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Selected material from
Fundamentals of Corporate Finance
Third Edition
Richard A. Brealey
Bank of England and London Business School
Stewart C. Myers
Sloan School of Management
Massachusetts Institute of Technology
Alan J. Marcus
Wallace E. Carroll School of Management
Boston College
with additional material from
Fundamentals of Corporate Finance, Alternate Fifth Edition
Essentials of Corporate Finance, Second Edition
Stephen A. Ross,
Massachusetts Institute of Technology
Randolph W. Westerfield, University of Southern California
Bradford D. Jordan, University of Kentucky
UNIVERSITY OF PHOENIX
Boston Burr Ridge, IL Dubuque, IA Madison, WI New York San Francisco St. Louis
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Selected material from
FUNDAMENTALS OF CORPORATE FINANCE, Third Edition
with additional material from
FUNDAMENTALS OF CORPORATE FINANCE, Alternate Fifth Edition
ESSENTIALS OF CORPORATE FINANCE, Second Edition
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Printed in the United States of America. Ex-
cept as permitted under the United States Copyright Act of 1976, no part of this publication may be reproduced or distrib-
uted in any form or by any means, or stored in a data base retrieval system, without prior written permission of the pub-

Quiz 70
Practice Problems 72
Challenge Problems 75
Solutions to Self-Test Questions 77
Minicase 79
Financial Planning 81
What Is Financial Planning? 82
Financial Planning Focuses on the Big Picture 83
Financial Planning Is Not Just Forecasting 84
Three Requirements for Effective Planning 84
Financial Planning Models 86
Components of a Financial Planning Model 87
An Example of a Planning Model 88
An Improved Model 89
Planners Beware 93
Pitfalls in Model Design 93
The Assumption in Percentage of Sales Models 94
The Role of Financial Planning Models 95
External Financing and Growth 96
Summary 100
Related Web Links 101
Key Terms 101
Quiz 101
Practice Problems 102
Challenge Problems 106
Solutions to Self-Test Questions 106
The Firm and the Financial
Manager 3
Organizing a Business 4
Sole Proprietorships 4

Future Value of Multiple Cash Flows 46
Present Value of Multiple Cash Flows 49
Level Cash Flows: Perpetuities and Annuities 50
Financial Statement Analysis 133
Financial Ratios 134
Leverage Ratios 138
Liquidity Ratios 139
Efficiency Ratios 141
Profitability Ratios 143
The Du Pont System 145
Other Financial Ratios 146
Using Financial Ratios 147
Choosing a Benchmark 147
Measuring Company Performance 150
The Role of Financial Ratios 151
Summary 153
Related Web Links 155
Key Terms 155
Quiz 155
Practice Problems 157
Challenge Problem 158
Solutions to Self-Test Questions 159
Minicase 160
IV CONTENTS
Accounting and Finance 111
The Balance Sheet 112
Book Values and Market Values 115
The Income Statement 117
Profits versus Cash Flow 118
The Statement of Cash Flows 119

Bank Loans 185
Commercial Paper 186
Secured Loans 186
The Cost of Bank Loans 187
Simple Interest 187
Discount Interest 188
Interest with Compensating Balances 189
Summary 190
Related Web Links 191
Key Terms 191
Quiz 191
Practice Problems 192
Challenge Problem 194
Solutions to Self-Test Questions 195
Minicase 197
Cash and Inventory Management 201
Cash Collection, Disbursement, and Float 202
Float 203
Valuing Float 204
CONTENTS V
Managing Float 205
Speeding Up Collections 206
Controlling Disbursements 209
Electronic Funds Transfer 210
Inventories and Cash Balances 211
Managing Inventories 212
Managing Inventories of Cash 215
Uncertain Cash Flows 216
Cash Management in the Largest Corporations 217
Investing Idle Cash: The Money Market 218

