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Essentials of Corporate Finance

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The McGraw-Hill Education Series in Finance, Insurance, and Real Estate

FINANCIAL MANAGEMENT Block, Hirt, and Danielsen Foundations of Financial Management Seventeenth Edition

Brealey, Myers, and Allen Principles of Corporate Finance Thirteenth Edition

Brealey, Myers, and Allen Principles of Corporate Finance, Concise Second Edition

Brealey, Myers, and Marcus Fundamentals of Corporate Finance Tenth Edition

Brooks FinGame Online 5.0

Bruner, Eades, and Schill Case Studies in Finance: Managing for Corporate Value Creation Eighth Edition

Cornett, Adair, and Nofsinger Finance: Applications and Theory Fifth Edition

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Higgins Analysis for Financial Management Twelfth Edition

Ross, Westerfield, Jaffe, and Jordan Corporate Finance Twelfth Edition

Ross, Westerfield, Jaffe, and Jordan Corporate Finance: Core Principles and Applications Fifth Edition

Ross, Westerfield, and Jordan Essentials of Corporate Finance Tenth Edition

Ross, Westerfield, and Jordan Fundamentals of Corporate Finance Twelfth Edition

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Stephen A. Ross

Randolph W. Westerfield University of Southern California

Bradford D. Jordan University of Kentucky

Essentials of Corporate Finance

Tenth Edition

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ESSENTIALS 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 © 2017, 2014, and 2011. 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.

Some ancillaries, including electronic and print components, may not be available to customers outside the United States.

This book is printed on acid-free paper.

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ISBN 978-1-260-01395-5 MHID 1-260-01395-2

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All credits appearing on page or at the end of the book are considered to be an extension of the copyright page.

Library of Congress Cataloging-in-Publication Data

Ross, Stephen A., author. | Westerfield, Randolph W., author. |  Jordan, Bradford D., author.  Essentials of corporate finance / Stephen A. Ross, Massachusetts  Institute of Technology, Randolph W. Westerfield, University of Southern  California, Bradford D. Jordan, University of Kentucky.  Tenth edition. | New York, NY : McGraw-Hill Education, [2020] |  Includes index.  LCCN 2018056010 | ISBN 9781260013955 (student edition : alk. paper)  LCSH: Corporations—Finance.  LCC HG4026 .R676 2020 | DDC 658.15—dc23  LC record available at https://lccn.loc.gov/2018056010

The Internet addresses listed in the text were accurate at the time of publication. The inclusion of a website does not indicate an endorsement by the authors or McGraw-Hill Education, and McGraw-Hill Education does not guarantee the accuracy of the information presented at these sites.

mheducation.com/highered

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About the Authors

Stephen A. Ross

Stephen A. Ross was 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 was widely recognized for his work in develop- ing the Arbitrage Pricing Theory and his substantial contributions to the discipline through his research in signaling, 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 also served as an associate editor of several academic and practitioner journals. He was a trustee of CalTech. He died suddenly in March 2017.

Randolph W. Westerfield 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 Emeritus. Professor West- erfield came to USC from the Wharton School, University of Pennsylvania, where he was the chair- man of the finance department and member of the finance faculty for 20 years. He is a member of the Board of Trustees of Oak Tree Capital Mutual Funds. His areas of expertise include corporate financial policy, investment management, and stock market price behavior.

Bradford D. Jordan Gatton College of Business and Economics, University of Kentucky

Bradford D. Jordan is Professor of Finance and holder of the duPont Endowed Chair in Banking and Financial Services. 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 finan- cial management policy. Professor Jordan has published numerous articles on issues such as cost of capital, capital structure, and the behavior of security prices. He is a past president of the Southern Finance Association and is coauthor of Fundamentals of Investments: Valuation and Management, 8th edition, a leading investments text, also published by McGraw-Hill Education.

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From the Authors

W hen we first wrote Essentials of Corporate Finance, we thought there might be a small niche for a briefer book that really focused on what students with widely varying backgrounds and interests needed to carry away from an introductory finance course. We were wrong. There was a huge niche! What we learned is that our text closely matches the needs of instructors and faculty at hundreds of schools across the country. As a result, the growth we have experienced through the first nine editions of Essentials has far exceeded anything we thought possible.

