Corporate Finance

MICHELLE R. CLAYMAN, CFA, is Founder, Managing Partner, and Chief Investment Officer of New Amsterdam Partners LLC, an institutional money management firm in New York City. She has been published in the Financial Analysts Journal and the Journal of Investing, and is a frequent commentator for CNBC, Bloomberg, and other financial media outlets. MARTIN S. FRIDSON, CFA, is CEO of FridsonVision LLC in New York City and is known for his innovative work in credit analysis and investment strategy. He is the author of several highly acclaimed books on financial statement analysis, high-yield debt, and financial history and is the youngest person ever inducted into the Fixed Income Analysts Society Hall of Fame.GEORGE H. TROUGHTON, CFA, is Professor Emeritus of Finance at California State University, Chico. He is a recipient of the C. Stewart Sheppard Award for the advancement of education in the investment profession as well as the Donald L. Tuttle Award for CFA Grading Excellence.

"Valuable reading not only for grad students and CFA wannabes but also for sophisticated investors and professional managers who want to understand what corporate finance is all about." (Seeking Alpha, April 2012)

• Foreword xi Acknowledgments xvAbout the CFA Institute Investment Series xviiCHAPTER 1 Corporate Governance 1Learning Outcomes 11. Introduction 12. Corporate Governance: Objectives and Guiding Principles 23. Forms of Business and Conflicts of Interest 33.1. Sole Proprietorships 43.2. Partnerships 53.3. Corporations 54. Specific Sources of Conflict: Agency Relationships 64.1. Manager–Shareholder Conflicts 64.2. Director–Shareholder Conflicts 105. Corporate Governance Evaluation 105.1. The Board of Directors 115.2. Examples of Codes of Corporate Governance 246. Environmental, Social, and Governance Factors 377. Valuation Implications of Corporate Governance 398. Summary 40Problems 42CHAPTER 2 Capital Budgeting 47Learning Outcomes 471. Introduction 482. The Capital Budgeting Process 493. Basic Principles of Capital Budgeting 504. Investment Decision Criteria 524.1. Net Present Value 524.2. Internal Rate of Return 534.3. Payback Period 554.4. Discounted Payback Period 574.5. Average Accounting Rate of Return 584.6. Profitability Index 584.7. NPV Profile 594.8. Ranking Conflicts between NPV and IRR 614.9. The Multiple IRR Problem and the No IRR Problem 654.10. Popularity and Usage of the Capital Budgeting Methods 685. Cash Flow Projections 705.1. Table Format with Cash Flows Collected by Year 705.2. Table Format with Cash Flows Collected by Type 725.3. Equation Format for Organizing Cash Flows 726. More on Cash Flow Projections 746.1. Straight-Line and Accelerated Depreciation Methods 746.2. Cash Flows for a Replacement Project 776.3. Spreadsheet Modeling 796.4. Effects of Inflation on Capital Budgeting Analysis 817. Project Analysis and Evaluation 827.1. Mutually Exclusive Projects with Unequal Lives 827.2. Capital Rationing 847.3. Risk Analysis of Capital Investments—Standalone Methods 867.4. Risk Analysis of Capital Investments—Market Risk Methods 927.5. Real Options 957.6. Common Capital Budgeting Pitfalls 998. Other Income Measures and Valuation Models 1018.1. The Basic Capital Budgeting Model 1018.2. Economic and Accounting Income 1028.3. Economic Profit, Residual Income, and Claims Valuation 1069. Summary 110Problems 113CHAPTER 3 Cost of Capital 127Learning Outcomes 1271. Introduction 1282. Cost of Capital 1282.1. Taxes and the Cost of Capital 1292.2. Weights of the Weighted Average 1312.3. Applying the Cost of Capital to Capital Budgeting and Security Valuation 1333. Costs of the Different Sources of Capital 1353.1. Cost of Debt 1353.2. Cost of Preferred Stock 1383.3. Cost of Common Equity 1404. Topics in Cost of Capital Estimation 1464.1. Estimating Beta and Determining a Project Beta 1464.2. Country Risk 1534.3. Marginal Cost of Capital Schedule 1544.4. Flotation Costs 1574.5. What Do CFOs Do? 1605. Summary 160Problems 163CHAPTER 4 Measures of Leverage 171Learning Outcomes 1711. Introduction 1712. Leverage 1723. Business Risk and Financial Risk 1733.1. Business Risk and Its Components 1743.2. Sales Risk 1743.3. Operating Risk 1763.4. Financial Risk 1823.5. Total Leverage 1843.6. Breakeven Points and Operating Breakeven Points 1893.7. The Risks of Creditors and Owners 1914. Summary 194Problems 194CHAPTER 5 Capital Structure 199Learning Outcomes 1991. Introduction 1992. The Capital Structure Decision 2002.1. Proposition I without Taxes: Capital Structure Irrelevance 2012.2. Proposition II without Taxes: Higher Financial Leverage Raises the Cost of Equity 2032.3. Taxes, the Cost of Capital, and the Value of the