edition Users of previous editions of this book will not find dramatic changes in either the material or the ordering of topics. But throughout we have made the book more up to date and easier to read. Here are some of the ways that we have done this.

Beyond the Page  The biggest change in this edition is the introduction of Beyond the Page digital extensions and applications. These digital extensions are not, as they may sound, false fingernails; they are additional examples, spreadsheet programs, and opportunities to explore topics in more depth. This material is very easily accessed on the web. For example, it is seamlessly available with a click on the e-versions of the book, but it is also readily accessible in the traditional hard copy of the text using either QR codes from a smartphone or shortcut URLs, both provided in the margins of relevant pages.

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Preface xi

Improving the Flow  A major part of our effort in revising this text was spent on improving the flow. Often this has meant a word change here or a redrawn diagram there, but sometimes we have made more substantial changes. Consider, for example, Chapter 1, where we have made three significant changes. First, we have included a completely rewritten section on corporate governance and agency issues. We empha- size that you need a good system of corporate governance to ensure that managers maximize value. Second, discussions of ethical issues often focus on the egregiously improper and illegal actions, but for honest financial managers the important problems are the gray areas. We have therefore addressed three topics for which there are no easy answers—the role of corporate raiders, short-selling, and tax avoidance. Finally, students tackling finance for the first time need some broad understanding of what the subject is all about. We therefore conclude Chapter 1 with a review of the big themes.

Updating  Of course, in each new edition we try to ensure that any statistics are as up to date as possible. For example, since the previous edition, we have available an extra 3 years of data on security returns. These show up in the figures in Chapter 11 of the long-run returns on stocks, bonds, and bills. Measures of EVA, data on security ownership, dividend payments, and stock repurchases are just a few of the other cases where data have been brought up to date.

Recent Events  We discussed the financial crisis of 2007–2009 in the previous edi- tion, but we have now been able to expand the discussion to include the spillover to the crisis in the eurozone and to introduce the Dodd-Frank Act. The eurozone crisis was also a reminder that government debt is not risk-free. We come back to that issue in Chapter 6 when we discuss default risk.

Concepts  There are several places where we have introduced new conceptual mate- rial. For example, students who have learned about the dividend discount model are often confused about how to value the many companies that also repurchase their stock. We introduce the issue in Chapter 13, and in Chapter 17 we explain how to value these companies. The growth in repurchases has also changed the way that we think about the dividend controversy. We have therefore substantially rewritten Chapter 17 to focus on the trade-off between dividends and repurchases. We have also added a final section that discusses how the payout decision changes over the life cycle of the firm.

New Illustrative Boxes  The text contains a number of boxes with illustrative real- world examples. Many of these are new. Look, for example, at the box in Chapter 15 that discusses the Facebook IPO or the box about how WobbleWorks used crowd- funding to finance its 3Doodler project.

More Worked Examples  We have added more worked examples in the text, many of them taken from real companies. For instance, when we discuss company valuation in Chapter 7, we show how to value the Cape Wind power project in Nantucket Sound.

New Calculator and Spreadsheet Boxes  We have reworked the explanations of how to use calculators or spreadsheets to solve financial problems. We now have separate subsections that show how they can be used to solve single-cash-flow and multiple-cash-flow problems. We think that this better integrates the material into the rest of the chapter and is easier for the student to follow.

Specific Chapter Changes in the Eighth Edition Chapter 1 contains an expanded discussion of agency issues, including additions

on corporate raiders, creative accounting, tax avoidance, and “say on pay.”

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xii Preface

Chapter 2 includes an additional discussion of the fi nancial crisis and its spillover to the sovereign debt crisis in the eurozone.

Chapter 3 introduces free cash fl ow in the discussion of accounting and fi nance and includes updated discussions of accounting malfeasance and the conver- gence of GAAP and IFRS accounting standards.

Chapter 5 has a reorganized and integrated discussion of calculators and spread- sheets.

Chapter 6 now includes an overview of the determinants of bond default risk in the discussion of credit spreads.

Chapter 7 contains an integrated discussion of sustainable growth in the develop- ment of the dividend growth model, includes a new box on Facebook’s IPO, and explains how to best deal with stock repurchases when using the dividend discount model.

Chapter 8 features an enhanced explanation of why mutually exclusive invest- ments are central to almost all real-life investment decisions and how that affects the capital budgeting decision.

Chapter 10 includes updated examples of real options and explains how those op- tions are integrated into a fi rm’s longer-term strategic considerations.

Chapter 11 introduces a simple derivation of the investment opportunity frontier and demonstrates the role of correlation in assessing the potential for an invest- ment to reduce risk through portfolio diversifi cation.

Chapter 12 contains a new discussion of how the index model can be used to measure and distinguish between systematic and diversifi able risks using an ex- tended example comparing the risks of mutual funds and individual stocks. The discussion also introduces key issues in performance evaluation, for example, the appropriate way to trade off average return versus risk.

Chapter 13 includes clarifi cations on real-world procedures used when computing the weighted-average cost of capital.

Chapter 14 features an extended treatment of corporate governance, particularly the composition of the board of directors.

Chapter 15 introduces alternative fundraising methods for start-ups, such as crowdsourcing.

Chapter 16 clarifi es the practical implications of Miller and Modigliani for debt policy and introduces new material on assessing the present value of tax shields associated with debt.

Chapter 17 contains a fully revamped treatment of the information content of div- idends as well the trade-offs governing the use of dividends versus repurchases.

Chapter 19 includes a closer integration of the analysis of sources and uses of funds with the fi rm’s statement of cash fl ows.

Chapter 21 features numerous updates to refl ect mergers that have taken place in recent years.

