THIRD EDITION

CORE PRINCIPLES AND APPLICATIONSOF CORPORATE FINANCE

Stephen A. RossSloan School of ManagementMassachusetts Institute of Technology

Randolph W.WesterfieldMarshall School of BusinessUniversity of Southern California

Jeffrey R JaffeWharton School of BusinessUniversity of Pennsylvania

Bradford D.JordanGatton College of Business and EconomicsUniversity of Kentucky

McGraw-HillIrwin

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>PART ONE OVERVIEW

I

CHAPTER ONEIntroduction to Corporate Finance 35

1.1 What Is Corporate Finance? 35

The Balance Sheet Model of theFirm 36

The Financial Manager 37

1.2 The Corporate Firm 38

The Sole Proprietorship 38

CHAPTER TWO

Financial Statements and Cash Flow 54

2.1 The Balance Sheet 54

Accounting Liquidity 55

Debt versus Equity 56

Value versus Cost 56

2.2 The Income Statement 57

Generally Accepted AccountingPrinciples 58

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1

1.3

1.4

1.5

The Partnership 38

The Corporation 39

A Corporation by AnotherName... 41

The Importance of Cash Flows 41

The Goal of Financial Management 44

Possible Goals 44

The Goal of Financial Management 45

A More General Goal 46

The Agency Problem and Controlof the Corporation 46

Agency Relationships 47

2.3

2.4

2.5

2.6

Noncash Items 58

Time and Costs 59

Taxes 59

Corporate Tax Rates 60

Average versus Marginal Tax Rates 60

Networking Capital 62

Financial Cash Flow 62

The Accounting Statement of CashFlows 65

Cash Flow from OperatingActivities 65

Cash Flow from InvestingActivities 66

Management Goals 47

Do Managers Act in the Stockholders'Interests? 48

Stakeholders 49

1.6 Regulation 49

The Securities Act of 1933 andthe Securities Exchange Actof 1934 50

Summary and Conclusions 51Closing Case: East Coast Yachts 53

Cash Flow from Financing Activities 67

Summary and Conclusions 68Closing Case: Cash Flows at East CoastYachts 76

CHAPTER THREEFinancial Statements Analysis

and Financial Models 78

3.1 Financial Statements Analysis 78

Standardizing Statements 79

CONTENTS

Common-Size Balance Sheets 79

Common-Size Income Statements 80

3.2 Ratio Analysis 82

Short- Term Solvency or Liquidity Measures 82

Long-Term Solvency Measures 84

Asset Management or Turnover Measures 85

Profitability Measures 87

Market Value Measures 88

3.3 The Du Pont Identity 91

A Closer Look at ROE 91

Problems with Financial Statement Analysis 93

3.4 Financial Models 95

A Simple Financial Planning Model 95

The Percentage of Sales Approach 96

3.5 External Financing and Growth 100

EFN and Growth 101

Financial Policy and Growth 103

A Note about Sustainable Growth RateCalculations 106

3.6 Some Caveats Regarding Financial PlanningModels 107

Summary and Conclusions 108Closing Case: Ratios and Financial Planningat East Coast Yachts 115

PART TWO VALUATION AND CAPITAL BUDGETINGCHAPTER FOURDiscounted Cash Flow Valuation 1184.1 Valuation: The One-Period Case 118

4.2 The Multiperiod Case 122

Future Value and Compounding 122

The Power of Compounding: A Digression 125

Present Value and Discounting 126

The Algebraic Formula 130

4.3 Compounding Periods 131

Distinction between Stated Annual Interest Rateand Effective Annual Rate 133

Compounding over Many Years 135

Continuous Compounding 135

4.4 Simplifications 137

Perpetuity 137

Growing Perpetuity 138

Annuity 140Trick 1: A Delayed Annuity 142 -^Trick 2: Annuity Due 143Trick 3: The Infrequent Annuity 144Trick 4: Equating Present Value of TwoAnnuities 144

