1 Hi? OH T

FinancialMarkets andCorporate

David Hillier,Mark Grinblatt andSheridan Titman

The McGraw-Hill Companies

London Boston Burr Ridge, IL Dubuque, IA Madison, Wl New York San FranciscoSt. Louis Bangkok Bogota Caracas Kuala Lumpur Lisbon Madrid Mexico CityMilan Montreal New Delhi Santiago Seoul Singapore Sydney Taipei Toronto

Detailed Table of Contents

PART I Financial Markets andFinancial Instruments

1 Raising Capital: the Process and thePlayers1.1 Financing the FirmDecisions Facing the FirmWho has the Biggest Capital Markets?

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1.2. Public and Private Sources of Capital 71.3 The Environment for Raising CapitalThe Legal EnvironmentInvestment BanksThe Underwriting ProcessThe Underwriting AgreementClassifying OfferingsThe Costs of Debt and Equity IssuesTypes of Underwriting Arrangements1.4 Raising Capital in InternationalMarketsEuromarketsDirect Issuance1.5 Major Financial Markets outside theUnited StatesGermanyJapan /United KingdomChina1.6 Trends in Raising CapitalGlobalizationDeregulationInnovative InstrumentsTechnologySecuritization1.7 Summary and ConclusionsReferences and Additional Readings

2 Debt Financing2.1 Bank LoansTypes of Bank LoanFloating RatesLoan Covenants2.2 Leases2.3 Commercial PaperWho Sells Commercial Paper?Buyback Provisions2.4 Corporate BondsBond CovenantsBond OptionsCash Flow Pattern

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31323333343436363637384044

Bond Prices: Par, Discount andPremium Bonds 46

Maturity 46Bond Ratings 48The High-Yield Debt Market 492.5 Asset-Backed Securities 512.6 More Exotic Securities 52Tax and Regulatory Frictions asMotivators for Innovation 52Macroeconomic Conditions andFinancial Innovation 52Financial Innovation in EmergingCapital Markets 53The Junk Bond Market and FinancialInnovation f 53A Perspective on the Pace of FinancialInnovation 532.7 Raising Debt Capital in theEuromarkets 54Features of Eurobonds 54Size and Growth of the EurobondMarket and the Forces behind theGrowth 54Eurocurrency Loans 552.8 Primary and Secondary Markets forDebt 56The Primary and Secondary Market forTreasury Securities 56The Primary and Secondary Market forCorporate Bonds 562.9 Bond Prices, Yields to Maturity andBond Market Conventions 57Settlement Dates 59Accrued Interest 59Yields to Maturity and Coupon Yields 622.10 Summary and Conclusions 64References and Additional Readings 67

3 Equity Financing 693.1 Types of Equity Securities 70Common Stock 70Preferred Stock 71Warrants 73Volume of Global Equity Financing 733.2 Shareholder Ownership around theWorld 733.3 The Globalization of EquityMarkets 743.4 Secondary Markets for Equity 75Types of Secondary Market for Equity 75Exchanges 76Electronic Communication Networks(ECNs) 76

VII

viii Chapter Detailed Table of Contents

3.5 Equity Market InformationalEfficiency and Capital Allocation 763.6 Private Equity 773.7 The Decision to Issue SharesPublicly 78Demand- and Supply-Side Explanationsfor IPO Cycles 79The Benefits of Going Public 79The Costs of Going Public 80The Process of Going Public 813.8 Stock Returns Associated with IPOsof Common Equity 83The Underpricing of IPOs 83What are the Long-Term Returns ofIPOs? 833.9 What Explains Underpricing? 84How Do I Get These UnderpricedShares? 84The Incentives of Underwriters 84The Case Where the Managers of theIssuing Firm have Better Informationthan Investors 85The Case Where Some Investors haveBetter Information than Other Investors 85The Case Where Investors haveInformation that the Underwriter DoesNot ' ' 86References and Additional Readings 89

PART I I Valuing Financial Assets

4 Portfolio Tools4.1 Portfolio WeightsThe Two-Stock PortfolioThe Many-Stock Portfolio4.2 Portfolio Returns4.3 Expected Portfolio ReturnsPortfolios of Two StocksPortfolios of Many Stocks

979999101102103103104

4.4 Variances and Standard Deviations 105Return Variances 105Estimating Variances: Statistical Issues 706Standard Deviation 1074.5 Covariances and Correlations 707Covariance 7074.6 Variances of Portfolios andCovariances between Portfolios 7 70Variances for Two-Stock Portfolios 7 70Correlations, Diversification andPortfolio Variances 712Portfolios of Many Stocks 7 75Covariances between Portfolio Returnsand Stock Returns 7 76

