Corporate finance - eBook PDF

Visit to download the full and correct content document:

https://ebooksecure.com/download/corporate-finance-ebook-pdf-2/
Corporate Finance
The McGraw-Hill Education Series in Finance, Insurance, and Real Estate
FINANCIAL MANAGEMENT Ross, Westerfield, and Jordan Saunders and Cornett
Essentials of Corporate Finance Financial Markets and Institutions
Block, Hirt, and Danielsen Ninth Edition Seventh Edition
Foundations of Financial Management
Seventeenth Edition Ross, Westerfield, and Jordan
Fundamentals of Corporate Finance INTERNATIONAL FINANCE
Brealey, Myers, and Allen Twelfth Edition
Principles of Corporate Finance Eun and Resnick
Twelfth Edition Shefrin International Financial Management
Behavioral Corporate Finance: Decisions That Eighth Edition
Brealey, Myers, and Allen Create Value
Principles of Corporate Finance, Concise Second Edition REAL ESTATE
Second Edition
Brueggeman and Fisher
Brealey, Myers, and Marcus INVESTMENTS Real Estate Finance and Investments
Fundamentals of Corporate Finance Sixteenth Edition
Ninth Edition Bodie, Kane, and Marcus
Essentials of Investments Ling and Archer
Brooks Eleventh Edition Real Estate Principles: A Value Approach
FinGame Online 5.0 Fifth Edition
Bodie, Kane, and Marcus
Bruner, Eades, and Schill Investments
Case Studies in Finance: Managing for Corporate Eleventh Edition FINANCIAL PLANNING
Value Creation AND INSURANCE
Eighth Edition Hirt and Block
Fundamentals of Investment Management Allen, Melone, Rosenbloom, and Mahoney
Cornett, Adair, and Nofsinger Tenth Edition Retirement Plans: 401(k)s, IRAs, and Other Deferred
Finance: Applications and Theory Compensation Approaches
Fourth Edition Jordan, Miller, and Dolvin
Fundamentals of Investments: Valuation Twelfth Edition
Cornett, Adair, and Nofsinger and Management Altfest
M: Finance Eighth Edition Personal Financial Planning
Fourth Edition Second Edition
Stewart, Piros, and Heisler
DeMello Running Money: Professional Portfolio Harrington and Niehaus
Cases in Finance Management Risk Management and Insurance
Third Edition First Edition Second Edition
Grinblatt (editor) Sundaram and Das Kapoor, Dlabay, Hughes, and Hart
Stephen A. Ross, Mentor: Influence through Generations Derivatives: Principles and Practice Focus on Personal Finance: An Active Approach to Help
Grinblatt and Titman Second Edition You Achieve Financial Literacy
Financial Markets and Corporate Strategy Sixth Edition
Second Edition FINANCIAL INSTITUTIONS
Kapoor, Dlabay, Hughes, and Hart
Higgins AND MARKETS Personal Finance
Analysis for Financial Management Rose and Hudgins Twelfth Edition
Twelfth Edition Bank Management and Financial Services Walker and Walker
Ross, Westerfield, Jaffe, and Jordan Ninth Edition Personal Finance: Building Your Future
Corporate Finance Rose and Marquis Second Edition
Twelfth Edition Financial Institutions and Markets
Ross, Westerfield, Jaffe, and Jordan Eleventh Edition
Corporate Finance: Core Principles and Saunders and Cornett
Applications Financial Institutions Management: A Risk Management
Fifth Edition Approach
Ninth Edition
Corporate Finance
TWELFTH EDITION

Stephen A. Ross

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

Jeffrey Jaffe
Wharton School of Business
University of Pennsylvania

Bradford D. Jordan
Gatton College of Business and Economics
University of Kentucky
 CORPORATE FINANCE

Published by McGraw-Hill Education, 2 Penn Plaza, New York, NY 10121. Copyright ©2019 by McGraw-Hill
Education. All rights reserved. Printed in the United States of America. 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 the
prior written consent of McGraw-Hill Education, including, but not limited to, in any network or other electronic
storage or transmission, or broadcast for distance learning.

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.

1 2 3 4 5 6 7 8 9 LWI 21 20 19 18

ISBN 978-1-260-09187-8
MHID 1-260-09187-2

Cover Image: ©Bahadir Yeniceri/Shutterstock

All credits appearing on page or at the end of the book are considered to be an extension of the copyright page.

The Internet addresses listed in the text were accurate at the time of publication. The inclusion of a website does
not indicate an endorsement by the authors or McGraw-Hill Education, and McGraw-Hill Education does not
guarantee the accuracy of the information presented at these sites.

mheducation.com/highered

ros91872_fm_ISE_iv.indd 4 9/8/18 2:48 PM

 To Stephen A. Ross and family
Our great friend, colleague, and coauthor Steve Ross passed away on
March 3, 2017, while we were working on this edition of Corporate
Finance. Steve’s influence on our textbook is seminal, deep, and
enduring, and we will miss him greatly. On the foundation of Steve’s
lasting and invaluable contributions, we pledge to continue our efforts
to provide the best possible textbook for today—and tomorrow.

R.W.W. J.F.J B.D.J.

This page intentionally left blank
About the Authors

STEPHEN A. ROSS Sloan School of Management, Massachusetts Institute of Technology

Stephen A. Ross was the Franco Modigliani Professor of Finance and Economics at the
Sloan School of Management, Massachusetts Institute of Technology. One of the most
widely published authors in finance and economics, Professor Ross was widely recognized
for his work in developing the Arbitrage Pricing Theory and his 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 also served as an associate editor of several academic
and practitioner journals. He was a trustee of CalTech. He died suddenly in March of 2017.

RANDOLPH W. WESTERFIELD 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 Emeritus.
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 the Board of Trustees of Oak Tree Capital Mutual Funds.
His areas of expertise include corporate financial policy, investment management, and
stock market price behavior.

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 jour-
nals 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 corpo-
rate insiders earn abnormal profits from their trades and that regulation has little effect on
these profits. He also has made contributions concerning initial public offerings, regulation
of utilities, the behavior of market makers, 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.

BRADFORD D. JORDAN Gatton College of Business and Economics, University of Kentucky

Bradford D. Jordan is Professor of Finance and holder of the duPont Endowed Chair
in Banking and Financial Services. He has a long-standing interest in both applied and
theoretical issues in corporate finance and has extensive experience teaching all levels of
corporate finance and financial management policy. Professor Jordan has published numer-
ous articles on issues such as cost of capital, capital structure, and the behavior of security
prices. He is a past president of the Southern Finance Association and is coauthor of
Fundamentals of Investments: Valuation and Management, 8th edition, a leading investments
text, also published by McGraw-Hill Education.

vii
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 announce-
ments in the financial press about takeovers, junk bonds, financial restructuring, initial
public offerings, bankruptcies, and derivatives. In addition, there are the new recognitions
of “real” options, private equity and venture capital, subprime mortgages, bailouts, and
credit spreads. As we have learned in the recent global credit crisis and stock market col-
lapse, 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 have placed 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 con-
temporary examples. Increasingly, many of these examples are outside the United States.
All too often, the beginning student views corporate finance as a collection of unre-
lated topics that are unified largely because they are bound together between the covers of
one book. We want our book to embody and reflect the main principle of finance: Namely,
good financial decisions will add value to the firm and to shareholders and bad financial
decisions will destroy value. The key to understanding how value is added or destroyed is
cash flows. To add value, firms must generate more cash than they use. We hope this simple
principle is manifest in all parts of this book.

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 knowl-
edge of these areas is not essential. The only mathematics prerequisite is basic algebra.

New to 12th Edition

THE TAX CUTS AND JOBS ACT (TCJA) IS INCORPORATED THROUGHOUT
There are six primary areas of change and they will be reflected in the 12th edition:
1. Corporate tax. The new, flat-rate 21 percent corporate rate is discussed and compared
to the old progressive system. The new rate is used throughout the text in examples
and problems. Entities other than C corporations still face progressive taxation, so the
discussion of marginal versus average tax rates remains relevant and is retained.

viii
 2. Bonus depreciation. For a limited time, businesses can take a 100 percent deprecia-
tion charge the first year for most non-real estate, MACRS-qualified investments. This
“bonus depreciation” ends in a few years and MACRS returns, so the MACRS mate-
rial remains relevant and is retained. The impact of bonus depreciation is illustrated in
various problems.
3. Limitations on interest deductions. The amount of interest that may be deducted for
tax purposes is limited. Interest that cannot be deducted can be carried forward to
future tax years (but not carried back; see next).
4. Carrybacks. Net operating loss (NOL) carrybacks have been eliminated and NOL
carryforward deductions are limited in any one tax year.
5. Dividends-received tax break. The tax break on dividends received by a corporation has
been reduced, meaning that the portion subject to taxation has increased.
6. Repatriation. The distinction between U.S. and non-U.S. profits essentially has been
eliminated. All “overseas” assets, both liquid and illiquid, are subject to a one-time
“deemed” tax.
With the 12th edition, we’ve also included coverage of
●● Inversions.

●● Negative interest rates.

●● NYSE market operations.

●● Direct listings and cryptocurrency initial coin offerings (ICOs).

●● Regulation CF.

●● Brexit.

●● Repatriation.

●● Changes in lease accounting.

In addition, each chapter has been updated and, where relevant, “internationalized.” We try
to capture the excitement of corporate finance with current examples, chapter vignettes,
and openers. Spreadsheet applications are spread throughout.

ix
 Students—study more efficiently, retain more
and achieve better outcomes. Instructors—focus
on what you love—teaching.

SUCCESSFUL SEMESTERS INCLUDE CONNECT

For Instructors
You’re in the driver’s seat.
Want to build your own course? No problem. Prefer to use our
turnkey, prebuilt course? Easy. Want to make changes throughout the
65%
Less Time
semester? Sure. And you’ll save time with Connect’s auto-grading too.
Grading

They’ll thank you for it.

Adaptive study resources like SmartBook® help your
students be better prepared in less time. You can
transform your class time from dull definitions to dynamic
debates. Hear from your peers about the benefits of
Connect at www.mheducation.com/highered/connect

Make it simple, make it affordable.

Connect makes it easy with seamless integration using any of the
major Learning Management Systems—Blackboard®, Canvas,
and D2L, among others—to let you organize your course in one
convenient location. Give your students access to digital materials
at a discount with our inclusive access program. Ask your
McGraw-Hill representative for more information.

©Hill Street Studios/Tobin Rogers/Blend Images LLC

Solutions for your challenges.
A product isn’t a solution. Real solutions are affordable,
reliable, and come with training and ongoing support
when you need it and how you want it. Our Customer
Experience Group can also help you troubleshoot
tech problems—although Connect’s 99% uptime
means you might not need to call them. See for
yourself at status.mheducation.com
 For Students
Effective, efficient studying.
Connect helps you be more productive with your
study time and get better grades using tools like
SmartBook, which highlights key concepts and creates
a personalized study plan. Connect sets you up for
success, so you walk into class with confidence and
walk out with better grades.
©Shutterstock/wavebreakmedia

Study anytime, anywhere.

“ I really liked this app—it
made it easy to study when
Download the free ReadAnywhere app and access your
online eBook when it’s convenient, even if you’re offline.
you don't have your textbook And since the app automatically syncs with your eBook in
in front of you.
”
- Jordan Cunningham,
Connect, all of your notes are available every time you open
it. Find out more at www.mheducation.com/readanywhere

Eastern Washington University

No surprises.
The Connect Calendar and Reports
tools keep you on track with the 13 14
work you need to get done and
your assignment scores. Life gets Chapter 12 Quiz Chapter 11 Quiz
busy; Connect tools help you keep
Chapter 13 Evidence of Evolution Chapter 11 DNA Technology
learning through it all.
Chapter 7 Quiz
Chapter 7 DNA Structure and Gene...
and 7 more...

Learning for everyone.

McGraw-Hill works directly with Accessibility Services
Departments and faculty to meet the learning needs of all
students. Please contact your Accessibility Services office
and ask them to email accessibility@mheducation.com, or
visit www.mheducation.com/about/accessibility.html for
more information.
Pedagogy

In this edition of Corporate 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 Finance is rich in valuable learning tools and support to help students
succeed in learning the fundamentals of financial management.

Chapter Opening Vignettes

Each chapter begins with a contemporary vignette that highlights the concepts in
the chapter and their relevance to real-world examples.

10 PART III: RISK

Lessons from Market History

With the S&P 500 Index returning about 19 percent and
the NASDAQ Composite Index up about 28 percent in
2017, stock market performance overall was very good.
In particular, investors in biopharmaceutical company
Madrigal Pharmaceuticals, Inc., had to be happy about the
These examples show that there were tremendous
potential profits to be made during 2017, but there was
also the risk of losing money—and lots of it. So what
should you, as a stock market investor, expect when you
invest your own money? In this chapter, we study more

ExcelMaster Icons
516 percent gain in that stock and investors in genomic than eight decades of market history to find out.
therapy company Sangamo Therapeutics had to feel pretty
good following that company’s 438 percent gain. Of
Please visit us at rwjcorporatefinance.blogspot.com for
course, not all stocks increased in value during the year.
Stock in Sears Holdings fell 61 percent during the year and
the latest developments in the world of corporate finance.
Topics covered in the comprehensive
stock in Under Armour dropped 48 percent.
ExcelMaster supplement (in Connect) are
indicated by ALLOCATED
an icon in the margin.
172 ■■■ PART II Valuation and Capital Budgeting

COSTS
Frequently a particular expenditure benefits a number of projects. Accountants allocate
10.1 Returns this cost across the different projects when determining income. However, for capital
budgeting purposes, this allocated cost should be viewed as a cash outflow of a project
only if it is an incremental cost of the project.
DOLLAR RETURNS
EXAMPLE
Excel Suppose the Video Concept Company has several thousand shares of stock outstanding 6.5 Allocated Costs The Voetmann Consulting Corp. devotes one wing of its suite of offices to a
Master and you are a shareholder. Further suppose that you purchased some of the shares of library requiring a cash outflow of $100,000 a year in upkeep. A proposed capital budgeting
coverage online project is expected to generate revenue equal to 5 percent of the overall firm’s sales. An
stock in the company at the beginning of the year; it is now year-end and you want to executive at the firm, David Pedersen, argues that $5,000 (= .05 × $100,000) should be viewed
figure out how well you have done on your investment. The return you get on an invest- as the proposed project’s share of the library’s costs. Is this appropriate for capital budgeting?
The answer is no. One must ask what the difference is between the cash flows of the entire
ment in stocks, like that in bonds or any other investment, comes in two forms. firm with the project and the cash flows of the entire firm without the project. The firm will spend
$100,000 on library upkeep whether or not the proposed project is accepted. Because accep-
As the owner of stock in the Video Concept Company, you are a part owner of the
How did the market tance of the proposed project does not affect this cash flow, the cash flow should be ignored

do today? Find out at company. If the company is profitable, it generally could distribute some of its profits to
finance.yahoo.com. the shareholders. Therefore, as the owner of shares of stock, you could receive some cash,
called a dividend, during the year. This cash is the income component of your return. In
addition to the dividends, the other part of your return is the capital gain—or, if it is nega-
tive, the capital loss (negative capital gain)—on the investment.
For example, suppose we are considering the cash flows of the investment in
coverage online
Figure 10.1, showing that you purchased 100 shares of stock at the beginning of the year
at a price of $37 per share. Your total investment, then, was:
C0 = $37 × 100 = $3,700
299
when calculating the NPV of the project. Suppose the project has a positive NPV without the
allocated costs but is rejected because of the allocated costs. In this case, the firm is losing
potential value that it could have gained otherwise.
6.2 The Baldwin Company: An Example
Excel We next consider the example of a proposed investment in machinery and related items.
Master Our example involves the Baldwin Company and colored bowling balls.
The Baldwin Company, originally established 16 years ago to make footballs, is now
a leading producer of tennis balls, baseballs, footballs, and golf balls. Nine years ago, the
company introduced “High Flite,” its first line of high-performance golf balls. Baldwin
management has sought opportunities in whatever businesses seem to have some potential
for cash flow. Recently W. C. Meadows, vice president of the Baldwin Company, identi-
fied another segment of the sports ball market that looked promising and that he felt was
not adequately served by larger manufacturers. That market was for brightly colored bowl-
ing balls, and he believed many bowlers valued appearance and style above performance.
He also believed that it would be difficult for competitors to take advantage of the oppor-
tunity because of both Baldwin’s cost advantages and its highly developed marketing skills.
As a result, the Baldwin Company investigated the marketing potential of brightly
colored bowling balls. Baldwin sent a questionnaire to consumers in three markets: Phila-
delphia, Los Angeles, and New Haven. The results of the three questionnaires were much
better than expected and supported the conclusion that the brightly colored bowling balls
could achieve a 10 to 15 percent share of the market. Of course, some people at Baldwin
complained about the cost of the test marketing, which was $250,000. (As we shall see
later, this is a sunk cost and should not be included in project evaluation.)
In any case, the Baldwin Company is now considering investing in a machine to
produce bowling balls. The bowling balls would be manufactured in a warehouse owned
by the firm and located near Los Angeles. This warehouse, which is vacant, and the land
can be sold for $150,000 after taxes.
Working with his staff, Meadows is preparing an analysis of the proposed new prod-
uct. He summarizes his assumptions as follows: The cost of the bowling ball machine is
$100,000 and it is expected to last five years. At the end of five years, the machine will be

xii
 240 ■■■ PART II Valuation and Capital Budgeting

Figure 8.2
Interest Rate Risk
and Time to Maturity

2,000
$1,768.62

30-year bond

Bond value ($)

