THIRD EDITION

CORE PRINCIPLES AND APPLICATIONS OF CORPORATE FINANCE

Stephen A. Ross
Sloan School of Management Massachusetts Institute of Technology

Randolph W.Westerfield
Marshall School of Business University of Southern California

Jeffrey R Jaffe
Wharton School of Business University of Pennsylvania

Bradford D.Jordan
Gatton College of Business and Economics University of Kentucky

McGraw-Hill Irwin

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PART ONE

OVERVIEW

CHAPTER TWO Financial Statements and Cash Flow 35 2.1 The Balance Sheet 54 54

CHAPTER ONE Introduction to Corporate Finance 1.1 What Is Corporate Finance? 35 The Balance Sheet Model of the Firm 36 The Financial Manager 1.2 The Corporate Firm 38 The Sole Proprietorship The Partnership * 38 38 37

Accounting Liquidity 55 Debt versus Equity 56 Value versus Cost 56 2.2 The Income Statement 57

Generally Accepted Accounting Principles 58 Noncash Items 58 Time and Costs 59 2.3 Taxes 59

The Corporation 39 A Corporation by Another Name... 41 1.3 The Importance of Cash Flows 41 44 2.4 2.5 45 2.6

Corporate Tax Rates 60 Average versus Marginal Tax Rates 60 Networking Capital 62

i .:

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r

1.4

The Goal of Financial Management Possible Goals 44 The Goal of Financial Management A More General Goal 46

Financial Cash Flow 62 The Accounting Statement of Cash Flows 65 Cash Flow from Operating Activities 65 Cash Flow from Investing Activities 66 Cash Flow from Financing Activities 67

1.5

The Agency Problem and Control of the Corporation 46 Agency Relationships 47 Management Goals 47

I
1.6

Do Managers Act in the Stockholders' Interests? 48 Stakeholders Regulation 49

Summary and Conclusions

68

Closing Case: Cash Flows at East Coast Yachts 76 CHAPTER THREE

49 Financial Statements Analysis and Financial Models 3.1 53 78 78

The Securities Act of 1933 and the Securities Exchange Act of 1934 50 Summary and Conclusions 51

Financial Statements Analysis Standardizing Statements 79

Closing Case: East Coast Yachts

CONTENTS

Common-Size Balance Sheets

79 80

4.4

Simplifications Perpetuity 137

137

Common-Size Income Statements 3.2 Ratio Analysis 82

Growing Perpetuity 82 Annuity 140

138

Short- Term Solvency or Liquidity Measures Long-Term Solvency Measures 84

Trick 1: A Delayed Annuity 85 Trick 2: Annuity Due 143

142 -^

Asset Management or Turnover Measures Profitability Measures Market Value Measures 3.3 The Du Pont Identity A Closer Look at ROE 91 91 87 88

Trick 3: The Infrequent Annuity

144

Trick 4: Equating Present Value of Two Annuities 144 Growing Annuity 4.5 93 145 147

Loan Types and Loan Amortization Pure Discount Loans 147 Interest-Only Loans 147

Problems with Financial Statement Analysis 3.4 Financial Models 95 95 96

A Simple Financial Planning Model The Percentage of Sales Approach 3.5 External Financing and Growth EFN and Growth 101 Financial Policy and Growth 103 100

Amortized Loans 148 4.6 What Is a Firm Worth? 151 153

Summary and Conclusions

Closing Case: The MBA Decision 165 CHAPTER FIVE Interest Rates and Bond Valuation 167
5.1 Bonds and Bond Valuation Bond Features and Prices 167 168

A Note about Sustainable Growth Rate Calculations 106 3.6 Some Caveats Regarding Financial Planning Models 107 108

Summary and Conclusions

Bond Values and Yields 168 Interest Rate Risk 171 Finding the Yield to Maturity: More Trial and Error 173

