A First Course in Corporate Finance

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A First Course in Corporate Finance Preview, Monday 9th October, 2006

A First Course in Corporate Finance © 2003–2006 by Ivo Welch. All rights reserved. Cartoons are copyright and courtesy of Mike Baldwin. See http://www.cornered.com/. ISBN: no number yet. Library of Congress: no number yet. Book Website: http://welch.econ.brown.edu/book/ Typesetting System: pdflatex. Cover Font

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Warning: This book is in development. It is not error-free.

A First Course in Corporate Finance Preview, Monday 9th October, 2006

Ivo Welch Professor of Finance and Economics Brown University

Far and away, the most important contributor to this book was Mary-Clare McEwing. As editor, she helped me improve the substance of the book tremendously. There are also a large number of other individuals who have helped me with this book. Among them were Rick Antle, Donna Battista, Randolph Beatty, Wolfgang Bühler, Kangbin Chua, Diego Garcia, Stan Garstka, Roger Ibbotson, Ludovic Phalippou, Matthew Spiegel, John Strong, Julie Yufe, and many anonymous (victim) students who had to use earlier error-ridden drafts. The reviewers of earlier drafts of the book spent an enormous amount of time and provided me with many great ideas. I owe them my deep gratitude for their engagement: Tony Bernardo Thomas Chemmanur Bill Christie Jennifer Conrad Josh Coval Amy Dittmar Richard Fendler Diego Garcia Sharon Garrison

James Gatti Simon Gervais Tom Geurtz Robert Hansen Milt Harris Ronald Hoffmeister Kurt Jesswin Darren Kisgen

Mark Klock

Tim Sullivan

Angeline Lavin

Chris Stivers

Joseph McCarthy

Mark Stohs

James Nelson

John Strong

Michael Pagano

Michael Troege

Mitch Petersen

Joel Vanden

Sarah Peck

Jaime Zender

Robert Ritchey

Miranda (Mei) Zhang

Bruce Rubin

A list of articles upon which the ideas in the book are based, and a list of articles that describe current ongoing academic research will eventually appear on the book’s website.

Warning: This book is in development. It is not error-free.

Dedicated to my parents, Arthur and Charlotte.

Last file change: Jul 19, 2006 (11:13h)

A Quick Adoption Checklist For Instructors This is the recommended checklist for this book (AFCIc) while the book is in beta test mode. This checklist will not apply after AFCIc is published (with full supplementary materials) by AddisonWesley-Pearson. ✓ Read this prologue and one or two sample chapters to determine whether you like the AFCIc approach. (Although not representative, I recommend that you also read the epilogue.) If you do like the AFCIc approach, then please continue. If you do not like AFCIc (or the chapters you read), please email [email protected] why you did not like it. I promise I will not shoot the messenger: I want to learn how to do it better.

✓ Continue to assign whatever other finance textbook you were planning to use, just add AFCIc. Use it as a supplementary text, or assign just a few chapters. • Although AFCIc is a full-service textbook for an introductory finance course, it should also work well as a complement to an existing textbook. Your students should relatively easily benefit from having access to both, because this book is both different from and similar to the competition. I believe that relative to relying only on your old textbook, AFCIc will not increase, but decrease your student’s confusion and workload. • Take the low risk route and see how well AFCIc works! (Take the Pepsi challenge!) Keeping your old textbook is also your insurance against using a novel textbook. And it will make students less critical of the remaining shortcomings in AFCIc, such as the limited number of exercises (and their occasionally erroneous solutions). Perhaps most importantly, AFCIc does not yet have full supplementary materials. It will when Addison-Wesley will publish it, but until then, the auxiliary materials from other textbooks may help. • For now, students can download the book chapters, so there is no printing cost involved. Affordability should not be a concern. • It should be a relatively simple matter to link AFCIc chapters into your curriculum, because the chapters are kept relatively straightforward and succinct.

You cannot go wrong if you try out at least a few chapters of AFCIc in this manner. ✓ You can receive permission to post the electronic AFCIc on your class website. (The website must be secured to allow only university-internal distribution.) Students can carry the files on their notebook computers with them. ✓ You can ask your copy center to print and bind the version on your website. You can also obtain a nicely printed and bound version for $40 from lulu.com. • Although versions on the AFCIc website at http://welch.econ.brown.edu/book will always have some improvements, it is a good idea for each class to agree on one definitive reference version.

✓ If you are using AFCIc and you are looking for lecture notes, feel free to “steal” and adapt my lecture notes (linked at http://welch.econ.brown.edu/book) to your liking. You can change and modify the lecture notes anyway you like, without copyright restrictions. ✓ Of course, I hope that the majority of your students (and you) will prefer reading AFCIc instead of your old textbook. At the end of the course, please ask your students which textbook they found more helpful. Please email your conclusions and impressions to [email protected]. Any suggestions for improvement are of course also very welcome. Any feedback would be appreciated, but it would be particularly helpful for me to learn in what respects they prefer their other textbook.

