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Principles of
Corporate Finance
● ● ● ● ●
THE MCGRAW HILL 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 Eleventh Edition Eighth Edition
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Eighteenth Edition Ross, Westerfield, and Jordan
Fundamentals of Corporate Finance International Finance
Brealey, Myers, Allen, and Edmans Thirteenth Edition
Principles of Corporate Finance Eun and Resnick
Fourteenth Edition Shefrin International Financial Management
Behavioral Corporate Finance: Decisions Ninth Edition
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That Create Value
Principles of Corporate Finance, Concise
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Second Edition Real Estate
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Finance: Applications and Theory Allen, Melone, Rosenbloom, and
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and Management
M: Finance Thirteenth Edition
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Corporate Finance: Core Principles and Financial Institutions Management: A Risk
Applications Management Approach
Sixth Edition Tenth Edition
Principles of
Corporate Finance
FOURTEENTH EDITION

Richard A. Brealey
Emeritus Professor of Finance
London Business School

Stewart C. Myers
Emeritus Professor of Financial Economics
Sloan School of Management
Massachusetts Institute of Technology

Franklin Allen
Professor of Finance and Economics
Imperial College London

Alex Edmans
Professor of Finance
London Business School
 Final PDF to printer

PRINCIPLES OF CORPORATE FINANCE

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Dedication

To our parents.
 About the Authors
⟩ Richard A. Brealey
Emeritus Professor of
Finance at London Busi-
ness School. He is the
former president of the
European Finance Associa-
tion and a former director
of the American Finance
Association. He is a fellow
of the British Academy
and has served as a special
adviser to the Governor of
the Bank of England and
director of a number of
financial institutions. Other
books written by Professor
Brealey include Introduc-
tion to Risk and Return
from Common Stocks.
vi
⟩ Stewart C. Myers
Emeritus Professor of
Financial Economics at
MIT’s Sloan School of
Management. He is past
president of the American
Finance Association, a
research associate at the
National Bureau of Eco-
nomic Research, a principal
of the Brattle Group Inc.,
and a retired director of
Entergy Corporation. His
research is primarily con-
cerned with the valuation
of real and financial assets,
corporate financial policy,
and financial aspects of
government regulation of
business. He is the author
of influential research
papers on many topics,
including adjusted present
value, rate of return regula-
tion, pricing and capital
allocation in insurance, real
options, and moral hazard
and information issues in
capital structure decisions.
⟩ Franklin Allen
Professor of Finance and
Economics, Imperial Col-
lege London, and Emeritus
Nippon Life Professor of
Finance at the Wharton
School of the University
of Pennsylvania. He is past
president of the Ameri-
can Finance Association,
­Western Finance Associa-
tion, Society for Financial
Studies, Financial Interme-
diation Research Society,
and Financial Management
Association. His research
has focused on financial
innovation, asset price
bubbles, comparing finan-
cial systems, and financial
crises. He is Director of
the Brevan Howard Centre
for Financial Analysis at
Imperial College Business
School.
⟩ Alex Edmans
Professor of Finance at
London Business School
and Mercers School Memo-
rial Professor of Business
at Gresham College. He
is Managing Editor of the
Review of Finance and
was previously a tenured
professor at Wharton,
where he won 14 teaching
awards in six years. His
research focuses on corpo-
rate finance, responsible
business, and behavioral
finance. He has spoken at
the World Economic Forum
in Davos and given the
TED talk “What to Trust
in a Post-Truth World” and
the TEDx talk “The Social
Responsibility of Busi-
ness”; he is also advisor to
several asset managers. He
is the author of Grow the
Pie: How Great Compa-
nies Deliver Both Purpose
and Profit. Poets & Quants
named him MBA Professor
of the Year for 2021.

⟩rate finance. We hardly need to explain why financial
This book describes the theory and practice of corpo-
managers have to master the practical aspects of their
job, but we should spell out why down-to-earth manag-
ers need to bother with theory.
Managers learn from experience how to cope with
routine problems. But the best managers are also able to
respond to change. To do so you need more than time-
honored rules of thumb; you must understand why com-
panies and financial markets behave the way they do. In
other words, you need a theory of finance.
That should not sound intimidating. Good theory
helps you to grasp what is going on in the world around
you. It helps you to ask the right questions when times
change and new problems need to be analyzed. It also
tells you which things you do not need to worry about.
Throughout this book, we show how managers use
financial theory to solve practical problems.
Of course, the theory presented in this book is not per-
fect and complete—no theory is. There are some famous
controversies where financial economists cannot agree.
We have not glossed over these disagreements. We set out
the arguments for each side and tell you where we stand.
Much of this book is concerned with understanding
what financial managers do and why. But we also say
what financial managers should do to increase company
value. Where theory suggests that financial managers
are making mistakes, we say so, while admitting that
there may be hidden reasons for their actions. In brief,
we have tried to be fair but to pull no punches.
This book may be your first view of the world of mod-
ern finance. If so, you will read first for new ideas, and
for an understanding of how finance theory translates
into practice. But eventually you will be in a position
to make financial decisions, not just study them. At that
point, you can turn to this book as a reference and guide.
⟩
Changes in the Fourteenth Edition
What has changed in this edition? You will have seen
the first change on the cover: Alex Edmans has joined
the author team. Alex is a global authority in corporate
finance, with particular expertise in corporate gover-
nance, responsible business, and behavioral finance—
three areas we have significantly bolstered as we will
shortly describe. In addition to being a leading researcher,
Preface
he has substantial practitioner expertise. He has also won
a multitude of teaching awards at MIT, Wharton, and
London Business School and is particularly noted for
the ability to explain complex finance concepts in simple
language. He recently gave a year-long Gresham College
public lecture series on the principles of finance attended
by a diverse audience, from schoolchildren to retirees.
This expansion of the author team has led to a number
of important changes. For example, in recent years many
observers have questioned companies’ focus on profits and
have suggested that managers should promote the interests
of all stakeholders rather than simply seeking to maximize
shareholder value. The issue is an important one and we
have, therefore, added a new chapter, Chapter 20, that
discusses these different corporate objectives, how far they
conflict, and how a responsible business should behave.
The structure of a firm’s governance is closely related
to its objectives. We have therefore moved the material on
corporate governance and agency issues to Chapter 19,
where it now sits next to the chapter on corporate objec-
tives. This chapter has also been substantially rewritten.
Other chapters with major changes include the two
chapters on the pricing of risky assets (Chapters 7 and 8).
Chapter 7 now focuses on portfolio choice and a stock’s
effect on portfolio risk, while Chapter 8 concentrates on
asset pricing. This is a clearer separation of topics than
in previous editions; we think that it is more logical and
helps understanding.
The discussion of market efficiency (Chapter 12)
has also undergone substantial revision with additional
and updated sections on empirical evidence. The chap-
ter also contains an expanded discussion of behavioral
finance and the evidence for behavioral biases.
Financial innovation today is being driven by techno-
logical developments such as artificial intelligence, big
data, and cloud computing. Chapter 13 now includes a
new section that reviews seven ways in which financial
technology is changing financial practice.
U.S. financial managers work in a global environ-
ment and need to understand the financial systems of
other countries. Also, many of the text’s readers come
from countries other than the United States. Therefore, in
recent editions, we have progressively introduced more
international material, including information about the
major developing economies, such as China and India.
Material on international differences in financing is now
vii
viii Preface
integrated in Chapter 14, while ­Chapter 19 includes a
discussion of governance systems around the world.
PEDAGOGICAL CHANGES
Throughout, we have tried to explain the material much
more clearly--importantly, without dumbing it down.
The style of this edition is more direct and less whim-
sical, with terms being precisely defined and key con-
cepts made explicit rather than having to be inferred
from the narrative. In many cases, the changes consist
of some updated data here and a new example there.
Often, these additions reflect some recent development
in the financial markets or company practice.
We have also changed the introduction to each chapter
to include summaries of the content of each of the chap-
ter’s sections. We think that this will make it easier for the
reader to understand the organization of the chapter and
to jump forward to a particular topic of interest. Chapters
now also conclude with key takeaway bullet points sum-
marizing the chapter’s principal lessons.
Within each chapter we have interspersed a number
of new self-test questions that provide an opportunity for
readers to pause and check their understanding. Answers
to these self-tests are located at the end of the chapter.
The Beyond the Page digital extensions and
applications provide additional examples, anecdotes,
spreadsheet programs, and more detailed explanations
and practice examples of some topics. This extra material
makes it possible to escape from the constraints of the
printed page by providing more explanation for readers
who need it and additional material for those who would
like to dig deeper. There are now more than 150 of these
apps. They are seamlessly available with a click on the
e-version of the book, but they are also readily accessible
in the traditional hard copy of the text using the shortcut
URLs provided in the margins of relevant pages. Check
out mhhe.com/brealey14e to learn more.
Examples of these applications include:
∙ Chapter 2 Would you like to learn more about how
to use Excel spreadsheets to solve time value of
money problems? A Beyond the Page application
shows how to do so.
∙ Chapter 3 Do you need to calculate a bond’s dura-
tion, see how it predicts the effect of small interest
rate changes on bond price, calculate the duration of
a common stock, or learn how to measure convexity?
The duration app allows you to do so.
∙ Chapter 5 Want more practice in valuing annuities?
There is an application that provides worked exam-
ples and hands-on practice.
∙ Chapter 7 Ever wondered how COVID-19 has
affected the risk of stocks in the travel industry? An
app provides the answer.
∙ Chapter 12 Want an example of how speculative
trading can swamp the actions of arbitrageurs? The
app on the explosion in the price of GameStop shares
provides one.
∙ Chapter 18 The text briefly describes the flow-to-
equity method for valuing businesses, but using the
method can be tricky. We provide an application that
guides you step by step.
∙ Chapter 22 The Black–Scholes Beyond the Page
application provides an option calculator. It also shows
how to estimate the option’s sensitivity to changes in
the inputs and how to measure an option’s risk.
⟩ Chapter Structure
Each chapter of the book includes an introductory
preview, a list of key takeaways, and suggested fur-
ther reading. The list of candidates for further read-
ing is now voluminous. Rather than trying to include
every important article, we largely list survey articles
or general books. We give more specific references in
footnotes.
In addition to the self-test questions within the chap-
ter, each chapter is followed by a set of problems on
both numerical and conceptual topics, together with a
few challenge problems.
We include a Finance on the Web section in chapters
where it makes sense to do so. This section now houses
a number of Web Projects, along with new Data Anal-
ysis problems. These exercises seek to familiarize the
reader with some useful websites and to explain how to
download and process data from the web.
The book also contains 12 end-of-chapter Mini-
Cases. These include specific questions to guide the
case analyses. Answers to the mini-cases are available
to instructors on the book’s website.
Spreadsheet programs such as Excel are tailor-
made for many financial calculations. Several chapters
include boxes that introduce the most useful financial
functions and provide some short practice questions.
We show how to use the Excel function key to locate
the function and then enter the data. We think that this
approach is much simpler than trying to remember the
formula for each function.
We conclude the book with a glossary of financial
terms.
The 34 chapters in this book are divided into 12 parts.
Parts 1, 2, and 3 cover valuation and capital investment

decisions, including portfolio theory, asset pricing
models, and the cost of capital. Parts 4 through 9 cover
financing decisions, payout policy and capital struc-
ture, corporate objectives and governance, options,
debt financing, and risk management. Part 10 covers
financial analysis, planning, and working-capital man-
agement. Part 11 covers mergers and acquisitions, and
corporate restructuring. Part 12 concludes.
We realize that instructors will wish to select topics
and may prefer a different sequence. We have therefore
written chapters so that topics can be introduced in
several logical orders. For example, there should be no
difficulty in reading the chapters on financial analysis
and planning before the chapters on valuation and
capital investment.
⟩ Acknowledgments
We have a long list of people to thank for their helpful
criticism of earlier editions and for assistance in pre-
paring this one. They include Faiza Arshad, Aleijda de
Cazenove Balsan, Donna Cheung, Kedran Garrison,
Robert Pindyck, and Gretchen Slemmons at MIT; Elroy
Dimson, Paul Marsh, Mike Staunton, and Stefania
Uccheddu at London Business School; Lynda Borucki,
Marjorie Fischer, Larry Kolbe, Michael Vilbert, Bente
Villadsen, and Fiona Wang at The Brattle Group Inc.;
Alex Triantis at Johns Hopkins University; Adam
Kolasinski at Texas A&M University; Simon Gervais
at Duke University; Michael Chui at Bank for Interna-
tional Settlements; Pedro Matos at the University of
Virginia; Yupana Wiwattanakantang at National Uni-
versity of Singapore; Nickolay Gantchev at Warwick
University; Tina Horowitz at the University of Pennsyl-
vania; Lin Shen at INSEAD; Darien Huang at Tudor
Investment; Julie Wulf at Harvard University; Jinghua
Yan at SAC Capital; Bennett Stewart at EVA Dimen-
sions; and Mobeen Iqbal, Antoine Uettwiller and Tong
Yu at Imperial College London.
We would also like to thank the dedicated experts
who have helped with updates to the instructor mate-
rials and online content in Connect and LearnSmart,
including Nicholas Racculia.
We want to express our appreciation to those instruc-
tors whose insightful comments and suggestions were
invaluable to us during the revision process:
Ibrahim Affaneh Indiana University of Pennsylvania
Neyaz Ahmed University of Maryland
Alexander Amati University of Connecticut
Anne Anderson Middle Tennessee State University
Noyan Arsen Koc University
Preface ix
Anders Axvarn Gothenburg University
John Banko University of Florida, Gainesville
Michael Barry Boston College
Jan Bartholdy Aarhus University
Penny Belk Loughborough University
Omar Benkato Ball State University
Erik Benrud Indiana University
Ronald Benson University of Maryland, University College
Peter Berman University of British Columbia
Kevin Boeh University of Washington
Tom Boulton Miami University of Ohio
Edward Boyer Temple University
Alon Brav Duke University
Jean Canil University of Adelaide
Robert Carlson Bethany College
Chuck Chahyadi Eastern Illinois University
Chongyang Chen Pacific Lutheran University
Fan Chen University of Mississippi
Bill Christie Vanderbilt University
Celtin Ciner University of North Carolina, Wilmington
John Cooney Texas Tech University
Charles Cuny Washington University, St. Louis
John Davenport Regent University
Ray DeGennaro University of Tennessee, Knoxville
Adri DeRidder Uppsala University
William Dimovski Deakin University, Melbourne
David Ding Nanyang Technological University
Robert Duvic University of Texas at Austin
Susan Edwards Grand Valley State University
Riza Emekter Robert Morris University
Robert Everett Millersville University
Dave Fehr Southern New Hampshire University
Donald Flagg University of Tampa
Frank Flanegin Robert Morris University
Zsuzanna Fluck Michigan State University
Connel Fullenkamp Duke University
Mark Garmaise University of California, Los Angeles
Sharon Garrison University of Arizona
Christopher Geczy University of Pennsylvania
George Geis University of Virginia
Bradford Gibbs Brown University
Stuart Gillan University of North Texas
Felix Goltz Edhec Business School
Ning Gong Deakin Business School
Levon Goukasian Pepperdine University
Gary Gray Pennsylvania State University
C. J. Green Loughborough University
Mark Griffiths Miami University
Anthony Gu SUNY Geneseo
Re-Jin Guo University of Illinois, Chicago
Pia Gupta California State University, Long Beach
Ann Hackert Idaho State University
Winfried Hallerbach Robeco Asset Management
Milton Harris University of Chicago
Mary Hartman Bentley College
Glenn Henderson University of Cincinnati
Donna Hitscherich Columbia University
Ronald Hoffmeister Arizona State University
James Howard University of Maryland, College Park
George Jabbour George Washington University
Ravi Jagannathan Northwestern University
x Preface
Abu Jalal Suffolk University
Nancy Jay Mercer University
Thadavillil Jithendranathan University of Saint Thomas
Travis Jones Florida Gulf Coast University
Kathleen Kahle University of Arizona
Jarl Kallberg NYU, Stern School of Business
Ron Kaniel University of Rochester
Steve Kaplan University of Chicago
Eric Kelley University of Tennessee, Knoxville
Arif Khurshed Manchester Business School
Ken Kim University at Buffalo School of Management, SUNY
Jiro Kondo McGill University
C. R. Krishnaswamy Western Michigan University
George Kutner Marquette University
Dirk Laschanzky University of Iowa
Scott Lee University of Nevada, Las Vegas
Becky Lafrancois Colorado School of Mines
Bob Lightner San Diego Christian College
David Lins University of Illinois, Urbana
Brandon Lockhart University of Nebraska, Lincoln
David Lovatt University of East Anglia
Greg Lucado University of the Sciences in Philadelphia
Debbie Lucas Massachusetts Institute of Technology
Brian Lucey Trinity College, Dublin
Suren Mansinghka University of California, Irvine
Ernst Maug University of Mannheim
George McCabe University of Nebraska
Eric McLaughlin California State University, Pomona
Joe Messina San Francisco State University
Tim Michael University of Houston, Clear Lake
Dag Michalsen BI Norwegian Business School
Franklin Michello Middle Tennessee State University
Peter Moles University of Edinburgh
Katherine Morgan Columbia University
James Nelson East Carolina University
James Owens West Texas A&M University
Darshana Palkar Minnesota State University, Mankato
Claus Parum Copenhagen Business School
Dilip Patro Federal Deposit Insurance Corporation (FDIC)
John Percival Minerva University
Birsel Pirim The Ohio State University
Latha Ramchand University of Houston
Narendar V. Rao Northeastern University
Rathin Rathinasamy Ball State University
Raghavendra Rau University of Cambridge
Joshua Rauh Stanford University
Charu Reheja TriageLogic Group
Thomas Rhee California State University, Long Beach
Tom Rietz University of Iowa
Robert Ritchey Texas Tech University
Michael Roberts University of Pennsylvania
Mo Rodriguez Texas Christian University
John Rozycki Drake University
Frank Ryan San Diego State University
Patricia Ryan Colorado State University
George Sarraf University of California, Irvine
Eric Sartell Whitworth University
Marc Schauten Vrije Universiteit Amsterdam
Anjolein Schmeits NYU Stern School of Business
Brad Scott Webster University
Nejat Seyhun University of Michigan
Jay Shanken Emory University
Chander Shekhar University of Melbourne
Hamid Shomali Golden Gate University
Richard Simonds Michigan State University
Bernell Stone Brigham Young University
John Strong College of William & Mary
Avanidhar Subrahmanyam University of California, Los Angeles
Tim Sullivan UKG (Ultimate Kronos Group)
Shrinivasan Sundaram Ball State University
Chu-Sheng Tai Texas Southern University
Tom Tallerico Dowling College
Stephen Todd Loyola University, Chicago
Walter Torous University of California, Los Angeles
Emery Trahan Northeastern University
Gary Tripp Southern New Hampshire University
Ilias Tsiakas University of Guelph
David Vang St. Thomas University
Nikhil Varaiya, San Diego State University
Steve Venti Dartmouth College
Joseph Vu DePaul University
John Wald University of Texas, San Antonio
Chong Wang Naval Postgraduate School
Faye Wang University of Illinois, Chicago
Kelly Welch University of Kansas
Jill Wetmore Saginaw Valley State University
John Wheeler University of Michigan
Patrick Wilkie University of Virginia
Matt Will University of Indianapolis
David Williams Texas A&M University, Commerce
Kalman Vadasz Stevens Institute of Technology
Art Wilson George Washington University
Albert Wang Auburn University
Shee Wong University of Minnesota, Duluth
Bob Wood Tennessee Tech University
Fei Xie University of Delaware
Minhua Yang University of Central Florida
David Zalewski Providence College
Chenying Zhang University of Pennsylvania
This list is surely incomplete. We know how much
we owe to our colleagues at London Business School,
MIT’s Sloan School of Management, Imperial College
London, and the University of Pennsylvania’s ­Wharton
School. In many cases, the ideas that appear in this book
are as much their ideas as ours.
We would also like to thank all those at McGraw Hill
Education who worked on the book, including Chuck
Synovec, Executive Brand Manager; Allison McCabe-
Carroll, Senior Product Developer; Trina Mauer, Execu-
tive Marketing Manager; Fran Simon, Project Manager;
and Matt Diamond, Designer.
Richard A. Brealey
Stewart C. Myers
Franklin Allen
Alex Edmans
 Guided Tour

Pedagogical Features Rev.confirming pages

Rev.confirming pages

11
⟩
Part 1 Value

Chapter Overview Part 1 Value

Each chapter begins with a brief narrative and outline to CHAPTER

explain the concepts that will be covered in more depth. CHAPTER

● ● ●

Useful websites related to material for each part are pro- ● ● ●

vided in the Connect library.