With the tenth edition of Essentials of Corporate Finance, we have continued to refine our focus on our target audience, which is the undergraduate student taking a core course in busi- ness or corporate finance. This can be a tough course to teach. One reason is that the class is usually required of all business students, so it is not uncommon for a majority of the students to be nonfinance majors. In fact, this may be the only finance course many of them will ever have. With this in mind, our goal in Essentials is to convey the most important concepts and principles at a level that is approachable for the widest possible audience.

To achieve our goal, we have worked to distill the subject down to its bare essentials (hence, the name of this book), while retaining a decidedly modern approach to finance. We always have maintained that the subject of corporate finance can be viewed as the workings of a few very powerful intuitions. We also think that understanding the “why” is just as important, if not more so, than understanding the “how”—especially in an introductory course. Based on the gratifying market feedback we have received from our previous editions, as well as from our other text, Fundamentals of Corporate Finance (now in its twelfth edition), many of you agree.

By design, this book is not encyclopedic. As the table of contents indicates, we have a total of 18 chapters. Chapter length is about 30 pages, so the text is aimed squarely at a single-term course, and most of the book can be realistically covered in a typical semester or quarter. Writ- ing a book for a one-term course necessarily means some picking and choosing, with regard to both topics and depth of coverage. Throughout, we strike a balance by introducing and covering the essentials (there’s that word again!) while leaving some more specialized topics to follow-up courses.

The other things we always have stressed, and have continued to improve with this edition, are readability and pedagogy. Essentials is written in a relaxed, conversational style that invites the students to join in the learning process rather than being a passive information absorber. We have found that this approach dramatically increases students’ willingness to read and learn on their own. Between larger and larger class sizes and the ever-growing demands on faculty time, we think this is an essential (!) feature for a text in an introductory course.

Throughout the development of this book, we have continued to take a hard look at what is truly relevant and useful. In doing so, we have worked to downplay purely theoretical issues and minimize the use of extensive and elaborate calculations to illustrate points that are either intuitively obvious or of limited practical use.

As a result of this process, three basic themes emerge as our central focus in writing Essentials of Corporate Finance:

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An Emphasis on Intuition We always try to separate and explain the principles at work on a commonsense, intuitive level before launching into any specifics. The underlying ideas are discussed first in very general terms and then by way of examples that illustrate in more concrete terms how a financial manager might proceed in a given situation.

A Unified Valuation Approach We treat net present value (NPV) as the basic concept underlying corporate finance. Many texts stop well short of consistently integrating this important principle. The most basic and important notion, that NPV represents the excess of market value over cost, often is lost in an overly mechanical approach that emphasizes computation at the expense of comprehension. In contrast, every subject we cover is firmly rooted in valuation, and care is taken throughout to explain how particular decisions have valuation effects.

A Managerial Focus Students shouldn’t lose sight of the fact that financial management concerns management. We emphasize the role of the financial manager as decision maker, and we stress the need for managerial input and judgment. We consciously avoid “black box” approaches to finance, and, where appropriate, the approximate, pragmatic nature of finan- cial analysis is made explicit, possible pitfalls are described, and limitations are discussed.

Today, as we prepare once again to enter the market, our goal is to stick with and build on the principles that have brought us this far. However, based on an enormous amount of feed- back we have received from you and your colleagues, we have made this edition and its package even more flexible than previous editions. We offer flexibility in coverage and pedagogy by pro- viding a wide variety of features in the book to help students learn about corporate finance. We also provide flexibility in package options by offering the most extensive collection of teaching, learning, and technology aids of any corporate finance text. Whether you use just the textbook, or the book in conjunction with other products, we believe you will find a combination with this edition that will meet your needs.

Randolph W. Westerfield Bradford D. Jordan

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Organization of the Text

W e designed Essentials of Corporate Finance to be as flexible and modular as possible. There are a total of nine parts, and, in broad terms, the instructor is free to decide the particular sequence. Further, within each part, the first chapter generally contains an over- view and survey. Thus, when time is limited, subsequent chapters can be omitted. Finally, the sections placed early in each chapter are generally the most important, and later sections frequently can be omitted without loss of continuity. For these reasons, the instructor has great control over the topics covered, the sequence in which they are covered, and the depth of coverage.

