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Fundamentals of
Corporate Finance
Tenth
EDITION
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Fundamentals of
Corporate Finance
Tenth
EDITION
Richard A. Brealey
London Business School
Stewart C. Myers
Sloan School of Management,
Massachusetts Institute of Technology
Alan J. Marcus
Carroll School of Management,
Boston College
FUNDAMENTALS OF CORPORATE FINANCE, TENTH EDITION
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Library of Congress Cataloging-in-Publication Data
Brealey, Richard A., author. | Myers, Stewart C., author. | Marcus, Alan J., author.
Fundamentals for corporate finance / Richard A. Brealey, London
Business School, Stewart C. Myers, Sloan School of Management,
Massachusetts Institute of Technology, Alan J. Marcus, Carroll School of
Management, Boston College.
Tenth Edition. | Dubuque, IA : McGraw-Hill Education, [2019] |
Revised edition of Fundamentals of corporate finance, [2018] | Includes
bibliographical references and index.
LCCN 2018047649 | ISBN 9781260013962 (student edition : alk. paper)
LCSH: Corporations?Finance.
LCC HG4026 .B6668 2019 | DDC 658.15?dc23
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Dedication
To Our Families
About
The Authors
Richard A. Brealey
Professor of Finance at the London Business School
Professor Brealey is the former president of the European Finance Association and
a former director of the American Finance Association. He is a fellow of the British
Academy and has served as Special Adviser to the Governor of the Bank of England
and as director of a number of financial institutions. Professor Brealey is also the
author (with Professor Myers and Franklin Allen) of this book?s sister text, Principles
of Corporate Finance (McGraw-Hill Education).
Courtesy of Richard A. Brealey
Stewart C. Myers
Gordon Y Billard Professor of Finance at MIT?s Sloan School of Management
Dr. Myers is past president of the American Finance Association and a research
associate of the National Bureau of Economic Research. His research has focused on
financing decisions, valuation methods, the cost of capital, and financial aspects of
government regulation of business. Dr. Myers is a director of The Brattle Group, Inc.
and is active as a financial consultant. He is also the author (with Professor Brealey
and Franklin Allen) of this book?s sister text, Principles of Corporate Finance
(McGraw-Hill Education).
Courtesy of Stewart C. Myers
Alan J. Marcus
Mario Gabelli Professor of Finance in the Carroll School of Management at Boston
College
Professor Marcus?s main research interests are in derivatives and securities m
? arkets.
He is co-author (with Zvi Bodie and Alex Kane) of the texts Investments and
Essentials of Investments (McGraw-Hill Education). Professor Marcus has served as
a research fellow at the National Bureau of Economic Research. Professor Marcus
also spent two years at Freddie Mac, where he helped to develop mortgage pricing
and credit risk models. He currently serves on the Research Foundation Advisory
Board of the CFA Institute.
Courtesy of Alan J. Marcus
vi
Preface
This book is an introduction to corporate finance. It focuses on how companies invest
in real assets, how they raise the money to pay for the investments, and how those
assets ultimately affect the value of the firm. It also provides a broad overview of the
financial landscape, discussing, for example, the major players in financial markets,
the role of financial institutions in the economy, and how securities are traded and
valued by investors. The book offers a framework for systematically thinking about
most of the important financial problems that both firms and individuals are likely to
confront.
Financial management is important, interesting, and challenging. It is important
because today?s capital investment decisions may determine the businesses that the
firm is in 10, 20, or more years ahead. Needless to say, a firm?s success or failure
also depends, in large part, on its ability to find the capital that it requires.
Finance is interesting for several reasons. Financial decisions often involve huge
sums of money. Large investment projects or acquisitions may involve billions of dollars. Also, the financial community is international and fast-moving, with colorful
heroes and a sprinkling of unpleasant villains.
Finance is challenging. Financial decisions are rarely cut and dried, and the financial markets in which companies operate are changing rapidly. Good managers can
cope with routine problems, but only the best managers can respond to change. To
handle new problems, you need more than rules of thumb; you need to understand
why companies and financial markets behave as they do and when common practice
may not be best practice. Once you have a consistent framework for making financial
decisions, complex problems become more manageable.
This book provides that framework. It is not an encyclopedia of finance. It
focuses instead on setting out the basic principles of financial management and
applying them to the main decisions faced by the financial manager. It explains
how managers can make choices between investments that may pay off at different
points of time or have different degrees of risk. It also describes the main features
of financial markets and discusses why companies may prefer a particular source
of finance.
