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Principles of
Corporate Finance
● ● ● ● ●
THE MCGRAW HILL SERIES IN FINANCE, INSURANCE, AND REAL ESTATE

Financial Management Ross, Westerfield, and Jordan Saunders and Cornett

Essentials of Corporate Finance Financial Markets and Institutions
Block, Hirt, and Danielsen Eleventh Edition Eighth Edition
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Eighteenth Edition Ross, Westerfield, and Jordan
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Brealey, Myers, Allen, and Edmans Thirteenth Edition
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Fourteenth Edition Shefrin International Financial Management
Behavioral Corporate Finance: Decisions Ninth Edition
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That Create Value
Principles of Corporate Finance, Concise
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Corporate Finance: Core Principles and Financial Institutions Management: A Risk
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Principles of
Corporate Finance
FOURTEENTH EDITION

Richard A. Brealey
Emeritus Professor of Finance
London Business School

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

Franklin Allen
Professor of Finance and Economics
Imperial College London

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

PRINCIPLES OF CORPORATE FINANCE

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Dedication

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

Pedagogical Features Rev.confirming pages

Rev.confirming pages

11
⟩
Part 1 Value

Chapter Overview Part 1 Value

Each chapter begins with a brief narrative and outline to CHAPTER

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

● ● ●

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

vided in the Connect library.

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

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their
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investments
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through
and
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Financial
ration
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managers
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increase
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Confirming pages
than shareholders
managers, therefore, can
the corpo-
referearn for
to the

appear in various chapters throughout the text. Aimed at

by raising additional
questions: First, what cash through borrowing
investments should from banks or
the company themselves. cost
opportunity The of shareholders’ investment by
the capital contributed opportunities
shareholders. out-

Compound Annual Returns

issuing Second,
make?
investment
shares tohow
Thus, the decision
investors.
financial
should it pay for those investments? The
manager
involves faces money;
spending two broad financial
the financing
sideManagers
the corporation
the corporation.
interests
are, of set the standard
course,
Financial managers,
and circumstances;
human beingsfor investments
they aretherefore,
with theirinside
not always refer
own
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bringing real-world flavor into the classroom, these boxes questions:

decision
⟩make?
The Second,
average
A large
First, raising
involves what investments
how should
returns
corporation
it.
shown
may it pay
in for
have Table
should the company
those 7.1investments?
hundreds areofarithmetic
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opportunity
fect servantscost
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combine
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are,
9governance
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−10
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3the Cost
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=of+10%
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provide insight into the business world today.

investment
of
averages. Indecision
shareholders. otherThese involves
words, we spending
simply added
shareholders money;
differ in the
the 121
many financing
annual
ways, interests and
incentives circumstances;
to make sure that they are not always
all managers the per-
and employees
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average return horizon. of fectThe
pull arithmetic
servants
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corporations you
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However, see that financial
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⟩ make thesurethe opportunity costandof capital for
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the wealth,
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an efficient and
stock investment
values
market, horizon.
thismultiplied
will in turn investments
pull together of
standardsimilar
to increase risk
errorsvalue.to Big Pharma
for a sample of railroad stock.
1. The
Corporate finance is all about maximizing shareholder value.
YetCanadian
69,754 wetimes.
increase shall see
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current they
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stock usually
price. average share
1.07 the same
return financial
is calculated 0.18 This geometric
chapter
companies average
introducesand for return
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occur
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by takingthe
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to0.97 average
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maximizing or
shareholder value.
increase
Why did
Instructing its current
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quotestockthe price.arithmetic
manager averageshareholder
to increase of 11.5%, effects on stakeholders
February 2020. such as customers,
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and is
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decisions, including their
to increase
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that let’s
will go use That
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ainsimple
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example.
future. say problem
but not very is how helpful.
to do Thecost
opportunitycapital is of
cost estimated
capital sets from the historic
standardreturns,
for
Industry portfolio 1.13 0.14 effects
onlyinvestment standard
on
the arithmetic error
stakeholdersaveragefor
suchthe asportfolio.
gives customers,
the right employees,
answer, not
Instructing
it. Suppose
That’s thethe that financial
purpose Bigof this manager
book. It to
Pharma’s increase
stock
covers price
the shareholder
is $100.
concepts that decisions.
value is
There
govern like
isgood advising
an equal
financial an
chance investor
decisions,that at andinthethe stock
end
it shows ofyoumarket
thehow year to find
to the
use the and
geometric average.7
the environment.
4. A safe dollar is worth more than a risky dollar.
stocks
stock
the that
will
tools of will
the go
be worth
trade up of
in$90,
the future.
modern $110, The problem
or $130;
finance. is how
there aretono do 3. The opportunity cost of capital sets the standard for
5. Good governance matters.
it. That’s theTherefore,
dividends. purpose of the this return
book. Itcould coversbe the–10%,
concepts +10%, that 5
investment decisions.

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

Numbered Examples the tools

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

Numbered and titled examples are called out within chap-

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

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

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

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

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

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

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

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

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

Beyond the Page Interactive Content bre80948_ch09_248-275.indd 257

How Fixed Costs Translate

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

of phase III should not be mad

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

for an 80% chance of a $100 m

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

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

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

a 25% chance of NPV = +$2

United Kingdom

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

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

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

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

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

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

⟩ Excel Exhibits Year

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

available in Connect and through the 2 Accumulated depreciation

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

⟩ TABLE 6.2 Initial forecast data for guano project.

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

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

xii Try It!

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

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

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

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

section of the chapter to which the question relates. a. Spread in year 4 holds1.atBehavioral biases (S11.1) Explain why setting a higher discount rate is not a cure for upward-
$1.20 per pound.
biased cash-flow forecasts.
b. The U.S. chemical company can start up polyzone production at 40 million pounds in year
This helps instructors create assignments and makes 1 rather than year 2. 2. Behavioral biases (S11.1) Look back to the cash flows for projects F and G in Section 5-3.
c. The U.S. company makesects
The cost of capital was assumed to be 10%. Assume that the forecasted cash flows for proj-
a technological advance that reduces itsaverage.
annual production
That is, thecosts
it simpler for students to look back for help. These
of this type are overstated by 8% on forecast for each cash flow from
to $25 million. Competitors’ production costs do not change.
each project should be reduced by 8%. But a lazy financial manager, unwilling to take the
time to argue with the projects’ sponsors, instructs
18. Equilibrium prices (S11.3) Demand for concave utility meters is expanding rapidly, them tobut
usethe
a discount rate of 18%.
end-of-chapter problems give students hands-on industry is highly competitive. A utility
a. What are meter plant costs
the projects’ true $50
NPVs? million to set up, and it has an
annual capacity of 500,000b.meters. The production cost is $5 per
What are the NPVs at the 18% discount rate?meter, and this cost is not
practice with key concepts and applications. expected to change. The machines have any
c. Are there
10%. What is the competitive price ofCould
an indefinite physical
circumstances
a utility
life and
in which the the
18%cost of capital
discount is
rate would
meter?bias be more severe for more-distant cash flows?)
give the correct NPVs?
(Hint: upward
a. $5
3. Market values (S11.2) Your brother-in-law wants you to join him in purchasing a building on
b. $10 the outskirts of town. You and he would then develop and run a Taco Palace restaurant. Both of
c. $15 you are extremely optimistic about future real estate prices in this area, and your brother-in-law
has prepared a cash-flow forecast that implies a large positive NPV. This calculation assumes
19. Opportunity costs (S11.3) New-model commercial airplanes are much more fuel-efficient Firstahead?
pages
sale of the property after 10 years. What further calculations should you do before going
than older models. How is it possible for airlines flying older models to make money when its
4. Market
competitors are flying newer planes?values
Explain(S11.2) Suppose that you are considering investing in an asset for which there
briefly.
is a reasonably good secondary market. Specifically, your company is Delta Airlines, and the
asset is a Boeing 767—a widely used airplane. How does the presence of a secondary market
simplify your problem in principle? Do you think these simplifications could be realized in
CHALLENGE PROBLEMSpractice? Explain.
686 Part Seven Options
20. Economic rents (S11.3)5.Accidental
Market values setbacks (S11.2) There in
can result is negative
an active,rents
competitive leasing
in any year. But(i.e., rental) market for most
can a project have expected standard typesin
positive rents ofsome
commercial
years and jets.negative
Many ofexpected
the planes flown
rents by the major domestic and inter-
in other
years? Explain. Mason national airlines
and Merton are not
review owned
a range by them
of option but leased to
applications forcorporate
periods ranging
finance:from a few months to
S.The
several and
P. Mason
years. Gamma Airlines, however, owns two long-range DC-11s just withdrawn from
21. Economic rents (S11.3) manufacture R. C.ofMerton, “Theacid
polysyllabic Roleisofa Contingent
competitiveClaims
industry.Analysis
Most in Corporate Finance,” in E.
Latin
I. Altman American
and M.tons. service. Gamma
G. Subrahmanyam, is considering using these planes to develop the potentially
plants have an annual output of 100,000 Operating costseds., are Recent
$0.90 aAdvances
ton, andinthe sales Finance (Homewood, IL:
Corporate
lucrative
Richard D. new
Irwin, route from Akron to Yellowknife. A considerable investment in terminal facili-
price is $1 a ton. A 100,000-ton plant costs1985).
$100,000 and has an indefinite life. Its current
scrap value of $60,000 Brennan ties, training,
is expected to and advertising
decline to $57,900 will be
over therequired.
next two Once
years. committed, Gamma will have to operate
and Schwartz have worked out an interesting application to natural resource investments:
the route for at least three years. One further complication: The manager of Gamma’s interna-
Phlogiston Inc. proposes to invest
M. J.tional
Brennan and$100,000
division in a plant
E.isS.opposing
Schwartz, that employs
“Evaluating
commitment theaplanes
Natural
of new low-cost
Resource pro-
to theInvestments,” Journal of
Akron–Yellowknife Business
route 58
because
cess to manufacture polysyllabic
(April acid. The
1985),
of anticipated plantgrowth
pp.future
135–157. has theinsame capacity
traffic through asGamma’s
existing units,
new hub but in Ulaanbaatar. How would
operating costs are $0.85 a you
Myers ton. Phlogiston
andevaluate
Read cover theestimates
proposed
the tax andthat it has two
Akron–Yellowknife
financing years’ project?
implicationsleadofover each
realGive a of
options.detailed list of the necessary
its rivals in use of the process but is your
unable to build any more howplants itself before year 2. Also
S. C. steps
Myersinand analysis.
J. A. Explain
Read, “Real Options, the airplane
Taxes leasing
and Leverage,” market
Criticalwould be taken
Finance into
Review account.
9 (June If
2020),
it believes that demand over the
the
pp. next two
project
29–76. years is likely
is attractive, to be sluggish
how would you respondand that
to theitsmanager
new plant of the international division?
will therefore cause temporary overcapacity.
6. Market values (S11.2) Suppose the current price of gold is $1,200 an ounce. Hotshot Con-
You can assume that there are no taxes and that the cost of capital is 10%.
● ● ● ● ● sultants advises you that gold prices will increase at an average rate of 12% for the next two
years. After that the growth rate will fall to a long-run trend of 3% per year. What is the pres-
PROBLEM SETS ent value of 1 million ounces ® ofSelect problems
gold produced inare
eightavailable in McGraw
years? Assume Hill’s
that gold prices have a
Connect.
beta of 0 and that the risk-free rate Please see the preface for more information.
is 5.5%.
7. Market
1. Expansionvalues (S11.2)
options On the
(S23.1) London
Look againMetals
at the Exchange,
valuation inthe price23.2
Table for copper to be delivered
of the option to invest
in
in one year isII$5,500
the Mark project.a Consider
ton. (Note: Paymentiniseach
a change madeof when the copper
the following is delivered.)
inputs. Would the The risk-
change
bre80948_ch11_301-326.indd 323
free interest
increase rate is 2%
or decrease theand the of
value expected market option?
the expansion return is 8%. 10/01/21 03:26 PM