Closing Case: Ratios and Financial Planning at East Coast Yachts 115

PART TWO VALUATION AND CAPITAL BUDGETING CHAPTER FOUR Discounted Cash Flow Valuation 118
4.1 4.2 Valuation: The One-Period Case The Multiperiod Case 122 118

5.2

More on Bond Features

175 177

Long-Term Debt: The Basics The Indenture 178 178

Terms of a Bond Security Seniority Repayment 125 5.3 179 179 179

Future Value and Compounding 122 The Power of Compounding: A Digression Present Value and Discounting The Algebraic Formula 130 5.4 4.3 Compounding Periods 131 Distinction between Stated Annual Interest Rate and Effective Annual Rate 133 Compounding over Many Years 135 Continuous Compounding 135 126

The Call Provision

180 180

Protective Covenants Bond Ratings 181

Some Different Types of Bonds Government Bonds Zero Coupon Bonds Floating-Rate Bonds Other Types of Bonds 182 183 184 185

182

CONTENTS

5.5

Bond Markets 185 How Bonds Are Bought and Sold 186 Bond Price Reporting 186 A Note on Bond Price Quotes. 189

Other Rights 218 Dividends 218 Preferred Stock Features 219 Stated Value 219 Cumulative and Noncumulative Dividends 219 Is Preferred Stock Really Debt? 219 6.6 The Stock Markets 220 Dealers and Brokers 220 Organization of the NYSE 220 Members 220 Operations 221 Floor Activity 221 NASDAQ Operations 222 ECNs 223 Stock Market Reporting 223 Summary and Conclusions 226 Closing Case: Stock Valuation at Ragan Engines 231

5.6

Inflation and Interest Rates 189 Real versus Nominal Rates 189 The Fisher Effect 190

5.7

Determinants of Bond Yields 191 The Term Structure of Interest Rates 191 Bond Yields and the Yield Curve: Putting It All Together 193 Conclusion 195

Summary and Conclusions 195 Closing Case: Financing East Coast Yachts' Expansion Plans with a Bond Issue 200 CHAPTER SIX Stock Valuation 6.1

202
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CHAPTER SEVEN

The Present Value of Common Stocks 202 Dividends versus Capital Gains 202 Valuation of Different Types of Stocks 204 Case 1 (Zero Growth) 204 Case 2 (Constant Growth) 204 Case 3 (Differential Growth) 205

Net Present Value and Other Investment Rules

7.1 7.2

233

Why Use Net Present Value? 233 The Payback Period Method 236 Defining the Rule 236 Problems with the Payback Method 237 Problem 1: Timing of Cash Flows within the Payback Period 237 Problem 2: Payments after the Payback Period 237 Problem 3: Arbitrary Standard for Payback Period 238 Managerial Perspective, 238 Summary of Payback 238

6.2

Estimates of Parameters in the Dividend Discount Model 207 Where Does g Come From? 207 Where Does R Come From? 208 A Healthy Sense of Skepticism 210 Total Payout 211

6.3

Growth Opportunities 211 Growth in Earnings and Dividends versus Growth Opportunities 213 The No-Payout Firm 213 7.3 7.4

The Discounted Payback Period Method 239 The Average Accounting Return Method 239 Defining the Rule 239 Step 1: Determining Average Net Income 240 Step 2: Determining Average Investment 241 Step 3: Determining AAR 241 Analyzing the Average Accounting Return Method 241

6.4 6.5

Price-Earnings Ratio 214 Some Features of Common and Preferred Stocks 216 Common Stock Features 216 Shareholder Rights 216 Proxy Voting 217 Classes of Stock 217 7.5 7.6

The Internal Rate of Return 241 Problems with the IRR Approach 244

CONTENTS

Definition of Independent and Mutually Exclusive Projects 244 Two General Problems Affecting Both Independent and Mutually Exclusive Projects 245 Problem 1: Investing or Financing? Problem 2: Multiple Rates of Return NPV Rule 247 247 248 246 246

8.3

Inflation and Capital Budgeting

279

Discounting: Nominal or Real? 280 8.4 -' Alternative Definitions of Operating Cash Flow 282 283 283 283