We organize the book around the key concepts of modern finance. These concepts,
properly explained, simplify the subject. They are also practical. The tools of financial
management are easier to grasp and use effectively when presented in a consistent
conceptual framework. This text provides that framework.
Modern financial management is not ?rocket science.? It is a set of ideas that can be
made clear by words, graphs, and numerical examples. The ideas provide the ?why?
behind the tools that good financial managers use to make investment and financing
decisions.
We wrote this book to make financial management clear, useful, and fun for the
beginning student. We set out to show that modern finance and good financial practice
go together, even for the financial novice.
Fundamentals and Principles of Corporate Finance
This book is derived in part from its sister text Principles of Corporate Finance. The
spirit of the two books is similar. Both apply modern finance to give students a working ability to make financial decisions. However, there are also substantial differences
between the two books.
vii
viii
Preface
First, we provide in Fundamentals much more detailed discussion of the principles and mechanics of the time value of money. This material underlies almost all of
this text, and we spend a lengthy chapter providing extensive practice with this key
concept.
Second, we use numerical examples in this text to a greater degree than in Principles.
Each chapter presents several detailed numerical examples to help the reader become
familiar and comfortable with the material.
Third, we have streamlined the treatment of most topics. Whereas Principles has
34 chapters, Fundamentals has only 25. The relative brevity of Fundamentals necessitates a broader-brush coverage of some topics, but we feel that this is an advantage
for a beginning audience.
Fourth, we assume little in the way of background knowledge. While most users
will have had an introductory accounting course, we review the concepts of accounting that are important to the financial manager in Chapter 3.
Principles is known for its relaxed and informal writing style, and we continue
this tradition in Fundamentals. In addition, we use as little mathematical notation as
possible. Even when we present an equation, we usually write it in words rather than
symbols. This approach has two advantages. It is less intimidating, and it focuses
attention on the underlying concept rather than the formula.
Organizational Design
Fundamentals is organized in eight parts.
Part 1 (Introduction) provides essential background material. In the first chap-
ter, we discuss how businesses are organized, the role of the financial manager,
and the financial markets in which the manager operates. We explain how shareholders with many disparate goals might all agree that they want managers to
take actions that increase the value of their investment, and we introduce the
concept of the opportunity cost of capital and the trade-off that the firm needs
to make when assessing investment proposals. We also describe some of the
mechanisms that help to align the interests of managers and shareholders. Of
course, the task of increasing shareholder value does not justify corrupt and
unscrupulous behavior. We, therefore, discuss some of the ethical issues that
confront managers.
Chapter 2 surveys and sets out the functions of financial markets and institutions.
This chapter also reviews the crisis of 2007?2009. The events of those years illustrate
clearly why and how financial markets and institutions matter.
A large corporation is a team effort, so the firm produces financial statements to
help the players monitor its progress. Chapter 3 provides a brief overview of these
financial statements and introduces two key distinctions?between market and book
values and between cash flows and profits. This chapter also discusses some of the
shortcomings in accounting practice. The chapter concludes with a summary of federal taxes.
Chapter 4 provides an overview of financial statement analysis. In contrast to most
introductions to this topic, our discussion is motivated by considerations of valuation
and the insight that financial ratios can provide about how management has added to
the firm?s value.
Part 2 (Value) is concerned with valuation. In Chapter 5, we introduce the concept of
the time value of money, and because most readers will be more familiar with their
own financial affairs than with the big leagues of finance, we motivate our discussion
by looking first at some personal financial decisions. We show how to value long-lived
Preface
ix
streams of cash flows and work through the valuation of perpetuities and annuities.
Chapter 5 also contains a short concluding section on inflation and the distinction
between real and nominal returns.
Chapters 6 and 7 introduce the basic features of bonds and stocks and give students a chance to apply the ideas of Chapter 5 to the valuation of these securities.
We show how to find the value of a bond given its yield, and we show how prices
of bonds fluctuate as interest rates change. We look at what determines stock prices
and how stock valuation formulas can be used to infer the return that investors
expect. Finally, we see how investment opportunities are reflected in the stock price
and why analysts focus on the price-earnings multiple. Chapter 7 also introduces
the concept of market efficiency. This concept is crucial to interpreting a stock?s
valuation; it also provides a framework for the later treatment of the issues that
arise when firms issue securities or make decisions concerning dividends or capital
structure.