Practice Problems
246
Challenge Problems
248
Solutions to Self-Test Questions
249
Minicase 250
Valuing Bonds 255
Bond Characteristics 256
Reading the Financial Pages 257
Bond Prices and Yields 259
How Bond Prices Vary with Interest Rates 260
Yield to Maturity versus Current Yield 261
Rate of Return 265
Interest Rate Risk 267
The Yield Curve 268
Nominal and Real Rates of Interest 268
Default Risk 270
Valuations in Corporate Bonds 273
Summary 273
Related Web Links 274
Key Terms 274
Quiz 274
Practice Problems 275
Challenge Problems 277
Solutions to Self-Test Questions 277
Valuing Stocks 279
Stocks and the Stock Market 280
Reading the Stock Market Listings 281
Book Values, Liquidation Values, and Market

Capital 317
Measuring Risk 318
Variance and Standard Deviation 318
A Note on Calculating Variance 322
Measuring the Variation in Stock Returns 322
Risk and Diversification 324
Diversification 324
Asset versus Portfolio Risk 325
Market Risk versus Unique Risk 330
Thinking about Risk 331
Message 1: Some Risks Look Big and Dangerous but
Really Are Diversifiable 331
Message 2: Market Risks Are Macro Risks 332
Message 3: Risk Can Be Measured 333
Summary 334
Related Web Links 334
Key Terms 334
Quiz 335
Practice Problems 336
Solutions to Self-Test Questions 338
SECTION 4 339
Net Present Value and Other Investment
Criteria 341
Net Present Value 343
A Comment on Risk and Present Value 344
Valuing Long-Lived Projects 345
Other Investment Criteria 349
Internal Rate of Return 349
A Closer Look at the Rate of Return Rule 350
Calculating the Rate of Return for Long-Lived

Beware of Allocated Overhead Costs 384
Discount Nominal Cash Flows by the Nominal Cost
of Capital 385
Separate Investment and Financing Decisions 386
Calculating Cash Flow 387
Capital Investment 387
Investment in Working Capital 387
Cash Flow from Operations 388
Example: Blooper Industries 390
Calculating Blooper’s Project Cash Flows 391
Calculating the NPV of Blooper’s Project 392
Further Notes and Wrinkles Arising from Blooper’s
Project 393
Summary 397
Related Web Links 398
Key Terms 398
Quiz 398
CONTENTS VII
Practice Problems 200
Challenge Problems 402
Solutions to Spreadsheet Model Questions 403
Solutions to Self-Test Questions 404
Minicase 405
Risk, Return, and Capital Budgeting 407
Measuring Market Risk 408
Measuring Beta 409
Betas for MCI WorldCom and Exxon 411
Portfolio Betas 412
Risk and Return 414
Why the CAPM Works 416

The Expected Return on Preferred Stock 449
Big Oil’s Weighted-Average Cost of Capital 450
Real Oil Company WACCs 450
Interpreting the Weighted-Average Cost of
Capital 451
When You Can and Can’t Use WACC 451
Some Common Mistakes 452
How Changing Capital Structure Affects Expected
Returns 452
What Happens When the Corporate Tax Rate Is Not
Zero 453
Flotation Costs and the Cost of Capital 454
Summary 454
Related Web Links 455
Key Terms 455
Quiz 455
Practice Problems 456
Challenge Problems 458
Solutions to Self-Test Questions 458
Minicase 459
SECTION 5 463
Project Analysis 465
How Firms Organize the Investment Process 466
Stage 1: The Capital Budget 467
Stage 2: Project Authorizations 467
Problems and Some Solutions 468
Some “What-If ” Questions 469
Sensitivity Analysis 469
Scenario Analysis 472
Break-Even Analysis 473

Debt Comes in Many Forms 501
Innovation in the Debt Market 504
Convertible Securities 507
Patterns of Corporate Financing 508
Do Firms Rely Too Heavily on Internal Funds? 508
External Sources of Capital 510
Summary 511
Related Web Links 512
Key Terms 512
Quiz 512
Practice Problems 513
Solutions to Self-Test Questions 514
How Corporations Issue Securities 517
Venture Capital 519
The Initial Public Offering 520
Arranging a Public Issue 521
The Underwriters 526
Who Are the Underwriters? 526
General Cash Offers by Public Companies 528
General Cash Offers and Shelf Registration 528
Costs of the General Cash Offer 529
Market Reaction to Stock Issues 530
The Private Placement 531
Summary 532
Related Web Links 533
Key Terms 533
Quiz 534
Practice Problems 534
Challenge Problem 536
Solutions to Self-Test Questions 537

