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Finance Disscussion 3

Corporate Finance

Eighth Canadian Edition

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Fundamentals of Corporate Finance Eighth Canadian Edition

Copyright © 2013, 2010, 2007, 2005, 2002, 1999 by McGraw-Hill Ryerson Limited, a Subsidiary of The McGraw-Hill Companies. Copyright © 1996, 1993 by Richard D. Irwin, a Times Mirror Higher Education Group, Inc. company. All rights reserved. No part of this publication may be reproduced or transmitted in any form or by any means, or stored in a data base or retrieval system, without the prior written permission of McGraw-Hill Ryerson Limited, or in the case of photocopying or other reprographic copying, a license from The Canadian Copyright Licensing Agency (Access Copyright). For an Access Copyright licence, visit www.accesscopyright.ca or call toll free to 1-800-893-5777.

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ISBN-13: 978-0-07-105160-6 ISBN-10: 0-07-105160-0

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Library and Archives Canada Cataloguing in Publication

Fundamentals of corporate finance / Stephen A. Ross … [et al.].—8th Canadian ed. Includes bibliographical references and indexes.

ISBN 978-0-07-105160-6

1. Corporations—Finance—Textbooks. I. Ross, Stephen A

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ABOUT THE AUTHORS

Stephen A. Ross Sloan School of Management, Franco Modigliani Professor of Finance and Economics, Massachusetts Institute of Technology

Stephen A. Ross is 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 is recognized for his work in developing the Arbitrage Pricing Theory and his substantial contributions to the discipline through his research in signalling, 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 currently serves as an associate editor of several academic and practitioner journals. He is a trustee of CalTech.

Randolph W. Westerf ield 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. He came to USC from the Wharton School, University of Pennsylvania, where he was the chairman of the finance department and a member of the finance faculty for 20 years. He is a member of several public company boards of directors, including Health Management Associates, Inc., William Lyons Homes, and the Nicholas Applegate growth fund. His areas of expertise include corporate financial policy, investment management, and stock market price behaviour.

Bradford D. Jordan Gatton College of Business and Economics, Professor of Finance and holder of the Richard W. and Janis H. Furst Endowed Chair in Finance, University of Kentucky

Bradford D. Jordan is Professor of Finance and holder of the Richard W. and Janis H. Furst Endowed Chair in Finance at the University of Kentucky. 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 financial management policy. Professor Jordan has published nu- merous articles on issues such as cost of capital, capital structure, and the behaviour of security prices. He is a past president of the Southern Finance Association, and he is co-author (with Thomas W. Miller, Jr.) of Fundamentals of Investments: Valuation and Management, 4e, a leading investments text, published by McGraw-Hill/Irwin.

Gordon S. Roberts Schulich School of Business, York University, Canadian Imperial Bank of Commerce Professor of Financial Services

Gordon S. Roberts is Canadian Imperial Bank of Commerce Professor of Financial Services at the Schulich School of Business, York University. His exten- sive teaching experience includes finance classes for un- dergraduate and MBA students, executives, and bankers in Canada and internationally. Professor Roberts con- ducts research on the pricing of bank loans and the reg- ulation of financial institutions. He has served on the editorial boards of several Canadian and international academic journals. Professor Roberts has been a consul- tant to a number of regulatory bodies responsible for the oversight of financial institutions and utilities.

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BRIEF CONTENTS

PREFACE xvii

P A R T 1

OVERVIEW OF CORPORATE FINANCE 1

1 Introduction to Corporate Finance 1 2 Financial Statements, Cash Flow, and Taxes 25

P A R T 2

FINANCIAL STATEMENTS AND LONG-TERM FINANCIAL PLANNING 53

3 Working with Financial Statements 53 4 Long-Term Financial Planning and

Corporate Growth 84

P A R T 3

VALUATION OF FUTURE CASH FLOWS 111

5 Introduction to Valuation: The Time Value of Money 111

6 Discounted Cash Flow Valuation 129 7 Interest Rates and Bond Valuation 165 8 Stock Valuation 196

P A R T 4

CAPITIAL BUDGETING 220

9 Net Present Value and Other Investment Criteria 220

10 Making Capital Investment Decisions 250 11 Project Analysis and Evaluation 288

P A R T 5

RISK AND RETURN 317

12 Lessons from Capital Market History 317 13 Return, Risk, and the Security Market Line 346

P A R T 6

COST OF CAPITAL AND LONG-TERM FINANCIAL POLICY 387

14 Cost of Capital 387 15 Raising Capital 423 16 Financial Leverage and Capital

Structure Policy 454 17 Dividends and Dividend Policy 490

P A R T 7

SHORT-TERM FINANCIAL PLANNING AND MANAGEMENT 519

18 Short-Term Finance and Planning 519 19 Cash and Liquidity Management 552 20 Credit and Inventory Management 572

P A R T 8

TOPICS IN CORPORATE FINANCE 606

21 International Corporate Finance 606 22 Leasing 634 23 Mergers and Acquisitions 655

P A R T 9

DERIVATIVE SECURITIES AND CORPORATE FINANCE 685

24 Enterprise Risk Management 685 25 Options and Corporate Securities 711 26 Behavioural Finance: Implications for

Financial Management 750

Glossary 773 Appendix A: Mathematical Tables (available on Connect) Appendix B: Answers to Selected End-of-Chapter Problems (available on Connect) Subject Index 781 Name Index 800 Equation Index 802

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CONTENTS

PREFACE xvii

P A R T 1

OVERVIEW OF CORPORATE FINANCE 1

C H A P T E R 1

INTRODUCTION TO CORPORATE FINANCE 1

1.1 Corporate Finance and the Financial Manager 1 What Is Corporate Finance? 2 The Financial Manager 2 Financial Management Decisions 2

1.2 Forms of Business Organization 4 Sole Proprietorship 4 Partnership 5 Corporation 5 Income Trust 6 Co-operative (Co-op) 7

1.3 The Goal of Financial Management 8 Possible Goals 8 The Goal of Financial Management 8 A More General Goal 9

1.4 The Agency Problem and Control of the Corporation 10 Agency Relationships 10 Management Goals 10 Do Managers Act in the Shareholders’ Interests? 10 Corporate Social Responsibility and Ethical Investing 12

1.5 Financial Markets and the Corporation 14 Cash Flows to and from the Firm 15 Money versus Capital Markets 15 Primary versus Secondary Markets 16

1.6 Financial Institutions 18

1.7 Trends in Financial Markets and Financial Management 20

1.8 Outline of the Text 21

1.9 Summary and Conclusions 22

C H A P T E R 2

FINANCIAL STATEMENTS, CASH FLOW, AND TAXES 25

2.1 Statement of Financial Position 25 Assets 26 Liabilities and Owners’ Equity 26 Net Working Capital 27 Liquidity 28 Debt versus Equity 28 Value versus Cost 28

2.2 Statement of Comprehensive Income 30 International Financial Reporting Standards (IFRS) 30 Non-Cash Items 31 Time and Costs 31

2.3 Cash Flow 32 Cash Flow from Assets 32 Cash Flow to Creditors and Shareholders 34 Net Capital Spending 36 Change in NWC and Cash Flow from Assets 36

2.4 Taxes 37 Individual Tax Rates 37 Average versus Marginal Tax Rates 37 Taxes on Investment Income 39 Corporate Taxes 39 Taxable Income 39 Global Tax Rates 40 Capital Gains and Carry-forward and Carry-back 40 Income Trust Income and Taxation 41

2.5 Capital Cost Allowance 42 Asset Purchases and Sales 43

2.6 Summary and Conclusions 45

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P A R T 2

FINANCIAL STATEMENTS AND LONG-TERM FINANCIAL PLANNING 53

C H A P T E R 3

WORKING WITH FINANCIAL STATEMENTS 53

3.1 Cash Flow and Financial Statements: A Closer Look 54 Sources and Uses of Cash 54 The Statement of Cash Flows 56

3.2 Standardized Financial Statements 57 Common-Size Statements 57 Common-Base-Year Financial Statements: Trend Analysis 59

3.3 Ratio Analysis 60 Short-Term Solvency or Liquidity Measures 61 Other Liquidity Ratios 63 Long-Term Solvency Measures 64 Asset Management, or Turnover, Measures 65 Profitability Measures 67 Market Value Measures 68

3.4 The Du Pont Identity 71

3.5 Using Financial Statement Information 73 Why Evaluate Financial Statements? 73 Choosing a Benchmark 74 Problems with Financial Statement Analysis 75

3.6 Summary and Conclusions 75

C H A P T E R 4

LONG-TERM FINANCIAL PLANNING AND CORPORATE GROWTH 84

4.1 What Is Financial Planning? 85 Growth as a Financial Management Goal 85 Dimensions of Financial Planning 86 What Can Planning Accomplish? 86

4.2 Financial Planning Models: A First Look 88 A Financial Planning Model: The Ingredients 88 A Simple Financial Planning Model 89

4.3 The Percentage of Sales Approach 90 An Illustration of the Percentage of Sales Approach 90

4.4 External Financing and Growth 95 External Financing Needed and Growth 95 Internal Growth Rate 97 Financial Policy and Growth 98 Determinants of Growth 100 A Note on Sustainable Growth Rate Calculations 101

4.5 Some Caveats on Financial Planning Models 103

4.6 Summary and Conclusions 103

Appendix 4 (available on Connect)

P A R T 3

VALUATION OF FUTURE CASH FLOWS 111

C H A P T E R 5

INTRODUCTION TO VALUATION: THE TIME VALUE OF MONEY 111

5.1 Future Value and Compounding 112 Investing for a Single Period 112 Investing for More than One Period 112 A Note on Compound Growth 118

5.2 Present Value and Discounting 118 The Single-Period Case 119 Present Values for Multiple Periods 119

5.3 More on Present and Future Values 121 Present versus Future Value 121 Determining the Discount Rate 122 Finding the Number of Periods 124