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

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

Excel Problems bre80948_ch11_301-326.indd 320

BEYOND THE PAGE

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

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

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

xiii
 Rev.confirming pages

220 Part Two Risk

⟩ Finance on the Web ● ● ● ● ●

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

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

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

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

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

Confirming pages

Chapter 10 Project Analysis 299

⟩ Mini-Cases MINI-CASE ● ● ● ● ●

Mini-cases are included in

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

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

Year

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

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

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

Preface vii I Part Six: Corporate Objectives and

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

I Part Two: Risk I Part Eight: Debt Financing

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

15 Payout Policy 434

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

xx
 Contents

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

Continuous Compounding

I Part One: Value • •

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

1 Introduction to Corporate
Finance 1 3 Valuing Bonds 52
1-1 Corporate Investment and Financing 3-1 Using the Present Value Formula to Value
Decisions 2 Bonds 53
Investment Decisions/Financing Decisions/What Is A Short Trip to Paris to Value a Government Bond/
a Corporation?/The Role of the Financial Manager Back to the United States: Semiannual Coupons
and Bond Prices
1-2 The Financial Goal of the Corporation 8
Shareholders Want Managers to Maximize 3-2 How Bond Prices Vary with Yields 57
Market Value/A Fundamental Result: Why Duration and Interest-Rate Sensitivity
Maximizing Shareholder Wealth Makes Sense/ 3-3 The Term Structure of Interest Rates 62
Should Managers Maximize Shareholder Wealth?/ Spot Rates, Bond Prices, and the Law of One
The Investment Trade-Off/Agency Problems and Price/Measuring the Term Structure/Why the
Corporate Governance Discount Factor Declines as Futurity Increases
1-3 Key Questions in Corporate Finance 14 3-4 Explaining the Term Structure 68
• •
Key Takeaways 15 Problem Sets 16 Solutions to Expectations Theory of the Term Structure/Interest
•
Self-Test Questions 18 Appendix: Why Maximizing Rate Risk/Inflation Risk
Shareholder Value Makes Sense 19 3-5 Real and Nominal Interest Rates 70
Indexed Bonds and the Real Rate of Interest/What
2 How to Calculate Present Determines the Real Rate of Interest?/Inflation and
Values 21 Nominal Interest Rates
3-6 The Risk of Default 74
2-1 How to Calculate Future and Present Values 22 Corporate Bonds and Default Risk/Sovereign
Calculating Future Values/Calculating Present Bonds and Default Risk
Values/Valuing an Investment Opportunity/Net
Present Value/Risk and Present Value/Present •
Key Takeaways 77 Further Reading 78 Problem •
Values and Rates of Return/Calculating Present •
Sets 78 Solutions to Self-Test Questions 83 •
Values When There Are Multiple Cash Flows/The Finance on the Web 83
Opportunity Cost of Capital
2-2 How to Value Perpetuities and Annuities 30 4 Valuing Stocks 84
How to Value Perpetuities/How to Value Annuities/
Valuing Annuities Due/Calculating Annual 4-1 How Stocks Are Traded 85
Payments/Future Value of an Annuity Trading Results for Cummins/Market Price vs.
2-3 How to Value Growing Perpetuities and Book Value
Annuities 37 4-2 Valuation by Comparables 88
Growing Perpetuities/Growing Annuities 4-3 Dividends and Stock Prices 90
xxi
xxii Contents
Dividends and Capital Gains/Two Versions of the
Dividend Discount Model
4-4 Dividend Discount Model Applications 95
Using the Constant-Growth DCF Model to Set
Water, Gas, and Electricity Prices/DCF Models
with Two or More Stages of Growth
4-5 Income Stocks and Growth Stocks 101
Calculating the Present Value of Growth
Opportunities for Establishment Electronics
4-6 Valuation Based on Free Cash Flow 105
Valuing the Concatenator Business/Valuation
Format/Estimating Horizon Value
• •
Key Takeaways 110 Problem Sets 112 Solutions to
•
Self-Test Questions 116 Finance on the Web 117
Mini-Case: Reeby Sports 117
5 Net Present Value and Other
Investment Criteria 119
5-1 A Review of the Net Present Value Rule 119
Net Present Value’s Competitors/Five Points to
Remember about NPV
5-2 The Payback and Accounting Rate of Return
Rules 123
The Payback Rule/Accounting Rate of Return
5-3 The Internal Rate of Return Rule 126
Calculating the IRR/The IRR Rule/Pitfall 1—
Lending or Borrowing?/Pitfall 2—Multiple Rates
of Return/Pitfall 3—Mutually Exclusive Projects/
Pitfall 4—What Happens When There Is More
Than One Opportunity Cost of Capital/The Verdict
on IRR
5-4 Choosing Capital Investments When Resources
Are Limited 135
How Important Is Capital Rationing in Practice?
•
Key Takeaways 139 Further Reading 140 Problem • Historical Evidence to Evaluate Today’s Cost of
•
Sets 140 Solutions to Self-Test Questions 145 • Capital
Mini-Case: Vegetron’s CFO Calls Again 146
6 Making Investment Decisions with
the Net Present Value Rule 149
6-1 Forecasting a Project’s Cash Flows 150
Rule 1: Discount Cash Flows, Not Profits/Rule 2:
Discount Incremental Cash Flows and Ignore Non-
Incremental Cash Flows/Rule 3: Treat Inflation
Consistently/Rule 4: Separate Investment and
Financing Decisions/Rule 5: Forecast Cash Flows
after Taxes
6-2 Corporate Income Taxes 157
Depreciation Deductions/Tax on Salvage Value/Tax
Loss Carry-Forwards
6-3 A Worked Example of a Project Analysis 159
The Three Components of Project Cash Flows/Cash
Flow from Capital Investment/Operating Cash Flow/
Investment in Working Capital/How to Construct a
Set of Cash Flow Forecasts: An Example/Capital
• Investment/Operating Cash Flow/Investment in
Working Capital/Accelerated Depreciation and
First-Year Expensing/Project Analysis
6-4 How to Choose between Competing
Projects 165
Problem 1: The Investment Timing Decision/
Problem 2: The Choice between Long- and Short-
Lived Equipment/Problem 3: When to Replace an
Old Machine/Problem 4: Cost of Excess Capacity
•
Key Takeaways 171 Further Reading 172 Problem •
•
Sets 172 Solutions to Self-Test Questions 180 •
Mini-Case: New Economy Transport (A) 181 New •
Economy Transport (B) 182
I Part Two: Risk
7 Introduction to Risk, Diversification,
and Portfolio Selection 184
7-1 The Relationship between Risk and Return 184
Over a Century of Capital Market History/Using
7-2 How to Measure Risk 190
Variance and Standard Deviation/Calculating
Risk/Estimating Future Risk
7-3 How Diversification Reduces Risk 195
Specific and Systematic Risk/Diversification
with Many Stocks

