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essentials of Corporate Finance

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

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

FINANCIAL MANAGEMENT

Block, Hirt, and Danielsen Foundations of Financial Management Fourteenth Edition

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

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

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

Brooks FinGame Online 5.0

Bruner Case Studies in Finance: Managing for Corporate Value Creation Seventh Edition

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

Cornett, Adair, and Nofsinger M: Finance Second Edition

DeMello Cases in Finance Second 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 Tenth Edition

Kellison Theory of Interest Third Edition

Ross, Westerfield, and Jaffe Corporate Finance Tenth Edition

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

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

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

Shefrin Behavioral Corporate Finance: Decisions that Create Value First Edition

White Financial Analysis with an Electronic Calculator Sixth Edition

INVESTMENTS

Bodie, Kane, and Marcus Essentials of Investments Ninth Edition

Bodie, Kane, and Marcus Investments Ninth Edition

Hirt and Block Fundamentals of Investment Management Tenth Edition

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

Saunders and Cornett Financial Markets and Institutions Fifth Edition

INTERNATIONAL FINANCE

Eun and Resnick International Financial Management Sixth Edition

REAL ESTATE

Brueggeman and Fisher Real Estate Finance and Investments Fourteenth Edition

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

FINANCIAL PLANNING AND INSURANCE

Allen, Melone, Rosenbloom, and Mahoney Retirement Plans: 401(k)s, IRAs, and Other Deferred Compensation Approaches Tenth Edition

Altfest Personal Financial Planning First Edition

Harrington and Niehaus Risk Management and Insurance Second Edition

Kapoor, Dlabay, and Hughes Focus on Personal Finance: An active approach to help you develop successful financial skills Fourth Edition

Kapoor, Dlabay, and Hughes Personal Finance Tenth Edition

Walker and Walker Personal Finance: Building Your Future First Edition

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essentials of Corporate Finance

E I G H T H E D I T I O N

Stephen A. Ross Massachusetts Institute of Technology

Randolph W. Westerfield University of Southern California

Bradford D. Jordan University of Kentucky

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www.mhhe.com

ESSENTIALS OF CORPORATE FINANCE, EIGHTH EDITION Published by McGraw-Hill/Irwin, a business unit of The McGraw-Hill Companies, Inc., 1221 Avenue of the Americas, New York, NY, 10020. Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved. Printed in the United States of America. Previous editions © 2011, 2008, and 2007. 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 The McGraw-Hill Companies, Inc., including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning.

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

This book is printed on acid-free paper.

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ISBN 978-0-07-803475-6 MHID 0-07-803475-2

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

Library of Congress Cataloging-in-Publication Data

Ross, Stephen A. Essentials of corporate finance / Stephen A. Ross, Randolph W. Westerfield, Bradford D. Jordan. -- 8th ed. p. cm. Includes index. ISBN-13: 978-0-07-803475-6 (alk. paper) ISBN-10: 0-07-803475-2 (alk. paper) 1. Corporations--Finance. I. Westerfield, Randolph W. II. Jordan, Bradford D. III. Title. HG4026.R676 2014 658.15--dc23 2012041243

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, and McGraw-Hill does not guarantee the accuracy of the information presented at these sites.

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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 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 currently serves as an associate editor of several academic and practitioner journals. He is a trustee of CalTech.

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. 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 has been a member of several public company boards of directors, including Health Management Associates, Inc., and Oak Tree Finance, LLC. 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 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 published numerous articles on issues such as the cost of capital, capital structure, and the behavior of security prices. He is a past president of the Southern Finance Association, and he is coauthor of Fundamentals of Investments: Valuation and Management, 6th edition, a leading investments text, also published by McGraw-Hill/Irwin.

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From the Authors

W hen we first wrote Essentials of Corporate Finance, we thought there might be a small niche for a briefer book that really focused on what students with widely vary- ing 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 seven editions of Essentials has far ex- ceeded anything we thought possible. With the eighth 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 business 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 impor- tant 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 have always maintained that the subject of corporate finance can be viewed as the working 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 introduc- tory 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 tenth 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 semes- ter or quarter. Writing 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 bal- ance 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 have always 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 theoreti- cal 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:

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

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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 manage- ment 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 financial analysis is made explicit, possible pitfalls are described, and limitations are discussed. Today, as we prepare to once again 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 feedback 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 providing 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 ex- tensive 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 current as well as your changing needs.

