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Discussion Question 1 – Summary & Critical Thinking – Week/Course Learning Outcomes   Welcome to the last week of your course. In this discussion question you have the opportunity to be creative and to relate what you have learned to your professional lives. Please explore and critically think about some of the learning outcomes and concepts presented in this course. Please effectively communicate how you would lead an organization (or a group of people within the organization) by applying the knowledge you have learned ethically and responsibly.  Your discussion should also include innovative thinking, and information-technology aspects (such as the Internet, social-media, computers, and so forth) that may assist you in decision-making. You may frame your discussion around any functional component of business, and in any context; problem-solving, management, leadership, organizational behavior, and so forth. BUS 710 Syllabus DOCTOR IN BUSINESS ADMINISTRATION PROGRAM BUS 710 Financial Decision Making & Risk Management Syllabus Table of Contents Course Description 3 Course Learning Outcomes (CLOs) Linked to Program Outcomes 4 CLA Linking Table 6 Detailed Course Outline 7 Course Description COURSE NAME Financial Risk Management CODE BUS 710 UNITS 3 LENGTH OF CLASS 8 weeks COURSE DESCRIPTION This course covers significant aspects of financial risk management as it relates to capital management, asset allocation, and budgeting. The information is presented in the framework of making intelligent financial decisions for an organization, in line with organizational goals, by including financial statements in analysis. REQUIRED TEXT Brealey, R., Myers, S., & Allen, F. (2020). Principles of corporate finance (13th ed.). McGraw Hill ISBN: 978-1260565553 METHOD OF INSTRUCTION The course is conducted in a hybrid modality. Students interact with each other and with the faculty in a classroom setting and in an online learning system. Learning will be facilitated through lecture-discussions, presentations, cooperative learning, and case studies. SCOPE Student outcomes are measured through professional individual assignments, discussion postings, comprehensive learning assessments, and class participation. Course Learning Outcomes (CLOs) Linked to Program Outcomes Learning outcomes are statements that describe significant and essential learning that learners have achieved, and can reliably demonstrate at the end of the course. Learning outcomes identify what the learner will know and be able to do by the end of a course – the essential and enduring knowledge, abilities (skills) and attitudes (values, dispositions) that constitute the integrated learning needed by a graduate of this course. The learning outcomes for this course summarize what you can expect to learn, and how this course is tied directly to the educational outcomes of your DBA degree. Course Learning Objectives (CLOs) DBA Program Objectives (K) Knowledge (S) Skill (A) Attitude 1. Define and summarize the concepts of value creation, cost of capital, financial markets, and a firm’s business cycle. Compare financial statements (balance sheets and income statements) as it relates to modern corporate finance and accounting principles that are used to prepare financial statements. 1, 2, 5, 6, 8, 10 K 2. Determine what the Managerial Balance sheet is and the relationship to a firm’s liquidity. Contrast the key factors in Liquidity Management and its relationship to the firm’s working capital and Financing Strategies. 1, 2, 5, 6, 8, 10 K 3. Critique the concept of Cash Flows including prepared statements, sources and managerial implications. Develop an understanding of diagnosing Profitability, Risk, and Growth. An analysis of return on equity, leveraging of risk, and self-sustainability should be assessed. 1, 2, 5, 6, 8, 10 K 4. Evaluate the process of the Net Present Value Rule as it relates to making value-creating investment decisions, and understand why the NPV rule is a good investment rule. Formulate alternatives to the NPV rule and identify some shortcomings and weaknesses of these alternatives when it comes to value-creating capacity. 1, 2, 5, 6, 8. 10 K 5. Explain how and what companies do to generate external funds to further value-creating functions. Emphasis should be placed on bank loans, leases, the sale of debt securities and stocks to investors, Summarize the firm’s cost of capital and explain the factors in estimating the cost. Include what mistakes or some misconceptions are made in this estimation. 1, 2, 5, 6, 8 & 10 K, S, A 6. Justify what factors influence the decision-making process when deciding which investment projects create the most value, and which mix of source capital is best when creating a value-creating capital structure. Contrast and explain approaches to firm valuation. 1, 2, 5, 6, 8. 10 K, A 7. Interpret the concept of risk, and risk management. Recommend the nature of the financial decisions to be made when conducting International business as it relates to inflation rates, interest rates, and exchange rates. 1, 2, 5, 6, 10 K 8. Verify how managers make capital allocation decisions that affect value creation. Validate the methodology to implementing a management financial system, evaluating the key drivers to such a system. 1, 2, 5, 6, 9 K, S CLA Linking Table Comprehensive Learning Assessments (CLAs), Professional Assessments (PAs) and Discussion Questions (DQs) directly measure Course Learning Outcomes and indirectly measure DBA Program Outcomes. The following table shows how all those are linked together. Comprehensive Learning Assessments (CLAs) Course Learning Outcomes (CLOs) DBA Program Outcomes CLA 1 (Week 4) 1, 2, 3, 4, 5, 6, 7, 8 1, 2, 5, 6, 8, 9, 10 CLA 2 (Week 8) 1, 2, 3, 4, 5, 6, 7, 8 1, 2, 5, 6, 8, 9, 10 PA Linking Table Professional Assessments (PAs) Course Learning Outcomes (CLOs) DBA Program Outcomes PA 1 (Week 2) 1, 3, 4, 5, 6, 7, 8 1, 2, 5, 6, 8, 9, 10 PA 2 (Week 6) 1, 3, 5, 6, 7 1, 2, 5, 6, 8, 10 DQ Linking Table Discussion Questions (DQs) Course Learning Outcomes (CLOs) DBA Program Outcomes DQ 1 (Week 1) 1, 3, 5, 6, 7, 8 1, 2, 5, 6, 8, 9, 10 DQ 1 (Week 2) 1, 3, 4, 5, 6, 7, 8 1, 2, 5, 6, 8, 9, 10 DQ 1 (Week 3) 1, 3, 4, 5, 6, 7, 8 1, 2, 5, 6, 8, 9, 10 DQ 1 (Week 4) 1, 3, 4, 5, 6, 7, 8 1, 2, 5, 6, 8, 9, 10 DQ 1 (Week 5) 1, 6, 7 1, 2, 5, 6, 8, 10 DQ 1 (Week 6) 1, 3, 4, 5, 6, 7, 8 1, 2, 5, 6, 8, 9, 10 DQ 1 (Week 7) 1, 2, 3, 4, 5, 6, 7, 8 1, 2, 5, 6, 8, 9, 10 DQ 1 (Week 8) 1, 2, 3, 4, 5, 6, 7, 8 1, 2, 5, 6, 8, 9, 10 Activity Linking Table Activity 1 1, 3, 4, 5, 6, 7 1, 2, 5, 6, 8, 10 Activity 2 1, 3, 4, 6, 8 1, 2, 5, 6, 8, 9, 10 Activity 3 1, 3, 4, 5, 6, 7, 8 1, 2, 5, 6, 8, 9, 10 Activity 4 1, 3, 5, 6, 7, 8 1, 2, 5, 6, 8, 9, 10 Detailed Course Outline The following outline provides important assignment details for this course, week by week. You are responsible for all of the assignments given. Please refer to the Detailed Description of Each Grading Criteria in the University Policies for specific information about each assignment. 