7-4 Systematic Risk Is Market Risk 201
Portfolio Choice with Borrowing and
Lending/Market Risk
7-5 Should Companies Diversify? 209
•
Key Takeaways 210 Further Reading 211 Problem • Certainty Equivalents 263
•
Sets 212 Solutions to Self-Test Questions 219
Finance on the Web 220
8 The Capital Asset Pricing
Model 222
8-1 Market Risk Is Measured by Beta 222
The Market Portfolio/Why Betas Determine
Portfolio Risk
8-2 The Relationship between Risk and Return
What If a Stock Did Not Lie on the Security Market
Line?/The Capital Market Line and the Security
Market Line/The Logic behind the Capital Asset
Pricing Model/Intuition: Why Do High Beta and
High Returns Go Together?/Applying the Capital
Asset Pricing Model
8-3 Does the CAPM Hold in the Real World?
How Large Is the Return for Risk?/Are Returns
Unrelated to All Other Characteristics?
8-4 Some Alternative Theories 237
Arbitrage Pricing Theory/A Comparison of the
Capital Asset Pricing Model and Arbitrage Pricing
Theory/The Three-Factor Model
•
Key Takeaways 241 Further Reading 242 Problem • Mini-Case: Waldo County 299
•
Sets 242 Solutions to Self-Test Questions 246
Finance on the Web 247
9 Risk and the Cost of Capital 248
9-1 Company and Project Costs of Capital 249
Company Cost of Capital for CSX/Three
Warnings/What about Investments That Are
Not Average Risk?/Perfect Pitch and the Cost
of Capital
9-2 Estimating Beta and the Company Cost of
Capital 254
Estimating Beta/Portfolio Betas
Contents xxiii
9-3 Analyzing Project Risk 257
1. The Determinants of Asset Betas/2. Don’t
Be Fooled by Diversifiable Risk/3. Avoid Fudge
Factors in Discount Rates/Discount Rates for
International Projects
• 9-4
•
Key Takeaways 266 Further Reading 268 Problem •
•
Sets 268 Solutions to Self-Test Questions 273 •
•
Finance on the Web 273 Mini-Case: The Jones
Family Incorporated 273
I Part Three: Best Practices in Capital
Budgeting
228 10 Project Analysis 276
10-1 Sensitivity and Scenario Analysis 277
Value of Information/Limits to Sensitivity Analysis/
Stress Tests and Scenario Analysis
10-2 Break-Even Analysis and Operating
Leverage 281
233 Break-Even Analysis/Operating Leverage
10-3 Real Options and the Value of Flexibility 284
The Option to Expand/The Option to Abandon/
Production Options/Timing Options/More on
Decision Trees/Pro and Con Decision Trees
•
Key Takeaways 291 Further Reading 292 Problem •
•
Sets 292 Solutions to Self-Test Questions 298 •
•
11 How to Ensure That Projects Truly
Have Positive NPVs 301
11-1 Behavioral Biases in Investment Decisions 302
11-2 Avoiding Forecast Errors 303
11-3 How Competitive Advantage Translates into
Positive NPVs 308
11-4 Marvin Enterprises Decides to Exploit a New
Technology—An Example 312
Forecasting Prices of Gargle Blasters/The Value
of Marvin’s New Expansion/Alternative Expansion
Plans/The Value of Marvin Stock/The Lessons of
Marvin Enterprises
xxiv Contents
•
Key Takeaways 319 Further Reading 319 Problem •
•
Sets 320 Solutions to Self-Test Questions 325
Mini-Case: Ecsy-Cola 326
I Part Four: Financing Decisions and
Market Efficiency
12 Efficient Markets and Behavioral
Finance 327
12-1 Differences between Investment and Financing
Decisions 328
NPV Matters for Both Investment and
Financing Decisions/The NPV of Financing
Decisions Is Zero in Efficient Markets/The
NPV of Financing Decisions in Inefficient
Markets
12-2 The Efficient Market Hypothesis 330
Forms of Market Efficiency/Why Do We Expect
Markets to Be Efficient?
12-3 Implications of Market Efficiency 335
What Market Efficiency Does Not Imply/What if
Markets Are Not Efficient? Implications for the
Financial Manager
12-4 Are Markets Efficient? The Evidence 345
Weak-Form Efficiency/Semistrong-Form
Efficiency/Strong-Form Efficiency
12-5 Behavioral Finance 352
Sentiment/Limits to Arbitrage/Agency and Incentive
Problems
•
Key Takeaways 360 Further Reading 361 Problem •
•
Sets 362 Solutions to Self-Test Questions 366
Finance on the Web 367
13 An Overview of Corporate
Financing 368
13-1 Patterns of Corporate Financing 369
How Much Do Firms Borrow?
13-2 Equity 372
Ownership of the Corporation/Preferred Stock
13-3 Debt 375
• The Different Kinds of Debt/A Debt by Any Other Name
13-4 The Role of the Financial System 378
The Payment Mechanism/Borrowing and Lending/
Pooling Risk/Information Provided by Financial
Markets
13-5 Financial Markets and Intermediaries 381
Financial Intermediaries/Investment Funds/
Financial Institutions
13-6 Financial Markets and Intermediaries around
the World 387
Conglomerates and Internal Capital Markets
13-7 The Fintech Revolution 391
Payment Systems/Person-to-Person Lending/
Crowdfunding/AI/ML Credit Scoring/Distributed
Ledgers and Blockchains/Cryptocurrencies/Initial
Coin Offerings
•
Key Takeaways 394 Further Reading 395 Problem •
•
Sets 396 Solutions to Self-Test Questions 398 •
Finance on the Web 398
14 How Corporations Issue
Securities 399
14-1 Venture Capital 399
The Venture Capital Market
14-2 The Initial Public Offering 404
The Public-Private Choice/Arranging an Initial
Public Offering/The Sale of Marvin Stock/The
Underwriters/Costs of a New Issue/Underpricing
of IPOs/Hot New-Issue Periods/The Long-Run
• Performance of IPO Stocks/Alternative Issue
Procedures/Types of Auction: A Digression
14-3 Security Sales by Public Companies 416
Public Offers/The Costs of a Public Offer/Rights
Issues/Market Reaction to Stock Issues
14-4 Private Placements 421
•
Key Takeaways 422 Further Reading 423 Problem •
•
Sets 423 Solutions to Self-Test Questions 429 •
•
Finance on the Web 429 Appendix: Marvin’s
New-Issue Prospectus 430

I Part Five: Payout Policy and Capital
Structure
15 Payout Policy 434
15-1 Facts about Payout 435
How Firms Pay Dividends/How Firms Repurchase
Stock/The Information Content of Dividends/The
Information Content of Share Repurchases
15-2 Dividends or Repurchases? Does the Choice
Affect Shareholder Value? 440
Dividends or Repurchases? An Example/Stock
Repurchases and DCF Valuation Models/
Dividends and Share Issues
15-3 Dividend Clienteles 444
15-4 Taxes and Payout Policy 445
Empirical Evidence on Payout Policies and Taxes/
Alternatives to the U.S. Tax System
15-5 Payout Policy and the Life Cycle of the Firm 449
The Agency Costs of Idle Cash/Payout and
Corporate Governance
•
Key Takeaways 452 Further Reading 453 Problem•
•
Sets 453 Solutions to Self-Test Questions 458 • Information/Implications of the Pecking Order/The
Finance on the Web 458
16 
Does Debt Policy Matter? 459
16-1 Financial Leverage and Shareholder Value 460
16-2 Modigliani and Miller’s Proposition 1 461
The Law of the Conservation of Value/An Example
of Proposition 1
16-3 L
 everage and Expected Returns: MM’s
Proposition 2 466
Proposition 2/Leverage and the Cost of Equity/
How Changing Capital Structure Affects the Equity
Beta/Watch Out for Hidden Leverage
16-4 No Magic in Financial Leverage 473
Today’s Unsatisfied Clienteles Are Probably
Interested in Financial Innovation/Imperfections
and Opportunities
16-5 A Final Word on the Cost of Capital 476
Contents xxv
•
Key Takeaways 478 Further Reading 478 Problem•
•
Sets 479 Solutions to Self-Test Questions 483 •
Mini-Case: Claxton Drywall Comes to the Rescue 483
17 How Much Should a Corporation
Borrow? 485
17-1 Debt and Taxes 486
How Do Interest Tax Shields Contribute to the
Value of Stockholders’ Equity?/Recasting Johnson
& Johnson’s Capital Structure/MM and Corporate
Tax/Corporate and Personal Taxes
17-2 Costs of Financial Distress 492
Bankruptcy Costs/Evidence on Bankruptcy Costs/
Direct versus Indirect Costs of Bankruptcy/Financial
Distress without Bankruptcy/Agency Costs of
Financial Distress/Risk Shifting: The First Game/
Refusing to Contribute Equity Capital: The Second
Game/And Three More Games, Briefly/What the
Games Cost/Costs of Distress Vary with Type of Asset
17-3 The Trade-Off Theory of Capital Structure 503
17-4 The Pecking Order of Financing Choices 505
Debt and Equity Issues with Asymmetric
Bright Side and the Dark Side of Financial Slack
17-5 The Capital Structure Decision 509
The Evidence/Is There a Theory of Optimal Capital
Structure?
•
Key Takeaways 512 Further Reading 513 Problem•
•
Sets 513 Solutions to Self-Test Questions 517 •
Finance on the Web 517
18 Financing and Valuation 518
18-1 The After-Tax Weighted-Average Cost of
Capital 519
Review of Assumptions/Mistakes People Make in
Using the Weighted-Average Formula
18-2 Valuing Businesses 523
Valuing Rio Corporation/Estimating Horizon
Value/Valuation by Comparables/Liquidation
Value/WACC vs. the Flow-to-Equity Method
xxvi Contents
18-3 Using WACC in Practice 528
Some Tricks of the Trade/Adjusting WACC when
Debt Ratios and Business Risks Differ/Three-
Step Procedure for Finding WACCs at Different
Debt Ratios/Unlevering and Relevering Betas/
Calculating Divisional WACCs/The Assumption of
a Constant Debt Ratio in the After-Tax WACC/The
Modigliani–Miller Formula
18-4 Adjusted Present Value 536
APV for the Perpetual Crusher/Other Financing
Side Effects/APV for Entire Businesses/APV
and Limits on Interest Deductions/APV for
International Investments
18-5 Your Questions Answered 541
•
Key Takeaways 543 Further Reading 544 Problem •
•
Sets 545 Solutions to Self-Test Questions 549 • Employees/Customers/Suppliers/Local and
•
Finance on the Web 550 Appendix: Discounting
•
Safe, Nominal Cash Flows 551 A Consistency
Check 553
I Part Six: Corporate Objectives and
Governance
19 Agency Problems and
Corporate Governance 555
19-1 What Agency Problems Should You Watch Out
For? 556
Reduced Effort/Private Benefits/Overinvestment/
Risk Taking/Short-Termism
19-2 Monitoring by the Board of Directors 560
U.S. and U.K. Boards of Directors/European
Boards of Directors
19-3 Monitoring by Shareholders 563
Voting/Engagement/Exit
19-4 Monitoring by Auditors, Lenders, and Potential
Acquirers 566
Auditors/Lenders/Takeovers
19-5 Management Compensation 568
Compensation Facts and Controversies/The
Structure of CEO Pay
19-6 Government Regimes around the World 575
Ownership and Control in Japan/Ownership and
Control in Germany/Ownership and Control in
Other Countries
19-7 Do These Differences Matter? 581
Public Market Myopia/Growth Industries and
Declining Industries
• •
Key Takeaways 583 Further Reading 584 Problem
•
Sets 585 Solutions to Self-Test Questions 587 •
Finance on the Web 587
20 Stakeholder Capitalism and
Responsible Business 588
20-1 Who Are the Stakeholders? 589
Regional Communities/The Environment/
The Government
20-2 The Case for Shareholder Capitalism 592
Government Policy Ensures Companies Will
Engage in Socially Responsible Behavior/
Maximizing Shareholder Value Allows Investors
to Pursue Social Objectives/Maximizing
Shareholder Value Requires a Company to
Invest in Stakeholders/Enlightened Shareholder
Value/Decision Making under Enlightened
Shareholder Value
20-3 The Case for Stakeholder Capitalism 596
Well-Functioning Governments/No Comparative
Advantage in Serving Society/Instrumental
Decision Making Is Effective/The Challenge of
Stakeholder Capitalism/Summary
20-4 Responsible Business 600
Defining Responsible Business/Decision
Making in Responsible Businesses/
Summary
20-5 Responsible Business in Practice 605
Shareholder Primacy in the United States
and United Kingdom/Benefit Corporations/
B Corps/Purpose/Reporting
• •
Key Takeaways 611 Further Reading 612 Problem
•
Sets 612 Solutions to Self-Test Questions 613 •
Finance on the Web 613

