College of Administrative
and Financial Sciences
Assignment 1
Principles of Finance (FIN101)
Deadline for students: (2/10/2022@ 23:59)
Course Name: Principles of Finance
Student’s Name:
Course Code: FIN101
Student’s ID Number:
Semester: 1st
CRN:
Academic Year: 1444/1445 H, Second Semester
For Instructor’s Use only
Instructor’s Name:
Students’ Grade:
Level of Marks:
Instructions – PLEASE READ THEM CAREFULLY
❖ This assignment is an individual assignment.
❖ The Assignment must be submitted only in WORD format via the allocated
folder.
❖ Assignments submitted through email will not be accepted.
❖ Students are advised to make their work clear and well presented. This also
includes filling in your information on the cover page.
❖ Students must mention question numbers clearly in their answers.
❖ Late submitted assignments will NOT be entertained.
❖ Avoid plagiarism; the work should be in your own words; copying from students
or other resources without proper referencing will result in ZERO marks. No
exceptions.
❖ All answered must be typed using Times New Roman (size 12, double-spaced)
font. No pictures containing text will be accepted and will be considered
plagiarism).
Submissions without this cover page will NOT be accepted.
Assignment Questions:
(Marks: 15)
1. A company had cash and marketable securities worth $200,000 accounts payables
worth $51,000, inventory of $1,501,500, accounts receivables of $5,288,128, shortterm notes payable worth $220,000, other current liabilities of 100,000, and other
current assets of $121,800. Calculate the company net working capital and describe
how managers manage the firm working capital. (2 Marks)
2. Your parents have given you $1,500 a year before your graduation so that you can
take a trip when you graduate. You wisely decide to invest the money in a bank CD
that pays 7% interest. You know that the trip costs $1600 right now and that
inflation for the year is predicted to be 3%. Will you have enough money in a year to
purchase the trip? Show your calculations. (2 Marks)
3. If the following financial information related to XYZ Company. Total Revenues last
year $970, depreciation expenses $50, costs of goods sold $450, and interest
expenses $55. At the end of the year, current assets were $121 and current liabilities
were $107. The company has an average tax rate of 35%. Calculate the net income
for XYZ Company by setting up an income statement. (2 Marks)
4. Calculate the common-size balance sheet from the following information for the
company: (2 Marks)
5. ten years ago, Amanda Cortez invested $20,000 in an account paying an annual
interest rate of 5%. What is the value of the investment today? What is the interest
on interest earned on this investment? (2 Marks)
6. You have just won a lottery that promises an annual payment of $120000 beginning
immediately. You will receive a total of 15 payments. If you can invest the cash flow
in an investment that is paying 8% annually, what is the present value of this
annuity? (2 Marks)
7. XXX company has forecast a rate of return of 20% if the economy booms (30%
probability); a rate of return of 19% if the economy in in a growth phase (40%
probability); a rate of return of 2.50% if the economy in in decline (20% probability);
and a rate of return of -10% if the economy in a depression (10% probability). What
is the company standard deviation of returns? (3 Marks)
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SECOND
EDITION
F U N D A M E N T A L S
O F
CORPORATE
FINANCE
Robert Parrino
Lamar Savings Centennial Professor of Finance
University of Texas at Austin
David S. Kidwell
Professor of Finance and Dean Emeritus
University of Minnesota
Thomas W. Bates
Department Chair and Associate Professor of Finance
Arizona State University
John Wiley & Sons, Inc.
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SECOND
EDITION
F U N D A M E N T A L S
O F
CORPORATE
FINANCE
Robert Parrino
Lamar Savings Centennial Professor of Finance
University of Texas at Austin
David S. Kidwell
Professor of Finance and Dean Emeritus
University of Minnesota
Thomas W. Bates
Department Chair and Associate Professor of Finance
Arizona State University
John Wiley & Sons, Inc.
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COVER PHOTO
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Greg Chaput
William A. Murray
Jennifer MacMillan
Maureen Eide
Benjamin Antony Monn/Gigia Marchiori Photo Agency
The CFA Institute Materials used in this book are reproduced and republished from the CFA Program Materials with
permission from the CFA Institute. The authors and publisher are grateful for permission to use this material.
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Dedication
ROBERT PARRINO
To my parents, whose life-long support and commitment to education
inspired me to become an educator and to my wife, Emily, for her
unending support.
DAVID KIDWELL
To my parents, Dr. William and Margaret Kidwell for their endless
support of my endeavors, to my son, David Jr., of whom I am very
proud, and to my wife Jillinda who is the joy of my life.
THOMAS BATES
To my wife, Emi, and our daughters Abigail and Lillian. Your support,
patience, fun, and friendship make me a better educator, scholar, and
person.
ABO U T T HE A U T HO RS
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ROBERT PARRINO
Lamar Savings Centennial Professor of Finance
McCombs School of Business, University of Texas at Austin
A member of the faculty at University of Texas since 1992, Dr. Parrino teaches courses in
regular degree and executive education programs at the University of Texas, as well as in
customized executive education courses for industrial, financial, and professional firms. He
has also taught at the University of Chicago, University of Rochester, and IMADEC University
in Vienna. Dr. Parrino has received numerous awards for teaching excellence at University
of Texas from students, faculty, and the Texas Ex’s (alumni association).
Dr. Parrino has been involved in advancing financial education outside of the classroom
in a variety of ways. As a Chartered Financial Analyst (CFA) charterholder he has been
very active with the CFA Institute, having been a member of the candidate curriculum
committee, served as a regular speaker at the annual Financial Analysts Seminar, spoken at
over 20 Financial Analyst Society meetings, and as a past member of the planning committee
for the CFA Institute’s Annual Meeting. In addition, Dr. Parrino is the founding director of
the Hicks, Muse, Tate & Furst Center for Private Equity Finance at the University of Texas.
Dr. Parrino was Vice President for Financial Education of the Financial Management
Association (FMA) from 2008 to 2010 and has been elected to serve as an academic director
of the FMA from 2011 to 2013.
Dr. Parrino is also co-founder of the Financial Research Association and is Associate Editor
of the Journal of Corporate Finance and the Journal of Financial Research. Dr. Parrino’s
research includes work on corporate governance, financial policies, restructuring, and
mergers and acquisitions, as well as research on private equity markets. He has published his
research in a number of journals, including the Journal of Finance, Journal of Financial
Economics, Journal of Financial and Quantitative Analysis, Journal of Law and Economics,
Journal of Portfolio Management, and Financial Management. Dr. Parrino has won a number
of awards for his research.
Dr. Parrino has experience in the application of corporate finance concepts in a variety of
business situations. Since entering the academic profession he has been retained as an
advisor on valuation issues concerning businesses with enterprise values ranging to more
than $1 billion and has consulted in areas such as corporate financing, compensation, and
corporate governance. Dr. Parrino is currently on the advisory council of Virgo capital, a
private equity firm, and was previously President of Sprigg Lane Financial, Inc., a financial
consulting firm with offices in Charlottesville, Virginia and New York City. While at Sprigg
Lane, he was on the executive, banking, and portfolio committees of the holding company
that owns Sprigg Lane. Before joining Sprigg Lane, Dr. Parrino was on the Corporate
Business Planning and Development staff at Marriott Corporation. At Marriott, he conducted fundamental business analyses and preliminary financial valuations of new business
development opportunities and potential acquisitions. Dr. Parrino holds a B.S. in chemical
engineering from Lehigh University, an MBA degree from The College of William and
Mary, and M.S. and Ph.D. degrees in applied economics and finance, respectively, from
University of Rochester.
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DAVID S. KIDWELL
THOMAS W. BATES
Professor of Finance and Dean Emeritus
Curtis L. Carlson School of Management, University of Minnesota
Department Chair and Associate Professor of Finance
W. P. Carey School of Business, Arizona State University
Dr. Kidwell has over 30 years experience in financial
education, as a teacher, researcher, and administrator. He
has served as Dean of the Carlson School at the University
of Minnesota and of the School of Business Administration
at the University of Connecticut. Prior to joining the
University of Connecticut, Dr. Kidwell held endowed chairs
in banking and finance at Tulane University, the University
of Tennessee, and Texas Tech University. He was also on the
faculty at the Krannert Graduate School of Management,
Purdue University where he was twice voted the outstanding
undergraduate teacher of the year.
Dr. Bates is the Chair of the Department of Finance and
Dean’s Council of 100 Distinguished Scholar at the
W. P. Carey School of Business, Arizona State University.
He has also taught courses in finance at the University of
Delaware, the Ivey School of Business at the University of
Western Ontario, and the University of Arizona where he
received the Scrivner teaching award. During his career as
an educator, Professor Bates has taught corporate finance
to students in undergraduate, MBA, executive MBA, and
Ph.D. programs, as well as in custom corporate educational courses.
An expert on the U.S. financial system, Dr. Kidwell is the
author of more than 80 articles dealing with the U.S.
financial system and capital markets. He has published his
research in the leading journals, including Journal of
Finance, Journal of Financial Economics, Journal of Financial
and Quantitative Analysis, Financial Management, and
Journal of Money, Credit, and Banking. Dr. Kidwell has also
participated in a number of research grants funded by the
National Science Foundation to study the efficiency of U.S.
capital markets, and to study the impact of government
regulations upon the delivery of consumer financial services.
Professor Bates is a regular contributor to the academic
finance literature in such journals as The Journal of Finance,
Journal of Financial Economics, and Financial Management.
His research addresses a variety of issues in corporate
finance including the contracting environment in mergers
and acquisitions, corporate liquidity decisions and cash
holdings, and the governance of corporations. In practice,
Dr. Bates has worked with companies and legal firms as an
advisor on issues related to the valuation of companies and
corporate governance. Dr. Bates received a B.A. in Economics from Guilford College and his doctorate in finance from
the University of Pittsburgh.
Dr. Kidwell has been a management consultant for Coopers &
Lybrand and a sales engineer for Bethlehem Steel Corporation.
He currently serves on the Board of Directors and is the
Chairman of the Audit and Risk Committee of the Schwan
Food Company. Dr. Kidwell is the past Secretary-Treasurer of
the Board of Directors of AACSB, the International Association
for Management Education and is a past member of the Boards
of the Minnesota Council for Quality, the Stonier Graduate
School of Banking, and Minnesota Center for Corporate
Responsibility. Dr. Kidwell has also served as an Examiner for
the 1995 Malcolm Baldrige National Quality Award, on the
Board of Directors of the Juran Center for Leadership in Quality,
and on the Board of the Minnesota Life Insurance Company.
Dr. Kidwell holds an undergraduate degree in mechanical
engineering from California State University at San Diego,
an MBA with a concentration in finance from California
State University at San Francisco, and a Ph.D. in finance
from the University of Oregon.
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Preface
We have written Fundamentals of Corporate Finance for use in an introductory course in
corporate finance at the undergraduate level. It is also suitable for advanced undergraduate, executive development, and traditional or executive MBA courses when supplemented with cases and outside readings. The main chapters in the book assume that
students are well-versed in algebra and that they have taken courses in principles of
economics and financial accounting. Optional chapters covering important economic
and financial accounting concepts are included for students and instructors seeking
such coverage.
Balance Between Conceptual Understanding
and Computational Skills
We wrote this corporate finance text for one very important reason. We want to provide students and instructors with a book that strikes the best possible balance between helping students develop an intuitive understanding of key financial concepts and providing them with
problem-solving and decision-making skills. In our experience, teaching students at all levels
and across a range of business schools, we have found that students who understand the intuition underlying the basic concepts of finance are better able to develop the critical judgment
necessary to apply financial tools to a broad range of real-world situations. An introductory
corporate finance course should provide students with a strong understanding of both the
concepts and tools that will help them in their subsequent business studies and their personal
and professional lives.
Market research supports our view. Many faculty members who teach the introductory
corporate finance course to undergraduates express a desire for a book that bridges the gap
between conceptually-focused and computationally-focused books. This text is designed to
bridge this gap. Specifically, the text develops the fundamental concepts underlying corporate
finance in an intuitive manner while maintaining a strong emphasis on developing computational skills. It also takes the students one step further by emphasizing the use of intuition and
analytical skills in decision making.
Our ultimate goal has been to write a book and develop associated learning tools that
help our colleagues succeed in the classroom—materials that are genuinely helpful in the
learning process. Our book offers a level of rigor that is appropriate for finance majors and yet
presents the content in a manner that both finance and non-finance students find accessible
and want to read. Writing a book that is both rigorous and accessible has been one of our key
objectives, and both faculty and student reviews of the first edition, as well as pre-publication
chapters from this second edition, suggest that we have achieved this objective.
We have also tried to provide solutions to many of the challenges facing finance faculty in
the current environment, who are asked to teach ever-increasing numbers of students with
limited resources. Faculty members need a book and associated learning tools that help them
effectively leverage their time. The organization of this book and the supplemental materials,
along with the innovative WileyPLUS Web-based interface, which offers extensive problem
solving opportunities and other resources for students, provide such leverage to an extent not
found with other textbooks.
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PREFACE
A Focus on Value Creation
This book is more than a collection of ideas, equations, and chapters. It has an important integrating theme—that of value creation. This theme, which is carried throughout the book,
provides a framework that helps students understand the relations between the various concepts covered in the book and makes it easier for them to learn these concepts.
The concept of value creation is the most fundamental notion in corporate finance. It is
in stockholders’ best interests for value maximization to be at the heart of the financial decisions made within the firm. Thus, it is critical that students be able to analyze and make
business decisions with a focus on value creation. The concept of value creation is introduced in the first chapter of the book and is further developed and applied throughout the
remaining chapters.
The theme of value creation is operationalized through the net present value (NPV)
concept. Once students grasp the fundamental idea that financial decision makers should
only choose courses of action whose benefits exceed their costs, analysis and decision making using the NPV concept becomes second nature. By helping students better understand
the economic rationale for a decision from the outset, rather than initially focusing on computational skills, our text keeps students focused on the true purpose of the calculations and
the decision at hand.
Integrated Approach: Intuition, Analysis, and Decision Making
To support the focus on value creation, we have emphasized three things: (1) providing an
intuitive framework for understanding fundamental finance concepts, (2) teaching students
how to analyze and solve finance problems, and (3) helping students develop the ability to use
the results from their analyses to make good financial decisions.
1. An Intuitive Approach: We believe that explaining finance concepts in an intuitive
context helps students develop a richer understanding of those concepts and gain better
insights into how finance problems can be approached. It is our experience that students
who have a strong conceptual understanding of financial theory better understand how
things really work and are better problem solvers and decision makers than students
who focus primarily on computational skills.
2. Analysis and Problem Solving: With a strong understanding of the basic principles of
finance, students are equipped to tackle a wide range of financial problems. In addition
to the many numerical examples that are solved in the text of each chapter, this book has
almost 1,200 end-of-chapter homework and review problems that have been written
with Bloom’s Taxonomy in mind. Solutions for these problems are provided in the
Instructor’s Manual. We strive to help students acquire the ability to analyze and solve
finance problems.
3. Decision Making: In the end, we want to prepare students to make sound financial
decisions. To help students develop these skills, throughout the text we illustrate how the
results from financial analyses are used in decision making.
ix
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Organization and Coverage
n order to help students develop the skills necessary to tackle
nvestment and financing decisions, we have arranged the
book’s 21 chapters into five major building blocks, that collecively comprise the seven parts of the book, as illustrated in the
ccompanying exhibit and described below.
ntroduction
Part 1, which consists of Chapter 1, provides an introduction
o corporate finance. It describes the role of the financial manger, the types of fundamental decisions that financial mangers
make, alternative forms of business organization, the goal of
he firm, agency conflicts and how they arise, and the imporance of ethics in financial decision-making. These discussions
et the stage and provide a framework that students can use to
hink about key concepts as the course progresses.
Foundations
Part 2 of the text consists of Chapters 2 through 4. These chapers present the basic institutional, economic, and accounting
Introduction
Part 1: Introduction
Chapter 1. The Financial
Manager and
the Firm
Basic Concepts
&
Tools
Part 3: Valuation of Future Cash Flows
Chapter 5. The Time Value of Money
Chapter 6. Discounted Cash Flows and
Valuation
Chapter 7 Risk and Return
Chapter 8. Bond Valuation and the
Structure of Interest Rates
Chapter 9. Stock Valuation
Part 2: Foundations
Chapter 2. The Financial System and the Level of Interest Rates
Chapter 3. Financial Statements, Cash Flows, and Taxes
Chapter 4. Analyzing Financial Statements
knowledge and tools that students should understand before
they begin the study of financial concepts. Most of the material in these chapters is typically taught in other courses.
Since students come to the corporate finance course with
varying academic backgrounds, and because the time that
has elapsed since students have taken particular prerequisite
courses also varies, the chapters in Part 2 can help the instructor ensure that all students have the same base level of
knowledge early in the course. Depending on the educational
background of the students, the instructor might not find it
necessary to cover all or any of the material in these chapters.
Some or all of these chapters might, instead, be assigned as
supplemental readings.
Chapter 2 describes the services financial institutions provide to businesses, how domestic and international financial
markets work, the concept of market efficiency, how firms use
financial markets, and how interest rates are determined in the
economy. Chapter 3 describes the key financial statements and
how they are related, as well as how these statements are related
to cash flows to investors. Chapter 4 discusses ratio analysis
Analysis
Part 4: Capital Budgeting Decisions
Chapter 10. The Fundamentals of
Capital Budgeting
Chapter 11. Cash Flows and Capital
Budgeting
Chapter 12. Evaluating Project
Economics and Capital
Rationing
Chapter 13. The Cost of Capital
Part 5: Working Capital Management
and Financing Decisions
Chapter 14. Working Capital
Management
Chapter 15. How Firms Raise Capital
Chapter 16. Capital Structure Policy
Chapter 17. Dividends, Stock
Repurchases, and Payout
Policy
Integration
Part 6: Business Formation,
Valuation, and Financial
Planning
Chapter 18. Business Formation,
Growth, and Valuation
Chapter 19. Financial Planning and
Forecasting
Part 7: Options in Corporate
Finance and International
Decisions
Chapter 20. Options and Corporate
Finance
Chapter 21. International Financial
Management
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ORGANIZATION AND COVERAGE
and other tools used to evaluate financial statements. Throughout Part 2, we emphasize the importance of cash flows to get
students thinking about cash flows as a critical component of
all valuation calculations and financial decisions.
Basic Concepts and Tools
Part 3 presents basic financial concepts and tools and illustrates their application. This part of the text, which consists of
Chapters 5 through 9, introduces time value of money and risk
and return concepts and then applies present value concepts to
bond and stock valuation. These chapters provide students
with basic financial intuitions and computational tools that
will serve as the building blocks for analyzing investment and
financing decisions in subsequent chapters.
Analysis
Parts 4 and 5 of the text focus on investment and financing
decisions. Part 4 covers capital budgeting. Chapter 10 introduces the concept of net present value and illustrates its application as the principle tool for evaluating capital projects. It
also discusses alternative capital budgeting decision rules, such
as internal rate of return, payback period, and accounting rate
of return, and compares them with the net present value criterion. This discussion provides a framework that will help students in the rest of Part 4 as they learn the nuances of capital
budgeting analysis in realistic settings.
