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Online Instructors Manual

for

Corporate Finance: The Core

Second Edition

Jonathan Berk Stanford University

Peter DeMarzo

Stanford University

Instructors Manual by

Janet Payne Texas State University

&

William Chittenden Texas State University

Copyright 2011, 2007 Pearson Prentice Hall. All Rights Reserved.

Acquisitions Editor: Tessa OBrien Developmental Editor: Rebecca Ferris-Caruso Production Editor: Alison Eusden Copyright 2011, 2007 Pearson Education, Inc., 75 Arlington Street, Boston, MA 02116. Pearson Prentice Hall. All rights reserved. Printed in the United States of America. This publication is protected by copyright and permission should be obtained from the publisher prior to any prohibited reproduction, storage in a retrieval system, or transmission in any form or by any means, electronic, mechanical, photocopying, recording, or likewise. For information regarding permission(s), write to: Rights and Permissions Department. This work is protected by United States copyright laws and is provided solely for the use of instructors in teaching their courses and assessing student learning. Dissemination or sale of any part of this work (including on the World Wide Web) will destroy the integrity of the work and is not permitted. The work and materials from it should never be made available to students except by instructors using the accompanying text in their classes. All recipients of this work are expected to abide by these restrictions and to honor the intended pedagogical purposes and the needs of other instructors who rely on these materials. Pearson Prentice Hall is a trademark of Pearson Education, Inc.

ISBN-13: 978-0-13-215403-1 ISBN-10: 0-13-215403-X

2011 Pearson Education, Inc. Publishing as Prentice Hall

Contents Chapter 1 The Corporation 1

Chapter 2 Introduction to Financial Statement Analysis 4

Chapter 3 Arbitrage and Financial Decision Making 8

Chapter 4 The Time Value of Money 12

Chapter 5 Interest Rates 17

Chapter 6 Investment Decision Rules 20

Chapter 7 Fundamentals of Capital Budgeting 23

Chapter 8 Valuing Bonds 27

Chapter 9 Valuing Stocks 31

Chapter 10 Capital Markets and the Pricing of Risk 35

Chapter 11 Optimal Portfolio Choice and the Capital Asset Pricing Model 39

Chapter 12 Estimating the Cost of Capital 44

Chapter 13 Investor Behavior and Capital Market Efficiency 48

Chapter 14 Capital Structure in a Perfect Market 52

Chapter 15 Debt and Taxes 55

Chapter 16 Financial Distress, Managerial Incentives, and Information 58

Chapter 17 Payout Policy 62

Chapter 18 Capital Budgeting and Valuation with Leverage 66

Chapter 19 Valuation and Financial Modeling: A Case Study 71


Chapter 1 The Corporation

I. Chapter Outline The chapter outline below is correlated to the PowerPoint Lecture Slides. The PowerPoint slides are referenced in bold.

Alternative Examples to selected textbook examples are available in the PowerPoint Lecture Slides. Alternative Examples are referenced in bold in the chapter outline below.

1.1 The Four Types of Firms (Slide 3) Sole Proprietorships (Slide 5) Partnerships (Slides 67) Interview with David Viniar Limited Liability Companies (Slide 8) Corporations (Slides 912)

Formation of a Corporation Ownership of a Corporation

Tax Implications for Corporate Entities (Slide 12) S Corporations

Example 1.1 Taxation of Corporate Earnings (Slides 1314) PowerPoint Alternative Example 1.1a (Slides 1516) PowerPoint Alternative Example 1.1b (Slides 1718) Example 1.2 Taxation of S Corporation Earnings (Slides 1920) PowerPoint Alternative Example 1.2a (Slides 2122) PowerPoint Alternative Example 1.2b (Slides 2324)

1.2 Ownership Versus Control of Corporations (Slide 25) The Corporate Management Team (Slide 25) The Financial Manager (Slide 27)

Investment Decisions Financing Decisions Cash Management

The Goal of the Firm (Slide 28) Ethics and Incentives within Corporations (Slide 29)

Agency Problems The CEOs Performance (Slide 30) Corporate Bankruptcy (Slide 31)

1.3 The Stock Market (Slides 3233) Primary and Secondary Markets (Slide 34)

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The Largest Stock Markets (Slide 35) NYSE (Slide 35) NASDAQ (Slide 35)

II. Learning Objectives 1-1 List and define the four major types of firms in the U.S.; describe major characteristics of each

type, including the means for distributing income to owners.

