Managerial – V

Chapter 7 Questions & Problems:  14, 15, 16

Chapter 11 Questions & Problems:  1, 2, 3, 4, 5

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Fundamentals of

Corporate Finance

Eighth EDITION

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Fundamentals of

Corporate Finance

Richard A. Brealey London Business School

Stewart C. Myers Sloan School of Management, Massachusetts Institute of Technology

Alan J. Marcus Carroll School of Management, Boston College

Eighth EDITION

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THE McGRAW-HILL/IRWIN SERIES IN FINANCE, INSURANCE, AND REAL ESTATE

Stephen A. Ross, Franco Modigliani Professor of Financial Economics Sloan School of Management, Massachusetts Institute of Technology Consulting Editor

Financial Management

Block, Hirt, and Danielsen Foundations of Financial Management Fifteenth Edition

Brealey, Myers, and Allen Principles of Corporate Finance Eleventh Edition

Brealey, Myers, and Allen Principles of Corporate Finance, Concise Second Edition

Brealey, Myers, and Marcus Fundamentals of Corporate Finance Eighth Edition

Brooks FinGame Online 5.0

Bruner Case Studies in Finance: Managing for Corporate Value Creation Seventh Edition

Cornett, Adair, and Nofsinger Finance: Applications and Theory Third Edition

Cornett, Adair, and Nofsinger M: Finance Second Edition

DeMello Cases in Finance Second Edition

Grinblatt (editor) Stephen A. Ross, Mentor: Influence through Generations

Grinblatt and Titman Financial Markets and Corporate Strategy Second Edition

Higgins Analysis for Financial Management Tenth Edition

Kellison Theory of Interest Third Edition

Ross, Westerfield, and Jaffe Corporate Finance Tenth Edition

Ross, Westerfield, Jaffe, and Jordan Corporate Finance: Core Principles and Applications Fourth Edition

Ross, Westerfield, and Jordan Essentials of Corporate Finance Eighth Edition

Ross, Westerfield, and Jordan Fundamentals of Corporate Finance Tenth Edition

Shefrin Behavioral Corporate Finance: Decisions That Create Value First Edition

White Financial Analysis with an Electronic Calculator Sixth Edition

Investments

Bodie, Kane, and Marcus Essentials of Investments Ninth Edition

Bodie, Kane, and Marcus Investments Tenth Edition

Hirt and Block Fundamentals of Investment Management Tenth Edition

Hirschey and Nofsinger Investments: Analysis and Behavior Second Edition

Jordan, Miller, and Dolvin Fundamentals of Investments: Valuation and Management Seventh Edition

Stewart, Piros, and Heisler Running Money: Professional Portfolio Management First Edition

Sundaram and Das Derivatives: Principles and Practice First Edition

Financial Institutions and Markets

Rose and Hudgins Bank Management and Financial Services Ninth Edition

Rose and Marquis Financial Institutions and Markets Eleventh Edition

Saunders and Cornett Financial Institutions Management: A Risk Management Approach Eighth Edition

Saunders and Cornett Financial Markets and Institutions Sixth Edition

International Finance

Eun and Resnick International Financial Management Seventh Edition

Real Estate

Brueggeman and Fisher Real Estate Finance and Investments Fourteenth Edition

Ling and Archer Real Estate Principles: A Value Approach Fourth Edition

Financial Planning and Insurance

Allen, Melone, Rosenbloom, and Mahoney Retirement Plans: 401(k)s, IRAs, and Other Deferred Compensation Approaches Eleventh Edition

Altfest Personal Financial Planning First Edition

Harrington and Niehaus Risk Management and Insurance Second Edition

Kapoor, Dlabay, and Hughes Focus on Personal Finance: An Active Approach to Help You Develop Successful Financial Skills Fourth Edition

Kapoor, Dlabay, and Hughes Personal Finance Eleventh Edition

Walker and Walker Personal Finance: Building Your Future First Edition

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Dedication To Our Wives

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FUNDAMENTALS OF CORPORATE FINANCE, EIGHTH EDITION

Published by McGraw-Hill Education, 2 Penn Plaza, New York, NY 10121. Copyright © 2015 by McGraw- Hill Education. All rights reserved. Printed in the United States of America. Previous editions © 2012, 2009, 2007, 2004, 2001, 1999, and 1995. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of McGraw-Hill Education, including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning.

Some ancillaries, including electronic and print components, may not be available to customers outside the United States.

This book is printed on acid-free paper.

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ISBN 978-0-07-786162-9 MHID 0-07-786162-0

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

Library of Congress Cataloging-in-Publication Data

Brealey, Richard A. Fundamentals of corporate finance / Richard A. Brealey, London Business School; Stewart C. Myers,

Sloan School of Management, Massachusetts Institute of Technology; Alan J. Marcus, Carroll School of Management, Boston College.—Eighth edition.

pages cm.—(The McGraw-Hill/Irwin series in finance, insurance and real estate) Includes index. ISBN-13: 978-0-07-786162-9 (alk. paper) ISBN-10: 0-07-338230-2 (alk. paper) 1. Corporations–Finance. I. Myers, Stewart C. II. Marcus, Alan J. III. Title. HG4026.B6668 2014 658.15–dc23 2014018986

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

www.mhhe.com

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vi

the Authors About

Richard A. Brealey Professor of Finance at the London Business School He is the former president of the European Finance Association 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 as director of a number of financial institutions. Professor Brealey is also the author (with Professor Myers and Franklin Allen) of this book’s sister text, Principles of Corporate Finance.

