Table of Contents
I The Basics 1
Chapter 1: Introduction 5
1·1 What is Finance? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
1·2 Money, Currency, and Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
1·3 Financial Institutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
1·3.A. Banks 10
1·3.B. Financial Markets 12
1·4 Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
1·4.A. The Basics of (Federal) Income Taxes 14
1·4.B. Before-Tax vs. After-Tax Expenses 16
1·4.C. Average and Marginal Tax Rates 17
1·4.D. Capital Gains Taxes 17
1·4.E. Other Taxes 18
1·4.F. What You Need To Know About Taxes For This Book 19
1·5 Transaction Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
1·6 Competitive Markets
...or You Get What You Pay For . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
1·7 Preview: Efficient Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
1·8 Random Variables and Expected Values . . . . . . . . . . . . . . . . . . . . . . . . . 26
1·9 Disagreements? Agency? Governance . . . . . . . . . . . . . . . . . . . . . . . . . . 29
1·10 A Convention for Time . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
1·11 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
a Q&A: Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
A Appendix: Historical Money: Photograph and Anecdote . . . . . . . . . . . . . . . 32
Chapter 2: Rates of Returns and Interest Rates 35
2·1 Basic Definitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
2·1.A. Returns, Net Returns, and Rates of Return 36
2·1.B. Loans, Bonds, and Interest Rates 37
2·2 Compounding Rates of Return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
2·3 Quoting Rates of Return Per Annum . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
2·4 Confusion: Interest Quotes vs. Interest Rates . . . . . . . . . . . . . . . . . . . . . . 44
2·5 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
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a Q&A: Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
Chapter 3: Horizon-Dependent Interest Rates 47
3·1 The Yield Curve in May 2002 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48
3·2 Working With Yield Curves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
3·3 Forward Interest Rates (Optional) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53
3·3.A. Extracting Forward Interest Rates From The Yield Curve 53
3·3.B. Speculating on Future Interest Rates 56
3·4 Are 2-year or 30-year Bonds a Better Deal? Interest Rate Changes and Bond Price
Changes. The Risk of Treasury Bonds. . . . . . . . . . . . . . . . . . . . . . . . . . . 60
3·5 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62
A Appendix: Locating Current Interest Rates . . . . . . . . . . . . . . . . . . . . . . . 63
B Nerd Appendix: Continuous Compounding . . . . . . . . . . . . . . . . . . . . . . . 64
a Q&A: Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65
Chapter 4: Frictions in Rates of Returns 67
4·1 Transaction Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68
4·2 Inflation and Real Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69
4·3 Taxable And Tax-Exempt Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71
4·3.A. Both Taxes and Inflation 73
4·4 Credit Risk (Default Risk) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75
4·4.A. Risk-Neutral Investors Demand Higher Promised Rates 75
4·4.B. A More Elaborate Example: Breakeven Interest Rates 76
4·4.C. Short Preview: Risk-Averse Investors Demand Higher Expected Rates 78
4·4.D. Bond Rating Agencies 80
4·4.E. Historical Interest Rates With Different Default Risks 82
4·5 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84
A Appendix: A List of Commonly Quoted Bonds . . . . . . . . . . . . . . . . . . . . . 85
a Q&A: Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88
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II Project Choices / Capital Budgeting 91
Chapter 5: Present Value, Future Value, and Net Present Value (NPV) 95
5·1 Projects, Firms, Families, and Markets . . . . . . . . . . . . . . . . . . . . . . . . . . 96