5.4 Summary and Conclusions 126

C H A P T E R 6

DISCOUNTED CASH FLOW VALUATION 129

6.1 Future and Present Values of Multiple Cash Flows 129 Future Value with Multiple Cash Flows 129 Present Value with Multiple Cash Flows 131 A Note on Cash Flow Timing 134

6.2 Valuing Level Cash Flows: Annuities and Perpetuities 135 Present Value for Annuity Cash Flows 135

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Future Value for Annuities 140 A Note on Annuities Due 141 Perpetuities 142 Growing Perpetuities 143 Formula for Present Value of Growing Perpetuity 144 Growing Annuity 145 Formula for Present Value of Growing Annuity 145

6.3 Comparing Rates: The Effect of Compounding 145 Effective Annual Rates and Compounding 146 Calculating and Comparing Effective Annual Rates 146 Mortgages 147 EARs and APRs 148 Taking It to the Limit: A Note on Continuous Compounding 149

6.4 Loan Types and Loan Amortization 150 Pure Discount Loans 150 Interest-Only Loans 150 Amortized Loans 151

6.5 Summary and Conclusions 155

Appendix 6A: Proof of Annuity Present Value Formula 164

C H A P T E R 7

INTEREST RATES AND BOND VALUATION 165

7.1 Bonds and Bond Valuation 165 Bond Features and Prices 165 Bond Values and Yields 166 Interest Rate Risk 169 Finding the Yield to Maturity 170

7.2 More on Bond Features 173 Is It Debt or Equity? 173 Long-Term Debt: The Basics 174 The Indenture 174

7.3 Bond Ratings 177

7.4 Some Different Types of Bonds 178 Financial Engineering 178 Stripped Bonds 179 Floating-Rate Bonds 180 Other Types of Bonds 180

7.5 Bond Markets 181 How Bonds Are Bought and Sold 181 Bond Price Reporting 182 A Note on Bond Price Quotes 182 Bond Funds 184

7.6 Inflation and Interest Rates 184 Real versus Nominal Rates 184 The Fisher Effect 185 Inflation and Present Values 186

7.7 Determinants of Bond Yields 186 The Term Structure of Interest Rates 187 Bond Yields and the Yield Curve: Putting It All Together 188 Conclusion 189

7.8 Summary and Conclusions 190

Appendix 7A: On Duration 194

Appendix 7B (available on Connect)

C H A P T E R 8

STOCK VALUATION 196

8.1 Common Stock Valuation 196 Common Stock Cash Flows 196 Common Stock Valuation: Some Special Cases 198 Changing the Growth Rate 202 Components of the Required Return 203

8.2 Common Stock Features 205 Shareholders’ Rights 205 Dividends 206 Classes of Stock 206

8.3 Preferred Stock Features 207 Stated Value 207 Cumulative and Non-Cumulative Dividends 207 Is Preferred Stock Really Debt? 208 Preferred Stock and Taxes 209 Beyond Taxes 209

8.4 Stock Market Reporting 210 Growth Opportunities 211 Application: The Price-Earnings Ratio 211

8.5 Summary and Conclusions 213

Appendix 8A: Corporate Voting 218

Contents vii

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P A R T 4

CAPITAL BUDGETING 220

C H A P T E R 9

NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA 220

9.1 Net Present Value 221 The Basic Idea 221 Estimating Net Present Value 222

9.2 The Payback Rule 225 Defining the Rule 225 Analyzing the Payback Period Rule 225 Redeeming Qualities 226 Summary of the Rule 226 The Discounted Payback Rule 227

9.3 The Average Accounting Return 228 Analyzing the Average Accounting Return Method 229

9.4 The Internal Rate of Return 230 Problems with the IRR 233 Redeeming Qualities of the IRR 237

9.5 The Profitability Index 238

9.6 The Practice of Capital Budgeting 239

9.7 Summary and Conclusions 241

Appendix 9A: The Modified Internal Rate of Return 248

C H A P T E R 1 0

MAKING CAPITAL INVESTMENT DECISIONS 250

10.1 Project Cash Flows: A First Look 251 Relevant Cash Flows 251 The Stand-Alone Principle 251

10.2 Incremental Cash Flows 251 Sunk Costs 251 Opportunity Costs 252 Side Effects 252 Net Working Capital 253 Financing Costs 253 Inflation 253

Capital Budgeting and Business Taxes in Canada 254 Other Issues 254

10.3 Pro Forma Financial Statements and Project Cash Flows 254 Getting Started: Pro Forma Financial Statements 254 Project Cash Flows 255 Project Total Cash Flow and Value 256

10.4 More on Project Cash Flow 257 A Closer Look at Net Working Capital 257 Depreciation and Capital Cost Allowance 258 An Example: The Majestic Mulch and Compost Company (MMCC) 259

10.5 Alternative Definitions of Operating Cash Flow 263 The Bottom-Up Approach 263 The Top-Down Approach 264 The Tax Shield Approach 264 Conclusion 265

10.6 Applying the Tax Shield Approach to the Majestic Mulch and Compost Company Project 265 Present Value of the Tax Shield on CCA 266 Salvage Value versus UCC 268

10.7 Some Special Cases of Discounted Cash Flow Analysis 269 Evaluating Cost-Cutting Proposals 269 Replacing an Asset 270 Evaluating Equipment with Different Lives 272 Setting the Bid Price 273

10.8 Summary and Conclusions 276

Appendix 10A: More on Inflation and Capital Budgeting 285

Appendix 10B: Capital Budgeting with Spreadsheets 286

C H A P T E R 1 1

PROJECT ANALYSIS AND EVALUATION 288

11.1 Evaluating NPV Estimates 288 The Basic Problem 289 Projected versus Actual Cash Flows 289 Forecasting Risk 289 Sources of Value 289

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11.2 Scenario and Other What-If Analyses 290 Getting Started 290 Scenario Analysis 291 Sensitivity Analysis 293 Simulation Analysis 295

11.3 Break-Even Analysis 296 Fixed and Variable Costs 296 Accounting Break-Even 297 Accounting Break-Even: A Closer Look 299 Uses for the Accounting Break-Even 299

11.4 Operating Cash Flow, Sales Volume, and Break-Even 300 Accounting Break-Even and Cash Flow 300 Cash Flow and Financial Break-Even Points 302

11.5 Operating Leverage 304 The Basic Idea 304 Implications of Operating Leverage 305 Measuring Operating Leverage 305 Operating Leverage and Break-Even 306

11.6 Managerial Options 307

11.7 Capital Rationing 310

11.8 Summary and Conclusions 311

P A R T 5

RISK AND RETURN 317

C H A P T E R 1 2

LESSONS FROM CAPITAL MARKET HISTORY 317

12.1 Returns 318 Dollar Returns 318 Percentage Returns 319

12.2 The Historical Record 321 A First Look 323 A Closer Look 324

12.3 Average Returns: The First Lesson 324 Calculating Average Returns 324 Average Returns: The Historical Record 324 Risk Premiums 325 The First Lesson 325

12.4 The Variability of Returns: The Second Lesson 326 Frequency Distributions and Variability 326 The Historical Variance and Standard Deviation 326 The Historical Record 328 Normal Distribution 329 Value at Risk 331 The Second Lesson 331 2008 The Bear Growled and Investors Howled 331 Using Capital Market History 332

12.5 More on Average Returns 333 Arithmetic versus Geometric Averages 333 Calculating Geometric Average Returns 333 Arithmetic Average Return or Geometric Average Return? 335

12.6 Capital Market Efficiency 335 Price Behaviour in an Efficient Market 336 The Efficient Markets Hypothesis 337 Market Efficiency—Forms and Evidence 339

12.7 Summary and Conclusions 341

C H A P T E R 1 3

RETURN, RISK, AND THE SECURITY MARKET LINE 346

13.1 Expected Returns and Variances 347 Expected Return 347 Calculating the Variance 349

13.2 Portfolios 351 Portfolio Weights 351 Portfolio Expected Returns 351 Portfolio Variance 352 Portfolio Standard Deviation and Diversification 353 The Efficient Set 355 Correlations in the Financial Crisis of 2007–2009 357

13.3 Announcements, Surprises, and Expected Returns 359 Expected and Unexpected Returns 359 Announcements and News 359

13.4 Risk: Systematic and Unsystematic 360 Systematic and Unsystematic Risk 360 Systematic and Unsystematic Components of Return 361

Contents ix

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13.5 Diversification and Portfolio Risk 361 The Effect of Diversification: Another Lesson from Market History 362 The Principle of Diversification 363 Diversification and Unsystematic Risk 364 Diversification and Systematic Risk 364 Risk and the Sensible Investor 364

13.6 Systematic Risk and Beta 365 The Systematic Risk Principle 366 Measuring Systematic Risk 366 Portfolio Betas 367

13.7 The Security Market Line 368 Beta and the Risk Premium 368 Calculating Beta 372 The Security Market Line 374

13.8 Arbitrage Pricing Theory And Empirical Models 377

13.9 Summary and Conclusions 379

Appendix 13A: Derivation of the Capital Asset Pricing Model 384

P A R T 6

COST OF CAPITAL AND LONG-TERM FINANCIAL POLICY 387

C H A P T E R 1 4

COST OF CAPITAL 387

14.1 The Cost of Capital: Some Preliminaries 388 Required Return versus Cost of Capital 388 Financial Policy and Cost of Capital 388

14.2 The Cost of Equity 389 The Dividend Growth Model Approach 389 The SML Approach 391 The Cost of Equity in Rate Hearings 392

14.3 The Costs of Debt and Preferred Stock 393 The Cost of Debt 393 The Cost of Preferred Stock 394

14.4 The Weighted Average Cost of Capital 394 The Capital Structure Weights 395 Taxes and the Weighted Average Cost of Capital 396 Solving the Warehouse Problem and Similar Capital Budgeting Problems 396 Performance Evaluation: Another Use of the WACC 398

