STEPHEN A. ROSS Massachuset ts Ins t i tu te o f Technolog y
RANDOLPH W. WESTERFIELD Univer s i t y o f Southern Ca l i fo rn ia
BRADFORD D. JORDAN Univer s i t y o f Kentucky
GORDON S. ROBERTS Schul ich School o f Bus iness , Yor k Univer s i t y
Fundamenta l s o f
Corporate Finance
Eighth Canadian Edition
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Fundamentals of Corporate Finance Eighth Canadian Edition
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Library and Archives Canada Cataloguing in Publication
Fundamentals of corporate finance / Stephen A. Ross … [et al.].—8th Canadian ed. Includes bibliographical references and indexes.
ISBN 978-0-07-105160-6
1. Corporations—Finance—Textbooks. I. Ross, Stephen A
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ABOUT THE AUTHORS
Stephen A. Ross Sloan School of Management, Franco Modigliani Professor of Finance and Economics, Massachusetts Institute of Technology
Stephen A. Ross is the Franco Modigliani Professor of Finance and Economics at the Sloan School of Management, Massachusetts Institute of Technology. One of the most widely published authors in finance and economics, Professor Ross is recognized for his work in developing the Arbitrage Pricing Theory and his substantial contributions to the discipline through his research in signalling, agency theory, option pricing, and the theory of the term structure of interest rates, among other topics. A past president of the American Finance Association, he currently serves as an associate editor of several academic and practitioner journals. He is a trustee of CalTech.
Randolph W. Westerf ield Marshall School of Business, University of Southern California
Randolph W. Westerfield is Dean Emeritus of the University of Southern California’s Marshall School of Business and is the Charles B. Thornton Professor of Finance. He came to USC from the Wharton School, University of Pennsylvania, where he was the chairman of the finance department and a member of the finance faculty for 20 years. He is a member of several public company boards of directors, including Health Management Associates, Inc., William Lyons Homes, and the Nicholas Applegate growth fund. His areas of expertise include corporate financial policy, investment management, and stock market price behaviour.
Bradford D. Jordan Gatton College of Business and Economics, Professor of Finance and holder of the Richard W. and Janis H. Furst Endowed Chair in Finance, University of Kentucky
Bradford D. Jordan is Professor of Finance and holder of the Richard W. and Janis H. Furst Endowed Chair in Finance at the University of Kentucky. He has a long- standing interest in both applied and theoretical issues in corporate finance and has extensive experience teaching all levels of corporate finance and financial management policy. Professor Jordan has published nu- merous articles on issues such as cost of capital, capital structure, and the behaviour of security prices. He is a past president of the Southern Finance Association, and he is co-author (with Thomas W. Miller, Jr.) of Fundamentals of Investments: Valuation and Management, 4e, a leading investments text, published by McGraw-Hill/Irwin.
Gordon S. Roberts Schulich School of Business, York University, Canadian Imperial Bank of Commerce Professor of Financial Services
Gordon S. Roberts is Canadian Imperial Bank of Commerce Professor of Financial Services at the Schulich School of Business, York University. His exten- sive teaching experience includes finance classes for un- dergraduate and MBA students, executives, and bankers in Canada and internationally. Professor Roberts con- ducts research on the pricing of bank loans and the reg- ulation of financial institutions. He has served on the editorial boards of several Canadian and international academic journals. Professor Roberts has been a consul- tant to a number of regulatory bodies responsible for the oversight of financial institutions and utilities.
