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Default Risk 270 Growth Stocks and Income Stocks 296
Valuations in Corporate Bonds 273 The Price-Earnings Ratio 298
Summary 273 What Do Earnings Mean? 298
Valuing Entire Businesses 301
Related Web Links 274
Key Terms 274
Summary 301
Quiz 274
Related Web Links 302
Practice Problems 275
Key Terms 302
Challenge Problems 277
Quiz 302
Solutions to Self-Test Questions 277
Practice Problems 303
Valuing Stocks 279 Challenge Problems 306
Solutions to Self-Test Questions 307
Stocks and the Stock Market 280
Reading the Stock Market Listings 281
VI CONTENTS


Risk and Diversification 324
Introduction to Risk, Return, and the
Diversification 324
Opportunity Cost of Capital 311
Asset versus Portfolio Risk 325
Rates of Return: A Review 312 Market Risk versus Unique Risk 330

Thinking about Risk 331
Seventy-Three Years of Capital Market
Message 1: Some Risks Look Big and Dangerous but
History 313
Really Are Diversifiable 331
Market Indexes 314
Message 2: Market Risks Are Macro Risks 332
The Historical Record 314
Message 3: Risk Can Be Measured 333
Using Historical Evidence to Estimate Today™s Cost of
Capital 317 Summary 334
Related Web Links 334
Measuring Risk 318
Key Terms 334
Variance and Standard Deviation 318
Quiz 335
A Note on Calculating Variance 322
Practice Problems 336
Measuring the Variation in Stock Returns 322
Solutions to Self-Test Questions 338


339
SECTION 4
Challenge Problems 373
Net Present Value and Other Investment
Solutions to Self-Test Questions 373
Criteria 341
Using Discounted Cash-Flow Analysis to
Net Present Value 343
Make Investment Decisions 377
A Comment on Risk and Present Value 344
Valuing Long-Lived Projects 345 Discount Cash Flows, Not Profits 379
Other Investment Criteria 349 Discount Incremental Cash Flows 381
Internal Rate of Return 349 Include All Indirect Effects 381
A Closer Look at the Rate of Return Rule 350 Forget Sunk Costs 382
Calculating the Rate of Return for Long-Lived Include Opportunity Costs 382
Projects 351 Recognize the Investment in Working Capital 383
A Word of Caution 352 Beware of Allocated Overhead Costs 384
Payback 352
Discount Nominal Cash Flows by the Nominal Cost
Book Rate of Return 355
of Capital 385
Investment Criteria When Projects Interact 356
Separate Investment and Financing Decisions 386
Mutually Exclusive Projects 356
Investment Timing 357 Calculating Cash Flow 387
Long- versus Short-Lived Equipment 359 Capital Investment 387
Replacing an Old Machine 361 Investment in Working Capital 387
Mutually Exclusive Projects and the IRR Rule 361 Cash Flow from Operations 388
Other Pitfalls of the IRR Rule 363
Example: Blooper Industries 390
Capital Rationing 365 Calculating Blooper™s Project Cash Flows 391
Soft Rationing 365 Calculating the NPV of Blooper™s Project 392
Hard Rationing 366 Further Notes and Wrinkles Arising from Blooper™s
Pitfalls of the Profitability Index 3667 Project 393
Summary 367 Summary 397
Related Web Links 368 Related Web Links 398
Key Terms 368 Key Terms 398
Quiz 368 Quiz 398
Practice Problems 369
CONTENTS VII


Practice Problems 200 Calculating Company Cost of Capital as a Weighted
Challenge Problems 402 Average 440
Solutions to Spreadsheet Model Questions 403 Market versus Book Weights 441
Solutions to Self-Test Questions 404 Taxes and the Weighted-Average Cost of Capital 442
Minicase 405 What If There Are Three (or More) Sources of
Financing? 443
Risk, Return, and Capital Budgeting 407 Wrapping Up Geothermal 444
Measuring Market Risk 408 Checking Our Logic 445
Measuring Beta 409
Measuring Capital Structure 446
Betas for MCI WorldCom and Exxon 411
Calculating Required Rates of Return 447
Portfolio Betas 412
The Expected Return on Bonds 448
Risk and Return 414
The Expected Return on Common Stock 448
Why the CAPM Works 416
The Expected Return on Preferred Stock 449
The Security Market Line 417
Big Oil™s Weighted-Average Cost of Capital 450
How Well Does the CAPM Work? 419
Using the CAPM to Estimate Expected Returns 420 Real Oil Company WACCs 450

