Tenth Edition

FUNDAMENTALS OFCORPORATE FINANCE

Stephen A. RossMassachusetts Institute of Technology

Randolph W. WesterfieldUniversity of Southern California

Bradford D.JordanUniversity of Kentucky

McGraw-HillIrwin

CHAPTER!

INTRODUCTION TO CORPORATE FINANCE 1

1.1 Corporate Finance and the Financial Manager 2What Is Corporate Finance? 2The Financial Manager 2Financial Management Decisions 2

Capital Budgeting 2Capital Structure 3Working Capital Management 4Conclusion 4

1.2 Forms of Business Organization 4Sole Proprietorship 4Partnership 5Corporation 5A Corporation by Another Name . . . 7

1.3 The Goal of Financial Management 7Possible Goals 8The Goal of Financial Management 8A More General Goal 9Sarbanes-Oxley 9

1.4 The Agency Problem and Controlof the Corporation 10Agency Relationships 10Management Goals 10Do Managers Act in the Stockholders! Interests? 11

Managerial Compensation 11Control of the Firm 12Conclusion 12

Stakeholders 121.5 Financial Markets and the Corporation 13

Cash Flows to and from the Firm 14Primary versus Secondary Markets 14

Primary Markets 14Secondary Markets 15

1 Dealer versus Auction Markets 15Trading in Corporate Securities 15Listing 16

1.6 Summary and Conclusions 16

CHAPTER 2

FINANCIAL STATEMENTS, TAXES,AND CASH FLOW 20

2.1 The Balance Sheet 21Assets: The Left Side 21Liabilities and Owners' Equity: The Right Side 21Net Working Capital 22Liquidity 23Debt versus Equity 24Market Value versus Book Value 24

2.2 The Income Statement 25GAAP and the Income Statement 26Noncash Items 27Time and Costs 27

2.3 Taxes 29Corporate Tax Rates 30Average versus Marginal Tax Rates 30

2.4 Cash Flow 32Cash Flow from Assets 32

Operating Cash Flow 33Capital Spending 33Change in Net Working Capital 34Conclusion 34A Note about "Free" Cash Flow 35

Cash Flow to Creditors and Stockholders 35Cash Flow to Creditors 35Cash Flow to Stockholders 35

An Example: Cash Flows for Dole Cola 37Operating Cash Flow 37Net Capital Spending 38Change in NWC and Cash Flow from Assets 38Cash Flow to Stockholders and Creditors 38

2.5 Summary and Cohclusions 39

CHAPTER 3

WORKING WITH FINANCIAL STATEMENTS 48

3.1 Cash Flow and Financial Statements:A Closer Look 49Sources and Uses of Cash 49The Statement of Cash Flows 51

3.2 Standardized Financial Statements 53Common-Size Statements 53

Common-Size Balance Sheets 53Common-Size Income Statements 54Common-Size Statements of Cash Flows 55

Common-Base Year Financial Statements:Trend Analysis 55Combined Common-Size and Base Year Analysis 55

xxxi

3.3 Ratio Analysis 56Short-Term Solvency, or Liquidity, Measures 57

Current Ratio 57The Quick (or Acid-Test) Ratio 58Other Liquidity Ratios 59

Long-Term Solvency Measures 59Total Debt Ratio 59A Brief Digression: Total Capitalization versusTotal Assets 60Times Interest Earned 60Cash Coverage 61

Asset Management, or Turnover, Measures 61Inventory Turnover and Days' Sales in Inventory 61Receivables Turnover and Days' Sales in-Receivables 62Asset Turnover Ratios 63

Profitability Measures 63Profit Margin 64Return on Assets 64Return on Equity 64

Market Value Measures 65Price-Earnings Ratio 65Price-Sales Ratio 65Market-to-Book Ratio 66Enterprise Value-EBITDA Ratio 66