Introduction to Corporate Finance
Introduction to Corporate Finance
T his book is about how corporations make financial
decisions. We start by explaining what these decisions
are and what they are intended to accomplish.
This chapter begins with specific examples of recent
Rev.confirming pages
investment and financing decisions made by well-known cor-
porations. The middle of the chapter covers what a corpora-

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and employees
decisionand
returns
including involves
theirdivided raising
wealth, byriskit.
121 to get and
tolerance, our investment
average return horizon. of fectThe
pull arithmetic
servants
together of increase
to average
value.of
shareholders. past returns
Therefore, gives must
corporations you
Yet Awelarge
11.5%. shallcorporation
However, see that financial
theymay have share
analysts
usually hundreds
maythealso of quote
same thousands the
financial exactly
combine the
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governance answer
rules as
introduces fivethe
and expected
procedures
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that with
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again and
of shareholders. These theshareholders thediffer in increase
manyrate ways, itagain
correctly
incentives tomeasures
⟩ make thesurethe opportunity costandof capital for
objective.
geometric They
average want (also known
financialasmanager
Beta
to
compound the
Standard
of
Error
throughout TABLE 9.1thatEstimates
book: all managers of betas employees
and 6
including
value
return). of Overtheir
the wealth,
the riskintolerance,
121-year
corporation; period
an efficient and
stock investment
values
market, horizon.
thismultiplied
will in turn investments
pull together of
standardsimilar
to increase risk
errorsvalue.to Big Pharma
for a sample of railroad stock.
1. The
Corporate finance is all about maximizing shareholder value.
YetCanadian
69,754 wetimes.
increase shall see
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current they
geometric
stock usually
price. average share
1.07 the same
return financial
is calculated 0.18 This geometric
chapter
companies average
introducesand for return
five anthemeson that
equally Big Pharma
occur
weighted stock
again and
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by takingthe
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CSX They
thesecretwantofthe
121st root financial
success of 69,754. manager
in1.18financial to gives
increase
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9.7%, is
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2.
again be portfolio
Maximizing
throughout shareholder thesevalue
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companies, considering
on the
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monthly of allMarch
decisions, including
to 8.8% their
value of theCitycorporation; in easy
an
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5
1.8
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increase
Kansas pointsThat
value.
Southern below is arithmetic
to0.97 average
but of
very 11.5%.
helpful.
0.20 1. Corporate (0.9 finance ×all
is 1.3 1/3
about − 1 = 0.088,
maximizing or
shareholder value.
increase
Why did
Instructing its current
thewefinancial
quotestockthe price.arithmetic
manager averageshareholder
to increase of 11.5%, effects on stakeholders
February 2020. such as customers,
The portfolio employees,
beta may
Norfolk Southern 1.33 0.18
Thus, theadvising
secret ofansuccess inin financial 2.
which Maximizing
and is
the be
less shareholder
more
than
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the value
than
opportunity involves
the betas
cost considering
ofof the
capital. the
Thus,
rather
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value is Pacific
like the geometric investoraverage the stockmanagement
1.09 of 9.7%? To under-
market to find is
0.16 long-term
if3.the individual
ofconsequences companies. of all Note the lower
decisions, including their
to increase
stand
stocks this, value.
that let’s
will go use That
up is easy
ainsimple
the to The
example.
future. say problem
but not very is how helpful.
to do Thecost
opportunitycapital is of
cost estimated
capital sets from the historic
standardreturns,
for
Industry portfolio 1.13 0.14 effects
onlyinvestment standard
on
the arithmetic error
stakeholdersaveragefor
suchthe asportfolio.
gives customers,
the right employees,
answer, not
Instructing
it. Suppose
That’s thethe that financial
purpose Bigof this manager
book. It to
Pharma’s increase
stock
covers price
the shareholder
is $100.
concepts that decisions.
value is
There
govern like
isgood advising
an equal
financial an
chance investor
decisions,that at andinthethe stock
end
it shows ofyoumarket
thehow year to find
to the
use the and
geometric average.7
the environment.
4. A safe dollar is worth more than a risky dollar.
stocks
stock
the that
will
tools of will
the go
be worth
trade up of
in$90,
the future.
modern $110, The problem
or $130;
finance. is how
there aretono do 3. The opportunity cost of capital sets the standard for
5. Good governance matters.
it. That’s theTherefore,
dividends. purpose of the this return
book. Itcould coversbe the–10%,
concepts +10%, that 5
investment decisions.

⟩
Technical note: For log normally distributed returns the annual compound return
govern
or +30%. good Thefinancial
expected decisions,
returnand is ⅓ it shows
(–10 +you 10how+ 30) to use
= is4.equal
A safe
to thedollar is worth
arithmetic averagemore
return than
minus ahalf
risky
the dollar.
variance. For example,

Numbered Examples the tools

+10%.
EXAMPLEIf we run
of the
This trade
is the
9.1 the process
●
of modernaverage.
arithmetic
A Railroad Industry
in reverse
expected cash flow by the expected rate of return, we get
finance.
Cost of the
and discount
the annual standard deviation of returns on the U.S. market was 0.195, or 19.5%.
5. Good wasgovernance
therefore 0.1952matters.
Capital for Berkshire Hathaway Rev.confirming pages
Variance , or 0.038. The compound annual return is about
0.038/2 = 0.019, or 1.9 percentage points less than the arithmetic average.
6
1

Numbered and titled examples are called out within chap-

You sometimes hear that the arithmetic average correctly measures the opportunity
Industry
back to Big betasPharma’s
are particularly helpful
current stock forsoconglomerate
price, this checks out: companies investing
cost of in many
capital for one-year cash different
flows, but not for more distant ones. Let us check.
industries. Berkshire Hathaway is today’s largest U.S. conglomerate, Suppose that you with
expectinvestments in of $121 in year 2. We know that one
to receive a cash flow
insurance, electric utilities,PV = ____110
pipelines,
= $100jewelry, chemicals, paints,
year hence investors will value
candies, batteries—the list that cash flow by discounting at 10% (the arithme-1
ters to further illustrate concepts. Students can learn how goes on and on. It also owns
ofThe
the expected
largest U.S.return railroads
1.10BNSF, the Burlington Northern Santa
and
of 10%Chapter would
6 have
is therefore the beenInvestment
correct
Making included
rate
tic average of possible returns). In other words, at the end of the year they will be
willing Fe
inDecisions
Table
know
railroad.
to pay
how to9.1
BNSF
PV1 = 121/1.10
valueifanitasset
with thewere
is one
= $110
still
that pays
Net
for the expected cash flow. But we already
offan
Present $110 in year 1—just discount at the 10%
Value Rule 06/17/21 157

to solve specific problems step-by-step and apply key prin-

bre80948_ch01_001-020.indd 1 opportunity cost of capital. Thus PV0 = PV1/1.10 = 110/1.1 = $100. 11:41 AM
Our example
independent
at which topublic discount company. BNSF and
the expected cashthe flowother
fromrailroads
Big in the table face similar business
demonstrates that the arithmetic average (10% in our example) provides a correct
and operating
Pharma’s risks.
stock. It isThe
alsocost
theof capital for cost
opportunity the comparable
of capital portfolio measure of oftherailroads
opportunity should be regardless
cost of capital a of the timing of the cash flow.
United
good
for States typically
discount
investments ratethat assume
for1have
Berkshire straight-line
the same Hathaway’s
degree of depreciation
risk as Big instead
investments in BNSF. 7
ofdiscussion
the accelerated deprecia-
ciples to answer concrete questions and scenarios.
Our assumed that we knew that the returns of –10, +10, and
bre80948_ch01_001-020.indd 06/17/21 11:41 AM
tion allowed by the U.S. tax code. We will highlight the differences
Pharma.
+30% between
were equallystraight-line and of the effect of uncertainty about
likely. For an analysis
the expected return see I. A. Cooper, “Arithmetic versus Geometric ● ● ●Mean ● ●Esti-
accelerated
Now supposedepreciationthat welaterobserve
in this chapter.
the returns on Big mators: Setting Discount Rates for Capital Budgeting,” European Financial
The next section
overtakes a broader
numberlook at corporate income taxes.

⟩
Pharma stock a large of years. If the odds Management 2 (1996), pp. 157–167; and E. Jacquier, A. Kane, and A. J. Mar-
cus, “Optimal Estimation of the Risk Premium for the Long Run and Asset

Self-Test Questions
are unchanged, the return will be –10% in a third of Allocation: A Case of Compounded Estimation Risk,” Journal of Financial
9.4years,
the Self-Test+10% in a further third, and +30% in the Confirming
are forecastedpages
6.4 Self-Test Econometrics 3 (2005), pp. 37–55. When future returns to distant
remaining years. The arithmetic average of these yearly horizons, the historical arithmetic means are upward-biased. This bias is small
Why does diversification increase the accuracy of beta estimates? Explain briefly.applications, however.
Each chapter includes a number of self-test questions that
Areturns
firm is is considering investment in a new manufacturing plant. inThe most corporate-finance
site is owned by the com-
290
pany, but existing buildings would need to be demolished. Which of the following should be
treated as incremental cash flows?
Part Three Best Practices in Capital B
allow students to check their understanding. Answers to a. The market value of the
9-3 Analyzing Project Risk
b. The market value the
A moresite. sensible method is to take the current interest rate on Treasury bills and add 7.8%,
average
of the existing premium shown in Table 7.1. For
riskbuildings. Chapter 10
example, suppose Project Analysis
that the current interest 283

these questions are given at the end of the chapter. c. Demolition costs and
Ad.business
The cost with high
ratesite
fixed
on Treasury
costs
clearance.bills is 2%. Adding the average risk premium gives
In Section 9.1, we estimated the asset beta for CSX and its company cost of capital. This asset beta
is said to have highr operating
= r + leverage.
normal risk Operating
premium lever- We work back through the t
is an estimate of of
thea average
new access riskroad put inrailroad
of CSX’s last year.business
S f and the company cost of capital
age is usually defined in terms of accounting profits rather than cash flows and is measured

⟩
is a measure
e. Lost cash of the expected
flows on an return
existing onproduct
the company
that willas bea=whole.
0.02 +Not
replaced 0.078
byallthe =new0.098,
railroad or 9.8%
investments
proposal.

Numbered Equations
by the percentage change in profits for each 1% change in sales. Thus the degree of operating
are average
f. Future risk, however.This
depreciation And if you
method
of the neware the afirst
gives
plant. lowerto use railroad-track
expected future return networksbecause as deep-space
interest rates are currently low—2%
leverage (DOL) is
transmission antennas, youinwill have no asset beta to start with
theand the company cost of capital
g. The reduction in the this firm’s example—compared
tax bill resulting with
from historic
depreciation average
of the new of plant.
3.7% in Table 7.1. This gap of 1.7%
percentage
return that change
will not provide a useful guide to the_______________________ you should in profits
demand.
NPV (upside
Where a result can be stated formally, we do so in the form
188 h. The DOLinventories
=
How can initial
you make investment
informedinjudgments of raw
about
percentage materials.
costs
changeof capital
in salesfor projects or lines of business
wheni.you suspect
Money that risk
already spentis on average? That
5 engineering
not is our
design of next
the newtopic. plant.
The following simple formula shows how DOL is related to the business’s fixed costs (includ-
of a numbered equation. However, we are also careful to
A company that wants to set a cost of capital for one particular line of business typically
ing depreciation) as a proportion of pretax profits:
looks for pure plays in that line of business. Pure-play companies are public firms that spe-
cialize in one activity. For example, suppose that CSX needs to assess the risk of investing in NPV (most li
explain the intuition behind a financial theory, so that read- 6-2 Corporate Income Taxes fixed costs including depreciation
____________________________
a bre80948_ch07_184-221.indd
new company headquarters. 188DOL =The 1 + asset beta for railroads is not helpful. You need to (10.1) know 10/18/21 10:05 PM
pretax profits
the beta of commercial real estate. Fortunately, portfolios of commercial real estate are traded.
Companies pay tax on their income. Look at Table 6.1, which shows corporate income tax
ers without a quantitative background should be able to
For example, you could estimate asset betas from returns on Real Estate Investment Trusts
rates in 11 countries.
For example, in year 2Theseof theare the tax
scooter rates imposed by the national governments, but cor-
project,
porations may also need to pay tax to a regional government. For example, in Canada, the
NPV (downsi
read with understanding. provincial governments levy an additional tax (4.5of+between
DOL = 1 + ________ = 4.50
states and some municipalities also impose an extra
1.5) 11% and 16%. In the United States,
1.72layer of corporate tax that averages around
4%. To complicate matters further, in many countries, the first part of income may be taxed at

⟩
a lower
A rate, orin
1% increase special arrangements
the project’s may applywould
year 2 revenues to some
resulttypes
in aof4.5% business.
rise in profits.

Beyond the Page Interactive Content bre80948_ch09_248-275.indd 257

How Fixed Costs Translate

EXAMPLE 10.1 ● Country
CorporateInto High
Tax Rate
BEYOND THE PAGE
(%) Operating Leverage
Since the downside NPV is ne
09/28/21 12:02 PM

of phase III should not be mad

and Applications Australia
Brazil
Try It! Figure
10.3: Decision
The following table shows how the profits of two auto producers, X and Y, vary between
30

for an 80% chance of a $100 m

boom and slump. The only difference between the two companies is that a greater proportion
34
Canada
tree for the 15

Additional resources and hands-on applications are just a click of X’s costs are fixed. China
France pharmaceutical program at this point in the de
25
33

away. Students can use the web address or click on the icon in X = High Fixed Cost
Germany
India
Slump
project
Y = Low Fixed Cost
Normal Boom
Now calculate the NPV a
16
30
Slump Normal Boom
mhhe.com/brealey14e
the eBook to learn more about key concepts and try out calcu- two years later depends on wh
Ireland 13
Revenue
Japan 22.5 30 40
2322.5 30 40
− Variable cost 9 12 16 19 12 16 21.3

a 25% chance of NPV = +$2

United Kingdom

lations, tables, and figures when they go Beyond the Page. − Fixed cost United States
− Depreciation
8
6
8
6
8
6
21 4
6
xi
4
6
4
6
⟩
TABLE 6.1 National corporate tax rates.
= Pretax profit −0.5 4 10 chance of cancellation
0.5 and NP 4 8.7
Source: PWC, Worldwide Tax Summaries: Corporate Taxes, 2018–2020, www.taxsummaries.pwc.com.

successful:
In normal times, the two companies earn the same profits, but X’s high fixed costs mean There is a 44% ch
ment is $18 million. Therefor
that it suffers more in a slump and gains more in a boom. As the economy moves from normal
to boom, revenues for both companies increase by 33.3%. For X with its high fixed costs,
profits increase by 150%, 4.5 times the increase in revenues. So DOL = 4.5. We get exactly
Excel Confirming pages

⟩ Spreadsheet Functions
USEFUL SPREADSHEET FUNCTIONS
Boxes ● ● ● ● ●

These boxes provide detailed examples
of how to use Excel spreadsheets when
applying financial concepts. Questions
that apply to the spreadsheet follow for
additional practice.
Estimating Stock and Market Risk
⟩Spreadsheets such as Excel have some built-in statistical
functions that are useful for calculating risk measures.
You can find these functions by clicking fx on the Excel
toolbar. If you then click on the function that you wish to
use, Excel will ask you for the inputs that it needs. At the
bottom left of the function box, there is a Help facility
with an example of how the function is used.
Here is a list of useful functions for estimating stock
and market risk. You can enter the inputs for all these
functions as numbers or as the addresses of cells that con-
tain the numbers. Note that different versions of Excel
may use slightly different names for these functions.
1. VAR.P and STDEV.P: Calculate variance and stan-
dard deviation of a series of numbers, as shown in
Section 7-2.
2. VAR.S and STDEV.S: Footnote 12 of Chapter 7
noted that when variance is estimated from a sample
of observations (the usual case), a correction should
be made for the loss of a degree of freedom. VAR.S
and STDEV.S provide the corrected measures. For
any large sample VAR.S and VAR.P will be similar.
3. SLOPE: Useful for calculating the beta of a stock
or portfolio.
4. CORREL: Useful for calculating the correlation
between the returns on any two investments.
5. COVARIANCE.P and COVARIANCE.S: Portfolio
risk depends on the covariance between the returns
Microsoft Excel
on each pair of stocks. These functions calculate the
covariance.
6. RSQ: R-squared is the square of the correlation
coefficient and is useful for measuring the propor-
tion of the variance of a stock’s returns that can be
explained by the market.
7. AVERAGE: Calculates the average of any series of
numbers.
If, say, you need to know the standard error of your
estimate of beta, you can obtain more detailed statistics
by going to the Tools menu and clicking on Data Analysis
and then on Regression.
Spreadsheet Questions
The following questions provide opportunities to practice
each of the Excel functions.
1. (VAR.P and STDEV.P) Choose two well-known
stocks and download the latest 61 months of adjusted
prices from finance.yahoo.com. Calculate the
monthly returns for each stock. Now find the vari-
ance and standard deviation of the returns for each
stock by using VAR.P and STDEV.P. Annualize
the variance by multiplying by 12 and the standard
deviation by multiplying by the square root of 12.
2. (AVERAGE, VAR.P, and STDEV.P) Now calculate
the annualized variance and standard deviation for a
portfolio that each month has equal holdings in the
two stocks. Is the result more or less than the average
of the standard deviations of the two stocks? Why?
3. (SLOPE) Download the Standard & Poor’s index for
^
the same period (its symbol is GSPC). Find the beta of
each stock and of the portfolio. (Note: You need to enter
the stock returns as the Y-values and market returns as
the X-values.) Is the beta of the portfolio more or less
than the average of the betas of the two stocks?
4. (CORREL) Calculate the correlation between the
returns on the two stocks. Use this measure and
your earlier estimates of each stock’s variance to
calculate the variance of a portfolio that is evenly
divided between the two stocks. (You may need to
reread Section 7-3 to refresh your memory of how
to do this.) Check that you get the same answer as
when you calculated the portfolio variance directly. Rev.confirming pages
5. (COVARIANCE.P) Repeat Question 4, but now cal-
culate the covariance directly rather than from the
correlations and variances.
267