4.7 The Mean-Standard DeviationDiagram s 7 76Combining a Risk-Free Asset w i tha Risky Asset in the Mean-StandardDeviation Diagram 7 77

Portfolios of Two Perfectly PositivelyCorrelated or Perfectly NegativelyCorrelated Assets 7 79The Feasible Means and StandardDeviations from Portfolios of OtherPairs of Assets 7204.8 Interpreting the Covariance as aMarginal Variance 72 7A Proof Using Derivatives f romCalculus 727Numerical Interpretations of theMarginal Variance Result 7224.9 Finding the M in imum VariancePortfolio 724Properties of a M in imum VariancePortfolio . 724Identifying the M in imum VariancePortfolio of Two Stocks 725Identifying the M in imum VariancePortfolio of Many Stocks 726

4.10 Summary and Conclusions 727References and Addit ional Readings 133

5 Mean-Variance Analysis and theCapital Asset Pricing Model 1345.1 Applications of Mean-VarianceAnalysis and the CAPM in Use Today 736Investment Applications ofMean-Variance Analysis and theCAPM 136Corporate Applications ofMean-Variance Analysis and the CAPM 7365.2 The Essentials of Mean-VarianceAnalysis 736The Feasible Set 736The Assumptions of Mean-VarianceAnalysis 7375.3 The Efficient Frontier andTwo-Fund Separation 739The Quest for the Holy Grai l : Opt imalPortfolios 139Two-Fund Separation 7395.4 The Tangency Portfolio andOpt imal Investment 74 7Opt imal Investment when a Risk-FreeAsset Exists 74 7Identification of the Tangency Portfolio 1445.5 Finding the Efficient Frontier ofRisky Assets 7465.6 How Useful Is Mean-VarianceAnalysis for Finding Efficient Portfolios? 1475.7 The Relation Between Risk andExpected Return 749Relevant Risk and the TangencyPortfolio 749Betas 750Marginal Variance versus TotalVariance 752

Detailed Table of Contents IX

Tracking Portfolios in PortfolioManagement and as a Theme forValuation 7525.8 The Capital Asset Pricing Model 754Assumptions of the CAPM 754The Conclusion of the CAPM 754The Market Portfolio 755Why the Market Portfolio is theTangency Portfolio 755Implications for Optimal Investment 7565.9 Estimating Betas, Risk-FreeReturns, Risk Premiums and the 757Market Portfolio 757Risk-Free or Zero-Beta Returns 758Beta Estimation and Beta Shrinkage 758Improving the Beta Estimated fromRegression 758Estimating the Market Risk Premium 767Identifying the Market Portfolio 7675.10 Empirical Tests of the CapitalAsset Pricing Model -76 7Can the CAPM Really be Tested? 762Is the Value-Weighted Market IndexMean-Variance Efficient? 763Cross-Sectional Tests of the CAPM 763Time-Series Tests of the CAPM 765Results of the Cross-Sectional andTime-Series Tests: Size, Market-to-Bookand Momentum 766International Evidence 769Interpreting the CAPM's EmpiricalShortcomings 769Are these CAPM Anomalies 'Disappearing? 7705.11 Summary and Conclusions 772References and Additional Readings 777

6 Factor Models and the ArbitragePricing Theory 7806.1 The Market Model: the First FactorModel 782The Market Model Regression 782The Market Model VarianceDecomposition 783Diversifiable Risk and Fallacious CAPMIntuition 784Residual Correlation and FactorModels 7856.2 The Principle of Diversification 785Insurance Analogies to Factor Risk andFirm-Specific Risk 786Quantifying the Diversification ofFirm-Specific Risk 7866.3 Multifactor Models 787The Multifactor Model Equation 787Interpreting Common Factors 7886.4 Estimating the Factors 788

Using Factor Analysis to GenerateFactor Portfolios 789Using Macroeconomic Variables toGenerate Factors 789Using Characteristic-Sorted Portfoliosto Estimate the Factors 7906.5 Factor Betas 797What Determines Factor Betas? 797Factor Models for Portfolios 7976.6 Using Factor Models to ComputeCovariances and Variances 793Computing Covariances in aOne-Factor Model 793Computing Covariances from FactorBetas in a Multifactor Model 794Factor Models and Correlationsbetween Stock Returns 795Applications of Factor Models toMean-Variance Analysis . 795Using Factor Models to ComputeVariances 7956.7 Factor Models and TrackingPortfolios 796Tracking Portfolios and CorporateHedging 797Capital Allocation Decisions ofCorporations and Tracking Portfolios 797Designing Tracking Portfolios 7976.8 Pure Factor Portfolios 799Constructing Pure Factor Portfoliosfrom More Primitive Securities 799The Risk Premiums of Pure FactorPortfolios 2006.9 Tracking and Arbitrage 207Using Pure Factor Portfolios to Trackthe Returns of a Security 202The Expected Return of the TrackingPortfolio 202Decomposing Pure Factor Portfoliosinto Weights on More PrimitiveSecurities 2036.10 No Arbitrage and Pricing: theArbitrage Pricing Theory 203The Assumptions of the ArbitragePricing Theory 204Arbitrage Pricing Theory with NoFirm-Specific Risk 204Graphing the APT Risk-ReturnEquation 205Verifying the Existence of Arbitrage 205The Risk-Expected Return Relation forSecurities with Firm-Specific Risk 208Violations of the APT Equation byLarge Numbers of Stocks ImplyArbitrage 2096.11 Estimating Factor Risk Premiumsand Factor Betas 2 70