14.5 Divisional and Project Costs of Capital 399 The SML and the WACC 399 Divisional Cost of Capital 401 The Pure Play Approach 401 The Subjective Approach 402

14.6 Flotation Costs and the Weighted Average Cost of Capital 403 The Basic Approach 403 Flotation Costs and NPV 404

14.7 Calculating WACC for Loblaw 406 Estimating Financing Proportions 406 Market Value Weights for Loblaw 406 Cost of Debt 407 Cost of Preferred Shares 408 Cost of Common Stock 408 CAPM 408 Dividend Valuation Model Growth Rate 409 Loblaw’s WACC 409

14.8 Summary and Conclusions 409

Appendix 14A: Adjusted Present Value 414

Appendix 14B: Economic Value Added and the Measurement of Financial Performance 419

C H A P T E R 1 5

RAISING CAPITAL 423

15.1 The Financing Life Cycle of a Firm: Early-Stage Financing and Venture Capital 423 Venture Capital 424 Some Venture Capital Realities 424 Choosing a Venture Capitalist 424 Conclusion 425

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15.2 The Public Issue 425

15.3 The Basic Procedure for a New Issue 426 Securities Registration 427 Alternative Issue Methods 427

15.4 The Cash Offer 427 Types of Underwriting 428 Bought Deal 428 Dutch Auction Underwriting 429 The Selling Period 429 The Overallotment Option 430 Lockup Agreements 430 The Quiet Period 430 The Investment Dealers 430

15.5 IPOs and Underpricing 431 IPO Underpricing: The 1999–2000 Experience 431 Evidence on Underpricing 432 Why Does Underpricing Exist? 435

15.6 New Equity Sales and the Value of the Firm 436

15.7 The Cost of Issuing Securities 437 IPOs in Practice: The Case of Athabasca Oil Sands 439

15.8 Rights 439 The Mechanics of a Rights Offering 439 Number of Rights Needed to Purchase a Share 440 The Value of a Right 441 Theoretical Value of a Right 442 Ex Rights 443 Value of Rights after Ex-Rights Date 444 The Underwriting Arrangements 444 Effects on Shareholders 444 Cost of Rights Offerings 445

15.9 Dilution 446 Dilution of Proportionate Ownership 446 Dilution of Value: Book versus Market Values 446

15.10 Issuing Long-term Debt 448

15.11 Summary and Conclusions 449

C H A P T E R 1 6

FINANCIAL LEVERAGE AND CAPITAL STRUCTURE POLICY 454

16.1 The Capital Structure Question 455 Firm Value and Stock Value: An Example 455 Capital Structure and the Cost of Capital 456

16.2 The Effect of Financial Leverage 456 The Basics of Financial Leverage 456 Corporate Borrowing and Homemade Leverage 460

16.3 Capital Structure and the Cost of Equity Capital 462 M&M Proposition I: The Pie Model 462 The Cost of Equity and Financial Leverage: M&M Proposition II 462 Business and Financial Risk 463

16.4 M&M Propositions I and II with Corporate Taxes 466 The Interest Tax Shield 466 Taxes and M&M Proposition I 466 Taxes, the WACC, and Proposition II 468

16.5 Bankruptcy Costs 470 Direct Bankruptcy Costs 470 Indirect Bankruptcy Costs 470 Agency Costs of Equity 471

16.6 Optimal Capital Structure 472 The Static Theory of Capital Structure 472 Optimal Capital Structure and the Cost of Capital 473 Optimal Capital Structure: A Recap 473 Capital Structure: Some Managerial Recommendations 475

16.7 The Pie Again 475 The Extended Pie Model 475 Marketed Claims versus Non-Marketed Claims 476

16.8 The Pecking-Order Theory 477 Internal Financing and the Pecking Order 477 Implications of the Pecking Order 477

16.9 Observed Capital Structures 478

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16.10 Long-Term Financing Under Financial Distress and Bankruptcy 479 Liquidation and Reorganization 480 Agreements to Avoid Bankruptcy 481

16.11 Summary and Conclusions 482

Appendix 16A: Capital Structure and Personal Taxes 487

Appendix 16B: Derivation of Proposition II (Equation 16.4) 489

C H A P T E R 1 7

DIVIDENDS AND DIVIDEND POLICY 490

17.1 Cash Dividends and Dividend Payment 491 Cash Dividends 491 Standard Method of Cash Dividend Payment 492 Dividend Payment: A Chronology 492 More on the Ex-Dividend Date 492

17.2 Does Dividend Policy Matter? 494 An Illustration of the Irrelevance of Dividend Policy 494

17.3 Real-World Factors Favouring a Low Payout 496 Taxes 496 Some Evidence on Dividends and Taxes in Canada 497 Flotation Costs 498 Dividend Restrictions 498

17.4 Real-World Factors Favouring a High Payout 499 Desire for Current Income 499 Uncertainty Resolution 499 Tax and Legal Benefits from High Dividends 500 Conclusion 500

17.5 A Resolution of Real-World Factors? 500 Information Content of Dividends 501 Dividend Signalling in Practice 501 The Clientele Effect 502

17.6 Establishing a Dividend Policy 503 Residual Dividend Approach 503

Dividend Stability 505 A Compromise Dividend Policy 507 Some Survey Evidence on Dividends 507

17.7 Stock Repurchase: An Alternative to Cash Dividends 508 Cash Dividends versus Repurchase 508 Real-World Considerations in a Repurchase 510 Share Repurchase and EPS 510

17.8 Stock Dividends and Stock Splits 510 Some Details on Stock Splits and Stock Dividends 511 Value of Stock Splits and Stock Dividends 512 Reverse Splits 512

17.9 Summary and Conclusions 513

P A R T 7

SHORT-TERM FINANCIAL PLANNING AND MANAGEMENT 519

C H A P T E R 1 8

SHORT-TERM FINANCE AND PLANNING 519

18.1 Tracing Cash and Net Working Capital 520

18.2 The Operating Cycle and the Cash Cycle 521 Defining the Operating and Cash Cycles 522 Calculating the Operating and Cash Cycles 524 Interpreting the Cash Cycle 525

18.3 Some Aspects of Short-Term Financial Policy 526 The Size of the Firm’s Investment in Current Assets 526 Alternative Financing Policies for Current Assets 528 Which Financing Policy is Best? 531 Current Assets and Liabilities in Practice 531

18.4 The Cash Budget 533 Sales and Cash Collections 533 Cash Outflows 534 The Cash Balance 534

18.5 A Short-Term Financial Plan 536 Short-Term Planning and Risk 537

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18.6 Short-Term Borrowing 537 Operating Loans 537 Letters of Credit 539 Secured Loans 539 Factoring 540 Securitized Receivables—A Financial Innovation 541 Inventory Loans 541 Trade Credit 542 Money Market Financing 543

18.7 Summary and Conclusions 545

C H A P T E R 1 9

CASH AND LIQUIDITY MANAGEMENT 552

19.1 Reasons for Holding Cash 552 Speculative and Precautionary Motives 553 The Transaction Motive 553 Costs of Holding Cash 553 Cash Management versus Liquidity Management 553

19.2 Determining the Target Cash Balance 554 The Basic Idea 554 Other Factors Influencing the Target Cash Balance 555

19.3 Understanding Float 556 Disbursement Float 556 Collection Float and Net Float 557 Float Management 557 Accelerating Collections 560 Over-the-Counter Collections 561 Controlling Disbursements 563

19.4 Investing Idle Cash 564 Temporary Cash Surpluses 564 Characteristics of Short-Term Securities 565 Some Different Types of Money Market Securities 567

19.5 Summary and Conclusions 568

Appendix 19A (available on Connect)

C H A P T E R 2 0

CREDIT AND INVENTORY MANAGEMENT 572

20.1 Credit and Receivables 572 Components of Credit Policy 573 The Cash Flows from Granting Credit 573 The Investment in Receivables 573

20.2 Terms of the Sale 574 Why Trade Credit Exists 574 The Basic Form 575 The Credit Period 575 Cash Discounts 576 Credit Instruments 578

20.3 Analyzing Credit Policy 578 Credit Policy Effects 578 Evaluating a Proposed Credit Policy 579

20.4 Optimal Credit Policy 581 The Total Credit Cost Curve 581 Organizing the Credit Function 581

20.5 Credit Analysis 583 When Should Credit Be Granted? 583 Credit Information 584 Credit Evaluation and Scoring 585

20.6 Collection Policy 588 Monitoring Receivables 588 Collection Effort 589 Credit Management in Practice 589

20.7 Inventory Management 590 The Financial Manager and Inventory Policy 590 Inventory Types 590 Inventory Costs 591

20.8 Inventory Management Techniques 591 The ABC Approach 592 The Economic Order Quantity (EOQ) Model 592 Extensions to the EOQ Model 595 Managing Derived-Demand Inventories 596 Materials Requirements Planning (MRP) 597 Just-In-Time Inventory 598

20.9 Summary and Conclusions 600

Appendix 20A (available on Connect)

Contents xiii

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P A R T 8

TOPICS IN CORPORATE FINANCE 606

C H A P T E R 2 1

INTERNATIONAL CORPORATE FINANCE 606

21.1 Terminology 607

21.2 Foreign Exchange Markets and Exchange Rates 608 Exchange Rates 609 Types of Transactions 611

21.3 Purchasing Power Parity 613 Absolute Purchasing Power Parity 613 Relative Purchasing Power Parity 614 Currency Appreciation and Depreciation 615

21.4 Interest Rate Parity, Unbiased Forward Rates, and the Generalized Fisher Effect 616 Covered Interest Arbitrage 616 Interest Rate Parity (IRP) 617 Forward Rates and Future Spot Rates 617 Putting It All Together 618