Chapter 6 Making Investment Decisions with the Net Present Value Rule 161

bre80948_ch09_248-275.indd 267 09/28/21 12:02 PM

⟩ Excel Exhibits Year

Select tables are set as spreadsheets, and 0 1 2 3 4 5 6 7
the corresponding Excel files are also 1 Capital investment 12,000 –1,949a

available in Connect and through the 2 Accumulated depreciation

3 Year-end book value 12,000
2,000
10,000
4,000
8,000
6,000
6,000
8,000 10,000 12,000
4,000 2,000 0
0
0
Beyond the Page features. 4 Working capital 550 1,289 3,261 4,890 3,583 2,002 0
5 Revenues 523 12,887 32,610 48,901 35,834 19,717
6 Expenses 4,000 3,037 8,939 20,883 30,809 23,103 13,602
7 Depreciationa 2,000 2,000 2,000 2,000 2,000 2,000 0
8 Pretax profit (5 – 6 – 7 – 1) –4,000 –4,514 1,948 9,727 16,092 10,731 4,115 1,949a
9 Tax at 21% –840c –948 409 2,043 3,379 2,254 864 409
10 Profit after tax (8 – 9) –3,160 –3,566 1,539 7,684 12,713 8,477 3,251 1,540

⟩ TABLE 6.2 Initial forecast data for guano project.

a
In the income statement, the initial investment of $12 million is depreciated straight-line over the six years.
b
Gain on sale of assets. The asset has been entirely depreciated for tax purposes and the entire sales price is, therefore, subject to tax.
c
A negative tax payment means a cash inflow, assuming that IM&C can use the tax loss on the guano project to shield income from
the rest of its operations.

Table 6.3 derives the expected cash flows from the accounting data in Table 6.2 BEYOND THE PAGE

xii Try It!

Capital Investment The guano
spreadsheets
Rows 1 through 4 of Table 6.3 show the cash flows from the investment in fixed assets. The
mhhe.com/brealey14e
project requires an investment of $12 million in plant and machinery. IM&C expects to sell
 Confirming pages

Chapter 11 How to Ensure That Projects Truly Have Positive NPVs 323

End-of-Chapter Features
∙ The technology for making BGs will not change. Capital and production costs will stay
the same in real terms.
∙ Competitors know the technology and can enter as soon as the patent expires, that is, they Confirming pages
can construct new plants in year 5 and start selling BGs in year 6.
∙ If your company invests immediately, full production begins after 12 months, that is, in
year 1.
∙ There are no taxes.
∙ BG production facilities last 12 years. They have no salvage value at the end of their useful life.
320 Part Three Best Practices in Capital Budgeting
16. Economic rents (S11.3) How would your answer to Problem 15 change if technological

⟩
improvements reduce the cost of new BG production facilities by 3% per year? Thus a new
Problem Sets plant
● ●built
● ●in●year 1 would cost only 25 (1 − 0.03) = $24.25 million, a plant built in year 2
would cost $23.52 million, and so on. Assume that production® costs per unit remain at $65.
Select problems are available in McGraw-Hill’s Connect.
17.PROBLEM SETS
Beside each end-of-chapter problem we note the Economic rents (S11.3) Reevaluate the NPV of the proposed polyzone
Please project
see the (Example
preface
under each of the following assumptions. What’s the right management decision in each case?
11.6)information.
for more

section of the chapter to which the question relates. a. Spread in year 4 holds1.atBehavioral biases (S11.1) Explain why setting a higher discount rate is not a cure for upward-
$1.20 per pound.
biased cash-flow forecasts.
b. The U.S. chemical company can start up polyzone production at 40 million pounds in year
This helps instructors create assignments and makes 1 rather than year 2. 2. Behavioral biases (S11.1) Look back to the cash flows for projects F and G in Section 5-3.
c. The U.S. company makesects
The cost of capital was assumed to be 10%. Assume that the forecasted cash flows for proj-
a technological advance that reduces itsaverage.
annual production
That is, thecosts
it simpler for students to look back for help. These
of this type are overstated by 8% on forecast for each cash flow from
to $25 million. Competitors’ production costs do not change.
each project should be reduced by 8%. But a lazy financial manager, unwilling to take the
time to argue with the projects’ sponsors, instructs
18. Equilibrium prices (S11.3) Demand for concave utility meters is expanding rapidly, them tobut
usethe
a discount rate of 18%.
end-of-chapter problems give students hands-on industry is highly competitive. A utility
a. What are meter plant costs
the projects’ true $50
NPVs? million to set up, and it has an
annual capacity of 500,000b.meters. The production cost is $5 per
What are the NPVs at the 18% discount rate?meter, and this cost is not
practice with key concepts and applications. expected to change. The machines have any
c. Are there
10%. What is the competitive price ofCould
an indefinite physical
circumstances
a utility
life and
in which the the
18%cost of capital
discount is
rate would
meter?bias be more severe for more-distant cash flows?)
give the correct NPVs?
(Hint: upward
a. $5
3. Market values (S11.2) Your brother-in-law wants you to join him in purchasing a building on
b. $10 the outskirts of town. You and he would then develop and run a Taco Palace restaurant. Both of
c. $15 you are extremely optimistic about future real estate prices in this area, and your brother-in-law
has prepared a cash-flow forecast that implies a large positive NPV. This calculation assumes
19. Opportunity costs (S11.3) New-model commercial airplanes are much more fuel-efficient Firstahead?
pages
sale of the property after 10 years. What further calculations should you do before going
than older models. How is it possible for airlines flying older models to make money when its
4. Market
competitors are flying newer planes?values
Explain(S11.2) Suppose that you are considering investing in an asset for which there
briefly.
is a reasonably good secondary market. Specifically, your company is Delta Airlines, and the
asset is a Boeing 767—a widely used airplane. How does the presence of a secondary market
simplify your problem in principle? Do you think these simplifications could be realized in
CHALLENGE PROBLEMSpractice? Explain.
686 Part Seven Options
20. Economic rents (S11.3)5.Accidental
Market values setbacks (S11.2) There in
can result is negative
an active,rents
competitive leasing
in any year. But(i.e., rental) market for most
can a project have expected standard typesin
positive rents ofsome
commercial
years and jets.negative
Many ofexpected
the planes flown
rents by the major domestic and inter-
in other
years? Explain. Mason national airlines
and Merton are not
review owned
a range by them
of option but leased to
applications forcorporate
periods ranging
finance:from a few months to
S.The
several and
P. Mason
years. Gamma Airlines, however, owns two long-range DC-11s just withdrawn from
21. Economic rents (S11.3) manufacture R. C.ofMerton, “Theacid
polysyllabic Roleisofa Contingent
competitiveClaims
industry.Analysis
Most in Corporate Finance,” in E.
Latin
I. Altman American
and M.tons. service. Gamma
G. Subrahmanyam, is considering using these planes to develop the potentially
plants have an annual output of 100,000 Operating costseds., are Recent
$0.90 aAdvances
ton, andinthe sales Finance (Homewood, IL:
Corporate
lucrative
Richard D. new
Irwin, route from Akron to Yellowknife. A considerable investment in terminal facili-
price is $1 a ton. A 100,000-ton plant costs1985).
$100,000 and has an indefinite life. Its current
scrap value of $60,000 Brennan ties, training,
is expected to and advertising
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and Schwartz have worked out an interesting application to natural resource investments:
the route for at least three years. One further complication: The manager of Gamma’s interna-
Phlogiston Inc. proposes to invest
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implicationsleadofover each
realGive a of
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its rivals in use of the process but is your
unable to build any more howplants itself before year 2. Also
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new plant of the international division?
will therefore cause temporary overcapacity.
6. Market values (S11.2) Suppose the current price of gold is $1,200 an ounce. Hotshot Con-
You can assume that there are no taxes and that the cost of capital is 10%.
● ● ● ● ● sultants advises you that gold prices will increase at an average rate of 12% for the next two
years. After that the growth rate will fall to a long-run trend of 3% per year. What is the pres-
PROBLEM SETS ent value of 1 million ounces ® ofSelect problems
gold produced inare
eightavailable in McGraw
years? Assume Hill’s
that gold prices have a
Connect.
beta of 0 and that the risk-free rate Please see the preface for more information.
is 5.5%.
7. Market
1. Expansionvalues (S11.2)
options On the
(S23.1) London
Look againMetals
at the Exchange,
valuation inthe price23.2
Table for copper to be delivered
of the option to invest
in
in one year isII$5,500
the Mark project.a Consider
ton. (Note: Paymentiniseach
a change madeof when the copper
the following is delivered.)
inputs. Would the The risk-
change
bre80948_ch11_301-326.indd 323
free interest
increase rate is 2%
or decrease theand the of
value expected market option?
the expansion return is 8%. 10/01/21 03:26 PM

a.
a. Suppose
Increasedthat you expect
uncertainty to produce
(higher anddeviation).
standard sell 10,000 tons of copper next year. What is the
PV of this output? Assume that the sale occurs at the end of the year.
b. More optimistic forecast (higher expected value) of the Mark II in 1985.
b. If copper has a beta of 1.2, what is the expected price of copper at the end of the year?
c. Increase in the required investment in 1985.
What is the certainty-equivalent end-year price?
2. Expansion options (S23.1) Look again at Table 23.2. How does the value in 1982 of the
option to invest in the Mark II change if
a. The investment required for the Mark II is $800 million (vs. $900 million)?
b. The present value of the Mark II in 1982 is $500 million (vs. $467 million)?

⟩
c. The standard deviation of the Mark II’s present value is only 20% (vs. 35%)?

Excel Problems bre80948_ch11_301-326.indd 320

BEYOND THE PAGE

3. Expansion options (S23.1) You own a one-year call option to buy one acre of 10/01/21 Los Angeles
03:26 PM

Most chapters contain problems, denoted by an icon,
specifically linked to Excel spreadsheets that are
mhhe.com/brealey14e
available in Connect and through the Beyond the
Page features.
real estate. The exercise price is $2 million, and the current, appraised market value of the
land is $1.7 million. The land is currently used as a parking lot, generating just enough money
Try it! The
Black-Scholes
to cover real estate taxes. The annual standard deviation is 15% and the interest rate 12%.
How much is your call worth? Use the Black–Scholes formula. You may find it helpful to go
model
to the spreadsheet for Chapter 22, which calculates Black–Scholes values (see the Beyond the
Page feature).
4. Expansion options (S23.1) A variation on Problem 3: Suppose the land is occupied by a
warehouse generating rents of $150,000 after real estate taxes and all other out-of-pocket
costs. The present value of the land plus warehouse is again $1.7 million. Other facts are as in
Problem 3. You have a European call option. What is it worth?
5. R&D (S23.1) Construct a sensitivity analysis of the value of the pharmaceutical R&D project
described in Figure 23.2. What input assumptions are most critical for the NPV of the proj-
ect? Be sure to check the inputs to valuing the real option to invest at year 2.
6. Real options and put-call parity (S23.2) Redo the example in Figure 23.2, assuming that
the real option is a put option allowing the company to abandon the R&D program if com-
mercial prospects are sufficiently poor at year 2. Use put-call parity. The NPV of the drug at
date 0 should again be +$7.7 million.
7. Timing options (S23.2) You own a parcel of vacant land. You can develop it now, or wait.
a. What is the advantage of waiting?
b. Why might you decide to develop the property immediately?

bre80948_ch23_666-690.indd 686 01/06/22 05:53 PM

xiii
 Rev.confirming pages

220 Part Two Risk

⟩ Finance on the Web ● ● ● ● ●

FINANCE ON
These web exercises give THE WEB
You can download data for Questions 1 and 2 from finance.yahoo.com. Refer to the Useful
Spreadsheet Functions box near the end of Chapter 9 for information on Excel functions.

students the opportunity to 1. Download to a spreadsheet the last three years of monthly adjusted stock prices for Coca-
Cola (KO), Citigroup (C), and Pfizer (PFE).
explore financial websites on a. Calculate the monthly returns.

their own. The web exercises b. Calculate the monthly standard deviation of those returns (see Section 7-2). Use the
Excel function STDEV.P to check your answer. Find the annualized standard deviation

make it easy to include cur- by multiplying by the square root of 12.

c. Use the Excel function CORREL to calculate the correlation coefficient between the
rent, real-world data in the monthly returns for each pair of stocks. Which pair provides the greatest gain from
diversification?
classroom. d. Calculate the standard deviation of returns for a portfolio with equal investments in the
three stocks.
2. A large mutual fund group such as Fidelity offers a variety of funds. They include sector
funds that specialize in particular industries and index funds that simply invest in the mar-
ket index. Log on to www.fidelity.com and find first the standard deviation of returns on
the Fidelity Spartan 500 Index Fund, which replicates the S&P 500. Now find the standard
deviations for different sector funds. Are they larger or smaller than the figure for the index
fund? How do you interpret your findings?

Confirming pages

Chapter 10 Project Analysis 299

⟩ Mini-Cases MINI-CASE ● ● ● ● ●

Mini-cases are included in

Waldo County
select chapters so students can Waldo County, the well-known real estate developer, worked long hours, and he expected his staff
apply their knowledge to real- to do the same. So George Chavez was not surprised to receive a call from the boss just as George
was about to leave for a long summer’s weekend.
world scenarios. Mr. County’s success had been built on a remarkable instinct for a good site. He would exclaim
“Location! Location! Location!” at some point in every planning meeting. Yet finance was not his
strong suit. On this occasion, he wanted George to go over the figures for a new $90 million outlet
mall designed to intercept tourists heading downeast from Bar Harbor through southern Maine.
“First thing Monday will do just fine,” he said as he handed George the file. “I’ll be in my house
in Bar Harbor if you need me.”
George’s first task was to draw up a summary of the projected revenues and costs. The results
are shown in Table 10.6. Note that the mall’s revenues would come from two sources: The com-
pany would charge retailers an annual rent for the space they occupied and, in addition, it would
receive 5% of each store’s gross sales.
Construction
bre80948_ch07_184-221.indd 220 of the mall was likely to take three years. The construction costs could be depre- 10/18/21 10:05 PM

ciated straight-line over 15 years starting in year 3. As in the case of the company’s other develop-
ments, the mall would be built to the highest specifications and would not need to be rebuilt until
year 17. The land was expected to retain its value, but could not be depreciated for tax purposes.
Construction costs, revenues, operating and maintenance costs, and local real estate taxes were
all likely to rise in line with inflation, which was forecasted at 2% a year. Local real estate taxes
are deductible for corporate tax. The company’s corporate tax rate was 25% and the cost of capital
was 9% in nominal terms.
George decided first to check that the project made financial sense. He then proposed to look at
some of the things that might go wrong. His boss certainly had a nose for a good retail project, but
he was not infallible. The Salome project had been a disaster because store sales had turned out to
be 40% below forecast. What if that happened here? George wondered just how far sales could fall
short of forecast before the project would be underwater.
Inflation was another source of uncertainty. Some people were talking about a zero long-term
inflation rate, but George also wondered what would happen if inflation jumped to, say, 10%.
A third concern was possible construction cost overruns and delays due to required zoning
changes and environmental approvals. George had seen cases of 25% construction cost overruns
and delays up to 12 months between purchase of the land and the start of construction. He decided
that he should examine the effect that this would have on the project’s profitability. But he realized

Year

0 1 2 3 4 5–17
Investment:
Land 30
Construction 20 30 10
Operations:
Rentals 12 12 12
Share of retail sales 24 24 24
Operating and maintenance costs 2 4 4 10 10 10
Local real estate taxes 2 2 3 4 4 4

⟩ TABLE 10.6 Projected revenues and costs in real terms for the Downeast
Tourist Mall (figures in $ millions).

xiv
bre80948_ch10_276-300.indd 299 09/30/21 06:40 PM

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 Brief Contents

Preface vii I Part Six: Corporate Objectives and

Governance
I Part One: Value
19 Agency Problems and Corporate Governance 555
1 Introduction to Corporate Finance 1 20 Stakeholder Capitalism and Responsible Business 588
2 How to Calculate Present Values 21
3 Valuing Bonds 52 I Part Seven: Options
4 Valuing Stocks 84
21 Understanding Options 614
5 Net Present Value and Other Investment Criteria 119
22 Valuing Options 637
6 Making Investment Decisions with the
Net Present Value Rule 149 23 Real Options 666

I Part Two: Risk I Part Eight: Debt Financing

7 Introduction to Risk, Diversification, 24 Credit Risk and the Value of Corporate Debt 691
and Portfolio Selection 184 25 The Many Different Kinds of Debt 710
8 The Capital Asset Pricing Model 222 26 Leasing 744
9 Risk and the Cost of Capital 248
I Part Nine: Risk Management
I Part Three: Best Practices in Capital
Budgeting 27 Managing Risk 763
28 International Financial Management 799
10 Project Analysis 276
11 How to Ensure That Projects Truly Have I Part Ten: Financial Planning and Working
Positive NPVs 301
Capital Management
I Part Four: Financing Decisions and 29 Financial Analysis 828
Market Efficiency 30 Financial Planning 857
31 Working Capital Management 888
12 Efficient Markets and Behavioral Finance 327
13 An Overview of Corporate Financing 368
I Part Eleven: Mergers, Corporate Control,
14 How Corporations Issue Securities 399
and Governance
I Part Five: Payout Policy and Capital 32 Mergers 918
Structure 33 Corporate Restructuring 950

