Lecture Notes in Introduction to Corporate Finance 10275_9789813149885_TP.indd 1 6/2/17 9:25 AM World Scientific Lecture Notes in Finance ISSN: 24249955 Series Editor: Professor Itzhak Venezia Published: Vol. 1 Lecture Notes in Introduction to Corporate Finance by Ivan E. Brick (Rutgers Business School at Newark and New Brunswick, USA) Forthcoming Titles: Lecture Notes in Fixed Income Fundamentals by Eliezer Z. Prisman (York University, Canada) Lecture Notes in Behavioral Finance by Itzhak Venezia (The Hebrew University of Jerusalem, Israel) Lecture Notes in Market Microstructure and Trading by Peter Joakim Westerholm (The University of Sydney, Australia) Lecture Notes in Risk Management by Zvi Wiener and Yevgeny Mugerman (The Hebrew University of Jerusalem, Israel) Shreya - Lecture Notes in Introduction to Corporate Finance.indd 1 02-02-17 8:52:06 AM World Scientific Lecture Notes in Finance – Vol. 1 Lecture Notes in Introduction to Corporate Finance Ivan E Brick Rutgers Business School at Newark and New Brunswick, USA World Scientific NEW JERSEY • LONDON • SINGAPORE • BEIJING • SHANGHAI • HONG KONG • TAIPEI • CHENNAI • TOKYO 10275_9789813149885_TP.indd 2 6/2/17 9:25 AM Published by World Scientific Publishing Co. Pte. Ltd. 5 Toh Tuck Link, Singapore 596224 USA office: 27 Warren Street, Suite 401-402, Hackensack, NJ 07601 UK office: 57 Shelton Street, Covent Garden, London WC2H 9HE Library of Congress Cataloging-in-Publication Data Names: Brick, Ivan E., author. Title: Lecture notes in introduction to corporate finance / Ivan E Brick (Rutgers Business School at Newark and New Brunswick, USA). Description: 1 Edition. | New Jersey : World Scientific, [2017. | Series: World scientific lecture notes in finance ; Volume 1 | Includes bibliographical references and index. Identifiers: LCCN 2017001764| ISBN 9789813149885 (hardcover) | ISBN 9789813149892 (pbk.) Subjects: LCSH: Corporations--Finance. Classification: LCC HG4026 .B6676 2017 | DDC 658.15--dc23 LC record available at https://lccn.loc.gov/2017001764 British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library. Copyright © 2017 by World Scientific Publishing Co. Pte. Ltd. All rights reserved. This book, or parts thereof, may not be reproduced in any form or by any means, electronic or mechanical, including photocopying, recording or any information storage and retrieval system now known or to be invented, without written permission from the publisher. For photocopying of material in this volume, please pay a copying fee through the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, USA. In this case permission to photocopy is not required from the publisher. Desk Editor: Shreya Gopi Typeset by Stallion Press Email: [email protected] Printed in Singapore Shreya - Lecture Notes in Introduction to Corporate Finance.indd 2 02-02-17 8:52:06 AM February 6, 2017 14:30 Lecture Notes in Introduction to Corporate Finance 9in x 6in b2704-fm page v CONTENTS About the Author ix Chapter 1. Introduction 1 WhatisFinance?..................... 1 WhatdoInvestorsWant?................. 2 What are the Concerns of Corporate Management? . 8 WhatistheObjectiveoftheFirm?........... 13 WhyMaximizetheValueoftheStock?......... 15 EfficientMarkets...................... 17 Remaining Misgivings Concerning Value Maximization........................ 18 Chapter 2. Time Value of Money 21 TheTimeValueofMoney................ 21 Finding the Present Value of Future Cash Flows . 21 UsingExceltoCalculatePresentValue......... 24 LumpSumExample.................... 25 Using a Financial Calculator to Calculate Present Value............................ 27 LumpSumExample.................... 27 ThePresentValueofAnAnnuity............ 29 InternalRateofReturn-YieldtoMaturity........ 43 ValuingPerpetuities.................... 49 v February 6, 2017 14:30 Lecture Notes in Introduction to Corporate Finance 9in x 6in b2704-fm page vi vi Lecture Notes in Introduction to Corporate Finance FutureValue........................ 54 MoreAdvancedProblems................. 60 SolutiontoMoreAdvancedProblems.......... 62 Chapter 3. Risk and Return 69 Introduction........................ 69 ExpectedReturn...................... 71 Risk............................. 73 The Mean-Standard Deviation Framework . 74 IntroductiontoPortfolioFinance............. 77 RiskandReturnProblems................ 89 Chapter 4. The Capital Asset Pricing Model 97 Introduction........................ 97 WhatistheObjectiveofthisChapter?......... 98 Assumptions........................ 99 TheCapitalAssetPricingModel............. 105 BacktotheInterview................... 106 SomeObservations:EfficientMarkets.......... 109 AdvancedTopics-CalculatingBeta............ 110 CAPMProblems...................... 