Just to get an idea of the breadth of coverage in the tenth edition of Essentials, the fol- lowing grid presents for each chapter some of the most significant new features, as well as a few selected chapter highlights. Of course, in every chapter, figures, opening vignettes, boxed features, and in-chapter illustrations and examples using real companies have been thoroughly updated as well. In addition, the end-of-chapter material has been completely revised.

Chapters Selected Topics Benefits to Users

PART ONE Overview of Financial Management

Chapter 1 New opener discussing Uber

Updated Finance Matters box on corporate ethics

Describes ethical issues in the context of mortgage fraud, offshoring, and tax havens.

Updated information on executive and celebrity compensation

Highlights important developments regarding the very current question of appropriate executive compensation.

Updated Work the Web box on stock quotes

Goal of the firm and agency problems Stresses value creation as the most fundamental aspect of management and describes agency issues that can arise.

Ethics, financial management, and executive compensation

Brings in real-world issues concerning conflicts of interest and current controversies surrounding ethical conduct and management pay.

New proxy fight example involving Trian Partners and Procter & Gamble

New takeover battle discussion involving Verizon and Yahoo!

PART TWO Understanding Financial Statements and Cash Flow

Chapter 2 New opener discussing the Tax Cuts and Jobs Act of 2017 Cash flow vs. earnings Clearly defines cash flow and spells out the differences

between cash flow and earnings. Market values vs. book values Emphasizes the relevance of market values over book values. New discussion of corporate taxes in light of the TCJA

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Chapters Selected Topics Benefits to Users

Chapter 3 Additional explanation of alternative formulas for sustainable and internal growth rates

Expanded explanation of growth rate formulas clears up a common misunderstanding about these formulas and the circumstances under which alternative formulas are correct.

Updated opener on PE ratios Updated examples on Amazon vs. Alibaba Updated Work the Web box on financial ratios

Discusses how to find and analyze profitability ratios.

Updated Finance Matters box on financial ratios

Describes how to interpret ratios.

PART THREE Valuation of Future Cash Flows

Chapter 4 First of two chapters on time value of money

Relatively short chapter introduces just the basic ideas on time value of money to get students started on this traditionally difficult topic.

Updated Finance Matters box on collectibles

Chapter 5 Second of two chapters on time value of money

Covers more advanced time value topics with numerous examples, calculator tips, and Excel spreadsheet exhibits. Contains many real-world examples.

Updated opener on professional athletes’ salaries

Provides a real-world example of why it’s important to properly understand how to value costs incurred today versus future cash inflows.

Updated Finance Matters box on lotteries

Updated Finance Matters box on student loans

PART FOUR Valuing Stocks and Bonds

Chapter 6 New opener on negative interest on various sovereign bonds

Discusses the importance of interest rates and how they relate to bonds.

Bond valuation Thorough coverage of bond price/yield concepts. Updated bond features example using Sprint issue Interest rates and inflation Highly intuitive discussion of inflation, the Fisher effect, and

the term structure of interest rates. Updated “fallen angels” example using Teva Pharmaceuticals issue “Clean” vs. “dirty” bond prices and accrued interest

Clears up the pricing of bonds between coupon payment dates and also bond market quoting conventions.

Updated Treasury quotes exhibit and discussion Updated historic interest rates figure FINRA’s TRACE system and transparency in the corporate bond market

Up-to-date discussion of new developments in fixed income with regard to price, volume, and transactions reporting.

“Make-whole” call provisions Up-to-date discussion of relatively new type of call provision that has become very common.

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Chapters Selected Topics Benefits to Users

Chapter 7 Stock valuation Thorough coverage of constant and nonconstant growth models. Updated opener on difference in dividend payouts Updated discussion of the NYSE, including its acquisition by ICE and rising role of technology of the floor

Up-to-date description of major stock market operations.

Updated Finance Matters box on the OTCBB and the Pink Sheets markets

PART FIVE Capital Budgeting

Chapter 8 Updated opener on GE’s “Ecomagination” program

Illustrates the growing importance of “green” business.

First of two chapters on capital budgeting Relatively short chapter introduces key ideas on an intuitive level to help students with this traditionally difficult topic.