Growing Annuity 145

4.5 Loan Types and Loan Amortization 147

Pure Discount Loans 147

Interest-Only Loans 147

Amortized Loans 148

4.6 What Is a Firm Worth? 151

Summary and Conclusions 153Closing Case: The MBA Decision 165

CHAPTER FIVEInterest Rates and Bond Valuation 1675.1 Bonds and Bond Valuation 167

Bond Features and Prices 168

Bond Values and Yields 168

Interest Rate Risk 171

Finding the Yield to Maturity: More Trial and Error 173

5.2 More on Bond Features 175

Long-Term Debt: The Basics 177The Indenture 178

Terms of a Bond 178Security 179Seniority 179Repayment 179The Call Provision 180Protective Covenants 180

5.3 Bond Ratings 181

5.4 Some Different Types of Bonds 182

Government Bonds 182

Zero Coupon Bonds 183

Floating-Rate Bonds 184

Other Types of Bonds 185

CONTENTS

5.5 Bond Markets 185

How Bonds Are Bought and Sold 186Bond Price Reporting 186A Note on Bond Price Quotes. 189

5.6 Inflation and Interest Rates 189

Real versus Nominal Rates 189

The Fisher Effect 190

5.7 Determinants of Bond Yields 191

The Term Structure of Interest Rates 191

Bond Yields and the Yield Curve: Putting It AllTogether 193Conclusion 195

Summary and Conclusions 195Closing Case: Financing East Coast Yachts' ExpansionPlans with a Bond Issue 200

CHAPTER SIXStock Valuation 202

r

6.1 The Present Value of Common Stocks 202Dividends versus Capital Gains 202

Valuation of Different Types of Stocks 204Case 1 (Zero Growth) 204Case 2 (Constant Growth) 204Case 3 (Differential Growth) 205

6.2 Estimates of Parameters in the Dividend DiscountModel 207

Where Does g Come From? 207Where Does R Come From? 208

A Healthy Sense of Skepticism 210

Total Payout 211

6.3 Growth Opportunities 211

Growth in Earnings and Dividendsversus Growth Opportunities 213The No-Payout Firm 213

6.4 Price-Earnings Ratio 214

6.5 Some Features of Common and PreferredStocks 216Common Stock Features 216

Shareholder Rights 216Proxy Voting 217Classes of Stock 217

Other Rights 218Dividends 218

Preferred Stock Features 219Stated Value 219Cumulative and Noncumulative Dividends 219Is Preferred Stock Really Debt? 219

6.6 The Stock Markets 220

Dealers and Brokers 220

Organization of the NYSE 220Members 220Operations 221Floor Activity 221

NASDAQ Operations 222ECNs 223

Stock Market Reporting 223Summary and Conclusions 226Closing Case: Stock Valuation at Ragan Engines 231

CHAPTER SEVENNet Present Value and Other InvestmentRules 2337.1 Why Use Net Present Value? 233

7.2 The Payback Period Method 236

Defining the Rule 236Problems with the Payback Method 237

Problem 1: Timing of Cash Flows within the PaybackPeriod 237Problem 2: Payments after the PaybackPeriod 237Problem 3: Arbitrary Standard for PaybackPeriod 238

Managerial Perspective, 238Summary of Payback 238

7.3 The Discounted Payback Period Method 239

7.4 The Average Accounting Return Method 239Defining the Rule 239

Step 1: Determining Average Net Income 240Step 2: Determining Average Investment 241Step 3: Determining AAR 241

Analyzing the Average Accounting Return Method 2417.5 The Internal Rate of Return 241

7.6 Problems with the IRR Approach 244

CONTENTS

Definition of Independent and Mutually ExclusiveProjects 244Two General Problems Affecting Both Independentand Mutually Exclusive Projects 245

Problem 1: Investing or Financing? 246Problem 2: Multiple Rates of Return 246NPV Rule 247Modified IRR 247The Guarantee against Multiple IRRs 248General Rules 248

