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CORPORATE
FINANCE
EIGHTH CANADIAN EDITION
Stephen A. Ross
Sloan School of Management, Massachusetts Institute of Technology
Randolph W. Westerfield
Marshall School of Business, University of Southern California
Jeffrey F. Jaffe
Wharton School of Business, University of Pennsylvania
Gordon S. Roberts
Schulich School of Business, York University
Hamdi Driss
Sobey School of Business, St. Mary’s University
Corporate Finance
Eighth Canadian Edition
Copyright © 2019, 2015, 2011, 2008, 2005, 2003, 1999, 1995 by McGraw-Hill Ryerson Limited. All rights reserved. No part
of this publication may be reproduced or transmitted in any form or by any means, or stored in a database or retrieval system,
without the prior written permission of McGraw-Hill Ryerson Limited, or in the case of photocopying or other reprographic
copying, a licence from The Canadian Copyright Licensing Agency (Access Copyright). For an Access Copyright licence, visit
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endorsement by the authors or McGraw-Hill Ryerson, and McGraw-Hill Ryerson does not guarantee the accuracy of information
presented at these sites.
ISBN-13: 978-1-25-927011-6
ISBN-10: 1-25-927011-4
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Printed and bound in Canada.
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information that enables it to rectify any reference or credit for subsequent editions.
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A B OU T T H E AUT HO R S
STEPHEN A. ROSS Sloan School of Management, trading, where he showed both that corporate insiders earn
Massachusetts Institute of Technology. Stephen Ross is the abnormal profits from their trades and that regulation has
Franco Modigliani Professor of Financial Economics at the little effect on these profits. He has also made contributions
Sloan School of Management, Massachusetts Institute of concerning initial public offerings, regulation of utilities, the
Technology. One of the most widely published authors in behaviour of marketmakers, the fluctuation of gold prices, the
finance and economics, Professor Ross is recognized for his theoretical effect of inflation on the interest rate, the empiri-
work in developing the arbitrage pricing theory, as well as for cal effect of inflation on capital asset prices, the relationship
having made substantial contributions to the discipline through between small capitalization stocks and the January effect,
his research in signalling, agency theory, option pricing, and the and the capital structure decision.
theory of the term structure of interest rates, among other top-
ics. A past president of the American Finance Association, he GORDON S. ROBERTS Schulich School of Business,
currently serves as an associate editor of several academic and York University. Gordon Roberts was a Canadian Imperial
practitioner journals. He is a trustee of CalTech and a director Bank of Commerce Professor of Financial Services at the
of the College Retirement Equity Fund (CREF), Freddie Mac, Schulich School of Business, York University. A winner of
and Algorithmics Inc. He is also the co-chairman of Roll and numerous teaching awards, his extensive experience included
Ross Asset Management Corporation. finance classes for undergraduate and MBA students, execu-
tives, and bankers in Canada and internationally. Professor
RANDOLPH W. WESTERFIELD Marshall School of Roberts conducted research in corporate finance and bank-
Business, University of Southern California. Randolph W. ing. He served on the editorial boards of several Canadian
Westerfield is Dean of the University of Southern California’s and international academic journals. Professor Roberts was
Marshall School of Business and holder of the Robert R. a consultant to a number of regulatory bodies responsible
Dockson Dean’s Chair of Business Administration. for the oversight of financial institutions and utilities.
He came to USC from the Wharton School, University Gordon Roberts passed away in March 2017 and his many
of Pennsylvania, where he was the chairman of the finance contributions to education and finance will be missed.
department and a member of the finance faculty for 20 years.
He is a member of several public company boards of direc- HAMDI DRISS Sobey School of Business, Saint Mary’s
tors, including Health Management Associates Inc., William University. Hamdi Driss is an Assistant Professor of Finance
Lyon Homes, and the Nicholas Applegate growth fund. at the Sobey School of Business, Saint Mary’s University.
His areas of expertise include corporate financial policy, His experience includes teaching corporate finance for
investment management, and stock market price behaviour. undergraduate and Master of Finance students. A holder of
several research grants, Professor Driss conducts research on
JEFFREY F. JAFFE Wharton School of Business, corporate finance and financial intermediation. Notably, he
University of Pennsylvania. Jeffrey F. Jaffe has been a fre- has made contributions to research on the certification func-
quent contributor to finance and economic literature in such tion of credit rating agencies and the quality of credit rat-
journals as the Quarterly Economic Journal, The Journal of ings under competition. His recent work was published in the
Finance, The Journal of Financial and Quantitative Analysis, Journal of Corporate Finance. Professor Driss has served as
The Journal of Financial Economics, and The Financial a referee for several Canadian and international academic
Analysts Journal. His best-known work concerns insider journals.
IN ME M O R IA M
We at McGraw-Hill Education Canada lost one of our most esteemed authors with the passing of
Gordon S. Roberts in March of 2017. Gordon was a professor emeritus of finance at the Schulich
School of Business at York University and a McGraw-Hill author for many years.
Gordon S. Roberts will be remembered as an extremely creative and thoughtful scholar with
a rigorous approach to questions of great importance. His contributions to the field of finance are
unquestioned and are reflected in his outstanding international reputation, research contributions,
and many awards and honours. In particular, Gordon will be remembered for making significant
contributions to the current textbook. His expertise and rigorous approach were key to making this
textbook exciting, accurate, fair, well-paced, and immediately useful.
Prior to development work on this eighth Canadian edition text, our very own portfolio manager,
Alwynn Pinard, had the pleasure of working closely with Gordon. Of him she says, “Gordon’s profes-
sionalism, adherence to deadlines and commitment to quality were all attributes that endeared him to
us here at McGraw-Hill Education and created the Canadian resource you are reading, today. Thank
you, Gordon. We will miss your dedication to your work and your students and perhaps most of all,
your warmth and wit.”
On behalf of the entire staff at McGraw-Hill Education who had the pleasure of working with
Gordon personally, or the pleasure of working on all the legacy projects he helped to build, we offer
our deepest sympathies to Gordon’s wife, Sonita, and his family. Gordon’s contributions to learning
will be treasured and never forgotten.
BRIEF CONTE N TS
PA RT 1 17 Capital Structure: Limits to the Use of Debt 459

Appendix 17A Some Useful Formulas of Financial
Overview 1
Structure (Available on Connect)
1 Introduction to Corporate Finance 1 Appendix 17B The Miller Model and the Graduated
Appendix 1A Taxes 25 Income Tax (Available on Connect)
Appendix 1B Finance Professional Careers 18 Valuation and Capital Budgeting for the
(Available on Connect) Levered Firm 493
2 Accounting Statements and Cash Flow 30 Appendix 18A The Adjusted Present Value Approach
Appendix 2A Financial Statement Analysis 46 to Valuing Leveraged Buyouts (Available on Connect)
Appendix 2B Statement of Cash Flows 56 19 Dividends and Other Payouts 512
3 Financial Planning and Growth 60
PA RT 5
PA RT 2 Long-Term Financing 545
Value and Capital Budgeting 78 20 Issuing Equity Securities to the Public 545
4 Financial Markets and Net Present Value: 21 Long-Term Debt 569
First Principles of Finance 78 22 Leasing 592
5 The Time Value of Money 96
Appendix 22A Adjusted Present Value Approach
Appendix 5A Using Financial Calculators to Leasing (Available on Connect)
(Available on Connect)
6 How to Value Bonds and Stocks 136
PA RT 6
Appendix 6A The Term Structure of Interest Rates 166
7 Net Present Value and Other Investment Rules 176 Options, Futures, and Corporate Finance 617
8 Net Present Value and Capital Budgeting 206 23 Options and Corporate Finance: Basic Concepts 617
Appendix 8A Capital Cost Allowance 235 24 Options and Corporate Finance: Extensions and
Appendix 8B Derivation of the Present Value of Applications 655
the Capital Cost Allowance Tax Shield Formula 240 25 Warrants and Convertibles 676
9 Risk Analysis, Real Options, and Capital Budgeting 242 26 Derivatives and Hedging Risk 695
PA RT 3 PA RT 7
Risk 267 Financial Planning and Short-Term Finance 724
10 Risk and Return: Lessons From Market History 267 27 Short-Term Finance and Planning 724
Appendix 10A The U.S. Equity Risk Premium: 28 Cash Management 751
Historical and International Perspectives
(Available on Connect) 29 Credit Management 768
11 Risk and Return: The Capital Asset Pricing Model 290 Appendix 29A Inventory Management
Appendix 11A Is Beta Dead? (Available on Connect)
12 An Alternative View of Risk and Return:
The Arbitrage Pricing Theory 328 PA RT 8
13 Risk, Return, and Capital Budgeting 348 Special Topics 786
Appendix 13A Economic Value Added and
30 Mergers and Acquisitions 786
the Measurement of Financial Performance 379
31 Financial Distress 821
PA RT 4 Appendix 31A Predicting Corporate Bankruptcy:
The Z-Score Model (Available on Connect)
Capital Structure and Dividend Policy 383 32 International Corporate Finance 835
14 Corporate Financing Decisions and Efficient Appendix A: Mathematical Tables
Capital Markets 383 (Available on Connect)
15 Long-Term Financing: An Introduction 414 Appendix B: Answers to Selected End-of-Chapter
16 Capital Structure: Basic Concepts 430 Problems (Available on Connect)
CON T ENTS
Pr ef ace xviii CHAPTER 2

PA RT 1 Accounting Statements and Cash Flow 30
Overview 1 Executive Summary 30
2.1 T H E S TAT E ME N T OF FI N AN C I AL
CHAPTER 1 P OS I T I ON 30
Liquidity 31
Introduction to Corporate Finance 1 Debt Versus Equity 31
Value Versus Cost 32
Executive Summary 1
Concept Questions 32
1.1 W H AT IS C OR P OR ATE F IN A NC E ? 2
2.2 S TAT E ME N T OF C OMP RE H E N S IVE
The Balance-Sheet Model of the Firm 2
I N C OME 32
Capital Structure 3
International Financial Reporting Standards 33
The Financial Manager 3
Non-Cash Items 34
Identification of Cash Flows 5
Time and Costs 34
Timing of Cash Flows 6
Risk of Cash Flows 7
2.3 N E T WORKI N G CAP I TAL 35
Concept Questions 7
1.2 C ORPO R ATE S EC UR I TI ES A S
C ON TIN GE NT C LA I MS ON TOTA L 2.4 FI N AN C I AL CAS H FLOW 35
F IRM VA LUE 7 Concept Questions 38
Concept Questions 8 2.5 S U MMARY AN D C ON C L U S I ON S 38
1.3 B U S IN E SS O RG A NI Z AT IO N FOR MS 8 Minicase: Cash Flows at Eshopwise Ltd. 44
The Sole Proprietorship 9 Appendix 2A Financial Statement Analysis 46
The Partnership 9 Appendix 2B Statement of Cash Flows 56
The Corporation 10
The Income Trust 11 CHAPTER 3
1.4 GOA LS O F T HE C OR P OR ATE F I R M 11 Financial Planning and Growth 60
Agency Costs and the Set-of-Contracts Executive Summary 60
Viewpoint 12 3.1 W H AT I S FI N AN C I AL P L AN N I N G? 60
Managerial Goals 12 Concept Questions 61
Separation of Ownership and Control 13
3.2 A FI N AN C I AL P L AN N I N G MODE L :
In Their Own Words: B. Espen Eckbo
T H E I N G RE DI E N T S 61
on corporate governance 14
Concept Questions 16 3.3 T H E P E RC E N TAG E OF S AL E S
ME T H OD 62
1.5 F IN A N C IA L IN ST IT UT IO NS, The Statement of Comprehensive Income 64
F IN A N C IA L MA R KE TS, A ND
TH E C O R PO R ATI ON 16 The Statement of Financial Position 65
Financial Institutions 16 Concept Questions 67
Money Versus Capital Markets 18 3.4 W H AT DE T E RMI N E S G ROW T H ? 67
Primary Versus Secondary Markets 18 Concept Questions 71
Listing 19 Some Caveats on Financial Planning Models 71
Foreign Exchange Market 20 In Their Own Words: Robert C. Higgins on
Concept Questions 20 sustainable growth 71
1.6 TR E N D S IN F IN A NC IA L MA R K E T S 3.5 S U MMARY AN D C ON C L U S I ON S 72
A N D MA N AGE MEN T 21 Minicase: Ratios and Financial Planning
In Their Own Words: Maria Strömqvist at East Coast Yachts 76
on hedge funds and the financial crisis
of 2008 22 PA RT 2
Concept Question 22 Value and Capital Budgeting 78
1.7 OU TLIN E O F T HE T EX T 22
1.8 SU M MA RY A ND C ON CL US IO N S 24 CHAPTER 4
Appendix 1A Taxes 25
Appendix 1B Finance Professional Careers Financial Markets and Net Present Value:
(Available on Connect) First Principles of Finance 78
Contents vii
Executive Summary 78 CHAPTER 6

4.1 THE FIN A NC IA L MA R K E T
E C O N OMY 79 How to Value Bonds and Stocks 136
The Anonymous Market 79
Executive Summary 136
Market Clearing 80
Concept Questions 80 6.1 DE FI N I T I ON AN D E X AMP L E O F
A B ON D 13 6
4.2 MA K I NG C ON SU MPT IO N C H OI C E S
OV ER TI ME 81 6.2 H OW TO VAL U E B ON DS 13 6
Concept Questions 82 Pure Discount Bonds 136
Level-Coupon Bonds 137
4.3 THE CO MPE TI TI V E MA R KE T 83
Consols 139
How Many Interest Rates Are There in a
Competitive Market? 84
Concept Questions 84 6.3 B ON D C ON C E P T S 140
Interest Rates and Bond Prices 140
4.4 THE BA S IC P R IN CI PL E 84
Yield to Maturity 141
Concept Question 84
Current Yield 141
4.5 PR ACT IS IN G TH E PR I N C I P L E 85
Holding-Period Return 141
A Lending Example 85
The Present Value Formulas for Bonds 141
A Borrowing Example 86
6.4 T H E P RE S E N T VAL U E OF C O M MO N
4.6 ILLU ST R AT IN G TH E IN V E S T ME N T S TOC KS 142
D E CI SI ON 87
Dividends Versus Capital Gains 142
Valuation of Different Types of Stocks 143
4.7 C O R PO R AT E IN V ES TME N T
6.5 E S T I MAT E S OF PARAME T E RS I N THE
D E CI SI ON MA K IN G 90
DI VI DE N D DI S C OU N T MO DE L 146
Concept Question 92
Where Does g Come From? 146
4.8 SUM MA RY A N D CO NC L U S I ON S 93 Where Does r Come From? 147
A Healthy Sense of Skepticism 148
CHAPTER 5 6.6 G ROW T H OP P ORT U N I T I ES 148
The Time Value of Money 96 NPVGOs of Real Companies 149
Growth in Earnings and Dividends
Executive Summary 96 Versus Growth Opportunities 151
5.1 THE ON E- PE R IO D CA SE 96 Dividends or Earnings: Which to Discount? 151
Concept Questions 99 The No-Dividend Firm 151
5.2 THE MULT IP ER I OD CA S E 99 6.7 T H E DI VI DE N D G ROW T H M O DE L AND
Future Value and Compounding 99 T H E N PVG O MODE L ( ADVAN C E D) 152
The Power of Compounding: The Dividend Growth Model 152
A Digression 103 The NPVGO Model 152
Present Value and Discounting 103 Summary 154
Finding the Number of Periods 107 6.8 C OMPARAB L E S 154
The Algebraic Formula 108 Price–Earnings Ratio 154
Concept Questions 108 Concept Questions 155
5.3 C O M PO UN DI NG P ER I OD S 108 6.9 VAL U I N G T H E E N T I RE FIRM 155
Compounding Over Many Years 110 6.10 S TOC K MARKE T RE P ORTI N G 157
Continuous Compounding (Advanced) 111 6.11 S U MMARY AN D C ON C L U SI O N S 157
Concept Questions 113 Minicase: Stock Valuation at Ragan Engines 165
5.4 SIMPL IF ICATI ON S 113 Appendix 6A The Term Structure of Interest Rates 166
Perpetuity 113 Concept Question 168
Growing Perpetuity 114
Annuity 116
Mortgages 118 CHAPTER 7
Using Annuity Formulas 119
Net Present Value and Other Investment Rules 176
Growing Annuity 122
Concept Questions 123 Executive Summary 176
5.5 WHAT I S A F IR M WORT H ? 1 23 7.1 W H Y U S E N E T P RE S E N T VAL UE ? 176
5.6 SUM MA RY A N D CO NC L U S I ON S 1 24 Concept Questions 178
Minicase: The MBA Decision 135 7.2 T H E PAY BAC K P E RI OD RUL E 178
Appendix 5A Using Financial Calculators Defining the Rule 178
(Available on Connect) Problems With the Payback Method 179
viii Contents
Managerial Perspective 179 The Tax Shield Approach 218

Summary of Payback 180 Conclusion 218
Concept Questions 180 8.5 AP P LY I N G T H E TAX S H I E L D
7.3 TH E D ISC O UN TE D PAY BAC K AP P ROAC H TO T H E MAJ E S T I C
PE R IO D RU LE 1 80 MU LC H AN D C OMP OS T
7.4 TH E AV E R AG E AC CO UN TI NG C OMPAN Y P ROJ E CT 218
R E TUR N 1 81 Present Value of the Tax Shield on Capital
Defining the Rule 181 Cost Allowance 219
Analyzing the Average Accounting Total Project Cash Flow Versus Tax Shield
Return Method 182 Approach 220
7.5 TH E IN TE RN A L R AT E OF R E TU R N 1 83 8.6 I N VE S T ME N T S OF U N E Q UAL L I VE S:
T H E E Q U I VAL E N T AN N UAL C OST
Concept Question 185
ME T H OD 221
7.6 PRO B LE MS W IT H TH E IN TE R N A L The General Decision to Replace (Advanced) 222
R ATE O F R E TU R N A PP ROACH 1 85
Definition of Independent and Mutually
Exclusive Projects 185 8.7 S U MMARY AN D C ON C L U S I ON S 226
Two General Problems Affecting Both Minicase: Beaver Mining Company 233
Independent and Mutually Exclusive Projects 186 Minicase: Goodweek Tires Inc. 234
Problems Specific to Mutually Exclusive Appendix 8A Capital Cost Allowance 235
Projects 189 Appendix 8B Derivation of the Present Value of
Redeeming Qualities of the Internal the Capital Cost Allowance Tax Shield Formula 240
Rate of Return 193
A Test 194 CHAPTER 9
7.7 TH E PRO FITA B I LI TY IN DE X 1 94 Risk Analysis, Real Options, and Capital Budgeting 242
7.8 TH E PR ACTI CE O F CA P ITA L 9.1 DE C I S I ON T RE E S 242
B U DGE TIN G 196 Concept Questions 244
7.9 SU M MA RY A ND C ON CL US IO N S 1 97 9.2 S E N S I T I VI T Y AN ALYS I S,
Minicase: BC Copper Mining 205 S C E N ARI O AN ALYS I S, AN D
B RE AK-E VE N AN ALYS I S 244
CHAPTER 8 Sensitivity Analysis and Scenario Analysis 244
Break-Even Analysis 247
Net Present Value and Capital Budgeting 206
Executive Summary 206 Break-Even Analysis, Equivalent Annual
8.1 IN C R E ME N TA L CA SH F LOW S 20 6 Cost, and Capital Cost Allowance 250
Cash Flows—Not Accounting Income 206 9.3 MON T E CARLO S I MU L AT I ON 2 50
Sunk Costs 207 Step 1: Specify the Basic Model 251
Opportunity Costs 207 Step 2: Specify a Distribution for Each
Side Effects 207 Variable in the Model 251
Allocated Costs 208 Step 3: The Computer Draws One Outcome 253
Concept Questions 208 Step 4: Repeat the Procedure 253
8.2 TH E MA JE S TI C MULCH A N D Step 5: Calculate Net Present Value 254
C OM PO ST C OMPA N Y : 9.4 RE AL OP T I ON S 2 54
A N E X A MPLE 20 8 The Option to Expand 255
An Analysis of the Project 210 The Option to Abandon 256
Which Set of Books? 211 Timing Options 258
A Note on Net Working Capital 212 Real Options in the Real World 259
Interest Expense 212 Concept Questions 260
Concept Questions 213 9.5 S U MMARY AN D C ON C L U S I ON S 2 60
8.3 IN FLATIO N A N D CA PI TA L Minicase: Bunyan Lumber, LLC 265
B U DGE TIN G 21 3
Interest Rates and Inflation 213 PA RT 3
Cash Flow and Inflation 214
Discounting: Nominal or Real? 215
RISK 267
8.4 A LTE R N ATI V E DE FIN IT IO NS O F CHAPTER 10
OPE R ATIN G CA S H FLOW 21 7
Risk and Return: Lessons From Market History 267
The Bottom-Up Approach 217
The Top-Down Approach 218 Executive Summary 267
Contents ix
10.1 R E TUR N S 268 11.6 DI VE RS I FI CAT I ON : AN E X AM P L E 3 06

