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Nom original: Corporate Finance.pdf
Titre: Corporate Finance (3rd Edition) (Pearson Series in Finance)
Auteur: Jonathan Berk and Peter DeMarzo

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CORPORATE
FINANCE
T H IRD E DIT ION

JONATHAN BERK
STANFORD UNIVERSITY

PETER D E MARZO
STANFORD UNIVERSITY

Boston Columbus Indianapolis New York San Francisco Upper Saddle River
Amsterdam Cape Town Dubai London Madrid Milan Munich Paris Montreal Toronto
Delhi Mexico City Sao Paulo Sydney Hong Kong Seoul Singapore Taipei Tokyo

To Rebecca, Natasha, and Hannah, for the love and for being there —J. B.
To Kaui, Pono, Koa, and Kai, for all the love and laughter —P. D.

Editor in Chief: Donna Battista
Acquisitions Editor: Katie Rowland
Executive Development Editor: Rebecca Ferris-Caruso
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Managing Editor: Jeff Holcomb
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Cover Designer: Jonathan Boylan
Cover Photo: Nikreates/Alamy

Media Director: Susan Schoenberg
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Credits and acknowledgments borrowed from other sources and reproduced, with permission, in this textbook appear on the
appropriate page within text and on this copyright page.
Credits: Cover: Sculpture in photo: Detail of Flamingo (1973), Alexander Calder. Installed in Federal Plaza, Chicago. Sheet
metal and paint, 1615.4 x 1828.8 x 731.5 cm. Copyright © 2013 Calder Foundation, New York/Artists Rights Society
(ARS), New York. Photo by Nikreates/Alamy; p. xxiii: Author photo: Nancy Warner
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Library of Congress Cataloging-in-Publication Data
Berk, Jonathan B., 1962–
Corporate finance / Jonathan Berk, Peter DeMarzo.—3rd ed.
p. cm.
Includes index.
ISBN 978-0-13-299247-3
1. Corporations—Finance. I. DeMarzo, Peter M. II. Title.
HG4026.B46 2014
658.15—dc22
10 9 8 7 6 5 4 3 2 1

www.pearsonhighered.com

ISBN 13: 978-0-13-299247-3
ISBN 10:
0-132-99247-7

The Pearson Series in Finance
Bekaert/Hodrick
International Financial Management
Berk/DeMarzo
Corporate Finance*
Berk/DeMarzo
Corporate Finance: The Core*
Berk/DeMarzo/Harford
Fundamentals of Corporate Finance*
Brooks
Financial Management: Core Concepts*
Copeland/Weston/Shastri
Financial Theory and Corporate Policy
Dorfman/Cather
Introduction to Risk Management
and Insurance
Eiteman/Stonehill/Moffett
Multinational Business Finance
Fabozzi
Bond Markets: Analysis and Strategies
Fabozzi/Modigliani
Capital Markets: Institutions and Instruments
Fabozzi/Modigliani/Jones
Foundations of Financial Markets
and Institutions
Finkler
Financial Management for Public, Health,
and Not-for-Profit Organizations
Frasca
Personal Finance
Gitman/Zutter
Principles of Managerial Finance*
Gitman/Zutter
Principles of Managerial Finance––Brief
Edition*

*denotes

Goldsmith
Consumer Economics: Issues and Behaviors
Haugen
The Inefficient Stock Market: What Pays
Off and Why
Haugen
The New Finance: Overreaction,
Complexity, and Uniqueness
Holden
Excel Modeling in Corporate Finance
Holden
Excel Modeling in Investments
Hughes/MacDonald
International Banking: Text and Cases
Hull
Fundamentals of Futures and Options Markets
Hull
Options, Futures, and Other Derivatives
Hull
Risk Management and Financial Institutions
Keown
Personal Finance: Turning Money into Wealth*
Keown/Martin/Petty
Foundations of Finance: The Logic
and Practice of Financial Management*
Kim/Nofsinger
Corporate Governance
Madura
Personal Finance*
Marthinsen
Risk Takers: Uses and Abuses of Financial
Derivatives
McDonald
Derivatives Markets

titles

McDonald
Fundamentals of Derivatives Markets
Mishkin/Eakins
Financial Markets and Institutions
Moffett/Stonehill/Eiteman
Fundamentals of Multinational Finance
Nofsinger
Psychology of Investing
Ormiston/Fraser
Understanding Financial Statements
Pennacchi
Theory of Asset Pricing
Rejda
Principles of Risk Management
and Insurance
Seiler
Performing Financial Studies:
A Methodological Cookbook
Smart/Gitman/Joehnk
Fundamentals of Investing*
Solnik/McLeavey
Global Investments
Stretcher/Michael
Cases in Financial Management
Titman/Keown/Martin
Financial Management: Principles
and Applications*
Titman/Martin
Valuation: The Art and Science
of Corporate Investment Decisions
Weston/Mitchel/Mulherin
Takeovers, Restructuring, and Corporate
Governance

Log onto www.myfinancelab.com to learn more

Brief Contents
PART 1
INTRODUCTION

Chapter 1
Chapter 2
Chapter 3

The Corporation
2
Introduction to Financial Statement Analysis
21
Financial Decision Making and the Law of One Price

PART 2
TIME, MONEY,
AND INTEREST RATES

Chapter 4
Chapter 5
Chapter 6

The Time Value of Money
Interest Rates
141
Valuing Bonds
169

PART 3
VALUING PROJECTS
AND FIRMS

Chapter 7
Chapter 8
Chapter 9

Investment Decision Rules
206
Fundamentals of Capital Budgeting
Valuing Stocks
271

PART 4
RISK AND RETURN

Chapter 10 Capital Markets and the Pricing of Risk
312
Chapter 11 Optimal Portfolio Choice and the Capital Asset
Pricing Model
351
Chapter 12 Estimating the Cost of Capital
400
Chapter 13 Investor Behavior and Capital Market Efficiency

96

233

PART 5
CAPITAL STRUCTURE

Chapter 14 Capital Structure in a Perfect Market
478
Chapter 15 Debt and Taxes
508
Chapter 16 Financial Distress, Managerial Incentives,
and Information
539
Chapter 17 Payout Policy
584

PART 6
ADVANCED VALUATION

Chapter 18 Capital Budgeting and Valuation with Leverage
Chapter 19 Valuation and Financial Modeling: A Case Study

PART 7
OPTIONS

Chapter 20 Financial Options
706
Chapter 21 Option Valuation
738
Chapter 22 Real Options 773

PART 8
LONG-TERM FINANCING

Chapter 23 Raising Equity Capital
Chapter 24 Debt Financing
836
Chapter 25 Leasing
859

PART 9
SHORT-TERM FINANCING

Chapter 26 Working Capital Management
Chapter 27 Short-Term Financial Planning

PART 10
SPECIAL TOPICS

Chapter 28
Chapter 29
Chapter 30
Chapter 31

806

Mergers and Acquisitions
930
Corporate Governance
961
Risk Management
985
International Corporate Finance

886
908

1026

437

626
674

59

Detailed Contents
PART 1 INTRODUCTION
Chapter 1 The Corporation

2

1.1 The Four Types of Firms

3

Sole Proprietorships 3
Partnerships 4
Limited Liability Companies 5
Corporations 5
Tax Implications for Corporate Entities 6
Corporate Taxation Around the
World 7

1.2 Ownership Versus Control of
Corporations 7
The Corporate Management Team 7
INTERVIEW with David Viniar 8
The Financial Manager 9
GLOBAL FINANCIAL CRISIS
The Dodd-Frank Act 10
The Goal of the Firm 10
The Firm and Society 11
Ethics and Incentives within
Corporations 11
GLOBAL FINANCIAL CRISIS
The Dodd-Frank Act on Corporate
Compensation and Governance 12
Citizens United v. Federal Election
Commission 12
Airlines in Bankruptcy 14

1.3 The Stock Market

14

Primary and Secondary Stock Markets 15
The Largest Stock Markets 15
INTERVIEW with Jean-François
Théodore 16
NYSE 16
NASDAQ 17
MyFinanceLab 17
Key Terms 18
Further Reading 18
Problems 19

Chapter 2 Introduction to Financial
Statement Analysis

21

2.1 Firms’ Disclosure of Financial
Information 22
Preparation of Financial
Statements 22

International Financial Reporting
Standards 22
INTERVIEW with Sue Frieden 23
Types of Financial Statements 24

2.2 The Balance Sheet

24

Assets 25
Liabilities 26
Stockholders’ Equity 27
Market Value Versus Book Value
Enterprise Value 28

2.3 The Income Statement
Earnings Calculations

27

28

29

2.4 The Statement of Cash Flows

30

Operating Activity 31
Investment Activity 32
Financing Activity 32

2.5 Other Financial Statement
n
I formation 33
Statement of Stockholders’ Equity
Management Discussion and
Analysis 34
Notes to the Financial
Statements 34

2.6 Financial Statement Analysis

33

35

Profitability Ratios 35
Liquidity Ratios 36
Working Capital Ratios 37
Interest Coverage Ratios 38
Leverage Ratios 39
Valuation Ratios 41
COMMON MISTAKE Mismatched
Ratios 41
Operating Returns 42
The DuPont Identity 44

2.7 Financial Reporting in
Practice 46
Enron 46
WorldCom 46
Sarbanes-Oxley Act 47
GLOBAL FINANCIAL CRISIS
Bernard Madoff’s Ponzi
Scheme 48
Dodd-Frank Act 48

v

vi

Contents
MyFinanceLab 49 ■ Key Terms 50 ■
Further Reading 51 ■ Problems 51 ■
Data Case 58

PART 2 TIME, MONEY, AND
INTEREST RATES
Chapter 4 The Time Value of Money

Chapter 3 Financial Decision Making
and the Law of One Price 59
3.1 Valuing Decisions

4.1 The Timeline

60

3.2 Interest Rates and the Time Value
of Money 63
The Time Value of Money 63
The Interest Rate: An Exchange Rate
Across Time 63

Net Present Value 66
The NPV Decision Rule 67
NPV and Cash Needs 69

3.4 Arbitrage and the Law of One
Price 70
71

109

Perpetuities 109
■ Historical Examples of Perpetuities 110
■ COMMON MISTAKE Discounting One
Too Many Times 112
Annuities 112
Growing Cash Flows 115

122

4.9 The Internal Rate of Return

MyFinanceLab 130 ■ Key Terms 131
Further Reading 132 ■ Problems 132
Data Case 137

Appendix Solving for the Number
of Periods 139
Problems

140

Chapter 5 Interest Rates 141


Arbitrage with Transactions Costs 90
92

126

■ USING EXCEL Excel’s IRR
Function 129

85
Key Terms

4.5 Perpetuities and Annuities

4.8 Solving for the Cash Payments 123

MyFinanceLab 79 ■ Key Terms 80
Further Reading 80 ■ Problems 81



4.4 Calculating the Net Present Value 107

4.7 Non-Annual Cash Flows

Valuing a Security with the Law of One
Price 72
■ An Old Joke 72
The NPV of Trading Securities and Firm
Decision Making 75
Valuing a Portfolio 76
■ Stock Index Arbitrage 77
■ GLOBAL FINANCIAL CRISIS
Liquidity and the Informational
Role of Prices 78
Where Do We Go from Here? 78

92

4.3 Valuing a Stream of Cash Flows 104

4.6 Using an Annuity Spreadsheet or
Calculator 120

3.5 No-Arbitrage and Security
Prices 72

MyFinanceLab
Problems 92

98

Rule 1: Comparing and Combining Values 98
Rule 2: Moving Cash Flows Forward
in Time 99
Rule 3: Moving Cash Flows Back
in Time 100
■ Rule of 72 101
Applying the Rules of Time Travel 102

■ USING EXCEL Calculating Present
Values in Excel 108

3.3 Present Value and the NPV Decision
Rule 66

Appendix The Price of Risk

97

4.2 The Three Rules of Time Travel

Analyzing Costs and Benefits 60
Using Market Prices to Determine Cash
Values 61
■ When Competitive Market Prices
Are Not Available 63

Arbitrage 70
■ NASDAQ SOES Bandits
Law of One Price 71

96



5.1 Interest Rate Quotes and
Adjustments 142
The Effective Annual Rate 142
■ COMMON MISTAKE Using the
Wrong Discount Rate in the Annuity
Formula 143
Annual Percentage Rates 144




vii

Contents

5.2 Application: Discount Rates and
Loans 146

Valuing a Coupon Bond Using
Zero-Coupon Yields 182
Coupon Bond Yields 183
Treasury Yield Curves 184

■ GLOBAL FINANCIAL CRISIS Teaser
Rates and Subprime Loans 148

5.3 The Determinants of Interest
Rates 147
Inflation and Real Versus Nominal
Rates 148
Investment and Interest Rate
Policy 149
The Yield Curve and Discount Rates 150
■ COMMON MISTAKE Using the
Annuity Formula When Discount Rates
Vary by Maturity 152
The Yield Curve and the Economy 152
■ INTERVIEW with Kevin M. Warsh 154

5.4 Risk and Taxes

6.4 Corporate Bonds

6.5 Sovereign Bonds

188

■ GLOBAL FINANCIAL CRISIS The
Credit Crisis and Bond Yields 189
■ GLOBAL FINANCIAL CRISIS
European Sovereign Debt Yields:
A Puzzle 191
■ INTERVIEW with Carmen
M. Reinhart 192
MyFinanceLab 193 ■ Key Terms 194
Further Reading 194 ■ Problems 195
Data Case 199

155

Risk and Interest Rates 156
After-Tax Interest Rates 157

5.5 The Opportunity Cost of Capital 158
■ COMMON MISTAKE States Dig a
$3 Trillion Hole by Discounting at the
Wrong Rate 159

184

Corporate Bond Yields 185
■ Are Treasuries Really Default-Free
Securities? 185
Bond Ratings 187
Corporate Yield Curves 188

Appendix Forward Interest Rates
Key Terms

204






201

Problems

204

MyFinanceLab 160 ■ Key Terms 161 ■
Further Reading 161 ■ Problems 161

Appendix Continuous Rates and Cash
Flows 167

Chapter 6 Valuing Bonds

169

VALUING PROJECTS
AND FIRMS

Chapter 7 Investment Decision Rules

6.1 Bond Cash Flows, Prices, and
Yields 170
Bond Terminology 170
Zero-Coupon Bonds 170
■ GLOBAL FINANCIAL CRISIS
Pure Discount Bonds Trading at a
Premium 172
Coupon Bonds 173

6.2 Dynamic Behavior of Bond
Prices 175
Discounts and Premiums 175
Time and Bond Prices 176
Interest Rate Changes and Bond
Prices 178
■ Clean and Dirty Prices for Coupon
Bonds 179

6.3 The Yield Curve and Bond
Arbitrage 181
Replicating a Coupon Bond

PART 3

181

206

7.1 NPV and Stand-Alone
Projects 207
Applying the NPV Rule 207
The NPV Profile and IRR 207
Alternative Rules Versus the NPV
Rule 208
■ INTERVIEW with Dick Grannis

209

7.2 The Internal Rate of Return
Rule 210
Applying the IRR Rule 210
Pitfall #1: Delayed Investments 210
Pitfall #2: Multiple IRRs 211
Pitfall #3: Nonexistent IRR 213
■ COMMON MISTAKE IRR Versus the
IRR Rule 213

7.3 The Payback Rule

214

Applying the Payback Rule 214
Payback Rule Pitfalls in Practice 215

viii

Contents
Comparing Free Cash Flows for Cisco’s
Alternatives 247

■ Why Do Rules Other Than the NPV
Rule Persist? 216

7.4 Choosing Between Projects

8.4 Further Adjustments to Free Cash
Flow 248

216

NPV Rule and Mutually Exclusive
Investments 216
IRR Rule and Mutually Exclusive
Investments 217
The Incremental IRR 218
■ When Can Returns Be
Compared? 219
■ COMMON MISTAKE IRR and Project
Financing 221

■ GLOBAL FINANCIAL CRISIS The
American Recovery and Reinvestment
Act of 2009 252

8.5 Analyzing the Project

7.5 Project Selection with Resource
Constraints 221
Evaluating Projects with Different
Resource Requirements 221
Profitability Index 222
Shortcomings of the Profitability
Index 224

Appendix MACRS Depreciation


Chapter 9 Valuing Stocks

271

9.1 The Dividend-Discount Model

272

A One-Year Investor 272
Dividend Yields, Capital Gains, and Total
Returns 273
■ The Mechanics of a Short Sale 274
A Multiyear Investor 275
The Dividend-Discount Model Equation 276