21.5 International Capital Budgeting 620 Method 1: The Home Currency Approach 620 Method 2: The Foreign Currency Approach 621 Unremitted Cash Flows 621

21.6 Financing International Projects 622 The Cost of Capital for International Firms 622 International Diversification and Investors 622 Sources of Short- and Intermediate-Term Financing 623

21.7 Exchange Rate Risk 624 Transaction Exposure 624 Economic Exposure 625 Translation Exposure 626 Managing Exchange Rate Risk 627

21.8 Political and Governance Risks 627 Corporate Governance Risk 628

21.9 Summary and Conclusions 629

C H A P T E R 2 2

LEASING 634

22.1 Leases and Lease Types 634 Leasing versus Buying 635 Operating Leases 635 Financial Leases 636

22.2 Accounting and Leasing 637

22.3 Taxes, Canada Revenue Agency (CRA), and Leases 639

22.4 The Cash Flows from Leasing 639 The Incremental Cash Flows 640

22.5 Lease or Buy? 641 A Preliminary Analysis 641 NPV Analysis 642 A Misconception 643 Asset Pool and Salvage Value 643

22.6 A Leasing Paradox 644 Resolving the Paradox 645 Leasing and Capital Budgeting 647

22.7 Reasons for Leasing 649 Good Reasons for Leasing 649 Bad Reasons for Leasing 649 Other Reasons for Leasing 650 Leasing Decisions in Practice 650

22.8 Summary and Conclusions 651

C H A P T E R 2 3

MERGERS AND ACQUISITIONS 655

23.1 The Legal Forms of Acquisitions 656 Merger or Consolidation 656 Acquisition of Stock 657 Acquisition of Assets 657 Acquisition Classifications 657 A Note on Takeovers 658 Alternatives to Merger 659

23.2 Taxes and Acquisitions 659 Determinants of Tax Status 659 Taxable versus Tax-Free Acquisitions 660

xiv Contents

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23.3 Accounting for Acquisitions 660

23.4 Gains from Acquisition 661 Synergy 661 Revenue Enhancement 662 Cost Reductions 663 Tax Gains 664 Changing Capital Requirements 665 Avoiding Mistakes 665 A Note on Inefficient Management and Opportunistic Takeover Offers 666 The Negative Side of Takeovers 666

23.5 Some Financial Side Effects of Acquisitions 667 EPS Growth 667 Diversification 668

23.6 The Cost of an Acquisition 668 Case I: Cash Acquisition 669 Case II: Stock Acquisition 669 Cash versus Common Stock 670

23.7 Defensive Tactics 670 The Control Block and the Corporate Charter 671 Repurchase ∕ Standstill Agreements 671 Exclusionary Offers and Dual Class Stock 672 Share Rights Plans 672 Going Private and Leveraged Buyouts 673 LBOs to Date: The Record 674 Other Defensive Devices 674

23.8 Some Evidence on Acquisitions 676

23.9 Divestitures and Restructurings 678

23.10 Summary and Conclusions 679

P A R T 9

DERIVATIVE SECURITIES AND CORPORATE FINANCE 685

C H A P T E R 2 4

ENTERPRISE RISK MANAGEMENT 685

24.1 Insurance 686

24.2 Managing Financial Risk 687 The Impact of Financial Risk: The Credit Crisis of 2007–2009 687

The Risk Profile 688 Reducing Risk Exposure 688 Hedging Short-Run Exposure 689 Cash Flow Hedging: A Cautionary Note 690 Hedging Long-Term Exposure 690 Conclusion 690

24.3 Hedging with Forward Contracts 691 Forward Contracts: The Basics 691 The Payoff Profile 691 Hedging with Forwards 692

24.4 Hedging with Futures Contracts 694 Trading in Futures 694 Futures Exchanges 694 Hedging with Futures 698

24.5 Hedging with Swap Contracts 698 Currency Swaps 699 Interest Rate Swaps 699 Commodity Swaps 699 The Swap Dealer 699 Interest Rate Swaps: An Example 700 Credit Default Swaps (CDS) 701

24.6 Hedging with Option Contracts 701 Option Terminology 701 Options versus Forwards 702 Option Payoff Profiles 702 Option Hedging 703 Hedging Commodity Price Risk with Options 703 Hedging Exchange Rate Risk with Options 704 Hedging Interest Rate Risk with Options 704 Actual Use of Derivatives 706

24.7 Summary and Conclusions 707

C H A P T E R 2 5

OPTIONS AND CORPORATE SECURITIES 711

25.1 Options: The Basics 711 Puts and Calls 712 Stock Option Quotations 712 Option Payoffs 713 Put Payoffs 716 Long-Term Options 716

Contents xv

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25.2 Fundamentals of Option Valuation 716 Value of a Call Option at Expiration 717 The Upper and Lower Bounds on a Call Option’s Value 718 A Simple Model: Part I 719 Four Factors Determining Option Values 720

25.3 Valuing a Call Option 721 A Simple Model: Part II 721 The Fifth Factor 722 A Closer Look 723

25.4 Employee Stock Options 724 ESO Features 725 ESO Repricing 725

25.5 Equity as a Call Option on the Firm’s Assets 726 Case I: The Debt Is Risk-Free 726 Case II: The Debt Is Risky 727

25.6 Warrants 729 The Difference between Warrants and Call Options 729 Warrants and the Value of the Firm 730

25.7 Convertible Bonds 732 Features of a Convertible Bond 732 Value of a Convertible Bond 732

25.8 Reasons for Issuing Warrants and Convertibles 734 The Free Lunch Story 735 The Expensive Lunch Story 735 A Reconciliation 735

25.9 Other Options 736 The Call Provision on a Bond 736 Put Bonds 736 The Overallotment Option 736 Insurance and Loan Guarantees 737 Managerial Options 737

25.10 Summary and Conclusions 740

Appendix 25A: The Black–Scholes Option Pricing Model 745

C H A P T E R 2 6

BEHAVIOURAL FINANCE: IMPLICATIONS FOR FINANCIAL MANAGEMENT 750

26.1 Introduction to Behavioural Finance 751

26.2 Biases 751 Overconfidence 751 Overoptimism 751 Confirmation Bias 752

26.3 Framing Effects 752 Loss Aversion 753 House Money 754

26.4 Heuristics 755 The Affect Heuristic 755 The Representativeness Heuristic 756 Representativeness and Randomness 756 The Gambler’s Fallacy 757

26.5 Behavioural Finance and Market Efficiency 758 Limits to Arbitrage 758 Bubbles and Crashes 761

26.6 Market Efficiency and the Performance of Professional Money Managers 766

26.7 Summary and Conclusions 770

Glossary 773 Appendix A: Mathematical Tables (available on Connect) Appendix B: Answers to Selected End-of-Chapter Problems (available on Connect) Subject Index 781 Name Index 800 Equation Index 802

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PREFACE

Fundamentals of Corporate Finance continues on its tradition of excellence that has earned it its status as market leader. The rapid and extensive changes in financial markets and instruments has placed new burdens on the teaching of Corporate Finance in Canada. As a result, every chapter has been updated to provide the most current examples that reflect Corporate Finance in today’s world. This best-selling text is written with one strongly held principle—that Corporate Finance should be developed and taught in terms of a few integrated powerful ideas: Emphasis on Intuition, Unified Valuation Approach, and Managerial Focus.

An Emphasis on Intuition We are always careful to separate and explain the principles at work on an 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 un- derlying corporate finance. Many texts stop well short of consistently integrating this important principle. The most basic notion—that NPV represents the excess of market value over cost— tends to get lost in an overly mechanical approach to NPV that emphasizes computation at the expense of understanding. Every subject covered in Fundamentals of Corporate Finance is firmly rooted in valuation, and care is taken throughout the text to explain how particular decisions have valuation effects.

A Managerial Focus Students will not lose sight of the fact that financial management con- cerns management. Throughout the text, the role of the financial manager as decision maker is emphasized, and the need for managerial input and judgement is stressed. “Black box” approaches to finance are consciously avoided.

These three themes work together to provide a sound foundation, and a practical and work- able understanding of how to evaluate and make financial decisions.

New to This Edition In addition to retaining the coverage that has characterized Fundamen- tals of Corporate Finance from the beginning, the Eighth Canadian Edition features enhanced Canadian content on current issues such as:

• Perspective on the financial crisis of 2007–2009 and its aftermath, in particular, the Euro- pean government debt credit crisis (Chapters 1, 12, and 24, among others).

• Updated and expanded coverage of corporate governance, social responsibility, ethical in- vesting, and shareholder activism (Chapters 1, 8, and 23).

• Addition of a new chapter on Behavioural Finance (Chapter 26). • Refocusing of the derivatives coverage on Enterprise Risk Management (Chapter 24).

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COVERAGE

This book was designed and developed explicitly for a first course in business or corporate finance, for both finance majors and non-majors alike. In terms of background or prerequisites, the book is nearly self-contained, assuming some familiarity with basic algebra and accounting concepts, while still reviewing important accounting principles very early on. The organization of this text has been developed to give instructors the flexibility they need.

Just to give an idea of the breadth of coverage in the Eighth Canadian Edition, the following grid presents, for each chapter, some of the most significant features, as well as a few selected chapter highlights. Of course, in every chapter, opening vignettes, boxed features, in-chapter illustrated examples using real companies, and end-of-chapter materials have been thoroughly updated as well.

Chapters Selected Topics of Interest Benefits to You

PART ONE OVERVIEW OF CORPORATE FINANCE Chapter 1 Introduction to Corporate Finance

• New material: Perspective on the financial crisis of 2007–2009 and its aftermath, in particular, the European government debt credit crisis

• Links to headlines on financial crisis.

• 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.