Conclusion 673.4 The DuPont Identity 68

A Closer Look at ROE 68An Expanded DuPont Analysis 69

3.5 Using Financial Statement Information 71Why Evaluate Financial Statements? 71

Internal Uses 72External Uses 72

Choosing a Benchmark 72Time Trend Analysis 72Peer Group Analysis 72

Problems with Financial Statement Analysis 773.6 Summary and Conclusions 78

CHAPTER 4

LONG-TERM FINANCIAL PLANNINGAND GROWTH 90

4.1 What Is Financial Planning? 92Growth as a Financial Management Goal 92Dimensions of Financial Planning 92What Can Planning Accomplish? 93

Examining Interactions 93Exploring Options 93Avoiding Surprises 93Ensuring Feasibility and Internal Consistency 94Conclusion 94

4.2 Financial Planning Models: A First Look 94A Financial Planning Model: The Ingredients 94

Sales Forecast 94Pro Forma Statements 95Asset Requirements 95Financial Requirements 95The Plug 95

Economic Assumptions 96A Simple Financial Planning Model 96

4.3 The Percentage of Sales Approach 97The Income Statement 97The Balance Sheet 98A Particular Scenario 700An Alternative Scenario 707

4.4 External Financing and Growth 704EFN and Growth 704Financial Policy and Growth 706

The Internal Growth Rate 106The Sustainable Growth Rate 107Determinants of Growth 108

A Note about Sustainable Growth RateCalculations 7 70

4.5 Some Caveats regarding FinancialPlanning Models 7 7 7

4.6 Summary and Conclusions 712

CHAPTER 5

INTRODUCTION TO VALUATION: THE TIMEVALUE OF MONEY 722

5.1 Future Value and Compounding 723Investing for a Single Period 723Investing for More Than One Period 723A Note about Compound Growth 729

5.2 Present Value and Discounting 730The Single-Period Case 730Present Values for Multiple Periods 737

5.3 More about Present and Future Values 733Present versus Future Value 734Determining the Discount Rate, 734Finding the Number of Periods 738

5.4 Summary and Conclusions 747

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CHAPTER 6

DISCOUNTED CASH FLOW VALUATION 747

6.1 Future and Present Values of Multiple Cash Flows 748Future Value with Multiple Cash Flows 748Present Value with Multiple Cash Flows 757A Note about Cash Flow Timing 754

6.2 Valuing Level Cash Flows: Annuities andPerpetuities 755Present Value for Annuity Cash Flows 755

Annuity Tables 156Finding the Payment 158Finding the Rate 159

Future Value for Annuities 767A Note about Annuities Due -162Perpetuities 763Growing Annuities and Perpetuities 765

6.3 Comparing Rates: The Effect of Compounding 765Effective Annual Rates and Compounding 766Calculating and Comparing Effective Annual Rates 766EARS and APRS 768

Taking It to the Limit: A Note about ContinuousCompounding 770

6.4 Loan Types and Loan Amortization 7 77Pure Discount Loans 7 77Interest-Only Loans 7 72Amortized Loans 7 72

6.5 Summary and Conclusions 7 77

CHAPTER 7

INTEREST RATES AND BOND VALUATION 792

7.1 Bonds and Bond Valuation 793Bond Features and Prices 193Bond Values and Yields 793Interest Rate Risk 797Finding the Yield to Maturity: More Trial and Error 798

7.2 More about Bond Features 203Is It Debt or Equity? 203Long-Term Debt: The Basics 203The Indenture 205

Terms of a Bond 205Security 206Seniority 206Repayment 206The Call Provision 207Protective Covenants 207

7.3 Bond Ratings 2087.4 Some Different Types of Bonds 209

Government Bonds 209Zero Coupon Bonds 270Floating-Rate Bonds 27 7

Other Types of Bonds 272Sukuk 274

7.5 Bond Markets 275How Bonds Are Bought and Sold 276Bond Price Reporting 276A Note about Bond Price Quotes 277

7.6 Inflation and Interest Rates 279Real versus Nominal Rates 279The Fisher Effect 220Inflation and Present Values 227

7.7 Determinants of Bond Yields 222The Term Structure of Interest Rates 222Bond Yields and the Yield Curve: Putting It AllTogether 223Conclusion 225

