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ContentsPART 4 RISK AND RETURNChapter 10 Capital Markets and the Pricingof Risk 35010.1 Risk and Return: Insights from 89 Yearsof Investor History 35110.2 Common Measures of Riskand Return 354Probability Distributions 354Expected Return 354Variance and Standard Deviation 35510.3 Historical Returns of Stocksand Bonds 357Computing Historical Returns 357Average Annual Returns 359The Variance and Volatility ofReturns 361Estimation Error: Using Past Returnsto Predict the Future 362 Arithmetic Average Returns VersusCompound Annual Returns 36410.4 The Historical Trade Off Between Riskand Return 364The Returns of Large Portfolios 365The Returns of Individual Stocks 36610.5 Common Versus independent Risk 367Theft Versus Earthquake Insurance:An Example 367The Role of Diversification 36810.6 Diversification in StockPortfolios 369Firm-Specific Versus Systematic Risk 370No Arbitrage and the RiskPremium 371 GLOBAL FINANCIAL CRISISDiversification Benefits DüringMarket Crashes 373 COMMON MISTAKE A Fallacyof Long-Run Diversification 37410.7 Measuring Systematic Risk 375Identifying Systematic Risk: The MarketPortfolio 375Sensitivity to Systematic Risk: Beta 37510.8 Beta and the Cost of Capital 378Estimating the Risk Premium 378 COMMON MISTAKEBeta Versus Volatility 378The Capital Asset Pricing Model 380MyFinanceLab 380 i Key Terms 382Further Reading 382 i Problems 382Data Case 3879Chapter 11 Optimal Portfolio Choiceand the Capital Asset PricingModel 38911.1 The Expected Return of aPortfolio 39011.2 The Volatility of a Two-StockPortfolio 391Combining Risks 391Determining Covarianceand Correlation 392 COMMON MISTAKEComputing Variance, Covariance,and Correlation in Excel 394Computing a Portfolio's Varianceand Volatility 39511.3 The Volatility of a Large Portfolio 397Large Portfolio Variance 397Diversification with an Equally WeightedPortfolio 398 INTERVIEW with John Powers 400Diversification with GeneralPortfolios 40111.4 Risk Versus Return: Choosingan Efficient Portfolio 401Efficient Portfolios with Two Stocks 402The Effect of Correlation 404Short Sales 405Efficient Portfolios with ManyStocks 406 NOBEL PRIZES Harry Markowitzand James Tobin 40711.5 Risk-Free Saving and Borrowing 409Investing in Risk-Free Securities 409Borrowing and Buying Stockson Margin 410Identifying the Tangent Portfolio 41111.6 The Efficient Portfolio and RequiredReturns 413Portfolio Improvement: Betaand the Required Return 413Expected Returns and the EfficientPortfolio 41511.7 The Capital Asset Pricing Model 417The CAPM Assumptions 417Supply, Demand, and the Efficiencyof the Market Portfolio 418Optimal Investing: The CapitalMarket Line 41811.8 Determining the Risk Premium 419Market Risk and Beta 419 NOBEL PRIZE William Sharpeon the CAPM 421

10ContentsThe Security Market Line 422Beta of a Portfolio 422Summary of the Capital AssetPricing Model 424MyFinanceLab 424 a Key Terms 427 Further Reading 427 Problems 428 Data Case 434Appendix The CAPM with DifferingInterest Rates 436The Efficient Frontier with Differing Savingand Borrowing Rates 436The Security Market Line with DifferingInterest Rates 436Chapter 12 Estimating the Costof Capital 43912.1 The Equity Cost of Capital 44012.2 The Market Portfolio 441Constructing the Market Portfolio 441Market Indexes 441 Value-Weighted Portfolios andRebalancing 442The Market Risk Premium 44312.3 Beta Estimation 445Using Historical Returns 445Identifying the Best-Fitting Line 447Using Linear Regression 448 Why Not Estimate Expected ReturnsDirectly? 