Problems Specific to Mutually Exclusive Projects 249The Scale Problem 249The Timing Problem 251

Redeeming Qualities of IRR 253

A Test 253

7.7 The Profitability Index 254

Calculation of Profitability Index 254Application of the Profitability Index 254

7.8 The Practice of Capital Budgeting 256

Summary and Conclusions 258Closing Case: Bullock Gold Mining 269

CHAPTER EIGHTMaking Capital Investment Decisions 2708.1 Incremental Cash Flows 270

Cash FlowsNot Accounting Income 270

Sunk Costs 271

Opportunity Costs 271

Side Effects 272

Allocated Costs 272

8.2 The Baldwin Company: An Example 273

An Analysis of the Project 274Investments 274Income and Taxes 275Salvage Value 276Cash Flow 277Net Present Value 277

Which Set of Books? 277

A Note on Net Working Capital 277

A Note on Depreciation 278

Interest Expense 279

8.3 Inflation and Capital Budgeting 279

Discounting: Nominal or Real? 280

8.4 -' Alternative Definitions of Operating Cash

Flow 282

The Bottom-Up Approach 283

The Top-Down Approach 283

The Tax Shield Approach 283

Conclusion 2848.5 Investments of Unequal Lives: The Equivalent Annual

Cost Method 284

The General Decision to Replace 286

Summary and Conclusions 288Closing Cases: Expansion at East Coast Yachts 299

Bethesda Mining Company 299

CHAPTER NINERisk Analysis, Real Options, and CapitalBudgeting 3019.1 Decision Trees 301

Warning 303

9.2 Sensitivity Analysis, Scenario Analysis, andBreak-Even Analysis 303

Sensitivity Analysis and Scenario Analysis 304Revenues 304Costs 305

Break-Even Analysis 307Accounting Profit 307Present Value 309

9.3 Monte Carlo Simulation 310Step 1: Specify the Basic Model 310Step 2: Specify a Distribution for Each Variablein the Model 310Step 3: The Computer Draws OneOutcome 312Step 4: Repeat the Procedure 312Step 5: Calculate NPV 312

9.4 Real Options 313

The Option to Expand 313

The Option to Abandon 314

Timing Options 316

Summary and Conclusions 317Closing Case: Bunyan Lumber, LLC 325

CONTENTS

PART THREE RISK AND RETURNCHAPTER TENRisk and Return Lessons from MarketHistory 32710.1 Returns 327

Dollar Returns 327

Percentage Returns 329

10.2 Holding Period Returns 331

10.3 Return Statistics 33710.4 Average Stock Returns and Risk-Free

Returns 338

10.5 Risk Statistics 340

Variance 340

Normal Distribution and Its Implicationsfor Standard Deviation 341

10.6 The U.S. Equity Risk Premium: Historical andInternational Perspectives 342

10.7 2008: A Year of Financial Crisis 345

10.8 More on Average Returns 346

Arithmetic versus Geometric Averages 346

Calculating Geometric Average Returns 347

Arithmetic Average Return or GeometricAverage Return? 348

Summary and Conclusions 349Closing Case: A Job at East Coast Yachts,Parti 353

CHAPTER ELEVENReturn and Risk: The Capital Asset PricingModel (CAPM) 35511.1 Individual Securities 355

11.2 Expected Return, Variance, and Covariance 356

Expected Return and Variance 356

Covariance and Correlation 357

11.3 The Return and Risk for Portfolios 360

The Expected Return on a Portfolio 360Variance and Standard Deviation of a Portfolio 361

The Variance 361Standard Deviation of a Portfolio 361The Diversification Effect 362An Extension to Many Assets 363