To The Instructor

This book is intentionally different.

Most corporate finance textbooks cover a similar canon of concepts, and this textbook is no exception. A quick glance at the Table of Contents will show you that most—though not all—of the topics in A First Course in Corporate Finance overlap with those in traditional finance textbooks. But this does not mean that this book is not different. Although I cover similar conceptual territory, there are also important departures. Innovations in Approach Here is my view of how this book differs from what is currently out there. I do not claim that other traditional textbooks do not teach any of what I will list, but I do maintain that my emphasis on these points is much stronger than what you will find elsewhere.

Conversational Tone.

Conversational Tone: The tone is more informal and conversational, which (I hope) makes the subject more accessible.

The method of instruction is “step-by-step numerical examples.”

Numerical-Example Based: I learn best by numerical example, and firmly believe that students do, too. Whenever I want to understand an idea, I try to construct numerical examples for myself (the simpler, the better). I do not particularly care for long algebra or complex formulas, precise though they may be. I do not much like many diagrams with long textual descriptions but no specific examples, either—I often find them too vague, and I am never sure whether I have really grasped the whole mechanism by which the concept works. Therefore, I wanted to write a textbook that relies on numerical examples as its primary tutorial method. This approach necessitates a rearrangement of the tutorial textbook progression. Most conventional finance textbooks start with a bird’s eye view and then work their way down. The fundamental difference of this book is that it starts with a worm’s eye view and works its way up. The organization is built around critical question like “What would it be worth?,” which is then answered in numerical step-by-step examples from first principles. Right under numerical computations are the corresponding symbolic formulas. In my opinion, this structure clarifies the meaning of these formulas, and is better than either an exclusively textual or algebraic exposition. I believe that the immediate duality of numerics with formulas will ultimately help students understand the material on a higher level and with more ease. (Of course, this book also provides some overviews, and ordinary textbooks also provide some numerical examples.)

Students should have a method of thinking, not just formulas.

Problem Solving: An important goal of this book is to teach students how to approach new problems that they have not seen before. Our goal should be send students into the real world with the analytical tools that allow them to disect new problems, and not just with a chest full of formulas. I believe that if students adopt the numerical example method—the “start simple and then generalize” method—they should be able to solve all sorts of new problems. It should allow them to figure out and perhaps even generalize the formulas that they learn in this book. Similarly, if students can learn how to verify others’ complex new claims with simple examples first, it will often help them to determine whether the emperor is wearing clothes.

We build a foundation first—so we are deeper!

Deeper, Yet Easier: I believe that formulaic memorization is ultimately not conducive to learning. In my opinion, such an alternative “canned formula” approach is akin to a house without a foundation. I believe that shoring up a poorly built house later is more costly than building it right to begin with. Giving students the methods of how to think about problems and then showing them how to develop the formulas themselves will make finance seem easier and simpler in the end, even if the coverage is conceptually deeper. In my case, when I haved learned new subjects, I have often found it especially frustrating if I understand a subject just a little but I also suspect that the pieces are really not all in place. A little knowledge can also be dangerous. If I do not understand where a formula comes from, how would I know

whether I can or cannot use it in a new situation? And I believe that even average students can understand the basic ideas of finance and where the formulas come from. Brevity: Sometimes, less is more. This book is intentionally concise, even though it goes into more theoretical detail than other books! Institutional descriptions are short. Only the concepts are explained in great detail. My view is that when students are exposed to too much material, they won’t read it, they won’t remember it, and they won’t know what is really important and what is not. Ten years after our students graduate, they should still solidly remember the fundamental ideas of finance, be able to look up the details when they need them, and be able to solve new (financial) problems. Many institutional details will have changed, anyway—it is the ideas, concepts, and tools that will last longer.

Brevity is important. The book focus is on explanations, not institutions.

Self-Contained for Clarity: Finance is a subject that every student can comprehend, regardless Self-contained means of background. It is no more difficult than economics or basic physics. But, it is often students can backtrack. a problem that many students come into class with a patchwork on knowledge. We, the instructors, then often erroneously believe the students have all the background covered. Along the way, such students get lost. It is easy to mistake such them for “poor students,” especially if there is no reference source, where they can quickly fill in the missing parts. In this book, I try to make each topic’s development self-contained. This means that I try to explain everything from first principles, but in a way that every student can find interesting. For example, even though the necessary statistical background is integrated in the book for the statistics novice, the statistics-savvy student also should find value in reading it. This is because statistics is different in our finance context than when it is taught for its own sake in a statistics course. Closer Correspondence with the Contemporary Curriculum: I believe that most finance core Less Chapter courses taught today follow a curriculum that is closer in spirit to this book—and more Reordering. logical—than it is to the order in older, traditional finance textbooks. In the places where this book covers novel material (see below), I hope that you will find that the new material has merit—and if you agree, that covering it is much easier with this book than with earlier books. Innovations in Particular Topics The book also offers a number of topical and expositional innovations. Here is a selection: Progression to Risk and Uncertainty: The book starts with a perfect risk-free world, then adds horizon-dependent interest rates, uncertainty under risk neutrality, imperfect market frictions (e.g., taxes), uncertainty under risk-aversion, and finally uncertainty under risk aversion and with taxes (e.g., WACC and APV). Frictions (Ch6): PV0 =