5·2 The Present Value of Future Cash Flows . . . . . . . . . . . . . . . . . . . . . . . . . 97
5·2.A. Discount Factors and The Present Value (PV) 97
5·2.B. Net Present Value (NPV) 98
5·2.C. The Link Between Cash Flow (Earnings) Growth, Dividend Growth, and Value 101
5·2.D. Valuing Coupon Bonds and The Effects of Yield Curve Changes 103
5·3 The Role of Perfect Capital Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108
5·3.A. Does When You Need Cash Influence Decisions and Value? 108
5·3.B. Different Borrowing and Lending Interest Rates 109
5·4 Perpetuities and Annuities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112
5·4.A. The Perpetuity Formula 112
5·4.B. The Growing Perpetuity Formula 113
5·4.C. A Growing Perpetuity Application: Stock Valuation with the Gordon Dividend
Growth Model 114
5·4.D. The Annuity Formula 115
5·4.E. An Annuity Application: Fixed-Rate Mortgage Payments 116
5·5 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 118
a Q&A: Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120
Chapter 6: Uncertainty and Errors in Capital Budgeting (NPV) 123
6·1 Project Ownership and Payoff Tables . . . . . . . . . . . . . . . . . . . . . . . . . . . 124
6·2 Splitting Project Payoffs into Debt and Equity . . . . . . . . . . . . . . . . . . . . . . 127
6·2.A. The Loan 127
6·2.B. The Levered Equity 129
6·2.C. Reflections On The Example: Debt and Equity Risk 130
6·2.D. More Than Two Possible Outcomes 133
6·3 Robustness: How Bad are Mistakes? . . . . . . . . . . . . . . . . . . . . . . . . . . . . 136
6·3.A. Short-Term Projects 136
6·3.B. Long-Term Projects 137
6·4 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138
a Q&A: Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 139
Chapter 7: Capital Budgeting (NPV) Applications and Advice 141
7·1 Handling Taxes and Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 142
7·1.A. Inflation 142
7·1.B. Taxes 143
7·2 Economics and Project Interactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146
7·2.A. The Ultimate Project Selection Rule 146
7·2.B. Project Pairs — A Classification 146
7·2.C. Zero Project Interactions 147
7·2.D. Positive Project Interactions 148
7·2.E. Negative Project Interactions 149
7·2.F. One More Project: Marginal Rather Than Average Contribution 150
7·2.G. Sunk Costs 151
7·3 Other Errors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 152
7·3.A. Expected, Typical, and Most Likely Scenarios 152
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7·3.B. Future Contingencies and Real Options 153
7·3.C. Human Estimation Biases 154
7·3.D. Incentive (Agency) Biases 156
7·4 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 158
7·5 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 158
a Q&A: Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159
Chapter 8: Other Important Capital Budgeting Topics 161
8·1 The Internal Rate of Return (IRR) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162
8·2 Problems Of IRR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 163
8·2.A. Computation Problems 163
8·2.B. Comparison Problems 164
8·3 So Many Returns: The Internal Rate of Return, the Cost of Capital, the Hurdle
Rate, and the Expected Rate of Return . . . . . . . . . . . . . . . . . . . . . . . . . . 165
8·4 The Bond Context . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 166
8·4.A. Yield-to-Maturity 166
8·4.B. Duration 166
8·5 Other Capital Budgeting Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 169
8·6 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 170
a Q&A: Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171
Chapter 9: Financial Statement Analysis 173
9·1 Financial Statement Basics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174
9·2 The Hypothetical Bottom-Up Example — Long-Term Accruals (Depreciation) . . 176
9·2.A. Doing Accounting 176
9·2.B. Doing Finance 179
9·2.C. Translating Accounting into Finance 181
9·3 The Hypothetical Bottom-Up Example — Short-Term Accruals . . . . . . . . . . . 184
9·3.A. Working Capital 184
9·3.B. Other Sources and Uses of Cash 187