44912.4 The Debt Cost of Capital 449Debt Yields Versus Returns 449 COMMON MISTAKE Using the DebtYield as Its Cost of Capital 450Debt Betas 45112.5 A Project's Cost of Capital 452All-Equity Comparables 452Levered Firms as Comparables 453The Unlevered Cost of Capital 453Industry Asset Betas 45512.6 Project Risk Characteristicsand Financing 457Differences in Project Risk 457 COMMON MISTAKE Adjustingfor Execution Risk 459Financing and the Weighted Average Costof Capital 459 INTERVIEW with Shelagh Glaser 460 COMMON MISTAKEUsing a Single Cost of Capitalin Multi-Divisional Firms 46112.7 Final Thoughts on Usingthe CAPM 462MyFinanceLab 463 KeyTerr. r 465Further Reading 465 * Problem 466Data Case 470Appendix Practica! Considerations WhertForecasting Beta 471Time Horizon 471The Market Proxy 471Beta Variation and Extrapolation 71Outliers 472 COMMON MISTAKE Chang i ithe Index to Improve the Fit'3 USING EXCEL Estimating Be(yUsing Excel 474Other Considerations 475Chapter 13 Investor Behavior and CapitalMarket Efficiency 47713.1 Competition and Capital Markets 478Identifying a Stock's Alpha 478Profiting from Non-Zero Alpha Stocks 47913.2 Information and RationalExpectations 480Informed Versus UninformedInvestors 480Rational Expectations 48113.3 The Behavior of IndividualInvestors 482Underdiversification and PortfolioBiases 482Excessive Trading andOverconfidence 483Individual Behavior and MarketPrices 48513.4 Systematic Trading Biases 485Hanging on to Losers and theDisposition Effect 485 NOBEL PRIZE Kahneman andTversky's Prospect Theory 486Investor Attention, Mood,and Experience 486Herd Behavior 487Implications of BehavioralBiases 48713.5 The Efficiency of the MarketPortfolio 488Trading on News orRecommendations 488 NOBEL PRIZE The 2013 Prize:An Enigma? 490

ContentsThe Performance of Fund Managers 490The Winners and Losers 49313.6 Style-Based Techniques and the MarketEfficiency Debate 494Size Effects 494 INTERVIEW withJonathan Clements 496Momentum 498 Market Efficiency and the Efficiencyof the Market Portfolio 499Implications of Positive-Alpha TradingStrategies 49913.7 Multifactor Models of Risk 501Using Factor Portfolios 502Selecting the Portfolios 503The Cost of Capital with Fama-FrenchCarhart Factor Specification 50413.8 Methods Used in Practice 506Financial Managers 506Investors 507MyFinanceLab 508 Key Terms 510 Further Reading 510 Problems 511Appendix Building a Multifactor Model 517PART 5 CAPITAL STRUCTUREChapter 14 Capital Structure in a PerfectMarket 52014.1 Equity Versus Oebt Financing 521Financing a Firm with Equity 521Financing a Firm with Debtand Equity 522The Effect of Leverage on Riskand Return 52314.2 Modigliani-Miller I: Leverage, Arbitrage,and Firm Value 525MM and the Law of One Price 525Homemade Leverage 525 MM and the Real World 526The Market Value Balance Sheet 527Application: A LeveragedRecapitalization 52814.3 Modigliani-Miller II: Leverage, Risk,and the Cost of Capital 530Leverage and the Equity Costof Capital 530Capital Budgeting and the WeightedAverage Cost of Capital 531 COMMON MISTAKEIs Debt Better Than Equity? 