Fluent Essays

finance FNCE 623: Week 5 Assignment Complete all parts of Question 22 on page 64-65 of your text.. Turn in one file using excel or word. Stephen A. Ross Massachusetts Institute of Technology Randolph W. Westerfield University of Southern California Bradford D. Jordan University of Kentucky Gordon S. Roberts Schulich School of Business, York University J. Ari Pandes Haskayne School of Business, University of Calgary Thomas A. Holloway Haskayne School of Business, University of Calgary Tenth Canadian Edition OF CORPORATE FINANCE FUNDAMENTALS ross54753_fm_i-xxvi.indd 1 1/17/19 10:50 AM Fundamentals of Corporate Finance Tenth Canadian Edition Copyright © 2019, 2016, 2013, 2010, 2007, 2005, 2002, 1999 by McGraw-Hill Ryerson Limited. Copyright © 1996, 1993 by Richard D. Irwin, a Times Mirror Higher Education Group, Inc. company. All rights reserved. No part of this publication may be reproduced or transmitted in any form or by any means, or stored in a data base or retrieval system, without the prior written permission of McGraw-Hill Ryerson Limited, or in the case of photocopying or other reprographic copying, a licence from The Canadian Copyright Licensing Agency (Access Copyright). For an Access Copyright licence, visit www.accesscopyright.ca or call toll free to 1-800-893-5777. 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 Ryerson, and McGraw-Hill Ryerson does not guarantee the accuracy of information presented at these sites. ISBN-13: 978-1-25-965475-6 ISBN-10: 1-25-965475-3 1 2 3 4 5 6 7 8 9 0 TCP 1 2!3 4 5 6 7 8 9! Printed and bound in Canada. Care has been taken to trace ownership of copyright material contained in this text; however, the publisher will welcome any information that enables it to rectify any reference or credit for subsequent editions. Director of Product, Canada: Rhondda McNabb Portfolio Managers:!Alwynn Pinard, Sara Braithwaite Senior Marketing Manager: Loula March Content Development Manager: Denise Foote Content Developer: Tammy Mavroudi Photo/Permissions Research: Mac/Cap Permissions Portfolio Team Associates: Stephanie Giles,!Tatiana Sevciuc Supervising Editor: Janie Deneau Copy Editor: Karen Rolfe Plant Production Coordinator: Sarah Strynatka Manufacturing Production Coordinator: Jason Stubner Cover Design: Katherine!Strain Cover Image: pawel.gaul/Getty!Images Interior Design: Jodie Bernard,!Lightbox!Communications,!Inc. Page Layout: MPS!Limited Printer: Transcontinental Printing Group ross54753_fm_i-xxvi.indd 2 1/17/19 10:50 AM ABOUT THE AUTHORS Stephen A. Ross Sloan School of Management, Massachusetts Institute of Technology Stephen A. Ross was the Franco Modigliani Professor of Finance and Economics at the Sloan School of Management, Massachusetts Institute of Technology. One of the most widely published authors in finance and economics, Professor Ross was widely recognized for his work in developing the Arbitrage Pricing Theory and his substantial contributions to the discipline through his research in signalling, agency theory, option pricing, and the theory of the term structure of interest rates, among other topics. A past president of the American Finance Association, he also served as an associate editor of several academic and practitioner journals. He was a trustee of CalTech. Stephen passed away in March 2017. Randolph W. Westerfield Marshall School of Business, University of Southern California Randolph W. Westerfield is Dean Emeritus and the Charles B. Thornton Professor!Emeritus in Finance of the University of Southern California’s Marshall School of Business. Professor Westerfield came to USC from the Wharton School, University of Pennsylvania, where he was the chairman of the finance department and a member of the finance faculty for 20 years. He is a member of the board of trustees of Oaktree Capital mutual funds. His areas of expertise include corporate financial policy, investment management, and stock market price behaviour. Bradford D. Jordan Gatton College of Business and Economics, University of Kentucky Bradford D. Jordan is professor of finance and holder of the Richard W. and Janis H. Furst Endowed Chair in Finance at the University of Kentucky. He has a long- standing interest in both applied and theoretical issues in corporate finance and has extensive experience teaching all levels of corporate finance and financial management policy. Professor Jordan has published numerous articles on issues such as cost of capital, capital structure, and the behaviour of security prices. He is a past president of the Southern Finance Association, and he is co-author of Fundamentals of Investments: Valuation and Management,!8th edition, a leading investments text, also published by McGraw-Hill Education. Gordon S. Roberts Schulich School of Business, York University Gordon S. Roberts was a Canadian Imperial Bank of Commerce Professor of Financial Services at the Schulich School of Business, York University. His extensive teaching experience included finance classes for undergraduate and MBA students, executives, and bankers in Canada and internationally. Professor Roberts conducted research on the pricing of bank loans and the regulation of financial institutions. He served on the editorial boards of several Canadian and international academic journals. Professor Roberts was a consultant to a number of regulatory bodies responsible for the oversight of financial institutions and utilities.! Gordon retired in 2016 and passed away in March 2017. J. Ari Pandes Haskayne School of Business, University of Calgary J. Ari Pandes is an Associate Professor of Finance at the University of Calgary’s!Haskayne School of Business. At Haskayne, he teaches courses at the PhD, Executive MBA, MBA, and senior undergraduate levels. He also teaches courses to corporate executives. Professor Pandes conducts research on the capital markets, which he has presented at conferences and universities internationally, as well as to policymakers, including the U.S. Securities and Exchange Commission and the Bank of Canada. In addition, Professor Pandes’ research has been cited in the press, and he frequently provides financial and economic insights to various media outlets. Thomas A. Holloway Haskayne School of Business, University of Calgary Thomas Holloway is a full-time faculty member at Haskayne and co-founder of hybrid wealth management startup Responsive AI. At Haskayne, he is the faculty supervisor of the student-managed investment fund Calgary Portfolio Management Trust and teaches courses in corporate finance and corporate governance. Mr. Holloway was formerly a fixed income analyst for one of Canada’s leading independent institutional investment managers and is a member of Calgary CFA Society. ross54753_fm_i-xxvi.indd 3 1/17/19 10:50 AM IN MEMORIAM We at McGraw-Hill Education Canada lost one of our most esteemed authors with the passing of Gordon S. Roberts in March 2017. Gordon was a Professor Emeritus of Finance at the Schulich School of Business at York University and a McGraw-Hill author for many years. Gordon S. Roberts will be remembered as an extremely creative and thoughtful scholar with a rigorous approach to questions of great importance. His contributions to the