7.8 Summary and Conclusions 226

CHAPTER 8

STOCK VALUATION 234

8.1 Common Stock Valuation 235Cash Flows 235Some Special Cases 237

Zero Growth 237Constant Growth 237Nonconstant Growth 240Two-Stage Growth 242

Components of the Required Return 243Stock Valuation Using Multiples 244

8.2 Some Features of Common and PreferredStocks 246Common Stock Features 246

Shareholder Rights 246Proxy Voting 247Classes of Stock 247Other Rights 248Dividends 248

Preferred Stock Features 249Stated Value 249Cumulative and Noncumulative Dividends 249Is Preferred Stock Really Debt? 249

8.3 The Stock Markets 250Dealers and Brokers 250Organization of the NYSE 257

Members 251Operations 252Floor Activity 252

NASDAQ Operations 253ECNs 254

Stock Market Reporting 2548.4 Summary and Conclusions 256

CHAPTER 9

NET PRESENT VALUE AND OTHER INVESTMENTCRITERIA 266

9.1 Net Present Value 267The Basic Idea 267Estimating Net Present Value 268

9.2 The Payback Rule 277Defining the Rule 277Analyzing the Rule 272Redeeming Qualities of the Rule 273Summary of the Rule 274

9.3 The Discounted Payback 2749.4 The Average Accounting Return 2779.5 The Internal Rate of Return 279

Problems with the IRR 283Nonconventional Cash Flows 283Mutually Exclusive Investments 285Investing or Financing? 287

Redeeming Qualities of the IRR 288The Modified Internal Rate of Return (MIRR) 289

Method # 7; The Discounting Approach 289Method #2: The Reinvestment Approach 289Method #3: The Combination Approach 289MIRR or IRR: Which Is Better? 290

9.6 The Profitability Index 2909.7 The Practice of Capital Budgeting 2979.8 Summary and Conclusions 294

CHAPTER 10

MAKING CAPITAL INVESTMENT DECISIONS 305

10.1 Project Cash Flows: A First Look 306Relevant Cash Flows 306The Stand-Alone Principle 306

10.2 Incremental Cash Flows 307Sunk Costs 307Opportunity Costs 307Side Effects 308Net Working Capital 308Financing Costs 308Other Issues 309

10.3 Pro Forma Financial Statements and ProjectCash Flows 309Getting Started: Pro Forma Financial Statements 309Project Cash Flows 370

Project Operating Cash Flow 310Project Net Working Capital and Capital Spending 311

Projected Total Cash Flow and Value 37 7

10.4 More about Project Cash Flow 372A Closer Look at Net Working Capital 372Depreciation 375

Modified ACRS Depreciation (MACRS) 315Book Value versus Market Value 316

An Example: The Majestic Mulch and CompostCompany (MMCC) 378

Operating Cash Flows 318Change in NWC 318Capital Spending 321Total Cash Flow and Value 321Conclusion 321

10.5 Alternative Definitions of Operating Cash Flow 322The Bottom-Up Approach 323The Top-Down Approach 323The Tax Shield Approach 323Conclusion 324

10.6 Some Special Cases of DiscountedCash Flow Analysis 324Evaluating Cost-Cutting Proposals 324Setting the Bid Price 326Evaluating Equipment Options with Different Lives 328

10.7 Summary and Conclusions 330

CHAPTER 11

PROJECT ANALYSIS AND EVALUATION 343

11.1 Evaluating NPV Estimates 344The Basic Problem 344Projected versus Actual Cash Flows 344Forecasting Risk 344Sources of Value 345

11.2 Scenario and Other What-lf Analyses 346Getting Started 346Scenario Analysis 347Sensitivity Analysis 349Simulation Analysis 350

11.3 Break-Even Analysis 357Fixed and Variable Costs 357

Variable Costs 351Fixed Costs 353Total Costs 353

Accounting Break-Even 354Accounting Break-Even: A Closer Look 355Uses for the Accounting Break-Even 356

