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Fundamentals of

Corporate Finance

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Richard A. Brealey London Business School

Stewart C. Myers Sloan School of Management, Massachusetts Institute of Technology

Alan J. Marcus Carroll School of Management, Boston College

Fundamentals of

Corporate Finance

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FUNDAMENTALS OF CORPORATE FINANCE, TENTH EDITION

Published by McGraw-Hill Education, 2 Penn Plaza, New York, NY 10121. Copyright ©2020 by McGraw-Hill Education. All rights reserved. Printed in the United States of America. Previous editions ©2018, 2015, and 2012. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of McGraw-Hill Education, including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning.

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ISBN 978-1-260-01396-2 (bound edition) MHID 1-260-01396-0 (bound edition) ISBN 978-1-260-70390-0 (loose-leaf edition) MHID 1-260-70390-8 (loose-leaf edition)

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Library of Congress Cataloging-in-Publication Data

Brealey, Richard A., author. | Myers, Stewart C., author. | Marcus, Alan J., author. Fundamentals for corporate finance / Richard A. Brealey, London Business School, Stewart C. Myers, Sloan School of Management, Massachusetts Institute of Technology, Alan J. Marcus, Carroll School of Management, Boston College. Tenth Edition. | Dubuque, IA : McGraw-Hill Education, [2019] | Revised edition of Fundamentals of corporate finance, [2018] | Includes bibliographical references and index. LCCN 2018047649 | ISBN 9781260013962 (student edition : alk. paper) LCSH: Corporations—Finance. LCC HG4026 .B6668 2019 | DDC 658.15—dc23 LC record available at https://lccn.loc.gov/2018047649

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To Our FamiliesDedication

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vi

Alan J. Marcus Mario Gabelli Professor of Finance in the Carroll School of Management at Boston College Professor Marcus’s main research interests are in derivatives and securities markets. He is co-author (with Zvi Bodie and Alex Kane) of the texts Investments and Essentials of Investments (McGraw-Hill Education). Professor Marcus has served as a research fellow at the National Bureau of Economic Research. Professor Marcus also spent two years at Freddie Mac, where he helped to develop mortgage pricing and credit risk models. He currently serves on the Research Foundation Advisory Board of the CFA Institute.

Stewart C. Myers Gordon Y Billard Professor of Finance at MIT’s Sloan School of Management Dr. Myers is past president of the American Finance Association and a research associate of the National Bureau of Economic Research. His research has focused on financing decisions, valuation methods, the cost of capital, and financial aspects of government regulation of business. Dr. Myers is a director of The Brattle Group, Inc. and is active as a financial consultant. He is also the author (with Professor Brealey and Franklin Allen) of this book’s sister text, Principles of Corporate Finance (McGraw-Hill Education).

Richard A. Brealey Professor of Finance at the London Business School Professor Brealey is the former president of the European Finance Association and a former director of the American Finance Association. He is a fellow of the British Academy and has served as Special Adviser to the Governor of the Bank of England and as director of a number of financial institutions. Professor Brealey is also the author (with Professor Myers and Franklin Allen) of this book’s sister text, Principles of Corporate Finance (McGraw-Hill Education).

The AuthorsAbout

Courtesy of Richard A. Brealey

Courtesy of Stewart C. Myers

Courtesy of Alan J. Marcus

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vii

This book is an introduction to corporate finance. It focuses on how companies invest in real assets, how they raise the money to pay for the investments, and how those assets ultimately affect the value of the firm. It also provides a broad overview of the financial landscape, discussing, for example, the major players in financial markets, the role of financial institutions in the economy, and how securities are traded and valued by investors. The book offers a framework for systematically thinking about most of the important financial problems that both firms and individuals are likely to confront.

Financial management is important, interesting, and challenging. It is important because today’s capital investment decisions may determine the businesses that the firm is in 10, 20, or more years ahead. Needless to say, a firm’s success or failure also depends, in large part, on its ability to find the capital that it requires.

Finance is interesting for several reasons. Financial decisions often involve huge sums of money. Large investment projects or acquisitions may involve billions of dol- lars. Also, the financial community is international and fast-moving, with colorful heroes and a sprinkling of unpleasant villains.

Finance is challenging. Financial decisions are rarely cut and dried, and the finan- cial markets in which companies operate are changing rapidly. Good managers can cope with routine problems, but only the best managers can respond to change. To handle new problems, you need more than rules of thumb; you need to understand why companies and financial markets behave as they do and when common practice may not be best practice. Once you have a consistent framework for making financial decisions, complex problems become more manageable.