1,500

$1,047.62 1-year bond

1,000 278 ■■■ PART II Valuation and Capital Budgeting
$916.67

500 $502.11
Figures and Tables
In this case, total return works out to be:
R = $1/$20 + .10
= .05 + .10
This text makes extensive use of real data and
= .15, or 15%
This stock has an expected return of 15 percent.
5 10
Interest rate (%)
15 20
presents them
We can verify in various
this answer figures
by calculating the and
price in one year, Ptables. Ex-
, using 15 percent
1
as the required expected return. Because the dividend expected to be received in one year
Value of a Bond with a 10 Percent Coupon Rate for Different Interest Rates and Maturities
planations in the
is $1 and the expected growth narrative,
rate of dividends isexamples, andexpected
10 percent, the dividend end-to
Time to Maturity be received in two years, D , is $1.10. Based on the dividend growth model, the stock
of-chapter problems will refer to many of these
2
Interest Rate 1 Year 30 Years price in one year will be:
5% $1,047.62 $1,768.62
P = D /(R − g)
10
15
1,000.00
956.52
1,000.00
671.70
exhibits. 1 2
= $1.10/(.15 − .10)
20 916.67 502.11 = $1.10/.05
= $22
Notice that this $22 is $20 × 1.1, so the stock price has grown by 10 percent, as it should.
This means the capital gains yield is 10 percent, which equals the growth rate in dividends.
What is the investor’s total expected return? If you pay $20 for the stock today, you
tells us that a relatively small change in interest rates will lead to a substantial change will get a $1 dividend at the end of the year, and you will have a $22 − 20 = $2 gain.
in the bond’s value. In comparison, the 1-year bond’s price is relatively insensitive to Your dividend yield is $1/$20 = .05, or 5 percent. Your capital gains yield is $2/$20 =
interest rate changes. .10, or 10 percent, so your total expected return would be 5 percent + 10 percent = 15
Intuitively, shorter-term bonds have less interest rate sensitivity because the $1,000 percent, as we calculated above.
face amount is received so quickly. The present value of this amount isn’t greatly affected To get a feel for actual numbers in this context, consider that, according to the 2017
by a small change in interest rates if the amount is received in, say, one year. However, Value Line Investment Survey, Procter & Gamble’s dividends were expected to grow by
even a small change in the interest rate, once compounded for, say, 30 years, can have a 6.5 percent over the next 5 or so years, compared to a historical growth rate of 6.0 percent
significant effect on present value. As a result, the present value of the face amount will over the preceding 5 years and 8.5 percent over the preceding 10 years. In 2017, the
be much more volatile with a longer-term bond. projected dividend for the coming year was given as $2.85. The stock price at that time
The other thing to know about interest rate risk is that, like many things in finance was $94.40 per share. What is the expected return investors require on P&G? Here, the
and economics, it increases at a decreasing rate. A 10-year bond has much greater interest dividend yield is 3.0 (= $2.85/$94.40) percent and the capital gains yield is 6.5 percent,
rate risk than a 1-year bond has. However, a 30-year bond has only slightly greater interest giving a total required return of 9.5 percent on P&G stock.
rate risk than a 10-year bond.
The reason that bonds with lower coupons have greater interest rate risk is essen-EXAMPLE
tially the same. As we discussed earlier, the value of a bond depends on the present
Examples
value of both its coupons and its face amount. If two bonds with different coupon
rates have the same maturity, the value of the lower-coupon bond is proportionately
9.5 Calculating the Required Return Pagemaster Enterprises, the company examined in
Example 9.4, has 1,000,000 shares of stock outstanding. The stock is selling at $10. What is the
required return on the stock?
more dependent on the face amount to be received at maturity. As a result, its value The payout ratio is the ratio of dividends/earnings. Because Pagemaster’s retention ratio is
Separate called-out examples are integrated
will fluctuate more as interest rates change. Put another way, the bond with the higher 40 percent, the payout ratio, which is 1 – Retention ratio, is 60 percent. Recall both that Page-
master reported earnings of $2,000,000 and that the firm’s growth rate is 6.4 percent.
throughout the chapters. Each example Earnings a year from now will be $2,128,000 (= $2,000,000 × 1.064), implying that divi-
dends will be $1,276,800 (= .60 × $2,128,000). Dividends per share will be $1.28
illustrates an intuitive or mathematical ap- (= $1,276,800/1,000,000). Given that g = .064, we calculate R from Equation 9.9 as follows:
$1.28
.192 = ______ + .064
plication in a step-by-step format. There is $10.00

enough detail in the explanations so stu-

A HEALTHY SENSE OF SKEPTICISM
dents don’t have to look elsewhere for It is important to emphasize that our approach merely estimates g; our approach does
not determine g precisely. We mentioned earlier that our estimate of g is based on a
additional information. number of assumptions. We assumed that the return on reinvestment of future retained

In Their Own Words

ROBERT C. HIGGINS ON SUSTAINABLE
GROWTH
Most financial officers know intuitively that it takes
money to make money. Rapid sales growth requires
increased assets in the form of accounts receivable,
inventory, and fixed plant, which, in turn, require money
to pay for assets. They also know that if their company
does not have the money when needed, it can literally
be what to do with all the cash that keeps piling up in
the till.
Bankers also find the sustainable growth equation
useful for explaining to financially inexperienced small
business owners and overly optimistic entrepreneurs
that, for the long-run viability of their business, it is nec-
essary to keep growth and profitability in proper
balance.
Finally, comparison of actual to sustainable growth

“In Their Own Words” Boxes

“grow broke.” The sustainable growth equation states
these intuitive truths explicitly.
Sustainable growth is often used by bankers and other
external analysts to assess a company’s creditworthiness.
They are aided in this exercise by several sophisticated
computer software packages that provide detailed analy-
ses of the company’s past financial performance, includ-
ing its annual sustainable growth rate.
Bankers use this information in several ways. Quick
comparison of a company’s actual growth rate to its sus-
tainable rate tells the banker what issues will be at the
top of management’s financial agenda. If actual growth
consistently exceeds sustainable growth, management’s
problem will be where to get the cash to finance growth.
The banker thus can anticipate interest in loan products.
Conversely, if sustainable growth consistently exceeds
actual, the banker had best be prepared to talk about
investment products because management’s problem will
rates helps a banker understand why a loan applicant
needs money and for how long the need might continue.
In one instance, a loan applicant requested $100,000 to
pay off several insistent suppliers and promised to repay
in a few months when he collected some accounts receiv- Located throughout the chapters, this unique se-
able that were coming due. A sustainable growth analysis
revealed that the firm had been growing at four to six
times its sustainable growth rate and that this pattern
ries consists of articles written by distinguished
was likely to continue in the foreseeable future. This
alerted the banker that impatient suppliers were only a
scholars or practitioners about key topics in the
symptom of the much more fundamental disease of
overly rapid growth, and that a $100,000 loan would text. Boxes include essays by Edward I. Altman,
likely prove to be only the down payment on a much
larger, multiyear commitment. Robert S. Hansen, Robert C. Higgins, Michael C.
SOURCE: Robert C. Higgins is the Marguerite Reimers Professor of
Finance, Emeritus, at the Foster School of Business at the University of Jensen, Merton Miller, and Jay R. Ritter.
Washington. He pioneered the use of sustainable growth as a tool for
financial analysis.

xiii
3.6 Some Caveats Regarding Financial
Planning Models
Financial planning models do not always ask the right questions. A primary reason is that
 CHAPTER 4 Discounted Cash Flow Valuation ■■■ 97

Spreadsheet Applications SPREADSHEET APPLICATIONS

Using a Spreadsheet for Time Value of Money Calculations

Now integrated into select chapters, Spread- More and more, businesspeople from many different areas (not only finance and accounting) rely on spread-
sheets to do all the different types of calculations that come up in the real world. In this section, we will
sheet Applications boxes reintroduce students show you how to use a spreadsheet to handle the various time value of money problems we present in this
chapter. We will use Microsoft Excel™, but the commands are similar for other types of software. We assume
to Excel, demonstrating how to set up spread- you are already familiar with basic spreadsheet operations.
As we have seen, you can solve for any one

sheets in order to analyze common financial of the following four potential unknowns: future
value, present value, the discount rate, or the num-
To Find Enter This Formula

ber of periods. The box at right lists formulas that Future value = FV (rate,nper,pmt,pv)
problems—a vital part of every business stu- can be used in Excel to solve for each input in the
Present value
Discount rate
= PV (rate,nper,pmt,fv)
= RATE (nper,pmt,pv,fv)
time value of money equation. Number of periods = NPER (rate,pmt,pv,fv)
dent’s education. (For even more spreadsheet In these formulas, pv and fv are present value
and future value, nper is the number of periods,

example problems, check out ExcelMaster and rate is the discount, or interest, rate.
Two things are a little tricky here. First, unlike a financial calculator, the spreadsheet requires that the rate
be entered as a decimal. Second, as with most financial calculators, you have to put a negative sign on
in Connect). either the present value or the future value to solve for the rate or the number of periods. For the same
reason, if you solve for a present value, the answer will have a negative sign unless you input a negative
22 ■■■ PART I Overview
future value. The same is true when you compute a future value.
To illustrate how you might use these formulas, we will go back to an example in the chapter. If you invest
the least liquid kind of assets. Tangible fixed assets include property, plant, and equipment. $25,000 at 12 percent per year, how long until you have $50,000? You might set up a spreadsheet like this:
Annual and
quarterly financial These assets do not convert to cash from normal business activity, and they are not usu-
A B C D E F G H
statements for ally used to pay expenses such as payroll.
1
most public U.S. Some fixed assets are intangible. Intangible assets have no physical existence but can be 2 Using a spreadsheet for time value of money calculations
corporations can be very valuable. Examples of intangible assets are the value of a trademark or the value of a pat- 3
found in the EDGAR
ent. The more liquid a firm’s assets, the less likely the firm is to experience problems meeting 4 If we invest $25,000 at 12 percent, how long until we have $50,000? We need to solve
database at 5 for the unknown number of periods, so we use the formula NPER(rate,pmt,pv,fv).
www.sec.gov. short-term obligations. The probability that a firm will avoid financial distress can be linked to
6
the firm’s liquidity. Unfortunately, liquid assets frequently have lower rates of return than fixed 7 Present value (pv): $25,000
assets; for example, cash generates no investment income. To the extent a firm invests in liquid 8 Future value (fv): $50,000
assets, it sacrifices an opportunity to invest in potentially more profitable investment vehicles. 9 Rate (rate): .12
10
11 Periods: 6.1162554
DEBT VERSUS EQUITY 12
13 The formula entered in cell B11 is =NPER(B9,0,-B7,B8); notice that pmt is zero and that pv
Liabilities are obligations of the firm that require a payout of cash within a stipulated period.
14 has a negative sign on it. Also notice that rate is entered as a decimal, not a percentage.
Many liabilities involve contractual obligations to repay a stated amount plus interest over
a period. Liabilities are debts and are frequently associated with fixed cash burdens, called
debt service, that put the firm in default of a contract if they are not paid. Stockholders’ equity
is a claim against the firm’s assets that is residual and not fixed. In general terms, when the EXAMPLE
firm borrows, it gives the bondholders first claim on the firm’s cash flow.1 Bondholders can 4.9 Waiting for Godot You’ve been saving up to buy the Godot Company. The total cost will be
sue the firm if the firm defaults on its bond contracts. This may lead the firm to declare $10 million. You currently have about $2.3 million. If you can earn 5 percent on your money,
itself bankrupt. Stockholders’ equity is the difference between assets and liabilities: how long will you have to wait? At 16 percent, how long must you wait?
At 5 percent, you’ll have to wait a long time. From the present value equation:
Assets − Liabilities ≡ Stockholders’ equity
$2.3 million = $10 million/1.05t
This is the stockholders’ share in the firm stated in accounting terms. The accounting 1.05t = 4.35
CHAPTER 25 Derivatives and Hedging Risk ■■■ 771
value of stockholders’ equity increases when retained earnings are added. This occurs t ≅ 30 years
when the firm retains part of its earnings instead of paying them out as dividends. At 16 percent, things are a little better. Verify for yourself that it will take about 10 years.
Moon Chemical. Because there is a crude oil futures contract for every month, selecting the
correct futures contract is not difficult. Many other commodities have only five contracts per
VALUE VERSUS COST
The home page year, frequently necessitating buying contracts one month away from the month of production.
for the Financial The accounting value of a firm’s assets is frequently referred to as the carrying value or
Explanatory Website Links
Accounting As mentioned earlier,
the book Moon
value Chemical
of the assets.is2 interested in hedging
Under generally the risk
accepted of fluctuating
accounting oil
principles (GAAP),
Standards Board
prices because it cannot pass any cost increases on to the consumer. Suppose, alternatively, 3
audited financial statements of firms in the United States carry assets at cost. The terms
(FASB) is that Moon Chemical was not selling petrochemicals on a fixed contract to the U.S. government.
These web links are specifically selected to ac-
www.fasb.org. carrying value and book value are misleading and cause many readers of financial state-
Instead, imagine that the petrochemicals were to be sold to private industry at currently prevail-
ments to believe the firm’s assets are recorded at true market values. Market value is the
ing prices. The price of petrochemicals should move directly with oil prices because oil is a
company text material and provide students and
price at which willing buyers and sellers would trade the assets. It would be only a coin-
major component of petrochemicals. Because cost increases are likely to be passed on to the
cidence if accounting value and market value were the same. In fact, management’s job
consumer, Moon Chemical would probably not want to hedge in this case. Instead, the firm is
is to create value for the firm that exceeds its cost.
instructors with a quick reference to additional
likely to choose Strategy 1, buying the oil as it is needed. If oil prices increase between April 1
and, say, September
ferent.
Many peopleChemical,
1, Moon use the balance
of course, sheet,
will but
findthethatinformation each become
its inputs have may wish to extract is dif-
quite information on the Internet.
costly. However, in aAcompetitive
banker maymarket,look atitsa revenues
balance sheet for evidence
are likely to rise, of
as accounting
well. liquidity and working
Strategy 2 is called a long hedge because one purchases a futures contract to reduce risk. promptness
capital, while a supplier also may note the size of accounts payable and the general
In other words,of one
payments.
takes aMany long users
positionof financial statements,
in the futures market.including
In general,managers and investors,
a firm institutes a want to
long hedge whenknowitthe value of the
is committed to firm,
a fixednot its cost.
sales price.This
Oneinformation is not found
class of situations involves onactual
the balance sheet.
written contracts with customers, such as the one Moon Chemical had with the U.S. government.
Alternatively, a firm may find that it cannot easily pass on costs to consumers or does not want
to pass on these
1 costs. For example, a group of students opened a small meat market called
Bondholders are investors in the firm’s debt. They are creditors of the firm. In this discussion, the term bondholder means the
What’s Your Beef nearas the
same thing University of Pennsylvania in the late 1970s.6 This was a time of
creditor.
2
volatile consumer prices,
Confusion oftenespecially
arises becausefood
manyprices.
financial Knowing
accounting that
terms their fellow
have the students
same meaning. Forwere par-
example, the following terms
usually refer to the same thing: assets minus liabilities, net worth, stockholders’ equity, owners’ equity, book equity, and equity
ticularly budget-conscious,
capitalization.
the owners vowed to keep food prices constant regardless of price
movements in3Generally,
either direction.
the U.S. GAAPTheyrequire
accomplished this byatpurchasing
assets to be carried futures
the lower of cost contracts
or market value. Ininmost
various
instances, cost is lower
agricultural commodities.
than market value. However, in some cases when a fair market value can be readily determined, the assets have their value
adjusted to the fair market value.