11.4 Operating Cash Flow, Sales Volume, andBreak-Even 357Accounting Break-Even and Cash Flow 357

The Base Case 357

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Calculating the Break-Even Level 358Payback and Break-Even 358

Sales Volume and Operating Cash FlowCash Flow, Accounting, and FinancialBreak-Even Points 359

Accounting Break-Even Revisited 359Cash Break-Even 360Financial Break-Even 360Conclusion 360

358

11.5 Operating Leverage 362The Basic Idea 362Implications of Operating Leverage 362Measuring Operating Leverage 362Operating Leverage and Break-Even 364

11.6 Capital Rationing 364Soft Rationing 365Hard Rationing 365

11.7 Summary and Conclusions 365

CHAPTER 12 CHAPTER 13

SOME LESSONS FROM CAPITAL MARKET HISTORY 374 RETURN, RISK, AND THE SECURITY MARKET LINE 472

12.1 Returns 375Dollar Returns 375Percentage Returns 377

12.2 The Historical Record 379A First Look 379A Closer Look 387

12.3 Average Returns: The First Lesson 385Calculating Average Returns 385Average Returns: The Historical Record 385Risk Premiums 386

The First Lesson 38612.4 The Variability of Returns: The Second Lesson 387

Frequency Distributions and Variability 387The Historical Variance and Standard Deviation 388The Historical Record 390Normal Distribution 397The Second Lesson 3922008: The Bear Growled and Investors Howled 392Using Capital Market History 394More on the Stock Market Risk Premium 394

12.5 More about Average Returns 396Arithmetic versus Geometric Averages 396Calculating Geometric Average Returns 396Arithmetic Average Return or Geometric AverageReturn? 399

12.6 Capital Market Efficiency 400Price Behavior in an Efficient Market 400The Efficient Markets Hypothesis 407Some Common Misconceptions about the EMH 402The Forms of Market Efficiency 403

12.7 Summary and Conclusions 404

13.1 Expected Returns and Variances 473Expected Return 473Calculating the Variance 475

13.2 Portfolios 476Portfolio Weights 477Portfolio Expected Returns 47 7Portfolio Variance 478

13.3 Announcements, Surprises, and ExpectedReturns 420Expected and Unexpected Returns 420Announcements and News 420

13.4 Risk: Systematic and Unsystematic 422Systematic and Unsystematic Risk 422Systematic and Unsystematic Components ofReturn 422

13.5 Diversification and Portfolio Risk 423The Effect of Diversification: Another Lessonfrom Market History 423The Principle of Diversification 424Diversification and Unsystematic Risk 425Diversification and Systematic Risk 426

13.6 Systematic Risk and Beta 426The Systematic Risk Principle 427Measuring Systematic Risk 427Portfolio Betas 429

13.7 The Security Market Line 430Beta and the Risk Premium 430 ——

The Reward-to-Risk Ratio 431The Basic Argument 432The Fundamental Result 434

The Security Market Line 435Market Portfolios 435The Capital Asset Pricing Model 435

13.8 The SML and the Cost of Capital: A Preview 438The Basic Idea 438The Cost of Capital 438

13.9 Summary and Conclusions 439

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CHAPTER 14

COST OF CAPITAL 449

14.1

14.2

14.3

14.4

14.5

14.6

14.7

The Cost of Capital: Some Preliminaries 450Required Return versus Cost of Capital 450Financial Policy and Cost of Capital 457The Cost of Equity 457The Dividend Growth Model Approach 457

Implementing the Approach 451Estimating g 452Advantages and Disadvantages of the Approach 453

The SML Approach 453Implementing the Approach 454Advantages and Disadvantages of the Approach 454

The Costs of Debt and Preferred Stock 455The Cost of Debt 455The Cost of Preferred Stock 456The Weighted Average Cost of Capital 457The Capital Structure Weights 457Taxes and the Weighted Average Cost of Capital 458Calculating the WACC for Eastman Chemical 459