Chapter Detailed Table of Contents

6.12 Empirical Tests of the ArbitragePricing Theory 2 70Empirical Implications of the APT 277Evidence from Factor Analysis Studies 2 7 7Evidence from Studies w i thMacroeconomic Factors 27 7Evidence from Studies that Use FirmCharacteristics 2 726.13 Summary and Conclusions 272References and Addit ional Readings 276

7 Pricing Derivatives7.1 Examples of DerivativesForwards and FuturesSwapsOptionsReal AssetsMortgage-Backed SecuritiesStructured Notes

27922 722 7225227231231232

7.2 The Basics of Derivatives Pricing 232Perfect Tracking Portfolios 232No Arbitrage and Valuation 233Apply ing the Basic Principles ofDerivatives Valuation to ValueForwards 2337.3 Binomial Pricing Models 237Tracking and Valuation: Static versusDynamic Strategies 237Binomial Model Tracking of aStructured Bond 238Using Tracking Portfolios to ValueDerivatives , 239Risk-Neutral Valuation of Derivatives:the Industry Approach 2427.4 Mult iper iod Binomial Valuation 248H o w Restrictive is the BinomialProcess in a Mult iper iod Setting? 248Numerical Example of Mult iper iod-

. Binomial Valuation 249Algebraic Representation ofTwo-Period Binomial Valuation 2507.5 Valuation Techniques in theFinancial Services Industry 25 7Numerical Methods 25 7The Risk-Free Rate Used by IndustryPractitioners 2537.6 Market Frictions and Lessons fromthe Fate of Amaranth Advisors 2537.7 Summary and Conclusions 254References and Addit ional Readings 260

8 Options 26 78.1 A Description of Options andOptions Markets 262European and American Options 262The Four Features of Options 2638.2 Opt ion Expiration 2638.3 Put-Call Parity 264

Put-Call Parity and Forward Contracts:Deriving the Formula 264Put-Call Parity and a M in imum Valuefor a Call 267Put-Call Parity and the Pricing andPremature Exercise of American Calls 268Put-Call Parity and CorporateSecurities as Opt ions 277Put-Call Parity and Portfolio Insurance 2738.4 Binomial Valuation of EuropeanOptions 2758.5 Binomial Valuation of AmericanOptions 277American Puts 278Valuing American Options onDividend-Paying Stocks 280

8.6 Black-Scholes Valuation 280Black-Scholes Formula 287Dividends and the Black-Scholes Model 2828.7 Estimating Volat i l i ty 283Using Historical Data 283The Implied Volat i l i ty Approach 2858.8 Black-Scholes Price Sensitivity toStock Price, Volat i l i ty,Interest Rates and Expiration Time 286Delta: the Sensitivity to Stock PriceChanges 286Black-Scholes Opt ion Values andStock Volat i l i ty 287Opt ion Values and Time to Opt ionExpiration 288Option Values and the Risk-FreeInterest Rate 288A Summary of the Effects of theParameter Changes 2888.9 Valuing Opt ions on MoreComplex Assets 289The Forward Price Version of theBlack-Scholes Model 289Computing Forward Prices from SpotPrices 289Applications of the Forward PriceVersion of the Black-Scholes Formula 290American Options 290American Call and Put CurrencyOptions 2928.10 Empirical Biases in the Black-Scholes Formula 2928.11 Summary and Conclusions 294References and Addit ional Readings 297

PART I I I Valuing Real Assets

9 Discounting and Valuation 3059.1 Cash Flows of Real Assets 306Un levered Cash Flows 307Creating Pro-Forma Forecasts ofFinancial Statements 312

Detailed Table of Contents XI

9.2 Using Discount Rates to ObtainPresent Values 3 77Single-Period Returns and theirInterpretation 3 77Rates of Return in a Mult iperiodSetting 3 78Value Addit ivity and Present Values ofCash Flow Streams 320Inflation 32 7Annuities and Perpetuities 322Simple Interest 327Time Horizons and CompoundingFrequencies 3289.3 Summary and Conclusions 33 7References and AdditionalReadings 337