field of finance are unquestioned and are reflected in his outst anding inter national reput ation, research contributions, and many awards and honours. In particular, Gordon will be remembered for making significant contributions to the current textbook. His expertise and rigorous approach were key to making this textbook exciting, accurate, fair, well paced, and immediately useful. Prior to development work on this 10th Canadian edition text, our own Portfolio Manager, Alwynn Pinard, had the pleasure of working closely with Gordon. Of him she says, “Gordon’s professionalism, adherence to deadlines, and commitment to quality were all attributes that endeared him to us here at McGraw-Hill Education and created the Canadian resource you are reading today. Thank you, Gordon. We will miss your dedication to your work and your students and, perhaps most of all, your warmth and wit.” On behalf of the entire staff here at McGraw-Hill Education who had the pleasure of working with Gordon personally, or the pleasure of working on all the legacy projects he helped to build, we offer our deepest sympathies to Gordon’s wife, Sonita, and his family. Gordon’s contributions to learning will be treasured and never forgotten. ross54753_fm_i-xxvi.indd 4 2/15/19 7:08 PM BRIEF CONTENTS Preface xvii PART 1 Overview of Corporate Finance 1 1 Introduction to Corporate Finance 1 2 Financial Statements, Cash Flow, and Taxes 30 PART 2 Financial Statements and Long-Term Financial Planning 69 3 Working with Financial Statements 69 4 Long-Term Financial Planning and Corporate Growth 110 PART 3 Valuation of Future Cash Flows 146 5 Introduction to Valuation: The Time Value of Money 146 6 Discounted Cash Flow Valuation 170 7 Interest Rates and Bond Valuation 221 8 Stock Valuation 263 PART 4 Capital Budgeting 296 9 Net Present Value and Other Investment Criteria 296 10 Making Capital Investment Decisions 339 11 Project Analysis and Evaluation 393 PART 5 Risk and Return 431 12 Lessons from Capital Market History 431 13 Return, Risk, and the Security Market Line 467 PART 6 Cost of Capital and Long-Term Financial Policy 521 14 Cost of Capital 521 15 Raising Capital 575 16 Financial Leverage and Capital Structure Policy 617 17 Dividends and Dividend Policy 667 PART 7 Short-Term Financial Planning and Management 705 18 Short-Term Finance and Planning 19 Cash and Liquidity Management 753 20 Credit and Inventory Management 779 PART 8 Topics in Corporate Finance 822 21 International Corporate Finance 822 22 Leasing 859 23 Mergers and Acquisitions 887 PART 9 Derivative Securities and Corporate Finance 928 24 Enterprise Risk Management 928 25 Options and Corporate Securities 962 26 Behavioural Finance: Implications for Financial Management 1012 Glossary GL-1 Appendix A: Mathematical Tables (Available on Connect) Appendix B: Answers to Selected End-of-Chapter Problems (Available on Connect) Subject Index IN-1 Equation Index IN-22 ross54753_fm_i-xxvi.indd 5 1/17/19 10:50 AM CONTENTS Preface xvii PART 1 Overview of Corporate Finance 1 CHAPTER 1 Introduction to Corporate Finance 1 1.1 Corporate Finance and the Financial Manager 2 What Is Corporate Finance? 2 The Financial Manager 2 Financial Management Decisions 3 1.2 Forms of Business Organization 5 Sole Proprietorship 5 Partnership 6 Corporation 6 Income Trust 8 Co-operative (Co-op) 8 1.3 The Goal of Financial Management 9 Possible Goals 9 The Goal of Financial Management 10 A More General Goal 11 1.4 The Agency Problem and Control of the Corporation 12 Agency Relationships 12 Management Goals 12 Do Managers Act in the Shareholders’ Interests? 13 Corporate Social Responsibility and Ethical Investing 14 1.5 Financial Markets and the Corporation 17 Cash Flows to and from the Firm 17 Money versus Capital Markets 18 Primary versus Secondary Markets 18 1.6 Financial Institutions 20 1.7 Trends in Financial Markets and Financial Management 23 1.8 Outline of the Text 25 Summary and Conclusions 26 CHAPTER 2 Financial Statements, Cash Flow, and Taxes 30 2.1 Statement of Financial Position 31 Assets 31 Liabilities and Owners’ Equity 32 Net Working Capital 32 Liquidity 34 Debt versus Equity 34 Value versus Cost 34 2.2 Statement of Comprehensive Income 36 International Financial Reporting Standards (IFRS) 37 Non-Cash Items 38 Time and Costs 38 2.3 Cash Flow 39 Cash Flow from Assets 39 Cash Flow to Creditors and Shareholders 41 2.4 Taxes 45 Individual Tax Rates 46 Average versus Marginal Tax Rates 46 Taxes on Investment Income 46 Corporate Taxes 49 Taxable Income 51 Global Tax Rates 52 Capital Gains and Carry-Forward and Carry-Back 52 2.5 Capital Cost Allowance 53 Asset Purchases and Sales 54 Summary and Conclusions 58 PART 2 Financial Statements and Long-Term Financial Planning 69 CHAPTER 3 Working with Financial Statements 69 3.1 Cash Flow and Financial Statements: A Closer Look 70 Sources and Uses of Cash 70 Statement of Cash Flows 72 3.2 Standardized Financial Statements 74 Common-Size Statements 74 Common–Base Year Financial Statements: Trend Analysis 76 3.3 Ratio Analysis 78 Short-Term Solvency or Liquidity Measures 79 Other Liquidity Ratios 81 ross54753_fm_i-xxvi.indd 6 1/17/19 10:50 AM Contents vii Long-Term Solvency Measures 82 Asset Management, or Turnover, Measures 84 Profitability Measures 86 Market Value Measures 87 3.4 The DuPont Identity 90 3.5 Using Financial Statement Information 93 Why Evaluate Financial Statements? 93 Choosing a Benchmark 94 Problems with Financial Statement Analysis 95 Summary and Conclusions 96 CHAPTER 4 Long-Term Financial Planning and Corporate Growth 110 4.1 What Is Financial Planning? 111 Growth as a Financial Management Goal 112 Dimensions of Financial Planning 112 What Can Planning Accomplish? 113 4.2 Financial Planning Models: A First Look 114 A Financial Planning Model: The Ingredients 115 A Simple Financial Planning Model 116 4.3 The Percentage of Sales Approach 118 An Illustration of the Percentage of Sales Approach 118 4.4 External Financing and Growth 124 External Financing Needed and Growth 124 Internal Growth Rate 127 Financial Policy and Growth 128 Determinants of Growth 130 A Note on Sustainable Growth Rate Calculations 131 4.5 Some Caveats on Financial Planning Models 133 Summary and Conclusions 133 Appendix 4A: A Financial Planning Model For the Hoffman Company (Available on Connect) Appendix 4B: Derivation of the Sustainable Growth Formula (Available on Connect) PART 3 Valuation of Future Cash Flows 146 CHAPTER 5 Introduction to Valuation: The Time Value of Money 146 5.1 Future Value and Compounding 147 Investing for a Single Period 147 Investing for More than One Period 147 A Note on Compound Growth 153 5.2 Present Value and Discounting 154 The Single-Period Case 154 Present Values for Multiple Periods 155 5.3 More on Present and Future Values 157 Present versus Future Value 157 Determining the Discount Rate 158 Finding the Number of Periods 161 Summary and Conclusions 163 CHAPTER 6 Discounted Cash Flow Valuation 170 6.1 Future and Present Values of Multiple Cash Flows 171 Future Value with Multiple Cash Flows 171 Present Value with Multiple Cash Flows 173 A Note on Cash Flow Timing 176 6.2 Valuing Annuities and Perpetuities 178 Present Value for Annuity Cash Flows 178 Future Value for Annuities 183 A Note on Annuities Due 185 Perpetuities 185 Growing Perpetuities 187 Formula for Present Value of Growing Perpetuity 188 Growing Annuity 189 Formula for Present Value of Growing Annuity 189 6.3 Comparing Rates: The Effect of Compounding 190 Effective Annual Rates and Compounding 190 Calculating and Comparing Effective Annual Rates 191 Mortgages 193 EARs and APRs 194 Taking It to the Limit: A Note on Continuous Compounding 195 6.4 Loan Types and Loan Amortization 196 Pure Discount Loans 196 Interest-Only Loans 196 Amortized Loans 197 Summary and Conclusions 201 Appendix 6A: Proof of Annuity Present Value Formula 219 ross54753_fm_i-xxvi.indd 7 1/17/19 10:50 AM Contents viii CHAPTER 7 Interest Rates and Bond Valuation 221 7.1 Bonds and Bond Valuation 222 Bond Features and Prices 222 Bond Values and Yields 223 Interest Rate Risk 226 Finding the Yield to Maturity 228 7.2 More on Bond Features 231 Is It Debt or Equity? 