The Bottom-Up Approach The Top-Down Approach The Tax Shield Approach

Modified IRR

The Guarantee against Multiple IRRs General Rules 248

8.5 249 249 251

Problems Specific to Mutually Exclusive Projects The Scale Problem The Timing Problem

Conclusion 284 Investments of Unequal Lives: The Equivalent Annual Cost Method 284 The General Decision to Replace 286

Summary and Conclusions

288 299

Redeeming Qualities of IRR 253 A Test 253 7.7 The Profitability Index 254 254 254

Closing Cases: Expansion at East Coast Yachts Bethesda Mining Company CHAPTER NINE 299

Calculation of Profitability Index

Application of the Profitability Index 7.8 The Practice of Capital Budgeting 258 256

Risk Analysis, Real Options, and Capital Budgeting 301

9.1 Decision Trees Warning 301

Summary and Conclusions

303

Closing Case: Bullock Gold Mining CHAPTER EIGHT

269

9.2

Sensitivity Analysis, Scenario Analysis, and Break-Even Analysis 303 Sensitivity Analysis and Scenario Analysis 304

Making Capital Investment Decisions

8.1 Incremental Cash Flows 270

270

Revenues Costs 305

304

Cash FlowsNot Accounting Income Sunk Costs 271 Opportunity Costs 271 Side Effects 272

270

Break-Even Analysis Accounting Profit Present Value 9.3 309

307 307

Monte Carlo Simulation

310 310

Allocated Costs 272 8.2 The Baldwin Company: An Example An Analysis of the Project Investments 274 275 274 273

Step 1: Specify the Basic Model

Step 2: Specify a Distribution for Each Variable in the Model 310 Step 3: The Computer Draws One Outcome 312 Step 4: Repeat the Procedure Step 5: Calculate NPV 9.4 Real Options 313 312 312

Income and Taxes Salvage Value Cash Flow 277 276

Net Present Value

277

The Option to Expand 313 The Option to Abandon Timing Options 316 Summary and Conclusions 317 314

Which Set of Books? 277 A Note on Net Working Capital 277 A Note on Depreciation Interest Expense 279 278

Closing Case: Bunyan Lumber, LLC

325

CONTENTS

PART THREE RISK AND RETURN CHAPTER TEN Risk and Return Lessons from Market History 327
10.1 Returns 327 327 329 331 Dollar Returns

11.4

The Efficient Set

363 363 367

The Two-Asset Case

The Efficient Set for Many Securities 11.5 Riskless Borrowing and Lending The Optimal Portfolio 11.6 370 368

Announcements, Surprises, and Expected Returns Expected and Unexpected Returns Announcements and News 373 374 374 372

372

Percentage Returns 10.2 10.3

Holding Period Returns Return Statistics 337

11.7

Risk: Systematic and Unsystematic Systematic and Unsystematic Risk

10.4 Average Stock Returns and Risk-Free Returns 338 10.5 Risk Statistics Variance 340 340 11.8

Systematic and Unsystematic Components of Return 374 Diversification and Portfolio Risk 375

Normal Distribution and Its Implications for Standard Deviation 341 10.6 The U.S. Equity Risk Premium: Historical and International Perspectives 342 10.7 10.8 2008: A Year of Financial Crisis More on Average Returns 346 346 347 11.9 345

The Effect of Diversification: Another Lesson ' from Market History 375 The Principle of Diversification 375 377

Diversification and Unsystematic Risk Diversification and Systematic Risk Market Equilibrium 378

377

Arithmetic versus Geometric Averages Calculating Geometric Average Returns Arithmetic Average Return or Geometric Average Return? 348 Summary and Conclusions 349

Definition of the Market Equilibrium Portfolio Definition of Risk When Investors Hold the Market Portfolio 379 The Formula for Beta A Test 383 11.10 Relationship between Risk and Expected Return (CAPM) 383 Expected Return on Market 383 384 381