Stephen A. Ross Randolph W. Westerfield Bradford D. Jordan

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Organization of the Text

We designed Essentials of Corporate Finance to be as flexible and modular as pos-sible. 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 con-

tains an overview and survey. Thus, when time is limited, subsequent chapters can be omit-

ted. 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 eighth edition of Essentials, the

following 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 Updated opener on “Say on Pay.”

Updated corporate ethics box.

Goal of the firm and agency problems.

Ethics, financial management, and executive compensation.

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

Describes ethical issues in the context of recent insider trading scandals.

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

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

PART TWO Understanding Financial Statements and Cash Flow

Chapter 2 Cash flow vs. earnings.

Market values vs. book values.

New box on tax rates.

Clearly defines cash flow and spells out the differences between cash flow and earnings.

Emphasizes the relevance of market values over book values.

Discusses controversy surrounding tax rates paid by Warren Buffett, Greg Mankiw, and Mitt Romney.

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Chapters Selected Topics Benefits to Users

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

New ratio discussion.

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

Introduces and discusses the EBITDA/enterprise value ratio.

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.

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.

PART FOUR Valuing Stocks and Bonds

Chapter 6 New opener on bond ratings.

Bond valuation.

Interest rates and inflation.

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

FINRA’s TRACE system and transparency in the corporate bond market.

“Make-whole” call provisions.

Discusses the downgrade of U.S. Treasury debt from AAA to AA.

Thorough coverage of bond price/yield concepts.

Highly intuitive discussion of inflation, the Fisher effect, and the term structure of interest rates.

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

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

Up-to-date discussion of relatively new type of call provision that has become very common.

Chapter 7 Stock valuation.

New section on stock valuation.

NYSE and Nasdaq Market operations.

Thorough coverage of constant and nonconstant growth models.

Covers valuation using multiples.

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

PART FIVE Capital Budgeting

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

First of two chapters on capital budgeting.

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

Illustrates the growing importance of “green” business.

Relatively short chapter introduces key ideas on an intuitive level to help students with this traditionally difficult topic.

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

Chapter 9 Project cash flow.

Scenario and sensitivity “what-if” analyses.

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

Illustrates how to actually apply and interpret these tools in a project analysis.

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Chapters Selected Topics Benefits to Users

PART SIX Risk and Return

Chapter 10 New material on the 2008–2011 period.

Capital market history.

Market efficiency.

Geometric vs. arithmetic returns.

Discusses the dramatic collapse and equally dramatic rebound in equity prices over this period.

Extensive coverage of historical returns, volatilities, and risk premiums.

Efficient markets hypothesis discussed along with common misconceptions.

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

Chapter 11 Diversification, systematic, and unsystematic risk.

Beta and the security market line.

Illustrates basics of risk and return in a straightforward fashion.

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

PART SEVEN Long-Term Financing

Chapter 12 Cost of capital estimation.

Geometric vs. arithmetic growth rates.

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

Both approaches are used in practice. Clears up issues surrounding growth rate estimates.

Chapter 13 Basics of financial leverage.

Optimal capital structure.

Financial distress and bankruptcy.

Illustrates effect of leverage on risk and return.

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

Briefly surveys the bankruptcy process.

Chapter 14 Updated to reflect latest research on dividend policy.

Dividends and dividend policy.

Brings students the latest thinking and evidence on dividend policy and also the results of a natural experiment—the 2003 dividend tax cut.

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

Chapter 15 IPO valuation.

Dutch auctions.

New coverage on the “partial adjustment” phenomenon.

Extensive, up-to-date discussion of IPOs, including the 1999–2000 period and the recent Facebook IPO.

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

Explains the well-known relation between IPO underpricing and offer prices relative to file ranges.

PART EIGHT Short-Term Financial Management

Chapter 16 Operating and cash cycles.

