First national bank charges 10.1 percent compounded monthly

Essentials of Corporate Finance

ros13952_fm_i-xxxvi.indd 1 1/4/19 12:19 PM

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

Cornett, Adair, and Nofsinger M: Finance Fourth Edition

DeMello Cases in Finance Third Edition

Grinblatt (editor) Stephen A. Ross, Mentor: Influence through Generations Grinblatt and Titman Financial Markets and Corporate Strategy Second Edition

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

Shefrin Behavioral Corporate Finance: Decisions that Create Value Second Edition

INVESTMENTS Bodie, Kane, and Marcus Essentials of Investments Eleventh Edition

Bodie, Kane, and Marcus Investments Eleventh Edition

Hirt and Block Fundamentals of Investment Management Tenth Edition

Jordan, Miller, and Dolvin Fundamentals of Investments: Valuation and Management Eighth Edition

Stewart, Piros, and Heisler Running Money: Professional Portfolio Management First Edition

Sundaram and Das Derivatives: Principles and Practice Second Edition

FINANCIAL INSTITUTIONS AND MARKETS Rose and Hudgins Bank Management and Financial Services Ninth Edition

Rose and Marquis Financial Institutions and Markets Eleventh Edition

Saunders and Cornett Financial Institutions Management: A Risk Management Approach Ninth Edition

Saunders and Cornett Financial Markets and Institutions Seventh Edition

INTERNATIONAL FINANCE Eun and Resnick International Financial Management Eighth Edition

REAL ESTATE Brueggeman and Fisher Real Estate Finance and Investments Sixteenth Edition

Ling and Archer Real Estate Principles: A Value Approach Fifth Edition

FINANCIAL PLANNING AND INSURANCE Allen, Melone, Rosenbloom, and Mahoney Retirement Plans: 401(k)s, IRAs, and Other Deferred Compensation Approaches Twelfth Edition

Altfest Personal Financial Planning Second Edition

Harrington and Niehaus Risk Management and Insurance Second Edition

Kapoor, Dlabay, Hughes, and Hart Focus on Personal Finance: An Active Approach to Help you Achieve Financial Literacy Sixth Edition

Kapoor, Dlabay, Hughes, and Hart Personal Finance Thirteenth Edition

Walker and Walker Personal Finance: Building Your Future Second Edition

ros13952_fm_i-xxxvi.indd 2 1/4/19 12:19 PM

Stephen A. Ross

Randolph W. Westerfield University of Southern California

Bradford D. Jordan University of Kentucky

Essentials of Corporate Finance

Tenth Edition

ros13952_fm_i-xxxvi.indd 3 1/4/19 12:19 PM

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.

1 2 3 4 5 6 7 8 9 0 LWI 21 20 19

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

Portfolio Manager: Charles Synovec Product Developers: Michele Janicek, Jennifer Upton Marketing Manager: Trina Maurer Content Project Managers: Daryl Horrocks, Jill Eccher, Jamie Koch Buyer: Sandy Ludovissy Design: Matt Diamond Content Licensing Specialist: Melissa Homer Cover Image: ©vladitto/Shutterstock Compositor: MPS Limited

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

ros13952_fm_i-xxxvi.indd 4 1/4/19 12:19 PM

v

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.

ros13952_fm_i-xxxvi.indd 5 1/4/19 12:19 PM

vi

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:

ros13952_fm_i-xxxvi.indd 6 1/4/19 12:19 PM

vii

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

ros13952_fm_i-xxxvi.indd 7 1/4/19 12:19 PM

viii

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

ros13952_fm_i-xxxvi.indd 8 1/4/19 12:19 PM

ix

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.

ros13952_fm_i-xxxvi.indd 9 1/4/19 12:19 PM

x

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.

ros13952_fm_i-xxxvi.indd 10 1/4/19 12:19 PM

xi

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.

ros13952_fm_i-xxxvi.indd 11 1/4/19 12:19 PM

xii

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.

LO 4 Evaluate the impact of inflation on interest rates.

LO 5 Explain the term structure of interest rates and the determinants of bond yields.

PART FOUR Valuing Stocks and Bonds

REAL FINANCIAL DECISIONS We have included two key features that help students connect chapter concepts to how decision makers use this material in the real world.

ros13952_fm_i-xxxvi.indd 12 1/4/19 12:19 PM

xiii

! WORK THE WEB These in-chapter boxes show students how to research financial issues using the web and how to use the information they find to make business decisions. All the Work the Web boxes also include interactive follow-up questions and exercises.

! CHAPTER CASES Located at the end of most chapters, these cases focus on hypothetical company situations that embody corporate finance topics. Each case presents a new scenario, data, and a dilemma. Several questions at the end of each case require students to analyze and focus on all of the material they learned from the chapters in that part. These are great for homework or in-class exercises and discussions!

Most of the information is self-explanatory. The Price and Yield columns show the price and yield to maturity of the issues based on their most recent sales. If you need more information about a particular issue, clicking on it will give you more details such as coupon dates and call dates.

QUESTIONS 1. Go to this website and find the last bond shown in the accompanying table. When was

this bond issued? What was the size of the bond issue? What were the yield to maturity and price when the bond was issued?

2. When you search for Chevron bonds (CVX), you will find bonds for several companies listed. Why do you think Chevron has bonds issued with different corporate names?

W R K T H E W E B

Bond quotes have become more available with the rise of the web. One site where you can find current bond prices (from TRACE) is finra-markets.morningstar.com/BondCenter. We went to the site and entered “AZO” for AutoZone, the well-known auto parts company. We found a total of 10 bond issues outstanding. Here you see the information we pulled up.

EXPLANATORY WEB LINKS ► These web links are provided in the margins of the text. They are specifically selected to accompany text material and provide students and instructors with a quick way to check for additional information using the internet.

Bond Price Reporting In 2002, transparency in the corporate bond market began to improve dramatically. Under new regulations, corporate bond dealers are now required to report trade information through what is known as the Trade Reporting and Compliance Engine (TRACE). A nearby Work the Web box shows how to get TRACE prices.

As we mentioned before, the U.S. Treasury market is the largest securities market in the world. As with bond markets in general, it is an OTC market, so there is limited transpar ency. However, unlike the situation with bond markets in general, trading in Treasury issues, particularly recently issued ones, is very heavy. Each day, representative prices for outstand- ing Treasury issues are reported.

