THIRD EDITION

CORE PRINCIPLES AND APPLICATIONSOF CORPORATE FINANCE

Stephen A. RossSloan School of ManagementMassachusetts Institute of Technology

Randolph W.WesterfieldMarshall School of BusinessUniversity of Southern California

Jeffrey R JaffeWharton School of BusinessUniversity of Pennsylvania

Bradford D.JordanGatton College of Business and EconomicsUniversity of Kentucky

McGraw-HillIrwin

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>PART ONE OVERVIEW

I

CHAPTER ONE

Introduction to Corporate Finance 35

1.1 What Is Corporate Finance? 35

The Balance Sheet Model of theFirm 36

The Financial Manager 37

1.2 The Corporate Firm 38

The Sole Proprietorship 38

CHAPTER TWO

Financial Statements and Cash Flow 54

2.1 The Balance Sheet 54

Accounting Liquidity 55

Debt versus Equity 56

Value versus Cost 56

2.2 The Income Statement 57

Generally Accepted AccountingPrinciples 58

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1

1.3

1.4

1.5

The Partnership 38

The Corporation 39

A Corporation by AnotherName... 41

The Importance of Cash Flows 41

The Goal of Financial Management 44

Possible Goals 44

The Goal of Financial Management 45

A More General Goal 46

The Agency Problem and Controlof the Corporation 46

Agency Relationships 47

2.3

2.4

2.5

2.6

Noncash Items 58

Time and Costs 59

Taxes 59

Corporate Tax Rates 60

Average versus Marginal Tax Rates 60

Networking Capital 62

Financial Cash Flow 62

The Accounting Statement of CashFlows 65

Cash Flow from OperatingActivities 65

Cash Flow from InvestingActivities 66

Management Goals 47

Do Managers Act in the Stockholders'Interests? 48

Stakeholders 49

1.6 Regulation 49

The Securities Act of 1933 andthe Securities Exchange Actof 1934 50

Summary and Conclusions 51

Closing Case: East Coast Yachts 53

Cash Flow from Financing Activities 67

Summary and Conclusions 68

Closing Case: Cash Flows at East CoastYachts 76

CHAPTER THREE

Financial Statements Analysis

and Financial Models 78

3.1 Financial Statements Analysis 78

Standardizing Statements 79

CONTENTS

Common-Size Balance Sheets 79

Common-Size Income Statements 80

3.2 Ratio Analysis 82

Short- Term Solvency or Liquidity Measures 82

Long-Term Solvency Measures 84

Asset Management or Turnover Measures 85

Profitability Measures 87

Market Value Measures 88

3.3 The Du Pont Identity 91

A Closer Look at ROE 91

Problems with Financial Statement Analysis 93

3.4 Financial Models 95

A Simple Financial Planning Model 95

The Percentage of Sales Approach 96

3.5 External Financing and Growth 100

EFN and Growth 101

Financial Policy and Growth 103

A Note about Sustainable Growth RateCalculations 106

3.6 Some Caveats Regarding Financial PlanningModels 107

Summary and Conclusions 108

Closing Case: Ratios and Financial Planningat East Coast Yachts 115

PART TWO VALUATION AND CAPITAL BUDGETING

CHAPTER FOURDiscounted Cash Flow Valuation 118

4.1 Valuation: The One-Period Case 118