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BRIEF CONTENTS
PREFACE xvii
P A R T 1
OVERVIEW OF CORPORATE FINANCE 1
1 Introduction to Corporate Finance 1 2 Financial Statements, Cash Flow, and Taxes 25
P A R T 2
FINANCIAL STATEMENTS AND LONG-TERM FINANCIAL PLANNING 53
3 Working with Financial Statements 53 4 Long-Term Financial Planning and
Corporate Growth 84
P A R T 3
VALUATION OF FUTURE CASH FLOWS 111
5 Introduction to Valuation: The Time Value of Money 111
6 Discounted Cash Flow Valuation 129 7 Interest Rates and Bond Valuation 165 8 Stock Valuation 196
P A R T 4
CAPITIAL BUDGETING 220
9 Net Present Value and Other Investment Criteria 220
10 Making Capital Investment Decisions 250 11 Project Analysis and Evaluation 288
P A R T 5
RISK AND RETURN 317
12 Lessons from Capital Market History 317 13 Return, Risk, and the Security Market Line 346
P A R T 6
COST OF CAPITAL AND LONG-TERM FINANCIAL POLICY 387
14 Cost of Capital 387 15 Raising Capital 423 16 Financial Leverage and Capital
Structure Policy 454 17 Dividends and Dividend Policy 490
P A R T 7
SHORT-TERM FINANCIAL PLANNING AND MANAGEMENT 519
18 Short-Term Finance and Planning 519 19 Cash and Liquidity Management 552 20 Credit and Inventory Management 572
P A R T 8
TOPICS IN CORPORATE FINANCE 606
21 International Corporate Finance 606 22 Leasing 634 23 Mergers and Acquisitions 655
P A R T 9
DERIVATIVE SECURITIES AND CORPORATE FINANCE 685
24 Enterprise Risk Management 685 25 Options and Corporate Securities 711 26 Behavioural Finance: Implications for
Financial Management 750
Glossary 773 Appendix A: Mathematical Tables (available on Connect) Appendix B: Answers to Selected End-of-Chapter Problems (available on Connect) Subject Index 781 Name Index 800 Equation Index 802
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CONTENTS
PREFACE xvii
P A R T 1
OVERVIEW OF CORPORATE FINANCE 1
C H A P T E R 1
INTRODUCTION TO CORPORATE FINANCE 1
1.1 Corporate Finance and the Financial Manager 1 What Is Corporate Finance? 2 The Financial Manager 2 Financial Management Decisions 2
1.2 Forms of Business Organization 4 Sole Proprietorship 4 Partnership 5 Corporation 5 Income Trust 6 Co-operative (Co-op) 7
1.3 The Goal of Financial Management 8 Possible Goals 8 The Goal of Financial Management 8 A More General Goal 9
1.4 The Agency Problem and Control of the Corporation 10 Agency Relationships 10 Management Goals 10 Do Managers Act in the Shareholders’ Interests? 10 Corporate Social Responsibility and Ethical Investing 12
1.5 Financial Markets and the Corporation 14 Cash Flows to and from the Firm 15 Money versus Capital Markets 15 Primary versus Secondary Markets 16
1.6 Financial Institutions 18
1.7 Trends in Financial Markets and Financial Management 20
1.8 Outline of the Text 21
1.9 Summary and Conclusions 22
C H A P T E R 2
FINANCIAL STATEMENTS, CASH FLOW, AND TAXES 25
2.1 Statement of Financial Position 25 Assets 26 Liabilities and Owners’ Equity 26 Net Working Capital 27 Liquidity 28 Debt versus Equity 28 Value versus Cost 28
2.2 Statement of Comprehensive Income 30 International Financial Reporting Standards (IFRS) 30 Non-Cash Items 31 Time and Costs 31
2.3 Cash Flow 32 Cash Flow from Assets 32 Cash Flow to Creditors and Shareholders 34 Net Capital Spending 36 Change in NWC and Cash Flow from Assets 36
2.4 Taxes 37 Individual Tax Rates 37 Average versus Marginal Tax Rates 37 Taxes on Investment Income 39 Corporate Taxes 39 Taxable Income 39 Global Tax Rates 40 Capital Gains and Carry-forward and Carry-back 40 Income Trust Income and Taxation 41
2.5 Capital Cost Allowance 42 Asset Purchases and Sales 43