10 Investing in Risk-Free Projects 33810.1 Cash Flows 34010.2 Net Present Value 340Discounted Cash Flow and NetPresent Value 340Project Evaluation with the NetPresent Value Rule 342Present Values and Net Present ValuesHave the Value Additivity Property 344Using'NPVwith Capital Constraints 347Using NPV to Evaluate Projects that CanBe Repeated over Time 34810.3 Economic Value Added {EVA) 34910.4 Using NPV for Other CorporateDecisions , 35 710.5 Evaluating Real Investments wi ththe Internal Rate of Return 352Intuition for the IRR Method 353Numerical Iteration of the IRR 354NPV and Examples of IRR 354Term Structure Issues - 358Cash Flow Sign Patterns and theNumber of Internal Rates of Return 358Sign Reversals and Mult iple InternalRates of Return 362Mutually Exclusive Projects and theInternal Rate of Return 36310.6 Popular but Incorrect Proceduresfor Evaluating Real Investments 365The Payback Method 365The Accounting Rate of ReturnCriterion 36510.7 Summary and Conclusions 366References and Additional Readings 377Appendix 10A The Term Structure OfInterest Rates 37210A.1 Term Structure Varieties 37210A.2 Spot Rates, Annuity Rates andPar Rates 372References and Additional Readingsfor Appendix 10A 378

11 Investing in Risky Projects 37911.1 Tracking Portfolios and RealAsset Valuation 382Asset Pricing Models and the TrackingPortfolio Approach 382Implementing the Tracking PortfolioApproach 384Linking Financial Asset Tracking toReal Asset Valuation with the SML 38411.2 The Risk-Adjusted Discount RateMethod 385Defining and Implementing theRisk-Adjusted Discount Rate Methodwith Given Betas 385The Tracking Portfolio Method isImplicit in the Risk-Adjusted DiscountRate Method 38711.3 The Effect of Leverage onComparisons 387The Balance Sheet for an All-Equity-Financed Firm 388The Balance Sheet for a Firm PartiallyFinanced with Debt 388The Right-Hand Side of the BalanceSheet as a Portfolio 388Distinguishing Risk-Free Debt fromDefault-Free Debt 389Graphs and Numerical Illustrations of

the Effect of Debt on Risk 39011.4 Implementing the Risk-AdjustedDiscount Rate Formula withComparison Firms 397The CAPM, the Comparison Methodand Adjusting for Leverage 392Obtaining a Cost of Capital from theArbitrage Pricing Theory (APT) 393Costs of Capital Computed wi thAlternatives to CAPM and APT:Dividend Discount Models 394What if No Pure Comparison FirmExists? 39711.5 Pitfalls in Using the ComparisonMethod 397Project Betas are Not the Same as FirmBetas 398Growth Opportunities are Usually theSource of High Betas 399Multiperiod Risk-Adjusted Discount Rates 407Empirical Failures of the CAPM and

APT 404What if No Comparable Line ofBusiness Exists? 40511.6 Estimating Beta from Scenarios:the Certainty Equivalent Method 409Defining the Certainty EquivalentMethod 409Identifying the Certainty Equivalentfrom Models of Risk and Return 470

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The CAPM, Scenarios and the CertaintyEquivalent Method 472The APT and the Certainty EquivalentMethod 4 73The Relation between the CertaintyEquivalent Formula and the TrackingPortfolio Approach 47311.7 Obtaining Certainty Equivalentswith Risk-Free Scenarios - 4 74A Description of the Risk-Free ScenarioMethod 4 74Implementing the Risk-Free ScenarioMethod in a Multiperiod Setting 477Providing Certainty Equivalentswithout Knowing it 4 7911.8 Computing Certainty Equivalentsfrom Prices in Financial Markets 4 79Forward Prices 4 79Tracking Portfolios That ContainForward Contracts 4 7911.9 Summary and Conclusions 420References and Additional Readings 424Appendix 11A 425Statistical Issues in Estimating theCost of Capital for the Risk-AdjustedDiscount Rate Method 42511 A.I Estimation Error andDenominator-Based Biases in PresentValue Estimates 42511 A.2 Geometric versus ArithmeticMeans and the Compounding-BasedBias 426References and Additional Readingsfor Appendix 11A 429

