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A First Course in Finance

Preview, Thursday 30th March, 2006
A First Course in Finance

© 2003“2006 by Ivo Welch. All rights reserved.
Cartoons are copyright and courtesy of Mike Baldwin. See http://www.cornered.com/.
ISBN: no number yet.
Library of Congress: no number yet.
Book Website: http://welch.econ.brown.edu/book
Typesetting System: pd¬‚atex.


Cover Font Y&Y Lucida Casual 13-38pt.
Main Body Font Y&Y Lucida 10pt.
Other Fonts Y&Y Lucida variations
See http://www.tug.org/yandy/

Most graphics were created in R, open-source and free: www.r-project.org. Fonts were embedded using AFPL
ghostscript and Glyph Software™s xpdf.
The referenced spreadsheets are Excel (Microsoft) and OpenO¬ce (free).
Printed: Thursday 30th March, 2006 (from bookg.tex).




Warning: This book is in development.
It is not error-free.
A First Course in Finance

Preview, Thursday 30th March, 2006




Ivo Welch
Professor of Finance and Economics
Yale University
There are a large number of individuals who have helped me with this book. They will eventually be thanked here.
Until then, some random collection: Rick Antle. Donna Battista. Randolph Beatty. Wolfgang Bühler. Kangbin Chua.
Diego Garcia. Stan Garstka. Roger Ibbotson. Ludovic Phalippou. Matthew Spiegel. John Strong. Julie Yufe. Many
anonymous victim students using earlier error-ridden drafts. Most importantly, Mary-Clare McEwing helped me
improve the book.
Most of the review comments on early version of this book were very good, and I have tried hard to use them all.
Thanks to the reviewers, who really gave a lot of their valuable time and thoughts to help me.


Tony Bernardo Mark Klock Tim Sullivan
James Gatti
Bill Christie Angeline Lavin Chris Stivers
Simon Gervais
Jennifer Conrad Joseph McCarthy Mark Stohs
Tom Geurtz
Josh Coval Michael Pagano John Strong
Robert Hansen
Amy Dittmar Mitch Petersen Joel Vanden
Milt Harris
Richard Fendler Sarah Peck Jaime Zender
Ronald Ho¬meister
Diego Garcia Robert Ritchey Miranda (Mei) Zhang
Kurt Jesswin
Sharon Garrison Bruce Rubin


A list of articles upon which the ideas in the book are based, and a list of articles that describe current ongoing
academic research will eventually appear on the book™s website.




Warning: This book is in development.
It is not error-free.




Dedicated to my parents, Arthur and Charlotte.




last ¬le change: Jan 23, 2006 (07:01h)
i



A Quick Adoption Checklist For Instructors

This is the recommended checklist for this book (AFCIF) while the book is in beta test mode. This
checklist will not apply after AFCIF is published (with full supplementary materials) by Addison-
Wesley-Pearson.

Read this prologue and one or two sample chapters to determine whether you like the AFCIF
approach. (Although not representative, I recommend that you also read the epilogue.)

If you do like the AFCIF approach, then please continue. If you do not like AFCIF (or the chapters
you read), please email ivo_welch@brown.edu why you did not like it. I promise I will not shoot
the messenger: I want to learn how to do it better.

Continue to assign whatever other ¬nance textbook you were planning to use, just add AFCIF. Use
it as a supplementary text, or assign just a few chapters.

• Although AFCIF is a full-service textbook for an introductory ¬nance course, it should also work
well as a complement to an existing textbook. Your students should relatively easily bene¬t from
having access to both, because this book is both di¬erent from and similar to the competition. I
believe that relative to relying only on your old textbook, AFCIF will not increase, but decrease
your student™s confusion and workload.
• Take the low risk route and see how well AFCIF works! (Take the Pepsi challenge!) Keeping your
old textbook is also your insurance against using a novel textbook. And it will make students
less critical of the remaining shortcomings in AFCIF, such as the limited number of exercises (and
their occasionally erroneous solutions). Perhaps most importantly, AFCIF does not yet have full
supplementary materials. It will when Addison-Wesley will publish it, but until then, the auxiliary
materials from other textbooks may help.
• For now, students can download the book chapters, so there is no printing cost involved. Af-
fordability should not be a concern.
• It should be a relatively simple matter to link AFCIF chapters into your curriculum, because the
chapters are kept relatively straightforward and succinct.

You cannot go wrong if you try out at least a few chapters of AFCIF in this manner.

You can receive permission to post the electronic AFCIF on your class website. (The website must
be secured to allow only university-internal distribution.) Students can carry the ¬les on their
notebook computers with them.

You can ask your copy center to print and bind the version on your website. You can also obtain
a nicely printed and bound version for $40 from lulu.com.

• Although versions on the AFCIF website at http://welch.econ.brown.edu/book will always have
some improvements, it is a good idea for each class to agree on one de¬nitive reference version.

If you are using AFCIF and you are looking for lecture notes, feel free to “steal” and adapt my
lecture notes (linked at http://welch.econ.brown.edu/book) to your liking. You can change and
modify the lecture notes anyway you like, without copyright restrictions.

Of course, I hope that the majority of your students (and you) will prefer reading AFCIF instead
of your old textbook. At the end of the course, please ask your students which textbook they
found more helpful. Please email your conclusions and impressions to ivo.welch@yale.edu. Any
suggestions for improvement are of course also very welcome. Any feedback would be appreciated,
but it would be particularly helpful for me to learn in what respects they prefer their other textbook.
ii

To The Instructor

Most corporate ¬nance textbooks cover a similar canon of concepts, and this textbook is no
This book is
intentionally different. exception. A quick glance at the Table of Contents will show you that most”though not all”of
the topics in A First Course in Finance overlap with those in traditional ¬nance textbooks. But
this does not mean that this book is not di¬erent. Although I cover similar conceptual territory,
there are also important departures.

Innovations in Approach

So, here is my view of how this book di¬ers from what is currently out there. I do not claim
that other traditional textbooks do not teach any of what I will list, but I do maintain that my
emphasis on these points is much stronger than what you will ¬nd elsewhere.

Conversational Tone The tone is more informal and conversational, which (I hope) makes the
Conversational Tone.
subject more accessible.

Numerical-Example Based I learn best by numerical example, and ¬rmly believe that students
The method of
instruction is do, too. Whenever I want to understand an idea, I try to construct numerical examples
“step-by-step numerical
for myself (the simpler, the better). I do not particularly care for long algebra or complex
examples.”
formulas, precise though they may be. I do not much like many diagrams with long textual
descriptions but no speci¬c examples, either”I often ¬nd them too vague, and I am never
sure whether I have really grasped the whole mechanism by which the concept works.
Therefore, I wanted to write a textbook that relies on numerical examples as its primary
tutorial method.
This approach necessitates a rearrangement of the tutorial textbook progression. Most
conventional ¬nance textbooks start with a bird™s eye view and then work their way down.
The fundamental di¬erence of this book is that it starts with a worm™s eye view and
works its way up. The organization is built around critical question like “What would it be
worth?,” which is then answered in numerical step-by-step examples from ¬rst principles.
Right under numerical computations are the corresponding symbolic formulas. In my
opinion, this structure clari¬es the meaning of these formulas, and is better than either
an exclusively textual or algebraic exposition. I believe that the immediate duality of
numerics with formulas will ultimately help students understand the material on a higher
level and with more ease. (Of course, this book also provides some overviews, and ordinary
textbooks also provide some numerical examples.)

Problem Solving An important goal of this book is to teach students how to approach new
Students should have a
method of thinking, not problems that they have not seen before. Our goal should be send students into the real
just formulas.
world with the analytical tools that allow them to disect new problems, and not just with a
chest full of formulas. I believe that if students adopt the numerical example method”the
“start simple and then generalize” method”they should be able to solve all sorts of new
problems. It should allow them to ¬gure out and perhaps even generalize the formulas
that they learn in this book. Similarly, if students can learn how to verify others™ complex
new claims with simple examples ¬rst, it will often help them to determine whether the
emperor is wearing clothes.