Figure 6.3 shows a portion of the daily Treasury note and bond listings from The Wall Street Journal online. The only difference between a Treasury note and a Treasury bond is that notes have 10 years or less to maturity at the time of issuance. The entry that begins “5/15/2030” is highlighted. Reading from left to right, the “5/15/2030” tells us that the bond’s maturity is May 15, 2030. The 6.250 is the bond’s coupon rate. Treasury bonds all make semiannual payments

To learn more about TRACE, visit www.finra .org.

To purchase newly issued corporate bonds, go to www.incapital.com.

204 P A R T 4 Valuing Stocks and Bonds

Although Chris is aware of the bond features, he is uncertain as to the costs and benefits of some features, so he isn’t clear on how each feature would affect the coupon rate of the bond issue. You are Renata’s assis- tant, and she has asked you to prepare a memo to Chris describing the effect of each of the following bond fea- tures on the coupon rate of the bond. She also would like you to list any advantages or disadvantages of each feature.

Mark Sexton and Todd Story, the owners of S&S Air, have decided to expand their operations. They in- structed their newly hired financial analyst, Chris Guthrie, to enlist an underwriter to help sell $20 million in new 10-year bonds to finance construction. Chris has entered into discussions with Renata Harper, an underwriter from the firm of Crowe & Mallard, about which bond features S&S Air should consider and what coupon rate the issue will likely have.

CHAPTER CASE Financing S&S Air’s Expansion Plans with a Bond Issue

1. The security of the bond—that is, whether the bond has collateral.

2. The seniority of the bond. 3. The presence of a sinking fund. 4. A call provision with specified call dates and call

prices.

5. A deferred call accompanying the preceding call provision.

6. A make-whole call provision.

7. Any positive covenants. Also, discuss several possible positive covenants S&S Air might consider.

8. Any negative covenants. Also, discuss several possible negative covenants S&S Air might consider.

9. A conversion feature (note that S&S Air is not a publicly traded company).

10. A floating rate coupon.

Q U E S T I O N S

APPLICATION TOOLS Because there is more than one way to solve prob- lems in corporate finance, we include many sections that encourage students to learn or brush up on dif- ferent problem-solving methods, including financial calculator and Excel spreadsheet skills.

ros13952_fm_i-xxxvi.indd 13 1/4/19 12:19 PM

xiv

WHAT’S ON THE WEB? ► These end-of-chapter activities show students how to use and learn from the vast amount of financial resources available on the internet.

EXCEL MASTER ICONS ► Topics covered in the comprehensive Excel Master supplement (found in Connect) are indicated by an icon in the margin.

SPREADSHEET STRATEGIES ► The unique Spreadsheet Strategies feature is also in a self-contained section, showing students how to set up spreadsheets to solve problems—a vital part of every business student’s education.

6.1 Bond Quotes You can find current bond prices at finra-markets.morningstar.com/ BondCenter. You want to find the bond prices and yields for bonds issued by Pfizer. Enter the ticker symbol “PFE” to do a search. What is the shortest-maturity bond issued by Pfizer that is outstanding? What is the longest-maturity bond? What is the credit rating for Pfizer’s bonds? Do all of the bonds have the same credit rating? Why do you think this is?

6.2 Yield Curves You can find information regarding the most current bond yields at money.cnn.com. Go there and graph the yield curve for U.S. Treasury bonds. What is

WHAT’S ON THE WEB?

BONDS AND BOND VALUATION When a corporation (or government) wishes to borrow money from the public on a long- term basis, it usually does so by issuing, or selling, debt securities that are generically called bonds. In this section, we describe the various features of corporate bonds and some of the terminology associated with bonds. We then discuss the cash flows associated with a bond and how bonds can be valued using our discounted cash flow procedure.

6.1

coverage online

Excel Master

HOW TO CALCULATE BOND PRICES AND YIELDS USING A SPREADSHEET Like financial calculators, most spreadsheets have fairly elaborate routines available for calculating bond values and yields; many of these routines involve details that we have not discussed. However, setting up a simple spreadsheet to calculate prices or yields is straightforward, as our next two spreadsheets show:

SPREADSHEET STRATEGIES

A B C D E F G H 1 2 Using a spreadsheet to calculate bond yields 3 4 Suppose we have a bond with 22 years to maturity, a coupon rate of 8 percent, and a price of 5 $960.17. If the bond makes semiannual payments, what is its yield to maturity? 6 7 Settlement date: 1/1/00 8 Maturity date: 1/1/22 9 Annual coupon rate: .08 10 Bond price (% of par): 96.017 11 Face value (% of par): 100 12 Coupons per year: 2 13 Yield to maturity: .084 14

$ CALCULATOR HINTS Calculator Hints is a self-contained section occurring in various chapters that first introduces students to calculator basics and then illustrates how to solve problems with the calculator. Appendix D goes into more detailed instructions by solving problems with two specific calculators.

$ EXCEL SIMULATIONS Indicated by an Excel icon next to applicable end-of-chapter ques- tions and problems, Excel simulation exercises are available for selected problems in Connect. For even more spreadsheet practice, check out Excel Master, also available in Connect.

HOW TO CALCULATE BOND PRICES AND YIELDS USING A FINANCIAL CALCULATOR Many financial calculators have fairly sophisticated built-in bond valuation routines. However, these vary quite a lot in implementation, and not all financial calculators have them. As a result, we will illustrate a simple way to handle bond problems that will work on just about any financial calculator.

To begin, of course, we first remember to clear out the calculator! Next, for Example 6.3, we have two bonds to consider, both with 12 years to maturity. The first one sells for $935.08 and has a 10 per- cent coupon rate. To find its yield, we can do the following:

Enter 12 100 −935.08 1,000

I/ Y

Solve for 11

Notice that here we have entered both a future value of $1,000, representing the bond’s face value, and a payment of 10 percent of $1,000, or $100, per year, representing the bond’s annual coupon. Also notice that we have a negative sign on the bond’s price, which we have entered as the present value.