I Part Seven: Options
21 Understanding Options 614
21-1 Calls, Puts, and Shares 615
Call Options and Payoff Diagrams/Put Options/
Selling Calls and Puts/Payoff Diagrams Are Not
Profit Diagrams
21-2 Financial Alchemy with Options 619
Spotting the Option
21-3 What Determines the Value of a Call Option? 625
Risk and Option Values
•
Key Takeaways 630 Further Reading 631 Problem•
•
Sets 631 Solutions to Self-Test Questions 636 • •
Finance on the Web 636
22 Valuing Options 637
22-1 A Simple Option-Valuation Model 638
Why Discounted Cash Flow Won’t Work for
Options/Constructing Option Equivalents from
Common Stocks and Borrowing/Risk-Neutral
Valuation/Valuing the Amazon Put Option/Valuing
the Put Option by the Risk-Neutral Method/The
Relationship between Call and Put Prices
22-2 The Binomial Method for Valuing Options 644
Example: The Two-Step Binomial Method/The
General Binomial Method/The Binomial Method
and Decision Trees
22-3 The Black–Scholes Formula 649
Using the Black–Scholes Formula/How Black-
Scholes Values Vary with the Stock Price/The Risk
of an Option/The Black–Scholes Formula and the
Binomial Method/Some Practical Examples
22-4 Early Exercise and Dividend Payments 656
•
Key Takeaways 658 Further Reading 659 Problem•
•
Sets 659 Solutions to Self-Test Questions 663
• •
Finance on the Web 664 Mini-Case: Bruce
Honiball’s Invention 664
23 Real Options 666
23-1 The Option to Expand 666
Questions and Answers about Blitzen’s Mark II/
Other Expansion Options
Contents xxvii
23-2 Options in R&D 670
23-3 The Timing Option 672
Valuing the Malted Herring Option/Optimal
Timing for Real Estate Development
23-4 The Abandonment Option 675
Bad News for the Perpetual Crusher/Abandonment
Value and Project Life/Temporary Abandonment
23-5 Flexible Production and Procurement 678
Aircraft Purchase Options
23-6 Valuing Real Options 682
A Conceptual Problem?/What about Taxes?/
Practical Challenges
•
Key Takeaways 685 Further Reading 685 •
Problem Sets 686 Solutions to Self-Test
Questions 690
I Part Eight: Debt Financing
24 Credit Risk and the Value
of Corporate Debt 691
24-1 Yields on Corporate Debt 692
Distinguishing Promised and Expected Yields/
What Determines the Yield Spread?
24-2 Valuing the Option to Default 695
Finding Bond Values/The Value of Corporate Equity
24-3 Predicting the Probability of Default 699
Statistical Models of Default/Structural Models of
Default
•
Key Takeaways 706 Further Reading 706 Problem •
•
Sets 707 Solutions to Self-Test Questions 708 •
Finance on the Web 709
25 The Many Different Kinds of
Debt 710
25-1 Long-Term Corporate Bonds 711
Bond Terms/Security and Seniority/Asset-Backed
Securities/Call Provisions/Sinking Funds/Bond
Covenants/Privately Placed Bonds/Foreign Bonds
and Eurobonds
25-2 Convertible Securities and Some Unusual
Bonds 720
xxviii Contents
The Value of a Convertible at Maturity/
Forcing Conversion/Why Do Companies Issue
Convertibles?/Valuing Convertible Bonds/A
Variation on Convertible Bonds: The Bond–
Warrant Package/Innovation in the Bond Market
25-3 Bank Loans 727
Commitment/Maturity/Rate of Interest/Syndicated
Loans/Security/Loan Covenants
25-4 Commercial Paper and Medium-Term
Notes 731
Commercial Paper/Medium-Term Notes
•
Key Takeaways 733 Further Reading 734 • 27-5 Interest Rate Risk
•
Problem Sets 734 Solutions to Self-Test
•
Questions 739 Mini-Case: The Shocking Demise of
•
Mr. Thorndike 740 Appendix: Project Finance 741
Appendix Further Reading 743
26 Leasing 744
26-1 What Is a Lease? 744
26-2 Why Lease? 746
Sensible Reasons for Leasing/A Dubious Reason
for Leasing
26-3 Rentals on an Operating Lease 747
Example of an Operating Lease/Lease or Buy?
26-4 Valuing Financial Leases 750
Example of a Financial Lease/Valuing the Lease
Contract/Comparing the Lease with an Equivalent
Loan/Financial Leases When There Are Limits on
the Interest Tax Shield/Leasing and the Internal
Revenue Service
26-5 When Do Financial Leases Pay? 754
Leasing around the World
26-6 Setting Up a Leveraged Lease 756
•
Key Takeaways 757 Further Reading 757 Problem •
•
Sets 758 Solutions to Self-Test Questions 762
I Part Nine: Risk Management
27 Managing Risk 763
27-1 Why Manage Risk? 764
Reducing the Risk of Cash Shortfalls or Financial
Distress/Agency Costs May Be Mitigated by
Risk Management/The Evidence on Risk
Management
27-2 Insurance 767
27-3 Reducing Risk with Financial Options 769
27-4 Forward and Futures Contracts 770
A Simple Forward Contract/Futures Exchanges/
The Mechanics of Futures Trading/Trading
and Pricing Financial Futures Contracts/Spot
and Futures Prices—Commodities/More about
Forwards and Futures
776
Forward Rates of Interest and the Term Structure/
Borrowing and Lending at Forward Interest Rates/
• Forward Rate Agreements/Interest Rate Futures
27-6 Swaps 779
Interest Rate Swaps/Currency Swaps/Some
Other Swaps
27-7 How to Set Up a Hedge 783
Hedging Interest Rate Risk/Hedge Ratios and
Basis Risk
27-8 Is “Derivative” a Four-Letter Word? 787
•
Key Takeaways 788 Further Reading 789 Problem•
•
Sets 790 Solutions to Self-Test Questions 795 •
•
Finance on the Web 796 Mini-Case: Rensselaer
Advisers 796
28 International Financial
Management 799
28-1 The Foreign Exchange Market 799
28-2 Some Basic Relationships 802
Interest Rates and Exchange Rates/The Forward
Premium and Changes in Spot Rates/Changes in
the Exchange Rate and Inflation Rates/Interest
Rates and Inflation Rates/Is Life Really That
Simple?
28-3 Hedging Currency Risk 812
Transaction Exposure and Economic Exposure
28-4 International Investment Decisions 814
The Cost of Capital for International Investments
28-5 Political Risk 817