✒ Perfect World (Ch2): CF2 CF1 + + ··· PV0 = 1+r (1 + r )2

❅ ❅ ❅ ❘

 

Often Meaningless.  Various Modifications.

❅ ❅ ❘

Corporate Taxes (Ch18):

Uncertainty (Ch5): PV0 =

E (CF2 ) E (CF1 ) + +· · · 1 + E (˜ r1 ) 1 + E (˜ r0,2 )

✒

Horizon-Dependent Rates (Ch4): CF1 CF2 PV0 = + + ··· 1 + r0,1 1 + r0,2

First, no risk; then risk-neutral attitudes to risk; then risk-averse attitudes to risk.

❅

✲

PV0 =

❅ ❅ ❘

E (CF1,FM ) + ··· 1 + E (˜ r1,EQ ) + (1 − τ) · E (˜ r1,DT )

✒

Risk-Aversion (Part III): PV0 =

E (CF1 ) +··· 1 + r1,F + [E (˜ r1,M ) − r1,F ] · βi,M

Each step builds on concepts learned earlier. I believe it is an advantage to begin simply and then gradually add complexity. The unique roles of the more difficult concepts of risk

measurement, risk-aversion, and risk-aversion compensation then become much clearer. (There are some forward hints in the text that describe how the model will change when the world becomes more complex.) Drive home “default risk.”

A Strong Distinction between Expected and Promised Cash Flows: I have always been shocked by how many graduating students think that a Boston Celtics bond quotes 400 basis points in interest above a comparable Treasury bond because of the risk-premium, which they can calculate using the CAPM formula. Learning to avoid this fundamental error is more important than fancy theories: the main reason why the Boston Celtics bond promises 400 extra basis points is, of course, primarily its default risk (compensation for non-payment), not a risk-premium (compensation for risk-averse investors that comes from the correlation with the market rate of return). And for bonds, simple ICAPM-like equilibrium models suggest that the latter should be an order of magnitude smaller than the former. The CAPM itself can definitely not be used to claim a 400 basis point risk premmium. Although many instructors mention this difference at some point, 5 minutes of default risk discussion is often lost in 5 hours worth of CAPM discussion. But if students do not understand the basic distinction, the 5 hours of CAPM discussion are not just wasted but have only made matters worse. Traditional textbooks have not helped, because they have not sufficiently emphasized the distinction. In contrast, in this book, default risk is clearly broken out. The difference between quoted (promised) and expected returns, and quoted default compensation and risk compensation are important themes carried throughout.

Understand accounting without being an accounting textbook.

Financials from a Finance Perspective: Finance students need to solidly understand the relationship between financial statements and NPV. Although it is not bad if they also understand all the accounting nooks and crannies, it is more important that they understand the basic logic and relationship between finance and accounting. It is essential if they want to construct pro formas. Yet, when I was writing this book, I could not find good, concise, and self-contained explanations of the important aspects and logic of accounting statements from a finance perspective. Consequently, this book offers such a chapter. It does not just show students some financial statements and names the financial items; instead, it makes students understand how the NPV cash flows are embedded in the accounting statements. A fundamental understanding of financials is also necessary to understand comparables: for example, students must know that capital expenditures must be subtracted out if depreciation is not. (Indeed, the common use of EBITDA without a capital expenditures adjustment is often wrong. If we do not subtract out the pro-rated expense cost, we should subtract out the full expenses. Factories and the cash flows they produce do not fall from heaven.) Pro Formas: In any formal financial setting, professionals propose new projects—whether it is the expansion of a factory building within a corporation, or a new business for presentation to venture capitalists—through pro formas. A good pro forma is a combination of financial expertise, business expertise, and intuition. Both art and science go into its construction. The book’s final chapter, the capstone towards which the book works, is the creation of such a pro forma. It combines all the ingredients from earlier chapters— capital budgeting, taxes, the cost of capital, capital structure, and so on. Robustness: The book discusses the robustness of methods—the relative importance of errors and mistakes—and what first-order problems students should worry about and what second-order problems they can reasonably neglect. A Newer Perspective on Capital Structure: The academic perspective about capital structure has recently changed. A $1 million house that was originally financed by a 50% mortgage and then doubles in value now has only a 25% debt ratio. In analogous fashion, Chapter 20 shows how stock price movements have drastically changed the debt ratio of IBM from 2001 to 2003. Students can immediately eyeball the relative importance of market influences, issuing and other financial activities. The corporate market value changes are an important and robust factor determining capital structure—at least equal in magnitude to factors suggested in academic theories involving the pecking order or trade-offs. Moreover, we now know that most new equity shares appear in the context of M&A activity and

