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Copyright, iv
Foreword, vii
Preface, xxi
Part I. Finance and the Financial System, 1
Chapter 1. Financial Economics, 1
1.1. Defining Finance, 2
1.2. Why Study Finance?, 3
1.3. Financial Decisions of Households, 4
1.4. Financial Decisions of Firms, 6
1.5. Forms of Business Organization, 8
1.6. Separation of Ownership and Management, 9
1.7. The Goal of Management, 11
1.8. Market Discipline: Takeovers, 14
1.9. The Role of the Finance Specialist in a Corporation, 15
Summary, 17
Questions and Problems, 20
Chapter 2. Financial Markets and Institutions, 23
2.1. What Is the Financial System?, 24
2.2. The Flow of Funds, 24
2.3. The Functional Perspective, 26
Function 1: Transferring Resources across Time and Space, 26
Function 2: Managing Risk, 27
Function 3: Clearing and Settling Payments, 29
Function 4: Pooling Resources and Subdividing Shares, 29
Function 5: Providing Information, 30
Function 6: Dealing with Incentive Problems, 31
2.4. Financial Innovation and the “Invisible Hand”, 34
2.5. Financial Markets, 36
2.6. Financial Market Rates, 37
Interest Rates, 37
Rates of Return on Risky Assets, 40
Market Indexes and Market Indexing, 41
Rates of Return in Historical Perspective, 46
Inflation and Real Interest Rates, 52
Interest Rate Equalization, 56
The Fundamental Determinants of Rates of Return, 56
2.7. Financial Intermediaries, 58
Banks, 58
Other Depository Savings Institutions, 58
Insurance Companies, 59
Pension and Retirement Funds, 59
Mutual Funds, 59
Investment Banks, 59
Venture Capital Firms, 60
Asset Management Firms, 60
Information Services, 60
2.8. Financial Infrastructure and Regulation, 60
Rules for Trading, 61
Accounting Systems, 61
2.9. Governmental and Quasi-Governmental Organizations, 61
Central Banks, 61
Special-Purpose Intermediaries, 62
Regional and World Organizations, 62
Summary, 63
Questions and Problems, 67
Chapter 3. Managing Financial Health and Performance, 71
3.1. Functions of Financial Statements, 72
3.2. Review of Financial Statements, 73
The Balance Sheet, 73
The Income Statement, 75
The Cash Flow Statement, 76
Notes to Financial Statements, 78
3.3. Market Values versus Book Values, 80
3.4. Accounting versus Economic Measures of Income, 82
3.5. Returns to Shareholders versus Return on Book Equity, 83
3.6. Analysis Using Financial Ratios, 83
The Relations among Ratios, 86
The Effect of Financial Leverage, 87
Limitations of Ratio Analysis, 88
3.7. The Financial Planning Process, 88
3.8. Constructing a Financial Planning Model, 89
3.9. Growth and the Need for External Financing, 92
The Firm’s Sustainable Growth Rate, 92
3.10. Working Capital Management, 94
3.11. Liquidity and Cash Budgeting, 96
Summary, 96
Questions and Problems, 99
Part II. Time and Resource Allocation, 107
Chapter 4. Allocating Resources Over Time, 107
4.1. Compounding, 108
Calculating Future Values, 110
Saving for Old Age, 112
Reinvesting at a Different Rate, 112
Paying Back a Loan, 113
4.2. The Frequency of Compounding, 113
4.3. Present Value and Discounting, 114
When a $100 Gift Is Not Really $100, 117
Discounting with Compounding More Frequently Than Annually, 117
4.4. Alternative Discounted Cash Flow Decision Rules, 118
Investing in Land, 121
Other’s People Money, 122
4.5. Multiple Cash Flows, 123
Time Lines, 123
Future Value of a Stream of Cash Flows, 123
Present Value of a Stream of Cash Flows, 124
Investing with Multiple Cash Flows, 124
4.6. Annuities, 124
Future Value of Annuities, 124
Present Value of Annuities, 125
Buying an Annuity, 126
Taking a Mortgage Loan, 127
4.7. Perpetual Annuities, 128
Investing in Preferred Stock, 128
Investing in Common Stock, 129
4.8. Loan Amortization, 129
A Bargain Car Loan?, 130
4.9. Exchange Rates and Time Value of Money, 131
Computing NPV in Different Currencies, 131
4.10. Inflation and Discounted Cash Flow Analysis, 132
Inflation and Future Values, 132
Saving for College: 1, 133
Investing in Inflation-Proof CDs, 134
Why Debtors Gain from Unanticipated Inflation, 134
Inflation and Present Values, 134
Saving for College: 2, 135
Inflation and Savings Plans, 135
Saving for College: 3, 135
Inflation and Investment Decisions, 137
4.11. Taxes and Investment Decisions, 138
Invest in Tax-Exempt Bonds?, 138
Summary, 139
Questions and Problems, 142
Chapter 5. Household Saving and Investment Decisions, 148