Chapter 8 Fundamentals of Capital
Budgeting 233

9.2 Applying the Dividend-Discount
Model 276

234

Revenue and Cost Estimates 234
Incremental Earnings Forecast 235
Indirect Effects on Incremental
Earnings 237
■ COMMON MISTAKE The Opportunity
Cost of an Idle Asset 238
Sunk Costs and Incremental
Earnings 239
■ The Sunk Cost Fallacy 239
Real-World Complexities 240

8.2 Determining Free Cash Flow and
NPV 241
Calculating Free Cash Flow from
Earnings 241
Calculating Free Cash Flow Directly 243
Calculating the NPV 244
■ USING EXCEL Capital Budgeting
Using a Spreadsheet Program 245
Evaluating Manufacturing
Alternatives 246

269



Appendix Computing the NPV
Profile Using Excel’s Data
Table Function 232

8.3 Choosing Among Alternatives

255

MyFinanceLab 258 ■ Key Terms 260 ■
Further Reading 260 ■ Problems 260 ■
Data Case 267

MyFinanceLab 224 ■ Key Terms 225
Further Reading 225 ■ Problems 225
Data Case 231

8.1 Forecasting Earnings

252

Break-Even Analysis 252
Sensitivity Analysis 253
■ INTERVIEW with David Holland
Scenario Analysis 256
■ USING EXCEL Project Analysis
Using Excel 257

246

Constant Dividend Growth 276
Dividends Versus Investment and
Growth 277
■ John Burr Williams’ Theory of
Investment Value 278
Changing Growth Rates 280
Limitations of the Dividend-Discount
Model 282

9.3 Total Payout and Free Cash Flow
Valuation Models 282
Share Repurchases and the Total Payout
Model 282
The Discounted Free Cash Flow Model 284

9.4 Valuation Based on Comparable
Firms 288
Valuation Multiples 288
Limitations of Multiples 290
Comparison with Discounted Cash Flow
Methods 291
Stock Valuation Techniques: The Final
Word 292

ix

Contents
■ INTERVIEW with Douglas Kehring 293

9.5 Information, Competition, and
Stock Prices 294
Information in Stock Prices 294
Competition and Efficient Markets 295
Lessons for Investors and Corporate
Managers 297
■ Kenneth Cole Productions—What
Happened? 299
The Efficient Markets Hypothesis Versus
No Arbitrage 300
MyFinanceLab 300 ■ Key Terms 302 ■
Further Reading 302 ■ Problems 303 ■
Data Case 308

PART 4 RISK AND RETURN
Chapter 10 Capital Markets and the Pricing
of Risk 312
10.1 Risk and Return: Insights from 86
Years of Investor History 313
10.2 Common Measures of Risk and
Return 316
Probability Distributions 316
Expected Return 316
Variance and Standard Deviation

317

10.3 Historical Returns of Stocks and
Bonds 319
Computing Historical Returns 319
Average Annual Returns 321
The Variance and Volatility of Returns 323
Estimation Error: Using Past Returns to
Predict the Future 324
■ Arithmetic Average Returns Versus
Compound Annual Returns 326

10.4 The Historical Trade-Off Between
Risk and Return 326
The Returns of Large Portfolios 327
The Returns of Individual Stocks 328

10.5 Common Versus Independent
Risk 329
Theft Versus Earthquake Insurance:
An Example 329
The Role of Diversification 330

10.6 Diversification in Stock
Portfolios 331
Firm-Specific Versus Systematic
Risk 332

No Arbitrage and the Risk
Premium 333
■ GLOBAL FINANCIAL CRISIS
Diversification Benefits During Market
Crashes 335
■ COMMON MISTAKE A Fallacy of
Long-Run Diversification 336

10.7 Measuring Systematic Risk

337

Identifying Systematic Risk: The Market
Portfolio 337
Sensitivity to Systematic Risk: Beta 337

10.8 Beta and the Cost of Capital

340

Estimating the Risk Premium 340
■ COMMON MISTAKE Beta Versus
Volatility 340
The Capital Asset Pricing Model 342
MyFinanceLab 342 ■ Key Terms 344
Further Reading 344 ■ Problems 344
Data Case 349




Chapter 11 Optimal Portfolio Choice
and the Capital Asset Pricing
Model 351
11.1 The Expected Return of a
Portfolio 352
11.2 The Volatility of a Two-Stock
Portfolio 353
Combining Risks 353
Determining Covariance and
Correlation 354
■ COMMON MISTAKE Computing
Variance, Covariance, and Correlation in
Excel 356
Computing a Portfolio’s Variance
and Volatility 357

11.3 The Volatility of a Large
Portfolio 359
Large Portfolio Variance 359
Diversification with an Equally Weighted
Portfolio 360
■ INTERVIEW with John Powers 362
Diversification with General
Portfolios 363

11.4 Risk Versus Return: Choosing an
Efficient Portfolio 363
Efficient Portfolios with Two Stocks
The Effect of Correlation 366
Short Sales 367
Efficient Portfolios with Many
Stocks 368

364

x

Contents
Identifying the Best-Fitting Line 409
Using Linear Regression 410
■ Why Not Estimate Expected Returns
Directly? 411

■ NOBEL PRIZES Harry Markowitz and
James Tobin 369

11.5 Risk-Free Saving and
Borrowing 371

12.4 The Debt Cost of Capital

Investing in Risk-Free Securities 371
Borrowing and Buying Stocks on
Margin 372
Identifying the Tangent Portfolio 373

11.6 The Efficient Portfolio and Required
Returns 375
Portfolio Improvement: Beta and the
Required Return 375
Expected Returns and the Efficient
Portfolio 377

11.7 The Capital Asset Pricing
Model 379

11.8 Determining the Risk Premium 381
Market Risk and Beta 381
■ NOBEL PRIZE William Sharpe on the
CAPM 383
The Security Market Line 384
Beta of a Portfolio 384
Summary of the Capital Asset Pricing
Model 386
MyFinanceLab 386 ■ Key Terms 389
Further Reading 389 ■ Problems 390
Data Case 396

Appendix The CAPM with Differing Interest
Rates 398

Chapter 12 Estimating the Cost of
Capital 400
12.2 The Market Portfolio

401

402

Constructing the Market Portfolio 402
Market Indexes 402
■ Value-Weighted Portfolios and
Rebalancing 403
The Market Risk Premium 404
■ INTERVIEW with Michael A.
Latham 405

12.3 Beta Estimation

407

Using Historical Returns

407

12.5 A Project’s Cost of Capital

414

All-Equity Comparables 414
Levered Firms as Comparables 415
The Unlevered Cost of Capital 415
Industry Asset Betas 417

12.6 Project Risk Characteristics and
Financing 419

The CAPM Assumptions 379
Supply, Demand, and the Efficiency of the
Market Portfolio 380
Optimal Investing: The Capital Market
Line 380

12.1 The Equity Cost of Capital

411

Debt Yields Versus Returns 411
■ COMMON MISTAKE Using the Debt
Yield as Its Cost of Capital 412
Debt Betas 413

Differences in Project Risk 419
■ COMMON MISTAKE Adjusting for
Execution Risk 421
Financing and the Weighted Average Cost
of Capital 421

12.7 Final Thoughts on Using the
CAPM 423
■ INTERVIEW with Shelagh Glaser

424

MyFinanceLab 425 ■ Key Terms 427
Further Reading 427 ■ Problems 427
Data Case 431







Appendix Practical Considerations When
Forecasting Beta 433
■ COMMON MISTAKE Changing the
Index to Improve the Fit 436
Key Terms

436



Data Case

436

Chapter 13 Investor Behavior and Capital
Market Efficiency 437
13.1 Competition and Capital
Markets 438
Identifying a Stock’s Alpha 438
Profiting from Non-Zero Alpha Stocks 439

13.2 Information and Rational
Expectations 440
Informed Versus Uninformed
Investors 440
Rational Expectations 441

13.3 The Behavior of Individual
Investors 442
Underdiversification and Portfolio
Biases 442

xi

Contents
The Effect of Leverage on Risk
and Return 481

Excessive Trading and
Overconfidence 443
Individual Behavior and Market
Prices 445

14.2 Modigliani-Miller I: Leverage,
Arbitrage, and Firm Value 483

13.4 Systematic Trading Biases

MM and the Law of One Price 483
Homemade Leverage 483
■ MM and the Real World 484
The Market Value Balance Sheet 485
Application: A Leveraged
Recapitalization 486

445

Hanging on to Losers and the Disposition
Effect 445
■ NOBEL PRIZE Kahneman and
Tversky’s Prospect Theory 446
Investor Attention, Mood, and
Experience 446
Herd Behavior 447
Implications of Behavioral
Biases 447

14.3 Modigliani-Miller II: Leverage, Risk,
and the Cost of Capital 488

13.5 The Efficiency of the Market
Portfolio 448
Trading on News or
Recommendations 448
■ INTERVIEW with Jonathan
Clements 450
The Performance of Fund Managers
The Winners and Losers 454

451

13.6 Style-Based Techniques and the
Market Efficiency Debate 454

14.4 Capital Structure Fallacies

14.5 MM: Beyond the Propositions

461

Chapter 15 Debt and Taxes

465

MyFinanceLab 466 ■ Key Terms 468
Further Reading 469 ■ Problems 470

Appendix Building a Multifactor Model



475

PART 5 CAPITAL STRUCTURE
Chapter 14 Capital Structure in a Perfect
Market 478
14.1 Equity Versus Debt Financing
Financing a Firm with Equity 479
Financing a Firm with Debt and
Equity 480

499

MyFinanceLab 500 ■ Key Terms 501
Further Reading 501 ■ Problems 502
Data Case 506

Using Factor Portfolios 461
Selecting the Portfolios 462
The Cost of Capital with Fama-FrenchCarhart Factor Specification 463

13.8 Methods Used in Practice

495

Leverage and Earnings per Share 495
■ GLOBAL FINANCIAL CRISIS Bank
Capital Regulation and the ROE
Fallacy 497
Equity Issuances and Dilution 498

Size Effects 454
Momentum 458
Implications of Positive-Alpha Trading
Strategies 458
■ Market Efficiency and the Efficiency
of the Market Portfolio 459

13.7 Multifactor Models of Risk

Leverage and the Equity Cost of
Capital 488
Capital Budgeting and the Weighted
Average Cost of Capital 489
■ COMMON MISTAKE Is Debt Better
Than Equity? 492
Computing the WACC with Multiple
Securities 492
Levered and Unlevered Betas 492
■ NOBEL PRIZE Franco Modigliani
and Merton Miller 494

479




508

15.1 The Interest Tax Deduction

509

15.2 Valuing the Interest Tax Shield 511
The Interest Tax Shield and Firm
Value 511
The Interest Tax Shield with Permanent
Debt 512
■ Pizza and Taxes 513
The Weighted Average Cost of Capital
with Taxes 513
The Interest Tax Shield with a Target
Debt-Equity Ratio 514

15.3 Recapitalizing to Capture the Tax
Shield 516
The Tax Benefit

516

xii

Contents
The Share Repurchase 517
No Arbitrage Pricing 517
Analyzing the Recap: The Market Value
Balance Sheet 518

15.4 Personal Taxes

519

Including Personal Taxes in the Interest
Tax Shield 519
Valuing the Interest Tax Shield with
Personal Taxes 522
Determining the Actual Tax Advantage
of Debt 523
■ Cutting the Dividend Tax Rate 523

15.5 Optimal Capital Structure with
Taxes 524
Do Firms Prefer Debt? 524
Limits to the Tax Benefit of Debt 527
■ INTERVIEW with Andrew
Balson 528
Growth and Debt 529
Other Tax Shields 530
The Low Leverage Puzzle 530
■ Employee Stock Options 532
MyFinanceLab 532 ■ Key Term 533 ■
Further Reading 534 ■ Problems 534 ■
Data Case 538

Chapter 16 Financial Distress,
Managerial Incentives,
and Information 539
16.1 Default and Bankruptcy in a Perfect
Market 540
Armin Industries: Leverage and the Risk of
Default 540
Bankruptcy and Capital Structure 541

16.2 The Costs of Bankruptcy and
Financial Distress 542
The Bankruptcy Code 543
Direct Costs of Bankruptcy 543
Indirect Costs of Financial
Distress 544
■ GLOBAL FINANCIAL CRISIS
The Chrysler Prepack 547

16.3 Financial Distress Costs and Firm
Value 548
Armin Industries: The Impact of Financial
Distress Costs 548
Who Pays for Financial Distress
Costs? 548

16.4 Optimal Capital Structure: The
Trade-Off Theory 550
The Present Value of Financial Distress
Costs 550
Optimal Leverage 551

16.5 Exploiting Debt Holders: The
Agency Costs of Leverage 553
Excessive Risk-Taking and Asset
Substitution 553
Debt Overhang and Under-Investment 554
■ GLOBAL FINANCIAL CRISIS Bailouts,
Distress Costs, and Debt
Overhang 555
Agency Costs and the Value of
Leverage 556
The Leverage Ratchet Effect 557
Debt Maturity and Covenants 558

16.6 Motivating Managers: The Agency
Benefits of Leverage 559
Concentration of Ownership 559
Reduction of Wasteful Investment 560
■ Excessive Perks and Corporate
Scandals 561
Leverage and Commitment 561
■ GLOBAL FINANCIAL CRISIS Moral
Hazard, Government Bailouts, and the
Appeal of Leverage 562

16.7 Agency Costs and the Trade-Off
Theory 563
The Optimal Debt Level 563
Debt Levels in Practice 564

16.8 Asymmetric Information and
Capital Structure 564
Leverage as a Credible Signal 565
Issuing Equity and Adverse
Selection 566
■ NOBEL PRIZE The 2001 Nobel Prize
in Economics 567
Implications for Equity Issuance 568
Implications for Capital Structure 570

16.9 Capital Structure: The Bottom
Line 572
MyFinanceLab 573 ■ Key Terms 575
Further Reading 575 ■ Problems 575

Chapter 17 Payout Policy

584

17.1 Distributions to Shareholders
Dividends 585
Share Repurchases



587

585

xiii

Contents

PART 6 ADVANCED VALUATION

17.2 Comparison of Dividends and
Share Repurchases 588
Alternative Policy 1: Pay Dividend with
Excess Cash 588
Alternative Policy 2: Share Repurchase
(No Dividend) 589
■ COMMON MISTAKE Repurchases
and the Supply of Shares 591
Alternative Policy 3: High Dividend
(Equity Issue) 591
Modigliani–Miller and Dividend Policy
Irrelevance 592
■ COMMON MISTAKE The Bird in the
Hand Fallacy 593
Dividend Policy with Perfect Capital
Markets 593

Chapter 18 Capital Budgeting and
Valuation with Leverage
18.1 Overview of Key Concepts

Using the WACC to Value a Project 629
Summary of the WACC Method 630
Implementing a Constant Debt-Equity
Ratio 631

18.3 The Adjusted Present Value
Method 633
The Unlevered Value of the Project 633
Valuing the Interest Tax Shield 634
Summary of the APV Method 635

18.4 The Flow-to-Equity Method

595

The Effective Dividend Tax Rate 597
Tax Differences Across Investors 598
Clientele Effects 599

18.5 Project-Based Costs
of Capital 640

17.5 Payout Versus Retention of
Cash 602

Estimating the Unlevered Cost of
Capital 640
Project Leverage and the Equity Cost
of Capital 641
Determining the Incremental Leverage
of a Project 642
■ COMMON MISTAKE Re-Levering
the WACC 643

Retaining Cash with Perfect Capital
Markets 602
Taxes and Cash Retention 603
Adjusting for Investor Taxes 604
Issuance and Distress Costs 605
Agency Costs of Retaining Cash 606

608

Dividend Smoothing 608
Dividend Signaling 609
■ Royal & SunAlliance’s Dividend
Cut 610
Signaling and Share Repurchases 610

18.6 APV with Other Leverage
Policies 644
Constant Interest Coverage Ratio 645
Predetermined Debt Levels 646
A Comparison of Methods 647

17.7 Stock Dividends, Splits, and
Spin-Offs 612
Stock Dividends and Splits 612
■ INTERVIEW with John Connors
Spin-Offs 615
■ Berkshire Hathaway’s A & B
Shares 616

636

Calculating the Free Cash Flow to
Equity 637
Valuing Equity Cash Flows 638
Summary of the Flow-to-Equity
Method 638
■ What Counts as “Debt”? 639

17.4 Dividend Capture and Tax
Clienteles 597

17.6 Signaling with Payout Policy

627

18.2 The Weighted Average Cost of
Capital Method 628

17.3 The Tax Disadvantage of
Dividends 593
Taxes on Dividends and Capital
Gains 594
Optimal Dividend Policy with Taxes

626

18.7 Other Effects of Financing
613

MyFinanceLab 617 ■ Key Terms 618
Further Reading 619 ■ Problems 619
Data Case 623