1) Week 1 Assignments to complete this week: · Reading: · Chapter 1: Introduction to Corporate Finance · Chapter 2: How to Calculate Present Values · Post DQ Answers by Thursday at 11:59 p.m. · Post DQ Peer Responses by Sunday at 11:59 p.m. · Activity 1 due by Sunday at 11:59 p.m. Each week, students must post one (1) answer and one (1) peer response for every discussion question. Please see Grading Criteria for Discussion Board Participation in the University Policies for Discussion Question and Response expectations. Discussion Question 1 - CLO 1, CLO 3, CLO 5, CLO 6, CLO 7, & CLO 8 We, Executives of the F & H company, are reviewing complaints from the investors about the companys slow growth of profits and dividends. Unlike those doubters, we have confidence in the long-run demand for mechanical encabulators, despite competing digital products. We are, therefore, determined to invest to maintain our share of the overall encabulator market. F&H has a rigorous CAPEX approval process, and we are confident of returns around 8\% on investment. That’s a far better return than F&H earns on its cash holdings. The CFO went on to explain that F&H invested excess cash in short-term U.S. government securities, which are almost entirely risk-free but offered only a 4\% rate of return. Please answer the following questions in detail, provide examples whenever applicable, support your argument with citing peer-reviewed sources. a. Is a forecasted 8\% return in the encabulator business necessarily better than a 4\% safe return on short-term U.S. government securities? Justify why or why not? b. Is F&H’s opportunity cost of capital 4\%? c. How in principle should the CFO determine the cost of capital? Activity 1 - CLO 1, CLO 3, CLO 4, CLO 5, CLO 6, CLO 7 Several years ago, The Wall Street Journal reported that the winner of the Massachusetts State Lottery prize had the misfortune to be both bankrupt and in prison for fraud. The balance of the prize was $9,420,713, to be paid in 19 equal annual installments (There were 20 installments, but the winner had already received the first payment). The bankruptcy court judge ruled that the prize should be sold off to the highest bidder and the proceeds to be paid to the creditors. (a) If the interest rate was 8\%, how much would you have been prepared to bid for the prize? (b) Enhance Reinsurance Company was reported to have offered $4.2 million. Find the return that the company was looking for. Please explain your answer in detail and provide in-text citations. 2) Week 2 Assignments to complete this week: · Reading: · Chapter 5: Net Present Value and Other Investment Criteria · Post DQ Answers by Thursday at 11:59 p.m. · Post DQ Peer Responses by Sunday at 11:59 p.m. · Professional Assignment 1 due by Sunday at 11:59 p.m. Each week, students must post one (1) answer and one (1) peer response for every discussion question. Please see Grading Criteria for Discussion Board Participation in the University Policies for Discussion Question and Response expectations. Discussion Question 1 – CLO 1, CLO 3, CLO 4, CLO 5, CLO 6, CLO 7, CLO 8 Please answer the following questions in detail, provide examples whenever applicable, provide in-text citations. a. What is the payback period on each of the above projects? b. Given that you wish to use the payback rule with a cutoff period of two years, which projects would you accept? c. If you use a cutoff period of three years, which projects would you accept? d. If the opportunity cost of capital is 10\%, which projects have positive NPVs? e. If a firm uses a single cutoff period for all projects, it is likely to accept too many short-lived projects.” True or false? f. If the firm uses the discounted-payback rule, will it accept any negative-NPV projects? Will it turn down any positive NPV projects? Professional Assignment 1 – CLO 1, CLO 3, CLO 4, CLO 5, CLO 6, CLO 7, CLO 8 Consider the cash flows of the following three A, B, C projects. a. If the opportunity cost of capital is 11\%, and you have unlimited access to the capital, which one(s) would you accept? What would be your action if the cost of capital is 16\%? b. Suppose that you have limited access to the capital and you need to choose only one project. Which one would you choose? The discount rate is still 11\%. c. What is the payback period of each project? Please analyse if in general a decision based on payback is consistent with a decision based on NPV. d. What are the internal rates of return (IRR) on the three projects? Does the IRR rule in this case give the same decision as NPV? e. If the opportunity cost of capital is 11\%, what is the profitability index for each project? Please analyse if in general decisions based on profitability index is consistent with decisions based on NPV. f. What is the most generally accepted measure to choose between the projects? Please justify your answer. Please explain your answer in detail and provide in-text citations. *Please refer to the Grading Criteria for Professional Assignments in the University Policies for specific guidelines and expectations. 3) Week 3 Assignments to complete this week: · Reading: · Chapter 10: Project Analysis · Chapter 11: How to Ensure That Projects Truly Have Positive NPVs · Post DQ Answers by Thursday at 11:59 p.m. · Post DQ Peer Responses by Sunday at 11:59 p.m. · Activity 2 due by Sunday at 11:59 p.m. Each week, students must post one (1) answer and one (1) peer response for every discussion question. Please see Grading Criteria for Discussion Board Participation in the University Policies for Discussion Question and Response expectations. Discussion Question 1 – CLO 1, CLO 3, CLO 4, CLO 5, CLO 6, CLO 7, CLO 8 Please answer the following questions in detail, provide examples whenever applicable, provide in-text citations. 1. Please describe the real option inherent in each of the following cases and provide some real-life hypothetical cases. Also, explain in each case if the option seller is involved and who that seller might be. a. Moda di Milano postpones a major investment. The expansion has positive NPV on a discounted cash-flow basis, but top management wants to get a better fix on product demand before proceeding. b. Western Telecom commits to production of digital switching equipment specially designed for the European market. The project has a negative NPV, but it is justified on strategic grounds by the need for a strong market position in the rapidly growing, and potentially very profitable, market. c. Western Telecom vetoes a fully integrated, automated production line for the new digital switches. It relies on standard, less-expensive equipment. The automated production line is more efficient overall, according to a discounted cash-flow calculation. d. Mount Fuji Airways buys a jumbo jet with special equipment that allows the plane to be switched quickly from freight to passenger use or vice versa. 2. State if each of the following statements is true or false. Justify your answer. a. Decision trees can help identify and describe real options. b. The option to expand increases PV. c. High abandonment value decreases PV. d. If a project has a positive NPV, the firm should always invest immediately. 3. State if each of the following statements are true or false. Justify your answer. a. A firm that earns the opportunity cost of capital is earning economic rents. b. A firm that invests in positive NPV ventures expects to earn economic rents. c. Financial managers should try to identify areas where their firms can earn economic rents, because they think that positive NPV projects are likely to be found in projects that earn economic rent. d. Economic rent is the equivalent annual cost of operating capital equipment. Activity 2 - Equilibrium price – CLO 1, CLO 3, CLO 4, CLO 6, CLO 8 The company “World Airline System” is composed of the routes X and Y, and each route requires 10 aircrafts. These routes can be serviced by three types of aircrafts — A, B, and C. There are (five) 5 type A aircraft available, 10 type B, and 10 type C. These aircrafts are identical except for their operating costs, which are as follows: Annual operating cost ($ millions) Aircraft type Route X Route Y A 1.5 1.5 B 2.5 2.0 C 4.5 3.5 The aircrafts have a useful life of five years and a salvage value of $1 million. The aircrafts owners do not operate the aircrafts themselves but rent them to the operators. Owners act competitively to maximize their rental income, and operators attempt to minimize their operating costs. Airfares are also competitively determined. Assume the cost of capital is 10\%. a. Which aircraft would be used on which route, and how much would each aircraft be worth? b. What would happen to usage and prices of each aircraft if the number of type A aircrafts increased to 10. 