as executive compensation, not in the context of public equity offerings. Part IV of our book explains what the known first-order determinants of capital structure are, what the (important) second-order determinants are, and what the factors still under investigation are. Many Other Topical Improvements: For example, the yield curve gets its own (optional) chap- ...and many more. ter even before uncertainty is described in much detail, so that students understand that projects over different time horizons can offer different rates of return even in the absence of risk. There is a self-contained chapter on comparables as a valuation technique—a technique that many of our students will regularly have to use after they graduate. The corporate governance chapter has a perspective that is darker than it is in other textbooks. WACC, APV, and direct pro forma construction all incorporate the tax advantage of debt into valuation. This is bread-and-butter for CFOs. This book offers a clear explanation of how these methods usually come to similar results (and when not!). Throughout the book, I try to be open and honest about where our knowledge is solid and where it is shaky—and how sensitive our estimates are to the errors we inevitably commit. Although most of our curriculums are similar in their coverage of the basics, time constraints Webchapters will allow usually force us to exclude some topics. Your preferences as to what to cut may differ from a-la-carte choice. mine. For example, I find the financials part very important, because this is what most of our graduates will do when they become analysts, brokers, or consultants. However, you may instead prefer to talk more about international finance. It is of course impossible to satisfy everyone—and instructors have always chosen their own favorites, adding and deleting topics as they see fit. This book tries to accommodate some choice. Some chapters are available on the Web site (“Web Chapters”) accompanying this book. Chapter style and formatting are unmistakably identical to the book itself. Every instructor can therefore choose his/her own favorite selection and ask students to download it. These chapters are free and access is easy. The menu right now contains the following chapters: Real Options: Real options are briefly covered in Chapter 7 in the text, but not in great detail. This web chapter shows how to use spreadsheets, time-series analysis, Monte Carlo simulation, and optimization to determine the value of a plant that can shut down and reopen (for a cost) as output prices fluctuate. Option and Derivative Pricing: This is a difficult subject to cover in an introductory course, because it really requires a minimum of 4-6 class sessions to do it well. This chapter tries to help you cover the basics in 2 class sessions. It explains option contracts, static arbitrage relations (including put-call parity), dynamic arbitrage and the Black-Scholes formula, and binomial trees. International Finance: This chapter explains the role of currency translations and international market segmentation for both investments and corporate budgeting purposes. Ethics: This chapter is experimental—and provocative. There is neither a particular set of must-cover topics nor a template on how to present this material. Your choices and views may differ from mine. However, I believe that ethical considerations are too important for them never to be raised. Capital Structure Event Studies: This chapter describes the evidence (up-to-2003!) of how the stock market reacts to the announcements of new debt offerings, new equity offerings, and dividend payments. The title of the book is optimistic. A one-quarter course cannot cover the vast field that our profession has created over the last few decades. The book requires at least a one semester course, or, better yet, a full two-quarter sequence in finance—although I would recommend that the latter type of course sequence use the “general survey” version of this book, which goes into more detail in the investments part. I hope that this book will become your first choice in finance textbooks. If you do not like it, please drop me an email to let me know where it falls short. I would love to learn from you. (And even if I disagree, chances are that your comments will influence my next revision.)

SIDE NOTE If you use this book or some chapters therefrom, please permit me to use and post your homework and exam questions with answers. (Of course, this is not a requirement, only a plea for help.) My intent is for the Website to become collaborative: you will be able to see what other faculty do, and they can see what you do. The copyright will of course remain with you.

To The Student

Prerequisites This book and the subject itself are tough, but they are not forbidding, even to an average student. The main prerequisite is mathematical aptitude, but not mathematical sophistication.

What do you need to understand this book? You do not need any specific background in finance. You do need to be thoroughly comfortable with arithmetic and generally comfortable with algebra. You do need mathematical aptitude, but no knowledge of advanced mathematical constructs, such as calculus. Knowledge of statistics would be very helpful, but the book will explain the relevant concepts when the need arises. You should own a $20 scientific calculator. A financial calculator is not necessary and barely useful. Instead, you should learn how to operate a spreadsheet (such as Excel in Microsoft’s Office or the free OpenCalc spreadsheet in OpenOffice). The financial world is moving rapidly away from financial calculators and toward computer spreadsheets—it is easier to work with information on a large screen with a 2,000 MHz processor than on a small 2-line display with a 2MHz processor. Because I have tried hard to keep the book self-contained and to explain everything from first principles, you should not need to go hunting for details in statistics, economics, or accounting textbooks. But this is not to say that you do not need to take courses in these disciplines: they have way more to offer than just background knowledge for a finance textbook.