The remaining chapters of Part 2 are concerned with the company?s investment
decision. In Chapter 8, we introduce the concept of net present value and show how
to calculate the NPV of a simple investment project. We then consider more complex
investment proposals, including choices between alternative projects, machine replacement decisions, and decisions of when to invest. We also look at other measures of an
investment?s attractiveness?its internal rate of return, profitability index, and payback
period. We show how the profitability index can be used to choose between investment projects when capital is scarce. The appendix to Chapter 8 shows how to sidestep
some of the pitfalls of the IRR rule.
The first step in any NPV calculation is to decide what to discount. Therefore, in
Chapter 9, we work through a realistic example of a capital budgeting analysis, showing how the manager needs to recognize the investment in working capital and how
taxes and depreciation affect cash flows.
We start Chapter 10 by looking at how companies organize the investment
process and ensure everyone works toward a common goal. We then go on to
look at various techniques to help managers identify the key assumptions in their
estimates, such as sensitivity analysis, scenario analysis, and break-even analysis.
We explain the distinction between accounting break-even and NPV break-even.
We conclude the chapter by describing how managers try to build future flexibility into projects so that they can capitalize on good luck and mitigate the consequences of bad luck.
Part 3 (Risk) is concerned with the cost of capital. Chapter 11 starts with a historical
survey of returns on bonds and stocks and goes on to distinguish between the specific
risk and market risk of individual stocks. Chapter 12 shows how to measure market
risk and discusses the relationship between risk and expected return. Chapter 13 introduces the weighted-average cost of capital and provides a practical illustration of how
to estimate it.
Part 4 (Financing) begins our discussion of the financing decision. Chapter 14 provides an overview of the securities that firms issue and their relative importance as
sources of finance. In Chapter 15, we look at how firms issue securities, and we follow
a firm from its first need for venture capital, through its initial public offering, to its
continuing need to raise debt or equity.
Part 5 (Debt and Payout Policy) focuses on the two classic long-term financ-
ing decisions. In Chapter 16, we ask how much the firm should borrow, and we
summarize bankruptcy procedures that occur when firms can?t pay their debts. In
x
Preface
Chapter 17, we study how firms should set dividend and payout policy. In each
case, we start with Modigliani and Miller?s (MM?s) observation that in wellfunctioning markets, the decision should not matter, but we use this initial observation to help the reader understand why financial managers in practice do pay
attention to these decisions.
Part 6 (Financial Analysis and Planning) starts with long-term financial planning in Chapter 18, where we look at how the financial manager considers the combined effects of investment and financing decisions on the firm as a whole. We also
show how measures of internal and sustainable growth help managers check that
the firm?s planned growth is consistent with its financing plans. Chapter 19 is an
introduction to short-term financial planning. It shows how managers ensure that
the firm will have enough cash to pay its bills over the coming year. Chapter 20
addresses working capital management. It describes the basic steps of credit management, the principles of inventory management, and how firms handle payments
efficiently and put cash to work as quickly as possible. It also describes how firms
invest temporary surpluses of cash and how they can borrow to offset any temporary
deficiency. Chapter 20 is conceptually straightforward, but it contains a large dollop
of institutional material.
Part 7 (Special Topics) covers several important but somewhat more advanced
t? opics?mergers (Chapter 21), international financial management (Chapter 22),
options (Chapter 23), and risk management (Chapter 24). Some of these topics
are touched on in earlier chapters. For example, we introduce the idea of options
in Chapter 10, when we show how companies build flexibility into capital projects. However, Chapter 23 generalizes this material, explains at an elementary
level how options are valued, and provides some examples of why the financial
manager needs to be concerned about options. International finance is also not
confined to Chapter 22. As one might expect from a book that is written by
an international group of authors, examples from different countries and financial systems are scattered throughout the book. However, Chapter 22 tackles
the specific problems that arise when a corporation is confronted by different
currencies.
Part 8 (Conclusion) contains a concluding chapter (Chapter 25), in which we review
the most important ideas covered in the text. We also introduce some interesting questions that either were unanswered in the text or are still puzzles to the finance profession. Thus, the last chapter is an introduction to future finance courses as well as a
conclusion to this one.
Routes through the Book
There are about as many effective ways to organize a course in corporate finance as
there are teachers. For this reason, we have ensured that the text is modular so that topics can be introduced in different sequences.
We like to discuss the principles of valuation before plunging into financial planning. Nevertheless, we recognize that many instructors will prefer to move directly
from Chapter 4 (Measuring Corporate Performance) to Chapter 18 (Long-Term
Financial Planning) in order to provide a gentler transition from the typical prerequisite
accounting course. We have made sure that Part 6 (Financial Analysis and Planning)
can easily follow Part 1.