Stewart C. Myers Gordon Y Billard Professor of Finance at MIT’s Sloan School of Management He is past president of the American Finance Association and a research associate of the National Bureau of Economic Research. His research has focused on financing decisions, valuation methods, the cost of capital, and financial aspects of government regulation of business. Dr. Myers is a director of The Brattle Group Inc. and is active as a financial consultant. He is also the author (with Professor Brealey and Franklin Allen) of this book’s sister text, Principles of Corporate Finance.

Alan J. Marcus Mario Gabelli Professor of Finance in the Carroll School of Management at Boston College His main research interests are in derivatives and securities markets. He is co-author (with Zvi Bodie and Alex Kane) of the texts Investments and Essentials of Invest- ments. Professor Marcus has served as a research fellow at the National Bureau of Economic Research. Professor Marcus also spent two years at Freddie Mac, where he helped to develop mortgage pricing and credit risk models. He currently serves on the Research Foundation Advisory Board of the CFA Institute.

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vii

Preface

This book is about corporate finance. It focuses on how companies invest in real assets, how they raise the money to pay for these investments, and how those assets ulti- mately affect the value of the firm. It also provides a broad introduction to the financial landscape, discussing, for example, the major players in financial markets, the role of financial institutions in the economy, and how securities are traded and valued by investors. The book offers a framework for systematically thinking about most of the important financial problems that both firms and individuals are likely to confront.

Financial management is important, interesting, and challenging. It is important because today’s capital investment decisions may determine the businesses that the firm is in 10, 20, or more years ahead. Also, a firm’s success or failure depends in large part on its ability to find the capital that it needs.

Finance is interesting for several reasons. Financial decisions often involve huge sums of money. Large investment projects or acquisitions may involve billions of dollars. Also, the financial community is international and fast-moving, with colorful heroes and a sprinkling of unpleasant villains.

Finance is challenging. Financial decisions are rarely cut and dried, and the finan- cial markets in which companies operate are changing rapidly. Good managers can cope with routine problems, but only the best managers can respond to change. To handle new problems, you need more than rules of thumb; you need to understand why companies and financial markets behave as they do and when common practice may not be best practice. Once you have a consistent framework for making financial decisions, complex problems become more manageable.

This book provides that framework. It is not an encyclopedia of finance. It focuses instead on setting out the basic principles of financial management and applying them to the main decisions faced by the financial manager. It explains why the firm’s own- ers would like the manager to increase firm value and shows how managers choose between investments that may pay off at different points of time or have different degrees of risk. It also describes the main features of financial markets and discusses why companies may prefer a particular source of finance.

We organize the book around the key concepts of modern finance. These concepts, properly explained, simplify the subject. They are also practical. The tools of financial management are easier to grasp and use effectively when presented in a consistent conceptual framework. This text provides that framework.

Modern financial management is not “rocket science.” It is a set of ideas that can be made clear by words, graphs, and numerical examples. The ideas provide the “why” behind the tools that good financial managers use to make investment and financing decisions.

We wrote this book to make financial management clear, useful, interesting, and fun for the beginning student. We set out to show that modern finance and good finan- cial practice go together, even for the financial novice.

Fundamentals and Principles of Corporate Finance This book is derived in part from its sister text Principles of Corporate Finance. The spirit of the two books is similar. Both apply modern finance to give students a work- ing ability to make financial decisions. However, there are also substantial differences between the two books.

First, we provide much more detailed discussion of the principles and mechanics of the time value of money. This material underlies almost all of this text, and we spend a lengthy chapter providing extensive practice with this key concept.

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viii Preface

Second, we use numerical examples in this text to a greater degree than in Prin- ciples. Each chapter presents several detailed numerical examples to help the reader become familiar and comfortable with the material.

Third, we have streamlined the treatment of most topics. Whereas Principles has 34 chapters, Fundamentals has only 25. The relative brevity of Fundamentals neces- sitates a broader-brush coverage of some topics, but we feel that this is an advantage for a beginning audience.

Fourth, we assume little in the way of background knowledge. While most users will have had an introductory accounting course, we review the concepts of account- ing that are important to the financial manager in Chapter 3.

Principles is known for its relaxed and informal writing style, and we continue this tradition in Fundamentals. In addition, we use as little mathematical notation as pos- sible. Even when we present an equation, we usually write it in words rather than sym- bols. This approach has two advantages. It is less intimidating, and it focuses attention on the underlying concept rather than the formula.

Organizational Design Fundamentals is organized in eight parts.

Part 1 (Introduction)  provides essential background material. In the first chapter we discuss how businesses are organized, the role of the financial manager, and the financial markets in which the manager operates. We explain how shareholders want managers to take actions that increase the value of their investment, and we introduce the concept of the opportunity cost of capital and the trade-off that the firm needs to make when assessing investment proposals. We also describe some of the mecha- nisms that help to align the interests of managers and shareholders. Of course, the task of increasing shareholder value does not justify corrupt and unscrupulous behavior. We therefore discuss some of the ethical issues that confront managers.

Chapter 2 surveys and sets out the functions of financial markets and institutions. This chapter also reviews the crisis of 2007–2009. The events of those years illustrate clearly why and how financial markets and institutions matter.

A large corporation is a team effort, and so the firm produces financial statements to help the players monitor its progress. Chapter 3 provides a brief overview of these finan- cial statements and introduces two key distinctions—between market and book values and between cash flows and profits. This chapter also discusses some of the shortcom- ings in accounting practice. The chapter concludes with a summary of federal taxes.