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 Numbered Equations
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
Key equations are numbered and listed on the back
$40
PTB = ______
1 + R1 +
$40
________
2 +
$40
________ $40
+ ˙ ˙ ˙ + __________
$1,040
+ __________ (25.1) endsheets for easy reference.
(1 + R2) (1 + R3)3 (1 + R39)39 (1 + R40)40
Because an 8 percent coupon bond pays interest of $80 a year, the semiannual coupon
is $40. Principal and the semiannual coupon 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 the bond at the appropriate spot rate. Because the payments are semian-
nual, each spot rate is expressed in semiannual terms. That is, imagine a horizontal term
structure where the effective annual yield is 8 percent for all maturities. Because each
6
Ordinarily, an unusual firm name in this textbook is a tip-off that it is fictional. This, however, is a true story.

xiv
The end-of-chapter material reflects and builds upon the concepts learned from the chapter and study features.
790 ■■■ PART VI Options, Futures, and Corporate Finance

Summary and Conclusions Summary and Conclusions

1. Firms hedge to reduce risk. This chapter showed a number of hedging strategies.
2. A forward contract is an agreement by two parties to sell an item for cash at a later date.
The price is set at the time the agreement is signed. However, cash changes hands on the
The summary provides a quick review of key concepts
date of delivery. Forward contracts are generally not traded on organized exchanges.
3. Futures contracts are also agreements for future delivery. They have certain advantages,
such as liquidity, that forward contracts do not. An unusual feature of futures contracts
in the chapter.
is the mark-to-the-market convention. If the price of a futures contract falls on a particu-
lar day, every buyer of the contract must pay money to the clearinghouse. Every seller of
the contract receives money from the clearinghouse. Everything is reversed if the price
rises. The mark-to-the-market convention prevents defaults on futures contracts.
4. We divided hedges into two types: short hedges and long hedges. An individual or firm
Questions and Problems
that sells a futures contract to reduce risk is instituting a short hedge. Short hedges are
generally appropriate for holders of inventory. An individual or firm that buys a futures
contract to reduce risk is instituting a long hedge. Long hedges are typically used by firms Because solving problems is so critical to a student’s
with contracts to sell finished goods at a fixed price.
5. An interest rate futures contract employs a bond as the deliverable instrument. Because
of their popularity, we worked with Treasury bond futures contracts. We showed that
learning, new questions and problems have been
Treasury bond futures contracts can be priced using the same type of net present value
analysis that is used to price Treasury bonds themselves.
6. Many firms face interest rate risk. They can reduce this risk by hedging with interest rate
added and existing questions and problems have
futures contracts. As with other commodities, a short hedge involves the sale of a futures
contract. Firms that are committed to buying mortgages or other bonds are likely to institute been revised. All problems also have been thoroughly
short hedges. A long hedge involves the purchase of a futures contract. Firms that have
agreed to sell mortgages or other bonds at a fixed price are likely to institute long hedges.
7. Duration measures the average maturity of all the cash flows of a bond. Bonds with high reviewed and checked for accuracy.
duration have high price variability. Firms frequently try to match the duration of their
assets with the duration of their liabilities.
8. Swaps are agreements to exchange cash flows over time. The first major type is an inter-
Problems have been grouped according to level
est rate swap in which one pattern of coupon payments, say, fixed payments, is exchanged
for another, say, coupons that float with LIBOR. The second major type is a currency
swap, in which an agreement is struck to swap payments denominated in one currency
of difficulty with the levels listed in the margin: Basic,
124 ■■■ PART II Valuation and Capital Budgeting
CHAPTER 4 Discounted Cash Flow Valuation ■■■ 131
for payments in another currency over time.
Intermediate, and Challenge.
Well-known financial
18. Value
73. Present Interest
of aRates
Growing Perpetuity Whatwriter
is theAndrew Tobias
equation for argues that hevalue
the present can earn
of a 177
Additionally, one $10 we bottle ofhave
with a payment tried
fine Bordeaux per weekto
of C one periodmake from today the
He problems
percent per year buying wine by the case. Specifically, he assumes that he will consume
growing perpetuity
by C eachper period?
if the payments
for the next 12 weeks.
grow
can either pay $10
Concept Questions week or buy a case of 12 bottles today. If he buys the case, he receives a 10 percent

1. Hedging Strategies If a firm is selling futures contracts on lumber as a hedging strategy,

in the74.critical “concept”
A useful
Rule of 72discount and, rule
sumes the firstisbottle
discrete compounding
of thumb
by doing
chapters,
today. of
the “Rule
for the
so, earns
Do72.”
the time
you To
177 percent.
agree
usewith
such
it takes
the his
Assume
analysis?
Rule
as
an investment
of 72, Do youyou
those
he buystothe double
see a72
divide
wine with
on
and con-
problem
by thewith
his numbers?
rate to determine the number of periods it takes for a value today to double. For exam-
what must be true about the firm’s exposure to lumber prices?
2. Hedging Strategies If a firm is buying call options on pork belly futures as a hedging
value, risk,ple,19. and
if the rate iscapital
6 percent,
Calculating Number the structure,
Rule of 72
of Periods Onesays especially
it will
of your take 72/6
customers is = 12 yearschalleng-
delinquent to his
on double.
accounts
strategy, what must be true about the firm’s exposure to pork belly prices? This is approximately
payable balance. equal to the
You’ve actualagreed
mutually answerto of 11.90 years.
a repayment The Rule
schedule of 72
of $400 peralso
month.
3. Forwards and Futures What is the difference between a forward contract and a futures
contract? Why do you think that futures contracts are much more common? Are there any
ing and can interesting.
be applied
This is a balance
to determine
You will what rate
charge 1.1 percent
is $16,450, howfor
useful approximation long
perismonth
neededinterest
will rates
many it takeand
to double
for periods.
money
on the
the account
overduein abalance.
specifiedIf period.
to be rate
At what paid isoff?
the current
the Rule of
72 exact?
circumstances under which you might prefer to use forwards instead of futures? Explain.
4. Hedging Commodities Bubbling Crude Corporation, a large Texas oil producer, would
We provide
75. Rule of 69.3
answers
A corollary
toyouselected
the Rule and of
the Rule
problems
20. Calculating EAR Friendly’s Quick Loans, Inc., offers you “three for four or I knock
on your door.” This to means ofget72$3is today repay $4The
69.3. when Rule
inyourisAp-
youofget69.3 pay-
like to hedge against adverse movements in the price of oil because this is the firm’s check except
exactly correct in one for
week (or else).
rounding What’s
when ratestheareEAR Friendly’scontinuously.
compounded earns on thisProve lendingthebusi-
primary source of revenue. What should the firm do? Provide at least two reasons why it
pendix BRuleatof 69.3 the
ness?forIfend
paying?
you wereof
continuously bravethe
enoughbook.
compounded tointerest.
ask, what APR would Friendly’s say you were

INTERMEDIATE 21. Future Value What is the future value in 11 years of $1,000 invested in an account
(Questions 21–50) with an APR of 8.9 percent:
a. Compounded annually?
Excel Master It! Problems Excel Master It! Problem b. Compounded semiannually?
c. Compounded monthly?
d. Compounded continuously?
Excel Excel is a great tool for solving problems, but with many time value of money problems, you
e. Why does the future value increase as the compounding period shortens?
Included in the end-of-chapter material are prob- Master
coverage online
may still need to draw a time line. Consider a classic retirement problem. A friend is celebrat-
ing her birthday and wants
22. Simple to start
Interest versussaving for herInterest
Compound anticipated
Firstretirement.
Simple BankShepays
has5.3
thepercent
following
simple
years to retirement andon
interest retirement spending
its investment goals:If First Complex Bank pays interest on its accounts
accounts.
lems directly incorporating Excel, and new tips and compounded annually, what rate should the bank set if it wants to match First Simple
Bank over an investment horizon of 10 years?
Years until retirement 30
techniques taught in the chapter’s ExcelMaster 23. Calculating
To do
AmountAnnuities
to withdraw
this,toyou
You are year
each
will invest
planning to save for$90,000
retirement over the next 30 years.
$850 per month in a stock account and $350 per month
Years withdraw in retirement 20
in a Investment
bond account. The return of the stock account is expected to be 10 percent per
supplement. rate 8%
year, and the bond account will earn 6 percent per year. When you retire, you will
combine your money into an account with an annual return of 7 percent. How much
can you withdraw each month from your account assuming
Because your friend is planning ahead, the first withdrawal will not take place a 25-year withdrawal
until one
period?She wants to make equal annual deposits into her account for her retire-
year after she retires.

Excel Problems ment fund.24. Calculating Rates of Return Suppose an investment offers to quadruple your money in
a. If she 12 months
starts (don’t
making believe
these it). What
deposits rate year
in one of return
and per quarter
makes her are
lastyou being on
deposit offered?
the
25. sheCalculating
day Rates
retires, what must You’re
of Return
amount tryingannually
she deposit to choosetobetween
be abletwo different
to make the investments,
desired
both of which have
withdrawals in retirement? up-front costs of $65,000. Investment G returns $125,000 in 6 years.
Indicated by the Excel icon in the margin, these b. SupposeInvestment H returns
your friend $205,000a in
has inherited 10 years.
large sum of Which of these
money. investments
Rather than makinghas the higher
equal
annualreturn?
payments, she has decided to make one lump-sum deposit today to cover her
problems can be found at the end of almost all retirement
26. Growing
c. Suppose
needs.
laseryour
What amount
Perpetuities
eye friend’s
Markdoes
employer
surgery. His
she have
Weinstein
will will
technology contribute
to deposit
has been working
to the
be available
today?
on an advanced technology in
account
in the each He
near term. year as part his
anticipates
of the first annual cash
company’s flow from plan.
profit-sharing the technology
In addition, to beyour
$175,000,
friend received
expects two years from
a distribu-
chapters. Located in Connect Finance for Corpo- today.a Subsequent
tion from family trustannual cashyears
several flowsfrom
will grow
now. atWhat
3.8 percent
amount in must
perpetuity. What is the
she deposit
present
annually nowvalue of the
to be abletechnology
to make ifthe the desired
discount withdrawals
rate is 9.7 percent?
in retirement? The
rate Finance, 12e, Excel templates have been cre- details are:
27. Perpetuities A prestigious investment bank designed a new security that pays a
quarterly dividend of $2.25 in perpetuity. The first dividend occurs one quarter from

ated for each of these problems, where students today. What is the price of the security if the APR is 3.8 percent compounded
Employer’s annual contribution
quarterly?
Years until trust fund distribution
$ 1,500
20

can use the data in the problem to work out the Amount of trust fund distribution $25,000

solution using Excel skills.

132 ■■■ PART II Valuation and Capital Budgeting

End-of-Chapter Cases Mini Case THE MBA DECISION

Ben Bates graduated from college six years ago with a finance undergraduate degree. Although
he is satisfied with his current job, his goal is to become an investment banker. He feels that an
Located at the end of almost every chapter, these MBA degree would allow him to achieve this goal. After examining schools, he has narrowed
his choice to either Wilton University or Mount Perry College. Although internships are encour-
aged by both schools, to get class credit for the internship, no salary can be paid. Other than
mini cases focus on common company situations internships, neither school will allow its students to work while enrolled in its MBA program.
Ben currently works at the money management firm of Dewey and Louis. His annual salary
that embody important corporate finance topics. at the firm is $65,000 per year, and his salary is expected to increase at 3 percent per year until
retirement. He is currently 28 years old and expects to work for 40 more years. His current job
includes a fully paid health insurance plan, and his current average tax rate is 26 percent. Ben
Each case presents a new scenario, data, and a di- has a savings account with enough money to cover the entire cost of his MBA program.
The Ritter College of Business at Wilton University is one of the top MBA programs in
the country. The MBA degree requires two years of full-time enrollment at the university. The
lemma. Several questions at the end of each case annual tuition is $70,000, payable at the beginning of each school year. Books and other sup-
plies are estimated to cost $3,000 per year. Ben expects that after graduation from Wilton, he
require students to analyze and focus on all of the will receive a job offer for about $110,000 per year, with a $20,000 signing bonus. The salary
at this job will increase at 4 percent per year. Because of the higher salary, his average income
tax rate will increase to 31 percent.
material they learned in that chapter. The Bradley School of Business at Mount Perry College began its MBA program 16 years
ago. The Bradley School is smaller and less well known than the Ritter College. Bradley offers
an accelerated, one-year program, with a tuition cost of $85,000 to be paid upon matriculation.
Books and other supplies for the program are expected to cost $4,500. Ben thinks that he will
receive an offer of $92,000 per year upon graduation, with an $18,000 signing bonus. The
salary at this job will increase at 3.5 percent per year. His average tax rate at this level of xv
income will be 29 percent.
Both schools offer a health insurance plan that will cost $3,000 per year, payable at the
beginning of the year. Ben also estimates that room and board expenses will cost $2,000 more
per year at both schools than his current expenses, payable at the beginning of each year. The
appropriate discount rate is 4.7 percent.
1. How does Ben’s age affect his decision to get an MBA?
Comprehensive Teaching
and Learning Package

McGraw‐Hill Customer Care Contact

Information
At McGraw-Hill, we understand that getting the most from new technology can be chal-
lenging. That’s why our services don’t stop after you purchase our products. You can e-mail
our product specialists 24 hours a day to get product-training online. Or you can search
our knowledge bank of Frequently Asked Questions on our support website. For Customer
Support, call 800-331-5094 or visit mpss.mhhe.com. One of our Technical Support Analysts
will be able to assist you in a timely fashion.

Assurance of Learning Ready

Assurance of Learning is an important element of many accreditation standards. Corporate
Finance, 12e, is designed specifically to support your assurance of learning initiatives. Every
test bank question is labeled with 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 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
The McGraw-Hill Companies is a proud corporate member of AACSB International.
Understanding the importance and value of AACSB accreditation, Corporate Finance, 12e,
has sought to recognize the curricula guidelines detailed in the AACSB standards for busi-
ness accreditation by connecting selected questions in the test bank to the general knowl-
edge and skill guidelines found in the AACSB standards.
The statements contained in Corporate Finance, 12e, 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 Corporate
Finance, 12e, and the teaching package make no claim of any specific AACSB qualification
or evaluation, we have, within the test bank, labeled selected questions according to the six
general knowledge and skills areas.

Instructor Resources
The Instructor Library in Connect contains all the necessary supplements—Instructor’s
Manual, Test Bank, Computerized Test Bank, and PowerPoint—all in one place. Go to
connect.mheducation.com to find:
●● Instructor’s Manual
Prepared by Steven D. Dolvin, Butler 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

xvi
 outline for each chapter includes lecture tips, real-world tips, ethics notes, suggested
PowerPoint slides, and, when appropriate, a video synopsis.
●● Test Bank
Prepared by Kay Johnson
Here’s a great format for a better testing process. The Test Bank has over 100 questions per
chapter that closely link with the text material and provide 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.
●● TestGen
TestGen is a complete, state-of-the-art test generator and editing application software
that allows instructors to quickly and easily select test items from McGraw Hill’s
TestGen testbank content and to organize, edit, and customize the questions and
answers to rapidly generate paper tests. Questions can include stylized text, symbols,
graphics, and equations that are inserted directly into questions using built-in mathe-
matical templates. TestGen’s random generator provides the option to display different
text or calculated number values each time questions are used. With both quick-and-
simple test creation and flexible and robust editing tools, TestGen is a test generator
system for today’s educators.
●● PowerPoint Presentation System
Prepared by Steven D. Dolvin, Butler University
Customize our content for your course. This presentation has been thoroughly revised
to include more lecture-oriented 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 also
can 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.
●● Excel Simulations
Expanded for this edition! With 180 Excel simulation questions now included in
Connect, RWJJ is the unparalleled leader in offering students the opportunity to prac-
tice using the Excel functions they will use throughout their careers in finance.
●● Corporate Finance Videos
New for this edition, brief and engaging conceptual videos (and accompanying ques-
tions) help students to master the building blocks of the Corporate Finance course.

STUDENT SUPPORT
●● Narrated Presentations
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!

xvii
 ●● 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.
●● ExcelMaster
Developed by the authors for the RWJ franchise, this valuable and comprehensive
supplement provides a tutorial for students in using Excel in finance that is broken out
by chapter sections.