9·3.C. A Semi-Complete Formula To Compute Cash Flows 187
9·4 A Top-Down Example: PepsiCo’s Past Cash Flows . . . . . . . . . . . . . . . . . . . 191
9·5 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 196
A Appendix: Supplementary Financials . . . . . . . . . . . . . . . . . . . . . . . . . . . 197
a. Coca Cola’s Financials From EdgarScan 198
b. Coca Cola’s Financials From Yahoo!Finance 199
c. PepsiCo’s Unabbreviated Balance Sheet 200
d. PepsiCo’s Unabbreviated Cash Flow Statement 201
a Q&A: Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203
Chapter 10: Pro Forma Financial Statements 207
10·1 The Goal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 208
10·2 Pro Forma Terminal Values . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 210
10·2.A. The Economics of Horizon Choice 210
10·2.B. Projecting A Terminal (Market) Value 212
10·3 The Detailed Projection Phase . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 213
10·3.A. The Economics in the Initial Growth Phase 213
10·3.B. Method 1: Direct Extrapolation of Historical Cash Flows 214
10·3.C. Method 2: Pro Forma Projections With Detailed Modeling of Financials 215
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10·4 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225
a Q&A: Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 226
Chapter 11: Valuing From Comparables 227
11·1 The Price-Earnings (PE) Ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 228
11·1.A. Definition 228
11·1.B. The Theoretical Relation between P/E Ratio and Firm Growth 229
11·1.C. PVGO (The Present Value of Growth Opportunities) 230
11·1.D. Empirical Evidence: P/E Ratios and Growth Rates 231
11·1.E. P/E Ratio Application Example: Valuing Beverage Companies 234
11·2 Problems With P/E Ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 236
11·2.A. Selection of Comparison Firms 237
11·2.B. (Non-) Aggregation of Comparables 237
11·2.C. A Major Blunder: Never Average P/E ratios 239
11·2.D. Computing Trailing Twelve Month (TTM) Figures 241
11·2.E. Debt Adjustments? 242
11·3 Other Financial Ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 247
11·4 Closing Thoughts: Comparables or NPV? . . . . . . . . . . . . . . . . . . . . . . . . . 249
11·5 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 249
A Appendix: Other Ratios Used in Corporate Analysis . . . . . . . . . . . . . . . . . . 250
B Nerd Appendix: A Formula For Unlevering P/E ratios . . . . . . . . . . . . . . . . . 251
a Q&A: Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 254
III Investor Choices / Investments 257
Chapter 12: A First Look at Investments 261
12·1 Stocks, Bonds, and Money-Market, 1970–2002 . . . . . . . . . . . . . . . . . . . . . 262
12·1.A. Graphical Representation of Historical Money-Market Returns 262
12·1.B. Comparative Investment Performance 264
12·2 Visible and General Historical Stock Regularities . . . . . . . . . . . . . . . . . . . . 268
12·3 History or Opportunities? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 269
12·4 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 270
Chapter 13: Securities and Portfolios 271
13·1 Market Microstructure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 272
13·1.A. Exchanges and Non-Exchanges 272
13·1.B. Brokers and Prime Brokers 272
13·1.C. How Securities Appear and Disappear 273
13·2 Equities Transaction Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 274
13·2.A. Going Long 274
13·2.B. Going Short: The Academic Fiction 274
13·2.C. Going Short: The Real World 275
13·3 Portfolios and Indexes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 277
xviii TABLE OF CONTENTS
13·3.A. Portfolio Returns 277
13·3.B. Funds and Net Holdings 279
13·3.C. Some Common Indexes 281
13·3.D. Equal and Value Weighted Portfolios 282
13·3.E. Quo Vadis? Random Returns on Portfolios 286
13·4 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 286
a Q&A: Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 287
Chapter 14: Statistics 289
14·1 Historical and Future Rates of Return . . . . . . . . . . . . . . . . . . . . . . . . . . . 290