Chapter 4 provides an overview of financial statement analysis. In contrast to most introductions to this topic, our discussion is motivated by considerations of valuation and the insight that financial ratios can provide about how management has added to the firm’s value.

Part 2 (Value)  is concerned with valuation. In Chapter 5 we introduce the concept of the time value of money, and, since most readers will be more familiar with their own financial affairs than with the big leagues of finance, we motivate our discussion by looking first at some personal financial decisions. We show how to value long- lived streams of cash flows and work through the valuation of perpetuities and annui- ties. Chapter 5 also contains a short concluding section on inflation and the distinction between real and nominal returns.

Chapters 6 and 7 introduce the basic features of bonds and stocks and give students a chance to apply the ideas of Chapter 5 to the valuation of these securities. We show how to find the value of a bond given its yield, and we show how prices of bonds fluctuate as interest rates change. We look at what determines stock prices and how stock valuation formulas can be used to infer the return that investors expect. Finally, we see how investment opportunities are reflected in the stock price and why analysts focus on the price-earnings multiple. Chapter 7 also introduces the concept of market

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Preface ix

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

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

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

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

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

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

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

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

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x Preface

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

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

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

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

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

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

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

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

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Preface xi

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

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

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

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

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

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

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

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

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

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xii Preface

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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Preface xiii

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

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

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

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O RG

A N

IZ A

TI O

N Key Features

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

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

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

The Time Value of Money 5 CHAPTE

R

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

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

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

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

perpetuity Stream of level cash payments that never ends.

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

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

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

PV = 19.683 × 30-year annuity factor

= 19.683 × c1 r –

1 r (1 + r)30

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

c 1 .036

– 1

.036(1.036)30 d = 18.1638

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

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PE D

A G

O G

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

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

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

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

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

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

The Excel function for bond value is:

= PRICE(settlement date, maturity date, annual coupon rate, yield to maturity, redemption value as percent of face value, number of coupon payments per year)

(If you can’t remember the formula, just remember that you can go to the Formulas tab in Excel, and from the Financial tab pull down the PRICE function, which will prompt you for the necessary inputs.) For our 7.25% coupon bond, we would enter the values shown in the spreadsheet below. Alterna- tively, we could simply enter the following function in Excel:

= PRICE(DATE(2013,5,15),DATE(2016,5,15),.0725, .0035,100,1)

Solutions Spreadsheet Bond Valuation

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Finance in Practice Boxes These are excerpts that appear in most chapters, usually from the financial press, providing real-life illustrations of the chap- ter’s topics, such as ethi- cal choices in finance, disputes about stock valuation, financial plan- ning, and credit analysis.

But sometimes raids can enhance shareholder value. For example, in 2012 and 2013, Relational Investors teamed up with the California State Teachers’ Retirement System (CSTRS, a pension fund) to try to force Timken Co. to split into two separate companies, one for its steel business and one for its industrial bearings business. Relational and CSTRS believed that Timken’s combination of unrelated busi- nesses was unfocused and inefficient. Timken management responded that breakup would “deprive our shareholders of long-run value—all in an attempt to create illusory short-term gains through fi nancial engineering.” But Timken’s stock price rose at the prospect of a breakup, and a nonbinding share- holder vote on Relational’s proposal attracted a 53% majority.

How do you draw the ethical line in such examples? Was Relational Investors a “raider” (sounds bad) or an “activist investor” (sounds good)? Breaking up a portfolio of busi- nesses can create difficult adjustments and job losses. Some stakeholders lose. But shareholders and the overall economy

Short-Selling Investors who take short positions are betting that securities will fall in price. Usually they do this by borrowing the security, selling it for cash, and then waiting in the hope that they will be able to buy it back cheaply. * In 2007 hedge fund manager John Paulson took a huge short position in mortgage-backed securities. The bet paid off, and that year Paulson’s trade made a profi t of $1 billion for his fund. †

Was Paulson’s trade unethical? Some believe not only that he was profi ting from the misery that resulted from the crash in mortgage-backed securities but that his short trades accen- tuated the collapse. It is certainly true that short-sellers have never been popular. For example, following the crash of 1929, one commentator compared short-selling to the ghoulishness of “creatures who, at all great earthquakes and fi res, spring up to rob broken homes and injured and dead humans.”

Short-selling in the stock market is the Wall Street Walk on steroids. Not only do short-sellers sell all the shares they

Finance in Practice Ethical Disputes in Finance

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Excel Exhibits Selected exhibits are set as Excel spreadsheets. They are also available in Connect.

an example of how the function is used. Now let’s solve Example 5.2 in a spreadsheet. We can type the Excel function

= PV(rate, nper, pmt, FV)  =  PV(.08, 2, 0, 3000), or we can select the PV function from the pull-down menu of financial functions and fill in our inputs as shown in the dialog box below. Either way, you should get an answer of − $2,572. (Notice that you

SPREADSHEET 5.1 Using a spreadsheet to find the future value of $24

1

2

3

4

5

6

7

8

9

10

11

12

13

14

0.08

388

0

-24

$223,166,175,426,958

BA C D F

Finding the future value of $24 using a spreadsheet

Formula in cell B8

=FV(B3,B4,B5,B6)

INPUTS

Interest rate

Periods

Payment

Present value (PV)

Future value

Notice that we enter the present value in cell B6 as a negative number,

since the “purchase price” is a cash outflow. The interest rate in cell B3

is entered as a decimal, not a percentage.