15, or 20? c. State any additional assumptions you need to make. Please explain your answer in detail and provide in-text citations. 4) Week 4 Assignments to complete this week: · Reading: · Chapter 13: Efficient markets and Behavioral Finance · Chapter 14: An Overview of Corporate Financing · Post DQ Answers by Thursday at 11:59 p.m. · Post DQ Peer Responses by Sunday at 11:59 p.m. · CLA 1 due by Sunday at 11:59 p.m. Each week, students must post one (1) answer and one (1) peer response for every discussion question. Please see Grading Criteria for Discussion Board Participation in the University Policies for Discussion Question and Response expectations. Discussion Question 1 – CLO 1, CLO 3, CLO 4, CLO 5, CLO 6, CLO 7, CLO 8 Please answer the following questions in detail, provide examples whenever applicable, provide in-text citations. 1. State if each of the following statements is true or false. Justify your answers. The efficient-market hypothesis assumes that a. There are no taxes. b. There is perfect foresight. c. Successive price changes are independent. d. Investors are irrational. e. There are no transaction costs. f. Forecasts are unbiased. 2. Evaluate each of the following statements: a. “The random-walk theory, with its implication that investing in stocks is like playing roulette, is a powerful indictment of our capital markets.” b. “If everyone believes you can make money by charting stock prices, then price changes won’t be random.” c. “The random-walk theory implies that events are random, but many events are not random. If it rains today, there’s a fair bet that it will rain again tomorrow.” 3. Does the statement, “mutual fund X has had superior performance for each of the last 10 years” contradict the efficient market hypothesis? a. If fund X is the only fund, calculate the probability that only by chance it would have achieved superior performance for each of the past 10 years. b. Now recognize that there are nearly 10,000 mutual funds in the United States. What is the probability that by chance there is at least 1 out of 10,000 funds that obtained 10 successive years of superior performance? 4. Financial markets and intermediaries channel savings from investors to corporate investment. The savings make this journey by many different routes. Give a specific example for each of the following routes: a. Investor to financial intermediary, to financial markets, and to the corporation. b. Investor to financial markets, to a financial intermediary, and to the corporation. c. Investor to financial markets, to a financial intermediary, back to financial markets, and to the corporation. CLA 1 Comprehensive Learning Assessment – CLO 1, CLO 2, CLO 3, CLO 4, CLO 5, CLO 6, CLO 7, CLO 8 Taxes are costs, and, therefore, changes in tax rates can affect consumer prices, project lives and the value of existing firms. Evaluate the change in taxation on the valuation of the following project: Assumptions: Tax depreciation is straight-line over three years. Pre-tax salvage value is 25 in year 3 and 50 if the asset is scrapped in year 2. Tax on salvage value is 40\% of the difference between salvage value and book value of the investment. The cost of capital is 20\%. a. Please verify that the information given above yields NPV = 0. b. If you decide to terminate the project in year two (2) what would be the NPV of the project? c. Suppose that the government now changes tax depreciation to allow a 100\% write-off in year one (1). How does this affect your answers to parts a and b above? d. Would it now make sense to terminate the project after two rather than three years? e. How would your answers change if the corporate income tax were abolished entirely? Please explain your answer in detail and provide in-text citations. *Please refer to the Grading Criteria for Comprehensive Learning Assessments (CLAs) in the University Policies for specific guidelines and expectations. 5) Week 5 Assignments to complete this week: · Reading: · Chapter 20: Understanding Options · Chapter 21: Valuing Options · Chapter 22: Real Options · Post DQ Answers by Thursday at 11:59 p.m. · Post DQ Peer Responses by Sunday at 11:59 p.m. · Activity 3 due by Sunday at 11:59 p.m. Each week, students must post one (1) answer and one (1) peer response for every discussion question. Please see Grading Criteria for Discussion Board Participation in the University Policies for Discussion Question and Response expectations. Discussion Question 1 - CLO 1, CLO 6, CLO 7 Please answer the following questions in detail, provide examples whenever applicable, provide in-text citations. 1. Discuss the risks and payoffs of the following positions, accompanied by payoff graphs. · Buy stock and a put option on the stock. · Buy a stock. · Buy a call. · Buy stock and sell a call option on the stock (covered call). · Buy a bond. · Buy stock, buy a put, and sell a call. · Sell a put (naked put). 2. What is put–call parity and why does it hold? Could you apply the parity formula to a call and put options with different exercise prices? 3. Over the coming year, Ragwort’s stock price might drop from $100 to $50 or it might rise to $200. The one-year interest rate is 10\%. a. What is the delta of a one-year call option on Ragwort stock with an exercise price of $100? b. Use the replicating-portfolio method to value this call. c. In a risk-neutral world, what is the probability that Ragwort stock will rise in price? d. Use the risk-neutral method to check your valuation of the Ragwort option. e. If someone told you that in reality there is a 60\% chance that Ragwort’s stock price will rise to $200, would you change your view about the value of the option? Explain. Activity 3 – CLO 1, CLO 3, CLO 4, CLO 5, CLO 6, CLO 7, CLO 8 You have an option to purchase all of the assets of the Overland Railroad for $2.5 billion. The option expires in nine months. You estimate Overland’s current (month 0) present value (PV) as $2.7 billion. Overland generates after-tax free cash flow (FCF) of $50 million at the end of each quarter (i.e., at the end of each three-month period). If you exercise your option at the start of the quarter, that quarter’s cash flow is paid out to you. If you do not exercise, the cash flow goes to Overland’s current owners. In each quarter, Overland’s PV either increases by 10\% or decreases by 9.09\%. This PV includes the quarterly FCF of $50 million. After the $50 million is paid out, PV drops by $50 million. Thus, the binomial tree for the first quarter is (figures in millions): The risk-free interest rate is 2\% per quarter. a. Build a binomial tree for Overland, with one up or down change for each three-month period (three steps to cover your nine-month option). b. Suppose you can only exercise your option now, or after nine months (not at month 3 or 6). Would you exercise now? c. Suppose you can exercise now, or at month 3, 6, or 9. What is your option worth today? Should you exercise today, or wait? Please explain your answer in detail and provide in-text citations. 