Chapters 11 and 12 follow with in-depth discussions of how
cash flows are calculated and forecast. The cash flow calculations
are presented in Chapter 11 using a valuation framework that
will help students think about valuation concepts in an intuitive
way and will prepare them for the extension of these concepts to
business valuation in Chapter 18. Chapter 12 covers analytical
tools—such as breakeven, sensitivity, scenario, and simulation
analysis—that will give students a better appreciation for how
they can deal with the uncertainties associated with cash flow
forecasts. Capital rationing is also covered in Chapter 12.
Chapter 13 explains how the discount rates used in capital budgeting are estimated. This chapter uses an innovative
concept—that of the finance balance sheet—to help students
develop an intuitive understanding of the relations between
the costs of the individual components of capital and the
firm’s overall weighted average cost of capital. It also provides a detailed discussion of methods used to estimate the
costs of the individual components of capital that are used to
finance a firm’s investments and how these estimates are used
in capital budgeting.
Part 5 covers working capital management and financing
decisions. It begins, in Chapter 14, with an introduction to how
firms manage their working capital and the implications of
working capital management decisions for financing decisions
and firm value. This material is followed, in Chapters 15 and 16,
with discussions of how firms raise capital to fund their real
activities and the factors that affect how firms choose among
the various sources of capital available to them. Chapter 16 also
includes an extensive appendix on leasing concepts and buy vs.
lease analysis. Chapter 17 rounds out the discussion of financing
xi
decisions with an introduction to dividends, stock repurchases,
stock dividends and splits, and payout policy.
Integration
Part 6, which consists of Chapters 18 and 19, brings together many
of the key concepts introduced in the earlier parts of the text.
Chapter 18 covers financial aspects of business formation and
growth and introduces students to business valuation concepts
for both private and public firms. The discussions in this chapter
integrate the investment and financing concepts discussed in
Parts 4 and 5 to provide students with a more complete picture
of how all the financial concepts fit together. Chapter 19 covers
concepts related to financial planning and forecasting.
Part 7 introduces students to some important issues that
managers must deal with in applying the concepts covered in
the text to real-world problems. Chapter 20 introduces call
and put options and discusses how they relate to investment
and financing decisions. It describes options that are embedded in the securities that firms issue. It also explains, at an
accessible level, the idea behind real options and why traditional NPV analysis does not take such options into account.
In addition, the chapter discusses agency costs of debt and
equity and the implications of these costs for investment and
financing decisions. Finally, Chapter 20 illustrates the use of
options in risk management. Instructors can cover the topics
in Chapter 20 near the end of the course or insert them at the
appropriate points in Parts 4 and 5. Chapter 21 examines how
international considerations affect the application of concepts
covered in the book.
Unique Chapters
Chapter on Business Formation, Growth,
and Valuation
We wrote Chapter 18 in response to students’ heightened interest in new business formation (entrepreneurship) and in order
to draw together, in a comprehensive way, the key concepts
from capital budgeting, working capital management, and financial policy. This capstone chapter provides an overview of
practical finance issues associated with forecasting cash flows
and capital requirements for a new business, preparing a business plan, and business valuation. The discussion of business
valuation extends far beyond that found in other introductory
corporate finance textbooks.
Chapter on Options and Corporate Finance
Many other corporate finance textbooks have a chapter that
introduces students to financial options and how they are
valued. This chapter goes further. It provides a focused discussion of the different types of financial and non-financial
options that are of concern to financial managers, including
options embedded in debt and equity securities, real options
and their effect on project analysis, how option-like payoff
functions faced by stockholders, bondholders, and managers
affect agency relationships, and the use of options in risk
management.
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Proven Pedagogical Framework
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We have developed several distinctive features throughout the book to aid
student learning. The pedagogical features included in our text are as follows:
CHAPTER OPENER VIGNETTES
Each chapter begins with a
vignette that describes a real
company or personal application.
The vignettes illustrate concepts
that will be presented in the
chapter and are meant to
heighten student interest, motivate learning, and demonstrate
the real-life relevance of the
material in the chapter.
Learning Objectives
C HA P TE R S E V E N
© David Young-Wolff/PhotoEdit
1
Explain the relation between risk and return.
2
Describe the two components of a total
holding period return, and calculate this
return for an asset.
3
4
5
LEARNING OBJECTIVES
6
The opening vignette is
accompanied by learning
objectives that identify the
most important material for
students to understand while
reading the chapter. At the
end of the chapter, the
Summary of Learning Objectives summarizes the chapter
content in the context of the
learning objectives.
7
200
W
hen Blockbuster Inc. filed for bankruptcy protection
on Thursday, September 23, 2010, its days as the dominant
video rental firm were long gone. Netflix had become the most
successful competitor in the video rental market through its
Explain what an expected return is and
strategy of renting videos exclusively online and avoiding the
calculate the expected return for an asset.
high costs associated with operating video rental stores.
Explain what the standard deviation of
The bankruptcy filing passed control of Blockbuster to a
returns is and why it is very useful in finance,
group of bondholders, including the famous billionaire investor
and calculate it for an asset.
Carl Icahn, and the shares owned by the old stockholders beExplain the concept of diversification.
came virtually worthless. The bondholders planned to reorganize the company and restructure its financing so that it had a
Discuss which type of risk matters to inveschance of competing more effectively with Netflix in the future.
tors and why.
Over the previous five years, Blockbuster stockholders had
Describe what the Capital Asset Pricing
watched the value of their shares steadily decline as, year after
Model (CAPM) tells us and how to use it to
year, the company failed to respond effectively to the threat
evaluate whether the expected return of an
posed by Netflix. From September 23, 2005 to September 23,
asset is sufficient to compensate an investor
2010, the price of Blockbuster shares fell from $4.50 to $0.04. In
for the risks associated with that asset.
contrast, the price of Netflix shares rose from $24.17 to $160.47
over the same period. While the Blockbuster stockholders were
losing almost 100 percent of their investments, Netflix stockholders were earning an average return of 46 percent per year!
This chapter discusses risk, return, and the relation between them. The difference in the
returns earned by Blockbuster and Netflix stockholders from 2005 to 2010 illustrates a challenge faced by all investors. The shares of both of these companies were viewed as risky investments in 2005, and yet an investor who put all of his or her money in Blockbuster lost virtually
everything, while an investor who put all of his or her money in Netflix earned a very high
return. How should have investors viewed the risks of investing in these companys’ shares in
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Calculating the Return on an Investment
APPROACH:
Use Equation
7.1 to calculate the total holding period return. To calc07RiskandReturn.indd
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SOLUTION: The total holding period return is:
RT ⫽ RCA ⫹ RI ⫽
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7 . 1
culate RT using Equation 7.1, you must know P0, P1, and CF1. In this problem, you can
assume that the $7,000 was spent at the time you bought the car to purchase parts and
materials. Therefore, your initial investment, P0, was $1,500 ⫹ $7,000 ⫽ $8,500. Since
there were no other cash inflows or outflows between the time that you bought the car
and the time that you sold it, CF1 equals $0.
A P P L I C AT I O N
PROBLEM: You purchased a beat-up 1974 Datsun 240Z sports car a year ago for
$1,500. Datsun is what Nissan, the Japanese car company, was called in the 1970s. The
240Z was the first in a series of cars that led to the Nissan 370Z that is being sold today.
Recognizing that a mint-condition 240Z is a much sought-after car, you invested $7,000
and a lot of your time fixing up the car. Last week, you sold it to a collector for $18,000.
Not counting the value of the time you spent restoring the car, what is the total return you
earned on this investment over the one-year holding period?
LEARNING
BY
DOING
P1 ⫺ P0 ⫹ CF1
$18,000 ⫺ $8,500 ⫹ $0
⫽
⫽ 1.118, or 111.8%
P0
$8,500
LEARNING BY DOING APPLICATION
Along with a generous number of in-text examples, most chapters include several
Learning by Doing Applications. These applications contain quantitative problems
with step-by-step solutions to help students better understand how to apply their
intuition and analytical skills to solve important problems. By including these
exercises, we provide students with additional practice in the application of the
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concepts, tools, and methods that are discussed in the text.
BUILDING INTUITION
BUILDING
INTUITION
MORE RISK MEANS A HIGHER
EXPECTED RETURN
The greater the risk associated with an investment, the greater the return investors expect
from it. A corollary to this idea is that investors want the highest return for a given level of risk or the lowest risk for a given level of return. When choosing between two
investments that have the same level of risk, investors prefer the
investment with the higher return. Alternatively, if two investments have the same expected return, investors prefer the less
risky alternative.
Students must have an intuitive understanding of a number of
important principles and concepts to successfully master the
finance curriculum. Throughout the book, we emphasize these
important concepts by presenting them in Building Intuition
boxes. These boxes provide a statement of an important finance
concept, such as the relation between risk and expected return,
along with an intuitive example or explanation to help the student
“get” the concept. These boxes help the students develop
finance intuition. Collectively the Building Intuition boxes cover
the most important concepts in corporate finance.
DECISION
MAKING
Choosing between Two Investments
You should not invest in either stock. The expected returns for both of
them are below the values predicted by the CAPM for investments with the same level
of risk. In other words, both would plot below the line in Exhibit 7.11. This implies that
they are both overpriced.
7 . 2
DECISION:
E X A M P L E
SITUATION: You are trying to decide whether to invest in one or both of two different stocks. Stock 1 has a beta of 0.8 and an expected return of 7.0 percent. Stock 2 has
a beta of 1.2 and an expected return of 9.5 percent. You remember learning about the
CAPM in school and believe that it does a good job of telling you what the appropriate
expected return should be for a given level of risk. Since the risk-free rate is 4 percent and
the market risk premium is 6 percent, the CAPM tells you that the appropriate expected
rate of return for an asset with a beta of 0.8 is 8.8 percent. The corresponding value for
an asset with a beta of 1.2 is 11.2 percent. Should you invest in either or both of these
stocks?
DECISION-MAKING EXAMPLES
Throughout the book, we emphasize the role of the financial manager as a decision maker.
To that end, twenty chapters include Decision-Making Examples. These examples, which
emphasize the decision-making process rather than computation, provide students with
experience in financial decision making. Each Decision-Making Example outlines a scenario
and asks the student to make a decision based on the information presented.
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END OF CHAPTER PEDAGOGY
S um m a ry of Learning Objectives
SUMMARY OF LEARNING OBJECTIVES
Return.indd Page 233 7/20/11 1:02:01 PM user-f396
AND
KEY EQUATIONS
1
Explain the relation betweenuser-F396
risk and return.
5
At the end of the chapter, you will find a
ummary of the key chapter content
elated to each of the learning objectives
isted at the beginning of the chapter, as
well as an exhibit listing the key equations
n the chapter.
2
Describe the two components of a total holding period
return, and calculate this return for an asset.
The total holding period return on an investment consists of a
capital appreciation component and an income component. This
return is calculated using Equation 7.1. It is important to recognize that investors do not care whether they receive a dollar of
return through capital appreciation or as a cash dividend. Investors value both sources of return equally.
3
Explain what an expected return is and calculate the
expected return for an asset.
The expected return is a weighted average of the possible returns
f
i
h
h f h
i
i h db h
Explain the concept of diversification.
Diversification is reducing risk by investing in two or more assets whose values do not always move in the same direction at
the same time. Investing in a portfolio containing assets whose
prices do not always move together reduces risk because some
of the changes in the prices of individual assets offset each other.
This can cause the overall volatility in the value of an investor’s
portfolio to be lower than if it consisted of only a single asset.
Investors require greater returns for taking greater risk. They
prefer the investment with the highest possible return for a given
level of risk or the investment with the lowest risk for a given
level of return.
6
Discuss which type of risk matters to investors and why.
Investors care about only systematic risk. This is because they
can eliminate unsystematic risk by holding a diversified portfolio. Diversified investors will bid up prices for assets to the point
at which they are just being compensated for the systematic risks
they must bear.
7
Describe what the Capital Asset Pricing Model (CAPM)
tells us and how to use it to evaluate whether the expected return of an asset is sufficient to compensate an
S um m a ry of Key Equations
Equation
Description
Formula
7.1
Total holding period return
RT ⫽ RCA ⫹ RI ⫽
7.2
Expected return on an asset
E1RAsset 2 ⫽ a 1 pi ⫻ Ri 2
P1 ⫺ P0
CF1
¢P ⫹ CF1
⫹
⫽
P0
P0
P0
n
i51
Self-Study Problems
7.1 Kaaran made a friendly wager with a colleague that involves the result from flipping a coin. If heads
comes up, Kaaran must pay her colleague $15; otherwise, her colleague will pay Kaaran $15. What
is Kaaran’s expected cash flow, and what is the variance of that cash flow if the coin has an equal
probability of coming up heads or tails? Suppose Kaaran’s colleague is willing to handicap the bet by
paying her $20 if the coin toss results in tails. If everything else remains the same, what are Kaaran’s
expected cash flow and the variance of that cash flow?
SELF-STUDY PROBLEMS WITH
SOLUTIONS
7.2 You know that the price of CFI, Inc., stock will be $12 exactly one year from today. Today the price of
the stock is $11. Describe what must happen to the price of CFI, Inc., today in order for an investor
to generate a 20 percent return over the next year. Assume that CFI does not pay dividends.
7.3 The expected value of a normal distribution of prices for a stock is $50. If you are 90 percent sure that
the price of the stock will be between $40 and $60, then what is the variance of the stock price?
7.4 You must choose between investing in stock A or stock B. You have already used CAPM to calculate
the rate of return you should expect to receive for each stock given their systematic risk and decided
that the expected return for both exceeds that predicted by CAPM by the same amount. In other
words, both are equally attractive investments for a diversified investor. However, since you are still
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in school and do not have a lot of money, your investment portfolio is not diversified. You have dec07RiskandReturn.indd Page 234 7/22/11 2:10:30 PM user f-404
cided to invest in the stock that has the highest expected return per unit of total risk. If the expected
d
d dd i i
f
f
kA
10
d 25
i l
d
7.1 Part 1: E1cash flow2 ⫽ 10.5 ⫻ ⫺$152 ⫹ 10.5 ⫻ $152 ⫽ 0
s2Cash flow ⫽ 30.5 ⫻ 1⫺$15 ⫺ $02 2 4 ⫹ 30.5 ⫻ 1$15 ⫺ $02 2 4 ⫽ $225
Part 2: E1cash flow2 ⫽ 10.5 ⫻ ⫺$152 ⫹ 10.5 ⫻ $202 ⫽ $2.50
s2Cash flow ⫽ 30.5 ⫻ 1⫺$15 ⫺ $2.502 2 4 ⫹ 30.5 ⫻ 1$20 ⫺ $2.502 2 4 ⫽ $306.25
Solutions to Self-Study Problems
7.2 The expected return for CFI based on today’s stock price is ($12 ⫺ $11)/$11 ⫽ 9.09 percent, which is
lower than 20 percent. Since the stock price one year from today is fixed, the only way that you will
generate a 20 percent return is if the price of the stock drops today. Consequently, the price of the
stock today must drop to $10. It is found by solving the following: 0.2 ⫽ ($12 ⫺ x)/x, or x ⫽ $10.
Five problems similar to the in-text
Learning by Doing Applications follow
the summary and provide additional
F-404
examples with step-by-step solutions F-404
to help students further develop
their problem-solving and
computational skills.
7.3 Since you know that 1.645 standard deviations around the expected return captures 90 percent of
the distribution, you can set up either of the following equations:
$40 ⫽ $50 ⫺ 1.645s or $60 ⫽ $50 ⫹ 1.645s
and solve for s . Doing this with either equation yields:
s ⫽ $6.079 and s2 ⫽ 36.954
7.4 A comparison of the Sharpe Ratios for the two stocks will tell you which has the highest expected
return per unit of total risk.
E1RA 2 ⫺ Rrf
0.10 ⫺ 0.05
SA ⫽
⫽ 0.20
⫽
sRA
0.25
E1RB 2 ⫺ Rrf
0.15 ⫺ 0.05
⫽
⫽ 0.25
SB ⫽
sRB
0.40
CRITICAL THINKING QUESTIONS
At least ten qualitative questions,
called Critical Thinking Questions,
equire students to think through
heir understanding of key concepts
and apply those concepts to a
problem.
Critical Thinking Questions
7.1 Given that you know the risk as well as the expected return for two stocks, discuss what process
you might utilize to determine which of the two stocks is a better buy. You may assume that the
two stocks will be the only assets held in your portfolio.
7.2 What is the difference between the expected rate of return and the required rate of return? What
does it mean if they are different for a particular asset at a particular point in time?
7.3 Suppose that the standard deviation of the returns on the shares of stock at two different companies is exactly the same. Does this mean that the required rate of return will be the same for these
two stocks? How might the required rate of return on the stock of a third company be greater than
the required rates of return on the stocks of the first two companies even if the standard deviation
of the returns of the third company’s stock is lower?
7.4 The correlation between stocks A and B is 0.50, while the correlation between stocks A and C is
⫺0.5. You already own stock A and are thinking of buying either stock B or stock C. If you want
your portfolio to have the lowest possible risk, would you buy stock B or C? Would you expect the
stock you choose to affect the return that you earn on your portfolio?
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Questions and Problems
>
7.1 Returns: Describe the difference between a total holding period return and an expected return.
B ASIC
7.2 Expected returns: John is watching an old game show rerun on television called Let’s Make a
Deal in which the contestant chooses a prize behind one of two curtains. Behind one of the curtains is a gag prize worth $150, and behind the other is a round-the-world trip worth $7,200. The
game show has placed a subliminal message on the curtain containing the gag prize, which makes
the probability of choosing the gag prize equal to 75 percent. What is the expected value of the
selection, and what is the standard deviation of that selection?
QUESTIONS AND PROBLEMS
The Questions and Problems,
numbering 26 to 44 per chapter, are
primarily quantitative and are
classified as Basic, Intermediate, or
Advanced.
7.3 Expected returns: You have chosen biology as your college major because you would like to be a
medical doctor. However, you find that the probability of being accepted to medical school is about
10 percent. If you are accepted to medical school, then your starting salary when you graduate will be
$
f
d h
ld h
k
h
7.13 Expected returns: Jose is thinking about purchasing a soft drink machine and placing it in a business office. He knows that there is a 5 percent probability that someone who walks by the machine will
make a purchase from the machine, and he knows that the profit on each soft drink sold is $0.10. If
Jose expects a thousand people per day to pass by the machine and requires a complete return of his
investment in one
what1:02:04
is the maximum
price that he should be willing to pay for the soft
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drink machine? Assume 250 working days in a year and ignore taxes and the time value of money.