231 Long-Term Debt: The Basics 231 The Indenture 232 7.3 Bond Ratings 235 7.4 Some Different Types of Bonds 237 Financial Engineering 237 Stripped Bonds 239 Floating-Rate Bonds 240 Other Types of Bonds 240 7.5 Bond Markets 242 How Bonds Are Bought and Sold 242 Bond Price Reporting 242 A Note on Bond Price Quotes 244 Bond Funds 244 Bonds and Restructuring 244 7.6 Inflation and Interest Rates 245 Real versus Nominal Rates 245 The Fisher Effect 246 Inflation and Present Values 247 7.7 Determinants of Bond Yields 248 The Term Structure of Interest Rates 248 Bond Yields and the Yield Curve: Putting It All Together 249 Conclusion 251 Summary and Conclusions 252 Appendix 7A: Managing Interest Rate Risk 260 Appendix 7B: Callable Bonds and Bond Refunding (available on Connect) CHAPTER 8 Stock Valuation 263 8.1 Common Stock Valuation 264 Common Stock Cash Flows 264 Common Stock Valuation: Some Special Cases 265 Changing the Growth Rate 271 Components of the Required Return 272 8.2 Common Stock Features 274 Shareholders’ Rights 274 Dividends 275 Classes of Stock 276 8.3 Preferred Stock Features 277 Stated Value 277 Cumulative and Non-Cumulative Dividends 278 Is Preferred Stock Really Debt? 278 Preferred Stock and Taxes 279 Beyond Taxes 280 8.4 Stock Market Reporting 281 Growth Opportunities 282 Application: The Price–Earnings Ratio 282 Summary and Conclusions 284 Appendix 8A: Corporate Voting 293 PART 4 Capital Budgeting 296 CHAPTER 9 Net Present Value and Other Investment Criteria 296 9.1 Net Present Value 297 The Basic Idea 297 Estimating Net Present Value 298 9.2 The Payback Rule 302 Defining the Rule 302 Analyzing the Payback Period Rule 303 Redeeming Qualities 304 Summary of the Rule 304 The Discounted Payback Rule 305 9.3 The Average Accounting Return 306 Analyzing the Average Accounting Return Method 308 9.4 The Internal Rate of Return 308 Problems with the IRR 313 Redeeming Qualities of the IRR 318 9.5 The Profitability Index 319 9.6 The Practice of Capital Budgeting 320 9.7 Capital Rationing 323 Summary and Conclusions 324 Appendix 9A: The Modified Internal Rate of Return 336 CHAPTER 10 Making Capital Investment Decisions 339 10.1 Project Cash Flows: A!First!Look 340 Relevant Cash Flows 340 The Stand-Alone Principle 340 ross54753_fm_i-xxvi.indd 8 1/17/19 10:50 AM Contents ix 10.2 Incremental Cash Flows 341 Sunk Costs 341 Opportunity Costs 341 Side Effects 342 Net Working Capital 343 Financing Costs 343 Inflation 343 Capital Budgeting and Business Taxes in Canada 344 Other Issues 344 10.3 Pro Forma Financial Statements and Project Cash Flows 344 Getting Started: Pro Forma Financial Statements 344 Project Cash Flows 346 Project Total Cash Flow and Value 347 10.4 More on Project Cash Flow 348 A Closer Look at Net Working Capital 348 Depreciation and Capital Cost Allowance 350 An Example: The Majestic Mulch and Compost Company (MMCC) 350 10.5 Alternative Definitions of!Operating Cash Flow 354 The Bottom-up Approach 355 The Top-down Approach 356 The Tax Shield Approach 356 Conclusion 357 10.6 Applying the Tax Shield Approach to the Majestic Mulch and Compost Company Project 357 Present Value of the Tax Shield on CCA 359 Salvage Value versus UCC 359 10.7 Some Special Cases of Discounted Cash Flow Analysis 361 Evaluating Cost-Cutting Proposals 361 Replacing an Asset 363 Evaluating Equipment with Different Lives 366 Setting the Bid Price 368 Summary and Conclusions 370 Appendix 10A: More on Inflation and Capital Budgeting 388 Appendix 10B: Capital Budgeting with Spreadsheets 389 Appendix 10C: Deriving the Tax Shield on CCA! Formula 391 CHAPTER 11 Project Analysis and Evaluation 393 11.1 Evaluating NPV Estimates 394 The Basic Problem 394 Projected versus Actual Cash Flows 394 Forecasting Risk 395 Sources of Value 395 11.2 Scenario and Other What-If Analyses 396 Getting Started 396 Scenario Analysis 397 Sensitivity Analysis 400 Simulation Analysis 401 11.3 Break-Even Analysis 403 Fixed and Variable Costs 403 Accounting Break-Even 405 Accounting Break-Even: A Closer Look 407 Uses for the Accounting Break-Even 407 11.4 Operating Cash Flow, Sales Volume, and Break-Even 408 Accounting Break-Even and Cash Flow 408 Cash Flow and Financial Break-Even Points 410 11.5 Operating Leverage 413 The Basic Idea 414 Implications of Operating Leverage 414 Measuring Operating Leverage 414 Operating Leverage and Break-Even 416 11.6 Managerial Options 417 Summary and Conclusions 420 PART 5 Risk and Return 431 CHAPTER 12 Lessons from Capital Market History 431 12.1 Returns 432 Dollar Returns 432 Percentage Returns 434 12.2 The Historical Record 436 A First Look 439 A Closer Look 440 12.3 Average Returns: The First Lesson 440 Calculating Average Returns 441 Average Returns: The Historical Record 441 Risk Premiums 442 The First Lesson 442 ross54753_fm_i-xxvi.indd 9 1/17/19 10:50 AM Contents x 12.4 The Variability of Returns: The Second Lesson 443 Frequency Distributions and Variability 443 The Historical Variance and Standard Deviation 444 The Historical Record 446 Normal Distribution 446 Value at Risk 447 The Second Lesson 449 2008: The Bear Growled and Investors Howled 449 Using Capital Market History 449 12.5 More on Average Returns 451 Arithmetic versus Geometric Averages 451 Calculating Geometric Average Returns 451 Arithmetic Average Return or Geometric Average Return? 