15 Payout Policy 434

16 Does Debt Policy Matter? 459
I Part Twelve: Conclusion
17 How Much Should a Corporation Borrow? 485 34 Conclusion: What We Do and Do Not Know about
18 Financing and Valuation 518 Finance977

xx
 Contents

Preface vii 2-4 How Interest Is Paid and Quoted 39

Continuous Compounding

I Part One: Value • •

Key Takeaways 44 Problem Sets 45 Solutions to
•
Self-Test Questions 50 Finance on the Web 51

1 Introduction to Corporate
Finance 1 3 Valuing Bonds 52
1-1 Corporate Investment and Financing 3-1 Using the Present Value Formula to Value
Decisions 2 Bonds 53
Investment Decisions/Financing Decisions/What Is A Short Trip to Paris to Value a Government Bond/
a Corporation?/The Role of the Financial Manager Back to the United States: Semiannual Coupons
and Bond Prices
1-2 The Financial Goal of the Corporation 8
Shareholders Want Managers to Maximize 3-2 How Bond Prices Vary with Yields 57
Market Value/A Fundamental Result: Why Duration and Interest-Rate Sensitivity
Maximizing Shareholder Wealth Makes Sense/ 3-3 The Term Structure of Interest Rates 62
Should Managers Maximize Shareholder Wealth?/ Spot Rates, Bond Prices, and the Law of One
The Investment Trade-Off/Agency Problems and Price/Measuring the Term Structure/Why the
Corporate Governance Discount Factor Declines as Futurity Increases
1-3 Key Questions in Corporate Finance 14 3-4 Explaining the Term Structure 68
• •
Key Takeaways 15 Problem Sets 16 Solutions to Expectations Theory of the Term Structure/Interest
•
Self-Test Questions 18 Appendix: Why Maximizing Rate Risk/Inflation Risk
Shareholder Value Makes Sense 19 3-5 Real and Nominal Interest Rates 70
Indexed Bonds and the Real Rate of Interest/What
2 How to Calculate Present Determines the Real Rate of Interest?/Inflation and
Values 21 Nominal Interest Rates
3-6 The Risk of Default 74
2-1 How to Calculate Future and Present Values 22 Corporate Bonds and Default Risk/Sovereign
Calculating Future Values/Calculating Present Bonds and Default Risk
Values/Valuing an Investment Opportunity/Net
Present Value/Risk and Present Value/Present •
Key Takeaways 77 Further Reading 78 Problem •
Values and Rates of Return/Calculating Present •
Sets 78 Solutions to Self-Test Questions 83 •
Values When There Are Multiple Cash Flows/The Finance on the Web 83
Opportunity Cost of Capital
2-2 How to Value Perpetuities and Annuities 30 4 Valuing Stocks 84
How to Value Perpetuities/How to Value Annuities/
Valuing Annuities Due/Calculating Annual 4-1 How Stocks Are Traded 85
Payments/Future Value of an Annuity Trading Results for Cummins/Market Price vs.
2-3 How to Value Growing Perpetuities and Book Value
Annuities 37 4-2 Valuation by Comparables 88
Growing Perpetuities/Growing Annuities 4-3 Dividends and Stock Prices 90
xxi
xxii Contents
Dividends and Capital Gains/Two Versions of the
Dividend Discount Model
4-4 Dividend Discount Model Applications 95
Using the Constant-Growth DCF Model to Set
Water, Gas, and Electricity Prices/DCF Models
with Two or More Stages of Growth
4-5 Income Stocks and Growth Stocks 101
Calculating the Present Value of Growth
Opportunities for Establishment Electronics
4-6 Valuation Based on Free Cash Flow 105
Valuing the Concatenator Business/Valuation
Format/Estimating Horizon Value
• •
Key Takeaways 110 Problem Sets 112 Solutions to
•
Self-Test Questions 116 Finance on the Web 117
Mini-Case: Reeby Sports 117
5 Net Present Value and Other
Investment Criteria 119
5-1 A Review of the Net Present Value Rule 119
Net Present Value’s Competitors/Five Points to
Remember about NPV
5-2 The Payback and Accounting Rate of Return
Rules 123
The Payback Rule/Accounting Rate of Return
5-3 The Internal Rate of Return Rule 126
Calculating the IRR/The IRR Rule/Pitfall 1—
Lending or Borrowing?/Pitfall 2—Multiple Rates
of Return/Pitfall 3—Mutually Exclusive Projects/
Pitfall 4—What Happens When There Is More
Than One Opportunity Cost of Capital/The Verdict
on IRR
5-4 Choosing Capital Investments When Resources
Are Limited 135
How Important Is Capital Rationing in Practice?
•
Key Takeaways 139 Further Reading 140 Problem • Historical Evidence to Evaluate Today’s Cost of
•
Sets 140 Solutions to Self-Test Questions 145 • Capital
Mini-Case: Vegetron’s CFO Calls Again 146
6 Making Investment Decisions with
the Net Present Value Rule 149
6-1 Forecasting a Project’s Cash Flows 150
Rule 1: Discount Cash Flows, Not Profits/Rule 2:
Discount Incremental Cash Flows and Ignore Non-
Incremental Cash Flows/Rule 3: Treat Inflation
Consistently/Rule 4: Separate Investment and
Financing Decisions/Rule 5: Forecast Cash Flows
after Taxes
6-2 Corporate Income Taxes 157
Depreciation Deductions/Tax on Salvage Value/Tax
Loss Carry-Forwards
6-3 A Worked Example of a Project Analysis 159
The Three Components of Project Cash Flows/Cash
Flow from Capital Investment/Operating Cash Flow/
Investment in Working Capital/How to Construct a
Set of Cash Flow Forecasts: An Example/Capital
• Investment/Operating Cash Flow/Investment in
Working Capital/Accelerated Depreciation and
First-Year Expensing/Project Analysis
6-4 How to Choose between Competing
Projects 165
Problem 1: The Investment Timing Decision/
Problem 2: The Choice between Long- and Short-
Lived Equipment/Problem 3: When to Replace an
Old Machine/Problem 4: Cost of Excess Capacity
•
Key Takeaways 171 Further Reading 172 Problem •
•
Sets 172 Solutions to Self-Test Questions 180 •
Mini-Case: New Economy Transport (A) 181 New •
Economy Transport (B) 182
I Part Two: Risk
7 Introduction to Risk, Diversification,
and Portfolio Selection 184
7-1 The Relationship between Risk and Return 184
Over a Century of Capital Market History/Using
7-2 How to Measure Risk 190
Variance and Standard Deviation/Calculating
Risk/Estimating Future Risk
7-3 How Diversification Reduces Risk 195
Specific and Systematic Risk/Diversification
with Many Stocks

7-4 Systematic Risk Is Market Risk 201
Portfolio Choice with Borrowing and
Lending/Market Risk
7-5 Should Companies Diversify? 209
•
Key Takeaways 210 Further Reading 211 Problem • Certainty Equivalents 263
•
Sets 212 Solutions to Self-Test Questions 219
Finance on the Web 220
8 The Capital Asset Pricing
Model 222
8-1 Market Risk Is Measured by Beta 222
The Market Portfolio/Why Betas Determine
Portfolio Risk
8-2 The Relationship between Risk and Return
What If a Stock Did Not Lie on the Security Market
Line?/The Capital Market Line and the Security
Market Line/The Logic behind the Capital Asset
Pricing Model/Intuition: Why Do High Beta and
High Returns Go Together?/Applying the Capital
Asset Pricing Model
8-3 Does the CAPM Hold in the Real World?
How Large Is the Return for Risk?/Are Returns
Unrelated to All Other Characteristics?
8-4 Some Alternative Theories 237
Arbitrage Pricing Theory/A Comparison of the
Capital Asset Pricing Model and Arbitrage Pricing
Theory/The Three-Factor Model
•
Key Takeaways 241 Further Reading 242 Problem • Mini-Case: Waldo County 299
•
Sets 242 Solutions to Self-Test Questions 246
Finance on the Web 247
9 Risk and the Cost of Capital 248
9-1 Company and Project Costs of Capital 249
Company Cost of Capital for CSX/Three
Warnings/What about Investments That Are
Not Average Risk?/Perfect Pitch and the Cost
of Capital
9-2 Estimating Beta and the Company Cost of
Capital 254
Estimating Beta/Portfolio Betas
Contents xxiii
9-3 Analyzing Project Risk 257
1. The Determinants of Asset Betas/2. Don’t
Be Fooled by Diversifiable Risk/3. Avoid Fudge
Factors in Discount Rates/Discount Rates for
International Projects
• 9-4
•
Key Takeaways 266 Further Reading 268 Problem •
•
Sets 268 Solutions to Self-Test Questions 273 •
•
Finance on the Web 273 Mini-Case: The Jones
Family Incorporated 273
I Part Three: Best Practices in Capital
Budgeting
228 10 Project Analysis 276
10-1 Sensitivity and Scenario Analysis 277
Value of Information/Limits to Sensitivity Analysis/
Stress Tests and Scenario Analysis
10-2 Break-Even Analysis and Operating
Leverage 281
233 Break-Even Analysis/Operating Leverage
10-3 Real Options and the Value of Flexibility 284
The Option to Expand/The Option to Abandon/
Production Options/Timing Options/More on
Decision Trees/Pro and Con Decision Trees
•
Key Takeaways 291 Further Reading 292 Problem •
•
Sets 292 Solutions to Self-Test Questions 298 •
•
11 How to Ensure That Projects Truly
Have Positive NPVs 301
11-1 Behavioral Biases in Investment Decisions 302
11-2 Avoiding Forecast Errors 303
11-3 How Competitive Advantage Translates into
Positive NPVs 308
11-4 Marvin Enterprises Decides to Exploit a New
Technology—An Example 312
Forecasting Prices of Gargle Blasters/The Value
of Marvin’s New Expansion/Alternative Expansion
Plans/The Value of Marvin Stock/The Lessons of
Marvin Enterprises
xxiv Contents
•
Key Takeaways 319 Further Reading 319 Problem •
•
Sets 320 Solutions to Self-Test Questions 325
Mini-Case: Ecsy-Cola 326
I Part Four: Financing Decisions and
Market Efficiency
12 Efficient Markets and Behavioral
Finance 327
12-1 Differences between Investment and Financing
Decisions 328
NPV Matters for Both Investment and
Financing Decisions/The NPV of Financing
Decisions Is Zero in Efficient Markets/The
NPV of Financing Decisions in Inefficient
Markets
12-2 The Efficient Market Hypothesis 330
Forms of Market Efficiency/Why Do We Expect
Markets to Be Efficient?
12-3 Implications of Market Efficiency 335
What Market Efficiency Does Not Imply/What if
Markets Are Not Efficient? Implications for the
Financial Manager
12-4 Are Markets Efficient? The Evidence 345
Weak-Form Efficiency/Semistrong-Form
Efficiency/Strong-Form Efficiency
12-5 Behavioral Finance 352
Sentiment/Limits to Arbitrage/Agency and Incentive
Problems
•
Key Takeaways 360 Further Reading 361 Problem •
•
Sets 362 Solutions to Self-Test Questions 366
Finance on the Web 367
13 An Overview of Corporate
Financing 368
13-1 Patterns of Corporate Financing 369
How Much Do Firms Borrow?
13-2 Equity 372
Ownership of the Corporation/Preferred Stock
13-3 Debt 375
• The Different Kinds of Debt/A Debt by Any Other Name
13-4 The Role of the Financial System 378
The Payment Mechanism/Borrowing and Lending/
Pooling Risk/Information Provided by Financial
Markets
13-5 Financial Markets and Intermediaries 381
Financial Intermediaries/Investment Funds/
Financial Institutions
13-6 Financial Markets and Intermediaries around
the World 387
Conglomerates and Internal Capital Markets
13-7 The Fintech Revolution 391
Payment Systems/Person-to-Person Lending/
Crowdfunding/AI/ML Credit Scoring/Distributed
Ledgers and Blockchains/Cryptocurrencies/Initial
Coin Offerings
•
Key Takeaways 394 Further Reading 395 Problem •
•
Sets 396 Solutions to Self-Test Questions 398 •
Finance on the Web 398
14 How Corporations Issue
Securities 399
14-1 Venture Capital 399
The Venture Capital Market
14-2 The Initial Public Offering 404
The Public-Private Choice/Arranging an Initial
Public Offering/The Sale of Marvin Stock/The
Underwriters/Costs of a New Issue/Underpricing
of IPOs/Hot New-Issue Periods/The Long-Run
• Performance of IPO Stocks/Alternative Issue
Procedures/Types of Auction: A Digression
14-3 Security Sales by Public Companies 416
Public Offers/The Costs of a Public Offer/Rights
Issues/Market Reaction to Stock Issues
14-4 Private Placements 421
•
Key Takeaways 422 Further Reading 423 Problem •
•
Sets 423 Solutions to Self-Test Questions 429 •
•
Finance on the Web 429 Appendix: Marvin’s
New-Issue Prospectus 430

I Part Five: Payout Policy and Capital
Structure
15 Payout Policy 434
15-1 Facts about Payout 435
How Firms Pay Dividends/How Firms Repurchase
Stock/The Information Content of Dividends/The
Information Content of Share Repurchases
15-2 Dividends or Repurchases? Does the Choice
Affect Shareholder Value? 440
Dividends or Repurchases? An Example/Stock
Repurchases and DCF Valuation Models/
Dividends and Share Issues
15-3 Dividend Clienteles 444
15-4 Taxes and Payout Policy 445
Empirical Evidence on Payout Policies and Taxes/
Alternatives to the U.S. Tax System
15-5 Payout Policy and the Life Cycle of the Firm 449
The Agency Costs of Idle Cash/Payout and
Corporate Governance
•
Key Takeaways 452 Further Reading 453 Problem•
•
Sets 453 Solutions to Self-Test Questions 458 • Information/Implications of the Pecking Order/The
Finance on the Web 458
16 
Does Debt Policy Matter? 459
16-1 Financial Leverage and Shareholder Value 460
16-2 Modigliani and Miller’s Proposition 1 461
The Law of the Conservation of Value/An Example
of Proposition 1
16-3 L
 everage and Expected Returns: MM’s
Proposition 2 466
Proposition 2/Leverage and the Cost of Equity/
How Changing Capital Structure Affects the Equity
Beta/Watch Out for Hidden Leverage
16-4 No Magic in Financial Leverage 473
Today’s Unsatisfied Clienteles Are Probably
Interested in Financial Innovation/Imperfections
and Opportunities
16-5 A Final Word on the Cost of Capital 476
Contents xxv
•
Key Takeaways 478 Further Reading 478 Problem•
•
Sets 479 Solutions to Self-Test Questions 483 •
Mini-Case: Claxton Drywall Comes to the Rescue 483
17 How Much Should a Corporation
Borrow? 485
17-1 Debt and Taxes 486
How Do Interest Tax Shields Contribute to the
Value of Stockholders’ Equity?/Recasting Johnson
& Johnson’s Capital Structure/MM and Corporate
Tax/Corporate and Personal Taxes
17-2 Costs of Financial Distress 492
Bankruptcy Costs/Evidence on Bankruptcy Costs/
Direct versus Indirect Costs of Bankruptcy/Financial
Distress without Bankruptcy/Agency Costs of
Financial Distress/Risk Shifting: The First Game/
Refusing to Contribute Equity Capital: The Second
Game/And Three More Games, Briefly/What the
Games Cost/Costs of Distress Vary with Type of Asset
17-3 The Trade-Off Theory of Capital Structure 503
17-4 The Pecking Order of Financing Choices 505
Debt and Equity Issues with Asymmetric
Bright Side and the Dark Side of Financial Slack
17-5 The Capital Structure Decision 509
The Evidence/Is There a Theory of Optimal Capital
Structure?
•
Key Takeaways 512 Further Reading 513 Problem•
•
Sets 513 Solutions to Self-Test Questions 517 •
Finance on the Web 517
18 Financing and Valuation 518
18-1 The After-Tax Weighted-Average Cost of
Capital 519
Review of Assumptions/Mistakes People Make in
Using the Weighted-Average Formula
18-2 Valuing Businesses 523
Valuing Rio Corporation/Estimating Horizon
Value/Valuation by Comparables/Liquidation
Value/WACC vs. the Flow-to-Equity Method
xxvi Contents
18-3 Using WACC in Practice 528
Some Tricks of the Trade/Adjusting WACC when
Debt Ratios and Business Risks Differ/Three-
Step Procedure for Finding WACCs at Different
Debt Ratios/Unlevering and Relevering Betas/
Calculating Divisional WACCs/The Assumption of
a Constant Debt Ratio in the After-Tax WACC/The
Modigliani–Miller Formula
18-4 Adjusted Present Value 536
APV for the Perpetual Crusher/Other Financing
Side Effects/APV for Entire Businesses/APV
and Limits on Interest Deductions/APV for
International Investments
18-5 Your Questions Answered 541
•
Key Takeaways 543 Further Reading 544 Problem •
•
Sets 545 Solutions to Self-Test Questions 549 • Employees/Customers/Suppliers/Local and
•
Finance on the Web 550 Appendix: Discounting
•
Safe, Nominal Cash Flows 551 A Consistency
Check 553
I Part Six: Corporate Objectives and
Governance
19 Agency Problems and
Corporate Governance 555
19-1 What Agency Problems Should You Watch Out
For? 556
Reduced Effort/Private Benefits/Overinvestment/
Risk Taking/Short-Termism
19-2 Monitoring by the Board of Directors 560
U.S. and U.K. Boards of Directors/European
Boards of Directors
19-3 Monitoring by Shareholders 563
Voting/Engagement/Exit
19-4 Monitoring by Auditors, Lenders, and Potential
Acquirers 566
Auditors/Lenders/Takeovers
19-5 Management Compensation 568
Compensation Facts and Controversies/The
Structure of CEO Pay
19-6 Government Regimes around the World 575
Ownership and Control in Japan/Ownership and
Control in Germany/Ownership and Control in
Other Countries
19-7 Do These Differences Matter? 581
Public Market Myopia/Growth Industries and
Declining Industries
• •
Key Takeaways 583 Further Reading 584 Problem
•
Sets 585 Solutions to Self-Test Questions 587 •
Finance on the Web 587
20 Stakeholder Capitalism and
Responsible Business 588
20-1 Who Are the Stakeholders? 589
Regional Communities/The Environment/
The Government
20-2 The Case for Shareholder Capitalism 592
Government Policy Ensures Companies Will
Engage in Socially Responsible Behavior/
Maximizing Shareholder Value Allows Investors
to Pursue Social Objectives/Maximizing
Shareholder Value Requires a Company to
Invest in Stakeholders/Enlightened Shareholder
Value/Decision Making under Enlightened
Shareholder Value
20-3 The Case for Stakeholder Capitalism 596
Well-Functioning Governments/No Comparative
Advantage in Serving Society/Instrumental
Decision Making Is Effective/The Challenge of
Stakeholder Capitalism/Summary
20-4 Responsible Business 600
Defining Responsible Business/Decision
Making in Responsible Businesses/
Summary
20-5 Responsible Business in Practice 605
Shareholder Primacy in the United States
and United Kingdom/Benefit Corporations/
B Corps/Purpose/Reporting
• •
Key Takeaways 611 Further Reading 612 Problem
•
Sets 612 Solutions to Self-Test Questions 613 •
Finance on the Web 613