14·2 The Data: Twelve Annual Rates of Returns . . . . . . . . . . . . . . . . . . . . . . . 291
14·3 Univariate Statistics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 292
14·3.A. The Mean 292
14·3.B. The Variance and Standard Deviation 292
14·4 Bivariate Statistics: Covariation Measures . . . . . . . . . . . . . . . . . . . . . . . . 296
14·4.A. Intuitive Covariation 296
14·4.B. Covariation: Covariance, Correlation, and Beta 296
14·4.C. Computing Covariation Statistics For the Annual Returns Data 303
14·5 Risk and Reward of Portfolios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 305
14·5.A. The Formulas 305
14·5.B. Usage Example 1: The Annual Returns Data 307
14·5.C. Usage Example 2: PepsiCo, CocaCola, and Cadbury 310
14·6 Historical Statistics For Some Asset-Class Index Portfolios . . . . . . . . . . . . . . 313
A Appendix: More Historical Statistics . . . . . . . . . . . . . . . . . . . . . . . . . . . 317
a. Country Fund Rates of Return 318
b. Dow-Jones Constituents 319
B Appendix: Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 320
C Nerd Appendix: More Statistical Theory . . . . . . . . . . . . . . . . . . . . . . . . . 321
a. Historical and Future Statistics 321
b. Improving Future Estimates From Historical Estimates 321
c. The Portfolio Variance Formula 323
d. Translating Mean and Variance Statistics Into Probabilities 324
e. Correlation and Causation 326
a Q&A: Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 327
Chapter 15: The Principle of Diversification 331
15·1 Diversification: The Informal Way . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 332
15·2 Diversification: The Formal Way . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 333
15·2.A. Uncorrelated Securities 333
15·2.B. Correlated Securities 336
15·2.C. Measures of Diversification: Covariance, Correlation, or Beta? 337
15·3 Does Diversification Work in the Real World? . . . . . . . . . . . . . . . . . . . . . . 341
15·3.A. Diversification Among The Dow-Jones 30 Stocks 341
15·3.B. Mutual Funds 343
15·3.C. Alternative Assets 343
15·4 Diversification Over Time . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 345
15·5 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 348
A Nerd Appendix: Investor Preferences Assumed Irrelevant . . . . . . . . . . . . . . 349
a Q&A: Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 350
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Chapter 16: The Optimally Diversified Portfolio 353
16·1 The Mean-Variance Efficient Frontier . . . . . . . . . . . . . . . . . . . . . . . . . . . 354
16·1.A. The Mean-Variance Efficient Frontier With Two Risky Securities 354
16·1.B. The Mean-Variance Efficient Frontier With Many Risky Securities 359
16·2 Real-World MVE Frontier Implementation Problems . . . . . . . . . . . . . . . . . . 364
16·3 Combinations of Portfolios on The MVE Frontier . . . . . . . . . . . . . . . . . . . . 366
16·4 The Mean-Variance Efficient Frontier With A Risk-Free Security . . . . . . . . . . . 369
16·4.A. Risk-Reward Combinations of Any Portfolio Plus the Risk-Free Asset 369
16·4.B. The Best Risk-Reward Combinations With A Risk-Free Asset 372
16·4.C. The Formula to Determine the Tangency Portfolio 374
16·4.D. Combining The Risk-Free Security And the Tangency Portfolio 375
16·5 What does a Security need to offer to be in a MVE Frontier Portfolio? . . . . . . . 376
16·5.A. What if the Risk-Reward Relationship is Non-Linear? 376
16·5.B. What if the Risk-Reward Relationships is Linear? 378
16·5.C. The Line Parameters 380
16·5.D. An Example of Using The Linear Risk-Reward Relationship 382
16·6 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 383
A Nerd Appendix: Proofs For The Supernerd . . . . . . . . . . . . . . . . . . . . . . . 385
a. The Optimal Portfolio Weights Formula 385
b. The Combination of MVE Portfolios is MVE — With Risk-Free Security. 386
c. The Combination of Mean-Variance Efficient Portfolios is Mean-Variance Efficient
— Without Risk-Free Security. 387
d. Proof of the Linear Beta vs. Expected Rate of Return Relationship for MVE Frontier