Chapter 2 Financial Statements, Cash Flow, and Taxes

• New material: Financial statements conforming to IFRS • Links to current practice.

• Cash flow vs. earnings • Defines cash flow and the differences between cash flow and earnings.

• Market values vs. book values • Emphasizes the relevance of market values over book values.

PART TWO FINANCIAL STATEMENTS AND LONG-TERM FINANCIAL PLANNING Chapter 3 Working with Financial Statements

• Using financial statement information • Discusses the advantages and disadvantages of using financial statements.

Chapter 4 Long-Term Financial Planning and Corporate Growth

• Explanation of alternative formulas for sustainable and internal growth rates

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

• Thorough coverage of sustainable growth as a planning tool

• Provides a vehicle for examining the interrelationships among operations, financing, and growth.

PART THREE VALUATION OF FUTURE CASH FLOWS Chapter 5 Introduction to Valuation: The Time Value of Money

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

Chapter 6 Discounted Cash Flow Valuation

• 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.

Chapter 7 Interest Rates and Bond Valuation

• New material: Discussion of bond fund strategies at time of European government debt crisis

• Links chapter material to current events.

• “Clean” vs. “dirty” bond prices and accrued interest

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

• Bond ratings • Up-to-date discussion of bond rating agencies and ratings given to debt. Includes the latest descriptions of ratings used by DBRS.

Chapter 8 Stock Valuation

• New material: Stock valuation using multiples • Broadens coverage of valuation techniques.

• New material: Examples of shareholder activism at Canadian Pacific and Magna International

• Expands governance coverage and links chapter material to current events.

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Chapters Selected Topics of Interest Benefits to You PART FOUR CAPITAL BUDGETING

Chapter 9 Net Present Value and Other Investment Criteria

• New material: Enhanced discussion of multiple IRRs and modified IRR

• Clarifies properties of IRR.

• New material: Practice of capital budgeting in Canada • Current Canadian material demonstrates relevance of techniques presented.

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

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

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

Chapter 10 Making Capital Investment Decisions

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

• Alternative cash flow definitions • Emphasizes the equivalence of various formulas, thereby removing common misunderstandings.

• Special cases of DCF analysis • Considers important applications of chapter tools.

Chapter 11 Project Analysis and Evaluation

• New material: Detailed examples added of scenario analysis in gold mining and managerial options in zoo management

• Brings technique to life in real-world example.

• Sources of value • Stresses the need to understand the economic basis for value creation in a project.

• Scenario and sensitivity “what-if” analyses • Illustrates how to apply and interpret these tools in a project analysis.

• Break-even analysis • Covers cash, accounting, and financial break-even levels.

PART FIVE RISK AND RETURN Chapter 12 Lessons from Capital Market History

• New material: Capital market history updated through 2011, new section on market volatility in 2008, In Their Own Words box on the crash of 2008 and the efficient markets hypothesis

• Extensively covers historical returns, volatilities, and risk premiums.

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

• Market efficiency • Discusses efficient markets hypothesis along with common misconceptions.

Chapter 13 Return, Risk, and the Security Market Line

• New material: Correlations in the financial crisis • Explains instability in correlations with a current example.

• Diversification, systematic and unsystematic risk • Illustrates basics of risk and return in straightforward fashion.

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

PART SIX COST OF CAPITAL AND LONG-TERM FINANCIAL POLICY Chapter 14 Cost of Capital

• Cost of capital estimation • Contains a complete step-by-step illustration of cost of capital for publicly traded Loblaw Companies.

Chapter 15 Raising Capital

• Dutch auction IPOs • Explains uniform price auctions using Google IPO as an example.

• IPO “quiet periods” • Explains the OSC’s and SEC’s quiet period rules.

• Lockup agreements • Briefly discusses the importance of lockup agreements.

• IPOs in practice • Takes in-depth look at IPOs of Facebook and Athabasca Oil Sands.

Chapter 16 Financial Leverage and Capital Structure Policy

• New material: Pecking order theory • Expands coverage of capital structure.

• Basics of financial leverage • Illustrates the effect of leverage on risk and return.

• Optimal capital structure • Describes the basic trade-offs leading to an optimal capital structure.

• Financial distress and bankruptcy • Briefly surveys the bankruptcy process.

Chapter 17 Dividends and Dividend Policy

• New material: Recent Canadian survey evidence on dividend policy

• Survey results show the most important (and least important) factors that financial managers consider when setting dividend policy.

• Dividends and dividend policy • Describes dividend payments and the factors favouring higher and lower payout policies.

Coverage xix

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Chapters Selected Topics of Interest Benefits to You PART SEVEN SHORT-TERM FINANCIAL PLANNING AND MANAGEMENT

Chapter 18 Short-Term Finance and Planning

• Operating and cash cycles • Stresses the importance of cash flow timing.

• Short-term financial planning • Illustrates creation of cash budgets and potential need for financing.

Chapter 19 Cash and Liquidity Management

• Float management • Covers float management thoroughly.

• Cash collection and disbursement • Examines systems that firms use to handle cash inflows and outflows.

Chapter 20 Credit and Inventory Management

• Credit management • Analysis of credit policy and implementation.

• Inventory management • Briefly surveys important inventory concepts.

PART EIGHT TOPICS IN CORPORATE FINANCE Chapter 21 International Corporate Finance

• Exchange rate, political, and governance risks • Discusses hedging and issues surrounding sovereign and governance risks.

• Foreign exchange • Covers essentials of exchange rates and their determination.

• International capital budgeting • Shows how to adapt basic DCF approach to handle exchange rates.

Chapter 22 Leasing

• Synthetic leases • Discusses controversial practice of financing off the statement of financial position (also referred to as off-balance sheet financing).

• Leases and lease valuation • Discusses essentials of leasing.

Chapter 23 Mergers and Acquisitions

• New material: Expanded discussion of dual class stock, investor activism, and ownership and control

• Presents topical issues with Canadian examples.

• Alternatives to mergers and acquisitions • Covers strategic alliances and joint ventures and explains why they are important alternatives.

• Divestitures and restructurings • Examines important actions such as equity carve-outs, spins-offs, and split-ups.

• Mergers and acquisitions • Develops essentials of M&A analysis, including financial, tax, and accounting issues.

PART NINE DERIVATIVE SECURITIES AND CORPORATE FINANCE Chapter 24 Enterprise Risk Management

• New material: Enterprise risk management framework and insurance

• Illustrates need to manage risk and some of the most important types of risk.

• New material: Recent survey results on derivatives use • Relates material to practice by financial executives.

• Hedging with forwards, futures, swaps, and options • Shows how many risks can be managed with financial derivatives.

Chapter 25 Options and Corporate Securities

• Put-call parity and Black–Scholes • Develops modern option valuation and factors influencing option values.

• Options and corporate finance • Applies option valuation to a variety of corporate issues, including mergers and capital budgeting.

Chapter 26 (New Chapter) Behavioural Finance: Implications for Financial Management

• Introduction to Behavioural Finance • Introduces biases, framing effects, and heuristics.

• Behavioural Finance and market efficiency • Explains limits to arbitrage and discusses bubbles and crashes, including the Crash of 2008.

• Market efficiency and the performance of professional money managers

• Expands on efficient markets discussion in Chapter 12 and relates it to Behavioural Finance.

xx Coverage

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LEARNING SOLUTIONS

In addition to illustrating pertinent concepts and presenting up-to-date coverage, the authors strive to present the material in a way that makes it logical and easy to understand. To meet the varied needs of the intended audience, our text 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

Real F inancial Decis ions We have included key features that help students connect chapter concepts to how decision makers use this material in the real world.

In Their Own Words Boxes A unique series of brief essays are written by distinguished scholars and by Canadian practitioners on key topics in the text. To name just a few, these include essays by Jeremy Siegel on efficient market theory and the financial crisis, Eric Lie on option backdating, and Heather Pelant on investment risk.

Jeremy Siegel on Efficient Market Theory and the Crisis

Financial journalist and best-selling author Roger Lowenstein didn’t mince words in a piece for the Washington WW Post this summer: “The upside of the current Great Recession is that it could drive a stake through the heart of the academic nostrum known as the efficient-market hypothesis.” In a similar vein, thethethe highighiggghlyhlyhlyyy resresrespecpecpecpp tedtedted monmonmonmoneyeyey ey y manmanmanmanageageageageg rrr r andandand fifififinannannanciaciacialll l anaanaanalyslyslysyy ttt JJerJerJerJ emyemyemyy GGraGraGra thnthnthnthamamam wrowrowrottetete iininin hihishishis quaquaquaq trterterte lrlyrlyrlyy l tletletlettterterter llaslaslastttt JJanJanJanJ uaruaruary:y:y:yrrr “Th“ThThTheee iincincinc dredredredibliblibliblyyy y iinainainaccuccuccu tratratrateee ffieffieffieffi icieciecie tntntnt marmarmark tketketket ththethetheorororyyy yrrrr [[ca[ca[ca[ useuseused]d]d]d] ] aaa letletletlethalhalhalhallylylyly dandandandangergergergero sousousous comcomcomcombinbinbinbinatiatiatiationononon ofofofof assassassassetetetet b bbubbubbubbleblebleblesss,s, laxlaxlaxlax conconconcontrotrotrotrolslsls,ls,

thought that underlying collateral—the home—could always cover the principal in the event the homeowner defaulted. These models led credit agencies to rate these subprime mortgages as “investment grade.”

But this assessment was faulty. From 2000 through 2006, national home prices rose by 88.7%, far more than the 17.5% gaig n in the consumer prip ce index or the palp try yr 1% rise in median hhouhouhou hsehsehseh ldoldoldold iincincincomeomeome.. NNevNevNevererer b fbefbefbeforeoreore hhavhavhaveee hhomhomhomeee ipripriprip cescesces jjumjumjumj dpedpedpedp ththathathatttt ffarfarfar hahahah deadeadead fofofof prprprprp iiceiceices as as as a dndndnd iincincincomeomeomeomesss.s.