11.4 The Efficient Set 363

The Two-Asset Case 363

The Efficient Set for Many Securities 367

11.5 Riskless Borrowing and Lending 368

The Optimal Portfolio 370

11.6 Announcements, Surprises, and Expected Returns 372

Expected and Unexpected Returns 372

Announcements and News 373

11.7 Risk: Systematic and Unsystematic 374

Systematic and Unsystematic Risk 374

Systematic and Unsystematic Componentsof Return 374

11.8 Diversification and Portfolio Risk 375

The Effect of Diversification: Another Lesson 'from Market History 375

The Principle of Diversification 375

Diversification and Unsystematic Risk 377

Diversification and Systematic Risk 377

11.9 Market Equilibrium 378

Definition of the Market Equilibrium Portfolio 378

Definition of Risk When Investors Holdthe Market Portfolio 379

The Formula for Beta 381

A Test 383

11.10 Relationship between Risk and ExpectedReturn (CAPM) 383Expected Return on Market 383

Expected Return on Individual Security 384

Summary and Conclusions 386Closing Case: A Job at East Coast Yachts, Part 2 395

CHAPTER TWELVERisk, Cost of Capital, and Capital Budgeting 39712.1 The Cost of Equity Capital 397

12.2 Estimating the Cost of Equity Capital with the CAPM 398

The Risk-Free Rate 401

Market Risk Premium 401Method 1: Using Historical Data 401Method 2: Using the Dividend Discount Model(DDM) 401

CONTENTS

12:3 Estimation of Beta 402

Real-World Betas 403

Stability of Beta 403

Using an Industry Beta 404

12.4 Beta and Covariance 406

Beta and Covariance 406

12.5 Determinants of Beta 407

Cyclicality of Revenues 407

Operating Leverage 407

Financial Leverage and Beta 407

12.6 Dividend Discount Model 409

Comparison of DDM and CAPM 409

Can a Low-Dividend or a No-Dividend StockHave a High Cost of Capital? 410

12.7 Cost of Capital for Divisions and Projects 41112.8 Cost of Fixed Income Securities 412

Cost of Debt 412

Cost of Preferred Stock 413

12.9 The Weighted Average Cost of Capital 414

12.10 Estimating Eastman Chemical's Cost of Capital 417

Eastman's Cost of Equity 417

Eastman's Cost of Debt 418

Eastman's WACC 419

12.11 Flotation Costs and the Weighted Average Costof Capital 419

The Basic Approach 419

Flotation Costs and NPV 420

Internal Equity and Flotation Costs 421

Summary and Conclusions 421Closing Case: The Cost of Capital for GoffComputer, Inc. 428

IPART FOUR CAPITAL STRUCTURE

AND DIVIDEND POLICY

CHAPTER THIRTEENEfficient Capital Markets and BehavioralChallenges 42913.1 Can Financing Decisions Create Value? 429

13.2 A Description of Efficient Capital Markets 431

Foundations of Market Efficiency 433Rationality 433

Independent Deviations from Rationality 433Arbitrage 434

13.3 The Different Types of Efficiency 434

777e Weak Form 434

The Semistrong and Strong Forms 435

Some Common Misconceptions aboutthe Efficient Market Hypothesis 436

The Efficacy of Dart Throwing 437Price Fluctuations 437Stockholder Disinterest 437

13.4 The Evidence 437

The Weak Form 438

The Semistrong Form 439Event Studies 440The Record of Mutual Funds 441

77je Strong Form 44213.5 The Behavioral Challenge to Market

Efficiency 443Rationality 443Independent Deviations fromRationality 443

Arbitrage 444

13.6 Empirical Challenges to Market Efficiency 444

13.7 Reviewing the Differences 450

Representativeness 450

Conservatism 450

13.8 Implications for Corporate Finance 451

/. Accounting Choices, Financial Choices,and Market Efficiency 451

2. The Timing Decision 451

3. Speculation and Efficient Markets 454

4. Information in Market Prices 454

Summary and Conclusions 456Closing Case: Your 401 (k) Account at East CoastYachts 462

CHAPTER FOURTEENCapital Structure: Basic Concepts 464

14.1 The Capital Structure Question and the PieTheory 464

14.2 Maximizing Firm Value versus MaximizingStockholder Interests 465

CONTENTS

14.3 Financial Leverage and Firm Value: An Example 467Leverage and Returns to Shareholders 467The Choice between Debt and Equity 469A Key Assumption 471