Portfolios 389
a Q&A: Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 392
Chapter 17: The CAPM: A Cookbook Recipé Approach 395
17·1 Conceptual Basics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 396
17·2 Required Returns: The Informal Way . . . . . . . . . . . . . . . . . . . . . . . . . . . 397
17·3 The CAPM . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 397
17·3.A. The Premise and Formula 397
17·3.B. A Brief Usage Example and the Security Markets Line (SML) 398
17·4 Obtaining CAPM Constant Inputs: The Risk-Free Rate and the Equity Premium . 404
17·5 Obtaining CAPM Inputs: The Investment Project’s Market Beta . . . . . . . . . . . 407
17·5.A. Betas For Publicly Traded Firms 407
17·5.B. Betas From Comparables with Leverage Adjustments: Equity Beta vs. Asset Beta 408
17·5.C. Betas Based on Economic Intuition—And a Common Blunder 411
17·6 Robustness: How Bad are Mistakes? . . . . . . . . . . . . . . . . . . . . . . . . . . . . 414
17·7 The Finer Points of CAPM Application . . . . . . . . . . . . . . . . . . . . . . . . . . 416
17·7.A. Using the CAPM Cost of Capital in Multiperiod Contexts 416
17·7.B. Using the CAPM Cost of Capital in the NPV Context:
Revisiting Risk Premium and Default Premium 417
17·7.C. Does Risk-Reducing Diversification Create Value? 418
17·7.D. Avoiding Cost-of-Capital Mixup Blunders That Destroy Value 419
17·7.E. Valuing Gifts — Certainty Equivalence 422
17·7.F. For Further Capital Budgeting Applications: See Later Chapters. 426
17·8 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 427
a Q&A: Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 428
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Chapter 18: The CAPM: The Theory and CAPM Benchmarking 431
18·1 The Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 432
18·1.A. The Logic and Formula 432
18·1.B. Some Odds and Ends 433
18·2 Does the CAPM Hold? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 435
18·2.A. Listing All the CAPM Assumptions 435
18·2.B. Is the CAPM a good representation of reality? 437
18·2.C. Why not Optimization instead of the CAPM? 440
18·3 Portfolio Benchmarking with the CAPM? . . . . . . . . . . . . . . . . . . . . . . . . . 440
18·4 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 441
A Nerd Appendix: The Arbitrage Pricing Theory (APT) Alternative . . . . . . . . . . 442
a Q&A: Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 448
Chapter 19: Efficient Markets 451
19·1 Arbitrage and Great Bets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 452
19·2 Market Efficiency and Behavioral Finance . . . . . . . . . . . . . . . . . . . . . . . . 453
19·2.A. Basic Definition and Requirements 453
19·2.B. A (New) Classification Of Market Efficiency Beliefs 454
19·3 Consequence I: Random Walks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 457
19·4 Consequence II: Monkeys and Typewriters . . . . . . . . . . . . . . . . . . . . . . . . 461
19·5 Consequence III: Event Studies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 463
19·5.A. An Exogenous Event: The Value Impact of FDA Drug Rejections 463
19·5.B. Endogenous Regular Reports: Earnings Announcement Responses 467
19·5.C. Short Preview: Other Events 467
19·6 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 469
a Q&A: Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 470
IV Financing Choices / Capital Structure 471
Chapter 20: Financial Securities and Investment Banking 475
20·1 The Basic Building Blocks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 476
20·1.A. Bonds 476
20·1.B. Ordinary Equity (Common Stock) 479
20·1.C. Preferred Equity (Stock) 480
20·2 Viewing Securities as State-Contingent Claims . . . . . . . . . . . . . . . . . . . . . 481
20·2.A. Stocks and Bonds 481
20·2.B. Convertible Bonds 483
20·2.C. Call Options, Warrants, and Units 485
20·2.D. Callable Bonds — Or Where Payoff Diagrams and Tables Are Not Useful 489
20·3 The Selling Process For Corporate Securities . . . . . . . . . . . . . . . . . . . . . . 490