Control 567
22.1 The Market for Corporate Control 569
Method 1: Proxy Contests 569
Method 2: Mergers and Acquisitions 570
Method 3: Leveraged Buyouts 571
Method 4: Divestitures and Spin-offs 571
22.2 Sensible Motives for Mergers 572
Economies of Scale 573
Economies of Vertical Integration 573
Combining Complementary Resources 574
Mergers as a Use for Surplus Funds 574
22.3 Dubious Reasons for Mergers 575
Diversification 575
The Bootstrap Game 575
22.4 Evaluating Mergers 577
Mergers Financed by Cash 577
Mergers Financed by Stock 579
A Warning 580
Another Warning 580
22.5 Merger Tactics 582
Who Gets the Gains? 584
22.6 Leveraged Buyouts 585
Barbarians at the Gate? 587
22.7 Mergers and the Economy 588
Merger Waves 588
Do Mergers Generate Net Benefits? 589
22.8 Summary 590
Related Web Links 592
Key Terms 592
Quiz 592

The Firm and the Financial Manager
The Time Value of Money
Financial Statement Analysis
Section 1
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3
THE FIRM AND THE
FINANCIAL MANAGER
A meeting of a corporation’s directors.
Most large businesses are organized as corporations. Corporations are owned by stockholders,
who vote in a board of directors. The directors appoint the corporation’s top executives and
approve major financial decisions.
Comstock, Inc.
Organizing a Business
Sole Proprietorships
Partnerships
Corporations
Hybrid Forms of Business Organization
The Role of the Financial
Manager
The Capital Budgeting Decision
The Financing Decision
Financial Institutions and
Markets
Financial Institutions
Financial Markets
Other Functions of Financial Markets
and Institutions
Who Is the Financial
Manager?

After studying this material you should be able to
᭤
Explain the advantages and disadvantages of the most common forms of business
organization and determine which forms are most suitable to different types of
businesses.
᭤
Cite the major business functions and decisions that the firm’s financial managers
are responsible for and understand some of the possible career choices in finance.
᭤
Explain the role of financial markets and institutions.
᭤
Explain why it makes sense for corporations to maximize their market values.
᭤
Show why conflicts of interest may arise in large organizations and discuss how cor-
porations can provide incentives for everyone to work toward a common end.
4
T
Organizing a Business
SOLE PROPRIETORSHIPS
In 1901 pharmacist Charles Walgreen bought the drugstore in which he worked on the
South Side of Chicago. Today Walgreen’s is the largest drugstore chain in the United
States. If, like Charles Walgreen, you start on your own, with no partners or stockhold-
ers, you are said to be a sole proprietor. You bear all the costs and keep all the profits
The Firm and the Financial Manager 5
after the Internal Revenue Service has taken its cut. The advantages of a proprietorship
are the ease with which it can be established and the lack of regulations governing it.
This makes it well-suited for a small company with an informal business structure.
As a sole proprietor, you are responsible for all the business’s debts and other liabil-
ities. If the business borrows from the bank and subsequently cannot repay the loan, the
bank has a claim against your personal belongings. It could force you into personal