2.6 Summary and Conclusions 45
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P A R T 2
FINANCIAL STATEMENTS AND LONG-TERM FINANCIAL PLANNING 53
C H A P T E R 3
WORKING WITH FINANCIAL STATEMENTS 53
3.1 Cash Flow and Financial Statements: A Closer Look 54 Sources and Uses of Cash 54 The Statement of Cash Flows 56
3.2 Standardized Financial Statements 57 Common-Size Statements 57 Common-Base-Year Financial Statements: Trend Analysis 59
3.3 Ratio Analysis 60 Short-Term Solvency or Liquidity Measures 61 Other Liquidity Ratios 63 Long-Term Solvency Measures 64 Asset Management, or Turnover, Measures 65 Profitability Measures 67 Market Value Measures 68
3.4 The Du Pont Identity 71
3.5 Using Financial Statement Information 73 Why Evaluate Financial Statements? 73 Choosing a Benchmark 74 Problems with Financial Statement Analysis 75
3.6 Summary and Conclusions 75
C H A P T E R 4
LONG-TERM FINANCIAL PLANNING AND CORPORATE GROWTH 84
4.1 What Is Financial Planning? 85 Growth as a Financial Management Goal 85 Dimensions of Financial Planning 86 What Can Planning Accomplish? 86
4.2 Financial Planning Models: A First Look 88 A Financial Planning Model: The Ingredients 88 A Simple Financial Planning Model 89
4.3 The Percentage of Sales Approach 90 An Illustration of the Percentage of Sales Approach 90
4.4 External Financing and Growth 95 External Financing Needed and Growth 95 Internal Growth Rate 97 Financial Policy and Growth 98 Determinants of Growth 100 A Note on Sustainable Growth Rate Calculations 101
4.5 Some Caveats on Financial Planning Models 103
4.6 Summary and Conclusions 103
Appendix 4 (available on Connect)
P A R T 3
VALUATION OF FUTURE CASH FLOWS 111
C H A P T E R 5
INTRODUCTION TO VALUATION: THE TIME VALUE OF MONEY 111
5.1 Future Value and Compounding 112 Investing for a Single Period 112 Investing for More than One Period 112 A Note on Compound Growth 118
5.2 Present Value and Discounting 118 The Single-Period Case 119 Present Values for Multiple Periods 119
5.3 More on Present and Future Values 121 Present versus Future Value 121 Determining the Discount Rate 122 Finding the Number of Periods 124
5.4 Summary and Conclusions 126
C H A P T E R 6
DISCOUNTED CASH FLOW VALUATION 129
6.1 Future and Present Values of Multiple Cash Flows 129 Future Value with Multiple Cash Flows 129 Present Value with Multiple Cash Flows 131 A Note on Cash Flow Timing 134
6.2 Valuing Level Cash Flows: Annuities and Perpetuities 135 Present Value for Annuity Cash Flows 135
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Future Value for Annuities 140 A Note on Annuities Due 141 Perpetuities 142 Growing Perpetuities 143 Formula for Present Value of Growing Perpetuity 144 Growing Annuity 145 Formula for Present Value of Growing Annuity 145
6.3 Comparing Rates: The Effect of Compounding 145 Effective Annual Rates and Compounding 146 Calculating and Comparing Effective Annual Rates 146 Mortgages 147 EARs and APRs 148 Taking It to the Limit: A Note on Continuous Compounding 149
6.4 Loan Types and Loan Amortization 150 Pure Discount Loans 150 Interest-Only Loans 150 Amortized Loans 151
6.5 Summary and Conclusions 155
Appendix 6A: Proof of Annuity Present Value Formula 164
C H A P T E R 7
INTEREST RATES AND BOND VALUATION 165
7.1 Bonds and Bond Valuation 165 Bond Features and Prices 165 Bond Values and Yields 166 Interest Rate Risk 169 Finding the Yield to Maturity 170
7.2 More on Bond Features 173 Is It Debt or Equity? 173 Long-Term Debt: The Basics 174 The Indenture 174
7.3 Bond Ratings 177