14.4 Modigliani and Miller: Proposition II (No Taxes) 471Risk to Equityholders Rises with Leverage 471Proposition II: Required Return to EquityholdersRises with Leverage 472MM: An Interpretation 477

14.5 Taxes 478

The Basic Insight 478Present Value of the Tax Shield 480Value of the Levered Firm 480

Expected Return and Leverage under CorporateTaxes 482

The Weighted Average Cost of Capital RWACCand Corporate Taxes 483Stock Price and Leverage under Corporate Taxes 483

Summary and Conclusions 485Closing Case: Stephenson Real EstateRecapitalization 492

CHAPTER FIFTEENCapital Structure: Limits to the Use of Debt 493

15.1 Costs of Financial Distress 493 .>Direct Bankruptcy Costs 494Indirect Bankruptcy Costs 494Agency Costs 495

Summary of Selfish Strategies 49715.2 Can Costs of Debt Be Reduced? 498

Protective Covenants 498Consolidation of Debt 499

15.3 Integration of Tax Effects and FinancialDistress Costs 499Pie Again 499

15.4 Signaling 50215.5 Shirking, Perquisites, and Bad Investments: A Note

on Agency Cost of Equity 503Effect of Agency Costs of Equity onDebt-Equity Financing 505Free Cash Flow 505

15.6 The Pecking-Order Theory 506Rules of the Pecking Order 507

Rule #1 Use Internal Financing 507Rule #2 Issue Safe Securities First 508

Implications 508

15.7 Growth and the Debt-Equity Ratio 509

No Growth 509

Growth 509

15.8 How Firms Establish Capital Structure 511

15.9 A Quick Look at the Bankruptcy Process 515

Liquidation and Reorganization 516Bankruptcy Liquidation 516Bankruptcy Reorganization 517

Financial Management and the BankruptcyProcess 517

Agreements to Avoid Bankruptcy 518

Summary and Conclusions 518Closing Case: McKenzie Corporation's CapitalBudgeting 523

CHAPTER SIXTEENDividends and Other Payouts 524

16.1 Different Types of Dividends 524

16.2 Standard Method of Cash DividendPayment 525

16.3 The Benchmark Case: An Illustration of theIrrelevance of Dividend Policy 527

Current Policy: Dividends Set Equal to CashFlow 527

Alternative Policy: Initial Dividend Is Greater than CashFlow 528

The Indifference Proposition 528

Homemade Dividends 528

A Test 530

Dividends and Investment Policy 531

16.4 Repurchase of Stock 531

Dividend versus Repurchase: ConceptualExample 532

Dividends versus Repurchases: Real-WorldConsiderations 533

1. Flexibility 5332. Executive Compensation 533

CONTENTS

3. Offset to Dilution 5344. Repurchase as Investment 5345. Taxes 534

16.5 Personal Taxes, Issuance Costs, and Dividends 534

Firms without Sufficient Cash to Pay a Dividend 535

Firms with Sufficient Cash to Pay a Dividend 536

Summary on Personal Taxes 537

16.6 Real-World Factors Favoring a High-DividendPolicy 537

Desire for Current Income 537

Behavioral Finance 538

Agency Costs 539

Information Content of Dividends and DividendSignaling 540

16.7 The Clientele Effect: a Resolution of Real-WorldFactors? 541

16.8 What We Know and Do Not Know about DividendPolicy 542

Dividends and Dividend Payers 542

Corporations Smooth Dividends 544

Payouts Provide Information to the Market 545

Putting It All Together 545

Some Survey Evidence on Dividends 548

16.9 Stock Dividends and Stock Splits 549

Some Details on Stock Splits and Stock Dividends 549Example of a Small Stock Dividend 549Example of a Stock Split 550Example of a Large Stock Dividend 550