Deeper, Yet Easier I believe that formulaic memorization is ultimately not conducive to learn-
We build a foundation
¬rst”so we are deeper! ing. In my opinion, such an alternative “canned formula” approach is akin to a house
without a foundation. Yes, it may be quicker to build. It may work for a while. But there
is always the risk of collapse. Shoring up the house later is also more costly than building
it right to begin with.
Giving students the methods of how to think about problems and then showing them
how to develop the formulas themselves will make ¬nance seem easier and simpler in the
end, even if the coverage is conceptually deeper. In my case, when I haved learned new
subjects, I have often found it especially frustrating if I understand a subject just a little
but I also suspect that the pieces are really not all in place. A little knowledge can also
iii

be dangerous. If I do not understand where a formula comes from, how would I know
whether I can or cannot use it in a new situation? And I believe that even average students
can understand the basic ideas of ¬nance and where the formulas come from.
Brevity Sometimes, less is more. Brevity is important.
The book focus is on
This book is intentionally concise, even though it goes into more theoretical detail than explanations, not
other books! Institutional descriptions are short. Only the concepts are explained in great institutions.
detail.
My view is that when students are exposed to too much material, they won™t read it, they
won™t remember it, and they won™t know what is really important and what is not. Ten
years after our students graduate, they should still solidly remember the fundamental
ideas of ¬nance, be able to look up the details when they need them, and be able to solve
new (¬nancial) problems. Many institutional details will have changed, anyway”it is the
ideas, concepts, and tools that will last longer.
Self-Contained for Clarity Finance is a subject that every student can comprehend, regardless Self-contained means
students can backtrack.
of background. It is no more di¬cult than economics or basic physics. But, it is often
a problem that many students come into class with a patchwork on knowledge. We, the
instructors, then often erroneously believe the students have all the background covered.
Along the way, such students get lost. It is easy to mistake such them for “poor students,”
especially if there is no reference source, where they can quickly ¬ll in the missing parts.
In this book, I try to make each topic™s development self-contained. This means that I
try to explain everything from ¬rst principles, but in a way that every student can ¬nd
interesting. For example, even though the necessary statistical background is integrated
in the book for the statistics novice, the statistics-savvy student also should ¬nd value
in reading it. This is because statistics is di¬erent in our ¬nance context than when it is
taught for its own sake in a statistics course.
Closer Correspondence with the Contemporary Curriculum I believe that most ¬nance core Less Chapter Reordering.
courses taught today follow a curriculum that is closer in spirit to this book”and more
logical”than it is to the order in older, traditional ¬nance textbooks. In the places where
this book covers novel material (see below), I hope that you will ¬nd that the new material
has merit”and if you agree, that covering it is much easier with this book than with earlier
books.


Innovations in Particular Topics

The book also o¬ers a number of topical and expositional innovations. Here is a selection:

Progression to Risk and Uncertainty The book starts with a perfect risk-free world, then adds First, no risk; then
risk-neutral attitudes to
horizon-dependent interest rates, uncertainty under risk neutrality, imperfect market fric-
risk; then risk-averse
tions (e.g., taxes), uncertainty under risk-aversion, and ¬nally uncertainty under risk aver- attitudes to risk.
sion and with taxes (e.g., WACC and APV).
Frictions (Ch6):
±
 Often Meaningless.
PV0 =
 Various Modi¬cations.

 
 d
  d

Corporate Taxes (Ch22):
Uncertainty (Ch5):
Perfect World (Ch2):
E (CF1,FM )
E
E (CF1 ) E (CF2 )
CF1 CF2
PV0 = +
PV0 = + + ...
PV0 = + + ...
1 + E (˜1,EQ ) + (1 ’ „) · E (˜1,DT )
r r
(1 + r )2 1 + E (˜1 ) 1 + E (˜0,2 )
1+r r r ...
d d

  
 
   
d d

d d

   
Risk-Aversion (Part III):
Horizon-Dependent Rates (Ch4):
E (CF1 )
CF1 CF2
PV0 = + + ... PV0 = + ...
1 + r0,1 1 + r0,2 1 + r1,F + [E (˜1,M ) ’ r1,F ] · βi,M
r
iv

Each step builds on concepts learned earlier. I believe it is an advantage to begin simply
and then gradually add complexity. The unique roles of the more di¬cult concepts of risk
measurement, risk-aversion, and risk-aversion compensation then become much clearer.
(There are some forward hints in the text that describe how the model will change when
the world becomes more complex.)

A Strong Distinction between Expected and Promised Cash Flows I have always been shocked
Drive home “default
risk.” by how many graduating students think that a Boston Celtics bond quotes 400 basis points
in interest above a comparable Treasury bond because of the risk-premium, which they
can calculate using the CAPM formula. Learning to avoid this fundamental error is more
important than fancy theories: the main reason why the Boston Celtics bond promises 400
extra basis points is, of course, primarily its default risk (compensation for non-payment),
not a risk-premium (compensation for risk-averse investors that comes from the corre-
lation with the market rate of return). And for bonds, the latter is usually an order of
magnitude smaller than the former. The CAPM can de¬nitely not be used to ¬nd the 400
basis points. Although many instructors mention this di¬erence at some point, 5 min-
utes of default risk discussion is often lost in 5 hours worth of CAPM discussion. But if
students do not understand the basic distinction, the 5 hours of CAPM discussion are not
only wasted but will have made matters worse!
Traditional textbooks have not helped, because they have not su¬ciently emphasized the
distinction. In contrast, in this book, default risk is clearly broken out. The di¬erence
between quoted (promised) and expected returns, and quoted default compensation and
risk compensation are important themes carried throughout.

Financials from a Finance Perspective Finance students need to solidly understand the rela-
Understand accounting
without being an tionship between ¬nancial statements and NPV. They need to understand the basic rela-
accounting textbook.
tionships in order to construct pro formas. Yet, when I was writing this book, I could not
¬nd good, concise, and self-contained explanations of the important aspects and logic of
accounting statements from a ¬nance perspective. Consequently, this book o¬ers such a
chapter. It does not just show students some ¬nancial statements and names the ¬nan-
cial items; instead, it makes students understand how the NPV cash ¬‚ows are embedded
in the accounting statements.
A fundamental understanding of ¬nancials is also necessary to understand comparables:
for example, students must know that capital expenditures must be subtracted out if
depreciation is not. (Indeed, the common use of EBITDA without a capital expenditures
adjustment is often wrong. If we do not subtract out the pro-rated expense cost, we
should subtract out the full expenses. Factories and the cash ¬‚ows they produce do not
fall from heaven.)

Pro Formas In any formal ¬nancial setting, professionals propose new projects”whether it is
the expansion of a factory building within a corporation, or a new business for presen-
tation to venture capitalists”through pro formas. A good pro forma is a combination
of ¬nancial expertise, business expertise, and intuition. Both art and science go into its
construction. The book™s ¬nal chapter, our capstone towards which the book works, is
the creation of such a pro forma. It combines all the ingredients from earlier chapters”
capital budgeting, taxes, the cost of capital, capital structure, and so on.

“Hands-On” Investments The method of teaching investments is simple but revolutionary. It
Students work out
simple portfolios to carries through an example of three securities with twelve actual annual rates of return.
understand covariances
Students can easily relate to the problem of picking the best portfolio among these three
and theories.
stocks. Along the way, they get to compute variances, covariances, correlations, and
betas. They will internalize that the “double summation” variance formula is just a con-
venient computational shortcut to the variance computed from the time-series of returns
on the portfolio. The correspondence between a mean-variance e¬cient portfolio and the
risk-reward correspondence (the security markets line) similarly becomes obvious and
intuitive: students can pick a better portfolio from these three stocks if one o¬ers too
little or too much return for its contribution to portfolio risk. In the end, students really
understand investments, rather than just recipe formulas”and I believe they will ¬nd it
clearer and easier, too.
v

I know this sounds incredible. This level of detail is often considered too di¬cult and too
theoretical to be teachable in an average introductory ¬nance course. You really have to
see it to believe it.