6) Week 6 Assignments to complete this week: · Reading: · Chapter 23: Credit Risk and the Value of Corporate Debt · Chapter 24: The Many Different kinds of Debt · Chapter 25: Leasing · Post DQ Answers by Thursday at 11:59 p.m. · Post DQ Peer Responses by Sunday at 11:59 p.m. · Professional Assignment 2 due by Sunday at 11:59 p.m. Each week, students must post one (1) answer and one (1) peer response for every discussion question. Please see Grading Criteria for Discussion Board Participation on pages 9-10 of the University Policies for Discussion Question and Response expectations. Discussion Question 1 – CLO 1, CLO 3, CLO 4, CLO 5, CLO 6, CLO 7, CLO 8 Please answer the following questions in detail, provide examples whenever applicable, provide in-text citations. 1. A friend has mentioned that she has read somewhere that the following variables can be used to predict bankruptcy: (a) the company debt ratio; (b) the interest coverage; (c) the amount of cash relative to sales or assets; (d) the return on assets; (e) the market-to-book ratio; (f) the recent return on the stock; (g) the volatility of the stock returns. The problem is that she can’t remember whether a high value of each variable implies a high or a low probability of bankruptcy. Can you help her out? 2. Magna Charter has been asked to operate a Beaver bush plane for a mining company exploring north and west of Fort Liard. Magna will have a firm one-year contract with the mining company and expects that the contract will be renewed for the five-year duration of the exploration program. If the mining company renews at year 1, it will commit to use the plane for four more years. Magna Charter has the following choices: a. Buy the plane for $500,000. b. Take a one-year operating lease for the plane. The lease rate is $118,000, paid in advance. c. Arrange a five-year, noncancelable financial lease at a rate of $75,000 per year, paid in advance. These are net leases; all operating costs are absorbed by Magna Charter. How would you advise Agnes Magna, the charter company’s CEO? For simplicity assume five-year, straight-line depreciation for tax purposes. The company’s tax rate is 30\%. The weighted-average cost of capital for the bush-plane business is 14\%, but Magna can borrow at 9\%. The expected inflation rate is 4\%. Ms. Magna thinks the plane will be worth $300,000 after five years. But if the contract with the mining company is not renewed (there is a 20\% probability of this outcome at year 1), the plane will have to be sold on short notice for $400,000. If Magna Charter takes the five-year financial lease and the mining company cancels at year 1, Magna can sublet the plane, that is, rent it out to another user. Make additional assumptions as necessary. Professional Assignment 2 – CLO 1, CLO 3, CLO 5, CLO 6, CLO 7 Maple Aircraft has issued a 4¾\% convertible subordinated debenture due 3 years from now. The conversion price is $47.00 and the debenture is callable at 102.75\% of face value. The market price of the convertible is 91\% of face value, and the price of the common is $41.50. Assume that the value of the bond in the absence of a conversion feature is about 65\% of face value. a. In the absence of the conversion feature, what is the current yield and yield to maturity? b. What is the conversion ratio of the debenture? c. If the conversion ratio were 50, what would be the conversion price? d. What is the conversion value? e. At what stock price is the conversion value equal to the bond value? f. Can the market price be less than the conversion value? g. How much is the convertible holder paying for the option to buy one share of common stock? h. By how much does the common have to rise after 3 years to justify conversion? Please explain your answer in detail and provide in-text citations. *Please refer to the Grading Criteria for Professional Assignments in the University Policies for specific guidelines and expectations. 7) Week 7 Assignments to complete this week: · Reading: · Chapter 26: Managing Risk · Chapter 27: Managing International Risk · Post DQ Answers by Thursday at 11:59 p.m. · Post DQ Peer Responses by Sunday at 11:59 p.m. · Activity 4 due by Sunday at 11:59 p.m. Each week, students must post one (1) answer and one (1) peer response for every discussion question. Please see Grading Criteria for Discussion Board Participation in the University Policies for Discussion Question and Response expectations. Discussion Question 1 – CLO 1, CLO 2, CLO 3, CLO 4, CLO 5, CLO 6, CLO 7, CLO 8 Please answer the following questions in detail, provide examples whenever applicable, provide in-text citations. 1. Explain how companies can hedge risks in their operating costs by using each of the following instruments. Hypothetical examples are required. a. Futures and forward contracts b. Option contracts c. Swap contracts d. Buying one asset and selling another. What is the hedge ratio and how is it determined? 2. The websites of the major commodities exchanges provide futures prices. Calculate the annualized net convenience yield for a commodity of your choice. Retrieve the current risk free rate from the U.S. Government treasury site. (Note: You may need to use the futures price of a contract that is about to mature as your estimate of the current spot price.) 3. You can find spot and futures prices for a variety of equity indexes on www.wsj.com. Pick one and check whether it is fairly priced. You will need to do some research work to find the dividend yield on the index and the interest rate. 4. Define each of the following theories accompanied by equations. Hypothetical examples are required. a. Interest rate parity. b. Expectations theory of forward rates. c. Purchasing power parity. d. International capital market equilibrium (relationship of real and nominal interest rates in different countries). Activity 4 - CLO 1, CLO 3, CLO 5, CLO 6, CLO 7, CLO 8 Your investment bank has an investment of $100 million in the stock of the Swiss Roll Corporation and a short position in the stock of the Frankfurter Sausage Company. Here is the recent price history of the two stocks: Percentage price change Month Frankfurter Sausage Swiss Roll January -10\% -10\% February -10\% -5\% March -10\% 0\% April 10\% 0\% May 10\% 5\% June 10\% 10\% On the evidence of these six months, how large would your short position in Frankfurter Sausage need to be to hedge as far as possible against movements in the price of Swiss Roll? Please explain your answer in detail and provide in-text citations. 8) Week 8 Assignments to complete this week: · Reading: · Review all chapters covered that will assist in the completion of the CLA 2 assignment · Post DQ Answers by Thursday at 11:59 p.m. · Post DQ Peer Responses by Sunday at 11:59 p.m. · CLA 2 Presentation due in class · CLA 2 due by Sunday at 11:59 p.m. Each week, students must post one (1) answer and one (1) peer response for every discussion question. Please see Grading Criteria for Discussion Board Participation in the University Policies for Discussion Question and Response expectations. Discussion Question 1 – Summary & Critical Thinking – Week/Course Learning Outcomes   Welcome to the last week of your course. In this discussion question you have the opportunity to be creative and to relate what you have learned to your professional lives. Please explore and critically think about some of the learning outcomes and concepts presented in this course. Please effectively communicate how you would lead an organization (or a group of people within the organization) by applying the knowledge you have learned ethically and responsibly. Your discussion should also include innovative thinking, and information-technology aspects (such as the Internet, social-media, computers, and so forth) that may assist you in decision-making. You may frame your discussion around any functional component of business, and in any context; problem-solving, management, leadership, organizational behavior, and so forth. CLA 2 Comprehensive Learning Assessment 2 – CLO 1, CLO 2, CLO 3, CLO 4, CLO 