648

Issuance and Other Financing Costs 648
Security Mispricing 649
Financial Distress and Agency Costs 650
■ GLOBAL FINANCIAL CRISIS
Government Loan Guarantees 650

18.8 Advanced Topics in Capital
Budgeting 651
Periodically Adjusted Debt

651

xiv

Contents
Leverage and the Cost of Capital 654
The WACC or FTE Method with Changing
Leverage 655
Personal Taxes 657
MyFinanceLab 659 ■ Key Terms 661
Further Reading 661 ■ Problems 661
Data Case 668




Appendix Foundations and Further Details 670

Chapter 19 Valuation and Financial
Modeling: A Case Study

674
675

677

Operational Improvements 677
Capital Expenditures: A Needed
Expansion 678
Working Capital Management 679
Capital Structure Changes: Levering Up 679

19.3 Building the Financial Model

680

Forecasting Earnings 680
Working Capital Requirements 682
Forecasting Free Cash Flow 683
■ INTERVIEW with Joseph L. Rice,
III 685
The Balance Sheet and Statement of
Cash Flows (Optional) 686
■ USING EXCEL Auditing Your Financial
Model 688

19.4 Estimating the Cost of Capital
CAPM-Based Estimation 689
Unlevering Beta 690
Ideko’s Unlevered Cost of Capital

19.5 Valuing the Investment

689

691

692

707

Understanding Option Contracts 707
Interpreting Stock Option
Quotations 707
Options on Other Financial Securities 709

704

710

Long Position in an Option Contract 710
Short Position in an Option Contract 711
Profits for Holding an Option to
Expiration 713
Returns for Holding an Option to
Expiration 714
Combinations of Options 715

20.3 Put-Call Parity

718

20.4 Factors Affecting Option Prices 720
Strike Price and Stock Price 720
Arbitrage Bounds on Option Prices 720
Option Prices and the Exercise Date 721
Option Prices and Volatility 721

20.5 Exercising Options Early

722

Non-Dividend-Paying Stocks 722
Dividend-Paying Stocks 724

20.6 Options and Corporate Finance 727
Equity as a Call Option 727
Debt as an Option Portfolio 727
Credit Default Swaps 728
■ GLOBAL FINANCIAL CRISIS
Credit Default Swaps 729
Pricing Risky Debt 729
Agency Conflicts 730

Chapter 21 Option Valuation

738

21.1 The Binomial Option Pricing
Model 739
A Two-State Single-Period Model 739
The Binomial Pricing Formula 741
A Multiperiod Model 743
Making the Model Realistic 746

699

MyFinanceLab 700 ■ Key Terms 701
Further Reading 701 ■ Problems 701

Appendix Compensating Management

20.1 Option Basics

706

MyFinanceLab 731 ■ Key Terms 732
Further Reading 733 ■ Problems 733
Data Case 737

The Multiples Approach to Continuation
Value 692
The Discounted Cash Flow Approach
to Continuation Value 693
APV Valuation of Ideko’s Equity 695
■ COMMON MISTAKE Continuation
Values and Long-Run Growth 695
A Reality Check 696
■ COMMON MISTAKE Missing Assets
or Liabilities 697
IRR and Cash Multiples 697

19.6 Sensitivity Analysis

Chapter 20 Financial Options

20.2 Option Payoffs at Expiration

19.1 Valuation Using Comparables
19.2 The Business Plan

PART 7 OPTIONS



21.2 The Black-Scholes Option Pricing
Model 747
The Black-Scholes Formula

747




xv

Contents
Implied Volatility 752
■ GLOBAL FINANCIAL CRISIS The VIX
Index 753
The Replicating Portfolio 754
■ COMMON MISTAKE Valuing
Employee Stock Options 756
■ INTERVIEW with Myron S.
Scholes 757

21.3 Risk-Neutral Probabilities

761



22.1 Real Versus Financial Options 774
774

22.3 The Option to Delay an Investment
Opportunity 777
Investment as a Call Option 777
■ Why Are There Empty Lots in Built-Up
Areas of Big Cities? 779
Factors Affecting the Timing of
Investment 780
Investment Options and Firm Risk 782
■ GLOBAL FINANCIAL CRISIS
Uncertainty, Investment, and the
Option to Delay 783

22.4 Growth and Abandonment
Options 783
Valuing Growth Potential 783
The Option to Expand 785
■ INTERVIEW with Scott
Mathews 787
The Option to Abandon 788



PART 8 LONG-TERM FINANCING

773

Mapping Uncertainties on a Decision
Tree 775
Real Options 776

797

MyFinanceLab 798 ■ Key Terms 800
Further Reading 800 ■ Problems 800

Beta of Risky Debt 763
■ NOBEL PRIZE The 1997 Nobel Prize
in Economics 764
Agency Costs of Debt 766

22.2 Decision Tree Analysis

795

22.7 Key Insights from Real
Options 798

21.5 Corporate Applications of Option
Pricing 763

Chapter 22 Real Options

790

The Profitability Index Rule 795
The Hurdle Rate Rule 795
■ The Option to Repay a Mortgage

A Risk-Neutral Two-State Model 758
Implications of the Risk-Neutral
World 758
Risk-Neutral Probabilities and Option
Pricing 759

MyFinanceLab 767 ■ Key Terms 769
Further Reading 769 ■ Problems 769

Comparing Mutually Exclusive
Investments with Different Lives
■ Equivalent Annual Benefit
Method 791
Staging Mutually Dependent
Investments 792

22.6 Rules of Thumb

758

21.4 Risk and Return of an Option

22.5 Applications to Multiple
Projects 789

Chapter 23 Raising Equity Capital

806

23.1 Equity Financing for Private
Companies 807
Sources of Funding 807
Outside Investors 810
Exiting an Investment in a Private
Company 812

23.2 The Initial Public Offering

812

Advantages and Disadvantages of Going
Public 812
Types of Offerings 813
The Mechanics of an IPO 815
■ Google’s IPO 815

23.3 IPO Puzzles

820

Underpricing 820
Cyclicality 823
■ GLOBAL FINANCIAL CRISIS
Worldwide IPO Deals in
2008–2009 824
Cost of an IPO 824
Long-Run Underperformance 825

23.4 The Seasoned Equity Offering
The Mechanics of an SEO
Price Reaction 827
Issuance Costs 829

826

826

MyFinanceLab 829 ■ Key Terms 830
Further Reading 831 ■ Problems 831
Data Case 834




xvi

Contents

Chapter 24 Debt Financing 836
24.1 Corporate Debt

25.4 Reasons for Leasing

837

Public Debt 837
Private Debt 841

24.2 Other Types of Debt

MyFinanceLab 880 ■ Key Terms 881
Further Reading 881 ■ Problems 882

842

Sovereign Debt 842
Municipal Bonds 844
Asset-Backed Securities 844
■ GLOBAL FINANCIAL CRISIS CDOs,
Subprime Mortgages, and the Financial
Crisis 846

24.3 Bond Covenants

876

Valid Arguments for Leasing 877
Suspect Arguments for Leasing 879

845

24.4 Repayment Provisions

848

MyFinanceLab 854 ■ Key Terms 855
Further Reading 856 ■ Problems 856
Data Case 857

PART 9 SHORT-TERM FINANCING
Chapter 26 Working Capital
Management 886
26.1 Overview of Working Capital
The Cash Cycle 887
Firm Value and Working Capital

Call Provisions 848
■ New York City Calls Its Municipal
Bonds 850
Sinking Funds 852
Convertible Provisions 852

26.2 Trade Credit



890

26.3 Receivables Management

25.1 The Basics of Leasing

860

Examples of Lease Transactions 860
Lease Payments and Residual
Values 861
Leases Versus Loans 862
■ Calculating Auto Lease
Payments 863
End-of-Term Lease Options 863
Other Lease Provisions 865

25.2 Accounting, Tax, and Legal
Consequences of Leasing 865
Lease Accounting 866
■ Operating Leases at Alaska Air
Group 867
The Tax Treatment of Leases 868
Leases and Bankruptcy 869
■ Synthetic Leases 870

25.3 The Leasing Decision

870

Cash Flows for a True Tax Lease 871
Lease Versus Buy (An Unfair
Comparison) 872
Lease Versus Borrow (The Right
Comparison) 873
Evaluating a True Tax Lease 875
Evaluating a Non-Tax
Lease 876

890

892

Determining the Credit Policy 892
Monitoring Accounts Receivable 893

26.4 Payables Management

Chapter 25 Leasing 859

887

889

Trade Credit Terms 890
Trade Credit and Market Frictions
Managing Float 891




895

Determining Accounts Payable Days
Outstanding 895
Stretching Accounts Payable 896

26.5 Inventory Management

896

Benefits of Holding Inventory 897
Costs of Holding Inventory 897

26.6 Cash Management

898

Motivation for Holding Cash 898
Alternative Investments 899
■ GLOBAL FINANCIAL CRISIS
Hoarding Cash 899
MyFinanceLab 901 ■ Key Terms 902
Further Reading 902 ■ Problems 903
Data Case 906

Chapter 27 Short-Term Financial
Planning 908
27.1 Forecasting Short-Term Financing
Needs 909
Seasonalities 909
Negative Cash Flow Shocks 911
Positive Cash Flow Shocks 912

27.2 The Matching Principle

914

Permanent Working Capital 914
Temporary Working Capital 914
Financing Policy Choices 915




xvii

Contents

27.3 Short-Term Financing with Bank
Loans 916
Single, End-of-Period Payment Loan 916
Line of Credit 916
Bridge Loan 917
Common Loan Stipulations and Fees 917

27.4 Short-Term Financing with
Commercial Paper 919
■ GLOBAL FINANCIAL CRISIS
Short-Term Financing in Fall 2008

920

27.5 Short-Term Financing with Secured
Financing 921
Accounts Receivable as Collateral 921
■ A Seventeenth-Century Financing
Solution 921
Inventory as Collateral 922
MyFinanceLab 924 ■ Key Terms 925
Further Reading 925 ■ Problems 925

Golden Parachutes 948
Recapitalization 948
Other Defensive Strategies 949
Regulatory Approval 949
■ Weyerhaeuser’s Hostile Bid for
Willamette Industries 950

28.6 Who Gets the Value Added from a
Takeover? 950
The Free Rider Problem 950
Toeholds 951
The Leveraged Buyout 952
■ The Leveraged Buyout of RJR-Nabisco
by KKR 952
The Freezeout Merger 955
Competition 955
MyFinanceLab 956 ■ Key Terms 957
Further Reading 958 ■ Problems 958



Chapter 29 Corporate Governance

Chapter 28 Mergers and Acquisitions

930

28.1 Background and Historical
Trends 931

28.2 Market Reaction to a Takeover

933

934

Economies of Scale and Scope 935
Vertical Integration 935
Expertise 935
Monopoly Gains 936
Efficiency Gains 936
Tax Savings from Operating Losses 937
Diversification 938
Earnings Growth 938
Managerial Motives to Merge 939

28.4 The Takeover Process

940

Valuation 941
The Offer 941
Merger “Arbitrage” 943
Tax and Accounting Issues 944
Board and Shareholder Approval 945
Poison Pills 946
Staggered Boards 947
White Knights 948

946

29.2 Monitoring by the Board of
Directors and Others 963
Types of Directors 963
Board Independence 963
Board Size and Performance
Other Monitors 965

Merger Waves 931
Types of Mergers 933

28.5 Takeover Defenses

961

29.1 Corporate Governance and Agency
Costs 962

PART 10 SPECIAL TOPICS

28.3 Reasons to Acquire



29.3 Compensation Policies

965

966

Stock and Options 966
Pay and Performance Sensitivity

29.4 Managing Agency Conflict

966

968

Direct Action by Shareholders 968
■ Shareholder Activism at The New York
Times 969
Management Entrenchment 970
The Threat of Takeover 971

29.5 Regulation

971

The Sarbanes-Oxley Act 972
■ INTERVIEW with Lawrence E.
Harris 973
The Cadbury Commission 974
Dodd-Frank Act 975
Insider Trading 975
■ Martha Stewart and ImClone 976

29.6 Corporate Governance Around the
World 976
Protection of Shareholder Rights 976
Controlling Owners and Pyramids 977

xviii

Contents
The Stakeholder Model
Cross-Holdings 980

979

Swap-Based Hedging 1014
■ The Savings and Loan Crisis

29.7 The Trade-Off of Corporate
Governance 981
MyFinanceLab 981 ■ Key Terms 983
Further Reading 983 ■ Problems 983

Chapter 30 Risk Management
30.1 Insurance



985

Chapter 31 International Corporate
Finance 1026
31.1 Internationally Integrated Capital
Markets 1027

986

The Role of Insurance:
An Example 986
Insurance Pricing in a
Perfect Market 986
The Value of Insurance 988
The Costs of Insurance 990
The Insurance Decision 992

30.2 Commodity Price Risk

31.2 Valuation of Foreign Currency Cash
Flows 1028
WACC Valuation Method in Domestic
Currency 1029
Using the Law of One Price as a
Robustness Check 1031

31.3 Valuation and International
Taxation 1032

992

Hedging with Vertical Integration and
Storage 993
Hedging with Long-Term Contracts 993
Hedging with Futures Contracts 995
■ COMMON MISTAKE
Hedging Risk 997
■ Differing Hedging Strategies 998
Deciding to Hedge Commodity Price
Risk 998

30.3 Exchange Rate Risk

Single Foreign Project with Immediate
Repatriation of Earnings 1033
Multiple Foreign Projects and Deferral of
Earnings Repatriation 1033

31.4 Internationally Segmented Capital
Markets 1034
Differential Access to Markets 1034
Macro-Level Distortions 1035
Implications 1036

999

31.5 Capital Budgeting with Exchange
Risk 1037

Exchange Rate Fluctuations 999
Hedging with Forward Contracts 1000
Cash-and-Carry and the Pricing of Currency
Forwards 1001
■ GLOBAL FINANCIAL CRISIS
Arbitrage in Currency Markets? 1003
Hedging with Options 1005

30.4 Interest Rate Risk

1009

Interest Rate Risk Measurement:
Duration 1009
Duration-Based Hedging 1011

1016

MyFinanceLab 1018 ■ Key Terms 1020 ■
Further Reading 1020 ■ Problems 1021

■ INTERVIEW with Bill Barrett

1040

MyFinanceLab 1040 ■ Key Terms 1041
Further Reading 1041 ■ Problems 1042
Data Case 1044

Glossary
Index

1046

1065




Bridging Theory
and Practice
GLOBAL FINANCIAL CRISIS

European Sovereign Debt Yields: A Puzzle

Before the EMU created the euro as a single European currency, the yields of sovereign debt issued by European countries varied widely. These variations primarily reflected
differences in inflation expectations and currency risk (see
Figure 6.6). However, after the monetary union was put in
place at the end of 1998, the yields all essentially converged to
the yield on German government bonds. Investors seemed to
conclude that there was little distinction between the debt of
the European countries in the union––they seemed to feel that
all countries in the union were essentially exposed to the same
default, inflation and currency risk and thus equally “safe.”
Presumably, investors believed that an outright default
was unthinkable: They apparently believed that member

countries would be fiscally responsible and manage their
debt obligations to avoid default at all costs. But as illustrated by Figure 6.6, once the 2008 financial crisis revealed
the folly of this assumption, debt yields once again diverged
as investors acknowledged the likelihood that some countries (particularly Portugal and Ireland) might be unable to
repay their debt and would be forced to default.
In retrospect, rather than bringing fiscal responsibility,
the monetary union allowed the weaker member countries
to borrow at dramatically lower rates. In response, these
countries reacted by increasing their borrowing––and at
least in Greece’s case, borrowed to the point that default
became inevitable.

Focus on the Financial Crisis and Sovereign
Debt Crisis
Global Financial Crisis boxes reflect the reality of the recent
financial crisis and ongoing sovereign debt crisis, noting lessons
learned. 23 boxes across the book illustrate and analyze key
details.