4.2 The Multiperiod Case 122

Future Value and Compounding 122

The Power of Compounding: A Digression 125

Present Value and Discounting 126

The Algebraic Formula 130

4.3 Compounding Periods 131

Distinction between Stated Annual Interest Rateand Effective Annual Rate 133

Compounding over Many Years 135

Continuous Compounding 135

4.4 Simplifications 137

Perpetuity 137

Growing Perpetuity 138

Annuity 140

Trick 1: A Delayed Annuity 142 -^

Trick 2: Annuity Due 143

Trick 3: The Infrequent Annuity 144

Trick 4: Equating Present Value of TwoAnnuities 144

Growing Annuity 145

4.5 Loan Types and Loan Amortization 147

Pure Discount Loans 147

Interest-Only Loans 147

Amortized Loans 148

4.6 What Is a Firm Worth? 151

Summary and Conclusions 153

Closing Case: The MBA Decision 165

CHAPTER FIVEInterest Rates and Bond Valuation 167

5.1 Bonds and Bond Valuation 167

Bond Features and Prices 168

Bond Values and Yields 168

Interest Rate Risk 171

Finding the Yield to Maturity: More Trial and Error 173

5.2 More on Bond Features 175

Long-Term Debt: The Basics 177

The Indenture 178

Terms of a Bond 178

Security 179

Seniority 179

Repayment 179

The Call Provision 180

Protective Covenants 180

5.3 Bond Ratings 181

5.4 Some Different Types of Bonds 182

Government Bonds 182

Zero Coupon Bonds 183

Floating-Rate Bonds 184

Other Types of Bonds 185

CONTENTS

5.5 Bond Markets 185

How Bonds Are Bought and Sold 186

Bond Price Reporting 186

A Note on Bond Price Quotes. 189

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 AllTogether 193

Conclusion 195

Summary and Conclusions 195

Closing Case: Financing East Coast Yachts' ExpansionPlans with a Bond Issue 200

CHAPTER SIXStock Valuation 202

r6.1 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

6.2 Estimates of Parameters in the Dividend DiscountModel 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 Dividendsversus Growth Opportunities 213

The No-Payout Firm 213

6.4 Price-Earnings Ratio 214

6.5 Some Features of Common and PreferredStocks 216

Common Stock Features 216

Shareholder Rights 216

Proxy Voting 217

Classes of Stock 217

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

CHAPTER SEVENNet Present Value and Other Investment

Rules 233

7.1 Why Use Net Present Value? 233

7.2 The Payback Period Method 236

Defining the Rule 236

Problems with the Payback Method 237Problem 1: Timing of Cash Flows within the PaybackPeriod 237

Problem 2: Payments after the PaybackPeriod 237

Problem 3: Arbitrary Standard for PaybackPeriod 238

Managerial Perspective, 238

Summary of Payback 238

7.3 The Discounted Payback Period Method 239

7.4 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

7.5 The Internal Rate of Return 241

7.6 Problems with the IRR Approach 244

CONTENTS

Definition of Independent and Mutually ExclusiveProjects 244

Two General Problems Affecting Both Independentand Mutually Exclusive Projects 245

