DeMYSTiFieD / Corporate Finance DeMYSTiFieD / Adair / 907-1 / Front Matter
Corporate Finance
DeMYSTiFieD®

DeMYSTiFieD / Corporate Finance DeMYSTiFieD / Adair / 907-1 / Front Matter
DeMYSTiFieD / Corporate Finance DeMYSTiFieD / Adair / 907-1 / Front Matter
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Corporate
Finance

TO THE ACCURACY, ADEQUACY OR COMPLETENESS OF OR RESULTS TO BE OBTAINED FROM USING THE WORK,
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of the possibility of such damages. This limitation of liability shall apply to any claim or cause whatsoever whether such claim or cause
arises in contract, tort or otherwise.All there is to know
about financial
statements—
without the headache!
Contents
Acknowledgments
Introduction
Chapter 1 Four Basic Financial Statements
Chapter 2 Basic Concepts
Chapter 3 The Income Statement
Chapter 4 The Balance Sheet: Classifications and Concepts
Chapter 5 The Balance Sheet: A Closer Examination
Chapter 6 Statement of Cash Flows
Chapter 7 Reading the Financial Statements: The Auditors’ Reports and Financial Statement Footnotes
Chapter 8 Analysis of Financial Statements
Chapter 9 Additional Issues
Chapter 10 Fraudulently Misstated Financial Statements

University, the University of Michigan, Alma College, Hofstra University, and
Indiana University. He received his B.S. degree in Computers/Information
Science from the University of Alabama at Birmingham, his M.B.A. from the
University of North Dakota, and his Ph.D. in Finance from Indiana University.
Dr. Adair has written articles on bank regulator self-interest, analyst earnings
per share forecasting, and capital budgeting in continuous time, and is the
author of Excel Applications in Corporate Finance and Excel Applications in
Investments, and a coauthor of Finance: Applications and Theory.

vii
Contents
Acknowledgments xiii
Introduction xv
Part I Introduction 1
CHAPTER 1 What Is Corporate Finance? 3
What Is Finance? 4
The Subfields of Finance 6
The Parts of Corporate Finance 9
So, Why Is This So Complicated? 10
Why Are We Studying Corporate Finance? 11
Quiz 12
CHAPTER 2 Setting the Stage 15
Basic Forms of Business Organization 16
Goal of the Financial Manager 17
Agency Relationships and Conflicts 18
Quiz 20
CHAPTER 3 Accounting Statements and Cash Flows 23
The Balance Sheet: Assets versus Liabilities 24
The Balance Sheet: Short-Term versus
Long-Term Accounts 25

CHAPTER 6 Compounding and Interest Rate Conversion:
When What You’ve Got Isn’t What You Need 75
Interest Rate Flavors 76
APRs Explained 77
Just Because You Have a New Toy Doesn’t
Mean You Have To Use It! 78
Dealing with Other Nominal Rates 80
A Caution on Using Calculators or Textbook
Formulas to Convert Rates 81
Quiz 83
CHAPTER 7 Payment Composition and Amortization Schedules 85
Calculating Payment Components for Pure
Discount Loans 86
Calculating Payment Components for
Interest-Only Loans 87
DeMYSTiFieD / Corporate Finance DeMYSTiFieD / Adair / 907-1 / Front Matter

Contents ix
Amortized Loans: Constant-Payment Loans 88
Amortized Loans: Constant-Principal Loans 89
A Final Note on Amortized Loans 91
Quiz 93
Part III Valuation 95
chapter 8 Valuing Bonds 97
The Conventions of Bond Quotations 98
The Mathematics of a Bond 99
There are Rates, and then there are Rates
that aren’t Really Rates… 100
Solving for Bond Price 102
Solving for Anything But Bond Price 103