Options Available for Purchase

& Packaging
FINGAME ONLINE 5.0 ISBN-10: 0-07-721988-0 / ISBN-13: 978-0-07-721988-8
By LeRoy Brooks, John Carroll University.
$15.00 when packaged with this text. In this comprehensive simulation game, students con-
trol a hypothetical company over numerous periods of operation. 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.

xviii
Acknowledgments

Andras Danis Abu Jalai Ronald M. Shapiro

Georgia Institute of Technology Suffolk University Rutgers University
Sugata Das Robert James Stephen V. Smith
Montana State University–Billings Boston College Drexel University
Lowell D’Souza Victoria Javine Mete Tepe
Northeastern University University of Alabama Virginia Tech
Eric Eller Roger Klee Gary P. Tripp
Loras College Cleveland State University Southern New Hampshire University
Melissa B. Frye Wendy Liu Emre Unlu
University of Central Florida University of Kentucky University of Nebraska
Melody J. Gunter Jeremy Marcq Kainan Wang
Florida State University Tufts University and Harvard University University of Toledo
Atul Gupta Narasimha Mohan Arthur J. Wilson
Bentley University Baldwin Wallace University George Washington University
Janet Hamilton Hongsong Neuhauser
Portland State University Elizabethtown College
John Hartman Francis Blaise Roncagli
University of California–Santa Barbara Cleveland State University

xix
Brief Contents

Part I
OVERVIEW
1 Introduction to Corporate Finance 1
2 Financial Statements and Cash Flow 20
3 Financial Statements Analysis and Financial Models 42

Part II
VALUATION AND CAPITAL BUDGETING
4 Discounted Cash Flow Valuation 85
5 Net Present Value and Other Investment Rules 133
6 Making Capital Investment Decisions 169
7 Risk Analysis, Real Options, and Capital Budgeting 205
8 Interest Rates and Bond Valuation 235
9 Stock Valuation 270

Part III
RISK
10 Lessons from Market History 299
11 Return, Risk, and the Capital Asset Pricing Model 328
12 An Alternative View of Risk and Return 371
13 Risk, Cost of Capital, and Valuation 393

Part IV
CAPITAL STRUCTURE AND DIVIDEND POLICY
14 Efficient Capital Markets and Behavioral Challenges 428
15 Long-Term Financing 468
16 Capital Structure 487
17 Capital Structure 519
18 Valuation and Capital Budgeting for the Levered Firm 551
19 Dividends and Other Payouts 573

xx
Part V
LONG-TERM FINANCING
20 Raising Capital 612
21 Leasing 649

Part VI
OPTIONS, FUTURES, AND CORPORATE FINANCE
22 Options and Corporate Finance 673
23 Options and Corporate Finance: Extensions and Applications 718
24 Warrants and Convertibles 742
25 Derivatives and Hedging Risk 763

Part VII
SHORT-TERM FINANCE
26 Short-Term Finance and Planning 795
27 Cash Management 825
28 Credit and Inventory Management 847

Part VIII
SPECIAL TOPICS
29 Mergers, Acquisitions, and Divestitures 876
30 Financial Distress 919
31 International Corporate Finance 935

Appendix A: Mathematical Tables 963

Appendix B: Solutions to Selected End-of-Chapter Problems 972
Appendix C: Using the HP 10B and TI BA II Plus
Financial Calculators 975
Glossary 979
Name Index 987
Subject Index 989

xxi
Contents

PART I Overview 2.3 Taxes

Corporate and personal Tax Rates
26
26
Chapter 1 Average versus Marginal Tax Rates 26
2.4 Net Working Capital 27
Introduction to Corporate Finance 1 2.5 Cash Flow of the Firm 28
1.1 What Is Corporate Finance? 1 2.6 The Accounting Statement of Cash Flows 31
The Balance Sheet Model of the Firm 1 Cash Flow from Operating Activities 31
The Financial Manager 3 Cash Flow from Investing Activities 32
1.2 The Corporate Firm 4 Cash Flow from Financing Activities 32
The Sole Proprietorship 4 2.7 Cash Flow Management 33
The Partnership 4 Summary and Conclusions 34
The Corporation 5 Concept Questions 34
A Corporation by Another Name . . . 7 Questions and Problems 35
1.3 The Importance of Cash Flows 8 Excel Master It! Problem 39
Identification of Cash Flows 8 Mini Case: Cash Flows at Warf
Timing of Cash Flows 9 Computers, Inc. 40
Risk of Cash Flows 10
1.4 The Goal of Financial Management 10
Possible Goals 10
Chapter 3
The Goal of the Financial Manager 11 Financial Statements Analysis
A More General Goal 12 and Financial Models 42
1.5 The Agency Problem and Control
3.1 Financial Statements Analysis 42
of the Corporation 12
Standardizing Statements 42
Agency Relationships 13
Common-Size Balance Sheets 43
Management Goals 13
Common-Size Income Statements 44
Do Managers Act in the Stockholders’
3.2 Ratio Analysis 46
Interests? 14
Short-Term Solvency or Liquidity Measures 47
Stakeholders 15
Long-Term Solvency Measures 48
1.6 Regulation 16
Asset Management or Turnover Measures 50
The Securities Act of 1933 and the
Profitability Measures 52
Securities Exchange Act of 1934 16
Market Value Measures 53
Sarbanes-Oxley 17
3.3 The DuPont Identity 56
Summary and Conclusions 18
A Closer Look at ROE 56
Concept Questions 18
Problems with Financial Statement Analysis 58
3.4 Financial Models 59
Chapter 2 A Simple Financial Planning Model 59
The Percentage of Sales Approach 61
Financial Statements and Cash Flow 20 3.5 External Financing and Growth 65
2.1 The Balance Sheet 20 The Relationship Between EFN
Liquidity 21 and Growth 66
Debt versus Equity 22 Financial Policy and Growth 68
Value versus Cost 22 A Note about Sustainable Growth
2.2 The Income Statement 23 Rate Calculations 72
Generally Accepted Accounting 3.6 Some Caveats Regarding Financial
Principles 24 Planning Models 73
Noncash Items 25 Summary and Conclusions 74
Time and Costs 25 Concept Questions 74

xxii
 Questions and Problems 76 Problems with the Payback Method 137
Excel Master It! Problem 81 Managerial Perspective 138
Mini Case: Ratios and Financial Planning Summary of Payback 139
at East Coast Yachts 82 5.3 The Discounted Payback Period Method 139
5.4 The Internal Rate of Return 139
5.5 Problems with the IRR Approach 143
PART II Valuation and Definition of Independent and Mutually
Exclusive Projects 143
Capital Budgeting Two General Problems Affecting Both
Independent and Mutually
Chapter 4 Exclusive Projects 143
Discounted Cash Flow Valuation 85 The Modified Internal Rate of
Return (MIRR) 146
4.1 Valuation: The One-Period Case 85
Problems Specific to Mutually
4.2 The Multiperiod Case 89
Exclusive Projects 148
Future Value and Compounding 89
Redeeming Qualities of IRR 153
The Power of Compounding: A Digression 92
A Test 153
Present Value and Discounting 93
5.6 The Profitability Index 153
Finding the Number of Periods 96
Calculation of Profitability Index 154
The Algebraic Formula 99
5.7 The Practice of Capital Budgeting 155
4.3 Compounding Periods 100
Summary and Conclusions 157
Distinction between Annual Percentage
Concept Questions 158
Rate and Effective Annual Rate 101
Questions and Problems 160
Compounding over Many Years 102
Excel Master It! Problem 167
Continuous Compounding 102
Mini Case: Bullock Gold Mining 168
4.4 Simplifications 104
Perpetuity 104
Growing Perpetuity 106 Chapter 6
Annuity 107
Growing Annuity 113
Making Capital Investment Decisions 169
4.5 Loan Amortization 114 6.1 Incremental Cash Flows: The Key
4.6 What Is a Firm Worth? 118 to Capital Budgeting 169
Summary and Conclusions 120 Cash Flows—Not Accounting Income 169
Concept Questions 121 Sunk Costs 170
Questions and Problems 121 Opportunity Costs 171
Excel Master It! Problem 131 Side Effects 171
Mini Case: The MBA Decision 132 Allocated Costs 172
Appendix 4A: Net Present Value: First 6.2 The Baldwin Company: An Example 172
Principles of Finance 132 An Analysis of the Project 175
Appendix 4B: Using Financial Calculators 132 Which Set of Books? 177
A Note about Net Working Capital 177
A Note about Depreciation 178
Chapter 5 Interest Expense 179
Net Present Value and Other 6.3 Alternative Definitions of Operating
Investment Rules 133 Cash Flow 179
The Top-Down Approach 180
5.1 Why Use Net Present Value? 133 The Bottom-Up Approach 180
5.2 The Payback Period Method 136 The Tax Shield Approach 181
Defining the Rule 136 Conclusion 182

xxiii
6.4 Some Special Cases of Discounted 8.2 Government and Corporate Bonds 245
Cash Flow Analysis 182 Government Bonds 245
Evaluating Cost-Cutting Proposals 182 Corporate Bonds 246
Setting the Bid Price 184 Bond Ratings 248
Investments of Unequal Lives: The 8.3 Bond Markets 249
Equivalent Annual Cost Method 186 How Bonds Are Bought and Sold 249
6.5 Inflation and Capital Budgeting 187 Bond Price Reporting 250
Interest Rates and Inflation 187 A Note on Bond Price Quotes 253
Cash Flow and Inflation 189 8.4 Inflation and Interest Rates 254
Discounting: Nominal or Real? 190 Real versus Nominal Rates 254
Summary and Conclusions 192 Inflation Risk and Inflation-Linked
Concept Questions 193 Bonds 255
Questions and Problems 194 The Fisher Effect 256
Excel Master It! Problems 203 8.5 Determinants of Bond Yields 258
Mini Case: Bethesda Mining Company 203 The Term Structure of Interest Rates 258
Bond Yields and the Yield Curve:
Putting It All Together 260
Chapter 7 Conclusion 262
Risk Analysis, Real Options, Summary and Conclusions 262
and Capital Budgeting 205 Concept Questions 262
Questions and Problems 263
7.1 Sensitivity Analysis, Scenario Analysis, Excel Master It! Problem 267
and Break-Even Analysis 205 Mini Case: Financing East Coast
Sensitivity Analysis and Scenario Analysis 206 Yachts’s Expansion Plans with
Break-Even Analysis 209 a Bond Issue 268
7.2 Monte Carlo Simulation 213
Step 1: Specify the Basic Model 213
Step 2: Specify a Distribution for
Chapter 9
Each Variable in the Model 214
Step 3: The Computer Draws One Stock Valuation 270
Outcome 216 9.1 The Present Value of Common Stocks 270
Step 4: Repeat the Procedure 217 Dividends versus Capital Gains 270
Step 5: Calculate NPV 217 Valuation of Different Types of Stocks 271
7.3 Real Options 218 9.2 Estimates of Parameters in
The Option to Expand 218 the Dividend Discount Model 275
The Option to Abandon 219 Where Does g Come From? 275
Timing Options 221 Where Does R Come From? 277
7.4 Decision Trees 222 A Healthy Sense of Skepticism 278
Summary and Conclusions 224 Dividends or Earnings: Which
Concept Questions 225 to Discount? 279
Questions and Problems 226 The No-Dividend Firm 279
Excel Master It! Problem 232 9.3 Comparables 280
Mini Case: Bunyan Lumber, LLC 233 Price-Earnings Ratio 280
Enterprise Value Ratios 282
Chapter 8 9.4 Valuing Stocks Using Free Cash Flows 284
9.5 The Stock Markets 285
Interest Rates and Bond Valuation 235 Dealers and Brokers 285
8.1 Bonds and Bond Valuation 235 Organization of the NYSE 286
Bond Features and Prices 235 Types of Orders 289
Bond Values and Yields 236 NASDAQ Operations 289
Interest Rate Risk 239 Stock Market Reporting 290
Finding the Yield to Maturity: More Trial Summary and Conclusions 291
and Error 241 Concept Questions 292
Zero Coupon Bonds 243 Questions and Problems 293

xxiv
 Excel Master It! Problem 296 11.6 Diversification 345
Mini Case: Stock Valuation The Anticipated and Unanticipated
at Ragan Engines 297 Components of News 345
Risk: Systematic and Unsystematic 346
The Essence of Diversification 347
PART III Risk The Effect of Diversification: Another
Lesson from Market History 348
Chapter 10 11.7 Riskless Borrowing and Lending 349
The Optimal Portfolio 351
Lessons from Market History 299
11.8 Market Equilibrium 353
10.1 Returns 299 Definition of the Market Equilibrium
Dollar Returns 299 Portfolio 353
Percentage Returns 301 Definition of Risk When Investors Hold
10.2 Holding Period Returns 303 the Market Portfolio 354
10.3 Return Statistics 309 The Formula for Beta 356
10.4 Average Stock Returns and A Test 357
Risk-Free Returns 310 11.9 Relationship between Risk and Expected
10.5 Risk Statistics 312 Return (CAPM) 357
Variance 312 Expected Return on the Market 357
Normal Distribution and Its Implications Expected Return on an Individual Security 358
for Standard Deviation 314 Summary and Conclusions 361
10.6 More on Average Returns 315 Concept Questions 361
Arithmetic versus Geometric Averages 315 Questions and Problems 362
Calculating Geometric Average Returns 315 Excel Master It! Problem 368
Arithmetic Average Return or Geometric Mini Case: A Job at East Coast
Average Return? 317 Yachts, Part 2 369
10.7 The U.S. Equity Risk Premium: Historical Appendix 11A: Is Beta Dead? 370
and International Perspectives 317
10.8 2008: A Year of Financial Crisis 320
Summary and Conclusions 321 Chapter 12
Concept Questions 322 An Alternative View of Risk
Questions and Problems 322 and Return 371
Excel Master It! Problem 325
Mini Case: A Job at East Coast Yachts 326 12.1 Systematic Risk and Betas 371
12.2 Portfolios and Factor Models 374
Portfolios and Diversification 377
Chapter 11 12.3 Betas, Arbitrage, and Expected Returns 379
Return, Risk, and the Capital The Linear Relationship 379
The Market Portfolio and the
Asset Pricing Model 328
Single Factor 380
11.1 Individual Securities 328 12.4 The Capital Asset Pricing Model
11.2 Expected Return, Variance, and the Arbitrage Pricing Theory 381
and Covariance 329 Differences in Pedagogy 381
Expected Return and Variance 329 Differences in Application 381
Covariance and Correlation 330 12.5 Empirical Approaches to Asset Pricing 383
11.3 The Return and Risk for Portfolios 334 Empirical Models 383
The Expected Return on a Portfolio 334 Style Portfolios 384
Variance and Standard Deviation Summary and Conclusions 385
of a Portfolio 335 Concept Questions 386
11.4 The Efficient Set for Two Assets 338 Questions and Problems 387
11.5 The Efficient Set for Many Securities 342 Excel Master It! Problem 391
Variance and Standard Deviation Mini Case: The Fama-French Multifactor
in a Portfolio of Many Assets 344 Model and Mutual Fund Returns 391

xxv
Chapter 13 Foundations of Market Efficiency 432
14.3 The Different Types of Efficiency 433
Risk, Cost of Capital, and Valuation 393 The Weak Form 433
13.1 The Cost of Capital 393 The Semistrong and Strong Forms 434
13.2 Estimating the Cost of Equity Capital Some Common Misconceptions about
with the CAPM 394 the Efficient Market Hypothesis 436
The Risk-Free Rate 397 14.4 The Evidence 437
Market Risk Premium 397 The Weak Form 437
13.3 Estimation of Beta 398 The Semistrong Form 438
Real-World Betas 399 The Strong Form 441
Stability of Beta 399 14.5 The Behavioral Challenge
Using an Industry Beta 401 to Market Efficiency 442
13.4 Determinants of Beta 402 Rationality 442
Cyclicality of Revenues 402 Independent Deviations from Rationality 444
Operating Leverage 402 Arbitrage 445
Financial Leverage and Beta 403 14.6 Empirical Challenges to Market
13.5 The Dividend Discount Model Approach 404 Efficiency 446
Comparison of DDM and CAPM 405 14.7 Reviewing the Differences 451
13.6 Cost of Capital for Divisions 14.8 Implications for Corporate Finance 453
and Projects 406 1. Accounting Choices, Financial Choices,
13.7 Cost of Fixed Income Securities 408 and Market Efficiency 453
Cost of Debt 408 2. The Timing Decision 454
Cost of Preferred Stock 409 3. Speculation and Efficient Markets 455
13.8 The Weighted Average Cost of Capital 410 4. Information in Market Prices 457
13.9 Valuation with WACC 411 Summary and Conclusions 459
Project Evaluation and the WACC 412 Concept Questions 460
Firm Valuation with the WACC 412 Questions and Problems 463
13.10 Estimating Eastman Chemical’s Mini Case: Your 401(k) Account at
Cost of Capital 415 East Coast Yachts 466
13.11 Flotation Costs and the Weighted
Average Cost of Capital 417
The Basic Approach 417 Chapter 15
Flotation Costs and NPV 418 Long-Term Financing 468
Internal Equity and Flotation Costs 419
15.1 Some Features of Common
Summary and Conclusions 420
and Preferred Stocks 468
Concept Questions 420
Common Stock Features 468
Questions and Problems 422
Preferred Stock Features 471
Mini Case: Cost of Capital for
15.2 Corporate Long-Term Debt 472
Swan Motors 426
Is It Debt or Equity? 473
Appendix 13A: Economic Value Added
Long-Term Debt: The Basics 473
and the Measurement of
The Indenture 475
Financial Performance 427
15.3 Some Different Types of Bonds 478
Floating-Rate Bonds 478
Other Types of Bonds 478
PART IV Capital Structure 15.4 Bank Loans 479
and Dividend Policy 15.5 International Bonds 480
15.6 Patterns of Financing 480
Chapter 14 15.7 Recent Trends in Capital Structure 482
Efficient Capital Markets Which Are Best: Book or Market
Values? 482
and Behavioral Challenges 428
Summary and Conclusions 483
14.1 Can Financing Decisions Create Value? 428 Concept Questions 484
14.2 A Description of Efficient Capital Markets 430 Questions and Problems 485

xxvi
Chapter 16 17.6 Shirking, Perquisites, and Bad Investments:
A Note on Agency Cost of Equity 533
Capital Structure 487 Effect of Agency Costs of Equity
16.1 The Capital Structure Question on Debt-Equity Financing 535
and the Pie Theory 487 Free Cash Flow 535
16.2 Maximizing Firm Value versus 17.7 The Pecking-Order Theory 536
Maximizing Stockholder Interests 488 Rules of the Pecking Order 537
16.3 Financial Leverage and Firm Value: Implications 538
An Example 490 17.8 Personal Taxes 539
Leverage and Returns to Shareholders 490 The Basics of Personal Taxes 539
The Choice between Debt and Equity 492 The Effect of Personal Taxes on
A Key Assumption 494 Capital Structure 539
16.4 Modigliani and Miller: Proposition II 17.9 How Firms Establish Capital
(No Taxes) 494 Structure 540
Risk to Equityholders Rises with Summary and Conclusions 545
Leverage 494 Concept Questions 546
Proposition II: Required Return to Questions and Problems 546
Equityholders Rises with Leverage 495 Mini Case: McKenzie Corporation’s
MM: An Interpretation 501 Capital Budgeting 549
16.5 Taxes 503 Appendix 17A: Some Useful Formulas
The Basic Insight 503 of Financial Structure 550
Present Value of the Tax Shield 505 Appendix 17B: T  he Miller Model and the
Value of the Levered Firm 506 Graduated Income Tax550
Expected Return and Leverage
under Corporate Taxes 508
The Weighted Average Cost of Capital, Chapter 18
WACC, and Corporate Taxes 509 Valuation and Capital Budgeting
Stock Price and Leverage under for the Levered Firm 551
Corporate Taxes 510
Summary and Conclusions 512 18.1 Adjusted Present Value Approach 551
Concept Questions 512 18.2 Flow to Equity Approach 553
Questions and Problems 513 Step 1: Calculating Levered Cash
Mini Case: Stephenson Real Estate Flow (LCF) 553
Recapitalization 518 Step 2: Calculating RS 554
Step 3: Valuation 554
18.3 Weighted Average Cost
Chapter 17 of Capital Method 554
18.4 A Comparison of the APV, FTE,
Capital Structure 519
and WACC Approaches 555
17.1 Costs of Financial Distress 519 A Suggested Guideline 556
Bankruptcy Risk or Bankruptcy Cost? 519 18.5 Valuation When the Discount Rate
17.2 Description of Financial Distress Costs 521 Must Be Estimated 558
Direct Costs of Financial Distress: Legal 18.6 APV Example 560
and Administrative Costs of Liquidation 18.7 Beta and Leverage 563
or Reorganization 521 The Project Is Not Scale Enhancing 565
Indirect Costs of Financial Distress 523 Summary and Conclusions 566
Agency Costs 524 Concept Questions 566
17.3 Can Costs of Debt Be Reduced? 527 Questions and Problems 567
Protective Covenants 527 Mini Case: The Leveraged Buyout
Consolidation of Debt 528 of Cheek Products, Inc. 571
17.4 Integration of Tax Effects and Financial Appendix 18A: The Adjusted Present Value
Distress Costs 529 Approach to Valuing
Pie Again 530 Leveraged Buyouts 572
17.5 Signaling 531