Problem 1: Investing or Financing? 246

Problem 2: Multiple Rates of Return 246

NPV Rule 247

Modified IRR 247

The Guarantee against Multiple IRRs 248

General Rules 248

Problems Specific to Mutually Exclusive Projects 249

The Scale Problem 249

The Timing Problem 251

Redeeming Qualities of IRR 253

A Test 253

7.7 The Profitability Index 254

Calculation of Profitability Index 254

Application of the Profitability Index 254

7.8 The Practice of Capital Budgeting 256

Summary and Conclusions 258

Closing Case: Bullock Gold Mining 269

CHAPTER EIGHT

Making Capital Investment Decisions 270

8.1 Incremental Cash Flows 270

Cash Flows—Not Accounting Income 270

Sunk Costs 271

Opportunity Costs 271

Side Effects 272

Allocated Costs 272

8.2 The Baldwin Company: An Example 273

An Analysis of the Project 274

Investments 274

Income and Taxes 275

Salvage Value 276

Cash Flow 277

Net Present Value 277

Which Set of Books? 277

A Note on Net Working Capital 277

A Note on Depreciation 278

Interest Expense 279

8.3 Inflation and Capital Budgeting 279

Discounting: Nominal or Real? 280

8.4 -' Alternative Definitions of Operating Cash

Flow 282

The Bottom-Up Approach 283

The Top-Down Approach 283

The Tax Shield Approach 283

Conclusion 284

8.5 Investments of Unequal Lives: The Equivalent AnnualCost Method 284

The General Decision to Replace 286

Summary and Conclusions 288

Closing Cases: Expansion at East Coast Yachts 299

Bethesda Mining Company 299

CHAPTER NINE

Risk Analysis, Real Options, and CapitalBudgeting 301

9.1 Decision Trees 301

Warning 303

9.2 Sensitivity Analysis, Scenario Analysis, andBreak-Even Analysis 303

Sensitivity Analysis and Scenario Analysis 304

Revenues 304

Costs 305

Break-Even Analysis 307

Accounting Profit 307

Present Value 309

9.3 Monte Carlo Simulation 310

Step 1: Specify the Basic Model 310

Step 2: Specify a Distribution for Each Variablein the Model 310

Step 3: The Computer Draws OneOutcome 312

Step 4: Repeat the Procedure 312

Step 5: Calculate NPV 312

9.4 Real Options 313

The Option to Expand 313

The Option to Abandon 314

Timing Options 316

Summary and Conclusions 317

Closing Case: Bunyan Lumber, LLC 325

CONTENTS

PART THREE RISK AND RETURN

CHAPTER TENRisk and Return Lessons from MarketHistory 327

10.1 Returns 327

Dollar Returns 327

Percentage Returns 329

10.2 Holding Period Returns 331

10.3 Return Statistics 337

10.4 Average Stock Returns and Risk-FreeReturns 338

10.5 Risk Statistics 340

Variance 340

Normal Distribution and Its Implicationsfor Standard Deviation 341

10.6 The U.S. Equity Risk Premium: Historical andInternational Perspectives 342

10.7 2008: A Year of Financial Crisis 345

10.8 More on Average Returns 346

Arithmetic versus Geometric Averages 346

Calculating Geometric Average Returns 347

Arithmetic Average Return or GeometricAverage Return? 348

Summary and Conclusions 349

Closing Case: A Job at East Coast Yachts,Parti 353

CHAPTER ELEVENReturn and Risk: The Capital Asset PricingModel (CAPM) 355

11.1 Individual Securities 355

11.2 Expected Return, Variance, and Covariance 356

Expected Return and Variance 356

Covariance and Correlation 357

11.3 The Return and Risk for Portfolios 360

The Expected Return on a Portfolio 360

Variance and Standard Deviation of a Portfolio 361

The Variance 361

Standard Deviation of a Portfolio 361

The Diversification Effect 362

An Extension to Many Assets 363

11.4 The Efficient Set 363

The Two-Asset Case 363

The Efficient Set for Many Securities 367

11.5 Riskless Borrowing and Lending 368

The Optimal Portfolio 370

11.6 Announcements, Surprises, and Expected Returns 372

Expected and Unexpected Returns 372

Announcements and News 373

11.7 Risk: Systematic and Unsystematic 374

Systematic and Unsystematic Risk 374

Systematic and Unsystematic Componentsof Return 374

11.8 Diversification and Portfolio Risk 375