< IN TERM EDIATE
7.14 Interpreting the variance and standard deviation: The distribution of grades in an
introductory finance class is normally distributed, with an expected grade of 75. If the standard
AD VANC E D > 7.27 David is going to purchase two stocks to form the initial holdings in his portfolio. Iron stock has
an expected return of 15 percent, while Copper stock has an expected return of 20 percent. If
David plans to invest 30 percent of his funds in Iron and the remainder in Copper, what will be the
expected return from his portfolio? What if David invests 70 percent of his funds in Iron stock?
CFA PR O BLEM S > 11.37 FITCO is considering the purchase of new equipment. The equipment costs $350,000, and an addi-
CFA PROBLEMS
tional $110,000 is needed to install it. The equipment will be depreciated straight-line to zero over a
five-year life. The equipment will generate additional annual revenues of $265,000, and it will have
annual cash operating expenses of $83,000. The equipment will be sold for $85,000 after five years.
An inventory investment of $73,000 is required during the life of the investment. FITCO is in the
40 percent tax bracket, and its cost of capital is 10 percent. What is the project NPV?
a. $47,818.
b. $63,658.
c. $80,189.
d. $97,449.
Problems from CFA readings are
included in the Question and Problem section in appropriate chapters.
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EXCEL PROBLEMS
158
CHAPTER 5 I The Time Value of Money
5.35 Sam Bradford, a number 1 draft pick of the St. Louis Rams, and his agent are evaluating three
contract options. Each option offers a signing bonus and a series of payments over the life of the
contract. Bradford uses a 10.25 percent rate of return to evaluate the contracts. Given the cash
flows for each option, which one should he choose?
Year
Cash Flow Type
Option A
Option B
Option C
0
1
2
3
Signing Bonus
Annual Salary
Annual Salary
Annual Salary
$3,100,000
$ 650,000
$ 715,000
$ 822,250
$4,000,000
$ 825,000
$ 850,000
$ 925,000
$4,250,000
$ 550,000
$ 625,000
$ 800,000
Sample Test Problems
SAMPLE TEST PROBLEMS
Finally, five Sample Test Problems call for
straightforward applications of the chapter
concepts. These problems are intended to be
representative of the kind of problems that
may be used in a test, and instructors can
encourage students to solve them as if they
were taking a quiz. Solutions are provided in
the Instructor’s Manual.
END OF PART ETHICS CASES
Ethics is an important topic in finance
and this text addresses ethical issues
in several ways. In Chapter 1, we
introduce a framework for consideration of ethical issues in corporate
finance. Many ethical issues can be
analyzed in the context of informational asymmetry between parties to
a transaction, conflicts of interest,
Nearly all problems can be solved
using Excel templates at the student
Web site within WileyPLUS.
7.1 Friendly Airlines stock is selling at a current price of $37.50 per share. If the stock does not pay a dividend
and has a 12 percent expected return, what is the expected price of the stock one year from today?
7.2 Stefan’s parents are about to invest their nest egg in a stock that he has estimated to have an expected
return of 9 percent over the next year. If the return on the stock is normally distributed with a 3 percent
standard deviation, in what range will the stock return fall 95 percent of the time?
7.3 Elaine has narrowed her investment alternatives to two stocks (at this time she is not worried about
diversifying): Stock M, which has a 23 percent expected return, and Stock Y, which has an 8 percent
expected return. If Elaine requires a 16 percent return on her total investment, then what proportion
of her portfolio will she invest in each stock?
7.4 You have just prepared a graph similar to Exhibit 7.9, comparing historical data for Pear Computer Corp.
and the general market. When you plot the line of best fit for these data, you find that the slope of that line
is 2.5. If you know that the market generated a return of 12 percent and that the risk-free rate is 5 percent,
then what would your best estimate be for the return of Pear Computer during that same time period?
7.5 The CAPM predicts that the return of MoonBucks Tea Corp. is 23.6 percent. If the risk-free rate of return is 8 percent and the expected return on the market is 20 percent, then what is MoonBucks’ beta?
breaches of confidentiality, and
breaches of fiduciary duty (principalagent relationships); we highlight
examples of such analysis throughout the text. In addition, seven ethics
cases are included throughout this
book in order to help students better
understand how to analyze ethical
dilemmas in the context of the
framework. Real company examples
are presented, including timeless
cases about Arthur Anderson and
Martha Stewart’s scandal involving
ImClone, and more timely topics
such as the subprime mortgage
crisis and the advent of sustainable
living plans by corporations. Each
case includes questions for followup discussion in class or as an
assignment.
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New to This Edition
In revising Fundamentals of Corporate Finance we have improved the presentation
and organization of key topics, added important new content, updated the text to
reflect changes in market and business conditions since the first edition was written,
improved key in-chapter pedagogical features, added to the number and quality of
the end-of-chapter problem sets, and updated the ethics cases.
Improved Presentation and Organization
We have edited and extended discussions throughout the text in an effort to improve the pedagogical presentation of key topics. We also have rearranged the order of some material to improve the effectiveness of the presentation. For example,
the discussion of the stock market (Section 2.4 in the first edition) has been incorporated into the section on the market for stocks in Chapter 9 and new content on international stock markets has been added to this discussion. This change improves
the flow of the text and provides a more natural lead-in to the stock valuation concepts that are subsequently discussed in Chapter 9. Also, material on capital market
efficiency (Section 8.1 in the first edition) has being moved to the initial discussion of
financial markets in Chapter 2. This change introduces the student to the concept of
market efficiency earlier in the book and improves the focus of Chapter 8, which
discusses bond valuation and interest rates.
New Content
There have been numerous additions to the content of the book. Some of the most
noteworthy include the following. A new section on cash flows to investors has been
added to Chapter 3 immediately after the discussion of how the financial statements
tie together (Section 3.6 in the first edition). This new section helps students develop
an understanding of the sources and uses of investor cash flows in the context of
the discussion of financial statements. It also enables them to develop an intuitive
understanding of the importance of cash flows to investors prior to the chapters on
the time value of money, risk and return, capital budgeting, and valuation.
A discussion of the Sharpe Ratio has being incorporated into Section 7.4, immediately after the existing material on the coefficient of variation. This discussion
helps students develop a stronger intuition about the relation between risk and return earlier in the book.
An extensive discussion of leasing policy and analysis has been added as an appendix to the chapter on financial policy, Chapter 16. This section introduces students
to leasing as an alternative means of financing the acquisition of an asset, outlines the
conflicts that can arise in lease agreements and mechanisms for reducing the costs of
these conflicts, discusses why certain types of assets are more or less likely to be
leased, and summarizes how financial managers make buy vs. lease decisions. This
material is presented within the same agency framework used in Chapter 16 and can
be taught in conjunction with the rest of Chapter 16, or independently.
The discussion of options in Chapter 20 has been extended to include different types of options embedded in the debt and equity securities that firms issue.
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NEW TO THIS EDITION
This discussion provides students with a more complete picture of the range of financial and non-financial options that are of concern to financial managers.
Current Financial Market and Business Information
Throughout the text, all financial market and business information for which more
current data are available have been updated. Not only have the exhibits been updated, but financial values such as interest rates, risk premia, and foreign currency
exchange rates have been updated throughout the discussions in text, in-text
examples, and end-of-chapter problems. In addition, 19 of the 21 chapter opener
vignettes are completely new. Eighteen of these examples are from 2010, and one is
from 2009. The remaining two opener vignettes have been edited to ensure that
they remain current. All of the chapter openers provide timely examples of how the
material covered in the chapter is relevant to financial decision-making.
In-Chapter Features
The Learning Objectives at the beginning of each chapter have been revised to
more fully reflect the important content in the associated sections of the chapters.
New Building Intuition Boxes have been added where appropriate and existing
Building Intuition Boxes have been edited to ensure clarity.
All Learning by Doing Applications have been reviewed and, where appropriate,
updated or replaced.
All existing Decision-Making Examples have been reviewed and updated where necessary. In addition, six new Decision-Making Examples have been added to the text.
The Summary of Learning Objectives and Key Equations at the end of each chapter
have been updated to reflect other changes in the chapter and to improve the pedagogical value of these features.
Refined and Extended Problem Sets
We have carefully edited the end-of-chapter questions and problems throughout the
book to ensure that the examples are current and clearly presented. In addition, new
questions and problems have been added to ensure appropriate coverage of key
concepts at all levels of difficulty. A total of 96 new questions and problems have
been added to the end-of-chapter problem sets, which brings the total number of
end-of-chapter questions and problems, including self-study problems and self-test
questions, for the entire text to 1,184.
Updated Ethics Cases and Their Organization
The Schwan Foods case has been replaced at the end of Chapter 11 with a new
case concerning the Unilever global Sustainable Living Plan. This case challenges
the student to think about how a sustainability plan can be consistent with stockholder value maximization. In addition, the case on affinity credit cards at the end
of Chapter 6 has been updated to reflect the effects of the Credit Card Act of 2009
and new data on the use of these cards as of 2010. The case on the Subprime Mortgage Market Meltdown has been moved from the end of Chapter 18 to the end of
Chapter 8 so that students can address the timely issues raised in this case earlier in
the course.
xvii
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Instructor and Student Resources
Fundamentals of Corporate Finance Second Edition features a
ull line of teaching and learning resources that were developed under the close review of the authors. Driven by the same
basic beliefs as the textbook, these supplements provide a conistent and well-integrated learning system. This hands-on
package guides instructors through the process of active learnng and provides them with the tools to create an interactive
earning environment. With its emphasis on activities, exerises, and the Internet, the package encourages students to take
n active role in the course and prepares them for decision
making in a real-world context.
WileyPLUS is a research-based, online
environment for effective teaching and
learning. WileyPLUS builds students’ confidence because it takes the guesswork out
of studying by providing students with a clear roadmap:
what to do, how to do it, if they did it right. This interactive
pproach focuses on:
Design: Research-based design is based on proven instrucional methods. Content is organized into small, more accesible amounts of information, helping students build better
ime management skills.
Engagement: Students can visually track their progress as they
move through the material at a pace that is right for them. Engaging in individualized self-quizzes followed by immediate
eedback helps to sustain their motivation to learn.
Outcomes: Self-assessment lets students know the exact outome of their effort at any time. Advanced reporting allows
nstructors to easily spot trends in the usage and performance
data of their class in order to make more informed decisions.
With WileyPLUS, students will always know:
What to do: Features, such as the course calendar, help students stay on track and manage their time more effectively.
How to do it: Instant feedback and personalized learning
plans are available 24/7.
If they’re doing it right: Self-evaluation tools take the guesswork
out of studying and help students focus on the right materials.
WileyPLUS for Fundamentals of Corporate Finance, Second
Edition includes numerous valuable resources, among them:
• Animated Learning by Doing Applications
• Wiley Corporate Finance Video Collection
• Prerequisite Course Reviews
• Animated Tutorials
• Excel Templates and Spreadsheet Solutions
• Flashcards
• Crosswords
• Narrated PowerPoint Review
• Student Study Guide
• Hot Topics Modules
• Learning Styles Survey
Book Companion Site—For Instructors.
An extensive support package, including print and technology
tools, helps you maximize your teaching effectiveness. We offer
useful supplements for instructors with varying levels of experience and different instructional circumstances.
On this Web site instructors will find electronic versions of the
Solutions Manual, Test Bank, Instructor’s Manual, Computerized Test Bank, and other valuable resources: www.wiley.com/
college/Parrino.
Instructor’s Manual. Included for each chapter are lecture
outlines, a summary of learning objectives and key equations, and
alternative approaches to the material. The Solutions Manual
includes detailed solutions to the Before You Go On questions,
Self-Study problems, Critical Thinking Questions, and all of the
Questions and Problems at the end of each chapter.
Test Bank. With over 2000 questions, the test bank allows
instructors to tailor examinations according to study objectives and difficulty. Multiple-choice, true/false, and essay questions are included.
Computerized Test Bank. The computerized test bank
allows instructors to create and print multiple versions of the
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INSTRUCTOR AND STUDENT RESOURCES
same test by scrambling the order of all questions found in the
Word version of the test bank. The computerized test bank also
allows users to customize exams by altering or adding new
problems.
PowerPoint Presentations. The PowerPoint presentations contain a combination of key concepts, figures and tables,
and problems and examples from the textbook as well as lecture notes and illustrations.
WebCT and Angel. WebCT or Angel offer an integrated set of
course management tools that enable instructors to easily design,
develop and manage Web-based and Web-enhanced courses.
Book Companion Site — For Students.
The Fundamentals of Corporate Finance student Web site provides a wealth of support materials that will help students develop their conceptual understanding of class material and increase their ability to solve problems. On this Web site students
will find Excel templates, study tools, Web quizzing, and other
resources: www.wiley.com/college/Parrino.
ACKNOWLEDGMENTS
The nearly 300 colleagues listed below provided valuable feedback during the development process and added greatly to the
content and pedagogy of the book. Their commitment to teaching and willingness to become involved in such a project was a
source of inspiration to the authors. We would like to acknowledge the contribution made by the following professors whose
thoughtful comments contributed to the quality, relevancy, and
accuracy of the first and second editions of this text:
Reviewers
Saul Adelman, Miami University
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Advisory Board
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teven Lifland, High Point University
ason Lin, Truman State University
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onathan Wagoner, Fairmont State College
The following people developed and
revised valuable student and instructor
resources available on the book
companion site and WileyPLUS:
Accuracy Checkers
Publishing Team
Robert J. Balik, Western Michigan University
Babu Baradwaj, Towson University
im P. DeMello, Western Michigan University
haron Garrison, University of Arizona
anjay Jain, Salem State University
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nayat U. Mangla, Western Michigan University
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udith Swisher, Western Michigan University
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We also thank the publishing team who was always calm, supportive, and gracious under fire as we suffered the travail of
college textbook writing and revising, where deadlines are
always yesterday. Those showing extraordinary patience and
support include Joseph Heider, Senior Vice President and
General Manager; Timothy Stookesberry, Vice President, Product
and eBusiness Development; George Hoffman, Vice President
and Executive Publisher; and Susan Elbe, Vice President, Market
Development and Marketing. Those warranting special praise
are Jennifer Manias, Project Editor, who coordinated the complex scheduling of the book and all of its resources; Amy
Scholz, Associate Director of Marketing; and the Wiley sales
force for their creativity and success in selling our book. Other
Wiley staff who contributed to the text and media include
Babu Baradwaj, Towson University
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James DeMello, Western Michigan University
James Dow, G. Michael Phillips, Kenneth Leslie, California State
University, Northridge
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Contributor Team
We owe a special thanks to members of the contributor team
for their hard work, exceptional creativity, consummate communications skills, and advice: Dr. Babu Baradwaj of Towson
State University and Dr. Wendell Licon of Arizona State University who wrote the Instructor’s Manual, student Study
Guide, and major sections of the end-of-chapter materials for
the First Edition. Dr. Norm Bowie of the University of Minnesota wrote most of the ethics cases. Petra Kubalova, of the
Schwan Food Company, worked extensively with Professor
Kidwell on this project during and after completing her MBA
studies at Georgetown University. Dr. Zekiye Selvili of University of Southern California, Steven Gallaher of Southern New
Hampshire University, and Nicholas Crane of University of
Texas at Austin also contributed in a number of areas.
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INSTRUCTOR AND STUDENT RESOURCES
Barbara Heaney, Director of Product and Market Development; Howard Averback, Instructional Designer; Emily McGee and Erica Horowitz, Editorial Assistants; Courtney Luzzi,
Marketing Assistant; Allie Morris, Senior Product Designer;
and Greg Chaput, Product Designer; William Murray, Senior
Production Editor; Maureen Eide, Senior Designer; and
Jennifer MacMillan, Senior Photo Editor.
Colleagues
Robert Parrino would also like to thank some of his colleagues
for their inspiration and helpful discussions. Among those who
have significantly influenced this book are Robert Bruner of
University of Virginia, Jay Hartzell of University of Texas at Austin, and Mark Huson of University of Alberta. Special thanks are
owed to Clifford Smith, of University of Rochester, whose classes
really helped one author make sense of finance. In addition, recognition should go to Michael J. Barclay, who inspired generations of students through his selfless support and example and
who was both a great researcher and teacher.
David Kidwell would like to thank some of his former
professors and colleagues for their inspiration and willingness
xxiii
to share their intellectual capital. George Kaufman and Michael
Hopewell who contributed to Dr. Kidwell’s knowledge of economics and finance and were critical professors during his
doctoral program at the University of Oregon. Richard West,
former dean and professor at the University of Oregon, who
unlocked the secrets of research and inspired Dr. Kidwell’s
love of teaching and scholarship. Robert Johnson of Purdue
University whose dignity and academic bearing served as an
academic role model and whose love of teaching and research
inspired Dr. Kidwell to follow in his footsteps and to write
this book. David Blackwell of Texas A&M University who
helped conceptualize the idea for the book and contributed
numerous insights to various chapters during the book’s writing. Finally, to John Harbell and Jonas Mittelman, of San
Francisco State University who started Dr. Kidwell on his
academic journey.
Thomas Bates would like to thank the professors, coauthors, and colleagues who have made him a better scholar
and educator, including Robert Williams, who first introduced
him to the analytical elegance of economics, and Kenneth Lehn
who inspired him to pursue excellence in research and teaching in the field of finance.