Short-term financial planning.

Stresses the importance of cash flow timing.

Illustrates creation of cash budgets and potential need for financing.

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Chapters Selected Topics Benefits to Users

Chapter 17 Cash collection and disbursement.

Credit management.

Inventory management.

Examination of systems used by firms to handle cash inflows and outflows.

Analysis of credit policy and implementation.

Brief overview of important inventory concepts.

PART NINE Topics in Business Finance

Chapter 18 Foreign exchange.

International capital budgeting.

Exchange rate and political risk.

Covers essentials of exchange rates and their determination.

Shows how to adapt the basic DCF approach to handle exchange rates.

Discusses hedging and issues surrounding sovereign risk.

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Learning Solutions

In addition to illustrating relevant concepts and presenting up-to-date coverage, Essen-tials of Corporate Finance strives to present the material in a way that makes it engag- ing and easy to understand. To meet the varied needs of the intended audience, Essentials

of Corporate 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

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.

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

In modern history, about the safest investment available has been U.S. Treasury bonds. And low risk meant that U.S. Treasury bonds paid a lower return, or “yield,” than other bonds. However,

in February 2010, insurer Berkshire Hathaway issued bonds with a

lower promised yield than Treasury bonds. Berkshire Hathaway was

not alone: Proctor & Gamble, Johnson & Johnson, and Lowe’s all

were able to sell bonds with lower promised yields.

So what happened? Apparently, the bond market was saying

that these four corporations had lower risk than the U.S. govern-

ment. In August 2011, credit rating agency S&P agreed when it

lowered the credit rating on U.S. Treasury bonds from the vaunted

AAA. Other countries had similar experiences. About the same time,

Japan’s government debt was downgraded, and on a single day

PART FOUR Valuing Stocks and Bonds

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

Interest Rates and Bond Valuation

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learning objectives

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C H A P T E R 4 Introduction to Valuation: The Time Value of Money 111FINANCE MATTERS

Collectibles as Investments?

It used to be that trading in collectibles such as base-ball cards, art, and old toys occurred mostly at auctions, swap meets, and collectible shops, all of which were lim- ited to regional traffic. However, with the growing popularity of online auctions such as eBay, trading in collectibles has expanded to an international arena. The most visible form of collectible is probably the baseball card, but Furbies, Beanie Babies, and Pokémon cards have been extremely hot collectibles in the recent past. However, it’s not just fad items that spark interest from collectors; virtually anything of sentimental value from days gone by is considered col- lectible, and, more and more, collectibles are being viewed as investments. Collectibles typically provide no cash flows until they are sold, and condition and buyer sentiment are the major determinants of value. The rates of return have been amaz- ing at times, but care is needed in interpreting them. For ex- ample, in 2011, an 1855-S Indian Head gold $3 coin sold for $1,322,500. While that looks like a whopping price increase to the untrained eye, check for yourself that the actual return on the investment was only about 8.69 percent per year. Not

too bad, but nowhere near the return most people expect from looking at the sales price. Comic books have recently grown in popularity among collectors. Spiderman, who first appeared in Amazing Fan- tasy No. 15, is an extremely popular superhero. The comic book sold in August 1963 at a cover price of 12 cents. In 2011, a copy of this issue had mutated to a price of $1.1 mil- lion at auction, the first Marvel Comics superhero to hit the million dollar mark. This seems like a very high return to the untrained eye, and indeed it is! Check for yourself that the return was about 39.65 percent per year. Stamp collecting (or philately) is a another popular ac- tivity. Possibly the most desirable stamp in the world is the Mauritius “Post Office” stamp, issued in 1847. One thousand of the stamps were originally printed, and many were used on invitations by the wife of the Governor of Mauritius for a ball she was holding. Only 27 of the stamps are confirmed to remain in existence. In 2011, a blue two pence version of the stamp sold for £1,053,090 (about $1,645,000). Assuming two pence is equal to two cents, see for yourself that this repre- sents an annual return of about 11.75 percent.

For the latest news on the topics covered in this chapter, scan here.

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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 everyday financial de- cision making.

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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.

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.

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APPLICATION TOOLS

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