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

The Principle of Diversification 375

Diversification and Unsystematic Risk 377

Diversification and Systematic Risk 377

11.9 Market Equilibrium 378

Definition of the Market Equilibrium Portfolio 378

Definition of Risk When Investors Holdthe Market Portfolio 379

The Formula for Beta 381

A Test 383

11.10 Relationship between Risk and ExpectedReturn (CAPM) 383

Expected Return on Market 383

Expected Return on Individual Security 384

Summary and Conclusions 386

Closing Case: A Job at East Coast Yachts, Part 2 395

CHAPTER TWELVERisk, Cost of Capital, and Capital Budgeting 397

12.1 The Cost of Equity Capital 397

12.2 Estimating the Cost of Equity Capital with the CAPM 398

The Risk-Free Rate 401

Market Risk Premium 401Method 1: Using Historical Data 401

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

CONTENTS

12:3 Estimation of Beta 402

Real-World Betas 403

Stability of Beta 403

Using an Industry Beta 404

12.4 Beta and Covariance 406

Beta and Covariance 406

12.5 Determinants of Beta 407

Cyclicality of Revenues 407

Operating Leverage 407

Financial Leverage and Beta 407

12.6 Dividend Discount Model 409

Comparison of DDM and CAPM 409

Can a Low-Dividend or a No-Dividend StockHave a High Cost of Capital? 410

12.7 Cost of Capital for Divisions and Projects 411

12.8 Cost of Fixed Income Securities 412

Cost of Debt 412

Cost of Preferred Stock 413

12.9 The Weighted Average Cost of Capital 414

12.10 Estimating Eastman Chemical's Cost of Capital 417

Eastman's Cost of Equity 417

Eastman's Cost of Debt 418

Eastman's WACC 419

12.11 Flotation Costs and the Weighted Average Costof Capital 419

The Basic Approach 419

Flotation Costs and NPV 420

Internal Equity and Flotation Costs 421

Summary and Conclusions 421

Closing Case: The Cost of Capital for GoffComputer, Inc. 428

I

PART FOUR CAPITAL STRUCTUREAND DIVIDEND POLICY

CHAPTER THIRTEEN

Efficient Capital Markets and BehavioralChallenges 429

13.1 Can Financing Decisions Create Value? 429

13.2 A Description of Efficient Capital Markets 431

Foundations of Market Efficiency 433

Rationality 433

Independent Deviations from Rationality 433

Arbitrage 434

13.3 The Different Types of Efficiency 434

777e Weak Form 434

The Semistrong and Strong Forms 435

Some Common Misconceptions aboutthe Efficient Market Hypothesis 436

The Efficacy of Dart Throwing 437

Price Fluctuations 437

Stockholder Disinterest 437

13.4 The Evidence 437

The Weak Form 438

The Semistrong Form 439

Event Studies 440

The Record of Mutual Funds 441

77je Strong Form 442

13.5 The Behavioral Challenge to MarketEfficiency 443

Rationality 443

Independent Deviations fromRationality 443

Arbitrage 444

13.6 Empirical Challenges to Market Efficiency 444

13.7 Reviewing the Differences 450

Representativeness 450

Conservatism 450

13.8 Implications for Corporate Finance 451

/. Accounting Choices, Financial Choices,and Market Efficiency 451

2. The Timing Decision 451

3. Speculation and Efficient Markets 454

4. Information in Market Prices 454

Summary and Conclusions 456

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

CHAPTER FOURTEENCapital Structure: Basic Concepts 464

14.1 The Capital Structure Question and the PieTheory 464

14.2 Maximizing Firm Value versus MaximizingStockholder Interests 465

CONTENTS

14.3 Financial Leverage and Firm Value: An Example 467

Leverage and Returns to Shareholders 467

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 EquityholdersRises with Leverage 472

MM: An Interpretation 477

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 CorporateTaxes 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 EstateRecapitalization 492

CHAPTER FIFTEEN

Capital Structure: Limits to the Use of Debt 493

15.1 Costs of Financial Distress 493 .>

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 FinancialDistress Costs 499