453 12.6 Capital Market Efficiency 454 Price Behaviour in an Efficient Market 454 The Efficient Markets Hypothesis 455 Market Efficiency—Forms and Evidence 457 Summary and Conclusions 459 CHAPTER 13 Return, Risk, and the Security Market Line 467 13.1 Expected Returns and Variances 468 Expected Return 468 Calculating the Variance 470 13.2 Portfolios 472 Portfolio Weights 472 Portfolio Expected Returns 473 Portfolio Variance 474 Portfolio Standard Deviation and Diversification 475 The Efficient Set 478 Correlations in the Financial Crisis of 2007–2009 481 13.3 Announcements, Surprises, and Expected Returns 481 Expected and Unexpected Returns 482 Announcements and News 482 13.4 Risk: Systematic and Unsystematic 483 Systematic and Unsystematic Risk 484 Systematic and Unsystematic Components of Return 484 13.5 Diversification and Portfolio Risk 485 The Effect of Diversification: Another Lesson from Market History 485 The Principle of Diversification 486 Diversification and Unsystematic Risk 487 Diversification and Systematic Risk 488 Risk and the Sensible Investor 488 13.6 Systematic Risk and Beta 490 The Systematic Risk Principle 490 Measuring Systematic Risk 490 Portfolio Betas 491 13.7 The Security Market Line 493 Beta and the Risk Premium 493 Calculating Beta 498 The Security Market Line 501 13.8 Arbitrage Pricing Theory and Empirical Models 505 Summary and Conclusions 507 Appendix 13A: Derivation of the Capital Asset Pricing Model 518 PART 6 Cost of Capital and Long-Term Financial Policy 521 CHAPTER!14 Cost of Capital 521 14.1 The Cost of Capital: Some Preliminaries 522 Required Return versus Cost of Capital 522 Financial Policy and Cost of Capital 523 14.2 The Cost of Equity 523 The Dividend Growth Model Approach 523 The SML Approach 526 The Cost of Equity in Rate Hearings 527 14.3 The Costs of Debt and Preferred Stock 529 The Cost of Debt 529 The Cost of Preferred Stock 529 14.4 The Weighted Average Cost of Capital 530 The Capital Structure Weights 531 Taxes and the Weighted Average Cost of Capital 531 Solving the Warehouse Problem and Similar Capital Budgeting Problems 533 Performance Evaluation: Another Use of the WACC 535 14.5 Divisional and Project Costs of Capital 535 The SML and the WACC 536 Divisional Cost of Capital 538 The Pure Play Approach 538 The Subjective Approach 539 ross54753_fm_i-xxvi.indd 10 1/17/19 10:50 AM Contents xi 14.6 Company Valuation with the WACC 540 14.7 Flotation Costs and the Weighted Average Cost of Capital 543 The Basic Approach 543 Flotation Costs and NPV 544 Internal Equity and Flotation Costs 545 14.8 Calculating WACC for Loblaw 547 Estimating Financing Proportions 547 Market Value Weights for Loblaw 547 Cost of Debt 548 Cost of Preferred Shares 549 Cost of Common Stock 550 CAPM 550 Dividend Valuation Model Growth Rate 551 Loblaw’s WACC 551 Summary and Conclusions 552 Appendix 14A: Adjusted Present Value 564 Appendix 14B: Economic Value Added and the Measurement of Financial Performance 570 CHAPTER 15 Raising Capital 575 15.1 The Financing Life Cycle of a Firm: Early-Stage Financing and Venture Capital 576 Venture Capital 576 Some Venture Capital Realities 577 Choosing a Venture Capitalist 577 Conclusion 578 15.2 The Public Issue 578 15.3 The Basic Procedure for a New Issue 579 Securities Registration 580 Exempt Securities and Crowdfunding 580 Alternative Issue Methods 581 15.4 The Cash Offer 582 Types of Underwriting 583 Bought Deal 583 Dutch Auction Underwriting 583 The Selling Period 584 The Overallotment Option 585 Lockup Agreements 585 The Quiet Periods 585 The Investment Dealers 586 15.5 IPOs and Underpricing 587 IPO Underpricing: The 1999–2000 Experience 587 Evidence on Underpricing 587 Why Does Underpricing Exist? 589 15.6 New Equity Sales and the Value of the Firm 592 15.7 The Cost of Issuing Securities 594 IPOs in Practice: The Case of Seven Generations Energy 596 15.8 Rights 597 The Mechanics of a Rights Offering 597 Number of Rights Needed to Purchase a Share 598 The Value of a Right 599 Theoretical Value of a Right 601 Ex Rights 601 Value of Rights after Ex-Rights Date 602 The Underwriting Arrangements 602 Effects on Shareholders 603 Cost of Rights Offerings 604 15.9 Dilution 605 Dilution of Proportionate Ownership 605 Dilution of Value: Book versus Market Values 605 15.10 Issuing Long-Term Debt 607 Summary and Conclusions 609 CHAPTER 16 Financial Leverage and Capital Structure Policy 617 16.1 The Capital Structure Question 618 Firm Value and Stock Value: An Example 618 Capital Structure and the Cost of Capital 620 16.2 The Effect of Financial Leverage 620 The Basics of Financial Leverage 620 Corporate Borrowing and Homemade Leverage 625 16.3 Capital Structure and the Cost of Equity Capital 627 M&M Proposition I: The Pie Model 627 The Cost of Equity and Financial Leverage: M&M Proposition II 628 Business and Financial Risk 629 16.4 M&M Propositions I and II with Corporate Taxes 632 The Interest Tax Shield 633 Taxes and M&M Proposition I 633 Taxes, the WACC, and Proposition II 635 16.5 Bankruptcy Costs 637 Direct Bankruptcy Costs 638 Indirect Bankruptcy Costs 638 Agency Costs of Equity 639 ross54753_fm_i-xxvi.indd 11 1/17/19 10:50 AM Contents xii 16.6 Optimal Capital Structure 640 The Static Theory of Capital Structure 640 Optimal Capital Structure and the Cost of Capital 641 Optimal Capital Structure: A Recap 642 Capital Structure: Some Managerial Recommendations 644 16.7 The Pie Again 645 The Extended Pie Model 645 Marketed Claims versus Non-Marketed Claims 646 16.8 The Pecking-Order Theory 647 Internal Financing and the Pecking Order 647 Implications of the Pecking Order 647 16.9 Observed Capital Structures 648 16.10 Long-Term Financing under Financial Distress and Bankruptcy 650 Liquidation and Reorganization 650 Agreements to Avoid Bankruptcy 652 Summary and Conclusions 653 Appendix 16A: Capital Structure and Personal Taxes 663 Appendix 16B: Derivation of Proposition II (Equation 16.4) 666 CHAPTER 17 Dividends and Dividend Policy 667 17.1 Cash Dividends and Dividend Payment 668 Cash Dividends 669 Standard Method of Cash Dividend Payment 669 Dividend Payment: A Chronology 669 More on the Ex-Dividend Date 670 17.2 Does Dividend Policy Matter? 672 An Illustration of the Irrelevance of Dividend Policy 672 17.3 Real-World Factors Favouring a Low Payout 674 Taxes 675 Some Evidence on Dividends and Taxes in Canada 677 Flotation Costs 677 Dividend Restrictions 678 17.4 Real-World Factors Favouring a High Payout 678 Desire for Current Income 678 Uncertainty Resolution 679 Tax and Legal Benefits from High Dividends 679 Conclusion 680 17.5 A Resolution of Real-World Factors? 680 Information Content of Dividends 680 Dividend Signalling in Practice 681 The Clientele Effect 682 17.6 Establishing a Dividend Policy 683 Residual Dividend Approach 684 Dividend Stability 687 A Compromise Dividend Policy 688 Some Survey Evidence on Dividends 688 17.7 Stock Repurchase: An Alternative to Cash Dividends 690 Cash Dividends versus Repurchase 691 Real-World Considerations in a Repurchase 692 Share Repurchase and EPS 692 17.8 Stock Dividends and Stock Splits 693 Some Details on Stock Splits and Stock Dividends 693 Value of Stock Splits and Stock Dividends 694 Reverse Splits 695 Summary and Conclusions 696 PART 7 Short-Term Financial Planning and Management 705 CHAPTER 18 Short-Term Finance and Planning 705 18.1 Tracing Cash and Net Working Capital 706 18.2 The Operating Cycle and the Cash Cycle 708 Defining the Operating and Cash Cycles 709 Calculating the Operating and Cash Cycles 711 Interpreting the Cash Cycle 714 18.3 Some Aspects of Short-Term Financial Policy 715 The Size of the Firm’s Investment in Current Assets 716 Alternative Financing Policies for Current Assets 717 Which Financing Policy Is Best? 721 Current Assets and Liabilities in Practice 722 18.4 The Cash Budget 724 Sales and Cash Collections 724 Cash Outflows 725 The Cash Balance 726 18.5 A Short-Term Financial Plan 727 Short-Term Planning and Risk 728 ross54753_fm_i-xxvi.indd 12 1/17/19 10:50 AM Contents xiii 18.6 Short-Term Borrowing 729 Operating Loans 729 Letters of Credit 731 Secured Loans 731 Factoring 733 Securitized Receivables—A