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Brief Contents
PART 1 INTRODUCTION
12 Evaluating Project Economics and Capital
1 The Financial Manager and the Firm
1
Rationing
380
13 The Cost of Capital
PART 2 FOUNDATIONS
PART 5 WORKING CAPITAL MANAGEMENT
AND FINANCING DECISIONS
2 The Financial System and the Level of
Interest Rates
27
14 Working Capital Management 441
15 How Firms Raise Capital 472
16 Capital Structure Policy 504
17 Dividends, Stock Repurchases, and Payout
3 Financial Statements, Cash Flows,
and Taxes
48
4 Analyzing Financial Statements
81
PART 3 VALUATION OF FUTURE CASH
FLOWS AND RISK
5 The Time Value of Money 124
6 Discounted Cash Flows and Valuation 159
7 Risk and Return 200
8 Bond Valuation and the Structure of Interest
Rates
238
Policy
561
PART 6 BUSINESS FORMATION,
VALUATION, AND FINANCIAL
PLANNING
18 Business Formation, Growth,
and Valuation
569
19 Financial Planning and Forecasting
9 Stock Valuation
606
270
PART 4 CAPITAL BUDGETING DECISIONS
1 0 The Fundamentals of Capital
Budgeting
409
301
1 1 Cash Flows and Capital Budgeting
341
PART 7 OPTIONS IN CORPORATE
FINANCE AND INTERNATIONAL
DECISIONS
20 Options and Corporate Finance 641
21 International Financial Management 671
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Contents
PART 1 INTRODUCTION
C HA PT ER
1
The Financial Manager and the Firm 1
1.1 THE ROLE OF THE FINANCIAL MANAGER 2
Stakeholders 2
It’s All about Cash Flows 2
Building Intuition: Cash Flows Matter Most to Investors 4
Three Fundamental Decisions in Financial
Management 4
Building Intuition: Sound Investments are Those Where the Value of the Benefits
Exceeds Their Cost 5
Building Intuition: Financing
Decisions Affect the Value of the Firm 5
1.2 FORMS OF BUSINESS ORGANIZATION 6
Sole Proprietorships 6
Partnerships 7
Corporations 7
Hybrid Forms of Business
Organization 8
1.3 MANAGING THE FINANCIAL FUNCTION 9
Organizational Structure 9
Positions Reporting
to the CFO 10
External Auditors 10
The Audit Committee 10
The Compliance
and Ethics Director 10
1.4 THE GOAL OF THE FIRM 11
What Should Management Maximize? 11
Why Not Maximize Profits? 11
Building Intuition: The Timing of Cash Flows Affects
Their Value 11
Building Intuition: The Riskiness of
Cash Flows Affects Their Value 12
Maximize the
Value of the Firm’s Stock 12
Building Intuition:
The Financial Manager’s Goal Is to Maximize the
Value of the Firm’s Stock 12
Can Management
Decisions Affect Stock Prices? 12
1.5 AGENCY CONFLICTS: SEPARATION OF
OWNERSHIP AND CONTROL 13
Ownership and Control 14
Agency
Relationships 14
Do Managers Really Want
to Maximize Stock Price? 14
Aligning the
Interests of Management and Stockholders 14
Sarbanes-Oxley and Other Regulatory
Reforms 16
1.6 THE IMPORTANCE OF ETHICS IN BUSINESS 18
Business Ethics 18
Are Business Ethics Different
from Everyday Ethics? 18
Types of Ethical Conflicts
in Business 19
The Importance of an Ethical Business Culture 20
Serious Consequences 20
Summary of Learning Objectives • Self-Study
Problems • Solutions to Self-Study Problems •
Critical Thinking Questions • Questions and Problems •
Sample Test Problems
PART 2 FOUNDATIONS
C HA PT ER
2.2 DIRECT FINANCING 27
2
The Financial System and the Level of
Interest Rates 24
2.1 THE FINANCIAL SYSTEM 25
The Financial System at Work 26
through the Financial System 26
How Funds Flow
A Direct Market Transaction 28
and Direct Financing 28
Investment Banks
2.3 TYPES OF FINANCIAL MARKETS 30
Primary and Secondary Markets 30
Exchanges and Over-the-Counter Markets 31
Money and Capital Markets 31
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CONTENTS
Public and Private Markets 31
Markets 32
Futures and Options
Corporate Income Tax Rates 72
Average versus
Marginal Tax Rates 72
Unequal Treatment of Dividends and Interest Payments 73
2.4 MARKET EFFICIENCY 33
Efficient Market Hypotheses 33
2.5 FINANCIAL INSTITUTIONS AND INDIRECT
FINANCING 34
Indirect Market Transactions 35
Financial Institutions
and Their Services 35
Corporations and the Financial
System 36
2.6 THE DETERMINANTS OF INTEREST
RATE LEVELS 38
Summary of Learning Objectives • Summary of Key Equations •
Self-Study Problems • Solutions to Self-Study Problems •
Critical Thinking Questions • Questions and Problems •
Sample Test Problems
3
Financial Statements, Cash Flows,
and Taxes 48
3.1 FINANCIAL STATEMENTS AND ACCOUNTING
PRINCIPLES 49
The Annual Report 49
Generally Accepted Accounting Principles 50
Fundamental Accounting
Principles 50
International GAAP 51
Illustrative
Company: Diaz Manufacturing 51
3.2 THE BALANCE SHEET 52
Current Assets and Liabilities 53
and Liabilities 54
Equity 55
Long-Term Assets
3.3 MARKET VALUE VERSUS BOOK VALUE 57
A More Informative Balance Sheet 57
Value Balance Sheet 58
A Market-
3.4 THE INCOME STATEMENT AND THE STATEMENT
OF RETAINED EARNINGS 60
The Income Statement 60
Retained Earnings 63
Summary of Learning Objectives • Summary of
Key Equations • Self-Study Problems • Solutions
to Self-Study Problems • Critical Thinking Questions •
Questions and Problems • Sample Test Problems
CH AP TE R
The Real Rate of Interest 38
Loan Contracts
and Inflation 40
The Fisher Equation and
Inflation 40
Cyclical and Long-Term Trends
in Interest Rates 42
C HA PT ER
3.8 FEDERAL INCOME TAX 71
The Statement of
3.5 THE STATEMENT OF CASH FLOWS 63
4
Analyzing Financial Statements 81
4.1 BACKGROUND FOR FINANCIAL STATEMENT
ANALYSIS 82
Perspectives on Financial Statement
Analysis 82
Guidelines for Financial
Statement Analysis 83
4.2 COMMON-SIZE FINANCIAL
STATEMENTS 84
Common-Size Balance Sheets 84
Income Statements 85
Common-Size
4.3 FINANCIAL RATIOS AND FIRM PERFORMANCE 86
Why Ratios Are Better Measures 86
Short-Term
Liquidity Ratios 87
Efficiency Ratios 89
Leverage Ratios 93
Profitability Ratios 97
Market-Value Indicators 100
Concluding
Comments on Ratios 101
4.4 THE DUPONT SYSTEM: A DIAGNOSTIC
TOOL 101
An Overview of the DuPont System 101
The ROA
Equation 101
The ROE Equation 103
The
DuPont Equation 103
Applying the DuPont
System 104
Is Maximizing ROE an Appropriate
Goal? 104
4.5 SELECTING A BENCHMARK 106
Trend Analysis 106
Group Analysis 106
Industry Analysis 106
4.6 USING FINANCIAL RATIOS 108
Performance Analysis of Diaz Manufacturing 108
Limitations of Financial Statement Analysis 111
Sources and Uses of Cash 63
3.6 TYING THE FINANCIAL STATEMENTS
TOGETHER 66
3.7 CASH FLOWS TO INVESTORS 67
Net Income versus the Cash Flow to Investors 67
Cash Flow To Investors: Putting It All Together 70
Summary of Learning Objectives • Summary of
Key Equations • Self-Study Problems • Solutions
to Self-Study Problems • Critical Thinking Questions •
Questions and Problems • Sample Test Problems
E T H I C S C A S E : A S a d Ta le : T h e D emi s e o f
A r th u r A n d e r s e n 1 2 2
Peer
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CONTENTS
xxvii
PART 3 VALUATION OF FUTURE CASH FLOWS AND RISK
C HA PT ER
6.4 THE EFFECTIVE ANNUAL INTEREST RATE 185
5
The Time Value of Money 124
5.1 THE TIME VALUE OF MONEY 125
Consuming Today or Tomorrow 125
Building
Intuition: The Value of Money Changes with Time 126
Time Lines as Aids to Problem Solving 126
Financial Calculator 127
5.2 FUTURE VALUE AND COMPOUNDING 127
Single-Period Investment 127
Two-Period
Investment 128
The Future Value Equation 129
The Future Value Factor 131
Applying the
Future Value Formula 132
Building Intuition:
Compounding Drives Much of the Earnings on
Long-Term Investments 134
Calculator Tips for
Future Value Problems 137
5.3 PRESENT VALUE AND DISCOUNTING 140
Single-Period Investment 140
Multiple-Period
Investment 141
The Present Value Equation 142
Future and Present Value Equations Are the Same 142
Applying the Present Value Formula 142
The Relations
among Time, the Discount Rate, and Present Value 144
Calculator Tips for Present Value Problems 145
Future Value versus Present Value 146
5.4 ADDITIONAL CONCEPTS AND
APPLICATIONS 147
Summary of Learning Objectives • Summary of Key Equations •
Self-Study Problems • Solutions to Self-Study Problems •
Critical Thinking Questions • Questions and Problems •
Sample Test Problems
6
Discounted Cash Flows and Valuation 159
6.1 MULTIPLE CASH FLOWS 160
Future Value of Multiple Cash Flows 160
Value of Multiple Cash Flows 163
Summary of Learning Objectives • Summary of Key
Equations • Self-Study Problems • Solutions to Self-Study
Problems • Critical Thinking Questions • Questions and
Problems • Sample Test Problems
A P P E N D I X : Deriving the Formula for the
Present Value of an Ordinar y Annuity 196
P ro ble m 1 9 7
E T H I C S C A S E : Buy It on Credit and Be True to
Your School 198
CH AP TE R
7
Risk and Return 200
7.1 RISK AND RETURN 201
Building Intuition: More Risk Means a Higher Expected
Return 202
7.2 QUANTITATIVE MEASURES OF RETURN 202
Holding Period Returns 202
Finding the Interest Rate 148
Finding How Many
Periods It Takes an Investment to Grow a Certain
Amount 149
The Rule of 72 150
Compound
Growth Rates 150
Concluding Comments 152
C HA P T ER
Why the Confusion? 185
Calculating the
Effective Annual Interest Rate 185
Comparing
Interest Rates 186
Consumer Protection Acts
and Interest Rate Disclosure 187
The Appropriate
Interest Rate Factor 188
Present
6.2 LEVEL CASH FLOWS: ANNUITIES AND
PERPETUITIES 167
Present Value of an Annuity 167
Future Value
of an Annuity 177
Perpetuities 179
Annuities Due 181
6.3 CASH FLOWS THAT GROW AT A CONSTANT
RATE 183
Expected Returns 203
7.3 THE VARIANCE AND STANDARD DEVIATION AS
MEASURES OF RISK 207
Calculating the Variance and Standard Deviation 207
Interpreting the Variance and Standard Deviation 208
Historical Market Performance 211
7.4 RISK AND DIVERSIFICATION 214
Single-Asset Portfolios 215
Portfolios with More
Than One Asset 217
Building Intuition: Diversified
Portfolios are Less Risky 223
The Limits of Diversification 223
7.5 SYSTEMATIC RISK 224
Why Systematic Risk Is All That Matters 224
Building Intuition: Systematic Risk Is the Risk That
Matters 224
Measuring Systematic Risk 225
7.6 COMPENSATION FOR BEARING SYSTEMATIC
RISK 227
7.7 THE CAPITAL ASSET PRICING MODEL 228
The Security Market Line 228
The Capital Asset
Pricing Model andPortfolio Returns 230
Summary of Learning Objectives • Summary of Key
Equations • Self-Study Problems • Solutions to Self-Study
Problems • Critical Thinking Questions • Questions and
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xxviii
CONTENTS
C HA PT ER
8
CH AP TE R
Bond Valuation and the Structure of
nterest Rates 238
8.1 CORPORATE BONDS 239
Market for Corporate Bonds 239
Bond Price Information 240
Types of Corporate Bonds 240
8.2 BOND VALUATION 241
The Bond Valuation Formula 242
Calculator Tip:
Bond Valuation Problems 243
Par, Premium,
and Discount Bonds 244
Semiannual
Compounding 246
Zero Coupon Bonds 246
8.3 BOND YIELDS 248
Yield to Maturity 249
Realized Yield 252
Effective Annual Yield 250
8.4 INTEREST RATE RISK 252
Bond Theorems 253
Applications 255
Bond Theorem
8.5 THE STRUCTURE OF INTEREST RATES 255
Marketability 255
Call Provision 256
Default
Risk 256
The Term Structure of Interest Rates 258
Summary of Learning Objectives • Summary …
Purchase answer to see full
attachment
and Financial Sciences
Assignment 1
Principles of Finance (FIN101)
Deadline for students: (2/10/2022@ 23:59)
Course Name: Principles of Finance
Student’s Name:
Course Code: FIN101
Student’s ID Number:
Semester: 1st
CRN:
Academic Year: 1444/1445 H, Second Semester
For Instructor’s Use only
Instructor’s Name:
Students’ Grade:
Level of Marks:
Instructions – PLEASE READ THEM CAREFULLY
❖ This assignment is an individual assignment.
❖ The Assignment must be submitted only in WORD format via the allocated
folder.
❖ Assignments submitted through email will not be accepted.
❖ Students are advised to make their work clear and well presented. This also
includes filling in your information on the cover page.
❖ Students must mention question numbers clearly in their answers.
❖ Late submitted assignments will NOT be entertained.
❖ Avoid plagiarism; the work should be in your own words; copying from students
or other resources without proper referencing will result in ZERO marks. No
exceptions.
❖ All answered must be typed using Times New Roman (size 12, double-spaced)
font. No pictures containing text will be accepted and will be considered
plagiarism).
Submissions without this cover page will NOT be accepted.
Assignment Questions:
(Marks: 15)
1. A company had cash and marketable securities worth $200,000 accounts payables
worth $51,000, inventory of $1,501,500, accounts receivables of $5,288,128, shortterm notes payable worth $220,000, other current liabilities of 100,000, and other
current assets of $121,800. Calculate the company net working capital and describe
how managers manage the firm working capital. (2 Marks)
2. Your parents have given you $1,500 a year before your graduation so that you can
take a trip when you graduate. You wisely decide to invest the money in a bank CD
that pays 7% interest. You know that the trip costs $1600 right now and that
inflation for the year is predicted to be 3%. Will you have enough money in a year to
purchase the trip? Show your calculations. (2 Marks)
3. If the following financial information related to XYZ Company. Total Revenues last
year $970, depreciation expenses $50, costs of goods sold $450, and interest
expenses $55. At the end of the year, current assets were $121 and current liabilities
were $107. The company has an average tax rate of 35%. Calculate the net income
for XYZ Company by setting up an income statement. (2 Marks)
4. Calculate the common-size balance sheet from the following information for the
company: (2 Marks)
5. ten years ago, Amanda Cortez invested $20,000 in an account paying an annual
interest rate of 5%. What is the value of the investment today? What is the interest
on interest earned on this investment? (2 Marks)
6. You have just won a lottery that promises an annual payment of $120000 beginning
immediately. You will receive a total of 15 payments. If you can invest the cash flow
in an investment that is paying 8% annually, what is the present value of this
annuity? (2 Marks)
7. XXX company has forecast a rate of return of 20% if the economy booms (30%
probability); a rate of return of 19% if the economy in in a growth phase (40%
probability); a rate of return of 2.50% if the economy in in decline (20% probability);
and a rate of return of -10% if the economy in a depression (10% probability). What
is the company standard deviation of returns? (3 Marks)
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SECOND
EDITION
F U N D A M E N T A L S
O F
CORPORATE
FINANCE
Robert Parrino
Lamar Savings Centennial Professor of Finance
University of Texas at Austin
David S. Kidwell
Professor of Finance and Dean Emeritus
University of Minnesota
Thomas W. Bates
Department Chair and Associate Professor of Finance
Arizona State University
John Wiley & Sons, Inc.
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LibraryPirate
SECOND
EDITION
F U N D A M E N T A L S
O F
CORPORATE
FINANCE
Robert Parrino
Lamar Savings Centennial Professor of Finance
University of Texas at Austin
David S. Kidwell
Professor of Finance and Dean Emeritus
University of Minnesota
Thomas W. Bates
Department Chair and Associate Professor of Finance
Arizona State University
John Wiley & Sons, Inc.
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VICE PRESIDENT, EXECUTIVE PUBLISHER
PROJECT EDITOR
EDITORIAL ASSISTANT
ASSOCIATE DIRECTOR OF MARKETING
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COVER PHOTO
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Courtney Luzzi
Allie K. Morris
Greg Chaput
William A. Murray
Jennifer MacMillan
Maureen Eide
Benjamin Antony Monn/Gigia Marchiori Photo Agency
The CFA Institute Materials used in this book are reproduced and republished from the CFA Program Materials with
permission from the CFA Institute. The authors and publisher are grateful for permission to use this material.
This book was set in Minion Pro by Aptara, Inc. and printed and bound by Courier/Kendallville. The cover was
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Dedication
ROBERT PARRINO
To my parents, whose life-long support and commitment to education
inspired me to become an educator and to my wife, Emily, for her
unending support.
DAVID KIDWELL
To my parents, Dr. William and Margaret Kidwell for their endless
support of my endeavors, to my son, David Jr., of whom I am very
proud, and to my wife Jillinda who is the joy of my life.
THOMAS BATES
To my wife, Emi, and our daughters Abigail and Lillian. Your support,
patience, fun, and friendship make me a better educator, scholar, and
person.
ABO U T T HE A U T HO RS
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ROBERT PARRINO
Lamar Savings Centennial Professor of Finance
McCombs School of Business, University of Texas at Austin
A member of the faculty at University of Texas since 1992, Dr. Parrino teaches courses in
regular degree and executive education programs at the University of Texas, as well as in
customized executive education courses for industrial, financial, and professional firms. He
has also taught at the University of Chicago, University of Rochester, and IMADEC University
in Vienna. Dr. Parrino has received numerous awards for teaching excellence at University
of Texas from students, faculty, and the Texas Ex’s (alumni association).
Dr. Parrino has been involved in advancing financial education outside of the classroom
in a variety of ways. As a Chartered Financial Analyst (CFA) charterholder he has been
very active with the CFA Institute, having been a member of the candidate curriculum
committee, served as a regular speaker at the annual Financial Analysts Seminar, spoken at
over 20 Financial Analyst Society meetings, and as a past member of the planning committee
for the CFA Institute’s Annual Meeting. In addition, Dr. Parrino is the founding director of
the Hicks, Muse, Tate & Furst Center for Private Equity Finance at the University of Texas.
Dr. Parrino was Vice President for Financial Education of the Financial Management
Association (FMA) from 2008 to 2010 and has been elected to serve as an academic director
of the FMA from 2011 to 2013.
Dr. Parrino is also co-founder of the Financial Research Association and is Associate Editor
of the Journal of Corporate Finance and the Journal of Financial Research. Dr. Parrino’s
research includes work on corporate governance, financial policies, restructuring, and
mergers and acquisitions, as well as research on private equity markets. He has published his
research in a number of journals, including the Journal of Finance, Journal of Financial
Economics, Journal of Financial and Quantitative Analysis, Journal of Law and Economics,
Journal of Portfolio Management, and Financial Management. Dr. Parrino has won a number
of awards for his research.
Dr. Parrino has experience in the application of corporate finance concepts in a variety of
business situations. Since entering the academic profession he has been retained as an
advisor on valuation issues concerning businesses with enterprise values ranging to more
than $1 billion and has consulted in areas such as corporate financing, compensation, and
corporate governance. Dr. Parrino is currently on the advisory council of Virgo capital, a
private equity firm, and was previously President of Sprigg Lane Financial, Inc., a financial
consulting firm with offices in Charlottesville, Virginia and New York City. While at Sprigg
Lane, he was on the executive, banking, and portfolio committees of the holding company
that owns Sprigg Lane. Before joining Sprigg Lane, Dr. Parrino was on the Corporate
Business Planning and Development staff at Marriott Corporation. At Marriott, he conducted fundamental business analyses and preliminary financial valuations of new business
development opportunities and potential acquisitions. Dr. Parrino holds a B.S. in chemical
engineering from Lehigh University, an MBA degree from The College of William and
Mary, and M.S. and Ph.D. degrees in applied economics and finance, respectively, from
University of Rochester.