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bond is more sensitive to interest rate fluctuations than the 3 year bond. This should not surprise you. If you buy a 3-year bond and rates then rise, you will be stuck with a bad deal—you could have got a better interest rate if you had waited. However, think how much worse it would be if the loan had been for 30 years rather than 3 years. The longer the loan, the more income you have lost by accepting what turns out to be a low interest rate. This shows up in a bigger decline in the price of the longer-term bond. Of course, there is a flip side to this effect, which you can also see from Figure 6.5 . When interest rates fall, the longer-term bond responds with a greater increase in price.

Suppose that the market interest rate is 8% and then drops overnight to 4%. Calculate the present values of the 7.25%, 3-year bond and of the 7.25%, 30-year bond both before and after this change in interest rates. Assume annual coupon payments. Confirm that your answers correspond with Figure 6.5 . Use your financial calculator or a spreadsheet. You can find a box on b d i i i E l 176

Self-Test 6.4

y

Which is the longer term bond?

BEYOND THE PAGE

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Multiple Cash Flows Valuing multiple cash flows with a spreadsheet is no dif- ferent from valuing single cash flows. You simply find the present value of each flow and then add them up. Spreadsheet 5.3 shows how to find the solution to Example 5.7.

The time until each payment is listed in column A. This value is then used to set the number of periods (nper) in the formula in column C. The values for the cash flow in each future period are entered as negative numbers in the PV formula. The present val- ues (column C) therefore appear as positive numbers. Column E shows an alternative to the use of the PV function, where we calculate present values directly. This allows us to see exactly what we are doing.

Using Excel to solve time- value-of-money problems

BEYOND THE PAGE

brealey.mhhe.com/ch05-02

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the €1,000 future payment by the 2-year discount factor:

PV = :1,000 × 1

(1.019)2

= :1,000 × .96306 = :963.06

Suppose that the Italian government had promised to pay € 1,000 at the end of 3 years. If the market interest rate was 2.5%, how much would you have been prepared to pay for a 3-year IOU of € 1,000?

Self-Test 5.3

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Calculator Financial You can use a fi nancial calculator to calculate the yield to maturity on our 7.25% Treasury bond. The inputs are:

Using a Financial Calculator to Compute Bond Yield

n i PV PMT FV

Inputs 3 –1205.56 72.5 1000 Compute .35

n i PV PMT FV

Inputs 6 –1205.56 36.25 1000 Compute .1777

Now compute i and you should get an answer of .35%. Let’s now redo this calculation but recognize that the cou-

pons are paid semiannually. Instead of three annual coupon payments of $72.5, the bond makes six semiannual payments

This yield to maturity, of course, is a 6-month yield, not an annual one. Bond dealers would typically annualize the semiannual rate by doubling it, so the yield to maturity would be quoted as .1777  ×  2  =  .3554%.

of $36.25. Therefore, we can fi nd the semiannual yield as follows:

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Calculator Boxes and Exercises In a continued effort to help students grasp the critical concept of the time value of money, many pedagogical tools have been added throughout the first section of the text. Financial Calculator boxes provide examples for solving a variety of problems, with directions for the three most popular financial calculators.

Self-Test Questions Provided in each chapter, these help- ful questions enable students to check their understanding as they read. Answers are worked out at the end of each chapter.

“Beyond the Page” Interactive Content and Applications New to this edition! Additional resources and hands-on applications are just a click away. Students can scan the in-text QR codes or use the direct web link to learn more about key concepts and try out calculations, tables, and figures when they go “Beyond the Page.”

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QUESTIONS AND PROBLEMS 1. Compound Interest. Old Time Savings Bank pays 4% interest on its savings accounts. If you

deposit $1,000 in the bank and leave it there: (LO5-1)

a. How much interest will you earn in the first year? b. How much interest will you earn in the second year? c. How much interest will you earn in the tenth year?

2. Compound Interest. New Savings Bank pays 4% interest on its deposits. If you deposit $1,000 in the bank and leave it there, will it take more or less than 25 years for your money to double? You should be able to answer this without a calculator or interest rate tables. (LO5-1)

3. Compound Interest. Investments in the stock market have increased at an average compound rate of about 5% since 1900. It is now 2013. (LO5-1)

a. If you invested $1,000 in the stock market in 1900, how much would that investment be worth today?

b. If your investment in 1900 has grown to $1 million, how much did you invest in 1900?

4. Future Values. Compute the future value of a $100 cash flow for the following combinations of

finance

®

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CHALLENGE PROBLEMS 66. Future Values. Your wealthy uncle established a $1,000 bank account for you when you were

born. For the first 8 years of your life, the interest rate earned on the account was 6%. Since then, rates have been only 4%. Now you are 21 years old and ready to cash in. How much is in your account? (LO5-1)

67. Present Values. If the interest rate this year is 8% and the interest rate next year will be 10%, what is the future value of $1 after 2 years? What is the present value of a payment of $1 to be received in 2 years? (LO5-2)

68. Perpetuities and Effective Interest Rate. What is the value of a perpetuity that pays $100 every 3 months forever? The interest rate quoted on an APR basis is 6%. (LO5-3)

69. Amortizing Loans and Inflation. Suppose you take out a $100,000, 20-year mortgage loan to buy a condo. The interest rate on the loan is 6%, and to keep things simple, we will assume you make payments on the loan annually at the end of each year. (LO5-3)

a. What is your annual payment on the loan? b. Construct a mortgage amortization table in Excel similar to Table 5.5 in which you compute

Templates can be found in Connect.

