Introduction to Corporate Finance

Part 1 The Financial Environment


1 An Introduction to Finance 1-1


1.1 Finance Defined 1-1


1.2 Real versus Financial Assets 1-2


1.3 The Financial System 1-6


1.4 Financial Instruments and Markets 1-14


1.5 The Global Financial Community 1-18


Summary 1-20


2 Business (Corporate) Finance 2-1


2.1 Types of Business Organizations 2-1


2.2 The Goals of the Corporation 2-6


2.3 The Role of Management and Agency Issues 2-8


2.4 Aligning Managers’ and Owners’ Interest 2-10


2.5 Corporate Finance 2-15


2.6 Finance Careers and the Organization of the Summary 2-19


Part 2 Financial Analysis Tools


3 Financial Statements 3-1


3.1 Accounting Principles 3-1


3.2 Organizing a Firm’s Transactions 3-6


3.3 Preparing Accounting Statements 3-10


3.4 Canadian Pacific Accounting Statements 3-17


Summary 3-32


4 Financial Statement Analysis and Forecasting 4-1



4.1 Consistent Financial Analysis 4-1


4.2 A Framework for Financial Analysis 4-2


4.3 Leverage Ratios 4-6


4.4 Efficiency Ratios 4-9


4.5 Productivity Ratios 4-12


4.6 Liquidity Ratios 4-14


4.7 Valuation Ratios 4-17


4.8 Financial Forecasting 4-20


4.9 Formula Forecasting 4-27


4.10 CP’s External Financing Requirements 4-30


Summary 4-33


Part 3 Valuation Basics


5 Time Value of Money 5-1


5.1 Opportunity Cost 5-1


5.2 Simple Interest 5-2


5.3 Compound Interest 5-4


5.4 Annuities and Perpetuities 5-12


5.5 Growing Perpetuities and Annuities 5-19


5.6 Quoted versus Effective Rates 5-20


5.7 Loan or Mortgage Arrangements 5-24


5.8 Comprehensive Examples 5-29


6 Bond Valuation and Interest Rates 6-1


6.1 The Basic Structure of Bonds 6-2


6.2 Bond Valuation 6-4


6.3 Bond Yields 6-14


6.4 Interest Rate Determinants 6-17


6.5 Other Types of Bonds/Debt Instruments 6-26


Summary 6-33


7 Equity Valuation 7-1


7.1 Equity Securities 7-1


7.2 Preferred Share Valuation 7-3


7.3 Common Share Valuation: The Dividend Discount Model (DDM) 7-5


7.4 Using Multiples to Value Shares 7-16


7.5 A Simple Valuation Example 7-20


Summary 7-28


Part 4 Portfolio and Capital Market Theory


8 Risk, Return, and Portfolio Theory 8-1


8.1 Measuring Returns 8-1


8.2 Types of Average Returns 8-5


8.3 Measuring Risk 8-8


8.4 Expected Return and Risk for Portfolios 8-12


8.5 The Efficient Frontier 8-22


8.6 Diversification 8-25


Summary 8-34


9 The Capital Asset Pricing Model (CAPM) 9-1


9.1 The New Efficient Frontier 9-1


9.2 The Capital Asset Pricing Model (CAPM) 9-8


9.3 The CAPM and Market Risk 9-12


9.4 Alternative Asset Pricing Models 9-20


Summary 9-24


10 Market Efficiency 10-1


10.1 Defining Market Efficiency 10-1


10.2 The Efficient Market Hypothesis (EMH) 10-5


10.3 Empirical Evidence Regarding Market Efficiency 10-6


10.4 Behavioural Finance 10-16


10.5 Implications of Market Efficiency 10-22


Summary 10-24


Part 5 Derivative Securities


11 Forwards, Futures, and Swaps 11-1


11.1 Forward Contracts 11-1


11.2 Futures Contracts 11-10


11.3 Swaps 11-18


11.4 The Financial Crisis and the Credit Default Swap Market 11-24


Summary 11-31


12 Options 12-1


12.1 Call Options 12-1


12.2 Put Options 12-9


12.3 Put-Call Parity 12-12


12.4 The Black-Scholes Option Pricing Model 12-20


12.5 Options Markets 12-24


Summary 12-30


Part 6 Long-Term Investment Decisions


13 Capital Budgeting, Risk Considerations, and Other Special Issues 13-1


13.1 Capital Expenditures 13-1


13.2 Evaluating Investment Alternatives 13-6