The Law of One Price as the Unifying Valuation
Framework
The Law of One Price framework reflects the modern idea that
the absence of arbitrage is the unifying concept of valuation. This
critical insight is introduced in Chapter 3, revisited in each part
opener, and integrated throughout the text—motivating all major
concepts and connecting theory to practice.
COMMON MISTAKE

Discounting One Too Many Times

The perpetuity formula assumes that the first payment
occurs at the end of the first period (at date 1). Sometimes
perpetuities have cash flows that start later in the future. In
this case, we can adapt the perpetuity formula to compute
the present value, but we need to do so carefully to avoid a
common mistake.
To illustrate, consider the MBA graduation party
described in Example 4.7. Rather than starting immediately, suppose that the first party will be held two years from
today (for the current entering class). How would this delay
change the amount of the donation required?
Now the timeline looks like this:
0

1

2
$30,000

3

...
$30,000

We need to determine the present value of these cash flows,
as it tells us the amount of money in the bank needed today
to finance the future parties. We cannot apply the perpetuity
formula directly, however, because these cash flows are not
exactly a perpetuity as we defined it. Specifically, the cash
flow in the first period is “missing.” But consider the situation on date 1—at that point, the first party is one period

Kevin M. Warsh, a lecturer at Stanford’s
Graduate School of Business and a
distinguished visiting fellow at the

away and then the cash flows are periodic. From the perspective of date 1, this is a perpetuity, and we can apply the
formula. From the preceding calculation, we know we need
$375,000 on date 1 to have enough to start the parties on
date 2. We rewrite the timeline as follows:
0

1
$375,000

2
$30,000

3
...
$30,000

Our goal can now be restated more simply: How much do
we need to invest today to have $375,000 in one year? This
is a simple present value calculation:

clarity and confidence in the financial
wherewithal of each other. One effective, innovative tool, the Term Auction
Facility (TAF), stimulated the economy
by providing cheap and readily available term funding to banks, large and
small, on the front lines of the economy,
thus encouraging them to extend credit
to businesses and consumers. After
reducing the policy rate to near zero
to help revive the economy, the Fed
instituted two Quantitative Easing (QE)
programs––special purchases of government and agency securities––to increase
money supply, promote lending, and
according to some proponents, increase
prices of riskier assets.
The Fed also addressed the global
financial crisis by establishing temporary central bank
liquidity swap lines with the European Central Bank and
other major central banks. Using this facility, a foreign
central bank is able to obtain dollar funding for its customers by swapping Euros for dollars or another currency and
agreeing to reverse the swap at a later date. The Fed does
not take exchange rate risk, but it is subject to the credit
risk of its central bank counterparty.

Kevin M. Warsh

markets.
QUESTION: What are the main policy
instruments used by central banks to control
the economy?
ANSWER: The Federal Reserve (Fed)

deploys several policy tools to achieve its
goals of price stability, maximum sustainable employment, and financial stability.
Lowering the federal funds short-term
interest rate, the primary policy instrument,
stimulates the economy. Raising the federal funds rate generally slows the economy. Buying and selling short-term U.S.
Treasury securities through open market operations is standard
practice. Prior to the 2007–2009 financial crisis, the Fed’s
balance sheet ranged from $700–$900 billion. But when
the Fed was unable to lower interest rates further because
rates were so close to zero already, it resorted to large-scale,
longer-term open market operations to increase liquidity in
the financial system in the hopes of stimulating the economy
further, thus growing its balance sheet significantly. With
open mouth operations, the Fed’s announcements of its intent
to buy or sell assets indicates its desired degree of future
policy accommodation, often prompting markets to react
by adjusting interest rates immediately. The Fed’s Lender-ofLast-Resort authority allows it to lend money against good
ll
l
bl d i i i
d
i
di i

To be successful, students need to master the core concepts and
learn to identify and solve problems that today’s practitioners face.
Common Mistakes boxes alert students to frequently made
mistakes stemming from misunderstanding core concepts and
calculations—in the classroom and in the field.

PV = $375,000/1.08 = $347,222 today
A common mistake is to discount the $375,000 twice
because the first party is in two periods. Remember—the
present value formula for the perpetuity already discounts the
cash flows to one period prior to the first cash flow. Keep in
mind that this common mistake may be made with perpetuities, annuities, and all of the other special cases discussed in
this section. All of these formulas discount the cash flows to
one period prior to the first cash flow.

INTERV IEW WITH

Hoover Institution, was a Federal
Reserve governor from 2006 to 2011,
serving as chief liaison to the financial

Study Aids with a Practical Focus

QUESTION: What tools is the European Central Bank
(ECB) using to address the sovereign debt crisis? How does its
approach compare to the Fed’s approach to the 2007–2009
financial crisis?

EXAMPLE 4.14

Evaluating an Annuity with Monthly Cash Flows
Problem

Worked Examples
accompany every important concept using a
step-by-step procedure
that guides students
through the solution
process. Clear labels
make them easy to find
for help with homework and studying.

You are about to purchase a new car and have two options to pay for it. You can pay $20,000 in
cash immediately, or you can get a loan that requires you to pay $500 each month for the next
48 months (four years). If the monthly interest rate you earn on your cash is 0.5%, which option
should you take?
Solution

Let’s start by writing down the timeline of the loan payments:
1

2

$500

$500

48
...

0

$500

The timeline shows that the loan is a 48-period annuity. Using the annuity formula the present
value is
1
1
¢1 ≤
PV (48@period annuity of $500) = $500 *
0.005
1.00548
= $21,290
Alternatively, we may use the annuity spreadsheet to solve the problem:
Given
Solve for PV

NPER
48

RATE
0.50%

PV

PMT
500

(21,290)

FV
0

Excel Formula
PV( 0. 005, 48, 500, 0)

Thus, taking the loan is equivalent to paying $21,290 today, which is costlier than paying cash.
You should pay cash for the car.

Applications that Reflect Real Practice
Corporate Finance features actual companies and leaders in the field.
Interviews with notable practitioners—seven new for this edition—highlight leaders in the field and address the effects of the
financial crisis.
General Interest boxes highlight timely material from financial
publications that shed light on business problems and realcompany practices.

ANSWER: As a novel economic federation, the ECB
finds itself in a more difficult position than the Fed The

xix

Teaching Students
to Think Finance
With a consistency in presentation and an innovative set of learning aids, Corporate Finance simultaneously meets the needs of
both future financial managers and non-financial managers. This textbook truly shows every student how to “think finance.”

Simplified Presentation of Mathematics
One of the hardest parts of learning finance is mastering the
jargon, math, and non-standardized notation. Corporate Finance
systematically uses:
Notation Boxes: Each chapter opens by defining the variables
and acronyms used in the chapter as a ‘legend’ for students’
reference.

USING EXCEL
Excel’s IRR Function

Timelines: Introduced in Chapter 4, timelines are emphasized
as the important first step in solving every problem that
involves cash flows.

Excel also has a built-in function, IRR, that will calculate the IRR of a stream of cash flows.
Excel’s IRR function has the format, IRR (values, guess), where “values” is the range containing
the cash flows, and “guess” is an optional starting guess where Excel begins its search for an IRR.
See the example below:

There are three things to note about the IRR function. First, the values given to the IRR function should include all of the cash flows of the project, including the one at date 0. In this
sense, the IRR and NPV functions in Excel are inconsistent. Second, like the NPV function, the
IRR ignores the period associated with any blank cells. Finally, as we will discuss in Chapter 7,
in some settings the IRR function may fail to find a solution, or may give a different answer,
depending on the initial guess.

Numbered and Labeled Equations: The first time a full equation is given in notation form it is numbered. Key equations
are titled and revisited in the summary and in end papers.
Using Excel Boxes: Provide hands-on instruction of Excel
techniques and include screenshots to serve as a guide for students.
Spreadsheet Tables: Select tables are available as Excel files,
enabling students to change inputs and manipulate the underlying calculations.

TABLE 8.1
SPREADSHEET

HomeNet’s Incremental Earnings Forecast

Year
0
1
2
3
4
5
Incremental Earnings Forecast ($000s)

1 Sales

26,000 26,000 26,000 26,000

2 Cost of Goods Sold

(11,000) (11,000) (11,000) (11,000)

3 Gross Profit

15,000 15,000 15,000 15,000

4 Selling, General, and Administrative —
(2,800) (2,800) (2,800) (2,800)
5 Research and Development
(15,000)




6 Depreciation

(1,500) (1,500) (1,500) (1,500) (1,500)
7 EBIT
(15,000) 10,700 10,700 10,700 10,700 (1,500)
8 Income Tax at 40%
6,000
(4,280) (4,280) (4,280) (4,280)
600
9 Unlevered Net Income
(9,000)
6,420
6,420
6,420
6,420
(900)

Practice Finance to Learn Finance
Working problems is the proven way to cement and demonstrate
an understanding of finance.
Concept Check questions at the end of each section enable
students to test their understanding and target areas in which
they need further review.
End-of-chapter problems written personally by Jonathan
Berk and Peter DeMarzo offer instructors the opportunity
to assign first-rate materials to students for homework and
practice with the confidence that the problems are consistent
with chapter content. Both the problems and solutions, which
were also written by the authors, have been class-tested and
accuracy-checked to ensure quality.
Data Cases present in-depth scenarios in a business setting
with questions designed to guide students’ analysis. Many
questions involve the use of Internet resources and Excel
techniques.

xx

Data Case

Few IPOs have garnered as much attention as social media giant Facebook’s public offering on May
18, 2012. It was the biggest IPO in Internet history, easily topping Google’s initial public offering
eight years earlier. Let’s take a closer look at the IPO itself, as well as the payoffs to some of Facebook’s early investors.
1. Begin by navigating to the SEC EDGAR Web site, which provides access to company filings:
http://www.sec.gov/edgar.shtml. Choose “Search for Company Filings” and pick search by company name. Enter “Facebook” and then search for its IPO prospectus, which was filed on the date
of the IPO and is listed as filing “424B4” (this acronym derives from the rule number requiring the firm to file a prospectus, Rule 424(b)(4)). From the prospectus, calculate the following
information:
a. The underwriting spread in percentage terms. How does this spread compare to a typical
IPO?

b. The fraction of the offering that comprised primary shares and the fraction that comprised
secondary shares.

c. The size, in number of shares, of the greenshoe provision. What percent of the deal did the
greenshoe provision represent?
2. Next, navigate to Google Finance and search for “Facebook.” Determine the closing price of the
stock on the day of the IPO (use the “Historical prices” link). What was the first day return? How
does this return compare to the typical IPO?
3. Using the data provided by Google Finance, calculate the performance of Facebook in the threemonth post-IPO period. That is, calculate the annualized return an investor would have received
if he had invested in Facebook at the closing price on the IPO day and sold the stock three
months later. What was the return for a one-year holding period?

MyFinanceLab
Because practice with homework problems is crucial to learning finance, Corporate Finance is available with MyFinanceLab, a
fully integrated homework and tutorial system. MyFinanceLab revolutionizes homework and practice with material written and
developed by Jonathan Berk and Peter DeMarzo.

Online Assessment Using End-of-Chapter Problems
The seamless integration among the textbook, assessment materials, and online
resources sets a new standard in corporate finance education.
End-of-chapter problems—every single one
—appear online. The values in the problems
are algorithmically generated, giving students
many opportunities for practice and mastery.
Problems can be assigned by professors and
completed online by students.
Helpful tutorial tools, along with the same
pedagogical aids from the text, support
students as they study. Links to the eText
direct students right to the material they most
need to review.

Additional Resources in
Video clips profile high-profile firms such
as Boeing, Cisco, Delta, and Intel through
interviews and analysis. The videos focus on
core topical areas, including capital budgeting,
mergers and acquisitions, and risk and return.
Interactive animations, which enable students
to manipulate inputs, cover topics such as
bonds, stock valuation, NPV, IRR, financial
statement modeling, and more.
Finance in the News provides weekly postings
of a relevant and current article from a newspaper or journal article with discussion questions that are assignable in MyFinanceLab.
Live news and video feeds from The Financial
Times and ABC News provide real-term news
updates.
To learn more about MyFinanceLab,
contact your local Pearson representative
(www.pearsoneducation.com/replocator) or
visit www.myfinancelab.com.

xxi

Hands-On Practice,
Hands-Off Grading
Hands-On, Targeted Practice
Students can take pre-built Practice Tests
for each chapter, and their test results will
generate an individualized Study Plan.
With the Study Plan, students learn to
focus their energies on the topics they need
to be successful in class, on exams, and,
ultimately, in their careers.

Powerful Instructor Tools
MyFinanceLab provides flexible tools that
enable instructors to easily customize the
online course materials to suit their needs.
Easy-to-Use Homework Manager.
Instructors can easily create and assign
tests, quizzes, or graded homework
assignments. In addition to pre-built
MyFinanceLab questions, the Test
Bank is also available so that instructors
have ample material with which to
create assignments.
Flexible Gradebook. MyFinanceLab
saves time by automatically grading
students’ work and tracking results in
an online Gradebook.
Downloadable Classroom Resources. Instructors also have access to online
versions of each instructor supplement, including the Instructor’s Manual,
Solutions Manual, PowerPoint Lecture Notes, and Test Bank.
To learn more about MyFinanceLab, contact your local Pearson representative
(www.pearsoneducation.com/replocator) or visit www.myfinancelab.com.

xxii

About the Authors
Jonathan Berk is the A.P. Giannini Professor of Finance at the Graduate School of Busi-

ness, Stanford University and is a Research Associate at the National Bureau of Economic
Research. Before coming to Stanford, he was the Sylvan Coleman Professor of Finance at
Haas School of Business at the University of California, Berkeley. Prior to earning his Ph.D.,
he worked as an Associate at Goldman Sachs (where his education in finance really began).
Professor Berk’s research interests in finance include corporate valuation, capital structure, mutual funds, asset pricing, experimental economics, and labor economics. His work
has won a number of research awards including the TIAA-CREF Paul A. Samuelson Award,
the Smith Breeden Prize, Best Paper of the Year in The Review of Financial Studies, and the
FAME Research Prize. His paper, “A Critique of Size-Related Anomalies,” was selected as
one of the two best papers ever published in The Review of Financial Studies. In recognition
of his influence on the practice of finance he has received the Bernstein-Fabozzi/Jacobs
Levy Award, the Graham and Dodd Award of Excellence, and the Roger F. Murray Prize.
He served as an Associate Editor of the Journal of Finance for
eight years, is currently a Director of the American Finance
Association, an Academic Director of the Financial Management Association, and is a member of the advisory board of the
Journal of Portfolio Management.
Born in Johannesburg, South Africa, Professor Berk is married, with two daughters, and is an avid skier and biker.
Peter DeMarzo is the Mizuho Financial Group Professor of
Finance and Senior Associate Dean for Academic Affairs at the
Stanford Graduate School of Business. He is also a Research
Associate at the National Bureau of Economic Research. He
currently teaches MBA and Ph.D. courses in Corporate Finance
Peter DeMarzo and Jonathan Berk
and Financial Modeling. In addition to his experience at the
Stanford Graduate School of Business, Professor DeMarzo has taught at the Haas School of
Business and the Kellogg Graduate School of Management, and he was a National Fellow
at the Hoover Institution.
Professor DeMarzo received the Sloan Teaching Excellence Award at Stanford in 2004
and 2006, and the Earl F. Cheit Outstanding Teaching Award at U.C. Berkeley in 1998.
Professor DeMarzo has served as an Associate Editor for The Review of Financial Studies,
Financial Management, and the B.E. Journals in Economic Analysis and Policy, as well as a Director of the American Finance Association. He has served as Vice President and President
of the Western Finance Association. Professor DeMarzo’s research is in the area of corporate
finance, asset securitization, and contracting, as well as market structure and regulation. His
recent work has examined issues of the optimal design of contracts and securities, the regulation of insider trading and broker-dealers, and the influence of information asymmetries
on corporate investment. He has received numerous awards including the Western Finance
Association Corporate Finance Award and the Barclays Global Investors/Michael Brennan
best-paper award from The Review of Financial Studies.
Professor DeMarzo was born in Whitestone, New York, and is married with three boys.
He and his family enjoy hiking, biking, and skiing.
xxiii

Preface

W

E WERE MOTIVATED TO WRITE THIS TEXTBOOK BY A CENTRAL

insight: The core concepts in finance are simple and intuitive. What makes
the subject challenging is that it is often difficult for a novice to distinguish between these core ideas and other intuitively appealing approaches that, if used in financial
decision making, will lead to incorrect decisions. De-emphasizing the core concepts that
underlie finance strips students of the essential intellectual tools they need to differentiate
between good and bad decision making.
We present corporate finance as an application of a set of simple, powerful ideas. At the
heart is the principal of the absence of arbitrage opportunities, or Law of One Price—in
life, you don’t get something for nothing. This simple concept is a powerful and important
tool in financial decision making. By relying on it, and the other core principles in this
book, financial decision makers can avoid the bad decisions brought to light by the recent
financial crisis. We use the Law of One Price as a compass; it keeps financial decision
makers on the right track and is the backbone of the entire book.