• •
Key Takeaways 820 Further Reading 821 Problem
• •
Sets 822 Solutions to Self-Test 825 Finance on the
•
Web 826 Mini-Case: Exacta, s.a. 826
I Part Ten: Financial Planning and Working
Capital Management
29 Financial Analysis 828
29-1 Understanding Financial Statements 829
The Balance Sheet/The Income Statement
29-2 Measuring Company Performance 833
Economic Value Added/Accounting Rates of
Return/Problems with EVA and Accounting Rates
of Return
29-3 Measuring Efficiency 838
The DuPont Formula/Other Efficiency Measures
29-4 Measuring Leverage 841
Leverage and the Return on Equity
29-5 Measuring Liquidity 844
29-6 Interpreting Financial Ratios 846
• •
Key Takeaways 849 Further Reading 849 Problem
•
Sets 850 Solutions to Self-Test Questions 855 •
Finance on the Web 855
30 Financial Planning 857
30-1 What Are the Links between Short-Term and
Long-Term Financing Decisions? 857
30-2 Tracing and Forecasting Changes in Cash 860
Tracing Changes in Cash/Forecasting Dynamic’s
Cash Needs
30-3 Developing a Short-Term Financial Plan 866
Dynamic Mattress’s Financing Plan/Evaluating the
Plan/Short-Term Financial Planning Models
30-4 Using Long-Term Financial Planning
Models 869
Why Build Financial Plans?/A Long-Term
Financial Planning Model for Dynamic Mattress/
Pitfalls in Model Design/Choosing a Plan
30-5 Long-Term Planning Models and Company
Valuation 874
Contents xxix
30-6 The Relationship between Growth and External
Financing 875
• •
Key Takeaways 877 Further Reading 877 Problem
•
Sets 878 Solutions to Self-Test Questions 885 •
Finance on the Web 887
31 Working Capital Management 888
31-1 The Working Capital Requirement 888
The Cash Cycle
31-2 Managing Inventories 892
31-3 Accounts Receivable Management 894
Terms of Sale/Credit Analysis/The Credit Decision/
Collection Policy
31-4 Cash Management 900
How Purchases Are Paid For/Changes in Check
Usage/Speeding Up Check Collections/Electronic
Payment Systems/International Cash Management/
Paying for Bank Services
31-5 Investing Surplus Cash 904
Investment Choices/Calculating the Yield on
Money Market Investments/Returns on Money
Market Investments/The International Money
Market/Money Market Instruments
• •
Key Takeaways 909 Further Reading 910 Problem
•
Sets 910 Solutions to Self-Test Questions 916 •
Finance on the Web 917
I Part Eleven: Mergers, Corporate Control,
and Governance
32 Mergers 918
32-1 Types of Merger 919
32-2 Some Sensible Motives for Mergers 919
Economies of Scale and Scope/Economies of
Vertical Integration/Complementary Resources/
Changes in Corporate Control/Industry
Consolidation/Logic Does Not Guarantee Success
32-3 Some Dubious Motives for Mergers 923
Diversification/Increasing Earnings per Share:
The Bootstrap Game/Lower Borrowing Costs/
Management Motives
Another random document with
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 The tenderness of his voice checked her in an instant. His hand moved
up and down her bare arm, lingering over its curves, tracing the outline with
a touch that made her shiver.
‘Lovely smooth arm,’ he whispered. ‘You are so lovely.’
‘No.’
‘Yes. I think so. I’ve always thought so.’
‘As long as you think so, then—that’s all I care about. You—can have it
all.’
‘Oh, Judy!’
Now the moon rose, clear at last above the tree tops, and gleamed
strangely into the eyes bent upon her face. His lips were smiling a faint
fixed smile. His teeth glinted. The two faces gazed at one another, floating
wan upon darkness.
The web had broken. Roddy had shaken himself free and come close at
last. The whole of their past lives had led them inevitably to this hour.
‘Oh, Roddy, I love your hair....’ Her hand went up and stroked it; and he
shut his eyes. ‘I love your eyes.’
‘I love you all—every bit of you.’
Breathless, sure of him at last, with a delicious last-minute postponement
of his embrace she moved away, softly laughing.
‘Roddy, how much do you like me? This much?’
She held out her hands, parting them slowly.
‘More than that.’
‘This much?’
He copied her, laughing eagerly but silently.
‘This much?’
He held his arms out wide. She hesitated a moment and then came into
them; and he was not laughing any more, but covering her face and neck
with kisses.
It was a quivering darkness of all the senses, warm, melting, relentless,
tender. This stranger was draining her of power; but underneath, the springs
of life welled up and up with a strong new beat. He clung to her with all his
force as if he could never let her go. He was a stranger, but she knew him
and had known him always. She took his caressing hands and held them on
her breast. In that moment he was her child; and she longed to lay his head
where his hands quietly lay. He drew deep breaths, and now and then his
rich voice murmured a broken word or two.
She raised her head from his shoulder and gazed in passionate detail at
his face.
‘Speak, Roddy, speak.’
He shook his head and smiled—a ghost of his former smile, flickering
on his lips alone. His half-shut eyes glittered as if with tears. In the
moonlight she worshipped his dark head and moon-blanched features.
Gradually he loosened his hold, threw his head back, and stood motionless,
arms hanging at his sides, his face an unconscious, sleeping mask. If Roddy
were to die young, this was how he would look.
‘Roddy—Roddy—Roddy—I love you—I love you—I love you.’
No answer. He stooped his head and fell to closer kissing.
‘Roddy—say——’
‘What do you want me to say?’ he whispered. Again the flickering
smile.
‘I love you, Roddy.’
Ah, if he would whisper back those few words, there would be peace for
ever.
She laid her cheek against his, murmuring endearments.
‘My dear, my darling, my little one, I love you. My dear, I’ve always
loved you. Did you know it?’
He shook his head faintly.
‘I love you too much, I’m afraid.’
Oh, far too much, if she was to wait in vain for any response save
kisses....
‘No, Judy, no.’ The words broke from him painfully. ‘You must forget
about me now. Kiss me and say good-bye.’
‘Why, oh, why?’ She clutched him desperately.
‘I’m going away,’ he whispered.
‘But you’ll come back? You’ll come back, Roddy?’
He was silent, utterly silent.
‘I can’t. I can’t,’ he said at last.
 ‘I’ll wait, Roddy. I don’t care how long I wait. I shall never want anyone
else. I’ll wait years.’ There was no answer; and after a while she added in a
small laboured whisper: ‘If you love me a little.’
‘Oh!’ He threw up his head with a sort of groan. ‘Yes. Yes. Yes.’
‘You love me?’
He must, he must say it.
‘Yes, I love you.’ The words came out on a groaning breath. She put her
lips on his, and stood silent, drinking in her bliss.
He tossed his head suddenly, as if waking up.
‘Oh, Judy, we must go back, we must go back.’
He sighed and sighed.
‘No. A little longer. We’ll talk a little before we go. We must talk.’
He laughed—a normal teasing laugh.
‘A little conversation,’ he said. ‘You’re a tiger for conversation, aren’t
you?’
‘I don’t mind your laughing at me.’
They were going to laugh gaily at each other, with each other, for ever.
He put his hand beneath her chin and turned her face up to his.
‘Lovely Judy. Lovely dark eyes.... Oh, your mouth. I’ve wanted to kiss it
for years.’
‘Oh, Roddy, you can kiss it whenever you want to. I love you to kiss me.
All of me belongs to you.’
He muttered a brief ‘Oh!’ beneath his breath, and seized her, clasped her
wildly. She could neither move nor breathe; her long hair broke from its last
pins and fell down her back, and he lifted her up and carried her beneath the
unstirring willow-trees.

He had brought her back home. Languorous and bemused she stepped
out upon the bank in the breaking dawn, and turned to look at him beneath
her heavy lids. She could not see him clearly, he seemed blurred, far away.
‘Good-bye,’ he said briefly.
‘I’ll see you before you go,’ she said mechanically.
 Not that it really mattered now. Time was not any more and he would be
with her for ever.
He nodded; and then abruptly turned the canoe down stream again:
looked at her once, faintly smiled, waved his hand an instant and went on.
She walked through the waiting, clear pale-coloured garden, into the
house, up to her bedroom; stared in the dim glass at her strange face; sank
into bed at last.