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L I S T I N G O F E Q UAT I O N S

5.1 Future value  =  present value  ×  (1  +   r ) t

5.2 Present value = future value after t periods

(1 + r)t

5.3 PV of perpetuity = C r =

cash payment

interest rate

5.4 Present value of t-year annuity = C c1 r –

1

r(1 + r)t d

5.5 Future value (FV) of annuity of $1 a year = present value of annuity of $1 a year × (1 + r)t

c1 1 d

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SUMMARY Investors and other stakeholders in the firm need regular financial information to help them monitor the firm’s progress. Accountants summarize this information in a balance sheet, income statement, and statement of cash flows.

The balance sheet provides a snapshot of the firm’s assets and liabilities. The assets consist of current assets that can be rapidly turned into cash and fixed assets such as plant and machinery. The liabilities consist of current liabilities that are due for payment within a year and long-term debts. The difference between the assets and the liabilities represents the amount of the shareholders’ equity.

The income statement measures the profitability of the company during the year. It shows the difference between revenues and expenses.

The statement of cash flows measures the sources and uses of cash during the year. The change in the company’s cash balance is the difference between sources and uses.

It is important to distinguish between the book values that are shown in the company accounts

What information is contained in the balance sheet, income statement, and statement of cash flows? (LO3-1)

What is the difference

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Summary This feature helps review the key points and learning objectives to provide closure to the chapter.

End-of-Chapter Material

Listing of Equations In selected chapters, the numbered equa- tions are summarized for quick and easy reference.

Questions and Problems The end-of-chapter questions and problems have been updated and reorganized by Learn- ing Objective and level of difficulty. Each question is labeled by topic, and Challenge Problems are listed in a separate section.

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c. Plot the values in columns D and E as a function of the interest rate. Which bond’s price is proportionally more sensitive to interest rate changes?

d. Can you explain the result you found in part (c)? Hint: Is there any sense in which a bond that pays a high coupon rate has lower “average” or “effective” maturity than a bond that pays a low coupon rate?

36. Yield Curve. In Figure 6.7, we saw a plot of the yield curve on stripped Treasury bonds and pointed out that bonds of different maturities may sell at different yields to maturity. In prin- ciple, when we are valuing a stream of cash flows, each cash flow should be discounted by the yield appropriate to its particular maturity. Suppose the yield curve on (zero-coupon) Treasury strips is as follows:

Years to Maturity Yield to Maturity

1 4.0% 2 5.0

3–5 5.5 6–10 6.0

You wish to value a 10-year bond with a coupon rate of 10%, paid annually. (LO6-4)

a. Set up an Excel spreadsheet to value each of the bond’s annual cash flows using this table of yields. Add up the present values of the bond’s 10 cash flows to obtain the bond price.

b. What is the bond’s yield to maturity? c. Compare the yield to maturity of the 10-year, 10% coupon bond with that of a 10-year

zero-coupon bond or Treasury strip. Which is higher? Why does this result make sense given this yield curve?

37. Credit Risk. Slush Corporation has two bonds outstanding, each with a face value of $2 mil- lion. Bond A is secured on the company’s head office building; bond B is unsecured. Slush has suffered a severe downturn in demand. Its head office building is worth $1 million, but its remaining assets are now worth only $2 million If the company defaults what payoff can the

Templates can be found in Connect.

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SOLUTIONS TO SPREADSHEET QUESTIONS 1. NPV = $4,515

2. NPV = $4,459

3. NPV = $5,741. NPV rises because the real value of depreciation allowances and the deprecia- tion tax shield is higher when the inflation rate is lower.

MINICASE Jack Tar, CFO of Sheetbend & Halyard Inc. opened the company confidential envelope. It contained a draft of a competitive bid for a contract to supply duffel canvas to the U.S. Navy. The cover memo from Sheetbend’s CEO asked Mr. Tar to review the bid before it was submitted.

The bid and its supporting documents had been prepared by Sheetbend’s sales staff. It called for Sheetbend to supply 100,000 yards of duffel canvas per year for 5 years. The proposed selling price was fixed at $30 per yard.

Mr. Tar was not usually involved in sales, but this bid was unusual in at least two respects. First, if accepted by the navy, it

would commit Sheetbend to a fixed-price, long-term contract. Sec- ond, producing the duffel canvas would require an investment of $1.5 million to purchase machinery and to refurbish Sheetbend’s plant in Pleasantboro, Maine.

Mr. Tar set to work and by the end of the week had collected the following facts and assumptions:

• The plant in Pleasantboro had been built in the early 1900s and is now idle. The plant was fully depreciated on Sheetbend’s books, except for the purchase cost of the land (in 1947) of $10,000.

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WEB EXERCISES 1. Log on to www.investopedia.com to find a simple calculator for working out bond prices.

Check whether a change in yield has a greater effect on the price of a long-term or a short-term bond.

2. When we plotted the yield curve in Figure 6.7, we used the prices of Treasury strips. You can find current prices of strips by logging on to the Wall Street Journal website (www.wsj.com) and clicking on Markets Data Center and then Bonds, Rates and Credit Markets. Try plotting the yields on stripped coupons against maturity. Do they currently increase or decline with maturity? Can you explain why? You can also use the Wall Street Journal site to compare the yields on nominal Treasury bonds with those on TIPS. Suppose that you are confident that infla- tion will be 3% per year. Which bonds are the better buy?

3. You can find the most recent bond rating for many companies by logging on to finance.yahoo. com and going to the Bond Center. Find the bond rating for some major companies. Were they investment-grade or below?