Financial … Stephen A. Ross Massachusetts Institute of Technology Randolph W. Westerfield University of Southern California Bradford D. Jordan University of Kentucky Gordon S. Roberts Schulich School of Business, York University J. Ari Pandes Haskayne School of Business, University of Calgary Thomas A. Holloway Haskayne School of Business, University of Calgary Tenth Canadian Edition OF CORPORATE FINANCE FUNDAMENTALS ross54753_fm_i-xxvi.indd 1 1/17/19 10:50 AM Fundamentals of Corporate Finance Tenth Canadian Edition Copyright © 2019, 2016, 2013, 2010, 2007, 2005, 2002, 1999 by McGraw-Hill Ryerson Limited. Copyright © 1996, 1993 by Richard D. Irwin, a Times Mirror Higher Education Group, Inc. company. All rights reserved. No part of this publication may be reproduced or transmitted in any form or by any means, or stored in a data base or retrieval system, without the prior written permission of McGraw-Hill Ryerson Limited, or in the case of photocopying or other reprographic copying, a licence from The Canadian Copyright Licensing Agency (Access Copyright). For an Access Copyright licence, visit www.accesscopyright.ca or call toll free to 1-800-893-5777. 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 Ryerson, and McGraw-Hill Ryerson does not guarantee the accuracy of information presented at these sites. ISBN-13: 978-1-25-965475-6 ISBN-10: 1-25-965475-3 1 2 3 4 5 6 7 8 9 0 TCP 1 2!3 4 5 6 7 8 9! Printed and bound in Canada. Care has been taken to trace ownership of copyright material contained in this text; however, the publisher will welcome any information that enables it to rectify any reference or credit for subsequent editions. Director of Product, Canada: Rhondda McNabb Portfolio Managers:!Alwynn Pinard, Sara Braithwaite Senior Marketing Manager: Loula March Content Development Manager: Denise Foote Content Developer: Tammy Mavroudi Photo/Permissions Research: Mac/Cap Permissions Portfolio Team Associates: Stephanie Giles,!Tatiana Sevciuc Supervising Editor: Janie Deneau Copy Editor: Karen Rolfe Plant Production Coordinator: Sarah Strynatka Manufacturing Production Coordinator: Jason Stubner Cover Design: Katherine!Strain Cover Image: pawel.gaul/Getty!Images Interior Design: Jodie Bernard,!Lightbox!Communications,!Inc. Page Layout: MPS!Limited Printer: Transcontinental Printing Group ross54753_fm_i-xxvi.indd 2 1/17/19 10:50 AM ABOUT THE AUTHORS Stephen A. Ross Sloan School of Management, Massachusetts Institute of Technology Stephen A. Ross was the Franco Modigliani Professor of Finance and Economics at the Sloan School of Management, Massachusetts Institute of Technology. One of the most widely published authors in finance and economics, Professor Ross was widely recognized for his work in developing the Arbitrage Pricing Theory and his substantial contributions to the discipline through his research in signalling, agency theory, option pricing, and the theory of the term structure of interest rates, among other topics. A past president of the American Finance Association, he also served as an associate editor of several academic and practitioner journals. He was a trustee of CalTech. Stephen passed away in March 2017. Randolph W. Westerfield Marshall School of Business, University of Southern California Randolph W. Westerfield is Dean Emeritus and the Charles B. Thornton Professor!Emeritus in Finance of the University of Southern California’s Marshall School of Business. Professor Westerfield came to USC from the Wharton School, University of Pennsylvania, where he was the chairman of the finance department and a member of the finance faculty for 20 years. He is a member of the board of trustees of Oaktree Capital mutual funds. His areas of expertise include corporate financial policy, investment management, and stock market price behaviour. Bradford D. Jordan Gatton College of Business and Economics, University of Kentucky Bradford D. Jordan is professor of finance and holder of the Richard W. and Janis H. Furst Endowed Chair in Finance at the University of Kentucky. He has a long- standing interest in both applied and theoretical issues in corporate finance and has extensive experience teaching all levels of corporate finance and financial management policy. Professor Jordan has published numerous articles on issues such as cost of capital, capital structure, and the behaviour of security prices. He is a past president of the Southern Finance Association, and he is co-author of Fundamentals of Investments: Valuation and Management,!8th edition, a leading investments text, also published by McGraw-Hill Education. Gordon S. Roberts Schulich School of Business, York University Gordon S. Roberts was a Canadian Imperial Bank of Commerce Professor of Financial Services at the Schulich School of Business, York University. His extensive teaching experience included finance classes for undergraduate and MBA students, executives, and bankers in Canada and internationally. Professor Roberts conducted research on the pricing of bank loans and the regulation of financial institutions. He served on the editorial boards of several Canadian and international academic journals. Professor Roberts was a consultant to a number of regulatory bodies responsible for the oversight of financial institutions and utilities.! Gordon retired in 2016 and passed away in March 2017. J. Ari Pandes Haskayne School of Business, University of Calgary J. Ari Pandes is an Associate Professor of Finance at the University of Calgary’s!Haskayne School of Business. At Haskayne, he teaches courses at the PhD, Executive MBA, MBA, and senior undergraduate levels. He also teaches courses to corporate executives. Professor Pandes conducts research on the capital markets, which he has presented at conferences and universities internationally, as well as to policymakers, including the U.S. Securities and Exchange Commission and the Bank of Canada. In addition, Professor Pandes’ research has been cited in the press, and he frequently provides financial and economic insights to various media outlets. Thomas A. Holloway Haskayne School of Business, University of Calgary Thomas Holloway is a full-time faculty member at Haskayne and co-founder of hybrid wealth management startup Responsive AI. At Haskayne, he is the faculty supervisor of the student-managed investment fund Calgary Portfolio Management Trust and teaches courses in corporate finance and corporate governance. Mr. Holloway was formerly a fixed income analyst for one of Canada’s leading independent institutional investment managers and is a member of Calgary CFA Society. ross54753_fm_i-xxvi.indd 3 1/17/19 10:50 AM IN MEMORIAM We at McGraw-Hill Education Canada lost one of our most esteemed authors with the passing of Gordon S. Roberts in March 2017. Gordon was a Professor Emeritus of Finance at the Schulich School of Business at York University and a McGraw-Hill author for many years. Gordon S. Roberts will be remembered as an extremely creative and thoughtful scholar with a rigorous approach to questions of great importance. His contributions to the field of finance are unquestioned and are reflected in his outst anding inter national reput ation, research contributions, and many awards