Introduction to corporate finance: managing Canadian firms in a global environment

Cover......Page 1
Title Page......Page 5
Copyright......Page 6
Contents......Page 18
Part 1: The Financial Environment......Page 25
Chapter 1: An Introduction to Finance......Page 27
Canada’s Balance Sheet......Page 28
Financial Assets......Page 29
Households......Page 31
Channels of Intermediation......Page 33
Intermediaries......Page 35
The Major Borrowers......Page 38
Financial Instruments......Page 40
Financial Markets......Page 41
1.5 The Global Financial Community......Page 45
Global Financial Markets......Page 46
1.6 The Structure of This Text......Page 48
Summary......Page 49
Chapter 2: Business (Corporate) Finance......Page 53
Sole Proprietorships......Page 54
Partnerships......Page 55
Trusts......Page 56
Corporations......Page 58
2.2 The Goals of the Corporation......Page 59
The Agency Relationship and Agency Costs......Page 62
Aligning Managers’ and Owners’ Interest......Page 64
Corporate Governance......Page 68
2.4 Corporate Finance......Page 69
Positions in Non-Financial Companies......Page 70
Positions in Financial Companies......Page 72
Summary......Page 74
Part 2: Financial Analysis Tools......Page 79
Chapter 3: Financial Statements......Page 81
Canadian and International Standards......Page 82
The Impact of Accounting Scandals......Page 84
Bookkeeping......Page 87
Accounting Conventions: The Basic Principles......Page 89
The Balance Sheet and the Income Statement......Page 92
Changing Accounting Assumptions......Page 94
Tax Statements......Page 95
Cash Flow Statements......Page 96
3.4 Canadian Pacific Accounting Statements......Page 99
Canadian Pacific’s Balance Sheet......Page 100
Canadian Pacific’s Cash Flow Statement......Page 104
3.5 The Canadian Tax System......Page 107
Corporate Taxes......Page 108
Personal Tax......Page 112
Summary......Page 115
Chapter 4: Financial Statement Analysis and Forecasting......Page 121
Return on Equity (ROE) and the DuPont System......Page 122
Interpreting Ratios......Page 125
4.3 Leverage Ratios......Page 127
4.4 Efficiency Ratios......Page 131
4.5 Productivity Ratios......Page 134
4.6 Liquidity Ratios......Page 136
4.7 Valuation Ratios......Page 139
The Percentage of Sales Method......Page 143
4.9 Formula Forecasting......Page 150
4.10 CP’S External Financing Requirements......Page 152
Summary......Page 156
Part 3: Valuation Basics......Page 165
Chapter 5: Time Value of Money......Page 167
5.2 Simple Interest......Page 168
Compounding (Computing Future Values)......Page 169
Discounting (Computing Present Values)......Page 174
Determining Rates of Return or Holding Periods......Page 175
Ordinary Annuities......Page 177
Annuities Due......Page 180
Perpetuities......Page 182
Annuities and Perpetuities Summarized......Page 183
Growing Perpetuities......Page 184
Determining Effective Annual Rates......Page 185
Effective Rates for “Any” Period......Page 187
5.7 Loan or Mortgage Arrangements......Page 189
Mortgages......Page 190
5.8 Comprehensive Examples......Page 194
Summary......Page 198
Chapter 6: Bond Valuation and Interest Rates......Page 209
Basic Bond Terminology......Page 210
Additional Bond Features......Page 211
6.2 Bond Valuation......Page 213
Factors Affecting Bond Prices......Page 216
Bond Quotes......Page 219
Cash Prices versus Quoted Prices......Page 221
Yield to Maturity......Page 222
Current Yield......Page 224
Base Interest Rates......Page 225
Global Influences on Interest Rates......Page 227
The Term Structure of Interest Rates......Page 228
Risk Premiums......Page 230
Treasury Bills......Page 235
Zero Coupon Bonds......Page 236
Canada Savings Bonds......Page 237
Appendix 6A: Interest Rate Parity......Page 238
Yield to Call......Page 240
Summary......Page 241
Chapter 7: Equity Valuation......Page 249
Valuation of Equity Securities......Page 250
7.2 Preferred Share Valuation......Page 251
