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