378

Closing Case: A Job at East Coast Yachts, Parti 353 CHAPTER ELEVEN Return and Risk: The Capital Asset Pricing Model (CAPM) 355
11.1 11.2 Individual Securities 355 356 Expected Return, Variance, and Covariance Expected Return and Variance Covariance and Correlation 356

Expected Return on Individual Security Summary and Conclusions 386

Closing Case: A Job at East Coast Yachts, Part 2 395 CHAPTER TWELVE Risk, Cost of Capital, and Capital Budgeting 397
12.1 12.2 361 The Cost of Equity Capital 397 398 360 Estimating the Cost of Equity Capital with the CAPM The Risk-Free Rate 401

357 360

11.3 The Return and Risk for Portfolios The Expected Return on a Portfolio

Variance and Standard Deviation of a Portfolio The Variance 361 361

Standard Deviation of a Portfolio The Diversification Effect 362

Market Risk Premium 401 Method 1: Using Historical Data

401

An Extension to Many Assets

363

Method 2: Using the Dividend Discount Model (DDM) 401

CONTENTS

12:3

Estimation of Beta Real-World Betas Stability of Beta

402 403 403 404 406 13.3

Independent Deviations from Rationality Arbitrage 434 434

433

The Different Types of Efficiency 777e Weak Form 434

Using an Industry Beta 12.4 Beta and Covariance

The Semistrong and Strong Forms 435 Some Common Misconceptions about the Efficient Market Hypothesis 436 The Efficacy of Dart Throwing Price Fluctuations 407 13.4 The Evidence 437 The Weak Form 438 The Semistrong Form 439 Event Studies 440 441 437 437 437

Beta and Covariance 406 12.5 Determinants of Beta 407

Cyclicality of Revenues 407 Operating Leverage 407 Financial Leverage and Beta 12.6 Dividend Discount Model

Stockholder Disinterest 409

Comparison of DDM and CAPM 409 Can a Low-Dividend or a No-Dividend Stock Have a High Cost of Capital? 410 12.7 12.8 Cost of Capital for Divisions and Projects Cost of Fixed Income Securities Cost of Debt 412 Cost of Preferred Stock 12.9 413 414 417 412 13.5 411

The Record of Mutual Funds 77je Strong Form 442

The Behavioral Challenge to Market Efficiency 443 Rationality 443

The Weighted Average Cost of Capital

12.10 Estimating Eastman Chemical's Cost of Capital Eastman's Cost of Equity Eastman's Cost of Debt Eastman's WACC 419 417 418

Independent Deviations from Rationality 443 Arbitrage 13.6 13.7 444 444

Empirical Challenges to Market Efficiency Reviewing the Differences Representativeness Conservatism 450 450 450

12.11 Flotation Costs and the Weighted Average Cost of Capital 419 The Basic Approach 419 13.8 Flotation Costs and NPV 420 Internal Equity and Flotation Costs 421 Summary and Conclusions 421

Implications for Corporate Finance

451

/. Accounting Choices, Financial Choices, and Market Efficiency 451 2. The Timing Decision 451 454

Closing Case: The Cost of Capital for Goff Computer, Inc. 428 I PART FOUR CAPITAL STRUCTURE AND DIVIDEND POLICY

3. Speculation and Efficient Markets 4. Information in Market Prices Summary and Conclusions 456 454

CHAPTER THIRTEEN Efficient Capital Markets and Behavioral Challenges 429

13.1 13.2 Can Financing Decisions Create Value? A Description of Efficient Capital Markets Foundations of Market Efficiency Rationality 433 433 429 431

Closing Case: Your 401 (k) Account at East Coast Yachts 462

CHAPTER FOURTEEN Capital Structure: Basic Concepts

14.1

464

The Capital Structure Question and the Pie Theory 464 Maximizing Firm Value versus Maximizing Stockholder Interests 465