Jargon can trip up the reader.

One word of caution: the biggest problem for a novice of any field, but especially of finance, is jargon: the specialized terminology known only to the initiated. Worse, in finance, much jargon is ambiguous. Different people may use different terms for the same thing, and the same term may mean different things to different people. You have been warned! This book attempts to point out such ambiguous usage. Luckily, the bark of jargon is usually worse than its bite. It is only a temporary barrier to entry into the field of finance. How to Read The Book

This book is concise, focusing on the essence of arguments.

This textbook tries to be concise. It wants to communicate the essential material in a straightforward (and thus compact), but also conversational (and thus more interactive) and accessible fashion. There are already many finance textbooks with over a thousand pages. Much of the content of these textbooks is interesting and useful but not essential to an understanding of finance. (I personally find some of this extra content distracting.)

The layout of the book.

The book is organized into four parts: the basics consist of return computations and capital budgeting. Next are corporate financials, then investments (asset pricing), and financing (capital structure). Major sections within chapters end with questions that ask you to review the points just made with examples or questions similar to those just covered. You should not proceed beyond a section without completing these questions (and in “closed book” format)! Many, but not all, questions are easy and/or straightforward replications of problems that you will have just encountered in the chapter. Others are more challenging. Each chapter ends with answers to these review questions. Do not move on until you have mastered these review questions. (The published version of this book will contain many more student questions, and there will be a separate student testbank.)

There are “annotations” on the left side of most paragraphs throughout the text. Suggestion: This is an annotation. use the remaining white space in the margin to scribble your own notes, preferably in pencil so that you can revise them. Other notices.

IMPORTANT:

Especially important concepts that you should memorize are typeset like this.

“Side notes” and “digging deeper” notes can be safely omitted from reading without compromising understanding: Interesting, related points that either interrupt the flow of an argument or that are not absolutely necessary are marked like this. They are not crucial for understanding the material. They are usually not excessively technical.

SIDE NOTE

DIG DEEPER

“Digging-deeper notes” are more detailed technical points. They should be of interest only to the student who is interested in pursuing finance beyond the introductory course. They are often just curious facts or derivations that rely on excessive algebra.

Sometimes, an appendix contains further advanced material. A final warning: I have a strange sense of humor. Please do not be easily turned off.

Sense of Humor

Other Readings This book cannot do it all. It is important for you to keep up with current financial devel- Advice: Follow current opments. Frequent reading of the financial section of a major newspaper (such as the New coverage of financial topics elsewhere! York Times [N.Y.T.]), the Wall Street Journal [W.S.J.], or the Financial Times [F.T.] can help, as can regular consumption of good business magazines, such as The Economist or Business Week. (See the website at http://welch.econ.brown.edu/book for more useful resource links.) Although this is not a book on “how to read and understand the newspaper,” you should be able to understand most of the contents of the financial pages after consuming this textbook. You should also know how to cruise the web—sites such as Yahoo!Finance contain a wealth of useful financial information. Yahoo!Finance is also used extensively in this book.

Table of Contents I

Investments and Returns

1

Chapter 1: A Short Introduction 1·1 1·2 1·3 1·4

5

The Goal of Finance: Relative Valuation . . . . . How do Chief Financial Officers (CFOs) Decide? Learning How to Approach New Problems . . . . The Main Parts of This Book . . . . . . . . . . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

Chapter 2: The Time Value of Money 2·1

2·2 2·3

11

Basic Background and Definitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2·1.A.

Investments, Projects, and Firms

2·1.B.

Loans and Bonds

2·1.C.

U.S. Treasuries

2·5

14 14

Returns, Net Returns, and Rates of Return . . . . . . . . . . . . . . . . . . . . . . . . . . . . The Time Value of Money, Future Value, and Compounding . . . . . . . . . . . . . . . . . 2·3.A.

The Future Value (FV) of Money

18

2·3.B.

Compounding and Future Value

18

2·3.C.

How Bad Are Mistakes?

2·4.A.

Discount factors and present value (PV)

2·4.B.

Net Present Value (NPV)

3·2

3·3

15 17

21

Capital Budgeting, Present Values, and Net Present Values . . . . . . . . . . . . . . . . . .

23

23

27

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Chapter 3: More Time Value of Money 3·1

12

12

Interest Rates vs. Interest Quotes Confusion

2·4

6 7 8 9

30

35

Separating Investment Decisions and Present Values From Other Considerations . . . . 3·1.A.

Does It Matter When You Need Cash?

3·1.B.

Are Faster Growing Firms Better Bargains?

3·1.C.