Capital Budgeting and Project Risk 422 Interpreting the Weighted-Average Cost of
Capital 451
Company versus Project Risk 422
Determinants of Project Risk 423 When You Can and Can™t Use WACC 451
Don™t Add Fudge Factors to Discount Rates 424 Some Common Mistakes 452
How Changing Capital Structure Affects Expected
Summary 425
Returns 452
Related Web Links 426
What Happens When the Corporate Tax Rate Is Not
Key Terms 426
Zero 453
Quiz 426
Flotation Costs and the Cost of Capital 454
Practice Problems 427
Challenge Problem 432
Summary 454
Solutions to Self-Test Questions 432
Related Web Links 455
Key Terms 455
The Cost of Capital 435 Quiz 455
Geothermal™s Cost of Capital 436 Practice Problems 456
Challenge Problems 458
Calculating the Weighted-Average Cost of
Solutions to Self-Test Questions 458
Capital 438
Minicase 459


463
SECTION 5
NPV Break-Even Analysis 475
Project Analysis 465
Operating Leverage 478
How Firms Organize the Investment Process 466
Flexibility in Capital Budgeting 481
Stage 1: The Capital Budget 467
Decision Trees 481
Stage 2: Project Authorizations 467
The Option to Expand 482
Problems and Some Solutions 468
Abandonment Options 483
Some “What-If ” Questions 469 Flexible Production Facilities 484
Sensitivity Analysis 469 Investment Timing Options 484
Scenario Analysis 472
Summary 485
Break-Even Analysis 473 Related Web Links 485
Accounting Break-Even Analysis 474 Key Terms 485
VIII CONTENTS


Quiz 485 Quiz 512
Practice Problems 486 Practice Problems 513
Challenge Problems 489 Solutions to Self-Test Questions 514
Solutions to Self-Test Questions 489
How Corporations Issue Securities 517
Minicase 491
Venture Capital 519
An Overview of Corporate
Financing 493 The Initial Public Offering 520
Arranging a Public Issue 521
Common Stock 494
The Underwriters 526
Book Value versus Market Value 496
Who Are the Underwriters? 526
Dividends 497
Stockholders™ Rights 497 General Cash Offers by Public Companies 528
Voting Procedures 497 General Cash Offers and Shelf Registration 528
Classes of Stock 498 Costs of the General Cash Offer 529
Corporate Governance in the United States and Market Reaction to Stock Issues 530
Elsewhere 498
The Private Placement 531
Preferred Stock 499
Summary 532
Corporate Debt 500 Related Web Links 533
Debt Comes in Many Forms 501 Key Terms 533
Innovation in the Debt Market 504 Quiz 534
Practice Problems 534
Convertible Securities 507
Challenge Problem 536
Patterns of Corporate Financing 508 Solutions to Self-Test Questions 537
Do Firms Rely Too Heavily on Internal Funds? 508 Minicase 537
External Sources of Capital 510
Appendix: Hotch Pot™s New Issue Prospectus 539
Summary 511
Related Web Links 512
Key Terms 512



545
APPENDIX B
Leasing 547 Lease or Buy? 555
A Preliminary Analysis 555
Leasing versus Buying 548
Three Potential Pitfalls 555
Operating Leases 548
NPV Analysis 556
Financial Leases 549
A Misconception 556
Tax-Oriented Leases 549
Leverage and Capital Structure
Leveraged Leases 550
559
Sale and Leaseback Agreements 550
The Capital Structure Question 560
Accounting and Leasing 550
The Effect of Financial Leverage 560
Taxes, the IRS, and Leases 552
The Impact of Financial Leverage 560
The Cash Flows from Leasing 553 Financial Leverage, EPS, and ROE:
The Incremental Cash Flows 553 An Example 561
A Note on Taxes 554 EPS versus EBIT 561
CONTENTS IX



565
SECTION 6
Related Web Links 592
Mergers, Acquisitions, and Corporate
Key Terms 592
Control 567
Quiz 592
22.1 The Market for Corporate Control 569 Practice Problems 593
Challenge Problems 594
Method 1: Proxy Contests 569
Solutions to Self-Test Questions 595
Method 2: Mergers and Acquisitions 570
Minicase 595
Method 3: Leveraged Buyouts 571
Method 4: Divestitures and Spin-offs 571
International Financial
Management 597
22.2 Sensible Motives for Mergers 572
Economies of Scale 573
23.1 Foreign Exchange Markets 598
Economies of Vertical Integration 573
23.2 Some Basic Relationships 602
Combining Complementary Resources 574
Mergers as a Use for Surplus Funds 574 Exchange Rates and Inflation 602
Inflation and Interest Rates 606
22.3 Dubious Reasons for Mergers 575
Interest Rates and Exchange Rates 608
Diversification 575
The Forward Rate and the Expected Spot Rate 609
The Bootstrap Game 575
Some Implications 610
22.4 Evaluating Mergers 577 23.3 Hedging Exchange Rate Risk 612
Mergers Financed by Cash 577
23.4 International Capital Budgeting 613
Mergers Financed by Stock 579
Net Present Value Analysis 613
A Warning 580

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