53411Computing the WACC with MultipleSecurities 534Levered and Unlevered Betas 534 NOBEL PRIZE Franco Modiglianiand Merton Miller 53614.4 Capital Structure Fallacies 537Leverage and Earnings per Share 537 GLOBAL FINANCIAL CRISISBank Capital Regulation andthe ROE Fallacy 539Equity Issuances and Dilution 54014.5 MM: Beyond the Propositions 541MyFinanceLab 542 Key Terms 543 Further Reading 543 Problems 544 Data Case 548Chapter 15 Debt and Taxes 55115.1 The Interest Tax Deduction 55215.2 Valuing the Interest Tax Shield 554The Interest Tax Shield and FirmValue 554 Pizza and Taxes 555The Interest Tax Shield with PermanentDebt 555The Weighted Average Cost of Capitalwith Taxes 556 The Repatriation Tax: Why SomeCash-Rich Firms Borrow 557The Interest Tax Shield with a TargetDebt-Equity Ratio 55815.3 Recapitalizing to Capture the TaxShield 560The Tax Benefit 560The Share Repurchase 561No Arbitrage Pricing 561Analyzing the Recap: The Market ValueBalance Sheet 56215.4 Personal Taxes 563Including Personal Taxes in the InterestTax Shield 563Valuing the Interest Tax Shieldwith Personal Taxes 566Determining the Actual Tax Advantageof Debt 567 Cutting the Dividend Tax Rate 56715.5 Optimal Capital Structurewith Taxes 568Do Firms Prefer Debt? 568Limits to the Tax Benefit of Debt 571 INTERVIEW withAndrew Balson 572

12ContentsGrowth and Debt 573Other Tax Shields 574The Low Leverage Puzzle 574 Employee Stock Options 576MyFinanceLab 576 Key Terms 577 #Further Reading 577 Problems 578 Data Case 582Chapter 16 Financial Distress,Managerial Incerttives,and Information 58316.1 Default and Bankruptcy in a PerfectMarket 584Armin Industries: Leverage and the Riskof Default 584Bankruptcy and Capital Structure 58516.2 The Costs of Bankruptcy and FinancialDistress 586The Bankruptcy Code 587Direct Costs of Bankruptcy 587Indirect Costs of FinancialDistress 588 GLOBAL FINANCIAL CRISISThe Chrysler Prepack 59116.3 Financial Distress Costs and FirmValue 592Armin Industries: The Impact of FinancialDistress Costs 592Who Pays for Financial DistressCosts? 59216.4 Optimal Capital Structure: TheTrade-Off Theory 594The Present Value of FinancialDistress Costs 594Optimal Leverage 59516.5 Exploiting Debt Holders: The AgencyCosts of Leverage 597Excessive Risk-Taking and AssetSubstitution 597Debt Overhang and Under-Investment 598 GLOBAL FINANCIAL CRISISBailouts, Distress Costs, and DebtOverhang 599Agency Costs and the Valueof Leverage 600The Leverage Ratchet Effect 601Debt Maturity and Covenants 602 Why Do Firms Go Bankrupt? 60216.6 Motivating Managers: The AgencyBenefits of Leverage 603Concentration of Ownership 604Reduction of Wasteful Investment 604 Excessive Perks and CorporateScandals 605 GLOBAL FINANCIAL CRISISMoral Hazard, Government Bailouts,and the Appeal of Leverage 606Leverage and Commitment 60716.7 Agency Costs and the Trade-OffTheory 607The Optimal Debt Level 608Debt Levels in Practice 60916.8 Asymmetrie Information and CapitalStructure 609Leverage as a Credible Signal 609Issuing Equity and AdverseSelection 611 NOBEL PRIZE The 2001 Nobel Prizein Economics 613Implications for Equity Issuance 613Implications for Capital Structure 61416.9 Capital Structure: The BottomLine 617MyFinanceLab 618 Key Terms 620 mFurther Reading 620 Problems 620Chapter 17 Payout Policy62917.1 Distributions to Shareholders 630Dividends 630Share Repurchases 63217.2 Comparison of Dividends and ShareRepurchases 633Alternative Policy 1: Pay Dividendwith Excess Cash 633Alternative Policy 2: Share Repurchase(No Dividend) 634 COMMON MISTAKE Repurchasesand the Supply of Shares 636Alternative Policy 3: High Dividend(Equity Issue) 636Modigliani-Miller and Dividend PolicyIrrelevance 637 COMMON MISTAKE The Birdin the Hand Fallacy 638Dividend Policy with Perfect CapitalMarkets 63817.3 The Tax Disadvantageof Dividends 638Taxes on Dividends and CapitalGains 639Optimal Dividend Policywith Taxes 640