Dollar Earnings 268 Risk and the Sensible Investor 309
Percentage Returns or Rate of Return 269 Concept Questions 309
Concept Questions 271 11.7 RI S K-FRE E B ORROW I N G
10.2 HO LD IN G- PE R IO D R ET U R N S 27 1 AN D L E N DI N G 3 09
Concept Questions 275 The Optimal Portfolio 311
10.3 R E TUR N S TAT IS TI CS 27 5 Concept Questions 312
Concept Question 276 11.8 MARKE T E Q U I L I B RI U M 3 13
10.4 AV E R AGE S TO CK R E TU R N S Definition of the Market Equilibrium Portfolio 313
A N D R I SK-F R EE R E TU R N S 27 6 Definition of Risk When Investors Hold
Concept Questions 278 the Market Portfolio 313
10.5 R ISK STATI ST IC S 27 8 The Formula for Beta 315
Variance and Standard Deviation 279 A Test 316
Normal Distribution and Its Implications Concept Questions 316
for Standard Deviation 279 11.9 RE L AT I ON S H I P B E T W E E N
Value at Risk 280 RI S K AN D E X P E CT E D RE TURN
Further Perspective on Returns and Risk 281 ( CAP I TAL AS S E T P RI C I NG M O DEL) 3 16
Concept Questions 281 Expected Return on Market 316
Expected Return on Individual Security 317
10.6 MO RE O N AV E R AGE R E T U R N S 282
Arithmetic Versus Geometric Averages 282
Calculating Geometric Average Returns 282 11.10 S U MMARY AN D C ON C L U SI O N S 320
Arithmetic Average Return or Geometric Minicase: A Job at Deck Out My Yacht,
Average Return? 283 Part 2 327
Concept Question 284 Appendix 11A Is Beta Dead? (Available on Connect)
10.7 200 8: A Y E A R O F F IN A N C I A L
C R ISI S 284 CHAPTER 12
10.8 SUM MA RY A N D CO NC L U S I ON S 285 An Alternative View of Risk and Return:
Minicase: A Job at Deck Out My Yacht
The Arbitrage Pricing Theory 328
Corporation 287
Appendix 10A The U.S. Equity Risk Premium: Executive Summary 328
Historical and International Perspectives 12.1 FACTOR MODE L S :
(Available on Connect) AN N OU N C E ME N T S, S U RP RI SE S,
AN D E X P E CT E D RE T U RNS 328
CHAPTER 11 12.2 RI S K: SYS T E MAT I C AN D
U N SYS T E MAT I C 330
Risk and Return: The Capital Asset
Pricing Model 290
12.3 SYS T E MAT I C RI S K AN D BE TAS 331
Executive Summary 290 Concept Questions 333
11.1 IN D I V ID UA L SE CU R IT IE S 290 12.4 P ORT FOL I OS AN D FACTOR
11.2 E X PECTE D R ET UR N , VA R I A N C E , MODE L S 333
A N D C OVA R I A NC E 291 Portfolios and Diversification 335
Expected Return and Variance 291 Concept Questions 337
Covariance and Correlation 293 12.5 B E TAS AN D E X P E CT E D RE TURNS 337
Concept Questions 295 The Linear Relationship 337
11.3 THE R IS K A ND R E TU R N FOR The Market Portfolio and the Single Factor 338
PO RT FOL IO S 296 Concept Question 339
The Example of Supertech and Slowpoke 296 12.6 T H E CAP I TAL AS S E T P RIC I N G
The Expected Return on a Portfolio 296 MODE L AN D T H E ARB I T RAG E
Variance and Standard Deviation of a P RI C I N G T H E ORY 339
Portfolio 297 Differences in Pedagogy 339
Concept Questions 300 Differences in Application 339
11.4 THE EF FIC IE NT S ET F OR T WO Concept Questions 340
A SS ET S 30 0 12.7 PARAME T RI C AP P ROAC H E S TO
Application to International Diversification 303 AS S E T P RI C I N G 3 41
Concept Questions 303 Empirical Models 341
11.5 THE EF FIC IE NT S ET F OR MA N Y Style Portfolios 342
SE CU R IT IE S 30 4 Concept Questions 342
Variance and Standard Deviation in a 12.8 S U MMARY AN D C ON C L U SI O N S 3 42
Portfolio of Many Assets 305 Minicase: The Fama–French Multifactor
Concept Questions 306 Model and Mutual Fund Returns 346
x Contents
CHAPTER 13 14.1 CAN FI N AN C I N G DE C I S I ON S

C RE AT E VAL U E ? 383
Risk, Return, and Capital Budgeting 348 Concept Question 385
14.2 A DE S C RI P T I ON OF E FFI C I E N T
CAP I TAL MARKE T S 385
13.1 TH E C O ST OF E QU IT Y CA P ITA L 349 Foundations of Market Efficiency 387
13.2 E STIMATIO N OF B E TA 351 14.3 T H E DI FFE RE N T T Y P E S OF
Concept Question 353 E FFI C I E N CY 388
Beta Estimation in Practice 353 The Weak Form 388
Stability of Beta 354 The Semistrong and Strong Forms 388
Using an Industry Beta 354 Some Common Misconceptions About the
Concept Questions 355 Efficient Market Hypothesis 390
13.3 D E TE R MIN A NT S OF B E TA 356 Concept Questions 391
Cyclicality of Revenues 356 14.4 T H E E VI DE N C E 3 91
Operating Leverage 356 The Weak Form 391
Financial Leverage and Beta 358 The Semistrong Form 392
Concept Questions 359 The Strong Form 395
13.4 E XT E N SIO N S OF T HE BA SI C Concept Questions 396
M OD E L 359 14.5 T H E B E H AVI OU RAL C H AL L E N G E
The Firm Versus the Project: TO MARKE T E FFI C I E N CY 3 96
Vive la différence 359 Concept Question 397
The Cost of Debt 360 14.6 E MP I RI CAL C H AL L E N G E S TO
The Cost of Preferred Stock 360 MARKE T E FFI C I E N CY 3 97
The Weighted Average Cost of Capital 360 Concept Question 401
The Capital Structure Weights 361 14.7 RE VI E W I N G T H E DI FFE RE N C E S 402
Taxes and the Weighted Average In Their Own Words: A random talk
Cost of Capital 361 with Burton Malkiel 403
14.8 I MP L I CAT I ON S FOR C ORP ORATE
13.5 E STIMATIN G TH E CO ST O F FI N AN C E 404
CA P ITA L F O R SU NC OR EN ERGY 36 5 Accounting and Efficient Markets 404
Concept Question 367 The Timing Decision 405
13.6 F LOTATIO N CO ST S A ND T HE Speculation and Efficient Markets 407
W E IGHTE D AV E R AGE C OS T Information in Market Prices 407
OF CA PITA L 367
The Basic Approach 367
14.9 S U MMARY AN D C ON C L U S I ON S 409
Flotation Costs and Net Present Value 368
Minicase: Your Retirement Plan at Deck
Internal Equity and Flotation Costs 369
Out My Yacht 412
13.7 R E D UC IN G TH E CO ST O F
CA P ITA L 36 9 CHAPTER 15
What Is Liquidity? 370
Liquidity, Expected Returns, and the Long-Term Financing: An Introduction 414
Cost of Capital 370
Liquidity and Adverse Selection 371 Executive Summary 414
What the Corporation Can Do 371 15.1 C OMMON S TOC K 41 4
Concept Questions 371 Authorized Versus Issued Common Stock 415
13.8 SU M MA RY A ND C ON CL US IO N S 372 Retained Earnings 415
Minicase: The Cost of Capital for Goff Market Value, Book Value, and
Communications Inc. 378 Replacement Value 416
Shareholders’ Rights 416
Appendix 13A Economic Value Added and the
Measurement of Financial Performance 379 Dividends 417
Classes of Shares 418
In Their Own Words: Shares climb as
PA RT 4 Stronach to give up voting control 419
Capital Structure and Dividend Policy 383 Concept Questions 420
15.2 C ORP ORAT E LON G -T E RM DE BT :
CHAPTER 14 T H E BAS I C S 42 0
Interest Versus Dividends 420
Corporate Financing Decisions and Efficient Is It Debt or Equity? 420
Capital Markets 383 Basic Features of Long-Term Debt 420
Different Types of Debt 421
Executive Summary 383 Repayment 421
Contents xi
Seniority 422 CHAPTER 17

Security 422
Indenture 422 Capital Structure: Limits to the Use of Debt 459
15.3 PR E F ER R E D SH A R ES 423
17.1 C OS T S OF FI N AN C I AL DI STRE SS 459
Stated Value 423
Bankruptcy Risk or Bankruptcy Cost? 459
Cumulative and Non-Cumulative Dividends 423
Are Preferred Shares Really Debt? 423
Preferred Shares and Taxes 424 17.2 DE S C RI P T I ON OF C OS T S 461
Beyond Taxes 425 Direct Costs of Financial Distress:
Legal and Administrative Costs of
Liquidation or Reorganization 462
15.4 IN C O ME TRUS TS 425 Indirect Costs of Financial Distress 462
Income Trust Income and Taxation 425 Agency Costs 463
15.5 PAT T ER N S OF LON G-T E R M Concept Questions 465
FIN A NC IN G 426
17.3 CAN DE BT C OS T S B E REDUC E D? 465
Protective Covenants 465
15.6 SUM MA RY A N D CO NC L U S I ON S 427 Consolidation of Debt 467
CHAPTER 16 17.4 I N T E G RAT I ON OF TAX
Capital Structure: Basic Concepts 430 E FFE CT S AN D FI N AN C I AL
DI S T RE S S C OS T S 467
Executive Summary 430 Pie Again 468
16.1 THE CA PI TA L ST RU CT U R E Concept Questions 470
QUES TI ON A N D TH E PI E MODE L 430 17.5 S I G N AL L I N G 470
Concept Question 431 Concept Questions 471
16.2 MA X IMI Z IN G FIR M VA L U E 17.6 SHIRKING, PERQUISITES, AND
V E RS US MA X I MIZ I NG BAD INVESTMENTS: A N OT E
SHA R EH OL DE R I NT ER E S T S 431 ON AG E N CY C OS T OF E QUI TY 472
Concept Question 432 Effect of Agency Costs of Equity on
16.3 FIN A NC IA L L EV E R AGE A N D Debt-to-Equity Financing 473
FIR M VA L UE : A N EX A M P L E 433 Free Cash Flow 473
Leverage and Returns to Shareholders 433 Concept Questions 474
The Choice Between Debt and Equity 434 17.7 T H E P E C KI N G -ORDE R T HE O RY 474
A Key Assumption 437 Rules of the Pecking Order 475
Concept Questions 437 Implications 476
16.4 MO D IG LI A NI A N D MIL L E R : Concept Questions 477
PRO P OS IT IO N II ( NO TA X E S ) 437 17.8 G ROW T H AN D T H E DE BT-TO -
Risk to Equityholders Rises With Leverage 437 E Q U I T Y RAT I O 477
Proposition II: Required Return to No Growth 477
Equityholders Rises With Leverage 438 Growth 478
Modigliani and Miller: An Interpretation 443 Concept Question 479
In Their Own Words: Merton Miller on 17.9 P E RS ON AL TAX E S 479
the MM results 444
The Miller Model 480
16.5 TA X ES 445
17.10 H OW FI RMS E S TAB L I S H CAP I TAL
The Basic Insight 445 S T RU CT U RE 48 3
Taxation of Corporate Income 445 Concept Questions 487
Present Value of the Tax Shield 446
17.11 S U MMARY AN D C ON C L U SI O N S 48 7
Value of the Levered Firm 447
Minicase: McKenzie Restaurants
Expected Return and Leverage Under Capital Budgeting 491
Corporate Taxes 449
The Weighted Average Cost of Capital Appendix 17A Some Useful Formulas of
and Corporate Taxes 450 Financial Structure (Available on Connect)
Stock Price and Leverage Under Appendix 17B The Miller Model and the
Corporate Taxes 450 Graduated Income Tax (Available on Connect)
16.6 SUM MA RY A N D CO NC L U S I ON S 452 CHAPTER 18
Minicase: Stephenson Real Estate
Valuation and Capital Budgeting
Recapitalization 458
for the Levered Firm 493
xii Contents
Executive Summary 493 19.4 RE P U RC H AS E OF S TOC K 52 0

18.1 A D JUSTE D PR E SE NT VA LU E Dividend Versus Repurchase:
A PPROAC H 49 3 Conceptual Example 521
Concept Questions 495 Dividends Versus Repurchases:
18.2 F LOW TO EQ UI TY A PP ROACH 49 5 Real-World Considerations 522
Step 1: Calculating Levered Cash Flow 495
Step 2: Calculating rS 496 19.5 P E RS ON AL TAX E S, I S S UAN C E
C OS T S, AN D DI VI DE N DS 52 3
Step 3: Valuation 496
Firms Without Sufficient Cash to
Pay a Dividend 523
18.3 W E IGHTE D AV E R AGE C OS T OF Firms With Sufficient Cash to Pay a Dividend 524
CA P ITA L ME TH OD 49 6
Summary of Personal Taxes 525
18.4 A C O MPA RI SO N OF T HE A D JU S T E D
19.6 RE AL-WORL D FACTORS FAVOU RI N G
PR E SE N T VA LU E, FLOW TO EQ U I T Y,
A H I G H -DI VI DE N D P OL I CY 52 6
A N D WE IGH TE D AV E R AGE C OS T
OF CA PITA L A PP ROACH ES 497 Desire for Current Income 526
Caveat: Adjusted Present Value, Flow to Behavioural Finance 526
Equity, and Weighted Average Cost of Capital Agency Costs 527
Do Not Always Yield the Same Results 498 Information Content of Dividends and
A Guideline 498 Dividend Signalling 528
Concept Questions 500 Concept Question 530
18.5 A D JUSTE D PR E SE NT VA LU E 19.7 T H E C L I E N T E L E E FFE CT :
E XAMPLE 50 0 A RE S OL U T I ON OF RE AL-WORLD
Concept Question 502 FACTORS ? 53 0
18.6 CA P ITA L B U DG ET IN G WH EN
TH E D ISC O UN T R AT E MUS T In Their Own Words: Why Amazon.com
B E E STIMAT ED 50 2 Inc. pays no dividend 532
Concept Question 504 Why Rogers Communications pays
dividends 532
18.7 B E TA A N D L EV E R AGE 50 4
19.8 W H AT W E KN OW AN D DO N OT
The Project Is Not Scale Enhancing 505
KN OW AB OU T DI VI DE N D P OL I CY 53 2
Corporate Dividends Are Substantial 532
18.8 SU M MA RY A ND C ON CL US IO N S 50 6 Fewer Companies Pay Dividends 533
Minicase: The Leveraged Buyout of Corporations Smooth Dividends 533
Cheek Products Ltd. 510
Some Survey Evidence on Dividends 534
Appendix 18A The Adjusted Present Value 19.9 P U T T I N G I T AL L TOG E T H E R 53 5
Approach to Valuing Leveraged Buyouts
19.10 S TOC K DI VI DE N DS AN D
S TOC K S P L I T S 53 6
Some Details on Stock Splits and
CHAPTER 19 Stock Dividends 536
Value of Stock Splits and Stock Dividends 537
Dividends and Other Payouts 512 Reverse Splits 538
19.11 S U MMARY AN D C ON C L U S I ON S 53 8
19.1 D IFFE R E N T T Y PE S OF
D IV ID E N D S 51 2 Minicase: Electronic Timing Ltd. 544
19.2 STA N DA R D MET HO D OF CA S H
D IV ID E N D PAY ME NT 51 3 PA RT 5
Concept Questions 515 Long-Term Financing 545
19.3 TH E B E N C HMA R K CA S E:
A N ILLUSTR AT IO N OF T HE
IR R E LE VA N CE O F D IV I DE ND CHAPTER 20
POL ICY 51 5
Current Policy: Dividends Set Equal to Issuing Equity Securities to the Public 545
Cash Flow 515
Alternative Policy: Initial Dividend
Is Greater Than Cash Flow 516 20.1 T H E P U B L I C I S S U E 545
The Indifference Proposition 516 20.2 T H E BAS I C P ROC E DU RE FOR
Homemade Dividends 516 A NEW ISSUE 546
A Test 519 The Prompt Offering Prospectus System 547
Dividends and Investment Policy 519 Alternative Issue Methods 548
Contents xiii
20.3 THE CA SH O FFER 548 21.5 S OME DI FFE RE N T T Y P E S

Types of Underwriting 548 OF B ON DS 58 3
The Selling Period 549 Zero-Coupon Bonds 583
The Overallotment Option 549 Floating-Rate Bonds 584
Investment Banks 549 Financial Engineering and Bonds 585
The Offering Price and Underpricing 550 Concept Questions 586
The Decision to Go Public 550 21.6 DI RE CT P L AC E ME N T C OM PARE D
Pricing Initial Public Offerings 550 TO P U B L I C I S S U E S 58 6
Underpricing: A Possible Explanation 551 Concept Questions 586
In Their Own Words: Jay Ritter on 21.7 LON G -T E RM SY N DI CAT E D
IPO underpricing around the world 552 BAN K LOAN S 58 6
20.4 THE A NN OU NC EME NT O F N E W 21.8 S U MMARY AN D C ON C L U SI O N S 58 7
E QUI TY A ND T HE VA LU E OF Minicase: Financing the Expansion of
THE FIR M 553 East Coast Yachts With a Bond Issue 590
20.5 THE CO ST O F I SS UI NG
SE CU R IT IE S 554
The Costs of Going Public: A Case Study 556
CHAPTER 22
Concept Questions 556 Leasing 592
20.6 R IGHT S 556
The Mechanics of a Rights Offering 556 Executive Summary 592
Subscription Price 557 22.1 T Y P E S OF L E AS E S 592
Number of Rights Needed to Purchase a Share 557 The Basics 592
The Value of a Right 558 Operating Leases 593
Ex-Rights 560 Financial Leases 594
Value of Rights After Ex-Rights Date 560 Concept Questions 594
The Underwriting Arrangements 561 22.2 AC C OU N T I N G AN D L E ASI N G 595
Effects on Shareholders 561 Concept Questions 596
Cost of Rights Offerings 561 22.3 TAX E S AN D L E AS E S 597
20.7 THE PR I VATE E QU IT Y M A R KE T 562 22.4 T H E CAS H FLOW S OF FI N AN C I AL
Private Placement 562 L E AS I N G 597
The Private Equity Firm 562 The Incremental Cash Flows 597
Venture Capital 563 Concept Questions 599
Suppliers of Venture Capital 563 22.5 A DE TOU R ON DI S C OU N TI N G
Stages of Financing 564 AN D DE BT CAPAC I T Y W I TH
Some Venture Capital Realities 564 C ORP ORAT E TAX E S 599
Concept Questions 564 Present Value of Risk-Free Cash Flows 599
20.8 SUM MA RY A N D CO NC L U S I ON S 565 Optimal Debt Level and Risk-Free Cash
Minicase: East Coast Yachts Goes Public 567 Flows (Advanced) 600
CHAPTER 21 22.6 N E T P RE S E N T VAL U E AN ALYSI S
OF T H E L E AS E -VE RS U S -B UY
Long-Term Debt 569 DE C I S I ON 601
The Discount Rate 601
Asset Pool and Salvage Value 602
21.1 LO NG -TE R M D EBT: A R E V I E W 569
22.7 DE BT DI S P L AC E ME N T AN D
21.2 THE PU B LI C IS SU E OF B ON DS 57 0 L E AS E VAL UAT I ON 602
The Basic Terms 570 The Basic Concept of Debt Displacement
Security 572 (Advanced) 602
Seniority 573 Optimal Debt Level in the TransCanada
Protective Covenants 573 Taxis Example (Advanced) 603
The Sinking Fund 573 22.8 DOE S L E AS I N G E VE R PAY?
The Call Provision 574 T H E BAS E CAS E 606
Concept Questions 574 22.9 RE AS ON S FOR L E AS I N G 607
21.3 B O N D R EF UN DI NG 574 Good Reasons for Leasing 607
Should Firms Issue Callable Bonds? 575 Bad Reasons for Leasing 610
Calling Bonds: When Does It Make Sense? 577 Leasing Decisions in Practice 610
21.4 B O N D R AT IN GS 580 22.10 S OME U N AN S W E RE D Q U E STI O NS 611
Junk Bonds 581 Are the Uses of Leases and of
Concept Questions 583 Debt Complementary? 611
xiv Contents
Why Are Leases Offered by Both Executive Summary 655