Pie Again 499

15.4 Signaling 502

15.5 Shirking, Perquisites, and Bad Investments: A Noteon Agency Cost of Equity 503

Effect of Agency Costs of Equity onDebt-Equity Financing 505

Free Cash Flow 505

15.6 The Pecking-Order Theory 506

Rules of the Pecking Order 507

Rule #1 Use Internal Financing 507

Rule #2 Issue Safe Securities First 508

Implications 508

15.7 Growth and the Debt-Equity Ratio 509

No Growth 509

Growth 509

15.8 How Firms Establish Capital Structure 511

15.9 A Quick Look at the Bankruptcy Process 515

Liquidation and Reorganization 516

Bankruptcy Liquidation 516

Bankruptcy Reorganization 517

Financial Management and the BankruptcyProcess 517

Agreements to Avoid Bankruptcy 518

Summary and Conclusions 518

Closing Case: McKenzie Corporation's CapitalBudgeting 523

CHAPTER SIXTEEN

Dividends and Other Payouts 524

16.1 Different Types of Dividends 524

16.2 Standard Method of Cash DividendPayment 525

16.3 The Benchmark Case: An Illustration of theIrrelevance of Dividend Policy 527

Current Policy: Dividends Set Equal to CashFlow 527

Alternative Policy: Initial Dividend Is Greater than CashFlow 528

The Indifference Proposition 528

Homemade Dividends 528

A Test 530

Dividends and Investment Policy 531

16.4 Repurchase of Stock 531

Dividend versus Repurchase: ConceptualExample 532

Dividends versus Repurchases: Real-WorldConsiderations 533

1. Flexibility 533

2. Executive Compensation 533

CONTENTS

3. Offset to Dilution 534

4. Repurchase as Investment 534

5. Taxes 534

16.5 Personal Taxes, Issuance Costs, and Dividends 534

Firms without Sufficient Cash to Pay a Dividend 535

Firms with Sufficient Cash to Pay a Dividend 536

Summary on Personal Taxes 537

16.6 Real-World Factors Favoring a High-DividendPolicy 537

Desire for Current Income 537

Behavioral Finance 538

Agency Costs 539

Information Content of Dividends and DividendSignaling 540

16.7 The Clientele Effect: a Resolution of Real-WorldFactors? 541

16.8 What We Know and Do Not Know about DividendPolicy 542

Dividends and Dividend Payers 542

Corporations Smooth Dividends 544

Payouts Provide Information to the Market 545

Putting It All Together 545

Some Survey Evidence on Dividends 548

16.9 Stock Dividends and Stock Splits 549

Some Details on Stock Splits and Stock Dividends 549

Example of a Small Stock Dividend 549

Example of a Stock Split 550

Example of a Large Stock Dividend 550

Value of Stock Splits and Stock Dividends 550

1 The Benchmark Case 550

Popular Trading Range 551

Reve'rse Splits 551

Summary and Conclusions 552

Closing Case: Electronic Timing, Inc. 559

PART FIVE SPECIAL TOPICS

CHAPTER SEVENTEEN

Options and Corporate Finance 561

17.1 Options 561

17.2 Call Options 562

The Value of a Call Option at Expiration 562

17.3 Put Options 563

The Value of a Put Option at Expiration 563

17.4 Selling Options 565

17.5 Option Quotes 566

17.6 Combinations of Options 567

17.7 Valuing Options 570

Bounding the Value of a Call 570

Lower Bound 570

Upper Bound 570

The Factors Determining Call Option Values 570

Exercise Price 570

Expiration Date 571

Stock Price 571

The Key Factor: The Variability of theUnderlying Asset 572

The Interest Rate 573

A Quick Discussion of Factors DeterminingPut Option Values 573

17.8 An Option Pricing Formula 574

A Two-State Option Model 575

Determining the Delta 575

Determining the Amount of Borrowing 576

Risk-Neutral Valuation 576

The Black-Scholes Model 577

17.9 Stocks and Bonds as Options 581

The Firm Expressed in Terms of Call Options 582

The Stockholders 582

The Bondholders 583

The Firm Expressed in Terms of Put Options 584

The Stockholders 584

The Bondholders 584

A Resolution of the Two Views 584

A Note on Loan Guarantees 586

17.10 Options and Corporate Decisions: SomeApplications 586

Mergers and Diversification 587

Options and Capital Budgeting 588