I Part Seven: Options
21 Understanding Options 614
21-1 Calls, Puts, and Shares 615
Call Options and Payoff Diagrams/Put Options/
Selling Calls and Puts/Payoff Diagrams Are Not
Profit Diagrams
21-2 Financial Alchemy with Options 619
Spotting the Option
21-3 What Determines the Value of a Call Option? 625
Risk and Option Values
•
Key Takeaways 630 Further Reading 631 Problem•
•
Sets 631 Solutions to Self-Test Questions 636 • •
Finance on the Web 636
22 Valuing Options 637
22-1 A Simple Option-Valuation Model 638
Why Discounted Cash Flow Won’t Work for
Options/Constructing Option Equivalents from
Common Stocks and Borrowing/Risk-Neutral
Valuation/Valuing the Amazon Put Option/Valuing
the Put Option by the Risk-Neutral Method/The
Relationship between Call and Put Prices
22-2 The Binomial Method for Valuing Options 644
Example: The Two-Step Binomial Method/The
General Binomial Method/The Binomial Method
and Decision Trees
22-3 The Black–Scholes Formula 649
Using the Black–Scholes Formula/How Black-
Scholes Values Vary with the Stock Price/The Risk
of an Option/The Black–Scholes Formula and the
Binomial Method/Some Practical Examples
22-4 Early Exercise and Dividend Payments 656
•
Key Takeaways 658 Further Reading 659 Problem•
•
Sets 659 Solutions to Self-Test Questions 663
• •
Finance on the Web 664 Mini-Case: Bruce
Honiball’s Invention 664
23 Real Options 666
23-1 The Option to Expand 666
Questions and Answers about Blitzen’s Mark II/
Other Expansion Options
Contents xxvii
23-2 Options in R&D 670
23-3 The Timing Option 672
Valuing the Malted Herring Option/Optimal
Timing for Real Estate Development
23-4 The Abandonment Option 675
Bad News for the Perpetual Crusher/Abandonment
Value and Project Life/Temporary Abandonment
23-5 Flexible Production and Procurement 678
Aircraft Purchase Options
23-6 Valuing Real Options 682
A Conceptual Problem?/What about Taxes?/
Practical Challenges
•
Key Takeaways 685 Further Reading 685 •
Problem Sets 686 Solutions to Self-Test
Questions 690
I Part Eight: Debt Financing
24 Credit Risk and the Value
of Corporate Debt 691
24-1 Yields on Corporate Debt 692
Distinguishing Promised and Expected Yields/
What Determines the Yield Spread?
24-2 Valuing the Option to Default 695
Finding Bond Values/The Value of Corporate Equity
24-3 Predicting the Probability of Default 699
Statistical Models of Default/Structural Models of
Default
•
Key Takeaways 706 Further Reading 706 Problem •
•
Sets 707 Solutions to Self-Test Questions 708 •
Finance on the Web 709
25 The Many Different Kinds of
Debt 710
25-1 Long-Term Corporate Bonds 711
Bond Terms/Security and Seniority/Asset-Backed
Securities/Call Provisions/Sinking Funds/Bond
Covenants/Privately Placed Bonds/Foreign Bonds
and Eurobonds
25-2 Convertible Securities and Some Unusual
Bonds 720
xxviii Contents
The Value of a Convertible at Maturity/
Forcing Conversion/Why Do Companies Issue
Convertibles?/Valuing Convertible Bonds/A
Variation on Convertible Bonds: The Bond–
Warrant Package/Innovation in the Bond Market
25-3 Bank Loans 727
Commitment/Maturity/Rate of Interest/Syndicated
Loans/Security/Loan Covenants
25-4 Commercial Paper and Medium-Term
Notes 731
Commercial Paper/Medium-Term Notes
•
Key Takeaways 733 Further Reading 734 • 27-5 Interest Rate Risk
•
Problem Sets 734 Solutions to Self-Test
•
Questions 739 Mini-Case: The Shocking Demise of
•
Mr. Thorndike 740 Appendix: Project Finance 741
Appendix Further Reading 743
26 Leasing 744
26-1 What Is a Lease? 744
26-2 Why Lease? 746
Sensible Reasons for Leasing/A Dubious Reason
for Leasing
26-3 Rentals on an Operating Lease 747
Example of an Operating Lease/Lease or Buy?
26-4 Valuing Financial Leases 750
Example of a Financial Lease/Valuing the Lease
Contract/Comparing the Lease with an Equivalent
Loan/Financial Leases When There Are Limits on
the Interest Tax Shield/Leasing and the Internal
Revenue Service
26-5 When Do Financial Leases Pay? 754
Leasing around the World
26-6 Setting Up a Leveraged Lease 756
•
Key Takeaways 757 Further Reading 757 Problem •
•
Sets 758 Solutions to Self-Test Questions 762
I Part Nine: Risk Management
27 Managing Risk 763
27-1 Why Manage Risk? 764
Reducing the Risk of Cash Shortfalls or Financial
Distress/Agency Costs May Be Mitigated by
Risk Management/The Evidence on Risk
Management
27-2 Insurance 767
27-3 Reducing Risk with Financial Options 769
27-4 Forward and Futures Contracts 770
A Simple Forward Contract/Futures Exchanges/
The Mechanics of Futures Trading/Trading
and Pricing Financial Futures Contracts/Spot
and Futures Prices—Commodities/More about
Forwards and Futures
776
Forward Rates of Interest and the Term Structure/
Borrowing and Lending at Forward Interest Rates/
• Forward Rate Agreements/Interest Rate Futures
27-6 Swaps 779
Interest Rate Swaps/Currency Swaps/Some
Other Swaps
27-7 How to Set Up a Hedge 783
Hedging Interest Rate Risk/Hedge Ratios and
Basis Risk
27-8 Is “Derivative” a Four-Letter Word? 787
•
Key Takeaways 788 Further Reading 789 Problem•
•
Sets 790 Solutions to Self-Test Questions 795 •
•
Finance on the Web 796 Mini-Case: Rensselaer
Advisers 796
28 International Financial
Management 799
28-1 The Foreign Exchange Market 799
28-2 Some Basic Relationships 802
Interest Rates and Exchange Rates/The Forward
Premium and Changes in Spot Rates/Changes in
the Exchange Rate and Inflation Rates/Interest
Rates and Inflation Rates/Is Life Really That
Simple?
28-3 Hedging Currency Risk 812
Transaction Exposure and Economic Exposure
28-4 International Investment Decisions 814
The Cost of Capital for International Investments
28-5 Political Risk 817

• •
Key Takeaways 820 Further Reading 821 Problem
• •
Sets 822 Solutions to Self-Test 825 Finance on the
•
Web 826 Mini-Case: Exacta, s.a. 826
I Part Ten: Financial Planning and Working
Capital Management
29 Financial Analysis 828
29-1 Understanding Financial Statements 829
The Balance Sheet/The Income Statement
29-2 Measuring Company Performance 833
Economic Value Added/Accounting Rates of
Return/Problems with EVA and Accounting Rates
of Return
29-3 Measuring Efficiency 838
The DuPont Formula/Other Efficiency Measures
29-4 Measuring Leverage 841
Leverage and the Return on Equity
29-5 Measuring Liquidity 844
29-6 Interpreting Financial Ratios 846
• •
Key Takeaways 849 Further Reading 849 Problem
•
Sets 850 Solutions to Self-Test Questions 855 •
Finance on the Web 855
30 Financial Planning 857
30-1 What Are the Links between Short-Term and
Long-Term Financing Decisions? 857
30-2 Tracing and Forecasting Changes in Cash 860
Tracing Changes in Cash/Forecasting Dynamic’s
Cash Needs
30-3 Developing a Short-Term Financial Plan 866
Dynamic Mattress’s Financing Plan/Evaluating the
Plan/Short-Term Financial Planning Models
30-4 Using Long-Term Financial Planning
Models 869
Why Build Financial Plans?/A Long-Term
Financial Planning Model for Dynamic Mattress/
Pitfalls in Model Design/Choosing a Plan
30-5 Long-Term Planning Models and Company
Valuation 874
Contents xxix
30-6 The Relationship between Growth and External
Financing 875
• •
Key Takeaways 877 Further Reading 877 Problem
•
Sets 878 Solutions to Self-Test Questions 885 •
Finance on the Web 887
31 Working Capital Management 888
31-1 The Working Capital Requirement 888
The Cash Cycle
31-2 Managing Inventories 892
31-3 Accounts Receivable Management 894
Terms of Sale/Credit Analysis/The Credit Decision/
Collection Policy
31-4 Cash Management 900
How Purchases Are Paid For/Changes in Check
Usage/Speeding Up Check Collections/Electronic
Payment Systems/International Cash Management/
Paying for Bank Services
31-5 Investing Surplus Cash 904
Investment Choices/Calculating the Yield on
Money Market Investments/Returns on Money
Market Investments/The International Money
Market/Money Market Instruments
• •
Key Takeaways 909 Further Reading 910 Problem
•
Sets 910 Solutions to Self-Test Questions 916 •
Finance on the Web 917
I Part Eleven: Mergers, Corporate Control,
and Governance
32 Mergers 918
32-1 Types of Merger 919
32-2 Some Sensible Motives for Mergers 919
Economies of Scale and Scope/Economies of
Vertical Integration/Complementary Resources/
Changes in Corporate Control/Industry
Consolidation/Logic Does Not Guarantee Success
32-3 Some Dubious Motives for Mergers 923
Diversification/Increasing Earnings per Share:
The Bootstrap Game/Lower Borrowing Costs/
Management Motives
xxx Contents

32-4 Estimating Merger Gains and Costs 928
Estimating NPV When the Merger Is Financed
by Cash/Estimating NPV When the Merger Is
Financed by Stock/Asymmetric Information/More
on Estimating Costs—What If the Target’s Stock
Price Anticipates the Merger?/Right and Wrong
Ways to Estimate the Benefits of Mergers
32-5 The Mechanics of a Merger 932
Mergers, Antitrust Law, and Popular Opposition/
The Form of Acquisition/Merger Accounting/Some
Tax Considerations
32-6 Takeovers and the Market for Corporate
Control 936
32-7 Merger Waves and Merger Profitability 938
Merger Waves/Who Gains and Loses from
Mergers?/Buyers vs. Sellers/Mergers and Society
•
Key Takeaways 942 Further Reading 943 Problem•
I Part Twelve: Conclusion
34 Conclusion: What We Do
and Do Not Know about
Finance 977
34-1 What We Do Know: The Seven Most Important
Ideas in Finance 977
1. Net Present Value/2. The Capital Asset Pricing
Model/3. Efficient Capital Markets/4. Value
Additivity and the Law of Conservation of Value/
5. Capital Structure Theory/6. Option Theory/
7. Agency Theory
34-2 What We Do Not Know: 10 Unsolved Problems
in Finance 980
1. What Determines Project Risk and Present
Value?/2. Risk and Return—What Have We

•
Sets 943 Solutions to Self-Test Questions 946 • Missed?/3. How Important Are the Exceptions to

•
Finance on the Web 947 Appendix: Conglomerate
the Efficient-Market Theory?/4. Is Management
an Off-Balance-Sheet Liability?/5. How Can We
Mergers and Value Additivity 948
Explain the Success of New Securities and New
Markets?/6. How Can We Resolve the Payout
33 Corporate Restructuring 950 Controversy?/7. What Risks Should a Firm
Take?/8. What Is the Value of Liquidity?/9. How
33-1 Leveraged Buyouts 950 Can We Explain Merger Waves?/10. Why Are
The RJR Nabisco LBO/Barbarians at the Gate?/ Financial Systems So Prone to Crisis?
Leveraged Restructurings
34-3 A Final Word 986
33-2 The Private-Equity Market 956
Private-Equity Partnerships/Are Private-Equity
Funds Today’s Conglomerates? GLOSSARY G-1

33-3 Fusion and Fission in Corporate Finance 961 INDEX I-1

Spin-Offs/Carve-Outs/Asset Sales/Privatization
and Nationalization Note: Present value tables are available in Connect.
33-4 Bankruptcy 967
Is Chapter 11 Efficient?/Workouts/Alternative
Bankruptcy Procedures

•
Key Takeaways 973 Further Reading 973 Problem•
•
Sets 974 Solutions to Self-Test Questions 976

Introduction to Corporate Finance
T his book is about how corporations make financial
decisions. We start by explaining what these decisions
are and what they are intended to accomplish.
Corporations invest in real assets, which generate
income. Some of these assets, such as plant and machinery,
are tangible; others, such as brand names and patents, are
intangible. Corporations finance their investments through
the money they earn from selling goods and services, and
by raising additional cash through borrowing from banks or
issuing shares to investors.
Thus, the financial manager faces two broad financial
questions: First, what investments should the company
make? Second, how should it pay for those investments? The
investment decision involves spending money; the financing
decision involves raising it.
A large corporation may have hundreds of thousands
of shareholders. These shareholders differ in many ways,
including their wealth, risk tolerance, and investment horizon.
Yet we shall see that they usually share the same financial
objective. They want the financial manager to increase the
value of the corporation; in an efficient market, this will in turn
increase its current stock price.
Thus, the secret of success in financial management is
to increase value. That is easy to say but not very helpful.
Instructing the financial manager to increase shareholder
value is like advising an investor in the stock market to find
stocks that will go up in the future. The problem is how to do
it. That’s the purpose of this book. It covers the concepts that
govern good financial decisions, and it shows you how to use
the tools of the trade of modern finance.
1
Part 1 Value
CHAPTER
● ● ●
This chapter begins with specific examples of recent
investment and financing decisions made by well-known cor-
porations. The middle of the chapter covers what a corpora-
tion is and what its financial managers do. We conclude by
explaining why increasing the market value of the corpora-
tion is a sensible financial goal.
Financial managers increase value whenever the corpo-
ration earns a higher return than shareholders can earn for
themselves. The shareholders’ investment opportunities out-
side the corporation set the standard for investments inside
the corporation. Financial managers, therefore, refer to the
opportunity cost of the capital contributed by shareholders.
Managers are, of course, human beings with their own
interests and circumstances; they are not always the per-
fect servants of shareholders. Therefore, corporations must
combine governance rules and procedures with appropriate
incentives to make sure that all managers and employees
pull together to increase value.
This chapter introduces five themes that occur again and
again throughout the book:
1. Corporate finance is all about maximizing shareholder value.
2. Maximizing shareholder value involves considering the
long-term consequences of all decisions, including their
effects on stakeholders such as customers, employees,
and the environment.
3. The opportunity cost of capital sets the standard for
investment decisions.
4. A safe dollar is worth more than a risky dollar.
5. Good governance matters.
1
2 Part One Value

The second point is important, but frequently misun-
derstood. We will stress that maximizing the current stock
price does not involve focusing on short-term profits,
and increasing shareholder value does not involve price-­
gouging customers, overworking employees, or polluting the
● ● ● ● ●
environment. In a forward-looking market, even the short-
term share price takes these long-term effects into account.
However, we will also highlight the arguments for managers
having objectives other than shareholder value.

1-1 Corporate Investment and Financing Decisions

To do business, a corporation needs an almost endless variety of real assets. These may be
tangible assets, such as oil fields, factories, and machines, or intangible assets, such as patents,
brands, and corporate culture.
Real assets don’t drop free from a blue sky. Corporations pay for their real assets by selling
claims on them and the cash flows they will generate.These claims are called financial assets.
One example of a financial asset is a bank loan. The bank provides the corporation with cash
in exchange for a financial asset, which is the corporation’s promise to repay the loan with
interest. A second example is a corporate bond. The corporation sells the bond to investors in
exchange for the promise to pay interest on the bond and to pay off the bond at its maturity.
The main difference between a bond and a bank loan is that bonds can be sold second-hand
to other investors in financial markets. Tradeable financial assets are known as securities.
Shares of stock are also securities, as are a dizzying variety of specialized i­nstruments such
as options. We describe bonds in Chapter 3, stocks in Chapter 4, and other securities in later
chapters.
The above discussion suggests the following definitions:
Investment decision = purchase of real assets
​​      ​  ​  ​  ​​​
Financing decision = sale of financial assets
But these equations are too simple. The investment decision also involves managing assets
already in place and deciding when to shut down and dispose of assets that are no longer profit-
able. The corporation also has to manage and control the risks of its investments. The financ-
ing decision includes not just raising cash today but also meeting its obligations to banks,
bondholders, and shareholders that have contributed financing in the past. For example, the
corporation has to repay its debts when they become due. If it cannot do so, it ends up insolvent
and bankrupt. Sooner or later the corporation will also want to pay out cash to its shareholders.1

1.1 Self-Test

Are the following assets tangible, intangible, or financial?

a. Unsold goods on your store shelves.
b. Your company’s reputation for customer service.
c. The negotiation skills of your company’s sales force.
d. A 5% stake in your main supplier.

1
We have referred to the corporation’s owners as “shareholders” and “stockholders.” The two terms mean exactly the same thing and
are used interchangeably. Corporations are also referred to casually as “companies,” “firms,” or “businesses.” We also use these terms
interchangeably.
 Chapter 1 Introduction to Corporate Finance 3

Let’s go to more specific examples. Table 1.1 lists 10 well-known corporations from all
over the world.