Eastman's Cost of Equity 459Eastman's Cost of Debt 461Eastman's WACC 462

Solving the Warehouse Problem and Similar CapitalBudgeting Problems 462Performance Evaluation: Another Use of the WACC 465Divisional and Project Costs of Capital 466The SML and the WACC 467Divisional Cost of Capital 468The Pure Play Approach 468The Subjective Approach 469Flotation Costs and the Weighted Average Cost ofCapital 470Tfye Basic Approach 477

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Summary and Conclusions 474

Flotation Costs and NPVInternal Equity and Flotation Costs

CHAPTER 15

RAISING CAPITAL 483

15.1 The Financing Life Cycle of a Firm: Early-StageFinancing and Venture Capital 484Venture Capital 484Some Venture Capital Realities 485Choosing a Venture Capitalist 485Conclusion 486

15.2 Selling Securities to the Public: The BasicProcedure 486

15.3 Alternative Issue Methods 48715.4 Underwriters 489

Choosing an Underwriter 490Types of Underwriting 490

Firm Commitment Underwriting 490Best Efforts Underwriting 491Dutch Auction Underwriting 491

The Aftermarket 497The Green Shoe Provision 492Lockup Agreements 492The Quiet Period 492

15.5 IPOs and Underpricing 493IPO Underpricing: The 1999-2000 Experience 493Evidence on Underpricing 493Why Does Underpricing Exist? 498

15.6 New Equity Sales and the Value of the Firm 49915.7 The Costs of Issuing Securities 500

The Costs of Selling Stock to the Public 500The Costs of Going Public: A Case Study 504

15.8 Rights 504The Mechanics of a Rights Offering 504Number of Rights Needed to Purchase a Share 505The Value of a Right 506Ex Rights 508The Underwriting Arrangements 509Effects on Shareholders 509

15.9 Dilution 570Dilution of Proportionate Ownership 570Dilution of Value: Book versus Market Values 570

A Misconception 511The Correct Arguments 512

15.10 Issuing Long-Term Debt 57215.11 Shelf Registration 57315.12 Summary and Conclusions 574

CHAPTER 16

FINANCIAL LEVERAGE AND CAPITALSTRUCTURE POLICY 527

16.1 The Capital Structure Question 522Firm Value and Stock Value: An Example 522Capital Structure and the Cost of Capital 523

16.2 The Effect of Financial Leverage 524The Basics of Financial Leverage 524

Financial Leverage, EPS, and ROE: An Example 524EPS versus EBIT 525

Corporate Borrowing and Homemade Leverage 52716.3 Capital Structure and the Cost of Equity Capital 528

M&M Proposition I: The Pie Model 528

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The Cost of Equity and Financial Leverage: M&MProposition II 529Business and Financial Risk 537

16.4 M&M Propositions I and II with Corporate Taxes 532The Interest Tax Shield 533Taxes and M&M Proposition I 533Taxes, the WACC, and Proposition II 534Conclusion 535

16.5 Bankruptcy Costs 537Direct Bankruptcy Costs 538Indirect Bankruptcy Costs 538

16.6 Optimal Capital Structure 539The Static Theory of Capital Structure 539Optimal Capital Structure and the Cost of Capital 540Optimal Capital Structure: A Recap 547Capital Structure: Some ManagerialRecommendations 543

Taxes 543Financial Distress 543

16.7 The Pie Again 543The Extended Pie Model 544Marketed Claims versus Nonmarketed Claims 545

16.8 The Pecking-Order Theory 545Internal Financing and the Pecking Order 545Implications of the Pecking Order 546

16.9 Observed Capital Structures 54716.10 A Quick Look at the Bankruptcy Process 549

Liquidation and Reorganization 549Bankruptcy Liquidation 549Bankruptcy Reorganization 550

Financial Management and the BankruptcyProcess ,557Agreements to Avoid Bankruptcy 552