in the stock.
While the stockholders of a corporation own the firm, they do not usually manage
it. Instead, they elect a board of directors, which in turn appoints the top managers. The
board is the representative of shareholders and is supposed to ensure that management
is acting in their best interests.
This separation of ownership and management is one distinctive feature of corpora-
tions. In other forms of business organization, such as proprietorships and partnerships,
the owners are the managers.
The separation between management and ownership gives a corporation more flex-
ibility and permanence than a partnership. Even if managers of a corporation quit or are
SOLE PROPRIETOR
Sole owner of a business
which has no partners and
no shareholders. The
proprietor is personally liable
for all the firm’s obligations.
PARTNERSHIP
Business owned by two or
more persons who are
personally responsible for all
its liabilities.
CORPORATION
Business owned by
stockholders who are not
personally liable for the
business’s liabilities.
LIMITED LIABILITY
The owners of the
corporation are not
personally responsible for its

supposed to make financial decisions that serve shareholders’ interests. Table 1.1 pre-
sents the distinctive features of the major forms of business organization.
HYBRID FORMS OF BUSINESS ORGANIZATION
Businesses do not always fit into these neat categories. Some are hybrids of the three
basic types: proprietorships, partnerships, and corporations.
For example, businesses can be set up as limited partnerships. In this case, partners
are classified as general or limited. General partners manage the business and have un-
limited personal liability for the business’s debts. Limited partners, however, are liable
only for the money they contribute to the business. They can lose everything they put
in, but not more. Limited partners usually have a restricted role in management.
In many states a firm can also be set up as a limited liability partnership (LLP) or,
equivalently, a limited liability company (LLC). These are partnerships in which all
To summarize, the corporation is a distinct, permanent legal entity. Its
advantages are limited liability and the ease with which ownership and
management can be separated. These advantages are especially important for
large firms. The disadvantage of corporate organization is double taxation.
1
The United States is unusual in its taxation of corporations. To avoid taxing the same income twice, most
other countries give shareholders at least some credit for the taxes that their company has already paid.
2
For example, when Microsoft was initially established as a corporation, its shares were closely held by a
small number of employees and backers. Microsoft shares were issued to the public in 1986.
The Firm and the Financial Manager 7
partners have limited liability. This form of business organization combines the tax ad-
vantage of partnership with the limited liability advantage of incorporation. However,
it still does not suit the largest firms, for which widespread share ownership and sepa-
ration of ownership and management are essential.
Another variation on the theme is the professional corporation (PC), which is com-
monly used by doctors, lawyers, and accountants. In this case, the business has limited
liability, but the professionals can still be sued personally for malpractice, even if the

ally refers to financial assets that are widely held, like the shares of IBM. An IOU (“I owe you”) from your
brother-in-law, which you might have trouble selling outside the family, is also a financial asset, but most peo-
ple would not think of it as a security.
REAL ASSETS Assets
used to produce goods and
services.
FINANCIAL ASSETS
Claims to the income
generated by real assets.
Also called securities.
The manager Partners Shareholders
No No Usually
Unlimited Unlimited Limited
No No Ye s
8 SECTION ONE
stream of interest payments and to repayment of the loan. The company’s real assets
need to produce enough cash to satisfy these claims.
Financial managers stand between the firm’s real assets and the financial markets
in which the firm raises cash. The financial manager’s role is shown in Figure 1.1,
which traces how money flows from investors to the firm and back to investors again.
The flow starts when financial assets are sold to raise cash (arrow 1 in the figure). The
cash is employed to purchase the real assets used in the firm’s operations (arrow 2).
Later, if the firm does well, the real assets generate enough cash inflow to more than
repay the initial investment (arrow 3). Finally, the cash is either reinvested (arrow 4a)
or returned to the investors who contributed the money in the first place (arrow 4b). Of
course the choice between arrows 4a and 4b is not a completely free one. For example,
if a bank lends the firm money at stage 1, the bank has to be repaid this money plus in-
terest at stage 4b.
This flow chart suggests that the financial manager faces two basic problems. First,
how much money should the firm invest, and what specific assets should the firm in-