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IN THEIR OWN WORDSIN THEIR OWN WORDS…

Enhanced Real-World Examples There are many current examples integrated throughout the text, tying chapter concepts to real life through illustration and reinforcing the relevance of the material. For added reinforcement, some examples tie into the chapter-opening vignettes.

Web Links We have added and updated website references, a key research tool directing stu- dents to websites that tie into the chapter material.

Integrative Mini Cases These longer problems seek to integrate a number of topics from within the chapter. The Mini Cases allow students to test and challenge their abilities to solve real-life situations for each of the key sections of the text material.

Internet Application Questions Questions relevant to the topic discussed in each chapter, are presented for the students to explore using the Internet. Students will find direct links to the websites included in these questions on the Ross Connect site and linked out directly from the eBook.

Appl icat ion Tools Realizing that there is more than one way to solve problems in Corporate Finance, we include sections that will not only encourage students to learn different problem-solving methods, but will also help them learn or brush up on their financial calculator and Excel® spreadsheet skills.

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Calculator Hints This feature introduces students to problem solving with the assistance of a financial calculator. Sample keystrokes are provided for illustrative purposes, although individual calculators will vary.

Annuity Payments

Finding annuity payments is easy with a financial calculator. In our example just above, the PV is $100,000, the interest rate is 18 percent, and there are five years. We find the pay- ment as follows:

Enter 5 18 100,000

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CALCULATOR HINTS

Spreadsheet Strategies This feature either introduces students to Excel® or helps them brush up on their Excel® spreadsheet skills, particularly as they relate to Corporate Finance. This feature appears in self-contained sections and shows students how to set up spreadsheets to ana- lyze common financial problems—a vital part of every business student’s education.

How to Calculate Bond Prices and Yields Using a Spreadsheet

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:

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SPREADSHEET STRATEGIES

Excel® Spreadsheet Templates Selected questions within the end-of-chapter material, identified by the following icon: , can be solved using the Excel® Spreadsheet Templates available on this text’s Connect. These Excel® templates are a valuable extension of the Spreadsheet Strategies feature.

Study Aids We want students to get the most from this resource and their course, and we realize that students have different learning styles and study needs. We therefore present a number of study features to appeal to a wide range of students.

Chapter Learning Objectives This feature maps out the topics and learning goals in each chapter. Each end-of-chapter problem is linked to a learning objective to help students organize their study time appropriately.

DISCOUNTED CASH FLOW VALUATIONAA

C H A P T E R 6

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bonuses, the signing of big-name ath-

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great fanfare, but the numbers can often be mislead-

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Concept Building Chapter sections are intentionally kept short to promote a step-by-step, building block approach to learning. Each section 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.

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 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.

Key Terms Within each chapter, key terms are highlighted in boldface type the first time they appear. Key terms are defined in the text, and also in a running glossary in the margins of the text for quick reminders. For reference, there is a list of key terms at the end of each chapter and a full glossary with page references for each term at the back of the textbook.

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.

Key Equations These are called out in the text and identified by equation number. An Equa- tion Index is available at the end of the book and a Formula Sheet can be found on the text’s Connect site.

Chapter Summary and Conclusion These paragraphs review the chapter’s key points and provide closure to the chapter.

Chapter Review Problems and Self-Test Appearing after the Summary and Conclusions and Key Terms, each chapter includes Chapter Review Problems and a Self-Test section. These questions and answers allow students to test their abilities in solving key problems related to the chapter content and provide instant reinforcement.

Concepts Review and Critical Thinking Questions This section facilitates students’ knowledge of key principles, and their intuitive understanding of chapter concepts. A number of the questions relate to the chapter-opening vignette—reinforcing students’ critical-thinking skills and the learning of chapter material.

Concepts Review and Critical Thinking Questions 1. (LO3) What effect would the following actions have on a

firm’s current ratio? Assume that net working capital is positive. a. Inventory is purchased. b. A supplier is paid. c. A short-term bank loan is repaid. d. A long-term debt is paid off early. e. A customer pays off a credit account. f. Inventory is sold at cost. gg.g InveInventorntory isy isy solsold fod for ar a profprofp itit.

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closely watched for semiconductor manufacturers. A ratio of 0.93 indicates that for every $100 worth of chips shipped over some period, only $93 worth of new orders is received. In Feb- ruary 2006, the semiconductor equipment industry’s book-to- bill reached 1.01, compared to 0.98 during the month of January 2006. The book-to-bill ratio reached a low of 0.78 during October 2006. The three-month average of worldwide bookings in January 2006 was $1.30 billion, an increase of 6 percent over January 2005, while the three-month average of billbillingsingsg inin FebrFebruaryuaryy 20062006 waswas $1 2$1.2$ 99 billbillionion,, aa 22 percpercp entent in-in- creacreacreasese se fffromfromfrom bF bFebrFebrFebruaryuaryuaryy 2005200520052005. . hWh tWhatWhatWhat iisis is hthithisthisthis tiratiratiratioo o i tinteinteinte d dd dndedndednded ttototo measmeasmeas ?ure?ure?ure? WhWhyWhyWhyy ddododo youyouyou y hithinthinthink ik itk itk it iisisis so cso cso clloseloseloselly wly wly wy hatchatchatch d?ed?ed?ed?

9999.9. ((LO5(LO5(LO5(LO5(LO5( ))))))) SSo cSo-cSo-c llalleallealledddd ““samsamsame ste-ste-storeoreore lsalesalesale ”s”ss areareare aaa veryveryveryyy impoimpoimpop rtanrtanrtanttt meamea-mea- f i di C di Ti d Ti H

Questions and Problems We have found that many students learn better when they have plenty of opportunity to practise; therefore, we provide extensive end-of-chapter questions and problems. These are labelled by topic and separated into three learning levels: Basic, Intermediate, and Challenge. Throughout the text, we have worked to supply interesting problems that illustrate real-world applications of chapter material. Answers to selected end-of-chapter material appear in Appendix B (now available on Connect).

As described earlier in this Preface, students’ learning and understanding of the chapter con- tent is further supported by the following end-of-chapter materials:

• Internet Application Questions • Mini Cases • Suggested Readings (now available on Connect)

Learning Solutions xxiii

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McGraw-Hill Connect™ is a web-based assignment and assessment platform that gives students the means to better connect with their coursework, with their instructors, and with the important concepts that they will need to know for success now and in the future.

With Connect, instructors can deliver assignments, quizzes, and tests online. Nearly all the questions from the text are presented in an auto-gradeable format and tied to the text’s learning objectives. Instructors can edit existing questions and write entirely new problems. Instructors can track individual student performance—by question, assignment, or in relation to the class overall—with detailed grade reports. Integrate grade reports easily with Learning Management Systems (LMS) such as WebCT and Blackboard.

By choosing Connect, instructors are providing their students with a powerful tool for improving academic performance and truly mastering course material. Connect allows students to practise important skills at their own pace and on their own schedule. Importantly, students’ assessment results and instructors’ feedback are all saved online—so students can continually review their progress and plot their course to success.

Connect also provides 24/7 online access to an eBook—an online edition of the text—to aid them in successfully completing their work, wherever and whenever they choose.

Key Features Simple Assignment Management With Connect, creating assignments is easier than ever, so you can spend more time teaching and less time managing.

• Create and deliver assignments easily with selectable end-of-chapter questions and testbank material to assign online.

• Streamline lesson planning, student progress reporting, and assignment grading to make classroom management more efficient than ever.

• Go paperless with the eBook and online submission and grading of student assignments.

Smart Grading When it comes to studying, time is precious. Connect helps students learn more efficiently by providing feedback and practice material when they need it, where they need it.

• Automatically score assignments, giving students immediate feedback on their work and side- by-side comparisons with correct answers.

• Access and review each response; manually change grades or leave comments for students to review.

• Reinforce classroom concepts with practice tests and instant quizzes.

Instructor Library The Connect Instructor Library is your course creation hub. It provides all the critical resources you’ll need to build your course, just how you want to teach it.

• Assign eBook readings and draw from a rich collection of textbook-specific assignments. • Access to all instructor resources:

Connect content Prepared by Merlyn Foo, Athabasca University. Instructor’s Manual Prepared by Lewis Stevenson, Brock University. The Instructor’s Manual contains two main sections. The first section contains a chapter outline with lecture tips, real-world tips, and ethics notes. The second section includes detailed solutions for all end-of-chapter problems.

TECHNOLOGY SOLUTIONS

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TECHNOLOGY SOLUTIONS

Computerized Test Bank Prepared by Sepand Jazzi, Kwantlen Polytechnic University. The computerized test bank is available through EZ Test Online—a flexible and easy-to-use electronic testing program—that allows instructors to create tests from book-specific items. EZ Test accommodates a wide range of question types and allows instructors to add their own questions. Test items are also available in Word format (Rich text format). For secure online testing, exams created in EZ Test can be exported to WebCT and Blackboard. EZ Test Online is supported at mhhe.com/eztest where users can download a Quick Start Guide, access FAQs, or log a ticket for help with specific issues. PowerPoint® Presentation Prepared by Anne Inglis. The Microsoft® PowerPoint® Pre- sentation slides have been enhanced to better illustrate chapter concepts. Image Bank All figures and tables are available in digital format on the McGraw-Hill Con- nect™ site associated with this text, which can be found at mcgrawhillconnect.ca. Excel® Templates (with Solutions) Prepared by Brent Matheson, University of Water- loo. Excel® templates are included with solutions for end-of-chapter problems indicated by an Excel® icon in the margin of the text. • View assignments and resources created for past sections. • Post your own resources for students to use.

eBook Connect reinvents the textbook learning experience for the modern student. Every Connect subject area is seamlessly integrated with Connect eBooks, which are designed to keep students focused on the concepts key to their success.