Value of Stock Splits and Stock Dividends 5501 The Benchmark Case 550

Popular Trading Range 551

Reve'rse Splits 551

Summary and Conclusions 552Closing Case: Electronic Timing, Inc. 559

PART FIVE SPECIAL TOPICS

CHAPTER SEVENTEENOptions and Corporate Finance 56117.1 Options 561

17.2 Call Options 562

The Value of a Call Option at Expiration 562

17.3 Put Options 563

The Value of a Put Option at Expiration 563

17.4 Selling Options 565

17.5 Option Quotes 566

17.6 Combinations of Options 567

17.7 Valuing Options 570

Bounding the Value of a Call 570Lower Bound 570Upper Bound 570

The Factors Determining Call Option Values 570Exercise Price 570Expiration Date 571Stock Price 571The Key Factor: The Variability of theUnderlying Asset 572The Interest Rate 573

A Quick Discussion of Factors DeterminingPut Option Values 573

17.8 An Option Pricing Formula 574

A Two-State Option Model 575Determining the Delta 575Determining the Amount of Borrowing 576Risk-Neutral Valuation 576

The Black-Scholes Model 577

17.9 Stocks and Bonds as Options 581

The Firm Expressed in Terms of Call Options 582The Stockholders 582The Bondholders 583

The Firm Expressed in Terms of Put Options 584The Stockholders 584The Bondholders 584

A Resolution of the Two Views 584

A Note on Loan Guarantees 586

17.10 Options and Corporate Decisions: SomeApplications 586

Mergers and Diversification 587

Options and Capital Budgeting 588

17.11 Investment in Real Projects and Options 590Summary and Conclusions 592Closing Case: Exotic Cuisines Employee StockOptions 601

CONTENTS

CHAPTER EIGHTEENShort-Term Finance and Planning 60218.1 Tracing Cash and Networking Capital 60318.2 The Operating Cycle and the Cash Cycle 604

Defining the Operating and Cash Cycles 605The Operating Cycle 605The Cash Cycle 605

The Operating Cycle and the Firm's OrganizationChart 607

Calculating the Operating and Cash Cycles 608The Operating Cycle 608The Cash Cycle 609

Interpreting the Cash Cycle 61018.3 Some Aspects of Short-Term Financial Policy 611

The Size of the Firm's Investment in CurrentAssets 611

Alternative Financing Policies for Current Assets 612An Ideal Case 612Different Policies for Financing Current Assets 614

Which Financing Policy Is Best? 616Current Assets and Liabilities in Practice 617

18.4 The Cash Budget 617

Sales and Cash Collections 617Cash Outflows 618The Cash Balance 619

18.5 Short-Term Borrowing 619Unsecured Loans 620

Compensating Balances 620f Cost of a Compensating Balance 620

Letters of Credit 621Secur-ed Loans 621

Accounts Receivable Financing 621Inventory Loans 622

Commercial Paper 622

Trade Credit 622Understanding Trade Credit Terms 622Cash Discounts 623

18.6 A Short-Term Financial Plan 624

Summary and Conclusions 625Closing Case: Keafer Manufacturing Working CapitalManagement 633

CHAPTER NINETEENRaising Capital 63519.1 The Financing Life Cycle of a Firm: Early-Stage

Financing and Venture Capital 636Venture Capital 636

Some Venture Capital Realities 637

Choosing a Venture Capitalist 637Conclusion 637

19.2 Selling Securities to the Public: The BasicProcedure 637

19.3 Alternative Issue Methods 640

19.4 Underwriters 641

Choosing an Underwriter 641

Types of Underwriting 641Firm Commitment Underwriting 641Best Efforts Underwriting .,641Dutch Auction Underwriting 642

The Green Shoe Provision 642The Aftermarket 643

Lockup Agreements 643The Quiet Period 643

19.5 IPOs and Underpricing 643Evidence on Underpricing 644IPO Underpricing: The 1999-2000 Experience 645Why Does Underpricing Exist? 648