Similarly, we like to discuss working capital only after the student is familiar with
the basic principles of valuation and financing, but we recognize that here also
Preface
xi
many instructors prefer to reverse our order. There should be no difficulty in taking
Chapter 20 out of order.
When we discuss project valuation in Part 2, we stress that the opportunity cost of
capital depends on project risk. But we do not discuss how to measure risk or how
return and risk are linked until Part 3. This ordering can easily be modified. For example, the chapters on risk and return can be introduced before, after, or midway through
the material on project valuation.
Changes in the Tenth Edition
Users of previous editions of this book will not find dramatic changes in either
the material or the ordering of topics. But, throughout, we have made the book
more up to date and easier to read. Here are some of the ways that we have
done this.
Beyond the Page The Beyond the Page digital extensions and applications provide
additional examples, anecdotes, spreadsheet programs, and more thoroughgoing
explanations of some topics. This material is very easily accessed on the web. In this
edition, we have updated them and added a number of additional applications and
made them easier to access. For example, the applications are seamlessly available
with a click on the e-version of the book, but they are also readily accessible in the
traditional hard copy of the text using the shortcut URLs provided in the margins of
relevant pages.
Improving the Flow A major part of our effort in revising this text was spent on
improving the flow. Often this has meant a word change here or a redrawn diagram
there, but sometimes we have made more substantial changes. One example is the discussion of discounted cash flow analysis in Chapter 9. Rather than presenting a series
of disconnected examples, we now illustrate the many aspects of cash flow analysis in
one integrated application. The material is substantially unchanged, but we think that
the flow is much improved.
Updating Major updates in this edition revolved around the implications of recent
tax reform legislation. The Tax Cuts and Jobs Act of 2017 mandated substantial
changes in corporate and personal tax rates as well as in the tax treatment of depreciation and investment income. All of these changes potentially affect firms? capital
budgeting and financing decisions.
Of course, in each new edition we also try to ensure that any statistics are as up to
date as possible. For example, since the previous edition, we have available an extra
2 years of data on security returns. These show up in the figures in Chapter 11 of
the long-run returns on stocks, bonds, and bills. Measures of EVA, data on security
ownership, dividend payments, and stock repurchases are just a few of the other cases
where data have been brought up to date.
New Illustrative Boxes The text contains a number of boxes with illustrative real-world examples. Many of these are new. Look, for example, at the
box in Chapter 2 that describes prediction markets and what they had to
say about the 2016 presidential election. Or look at the box in Chapter 15 that
shows how the JOBS Act of 2012 cleared the way for companies to use crowdfunding to raise up to $50 million from small investors who wish to invest in
start-up firms.
xii
Preface
More Worked Examples We have added more worked examples in the text, many of
them taken from real companies.
Specific Chapter Changes in the Tenth Edition
Here are a few of the additions to chapter material:
Chapter 1 contains updated and timely examples of real capital expenditure decisions by major corporations.
Chapter 2 includes a discussion of prediction markets in the most recent presidential election.
Chapter 3 includes updated discussions of recent changes in tax law.
Chapter 6 includes a new Finance in Practice box to show how to find bond information on the web.
Chapter 7 provides new evidence on efficient markets and some of the anomalies
literature.
Chapter 9 now illustrates cash flow analysis in one integrated, extended
example. It also discusses and provides several examples of the impact of
accelerated depreciation and immediate expensing on the value of a capital
investment.
Chapter 14 now includes more coverage of alternative sources of cash as well as
extended treatment of the variety of corporate debt.
Chapter 16 reconsiders the present value of interest tax shields at the new, lower,
corporate tax rate.
Chapter 20 introduces the components of working capital and the determinants of
the cash cycle. It then looks briefly at each of the components including shortterm debt. It provides updated discussions on recent trends in the United States
concerning investments in working capital.
Chapter 21 features numerous updates to our coverage of the market for corporate
control, for example, GE?s divestment of major sectors of the firm, recent activist investor initiatives, and tax inversion strategies in the wake of recent changes
to tax law.
Assurance of Learning
Assurance of learning is an important element of many accreditation standards.
Fundamentals of Corporate Finance, Tenth Edition, is designed specifically to support your assurance-of-learning initiatives. Each chapter in the book begins with
a list of numbered learning objectives, which are referred to in the end-of-chapter problems and exercises. Every test bank question is also linked to one of these
objectives, in addition to level of difficulty, topic area, Bloom?s Taxonomy level, and
AACSB skill area. Connect, McGraw-Hill?s online homework solution, and EZ Test,
McGraw-Hill?s easy-to-use test bank software, can search the test bank by these and
other categories, providing an engine for targeted assurance-of-learning analysis
and assessment.