• Provide students with a Connect eBook, allowing for anytime, anywhere access to the text- book.

• Merge media, animation and assessments with the text’s narrative to engage students and im- prove learning and retention.

• Pinpoint and connect key concepts in a snap using the powerful eBook search engine. • Manage notes, highlights, and bookmarks in one place for simple, comprehensive review.

No two students are alike. McGraw-Hill LearnSmart™ is an intelligent learning system that uses a series of adaptive questions to pinpoint each student’s knowledge gaps. LearnSmart then provides an optimal learning path for each student, so that they spend less time in areas they already know and more time in areas they don’t. The result is LearnSmart’s adaptive learning path helps students retain more knowledge, learn faster, and study more efficiently.

Lyryx for Corporate F inance Lyryx Assessment for Finance is a leading-edge online assessment system, designed to support both students and instructors. The assessment takes the form of a homework assignment called a Lab. The assessments are algorithmically generated and automatically graded so that students get instant grades and feedback. New Labs are randomly generated each time, providing the student with unlimited opportunities to try a type of question. After they submit a Lab for marking, students receive extensive feedback on their work, thus promoting their learning experience.

Please contact your iLearning Sales Specialist for additional information on the Lyryx As- sessment Finance system. Visit lyryx.com.

a d v a n c i n g l e a r n i n g

Technology Solutions xxv

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Superior Learning Solut ions and Support The McGraw-Hill Ryerson team is ready to help you assess and integrate any of our products, technology, and services into your course for optimal teaching and learning performance. Whether it’s helping your students improve their grades, or putting your entire course online, the McGraw-Hill Ryerson team is here to help you do it. Contact your iLearning Sales Specialist today to learn how to maximize all of McGraw-Hill Ryerson’s resources!

For more information on the latest technology and Learning Solutions offered by McGraw-Hill Ryerson and its partners, please visit us online: mcgrawhill.ca/he/solutions.

Solutions that make a difference.

Course Management CourseSmart brings together thousands of textbooks across hundreds of courses in an e-

textbook format, providing unique benefits to students and faculty. By purchasing an e-textbook, students can save up to 50 percent off the cost of a print textbook, reduce their impact on the environment, and gain access to powerful Web tools for learning, including full-text search, notes and highlighting, and e-mail tools for sharing notes between classmates. For faculty, CourseSmart provides instant access to review and compare textbooks and course materials in their discipline area without the time, cost, and environmental impact of mailing print examination copies. For further details contact your McGraw-Hill Ryerson iLearning Sales Specialist or go to coursesmart.com.

McGraw-Hill Ryerson offers a range of flexible integration solutions for Blackboard, WebCT, Desire2Learn, Moodle, and other leading learning management platforms. Please contact your local McGraw-Hill Ryerson iLearning Sales Specialist for details.

McGraw-Hill’s Create Online gives you access to the most abundant resource at your finger- tips—literally. With a few mouse clicks, you can create customized learning tools simply and af- fordably. McGraw-Hill Ryerson has included many of our market-leading textbooks within Create Online for ebook and print customization as well as many licensed readings and cases. For more information, go to mcgrawhillcreate.ca.

xxvi Technology Solutions

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We never would have completed this book without the incredible amount of help and support we received from colleagues, editors, family members, and friends. We would like to thank, without implicating, all of you.

For starters, a great many of our colleagues read the drafts of our first and current editions. Our reviewers continued to keep us working on improving the content, organization, exposition, and Canadian content of our text. To the following reviewers, we are grateful for their many con- tributions to the Eighth Canadian Edition:

Mohamed Ayadi, Brock University Larry Bauer, Memorial University Jaime Morales Burgos, Trent University Bill Dawson, University of Western Ontario Chris Duff, Royal Roads University Shantanu Dutta, University of Ontario Institute of Technology Larbi Hammami, McGill University Andras Marosi, University of Alberta Brent Matheson, University of Waterloo Judy Palm, Vancouver Island University William Rentz, University of Ottawa David Roberts, Southern Alberta Institute of Technology Jun Yang, Acadia University Yuriy Zabolotnyuk, Carleton University

A special thank you must be given to Hamdi Driss, Schulich School of Business, and VijayShree Vethantham for their vigilant effort of technical proofreading and, in particular, care- ful checking of the solutions in the Instructor’s Manual. Their keen eyes and attention to detail have contributed greatly to the quality of the final product.

Several of our most respected colleagues and journalists contributed essays, entitled “In Their Own Words,” that appear in selected chapters. To these individuals we extend a special thanks:

Edward Altman, New York University James Darroch, York University Christine Dobby, Financial Post Robert C. Higgins, University of Washington Ken Hitzig, Accord Financial Corp. Erik Lie, University of Iowa Robert C. Merton, Harvard University Merton H. Miller, University of Chicago Heather Pelant, Barclays Global Investors Canada Jay R. Ritter, University of Florida Robert J. Schiller, Yale University Hersh Shefrin, Santa Clara University Jeremy Siegel, University of Pennsylvania Bennett Stewart, Stern Stewart & Co. Jamie Sturgeon, Financial Post Samuel Weaver, The Hershey Company David Weitzner, York University

Ganesh Kannan, recent Schulich MBA graduate, deserves special mention for his role in producing the Eighth Canadian Edition. He capably researched updates, drafted revisions, and responded to editorial queries; and his excellent input was essential to this edition.

ACKNOWLEDGEMENTS

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Much credit goes to a “AAA-rated” group of people at McGraw-Hill Ryerson who worked on the Eighth Canadian Edition. Leading the team was Kimberley Veevers, Senior Product Manager, who continued her role as champion of this project by arranging unparalleled support for the development of the text and support package for this edition. Maria Chu, Senior Product Developer, efficiently and cheerfully supervised the reviews and revision as she has done for many prior editions. Production and copy-editing were handled ably by Joanne Limebeer, Supervising Editor, and Robert Templeton and Bradley T. Smith, First Folio Resource Group Inc., Copy Editors.

Through the development of this edition, we have taken great care to discover and eliminate errors. Our goal is to provide the best Canadian textbook available in Corporate Finance.

Please forward your comments to: Professor Gordon S. Roberts Schulich School of Business, York University 4700 Keele Street, Toronto, Ontario M3J IP3

Or, email your comments to groberts@schulich.yorku.ca.

Stephen A. Ross Randolph W. Westerfield

Bradford D. Jordan Gordon S. Roberts

xxviii Acknowledgements

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Chapters Selected Topics of Interest Benefits to You

PART ONE OVERVIEW OF CORPORATE FINANCE

Chapter 1 Introduction to Corporate Finance

• New material: Perspective on the financial crisis of 2007–2009 and its aftermath, in particular, the European government debt credit crisis

• Links to headlines on financial crisis.

• 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.

Chapter 2 Financial Statements, Cash Flow, and Taxes

• New material: Financial statements conforming to IFRS

• Links to current practice.

• Cash flow vs. earnings • Defines cash flow and the differences between cash flow and earnings.

• Market values vs. book values • Emphasizes the relevance of market values over book values.

PART TWO FINANCIAL STATEMENTS AND LONG-TERM FINANCIAL PLANNING

Chapter 3 Working with Financial Statements

• Using financial statement information • Discusses the advantages and disadvantages of using financial statements.

Chapter 4 Long-Term Financial Planning and Corporate Growth

• Explanation of alternative formulas for sustainable and internal growth rates

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

• Thorough coverage of sustainable growth as a planning tool

• Provides a vehicle for examining the interrelationships among operations, financing, and growth.

PART THREE VALUATION OF FUTURE CASH FLOWS

Chapter 5 Introduction to Valuation: The Time Value of Money

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

Chapter 6 Discounted Cash Flow Valuation

• 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.

Chapter 7 Interest Rates and Bond Valuation

• New material: Discussion of bond fund strategies at time of European government debt crisis

• Links chapter material to current events.

• “Clean” vs. “dirty” bond prices and accrued interest

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

• Bond ratings • Up-to-date discussion of bond rating agencies and ratings given to debt. Includes the latest descriptions of ratings used by DBRS.

Chapter 8 Stock Valuation

• New material: Stock valuation using multiples • Broadens coverage of valuation techniques.

• New material: Examples of shareholder activism at Canadian Pacific and Magna International

• Expands governance coverage and links chapter material to current events.

PART FOUR CAPITAL BUDGETING

Chapter 9 Net Present Value and Other Investment Criteria

• New material: Enhanced discussion of multiple IRRs and modified IRR

• Clarifies properties of IRR.

• New material: Practice of capital budgeting in Canada

• Current Canadian material demonstrates relevance of techniques presented.

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

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

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

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Chapters Selected Topics of Interest Benefits to You

Chapter 10 Making Capital Investment Decisions

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

• Alternative cash flow definitions • Emphasizes the equivalence of various formulas, thereby removing common misunderstandings.

• Special cases of DCF analysis • Considers important applications of chapter tools.

Chapter 11 Project Analysis and Evaluation

• New material: Detailed examples added of scenario analysis in gold mining and managerial options in zoo management

• Brings technique to life in real-world example.

• Sources of value • Stresses the need to understand the economic basis for value creation in a project.

• Scenario and sensitivity “what-if” analyses • Illustrates how to apply and interpret these tools in a project analysis.

• Break-even analysis • Covers cash, accounting, and financial break-even levels.

PART FIVE RISK AND RETURN

Chapter 12 Lessons from Capital Market History

• New material: Capital market history updated through 2011, new section on market volatility in 2008, In Their Own Words box on the crash of 2008 and the efficient markets hypothesis

• Extensively covers historical returns, volatilities, and risk premiums.

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

• Market efficiency • Discusses efficient markets hypothesis along with common misconceptions.