20·4 Other Sources of Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 494
20·5 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 494
TABLE OF CONTENTS xxi
a Q&A: Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 495
Chapter 21: Idealized Capital Structure and Capital Budgeting 497
21·1 Conceptual Basics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 498
21·1.A. The Firm, The Charter, and The Capital Structure 498
21·1.B. Maximization of Equity Value or Firm Value? 498
21·2 Modigliani and Miller (M&M), The Informal Way . . . . . . . . . . . . . . . . . . . . 501
21·3 Modigliani and Miller (M&M), The Formal Way In Perfect Markets . . . . . . . . . . 502
21·4 Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 506
21·5 The Weighted Cost of Capital (WACC) in a Perfect M&M World . . . . . . . . . . . 507
21·5.A. The Numerical Example 507
21·5.B. The WACC Formula (Without Taxes) 511
21·5.C. The Big Picture: How to Think of Debt and Equity 512
21·6 A Major Blunder: If all securities are more risky, is the firm more risky? . . . . . 513
21·7 Using the CAPM and WACC Cost of Capital in the NPV Formula . . . . . . . . . . . 514
21·8 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 515
A Nerd Appendix: Compatibility of Beta, the WACC, and the CAPM Formulas in a
Perfect World. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 516
a Q&A: Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 517
Chapter 22: The Corporate Tax Advantage of Debt 519
22·1 Capital Budgeting If Equity and Debt Were Equally Taxed . . . . . . . . . . . . . . 520
22·2 Differential Taxation in The U.S. Tax Code . . . . . . . . . . . . . . . . . . . . . . . . 521
22·3 Firm Value Under Different Capital Structures . . . . . . . . . . . . . . . . . . . . . 522
22·3.A. Future Corporate Income Taxes and Owner Returns 523
22·3.B. The Discount Factor on Tax Obligations and Tax Shelters 524
22·4 Formulaic Valuation Methods: APV and WACC . . . . . . . . . . . . . . . . . . . . . 530
22·4.A. Adjusted Present Value (APV): Theory 530
22·4.B. APV: Application to a 60/40 Debt Financing Case 532
22·4.C. Tax-Adjusted Weighted Average Cost of Capital (WACC) Valuation: Theory 532
22·4.D. A Major Blunder: Applying APV and WACC to the Current Cash Flows 535
22·5 A Sample Application of Tax-Adjusting Valuation Techniques . . . . . . . . . . . 537
22·5.A. Direct Valuations from Pro-Forma Financials 538
22·5.B. APV 538
22·5.C. WACC 540
22·5.D. Some Concluding Thoughts 541
22·6 The Tax Subsidy on PepsiCo’s Financial Statement . . . . . . . . . . . . . . . . . . . 543
22·7 Odds and Ends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 544
22·7.A. When to use APV? When to use WACC? 544
22·7.B. A Heuristic Tax-Savings Rule 545
22·7.C. Getting Expected Rates of Return, the CAPM, and Taxes 545
22·7.D. Can Investment and Financing Decisions Be Separate? 546
A Nerd Appendix: Inflation and Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . 548
a Q&A: Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 549
b Q&A: Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 553
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Chapter 23: Personal Income Tax Considerations 555
23·1 The Basics of Personal Income Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . 556
23·1.A. The Tax Code For Security Owners 556
23·1.B. The Principle is “Joint Tax Avoidance” 556
23·1.C. Tax Clienteles 558
23·1.D. An Illustration of Clienteles and Joint Tax Burdens 560
23·2 Dividends and Share Repurchases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 562
23·3 Other Capital Structure Related Tax Avoidance Schemes (NOLs, Leases, Dividend
Capture, Units, Transfer Pricing, etc.) . . . . . . . . . . . . . . . . . . . . . . . . . . . 564
23·4 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 567
a Q&A: Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 568
Chapter 24: Non-Tax Capital Structure Considerations 569
24·1 Operating Policy Distortions: Behavior in Bad Times . . . . . . . . . . . . . . . . . 570
24·1.A. Direct and Indirect Bankruptcy Costs 570
24·1.B. Underinvestment 573