17.11 Investment in Real Projects and Options 590

Summary and Conclusions 592

Closing Case: Exotic Cuisines Employee StockOptions 601

CONTENTS

CHAPTER EIGHTEENShort-Term Finance and Planning 602

18.1 Tracing Cash and Networking Capital 603

18.2 The Operating Cycle and the Cash Cycle 604

Defining the Operating and Cash Cycles 605

The Operating Cycle 605

The Cash Cycle 605

The Operating Cycle and the Firm's OrganizationChart 607

Calculating the Operating and Cash Cycles 608

The Operating Cycle 608

The Cash Cycle 609

Interpreting the Cash Cycle 610

18.3 Some Aspects of Short-Term Financial Policy 611

The Size of the Firm's Investment in CurrentAssets 611

Alternative Financing Policies for Current Assets 612

An Ideal Case 612

Different Policies for Financing Current Assets 614

Which Financing Policy Is Best? 616

Current Assets and Liabilities in Practice 617

18.4 The Cash Budget 617

Sales and Cash Collections 617

Cash Outflows 618

The Cash Balance 619

18.5 Short-Term Borrowing 619

Unsecured Loans 620

Compensating Balances 620

f Cost of a Compensating Balance 620

Letters of Credit 621

Secur-ed Loans 621

Accounts Receivable Financing 621

Inventory Loans 622

Commercial Paper 622

Trade Credit 622

Understanding Trade Credit Terms 622

Cash Discounts 623

18.6 A Short-Term Financial Plan 624

Summary and Conclusions 625

Closing Case: Keafer Manufacturing Working CapitalManagement 633

CHAPTER NINETEENRaising Capital 635

19.1 The Financing Life Cycle of a Firm: Early-StageFinancing and Venture Capital 636

Venture Capital 636

Some Venture Capital Realities 637

Choosing a Venture Capitalist 637

Conclusion 637

19.2 Selling Securities to the Public: The BasicProcedure 637

19.3 Alternative Issue Methods 640

19.4 Underwriters 641

Choosing an Underwriter 641

Types of Underwriting 641

Firm Commitment Underwriting 641

Best Efforts Underwriting .,641

Dutch Auction Underwriting 642

The Green Shoe Provision 642

The Aftermarket 643

Lockup Agreements 643

The Quiet Period 643

19.5 IPOs and Underpricing 643

Evidence on Underpricing 644

IPO Underpricing: The 1999-2000 Experience 645

Why Does Underpricing Exist? 648

19.6 What CFOs Say aboutthe IPO Process 650

19.7 CEOs and the Value of the Firm 651

19.8 The Cost of Issuing Securities 652

19.9 Rights 656

The Mechanics of a Rights Offering 656

Subscription Price 657

Number of Rights Needed to Purchase aShare 657

Effect of Rights Offering on Price of Stock 657

Effects on Shareholders 659

The Underwriting Arrangements 659

The Rights Puzzle 660

19.10 Dilution 660

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

CHAPTER TWENTYInternational Corporate Finance 670

20.1 Terminology 671

20.2 Foreign Exchange Markets and ExchangeRates 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 theInternational 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 684I

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

20.7 Political Risk 690

Summary and Conclusions 691

Closing Case: East Coast Yachts GoesInternational 696

CHAPTER TWENTY-ONEMergers and Acquisitions 697

21.1 The Legal Forms of Acquisitions 698

Merger or Consolidation 698

Acquisition of Stock 698

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

S 3 CONTENTS

Case I: Cash Acquisition 710 APPENDIX A

Case ii: stock Acquisition 711 Mathematical Tables 725

Cash versus Common Stock 711 APPENDIX B

217 Defensive Tactics 712 Using the HP 10B and Tl BA II Plus FinancialCalculators 734

The Corporate Charter 712

Repurchase and Standstill Agreements 712 NAME INDEX 739

Poison Pills and Share Rights Plans 712 COMPANY .NDEX 741

Going Private and Leveraged Buyouts 714SUBJECT INDEX 743

Other Devices and Jargon of CorporateTakeovers 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 CoastSailboats Merger 723

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