This book provides that framework. It is not an encyclopedia of finance. It focuses instead on setting out the basic principles of financial management and applying them to the main decisions faced by the financial manager. It explains how managers can make choices between investments that may pay off at different points of time or have different degrees of risk. It also describes the main features of financial markets and discusses why companies may prefer a particular source of finance.

We organize the book around the key concepts of modern finance. These concepts, properly explained, simplify the subject. They are also practical. The tools of financial management are easier to grasp and use effectively when presented in a consistent conceptual framework. This text provides that framework.

Modern financial management is not “rocket science.” It is a set of ideas that can be made clear by words, graphs, and numerical examples. The ideas provide the “why” behind the tools that good financial managers use to make investment and financing decisions.

We wrote this book to make financial management clear, useful, and fun for the beginning student. We set out to show that modern finance and good financial practice go together, even for the financial novice.

Fundamentals and Principles of Corporate Finance

This book is derived in part from its sister text Principles of Corporate Finance. The spirit of the two books is similar. Both apply modern finance to give students a work- ing ability to make financial decisions. However, there are also substantial differences between the two books.

Preface

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viii Preface

First, we provide in Fundamentals much more detailed discussion of the princi- ples and mechanics of the time value of money. This material underlies almost all of this text, and we spend a lengthy chapter providing extensive practice with this key concept.

Second, we use numerical examples in this text to a greater degree than in Principles. Each chapter presents several detailed numerical examples to help the reader become familiar and comfortable with the material.

Third, we have streamlined the treatment of most topics. Whereas Principles has 34 chapters, Fundamentals has only 25. The relative brevity of Fundamentals neces- sitates a broader-brush coverage of some topics, but we feel that this is an advantage for a beginning audience.

Fourth, we assume little in the way of background knowledge. While most users will have had an introductory accounting course, we review the concepts of account- ing that are important to the financial manager in Chapter 3.

Principles is known for its relaxed and informal writing style, and we continue this tradition in Fundamentals. In addition, we use as little mathematical notation as possible. Even when we present an equation, we usually write it in words rather than symbols. This approach has two advantages. It is less intimidating, and it focuses attention on the underlying concept rather than the formula.

Organizational Design Fundamentals is organized in eight parts.

Part 1 (Introduction) provides essential background material. In the first chap- ter, we discuss how businesses are organized, the role of the financial manager, and the financial markets in which the manager operates. We explain how share- holders with many disparate goals might all agree that they want managers to take actions that increase the value of their investment, and we introduce the concept of the opportunity cost of capital and the trade-off that the firm needs to make when assessing investment proposals. We also describe some of the mechanisms that help to align the interests of managers and shareholders. Of course, the task of increasing shareholder value does not justify corrupt and unscrupulous behavior. We, therefore, discuss some of the ethical issues that confront managers.

Chapter 2 surveys and sets out the functions of financial markets and institutions. This chapter also reviews the crisis of 2007–2009. The events of those years illustrate clearly why and how financial markets and institutions matter.

A large corporation is a team effort, so the firm produces financial statements to help the players monitor its progress. Chapter 3 provides a brief overview of these financial statements and introduces two key distinctions—between market and book values and between cash flows and profits. This chapter also discusses some of the shortcomings in accounting practice. The chapter concludes with a summary of fed- eral taxes.

Chapter 4 provides an overview of financial statement analysis. In contrast to most introductions to this topic, our discussion is motivated by considerations of valuation and the insight that financial ratios can provide about how management has added to the firm’s value.

Part 2 (Value) is concerned with valuation. In Chapter 5, we introduce the concept of the time value of money, and because most readers will be more familiar with their own financial affairs than with the big leagues of finance, we motivate our discussion by looking first at some personal financial decisions. We show how to value long-lived

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Preface ix

streams of cash flows and work through the valuation of perpetuities and annuities. Chapter 5 also contains a short concluding section on inflation and the distinction between real and nominal returns.

Chapters 6 and 7 introduce the basic features of bonds and stocks and give stu- dents a chance to apply the ideas of Chapter 5 to the valuation of these securities. We show how to find the value of a bond given its yield, and we show how prices of bonds fluctuate as interest rates change. We look at what determines stock prices and how stock valuation formulas can be used to infer the return that investors expect. Finally, we see how investment opportunities are reflected in the stock price and why analysts focus on the price-earnings multiple. Chapter 7 also introduces the concept of market efficiency. This concept is crucial to interpreting a stock’s valuation; it also provides a framework for the later treatment of the issues that arise when firms issue securities or make decisions concerning dividends or capital structure.

The remaining chapters of Part 2 are concerned with the company’s investment decision. In Chapter 8, we introduce the concept of net present value and show how to calculate the NPV of a simple investment project. We then consider more complex investment proposals, including choices between alternative projects, machine replace- ment decisions, and decisions of when to invest. We also look at other measures of an investment’s attractiveness—its internal rate of return, profitability index, and payback period. We show how the profitability index can be used to choose between invest- ment projects when capital is scarce. The appendix to Chapter 8 shows how to sidestep some of the pitfalls of the IRR rule.