12 Allocating Capital and CorporateStrategy 43012.1 Sources of Positive Net PresentValue 431Sources of Competitive Advantage 432'Economies of Scope, Discounted CashFlow and Options 433Option Pricing Theory as a Tool forQuantifying Economies of Scope 43312.2 Valuing Strategic Options withthe Real Options Methodology 434Valuing a Mine with No StrategicOptions 434Valuing a Mine with an AbandonmentOption 437Valuing Vacant Land 440Valuing the Option to Delay the Startof a Manufacturing Project 442Valuing the Option to ExpandCapacity 445Valuing Flexibility in ProductionTechnology: the Advantage of BeingDifferent 446

12.3 The Ratio Comparison Approach 448The Price/Earnings Ratio Method 457When Comparison Investments areHidden in Multibusiness Firms 457The Effect of Earnings Growth andAccounting Methodology on Price/Earnings Ratios 452The Effect of Leverage on Price/EarningsRatios 453Adjusting for Leverage Differences 455

12.4 The Competitive AnalysisApproach 455Determining a Division's Contributionto Firm Value 456Disadvantages of the CompetitiveAnalysis Approach 45612.5 When to Use the DifferentApproaches 456Can these Approaches be Implemented? 457Valuing Asset Classes versus SpecificAssets 457Tracking Error Considerations 457Other Considerations 45712.6 Summary and Conclusions 458References and Additional Readings 463

13 Corporate Taxes and the Impact ofFinancing on Real Asset Valuation 46613.1 Corporate Taxes and theEvaluation of Equity-FinancedCapital Expenditures 468

. The Cost of Capital 468The Risk of the Components ofthe Firm's Balance Sheet withTax-Deductible Debt Interest 469Identifying the Unlevered Cost ofCapital 47713.2 The Adjusted Present ValueMethod 473Three Sources of Value Creation forShareholders 473Debt Capacity 474The APV Method is Versatile andUsable with Many ValuationTechniques 47513.3 The Weighted Average Cost ofCapital 487Valuing a Business with the WACCMethod when a Debt Tax ShieldExists 487WACC Components: the Cost of EquityFinancing 482WACC Components: the Cost of DebtFinancing 482Determining the Costs of Debt andEquity when the Project is Adopted 484The Effect of Leverage on a Firm'sWACC when there are no Taxes 485

Detailed Table of Contents XIII

The Effect of Leverage on a Firm'sWACC with a Debt Interest CorporateTax Deduction 486Evaluating Individual Projects with theWACC Method 49013.4 Discounting Cash Flows to EquityHolders 493Positive NPV Projects Can ReduceShare Prices when Transfers to DebtHolders Occur 493Computing Cash Flows to EquityHolders 494Valuing Cash Flow to Equity Holders 495Real Options versus the Risk-AdjustedDiscount Rate Method 49613.5 Summary and Conclusions 496References and Additional Readings 500

PART IV Capital Structure

14 How Taxes Affect FinancingChoices 50714.1 The Modigliani—MillerTheorem 508Slicing the Cash Flows of the Firm 508Proof of the Modigliani-MillerTheorem 570Assumptions of the Modigliani-MillerTheorem 57 714.2 How an Individual Investor Can'Undo' a Firm's Capital StructureChoice / 5 7314.3 How Risky Debt Affects theModigliani-Miller Theorem 573The Modigliani-Miller Theorem withCostless Bankruptcy 5 73Leverage Increases and WealthTransfers 5 7414.4 How Corporate Taxes Affect theCapital Structure Choice 5 76How Debt Affects After-Tax CashFlows 577How Debt Affects the Value of the Firm 5 7714.5 How Personal Taxes AffectCapital Structure 5 79The Effect of Personal Taxes on Debtand Equity Rates of Return 520Capital Structure Choices whenTaxable Earnings can be Negative 52314.6 Taxes and Preference Shares 52614.7 The Effect of Inflation on the TaxGain from Leverage 52614.8 The Empirical Implications of theAnalysis of Debt and Taxes 527Do Firms with More Taxable EarningsUse More Debt Financing? 52714.9 Are There Tax Advantages toLeasing? 528

Operating Leases and Capital Leases 528The After-Tax Costs of Leasing andBuying Capital Assets . 52914.10 Summary and Conclusions 537References and Additional Readings 535APPENDIX 14A 537How Personal Taxes Affect the CapitalStructure Choice: the Miller Equilibrium 537