New to This Edition
We have updated all text discussions and figures, tables and facts to accurately reflect
developments in the field in the last four years. Specific highlights include the following:
The 2007–2009 financial crisis and European sovereign debt crisis provide a valuable
pedagogical illustration of what can go wrong when practitioners ignore the core concepts that underlie financial decision making. We integrate this important lesson into
the book in a series of contextual Global Financial Crisis boxes. These boxes—23 in
total across the book—bring the relevance of the crises home to students by illustrating
and analyzing key details about the financial crisis and sovereign debt dynamics.
New centralized coverage of financial ratios in Chapter 2 in a specific section provides
students with the tools to analyze financial statements.
The reorganized flow of topics in Chapters 5 and 6—Chapter 6, “Valuing Bonds,” now
appears after Chapter 5, “Interest Rates”—provides an immediate application of time
value of money concepts.
Seven new practitioner interviews incorporate timely perspectives from leaders in the
field related to the recent financial crisis and ongoing European sovereign debt crisis.
New Using Excel boxes provide hands-on instruction of how to use Excel to solve
financial problems and include screenshots to serve as a guide for students.
We added 45 new problems and refined many others, once again personally writing and
solving each one. In addition, every single problem is available in MyFinanceLab, the
groundbreaking homework and tutorial system that accompanies the book.

The Law of One Price as the Unifying Principle of Valuation
This book presents corporate finance as an application of a small set of simple core ideas.
Modern finance theory and practice is grounded in the idea of the absence of arbitrage—or
the Law of One Price—as the unifying concept in valuation. We introduce the Law of One
Price concept as the basis for NPV and the time value of money in Chapter 3, Financial
xxiv

Preface

xxv

Decision Making and the Law of One Price. In the opening of each part and as pertinent
throughout the remaining chapters, we relate major concepts to the Law of One Price,
creating a framework to ground the student reader and connect theory to practice.

Table of Contents Overview
Corporate Finance offers coverage of the major topical areas for introductory-level MBA
students as well as the depth required in a reference textbook for upper-division courses.
Most professors customize their classes by selecting a subset of chapters reflecting the
subject matter they consider most important. We designed this book from the outset with
this need for flexibility in mind. Parts 2 through 6 are the core chapters in the book. We
envision that most MBA programs will cover this material—yet even within these core
chapters instructors can pick and choose.
Single quarter course: Cover Chapters 3–15; if time allows, or students are previously
familiar with the time value of money, add on Chapters 16–19.
Semester-long course: Incorporate options and Part 10, Special Topics, chapters as desired.
Single mini-semester: Assign Chapters 3–10, 14, and 15 if time allows.

Chapter

Highlights and Changes

1 The Corporation

Introduces the corporation and its governance; updated to included Dodd-Frank Act

2 Introduction to Financial
Statement Analysis

Introduces key financial statements; coverage of financial ratios has been centralized
to prepare students to analyze financial statements holistically

3 Financial Decision Making
and the Law of One Price

Introduces the Law of One Price and net present value as the basis of the book’s
unifying framework

4 The Time Value of Money

Introduces the mechanics of discounting; new examples with non-annual interest
rates provide time value of money applications in a personal loan context; new
Using Excel boxes familiarize students with spreadsheet functionality

5 Interest Rates

Discusses key determinants of interest rates and their relation to the cost of capital;
new interview with Kevin Warsh, former Federal Reserve governor ; new Common
Mistake box on states’ underfunded pensions

6 Valuing Bonds

Analyzes bond prices and yields, addresses the risk level of fixed-debt securities as
illustrated by the sovereign debt crisis, overviews European debt problems, and
examines whether Treasuries are risk-free securities; new interview with Carmen M.
Reinhart, John F. Kennedy School of Government, Harvard University

7 Investment Decision Rules

Introduces the NPV rule as the “golden rule” against which we evaluate other
investment decision rules; new appendix on using Excel Data Tables

8 Fundamentals of Capital
Budgeting

Provides a clear focus on the distinction between earnings and free cash flow, and
shows how to build a financial model to assess the NPV of an investment decision;
new Using Excel boxes demonstrate best-practices and sensitivity analysis

9 Valuing Stocks

Provides a unifying treatment of projects within the firm and the valuation of the
firm as a whole; new interview with Douglas Kehring, Oracle Corporation

10 Capital Markets and the
Pricing of Risk

Establishes the intuition for understanding risk and return, explains the distinction
between diversifiable and systematic risk, and introduces beta and the CAPM; new
analysis of historical holding period returns for alternative asset classes

11 Optimal Portfolio Choice
and the Capital Asset
Pricing Model

Presents the CAPM and develops the details of mean-variance portfolio
optimization; new interview with John Powers, Stanford Management Company

xxvi

Preface

Chapter

Highlights and Changes

12 Estimating the Cost of
Capital

Demonstrates the practical details of estimate the cost of capital for equity, debt, or a
project, and introduces asset betas, and the unlevered and weighted-average cost of capital;
new interview with Michael Latham, BlackRock Asset Management International Inc.

13 Investor Behavior and
Capital Market Efficiency

Examines the role of behavioral finance and ties investor behavior to the topic of
market efficiency and alternative models of risk and return; expanded discussion of
fund manager performance

14 Capital Structure in a
Perfect Market

Presents Modigliani and Miller’s results and introduces the market value balance sheet;
new Global Financial Crisis box, “Bank Capital Regulation and the ROE Fallacy”

15 Debt and Taxes

Analyzes the tax benefits of leverage, including the debt tax shield and the after-tax
WACC

16 Financial Distress,
Managerial Incentives,
and Information

Examines the role of asymmetric information and introduces the debt overhang
and leverage ratchet effect; new interview with John Lipsky, former First Deputy
Managing Director of the International Monetary Fund (IMF)

17 Payout Policy

Considers alternative payout policies including dividends and share repurchases;
analyzes the role of market imperfections in determining the firm’s payout policy

18 Capital Budgeting and
Valuation with Leverage

Develops in depth the three main methods for capital budgeting with leverage and
market imperfections: the weighted average cost of capital (WACC) method, the
adjusted present value (APV) method, and the flow-to-equity (FTE) method

19 Valuation and Financial
Modeling: A Case Study

Builds a financial model for a leveraged acquisition; revised discussion of balance
sheet and statement of cash flows includes stockholders’ equity equation and new
Using Excel box, “Auditing Your Financial Model”

20 Financial Options

Introduces the concept of a financial options, how they are used and exercised;
demonstrates how corporate securities may be interpreted using options

21 Option Valuation

Develops the binomial, Black-Scholes, and risk-neutral pricing methods for option
pricing; new interview with Nobel Prize winner Myron Scholes

22 Real Options

Analyzes real options using decision tree and Black-Scholes methods, and considers
the optimal staging of investment; new discussion of investment options and firm risk

23 Raising Equity Capital

Overview of the stages of equity financing, from venture capital to IPO to seasoned
equity offerings; new Data Case on Facebook IPO

24 Debt Financing

Overview of debt financing, including a discussion of asset-backed securities and
their role in the financial crisis

25 Leasing

Introduces leasing as an alternative form of levered financing; new section on how
leases can be used to mitigate debt overhang

26 Working Capital
Management

Introduces the Cash Conversion Cycle and methods for managing working capital

27 Short-Term Financial
Planning

Develops methods for forecasting and managing short-term cash needs

28 Mergers and Acquisitions

Considers motives and methods for mergers and acquisitions, including leveraged
buyouts

29 Corporate Governance

Evaluates direct monitoring, compensation policies, and regulation as methods to
manage agency conflicts within the firm; addresses impact of Dodd-Frank Act

30 Risk Management

Analyzes the methods and motives for the use of insurance, commodity futures,
currency forwards and options, and interest rate swaps to hedge risk

31 International Corporate
Finance

Analyzes the valuation of projects with foreign currency cash flows with integrated
or segregated capital markets

Preface

xxvii

A Complete Instructor and Student Support Package
A critical component of the text, MyFinanceLab will give all students the practice and
tutorial help they need to succeed. For more details, see pages xxi–xxii.

Instructor’s Resource Center
This password-protected site, accessible at www.pearsonhighered.com/irc, hosts all of the
instructor resources that follow. Instructors should click on the “IRC Help Center” link
for easy-to-follow instructions on getting access or may contact their sales representative
for further information.

Solutions Manual




Prepared by Jonathan Berk and Peter DeMarzo.
Provides detailed, accuracy-verified, class-tested solutions to every chapter problem.
See the Instructor’s Resource Center for spreadsheet solutions to select chapter problems and Data Cases.

Instructor’s Manual



Written by Janet Payne and William Chittenden of Texas State University.
Corresponding to each chapter, provides: chapter overview and outline correlated to the
PowerPoint Lecture Notes; learning objectives; guide to fresh worked examples in the
PowerPoint Lecture Notes; and listing of chapter problems with accompanying Excel
spreadsheets.

Test Item File





Revised by Janet Payne and William Chittenden of Texas State University.
Provides a wide selection of multiple-choice, short answer, and essay questions qualified
by difficulty level and skill type and correlated to chapter topics. Numerical-based problems include step-by-step solutions.
Available as Computerized Test Bank in TestGen.

PowerPoint Lecture Presentation





Also authored by Janet Payne and William Chittenden of Texas State University.
Offers outlines of each chapter with graphs, tables, key terms, and concepts from each
chapter.
Worked examples provide detailed, step-by-step solutions in the same format as the
boxes from the text and correlated to parallel specific textbook examples.

Study Guide



Written by Mark Simonson, Arizona State University.
Provides the learning tools students need to cement their understanding of key
concepts, including chapter synopses, review of select concepts and terms, and 5–10
questions per chapter as a self-test.

xxviii

Preface




Worked examples with step-by-step solutions guide students through the thought
process for arriving at each solution, instilling in them the essential intuition.
Available for download at MyFinanceLab.

Videos




Profile well-known firms such as Boeing and Intel through interview and analysis.
Focus on core topical areas such as capital budgeting and risk and return.
Available in MyFinanceLab.

Acknowledgments
Looking back, it is hard to believe that this book is in its third edition. We are heartened by
its success and impact on the profession through shaping future practitioners. As any textbook writer will tell you, achieving this level of success requires a substantial amount of help.
First and foremost we thank Donna Battista, whose leadership, talent, and market savvy are
imprinted on all aspects of the project and are central to its success; Denise Clinton, a friend and
a leader in fact not just in name, whose experience and knowledge are indispensable; Rebecca
Ferris-Caruso, for her unparalleled expertise in managing the complex writing, reviewing, and
editing processes and patience in keeping us on track—it is impossible to imagine writing
the book without her; Jami Minard, for spearheading marketing efforts; Katie Rowland, for
her energy and fresh perspective as our new editor; and Miguel Leonarte, for his central role
on MyFinanceLab. We were blessed to be approached by the best publisher in the business
and we are both truly thankful for the indispensable help provided by these and other professionals, including Emily Biberger, Dottie Dennis, Nancy Freihofer, Gillian Hall, Melissa
Honig, Carol Melville, and Elissa Senra-Sargent.
Updating a textbook like ours requires a lot of painstaking work, and there are many who
have provided insights and input along the way. We would especially like to call out Jared
Stanfield for his important contributions and suggestions throughout. We also thank Rebecca
Greenberg and Robert James for their tireless efforts to make sure this edition remained as
error-free as the past editions have been. We’re also appreciative of Marlene Bellamy’s work
conducting the lively interviews that provide a critically important perspective, and to the
interviewees who graciously provided their time and insights.
Of course, this third edition text is built upon the shoulders of the first two, and we have
many to thank for helping us make those early versions a reality. We remain forever grateful
for Jennifer Koski’s critical insights, belief in this project, and tireless effort, all of which were
critical to the first edition. Many of the later, non-core chapters required specific detailed
knowledge. Nigel Barradale, Reid Click, Jarrad Harford, and Marianne Plunkert ensured that
this knowledge was effectively communicated. Joseph Vu and Vance P. Lesseig contributed
their talents to the Concept Check questions and Data Cases, respectively.
Creating a truly error-free text is a challenge we could not have lived up to without our
team of expert error checkers; we owe particular thanks to Siddharth Bellur, Robert James,
Anand Goel, Ian Drummond Gow, Janet Payne, and Jared Stanfield. Thomas Gilbert and
Miguel Palacios tirelessly worked examples and problems in the first edition, while providing
numerous insights along the way.
A corporate finance textbook is the product of the talents and hard work of many talented
colleagues. We are especially gratified with the work of those who updated the impressive array
of print supplements to accompany the book: Mark Simonson, for the Study Guide; Janet
Payne and William Chittenden, for the Instructor’s Manual, Test Item File, and PowerPoint.

Preface

xxix

As a colleague of both of us, Mark Rubinstein inspired us with his passion to get the
history of finance right by correctly attributing the important ideas to the people who
first enunciated them. We have used his book, A History of the Theory of Investments: My
Annotated Bibliography, extensively in this text and we, as well as the profession as a whole,
owe him a debt of gratitude for taking the time to write it all down.
We could not have written this text if we were not once ourselves students of finance.
As any student knows, the key to success is having a great teacher. In our case we are lucky
to have been taught and advised by the people who helped create modern finance: Ken
Arrow, Darrell Duffie, Mordecai Kurz, Stephen Ross, and Richard Roll. It was from them
that we learned the importance of the core principles of finance, including the Law of One
Price, on which this book is based. The learning process does not end at graduation and
like most people we have had especially influential colleagues and mentors from which we
learned a great deal during our careers and we would like to recognize them explicitly here:
Mike Fishman, Richard Green, Vasant Naik, Art Raviv, Mark Rubinstein, Joe Williams,
and Jeff Zwiebel. We continue to learn from all of our colleagues and we are grateful to all
of them. Finally, we would like to thank those with whom we have taught finance classes
over the years: Anat Admati, Ming Huang, Robert Korajczyk, Paul Pfleiderer, Sergio
Rebelo, Richard Stanton, and Raman Uppal. Their ideas and teaching strategies have
without a doubt influenced our own sense of pedagogy and found their way into this text.
Finally, and most importantly, we owe our biggest debt of gratitude to our spouses,
Rebecca Schwartz and Kaui Chun DeMarzo. Little did we (or they) know how much
this project would impact our lives, and without their continued love and support—and
especially their patience and understanding—this text could not have been completed. We
owe a special thanks to Kaui DeMarzo, for her inspiration and support at the start of this
project, and for her willingness to be our in-house editor, contributor, advisor, and overall
sounding-board throughout each stage of its development.
Jonathan Berk
Peter DeMarzo

Contributors
We are truly thankful to have had so many manuscript reviewers, class testers, and focus
group participants. We list all of these contributors below, but Gordon Bodnar, James
Conover, Anand Goel, James Linck, Evgeny Lyandres, Marianne Plunkert, Mark Simonson,
and Andy Terry went so far beyond the call of duty that we would like to single them out.
We are very grateful for all comments—both informal and in written evaluations—
from Second Edition users. We carefully weighed each reviewer suggestion as we sought
to streamline the narrative to improve clarity and add relevant new material. The book has
benefited enormously for this input.