115 AnswerstotheProblemSet............... 116 Chapter 5. Capital Budgeting and Company Valuation 119 WhatisCapitalBudgeting?............... 119 WhatisNetPresentValue?................ 120 InternalRateofReturn.................. 122 WhatCouldGoWrong?.................. 124 Will NPV and IRR Always Give the Same Answer?........................... 124 Does NPV Always Work? — Capital Rationing . 126 Does NPV Always Work? — Unequal Lives . 128 How Do We Find the Cost of Funds? . ........ 132 CapitalAssetPricingModel............... 137 MoreComplicatedATWACOC.............. 138 February 6, 2017 14:30 Lecture Notes in Introduction to Corporate Finance 9in x 6in b2704-fm page vii Contents vii HowDoWeDefineCashFlows?............. 143 IncrementalCashFlows.................. 146 CaseStudy-FirmValuation................ 150 SolutionforCaseStudy.................. 150 CapitalBudgetingAppendix............... 153 Do the Various Capital Budgeting Approaches Yield IdenticalNPVs?...................... 155 CapitalBudgetingProblems............... 161 More Advanced Capital Budgeting Problem . 164 SolutiontoProblemSet.................. 165 Chapter 6. The Financing Decision 169 WhatistheFinancingDecision?............. 169 OperatingversusFinancialLeverage........... 173 Question: What Happens to EPS as Leverage Changes?.......................... 176 What Are the Factors that Determine the Optimal FinancingMix?....................... 177 CostofCapitalandLeverage............... 186 FinancingDecisionProblems............... 192 Solution to the Financing Decision Problem Set . 193 AdvancedFinancingDecisionProblems......... 196 Solution to the Advanced Financing Decision ProblemSet........................ 198 Chapter 7. Leasing versus Buying or is it Leasing versus Borrowing? 203 Introduction........................ 203 LeasingforCorporations................. 205 TrueLeaseorInstallmentSale.............. 216 WhyisthereLeasing?................... 217 Subsidized Loans . ............... 218 Bond Refunding . ............... 220 MultipleChoiceQuestions................ 223 February 6, 2017 14:30 Lecture Notes in Introduction to Corporate Finance 9in x 6in b2704-fm page viii viii Lecture Notes in Introduction to Corporate Finance AdvancedProblems.................... 227 SolutiontotheAdvancedProblems........... 228 Chapter 8. Mergers and Acquisitions 233 TheBoardMeeting.................... 233 TypesofMergers...................... 234 Issues Concerning GEM’s Acquisition Policy . 238 EvaluationofMergers................... 239 GEM’sAcquisitionPolicyRevisited........... 242 MergerProblem...................... 244 SolutiontotheProblem.................. 245 Epilogue 247 ConcludingRemarksandAppreciation......... 247 Index 251 February 6, 2017 14:30 Lecture Notes in Introduction to Corporate Finance 9in x 6in b2704-fm page ix ABOUT THE AUTHOR Professor Ivan Brick joined Rutgers Business School at Newark and New Brunswick in 1978. He has been the Chair of the Finance and Economics department since 1996. Professor Brick has pub- lished numerous papers in academic journals such as the Journal of Finance, Journal of Financial Quantitative Analysis, International Economic Review, Review of Economics and Statistics, Journal of Industrial Economics, Journal of Corporate Finance,andFinan- cial Management. His research interests include corporate finance, optimal security design and corporate governance. Currently, he is an associate editor for the Review of Quantitative Finance and Accounting. Previously, he has served as an Associate Editor of Financial Management and Multinational Finance Journal.Profes- sor Brick has received several teaching awards at the Rutgers Busi- ness School. He received the “Outstanding Educator Award” by the 1995 Executive MBA Class. Professor Brick was awarded the “Far- rokh Langdana Excellence in Teaching Award” by the 2011 MBA Class. In 2012, the Newark Undergraduate Program awarded him the Dean’s Advisory Council Award for the “Most Knowledgeable Finance Professor”, “The Most Caring Finance Professor”, as well as “The Most Motivational Finance Professor”. For his outstanding service, Professor Brick was awarded the RBS Dean’s Service Award in 2013 and 2016. ix b2530 International Strategic Relations and China’s National Security: World at the Crossroads This page intentionally left blank b2530_FM.indd 6 01-Sep-16 11:03:06 AM February 6, 2017 14:28 Lecture Notes in Introduction to Corporate Finance 9in x 6in b2704-ch01 page 1 CHAPTER 1 INTRODUCTION What is Finance? Consider a Euro coin. On the right side of the coin are the investors who wish to invest. They invest in financial securities such as stock and debt securities. They also invest in commodities, real estate and derivative securities such as options. Many