1-2 Distinguish between limited and unlimited liability, and list firm types that are subject to each type of liability.

1-3 Describe the taxation consequences for C and S corporate forms. 1-4 Discuss the division of corporate ownership into shares of stock; evaluate the implications of

that division for corporate decision making.

1-5 Explain how corporate bankruptcy can be viewed as a change in firm ownership. 1-6 Compare and contrast the characteristics of shares that are publicly traded and the

characteristics of those that are not.

III. Chapter Overview Chapter 1 begins by discussing the birth of the modern corporation. The chapter examines important characteristics of the four major types of firms in the United States; however, the focus is on the corporation. Section 1.2 defines the agency relationships that sometimes occur in a corporation. Section 1.3 focuses on the stock market and its advantages in raising capital.

1.1 The Four Types of Firms The four major types of firm in the United States are the sole proprietorship, partnership, limited liability company, and corporation. The section begins by defining each type, then highlights the differences among them. Particular emphasis is placed on the following areas that distinguish the four types:

1. Ease of formation. 2. Separation between the firm and the owner from the perspective of the owners personal

liability. 3. Lifespan of the firm. 4. Ease of transference of ownership. The text emphasizes the corporate form. In this chapter, the authors focus on the fact that,

although corporations take a great deal of effort to form, they have some distinct advantages. The life of the firm is not limited by the life of any particular individual. Ownership in the corporation is very easy to transfer either via purchase, or sale of shares of stock. However, there are some disadvantages as well. Each shareholder is likely to own only a small percentage of the stock; agency problems can be pretty serious (see Section 1.3). There is extreme separation between the firm and its owner.

Corporations are taxed in a very different way than other types of firms. Example 1.1 shows the double taxation of corporate earnings when dividends are paid. Example 1.2 shows how taxation of S corporations differs from that of C corporations.

1.2 Ownership Versus Control of Corporations. Section 1.2 highlights the separation of ownership and control in the corporation, with particular emphasis on principal-agent problems. The chapter emphasizes the market for corporate control as

Berk/DeMarzo Corporate Finance, Second Edition 3


the primary means for encouraging managers and boards of directors to act in the best interest of shareholders.

One further stakeholder in a corporation is debt holders. If the corporation fails to repay the debt holders, it will be forced into bankruptcy.

1.3 The Stock Market An important feature of equity investment is its liquidity. Stock markets improve liquidity for investors by enabling investors to trade shares of public corporations. The NYSE is the worlds largest stock market. It has a physical location, where market makers match buyers to sellers. The NASDAQ is an electronic network, where prices are posted so that they can be viewed by all participants.

IV. Spreadsheet Solutions in Excel The following Problems for Chapter 1 have spreadsheet versions of the problems available: 1-6 and 1-7.

These spreadsheets are available on the Instructor's Resource CD-ROM or can be downloaded from the Instructor's Resource Center at: www.pearsonhighered.com/berk_demarzo. If you do not have a login and password for this Web site, contact your Prentice Hall sales representative.


Chapter 2 Introduction to Financial Statement Analysis

I. Chapter Outline The chapter outline below is correlated to the PowerPoint Lecture Slides. The PowerPoint slides are referenced in bold.

Alternative Examples to selected textbook examples are available in the PowerPoint Lecture Slides. Alternative Examples are referenced in bold in the chapter outline below.

2.1 Firms Disclosure of Financial Information (Slide 5) Preparation of Financial Statements (Slide 6) Interview with Sue Frieden International Financial Reporting Standards Types of Financial Statements (Slide 7)

2.2 The Balance Sheet (Slide 8) Assets (Slides 9-12)

Current Assets Long-Term Assets

Liabilities (Slides 13-16) Current Liabilities Long-term Liabilities

Stockholders Equity (Slide 17) Example 2.1 Market Versus Book Value (Slides 18-19) PowerPoint Alternative Example 2.1 (Slides 20-21)

2.3 Balance Sheet Analysis (Slides 22-23) Market-to-Book Ratio (Slide 22) Debt-Equity Ratio (Slide 23) Enterprise Value (Slide 23)

Example 2.2 Computing Enterprise Value (Slides 24-25) PowerPoint Alternative Example 2.2 (Slides 26-27)

Other Balance Sheet Information (Slide 28)

2.4 The Income Statement (Slide 29) Earnings Calculations (Slides 29-33)

Gross Profit (Slide 29) Operating Expenses (Slide 30) Earnings Before Interest and Taxes (Slide 31) Pretax and Net Income (Slides 32-35)