4
It was on the next evening that she awoke to the realization that Roddy
had not come—might not—certainly would not now. He was going away.
He, who always found self-expression, explanations, so difficult, would be
at a loss to know what to say when he too woke up. He who never made
plans would be helpless when it came to making any which should include
her too in the future. Last night he had been dumb, he had sighed and
sighed, whispered inarticulately: he would find it hard to be the first to
break silence, to endeavour to re-establish the balance of real life between
them. She would write him a letter, tell him all; yes, she would tell him all.
Her love for him need no longer be like a half-shameful secret. If she posted
a letter to-night, he would get it to-morrow morning, just before he left.
She wrote:
 Roddy, this is to say good-bye once more and to send you all my love till
we meet again. I do love you, indeed, in every sort of way, and to any
degree you can possibly imagine; and beyond that more, more, more,
unimaginably. The more my love for you annihilates me, the more it
becomes a sense of inexhaustible power.
Do you love me, Roddy? Tell me again that you do; and don’t think me
importunate.
I am so wrapped round and rich in my thoughts of you that at the
moment I feel I can endure your absence. I almost welcome it because it
will give me time to sit alone, and begin to realise my happiness. So that
when you come back—Oh, Roddy, come back soon!
I have loved you ever since I first saw you when we were little, I
suppose,—only you, always you. I’m not likely ever to stop loving you.
Thank God I can tell you so at last. Will you go on loving me? Am I to go
on loving you? Oh, but you won’t say no, after last night. If you don’t want
to be tied quite yet, I shall understand. I can wait years quite happily, if you
love me. Roddy, I am yours. Last night I gave you what has always
belonged to you. But I can’t think about last night yet. It is too close and
tremendous and shattering. I gasp and nearly faint when I try to recall it. I
dissolve.
When I came back to my room in the dawn I stared and stared at my face
in the glass, wondering how it was I could recognize it. How is it I look the
same, and move, eat, speak, much as usual?
Ought I to have been more coy, more reluctant last night? Would it have
been more fitting—would you have respected me more? Was I too bold?
Oh, this is foolishness: I had no will but yours. But because I love you so
much I am a little fearful. So write to me quickly and tell me what to think,
feel, do. I shall dream till then.
There is so much more to tell you, and yet it is all the same really. My
darling, I love you!
Judy.
She posted it. Next morning she hurriedly dressed and ran downstairs in
the sudden expectation of finding a letter from him; but there was none.
Now he would have got hers.... Now he would have read it.... Now he
would be walking to the station....
 She heard the train steam out; and doubt and sorrow came like a cloud
upon her; but only for a little while.
In the cool of the evening she wandered down to the river and sat beside
it dreaming. She dreamt happily of Jennifer. She would be able to love
Jennifer peacefully now, think of her without that ache, see her again,
perhaps, with all the old restlessness assuaged. Jennifer’s letter would
surely come soon now....
If Roddy were to ask her to come away with him at once, for ever, she
would take just the copper bowl from her table and spring to him, and leave
all the rest of the past without a pang.
Perhaps Roddy had written her a letter just before he had gone away; and
if so it might have come by the evening post. She left the river and went to
seek it.
Who could it be coming towards her down the little pathway which led
from the station to the bottom of the garden and then on to the blue gate in
the wall of the garden next door? She stood still under the overhanging
lilacs and may-trees, her heart pounding, her limbs melting. It was Roddy,
in a white shirt and white flannels,—coming from the station. He caught
sight of her, seemed to hesitate, came on till he was close to her; and she
had the strangest feeling that he intended to pass right by her as if he did not
see her.... What was the word for his face? Smooth: yes, smooth as a stone.
She had never before noticed what a smooth face he had; but she could not
see him clearly because of the beating of her pulses.
‘Roddy!’
He lifted his eyebrows.
‘Oh, hullo, Judith.’
‘I thought you’d gone away.’
‘I’m going to-morrow. A girl I know rang up this morning to suggest
coming down for the day, so I waited. I’ve just seen her off.’
A girl he knew.... Roddy had always had this curious facility in the
dealing of verbal wounds.
‘I see.... How nice.’
A face smooth and cold as a stone. Not the faintest expression in it. Had
he bidden the girl he knew good-bye with a face like this? No, it had
certainly been twinkling and teasing then.
 ‘Well, I must get on.’ He looked up the path as if meditating immediate
escape; then said, without looking at her, and in a frozen voice: ‘I got a
letter from you this morning.’
‘Oh, you did get it?’
There could never have been a more foolish-sounding bleat. In the
ensuing silence she added feebly: ‘Shall you—answer it—some time?’
‘I thought the best thing I could do was to leave it unanswered.’
‘Oh....’
Because of course it had been so improper, so altogether monstrous to
write like that....
‘Well,’ she said. ‘I thought.... I’m sorry.’
She ought to apologise to him, because he had meant to go away without
saying anything, and she had come on him unawares and spoilt his escape.
‘I was very much surprised at the way you wrote,’ he said.
‘How do you mean, surprised, Roddy?’ she said timidly.
She had known all along in the deepest layer of her consciousness that
something like this would happen. Permanent happiness had never been for
her.
It was not much of a shock. In a moment that night was a far, unreal
memory.
‘Well’—he hesitated. ‘If a man wants to ask a girl to—marry him he
generally asks her himself—do you see?’
‘You mean—it was outrageous of me not to wait—to write like that?’
‘I thought it a little odd.’
‘Oh, but Roddy, surely—surely that’s one of those worn-out
conventions.... Surely a woman has a perfect right to say she—loves a man
—if she wants to—it’s simply a question of having the courage.... I can’t
see why not.... I’ve always believed one should....’
It was no good trying to expostulate, to bluff like that, with his dead face
confronting her. He would not be taken in by any such lying gallantries.
How did one combat people whose features never gave way by so much as
a quiver? She leaned against the wooden fence and tried to fix her eyes
upon the may-tree opposite. Very far, but clear, she heard her mother at the
other end of the garden, calling her name: but that was another Judith.
 ‘I’m afraid you’ve misunderstood me,’ he said.
‘Yes. I’ve misunderstood you. You see—this sort of thing has never
happened to me before and I thought ... when a person said.... Why did you
say.... I didn’t know people said that without meaning it.... I suppose we
must mean different things by it. That’s what it is. Well....’ Her voice was
terrible: a little panting whine.
‘I don’t know what you mean.’
Probably that was true: he had forgotten he had ever said: ‘I love you.’
She could not remind him; for in any case he would not be affected. What
were three little words?... And after all, she had probably more or less
forced him to say them: she had wanted to hear them so much, she had
driven him to say them. Yes, he had groaned, and quickly repeated them to
keep her quiet, stop her mouth so that he could go on kissing her. She said:
‘But why, Roddy, why did you take me out ... behave as you did ... kiss
me so—so.... I don’t understand why you bothered ... why you seemed....’
He was silent. O God! If only he would wound and wound with clean
thrusts of truth, instead of standing there mute, deaf.
‘Roddy, after all these years, these years we’ve known each other, can’t
you tell me the truth? We were good friends once, weren’t we?’
‘Yes, I think so.’
‘Oh, I see! I see! And you could never feel like being—more than that.’
He shook his head.
‘I see, Roddy.’ The pain was sharp now, hard to fight down. ‘I see. And
you thought there had better be an end ... because you were never going to
love me: and I obviously—was it obviously?—was becoming more and
more—foolish—and tiresome. So you thought—you’d say good-bye—like
that—and then go away for good. Was that it!’
He passed a hand across his forehead: his first gesture. Then he too was
feeling, however slightly.
‘I thought that was what you wanted: what you were asking for,’ he said.
‘Oh, so you thought you’d oblige——’ No, no, not sarcasm. She waited
a moment and added: ‘I see. You misunderstood me. I daresay it was quite
natural. You thought I wanted what you wanted—just a little—a little
passion—to round off a flirtation—and be done with it. Well....’
 The lane was so still that she could hear the dull beat of oars in passing
boats on the other side of the fence. The evening had become very cold.
She gave a little laugh and said:
‘I really am very sorry to make this fuss. It’s too laughable that I should
—I! ... I suppose you never dreamed I—wasn’t used to this sort of thing—
from men?’
‘I thought you knew pretty well what you were about.’
‘And I didn’t! I didn’t! I was being deceived—like any.... Oh, it’s so
vulgar!’ She shut her eyes, laughing weakly. ‘That’s why you didn’t make
your meaning plainer, I suppose. You thought I was quite used to—that sort
of thing—kissing—just for a lark. Just for a lark, Roddy—that was it,
wasn’t it? And I got serious, and tried to—to let you in for more.... I tried to
catch you. Poor Roddy! But you’d never get let in, would you? You know
your own mind. You’re cautious. You’ll see—,’ she waved her hand
slightly, ‘I’m not dangerous. I’ll never bother you any more. And I’m very
very sorry.’ She broke down with a gasp, but did not weep.
‘I’m sorry, Judith. I apologise. I——’ His voice had now the faintest
trace of emotion.
‘Oh!’ She controlled herself. ‘Apologise! Have I accused you? This is
just another damned muddle. I’m only trying to understand it.’
‘I really think I had better go,’ he said.
‘No!’ She put out a hand and clutched his arm in desperate protest. ‘Not
yet, Roddy. Not for a moment. Can’t we—O God! I wish I’d never written
that letter. Then there’d have been no need for all this.... You’d have gone
away and said nothing—and gradually I’d have understood. I should have
seen it all in its proper light. Things would have somehow come right again,
perhaps. And now I suppose they never can.... Can they, Roddy, can they?
Oh, if they could!’
How he was hating this scene! It was a shame to prolong it. He
swallowed hard and said, rather nervously:
‘Do you suppose you really meant—all you said in your letter?’
It was her chance. She must say it was all nonsense, that letter, that it
was written in a moment of madness; that she did not mean it now. Then
they might somehow manage to laugh together and part friends. He was
such a good laugher! She could go away and bury her disappointment; and
next time they met, be to him what he wanted: a light flame of passion,
blown out, relit again. He had given her the taste for his kisses. She would
miss them, and desire them painfully. If she could act her part skilfully now,
she need not be for ever without them.
But it was no good: the thing would not be lied about.
She nodded, gazing at him in utter despair. She went on nodding and
nodding, asserting the truth in silence and with all her force, compelling
him to believe it. She saw him flush faintly beneath his sallow skin.
‘I’m very sorry then,’ he said, in his frozen voice.
She cried out:
‘Oh, Roddy! Did you never like me? Didn’t you even like me? All these
years! It seemed as if you did.... I couldn’t have grown to—like you so
much if you hadn’t given me a little—a little return....’
‘Of course I liked you very much,’ he said. ‘I always thought you were
extremely attractive.’
‘Attractive!’ She bowed her face in her hands. ‘Yes. I was attractive to
you. And so.... That you should have treated me so lightly, Roddy! Oh, did I
really, really deserve that?’
He was silent.
‘If you’d warned me, Roddy ... given me some hint. I was so romantic
and idealistic about you—you’ve no idea.... I thought you must think of me
in the same sort of way I thought about you.... Couldn’t you have warned
me?’
He said in a voice choked with exasperation:
‘I did try to shew you, I tell you. I should have thought I’d shewn you
often enough. Didn’t I say I was never to be taken seriously?’
She sighed and nodded her head drearily. She was beaten.
‘Yes. Yes, you did. I wouldn’t be warned, I was such a fool. Oh, it’s all
my fault. A good sell for me.’
‘Well, I’d better go now,’ he said after a pause.
He took a step or two and then turned back. She still leaned against the
wall, and something in her attitude or expression seemed suddenly to move
him. He lingered, hesitated. His face shewed a little trouble and confusion.
‘I suppose you’re all right?’ he said.
 ‘Oh, I shall be quite all right.’
‘Please forget all about me.’
‘I shan’t forget about you. But I shall forget all this—if you will do the
same. We will meet in the future, Roddy, won’t we?—just as usual,—with
all the others?’
‘I think it would be better not to. I think we’d better not write to each
other or ever meet again.’
‘Not ever meet again, Roddy?’ How did he come to be master of such
cold decisions? She felt like a child in futile conflict with the fixed and
unalterable will of a grown-up person. ‘Why? Why? Why? Please do let
me. Please do. I won’t ever be a nuisance again, I promise. You’ve said you
liked me. Oh, I must see you! If I can’t see you, I can’t ever see any of them
again. Don’t you see? And then I’d have nothing.... You wouldn’t tell them,
would you, Roddy? Please let me see you again.’
It had lasted too long. In another moment she would be on her knees to
him, hysterical, loathsome.
A nervous quiver of his lips checked her suddenly and made her quiet. In
some obscure way he was suffering too. He looked like the little boy whose
face had implored her not to cry that time of the rabbit’s death. Yes, the
spectacle of other people’s pain had always affected him unpleasantly.
‘It’s all right, Roddy,’ she said. ‘Don’t worry about me. I’ll get on
without you.’
‘I’m not worth wasting one moment’s regret on,’ he said, almost
earnestly. ‘Believe me, Judith. It’s true.’ He looked at her for the last time.
‘I can only say again I’m very sorry and ask you to forget all about it.’
She took a deep breath.
‘One thing more,’ she said. ‘I’m not ashamed of anything I’ve done.
There’s nothing to be ashamed of in loving a person and saying so.’
It was not true. The shame of her surrender, her letter, her unrequited
love would go on gnawing, burning, till the end of her life.
He left her, walking away from her with a graceful and noiseless tread.