4. In Figure 6.9 we showed how bonds with greater credit risk have promised higher yields to maturity. This yield spread goes up when the economic outlook is particularly uncer- tain. You can check how much extra yield lower-grade bonds offer today by logging on to www.federalreserve.gov and comparing the yields on Aaa and Baa bonds. How does the spread in yields compare with the spread in November 2008 at the height of the financial crisis?

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Excel Problems Most chapters contain problems, denoted by an icon, specifically linked to Excel templates that are available in Connect.

Web Exercises Select chapters include Web Exer- cises that allow students to utilize the Internet to apply their knowl- edge and skills with real-world companies.

Minicases Integrated minicases allow students to apply their knowledge to rela- tively complex, practical problems and typical real-world scenarios.

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In addition to the overall refinement and improvement of the text material, considerable effort was put into develop- ing an exceptional supplement package to provide students and instructors with an abundance of teaching and learn- ing resources.

For the Instructor Instructor’s Manual This updated and enhanced manual includes a descriptive preface containing alternative course formats and case teach- ing methods, a chapter overview and out- line, key terms and concepts, a description of the PowerPoint slides, video teaching notes, related web links, and pedagogical ideas.

PowerPoint Presentations These visually stimulating slides have been fully updated by Matthew Will, University of Indianapolis, with colorful graphs, charts, and lists. The slides can be edited or manipulated to fit the needs of a particular course.

Print and Online Test Bank Kay Johnson has revised the test bank and added new questions and problems. Over 2,000 true/false, multiple-choice, and dis- cussion questions/problems are available to the instructor at varying levels of dif- ficulty and comprehension. All questions are tagged by learning objective, topic, AACSB category, and Bloom’s Taxonomy level. Complete answers are provided for all test questions and problems, and creat- ing computerized tests is easy with EZ Test Online!

Solutions Manual Matthew Will, University of Indianapolis, worked with the authors to prepare this resource containing detailed and thought- ful solutions to all the end-of-chapter problems.

grading to make classroom management more efficient than ever.

• Go paperless with the eBook and online submission and grading of student assignments.

Smart Grading    When it comes to studying, time is precious. Connect Finance helps students learn more effi- ciently by providing feedback and practice material when they need it, where they need it. When it comes to teaching, your time also is precious. The grading function enables you to:

• Have assignments scored automatically, giving students immediate feedback on their work and side-by-side comparisons with correct answers.

• Access and review each response and manually change grades or leave com- ments for students to review.

• Reinforce classroom concepts with prac- tice tests and instant quizzes.

Instructor Library    The Connect Finance Instructor Library is your reposi- tory for additional resources to improve student engagement in and out of class. You can select and use any asset that enhances your lecture. The Connect Finance Instructor Library includes all of the instructor supplements for this text.

Student Study Center    The Connect Finance Student Study Center is the place for students to access additional resources. The Student Study Center:

• Offers students quick access to lectures, eBooks, and more.

• Provides instant practice material and study questions, easily accessible on the go.

McGraw-Hill Connect Finance Less Managing. More Teaching. Greater Learning. McGraw-Hill Connect Finance is an online assignment and assessment solution that connects students with the tools and resources they’ll need to achieve success.

McGraw-Hill Connect Finance helps prepare students for their future by enabling faster learning, more effi- cient studying, and higher retention of knowledge.

McGraw-Hill Connect Finance  Features Connect Finance offers a number of powerful tools and features to make managing assignments easier, so faculty can spend more time teaching. With Connect Finance, students can engage with their coursework anytime and anywhere, making the learning process more accessible and efficient.

Simple Assignment Manage- ment    With Connect Finance, creating assignments is easier than ever, so you can spend more time teaching and less time managing. The assignment management function enables you to:

• Create and deliver assignments easily with selectable end-of-chapter questions and test bank items.

• Streamline lesson planning, student progress reporting, and assignment

Supplements

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Tegrity Campus: Lectures 24/7

Tegrity Campus is a service that makes class time available 24/7 by automatically capturing every lecture in a searchable for- mat for students to review when they study and complete assignments. With a simple one-click, start-and-stop process, you cap- ture all computer screens and correspond- ing audio. Students can replay any part of any class with easy-to-use, browser-based viewing on a PC or Mac.

Educators know that the more stu- dents can see, hear, and experience class resources, the better they learn. In fact, studies prove it. With Tegrity Campus, stu- dents quickly recall key moments by using Tegrity Campus’s unique search feature. This search helps students efficiently find what they need, when they need it, across an entire semester of class recordings. Help turn all your students’ study time into learning moments immediately supported by your lecture.

To learn more about Tegrity, watch a 2-minute Flash demo at http://tegritycam- pus.mhhe.com .

McGraw-Hill Customer Care Contact Information At McGraw-Hill, we understand that get- ting the most from new technology can be challenging. That’s why our services don’t stop after you purchase our products. You can e-mail our product specialists 24 hours a day to get product training online. Or you can search our knowledge bank of frequently asked questions on our support website. For customer support, call 800- 331-5094 or visit www.mhhe.com/sup- port . One of our technical support analysts will be able to assist you in a timely fashion.

• Access an instant view of student or class performance relative to learning objectives.

• Collect data and generate reports required by many accreditation organizations, such as AACSB and AICPA.

McGraw-Hill Connect Plus Finance    McGraw-Hill reinvents the textbook learning experience for the mod- ern student with Connect Plus Finance. A seamless integration of an eBook and Connect Finance, Connect Plus Finance provides all of the Connect Finance fea- tures plus the following:

• An integrated eBook, allowing for anytime, anywhere access to the textbook.

