Fundamentals of corporate finance (8/e): part 1

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Standard Edition FUNDAMENTALS OF CORPORATE FINANCE ros3062x_fm_Standard.indd i 2/9/07 6:01:58 PM The McGraw-Hill/Irwin Series in Finance, Insurance, and Real Estate Stephen A. Ross Franco Modigliani Professor of Finance and Economics Sloan School of Management Massachusetts Institute of Technology Consulting Editor Financial Management Adair Excel Applications for Corporate Finance First Edition Benninga and Sarig Corporate Finance: A Valuation Approach Block and Hirt Foundations of Financial Management Twelfth Edition Brealey, Myers, and Allen Principles of Corporate Finance Eighth Edition Brealey, Myers, and Marcus Fundamentals of Corporate Finance Fifth Edition Brooks FinGame Online 4.0 Bruner Case Studies in Finance: Managing for Corporate Value Creation Fifth Edition Chew The New Corporate Finance: Where Theory Meets Practice Third Edition Chew and Gillan Corporate Governance at the Crossroads: A Book of Readings First Edition DeMello Cases in Finance Second Edition Grinblatt and Titman Financial Markets and Corporate Strategy Second Edition Helfert Techniques of Financial Analysis: A Guide to Value Creation Eleventh Edition Higgins Analysis for Financial Management Eighth Edition Kester, Ruback, and Tufano Case Problems in Finance Twelfth Edition Ross, Westerfield, and Jaffe Corporate Finance Eighth Edition ros3062x_fm_Standard.indd ii Ross, Westerfield, Jaffe, and Jordan Corporate Finance: Core Principles and Applications First Edition Ross, Westerfield, and Jordan Essentials of Corporate Finance Fifth Edition Ross, Westerfield, and Jordan Fundamentals of Corporate Finance Eighth Edition Shefrin Behavioral Corporate Finance: Decisions that Create Value First Edition Saunders and Cornett Financial Institutions Management: A Risk Management Approach Fifth Edition Saunders and Cornett Financial Markets and Institutions: An Introduction to the Risk Management Approach Third Edition International Finance White Financial Analysis with an Electronic Calculator Sixth Edition Eun and Resnick International Financial Management Fourth Edition Kuemmerle Case Studies in International Entrepreneurship: Managing and Financing Ventures in the Global Economy First Edition Investments Real Estate Adair Excel Applications for Investments First Edition Brueggeman and Fisher Real Estate Finance and Investments Thirteenth Edition Corgel, Ling, and Smith Real Estate Perspectives: An Introduction to Real Estate Fourth Edition Ling and Archer Real Estate Principles: A Value Approach Second Edition Bodie, Kane, and Marcus Essentials of Investments Sixth Edition Bodie, Kane, and Marcus Investments Seventh Edition Hirt and Block Fundamentals of Investment Management Eighth Edition Hirschey and Nofsinger Investments: Analysis and Behavior First Edition Jordan and Miller Fundamentals of Investments: Valuation and Management Fourth Edition Financial Institutions and Markets Rose and Hudgins Bank Management and Financial Services Seventh Edition Rose and Marquis Money and Capital Markets: Financial Institutions and Instruments in a Global Marketplace Ninth Edition Financial Planning and Insurance Allen, Melone, Rosenbloom, and Mahoney Pension Planning: Pension, Profit-Sharing, and Other Deferred Compensation Plans Ninth Edition Altfest Personal Financial Planning First Edition Harrington and Niehaus Risk Management and Insurance Second Edition Kapoor, Dlabay, and Hughes Focus on Personal Finance: An active approach to help you develop successful financial skills First Edition Kapoor, Dlabay, and Hughes Personal Finance Eighth Edition 2/9/07 6:01:59 PM Standard Edition Eighth Edition FUNDAMENTALS OF CORPORATE FINANCE Stephen A. Ross Massachusetts Institute of Technology Randolph W. Westerfield University of Southern California Bradford D. Jordan University of Kentucky Boston Burr Ridge, IL Dubuque, IA New York San Francisco St. Louis Bangkok Bogotá Caracas Kuala Lumpur Lisbon London Madrid Mexico City Milan Montreal New Delhi Santiago Seoul Singapore Sydney Taipei Toronto iii ros3062x_fm_Standard.indd iii 2/9/07 6:01:59 PM FUNDAMENTALS OF CORPORATE FINANCE Published by McGraw-Hill/Irwin, a business unit of The McGraw-Hill Companies, Inc., 1221 Avenue of the Americas, New York, NY, 10020. Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of The McGraw-Hill Companies, Inc., including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning. Some ancillaries, including electronic and print components, may not be available to customers outside the United States. This book is printed on acid-free paper. 1 2 3 4 5 6 7 8 9 0 WCK/WCK 0 9 8 7 ISBN MHID ISBN MHID ISBN MHID 978-0-07-353062-8 (standard edition) 0-07-353062-X (standard edition) 978-0-07-328211-4 (alternate edition) 0-07-328211-1 (alternate edition) 978-0-07-328212-1 (annotated instructor’s edition) 0-07-328212-X (annotated instructor’s edition) Editorial director: Brent Gordon Executive editor: Michele Janicek Developmental editor II: Jennifer Rizzi Senior marketing manager: Julie Phifer Senior media producer: Victor Chiu Lead project manager: Christine A. Vaughan Lead production supervisor: Carol A. Bielski Senior designer: Kami Carter Lead media project manager: Cathy L. Tepper Cover design: Kiera Cunningham Pohl Cover image: © Corbis Images Typeface: 10/12 Times Roman Compositor: ICC Macmillan Inc. Printer: Quebecor World Versailles Inc. Library of Congress Cataloging-in-Publication Data Ross, Stephen A. Fundamentals of corporate finance/Stephen A. Ross, Randolph W. Westerfield, Bradford D. Jordan. -- 8th ed., Standard ed. p. cm. -- (The McGraw-Hill/Irwin series in finance, insurance and real estate) Includes index. ISBN-13: 978-0-07-353062-8 (standard edition : alk. paper) ISBN-10: 0-07-353062-X (standard edition : alk. paper) ISBN-13: 978-0-07-328211-4 (alternate edition : alk. paper) ISBN-10: 0-07-328211-1 (alternate edition : alk. paper) [etc.] 1. Corporations--Finance. I. Westerfield, Randolph. II. Jordan, Bradford D. HG4026.R677 2008 658.15--dc22 2007002136 www.mhhe.com Copyright_page_FM.indd iv III. Title. 2/9/07 6:25:23 PM To our families and friends with love and gratitude. S.A.R. R.W.W. B.D.J. v ros3062x_fm_Standard.indd v 2/9/07 6:02:00 PM About the Authors 3 STEPHEN A. ROSS Sloan School of Management, Franco Modigliani Professor of Finance and Economics, Massachusetts Institute of Technology Stephen A. Ross is 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 is recognized for his work in developing the Arbitrage Pricing Theory and his substantial contributions to the discipline through his research in signaling, 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 currently serves as an associate editor of several academic and practitioner journals. He is a trustee of CalTech and Freddie Mac. RANDOLPH W. WESTERFIELD Marshall School of Business, University of Southern California Randolph W. Westerfield is Dean Emeritus of the University of Southern California’s Marshall School of Business and is the Charles B. Thornton Professor of Finance. He 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 several public company boards of directors including Health Management Associates, Inc., and the Nicholas Applegate growth fund. His areas of expertise include corporate financial policy, investment management, and stock market price behavior. 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 behavior of security prices. He is a past president of the Southern Finance Association, and he is coauthor of Fundamentals of Investments: Valuation and Management, 4e, a leading investments text, also published by McGraw-Hill/Irwin. vi ros3062x_fm_Standard.indd vi 2/9/07 6:02:00 PM Preface from the Authors When the three of us decided to write a book, we were united by one strongly held principle: Corporate finance should be developed in terms of a few integrated, powerful ideas. We believed that the subject was all too often presented as a collection of loosely related topics, unified primarily by virtue of being bound together in one book, and we thought there must be a better way. One thing we knew for certain was that we didn’t want to write a “me-too” book. So, with a lot of help, we took a hard look at what was truly important and useful. In doing so, we were led to eliminate topics of dubious relevance, downplay purely theoretical issues, and minimize the use of extensive and elaborate calculations to illustrate points that are either intuitively obvious or of limited practical use. As a result of this process, three basic themes became our central focus in writing Fundamentals of Corporate Finance: AN EMPHASIS ON INTUITION We always try to separate and explain the principles at work on a commonsense, intuitive level before launching into any specifics. The underlying ideas are discussed first in very general terms and then by way of examples that illustrate