Chapter 23 presents a new treatment of the VIX contract and its use as a “fear index.”

Chapter 24 includes a new discussion of a practical issue in risk management— banks that have lost hundreds of millions after “rogue traders” made large but unauthorized trades.

Assurance of Learning Assurance of learning is an important element of many accreditation standards. Fun- damentals of Corporate Finance, Eighth Edition, is designed specifically to support your assurance-of-learning initiatives. Each chapter in the book begins with a list of numbered learning objectives, which are referred to in the end-of-chapter problems and exercises. Every test bank question is also linked to one of these objectives, in addition to level of difficulty, topic area, Bloom’s Taxonomy level, and AACSB skill area. Connect, McGraw-Hill’s online homework solution, and EZ Test, McGraw-Hill’s

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Preface xiii

easy-to-use test bank software, can search the test bank by these and other categories, providing an engine for targeted assurance-of-learning analysis and assessment.

AACSB Statement McGraw-Hill Education is a proud corporate member of AACSB International. Understanding the importance and value of AACSB accreditation, Fundamentals of Corporate Finance, Eighth Edition, has sought to recognize the curricula guidelines detailed in the AACSB standards for business accreditation by connecting selected questions in the test bank to the general knowledge and skill guidelines found in the AACSB standards.

The statements contained in Fundamentals of Corporate Finance, Eighth Edition, are provided only as a guide for the users of this text. The AACSB leaves content coverage and assessment within the purview of individual schools, the mission of the school, and the faculty. While Fundamentals of Corporate Finance, Eighth Edition, and the teaching package make no claim of any specific AACSB qualification or eval- uation, we have, within the test bank, labeled selected questions according to the six general knowledge and skills areas.

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N Key Features

New and Enhanced Pedagogy A great deal of effort has gone into expanding and enhancing the features in Fundamentals of Corporate Finance.

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Chapter Opener Each chapter begins with a chapter narrative to help set the tone for the material that follows. Learn- ing Objectives are also included to provide a quick introduction to the material students will learn and should understand fully before mov- ing to the next chapter.

Brealey / Myers / Marcus Your guide through the challenging landscape of corporate finance

The Time Value of Money 5 CHAPTE


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5.5 Level Cash Flows: Perpetuities and Annuities Frequently, you may need to value a stream of equal cash flows. For example, a home mortgage might require the homeowner to make equal monthly payments for the life of the loan. For a 30-year loan, this would result in 360 equal payments. A 4-year car loan might require 48 equal monthly payments. Any such sequence of equally spaced, level cash flows is called an annuity . If the payment stream lasts forever, it is called a perpetuity .

How to Value Perpetuities Some time ago the British government borrowed by issuing loans known as consols. Consols are perpetuities. In other words, instead of repaying these loans, the British government pays the investors a fixed annual payment in perpetuity (forever).

How might we value such a security? Suppose that you could invest $100 at an interest rate of 10%. You would earn annual interest of .10  ×  $100  =  $10 per year and

annuity Level stream of cash flows at regular intervals with a finite maturity.

perpetuity Stream of level cash payments that never ends.

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Key Terms in the Margin Key terms are presented in bold and defined in the margin as they are introduced. A glossary is also avail- able at the back of the book.

Example 5.8 Winning Big at the Lottery In May 2013 an 84-year-old Florida woman invested $10 in five Powerball lottery tickets and won a record $590.5 million. We suspect that she received unsolicited congratulations, good wishes, and requests for money from dozens of more or less worthy charities, relations, and newly devoted friends. In response, she could fairly point out that the prize wasn’t really worth $590.5 million. That sum was to be paid in 30 equal annual installments of $19.683 million each. Assuming that the first pay- ment occurred at the end of 1 year, what was the present value of the prize? The interest rate at the time was about 3.6%.

The present value of these payments is simply the sum of the present values of each annual payment. But rather than valuing the payments separately, it is much easier to treat them as a 30-year annuity. To value this annuity, we simply multiply $19.683 million by the 30-year annuity factor:

PV = 19.683 × 30-year annuity factor

= 19.683 × c1 r –

1 r (1 + r)30

d At an interest rate of 3.6%, the annuity factor is

c 1 .036

– 1

.036(1.036)30 d = 18.1638

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Numbered Examples Numbered and titled examples are integrated in each chapter. Students can learn how to solve specific problems step-by-step as well as gain insight into general principles by seeing how they are applied to answer concrete questions and scenarios.

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Y What makes Fundamentals of Corporate Finance such a powerful learning tool?

Spreadsheet Solutions Boxes These boxes provide the student with detailed examples of how to use Excel spreadsheets when applying financial con- cepts. The boxes include questions that apply to the spreadsheet, and their solutions are given at the end of the applicable chapter. Denoted by an icon, these spreadsheets are available in Connect.

The DATE function in Excel, which we use for both the settlement and maturity dates, uses the format DATE(year, month,day).

Notice that the coupon rate and yield to maturity are expressed as decimals, not percentages. In most cases, redemption value will be 100 (i.e., 100% of face value), and the resulting price will be expressed as a percent of face value. Occasionally, however, you may encounter bonds that pay off at a premium or discount to face value. One example would be callable bonds, which give the company the right to buy back the bonds at a premium before maturity.

The value of the bond assuming annual coupon payments is 120.556% of face value, or $1,205.56. If we wanted to assume semiannual coupon payments, as in Example 6.1, we would simply change the entry in cell B10 to 2 (see col- umn D), and the bond value would change to 120.574% of face value, as we found in that example.

Excel and most other spreadsheet programs provide built-in functions to compute bond values and yields. They typically ask you to input both the date you buy the bond (called the settlement date ) and the maturity date of the bond.

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