and honours. In particular, Gordon will be remembered for making significant contributions to the current textbook. His expertise and rigorous approach were key to making this textbook exciting, accurate, fair, well paced, and immediately useful. Prior to development work on this 10th Canadian edition text, our own Portfolio Manager, Alwynn Pinard, had the pleasure of working closely with Gordon. Of him she says, “Gordon’s professionalism, adherence to deadlines, and commitment to quality were all attributes that endeared him to us here at McGraw-Hill Education and created the Canadian resource you are reading today. Thank you, Gordon. We will miss your dedication to your work and your students and, perhaps most of all, your warmth and wit.” On behalf of the entire staff here at McGraw-Hill Education who had the pleasure of working with Gordon personally, or the pleasure of working on all the legacy projects he helped to build, we offer our deepest sympathies to Gordon’s wife, Sonita, and his family. Gordon’s contributions to learning will be treasured and never forgotten. ross54753_fm_i-xxvi.indd 4 2/15/19 7:08 PM BRIEF CONTENTS Preface xvii PART 1 Overview of Corporate Finance 1 1 Introduction to Corporate Finance 1 2 Financial Statements, Cash Flow, and Taxes 30 PART 2 Financial Statements and Long-Term Financial Planning 69 3 Working with Financial Statements 69 4 Long-Term Financial Planning and Corporate Growth 110 PART 3 Valuation of Future Cash Flows 146 5 Introduction to Valuation: The Time Value of Money 146 6 Discounted Cash Flow Valuation 170 7 Interest Rates and Bond Valuation 221 8 Stock Valuation 263 PART 4 Capital Budgeting 296 9 Net Present Value and Other Investment Criteria 296 10 Making Capital Investment Decisions 339 11 Project Analysis and Evaluation 393 PART 5 Risk and Return 431 12 Lessons from Capital Market History 431 13 Return, Risk, and the Security Market Line 467 PART 6 Cost of Capital and Long-Term Financial Policy 521 14 Cost of Capital 521 15 Raising Capital 575 16 Financial Leverage and Capital Structure Policy 617 17 Dividends and Dividend Policy 667 PART 7 Short-Term Financial Planning and Management 705 18 Short-Term Finance and Planning 19 Cash and Liquidity Management 753 20 Credit and Inventory Management 779 PART 8 Topics in Corporate Finance 822 21 International Corporate Finance 822 22 Leasing 859 23 Mergers and Acquisitions 887 PART 9 Derivative Securities and Corporate Finance 928 24 Enterprise Risk Management 928 25 Options and Corporate Securities 962 26 Behavioural Finance: Implications for Financial Management 1012 Glossary GL-1 Appendix A: Mathematical Tables (Available on Connect) Appendix B: Answers to Selected End-of-Chapter Problems (Available on Connect) Subject Index IN-1 Equation Index IN-22 ross54753_fm_i-xxvi.indd 5 1/17/19 10:50 AM CONTENTS Preface xvii PART 1 Overview of Corporate Finance 1 CHAPTER 1 Introduction to Corporate Finance 1 1.1 Corporate Finance and the Financial Manager 2 What Is Corporate Finance? 2 The Financial Manager 2 Financial Management Decisions 3 1.2 Forms of Business Organization 5 Sole Proprietorship 5 Partnership 6 Corporation 6 Income Trust 8 Co-operative (Co-op) 8 1.3 The Goal of Financial Management 9 Possible Goals 9 The Goal of Financial Management 10 A More General Goal 11 1.4 The Agency Problem and Control of the Corporation 12 Agency Relationships 12 Management Goals 12 Do Managers Act in the Shareholders’ Interests? 13 Corporate Social Responsibility and Ethical Investing 14 1.5 Financial Markets and the Corporation 17 Cash Flows to and from the Firm 17 Money versus Capital Markets 18 Primary versus Secondary Markets 18 1.6 Financial Institutions 20 1.7 Trends in Financial Markets and Financial Management 23 1.8 Outline of the Text 25 Summary and Conclusions 26 CHAPTER 2 Financial Statements, Cash Flow, and Taxes 30 2.1 Statement of Financial Position 31 Assets 31 Liabilities and Owners’ Equity 32 Net Working Capital 32 Liquidity 34 Debt versus Equity 34 Value versus Cost 34 2.2 Statement of Comprehensive Income 36 International Financial Reporting Standards (IFRS) 37 Non-Cash Items 38 Time and Costs 38 2.3 Cash Flow 39 Cash Flow from Assets 39 Cash Flow to Creditors and Shareholders 41 2.4 Taxes 45 Individual Tax Rates 46 Average versus Marginal Tax Rates 46 Taxes on Investment Income 46 Corporate Taxes 49 Taxable Income 51 Global Tax Rates 52 Capital Gains and Carry-Forward and Carry-Back 52 2.5 Capital Cost Allowance 53 Asset Purchases and Sales 54 Summary and Conclusions 58 PART 2 Financial Statements and Long-Term Financial Planning 69 CHAPTER 3 Working with Financial Statements 69 3.1 Cash Flow and Financial Statements: A Closer Look 70 Sources and Uses of Cash 70 Statement of Cash Flows 72 3.2 Standardized Financial Statements 74 Common-Size Statements 74 Common–Base Year Financial Statements: Trend Analysis 76 3.3 Ratio Analysis 78 Short-Term Solvency or Liquidity Measures 79 Other Liquidity Ratios 81 ross54753_fm_i-xxvi.indd 6 1/17/19 10:50 AM Contents vii Long-Term Solvency Measures 82 Asset Management, or Turnover, Measures 84 Profitability Measures 86 Market Value Measures 87 3.4 The DuPont Identity 90 3.5 Using Financial Statement Information 93 Why Evaluate Financial Statements? 93 Choosing a Benchmark 94 Problems with Financial Statement Analysis 95 Summary and Conclusions 96 CHAPTER 4 Long-Term Financial Planning and Corporate Growth 110 4.1 What Is Financial Planning? 111 Growth as a Financial Management Goal 112 Dimensions of Financial Planning 112 What Can Planning Accomplish? 113 4.2 Financial Planning Models: A First Look 114 A Financial Planning Model: The Ingredients 115 A Simple Financial Planning Model 116 4.3 The Percentage of Sales Approach 118 An Illustration of the Percentage of Sales Approach 118 4.4 External Financing and Growth 124 External Financing Needed and Growth 124 Internal Growth Rate 127 Financial Policy and Growth 128 Determinants of Growth 130 A Note on Sustainable Growth Rate Calculations 131 4.5 Some Caveats on Financial Planning Models 133 Summary and Conclusions 133 Appendix 4A: A Financial Planning Model For the Hoffman Company (Available on Connect) Appendix 4B: Derivation of the Sustainable Growth Formula (Available on Connect) PART 3 Valuation of Future Cash Flows 146 CHAPTER 5 Introduction to Valuation: The Time Value of Money 146 5.1 Future Value and Compounding 147 Investing for a Single Period 147 Investing for More than One Period 147 A Note on Compound Growth 153 5.2 Present Value and Discounting 154 The Single-Period Case 154 Present Values for Multiple Periods 155 5.3 More on Present and Future Values 157 Present versus Future Value 157 Determining the Discount Rate 158 Finding the Number of Periods 161 Summary and Conclusions 163 CHAPTER 6 Discounted Cash Flow Valuation 170 6.1 Future and Present Values of Multiple Cash Flows 171 Future Value with Multiple Cash Flows 171 Present Value with Multiple Cash Flows 173 A Note on Cash Flow Timing 176 6.2 Valuing Annuities and Perpetuities 178 Present Value for Annuity Cash Flows 178 Future Value for Annuities 183 A Note on Annuities Due 185 Perpetuities 185 Growing Perpetuities 187 Formula for Present Value of Growing Perpetuity 188 Growing Annuity 189 Formula for Present Value of Growing Annuity 189 6.3 Comparing Rates: The Effect of Compounding 190 Effective Annual Rates and Compounding 190 Calculating and Comparing Effective Annual Rates 191 Mortgages 193 EARs and APRs 194 Taking It to the Limit: A Note on Continuous Compounding 195 6.4 Loan Types and Loan Amortization 196 Pure Discount Loans 196 Interest-Only Loans 196 Amortized Loans 197 Summary and Conclusions 201 Appendix 6A: Proof of Annuity Present Value Formula 219 ross54753_fm_i-xxvi.indd 7 1/17/19 10:50 AM Contents viii CHAPTER 7 Interest Rates and Bond Valuation 221 7.1 Bonds and Bond Valuation 222 Bond Features and Prices 222 Bond Values and Yields 223 Interest Rate Risk 226 Finding the Yield to Maturity 228 7.2 More on Bond Features 231 Is It Debt or Equity? 