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DAVID S. KIDWELL
THOMAS W. BATES
Professor of Finance and Dean Emeritus
Curtis L. Carlson School of Management, University of Minnesota
Department Chair and Associate Professor of Finance
W. P. Carey School of Business, Arizona State University
Dr. Kidwell has over 30 years experience in financial
education, as a teacher, researcher, and administrator. He
has served as Dean of the Carlson School at the University
of Minnesota and of the School of Business Administration
at the University of Connecticut. Prior to joining the
University of Connecticut, Dr. Kidwell held endowed chairs
in banking and finance at Tulane University, the University
of Tennessee, and Texas Tech University. He was also on the
faculty at the Krannert Graduate School of Management,
Purdue University where he was twice voted the outstanding
undergraduate teacher of the year.
Dr. Bates is the Chair of the Department of Finance and
Dean’s Council of 100 Distinguished Scholar at the
W. P. Carey School of Business, Arizona State University.
He has also taught courses in finance at the University of
Delaware, the Ivey School of Business at the University of
Western Ontario, and the University of Arizona where he
received the Scrivner teaching award. During his career as
an educator, Professor Bates has taught corporate finance
to students in undergraduate, MBA, executive MBA, and
Ph.D. programs, as well as in custom corporate educational courses.
An expert on the U.S. financial system, Dr. Kidwell is the
author of more than 80 articles dealing with the U.S.
financial system and capital markets. He has published his
research in the leading journals, including Journal of
Finance, Journal of Financial Economics, Journal of Financial
and Quantitative Analysis, Financial Management, and
Journal of Money, Credit, and Banking. Dr. Kidwell has also
participated in a number of research grants funded by the
National Science Foundation to study the efficiency of U.S.
capital markets, and to study the impact of government
regulations upon the delivery of consumer financial services.
Professor Bates is a regular contributor to the academic
finance literature in such journals as The Journal of Finance,
Journal of Financial Economics, and Financial Management.
His research addresses a variety of issues in corporate
finance including the contracting environment in mergers
and acquisitions, corporate liquidity decisions and cash
holdings, and the governance of corporations. In practice,
Dr. Bates has worked with companies and legal firms as an
advisor on issues related to the valuation of companies and
corporate governance. Dr. Bates received a B.A. in Economics from Guilford College and his doctorate in finance from
the University of Pittsburgh.
Dr. Kidwell has been a management consultant for Coopers &
Lybrand and a sales engineer for Bethlehem Steel Corporation.
He currently serves on the Board of Directors and is the
Chairman of the Audit and Risk Committee of the Schwan
Food Company. Dr. Kidwell is the past Secretary-Treasurer of
the Board of Directors of AACSB, the International Association
for Management Education and is a past member of the Boards
of the Minnesota Council for Quality, the Stonier Graduate
School of Banking, and Minnesota Center for Corporate
Responsibility. Dr. Kidwell has also served as an Examiner for
the 1995 Malcolm Baldrige National Quality Award, on the
Board of Directors of the Juran Center for Leadership in Quality,
and on the Board of the Minnesota Life Insurance Company.
Dr. Kidwell holds an undergraduate degree in mechanical
engineering from California State University at San Diego,
an MBA with a concentration in finance from California
State University at San Francisco, and a Ph.D. in finance
from the University of Oregon.
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Preface
We have written Fundamentals of Corporate Finance for use in an introductory course in
corporate finance at the undergraduate level. It is also suitable for advanced undergraduate, executive development, and traditional or executive MBA courses when supplemented with cases and outside readings. The main chapters in the book assume that
students are well-versed in algebra and that they have taken courses in principles of
economics and financial accounting. Optional chapters covering important economic
and financial accounting concepts are included for students and instructors seeking
such coverage.
Balance Between Conceptual Understanding
and Computational Skills
We wrote this corporate finance text for one very important reason. We want to provide students and instructors with a book that strikes the best possible balance between helping students develop an intuitive understanding of key financial concepts and providing them with
problem-solving and decision-making skills. In our experience, teaching students at all levels
and across a range of business schools, we have found that students who understand the intuition underlying the basic concepts of finance are better able to develop the critical judgment
necessary to apply financial tools to a broad range of real-world situations. An introductory
corporate finance course should provide students with a strong understanding of both the
concepts and tools that will help them in their subsequent business studies and their personal
and professional lives.
Market research supports our view. Many faculty members who teach the introductory
corporate finance course to undergraduates express a desire for a book that bridges the gap
between conceptually-focused and computationally-focused books. This text is designed to
bridge this gap. Specifically, the text develops the fundamental concepts underlying corporate
finance in an intuitive manner while maintaining a strong emphasis on developing computational skills. It also takes the students one step further by emphasizing the use of intuition and
analytical skills in decision making.
Our ultimate goal has been to write a book and develop associated learning tools that
help our colleagues succeed in the classroom—materials that are genuinely helpful in the
learning process. Our book offers a level of rigor that is appropriate for finance majors and yet
presents the content in a manner that both finance and non-finance students find accessible
and want to read. Writing a book that is both rigorous and accessible has been one of our key
objectives, and both faculty and student reviews of the first edition, as well as pre-publication
chapters from this second edition, suggest that we have achieved this objective.
We have also tried to provide solutions to many of the challenges facing finance faculty in
the current environment, who are asked to teach ever-increasing numbers of students with
limited resources. Faculty members need a book and associated learning tools that help them
effectively leverage their time. The organization of this book and the supplemental materials,
along with the innovative WileyPLUS Web-based interface, which offers extensive problem
solving opportunities and other resources for students, provide such leverage to an extent not
found with other textbooks.
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PREFACE
A Focus on Value Creation
This book is more than a collection of ideas, equations, and chapters. It has an important integrating theme—that of value creation. This theme, which is carried throughout the book,
provides a framework that helps students understand the relations between the various concepts covered in the book and makes it easier for them to learn these concepts.
The concept of value creation is the most fundamental notion in corporate finance. It is
in stockholders’ best interests for value maximization to be at the heart of the financial decisions made within the firm. Thus, it is critical that students be able to analyze and make
business decisions with a focus on value creation. The concept of value creation is introduced in the first chapter of the book and is further developed and applied throughout the
remaining chapters.
The theme of value creation is operationalized through the net present value (NPV)
concept. Once students grasp the fundamental idea that financial decision makers should
only choose courses of action whose benefits exceed their costs, analysis and decision making using the NPV concept becomes second nature. By helping students better understand
the economic rationale for a decision from the outset, rather than initially focusing on computational skills, our text keeps students focused on the true purpose of the calculations and
the decision at hand.
Integrated Approach: Intuition, Analysis, and Decision Making
To support the focus on value creation, we have emphasized three things: (1) providing an
intuitive framework for understanding fundamental finance concepts, (2) teaching students
how to analyze and solve finance problems, and (3) helping students develop the ability to use
the results from their analyses to make good financial decisions.
1. An Intuitive Approach: We believe that explaining finance concepts in an intuitive
context helps students develop a richer understanding of those concepts and gain better
insights into how finance problems can be approached. It is our experience that students
who have a strong conceptual understanding of financial theory better understand how
things really work and are better problem solvers and decision makers than students
who focus primarily on computational skills.
2. Analysis and Problem Solving: With a strong understanding of the basic principles of
finance, students are equipped to tackle a wide range of financial problems. In addition
to the many numerical examples that are solved in the text of each chapter, this book has
almost 1,200 end-of-chapter homework and review problems that have been written
with Bloom’s Taxonomy in mind. Solutions for these problems are provided in the
Instructor’s Manual. We strive to help students acquire the ability to analyze and solve
finance problems.
3. Decision Making: In the end, we want to prepare students to make sound financial
decisions. To help students develop these skills, throughout the text we illustrate how the
results from financial analyses are used in decision making.
ix
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Organization and Coverage
n order to help students develop the skills necessary to tackle
nvestment and financing decisions, we have arranged the
book’s 21 chapters into five major building blocks, that collecively comprise the seven parts of the book, as illustrated in the
ccompanying exhibit and described below.
ntroduction
Part 1, which consists of Chapter 1, provides an introduction
o corporate finance. It describes the role of the financial manger, the types of fundamental decisions that financial mangers
make, alternative forms of business organization, the goal of
he firm, agency conflicts and how they arise, and the imporance of ethics in financial decision-making. These discussions
et the stage and provide a framework that students can use to
hink about key concepts as the course progresses.
Foundations
Part 2 of the text consists of Chapters 2 through 4. These chapers present the basic institutional, economic, and accounting
Introduction
Part 1: Introduction
Chapter 1. The Financial
Manager and
the Firm
Basic Concepts
&
Tools
Part 3: Valuation of Future Cash Flows
Chapter 5. The Time Value of Money
Chapter 6. Discounted Cash Flows and
Valuation
Chapter 7 Risk and Return
Chapter 8. Bond Valuation and the
Structure of Interest Rates
Chapter 9. Stock Valuation
Part 2: Foundations
Chapter 2. The Financial System and the Level of Interest Rates
Chapter 3. Financial Statements, Cash Flows, and Taxes
Chapter 4. Analyzing Financial Statements
knowledge and tools that students should understand before
they begin the study of financial concepts. Most of the material in these chapters is typically taught in other courses.
Since students come to the corporate finance course with
varying academic backgrounds, and because the time that
has elapsed since students have taken particular prerequisite
courses also varies, the chapters in Part 2 can help the instructor ensure that all students have the same base level of
knowledge early in the course. Depending on the educational
background of the students, the instructor might not find it
necessary to cover all or any of the material in these chapters.
Some or all of these chapters might, instead, be assigned as
supplemental readings.
Chapter 2 describes the services financial institutions provide to businesses, how domestic and international financial
markets work, the concept of market efficiency, how firms use
financial markets, and how interest rates are determined in the
economy. Chapter 3 describes the key financial statements and
how they are related, as well as how these statements are related
to cash flows to investors. Chapter 4 discusses ratio analysis
Analysis
Part 4: Capital Budgeting Decisions
Chapter 10. The Fundamentals of
Capital Budgeting
Chapter 11. Cash Flows and Capital
Budgeting
Chapter 12. Evaluating Project
Economics and Capital
Rationing
Chapter 13. The Cost of Capital
Part 5: Working Capital Management
and Financing Decisions
Chapter 14. Working Capital
Management
Chapter 15. How Firms Raise Capital
Chapter 16. Capital Structure Policy
Chapter 17. Dividends, Stock
Repurchases, and Payout
Policy
Integration
Part 6: Business Formation,
Valuation, and Financial
Planning
Chapter 18. Business Formation,
Growth, and Valuation
Chapter 19. Financial Planning and
Forecasting
Part 7: Options in Corporate
Finance and International
Decisions
Chapter 20. Options and Corporate
Finance
Chapter 21. International Financial
Management
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ORGANIZATION AND COVERAGE
and other tools used to evaluate financial statements. Throughout Part 2, we emphasize the importance of cash flows to get
students thinking about cash flows as a critical component of
all valuation calculations and financial decisions.
Basic Concepts and Tools
Part 3 presents basic financial concepts and tools and illustrates their application. This part of the text, which consists of
Chapters 5 through 9, introduces time value of money and risk
and return concepts and then applies present value concepts to
bond and stock valuation. These chapters provide students
with basic financial intuitions and computational tools that
will serve as the building blocks for analyzing investment and
financing decisions in subsequent chapters.
Analysis
Parts 4 and 5 of the text focus on investment and financing
decisions. Part 4 covers capital budgeting. Chapter 10 introduces the concept of net present value and illustrates its application as the principle tool for evaluating capital projects. It
also discusses alternative capital budgeting decision rules, such
as internal rate of return, payback period, and accounting rate
of return, and compares them with the net present value criterion. This discussion provides a framework that will help students in the rest of Part 4 as they learn the nuances of capital
budgeting analysis in realistic settings.
Chapters 11 and 12 follow with in-depth discussions of how
cash flows are calculated and forecast. The cash flow calculations
are presented in Chapter 11 using a valuation framework that
will help students think about valuation concepts in an intuitive
way and will prepare them for the extension of these concepts to
business valuation in Chapter 18. Chapter 12 covers analytical
tools—such as breakeven, sensitivity, scenario, and simulation
analysis—that will give students a better appreciation for how
they can deal with the uncertainties associated with cash flow
forecasts. Capital rationing is also covered in Chapter 12.
Chapter 13 explains how the discount rates used in capital budgeting are estimated. This chapter uses an innovative
concept—that of the finance balance sheet—to help students
develop an intuitive understanding of the relations between
the costs of the individual components of capital and the
firm’s overall weighted average cost of capital. It also provides a detailed discussion of methods used to estimate the
costs of the individual components of capital that are used to
finance a firm’s investments and how these estimates are used
in capital budgeting.
Part 5 covers working capital management and financing
decisions. It begins, in Chapter 14, with an introduction to how
firms manage their working capital and the implications of
working capital management decisions for financing decisions
and firm value. This material is followed, in Chapters 15 and 16,
with discussions of how firms raise capital to fund their real
activities and the factors that affect how firms choose among
the various sources of capital available to them. Chapter 16 also
includes an extensive appendix on leasing concepts and buy vs.
lease analysis. Chapter 17 rounds out the discussion of financing
xi
decisions with an introduction to dividends, stock repurchases,
stock dividends and splits, and payout policy.
Integration
Part 6, which consists of Chapters 18 and 19, brings together many
of the key concepts introduced in the earlier parts of the text.
Chapter 18 covers financial aspects of business formation and
growth and introduces students to business valuation concepts
for both private and public firms. The discussions in this chapter
integrate the investment and financing concepts discussed in
Parts 4 and 5 to provide students with a more complete picture
of how all the financial concepts fit together. Chapter 19 covers
concepts related to financial planning and forecasting.
Part 7 introduces students to some important issues that
managers must deal with in applying the concepts covered in
the text to real-world problems. Chapter 20 introduces call
and put options and discusses how they relate to investment
and financing decisions. It describes options that are embedded in the securities that firms issue. It also explains, at an
accessible level, the idea behind real options and why traditional NPV analysis does not take such options into account.
In addition, the chapter discusses agency costs of debt and
equity and the implications of these costs for investment and
financing decisions. Finally, Chapter 20 illustrates the use of
options in risk management. Instructors can cover the topics
in Chapter 20 near the end of the course or insert them at the
appropriate points in Parts 4 and 5. Chapter 21 examines how
international considerations affect the application of concepts
covered in the book.
Unique Chapters
Chapter on Business Formation, Growth,
and Valuation
We wrote Chapter 18 in response to students’ heightened interest in new business formation (entrepreneurship) and in order
to draw together, in a comprehensive way, the key concepts
from capital budgeting, working capital management, and financial policy. This capstone chapter provides an overview of
practical finance issues associated with forecasting cash flows
and capital requirements for a new business, preparing a business plan, and business valuation. The discussion of business
valuation extends far beyond that found in other introductory
corporate finance textbooks.
Chapter on Options and Corporate Finance
Many other corporate finance textbooks have a chapter that
introduces students to financial options and how they are
valued. This chapter goes further. It provides a focused discussion of the different types of financial and non-financial
options that are of concern to financial managers, including
options embedded in debt and equity securities, real options
and their effect on project analysis, how option-like payoff
functions faced by stockholders, bondholders, and managers
affect agency relationships, and the use of options in risk
management.
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Proven Pedagogical Framework
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We have developed several distinctive features throughout the book to aid
student learning. The pedagogical features included in our text are as follows:
CHAPTER OPENER VIGNETTES
Each chapter begins with a
vignette that describes a real
company or personal application.
The vignettes illustrate concepts
that will be presented in the
chapter and are meant to
heighten student interest, motivate learning, and demonstrate
the real-life relevance of the
material in the chapter.
Learning Objectives
C HA P TE R S E V E N
© David Young-Wolff/PhotoEdit
1
Explain the relation between risk and return.
2
Describe the two components of a total
holding period return, and calculate this
return for an asset.
3
4
5
LEARNING OBJECTIVES
6
The opening vignette is
accompanied by learning
objectives that identify the
most important material for
students to understand while
reading the chapter. At the
end of the chapter, the
Summary of Learning Objectives summarizes the chapter
content in the context of the
learning objectives.
7
200
W
hen Blockbuster Inc. filed for bankruptcy protection
on Thursday, September 23, 2010, its days as the dominant
video rental firm were long gone. Netflix had become the most
successful competitor in the video rental market through its
Explain what an expected return is and
strategy of renting videos exclusively online and avoiding the
calculate the expected return for an asset.
high costs associated with operating video rental stores.
Explain what the standard deviation of
The bankruptcy filing passed control of Blockbuster to a
returns is and why it is very useful in finance,
group of bondholders, including the famous billionaire investor
and calculate it for an asset.
Carl Icahn, and the shares owned by the old stockholders beExplain the concept of diversification.
came virtually worthless. The bondholders planned to reorganize the company and restructure its financing so that it had a
Discuss which type of risk matters to inveschance of competing more effectively with Netflix in the future.
tors and why.
Over the previous five years, Blockbuster stockholders had
Describe what the Capital Asset Pricing
watched the value of their shares steadily decline as, year after
Model (CAPM) tells us and how to use it to
year, the company failed to respond effectively to the threat
evaluate whether the expected return of an
posed by Netflix. From September 23, 2005 to September 23,
asset is sufficient to compensate an investor
2010, the price of Blockbuster shares fell from $4.50 to $0.04. In
for the risks associated with that asset.
contrast, the price of Netflix shares rose from $24.17 to $160.47
over the same period. While the Blockbuster stockholders were
losing almost 100 percent of their investments, Netflix stockholders were earning an average return of 46 percent per year!
This chapter discusses risk, return, and the relation between them. The difference in the
returns earned by Blockbuster and Netflix stockholders from 2005 to 2010 illustrates a challenge faced by all investors. The shares of both of these companies were viewed as risky investments in 2005, and yet an investor who put all of his or her money in Blockbuster lost virtually
everything, while an investor who put all of his or her money in Netflix earned a very high
return. How should have investors viewed the risks of investing in these companys’ shares in
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Calculating the Return on an Investment
APPROACH:
Use Equation
7.1 to calculate the total holding period return. To calc07RiskandReturn.indd
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SOLUTION: The total holding period return is:
RT ⫽ RCA ⫹ RI ⫽
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7 . 1
culate RT using Equation 7.1, you must know P0, P1, and CF1. In this problem, you can
assume that the $7,000 was spent at the time you bought the car to purchase parts and
materials. Therefore, your initial investment, P0, was $1,500 ⫹ $7,000 ⫽ $8,500. Since
there were no other cash inflows or outflows between the time that you bought the car
and the time that you sold it, CF1 equals $0.
A P P L I C AT I O N
PROBLEM: You purchased a beat-up 1974 Datsun 240Z sports car a year ago for
$1,500. Datsun is what Nissan, the Japanese car company, was called in the 1970s. The
240Z was the first in a series of cars that led to the Nissan 370Z that is being sold today.