in more concrete terms how a financial manager might proceed in a given situation. A UNIFIED VALUATION APPROACH We treat net present value (NPV) as the basic concept underlying corporate finance. Many texts stop well short of consistently integrating this important principle. The most basic and important notion, that NPV represents the excess of market value over cost, often is lost in an overly mechanical approach that emphasizes computation at the expense of comprehension. In contrast, every subject we cover is firmly rooted in valuation, and care is taken throughout to explain how particular decisions have valuation effects. A MANAGERIAL FOCUS Students shouldn’t lose sight of the fact that financial management concerns management. We emphasize the role of the financial manager as decision maker, and we stress the need for managerial input and judgment. We consciously avoid “black box” approaches to finance, and, where appropriate, the approximate, pragmatic nature of financial analysis is made explicit, possible pitfalls are described, and limitations are discussed. In retrospect, looking back to our 1991 first edition IPO, we had the same hopes and fears as any entrepreneurs. How would we be received in the market? At the time, we had no idea that just 16 years later, we would be working on an eighth edition. We certainly never dreamed that in those years we would work with friends and colleagues from around the world to create country-specific Australian, Canadian, and South African editions, an International edition, Chinese, French, Polish, Portuguese, Thai, Russian, Korean, and Spanish language editions, and an entirely separate book, Essentials of Corporate Finance, now in its fifth edition. Today, as we prepare to once more enter the market, our goal is to stick with the basic principles that have brought us this far. However, based on an enormous amount of feedback we have received from you and your colleagues, we have made this edition and its package even more flexible than previous editions. We offer flexibility in coverage, by continuing to offer a variety of editions, and flexibility in pedagogy, by providing a wide variety of features in the book to help students to learn about corporate finance. We also provide flexibility in package options by offering the most extensive collection of teaching, learning, and technology aids of any corporate finance text. Whether you use just the textbook, or the book in conjunction with our other products, we believe you will find a combination with this edition that will meet your current as well as your changing needs. Stephen A. Ross Randolph W. Westerfield Bradford D. Jordan vii ros3062x_fm_Standard.indd vii 2/9/07 6:02:03 PM viii PA RT 1 Part Title Goes Here on Verso Page Coverage This book was designed and developed explicitly for a first course in business or corporate finance, for both finance majors and non-majors alike. In terms of background or prerequisites, the book is nearly self-contained, assuming some familiarity with basic algebra and accounting concepts, while still reviewing important accounting principles very early on. The organization of this text has been developed to give instructors the flexibility they need. Just to get an idea of the breadth of coverage in the eighth edition of Fundamentals, the following grid presents, for each chapter, some of the most significant new features as well as a few selected chapter highlights. Of course, in every chapter, opening vignettes, boxed features, in-chapter illustrated examples using real companies, and end-of-chapter material have been thoroughly updated as well. Chapters PART 1 Selected Topics of Interest Overview of Corporate Finance Chapter 1 Introduction to Corporate Finance Chapter 2 Financial Statements, Taxes, and Cash Flow PART 2 Benefits to You New section: Sarbanes–Oxley. Goal of the firm and agency problems. Stresses value creation as the most fundamental aspect of management and describes agency issues that can arise. Ethics, financial management, and executive compensation. Brings in real-world issues concerning conflicts of interest and current controversies surrounding ethical conduct and management pay. Mini-case: Cash Flows and Financial Statements at Sunset Boards, Inc. New case written for this edition reinforces key cash flow concepts in a small-business setting. Cash flow vs. earnings. Clearly defines cash flow and spells out the differences between cash flow