For the second bond, we now know that the relevant yield is 11 percent. It has a 12 percent coupon

CALCULATOR HINTS

INTERMEDIATE (Questions 18–33)

18. Bond Price Movements. Bond X is a premium bond making semiannual payments. The bond has a coupon rate of 7.5 percent, a YTM of 6 percent, and 13 years to maturity. Bond Y is a discount bond making semiannual payments. This bond has a coupon rate of 6 percent, a YTM of 7.5 percent, and also 13 years to maturity. What are the prices of these bonds today assuming both bonds have a $1,000 par value? If interest rates remain unchanged, what do you expect the prices of these bonds to be in one year? In three years? In eight years? In 12 years? In 13 years? What’s going on here? Illustrate your answers by graphing bond prices versus time to maturity.

19. Interest Rate Risk. Both Bond Bill and Bond Ted have 5.8 percent coupons, make semiannual payments, and are priced at par value. Bond Bill has 5 years to maturity, whereas Bond Ted has 25 years to maturity. If interest rates suddenly rise by 2 percent, what is the percentage change in the price

LO 2

LO 2

ros13952_fm_i-xxxvi.indd 14 1/4/19 12:19 PM

xv

! LEARNING OBJECTIVES Each chapter begins with a number of learning objectives that are key to the student’s understanding of the chapter. Learn- ing objectives also are linked to end-of-chapter problems and test bank questions.

CRITICAL THINKING QUESTIONS ► Every chapter ends with a set of critical thinking questions that challenge the students to apply the concepts they learned in the chapter to new situations.

! PEDAGOGICAL USE OF COLOR We continue to use a full-color palette in Essen- tials not only to make the text more inviting, but, more important, as a functional element to help students follow the discussion. In almost every chapter, color plays an important, largely self- evident role.

$ CONCEPT QUESTIONS Chapter sections are intentionally kept short to promote a step-by-step, building-block approach to learning. Each sec- tion is then followed by a series of short concept questions that highlight the key ideas just presented. Students use these questions to make sure they can identify and understand the most important concepts as they read.

What do professional athletes Alex Avila, Yu Darvish, and Jimmy Garoppolo have in common? All three signed big contracts in 2018. The contract values were reported as $8.25 mil

lion, $126 million, and $137.5 million, respectively. That’s definitely

major league money, but, even so, reported numbers like these can

be misleading. For example, in January 2018, Avila signed with the

Arizona Diamondbacks. His contract called for a salary of $4 million

in 2018 and $4.25 million for 2019. Not bad, especially for someone

who makes a living using the “tools of ignorance” ( jock jargon for a

catcher’s equipment).

A closer look at the numbers shows that Alex, Yu, and Jimmy

did pretty well, but nothing like the quoted figures. Using Yu’s

contract as an example, although the value was reported to be

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

LO 1 Determine the future value and present value of investments with multiple cash flows.

LO 2 Calculate loan payments, and find the interest rate on a loan.

LO 3 Describe how loans are amortized or paid off.

LO 4 Explain how interest rates are quoted (and misquoted).

CRITICAL THINKING AND CONCEPTS REVIEW LO 2 14.1 Dividend Policy Irrelevance. How is it possible that dividends are so

important, but, at the same time, dividend policy is irrelevant?

LO 4 14.2 Stock Repurchases. What is the impact of a stock repurchase on a company’s debt ratio? Does this suggest another use for excess cash?

LO 1 14.3 Life Cycle Theory of Dividends. Explain the life cycle theory of dividend payments. How does it explain corporate dividend payments that are seen in the stock market?

LO 1 14.4 Dividend Chronology. On Friday, December 8, Hometown Power Co.’s board of directors declares a dividend of 75 cents per share payable on Wednesday, January 17, to shareholders of record as of Wednesday, January 3. When is the ex-dividend date? If a shareholder buys stock before that date, who gets the dividends on those shares, the buyer or the seller?

LO 1 14.5 Alternative Dividends. Some corporations, like one British company that offers its large shareholders free crematorium use, pay dividends in kind (i.e., offer their services to shareholders at below-market cost). Should mutual funds invest in stocks that pay these dividends in kind? (The fundholders do not receive these services.)

14.6 Dividends and Stock Price. If increases in dividends tend to be followed

Thursday, January

15

Declaration date

Wednesday, January

28

Ex-dividend date

Friday, January

30

Record date

Monday, February

16

Payment date

1. Declaration date: The board of directors declares a payment of dividends. 2. Ex-dividend date: A share of stock goes ex dividend on the date the seller

is entitled to keep the dividend; under NYSE rules, shares are traded ex dividend on and after the second business day before the record date.

3. Record date: The declared dividends are distributable to those who are shareholders of record as of this specific date.

4. Payment date: The dividend checks are mailed to shareholders of record.

Example of the procedure for dividend payment

FIGURE 14.1

CONCEPT QUESTIONS

6.1a What are the cash flows associated with a bond? 6.1b What is the general expression for the value of a bond? 6.1c Is it true that the only risk associated with owning a bond is that the issuer will not

make all the payments? Explain.

STUDY AIDS We want students to get the most from this book and this course, and we realize that students have different learning styles and study needs. We there- fore present a number of study features to appeal to a wide range of students.

ros13952_fm_i-xxxvi.indd 15 1/4/19 12:19 PM

xvi

$ NUMBERED EXAMPLES Separate numbered and titled examples are extensively integrated into the chapters. These examples provide detailed applications and illustrations of the text material in a step-by- step format. Each example is completely self-contained so that students don’t have to search for additional information. Based on our classroom testing, these examples are among the most useful learning aids because they provide both detail and explanation.

EXAMPLE 11.4 Portfolio Variance and Standard Deviation

In Example 11.3, what are the standard deviations on the two portfolios? To answer, we first have to calculate the portfolio returns in the two states. We will work with the second portfolio, which has 50 percent in Stock A and 25 percent in each of Stocks B and C. The relevant calculations can be summarized as follows:

State of Economy

Probability of State

Returns

Stock A Stock B Stock C

Boom .40 10% 15% 20% Bust .60 8 4 0

SUMMARY TABLES ► These tables succinctly restate key principles, results, and equations. They appear whenever it is useful to emphasize and summarize a group of related concepts.

I. Internal growth rate

Internal growth rate = ROA × b ___________ 1 − ROA × b

where ROA = Return on assets = Net income/Total assets b = Plowback (retention) ratio = Addition to retained earnings/Net income = 1 - Dividend payout ratio The internal growth rate is the maximum growth rate that can be achieved with no external financing of any kind.