Recognizing that a mint-condition 240Z is a much sought-after car, you invested $7,000
and a lot of your time fixing up the car. Last week, you sold it to a collector for $18,000.
Not counting the value of the time you spent restoring the car, what is the total return you
earned on this investment over the one-year holding period?
LEARNING
BY
DOING
P1 ⫺ P0 ⫹ CF1
$18,000 ⫺ $8,500 ⫹ $0
⫽
⫽ 1.118, or 111.8%
P0
$8,500
LEARNING BY DOING APPLICATION
Along with a generous number of in-text examples, most chapters include several
Learning by Doing Applications. These applications contain quantitative problems
with step-by-step solutions to help students better understand how to apply their
intuition and analytical skills to solve important problems. By including these
exercises, we provide students with additional practice in the application of the
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concepts, tools, and methods that are discussed in the text.
BUILDING INTUITION
BUILDING
INTUITION
MORE RISK MEANS A HIGHER
EXPECTED RETURN
The greater the risk associated with an investment, the greater the return investors expect
from it. A corollary to this idea is that investors want the highest return for a given level of risk or the lowest risk for a given level of return. When choosing between two
investments that have the same level of risk, investors prefer the
investment with the higher return. Alternatively, if two investments have the same expected return, investors prefer the less
risky alternative.
Students must have an intuitive understanding of a number of
important principles and concepts to successfully master the
finance curriculum. Throughout the book, we emphasize these
important concepts by presenting them in Building Intuition
boxes. These boxes provide a statement of an important finance
concept, such as the relation between risk and expected return,
along with an intuitive example or explanation to help the student
“get” the concept. These boxes help the students develop
finance intuition. Collectively the Building Intuition boxes cover
the most important concepts in corporate finance.
DECISION
MAKING
Choosing between Two Investments
You should not invest in either stock. The expected returns for both of
them are below the values predicted by the CAPM for investments with the same level
of risk. In other words, both would plot below the line in Exhibit 7.11. This implies that
they are both overpriced.
7 . 2
DECISION:
E X A M P L E
SITUATION: You are trying to decide whether to invest in one or both of two different stocks. Stock 1 has a beta of 0.8 and an expected return of 7.0 percent. Stock 2 has
a beta of 1.2 and an expected return of 9.5 percent. You remember learning about the
CAPM in school and believe that it does a good job of telling you what the appropriate
expected return should be for a given level of risk. Since the risk-free rate is 4 percent and
the market risk premium is 6 percent, the CAPM tells you that the appropriate expected
rate of return for an asset with a beta of 0.8 is 8.8 percent. The corresponding value for
an asset with a beta of 1.2 is 11.2 percent. Should you invest in either or both of these
stocks?
DECISION-MAKING EXAMPLES
Throughout the book, we emphasize the role of the financial manager as a decision maker.
To that end, twenty chapters include Decision-Making Examples. These examples, which
emphasize the decision-making process rather than computation, provide students with
experience in financial decision making. Each Decision-Making Example outlines a scenario
and asks the student to make a decision based on the information presented.
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END OF CHAPTER PEDAGOGY
S um m a ry of Learning Objectives
SUMMARY OF LEARNING OBJECTIVES
Return.indd Page 233 7/20/11 1:02:01 PM user-f396
AND
KEY EQUATIONS
1
Explain the relation betweenuser-F396
risk and return.
5
At the end of the chapter, you will find a
ummary of the key chapter content
elated to each of the learning objectives
isted at the beginning of the chapter, as
well as an exhibit listing the key equations
n the chapter.
2
Describe the two components of a total holding period
return, and calculate this return for an asset.
The total holding period return on an investment consists of a
capital appreciation component and an income component. This
return is calculated using Equation 7.1. It is important to recognize that investors do not care whether they receive a dollar of
return through capital appreciation or as a cash dividend. Investors value both sources of return equally.
3
Explain what an expected return is and calculate the
expected return for an asset.
The expected return is a weighted average of the possible returns
f
i
h
h f h
i
i h db h
Explain the concept of diversification.
Diversification is reducing risk by investing in two or more assets whose values do not always move in the same direction at
the same time. Investing in a portfolio containing assets whose
prices do not always move together reduces risk because some
of the changes in the prices of individual assets offset each other.
This can cause the overall volatility in the value of an investor’s
portfolio to be lower than if it consisted of only a single asset.
Investors require greater returns for taking greater risk. They
prefer the investment with the highest possible return for a given
level of risk or the investment with the lowest risk for a given
level of return.
6
Discuss which type of risk matters to investors and why.
Investors care about only systematic risk. This is because they
can eliminate unsystematic risk by holding a diversified portfolio. Diversified investors will bid up prices for assets to the point
at which they are just being compensated for the systematic risks
they must bear.
7
Describe what the Capital Asset Pricing Model (CAPM)
tells us and how to use it to evaluate whether the expected return of an asset is sufficient to compensate an
S um m a ry of Key Equations
Equation
Description
Formula
7.1
Total holding period return
RT ⫽ RCA ⫹ RI ⫽
7.2
Expected return on an asset
E1RAsset 2 ⫽ a 1 pi ⫻ Ri 2
P1 ⫺ P0
CF1
¢P ⫹ CF1
⫹
⫽
P0
P0
P0
n
i51
Self-Study Problems
7.1 Kaaran made a friendly wager with a colleague that involves the result from flipping a coin. If heads
comes up, Kaaran must pay her colleague $15; otherwise, her colleague will pay Kaaran $15. What
is Kaaran’s expected cash flow, and what is the variance of that cash flow if the coin has an equal
probability of coming up heads or tails? Suppose Kaaran’s colleague is willing to handicap the bet by
paying her $20 if the coin toss results in tails. If everything else remains the same, what are Kaaran’s
expected cash flow and the variance of that cash flow?
SELF-STUDY PROBLEMS WITH
SOLUTIONS
7.2 You know that the price of CFI, Inc., stock will be $12 exactly one year from today. Today the price of
the stock is $11. Describe what must happen to the price of CFI, Inc., today in order for an investor
to generate a 20 percent return over the next year. Assume that CFI does not pay dividends.
7.3 The expected value of a normal distribution of prices for a stock is $50. If you are 90 percent sure that
the price of the stock will be between $40 and $60, then what is the variance of the stock price?
7.4 You must choose between investing in stock A or stock B. You have already used CAPM to calculate
the rate of return you should expect to receive for each stock given their systematic risk and decided
that the expected return for both exceeds that predicted by CAPM by the same amount. In other
words, both are equally attractive investments for a diversified investor. However, since you are still
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in school and do not have a lot of money, your investment portfolio is not diversified. You have dec07RiskandReturn.indd Page 234 7/22/11 2:10:30 PM user f-404
cided to invest in the stock that has the highest expected return per unit of total risk. If the expected
d
d dd i i
f
f
kA
10
d 25
i l
d
7.1 Part 1: E1cash flow2 ⫽ 10.5 ⫻ ⫺$152 ⫹ 10.5 ⫻ $152 ⫽ 0
s2Cash flow ⫽ 30.5 ⫻ 1⫺$15 ⫺ $02 2 4 ⫹ 30.5 ⫻ 1$15 ⫺ $02 2 4 ⫽ $225
Part 2: E1cash flow2 ⫽ 10.5 ⫻ ⫺$152 ⫹ 10.5 ⫻ $202 ⫽ $2.50
s2Cash flow ⫽ 30.5 ⫻ 1⫺$15 ⫺ $2.502 2 4 ⫹ 30.5 ⫻ 1$20 ⫺ $2.502 2 4 ⫽ $306.25
Solutions to Self-Study Problems
7.2 The expected return for CFI based on today’s stock price is ($12 ⫺ $11)/$11 ⫽ 9.09 percent, which is
lower than 20 percent. Since the stock price one year from today is fixed, the only way that you will
generate a 20 percent return is if the price of the stock drops today. Consequently, the price of the
stock today must drop to $10. It is found by solving the following: 0.2 ⫽ ($12 ⫺ x)/x, or x ⫽ $10.
Five problems similar to the in-text
Learning by Doing Applications follow
the summary and provide additional
F-404
examples with step-by-step solutions F-404
to help students further develop
their problem-solving and
computational skills.
7.3 Since you know that 1.645 standard deviations around the expected return captures 90 percent of
the distribution, you can set up either of the following equations:
$40 ⫽ $50 ⫺ 1.645s or $60 ⫽ $50 ⫹ 1.645s
and solve for s . Doing this with either equation yields:
s ⫽ $6.079 and s2 ⫽ 36.954
7.4 A comparison of the Sharpe Ratios for the two stocks will tell you which has the highest expected
return per unit of total risk.
E1RA 2 ⫺ Rrf
0.10 ⫺ 0.05
SA ⫽
⫽ 0.20
⫽
sRA
0.25
E1RB 2 ⫺ Rrf
0.15 ⫺ 0.05
⫽
⫽ 0.25
SB ⫽
sRB
0.40
CRITICAL THINKING QUESTIONS
At least ten qualitative questions,
called Critical Thinking Questions,
equire students to think through
heir understanding of key concepts
and apply those concepts to a
problem.
Critical Thinking Questions
7.1 Given that you know the risk as well as the expected return for two stocks, discuss what process
you might utilize to determine which of the two stocks is a better buy. You may assume that the
two stocks will be the only assets held in your portfolio.
7.2 What is the difference between the expected rate of return and the required rate of return? What
does it mean if they are different for a particular asset at a particular point in time?
7.3 Suppose that the standard deviation of the returns on the shares of stock at two different companies is exactly the same. Does this mean that the required rate of return will be the same for these
two stocks? How might the required rate of return on the stock of a third company be greater than
the required rates of return on the stocks of the first two companies even if the standard deviation
of the returns of the third company’s stock is lower?
7.4 The correlation between stocks A and B is 0.50, while the correlation between stocks A and C is
⫺0.5. You already own stock A and are thinking of buying either stock B or stock C. If you want
your portfolio to have the lowest possible risk, would you buy stock B or C? Would you expect the
stock you choose to affect the return that you earn on your portfolio?
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Questions and Problems
>
7.1 Returns: Describe the difference between a total holding period return and an expected return.
B ASIC
7.2 Expected returns: John is watching an old game show rerun on television called Let’s Make a
Deal in which the contestant chooses a prize behind one of two curtains. Behind one of the curtains is a gag prize worth $150, and behind the other is a round-the-world trip worth $7,200. The
game show has placed a subliminal message on the curtain containing the gag prize, which makes
the probability of choosing the gag prize equal to 75 percent. What is the expected value of the
selection, and what is the standard deviation of that selection?
QUESTIONS AND PROBLEMS
The Questions and Problems,
numbering 26 to 44 per chapter, are
primarily quantitative and are
classified as Basic, Intermediate, or
Advanced.
7.3 Expected returns: You have chosen biology as your college major because you would like to be a
medical doctor. However, you find that the probability of being accepted to medical school is about
10 percent. If you are accepted to medical school, then your starting salary when you graduate will be
$
f
d h
ld h
k
h
7.13 Expected returns: Jose is thinking about purchasing a soft drink machine and placing it in a business office. He knows that there is a 5 percent probability that someone who walks by the machine will
make a purchase from the machine, and he knows that the profit on each soft drink sold is $0.10. If
Jose expects a thousand people per day to pass by the machine and requires a complete return of his
investment in one
what1:02:04
is the maximum
price that he should be willing to pay for the soft
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drink machine? Assume 250 working days in a year and ignore taxes and the time value of money.
< IN TERM EDIATE
7.14 Interpreting the variance and standard deviation: The distribution of grades in an
introductory finance class is normally distributed, with an expected grade of 75. If the standard
AD VANC E D > 7.27 David is going to purchase two stocks to form the initial holdings in his portfolio. Iron stock has
an expected return of 15 percent, while Copper stock has an expected return of 20 percent. If
David plans to invest 30 percent of his funds in Iron and the remainder in Copper, what will be the
expected return from his portfolio? What if David invests 70 percent of his funds in Iron stock?
CFA PR O BLEM S > 11.37 FITCO is considering the purchase of new equipment. The equipment costs $350,000, and an addi-
CFA PROBLEMS
tional $110,000 is needed to install it. The equipment will be depreciated straight-line to zero over a
five-year life. The equipment will generate additional annual revenues of $265,000, and it will have
annual cash operating expenses of $83,000. The equipment will be sold for $85,000 after five years.
An inventory investment of $73,000 is required during the life of the investment. FITCO is in the
40 percent tax bracket, and its cost of capital is 10 percent. What is the project NPV?
a. $47,818.
b. $63,658.
c. $80,189.
d. $97,449.
Problems from CFA readings are
included in the Question and Problem section in appropriate chapters.
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EXCEL PROBLEMS
158
CHAPTER 5 I The Time Value of Money
5.35 Sam Bradford, a number 1 draft pick of the St. Louis Rams, and his agent are evaluating three
contract options. Each option offers a signing bonus and a series of payments over the life of the
contract. Bradford uses a 10.25 percent rate of return to evaluate the contracts. Given the cash
flows for each option, which one should he choose?
Year
Cash Flow Type
Option A
Option B
Option C
0
1
2
3
Signing Bonus
Annual Salary
Annual Salary
Annual Salary
$3,100,000
$ 650,000
$ 715,000
$ 822,250
$4,000,000
$ 825,000
$ 850,000
$ 925,000
$4,250,000
$ 550,000
$ 625,000
$ 800,000
Sample Test Problems
SAMPLE TEST PROBLEMS
Finally, five Sample Test Problems call for
straightforward applications of the chapter
concepts. These problems are intended to be
representative of the kind of problems that
may be used in a test, and instructors can
encourage students to solve them as if they
were taking a quiz. Solutions are provided in
the Instructor’s Manual.
END OF PART ETHICS CASES
Ethics is an important topic in finance
and this text addresses ethical issues
in several ways. In Chapter 1, we
introduce a framework for consideration of ethical issues in corporate
finance. Many ethical issues can be
analyzed in the context of informational asymmetry between parties to
a transaction, conflicts of interest,
Nearly all problems can be solved
using Excel templates at the student
Web site within WileyPLUS.
7.1 Friendly Airlines stock is selling at a current price of $37.50 per share. If the stock does not pay a dividend
and has a 12 percent expected return, what is the expected price of the stock one year from today?
7.2 Stefan’s parents are about to invest their nest egg in a stock that he has estimated to have an expected
return of 9 percent over the next year. If the return on the stock is normally distributed with a 3 percent
standard deviation, in what range will the stock return fall 95 percent of the time?
7.3 Elaine has narrowed her investment alternatives to two stocks (at this time she is not worried about
diversifying): Stock M, which has a 23 percent expected return, and Stock Y, which has an 8 percent
expected return. If Elaine requires a 16 percent return on her total investment, then what proportion
of her portfolio will she invest in each stock?
7.4 You have just prepared a graph similar to Exhibit 7.9, comparing historical data for Pear Computer Corp.
and the general market. When you plot the line of best fit for these data, you find that the slope of that line
is 2.5. If you know that the market generated a return of 12 percent and that the risk-free rate is 5 percent,
then what would your best estimate be for the return of Pear Computer during that same time period?
7.5 The CAPM predicts that the return of MoonBucks Tea Corp. is 23.6 percent. If the risk-free rate of return is 8 percent and the expected return on the market is 20 percent, then what is MoonBucks’ beta?
breaches of confidentiality, and
breaches of fiduciary duty (principalagent relationships); we highlight
examples of such analysis throughout the text. In addition, seven ethics
cases are included throughout this
book in order to help students better
understand how to analyze ethical
dilemmas in the context of the
framework. Real company examples
are presented, including timeless
cases about Arthur Anderson and
Martha Stewart’s scandal involving
ImClone, and more timely topics
such as the subprime mortgage
crisis and the advent of sustainable
living plans by corporations. Each
case includes questions for followup discussion in class or as an
assignment.
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New to This Edition
In revising Fundamentals of Corporate Finance we have improved the presentation
and organization of key topics, added important new content, updated the text to
reflect changes in market and business conditions since the first edition was written,
improved key in-chapter pedagogical features, added to the number and quality of
the end-of-chapter problem sets, and updated the ethics cases.
Improved Presentation and Organization
We have edited and extended discussions throughout the text in an effort to improve the pedagogical presentation of key topics. We also have rearranged the order of some material to improve the effectiveness of the presentation. For example,
the discussion of the stock market (Section 2.4 in the first edition) has been incorporated into the section on the market for stocks in Chapter 9 and new content on international stock markets has been added to this discussion. This change improves
the flow of the text and provides a more natural lead-in to the stock valuation concepts that are subsequently discussed in Chapter 9. Also, material on capital market
efficiency (Section 8.1 in the first edition) has being moved to the initial discussion of
financial markets in Chapter 2. This change introduces the student to the concept of
market efficiency earlier in the book and improves the focus of Chapter 8, which
discusses bond valuation and interest rates.
New Content
There have been numerous additions to the content of the book. Some of the most
noteworthy include the following. A new section on cash flows to investors has been
added to Chapter 3 immediately after the discussion of how the financial statements
tie together (Section 3.6 in the first edition). This new section helps students develop
an understanding of the sources and uses of investor cash flows in the context of
the discussion of financial statements. It also enables them to develop an intuitive
understanding of the importance of cash flows to investors prior to the chapters on
the time value of money, risk and return, capital budgeting, and valuation.
A discussion of the Sharpe Ratio has being incorporated into Section 7.4, immediately after the existing material on the coefficient of variation. This discussion
helps students develop a stronger intuition about the relation between risk and return earlier in the book.
An extensive discussion of leasing policy and analysis has been added as an appendix to the chapter on financial policy, Chapter 16. This section introduces students
to leasing as an alternative means of financing the acquisition of an asset, outlines the
conflicts that can arise in lease agreements and mechanisms for reducing the costs of
these conflicts, discusses why certain types of assets are more or less likely to be
leased, and summarizes how financial managers make buy vs. lease decisions. This
material is presented within the same agency framework used in Chapter 16 and can
be taught in conjunction with the rest of Chapter 16, or independently.
The discussion of options in Chapter 20 has been extended to include different types of options embedded in the debt and equity securities that firms issue.
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NEW TO THIS EDITION
This discussion provides students with a more complete picture of the range of financial and non-financial options that are of concern to financial managers.
Current Financial Market and Business Information
Throughout the text, all financial market and business information for which more
current data are available have been updated. Not only have the exhibits been updated, but financial values such as interest rates, risk premia, and foreign currency
exchange rates have been updated throughout the discussions in text, in-text
examples, and end-of-chapter problems. In addition, 19 of the 21 chapter opener
vignettes are completely new. Eighteen of these examples are from 2010, and one is
from 2009. The remaining two opener vignettes have been edited to ensure that
they remain current. All of the chapter openers provide timely examples of how the
material covered in the chapter is relevant to financial decision-making.
In-Chapter Features
The Learning Objectives at the beginning of each chapter have been revised to
more fully reflect the important content in the associated sections of the chapters.