Reviewers
Ashok B. Abbott, West Virginia University
Michael Adams, Jacksonville University
Ilan Adler, University of California, Berkeley
Ibrahim Affaneh, Indiana University of Pennsylvania
Kevin Ahlgrim, Illinois State University
Andres Almazan, University of Texas, Austin
Confidence Amadi, Florida A&M University
Christopher Anderson, University of Kansas

Tom Arnold, University of Richmond
Nigel Barradale, Copenhagen Business School
Peter Basciano, Augusta State University
Thomas Bates, University of Arizona
Paul Bayes, East Tennessee State University
Omar Benkato, Ball State University
Gordon Bodnar, Johns Hopkins University
Waldo Born, Eastern Illinois University

xxx

Preface

Alex Boulatov, Higher School of Economics, Moscow
Tyrone Callahan, University of Southern California
Yingpin (George) Chang, Grand Valley State University
William G. Christie, Vanderbilt University
Ting-Heng Chu, East Tennessee State University
Engku Ngah S. Engku Chik, University
Utara Malaysia
John H. Cochrane, University of Chicago
James Conover, University of North Texas
James Cordeiro, SUNY Brockport
Henrik Cronqvist, Claremont McKenna College
Maddur Daggar, Citigroup
Hazem Daouk, Cornell University
Daniel Deli, DePaul University
Andrea DeMaskey, Villanova University
B. Espen Eckbo, Dartmouth College
Larry Eisenberg, University of Southern Mississippi
Riza Emekter, Robert Morris University
T. Hanan Eytan, Baruch College
Andre Farber, Universite Libre de Bruxelles
Eliezer Fich, Drexel University
Michael Fishman, Northwestern University
Fangjian Fu, Singapore Management University
Michael Gallmeyer, University of Virginia
Diego Garcia, University of North Carolina
Tom Geurts, Marist College
Frank Ghannadian, University of Tampa
Thomas Gilbert, University of Washington
Anand Goel, DePaul University
Marc Goergen, Cardiff Business School
David Goldenberg, Rensselaer Polytechnic Institute
Qing (Grace) Hao, University of Missouri
Milton Harris, University of Chicago
Christopher Hennessy, London Business School
J. Ronald Hoffmeister, Arizona State University
Vanessa Holmes, Xavier University
Wenli Huang, Boston University School of Management
Mark Hutchinson,University College Cork
Stuart Hyde, University of Manchester
Robert James, Boston College
Keith Johnson, University of Kentucky
Jouko Karjalainen, Helsinki University of Technology
Ayla Kayhan, Louisiana State University
Doseong Kim, University of Akron
Kenneth Kim, State University of New York—Buffalo
Halil Kiymaz, Rollins College
Brian Kluger, University of Cincinnati
John Knopf, University of Connecticut

C.N.V. Krishnan, Case Western Reserve University
George Kutner, Marquette University
Vance P. Lesseig, Texas State University
Martin Lettau, University of California, Berkeley
Michel G. Levasseur, Esa Universite de Lille 2
Jose Liberti, DePaul University
James Linck, University of Georgia
David Lins, University of Illinois at Urbana-Champaign
Lan Liu, California State University, Sacramento
Michelle Lowry, Pennsylvania State University
Deborah Lucas, Massachusetts Institute of Technology
Peng (Peter) Liu, Cornell University
Evgeny Lyandres, Boston University
Balasundram Maniam, Sam Houston State University
Suren Mansinghka, University of California, Irvine
Daniel McConaughy, California State University,
Northridge
Robert McDonald, Northwestern University
Mark McNabb, University of Cincinnati
Ilhan Meric, Rider University
Timothy Michael, James Madison University
Dag Michalsen, Norwegian School of Management
Todd Milbourn, Washington University in St. Louis
James Miles, Penn State University
Darius Miller, Southern Methodist University
Emmanuel Morales-Camargo, University of New Mexico
Helen Moser, University of Minnesota
Arjen Mulder, Erasmus University
Michael Muoghalu, Pittsburg State University
Jeryl Nelson, Wayne State College
Tom Nelson, University of Colorado
Chee Ng, Fairleigh Dickinson University
Ben Nunnally, University of North Carolina, Charlotte
Terrance Odean, University of California, Berkeley
Frank Ohara, University of San Francisco
Marcus Opp, University of California, Berkeley
Henry Oppenheimer, University of Rhode Island
Miguel Palacios, Vanderbilt University
Mitchell Petersen, Northwestern University
Marianne Plunkert, University of Colorado at Denver
Paul Povel, University of Houston
Eric A. Powers, University of South Carolina
Michael Provitera, Barry University
Brian Prucyk, Marquette University
P. Raghavendra Rau, University of Cambridge
Charu Raheja, TriageLogic Management
Latha Ramchand, University of Houston
Adriano Rampini, Duke University

Preface

S. Abraham Ravid, Yeshiva University
William A. Reese, Jr., Tulane University
Ali Reza, San Jose State University
Steven P. Rich, Baylor University
Antonio Rodriguez, Texas A&M International
University
Bruce Rubin, Old Dominion University
Mark Rubinstein, University of California, Berkeley
Doriana Ruffino, University of Minnesota
Harley E. Ryan, Jr., Georgia State University
Jacob A. Sagi, Vanderbilt University
Harikumar Sankaran, New Mexico State University
Mukunthan Santhanakrishnan, Idaho State University
Frederik Schlingemann, University of Pittsburgh
Mark Seasholes, Hong Kong University of Science and
Technology
Eduardo Schwartz, University of California, Los Angeles
Mark Shackleton, Lancaster University
Jay Shanken, Emory University
Dennis Sheehan, Penn State University
Anand Shetty, Iona College
Clemens Sialm, University of Texas at Austin
Mark Simonson, Arizona State University
Rajeev Singhal, Oakland University
Erik Stafford, Harvard Business School
David Stangeland, University of Manitoba
Richard H. Stanton, University of California, Berkeley
Mark Hoven Stohs, California State University,
Fullerton
Ilya A. Strebulaev, Stanford University
Ryan Stever, Bank for International Settlements
John Strong, College of William and Mary
Diane Suhler, Columbia College
Lawrence Tai, Zayed University
Mark Taranto, University of Maryland
Amir Tavakkol, Kansas State University
Andy Terry, University of Arkansas at Little Rock
John Thornton, Kent State University
Alex Triantis, University of Maryland
Sorin Tuluca, Fairleigh Dickinson University
P. V. Viswanath, Pace University
Joe Walker, University of Alabama at Birmingham
Edward Waller, University of Houston, Clear Lake
Shelly Webb, Xavier University
Peihwang Wei, University of New Orleans
Peter Went, Global Association of Risk Professionals
(GARP)
John White, Georgia Southern University

xxxi

Michael E. Williams, University of Denver
Annie Wong, Western Connecticut State University
K. Matthew Wong, International School
of Management, Paris
Bob Wood, Jr., Tennessee Tech University
Lifan (Frank) Wu, California State University,
Los Angeles
Tzyy-Jeng Wu, Pace University
Jaime Zender, University of Colorado
Jeffrey H. Zwiebel, Stanford University

Chapter Class Testers
Jack Aber, Boston University
John Adams, University of South Florida
James Conover, University of North Texas
Lou Gingerella, Rensselaer Polytechnic Institute
Tom Geurts, Marist College
Keith Johnson, University of Kentucky
Gautum Kaul, University of Michigan
Doseong Kim, University of Akron
Jennifer Koski, University of Washington
George Kutner, Marquette University
Larry Lynch, Roanoke College
Vasil Mihov, Texas Christina University
Jeryl Nelson, Wayne State College
Chee Ng, Fairleigh Dickinson University
Ben Nunnally, University of North Carolina, Charlotte
Michael Proviteria, Barry University
Charu G. Raheja, Vanderbilt University
Bruce Rubin, Old Dominion University
Mark Seasholes, University of California, Berkeley
Dennis Sheehan, Pennsylvania State University
Ravi Shukla, Syracuse University
Mark Hoven Stohs, California State University,
Fullerton
Andy Terry, University of Arkansas
Sorin Tuluca, Fairleigh Dickinson University
Joe Ueng, University of Saint Thomas
Bob Wood, Tennessee Technological University

End-of-Chapter Problems Class Testers
James Angel, Georgetown University
Ting-Heng Chu, East Tennessee State University
Robert Kravchuk, Indiana University
George Kutner, Marquette University
James Nelson, East Carolina University
Don Panton, University of Texas at Arlington
P. Raghavendra Rau, Purdue University

xxxii

Preface

Carolyn Reichert, University of Texas at Dallas
Mark Simonson, Arizona State University
Diane Suhler, Columbia College

Focus Group Participants
Christopher Anderson, University of Kansas
Chenchu Bathala, Cleveland State University
Matthew T. Billett, University of Iowa
Andrea DeMaskey, Villanova University
Anand Desai, Kansas State University
Ako Doffou, Sacred Heart University
Shannon Donovan, Bridgewater State University
Ibrahim Elsaify, Goldey-Beacom College
Mark Holder, Kent State University
Steve Isberg, University of Baltimore
Arun Khanna, Butler University
Brian Kluger, University of Cincinnati
Greg La Blanc, University of California, Berkeley
Dima Leshchinskii, Rensselaer Polytechnic University
James S. Linck, University of Georgia
Larry Lynch, Roanoke College
David C. Mauer, Southern Methodist University
Alfred Mettler, Georgia State University
Stuart Michelson, Stetson University
Vassil Mihov, Texas Christian University
Jeryl Nelson, Wayne State College
Chee Ng, Fairleigh Dickinson University
Ben Nunnally, University of North Carolina at Charlotte
Sunny Onyiri, Campbellsville University
Janet Payne, Texas State University
Michael Provitera, Barry University
S. Abraham Ravid, Rutgers University

William A. Reese, Jr., Tulane University
Mario Reyes, University of Idaho
Hong Rim, Shippensburg University
Robert Ritchey, Texas Tech University
Antonio Rodriquez, Texas A&M International
University
Dan Rogers, Portland State University
Harley E. Ryan, Jr., Georgia State University
Harikumar Sankaran, New Mexico State University
Sorin Sorescu, Texas A&M University
David Stangeland, University of Manitoba
Jonathan Stewart, Abilene Christian University
Mark Hoven Stohs, California State University,
Fullerton
Tim Sullivan, Bentley College
Olie Thorp, Babson College
Harry Turtle, Washington State University
Joseph Vu, DePaul University
Joe Walker, University of Alabama at Birmingham
Jill Wetmore, Saginaw Valley State University
Jack Wolf, Clemson University
Bob Wood, Jr., Tennessee Tech University
Donald H. Wort, California State University,
East Bay
Scott Wright, Ohio University
Tong Yao, University of Arizona

Contributors
Carlos Bazan, San Diego State University
Ting-Heng Chu, East Tennessee State University
Shannon Donovan, Bridgewater State College
Michael Woodworth

PART

Introduction

1

WHY STUDY CORPORATE FINANCE? No matter what your role in a

CHAPTER 1

corporation, an understanding of why and how financial decisions are

The Corporation

made is essential. The focus of this book is how to make optimal corporate financial decisions. In this part of the book, we lay the foundation
for our study of corporate finance. We begin, in Chapter 1, by introducing the corporation and related business forms. We then examine the role
of financial managers and outside investors in decision making for the
firm. To make optimal decisions, a decision maker needs information. As
a result, in Chapter 2, we review an important source of information for

CHAPTER 2
Introduction
to Financial
Statement
Analysis

corporate decision-making—the firm’s financial statements.
We then introduce the most important idea in this book, the concept of
the absence of arbitrage or Law of One Price in Chapter 3. The Law of One
Price states that we can use market prices to determine the value of an
investment opportunity to the firm. We will demonstrate that the Law of
One Price is the one unifying principle that underlies all of financial eco-

CHAPTER 3
Financial
Decision Making
and the Law of
One Price

nomics and links all of the ideas throughout this book. We will return to
this theme throughout our study of Corporate Finance.

1

C H A P T ER

1

The Corporation

T

HE MODERN U.S. CORPORATION WAS BORN IN A COURTroom in Washington, D.C., on February 2, 1819. On that day the
U.S. Supreme Court established the legal precedent that the

property of a corporation, like that of a person, is private and entitled to
protection under the U.S. Constitution. Today, it is hard to entertain the
possibility that a corporation’s private property would not be protected
under the Constitution. However, before the 1819 Supreme Court decision, the owners of a corporation were exposed to the possibility that the
state could take their business. This concern was real enough to stop most
businesses from incorporating and, indeed, in 1816 that concern was realized: The state seized Dartmouth College.
Dartmouth College was incorporated in 1769 as a private educational
institution governed by a self-perpetuating board of trustees. Unhappy
with the political leanings of the board, the state legislature effectively
took control of Dartmouth by passing legislation in 1816 that established
a governor-appointed board of overseers to run the school. The legislation
had the effect of turning a private university under private control into a
state university under state control. If such an act were constitutional, it
implied that any state (or the federal government) could, at will, nationalize any corporation.
Dartmouth sued for its independence and the case made it to the
Supreme Court under Chief Justice John Marshall in 1818. In a nearly
unanimous 5–1 decision, the court struck down the New Hampshire law,
ruling that a corporation was a “contract” and that, under Article 1 of the
Constitution, “the state legislatures were forbidden to pass any law
impairing the obligation of contracts.”1 The precedent was set: Owners of
businesses could incorporate and still enjoy the protection of private
property, as well as protection from seizure, both guaranteed by the U.S.
Constitution. The modern business corporation was born.
1

2

The full text of John Marshall’s decision can be found at http://www.constitution.org/
dwebster/dartmouth_decision.htm.

1.1 The Four Types of Firms

3

Today, the corporate structure is ubiquitous all over the world, and yet continues
to evolve in the face of new forces. In 2008 the financial crisis once again transformed
the financial landscape, bringing down giants like Bear Stearns, Lehman Brothers, and
AIG and reshaping investment banks like Goldman Sachs into government-guaranteed
commercial banks. These changes have as profound an effect on the future of corporate finance as the Dartmouth decision did almost 200 years ago. Government bailouts
have provoked challenging questions regarding the role of the federal government in
the control and management of private corporations. In the wake of the crisis, significant reforms of the regulation and oversight of financial markets were passed into law.
Understanding the principles of corporate finance has never been more important to
the practice of business than it is now, during this time of great change.
The focus of this book is on how people in corporations make financial decisions.
This chapter introduces the corporation and explains alternative business organizational forms. A key factor in the success of corporations is the ability to easily trade
ownership shares, and so we will also explain the role of stock markets in facilitating
trading among investors in a corporation and the implications that has for the ownership and control of corporations.

1.1 The Four Types of Firms
We begin our study of corporate finance by introducing the four major types of firms: sole
proprietorships, partnerships, limited liability companies, and corporations. We explain each
organizational form in turn, but our primary focus is on the most important form—the
corporation. In addition to describing what a corporation is, we also provide an overview
of why corporations are so successful.

Sole Proprietorships
A sole proprietorship is a business owned and run by one person. Sole proprietorships
are usually very small with few, if any, employees. Although they do not account for much
sales revenue in the economy, they are the most common type of firm in the world, as
shown in Figure 1.1. Statistics indicate that 71% of businesses in the United States are sole
proprietorships, although they generate only 5% of the revenue.2 Contrast this with corporations, which make up only 19% of firms but are responsible for 84% of U.S. revenue.
Sole proprietorships share the following key characteristics:
1. Sole proprietorships are straightforward to set up. Consequently, many new businesses use this organizational form.
2. The principal limitation of a sole proprietorship is that there is no separation
between the firm and the owner—the firm can have only one owner. If there are
other investors, they cannot hold an ownership stake in the firm.
3. The owner has unlimited personal liability for any of the firm’s debts. That is, if the
firm defaults on any debt payment, the lender can (and will) require the owner to
2

This information, as well as other small business statistics, can be found at www.bizstats.com. See their
on-site disclosures page for a description of their methodology.

4

Chapter 1 The Corporation

FIGURE 1.1
Types of U.S. Firms
There are four different
types of firms in
the United States.
As (a) and (b) show,
although the majority
of U.S. firms are
sole proprietorships,
they generate only a
small fraction of total
revenue, in contrast to
corporations.
Source : www.bizstats.com

Limited Liability
Companies
6%
Partnerships
4%

Limited Liability
Sole
Companies
Proprietorships
Partnerships
6%
5%
5%

Corporations
19%
Sole
Proprietorships
71%

(a) Percentage of Businesses

Corporations
84%

(b) Percentage of Revenue

repay the loan from personal assets. An owner who cannot afford to repay the loan
must declare personal bankruptcy.
4. The life of a sole proprietorship is limited to the life of the owner. It is also difficult
to transfer ownership of a sole proprietorship.
For most businesses, the disadvantages of a sole proprietorship outweigh the advantages.
As soon as the firm reaches the point at which it can borrow without the owner agreeing
to be personally liable, the owners typically convert the business into a form that limits the
owner’s liability.

Partnerships
A partnership is identical to a sole proprietorship except it has more than one owner. The
following are key features of a partnership:
1. All partners are liable for the firm’s debt. That is, a lender can require any partner to
repay all the firm’s outstanding debts.
2. The partnership ends on the death or withdrawal of any single partner, although
partners can avoid liquidation if the partnership agreement provides for alternatives
such as a buyout of a deceased or withdrawn partner.
Some old and established businesses remain partnerships or sole proprietorships. Often
these firms are the types of businesses in which the owners’ personal reputations are the
basis for the businesses. For example, law firms, groups of doctors, and accounting firms
are often organized as partnerships. For such enterprises, the partners’ personal liability
increases the confidence of the firm’s clients that the partners will strive to maintain their
reputation.
A limited partnership is a partnership with two kinds of owners, general partners
and limited partners. General partners have the same rights and privileges as partners in
a (general) partnership—they are personally liable for the firm’s debt obligations. Limited
partners, however, have limited liability—that is, their liability is limited to their investment. Their private property cannot be seized to pay off the firm’s outstanding debts. Furthermore, the death or withdrawal of a limited partner does not dissolve the partnership,

1.1 The Four Types of Firms

5

and a limited partner’s interest is transferable. However, a limited partner has no management authority and cannot legally be involved in the managerial decision making for the
business.
Private equity funds and venture capital funds are two examples of industries dominated
by limited partnerships. In these firms, a few general partners contribute some of their
own capital and raise additional capital from outside investors who are limited partners.
The general partners control how all the capital is invested. Most often they will actively
participate in running the businesses they choose to invest in. The outside investors play no
active role in the partnership other than monitoring how their investments are performing.