II. Sustainable growth rate

Sustainable growth rate = ROE × b ___________ 1 − ROE × b

where ROE = Return on equity = Net income/Total equity b = Plowback (retention) ratio = Addition to retained earnings/Net income = 1 – Dividend payout ratio The sustainable growth rate is the maximum growth rate that can be achieved with no external equity financing while maintaining a constant debt-equity ratio.

Summary of internal and sustainable growth rates

TABLE 3.9

$ KEY TERMS These are printed in blue the first time they appear and are defined within the text and in the margin.

RATIO ANALYSIS Another way of avoiding the problems involved in comparing companies of different sizes is to calculate and compare financial ratios. Such ratios are ways of comparing and investigat- ing the relationships between different pieces of financial information. We cover some of the more common ratios next, but there are many others that we don’t touch on.

One problem with ratios is that different people and different sources frequently don’t compute them in exactly the same way, and this leads to much confusion. The specific defi- nitions we use here may or may not be the same as ones you have seen or will see elsewhere. If you are ever using ratios as a tool for analysis, you should be careful to document how you

3.2

coverage online

Excel Master

financial ratios Relationships determined from a firm’s financial information and used for

KEY EQUATIONS ► These are called out in the text and iden- tified by equation numbers. Appendix B shows the key equations by chapter.

$ HIGHLIGHTED PHRASES Throughout the text, important ideas are presented separately and printed in boxes to indicate their importance to the students.

Maximize the market value of the existing owners’ equity.

Total Debt Ratio The total debt ratio takes into account all debts of all maturities to all creditors. It can be defined in several ways, the easiest of which is:

Total debt ratio = Total assets - Total equity

__________________ Total assets [3.4]

= $3,630 - 2,625

______________ $3,630 = .28 times

In this case, an analyst might say that Prufrock uses 28 percent debt.1 Whether this is high or low or whether it even makes any difference depends on whether or not capital structure matters, a subject we discuss in a later chapter.

Prufrock has $.28 in debt for every $1 in total assets. Therefore, there is $.72 in equity (= $1 − .28) for every $.28 in debt. With this in mind, we can define two useful variations on the total debt ratio, the debt-equity ratio and the equity multiplier:

Debt-equity ratio = Total debt/Total equity [3.5] = $.28/$!.72 = .!38 times

Equity multiplier = Total assets / Total equity [3.6] = $1 / $.72 = 1.38 times

The fact that the equity multiplier is 1 plus the debt-equity ratio is not a coincidence:

Equity multiplier = Total assets / Total equity = $1 / $.72 = 1.38 times = (Total equity + Total debt)/ Total equity = 1 + Debt-equity ratio = 1.38 times

The thing to notice here is that given any one of these three ratios, you can immediately calculate the other two, so they all say exactly the same thing.

Times Interest Earned Another common measure of long-term solvency is the times interest earned (TIE) ratio. Once again, there are several possible (and common) definitions, but we’ll stick with the most traditional:

Times interest earned ratio = EBIT _______ Interest [3.7]

= $741 _____ $141 = 5.26 times

As the name suggests, this ratio measures how well a company has its interest obligations covered, and it is often called the interest coverage ratio. For Prufrock, the interest bill is covered 5.26 times over.

ros13952_fm_i-xxxvi.indd 16 1/4/19 12:19 PM

xvii

CHAPTER SUMMARY AND CONCLUSIONS " These paragraphs review the chapter’s key points and provide closure to the chapter.

SUMMARY AND CONCLUSIONS This chapter has described how to go about putting together a discounted cash flow analysis and evaluating the results. In it, we covered:

1. The identification of relevant project cash flows. We discussed project cash flows and described how to handle some issues that often come up, including sunk costs, opportunity costs, financing costs, net working capital, and erosion.

2. Preparing and using pro forma, or projected, financial statements. We showed how pro forma financial statement information is useful in coming up with projected cash flows.

3. The use of scenario and sensitivity analysis. These tools are widely used to evaluate the impact of assumptions made about future cash flows and NPV estimates.

$ CHAPTER REVIEW AND SELF-TEST PROBLEMS Review and self-test problems appear after the chapter summaries. Detailed answers to the self-test problems im- mediately follow. These questions and answers allow students to test their abilities in solving key problems related to the content of the chapter. These problems are mapped to similar problems in the end-of-chapter mate- rial. The aim is to help students work through difficult problems using the authors’ work as an example.

CHAPTER REVIEW AND SELF-TEST PROBLEMS 9.1 Calculating Operating Cash Flow. Mater Pasta, Inc., has projected a sales

volume of $1,432 for the second year of a proposed expansion project. Costs normally run 70 percent of sales, or about $1,002 in this case. The depreciation expense will be $80, and the tax rate is 22 percent. What is the operating cash flow? (See Problem 9.)

9.2 Scenario Analysis. A project under consideration costs $500,000, has a five-year life, and has no salvage value. Depreciation is straight-line to zero. The required return is 15 percent, and the tax rate is 21 percent. Sales are projected at 400 units per year. Price per unit is $3,000, variable cost per unit is $1,900, and fixed costs are $250,000 per year. No net working capital is required.

Suppose you think the unit sales, price, variable cost, and fixed cost projections are accurate to within 5 percent. What are the upper and lower bounds for these pro- jections? What is the base-case NPV? What are the best- and worst-case scenario NPVs? (See Problem 21.)

END-OF-CHAPTER QUESTIONS AND PROBLEMS ► We have found that many students learn better when they have plenty of opportunity to practice. We therefore provide extensive end-of-chapter questions and problems linked to Learning Objectives. The questions and problems are generally separated into three levels—Basic, Intermediate, and Challenge. All problems are fully annotated so that students and instructors can readily identify particular types. Throughout the text, we have worked to supply interesting problems that illustrate real-world applications of chapter material. Answers to selected end-of- chapter problems appear in Appendix C.

QUESTIONS AND PROBLEMS

BASIC (Questions 1–22)

1. Calculating Payback. What is the payback period for the following set of cash flows?

Year Cash Flow

0 −$7,800 1 3,100 2 3,200 3 2,200 4 1,400

2. Calculating Payback. An investment project provides cash inflows of $865 per year for eight years. What is the project payback period if the initial cost is $3,100? What if the initial cost is $4,300? What if it is $7,900?