and earnings. Market values vs. book values. Emphasizes the relevance of market values over book values. Financial Statements and Long-Term Financial Planning Chapter 3 Working with Financial Statements Chapter 4 Long-Term Financial Planning and Growth New ratios: PEG, price-to-sales, and Tobin’s Q. Expanded Du Pont analysis. New section expands the basic Du Pont equation to better explore the interrelationships between operating and financial performance. New material: Du Pont analysis for real companies using data from S&P Market Insight. New analysis shows students how to get and use real-world data, thereby applying key chapter ideas. Ratio and financial statement analysis using smaller firm data. Uses firm data from RMA to show students how to actually get and evaluate financial statements benchmarks. Expanded discussion on sustainable growth calculations. New case written for this edition illustrates the importance of financial planning in a small firm. Mini-case: Planning for Growth at S&S Air. Explanation of alternative formulas for sustainable and internal growth rates. Thorough coverage of sustainable growth as a planning tool. Explanation of growth rate formulas clears up a common misunderstanding about these formulas and the circumstances under which alternative formulas are correct. Provides a vehicle for examining the interrelationships between operations, financing, and growth. viii ros3062x_fm_Standard.indd viii 2/9/07 6:02:03 PM Chapters PART 3 Selected Topics of Interest Benefits to You Valuation of Future Cash Flows Chapter 5 Introduction to Valuation: The Time Value of Money First of two chapters on time value of money. Relatively short chapter introduces just the basic ideas on time value of money to get students started on this traditionally difficult topic. Chapter 6 Discounted Cash Flow Valuation New section: Growing annuities and perpetuities. Second of two chapters on time value of money. New minicase: The MBA Decision. Covers more advanced time value topics with numerous examples, calculator tips, and Excel spreadsheet exhibits. Contains many real-world examples. Chapter 7 Interest Rates and Bond Valuation New section: Inflation and present values. “Clean” vs. “dirty” bond prices and accrued interest. Clears up the pricing of bonds between coupon payment dates and also bond market quoting conventions. NASD’s new TRACE system and transparency in the corporate bond market. Up-to-date discussion of new developments in fixed income with regard to price, volume, and transactions reporting. “Make-whole” call provisions. Up-to-date discussion of a relatively new type of call provision that has become very common. New minicase: Stock Valuation at Ragan, Inc. Minicase: Financing S&S Air’s Expansion Plans with a Bond Issue. New case written for this edition examines the debt issuance process for a small firm. Stock valuation. Thorough coverage of constant and nonconstant growth models. NYSE and NASDAQ Market Operations. Up-to-date description of major stock market operations Chapter 8 Stock Valuation PART 4 Capital Budgeting Chapter 9 Net Present Value and Other Investment Criteria Chapter 10 Making Capital Investment Decisions New section: Modified internal rate of return (MIRR). New minicase: Bullock Gold Mining. First of three chapters on capital budgeting. Relatively short chapter introduces key ideas on an intuitive level to help students with this traditionally difficult topic. NPV, IRR, payback, discounted payback, and accounting rate of return. Consistent, balanced examination of advantages and disadvantages of various criteria. Projected cash flow. Thorough coverage of project cash flows and the relevant numbers for a project analysis. Emphasizes the equivalence of various formulas, thereby removing common misunderstandings. Considers important applications of chapter tools. Alternative cash flow definitions. Special cases of DCF analysis. Chapter 11 Project Analysis and Evaluation Minicase: Conch Republic Electronics. Sources of value. Scenario and sensitivity “what-if” analyses. Break-even analysis. Case analyzes capital budgeting issues and complexities. Stresses the need to understand the economic basis for value creation in a project. Illustrates how to actually apply and interpret these tools in a project analysis. Covers cash, accounting, and financial break-even levels. ix ros3062x_fm_Standard.indd ix 2/9/07 6:02:05 PM
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