(a bundle
of real assets)
Financial
markets
(investors holding
financial assets)
FIGURE 1.1
Flow of cash between capital
markets and the firm’s
operations. Key: (1) Cash
raised by selling financial
assets to investors; (2) cash
invested in the firm’s
operations; (3) cash
generated by the firm’s
operations; (4a) cash
reinvested; (4b) cash
returned to investors.
FINANCIAL MARKETS
Markets in which financial
assets are traded.
CAPITAL BUDGETING
DECISION Decision as
to which real assets the firm
should acquire.
FINANCING DECISION
Decision as to how to raise
the money to pay for
investments in real assets.
The Firm and the Financial Manager 9

capital markets for long-term debt financing or should it borrow from a bank? Should
it borrow in Paris, receiving and promising to repay euros, or should it borrow dollars
in New York? Should it demand the right to pay off the debt early if future interest rates
fall?
The decision to invest in a new factory or to issue new shares of stock has long-term
consequences. But the financial manager is also involved in some important short-term
decisions. For example, she needs to make sure that the company has enough cash on
hand to pay next week’s bills and that any spare cash is put to work to earn interest. Such
short-term financial decisions involve both investment (how to invest spare cash) and
financing (how to raise cash to meet a short-term need).
Businesses are inherently risky, but the financial manager needs to ensure that risks
are managed. For example, the manager will want to be certain that the firm cannot be
wiped out by a sudden rise in oil prices or a fall in the value of the dollar. We will look
at the techniques that managers use to explore the future and some of the ways that the
firm can be protected against nasty surprises.
4
Accountants may treat investments in R&D differently than investments in plant and equipment. But it is
clear that both investments are creating real assets, whether those assets are physical capital or know-how;
both investments are essential capital budgeting activities.
5
Money markets are used for short-term financing.
CAPITAL STRUCTURE
Firm’s mix of long-term
financing.
CAPITAL MARKETS
Markets for long-term
financing.
10 SECTION ONE
᭤
Self-Test 2 Are the following capital budgeting or financing decisions?

to arrange loans from many individuals:
Company
Investors
Issues debt (borrows)
$2.5 million
However, it is far more convenient and efficient for a bank, which has ongoing relations
with thousands of depositors, to raise the funds from them, and then lend the money to
the company:
FINANCIAL
INTERMEDIARY
Firm
that raises money from many
small investors and provides
financing to businesses or
other organizations by
investing in their securities.
The Firm and the Financial Manager 11
The bank provides a service. To cover the costs of this service, it charges borrowers a
higher interest rate than it pays its depositors.
Banks and their immediate relatives, such as savings and loan companies, are the
most familiar financial intermediaries. But there are many others, such as insurance
companies.
In the United States, insurance companies are more important than banks for the
long-term financing of business. They are massive investors in corporate stocks and
bonds, and they often make long-term loans directly to corporations.
Suppose a company needs a loan for 9 years, not 9 months. It could issue a bond di-
rectly to investors, or it could negotiate a 9-year loan with an insurance company:
Company
Bank
(intermediary)

cies. Second, it invests that money in financial assets, for example, in stocks, bonds, or
loans to businesses or individuals. The manufacturing company’s main investments are
in plant, equipment, and other real assets.
FINANCIAL MARKETS
As firms grow, their need for capital can expand dramatically. At some point, the firm
may find that “cutting out the middle-man” and raising funds directly from investors is
advantageous. At this point, it is ready to sell new financial assets, such as shares of
stock, to the public. The first time the firm sells shares to the general public is called
the initial public offering, or IPO. The corporation, which until now was privately
owned, is said to “go public.” The sale of the securities is usually managed by a group
of investment banks such as Goldman Sachs or Merrill Lynch. Investors who buy shares
are contributing funds that will be used to pay for the firm’s investments in real assets.
In return, they become part-owners of the firm and share in the future success of the en-
terprise. Anyone who followed the market for Internet IPOs in 1999 knows that these
expectations for future success can be on the optimistic side (to put it mildly).
12 SECTION ONE
An IPO is not the only occasion on which newly issued stock is sold to the public.
Established firms also issue new shares from time to time. For example, suppose Gen-
eral Motors needs to raise funds to renovate an auto plant. It might hire an investment
banking firm to sell $500 million of GM stock to investors. Some of this stock may be
bought by individuals; the remainder will be bought by financial institutions such as
pension funds and insurance companies. In fact, about a quarter of the shares of U.S.
companies are owned by pension funds.
A new issue of securities increases both the amount of cash held by the company and
the amount of stocks or bonds held by the public. Such an issue is known as a primary
issue and it is sold in the primary market. But in addition to helping companies raise
new cash, financial markets also allow investors to trade stocks or bonds between them-
selves. For example, Smith might decide to raise some cash by selling her AT&T stock
at the same time that Jones invests his spare cash in AT&T. The result is simply a trans-
fer of ownership from Smith to Jones, which has no effect on the company itself. Such