Robustness The book looks at the robustness of our methods”the relative importance of
errors and mistakes”and what ¬rst-order problems students should worry about and
what second-order problems they can reasonably neglect.

A Newer Perspective on Capital Structure The academic perspective about capital structure
has recently changed. A $1 million house that was originally ¬nanced by a 50% mortgage
and then doubles in value now has only a 25% debt ratio. In analogous fashion, Chapter 25
shows how stock price movements have drastically changed the debt ratio of IBM from
2001 to 2003. Students can immediately eyeball the relative importance of market in¬‚u-
ences, issuing and other ¬nancial activities. The corporate market value changes are an
important and robust factor determining capital structure”at least equal in magnitude
to factors suggested in academic theories involving the pecking order or trade-o¬s. More-
over, we now know that most new equity shares appear in the context of M&A activity and
as executive compensation, not in the context of public equity o¬erings. Part IV of our
book explains what the known ¬rst-order determinants of capital structure are, what the
(important) second-order determinants are, and what the factors still under investigation
are.

Many Other Topical Improvements For example, the yield curve gets its own chapter even ...and many more.
before uncertainty is described in much detail, so that students understand that projects
over di¬erent time horizons can o¬er di¬erent rates of return even in the absence of risk.
There is a self-contained chapter on comparables as a valuation technique”a technique
that many of our students will regularly have to use after they graduate. The corporate
governance chapter has a perspective that is darker than it is in other textbooks. WACC,
APV, and direct pro forma construction all incorporate the tax advantage of debt into
valuation. This is bread-and-butter for CFOs. This book o¬ers a clear explanation of how
these methods usually come to similar results (and when not!). Throughout the book, I
try to be open and honest about where our knowledge is solid and where it is shaky”and
how sensitive our estimates are to the errors we inevitably commit.

Although most of our curriculums are similar in their coverage of the basics, time constraints Webchapters will allow
a-la-carte choice.
usually force us to exclude some topics. Your preferences as to what to cut may di¬er from
mine. For example, I ¬nd the ¬nancials part very important, because this is what most of
our graduates will do when they become analysts, brokers, or consultants. However, you may
instead prefer to talk more about international ¬nance. It is of course impossible to satisfy
everyone”and instructors have always chosen their own favorites, adding and deleting topics
as they see ¬t.
This book tries to accomodate some choice. Some chapters are available on the Web site (“Web
Chapters”) accompanying this book. Chapter style and formatting are unmistakably identical
to the book itself. Every instructor can therefore choose his/her own favorite selection and
ask students to download it. These chapters are free and access is easy. The menu right now
contains the following chapters:

Real Options Real options are brie¬‚y covered in Chapter 7 in the text, but not in great detail.
This web chapter shows how to use spreadsheets, time-series analysis, Monte Carlo simu-
lation, and optimization to determine the value of a plant that can shut down and reopen
(for a cost) as output prices ¬‚uctuate.

Option and Derivative Pricing This is a di¬cult subject to cover in an introductory course,
because it really requires a minimum of 4-6 class sessions to do it well. This chapter
tries to help you cover the basics in 2-3 class sessions. It explains option contracts, static
arbitrage relations (including put-call parity), dynamic arbitrage and the Black-Scholes
formula, and binomial trees.
vi

International Finance This chapter explains the role of currency translations and international
market segmentation for both investments and corporate budgeting purposes.

Ethics This chapter is experimental”and provocative. There is neither a particular set of must-
cover topics nor a template on how to present this material. Your choices and views may
di¬er from mine. However, I believe that ethical considerations are too important for
them never to be raised.

Capital Structure Event Studies This chapter describes the evidence (up-to-2003!) of how the
stock market reacts to the announcements of new debt o¬erings, new equity o¬erings,
and dividend payments.

The title of the book is optimistic. A one-quarter course cannot cover the vast ¬eld that our
profession has created over the last few decades. The book requires at least a one semester
course, or, better yet, a full two-quarter sequence in ¬nance”although the latter may prefer
the “general survey” version of this book, which goes into more detail in the investments part.
I hope that this book will become your ¬rst choice in ¬nance textbooks. If you do not like it,
please drop me an email to let me know where it falls short. I would love to learn from you.
(And even if I do disagree, chances are that your comments will in¬‚uence my next revision.)

Side Note: If you use this book or some chapters therefrom, please permit me to use and post your homework
and exam questions with answers. (Of course, this is not a requirement, only a plea for help.) My intent is for
the Website to become collaborative: you will be able to see what other faculty do, and they can see what you
do. The copyright will of course remain with you.




To The Student

Prerequisites

What do you need to understand this book? You do not need any speci¬c background in ¬-
This book and the
subject itself are tough, nance. You do need to be thoroughly comfortable with arithmetic and generally comfortable
but they are not
with algebra. You do need mathematical aptitude, but no knowledge of advanced mathemat-
forbidding, even to an
ical constructs, such as calculus. Knowledge of statistics would be very helpful, but I will
average student. The
main prerequisite is
explain the relevant concepts when the need arises. You should own a $20 scienti¬c calcu-
mathematical aptitude,
lator. (Financial calculators are not bad but also not necessary.) You should learn how to
but not mathematical
sophistication. operate a spreadsheet (such as Excel in Microsoft™s O¬ce or the free OpenCalc spreadsheet in
OpenO¬ce). The ¬nancial world is moving rapidly away from ¬nancial calculators and toward
computer spreadsheets”it is easier to work with information on a large screen with a 2,000
MHz processor than on a small 2-line display with a 2MHz processor. Because I have tried hard
to keep the book self-contained and to explain everything from ¬rst principles, you should not
need to go hunting for details in statistics, economics, or accounting textbooks. But this is not
to say that you do not need to take courses in these disciplines: they have way more to o¬er
than just background knowledge for a ¬nance textbook.
One word of caution: the biggest problem for a novice of any ¬eld, but especially of ¬nance,
Jargon can trip up the
reader. is jargon: the specialized terminology known only to the initiated. Worse, in ¬nance, much
jargon is ambiguous. Di¬erent people may use di¬erent terms for the same thing, and the
same term may mean di¬erent things to di¬erent people. You have been warned! This book
attempts to point out such ambiguous usage. Luckily, the bark of jargon is usually worse than
its bite. It is only a temporary barrier to entry into the ¬eld of ¬nance.
vii

How to Read The Book

This textbook is concise. I wants to communicate the essential material in a straightforward This book is concise,
focusing on the essence
(and thus compact), but also conversational (and thus more interactive) and accessible fashion.
of arguments.
There are already many ¬nance textbooks with over a thousand pages. Much of the content of
these textbooks is interesting and useful but not essential to an understanding of ¬nance. (I
personally ¬nd some of this extra content distracting.)
The book is organized into four parts: the basics consist of return computations and capital The layout of the book.
budgeting. Next are corporate ¬nancials, then investments (asset pricing), and ¬nancing (capital
structure). Major sections within chapters end with questions that ask you to review the points
just made with examples or questions similar to those just covered. You should not proceed
beyond a section without completing these questions (and in “closed book” format)! Many,
but not all, questions are easy and/or straightforward replications of problems that you will
have just encountered in the chapter. Others are more challenging. Each chapter ends with
answers to these review questions. Do not move on until you have mastered these review
questions. (The published version of this book will contain many more student questions, and
there will be a separate student testbank.)
There are “annotations” on the left side of most paragraphs throughout the text. Suggestion: This is an annotation.
use the remaining white space in the margin to scribble your own notes, preferably in pencil
so that you can revise them.
Especially important concepts that you should memorize are in red boxes: These are other notices.