xxvii
Chapter 19 PART V Long‐Term
Dividends and Other Payouts 573 Financing
19.1 Different Types of Payouts 573
19.2 Standard Method of Cash Chapter 20
Dividend Payment 574 Raising Capital 612
19.3 The Benchmark Case: An Illustration
of the Irrelevance of Dividend Policy 576 20.1 Early-Stage Financing and
Current Policy: Dividends Set Equal Venture Capital 612
to Cash Flow 576 Venture Capital 613
Alternative Policy: Initial Dividend Stages of Financing 614
Is Greater Than Cash Flow 576 Some Venture Capital Realities 615
The Indifference Proposition 577 Venture Capital Investments and
Homemade Dividends 577 Economic Conditions 616
A Test 578 20.2 The Public Issue 616
Dividends and Investment Policy 579 Direct Listing 617
19.4 Repurchase of Stock 579 Crowdfunding 617
Dividend versus Repurchase: Conceptual Initial Coin Offerings (ICOs) 619
Example 581 20.3 Alternative Issue Methods 620
Dividends versus Repurchases: 20.4 The Cash Offer 621
Real-World Considerations 582 Investment Banks 623
19.5 Personal Taxes, Dividends, The Offering Price 625
and Stock Repurchases 583 Underpricing: A Possible Explanation 625
Firms without Sufficient Cash to Pay Evidence on Underpricing 627
a Dividend 583 The Partial Adjustment Phenomenon 628
Firms with Sufficient Cash to Pay 20.5 The Announcement of New Equity
a Dividend 584 and the Value of the Firm 629
Summary of Personal Taxes 586 20.6 The Cost of New Issues 630
19.6 Real-World Factors Favoring The Costs of Going Public: A Case
a High-Dividend Policy 587 Study 632
Desire for Current Income 587 20.7 Rights 634
Behavioral Finance 587 The Mechanics of a Rights Offering 634
Agency Costs 588 Subscription Price 634
Information Content of Dividends Number of Rights Needed to Purchase
and Dividend Signaling 589 a Share 635
19.7 The Clientele Effect: A Resolution Effect of Rights Offering on Price
of Real-World Factors? 591 of Stock 635
19.8 What We Know and Do Not Know Effects on Shareholders 636
about Dividend Policy 593 The Underwriting Arrangements 637
Corporate Dividends Are Substantial 593 20.8 The Rights Puzzle 638
Fewer Companies Pay Dividends 594 20.9 Dilution 639
Corporations Smooth Dividends 595 Dilution of Percentage Ownership 639
Some Survey Evidence about Dividends 597 Dilution of Stock Price 639
19.9 Putting It All Together 598 Dilution of Book Value 640
19.10 Stock Dividends and Stock Splits 600 Dilution of Earnings Per Share 641
Some Details about Stock Splits Conclusion 641
and Stock Dividends 600 20.10 Shelf Registration 641
Value of Stock Splits and Stock Dividends 602 20.11 Issuing Long-Term Debt 642
Reverse Splits 603 Summary and Conclusions 643
Summary and Conclusions 604 Concept Questions 643
Concept Questions 604 Questions and Problems 645
Questions and Problems 606 Mini Case: East Coast Yachts
Mini Case: Electronic Timing, Inc. 610 Goes Public 648

xxviii
Chapter 21 22.3 Put Options 675
The Value of a Put Option at Expiration 676
Leasing 649 22.4 Selling Options 677
21.1 Types of Leases 649 22.5 Option Quotes 678
The Basics 649 22.6 Combinations of Options 679
Operating Leases 650 22.7 Valuing Options 682
Financial Leases 650 Bounding the Value of a Call 683
21.2 Accounting and Leasing 651 The Factors Determining Call
21.3 Taxes, the IRS, and Leases 653 Option Values 684
21.4 The Cash Flows of Leasing 654 A Quick Discussion of Factors
A Note about Taxes 656 Determining Put Option Values 687
21.5 A Detour for Discounting and Debt 22.8 An Option Pricing Formula 687
Capacity with Corporate Taxes 656 A Two-State Option Model 688
Present Value of Riskless Cash Flows 656 The Black-Scholes Model 690
Optimal Debt Level and Riskless 22.9 Stocks and Bonds as Options 695
Cash Flows 656 The Firm Expressed in Terms
21.6 NPV Analysis of the Lease-versus-Buy of Call Options 696
Decision 658 The Firm Expressed in Terms
The Discount Rate 658 of Put Options 697
21.7 Debt Displacement and Lease Valuation 659 A Resolution of the Two Views 698
The Basic Concept of Debt A Note about Loan Guarantees 699
Displacement 659 22.10 Options and Corporate Decisions:
Optimal Debt Level in the Xomox Some Applications 700
Example 660 Mergers and Diversification 700
21.8 Does Leasing Ever Pay? The Base Options and Capital Budgeting 702
Case 662 22.11 Investment in Real Projects
21.9 Reasons for Leasing 663 and Options 704
Good Reasons for Leasing 663 Summary and Conclusions 707
Bad Reasons for Leasing 666 Concept Questions 707
21.10 Some Unanswered Questions 667 Questions and Problems 708
Are the Uses of Leases and Debt Excel Master It! Problem 715
Complementary? 667 Mini Case: Clissold Industries Options 716
Why Are Leases Offered by Both
Manufacturers and Third-Party Lessors? 667 Chapter 23
Why Are Some Assets Leased More
Than Others? 667 Options and Corporate Finance:
Summary and Conclusions 668 Extensions and Applications 718
Concept Questions 668 23.1 Executive Stock Options 718
Questions and Problems 669 Why Options? 718
Mini Case: The Decision to Lease or Valuing Executive Compensation 719
Buy at Warf Computers 672 23.2 Valuing a Start-Up 722
Appendix 21A: APV Approach to Leasing 672 23.3 More about the Binomial Model 725
Heating Oil 725
23.4 Shutdown and Reopening Decisions 731
PART VI Options, Futures, Valuing a Gold Mine 731
and Corporate Finance The Abandonment and Opening
Decisions 732
Chapter 22 Valuing the Simple Gold Mine 734
Summary and Conclusions 738
Options and Corporate Finance 673
Concept Questions 738
22.1 Options 673 Questions and Problems 739
22.2 Call Options 674 Mini Case: Exotic Cuisines’ Employee
The Value of a Call Option at Expiration 674 Stock Options 741

xxix
Chapter 24 Currency Swaps 786
Credit Default Swaps 787
Warrants and Convertibles 742 Exotics 787
24.1 Warrants 742 25.8 Actual Use of Derivatives 788
24.2 The Difference between Warrants Summary and Conclusions 790
and Call Options 743 Concept Questions 790
How the Firm Can Hurt Warrant Holders 746 Questions and Problems 792
24.3 Warrant Pricing and the Mini Case: Williamson Mortgage, Inc. 794
Black-Scholes Model 746
24.4 Convertible Bonds 747
24.5 The Value of Convertible Bonds 748 PART VII Short‐Term
Straight Bond Value 748
Conversion Value 749 Finance
Option Value 750
24.6 Reasons for Issuing Warrants
Chapter 26
and Convertibles 751 Short-Term Finance and Planning 795
Convertible Debt versus Straight Debt 751
26.1 Tracing Cash and Net Working Capital 796
Convertible Debt versus Common Stock 752
26.2 The Operating Cycle and the Cash Cycle 797
The “Free Lunch” Story 753
Defining the Operating and Cash Cycles 798
The “Expensive Lunch” Story 754
The Operating Cycle and the Firm’s
A Reconciliation 754
Organization Chart 799
24.7 Why Are Warrants and Convertibles
Calculating the Operating and
Issued? 754
Cash Cycles 800
Matching Cash Flows 754
Interpreting the Cash Cycle 803
Risk Synergy 755
A Look at Operating and Cash Cycles 803
Agency Costs 755
26.3 Some Aspects of Short-Term
Backdoor Equity 756
Financial Policy 804
24.8 Conversion Policy 756
The Size of the Firm’s Investment in
Summary and Conclusions 757
Current Assets 804
Concept Questions 758
Alternative Financing Policies for
Questions and Problems 759
Current Assets 807
Mini Case: S&S Air’s Convertible Bond 761
Which Is Best? 809
26.4 Cash Budgeting 810
Chapter 25 Cash Outflow 811
The Cash Balance 811
Derivatives and Hedging Risk 763 26.5 The Short-Term Financial Plan 812
25.1 Derivatives, Hedging, and Risk 763 Unsecured Loans 812
25.2 Forward Contracts 764 Secured Loans 812
25.3 Futures Contracts 765 Other Sources 813
25.4 Hedging 769 Summary and Conclusions 813
25.5 Interest Rate Futures Contracts 771 Concept Questions 814
Pricing of Treasury Bonds 771 Questions and Problems 814
Pricing of Forward Contracts 772 Excel Master It! Problem 822
Futures Contracts 773 Mini Case: Keafer Manufacturing
Hedging in Interest Rate Futures 774 Working Capital Management 823
25.6 Duration Hedging 778
The Case of Zero Coupon Bonds 778 Chapter 27
The Case of Two Bonds with the Same
Maturity but with Different Coupons 779 Cash Management 825
Duration 780 27.1 Reasons for Holding Cash 825
Matching Liabilities with Assets 782 The Speculative and Precautionary
25.7 Swaps Contracts 784 Motives 825
Interest Rate Swaps 785 The Transaction Motive 826

xxx
 Compensating Balances 826 28.5 Credit Analysis 857
Costs of Holding Cash 826 When Should Credit Be Granted? 857
Cash Management versus Liquidity Credit Information 859
Management 826 Credit Evaluation and Scoring 860
27.2 Understanding Float 827 28.6 Collection Policy 860
Disbursement Float 827 Monitoring Receivables 860
Collection Float and Net Float 828 Collection Effort 861
Float Management 829 28.7 Inventory Management 861
Electronic Data Interchange and The Financial Manager and
Check 21: The End of Float? 832 Inventory Policy 862
27.3 Cash Collection and Concentration 833 Inventory Types 862
Components of Collection Time 833 Inventory Costs 862
Cash Collection 834 28.8 Inventory Management Techniques 863
Lockboxes 834 The ABC Approach 863
Cash Concentration 835 The Economic Order Quantity Model 863
Accelerating Collections: An Example 836 Extensions to the EOQ Model 868
27.4 Managing Cash Disbursements 838 Managing Derived-Demand Inventories 868
Increasing Disbursement Float 838 Summary and Conclusions 870
Controlling Disbursements 839 Concept Questions 871
27.5 Investing Idle Cash 840 Questions and Problems 872
Temporary Cash Surpluses 840 Mini Case: Credit Policy at Braam
Characteristics of Short-Term Securities 841 Industries 875
Some Different Types of Money Appendix 28A: More about Credit Policy
Market Securities 841 Analysis875
Summary and Conclusions 842
Concept Questions 843
Questions and Problems 844
Mini Case: Cash Management
PART VIII Special Topics
at Richmond Corporation 846
Chapter 29
Appendix 27A: Determining the Target
Cash Balance 846 Mergers, Acquisitions, and
Appendix 27B: Adjustable Rate Preferred Divestitures 876
Stock, Auction Rate Preferred
29.1 The Basic Forms of Acquisitions 876
Stock, and Floating-Rate
Merger or Consolidation 876
Certificates of Deposit 846
Acquisition of Stock 877
Acquisition of Assets 877
Chapter 28 A Classification Scheme 878
A Note about Takeovers 878
Credit and Inventory Management 847
29.2 Synergy 879
28.1 Credit and Receivables 847 29.3 Sources of Synergy 880
Components of Credit Policy 848 Revenue Enhancement 880
The Cash Flows from Granting Credit 848 Cost Reduction 881
The Investment in Receivables 848 Tax Gains 883
28.2 Terms of the Sale 849 Reduced Capital Requirements 885
The Basic Form 849 29.4 Two Financial Side Effects
The Credit Period 849 of Acquisitions 886
Cash Discounts 851 Earnings Growth 886
Credit Instruments 852 Diversification 887
28.3 Analyzing Credit Policy 853 29.5 A Cost to Stockholders
Credit Policy Effects 853 from Reduction in Risk 888
Evaluating a Proposed Credit Policy 853 The Base Case 888
28.4 Optimal Credit Policy 855 Both Firms Have Debt 888
The Total Credit Cost Curve 856 How Can Shareholders Reduce Their
Organizing the Credit Function 857 Losses from the Coinsurance Effect? 890

xxxi
29.6 The NPV of a Merger 890 Chapter 31
Cash 890
Common Stock 892
International Corporate Finance 935
Cash versus Common Stock 893 31.1 Terminology 936
29.7 Friendly versus Hostile Takeovers 894 31.2 Foreign Exchange Markets
29.8 Defensive Tactics 896 and Exchange Rates 936
Deterring Takeovers before Being in Play 896 Exchange Rates 937
Deterring a Takeover after the Company 31.3 Purchasing Power Parity 942
Is in Play 897 Absolute Purchasing Power Parity 942
29.9 Have Mergers Added Value? 899 Relative Purchasing Power Parity 943
Returns to Bidders 901 31.4 Interest Rate Parity, Unbiased
Target Companies 902 Forward Rates, and the
The Managers versus the Stockholders 902 International Fisher Effect 945
29.10 The Tax Forms of Acquisitions 904 Covered Interest Arbitrage 945
29.11 Accounting for Acquisitions 906 Interest Rate Parity 946
29.12 Going Private and Leveraged Buyouts 907 Forward Rates and Future Spot Rates 947
29.13 Divestitures 908 Putting It All Together 948
Sale 908 31.5 International Capital Budgeting 949
Spin-Off 908 Method 1: The Home Currency Approach 950
Carve-Out 909 Method 2: The Foreign Currency
Tracking Stocks 909 Approach 951
Summary and Conclusions 910 Unremitted Cash Flows 951
Concept Questions 910 The Cost of Capital for International
Questions and Problems 911 Firms 952
Mini Case: The Birdie Golf-Hybrid 31.6 Exchange Rate Risk 952
Golf Merger 917 Short-Term Exposure 952
Long-Term Exposure 953
Translation Exposure 954
Chapter 30 Managing Exchange Rate Risk 955
Financial Distress 919 31.7 Political Risk 955
The Tax Cuts and Jobs Act of 2017 955
30.1 What Is Financial Distress? 919
Managing Political Risk 956
30.2 What Happens in Financial Distress? 921
Summary and Conclusions 957
30.3 Bankruptcy Liquidation and
Concept Questions 957
Reorganization 923
Questions and Problems 959
Bankruptcy Liquidation 923
Excel Master It! Problem 961
Bankruptcy Reorganization 925
Mini Case: East Coast Yachts Goes
30.4 Private Workout or Bankruptcy:
International 962
Which Is Best? 928
The Marginal Firm 929
Holdouts 929
Appendix A: Mathematical Tables 963
Complexity 929
Appendix B: Solutions to Selected
Lack of Information 929
End-of-Chapter Problems 972
30.5 Prepackaged Bankruptcy 929
Appendix C: Using the HP 10B and TI BA II Plus
30.6 Predicting Corporate Bankruptcy:
Financial Calculators 975
The Z-Score Model 931
Glossary 979
Summary and Conclusions 932
Name Index 987
Concept Questions 933
Subject Index 989
Questions and Problems 933

xxxii
 1 PART I: OVERVIEW

Introduction to
Corporate Finance
In 2009, Travis Kalanick and Garrett Camp started the
ride service app Uber. Uber shot out of the gate, complet-
ing more than five billion rides by the middle of 2017.
Even though Uber was losing more than $100 million per
quarter, its market value reached $70 billion, with
Kalanick’s personal wealth exceeding $6 billion. Unfortu-
nately, Kalanick was accused of knowing about sexual
harassment in the company and doing nothing to resolve
the problem. Then, he was videotaped berating an Uber
driver. As a result, he was forced to step down as CEO
of the company in June 2017, although he remained the
by a major shareholder for fraud, breach of contract, and
breach of fiduciary responsibility.
Understanding Kalanick’s journey from the founder
of a ride-sharing app, to corporate executive, and finally
to embattled board chair takes us into issues involving
the corporate form of organization, corporate goals, and
corporate control—all of which we discuss in this chapter.
And if you are willing to share the ride with us, you’re
going to learn an uber-lot as you read.
Please visit us at rwjcorporatefinance.blogspot.com

chair of the company’s board of directors. And, reminis- for the latest developments in the world of corporate

cent of a runaway car, in August 2017, Kalanick was sued 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 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 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 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, like

1
2  ■■■  PART I Overview

Figure 1.1
The Balance Sheet
Model of the Firm
Net Current liabilities
working
Current assets capital

Long-term debt

Fixed assets

1. Tangible fixed
assets
2. Intangible fixed Shareholders’ equity
assets

Total Value of Assets Total Value of the Firm

to Investors

buildings. Some fixed assets are tangible, such as machinery and equipment. Other fixed
assets are intangible, including patents and trademarks. The other category of assets, cur-
rent assets, comprises those that have short lives, such as inventory. The tennis balls that
your firm has made, but not yet sold, are part of its inventory. Unless you have overpro-
duced, they will leave the firm shortly.
Before a company can invest in an asset, it first must obtain financing, which means
that it must raise the money to pay for the investment. The forms of financing are repre-
sented on the right side of the balance sheet. A firm will issue (sell) pieces of paper called
debt (loan agreements) or equity shares (stock certificates). Both assets and liabilities can
be classified as long-lived or short-lived. 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. Sharehold-
ers’ 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 left side
of the balance sheet. Of course, the types and proportions of assets the firm needs
tend to be set by the nature of the business. We use the term capital budgeting to
describe the process of making and managing expenditures on long-lived assets.
2. How can the firm raise cash for required capital expenditures? This question con-
cerns the right side of the balance sheet. The answer to this question 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
 CHAPTER 1 Introduction to Corporate Finance  ■■■  3

timing of cash inflows and cash outflows during operating activities. Furthermore,
the amount and timing of operating cash flows are not known with certainty. Finan-
cial 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 lia-
bilities. From a financial perspective, short-term cash flow problems come from the
mismatching of cash inflows and outflows. This is the subject of short-term finance.