economy. Here are some examples.
7
6
National Association of Security Dealers Automated Quotation system.
7
Robert Merton gives an excellent overview of these functions in “A Functional Perspective of Financial In-
termediation,” Financial Management 24 (Summer 1995), pp. 23–41.
PRIMARY MARKET
Market for the sale of new
securities by corporations.
SECONDARY MARKET
Market in which already
issued securities are traded
among investors.
The Firm and the Financial Manager 13
The Payment Mechanism. Think how inconvenient life would be if you had to pay for
every purchase in cash or if General Motors had to ship truckloads of hundred-dollar bills
round the country to pay its suppliers. Checking accounts, credit cards, and electronic
transfers allow individuals and firms to send and receive payments quickly and safely over
long distances. Banks are the obvious providers of payment services, but they are not
alone. For example, if you buy shares in a money-market mutual fund, your money is
pooled with that of other investors and used to buy safe, short-term securities. You can
then write checks on this mutual fund investment, just as if you had a bank deposit.
Borrowing and Lending. Financial institutions allow individuals to transfer expen-
ditures across time. If you have more money now than you need and you wish to save
for a rainy day, you can (for example) put the money on deposit in a bank. If you wish
to anticipate some of your future income to buy a car, you can borrow money from the
bank. Both the lender and the borrower are happier than if they were forced to spend
cash as it arrived. Of course, individuals are not alone in needing to raise cash from time
to time. Firms with good investment opportunities raise cash by borrowing or selling

person is responsible for all the decisions discussed in this book. Responsibility is dis-
persed throughout the firm. Top management is of course constantly involved in finan-
cial decisions. But the engineer who designs a new production facility is also involved:
the design determines the kind of asset the firm will invest in. Likewise the marketing
manager who undertakes a major advertising campaign is making an investment deci-
sion: the campaign is an investment in an intangible asset that will pay off in future sales
and earnings.
Nevertheless, there are managers who specialize in finance, and their functions are
summarized in Figure 1.2. The treasurer is usually the person most directly responsi-
ble for looking after the firm’s cash, raising new capital, and maintaining relationships
with banks and other investors who hold the firm’s securities.
For small firms, the treasurer is likely to be the only financial executive. Larger cor-
porations usually also have a controller, who prepares the financial statements, man-
ages the firm’s internal accounting, and looks after its tax affairs. You can see that the
treasurer and controller have different roles: the treasurer’s main function is to obtain
and manage the firm’s capital, whereas the controller ensures that the money is used ef-
ficiently.
The largest firms usually appoint a chief financial officer (CFO) to oversee both
the treasurer’s and the controller’s work. The CFO is deeply involved in financial poli-
cymaking and corporate planning. Often he or she will have general responsibilities be-
yond strictly financial issues.
Usually the treasurer, controller, or CFO is responsible for organizing and supervis-
ing the capital budgeting process. However, major capital investment projects are so
closely tied to plans for product development, production, and marketing that managers
from these other areas are inevitably drawn into planning and analyzing the projects. If
the firm has staff members specializing in corporate planning, they are naturally in-
volved in capital budgeting too.
Because of the importance of many financial issues, ultimate decisions often rest by
law or by custom with the board of directors.
9

accounting, and auditing.
CHIEF FINANCIAL
OFFICER (CFO)
Officer
who oversees the treasurer
and controller and sets
overall financial strategy.