Investment Decisions
The second column of Table 1.1 shows an important recent investment decision for each
corporation. Some of the investments in Table 1.1, such as Shell’s new oil field or Intel’s
factory, involve buying or building tangible assets. Such investment decisions are often
referred to as capital expenditure (CAPEX) or capital budgeting decisions. How-
ever, corporations also need to invest in intangible assets, through undertaking research
and development (R&D), advertising, and developing computer software. For example,
GlaxoSmithKline and other major pharmaceutical companies invest billions every year on
R&D for new drugs. Similarly, consumer goods companies, such as Unilever or Procter
& Gamble, invest huge sums in advertising and marketing their products. These outlays
are investments because they build know-how, brand recognition, and reputation for the
long run.
Today’s investments generate future cash returns. Sometimes the cash inflows last for
decades. For example, many U.S. nuclear power plants, which were initially licensed by the
Nuclear Regulatory Commission to operate for 40 years, are now being re-licensed for 20
more years and may be able to operate efficiently for 80 years overall. Investing to develop
self-driving cars or reduce greenhouse gas emissions also has long-term payoffs.
Of course, not all investments have such distant payoffs. For example, Walmart spends
about $50 billion each year to stock up its stores and warehouses before the holiday season.
The company’s return on this investment comes within months as the inventory is drawn
down and the goods are sold.
In addition, financial managers know (or quickly learn) that cash returns are not guaran-
teed. An investment could be a smashing success or a dismal failure. For example, Disneyland
Paris opened in 1992 and became Europe’s largest tourist attraction by visitor numbers. After

Company Recent Investment Decisions Recent Financing Decisions

Intel (U.S.)
Amazon (U.S.)
Tesla (U.S.)
Shell (U.K./Holland)
GlaxoSmithKline (U.K.)
Ørsted (Denmark)
Unilever (U.K./Holland)
Carnival Corporation (U.S./U.K.)
Invests $7 billion in expanding
semiconductor plant in Chandler, Arizona.
Acquires self-driving start-up, Zoox,
for over $1.2 billion
Announces construction of new plant to
build the electric Cybertruck
Starts production at a deep-water
development in the Gulf of Mexico
Spends $6 billion on research and
development for new drugs.
Completes a 230-MW wind farm in
Nebraska
Spends $8 billion on advertising and
marketing
Launches four new cruise ships
Borrows $600 million from Chandler
Industrial Development Authority.
Reinvests $33 billion that it generates
from operations
Announces plans to sell $2 billion of shares
Cuts dividend to preserve cash
Raises $1 billion by an issue 8-year bonds
Arranges a borrowing facility with 14
international banks
Pays a dividend and completes
$200 million program to buy back shares
Raises $770 million by sale of bonds; each
bond can be converted into about 19 shares

⟩ TABLE 1.1 Examples of recent investment and financing decisions by major public corporations.
4 Part One Value

Europe’s debt crisis in the early 2010s and subsequent terror attacks in Paris, attendance fell,
and its huge debts led Disney to bail it out in 2014 and 2017.

Financing Decisions
The third column of Table 1.1 lists a recent financing decision by each corporation.
A corporation can raise money from lenders or from shareholders. If it borrows, the lenders
contribute the cash, and the corporation promises to pay back the debt plus a fixed rate
of interest. If the shareholders put up the cash, they do not get a fixed return, but instead
a fraction of any future dividends the company chooses to pay out. The shareholders are
equity investors, who contribute equity financing. The choice between debt and equity
financing is called the capital structure decision. Capital refers to the firm’s sources of
long-term financing.
The financing choices available to large corporations seem almost endless. Suppose the
firm decides to borrow. Should it borrow from a bank or issue tradeable bonds? Should it
borrow for 1 year or 20 years? If it borrows for 20 years, should it reserve the right to pay off
the debt early? Should it borrow in Paris, receiving and promising to repay euros, or should it
borrow dollars in New York?
Corporations raise equity financing in two ways. First, they can issue new shares of stock.
The investors who buy the new shares put up cash in exchange for a fraction of the corpora-
tion’s future cash flow and profits. Second, the corporation can take the cash flow generated
by its existing assets and reinvest that cash in new assets. In this case the corporation is rein-
vesting on behalf of existing shareholders. No new shares are issued.
That last observation is important. Often, a manager may think that a corporation’s
money is hers, free to invest as she pleases. But whenever a manager reinvests cash, she’s
choosing not to pay out that cash to shareholders—she’s effectively raising money from
shareholders. For example, let’s say you own a house and hire a property management
company to rent it out for you. You receive the monthly rental payments, less the com-
pany’s management fee and expenses. So if the management company uses some of the
rent to pay for repairs, it’s you who’s financing the repairs because they come out of your
monthly income.
What happens when a corporation does not reinvest all of the cash flow generated by its
existing assets? It may hold the cash in reserve for future investment, or it may pay the cash
back to its shareholders. Table 1.1 shows that Unilever paid back $200 million to its share-
holders by repurchasing shares, in addition to paying a cash dividend. The decision to pay
dividends or repurchase shares is called the payout decision. We cover payout decisions in
Chapter 15.
Both investment and financing decisions are important, so we will consider both carefully
in this book. But the real value of a company stems from its investment decisions—what
makes a company great is what it does (its investment decisions) rather than how it pays for
it (its financing decisions). That’s why financial managers say that “value comes mainly
from the asset side of the balance sheet.” Take Apple as an example. Its market capitaliza-
tion or market cap is about $2 trillion. Where did this market value come from? It came
from Apple’s best-selling products, from its brand name and worldwide customer base, from
its research and development, and from its ability to make profitable future investments. The
value did not come from sophisticated financing. Apple’s financing strategy is very simple:
It carries no debt to speak of and finances almost all investment by retaining and reinvesting
cash flow. Indeed, the most successful corporations sometimes have the simplest financing
strategies.
 Chapter 1 Introduction to Corporate Finance 5

While investment decisions matter more on the upside, financial decisions are particularly
important on the downside. Financing decisions alone can’t turn a company into a success, but
they can cause it to fail. For example, after a consortium of investment companies bought the
energy giant TXU in 2007, the company took on an additional $50 billion of debt. This deci-
sion proved fatal. The consortium did not foresee the expansion of shale gas production and
the resulting sharp fall in natural gas and electricity prices. In 2014, the company (renamed
Energy Future Holdings) was no longer able to service its debts and filed for bankruptcy.
Business is inherently risky. The financial manager needs to identify the risks and make
sure they are managed properly. For example, debt has its advantages, but too much debt
can land the company in bankruptcy, as the buyers of TXU discovered. Companies can also
be knocked off course by recessions, by changes in commodity prices, interest rates and
exchange rates, or by adverse political developments. Some of these risks can be hedged or
insured, however, as we explain in Chapters 27 and 28.

1.2 Self-Test

Are the following decisions investment or financing decisions?

a. Redesigning your products’ packaging to use less plastic.
b. Launching a program to improve employee mental health.
c. Lending to your supplier to enable them to develop a new technology.
d. Accepting a capital injection from a venture capital firm.
e. Selling an airplane and leasing it back.

What Is a Corporation?
We have been referring to “corporations.” Before going too far or too fast, we need to offer
some basic definitions. Details follow in later chapters.
A corporation is a legal entity. In the view of the law, it is a legal person that is owned by
its shareholders. As a legal person, the corporation can make contracts, carry on a business,
borrow or lend money, and sue or be sued. It must also pay taxes. Unlike an actual person, a
corporation cannot vote, but it can buy another corporation.
In the United States, corporations are formed under state law, based on articles of BEYOND THE PAGE
­incorporation that set out the purpose of the business and how it is to be governed and
­operated.2 For example, the articles of incorporation specify the composition and role of the Zipcar’s
articles
board of directors.3 A corporation’s directors are elected by the shareholders. They choose
and advise top management and must sign off on important corporate actions, such as ­mergers mhhe.com/brealey14e
and the payment of dividends to shareholders. We’ll consider how a corporation is governed
in more detail in Chapter 19, and the purpose of the corporation in Chapter 20.
A corporation is owned by its shareholders but is legally distinct from them. Therefore the
shareholders have limited liability, which means that they cannot be held personally respon-
sible for the corporation’s debts. When the U.S. financial corporation Lehman Brothers failed
in 2008, its shareholders did not have to put up more money to cover Lehman’s massive debts.
Shareholders can lose their entire investment in a corporation, but no more.

2
In the U.S., corporations are identified by the label “Corporation,” “Incorporated,” or “Inc.,” as in Iridium Communications Inc.
The U.K. identifies public corporations by “plc” (short for “Public Limited Corporation”). French corporations have the suffix
“SA” (“Société Anonyme”). The corresponding labels in Germany are “GmbH” (“Gesellschaft mit beschränkter Haftung”) or “AG”
(“Aktiengesellschaft”).
3
The corporation’s bylaws set out in more detail the duties of the board of directors and how the firm should conduct its business.
6 Part One Value

When a corporation is first established, its shares may be privately held by a small group
of investors, such as the company’s managers and a few backers. In this case, the shares are
not publicly traded and the company is closely held. Eventually, when the firm grows and new
shares are issued to raise additional capital, its shares are traded in public markets such as the
New York Stock Exchange or Hong Kong Stock Exchange. These corporations are known as
public companies. Most well-known corporations in the United States are public companies
with widely dispersed shareholdings. In other countries, it is more common for large corpo-
rations to remain in private hands, and many public companies may be controlled by just a
handful of investors. The latter category includes such well-known names as Volkswagen
(Germany), Alibaba (China), Softbank (Japan), and the Swatch Group (Switzerland).
BEYOND THE PAGE A large public corporation may have millions of shareholders, who own the business but
cannot possibly manage or control it directly. This separation of ownership and control gives
Zipcar’s
bylaws
corporations permanence. Even if managers quit or are dismissed and replaced, the ­corporation
survives. Today’s shareholders can sell all their shares to new investors without disrupting
mhhe.com/brealey14e the operations of the business. Corporations can, in principle, live forever, and in practice,
they may survive many human lifetimes. One of the oldest corporations is the ­Hudson’s Bay
Company, which was formed in 1670 to profit from the fur trade between northern Canada
and England. Although the company still operates as one of Canada’s l­eading retail chains,
its shareholders voted in 2020 to turn it into a private company, and it was delisted from the
Toronto Stock Exchange.
BEYOND THE PAGE The separation of ownership and control can also have a downside because it can open the
door for managers and directors to act in their own interests rather than in the shareholders’
An Early
Corporation interest. We return to this problem later in this chapter and again in Chapter 19.
Almost all large and medium-sized businesses are corporations, but the nearby Finance in
mhhe.com/brealey14e Practice box describes how smaller businesses may be organized.

1.3 Self-Test

A company is bankrupt and has outstanding debt of $100 million. Its assets can be liquidated
for $80 million.
a. How much will creditors receive?
b. How much will shareholders receive?
c. How much extra are shareholders obliged to pay into the company to stop it from
going bankrupt?

The Role of the Financial Manager

What is the essential role of the financial manager? Figure 1.1 gives one answer. The figure
traces how money flows from investors to the corporation and back to investors again. The
flow starts when cash is raised from investors (arrow 1 in the figure). The cash could come
from banks or from securities sold to investors in financial markets. The cash is then used to
pay for the real assets needed for the corporation’s business (arrow 2). Later, as the business
operates, the assets produce cash inflows (arrow 3). That cash is either reinvested (arrow 4a)
or returned to the investors who furnished the money in the first place (arrow 4b). Of course,
the choice between arrows 4a and 4b is constrained by the promises made when cash was
raised at arrow 1. For example, if the firm borrows money from a bank at arrow 1, it must
repay this money plus interest at arrow 4b.
 FINANCE IN PRACTICE ● ● ● ● ●

Other Forms of Business Organization

⟩ Corporations do not have to be prominent, multina-
tional businesses such as those listed in Table 1.1. You
can organize a local plumbing contractor or barber shop
as a corporation if you want to take the trouble. But
most corporations are larger businesses or businesses
that aspire to grow. Small “mom-and-pop” businesses
are usually organized as sole proprietorships.
What about the middle ground? What about busi-
nesses that grow too large for sole proprietorships but
don’t want to reorganize as corporations? For example,
suppose you wish to pool money and expertise with
some friends or business associates. The solution is to
form a partnership and enter into a partnership agree-
ment that sets out how decisions are to be made and
how profits are to be split up. Partners, like sole propri-
etors, face unlimited liability. If the business runs into
difficulties, each partner can be held responsible for all
the business’s debts.
Partnerships have a tax advantage. Partnerships,
unlike corporations, do not have to pay income taxes.
The partners simply pay personal income taxes on their
shares of the profits.
Some businesses are hybrids that combine the tax
advantage of a partnership with the limited liability
advantage of a corporation. In a limited partnership,
partners are classified as general or limited. General
partners manage the business and have unlimited per-
sonal liability for its debts. Limited partners are liable
only for the money they invest and do not participate in
management.
Many states allow limited liability partnerships
(LLPs) or, equivalently, limited liability companies
(LLCs). These are partnerships in which all partners
have limited liability.
Another variation on the theme is the professional
corporation (PC) or professional limited liability com-
pany (PLCC), which is commonly used by doctors,
lawyers, and accountants. In this case, the business has
limited liability, but the professionals can still be sued
personally—for example, for malpractice.
Most large investment banks such as Morgan Stanley
and Goldman Sachs started as partnerships. But eventu-
ally these companies and their financing requirements
grew too large for them to continue as partnerships, and
they reorganized as corporations. The partnership form
of organization does not work well when ownership is
widespread and separation of ownership and manage-
ment is essential.

(2) (1) ◗ FIGURE 1.1

Flow of cash between financial markets
Financial and the firm’s operations. Key: (1) Cash
Firm’s operations Financial markets raised by selling financial assets to
manager (4a)
(a bundle of real (investors holding investors; (2) cash invested in the firm’s
assets) financial assets) operations and used to purchase real
assets; (3) cash generated by the firm’s
(3) (4b) operations; (4a) cash reinvested; (4b)
cash returned to investors.

You can see examples of arrows 4a and 4b in Table 1.1. Amazon financed its new projects BEYOND THE PAGE
by reinvesting earnings (arrow 4a). Unilever decided to return cash to shareholders by paying
S-corpora­
cash dividends and by buying back its stock (arrow 4b). tions
Notice how the financial manager stands between the firm and outside investors. On the
one hand, the financial manager helps manage the firm’s operations, particularly by help- mhhe.com/brealey14e
ing to make good investment decisions. On the other hand, the financial manager deals with
investors—not just with shareholders but also with financial institutions such as banks and
with financial markets such as the New York Stock Exchange.
7
8 Part One Value

BEYOND THE PAGE Notice also that the structure of Figure 1.1 mirrors the structure of a company’s balance
sheet. A company’s investments are on the left-hand side of the balance sheet, and the finan-
The financial
managers
cial assets that it has issued—its liabilities— are on the right-hand side.4

mhhe.com/brealey14e

1-2 The Financial Goal of the Corporation

Shareholders Want Managers to Maximize Market Value

Major corporations may have millions of shareholders. There is no way that all of these share-
holders can be actively involved in management; it would be like trying to run a city solely
through local meetings where residents vote on every tax and expenditure decision. Authority
has to be delegated to professional managers, just as residents delegate the running of a city
to the mayor.
A mayor’s job is complex. She is supposed to act in residents’ interests. But residents have
different views on how high taxes should be and what projects money should be spent on—
and these views may change over time. It would be impractical to run every decision past the
residents. Then, how does the mayor know what to do to serve their interests?
It might seem that a company manager’s job is equally complex. Shareholders have differ-
ent interests. Some may plan to cash in their investments next year; others may be investing
for a distant old age. Some may be wary of taking much risk; others may be more venture-
some. How does the manager know what to do to serve their interests? Fortunately, for man-
agers, there is a natural financial objective on which most shareholders can agree despite their
differences: Maximize the current market value of shareholders’ investment in the firm.
A smart and effective manager makes decisions that increase the current market value of
the company’s shares. This increased market value can then be put to whatever purposes the
shareholders want. They can sell their shares and give the proceeds to charity or spend them
on exotic holidays; they can alternatively retain their entire investment in the firm. Whatever
their personal tastes or objectives, they can all do more when their shares are worth more.
Thus, every investor wants the financial manager to increase shareholder wealth.
Maximizing market value is a sensible goal when the shareholders have access to well-
functioning financial markets.5 Financial markets allow them to transport savings across time,
by borrowing money or selling shares (if they wish to consume today) or lending money or
buying more shares (if they prefer to consume in the future). For example, the corporation’s
roster usually includes investors with both long horizons (such as a child’s trust fund) and
short horizons (such as retirees). You might expect short-horizon investors to say, “Sure, max-
imize value, but don’t invest in too many long-term projects.” But they won’t, because if the
long-term project increases shareholder wealth and thus market value, short-horizon investors
can sell their shares for a higher price and thus consume more today.
The same is true for risk. Financial markets allow shareholders to adjust the risk they
bear. A corporation’s roster of shareholders usually includes both risk-averse and risk-tolerant
investors. You might expect the risk-averse to say, “Sure, maximize value, but don’t touch too
many high-risk projects.” Instead, they say, “Risky projects are OK, provided that expected

4
Note that the investments on the left-hand side of a balance sheet include both real and financial assets. A company may own cash,
Treasury bills, and shares in other companies.
5
Here we use “financial markets” as shorthand for the financial sector of the economy. Strictly speaking, we should say “access to
well-functioning financial markets and institutions.” Many investors deal mostly with financial institutions, for example, banks, insur-
ance companies, or mutual funds. The financial institutions in turn engage in financial markets, including the stock and bond markets.
The institutions act as financial intermediaries on behalf of individual investors.
 Chapter 1 Introduction to Corporate Finance 9

returns are more than enough to offset the risks. If this firm ends up too risky for my taste,
I’ll adjust my investment portfolio to make it safer.” They could sell their shares in the risky
firm and buy safer ones or government bonds. If the risky investments increase market value,
the departing shareholders can sell at a higher price, and thus are better off, than if the risky
investments were turned down. Financial markets give them the flexibility to manage their
own savings and investment plans, leaving the corporation’s financial managers with only one
task: to increase market value and hence shareholder wealth.
Sometimes, managers say that, rather than maximizing wealth, their job is to “maximize
profits.” That sounds reasonable. After all, don’t shareholders want their company to be prof-
itable? But taken literally, profit maximization is not a well-defined financial objective for at
least two reasons:
1. Which year’s profits? A corporation may be able to increase current profits by cutting
R&D, but that may result in lower profits in the future. How do we know whether “prof-
its” are maximized if some years’ profits rise and others fall?
2. What about risk? If a project will increase the company’s profits but also make it risk-
ier, it is not clear that the manager should take it. As we’ll soon explain, risk is a crucial
factor that affects shareholder wealth.
While profits are not defined, shareholder wealth is. As Chapter 2 will show, it considers all
future profits from a company and converts them into the common currency of current share-
holder wealth that takes into account whether they are short-term or long-term, risky or safe.