7.4 Some Different Types of Bonds 178 Financial Engineering 178 Stripped Bonds 179 Floating-Rate Bonds 180 Other Types of Bonds 180
7.5 Bond Markets 181 How Bonds Are Bought and Sold 181 Bond Price Reporting 182 A Note on Bond Price Quotes 182 Bond Funds 184
7.6 Inflation and Interest Rates 184 Real versus Nominal Rates 184 The Fisher Effect 185 Inflation and Present Values 186
7.7 Determinants of Bond Yields 186 The Term Structure of Interest Rates 187 Bond Yields and the Yield Curve: Putting It All Together 188 Conclusion 189
7.8 Summary and Conclusions 190
Appendix 7A: On Duration 194
Appendix 7B (available on Connect)
C H A P T E R 8
STOCK VALUATION 196
8.1 Common Stock Valuation 196 Common Stock Cash Flows 196 Common Stock Valuation: Some Special Cases 198 Changing the Growth Rate 202 Components of the Required Return 203
8.2 Common Stock Features 205 Shareholders’ Rights 205 Dividends 206 Classes of Stock 206
8.3 Preferred Stock Features 207 Stated Value 207 Cumulative and Non-Cumulative Dividends 207 Is Preferred Stock Really Debt? 208 Preferred Stock and Taxes 209 Beyond Taxes 209
8.4 Stock Market Reporting 210 Growth Opportunities 211 Application: The Price-Earnings Ratio 211
8.5 Summary and Conclusions 213
Appendix 8A: Corporate Voting 218
Contents vii
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P A R T 4
CAPITAL BUDGETING 220
C H A P T E R 9
NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA 220
9.1 Net Present Value 221 The Basic Idea 221 Estimating Net Present Value 222
9.2 The Payback Rule 225 Defining the Rule 225 Analyzing the Payback Period Rule 225 Redeeming Qualities 226 Summary of the Rule 226 The Discounted Payback Rule 227
9.3 The Average Accounting Return 228 Analyzing the Average Accounting Return Method 229
9.4 The Internal Rate of Return 230 Problems with the IRR 233 Redeeming Qualities of the IRR 237
9.5 The Profitability Index 238
9.6 The Practice of Capital Budgeting 239
9.7 Summary and Conclusions 241
Appendix 9A: The Modified Internal Rate of Return 248
C H A P T E R 1 0
MAKING CAPITAL INVESTMENT DECISIONS 250
10.1 Project Cash Flows: A First Look 251 Relevant Cash Flows 251 The Stand-Alone Principle 251
10.2 Incremental Cash Flows 251 Sunk Costs 251 Opportunity Costs 252 Side Effects 252 Net Working Capital 253 Financing Costs 253 Inflation 253
Capital Budgeting and Business Taxes in Canada 254 Other Issues 254
10.3 Pro Forma Financial Statements and Project Cash Flows 254 Getting Started: Pro Forma Financial Statements 254 Project Cash Flows 255 Project Total Cash Flow and Value 256
10.4 More on Project Cash Flow 257 A Closer Look at Net Working Capital 257 Depreciation and Capital Cost Allowance 258 An Example: The Majestic Mulch and Compost Company (MMCC) 259
10.5 Alternative Definitions of Operating Cash Flow 263 The Bottom-Up Approach 263 The Top-Down Approach 264 The Tax Shield Approach 264 Conclusion 265
10.6 Applying the Tax Shield Approach to the Majestic Mulch and Compost Company Project 265 Present Value of the Tax Shield on CCA 266 Salvage Value versus UCC 268
10.7 Some Special Cases of Discounted Cash Flow Analysis 269 Evaluating Cost-Cutting Proposals 269 Replacing an Asset 270 Evaluating Equipment with Different Lives 272 Setting the Bid Price 273
10.8 Summary and Conclusions 276
Appendix 10A: More on Inflation and Capital Budgeting 285
Appendix 10B: Capital Budgeting with Spreadsheets 286
C H A P T E R 1 1
PROJECT ANALYSIS AND EVALUATION 288
11.1 Evaluating NPV Estimates 288 The Basic Problem 289 Projected versus Actual Cash Flows 289 Forecasting Risk 289 Sources of Value 289