16.11 Summary and Conclusions 553

CHAPTER 17

t DIVIDENDS AND PAYOUT POLICY 560

17.1 /Cash Dividends and Dividend Payment 567Cash Dividends 567Standard Method of Cash Dividend Payment 567Dividend Payment: A Chronology 562More about the Ex-Dividend Date 562

17.2 Does Dividend Policy Matter? 564An Illustration of the Irrelevance of Dividend Policy 564

Current Policy: Dividends Set Equal to Cash Flow 565Alternative Policy: Initial Dividend Greater Than CashFlow 565

Homemade Dividends 565A Test 566

17.3 Real-World Factors Favoring a Low DividendPayout 567Taxes 567Flotation Costs 567Dividend Restrictions 567

17.4 Real-World Factors Favoring a High DividendPayout 568Desire for Current Income 568Tax and Other Benefits from High Dividends 569

Corporate Investors 569Tax-Exempt Investors 569

Conclusion 56917.5 A Resolution of Real-World Factors? 569

Information Content of Dividends 569The Clientele Effect 577

17.6 Stock Repurchases: An Alternative to Cash• Dividends 577

Cash Dividends versus Repurchase 573Real-World Considerations in a Repurchase 574Share Repurchase and EPS 575

17.7 What We Know and Do NotKnow about Dividend and Payout Policies 575Dividends and Dividend Payers 575Corporations Smooth Dividends 578Putting It All Together 578Some Survey Evidence on Dividends 580

17.8 Stock Dividends and Stock Splits 582Some Details about Stock Splits and StockDividends 582

Example of a Small Stock Dividend 582Example of a Stock Split 583Example of a Large Stock Dividend 583

Value of Stock Splits and Stock Dividends 583The Benchmark Case 584Popular Trading Range 584

Reverse Splits 58417.9 Summary and Conclusions 585

CHAPTER 18 19-2

SHORT-TERM FINANCE AND PLANNING 593

18.1 Tracing Cash and Net Working Capital 59418.2 The Operating Cycle and the Cash Cycle 595

Defining the Operating and Cash Cycles 596The Operating Cycle 596The Cash Cycle 596

The Operating Cycle and the Firm's OrganizationalChart 597Calculating the Operating and Cash Cycles 598 19.3

The Operating Cycle 599The Cash Cycle 600

Interpreting the Cash Cycle 60718.3 Some Aspects of Short-Term Financial Policy 607

The Size of the Firm's Investment in Current Assets 602Alternative Financing Policies for Current Assets 603 19.4

An Ideal Case 603Different Policies for Financing Current Assets 603

Which Financing Policy Is Best? 606Current Assets and Liabilities in Practice 607

18.4 The Cash Budget 608 19.5Sales And Cash Collections 608Cash Outflows 609The Cash Balance 609

18.5 Short-Term Borrowing 670Unsecured Loans 67 7

Compensating Balances 611Cost of a Compensating Balance 611Letters of Credit 612

Secured Loans 672

Accounts Receivable Financing 612 19.6Inventory Loans 613 19A

Other Sources 673*18.6 A, Short-Term Financial Plan 67418.7 Summary and Conclusions 675

CHAPTER 19

CASH AND LIQUIDITY MANAGEMENT 626

19.1 Reasons for Holding Cash 627

The Speculative and Precautionary Motives 627The Transaction Motive 627Compensating Balances 627Costs of Holding Cash 627Cash Management versus Liquidity Management 628

Understanding Float 628Disbursement Float 628Collection Float and Net Float 629Float Management 630

Measuring Float 630Some Details 631Cost of the Float 631Ethical and Legal Questions 633

Electronic Data Interchange and Check 21: TheEnd of Float? 634Cash Collection and Concentration 635Components of Collection Time 635Cash Collection 635Lockboxes 635Cash Concentration 637Accelerating Collections: An Example 638Managing Cash Disbursements 639Increasing Disbursement Float 639Controlling Disbursements 640