NPV, IRR, MIRR, payback, discounted payback, and accounting rate of return

Consistent, balanced examination of advantages and disadvantages of various criteria.

Chapter 9 Project cash flow Thorough coverage of project cash flows and the relevant numbers for a project analysis.

New opener on project failures and successes Shows the importance of properly evaluating net present value. New discussion of bonus depreciation Scenario and sensitivity “what-if” analyses Illustrates how to actually apply and interpret these tools in a

project analysis.

PART SIX Risk and Return Chapter 10 Updated opener on stock market

performance Discusses the relationship between risk and return as it relates to personal investing.

Capital market history Extensive coverage of historical returns, volatilities, and risk premiums.

Market efficiency Efficient markets hypothesis discussed along with common misconceptions.

Geometric vs. arithmetic returns Discusses calculation and interpretation of geometric returns. Clarifies common misconceptions regarding appropriate use of arithmetic vs. geometric average returns.

Updated Finance Matters box on professional fund management and performance

Chapter 11 Diversification, systematic, and unsystematic risk

Illustrates basics of risk and return in a straightforward fashion.

Updated opener on stock price reactions to announcements Updated beta coefficients exhibit and associated discussion

Develops the security market line with an intuitive approach that bypasses much of the usual portfolio theory and statistics.

New discussion of alpha

PART SEVEN Long-Term Financing

Chapter 12 Cost of capital estimation Intuitive development of the WACC and a complete, web- based illustration of cost of capital for a real company.

Updated WACC calculations for Eastman Geometric vs. arithmetic growth rates Both approaches are used in practice. Clears up issues

surrounding growth rate estimates.

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Chapters Selected Topics Benefits to Users

Updated section on company valuation with the WACC

Explores the difference between valuing a project and valuing a company.

Chapter 13 Basics of financial leverage Illustrates effect of leverage on risk and return. Optimal capital structure Describes the basic trade-offs leading to an optimal capital

structure. New chapter opener on Tax Cuts and Jobs Act New discussion of the effects of the TCJA on corporate taxes Financial distress and bankruptcy Briefly surveys the bankruptcy process.

Chapter 14 Updated opener with Apple dividend announcement

Raises questions about why raising dividends and repurchasing stock would please investors.

Updated figures on aggregate dividends, stock repurchases, and proportion of firms paying dividends

Brings students the latest thinking and evidence on dividend policy.

Dividends and dividend policy Describes dividend payments and the factors favoring higher and lower payout policies. Includes recent survey results on setting dividend policy.

Updated examples and Finance Matters box covering buyback activity

Explores the reasons that buybacks are gaining in popularity now, following the recent recession.

Chapter 15 IPO valuation Extensive, up-to-date discussion of IPOs, including the 1999–2000 period and the recent Alibaba IPO.

Dutch auctions Explains uniform price (“Dutch”) auctions using Google IPO as an example.

New subsection on crowdfunding Discusses the JOBS Act and crowdfunding. New subsection on initial coin offerings New discussion of direct listing Updated tables and figures on IPO initial returns and number of offerings

PART EIGHT Short-Term Financial Management

Chapter 16 Operating and cash cycles Stresses the importance of cash flow timing. Short-term financial planning Illustrates the creation of cash budgets and the potential

need for financing. Updated Finance Matters box discussing operating and cash cycles

Explores how comparing the cash cycles of companies can reveal whether a company is performing well.

Chapter 17 Cash collection and disbursement Examination of systems used by firms to handle cash inflows and outflows.

Credit management Analysis of credit policy and implementation. Inventory management Brief overview of important inventory concepts.

PART NINE Topics in Business Finance

Chapter 18 New opener on corporate cash held in international accounts

Raises questions about how currency appreciation affects the broader economy.

Foreign exchange Covers essentials of exchange rates and their determination. International capital budgeting Shows how to adapt the basic DCF approach to handle

exchange rates. Updated discussion of exchange rates and political risk

Discusses hedging and issues surrounding sovereign risk.

New discussion of the Tax Cuts and Jobs Act

Discusses how U.S. legislation changes the way that corporations manage their profits to minimize taxes.