14.2

CONTENTS

14.3 Financial Leverage and Firm Value: An Example 467 Leverage and Returns to Shareholders 467

15.6 The Pecking-Order Theory 506

Rules of the Pecking Order 507 Rule #1 Use Internal Financing 507 508

The Choice between Debt and Equity 469 A Key Assumption 471 14.4 Modigliani and Miller: Proposition II (No Taxes) 471 Risk to Equityholders Rises with Leverage 471 Proposition II: Required Return to Equityholders Rises with Leverage 472 MM: An Interpretation 14.5 Taxes 478 The Basic Insight 478 Present Value of the Tax Shield 480 Value of the Levered Firm 480 Expected Return and Leverage under Corporate Taxes 482 The Weighted Average Cost of Capital RWACC and Corporate Taxes 483 Stock Price and Leverage under Corporate Taxes 483 Summary and Conclusions 485
Closing Case: Stephenson Real Estate Recapitalization 492 CHAPTER FIFTEEN Capital Structure: Limits to the Use of Debt 493 15.7

Rule #2 Issue Safe Securities First Implications 508 509

Growth and the Debt-Equity Ratio No Growth Growth 509

509 511 515

477

15.8 15.9

How Firms Establish Capital Structure A Quick Look at the Bankruptcy Process Liquidation and Reorganization Bankruptcy Liquidation 516 517 516

Bankruptcy Reorganization

Financial Management and the Bankruptcy Process 517 Agreements to Avoid Bankruptcy Summary and Conclusions 518 518

Closing Case: McKenzie Corporation's Capital Budgeting 523 CHAPTER SIXTEEN Dividends and Other Payouts 16.1 16.2 Different Types of Dividends 524 524

15.1 Costs of Financial Distress

493

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16.3

Standard Method of Cash Dividend Payment 525 The Benchmark Case: An Illustration of the Irrelevance of Dividend Policy 527 Current Policy: Dividends Set Equal to Cash Flow 527 Alternative Policy: Initial Dividend Is Greater than Cash Flow 528 The Indifference Proposition Homemade Dividends A Test 530 Dividends and Investment Policy 531 528 528

Direct Bankruptcy Costs 494 Indirect Bankruptcy Costs 494 Agency Costs 495 Summary of Selfish Strategies 497 15.2 Can Costs of Debt Be Reduced? 498 Protective Covenants 498 Consolidation of Debt 499 15.3 Integration of Tax Effects and Financial Distress Costs 499 Pie Again 499 15.4 Signaling 502 15.5 Shirking, Perquisites, and Bad Investments: A Note on Agency Cost of Equity 503 Effect of Agency Costs of Equity on Debt-Equity Financing 505 Free Cash Flow 505

16.4

Repurchase of Stock

531

Dividend versus Repurchase: Conceptual Example 532 Dividends versus Repurchases: Real-World Considerations 533 1. Flexibility 533 533

2. Executive Compensation

CONTENTS

3. Offset to Dilution

534 534

17.3

Put Options

563 563

4. Repurchase as Investment 5. Taxes 16.5 534

The Value of a Put Option at Expiration 17.4 534 535 17.6 Combinations of Options Valuing Options 570 567 17.7 17.5 Selling Options Option Quotes 565 566

Personal Taxes, Issuance Costs, and Dividends Firms without Sufficient Cash to Pay a Dividend Firms with Sufficient Cash to Pay a Dividend Summary on Personal Taxes 537

536 Bounding the Value of a Call 570 Lower Bound Upper Bound 570 570

16.6

Real-World Factors Favoring a High-Dividend Policy 537 Desire for Current Income Behavioral Finance 538 Agency Costs 539 Information Content of Dividends and Dividend Signaling 540 537

The Factors Determining Call Option Values 570 Exercise Price Expiration Date Stock Price 571 570 571

16.7 16.8

The Clientele Effect: a Resolution of Real-World Factors? 541 What We Know and Do Not Know about Dividend Policy 542 Dividends and Dividend Payers 542 17.8 Corporations Smooth Dividends 544 545 Payouts Provide Information to the Market Putting It All Together 545 Some Survey Evidence on Dividends 548