3. Calculating Payback. Stenson, Inc., imposes a payback cutoff of three years for its international investment projects. If the company has the following two projects available, should it accept either of them?

LO 1

LO 1

LO 1

Select problems are available in McGraw-Hill Connect. Please see the pack- aging options section of the preface for more information.

ros13952_fm_i-xxxvi.indd 17 1/4/19 12:19 PM

You’re in the driver’s seat. Want to build your own course? No problem. Prefer to use our turnkey, prebuilt course? Easy. Want to make changes throughout the semester? Sure. And you’ll save time with Connect’s auto-grading too.

They’ll thank you for it. Adaptive study resources like SmartBook® help your students be better prepared in less time. You can transform your class time from dull definitions to dynamic debates. Hear from your peers about the benefits of Connect at www.mheducation.com/highered/connect

Make it simple, make it affordable. Connect makes it easy with seamless integration using any of the major Learning Management Systems—Blackboard®, Canvas, and D2L, among others—to let you organize your course in one convenient location. Give your students access to digital materials at a discount with our inclusive access program. Ask your McGraw-Hill representative for more information.

Solutions for your challenges. A product isn’t a solution. Real solutions are affordable, reliable, and come with training and ongoing support when you need it and how you want it. Our Customer Experience Group can also help you troubleshoot tech problems—although Connect’s 99% uptime means you might not need to call them. See for yourself at status.mheducation.com

Students—study more efficiently, retain more and achieve better outcomes. Instructors— focus on what you love—teaching.

SUCCESSFUL SEMESTERS INCLUDE CONNECT

65% Less Time Grading

©Hill Street Studios/Tobin Rogers/Blend Images LLC

FOR INSTRUCTORS

ros13952_fm_i-xxxvi.indd 18 1/4/19 12:19 PM

Effective, efficient studying. Connect helps you be more productive with your study time and get better grades using tools like SmartBook, which highlights key concepts and creates a personalized study plan. Connect sets you up for success, so you walk into class with confidence and walk out with better grades.

Study anytime, anywhere. Download the free ReadAnywhere app and access your online eBook when it’s convenient, even if you’re offline. And since the app automatically syncs with your eBook in Connect, all of your notes are available every time you open it. Find out more at www.mheducation.com/ readanywhere

No surprises. The Connect Calendar and Reports tools keep you on track with the work you need to get done and your assignment scores. Life gets busy; Connect tools help you keep learning through it all.

Learning for everyone. McGraw-Hill works directly with Accessibility Services Departments and faculty to meet the learning needs of all students. Please contact your Accessibility Services office and ask them to email accessibility@mheducation.com, or visit www.mheducation.com/about/accessibility.html for more information.

“I really liked this app—it made it easy to study when

you don’t have your text- book in front of you.”

- Jordan Cunningham, Eastern Washington University

Chapter 12 Quiz Chapter 11 Quiz

Chapter 7 Quiz

Chapter 13 Evidence of Evolution Chapter 11 DNA Technology

Chapter 7 DNA Structure and Gene...

and 7 more...

13 14

©Shutterstock/wavebreakmedia

FOR STUDENTS

ros13952_fm_i-xxxvi.indd 19 1/4/19 12:19 PM

xx

T his edition of Essentials has more options than ever in terms of the textbook, instructor supplements, student supplements, and multimedia products. Mix and match to create a package that is perfect for your course!

Assurance of Learning Ready Assurance of learning is an important element of many accreditation standards. Essentials of Corporate Finance, tenth edition, is designed specifically to support your assurance of learn- ing initiatives. Each chapter in the book begins with a list of numbered learning objectives that appear throughout the end-of-chapter problems and exercises. Every test bank question also is 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. Under- standing the importance and value of AACSB Accreditation, Essentials of Corporate Fi- nance, 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.

The statements contained in Essentials of Corporate Finance, tenth edition, are provided only as a guide for the users of this text. The AACSB leaves content coverage and assessment within the purview of individual schools, the mission of the school, and the faculty. While Essentials of Corporate Finance, tenth edition, and the teaching package make no claim of any specific AACSB qualification or evaluation, we have, within the test bank, labeled se- lected questions according to the six general knowledge and skills areas.

McGraw-Hill Customer Care Contact Information At McGraw-Hill, we understand that getting the most from new technology can be chal- lenging. That’s why our services don’t stop after you purchase our products. You can e-mail our Product Specialists 24 hours a day to get product training online. Or you can search our knowledge bank of Frequently Asked Questions on our support website. For Customer Support, call 800-331-5094, or visit mpss.mhhe.com. One of our Technical Support Analysts will be able to assist you in a timely fashion.

Instructor Supplements ■ Instructor’s Manual (IM)

Prepared by LaDoris Baugh, Athens State University A great place to find new lecture ideas! This annotated outline for each chapter includes Lecture Tips, Real-World Tips, Ethics Notes, suggested PowerPoint slides, and, when appropriate, a video synopsis.

Comprehensive Teaching and Learning Package

ros13952_fm_i-xxxvi.indd 20 1/4/19 12:19 PM

xxi

■ Solutions Manual (SM) Prepared by Joseph Smolira, Belmont University, Bradford D. Jordan, University of Kentucky The Essentials Solutions Manual provides detailed solutions to the extensive end- of-chapter material, including concept review questions, quantitative problems, and cases. Select chapters also contain calculator solutions.

■ Test Bank Prepared by Joseph Hegger, University of Missouri Great format for a better testing process! All questions closely link with the text material, listing section number, Learning Objective, Bloom’s Taxonomy Question Type, and AACSB topic when applicable. Each chapter covers a breadth of topics and types of questions, including questions that test the understanding of the key terms; questions patterned after the learning objectives, concept questions, chapter- opening vignettes, boxes, and highlighted phrases; multiple-choice and true/false problems patterned after the end-of-chapter questions, in basic, intermediate, and challenge levels; and essay questions to test problem-solving skills and more advanced understanding of concepts. Each chapter also includes new problems that pick up questions directly from the end-of-chapter material and converts them into parallel test bank questions. For your reference, each test bank question in this part is linked with its corresponding question in the end-of-chapter section.