5.1. A Life-Cycle Model of Saving, 149
Approach 1: Target Replacement Rate of Preretirement Income, 149
Approach 2: Maintain the Same Level of Consumption Spending, 151
5.2. Taking Account of Social Security, 157
5.3. Deferring Taxes Through Voluntary Retirement Plans, 158
5.4. Should You Invest in a Professional Degree?, 159
5.5. Should You Buy or Rent?, 160
Summary, 161
Questions and Problems, 165
Chapter 6. The Analysis of Investment Projects, 170
6.1. The Nature of Project Analysis, 171
6.2. Where Do Investment Ideas Come From?, 172
6.3. The Net Present Value Investment Rule, 172
6.4. Estimating a Project’s Cash Flows, 174
6.5. Cost of Capital, 176
6.6. Sensitivity Analysis Using Spreadsheets, 178
Break-Even Point, 178
Sensitivity of NPV to Sales Growth, 181
6.7. Analyzing Cost-Reducing Projects, 181
6.8. Projects with Different Lives, 183
6.9. Ranking Mutually Exclusive Projects, 184
6.10. Inflation and Capital Budgeting, 184
Summary, 186
Questions and Problems, 190
Part III. Valuation Models, 197
Chapter 7. Principles of Market Valuation, 197
7.1. The Relation between an Asset’s Value and Its Price, 198
7.2. Value Maximization and Financial Decisions, 198
7.3. The Law of One Price and Arbitrage, 200
7.4. Arbitrage and the Prices of Financial Assets, 201
7.5. Interest Rates and the Law of One Price, 202
7.6. Exchange Rates and Triangular Arbitrage, 203
7.7. Valuation Using Comparables, 205
7.8. Valuation Models, 206
Valuing Real Estate, 206
Valuing Shares of Stock, 207
7.9. Accounting Measures of Value, 207
7.10. How Information Is Reflected in Security Prices, 208
7.11. The Efficient Markets Hypothesis, 209
Summary, 212
Questions and Problems, 215
Chapter 8. Valuation of Known Cash Flows: Bonds, 222
8.1. Using Present Value Factors to Value Known Cash Flows, 223
8.2. The Basic Building Blocks: Pure Discount Bonds, 225
8.3. Coupon Bonds, Current Yield, and Yield to Maturity, 227
Beware of “High-Yield” U.S. Treasury Bond Funds, 230
8.4. Reading Bond Listings, 230
8.5. Why Yields for the Same Maturity May Differ, 231
The Effect of the Coupon Rate, 232
The Effect of Default Risk and Taxes, 233
Other Effects on Bond Yields, 233
8.6. The Behavior of Bond Prices over Time, 234
The Effect of the Passage of Time, 234
Interest-Rate Risk, 236
Summary, 237
Questions and Problems, 240
Chapter 9. Valuation of Common Stocks, 244
9.1. Reading Stock Listings, 245
9.2. The Discounted Dividend Model, 245
The Constant-Growth-Rate, Discounted Dividend Model, 247
9.3. Earnings and Investment Opportunities, 248
9.4. A Reconsideration of the Price/Earnings Multiple Approach, 252
9.5. Does Dividend Policy Affect Shareholder Wealth?, 253
Cash Dividends and Share Repurchases, 253
Stock Dividends, 254
Dividend Policy in a Frictionless Environment, 256
Dividend Policy in the Real World, 257
Summary, 259
Questions and Problems, 261
Part IV. Risk Management and Portfolio Theory, 267
Chapter 10. Principles of Risk Management, 267
10.1. What Is Risk?, 268
Risk Management, 269
Risk Exposure, 270
10.2. Risk and Economic Decisions, 270
Risks Facing Households, 271
Risks Facing Firms, 271
The Role of Government in Risk Management, 272
10.3. The Risk-Management Process, 273
Risk Identification, 273
Risk Assessment, 274
Selection of Risk-Management Techniques, 275
Implementation, 275
Review, 275
10.4. The Three Dimensions of Risk Transfer, 276
Hedging, 276
Insuring, 276
Diversifying, 277
10.5. Risk Transfer and Economic Efficiency, 278
Efficient Bearing of Existing Risks, 279
Risk and Resource Allocation, 279
10.6. Institutions for Risk Management, 280
10.7. Portfolio Theory: Quantitative Analysis for Optimal Risk Management, 282
10.8. Probability Distributions of Returns, 283
10.9. Standard Deviation as a Measure of Risk, 285
Summary, 287
Questions and Problems, 290
Chapter 11. Hedging, Insuring, and Diversifying, 296
11.1. Using Forward and Futures Contracts to Hedge Risk, 297
11.2. Hedging Foreign-Exchange Risk with Swap Contracts, 302
11.3. Hedging Shortfall Risk by Matching Assets to Liabilities, 303
11.4. Minimizing the Cost of Hedging, 303
11.5. Insuring versus Hedging, 304
11.6. Basic Features of Insurance Contracts, 306
Exclusions and Caps, 306
Deductibles, 306
Copayments, 306
11.7. Financial Guarantees, 307
11.8. Caps and Floors on Interest Rates, 307