Firm Value Today is “All Inflows” and “All Outflows”

36

36 37 38

Perpetuities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3·2.A.

The Simple Perpetuity Formula

3·2.B.

The Growing Perpetuity Formula

3·2.C.

Application: Stock Valuation with A Gordon Growth Model

39

39 41 42

The Annuity Formula . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3·3.A.

Application: Fixed-Rate Mortgage Payments

3·3.B.

Application: A Level-Coupon Bond

3·3.C.

Application: Projects With Different Lives and Rental Equivalents

44

44

45 48

3·4 3·5

Summary of Special Cash Flow Stream Formulas . . . . . . . . . . . . . . . . . . . . . . . . Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

50 52

A

Perpetuity and Annuity Derivations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

55

Chapter 4: Time-Varying Rates of Returns, Treasury Bonds, and The Yield Curve 4·1 4·2 4·3

4·4

Time-Varying Rates of Return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Annualized Rates of Return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The Yield Curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4·3.A.

An Example: The Yield Curve in May 2002

4·3.B.

Compounding With The Yield Curve

4·3.C.

Yield Curve Shapes

4·5

4·8

65

Valuing A Coupon Bond With A Particular Yield Curve

The Effect of Interest Rate Changes on Short-Term and Long-Term Bonds

Extracting Forward Interest Rates

4·7.B.

Shorting and Locking in Forward Interest Rates

4·7.C.

Bond Duration

4·7.D.

Continuous Compounding

5·2

5·3

5·4 5·5

76

78 82

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

An Introduction to Statistics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5·1.A.

Random Variables and Expected Values

5·1.B.

Risk-Neutrality (and Risk-Aversion Preview)

6·2

6·3

83

89 90

90 93

Interest Rates and Credit Risk (Default Risk) . . . . . . . . . . . . . . . . . . . . . . . . . . . 5·2.A.

Risk-Neutral Investors Demand Higher Promised Rates

5·2.B.

A More Elaborate Example With Probability Ranges

5·2.C.

Credit Ratings and Default Rates

5·2.D.

Preview: Differences in Expected Rates of Return?

5·2.E.

Credit Default Swaps

94

94

95

97 98

101

Uncertainty in Capital Budgeting, and Debt and Equity . . . . . . . . . . . . . . . . . . . . . 102 5·3.A.

Present Value With State-Contingent Payoff Tables

5·3.B.

Splitting Project Payoffs into Debt and Equity

102

105

How Bad are Mistakes?: The Robustness of the NPV Formula . . . . . . . . . . . . . . . . . 112 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114

Chapter 6: Dealing With Imperfect Markets 6·1

72 74

74

Chapter 5: Uncertainty, Default, and Risk 5·1

69

70

The Yield To Maturity (YTM) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Optional Bond Topics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4·7.A.

66

67

Why is the Yield Curve not Flat? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4·5.A.

4·6 4·7

62

64

Present Values With Time-Varying Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . 4·4.A.

57 58 59 62

121

Causes and Consequences of Imperfect Markets . . . . . . . . . . . . . . . . . . . . . . . . . 122 6·1.A.

Perfect Market Assumptions and Violations

6·1.B.

Application: How Perfect is the Market for PepsiCo Shares?

6·1.C.

Ambiguous Value in Imperfect Markets

6·1.D.

Some Imperfect Market Examples

6·1.E.

Do You Always Get What You Pay For?

6·1.F.

Social Value and Surplus

6·1.G.

Preview: Efficient Markets

122 123

124

125 125

126 126

The Effect of Disagreements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128 6·2.A.

Expected Return Differences vs. Promised Return Differences

6·2.B.

Corporate Finance vs. Entrepreneurial or Personal Finance

6·2.C.

Covenants, Collateral, and Credit Rating Agencies

128

129

130

Market Depth and Transaction Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131 6·3.A.

Typical Costs When Trading Real Goods—Real Estate

131

6·3.B.

Typical Costs When Trading Financial Goods—Stocks

133

6·4

6·5

6·6

6·7

6·8

6·3.C.

Transaction Costs in Returns and Net Present Values

6·3.D.

The Intrinsic Value of Liquidity

134

135

An Introduction to The Tax Code . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 136 6·4.A.

The Basics of (Federal) Income Taxes

6·4.B.

Before-Tax vs. After-Tax Expenses

6·4.C.

Average and Marginal Tax Rates

6·4.D.

Dividend and Capital Gains Taxes

6·4.E.

Other Taxes

6·4.F.

What You Need To Know About Taxation For This Book

136

139 139 140

142 142

Working With Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143 6·5.A.

Taxes in Rates of Returns

6·5.B.

Tax-Exempt Bonds and the Marginal Investor

6·5.C.

Taxes in Net Present Values

6·5.D.

Tax Timing

143 144

145

147

Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147 6·6.A.