Manufacturers and Third-Party Lessors? 611 24.1 E X E C U T I VE S TOC K OP T I ON S 655
Why Are Some Assets Leased More Why Options? 655
Commonly Than Others? 611 Executive Compensation: Where Are
22.11 SU M MA RY A ND C ON CL US IO N S 612 We Now? 656
Minicase: The Decision to Lease or In Their Own Words: Jim Middlemiss on
Buy at Warf Computers Ltd. 615 options backdating 657
Appendix 22A Adjusted Present Value Approach Valuing Executive Compensation 658
to Leasing (Available on Connect) Concept Question 660
24.2 VAL U I N G A S TART-U P 660
PA RT 6 Concept Questions 663
Options, Futures, and Corporate Finance 617 24.3 MORE AB OU T T H E B I N OMI AL
MODE L 663
Heating Oil 663
CHAPTER 23
24.4 S H U T DOW N AN D RE OP E N I N G
Options and Corporate Finance: Basic Concepts 617 DE C I S I ON S 668
Valuing a Gold Mine 668
Executive Summary 617 The Abandonment and Opening Decisions 669
23.1 OPT IO N S 617 Valuing the Simple Gold Mine 669
23.2 CA L L O PTIO N S 618 24.5 S U MMARY AN D C ON C L U S I ON S 673
The Value of a Call Option at Expiration 618 Minicase: Exotic Cuisines Employee
Concept Questions 619 Stock Options 675
23.3 PU T O PTIO NS 6 20
The Value of a Put Option at Expiration 620 CHAPTER 25
Warrants and Convertibles 676
23.4 SE LLIN G OP TI ON S 6 21
23.5 STOC K O PT IO N QU OTATI ON S 6 22 Executive Summary 676
Long-Term Equity Anticipation Securities 622 25.1 WARRAN T S 676
23.6 C OM B IN AT IO NS O F O PT IO NS 6 24 Concept Question 678
Concept Questions 627 25.2 T H E DI FFE RE N C E B E T W E E N
23.7 VA LUIN G O PT IO NS 6 27 WARRAN T S AN D CAL L
OP T I ON S 678
Bounding the Value of an American Call 627
How the Firm Can Hurt Warrant Holders 680
The Factors Determining Call Option Values 627
A Quick Discussion of Factors Determining
Put Option Values 630 25.3 WARRAN T P RI C I N G AN D T H E
Concept Questions 631 B L AC K–S C H OL E S MODE L
( ADVAN C E D) 68 0
23.8 A N O PTIO N P R IC IN G FOR MU L A 6 31
A Two-State Option Model 632
25.4 C ON VE RT I B L E B ON DS 68 1
The Black–Scholes Model 634
25.5 T H E VAL U E OF C ON VE RT I B L E
23.9 STOC KS A ND B O ND S
B ON DS 68 2
A S O PTIO N S 6 38
Straight Bond Value 683
The Firm Expressed in Terms of Call Options 639
Conversion Value 683
The Firm Expressed in Terms of Put Options 640
Option Value 684
A Resolution of the Two Views 641
A Note on Loan Guarantees 642
Concept Questions 643 25.6 RE AS ON S FOR I S S U I N G
WARRAN T S AN D
23.10 IN V E STME NT I N R EA L P RO JE CT S C ON VE RT I B L E S 68 5
A N D O PTIO NS 6 43
Convertible Debt Versus Straight Debt 685
Convertible Debt Versus Common Stock 686
23.11 C ON TIN GE NT VA LU E R IG HT S, The “Free Lunch” Story 686
M E RGE R S, A N D CO R PO R AT E
The “Expensive Lunch” Story 687
D E C ISIO N S 6 45
A Reconciliation 687
23.12 SU M MA RY A ND C ON CL US IO N S 6 46
25.7 W H Y ARE WARRAN T S AN D
Minicase: Clissold Industries Options 653
C ON VE RT I B L E S I S S U E D? 68 8
Matching Cash Flows 688
C H A P T E R 24 Risk Synergy 688
Options and Corporate Finance: Agency Costs 689
Backdoor Equity 689
Extensions and Applications 655
Contents xv
25.8 C O NV E R SI ON P OL ICY 689 Concept Questions 728

Concept Questions 690 27.3 T H E OP E RAT I N G CYC L E AN D
25.9 SUM MA RY A N D CO NC L U S I ON S 690 T H E CAS H CYC L E 72 8
Minicase: S&S Air’s Convertible Bond 694 Interpreting the Cash Cycle 730
CHAPTER 26 27.4 S OME AS P E CT S OF S H O RT-TE RM
FI N AN C I AL P OL I CY 73 0
Derivatives and Hedging Risk 695 The Size of the Firm’s Investment in Current
Assets 731
Alternative Financing Policies for Current
26.1 D E R IVAT IV E S, H ED GI NG , Assets 733
A N D R I SK 695
Current Assets and Liabilities in Practice 735
The Impact of Financial Risk:
The Credit Crisis of 2007–09 696
27.5 CAS H B U DG E T I N G 73 6
26.2 FO RWA R D CO NT R ACTS 696
Cash Outflow 737
The Cash Balance 738
26.3 FUTUR E S CO NT R ACTS 697
27.6 T H E S H ORT-T E RM FI N ANC I AL
26.4 HE DG IN G 701 P L AN 73 8
Hedging With Futures Versus Hedging Short-Term Planning and Risk 738
With Options 703
Short-Term Borrowing 739
In the Absence of Short-Term Borrowing 741
26.5 IN TE R ES T R AT E FUT UR E S Concept Questions 741
C O NT R ACTS 703
27.7 S U MMARY AN D C ON C L U SI O N S 742
Pricing of Government of Canada Bonds 703
Minicase: Keafer Manufacturing Working
Pricing of Forward Contracts 703
Capital Management 750
Futures Contracts 705
Hedging in Interest Rate Futures 705 CHAPTER 28
26.6 D UR AT IO N HE DG IN G 709 Cash Management 751
The Case of Zero-Coupon Bonds 709
The Case of Two Bonds With the Same
Maturity but With Different Coupons 710 28.1 RE AS ON S FOR H OL DI N G CASH 751
Duration 711 The Speculative and Precautionary Motives 751
Matching Liabilities With Assets 712 The Transaction Motive 752
Duration in Practice 714 Costs of Holding Cash 752
Concept Questions 715 Cash Management Versus Liquidity
Management 752
26.7 SWAP C ON TR ACT S 715
Interest Rate Swaps 715
Currency Swaps 716 28.2 MAN AG I N G T H E C OL L E CTI O N
AN D DI S B U RS E ME N T OF CASH 753
Electronic Data Interchange:
Credit Default Swaps 717
The End of Float? 755
Exotics 718
Accelerating Collections 756
Movement Toward Exchange Trading
Controlling Disbursements 759
for Swaps 718
Ethical and Legal Questions 759
26.8 ACTUA L U SE O F D ER I VAT I V E S 719
26.9 SUM MA RY A N D CO NC L U S I ON S 720
28.3 I N VE S T I N G I DL E CAS H 760
Minicase: Williamson Mortgage Inc. 723
Seasonal or Cyclical Activities 761
Planned Expenditures 761
PA RT 7 Characteristics of Short-Term Securities 761
Financial Planning and Short-Term Finance 724 Some Different Types of Money
Market Securities 763
CHAPTER 27 In Their Own Words: Credit crisis made
in Canada 764
Short-Term Finance and Planning 724 Concept Questions 765
28.4 S U MMARY AN D C ON C L U SI O N S 765
Executive Summary 724 Minicase: Cash Management at
27.1 TR ACI NG CA S H A ND N E T Richmond Ltd. 767
WO RK IN G CA PI TA L 725
27.2 D E FIN IN G CA SH I N TE R MS OF CHAPTER 29
OTHE R E LE MEN TS 725
The Sources and Uses of Cash Statement 727 Credit Management 768
xvi Contents
Executive Summary 768 30.4 DE T E RMI N I N G T H E SY N E RGY

29.1 TE R MS O F T HE S A LE 769 FROM AN AC Q U I S I T I ON 792
Why Trade Credit Exists 769 30.5 S OU RC E S OF SY N E RGY FROM
The Basic Form 770 AC Q U I S I T I ON S 792
Credit Period 770 Revenue Enhancement 792
Cash Discounts 771 Cost Reduction 793
Credit Instruments 773 Tax Gains 795
Concept Questions 773 Lower Cost of Capital 796
29.2 TH E D E C IS IO N TO G R A NT C R E DI T : Concept Question 796
R ISK A N D I NF OR MATI ON 773 30.6 CALC U L AT I N G T H E VAL U E OF TH E
The Value of New Information About FI RM AFT E R AN AC Q U I S I T I ON 796
Credit Risk 774 Avoiding Mistakes 797
Future Sales 775 30.7 A C OS T TO S H ARE H OL DE RS
Concept Question 776 FROM RE DU CT I ON I N RI S K 797
29.3 OPT IMA L CR E DI T PO LI CY 776 The Base Case 798
Credit Insurance 777 The Case Where One Firm Has Debt 799
Concept Question 778 How Can Shareholders Reduce Their Losses
From the Coinsurance Effect? 799
29.4 C R E D IT A NA LYS IS 778
Credit Information 778
Credit Evaluation and Scoring 778 30.8 T WO “ BAD” RE AS ON S FOR
ME RG E RS 8 00
Earnings Growth 800
29.5 C OL LE CTIO N P OL ICY 779
Diversification 800
Average Collection Period 779
Aging Schedule 780
30.9 T H E N E T P RE S E N T VAL U E OF
Collection Effort 780
A ME RG E R 8 01
Cash 801
29.6 OTHE R A SP ECTS O F C R ED IT Common Stock 802
POL ICY 7 81
Cash Versus Common Stock 803
Factoring 781
How to Finance Trade Credit 781
Defensive Tactics 804
Divestitures 804
29.7 SU M MA RY A ND C ON CL US IO N S 7 82 The Control Block and the Corporate Charter 806
Minicase: Credit Policy at Braam Industries 784 Standstill Agreements 807
Appendix 29A Inventory Management Exclusionary Offers and Non-Voting Stock 807
(Available on Connect) Going Private and Leveraged Buyouts 807
Other Defensive Devices 808
PA RT 8 Concept Question 809
SPECIAL TOPICS 786 30.10 S OME E VI DE N C E ON
AC Q U I S I T I ON S 8 09
CHAPTER 30 Do Acquisitions Benefit Shareholders? 809
The Managers Versus the Shareholders 811
Mergers and Acquisitions 786 Real Productivity 813
30.11 S U MMARY AN D C ON C L U S I ON S 813
30.1 TH E BA SIC FOR MS O F
Minicase: The Birdie Golf–Hybrid
AC Q UISITIO N S 7 86
Golf Merger 819
Merger or Consolidation 786
Acquisition of Stock 787
CHAPTER 31
Acquisition of Assets 788
A Classification Scheme 788 Financial Distress 821
A Note on Takeovers 788
30.2 TH E TA X FO R MS O F 31.1 W H AT I S FI N AN C I AL DI S T RE S S ? 821
AC Q UISITIO N S 790 Concept Questions 824
Determinants of Tax Status 790 31.2 W H AT H AP P E N S I N FI N AN C I AL
Taxable Versus Tax-Free Acquisitions 790 DI S T RE S S ? 8 24
30.3 AC C O UN TIN G FOR 31.3 BANKRUPTCY LIQUIDATION AND
AC Q UISITIO N S 790 REORGANIZATION 826
The Acquisition Method 790 Bankruptcy Liquidation 826
Concept Questions 791 Bankruptcy Reorganization 828
Contents xvii
Agreements to Avoid Bankruptcy 830 32.4 I N T E RE S T RAT E S AN D

Concept Questions 830 E XC H AN G E RAT E S 8 42
31.4 C UR R EN T IS SU ES I N FI N A N C I AL The Dollar Investment 843
D IST R ES S 830 The Euro Investment 843
Private Workout or Bankruptcy: The Forward Discount and Expected
Which Is Better? 830 Spot Rates 844
Holdouts 830 Exchange Rate Risk 844
Complexity 831 More Advanced Short-Term Hedges 845
Lack of Information 831 The Hedging Decision in Practice 846
Prepackaged Bankruptcy 831 Concept Questions 846
Concept Questions 831 32.5 I N T E RN AT I ON AL CAP I TAL
31.5 THE DE CI SI ON TO SE EK C OU RT B U DG E T I N G 8 46
PROT ECTI ON : TH E CA S E OF Foreign Exchange Conversion 847
CA NW ES T GLOBA L Unremitted Cash Flows 847
C O M MUN ICATI ON S The Cost of Capital for International Firms 848
C O R PO R AT IO N 832 Concept Questions 850
Concept Questions 832 32.6 I N T E RN AT I ON AL FI N AN C I N G
31.6 SUM MA RY A N D CO NC L U S I ON S 833 DE C I S I ON S 8 50
Appendix 31A Predicting Corporate Bankruptcy: Short-Term and Medium-Term Financing 851
The Z-Score Model (Available on Connect) International Bond Markets 851
In Their Own Words: Merkel:
Europe faces historic test in euro crisis 853
CHAPTER 32 Concept Questions 854
International Corporate Finance 835 32.7 RE P ORT I N G FORE I G N
OP E RAT I ON S 8 54
Executive Summary 835 Concept Question 855
32.1 TE R M IN OLOGY 835 32.8 P OL I T I CAL RI S K 8 55
Concept Question 836 32.9 S U MMARY AN D C ON C L U SI O N S 8 55
32.2 FO RE IG N EXC HA N GE M A R KE T S Minicase: East Coast Yachts Goes
A N D E XCH A NG E R AT ES 837 International 859
Exchange Rates 837 Appendix A Mathematical Tables
Types of Transactions 840 (Available on Connect)
Concept Questions 840 Appendix B Answers to Selected
32.3 THE LAW OF O NE P R IC E A N D End-of-Chapter Problems (Available on Connect)
PURC HA S IN G POW ER PA R I T Y 840
Concept Questions 842 Glossary GL- 1
Index IN- 1
P R E FAC E
The teaching and practice of corporate finance in Canada are more challenging and exciting
than ever before. The last decade alone has seen fundamental changes in financial markets and
financial instruments. In the early years of the twenty-first century, announcements in the finan-
cial press about takeovers, junk bonds, financial restructuring, initial public offerings, bank-
ruptcy, and derivatives are still commonplace. In addition, there is the new recognition of “real”
options (Chapter 9), private equity and venture capital (Chapter 20), and the reappearing divi-
dend (Chapter 19). The world’s financial markets are more integrated than ever before. Both the
theory and practice of corporate finance have been moving ahead with uncommon speed, and our
teaching, as always, must keep pace.
These developments place new burdens on the teaching of corporate finance. On the one hand,
the changing world of finance makes it more difficult to keep materials up to date. On the other
hand, the teacher must distinguish the permanent from the temporary and avoid the temptation to
follow fads. Our solution to this problem is to emphasize the modern fundamentals of the theory
of finance and make the theory come to life with contemporary examples. All too often, the novice
student views corporate finance as a collection of unrelated topics that are unified largely because
they are bound together between the covers of one book. As in the previous editions, our aim is
to present corporate finance as the collaboration of a small number of integrated and powerful
institutions.
This book has been written for the introductory courses in corporate finance at the MBA level
and for the intermediate courses in many undergraduate programs. Some instructors will find this
text appropriate for the introductory course at the undergraduate level as well.
It is assumed that most students either will take, or will be concurrently enrolled in, courses in
accounting, statistics, and economics. This exposure will help students understand some of the more
difficult material. However, the book is self-contained, and prior knowledge of these areas is not
essential. The only mathematics prerequisite is basic algebra.
NEW TO THE EIGHTH CANADIAN EDITION

• Executive summaries have been updated.
• Minicases have been reviewed and replaced where necessary to ensure that each is related to the
material covered in the corresponding chapter.
• Practice problems have been updated and new ones have been added.
• Tables, figures, and examples have been updated throughout the text.
• New and recent Canadian examples have been added.
• Concept questions have been updated and new ones have been added.
• End-of-chapter material has been substantially updated and refreshed.
• New highlighted concepts have been added.
• The discussion on taxes in Chapter 1 has been updated.
• The discussion on capital cost allowance in Chapter 8 has been streamlined and special cases have
been introduced.
• New examples on real options have been added in Chapter 9.
• Capital market data have been updated through 2016 in Chapter 10.
PEDAGOGY
Keeping the theory and concepts current is only one phase of developing our corporate finance text.
To be an effective teaching tool, the text must present the theory and concepts in a coherent way that
can be easily learned. With this in mind, we have included the following study features.
Executive Summary
Each chapter begins with a road map that describes the objectives of the chapter and how it connects
with concepts already learned in previous chapters. Real company examples that will be discussed
are highlighted in this section.
Ch a p t er 1
Introduction to Corporate Finance Preface xix
E XE CUTIV E S UMMA RY
Barrick Gold Corporation has long been known as the largest gold mining company in the world. With the recent recession,
gold prices and Barrick’s share price increased as investors sought a safe investment. However, in 2013 Barrick’s shares
plunged in value by 54 percent to a 20-year low. While the accompanying fall in the value of gold was beyond the compa-
ny’s control, the poor performance was attributed primarily to the failure of key projects, misallocation of capital resources,
and the legal mess associated with the Pascua-Lama mine in Chile. Accompanying this poor performance, the company’s
proxy circular revealed that six executives were to be compensated for a combined $47.4 million and board chair Peter
Munk was to receive $4.3 million. In addition, the company awarded a US$11.9 million signing bonus to John Thornton for
joining the company as co-chair.1 Consequently, several major shareholders of Barrick Gold Corporation invoked a “say
on pay” vote, which rejected the pay packages and led to the appointment of new independent directors and to Munk
stepping down as board chair. Recent events at Barrick Gold Corporation illustrate both the importance of governance
issues and the need for management to make key corporate finance decisions relating to the following questions:
1. What long-term investment strategy should a company take on?
2. How can cash be raised?
In Their Own Words Boxes

3. How much short-term cash flow does a company need to pay its bills?
These are not the only questions of corporate finance. For example, another important question covered in this
Located
14 threethroughout
text is: How should a
Part 1 on the chapters,
company
Overview this unique
divide earnings between series
payoutsconsists of articles
to shareholders written
(dividends) by distinguished
and reinvestment? The
questions our list are among the most important, however, and, taken in order, they provide a rough outline
scholars or book.
of our practitioners onwekey
In Section 1.1 topics.
introduce the basic ideas of corporate finance.
One way that companies raise cash to finance their investment activities is by selling or issuing securities. The
securities, sometimes called financial instruments or claims, may be roughly classified as equity or debt, loosely called
IN THEIR OWN WORDS
stocks or bonds. The difference between equity and debt is a basic distinction in the modern theory of finance. All
securities of a firm are claims that depend on or are contingent on the value of the firm.2 In Section 1.2 we show how
B. ESPEN ECKBO on corporate governance
debt and equity securities depend on the firm’s value, and we describe them as different contingent claims.
In Section 1.3 we discuss different organizational forms and the pros and cons of the decision to become a corporation.
The In Section growth
substantial 1.4 we take a close
in equity indexlook at the over
investing goalstheof the corporation
easily swamps and discuss returns.
investment why maximizing shareholder
As a result, they no
wealth is likely
past twenty yearstohasbelowered
its primary goal.
average Throughout
shareholder the rest
incen- of the
longer book,
show up we assume
to annual that theand
meetings firm’s performance
either vote with
depends
tives to on the value
monitor it creates for of
the management its individual
shareholders. Shareholders
portfolio are made
management or better
simplyoff when the value
throw proxyofform
theirinshares
the
is increasedThe
companies. by the firm’sshareholder
resulting decisions. absenteeism effec- wastebasket. The resulting combination of voluntary
tivelyA transfers
company raises cashcontrol
corporate by issuing securities
rights in the financial
to increasingly markets. In
shareholder Section 1.5 we
absenteeism anddescribe
strong some of theinsid-
corporate basic
features
powerful of the financial
corporate markets.
executives and Roughly speaking,
other insiders. there ers
Today, are creates
two types of financial
a problem thatmarkets:
lies at money markets
the heart and
of many
capital markets.
an important counterweight to this massive shift in the bal- of today’s governance controversies. An important his-
anceSection
of power 1.6between
covers trends in financial
the firm’s owners andmarkets and management,
managers and the
is torical lesson last the
is that section of this shareholder
absentee chapter (Section
system1.7)
outlines
a small settheofrest of the
active book. who occasionally decide to can breed arrogance on the part of corporate insid-
investors
bear the cost of challenging incumbent management teams. ers. A vigorous Chaptercorporate
1 Introduction
governance to Corporate
system isFinance
thus 7
In countries with highly developed financial systems, required to prevent shareholder rights being expropri-
much of the governance 1 debate focuses on this shift in ated by insiders.
the balance of power between Risk of Cash Flows
Theresa Tedesco, “Barrick Gold could have avoided say-on-pay public backlash,” Financial Post, April 23, 2013. http://business
shareholders, boards, and A major task of the board is to hire and fire top manag-
.financialpost.com/news/fp-street/barrick-gold-executive-compensation-wednesday
top executives in widely Theheld
2 public
firm
We tend to use companies.
mustthe words firm,The
consider risk.
company, anders
bal- The andinterchangeably.
amount
business to and
set their
timing compensation.
of cash
However, Therefore,
there isflows notcorporate
are between
a difference usually
these andknown with
ance is affected by four major factors,
certainty.
a corporation. Wewhich
Most tend
investors
discuss tohave
differin
this difference insiders
anSection 1.3. come
aversion with an inherent conflict of interest when
to risk.
greatly across countries: (1) The cost of taking legal action they sit on boards. Nevertheless, corporate insiders sit
and the strength of law enforcement. (2) The efficiency of on boards in major developed countries. In the United
the director election process EXandAMPL 1.3
the costE of challeng- States, until twenty years ago, it was even common for the
ing and replacing directors. (3) The cost of shareholder chief executive officer (CEO) to occupy the post of board
activism and of transacting in the market for corporate chair. Several companies have since voluntarily replaced
The Midland
control. (4) The political strength
ros70114_ch01_001-029.indd 1 Company
of employee is considering
unions. thisexpanding
practice operations overseas.role
with a split-chair It is(using
evaluating Europe and
a combination Japan
12/3/18 5:45 as
PM
possible
Early in a firm’s lifecycle, when sites.
shareEurope
ownershipis considered
is of toCEO
be relatively
chair and safe, whereas
a “lead” Japan or
director) is seen as very risky.
a complete In both cases
separa-
highly concentrated, this balance of power
the company would is close
hardly tion of the
an operations
down roles
after oneofyear.
CEO and chair.
issue. However, as the company Aftergrows
doing aand prospers,
complete In Europe,
financial analysis, the tradition
Midland has come hasup been
withnot thetofollowing
place thecashCEOflows of the
and founders diversify their initial investment by bring- in the chair, in some countries by statute. However, while
alternative plans for expansion under three scenarios: pessimistic, realistic, and optimistic.
ing in new and smaller owners, the balance starts to non-executive members make up a clear majority of direc-
change. Corporate insiders, who themselves have much tors in the United States, there is a tradition in Europe for
of their human capital invested in the firm, increasingly placing a greater portion of employees on boards, which
Pessimistic Realistic Optimistic
view shareholders as a remote constituency and even as also raises conflict of interest issues.
irrelevant for the company on a daily basis.Europe By choosing $75,000
The typical defence of$100,000
having insiders on $125,000
boards is one
to diversify, shareholders for their part agree Japan to play a of efficiency: 0 the board requires
150,000CEO and200,000 other manage-
diminished role in the company’s affairs. ment input to make proper decisions. What this defence
For shareholders who diversify their investment leaves unanswered, however, is why the CEO needs a
across a broad portfolio of Ifcompanies,we ignore the thepessimistic vote onperhaps
cost of scenario, the boardJapan(letisalone the chair)
the better in order
alternative. to supply
When we take the pes-
actively monitoring the performance
simistic scenario of into account, thethe
management board
choice with his Japan
is unclear. or herappears
information.
to be riskier, but it may also offer a
Concept Questions
higher expected level of cash flow. What is risk and how can it be defined? We must try to answer this
important question. Corporate finance cannot avoid coping with risky alternatives, and much of our book
Included after each major issection
closely devoted toindeveloping
a chapter,
held corporations. Concept
methods
However, Questions
for evaluating
shareholders risky
have point
control to
opportunities.
several essential
devices material
(some more effectiveand
allow students to test their recalltoand
than others) bondcomprehension before moving
management to the self-interest forward.
of shareholders:
CONCEPT • What are three basic questions of corporate finance?