Important: This is an important point to remember.



Interesting, related points that either interrupt the ¬‚ow of an argument, or that are not abso-
lutely necessary are marked

This is an interesting related note, not crucial for understanding the material. It is usually not
Side Note:
excessively technical.


More detailed technical points are “digging-deeper notes,” which should be of interest only to
the student who is interested in pursuing ¬nance beyond the introductory course:

If you are really interested, here is a curious fact or a derivation that most likely relies on
Digging Deeper:
excessive algebra.


Both can be safely omitted from reading without compromising understanding. Sometimes, an
appendix contains further advanced material.
A ¬nal warning: I have a strange sense of humor. Please do not be easily turned o¬. Sense of Humor


Other Readings

This book cannot do it all. It is important for you to keep up with current ¬nancial devel- Advice: Follow current
coverage of ¬nancial
opments. Frequent reading of the ¬nancial section of a major newspaper (such as the New
topics elsewhere!
York Times [N.Y.T.]), the Wall Street Journal [W.S.J.], or the Financial Times [F.T.] can help,
as can regular consumption of good business magazines, such as The Economist or Business
Week. (See the website at http://welch.econ.brown.edu/book for more useful resource links.)
Although this is not a book on “how to read and understand the newspaper,” you should be
able to understand most of the contents of the ¬nancial pages after consuming this textbook.
You should also know how to cruise the web”sites such as Yahoo!Finance contain a wealth of
useful ¬nancial information. Yahoo!Finance is also used extensively in this book.
viii
TABLE OF CONTENTS ix

(This particular printout is of a version that contains questions and notes to reviewers, and the
book itself ends early”covering only the more polished and edited chapters. However, the follow-
ing table of contents corresponds to the complete and standard version of the book. Consequently,
the page numbers are not correct. A parenthesized chapter title means that the chapter has not
yet been completed.)




Table of Contents




I Investments and Returns 1

Chapter 1: A Short Introduction 5
1·1 The Goal of Finance: Relative Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
1·2 How do CFOs do It? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
1·3 Learning How to Approach New Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
1·4 The Main Parts of This Book . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10


Chapter 2: The Time Value of Money 11
2·1 Basic De¬nitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
2·1.A. Investments, Projects, and Firms 12
2·1.B. Loans and Bonds 13
2·1.C. U.S. Treasuries 14
2·2 Returns, Net Returns, and Rates of Return . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
2·3 The Time Value of Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
2·3.A. The Future Value of Money 17
2·3.B. Compounding 17
2·3.C. Confusion: Interest Rates vs. Interest Quotes 21
2·4 Capital Budgeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
2·4.A. Discount Factor and Present Value (PV) 23
2·4.B. Net Present Value (NPV) 26
2·5 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30



Chapter 3: More Time Value of Money 33
3·1 Separating Investment Decisions and Present Values From Other Considerations . . . . 34
3·1.A. Does It Matter When You Need Cash? 34
3·1.B. Corporate Valuation: Growth as Investment Criteria? 35
3·1.C. The Value Today is just “All In¬‚ows” or just “All Out¬‚ows” 36
3·2 Perpetuities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
3·2.A. The Simple Perpetuity Formula 38
3·2.B. The Growing Perpetuity Formula 40
3·2.C. A Growing Perpetuity Application: Individual Stock Valuation with Gordon Growth Mod-
els 41
x TABLE OF CONTENTS

3·3 The Annuity Formula . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
3·3.A. An Annuity Application: Fixed-Rate Mortgage Payments 43
3·3.B. An Annuity Example: A Level-Coupon Bond 44
3·3.C. The Special Cash Flow Streams Summarized 47
3·4 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49

Advanced Appendix: Proofs of Perpetuity and Annuity Formulas . . . . . . . . . . . . . .
a 52


Chapter 4: Investment Horizon, The Yield Curve, and (Treasury) Bonds 53
4·1 Time-Varying Rates of Return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54
4·2 Annualized Rates of Return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55
4·3 The Yield Curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58
4·3.A. An Example: The Yield Curve in May 2002 58
4·3.B. Compounding With The Yield Curve 60
4·3.C. Yield Curve Shapes 61
4·4 Present Values With Time-Varying Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . 62
4·4.A. Valuing A Coupon Bond With A Particular Yield Curve 63
4·5 Why is the Yield Curve not Flat? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65
4·5.A. The E¬ect of Interest Rate Changes on Short-Term and Long-Term Treasury Bond Val-
ues 66
4·6 The Yield To Maturity (YTM) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68
4·7 Optional Bond Topics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70
4·7.A. Extracting Forward Interest Rates 70
4·7.B. Shorting and Locking in Forward Interest Rates 72
4·7.C. Bond Duration 74
4·7.D. Continuous Compounding 78
4·8 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79



Chapter 5: Uncertainty, Default, and Risk 83
5·1 An Introduction to Statistics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84
5·1.A. Random Variables and Expected Values 84
5·1.B. Risk Neutrality (and Risk Aversion Preview) 87
5·2 Interest Rates and Credit Risk (Default Risk) . . . . . . . . . . . . . . . . . . . . . . . . . . . 88
5·2.A. Risk-Neutral Investors Demand Higher Promised Rates 88
5·2.B. A More Elaborate Example With Probability Ranges 89
5·2.C. Preview: Risk-Averse Investors Have Demanded Higher Expected Rates 91
5·3 Uncertainty in Capital Budgeting, Debt, and Equity . . . . . . . . . . . . . . . . . . . . . . . 93
5·3.A. Present Value With State-Contingent Payo¬ Tables 93
5·3.B. Splitting Project Payo¬s into Debt and Equity 96
5·4 Robustness: How Bad are Your Mistakes? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104
5·4.A. Short-Term Projects 104
5·4.B. Long-Term Projects 104
5·4.C. Two Wrongs Do Not Make One Right 105
5·5 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106



Chapter 6: Dealing With Imperfect Markets 111
6·1 Causes and Consequences of Imperfect Markets . . . . . . . . . . . . . . . . . . . . . . . . . 112
6·1.A. Perfect Market Assumptions 112
6·1.B. Value in Imperfect Markets 113
6·1.C. Perfect, Competitive, and E¬cient Markets 113
6·2 The E¬ect of Disagreements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 117
6·2.A. Expected Return Di¬erences vs. Promised Return Di¬erences 117
6·2.B. Corporate Finance vs. Entrepreneurial or Personal Finance? 118
6·2.C. Covenants, Collateral, and Credit Rating Agencies 119
TABLE OF CONTENTS xi

6·3 Market Depth and Transaction Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123
6·3.A. Typical Costs When Trading Real Goods”Houses 123
6·3.B. Typical Costs When Trading Financial Goods”Stocks 124
6·3.C. Transaction Costs in Returns and Net Present Values 126
6·3.D. Liquidity 127
6·4 An Introduction to The Tax Code . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128
6·4.A. The Basics of (Federal) Income Taxes 128
6·4.B. Before-Tax vs. After-Tax Expenses 130
6·4.C. Average and Marginal Tax Rates 131
6·4.D. Dividend and Capital Gains Taxes 131
6·4.E. Other Taxes 132
6·4.F. What You Need To Know About Tax Principles In Our Book 133
6·5 Working With Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134
6·5.A. Taxes in Rates of Returns 134
6·5.B. Tax-Exempt Bonds and the Marginal Investor 134
6·5.C. Taxes in NPV 135
6·5.D. Tax Timing 137
6·6 In¬‚ation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138
6·6.A. De¬ning the In¬‚ation Rate 138
6·6.B. Real and Nominal Interest Rates 139
6·6.C. Handling In¬‚ation in Net Present Value 141
6·6.D. Interest Rates and In¬‚ation Expectations 142
6·7 Multiple E¬ects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144
6·7.A. How to Work Problems You Have Not Encountered 144
6·7.B. Taxes on Nominal Returns? 145
6·8 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147