New Building Intuition Boxes have been added where appropriate and existing
Building Intuition Boxes have been edited to ensure clarity.
All Learning by Doing Applications have been reviewed and, where appropriate,
updated or replaced.
All existing Decision-Making Examples have been reviewed and updated where necessary. In addition, six new Decision-Making Examples have been added to the text.
The Summary of Learning Objectives and Key Equations at the end of each chapter
have been updated to reflect other changes in the chapter and to improve the pedagogical value of these features.
Refined and Extended Problem Sets
We have carefully edited the end-of-chapter questions and problems throughout the
book to ensure that the examples are current and clearly presented. In addition, new
questions and problems have been added to ensure appropriate coverage of key
concepts at all levels of difficulty. A total of 96 new questions and problems have
been added to the end-of-chapter problem sets, which brings the total number of
end-of-chapter questions and problems, including self-study problems and self-test
questions, for the entire text to 1,184.
Updated Ethics Cases and Their Organization
The Schwan Foods case has been replaced at the end of Chapter 11 with a new
case concerning the Unilever global Sustainable Living Plan. This case challenges
the student to think about how a sustainability plan can be consistent with stockholder value maximization. In addition, the case on affinity credit cards at the end
of Chapter 6 has been updated to reflect the effects of the Credit Card Act of 2009
and new data on the use of these cards as of 2010. The case on the Subprime Mortgage Market Meltdown has been moved from the end of Chapter 18 to the end of
Chapter 8 so that students can address the timely issues raised in this case earlier in
the course.
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Instructor and Student Resources
Fundamentals of Corporate Finance Second Edition features a
ull line of teaching and learning resources that were developed under the close review of the authors. Driven by the same
basic beliefs as the textbook, these supplements provide a conistent and well-integrated learning system. This hands-on
package guides instructors through the process of active learnng and provides them with the tools to create an interactive
earning environment. With its emphasis on activities, exerises, and the Internet, the package encourages students to take
n active role in the course and prepares them for decision
making in a real-world context.
WileyPLUS is a research-based, online
environment for effective teaching and
learning. WileyPLUS builds students’ confidence because it takes the guesswork out
of studying by providing students with a clear roadmap:
what to do, how to do it, if they did it right. This interactive
pproach focuses on:
Design: Research-based design is based on proven instrucional methods. Content is organized into small, more accesible amounts of information, helping students build better
ime management skills.
Engagement: Students can visually track their progress as they
move through the material at a pace that is right for them. Engaging in individualized self-quizzes followed by immediate
eedback helps to sustain their motivation to learn.
Outcomes: Self-assessment lets students know the exact outome of their effort at any time. Advanced reporting allows
nstructors to easily spot trends in the usage and performance
data of their class in order to make more informed decisions.
With WileyPLUS, students will always know:
What to do: Features, such as the course calendar, help students stay on track and manage their time more effectively.
How to do it: Instant feedback and personalized learning
plans are available 24/7.
If they’re doing it right: Self-evaluation tools take the guesswork
out of studying and help students focus on the right materials.
WileyPLUS for Fundamentals of Corporate Finance, Second
Edition includes numerous valuable resources, among them:
• Animated Learning by Doing Applications
• Wiley Corporate Finance Video Collection
• Prerequisite Course Reviews
• Animated Tutorials
• Excel Templates and Spreadsheet Solutions
• Flashcards
• Crosswords
• Narrated PowerPoint Review
• Student Study Guide
• Hot Topics Modules
• Learning Styles Survey
Book Companion Site—For Instructors.
An extensive support package, including print and technology
tools, helps you maximize your teaching effectiveness. We offer
useful supplements for instructors with varying levels of experience and different instructional circumstances.
On this Web site instructors will find electronic versions of the
Solutions Manual, Test Bank, Instructor’s Manual, Computerized Test Bank, and other valuable resources: www.wiley.com/
college/Parrino.
Instructor’s Manual. Included for each chapter are lecture
outlines, a summary of learning objectives and key equations, and
alternative approaches to the material. The Solutions Manual
includes detailed solutions to the Before You Go On questions,
Self-Study problems, Critical Thinking Questions, and all of the
Questions and Problems at the end of each chapter.
Test Bank. With over 2000 questions, the test bank allows
instructors to tailor examinations according to study objectives and difficulty. Multiple-choice, true/false, and essay questions are included.
Computerized Test Bank. The computerized test bank
allows instructors to create and print multiple versions of the
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INSTRUCTOR AND STUDENT RESOURCES
same test by scrambling the order of all questions found in the
Word version of the test bank. The computerized test bank also
allows users to customize exams by altering or adding new
problems.
PowerPoint Presentations. The PowerPoint presentations contain a combination of key concepts, figures and tables,
and problems and examples from the textbook as well as lecture notes and illustrations.
WebCT and Angel. WebCT or Angel offer an integrated set of
course management tools that enable instructors to easily design,
develop and manage Web-based and Web-enhanced courses.
Book Companion Site — For Students.
The Fundamentals of Corporate Finance student Web site provides a wealth of support materials that will help students develop their conceptual understanding of class material and increase their ability to solve problems. On this Web site students
will find Excel templates, study tools, Web quizzing, and other
resources: www.wiley.com/college/Parrino.
ACKNOWLEDGMENTS
The nearly 300 colleagues listed below provided valuable feedback during the development process and added greatly to the
content and pedagogy of the book. Their commitment to teaching and willingness to become involved in such a project was a
source of inspiration to the authors. We would like to acknowledge the contribution made by the following professors whose
thoughtful comments contributed to the quality, relevancy, and
accuracy of the first and second editions of this text:
Reviewers
Saul Adelman, Miami University
Kenneth Ahern, University of Michigan
Esther Ancel, University of Wisconsin—Milwaukee
Ronald Anderson, American University
Gene Andrusco, California State University San Bernardino
Evrim Akdogu, Southern Methodist University
Kofi Amoateng, North Carolina Central University
Kavous Ardalan, Marist College
Bala Arshanapalli, Indiana University Northwest
Saul Auslander, Bridgewater State College
Alan Bailey, University of Texas San Antonio
Robert Balik, Western Michigan University
John Banko, University of Florida
Babu Baradwaj, Towson University
Nina Baranchuk, University of Texas at Dallas
Karen Barnhart, Missouri State University
Janet Bartholow, Kent State University
John Becker-Blease, Washington State University
Omar Benkato, Ball State University
Vashishta Bhaskar, Duquesne University
Wilfred Jerome Bibbins, Troy University
Hamdi Bilici, California State University Long Beach
Ken Bishop, Florida Atlantic University
David Blackwell, Texas A&M University
Charles Blaylock, Murray State University
Vigdis Boasson, Central Michigan University
Carol Boyer, William Patterson University
David Bourff, Boise State University
Joe Brocato, Tarleton State University
Jeffrey Brookman, Idaho State University
Jeff Bruns, Bacone College
James Buck, East Carolina University
Juan Cabrera, Ramapo College
Michael Carter, University of North Texas—Dallas
Theodore Chadwick, Boston University
Surya Chelikani, Quinnipiac University
Ji Chen, University of Colorado Denver
Jun Chen, University of North Carolina at Charlotte
Yea-Mow Chen, San Francisco State University
Paul Chiou, Shippensburg University
William Chittenden, Texas State University
Tarun Chordia, Emory University
Ting-Heng Chu, East Tennessee State University
Cetin Ciner, University of North Carolina at Wilmington
Jonathan Clarke, Georgia Tech
Thomas Coe, Quinnipiac University
Hugh Colaco, Merrimack College
Colene Coldwell, Baylor University
Boyd D. Collier, Tarleton State University
Roger Collier, Northeastern State University
Lary B. Cowart, The University of Alabama at Birmingham
Susan J. Crain, Missouri State University
Tony Crawford, University of Montana
Sandeep Dahiva, Georgetown University
Julie Dahlquist, University of Texas at San Antonio
Brent Dalrymple, University of Central Florida
Amadeu DaSilva, California State University, Fullerton
Sergio Davalos, University of Washington
Diane Del Guercio, University of Oregon
Zane Dennick-Ream, Robert Morris University
John Dexter, Northwood University
Robert Dildine, Metropolitan State University
Robert Dubil, University of Utah
Heidi Dybevik, University of Iowa
Michael Dyer, University of Illinois at Urbana-Champaign
David Eckmann, University of Miami
Susan Edwards, Grand Valley State University
Ahmed El-Shahat, Florida International University
Frank Elston, Concordia College
Maryellen Epplin, University of Central Oklahoma
Stephen Ferris, University of Missouri Columbia
Ron Filante, Pace University
J. Howard Finch, Florida Gulf Coast University
Kathy Fogel, Northern Kentucky University
Joann Fredrickson, Bemidji State University
Sharon Garrison, University of Arizona
Louis Gasper, University of Dallas
John Gawryk, Central Michigan University
Edward Graham, University of North Carolina at Wilmington
Richard P. Gregory, East Tennessee State University
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Nicolas Gressis, Wright State University
Anthony Gu, SUNY Geneseo
Roxane Gunser, University of Wisconsin Platteville
Manak Gupta, Temple University
ally Guyton, Texas A&M University
Matthew Haertzen, Northern Arizona University
Karen Hallows, George Mason University
Karen Hamilton, Georgia Southern University
ohn Hatem, Georgia Southern University
George Haushalter, Pennsylvania State University
Andrew Head, Western Kentucky University
Matthew Hood, University of Southern Mississippi
ames Howard, University of Maryland University College
ian Huang, Washington State University
Christy Huebner Caridi, Marist College
tephen Huffman, University of Wisconsin Oshkosh
Rob Hull, Washburn University
Kenneth Hunsader, University of South Alabama
ae-Kwang Hwang, Virginia State University
Zahid Iqbal, Texas Southern University
ide Iwawere, Howard University
Benjamas Jirasakuldech, Slippery Rock University
urendranath Jory, University of Michigan at Flint
arl Kallberg, New York University
Ahmet Karagozoglu, Hofstra University
Burhan Kawosa, Wright State University
Gary Kayakachoian, University of Rhode Island
Ayla Kayhan, Louisianna State University Baton Rouge
ames Kehr, Miami University of Ohio
Peppi Kenny, Western Illinois University
ames Keys, Florida International University
Robert Kieschnick, University of Texas Dallas
aemin Kim, San Diego State University
Kee Kim, Missouri State University
Kenneth Kim, SUNY Buffalo
Brett King, University of North Alabama
Halil Kiymaz, Rollins College
ohn Knight, University of the Pacific
C.R. Krishna-Swamy, Western Michigan University
Robert Krell, University of Phoenix
Thomas J. Krissek, Northeastern Illinois University
Raman Kumar, Virginia Tech University
George Kutner, Marquette University
Frances Kwansa, University of Delaware
ulia Kwok, Northeastern State University
Pamela LaBorde, Western Washington University
tephen Lacewell, Murray State University
Gene Lai, Washington State University
Mark Laplante, University of Georgia
Duong Le, University of Arkansas at Little Rock
erry Leabman, Bentley College
Gregory LeBlanc, University of California Berkeley
Rick Le Compte, Wichita State University
Alice Lee, San Francisco State University
Cheng Few Lee, Rutgers University
eong Lee, University of North Dakota
Richard Lee, Barton College
Canlin Li, University of California at Riverside
Mingsheng Li, Bowling Green State University
Bing Liang, University of Massachusetts Amherst
Wendell Licon, Arizona State University Tempe
Steven Lifland, High Point University
Ralph Lim, Sacred Heart University
Bingxuan Lin, University of Rhode Island
Hong-Jen Lin, Brooklyn College
Jason Lin, Truman State University
David Lins, University of Illinois
Peter Locke, George Washington State University
Robert Lutz, University of Utah
Yulong Ma, California State University Long Beach
Y. Lal Mahajan, Monmouth University
Dana Manner, University of Miami
Carol Mannino, Milwaukee School of Engineering
Timothy Manuel, University of Montana
Barry Marchman, Georgia Tech
Richard Mark, Dowling College
Brian Maris, Northern Arizona University
Rand Martin, Bloomsburg University of Pennsylvania
Richmond Mathews, Duke University
Leslie Mathis, University of Memphis
Stefano Mazzotta, Kennesaw State University
Joseph McCarthy, Bryant University
Lee McClain, Western Washington University
Michael McNamara, Washington State University
Kathleen McNichol, La Salle University
Seyed Mehdian, University of Michigan at Flint
Robert Meiselas, Stony Brook University
Timothy Michael, Univeristy of Houston Clear Lake
Jill Misuraca, Central Connecticut State University
Sunil Mohanty, University of St. Thomas
Dianne Morrison, University of Wisconsin, La Crosse
Shane Moser, University of Mississippi
Michael Muoghalu, Pittsburg State University
Suzan Murphy, University of Tennessee
Dina Naples-Layish, SUNY Binghamton
Vivian Nazar, Ferris State University
Steven Nenninger, Southeast Missouri State University
Chee Ng, Fairleigh Dickinson University
Brian Nichols, Missouri Southern State University
Terry D. Nixon, Miami University
Deniz Ozenbas, Montclair State University
Vivek Pandey, University of Texas Tyler
James Pandjiris, University of Missouri at St. Louis
Nick Panepinto, Flagler College
Coleen Pantalone, Northeastern University
Robert Pavlik, Elon University
Ivelina Pavlova, University of Houston, Clear Lake
Anil Pawar, San Diego State University
Janet Payne, Texas State University
Chien-Chih Peng, Morehead State University
G. Michael Phillips, California State University Northridge
James Philpot, Southwest Missouri State University
Greg Pierce, Pennsylvania State University
Steve Pilloff, George Mason University
Wendy Pirie, Valparaiso University
Tony Plath, University of North Carolina, Charlotte
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Vassilis Polimenis, University of California Riverside
Percy Poon, University of Nevada Las Vegas
Terry Pope, Abilene Christian University
Gary Powell, Towson University
Richard Powell, Villanova University
Dev Prasad, University of Massachusetts Lowell
Rose Prasad, Central Michigan University
Shoba Prekumar, Iowa State University
Robert Puelz, Southern Methodist University
Russell B. Raimer, Cleveland State University
S. Rao, University of Louisiana at Lafayette
Vadhindran K. Rao, Metropolitan State University
Jong Rhim, University of Indiana
Greg Richey, California State University, San Bernadino
Hong Rim, Shippensburg University
Luis Rivera, Dowling College
Kenneth Roskelley, Mississippi State University
Bruce Rubin, Old Dominion University
David Rystrom, Western Washington University
Helen Saar, University of Hawaii, Manoa
Murray Sabrin, Ramapo College
Sundarrajan Sankar, Tarleton State University
Mukunthan Santhanakrishnan, Idaho State University
Salil Sarkar, University of Texas Arlington
Steven Scheff, Florida Gulf Coast University
George Seldat, Southwest Minnesota State University
Vivek Sharma, University of Michigan Dearborn
Val Sibilkov, University of Wisconsin, Milwaukee
Ana Silva, Merrimack College
Betty Simkins, Oklahoma State University Stillwater
Sudhir Singh, Frostburg State University
Kim Small, Illinois State University
Joe Smolira, Belmont University
Andrew Spieler, Hofstra University
Cliff Stephens, Louisiana State University
Mark Hoven Stohs, California State University, Fullerton
Gene Stout, Central Michigan University
David Suk, Rider University
Charlene Sullivan, Purdue University
Michael Sullivan, University of Nevada at Las Vegas
Alice Sun, California State Polytechnic University Pomona
Srinivasan Sundaram, Ball State University
Janikan Supanvanij, St. Cloud State University
Robert Sweeney, Wright State University
Philip Swensen, Utah State University
Chu-Sheng Tai, Texas Southern University
Thomas Tallerico, Dowling College
Richard Taylor, Arkansas State University
Bill Templeton, Butler University
Diana Tempski, University of Wisconsin, La Crosse
Rhonda Tenkku, University of Missouri at St. Louis
Manish Tewari, The College at Brockport, State University of New York
Philip Thames, California State University Long Beach
Harold Thiewes Minnesota State University
Paul Thistle, University of Nevada at Las Vegas
Nancy Titus-Piersma, Oklahoma State at Stillwater
Damir Tokic, University of Houston Downtown
K.C. Tseng, California State University Fresno
Sergey Tsyplakov, University of South Carolina
David Tufte, Southern Utah University
Cathyann Tully, Kean University
Marian Turac, Georgia State University
Harry Turtle, Washington State University
Pieter Vandenberg, San Diego State University
Bonnie Van Ness, University of Mississippi
Kristen Van Rensselaer, University of North Alabama
Zoë L. Van Schyndel, University of Miami
Sanjay Varshney, SUNY Institute of Technology
Rahul Verma, University of Houston Downtown
Jill Lynn Vihtelic, Saint Mary’s College
Anna Vygodina, California State University Sacramento
Jonathan Wagoner, Fairmont State University
Joe Walker, University of Alabama at Birmingham
Peggy Ward, Wichita State University
Jim Washam, Arkansas State University
Gwendolyn Webb, Baruch College
Paul Weinstock, Ohio State University
Susan White, University of Maryland
Michael Willoughby, University of California San Diego
Yangru Wu, Rutgers Business School
Feixue Xie, University of Texas at El Paso
Yan (Alice) Xie, University of Michigan Dearborn
Devrim Yaman, Western Michigan University
Hua Yang, Old Dominion University
David Yamoah, Kean University
Keven Yost, Auburn University
Lei Yu, University of Notre Dame
Jasmine Yur-Austin, California State University, Long Beach
David Zhang, Arizona State University West
Ge Zhang, William Patterson University
Zhou-go Zhou, California State University Northridge
Kermit C. Zieg, Florida Institute of Technology
Advisory Board
Francisca M. Beer, California State University, San Bernardino
Susan J. Crain, Missouri State University
Praveen Kumar Das, University of Louisiana
Amadeu DaSilva, California State University, Fullerton
Beverly Hadaway, The University of Texas at Austin
James D. Keys, Florida International University
G. Michael Phillips, California State University, Northridge
Helen Saar, University of Hawaii, Manoa
Mark Stohs, California State University, Fullerton
Devrim Yaman, Western Michigan University
Jasmine Yur-Austin, California State University, Long Beach
Kermit C. Zieg, Florida Institute of Technology
Class Testers
Saul W. Adelman, Miami University
Babu Baradwaj, Towson University
Jeffrey Brookman, Idaho State University
Juan Cabrera, Ramapo College
Michael Carter, University of North Texas
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INSTRUCTOR AND STUDENT RESOURCES
un Chen, University of North Carolina at Charlotte
onathan Clarke, Georgia Tech
Thomas Coe, Quinnipiac College
Hugh Colaco, Merrimack College
Boyd Collier, Tarleton State University
Roger Collier, Northeastern State University
ames Cordiero, The College at Brockport, State University of New York
rving DeGraw, St. Petersburg Junior College
Zane Dennick-Ream, Robert Morris College
Michael Dyer, University of Illinois, Urbana-Champaign
Ronald Filante, Pace University
Louis Gasper, University of Dallas
. Edward Graham, University of North Carolina, Wilmington
Richard Gregory, East Tennessee State University
Nicolas Gressis, Wright State University
Matthew Haertzen, Northern Arizona University
Karen L. Hamilton, Georgia Southern University
Gary Kayakachoian, University of Rhode Island
Peppi Kenny, Western Illinois University
ulia Kwok, Northeastern State University
Pamela LaBorde, Western Washington University
Duong Le, University of Arkansas at Little Rock
Mingsheng Li, Bowling Green State University
Wendell Licon, Arizona State University
teven Lifland, High Point University
ason Lin, Truman State University
Hong-Jen Lin, Brooklyn College
Robert Lutz, University of Utah
Brian A. Maris, Northern Arizona University
uzan Murphy, University of Tennessee
. P. UMA Rao, University of Louisiana at Lafayette
Luis Rivera, Dowling College
David Rystrom, Western Washington University
Murray Sabrin, Ramapo College
Michael Sullivan, University of Nevada at Las Vegas
Chu-Sheng Tai, Texas Southern University
Thomas Tallerico, Dowling College
Diana Tempski, University of Wisconsin, La Crosse
onathan Wagoner, Fairmont State College
The following people developed and
revised valuable student and instructor
resources available on the book
companion site and WileyPLUS:
Accuracy Checkers
Publishing Team
Robert J. Balik, Western Michigan University
Babu Baradwaj, Towson University
im P. DeMello, Western Michigan University
haron Garrison, University of Arizona
anjay Jain, Salem State University
Mary Lou Poloskey, The University of Texas at Austin
nayat U. Mangla, Western Michigan University
ill Misuraca, University of Tampa
Dianne Morrison, University of Wisconsin
Napoleon Overton, University of Memphis
Craig A. Peterson, Western Michigan University
ames Philpot, Missouri State University
udith Swisher, Western Michigan University
Rhonda Tenkku, University of Missouri
We also thank the publishing team who was always calm, supportive, and gracious under fire as we suffered the travail of
college textbook writing and revising, where deadlines are
always yesterday. Those showing extraordinary patience and
support include Joseph Heider, Senior Vice President and
General Manager; Timothy Stookesberry, Vice President, Product
and eBusiness Development; George Hoffman, Vice President
and Executive Publisher; and Susan Elbe, Vice President, Market
Development and Marketing. Those warranting special praise
are Jennifer Manias, Project Editor, who coordinated the complex scheduling of the book and all of its resources; Amy
Scholz, Associate Director of Marketing; and the Wiley sales
force for their creativity and success in selling our book. Other
Wiley staff who contributed to the text and media include
Babu Baradwaj, Towson University
Charles Beauchamp, Middle Tennessee State University
Michael Carter, University of North Texas, Dallas
James DeMello, Western Michigan University
James Dow, G. Michael Phillips, Kenneth Leslie, California State
University, Northridge
James Keys, Florida International University
Patrick Lach, Eastern Illinois University
Pamela LaBorde, Western Washington University
Wendell Licon, Arizona State University
Steven Lifland, High Point University
Bridget Lyons, Sacred Heart University
Dianne Morrison, University of Wisconsin, La Crosse
Mary Lou Poloskey, The University of Texas at Austin
Philip Thames, California State University, Long Beach
Susan White, University of Maryland
Devrim Yaman, Western Michigan University
Contributor Team
We owe a special thanks to members of the contributor team
for their hard work, exceptional creativity, consummate communications skills, and advice: Dr. Babu Baradwaj of Towson
State University and Dr. Wendell Licon of Arizona State University who wrote the Instructor’s Manual, student Study
Guide, and major sections of the end-of-chapter materials for
the First Edition. Dr. Norm Bowie of the University of Minnesota wrote most of the ethics cases. Petra Kubalova, of the
Schwan Food Company, worked extensively with Professor
Kidwell on this project during and after completing her MBA
studies at Georgetown University. Dr. Zekiye Selvili of University of Southern California, Steven Gallaher of Southern New
Hampshire University, and Nicholas Crane of University of
Texas at Austin also contributed in a number of areas.