QUESTIONS 1. Shareholders determine the membership of the board of directors by voting. Thus, share-
• Describe capital structure.
holders control the directors, who in turn select the management team.
• List three reasons why value creation is difficult.
2. Contracts with management and arrangements for compensation, such as stock option
plans, can be made so that management has an incentive to pursue shareholders’ goals.
Similarly, management may be given loans to buy the firm’s shares.
1.2 C O R P O R ATE SE CUR ITIE S A S CO N TIN GE N T
3. If the price of a firm’s stock drops too low because of poor management, the firm may
Figures Cand
L A ITables
be acquired by a group of shareholders, another firm, or an individual. This is called a
M S O N TOTA L FIR M VA L UE
takeover. In a takeover, top management of the acquired firm may find itself out of a job.
This text makes extensive use For of
example, the CEO
real data andof Chapters
presentsInc.them
lost his
injob when thefigures
various bookseller wastables.
and taken over by
Explana-
WhatIndigo
is theinessential
2001. This pressures
difference management
between to make
debt and decisions
equity? in the can
The answer shareholders’ inter-
be found by thinking about
tions in the narrative, examples,
whatests.
andof
Fear
happens
end-of-chapter
a takeover
to the payoffsgives
problems
managers
to debt
will refertake
an incentive
and equity
to many
when thetovalue actions of these
that
of the firm
exhibits.
will maximize
changes.
stock prices.feature of debt is that it is a promise by the borrowing firm to repay a fixed dollar
The basic
amount by a certain date. The shareholders’ claim on firm value at the end of the period is the amount
that remains after the debtholders are paid. Of course, shareholders get nothing if the firm’s value is
equal to or less than the amount promised to the debtholders.
ate payment is known with certainty, whereas the later inflows can only be estimated. Thus, we need to know the
relationship between a dollar today and a (possibly uncertain) dollar in the future before deciding on the project.
This relationship is called the time value of money concept. It is important in such areas as capital budgeting,
xx Preface
lease-versus-buy decisions, accounts receivable analysis, financing arrangements, mergers, and pension funding.
The basics are presented in this chapter. We begin by discussing two fundamental concepts: future value and
present value. Next, we explore simplifying formulas such as perpetuities and annuities.
Examples
Separate called-out examples are integrated throughout the chapters. Each example illustrates
an intuitive or mathematical application in a step-by-step format. There is enough detail in the
5.1 THEexplanations
O NE -PE RIO Ddon’t
that students CASE
have to look elsewhere for additional information.
EX A M PLE 5.1
Antony Robart is trying to sell a piece of land in Saskatchewan. Yesterday, he was offered $10,000 for the
property. He was ready to accept the offer when another individual offered him $11,424. However, the
second offer was to be paid a year from now. Antony has satisfied himself that both buyers are honest,
10 soPart
he 1has no
Overview
fear that the offer he selects will fall through. These two offers are pictured as cash flows in
Figure 5.1. Which offer should Antony choose?
It is very difficult for large business organizations to exist as sole proprietorships or
partnerships. The main advantage is the cost of getting started. Afterward, the disadvantages,
FIGURE which
5.1 may become severe, are (1) unlimited liability, (2) limited life of the enterprise, and
Cash Flow(3)
fordifficulty
Antony’s of transferring
Sale ownership. These three disadvantages lead to (4) the difficulty of
raising cash.
Alternative $10,000 $11,424

saleThe
pricesCorporation
Of the many forms of business enterprise, the corporation is by far the most important. Most large
Canadian firms, such as Bank of Montreal and Bombardier, are organized as corporations. As a
distinct legal entity, a corporation can have a name and enjoy many of the legal powers of natural
persons. For example, corporations can acquire and exchange property. Corporations may enter into
contracts and may sue and be sued. For jurisdictional purposes, the corporation is a citizen of its
Year province of incorporation. (It cannot vote, however.) 0 1
Starting a corporation is more complicated than starting a proprietorship or partnership. The
incorporators must prepare articles of incorporation and a set of bylaws. The articles of incorporation
must include
Equations 1. Name of the corporation.

2. Business purpose.
Key equations are numbered and highlighted
3. Number of shares that thefor easy reference.
corporation is authorized to issue, with a statement of limitations
and rights of different classes of shares.
Highlighted Concepts 4. Nature of the rights granted to shareholders.

5. Number of members of the initial board of directors.
Throughout the text, important ideas are pulled out and presented in a box—signalling to students
that this material is particularly relevant and critical to their understanding.
A Comparison of Partnerships and Corporations

Corporation Partnership
Liquidity and Common stock can be listed on a stock exchange. Units are subject to substantial restrictions on
marketability transferability. There is no established trading market for
partnership units.
Voting rights Usually each share of common stock entitles each holder Limited partners have some voting rights. However,
to one vote per share on matters requiring a vote and general partners have exclusive control and management
on the election of the directors. Directors determine top of operations.
management.
Taxation Corporate income is taxable at the corporate tax rate. Partnership income is taxed as personal income to the
Dividends to shareholders are also taxable with partial partners.
integration through use of the dividend tax credit.
Reinvestment and Corporations have broad latitude on dividend payout Partnerships are generally prohibited from reinvesting
dividend payout decisions. partnership cash flow. All net cash flow is distributed
to partners.
Liability Shareholders are not personally liable for obligations of the Limited partners are not liable for obligations of
corporation. partnerships. General partners may have unlimited
liability.
Continuity of existence Corporations have a perpetual life. Partnerships have a limited life.
The bylaws (the rules to be used by the corporation to regulate its own existence) concern its
shareholders, directors, and officers. Bylaws for the corporation’s management range from the brief-
End-of-Chapter Material est possible statement of rules to hundreds of pages of text.
In its simplest form, the corporation comprises three sets of distinct interests: the
The end-of-chapter material reflects
shareholders (the and builds
owners), upon theand
the directors, concepts learned
the corporation in the(the
officers chapter.
top management).
Traditionally, the shareholders control the corporation’s direction, policies, and activities.
The shareholders elect a board of directors, who in turn select top management who serve as
corporate officers.
ros70114_ch01_001-029.indd 10 12/3/18 5:45 PM

tain or expand the current asset base. (We return to free cash flow in Chapter 17.)
CONCEPT • How is cash flow different from changes in net working capital? Preface xxi
QUESTIONS • What is the difference between the operating cash flow and the total cash flow of the
firm?
Summary and Conclusions • What is free cash flow?
The numbered summary provides a quick review of key concepts in the chapter.
2.5 S UMMA RY A N D C O N C L U S I O N S
Besides introducing you to corporate accounting, the purpose of this chapter was to teach you how
to determine cash flow from the accounting statements of a typical company.
1. Cash flow is generated by the firm and paid to creditors and shareholders. It can be
classified as
a. Cash flow from operations.
b. Cash flow from changes in long-term assets.
c. Cash flow from changes in working capital.
2. There is a cash flow identity that says that cash flow from assets equals cash flow to bondhold-
ers and shareholders.
3. Calculations of cash flow are not difficult, but they require care and particular attention to
detail in properly accounting for non-cash expenses such as depreciation and deferred taxes. It
is especially important that you do not confuse cash flow with changes in net working capital
and net income.
List of Key Terms

ros70114_ch02_030-059.indd 38 12/3/18 8:51 PM
A list of the boldfaced key terms in the text with page numbers is included for easy reference.
Questions and Problems

Because solving problems is so critical to a student’s learning, new questions and problems have
been added and existing questions and problems have been revised. All problems have also been thor-
oughly reviewed and checked for accuracy. Problems have been grouped according to the concepts
they test, with the concept headings listed at the beginning of each group.
Additionally, we have tried to make the problems in the critical “concept” chapters—such
as those on value, risk, and capital structure—especially challenging and interesting. We provide
answers to selected problems in Appendix B, available on Connect.
Microsoft Excel Problems

Indicated by the Microsoft Excel icon in the margin, these Microsoft Excel problems
can be found at the end of almost all chapters. Located on Connect, Microsoft Excel
templates have been created for each of these problems, where students can use the
data in the problem to work out the solution using Microsoft Excel skills.
Minicases
These Minicases, located in most chapters, apply what is learned in a number of chapters to a real-
world scenario. After presenting the facts, the case gives students guidance in rationalizing a sound
business decision.
MARKET LEADING TECHNOLOGY

Learn Without Limits
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can take advantage of McGraw-Hill’s trusted content to seamlessly deliver assignments, quizzes and
tests online. McGraw-Hill Connect is a learning platform that continually adapts to each student,
delivering precisely what they need, when they need it, so class time is more engaging and effective.
Connect makes teaching and learning personal, easy, and proven.
xxii Preface
Connect Key Features

SmartBook®
As the first and only adaptive reading experience, SmartBook is changing the way students read
and learn. SmartBook creates a personalized reading experience by highlighting the most important
concepts a student needs to learn at that moment in time. As a student engages with SmartBook, the
reading experience continuously adapts by highlighting content based on what each student knows
and doesn’t know. This ensures that he or she is focused on the content needed to close specific
knowledge gaps, while it simultaneously promotes long-term learning.
Connect Insight®
Connect Insight is Connect’s new one-of-a-kind visual analytics dashboard—now available for
instructors—that provides at-a-glance information regarding student performance, which is imme-
diately actionable. By presenting assignment, assessment, and topical performance results together
with a time metric that is easily visible for aggregate or individual results, Connect Insight gives
instructors the ability to take a just-in-time approach to teaching and learning, which was never
before available. Connect Insight presents data that helps instructors improve class performance in a
way that is efficient and effective.
Simple Assignment Management
With Connect, creating assignments is easier than ever, so instructors can spend more time teaching
and less time managing.
• Assign SmartBook learning modules.
• Edit existing questions and create personalized questions.
• Draw from a variety of text specific questions, resources, and test bank material to assign online.
• Streamline lesson planning, student progress reporting, and assignment grading to make
classroom management more efficient than ever.
Smart Grading
When it comes to studying, time is precious. Connect helps students learn more efficiently by
providing feedback and practice material when they need it, where they need it.
• Automatically score assignments, giving students immediate feedback on their work and
comparisons with correct answers.
• Access and review each response; manually change grades or leave comments for students to
review.
• Track individual student performance—by question, by assignment, or in relation to the class
overall—with detailed grade reports.
• Reinforce classroom concepts with practice tests and instant quizzes.
• Integrate grade reports easily with learning management systems including Blackboard, D2L,
and Moodle.
Mobile Access
Connect makes it easy for students to read and learn using their smartphones and tablets. With
the mobile app, students can study on the go—including reading and listening using the audio
functionality—without constant need for Internet access.
Instructor Library
The Connect Instructor Library is a repository for additional resources to improve student engage-
ment in and out of the class. It provides all the critical resources instructors need to build their
course.
• Access instructor resources.
• View assignments and resources created for past sections.
• Post your own resources for students to use.
Instructor Resources
• Instructor’s Manual. Prepared by Larbi Hammami, Desautels Faculty of Management,
McGill University.
• Instructor’s Solutions Manual. Prepared by Hamdi Driss, Sobey School of Management,
St. Mary’s University.
Preface xxiii
• Microsoft PowerPoint Presentations. Updated by Tsvetanka Karagyozova, Department of

Economics, Faculty of Liberal Arts and Professional Studies, York University.
• Computerized Test Bank. Prepared by Shantanu Dutta, Telfer School of Management,
University of Ottawa.
• Microsoft Excel Templates (with solutions). Prepared by Vishaal Baulkaran, Dhillon School of
Business, University of Lethbridge.
SUPERIOR LEARNING SOLUTIONS AND SUPPORT

The McGraw-Hill Education team is ready to help instructors assess and integrate any of our prod-
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For more information, please visit us online: http://www.mheducation.ca/he/solutions
ACKNOWLEDGMENTS
Many people have contributed their time and expertise to the development and production of this
text. I extend my thanks and gratitude for their contributions.
A special thank-you must be given to our technical checker, Larbi Hammami of the Desautels
Faculty of Management at McGill University. Thank you for your vigilant efforts reviewing this text
and its solutions. Your keen eye and attention to detail have contributed greatly to the quality of the
final product.
Much credit must go to a first-class group of people at McGraw-Hill Education who worked on
the eighth Canadian edition. Leading the team were senior product managers Alwynn Pinard and
Sara Braithwaite, and content developer Tammy Mavroudi. Copy editing and proofreading of the
manuscript was diligently done by Laurel Sparrow, with in-house supervision by Janie Deneau. And
many thanks to Alison Lloyd Baker for overseeing permissions for this project.
Through the development of this edition, our team has taken great care to discover and eliminate
errors. Our goal is to provide the best Canadian textbook available on this subject. Please send com-
ments and feedback to:
Professor Hamdi Driss

Sobey School of Business, Saint Mary’s University
923 Robie Street
Halifax, Nova Scotia
B3H 3C3
Email: hamdi.driss@smu.ca.
Sincerely,
Hamdi Driss
This page intentionally left blank
PA RT 1 OV E RV IE W
Chapter 1
Introduction to Corporate Finance
E XE C UT IV E S UM M A RY
Barrick Gold Corporation has long been known as the largest gold mining company in the world. With the recent recession,
gold prices and Barrick’s share price increased as investors sought a safe investment. However, in 2013 Barrick’s shares
plunged in value by 54 percent to a 20-year low. While the accompanying fall in the value of gold was beyond the compa-
ny’s control, the poor performance was attributed primarily to the failure of key projects, misallocation of capital resources,
and the legal mess associated with the Pascua-Lama mine in Chile. Accompanying this poor performance, the company’s
proxy circular revealed that six executives were to be compensated for a combined $47.4 million and board chair Peter
Munk was to receive $4.3 million. In addition, the company awarded a US$11.9 million signing bonus to John Thornton for
joining the company as co-chair.1 Consequently, several major shareholders of Barrick Gold Corporation invoked a “say
on pay” vote, which rejected the pay packages and led to the appointment of new independent directors and to Munk
stepping down as board chair. Recent events at Barrick Gold Corporation illustrate both the importance of governance
issues and the need for management to make key corporate finance decisions relating to the following questions:
1. What long-term investment strategy should a company take on?
2. How can cash be raised?
3. How much short-term cash flow does a company need to pay its bills?
These are not the only questions of corporate finance. For example, another important question covered in this
text is: How should a company divide earnings between payouts to shareholders (dividends) and reinvestment? The
three questions on our list are among the most important, however, and, taken in order, they provide a rough outline
of our book. In Section 1.1 we introduce the basic ideas of corporate finance.
One way that companies raise cash to finance their investment activities is by selling or issuing securities. The
securities, sometimes called financial instruments or claims, may be roughly classified as equity or debt, loosely called
stocks or bonds. The difference between equity and debt is a basic distinction in the modern theory of finance. All
securities of a firm are claims that depend on or are contingent on the value of the firm.2 In Section 1.2 we show how
debt and equity securities depend on the firm’s value, and we describe them as different contingent claims.
In Section 1.3 we discuss different organizational forms and the pros and cons of the decision to become a corporation.
In Section 1.4 we take a close look at the goals of the corporation and discuss why maximizing shareholder
wealth is likely to be its primary goal. Throughout the rest of the book, we assume that the firm’s performance
depends on the value it creates for its shareholders. Shareholders are made better off when the value of their shares
is increased by the firm’s decisions.
A company raises cash by issuing securities in the financial markets. In Section 1.5 we describe some of the basic
features of the financial markets. Roughly speaking, there are two types of financial markets: money markets and
capital markets.
Section 1.6 covers trends in financial markets and management, and the last section of this chapter (Section 1.7)
outlines the rest of the book.
1
Theresa Tedesco, “Barrick Gold could have avoided say-on-pay public backlash,” Financial Post, April 23, 2013. http://business
.financialpost.com/news/fp-street/barrick-gold-executive-compensation-wednesday
2
We tend to use the words firm, company, and business interchangeably. However, there is a difference between these and
a corporation. We discuss this difference in Section 1.3.
2 Part 1 Overview
1.1 WHAT I S COR PO RATE F I NA NC E ?