After all, it did not seem to hurt much: certainly not more than could be
borne in secret, without a sign.
 It had all been experience, and that was a salutary thing.
You might write a book now, and make him one of the characters; or
take up music seriously; or kill yourself.
It was all so extraordinary.... That night had seemed to Roddy so
insignificant that instead of hurrying away quickly when he got that letter,
he had had a girl he knew down for the day: and that was how he had spoilt
his own escape.
Shut the door on Roddy and turn the key and never open that room
again. Surely it would be quite easy. She saw herself as a tiny person
walking firmly away and not once looking back. There were plenty of other
things to think about.... What was there, safe and simple, to think about?
Strawberries and cream for supper. Good. Two new frocks: but he was to
have admired her in them.... A visit to London next week, and a play.
She noticed suddenly that her hands were bleeding from slight abrasions.
How had that happened? Best to go in now and arrange her face a little.
This shivering had been going on for a long time.

5
Three weeks later she stepped out of the train at a little country station in
Hampshire; and was there met by a beaming Martin, and conveyed swiftly
in his car to his home.
The long drive wound through shrubbery and great beech trees, and
opened in a wide sweep before the long low many-windowed house-front.
It was an old manor, built of exquisitely time-tempered brick. The great
porch was covered with clematis and jasmine; and here and there climbing
bushes of yellow or white roses wove their way up the walls and coiled
around the window-frames. Beyond it and on each side of it she caught or
imagined glimpses of a rich old garden, lawns and a herbaceous border,
cedar trees, yew hedges, and an espalier of peach-trees along a high wall.
A butler appeared, took her suitcase and slid away again.
Martin led the way through the oak-panelled hall into a large bright
flowery chintz drawing-room. All the colours were blue and pink and
white; and there were photographs everywhere, and vases full of
delphiniums, roses and lilies. The French windows opened on to the sunny
lawn, and, set in front of them, the tea-table shone with blue and white
china, and silver, and glass jars of honey and jam. Behind the tea-table sat
Martin’s mother, smiling.
She was as clean and fresh, as white and pink and blue as her drawing-
room. Her erect and trim little figure was crowned with white hair; her blue
rather prominent eyes held the wistful appeal of the short-sighted as she
looked into Judith’s face to greet her. Her thin mouth smiled and went on
smiling, happily, vaguely, with a kind of sweet and weak persistence. All
the lines in her face ran upwards as if she had spent her life smiling. She
had a white skin with a clear rose flush over each cheekbone. She was
really very pretty in her white lace dress and fleecy pale blue wrap: a
mother to take out to dine in her best black frock and all her diamonds and
feel proud of.
‘So this is Judith that I’ve heard so much about,’ she said charmingly;
and put a hand on her arm to lead her to the tea-table.
Three black spaniels begged and adored at her feet; or rolled over,
waving limp self-conscious devotional paws.
Over the mantelpiece hung the portrait of Martin’s dead father. He had
been Governor of somewhere: an important man. He looked reliable and
kindly, with Martin’s brown eyes and untidy features.
On the opposite wall hung a sentimental pastel portrait, life-size, of
Martin at the age of three: golden-brown curls, pink cheeks, a white silk
blouse with a frilly collar. There were some books in glass-fronted book-
cases, some goodish furniture and china; one or two good water-colours and
some indifferent ones; abundant plump cushions in broad soft chairs and
couches. It was a house that shewed in every detail the honourable,
conventional, deeply-rooted English traditions of Martin’s people.
And yet not they, with their sober steadfastness, but that wild sister, the
disgrace, Mariella’s mother, had prepared, it seemed, the strange mould for
the next generations: for all, that is, save Martin himself.
He was in high spirits. He smiled with all his white teeth, and threw
sandwiches to the dogs, and teased his mother, and stared in a sort of
delighted astonishment to see her actually sitting at tea with him in his
home. He looked almost handsome in his bright blue shirt, open to shew a
white strong well-modeled throat rising cleanly from the broad shoulders.
He did not know that Judith was dead: that a dummy was sitting beside
him. He had declared several times how well she was looking.
 He said suddenly:
‘Heard from Roddy, Judith?’
She was not prepared for that name; and she felt a faintness sweep over
her.
‘No, Martin, I haven’t.’
‘I had a letter from him this morning. It’s pure agony for Roddy to
answer an invitation, even, so I was flattered. He and I and one or two other
chaps are going to do some sailing next month, off the Isle of Wight, and he
actually wrote to make arrangements.’
‘What fun that will be, Martin.’
She bowed her head over the plate in her lap, crumbling a scone to
fragments.
‘Why don’t you come too, Judith? Do! It’d be perfectly proper wouldn’t
it, Mummie? We’re her bachelor uncles.’
It was precisely at those words, at the unexpected recalling of all that
light-heartedness, that happiest day of all, that the thing leapt to life within
her, and fiercely, horribly pressed towards birth. Oh, now there was no
hope. Roddy had arisen all in a moment from his false burial.
With a vast effort she prevented her eyes from closing quite; but to speak
was impossible.
‘Roddy says——’ began Martin, glanced across at her, and stopped
uncertainly, startled. He was silent, and then said:
‘Tired, Judith?’
‘A bit—after my journey—it’s so hot to travel. Isn’t it?’ She turned to
his mother.
‘Yes, my dear, it is,’ she said cooingly. ‘Come, I’ll take you to your room
and you shall rest till dinner.’
Martin had got up and was hovering over her, anxious and despondent.
But she could smile at him now, and she said:
‘I’d rather go out if I may, and get cool. The garden looks so lovely.’
‘That’s right then,’ said Martin’s mother encouragingly. ‘Take her out,
Martin darling, and shew her the rock-garden. Martin and I have been
making a rock-garden, Judith—I may call you Judith, mayn’t I?’ She laid a
hand again on Judith’s arm. ‘It’s such fun. Martin and I are both ridiculous
potterers and experimenters. Are you like that?’
‘Not practically, I’m afraid.’
‘Ah, well, it’s a delightful hobby. It keeps me busy and healthy, doesn’t
it, Martin?’ She looked up into his face, and he put a large hand upon her
little shoulder. ‘There,’ she added, ‘Run along now. Don’t let Martin take
you in the fields or up to his precious farm: you’ll spoil your pretty shoes.
Aren’t they darling shoes, Martin? And such a pretty frock.’
With little pats and handwavings and vague benevolence she saw them
out of the French windows down the steps into the garden.