Limited Liability Companies
A limited liability company (LLC) is a limited partnership without a general partner.
That is, all the owners have limited liability, but unlike limited partners, they can also run
the business.
The LLC is a relatively new phenomenon in the United States. The first state to pass
a statute allowing the creation of an LLC was Wyoming in 1977; the last was Hawaii in
1997. Internationally, companies with limited liability are much older and established.
LLCs rose to prominence first in Germany over 100 years ago as a Gesellschaft mit
beschränkter Haftung (GmbH) and then in other European and Latin American countries. An LLC is known in France as a Société à responsabilité limitée (SARL), and by
similar names in Italy (SRL) and Spain (SL).

Corporations
The distinguishing feature of a corporation is that it is a legally defined, artificial being (a
judicial person or legal entity), separate from its owners. As such, it has many of the legal
powers that people have. It can enter into contracts, acquire assets, incur obligations, and,
as we have already established, it enjoys protection under the U.S. Constitution against
the seizure of its property. Because a corporation is a legal entity separate and distinct
from its owners, it is solely responsible for its own obligations. Consequently, the owners
of a corporation (or its employees, customers, etc.) are not liable for any obligations the
corporation enters into. Similarly, the corporation is not liable for any personal obligations
of its owners.
Formation of a Corporation. Corporations must be legally formed, which means that
the state in which it is incorporated must formally give its consent to the incorporation by
chartering it. Setting up a corporation is therefore considerably more costly than setting
up a sole proprietorship. Delaware has a particularly attractive legal environment for corporations, so many corporations choose to incorporate there. For jurisdictional purposes, a
corporation is a citizen of the state in which it is incorporated. Most firms hire lawyers to
create a corporate charter that includes formal articles of incorporation and a set of bylaws.
The corporate charter specifies the initial rules that govern how the corporation is run.
Ownership of a Corporation. There is no limit on the number of owners a corporation can have. Because most corporations have many owners, each owner owns only a
small fraction of the corporation. The entire ownership stake of a corporation is divided
into shares known as stock. The collection of all the outstanding shares of a corporation is
known as the equity of the corporation. An owner of a share of stock in the corporation is
known as a shareholder, stockholder, or equity holder and is entitled to dividend payments, that is, payments made at the discretion of the corporation to its equity holders.

6

Chapter 1 The Corporation

Shareholders usually receive a share of the dividend payments that is proportional to the
amount of stock they own. For example, a shareholder who owns 25% of the firm’s shares
will be entitled to 25% of the total dividend payment.
A unique feature of a corporation is that there is no limitation on who can own its stock.
That is, an owner of a corporation need not have any special expertise or qualification.
This feature allows free trade in the shares of the corporation and provides one of the most
important advantages of organizing a firm as a corporation rather than as sole proprietorship, partnership, or LLC. Corporations can raise substantial amounts of capital because
they can sell ownership shares to anonymous outside investors.
The availability of outside funding has enabled corporations to dominate the economy,
as shown by Panel (b) of Figure 1.1. Let’s take one of the world’s largest firms, Wal-Mart
Stores, as an example. Wal-Mart had over 2 million employees, and reported annual revenue of $422 billion in 2011. Indeed, the top five companies by sales volume in 2012
(Wal-Mart, Exxon Mobil, Chevron, ConocoPhillips, and General Motors) had combined
sales exceeding $1.5 trillion, an amount comparable to the total sales of the more than 22
million U.S. sole proprietorships.

Tax Implications for Corporate Entities
An important difference between the types of organizational forms is the way they are
taxed. Because a corporation is a separate legal entity, a corporation’s profits are subject to
taxation separate from its owners’ tax obligations. In effect, shareholders of a corporation
pay taxes twice. First, the corporation pays tax on its profits, and then when the remaining
profits are distributed to the shareholders, the shareholders pay their own personal income
tax on this income. This system is sometimes referred to as double taxation.

EXAMPLE 1.1

Taxation of Corporate Earnings
Problem

You are a shareholder in a corporation. The corporation earns $5 per share before taxes. After
it has paid taxes, it will distribute the rest of its earnings to you as a dividend. The dividend is
income to you, so you will then pay taxes on these earnings. The corporate tax rate is 40% and
your tax rate on dividend income is 15%. How much of the earnings remains after all taxes are
paid?
Solution

First, the corporation pays taxes. It earned $5 per share, but must pay 0.40 * $5 = $2 to
the government in corporate taxes. That leaves $3 to distribute. However, you must pay
0.15 * $3 = $0.45 in income taxes on this amount, leaving $3 - $0.45 = $2.55 per share after
all taxes are paid. As a shareholder you only end up with $2.55 of the original $5 in earnings; the remaining $2 + $0.45 = $2.45 is paid as taxes. Thus, your total effective tax rate is
2.45/5 = 49%.

S Corporations. The corporate organizational structure is the only organizational
structure subject to double taxation. However, the U.S. Internal Revenue Code allows an
exemption from double taxation for “S” corporations, which are corporations that elect
subchapter S tax treatment. Under these tax regulations, the firm’s profits (and losses) are
not subject to corporate taxes, but instead are allocated directly to shareholders based on

1.2 Ownership Versus Control of Corporations

7

Corporate Taxation Around the World
Most countries offer investors in corporations some relief
from double taxation. Thirty countries make up the Organization for Economic Co-operation and Development
(OECD), and of these countries, only Ireland offers no relief
whatsoever. A few countries, including Australia, Finland,
Mexico, New Zealand, and Norway, offer complete relief by

effectively not taxing dividend income. The United States
offers partial relief by having a lower tax rate on dividend
income than on other sources of income. As of 2012, for
most investors qualified dividends are taxed at 15%, a rate
significantly below their personal income tax rate.

their ownership share. The shareholders must include these profits as income on their individual tax returns (even if no money is distributed to them). However, after the shareholders have paid income taxes on these profits, no further tax is due.
EXAMPLE 1.2

Taxation of S Corporation Earnings
Problem

Rework Example 1.1 assuming the corporation in that example has elected subchapter S treatment and your tax rate on non-dividend income is 30%.
Solution

In this case, the corporation pays no taxes. It earned $5 per share. Whether or not the corporation chooses to distribute or retain this cash, you must pay 0.30 * $5 = $1.50 in income taxes,
which is substantially lower than the $2.45 paid in Example 1.1.

The government places strict limitations on the qualifications for subchapter S tax treatment. In particular, the shareholders of such corporations must be individuals who are U.S.
citizens or residents, and there can be no more than 100 of them. Because most corporations have no restrictions on who owns their shares or the number of shareholders, they
cannot qualify for subchapter S treatment. Thus most corporations are “C” corporations,
which are corporations subject to corporate taxes.
CONCEPT CHECK

1. What is a limited liability company (LLC)? How does it differ from a limited partnership?
2. What are the advantages and disadvantages of organizing a business as a
corporation?

1.2 Ownership Versus Control of Corporations
It is often not feasible for the owners of a corporation to have direct control of the firm
because there are sometimes many owners, each of whom can freely trade his or her stock.
That is, in a corporation, direct control and ownership are often separate. Rather than the
owners, the board of directors and chief executive officer possess direct control of the corporation. In this section, we explain how the responsibilities for the corporation are divided
between these two entities and how together they shape and execute the goals of the firm.

The Corporate Management Team
The shareholders of a corporation exercise their control by electing a board of directors,
a group of people who have the ultimate decision-making authority in the corporation.

8

Chapter 1 The Corporation

David Viniar is Chief Financial Officer and
head of the Operations, Technology and
Finance Division at Goldman Sachs—the
last major investment bank to convert
from a partnership to a corporation. As
the firm’s CFO, he played a leading role
in the firm’s conversion to a corporation
in 1999 and charting the firm’s course
through the financial crisis of 2008–2009.

INTERVIEW WITH

David Viniar

QUESTION: What are the advantages of
partnerships and corporations?
ANSWER: We debated this question at

length when we were deciding whether
to go public or stay a private partnership
in the mid-1990s. There were good arguments on both sides. Those in favor of
going public argued we needed greater
financial and strategic flexibility to achieve
our aggressive growth and market leadership goals. As a
public corporation, we would have a more stable equity
base to support growth and disperse risk; increased access
to large public debt markets; publicly traded securities with
which to undertake acquisitions and reward and motivate
our employees; and a simpler and more transparent structure with which to increase scale and global reach.
Those against going public argued our private partnership structure worked well and would enable us to achieve
our financial and strategic goals. As a private partnership, we
could generate enough capital internally and in the private
placement markets to fund growth; take a longer-term view
of returns on our investments with less focus on earnings volatility, which is not valued in public companies; and retain
voting control and alignment of the partners and the firm.
A big perceived advantage of our private partnership was
its sense of distinctiveness and mystique, which reinforced
our culture of teamwork and excellence and helped differentiate us from our competitors. Many questioned whether
the special qualities of our culture would survive if the firm
went public.
QUESTION: What was the driving force behind the

conversion?
ANSWER: We ultimately decided to go public for three

main reasons: to secure permanent capital to grow; to be
able to use publicly traded securities to finance strategic
acquisitions; and to enhance the culture of ownership and
gain compensation flexibility.

QUESTION: Did the conversion achieve its

goals?

ANSWER: Yes. As a public company, we
have a simpler, bigger and more permanent capital base, including enhanced
long-term borrowing capacity in the
public debt markets. We have drawn
on substantial capital resources to serve
clients, take advantage of new business
opportunities, and better control our own
destiny through changing economic and
business conditions. We have been able
to use stock to finance key acquisitions
and support large strategic and financial
investments. Given how the stakes in our
industry changed, how capital demands
grew, going public when we did fortunately positioned us to compete effectively
through the cycle.
Our distinctive culture of teamwork and excellence has
thrived in public form, and our equity compensation programs turned out better than we could have hoped. Making
everyone at Goldman Sachs an owner, rather than just 221
partners, energized all our employees. The growing size and
scope of our business—not the change to public form—has
presented the greatest challenges to the positive aspects of
our culture.
QUESTION: What prompted Goldman’s decision to become a
bank holding company in Fall 2008?
ANSWER: The market environment had become extraordinarily unstable following the collapse of Bear Stearns in
March 2008. There was an increased focus on the SECsupervised broker/dealer business model, and in September, market sentiment had become increasingly negative
with growing concerns over Lehman Brothers’ solvency.
Following the bankruptcy of Lehman Brothers and the
sale of Merrill Lynch in the middle of September, and
notwithstanding the reporting of quite strong earnings
by both Goldman Sachs and Morgan Stanley, it became
clear to us that the market viewed oversight by the
Federal Reserve and the ability to source insured bank
deposits as offering a greater degree of safety and soundness. By changing our status, we gained all the benefits
available to our commercial banking peers, including
access to permanent liquidity and funding, without
affecting our ability to operate or own any of our current
businesses or investments.

1.2 Ownership Versus Control of Corporations

9

In most corporations, each share of stock gives a shareholder one vote in the election of the
board of directors, so investors with the most shares have the most influence. When one or
two shareholders own a very large proportion of the outstanding stock, these shareholders
may either be on the board of directors themselves, or they may have the right to appoint
a number of directors.
The board of directors makes rules on how the corporation should be run (including
how the top managers in the corporation are compensated), sets policy, and monitors the
performance of the company. The board of directors delegates most decisions that involve
day-to-day running of the corporation to its management. The chief executive officer
(CEO) is charged with running the corporation by instituting the rules and policies set by
the board of directors. The size of the rest of the management team varies from corporation
to corporation. The separation of powers within corporations between the board of directors and the CEO is not always distinct. In fact, it is not uncommon for the CEO also to
be the chairman of the board of directors. The most senior financial manager is the chief
financial officer (CFO), who often reports directly to the CEO. Figure 1.2 presents part
of a typical organizational chart for a corporation, highlighting the key positions a financial
manager may take.

The Financial Manager
Within the corporation, financial managers are responsible for three main tasks: making investment decisions, making financing decisions, and managing the firm’s cash
flows.
Investment Decisions. The financial manager’s most important job is to make the

firm’s investment decisions. The financial manager must weigh the costs and benefits of
all investments and projects and decide which of them qualify as good uses of the money
stockholders have invested in the firm. These investment decisions fundamentally shape
what the firm does and whether it will add value for its owners. In this book, we will
develop the tools necessary to make these investment decisions.
FIGURE 1.2
Board of Directors

Organizational Chart of a Typical
Corporation
The board of directors, representing
the stockholders, controls the
corporation and hires the Chief
Executive Officer who is then
responsible for running the
corporation. The Chief Financial
Officer oversees the financial
operations of the firm, with the
Controller managing both tax and
accounting functions, and the
Treasurer responsible for capital
budgeting, risk management, and
credit management activities.

Chief Executive Officer
Chief Financial Officer
Controller

Chief Operating Officer

Treasurer
Accounting

Capital Budgeting

Tax Department

Risk Management
Credit Management

10

Chapter 1 The Corporation

GLOBAL FINANCIAL CRISIS

The Dodd-Frank Act

In response to the 2008 financial crisis, the U.S. federal government reevaluated its role in the control and management
of financial institutions and private corporations. Signed
into law on July 21, 2010, the Dodd-Frank Wall Street
Reform and Consumer Protection Act brought a sweeping change to financial regulation in response to widespread
calls for financial regulatory system reform after the near
collapse of the world’s financial system in the fall of 2008
and the ensuing global credit crisis. History indeed repeats
itself: It was in the wake of the 1929 stock market crash
and subsequent Great Depression that Congress passed the
Glass-Steagall Act establishing the Federal Deposit Insurance Corporation (FDIC) and instituted significant bank
reforms to regulate transactions between commercial banks
and securities firms.

The Dodd-Frank Act aims to (i) promote U.S. financial
stability by “improving accountability and transparency in
the financial system,” (ii) put an end to the notion of “too
big to fail,” (iii) “protect the American taxpayer by ending
bailouts,” and (iv) “protect consumers from abusive financial services practices.” Time will tell whether the Act will
actually achieve these important goals.
Implementing the wide-ranging financial reforms in the
Dodd-Frank Act requires the work of many federal agencies, either through rulemaking or other regulatory actions.
As of mid-2012, two years since Dodd-Frank’s passage, 129
of the reforms have been finalized, providing a clear picture
of the Dodd-Frank regulatory framework. But another 271
rules or actions, containing many of the core Dodd-Frank
reforms, await completion.

Financing Decisions. Once the financial manager has decided which investments to make,

he or she also decides how to pay for them. Large investments may require the corporation
to raise additional money. The financial manager must decide whether to raise more money
from new and existing owners by selling more shares of stock (equity) or to borrow the money
(debt). In this book, we will discuss the characteristics of each source of funds and how to
decide which one to use in the context of the corporation’s overall mix of debt and equity.
Cash Management. The financial manager must ensure that the firm has enough cash
on hand to meet its day-to-day obligations. This job, also commonly known as managing working capital, may seem straightforward, but in a young or growing company, it
can mean the difference between success and failure. Even companies with great products require significant amounts of money to develop and bring those products to market.
Consider the $150 million Apple spent during its secretive development of the iPhone,
or the costs to Boeing of producing the 787—the firm spent billions of dollars before the
first 787 left the ground. A company typically burns through a significant amount of cash
developing a new product before its sales generate income. The financial manager’s job is to
make sure that access to cash does not hinder the firm’s success.

The Goal of the Firm
In theory, the goal of a firm should be determined by the firm’s owners. A sole proprietorship has a single owner who runs the firm, so the goals of a sole proprietorship are the same
as the owner’s goals. But in organizational forms with multiple owners, the appropriate
goal of the firm—and thus of its managers—is not as clear.
Many corporations have thousands of owners (shareholders). Each owner is likely to have
different interests and priorities. Whose interests and priorities determine the goals of the firm?
Later in the book, we examine this question in more detail. However, you might be surprised
to learn that the interests of shareholders are aligned for many, if not most, important decisions. That is because, regardless of their own personal financial position and stage in life, all
the shareholders will agree that they are better off if management makes decisions that increase
the value of their shares. For example, by June 2012, Apple shares were worth over 60 times as

1.2 Ownership Versus Control of Corporations

11

much as they were in October 2001, when the first iPod was introduced. Clearly, regardless of
their preferences and other differences, all investors who held shares of Apple stock over this
period have benefited from the investment decisions Apple’s managers have made.