The Key Factor: The Variability of the Underlying Asset 572 The Interest Rate 573

A Quick Discussion of Factors Determining Put Option Values 573 An Option Pricing Formula A Two-State Option Model Determining the Delta 574 575 575 576

Determining the Amount of Borrowing Risk-Neutral Valuation The Black-Scholes Model 549 17.9 576 577 581

16.9

Stock Dividends and Stock Splits

549

Some Details on Stock Splits and Stock Dividends Example of a Small Stock Dividend Example of a Stock Split 550 550 550 549

Stocks and Bonds as Options

The Firm Expressed in Terms of Call Options 582 The Stockholders The Bondholders 582 583

Example of a Large Stock Dividend

Value of Stock Splits and Stock Dividends

1

The Firm Expressed in Terms of Put Options 584 The Stockholders The Bondholders 584 584

The Benchmark Case Popular Trading Range

550 551

Reve'rse Splits 551 Summary and Conclusions 552

A Resolution of the Two Views 584 A Note on Loan Guarantees 586

Closing Case: Electronic Timing, Inc. PART FIVE SPECIAL TOPICS

559

17.10 Options and Corporate Decisions: Some Applications 586 Mergers and Diversification 587 588 590

CHAPTER SEVENTEEN Options and Corporate Finance

17.1 17.2 Options 561 562 562

Options and Capital Budgeting

561

17.11 Investment in Real Projects and Options Summary and Conclusions 592

Call Options

The Value of a Call Option at Expiration

Closing Case: Exotic Cuisines Employee Stock Options 601

CONTENTS

CHAPTER EIGHTEEN Short-Term Finance and Planning 602

18.1 Tracing Cash and Networking Capital 18.2 The Operating Cycle and the Cash Cycle The Operating Cycle The Cash Cycle 605 605 603 604

CHAPTER NINETEEN Raising Capital 635

19.1 The Financing Life Cycle of a Firm: Early-Stage Financing and Venture Capital 636 Venture Capital 636 Some Venture Capital Realities 637 Choosing a Venture Capitalist Conclusion 637 19.2 Selling Securities to the Public: The Basic Procedure 637 640 637

Defining the Operating and Cash Cycles 605

The Operating Cycle and the Firm's Organization Chart 607 Calculating the Operating and Cash Cycles 608 The Operating Cycle The Cash Cycle 609 608

19.3 Alternative Issue Methods 19.4 611 Underwriters 641

Interpreting the Cash Cycle 610 18.3 Some Aspects of Short-Term Financial Policy The Size of the Firm's Investment in Current Assets 611 Alternative Financing Policies for Current Assets An Ideal Case 612 Different Policies for Financing Current Assets Which Financing Policy Is Best? 616 614 612

Choosing an Underwriter Types of Underwriting

641 641 641

Firm Commitment Underwriting Best Efforts Underwriting .,641 Dutch Auction Underwriting The Green Shoe Provision The Aftermarket 643 643 642

642

Lockup Agreements Current Assets and Liabilities in Practice 18.4 The Cash Budget 617 617 19.5 617

The Quiet Period 643 Sales and Cash Collections Cash Outflows 618 The Cash Balance 619 619 19.6 What CFOs Say aboutthe IPO Process 620 620 19.7 CEOs and the Value of the Firm 651 652 650 IPOs and Underpricing 643 644 645

Evidence on Underpricing

IPO Underpricing: The 1999-2000 Experience Why Does Underpricing Exist? 648

18.5 Short-Term Borrowing Unsecured Loans 620

Compensating Balances Letters of Credit Secur-ed Loans 621 621

f Cost of a Compensating Balance

19.8 The Cost of Issuing Securities 19.9 Rights 656

The Mechanics of a Rights Offering 656 621 Subscription Price 657 Number of Rights Needed to Purchase a Share 657 Effect of Rights Offering on Price of Stock 657 622 Effects on Shareholders 659 659 622