THE FINANCIAL MANAGER

For current issues In large firms, the finance activity is usually associated with a top officer of the firm,
facing CFOs, see
such as the vice president or chief financial officer, and some lesser officers. Figure 1.2
www.cfo.com.
depicts a general organizational structure emphasizing the finance activity within the firm.

Figure 1.2
Hypothetical
Organization Chart Board of Directors

Chairman of the Board and

Chief Executive Officer (CEO)

Vice President and Chief

Financial Officer (CFO)

Treasurer Controller

Cost Accounting
Cash Manager Credit Manager Tax Manager
Manager

Financial Information
Capital Financial
Accounting Systems
Expenditures Planning
Manager Manager
4  ■■■  PART I Overview

Reporting to the chief financial officer are the treasurer and the controller. The treasurer
is responsible for handling cash flows, managing capital expenditure decisions, and mak-
ing financial plans. The controller handles the accounting function, which includes taxes,
cost and financial accounting, and information systems.

1.2 The Corporate Firm

The firm is a way of organizing the economic activity of many individuals. A basic prob-
lem 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.
For more about
Here are some factors that are important in considering a sole proprietorship:
business types, see 1. The sole proprietorship is the cheapest business to form. No formal charter is
the “Launch your
Business” section at
required, and few government regulations must be satisfied for most industries.
www.sba.gov. 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 people 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 all of the debts of the
partnership. A partnership agreement specifies the nature of the arrangement. The part-
nership 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
 CHAPTER 1 Introduction to Corporate Finance  ■■■  5

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. 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.
4. It is difficult for a partnership to raise large amounts of cash. Equity contribu-
tions are usually limited to a partner’s ability and desire to contribute to the
partnership. Many companies, as was the case with Apple Inc., 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 difficult for large business organizations to exist as sole proprietorships or part-
nerships. The main advantage to a sole proprietorship or partnership 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) difficulty in raising cash.

THE CORPORATION
Of the 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 contracts and may sue and be sued. For juris­dic­
tional 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 partner-
ship. The incorporators must prepare articles of incorporation and a set of bylaws. The
articles of incorporation must include the following:
1. Name of the corporation.
2. Intended life of the corporation (it may be forever).
3. Business purpose.
4. 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.
6  ■■■  PART I Overview

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 brief­
est 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 corporate officers (the top manage-
ment). Traditionally, the shareholders control the corporation’s direction, policies, and
activities. The shareholders elect a board of directors, who in turn select top management.
Members of top management serve as corporate officers and manage the operations 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, the 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 indepen-
dently of those who own its shares, there is no limit to the transferability of shares
as there is in partnerships.
2. The corporation has unlimited life. Because the corporation is separate from its
owners, the death or withdrawal of an owner does not affect the corporation’s
legal existence. The corporation can continue 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 corporate form of business organization. These give the corporation an
enhanced ability to raise cash.
There is one great disadvantage to incorporation. The federal government taxes cor-
porate income (the states do as well). This tax is in addition to the personal income tax
that shareholders pay on dividend income they receive. This is double taxation for share-
holders when compared to taxation on sole proprietorships and partnerships. Table 1.1
summarizes our discussion of partnerships and corporations.
Today all 50 states have enacted laws allowing for the creation of a relatively new
form of business organization, the limited liability company (LLC). The goal of this entity
is to operate and be taxed like a partnership but retain limited liability for owners, so an
LLC is essentially a hybrid of partnership and corporation. Although states have differing
definitions for LLCs, the more important scorekeeper is the Internal Revenue Service
(IRS). The IRS will consider an LLC a corporation, thereby subjecting it to double taxa-
tion, unless it meets certain specific criteria. In essence, an LLC cannot be too corpora-
tion-like, or it will be treated as one by the IRS. LLCs have become common. For
example, Goldman, Sachs and Co., one of Wall Street’s last remaining partnerships,
decided to convert from a private partnership to an LLC (it later “went public,” becoming
a publicly held corporation). Large accounting firms and law firms have largely converted
to LLCs.
 CHAPTER 1 Introduction to Corporate Finance  ■■■  7

Table 1.1 A Comparison of Corporations and Partnerships

Corporation Partnership

Liquidity and Shares can be exchanged without termi-
­marketability nation of the corporation. Common
stock can be listed on a stock
exchange.
Voting rights Usually each share of common stock
entitles the holder to one vote per
share on matters requiring a vote and
on the election of the directors. Direc-
tors ­determine top management.
Taxation Corporations have double taxation:
Corporate income is taxable, and
dividends to shareholders are also
t­ axable.
Reinvestment and Corporations have broad latitude on
­dividend payout d­ividend payout decisions.
Liability Shareholders are not personally liable for
obligations of the corporation.
Continuity of ­existence Corporations may have a ­perpetual life.
Units are subject to substantial restrictions
on transferability. There is usually no
established trading market for partner-
ship units.
There are some voting rights by limited
partners. However, general partners
have exclusive control and management
of operations.
Partnerships are not taxable. Partners pay
­personal taxes on partnership profits.
Partnerships are generally prohibited from
reinvesting partnership profits. All profits
are distributed to partners.
Limited partners are not liable for obliga-
tions of partnerships. General partners
may have unlimited liability.
Partnerships have limited life.

A CORPORATION BY ANOTHER NAME . . .

The corporate form of organization has many variations around the world. The exact laws
and regulations differ from country to country, of course, but the essential features of
public ownership and limited liability remain. These firms are often called joint stock
companies, public limited companies, or limited liability companies, depending on the spe-
cific nature of the firm and the country of origin.
Table 1.2 gives the names of a few well-known international corporations, their coun-
tries of origin, and a translation of the abbreviation that follows each company name.

Table 1.2 International Corporations

Type of Company

Company Country of Origin In Original Language Interpretation

Bayerische Motoren Germany Aktiengesellschaft Corporation

Werke (BMW) AG
Red Bull GmbH Austria Gesellschaft mit Limited Liability
beschränkter Haftung Company
Rolls-Royce PLC United Kingdom Public Limited Company Public Limited Company
Shell UK Ltd. United Kingdom Limited Corporation
Unilever NV Netherlands Naamloze Vennootschap Joint stock company
Fiat SpA Italy Società per Azioni Joint stock company
Volvo AB Sweden Aktiebolag Joint stock company
Peugeot SA France Société Anonyme Joint stock company
8  ■■■  PART I Overview

1.3 The Importance of Cash Flows

The most important job of a financial manager is to create value from the firm’s capital
budgeting, financing, and net working capital activities. How do financial managers create
value? The answer is that the firm should:
1. Try to buy assets that generate more cash than they cost.
2. Sell bonds, stocks, and other financial instruments that raise more cash than
they cost.
The firm must create more cash flow than it uses. The cash flows paid to bondhold-
ers and stockholders of the firm should be greater than the cash flows put into the firm
by the bondholders and stockholders.
The interplay of the firm’s activities with the financial markets is illustrated in
Figure 1.3. The arrows in Figure 1.3 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 invest-
ment 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 sometimes not easy to observe cash flows directly. Much of the infor-
mation we obtain is in the form of accounting statements, and much of the work of
financial analysis is to extract cash flow information from these statements. The following
example illustrates how this is done.

Figure 1.3
Cash Flows
between the Firm
and the Financial Cash for securities issued by the firm (A)
Markets
Firm invests Financial
in assets markets
(B) Retained cash flows (E)
Short-term debt
Current assets Long-term debt
Fixed assets Cash flows Dividends and Equity shares
from firm (C) debt payments (F )
Taxes

Total Value of Assets Government Total Value of the Firm

(D) to Investors in
the Financial Markets
 CHAPTER 1 Introduction to Corporate Finance  ■■■  9

EXAMPLE
1.1 Accounting Profit versus Cash Flows 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.

The Midland Company

Accounting View Income Statement
Year Ended December 31

Sales $1,000,000
Costs     900,000
Profit $ 100,000

By generally accepted accounting principles (GAAP), the sale is recorded even though the cus-
tomer has yet to pay. It is assumed that the customer will pay soon. From the accounting per-
spective, Midland seems to be profitable. The corporate finance perspective focuses on cash
flows, as you can see in the following example.

The Midland Company

Financial View Income Statement
Year Ended December 31

Cash inflow $ 0
Cash outflow 900,000
−$900,000

The focus of corporate finance is on 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 a firm depends on the timing of cash flows. One of
the most important principles 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.

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

Year New Product A New Product B

1 $       0 $ 4,000
2 0 4,000
3 0 4,000
4 20,000 4,000
Total $20,000 $16,000
(continued)
10  ■■■  PART I Overview

At first, it appears that Product A would be best. However, the cash flows from Product B come
earlier than those of A. Without more information, we cannot decide which set of cash flows
would create the most value for the bondholders and shareholders. It depends on whether the
value of getting cash from B up front outweighs the extra total cash from A.

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.

EXAMPLE
1.3 Risk 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 operat-
ing in Japan is seen as very risky. In both cases, the company would close down operations
after one year.
After doing a complete financial analysis, Midland has come up with the following cash
flows of the alternative plans for expansion under three scenarios—pessimistic, most likely, and
optimistic.

Pessimistic Most Likely Optimistic

Europe $75,000 $100,000 $125,000

Japan 0 150,000 200,000

If we ignore the pessimistic scenario, then Japan is the better 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 alterna-
tives and much of our book is devoted to developing methods for evaluating risky opportunities.

1.4 The Goal of Financial Management

Assuming that we restrict our discussion to for-profit businesses, the goal of financial
management is to make money or add value for the owners. This goal is a little vague, of
course, so we examine some different ways of formulating it to come up with a more
precise definition. Such a definition is important because it leads to an objective basis for
making and evaluating financial decisions.

POSSIBLE GOALS
If we were to consider possible financial goals, we might come up with some ideas like
the following:
●● Survive.
●● Avoid financial distress and bankruptcy.
●● Beat the competition.
●● Maximize sales or market share.
 CHAPTER 1 Introduction to Corporate Finance  ■■■  11

●● Minimize costs.
●● Maximize profits.
●● Maintain steady earnings growth.
These are only a few of the goals we could list. Furthermore, each of these possibilities
presents problems as a goal for the financial manager.
For example, it’s easy to increase market share or unit sales: All we have to do is
lower our prices or relax our credit terms. Similarly, we can always cut costs by doing
away with things such as research and development. We can avoid bankruptcy by never
borrowing any money or never taking any risks, and so on. It’s unclear whether any of
these actions are in the stockholders’ best interests.
Profit maximization would probably be the most commonly cited goal, but even this
is not a precise objective. Do we mean profits this year? If so, then we should note that
actions such as deferring maintenance, letting inventories run down, and taking other
short-run cost-cutting measures will tend to increase profits now, but these activities aren’t
necessarily desirable.
The goal of maximizing profits may refer to some sort of “long-run” or “average” prof-
its, but it’s still unclear exactly what this means. First, do we mean something like accounting
net income or earnings per share? As we will see in more detail in the next chapter, these
accounting numbers may have little to do with what is good or bad for the firm. We are
actually more interested in cash flows. Second, what do we mean by the long run? As a
famous economist once remarked, in the long run, we’re all dead! More to the point, this
goal doesn’t tell us what the appropriate trade-off is between current and future profits.
The goals we’ve listed here are all different, but they tend to fall into two classes.
The first of these relates to profitability. The goals involving sales, market share, and cost
control all relate, at least potentially, to different ways of earning or increasing profits.
The goals in the second group, involving bankruptcy avoidance, stability, and safety, relate
in some way to controlling risk. Unfortunately, these two types of goals are somewhat
contradictory. The pursuit of profit normally involves some element of risk, so it isn’t
really possible to maximize both safety and profit. What we need is a goal that encom-
passes both factors.

THE GOAL OF THE FINANCIAL MANAGER

The financial manager in a corporation makes decisions for the stockholders of the firm.
So, instead of listing possible goals for the financial manager, we really need to answer a
more fundamental question: From the stockholders’ point of view, what is a good financial
management decision?
If we assume that stockholders buy stock because they seek to gain financially, then
the answer is obvious: Good decisions increase the value of the stock, and poor decisions
decrease the value of the stock.
From our observations, it follows that the financial manager acts in the shareholders’
best interests by making decisions that increase the value of the stock. The appropriate
goal for the financial manager can be stated quite easily:
The goal of financial management is to maximize the current value per share of the existing
stock.
The goal of maximizing the value of the stock avoids the problems associated with
the different goals we listed earlier. There is no ambiguity in the criterion, and there is
no short-run versus long-run issue. We explicitly mean that our goal is to maximize the
current stock value.
12  ■■■  PART I Overview

If this goal seems a little strong or one-dimensional to you, keep in mind that the
stockholders in a firm are residual owners. By this we mean that they are entitled only
to what is left after employees, suppliers, and creditors (and everyone else with legitimate
claims) are paid what they are due. If any of these groups go unpaid, the stockholders
get nothing. So if the stockholders are winning in the sense that the leftover, residual
portion is growing, it must be true that everyone else also is winning. In other words,
managers should make decisions that they believe will achieve the highest firm value
because, by doing so, shareholders will benefit the most.
Because the goal of financial management is to maximize the value of the stock, we
need to learn how to identify investments and financing arrangements that favorably
impact the value of the stock. This is precisely what we will be studying. In the previous
section, we emphasized the importance of cash flows in value creation. In fact, we could
have defined corporate finance as the study of the relationship between business decisions,
cash flows, and the value of the stock in the business.

A MORE GENERAL GOAL

If our goal is as stated in the preceding section (to maximize the value of the stock), an
obvious question comes up: What is the appropriate goal when the firm has no traded
stock? Corporations are certainly not the only type of business; and the stock in many
corporations rarely changes hands, so it’s difficult to say what the value per share is at
any particular time.
As long as we are considering for-profit businesses, only a slight modification is
needed. The total value of the stock in a corporation is equal to the value of the owners’
equity. Therefore, a more general way of stating our goal is as follows:
Maximize the value of the existing owners’ equity.
With this in mind, we don’t care whether the business is a sole proprietorship, a
partnership, or a corporation. For each of these structures, good financial decisions
increase the value of the owners’ equity, and poor financial decisions decrease it. In fact,
although we choose to focus on corporations in the chapters ahead, the principles we
develop apply to all forms of business. Many of them even apply to the not-for-profit
sector.
Finally, our goal does not imply that the financial manager should take illegal or
Business ethics are
considered at unethical actions in the hope of increasing the value of the equity in the firm. What we
www.business mean is that the financial manager best serves the owners of the business by identifying
-ethics.com. goods and services that add value to the firm because they are desired, legal, and valued
in the free marketplace.