Suppose you decide to start a firm to make tennis balls. To do this, you hire managers to buy
raw materials and assemble a workforce that will produce and sell finished tennis balls. In the
language of finance, you make an investment in assets, such as inventory, machinery, land, and
labour. The amount of cash you invest in assets must be matched by an equal amount of cash
raised by financing. When you begin to sell tennis balls, your firm will generate cash. This is
the basis of value creation. The purpose of the firm is to create value for you, the owner (share-
holder). In other words, the goal of the firm and its managers should be to maximize the value
of the shareholders’ wealth. The value is reflected in the framework of the simple balance-sheet
model of the firm.
The Balance-Sheet Model of the Firm

Suppose we take a financial snapshot of the firm and its activities at a single point in time. Figure 1.1,
a graphic conceptualization of the balance sheet, will help introduce you to corporate finance.
FIGURE 1.1
The Balance-Sheet Model of the Firm
Net Current liabilities

working
Current assets capital
Long-term debt
Fixed assets
1. Tangible fixed
assets
2. Intangible fixed Shareholders’ equity
assets
Total value of assets Total value of the firm to investors

Left side: total value of assets. Right side: total value of the firm to investors, which determines how the value
is distributed.
The assets of the firm are on the left side of the balance sheet. These assets can be thought of
as current and fixed. Fixed assets are those that will last a long time, such as a building. Some fixed
assets are tangible, such as machinery and equipment. Other fixed assets are intangible, such as
patents, trademarks, and the quality of management. The other category of assets, current assets,
comprises those that have short lives, such as inventory. The tennis balls that your firm has made
but not yet sold are part of its inventory. Unless you have overproduced, they will leave the firm
shortly.
Before a company can invest in an asset, it must obtain financing, which means that it
must raise the money to pay for the investment. The forms of financing are represented on the
right side of the balance sheet. A firm will issue (sell) pieces of paper called debt (loan agree-
ments) or equity shares (share certificates). Just as assets are classified as long lived or short
lived, so too are liabilities. A short-term debt is called a current liability. Short-term debt rep-
resents loans and other obligations that must be repaid within one year. Long-term debt is debt
that does not have to be repaid within one year. Shareholders’ equity represents the difference
between the value of the assets and the debt of the firm. In this sense, it is a residual claim on
the firm’s assets.
Chapter 1 Introduction to Corporate Finance 3
From the balance-sheet model of the firm, it is easy to see why finance can be thought of as the
study of the following three questions:
1. In what long-lived assets should the firm invest? This question concerns the left side of the
balance sheet. Of course, the types and proportions of assets the firm needs tend to be set
by the nature of the business. We use the terms capital budgeting and capital expenditure
to describe the process of making and managing expenditures on long-lived assets.
2. How can the firm raise cash for required capital expenditures? This question concerns the
right side of the balance sheet. The answer involves the firm’s capital structure, which
represents the proportions of the firm’s financing from current and long-term debt and
equity.
3. How should short-term operating cash flows be managed? This question concerns the
upper portion of the balance sheet. There is a mismatch between the timing of cash
inflows and cash outflows during operating activities. Furthermore, the amount and
timing of operating cash flows are not known with certainty. Financial managers must
attempt to manage the gaps in cash flow. From an accounting perspective, short-term
management of cash flow is associated with a firm’s net working capital, defined as
current assets minus current liabilities. From a financial perspective, the short-term
cash flow problem comes from the mismatching of cash inflows and outflows. It is the
subject of short-term finance.
Capital Structure
Financing arrangements determine how the value of the firm is sliced up like a pie. The persons or
institutions that buy debt from the firm are called creditors.3 The holders of equity shares are called
shareholders.
Thinking of the firm as a pie, initially, the size of the pie will depend on how well the firm has
made its investment decisions. After the firm has made its investment decisions, financial markets
determine the value of its assets (e.g., its buildings, land, and inventories).
The firm can then determine its capital structure. It might initially have raised the cash to invest
in its assets by issuing more debt than equity; now it can consider changing that mix by issuing more
equity and using the proceeds to buy back some of its debt. Financing decisions like this can be made
independently of the original investment decisions. The decisions to issue debt and equity affect how
the pie is sliced.
The pie we are thinking of is depicted in Figure 1.2. The size of the pie is the value of the firm
in the financial markets. We can write the value of the firm, V, as
V=B+S
where B is the value of the debt (bonds) and S is the value of the equity (shares). The pie diagram
considers two ways of slicing the pie: 50 percent debt and 50 percent equity, and 25 percent debt
and 75 percent equity. The way the pie is sliced could affect its value. If so, the goal of the financial
manager is to choose the ratio of debt to equity that makes the value of the pie—that is, the value of
the firm, V—as large as it can be.
The Financial Manager

In large firms, the finance activity is usually associated with a senior officer of the firm (such as a
chief financial officer (CFO)) and some lesser officers. Figure 1.3 depicts one example of a general
organizational structure emphasizing the finance activity within the firm. Reporting to the CFO are
the treasurer and the controller. The treasurer is responsible for handling cash flows, analyzing capi-
tal expenditures, and making financing plans. The controller handles the accounting function, which
includes taxes, cost and financial accounting, and information systems. Our discussion of corporate
finance is much more relevant to the treasurer’s function.
3
We tend to use the words creditors, debtholders, and bondholders interchangeably. In later chapters we examine the
differences among the kinds of creditors.
4 Part 1 Overview
FIGURE 1.2
Two Pie Models of the Firm
25% debt
50% debt 50% equity 75% equity
Capital structure 1 Capital structure 2
As Figure 1.3 shows, there are four general position categories under the treasurer. Corpora-
tions usually hire BA or MBA graduates with a finance background for these positions. In contrast,
the positions under the controller are geared more toward graduates with accounting majors or
professional designations, such as CGA, CMA, or CA.
We think that a financial manager’s most important job is to create value from the
firm’s capital budgeting, financing, and liquidity activities. How do financial managers create
value?
FIGURE 1.3
Hypothetical Organization Chart
Board of Directors
Chairman of the Board and

Chief Executive Officer (CEO)
Vice President and Chief

Financial Officer (CFO)
Treasurer Controller
Cost Accounting
Cash Manager Credit Manager Tax Manager Manager
Financial Information
Capital Financial
Accounting Systems
Expenditures Planning
Manager Manager
1. The firm should try to buy assets that generate more cash than they cost.
2. The firm should sell bonds, shares, and other financial instruments that raise more cash than
they cost.
Thus, the firm must create more cash flow than it uses. The cash flow paid to bondholders and
shareholders of the firm should be higher than the cash flows put into the firm by the bondholders
and shareholders. To see how this is done, we can trace the cash flows from the firm to the financial
markets and back again.
The interplay of the firm’s finance with the financial markets is illustrated in Figure 1.4. To
finance its planned investment, the firm sells debt and equity shares to participants in the finan-
cial markets. The result is cash flows from the financial markets to the firm (A). This cash is
used by the firm’s management to fund the investment activities of the firm (B). The cash gener-
ated by the firm (C) is paid to shareholders and bondholders (F). Shareholders receive cash from
the firm in the form of dividends or as share repurchases; bondholders who lent funds to the firm
receive interest and, when the initial loan is repaid, principal. Not all of the firm’s cash is paid
out to shareholders and bondholders. Some is retained (D), and some is paid to governments as
taxes (E).
FIGURE 1.4
Cash Flows Between the Firm and the Financial Markets
Firm issues securities (A)
Firm invests Financial

in assets markets
Retained cash flows (D)
Current assets Short-term debt
Fixed assets Long-term debt
(B) Cash flow Dividends and Equity shares
from firm (C) debt payments (F)
Taxes
Total value of assets Total value of the firm

Government to investors in
(E) the financial markets
(A) Firm issues securities to raise cash (the financing decision).

(B) Firm invests in assets (capital budgeting).
(C) Firm’s operations generate cash flows.
(D) Retained cash flows are reinvested in firm.
(E) Cash is paid to government as taxes.
(F) Cash is paid out to investors in the form of interest and dividends.
Over time, if the cash paid to shareholders and bondholders (F) is greater than the cash raised in
the financial markets (A), value will be created.
Identification of Cash Flows

Unfortunately, it is not easy to observe cash flows directly. Much of the information we obtain is in
the form of accounting statements, and much of the work of financial analysis is to extract cash flow
information from accounting statements. Example 1.1 illustrates how this is done.
6 Part 1 Overview
EX A MP LE 1.1
The Midland Company refines and trades gold. At the end of the year it sold some gold for $1 million. The
company had acquired the gold for $900,000 at the beginning of the year. The company paid cash for the
gold when it was purchased. Unfortunately, it has yet to collect from the customer to whom the gold was sold.
The following is a standard accounting of Midland’s financial circumstances at year-end:
THE MIDLAND COMPANY

Accounting View
Income Statement
Year Ended December 31
Sales $1,000,000
Costs -900,000
Profit $ 100,000
By International Financial Reporting Standards (IFRS), the sale is recorded even though the customer
has yet to pay. It is assumed that the customer will pay soon. From the accounting perspective, Midland
seems to be profitable. The perspective of corporate finance is different. It focuses on cash flows:
THE MIDLAND COMPANY

Corporate Finance View
Income Statement
Year Ended December 31
Cash inflow 0
Cash outflow -$900,000
-$900,000
The perspective of corporate finance examines whether cash flows are being created by the gold-
trading operations of Midland. Value creation depends on cash flows. For Midland, value creation depends
on whether and when it actually receives the $1 million.
Timing of Cash Flows

The value of an investment made by the firm depends on the timing of cash flows. One of the most
important principles of finance is that individuals prefer to receive cash flows earlier rather than later.
One dollar received today is worth more than one dollar received next year because today’s dollar can
be invested to earn interest.
EX A MP LE 1.2
The Midland Company is attempting to choose between two proposals for new products. Both proposals
will provide cash flows over a four-year period and will initially cost $10,000. The cash flows from the
proposals are as follows:
Year New Product A New Product B

1 0 $ 4,000
2 0 4,000
3 0 4,000
4 $20,000 4,000
Total $20,000 $16,000
At first it appears that new product A is better. However, the cash flows from proposal B come earlier than
those of A. Without more information, we cannot decide which set of cash flows would create greater value.
It depends on whether the value of getting cash from B upfront outweighs the extra total cash from A.
Risk of Cash Flows

The firm must consider risk. The amount and timing of cash flows are not usually known with
certainty. Most investors have an aversion to risk.
EX A M PLE 1.3
The Midland Company is considering expanding operations overseas. It is evaluating Europe and Japan as
possible sites. Europe is considered to be relatively safe, whereas Japan is seen as very risky. In both cases
the company would close down operations after one year.
After doing a complete financial analysis, Midland has come up with the following cash flows of the
alternative plans for expansion under three scenarios: pessimistic, realistic, and optimistic.
Pessimistic Realistic Optimistic

Europe $75,000 $100,000 $125,000
Japan 0 150,000 200,000
If we ignore the pessimistic scenario, perhaps Japan is the better alternative. When we take the pes-
simistic scenario into account, the choice is unclear. Japan appears to be riskier, but it may also offer a
higher expected level of cash flow. What is risk and how can it be defined? We must try to answer this
important question. Corporate finance cannot avoid coping with risky alternatives, and much of our book
is devoted to developing methods for evaluating risky opportunities.
CONCEPT • What are three basic questions of corporate finance?

QUESTIONS • Describe capital structure.
• List three reasons why value creation is difficult.
1.2 C OR POR AT E SEC U RI TI E S A S C O NTI NG E N T

C LAIMS O N TOTA L F I RM VA L U E
What is the essential difference between debt and equity? The answer can be found by thinking about
what happens to the payoffs to debt and equity when the value of the firm changes.
The basic feature of debt is that it is a promise by the borrowing firm to repay a fixed dollar
amount by a certain date. The shareholders’ claim on firm value at the end of the period is the amount
that remains after the debtholders are paid. Of course, shareholders get nothing if the firm’s value is
equal to or less than the amount promised to the debtholders.
EX A M PLE 1.4
The Canadian Corporation promises to pay $100 to the True North Insurance Company at the end of one
year. This is a debt of the Canadian Corporation. Holders of the Canadian Corporation’s debt will receive
$100 if the value of the Canadian Corporation’s assets equals $100 or more at the end of the year.
Formally, the debtholders have been promised an amount, F, at the end of the year. If the value of
the firm, X, is equal to or greater than F at year-end, debtholders will get F. Of course, if the firm does
not have enough to pay off the promised amount, the firm will be broke. It may be forced to liquidate its
assets for whatever they are worth, and bondholders will receive X. Mathematically, this means that the
debtholders have a claim to X or F, whichever is smaller. Figure 1.5 illustrates the general nature of the
payoff structure to debtholders.
Suppose at year-end the Canadian Corporation’s value is $100. The firm has promised to pay the True
North Insurance Company $100, so the debtholders will get $100.
8 Part 1 Overview
FIGURE 1.5
Debt and Equity as Contingent Claims
Payoff to Payoff to Payoffs to debtholders
debtholders equity shareholders and equity shareholders
Payoff to
equity
shareholders
F F
Payoff to
Value Value debtholders Value
of of of
F the F the F the
firm firm firm
(X ) (X ) (X )
F is the promised payoff to debtholders. X − F is the payoff to equity shareholders if X − F > 0. Otherwise the payoff
is 0.
Now suppose the Canadian Corporation’s value is $200 at year-end and the debtholders are promised
$100. How much will the debtholders receive? It should be clear that they will receive the same amount
as when the Canadian Corporation was worth $100.
Suppose the firm’s value is $75 at year-end and debtholders are promised $100. How much will the
debtholders receive? In this case the debtholders will get $75.
Suppose the Canadian Corporation will sell its assets for $200 at year-end. The firm has promised to
pay the insurance company $100 at that time. The shareholders will get the residual value of $100.
Algebraically, the shareholders’ claim is X − F if X > F and zero if X ≤ F. The sum of the debtholders’
claim and the shareholders’ claim is always the value of the firm at the end of the period.
The debt and equity securities issued by a firm derive their value from the total value of the
firm. In the words of finance theory, debt and equity securities are contingent claims on the total
firm value.
When the value of the firm exceeds the amount promised to debtholders, the shareholders obtain
the residual of the firm’s value over the amount promised the debtholders, and the debtholders obtain
the amount promised. When the value of the firm is less than the amount promised to the bondhold-
ers, the shareholders receive nothing and the debtholders get the value of the firm.
CONCEPT • What is a contingent claim?

QUESTIONS • Describe equity and debt as contingent claims.
1.3 BUS IN ESS O RG ANI ZATI O N F O RM S

The firm is a means of organizing the economic activity of many individuals. There are many reasons
why so much economic activity is carried out by firms and not by individuals. The theory of firms
does not tell us much about why most large firms are corporations rather than any of the other legal
forms that firms can assume, however.
A basic problem of the firm is how to raise cash. The corporate form of business (that is, orga-
nizing the firm as a corporation) is the standard method for solving problems encountered in raising
large amounts of cash. However, business can take other forms. In this section we consider the three
basic legal forms of organizing firms (sole proprietorship, partnership, and corporation), and we see
how firms raise cash under each form. We also introduce the income trust, a non-corporate form of
business organization.
The Sole Proprietorship

A sole proprietorship is a business owned by one person. Suppose you decide to start a business
to produce mousetraps. Going into business is simple: Announce to all who will listen, “Today I am
going to build a better mousetrap.”
Most large cities require that you obtain a business licence. Afterward, you can try to hire as
many people as you need and borrow whatever money you need. At year-end all the profits and the
losses will be yours.
Here are some important factors in considering a sole proprietorship:
1. The sole proprietorship is the cheapest type of business to form. No formal charter is
required, and few government regulations must be satisfied.
2. A sole proprietorship pays no corporate income taxes. All profits of the business are taxed
as individual income.
3. The sole proprietorship has unlimited liability for business debts and obligations.
No distinction is made between personal and business assets.
4. The life of the sole proprietorship is limited by the life of the sole proprietor.
5. Because the only money invested in the firm is the proprietor’s, the equity money that can
be raised by the sole proprietor is limited to the proprietor’s personal wealth.
The Partnership
Any two or more people can get together and form a partnership. Partnerships fall into two catego-
ries: general partnerships and limited partnerships.
In a general partnership all partners agree to provide some fraction of the work and cash and
to share the profits and losses. Each partner is liable for the debts of the partnership. A partnership
agreement specifies the nature of the arrangement. The partnership agreement may be an oral agree-
ment or a formal document setting forth the understanding.
Limited partnerships permit the liability of some of the partners to be limited to the amount
of cash each has contributed to the partnership. Limited partnerships usually require that (1) at
least one partner be a general partner and (2) the limited partners do not participate in managing
the business.
Here are some points that are important when considering a partnership:
1. Partnerships are usually inexpensive and easy to form. In complicated arrangements,

including general and limited partnerships, written documents are required. Business
licences and filing fees may be necessary.
2. General partners have unlimited liability for all debts. The liability of limited partners is
usually limited to the contribution each has made to the partnership. If one general partner
is unable to meet his or her commitment, the shortfall must be made up by the other general
partners.
3. The general partnership is terminated when a general partner dies or withdraws (but this is
not so for a limited partner). It is difficult for a partnership to transfer ownership without
dissolving. Usually, all general partners must agree. However, limited partners may sell their
interest in a business.
4. It is difficult for a partnership to raise large amounts of cash. Equity contributions are limited
to a partner’s ability and desire to contribute to the partnership. Sometimes the partners have
no choice about contributing. For example, in 2001, a major global management consulting
firm, McKinsey & Company, called on its partners to contribute up to $300,000 each to
finance growing accounts receivable. Many companies start life as a proprietorship or part-
nership, but at some point they need to convert to corporate form. For example, Tim Hortons
Inc., which was founded in 1964, went public in March 2006.
5. Income from a partnership is taxed as personal income to the partners.
6. Management control resides with the general partners. Usually a majority vote is required on
important matters, such as the amount of profit to be retained in the business.
10 Part 1 Overview
It is very difficult for large business organizations to exist as sole proprietorships or

partnerships. The main advantage is the cost of getting started. Afterward, the disadvantages,
which may become severe, are (1) unlimited liability, (2) limited life of the enterprise, and
(3) difficulty of transferring ownership. These three disadvantages lead to (4) the difficulty of
raising cash.
The Corporation
Of the many forms of business enterprise, the corporation is by far the most important. Most large
Canadian firms, such as Bank of Montreal and Bombardier, are organized as corporations. As a
distinct legal entity, a corporation can have a name and enjoy many of the legal powers of natural
persons. For example, corporations can acquire and exchange property. Corporations may enter into
contracts and may sue and be sued. For jurisdictional purposes, the corporation is a citizen of its
province of incorporation. (It cannot vote, however.)
Starting a corporation is more complicated than starting a proprietorship or partnership. The
incorporators must prepare articles of incorporation and a set of bylaws. The articles of incorporation
must include
1. Name of the corporation.

2. Business purpose.
3. Number of shares that the corporation is authorized to issue, with a statement of limitations
and rights of different classes of shares.
4. Nature of the rights granted to shareholders.
5. Number of members of the initial board of directors.
A Comparison of Partnerships and Corporations

Corporation Partnership
Liquidity and Common stock can be listed on a stock exchange. Units are subject to substantial restrictions on
marketability transferability. There is no established trading market for
partnership units.
Voting rights Usually each share of common stock entitles each holder Limited partners have some voting rights. However,
to one vote per share on matters requiring a vote and general partners have exclusive control and management
on the election of the directors. Directors determine top of operations.
management.
Taxation Corporate income is taxable at the corporate tax rate. Partnership income is taxed as personal income to the
Dividends to shareholders are also taxable with partial partners.
integration through use of the dividend tax credit.
Reinvestment and Corporations have broad latitude on dividend payout Partnerships are generally prohibited from reinvesting
dividend payout decisions. partnership cash flow. All net cash flow is distributed
to partners.
Liability Shareholders are not personally liable for obligations of the Limited partners are not liable for obligations of
corporation. partnerships. General partners may have unlimited
liability.
Continuity of existence Corporations have a perpetual life. Partnerships have a limited life.
The bylaws (the rules to be used by the corporation to regulate its own existence) concern its
shareholders, directors, and officers. Bylaws for the corporation’s management range from the brief-
est possible statement of rules to hundreds of pages of text.
In its simplest form, the corporation comprises three sets of distinct interests: the
shareholders (the owners), the directors, and the corporation officers (the top management).
Traditionally, the shareholders control the corporation’s direction, policies, and activities.
The shareholders elect a board of directors, who in turn select top management who serve as
corporate officers.
The separation of ownership from management gives the corporation several advantages over
proprietorships and partnerships:
1. Because ownership in a corporation is represented by shares, ownership can be readily

transferred to new owners. Because the corporation exists independently of those who own
its shares, there is no limit to the transferability of shares, as there is in partnerships.
2. The corporation has unlimited life. Because the corporation is separate from its owners, the
death or withdrawal of an owner does not affect its existence. The corporation can continue
on after the original owners have withdrawn.
3. The shareholders’ liability is limited to the amount invested in the ownership shares. For
example, if a shareholder purchased $1,000 in shares of a corporation, the maximum poten-
tial loss would be $1,000. In a partnership, a general partner with a $1,000 contribution could
lose the $1,000 plus any other indebtedness of the partnership.
Limited liability, ease of ownership transfer, and perpetual succession are the major advantages
of the corporate form of business organization. These give the corporation an enhanced ability to
raise cash.
There is, however, one great disadvantage to incorporation. Not only is corporate income taxable
by the federal and provincial governments, but also corporate dividends received by shareholders are
taxable. Nonetheless, the dividend tax credit for individual shareholders and a corporate dividend
exclusion provide a degree of tax integration for Canadian corporations. These tax provisions are
discussed in Appendix 1A.
The Income Trust

The income trust, a non-corporate form of business organization, grew in importance in Canada after
2001. Within this sector, the fastest-growing component of this form of business organization was
business income trusts, especially in real estate and oil and gas. Businesses—such as telephone list-
ings, container ports, and restaurant chains—usually organized as corporations were also included in
this component. In response to the growing importance of this sector, provincial legislation extended
limited liability protection—previously limited to corporate shareholders—to trust unitholders.
Along the same lines, at the end of 2005, the Toronto Stock Exchange (TSX) began to include trusts
in its benchmark S&P/TSX composite index.
Business income trusts (also called income funds) hold the debt and equity of an underlying
business and distribute the income generated to unitholders. Because income trusts are not corpora-
tions, they are not subject to corporate income tax and their income is typically taxed only in the
hands of unitholders. As a result, investors saw trusts as tax efficient and were generally willing to
pay more for a company after it converted from a corporation to a trust. This tax advantage largely
disappeared in 2006 when the government announced plans to tax income trusts as corporations,
prompting BCE Inc. (formerly known as Bell Canada Enterprises Inc.) to reverse its mid-October
2006 announced plan to convert to an income trust. As of mid-2017, most income trusts had con-
verted to corporations, with only 58 income trusts listed on the TSX and the TSX Venture Exchange,
with a quoted market value of $75.1 billion.4
CONCEPT • Define a proprietorship, a partnership, a corporation, and an income trust.