The Firm and Society
Are decisions that increase the value of the firm’s equity beneficial for society as a whole?
Most often they are. While Apple’s shareholders have become much richer since 2001, its
customers also are better off with products like the iPod and iPhone that they might otherwise never have had. But even if the corporation only makes its shareholders better off,
as long as nobody else is made worse off by its decisions, increasing the value of equity is
good for society.
The problem occurs when increasing the value of equity comes at the expense of others. Consider a corporation that, in the course of business, pollutes the environment and
does not pay the costs to clean up the pollution. Alternatively, a corporation may not itself
pollute, but use of its products may harm the environment. In such cases, decisions that
increase shareholder wealth can be costly for society as whole.
The 2008 financial crisis highlighted another example of decisions that can increase
shareholder wealth but are costly for society. In the early part of the last decade, banks took
on excessive risk. For a while, this strategy benefited the banks’ shareholders. But when the
bets went bad, the resulting financial crisis harmed the broader economy.
When the actions of the corporation impose harm on others in the economy, appropriate public policy and regulation is required to assure that corporate interests and societal
interests remain aligned. Sound public policy should allow firms to continue to pursue the
maximization of shareholder value in a way that benefits society overall.

Ethics and Incentives within Corporations
But even when all the owners of a corporation agree on the goals of the corporation, these
goals must be implemented. In a simple organizational form like a sole proprietorship, the
owner, who runs the firm, can ensure that the firm’s goals match his or her own. But a
corporation is run by a management team, separate from its owners, giving rise to conflicts
of interest. How can the owners of a corporation ensure that the management team will
implement their goals?
Agency Problems. Many people claim that because of the separation of ownership and

control in a corporation, managers have little incentive to work in the interests of the
shareholders when this means working against their own self-interest. Economists call this
an agency problem—when managers, despite being hired as the agents of shareholders,
put their own self-interest ahead of the interests of shareholders. Managers face the ethical
dilemma of whether to adhere to their responsibility to put the interests of shareholders
first, or to do what is in their own personal best interest.
This agency problem is commonly addressed in practice by minimizing the number
of decisions managers must make for which their own self-interest substantially differs
from the interests of the shareholders. For example, managers’ compensation contracts are
designed to ensure that most decisions in the shareholders’ interest are also in the managers’ interests; shareholders often tie the compensation of top managers to the corporation’s
profits or perhaps to its stock price. There is, however, a limitation to this strategy. By tying
compensation too closely to performance, the shareholders might be asking managers to
take on more risk than they are comfortable taking. As a result, managers may not make
decisions that the shareholders want them to, or it might be hard to find talented managers

12

Chapter 1 The Corporation

GLOBAL FINANCIAL CRISIS

The Dodd-Frank Act on Corporate Compensation
and Governance

Compensation is one of the most important conflicts of
interest between corporate executives and shareholders. To
limit senior corporate executives’ influence over their own
compensation and prevent excessive compensation, the Act
directs the SEC to adopt new rules that:


Mandate the independence of a firm’s compensation
committee and its advisers.



Provide shareholders the opportunity to approve—in a
non-binding, advisory vote—the compensation of executive officers at least once every three years (referred to as
a “Say-on-Pay” vote).



Require firm disclosure and shareholder approval of
large bonus payments (so-called “golden parachutes”) to
ousted senior executives as the result of a takeover.



Require disclosure of the relationship of executive pay to
the company’s performance, as well as the ratio between
the CEO’s total compensation and that of the median
employee.



Create “clawback” provisions that allow firms to recoup
compensation paid based on erroneous financial results.

willing to accept the job. On the other hand, if compensation contracts reduce managers’
risk by rewarding good performance but limiting the penalty associated with poor performance, managers may have an incentive to take excessive risk.
Further potential for conflicts of interest and ethical considerations arise when some
stakeholders in the corporation benefit and others lose from a decision. Shareholders and
managers are two stakeholders in the corporation, but others include the regular employees
and the communities in which the company operates, for example. Managers may decide
to take the interests of other stakeholders into account in their decisions, such as keeping a
loss-generating factory open because it is the main provider of jobs in a small town, paying
above-market wages to factory workers in a developing country, or operating a plant at a
higher environmental standard than local law mandates.
In some cases, these actions that benefit other stakeholders also benefit the firm’s shareholders by creating a more dedicated workforce, generating positive publicity with customers, or other indirect effects. In other instances, when these decisions benefit other
stakeholders at shareholders’ expense, they represent a form of corporate charity. Indeed,
many if not most corporations explicitly donate (on behalf of their shareholders) to local
and global charitable and political causes. For example, in 2010, Wal-Mart Stores gave
$320 million in cash to charity (making it the largest corporate donor of cash in that year).
These actions are costly and reduce shareholder wealth. Thus, while some shareholders
might support such policies because they feel that they reflect their own moral and ethical
priorities, it is unlikely that all shareholders will feel this way, leading to potential conflicts
of interest amongst shareholders.

Citizens United v. Federal Election Commission
On January 21, 2010, the U.S. Supreme Court ruled on
what some scholars have argued is the most important First
Amendment case in many years. In Citizens United v. Federal Election Commission the Court held, in a controversial
5–4 decision, that the First Amendment allows corporations
and unions to make political expenditures in support of a

particular candidate. This ruling overturned existing restrictions on political campaigning by corporations. But because
it is highly unlikely that all shareholders of a corporation
would unanimously support a particular candidate, allowing
such activities effectively guarantees a potential conflict of
interest.

1.2 Ownership Versus Control of Corporations

13

The CEO’s Performance. Another way shareholders can encourage managers to work in

the interests of shareholders is to discipline them if they don’t. If shareholders are unhappy
with a CEO’s performance, they could, in principle, pressure the board to oust the CEO.
Disney’s Michael Eisner, Hewlett Packard’s Carly Fiorina, and Yahoo’s Scott Thompson
were all reportedly forced to resign by their boards. Despite these high-profile examples,
directors and top executives are rarely replaced through a grassroots shareholder uprising.
Instead, dissatisfied investors often choose to sell their shares. Of course, somebody must
be willing to buy the shares from the dissatisfied shareholders. If enough shareholders are
dissatisfied, the only way to entice investors to buy (or hold on to) the shares is to offer
them a low price. Similarly, investors who see a well-managed corporation will want to purchase shares, which drives the stock price up. Thus, the stock price of the corporation is a
barometer for corporate leaders that continuously gives them feedback on their shareholders’ opinion of their performance.
When the stock performs poorly, the board of directors might react by replacing the
CEO. In some corporations, however, the senior executives are entrenched because boards
of directors do not have the will to replace them. Often the reluctance to fire results because
the board members are close friends of the CEO and lack objectivity. In corporations in
which the CEO is entrenched and doing a poor job, the expectation of continued poor
performance will decrease the stock price. Low stock prices create a profit opportunity.
In a hostile takeover, an individual or organization—sometimes known as a corporate
raider—can purchase a large fraction of the stock and acquire enough votes to replace the
board of directors and the CEO. With a new superior management team, the stock is a
much more attractive investment, which would likely result in a price rise and a profit for
the corporate raider and the other shareholders. Although the words “hostile” and “raider”
have negative connotations, corporate raiders themselves provide an important service to
shareholders. The mere threat of being removed as a result of a hostile takeover is often
enough to discipline bad managers and motivate boards of directors to make difficult decisions. Consequently, when a corporation’s shares are publicly traded, a “market for corporate control” is created that encourages managers and boards of directors to act in the
interests of their shareholders.
Corporate Bankruptcy. Ordinarily, a corporation is run on behalf of its sharehold-

ers. But when a corporation borrows money, the holders of the firm’s debt also become
investors in the corporation. While the debt holders do not normally exercise control
over the firm, if the corporation fails to repay its debts, the debt holders are entitled
to seize the assets of the corporation in compensation for the default. To prevent such
a seizure, the firm may attempt to renegotiate with the debt holders, or file for bankruptcy protection in a federal court. (We describe the details of the bankruptcy process
and its implications for corporate decisions in much more detail in Part 5 of the textbook.) Ultimately, however, if the firm is unable to repay or renegotiate with the debt
holders, the control of the corporation’s assets will be transferred to them.
Thus, when a firm fails to repay its debts, the end result is a change in ownership of the
firm, with control passing from equity holders to debt holders. Importantly, bankruptcy
need not result in a liquidation of the firm, which involves shutting down the business
and selling off its assets. Even if control of the firm passes to the debt holders, it is in
the debt holders’ interest to run the firm in the most profitable way possible. Doing so
often means keeping the business operating. For example, in 1990, Federated Department
Stores declared bankruptcy. One of its best-known assets at the time was Bloomingdale’s, a
nationally recognized department store. Because Bloomingdale’s was a profitable business,

14

Chapter 1 The Corporation

Airlines in Bankruptcy
On December 9, 2002, United Airlines filed for bankruptcy
protection following an unsuccessful attempt to convince
the federal government to bail out the company’s investors out by providing loan guarantees. Although United
remained in bankruptcy for the next three years, it continued to operate and fly passengers, and even expanded capacity in some markets. One of those expansions was “Ted,” an
ill-fated attempt by United to start a budget airline to compete directly with Southwest Airlines. In short, although
United’s original shareholders were wiped out, as far as
customers were concerned it was business as usual. People
continued to book tickets and United continued to fly and
serve them.

It is tempting to think that when a firm files for bankruptcy,
things are “over.” But often, rather than liquidate the firm,
bondholders and other creditors are better off allowing the firm
to continue operating as a going concern. United was just one
of many airlines to move in and out of bankruptcy since 2002;
others include U.S. Airways, Air Canada, Hawaiian Airlines,
Northwest Airlines, and Delta Airlines. In November 2011,
American Airlines became the latest airline to declare bankruptcy. Like United in 2002, American continues to operate
while it cuts costs and reorganizes. These efforts seem to be paying off—excluding the costs associated with the bankruptcy,
American reported earnings of $95 million in the second quarter of 2012, the first second-quarter operating profit since 2007.

neither equity holders nor debt holders had any desire to shut it down, and it continued
to operate in bankruptcy. In 1992, when Federated Department Stores was reorganized
and emerged from bankruptcy, Federated’s original equity holders had lost their stake in
Bloomingdale’s, but this flagship chain continued to perform well for its new owners, and
its value as a business was not adversely affected by the bankruptcy.
Thus, a useful way to understand corporations is to think of there being two sets of
investors with claims to its cash flows—debt holders and equity holders. As long as the
corporation can satisfy the claims of the debt holders, ownership remains in the hands of
the equity holders. If the corporation fails to satisfy debt holders’ claims, debt holders may
take control of the firm. Thus, a corporate bankruptcy is best thought of as a change in
ownership of the corporation, and not necessarily as a failure of the underlying business.
CONCEPT CHECK

1. What are the three main tasks of a financial manager?
2. What is a principal-agent problem that may exist in a corporation?
3. How may a corporate bankruptcy filing affect the ownership of a corporation?

1.3 The Stock Market
As we have discussed, shareholders would like the firm’s managers to maximize the value
of their investment in the firm. The value of their investment is determined by the price of
a share of the corporation’s stock. Because private companies have a limited set of shareholders and their shares are not regularly traded, the value of their shares can be difficult to
determine. But many corporations are public companies, whose shares trade on organized
markets called a stock market (or stock exchange). These markets provide liquidity and
determine a market price for the company’s shares. An investment is said to be liquid if it
is possible to sell it quickly and easily for a price very close to the price at which you could
contemporaneously buy it. This liquidity is attractive to outside investors, as it provides
flexibility regarding the timing and duration of their investment in the firm. In this section, we provide an overview of the world’s major stock markets. The research and trading
of participants in these markets give rise to share prices that provide constant feedback to
managers regarding investors’ views of their decisions.

1.3 The Stock Market

15

Primary and Secondary Stock Markets
When a corporation itself issues new shares of stock and sells them to investors, it does so
on the primary market. After this initial transaction between the corporation and investors, the shares continue to trade in a secondary market between investors without the
involvement of the corporation. For example, if you wish to buy 100 shares of Starbucks
Coffee, you would place an order on a stock exchange, where Starbucks trades under the
ticker symbol SBUX. You would buy your shares from someone who already held shares of
Starbucks, not from Starbucks itself.

The Largest Stock Markets
The best-known U.S. stock market and the largest stock market in the world is the New
York Stock Exchange (NYSE). Investors exchange billions of dollars of stock every day on
the NYSE. Other U.S. stock markets include the American Stock Exchange (AMEX), the
National Association of Security Dealers Automated Quotation (NASDAQ), and regional
exchanges such as the Midwest Stock Exchange. Most other countries have at least one stock
market. Outside the United States, the largest and most active stock markets are the Tokyo
Stock Exchange (TSE), the London Stock Exchange (LSE), and Euronext. Figure 1.3 displays the world’s largest stock markets by two of the most common measures—the total
annual volume of shares traded on the exchange and the total value of all domestic corporations listed on the exchange.

FIGURE 1.3

Worldwide Stock Markets Ranked by Two Common Measures

Korea Exchange, $2.0
Deutsche Börse, $2.1
Shenzhen SE, $2.9
Shanghai SE, $3.7

Hong Kong
Exchanges, $1.6

Hong Kong
Exchanges, $2.3

TMX Group, $1.9

Shanghai SE, $2.4
NYSE Euronext
(Europe), $2.4

NYSE Euronext
(Europe), $3.9

London SE
Group, $3.3

London SE
Group, $4.3
Tokyo SE
Group, $4.4

BM&FBOVESPA,
$1.2
Australian
Securities
Exchanges, $1.2
NASDAQ
OMX, $3.8

Tokyo SE
Group, $3.3

NYSE Euronext (US), $19.3

NASDAQ OMX, $28.9

(a) Total Volume ($ trillions)

NYSE Euronext (US), $11.8
(b) Total Value ($ trillions)

The 10 biggest stock markets in the world (a) by total volume of shares traded on the exchange in 2011 and (b) by
total value of all domestic corporations listed on the exchange at year-end 2011.
Source : www.world-exchanges.org

16

Chapter 1 The Corporation

Jean-François Théodore is the Deputy
CEO of NYSE Euronext, the largest stock
exchange group in the world.
QUESTION: How have technological innovations shaped financial markets?

INTERVIEW WITH

Jean-François
Théodore*

ANSWER: At the end of the 1980s, the

electronic execution of market orders
transformed the organization and operation of the financial markets, resulting in
continuous securities trading. Since then,
technology has become a key driver of
change in the financial industry, enabling
markets to become faster and increasingly
more competitive, at a time when client
requirements are growing and diversifying,
particularly regarding the speed of execution and volumes, notably from algorithmic traders.
QUESTION: The Paris Stock Exchange has experienced
profound upheavals recently. What have the most important
changes been?
ANSWER: The Paris Stock Exchange, like other leading

stock markets, has changed significantly in recent years.
With the decompartmentalization and globalization
of financial activities, securities markets, which were once
national, public, or cooperative institutions, have abandoned their cooperative status or listed for trading on their
own market. This change is transforming securities markets
into real capitalistic enterprises oriented toward innovation and the optimization of their resources. It also favors
mergers among the various market operators, with the
objective of creating greater homogeneity in the financial
markets, capital fluidity, diversity in the service offering,
and reduced costs for publicly traded companies, investors,
and intermediaries.
A few months after the introduction of the euro in September 2000, the Paris Stock Exchange played a pioneering

role by merging with the Amsterdam and
Brussels exchanges to become the first
pan-European stock exchange: Euronext.
Two years later, after its own initial public
offering, Euronext acquired the British
derivatives market Liffe and integrated
the Lisbon exchange. In April 2007, in
an unprecedented event for our business
sector, Euronext merged with the New
York Stock Exchange, resulting in NYSE
Euronext, the largest and most liquid securities market group in the world.
QUESTION: What benefits do companies
and investors receive from the merger of
NYSE and Euronext?
ANSWER: In 2007, over 4000 companies

from 55 different countries were listed for
trading on NYSE Euronext, representing a
total market capitalization of close to 21,000 billion euros,
more than the next four exchanges combined.
Present in six countries in the world, NYSE Euronext has
an unequaled listing offer, with increased visibility and liquidity and expanded financing opportunities for issuers. Backed
by a globally recognized label, NYSE Euronext enables companies to be listed on a market adapted to their size and location, within a stable regulatory environment, in dollars
and/or in euros (the world’s two leading currencies), and
under the accounting standards of their choice (IFRS or US
GAAP).
In addition, the integration of the different NYSE
Euronext markets, combined with the technological excellence of its digital market information system and the
diverse array of financial products and services, encourages
cross-border trading and increased liquidity, benefiting all
users. In fact, more than one spot trade out of every three
trades in the world is made on NYSE Euronext.
*This interview was conducted by Gunther Capelle-Blancard
and Nicolas Couderc.

NYSE
The NYSE is a physical place. On the floor of the NYSE, market makers (known on
the NYSE as specialists) match buyers and sellers. They post two prices for every stock
they make a market in: the price they stand willing to buy the stock at (the bid price)
and the price they stand willing to sell the stock for (the ask price). If a customer comes
to them wanting to make a trade at these prices, they will honor the price (up to a limited number of shares) and make the trade even if they do not have another customer
willing to take the other side of the trade. In this way, they ensure that the market is


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