Contents17.4 Dividend Capture and TaxCiienteles 642The Effective Dividend Tax Rate 642Tax Differences Across Investors 643Clientele Effects 644 INTERVIEW with John Connors 64517.5 Payout Versus Retention of Cash 647Retaining Cash with Perfect CapitalMarkets 648Taxes and Cash Retention 649Adjusting for Investor Taxes 650Issuance and Distress Costs 651Agency Costs of Retaining Cash 65217.6 Signaling with Payout Policy 654Dividend Smoothing 654Dividend Signaling 655 Royal & SunAlliance'sDividend Cut 656Signaling and Share Repurchases 65617.7 Stock Dividends, Splits,and Spin-Offs 658Stock Dividends and Splits 658Spin-Offs 660 Berkshire Hathaway'sA&BShares 661MyFinanceLab 662 Key Terms 663 Further Reading 664 Problems 664 Data Case 668PART 6 ADVANCED VALUATIONChapter 18 Capital Budgeting andValvation with Leverage67218.1 Overview of Key Concepts 67318.2 The Weighted Average Costof Capital Method 674 INTERVIEW with Zane Rowe 675Using the WACC to Value a Project 676Summary of the WACC Method 677Implementing a Constant Debt-EquityRatio 67818.3 The Adjusted Present Value Method 680The Unlevered Value of the Project 680Valuing the Interest Tax Shield 681Summary of the APV Method 68218.4 The Flow-to-Equity Method 684Calculating the Free Cash Flowto Equity 68413Valuing Equity Cash Flows 685 What Counts as "Debt"? 686Summary of the Flow-to-EquityMethod 68618.5 Project Based Costsof Capital 687Estimating the Unlevered Costof Capital 688Project Leverage and the Equity Costof Capital 688Determining the Incremental Leverageof a Project 690 COMMON MISTAKERe-Levering the WACC 69018.6 APV with Other Leverage Policies 692Constant Interest Coverage Ratio 692Predetermined Debt Levels 693A Comparison of Methods 69518.7 Other Effects of Financing 695Issuance and Other Financing Costs 695Security Mispricing 696Financial Distress and Agency Costs 697 GLOBAL FINANCIAL CRISISGovernment Loan Guarantees 69818.8 Advanced Topics in CapitalBudgeting 698Periodically Adjusted Debt 699Leverage and the Cost of Capital 701The WACC or FTE Method with ChangingLeverage 703Personal Taxes 704MyFinanceLab 706 Key Terms 708 Further Reading 708 Problems 709 Data Case 715Appendix Foundations and Further Details 717Deriving the WACC Method 717The Levered and UnleveredCost of Capital 718Solving for Leverage and ValueSimultaneously 719The Residual Income and Economic ValueAdded Valuation Methods 721Chapter 19 Valuation and FinancialModeling: A Case Study72319.1 Valuation Using Comparables 72419.2 The Business Plan 726Operational Improvements 726Capital Expenditures: A NeededExpansion 727