The Basic Dividend Discount Model......Page 252
The Constant Growth DDM......Page 255
Estimating the Value of Growth Opportunities......Page 256
Examining the Inputs of the Constant Growth DDM......Page 257
Estimating DDM Inputs......Page 258
The Multiple-Stage Growth Version of the DDM......Page 260
Limitations of the DDM......Page 262
The Basic Approach......Page 264
Applying the P/E Ratio Approach......Page 266
Limitations of P/E Ratios......Page 268
7.5 A Simple Valuation Example......Page 269
Appendix 7A: A Short Primer on Bubbles......Page 273
Appendix 7B: Additional Multiples or Relative Value Ratios......Page 274
Summary......Page 277
Part 4: Portfolio and Capital Market Theory......Page 287
Chapter 8: Risk, Return, and Portfolio Theory......Page 289
Ex Post versus Ex Ante Returns......Page 290
Measuring Average Returns......Page 293
Estimating Expected Returns......Page 295
8.2 Measuring Risk......Page 297
8.3 Expected Return and Risk for Portfolios......Page 300
Correlation Coefficient......Page 304
Correlation Coefficients and Portfolio Standard Deviation......Page 307
Two-Security Portfolio Combinations......Page 310
The Efficient Frontier......Page 311
Domestic Diversification......Page 313
International Diversification......Page 316
Appendix 8A: Two-Security Portfolio Frontiers......Page 319
Appendix 8B: Value at Risk (VAR)......Page 321
Summary......Page 322
Chapter 9: The Capital Asset Pricing Model (CAPM)......Page 331
The Efficient Frontier with Risk-Free Borrowing and Lending......Page 332
Risk-Free Investing......Page 334
The New Efficient Set and the Separation Theorem......Page 337
9.2 The Capital Asset Pricing Model (CAPM)......Page 338
The Market Portfolio and the Capital Market Line (CML)......Page 339
Risk-Adjusted Performance and Sharpe Ratios......Page 341
9.3 The CAPM and Market Risk......Page 343
The Security Market Line (SML)......Page 347
The SML and Market Equilibrium......Page 348
Using the SML to Estimate Long-Term Discount Rates......Page 349
9.4 Alternative Asset Pricing Models......Page 351
The Arbitrage Pricing Theory (APT)......Page 354
Summary......Page 355
Chapter 10: Market Efficiency......Page 363
10.1 Defining Market Efficiency......Page 364
Assumptions Underlying Market Efficiency......Page 365
The Components of Market Efficiency......Page 367
10.3 Empirical Evidence Regarding Market Efficiency......Page 368
Weak Form Evidence......Page 369
Semi-Strong Form Evidence......Page 374
Strong Form Evidence......Page 377
10.4 Behavioural Finance......Page 379
Irrational Forces Motivating Investors......Page 381
Market Efficiency and Speculative Bubbles......Page 383
10.5 Implications of Market Efficiency......Page 385
Summary......Page 388
Part 5: Derivative Securities......Page 395
Chapter 11: Forwards, Futures, and Swaps......Page 397
Basic Characteristics of Forward Contracts......Page 398
Using Forward Contracts......Page 399
Interest Rate Parity (IRP) Revisited......Page 404
Pricing Forward Contracts......Page 405
The Mechanics of Futures Contracts......Page 407
Futures Contracts Markets......Page 410
Trading/Hedging with Futures Contracts......Page 412
Summary of Forward and Futures Contracts......Page 414
Interest Rate Swaps......Page 415
The Evolution of Swap Markets......Page 418
11.4 The Financial Crisis and the Credit Default Swap Market......Page 422
Forward Interest Rates......Page 425
Forward Rate Agreements (FRAs)......Page 427
Summary......Page 429
Chapter 12: Options......Page 439
Call Option Basics......Page 440
Call Option Values......Page 443
Put Option Payoffs......Page 446
Put Option Values......Page 448
The Four Basic Option Positions......Page 450
Deriving the Put-Call Parity Relationship......Page 452
Creating Synthetic Positions by Using Put-Call Parity......Page 453
12.4 The Black-Scholes Option Pricing Model......Page 458
The “Greeks”......Page 462