Chapter 7: Capital Budgeting (NPV) Applications and Advice 153
7·1 The Economics of Project Interactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 154
7·1.A. The Ultimate Project Selection Rule 154
7·1.B. Project Pairs and Externalities 155
7·1.C. One More Project: Marginal Rather Than Average Contribution 157
7·2 Comparing Projects With Di¬erent Lives and Rental Equivalents . . . . . . . . . . . . . . . 162
7·3 Expected, Typical, and Most Likely Scenarios . . . . . . . . . . . . . . . . . . . . . . . . . . . 164
7·4 Future Contingencies and Real Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165
7·4.A. A Basic Introduction 165
7·4.B. More Complex Option Valuation in a Risk-Neutral World 166
7·4.C. Decision Trees: One Set of Parameters 166
7·4.D. Decision Trees: One Set of Parameters 171
7·4.E. Summary 173
7·5 Mental Biases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175
7·6 Incentive (Agency) Biases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176
7·7 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180



Chapter 8: Other Important Capital Budgeting Topics 183
8·1 Pro¬tability Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 184
8·2 The Internal Rate of Return (IRR) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 185
8·2.A. De¬nition 185
8·2.B. Problems with IRR 187
8·3 So Many Returns: The Internal Rate of Return, the Cost of Capital, the Hurdle Rate, and
the Expected Rate of Return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 188
8·4 Other Capital Budgeting Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 189
8·4.A. The Problems of Payback 189
8·4.B. More Rules 190
xii TABLE OF CONTENTS

8·5 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 191




II Corporate Financials 193


Chapter 9: Understanding Financial Statements 197
9·1 Financial Statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 198
9·1.A. The Contents of Financials 199
9·1.B. PepsiCo™s 2001 Financials 205
9·1.C. Why Finance and Accounting Think Di¬erently 206
9·2 The Bottom-Up Example ” Long-Term Accruals (Depreciation) . . . . . . . . . . . . . . . 208
9·2.A. Doing Accounting 208
9·2.B. Doing Finance 211
9·2.C. Translating Accounting into Finance 212
9·3 The Hypothetical Bottom-Up Example ” Short-Term Accruals . . . . . . . . . . . . . . . . 215
9·3.A. Working Capital 215
9·3.B. Earnings Management 218
9·4 Completing the Picture: PepsiCo™s Financials . . . . . . . . . . . . . . . . . . . . . . . . . . . 219
9·5 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 224

A Appendix: Supplementary Financials ” Coca Cola . . . . . . . . . . . . . . . . . . . . . . . 225
a. Coca Cola™s Financials From EdgarScan 226
b. Coca Cola™s Financials From Yahoo!Finance 227
B Appendix: Abbreviated PepsiCo Income Statement and Cash Flow Statement . . . . . . . 228



Chapter 10: Valuation From Comparables 233
10·1 Comparables vs. NPV . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 234
10·2 The Price-Earnings (PE) Ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 235
10·2.A. De¬nition 235
10·2.B. Why P/E Ratios di¬er 236
10·2.C. P/E Ratio Application Example: Valuing Beverage Companies 244
10·3 Problems With P/E Ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 245
10·3.A. Selection of Comparison Firms 246
10·3.B. (Non-) Aggregation of Comparables 247
10·3.C. A Major Blunder: Never Average P/E ratios 248
10·3.D. Computing Trailing Twelve Month (TTM) Figures 250
10·3.E. Leverage Adjustments For P/E Ratios 251
10·4 Other Financial Ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 255
10·4.A. Value-Based Ratios 255
10·4.B. Non-Value-Based Ratios Used in Corporate Analyses 257
10·5 Closing Thoughts: Comparables or NPV? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 262
10·6 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 262

Advanced Appendix: A Formula For Unlevering P/E ratios . . . . . . . . . . . . . . . . . . . 263
A
TABLE OF CONTENTS xiii


III Risk and Investments 267

Chapter 11: A First Look at Investments 271
11·1 Stocks, Bonds, and Cash, 1970“2004 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 272
11·1.A. Graphical Representation of Historical Stock Market Returns 272
11·1.B. Comparative Investment Performance 276
11·1.C. Comovement, Beta, and Correlation 280
11·2 Visible and General Historical Stock Regularities . . . . . . . . . . . . . . . . . . . . . . . . 282
11·3 History or Opportunities? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 283
11·4 Eggs and Baskets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 284
11·4.A. The Overall Basket 284
11·4.B. The Marginal Risk Contribution 285
11·4.C. The Market Equilibrium 285
11·5 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 286


Chapter 12: Securities and Portfolios 287
12·1 Some Background Information About Equities Market Microstructure . . . . . . . . . . . 288
12·1.A. Brokers 288
12·1.B. Exchanges and Non-Exchanges 288
12·1.C. How Securities Appear and Disappear 289
12·2 Equities Transaction Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 291
12·2.A. Going Long 291
12·2.B. Going Short: The Academic Fiction 291
12·2.C. Going Short: The Real World 292
12·3 Portfolios and Indexes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 294
12·3.A. Portfolio Returns 294
12·3.B. Funds and Net Holdings 296
12·3.C. Some Common Indexes 297
12·3.D. Equal-Weighted and Value-Weighted Portfolios 298
12·3.E. Quo Vadis? Random Returns on Portfolios 301
12·4 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 302



Chapter 13: Statistics 305
13·1 Historical and Future Rates of Return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 306
13·2 The Data: Twelve Annual Rates of Returns . . . . . . . . . . . . . . . . . . . . . . . . . . . . 307
13·3 Univariate Statistics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 308
13·3.A. The Mean 308
13·3.B. The Variance and Standard Deviation 308
13·4 Bivariate Statistics: Covariation Measures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 311
13·4.A. Intuitive Covariation 311
13·4.B. Covariation: Covariance, Correlation, and Beta 312
13·4.C. Computing Covariation Statistics For The Annual Returns Data 320
13·5 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 323
Advanced Appendix: More Statistical Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . 324
13·6
13·6.A. Historical and Future Statistics 324
13·6.B. Improving Future Estimates From Historical Estimates 324
13·6.C. Other Measures of Spread 326
13·6.D. Translating Mean and Variance Statistics Into Probabilities 326
13·6.E. Correlation and Causation 327
xiv TABLE OF CONTENTS


Chapter 14: Statistics of Portfolios 329
14·1 Two Investment Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 331
14·1.A. Expected Rates of Returns 331
14·1.B. Covariance 332
14·1.C. Beta 333
14·1.D. Variance 334
14·2 Three and More Investment Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 336
14·2.A. Expected Returns, Covariance, Beta 336
14·2.B. Variance 338
Advanced Nerd Section: Variance with N Securities and Double Summations
14·2.C. 340
14·2.D. Another Variance Example: PepsiCo, CocaCola, and Cadbury 342
14·3 Historical Statistics For Some Asset-Class Index Portfolios . . . . . . . . . . . . . . . . . . 345
14·4 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 349

A Appendix: More Historical Statistics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 351
a. Country Fund Rates of Return 352
b. Dow-Jones Constituents 353




Chapter 15: The Principle of Diversi¬cation 357
15·1 What Should You Care About? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 358
15·2 Diversi¬cation: The Informal Way . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 359
15·3 Diversi¬cation: The Formal Way . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 360
15·3.A. Uncorrelated Securities 360
15·3.B. Correlated Securities 363
15·3.C. Measures of Contribution Diversi¬cation: Covariance, Correlation, or Beta? 363
15·4 Does Diversi¬cation Work in the Real World? . . . . . . . . . . . . . . . . . . . . . . . . . . 368
15·4.A. Diversi¬cation Among The Dow-Jones 30 Stocks 368
15·4.B. Mutual Funds 370
15·4.C. Alternative Assets 370
15·5 Diversi¬cation Over Time . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 372
15·6 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 376