QUESTIONS • What are the advantages of the corporate form of business organization?
1.4 GOALS O F TH E C O RP O RATE F I RM

What is the primary goal of the corporation? Managers in a corporation make decisions for the share-
holders because the shareholders own and control the corporation. Thus, the traditional answer is that
the goal of the corporation is to add value for the shareholders. This goal is a little vague and so we
4
https://www.tmxmoney.com/en/research/income_trusts.html (accessed September 22, 2017).
12 Part 1 Overview
will try to come up with a more precise formulation. It is impossible to give a definitive answer to
this important question, however, because the corporation is an artificial being, not a natural person;
it exists in the “contemplation of the law.”5
It is necessary to identify precisely who controls the corporation. We shall consider the set-of-
contracts viewpoint. This viewpoint suggests that the corporate firm will attempt to maximize the
shareholders’ wealth by taking actions that increase the current value per share of existing stock of
the firm.
Agency Costs and the Set-of-Contracts Viewpoint

The set-of-contracts viewpoint of the firm states that the firm can be viewed as nothing more than
a set of contracts.6 One of the contract claims is a residual claim (equity) on the firm’s assets and
cash flows. The equity contract can be defined as a principal–agent relationship. The members of the
management team are the agents hired to act on behalf of the equity investors (shareholders), who are
the principals. This discussion focuses on conflict between shareholders and managers. It is assumed
that each of the two groups, left alone, will attempt to act in its own self-interest. We also assume that
shareholders are unanimous in defining their self-interest. (We explain how perfect markets make
this happen in Chapter 4.)
The shareholders, however, can discourage the managers from diverging from the sharehold-
ers’ interests by devising appropriate incentives for managers and then monitoring their behaviour.
Doing so is complicated and costly, unfortunately. The costs of resolving the conflicts of interest
between managers and shareholders are special types of costs called agency costs. These costs
include the monitoring costs of the shareholders and the incentive fee paid to the managers. It can be
expected that contracts will be devised that will provide the managers with appropriate incentives to
maximize the shareholders’ wealth. Thus, agency problems do not mean that the corporate firm will
not act in the best interests of shareholders, only that it is costly to make it do so. However, agency
problems can never be perfectly solved, and managers may not always act in the best interests of
shareholders. Residual losses are the lost wealth of the shareholders due to divergent behaviour of
the managers.
Managerial Goals
Managerial goals are different from those of shareholders. What will managers maximize if they are
left to pursue their own goals rather than shareholders’ goals?
Williamson proposes the notion of expense preference.7 He argues that managers obtain value
from certain kinds of expenses. In particular, company cars, office furniture, office location, and
funds for discretionary investment have value to managers beyond that which comes from their
productivity.
Donaldson conducted a series of interviews with chief executives of several large companies.8
He concluded that managers are influenced by three underlying motivations in defining the corporate
mission:
1. Survival. Organizational survival means that management must always command sufficient
resources to support the firm’s activities.
2. Independence. This is the freedom to make decisions and take action without encountering
external parties or depending on outside financial markets.
3. Self-sufficiency. Managers do not want to depend on external parties.
5
These are the words of U.S. Chief Justice John Marshall from The Trustees of Dartmouth College v. Woodward, 4, Wheaton
636 (1819).
6
M. C. Jensen and W. Meckling, “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure,” Journal
of Financial Economics 3 (1976).
7
O. Williamson, “Managerial Discretion and Business Behavior,” American Economic Review 53 (1963).
8
G. Donaldson, Managing Corporate Wealth: The Operations of a Comprehensive Financial Goals System (New York:
Praeger, 1984).
These motivations lead to what Donaldson concludes is the basic financial objective of manag-
ers: the maximization of corporate wealth. Corporate wealth is that wealth over which management
has effective control; it is closely associated with corporate growth and corporate size. Corporate
wealth is not necessarily shareholder wealth. Corporate wealth tends to lead to increased growth by
providing funds for growth and limiting the extent to which equity is raised. Increased growth and
size are not necessarily the same thing as increased shareholder wealth.
Separation of Ownership and Control

Some people argue that shareholders do not control the corporation. They argue that shareholder
ownership is too diffuse and fragmented for effective control of management. A striking feature of
the modern large corporation is the diffusion of ownership among thousands of investors. For exam-
ple, Table 1.1 shows that the largest corporations in Canada are widely held, with no shareholder
owning 10 percent or more of the shares. While this argument is certainly worth considering, it is
less true in Canada than in the United States. Over 70 percent of U.S. corporations were widely held
compared to only around 15 percent in Canada. Many domestically owned Canadian corporations
have controlling shareholders.9 Further, restricted voting shares, which facilitate narrow control, are
more popular in Canada.10 Still, controlling agency costs through re-examining the rules of corporate
governance is of considerable interest in corporate Canada.
The Five Largest Canadian Corporations by Revenue, Company

TABLE 1.1
2015 Year-End
Revenue Assets
(in $ millions) (in $ millions) Ownership
George Weston Ltd. 46,894 37,802 Widely held
Royal Bank of Canada 43,279 1,074,208 Widely held
Magna International Inc. 41,067 27,273 Widely held
Alimentation Couche-Tard Inc. 39,640 13,190 Widely held
Power Corp. of Canada 38,265 422,859 Widely held
Source: Adapted from “THE FP500: The Premier Ranking of Corporate Canada,” National Post, http://business.financialpost.com
/fp500-the-premier-ranking-for-corporate-canada (accessed August 10, 2017). Financial Post, a division of Postmedia Network Inc.
As we discussed earlier, one of the most important advantages of the corporate form of
business organization is that it allows ownership of shares to be transferred. The resulting dif-
fuse ownership, however, brings with it the separation of ownership and control of the large
corporation. The possible separation of ownership and control raises an important question:
Who controls the firm?
Do Shareholders Control Managerial Behaviour? The claim that managers can ignore the
interests of shareholders arises from the fact that ownership in large corporations is widely dispersed.
As a consequence, it is often said, individual shareholders cannot control management. There is some
merit in this argument, but it is too simplistic.
The extent to which shareholders can control managers depends on (1) the costs of moni-
toring management, (2) the costs of implementing the control devices, and (3) the benefits of
control.
When a conflict of interest exists between management and shareholders, who wins? Do manag-
ers or shareholders control the firm? Ownership in large corporations is diffuse compared to that in
9
Important exceptions are large banks (with an equity capitalization of $12 billion or more). The Bank Act prohibits any one
interest from owning more than 20 percent of any class of voting shares.
10
V. Jog, P. C. Zhu, and S. Dutta, “Impact of Restricted Voting Share Structure on Firm Value and Performance,” Corporate
Governance: An International Review 18:5 (2010), 415–437.
14 Part 1 Overview
IN THEIR OWN WORDS

B. ESPEN ECKBO on corporate governance
The substantial growth in equity index investing over the easily swamps investment returns. As a result, they no
past twenty years has lowered average shareholder incen- longer show up to annual meetings and either vote with
tives to monitor the management of individual portfolio management or simply throw the proxy form in the
companies. The resulting shareholder absenteeism effec- wastebasket. The resulting combination of voluntary
tively transfers corporate control rights to increasingly shareholder absenteeism and strong corporate insid-
powerful corporate executives and other insiders. Today, ers creates a problem that lies at the heart of many
an important counterweight to this massive shift in the bal- of today’s governance controversies. An important his-
ance of power between the firm’s owners and managers is torical lesson is that the absentee shareholder system
a small set of active investors who occasionally decide to can breed arrogance on the part of corporate insid-
bear the cost of challenging incumbent management teams. ers. A vigorous corporate governance system is thus
In countries with highly developed financial systems, required to prevent shareholder rights being expropri-
much of the governance debate focuses on this shift in ated by insiders.
the balance of power between shareholders, boards, and A major task of the board is to hire and fire top manag-
top executives in widely held public companies. The bal- ers and to set their compensation. Therefore, corporate
ance is affected by four major factors, which tend to differ insiders come with an inherent conflict of interest when
greatly across countries: (1) The cost of taking legal action they sit on boards. Nevertheless, corporate insiders sit
and the strength of law enforcement. (2) The efficiency of on boards in major developed countries. In the United
the director election process and the cost of challeng- States, until twenty years ago, it was even common for the
ing and replacing directors. (3) The cost of shareholder chief executive officer (CEO) to occupy the post of board
activism and of transacting in the market for corporate chair. Several companies have since voluntarily replaced
control. (4) The political strength of employee unions. this practice with a split-chair role (using a combination
Early in a firm’s lifecycle, when share ownership is of CEO chair and a “lead” director) or a complete separa-
highly concentrated, this balance of power is hardly an tion of the roles of CEO and chair.
issue. However, as the company grows and prospers, In Europe, the tradition has been not to place the CEO
and founders diversify their initial investment by bring- in the chair, in some countries by statute. However, while
ing in new and smaller owners, the balance starts to non-executive members make up a clear majority of direc-
change. Corporate insiders, who themselves have much tors in the United States, there is a tradition in Europe for
of their human capital invested in the firm, increasingly placing a greater portion of employees on boards, which
view shareholders as a remote constituency and even as also raises conflict of interest issues.
irrelevant for the company on a daily basis. By choosing The typical defence of having insiders on boards is one
to diversify, shareholders for their part agree to play a of efficiency: the board requires CEO and other manage-
diminished role in the company’s affairs. ment input to make proper decisions. What this defence
For shareholders who diversify their investment leaves unanswered, however, is why the CEO needs a
across a broad portfolio of companies, the cost of vote on the board (let alone the chair) in order to supply
actively monitoring the performance of management the board with his or her information.
closely held corporations. However, shareholders have several control devices (some more effective
than others) to bond management to the self-interest of shareholders:
1. Shareholders determine the membership of the board of directors by voting. Thus, share-
holders control the directors, who in turn select the management team.
2. Contracts with management and arrangements for compensation, such as stock option
plans, can be made so that management has an incentive to pursue shareholders’ goals.
Similarly, management may be given loans to buy the firm’s shares.
3. If the price of a firm’s stock drops too low because of poor management, the firm may
be acquired by a group of shareholders, another firm, or an individual. This is called a
takeover. In a takeover, top management of the acquired firm may find itself out of a job.
For example, the CEO of Chapters Inc. lost his job when the bookseller was taken over by
Indigo in 2001. This pressures management to make decisions in the shareholders’ inter-
ests. Fear of a takeover gives managers an incentive to take actions that will maximize
stock prices.
It takes strong-willed character to resist the will of the “deadwood”), those very same executives sit on a board
CEO–chair, even for directors that meet technical criteria vested with powers to thwart the takeover. Are they likely
for independence. In today’s system, the vast majority of to put the interests of shareholders ahead of their own?
directors sit on boards because the CEO recommended Insiders have largely succeeded in blocking the right of
their appointment, so a certain loyalty can be expected. small shareholders to even sell their shares to someone
Research shows more generally that countries with a who wants to accumulate a controlling block of stock.
French civil law tradition—as opposed to British common A particularly effective defence is the so-called poison
law—rely primarily on banks to finance corporate growth. pill. The pill is triggered if an investor accumulates more
With poorly developed stock markets, and with creditors than (typically) 10 percent share ownership in the target
and employees having a major influence on boards, risk- company. When this happens, all shareholders except the
taking is muted. In addition to France, civil law countries 10 percent blockholder get to purchase new shares for,
with historically small stock markets but broad-based say, half their market value. It is equivalent to asking the
banking systems include Germany, the countries of Scan- 10 percent blockholder to pay a dividend to all the other
dinavia, Italy, Spain, Japan, South Korea, and China. These shareholders, financed out of the blockholder’s personal
economies are also characterized by insider-controlled wealth. Under the “business judgement” rule that is so
companies, corporate cross-holdings of voting stock, and central to the U.S. corporate governance system, boards
pyramidal ownership structures allowing founding fami- have wide powers to use such a blatantly unequal treat-
lies to maintain control. ment of shareholders as a takeover defence.
In contrast, countries with a common law tradition— The poison pill has proven extremely effective. Hos-
such as the United Kingdom, the United States, English tile takeovers, which in the period 1975 through 1985
Canada, Australia, and India—have developed a greater resulted in numerous restructurings of inefficiently run
reliance on external equity markets, resulting in a more companies, have come to a virtual standstill in the United
pronounced dispersion of share ownership and a more States. Since the poison pill became sanctioned by U.S.
specialized role for banks. Ultimately, international courts, however, virtually every major U.S. company has a
trade and the global competition for capital force a Dar- pill, and not a single bidder has chosen to break through
winian convergence of both civil law and common law this defence.
countries toward a system of corporate governance and Rather, in the wave of active investors over the past
finance that promotes maximum economic efficiency. decade, hedge funds have elected to purchase target
Countries with small stock markets today must prepare shares without triggering the pill, relying on the less
these markets for the influx of future pension savings. expensive proxy contest to challenge boards and incum-
In his best-selling book Economics, Nobel laureate bent management teams. This new practice leaves the
Paul Samuelson explains that “Takeovers, like bankruptcy, poison pill standing as a relic of state-sanctioned expro-
represent one of Nature’s methods of eliminating dead- priation of shareholder rights, continuing to harm the
wood.” In the case of a hostile takeover bid designed to efficiency of the corporate resource allocation through a
replace inefficient executives (presumably one form of hostile takeover mechanism.
B. Espen Eckbo is the Tuck Centennial Professor of Finance and founding director of the Center for Corporate Governance at the Tuck School of Business at Dartmouth College. b.espen.eckbo@dartmouth.edu. This
material is excerpted with permission from B. Espen Eckbo.
4. Competition in the managerial labour market may force managers to perform in the best
interest of shareholders; otherwise, they will be replaced. Firms willing to pay the most will
lure good managers. These are likely to be firms that compensate managers based on the
value they create for shareholders. Compensation design is far from perfect, however, and
many firms have come under intense criticism for having high rates of executive compen-
sation. Further, there is some evidence that such compensation schemes encouraged bank
executives to take on greater risk: banks with performance-based executive pay did worse
during the financial crisis.11
The available evidence and theory are consistent with the idea of shareholder control. How-
ever, there can be no doubt that at times, corporations pursue managerial goals at the expense
of shareholders. In addition to the issue of excessive executive compensation already discussed,
management may change the firm’s corporate governance rules by removing independent
11
R. Fahlenbrach and Rene Stulz, “Bank CEO Incentives and the Credit Crisis,” Journal of Financial Economics 99:1 (2011), 11–26.
16 Part 1 Overview
directors who might challenge management. Major pension funds, such as the Alberta Teach-
ers’ Retirement Fund Board and the Ontario Teachers’ Pension Plan Board, have joined with
professional money managers to form the Canadian Coalition for Good Governance. The
Coalition has set up detailed governance guidelines backed by action in voting its shares at
annual meetings.12
Stakeholders In addition to shareholders and management, employees, customers, suppliers, and

the public all have a financial interest in the firm and its decisions. This enlarged stakeholder group
may introduce alternative goals such as preserving the environment or avoiding alcohol, tobacco,
gambling, nuclear power, and military weapons. Stakeholder concerns are attaining additional clout
through the growth of interest in ethical or socially responsible investing. Such investors and ethical
investment mutual funds screen and select securities based on social or environmental criteria and
may utilize the services of Sustainalytics, which provides social responsibility ratings for Canadian
firms based on over 200 indicators covering stakeholder issues involving community and society,
customers, corporate governance, employees, environment, and human rights. Interest in socially
responsible investing is growing, and assets invested according to such guidelines in Canada have
increased to $1,505.8 billion from $459.5 billion over the 2006–15 period.13 This raises the question
of the performance of socially responsible investing, and the results to date are mixed. Most studies
find that socially responsible investment practices do not consistently affect portfolio returns and
risk. While this finding raises doubts over whether corporate social responsibility translates into a
financial advantage, it is at least consistent with the view that such practices do no harm: “investing
for the soul may not hurt the bottom line.”14 Given the mixed evidence, major Canadian institutional
investors, such as the Ontario Teachers’ Pension Plan and the Ontario Municipal Employees’ Retire-
ment System, pay careful attention to corporate social responsibility in selecting investments but
place financial considerations first.
CONCEPT • What are two types of agency costs?

QUESTIONS
• How are managers bonded to shareholders?
• What are some managerial goals?
• What is the set-of-contracts viewpoint?
• What is socially responsible investing?
1.5 FIN AN CIAL IN STI TU TI O NS, F I NA NC I A L M A RK ETS,

A N D T HE COR PO RATI O N
We have seen that the primary advantages of the corporate form of organization are that (1) owner-
ship can be transferred more quickly and easily than with other forms and (2) money can be raised
more readily. Both advantages are significantly enhanced by the existence of financial institutions
and markets. Financial markets play an extremely important role in corporate finance.
Financial Institutions
Financial institutions act as intermediaries between investors (funds suppliers) and firms raising
funds. (Federal and provincial governments and individuals also raise funds in financial markets,
but our examples will focus on firms.) Financial institutions justify their existence by providing
a variety of services that promote efficient allocation of funds. Canadian financial institutions
include chartered banks and other depository institutions (trust companies and credit unions) as
well as non-depository institutions (investment dealers, insurance companies, pension funds, and
mutual funds).15
12
http://www.ccgg.ca (accessed September 25, 2017).
13
https://www.riacanada.ca/trendsreport/ (accessed August 10, 2017).
14
A Canadian study supporting the view that socially responsible investing does not harm returns is P. Amundson and S. R.
Foerster, “Socially Responsible Investing: Better for Your Soul or Your Bottom Line?” Canadian Investment Review (Winter
2001), pp. 26–34. A U.S. meta-study surveying 25 published papers reached a similar conclusion: S. Rathner, “The Influence
of Primary Study Characteristics on the Performance Differential Between Socially Responsible and Conventional Investment
Funds: A Meta-Analysis,” Journal of Business Ethics 118 (2013), 349–363.
15
Our discussion of Canadian financial institutions builds on and updates the framework in L. Kryzanowski and G. S. Roberts,
“Bank Structure in Canada,” in Banking Structure in Major Countries, ed. G. G. Kaufman (Boston: Kluwer, 1992).
Table 1.2 ranks Canada’s top six chartered banks by total assets as of the second fiscal quarter of
2017. Because they are allowed to diversify by operating in all provinces, Canada’s chartered banks
are good sized on an international scale.
TABLE 1.2 The Largest Chartered Banks in Canada, Q2 2017

Rank by total assets Assets (in $ millions)
Toronto-Dominion Bank 1 1,251,920
Royal Bank of Canada 2 1,202,919
Bank of Nova Scotia 3 921,646
Bank of Montreal 4 718,943
Canadian Imperial Bank of Commerce 5 528,591
National Bank of Canada 6 239,020
Q2 reports are drawn from SEDAR, http://www.sedar.com/search/search_form_pc_en.htm.
Chartered banks operate under federal regulation, accepting deposits from suppliers of funds; mak-
ing commercial loans to mid-sized businesses, corporate loans to large companies, and personal loans
to individuals; and granting mortgages to individuals. Banks derive the majority of their income from
the spread between the interest paid on deposits and the higher rate earned on loans. This process is
called indirect finance because banks receive funds in the form of deposits and engage in a separate
lending contract with funds demanders. The top panel of Figure 1.6 illustrates indirect finance.
FIGURE 1.6
Two Types of Finance
Deposits Financial Loans Funds

Funds suppliers Indirect finance
intermediaries demanders
Financial Funds
Funds suppliers Direct finance
intermediaries demanders
Chartered banks also provide other services that generate fees instead of earning spread income.
For example, a large corporate customer seeking short-term debt funding can borrow directly from
another large corporation with funds to supply through a banker’s acceptance. This is an interest-
bearing IOU that is stamped by a bank guaranteeing the borrower’s credit. Instead of spread income,
the bank receives a stamping fee. Banker’s acceptances are an example of direct finance, as illus-
trated in the lower panel of Figure 1.6. Notice that in this case, funds do not pass through the bank’s
balance sheet in the form of a deposit and loan. This is often called securitization because a security
(the banker’s acceptance) is created.
Trust companies also accept deposits and make loans. In addition, trust companies engage in fidu-
ciary activities—managing assets for estates, registered retirement savings plans, and so on. Banks own
all the major trust companies. Like trust companies, credit unions also accept deposits and make loans.
Investment dealers are non-depository institutions that assist firms in issuing new securities
in exchange for fee income. Investment dealers also aid investors in buying and selling securities.
Chartered banks own majority stakes in Canada’s top investment dealers.
Insurance companies include property and casualty insurance as well as health and life insur-
ance companies. Life insurance companies make loans and accept funds in a form similar to deposits.
Pension funds invest contributions from employers and employees in securities offered by finan-
cial markets. Mutual funds pool individual investments to purchase a diversified portfolio of securities.
We base this survey of the principal activities of financial institutions on their main activities
today. Recent deregulation allows chartered banks, insurance companies, and investment dealers to
engage in most activities of the others with one exception: chartered banks are not allowed to sell life
18 Part 1 Overview
insurance through their branch networks. Currently, banks sell insurance through their subsidiaries,
which use a variety of permitted channels, such as the Internet. In August 2009, the Bank of Nova
Scotia established a separate subsidiary, Scotia Life Financial, which then set up an office next to
one of the bank branches in order to sell insurance products. The federal government intends, how-
ever, to stop banks from using the Internet to promote and sell insurance products on their websites.
Although not every institution plans to become a one-stop financial supermarket, the different types
of institutions will likely continue to become more alike.
Like financial institutions, financial markets differ. Principal differences concern the types of
securities that are traded, how trading is conducted, and who the buyers and sellers are. Some of
these differences are discussed next.
Money Versus Capital Markets

Financial markets can be classified as either money markets or capital markets. Short-term debt secu-
rities of many varieties are bought and sold in money markets. These short-term debt securities are
often called money-market instruments. For example, a banker’s acceptance represents short-term
borrowing by large corporations and is a money-market instrument. Treasury bills are promissory
notes of the Government of Canada. Capital markets are the markets for long-term debt and shares
of stock, so the Toronto Stock Exchange, for example, is a capital market.
The money market is a dealer market. Generally speaking, dealers buy and sell something for
themselves at their own risk. A car dealer, for example, buys and sells automobiles. In contrast, bro-
kers and agents match buyers and sellers, but they do not actually own the commodity. A real estate
agent or broker, for example, does not normally buy and sell houses.
The largest money-market dealers are chartered banks and investment dealers. Their trading
facilities, along with other market participants, are connected electronically via telephone and
computer so the money market has no actual physical location.
Primary Versus Secondary Markets