DeMYSTiFieD / Corporate Finance DeMYSTiFieD / Adair / 907-1 / Front Matter
Modified IRR (MIRR) 140
Profitability Index (PI) 141
Quiz 144
Part IV Where Do Interest Rates Come From? Risk, Return,
and the Cost of Capital 147
CHAPTER 11 Measuring Risk and Return 149
Using the Past to Predict the Future:
Computing the Average and Standard Deviation
of Historic Returns 150
Explicit Guessing: Calculating the Expected
Return and Standard Deviation across
Expected States of Nature 153
Choosing Which Method to Use for Average
and Standard Deviation 155
Portfolio Averages and Standard Deviations 155
Quiz 158
CHAPTER 12 Calculating Beta 161
Beta Estimation Methodology 162
Choosing and Gathering the Necessary Data 163
Calculating the Beta 164
Portfolio Betas 166
Quiz 167
CHAPTER 13 Analyzing the Security Market Line 171
The Relationship between the Security
Market Line and the CAPM Equation 172
Estimating the Intercept of the SML 173
Estimating the Slope of the SML 173
Estimating the X Variable, Beta 174
Bringing It All Together 175

CHAPTER 16 Scenario Analysis and Sensitivity Analysis 201
Sample Project 202
Scenario Analysis 203
Sensitivity Analysis 206
When to Use Which 210
Quiz 211
CHAPTER 17 Option Valuation 215
Options: The Basics 216
Values of Options at Expiration 218
Valuing a Call Option before Expiration:
The Binomial Option Pricing Model 223
Valuing a Call Option before Expiration:
The Black-Scholes Option Pricing Model 229
Put-Call Parity 230
Quiz 232
Final Exam 235
Answers to Quizzes and Final Exam 263
Appendix A: Depreciation Charts 267
Appendix B: Values for the Standard
Normal Cumulative Distribution Function 271
Index 275

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xiii
Acknowledgments
The successful completion of this book is due mostly to the assistance of the
very capable folks at McGraw-Hill, with special thanks going to Margie McAneny
and Agatha Kim. Any errors, of course, are solely my responsibility.


xvi CORPORATE FINANCE DeMYSTiFieD
DeMYSTiFieD / Corporate Finance DeMYSTiFieD / Adair / 907-1 / Front Matter
How to Use This Book
When you first start a finance class, you get the impression that finance is all
about the math. Well, it is and it isn’t: you do need to know how to do the math,
and, for a lot of students, that can seem pretty overwhelming. This book tries
to make learning the necessary math as straightforward as possible by giving
you lots of tips and techniques, but they will be less than useless if you don’t
practice them.
To help you get that necessary practice, this book contains a quiz at the end
of each chapter and a comprehensive, 100-question final exam at the end of
the book. All of these are multiple-choice, and the questions are similar to the
sorts of questions used in standardized tests. The best way to use each chapter
quiz is to study the chapter until you’re comfortable with the material and then
take the entire quiz, rather than trying to solve selected problems as you study.
The answers are listed in the back of the book, and you should stick with a
chapter until you get most of the answers right.
However, as mentioned above, finance is also about more than the math. You
may not believe that, particularly if you’ve just started a finance course, because
most professors spend the first one-third to one-half of the course dwelling on
the mathematical formulas, but the real focus of finance is on the problems and
decisions that can be solved with the math.
Along those lines, there is one important point that needs to be made about
this book: it does not contain recipes for solving every possible type of financial
problem. It can’t; no book can, because there is an almost infinite number of
types of such problems. What it does do is try to give you the necessary insight
into the relevant formulas and concepts so that you can figure out how to solve
a problem from basic principles.
To get the most out of this approach, after you’ve gone through the in-
chapter examples and solved the end-of-chapter quiz, sit back and ask yourself,


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

1
What Is
Corporate Finance?
CHAPTER OBJECTIVES
At the end of this chapter, the reader should be able to:
Explain and illustrate the primary cash flows of finance

Detail and explain the four major subfields of finance

Compare and contrast the capital structure decision, the capital budgeting

decision, and the dividend decision