Martin said:
‘Wait. I’ll take a gun. We’re simply tripping over rabbits this year. It’s
awful.’
She did not hear properly; nor, when Martin came back to her, did she
grasp the significance of the gun over his shoulder.
He led her out of the garden by a wooden bridge over a stream half-
hidden in forget-me-nots, kingcups and iris plants; through the meadow
where grazed the pedigree cows which, so he said, were his mother’s pride;
over a stile and up on to the chalky rabbit-pitted hillside.
She was standing among the willow trees, and out of the moonlight a
voice was saying in a low hurry: ‘I love you’—and saying another thing
damnably characteristic: ‘Lovely Judy! Lovely dark eyes!’ His teeth
gleamed as he smiled in the moonlight.... He closed his eyes.... It was all in
such bad taste, in such bad taste....
Martin was pointing out the marches of the estate. There were beech
copses and farms and two gentle folds of sun-drenched sheep-strewn hill
between them and its final hedgerows.
‘You know I do love it,’ said Martin shyly. ‘I worship the soil.’ He
hesitated and then said with a laugh: ‘Funny: Sometimes I absolutely wish I
were dead so that I could be buried in it and have it all over me and inside
me for ever and ever.... Look at the way those slopes overlap....’ His eyes
fastened on them, with a hungry expression.
Then this was Martin’s secret bread. It was his land that nourished him at
the source, and made of him this man with an individual dignity and
simplicity at the core of his ordinariness. She made an effort to come nearer
to him in mind.
‘Yes ... I know Martin.’
He turned joyfully.
‘I always tell you everything, Judith. I suppose it’s because I know
you’ll understand.’
‘Which bit do you want to be buried in, Martin?’
‘I don’t care—as long as I’m well inside it.’
‘Would you ever commit suicide?’
‘Would I what?’
‘Commit suicide. To—to get there quicker.’
He laughed and said comfortably:
‘Well, I’ve never been tempted to so far....’
‘It’s an old family place is it, Martin?’
‘Oh, yes. My father was born here, and all the others. Roddy’s father and
Julian’s, and the only sister—Mariella’s mother. She was very beautiful you
know—and absolutely wild—almost mad I should think. She ran away
from her husband and goodness knows what sort of life she led. I believe it
simply broke my grandfather’s heart. He died, and then Grannie—you
remember Grannie?—couldn’t bear to go on living here alone. All the
children were scattered or married or dead. So she moved to the little place
on the river—next door to you.... Poor old lady, she didn’t have much of a
time. She outlived all her children except Roddy’s father: and he was never
much use to her. He quarrelled with his father when he was quite a boy and
left home. I don’t know what about. Grandpapa was a terrible martinet....
Yes, they were an unlucky family.’
‘And they all died young, Martin?’
‘More or less. But we none of us ever live to be old,’ he said cheerfully.
They had reached the top of the hill; and, suddenly, up went Martin’s
gun. Then, with an exclamation of disgust, he lowered it again.
‘Wasn’t ready for him. Once they get into that bracken——’
‘What’s that, Martin?’
‘Rabbit. Didn’t you see? Beastly vermin.... Never saw anything like
them. Much as we can do to keep pace with them.’
 He was muttering to himself in an annoyed way.
‘But, Martin—do you mean to shoot them?’
‘Shoot them? I should say I do, if I get the chance.’
‘I never have been able to understand how people can bear to shoot
rabbits.’
‘Hum,’ said Martin, grim and indifferent. ‘You mustn’t expect me to be
sentimental about ’em.’
His eyes roved round alertly; his gun was ready to go up in a trice. He
was not giving a thought now to Judith walking beside him.
Just over the crest of the hill came a sudden small kicking and flurry. A
tiny pair of fur legs started away into the bracken, the white scut glancing
and bobbing. But the bracken thinned away to nothing here: the small form
was bound to emerge again in a moment.
There was a sharp crack.
‘Aha!’ said Martin; and he went forward to where something flipped in
the air and fell back again, horribly twitching in a mechanical and aimless
motion.
‘Oh! Oh! Oh!’ She stood rooted where he had left her, aghast.
He was stooping to examine it....
She knew how it was looking—laid on its flat side and shewing the
tender and vulnerable whiteness beneath its frail stiff paws. He was
stooping just as a figure had stooped above that other rabbit.... What years
ago!... Roddy’s rabbit whose death and burial had started this awful loving.
Who was it devilish enough to prepare these deliberate traps for memory,
these malicious repetitions and agonizing contrasts?
Oh, this world!... No hope, no meaning in it; nothing but perversities,
cruelties indulged in for sport, lickings of lips over helpless victims. Men
treated each other just as Martin treated small animals. The most you could
hope for was a little false security: they gave you that to sharpen their
pleasure in the blow they were preparing: even the ones that looked kind:
Martin for instance. As for Roddy—Roddy liked experimenting. He chose
girls sometimes: that was more voluptuous. She saw his face, pallid and
grinning, crowds of leering faces, all his. The hillside darkened. She sank
on her knees, shaking and perspiring.
He was striding back.
 ‘I buried it,’ he called. ‘It was a little smashed about the head.’
She had to lift her face towards him; but she made it blind. He came and
stood beside her—he dared to, red-handed as he was.
‘I’m afraid it wasn’t one of the cleanest shots,’ he said cheerfully. ‘I got
him at too long a range. Still,—that’s one less.... Come on.’
Her mind would frame only one sentence; and she tried over and over
again to say it.
‘I will not be a witness of your butcheries. I will not be a witness of your
butcheries.’
But he would not understand. Perhaps it did not make sense anyway.
‘Oh dear!’ She sat there, tearing up turf with shaking cold wet hands,
face averted, eyes staring, mouth open and out of shape, impossible to
control. ‘Oh dear! Oh dear! Oh dear!’ The repetition was a sort of whine or
mew.
‘What’s the matter?’ he said sharply. He sank down beside her, and his
astounded face came round her shoulder.
‘Oh, the poor little thing, the poor little thing!...’
‘Do you mean the rabbit?’
She nodded.
‘But, Judith—good heavens! A rabbit.... Judith. I’d never have shot it if
I’d dreamed you’d mind.’
She went on staring and pulling up the grass.
‘Oh, this world!’
‘Judith....’ He was silent, completely at a loss.
‘Still—it can’t be helped.... I suppose one gets accustomed....’
Her mind grew black again with formless and colossal conceptions of
torture, murder, lust: and Roddy’s face went on grinning among them. All
was lost, lost.
‘I’m very sorry,’ said Martin helplessly.
‘Oh, I don’t blame....’
‘It didn’t suffer you know. Did you think it had? That kicking didn’t
mean anything: it was simply reflex action.’ He thought he had found the
clue; and added cheerfully: ‘You’d do the same if I shot you dead at the
back of the head.’
 ‘I wish you had.’
She wept.
‘Good God! Really, Judith.... I’ve said I’m sorry. I can’t go on saying it,
can I? I didn’t know you were so—you oughtn’t to be so—easily upset.
Rabbits have to be kept down, you know. They destroy everything. Ask my
mother.’
She went on weeping; and after a little while he got up and strode a few
steps away, and stood with his back to her, shoulders hunched.
Worse and worse: he was deserting her.... She bit hard on her thumb till
the pain of it steadied her, waited and then called tremblingly:
‘Martin!’
He turned, saw her hand held out and came quickly and knelt beside her.
‘What is it, Judy, what is it?’
‘Oh, Martin! Oh, it’s nothing. Don’t ask, don’t.... Only—just—only
——’
His arms went round her and she abandoned herself against him,
pressing her head into his shoulder, groping for comfort, sobbing vast sobs,
while he knelt beside her quietly and let himself be wept on; and now and
then gave her shoulder a little pat.

After a long time she was so empty of tears that their source seemed dry
for ever. She would never in her life weep any more. In the thin crystalline
buoyancy of exhaustion she lay back on his shoulder and observed the gold
light lying tender and still in the folds of the hills; and two rabbits skipping
unperturbed not so very far away; and blue butterflies swinging on the long
grasses; and all the evening shadows slanting beautifully downwards. Peace
and comfort dropped upon her. The heavy ache for Roddy was gone. Oh,
now to make this no-pain permanent, to fix this languor and mindless calm,
to smother the voice which cried and cried: ‘I am cheap and shameful. I
have been used for sport!’ Now was the time to turn to Martin and see if he
could save her.
She sat up and dried her eyes.
‘There!’ she said. ‘I’m sorry. Thank you, Martin. You are a dear. You’ve
always been very kind to me, haven’t you?’
‘Kind to you! Oh, Judith, you know——’
 ‘I think you must rather like me, Martin.’
He said with a deep intake of breath:
‘Like you! You know I’ve loved you for years.’
She was silent, tasting a faint relief and satisfaction; and then said:
‘Well, what would you like me to do about it, Martin?’
She saw that his hands were trembling, and he answered shakily:
‘Do about it ... I.... What do you want to do about it?... I’ve said I——’
‘Would you like me to marry you?’ she asked softly.
‘God! If there was a chance!...’
‘Well—I might, Martin.’
She started to laugh and cry weakly at sight of the transfigured face he
turned towards her; and a voice went on protesting inside her: ‘No! No! No!
It isn’t true. I never will.’
‘Oh, I’m so tired, Martin, I’m so tired!’
‘Come home, my dear, come home.’
It was compassion and exultation and doubt and certainty, all mixed in
an inarticulate eloquence.
He lifted her and brushed her skirt.
There was nothing to do but accompany him down the hill.
He left her at her bedroom door. His mother, he said, would come and
give her aspirin and put her to bed, and see that dinner was brought up to
her. His mother was splendid about headaches. To-morrow there would be
plenty of time to talk.
He had behaved perfectly.

She fell asleep that night in her white room with its cretonne wreaths of
pink roses tied up with blue ribbon, and dreamed of Roddy. He sat on the
hill, close to where the rabbit had been shot, and conversed in friendly
fashion. He had come back from abroad, from some remote island. He took
a puff at his pipe and said with apparent irrelevance: ‘Not wives, my dear
girl—mistresses. It’s more convenient. When I return I intend to take
Martin as my partner.’
‘Martin wouldn’t come. Not if it’s mistresses....’