A Fundamental Result: Why Maximizing Shareholder Wealth Makes Sense

The goal of maximizing shareholder value is widely accepted in both theory and practice. It’s
important to understand why. Let’s walk through the argument step by step, assuming that the
financial manager should act in the interests of the firm’s owners, its shareholders.
1. Each shareholder wants three things:
a. To be as rich as possible–that is, to maximize his current wealth.
b. To manage the timing of his consumption plan by deciding whether to consume his
wealth now or invest it to spend later.
c. To manage the risk characteristics of that consumption plan.
2. But shareholders don’t need the financial manager’s help to achieve the best time pat-
tern of consumption. They can do that on their own, provided they have free access
to competitive financial markets, by deciding when to sell their shares. They can also
choose the risk characteristics of their consumption plan by investing in more- or less-
risky securities.
3. How then can the financial manager help the firm’s shareholders? There is only one
way: by increasing their wealth. That means increasing the market value of the firm and
the current price of its shares.
Economists have proved this value-maximization principle with great rigor and general-
ity. It is known as the Fisher separation theorem, because it shows that a financial manager’s
investment decisions can be separated from shareholder preferences. After you have absorbed
this chapter, take a look at the Appendix, which contains a simple example that illustrates how
the principle of value maximization follows from formal economic reasoning.
It’s important to highlight the role of well-functioning financial markets in this result. We
often think that the main role of financial markets is to allow companies to raise funds for
investment. Primary financial markets are where companies obtain new money—through
selling shares, issuing bonds, or taking out a bank loan. But most activity takes place in
10 Part One Value

secondary financial markets. On a typical day in the New York Stock Exchange, investors
trade over 1 trillion shares with each other. These shares are “second hand”—they’d been
issued previously. No new money flows to companies, yet secondary financial markets have
an important social function. By giving shareholders freedom to do what they want with
their wealth, they not only improve shareholders’ welfare but also make the manager’s task
simple—to maximize shareholder wealth.

Should Managers Maximize Shareholder Wealth?

We earlier wrote that managers have a single objective: to “maximize the current market
value of shareholders’ investment in the firm.” We’ve explained how this idea has several
advantages—it gives a clear decision rule for managers and benefits almost all shareholders
regardless of their preferences.
But this idea has also been heavily criticized. One challenge is that maximizing the “cur-
rent” market value leads managers to be short-termist—that is, focus on short-term profits
by reducing investment or cutting wages. A second criticism is that it’s narrowly focused
on shareholders at the expense of stakeholders—other parties affected by the company, such
as customers, employees, suppliers, the environment, communities, and taxpayers. A single-
minded focus on shareholders might cause managers to price-gouge customers, overwork
employees, or pollute the environment in pursuit of shareholder wealth.
These two criticisms must be taken seriously. Indeed, they have led to capitalism becoming
unpopular with many citizens and politicians. Perhaps in response, in August 2019, 181 CEOs
of the largest U.S. companies signed a statement claiming their objective was no longer solely
“generating long-term value for shareholders” but also “delivering value to our customers . . .
investing in our employees . . . dealing fairly and ethically with our suppliers . . . supporting
the communities in which we work.”*
However, these criticisms are not fully warranted. Starting with the former, as we’ll explain
in Chapter 2, current shareholder wealth depends on all future cash flows generated by a com-
pany, not just current cash flows. A company developing renewable energy may be improving
current shareholder wealth, even if the project is not profitable for 20 years. A company fail-
ing to train its workforce may be destroying shareholder value, even though the cost savings
will boost short-term profits.
Moving to the latter, it is not true that a focus on enriching the shareholders means that
managers must act as greedy mercenaries riding roughshod over the weak and helpless. In
most instances, little conflict arises between doing well (increasing shareholder value) and
doing good (increasing stakeholder value). Investing in stakeholders often benefits shareholders,
and any financial manager who fails to take these effects into account is failing at her job. Profit-
able firms are those with satisfied customers and loyal employees; firms with dissatisfied
customers and a disgruntled workforce will probably end up with declining profits and a low
stock price. Indeed, as we explain in Chapter 20, evidence shows that companies that treat
customers, employees, and the environment well also generate higher longer-term returns to
their shareholders.
So, when we say that the objective of the firm is to maximize shareholder wealth, we don’t
mean that managers should ignore everything else. The law deters managers from making bla-
tantly exploitative decisions. But managers shouldn’t be simply concerned with observing the
letter of the law or with keeping to written contracts—they should go above and beyond. This
is not just for “ethical” reasons; it’s good business sense. In business and finance, as in other

*Source: Fitzgerald, Maggie. “The CEOs of nearly 200 companies just said shareholder value is no longer their main objective”
CNBC, August 19, 2019.
 Chapter 1 Introduction to Corporate Finance 11

day-to-day affairs, there are unwritten rules of behavior that can’t be specified in a contract.
These rules make routine transactions feasible because each party trusts the other to keep their
side of the bargain. Corporations create shareholder value by building long-term relationships
with their customers and establishing a reputation for fair dealing and financial integrity.
When something happens to damage that trust, the costs can be enormous. Volkswagen
(VW) is a case in point. VW had installed secret software that cut emissions by up to forty
times when it detected a test was being conducted. Discovery of the software in 2015 caused
a tidal wave of criticism. VW’s stock price dropped by 35%. Its CEO was fired. VW diesel
vehicles piled up unsold in car dealers’ lots. In the United States alone, the scandal may ulti-
mately cost the company more than $35 billion in fines and compensation payments.
While we have explained how shareholder and stakeholder value are much more aligned
than commonly believed, it is important to acknowledge that the two preceding criticisms
may sometimes be valid. This is why we earlier said that they are “not fully warranted” rather
than “unwarranted.”
Starting with the short-termism critique, we’ve implicitly assumed that the stock market is
efficient—an assumption we will later devote an entire chapter to scrutinizing (Chapter 12).
In an efficient stock market, the share price indeed takes into account all future cash flows
from a company. But what if the stock market is myopic and ignores cash flows far into the
future? Then, market value no longer equals shareholder value. A company that undertakes a
far-sighted investment might be unfairly punished with a low stock price. Knowing that, the
manager may turn down the investment even if it creates shareholder value. As we’ll explain
in Chapter 19, a solution is to pay the manager in long-term shares, so that she is less con-
cerned with the short-term stock price.
Let’s move to the second criticism, that maximizing shareholder value means exploiting
stakeholders. We’ve argued that, in many cases, maximizing shareholder value involves tak-
ing seriously a company’s responsibility to stakeholders. But some investments in stakehold-
ers won’t fully feed back into shareholder value, even in the long term. If a company invests
billions in reducing its greenhouse gas emissions, the benefits are enjoyed by many, but the
company’s own share of the gains may be small. The consequences that companies exert on
society, but don’t feed back into their profits, are known as externalities. A company that’s
focused on shareholder wealth will ignore externalities and thus may turn down certain invest-
ments in stakeholders. As a result, managers’ objectives may need to be broadened for them to
fully take stakeholder interests into account.
We’ll revisit this issue in Chapter 20 and consider how a financial manager makes deci-
sions under multiple objectives. This is not to sweep it under the carpet; in contrast, the idea
that the purpose of the corporation may be wider than shareholder wealth should be taken suf-
ficiently seriously that it merits its own chapter. For now, we will take the manager’s objective
as maximizing shareholder wealth for two main reasons. First, it does take into account most
effects on stakeholders, even those that arise in the very long-term. Second, it leads to a clear
framework for making decisions. Under multiple objectives, it is unclear (for example) how
much to pay workers. Increasing wages will benefit employees but may hurt shareholders,
and there’s no clear way of evaluating this trade-off. Under shareholder wealth maximiza-
tion, there is a clear rule—balance the financial costs of higher pay with the financial benefits
stemming from superior worker recruitment, retention, and motivation.

1.4 Self-Test

a. Does maximizing current shareholder value lead managers to be short-termist?

b. Does maximizing current shareholder value lead to managers completely ignoring
stakeholders?
12 Part One Value

The Investment Trade-Off

Taking the manager’s objective as being market value, we now must ask: Why do some invest-
ments increase market value while others reduce it? The answer is given by Figure 1.2, which
sets out the fundamental trade-off for corporate investment decisions. Suppose the corpora-
tion has a proposed investment in a real asset and enough cash on hand to finance it. If the
corporation doesn’t invest, it can instead pay out the cash to shareholders—say, as an extra
dividend. How does the financial manager decide whether to go ahead with the project or to
pay out the cash? (The investment and dividend arrows in Figure 1.2 are arrows 2 and 4b in
Figure 1.1.)
Assume that the financial manager is acting in the interests of the corporation’s owners,
its shareholders. What do these shareholders want the financial manager to do? The answer
depends on the project’s rate of return versus the rate of return that the shareholders can earn
by investing in financial markets.
To see this, let’s say the investment project in Figure 1.2 is a proposal for Tesla to launch a
new electric car. Suppose Tesla has set aside cash to launch the new model in 2025. It could
go ahead with the launch, or it could cancel the investment and instead pay the cash out to its
shareholders. If it pays out the cash, the shareholders can then invest for themselves.
Suppose that Tesla’s new project is just about as risky as the U.S. stock market and that
investment in the stock market offers a 10% expected rate of return. If the project offers a
superior rate of return—say, 20%—then Tesla’s shareholders would be happy for the com-
pany to keep the cash and invest it in the new model. If the project offers only a 5% return,
then the shareholders are better off with the cash and without the new model; in that case, the
financial manager should turn down the project.
As long as a corporation’s proposed investments offer higher rates of return than its
shareholders can earn for themselves in financial markets, its shareholders will welcome the
investments, and its stock price will increase. But if the company earns an inferior return,
shareholders are unhappy, the stock price falls, and shareholders demand their money back so
that they can invest on their own.
In our example, the minimum acceptable rate of return on Tesla’s new car is 10%. This
minimum rate of return is called the opportunity cost of capital (or cost of capital for short)
because it depends on the investment opportunities available to investors in financial markets.
Whenever a corporation invests cash in a new project, its shareholders lose the opportunity to
invest the cash on their own. Corporations increase value by accepting all investment projects
that earn more than the opportunity cost of capital. For this reason, the cost of capital is also

◗ FIGURE 1.2
The firm can either keep Cash
and reinvest cash or return
it to ­investors. (Arrows
­represent ­possible cash
flows or transfers.) If
cash is ­reinvested, the
­opportunity cost is the Investment Investment
Financial
expected rate of return project Shareholders opportunity
manager
that shareholders could (real asset) (financial asset)
have obtained by invest-
ing in financial assets.
Invest Alternative: Shareholders
pay dividend invest for themselves
to shareholders
 Chapter 1 Introduction to Corporate Finance 13

known as the hurdle rate, because a project’s return must be higher than this hurdle for it to
create value for shareholders.
Notice that the opportunity cost of capital depends on the risk of the proposed investment
project. The “apples-to-apples” alternative of investing in a project is to pay out the cash to
shareholders and allow them to invest in financial markets at the same level of risk. In turn,
the return that shareholders get when they invest on their own depends on the risk they take.
The safest investments, such as U.S. government debt, offer low rates of return. Investments
with higher expected rates of return—the stock market, for example—are riskier and some-
times deliver painful losses. (The U.S. stock market was down 38% in 2008 and fell more than
20% in March 2020, for example.) Other investments, such as high-tech growth stocks, are
riskier still and thus investors demand higher returns.
That the hurdle rate is an opportunity cost of investing elsewhere should make it clear that
the minimum required return for a project depends entirely on external factors—the rates of
return that shareholders could obtain elsewhere. It does not depend on internal factors, such
as the interest rate the company pays on a bank loan, or the return on a company’s existing
investments.
Managers look to the financial markets to measure the opportunity cost of capital for the
firm’s investment projects. They can observe the opportunity cost of capital for safe invest-
ments by looking up current interest rates on safe debt securities. For risky investments, the
opportunity cost of capital has to be estimated. We start to tackle this task in Chapter 7.

1.5 Self-Test

a. Epsilon is taking out a low-interest-rate bank loan to finance construction of a

­number of stores in South Carolina. Upsilon is making a similar-risk investment in
North Carolina, which it is financing with an issue of shares. Should Upsilon require
a higher return than Epsilon on its investment?
b. Two pharmaceuticals companies are developing a cure for cancer. Company A has
been successful in drug development in the past and earned a 25% rate of return
on its past investments. Company B has been less successful and only yielded 15%.
Should Company A require a higher, lower, or the same return on the cancer cure
than Company B?

Agency Problems and Corporate Governance

We have emphasized the separation of ownership and control in public corporations.
The owners (shareholders) cannot control what the managers do, except indirectly through
the board of directors. This separation is necessary but also dangerous. You can see the risks.
Managers may be tempted to buy flashy corporate jets or to schedule business meetings at
luxury resorts. They may shy away from attractive but risky projects because they are worried
more about the safety of their jobs than about maximizing shareholder value. They may work
just to maximize their own bonuses, and therefore slash investment in employees or reducing
their company’s carbon footprint.
Conflicts between shareholders’ and managers’ objectives create agency problems.
Agency problems arise when agents work for principals. The shareholders are the principals;
the managers are their agents. Agency costs are incurred when (1) managers do not attempt to
maximize firm value and (2) shareholders incur costs to monitor the managers and constrain
their actions.
Agency problems can sometimes lead to outrageous behavior. For example, when Dennis
Kozlowski, the CEO of Tyco, threw a $2 million 40th birthday bash for his wife, he charged
half of the cost to the company. This, of course, was an extreme conflict of interest, as well as
14 Part One Value

illegal. But more subtle and moderate agency problems arise whenever managers don’t own
the entirety of their firm. As we’ll revisit in Chapter 20, errors of omission (failing to take
good actions, such as launching a new product or closing down an unprofitable division) are
often even more serious than errors of commission (undertaking bad actions).
Later in the book, and in particular in Chapter 19, we will look at how good systems
of governance ensure that managers’ hearts are close to shareholders’ pockets. This means
well-designed incentives for managers, standards for accounting and disclosure to investors,
requirements for boards of directors, and legal sanctions for self-dealing by management.
When scandals happen, we say that corporate governance has broken down. When corpora-
tions compete effectively and ethically to deliver value to shareholders, we conclude that
governance is working properly.

1-3 Key Questions in Corporate Finance

Figure 1.2 illustrates how the financial manager can add value for the firm and its sharehold-
ers. She searches for investments that offer rates of return higher than the opportunity cost of
capital. But that search opens up a treasure chest of follow-up questions.
∙ How do I calculate the rate of return? The rate of return is calculated from the cash
inflows and outflows generated by the investment project (Chapters 2 and 5).
∙ Is a higher rate of return on investment always better? Not always, for two reasons. First,
a lower-but-safer return can be better than a higher-but-riskier return. Second, an invest-
ment with a higher percentage return can generate less value than a lower-return invest-
ment that is larger or lasts longer. In Chapter 2, we show how to calculate the present
value (PV) of the stream of cash flows from an investment. Present value is a workhorse
concept of corporate finance that shows up in almost every chapter.
∙ What determines value in financial markets? We cover valuation of bonds and common
stocks in Chapters 3 and 4. We will return to valuation principles again and again in later
chapters. Sometimes the financial manager may be lucky and find an almost identical
asset whose value is already known. The idea that identical assets must have the same
value is known as the law of one price. But there is no identical asset to Shell’s offshore
oil field in the Gulf of Mexico or GlaxoSmithKline’s investment in research. For most
major financial decisions, the manager needs some fundamental principles to help him to
determine value.
∙ What are the cash flows? The future cash flows from an investment project should be the
sum of all cash inflows and outflows caused by the decision to invest. Cash flows are cal-
culated after corporate taxes are paid. They are the free cash flows that can be paid out to
shareholders or reinvested on their behalf. Chapter 6 explains how to calculate these cash
flows.
∙ How does the financial manager judge whether cash-flow forecasts are realistic? As
Niels Bohr, the 1922 Nobel Laureate in Physics, observed, “Prediction is difficult, espe-
cially if it’s about the future.” But good financial managers take care to assemble relevant
information and to purge forecasts of bias and thoughtless optimism. See Chapters 6, 9,
10 and 11.
∙ How do we measure risk? We look to the risks borne by shareholders, recognizing that
investors can dilute or eliminate some risks by holding diversified portfolios (Chapter 7).
∙ How does risk affect the opportunity cost of capital? Here we need a theory of risk and
return in financial markets. The most widely used theory is the capital asset pricing
model (Chapters 8 and 9).
Another random document with
no related content on Scribd:
 Listen, as she condoles with a widower, on his recent
bereavement:

Sickness and afflictions is trials sent

By the will of a wise creation,
And always ought to be underwent
With fortitude and resignation.
Then mourn not for your pardner’s death,
But to forgit endevver,
For, sposen she hadn’t a died so soon,
She couldn’t a lived forever.

And when, at last, she secured a widower of her own, the Rev.
Shadrack Sniffles, how jubilant her muse became:

The heart that was scornful and cold as a stun,

Has surrendered at last to the fortinit one.
Farewell to the miseries and griefs I have had!
I’ll never desert thee, O Shadrack, my Shad.

The wonderful puns and repartees of Charles Lamb and Sydney

Smith, prince and king of wits! are open to the same objection as
those alluded to above: they are only too familiar, already. But as
that is equivalent to saying that they have charmed only too many
people; turned too many sorrowful or wearied minds out of their
ordinary channels; excited too much healthful and delightful laughter;
we are, after all, not disposed to complain. Rather let us, Sancho-
Panza-like, invoke a benison, first on Cervantes himself; then on the
English Hood and Hook, and Moore and Sheridan and Lamb, on the
three Smiths, Sydney and James and Horace; on Dickens,
Thackeray and Jerrold, and Edmund Lear; on our own Irving, Derby,
Whicher, Morris, Brown, the Clarkes; our Lowell, Saxe, Holmes,
Strong; our Warner, Cozzens, Dodgson, Gilbert, Locke, Bret Harte;
our Grail Hamilton, and our Phebe Carey; and on all the named and
unnamed, known and unknown writers, through whom have come to
us the exquisite sense of fun, the blessing of irrepressible mirth, and
of hearty, wholesome, innocent, delicious laughter!
 And if, despite our struggles, we are accused, as we shall be,
and justly, of having told some more than twice-told tales, of quoting
already hackneyed quotations charity will urge in our behalf (and, let
us trust, not vainly), Burns’ pathetic plea, reminding the critics, that
while

“What’s done they” easily “compute.

They know not what’s resisted.”

“SOUND AND” UNSOUND, “SIGNIFYING

NOTHING.”
A young gentleman of Rochester, suspecting that the poetical
enthusiasm of certain of his young lady acquaintances was not
genuine; that they appreciated the musical jingle of verses, without in
the least regarding the sentiment, laid a wager with one of his
friends, that he could write a set of stanzas, which should not contain
one grain of sense, and yet would be just as warmly applauded by
those young ladies as the most eloquent poetry.
He won the wager. (But this occurred many years ago. There are
no such young ladies in Rochester now).