Zero-Balance Accounts 640Controlled Disbursement Accounts 641

Investing Idle Cash 647Temporary Cash Surpluses 647

Seasonal or Cyclical Activities 641Planned or Possible Expenditures 641

Characteristics of Short-Term Securities 642Maturity 642Default Risk 642Marketability 642Taxes 642

Some Different Types of Money Market Securities 643Summary and Conclusions 644Determining the Target Cash Balance 649The Basic Idea 649The BAT Model 650

The Opportunity Costs 651The Trading Costs 652The Total Cost 652The Solution 652Conclusion 654

The Miller-Orr Model: A More General Approach 654The Basic Idea 654Using the Model 654

Implications of the BAT and Miller-Orr Models 655Other Factors Influencing the Target Cash Balance 656

CHAPTER 20

CREDIT AND INVENTORY MANAGEMENT 659

20.1 Credit and Receivables 660Components of Credit Policy 660The Cash Flows from Granting Credit 660The Investment in Receivables 667

20.2 Terms of the Sale 667The Basic Form 662The Credit Period 662

The Invoice Date 662Length of the Credit Period 662

Cash Discounts 663Cost of the Credit 664Trade Discounts 664The Cash Discount and the ACP 664

Credit Instruments 66520.3 Analyzing Credit Policy 665

Credit Policy Effects 665Evaluating a Proposed Credit Policy 666

NPV of Switching Policies 666A Break-Even Application 668

20.4 Optimal Credit Policy 668The Total Credit Cost Curve 668Organizing the Credit Function 669

20.5 Credit Analysis 670When Should Credit Be Granted? 670

A One-Time Sale 670Repeat Business 671

Credit Information 672Credit Evaluation and Scoring 672

20.6 Collection Policy 673Monitoring Receivables 673Collection Effort 674

20.7 Inventory Management 674The Financial Manager and Inventory PolicyInventory Types 675Inventory Costs 675

20.8 Inventory Management Techniques 676The ABC Approach 676The Economic Order Quantity Model 676

Inventory Depletion 678The Carrying Costs 678The Restocking Costs 679The Total Costs 679

Extensions to the EOQ Model 687Safety Stocks 681Reorder Points 681

Managing Derived-Demand Inventories 687Materials Requirements Planning 683Just-in-Time Inventory 683

20.9 Summary and Conclusions 68320A More about Credit Policy Analysis 690

Two Alternative Approaches 690The One-Shot Approach 690The Accounts Receivable Approach 691

Discounts and Default Risk 692NPV of the Credit Decision 693A Break-Even Application 693

674

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CHAPTER 21

INTERNATIONAL CORPORATE FINANCE 697

21.1 Terminology 69821.2 Foreign Exchange Markets and Exchange Rates 699

Exchange Rates 700Exchange Rate Quotations 700Cross-Rates and Triangle Arbitrage 701Types of Transactions 703

21.3 Purchasing Power Parity 704Absolute Purchasing Power Parity 704Relative Purchasing Power Parity 706

The Basic Idea 706The Result 706Currency Appreciation and Depreciation 707

21.4 Interest Rate Parity, Unbiased Forward Rates, andthe International Fisher Effect 708Covered Interest Arbitrage 708Interest Rate Parity 709Forward Rates and Future Spot Rates 770Putting It All Together 770

Uncovered Interest Parity 711 "~The International Fisher Effect 711

21.5 International Capital Budgeting 772Method 1: The Home Currency Approach 772Method 2: The Foreign Currency Approach 773Unremitted Cash Flows 774

21.6 Exchange Rate Risk 774Short-Run Exposure 774Long-Run Exposure 775

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Translation Exposure 776Managing Exchange Rate Risk 77 7

21.7 Political Risk 77721.8 Summary and Conclusions 778

APPENDIX A

MATHEMATICAL TABLES A-1

APPENDIX B

KEY EQUATIONS B-1

APPENDIX C

ANSWERS TO SELECTED END-OF-CHAPTERPROBLEMS C

APPENDIX D

USING THE HP 10B AND Tl BA IIPLUS FINANCIAL CALCULATORS D

Index /