1.5 The Agency Problem and Control

of the Corporation
We’ve seen that the financial manager acts in the best interests of the stockholders by
taking actions that increase the value of the stock. However, in large corporations, owner-
ship can be spread over a huge number of stockholders. This dispersion of ownership
arguably means that management effectively controls the firm. In this case, will manage-
ment necessarily act in the best interests of the stockholders? Put another way, might not
management pursue its own goals at the stockholders’ expense? In the following pages,
we briefly consider some of the arguments relating to this question.
Another random document with
no related content on Scribd:
theory requires them to be, namely honest interpreters of the popular
will instead of crooked agents of sinister influence into which they will
otherwise degenerate. Taking the most moderate view of the benefits
to arise from such reforms, therefore, it would seem a clear duty of
all patriotic citizens and statesmen to work first for the publicity of
campaign contributions and afterwards for such other restrictions
upon their collection and use as experience may suggest.

FOOTNOTES:
[67] “Present Discontents,” Bohn ed. vol. i, p. 375.
[68] Cf. Jane Addams, “Democracy and Social Ethics,” ch. vii.
[69] Cf. “The Rise and Growth of American Politics,” p. 312.
[70] Cf. “The Rise and Growth of American Politics,” p. 323. He
adds that: “No other nation in the world is rich enough for the
political experimentation which the United States is carrying on;
but when the end crowns the work, its cost may be found to have
been small in comparison with the value of the recompense.”
[71] Nevada was the first state to enact legislation of this
character. (L. 1895, ch. 103; repealed, 1899, ch. 108.) In the
same year a Minnesota law (ch. 277) presented a very detailed
definition of legitimate expenses. The laws of Pennsylvania
(1906, ch. 17), and of New York (1906, ch. 503), are very
significant. Professor Merriam sums them up as follows: “Both
provide that no expenses shall be incurred except of the classes
authorised in the act. The New York list, which is rather more
liberal in this respect than that of Pennsylvania, includes rent of
halls and compensation of speakers, music, and fireworks,
advertisement and incidental expenses of meetings, posters,
lithographs, banners, and literary material, payments to agents to
supervise the preparation of campaign articles and
advertisements, and furnish information to newspapers; for
advertising, pictures, reading material, etc.; for rent of offices and
club rooms, compensation of clerks and agents; for attorneys at
law; for preparation of lists of voters; for necessary personal and
travelling expenses of candidates and committeemen; for
postage, express, telegraph, and telephone; for preparing
nominating petitions; for workers and watchers at the polls, and
food for the same; for transportation of the sick and infirm to the
polls.” (“N. Y. State Library Review of Legislation, 1906,” p. 160.)
Cf. also Virginia, L. 1903, ch. 98; South Dakota, L. 1907, ch. 146;
and California, L. 1907, ch. 350.
In 1907, New York took the further step of limiting the amount of
expenditure for a given purpose, ch. 398 of that year providing
that not more than three carriages in a city district, nor more than
six in other districts, should be used for the transportation of
voters. Acting on the same principle Massachusetts in 1908 (ch.
85), prohibited the employment by political committees of more
than six persons in a voting precinct or city ward. As the lavish
expenditure of campaign funds for service, rents, and
commodities may become nothing more than a veiled form of
vote buying, the significance of the action of New York and
Massachusetts is apparent. The English Act of 1883 contains
similar provisions.
The New Jersey law of 1906 (ch. 208) contains a long list of
prohibited expenditures, including payments for entertainment, for
fitting up club rooms for social or recreative purposes, or
providing uniforms for any organised club, and the payment for
insertion of articles in newspapers and magazines unless labelled
as paid articles.
[72] Cf. also the Oregon law proposed by initiative petition and
adopted June 1, 1908.
[73] New York now requires full reports from committees also
(ch. 502, L. 1906).
[74] Iowa, L. 1907, ch. 50, followed New York’s example.
[75] “Republican Campaign Text Book,” 1908, p. 25. In his
message at the beginning of the second (i. e., the first regular)
session of the Sixty-first Congress on December 7, 1909,
President Taft returns to the subject as follows:
“I urgently recommend to Congress that a law be passed
requiring that candidates in elections of Members of the House of
Representatives, and committees in charge of their candidacy
and campaign, file in a proper office of the United States
Government a statement of the contributions received and of the
expenditures incurred in the campaign for such elections, and that
similar legislation be enacted in respect to all other elections
which are constitutionally within the control of Congress.”
 The passage in the foregoing, italicised by the writer, is
noteworthy in that it indicates a step in advance by the president.
His speech of acceptance referred to contributions only, whereas
the message of December 7, 1909, demands publicity of
expenditures as well as of party income.
[76] New York Tribune, November 24, 1908, p. 3. The
Cincinnati Enquirer of November 22, 1908, said that
approximately 20,000 persons contributed to the Republican fund.
Possibly the discrepancy is due to the inclusion in the latter figure
of contributors to the finance committees of the Republican
National Committee in the several states, which as noted above
collected $620,150.
[77] Cincinnati Commercial-Tribune, November 23, 1908.
According to the New York Tribune of November 24, 1908, p. 3, in
which is given a list of contributors to the Republican fund in sums
of $500 and upward the larger contributors to the Republican fund
were as follows: C. P. Taft, $110,000; Union League Club, New
York, $34,377, Larz Anderson and G. A. Garrotson, each
$25,000; Union League Club, Philadelphia, $22,500; Andrew
Carnegie and J. P. Morgan each $20,000. In addition to these
there were fifteen contributors of sums of between $6000 and
$15,000 inclusive; twenty-four contributors of $5000 each; thirty-
four of sums between $2500 and $4000 inclusive; twenty of
$2000 each; twenty-eight of sums between $1250 and $1500
inclusive; one hundred and nineteen contributors of $1000 each;
ten of between $750 and $900 inclusive; and two hundred and
fifty contributors of $500 each.
The Democrats made a preliminary report of contributions on
October 15, and daily reports thereafter until the election. As the
newspapers did not state clearly whether the later figures
regarding contributions were inclusive or additional it is difficult to
summarise the larger contributions accurately. According to the
New York Times of October 14, Tammany Hall sent a check for
$10,000 to the Democratic National Committee. The general
report issued October 15, showed the following contributors in
excess of $2000: C. J. Hughes, $5000; W. J. Bryan, Profits of the
Commoner, $4046; Nathan Straus, $2500; National Democratic
Club, $2500; Norman E. Mack, $2000; Sen. W. A. Clark, $2000;
George W. Harris, $2000. Some of the foregoing were reported
as making contributions after October 15, and if other
contributions reported at various times were not repetitions the list
of contributors of $2000 and over would be somewhat increased.
On October 29, the New York Times reported a gift of $10,000
from Herman Ridder, Treasurer of the Democratic Committee,
and gifts of $9000 each from his three sons, Victor, Bernard, and
Joseph. A contribution of $3000 from E. F. Goltra was also
reported on this date. In addition to the foregoing, five
contributions of between $1000 and $1500, and thirty-three of a
thousand dollars each were reported. According to the Cincinnati
Commercial-Tribune of October 16, Democratic newspapers
collected almost $100,000 out of the $248,000 obtained up to that
date. The New York Times of October 31, noted that one paper,
The New Orleans States, had collected a total of $22,000, said to
be the record contribution for any one newspaper.
[78] “The Dollars Behind the Ballots,” World To-day, vol. xv
(1908), p. 946.
[79] Cf. p. 145, supra.
[80] As final corrections were being made upon these pages
the continental press announces the passage of a publicity
measure by Congress. Unfortunately the writer is unable to
secure details upon which to base a judgment of the new law.
That publicity before election was not provided for is, in his
opinion, to be regretted. On the other hand the enactment as
federal law of a measure of this character represents a decided
victory for a principle capable of great expansion. In this
connection the able and persistent propagandist work of the
National Publicity Law Association under the presidency of Mr.
Perry Belmont deserves the warmest commendation. Noteworthy
also is the fact that the Association includes in its membership
many of the most distinguished leaders of both political parties.—
Paris, July 1, 1910.
[81] According to the English Corrupt and Illegal Practice
Prevention Act of 1883, bribery as the unauthorised act of an
agent renders the election invalid and disqualifies the candidate
from representing the constituency in which the offence was
committed for seven years. While the penalty may seem drastic it
has the good effect of compelling candidates to scrutinise
expenditures in their behalf with a degree of anxious care seldom
duplicated on this side of the Atlantic.
[82] Missouri, L. 1907, p. 261. This law was declared
unconstitutional in 1908, however, on the ground that it impaired
liberty of press and speech. Ex parte Harrison, 110 S. W. 709.
 [83] A similar provision was included in the Massachusetts law
of 1892.
[84] A Michigan law which went into effect in 1892 (Repealed,
ch. 61, 1901) provided that all expenditures on behalf of
candidates, with few exceptions, should be made through the
party committees.
[85] Following the four states which took action in 1897,
Kentucky forbade corporate contributions in 1900. In 1905,
Minnesota (ch. 291) made it a felony for an officer of a business
corporation to vote money to a campaign fund. Wisconsin in the
same year (ch. 492) made it a felony for a corporation to
contribute to political parties for the purpose of influencing
legislation or promoting or defeating the candidacy of persons for
public office. New York in 1906, (ch. 239) prohibited political
contributions by corporations and made violation of the act a
misdemeanor. Alabama, Iowa, North Dakota, South Dakota, and
Texas were the five states which forbade corporate contributions
in 1907, and the following eleven were reported as specifically
prohibiting contributions from life insurance companies in that
year: Delaware, Indiana, Michigan, Minnesota, Montana, New
Hampshire, New Jersey, North Carolina, North Dakota,
Tennessee, and West Virginia. In 1908, Ohio, Georgia,
Massachusetts, and Mississippi also forbade corporate
contributions. Altogether to the end of 1908, seventeen states had
forbidden corporate contributions in general, and eleven had
specifically forbidden contributions from life insurance companies.
[86] Massachusetts, L. 1908, ch. 85.
[87] Ohio, L. 1896, p. 123; repealed, L. 1902, p. 77.
[88] Nebraska in L. 1899, ch. 29, fixed the same maxima and
minima as the Garfield Act. The sliding scale principle was
employed in the English Act of 1883.
[89] California, L., 1893, ch. 2; Missouri, L. 1893, p. 157;
Montana, Penal Code, 1895, sec. 80 ff.; Minnesota, L. 1895, ch.
277; and New York, L. 1907, ch. 584.
[90] New York, L. 1895, 155; Connecticut, L. 1895, 338.
[91] California, L. 1907, ch. 350.
[92] New York, L. 1906, ch. 503.
[93] Cf. p. 177, supra.
 [94] See p. 250, supra.
[95] Cf. p. 246, supra.
[96] Wisconsin, L. 1897, 358.
[97] Cf. President Arthur T. Hadley’s discussion of “The
Constitutional Position of Property in America” in the Independent
of April 16, 1908.
[98] Cf. Professor C. Edward Merriam’s “Primary Elections.”
[99] Laws of 1896, p. 123. The repeal was due to minor defects
in the law which could easily have been corrected by amendment.
[100] Laws of 1906, ch. 17.
[101] Nebraska, L. 1901, 30; Virginia L. 1903, ch. 98; Georgia,
L. 1908, 63.
[102] An able argument on this point is presented by Mr. Perry
Belmont in his “Publicity of Election Expenditures,” North
American Review, vol. clxxx (1905), p. 166. For many of the most
important facts cited in the preceding pages of this study the
writer is indebted to Mr. Belmont’s valuable article.
[103] Cf. the Association’s searching “Report of Examination of
Election Expense Statements, 1908;” also its leaflet on “Future
Plans to Prevent Corrupt Practices.”
CORRUPTION AND NOTORIETY: THE
MEASURE OF OUR OFFENDING
 VII
CORRUPTION AND NOTORIETY: THE MEASURE OF OUR