The first step in any NPV calculation is to decide what to discount. Therefore, in Chapter 9, we work through a realistic example of a capital budgeting analysis, show- ing how the manager needs to recognize the investment in working capital and how taxes and depreciation affect cash flows.

We start Chapter 10 by looking at how companies organize the investment process and ensure everyone works toward a common goal. We then go on to look at various techniques to help managers identify the key assumptions in their estimates, such as sensitivity analysis, scenario analysis, and break-even analysis. We explain the distinction between accounting break-even and NPV break-even. We conclude the chapter by describing how managers try to build future flexibil- ity into projects so that they can capitalize on good luck and mitigate the conse- quences of bad luck.

Part 3 (Risk) is concerned with the cost of capital. Chapter 11 starts with a historical survey of returns on bonds and stocks and goes on to distinguish between the specific risk and market risk of individual stocks. Chapter 12 shows how to measure market risk and discusses the relationship between risk and expected return. Chapter 13 intro- duces the weighted-average cost of capital and provides a practical illustration of how to estimate it.

Part 4 (Financing) begins our discussion of the financing decision. Chapter 14 pro- vides an overview of the securities that firms issue and their relative importance as sources of finance. In Chapter 15, we look at how firms issue securities, and we follow a firm from its first need for venture capital, through its initial public offering, to its continuing need to raise debt or equity.

Part 5 (Debt and Payout Policy) focuses on the two classic long-term financ- ing decisions. In Chapter 16, we ask how much the firm should borrow, and we summarize bankruptcy procedures that occur when firms can’t pay their debts. In

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x Preface

Chapter 17, we study how firms should set dividend and payout policy. In each case, we start with Modigliani and Miller’s (MM’s) observation that in well- functioning markets, the decision should not matter, but we use this initial obser- vation to help the reader understand why financial managers in practice do pay attention to these decisions.

Part 6 (Financial Analysis and Planning) starts with long-term financial plan- ning in Chapter 18, where we look at how the financial manager considers the com- bined effects of investment and financing decisions on the firm as a whole. We also show how measures of internal and sustainable growth help managers check that the firm’s planned growth is consistent with its financing plans. Chapter 19 is an introduction to short-term financial planning. It shows how managers ensure that the firm will have enough cash to pay its bills over the coming year. Chapter 20 addresses working capital management. It describes the basic steps of credit man- agement, the principles of inventory management, and how firms handle payments efficiently and put cash to work as quickly as possible. It also describes how firms invest temporary surpluses of cash and how they can borrow to offset any temporary deficiency. Chapter 20 is conceptually straightforward, but it contains a large dollop of institutional material.

Part 7 (Special Topics) covers several important but somewhat more advanced topics—mergers (Chapter 21), international financial management (Chapter 22), options (Chapter 23), and risk management (Chapter 24). Some of these topics are touched on in earlier chapters. For example, we introduce the idea of options in Chapter 10, when we show how companies build flexibility into capital proj- ects. However, Chapter 23 generalizes this material, explains at an elementary level how options are valued, and provides some examples of why the financial manager needs to be concerned about options. International finance is also not confined to Chapter 22. As one might expect from a book that is written by an international group of authors, examples from different countries and finan- cial systems are scattered throughout the book. However, Chapter 22 tackles the specific problems that arise when a corporation is confronted by different currencies.

Part 8 (Conclusion) contains a concluding chapter (Chapter 25), in which we review the most important ideas covered in the text. We also introduce some interesting ques- tions that either were unanswered in the text or are still puzzles to the finance profes- sion. Thus, the last chapter is an introduction to future finance courses as well as a conclusion to this one.

Routes through the Book There are about as many effective ways to organize a course in corporate finance as there are teachers. For this reason, we have ensured that the text is modular so that top- ics can be introduced in different sequences.

We like to discuss the principles of valuation before plunging into financial plan- ning. Nevertheless, we recognize that many instructors will prefer to move directly from Chapter 4 (Measuring Corporate Performance) to Chapter 18 (Long-Term Financial Planning) in order to provide a gentler transition from the typical prerequisite accounting course. We have made sure that Part 6 (Financial Analysis and Planning) can easily follow Part 1.

Similarly, we like to discuss working capital only after the student is familiar with the basic principles of valuation and financing, but we recognize that here also

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Preface xi

many instructors prefer to reverse our order. There should be no difficulty in taking Chapter 20 out of order.