Defining the Inflation Rate

6·6.B.

Real and Nominal Interest Rates

6·6.C.

Inflation in Net Present Values

6·6.D.

Interest Rates, The Yield Curve, and Inflation Expectations

148 149 150 152

Multiple Effects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 154 6·7.A.

How to Work Problems You Have Not Yet Encountered

6·7.B.

Taxes on Nominal Returns?

154

155

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 156

Chapter 7: Capital Budgeting Applications and Advice 7·1

7·2 7·3

7·4 7·5 7·6

The Economics of Project Interactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 164 7·1.A.

The Ultimate Project Selection Rule

7·1.B.

Project Pairs and Externalities

7·1.C.

One More Project: Marginal Rather Than Average Contribution

164

165 167

Expected, Typical, and Most Likely Scenarios . . . . . . . . . . . . . . . . . . . . . . . . . . . 172 Future Contingencies and Real Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 173 7·3.A.

A Basic Introduction

7·3.B.

More Complex Option Valuation in a Risk-Neutral World

7·3.C.

Decision Trees: One Set of Parameters

173

7·3.D.

Projects With Different Parameters

7·3.E.

Summary

174

175

179

181

Mental Biases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 183 Incentive (Agency) Biases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 185 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 189

Chapter 8: Some Other Capital Budgeting Methods 8·1 8·2

8·4

193

The Profitability Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 194 The Internal Rate of Return (IRR) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 195 8·2.A.

Definition

8·2.B.

Problems with IRR

8·2.C.

So Many Returns: The Internal Rate of Return, the Cost of Capital, the Hurdle Rate, and

195 196

the Expected Rate of Return

8·3

163

198

Other Capital Budgeting Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 199 8·3.A.

Payback and Its Problems

199

8·3.B.

More Real-World Choices

200

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200

II

Corporate Financials

203

Chapter 9: Understanding Financial Statements 9·1

207

Financial Statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 208 9·1.A.

The Contents of Financials

9·1.B.

PepsiCo’s 2001 Financials

9·1.C.

Why Finance and Accounting Think Differently

9·2

209 215 216

A Bottom-Up Example — Long-Term Accruals (Depreciation) . . . . . . . . . . . . . . . . . 218 9·2.A.

Doing Accounting

9·2.B.

Doing Finance

9·2.C.

Reverse-Engineering Accounting into Finance

9·2.D.

Accounting Nuances

9·3

218

220 222

224

A Bottom-Up Example — Short-Term Accruals . . . . . . . . . . . . . . . . . . . . . . . . . . 225 9·3.A.

9·4 9·5 9·6

Working Capital

225

Earnings Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 229 Extracting PV Cash Flows from PepsiCo’s Financials . . . . . . . . . . . . . . . . . . . . . . 230 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 234

A

Supplementary Financials — Coca Cola . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 239 a.

Coca Cola’s Financials From EdgarScan, Restated

b.

Coca Cola’s Financials From Yahoo!Finance, Not Restated

239 239

Chapter 10: Valuation From Comparables and Financial Ratios 10·1

Comparables and Net Present Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 244 10·1.A.

10·2

10·3

10·4

10·5

243

The Law of One Price

244

The Price-Earnings (P/E) Ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 247 10·2.A.

Definition

10·2.B.

Why P/E Ratios differ

10·2.C.

Empirical Evidence

247 248

251

Problems With P/E Ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 256 10·3.A.

Selection of Comparison Firms

10·3.B.

(Non-) Aggregation of Comparables

10·3.C.

Trailing Twelve Month (TTM) Figures and Other Adjustments

10·3.D.

Debt Adjustments For P/E Ratios

258 259 263

264

Other Financial Ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 266 10·4.A.

Valuation Ratios

10·4.B.

Non-Valuation Diagnostic Financial Ratios

266 269

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 274

III

Risk and the Opportunity Cost of Capital / Abbreviated Investments

279

Chapter 11: A First Look at Investments 11·1

283

Stocks, Bonds, and Cash, 1970–2004 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 284 11·1.A.

Graphical Representations of Historical Returns

11·1.B.

Historical Investment Performance of Individual Stocks and Asset Classes

11·1.C.

Comovement, Market-Beta, and Correlation

11·2

284 285

287

Historical Lessons . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 292 11·2.A.

11·3

History or Future?

293

Eggs and Baskets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 294 11·3.A.

How To Stack Your Overall Basket

11·3.B.

The Marginal Risk Contribution of One Egg

11·3.C.

The Market Equilibrium: The Price of Eggs

294 295 296

11·4

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 296

A

Some Background Information About Equities Market Microstructure . . . . . . . . . . . 298 a.

Brokers

b.

Exchanges and Non-Exchanges

c.

How Securities Appear and Disappear

298 298 300

Chapter 12: Investor Choice: Risk and Reward 12·1

12·2

Measuring Risk and Reward . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 304 12·1.A.