11.9. Options as Insurance, 307
Put Options on Stocks, 308
Put Options on Bonds, 309
11.10. The Diversification Principle, 310
Diversification with Uncorrelated Risks, 310
Nondiversifiable Risk, 312
11.11. Diversification and the Cost of Insurance, 313
Summary, 315
Questions and Problems, 317
Chapter 12. Portfolio Opportunities and Choice, 333
12.1. The Process of Personal Portfolio Selection, 334
The Life Cycle, 334
Time Horizons, 335
Risk Tolerance, 337
The Role of Professional Asset Managers, 337
12.2. The Trade-Off between Expected Return and Risk, 338
What Is the Riskless Asset?, 338
Combining the Riskless Asset and a Single Risky Asset, 339
Achieving a Target Expected Return: 1, 342
Portfolio Efficiency, 342
12.3. Efficient Diversification with Many Risky Assets, 343
Portfolios of Two Risky Assets, 343
The Optimal Combination of Risky Assets, 346
Selecting the Preferred Portfolio, 347
Achieving a Target Expected Return: 2, 349
Portfolios of Many Risky Assets, 350
Summary, 351
Questions and Problems, 353
Part V. Asset Pricing, 359
Chapter 13. Capital Market Equilibrium, 359
13.1. The Capital Asset Pricing Model in Brief, 360
13.2. Determinants of the Risk Premium on the Market Portfolio, 362
13.3. Beta and Risk Premiums on Individual Securities, 364
13.4. Using the CAPM in Portfolio Selection, 366
13.5. Valuation and Regulating Rates of Return, 368
Discounted Cash Flow Valuation Models, 369
Cost of Capital, 369
Regulation and Cost-Plus Pricing, 370
13.6. Modifications and Alternatives to the CAPM, 370
Summary, 371
Questions and Problems, 372
Chapter 14. Forward and Futures Markets, 377
14.1. Distinctions between Forward and Futures Contracts, 378
14.2. The Economic Function of Futures Markets, 380
14.3. The Role of Speculators, 381
14.4. Relation between Commodity Spot and Futures Prices, 382
14.5. Extracting Information from Commodity Futures Prices, 383
14.6. Forward-Spot Price Parity for Gold, 383
The “Implied” Cost of Carry, 385
14.7. Financial Futures, 386
14.8. The “Implied” Riskless Rate, 388
14.9. The Forward Price Is Not a Forecast of the Future Spot Price, 389
14.10. Forward-Spot Price-Parity Relation With Cash Payouts, 390
14.11. “Implied” Dividends, 391
14.12. The Foreign-Exchange Parity Relation, 391
14.13. The Role of Expectations in Determining Exchange Rates, 392
Summary, 393
Questions and Problems, 396
Chapter 15. Markets for Options and Contingent Claims, 400
15.1. How Options Work, 401
Index Options, 403
15.2. Investing with Options, 404
15.3. The Put-Call Parity Relation, 407
15.4. Volatility and Option Prices, 411
15.5. Two-State (Binomial) Option Pricing, 412
15.6. Dynamic Replication and the Binomial Model, 414
15.7. The Black-Scholes Model, 416
15.8. Implied Volatility, 418
15.9. Contingent Claims Analysis of Corporate Debt and Equity, 420
15.10. Credit Guarantees, 422
A Hypothetical Example, 424
15.11. Other Applications of Option-Pricing Methodology, 425
Summary, 426
Questions and Problems, 429
Part VI. Corporate Finance, 433
Chapter 16. Financial Structure of the Firm, 433
16.1. Internal versus External Financing, 434
16.2. Equity Financing, 435
16.3. Debt Financing, 435
Secured Debt, 436
Long-Term Leases, 436
Pension Liabilities, 437
16.4. The Irrelevance of Capital Structure in a Frictionless Environment, 439
16.5. Creating Value through Financing Decisions, 442
16.6. Reducing Costs, 443
Taxes and Subsidies, 443
Costs of Financial Distress, 446
16.7. Dealing with Conflicts of Interest, 447
Incentive Problems: Free Cash Flow, 447
Conflicts between Shareholders and Creditors, 448
16.8. Creating New Opportunities for Stakeholders, 449
16.9. Financing Decisions in Practice, 449
The Five Companies, 449
The Five Financing Methods, 450
16.10. How to Evaluate Levered Investments, 451
Three Valuation Methods Compared, 451
Summary, 454
Questions and Problems, 457
Chapter 17. Real Options, 465
17.1. Investing in Real Options, 466
Types of Real Options, 466
An Example, 467
17.2. A Deferral Option: The Case of Uncertainty and Irreversibility, 469
Sensitivity Analysis, 471
Valuing the Deferral Option Using the Binomial Option Pricing Model, 472
17.3. Applying the Black-Scholes Formula to Value Real Options, 474
Summary, 477
Questions and Problems, 478
Suggested Readings, 481
Glossary, 484
Index, 491

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