15 How Taxes Affect Dividends andShare Repurchases 53915.1 How Much of CorporateEarnings is Distributed toShareholders? 540Aggregate Dividend Payouts 540Dividend Policies of Selected Firms 54 715.2 Distribution Policy in FrictionlessMarkets 542The Miller—Modigliani DividendIrrelevancy Theorem 542Optimal Payout Policy in the Absenceof Taxes and Transaction Costs 54415.3 The Effect of Taxes andTransaction Costs on DistributionPolicy 545A Comparison of the Classical andImputation Tax Systems 546The Tax System in the UnitedKingdom 546Other Tax Systems 547How Taxes Affect Dividend Policy 547Dividend Clienteles 548Why do Corporations Pay Out SoMuch in Taxed Dividends? 54915.4 How Dividend Policy AffectsExpected Stock Returns 550Ex-Dividend Stock Price Movements 550The Cross-Sectional Relation betweenDividend Yields and Stock Returns 55215.5 How Dividend Taxes AffectFinancing and Investment Choices 553Dividends, Taxes and FinancingChoices 553Dividends, Taxes and InvestmentDistortions 55315.6 Personal Taxes, Payout Policyand Capital Structure 55915.7 Summary and Conclusions 560References and Additional Readings 563

16 Bankruptcy Costs and Debt Holder-Equity Holder Conflicts 56616.1 Bankruptcy 568Bankruptcy in the United Kingdom 568Bankruptcy in Other Countries 569The Direct Costs of Bankruptcy 56916.2 Debt Holder-Equity HolderConflicts: an Indirect Bankruptcy Cost 577

xiv Chapter Detailed Table of Contents

Equity Holder Incentives 577The Debt Overhang Problem 572The Shortsighted Investment Problem 576The Asset Substitution Problem 578The Incentives of a Firm to TakeHigher Risks: the Case of Unistar 578How Do Debt Holders Respond toShareholder Incentives? 579The Reluctance to Liquidate Problem 58516.3 How Administration MitigatesDebt Holder-Equity HolderIncentive Problems 58816.4 How Can Firms Minimize DebtHolder-Equity HolderIncentive Problems? 589Protective Covenants 590Bank and Privately Placed Debt ' 592The Use of Short-Term versusLong-Term Debt 593Security Design: the Use ofConvertibles 594The Use of Project Financing 594Management CompensationContracts 59516.5 Empirical Implications forFinancing Choices 596How Investment OpportunitiesInfjuence Financing Choices 596How Financing Choices InfluenceInvestment Choices 596Firm Size and Financing Choices 597Evidence from Bank-Based Economies 59716.6 Summary and Conclusions 598References and Additional Readings 602

1 7 Capital Structure and CorporateStrategy 60617.1 The Stakeholder Theory of 'Capital Structure 608Non-Financial Stakeholders 608How the Costs Imposed onStakeholders Affect the CapitalStructure Choice 609Financial Distress and Reputation 67 7Who Would You Rather Work For? 6 73Summary of the Stakeholder Theory 6 7417.2 The Benefits of Financial Distresswith Committed Stakeholders 6 75Bargaining with Unions 675Bargaining with the Government 67617.3 Capital Structure and CompetitiveStrategy 677Does Debt Make Firms More or LessAggressive Competitors? 6 77Debt and Predation 6 78Empirical Studies of the Relationshipbetween Debt Financing and MarketShare 6 79

17.4 Dynamic Capital StructureConsiderations 627The Pecking Order of FinancingChoices 622An Explanation Based on ManagementIncentives 623An Explanation Based on ManagersHaving More Information thanInvestors 623An Explanation Based on theStakeholder Theory 623An Explanation Based on DebtHolder-Equity Holder Conflicts 623Market Timing Behaviour ofManagers 62517.5 Empirical Evidence on theCapital Structure Choice 625Market Timing Versus Pecking Order 62617.6 Summary and Conclusions 628References and Additional Readings 637

PART V Incentives, Information andCorporate Control

18 How Managerial Incentives AffectFinancial Decisions 63918.1 The Separation of Ownershipand Control 640Whom Do Managers Represent? 641What Factors Influence ManagerialIncentives? 64 7How Management Incentive ProblemsHurt Shareholder Value 642Why Shareholders Cannot ControlManagers 642Changes in Corporate Governance 645Do Corporate Governance ProblemsDiffer Across Countries? 64718.2 Management Shareholdings andMarket Value 647The Effect of ManagementShareholdings on Stock Prices 649Management Shareholdings and FirmValue: The Empirical Evidence 65018.3 How Management ControlDistorts Investment Decisions 65 7The Investment Choices ManagersPrefer 657Outside Shareholders and ManagerialDiscretion 65318.4 Capital Structure and ManagerialControl 654The Relation between ShareholderControl and Leverage 654How Leverage Affects the Level ofInvestment 655A Monitoring Role for Banks 657A Monitoring Role for Private Equity 658

Detailed Table of Contents xv

18.5 Executive Compensation 658The Agency Problem 658Is Executive Pay Closely Tied toPerformance? 660Post-Enron Changes 667How Does Firm Value Relate to theUse of Performance-Based Pay? 662Is Executive Compensation Tied toRelative Performance? 663Stock-Based versus Earnings-BasedPerformance Pay 663Compensation Issues, Mergers andDivestitures 66518.6 Summary and Conclusions 667References and Addit ional Readings 670