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INSTRUCTOR AND STUDENT RESOURCES
Barbara Heaney, Director of Product and Market Development; Howard Averback, Instructional Designer; Emily McGee and Erica Horowitz, Editorial Assistants; Courtney Luzzi,
Marketing Assistant; Allie Morris, Senior Product Designer;
and Greg Chaput, Product Designer; William Murray, Senior
Production Editor; Maureen Eide, Senior Designer; and
Jennifer MacMillan, Senior Photo Editor.
Colleagues
Robert Parrino would also like to thank some of his colleagues
for their inspiration and helpful discussions. Among those who
have significantly influenced this book are Robert Bruner of
University of Virginia, Jay Hartzell of University of Texas at Austin, and Mark Huson of University of Alberta. Special thanks are
owed to Clifford Smith, of University of Rochester, whose classes
really helped one author make sense of finance. In addition, recognition should go to Michael J. Barclay, who inspired generations of students through his selfless support and example and
who was both a great researcher and teacher.
David Kidwell would like to thank some of his former
professors and colleagues for their inspiration and willingness
xxiii
to share their intellectual capital. George Kaufman and Michael
Hopewell who contributed to Dr. Kidwell’s knowledge of economics and finance and were critical professors during his
doctoral program at the University of Oregon. Richard West,
former dean and professor at the University of Oregon, who
unlocked the secrets of research and inspired Dr. Kidwell’s
love of teaching and scholarship. Robert Johnson of Purdue
University whose dignity and academic bearing served as an
academic role model and whose love of teaching and research
inspired Dr. Kidwell to follow in his footsteps and to write
this book. David Blackwell of Texas A&M University who
helped conceptualize the idea for the book and contributed
numerous insights to various chapters during the book’s writing. Finally, to John Harbell and Jonas Mittelman, of San
Francisco State University who started Dr. Kidwell on his
academic journey.
Thomas Bates would like to thank the professors, coauthors, and colleagues who have made him a better scholar
and educator, including Robert Williams, who first introduced
him to the analytical elegance of economics, and Kenneth Lehn
who inspired him to pursue excellence in research and teaching in the field of finance.
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Brief Contents
PART 1 INTRODUCTION
12 Evaluating Project Economics and Capital
1 The Financial Manager and the Firm
1
Rationing
380
13 The Cost of Capital
PART 2 FOUNDATIONS
PART 5 WORKING CAPITAL MANAGEMENT
AND FINANCING DECISIONS
2 The Financial System and the Level of
Interest Rates
27
14 Working Capital Management 441
15 How Firms Raise Capital 472
16 Capital Structure Policy 504
17 Dividends, Stock Repurchases, and Payout
3 Financial Statements, Cash Flows,
and Taxes
48
4 Analyzing Financial Statements
81
PART 3 VALUATION OF FUTURE CASH
FLOWS AND RISK
5 The Time Value of Money 124
6 Discounted Cash Flows and Valuation 159
7 Risk and Return 200
8 Bond Valuation and the Structure of Interest
Rates
238
Policy
561
PART 6 BUSINESS FORMATION,
VALUATION, AND FINANCIAL
PLANNING
18 Business Formation, Growth,
and Valuation
569
19 Financial Planning and Forecasting
9 Stock Valuation
606
270
PART 4 CAPITAL BUDGETING DECISIONS
1 0 The Fundamentals of Capital
Budgeting
409
301
1 1 Cash Flows and Capital Budgeting
341
PART 7 OPTIONS IN CORPORATE
FINANCE AND INTERNATIONAL
DECISIONS
20 Options and Corporate Finance 641
21 International Financial Management 671
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Contents
PART 1 INTRODUCTION
C HA PT ER
1
The Financial Manager and the Firm 1
1.1 THE ROLE OF THE FINANCIAL MANAGER 2
Stakeholders 2
It’s All about Cash Flows 2
Building Intuition: Cash Flows Matter Most to Investors 4
Three Fundamental Decisions in Financial
Management 4
Building Intuition: Sound Investments are Those Where the Value of the Benefits
Exceeds Their Cost 5
Building Intuition: Financing
Decisions Affect the Value of the Firm 5
1.2 FORMS OF BUSINESS ORGANIZATION 6
Sole Proprietorships 6
Partnerships 7
Corporations 7
Hybrid Forms of Business
Organization 8
1.3 MANAGING THE FINANCIAL FUNCTION 9
Organizational Structure 9
Positions Reporting
to the CFO 10
External Auditors 10
The Audit Committee 10
The Compliance
and Ethics Director 10
1.4 THE GOAL OF THE FIRM 11
What Should Management Maximize? 11
Why Not Maximize Profits? 11
Building Intuition: The Timing of Cash Flows Affects
Their Value 11
Building Intuition: The Riskiness of
Cash Flows Affects Their Value 12
Maximize the
Value of the Firm’s Stock 12
Building Intuition:
The Financial Manager’s Goal Is to Maximize the
Value of the Firm’s Stock 12
Can Management
Decisions Affect Stock Prices? 12
1.5 AGENCY CONFLICTS: SEPARATION OF
OWNERSHIP AND CONTROL 13
Ownership and Control 14
Agency
Relationships 14
Do Managers Really Want
to Maximize Stock Price? 14
Aligning the
Interests of Management and Stockholders 14
Sarbanes-Oxley and Other Regulatory
Reforms 16
1.6 THE IMPORTANCE OF ETHICS IN BUSINESS 18
Business Ethics 18
Are Business Ethics Different
from Everyday Ethics? 18
Types of Ethical Conflicts
in Business 19
The Importance of an Ethical Business Culture 20
Serious Consequences 20
Summary of Learning Objectives • Self-Study
Problems • Solutions to Self-Study Problems •
Critical Thinking Questions • Questions and Problems •
Sample Test Problems
PART 2 FOUNDATIONS
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2.2 DIRECT FINANCING 27
2
The Financial System and the Level of
Interest Rates 24
2.1 THE FINANCIAL SYSTEM 25
The Financial System at Work 26
through the Financial System 26
How Funds Flow
A Direct Market Transaction 28
and Direct Financing 28
Investment Banks
2.3 TYPES OF FINANCIAL MARKETS 30
Primary and Secondary Markets 30
Exchanges and Over-the-Counter Markets 31
Money and Capital Markets 31
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Public and Private Markets 31
Markets 32
Futures and Options
Corporate Income Tax Rates 72
Average versus
Marginal Tax Rates 72
Unequal Treatment of Dividends and Interest Payments 73
2.4 MARKET EFFICIENCY 33
Efficient Market Hypotheses 33
2.5 FINANCIAL INSTITUTIONS AND INDIRECT
FINANCING 34
Indirect Market Transactions 35
Financial Institutions
and Their Services 35
Corporations and the Financial
System 36
2.6 THE DETERMINANTS OF INTEREST
RATE LEVELS 38
Summary of Learning Objectives • Summary of Key Equations •
Self-Study Problems • Solutions to Self-Study Problems •
Critical Thinking Questions • Questions and Problems •
Sample Test Problems
3
Financial Statements, Cash Flows,
and Taxes 48
3.1 FINANCIAL STATEMENTS AND ACCOUNTING
PRINCIPLES 49
The Annual Report 49
Generally Accepted Accounting Principles 50
Fundamental Accounting
Principles 50
International GAAP 51
Illustrative
Company: Diaz Manufacturing 51
3.2 THE BALANCE SHEET 52
Current Assets and Liabilities 53
and Liabilities 54
Equity 55
Long-Term Assets
3.3 MARKET VALUE VERSUS BOOK VALUE 57
A More Informative Balance Sheet 57
Value Balance Sheet 58
A Market-
3.4 THE INCOME STATEMENT AND THE STATEMENT
OF RETAINED EARNINGS 60
The Income Statement 60
Retained Earnings 63
Summary of Learning Objectives • Summary of
Key Equations • Self-Study Problems • Solutions
to Self-Study Problems • Critical Thinking Questions •
Questions and Problems • Sample Test Problems
CH AP TE R
The Real Rate of Interest 38
Loan Contracts
and Inflation 40
The Fisher Equation and
Inflation 40
Cyclical and Long-Term Trends
in Interest Rates 42
C HA PT ER
3.8 FEDERAL INCOME TAX 71
The Statement of
3.5 THE STATEMENT OF CASH FLOWS 63
4
Analyzing Financial Statements 81
4.1 BACKGROUND FOR FINANCIAL STATEMENT
ANALYSIS 82
Perspectives on Financial Statement
Analysis 82
Guidelines for Financial
Statement Analysis 83
4.2 COMMON-SIZE FINANCIAL
STATEMENTS 84
Common-Size Balance Sheets 84
Income Statements 85
Common-Size
4.3 FINANCIAL RATIOS AND FIRM PERFORMANCE 86
Why Ratios Are Better Measures 86
Short-Term
Liquidity Ratios 87
Efficiency Ratios 89
Leverage Ratios 93
Profitability Ratios 97
Market-Value Indicators 100
Concluding
Comments on Ratios 101
4.4 THE DUPONT SYSTEM: A DIAGNOSTIC
TOOL 101
An Overview of the DuPont System 101
The ROA
Equation 101
The ROE Equation 103
The
DuPont Equation 103
Applying the DuPont
System 104
Is Maximizing ROE an Appropriate
Goal? 104
4.5 SELECTING A BENCHMARK 106
Trend Analysis 106
Group Analysis 106
Industry Analysis 106
4.6 USING FINANCIAL RATIOS 108
Performance Analysis of Diaz Manufacturing 108
Limitations of Financial Statement Analysis 111
Sources and Uses of Cash 63
3.6 TYING THE FINANCIAL STATEMENTS
TOGETHER 66
3.7 CASH FLOWS TO INVESTORS 67
Net Income versus the Cash Flow to Investors 67
Cash Flow To Investors: Putting It All Together 70
Summary of Learning Objectives • Summary of
Key Equations • Self-Study Problems • Solutions
to Self-Study Problems • Critical Thinking Questions •
Questions and Problems • Sample Test Problems
E T H I C S C A S E : A S a d Ta le : T h e D emi s e o f
A r th u r A n d e r s e n 1 2 2
Peer
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PART 3 VALUATION OF FUTURE CASH FLOWS AND RISK
C HA PT ER
6.4 THE EFFECTIVE ANNUAL INTEREST RATE 185
5
The Time Value of Money 124
5.1 THE TIME VALUE OF MONEY 125
Consuming Today or Tomorrow 125
Building
Intuition: The Value of Money Changes with Time 126
Time Lines as Aids to Problem Solving 126
Financial Calculator 127
5.2 FUTURE VALUE AND COMPOUNDING 127
Single-Period Investment 127
Two-Period
Investment 128
The Future Value Equation 129
The Future Value Factor 131
Applying the
Future Value Formula 132
Building Intuition:
Compounding Drives Much of the Earnings on
Long-Term Investments 134
Calculator Tips for
Future Value Problems 137
5.3 PRESENT VALUE AND DISCOUNTING 140
Single-Period Investment 140
Multiple-Period
Investment 141
The Present Value Equation 142
Future and Present Value Equations Are the Same 142
Applying the Present Value Formula 142
The Relations
among Time, the Discount Rate, and Present Value 144
Calculator Tips for Present Value Problems 145
Future Value versus Present Value 146
5.4 ADDITIONAL CONCEPTS AND
APPLICATIONS 147
Summary of Learning Objectives • Summary of Key Equations •
Self-Study Problems • Solutions to Self-Study Problems •
Critical Thinking Questions • Questions and Problems •
Sample Test Problems
6
Discounted Cash Flows and Valuation 159
6.1 MULTIPLE CASH FLOWS 160
Future Value of Multiple Cash Flows 160
Value of Multiple Cash Flows 163
Summary of Learning Objectives • Summary of Key
Equations • Self-Study Problems • Solutions to Self-Study
Problems • Critical Thinking Questions • Questions and
Problems • Sample Test Problems
A P P E N D I X : Deriving the Formula for the
Present Value of an Ordinar y Annuity 196
P ro ble m 1 9 7
E T H I C S C A S E : Buy It on Credit and Be True to
Your School 198
CH AP TE R
7
Risk and Return 200
7.1 RISK AND RETURN 201
Building Intuition: More Risk Means a Higher Expected
Return 202
7.2 QUANTITATIVE MEASURES OF RETURN 202
Holding Period Returns 202
Finding the Interest Rate 148
Finding How Many
Periods It Takes an Investment to Grow a Certain
Amount 149
The Rule of 72 150
Compound
Growth Rates 150
Concluding Comments 152
C HA P T ER
Why the Confusion? 185
Calculating the
Effective Annual Interest Rate 185
Comparing
Interest Rates 186
Consumer Protection Acts
and Interest Rate Disclosure 187
The Appropriate
Interest Rate Factor 188
Present
6.2 LEVEL CASH FLOWS: ANNUITIES AND
PERPETUITIES 167
Present Value of an Annuity 167
Future Value
of an Annuity 177
Perpetuities 179
Annuities Due 181
6.3 CASH FLOWS THAT GROW AT A CONSTANT
RATE 183
Expected Returns 203
7.3 THE VARIANCE AND STANDARD DEVIATION AS
MEASURES OF RISK 207
Calculating the Variance and Standard Deviation 207
Interpreting the Variance and Standard Deviation 208
Historical Market Performance 211
7.4 RISK AND DIVERSIFICATION 214
Single-Asset Portfolios 215
Portfolios with More
Than One Asset 217
Building Intuition: Diversified
Portfolios are Less Risky 223
The Limits of Diversification 223
7.5 SYSTEMATIC RISK 224
Why Systematic Risk Is All That Matters 224
Building Intuition: Systematic Risk Is the Risk That
Matters 224
Measuring Systematic Risk 225
7.6 COMPENSATION FOR BEARING SYSTEMATIC
RISK 227
7.7 THE CAPITAL ASSET PRICING MODEL 228
The Security Market Line 228
The Capital Asset
Pricing Model andPortfolio Returns 230
Summary of Learning Objectives • Summary of Key
Equations • Self-Study Problems • Solutions to Self-Study
Problems • Critical Thinking Questions • Questions and
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CONTENTS
C HA PT ER
8
CH AP TE R
Bond Valuation and the Structure of
nterest Rates 238
8.1 CORPORATE BONDS 239
Market for Corporate Bonds 239
Bond Price Information 240
Types of Corporate Bonds 240
8.2 BOND VALUATION 241
The Bond Valuation Formula 242
Calculator Tip:
Bond Valuation Problems 243
Par, Premium,
and Discount Bonds 244
Semiannual
Compounding 246
Zero Coupon Bonds 246
8.3 BOND YIELDS 248
Yield to Maturity 249
Realized Yield 252
Effective Annual Yield 250
8.4 INTEREST RATE RISK 252
Bond Theorems 253
Applications 255
Bond Theorem
8.5 THE STRUCTURE OF INTEREST RATES 255
Marketability 255
Call Provision 256
Default
Risk 256
The Term Structure of Interest Rates 258
Summary of Learning Objectives • Summary …
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