5, CLO 6, CLO 7, CLO 8 Carpet Baggers Inc. is proposing to construct a new bagging plant in a country in Europe. The two prime candidates are Germany and Switzerland. The forecasted cash flows from the proposed plants are as follows: The spot exchange rate for euros is $1.3/€, while the rate for Swiss francs is CHF 1.5/$. The interest rate is 5\% in the United States, 4\% in Switzerland, and 6\% in the euro countries. The financial manager has suggested that, if the cash flows were stated in dollars, a return in excess of 10\% would be acceptable. Should the company go ahead with either project? If it must choose between them, which should it take? Please explain your answer in detail and provide in-text citations. *Please refer to the Grading Criteria for Comprehensive Learning Assessments (CLAs) in the University Policies for specific guidelines and expectations. CLA 2 Comprehensive Learning Assessment (CLA 2) Presentation In addition to your CLA 2 report, please prepare a professional PowerPoint presentation summarizing your findings for CLA 2. The presentation will consist of your major findings, analysis, and recommendations in a concise presentation of 18 slides (minimum). You should use content from your CLA 2 report as material for your PowerPoint presentation. In addition, you should include learning outcomes from all your major assignments. This would include PA 1, CLA 1, PA 2, and of course, CLA 2 (unless otherwise specified by your Professor). An agenda, executive summary, and references slides should also be included. Please keep in mind that the university is moving towards a more digital footprint for our students. This means that your final CLA 2 presentation may be recorded, so that you may include it in your “e-portfolio” (graduating students should have all of their CLA 2 presentations on a flash-drive, in addition to student biography, resume, interests, and so forth). Students will present their PowerPoint during the last week of class in either the On-Campus Class Session or the online Virtual Class Session, as determined by the professor. Presentations should not exceed 18 minutes. *Please refer to the Grading Criteria for CLA 2 Presentations in the University Policies for specific guidelines and expectations. of ● ● ● ● ● bre13901_fm_i-xxx.indd i 10/12/18 03:41 PM Principles of Corporate Finance Final PDF to printer bre13901_fm_i-xxx.indd ii 10/12/18 03:41 PM Financial Management Block, Hirt, and Danielsen Foundations of Financial Management Seventeenth Edition Brealey, Myers, and Allen Principles of Corporate Finance Thirteenth Edition Brealey, Myers, and Allen Principles of Corporate Finance, Concise Second Edition Brealey, Myers, and Marcus Fundamentals of Corporate Finance Ninth Edition Brooks FinGame Online 5.0 Bruner Case Studies in Finance: Managing for Corporate Value Creation Eighth Edition Cornett, Adair, and Nofsinger Finance: Applications and Theory Fourth Edition Cornett, Adair, and Nofsinger M: Finance Fourth Edition DeMello Cases in Finance Second Edition Grinblatt (editor) Stephen A. Ross, Mentor: Influence through Generations Grinblatt and Titman Financial Markets and Corporate Strategy Second Edition Higgins Analysis for Financial Management Twelfth Edition Ross, Westerfield, Jaffe, and Jordan Corporate Finance Twelfth Edition Ross, Westerfield, Jaffe, and Jordan Corporate Finance: Core Principles and Applications Fifth Edition Ross, Westerfield, and Jordan Essentials of Corporate Finance Ninth Edition Ross, Westerfield, and Jordan Fundamentals of Corporate Finance Twelfth Edition Shefrin Behavioral Corporate Finance: Decisions that Create Value Second Edition Investments Bodie, Kane, and Marcus Essentials of Investments Eleventh Edition Bodie, Kane, and Marcus Investments Eleventh Edition Hirt and Block Fundamentals of Investment Management Tenth Edition Jordan and Miller Fundamentals of Investments: Valuation and Management Eighth Edition Stewart, Piros, and Heisler Running Money: Professional Portfolio Management Sundaram and Das Derivatives: Principles and Practice Second Edition Financial Institutions and Markets Rose and Hudgins Bank Management and Financial Services Tenth Edition Rose and Marquis Financial Institutions and Markets Eleventh Edition Saunders and Cornett Financial Institutions Management: A Risk Management Approach Ninth Edition Saunders and Cornett Financial Markets and Institutions Seventh Edition International Finance Eun and Resnick International Financial Management Eighth Edition Real Estate Brueggeman and Fisher Real Estate Finance and Investments Sixteenth Edition Ling and Archer Real Estate Principles: A Value Approach Fifth Edition Financial Planning and Insurance Allen, Melone, Rosenbloom, and Mahoney Retirement Plans: 401(k)s, IRAs, and Other Deferred Compensation Approaches Twelfth Edition Altfest Personal Financial Planning Second Edition Kapoor, Dlabay, and Hughes Focus on Personal Finance: An Active Approach to Help You Develop Successful Financial Skills Sixth Edition Kapoor, Dlabay, and Hughes Personal Finance Twelfth Edition Walker and Walker Personal Finance: Building Your Future Second Edition THE MCGRAW-HILL/IRWIN SERIES IN FINANCE, INSURANCE, AND REAL ESTATE Final PDF to printer bre13901_fm_i-xxx.indd iii 10/12/18 03:41 PM Richard A. Brealey Professor of Finance London Business School Stewart C. Myers Professor of Financial Economics Sloan School of Management Massachusetts Institute of Technology Franklin Allen Professor of Finance and Economics Imperial College London THIRTEENTH EDITION Principles of Corporate Finance Final PDF to printer bre13901_fm_i-xxx.indd iv 10/12/18 03:41 PM PRINCIPLES OF CORPORATE FINANCE, THIRTEENTH EDITION Published by McGraw-Hill Education, 2 Penn Plaza, New York, NY 10121. Copyright © 2020 by McGraw-Hill Education. All rights reserved. Printed in the United States of America. Previous editions © 2017, 2014, and 2011. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of McGraw-Hill Education, including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning. Some ancillaries, including electronic and print components, may not be available to customers outside the United States. This book is printed on acid-free paper. 1 2 3 4 5 6 7 8 9 0 LWI/LWI 22 21 20 19 ISBN 978-1-260-01390-0 MHID 1-260-01390-1 Portfolio Manager: Charles Synovec Product Developer: Noelle Bathurst Marketing Manager: Allison McCabe-Carroll Content Project Managers: Fran Simon and Jamie Koch Buyer: Laura Fuller Design: Matt Diamond Content Licensing Specialist: Ann Marie Jannette Cover Image: Emily Tolan/Shutterstock Compositor: SPi Global All credits appearing on page or at the end of the book are considered to be an extension of the copyright page. Library of Congress Cataloging-in-Publication Data Names: Brealey, Richard A., author. | Myers, Stewart C., author. | Allen, Franklin, 1956- author. Title: Principles of corporate finance / Richard A. Brealey, Professor of Finance, London Business School, Stewart C. Myers, Robert C. Merton (1970) Professor of Finance, Sloan School of Management, Massachusetts Institute of Technology, Franklin Allen, Professor of Finance and Economics, Imperial College London. Description: Thirteenth edition. | New York, NY : McGraw-Hill Education, [2020] Identifiers: LCCN 2018040697 | ISBN 9781260013900 (alk. paper) Subjects: LCSH: Corporations—Finance. Classification: LCC HG4026 .B667 2020 | DDC 658.15—dc23 LC record available at https://lccn.loc.gov/2018040697 The Internet addresses listed in the text were accurate at the time of publication. The inclusion of a website does not indicate an endorsement by the authors or McGraw-Hill Education, and McGraw-Hill Education does not guarantee the accuracy of the information