Chapter 16: The E¬cient Frontier”Optimally Diversi¬ed Portfolios 381
16·1 The Mean-Variance E¬cient Frontier . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 382
16·1.A. The Mean-Variance E¬cient Frontier With Two Risky Securities 382
16·1.B. Di¬erent Covariance Scenarios 385
16·1.C. The Mean-Variance E¬cient Frontier With Many Risky Securities 386
16·2 Real-World Mean-Variance E¬cient Frontier Implementation Problems . . . . . . . . . . . 392
16·3 Combinations of Portfolios on The E¬cient Frontier . . . . . . . . . . . . . . . . . . . . . . 394
16·4 The Mean-Variance E¬cient Frontier With A Risk-Free Security . . . . . . . . . . . . . . . 397
16·4.A. Risk-Reward Combinations of Any Portfolio Plus the Risk-Free Asset 397
16·4.B. The Best Risk-Reward Combinations With A Risk-Free Asset 399
16·4.C. The Formula to Determine the Tangency Portfolio 400
16·4.D. Combining The Risk-Free Security And the Tangency Portfolio 402
16·5 What does a Security need to o¬er to be in an E¬cient Frontier Portfolio? . . . . . . . . 403
16·5.A. What if the Risk-Reward Relationship is Non-Linear? 403
16·5.B. What if the Risk-Reward Relationships is Linear? 404
16·5.C. The Line Parameters 406
16·6 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 409

Advanced Appendix: Excessive Proofs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 411
A
a. The Optimal Portfolio Weights Formula 411
b. The Combination of MVE Portfolios is MVE ” With Risk-Free Security. 412
TABLE OF CONTENTS xv

c. The Combination of Mean-Variance E¬cient Portfolios is Mean-Variance E¬cient ” With-
out Risk-Free Security. 413
d. Proof of the Linear Beta vs. Expected Rate of Return Relationship for MVE Frontier Portfo-
lios 413




Chapter 17: The CAPM: A Cookbook Recipe Approach 421
17·1 The Opportunity Cost of Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 422
17·2 The CAPM . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 423
17·2.A. The Premise and Formula 423
17·2.B. The Security Markets Line (SML) 424
17·3 Using the CAPM Cost of Capital in the NPV Context:
Revisiting The Default Premium and Risk Premium . . . . . . . . . . . . . . . . . . . . . . . 427
17·4 Estimating CAPM Inputs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 429
The Equity Premium E (˜M ) ’ rF
r
17·4.A. 429
17·4.B. The Risk-Free Rate and Multi-Year Considerations (rF ) 433
17·4.C. Investment Projects™ Market Betas (βi,M ) 433
17·4.D. Betas For Publicly Traded Firms 435
17·4.E. Betas From Comparables and Leverage Adjustments:
Equity Beta vs. Asset Beta 435
17·4.F. Betas Based on Economic Intuition 438
17·5 Value Creation and Destruction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 439
17·5.A. Does Risk-Reducing Corporate Diversi¬cation (or Hedging) Create Value? 439
17·5.B. Avoiding Cost-of-Capital Mixup Blunders That Destroy Value 441
17·5.C. Di¬erential Costs of Capital ” Theory and Practice! 442
17·6 Empirical Reality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 445
17·6.A. Non-CAPM Worlds and Non-Linear SMLs 445
17·6.B. How Well Does the CAPM Work? 447
17·7 Robustness: How Bad are Mistakes in CAPM Inputs? . . . . . . . . . . . . . . . . . . . . . . 449
17·8 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 451

A Appendix: Valuing Goods Not Priced at Fair Value via Certainty Equivalence . . . . . . . 452
a. Finding The True Value of A Good That is Not Fairly Priced 452
b. An Application of the Certainty Equivalence Method 455




Chapter 18: The CAPM: The Theory and its Limits 461
18·1 The Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 462
18·1.A. The Logic and Formula 462
18·1.B. Some Odds and Ends 463
18·2 Does the CAPM Hold? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 465
18·2.A. Listing All the CAPM Assumptions 465
18·2.B. Is the CAPM a good representation of reality? 466
18·2.C. Professorial Opinions on the CAPM 467
18·2.D. Why not Optimization instead of the CAPM? 469
18·3 Portfolio Benchmarking with the CAPM? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 469
18·4 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 470

Advanced Appendix: The Arbitrage Pricing Theory (APT) Alternative . . . . . . . . . . . . 471
A



Chapter 19: E¬cient Markets, Classical Finance, and Behavioral Finance 477
19·1 Arbitrage and Great Bets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 478
19·2 Market E¬ciency and Behavioral Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 479
19·2.A. Basic De¬nition and Requirements 479
19·2.B. Classi¬cations Of Market E¬ciency Beliefs 481
19·2.C. The Fundamentals Based Classi¬cation 481
xvi TABLE OF CONTENTS

19·2.D. The Traditional Classi¬cation 483
19·3 E¬cient Market Consequences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 485
19·3.A. Stock Prices and Random Walks 485
19·3.B. Are Fund Managers Just Monkeys on Typewriters? 490
19·3.C. Corporate Consequences 493
19·3.D. Event Studies Can Measure Instant Value Impacts 495
19·4 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 501




IV Financing Choices / Capital Structure 503


Chapter 20: Corporate Financial Claims 507
20·1 The Basic Building Blocks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 508
20·1.A. Bonds 508
20·1.B. Ordinary Equity (Common Stock) 509
20·1.C. Debt and Equity as Contingent Claims 510
20·2 More About Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 512
20·2.A. Bond Features 512
20·2.B. Convertible Bonds 514
20·3 More About Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 517
20·3.A. Preferred Equity (Stock) 517
20·3.B. OPTIONAL: Options and Warrants 517
20·4 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 522



Chapter 21: Capital Structure and Capital Budgeting in a Perfect Market 525
21·1 Conceptual Basics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 526
21·1.A. The Firm, The Charter, and The Capital Structure 526
21·1.B. Maximization of Equity Value or Firm Value? 526
21·2 Modigliani and Miller (M&M), The Informal Way . . . . . . . . . . . . . . . . . . . . . . . . . 528
21·3 Modigliani and Miller (M&M), The Formal Way In Perfect Markets . . . . . . . . . . . . . . 530
21·4 Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 533
21·5 The Weighted Average Cost of Capital (WACC) in a Perfect M&M World . . . . . . . . . . . 534
21·5.A. The Numerical Example In a Risk-Averse World Where Riskier Equity Must O¬er Higher A
Expected Rate of Return 534
21·5.B. The WACC Formula (Without Taxes) 537
21·5.C. A Graphical Illustration 538
21·5.D. A Major Blunder: If all securities are more risky, is the ¬rm more risky? 542
21·5.E. The E¬ect of Leverage Price-Earnings Ratios (Again) 542
21·6 The Big Picture: How to Think of Debt and Equity . . . . . . . . . . . . . . . . . . . . . . . . 543
21·7 Using the CAPM and WACC Cost of Capital in the NPV Formula . . . . . . . . . . . . . . . 544
21·8 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 545

Advanced Appendix: Compatibility of Beta, the WACC, and the CAPM Formulas in a
A
Perfect World. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 546
TABLE OF CONTENTS xvii