• Dynamic links between the problems or questions you assign to your students and the location in the eBook where that problem or question is covered.

• A powerful search function to pinpoint and connect key concepts in a snap.

Smartbook  Smartbook is an extension of LearnSmart—an adaptive eBook that helps students focus their study time more effectively. As students read, Smartbook assesses comprehension and dynamically highlights where they need to study more.

Connect Finance offers you and your students powerful tools and features that optimize your time and energies, enabling you to focus on course content, teaching, and student learning. Connect Finance also offers a wealth of content resources for both instructors and stu- dents. This state-of-the-art, thoroughly tested system supports you in preparing students for the world that awaits.

For more information about Connect, go to http://connect.mheducation.com , or contact your local McGraw-Hill sales representative.

Diagnostic and Adap- tive Learning of Concepts: LearnSmart    Students want to make the best use of their study time. The LearnSmart adaptive self-study technol- ogy within Connect Finance provides students with a seamless combination of practice, assessment, and remedia- tion for every concept in the textbook. LearnSmart’s intelligent software adapts to every student response and automati- cally delivers concepts that advance stu- dents’ understanding while reducing time devoted to the concepts already mastered. The result for every student is the fastest path to mastery of the chapter concepts. LearnSmart:

• Applies an intelligent concept engine to identify the relationships between concepts and to serve new concepts to each student only when he or she is ready.

• Adapts automatically to each student, so students spend less time on the topics they understand and practice more on those they have yet to master.

• Provides continual reinforcement and remediation, but gives only as much guidance as students need.

• Integrates diagnostics as part of the learning experience.

• Enables you to assess which concepts students have efficiently learned on their own, thus freeing class time for more applications and discussion.

Student Progress Tracking    Connect Finance keeps instructors informed about how each student, section, and class is performing, allowing for more productive use of lecture and office hours. The progress-tracking function enables you to:

• View scored work immediately and track individual or group performance with assignment and grade reports.

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McGraw-Hill Higher Education and Blackboard have teamed up. What does this mean for you?

1. Your life, simplified. Now you and your students can access McGraw- Hill’s Connect and Create right from within your Blackboard course—all

Blackboard? We thought so. When a student completes an integrated Connect assignment, the grade for that assignment automatically (and instantly) feeds your Blackboard grade center.

4. A solution for everyone. Whether your institution is already using Blackboard or you just want to try Blackboard on your own, we have a solution for you. McGraw-Hill and Blackboard can now offer you easy access to industry-lead- ing technology and content, whether your campus hosts it or we do. Be sure to ask your local McGraw-Hill repre- sentative for details.

with one single sign-on. Say goodbye to the days of logging in to multiple applications.

2. Deep integration of content and tools. Not only do you get single sign-on with Connect and Create; you also get deep integration of McGraw-Hill content and content engines right in Black- board. Whether you’re choosing a book for your course or building Connect assignments, all the tools you need are right where you want them—inside Blackboard.

3. Seamless Gradebooks. Are you tired of keeping multiple gradebooks and manually synchronizing grades into

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Marlena Akhbari Wright State University

Timothy Alzheimer Montana State University

Tom Arnold University of Richmond

Robert Balik Western Michigan University

Anindam Bandopadhyaya University of Massachusetts–Boston

Chenchu Bathala Cleveland State University

Deborah Bauer University of Oregon

Richard Bauer Saint Mary’s University

LaDoris Baugh Athens State University

John R. Becker Blease Washington State University–Vancouver

Theologos Bonitsis New Jersey Institute of Technology

Stephen Borde University of Central Florida

Edward Boyer Temple University

Stephen Buell Lehigh University

Deanne Butchey Florida International University

Shelley Canterbury George Mason University

Michael Casey University of Central Arkansas

Fan Chen University of Mississippi

Nicole Choi Washington State University–Pullman

Bruce Costa University of Montana

Kenneth Daniels Virginia Commonwealth University

Morris Danielson St. Joe’s University

Natalya Delcoure Sam Houston State University

Jared DeLisle Washington State University–Vancouver

Steven Dennis University of North Dakota

Robert Dubil University of Utah–Salt Lake City

Alan D. Eastman Indiana University of Pennsylvania

Michael Ehrlich New Jersey Institute of Technology

Richard Elliot University of Utah–Salt Lake City

Mike Evans Winthrop University

James Falter Franklin University

John Fay Santa Clara University

Richard Fedler Georgia State University

Michael Ferguson University of Cincinnati

Dov Fobar Brooklyn College

Eric Fricke California State University– East Bay

Steve Gallaher Southern New Hampshire University

Sharon Garrison University of Arizona

Ashley Geisewite Southwest Tennessee Community College

Homaifar Ghassem Middle Tennesee State University

Phillip Giles Columbia University

Gary Gray Penn State University– University Park

John Halstead Liberty University

Mahfuzul Haque Indiana State University

Larry Holland University of Arkansas– Little Rock

James J. Hopper Mississippi State University

Jian “Emily” Huang Washington State University–Pullman

Stoyu Ivanov San Jose State University

Raymond Jackson University of Massachusetts–Dartmouth

Keith Jacob University of Montana

Bharat Jain Towson University

Benjamas Jirasakuldech Slippery Rock University of Pennsylvania

Mark Johnson Loyola University Maryland

Steve Johnson Sam Houston State University

Daniel Jubinski Saint Joseph’s University

Alan Jung San Francisco State University

Ayala Kayhan Louisiana State University

Marvin Keene Coastal Carolina University

Eric Kelley University of Arizona

Dong Man Kim California State University– San Bernardino

Jullavut Kittiakarasakun University of Texas at San Antonio

Ladd Kochman Kennesaw State University

David Kuipers University of Missouri– Kansas City

Mark Lane Hawaii Pacific University–Honolulu

We take this opportunity to thank all of the individuals who helped us prepare this Eighth Edition. We want to express our appreciation to those instructors whose insightful comments and suggestions were invaluable to us during this revision.