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11.2 Scenario and Other What-If Analyses 290 Getting Started 290 Scenario Analysis 291 Sensitivity Analysis 293 Simulation Analysis 295
11.3 Break-Even Analysis 296 Fixed and Variable Costs 296 Accounting Break-Even 297 Accounting Break-Even: A Closer Look 299 Uses for the Accounting Break-Even 299
11.4 Operating Cash Flow, Sales Volume, and Break-Even 300 Accounting Break-Even and Cash Flow 300 Cash Flow and Financial Break-Even Points 302
11.5 Operating Leverage 304 The Basic Idea 304 Implications of Operating Leverage 305 Measuring Operating Leverage 305 Operating Leverage and Break-Even 306
11.6 Managerial Options 307
11.7 Capital Rationing 310
11.8 Summary and Conclusions 311
P A R T 5
RISK AND RETURN 317
C H A P T E R 1 2
LESSONS FROM CAPITAL MARKET HISTORY 317
12.1 Returns 318 Dollar Returns 318 Percentage Returns 319
12.2 The Historical Record 321 A First Look 323 A Closer Look 324
12.3 Average Returns: The First Lesson 324 Calculating Average Returns 324 Average Returns: The Historical Record 324 Risk Premiums 325 The First Lesson 325
12.4 The Variability of Returns: The Second Lesson 326 Frequency Distributions and Variability 326 The Historical Variance and Standard Deviation 326 The Historical Record 328 Normal Distribution 329 Value at Risk 331 The Second Lesson 331 2008 The Bear Growled and Investors Howled 331 Using Capital Market History 332
12.5 More on Average Returns 333 Arithmetic versus Geometric Averages 333 Calculating Geometric Average Returns 333 Arithmetic Average Return or Geometric Average Return? 335
12.6 Capital Market Efficiency 335 Price Behaviour in an Efficient Market 336 The Efficient Markets Hypothesis 337 Market Efficiency—Forms and Evidence 339
12.7 Summary and Conclusions 341
C H A P T E R 1 3
RETURN, RISK, AND THE SECURITY MARKET LINE 346
13.1 Expected Returns and Variances 347 Expected Return 347 Calculating the Variance 349
13.2 Portfolios 351 Portfolio Weights 351 Portfolio Expected Returns 351 Portfolio Variance 352 Portfolio Standard Deviation and Diversification 353 The Efficient Set 355 Correlations in the Financial Crisis of 2007–2009 357
13.3 Announcements, Surprises, and Expected Returns 359 Expected and Unexpected Returns 359 Announcements and News 359
13.4 Risk: Systematic and Unsystematic 360 Systematic and Unsystematic Risk 360 Systematic and Unsystematic Components of Return 361
Contents ix
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13.5 Diversification and Portfolio Risk 361 The Effect of Diversification: Another Lesson from Market History 362 The Principle of Diversification 363 Diversification and Unsystematic Risk 364 Diversification and Systematic Risk 364 Risk and the Sensible Investor 364
13.6 Systematic Risk and Beta 365 The Systematic Risk Principle 366 Measuring Systematic Risk 366 Portfolio Betas 367
13.7 The Security Market Line 368 Beta and the Risk Premium 368 Calculating Beta 372 The Security Market Line 374
13.8 Arbitrage Pricing Theory And Empirical Models 377
13.9 Summary and Conclusions 379
Appendix 13A: Derivation of the Capital Asset Pricing Model 384
P A R T 6
COST OF CAPITAL AND LONG-TERM FINANCIAL POLICY 387
C H A P T E R 1 4
COST OF CAPITAL 387
14.1 The Cost of Capital: Some Preliminaries 388 Required Return versus Cost of Capital 388 Financial Policy and Cost of Capital 388
14.2 The Cost of Equity 389 The Dividend Growth Model Approach 389 The SML Approach 391 The Cost of Equity in Rate Hearings 392
14.3 The Costs of Debt and Preferred Stock 393 The Cost of Debt 393 The Cost of Preferred Stock 394