19 The Information Conveyed byFinancial Decisions 67419.1 Management Incentives whenManagers have BetterInformation than Shareholders 675Conflicts between Short-Term andLong-Term Share Price Maximization 67619.2 Earnings Manipulation 678Incentives to Manipulate AccountingFigures 67919.3" Shortsighted Investment Choices 679Management's Reluctance toUndertake Long-Term Investments 680What Determines a Manager's

Incentive to be Shortsighted? 68719.4 The Information Content ofDividend and Share RepurchaseAnnouncements 68 7Empirical Evidence on Stock Returnsat the Time of DividendAnnouncements 68 7A Dividend Signalling Mode l ' 682Dividend Policy and InvestmentIncentives 686Dividends Attract Attention 688Dividends across Countries 68919.5 The Information Content of theDebt-Equity Choice 689A Signalling Model Based on the TaxGain/Financial Distress Cost Trade-Off 689Adverse Selection Theory 69719.6 Empirical Evidence 696What is an Event Study? 696Event Study Evidence 697Behavioural Explanations 707How Does the Availabil i ty of CashAffect Investment Expenditures? 70219.7 Summary and Conclusions 703References and Additional Readings 707

20 Mergers and Acquisitions20.1 A History of Mergers andAcquisitions20.2 Types of Mergers andAcquisitionsStrategic AcquisitionsFinancial AcquisitionsConglomerate Acquisitions

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Summary of Mergers and Acquisitions 77720.3 Recent Trends in TakeoverActivity 777The Fall and Rise of HostileTakeovers 77820.4 Sources of Takeover Gains 778Tax Motivations 779Operating Synergies 720Is an Acquisition Required to RealizeTax Gains, Operating Synergies,Incentive Gains or Diversification? 72520.5 The Disadvantages of Mergersand Acquisitions 725Conglomerates Can Misal locateCapital 726Mergers Can Reduce the InformationContained in Stock Prices 726A Summary of the Gains and Costs ofDiversification 72620.6 Empirical Evidence on TakeoverGains for Non-LBO Takeovers 727Stock Returns around the Time ofTakeover Announcements 727Empirical Evidence on the Gains toDiversification 730Accounting Studies 73020.7 Empirical Evidence on the Gainsfrom Leveraged Buyouts (LBOs) 73 7How Leveraged Buyouts Affect StockPrices 732Cash Flow Changes FollowingLeveraged Buyouts 73220.8 Valuing Acquisitions 734Valuing Synergies 734A Guide to the Valuation of Synergies 73520.9 Financing Acquisitions 738Tax Implications of the Financing of aMerger or an Acquisition 739Capital Structure Implications in theFinancing of a Merger or an Acquisition 739Information Effects from the Financingof a Merger or an Acquisition 73920.10 Bidding Strategies in HostileTakeovers 740The Free-Rider Problem 740Solutions to the Free-Rider Problem 74 720.11 Management Defences 744Greenmail 744Staggered Boards and SupermajorityRules 744

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Poison Pills ~ 744Are Takeover Defences Good forShareholders? 74520.12 Summary and Conclusions 746References and Additional Readings 749

PART IV Risk Management

21 Risk Management and CorporateStrategy 75721.1 Risk Management and theModigliani-Miller Theorem 758The Investor's Hedging Choice 758Implications of the Modigliani-Mil lerTheorem for Hedging 759Relaxing the Modigliani-Mil lerAssumptions 75921.2 Why Do Firms Hedge? 760A Simple Analogy 760How Does Hedging Increase ExpectedCash Flows? 76 7How Hedging Reduces Taxes 762Hedging to Avoid Financial DistressCosts 762Hedging to Help Firms Plan for theirCapital Needs 764How Hedging Improves ExecutiveCompensation Contracts andPerformance Evaluation 766How Hedging Improves DecisionMaking 76821.3 The Motivation to Hedge AffectsWhat is Hedged 77721.4 How Should CompaniesOrganize their Hedging Activities? 77721.5 Do Risk ManagementDepartments Always Hedge? 77221.6 How Hedging Affects the Firm'sStakeholders 773How Hedging Affects Debt Holdersand Equity Holders 773How Hedging Affects Employees andCustomers 773Hedging and Managerial Incentives 77321.7 The Motivation to ManageInterest Rate Risk 774Alternative Liability Streams 775How do Corporations Choosebetween Different Liability Streams? 77621.8 Foreign Exchange RiskManagement 778Types of Foreign Exchange Risk 778Why do Exchange Rates Change? 779Why Most Firms do not HedgeEconomic Risk 78221.9 Which Firms Hedge? TheEmpirical Evidence 783Larger Firms are More Likely

than Smaller Firms to UseDerivatives 783Firms with More GrowthOpportunities are More Likely to UseDerivatives 783Highly Levered Firms are More Likelyto Use Derivatives 784Risk Management Practices in theGold Mining Industry 784Risk Management Practices in the Oiland Gas Industry 78421.10 Summary and Conclusions 785References and Additional Readings 788