AACSB Statement
McGraw-Hill Education is a proud corporate member of AACSB International.
Understanding the importance and value of AACSB accreditation, Fundamentals of
Corporate Finance, Tenth Edition, has sought to recognize the curricula guidelines
detailed in the AACSB standards for business accreditation by connecting selected
questions in the test bank to the general knowledge and skill guidelines found in the
AACSB standards.
Preface
xiii
The statements contained in Fundamentals of Corporate Finance, Tenth Edition,
are provided only as a guide for the users of this text. The AACSB leaves content
coverage and assessment within the purview of individual schools, the mission of the
school, and the faculty. While Fundamentals of Corporate Finance, Tenth Edition, and
the teaching package make no claim of any specific AACSB qualification or evaluation, we have, within the test bank, labeled selected questions according to the six
general knowledge and skills areas.
TABLE 5.4 An example of an
annuity table, showing the
present value today of $1 a year
received for each of t years
Unique Features
Interest Rate per Year
Number
of Years
5%
6%
7%
8%
9%
10%
1
2
3
4
5
10
20
30
0.9524
1.8594
2.7232
3.5460
4.3295
7.7217
12.4622
15.3725
0.9434
1.8334
2.6730
3.4651
4.2124
7.3601
11.4699
13.7648
0.9346
1.8080
2.6243
3.3872
4.1002
7.0236
10.5940
12.4090
0.9259
1.7833
2.5771
3.3121
3.9927
6.7101
9.8181
11.2578
0.9174
1.7591
2.5313
3.2397
3.8897
6.4177
9.1285
10.2737
0.9091
1.7355
2.4869
3.1699
3.7908
6.1446
8.5136
9.4269
Remembering formulas is about as difficult as remembering other people?s birthdays. But as long as you bear in mind that an annuity is equivalent to the difference
between an immediate and a delayed perpetuity, you shouldn?t have any difficulty.
You can use a calculator or spreadsheet to work out annuity factors (we show you
how momentarily), or you can use a set of annuity tables. Table 5.4 is an abridged
annuity table (an extended version is shown in Table A.3 at the end of the book).
Check that you can find the 3-year annuity factor for an interest rate of 10%.
Compare Table 5.4 with Table 5.3, which presented the present value of a single
cash flow. In both tables, present values fall as we move across the rows to higher discount rates. But in contrast to those in Table 5.3, present values in Table 5.4 increase
as we move down the columns, reflecting the greater number of payments made by
longer annuities.
What makes Fundamentals of Corporate Finance
such a powerful learning tool?
5.6
Self-Test
If the interest rate is 8%, what is the 4-year discount factor? What is the 4-year
annuity factor? What is the relationship between these two numbers? Explain.
Integrated Examples
Numbered and titled examples are
integrated in each chapter. Students
can learn how to solve specific
problems step-by-step as well as gain
insight into general principles by
seeing how to approach and analyze
different problems.
Example
5.8 ?
Winning Big at the Lottery
In August 2017, a Massachusetts woman bought a Powerball lottery ticket and won a record
$758.7 million. We suspect that she received unsolicited congratulations, good wishes, and
requests for money from dozens of more or less worthy charities, relations, and newly
devoted friends. In response, she could fairly point out that the prize wasn?t really worth
$758.7 million. That sum was to be paid in 30 annual installments of about $23 million each.
Assuming that the first payment occurred at the end of 1 year, what was the present value of
the prize? The interest rate at the time was about 2.7%.
The present value of these payments is simply the sum of the present values of each
annual payment. But rather than valuing the payments separately, it is much easier to treat
them as a 30-year annuity. To value this annuity, we multiply $23 million by the 30-year annuity factor:
PV = 23 ? 30-year annuity factor
1
1
= 23 ? __ – _______
r r (1 + r)30
[
]
At an interest rate of 2.7%, the annuity factor is
[
]
1
1
____
– ___________ = 20.3829
.027 .027(1.027)30
Spreadsheet Solutions Boxes
These boxes provide the student with
detailed examples of how to use Excel
spreadsheets when applying financial
concepts. The boxes include questions
that apply to the spreadsheet, and their
solutions are given at the end of the
applicable chapter. These spreadsheets
are available for download in Connect.
Spreadsheet Solutions
=PRICE(settlement dat