Acknowledgments

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Linda Lange Regis University

Doug Letsch Walden University

Paul Lewandowski Saginaw Valley State University

Scott W. Lowe James Madison University

Yuming Li California State University–Fullerton

Qianqiu Liu University of Hawaii–Manoa

Sheen Liu Washington State University–Vancouver

Wilson Liu James Madison University

Qingzhong Ma Cornell University–Ithaca

Yulong Ma California State University– Long Beach

Brian Maris Northern Arizona University

Jinghan Meng University of North Carolina–Chapel Hill

Jose Mercardo University of Central Missouri

Paulo Miranda Purdue University–Calumet Hammond

Derek Mohr State University of New York at Buffalo

Helen Moser University of Minnesota–Minneapolis

Tammie Mosley California State University– East Bay

Vivian Nazar Ferris State University

Steve Nenninger Sam Houston State University

Bonnie Van Ness University of Mississippi

Srinivas Nippani Texas A&M University–Commerce

Prasad Padmanabhan Saint Mary’s University

Ohaness Paskelian University of Houston–Downtown

Jeffrey Phillips Colby-Sawyer College

Richard Ponarul California State University–Chico

Gary Porter John Carroll University

Eric Powers University of South Carolina

Ronald Prange Western Michigan University

Robert Puelz Southern Methodist University

Nicholas Racculia Saint Vincent College

Sunder Raghavan Embry-Riddle University

Vedpauri Raghavan Embry-Riddle Aero University–Daytona Beach

Ganas K. Rakes Ohio University

Adam Reed University of North Carolina–Chapel Hill

Thomas Rhee California State University– Long Beach

Jong Rhim University of Southern Indiana

Joe Riotto New Jersey City University

Mukunthan Santhanakrishnan Idaho State University

Maria Schutte Michigan Technological University

Adam Schwartz Washington & Lee University

John Settle Portland State University

Michael G. Sher Metropolitan State University

Henry Silverman Roosevelt University

Ron Spicer Colorado Tech University

Roberto Stein Tulane University

Tom Strickland Middle Tennessee State University

Jan Strockis Santa Clara University

Joseph Tanimura San Diego State University

Steve Tokar University of Indianapolis

Damir Tokic University of Houston–Downtown

Michael Toyne Northeastern State University

James Turner Weber State Universtiy

Joe Walker University of Alabama–Birmingham

Kenneth Washer Texas A&M University–Commerce

K. Matthew Wong St. John’s University

David Yamoah Kean University

Fred Yeager St. Louis University

Kevin Yost Auburn University

Emilio R. Zarruk Florida Atlantic University

Shaorong Zhang Marshall University

Yilei Zhang University of North Dakota

Zhong-Guo Zhou California State University–Northridge

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In addition, we would like to thank our supplement authors, Kay Johnson, Mishal Rawaf, Matt Will, Steven Dennis, Peter Crabb, Deb Bauer, and Nicholas Racculia. Their efforts are much appreciated as they will help both students and instructors. We also appreciate help from Aleijda de Cazenove Balsan and Malcolm Taylor.

We are grateful to the talented staff at McGraw-Hill/Irwin, especially Noelle Bathurst, Development Editor; Chuck Synovec, Executive Brand Manager; Kevin Shanahan, Digital Product Analyst; Meg Maloney, Digital Development Editor; Kathryn Wright and Kristin Bradley, Content Project Managers; Matthew Diamond, Senior Designer; Melissa Caughlin, Executive Marketing Manager; Jennifer Jelinski, Marketing Specialist; and Keri Johnson, Photo Researcher.

Finally, as was the case with the last seven editions, we cannot overstate the thanks due to our wives, Diana, Maureen, and Sheryl.

Richard A. Brealey

Stewart C. Myers

Alan J. Marcus

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xxvi

1 Goals and Governance of the Corporation 2 2 Financial Markets and Institutions 32 3 Accounting and Finance 54 4 Measuring Corporate Performance 82

5 The Time Value of Money 116 6 Valuing Bonds 164 7 Valuing Stocks 192 8 Net Present Value and Other Investment Criteria 234 9 Using Discounted Cash-Flow Analysis to Make Investment Decisions 270 10 Project Analysis 298

11 Introduction to Risk, Return, and the Opportunity Cost of Capital 326 12 Risk, Return, and Capital Budgeting 356 13 The Weighted-Average Cost of Capital and Company Valuation 386

14 Introduction to Corporate Financing 414 15 How Corporations Raise Venture Capital and Issue Securities 436

16 Debt Policy 460 17 Payout Policy 496

18 Long-Term Financial Planning 520 19 Short-Term Financial Planning 544 20 Working Capital Management 576

21 Mergers, Acquisitions, and Corporate Control 606 22 International Financial Management 634 23 Options 660 24 Risk Management 686

25 What We Do and Do Not Know about Finance 706

Appendix: Present Value and Future Value Tables A-1 Glossary G-1 Global Index IND-1 Subject Index IND-5 Credits C-1

Part One Introduction

Part Two Value

Part Three Risk

Part Four Financing

Part Five Debt and Payout

Policy