2.5 Income Statement Analysis (Slides 36-43)

Berk/DeMarzo Corporate Finance, Second Edition 5


Profitability Ratios (Slide 36) Working Capital Days (Slide 37) EBITDA (Slide 37) Leverage Ratios (Slide 38) Investment Returns (Slide 39) The DuPont Identity (Slide 40)

Example 2.3 Determinants of ROE (Slides 41-42) Valuation Ratios (Slide 43)

Common Mistake: Mismatched Ratios Example 2.4 Computing Profitability and Valuation Ratios (Slides 44-45) PowerPoint Alternative Example 2.4 (Slides 46-49)

2.6 The Statement of Cash Flows (Slides 50-54) Operating Activity (Slide 52) Investment Activity (Slide 53) Financing Activity (Slide 53) Example 2.5 The Impact of Depreciation on Cash Flow (Slides 55-56)

2.7 Other Financial Statement Information (Slide 57) Management Discussion and Analysis (Slide 57) Statement of Stockholders Equity (Slide 57) Notes to the Financial Statements (Slide 57) Example 2.6 Sales by Product Category (Slides 58-59) PowerPoint Alternative Example 2.6 (Slides 60-62)

2.8 Financial Reporting in Practice (Slide 63) Enron (Slide 63) WorldCom (Slide 63) Sarbanes-Oxley Act (Slide 63)

II. Learning Objectives 2-1 List the four major financial statements required by the SEC for publicly traded firms, define

each of the four statements, and explain why each of these financial statements is valuable.

2-2 Discuss the difference between book value and market value of stockholders equity; explain why the two numbers are almost never the same.

2-3 Compute the following measures, and describe their usefulness in assessing firm performance: debt-equity ratio, enterprise value, earnings per share, operating margin, net profit margin, accounts receivable days, accounts payable days, inventory days, interest coverage ratio, return on equity, return on assets, price-earnings ratio, and market-to-book ratio.

2-4 Discuss the uses of the DuPont identity in disaggregating ROE, and assess the impact of increases and decreases in the components of the identity on ROE.

2-5 Describe the importance of ensuring that valuation ratios are consistent with one another in terms of the inclusion of debt in the numerator and the denominator.

6 Berk/DeMarzo Corporate Finance, Second Edition


2-6 Distinguish between cash flow, as reported on the statement of cash flows, and accrual-based income, as reported on the income statement; discuss the importance of cash flows to investors, relative to accrual-based income.

2-7 Explain what is included in the management discussion and analysis section of the financial statements that cannot be found elsewhere in the financial statements.

2-8 Explain the importance of the notes to the financial statements. 2-9 List and describe the financial scandals described in the text, along with the new legislation

designed to reduce those types of fraud.

III. Chapter Overview This chapter reviews the four main financial statements and discusses some useful financial ratios. The chapter closes with a look at some recent financial scandals.

2.1 Firms Disclosure of Financial Information The four statements that are required by the U.S. Securities and Exchange Commission (SEC) are the balance sheet, the income statement, the statement of cash flows, and the statement of stockholders equity.

The section includes a summary of steps taken toward standardizing financial statements across countries via International Financial Reporting Standards.

2.2 The Balance Sheet The balance sheet lists the firms assets and liabilities. This section describes current assets, long-term assets, current liabilities and long-term liabilities, with examples of the major components of each. The authors emphasize the difference between market value and book value of equity, and give some specific reasons why the two are seldom the same. Example 2.1 illustrates a case in which they are different. 2.3 Balance Sheet Analysis

Book value of equity is sometimes used as an estimate of the liquidation value of the firm. Important tools for analyzing the firms value, leverage, and short-term cash needs, from information found on the balance sheet include:

a. the market-to-book ratio, which is often used to classify firms as value stocks or growth stocks.

b. the debt-equity ratio, a measure of the firms leverage. c. enterprise value, which assesses the value of underlying business assets, not including cash

(Example 2.2 shows how enterprise value is calculated). d. current and quick ratios, which are sometimes used to assess the firms working capital

position.

2.4 The Income Statement The income statement lists the firms revenues and expenses over a period of time. This section of the text discusses the calculation of earnings from the components of the income statement. Earnings per share (and diluted earnings per share) are often calculated to assess the size of net income relative to that of similar firms. 2.5 Income Statement Analysis Profitability ratios, such as operating margin and net profit margin, are often used to measure the fraction of revenues that is available to common shareholders. Some examples of ratios that use both

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