14Contents19.319.419.519.6Working Capital Management 728Capital Structure Changes: Levering Up 728Building the Financial Model 729Forecasting Earnings 729 INTERVIEW withJoseph L. Rice, III 730Working Capital Requirements 732Forecasting Free Cash Flow 733 USING EXCELSummarizing Model Outputs 735The Balance Sheet and Statementof Cash Flows (Optional) 736 USING EXCELAuditing Your Financial Model 738Estimating the Cost of Capital 739CAPM-Based Estimation 739Unlevering Beta 740Ideko's Unlevered Cost of Capital 740Valuing the Investment 741The Multiples Approach to ContinuationValue 742The Discounted Cash Flow Approachto Continuation Value 743 COMMON MISTAKE ContinuationValues and Long-Run Growth 745APV Valuation of Ideko's Equity 745A Reality Check 746 COMMON MISTAKEMissing Assets or Liabilities 746IRR and Cash Multiples 747Sensitivity Analysis 748MyFinanceLab 749 a Key Terms 750 Further Reading 750 Problems 751Appendix Compensating Management 753PART 7 OPTIONSChapter 20 Financial Options 75620.1 Option Basics 757Understanding Option Contracts 757Interpreting Stock Option Quotations 757Options on Other Financial Securities 75920.2 Option Payoffs at Expiration 760Long Position in an Option Contract 760Short Position in an Option Contract 761Profits for Holding an Optionto Expiration 763Returns for Holding an Optionto Expiration 764Combinations of Options 76520.3 Put-CaJI Parity 76820.4 Factors Affecting Option Prices 771Strike Price and Stock Price 771Arbitrage Bounds on Option Prices 771Option Prices and the Exercise Date 771Option Prices and Volatility 77220.5 Exercising Options Early 773Non-Dividend-Paying Stocks 773Dividend-Paying Stocks 775206Options and Corporate Finance 777Equity as a Call Option 777Debt as an Option Portfolio 778Credit Default Swaps 778 GLOBAL FINANCIAL CRISISCredit Default Swaps 779Pricing Risky Debt 780Agency Conflicts 781MyFinanceLab 782 Key Terms 783 Further Reading 783 Problems 783 Data Case 788Chapter 21 Option Valuation789The Binomial Option PricingModel 790A Two-State Single-Period Model 790The Binomial Pricing Formula 792A Multiperiod Model 793Making the Model Realistic 797 The Black-Scholes Option PricingModel 798The Black-Scholes Formula 798 INTERVIEW withMyron S. Scholes 799Implied Volatility 804a GLOBAL FINANCIAL CRISfSThe VIX Index 805The Replicating Portfolio 806213 Risk-Neutral Probabilities 808A Risk-Neutral Two-State Model 808Implications of the Risk-NeutralWorld 808Risk-Neutral Probabilities and OptionPricing 80921.4 Risk and Return of an Option 81121.5 Corporate Applications of OptionPricing 813Beta of Risky Debt 813 COMMON MISTAKEValuing Employee Stock Options 816 NOBEL PRIZE The 1997 Nobel Prizein Economics 817

ContentsAgency Costs of Debt 817MyFinanceLab 818 Key Terms 820 Further Reading 820 Problems 820Chapter 22 Real Options 82522.1 Real Versus Financial Options 82622.2 Decision Tree Analysis 826Representing Uncertainty 827Real Options 828Solving Decision Trees 82822.3 The Option to Delay: Investmentas a Call Option 829An Investment Option 829 Why Are There Empty Lots in Built-UpAreas of Big Cities? 832Factors Affecting the Tinningof Investment 833Investment Options and Firm Risk 834 GLOBAL FINANCIAL CRISISUncertainty, Investment, andthe Option to Delay 83522.4 Growth and AbandonmentOptions 836Valuing Growth Potential 836The Option to Expand 838 INTERVIEW withScott Mathews 839The Option to Abandon 84022.5 Investments with Different Lives 842 Equivalent Annual BenefitMethod 84322.6 Optimally Staging Investments 84422.7 Rules of Thumb 847The Profitability Index Rule 848The Hurdle Rate Rule 848 The Option to Repay a Mortgage 85022.8 Key Insights from Real Options 851MyFinanceLab 851 Key Terms 853 Further Reading 853 Problems 853PART 8 LONG-TERM FINANCINGChapter 23 Raising Equity Capital 86023.1 Equity Financing for PrivateCompanies 861Sources of Funding 861 Crowdfunding: The Waveof the Future? 