■ PowerPoint Presentation System Prepared by LaDoris Baugh, Athens State University Customize our content for your course! This presentation has been thoroughly revised to include more lecture-oriented slides, as well as exhibits and examples both from the book and from outside sources. Applicable slides have web links that take you directly to specific internet sites or spreadsheet links to show an example in Excel. You also can go to the Notes Page function for more tips in presenting the slides. Additional PowerPoint slides work through example problems for instructors to show in class. If you already have PowerPoint installed on your computer, you have the ability to edit, print, or rearrange the complete presentation to meet your specific needs.

■ Computerized Test Bank TestGen is a complete, state-of-the-art generator and editing application software that allows instructors to quickly and easily select test items from McGraw-Hill’s test bank content. The instructors then can organize, edit, and customize questions and answers to rapidly generate tests for paper or online administration. Questions can include stylized text, symbols, graphics, and equations that are inserted directly into questions using built-in mathematical templates. TestGen’s random generator provides the option to display different text or calculated number values each time questions are used. With both quick-and-simple test creation and flexible and robust editing tools, TestGen is a complete test generator system for today’s educators.

■ Excel Simulations Expanded for this edition! With 180 Excel simulation questions now included in Connect, McGraw-Hill’s Ross series is the unparalleled leader in offering students the opportunity to practice using the Excel functions they will use throughout their careers in finance.

■ Corporate Finance Videos New for this edition, brief and engaging conceptual videos (and accompanying questions) help students to master the building blocks of the Corporate Finance course.

ros13952_fm_i-xxxvi.indd 21 1/4/19 12:19 PM

xxii

Student Supplements ■ Excel Resources

A great resource for those seeking additional practice, students can access Excel template problems and the Excel Master tutorial designed by Brad Jordan and Joe Smolira.

■ Narrated Lecture Videos Updated for this edition, the Narrated Lecture Videos provide real-world examples accompanied by step-by-step instructions and explanations for solving problems presented in the chapter. The Concept Checks from the text also are integrated into the slides to reinforce the key topics in the chapter. Designed specifically to appeal to different learning styles, the videos provide a visual and audio explanation of topics and problems.

Teaching Support Along with having access to all of the same material your students can view through Con- nect, you also have password-protected access to the Instructor’s Manual, solutions to end-of-chapter problems and cases, Instructor’s Excel Master, PowerPoint, Excel template solutions, video clips, and video projects and questions.

ros13952_fm_i-xxxvi.indd 22 1/4/19 12:19 PM

xxiii

C learly, our greatest debt is to our many colleagues (and their students) around the world who, like us, wanted to try an alternative to what they were using and made the switch to our text. Our plan for developing and improving Essentials, tenth edition, revolved around the detailed feedback we received from many of our colleagues over the years who had an interest in the book and regularly teach the introductory course. These dedicated scholars and teachers to whom we are very grateful are:

Vaughn S. Armstrong, Utah Valley University Juan Avendano, Augsburg College R. Brian Balyeat, Xavier University John Barkoulas, Georgia Southern University Laura Beal, University of Nebraska at Omaha Stephen G. Buell, Lehigh University Manfen Chen, University of Southern Indiana Su-Jane Chen, Metropolitan University College of Denver Ingyu Chiou, Eastern Illinois University Paul Chiou, Northeastern University Brandon Cline, Mississippi State University Susan Coleman, University of Hartford Bruce A. Costa, University of Montana Maria E. de Boyrie, New Mexico State University David Dineen, Seton Hall University Alan Eastman, Indiana University of Pennsylvania David Eckmann, University of Miami Dan Ervin, Salisbury University Jocelyn Evans, College of Charleston Ramon T. Franklin, Clemson University Sharon H. Garrison, University of Arizona Victoria Geyfman, Bloomsburg University of Pennsylvania Kimberly R. Goodwin, University of Southern Mississippi Michael Gunderson, Purdue University Karen L. Hamilton, Lasell College Mahfuzul Haque, Indiana State University John J. Harrington Jr., Seton Hall University John Hatem, Georgia Southern University Rodrigo Hernandez, Radford University Keith Jakob, University of Montana Abu Jalal, Suffolk University

Acknowledgments

ros13952_fm_i-xxxvi.indd 23 1/4/19 12:19 PM

xxiv

Marlin Jensen, Auburn University Samuel Kyle Jones, Stephen F. Austin State University Douglas Jordan, Sonoma State University Ashok K. Kapoor, Augsburg College Howard Keen, Temple University Marvin Keene, Coastal Carolina University James D. Keys, Florida International University Ladd Kochman, Kennesaw State University Denise Letterman, Robert Morris University–Pittsburgh, PA Seongyeon (Sonya) Lim, DePaul University Alethea Lindsay, Grambling State University Qingfeng “Wilson” Liu, James Madison University Angelo Luciano, Columbia College–Chicago Suzan Murphy, University of Tennessee Ohanes Paskelian, University of Houston Downtown Milena Petrova, Syracuse University Ted Pilger, Southern Illinois University–Carbondale Alexandros P. Prezas, Suffolk University Charles Reback, University of South Carolina Upstate Thomas A. Rhee, California State University–Long Beach Jong C. Rhim, University of Southern Indiana Clarence C. Rose, Radford University Camelia S. Rotaru, St. Edward’s University Andrew Saporoschenko, St. Louis University Michael J. Seiler, Old Dominion University Roger Severns, Minnesota State University–Mankato Gowri Shankar, University of Washington–Bothell Luke Sparvero, SUNY–Oswego Carolyn Spencer, Dowling College Andrew Spieler, Hofstra University Glenn Tanner, Texas State University John Thornton, Kent State University Hiep Tran, California State University–Sacramento Cathyann Tully, Kean University James A. Turner, Weber State University John B. White, United States Coast Guard Academy Susan White, University of Maryland Fred Yeager, Saint Louis University Tarek Saad Zaher, Indiana State University

We owe a special debt to our colleagues for their dedicated work on the many supple- ments that accompany this text: LaDoris Baugh, for her development of the Instructor’s Manual and PowerPoint slides, and Joseph Hegger, for his extensive revision and improve- ment of the Test Bank.

ros13952_fm_i-xxxvi.indd 24 1/4/19 12:19 PM

xxv

We also thank Joseph C. Smolira, Belmont University, for his work on this edition. Joe worked closely with us to develop the solutions manual, along with many of the vignettes and real-world examples we have added to this edition.