Chapter 22: Corporate Taxes and A Tax Advantage of Debt 549
22·1 Capital Budgeting If Equity and Debt Were Equally Taxed . . . . . . . . . . . . . . . . . . . 550
22·2 Di¬erential Debt and Equity Taxation in The U.S. Tax Code . . . . . . . . . . . . . . . . . . 551
22·3 Firm Value Under Di¬erent Capital Structures . . . . . . . . . . . . . . . . . . . . . . . . . . 552
22·3.A. Future Corporate Income Taxes and Owner Returns 553
22·4 Formulaic Valuation Methods: APV and WACC . . . . . . . . . . . . . . . . . . . . . . . . . . 554
22·4.A. Adjusted Present Value (APV): Theory 554
22·4.B. APV: Application to a 60/40 Debt Financing Case 556
22·4.C. Tax-Adjusted Weighted Average Cost of Capital (WACC) Valuation: Theory 556
22·4.D. A Major Blunder: Applying APV and WACC to the Current Cash Flows 559
22·5 A Sample Application of Tax-Adjusting Valuation Techniques . . . . . . . . . . . . . . . . 560
22·5.A. The Flow-To-Equity Direct Valuation from the Pro Forma Financials 561
22·5.B. APV 561
22·5.C. WACC 563
22·6 The Tax Subsidy on PepsiCo™s Financial Statement . . . . . . . . . . . . . . . . . . . . . . . 565
22·7 Odds and Ends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 566
22·7.A. Which Valuation Method is Best? 566
22·7.B. A Quick-and-Dirty Heuristic Tax-Savings Rule 567
22·7.C. Can Investment and Financing Decisions Be Separate? 567
22·7.D. Using Our Tax Formulas 568
22·7.E. Other Capital Structure Related Tax Avoidance Schemes 569
22·8 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 571

Advanced Appendix: The Discount Factor on Tax Obligations and Tax Shelters . . . . . 576
a


Chapter 23: Other Capital Structure Considerations 581
23·1 The Role of Personal Income Taxes and Clientele E¬ects . . . . . . . . . . . . . . . . . . . 582
23·1.A. Background: The Tax Code For Security Owners 582
23·1.B. The Principle Should Be “Joint Tax Avoidance” 583
23·1.C. Tax Clienteles 584
23·2 Operating Policy Distortions: Behavior in Bad Times (Financial Distress) . . . . . . . . . . 592
23·2.A. The Tradeo¬ in the Presence of Financial Distress Costs 592
23·2.B. Direct Losses of Firm Value 593
23·2.C. Operational Distortions of Incentives 596
23·2.D. Strategic Considerations 598
23·3 Operating Policy Distortions: Behavior in Good Times . . . . . . . . . . . . . . . . . . . . . 599
23·3.A. Agency Issues 599
23·4 Bondholder Expropriation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 601
23·4.A. Project Risk Changes 601
23·4.B. Issuance of Bonds of Similar Priority 602
23·4.C. Counteracting Forces 603
23·5 Inside Information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 606
23·6 Transaction Costs and Behavioral Explanations . . . . . . . . . . . . . . . . . . . . . . . . . 609
23·7 Corporate Payout Policy: Dividends and Share Repurchases . . . . . . . . . . . . . . . . . 610
23·8 Further Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 613
23·8.A. Interactions 613
23·8.B. Reputation and Capital Structure Recommendations 613
23·8.C. Final Note: Cost of Capital Calculations 614
23·9 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 615
xviii TABLE OF CONTENTS


Chapter 24: Clinical Observations About Capital Structure 621
24·1 Tracking IBM™s Capital Structure From 2001 to 2003 . . . . . . . . . . . . . . . . . . . . . . 622
24·2 IBM™s Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 625
24·2.A. Long-Term Debt 625
24·2.B. Current Liabilities 626
24·2.C. Other Liabilities 626
24·2.D. Other Observations and Discussion 626
24·3 IBM™s Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 630
24·4 Assessing IBM™s Capital Structure Change . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 632
24·5 The Capital Structure of Other Firms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 632
24·5.A. Very Large Firms 632
24·5.B. Smaller Firms 633
24·6 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 637



Chapter 25: The Dynamics of Capital Structure and Firm Size 641
25·1 The Dynamics of Capital Structure and Firm Scale . . . . . . . . . . . . . . . . . . . . . . . 641
25·2 The Managerial Perspective . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 643
25·2.A. The Holistic View 643
25·2.B. Meaningful Questions 644
25·2.C. Financial Flexibility and Cash Management 645
25·2.D. Market Pressures Towards the Optimal Capital Structure? 646
25·3 The Capital Issuing Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 648
25·3.A. The Pecking Order (and Financing Pyramid) 648
25·3.B. Debt and Debt-Hybrid O¬erings 649
25·3.C. Seasoned Equity O¬erings 651
25·3.D. Initial Public O¬erings 652
25·3.E. Raising Funds Through Other Claims and Means 655
25·3.F. The In¬‚uence of Stock Returns 655
25·4 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 657

A Appendix: Standard&Poor™s 04/24/2005 Bond Report on IBM™s 2032 5.875% Coupon
Bond . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 659


Chapter 26: How Have Firms™ Capital Structures Evolved? 661
26·1 Mechanisms vs. Rationales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 662
26·2 The Relative Importance of Capital Structure Mechanisms . . . . . . . . . . . . . . . . . . 662
26·2.A. Net Issuing Activity 663
26·2.B. Firm Value Changes 664
26·3 Deeper Causality ” Capital Structure In¬‚uences . . . . . . . . . . . . . . . . . . . . . . . . 666
26·3.A. A Large-Scale Empirical Study 666
26·3.B. Theory vs. Empirics 668
26·3.C. Evidence on Equity Payouts: Dividends and Equity Repurchasing 669
26·3.D. Forces Acting Through the Equity Payout Channel 670
26·4 Survey Evidence From CFOs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 671
26·5 Leverage Ratios By Firm Size, Pro¬tability, and Industry . . . . . . . . . . . . . . . . . . . . 673
26·6 Perspective . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 677
26·7 The Capital Market Response to Issue and Dividend Announcements . . . . . . . . . . . 678
26·8 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 678

A Appendix: A List of Some Recent Empirical Capital-Structure Related Publications . . . 680
TABLE OF CONTENTS xix


Chapter 27: Investment Banking 683
27·1 Investment Bankers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 684
27·1.A. Underwriting Functions 684
27·1.B. The Major Underwriters 685
27·2 The Underwriting Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 687
27·2.A. Direct Issuing Costs 687
27·2.B. Underwriter Selection 689
27·2.C. Sum-Total Issuing Costs ” The Financial Market Reaction 689
27·3 Mergers and Acquisitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 693
27·3.A. M&A Participants, Deal Characteristics, and Advisory Fees 695
27·4 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 697



Chapter 28: Corporate Governance 699
28·1 Less Fact, More Fiction: In Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 700
28·2 Managerial Temptations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 701
28·2.A. Illegal Temptations 701
28·2.B. Legal Temptations 703
28·2.C. The Incentive of the Entrepreneur to Control Temptations 706
28·3 Equity Protection . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 708
28·3.A. Subsequent Equity O¬erings 708
28·3.B. The Corporate Board 709
28·3.C. The Role of Votes 710
28·3.D. Large Shareholders 714
28·3.E. The Legal Environment 716
28·3.F. Ethics, Publicity, and Reputation 718
28·3.G. Conclusion 719
28·4 Debt Protection . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 720
28·5 The E¬ectiveness of Corporate Governance . . . . . . . . . . . . . . . . . . . . . . . . . . . . 722
28·5.A. An Opinion: What Works and What Does not Work 722
28·5.B. Where are we going? Sarbanes-Oxley and Beyond 723
28·6 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 725
xx TABLE OF CONTENTS


V Putting It All Together “ Pro Formas 727


Chapter 29: Corporate Strategy and NPV Estimation With Pro Forma Fi-
nancial Statements 729
29·1 The Goal and Logic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 730
29·1.A. The Template 731
29·2 The Detailed Horizon vs. The Terminal Time Break . . . . . . . . . . . . . . . . . . . . . . . 733
29·3 The Detailed Projection Phase . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 735
29·3.A. Method 1: Direct Extrapolation of Historical Cash Flows 736
29·3.B. Method 2: Pro Forma Projections With Detailed Modeling of Financials 737
29·3.C. Policy and Calculations o¬ the Pro Forma Components 742
29·4 Pro Forma Terminal Values . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 743
29·4.A. The Cost of Capital 743
29·4.B. The Cost of Capital Minus the Growth Rate of Cash Flows 745
29·5 Complete Pro Formas . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 747
29·5.A. An Unbiased Pro Forma 747
29·5.B. A Calibrated Pro Forma 749
29·6 Alternative Assumptions and Sensitivity Analysis . . . . . . . . . . . . . . . . . . . . . . . . 752
29·6.A. Fiddle With Individual Items 752
29·6.B. Do Not Forget Failure 753
29·6.C. Assessing the Pro Forma 753
29·7 Proposing Capital Structure Change . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 754
29·8 Hindsight . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 756
29·9 Caution ” The Emperor™s New Clothes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 758
29·10 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 759