24·1.C. Reluctance to Liquidate 574
24·1.D. Strategic Considerations 574
24·2 Operating Policy Distortions: Behavior in Good Times . . . . . . . . . . . . . . . . 576
24·2.A. Free Cash Flow and Agency Concerns 576
24·3 Deliberate Bondholder Expropriation . . . . . . . . . . . . . . . . . . . . . . . . . . . 577
24·3.A. Project Risk Changes 577
24·3.B. Issuance of Bonds of Similar Priority 580
24·4 Inside Information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 581
24·5 Transaction Costs and Behavioral Explanations . . . . . . . . . . . . . . . . . . . . 583
24·6 Interactions: From Here to There . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 584
24·7 Reputation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 585
24·8 Capital Structure Recommendations . . . . . . . . . . . . . . . . . . . . . . . . . . . 585
24·9 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 586
a Q&A: Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 588
Chapter 25: Corporate Governance 589
25·1 Less Fact, More Fiction: In Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 590
25·2 Managerial Temptations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 591
25·2.A. Illegal Temptations 591
25·2.B. Legal Temptations 593
25·2.C. Temptation Control Mechanisms 595
25·3 Equity Protection . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 597
25·3.A. Voting: Shareholder Proposals, Proxy Contests, and Hostile Takeovers 597
25·3.B. Large Shareholders 601
25·3.C. The Corporate Board 603
25·3.D. The Legal Environment 605
25·3.E. Ethics, Publicity, and Reputation 606
25·4 Debt Protection . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 608
25·5 The Effectiveness of Corporate Governance . . . . . . . . . . . . . . . . . . . . . . . 610
25·5.A. An Opinion: What Works, What Doesn’t Work. 610
25·5.B. Quo Vadis? 611
25·6 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 613
TABLE OF CONTENTS xxiii
V Appendices 615
Chapter A: Epilogue 617
A·1 Thoughts on Business and Finance Education . . . . . . . . . . . . . . . . . . . . . . 618
A·1.A. Common Student Misconceptions 618
A·1.B. Common Faculty Misconceptions 619
A·1.C. Business School vs. Practice 620
A·1.D. The Rankings 621
A·2 Finance: As A Discipline . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 622
A·2.A. Art or Science? 622
A·2.B. Will We Ever Fully Understand Finance? 623
A·3 Finance Research . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 624
A·3.A. Accomplishments of Finance 624
A·3.B. Interesting Current Academic Research 624
A·3.C. Getting Involved in Academic Research 624
A·3.D. Finance Degrees 624
A·3.E. Academic Careers in Finance and Economics: A Ph.D.? 625
A·3.F. Top Finance Journals 626
A·4 Bon Voyage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 627
Chapter B: More Resources 629
2·1 An NPV Checklist . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 630
2·2 Prominently Used Data Websites . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 633
2·3 Necessary Algebraic Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 634
2·4 Laws of Probability, Portfolios, and Expectations . . . . . . . . . . . . . . . . . . . . 635
2·4.A. Single Random Variables 635
2·4.B. Portfolios 637
2·5 Cumulative Normal Distribution Table . . . . . . . . . . . . . . . . . . . . . . . . . . 640
a Q&A: Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 641
Chapter C: (Sample Exams) 643
3·1 An Exam for Part I (Basics) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 643
3·2 An Exam for Part II (Valuation and Capital Budgeting) . . . . . . . . . . . . . . . . 644
3·3 An Exam for Part III . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 646
3·4 An Exam for Part IV (Financing) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 648
a Q&A: Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 649
xxiv TABLE OF CONTENTS
Chapter A: Index 653
1·1 Main Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 653
1·2 Internal: Planned Improvements and To-Dos . . . . . . . . . . . . . . . . . . . . . . 655
1·2.A. To Do List 655
1·2.B. Text Analysis 657