231 Long-Term Debt: The Basics 231 The Indenture 232 7.3 Bond Ratings 235 7.4 Some Different Types of Bonds 237 Financial Engineering 237 Stripped Bonds 239 Floating-Rate Bonds 240 Other Types of Bonds 240 7.5 Bond Markets 242 How Bonds Are Bought and Sold 242 Bond Price Reporting 242 A Note on Bond Price Quotes 244 Bond Funds 244 Bonds and Restructuring 244 7.6 Inflation and Interest Rates 245 Real versus Nominal Rates 245 The Fisher Effect 246 Inflation and Present Values 247 7.7 Determinants of Bond Yields 248 The Term Structure of Interest Rates 248 Bond Yields and the Yield Curve: Putting It All Together 249 Conclusion 251 Summary and Conclusions 252 Appendix 7A: Managing Interest Rate Risk 260 Appendix 7B: Callable Bonds and Bond Refunding (available on Connect) CHAPTER 8 Stock Valuation 263 8.1 Common Stock Valuation 264 Common Stock Cash Flows 264 Common Stock Valuation: Some Special Cases 265 Changing the Growth Rate 271 Components of the Required Return 272 8.2 Common Stock Features 274 Shareholders’ Rights 274 Dividends 275 Classes of Stock 276 8.3 Preferred Stock Features 277 Stated Value 277 Cumulative and Non-Cumulative Dividends 278 Is Preferred Stock Really Debt? 278 Preferred Stock and Taxes 279 Beyond Taxes 280 8.4 Stock Market Reporting 281 Growth Opportunities 282 Application: The Price–Earnings Ratio 282 Summary and Conclusions 284 Appendix 8A: Corporate Voting 293 PART 4 Capital Budgeting 296 CHAPTER 9 Net Present Value and Other Investment Criteria 296 9.1 Net Present Value 297 The Basic Idea 297 Estimating Net Present Value 298 9.2 The Payback Rule 302 Defining the Rule 302 Analyzing the Payback Period Rule 303 Redeeming Qualities 304 Summary of the Rule 304 The Discounted Payback Rule 305 9.3 The Average Accounting Return 306 Analyzing the Average Accounting Return Method 308 9.4 The Internal Rate of Return 308 Problems with the IRR 313 Redeeming Qualities of the IRR 318 9.5 The Profitability Index 319 9.6 The Practice of Capital Budgeting 320 9.7 Capital Rationing 323 Summary and Conclusions 324 Appendix 9A: The Modified Internal Rate of Return 336 CHAPTER 10 Making Capital Investment Decisions 339 10.1 Project Cash Flows: A!First!Look 340 Relevant Cash Flows 340 The Stand-Alone Principle 340 ross54753_fm_i-xxvi.indd 8 1/17/19 10:50 AM Contents ix 10.2 Incremental Cash Flows 341 Sunk Costs 341 Opportunity Costs 341 Side Effects 342 Net Working Capital 343 Financing Costs 343 Inflation 343 Capital Budgeting and Business Taxes in Canada 344 Other Issues 344 10.3 Pro Forma Financial Statements and Project Cash Flows 344 Getting Started: Pro Forma Financial Statements 344 Project Cash Flows 346 Project Total Cash Flow and Value 347 10.4 More on Project Cash Flow 348 A Closer Look at Net Working Capital 348 Depreciation and Capital Cost Allowance 350 An Example: The Majestic Mulch and Compost Company (MMCC) 350 10.5 Alternative Definitions of!Operating Cash Flow 354 The Bottom-up Approach 355 The Top-down Approach 356 The Tax Shield Approach 356 Conclusion 357 10.6 Applying the Tax Shield Approach to the Majestic Mulch and Compost Company Project 357 Present Value of the Tax Shield on CCA 359 Salvage Value versus UCC 359 10.7 Some Special Cases of Discounted Cash Flow Analysis 361 Evaluating Cost-Cutting Proposals 361 Replacing an Asset 363 Evaluating Equipment with Different Lives 366 Setting the Bid Price 368 Summary and Conclusions 370 Appendix 10A: More on Inflation and Capital Budgeting 388 Appendix 10B: Capital Budgeting with Spreadsheets 389 Appendix 10C: Deriving the Tax Shield on CCA! Formula 391 CHAPTER 11 Project Analysis and Evaluation 393 11.1 Evaluating NPV Estimates 394 The Basic Problem 394 Projected versus Actual Cash Flows 394 Forecasting Risk 395 Sources of Value 395 11.2 Scenario and Other What-If Analyses 396 Getting Started 396 Scenario Analysis 397 Sensitivity Analysis 400 Simulation Analysis 401 11.3 Break-Even Analysis 403 Fixed and Variable Costs 403 Accounting Break-Even 405 Accounting Break-Even: A Closer Look 407 Uses for the Accounting Break-Even 407 11.4 Operating Cash Flow, Sales Volume, and Break-Even 408 Accounting Break-Even and Cash Flow 408 Cash Flow and Financial Break-Even Points 410 11.5 Operating Leverage 413 The Basic Idea 414 Implications of Operating Leverage 414 Measuring Operating Leverage 414 Operating Leverage and Break-Even 416 11.6 Managerial Options 417 Summary and Conclusions 420 PART 5 Risk and Return 431 CHAPTER 12 Lessons from Capital Market History 431 12.1 Returns 432 Dollar Returns 432 Percentage Returns 434 12.2 The Historical Record 436 A First Look 439 A Closer Look 440 12.3 Average Returns: The First Lesson 440 Calculating Average Returns 441 Average Returns: The Historical Record 441 Risk Premiums 442 The First Lesson 442 ross54753_fm_i-xxvi.indd 9 1/17/19 10:50 AM Contents x 12.4 The Variability of Returns: The Second Lesson 443 Frequency Distributions and Variability 443 The Historical Variance and Standard Deviation 444 The Historical Record 446 Normal Distribution 446 Value at Risk 447 The Second Lesson 449 2008: The Bear Growled and Investors Howled 449 Using Capital Market History 449 12.5 More on Average Returns 451 Arithmetic versus Geometric Averages 451 Calculating Geometric Average Returns 451 Arithmetic Average Return or Geometric Average Return? 