Chapter 13 Return, Risk, and the Security Market Line

• New material: Correlations in the financial crisis • Explains instability in correlations with a current example.

• Diversification, systematic and unsystematic risk • Illustrates basics of risk and return in straightforward fashion.

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

PART SIX COST OF CAPITAL AND LONG-TERM FINANCIAL POLICY

Chapter 14 Cost of Capital

• Cost of capital estimation • Contains a complete step-by-step illustration of cost of capital for publicly traded Loblaw Companies.

Chapter 15 Raising Capital

• Dutch auction IPOs • Explains uniform price auctions using Google IPO as an example.

• IPO “quiet periods” • Explains the OSC’s and SEC’s quiet period rules.

• Lockup agreements • Briefly discusses the importance of lockup agreements.

• IPOs in practice • Takes in-depth look at IPOs of Facebook and Athabasca Oil Sands.

Chapter 16 Financial Leverage and Capital Structure Policy

• New material: Pecking order theory • Expands coverage of capital structure.

• Basics of financial leverage • Illustrates the effect of leverage on risk and return.

• Optimal capital structure • Describes the basic trade-offs leading to an optimal capital structure.

• Financial distress and bankruptcy • Briefly surveys the bankruptcy process.

Chapter 17 Dividends and Dividend Policy

• New material: Recent Canadian survey evidence on dividend policy

• Survey results show the most important (and least important) factors that financial managers consider when setting dividend policy.

• Dividends and dividend policy • Describes dividend payments and the factors favouring higher and lower payout policies.

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Chapters Selected Topics of Interest Benefits to You

PART SEVEN SHORT-TERM FINANCIAL PLANNING AND MANAGEMENT

Chapter 18 Short-Term Finance and Planning

• Operating and cash cycles • Stresses the importance of cash flow timing.

• Short-term financial planning • Illustrates creation of cash budgets and potential need for financing.

Chapter 19 Cash and Liquidity Management

• Float management • Covers float management thoroughly.

• Cash collection and disbursement • Examines systems that firms use to handle cash inflows and outflows.

Chapter 20 Credit and Inventory Management

• Credit management • Analysis of credit policy and implementation.

• Inventory management • Briefly surveys important inventory concepts.

PART EIGHT TOPICS IN CORPORATE FINANCE

Chapter 21 International Corporate Finance

• Exchange rate, political, and governance risks • Discusses hedging and issues surrounding sovereign and governance risks.

• Foreign exchange • Covers essentials of exchange rates and their determination.

• International capital budgeting • Shows how to adapt basic DCF approach to handle exchange rates.

Chapter 22 Leasing

• Synthetic leases • Discusses controversial practice of financing off the statement of financial position (also referred to as off-balance sheet financing).

• Leases and lease valuation • Discusses essentials of leasing.

Chapter 23 Mergers and Acquisitions

• New material: Expanded discussion of dual class stock, investor activism, and ownership and control

• Presents topical issues with Canadian examples.

• Alternatives to mergers and acquisitions • Covers strategic alliances and joint ventures and explains why they are important alternatives.

• Divestitures and restructurings • Examines important actions such as equity carve-outs, spins-offs, and split-ups.

• Mergers and acquisitions • Develops essentials of M&A analysis, including financial, tax, and accounting issues.

PART NINE DERIVATIVE SECURITIES AND CORPORATE FINANCE

Chapter 24 Enterprise Risk Management

• New material: Enterprise risk management framework and insurance

• Illustrates need to manage risk and some of the most important types of risk.

• New material: Recent survey results on derivatives use

• Relates material to practice by financial executives.

• Hedging with forwards, futures, swaps, and options

• Shows how many risks can be managed with financial derivatives.

Chapter 25 Options and Corporate Securities

• Put-call parity and Black–Scholes • Develops modern option valuation and factors influencing option values.

• Options and corporate finance • Applies option valuation to a variety of corporate issues, including mergers and capital budgeting.

Chapter 26 (New Chapter) Behavioural Finance: Implications for Financial Management

• Introduction to Behavioural Finance • Introduces biases, framing effects, and heuristics.

• Behavioural Finance and market efficiency • Explains limits to arbitrage and discusses bubbles and crashes, including the Crash of 2008.

• Market efficiency and the performance of professional money managers

• Expands on efficient markets discussion in Chapter 12 and relates it to Behavioural Finance.

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To begin our study of modern corporate fi nance and fi nancial management, we need to address two central issues: First, what is corporate fi nance, and what is the role of the fi nancial manager in the corporation? Second, what is the goal of fi nancial management? To describe the fi nancial management environment, we look at the corporate form of organization and discuss some con- fl icts that can arise within the corporation. We also take a brief look at fi nancial institutions and fi nancial markets in Canada.

1.1 Corporate Finance and the Financial Manager

In this section, we discuss where the fi nancial manager fi ts in the corporation. We start by looking at what corporate fi nance is and what the fi nancial manager does.

INTRODUCTION TO CORPORATE FINANCE

C H A P T E R 1

T im Hortons Inc. has come a long way since its 1964 inception in Hamilton, Ontario under the title “Tim Horton Donuts.” Today, the com-

pany is the largest quick-service restaurant chain in

Canada, and is among the well-recognized brands

in the country. Founded as a sole proprietorship by

Tim Horton, and later run as a partnership with Ron

Joyce, the company began with a specialized focus

on coffee and donuts. Following Horton’s death in

1974, Joyce continued to run the business under an

aggressive expansion strategy. By February 1987,

Tim Hortons had opened 300 stores across Canada.

In 1995, Tim Hortons was acquired by Wendy’s

International Inc., which gave new impetus to the

expansion of the brand in the United States. Eleven

years later in March of 2006, Tim Hortons held its

initial public offering (IPO) and was fully spun off

by Wendy’s International in September of the same

year. With more than 4,000 locations in Canada, the

United States, and the Gulf Cooperation Council,

the majority of which are franchisee owned, the Tim

Hortons story touches on different business forms,

corporate goals, and corporate control, all topics

that are discussed in this chapter. Tim Hortons is a

registered trademark of The TDL Marks Corporation.

Used with permission.

Learning Object ives

After studying this chapter, you should understand:

LO1 The basic types of financial management decisions and the role of the financial manager.

LO2 The financial implications of the different forms of business organization.

LO3 The goal of financial management.

LO4 The conflicts of interest that can arise between managers and owners.

LO5 The roles of financial institutions and markets.

P A R T 1

Ti m

H or

to ns

is a

re

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t ra

de m

ar k

of T

he T

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is si

on .

01Ross_Chapter01_3rd_A.indd 101Ross_Chapter01_3rd_A.indd 1 12-11-12 13:3012-11-12 13:30

What Is Corporate Finance? Imagine that you were to start your own business. No matter what type you started, you would have to answer the following three questions in some form or another:

1. What long-term investments should you take on? That is, what lines of business will you be in and what sorts of buildings, machinery, equipment, and research and development facili- ties will you need?

2. Where will you get the long-term financing to pay for your investment? Will you bring in other owners or will you borrow the money?

3. How will you manage your everyday financial activities, such as collecting from customers and paying suppliers?

Th ese are not the only questions by any means, but they are among the most important. Cor- porate fi nance, broadly speaking, is the study of ways to answer these three questions.

Accordingly, we’ll be looking at each of them in the chapters ahead. Th ough our discussion focuses on the role of the fi nancial manager, these three questions are important to managers in all areas of the corporation. For example, selecting the fi rm’s lines of business (Question 1) shapes the jobs of managers in production, marketing, and management information systems. As a result, most large corporations centralize their fi nance function and use it to measure perform- ance in other areas. Most CEOs have signifi cant fi nancial management experience.

The Financial Manager A striking feature of large corporations is that the owners (the shareholders) are usually not directly involved in making business decisions, particularly on a day-to-day basis. Instead, the corporation employs managers to represent the owners’ interests and make decisions on their behalf. In a large corporation, the fi nancial manager is in charge of answering the three questions we raised earlier.

It is a challenging task because changes in the fi rm’s operations and shift s in Canadian and global fi nancial markets mean that the best answers for each fi rm are changing, sometimes quite rapidly. Globalization of markets and advanced communications and computer technology, as well as increased volatility of interest rates and foreign exchange rates, have raised the stakes in fi nancial management decisions. We discuss these major trends and how they are changing the fi nancial manager’s job aft er we introduce you to some of the basics of corporate fi nancial decisions.

Th e fi nancial management function is usually associated with a top offi cer of the fi rm, such as a vice president of fi nance or some other chief fi nancial offi cer (CFO). Figure 1.1 is a simpli- fi ed organization chart that highlights the fi nance activity in a large fi rm. Th e CFO reports to the president, who is the chief operating offi cer (COO) in charge of day-to-day operations. Th e COO reports to the chairman, who is usually chief executive offi cer (CEO). However, as businesses become more complex, there is a growing pattern among large companies to separate the roles of Chairman and CEO. Th e CEO has overall responsibility to the board. As shown, the vice presi- dent of fi nance coordinates the activities of the treasurer and the controller. Th e controller’s offi ce handles cost and fi nancial accounting, tax payments, and management information systems. Th e treasurer’s offi ce is responsible for managing the fi rm’s cash, its fi nancial planning, and its capital expenditures. Th ese treasury activities are all related to the three general questions raised earlier, and the chapters ahead deal primarily with these issues. Our study thus bears mostly on activities usually associated with the treasurer’s offi ce.

Financial Management Decisions As our discussion suggests, the fi nancial manager must be concerned with three basic types of questions. We consider these in greater detail next.

CAPITAL BUDGETING The first question concerns the firm’s long-term investments. The process of planning and managing a firm’s long-term investments is called capital budget- ing. In capital budgeting, the financial manager tries to identify investment opportunities that are worth more to the firm than they will cost to acquire. Loosely speaking, this means that the value

For current issues facing CFOs, see cfo.com