12.5 Options Markets......Page 463
Binomial Option Pricing......Page 466
Risk-Neutral Probabilities......Page 469
Summary......Page 470
Part 6: Long-Term Investment Decisions......Page 479
Chapter 13: Capital Budgeting, Risk Considerations, and Other Special Issues......Page 481
The Importance of the Capital Expenditure Decision......Page 482
13.2 Evaluating Investment Alternatives......Page 485
Payback Period and Discounted Payback Period......Page 486
Net Present Value (NPV) Analysis......Page 487
The Internal Rate of Return (IRR)......Page 490
A Comparison of NPV and IRR......Page 492
Profitability Index (PI)......Page 495
13.3 Independent and Interdependent Projects......Page 496
13.4 Capital Rationing......Page 500
The Appropriate Discount Rate......Page 503
13.5 International Considerations......Page 504
Appendix 13A: The Modified Internal Rate of Return (MIRR)......Page 506
Summary......Page 508
Chapter 14: Cash Flow Estimation and Capital Budgeting Decisions......Page 517
14.1 General Guidelines for Capital Expenditure Analysis......Page 518
The Initial After-Tax Cash Flow (CF0)......Page 520
Expected Annual After-Tax Cash Flows (CFt)......Page 521
Ending (or Terminal) After-Tax Cash Flow (ECFn)......Page 523
Putting It All Together......Page 525
Valuation by Components......Page 527
14.3 Replacement Decisions......Page 531
Sensitivity Analysis and Scenario Analysis......Page 533
Real Option Valuation (ROV)......Page 536
NPV Break-Even Analysis......Page 537
14.5 Inflation and Capital Budgeting Decisions......Page 538
Summary......Page 542
Chapter 15: Mergers and Acquisitions......Page 553
15.1 Types of Takeovers......Page 554
Amalgamations......Page 555
Critical Thresholds......Page 557
Takeover Rules......Page 558
Friendly Takeovers......Page 560
Hostile Takeovers......Page 562
Classifications of Mergers and Acquisitions......Page 565
M&A Activity......Page 567
Value Creation Motivations for M&As......Page 568
Gains Resulting from Mergers: Empirical Evidence......Page 573
The Concept of Fair Market Value......Page 575
Multiples Valuation......Page 578
Liquidation Valuation......Page 581
Discounted Cash Flow Analysis......Page 582
The Acquisition Decision......Page 585
The Effect of an Acquisition on Earnings per Share......Page 586
15.6 Accounting for Acquisitions......Page 587
Summary......Page 588
Chapter 16: Leasing......Page 595
16.1 Leasing Arrangements......Page 596
Types of Asset-Based Financing......Page 598
16.2 Accounting for Leases......Page 600
Financial Statement Effects of Lease Classification......Page 601
16.3 Evaluating the Lease Decision......Page 605
16.4 Motivation for Leasing......Page 613
Case Example......Page 614
Summary......Page 616
Part 7: Long-Term Financing......Page 623
Chapter 17: Investment Banking and Securities Law......Page 625
The Basic Problem of Asymmetric Information......Page 626
Real-World Examples of Fraudulent Activities......Page 627
Some Canadian Examples of Fraudulent Activities......Page 632
Securities Legislation—Basic Responsibilities......Page 633
Security Offerings......Page 635
The Motivation for IPOs......Page 639
The Stages of the IPO Process......Page 641
IPO Underpricing......Page 645
The Post-IPO Market......Page 647
Seasoned Offerings and Short-Form Prospectuses......Page 648
The Size of the Investment Banking Market......Page 649
Summary......Page 650
Chapter 18: Debt Instruments......Page 655
18.1 What Is Debt?......Page 656
Government Treasury Bills......Page 658
Commercial Paper......Page 659
Bankers’ Acceptances (BAs)......Page 662
Lines of Credit (LCs)......Page 665
Term Loans......Page 666
18.4 Long-Term Debt and the Money Market......Page 667
Interpreting Debt Ratings......Page 671
Determining Bond Ratings......Page 672
Empirical Evidence Regarding Debt Ratings......Page 674
Summary......Page 677
Chapter 19: Equity and Hybrid Instruments......Page 683