453 12.6 Capital Market Efficiency 454 Price Behaviour in an Efficient Market 454 The Efficient Markets Hypothesis 455 Market Efficiency—Forms and Evidence 457 Summary and Conclusions 459 CHAPTER 13 Return, Risk, and the Security Market Line 467 13.1 Expected Returns and Variances 468 Expected Return 468 Calculating the Variance 470 13.2 Portfolios 472 Portfolio Weights 472 Portfolio Expected Returns 473 Portfolio Variance 474 Portfolio Standard Deviation and Diversification 475 The Efficient Set 478 Correlations in the Financial Crisis of 2007–2009 481 13.3 Announcements, Surprises, and Expected Returns 481 Expected and Unexpected Returns 482 Announcements and News 482 13.4 Risk: Systematic and Unsystematic 483 Systematic and Unsystematic Risk 484 Systematic and Unsystematic Components of Return 484 13.5 Diversification and Portfolio Risk 485 The Effect of Diversification: Another Lesson from Market History 485 The Principle of Diversification 486 Diversification and Unsystematic Risk 487 Diversification and Systematic Risk 488 Risk and the Sensible Investor 488 13.6 Systematic Risk and Beta 490 The Systematic Risk Principle 490 Measuring Systematic Risk 490 Portfolio Betas 491 13.7 The Security Market Line 493 Beta and the Risk Premium 493 Calculating Beta 498 The Security Market Line 501 13.8 Arbitrage Pricing Theory and Empirical Models 505 Summary and Conclusions 507 Appendix 13A: Derivation of the Capital Asset Pricing Model 518 PART 6 Cost of Capital and Long-Term Financial Policy 521 CHAPTER!14 Cost of Capital 521 14.1 The Cost of Capital: Some Preliminaries 522 Required Return versus Cost of Capital 522 Financial Policy and Cost of Capital 523 14.2 The Cost of Equity 523 The Dividend Growth Model Approach 523 The SML Approach 526 The Cost of Equity in Rate Hearings 527 14.3 The Costs of Debt and Preferred Stock 529 The Cost of Debt 529 The Cost of Preferred Stock 529 14.4 The Weighted Average Cost of Capital 530 The Capital Structure Weights 531 Taxes and the Weighted Average Cost of Capital 531 Solving the Warehouse Problem and Similar Capital Budgeting Problems 533 Performance Evaluation: Another Use of the WACC 535 14.5 Divisional and Project Costs of Capital 535 The SML and the WACC 536 Divisional Cost of Capital 538 The Pure Play Approach 538 The Subjective Approach 539 ross54753_fm_i-xxvi.indd 10 1/17/19 10:50 AM Contents xi 14.6 Company Valuation with the WACC 540 14.7 Flotation Costs and the Weighted Average Cost of Capital 543 The Basic Approach 543 Flotation Costs and NPV 544 Internal Equity and Flotation Costs 545 14.8 Calculating WACC for Loblaw 547 Estimating Financing Proportions 547 Market Value Weights for Loblaw 547 Cost of Debt 548 Cost of Preferred Shares 549 Cost of Common Stock 550 CAPM 550 Dividend Valuation Model Growth Rate 551 Loblaw’s WACC 551 Summary and Conclusions 552 Appendix 14A: Adjusted Present Value 564 Appendix 14B: Economic Value Added and the Measurement of Financial Performance 570 CHAPTER 15 Raising Capital 575 15.1 The Financing Life Cycle of a Firm: Early-Stage Financing and Venture Capital 576 Venture Capital 576 Some Venture Capital Realities 577 Choosing a Venture Capitalist 577 Conclusion 578 15.2 The Public Issue 578 15.3 The Basic Procedure for a New Issue 579 Securities Registration 580 Exempt Securities and Crowdfunding 580 Alternative Issue Methods 581 15.4 The Cash Offer 582 Types of Underwriting 583 Bought Deal 583 Dutch Auction Underwriting 583 The Selling Period 584 The Overallotment Option 585 Lockup Agreements 585 The Quiet Periods 585 The Investment Dealers 586 15.5 IPOs and Underpricing 587 IPO Underpricing: The 1999–2000 Experience 587 Evidence on Underpricing 587 Why Does Underpricing Exist? 589 15.6 New Equity Sales and the Value of the Firm 592 15.7 The Cost of Issuing Securities 594 IPOs in Practice: The Case of Seven Generations Energy 596 15.8 Rights 597 The Mechanics of a Rights Offering 597 Number of Rights Needed to Purchase a Share 598 The Value of a Right 599 Theoretical Value of a Right 601 Ex Rights 601 Value of Rights after Ex-Rights Date 602 The Underwriting Arrangements 602 Effects on Shareholders 603 Cost of Rights Offerings 604 15.9 Dilution 605 Dilution of Proportionate Ownership 605 Dilution of Value: Book versus Market Values 605 15.10 Issuing Long-Term Debt 607 Summary and Conclusions 609 CHAPTER 16 Financial Leverage and Capital Structure Policy 617 16.1 The Capital Structure Question 618 Firm Value and Stock Value: An Example 618 Capital Structure and the Cost of Capital 620 16.2 The Effect of Financial Leverage 620 The Basics of Financial Leverage 620 Corporate Borrowing and Homemade Leverage 625 16.3 Capital Structure and the Cost of Equity Capital 627 M&M Proposition I: The Pie Model 627 The Cost of Equity and Financial Leverage: M&M Proposition II 628 Business and Financial Risk 629 16.4 M&M Propositions I and II with Corporate Taxes 632 The Interest Tax Shield 633 Taxes and M&M Proposition I 633 Taxes, the WACC, and Proposition II 635 16.5 Bankruptcy Costs 637 Direct Bankruptcy Costs 638 Indirect Bankruptcy Costs 638 Agency Costs of Equity 639 ross54753_fm_i-xxvi.indd 11 1/17/19 10:50 AM Contents xii 16.6 Optimal Capital Structure 640 The Static Theory of Capital Structure 640 Optimal Capital Structure and the Cost of Capital 641 Optimal Capital Structure: A Recap 642 Capital Structure: Some Managerial Recommendations 644 16.7 The Pie Again 645 The Extended Pie Model 645 Marketed Claims versus Non-Marketed Claims 646 16.8 The Pecking-Order Theory 647 Internal Financing and the Pecking Order 647 Implications of the Pecking Order 647 16.9 Observed Capital Structures 648 16.10 Long-Term Financing under Financial Distress and Bankruptcy 650 Liquidation and Reorganization 650 Agreements to Avoid Bankruptcy 652 Summary and Conclusions 653 Appendix 16A: Capital Structure and Personal Taxes 663 Appendix 16B: Derivation of Proposition II (Equation 16.4) 666 CHAPTER 17 Dividends and Dividend Policy 667 17.1 Cash Dividends and Dividend Payment 668 Cash Dividends 669 Standard Method of Cash Dividend Payment 669 Dividend Payment: A Chronology 669 More on the Ex-Dividend Date 670 17.2 Does Dividend Policy Matter? 672 An Illustration of the Irrelevance of Dividend Policy 672 17.3 Real-World Factors Favouring a Low Payout 674 Taxes 675 Some Evidence on Dividends and Taxes in Canada 677 Flotation Costs 677 Dividend Restrictions 678 17.4 Real-World Factors Favouring a High Payout 678 Desire for Current Income 678 Uncertainty Resolution 679 Tax and Legal Benefits from High Dividends 679 Conclusion 680 17.5 A Resolution of Real-World Factors? 680 Information Content of Dividends 680 Dividend Signalling in Practice 681 The Clientele Effect 682 17.6 Establishing a Dividend Policy 683 Residual Dividend Approach 684 Dividend Stability 687 A Compromise Dividend Policy 688 Some Survey Evidence on Dividends 688 17.7 Stock Repurchase: An Alternative to Cash Dividends 690 Cash Dividends versus Repurchase 691 Real-World Considerations in a Repurchase 692 Share Repurchase and EPS 692 17.8 Stock Dividends and Stock Splits 693 Some Details on Stock Splits and Stock Dividends 693 Value of Stock Splits and Stock Dividends 694 Reverse Splits 695 Summary and Conclusions 696 PART 7 Short-Term Financial Planning and Management 705 CHAPTER 18 Short-Term Finance and Planning 705 18.1 Tracing Cash and Net Working Capital 706 18.2 The Operating Cycle and the Cash Cycle 708 Defining the Operating and Cash Cycles 709 Calculating the Operating and Cash Cycles 711 Interpreting the Cash Cycle 714 18.3 Some Aspects of Short-Term Financial Policy 715 The Size of the Firm’s Investment in Current Assets 716 Alternative Financing Policies for Current Assets 717 Which Financing Policy Is Best? 721 Current Assets and Liabilities in Practice 722 18.4 The Cash Budget 724 Sales and Cash Collections 724 Cash Outflows 725 The Cash Balance 726 18.5 A Short-Term Financial Plan 727 Short-Term Planning and Risk 728 ross54753_fm_i-xxvi.indd 12 1/17/19 10:50 AM Contents xiii 18.6 Short-Term Borrowing 729 Operating Loans 729 Letters of Credit 731 Secured Loans 731 Factoring 733 Securitized Receivables—A Financial … FNCE 623: Week 5 Assignment Complete all parts of Question 22 on page 64-65 of your text.. Turn in one file using excel or word.