presented at these sites. mheducation.com/highered Final PDF to printer bre13901_fm_i-xxx.indd v 10/12/18 03:41 PM To our parents. Dedication Final PDF to printer vi bre13901_fm_i-xxx.indd vi 10/12/18 03:41 PM ⟩ Richard A. Brealey Professor of Finance at the London Business School. He is the former president of the European Finance Association and a former director of the American Finance Associa- tion. He is a fellow of the British Academy and has served as a spe- cial adviser to the Governor of the Bank of England and director of a number of financial institutions. Books written by Professor Brealey include Introduction to Risk and Return from Common Stocks. ⟩ Stewart C. Myers Professor of Financial Economics at MIT’s Sloan School of Manage- ment. He is past president of the American Finance Association, a research associate at the National Bureau of Economic Research, a principal of the Brattle Group Inc., and a retired director of Entergy Corporation. His research is pri- marily concerned with the valuation of real and financial assets, corpo- rate financial policy, and financial aspects of government regulation of business. He is the author of influential research papers on many topics, including adjusted present value, rate of return regulation, pricing and capital allocation in insurance, real options, and moral hazard and information issues in capital structure decisions. ⟩ Franklin Allen Professor of Finance and Econom- ics, Imperial College London, and Emeritus Nippon Life Professor of Finance at the Wharton School of the University of Pennsylvania. He is past president of the American Finance Association, Western Finance Association, Society for Financial Studies, Financial Intermediation Research Society, Financial Management Association, and a fellow of the Econometric Society and the British Academy. His research has focused on finan- cial innovation, asset price bubbles, comparing financial systems, and financial crises. He is Director of the Brevan Howard Centre for Financial Analysis at Imperial College Business School. About the Authors Final PDF to printer vii bre13901_fm_i-xxx.indd vii 10/12/18 03:41 PM Preface ⟩ This book describes the theory and practice of corpo- rate finance. We hardly need to explain why financial managers have to master the practical aspects of their job, but we should spell out why down-to-earth manag- ers need to bother with theory. Managers learn from experience how to cope with routine problems. But the best managers are also able to respond to change. To do so you need more than time- honored rules of thumb; you must understand why com- panies and financial markets behave the way they do. In other words, you need a theory of finance. Does that sound intimidating? It shouldn’t. Good theory helps you to grasp what is going on in the world around you. It helps you to ask the right questions when times change and new problems need to be analyzed. It also tells you which things you do not need to worry about. Throughout this book, we show how managers use financial theory to solve practical problems. Of course, the theory presented in this book is not per- fect and complete—no theory is. There are some famous controversies where financial economists cannot agree. We have not glossed over these disagreements. We set out the arguments for each side and tell you where we stand. Much of this book is concerned with understanding what financial managers do and why. But we also say what financial managers should do to increase company value. Where theory suggests that financial managers are making mistakes, we say so, while admitting that there may be hidden reasons for their actions. In brief, we have tried to be fair but to pull no punches. This book may be your first view of the world of modern finance. If so, you will read first for new ideas, for an understanding of how finance theory translates into practice, and occasionally, we hope, for entertain- ment. But eventually you will be in a position to make financial decisions, not just study them. At that point, you can turn to this book as a reference and guide. ⟩ Changes in the Thirteenth Edition We are proud of the success of previous editions of Principles, and we have done our best to make the thir- teenth edition even better. Some of the biggest changes in this edition were prompted by the tax changes enacted in the U.S. Tax Cuts and Jobs Act passed in December 2017. One of the chapters most affected was Chapter 6, which is con- cerned with calculating the present value of capital proj- ects. We describe the major tax changes in that chapter, and we work through an example of a capital budget- ing problem with 100\% bonus depreciation and a 21\% corporate tax rate. But the U.S. system of immediate expensing of capital expenditures is almost unique. So we also set out examples of the more common systems of straight-line depreciation and double- declining-balance, which is essentially identical to the former U.S. MACRS depreciation. Another 2017 tax change was the limit imposed on interest tax shields. For companies that are caught by this change, it may no longer make sense to discount cash flows by the weighted average cost of capital. We discuss the implications for company debt policy in Chapter 18. In Chapter 19, we show how adjusted present value can be used in these cases to value companies and projects. Similarly, the cap on interest tax shields complicates the valuation of leases. In Chapter 25, we show that when the cap is operative, leases need to be valued by constructing an equivalent loan. Finally, in Chapter 32, we consider the possible effect on the private-equity market. The third important change was the switch by the United States to a territorial tax system. This has major implications for tax strategies, which we largely dis- cuss in the chapters on working capital management ( Chapter 30) and mergers (Chapter 31). U.S. financial managers work in a global environment and need to understand the financial systems of other countries. Also, many of the text’s readers come from countries other than the United States. Therefore, in recent editions we have progressively introduced more interna- tional material, including information about the major developing economies, such as China and India. In the current edition, we have continued to augment the interna- tional content. We hope that an understanding of practices in other countries will also lead to a better understanding of the characteristics of one’s own financial system. Users of previous editions of this book will not find dramatic changes in coverage or in the ordering of top- ics. However, there are a number of chapters that have been thoroughly rewritten. For example, the material on agency issues in Chapter 12 has been substantially revised. Chapter 13 on market efficiency and behavioral Final PDF to printer viii Preface bre13901_fm_i-xxx.indd viii 10/12/18 03:41 PM finance is now fresher and more up to date. Chapter 23 on credit risk focuses more on the practical issues of forecasting default probabilities. Throughout, we have tried to make the book more up-to-date and easier to read. In many cases, the changes consist of some updated data here and a new example there. Often, these additions reflect some recent devel- opment in the financial markets or company practice. In the 11th edition, we added digital extensions through our Beyond the Page features, or “apps” as we call them. This extra material can allow us to escape from some of the constraints of the printed page by providing more explanation for readers who need it and additional mate- rial for those who would like to dig deeper. The Beyond the Page features include extra examples and spreadsheet programs, as