Steve Hailey and Emily Bello did outstanding work on this edition of Essentials. To them fell the unenviable task of technical proofreading, and, in particular, careful checking of each and every calculation throughout the text.

Finally, in every phase of this project, we have been privileged to have the complete and unwavering support of a great organization, McGraw-Hill Education. We especially thank the MHE sales organization. The suggestions they provided, their professionalism in assisting potential adopters, and their service to current adopters have been a major factor in our success.

We are deeply grateful to the select group of professionals who served as our devel- opment team on this edition: Chuck Synovec, Director; Jennifer Upton, Senior Product Developer; Trina Maurer, Senior Marketing Manager; Jill Eccher and Jamie Koch, Content Project Managers; Matt Diamond, Senior Designer; and Michele Janicek, Lead Product Developer. Others at McGraw-Hill, too numerous to list here, have improved the book in countless ways.

Throughout the development of this edition, we have taken great care to discover and eliminate errors. Our goal is to provide the best textbook available on the subject. To ensure that future editions are error-free, we will gladly offer $10 per arithmetic error to the first individual reporting it as a modest token of our appreciation. More than this, we would like to hear from instructors and students alike. Please send your comments to Dr. Brad Jordan, c/o Editorial—Finance, McGraw-Hill Education, 120 S. Riverside Drive, 12th Floor, Chicago, IL 60606.

Randolph W. Westerfield Bradford D. Jordan

ros13952_fm_i-xxxvi.indd 25 1/4/19 12:19 PM

xxvi

PART ONE OVERVIEW OF FINANCIAL MANAGEMENT 1 Introduction to Financial Management 1

PART TWO UNDERSTANDING FINANCIAL STATEMENTS AND CASH FLOW 2 Financial Statements, Taxes, and Cash Flow 22 3 Working with Financial Statements 50

PART THREE VALUATION OF FUTURE CASH FLOWS 4 Introduction to Valuation: The Time Value of Money 97 5 Discounted Cash Flow Valuation 122

PART FOUR VALUING STOCKS AND BONDS 6 Interest Rates and Bond Valuation 165 7 Equity Markets and Stock Valuation 205

PART FIVE CAPITAL BUDGETING 8 Net Present Value and Other Investment Criteria 237 9 Making Capital Investment Decisions 275

PART SIX RISK AND RETURN 10 Some Lessons from Capital Market History 310 11 Risk and Return 350

PART SEVEN LONG-TERM FINANCING 12 Cost of Capital 389 13 Leverage and Capital Structure 424 14 Dividends and Dividend Policy 457 15 Raising Capital 487

PART EIGHT SHORT-TERM FINANCIAL MANAGEMENT 16 Short-Term Financial Planning 521 17 Working Capital Management 553

PART NINE TOPICS IN BUSINESS FINANCE 18 International Aspects of Financial Management 589

APPENDICES A Mathematical Tables 616 B Key Equations 624 C Answers to Selected End-of-Chapter Problems 627 D Using the HP-10B and TI BA II Plus Financial Calculators 631

Brief Contents

ros13952_fm_i-xxxvi.indd 26 1/4/19 12:19 PM

xxvii

Contents PART ONE OVERVIEW OF FINANCIAL MANAGEMENT

1 Introduction to Financial Management 1 1.1 Finance: A Quick Look 2

The Four Basic Areas 2 Corporate Finance 2 Investments 2 Financial Institutions 3 International Finance 3

Why Study Finance? 3 Marketing and Finance 3 Accounting and Finance 3 Management and Finance 4 You and Finance 4

1.2 Business Finance and the Financial Manager 4 What Is Business Finance? 4 The Financial Manager 5 Financial Management Decisions 5

Capital Budgeting 6 Capital Structure 6 Working Capital Management 6 Conclusion 6

1.3 Forms of Business Organization 7 Sole Proprietorship 7 Partnership 7 Corporation 8 A Corporation by Another Name . . . 9

1.4 The Goal of Financial Management 9 Profit Maximization 9 The Goal of Financial Management in a Corporation 10 A More General Financial Management Goal 10 Sarbanes-Oxley Act 11

1.5 The Agency Problem and Control of the Corporation 12 Agency Relationships 12 Management Goals 12 Do Managers Act in the Stockholders’ Interests? 13

Managerial Compensation 13 Control of the Firm 13 Conclusion 14

Stakeholders 15

1.6 Financial Markets and the Corporation 15 Cash Flows to and from the Firm 15 Primary versus Secondary Markets 15

Primary Markets 16 Secondary Markets 16

Summary and Conclusions 18

Critical Thinking and Concepts Review 18

What’s on the Web? 20

CHAPTER CASE: The McGee Cake Company 21

PART TWO UNDERSTANDING FINANCIAL STATEMENTS AND CASH FLOW

2 Financial Statements, Taxes, and Cash Flow 22 2.1 The Balance Sheet 23

Assets: The Left-Hand Side 23 Liabilities and Owners’ Equity: The Right-Hand Side 23 Net Working Capital 24 Liquidity 25 Debt versus Equity 25 Market Value versus Book Value 26

2.2 The Income Statement 27 GAAP and the Income Statement 28 Noncash Items 28 Time and Costs 29 Earnings Management 30

2.3 Taxes 31 Corporate Tax Rates 31 Average versus Marginal Tax Rates 32

2.4 Cash Flow 33 Cash Flow from Assets 34

Operating Cash Flow 34 Capital Spending 35 Change in Net Working Capital 35 Conclusion 35 A Note on “Free” Cash Flow 36

Cash Flow to Creditors and Stockholders 36 Cash Flow to Creditors 36 Cash Flow to Stockholders 36

Conclusion 37 An Example: Cash Flows for Dole Cola 37

ros13952_fm_i-xxxvi.indd 27 1/4/19 12:19 PM

xxviii C O N T E N T S

Operating Cash Flow 37 Net Capital Spending 38 Change in NWC and Cash Flow from Assets 38 Cash Flow to Creditors and Stockholders 38