When we discuss project valuation in Part 2, we stress that the opportunity cost of capital depends on project risk. But we do not discuss how to measure risk or how return and risk are linked until Part 3. This ordering can easily be modified. For exam- ple, the chapters on risk and return can be introduced before, after, or midway through the material on project valuation.

Changes in the Tenth Edition

Users of previous editions of this book will not find dramatic changes in either the material or the ordering of topics. But, throughout, we have made the book more up to date and easier to read. Here are some of the ways that we have done this.

Beyond the Page The Beyond the Page digital extensions and applications provide additional examples, anecdotes, spreadsheet programs, and more thoroughgoing explanations of some topics. This material is very easily accessed on the web. In this edition, we have updated them and added a number of additional applications and made them easier to access. For example, the applications are seamlessly available with a click on the e-version of the book, but they are also readily accessible in the traditional hard copy of the text using the shortcut URLs provided in the margins of relevant pages.

Improving the Flow A major part of our effort in revising this text was spent on improving the flow. Often this has meant a word change here or a redrawn diagram there, but sometimes we have made more substantial changes. One example is the dis- cussion of discounted cash flow analysis in Chapter 9. Rather than presenting a series of disconnected examples, we now illustrate the many aspects of cash flow analysis in one integrated application. The material is substantially unchanged, but we think that the flow is much improved.

Updating Major updates in this edition revolved around the implications of recent tax reform legislation. The Tax Cuts and Jobs Act of 2017 mandated substantial changes in corporate and personal tax rates as well as in the tax treatment of depre- ciation and investment income. All of these changes potentially affect firms’ capital budgeting and financing decisions.

Of course, in each new edition we also try to ensure that any statistics are as up to date as possible. For example, since the previous edition, we have available an extra 2 years of data on security returns. These show up in the figures in Chapter 11 of the long-run returns on stocks, bonds, and bills. Measures of EVA, data on security ownership, dividend payments, and stock repurchases are just a few of the other cases where data have been brought up to date.

New Illustrative Boxes The text contains a number of boxes with illustra- tive real-world examples. Many of these are new. Look, for example, at the box in Chapter 2 that describes prediction markets and what they had to say about the 2016 presidential election. Or look at the box in Chapter 15 that shows how the JOBS Act of 2012 cleared the way for companies to use crowd- funding to raise up to $50 million from small investors who wish to invest in start-up firms.

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xii Preface

More Worked Examples We have added more worked examples in the text, many of them taken from real companies.

Specific Chapter Changes in the Tenth Edition Here are a few of the additions to chapter material:

Chapter 1 contains updated and timely examples of real capital expenditure deci- sions by major corporations.

Chapter 2 includes a discussion of prediction markets in the most recent presiden- tial election.

Chapter 3 includes updated discussions of recent changes in tax law. Chapter 6 includes a new Finance in Practice box to show how to find bond infor-

mation on the web. Chapter 7 provides new evidence on efficient markets and some of the anomalies

literature. Chapter 9 now illustrates cash flow analysis in one integrated, extended

example. It also discusses and provides several examples of the impact of accelerated depreciation and immediate expensing on the value of a capital investment.

Chapter 14 now includes more coverage of alternative sources of cash as well as extended treatment of the variety of corporate debt.

Chapter 16 reconsiders the present value of interest tax shields at the new, lower, corporate tax rate.

Chapter 20 introduces the components of working capital and the determinants of the cash cycle. It then looks briefly at each of the components including short- term debt. It provides updated discussions on recent trends in the United States concerning investments in working capital.

Chapter 21 features numerous updates to our coverage of the market for corporate control, for example, GE’s divestment of major sectors of the firm, recent activ- ist investor initiatives, and tax inversion strategies in the wake of recent changes to tax law.

Assurance of Learning Assurance of learning is an important element of many accreditation standards. Fundamentals of Corporate Finance, Tenth Edition, is designed specifically to sup- port your assurance-of-learning initiatives. Each chapter in the book begins with a list of numbered learning objectives, which are referred to in the end-of-chap- ter problems and exercises. Every test bank question is also linked to one of these objectives, in addition to level of difficulty, topic area, Bloom’s Taxonomy level, and AACSB skill area. Connect, McGraw-Hill’s online homework solution, and EZ Test, McGraw-Hill’s easy-to-use test bank software, can search the test bank by these and other categories, providing an engine for targeted assurance-of-learning analysis and assessment.

AACSB Statement McGraw-Hill Education is a proud corporate member of AACSB International. Understanding the importance and value of AACSB accreditation, Fundamentals of Corporate Finance, Tenth Edition, has sought to recognize the curricula guidelines detailed in the AACSB standards for business accreditation by connecting selected questions in the test bank to the general knowledge and skill guidelines found in the AACSB standards.