well as some interesting anecdotes. There are now more than 150 of these apps. They are all seamlessly available with a click on the e-versions of the book, but they are also readily accessible from the traditional hard copy of the text through the shortcut URLs. Check out mhhe.com/brealey13e to learn more. Examples of these applications include: ∙ Chapter 1  In Chapter 1, we refer to Bernard Madoff’s ponzi scheme. But this scam pales into insignificance compared with the great Albanian ponzi scheme, which is described in an app. ∙ Chapter 2 Do you need to learn how to use a finan- cial calculator? The Beyond the Page financial cal- culator application shows how to do so. ∙ Chapter 3 Would you like to calculate a bond’s dura- tion, see how it predicts the effect of small interest rate changes on bond price, calculate the duration of a com- mon stock, or learn how to measure convexity? The duration application for Figure 3.2 allows you to do so. ∙ Chapter 5 Want more practice in valuing annuities? There is an application that provides worked exam- ples and hands-on practice. ∙ Chapter 9  How about measuring the betas of the Fama–French three-factor model for U.S. stocks? The Beyond the Page beta estimation application does this. ∙ Chapter 14 Ever wonder why Google split its stock into A and C shares? An app provides the answer. ∙ Chapter 15  Want to now how companies can raise capital by an initial coin offering?  There is an app on the topic. ∙ Chapter 19  The text briefly describes the flow-to- equity method for valuing businesses, but using the method can be tricky. We provide an application that guides you step by step. ∙ Chapter 20  The Black–Scholes Beyond the Page application provides an option calculator. It also shows how to estimate the option’s sensitivity to changes in the inputs and how to measure an option’s risk. ∙ Chapter 28 Would you like to view the most recent financial statements for different U.S. companies and calculate their financial ratios? There is an appli- cation that will do this for you. We believe that the apps offer an opportunity to widen the types of material that can be made available and help the reader to decide how deeply he or she wishes to explore a topic. We have added end-of-chapter questions, merged what was becoming a false distinction between basic and intermediate questions, and reordered the questions to follow better the same sequence as the chapter. ⟩ Making Learning Easier Each chapter of the book includes an introductory pre- view, a summary, and an annotated list of suggested further reading. The list of possible candidates for fur- ther reading is now voluminous. Rather than trying to include every important article, we largely list survey articles or general books. We give more specific refer- ences in footnotes. Each chapter is followed by a set of problems on both numerical and conceptual topics and a few challenge problems. Answers to the starred problems appear in the Appendix at the end of the book. We included a Finance on the Web section in chap- ters where it makes sense to do so. This section now houses a number of Web Projects, along with new Data Analysis problems. These exercises seek to familiar- ize the reader with some useful websites and to explain how to download and process data from the web. The book also contains 13 end-of-chapter Mini- Cases. These include specific questions to guide the case analyses. Answers to the mini-cases are available to instructors on the book’s website. Spreadsheet programs such as Excel are tailor- made for many financial calculations. Several chapters include boxes that introduce the most useful financial functions and provide some short practice questions. We show how to use the Excel function key to locate the function and then enter the data. We think that this approach is much simpler than trying to remember the formula for each function. We conclude the book with a glossary of financial terms. The 34 chapters in this book are divided into 11 parts. Parts 1, 2, and 3 cover valuation and capital invest- ment decisions, including portfolio theory, asset pricing Final PDF to printer Preface ix bre13901_fm_i-xxx.indd ix 10/12/18 03:41 PM models, and the cost of capital. Parts 4 through 8 cover payout policy, capital structure, options (including real options), corporate debt, and risk management. Part 9 covers financial analysis, planning, and working-capital management. Part 10 covers mergers and acquisitions, corporate restructuring, and corporate governance around the world. Part 11 concludes. We realize that instructors will wish to select topics and may prefer a different sequence. We have therefore written chapters so that topics can be introduced in several logical orders. For example, there should be no difficulty in reading the chapters on financial analysis and planning before the chapters on valuation and capital investment. ⟩ Acknowledgments We have a long list of people to thank for their helpful criticism of earlier editions and for assistance in prepar- ing this one. They include Faiza Arshad, Aleijda de Caze- nove Balsan, Kedran Garrison, Robert Pindyck, Donna Cheung, and Gretchen Slemmons at MIT; Elroy Dim- son, Paul Marsh, Mike Staunton, and Stefania Uccheddu at London Business School; Lynda Borucki, Marjorie Fischer, Larry Kolbe, Michael Vilbert, Bente Villadsen, and Fiona Wang at The Brattle Group Inc.; Alex Triantis at the University of Maryland; Adam Kolasinski at Texas A&M University; Simon Gervais at Duke University; Michael Chui at Bank for International Settlements; Pedro Matos at the University of Southern California; Yupana Wiwattanakantang at National University of Singapore; Nickolay Gantchev at the Southern Methodist University; Tina Horowitz, and Lin Shen, at the University of Penn- sylvania; Darien Huang at Tudor Investment; Julie Wulf at Harvard University; Jinghua Yan at SAC Capital; Ben- nett Stewart at EVA Dimensions; and Mobeen Iqbal and Antoine Uettwiller at Imperial College London. We are grateful to Cyrus Brealey for his suggestions. We would also like to thank the dedicated experts who have helped with updates to the instructor mate- rials and online content in Connect and LearnSmart, including Kay Johnson, Blaise Roncagli, Deb Bauer, Mishal Rawaf, Marc-Anthony Isaacs, Frank Ryan, Peter Crabb, Victoria Mahan, Nicholas Racculia, Angela Treinen, and Kent Ragan. We want to express our appreciation to those instruc- tors whose insightful comments and suggestions were invaluable to us during the revision process: Ibrahim Affaneh Indiana University of Pennsylvania Neyaz Ahmed University of Maryland Alexander Amati Rutgers University, New Brunswick Anne Anderson Lehigh University Noyan Arsen Koc University Anders Axvarn Gothenburg University John Banko University of Florida, Gainesville Michael Barry Boston College Jan Bartholdy ASB, Denmark Penny Belk Loughborough University Omar Benkato Ball State University Eric Benrud University of Baltimore Ronald Benson University of Maryland, University College Peter Berman University of New Haven Tom Boulton Miami University of Ohio Edward Boyer Temple University Alon Brav Duke University Jean Canil University of Adelaide Robert Carlson Bethany College Chuck Chahyadi Eastern Illinois University Fan Chen University of Mississippi Celtin Ciner University of North Carolina, Wilmington John Cooney Texas Tech University Charles Cuny Washington University, St. Louis John Davenport Regent University Ray DeGennaro University of Tennessee, Knoxville Adri DeRidder Gotland University William Dimovski Deakin University, Melbourne David Ding Nanyang Technological University Robert Duvic University of Texas at Austin Alex Edmans London Business School Susan Edwards