Financial markets function as both primary and secondary markets for debt and equity securities. The
term primary market refers to the original sale of securities by governments and corporations. The
secondary markets are those where these securities are bought and sold after the original sale. Equi-
ties are, of course, issued solely by corporations. Debt securities are issued by both governments and
corporations. The following discussion focuses on corporate securities only.
Primary Markets In a primary market transaction, the corporation is the seller and raises money
through the transaction. For example, in 1999 and early 2000, many untested dot-com companies
issued public shares for the first time in initial public offerings (IPOs). Corporations engage in two
types of primary market transactions: public offerings and private placements. A public offering, as
the name suggests, involves selling securities to the general public, while a private placement is a
negotiated sale involving a specific buyer. These topics are detailed in Chapters 20 and 21, so we only
introduce the bare essentials here.
Most publicly offered debt and equity securities are underwritten. In Canada, underwriting
is conducted by investment dealers specializing in marketing securities. Three of Canada’s largest
underwriters are RBC Dominion, CIBC World Markets, and TD Securities Inc.
When a public offering is underwritten, an investment dealer or a group of investment dealers (called
a syndicate) typically purchases the securities from the firm and markets them to the public. The underwrit-
ers hope to profit by reselling the securities to investors at a higher price than they paid the firm for them.
By law, public offerings of debt and equity must be registered with provincial authorities, the
most important being the Ontario Securities Commission (OSC). Registration requires the firm
to disclose a great deal of information before selling any securities. The accounting, legal, and
underwriting costs of public offerings can be considerable.
Partly to avoid the various regulatory requirements and the expense of public offerings, debt
and equity are often sold privately to large financial institutions such as life insurance companies and
pension funds. Such private placements do not have to be registered with the OSC and do not require
the involvement of underwriters.
Secondary Markets A secondary market transaction involves one owner or creditor selling to
another. It is therefore the secondary markets that provide the means for transferring ownership of
corporate securities. There are two kinds of secondary markets: auction markets and dealer markets.
Dealer markets in stocks and long-term debt are called over-the-counter (OTC) markets. Today,
like the money market, a significant fraction of the market for stocks and all of the market for long-
term debt has no central location; the many dealers are connected electronically. NASDAQ in the
United States is a well-known OTC market. As Table 1.3 shows, it is the second-largest stock mar-
ket in the world. The name comes from the National Association of Securities Dealers (NASD),
which sets up the automated quotation (AQ) system. Many smaller technology stocks are listed on
NASDAQ, and the NASDAQ 100 index reflects the rise and fall of tech stocks.
The Largest Stock Markets in the World by Market Capitalization, as

TABLE 1.3
of June 2017
Market value (in US$ millions) Rank in 2017
NYSE 20,658,990.5 1
NASDAQ 8,745,952.4 2
Japan Exchange Group 5,501,975.5 3
Shanghai Stock Exchange 4,536,956.3 4
Euronext 4,034,233.5 5
LSE Group 4,004,811.9 6
Hong Kong Exchanges and Clearing 3,674,302.8 7
Shenzhen Stock Exchange 3,347,500.0 8
TMX Group 2,128,057.5 9
Deutsche Börse AG 1,993,797.0 10
Source: © 2017 WFE - The World Federation of Exchanges. All Rights Reserved. http://www.world-exchanges.org/statistics
/monthly-reports. Used with permission.
The equity shares of most large firms in Canada trade in organized auction and dealer markets.
The largest stock market in Canada is the Toronto Stock Exchange (TSX). Table 1.3 shows the top
10 stock exchanges in the world in 2017. The TMX, which owns and operates the TSX, ranked ninth.
Smaller exchanges in Canada include the Montreal Exchange and the TSX Venture, which consists
primarily of small oil and gas, mining, IT, and biotechnology companies that do not have the market
capitalization to list on the TSX.
Auction markets differ from dealer markets in two ways. First, an auction market or exchange,
unlike a dealer market, has a physical location (like Bay Street or Wall Street). Second, in a dealer mar-
ket, most buying and selling is done by the dealer. The primary purpose of an auction market, on the
other hand, is to match those who wish to sell with those who wish to buy. Dealers play a limited role.
For example, the TSX has computerized its floor trading, replacing the trading floor with a wide-area
computer network. This technological shift makes the TSX a hybrid of auction and dealer markets.
Listing
Stocks that trade on an organized exchange are said to be listed on that exchange. Companies seek
exchange listing in order to enhance the liquidity of their shares, making them more attractive to
investors by facilitating raising equity.16 To enhance liquidity benefits, companies can engage in cross-
listing—the act of listing on domestic and foreign exchanges—which generally provides for higher
security valuations. This effect is most notably seen with foreign firms that cross-list in the United
States.17 To be listed, firms must meet certain minimum criteria concerning, for example, the number
of shares and shareholders and the market value. These criteria differ for different exchanges. To be
listed on the TSX, a company must have at least 1 million shares trading, at least 300 public share-
holders, and a market value of $4 million. Smaller companies may list on the TSX Venture Exchange,
which has less stringent requirements while offering access to the benefits of exchange listing.
Listed companies face significant disclosure requirements. Particularly relevant for Canadian
companies listing in the United States is the Sarbanes-Oxley Act of 2002. The act, better known as
“Sarbox” or “SOX,” is intended to protect investors from corporate abuses. For example, one sec-
tion of Sarbox prohibits personal loans from a company to its officers, such as the loans that were
received by WorldCom CEO Bernie Ebbers.
16
Two relevant studies of Canadian companies listing in the United States are S. R. Foerster and G. A. Karolyi, “The Effects of Market
Segmentation and Investor Recognition on Asset Prices: Evidence From Foreign Listings in the U.S.,” Journal of Finance 54 (June
1999), 981–1013, and U. R. Mittoo, “The Winners and Losers of Listings in the U.S.,” Canadian Investment Review (Fall 1998), 13–17.
17
Michael R. King and Dan Segal, “The Long-Term Effects of Cross-Listing, Investor Recognition, and Ownership Structure on
Valuation,” Review of Financial Studies 22 (2009), 2393–2421.
20 Part 1 Overview
Section 404 of Sarbox requires, among other things, that each company’s annual report have an
assessment of the company’s internal control structure and financial reporting. The auditor must then
evaluate and attest to management’s assessment of these issues.
Sarbox contains other key requirements. For example, the officers of the corporation must
review and sign the annual reports. They must explicitly declare that the annual report does not
contain any false statements or material omissions, that the financial statements fairly represent the
financial results, and that they are responsible for all internal controls. Finally, the annual report must
list any deficiencies in internal controls. In essence, Sarbox makes company management responsible
for the accuracy of the company’s financial statements.
Of course, as with any law, there are compliance costs, and Sarbox has increased the cost of
corporate audits, sometimes dramatically. In 2004, the average compliance cost for large firms was
$4.51 million. By 2007, the average compliance cost had fallen to $1.7 million, so the burden seems
to be easing, but it is still not trivial, particularly for a smaller firm.
In Canada, governance follows a comply-or-explain regime, which requires good governance and
disclosure, but does not mandate compliance with the recommendations. In June 2005, Canada intro-
duced National Policy 58-201 and National Instrument 58-101, which enhance disclosure requirements
and require firms to outline areas in which they do not comply and to explain how they plan to reach the
objectives of the recommendation. Similar to the effects of Sarbox, the policies of 2005 have improved
the corporate governance practices of Canadian firms and increased uniformity of compliance.18
In 2011, Canada moved to the IFRS accounting standards used by public enterprises in other
parts of the world. This makes company financial information provided to regulators and sharehold-
ers more comparable and transparent. As a result, Canadian companies should have easier access to
international capital, funding, and investment opportunities.
Foreign Exchange Market

The foreign exchange market is undoubtedly the world’s largest financial market. It is the market
where one country’s currency is traded for another’s. Most of the trading takes place in a few cur-
rencies: the U.S. dollar ($), the euro (€), the British pound sterling (£), the Japanese yen (¥), and the
Swiss franc (SF).
The foreign exchange market is an OTC market. There is no single location where traders get
together. Instead, traders are located in the major commercial and investment banks around the world.
They communicate using computer terminals, telephones, and other telecommunication devices.
One element in the communications network for foreign transactions is the Society for Worldwide
Interbank Financial Telecommunications (SWIFT), a Belgian not-for-profit cooperative. A bank
in Toronto can send messages to a bank in London via SWIFT’s regional processing centres.
The connections are through data-transmission lines.
The many different types of participants in the foreign exchange market include the following:
1. Importers converting their domestic currency to foreign currency to pay for goods from
foreign countries.
2. Exporters receiving foreign currency and wanting to convert to the domestic currency.
3. Portfolio managers buying and selling foreign stocks and bonds.
4. Foreign exchange brokers matching buy and sell orders.
5. Traders making the market in foreign exchange.
CONCEPT • Distinguish between money markets and capital markets.

QUESTIONS
• What is listing?
• What is the difference between a primary market and a secondary market?
• What are the principal types of financial institutions in Canada? What is the principal
role of each?
• What are direct and indirect finance? How do they differ?
• What is a dealer market? How do dealer and auction markets differ?
• What is the largest auction market in Canada?
18
Additional readings: K. MacAulay, S. Dutta, M. Oxner, and T. Hynes, “The Impact of a Change in Corporate Governance
Regulations on Firms in Canada,” Quarterly Journal of Finance and Accounting 48:4 (2009), 29–52.
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come will never more see an epic. One race may grow feeble and
decrepit and be unable to do any more work; but another may take
its place. After a time the Greek and Latin writers found that they had
no more to say; and a critic belonging to either nationality might have
shaken his head and said that all the great themes had been used
up and all the great ideas expressed; nevertheless, Dante,
Cervantes, Molière, Schiller, Chaucer, and Scott, then all lay in the
future.
Again, Mr. Pearson speaks of statecraft at the present day as
offering fewer prizes, and prizes of less worth than formerly, and as
giving no chance for the development of men like Augustus Cæsar,
Richelieu, or Chatham. It is difficult to perceive how these men can
be considered to belong to a different class from Bismarck, who is
yet alive; nor do we see why any English-speaking people should
regard a statesman like Chatham, or far greater that Chatham, as an
impossibility nowadays or in the future. We Americans at least will
with difficulty be persuaded that there has ever been a time when a
nobler prize of achievement, suffering, and success was offered to
any statesman than was offered both to Washington and to Lincoln.
So, when Mr. Pearson speaks of the warfare of civilized countries
offering less chance to the individual than the warfare of savage and
barbarous times, and of its being far less possible now than in old
days for a man to make his personal influence felt in warfare, we can
only express our disagreement. No world-conqueror can arise save
in or next to highly civilized States. There never has been a
barbarian Alexander or Cæsar, Hannibal or Napoleon. Sitting Bull
and Rain-in-the-Face compare but ill with Von Moltke; and no Norse
king of all the heroic viking age even so much as began to exercise
the influence upon the warfare of his generation that Frederick the
Great exercised on his.
It is not true that character of necessity decays with the growth of
civilization. It may, of course, be true in some cases. Civilization may
tend to develop upon the lines of Byzantine, Hindoo, and Inca; and
there are sections of Europe and sections of the United States where
we now tend to pay heed exclusively to the peaceful virtues and to
develop only a race of merchants, lawyers, and professors, who will
lack the virile qualities that have made our race great and splendid.
This development may come, but it need not come necessarily, and,
on the whole, the probabilities are against its coming at all.
Mr. Pearson is essentially a man of strength and courage. Looking
into the future, the future seems to him gray and unattractive; but he
does not preach any unmanly gospel of despair. He thinks that in
time to come, though life will be freer than in the past from dangers
and vicissitudes, yet it will contain fewer of the strong pleasures and
of the opportunities for doing great deeds that are so dear to mighty
souls. Nevertheless, he advises us all to front it bravely whether our
hope be great or little; and he ends his book with these fine
sentences: “Even so, there will still remain to us ourselves. Simply to
do our work in life, and to abide the issue, if we stand erect before
the eternal calm as cheerfully as our fathers faced the eternal unrest,
may be nobler training for our souls than the faith in progress.”
We do not agree with him that there will be only this eternal calm
to face; we do not agree with him that the future holds for us a time
when we shall ask nothing from the day but to live, nor from the
future but that we may not deteriorate. We do not agree with him that
there is a day approaching when the lower races will predominate in
the world and the higher races will have lost their noblest elements.
But after all, it matters little what view we take of the future if, in our
practice, we but do as he preaches, and face resolutely whatever
fate may have in store. We, ourselves, are not certain that progress
is assured; we only assert that it may be assured if we but live wise,
brave, and upright lives. We do not know whether the future has in
store for us calm or unrest. We cannot know beyond peradventure
whether we can prevent the higher races from losing their nobler
traits and from being overwhelmed by the lower races. On the whole,
we think that the greatest victories are yet to be won, the greatest
deeds yet to be done, and that there are yet in store for our peoples
and for the causes that we uphold grander triumphs than have ever
yet been scored. But be this as it may, we gladly agree that the one
plain duty of every man is to face the future as he faces the present,
regardless of what it may have in store for him, and, turning toward
the light as he sees the light, to play his part manfully, as a man
among men.
FOOTNOTES:
[21] The Sewanee Review, August, 1894.
XIV
“SOCIAL EVOLUTION”[22]
Mr. Kidd’s Social Evolution is a suggestive, but a very crude book;