Summary and Conclusions 39

Chapter Review and Self-Test Problem 40

Answer to Chapter Review and Self-Test Problem 41

Critical Thinking and Concepts Review 42

Questions and Problems 43

What’s on the Web? 47

Excel Master It! Problem 48

CHAPTER CASE: Cash Flows and Financial Statements at Sunset Boards, Inc. 49

3 Working with Financial Statements 50 3.1 Standardized Financial Statements 51

Common-Size Balance Sheets 52 Common-Size Income Statements 53

3.2 Ratio Analysis 54 Short-Term Solvency, or Liquidity, Measures 55

Current Ratio 55 Quick (or Acid-Test) Ratio 56 Cash Ratio 56

Long-Term Solvency Measures 57 Total Debt Ratio 57 Times Interest Earned 57 Cash Coverage 58

Asset Management, or Turnover, Measures 58 Inventory Turnover and Days’ Sales in Inventory 58 Receivables Turnover and Days’ Sales in Receivables 59 Total Asset Turnover 60

Profitability Measures 60 Profit Margin 61

Return on Assets 61 Return on Equity 61

Market Value Measures 61 Price-Earnings Ratio 62 Price-Sales Ratio 62 Market-to-Book Ratio 62 Enterprise Value-EBITDA Ratio 62

3.3 The DUPont Identity 64 An Expanded DuPont Analysis 66

3.4 Internal and Sustainable Growth 68 Dividend Payout and Earnings Retention 68 ROA, ROE, and Growth 69

The Internal Growth Rate 69 The Sustainable Growth Rate 69 Determinants of Growth 70 A Note on Sustainable Growth Rate Calculations 72

3.5 Using Financial Statement Information 72 Why Evaluate Financial Statements? 72

Internal Uses 73 External Uses 73

Choosing a Benchmark 73 Time-Trend Analysis 73 Peer Group Analysis 73

Problems with Financial Statement Analysis 79

Summary and Conclusions 80

Chapter Review and Self-Test Problems 81

Answers to Chapter Review and Self-Test Problems 83

Critical Thinking and Concepts Review 84

Questions and Problems 85

What’s on the Web? 93

Excel Master It! Problem 94

CHAPTER CASE: Ratios and Financial Planning at S&S Air, Inc. 95

PART THREE VALUATION OF FUTURE CASH FLOWS

4 Introduction to Valuation: The Time Value of Money 97 4.1 Future Value and Compounding 98

Investing for a Single Period 98 Investing for More Than One Period 98

4.2 Present Value and Discounting 104 The Single-Period Case 105 Present Values for Multiple Periods 105

4.3 More on Present and Future Values 108 Present versus Future Value 108 Determining the Discount Rate 109 Finding the Number of Periods 112

Summary and Conclusions 115

Chapter Review and Self-Test Problems 116

Answers to Chapter Review and Self-Test Problems 116

Critical Thinking and Concepts Review 117

Questions and Problems 118

What’s on the Web? 121

Excel Master It! Problem 121

5 Discounted Cash Flow Valuation 122 5.1 Future and Present Values of Multiple Cash Flows 123

Future Value with Multiple Cash Flows 123

ros13952_fm_i-xxxvi.indd 28 1/4/19 12:19 PM

C O N T E N T S xxix

Present Value with Multiple Cash Flows 126 A Note on Cash Flow Timing 130

5.2 Valuing Level Cash Flows: Annuities and Perpetuities 131 Present Value for Annuity Cash Flows 132

Annuity Tables 133 Finding the Payment 134 Finding the Rate 136

Future Value for Annuities 137 A Note on Annuities Due 137 Perpetuities 138

5.3 Comparing Rates: The Effect of Compounding Periods 140 Effective Annual Rates and Compounding 140 Calculating and Comparing Effective Annual Rates 141 EARs and APRs 142 EARs, APRs, Financial Calculators, and Spreadsheets 144

5.4 Loan Types and Loan Amortization 145 Pure Discount Loans 145 Interest-Only Loans 145 Amortized Loans 146

Summary and Conclusions 150

Chapter Review and Self-Test Problems 151

Answers to Chapter Review and Self-Test Problems 152

Critical Thinking and Concepts Review 154

Questions and Problems 154

What’s on the Web? 162

Excel Master It! Problem 163

CHAPTER CASE: S&S Air’s Mortgage 164

PART FOUR VALUING STOCKS AND BONDS

6 Interest Rates and Bond Valuation 165 6.1 Bonds and Bond Valuation 166

Bond Features and Prices 166 Bond Values and Yields 166 Interest Rate Risk 169 Finding the Yield to Maturity: More Trial and Error 171

6.2 More on Bond Features 175 Is It Debt or Equity? 176 Long-Term Debt: The Basics 176 The Indenture 177

Terms of a Bond 178 Security 178 Seniority 179 Repayment 179 The Call Provision 179 Protective Covenants 180

6.3 Bond Ratings 180

6.4 Some Different Types of Bonds 182 Government Bonds 182 Zero Coupon Bonds 183 Floating-Rate Bonds 184 Other Types of Bonds 185

6.5 Bond Markets 186 How Bonds Are Bought and Sold 186 Bond Price Reporting 188

A Note on Bond Price Quotes 188

6.6 Inflation and Interest Rates 190 Real versus Nominal Rates 190 The Fisher Effect 190

6.7 Determinants of Bond Yields 192 The Term Structure of Interest Rates 192 Bond Yields and the Yield Curve: Putting It All Together 193 Conclusion 195

Summary and Conclusions 196

Chapter Review and Self-Test Problems 196

Answers to Chapter Review and Self-Test Problems 197

Critical Thinking and Concepts Review 197

Questions and Problems 199

What’s on the Web? 203

Excel Master It! Problem 203

CHAPTER CASE: Financing S&S Air’s Expansion Plans with a Bond Issue 204

7 Equity Markets and Stock Valuation 205 7.1 Common Stock Valuation 206

Cash Flows 206 Some Special Cases 207

Zero Growth 208 Constant Growth 208 Nonconstant Growth 211

Components of the Required Return 213 Stock Valuation Using Comparables, or Comps 214

7.2 Some Features of Common and Preferred Stock 216 Common Stock Features 216

Shareholder Rights 216 Proxy Voting 217 Classes of Stock 217