19.6 What CFOs Say aboutthe IPO Process 650

19.7 CEOs and the Value of the Firm 651

19.8 The Cost of Issuing Securities 65219.9 Rights 656

The Mechanics of a Rights Offering 656Subscription Price 657

Number of Rights Needed to Purchase aShare 657

Effect of Rights Offering on Price of Stock 657

Effects on Shareholders 659

The Underwriting Arrangements 659The Rights Puzzle 660

19.10 Dilution 660

Dilution of Proportionate Ownership 660

CONTENTS 5)

Dilution of Value: Book versus Market Values 660A Misconception 661The Correct Arguments 662

19.11 Issuing Long-Term Debt 66219.12 Shelf Registration 663Summary and Conclusions 664Closing Case: East Coast Yachts Goes Public 668

CHAPTER TWENTYInternational Corporate Finance 67020.1 Terminology 67120.2 Foreign Exchange Markets and Exchange

Rates 672

Exchange Rates 673Exchange Rate Quotations 673Cross-Rates and Triangle Arbitrage 675Types of Transactions 676

20.3 Purchasing Power Parity 677Absolute Purchasing Power Parity 677Relative Purchasing Power Parity 679

The Basic Idea 679The Result 679Currency Appreciation and Depreciation 681

20.4 Interest Rate Parity, Unbiased Forward Rates, and theInternational Fisher Effect 681

Covered Interest Arbitrage 681Interest Rate Parity 682

Forward Rates and Future Spot Rates 683

f Putting It All Together 684Uncovered Interest Parity 684The International Fisher Effect 684I

20.5 International Capital Budgeting 685Method 1: The Home Currency Approach 686Method 2: The Foreign Currency Approach 686Unremitted Cash Flows 687

20.6 Exchange Rate Risk 687Short-Run Exposure 687Long-Run Exposure 688Translation Exposure 689

Managing Exchange Rate Risk 690

20.7 Political Risk 690

Summary and Conclusions 691Closing Case: East Coast Yachts GoesInternational 696

CHAPTER TWENTY-ONEMergers and Acquisitions 69721.1 The Legal Forms of Acquisitions 698

Merger or Consolidation 698Acquisition of Stock 698Acquisition of Assets 699

Acquisition Classifications 699

A Note on Takeovers 700

Alternatives to Merger 700

21.2 Taxes and Acquisitions 701

21.3 Accounting for Acquisitions 701777e Purchase Method 701

Pooling of Interests 702More on Goodwill 703

21.4 Gains from Acquisition 703Synergy 703

Revenue Enhancement 704Marketing Gains 704Strategic Benefits 704Market Power 705

Cost Reductions 705Economies of Scale 705Economies of Vertical Integration 706Complementary Resources 706

Lower Taxes 706Net Operating Losses 706Unused Debt Capacity 706Surplus Funds 706

Reductions in Capital Needs 707

Avoiding Mistakes 707A Note on Inefficient Management 708

21.5 Some Financial Side Effects of Acquisitions 708

EPS Growth 708

Diversification 709

21.6 The Cost of an Acquisition 710

S 3 CONTENTS

Case I: Cash Acquisition 710 APPENDIX ACase ii: stock Acquisition 711 Mathematical Tables 725

Cash versus Common Stock 711 APPENDIX B217 Defensive Tactics 712 Using the HP 10B and Tl BA II Plus Financial

Calculators 734The Corporate Charter 712

Repurchase and Standstill Agreements 712 NAME INDEX 739

Poison Pills and Share Rights Plans 712 COMPANY .NDEX 741Going Private and Leveraged Buyouts 714

SUBJECT INDEX 743Other Devices and Jargon of CorporateTakeovers 714

21.8 Some Evidence on Acquisitions: Does M&A Pay? 715

21.9 Divestitures and Restructurings 716Summary and Conclusions 716Closing Case: The East Coast Yachts-West CoastSailboats Merger 723

CONTENTS 0