for the writer is burdened by a certain mixture of dogmatism and
superficiality, which makes him content to accept half truths and
insist that they are whole truths. Nevertheless, though the book
appeals chiefly to minds of the kind which are uncharitably described
as “half-baked,” Mr. Kidd does suggest certain lines of thought which
are worth following—though rarely to his conclusions.
He deserves credit for appreciating what he calls “the outlook.” He
sketches graphically, and with power, the problems which now loom
up for settlement before all of us who dwell in Western lands; and he
portrays the varying attitudes of interest, alarm, and hope with which
the thinkers and workers of the day regard these problems. He
points out that the problems which now face us are by no means
parallel to those that were solved by our forefathers one, two, or
three centuries ago. The great political revolutions seem to be about
complete and the time of the great social revolutions has arrived. We
are all peering eagerly into the future to try to forecast the action of
the great dumb forces set in operation by the stupendous industrial
revolution which has taken place during the present century. We do
not know what to make of the vast displacements of population, the
expansion of the towns, the unrest and discontent of the masses,
and the uneasiness of those who are devoted to the present order of
things.
Mr. Kidd sees these problems, but he gropes blindly when he tries
to forecast their solution. He sees that the progress of mankind in
past ages can only have been made under and in accordance with
certain biological laws, and that these laws continue to work in
human society at the present day. He realizes the all-importance of
the laws which govern the reproduction of mankind from generation
to generation, precisely as they govern the reproduction of the lower
animals, and which, therefore, largely govern his progress. But he
makes a cardinal mistake in treating of this kind of progress. He
states with the utmost positiveness that, left to himself, man has not
the slightest innate tendency to make any onward progress
whatever, and that if the conditions of life allowed each man to follow
his own inclinations the average of one generation would always
tend to sink below the average of the preceding. This is one of the
sweeping generalizations of which Mr. Kidd is fond, and which mar
so much of his work. He evidently finds great difficulty in stating a
general law with the proper reservations and with the proper
moderation of phrase; and so he enunciates as truths statements
which contain a truth, but which also contain a falsehood. What he
here says is undoubtedly true of the world, taken as a whole. It is in
all probability entirely false of the highest sections of society. At any
rate, there are numerous instances where the law he states does not
work; and of course a single instance oversets a sweeping
declaration of such a kind.
There can be but little quarrel with what Mr. Kidd says as to the
record of the world being a record of ceaseless progress on the one
hand, and ceaseless stress and competition on the other; although
even here his statement is too broad, and his terms are used
carelessly. When he speaks of progress being ceaseless, he
evidently means by progress simply change, so that as he uses the
word it must be understood to mean progress backward as well as
forward. As a matter of fact, in many forms of life and for long ages
there is absolutely no progress whatever and no change, the forms
remaining practically stationary.
Mr. Kidd further points out that the first necessity for every
successful form engaged in this struggle is the capacity for
reproduction beyond the limits for which the conditions of life
comfortably provide, so that competition and selection must not only
always accompany progress, but must prevail in every form of life
which is not actually retrograding. As already said, he accepts
without reservation the proposition that if all the individuals of every
generation in any species were allowed to propagate their kind
equally, the average of each generation would tend to fall below the
preceding.
From this position he draws as a corollary, that the wider the limits
of selection, the keener the rivalry and the more rigid the selection,
just so much greater will be the progress; while for any progress at
all there must be some rivalry in selection, so that every progressive
form must lead a life of continual strain and stress as it travels its
upward path. This again is true in a measure, but is not true as
broadly as Mr. Kidd has stated it. The rivalry of natural selection is
but one of the features in progress. Other things being equal, the
species where this rivalry is keenest will make most progress; but
then “other things” never are equal. In actual life those species make
most progress which are farthest removed from the point where the
limits of selection are very wide, the selection itself very rigid, and
the rivalry very keen. Of course the selection is most rigid where the
fecundity of the animal is greatest; but it is precisely the forms which
have most fecundity that have made least progress. Some time in
the remote past the guinea pig and the dog had a common ancestor.
The fecundity of the guinea pig is much greater than that of the dog.
Of a given number of guinea pigs born, a much smaller proportion
are able to survive in the keen rivalry, so that the limits of selection
are wider, and the selection itself more rigid; nevertheless the
progress made by the progenitors of the dog since eocene days has
been much more marked and rapid than the progress made by the
progenitors of the guinea pig in the same time.
Moreover, in speaking of the rise that has come through the stress
of competition in our modern societies, and of the keenness of this
stress in the societies that have gone fastest, Mr. Kidd overlooks
certain very curious features in human society. In the first place he
speaks as though the stress under which nations make progress
was primarily the stress produced by multiplication beyond the limits
of subsistence. This, of course, would mean that in progressive
societies the number of births and the number of deaths would both
be at a maximum, for it is where the births and deaths are largest
that the struggle for life is keenest. If, as Mr. Kidd’s hypothesis
assumes, progress was most marked where the struggle for life was
keenest, the European peoples standing highest in the scale would
be the South Italians, the Polish Jews, and the people who live in the
congested districts of Ireland. As a matter of fact, however, these are
precisely the peoples who have made least progress when
compared with the dominant strains among, for instance, the English
or Germans. So far is Mr. Kidd’s proposition from being true that,
when studied in the light of the facts, it is difficult to refrain from
calling it the reverse of the truth. The race existing under conditions
which make the competition for bare existence keenest, never
progresses as fast as the race which exists under less stringent
conditions. There must undoubtedly be a certain amount of
competition, a certain amount of stress and strain, but it is equally
undoubted that if this competition becomes too severe the race goes
down and not up; and it is further true that the race existing under
the severest stress as regards this competition often fails to go
ahead as fast even in population as does the race where the
competition is less severe. No matter how large the number of births
may be, a race cannot increase if the number of deaths also grows
at an accelerating rate.
To increase greatly a race must be prolific, and there is no curse
so great as the curse of barrenness, whether for a nation or an
individual. When a people gets to the position even now occupied by
the mass of the French and by sections of the New Englanders,
where the death rate surpasses the birth rate, then that race is not
only fated to extinction but it deserves extinction. When the capacity
and desire for fatherhood and motherhood is lost the race goes
down, and should go down; and we need to have the plainest kind of
plain speaking addressed to those individuals who fear to bring
children into the world. But while this is all true, it remains equally
true that immoderate increase in no way furthers the development of
a race, and does not always help its increase even in numbers. The
English-speaking peoples during the past two centuries and a half
have increased faster than any others, yet there have been many
other peoples whose birth rate during the same period has stood
higher.
Yet, again, Mr. Kidd, in speaking of the stress of the conditions of
progress in our modern societies fails to see that most of the stress
to which he refers does not have anything to do with increased
difficulty in obtaining a living, or with the propagation of the race. The
great prizes are battled for among the men who wage no war
whatever for mere subsistence, while the fight for mere subsistence
is keenest among precisely the classes which contribute very little
indeed to the progress of the race. The generals and admirals, the
poets, philosophers, historians and musicians, the statesmen and
judges, the law-makers and law-givers, the men of arts and of
letters, the great captains of war and of industry—all these come
from the classes where the struggle for the bare means of
subsistence is least severe, and where the rate of increase is
relatively smaller than in the classes below. In civilized societies the
rivalry of natural selection works against progress. Progress is made
in spite of it, for progress results not from the crowding out of the
lower classes by the upper, but on the contrary from the steady rise
of the lower classes to the level of the upper, as the latter tend to
vanish, or at most barely hold their own. In progressive societies it is
often the least fit who survive; but, on the other hand, they and their
children often tend to grow more fit.
The mere statement of these facts is sufficient to show not only
how incorrect are many of Mr. Kidd’s premises and conclusions, but
also how unwarranted are some of the fears which he expresses for
the future. It is plain that the societies and sections of societies
where the individual’s happiness is on the whole highest, and where
progress is most real and valuable, are precisely these where the
grinding competition and the struggle for mere existence is least
severe. Undoubtedly in every progressive society there must be a
certain sacrifice of individuals, so that there must be a certain
proportion of failures in every generation; but the actual facts of life
prove beyond shadow of doubt that the extent of this sacrifice has
nothing to do with the rapidity or worth of the progress. The nations
that make most progress may do so at the expense of ten or fifteen
individuals out of a hundred, whereas the nations that make least
progress, or even go backwards, may sacrifice almost every man out
of the hundred.
This last statement is in itself partly an answer to the position
taken by Mr. Kidd, that there is for the individual no “rational
sanction” for the conditions of progress. In a progressive community,
where the conditions provide for the happiness of four-fifths or nine-
tenths of the people, there is undoubtedly a rational sanction for
progress both for the community at large and for the great bulk of its
members; and if these members are on the whole vigorous and
intelligent, the attitude of the smaller fraction who have failed will be
a matter of little consequence. In such a community the conflict
between the interests of the individual and the organism of which he
is a part, upon which Mr. Kidd lays so much emphasis, is at a
minimum. The stress is severest, the misery and suffering greatest,
among precisely the communities which have made least progress—
among the Bushmen, Australian black fellows, and root-digger
Indians, for instance.
Moreover, Mr. Kidd does not define what he means by “rational
sanction.” Indeed one of his great troubles throughout is his failure to
make proper definitions, and the extreme looseness with which he
often uses the definitions he does make. Apparently by “rational” he
means merely selfish, and proceeds upon the assumption that
“reason” must always dictate to every man to do that which will give
him the greatest amount of individual gratification at the moment, no
matter what the cost may be to others or to the community at large.
This is not so. Side by side with the selfish development in life there
has been almost from the beginning a certain amount of unselfish
development too; and in the evolution of humanity the unselfish side
has, on the whole, tended steadily to increase at the expense of the
selfish, notably in the progressive communities about whose future
development Mr. Kidd is so ill at ease. A more supreme instance of
unselfishness than is afforded by motherhood cannot be imagined;
and when Mr. Kidd implies, as he does very clearly, that there is no
rational sanction for the unselfishnsess of motherhood, for the
unselfishness of duty, or loyalty, he merely misuses the word
rational. When a creature has reached a certain stage of
development it will cause the female more pain to see her offspring
starve than to work for it, and she then has a very rational reason for
so working. When humanity has reached a certain stage it will cause
the individual more pain, a greater sense of degradation and shame
and misery, to steal, to murder, or to lie, than to work hard and suffer
discomfort. When man has reached this stage he has a very rational
sanction for being truthful and honest. It might also parenthetically be
stated that when he has reached this stage he has a tendency to
relieve the sufferings of others, and he has for this course the
excellent rational sanction that it makes him more uncomfortable to
see misery unrelieved than it does to deny himself a little in order to
relieve it.
However, we can cordially agree with Mr. Kidd’s proposition that
many of the social plans advanced by would-be reformers in the
interest of oppressed individuals are entirely destructive of all growth
and of all progress in society. Certain cults, not only Christian, but
also Buddhistic and Brahminic, tend to develop an altruism which is
as “supra-natural” as Mr. Kidd seemingly desires religion to be; for it
really is without foundation in reason, and therefore to be
condemned.
Mr. Kidd repeats again and again that the scientific development of
the nineteenth century confronts us with the fact that the interests of
the social organism and of the individual are, and must remain,
antagonistic, and the latter predominant, and that there can never be
found any sanction in individual reason for individual good conduct in
societies where the conditions of progress prevail. From what has
been said above it is evident that this statement is entirely without
basis, and therefore that the whole scheme of mystic and highly
irrational philosophy which he founds upon it at once falls to the
ground. There is no such necessary antagonism as that which he
alleges. On the contrary, in the most truly progressive societies, even
now, for the great mass of the individuals composing them the
interests of the social organism and of the individual are largely
identical instead of antagonistic; and even where this is not true,
there is a sanction of individual reason, if we use the word reason
properly, for conduct on the part of the individual which is
subordinate to the welfare of the general society.
We can measure the truth of his statements by applying them, not
to great societies in the abstract, but to small social organisms in the
concrete. Take for instance the life of a regiment or the organization
of a police department or fire department. The first duty of a regiment
is to fight, and fighting means the death and disabling of a large
proportion of the men in the regiment. The case against the identity
of interests between the individual and the organism, as put by Mr.
Kidd, would be far stronger in a regiment than in any ordinary
civilized society of the day. Yet as a matter of fact we know that in
the great multitude of regiments there is much more subordination of
the individual to the organism than is the case in any civilized state
taken as a whole. Moreover, this subordination is greatest in
precisely those regiments where the average individual is best off,
because it is greatest in those regiments where the individual feels
that high, stern pride in his own endurance and suffering, and in the
great name of the organism of which he forms a part, that in itself
yields one of the loftiest of all human pleasures. If Mr. Kidd means
anything when he says that there is no rational sanction for progress
he must also mean that there is no rational sanction for a soldier not
flinching from the enemy when he can do so unobserved, for a
sentinel not leaving his post, for an officer not deserting to the
enemy. Yet when he says this he utters what is a mere jugglery on
words. In the process of evolution men and societies have often
reached such a stage that the best type of soldier or citizen feels
infinitely more shame and misery from neglect of duty, from
cowardice or dishonesty, from selfish abandonment of the interests
of the organism of which he is part, than can be offset by the
gratification of any of his desires. This, be it also observed, often
takes place, entirely independent of any religious considerations.
The habit of useful self-sacrifice may be developed by civilization in
a great society as well as by military training in a regiment. The habit
of useless self-sacrifice may also, unfortunately, be developed; and
those who practice it are but one degree less noxious than the
individuals who sacrifice good people to bad.
The religious element in our development is that on which Mr. Kidd
most strongly dwells, entitling it “the central feature of human
history.” A very startling feature of his treatment is that in religious
matters he seemingly sets no value on the difference between truth
and falsehood, for he groups all religions together. In a would-be
teacher of ethics such an attitude warrants severe rebuke; for it is
essentially dishonest and immoral. Throughout his book he treats all
religious beliefs from the same standpoint, as if they were all
substantially similar and substantially of the same value; whereas it
is, of course, a mere truism to say that most of them are mutually
destructive. Not only has he no idea of differentiating the true from
the false, but he seems not to understand that the truth of a
particular belief is of any moment. Thus he says, in speaking of the
future survival of religious beliefs in general, that the most notable
result of the scientific revolution begun by Darwin must be “to
establish them on a foundation as broad, deep, and lasting as any
the theologians ever dreamed of.” If this sentence means anything it
means that all these religious beliefs will be established on the same
foundation. It hardly seems necessary to point out that this cannot be
the fact. If the God of the Christians be in very truth the one God,
and if the belief in Him be established, as Christians believe it will,
then the foundation for the religious belief in Mumbo Jumbo can be
neither broad, deep, nor lasting. In the same way the beliefs in
Mohammed and Buddha are mutually exclusive, and the various
forms of ancestor worship and fetichism cannot all be established on
a permanent basis, as they would be according to Mr. Kidd’s theory.
Again, when Mr. Kidd rebukes science for its failure to approach
religion in a scientific spirit he shows that he fails to grasp the full
bearing of the subject which he is considering. This failure comes in
part from the very large, not to say loose, way in which he uses the
words “science” and “religion.” There are many sciences and many
religions, and there are many different kinds of men who profess the
one or advocate the other. Where the intolerant professors of a given
religious belief endeavor by any form of persecution to prevent
scientific men of any kind from seeking to find out and establish the
truth, then it is quite idle to blame these scientific men for attacking
with heat and acerbity the religious belief which prompts such
persecution. The exigencies of a life and death struggle unfit a man
for the coldness of a mere scientific inquiry. Even the most
enthusiastic naturalist, if attacked by a man-eating shark, would be
much more interested in evading or repelling the attack than in
determining the precise specific relations of the shark. A less
important but amusing feature of his argument is that he speaks as if
he himself had made an entirely new discovery when he learned of
the important part played in man’s history by his religious beliefs. But
Mr. Kidd surely cannot mean this. He must be aware that all the
great historians have given their full importance to such religious
movements as the birth and growth of Christianity, the Reformation,
the growth of Islamism, and the like. Mr. Kidd is quite right in insisting
upon the importance of the part played by religious beliefs, but he
has fallen into a vast error if he fails to understand that the great
majority of the historical and sociological writers have given proper
weight to this importance.
Mr. Kidd’s greatest failing is his tendency to use words in false
senses. He uses “reason” in the false sense “selfish.” He then, in a
spirit of mental tautology, assumes that reason must be necessarily
purely selfish and brutal. He assumes that the man who risks his life
to save a friend, the woman who watches over a sick child, and the
soldier who dies at his post, are unreasonable, and that the more
their reason is developed the less likely they will be to act in these
ways. The mere statement of the assertion in such a form is
sufficient to show its nonsense to any one who will take the pains to
think whether the people who ordinarily perform such feats of self-
sacrifice and self-denial are people of brutish minds or of fair
intelligence.
If none of the ethical qualities are developed at the same time with
a man’s reason, then he may become a peculiarly noxious kind of
wild beast; but this is not in the least a necessity of the development
of his reason. It would be just as wise to say that it was a necessity
of the development of his bodily strength. Undoubtedly the man with
reason who is selfish and unscrupulous will, because of his added
power, behave even worse than the man without reason who is
selfish and unscrupulous; but the same is true of the man of vast
bodily strength. He has power to do greater harm to himself and to
others; but, because of this, to speak of bodily strength or of reason
as in itself “profoundly anti-social and anti-evolutionary” is
foolishness. Mr. Kidd, as so often, is misled by a confusion of names
for which he is himself responsible. The growth of rationalism,
unaccompanied by any growth in ethics or morality, works badly. The
society in which such a growth takes place will die out, and ought to
die out. But this does not imply that other communities quite as
intelligent may not also be deeply moral and be able to take firm root
in the world.
Mr. Kidd’s definitions of “supra-natural” and “ultra-rational”
sanctions, the definitions upon which he insists so strongly and at
such length, would apply quite as well to every crazy superstition of
the most brutal savage as to the teachings of the New Testament.
The trouble with his argument is that, when he insists upon the
importance of this ultra-rational sanction, defining it as loosely as he
does, he insists upon too much. He apparently denies that men can
come to a certain state at which it will be rational for them to do right
even to their own hurt. It is perfectly possible to build up a civilization
which, by its surroundings and by its inheritances, working through
long ages, shall make the bulk of the men and women develop such
characteristics of unselfishness, as well as of wisdom, that it will be
the rational thing for them as individuals to act in accordance with
the highest dictates of honor and courage and morality. If the
intellectual development of such a civilized community goes on at an
equal pace with the ethical, it will persistently war against the
individuals in whom the spirit of selfishness, which apparently Mr.
Kidd considers the only rational spirit, shows itself strongly. It will
weed out these individuals and forbid them propagating, and
therefore will steadily tend to produce a society in which the rational
sanction for progress shall be identical in the individual and the
State. This ideal has never yet been reached, but long steps have
been taken towards reaching it; and in most progressive civilizations
it is reached to the extent that the sanction for progress is the same
not only for the State but for each one of the bulk of the individuals
composing it. When this ceases to be the case progress itself will
generally cease and the community ultimately disappear.
Mr. Kidd, having treated of religion in a preliminary way, and with
much mystic vagueness, then attempts to describe the functions of
religious belief in the evolution of society. He has already given
definitions of religion quoted from different authors, and he now
proceeds to give his own definition. But first he again insists upon his
favorite theory, that there can be no rational basis for individual good
conduct in society, using the word rational, according to his usual
habit, as a synonym of selfish; and then asserts that there can be no
such thing as a rational religion. Apparently all that Mr. Kidd
demands on this point is that it shall be what he calls ultra-rational, a
word which he prefers to irrational. In other words he casts aside as
irrelevant all discussion as to a creed’s truth.
Mr. Kidd then defines religion as being “a form of belief providing
an ultra-rational sanction for that large class of conduct in the
individual where his interests and the interests of the social organism
are antagonistic, and by which the former are rendered subordinate
to the latter in the general interest of the evolution which the race is
undergoing,” and says that we have here the principle at the base of
all religions. Of course this is simply not true. All those religions
which busy themselves exclusively with the future life, and which
even Mr. Kidd could hardly deny to be religious, do not have this
principle at their base at all. They have nothing to do with the general
interests of the evolution which the race is undergoing on this earth.
They have to do only with the soul of the individual in the future life.
They are not concerned with this world, they are concerned with the
world to come. All religions, and all forms of religions, in which the
principle of asceticism receives any marked development are
positively antagonistic to the development of the social organism.
They are against its interests. They do not tend in the least to
subordinate the interests of the individual to the interests of the
organism “in the general interest of the evolution which the race is
undergoing.” A religion like that of the Shakers means the almost
immediate extinction of the organism in which it develops. Such a
religion distinctly subordinates the interests of the organism to the
interests of the individual. The same is equally true of many of the
more ascetic developments of Christianity and Islam. There is strong
probability that there was a Celtic population in Iceland before the
arrival of the Norsemen, but these Celts belonged to the Culdee sect
of Christians. They were anchorites, and professed a creed which
completely subordinated the development of the race on this earth to
the well-being of the individual in the next. In consequence they died
out and left no successors. There are creeds, such as most of the
present day creeds of Christianity, both Protestant and Catholic,
which do very noble work for the race because they teach its
individuals to subordinate their own interests to the interests of
mankind; but it is idle to say this of every form of religious belief.
It is equally idle to pretend that this principle, which Mr. Kidd says
lies at the base of all religions, does not also lie at the base of many
forms of ethical belief which could hardly be called religious. His
definition of religion could just as appropriately be used to define
some forms of altruism or humanitarianism, while it does not define
religion at all, if we use the word religion in the way in which it
generally is used. If Mr. Kidd should write a book about horses, and
should define a horse as a striped equine animal found wild in South
Africa, his definition would apply to certain members of the horse
family, but would not apply to that animal which we ordinarily mean
when we talk of a horse; and, moreover, it would still be sufficiently
loose to include two or three entirely distinct species. This is
precisely the trouble with Mr. Kidd’s definition of religion. It does not
define religion at all as the word is ordinarily used, and while it does
apply to certain religious beliefs, it also applies quite as well to
certain non-religious beliefs. We must, therefore, recollect that
throughout Mr. Kidd’s argument on behalf of the part that religion
plays he does not mean what is generally understood by religion, but
the special form or forms which he here defines.
Undoubtedly, in the race for life, that group of beings will tend
ultimately to survive in which the general feeling of the members,
whether due to humanitarianism, to altruism, or to some form of
religious belief proper, is such that the average individual has an
unselfish—what Mr. Kidd would call an ultra-rational—tendency to
work for the ultimate benefit of the community as a whole. Mr. Kidd’s
argument is so loose that it may be construed as meaning that, in
the evolution of society, irrational superstitions grow up from time to
time, affect large bodies of the human race in their course of
development, and then die away; and that this succession of
evanescent religious beliefs will continue for a very long time to
come, perhaps as long as the human race exists. He may further
mean that, except for this belief in a long succession of lies,
humanity could not go forward. His words, I repeat, are sufficiently
involved to make it possible that he means this, but, if so, his book
can hardly be taken as a satisfactory defence of religion.
If there is justification for any given religion, and justification for the
acceptance of supernatural authority as regards this religion, then
there can be no justification for the acceptance of all religions, good
and bad alike. There can, at the outside, be a justification for but one
or two. Mr. Kidd’s grouping of all religions together is offensive to
every earnest believer. Moreover, in his anxiety to insist only on the
irrational side of religion, he naturally tends to exalt precisely those
forms of superstition which are most repugnant to reasoning beings
with moral instincts, and which are most heartily condemned by
believers in the loftiest religions. He apparently condemns Lecky for
what Lecky says of that species of unpleasant and noxious anchorite
best typified by St. Simeon Stylites and the other pillar hermits. He
corrects Lecky for his estimate of this ideal of the fourth century, and
says that instead of being condemned it should be praised, as
affording striking evidence and example of the vigor of the immature
social forces at work. This is not true. The type of anchorite of which
Mr. Lecky speaks with such just condemnation flourished most
rankly in Christian Africa and Asia Minor, the very countries where
Christianity was so speedily overthrown by Islam. It was not an
example of the vigor of the immature social forces at work; on the
contrary, it was a proof that those social forces were rotten and had
lost their vigor. Where an anchorite of the type Lecky describes, and
Mr. Kidd impliedly commends, was accepted as the true type of the
church, and set the tone for religious thought, the church was
corrupt, and was unable to make any effective defence against the
scarcely baser form of superstition which received its development in
Islamism. As a matter of fact, asceticism of this kind had very little in
common with the really vigorous and growing part of European
Christianity, even at that time. Such asceticism is far more closely
related to the practices of some loathsome Mohammedan dervish
than to any creed which has properly developed from the pure and
lofty teachings of the Four Gospels. St. Simeon Stylites is more
nearly kin to a Hindoo fakir than to Phillips Brooks or Archbishop
Ireland.
Mr. Kidd deserves praise for insisting as he does upon the great
importance of the development of humanitarian feelings and of the
ethical element in humanity during the past few centuries, when
compared with the mere material development. He is, of course,
entirely right in laying the utmost stress upon the enormous part
taken by Christianity in the growth of Western civilization. He would
do well to remember, however, that there are other elements than
that of merely ceremonial Christianity at work, and that such
ceremonial Christianity in other races produces quite different
results, as he will see at a glance, if he will recall that Abyssinia and
Hayti are Christian countries.
In short, whatever Mr. Kidd says in reference to religion must be
understood as being strictly limited by his own improper terminology.
If we should accept the words religion and religious belief in their
ordinary meaning, and should then accept as true what he states, we
should apparently have to conclude that progress depended largely
upon the fervor of the religious spirit, without regard to whether the
religion itself was false or true. If such were the fact, progress would
be most rapid in a country like Morocco, where the religious spirit is
very strong indeed, far stronger than in any enlightened Christian
country, but where, in reality, the religious development has largely
crushed out the ethical and moral development, so that the country
has gone steadily backward. A little philosophic study would
convince Mr. Kidd that while the ethical and moral development of a
nation may, in the case of certain religions, be based on those
religions and develop with them and on the lines laid down by them,
yet that in other countries where they develop at all they have to
develop right in the teeth of the dominant religious beliefs, while in
yet others they may develop entirely independent of them. If he
doubts this let him examine the condition of the Soudan under the
Mahdi, where what he calls the ultra-rational and supra-natural
sanctions were accepted without question, and governed the lives of
the people to the exclusion alike of reason and morality. He will
hardly assert that the Soudan is more progressive than say Scotland
or Minnesota, where there is less of the spirit which he calls religious
and which old-fashioned folk would call superstitious.
Mr. Kidd’s position in reference to the central feature of his
argument is radically false; but he handles some of his other themes
very well. He shows clearly in his excellent chapter on modern
socialism that a state of retrogression must ensue if all incentives to
strife and competition are withdrawn. He does not show quite as
clearly as he should that over-competition and too severe stress
make the race deteriorate instead of improving; but he does show
that there must be some competition, that there must be some strife.
He makes it clear also that the true function of the State, as it
interferes in social life, should be to make the chances of competition
more even, not to abolish them. We wish the best men; and though
we pity the man that falls or lags behind in the race, we do not on
that account crown him with the victor’s wreath. We insist that the
race shall be run on fairer terms than before because we remove all
handicaps. We thus tend to make it more than ever a test of the real
merits of the victor, and this means that the victor must strive heart
and soul for success. Mr. Kidd’s attitude in describing socialism is
excellent. He sympathizes with the wrongs which the socialistic
reformer seeks to redress, but he insists that these wrongs must not
be redressed, as the socialists would have them, at the cost of the
welfare of mankind.
Mr. Kidd also sees that the movement for political equality has
nearly come to an end, for its purpose has been nearly achieved. To
it must now succeed a movement to bring all people into the rivalry
of life on equal conditions of social opportunity. This is a very
important point, and he deserves the utmost credit for bringing it out.
It is the great central feature in the development of our time, and Mr.
Kidd has seen it so clearly and presented it so forcibly that we
cannot but regret that he should be so befogged in other portions of
his argument.
Mr. Kidd has our cordial sympathy when he lays stress on the fact
that our evolution cannot be called primarily intellectual. Of course
there must be an intellectual evolution, too, and Mr. Kidd perhaps
fails in not making this sufficiently plain. A perfectly stupid race can
never rise to a very high plane; the negro, for instance, has been
kept down as much by lack of intellectual development as by
anything else; but the prime factor in the preservation of a race is its
power to attain a high degree of social efficiency. Love of order,
ability to fight well and breed well, capacity to subordinate the
interests of the individual to the interests of the community, these
and similar rather humdrum qualities go to make up the sum of
social efficiency. The race that has them is sure to overturn the race
whose members have brilliant intellects, but who are cold and selfish
and timid, who do not breed well or fight well, and who are not
capable of disinterested love of the community. In other words,
character is far more important than intellect to the race as to the
individual. We need intellect, and there is no reason why we should
not have it together with character; but if we must choose between
the two we choose character without a moment’s hesitation.
FOOTNOTES:
[22] North American Review, July, 1895.

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