22 The Practice of Hedging 79022.1 Measuring Risk Exposure 797Using Regression to Estimate the RiskExposure 792Measuring Risk Exposure withSimulations 792Prespecification of Factor Betas fromTheoretical Relations 793Volatility as a Measure of RiskExposure • 793Value at Risk as a Measure of RiskExposure 79422.2 Hedging Short-TermCommitments with Maturity-MatchedForward Contracts 795Review of Forward Contracts 795How Forward-Date Obligations

• Create Risk 796Using Forwards to Eliminate the OilPrice Risk of Forward Obligations 796Using Forward Contracts to HedgeCurrency Obligations 79722.3 Hedging Short-TermCommitments with Maturity-MatchedFutures Contracts 799Review of Futures Contracts, Markingto Market and Futures Prices 799Tailing the Futures Hedge 79922.4 Hedging and ConvenienceYields 807When Convenience Yields do notAffect Hedge Ratios 802How Supply and Demand forConvenience Determine ConvenienceYields 802Hedging the Risk from HoldingSpot Positions in Commodities withConvenience Yields 80322.5 Hedging Long-DatedCommitments with Short-MaturingFutures or Forward Contracts 804Maturity, Risk and Hedging in thePresence of a Constant ConvenienceYield 805

Detailed Table of Contents XVII

Quantitative Estimates of the OilFutures Stack Hedge Error 807Intuition for Hedging with a MaturityMismatch in the Presence of aConstant Convenience Yield 808Convenience Yield Risk Generated byCorrelation between Spot Prices andConvenience Yields 808Basis Risk 870

22.6 Hedging w i th Swaps 87 7

Review of Swaps 8 7 7

Hedging w i th Interest Rate Swaps 87 7

Hedging w i th Currency Swaps 8 73

22.7 Hedging w i th Opt ions 874

W h y Opt ion Hedging is Desirable 8 75

Covered Opt ion Hedging: Caps and

Floors 8 75

Delta Hedging w i th Opt ions 8 78

22.8 Factor-Based Hedging 820

Comput ing Factor Betas for Cash Flow

Combinat ions 820

Comput ing Hedge Ratios 82 7

Direct Hedge Ratio Computat ions:

Solving Systems of Equations 82 7

22.9 Hedging w i th Regression 823

Hedging a Cash Flow w i th a Single

Financial Instrument 823

Hedging with Multiple Regression 82422.10 Minimum Variance Portfoliosand Mean-Variance Analysis 825Hedging to Arrive at the MinimumVariance Portfolio / 825'Hedging.to Arrive at the TangencyPortfolio 82622.11 Summary and Conclusions 828References and Additional Readings 833

23 Interest Rate Risk Management 83423.1 The Value of a One Basis PointDecrease (PVOI) 835Methods Used to Compute PV01 forTraded Bonds 836Using PV01 to Estimate Price Changes 837PVO Is of Various Bond Types andPortfolios 837

Using PVO7s to Hedge Interest RateRisk 838How Compounding Frequency Affectsthe Stated PVO I 83923.2 Duration 840The Duration of Zero-Coupon Bonds 840The Duration of Coupon Bonds 84 7Durations of Discount and Premium-Coupon Bonds 842How Duration Changes as TimeElapses 842Durations of Bond Portfolios 843How Duration Changes as InterestRates increase 84323.3 Linking Duration to PV01 844Duration as a Derivative 844Formulas Relating Duration to PV01 846Hedging with PVO Is or Durations 84723.4 Immunization 848Ordinary Immunization 848Immunization Using PVO 7 85 7Practical Issues to Consider 857Contingent Immunization 852Immunization and Large Changes inInterest Rates 85323.5 Convexity 853Defining and Interpreting Convexity 853Estimating Price Sensitivity to Yield 855Misuse of Convexity 85523.6 Interest Rate Hedging when theTerm Structure is Not Flat 859The Yield-Beta Solution 859The Parallel Term Structure ShiftSolution: Term Structure PVO7 860MacAuley Duration and Present ValueDuration 860Present Value Duration as a Derivative 862

23.7 Summary and Conclusions 863References and Additional Readings 865

Appendix A Mathematical Tables 870Practical Insights for FinancialManagers 880Index 883