14.4 The Weighted Average Cost of Capital 394 The Capital Structure Weights 395 Taxes and the Weighted Average Cost of Capital 396 Solving the Warehouse Problem and Similar Capital Budgeting Problems 396 Performance Evaluation: Another Use of the WACC 398
14.5 Divisional and Project Costs of Capital 399 The SML and the WACC 399 Divisional Cost of Capital 401 The Pure Play Approach 401 The Subjective Approach 402
14.6 Flotation Costs and the Weighted Average Cost of Capital 403 The Basic Approach 403 Flotation Costs and NPV 404
14.7 Calculating WACC for Loblaw 406 Estimating Financing Proportions 406 Market Value Weights for Loblaw 406 Cost of Debt 407 Cost of Preferred Shares 408 Cost of Common Stock 408 CAPM 408 Dividend Valuation Model Growth Rate 409 Loblaw’s WACC 409
14.8 Summary and Conclusions 409
Appendix 14A: Adjusted Present Value 414
Appendix 14B: Economic Value Added and the Measurement of Financial Performance 419
C H A P T E R 1 5
RAISING CAPITAL 423
15.1 The Financing Life Cycle of a Firm: Early-Stage Financing and Venture Capital 423 Venture Capital 424 Some Venture Capital Realities 424 Choosing a Venture Capitalist 424 Conclusion 425
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15.2 The Public Issue 425
15.3 The Basic Procedure for a New Issue 426 Securities Registration 427 Alternative Issue Methods 427
15.4 The Cash Offer 427 Types of Underwriting 428 Bought Deal 428 Dutch Auction Underwriting 429 The Selling Period 429 The Overallotment Option 430 Lockup Agreements 430 The Quiet Period 430 The Investment Dealers 430
15.5 IPOs and Underpricing 431 IPO Underpricing: The 1999–2000 Experience 431 Evidence on Underpricing 432 Why Does Underpricing Exist? 435
15.6 New Equity Sales and the Value of the Firm 436
15.7 The Cost of Issuing Securities 437 IPOs in Practice: The Case of Athabasca Oil Sands 439
15.8 Rights 439 The Mechanics of a Rights Offering 439 Number of Rights Needed to Purchase a Share 440 The Value of a Right 441 Theoretical Value of a Right 442 Ex Rights 443 Value of Rights after Ex-Rights Date 444 The Underwriting Arrangements 444 Effects on Shareholders 444 Cost of Rights Offerings 445
15.9 Dilution 446 Dilution of Proportionate Ownership 446 Dilution of Value: Book versus Market Values 446
15.10 Issuing Long-term Debt 448
15.11 Summary and Conclusions 449
C H A P T E R 1 6
FINANCIAL LEVERAGE AND CAPITAL STRUCTURE POLICY 454
16.1 The Capital Structure Question 455 Firm Value and Stock Value: An Example 455 Capital Structure and the Cost of Capital 456
16.2 The Effect of Financial Leverage 456 The Basics of Financial Leverage 456 Corporate Borrowing and Homemade Leverage 460
16.3 Capital Structure and the Cost of Equity Capital 462 M&M Proposition I: The Pie Model 462 The Cost of Equity and Financial Leverage: M&M Proposition II 462 Business and Financial Risk 463
16.4 M&M Propositions I and II with Corporate Taxes 466 The Interest Tax Shield 466 Taxes and M&M Proposition I 466 Taxes, the WACC, and Proposition II 468
16.5 Bankruptcy Costs 470 Direct Bankruptcy Costs 470 Indirect Bankruptcy Costs 470 Agency Costs of Equity 471
16.6 Optimal Capital Structure 472 The Static Theory of Capital Structure 472 Optimal Capital Structure and the Cost of Capital 473 Optimal Capital Structure: A Recap 473 Capital Structure: Some Managerial Recommendations 475
16.7 The Pie Again 475 The Extended Pie Model 475 Marketed Claims versus Non-Marketed Claims 476
16.8 The Pecking-Order Theory 477 Internal Financing and the Pecking Order 477 Implications of the Pecking Order 477
16.9 Observed Capital Structures 478
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