Grand Valley State University Riza Emekter Robert Morris University Robert Everett Johns Hopkins University Dave Fehr Southern New Hampshire University Donald Flagg University of Tampa Frank Flanegin Robert Morris University Zsuzanna Fluck Michigan State University Connel Fullenkamp Duke University Mark Garmaise University of California, Los Angeles Sharon Garrison University of Arizona Christopher Geczy University of Pennsylvania George Geis University of Virginia Stuart Gillan University of Delaware Felix Goltz Edhec Business School Ning Gong Melbourne Business School Levon Goukasian Pepperdine University Gary Gray Pennsylvania State University C. J. Green Loughborough University Mark Griffiths Thunderbird, American School of International Management Re-Jin Guo University of Illinois, Chicago Ann Hackert Idaho State University Winfried Hallerbach Erasmus University, Rotterdam Milton Harris University of Chicago Mary Hartman Bentley College Glenn Henderson University of Cincinnati Donna Hitscherich Columbia University Ronald Hoffmeister Arizona State University James Howard University of Maryland, College Park George Jabbour George Washington University Final PDF to printer x Preface bre13901_fm_i-xxx.indd x 10/12/18 03:41 PM Ravi Jagannathan Northwestern University Abu Jalal Suffolk University Nancy Jay Mercer University Thadavillil (Nathan) Jithendranathan University of Saint Thomas Kathleen Kahle University of Arizona Jarl Kallberg NYU, Stern School of Business Ron Kaniel University of Rochester Steve Kaplan University of Chicago Eric Kelley University of Arizona Arif Khurshed Manchester Business School Ken Kim University of Wisconsin, Milwaukee Jiro Eduoard Kondo Northwestern University Kellogg School of Management C. R. Krishnaswamy Western Michigan University George Kutner Marquette University Dirk Laschanzky University of Iowa Scott Lee Texas A&M University Bob Lightner San Diego Christian College David Lins University of Illinois, Urbana Brandon Lockhart University of Nebraska, Lincoln David Lovatt University of East Anglia Greg Lucado University of the Sciences in Philadelphia Debbie Lucas Northwestern University Brian Lucey Trinity College, Dublin Suren Mansinghka University of California, Irvine Ernst Maug Mannheim University George McCabe University of Nebraska Eric McLaughlin California State University, Pomona Joe Messina San Francisco State University Tim Michael University of Houston, Clear Lake Dag Michalsen Bl, Oslo Franklin Michello Middle Tennessee State University Peter Moles University of Edinburgh Katherine Morgan Columbia University James Nelson East Carolina University James Owens West Texas A&M University Darshana Palkar Minnesota State University, Mankato Claus Parum Copenhagen Business School Dilip Patro Rutgers University John Percival University of Pennsylvania Birsel Pirim University of Illinois, Urbana Latha Ramchand University of Houston Narendar V. Rao Northeastern University Rathin Rathinasamy Ball State University Raghavendra Rau Purdue University Joshua Raugh University of Chicago Charu Reheja Wake Forest University Thomas Rhee California State University, Long Beach Tom Rietz University of Iowa Robert Ritchey Texas Tech University Michael Roberts University of Pennsylvania Mo Rodriguez Texas Christian University John Rozycki Drake University Frank Ryan San Diego State University Marc Schauten Eramus University Brad Scott Webster University Nejat Seyhun University of Michigan Jay Shanken Emory University Chander Shekhar University of Melbourne Hamid Shomali Golden Gate University Richard Simonds Michigan State University Bernell Stone Brigham Young University John Strong College of William & Mary Avanidhar Subrahmanyam University of California, Los Angeles Tim Sullivan Bentley College Shrinivasan Sundaram Ball State University Chu-Sheng Tai Texas Southern University Tom Tallerico Dowling College Stephen Todd Loyola University, Chicago Walter Torous University of California, Los Angeles Emery Trahan Northeastern University Gary Tripp Southern New Hampshire University Ilias Tsiakas University of Warwick David Vang St. Thomas University Steve Venti Dartmouth College Joseph Vu DePaul University John Wald Rutgers University Chong Wang Naval Postgraduate School Faye Wang University of Illinois, Chicago Kelly Welch University of Kansas Jill Wetmore Saginaw Valley State University Patrick Wilkie University of Virginia Matt Will University of Indianapolis David Williams Texas A&M University, Commerce Art Wilson George Washington University Shee Wong University of Minnesota, Duluth Bob Wood Tennessee Tech University Fei Xie George Mason University Minhua Yang University of Central Florida David Zalewski Providence College Chenying Zhang University of Pennsylvania This list is surely incomplete. We know how much we owe to our colleagues at the London Business School, MIT’s Sloan School of Management, Imperial College London, and the University of Pennsylvania’s Whar- ton School. In many cases, the ideas that appear in this book are as much their ideas as ours. We would also like to thank all those at McGraw-Hill Education who worked on the book, including Chuck Syn- ovec, Executive Brand Manager; Allison McCabe-Carroll, Senior Product Developer; Trina Mauer, Executive Mar- keting Manager; Dave O’Donnell, Marketing Specialist; Fran Simon, Project Manager; Matt Diamond, Designer; and Angela Norris, Digital Product Analyst. Richard A. Brealey Stewart C. Myers Franklin Allen Final PDF to printer xi bre13901_fm_i-xxx.indd xi 10/12/18 03:41 PM Guided Tour Pedagogical Features ⟩ Chapter Overview Each chapter begins with a brief narrative and out- line to explain the concepts that will be covered in more depth. Useful websites related to material for each Part are provided in the Connect library. ⟩ Finance in Practice Boxes Relevant news articles, often from financial pub- lications, appear in various chapters throughout the text. Aimed at bringing real-world flavor into the classroom, these boxes provide insight into the business world today. ⟩ Numbered Examples Numbered and titled examples are called out within chapters to further illustrate concepts. Students can learn how to solve specific problems step-by-step and apply key principles to answer concrete questions and scenarios. Rev.confirming pages ● ● ● 1 bre13901_ch01_001-019 1 07/19/18 06:24 PM Part 1 Value This book is about how corporations make financial decisions. We start by explaining what these decisions are and what they are intended to accomplish. Corporations invest in real assets, which generate income. Some of these assets, such as plant and machinery, are tan- gible; others, such as brand names and patents, are intangible. Corporations finance their investments by borrowing, by retain- ing and reinvesting cash flow, and by selling additional shares of stock to the corporation’s shareholders. Thus, the financial manager faces two broad financial questions: First, what invest- ments should the corporation make? Second, how should it pay for those investments? The investment decision involves spending money; the financing decision involves raising it. A large corporation may have hundreds of thousands of shareholders. These shareholders differ in many ways, including their wealth, risk tolerance, and investment horizon. Yet we shall see that they usually share the same financial objective. They want the financial manager to increase the value of the corporation and its current stock price. Thus, the secret of success in financial management is to increase value. That is easy to say but not very helpful. Instructing the financial manager to increase value is like advising an investor in the stock market to “buy low, sell high.” The problem is how …