A Appendix: In-a-Pinch Advice: Fixed vs. Variable Components . . . . . . . . . . . . . . . . 760




VI Appendices 769


Chapter A: Epilogue 773
A·1 Thoughts on Business and Finance Education . . . . . . . . . . . . . . . . . . . . . . . . . . 774
A·1.A. Common Student Misconceptions 774
A·1.B. Common Faculty Misconceptions 775
A·1.C. Business School vs. Practice 776
A·1.D. The Rankings 777
A·2 Finance: As A Discipline . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 778
A·2.A. Art or Science? 778
A·2.B. Will We Ever Fully Understand Finance? 778
A·3 Finance Research . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 779
A·3.A. Accomplishments of Finance 779
A·3.B. Interesting Current Academic Research 779
A·3.C. Getting Involved in Academic Research 779
A·3.D. Finance Degrees 779
A·3.E. Academic Careers in Finance and Economics: A Ph.D.? 780
A·3.F. Being a Professor ” A Dream Job for the Lazy? 781
TABLE OF CONTENTS xxi

A·3.G. Top Finance Journals 782
A·4 Bon Voyage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 783


Chapter B: More Resources 785
2·1 An NPV Checklist . . . . . . . . . . . ......... . . . . . . . . . . . . . . . . . . . . . . . . 786
2·2 Prominently Used Data Websites . ......... . . . . . . . . . . . . . . . . . . . . . . . . 788
2·3 Necessary Algebraic Background . ......... . . . . . . . . . . . . . . . . . . . . . . . . 789
2·4 Laws of Probability, Portfolios, and Expectations . . . . . . . . . . . . . . . . . . . . . . . . 791
2·4.A. Single Random Variables 791
2·4.B. Portfolios 793
2·5 Cumulative Normal Distribution Table . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 795
2·6 A Short Glossary of Some Bonds and Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . 797



Chapter C: Sample Exams 803
3·1 A Sample Midterm . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 804
3·2 A Sample Final . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 805

a Q&A: Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 809


Chapter A: Index 813
1·1 Main Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 813




Web Chapters na


Chapter : International Finance see website



Chapter : Ethics see website



Chapter : IPOs in Detail see website



Chapter : Options see website



Chapter : Empirical Corporate Finance see website



Chapter : Real Options see website
xxii TABLE OF CONTENTS
Part I

Investments and Returns




(A part of all versions of the book.)




1
3


What You Want to Accomplish in this Part
Aside from teaching the necessary background, the two primary goals of this ¬rst part of the
book is to explain how to work with rates of return, and how to decide whether to take or reject
investment projects.
The method of our book is to start with “simple” scenarios and then build on them. For any
tool to work in a more complex scenario, it has to also work in the simpler scenario, so what
you learn in earlier chapters lays the ground work for later chapters.

• In Chapter 1, you will learn where this book is going. Most of our goal is “relative valuation”
(valuing one opportunity relative to others), and everything will come together to be of
use only in our ¬nal “pro forma” chapter. It will also tell you more about the book™s
approach”its “method of thinking.”

• In Chapter 2, you will start with the simplest possible scenario. There are no taxes, trans-
action costs, disagreements, or limits as to the number of sellers and buyers in the market.
You know everything, and all rates of return in the economy are the same. A one-year
investment pays the same and perfectly known rate of return per annum as a ten-year in-
vestment. You want to know how one-year returns translate into multi-year returns; and
when you should take a project and when you should reject it. The chapter introduces
the most important concept of “present value.”

Typical questions: If you earn 5% per year, how much will you earn over 10
years? If you earn 100% over 10 years, how much will you earn per year? What
is the value of a project that will deliver $1,000,000 in 10 years? Should you buy
this project if it cost you $650,000?

• In Chapter 3, you will learn how to value particular kinds of projects”annuities and
perpetuities”if the economy-wide interest rate remains constant.

Typical questions: What is the monthly mortgage payment for a $300,000 mort-
gage if the interest rate is 4% per annum?

• In Chapter 4, you will abandon the assumption that returns are the same regardless of
investment horizon. For example, one-year investments may pay 2% per annum, while ten-
year investments may pay 5% per annum. Having time-varying rates of return is a more
realistic scenario than the previous chapter™s constant interest rate scenario. However,
the question that you want to answer are the same questions as those in Chapter 2. (The
chapter then also explains some more advanced aspects of bonds.)

Typical questions: If you earn 5% in the ¬rst year and 10% in the second year,
how much will you earn over both years? What is the meaning of a 4% annualized
interest rate? What is the meaning of a 4% yield-to-maturity? How can you value
projects if appropriate rates of return depend on investment horizon?

• In Chapter 5, you will abandon the assumption that you have perfect omniscience. To be
able to study uncertainty, you must begin with statistics. The chapter then explains an
important assumption about your risk preferences that makes this easy: risk-neutrality.
This lays the ground for discussing the role of uncertainty in ¬nance. (Later, in Part III,
you will learn what to do if investors are risk-averse.)
Uncertainty means that a project may not return the promised amount”the stated rate
of return would be higher than the expected rate of return. Although you are interested in
the latter, it is almost always only the former that you are quoted (promised). You must
always draw a sharp distinction between promised (stated) rates of return, and expected
rates of return. This chapter also explains the di¬erence between debt and equity, which
is only meaningful under uncertainty.
4

Typical questions: If there is a 2% chance that your borrower will not return
the money, how much extra in interest should you charge? From an investment
perspective, what is the di¬erence between debt and equity? How bad is the
role of inevitable mis-estimates in your calculations? If your cost of capital
(borrowing from the bank) is 10% and your savings interest rate (saving in the
bank) is 5%, should you take a project that will o¬er a 7% rate of return?


• In Chapter 6, you will abandon the perfect market assumptions and focus on four im-
portant frictions: disagreement, transaction costs, taxes, and in¬‚ation. This chapter also
explains the basics and principles of the tax code. Though not welcome, these frictions
matter, so you must consider them!

Typical questions: What are typical transaction costs, and how do you work
with them? Why are capital gains better than ordinary income? If you have to
pay 40% income taxes on interest receipts, the in¬‚ation rate is 2% per annum,
and your investment promises 5% per annum, how much more can you buy in
goods tomorrow if you invest? If you can earn 5% in taxable bonds, and 3%
in tax-exempt municipal bonds, which is the better investment for you? If the
in¬‚ation rate is 5% per year, and the interest rate is 10% per year, how much
more in goods can you actually buy if you save your money?


• Chapter 7 goes over a number of important issues that you should pay attention to when
you have to make investment decisions.

Typical questions: How should you think of projects that have sidee¬ects”for
example, projects that pollute the air? How should you think of sunk costs?
What is a “real option”? How do you value contingencies and your own ¬‚exibility
to change course in the future? How should your assessment of the value change
if someone else makes up the cash ¬‚ow estimates? How do humans”you”tend
to mis-estimate future cash ¬‚ows.


• Chapter 8 discusses other capital budgeting rules, ¬rst and foremost the pro¬tability
index and the internal rate of return.

Typical question: If your project costs $100, and returns $50 next year and $100
in ten years, what is your project™s internal rate of return?
CHAPTER 1
A Short Introduction

The First Draft
last ¬le change: Feb 23, 2006 (14:07h)

last major edit: Mar 2004




Before you set out for your journey into the world of ¬nance, this chapter outlines in very broad
strokes what this book is all about.


. 1
( 39)



>>