Accounts Receivable Financing Inventory Loans

Commercial Paper 622 Trade Credit 622 Understanding Trade Credit Terms Cash Discounts 623 624

The Underwriting Arrangements The Rights Puzzle 660 19.10 Dilution 660

18.6 A Short-Term Financial Plan Summary and Conclusions 625

Closing Case: Keafer Manufacturing Working Capital Management 633

Dilution of Proportionate Ownership

660

CONTENTS

5)

Dilution of Value: Book versus Market Values 660 A Misconception 661 The Correct Arguments 662 19.11 Issuing Long-Term Debt 662 19.12 Shelf Registration 663 Summary and Conclusions 664 Closing Case: East Coast Yachts Goes Public 668

20.7

Political Risk 690

Summary and Conclusions 691 Closing Case: East Coast Yachts Goes International 696 CHAPTER TWENTY-ONE

Mergers and Acquisitions

697

21.1 The Legal Forms of Acquisitions 698 Merger or Consolidation 698

CHAPTER TWENTY

Acquisition of Stock 698

International Corporate Finance

20.1 Terminology 671

670

Acquisition of Assets 699 Acquisition Classifications 699 A Note on Takeovers 700 Alternatives to Merger 700 21.2 Taxes and Acquisitions 701 21.3 Accounting for Acquisitions 701 777e Purchase Method 701 Pooling of Interests 702 More on Goodwill 703 21.4 Gains from Acquisition 703 Synergy 703 Revenue Enhancement 704 Marketing Gains 704 Strategic Benefits 704 Market Power 705 Cost Reductions 705 Economies of Scale 705 Economies of Vertical Integration 706 Complementary Resources 706 Lower Taxes 706 Net Operating Losses 706 Unused Debt Capacity 706 Surplus Funds 706 Reductions in Capital Needs 707 Avoiding Mistakes 707 A Note on Inefficient Management 708 21.5 Some Financial Side Effects of Acquisitions 708 EPS Growth 708 Diversification 709 21.6 The Cost of an Acquisition 710

20.2 Foreign Exchange Markets and Exchange Rates 672 Exchange Rates 673 Exchange Rate Quotations 673 Cross-Rates and Triangle Arbitrage 675 Types of Transactions 676 20.3 Purchasing Power Parity 677 Absolute Purchasing Power Parity 677 Relative Purchasing Power Parity 679 The Basic Idea 679 The Result 679 Currency Appreciation and Depreciation 681 20.4 Interest Rate Parity, Unbiased Forward Rates, and the International Fisher Effect 681 Covered Interest Arbitrage 681 Interest Rate Parity 682 Forward Rates and Future Spot Rates 683
f

Putting It All Together 684 Uncovered Interest Parity 684 The International Fisher Effect 684 I

20.5

International Capital Budgeting 685 Method 1: The Home Currency Approach 686 Method 2: The Foreign Currency Approach 686 Unremitted Cash Flows 687

20.6

Exchange Rate Risk 687 Short-Run Exposure 687 Long-Run Exposure 688 Translation Exposure 689 Managing Exchange Rate Risk 690

S3

CONTENTS

Case I: Cash Acquisition Case ii: stock Acquisition

710 711 711

APPENDIX A Mathematical Tables APPENDIX B Using the HP 10B and Tl BA II Plus Financial 725

Cash versus Common Stock 217 Defensive Tactics 712

The Corporate Charter 712 Repurchase and Standstill Agreements Poison Pills and Share Rights Plans 712

Calculators

734

NAME INDEX 739 COMPANY .NDEX 741 SUBJECT INDEX 743

712

Going Private and Leveraged Buyouts 714 Other Devices and Jargon of Corporate Takeovers 714 21.8 Some Evidence on Acquisitions: Does M&A Pay? 715 21.9 Divestitures and Restructurings 716 Summary and Conclusions 716

Closing Case: The East Coast Yachts-West Coast Sailboats Merger 723

CONTENTS