Shareholder Rights......Page 684
Different Classes of Shares......Page 687
Calculating Share Value and Dividend Yield......Page 689
Types of Preferred Shares......Page 693
Other Features of Preferred Shares......Page 695
Warrants......Page 697
Convertible Securities......Page 700
Categorizing Hybrids......Page 704
Creative Hybrids: Some Examples......Page 705
A Financing Hierarchy......Page 709
Summary......Page 711
Chapter 20: Cost of Capital......Page 717
Capital Structure......Page 718
Three Ways of Using the Valuation Equation......Page 720
Deriving the Required Income Statement......Page 722
Determining the Weighted Average Cost of Capital (WACC)......Page 723
Estimating Market Values......Page 725
Flotation Costs and the Marginal Cost of Capital (MCC)......Page 727
Debt......Page 728
Canadian Pacific Financing......Page 729
Sales Changes and Leverage......Page 732
The Importance of Adjusting for Growth......Page 734
The Constant Growth Model......Page 735
Growth and ROE......Page 737
Multi-Stage Growth Models......Page 740
The Fed Model......Page 743
Using the CAPM to Estimate the Cost of Common Equity......Page 744
Estimating Betas......Page 747
20.7 The Cost of Capital and Investment......Page 751
Summary......Page 754
Part 8: Financial Policies......Page 763
Chapter 21: Capital Structure Decisions......Page 765
Risk and Leverage......Page 766
The Rules of Financial Leverage......Page 768
Indifference Analysis......Page 772
21.2 Determining Capital Structure......Page 774
Financial Ratios and Credit Ratings......Page 776
M&M and Firm Value......Page 778
M&M and the Cost of Capital......Page 781
Introducing Corporate Taxes......Page 785
21.5 Financial Distress, Bankruptcy, and Agency Costs......Page 788
Costs of Bankruptcy......Page 789
Shareholders’ and Creditors’ Reactions to Bankruptcy......Page 790
The Static Trade-Off Theory......Page 792
21.6 Other Factors Affecting Capital Structure......Page 794
21.7 Capital Structure in Practice......Page 796
Appendix 21A: Personal Taxes and Capital Structure......Page 799
Summary......Page 800
Chapter 22: Dividend Policy......Page 809
The Mechanics of Cash Dividend Payments......Page 810
Other Forms of Dividends......Page 812
Reasons for Stock Dividends and Stock Splits......Page 813
22.2 Historical Dividend Data......Page 814
M&M, Dividends, and Firm Value......Page 818
M&M’s Homemade Dividend Argument......Page 821
22.4 The “Bird in the Hand” Argument......Page 823
22.5 Dividend Policy in Practice......Page 826
Transactions Costs......Page 827
Dividends and Signalling......Page 828
Taxes......Page 830
Repackaging Dividend-Paying Securities......Page 831
22.7 Share Repurchases......Page 833
Summary......Page 835
Part 9: Working Capital Management......Page 841
Chapter 23: Working Capital Management: General Issues......Page 843
23.1 The Importance of Working Capital Management......Page 844
A Classic Working Capital Problem......Page 846
The Cash Budget......Page 848
Cash Changes and Sales Growth......Page 852
Credit, Inventory, and Payables......Page 853
Working Capital Ratios......Page 856
Operating and Cash Conversion Cycles......Page 858
An Illustrative Example......Page 859
Summary......Page 862
Chapter 24: Working Capital Management: Current Assets and Current Liabilities......Page 867
Determining the Optimal Cash Balance......Page 868
Cash Management Techniques......Page 870
The Cash Balance “Puzzle”......Page 871
The Credit Decision......Page 873
Evaluation of Credit Information......Page 874
Credit Policies......Page 875
The Collection Process......Page 878
24.3 Inventory......Page 879
Evaluating Inventory Management......Page 880
Trade Credit......Page 881
Bank Loans......Page 883
Factor Arrangements......Page 884
Money Market Instruments......Page 885
Securitizations......Page 887
Summary......Page 889
Appendix 1......Page 893
Index......Page 895
EULA......Page 907