Company 2052.4. Costs of Financial Distress 2102.5. Agency Costs 2112.6. Costs of Asymmetric Information 2122.7. The Optimal Capital Structure According to the Static Trade-Off Theory 2133. Practical Issues in Capital Structure Policy 2163.1. Debt Ratings 2163.2. Evaluating Capital Structure Policy 2173.3. Leverage in an International Setting 2184. Summary 222Problems 223CHAPTER 6 Dividends and Share Repurchases: Basics 229Learning Outcomes 2291. Introduction 2292. Dividends: Forms 2302.1. Regular Cash Dividends 2312.2. Extra or Special (Irregular) Dividends 2322.3. Liquidating Dividends 2342.4. Stock Dividends 2342.5. Stock Splits 2363. Dividends: Payment Chronology 2383.1. Declaration Date 2383.2. Ex-Dividend Date 2383.3. Holder-of-Record Date 2393.4. Payment Date 2393.5. Interval between Key Dates in the Dividend Payment Chronology 2394. Share Repurchases 2414.1. Share Repurchase Methods 2434.2. Financial Statement Effects of Repurchases 2454.3. Valuation Equivalence of Cash Dividends and Share Repurchases: The Baseline 2495. Concluding Remarks 2506. Summary 251Problems 252CHAPTER 7 Dividends and Share Repurchases: Analysis 257Learning Outcomes 2571. Introduction 2582. Dividend Policy and Company Value: Theory 2582.1. Dividend Policy Does Not Matter 2582.2. Dividend Policy Matters: The Bird-in-the-Hand Argument 2602.3. Dividend Policy Matters: The Tax Argument 2602.4. Other Theoretical Issues 2612.5. Dividend Theory: Summary 2713. Factors Affecting Dividend Policy 2713.1. Investment Opportunities 2723.2. The Expected Volatility of Future Earnings 2723.3. Financial Flexibility 2733.4. Tax Considerations 2733.5. Flotation Costs 2763.6. Contractual and Legal Restrictions 2773.7. Factors Affecting Dividend Policy: Summary 2784. Payout Policies 2794.1. Types of Dividend Policies 2794.2. The Dividend versus Share Repurchase Decision 2854.3. Global Trends in Payout Policy 2915. Analysis of Dividend Safety 2936. Summary 297Problems 298CHAPTER 8 Working Capital Management 303Learning Outcomes 3031. Introduction 3042. Managing and Measuring Liquidity 3052.1. Defining Liquidity Management 3052.2. Measuring Liquidity 3073. Managing the Cash Position 3123.1. Forecasting Short-Term Cash Flows 3133.2. Monitoring Cash Uses and Levels 3154. Investing Short-Term Funds 3164.1. Short-Term Investment Instruments 3164.2. Strategies 3204.3. Evaluating Short-Term Funds Management 3225. Managing Accounts Receivable 3235.1. Key Elements of the Trade Credit Granting Process 3245.2. Managing Customers’ Receipts 3265.3. Evaluating Accounts Receivable Management 3286. Managing Inventory 3306.1. Approaches to Managing Levels of Inventory 3316.2. Inventory Costs 3326.3. Evaluating Inventory Management 3327. Managing Accounts Payable 3347.1. The Economics of Taking a Trade Discount 3357.2. Managing Cash Disbursements 3367.3. Evaluating Accounts Payable Management 3378. Managing Short-Term Financing 3378.1. Sources of Short-Term Financing 3378.2. Short-Term Borrowing Approaches 3398.3. Asset-Based Loans 3408.4. Computing the Costs of Borrowing 3419. Summary 343Problems 344CHAPTER 9 Financial Statement Analysis 347Learning Outcomes 3471. Introduction 3472. Common-Size Analysis 3482.1. Vertical Common-Size Analysis 3502.2. Horizontal Common-Size Analysis 3533. Financial Ratio Analysis 3563.1. Activity Ratios 3573.2. Liquidity Analysis 3633.3. Solvency Analysis 3653.4. Profitability Analysis 3693.5. Other Ratios 3833.6. Effective Use of Ratio Analysis 3864. Pro Forma Analysis 3924.1. Estimating the Sales-Driven Relations 3954.2. Estimating the Fixed Burdens 3964.3. Forecasting Revenues 3974.4. Constructing Pro Forma Statements 3975. Summary 401Problems 402CHAPTER 10 Mergers and Acquisitions 407Learning Outcomes 4071. Introduction 4082. Mergers and Acquisitions: Definitions and Classifications 4103. Motives for Merger 4133.1. Synergy 4133.2. Growth 4133.3. Increasing Market Power 4143.4. Acquiring Unique Capabilities and Resources 4143.5. Diversification 4143.6. Bootstrapping Earnings 4153.7. Managers’ Personal Incentives 4163.8. Tax Considerations 4163.9. Unlocking Hidden Value 4163.10. Cross-Border Motivations 4174. Transaction Characteristics 4184.1. Form of Acquisition 4194.2. Method of Payment 4204.3. Mind-Set of Target Management 4225. Takeovers 4245.1. Pre-Offer Takeover Defense Mechanisms 4245.2. Post-Offer Takeover Defense Mechanisms 4266. Regulation 4296.1. Antitrust 4306.2. Securities Laws 4337. Merger Analysis 4347.1. Target Company Valuation 4347.2. Bid Evaluation 4468. Who Benefits from Mergers? 4509. Corporate Restructuring 45110. Summary 452Problems 454Glossary 463References 475About the Authors 481About the CFA Program 487Index 489