862 INTERVIEW with Kevin Laws 86315Venture Capital investing 866Venture Capital Financing Terms 868 COMMON MISTAKE MisinterpretingStart-Up Valuations 868S From Launch to Liquidity 870Exiting an Investment in a PrivateCompany 87223.2 The initial Public Offering 872Advantages and Disadvantagesof Going Public 872Types of Offerings 873The Mechanics of an IPO 875 Google's IPO 87523.3 IPO Puzzles 880Underpricing 880Cyclicality 883 GLOBAL FINANCIAL CRISISWorldwide IPO Dealsin 2008-2009 884Cost of an IPO 884Long-Run Underperformance 88523.4 The Seasoned Equity Offering 886The Mechanics of an SEO 886Price Reaction 888Issuance Costs 889MyFinanceLab 889 Key Terms 890 mFurther Reading 891 Problems 892 Data Case 895Chapter 24 Debt Financing 89724.1 Corporate Debt 898Public Debt 898Private Debt 90224.2 Other Types of Debt 903Sovereign Debt 903Municipal Bonds 905 Detroit's Art Museum at Risk 905Asset-Backed Securities 906 GLOBAL FINANCIAL CRISISCDOs, Subprime Mortgages,and the Financial Crisis 90624.3 Bond Covenants 90824.4 Repayment Provisions 909Call Provisions 909 New York City Calls Its MunicipalBonds 911Sinking Funds 913Convertible Provisions 913MyFinanceLab 915 Key Terms 916 Further Reading 917 Problems 917 Data Case 918

16ContentsChapter 25 Leasing 92125.1 The Basics of Leasing 922Examples of Lease Transactions 922Lease Payments and ResidualValues 923Leases Versus Loans 924 Calculating Auto LeasePayments 925End-of-Term Lease Options 925Other Lease Provisions 92725.2 Accounting, Tax, and LegalConsequences of Leasing 927Lease Accounting 928 Operating Leases at AlaskaAir Group 929The Tax Treatment of Leases 930Leases and Bankruptcy 931 Synthetic Leases 93225.3 The Leasing Decision 932Cash Flows for a True Tax Lease 933Lease Versus Buy (An UnfairComparison) 934Lease Versus Borrow {The RightComparison) 935Evaluating a True Tax Lease 937Evaluating a Non-TaxLease 93825.4 Reasons for Leasing 938Valid Arguments for Leasing 939 INTERVIEW with Mark Long 941Suspect Arguments for Leasing 942MyFinanceLab 943 Key Terms 944 Further Reading 944 Problems 945PART 9 SHORT-TERM FINANCINGChapter 26 Working CapitalManagement 95026.1 Overview of Working Capital 951The Cash Cycle 951Firm Value and Working Capital 95326.2 Trade Credit 954Trade Credit Terms 954Trade Credit and Market Frictions 954Managing Float 95526.3 Receivables Management 956Determining the Credit Policy 956Monitoring Accounts Receivable 95726.4 Payables Management 959Determining Accounts Payable DaysOutstanding 959Stretching Accounts Payable 960OÄ cInventory Management 960Benefits of Holding Inventory 961Costs of Holding Inventory 96126.6 Cash Management 962Motivation for Holding Cash 962Alternative Investments 963 Hoarding Cash 963MyFinanceLab 965 Key Terms 966 Further Reading 966 Problems 967 Data Case 970/n»««*«. onOtiapter H Short-Term FinancialFlanning 97327.1 Forecasting Short-Term FinancingNeeds 974Seasonalities 974Negative Cash Flow Shocks 977Positive Cash Flow Shocks 9

or Calculator 154 4.7 Non-Annual Cash Flows 156 . 6.1 Bond Cash Flows, Prices, and Yields 206 Bond Terminology 206 . Interest Rate Changes and Bond Prices 214 Clean and Dirty Prices for Coupon Bonds 215 6.3 The Yield Curve and Bond Arbitrage 217 Replicating a Coupon Bond 217 Valuing a Coupon Bond Using Zero-Coupon Yields 218