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Learning Solutions

I n addition to illustrating relevant concepts and presenting up-to-date coverage, Essentials of Corporate Finance strives to present the material in a way that makes it engaging and easy to understand. To meet the varied needs of the intended audience, Essentials of Corpo- rate Finance is rich in valuable learning tools and support.

Each feature can be categorized by the benefit to the student:

■ Real financial decisions ■ Application tools ■ Study aids

! CHAPTER-OPENING VIGNETTES Each chapter begins with a contemporary real-world event to introduce students to chapter concepts.

" FINANCE MATTERS BOXES Most chapters include at least one Finance Matters box, which takes a chapter issue and shows how it is being used right now in every- day financial decision making.

Exotic Bonds

Bonds come in many flavors. The unusual types are called “exotics” and can range from the fairly simple to the truly esoteric. Take the case of mortgage-backed securities (MBSs). MBSs are a type of securitized financial instrument. In securitization, cash flows from financial assets are pooled together into securities, and the securities are sold to inves- tors. With an MBS, banks or mortgage brokers who originate mortgages sell the mortgages to a trust. The trust pools the mortgages and sells bonds to investors. Bondholders re- ceive payments based on the mortgage payments made by homeowners. During 2008, problems with MBSs skyrock- eted due to the precipitous drop in real estate values and the sharply increased default rates on the underlying mortgages.

The reverse convertible is a relatively new type of structured note. One type generally offers a high coupon rate, but the redemption at maturity can be paid in cash at par value or paid in shares of stock. For example, one recent General Motors (GM) reverse convertible had a coupon rate of 16 percent, which is a very high coupon rate in today’s in- terest rate environment. However, at maturity, if GM’s stock declined sufficiently, bondholders would receive a fixed number of GM shares that were worth less than par value. So, while the income portion of the bond return would be high, the potential loss in par value easily could erode the extra return.

CAT bonds are issued to cover insurance companies against natural catastrophes. The type of natural catastro- phe is outlined in the bond. For example, about 30 percent of all CAT bonds protect against a North Atlantic hurricane. The way these issues are structured is that the borrowers can suspend payment temporarily (or even permanently) if they have significant hurricane-related losses. These CAT bonds may seem like pretty risky investments, but, to date, only five have not been paid in full. Because of Hurricane Katrina, CAT bondholders lost $190 million. CAT bondhold- ers also lost $300 million due to the 2011 tsunami in Japan. During 2011, two other CAT bond issues, each worth $100 million, were triggered due to an unusually active tornado season, and a CAT bond was triggered due to the 2017 earthquake in Mexico. This bond was issued on August 4th and the earthquake occurred on September 7th.

Perhaps the most unusual bond (and certainly the most ghoulish) is the “death bond.” Companies such as Stone Street Financial purchase life insurance policies from indi- viduals who are expected to die within the next 10 years. They then sell bonds that are paid off from the life insurance proceeds received when the policyholders die. The return on the bonds to investors depends on how long the policyhold- ers live. A major risk is that if medical treatment advances quickly, it will raise the life expectancy of the policyholders, thereby decreasing the return to the bondholder.

FINANCE MATTERS

Generally, when you make an investment, you expect that you will get back more money in the future than you invested today. But in December 2017, this wasn’t the case for many bond investors.

The yield on a 5-year German government bond was about negative

.20 percent, and the yields on 2-year and 5-year Japanese govern-

ment bonds were negative .14 percent and negative .09 percent, re-

spectively. In fact, in 2016, the amount of debt worldwide that had a

negative yield reached a record $13.4 trillion! And negative yields

were not restricted to government bonds, as at one point the yield on

a bond issued by chocolate maker Nestlé was negative as well.

So what happened? Central banks were in a race to the bot-

tom, lowering interest rates in an attempt to improve their domestic

economies.

This chapter takes what we have learned about the time value

of money and shows how it can be used to value one of the most

common of all financial assets, a bond. It then discusses bond fea-

Interest Rates and Bond Valuation6

LEARNING OBJECTIVES After studying this chapter, you should be able to:

LO 1 Identify important bond features and types of bonds.

LO 2 Describe bond values and why they fluctuate.

LO 3 Discuss bond ratings and what they mean.