OFFENDING

Charges of corruption make up a large and important part of the

stock in trade of the ordinary American journalist, politician, and
reformer. One unfortunate result of this condition of affairs is that,
taking us at our word, Europe is forming a very low estimate of the
honesty of governmental and business practices on this side of the
Atlantic. Even among ourselves corruption is coming to be thought of
as an indefinite percentage of evil corroding the general service of
the state, and this percentage is assumed to be much larger in the
United States than abroad. Similar comparisons are drawn between
the principal local and state governments of the country. One popular
writer owes no small part of his vogue to the crisp and supposedly
accurate tags which he has affixed to several of our municipalities
and states, e.g., “corrupt and contented,” “half free and fighting on,”
“a city ashamed,” “bad and glad of it,” “a traitor state,” “a state for
sale,” and so on. Between actual corruption, however, and the
notoriety attached to it no definite and known ratio can be said to
exist. Much as it is to be regretted quantitative measures of this
political and social evil are at present quite impossible. Many
difficulties stand in the way even of approximations sufficiently exact
for comparisons of any value. It may perhaps be as well worth while
to consider the nature of these difficulties as to indulge in
denunciation regardless of them.
In the first place a thoroughgoing policy of concealment and
silence would seem absolutely essential on the part of those who
engage in corrupt practices. Our most astute leaders and
manipulators realise this fact. All observers agree, however, that
among the initiated, which usually means a pretty large circle,
corrupt transactions are discussed with comparative freedom. It is a
matter of no great difficulty for an ordinarily capable reporter to learn
in a general way what has been done by the boss or gang in certain
instances, although this, of course, is sufficiently far from being legal
evidence. And it is notorious that our politicians of the baser sort
often indulge their cronies with boasting accounts of their own
achievements in grafting. No one has commented upon this fact with
greater vigour than Professor H. J. Ford of Princeton in his admirable
review of Mr. Steffens’ Shame of the Cities.
“The facts with which Mr. Steffens deals,” writes Professor Ford,
“are superficial symptoms. Hardly any disguise of them is attempted in
the ordinary talk of local politicians. One of the first things which
practical experience teaches is that the political ideals which receive
literary expression have a closely limited range. One soon reaches
strata of population in which they disappear, and the relation of boss
and client appears to be proper and natural. The connection between
grafting politicians and their adherents is such that ability to levy
blackmail inspires the same sort of respect and admiration which Rob
Roy’s followers felt for him in the times that provided a career for his
particular talents. And as in Rob Roy’s day, intimate knowledge finds
in the type some hardy virtues. For one thing, politicians of this type
do not indulge in cant. They are no more shamefaced in talking about
their grafting exploits to an appreciative audience than a mediæval
baron would have been in discussing the produce of his feudal fees
and imposts. Mr. Steffens has really done no more than to put
together material lying about loose upon the surface of municipal
politics and give it effective presentation. The general truth of his
statement of the case is indisputable.”[104]
Possibly, however, Professor Ford underestimates the penetrating
force of “political ideals which receive literary expression.” If by this
phrase he means only the highest conclusions of philosophy clothed
in the noblest language, it is apparent that a very small circle will be
reached at first, although in time these ideals also are certain to be
widely diffused by the schools, by journalism and by the learned
professions. If, on the other hand, “literary expression” is understood
to include the news and editorial columns and the cartoons of the
daily newspaper, a great and constantly increasing body of readers
are becoming amenable to ideals higher than those bred by the
personal relation of “boss and client.” Tweed’s sensitiveness to the
terribly cutting cartoons of Thomas Nast shows this process in the
course of development. In spite of the fact, of which the Tammany
chieftain had boasted, that most of his constituents could not read,
he was nevertheless forced to exclaim:—“If those picture papers
would only leave me alone I wouldn’t care for all the rest. The people
get used to seeing me in stripes, and by and by grow to think I ought
to be in prison.”[105] Even that portion of our foreign population which
differs most widely in language and customs from the native
American stock is being brought with amazing swiftness under the
influence of the daily papers published in English.[106] That influence
may not be all that we would like it, but at any rate it is much more
broadening than the ethics of the clan.
In addition to the perverted class ideas current in the lower political
ranks there are other causes of the astounding garrulity which
prevails regarding corrupt practices. One of these is the exaggerated
vanity which all penologists note as a common trait of criminal
character. The most adequate explanation, however, is to be found
in the fact that so many of the offenders of this sort are allowed to
escape the penalties of the law. If corruption even in its grosser
forms were as certain of punishment as burglary or forgery, its still
unterrified votaries would speedily learn to keep their mouths shut.
One almost amusing consequence of the large degree of immunity
they enjoy at present is the maudlin sympathy expressed by
confrères when an occasional unlucky rascal is fairly caught in the
net of the law. Well they know, these friends of his, that he is no
more guilty than a score of others who go scot free. Often the
untoward event is made the subject of denunciations on the flagrant
injustice involved, and if the gang is particularly impudent its next
accession to power is pretty apt to be marked by the complete
rehabilitation of the “martyrs” who suffered during the reform
uprising.
As a result of the reckless and often exaggerated gabble of the
grafters, sensational newspapers and magazines find it an easy
matter to keep their columns filled continually with highly spiced
political exposures. In all probability comparatively few out of the
total of corrupt transactions that actually take place are thus made
public, but the prominence given these few may easily lead to
overestimates of the extent of this evil in our political life.
Undoubtedly, also, our practical political leaders are sometimes
accused of offences in which they had no part. Inefficiency, as we
have seen, is very common and very similar in appearance to
corruption. No great reportorial or editorial skill is required to dress it
in the garb of the latter. The constant reiteration of stories of this kind
creates as well as meets a popular demand. Ordinarily a saving
sense of the exaggeration and partisanship indulged in by a section
of the press leads readers to make the necessary discount in
forming their opinions of the published accounts of corruption. At
times, however, the popular craving for pungent stories of corruption
amounts to a positive mania. Such was the case in 1905, 1906, and
1907, as any comparison of the tables of contents of certain
magazines and papers of that period with previous years will
abundantly show. On the other hand there can be no doubt that a
considerable part of this literature of exposure and denunciation was
substantially accurate, and that its publication was a service of high
merit. That it was also profitable is no reproach: society is the gainer
when instead of ostracism and punishment it provides rewards and
honours for those who attack real public abuses. In not a few cases
where corruption was thus charged by journalists subsequent
investigations before commissions and courts left no doubt of the
existence of vicious practices, and led to reforms of a most
beneficent character.
Extremely deplorable as must be the effect of false accusations
inspired by selfish motives, a policy of the widest publicity offers
great advantages over one of suppression and silence. Better fifty
exposures, ten or even twenty of which are misleading, than blind
concealment of official misdoing. Disproof of false charges is
comparatively easy and when effectively made redounds to the
prestige of the official or individual who has been unjustly assailed.
As for those newspapers and periodicals which flagrantly abuse their
privilege, it is seldom that they altogether escape penalties in the
form of loss of influence if not of circulation. If penalties of these
kinds can be made effective press censorship and lese majeste
laws, such as exist in autocratic governments, need never be
resorted to in America. From this point of view the horror frequently
expressed by continental publicists at the corruption existing in the
United States appears rather equivocal. Bad as some of our political
conditions may be, we at least deserve credit for our willingness,
nay, our determination, to hear the worst about ourselves. Certainly
there would seem to be greater hope of improvement under our
policy than in a country whose chief national hero used the
enormous income from the sequestered estates of the House of
Hanover to fill the news and editorial columns of the “reptile” press
with lying articles favourable to his policies, and in which only
recently the facts concerning the Camarilla surrounding the Emperor
were so cautiously and partially brought to light. And it is well known
that in Russia the censorship was deliberately used by provincial
bureaucrats to conceal their misdeeds from the knowledge of the
Czar.
As between countries which muzzle the press and those which
allow liberty it is inevitable, then, that the governments of the latter
will be charged far more openly and frequently with corruption.
Citizens who are shocked by the accusations thus trumpeted forth
may be pardoned some apprehensions for the continued stability
and success of their institutions. The sentiment does them more
credit than callous disregard or brazen Chauvinism, and is altogether
more likely to be productive of good works in the future. But it may
easily be carried to an extreme. National shamefacedness is not a
virtue. In forming a judgment of the extent of contemporary
corruption the garrulity of politicians, the sensationalism of the press,
the popular demand for highly spiced accounts of official sinning
should all be taken into account. A cynical representative of yellow
journalism, replying to the criticism that his paper indulged too much
in lengthy and lurid accounts of crime and immorality, remarked
rather sententiously that “sin is news.” The statement is only partially
true. Most sins are too common and too petty to have any news
value. Only those offences that to current estimation seem large and
dangerous are given prominence and headlines. If Turkey and China
enjoyed the blessings of a free press it is hardly probable that the
papers of those countries would give much space to what, according
to Western standards, would be frankly considered corrupt and
extortionate practices on the part of their pashas and mandarins.
Such practices would be so common, so universally known, and so
little in conflict with contemporary Turkish and Chinese political
morals that they would excite little interest and comment. If then, as
in our own papers, accounts of atrocious crimes and accusations of
corrupt practices are given the same large measure of prominence it
means simply that both kinds of offences are considered to possess
a high degree of news value. Puritans may deplore the popular taste
which finds interest in such reports, but we cannot deny the
existence of that interest. Primarily it exists not because sin as such
is news but because offences which are considered large and
dangerous appeal powerfully to the popular mind.
To the normal reader, of course, the fascination of such accounts
is the fascination of repulsion, not of attraction. In attempting to
explain the pornographic note in modern French literature, Professor
Barrett Wendell makes a most ingenious suggestion that is not
without its application to the present argument.[107] With the
exception of a class forming a small part of the whole population,
French family life is conspicuously pure. Why, then, asks Professor
Wendell, should fathers and mothers who themselves practise every
conjugal virtue delight in novels and dramas that dissect all the
prurient phases of divorce, adultery, and sexual laxity? Simply
because such topics take them out of themselves by presenting
situations quite foreign to their experience and hence strikingly
interesting. In some degree the same answer applies to American
public interest in corrupt practices. The great mass of business and
professional men, and of politicians as well, who sincerely attempt to
live up to the best standards of their vocations nevertheless read and
hear with avidity spicy accounts of the malpractices of their
disreputable colleagues. Nor can this interest on their part be
denounced as morbid so long as it leads not to palliation and
imitation but to reprobation and efforts for the wiping out of abuses.
Would the situation be really improved if instead of the daily grists
presented to us by the newspapers we should read nothing but
accounts of the straightforward methods which are employed in the
great bulk of political, business, and professional transactions? The
habit might be exemplary but it would certainly be supremely dull.
While it is not true that all sin is news there would seem to be
nothing to regret in the fact that neither are all virtues. Of the two the
former undoubtedly has the greater news value. But the reason for
this is that relative to the sum total of everyday transactions the more
heinous offences against morals and law are to a high degree
unusual. Virtue and ability, on the other hand, are so commonplace
that it requires a most exceptional display of either to secure public
notice. Considerable vogue has been enjoyed recently by the term
“smokeless sin,” as applied to certain forms of social evil-doing
which although large and dangerous are also so subtle and
complicated that responsibility for them can easily be avoided.[108]
Students of sin would do well to remember, however, that now as
always virtue as a whole possesses the quality of smokelessness to
a much more eminent degree than vice.
Admitting that political corruption exists among us to a disquieting
extent the point is frequently made that the vigour with which it has
recently been exposed and attacked is in itself evidence of moral
health and harbinger of ultimate victory over the evil. Such exposure
and attacks, it is said, signify the development of higher ideals
measured by which practices formerly tolerated are now condemned
by public opinion and will later be condemned by law. As to the
emergence of higher ideals there can be no doubt, and so far we
have just ground for encouragement. Reform sentiment as a whole,
however, can scarcely be accepted at its full face value. A
considerable part of the denunciation which accompanies it is as
much exaggerated as the corresponding campaign “literature” and
“oratory” of the practical politician. Thus the volume of clamour is
augmented and the difficulty of correctly estimating honesty in public
life increased. There are always those who deliberately attach
themselves to reform movements solely because they foresee
victory at the polls with office and emoluments and other less
legitimate opportunities for themselves. In other words while
ostensibly fighting corruption the motives of such persons are at
bottom corrupt from the start. Bandit Mendoza of the Sierras, that
eminent socialist of Shaw’s creation, was not entirely wrong in
maintaining that “a movement which is confined to philosophers and
honest men can never exercise any real political influence: there are
too few of them. Until a movement shows itself capable of spreading
among brigands, it can never hope for a political majority.” In some
American cities charges have even been made that corporate
interests which did not enjoy the favour of the gang or boss have
contributed largely to “anti-graft” campaigns, their real purpose being
to place themselves in a position to claim the favour of the “honest”
administration elected by their efforts. Knowledge of corrupt
transactions, discretely hinted at in the press, has been used in other
instances as a sort of political blackmail to club the gang or boss into
the granting of privileges to applicants who had hitherto been denied.
The mere volume of clamour developed by reform movements
against corrupt practices is, therefore, no certain index of higher
moral standards. There is even danger that we may too
complacently accept mere denunciation for real achievement. Nor
can the work be deemed finished when popular uproar has secured
new legislation, for laws, notoriously, do not execute themselves.
Discouragement then too easily overtakes the rank and file of the
anti-corrupt element; hence, in part, the spasmodic character of
many reform movements. When every necessary deduction has
been made, however, the fundamental strength and continued
progress of the cause of honesty in politics is beyond question. Even
the selfish interests that attach themselves to it prove this contention.
It is true they bring no enthusiasm for higher standards as such, and
also that the results of alliances of this character are often
disheartening. Nevertheless the mere fact that such alliances are
entered into by practical politicians is pretty strong testimony, coming
as it does from men who are very little affected by considerations of
sentiment, to the power of the sincere reform element which is
pursuing no ulterior ends. In all cases of this sort the selfish politician
is seeking to strike with the strength of others, and this strength must
be reckoned with as a real factor, no matter what uses designing
men endeavour to make of it. Here as elsewhere the counterfeit
bears witness to the value of the genuine.
Whatever may be the extent of corruption in the United States it is
under fire all along the line. Moreover we regard and attack as
abuses practices which in other countries are considered free from
reproach or even as pillars of the state. Comparisons to our
disadvantage on the score of corruption are most frequently made
with England and Germany. In England, however, the privileges of
peerage, gentry, clergy, and the landholding class generally are
enormous.[109] Land is assessed at a fraction of its real value, local
rates are thrown upon the tenant, railroads seeking charters and
cities seeking legislation to wipe out disease-breeding slums or to
take over badly managed docks find themselves mulcted by special
acts exacting excessive prices for the property taken, and the
interests responsible for all these conditions sit enthroned in an
omnipotent parliament. Landlordism has progressed to a
considerable degree in the United States, to be sure, and we
possess a more than plentiful supply of slum landlords. Property
rights in realty are abundantly protected among us, but our
landowners are very far from enjoying the class privileges or the
social standing accorded them in England. Moreover when abuses
arise in connection with their management, public opinion does not
hesitate to express itself unmistakably, nor is corrective legislation
difficult to procure. In Germany, which like England is frequently
extolled for its high political morality, autocracy, aristocracy,
Junkertum, and the swaggering military class are sacrosanct.
Landtag and city councils in Prussia are elected under a three-class
voting system which fills these bodies with agents of the landed and
plutocratic interests and deprives the great mass of the people of
adequate representation. Against these and kindred abuses has
risen the menace of social-democracy. The prospects for peaceful
reform in the near future are not altogether bright. Autocratic,
aristocratic, and plutocratic rule is seated firmly in the saddle, and is
not inclined to listen to proposals that it shall reduce its own powers.
Special privileges exist in the United States, it is true, but they are
always regarded as questionable, they must continually justify
themselves to a majority of the whole people, they can never feel
themselves secure in public opinion even if for the time being they
have the support of law. “Grafting,” said Governor Folk of Missouri,
“may or may not be unlawful. It is either a special privilege exercised
contrary to law or one that the law itself may give. Special privileges
are grafts and should be hateful to all good citizens.”[110] The
statement is an unguarded one, but it is thoroughly typical of a deep-
seated American tendency to suspect corruption in every special
privilege, whether it be legal or illegal, whether it be condemned by a
sweeping consensus of moral opinion or only by some reforming
voice crying in the wilderness.
It is no part of this argument to assert that the rights and
immunities enjoyed by the English aristocracy, for example, are
corrupt. Under the definition earlier proposed this is clearly not the
case. On the contrary these privileges have as yet the support of
law, tradition, custom, public opinion, and public deference. A radical
democrat might say that all this simply proves the blind ignorance of
the great mass of Englishmen and the fatal ease with which they can
be exploited by a horde of social parasites. From an unprejudiced
point of view, however, we must concede the right of a people to
govern itself according to its own lights. The English may be
committing a monstrous political blunder in tolerating their
aristocracy, but if they decide to do so that is their own concern, and
the privilege so established is, both in morals and in law, beyond the
accusation of corruption. Exactly the same defence may be made for
the Prussian Junkertum and the German military class, or, for that
matter, for the caste system of India. The development of new
standards of public opinion, morals, and politics, in these countries
may at some time bring their privileged classes under effective
criticism; the conviction that they are socially harmful may gain
ground; and out of this conviction may come reform movements
designed to secure their abolition. Until that time, however, while we
may perceive clearly enough the political ills entailed upon our
neighbours by special privilege, we cannot denounce them as
corrupt because they tolerate it.
It may even be conceded that in some cases the glorification of a
class is in the best interests of the state as a whole. Feudal
aristocracy was certainly functional and efficient, whatever one may
think of its modern descendants. Considering Germany’s powerful
neighbours and her extended frontier there is much to be said even
for the privileges at present granted to her military class, however
odious they may appear to the citizen of a non-militant country. One
need not go far afield in search of illustrations of this sort. Under our
tariff system advantages accrue particularly to manufacturers that
are not entirely dissimilar to the special privileges referred to above.
Protection was established, however, on the ground that while
manufacturers might benefit primarily by duties on imports, the
resulting advantages would be widely diffused, and the interests of
the country as a whole advanced by this policy. It is possible that the
majority was mistaken in so thinking, just as the English may be
mistaken in thinking that the maintenance of an aristocracy is to their
national advantage. Deeply as our protective system is entrenched,
however, it has no such support as aristocracy in England, as
militancy in Germany. It has continuously been criticised by very
large minorities, and the only real basis of defence it possesses is
the conviction of the majority that it is conducive to the welfare of the
country as a whole. If it once loses this support its ultimate fall is
assured. Other forms of privilege existing among us,—railroad
interests, franchise interests, interests seeking land, timber, and
mineral grants, or subsidies, and corporations generally,—are on the
defensive to an even greater degree than the protective system.
The argument so far as it relates to special privileges may now be
summed up as follows: Special privileges are not necessarily
corrupt; they may be in the public interest and recognised as such.
They exist in the United States, but are much more common in
England and Germany. We, however, have chosen to regard all of
them with suspicion and to attack many of them vigorously, charging
them not only with corruption but with every other political crime in
the calendar. Abroad they enjoy greater security and respectability.
Even when they are assailed by English and continental publicists
more deferential methods of attack are employed than we are used
to in America. Rude words such as “graft” are avoided.[111] Hence in
part the greater appearance of corruption which we present to
Europe, and which we seem to confirm by the criminations and
recriminations which issue from our own mouths. Mr. Frederic C.
Howe is therefore right in maintaining the probability that “it is not so
much in the badness, as in our knowledge of the badness, that
America differs from the rest of the world.” Without underestimating
the enormous power of the forms of special privilege which exist
among us, and the difficulty of restraining and regulating them,[112]
European nations may nevertheless find it a far more trying task to
adjust the claims of their own widespread and deeply rooted forms of
privilege when they come into conflict with the rising tide of
democratic and socialistic sentiment. So far as privilege in autocratic,
aristocratic, and clerical forms, is concerned we have every reason
to be grateful that the fathers of the Republic long ago made away
with it. They left the awful heritage of slavery, but privilege resting
upon that basis has also been wiped out. We ourselves must face
the power of the political machine and massed wealth, and we are
facing it. Momentous as is the issue, we have, at least, the
satisfaction of being able to rejoice, in the trenchant and essentially
true words of Mr. William Allen White, that the United States is “a
country where you can buy men only with money.”[113]
In comparing the political morality of Europe and America
reference must finally be made, even at the risk of repetition, to the
greater political trust imposed in the mass of our people. As regards
the number participating suffrage is not materially different in the
United States from the systems of the leading European nations.
The tendency abroad, however, is to limit the direct popular vote to
legislative offices only and to the smallest possible number of these.
It is undeniable that we have gone too far in the opposite direction.
We crowd not only legislative but also many judicial and
administrative offices on our “blanket” ballots, and as a result the
total number of places submitted to the popular vote passes all
bounds. Instead of realising greater democracy by this method we
enable the machine to take advantage of the confusion which the
elector feels when confronted by so many places and candidates,
and his consequent inclination to vote “straight.”[114] Apart from this
point, however, it is extremely important to note that the power of the
vote to confer place is much greater in the United States than
abroad, and consequently, if it is to be corruptly purchased or
misused, its value is higher. To put the matter in another way, the
trust imposed by the Republic in the voter is greater. The number of
offices to which the ordinary citizen is eligible by ballot without regard
to class standing or desirable preparation, the greater importance of
state and local government, and the placing of the latter under
popular control,—all contribute to increase the burden of
responsibility which is imposed upon the great mass. We must admit
that the trust thus created is often violated, but on the other hand we
deserve such credit as may arise from the fact that we have
deliberately chosen to believe in the virtue of the whole people and
have established a system which puts that virtue to a supreme test.
European nations which take the “holier than thou” attitude with
reference to our corruption might be forced to abandon their
pretensions if they were to lodge as much power in their electorates
as we do in ours. Given two communities, one “dry” and the other
“wet,” the mere fact that there was more drunkenness in the latter
would not prove a less degree of moral control of appetite on the part
of its inhabitants. One would have to take into account that the
citizens of the “wet” community could satisfy their thirst openly and
frequently, whereas some of the “drys” must be sober at times simply
because they cannot get liquor. On the other hand, those citizens of
the “wet” community who abstain must do so of their own volition
and in the face of constant temptation. Similarly it may be said of the
political vice existing in the United States that its magnitude is in part
due to the fact that, loving democracy “not wisely but too well,” we
have distributed powers and responsibilities broadcast with the
consequence that they have fallen partly into unworthy hands. And
of such political virtue as we possess at least we may assert that it is
not the anemic innocence which has never known the approach of
temptation.
It would appear from the foregoing that the various factors which
must be taken into account in attempting to determine the extent of
existing corruption are extremely conflicting and uncertain. As
between country and country, city and city, comparisons are certain
to be odious and likely to be misleading. Each has problems
sufficiently pressing and extended to occupy its reform energies to
better advantage. We in the United States may not be so wicked as
our neighbours believe, but our work is cut out for us, and it is work
that will require the greatest intelligence and the greatest virtue that
the republic possesses. Hasty conclusions regarding the outcome,