13.3 Independent and Interdependent Projects 13-17


13.4 Capital Rationing 13-21


13.5 International Considerations 13-24


Summary 13-28


14 Cash Flow Estimation and Capital Budgeting Decisions 14-1


14.1 General Guidelines for Capital Expenditure Analysis 14-1


14.2 Estimating and Discounting Cash Flows 14-3


14.3 Replacement Decisions 14-17


14.4 Sensitivity to Inputs 14-19


14.5 Inflation and Capital Budgeting Decisions 14-24


Summary 14-27


15 Mergers and Acquisitions 15-1


15.1 Types of Takeovers 15-1


15.2 Securities Legislation and Takeovers 15-4


15.3 Friendly versus Hostile Takeovers 15-7


15.4 Motivations for Mergers and Acquisitions 15-12


15.5 Valuation Issues 15-20


15.6 Accounting for Acquisitions 15-32


Summary 15-34


16 Leasing 16-1


16.1 Leasing Arrangements 16-1


16.2 Accounting for Leases 16-5


16.3 Evaluating the Lease Decision 16-12


16.4 Motivation for Leasing 16-15


Summary 16-16


Part 7 Long-Term Financing


17 Investment Banking and Securities Law 17-1


17.1 Conflicts Between Issuers and Investors 17-2


17.2 Securities Legislation—Basic Responsibilities 17-9


17.3 Security Offerings 17-11


17.4 IPOs and Investment Banking 17-15


17.5 Post-IPO Regulation and Seasoned Offerings 17-22


Summary 17-25


18 Debt Instruments 18-1


18.1 What is Debt? 18-1


18.2 Short-Term Debt and the Money Market 18-4


18.3 Bank Financing 18-10


18.4 Long-Term Debt and the Money Market 18-13


18.5 Bond Ratings 18-16


Summary 18-23


19 Equity and Hybrid Instruments 19-1


19.1 Shareholder Rights 19-2


19.2 Different Classes of Shares 19-5


19.3 Preferred Shares 19-10


19.4 Warrants and Convertible Securities 19-14


19.5 Other Hybrids 19-21


Summary 19-27


20 Cost of Capital 20-1


20.1 Financing Sources 20-2


20.2 The Cost of Capital 20-7


20.3 Estimating the Non-Equity Component Costs 20-11


20.4 The Effects of Operating and Financial Leverage 20-16


20.5 Growth Models and the Cost of Common Equity 20-18


20.6 Risk-Based Models and the Cost of Common Equity 20-28


20.7 The Cost of Capital and Investment 20-35


Summary 20-37


Part 8 Financial Policies


21 Capital Structure Decisions 21-1


21.1 Financial Leverage 21-1


21.2 Determining Capital Structure 21-10


21.3 The Modigliani and Miller (M&M) Irrelevance Theorem 21-14


21.4 The Impact of Taxes on Capital Structure 21-20


21.5 Financial Distress, Bankruptcy, and Agency Costs 21-24


21.6 Other Factors Affecting Capital Structure 21-30


21.7 Capital Structure in Practice 21-31


Summary 21-35


22 Dividend Policy 22-1


22.1 Forms of Dividend Payments 22-1


22.2 Historical Dividend Data 22-6


22.3 Modigliani and Miller’s Dividend Irrelevance Theorem 22-10


22.4 The “Bird in the Hand” Argument 22-14


22.5 Dividend Policy in Practice 22-17


22.6 Relaxing the M&M Assumptions: Welcome to the Real World! 22-19


22.7 Share Repurchases 22-24


Summary 22-27


Part 9 Working Capital Management


23 Working Capital Management: General Issues 23-1


23.1 The Importance of Working Capital Management 23-1


23.2 An Integrated Approach to Net Working Capital (NWC) Management 23-3


23.3 Analyzing Cash Inflows and Outflows 23-9


23.4 Working Capital Management in Practice 23-14


Summary 23-20


24 Working Capital Management: Current Assets and Current Liabilities 24-1


24.1 Cash and Marketable Securities 24-1


24.2 Accounts Receivable 24-6


24.3 Inventory 24-13


24.4 Short-Term Financing Considerations 24-14


Summary 24-21


Appendix 1 A-1


Index I-1