See! the fragrant twilight whispers

O’er the orient western sky,
While Aurora’s verdant vespers
Tell her evening reign is nigh.

Now a louder ray of darkness,

Carols o’er the effulgent scene,
And the lurid light falls markless
On the horizon’s scattered screen.

Night is near, with all his horrors,

Sweetly swerving in his breast,
And the ear of fancy borrows
Morning mists to lull the west.
 Ere he comes in all his splendor,
Hark! the milky way is seen,
Sighing like a maiden tender
In her bower of ruby green.

Such a scene, ah! who can list to,

And not saddened, silent, seek
To unveil the burning vista
Of Diana’s raven cheek?

Thus tremulous, and ever dear,

Robed in repellant rapture;
Our hours shall stay, swift as the year,
Illumed by Cupid’s capture!

And when hyenal joys are ours,

And memory soars above us,
Hope shall retrace for future years
The love of all who love us.

Something of the same character is the subjoined:

EVENING SONG.

Brightly blue the stars shine o’er us,

While the sinking sun ascends
To the wide spread waves before us,
And a pleasing softness lends.

Homeward now the aged plough-boys

Wing their way o’er hill and dale,
And the laughter-loving cow goes
Tripping lightly down the vale.

Gentle zephyrs’ ink-stained fingers

Point the hour-hand of the clock,
There the warbling sheep-fold lingers—
Save it from the cruel hawk!

Thus excoriate the hours,

Till the red volcano’s powers
 Kindle on the hearth its fires:
Poets! dissipate your lyres!

In the following musical poem, the letter e does duty so well for
all the other vowels, as to suggest the idea that our ordinary lavish
use of them is a piece of extravagance!

When the September eves were new,

When fresh the western breezes blew,
When meek Selene, gem-besprent,
The dew her crested jewels lent;
We met, Belle, where the beeches grew,
When the September eves were new.

When the September eves were new,

Endless, meseemed, the sweets we knew!
Sweet fell the dew; sweet swept the breeze;
Sweet were the templed beechen trees;
The spell yet sweeter, tenderer grew,
When the September eves were new!

When the September eves were eld,

The templed beechen trees were felled;
Keen-edged the western breezes blew;
Crestless the meek Selene grew;
The fettered dew her jewels held,
When the September eves were eld.

When the September eves were eld,

Fled were the scenes we erst beheld—
Reft were the tender scenes we knew;—
The desert, where the beeches grew!
Yet, Belle, we sweeter secrets held,
Ere the September eves were eld!

The construction of the following verses, from which the letter s is

omitted, shows that our language is not of necessity a succession of
sibilant sounds, as it is generally supposed to be:
 Oh! come to-night, for naught can charm
The weary time when thou’rt away.
Oh, come! the gentle moon hath thrown
O’er bower and hall her quivering ray.
The heather bell hath mildly flung
From off her fairy leaf the bright
And diamond dew-drop that had hung
Upon that leaf a gem of light.
Then come, love, come!

To-night the liquid wave hath not,

(Illumined by the moonlit beam
Playing upon the lake beneath,
Like frolic in a fairy dream—)
The liquid wave hath not, to-night,
In all her moonlit pride, a fair
Gift-like to them that, on thy lip,
Do breathe and laugh and home it there.
Then come, love, come!

To-night, to-night, my gentle one,

The flower-bearing Amra tree
Doth long, with fragrant moan, to meet
The love-lip of the honey-bee.
But not the Amra tree can long
To greet the bee, at evening light,
With half the deep, fond love I long
To meet my Nama here to-night.
Then come, love, come!

What a boon would a volume of poems, modeled on the above

principle of architecture, be to perthonth troubled with a lithp; whose
reading at present (through the perverseness of the English
language), sounds thus:

Thweetly murmurth the breethe from the thea,

Thoothing my thoul to thlumberth,
Fond memorieth bearing to me,
Of the patht, in endleth numberth.
I thigh ath I think how yearth have thped,
How joy hath left me to thorrow;
My heart now thleepeth the thleep of the dead;
 Will it waken to gladneth to-morrow?

THE NIMBLE BANK-NOTE.

“And he rose with a sigh,
And he said, ‘Can this be?’”

(Motto chosen chiefly for its inappropriateness.)

One evening at the house of a friend of mine, while we were
seated at the table, Mr. Baker, my friend’s husband, absently feeling
in his vest pocket, found a five dollar note which he had no
recollection of putting there.
“Hallo!” he exclaimed, “that is no place for you. I should have put
you in my pocketbook. Here, wife, don’t you want some ready
money?” and he threw the note across the table to her.
“Many thanks,” she replied; “money is always acceptable,
although I have no present need of it.” She folded the note and put it
under the edge of the tea-tray, and then proceeded to pour out the
tea and attend to the wants of her guests.
At her right sat Mrs. Easton, or Aunt Susan, whom we all knew as
an acquaintance who, from time to time, spent a week with Mrs.
Baker. Her visit was just at an end, and she was to return home that
evening.
As Mrs. Baker was pouring her tea, it occurred to her that she
was in her aunt’s debt for certain small matters, and when she had
the opportunity, she pushed the note under her plate, saying:
“Here, auntie, take this five dollars in part payment of my debt.”
“Very well,” she replied, “but the money does not belong to me. I
owe you fifteen dollars, my dear Grace, which you lent me last
Saturday. I had to pay the taxes on my little home, and had not the
ready money, and Grace lent it to me,” explained Aunt Susan.
 Grace, an orphan, was a cousin of Mrs. Baker. She and her
brother Frank boarded with her, and made a very pleasant addition
to the family circle. She was studying music, and her brother was a
clerk in a mercantile establishment.
As soon as Aunt Susan received the note, she handed it to
Grace, saying:
“I will give you this now on account, and the rest as soon as I get
it.”
“All right,” answered Grace, laughing, “and since we all seem in
the humor of paying our debts, I will follow suit. Frank, I owe you
something for music you bought me; here is part of it,” and she threw
the bank-note across the table to her brother, who sat opposite.
We were all highly amused to see how the note wandered around
the table.
“This is a wonderful note,” said Mr. Baker; “I only wish somebody
owed me something, and I owed somebody something, so that I
might come into the ring.”
“You can,” said Frank. “I owe Mrs. Baker—or you, it’s all the
same—for my board; I herewith pay you part of it.”
Amid general laughter, Mr. Baker took the note and playfully
threw it to his wife again, saying:
“It’s yours again, Lucy, because what belongs to me belongs to
you. It has completed the round, and we have all had the benefit of
it.”
“And now it must go around again,” replied she gayly. “I like to
see money circulate; it should never lie idle. Aunt Susan you take it.
Now I have paid you ten dollars.”
“Dear Grace, here is another five dollars on my account,” said
Aunt Susan, handing it to Grace.
“And you Frank, have paid ten dollars for the music you bought
me,” said Grace, handing it to her brother.
 “And I pay you ten dollars for my board,” he continued, and the
note once more rested in Mr. Baker’s hands.
The exchanges were quick as thought, and we were convulsed
with laughter.
“Was there ever so wonderful an exchange?” exclaimed Grace.
“It’s all nonsense!” exclaimed Mr. Baker.
“Not in the least,” answered his wife. “It’s all quite right.”
“Certainly,” said Frank; “when the money belonged to you, you
could dispose of it as you would; I have the same right; it is a fair
kind of exchange, though very uncommon.”
“It shows the use of money,” said Aunt Susan. “It makes the
circuit of the world and brings its value to every one who touches it.”
“And this note has not finished its work yet, as I will show you, my
dear, if you will give it to me again, said Mrs. Baker to her husband.
“I present you with this five dollar note,” said Mr. Baker.
“And I give it to you, Aunt Susan—I owed you fifteen dollars, and
I have paid my debt.”
“You have, my dear friend, without doubt; and now, my dear
Grace, I pay you my indebtedness, with many thanks for your
assistance.”
“I take it with thanks, Aunt Susan,” replied Grace; “and now the
time has come when this wonder-working, this inexhaustibly rich
bank-note must be divided, because I do not owe Frank five dollars
more. How much have I to pay you?”
“Two dollars and sixty-two cents,” replied Frank.
“Can you change it?”
“Let me see; sixty-two, thirty-eight, yes, there is the change; the
spell is broken, Grace, and you and I divide the spoils.”
“This bank-note beats all I ever saw. How much has it paid? Let
us count up,” said Grace. “Mrs. Baker gave Aunt Susan fifteen
dollars, which Aunt Susan gave me; I gave Frank twelve dollars and
sixty-two cents; Frank gave Mr. Baker ten dollars—altogether fifty-
two dollars and sixty-two cents.”
“It’s all nonsense, I tell you,” cried Mr. Baker, again; “you all owe
each other what you owed before.”
“You are deceived, my dear, by the rapid, unbroken race this little
sum has made; to me it is as clear as daylight,” replied Mrs. Baker.
“If it is all nonsense, how could the note which you gave Mrs.
Baker, if nothing to me or to you, be divided between us two?” asked
Grace.
Mr. Baker did not seem to see it very clearly, but the others did,
and they often relate this little history for the amusement of their
friends.

THE RATIONALISTIC CHICKEN.

(Inspecting its shell.)
BY J. S. STONE.

Most strange!
Most queer,—although most excellent a change!
Shades of the prison-house, ye disappear!
My fettered thoughts have won a wider range,
And, like my legs, are free;
No longer huddled up so pitiably:
Free now to pry and probe, and peep and peer,
And make these mysteries out.
Shall a free-thinking chicken live in doubt?
For now in doubt undoubtedly I am:
This Problem’s very heavy on my mind,
And I’m not one either to shirk or sham:
I won’t be blinded, and I won’t be blind.

Now, let me see:

First, I would know how did I get in there?
Then, where was I of yore?
Besides, why didn’t I get out before?
Dear me!
Here are three puzzles (out of plenty more)
Enough to give me pip upon the brain!
But let me think again.
How do I know I ever was inside?
Now I reflect, it is, I do maintain,
Less than my reason, and beneath my pride,
To think that I could dwell
In such a paltry miserable cell
As that old shell.
Of course I couldn’t! How could I have lain,
Body and beak and feathers, legs and wings,
And my deep heart’s sublime imaginings,
In there?

I meet the notion with profound disdain;

It’s quite incredible; since I declare
(And I’m a chicken that you can’t deceive)
What I can’t understand I won’t believe.
Where did I come from, then? Ah! where, indeed?
This is a riddle monstrous hard to read.
I have it! Why, of course,
All things are moulded by some plastic force,
Out of some atoms somewhere up in space,
Fortuitously concurrent anyhow;—
There, now!
That’s plain as is the beak upon my face.

What’s that I hear?

My mother cackling at me! Just her way,
So prejudiced and ignorant I say;
So far behind the wisdom of the day.
What’s old I can’t revere.
Hark at her. “You’re a silly chick, my dear,
That’s quite as plain, alack!
As is the piece of shell upon your back!”
How bigoted! upon my back, indeed!
I don’t believe it’s there,
For I can’t see it: and I do declare,
For all her fond deceivin’,
What I can’t see I never will believe in!
 A MEDLEY.
I only know she came and went, [Lowell.
Like troutlets in a pool; [Hood.
She was a phantom of delight, [Wordsworth.
And I was like a fool. [Eastman.
One kiss, dear maid, I said, and sighed, [Coleridge.
Out of those lips unshorn! [Longfellow.
She shook her ringlets round her head, [Stoddard.
And laughed in merry scorn. [Tennyson.
Ring out, wild bells, to the wild sky, [Tennyson.
You hear them, Oh, my heart, [Alice Cary.
’Tis twelve at night by the castle clock— [Coleridge.
Beloved, we must part. [Alice Cary.
Come back, come back, she cried in grief, [Campbell.
My eyes are dim with tears; [B. Taylor.
How shall I live through all the days, [Mrs. Osgood.
All through a hundred years? [J. J. Perry.
’Twas in the prime of summer time, [Hood.
She blessed me with her hand; [Hoyt.
We strayed together deeply blest, [Mrs. Edwards.
Into the dreaming land. [Cornwall.
The laughing bridal roses blew, [Patmore.
To deck her dark brown hair, [B. Taylor.
No maiden may with her compare, [Brailsford.
Most beautiful, most rare! [Read.
I clasped it on her sweet cold hand, [Browning.
The precious golden link; [Smith.
I calmed her fears, and she was calm— [Coleridge.
Drink, pretty creature, drink! [Wordsworth.
And so I won my Genevieve, [Coleridge.
And walked in Paradise; [Hervey.
The fairest thing that ever grew [Wordsworth.
Atween me and the skies! [Tennyson.

ANOTHER MEDLEY.
 (WHO ARE THE AUTHORS?)

The curfew tolls the knell of parting day,

In every clime, from Lapland to Japan;
To fix one spark of beauty’s heavenly ray,
The proper study of mankind is man.

Tell, for you can, what is it to be wise,

Sweet Auburn, loveliest village of the plain!
“The man of Ross,” each lisping babe replies,
And drags, at each remove a length’ning chain.

Ah, who can tell how hard it is to climb

Far as the solar walk, or milky way?
Procrastination is the thief of time,
Let Hercules himself do what he may.

’Tis education forms the common mind,

The feast of reason and the flow of soul;
I must be cruel only to be kind,
And waft a sigh from Indus to the pole.

Syphax! I joy to meet thee thus alone,

Where’er I roam, whatever lands I see;
A youth to fortune and to fame unknown,
In maiden meditation, fancy free.

Farewell! and wheresoe’er thy voice be tried,

Why to yon mountain turns the gazing eye?
With spectacles on nose, and pouch on side,
That teach the rustic moralist to die.

Pity the sorrows of a poor old man,

Whose beard descending, swept his aged breast;
Laugh where we must, be candid where we can,
Man never is, but always to be blest.

AND ANOTHER MEDLEY.

The moon was shining silver bright,
 All bloodless lay the untrodden snow,
When freedom from her mountain height,
Exclaimed, “Now don’t be foolish, Joe!”

An hour passed by; the Turk awoke,

Ten days and nights with sleepless eye,
To hover in the sulphur smoke,
And spread its pall upon the sky.

His echoing axe the settlers swung,

He was a lad of high degree;
And deep the pearly caves among,
Sweet Mary, weep no more for me.

Loud roars the wild, inconstant blast,

And cloudless sets the sun at even;
When twilight dews are falling fast,
And rolls the thunder-drum of heaven.

Oh, ever thus, from childhood’s hour,

By torch and trumpet fast arrayed,
Beneath yon ivy-mantled tower,
They lingered in the forest shade.

My love is like the red, red rose;

He bought a ring with posy true;
Deep terror then my vitals froze;
And, Saxon, I am Rhoderick Dhu!

LIFE.
Why all this toil for triumph of an hour?
[Young.
Life’s a short summer—man is but a flower;
[Dr. Johnson.
By turns we catch the fatal breath and die—
[Pope.
The cradle and the tomb, alas! so nigh.
[Prior.
To be is better far than not to be,
 [Sewell.
Though all man’s life may seem a tragedy:
[Spencer.
But light cares speak when mighty griefs are dumb—
[Daniel.
The bottom is but shallow whence they come.
[Sir Walter Raleigh.
Your fate is but the common fate of all;
[Longfellow.
Unmingled joys may here no man befall;
[Southwell.
Nature to each allots his proper sphere,
[Congreve.
Fortune makes folly her peculiar care;
[Churchill.
Custom does often reason overrule,
[Rochester.
And throw a cruel sunshine on a fool.
[Armstrong.
Live well—how long or short permit to heaven;
[Milton.
They who forgive most shall be most forgiven,
[Bailey.
Sin may be clasped so close we cannot see its face—
[French.
Vile intercourse where virtue has no place,
[Sommerville.
Then keep each passion down, however dear.
[Thompson.
Thou pendulum betwixt a smile and tear;
[Byron.
Her sensual snares let faithless Pleasure lay,
[Smollet.
With craft and skill to ruin and betray,
[Crabbe.
Soar not too high to fall, but stoop to rise,
[Massinger.
We masters grow of all that we despise.
[Cowley.
Oh, then, renounce that impious self-esteem;
[Beattie.
Riches have wings; and grandeur is a dream.
[Cowper.
Think not ambition wise because ’tis brave,
[Sir Walter Davenant.
The paths of glory lead but to the grave,
[Gray.
What is ambition? ’Tis a glorious cheat.
[Willis.
Only destructive to the brave and great.
[Addison.
What’s all the gaudy glitter of a crown?
[Dryden.
The way to bliss lies not on beds of down.
[Francis Quarles.
How long we live, not years but actions tell;
[Watkins.
That man lives twice who lives the first life well.
[Herrick.
Make then, while yet you may, your God your friend.
[William Mason.
Whom Christians worship, yet not comprehend.
[Hill.
The trust that’s given guard, and to yourself be just;
[Dana.
For live we how we may, yet die we must.
[Shakespeare.
 THE KEY.

ANSWERS TO PUZZLES.

1. Cobweb. M. A. R.
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2. Thanks.
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3. Of course I can! (Of Corsican.)

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4. Maid of Orleans.
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5. Because they have studded the heavens for centuries.

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6. The winds blue, and the waves rose.

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7. In violet.
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8. They leave out their summer dress.
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9. Because I am the querist.

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10. Penmanship. English Paper.

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11. Heather: weather. Hearth and Home.

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12. Nothing.
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13. It contains all the letters of the alphabet.

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14. A lawsuit.
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15. His father was Enoch, who did not die.

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16. Yes: he was the Daughter-of-Pharaoh’s son.

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17. When Autumn is turning the leaves.

 Back to puzzle

18. Bud-dhism.
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19. Starch. (Star, sac, scar, tar, trash, act, arc, arch, art, ash, rat,
rash, chart, cart, cat, car, chat, cash, cast, crash, hart, hat.)
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20. Ague. (Hague; league; plague.)

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21. Lettuce, alone. (Let us alone!)

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22. The moon.

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23. A human being. The Sphinx Riddle.

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24. Noah.
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25. Macaulay. Rural New Yorker.

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26. N R G.
 Back to puzzle

27. M T.
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28. O B C T.
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29. X L N C.
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30. L E G.
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31. Dutch S.
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32. French L.
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33. K.
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34. In the days of no A (Noah,) before U and I were born.

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35. T.
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 36. Q.
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37. It’s laudin’ ’em.

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38. No man has three feet; a man has two feet more than no
man: therefore, a man has five feet.
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39. A branch. M. L. C.
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40. Love Me Little: Love Me Long.

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41. Ma mère. E. P.
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42. Amiable (Am I able?)

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43. Conundrum.
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44. Purcell. M. D.
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