Measuring Reward: The Expected Rate of Return

12·1.B.

Measuring Risk: The Standard Deviation of the Rate of Return

12·4 12·5

306

Aggregate Investor Preferences: Only Risk and Reward

309

How To Measure Risk Contribution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 310 12·3.A.

An Investment’s own Risk is not a Good Measure for Risk Contribution To a Portfolio

12·3.B.

Beta Is a Good Measure for Risk Contribution to a Portfolio

12·3.C.

Computing Market Betas from Rates of Returns

12·3.D.

Covariance, Beta, and Correlation

12·3.E.

Interpreting Typical Stock Market Betas

315

316 317

Caution on Blind Trust in Statistical Formulas using Historical Data

321

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 323

Chapter 13: The Capital Asset Pricing Model 13·1 13·2

13·4

The Security Markets Line (SML)

329

The CAPM Cost of Capital in the Present Value Formula:Revisiting The Default Premium and Risk Premium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 332 Estimating the CAPM Inputs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 334 13·4.A. 13·4.B. 13·4.C.

13·5

327

What You Already Know And What You Want To Know . . . . . . . . . . . . . . . . . . . . 328 The Capital-Asset Pricing Model (CAPM) — A Cookbook Recipe Approach . . . . . . . . . 328 13·2.A.

13·3

310

312

Expected Rates of Return and Market-Betas For (Weighted) Portfolios and Firms . . . . . 318 Spreadsheet Calculations For Risk and Reward . . . . . . . . . . . . . . . . . . . . . . . . . 321 12·5.A.

12·6

304

Portfolios, Diversification, and Investor Preferences . . . . . . . . . . . . . . . . . . . . . . 307 12·2.A.

12·3

303

The Equity Premium [E (˜ rM − rF )]

334

The Risk-Free Rate (rF ) and Multi-Year Considerations Investment Projects’ Market Betas (βi,M )

338

338

Value Creation and Destruction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 343 13·5.A.

Does Risk-Reducing Corporate Diversification (or Hedging) Create Value?

13·5.B.

A Common Misuse of the CAPM: Using Badly Blended Cost-of-Capitals

13·5.C.

Differential Costs of Capital — Theory and Practice

347

344

346

13·6

Empirical Reality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 350 13·6.A.

Non-CAPM Worlds and Non-Linear SMLs

13·6.B.

Where Does the CAPM Work? Where Does it Not?

13·7 13·8

350 352

How Bad are Mistakes? Relative Robustness of CAPM Inputs . . . . . . . . . . . . . . . . . 354 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 355

A

Valuing Goods Not Priced at Fair Value via Certainty Equivalence . . . . . . . . . . . . . . 359 a.

Finding The True Value of A Good That is Not Fairly Priced

b.

An Application of the Certainty Equivalence Method: The CAPM Cost of Capital For a Non-Traded Good

360

362

Chapter 14: Optional: The Optimal Portfolio and The Efficient Frontier 14·1

14·2 14·3

367

An Investor’s Risk vs Reward Tradeoff . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 368 14·1.A.

A Short-Cut Formula For the Risk of a Portfolio

14·1.B.

Graphing the Mean-Variance Efficient Frontier

14·1.C.

Adding a Risk-Free Rate

369 370

373

The Mean-Variance Efficient Frontier and the CAPM Formula . . . . . . . . . . . . . . . . . 377 Simplifications and Perspective . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 379 14·3.A.

Harmless Simplifications

14·3.B.

Critical Simplifications

14·3.C.

The Arbitrage Pricing Theory — An Alternative?

379 379 381

14·4

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 382

A

More than Two Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 385

Chapter 15: Efficient Markets, Classical Finance, and Behavioral Finance 15·1 15·2

15·3

15·4

389

Arbitrage and Great Bets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 390 Market Efficiency and Behavioral Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 391 15·2.A.

Basic Definition and Requirements

15·2.B.

Classifications Of Market Efficiency Beliefs

15·2.C.

The Fundamentals Based Classification

15·2.D.

The Traditional Classification

391 393

393

396

Efficient Market Consequences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 397 15·3.A.

Stock Prices and Random Walks

15·3.B.

Are Fund Managers Just Monkeys on Typewriters?

15·3.C.

Corporate Consequences

15·3.D.

Event Studies Can Measure Instant Value Impacts

397 402

404 406

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 411

IV

Financing Choices / Capital Structure

415

Chapter 16: Corporate Financial Claims 16·1

16·2

16·3

16·4

16·5

421

The Basic Building Blocks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 422 16·1.A.

Bonds

16·1.B.

Ordinary Equity (Common Stock)

16·1.C.

Non-Financial Claims

16·1.D.

Debt and Equity as Contingent Claims

422 423

424 424

More About Corporate Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .